Immaterial lies: condoning deceit in the name of securities regulation.

• Author: Padfield, Stefan J.

ABSTRACT

The financial crisis of 2008 is raising the issue of investor trust and confidence in the market once again. Investors are questioning how managers could have taken such significant risks in the subprime-lending and credit-default-swap markets without, apparently, providing adequate disclosure to the market. The pending flood of lawsuits following in the wake of this financial crisis provides an opportunity, however, for courts to restore some of this lost trust.

This Article argues that one of the ways courts can do this is by curtailing their overdependence on using materiality as the basis for dismissing what they deem to be frivolous lawsuits under Rule 10b-5. There are at least four good reasons for doing so. First, condoning managerial misstatements on the basis of immateriality arguably has a negative impact on investor confidence because whenever courts find a misstatement to be immaterial as a matter of law they are effectively concluding that shareholders will receive no relief even where the statement was made with full knowledge of its falsity and with the requisite intent to defraud. Second, the materiality "safety valve" doctrines that have evolved to assist courts in dismissing frivolous suits are often in direct conflict with Supreme Court guidance as to both the proper definition and analysis of materiality in the context of Rule 10b-5. Third, when the courts routinely categorize managerial misstatements as immaterial to dismiss frivolous suits, they create a tension with the disclosure rules, which are premised on ideals of full and fair disclosure and often turn on materiality determinations. Finally, dependence on materiality is unnecessary because other elements of Rule 10b-5, such as scienter, have been strengthened to the point where they allow courts to deal with frivolous suits without having to rule on materiality.

The message that pervades society is that it's O.K. to lie--you can get away with it. One of the things I found in my research is that when you confront people with their lies, they very rarely display remorse. Lying is not seen as being morally reprehensible in any strong way. (1) If investor confidence is to come back ..., the law must advance. (2) CONTENTS I. INTRODUCTION II. BACKGROUND ON THE ELEMENT OF MATERIALITY IN RULE 10B-5 A. Securities Regulation and the Role of Rule 10b-5 B. The Elements of Rule 10b-5 C. The Definition of Materiality 1. The TSC/Basic Definitions 2. A Fact-Intensive Analysis 3. No Bright-Line Rules 4. Who is the Reasonable Investor and Why Don't We Ask Her What She Thinks? D. The Fraud-on-the-Market Presumption and "Frivolous" Litigation as the Greatest Threat to Our Economy E. The Evolution of Materiality "Safety Valves" 1. Puffery 2. Bespeaks Caution and the PSLRA 3. Truth on the Market and the Simple-Math Rule 4. Bright-Line Price-Movement Rules III. THE PROBLEM OF OVERDEPENDENCE ON MATERIALITY A. When Courts Dismiss on Materiality Grounds They Are Immunizing Lies B. The "Safety Valve" Materiality Doctrines Are in Conflict with the Purposes of Our Securities Regulation Regime and Supreme Court Guidance 1. Puffery a) Behavioral Economics b) The Doctrine of Caveat Emptor c) Ignoring the Total Mix d) Contradicted by Market Realities 2. Bespeaks Caution: Contrary to the Admonition Against Bright-Line Rules 3. Truth-on-the-Market: The Misplaced Materiality Defense 4. Bright-Line Price Movement C. Excessive Characterization of Disclosures as Immaterial Creates Conflicts with Disclosure Regime IV. THE SOLUTION: SHIFT FOCUS TO OTHER ELEMENTS OF RULE 10B-5 A. Dependence on Materiality Unnecessary B. Scienter C. Loss Causation D. Reliance and Rebutting the Fraud-on-the-Market Presumption E. Dismissing Secondary Actors, Pleading Standards, Statutes of Limitations, and Sanctions V. CRITICISMS VI. CONCLUSION I. INTRODUCTION

Rule 10b-5 (3) of the Securities Exchange Act of 1934 (4) is the primary vehicle for challenging alleged corporate securities fraud. (5) In order to make out a Rule 10b-5 claim, a plaintiff must show that there was (1) a misrepresentation or actionable omission of fact, (2) that is material, (3) made with scienter, (4) in connection with the purchase or sale of security, (5) that was justifiably relied upon by the plaintiff, and (6) that proximately caused the plaintiff's loss. (6) A fact is generally judged to be material in the context of securities regulation if there is a substantial likelihood that a reasonable investor would consider it important in deciding whether to buy or sell a security. (7) Put another way, a fact is material if there is a substantial likelihood that a reasonable investor would have viewed the fact as significantly altering the total mix of information available. (8) The Supreme Court has cautioned that materiality is a fact-intensive issue, rarely to be decided on a motion to dismiss. (9)

Following the Supreme Court's decision in Basic Inc. v. Levinson, (10) which allowed class action plaintiffs to take advantage of a "fraud on the market" presumption of reliance, the prospect of crippling damage awards skyrocketed. (11) Concern soon mounted that the concomitant increase in the potential cost to corporations for failing to settle these suits would translate into an increase in the filing of frivolous "strike suits." (12) In response to this concern, courts began to look for various "safety valves" to dismiss these claims. (13) The focus of these safety valves was often the issue of materiality. Courts used doctrines such as: "puffery," "bespeaks caution," "truth-on-the-market," and bright-line rules tied to the price movements of stock, (14) to dismiss claims by concluding that the alleged misrepresentation or omission was immaterial as a matter of law.

There are a number of problems, however, with overdependence on materiality safety valves. First, courts' repeated declarations that management is free to lie, so long as that lie is immaterial, arguably sends the message to executives that it is often okay to embellish the truth--and sends the message to investors that they should adopt an attitude of caveat emptor ("buyer beware") when it comes to the statements of corporate executives. One might argue that it is overly pejorative to characterize these disclosures as lies. However, when a court grounds dismissal on a finding of immateriality, it is effectively saying that there is no basis for liability even if it were proven that an executive misstated the facts with intent to deceive (i.e., there was a lie). (15) Second, the safety valves themselves twist the definition of materiality to the point that they seemingly make a mockery of the Supreme Court's declarations on the issue. Finally, courts' excessive reliance on these safety valves creates a conflict with the disclosure rules, which often turn on determinations of materiality. Fortunately, there is a better way: focusing on the other elements of Rule 10b-5.

With the financial crisis of 2008 raising the issue of investor trust and confidence in the market once again, investors are questioning how managers could have taken such significant risks in the subprime lending and credit default swap markets without apparently providing adequate disclosure to the market. (16) The pending flood of lawsuits following in the wake of this financial crisis provides an opportunity, however, for courts to restore some of this lost trust by refusing to label lies immaterial unless absolutely necessary. (17)

2. BACKGROUND ON THE ELEMENT OF MATERIALITY IN RULE 10B-5

   In this Part, I will briefly review the role of Rule 10b-5 in securities regulation generally, including its various elements. I will then focus on the definition of the critical element of materiality, including its fact-intensive nature and questions surrounding the status of the "reasonable investor" whose judgment is deemed determinative. Finally, I will conclude this Part by reviewing the various materiality safety valves that have arisen to assist judges in dismissing what they deem to be frivolous lawsuits, including the doctrines of "puffery," "bespeaks caution," "truth-on-the-market," and bright-line price-movement rules.

   1. Securities Regulation and the Role of Rule 10b-5

      Section 10(b) of the Securities Exchange Act of 1934 provides in relevant part that "[i]t shall be unlawful for any person ... [t]o use ... any manipulative or deceptive device ... in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors." (18) Rule 10b-5, promulgated by the Securities and Exchange Commission pursuant to [section] 10(b), further provides in relevant part:

      It shall be unlawful for any person ... [t]o make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading ... in connection with the purchase or sale of any security. (19) "For more than twenty-five years, the primary private remedy for fraud available under the Securities Exchange Act has been the one implied from SEC Rule 10b-5." (20) Justice Rehnquist has famously characterized the implied private right of action under Rule 10b-5 as "a judicial oak which has grown from little more than a legislative acorn." (21) While there is much debate, recent empirical work continues to suggest that this "judicial oak" provides a net gain to society. (22)

   2. The Elements of Rule 10b-5

      In order to make out a claim under Rule 10b-5, a plaintiff must prove that there was "1) a misstatement or omission 2) of material fact 3) occurring in connection with the purchase or sale of a security, that 4) was made with scienter and 5) upon which the plaintiff justifiably relied, 6) and that proximately caused injury to the plaintiff." (23) In the following pages, I will explore the concept of materiality in...