Materiality - Securities Regulation

Materiality

1. In General

   1. "An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote." TSC Industries, Inc. v. Northway, Inc. (pg. 586)

      1. To fulfill the materiality requirement "there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available." TSC Industries, Inc. v. Northway, Inc. (pg. 586)

      2. "[M]ateriality depends on the significance the reasonable investor would place on the withheld or misrepresented information." Basic Inc. v. Levinson (pg. 596)

   2. An omitted or misstated fact can be either qualitatively or quantitatively material.

   3. Rules of Thumb

      1. A common rule of thumb has been that a misstatement regarding a financial statement item of 5% or less is not material.

         • BUT the SEC staff rejects this approach as too limited in scope. See SEC Staff Accounting Bulletin No. 99 (pg. 587)

           • This bulletin reminds lawyers and accountants to assess materiality in light of the total mix of information; a change of less than 5% could still be material if, for example, it masked a change in sales or earnings trend, changed a loss into income, or vice versa, hides a factor to meet analysts' expectations, concerns a segment of the business that has been identified as playing a significant role in operations, and the like.

   4. "Buried Facts" Doctrine

      1. This doctrine applies to render misleading a document in which all the substantive information has been set forth but in such a manner that the mosaic can only be assembled with great difficulty and only with advanced knowledge that the whole picture requires a great deal of assembly. See Kohn v. American Metal Climax, Inc. (pg. 589)

   5. In Matrixx initiatives, Inc. v. Siracusamo (Supp. pg. 97), the court determined that the failure of Matrixx to disclose reports of a possible link between its product Zicam and loss of smell by customers was deemed material.

2. Contingent or Speculative Information or Events

   1. "[W]ith respect to contingent or speculative information or events . . . materiality 'will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.'" Basic Inc. v. Levinson (quoting SEC v. Texas Gulf Sulphur Co.) (pp. 594-95)

      1. "[I]n order to assess the probability that the event will occur, a factfinder will need to look to indicia of interest in the transaction at the highest corporate levels." Basic Inc. v. Levinson (pg. 595)

         • Indicia of interest includes (1) board resolutions, (2) instructions to investment bankers, and (3) actual negotiations between principals or their intermediaries. Basic Inc. v. Levinson (pg. 595)

      2. "To assess the magnitude of the transaction to the issuer . . . , a factfinder will need to consider such facts as [1] the size of the two corporate entities and [2] of the potential premiums over market value." Basic Inc. v. Levinson (pg. 595)

   2. In Basic, the Court noted that there is "no valid justification for artificially excluding from the definition of materiality information concerning merger discussions, which would otherwise be considered significant to the trading decision of a reasonable investor." Basic Inc. v. Levinson (pg. 594)

   3. In Kronfield v. Trans World Airlines, Inc., the Second Circuit held that failure to disclose in a prospectus the possibility that Trans World Corporation (TWC) was considering severing TWA as a subsidiary was deemed material based almost exclusively upon the magnitude portion of the test despite the very low probability of the event. (pg. 596)

3. Post-Disclosure Market Price Movements as a Proxy for Materiality

   1. Post-disclosure price movements can serve as a useful proxy for materiality.

   2. Many courts have used the presence of post-disclosure price movements as strong evidence favoring a determination of materiality, at least where no other factors seem to account for a price change. See, e.g., Elkind v. Liggett & Myers, Inc. (pg. 600)

4. Puffery

   1. "Everyone knows that someone trying to sell something is going to look and talk on the bright side. You sell a product by bad mouthing it." Eisenstadt v. Centel Corp. (pg. 607)

   2. "It would be unreasonable for investors to attach significance to general expressions of satisfaction with the progress of the seller's efforts to sell, just as it would be unreasonable for them to infer from a potential bidder's apparent lack of enthusiasm that the bidder was uninterested rather than just jockeying for a better price." Eisenstadt v. Centel Corp. (pg. 607)

      1. "The heart of a reasonable investor does not begin to flutter when a firm announces that some project or process is proceeding smoothly, and so the announcement will not drive up the price of the firm's shares to an unsustainable level." Eisenstadt v. Centel Corp. (pg. 607)

      2. "'Going smoothly' may mean nothing more than - going; but it means at least that . . . ." Eisenstadt v. Centel Corp. (pg. 607)

      3. "Where puffing is the order of the day, literal truth can be profoundly misleading, as senders and recipients of letters of recommendation well know." Eisenstadt v. Centel Corp. (pg. 607)

   3. In Eisenstadt, the court found that the statement that the auction process was "going smoothly" was not materially misleading as "'[g]oing smoothly' may mean nothing more than - going; but it means at least that . . . ." Thus, the court found that such a statement was merely puffery.

5. Statements of Opinion

   1. If you lie about what your opinion is, that is material. See Virginia Bankshares, Inc. v. Sandberg (pp. 608-09)

      1. Objective Falseness

         • An assertion of "fairness" could be false because the price was not fair or high.

           • This is objective falseness and can be a basis for liability.

      2. Subjective Falseness

         • An assertion of "fairness" could be false because the person making the statement did not believe the price was fair, even if objectively the price was high or even fair.

           • This is subjective falseness and is NOT a basis for liability because of its dependence on matters that are not objectively verifiable.

         • BUT, if there is objective evidence that you lied about what your opinion is, then that is material.

           • In this case, because there was objective evidence before the directors that was inconsistent with their professed opinions, the plaintiffs had pled more than a mere subjective disbelief or undisclosed motive.

6. Forward-Looking Information (e.g., projections, forecasts, etc.)

   1. In General

      1. Soft information (e.g., projections) describes events or activities that will occur, if at all, at some future date.

         • E.g., Item 303 of Regulation S-K, the MD&A, requires management to disclose trends that are likely to affect the firm's financial performance, liquidity, or capital resources as well as the effects of inflation on operations.

      2. "[C]ases involving forward-looking statements are unique. . . . [P]redictions of future performance are inevitably inaccurate because things almost never go exactly as planned. . . . [P]laintiffs must allege 'specific facts which illustrate that the company's predictions lacked a reasonable basis. . . . Projections which turn out to be inaccurate are not fraudulent simply because subsequent events reveal that a different projection would have been more reasonable.'" Moss v. Healthcare Compare Corp. (pg. 611)

      3. Some Courts: Apply the "guaranty standard"

         • Under this alternative test, the Fourth Circuit sometimes determines that whether a forward-looking statement is harmless by a test similar to that employed with respect to puffery.

           • The alternative test holds that before a forward-looking statement is material it must rise to the level of a guarantee. See Hillson Partners Ltd. Partnership v. Adage, Inc. (pg. 616)

             • This "guaranty standard" is sometimes employed in other Circuits. See, e.g., Lasker v. New York State Electirc & Gas Corp. (pg. 616)

   2. The "Bespeaks Caution" Doctrine

      1. The first line of defense for a "missed" forecast under the case law is whether the forecast was accompanied by meaningful cautionary language.

      2. Under the "bespeaks caution" doctrine, meaningful cautionary language negates the materiality of the alleged misrepresentation or omission. See Kaufman v. Trump's Castle Funding (pg. 614)

         • When a "document's forecasts, opinions or projections are accompanied by meaningful cautionary statements, the forward-looking statement will not form the basis for a securities fraud claim if those statements did not affect the 'total mix' of information the document provided investors." Kaufman v. Trump's Castle Funding (pg. 614)

           • "In other words, cautionary language, if sufficient, renders the alleged omissions or misrepresentations immaterial as a matter of law." Kaufman v. Trump's Castle Funding (pg. 614)

             • BUT "a vague or blanket (boilerplate) disclaimer which merely warns the reader that the investment has risks will ordinarily be inadequate to prevent misinformation." Kaufman v. Trump's Castle Funding (pg. 615)

             • "To suffice, the cautionary statements must be substantive and tailored to the specific future projections, estimates or opinions . . . which the plaintiffs challenge." Kaufman v. Trump's Castle Funding (pg. 615)

         • In Kaufman, the court concluded that the cautionary language in the prospectus was sufficient because it "clearly and precisely cautioned that the bonds represented an exceptionally...