So now we have a new way to determine whether something is material. If an activity is widespread, then it must be material. This statement was made by the trial judge in the civil case brought by the SEC against Brocade ex-CEO Gregory Reyes in response to Reyes' argument that the backdating in that case was not material. This seems to be an odd test for materiality. (Law.com story here.)
Reyes' counsel (Skadden) used more scientific measures of materiality -- namely, whether the announcement of the backdating had any negative effect on the share price. Although the price dipped the day of the announcement, by the second day, the stock was fully recovered. The SEC pointed out that two weeks before, when Brocade announced that there would be a restatement of earnings, the price dropped 7%. However, doesn't it undercut the SEC's argument if when faced with an unexplained restatement the market dropped but then it rebounded once it found it the restatement was due to backdating? Anyway, the article reminds us that even though civil plaintiffs don't get very far when there are no market losses caused by an activity, to the SEC (and the parallel criminal case), materiality is not tied to market movement.
Supposedly, we would want companies to disclose material things because we think that facts that rise to that level would be important to shareholders in making decisions as to whether to buy, hold or sell securities. Once we know that something doesn't seem to be a factor in those decisions, can it still be considered material?
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1. Posted by Brett McDonnell on May 15, 2007 @ 8:15 | Permalink
Christine,
So, the price dropped 7% when they announced there would be a restatement, then didn't change when the exact reason for the restatement was announced. I don't see how that undercuts the SEC's argument. The 7% drop presumably reflects the market's best guess as to the degree of damage that will be caused by the restatement, given considerable uncertainty as to the nature of the problem. A few weeks later, that uncertainty is resolved, and the price remains basically constant. Doesn't that imply that the market basically guessed right weeks earlier with the 7% drop? For your point to be correct, wouldn't the price have to rise after the backdating was announced, back to the level it was at before the fact of a restatement was announced? As is, doesn't the 7% drop represent our best guess as to the effect of the options backdating? Putting aside, that is, correction for what was going on in the market generally at that time, and other news related to the company.
2. Posted by JLM on May 15, 2007 @ 21:40 | Permalink
Brett,
According to Christine, the stock rebounded. I'm not sure whether it did and to what extent it did, but Christine wrote, "the market dropped but then it rebounded once it found it the restatement was due to backdating".
Second, a market drop based on announcement of backdating investigations isn't necessarily a market reaction to a negative impact (if any) of backdating, but is perhaps a reaction to the negative impact of criminal sanctions, negative publicity, civil fines, etc.
In other words, it's possible that the securities laws enacted to protect investors does just the opposite.
The judge's question of why the practice is so prevelant is laughable.
3. Posted by Brett McDonnell on May 16, 2007 @ 10:31 | Permalink
JLM,
As I read the underlying article that Christine cites, the rebound was just back to the level at the time just before the 2nd announcement (revealing the actual restatement). It did not rebound (at least not immediately; the article does not discuss the longer term price movement) to the level at the time of the first announcement.
As to that first announcement, as I read the article it was just an announcement that there would be a restatement, not an announcement concerning backdating. Is your point that investors care about restatements not because they reveal negative information about the company but because a restatement increases the chances of being punished for violating the securities laws? That may indeed be a part of the reason for the reaction to restatements, but it strikes me as a real stretch to suggest that fully explains why prices drop when companies announce they will be restating.
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