I have long thought that the doctrine relating to materiality suffered from a fundamental contradiction.  On the one hand, Basic set materiality on a path toward an empirical approach to the question.  By adopting TSC’s “reasonable investor” standard for Rule 10b-5 in the same opinion in which the Court endorsed the efficient capital market hypothesis in adopting the fraud-on-the-market presumption of reliance, the Court set the stage for a market test for materiality.  Did the stock of the company experience an abnormal return when the misstatement was made, or subsequently, when the omitted information was revealed?  The presumption is that the market consists of reasonable investors (or at least that the reasonable investors are the one that drive price discovery.  It follows that the consensus of those investors, as reflected in changes in that market price, is the best evidence with respect to whether reasonable investors considered the information relevant to their buying and selling decisions.  This version of materiality has a nice, objective appeal.  On the other hand, the SEC has long insisted that managerial integrity is material to reasonable investors, most notably in the Franchard decision.  This view would also seem to be supported by the legislative history of the securities laws, born as they were of the scandal mongering of the Pecora hearings and FDR’s polemics against the moneyed classes.  To put the matter more generously, “sunlight is the best disinfectant,” that is, disclosure is likely to have a therapeutic effect on agency costs.

Both approaches are more appealing in theory than in practice.  A market test for materiality has objective appeal until one gets down to the messy business of measuring it.  Objective is not the same thing as accurate.  Relying on abnormal market movements as the measure of materiality invites manipulation by fraudulent corporations, who will have every incentive to bury the revelation of a prior misstatement in amongst positive news, daring the plaintiffs’ expert to untangle the resulting mess.   Also complicating measurement are the various components that are reflected in the stock market’s response to the revelation of the bad news.  Part of the response is a revaluation of the company’s prospects in light of new information about its earnings prospects, but part of the response reflects the market’s assessment that the company will face a class action lawsuit or an SEC enforcement action.    These costs could lead to an abnormal return, even if the original misstatement was not material.  The market surely understands that materiality judgments are a murky area for courts, and therefore prone to error.  A sufficiently high probability of error means that the company will bear heavy distraction and settlement costs, even for a trivial misstatement.  Finally, the market test for materiality can only be applied ex post, which is not very useful for lawyers trying to make materiality assessments when they are crafting disclosures.

The weakness of the integrity approach is that is likely to be taken hostage by the SEC’s nanny-state paternalism.  The agency has a low threshold for outrage, triggered by anything likely to provoke embarrassing headlines if revealed.  Reasonable investors know that firm specific risks can be managed through diversification, so they are likely to have a higher threshold for outrage at management.  Earnings management of the income smoothing variety is unlikely to provoke much outrage among hedge fund managers, who likely expect a certain amount of such behavior, but from the SEC’s perspective, it raises fundamental questions about the senior management team’s capacity to lead.  The SEC’s delicate sensitivities would be tolerable if its views only played out in enforcement actions, but they are also likely to influence class actions.

Park does not have the silver bullet that would resolve the existing tensions in materiality doctrine.    Instead, he wants to further complicate the matter, bringing the question of damages reform into the mix.  Specifically, he proposes to use materiality doctrine to limit vicarious corporate liability to cases in which there has been a sustained misstatement in a company’s financial statements.  Such misstatements make it difficult for market participants to value a company’s future earnings, in Park’s view.   By contrast, liability for minor misstatements would be measured by whether a defendant gained from the fraud.  So, stock options that were bumped into the money by shifting revenues up a quarter would be subject to disgorgement.  The result is some shifting of the liability burden from corporations to executives.

Damages reform is near and dear to my heart, but I am not persuaded that materiality is the best doctrinal hook for addressing the issue.  A number of issues highlighted by Park as relevant to the question of materiality are already part of the Rule 10b-5 inquiry, in particular, the scienter element.  Was a misrepresentation isolated or persistent?  That’s probative evidence on recklessness.  Was an officer enriched by the misstatement?  That’s motive and opportunity.  The strength of evidence showing scienter is a key factor for settlement negotiations, so practically speaking, these questions are already incorporated into the penalty calculus of Rule 10b-5 actions.  And they are clearly already factors that the SEC considers in assessing penalties in its enforcement actions.   

A broader objection to Park’s proposal is that if damages should be reformed, they should be reformed across the board, and not just with respect to financial misstatements.  Other misstatements, both historical and forward-looking, also give rise to liability.  Why single out financial misstatements for lower penalties against the corporation?  Given the importance of financial information, why should companies enjoy a lower antifraud standard for that set of misstatements?

Park’s standard would appear to make the greatest difference in § 11 cases.  But couldn’t we achieve much the same result by giving the issuer a due diligence defense?  And all of this assumes that we should relax issuer liability standards in public offering cases.  Given the institutional incentive to inflate the company’s prospects when it is raising capital, relaxing standards in the context is not obviously a good idea.

One minor nit.  Park suggests that misstatements might lead a corporation into insolvency because it might induce the corporation to take on an excessive debt load (MS. p. 38).  This seems implausible to me.  I have no doubt that misstatements are positively correlated with insolvency, but it seems a stretch to suggest causation.  If managers are misrepresenting the financials, they presumably know this, and they are basing their financing decisions on the true picture, not the one that they are presenting to investors.  Insolvency is unpleasant for corporate managers; it seems doubtful that they are actively courting it through their misrepresentations.  More likely that they are seeking to avoid it by papering over the weaknesses in the business.

Overall, I enjoyed the paper, which I think canvasses the existing problems with materiality doctrine quite ably.  I’m not sure that I agree with the proposal that comes out of those problems, but thinking about it in these terms is certainly a step in the right direction.

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