. James attempts a middle path between qualitative and quantitative materiality standards for financial misstatements, salvaging aspects of both by adding some modifications.

James argues that materiality analysis should include an assessment of the persistence of financial misstatement, since persistent misstatements are much more likely to mislead markets than isolated ones. Underlying this persistence prescription is the assertion that fundamental value analysis—discounted cash flow analysis—should be preferred to mere market price fluctuation as the relevant valuation methodology for purposes of assessing materiality of financial misstatements. For James, market fluctuations are unreliable indicators of whether and how rational investors react to misstatements, since many other factors may be reflected in those stock price movements. With fundamental analysis as our valuation method, James goes on to argue that even small but persistent misstatements are likely to permanently skew investors’ stock valuations, even if a single small misstatement might not. By contrast, one isolated misstatement may not necessarily affect the market’s long-term assessment of the firm’s future cash flows, and so should have little effect on fundamental value analysis. James argues that persistent misstatements should be presumed material, while isolated misstatements should enjoy the opposite presumption, even if such an isolated misstatement affects earnings by more than 5%—the traditional quantitative threshold for materiality.

James’s idea is an interesting one. Persistence analysis basically permits a court to aggregate the effects of individual small misstatements over time in order to find materiality, even if no individual misstatement by itself would meet the materiality threshold. This idea seems unobjectionable as far as it goes. Fundamental analysis no doubt qualifies as an accepted and widely used valuation method, and with this approach, repeated small earnings misstatements may do much more to miscast a company’s performance than a larger one-time perturbation. James captures this idea well with specific numerical examples. So the affirmative case seems strong for including persistence of misstatements as a factor in the materiality analysis, and for resisting any move back to the straight quantitative approach.

On the other hand, the case against other valuation approaches and the consequences for materiality analysis seems less convincing. Enshrining fundamental analysis as the touchstone for determining materiality of financial misstatements may be too narrow. Market actors clearly react to individual earnings statements. Legal rules that facilitate large but isolated misstatements may therefore create lemons problems. Market participants may have to discount their valuations across the board to account for the possibility of one-off frauds. James is no doubt correct that market price fluctuations are noisy indicators of materiality, and that that noise may increase the costs of firms’ internal controls to insure accuracy of financial statements. For my money, though, the presumption against materiality for one-off financial misstatements seems to cut too wide a swath for fraud.

Persistence creates some new issues as well. First, it imports a new facet of uncertainty into securities fraud analysis. What counts as persistence? While one financial misstatement presumably is insufficient, two in close proximity may offer a stronger case. Three small scattered misstatements over a five-year period may be tougher. You get the drift. Ultimately, a court would have to decide which if any in a series of small misstatements tipped the persistence scale in favor of materiality. This also starts the class period, since there can be no fraud on the market until a material misstatement is made. And of course, this timing issue is also crucial to the damages calculation. So with a whole lot riding on it, a court must look at a series of small misstatements and somewhat arbitrarily pick the crucial misstatement that triggers materiality. Fundamental analysis seems not to offer any obvious conceptual basis for picking from among the various misstatements. Of course, all materiality analysis has some arbitrariness to it, so persistence analysis may be no different on that score.

To be fair, my complaints are really just nibbling around the edges. James’ central idea is creative and thought provoking. He has made a good case for incorporating persistence into materiality analysis for financial misstatements. So let me end where I started: James has written a very interesting paper gives us a reason to rethink materiality.

Thanks very much Christine and Conglomerate for the opportunity to take part in this junior on-line faculty forum.

I'm very grateful for the number of commentators who have taken the time to read the paper and give feedback. So thanks also to Professors Pritchard, Cunningham, Hemingway, Gutentag, Hoffman, and Tung.

I'll do my best to post some thoughts/reactions to these helpful comments throughout the day.

Best, Jim

and I see now, also thanks to Professor Nowicki!

Fortunately, I've blocked out this day to post comments, etc.

Professor Pritchard,

Your post sets forth the basic tension between the quantitative and qualitative approaches in a more articulate way than I ever could.

I've thought a little about your comment on why scienter is not already the gatekeeper because that is where persistence and unjust enrichment is considered. My sense of the case law is that courts look most often to the existence of unusual insider trading in determining whether or not there is scienter (I remember reading in one of your articles that after the PSLRA, plaintiffs are now more likely to include allegations of insider trading in their complaints). If such an allegation of insider trading is there, there's likely to be a finding of scienter. Thus, I'm not sure that persistence is currently much of a gatekeeper in the scienter context. If there are credible allegations of insider trading, then courts won't assess persistence with respect to scienter.

Under my proposal, that would not be possible. Even if there is a claim of insider trading that would support scienter, courts would also have to assess the issue of persistence independently to determine if the materiality inquiry has been met.

In other words, under the current system, if there's a good allegation of insider trading, the case goes forward because scienter has been met and materiality is not a gatekeeper. Under my proposal, even if there is a claim of insider trading, the claim may not go forward even though there is scienter if the misstatement is clearly isolated. (this is all with respect to liability against the company, a case could go forward against the individual). So, under my proposal, there would be an additional screen that plaintiffs would need to overcome.

I had not thought of your point that under my second proposal, it would be easier for companies to avoid liability for financial misstatements relative to non-financial misstatements. My only thought is that there are already a number of heuristics such as the puffery and bespeaks caution that apply to non-financial misstatements. So the proposal might remedy an existing disparity rather than create one.

Thanks.

Larry, thanks for reading this paper twice! Your comments were helpful the first time around, and I hope I've cleared up some of the issues you identified earlier. I'm really grateful for your willingness to help someone who is just starting out.

I have not read the CIFR report yet, but it's great to see that the issue is timely.

I was intrigued by your comment about the way in which markets react to different accounting categories and classifications. I suppose that over time, informal understandings about the meaning of such classifications will arise. But initially, I'm sure there is a transitional period when a new accounting measure is introduced where the market is either fooled or not sure about what to make of a new accounting practice. I agree that persistence will not be as useful in this context. My sense of some accounting fraud cases is that they involve transitional issues like this. Should shareholders have causes of action for stock price declines that occur as a result of such transitions? Or should we let thing work out informally between the market and company? Could be the topic for another paper.

Thanks again, Jim

Professor Heminway,

I'm glad you found the paper "gutsy"! It looks like we have similar interests, and I'm looking forward to seeing more of your comments.

On the valuation issue, there are many ways to value companies, but I've found that the discounted cash flow method is the most prevalent. My hope is that setting up the test as a set of presumptions rather than bright line tests will help judges better identify what is material in certain cases, while giving them the flexibility to make adjustments in close cases. In other words, if there are relevant valuation criteria that exist apart from the DCF model that are relevant, the parties can bring those criteria to the judge's attention.

I agree that my reading of SAB-99 may be narrow. And indeed, the point of SAB-99 is to set forth a very broad standard of materiality. To some extent, the proposals try to cabin SAB-99 to a certain category of cases, and I have to do more to acknowledge that.

Thanks!

Professor Gutentag, thanks very much for your comments. I agree that I need to deepen the discussion about the merits of share price accuracy and the theoretical reasons for disclosure, especially Mahoney's agency costs rationale.

I agree that there are a wide variety of valuation methods, but I focus on DCF because of its prominence, and also because I'm trying to extract some basic principles that judges can apply. As noted in my post to Professor Heminway, a system of presumptions will allow judges to consider additional methods of valuation if necessary.

thanks!

Professor Hoffman,

Thanks very much for your comments.

I just read your article Duty to Be a Rational Shareholder. You make a compelling case that materiality is being used as a screen, though primarily with respect to qualitative (as opposed to financial) misstatements. I will have to make some revisions to adjust.

I agree that I need to do more to address the assumption that we primarily need to focus on rational shareholders. To some extent, I think that this move is necessary not because it is more theoretical accurate, but because of the pressures by many to limit or do away with shareholder fraud actions. If it means the 10b-5 suit would survive, I would accept some limits that focus on rational shareholders, even if there are good arguments on the other side. It seems to me that financial statements are a place where it makes sense to implement such limits.

I appreciate your point about how in practice, the standard may not be an effective screen. But I think that persistence will still give judges a useful criteria by which to assess materiality. Even if the net result is not to screen cases, hopefully the inquiry will link the securities action more tightly to misstatements that are important to the market.

Finally, I haven't thought enough about the issue of settlement. My hope is that the persistence of a financial misstatement could largely be determined by looking at publicly available financial misstatements. If that's the case, the standard would increase rather than decrease the number of cases that are dismissed, perhaps reducing the number of cases without merit that are settled to make the plaintiff go away.

thanks!

Professor Nowicki, thanks for commenting.

Your remark about 2 papers is one that others have made. Ultimately, I'm leaning towards keeping it as one, though I may try to expand on some of the ideas in later pieces.

I too am ambivalent about moving away from the "reasonable investor" standard. If I had my way, we would deter all types of fraud. But to some extent, my argument is shaped by the reality that there are powerful forces seeking to limit securities fraud class actions. I would rather see the action limited through reasonable compromises with respect to the legal standard, than through arbitrary procedural limits.

Thanks.

Professor Tung, thanks for your post.

I too have some hesitancy about allowing isolated misstatements. I guess that ultimately, given the limited resources of the courts, I would rather see them focus on persistent misstatements, especially given the recent critiques of fraud class actions. And the standard does allow courts leeway in that it sets up presumptions rather than a bright-line rule.

I agree that persistence may be difficult to determine and in the end the standard may not be clearer than it is. But my hope is that the distinction will give judges additional traction in differentiating between misstatements.

Best, Jim