Professor James Park’s Assessing the Materiality of Financial Misstatements is a gutsy piece of scholarship that arrived on my desk at the right time.  “Gutsy,” in that he takes on a hugely complicated area; and timely in that I am finishing off a paper relating to the conceptualization of the reasonable investor in materiality analysis then plan to extend my earlier work on materiality in a paper that I am writing during the fall and winter.  Professor Park’s article focuses generally on rationalizing the assessment of the materiality of financial misstatements and specifically on making sense of the use of quantitative and qualitative measures in those materiality determinations.  It is an insightful piece, although I do disagree with some of the underlying observations and characterizations.  As has become my habit, I am affording my more detailed comments to Professor Park individually, offline.  A summary of key points follows.

Park hits the nail squarely on the head when he states that “[t]he current debate myopically focuses on the practicalities of the standard – whether it is easy to apply (favoring the quantitative standard) or allows prevention of earnings manipulation (favoring the qualitative standard).”  In this piece, Professor Park attempts to widen the debate by looking at the overall significance of financial reporting to the securities regulation scheme.  He is largely successful in that effort.

In a new tweak on the “short-term vs. long-term investor” debate and in contravention of those arguing for a definition of materiality that relies on price effects, Professor Park first argues for the inclusion of persistence in financial misstatement materiality assessments.   Ultimately, I like this argument, although I will not, with my limited finance expertise, validate or challenge the simple valuation analyses he uses to support his position.  (I know from 15 years of hard labor with investment bankers and valuation experts that there’s more than one way to value a company . . . .)  There’s plenty more there in the paper for nonquants like me to grasp onto and rely on, in any event.  If I had one wish about this part of the paper, it would be that Professor Park should tie his observations back to the policy underpinnings of the securities laws more directly and clearly.  Why does his approach, e.g., better assure market integrity?  And how does his approach better protect investors, especially short-term investors?  Are these two policy underpinnings put into conflict or do they coexist symbiotically or synchronistically in this environment?

Professor Park then goes on to suggest that corporations and their agents be treated differently for purposes of liability in fraud-on-the-market cases (although I think he means to reference securities fraud actions—at least private enforcement actions—more broadly).  I find this part of  Professor Park’s article less persuasive, largely because he builds it off a narrow view of the purpose of qualitative materiality assessments.  He asserts that qualitative materiality exists to prevent self-dealing/conflicts of interest.  Certainly, concern about management conflicts drives the consideration of matters other than bright-line financial tests in determining materiality.  But there is more than that in qualitative materiality.  Said another way, earnings management is only a part of the overall picture of what materiality addresses in the financial statement area.  As Professor Park himself notes: “[n]ot all accounting frauds are alike.”

Professor Park would be on safer ground if he narrowed his claim in this part of the article to the role of qualitative materiality in addressing earnings management.  Also, in this part of the paper, he refers to the “vicarious” liability of a corporation for material financial misstatements.  In spite of these references, I do believe that he realizes that the liability of an issuer/registrant for material misrepresentations in its financial statements is primary, statutory liability, not merely the common law liability of a principal for the actions of its agent.  He does offer one express statement in that regard (noting that “[i]ndeed, liability for financial misstatements may be an issue of direct rather than vicarious liability”), and he also admits as much in his discussion of securities fraud under Section 11 of the 1933 Act and Section 10(b)/Rule 10b-5 under the 1934 Act and in his discussion of proposals to exempt issuers from that liability.

I do have a few lesser substantive quarrels with statements Professor Park makes in his article.  For example, he indicates without citational support that the concept of the reasonable investor may differ based on the type of statement at issue:  “While the term ‘reasonable investor’ can encompass both irrational and rational investors, the case for focusing on the perspective of the rational investor is strongest with respect to financial misstatements.”  I am not confident, based on my own research, that this is correct as a positive or normative matter.  Moreover, the narrow focus on rational vs. irrational investors (without taking into account other conceptions of the reasonable investor) did not satisfy me.  I would like to see more on this in the paper—or at least an acknowledgement of the academic debate—if he intends to rely on contextual differences in the reasonable investor to any significant extent.  He does mention the existence of a debate briefly in passing, so I know he’s aware of it . . . .

Also, at the outset and throughout the article, Professor Park draws a distinction between quantitative and qualitative materiality in evaluating the significance of financial statement misstatements.  He narrowly defines quantitative materiality to include principally the debunked “5% test” (but also other bright-line financial tests).  He then states that SAB No. 99 adopts qualitative materiality as the exclusive test.  I disagree with that characterization.  SAB No. 99 adopts the TSC/Basic formulation of materiality, which includes both quantitative and qualitative components; “[e]valuation of materiality requires a registrant and its auditor to consider all the relevant circumstances” and the “interaction of quantitative and qualitative considerations.”  Nevertheless, his overall views on the vagueries of the existing materiality standard are dead-on right.

All in all, this is a valuable piece of work that contributes new insights to the literature on materiality.  I am grateful for the opportunity to contribute to the dialog.  Thanks, again, to Christine, Gordon, and the whole Glom gang for inviting me to participate.

Jo

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