The nettlesome issue of how to implement the materiality standard is one of the crucial open questions in securities regulation.  It’s good to see Professor Park make a solid effort to advance our understanding of this issue.  Park is clearly correct that leaving judges and juries with the task of interpreting a vague “reasonable investor” standard is a cop out, and the SEC is struggling to come up with a better solution.  But I would want a more precise connection to theoretical rationales for securities regulation and more research on the types of information sophisticated investors actually use to value stocks before endorsing Park's many recommendations.

To review, the Supreme Court has borrowed the reasonable person standard from other areas of law and adopted a "reasonable investor" standard to evaluate when information disclosed by public companies is material.  But, as Park correctly points out, there are many questions that come about in implementing a reasonable investor standard.  Should only rational investors be considered?  Is a quantitative test an efficient way to reduce the transaction costs associated with determining when information is material?

I will address two areas in which I think more careful consideration could improve Park’s article.  First, Park could be more thorough in identifying the larger theoretical issues that any discussion about how to implement the materiality standard should build upon.  Second, looking more carefully at the types of information that sophisticated investors actually use to value companies would help to better elucidate how to apply a “reasonable investor” standard.

On the theoretical front, Park is not sufficiently thorough in considering why public securities are regulated.  He does mention the importance of share price accuracy, noting the work of Professor Fox.  But he does not acknowledge the problems with these claims identified by Roberta Romano (and myself).  He also fails to mention Paul Mahoney’s excellent work distinguishing between the accuracy enhancing and agency cost reducing benefits of requiring disclosure.

These theoretical debates about securities regulation have direct implications for how to implement the materiality standard.  For example, if agency cost reduction is an important aspect of disclosure regulation, then it is the transactions between the agent and the firm that may be more important to monitor, regardless of scale.  The analysis gets more complicated if, as I have argued, there are certain types of information that simultaneously increase accuracy enhancement and reduce agency costs (for example, by reducing opportunities for agents to capture for themselves the value of information asymmetries).  Park’s discussion alludes to these issues, but a more explicit discussion of theoretical issues is needed. Such considerations would be helpful, for example, in clarifying Park’s effort to distinguish large scale fraud from other kinds of misleading statements.  Working with a broader theoretical palette, in part by acknowledging the potential relevance of the work of Romano and Mahoney among others, would lead to a more satisfying answer to the puzzle of materiality.

On the practical front, Park chooses to focus on the perspective of the rational investor, which I think is the correct approach.  But then he goes on to rely on what I find to be an overly simplistic description of how the rational investor would rely on earnings in carrying out a Discounted Cash Flow (DCF) analysis to value securities.  Park needs to make more of an effort to research the types of information that sophisticated investors actually use to value firms.  In supporting an argument that the appropriate standard for materiality should use as a template the disclosures required by sophisticated investors in private transactions I did such research (Florida State, 2004).  Park cites textbooks and a few academic studies.  (His footnote 107 is a little better, but later in the article he does not incorporate this complexity).  Even if DCF analysis and earnings estimates are important tools in valuing firms, the inputs into sophisticated financial analysis tend to be more diverse than Park acknowledges.   

It is primarily by relying on a relatively simple DCF valuation technique to model the rational investor that Park is able to justify one of his main claims, that separating misstatements into two categories, temporary misstatements and ongoing misstatements, would be a helpful addition to the law.  Once we move away from a simple DCF valuation technique, such distinctions become more problematic.  It does not work to equate one-time write-downs with one-time misstatements.  As but one example, of which I'm sure Park is aware, a one-time change in income has on ongoing effect on the balance sheet.

Materiality is an important issue in securities regulation and enforcement.  I hope these comments help to make a good article better.

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