Securities Regulation
Materiality
What matters to investors?
(last updated 17 Jan 13)
Securities Fraud Action
• Parties
– Plaintiff (purchasers or sellers)
– Defendant (primary violator /
including company)
• Elements
–
–
–
–
–
–
Material
Misrepresentation or omission
Scienter
Reliance
Causation
Damages
• Required nexus
– Jurisdictional nexus (federal court)
– Transactional nexus (“in
connection with purchase or sale
of securities”)
Materiality “test”
TSC Industries v. Northway (US 1976):
A fact is material if "there is a
substantial likelihood a reasonable
investor would consider it important"
in deciding how to vote [whether to
buy or sell stock.]
Put another way, there must be a
substantial likelihood that the
disclosure of the omitted fact would
have been viewed by the reasonable
investor as having significantly
altered the "total mix" of information
made available.
Materiality contexts
Forward-looking information
Objective tests
Total mix
Management integrity
Forward-looking information
Basic Inc. v. Levinson (US 1987):
• What kind of lawsuit?
• What did plaintiffs allege?
• What were company’s arguments?
– Overwhelm investors
– Need secrecy
– Knowability
• What does 6th Circuit say?
• What does Supreme Court hold?
Forward-looking information
Basic Inc. v. Levinson (US 1987):
... with respect to contingent or
speculative information or
events .... materiality "will
depend at any given time upon
a balancing of both the
indicated probability that the
event will occur and the
anticipated magnitude of the
event in light of the totality of
the company activity"
Justice Harry Blackmun
Hypothetical #1
The CEOs of Six Feet and Dearly Departed
(two mortuary companies – Six Feet is
publicly-traded; Dearly Departed is
privately-held) have discussed a merger.
Price? Ratio? Survivor? Antitrust
scrutiny?
A reporter from Eulogy Magazine interviews
David and asks, “Does Six Feet have any
acquisitions in the pipeline?”
David turns to you, his lawyer. What do you
whisper to him?
Basic Inc. v. Levinson (US 1987):
... a factfinder will need to look to
indicia of interest in the transaction at
the highest corporate levels. Without
attempting to catalog all such
possible factors, we not by way of
example that board resolutions,
instructions to investment bankers,
and actual negotiations between
principals or their intermediaries may
serve as indicia of interest.
fn 17. To be actionable, of course, a
statement must also be misleading.
Silence, absent a duty to disclose, is
not misleading under Rule 10b-5.
"No comment" statements are
generally the functional equivalent of
silence.
Justice Harry Blackmun
Find Primary Material
(1) Statute: ’34 Act §12(b) [PDF]
(2) Form: 10-K, Item 7 [description / form)
(3) Reg S-K: Item 303 (MD&A)
Full Fiscal Years. ... [Reg S-K / Item 303]
(a)(1) Identify any known trends or any known
... events ... that will result in or that are
reasonably likely to result in the registrant's
liquidity increasing or decreasing in any material
way.
(4) Rule: 12b-20 [‘34 Act Rules / 12b-20]
In addition to the information expressly required to
be included in a statement or report, there shall be
added such further material information, if any, as
may be necessary to make the requirement
statements, in the light of the circumstances under
which they are made not misleading.
Hypothetical #2
The Six Feet and Dearly Departed merger
plans continue apace, but still no final
deal on price and structure.
Six Feet is about to file its annual report with
the SEC. Six Feet projects cash flow from
DD of about $25,000,000 next year
growing at 10% for 5 years, with cash
flows afterward of $40,000,000 – all
discounted 20%.
CEO David turns to you again. Must Six Feet
mention the possibility of a merger? (By
the way, Six Feet’s capitalization is about
$350,000,000.)
Valuation - Dearly Departed
Year
CF ($000,000)
Discount
rate
20%
PV ($000,000)
1
25.0
20.8
2
27.5
19.1
3
30.3
17.5
4
33.3
16.0
5
36.6
14.7
6
40.3
13.5
7+ (perpetuity)
200.0
67.0
Perpetuity
= $40 / .20
= $200
Total
$168.7
Materiality contexts
Forward-looking information
Objective tests
Total mix
Management integrity
Litwin v. Blackstone Group LP (2d Cir 2011)
• What kind of lawsuit?
– What does complaint allege?
– Basis for dismissal?
• Omission from IPO prospectus?
– MD&A: known trends reasonably likely
to cause financial info misleading
– FGIC; credit default swaps (insurance)
on CDOs / RMBSs downward trend in
real estate mkt
• Not material – below SEC 5% test
– $331 million = 0.4% of assets under
mgt
– $122 million decline = 4% annual
revenue
– Qualitative: No significant mkt reaction
/ no analyst surprise
• Material - qualitative
– Corp PE significant segment
– Mask change in earnings / affect mgt
pay
Corporate Private Equity
Real Estate
Marketable Alternative Asset Mgt
Financial Advisory
SEC Staff Accounting Bulletin
“qualitative factors may cause
misstatements of quantitatively
small amounts to be material”
1. hides unlawful transactions
2. Relates to significant segment
3. Significant market react to
disclosure
4. Hide failure to meet analyst
expectations
5. Changed income
6. Affect compliance with loan
covenants
Blackstone IPO –
August 2007
In re Merck & Co. Sec Litig (3d Cir 2005)
•
What was Medco’s “revenue
recognition” policy?
– Why recognize revenues that are
later netted out in computing net
profits?
– Why is Merck’s stock price
affected by sub’s “net zero”
revenue recognition?
– What was the Medco IPO? And
why was it scuttled?
•
What is Merck’s argument that
Medco’s revenue recognition was
not material?
– Wasn’t 4/17 disclosure opaque?
– Only when WSJ did the math?
•
What does the court conclude
about Merck’s “delayed,
piecemeal” disclosure?
7/5 – 4th S-1 Filing
4/17 – 1st S-1 filing
6/21 – WSJ story
7/9 – end of class period
An efficient market?
Mattrixx Initiatives v. Siracusano (US 2011)
• Plaintiff’s allegations?
– Reports: consumers who use Zicam
report loss of smell
– Jafek study: 10 patients lose smell after
using Zicam / studies linking zinc sulfate
– Company gives rosy picture and
predicts revenue/earnings rise
– FDA investigation reported: stock price
falls 11.7%
– GMA story: highlights Jafek study, stock
falls again
• Defendant’s argument?
– Adverse event reports that not
statistically significant not material
– Adverse events not establish causation/
just random event
– Otherwise bury investors with “trivial
information”
• Court decision?
– Medical researchers use not only stat
sig / rare events, ethics
– FDA acts on suspicion of causation, as
do consumers, thus investors
6/17/09: FDA warns consumers
to stop using Zircam: may cause
loss of smell
12/14/10: Matrixx sold to private
investors for $75.2 million
Materiality contexts
Forward-looking information
Objective tests
Total mix
Management integrity
Longman v. Food Lion, Inc (4th Cir 1999)
8/90 – UFCW labor union alleges
widespread labor violations / FL denies
employee mistreatment
11/91 – UFCW brings DOL complaint and
issues press release / company says has
clear policy against “off the clock”
11/92 – PrimeTimeLive trashes Food Lion’s
labor practices and sanitation
– Employees forced to work off the clock /
big $$$ back pay liability
– Meat pulled out of dumpster and bleached
/ Ees re-date packages
– Stock falls 11%
Longman v. Food Lion, Inc (4th Cir 1999)
Fourth Circuit:
… nature of the off-the-clock claims and
the claims’ risk to earnings were in
fact well known to the market before
the PTL broadcast [no price drop
after DOL settlement]
… statements [about cleanliness] are a
kind of puffery … most of broadcast
was inadmissible hearsay … isolated
instances of workplace errors
Sec Reg Record?
Would you invest in this man?
Management Discussion & Analysis:
“The partnership [to build an Atlantic City
mega-casino] believes that funds generated
from the operation of the Taj Mahal will be
sufficient to cover all of its debt service ...
Elsewhere in the prospectus:
“… no history of earnings … its operations
will be subject to all of the risk inherent in
the establishment of a new business
enterprise”
“… [timing of payments] could adversely
affect its ability to pay interest"
“… no assurance can be given that Taj
Mahal will generate cash flow sufficient to
pay debt service"
The “Donald”
Materiality in context
Context
(1) Historical facts
Test
TSC v. Northway
(“reasonable investor”)
(2) Speculative
Basic v. Levinson
(“prob + magnitude”
(3) Contextual
“Truth on market” /
“bespeaks caution”
Materiality in context
Context
(1) Historical facts
Test
TSC v. Northway
(“reasonable investor”)
(2) Speculative
Basic v. Levinson
(“prob + magnitude”)
(3) Contextual
“Truth on market” /
“bespeaks caution”
Materiality in context
Context
(1) Historical facts
Test
TSC v. Northway
(“reasonable investor”)
(2) Speculative
Basic v. Levinson
(“prob + magnitude”
(3) Contextual
“Truth on market” /
“bespeaks caution”
Materiality contexts
Forward-looking information
Objective tests
Total mix
Management integrity
Philosophy
“Sunlight is said to be the
best of disinfectants; electric
light the most efficient
policeman.”
Louis Brandeis
Other People’s Money (1913)
Corporate federalism
“Thus social standards newly
defined [by the Securities
Act of 1933] gradually
establish themselves as
new business habits.”
Felix Frankfurter
”creator of ’33 Act”
In Matter Franchard Corp (SEC 1964)
Investors
Glickman
Class A
shares
Franchard Corp.
Venada Corp.
Class B
shares
Glickman -• withdraws $2.4 MM
from company
• pledges stock on
$4.2 MM loans (24%
interest)
• departs after being
caught in more lies
In Matter Franchard Corp (SEC 1964)
Disclosure of self-dealing
• “Of cardinal importance in
any business is the quality of
management”
– Withdrawals =
1.5% book value
– Diversion to Venada =
Glicksman dominated
– Pledges of stock =
personal loans
– Default terms on loans =
change of control possible
• Is all self-dealing “material”?
Beyond SEC line items?
Rule 12b-20 [See also Rule 408]
In addition to the information
expressly required to be
included in a statement or
report, there shall be added
such further material
information, if any, as may be
necessary to make the
requirement statements, in the
light of the circumstances
under which they are made not
misleading.
Corporate federalism
“To generally require information
… as to whether directors
have performed their duties in
accordance with the
standards of responsibility
required of them under State
law would stretch disclosure
beyond the limitations
contemplated by the statutory
scheme …
William Cary
Chair, SEC (1961-1964)
Criminal behavior …
SEC v. Fehn (9th Cir 1996)
Would you have invested –
– “blind pool” public offering?
– Earlier securities law
violations?
– Not disclose CEO Wheeler?
– Manipulate price in
aftermarket?
Should lawyer be responsible?
– What is “aiding and abetting”?
– What if CEO identity not
required by line-item form?
– Must incriminate / disclose
possible illegality?
The end
Hypothetical
Intersection of securities law
and other regulatory regimes
Self incrimination
Drug kingpin Pablo Escobar
hires your client Key Airways,
Inc to bring “cargos” into the
United States. The contract It
represents 1.5% of total
revenues.
Must Key Airways, a public
company, disclose this
contract in its upcoming
quarterly report? Including
possible criminality?
Self incrimination
“The mere possibility of incrimination is
insufficient to defeat the strong policies
in favor of disclosure.”
California v. Byers (US 1971)
***
“… the distinction between “mere”
bribes to foreign officials] and bribes
coupled with kickbacks to the directors
… is fundamental to a meaningful
concept of materiality …. And the
preservation of state corporate law.”
Gaines v. Houghton (9th Cir. 1981)
Oran v. Stafford (3d Cir 2000)
Oran v. Stafford (3d Cir 2000)
Timeline:
• 2/94 – Belgian cardiologist
notices link to heart valve leaks
• 11/95 – AHP knows of 31
European cases / FDA panel
approves drug
• 3/97 – AHP learns from Mayo
Clinic of heart-valve abnormalities
in 17 fen-phen users
• 7/97 – Mayo data disclosed to
public / AHP says “investigating”
• 9/97 – FDA says survey shows
1/3 fen-phen users have heart
troubles
•
Investors who bought while
AHP knew more than public
sue. What theory?
– 3/97 annual report (new
drugs big hit, no mention of
European, Mayo data)
– 4/97 press release
(responds to news reports
that drugs “safe & effective”
– 7/97 press release
(discusses Mayo data, but
no mention knew 3 mos
ago)
– AHP withdraws drug / stock price
falls 5%
– WSJ reports possible lawsuits /
price drops another 6%
•
Should have disclosed:
– Mayo and European data
– Misled FDA
– Knew data earlier than said
Oran v. Stafford (3d Cir 2000)
Third Circuit (Materiality of
omissions):
– AHP stock price went up after 7/97
press release on Mayo data
– European data was not statistically
significant / “inconclusive”
– AHP description of FDA approval
process was factually correct
– Mayo and European data was
“purely speculative” until FDA
notified AHP of link
Oran v. Stafford (3d Cir 2000)
Third Circuit (Failure to satisfy
SEC rules):
– Even if obligated to disclose in
periodic reports (item 303, Reg SK), no private cause of action
– SEC standard of materiality
“signficantly beyond” price
+magnitude test of Basic
– Violation of SEC line-item rules not
necessarily violation of 10b-5
’34 Act S12(b) [find this]
Form 10-K, Item 7 [find this: 1  2  3  4)
Regulation S-K, Item 303 (MD&A)
Full Fiscal Years. ... [find this]
(a)(1) Identify any known trends or any known ...
events ... that will result in or that are reasonably
likely to result in the registrant's liquidity increasing or
decreasing in any material way.
Rule 12b-20 [find this]
In addition to the information expressly required to be
included in a statement or report, there shall be added
such further material information, if any, as may be
necessary to make the requirement statements, in the
light of the circumstances under which they are made not
misleading.
’34 Act Release 26,831 [find this]
… the MD&A need not contain a discussion of the impact
of [merger] negotiations where, in the registrant's view,
inclusion of such information would jeopardize completion
of the transaction.
Ganino v. Citizens Utilities Co (2d Cir 2000)
• Why are steadily increasing
earnings so important?
– Why did Citizens recognize
1995 fees in 1996? “store
income”?
– What happened when
company comes clean? 4/97
– rumors, 8/97 10Q
– Why should investors be
concerned if fees from
Hungarian company
constituted only 1.7% of total
revenues?
• What did the court decide?
Va Bankshares v. Sandberg (US 1991)
Proxy statement:
The Plan of Merger has been
approved by the Board of Directors
because it provides an opportunity
for the Bank’s public shareholders
to achieve high value for their
shares.
The price to be paid is about 30%
higher than the [last trade price
before announcement of the
proposal]. The $42 per share to be
paid public holders represents a
premium of approximately 26% over
book value.
Va Bankshares v. Sandberg (US 1991)
Supreme Court (actionability of statements
of opinion)
… Shareholders know that directors
usually have knowledge and expertness
far exceeding the normal investor’s
resources …
… statements of belief are factual in two
senses: directors hold the belief stated …
statement about belief expressed.
… disbelief, standing alone, is insufficient
to satisfy element of fact
Justice David Souter