What keeps securities lawyers up at night? The list is long – a neighbor’s motion-triggered backyard spotlight, a hyperactive three-year-old, a teenager trying to sneak past the dog at 1 a.m. And determining what is “material” for disclosure purposes. Recent Supreme Court and Second Circuit decisions have removed some of the opacity surrounding this highly subjective issue.
What Is Material?
The traditional definition of materiality is whether there is “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.” Basically this means that a number or event is material if it is information that a reasonable investor would consider significant in making investment decisions.
The subjectivity inherent in this definition has led to many difficult conversations and decisions over the years as companies attempted to walk the fine line between full disclosure and over disclosure. Keep in mind also that disclosable material information need not be negative; positive material information is equally discloseable.
To further complicate matters, the SEC’s rules apply different materiality tests to determine disclosure in different contexts. For example, Management’s Discussion and Analysis must disclose “any known trends or any unknown demands, commitments, events or uncertainties that… are reasonably likely” to impact the company “materially.” The Form 8-K rules offer a plethora of tests for material contracts, material impairments, material amendments to various types of agreements and so on. Litigation is deemed “material” if, among other things, the amount involved exceeds 10% of the total assets of the company.
So how should companies approach materiality determinations?
Not Just a Quantitative Analysis
We frequently get some version of the following question from clients and colleagues: “What is the dollar amount for determining if something is material?” Perhaps in the back of their minds they are recalling an SEC Staff Accounting Bulletin released in 1999, which noted that the 5% rule of thumb could serve as the basis for a “preliminary assumption,” below which an amount was not material. Frequently ignored, however, was the additional language requiring a company also to consider all “relevant circumstances” in connection with such preliminary assumption. Materiality has never been as easy as “more than 5%.”
A recent Second Circuit decision reiterated this concept by expressly rejecting a formulaic approach and requiring companies to consider both quantitative and qualitative factors in an integrated manner. The Second Circuit allowed the use of a 5% threshold as a “starting place,” but required a qualitative analysis as well. The Court made it clear that, under certain circumstances, an event could be deemed to be material even if it is quantitatively small. According to the Court, in those cases, the company must consider such issues as if:
- the omissions conceal unlawful transactions or conduct;
- the omissions relate to a significant aspect of a company’s business;
- there was a significant market reaction to the (eventual) public disclosure of the omissions;
- the omissions hide a failure to meet analysts’ expectations;
- the omissions changed a loss into income or vice versa; or
- the omissions affected the company’s compliance with loan covenants or other contractual requirements.
While this certainly is not intended to be an exclusive list of qualitative considerations, it is perhaps the best, and is certainly the most recent, guidance available.
But We Followed the Rules!
It is possible to comply technically with certain SEC reporting requirements, but still omit information that should have been disclosed. In a recent example, a group of stockholders alleged that The Blackstone Group omitted from its filings certain risks related to losses at two of its portfolio companies. Blackstone argued that the investments in question each accounted for less than 3.5% of Blackstone’s total assets and fell below the presumptive 5% threshold for materiality. Noting that one fund represented 9.4% of Blackstone’s largest segment’s assets and was nearly three times larger than the next investment in that segment, the Second Circuit rejected Blackstone’s argument, holding that “even where a misstatement or omission may be quantitatively small compared to a registrants firm-wide financial results, its significance to a particularly important segment of a registrant’s business tends to show its materiality.” Blackstone appealed the decision to the Supreme Court, and on October 3, 2011, the Supreme Court refused to review the case and allowed the Second Circuit’s decision to stand.
In light of this decision, companies should be sure their materiality net is cast wide enough to catch developments that might be material to a particular segment, even if the development might seem immaterial to the company as a whole.
“Statistically Insignificant” Yet Material
The Supreme Court recently issued a unanimous opinion resolving a circuit split, holding that the determination of materiality “requires delicate assessments of the inferences a ‘reasonable shareholder’ would draw from a given set of facts and the significance of those inferences to him.” It further highlighted that a number or event can be small in dollar amount but still be material from a qualitative perspective.
In March 2011, the Supreme Court in Siracusano v. Matrixx Initiatives, Inc. rejected a bright-line rule that would have required statistical significance as a prerequisite to adequately pleading the materiality of reports of adverse events concerning a company’s product. The complaint alleged that the defendant pharmaceutical company failed to disclose reports that the use of its Zircam cold remedy, which accounted for 70% of the company’s sales, caused consumers to lose their sense of smell. At the same time, the company publicly stated that the product was “poised for growth” and projected revenue increases of 50% and then 80%, along with corresponding increases in earnings per share. In response to reports of Zircam’s side effects, the company, without supporting research, claimed that the reports were “completely unfounded and misleading.” The Court held that even though the adverse events were statistically insignificant at the time, a reasonable investor might have viewed the undisclosed information as having significantly altered the total mix of information made available, making it material.
What Should Companies Do?
First, companies must collect all relevant information in order to assess whether it is material and disclosable. Companies should use a mix of formal training and periodic reminders to inform employees of the types of transactions or events that may require disclosure. Many companies use quarterly reminders, which are targeted towards employees who are likely to know the types of developments that may require disclosure. In addition, employees should be reminded to “bubble up” information to the persons charged with making materiality decisions.
As part of the SEC’s rulemaking regarding CEO/CFO certifications under Sarbanes-Oxley, the SEC recommended – but did not mandate – that companies form disclosure committees in connection with their internal controls and procedures. The purpose of disclosure controls and procedures is to make certain that the information required to be disclosed is “accumulated and communicated to the issuer’s management… to allow timely decisions regarding required disclosure.” In most cases, it is a company’s disclosure committee that has been charged with carrying out this requirement.
Disclosure committee members must be trained to make materiality judgments on both quantitative and qualitative bases and should understand the disclosure obligations and the decision-making process for disclosures.
Allow sufficient time to conduct a thorough analysis of the issue. All too often, complex materiality decisions are made at the last minute using incomplete information and analysis because of looming filing deadlines. Be sure that your internal processes make this a rare exception, rather than the rule.
Recent cases reiterate that there is no bright-line rule for determining whether event reports are “material.” Therefore, you must carefully consider the context of the potential disclosure and any related facts and circumstances, including considering whether additional investigation would be prudent to assess the merit and materiality of such reports and related claims, and formulate an appropriate response.
Additional Articles from the Fall 2011 Public Company Forum:
A Proxy Advisor’s Negative Recommendation on Say-on-Pay: How Much Should You Care?
Director Diversity = Dollars
What’s Market? Are Press Releases Passé?
Dodd-Frank Act Progress Report: Fall 2011