The Two Faces of Materiality

In order to prove securities fraud under federal law, one must show that the defendant either misrepresented a material fact or omitted to state a material fact when under a duty to speak. The fact must somehow matter to investors. But the courts have struggled mightily to determine when a fact is material.

On the one hand, the Supreme Court has held that a fact is material if it would be important to a reasonable investor in deciding how to act—how to vote or whether to trade. The information need not be so important that it would change the outcome. But it cannot be so trivial that it would not affect the total mix of available information. Moreover, it must matter in the sense that an investor can do something with the information. For example, although the fact that a merger lacks a business purpose or that the board of directors thinks the price is low might be important in some sense, these facts may not be material if the investor has no vote on the matter or the controlling stockholder has enough votes to assure approval.

On the other hand, the Supreme Court has also equated materiality with price impact in endorsing the fraud-on-the-market (FOTM) theory that a reasonable investor presumably relies on the integrity of the market and that a material misrepresentation presumably affects stock price. Arguably, this definition of materiality (if it is a definition) is at odds with the other definition. It is quite clear under the first definition that a fact can be material and yet not be so important that it affects the actions of a reasonable investor. But under the second definition it is equally clear that to be material a fact must affect the actions of at least some investors—otherwise there would be no price impact. In other words, some number of investors who would not otherwise have traded must have been motivated to buy or sell or else stock price would not likely have changed any more than can be explained by the normal Brownian motion of the market.

So which is it? Must a fact have price impact to be material? Or is it enough that the fact is important to investors even though it does not affect market price? Although these two definitions of materiality seem to be completely at odds with each other, they can in fact be reconciled. The apparent conflict comes from focusing on an individual reasonable investor in one case and the collective action of many such investors in the other case. To be material, a fact need not be so important that every investor would alter his behavior or change his mind somehow. But a fact cannot be material if it has no perceptible effect on the behavior of any investor.

In other words, the reasonable investor is a bit like Schrödinger’s Cat—both dead and alive at the same time. There is plenty of room for both investors who react and those who do not. Not all investors need react to the new information. But some investors must react. Indeed, this tracks the decisions of the Supreme Court perfectly. To be material a fact need not be outcome determinative. But it must matter somehow.

The issue of materiality was again before the Supreme Court in Amgen, Inc. v. Connecticut Retirement Plans & Trust Funds, 2013 U.S. LEXIS 1862, where the defendant argued that under the FOTM theory it should be allowed to show lack of price impact to defeat class certification. The Court chose to affirm on the narrowest of possible grounds—that materiality is a matter of merits that may not be decided as in connection with class certification even though materiality is thus not likely to be addressed at all—because once a case is certified as a class action, it invariably settles. To be sure, the Amgen Court encouraged motions for summary judgment on the issue of materiality at least insofar as it may be possible to prove that the facts in question had no effect on market price. Nevertheless, it is regrettable that the Court did not reverse Amgen since there is little doubt about price impact in most meritorious cases. And if plaintiffs cannot show price impact, they will not be able to show damages or loss causation. So it is unlikely that any meritorious case would be dropped for lack of class certification. Moreover, the decision does not appear to preclude rebuttal of the FOTM presumption on other grounds such as typicality and adequacy of representation.

Despite its decision in Amgen, it appears that the Court may be ready to rethink the FOTM presumption. On November 15, the Court granted a second petition for certiorari in Halliburton Co. v. Erica P. John Fund, Inc., 2013 U.S. LEXIS 8154, to consider (1) whether it should overrule or substantially modify the holding of Basic to the extent that it recognizes a presumption of class-wide reliance derived from the FOTM theory, and (2) whether, in a case where the plaintiff invokes the presumption of reliance to seek class certification, the defendant may rebut the presumption and prevent class certification by introducing evidence that the alleged misrepresentations did not distort the market price of its stock.

To be clear, Halliburton I held that loss causation need not be shown in order to gain class certification, and Amgen held the same as to materiality (although the real issue in both cases was whether loss causation or materiality could be disproven at the certification stage). Both decisions avoided questions as to how the presumption may be rebutted by focusing instead on the elements of the action, the substance of which may not be addressed in connection with certification under precedents governing class actions. Halliburton II confronts the question of rebuttal head-on. But it also goes further in raising the question whether the FOTM presumption should be eliminated entirely.

While there is no good reason to preclude defendants from offering rebuttal evidence at the certification stage, it makes no sense to banish the idea of the efficient market from the courtroom. There is no doubt that information affects market prices and does so efficiently enough that traders are unable to beat the market any more often than is consistent with chance. Moreover, even if the Court were to overrule the FOTM presumption in connection with misrepresentations, the presumption would remain with regard to omissions. And almost every securities fraud class action can be characterized as an omission to correct an earlier positive misstatement.

The problem with securities fraud class actions is not the FOTM theory but rather the idea that investors should be able to recover from the company where the fraud arises in trading outstanding shares. As in musical chairs, someone will suffer a loss when the truth comes out. In such cases, buyers’ losses are offset by sellers’ gains (or vice versa)—in contrast to cases in which the company itself has issued (or repurchased) shares. Since most stockholders are well diversified, the only genuine loss in such cases of open market fraud comes from the excess decrease (if any) in the value of the company and its stock that is attributable to an increase in the cost of capital going forward or to litigation expenses (including fines). So it is the company itself that should recover derivatively from the individual wrongdoers for the benefit of all stockholders and not just traders.

The full article is available for download here.