In Corporate Disclosure, a Murky Definition of Material – NYTimes

Posted on April 6, 2011 by


Why all the secrecy?

It seems that each day brings a new revelation of a company tardily disclosing something important. Goldman Sachs was slow to disclose that there was an investigation into the Abacus transaction; Goldman, as well as Procter & Gamble and AMR, all said nothing when one of their directors, Rajat K. Gupta, became ensnared in the Galleon Group insider trading investigation. There is the debate about what Apple should say publicly about Steve Jobs’s health.

Most recently, Berkshire Hathaway said a senior executive, David L. Sokol, had bought shares of a company before that company was acquired by Berskshire — a revelation it made only when it announced Mr. Sokol’s resignation.

It’s all a matter of materiality.

American securities laws are quirky when it comes to disclosure. They do not require, as they do in Britain, that all material information be disclosed on a continuous basis. Instead, companies must periodically file reports with the Securities and Exchange Commission disclosing all material information. Certain categories of such information, like director resignations, are required to be reported within two business days. But most information is allowed to be reported quarterly or yearly.

Even then, the information is typically required to be disclosed only if it is deemed material.

What is material information? It has been defined by the United States Supreme Court as “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.”

This is a subjective legal standard, so there is no bright line rule for what is material. Each situation is different. It also allows lawyers and others to argue that something is not material because they didn’t think it was certain or important enough to affect the stock price of the company significantly.

It’s here where companies have gotten into trouble. A company’s disclosure of controversial information is run past the lawyers, who look at it through a legal perspective. Since materiality is a legal concept to them, the lawyers too often find ways to judge it not material. It’s not directly related to the business (Mr. Jobs), no official allegations have been made (Mr. Gupta) or it’s not relevant to judging business performance (Abacus).

Then there is the odd case of Mr. Sokol. Looking at it from a legal perspective, the question whether his trading may violate insider trading laws is murky. One issue is whether the information he possessed, Berkshire’s possible interest in acquiring Lubrizol, was material.

A court would look at this by assessing the probability that the Lubrizol transaction would have occurred. Under current precedent on insider trading, this conclusion is driven by the fact that Mr. Sokol did not have final decision-making power to do the transaction — mitigating against materiality. And the question of materiality in this context is a legal swamp, one where there is anything but certainty. So, it may very well be that Mr. Sokol has a solid legal defense to his trades. (Mr. Sokol has said publicly that he has done nothing wrong in his purchase of Lubrizol shares.)

The trial of the Galleon hedge fund manager Raj Rajaratnam on insider trading charges raises the same kind of issue. His defense is the mosaic theory, arguing that that he was only collecting bits of nonmaterial information that he then put together to make an investment decision.

To nonlawyers, these efforts to find distinctions between material and nonmaterial can seem baffling. If Berkshire Hathaway was looking to bid on a company, of course any investor would want to know. An investor would especially want to know if the person interested in the purchase was a top executive.

This is the problem with the current disclosure scheme and its definition of materiality. It is increasingly disconnected from the desires of investors and the marketplace. Investors live in a digital world of real-time communication. Information is a commodity whose value rapidly deteriorates — the faster a company discloses, the better, from an investor’s perspective. The definition of materiality is from the 1980s, another time.

Companies have not kept up and too often view disclosure as a game, with the goal to avoid disclosure. This is what happened in another case of tardy disclosure, Bank of America’s consideration of an effort to terminate the Merrill Lynch transaction and Bank of America’s subsequent bailout by the government, neither of which were disclosed until weeks after the fact. Bank of America lawyers massaged the information internally until they could get to a position that it did not have to be disclosed.

Because materiality is a complicated legal standard, Mr. Sokol can defend trades that others see as not only unseemly, but as a example of what insider trading laws should prohibit.

For investors’ sake, companies need to view materiality from a broader perspective. It is not just about whether the S.E.C. could bring an action, but what investors will find important — in other words, will it move the market price?

Common sense works here. The information kept by Bank of America, Goldman and Berkshire was important to investors whether or not companies were required to disclose it immediately. Companies need to understand that information disclosure is not just a legal game. Failure to disclose important information on a timely basis can harm a company’s reputation.

The S.E.C. could consider expanding the disclosure requirements beyond periodic reporting. In today’s markets disclosure may be better made on a real-time basis. Such a regime has its own costs as it exposes a company to more liability for misstatements in such disclosure. But a more enhanced disclosure scheme may be a trade-off for reductions in potential liability for such disclosure or safe harbors.

Then there is the question of materiality. The definition has become legally constrained, fraught with multiple interpretations and views. There is a need for renewed guidance, if not new legislation.

The definition of materiality would be simpler and clearer if its test was what is important to the investor, instead of a calculation of whether the mix of information has been altered. It is more straightforward in Britain, which considers whether there would have been a significant effect on the share price in determining what is material.

A failure to act here may lead to increasing distrust of the markets by an already wary public. Congress said it best when it adopted the Securities Exchange Act, the cornerstone of company disclosure, in 1934 under the concept that “there cannot be honest markets without honest publicity. Manipulation and dishonest practices of the market place thrive upon mystery and secrecy.”

The principle remains true today.

Posted in: USA