The difficulty with gauging materiality, part infinity

Risk factor disclosures are required under SEC rules, and encouraged under the PSLRA (which insulates from private liability forward-looking statements that are “accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement,” 15 U.S.C. § 78u-5).  The theory is that investors, armed with adequate warnings, can make intelligent decisions about how to value a company’s securities.

Both the SEC in its guidance, and Congress when passing the PSLRA, emphasized that “boilerplate” warnings are not helpful; investors must be given specific, tailored information about the firm-specific risks that the company faces.  For example, the SEC instructs firms, “Do not present risks that could apply to any issuer or any offering. Explain how the risk affects the issuer or the securities being offered.”  17 C.F.R. § 229.303.  Meanwhile, in the PSLRA’s legislative history, the Conference Report states that “boilerplate warnings will not suffice.... The cautionary statements must convey substantive information about factors that realistically could cause results to differ materially from those projected.”

Scholars have documented that firm-specific risk warnings are helpful to investors.  For example, a while ago I blogged about a study by Karen K. Nelson and Adam C. Pritchard documenting how risk factor disclosures may assist investors.

The difficulty is, how does one distinguish boilerplate risk factors from “meaningful” firm-specific ones?  The impossibility of that task has frustrated several courts, with the First Circuit calling the PSLRA’s safe harbor a “license to defraud,” In re Stone & Webster, Inc., Securities Litig., 414 F.3d 187 (1st Cir. 2005), and the Second and Seventh Circuits expressing bewilderment as to how the adequacy of cautionary language is to be assessed, Slayton v. American Exp. Co., 604 F.3d 758 (2d Cir. 2010); Asher v. Baxter Int’l, 377 F.3d 717 (7^th Cir. 2004).

Scholars have also assailed the judiciary for adopting unrealistic standards of how investors read and interpret corporate disclosures, and, in particular, for overestimating ordinary investors’ ability to digest corporate disclosures and correctly incorporate them into their decisionmaking. David A. Hoffman, The “Duty” to Be a Rational Shareholder, 90 Minn. L. Rev. 537 (2006); Stephen M. Bainbridge & G. Mitu Gulati, How Do Judges Maximize? (The Same Way Everybody Else Does—Boundedly): Rules of Thumb in Securities Fraud Opinions, 51 Emory L.J. 83 (2002); Stefan J. Padfield, Is Puffery Material to Investors? Maybe We Should Ask Them, 10 U. PA. J. Bus. & Emp. L. 339 (2008).

A new study by Richard A. Cazier, Jeff L. McMullin, and John Spencer Treu supports scholars’ intuition – and courts’ frustration – by demonstrating that standards generated by judges and the SEC appear to encourage firms to include lengthier, less informative risk disclosures in their SEC filings, despite the fact that long, boilerplate warnings may actually harm firms by increasing their cost of capital.  In Are Lengthy and Boilerplate Risk Factor Disclosures Inadequate? An Examination of Judicial and Regulatory Assessments of Risk Factor Language, the authors demonstrate that in the event of a lawsuit, judges are more likely to find risk factors adequate if they are lengthier and more boilerplate.  Moreover, the SEC is less likely to issue a comment letter if the risk factors match those of peer companies rather than identify firm-specific risks.  In other words, the legal system encourages firms to adopt practices that are the opposite of what would benefit the market. 

At this point, I just have to quote myself – sorry! – from an earlier blog post:

[A]ll of our measures of impact and harm and loss are, at this point, so far removed from reality as to border on complete legal fiction.  Materiality is a construct from case law, with numerous additional doctrines piled on to it by courts without any heed for actual evidence of how markets behave. …. [W]hat we call “harm” and “damage” for the purpose of private securities fraud lawsuits have become so artificial that it no longer seems as though we’re even trying to measure the actual real-world effects of fraud.  I believe private lawsuits are an essential supplement to SEC action but a system of fines or statutory damages would make so much more sense.

(As long as I’m plugging myself, I’ve also proposed having distinct damages and liability regimes for investors who can prove actual reliance, since I think the fraud on the market context often leads courts astray).  But more immediately, here’s hoping the SEC takes notice of these findings and incorporates them into its practice.