Saturday, May 26, 2018

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 (7th 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.

Ann Lipton | Permalink


Ann -- this is very interesting, though I wonder whether we are getting a complete picture by looking only at risk factor disclosures, as the Cazier et al. study does. Other disclosure requirements, particularly Reg. S-K Item 303 and Reg. S-K Item 103 provide a number of useful inputs for interpreting firm-specific risk. For example, Item 303 (MD&A) requires the disclosure of known trends and uncertainties affecting the business, off-balance sheet arrangements, contractual obligations, liquidity and capital resources (including counterparty risk), etc. Item 103 requires the disclosure of pending legal proceedings. This information is undoubtedly helpful in giving content and context to risk factors that may otherwise be classified as general or boilerplate. The authors of the study control for several variables, but not for the content of the rest of the disclosure document and the firm-specific information disclosed in response to Item 303 and Item 103.

I think the problem with risk factors is less about gauging materiality and more about firms' disclosure practices and the SEC's guidance around risk factors. For example, Rule 421(d) of Reg. C requires the presentation of risk factors in "Plain English" which can be somewhat limiting in conveying nuanced firm-specific information ("no legal jargon or highly technical business terms"). Notably, the "Plain English" mandate does not apply to the rest of the disclosure requirements. So, there may simply be a natural limit to the usefulness of the risk factor disclosure section, especially when read in isolation. (As for materiality, I definitely agree that there are problems with it as I've discussed in some of my work.)

Posted by: George S. Georgiev | May 26, 2018 9:19:10 AM

Hi, George, thanks for commenting! You're right - a lot of other information is disclosed in other parts of these documents. But - and I admit, I haven't gone back over all of the studies on this - my recollection is that there are several that find that markets do react to risk disclosures specifically, and that pricing is better or worse depending on their quality. I mean, if none of them control for the rest of the document, it's possible that there's some correlation between quality of risk disclosure and quality of MD&A, but I believe there are some convincing findings that risk factors have standalone value, which - according to this paper - is being undermined by how courts and the SEC interpret the requirements.

Posted by: Ann Lipton | May 26, 2018 9:39:31 AM

Thanks for this post, Ann, and for your comment George. I agree with what's been said to date here in the comments, and I would also note that I think "Risk Factors" disclosures are often litigated, making them particularly important (although perhaps unduly narrow) public disclosures for study. But as you both know, I have more to say on this!

First, I offer a bit more on the existing regulation and guidance piece. References to customized disclosure in Regulation S-K include the one that you cite in the post, Ann. The Risk Factors disclosure mandate in Item 503(c) includes similar exhortations: “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.” And materiality is contextualized in significant ways throughout Regulation S-K—in the requirements for business, property, and legal proceedings, for example. All of these play a role in PSLRA actions.

Second, I wonder, Ann, why you call the SEC to arms at the end. As I read, I could not help but think that it is the judiciary that needs to be poked a bit. As someone who drafted disclosure for many years, I actually do not think it's as difficult as it may seem to identify boilerplate disclosures. At a minimum, the tools offered by Bloomberg Law can help judges and their clerks to see which disclosures are being copied from issuer to issuer (or registrant to registrant) without customization.

Having said that, I also will note that the judicial inquiry needs to be deeper than a mere comparative language analysis. The process for generating the disclosure should be carefully vetted in legal actions. Although disclosure drafting does involve a search for models to identify any relevant norms, it also involves at the start (before that language is identified) an assessment of the actual risks inherent in the firm's business--something that, if done well, involves a detailed conversation guided by legal counsel. And even if and after precedent disclosures are identified, the disclosure drafting process involves customizing those precedent disclosures to the business of the particular issuer or registrant for whom they are being crafted.

So, why should we not put more of the onus on the judiciary to engage in a deep inquiry regarding the text and the process for creating it? I took the disclosure drafting burden seriously in practice both before and after the PSLRA (noting here that the bespeaks caution doctrine predates the PSLRA). I assume others also did and do that. Maybe the three of us should write a guide for the judiciary using our combined skill sets . . . . Something to consider.

Posted by: joanheminway | May 28, 2018 8:48:48 AM

Hi Joan - thanks for commenting! I suppose I figured the SEC is probably more amenable to pressure for many reasons: first, they're specialists, unlike the judiciary; second, the judiciary may feel wedded to precedent; third, the lawsuit context may put additional pressures on judges - i.e., their feelings about the underlying merit of the suit may affect the analysis; and fourth, because in legal disputes these issues are usually decided on a motion to dismiss, there's no discovery and no opportunity for the judge to delve into the issuer's specific business risks - a point that the Baxter court highlighted. The SEC is in a better position to negotiate for more information about issuers.

That said, I'd love it if judges could be educated to be more skeptical of boilerplate disclosures! A general guide, or even an amicus brief in the appropriate case, might be helpful! Your real-world experience in particular would provide really helpful insight (in my practice, I got a hold of them after they'd been drafted, in the context of litigation!)

Posted by: Ann Lipton | May 28, 2018 9:34:34 AM

OK. I understand. I agree that the court context often does not allow for the kind of inquiry I suggest.

I am not sure what more the SEC can do--other than clarifying that length is not an indication of appropriate tailoring and issuing more thoughtful comment letters--ones that highlight the dangers of mere copying. But unless the judiciary follows suit, I am not sure that the guidance will impact many. Most folks pay more attention to federal litigation outcomes, in my experience, than SEC guidance (although I do believe that SEC guidance is critical and often can help courts).

So, I will take your idea that I provide insight under advisement. Maybe that insight could help the SEC and the judiciary. Food for thought . . . .

Posted by: joanheminway | May 28, 2018 10:06:18 AM

Thank you, Ann and Joan, for these additional insights. On the question of "What can the SEC do?", consider recent developments in the EU: Under the new EU Prospectus Regulation which comes into force in 2019, issuers will be required to group risk factors in a limited number of categories, with the most material risk factors being disclosed first within each category; issuers will also be permitted to disclose their assessment of the materiality of a given risk using a scale of low, medium, or high (which, if optional, would probably be unwise for issuers to do); and the number of risk factors included in the summary section of the prospectus will be limited to 15. So, this is one possible solution to the problem of general and boilerplate risk factor disclosures, though the EU approach may be overly formulaic. I’m still a bit skeptical about the payoff from focusing solely on risk factor disclosures. Even “general” and “boilerplate” risk factors may not be a big problem for investors as long as other sections of the prospectus provide the firm-specific information about risks, trends, and contingencies called for by existing disclosure requirements. In any event, there's lots to think about here, and I’d love to continue this conversation offline.

Posted by: George S. Georgiev | May 29, 2018 9:56:45 PM

George - that's really interesting about the EU. And that's exactly the kind of change in regulation that prompts a lot of empirical work, so we might see some interesting data coming out of that, as well.

Posted by: Ann Lipton | May 30, 2018 2:36:20 AM

Don Langevoort has published an interesting theory related to the judicial bias related to the acceptance of the puffery defense in the 80s and 90s... (Are Judges Motivated to Create "Good" Securities Fraud Doctrine? Donald C. Langevoort
Georgetown University Law Center, 2002). He hypothesizes that a general perception that there was too much frivolous litigation at the time as well as the rise of efficient market theory compelled the courts to circumvent the materiality determination, which should be fact specific, and accept puffery defense outright. I think a guide for the courts is a great idea, with respect to materiality as well as puffery, an equally difficult area. O'Hare and Padfield also have done great work in this area of puffery and materiality and looking at what courts have decided vs. what a reasonable investor may believe. Thanks for this original post and all the great comments.

Posted by: Jean Rogers | Oct 16, 2018 2:26:05 PM

Hi, Jean - glad you like the post! I agree courts are trying to get rid of frivolous litigation - the difficulty arises with what they perceive as frivolous. Anyhoo, the whole mess makes me think we need some kind of dramatically new approach to 10b cases.

Posted by: Ann Lipton | Oct 16, 2018 2:39:31 PM

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