Monday, July 28, 2008

Materiality and the Little Voice in Your Head

Sailors have a saying: “The time to take a reef in your sails is the first time you think about it.”  What they mean by this is that it is if you think the wind is getting stronger, you are much better off shortening your sails now, before you are overpowered by the wind and the act of reefing becomes very difficult, if not dangerous.  There is a similar analogy that can be made with respect to whether you think a piece of information is material and should be disclosed. That is, if you have to stop and think about whether something is material, it probably is.  Or, to complete the analogy, the time to disclose information is the first time you think about whether it is material. 


I know that this goes against the grain of most corporate disclosure policies, which seem to be, “The time to disclose information is when we absolutely, positively have to, and can find no reason to hide behind, and can’t convince our lawyers that this really isn’t as important as it sounds.”  Nor is the legal profession without blemish in this regard.  There is a corollary, unwritten rule which seems to be, “If the Chairman doesn’t think something is material because he really doesn’t want to talk about it, (or he has goofed and let something slip, but now doesn’t want egg on his face by having to make a formal announcement) the General Counsel and outside attorneys will find a way to justify the information not being material. So I thought I would take a moment and wade into the legal thicket of what information is material. In a later post I will discuss when you should, as opposed to must, disclose material information.


The classic definition of what constitutes material information was set out by the United States Supreme Court in two cases, TSC Industries, Inc. v. Northway and Basic v. Levinson.  The pertinent language of the court was contained in two statements:  “Information is material if there is a substantial likelihood that a reasonable shareholder would consider it important in making an investment decision.” And “There must be a substantial likelihood that the disclosure of an omitted fact would have been viewed by the reasonable investor as having significantly altered the “total” mix of information made available.”


This seems relatively straightforward to me, as most of us can put ourselves in the shoes of a reasonable investor, and there is no mention in the Court’s language about the information being either positive or negative – it just has to be important.  Nevertheless, countless billable hours of lawyers’ time has been spent on this issue, which, when you think about it, is pretty silly.  Investor relations officers spent most of their time talking to – you guessed it – investors.  Who better to know what the reasonable investor considers important?  Yet we constantly have lawyers and accountants weighing in on the subject, even though none of them would know an investor if they ran into one.  Does this make sense?

The practice of investor relations involves a high degree of repetition in answering investors’ questions.  It doesn’t take long for an investor relations officer to get a pretty good feel for what investors consider important (of course, there are some analysts who think everything is important, but they, by definition, are not reasonable investors).    Therefore, as a corollary to the Supreme Court’s guidelines, allow me to propose another one of Palizza’s Principles: Something is material if the little voice in your head (or, if you prefer, your gut) tells you that investors would think this is important information. It seems to me that this is no less obscure than the language often used by the Supreme Court.  After all, it was Supreme Court Justice Potter Stewart who was famous for stating; “[I can’t define obscenity, but] I know it when I see it”.

1 comment:

Jeffluth said...

Call me old fashioned, but I remember NIRI espousing the principle that companies have a duty to update the market if they expect a "materal" variance to expectations. (Your blog notwithstanding, let's ignore for a moment the definition of "materal." There was a time when "expectations" meant the analysts' estimates. So if the consensus was $0.50 and the company woke up and realized that they would do $0.40, then bamm! there goes a pre-announcement. In the age of guidance, "expectations" means, first and foremost, what they company said, and secondly, what the Street thought the company actually meant. In this respect, things have not changed, in that companies are generally responsible about updating the Street if they expect to seriously under-deliver. But I was absolutely stunned by comments from a team of disclosure experts (including a representative from the SEC!) during a NIRI Annual Conference panel. I asked the question of whether companies had a duty to update the market if their guidance proved to be too light; that is, if they woke up one day and found out they they were going to have a "material" upside to guidance. The panel essentially said "who cares?" suggesting that investors were only concerned if the quarter was going to be worse than expected, rather than better.
Now I'd hate to be an investor who sold his position heading into earnings to, let's say, lock in some profits, when lo and behold, one week later the company blows through its guidance and - who would have thunk it - the stock moves up 20%. I understand the class action law firms ain't what they used to be, but this still smells to me like a material omission, and one that is actionable.

I'd like to see some discussion on this topic.

Jeff Luth
Scottsdale, AZ