The most common and most important question for any securities practitioner is the cornerstone question, "Is it material?"
The federal securities laws governing US capital markets are built around the core concept of full and fair disclosure. Most duties to disclose information as part of securities purchases and sales, antifraud provisions and continuous disclosure obligations are qualified by the modifier that the duty to disclose applies only to material information. The essential tool to define the scope of most securities and disclosure regulations lies in the materiality standard.
The following list of the top 10 questions to ask summarizes some of the factors that should be considerations when making a materiality determination and can help to ensure all bases in deciding materiality are covered. It is not an exhaustive summary of issues but is a companion piece to the Practical Law complete Practice Note, and Determining Materiality in Securities Offerings and Corporate Disclosure and Checklist, Is it Material? Asking the Right Questions Checklist available with a free trial to the online service.
1. Is there is a substantial likelihood that a reasonable investor would consider the information in question to be important in making a buy, sell or hold investment decision or a voting decision?
There must be a substantial likelihood that a fact would be viewed by a reasonable investor as significantly altering the "total mix" of information made available. This materiality standard does not require the substantial likelihood that a misstated or omitted fact would result in a reasonable investor changing an investment or voting decision.
2. Irrespective of whether it would change an investment decision, is there a substantial likelihood that proper disclosure of the misstated or omitted fact would have assumed actual significance in the deliberations of a reasonable investor?
Put another way, would the significance of the information go beyond what a reasonable investor simply "might" consider important and actually function as an important factor in the investment decision? Courts have expressly rejected adopting a materiality standard that focused on what a reasonable investor "might" consider important.
3. Is the event or information in question contingent on something else happening or speculative by nature?
For contingent or speculative events, materiality determinations must balance both the:
As with all materiality determinations, this balancing becomes fact specific. An event that is highly likely to occur and would be material if it did occur, but is relatively insignificant, may not be considered material and necessary to disclose until the probability of occurrence becomes higher. Similarly, if an event is improbable but its significance is so high that it would lead to a major impact on the company, it may be material and ripe for disclosure.
4. Does an item in question account for more than 5% of net revenue, more than 10% of total assets or does the potential misstatement or mission create a deviation in the financial statements of more than 2%?
The SEC staff strongly cautions against reliance on any numerical cutoff or threshold beyond a preliminary assumption that, before considering all relevant circumstances, an item is likely or unlikely to be material. The questions above are simply some examples that might require further analysis.
5. Are there qualitative considerations that can cause a quantitatively small misstatement to be material?
Materiality determinations require experienced human judgment of the size in numerical terms of the misstatement (quantitative factors) but also of the full factual context of the effect on the company (qualitative factors).
Qualitative factors can cause small quantitative misstatements to be material. A simple example of this is where financial statements are incorrect in one area and only by a small amount, but the misstatement is caused by management misconduct. Depending on the seniority level of management involved, the smallest of misstatements could be material.
6. Is there a single or isolated event or problem with a product or business line or a reporting segment that can have a significant impact on the company despite the fact that the problem is not widespread or statistically significant?
The size of the event, problem, misstatement or omission should be balanced against the size and importance to the company of the product or business line or that reporting segment.
7. Has there in the past been a demonstrated price volatility in the company's securities (or in the securities of comparable companies) in response to disclosures of a type similar to the information question?
When there are expectations based, for example, on patterns or market performance, that a misstatement may result in significant positive or negative market reaction, the expected reaction should be taken into account in the materiality determination. However, as with all factors in materiality determinations, market performance represents only one quantitative factor that must be considered in full context.
8. Have any misstatements of individual amounts been aggregated or netted?
The misstatement of an individual amount may not be material but multiple immaterial misstatements, when aggregated, can render the financial statements materially misleading as a whole. All misstatements and omissions should be assessed both separately and in the aggregate to determine the materiality of resulting line item amounts and total misstatements. Materiality cannot be diminished by netting a misstated amount with another misstatement in the financial statements. For example, if revenues are materially overstated but the effect on earnings is completely offset by an overstatement of expenses, the financial statements taken as a whole are still materially misleading.
9. Even if there are misstatements that are individually immaterial, could the multiple misstatements cumulatively render financial statements materially misleading as a whole?
Companies and their auditors and counsel should also be mindful of the cumulative effect of misstatements from prior periods. If a misstatement is considered immaterial, no changes would be made to the financial statements.
However, as multiple periods and years are presented in financial statements, those immaterial misstatements are carried over into future financial statements. Past misstatements can be immaterial but can add up to a material misstatement in current financial statements, especially if the immaterial misstatement recurs in several periods or years.
10. Have you checked with the company's securities exchange listing standards?
Both the New York Stock Exchange and NASDAQ have listing rules that require disclosure of material information and both exchanges offer examples of materiality that should be considered.
NYSE examples can be found in Rule 202.06(A) of the NYSE Listed Company Manual. NASDAQ examples can be found in Rule 5250(b)(1) of the NASDAQ Listing Rules.
There is an intentional lack of bright line guidance on this topic: the materiality standard needs to be flexible and adaptable to any factual situation so that those with a full understanding of the information and context (a company's management and its accounting and legal advisors) can make a reasoned, experienced decision on what is material and whether and to what extent information should be disclosed. While materiality determinations are necessarily highly dependent on the particular facts and circumstances of each situation, asking these questions can be an important start in applying the materiality standard to any factual situation.
Jerry Carannante is a Senior Legal Editor for Practical Law Capital Markets & Securities. Jerry joined Practical Law from Sullivan & Cromwell LLP where he specialized in a variety of corporate finance and securities transactions
Reprinted with permission from the Association of Corporate Counsel 2015 All Rights Reserved