Academic

Assessing the Materiality of Financial Misstatements:  Two Articles for the Price of One.

Many thanks to Christine Hurt and the folks here at the ?Glom for including me in Junior Scholars Forum.  This is my third year participating, and the papers I have been asked to read are always stellar.

This year, I had the good fortune to read Professor James Park?s article, Assessing the Materiality of Financial Misstatements.  What I found was that I was actually reading two articles, one on materiality in the context of financial misstatements and one on vicarious liability for securities fraud related to financial misstatements.  While I favor Professor Park?s latter article more than his former, I applaud Professor Park for taking on two major topics and boldly addressing the vexing factual issues implicated in accounting fraud.

Regarding materiality, Professor Park takes the position that the two methods normally bandied about for assessing the materiality of financial misstatements ? the qualitative and the quantitative methods ? are unacceptable.  He maintains that courts should instead assess the persistence of a financial misstatement (whether the misstatement inflates earnings or hides significant declines in earnings over multiple reporting periods as opposed to simply changing a company?s financial picture at one moment) in assessing its materiality.  Regarding vicarious liability, Park maintains that vicarious liability for securities fraud in the context of financial misstatements merits revisiting, and vicarious liability should only be imposed in the context of quantitatively large misstatements .

In a nutshell, Professor Park does a wonderful job of explaining and unpacking the factual aspects of accounting fraud.  His detailed examination of financial statements and various ways to manipulate financial statements is worth reading in and of itself.  His subsequent materiality discussion and proposals to revise the way materiality assessments are make in the context of accounting fraud, however, raises a few questions for me, as discussed in detail below.  The vicarious liability section of his paper is a solid exposition of a minimally examined issue, and I imagine the more he develops this section of his paper (perhaps even making it its own paper), the further he will help advance the debate on how to address vicarious liability.  The reality is that courts rarely examine the propriety  of imposing liability vicariously in securities fraud cases.  Most courts simply impose vicarious liability on issuers without comment.  Park raises enough concerns about this issue, in the vein opened by Professors Carney and Arlen more than 15 years ago in their article titled Vicarious Liability for Fraud on Securities Markets:  Theory and Evidence, that he has the potential to inspire courts to re-examine the sensibility of imposing vicarious liability without analysis.  While I am not sure I necessarily agree with his ultimate conclusion that vicarious liability should only be imposed in the case of quantitatively large financial misstatements while individuals should be liable for both quantitatively small and large financial misstatements ?especially if they cause stock price fluctuations,? I think his discussion of the issues is thought-provoking and likely to inspire further debate.  In this environment where some say law review articles are irrelevant to courts, I think more examination of the propriety of, fairness of, policy concerns implicated by, and deterrent effects of vicarious liability in securities fraud cases involving financial misstatements is much needed.  I look forward to Professor Park leading that charge.

Where I want to focus my specific comments, then, is on his materiality proposal.  As above stated, Professor Park maintains in his paper that the law regarding materiality in the context of financial misstatements merits revision.  While traditionally the debate about materiality has focused on whether it is appropriate to measure materiality against a qualitative or a quantitative standard, Park argues that this is myopic as neither standard is ideal.  Parks suggests that courts should add to their calculus a ?persistence? analysis, which examines whether an allegedly material misstatement inflates earnings or hides significant declines in earnings over multiple reporting periods.  ?Persistent misstatements,? he says? should be presumed to be material while isolated misstatements should be presumed to be immaterial.?

In reaching this conclusion, he reviews expertly the methodology by which investors value firms.  ?A deeper analysis of what misstatements are most likely to affect the market?s assessment o f a company?s value,? he instructs, is necessary in developing a new materiality standard.  When looking at the market price method of valuation, he maintains that using this as a gauge for materiality is inappropriate in part because market price fluctuations can be arbitrary.  Information that impacts a firm?s short term stock price cannot be presumed to be material by virtue of simply having impacted stock price.  When looking at a fundamental analysis of valuation, however, he notes that persistent misstatements are more likely to impact valuation, such that it seems more appropriate to target these misstatements as presumptively material.

My biggest concern with this analysis and conclusion is that it reworks the true nature of a materiality assessment.  A materiality assessment, in the context of disclosure and financial misstatements, is intended to separate the wheat from the chaff.  Some things investors want to know about and are likely to care about when buying or selling a stock, and some things are not so important.  If I am the CEO of Disney, and I lie on Squawkbox about whether I like the Disney President?s necktie, that is an insignificant lie.  That is immaterial.  No investor is likely to care about that lie.  If I am the CEO of Disney, and I lie on Squawkbox about whether I think the Disney President is an incompetent sociopath, that is not an insignificant lie.  (I am making reference to the time years ago when Ovitz and Eisner were on some business news show together and professed to adore each other, very shortly before Disney announced that Ovitz was being forced out.) 

The Supreme Court has said that, in the context of financial misstatements, a fact is material if there is a substantial likelihood a reasonable investor would consider it important, in the context of the total mix of information available, in making her investment decision.  What Park does is wholly take us away from that Supreme Court standard as a normative matter, yet nowhere does not acknowledge this point and justify it.  If we move to his standard, where we use ?persistence? as a more controlling factor for assessing materiality, we leave behind the focus on what an investor is likely to consider important in making her investment decision in favor of what is important in a longer-term objective valuation.  This fundamentally changes what the Supreme Court has said we should do in assessing materiality.

Looking at persistence deprives the investor who is making an investment decision today of the right to have information that is accurate today, regardless of whether that information will ?persist? in its effect on a company?s longer timer value.  By using a persistence analysis, or incorporating persistence into the materiality analysis as a defining factor, we would be obliterating a category of material misstatements that are overt lies with only a short term impact.  That does not strike me as such a good thing, particularly for the poor investor who bought the stock based on those financial misstatements.  Moreover, it reworks the fundamental nature of the Supreme Court?s construct ? ?a substantial likelihood that a reasonable investor would consider the information important in making their investment decision.?  In a related vein, nowhere does Park account for the shareholder decision-making perspective which is, by nature, a time-limited perspective in some sense (either a shareholder will buy stock today or not; either a shareholder will sell stock today or not).

It speaks well of Park?s boldness and the magnitude of the issues Park addresses in his paper that I had to stop several times while it to simply chew on his analysis and his suggestions.  When reading law review articles, I usually do not have to completely stop reading to just let the wheels turn in silence.  That I had to do so in this case speaks well of Park?s willingness (as a junior scholar!) to take on big, complex, vexing topics.

Part of what kept stopping me was a lurking wonder if Park?s valuation and persistence concerns had more to do with damages than with materiality.  I have twice published about securities fraud and materiality, and, both times, I have observed that courts and scholars often mix materiality, damages, and reliance analysis together.  While reading Park?s bold paper, I could not help but ask ?doesn?t the assessment of the impact a misstatement has on the long-term valuation of the company have more to do with damages than materiality?  By focusing on persistence, aren?t we conflating (even worse than we currently do) the damages and materiality assessments?  As a matter of common law fraud, on which Section 10(b) was based, isn?t this objectionable??

I leave Professor Park with these questions, recognizing again that I am glad he has written a paper strong enough to inspire me to ask such questions.  Although I respectfully disagree with his conclusion that materiality should be reworked to focus on persistence, I commend his intellectual curiosity and willingness to take on such a major topic.  I applaud his boldness in making a radical proposal, and I am sure he will inspire debate in the future on incredibly important securities fraud topics.  I thank him in advance, and I look forward to reading his future work.