A paper to be published next year argues that the materiality standard is lower under the relatively new criminal securities fraud provisions contained in Sarbanes-Oxley than under the traditional securities fraud provisions. Although not widely used currently, the lower standard arguably gives prosecutors greater discretion on cases to bring to trial. Materiality has not been a key component for most of the recent insider trading cases, which typically have featured relatively clear-cut examples of inside information, such as leaked revenues or earnings. However, any expansion of the materiality definition is potentially damaging to securities research.
“Criminal Securities Fraud and the Lower Materiality Standard” by Wendy Gerwick Couture, an Associate Professor at the University of Idaho College of Law in Boise, is scheduled to be published next year in the Securities Regulation Law Journal.
The paper compares the materiality standard under § 807 of the Sarbanes-Oxley Act, 18 U.S.C. § 1348, to the traditional securities fraud provision, § 10(b) of the Securities and Exchange Act of 1934. The traditional standard incorporates what a reasonable investor would consider important: “a substantial likelihood that the . . . fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available.”
The new securities fraud provisions were intended Patrick Leahy (D-VT), the author of the provision, to replicate federal mail and bank fraud statutes. The new statute does not require materiality, simply requiring “false or fraudulent pretenses, representations, or promises”. However, the Supreme Court previously ruled in Neder v. United States that materiality is an element of the federal mail, wire and bank fraud statutes,and by inference the securities fraud statute in Sarbox. The problem arises in the materiality definition used by the Supreme Court in affirming that materiality is relevant to existing fraud statutes.
In Neder v. United States a fact is material if it has “a natural tendency to influence, or [is] capable of influencing, the decision of the decision making body to which it was addressed.” In other words, inside information would be material if it is “capable of influencing,” even if it does not have a “natural tendency” to do so. For example, an earnings estimate from a small boutique research firm might be deemed material as ‘capable of influencing’, even if that firm has never had any impact on the markets previously.
The Sarbox securities fraud provision has not been widely used yet. According to the Bureau of Justice Statistics, only 45 defendants were charged with violating § 1348 from 2002 through 2010. Also, materiality has been moot in many of the insider-trading cases to date because they involved key financial information which had yet been publicly released. Any reasonable investor would agree that such information is important.
A few of the cases have seemed border line material, however. Manosha Karunatilaka, a manager at Taiwan Semiconductor, pleaded guilty to passing on bookings information about clients of Taiwan Semiconductor. This was clearly confidential, but not so clearly material. Bookings represent advance estimates, usually months before actual orders, of potential demand. They are usually revised, often more than once, before orders are actually placed. Bookings represent much softer information which is more subject to analyst interpretation than, say, non-public revenue or sales numbers. However, because Karunatilaka pleaded guilty, the case never came to trial and materiality was not tested.
As we have noted in the past, the trial of one of Primary Global Research’s salespeople, James Fleishman, centered on his guilt in causing experts to breach their fiduciary duties of confidentiality rather than the materiality of the information.
If prosecutors begin to use the broader “capable of influencing” materiality standard, this will likely have a chilling effect on securities research. Securities analysts will become more circumspect in piecing together their mosaics, as the “mosaic theory” safe harbor becomes less safe.