October 23, 2017

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Materiality – “Shoulda, Coulda, Woulda?”

John Jenkins recently took note of this letter from the SEC’s Office of Investor Advocate commenting on a proposal by the Financial Accounting Standards Board to amend the definition of “materiality” in Concepts Statement No. 8, Conceptual Framework for Financial Reporting.  That Concepts Statement currently defines “materiality” as follows:

Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity.

With all due respect to the FASB, I find the above definition to be absurdly overbroad.  “Could” is the past tense of “can” which means to be able.  The word “could” is therefore used to indicate that something is possible.  As I’ve previously noted, saying something is “possible” is not the same as saying something is “probable”.  An event may be extremely improbable and yet will be possible.  For information not to be material under the FASB’s definition requires that there be no possibility that an omission or misstatement would influence the decision.  If even a very remote possibility exists, the information is material because it could influence decisions.

The U.S. Supreme Court’s definition at least focuses on probability by requiring a “likelihood” (as opposed to a possibility):

An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.

TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).  The Supreme Court’s definition also builds in the concept of a “reasonable shareholder”.  In contrast, the FASB refers only to “users”.  Thus, the FASB’s definition is not explicitly moored to any objective standard.

The U.S. Supreme Court’s definition, however, suffers from the use of “substantial” which provides not certain guidelines.  While possibilities are binary (something is either possible or it’s not), probabilities can be expressed by dividing the number of specified outcomes by the total number of possible outcomes.  For example, the probability that a fair die will roll “snake-eyes” is 1/6 or approximately .17.  Calculated in this manner, probabilities will range from 0 (impossible) to 1 (certain).  Where on this line is substantial?

In summary, the FASB “shoulda” referred to probability, not possibility, and the Supreme Court “coulda” defined “substantial”.  I only wish that they both “woulda”.

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About this Author

Keith Paul Bishop, Corporate Transactions Lawyer, finance securities attorney, Allen Matkins Law Firm
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Keith Paul Bishop is a partner in Allen Matkins' Corporate and Securities practice group, and works out of the Orange County office. He represents clients in a wide range of corporate transactions, including public and private securities offerings of debt and equity, mergers and acquisitions, proxy contests and tender offers, corporate governance matters and federal and state securities laws (including the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Act), investment adviser, financial services regulation, and California administrative law. He regularly advises clients...

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