The Second Circuit has provided new guidance on what "material" means under Section 11 and Section 12(a)(2) of the Securities Act of 1933, which prohibit material misstatements and omissions in registration statements and prospectuses.
Investors in a 2007 IPO by The Blackstone Group, L.P., a financial advisory firm and one of the largest independent alternative asset managers, sued Blackstone, alleging that it made material misstatements and omissions in its prospectus and registration statement in connection with the IPO. Specifically, the investors claimed that Blackstone did not adequately disclose risks associated with its investments in FGIC Corp., which issued credit default swaps in connection with residential subprime mortgage backed securities, and Freescale Semiconductor, Inc., which recently lost its exclusive contract with Motorola. The investors further claimed that Blackstone did not adequately disclose general risks facing the fund due to the general downturn in the subprime residential mortgage market.
Courts analyze whether a reasonable investor would have considered certain facts significant in making an investment decision, and whether there is a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the "total mix" of information available. A plaintiff need not assert that the investor would have acted differently if the disclosure were made, but only that such disclosure would have been significant in the investor's decision to invest. Courts and the SEC have accepted 5% as the materiality threshold (based on the percentage of which an investment represents the company's total assets under management), but courts look to both quantitative and qualitative factors in assessing materiality (e.g., whether the omission concealed unlawful transactions or relates to a significant aspect of the issuer's business, whether there is a significant market reaction to the public disclosure of omitted information or whether the omission changed a loss into income, or vice versa).
The court rejected the defendant's motion to dismiss, stressing that the pleading burden under Sections 11 and 12(a)(2) with respect to materiality is relatively minimal and provided new guidance for assessing materiality in two respects. First, the court held that issuers have a duty to disclose relevant information to investors notwithstanding that such information may be public knowledge. Second, the court held that the 5% threshold for materiality can be measured at a business segment level as opposed to a firm-wide level, stating that "[e]ven where a misstatement or omission may be quantitatively small compared to a registrant's firm-wide financial results, its significance to a particularly important segment of a registrant's business tends to show its materiality."
This ruling will make it more difficult for defendants to dismiss Section 11 or 12(a)(2) claims on materiality grounds. The decision also lowers the threshold for proving materiality by allowing plaintiffs to focus on a single business sector of the issuer, which effectively allows plaintiffs to work with a lower denominator in getting to the 5% materiality threshold.
Landmen Partners, Inc. v. The Blackstone Group, L.P., No. 09-4426, slip op. at 1 (2d Cir. Feb. 10, 2011)