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What constitutes a “material” omission in securities fraud cases?

The Securities and Exchange Act of 1934 (the Exchange Act) and SEC Rule 10b-5 together supply the statutory and regulatory backbone for many securities fraud lawsuits. Among other provisions, they outlaw statements made in connection with the purchase or sale of a security that omit a “material” fact necessary to make a statement not misleading.

The ban on material omissions tends to strike fear, or at least uncertainty, in the hearts of corporate officers and directors. Generally speaking, companies do not have an obligation to disclose all information that investors might find relevant in deciding to buy or sell shares and other securities issued by the company. But that general principle has limits, and the concept of materiality defines its outer edge.

Here’s a quick review of what it means for an omission of fact to be material in a securities fraud case.

Materiality (sort of) defined

SEC regulations define material information as information “to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to buy or sell the securities registered”.  By design, however, that definition leaves lots of room for interpretation.

Courts interpreting it have emphasized that deciding whether an omission of fact was material requires a fact-specific inquiry that takes into account the total mix of information available to a reasonable investor in making an investment decision. Most of the time, courts leave that detailed inquiry to finders-of-fact — that is, arbitrators, judges, or juries — in securities fraud cases.

A recent illustration of materiality

Rather than relying on a definition alone, understanding what might make an omission material usually requires placing the analysis in context. A recent decision by the Ninth Circuit Court of Appeals in a securities fraud case provides a useful illustration.

In In Re Alphabet, Inc. Securities Litigation, the appeals court considered a pension fund’s claim that Alphabet, Inc., the parent company of Google, had made material omissions of fact in its April and July 2018 10-Q filings with the SEC. Specifically, the fund alleged that Alphabet had discovered cybersecurity vulnerabilities in its Google+ social media platform that it recognized would likely attract regulatory interest if disclosed, but failed to disclose that discovery in its quarterly filings, instead stating that its business had experienced no material change in its risk factors since its prior year 10-K.

A trial court dismissed the pension fund’s claim, finding that the omissions were not plausibly material to a reasonable investor. The appeals court, however, reversed the trial court’s decision and allowed the lawsuit to proceed.  The court noted in particular that Alphabet’s prior year 10-K had generally mentioned cybersecurity vulnerabilities as potential risk factors to the company, and that its executives had made public statements about the importance of ensuring user privacy and data security. In light of those statements, the court found that the alleged failure by the company to disclose the subsequent discovery of potentially-significant vulnerabilities could amount to a material omission supporting a securities fraud claim.

What to remember

The materiality of a fact omitted from a corporate statement on which an investor might reasonably rely is a fact-focused inquiry. Courts will look to a company’s own past statements about risks to its businesses in weighing the materiality of an omission related to those same risks.