Litigation: Materiality under the Securities Act

Section 11 of the Securities Act of 1933 imposes liability on issuers and other signatories of a registration statement that "contains an untrue statement of a material fact or omits to state a material fact required to be stated therein or necessary to make the statements therein not misleading." Materiality is satisfied when a plaintiff alleges "a statement or omission that a reasonable investor would have considered significant in making investment decisions." In other words, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by a reasonable investor as having significantly altered the "total mix" of information made available.

That seems straightforward enough, but its application is anything but straightforward. A recent 2nd Circuit decision only bolsters the point, reinforcing the court's long-held view that the materiality assessments must go beyond a formulaic approach and include qualitative factors that are more difficult to measure. In Litwin v. Blackstone Group LP, the 2nd Circuit addressed whether defendant's Registration Statement and Prospectus omitted material information that it was legally required to disclose pursuant to Item 303 of the Securities and Exchange Commission's (SEC) Regulation S-K. Under Item 303, a registrant must "describe any known trends or uncertainties...that the registrant reasonably expects will have a material...unfavorable impact on...revenues or income from continuing operations."

In Litwin, Plaintiffs brought a putative securities class action on behalf of investors who purchased the common units of the Blackstone Group, L.P at the time of its IPO on June 21, 2007. Plaintiffs alleged that Blackstone, and certain of its officers, failed to disclose facts relating to its substantial investment in a monoline insurer that insured collateralized debt obligations (CDOs) backed by sub-prime mortgages to higher-risk borrowers, and residential mortgage backed securities (RMBSs) linked to non-prime and sub-prime mortgages. The district court dismissed the action for failing to allege a material omission. On Feb. 10, 2011, the 2nd Circuit reversed, concluding that the plaintiffs had plausibly alleged that material information was omitted from defendants' initial public offering (IPO) registration statement and prospectus in violation of Sections 11 and 12(a)(2) of the Securities Act.

The court provided a helpful analysis of its materiality jurisprudence. As guidance regarding the proper assessment of materiality, the court observed with approval that the SEC has stated that "the use of a percentage as a numerical threshold, such as 5 percent, may provide the basis for a preliminary assumption that a deviation of less than the specified percentage with respect to a particular item is unlikely to be material. But quantifying...the magnitude of a misstatement...cannot appropriately be used as a substitute for a full analysis of all relevant considerations." Therefore, according to the 2nd Circuit, a court must consider both "quantitative" and "qualitative" factors in assessing an item's materiality.

Prior to its June IPO, Blackstone made at least two significant investments that purportedly caused a dramatic decrease in revenues for the company and its shareholders. In 2003, Blackstone purchased a large stake in FGIC Corp. (FGIC) for approximately $1.86 billion. FGIC is a monoline financial guarantor, and the parent company of Financial Guaranty. Because Financial Guaranty began writing insurance on CDOs backed by subprime mortgages and RMBS linked to nonprime and subprime mortgages, FGIC became exposed to billions of dollars of subprime mortgages at the time of Blackstone's IPO in the summer of 2007. Blackstone's Private Equity segment, which constituted approximately 37.4 percent of its total AUM, reported an 18 percent decrease in revenues by early 2008, most of which directly resulted from its FGIC investments. Plaintiffs alleged that, given Blackstone's significant equity interest in FGIC at the time of its IPO, Blackstone was required to disclose the then-known "trends, events or uncertainties" related to FGIC's business that were reasonably likely to cause Blackstone's financial information not to be indicative of future operating results.

Blackstone also invested approximately $3.1 billion in Freescale Semiconductor, Inc., a semiconductor designer and manufacturer. Shortly before Blackstone's IPO, Freescale lost an exclusive agreement to manufacture wireless 3G chipsets for its largest customer, Motorola Inc., which led to a significant sales decline. Plaintiffs contended that these were "adverse facts that had a materially adverse effect on Freescale's business and, concomitantly, the material corporate private equity fund controlled by Blackstone."

Blackstone argued that the relevant information related to FGIC and Freescale that it purportedly omitted was not material because it was already party of the "total mix" of information available to investors. Although the "total mix" of information may include facts already known or reasonably available to investors, the 2nd Circuit determined that plaintiffs were not seeking the mere fact of Blackstone's investments in FGIC and Freescale. Rather, plaintiffs sought information regarding the future impact of Blackstone's investments - namely, whether the particular known trend, event or uncertainty might have been reasonably expected to materially affect Blackstone's investments. This future impact was not public knowledge and, thus, could not be considered part of the "total mix" of information already available to investors.

The 2nd Circuit also found that, despite that Blackstone's investments in FGIC and Freescale fell below the presumptive 5% threshold of materiality, the district court erred in its analysis of certain qualitative factors related to materiality. For instance, the lower court erred in finding that the alleged omissions did not relate to a significant aspect of Blackstone's operations. Because the company's private equity segment played such a large role in Blackstone's business and provided value to other parts of the business, the 2nd Circuit determined that a reasonable investor would want to know if information relating to that part of the business would have a material adverse effect on future revenues. Indeed, "even 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."

For in-house counsel, the 2nd's Circuit's decision provides a comprehensive roadmap for determining materiality under the Securities Act, and helpful guidance on the types of disclosures that registrants are required to make under SEC regulations. It clarifies the circumstances under which registrants have an affirmative obligation to disclose known trends, demands, events or uncertainties that are reasonably likely to have material effects on its financial condition, and makes clear, in particular, that qualitative assessments (e.g., the importance of the business segment) may well be paramount. For the many inside counsel who manage disclosure issues, Litwin is a good read and a very important case to keep in mind.

Read Matthew Ingber's previous column.

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