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CALIFORNIA CORPORATE & SECURITIES LAW

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 no 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 two pips 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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