Avoiding Material Omissions Under the Federal Securities Laws, written by Leonard W. Wang, Esq., Former Assistant Director, Division of Enforcement at the SEC, discusses one of the most challenging problems in the federal securities laws: complying with rules against lying through omission. Lying through omission consists of making statements that paint an incomplete or inaccurate picture, and not revealing other material information necessary to present the entire truth. The federal securities laws require public companies, whenever they speak, to disclose all material information that would be necessary to present the truth entirely.
This duty, which the Portfolio calls the “duty to avoid material omissions,” is found in both SEC antifraud and financial reporting rules. Failure to comply with this duty can, in extreme cases, result in criminal prosecution.
This Portfolio discusses the legal foundations of the duty to avoid material omissions. The duty is worded generally, and contains subtleties that may seem difficult to apply in concrete settings. In order to illustrate the varied applications of the duty, the Portfolio discusses numerous SEC enforcement cases.
First, this Portfolio explains the legal foundations of SEC disclosure requirements, and then traces the development of the duty to avoid material omissions. It then focuses on materiality, the heart of the duty to avoid material omissions.
Drawing upon these cases and other pertinent authorities, this Portfolio explains the conceptual boundaries of the duty and suggests numerous practical guidelines for complying with the duty. It discusses and analyzes the duty to avoid material omissions under the federal securities laws, reviewing crucial SEC source materials including a Staff Accounting Bulletin, SAB 99, and numerous enforcement proceedings.
This Portfolio summarizes and analyzes concepts of materiality found in court cases and SEC materials and, respectively, addresses two corollaries of the duty to avoid material omissions: the duty to correct prior disclosures and the duty to update prior disclosures. It then analyzes numerous SEC enforcement actions that have interpreted and applied the duty to avoid material omissions. Drawing upon the previous sections in the Portfolio, Avoiding Material Omissions Under the Federal Securities Laws suggests practical guidelines for evaluating the materiality of undisclosed information.
Readers should appreciate that this Portfolio is intended first and foremost to provide practical assistance to the management and directors of public companies, and is not meant to be a traditional legal treatise.
Consequently, this Portfolio is written in the vernacular as much as possible, and gives preference to comprehensibility for the layperson over technical legal considerations.
Avoiding Material Omissions Under the Federal Securities Laws has been written primarily to help company managers and directors resolve questions of whether to disclose particular information. Readers are also urged to consult with legal counsel concerning the scope of their company's duty to disclose information.
The concept of materiality plays a critical role in determinations of whether to record particular numbers or other information in company financial statements. In making those decisions, accountants and auditors are required to apply certain tests for materiality that overlap in part with the tests this Portfolio describes. The duty to avoid material omissions, along with other relevant tests, applies to any financial statements governed by the federal securities laws (such as those filed with the SEC).
The Portfolio's worksheets include the full texts of selected SEC releases to which the Portfolio refers and SEC Staff Accounting Bulletins 99 and 108.
Avoiding Material Omissions Under the Federal Securities Laws allows you to benefit from:
This Portfolio is included in the Accounting Policy & Practice Series, a comprehensive series of titles which explain, explicate, and offer commentary on a wide range of accounting and financial management topics, including revenue recognition, income taxes, leasing, business combinations, debt instruments, risk management, internal controls and more.
I. Nature of Duty
B. Scope and Contents of Portfolio
II. Legal Foundations of Disclosure Requirements
A. Line Item Requirements
B. General Disclosure Requirements
2. Antifraud Rules
3. Nonfraud Rules
C. Application of the Duty to Avoid Material Omissions
D. Implications for Principles-Based Accounting
E. Regulation FD
III. Development of the Duty to Avoid Material Omissions
A. Rule 10b-5
1. Adoption of the Rule
2. Ward La France Truck Corporation
a. Facts Leading to Stock Sales
b. Initiation of SEC Investigation
c. SEC's Analysis
d. Emergent Principles
B. United States v. Simon
C. 1984 Interpretive Release
IV. The Heart of the Duty to Avoid Material Omissions: Materiality
A. The Basic Test of Materiality: TSC Industries, Inc. v. Northway.
1. Objective Standard
2. Comparison to Accounting Standard
B. Avoid Numerical Tests: Basic Inc. v. Levinson
C. SEC Staff Accounting Bulletin 99
1. Background and Purposes
2. Key Points
D. Ganino v. Citizens Utility Company
E. SEC Staff Accounting Bulletin 108
F. Limitations of Boilerplate Disclosure
1. Westinghouse Securities Litigation
2. Rubenstein v. Collins
3. Huddleston v. Herman & MacLean, et al.
4. Summary as to Boilerplate
V. The Duty to Correct Prior Disclosures
VI. The Duty to Update Prior Disclosures
C. SEC Rule 14a-9
VII. Application of the Duty to Avoid Material Omissions in the SEC Enforcement Process
A. Materiality Generally in the SEC Enforcement Process
1. In the Matter of Richard P. Scalzo, CPA
2. Microsoft Corporation
B. Cases Applying the Duty to Avoid Material Omissions
1. The Need to Disclose Matters Involving the Survival or Viability of the Company
a. Stansbury Holdings Corporation
b. Dauphin County General Authority
c. Former Kmart Executives
d. Biopure Corporation
e. Former Officers and Directors of Spiegel, Inc.
2. The Truth About Operations and Performance
a. Trump Hotels & Casino Resorts, Inc.
b. Massachusetts Turnpike Authority
c. Charter Communications, Inc.
d. McLeodUSA Incorporated
e. Elan Corporation
f. Craig Scott
g. Former Qwest Communications Executives
h. Time Warner
i. Global Crossing Ltd.
j. The Coca Cola Company
k. Mount Sinai Medical Center of Florida, Inc.
l. Bio One Corporation
m. MBIA, Inc.
n. Tenet Healthcare Corporation
3. Failure to Reveal Improper Accounting or Accounting Error
a. Gerber Scientific, Inc.
b. Warnaco Group, Inc.
c. Fleming Companies, Inc.
d. Dennis O'Connor
e. Gregory A. Brady, William M. Beecher and Reagan L. Lancaster
f. John R. Behrmann
g. Former Bristol-Myers Squibb Officers
h. Martin E. Kenney, Jr.
i. Netopia, Inc.
j. Former Comverse Technology Officers
k. Walid H. Maghribi
l. Steven J. Landmann and Gary C. Gerhardt
m. International Business Machines Corporation
4. Management Integrity
a. Washington County Utility District
b. Former Enron Officers
5. Management Compensation and Benefits
a. W.R. Grace & Co.
b. Tyson Foods, Inc. and Donald Tyson
6. Regulation FD
a. Motorola Investigative Report
b. Flowserve Corporation
7. Causing Violations
b. Example: Ture Roland Fahlin
8. Summary of Enforcement Actions
VIII. Planning Points: Practical Guidelines for Evaluating Materiality of Undisclosed Information
A. General Considerations
1. Basic Elements
2. Materiality Will Be the Crucial Question
3. Avoid Reliance on Quantitative Measures
4. Contingent or Speculative Disclosures
5. Be Candid in Using the Guidelines
6. Application of Guidelines to Misstatements
7. How to Use the Guidelines
B. Planning Point: What If Others Learn of the Information?
1. What would a major shareholder, or creditor, of the company, who is not affiliated with management or any insider, think about the information?
2. What if the disclosure counsel at the company's outside law firm found out?
3. What if the company's auditors learned of the information?
4. What reaction would the SEC staff likely have if they found out?
5. Would a governmental agency be likely to take action if it became aware of the information?
6. Would you be concerned about your employment situation at the company if the information were not disclosed?
7. Would the employment status of a member of executive management of the company come into question if disclosure were made?
8. Would a significant proportion of the company's customers, suppliers or vendors be concerned if they were to learn of the information?
9. Are you tempted to destroy, discard, alter or conceal records relating to the information so that the company's auditors and the SEC cannot find out about it?
10. Do you feel the need to keep dual sets of records in order to keep track of the company's activities and be able to reconcile them with the company's publicly filed financial reports?
11. Have others within the company tried to conceal the information?
12. Consider information relating to debt covenants
13. Consider discretionary dealings with creditors.
14. If a reporter learned of the information, would he or she be interested in writing a story about it?
15. Is the information something in which a stock analyst would be interested?
16. Is the information something that a rating agency would like to know?
C. Pecuniary Considerations
1. Does the information in question make you feel poorer (in the case of negative information) or wealthier (in the case of positive information)?
2. Do you think the company stock's price would change if and when the information is disclosed? If so, by how much?
3. Have others in the company argued against disclosure because they stand to make money or avoid losing money, from nondisclosure? Are you tempted to withhold or delay disclosure for the same reason?
4. Does the information make you want to buy or sell the company's stock or options before disclosure is made?
5. Do you have reason to believe that others in the company who know of the undisclosed information have traded in the company's stock because of the information, or have tipped others who may have traded?
6. If your family or in-laws hold stock in the company, would they be annoyed with you for not tipping them off in advance about the information?
7. If you were making a bid for the company, would the information lead you to consider adjusting the price you would pay for the company or withdrawing your bid?
8. Would disclosure make the company more vulnerable or less vulnerable to an unwanted takeover bid?
9. Would disclosure of the information pressure management and the board to consider strategic change, such as placing the company or a significant part of the company up for sale?
10. Would a labor union representing company employees regard the information as important to ongoing or future contract negotiations?
D. Other Considerations
1. Are there anomalies in the company's sales or shipment of goods?
a. The Coca Cola Company
b. Walid H. Maghribi
2. Is the company having product development problems?
3. Guidance from SAB 99 Concerning Quantitatively Small Items
4. Guidance from SAB 99 and SAB 108 Concerning Multiple Misstatements and the Aggregation of Immaterial Misstatements
5. Does the Omission Significantly Affect the Presentation of Management Compensation or Perquisites?
E. Summary of Planning Points
TABLE OF WORKSHEETS
Worksheet 1 TSC Industries Inc. v. Northway Inc., 426 U.S. 438 (1976)
Worksheet 2 Basic Inc. v. Levinson, 485 U.S. 224 (1988)
Worksheet 3 Ganino et al. v. Citizens Utility Co. et al., 228 F.3d 154 (2d Cir. 2000)
Worksheet 4 In the Matter of The Purchase and Retirement of Ward La France Truck Corporation Class "A" and Class "B" Stocks, 13 S.E.C. 373 (1943)
Worksheet 5 United States v. Simon et al., 425 F.2d 796 (2d Cir. 1969), cert. denied, 397 U.S. 1006 (1970)
Worksheet 6 Public Statements by Corporate Representatives, Securities Exchange Act Release No. 33-6504 (Jan. 13, 1984)
Worksheet 7 In the Matter of Trump Hotels & Casino Resorts Inc., Securities Exchange Act Release No. 34-45287 (Jan. 16, 2002)
Worksheet 8 In the Matter of Massachusetts Turnpike Authority and James J. Kerasiotes, Securities Act Release No. 33-8260 (July 31, 2003)
Worksheet 9 In the Matter of Dauphin County General Authority, Securities Act Release No. 33-8415 (April 26, 2004)
Worksheet 10 In the Matter of Ture Roland Fahlin, Securities Exchange Act Release No. 34-50519 (Oct. 13, 2004)
Worksheet 11 In the Matter of The Coca Cola Company, Securities Act Release No. 33-8569 (April 18, 2005)
Worksheet 12 SEC Staff Accounting Bulletin: No. 99 - Materiality, Exchange Act Release No. SAB 99, 17 C.F.R. Part 211
Worksheet 13 U.S. Securities and Exchange Commission, SEC Staff Accounting Bulletin: No. 108, Financial Statements (Sept. 13, 2006), 17 C.F.R. Part 211
Worksheet 14 SEC v. Tenet Heathcare Corporation, David L. Dennis, Thomas B. Mackey, Christi R. Sulzbach, and Raymond L. Mathiasen, Civil Action No. CV 07-2144 (C.D. Cal. April 2, 2007), Complaint
U.S. Department of Justice Materials:
U.S. Securities and Exchange Commission Materials:
SEC Administrative Proceedings:
SEC Staff Bulletins and Staff Guidance:
SEC Press Releases:
SEC Litigation Releases:
American Institute of Certified Public Accountants
Financial Accounting Standards Board
New York Stock Exchange
The Nasdaq Stock Market, Inc.
American Stock Exchange
Bureau of National Affairs, Inc.
The Wall Street Journal