CLS Blue Sky Blog

The Circularity of Materiality

The following post comes to us from Wendy Gerwick Couture, Associate Professor at the University of Idaho College of Law.  It is based on her recent paper entitled “Materiality and a Theory of Legal Circularity,” which is forthcoming in the University of Pennsylvania Journal of Business Law and is available here.

I will assume that you, as a reader of this blog, are a reasonable investor. As such, would you find a prediction of future growth coupled with cautionary language to be important when making an investment decision? How about a CEO’s statement that the company is “well-positioned” to take advantage of synergies? My guess is “no,” not necessarily because the substance of these statements is intrinsically unimportant, but because you know that these types of statements are routinely dismissed by courts as immaterial as a matter of law. Therefore, you understand that the speakers bear no risk of liability for falsity, rendering it unreasonable for you to rely on statements of this sort.

These simple examples demonstrate that the materiality doctrine, which lies at the heart of securities fraud (as well as other securities liability provisions), has the potential to operate as a self-fulfilling prophecy. The materiality standard focuses on whether there is a substantial likelihood that a reasonable investor would consider information important when making an investment decision. I argue that – just like you did – a reasonable investor would consider prior materiality precedent when assessing whether information is important to his or her investment decision because that precedent affects the reliability of that information. Therefore, an earlier ruling that a certain type of statement is immaterial as a matter of law operates as a self-fulfilling prophecy. Merely by virtue of its effect on reasonable investors, the earlier ruling becomes true.

I label this phenomenon “legal circularity.” In order to place the legal circularity of materiality in context among the various other legal doctrines that share this potential, I propose a two-part Theory of Legal Circularity. First, I propose a Legal Circularity Test to identify potentially circular legal doctrines. Second, I propose a Framework to Assess Legal Circularity, with the goal of providing guidance about whether to embrace a doctrine’s potential legal circularity.

Under my Legal Circularity Test, a legal doctrine is potentially circular if: (1) the legal doctrine incorporates the behavior or attitude of a population or person, either hypothetical or real; and (2) the subject population or person either would (if hypothetical) or does (if real) consider prior precedent interpreting the legal doctrine when choosing said behavior or when adopting said attitude. Materiality, as discussed above, arguably satisfies this test, but materiality is not alone. For example, Professor Michael Abramowicz in his article Constitutional Circularity, 49 U.C.L.A. L. Rev. 1 (2001), has identified other doctrines that likewise operate as self-fulfilling prophecies, such as the takings analysis of whether governmental action has interfered with “reasonable investment backed expectations.” Of course, merely because a doctrine has the potential to be legally circular does not mean that courts should embrace that circularity, necessitating application of my proposed framework.

My Framework to Assess Legal Circularity draws from the rich scholarship on the related but distinct concepts of stare decisis, substantive law heuristics, and precedential herding. Under my framework, courts and scholars should weigh (1) the risk of a “wrong” rule; (2) the effects of greater predictability; and (3) the import of reconceiving the courts’ role. In short, legal circularity is path dependent, operating like a super-charged stare decisis and mimicking the entrenchment effects of substantive law heuristics and precedential herding. Therefore, there is a risk of entrenching a “wrong” rule to the extent that the doctrine embodies intrinsic values rather than merely serving as a coordination mechanism. The greater predictability afforded by this entrenchment has positive and negative effects on the actors operating within the regime, litigants, courts, and the public, and those effects must be weighed for the legal doctrine at issue. Finally, when courts interpret legally circular doctrines, they are moving beyond their role as rule-appliers, or even rule-makers. Rather, by issuing rulings on legally circular doctrines, they are actually entering the fray as active participants who affect the behavior of others. Whether courts should embrace this enhanced role depends on whether there are others with more expertise and less bias who are actively regulating in the area.

Finally, in order to reach a recommendation about whether to embrace materiality’s potential for legal circularity, I apply my framework to the materiality doctrine. First, I argue that the primary function of the materiality doctrine is coordination, thus minimizing the risk of harm from the entrenchment of a “wrong” materiality rule. To the extent that an intrinsically wrong materiality rule were entrenched via legal circularity, the coalescence created by legal circularity would allow the pressure to build, which would perhaps incentivize Congress or the SEC to correct course. Second, greater predictability about the scope of materiality would allow market participants to engage in more value-enhancing transactions, limit compliance and litigation costs, and save judicial resources. At the same time, however, greater predictability would enable actors to fit their potentially harmful behavior into materiality safe harbors. If investors were likewise aware of these safe harbors, the harm could be minimized. But in light of the wealth of recent scholarship on the effect of cognitive biases on investors, it is debatable whether investors are capable of acting on the enhanced materiality guidance afforded by legal circularity. Investor education about the concept of materiality and the current state of the case law would be a partial solution, allowing the benefits of greater predictability to be reaped while at least lessening the harms. Third, courts are not operating alone in this arena. Indeed, the SEC is empowered to regulate in this area and has greater expertise. Yet, despite calls from myriad corners for more SEC guidance about materiality, the SEC has not heeded these calls. Therefore, in the absence of SEC action, perhaps there is a need for an enhanced role by courts in the area of materiality.

In sum, although the results of this framework are mixed, I argue that courts should embrace the legal circularity of materiality. In addition, I hope that scholars in other disciplines will find my Theory of Legal Circularity helpful when identifying and analyzing other potentially circular legal doctrines.

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