The core concepts of securities regulation tend to be similar across jurisdictions. However, there are differences that may seem small and insignificant at first glance but in fact generate the potential for arbitrage by the kind of sophisticated actors that engage in cross-border mergers and acquisitions.
In a recent paper, we shed light on significant differences in the rules governing the definition of what is material information with regard to unfolding events.
Both the U.S. and European jurisdictions treat information regarding “material” events as important to investors and apply insider trading prohibitions when material information remains nonpublic. Hence, “materiality” is a common principle of securities regulation.
Determining whether information is material is one of the most common tasks of corporate officers and securities law practitioners. The determination can be based on precise numerical thresholds, such as the effect of a certain transaction on the annual revenue of the corporation, the value of its asset portfolio, or its obligations. Some information, however, is “softer” but still material. This type of information may include regulatory changes that may influence the future value of the corporation, sea changes in market competitiveness, an illness of the founder of the corporation, the CEO’s stepping down unplanned, and potential exposure to lawsuits due to wrongdoing.
Many material events in the life of a corporation are sudden or unexpected. Securities regulations often require corporations to make immediate disclosure of such events. Otherwise, insiders are required to abstain from trading in the corporation’s securities while the information is nonpublic. This is often described as the disclose-or-abstain-rule.
Determining materiality becomes complicated when the underlying events have not yet occurred but are in the process of unfolding. Even if material information about a future event is not made public, determining its materiality is important. When corporate insiders possess material nonpublic information, they have an unfair advantage over other market players, and therefore are prohibited from trading in the corporate securities in such circumstances.
The U.S. and European Union have different methods of determining the materiality of information about future events. In the U.S., the probability/magnitude test has been developed to determine when information about an unfolding event becomes material (formulated in SEC v. Texas Gulf Sulphur, 401 F.2d 833 (2d Cir. 1968) and entrenched in Basic, Inc. v. Levinson, 485 U.S. 224 (1988)). This test weighs the magnitude of the foreseen event and the probability that it will occur at any given time. In contrast, in the EU, a probabilistic bright-line test applies. According to this test (as formulated in the Market Abuse Regulation (EU) No. 596/2014), information about an unfolding event becomes material when the “more likely than not” threshold is crossed.
The different tests imply that the same information can potentially be classified as material at different times, depending on the applicable rule. As an example, we look at Volkswagen’s emissions scandal, known as “dieselgate”. In this case, the Environmental Protection Agency (EPA) in the United States uncovered in 2015 that Volkswagen manipulated the engines in its diesel vehicles to pass nitrous oxide (NOx) emission tests. The scandal triggered private litigation against Volkswagen, particularly for delaying the disclosure about the consequences of the EPA’s investigation.[1] The case presents a good example of the outcomes resulting from the different regimes and explains why Volkswagen, and other European multinational corporations traded on European stock markets, preferred not to expose themselves to U.S. securities regulation.
The interjurisdictional difference in determining materiality has implications for transnational corporations that may seize regulatory arbitrage opportunities to avoid burdensome disclosure regimes and the associated liability. It has implications also in cases of cross-border mergers and acquisitions of listed corporations. We argue that the interjurisdictional difference undermines cross-border financial investments as well as optimal corporate governance in transnational corporations. Because of these significant implications, it is important to discuss the potential for arbitrage that the disparity in the threshold of materiality creates – especially in the enforcement of insider trading prohibitions. Our theoretical model of the different regimes shows that the European regulation is more relaxed, and consequently European insiders have the opportunity to trade in corporate securities based on their private information, thereby gaining an unfair advantage over uninformed market players.
Therefore, our paper proposes the adoption of a global test for determining the materiality of future events. The proposal is based on the advantages of harmonization in securities regulation across the globe and on the superiority of the U.S. probability/magnitude test over the EU bright-line test. We show that the probability/magnitude test casts a wider net on events of greater material consequence. In this respect, it serves the integrity of the stock markets better by guaranteeing that corporate insiders do not profit opportunistically from nonpublic material information and that top executives focus on maximizing corporate profits rather than on seeking self-serving trading opportunities.
ENDNOTE
[1] Nicola Clark, Volkswagen Shareholders Seek $9.2 Billion Over Diesel Scandal, N.Y. Times (Sept. 21, 2016), https://www.nytimes.com/2016/09/22/business/international/volkswagen-vw-investors-lawsuit-germany.html.
This post comes to us from Ido Baum, a senior lecturer at the Haim Striks Faculty of Law, College of Management-Academic Studies (Colman), and director of the Rina and Meir Heth Center for Competition and Regulation and from Dov Solomon, an associate professor of law and head of the Commercial Law Department and the LL.M. program at the College of Law and Business, Ramat Gan Law School. The post is based on their recent paper, “When Should You Abstain? A Call for a Global Rule of Insider Trading,” available here.