Article by Lawrence A. Cunningham
Drawing on language in Judge Frank Easterbrook's opinion in Wielgos v. Commonwealth Edison Co., a significant and growing line of federal securities law cases has radically departed from the established standards for determining when a duty to disclose material information arises under the federal securities laws. The new standard, which is simply a term of art drawn from financial-economic theory, is whether information is “firm specific.” Under this standard, a duty to disclose cannot arise under the federal securities laws except with respect to firm-specific information, and information cannot be material under those laws unless it is firm specific. Courts using this firm-specific approach thus ignore carefully developed and abundant precedent defining a litany of duties to disclose, none of which depends on whether the related information is firm specific. They also ignore the conventional approaches to materiality, which investigate whether information would have been important to a reasonable investor in making an investment decision. That approach investigates whether the information would alter the “total mix” of information made available, not whether it was firm specific.
These judicial innovations demand some explanation. It is possible that Judge Easterbrook only intended the firm-specific language to constitute a short-hand way of distinguishing between public and nonpublic information, a conventional way of evaluating whether information is material under the “total mix” test. On the other hand, Judge Easterbrook's use of the term “firm specific” in Wielgos also could be read to imply a discrete standard for defining disclosure obligations, rather than another way of stating the traditional standards. As for the courts following Judge Easterbrook, they could be read as invoking the firm-specific test as a way to refine the test for materiality on the grounds that the test, as currently formulated, is somehow inadequate. If so, these courts would deserve some credit for innovating a sharper way of analyzing difficult questions concerning what information is material under the federal securities laws. Unfortunately, these courts do not articulate their use of the firm-specific standard in this way. Even if they had, the refinement would be ineffective because it not only offers no better approach to the materiality investigation than the conventional approach, but also confuses it.
While many law review articles necessarily conduct retrospective analyses of legal problems by criticizing doctrine and theory that are already fully developed, this Article embraces the more immediate goal of arresting the spread of the line of cases embracing the firm-specific approach, which is deeply infected by doctrinal and etymological flaws. Beyond this immediate aim, the Article also seeks the more subtle objective of identifying and assessing the theoretical underpinnings of the firm-specific approach, which also prove to be deficient. The methodology is a critique of the firm-specific approach using Wielgos and its progeny as the centerpiece.
Part II introduces conventional jurisprudence governing securities fraud actions under Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 thereunder (a “10b-5 action”). It then discusses Wielgos in light of the elements of a 10b-5 action it invokes, the duty to disclose and materiality. The Article attempts to interpret Wielgos in a manner consistent with the existing framework for analyzing these elements of a 10b-5 action, suggesting that Judge Easterbrook did not intend his use of the term “firm specific” to be taken for the innovation later courts have attributed to it. Despite the effort, however, the manner in which the Wielgos opinion ultimately uses the term does constitute a departure from prior case law and therefore could have justified later courts in drawing on it as such.
Either way, as shown in Part III, through unreflective reliance on language in Wielgos limiting disclosure obligations to firm-specific information, cases following Wielgos depart significantly from the conventional standards governing materiality and the duty to disclose set forth in Part II. Part III also reveals additional dangers posed by the firm-specific approach. While courts applying that standard do not define the term “firm specific,” the definition they imply renders the approach inconsistent with the traditional purpose and structure of federal securities laws.
Part III then evaluates a doctrinal defense of the firm-specific approach, which claims that it is useful to counteract perceived overzealous enforcement of some of the federal securities laws by the Securities and Exchange Commission (SEC). This defense assumes that the SEC's approach, epitomized by its Caterpillar enforcement action, will lead to undue civil liability for corporations and their management. That assumption is challenged, however, on the grounds that the firm-specific approach is inapposite to the SEC's position and that, in any case, the concerns about undue civil liability are better addressed by more tailored measures than by innovations like the firm-specific approach.
Part IV goes beyond doctrine and etymology to investigate possible theoretical support for the firm-specific approach. The investigation is motivated in part by the question raised in Part I: Did Judge Easterbrook intend his statements in Wielgos concerning firm-specific information to constitute a new approach to defining disclosure obligations under the federal securities laws, or was he simply expressing conventional doctrine in a new way? Accordingly, the focus in Part IV is Judge Easterbrook's general theory of federal mandatory disclosure and the place of the firm-specific approach within it. In particular, the firm-specific approach draws theoretical support from the claim that federal mandatory disclosure rules should allocate duties to disclose information based on who can provide the information at least cost. The legitimacy of this least-cost-provider rationale depends on the validity of the efficient capital market hypothesis (ECMH). However, because there is now substantial evidence that the ECMH is not an accurate account of public capital market behavior, the least-cost-provider rationale is illegitimate. The firm-specific approach is thus left without a theoretical defense. Regardless of whether Judge Easterbrook intended innovation, this Article condemns the use of the firm-specific approach to define a legal duty to disclose and to establish a legal definition of materiality on the basis of doctrine, etymology, and theory.
About the Author
Lawrence A. Cunningham. Assistant Professor of Law, Benjamin N. Cardozo School of Law, Yeshiva University.
Citation
68 Tul. L. Rev. 1409 (1994)