Materiality is one of the most hotly litigated issues in securities cases, and expert testimony on this topic can be the difference between winning and losing. In a securities fraud misstatement case, it must be proven that the misstatement or omission would have been “material” to a reasonable investor. Particularly when a case involves complex securities and the marketplace where the securities trade would not be familiar to the average juror, securities litigants are entitled to—and should—use expert witnesses to litigate materiality.
The Materiality Prong Is “Unpredictable” and “Elusive”
Securities laws make it unlawful for any person to “make untrue statements of a material fact or to omit to state a material fact necessary in order to make the statements made in the light of the circumstances under which they were made, not misleading.” Whether the statement is “material” is commonly referred to as the “materiality” requirement, and has always been a vigorously litigated issue throughout securities cases. A misrepresentation satisfies the materiality requirement if there is “a substantial likelihood that a reasonable investor would find the . . . misrepresentation important in making an investment decision.” Misstatements do not satisfy the materiality requirement when they are “so obviously unimportant to a reasonable investor that reasonable minds could not differ on the question of their importance.”
However, there is no hard and fast rule. Courts have deemed materiality to be “one of the most unpredictable and elusive concepts of the federal securities laws.” The truth is that different industries, securities, and marketplaces treat information differently when determining whether to invest. A bond-trader would react differently to a piece of information in a particular industry than a high-frequency trader might in a different industry. For example, in a securities fraud case related to a pharmaceutical company, the Supreme Court rejected a bright-line rule requiring that results of a clinical trial must be “statistically significant” in order to be considered material for purposes of disclosure. The Court opted for a case-by-case assessment of whether an adverse event or trial outcome is material. The Court further opined that “materiality is a fact-specific inquiry, requiring consideration of [the] source, content, and context” of adverse reports.
All securities are not the same. The method by which investors determine price and choose whether to invest is specific to each industry and marketplace. That sort of knowledge is not generally known to the average juror. As such, experts should be utilized to educate the Court and the jury so that they can knowledgeably determine whether materiality has been satisfied.
Using Expert Testimony to Fight Materiality
The Courts have been giving defendants a broad license to use expert witnesses to fight the materiality prong. Particularly when the securities at issue are not sold on widely available public exchanges, defendants are entitled to use expert witnesses to argue that the claimed misstatements fail to meet the materiality requirement. Essentially, these defense experts would testify that an investor in this particular market would not have relied upon the alleged misstatement or omission to influence the investment decision.
In one rather high-profile prosecution, United States v Litvak, the failure to allow portions of the defendant’s expert witnesses’ testimony caused the Second Circuit to overturn portions of the conviction.
In Litvak, the government claimed that a defendant-bond trader had made a number of misstatements while trying to sell residential mortgage backed securities (“RMBS”). The defendant sought to fight materiality by eliciting expert testimony from a witness who was a business school professor and former portfolio manager with “extensive experience in portfolio management in the fixed income asset class.” The defense claimed that the expert was going to testify about how investment managers made these sorts of investment decisions in this market. He would provide background as to how a reasonable investor in that industry would have known that the sort of statements made by the defendant were unworthy of consideration. The trial court precluded the expert from testifying and the defendant was convicted.
On appeal, the defendant argued that the trial court wrongly barred the expert testimony “about the process investment managers use to evaluate a security.” The Second Circuit agreed, holding that the expert’s proposed testimony “would have been highly probative of materiality, the central issue in the case.” The Court noted that RMBS are complex securities that are not traded on a traditional electronic exchange, and that the jury “was likely only familiar, if at all, with securities traded on public exchanges.” In particular, the defendant’s expert should have been able to testify that reasonable RMBS investors would have relied on their own “rigorous valuation procedures” and “sophisticated valuation methods and computer model[s]” rather than listen to what a sell-side broker is saying about the RMBS.
There are however, other prosecutions in which the defense was not entitled to use expert witnesses to fight materiality. This is particularly prevalent when the Court determines that the financial transactions are “simple and easily comprehensible to jurors hearing only lay testimony.” See United States v. Newkirk, No. 14-cr-534-02, 2016 U.S. Dist. LEXIS 54112, at *9 n. 1 (S.D.N.Y. Apr. 19, 2016).
The most notable take-away from the Litvak case is the expansive approach the Court has been taking in determining when the defense is entitled to use expert witnesses to defend the materiality prong. When the securities at issue are complex and are not traded on a traditional electronic market it is increasingly likely that the defense will be entitled to call expert witnesses to combat materiality.
Expert Event Studies Should be Utilized to Litigate Materiality
“An event study is a technique used to analyze the effect of a predetermined ‘event’ on the value of a company’s security.” The materiality prong is a complex issue because the Court and the jury must get into the mind of a reasonable investor and determine what would have been important in the decision-making at a particular point in time. Since Courts refer to this analysis as “unpredictable” and “elusive” and it is inherently subjective, Courts have been looking to experts and event studies for a more objective approach. These studies help the Court determine whether the alleged misstatement actually affected the price and, ultimately, whether a reasonable investor would have viewed the misstatement as material information at that point in time. Event studies have become “an accepted method for the evaluation of materiality” and some commentators say that securities litigants who “fail to offer an event study performed by a qualified expert ha[ve] little chance of prevailing.”
Event studies are typically a statistical analysis that examines an event, such as an alleged misstatement or failure to disclose, and attempts to determine whether it actually affected the price of the underlying security. In this regard, experts are routinely used to empirically analyze the relationship between the disclosure of corporate information and the underlying stock price. Plaintiff and government experts will generally testify that the misrepresentation of non-disclosure caused the price movement (and the attorney will argue that materiality is proved) while defendant experts will typically testify that the price movement was unrelated, the information is already publicly available or that an investor would not have relied upon it (and the defending attorney will argue that materiality has not been established).
Courts have excluded experts from testifying when they have not performed an event study or similar analysis calling the application for them to testify “fatally deficient.” Similarly, Courts have called expert testimony into question because of the “failure to indicate . . . whether [the expert] conducted an ‘event study.”
There have been a number of cases brought by the Securities and Exchange Commission where the defendant prevailed in large part because the expert witness tipped the scales on the materiality prong. In SEC v. Kozvan, the jury held that omissions were not material when the defense’s expert displayed an event study showing that the stock price did not empirically react to these sorts of omissions. One commentator notes that “the SEC is less likely to prevail where a case comes down to a battle of the experts particularly on the issue of materiality.”
Expert witnesses can be used from start to finish in securities litigation. It is critical that the expert used by either side performs an event study to ensure that they will be able to testify in the first place and also to provide credibility and reliability to the testimony regarding materiality.
Which Expert Do I Need?
Since the materiality question is so fact and industry-specific, the expert will have to have experience in the particular industry, security and marketplace at issue. An expert witness who will testify related to the materiality prong must be able to answer the question: what does an investor rely upon when making investment decisions in this particular market?
As recently repeated by the Second Circuit “experts of all kinds tie observations to conclusions through the use of what Judge Learned Hand called ‘general truths derived from . . . specialized experience.’” For example, if the securities at issue relates to a pharmaceutical company the litigant may want to employ an expert who has spent many years investing in pharmaceutical and similar securities. If it is a case related to the bond-market an expert with experience managing and making investment decisions in the bond-market would be helpful. Many experts used for these cases also teach complex securities investments and valuations at leading academic institutions. Whether the case involves stocks, options, bonds, derivatives, mortgage-backed securities or other complex securities or a particular industry such as pharmaceutical, technology, biotechnology or any other, litigants would be well-served to hire experienced experts to inform the Court and the jury about how investment decisions are made in that particular area.
Experts should be employed early and often in this area. If a plaintiff’s lawyer retains an expert to perform an event study pre-litigation it could inform the plaintiff whether or not the case is worth pursuing and also will guide the litigant through settlement discussions. Similarly, event studies can inform civil, regulatory and criminal defendants to evaluate their exposure and to decide whether or not to cut a deal. Materiality is one of the most vigorously litigated securities issues and going to battle without a qualified expert runs the risk of significantly lowering the likelihood of success.
Joseph B. Evans focuses his practice on the defense of Federal and New York State criminal and regulatory inquiries and the prosecution of complex litigation matters. He is an associate at Gage Spencer & Fleming LLP, a trial law firm well known for defending the nation’s most high-profile white-collar criminal cases from inception to verdict.