Materiality = Economic Impact

According to Second Circuit precedent, for a court to determine on a motion to dismiss in a securities fraud case that the alleged misstatement or omission is immaterial, it must be “so obviously unimportant to a reasonable investor that reasonable minds could not differ on the question of [its] importance.” Judges in the S.D.N.Y. recently have been exploring what “obviously unimportant” means, with favorable results for defendants. (See this post in The 10b-5 Daily for a discussion of the Allied Capital case.)

In re Duke Energy Corp. Sec. Litig., 2003 WL 22170716 (S.D.N.Y. September 17, 2003), involved allegations that Duke Energy had failed adequately to disclose that its revenues were overstated due to “round trip” or “wash transactions,” involving simultaneous sales and purchases of energy at the same prices and in the same amounts. The stock price dropped over the time period that the company made announcements concerning the discovery of these trades. Finally, in August 2002, the company confirmed that it had engaged in $217 million of these transactions.

The court found that the concealment of these transactions could not have been material. An inflation of $217 million in Duke Energy’s revenues over a two-year period amounted to about 0.3% of the company’s total revenues — a total that the court found immaterial as a matter of law. The plaintiffs made two counterarguments that were rejected by the court as insufficient.

First, the plaintiffs argued that the fall in share price after the announcement of the discovery of these transactions demonstrated that they were material to investors. The court found: (a) the plaintiffs’ allegations of a connection between the company’s disclosures and the stock price decline were too vague (really a loss causation argument); and (b) “bare allegations of stock price declines cannot cure the immateriality of an overstatement as small as the one here at issue.”

Second, the plaintiffs argued that the nondisclosure was qualitatively material because it involved illegal activity. The court found that even assuming that the transactions were illegal, the failure to disclose them did “not give rise to a securities claims if their only effect in terms of what was disclosed to the public was a miniscule 0.3% inflation of revenues.”

Holding: Motion to dismiss with prejudice granted.

Quote of note: “Plaintiffs are vague about what constituted this underlying ‘illegality,’ as ‘wash sales’ and ’round-trip trading’ are not necessarily illegal per se. But even assuming they were, illegality of a financial nature (as opposed, say, to rape or murder) must still be assessed, for disclosure purposes, by its economic impact. Otherwise, every time a giant corporation failed to disclose a petty theft in its mailroom, it would be liable under the securities laws.”

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