How to Manage Materiality Decisions

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One of the recurring questions we receive from clients is how to determine when a fact is material for purposes of a bond offering. For many in the municipal securities market, the question of when a fact is material for bond offering purposes is a confusing question. In this article, we attempt to de-mystify this question and also offer some practical tips as to how to answer this critical question.

Under the law, when is a fact material (and when is it not?)?

When a fact is material is fundamental to the federal antifraud laws, which govern offerings of municipal securities. Both federal antifraud laws that apply to municipal securities (Rule 10b-5 promulgated under the Securities Exchange Act of 1934 and Section 17(a)(2) of the Securities Act of 1933) only apply to “material” misstatements of fact and omissions of “material” facts necessary to avoid the statements as a whole from being misleading. In other words, only misstatements and omissions of “material” facts can violate the federal antifraud laws.

“Material” is a pervasively used term in the federal securities laws—from the federal antifraud laws to the more proscriptive requirements of the corporate securities regime. But neither the Securities Act of 1933 nor the Securities Act of 1934 define the term “material” for many uses of the term throughout the statutory and regulatory provisions. Rather, the definition of “materiality” has come from the United States Supreme Court in a couple of key cases that have set forth how the securities laws define materiality. The Supreme Court has determined that a fact is material if there is “a substantial likelihood that the ... fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” (TSC Industries v. Northway, Inc. (1976) and Basic, Inc. v. Levinson (1988)).

While this definition may sound like it provides no help in assisting in making materiality determinations, breaking down the words the Supreme Court uses to define materiality can be more helpful than it seems. Before breaking down the guidance into specific words and phrases, the overall import of the definition focuses on (1) what an investor considers to be important (in other words it is viewed from the perspective and for the benefit of the investor), and (2) the investor’s investment decision (in other words, important for the purpose of making an investment decision and not for other purposes). With that, let us look at some of the specific terms the Supreme Court uses in this definition:

Substantial likelihood

When assessing whether a potential development is material, likelihood matters. One way that practitioners have used to assess the materiality of developments is the magnitude of the development multiplied by the likelihood—in other words, the more financially or operationally significant the potential development the less likely it needs to be, and vice versa. But the critical point is that the question of materiality is not a theoretical question of what is possible but instead is a question that, given the magnitude of the potential development, what is substantially likely.

Fact

While we could read right over the use of the word “fact,” the use of this particular word is more helpful than one might assume. The federal antifraud laws require the disclosure of facts, not opinions. Now, when an opinion is provided in a disclosure document, the federal antifraud laws require the disclosure of any facts that are necessary to avoid the disclosure of that opinion being misleading. But the “materiality” requirement is focused on facts not opinions.

Reasonable investor

As we discuss above, “materiality” is evaluated from the perspective of the investor—not the issuer. However, the law views it from the perspective of what the Supreme Court refers to as a “reasonable investor.” What is meant by this is that “materiality” is viewed from the perspective of a kind of investor that really is a legal fiction—it is viewed from the perspective of an investor who is evaluating the financial and operating condition of the issuer from the purely rational perspective of protecting its investment.

Significantly altered

Oftentimes a question arises if more current financial or operating data than that which is currently included in an offering document is material. Usually the more current data is more up-to-date information of monthly or quarterly data and does not represent a significant change in the information from earlier periods. The materiality requirement applies when this data significantly alters the information that is presented in the offering document—mere ordinary updates are not necessarily material to an investor.

Total mix of information

The “materiality” requirement evaluates all of the information provided to the investor to make its investment decision and evaluates the question of whether a particular fact is material as it fits within the whole of that information. A good example of this is that the fact that revenues are less than projected may at first review appear material but if expenses have been reduced as well, then it may be that the change in the financial condition of an issuer, as a whole, is not material when viewing the information as a whole.

Practical tips on how to approach materiality decisions

Seek to make a good faith determination, not attempt to get the theoretically perfect answer.

When making materiality decisions, it is important to remember that in the municipal securities market (as opposed to public corporate securities offerings) disclosure liability is not strict liability. The Securities and Exchange Commission has predicated a number of enforcement actions under Section 17(a)(2) on negligence, and actions under Rule 10b-5 require a finding of scienter, which essentially involves knowledge of wrongdoing. In other words, usually one of the best ways to address difficult disclosure questions in the municipal securities market is to wrap the decision with appropriate process, including documenting that process, that evidences a good faith determination of materiality. In that case, even if one can argue that the materiality decision is the wrong answer, from a process perspective, the good faith and careful process undertaken would make any finding of negligence very difficult to prove.

Where no disclosure is made, the kinds of materiality decisions we are the most concerned about are the ones where one person within an issuer is aware of the issue and makes the materiality decision about such issue without the assistance of others, and consequently the issue is never raised to others involved in the offering. Where no disclosure is made, the kinds of materiality decisions we are most comfortable with are where the issuer’s internal working group thinks through the question and determines it is not material, and then provides other members of the bond working group with notice of the issue, the issuer’s analysis, and an opportunity to review and assess the decision. Where an issuer can show that it has carefully considered the question and was transparent with the underwriters and other working group members about its decision, it can almost preclude the ability to prove that the issuer acted with unreasonable process. Accordingly, we place a lot of focus on the process by which a materiality decision is made because sometimes there is no clear-cut answer on materiality but there could be a clear cut answer about whether the process was reasonable and in good faith.

Identify and eliminate influences that can confuse the analysis

Isolate bond investors from other financial stakeholders. The municipal securities market can be different than the corporate securities market because the same financial or operating data can have a range of importance depending on which financial stakeholder is evaluating the data. A good example of this is pension plan data. Employees will evaluate pension plan data to evaluate what kind of financial strength is behind their benefit. Taxpayers will evaluate pension plan data to determine how much of their tax revenues are dedicated to paying for pensions and how those payments may take away from other essential services. But investors will evaluate pension plan data just to understand how a governmental sponsor may experience financial stress due to its future contributions. Accordingly, what each of those stakeholders considers to be important in that information will differ. Without realizing that different stakeholders are looking at the same information very differently, materiality can become very confusing because all of these perspectives can become conflated and then this can devolve into an over-disclosure approach where facts are disclosed almost defensively rather than a thoughtful exercise of considering what investors need to know. While this may seem to be a good approach, what happens is that the disclosure tends toward the stakeholders who shout the loudest and may actually end up leaving out what investors need to know.
Isolate materiality decisions for purposes of disclosure from other materiality decisions. Another reason why materiality decisions can be confusing is that the term “materiality” is not just used in the federal securities laws. Materiality is a term of art in a number of areas. In accounting, for example, materiality is applied to a number of accounting decisions and, for governments, can end up with a different result for disclosure in financial statements than what may result in an offering document. In contracts, when a breach is material can depend on the nature of the contract and also can differ from a securities law analysis. Accordingly, part of avoiding confusion when making materiality determinations is to understand other areas where the term “material” is being applied to the same information and be clear about how the securities law will define material in a way that is different than those other areas.

Focus on the cash flow

The heart of material facts when it comes to municipal securities offerings is the cash flow that supports repayment of debt service on the municipal securities. In the end, the vast majority of what investors will consider important for investment decisions in municipal securities are the characteristics of the stream of cash flow that will be used to pay debt service on the municipal securities, and whether the levels of cash flow can trigger defaults under rate covenants and other financial covenants. This requires a complete understanding and view of this stream of cash flow. Here are some elements we recommend considering:

What are the characteristics of the revenues? When evaluating the revenues that support debt service on municipal securities, the kind of fund that supports the municipal securities can result in very different analyses. For example, a general fund of a city or county will tend to have its revenues supported by specific tax revenues whereas a water revenue fund will generally be supported by water rates for delivery of water. Understanding the strengths and weaknesses of that revenue stream will serve as the base for this analysis. Comparing general fund-backed municipal securities with water revenue bonds, tax revenues have strengths when compared to water revenues because tax revenues tend to be generated regardless of what services the issuer provides. However, water revenues can have advantages over general fund tax revenues because they tend to be easier to increase and easier to maintain in proportion to the expenditures of the water revenue fund.
What are the characteristics of the revenues? When evaluating the revenues that support debt service on municipal securities, the kind of fund that supports the municipal securities can result in very different analyses. For example, a general fund of a city or county will tend to have its revenues supported by specific tax revenues whereas a water revenue fund will generally be supported by water rates for delivery of water. Understanding the strengths and weaknesses of that revenue stream will serve as the base for this analysis. Comparing general fund-backed municipal securities with water revenue bonds, tax revenues have strengths when compared to water revenues because tax revenues tend to be generated regardless of what services the issuer provides. However, water revenues can have advantages over general fund tax revenues because they tend to be easier to increase and easier to maintain in proportion to the expenditures of the water revenue fund.
What are the expenditures that are higher in priority or compete with debt service? Like revenues, the kind of expenditures that have higher priority or compete with debt service varies significantly depending on the fund supporting debt service. For a general fund, oftentimes debt service is unsecured and thus no specific expenditure has any priority over any other, which can mean that policy considerations can end up deciding which expenditures will be prioritized. For revenue funds, however, operating expenses are usually senior and capital expenditures are usually subordinate.
What is the historical and prospective balance of the revenues and expenditures? In the end, the most critical question for cash flow is whether the fund has maintained a historical balance of revenues and expenditures and whether the prospective financial condition of the fund establishes a likelihood that the balance will be maintained in the future or whether there are problems that may jeopardize that.
What are the reserves or liquidity of the fund? The next question is what is the margin for error for the fund. Whether in the form of reserves or fund balance or other form, what is the financial liquidity of the fund to absorb unexpected drops in revenues or increases in expenditures.
What are the contingencies? Finally, what contingencies could affect the cash flow? This could be litigation or casualty events—any contingencies that could end up surprising the fund and affecting the cash flow. When all of these factors are developed, then that can create a big picture of what matters to the essential cash flow that will repay debt service and will be needed to comply with any financial covenants such as a rate covenant. The whole picture is needed, however, because each piece will play into the “total mix of information” as the Supreme Court says. If the fund has significant reserves, then it may lessen the concerns about structure imbalances of revenues and expenditures, and weaker liquidity may place higher emphasis on structural balance.

Keep an eye out for outside-the-box ways a fact could be material even when it may not seem like it is.

While the stream of cash flow will represent the heart of the materiality analysis, we should not put blinders on that cause us not to consider other elements that could be material too. Here are some examples:

Even if it does not affect cash flow, would a fact cause the rating agencies to downgrade or otherwise adversely impact the ratings on the municipal securities? At times, the rating agencies will downgrade a specific fund of an issuer due to activities occurring outside of that fund. There are even instances where there is no legal connection between those activities and the likelihood of repayment of debt service. But if an issuer knows that various facts will trigger a rating agency review and it has a likelihood of a downgrade, then that will be important to investors even if the cash flow of the fund is unaffected by the fact.
If the municipal securities are labeled bonds, we should assume that those statements are material even if they do not impact cash flow. If an issuer labels its municipal securities as “Green Bonds” or “Social Bonds,” and highlights for investors that the proceeds of the municipal securities are targeted for a particular purpose. When an offering document holds out an offering in this way, it is highlighting this information for the benefit of investors and to attract investor attention. Just because an inaccuracy in such a description does not go to the cash flow of the fund does not mean that it is not important to investors.

Final Thoughts

In the end, sound materiality determinations come down to two disciplines: first, being intentional on evaluating the question from the perspective of an investor in making an investment decision and, second, using a good faith process for reaching materiality determinations. Accordingly, materiality determinations ought not be perceived as inherently complicated or so ambiguous as to yield not good answers. In fact, it is a question of being intentional and careful like so many other areas of disclosure.