Media reports recently revealed that the U.S. Attorney’s office for the Southern District of New York was investigating 21st Century Fox Inc., trying to determine whether Fox had adequately disclosed settlements of sexual harassment claims brought against former against Fox News Chairman and Chief Executive Roger Ailes. Ailes resigned last summer after former Fox News anchor Gretchen Carlson sued him and Fox for sexual harassment; Carlson’s suit encouraged a number of additional women to come forward also alleging sexual harassment at Fox. Carlson and Fox ultimately settled her claims for a reported $20 million. It was also reported that other women had settled claims for smaller amounts, which apparently led to the current federal investigation. News of the SDNY investigation came out when a lawyer for one of the women currently suing Fox News for harassment disclosed that his client had received a subpoena to testify before a grand jury.
The reported investigation reflects the “when it rains, it pours” quality of securities enforcement. Any time a public company reveals a problem with its business, it has to worry that the disclosure will prompt an investigation by the SEC or a prosecutor (federal or state). Enforcement is attracted by above-the-fold headlines, as seen with the options backdating scandals of a decade ago. Preet Bharara, the current U.S. Attorney for the Southern District, follows a long line of New York prosecutors, state and federal, with a penchant for finding their way into the media spotlight through attention-grabbing prosecutions. Bharara’s campaign against insider trading gave him a long run in the headlines until the Second Circuit threw up a roadblock with its decision in United States v. Newman (PDF: 357 KB).[1] Going after Fox News promises a new round of headlines for Bharara and his team of prosecutors.
Two elements of securities fraud, both notoriously vague, are relevant to the Fox investigation: 1) a misstatement or omission; and 2) materiality. The boundaries of the misstatement or omission requirement are fuzzy because it is hard to predict what will count as a misleading “half-truth” when viewed with the perspicacity of hindsight. In Fox’s case, however, some reports suggest that the company may have labeled the settlement payments as something else, which would make the disclosure an affirmative misstatement.
Even affirmative misstatements must be material in order to be actionable. Materiality doctrine promises predictability because it is an objective standard. Facts are material only if they would be “viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”[2] Evaluations of idiosyncratic investors are irrelevant under this formulation. Moreover, for forward-looking information, the materiality standard has a formulation that appears positively mathematical: probability x magnitude.[3]
One common measure of materiality is the reaction of the company’s stock price. The idea is simple enough: in an efficient market, market prices move only in response to the revelation of new information that causes investors to change their valuation of the company’s future cash flows. The change in the stock price reflects the consensus of investors about what the news means for the company’s prospects. In Fox’s case, that reaction is less than conclusive. The company’s stock price declined as the allegations against Ailes trickled out, finally bottoming out at $23.33. The company’s stock price has recovered post-election and it now trades around $30, around its level before Carlson’s lawsuit came to light. Depending on your view of how rapidly the market digests information that comes out in dribs-and-drabs, either the initial decline confirms that the omissions were material, or the eventual rebound shows that the news was immaterial.
Fox’s decline and rebound highlights the tension between financial economists and lawyers on the question of materiality. The orthodox view of financial economics is that an abnormal stock price reaction is almost dispositive on the question of whether investors deem the information important. Lawyers, and most importantly, judges, are more equivocal. Judges are less easily persuaded by a significant market reaction—or conversely, the lack thereof—as determinative of materiality.
The settlements with Carlson and the other women were unlikely to have had a significant impact on Fox’s bottom line. That quantitative benchmark suggests the settlements are immaterial. But lurking in the news of Carlson’s lawsuit was the possibility that Fox would be forced to change the way it does business, most conspicuously, the prospect that Roger Ailes, the architect of Fox News’ growth, would be forced out, which is ultimately what happened. Depending on Ailes’ contribution to Fox News’ profitability, his potential departure might be a big deal or a non-event for Fox. Ailes’ contribution is one that a financial analyst might be able to assess. But the likelihood of Ailes’ departure, the other factor in the probability x magnitude standard, turned on the extent of the public relations blowback that Fox would receive.
Fox’s profitability depends on its appeal to viewers, but more importantly, the willingness of advertisers to buy commercial time. Advertisers have no interest in alienating potential customers, so the impact of the scandal on Fox depended on the reaction of consumers who might be offended by the revelations of sexual harassment. That reaction might be profoundly unreasonable: it is almost costless to the consumer to register their disapproval by shifting their viewing habits. Predicting whether consumers will do so poses an enormously difficult task for the reasonable investor.
But the task is unavoidable under current materiality doctrine, as illustrated by Matrixx Initiatives, Inc. v. Siracusano (PDF: 196 KB).[4] In Matrixx, the Supreme Court rejected the contention that reports of adverse reactions to the company’s cold remedy were immaterial because the isolated reports were insufficient in number to lead to a statistically significant inference. Because consumers might quickly abandon the cold remedy, even if the available scientific evidence was inadequate to show that it was unsafe, the conclusion of materiality was virtually inescapable in Matrixx. The Fox case appears to be much closer to the line, and correspondingly, much harder to assess. How would consumers (and thus, advertisers) react to the allegations against Roger Ailes? Would the reaction be transitory or sustained? For companies that depend heavily on the good will of consumers, the notion that materiality is an objective standard is largely illusory.
Footnotes
[1] 773 F.3d 438 (2014).
[2] TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).
[3] Basic Inc. v. Levinson, 485 U.S. 224, 238 (1988).
[4] 563 U.S. 27 (2011).
Adam C. Pritchard, is the Frances and George Skestos Professor of Law at University of Michigan School of Law. He is the author, with Stephen J. Choi, of Securities Regulation: Cases and Analysis, currently in its fourth edition.
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