My Crypto Lawyer Sec Speeches Cryptocurrency The Art and Science of Materiality

Good morning. Thank you all for being here. Before I begin, I would like to remind you that my views are my own as a Commissioner and not necessarily those of the Commission or my fellow Commissioners. I am happy to report, and you are all undoubtedly happy to hear that I will never have to give that disclaimer at another SEC Speaks again.

Since we last met at this event nearly a year ago, the Commission has been hard at work, taking actions both large and small, to fulfill our mission. Among other things, the Commission has been focused on providing crypto clarity and facilitating capital formation, two areas in particular need of Commission attention.

Today, however, I want to discuss a different topic—the limits of our disclosure rulemaking authority. Authority should be front of mind for all regulatory agencies in a landscape that has been reshaped by Loper Bright,[1] Cornerpost,[2] and other important Supreme Court decisions. The SEC should pay particular attention to this topic because the graveyard of rules vacated or remanded by courts is filling up fast.[3] Understanding—and remaining within—our statutory boundaries is an essential element of good regulatory work and part of our constitutional duty.

Before turning to the limits of the Commission’s authority, humor me by considering this question: How would you describe the Mona Lisa to a person who has never seen it before? A half-length portrait of a woman? Wouldn’t you need to add that her smile is slight and her eyes seem to follow you wherever you go? But is that description sufficient to convey what the Mona Lisa is? Probably not. What else do you need to say? You might want to reveal that the artist was Leonardo da Vinci. Perhaps you would explain that the subject’s gaze is off-center and that she stands in a three-quarter profile with her right hand resting on top of her left. You also may need to note her resemblance to contemporary depictions of the Virgin Mary.[4] What about the background—a debatably imaginary landscape that was anomalous for portraits at the time?[5] And perhaps you would mention the modest dimensions of the portrait, a fact that has jarred many Louvre visitors over the years?[6] You also might want to reveal that the subject of the painting may be Lisa del Giocondo, a Florentine woman of the late 15^th and early 16^th centuries.[7] I could keep going, but you get the point. Describing a work of art requires choosing which among a large body of facts to convey. Knowing when you have described something adequately is difficult. And even if you believe you have described something adequately, your audience might disagree.

At the SEC we deal with public companies, not paintings, and financial statements, not brushstrokes. Nevertheless, we encounter the same problem. We tell public companies to describe themselves. One could say a lot of things about a company to describe it, but what type of description accurately captures a public company’s essence? More precisely, what should the Commission, as a regulator, mandate that companies disclose about themselves?

In assigning you the task of describing the Mona Lisa, I left out an important guidepost: I did not tell you who your audience would be. I mentioned only that the person to whom you were describing the painting had never seen it. You probably assumed that you were being asked to convey the painting’s essence to an average person with an ordinary interest in art. Your description might have changed if you were speaking instead to an art historian working on a book about cultural context or craquelure,[8] an archivist for whom special elements in need of preservation would have been most interesting, a reader of the Da Vinci Code curious about what the painting purportedly hides rather than what is in view,[9] or a climate protestor who needs information about how to best aim her pumpkin soup at the painting.[10] If you are going to succeed at the mission of describing the Mona Lisa, you need to know to whom you will be describing the painting.

Similarly, if public companies are making disclosures, they need to know who the intended audience is. And the SEC, as crafter of disclosure mandates needs to know too. Only then will the disclosures meet that audience’s need. Congress did a better job than I did when I assigned you the Mona Lisa task; Congress told us to whom securities disclosures should be aimed: investors.[11]

Not only did Congress identify investors as the intended audience for public company disclosures, but Congress also gave examples of the type of disclosures this economic-return-loving and risk-sensitive audience needed. I reiterate that Congress focused its statutory assignment to the SEC better than I did my artistic assignment to you. For example, disclosure required by Securities Act section 7(a) is enumerated in Schedule A, which contains 32 unique items that constitute the information a registration statement should contain.[12] Schedule A focuses on providing investors with the essential facts of the counterparty, management of the issuer, and the price of the securities being sold.[13] Similarly, Section 12 of the Exchange Act requires disclosure by companies that, among other things, register securities on a national exchange. Those disclosure requirements cover topics such as the fundamental nature of the business, its financial condition, and its securities.[14] Congress sometimes permitted the Commission to add to the statutorily mandated disclosures, but the authority always had strict limits, and any disclosure under the securities laws should serve a fundamentally economic purpose.[15] Andrew Vollmer explained that the statutes “limit[] the SEC’s power to issue disclosure rules to specific types of information closely related to the disclosing company’s value and prospects for financial success.”[16]

The statutes’ emphasis on financial matters focuses the Commission’s efforts in a way that is consistent with the needs of its investor audience. But what is an investor? The dictionary tells us that an “investor” is “one that seeks to commit funds for long-term profit with a minimum of risk.”[17] An investor then—whether an institutional investor or a member of one of the nearly sixty percent of American households who are investors[18]—is someone who cares about economic returns and risk. The pursuit of risk-adjusted economic returns is the common thread running through an otherwise diversely motivated population. Knowing that investors, despite the many other things that matter to them, all share an interest in risk-adjusted economic returns guides our disclosure mandates. The Commission’s disclosure work should focus on, as Professor Sean Griffith puts it, “investors qua investors.”[19] As Griffith explains, “[u]nderstanding financial return as the core concern of investors clarifies the limits of the SEC’s authority to regulate for the purpose of investor protection.”[20] The “reasonable investor” who shows up in the Supreme Court’s classic materiality cases has her eyes trained in an unwavering Mona Lisa like stare on risk-based financial returns.[21] Commissioner Roisman put it this way: “while any given shareholder may have bought securities for reasons other than or in addition to making money, it seems clear that a ‘reasonable investor’ is someone whose interest is in a financial return on an investment.”[22] While it is not unreasonable to consider non-economic factors when investing, a person is an investor because she does consider economic returns. She may be thinking about other things too, but the common element of investor status derives from her consideration of economic returns. Fulfilling our “foremost”[23] policy objective, protecting investors, requires us to ensure that investors have access to material financial information.

Companies are free to disclose information to satisfy the non-economic interests of investors and non-investors, but the Commission is not free to mandate such disclosures unless Congress expressly tells us to do so. Congress generally keeps the Commission focused on serving “investors qua investors.” That limited mandate focuses our discretionary disclosure efforts solely on material information.

Just as some in-person Mona Lisa viewers balk at its diminutive size, past colleagues, law professors, and comment letter authors look askance at materiality constraints on SEC disclosure authority. Advocates of broad disclosure authority point to references in Section 7(a) of the Securities Act and Section 12(b) of the Exchange Act to “necessary or appropriate in the public interest or for the protection of investors.”[24] This broad language, they contend, reflects a Congressional delegation of “the [difficult] task of keeping up with the rapid evolution of financial markets and of regulating those markets to a specialized agency—the Commission.”[25] Congress cannot delegate without bounds, and the Supreme Court has made clear that “public interest” has to be read in the context of our mission.[26]

“Public interest” and “investor protection” have specific meanings derived from the statutory context of the Securities Act and the Exchange Act. Divorced from their context and from the textually based purpose of the securities laws, those words would empower the SEC to be the only regulator in town; we could use disclosure mandates to shape corporate behavior in areas like employee and customer rights and environmental and social practices. Hence, no matter how broad the language, it never extends beyond our mandate. The Commission stated as much in 2016 when it said that: “disclosure relating to environmental and other matters of social concern should not be required of all registrants unless appropriate to further a specific congressional mandate or unless, under the particular facts and circumstances, such matters are material.”[27] In doing so, it echoed the Commission’s 1975 “view that the discretion vested in the Commission under the Securities Act and the Securities Exchange Act to require disclosure which is necessary or to consider appropriate ‘in the public interest’ does not generally permit the Commission to require disclosure for the sole purpose of promoting social goals unrelated to those underlying these Acts.”[28] Bernard Sharfman describes the phrase “in the public interest” as “an empty shell of a policy objective, a non-ascertainable standard when standing alone that does not provide an agency with guidance on its mission or a reviewing court the boundaries of delegated authority that it can use in its review.”[29] The “ascertainable standards” with which that shell must be filled, argues Sharfman, are two “policy objectives”—“[i]nvestor protection and promoting efficiency, competition, and capital formation”—and one “soft” policy constraint—materiality.[30]

Whether one thinks of them as policy objectives or directives, investor protection and promoting efficiency, competition, and capital formation may be in tension at times, but also can work in tandem. The second directive derives from the National Securities Markets Improvement Act (“NSMIA”). NSMIA directed the Commission, when making a public interest determination, to consider, “in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation.”[31] Professor J. W. Verret makes the point that an immaterial disclosure requirement would have trouble “surviv[ing] the kind of cost-benefit analysis contemplated by” NSMIA.[32]

NSMIA makes clear that costs matter, but mandatory cost consideration is also baked directly into the Commission’s investor protection objective. Disclosure demanded by a subset of investors hits the pocketbooks of all investors in the company. Costs include not only the time of the lawyers and accountants to prepare the disclosures, but also the time and attention of company personnel devoted to tracking, verifying, and reporting information, and the potential litigation and competitive costs of making the disclosure. Forced disclosures can substantively change how corporations behave.[33] They also can empower people who seek to harm a corporation.[34] The Commission needs to be aware that demanders of disclosure may not be acting in the best interests of the reasonable investor.[35] As Professor Griffith notes, “[p]rotecting investors qua investors means protecting them from the concerned citizens” and “from groups of investors (even a majority group) with opposing interests.”[36] So even if information is material, mandating disclosure of it may not be consistent with our statutory obligations if the direct and indirect costs (borne by investors) of producing it outweigh the benefits to investors of consuming it.

If we are taking our statutory obligations seriously, why would the SEC, of its own volition, mandate disclosure of information that is not material? By definition, immaterial information costs more to produce than it is worth to the investors for whom it is being produced. If information is not material to the reasonable investor the resultant investor protection benefit is de minimis.

For materiality to be an effective check on impermissible disclosure mandates, we have to treat it with respect. First, materiality determinations require judgment by a company, its lawyers, and its auditors. Investors, regulators, and courts will continue to scrutinize those determinations and, at times, take issue with them. Regulators should not substitute their judgment for companies making materiality judgments in good faith. We cannot short-circuit that company-specific judgment with one-size-fits-all prescriptive rules on all manner of topics. Second, materiality modifiers do not cure prescriptive rules. In fact, materiality qualifiers in rules are often definitionally discordant with our statutory understanding of materiality, as happened in the climate rule.[37] Third, we should guard against what Meredith Cross calls “fuzzing up materiality.”[38] “Materiality” is used for reporting in other contexts, but it does not necessarily mean the same thing that it does under our securities laws. That definitional slippage complicates materiality analyses under securities law. Fourth, straining or ignoring materiality could turn us from a disclosure regulator to a substantive regulator. Commissioner A. A. Sommer explained fifty years ago, when the Commission was under pressure to expand its disclosure mandates: “[T]he value of the concept of materiality derives from its very breadth, imprecision, and defiance of exact definition. It reflects the complexity of human affairs, the multitude of situations in which human beings find themselves involved and the multiplicity of relationships that they create.”[39] But he also cautioned:

It is extremely important to keep in perspective what the disclosure documents filed with the Commission and circulated to investors are supposed to be. If the enforcement of the disclosure laws becomes in effect a substitute for the enforcement of other substantive laws, then I would suggest that the Commission will have been diverted from its true mission which is to provide information to investors about matters that are likely to impact the future prospects of the corporation, as well as historical information.[40]

A deeper commitment to disclosure rules that enable reasonable investors to obtain the material information they need in pursuit of economic returns will help us stay within the lane Congress set for us. Limits to authority may seem like unwelcome constraints for a regulator. I find them useful. They help us to shepherd our resources well. The most valuable of those resources is our brilliant and talented staff. If the Commission directs the staff to work on things outside the SEC’s authority, they have less time to work on the important mission Congress entrusted to us. Moreover, a successful legal challenge would eliminate any benefits of the work. Empowering our staff to write and enforce sensible rules within our grant of authority is the best way to steward their time and to protect investors.

Let me end where I started—with a disclaimer: While I certainly did not address all the arguments in this debate, I hope you, the reasonable audience, are satisfied that I hit a few of the material points.