Assessing Materiality in the Disclosure of Financial Information

The recent financial downturn raised concerns about the materiality of information on financial risk exposition. A wave of litigation has risen, where plaintiffs argue that public companies did not disclose appropriately their exposition in different types of financial instruments, including Mortgage Backed Securities (MBS), Credit Default Swaps (CDS), and Currency Derivatives Contracts (CDC).Regulators, either in choosing when to pursue the enforcement of securities regulations or in deciding how to issue new regulation, must analyze what of those claims are legitimate. The underlying reasoning in these complaints is that, since the losses originated in these financialinstruments turned out to be so large, the companies clearly understated the risk in previous financial reports and prospectuses for new emissions.In this document we first consider to with extent the assessment of materiality of financial information could be plagued by a hindsight bias. After acknowledging that there is a high risk of overstating materiality ex post facto, we propose a standard in assessing materiality in similar cases. Regulators and judges should evaluate what was the scenario by the time companies issued financial reports and prospectuses, looking for empirical evidence of the probability distributions.Furthermore, from the defendants' perspective, the mere claim that a large number of companies failed to anticipate the crisis is not enough in assessing what was the scenario before the losses occur. Most of the reasoning in repeals to the complaints just enumerates a number of seemly related cases, to make the point that any alternate scenario was unforeseeable. Objective information in every contentious financial instrument and business strategy is available from a fairly large number of sources, so regulators and judges should use them when assessing materiality in these cases