(CN) – Information that stock brokers leave out of sales pitches are material to determining securities violations in Securities and Exchange Commission cases, the 11th Circuit ruled.
As such Morgan Keegan & Co. may be liable for brokers who did not tell their customers about the about the risks of auction-rate securities.
ARS are securities that pay interest on their face value to investors and can only be redeemed at periodic auctions. If an investor can not sell their ARS at an auction, he continues to receive interest on his investment but can not reclaim his principal until the ARS is sold, if ever, at auction.
The SEC claimed in the Northern District of Georgia that Morgan Keegan brokers misled customers to sell them $925 million in auction-rate securities that became illiquid after the market for the securities collapsed in early 2008. Regulators wanted the firm to buy back all of the ARS it sold between January and March 2008.
Four customers testified that the their brokers told them ARS were “as good as cash,” “completely liquid,” presented “zero concerns and zero risk,” and were “just as good as” an investment in a certificate of deposit insured by the Federal Deposit Insurance Corporation.
A federal judge found that, because the firm made a complete disclosure on its website about the risks of auction-rate securities, there was no institutional intention to mislead investors.
The decision focused on the number of misrepresentations that might have been made, saying that “the oral statements of four brokers out of hundreds would not lead a rational jury to believe that Morgan Keegan, as a whole, misrepresented the risks of ARS investments to its customers.”
In granting summary judgment to Morgan Keegan, the District Court concluded that SEC “must do more than show a few isolated instances of alleged broker misconduct to obtain the relief it seeks.”
But the Atlanta-based federal appeals court reversed Wednesday, rejecting the narrow focus on the number of alleged victims and the emphasis on how the SEC could prove institutional intent behind the brokers’ actions.
Rejecting materiality on the bases of a small number of complaints was too close to the “bright-line” tests the Supreme Court rejected in series of materiality cases, according to the three-judge panel.
Citing the Supreme’s in Basic v Levinson, the panel said the test for materiality is if there is “substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”
This test was applied to the individual investor, and did not place a threshold on the number of investors needed to sustain materiality, according to the unsigned ruling.
Indeed the highest court rejected such thresholds in Matrixx Initiatives v Siracisano in which it said reliance on such thresholds to demonstrate materiality would “artificially exclude information that would otherwise be considered significant to the trading decision of a reasonable investor,” the panel said.
The commission does not need to show such intent to prove that Morgan Keegan tried to mislead all of its customers through public statements, it added.
“The problem for Morgan Keegan is the SEC enjoys the authority to seek relief for any violation of the securities laws, no matter how small or inconsequential,” the decision states.
As a result, the firm “cannot show that its oral misstatements were immaterial merely by showing that those statements were not made publicly.”
Morgan Keegan tried to argue that its written disclosures of the risks of ARS outweighed the oral misstatements.
Though the panel agreed in principle that a written disclosure of risks might outweigh sales pitch omissions, it said circuit precedent “did not allow the written disclosures to trump oral misrepresentations as a matter of law.”
“The oral misstatements must be considered in the factual context of a weak, or non-existent, distribution of the written disclosures,” the decision states
The customers brought forth by the SEC said no one told them about either a Morgan Keenan manual or brochure on ARS risks. Nor were they allegedly aware that the information was available on the firm’s website, four navigational steps from its homepage.
“Because Morgan Keegan’s written disclosures were not given directly to customers but were distributed only in the weak or non-effective manner outlined above, the brokers’ misleading statements and failure to disclose the known liquidity risk of ARS could have ‘been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available,'” the panel concluded.
In remanding the decision to the Northern District of Georgia, the panel made clear that its ruling was “narrow and limited to materiality” and that it did not address whether the SEC had met any other elements of its claims.