Materiality and the “Substantial Likelihood Test”
Materiality in is a type of fraud, because it uses informational defects to evade a transaction. A fact is material if “there is a substantial likelihood a reasonable investor would consider important” while deciding something concerning securities. (TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976). The Supreme Courts wanted to make the definition stronger than the mere possibility that an investor would consider it important, they wanted it more than likely that that bit of information would be deemed decisive by the investor. The misinformation must therefore be significant enough to sway an investor’s decision on whether or not they would buy the securities being offered.
A reasonable investor is one who is not an irrational investor, someone who suffers from hindsight bias, over-optimism, availability bias, endowment effects, or just one who follows what everyone else thinks. Most of this disclosure is meant for professional securities analysts who usually combine the new data with their prior knowledge to get a confirmation about the company. In some court cases materiality is a mixture of law and fact, and the judges have to decide whether or not the issue concerns the law or not, assuming the role of the “reasonable investor.”