Materiality and Social Change: The Case for Replacing the Reasonable Investor with the Least Sophisticated Investor in Inefficient Markets

The current materiality standard for federal securities fraud is a mid-twentieth-century construct that fails to accommodate certain twenty-first century realities. This Article argues that its reach should be restricted to preserve it for the many circumstances in which it continues to function well. The current standard measures materiality from the standpoint of the reasonable investor, a savvy person who grasps market fundamentals. This standard has a fatal flaw: its inability to protect unsophisticated investors who are duped by implausible falsehoods in inefficient markets. This flaw can no longer be ignored given Internet and telemarketing securities fraud and its many unsophisticated, elderly, and immigrant victims. In recent SEC and Justice Department actions against the perpetrators, courts have conceded the implausibility of the falsehoods but have nonetheless found them to be material. While commendable as investor protection, these decisions threaten the very concept of the reasonable investor. This Article proposes an alternative materiality standard for courts to apply in inefficient markets. The alternative standard replaces the reasonable investor with the least sophisticated investor, a construct modeled on the least sophisticated consumer from federal consumer law. In exchange for lowering the required level of materiality, the alternative standard raises the required level of scienter. The trade-off between lowered materiality and heightened scienter finds support in tort law, long a wellspring of federal securities fraud jurisprudence