Materiality is in the eye of the beholder. In an increasingly disclosure-aware environment, unique angles are emerging that spotlight the effect of information. New research by Accounting Professor Hayoung Yoon of SMU Cox, with coauthors Thompson and Urcan, shows how presumably immaterial redacted information can have material consequences for investors.

The research is novel by focusing on the implications of information that companies do not disclose. Specifically, the SEC requires issuer firms to disclose entry into material contracts within four days of contract signing in an 8-K filing and to file the contract at the same time or in the next periodic filing. However, the SEC permits firms to redact portions of the contract if that information is both commercial sensitive and immaterial. From a legal standpoint, an item is material if there is a substantial likelihood that the omitted information would affect the total mix of information available. On the other hand, economic materiality can be characterized as having an impact on a company’s financial performance and stock price.

“The information that firms are allowed to redact must cause competitive harm,” notes Yoon. “But it should not be material to investors?” she questions. “Commercially sensitive information that would cause competitive harm, if disclosed, is likely to be important to an investor’s decision making.” Recent studies suggest that the differences between the economic and legal definitions of materiality can impose adverse consequences on equity investors.

The research pertains to the information mix of publicly-traded firm disclosures. When firms redact information, they often provide some other form of information. Alternatively, redacted information could potentially come from another source. Some “material” contracts contain proprietary information. Companies can redact specific information from contracts deemed material if the redacted information would cause competitive harm if disclosed and is immaterial to investors, the authors note. Seemingly, disclosure strategies among firms can be varied and nuanced.

Testing the unknowns

Before embarking on this project, Yoon and her co-authors examined cases of redacted information to sort through the nature of redactions. They noted that the redacted information is often performance related. One simple example was an agreement with a buyer specifying prices and quantities of an aloe vera gel product with specifications about the ingredients. “We thought that redacted information could be important information to investors,” says Yoon about their observations.

The authors first looked at how redacted versus non-redacted information impacted stock price discovery. Using a sample of SEC filings with material contract exhibits between January 2007 and April 2019, the authors compare the speed of the stock market price discovery process over the 253 trading-days following SEC filings between companies with and without redacted material contract filings. “Redaction slows down the price discovery process, or how fast investors impound the information into stock prices,” notes Yoon.

Second, Yoon and her co-authorsexamine insider trading activity using short-window event study tests around the material contract filing dates. If the redacted information is economically immaterial, they expected no change in insider trading activity around SEC filings with redacted contracts. They found that insider sales and purchases increase significantly immediately after firms file a material contract with redacted information. Together, stock price discovery and insider trading tests suggest that legally immaterial redacted information is economically material.

Firms can now redact more easily

The study analyzes before versus after the implementation of the 2019 FAST Act Modernization and Simplification of Regulation S-K (hereafter, the FAST Act). Prior to the FAST Act, companies were required to petition the SEC for approval to redact information from material contracts. After the FAST act, companies no longer need to request permission to redact. This made it easier to redact. The frequency of redactions increases by 23% between the pre- and post-FAST Act periods. Firms with high profitability, R&D expenditures, and contract filing intensity are more likely to initiate redaction in the post-FAST period.

In the post-FAST study period, growth firms appear to fit into the relevance of the research given the incidence of firms of high profitability and R&D spending. An example could be a search engine company. If a search engine company arrives at an agreement with an artificial intelligence firm, and disclosing certain bits of information could cause competitive harm, owing to the fact that their competitors would know what they plan, then it could be redacted.

Important to Yoon, the research tests the magnitude of an effect which was not disclosed, ie., a hidden factor. They essentially dig into how to identify information that is hidden which is playing a role in stock price discovery and insider trading behavior. “Testing for this was difficult,” says Yoon, “and a large amount of work was done to develop ways to test this using empirical data.”

A key takeaway was that, in fact, [redacted information] was material. Yoon emphasizes, “We operationalize the economic significance of redacted information using its impact on price discovery process and insider trading behavior.” Now, with increased attention about corporate disclosure post-pandemic, the ease with which companies can redact information may become even more important.

Measuring that which is not revealed—redacted—is tricky.

The paper, “Do companies redact material information from confidential SEC filings? Evidence from the FAST Act,” by Hayoung Yoon of Southern Methodist University’s Cox School of Business, Anne Thompson of The University of Illinois at Urbana-Champaign, and Oktay Urcan
at The University of Illinois at Urbana-Champaign is forthcoming in The Accounting Review.

Written by Jennifer Warren.