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E-MailAnne Thompson is an Associate Professor of Accountancy and Oktay Urcan is a Professor of Accountancy at the University of Illinois Gies College of Business. Hayoung Yoon is an Assistant Professor of Accounting at Southern Methodist University Cox School of Business. This post is based on their recent paper, forthcoming in The Accounting Review.
Recent research suggests that differences between the economic and legal definitions of materiality can impose adverse consequences on equity investors. We explore this issue in the context of redacted Securities and Exchange Commission (SEC) filings. The SEC requires issuer firms to disclose entry into material contracts within four days of contract signing in an 8-K filing and file the agreement in EDGAR either as an exhibit in an 8-K or in the next periodic filing. Because some material contracts contain proprietary information, firms can redact specific information from material contracts so long as the redacted information 1) would cause competitive harm if disclosed and 2) is immaterial to investors. These joint criteria are inherently contradictory because commercially sensitive information that would cause competitive harm, if disclosed, is likely to be important to an investor’s decision making. However, the SEC rarely rejects companies’ redactions which suggests that most companies meet this joint requirement. Together, these statements imply that the SEC’s threshold when assessing legal materiality may be different from the threshold investors apply when assessing economic materiality.
Using a sample of SEC filings with material contract exhibits between January 2007 and April 2019, we conduct two sets of tests that are designed to assess the implications of non-disclosed information (in this case, redacted information) to the market. First, we compare the speed of the stock market price discovery process over the 253 trading-days following SEC filings with at least one redacted material contract to SEC filings with non-redacted material contracts. If redacted information is economically material to investors, we expect slower price discovery because the redacted information should hamper the informational efficiency of stock prices. We find that price discovery is significantly slower following SEC filings that contain redacted contracts as compared to SEC filings with only non-redacted contracts. To address the concern that redacting firms might be significantly different than non-redacting firms due to unobservable factors, we restrict the sample to firms that redact and focus on variation between filings with redacted versus non-redacted contracts. We find qualitatively similar results in these tests. We then examine the subsample of redacted contracts where SEC required the company to disclose some previously redacted information because the SEC staff judged the information to be material and/or ineligible for redaction (i.e., un-redactions). During the period when the un-redacted contracts are under SEC review, we find that stock market price discovery is significantly slower than non-redacted contracts and is not significantly different than other redacted contracts. After these contracts are un-redacted, stock price discovery increases and is not significantly different than non-redacted contracts. Because un-redactions provide a reliable ex-post indicator that managers redacted material information, this test validates our conclusions that material redactions contribute to slower price discovery.
Second, we examine insider trading activity using short-window event study tests around the material contract filing dates. If the redacted information is economically immaterial, we expect no change in insider trading activity around SEC filings with redacted contracts. We document that insider sales and purchases increase significantly immediately after firms file a material contract with redacted information. Together, our stock price discovery and insider trading tests suggest that legally immaterial redacted information is economically material.
Finally, we examine changes in the frequency and economic importance of redacted information 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. Under the FAST Act, companies are no longer required to petition the SEC for approval and, hence, the SEC has reduced oversight in the redaction process. We use this setting to test how decreased SEC monitoring affects the economic materiality of redacted information. In univariate tests, we document that the frequency of redactions increases by 23% between the pre- and post-FAST Act periods and this increase is driven by firms with high profitability, R&D expenditures, and contract filing intensity. This evidence supports the SEC’s intent to streamline the redaction process to make it easier for firms with high proprietary costs to redact information. We then test whether the economic materiality of redacted information is incrementally larger in the post-FAST Act period. We find that insider trading immediately after filing a contract with redacted information increases incrementally more in the post-FAST period as compared to pre-FAST period and this result is driven by insider sales. Although we find that stock price discovery is significantly slower after filing redacted contracts compared to non-redacted contracts in the post-FAST Act period, this effect is not significantly different between the pre- versus post-FAST Act periods. In sum, we document some evidence that decreasing SEC oversight on the redaction process results in more economically material information being redacted.
Our results support investor concerns that some companies improperly redact material information, as well as Congressional and internal SEC concerns regarding the SEC’s monitoring over redacted information. Our evidence suggests that investors may benefit from stronger SEC monitoring over redactions rather than reduced oversight under the FAST Act. Our findings also imply that corporate boards of directors may wish to consider whether the firm’s insider trading policies should address the information advantage that redaction provides to insiders relative to outside investors. Finally, we contribute to the academic literature by providing novel evidence that legally immaterial information can be economically material to investors, by providing the difference between economic and legal materiality as an explanation for why redacting firms have weaker information environments, and by providing evidence on the effect of the FAST Act.
The complete paper is available at here.
