Too Big to Disclose
I would like to thank Professor George Georgiev for the expression “Too Big to Disclose”. He uses it in the title to an excellent paper he wrote. The paper focuses on how as firms get bigger, they get to hide more and more relevant information from investors (and also competitors).
What allows large firms to hide relevant information from investors? The reliance on the materiality standard in the disclosure regulations.
So what is the materiality standard. As Professor Georgiev observes:
The classic definition of materiality comes from a 1976 U.S. Supreme Court decision holding that “[a]n omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.” The Court went on to note that “[p]ut another way, there must be a 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.” …
Hmmm…. By design, the materiality standard promotes opacity. It creates a “hurdle” over which a fact must get in order for the fact to be disclosed.
As a practical matter, determining whether any particular piece of information is substantially likely to be important to a reasonable investor and whether it affects “the total mix” is fraught with challenges….
You can say that again!
Certain other features of the materiality standard further complicate firms’ disclosure analysis, as well as the interpretation and use of disclosure by investors. The most prominent of these is the requirement that materiality be evaluated with respect to the “reasonable investor”—an artificial judicial construct….
An artificial judicial construct that doesn’t take into account the “reasonable investor” is a moving target. In 1976, you could think of a reasonable investor as sitting at their kitchen table and reading quarterly or annual reports. In 2018, the reasonable investor is now an asset manager the individual has hired. In 1976, the reasonable investor used a calculator and perhaps called a few friends to help evaluate an investment. In 2018, even sitting at a kitchen table, an investor or their portfolio manager can use their computer and the Internet to access virtually unlimited analytical capabilities to evaluate an investment.
In short, the reasonable investor has become a lot more sophisticated and capable of processing any information that is disclosed. This in turn should lower the hurdle for qualifying for disclosure.
So has the idea of materiality changed to keep pace with the increasing sophistication and capabilities of the reasonable investor? No.
The multiple ambiguities inherent in the materiality standard give large firms opportunities to avoid disclosure. On a conceptual level the larger the firm, the less likely it is that any individual matter would alter the “total mix” of available information. The size and complexity of large firms gives them a much larger “total mix,” which—in turn—sets a very high threshold for what should stand out within this total mix of information and be disclosed. [emphasis added]
Why does the materiality standard even exist?
The materiality standard is designed to limit firms’ disclosure to information that would be of importance to investors, and to prevent the overproduction of information.
A response every card carrying member of the Opacity Protection Team loves.
However, the concept of materiality only applies to the minimum level of disclosure.
The mandatory disclosure requirements provide a baseline for the information all public companies must disclose to investors. Firms are free to disclose other information on a voluntary basis as long as it is not false or misleading. [emphasis added]
The Transparency Label Initiative takes advantage of the fact firms are not restricted by any laws from providing more disclosure. The Initiative asks the simple question “what information does an investor need so they can know what they own”. Frequently, the Initiative finds the information the investor needs is much more than what is actually disclosed.
Let me give you an example: banks.
For an investor to know what they own, they need to know each bank’s current exposure details. Without this information, an investor cannot assess how risky a bank is.
Before you argue with this statement of fact, consider bank examiners look at a bank’s current exposure details to assess the bank’s safety and soundness.
Surely, if looking at a bank’s current exposure details is a necessity for assessing the safety and soundness of a bank, it is also necessary when investors do the same type of analysis when assessing how risky a bank is.
The materiality standard creates opacity. By itself, no individual bank loan or security investment would qualify for being reported. However, it is the individual exposures that must be looked at to understand a bank’s risk.
Please note, I used banks as an example. Roughly 40% of the securities outstanding in the global financial system are opaque despite meeting the required minimum disclosure standards. The information investors need to know what they own isn’t disclosed. A primary reason why the information isn’t disclosed is the materiality standard.
About Post Author
