Do firms redact information in their SEC filings to protect proprietary information or to conceal bad news?

Under US securities laws, the Securities and Exchange Commission (SEC) regulates and monitors the financial reporting and disclosure of SEC registrants (companies) with the aims of increasing corporate transparency and protecting investors. Nonetheless, companies’ interests are also considered under the securities laws, which allow companies to make confidential treatment requests to redact certain information from material contracts in SEC filings (current reports, periodic reports, and registration statements), if the information is both proprietary and immaterial to investors. Proprietary information means, in a broad sense, that the disclosure of it may reveal the company’s trade secrets or recipes for its profitability, thus harming the company’s competitiveness. SEC Rule 12b-2 defines materiality as any information “to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to buy or sell the securities registered.” Recently, requests for confidential treatment have increased.

In 2019, the SEC adopted new rules that permit registrants to file redacted material contracts without applying for confidential treatment in advance. Before these rules were adopted, registrants (companies) were required to submit a confidential treatment application to the SEC to redact information from material contracts, analyzing how disclosing the redacted information would cause competitive harm. A confidential treatment request is an application made by an SEC registrant to the SEC requesting that certain information contained in a required SEC filing be afforded confidential treatment and thus redacted from the filing and not publicly disclosed for a specified period. When a firm chooses to do so, it simultaneously uploads a redacted filing to the Electronic Data Gathering, Analysis, and Retrieval (EDGAR) website and submits a confidential treatment request as well as a complete (unredacted) version of the filing to the SEC for staff review, which is a private communication initially unobservable to the public. The SEC then assesses the materiality and competitive harm pertinent to the subject matter of the confidential treatment request. If the SEC approves the request, the company can legally redact information for a specified period from the required SEC filing that is otherwise made available to the public.

Although prior studies provide evidence that companies use redactions to protect proprietary information from their competitors, anecdotal evidence suggests otherwise. For example, Tesla, in the two fiscal quarters ending June 30 and September 30, 2017—in which the company lost $955 million—made an unusually high number of confidential treatment requests for the same period, by which it was able to generate almost 3,000 redactions. In another example, TheStreet questioned SolarCity’s redactions in 2015, speculating that the information withheld was unfavorable to investors. In yet another example, Asensio.com questioned Universal Display Corporation’s heavy redaction in its supply and licensing agreements with Samsung, which potentially allowed the company to withhold unfavorable information about its red emitter sales.

Echoing the concerns, the audit report of the Office of Inspector General (OIG) states that the SEC (in particular, the Corporate Division) “is not performing a robust review and examination of many confidential treatment requests…As a result, the OIG believes there is an increased risk that material information to investors may not be disclosed.” These anecdotes make you wonder whether managers redact information from material contracts opportunistically to withhold negative information from investors. This question is particularly important, given that the SEC recently adopted the FAST Act Modernization and Simplification of Regulation S-K, which became effective on April 2, 2019. The new rule permits firms to redact information from material contracts without seeking the SEC’s approval in advance. Under the new rules, SEC staff monitor the redactions using the regular filing review.

Our recent paper “Do Firms Redact Information from Material Contracts to Conceal Bad News?” looks at the incentives to redact information from material contracts. Considering that redactions are also motivated by proprietary cost concerns, we control for the effect of product market and technological competition on redactions to ensure that our results are robust to controlling for proprietary-cost-based motives arising from competitive pressures. Our results suggest that managers redact information from material contracts to conceal bad news, especially when litigation risk does not deter managers from withholding bad news; when CEO’s equity-based compensation provides incentives to maximize their personal benefits; and when external monitoring from institutional investors is not sufficient, consistent with the notion that managers’ tendency to withhold negative information increases due to personal interests and agency conflicts. We also observe redactions to conceal bad news in eight out of nine categories of material contract, suggesting that managers redact unfavorable information from a wide range of contracts.

We next examine the effect of redactions on firms’ stock price crash risk and future performance. To the extent that stock price crashes are caused by bad news hoarding, withholding bad news through confidential treatments will result in greater crash risk. We also expect poorer future performance for firms withholding bad news because doing so allows managers to continue with bad projects. We find that firms redating more information from material contracts have greater stock price crash risk in the following year, and the greater crash risk is driven primarily by redactions made to conceal bad news. We also find that redactions made to conceal bad news are negatively associated with future accounting and stock performance. By contrast, confidential treatment requests made to protect proprietary information are positively associated with future accounting and stock performance. Taken together, our results suggest that not all confidential treatment requests are made to protect proprietary information, and managers redact information from material contracts to conceal bad news.

The results of our study provide important policy implications. The streamlined process of permitting firms to redact information from material contracts without seeking the SEC’s approval in advance may provide more opportunities for firms to conceal bad news. Then SEC commissioner Robert Jackson dissented on the new rule and opined that it “removes our staff’s role as gatekeepers when companies redact information from disclosures”, and “investors, without the assurance that redactions have been reviewed by our staff, will face more uncertainty.” Our results add to this debate by providing empirical evidence that firms redact information to conceal bad news.

Dichu Bao is an Associate Professor at Deakin University

Yongtae Kim is Robert and Barbara McCullough Professor at Santa Clara University

Lixin (Nancy) Su is a Professor and Head of the School of Accounting and Finance at Hong Kong Polytechnic University

This post is adapted from their paper, “Do Firms Redact Information from Material Contracts to Conceal Bad News?” available on SSRN.

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