Minding the Materiality Gap between Investors, C-suite, and Board
By Judy McLevey, former Associate Director, The Conference Board Governance Center
Investors, the C-suite and boards have different views about what is, or should be, considered material information. A company’s financial results would be considered material by all parties. Based on SEC rules, companies are required to provide updates on their financial results on a quarterly and annual basis (10-Q and 10-K, respectively) and also timely disclose specified material developments that occur in between quarters (8-K and/or press release). Beyond pure financial information, other examples of material news would include merger & acquisition activity, changes in control and/or management changes, significant product announcements, dividends, etc.
The definition of materiality varies from company to company and industry to industry because it is a fact-based determination that is subject to interpretation. The Supreme Court, SEC, Financial Accounting Standards Board (FASB), international regulators, etc. have all offered their opinions/guidance on the definition of materiality. The SEC, in its Selective Disclosure and Insider Trading Rule, defined material information as something where “there is a substantial likelihood that a reasonable shareholder would consider it important” in making an investment decision. To fulfill the materiality requirement, there must be a substantial likelihood that a fact “would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”
Public company reporting requirements are primarily focused on financial information, so materiality is typically connected to something that would impact financial results (e.g. earnings). Because most investors measure performance in terms of market value, or stock price, anything that could affect the trading in a company’s stock should be viewed as a potential material event. Some issues like litigation activity, regulatory actions, FDA product activity, a data breach, delays or other hiccups in merger approvals and certain other non-financial information can be considered material or develop into a material event Both good and bad developments can be material.
Today, investors are looking beyond pure financial information. Softer (non-financial) information is of increasing importance to investors in helping them to make investment decisions; in particular, how companies have been, or will be, socially and environmentally responsible. Examples of social and environmental initiatives that are important to investors include a very wide array of issues, including recycling efforts, worker safety initiatives, creating more energy efficient products, reducing carbon emissions/footprint, corporate culture, diversity and inclusion initiatives, use of biodegradable parts/products, etc. Many companies have begun to voluntarily publish sustainability reports to share information about their corporate values and governance, and how environmental and social issues are being addressed at the company. However, according to the Sustainability Accounting Standards Board’s (SASB) State of Disclosure Report, a majority of companies used boilerplate or “nonspecific language to describe sustainability topics.”
SEC rules require public companies to disclose the impact of their sustainability initiatives, if they are material to their financial results. But, does this go far enough? Have companies really made the link between their sustainability disclosures and their financial efforts, strategy, risks and opportunities? Investors have been pushing the SEC to adopt rules for sustainability reporting so they can better evaluate companies and their peers in this area, but that does not seem to be in the cards for now. Outgoing SEC Chair Mary Jo White said in her speech at the International Corporate Governance Network’s (ICGN) Annual Conference that there is “more work and thinking to be done on sustainability reporting at the SEC.”
I would argue that the ship has sailed on how sustainability reporting should be viewed by the C-suite and board because “reasonable investors have said they would consider it important in making an investment decision.” If investors are not getting the information they want or need from their portfolio companies directly, they are looking to other sources. Since sustainability data and peer tracking is an emerging area, the data is difficult to gather and the data published by sources external to the company may be inconsistent or incorrect. In the absence of specific information from the company, investors are utilizing external sources to gain sustainability information to help them vet their investment options. Here are a few things companies and boards may want to consider:
- Standard-setting organizations. The Global Reporting Initiative (GRI), SASB, etc. provide frameworks/standards for companies to use for disclosing and/or measuring their sustainability efforts. As an example, the SASB has developed non-financial standards that target material sustainability information for 79 industries. It would seem important for management and the board to be knowledgeable about these industry standards, how they connect to the company’s operations, risks and opportunities, and how the company and its peers are performing against these standards. Investors are already looking at these standards to gain insight on company sustainability efforts and to benchmark companies against their peers. In addition, a number of investors have signed on to the Principles for Responsible Investment (PRI), which provides principles for how investors will incorporate Environment, Social, Governance (ESG) in their investment decisions and how they will engage with their portfolio companies on ESG issues. Are your investors PRI “signatories?” (See Governance Center Senior Fellow Rhonda Brauer’s October 25, 2016 blog post UN PRI: What Will its Second Decade Bring to Global Investors? )
- Big data. Most boards are familiar with looking at “buy,” “sell” or “hold” analyst reports from investment banks as a means of measuring investor sentiment. But there is another type of analyst: one that collects big data around environmental and social responsibility activities. Investors are well acquainted with and actively use analyst reports and data screening tools from MSCI, Bloomberg, Sustainalytics, etc. Boards should ask to see this data for themselves and their peers or get access to a Bloomberg terminal directly to see their ratings. With the 2017 proxy season coming up, staying on top of ESG-related shareholder proposals and other activity is another way to gauge potential issues and/or trends.
- Social media. Companies are looking at social media from the customer’s view and even to gauge employee satisfaction, but they should also be looking at social media through the investor’s eye. These sites can give investors important clues about the softer details about a company like its culture, ethics, diversity initiatives, etc. As one example, some investors have said they may look to Glassdoor for insight into the C-suite and board, the company’s culture, how open management is to new ideas, processes, compliance concerns, etc. Social media comments should be reviewed carefully and management and the board may want to take a look as well.
- Materiality assessment. Sustainability issues are complex and cross over many different departments including HR, Finance, Operations, Sales, IR, Procurement, etc. By conducting a periodic materiality assessment, companies can ensure they have all the information necessary to determine what is material and must be disclosed. As in the Wells Fargo fraudulent bank accounts case, small things like incentives for your sales team, can lead to big things like regulatory actions, litigation, reputation damage and investor dissatisfaction. The assessment should be reviewed with the board so directors can see the data and be aware of the results. This review can be completed internally or through a third party.
Rather than have new rules put in place by the SEC, companies and boards can seize the opportunity to open up and tell their story about how they are looking at their future: how they incorporate sustainability throughout their operations to ensure longevity and/or why now is not the right time for them to do so (e.g. technology not ready, would not be a profitable investment at this time). It’s time to share the strategy, its risks and opportunities, and how sustainability connects to the company’s financial performance.
Judy McLevey is a highly accomplished leader with significant experience in addressing proxy voting, corporate governance, and broader legal and compliance issues. She has been actively engaged with advising clients, creating educational forums and thought-leadership content, and building strong relationships in the governance and ESG community. Previously, Judy was a Vice President of the New York Stock Exchange where she oversaw proxy voting and corporate governance rules, policies, advocacy and regulatory initiatives.
The views presented on the Governance Center Blog are not the official views of The Conference Board or the Governance Center and are not necessarily endorsed by all members, sponsors, advisors, contributors, staff members, or others associated with The Conference Board or the Governance Center.