The Securities and Exchange Commission (SEC) regulates and monitors companies to increase transparency and protect investors. The securities laws consider the companies’ interests and allow them to make requests to redact certain information in SEC filings and not publicly disclose such information for a specified period of time, if the information is both proprietary and immaterial to investors – proprietary in the sense that disclosure may reveal trade secrets or information about profitability that harms companies’ competitiveness. There has been an overall uptick in confidential treatment requests in recent years.
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, allowing the company to generate almost 3,000 redactions. In another example, TheStreet questioned SolarCity’s redactions in 2015, speculating that the withheld information was unfavorable to investors. In yet another example, Asensio.com questioned the Universal Display Corporation’s heavy redaction in its supply and licensing agreements with Samsung, which potentially allows the company to withhold unfavorable information regarding its red emitter sales.
In a new paper, we look into the incentives of firms to redact information from material contracts and propose that firms redact information also to conceal bad news. To capture bad news possessed by managers, we use residual short interest as a proxy measure because there is significant overlap in managers’ and short sellers’ information, as documented by prior studies. Following Bao, Kim, Mian, and Su (2019), we estimate a residual measure of the short-interest level that is purged of factors that are not reflective of bad news.
To ensure that residual short interest captures managers’ private negative information, we link it to future returns and managerial actions that reflect their private information. We show that residual short interest predicts negative future abnormal returns, suggesting that it indeed captures negative information that is yet to be reflected in stock prices. We also show that residual short interest is negatively associated with net insider buying and stock repurchases and positively associated with material financial misstatements that are subsequently restated downwards. These results validate residual short interest as a proxy for managers’ private negative information, which is reflected in their actions.
Turning to our main analysis, we find that residual short interest is positively associated with the frequency of confidential treatment requests filed in the following quarter. Considering that redactions are also motivated by concerns of disclosure revealing proprietary information to competitors, we control for product market and technological competition. We also find that the positive association is more pronounced for firms with lower litigation risk, higher CEO equity incentives, and lower external monitoring by institutional investors, consistent with the conclusion that managers’ personal interests and agency conflicts increasr their tendency to withhold negative information through confidential treatment requestsWe also find that firms that make more confidential treatment requests have greater stock-price crash risk in the following year, and the greater crash risk is driven primarily by confidential treatment requests made when residual short interest is high. We also find that confidential treatment requests filed when residual short interest is high are negatively associated with future accounting and stock performance, suggesting that redacted information is bad news. By contrast, confidential treatment requests made when residual short interest is low are positively associated with future accounting and stock performance, indicating that such redactions are made to protect proprietary information. 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 in our study have important policy implications given that the FAST Act Modernization and Simplification of Regulation S-K, which became effective April 2, 2019, now permits firms to redact information from material contracts without seeking the SEC’sadvance approval. This streamlined process may provide more opportunities for firms to conceal bad news.
This post comes to us from professors Dichu Bao at Deakin University, Yongtae Kim at Santa Clara University’s Leavey School of Business, and Lixin (Nancy) Su at Hong Kong Polytechnic University’s School of Accounting and Finance. It is based on their recent article, “Do Firms Redact Information from Material Contracts to Conceal Bad News?” forthcoming in The Accounting Review and available here.