Mervyn King

Law, jurisprudence and courts are challenged to keep up with winds of change

March 2017 User View by Mervyn King, former Judge of the Supreme Court of South Africa and Chairman of the King Committee on Corporate Governance in South Africa

THERE are differences in how materiality is defined by the accounting profession, the legal profession, courts, stock exchanges and regulators. Materiality has been molded over 100 years via legal judgments and court decisions, as well as by accounting standards bodies. Lack of agreement across the Atlantic on what constitutes common international standards for financial reporting has led, among others, to a proliferation in definitions of materiality. It is against this background that as IIRC Chairman I asked the heads of the internationally leading reporting standards bodies to join a discussion under the Corporate Reporting Dialogue. Today they collectively look into overlap and convergence. They’ve come up with an agreed general definition of materiality, and now have a basis from which to tackle more technical matters such as appropriate thresholds to apply in determining materiality.

Convening the Corporate Reporting Dialogue, the International Integrated Reporting Council (IIRC) arranged for among others the International Accounting Standards Board (IASB), Global Reporting Initiative (GRI) as well as the Financial Accounting Standards Board (FASB) and Sustainability Accounting Standards Board in the USA to develop a general definition of materiality which could be applied in both the accounting world and the sustainability world. The definition developed is as follows:

“Material information is any information which is reasonably capable of making a difference to the conclusions stakeholders may draw when reviewing related information.”

In judging on materiality, legal experts and courts consider any public disclosures, not only reports or annual statements as such. They ask what is material to a case issue involved, material to the matter of dispute between two parties, or material to the business of a company. That is different to material matters where an accountant or auditor looks at report preparation or assurance of its material content. Levels of materiality will also differ from company to company. It depends on contextual factors such as industry, market and historical track record of the company.

New information technology and data analytics will help tremendously in improving analysis of data and circumstances relevant to a company. The work gets automated versus being done by young analysts. There is definitely an issue of information overload, and what is reported daily in the media – including social media – is not necessarily the best guide to what is most material to individual companies. But if there is a legal dispute between a company and someone, any public statement will be assessed in the context of determining the relative credibility of two parties involved in a dispute.

In the litigious society that is the USA, much weight is put on use of the term materiality from an evidential point of view. As a result lawyers advise people not to use terms such as materiality outside of their statutory filings. The assumption is that materiality implies clear financial consequences, and the term should not be used loosely, certainly not inconsistently between different types of reports. But more weight should not be given to statutory documents. The question of materiality should be treated on the basis of parity when it comes to reporting on matters which could result in the reader or user drawing a different conclusion from the one reported. It doesn’t follow since the term appears in a statutory document that you should give more weight to it. When you are complying with a statutory requirement there is always the factor of mindless compliance. You don’t apply your mind to the question of what is material or not, and you end up with so-called boilerplate disclosures. Mindless compliance implies there is no application of the collective mind of a Board on the issues involved.

Financial accounting standards recognize that deciding on materiality involves considering not only financial and quantitative information, but also non-financial and qualitative information. Behind a quantitative financial figure, there is lots of judgment, valuation and application of standards to come up with a number that is presented as a fair statement of the financial position of a company. Thus there is a qualitative aspect to the quantitative number. In making those judgment calls managers consider what is significant and what is important in valuing for example a major asset. Eventually the auditor will say I have examined this and believe it is a reasonable conclusion. He gives a reasonable assurance audit of that number. But qualitative judgment calls went into the decision-making process. The financial statement on face of it is quantitative, but there is extensive qualitative reflection underneath it.

From a qualitative judgment point of view, you also have to feed sustainability trends into your assessment of risks. Consider that we now have extinction accounting, applied by for example a food retailer when assessing the consequences of the depletion of bee populations. These include the impact of decreasing pollination for wheat production, implications for supply risks and ultimately for a fair presentation of the financial position of the food retailer. In our resource deprived world, extinction accounting is becoming an important discipline. This includes valuation of Natural Capital and its translation into financial figures. Of course, you cannot monetize everything and you cannot divorce it from the judgmental call being made because a risk has to be accounted for. New research is considering whether we should stop calling things “financial and non-financial”, since the non-financial can easily destroy a company. Maybe we should just refer to “assets and liabilities”.

Over the last decade “non-financial” disclosure requirements have been growing in number. Yet what is required by law or by regulation to be reported is not by definition material. Just the opposite. Regulations and reporting standards are not a constant. They are dynamic, always changing. As you have corporate scandals and failures, new regulations are introduced and add complexity. For many this has become incomprehensible. It may be that some report preparer has applied a requirement, for example a new standard on revenue recognition, but it is a mindless compliance. Legal requirements can result in boilerplate text repeated annually with what is not necessarily material information.

The approach to materiality as interpreted by courts and market regulators are challenged to keep up with the realities of the marketplace and the demands of sustainability. The “reasonable investor” as referred to by the US Supreme Court in its 1976 definition of materiality has in mind an outdated archetype, a rational private individual not very active in seeking to influence the management of companies or holding investments for long-term value. This approach is far removed from the type of public institution today that is an institutional, responsible investor.

Consider that some four decades ago the average holding on a stock exchange was 5-7 years, whereas today it is 5-7 months (see figure below). Investors have become transient. Today we have electronic trading and custodians of shares. Your name as individual shareholder is not even recorded. Your custodian is your asset manager that will vote at an AGM based on the mandate you gave. Furthermore, the vast majority of equity today is held not by individuals but by financial institutions. So we have moved away from looking at the individual shareholders to the great asset owners and asset managers.

The question of responsible investment has therefore become critical in the world of governance today. The Principles for Responsible Investment (PRI) have been agreed to by many of the world’s great asset owners and asset managers involving trillions of dollars of investment. Many countries have introduced their own Codes of Responsible Investment. The PRI requires inter alia due diligence, so that the trustee of a pension fund needs to do due diligence on the investee company and its supply chain. Looking at the investee’s balance sheet, it needs to assess what is regarded as intangible assets and ask why there is a significant difference between market value and book value.

Some expect electronic trading to enhance short-termism dominating decision-making. But consider the position taken by leading investment managers. When last year BlackRock’s Larry Fink sent a letter to the CEOs of the S&P 500, he said before we invest we want to know the long-term business strategy of the target company, knowing if it has a strategy that will maintain sustainable value creation in the long term. BlackRock is aware that the bulk of its payments liability is  over an extended period, and it needs to be sure that the investee company will still be around long term.

In 1976 the profile of shareholders of a listed company in the USA may have shown dominance by wealthy individuals. But it certainly is no longer common today. Consider the presence of pension or superannuation funds that represent pension holders, ordinary citizens like us who are the ultimate beneficiaries. Note also that the 1980s idea of shareholder primacy has become outdated.  Company directors own their duties of good faith, care, skill and diligence to the company as an artificial person, but need to take into account the legitimate and reasonable needs, interests and expectations of its material stakeholders – one of which is the shareholders. In sum, the world looks very different today from 40 years ago.

 

The author can be reached at: mervyn@mervynking.co.za

 

Average stock holding periods in USA, UK and elsewhere over recent decades:

Source: Generation Foundation and KKS Advisors (2014)