Suyash Sharma and I have a piece in today’s Financial express on SEBI’s new disclosure norms based on materiality:
In June 2023, the Securities and Exchange Board of India (SEBI) introduced extensive changes to the regulatory framework governing disclosures for listed companies through the SEBI (Listing Obligations and Disclosure Requirements) (Second Amendment) Regulations, 2023 (“Amendments”). These Amendments are largely based on the recommendations outlined in three consultation papers released by SEBI between November 2022 and February 2023. The Amendments, introduced a quantitative threshold for determining ‘materiality’ of events/information, which trigger a disclosure requirement once such threshold is met.
Regulation 30 of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“LODR Regulations”) mandates disclosure of material events to the stock exchanges by listed entities. Specifically, Para A of Part A of Schedule III of LODR Regulations (“Para A”) provides a list of events which are deemed material and require disclosure while Para B of Part A of Schedule III of LODR Regulations (“Para B”) specifies events which are required to be disclosed based on the application of ‘guidelines on materiality’. All listed entities are required to formulate a ‘Materiality Policy’ based on the criteria specified in regulation 30(4) of LODR Regulations, which essentially lay the groundwork for the entity to determine materiality of an event/information and whether it would require disclosure.
In the Consultation Paper dated November 12, 2023, SEBI noted that several complaints were being filed against listed entities for non-disclosure of material events and failure to comply with disclosure timelines. Moreover, several other listed entities had themselves sought uniformity in guidance regarding determining materiality and disclosure requirements. There seemed to be a gap in what SEBI intended with respect to the guidelines on determining materiality versus how the entities adopted it in their materiality policies. This led to several regulatory actions against entities for non-disclosure of ‘material’ events which, according to their policy, was not ‘material.’
The Consultation Paper sought to fill this gap by introducing an objective quantitative threshold which would be non-discretionary, based on the value or the expected quantitative impact of the event/information. A combination of the effect of events/information on turnover, net worth and profit/loss after taxes has been envisaged by the Amendments pursuant to the discourse in the Consultation Paper. It states that an event/information, whose value or the expected impact on value exceeds the lower of: 2% of turnover, 2% of net-worth, 5% of the average of absolute value of profit or loss after tax would be deemed material and would require disclosure.
This regulation finds some precedents globally, as countries such as Japan and the UK have quantitative thresholds for events/information, the crossing of which requires a listed entity to make disclosures to their respective exchanges. The quantitative thresholds however vary across jurisdictions, for example, UK has set the limit for ‘materiality’ at variation of 5% to gross assets, profits before taxes, consideration and gross capital. Japanese regulations are very precise, listing down the various numerical thresholds for various events. For example, an event in terms of the Japanese regulation would have to be disclosed- if 3% or more damages is caused to assets in case of natural disasters, 3% compensation is paid out of net consolidated assets in case of a lawsuit, there is a 30% increase in net consolidated assets in case of a merger, etc.
The SEC in the US follows a prescriptive approach as well, by laying down a comprehensive list of events that are presumptively material and require disclosure. However, the definition of materiality in the US has been developed by courts and is not delimited by the notion of the effect on the price of an issuer’s securities. On the other hand, jurisdictions such as the EU and Brazil opt for a more principle-based approach by laying down general obligation of materiality comprising price sensitive information and various other criteria, without specifically describing the types of events that would be deemed material.
It is pertinent to understand that these differences in regulations have evolved due to differences in the characteristics of each market and its legal and institutional history. It may be difficult in determining which approach is objectively better and can serve the investors better. No doubt, the principle-based approach leaves room for entities to exploit the lack of a standard norms and get away with inadequate disclosures under the guise of deeming events immaterial. Stringent quantitative thresholds on the other hand might lead to overregulation and become unnecessarily burdensome on entities in terms of compliance.
SEBI’s Amendments seem to take a middle ground by prescribing a numerical threshold but keeping it broad enough to encompass a wide range of events which could qualify as material. However, it may not completely address the core issue which the regulator was trying to address, which shall be discussed below with an example. If a bright-line test approach has to be followed, perhaps going the route the Japanese regulators took may be worth looking into by providing specific thresholds for various scenarios. This would ensure that the entire process of determining materiality is completely objective in every scenario and there is no room for manipulation, although at the cost of increased compliance.
Circling back to the core issue at the heart of the Amendments, i.e., a standard objective threshold for determining materiality; the ‘expected impact on value’ clause may not sufficiently address it. Considering that entities are required to disclose even those events which may affect the prescribed values, it boils down to subjective analysis as to when an event/information becomes material. To substantiate with a hypothetical: suppose a listed entity ‘A’ is engaged in the construction business and bags contracts which are usually worth INR 30 crores. A is in the final stages of negotiation with the government of India to secure contract worth INR 150 crores to develop metro infrastructure in Mumbai for the year 2024. This contract will likely substantially increase its revenue and profitability and affect the financials enough to be classified as material in light of the Amendments. However, the regulations in Para B specify that any contracts bagged ‘outside the normal course of business’ would have to be disclosed. The question then is whether such a contract would require disclosure? The work may be in the normal course of business for A but the value of the contract and its effect on the financials would be material based on the new norms. It leads to the same issue i.e., subjectivity in determining materiality which the regulators were trying to address, albeit with more complications. The economic cost of non-disclosure versus its benefit has to be considered as well. For events which can substantially alter (positively or negatively) the financials of an entity, the business owners might be willing risk regulatory action if the cost of disclosure far exceeds the cost of non-disclosure.
To summarise, in adopting a balanced approach, SEBI's introduction of quantitative thresholds for materiality may fall short in addressing the core issue. The "expected impact on value" clause introduces subjectivity, leaving room for ambiguity in determining materiality. While the attempt to find a middle ground is commendable, potential challenges suggest that a more nuanced and specific regulatory framework might achieve the intended objectives more effectively. In addition, we should also consider cases where confidentiality is necessary and premature disclosure may hurt, say a potential acquisition. In such cases, US has an informal system of dispensing confidential treatment after a discussion with the exchanges.
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