October 18, 2016
The Wells Fargo debacle shone a bright light on one of the core aspects of investor relations: materiality. When is something important enough to a company’s business that it needs to tell investors?
Specifically, Wells Fargo did not publicly disclose that the Consumer Financial Protection Bureau and the Office of the Comptroller of the Currency were investigating the bank’s abusive sales practices until the September 8 announcement of the settlement and enforcement action, which included $185 million in fines.
Asked why the investigation had not been disclosed earlier, Wells Fargo Chairman and CEO John Stumpf told a U.S. Senate panel that the matter was “not a material event.”
In hindsight, the matter was about as “material” as an event can get. Through the end of September, the stock lost nearly 10% of its value, or about $23 billion, according to news reports.
And the damage keeps coming. The states of California, Ohio and Illinois, along with Chicago and Seattle, have all announced sanctions against Wells, and other states have said they are reviewing their business relationships with the bank. Three senators have asked the Securities and Exchange Commission to investigate whether Wells violated the laws governing disclosure. And now Mr. Stumpf has retired (without severance) in a management and board shakeup.
Unreliable Rules of Thumb
So where might investor relations thinking have gone wrong at Wells? Perhaps executives relied on the traditional rule of thumb that something has to make up at least a meaningful portion of the company’s business to be considered material. According to that line of thinking, the added revenues from aggressive cross-selling practices were not material because they generated at most a tiny portion of Wells’ business. Even the $185 million in fines was less than 1% of the company’s prior-year earnings.
Another widely used guideline for materiality asks whether a “reasonable investor” would consider the information important enough to affect the decision to buy or sell the company’s stock. Perhaps Wells management was lulled by the fact that investors apparently paid no attention to the December 2013 Los Angeles Times exposé that first brought to light the bank’s “pressure-cooker sales culture.” Wells stock continued to rise right through that news on its way from about $44 per share to a five-year high of $58 in July 2015. I guess they don’t read the L.A. Times on Wall Street.
Clearly, the standard materiality rules failed in this case. So let’s propose three new guidelines that might have better served Wells:
1. If a reasonable investor would consider certain information important enough to affect the decision to buy or sell a company’s securities after that information is reported by the national financial media, then that information is probably material.
2. If a company consistently highlights a metric in the opening remarks of its quarterly earnings call and in its non-deal roadshow investor presentations – as Wells did with its cross-selling performance numbers – then new information that raises questions about the reliability of that metric is probably material.
3. If a metric is cited in the proxy statement as a factor in justifying executive compensation – as cross-selling ratios were in authorizing the $9 million in annual pay and $7.3 million in stock and cash bonuses granted to the head of community banking at Wells in 2015 – then new information that raises questions about the reliability of that metric is probably material.
Although Wells focused on cross-selling, these guidelines would apply to any metric a company might emphasize as a key component of its strategy. The point is to beware of looking at materiality too narrowly and not to rely solely on traditional rules of thumb to determine what information should be made public.
A Bigger Problem Than Materiality
Ultimately, the materiality question is a side issue in the larger story of how Wells Fargo – perhaps the most admired U.S. megabank prior to this debacle – permitted the egregious consumer banking sales practices and then failed to act decisively after they were revealed.
This scandal could have been nipped in the bud. But the bank didn’t seem to have a clue about the scope of the problem. In the two quarterly earnings calls following the Los Angeles Times story, Mr. Stumpf continued to tout the exceptional cross-selling numbers in his opening remarks. And, as recently as the July 2016 quarterly earnings call, he lauded the head of community banking for her contributions to the bank, ahead of her planned retirement at year-end.
Clearly, there are crucial lessons here, not only for investor relations teams, top executives and boards of directors, but also for outside advisors, who need to avoid being so close to their clients that they cannot see the forest for the trees.
Would your company have made the right decision in comparable circumstances?
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