The “Treat all items as folders…” preference is perhaps a little vague as to what it does. I think it is because the concept itself is unfamiliar to most people. What precisely defines treating everything a a folder? That is an unusual concept, when taken out of context. The ability to place documents beneath documents will probably be a pleasant surprise to most, but connecting that ability between this phrase might not be made.
Despite all of that, the wording probably should at least be changed to “Treat all items as groups…” since that is the terminology used everywhere else.