Last month, after much comment and some controversy, a divided Securities and Exchange Commission promulgated Regulation FD (meaning Fair Disclosure).
While gathering our thoughts on the topic, we could not avoid bemusement at the instant reaction of some of our colleagues who variously proclaimed the end of one-on-one conversations with analysts, the end of commenting on analysts models, the end of participation in broker-dealer sponsored events and indeed the end of guidance from issuers to the analyst community.
The reality is that companies will continue to offer access to the analyst community in exchange for coverage by that community, although guidance relating to earnings will likely be dramatically curtailed. Our view is that most corporate officers have long been law-abiding citizens, and what Regulation FD threatens them with is not a sudden burst of investigative energy from the SEC but rather an enhanced duty of caution in their daily lives - a duty which good counsel, outside directors knowledgeable about and respectful of Regulation FD, and an adroit use of technology can help them discharge.
Regulation FD prohibits selective disclosure of material information to investment professionals while not bothering to define materiality. The Commission's commentary to the regulation does, however, provide a list of topics which are presumptively material and at the top of the list is earnings. The Commission's stark language bears quoting:
"One common situation that raises special concerns about selective disclosure has been the practice of securities analysts seeking 'guidance' from issuers regarding earnings forecasts. When an issuer official engages in a private discussion with an analyst who is seeking guidance about earnings estimates, he or she takes on a high degree of risk under Regulation FD. If the issuer official communicates selectively to the analyst nonpublic information that the company's anticipated earnings will be higher than, lower than, or even the same as analysts have been forecasting, the issuer likely will have violated Regulation FD. This is true whether the information about earnings is communicated expressly or through indirect 'guidance,' the meaning of which is apparent though implied. Similarly, an issuer cannot render material information immaterial simply by breaking it into ostensibly non-material pieces.
"At the same time, an issuer is not prohibited from disclosing a non-material piece of information to an analyst, even if, unbeknownst to the issuer, that piece helps the analyst complete a mosaic of information that, taken together, is material. Similarly, since materiality is an objective test keyed to the reasonable investor, Regulation FD will not be implicated where an issuer discloses immaterial information whose significance is discerned by the analyst." (emphasis supplied.)
These words inspire contradictory reactions in us. We can't quarrel with the Commission's seeking to put an end to the selective guiding of analysts up or down. We are a little surprised, however, that the Commission may now be prohibiting private expressions of comfort with analysts' estimates. It may be that private discussions with investment professionals concerning earnings prospects are now simply taboo. Indeed, a majority of the public companies responding to a recent National Investor Relations Institute survey said they will probably limit their communications with analysts and investors as a result of Regulation FD. Our suspicion, however, is that one-on-one meetings and attendance at investor conferences will still continue, but subject to the new rules of engagement outlined elsewhere in this Corporate Advisor.
Our experience with the SEC has been that the Commission does not bring frivolous proceedings and that appeals to the Commission's common sense - whether in an informal dialogue or in formal written submissions - prove constructive a high percentage of the time. So our disquietude is somewhat muted.
That said, we have two concerns, quite apart from the difficulty inherent in changing the folkways of Corporate America. First, selective disclosure cases will be tempting ones for Commission lawyers seeking quick victories. Unlike revenue recognition cases which require painstaking discovery and a mastery of accounting rules, a selective disclosure case only needs an otherwise unexplainable trading blip which the market surveillance cops are already very effective in identifying. Thereafter, the case is merely what corporate official said what to what analyst when. A potentially easy score.
Second, we want to return to the Commission's quotation we italicized earlier.
"This is true whether the information about earnings is communicated expressly or through indirect 'guidance,' the meaning of which is apparent though implied."
That sentence seems mildly ominous. True, we are already accustomed to seeing people trade and suffer the consequences for shrewd deconstruction of oblique words. The reassurance that "your bunny has a very good nose" prompted a senior banker a decade and a half ago to quickly and profitably close out a position - and to spend 109 days in a Club Fed for the pleasure of having done so.
We also can understand the Commission pursuing an issuer for some officer's intentional winks, blinks, nods or body language which spoke words about that corporate officer's state of mind. Imagine, however, a CFO who in response to an analyst's query "How's the quarter going?" promptly assumes - quite involuntarily - the bereaved air of the nephew who just discovers his well-off maiden aunt has died, leaving everything to her Siamese cats. Suppose further that the analyst observes this change in demeanor and gets his clients out of the shares. Will the Commission bring an enforcement action based simply on the emotional transparency of the CFO?
Polonius instructed his manservant "by indirections find directions out." No community has ever taken Polonius' instructions more to heart than the analyst community. If the SEC takes too seriously its prohibition on "apparent though implied" guidance, private meetings with analysts really will have to cease. We hope the Commission will not push a good point too far.
Note: For additional information on Regulation FD, including a summary of the new rules and practical guidance on living with Regulation FD, please see our September 2000 Corporate Advisor.