Regulation Fair Disclosure After Five Years
By Louis M. Thompson, Jr.

The SEC’s controversial Regulation Fair Disclosure rule took effect on October 23, 2000.¹ The proposed rule was challenged by the American Bar Association, the Securities Industry Association, and the Association for Investment Management and Research (now called the Chartered Financial Analyst Institute), among others. Much of the opposition was over the fear that Reg FD would chill the flow of important corporate information to the investment community.

Rather than opposing the proposed rule, the National Investor Relations Institute (NIRI) decided to work with the SEC staff in shaping it to minimize the chill. We proposed what became an extremely important concept that helped accomplish a more free flow of information to the market: specifically, that a fully accessible conference call or presentation before an investment conference or other limited access forum would constitute full and fair disclosure. This eliminated concern that if a company spokesperson were to disclose new material information in such a forum, it might result in an SEC investigation.

Was Reg FD necessary?

NIRI conducted its first corporate disclosure practices survey in 1995, and learned that about 60% of the respondents had provided selective information—largely earnings guidance—to certain financial analysts following the company. While this was not illegal at the time, it certainly was not fair. In 1998, then SEC Chairman Arthur Levitt said it was time to level the playing field and end the “game of nods and winks,” particularly when it came to providing earnings guidance.²

Is Reg FD working?

Evidence suggests that Reg FD is accomplishing what the Commission intended. Today, 97% of the more than 2,200 public companies represented by the NIRI membership continue to conduct one-on-one meetings with analysts and investors, and provide a great deal of information during the course of those meetings. Yet, many of the mutual fund managers complained early on that, while companies continued to meet with them, the “quality of information” had fallen off the charts. Fidelity’s general counsel made that very point in an SEC-sponsored roundtable meeting convened to assess Reg FD after the first six months.³ As a participant in that meeting, I asked if that statement was not code for complaining that companies are not telling all that they used to. In the past, the buy-side would sometimes encourage companies to share information on the grounds that they didn’t publish analyst reports like the sell-side, and information shared with them would be used internally. If Reg FD substantially curtailed the flow of material nonpublic information to selected funds and research analysts, then it has accomplished what it was supposed to—that is, leveling the playing field.

Financial analysts, in particular, look for a competitive edge in their reports on companies they follow, and since the liability for providing material nonpublic information rests on the shoulders of companies, not the analysts, they still try to get companies to give them a sense—one-on-one—of what earnings per share (EPS) are likely to be. After five years, Reg FD is well incorporated into companies’ disclosure policies and practices and the investor relations officers are careful to avoid that trap. Good analysts still can gain a competitive edge through their research without relying on companies to spoon feed them through their earnings guidance process.4

There have been literally tens of thousands of conversations with analysts and investors over the past five years, but there have only been six SEC enforcement cases (discussed below) and one investigative report that did not result in a complaint. Those numbers suggest that Reg FD has not turned into the “information killer” many expected.

What Does Regulation FD Require?

In creating Reg FD, the SEC said that companies could not selectively disclose material, nonpublic information. Instead, companies disclosing material information should file an 8-K for current information, a 10-K or 10-Q for annual and quarterly information, or issue a news release that will be fully disseminated to the public.

The SEC also created two categories of selective disclosure: intentional and unintentional. The first occurs when a spokesperson discloses material nonpublic information in a nonpublic forum and does so either knowing the information was material or recklessly not knowing the information was material. For this violation, there is no cure. For unintentional disclosures of material nonpublic information, once the person realizes such a disclosure occurred, the company has 24 business hours to correct the lapse by issuing the information in a news release or filing an 8-K. This makes it very important for the company official covered by the rule to have the investor relations officer or someone else who is intimately familiar with the company’s disclosure record be present at all meetings with investors or analysts to determine if a disclosure of material nonpublic information was made inadvertently. That way a news release can be issued or an 8-K can be filed promptly.

Companies were quick to learn that webcasting conference calls or presentations at analyst meetings or investor conferences was an insurance policy should an intentional or unintentional disclosure be made, which is not unusual when responding to questions. Companies often have to pay extra to have their presentations webcast, particularly at conferences sponsored by some brokerage firms, but some refuse to present any other way.

The burden for complying with Reg FD, and hence the liability for failure to comply, falls squarely on companies. Because of the Supreme Court’s decision in SEC v. Dirks,⁵ it is difficult for the SEC to pursue cases where members of the investment community use or trade on selectively disclosed information from a company. This decision created the “personal benefits test,” under which a “tippee” is liable only if he knew or was reckless in not knowing that the “tipper” breached a fiduciary duty in selectively disclosing nonpublic information and the tipper received a personal benefit from the disclosure. The facts that have come out from the FD enforcement actions discussed below suggest that insiders were interested in guiding estimates or correcting errors in projections to help the company (and by extension, the shareholders), not for any personal gain.

Reg FD is focused on “material” information, but the SEC has not made the materiality determination easy. The Reg FD adopting release does not define “materiality,” but instead defers to “existing definitions . . . established in the case law.”⁶ However, in Staff Accounting Bulletin 99,⁶ which was intended to help companies determine materiality for information to be included in SEC-filed documents, there is a discussion that says that, in addition to quantitative information, qualitative information also may be material. Moreover, SAB 99 says that stock price movement may be evidence of materiality. This interpretation gives the SEC the opportunity to look at materiality through 20/20 hindsight.

Another factor that makes materiality determinations risky is the mosaic theory—a term that refers to an analyst or investor piecing together information gleaned from various sources. So long as the “mosaic” does not incorporate material nonpublic information from the company, the analyst or investor may come to a material conclusion and use that information or trade on it. As a result, although significant stock price movement or trading volume following a company meeting with analysts or investors may be a red flag, this alone is not sufficient evidence that the company made a material nonpublic disclosure.

The Empirical Evidence

One of the concerns voiced during the comment period after Reg FD was proposed was that it would create greater stock price volatility and a greater spread in earnings estimates. Yet, in a June 2004 article published in the Harvard Business Review, New York University professor Baruch Lev explained that fuller disclosure was related to narrower bid-ask spreads of stocks (implying a lower cost of capital), as well as lower volatility in the company’s stock price.⁸

In a 2002 study entitled “Regulation FD and Market Behavior around Earnings Announcements: Is the Cure Worse than the Disease?,” the researchers said that Reg FD appears to impair the ability of the market to reach a consensus on earnings estimates, although the accuracy of the current quarterly earnings forecasts seems unaffected.⁹ Importantly, the authors found that concerns that Reg FD would decrease the quality of information were unfounded. They said the rule seems to have increased the quantity of information available to the public while demanding more effort and struggle from investment professionals to forecast future results.

A 2001 study entitled “Open versus Closed Conference Calls: The Determinants and Effects of Broadening Access to Disclosure” found that open conference calls were associated with higher stock price volatility. That suggests that individual investor access to the calls changed the amount of information and/or consensus in the market, though it was possible that individual investors over-reacted to the information they heard. Interestingly, the authors cited evidence of a significantly higher percentage of small trades for companies that webcast their conference calls than those that only made their calls available over the phone.¹⁰

Another impact of Reg FD according to a 2004 Wharton study was reallocation of information processing resources on the part of sell-side firms. Specifically, small firms lost, on average, 17 percent of their analyst following, and large firms gained, on average, a seven percent increase in their analyst coverage. However, the larger firms were twice as likely to make voluntary preannouncements of earnings than were the smaller ones. Companies that avoided making pre-announcements and waited until the end of the quarter to tell investors that their results were different than what analysts expected saw higher forecast errors and greater volatility.¹¹ In other words, Wall Street does not like surprises!

The Enforcement Actions

Again, the SEC has found actionable violations of Reg FD only six times in the past five years. The six enforcement actions were against Raytheon and Secure Computing in 2002, Siebel Systems in 2002 and again in 2004, Schering Plough in 2003, and Flowserve in 2005. There also was an investigative report, from 2002, focused on Motorola, that did not result in an enforcement action. So, what can we learn from these cases?

Raytheon

In the first case, Raytheon’s CFO conducted the company’s annual meeting with analysts in January 2001 and gave annualized earnings guidance. When the analysts’ estimates came out, the CFO realized they had straight-lined their estimates over the four quarters. He went back to most of them to explain that the results would be back-end loaded and that they should take their earlier estimates down. Telling analysts one-on-one that their estimates were not in accord with the company’s projections was a violation of Reg FD. While the analysts’ revised estimates were not significantly lower than what they had previously reported, the SEC said that the additional information the CFO provided was clearly material and sufficient evidence of a rule violation.

Siebel Systems I

In the first case against Siebel Systems in 2002, the SEC alleged that CEO Thomas Siebel, in an investor conference, made statements that were more optimistic than what the company had said publicly. Those statements were followed by significant trading activity on the part of those attending the meeting.

Schering-Plough

In 2003, the SEC brought a case against Schering- Plough and its then Chairman & CEO Richard Kogan for allegedly providing material nonpublic information in a series of closed meetings with significant institutional investors. During these meetings, the SEC claimed that Mr. Kogan had noted that sales of Claritin were declining and that the decline likely would affect results for the quarter. He also allegedly disclosed that there were indications that the results for 2003 would significantly decline. Although Mr. Kogan was accompanied at the meetings by his senior vice president for investor relations, they did not issue a news release containing this information because they probably believed it was already in the marketplace in some form. The SEC contended that Kogan’s statements were more negative than what the company had said publicly.

Based on Kogan’s information, two firms the CEO had met with on the first day sold more than 10 million shares each over the next three days, accounting for a 17% decline in the company’s stock price and more than four times the normal trading volume. Still, the company did not issue a news release.

Several weeks later, the company held a meeting for roughly 25 analysts and portfolio managers where Mr. Kogan said, among other things, that 2003 earnings would be “terrible.” Finally, that evening the company issued a news release providing earnings guidance for the remainder of 2002 and 2003 that was materially below the analysts’ consensus estimates, and with regard to 2002 was materially below the company’s own prior earnings guidance. By that time, it was too late to address the CEO’s disclosures in the earlier private meetings.

What made the Schering-Plough case significant was the SEC’s contention that, “through a combination of spoken language, tone, emphasis, and demeanor, Kogan disclosed negative and material nonpublic information regarding Schering’s earnings prospects.”¹² This alarmed many lawyers, who wondered if the SEC was now going to become the “body language cop.”

Ultimately, Schering-Plough was required to pay $1 million and Mr. Kogan agreed to pay $50,000. The investor relations officer was not cited in the case.

Flowserve

In 2005, the SEC brought an action against Flowserve Corp. that has caused companies to significantly revise their disclosure practices related to reaffirming public guidance in private meetings.

Flowserve had issued annualized guidance in January 2002, publicly revised it downward in July, again on September 27, and once again in a news release on October 22. These revisions represented a 30% decline in EPS estimates since the beginning of the year. On November 19, 2002—just 42 days before the end of the fourth quarter and the calendar year—Flowserve’s CEO Scott Greer and the vice president for investor relations Michael Conley met with analysts from four investment and brokerage firms. According to the SEC, at one point in the meeting, when an analyst asked about the company’s earnings guidance for the year, “[n]either Conley nor Greer gave the response required by the Company’s policy that earnings guidance was effective at the date given and would not be updated until the company publicly announced the updated guidance.”¹³ In addition:

Conley did not caution Greer before Greer answered the analyst’s questions. In fact, Conley remained altogether silent. Instead, in response to the question, Greer reaffirmed the previous guidance issued on October 22 and provided additional material nonpublic information. Having heard the exchange between Greer and the analyst, again Conley was silent and did nothing to explain Greer’s statements. Conley also failed to reiterate the Company policy as to earnings guidance.¹⁴

The day after the meeting, one of the analysts who attended issued a report to the investment firm’s subscribers saying that Flowserve reaffirmed its October 22 guidance, which appeared to be good news considering that EPS estimates had been on a continuing downward course. Two days after the meeting, Flowserve’s closing stock price was 6% higher than the previous day’s closing price, and trading volume was approximately 75% higher. Recognizing this trading activity, Flowserve issued an 8-K acknowledging that it had “reaffirmed its full year 2002 estimated earnings per share.”

What is interesting about this case is that only one of the analysts attending the meeting picked up on the significance of Mr. Greer’s reaffirmation of EPS guidance and used that information for the firm’s subscribers. Yet, the SEC contended that Mr. Greer had intentionally disclosed material nonpublic information or was reckless in not knowing it was material.

As mentioned earlier, this case has caused many companies to re-examine their disclosure policies on reaffirming EPS guidance, whether it is quarterly, annual, or both.¹⁵ In a March 2005 NIRI survey, 93% of the respondents said they will publicly update their EPS guidance when there are material changes.¹⁶ When Reg FD was first issued in 2000, then SEC general counsel David Becker participated in a conference call discussing the rule sponsored by the Business Roundtable and the American Society of Corporate Secretaries. During the Q&A, Mr. Becker was asked how far into the quarter company could reaffirm privately its EPS guidance without that becoming a material disclosure. He said as lawyer he did not like to draw bright lines, but that much after mid-quarter, a company probably would have better indication of how the quarter was going and reaffirmation then might be considered new material information.

That answer caused many companies to adopt the practice of issuing mid-quarter updates on EPS guidance through a news release or a fully accessible conference call. Now, as a result of Flowserve, a number of companies will not reaffirm EPS guidance privately. If asked “Are you still comfortable with your earlier guidance?” their practice is to respond “This is what we said on (date).” Some companies will reaffirm their earlier guidance privately, but not much more than a week beyond a public announcement. A few companies have adopted the practice when they are going on the road for a series of investor meetings of issuing an 8-K with the most current guidance so they can refer to the public document when asked about projected EPS. By issuing an 8-K in advance of the trip, the company, in effect, pre-empts the question.

In the Flowserve case, the company was fined $350,000, and Mr. Greer consented to a $50,000 civil penalty. Mr. Conley was not fined but was cited for not intervening when Mr. Greer responded to the analyst’s questions.

From the investor relations perspective, this case clearly says the SEC expects the investor relations officer to ensure company officials comply with the rule and the company’s disclosure policies. In other words, the investor relations officer should be the company’s “chief compliance officer” for Reg FD.

Siebel Systems II

In the second case against Siebel, the SEC alleged that CFO Kenneth Goldman, in two 2003 private meetings with investors, provided material nonpublic information that was subsequently used for trading by a number of those in attendance. The SEC also charged senior vice president Mark Hanson, who at the time was in charge of investor relations, with violating his obligation to maintain adequate disclosure controls to ensure the company’s compliance with Reg FD—particularly since the company was under a cease and desist order from the first case.

Siebel Systems was the first company cited for violating Reg FD to challenge the SEC in court. In responding to the SEC’s suit, Siebel Systems argued that Reg FD was unconstitutional on First Amendment grounds, among other things, and that the SEC lacked authority to adopt the rules. These arguments were supported by the U.S. Chamber of Commerce, which filed an amicus brief supporting Siebel’s defenses.

On September 1, 2005, Judge Daniels of the Southern District of New York dismissed all six causes of action asserted by the SEC against Siebel.¹⁷ The court did not rule on the constitutional arguments.¹⁸

Judge Daniels’ decision was characterized in the media as a strong rebuke of the SEC’s enforcement of Reg FD. In reaching the decision, the court said Mr. Goldman’s four challenged statements during the 2003 investor meetings were not materially different from what had been previously disclosed by the company and did not alter the total mix of information available to the reasonable investor. Moreover, “Regulation FD was never intended to be utilized in the manner attempted by the SEC under these circumstances.”¹⁹ The court criticized the SEC’s use of the regulation “in an overly aggressive manner.”²⁰ For example:

[T]he SEC has scrutinized, at an extremely heightened level, every particular word used in the statement, including the tense of verbs and the general syntax of each sentence. No support for such an approach can be found in Regulation FD itself, or in the Proposing and Adopting Releases. Such an approach places an unreasonable burden on a company’s management and spokespersons to become linguistic experts, or otherwise live in fear of violating Regulation FD should the words they use later be interpreted by the SEC as connoting even the slightest variance from the company’s public statements.²¹

The decision cites the SEC’s statements in the Reg FD proposing release about the regulation’s potential “chilling effect,” in that “corporate officials (might) become cautious in communicating with analysts or selected investors,” especially when these communications take the form of “unrehearsed question-and-answer sessions, and responses to unsolicited inquiries.”²² The SEC noted in that same release that it was “mindful of the potential burdens of requiring instant materiality judgments to be made by those put in a position of responding immediately to questions.”²³

The SEC’s complaint alleges that soon after Mr. Goldman’s private statements, Siebel’s stock price rose significantly and trading surged, suggesting that Mr. Goldman disclosed information that was both new and material. Citing United States v. Bilzerian, Judge Daniels wrote, “Although stock price movement is a relevant factor to be considered in making the determination as to materiality, it is not, however, a significant factor alone to establish materiality.”²⁴

Conclusion

The court rejected the SEC’s claims that Siebel Systems lacked the necessary controls and procedures to avoid selective disclosure of material, nonpublic information because it ruled that what the CFO said was not material.²⁵ While this may have been a legal technicality, we believe the SEC still views the investor relations officer as the chief compliance officer” for Reg FD. This means having written disclosure policy, briefing spokespersons before meeting with analysts and investors as to what is on the public record, debriefing them if they are unaccompanied by someone familiar with the company’s disclosure record, and conducting educational sessions on the rule’s compliance requirements.

Will the Siebel decision cause companies to relax their vigilance over complying with the rule? Probably not. Reg FD’s requirements are fully engrained in companies’ disclosure policies and practices. However, company spokespersons may be able to sleep better at night knowing that their words used in private meetings will not be parsed with what has been said publicly.

There remains a concern that a meeting with investors may prompt a major investor to buy or sell a company’s stock based on the mosaic concept or because the meeting altered the investor’s level of confidence or discomfort with a CEO’s vision for the company or the investor’s perception of the CEO’s ability to deliver on that vision. Such a decision may have no relationship to specific information presented in the meeting or nonverbal language,²⁶ but merely the investor’s own conclusions.

The investing public would be well served if the SEC were to delink the materiality discussion in the adopting release from SAB 99, which emphasizes the subjective nature of materiality decisions. This bulletin is a staff opinion and has not gone through the administrative rule-making process. Materiality decisions are sometimes difficult to make, particularly in spontaneous situations. The basic definition from TSC Industries v. Northway that, within the total mix of information, information that would cause the reasonable investor to make an investment decision is “material,” is guidance enough without introducing the notion that information that may move the stock price also may be material.

The basic premise of Reg FD—to level the playing field in terms of material information that investors have access to if they so chose—serves investors well. And, for the most part, the SEC seems to have been prudent in pursuing possible violations. Perhaps Judge Daniels’ decision may bring the SEC back to where it said it would be five years ago—not pursuing close call cases on materiality judgments made in situations where one has to make a snap decision before responding to a question in a private meeting.

After five years, one would be hard pressed to say that Reg FD has not accomplished the SEC’s goal to level the playing field by providing investors and analysts equal access to new material information. Whether investors seek access to that information and how they use it is their decision. The public company’s obligation is to make the information available, and there is ample evidence that corporations have done this well with very few exceptions.

NOTES

1. SEC Release No. 33-7881 (Aug. 15, 2000), available at www.sec.gov/rules/fi nal/33-7881.htm.

2. Remarks by Chairman Arthur Levitt, “The Numbers Game,” September 28, 1998, available at www.sec.gov/news/speech/speecharchive/1998/spch220.txt.

3. Comments by Eric Roiter, Regulation FD Roundtable amended transcript, pp. 224-25, available at www.sec.gov/news/studies/regfdconf.txt.

4. A March 2005 NIRI survey found that 29% of public companies no longer offer earnings guidance.

5. 463 U.S. 646 (1983).

6. SEC Release No. 33-7881, supra note 1, Section II.B.2.

7. Staff Accounting Bulletin 99 is available at www.sec.gov/interps/account/sab99.htm.

8. Baruch Lev, “Sharpening the Intangibles Edge,” Harvard Bus. Rev., June 2004, 109, 115, available at http://pages.stern.nyu.edu/~blev/docs/Sharpening%20the%20Intangibles%20Edge.pdf.

9. Warren Bailey, Haitao Li, Connie X. Mao and Rui Zhong (2003), “Regulation FD and Market Behavior around Earnings Announcements: Is the Cure Worse than the Disease?,” Journal of Finance, 2487-2514.

10. Brian J. Bushee, Dawn A. Matsumoto, and Gregory S. Miller, “Open versus closed conference calls: the determinants and effects of broadening access to disclosure,” Journal of Accounting and Econ., Vol. 34, Jan. 2003, 149-180, available at www.sciencedirect.com/science/article/B6V87-47JBCYV-9/2/bb9f666d7da8d44461c2e5e2bc8d8907.

11. Armando Gomes, Gary Gorton, and Leonardo Madureira, “SEC Regulation Fair Disclosure, Information and the Cost of Capital,” March 29, 2004, available at http://fi nance.wharton.upenn.edu/~rlwctr/papers/0413.pdf.

12. SEC Release No. 34-48461 (Sept. 9, 2003), Section III.A., available at www.sec.gov/litigation/admin/34-48461.htm.

13. SEC Release No. 34-51427 (Mar. 24, 2005), at 3, available at www.sec.gov/litigation/admin/34-51427.pdf.

14. Id.

15. When proposing Reg FD, the SEC staff was very much focused on the issue of earnings guidance. Of the items listed in the adopting release as material issues, EPS guidance was number one. See SEC Release No. 33-7881, supra note 1, Section II.B.2.

16. See NIRI Executive Alert, March 30, 2005, “NIRI Issues 2005 Survey Results on Earnings Guidance Practices.”

17. SEC v. Siebel Sys., Inc., No. 04 CV 5130 (GBD) (S.D.N.Y. Sept. 1, 2005).

18. Columbia University law professor John Coffee, who fi led an amicus brief supporting the constitutionality of Reg FD, was reported by Dow Jones Newswires as saying, “The issue of constitutionality is still out there, and a judge is going to have to face it.” By not doing so, Coffee said this court had “avoided the hard issue.” For more on the constitutionality of Regulation FD, see “Regulation Fair Disclosure and the First Amendment,” in this issue of Wall Street Lawyer.

19. Siebel Systems, supra note 17, at 15.

20. Id. at 23.

21. Id. at 16.

22. SEC Release No. 34-42259 (Dec. 20, 1999), Section II.B.2, available at www.sec.gov/rules/proposed/34-42259.htm.

23. Id.

24. Siebel Systems, supra note 17, at 21.

25. Id. at 26.

26. “Although Regulation FD pertains solely to disclosure of information, the challenged communication need not be an expressed verbal or written statement. Tacit communications, such as a wink, nod, or a thumbs up or down gesture, may give rise to a Regulation FD violation.” Id. at n. 14.

About the Author

Lou Thompson (lthompson@niri.org) is President & CEO of the
National Investor Relations Institute.