After Regulation FD: Talking to Your Constituents

n August the SEC issued new regulation FD, which will redefine how companies and their senior executives interact with analysts and the public in disclosing material information. The regulation (Fair Disclosure, one of three new rules set forth in SEC release “Selective Disclosure and Insider Trading” nos. 33-7881 and 34-43154) took effect in October despite pleas from several industry groups to delay its implementation. Coming to terms with regulation FD and how it will affect a company’s relationship with its analysts has become a priority for CFOs and corporate spokespeople. Because this regulation affects how companies communicate with market professionals and the investing public, it is important for CPAs to know the rule’s components and implications.

REGULATION FD’s IMPACT

One of the reasons behind the SEC’s adoption of regulation FD was the cozy relationship that some analysts shared with corporate management in order to deliver accurate earnings forecasts. The SEC was aware of the cat-and-mouse games that some corporate executives played with analysts as the latter looked at a company’s performance based on earnings reports. The commission expressed concern that investors were at a disadvantage if they lacked direct access to analysts’ conference calls and corporate officers.

With regulation FD, the commission is attempting to level the informational playing field by barring companies from releasing market-sensitive information to Wall Street insiders before announcing the news to the general public. Basically, corporations whose senior executives provide market-moving information to a few professionals must make the news public at the same time for intentional disclosures, or promptly for unintentional disclosures. The regulation is designed to address the problem of selective disclosure made to those who might buy or sell the stock based on the information or advise others to do so. (See “Highlights,” JofA, Oct.00, page 8 and the SEC Web site, www.sec.gov . )

Will regulation FD really address the risks of leaks? W. David Malone, CFA with FinArc, LLC, an investment management firm in Newton, Massachusetts, thinks not. In his view the high-risk areas of leaks do not spring from company discussions of earnings with their analysts but rather involve insider trading violations which are addressed by other federal securities laws. He believes that “increased scrutiny of what companies can or cannot communicate will decrease the amount of information provided to the public and analysts alike. Security prices will be driven lower because of higher volatility of expected earnings as the question and answer sessions in conference calls will be abbreviated and provide less insight of future expectations. Over the next year company communication will be worse than before regulation FD, as this regulation effectively handcuffs public companies in disseminating future earnings information to the public and to analysts. Nothing will be disclosed (by corporate executives) unless the lawyers review it.”

WHAT TO DO?

It will be interesting to see if predictions of “chilling the information flow” become a consequence of the regulation, or if the controversial rule actually scores a victory for the small investor. So what are regulation FD’s implications for analyst conference calls? At this stage companies are wary of discussing the new rule and are in a period of adjustment as they try to sort out the best approach to take.

Learn the facts. CPA Vernon Brannon, CFO of HLM Design, Inc. in Charlotte, North Carolina, a company that provides architectural, engineering and planning services, says the first step is to learn how to handle regulation FD’s requirements. Company employees received training about the regulation from attorneys from the SEC and private practice on the regulation’s practical applications. “We have always had tight controls on what gets communicated. That will serve us well. We will have a written plan that will dictate the procedures that will be initiated, if necessary. We have hired no special consultants to deal with regulation FD; we don’t foresee hiring any additional personnel, and other than the cost of training, and potentially issuing additional press releases, we don’t anticipate having a major expenditure as a result of this new regulation,” notes Brannon. As for whether regulation FD has affected the rules in dealing with analysts, he says, “We will not give any information to analysts that is not historical.”

No change. At Pfizer Inc., a global pharmaceutical manufacturer headquartered in New York City, regulation FD will not have much impact. Margaret M. Foran, vice-president, corporate governance, says, “For Pfizer, regulation FD has not been earth-shattering. We’ve always had a robust earnings press release that provided a forecast, and that was given to the public. Along with that release we had a Q&A that provided investors with detailed specific information. Also, we’ve Webcast our analyst conference calls for a while, so we’re in pretty good shape for FD.” Foran adds, “For other companies, the impact of FD will result in ‘more companies putting out more public information so they won’t be selectively-disclosing.’”

Pfizer shareholders are made aware of conference calls and Webcasts through press releases, the company Web site and media newswires. Pfizer’s CEO, the president and chief operating officer, the CFO and the vice-chairman are always present during analyst calls.

Consult attorneys. Nancy Pierce, treasurer of Carrier Access Corp. in Boulder, Colorado, is watching to see how other companies handle compliance with the regulation and sees practical problems in its implementation. “In the past, you allowed analysts to participate in your general conference calls,” she says. “You would talk about the successes of the past quarter, technology directions for the company, the drivers that helped you achieve your results and any trends that might affect your financial performance in the upcoming quarter. Regulation FD now requires that the general conference call be open to the public. Does this require immediate, live audience access? How do you get the information to millions of investors? And who is going to absorb the cost?” These are new questions for some individuals who work with corporate disclosures; the answers will come over time as they become familiar with the new regulation. It is safe to say, though, that a company’s successful compliance will require the shared efforts of CFOs and CEOs along with legal departments or outside counsel and public and investor relations departments.

Because regulation FD is new, attorneys are just beginning to advise their publicly traded clients on its practical implementation. What will trigger SEC scrutiny is how the earnings reports are released to security analysts since the commission wants to prevent analysts from getting the inside track ahead of the rest of the market. Jayne Donegan, a securities attorney and partner with Brown, Rudnick, Freed & Gesmer in Providence, Rhode Island, suggests businesses take the following steps:

Designate one person (or a very small number of people) to communicate with analysts and institutional investors.

Establish a procedure for reviewing all communications to determine if they contain material nonpublic information. Someone in the company’s investor relations department who has both a historic and current understanding of what has already been publicly disclosed about the company should review written communications to analysts and institutional investors before they are issued, and oral communications after they are made, to detect any disclosures of material nonpublic information. The company can then comply with the rule and disclose the information to the investing public immediately according to an established procedure.

Consult with your attorney if you believe you have unintentionally made a selective disclosure.

STOPPING SELECTIVE DISCLOSURE

When the SEC proposed Regulation FD in December 1999 it prompted an enormous response—6,000 comment letters, the overwhelming majority from investors who urged adoption because they were frustrated with the practice of selective disclosure of material information by issuers. While investors clamored for the new rule, other SEC constituents believed the need for the regulation was based on limited anecdotal evidence. In a 1998 study by the National Investors Relations Institute (NIRI) on corporate disclosure practices, issuers acknowledged significant use of selective disclosure. Another NIRI study released in February 2000 found companies had begun to open certain calls to individual investors. These steps were not enough, according to the SEC, to bolster investor confidence in the fairness of the disclosure process. Indeed, some of the remedial efforts that companies undertook before the SEC proposed regulation FD resulted from the glare of public attention created by investor and SEC scrutiny.

The SEC issued regulation FD because it believed selective disclosure diminished investor confidence in market integrity. When SEC Chairman Arthur Levitt, Jr. announced the rule’s approval, he commented, “Regulation FD [will] bring all investors, regardless of the size of their holdings, into the information loop—where they belong. To all of America’s investors, it’s well past time to say, ‘Welcome to the neighborhood.’”

Will passage of the rule change the way companies operate when talking to market professionals? “Yes, that is exactly the intent and purpose of the regulation,” says Stephen Cutler, a deputy director for the SEC’s division of enforcement. Will the rule cause a disruptive shutdown of information as many critics predicted? Cutler thinks not. “In the long run, markets demand information and issuers understand that,” Cutler says. With regulation FD in place, “Telling company officers now to say nothing is not good advice.”

RULE’S SCOPE NARROWED

The corporate officers, market professionals and others who will try to come to terms with this new regulation may find it useful to consider some of the options the SEC left open:

The rule does not apply to all communications with outsiders but only to contacts with securities market professionals and to shareholders who might be expected to trade on the basis of the information.

The rule covers those who are most likely to receive improper disclosures (analysts and institutional investors) but does not cover those who engage in ordinary-course-of-business communications with the issuers. It does not interfere with disclosures to the media or to government agencies, and does not apply to foreign private issuers.

Any violations for failure to disclose under regulation FD do not create new duties for senior corporate officers under the antifraud provisions of federal securities law (Rule 10b-5), nor can plaintiffs rely on regulation FD as a basis for a private action under Rule 10b-5.

The regulation discusses “knowing or reckless” disclosures. The SEC does not want to second guess issuers on close materiality judgments, however, and cannot bring enforcement actions for mistaken materiality determinations that were not reckless.

Companies that do not comply with FD requirements can be subject to fines, but the commission has not yet established specific penalties. When the rule went into effect in October, the SEC posted on its Web site a series of Qs&As related to the implementation of FD (the supplements to the Division of Corporation Finance’s telephone interpretation manual; see www.sec.gov/offices/corpfin/phon-its4.htm ). Topics include confirming a previous forecast, disclosure of road show materials, disclosure of nonpublic information to employees and use of confidentiality agreements.

INDUSTRY GROUPS PROTEST

Regulation FD has not gone over well with some SEC constituencies. The National Investor Relations Institute, the Securities Industry Association and the Association for Investment Management and Research (AIMR) objected to various aspects of the regulation. AIMR awards the chartered financial analyst designation and has over 47,000 regular members worldwide, many of whom work in investment management. According to Patricia Walters, AIMR’s vice-president of advocacy, the organization objects to the fact that regulation FD requires the company providing information to determine what is material, which is a standard that varies among recipients. “If you shift the burden of determining what is material to the giver, rather than the receiver, then everything has the potential to be material,” Walters says. “Under FD, we believe that companies won’t explain even immaterial items because they won’t know if what they say will affect an analyst’s valuation. Our members are already finding that companies just don’t want to talk about anything except in completely public forums.”

AIMR submitted two comment letters to the commission objecting to the regulation when it was proposed, arguing the proposal would negatively affect both the quantity and quality of information available in financial markets by reducing issuer disclosures to sound bites and boilerplate, leaving investors worse off both informationally and economically. In urging the SEC to reconsider the regulation’s effect on corporate behavior, AIMR recommended the creation of a blue ribbon panel that would include analysts, portfolio managers and institutional and retail investors participating in equity, fixed income and derivative markets who would (1) evaluate the current disclosure practices; (2) work to narrow the definition of “materiality”; and (3) establish a body of “best practices” for corporate communications with the investment community and the general public.

There are certainly conflicting views among those dealing with the regulation as to how its implications will play out. Investors hope for a more level playing field in which the natural advantage investment professionals enjoy will be lessened. Corporate management will look at the rule and monitor their compliance with it, as well as what other companies are doing. It remains to be seen whether regulation FD produces unintended consequences.