ABA Section of Business Law
ABA Section of Business Law
Business Law Today
July/August 1999
Getting - or not getting - the word out
Disclosure for analysts, investors and the press
By KARL A. GROSKAUFMANIS
Groskaufmanis is a partner in the Washington office of Fried, Frank, Harris, Shriver & Jacobson.
One hallmark of today’s financial markets is a constant pressure for "real-time" disclosure to analysts, investors and the financial press. As one of its initiatives this year, the Section commissioned an ad-hoc committee to study public company disclosure practices in this fast-changing environment. The author serves as the committee’s co-chair. The views expressed below, in the form of a memorandum to a public company’s senior management, reflect those of the author alone.
To: Senior management
From: Counsel
Re: Contacts with analysts, investors and the financial press
A crucible is a heat-resistant container used to melt compounds at intensely high temperatures. While most of us have not seen one since our high school chemistry classes, we think of the crucible each time our company prepares for a quarterly conference call with securities analysts. The contacts are only one part of a continuing exchange that we, like other public companies, have with analysts, portfolio managers, financial reporters and our shareholders.
These contacts are fundamentally different from the periodic reports we are required to file as a public company. This is disclosure on a "real time" basis. Senior management must tell the company’s story "on the spot" without the filter provided by financial and legal advisers. The process requires split-second judgments before a demanding audience.
What makes the process difficult — what makes it a crucible — is the legal risk that permeates each of these contacts. As your legal department, we have had many conversations about how we balance management’s desire to communicate its vision to the marketplace with a desire to contain those legal risks. You have asked us to prepare a terse summary of the points we have discussed.
To put the legal framework in some perspective, it helps to think of disclosure as falling into two categories. The first is a formal disclosure regimen mandated by the SEC’s rules. All public companies are required to file quarterly reports on Forms 10-Q and an annual report on Form 10-K. As you know, the SEC has developed a detailed labyrinth of rules addressing all aspects of this disclosure (down to who signs the filing). Even on the more subjective aspects, such as the section devoted to management discussion and analysis, the SEC has provided extensive interpretive guidance. Securities lawyers tend to focus on this aspect of the disclosure process (as does most of the legal literature on disclosure).
The second component relates to disclosure that is inherently informal. This includes quarterly analyst conference calls, investor conferences, "one-on-one" meetings with shareholders and contacts with the media. There is no question that these contacts are important. They have become a critical component of our company’s disclosure to the marketplace.
Despite this importance, there is virtually no regulatory structure to guide the informal disclosure process. SEC rules, for example, do not dictate how an analyst conference call must be conducted. That is not to say that there are no legal standards. The regulation of this disclosure process effectively occurs after the fact through SEC enforcement actions and civil litigation.
With any informal contact, there is the risk, for example, that the SEC will allege that the selective disclosure of material, nonpublic information to certain analysts constitutes illegal "tipping" under federal insider trading law. If an issuer’s CEO calls certain analysts and warns them that an adverse earnings announcement is imminent, it would allow clients of the analysts to trade on the basis of market-sensitive information before the rest of the market. The commission made such allegations in 1991 involving Phillip Stevens, the CEO of a public company. Stevens settled the case by paying a penalty of about $126,000 — a the amount of losses avoided by the clients of the analysts with whom he was alleged to have spoken. SEC v. Stevens, Litigation Rel. No. 12813 (Mar. 19, 1991).
Enforcement actions like the case brought against Stevens are rare because they pose a unique legal challenge for the SEC. Under the standard for illegal tipping violations crafted by the Supreme Court, the SEC must establish in a selective disclosure case that (1) the corporate insider breached a fiduciary duty to the company by making the disclosure, (2) that the corporate insider received some benefit from the disclosure and (3) the recipient of the information knew or should have known that the information was provided in breach of a duty. Dirks v. SEC, 463 U.S. 646, 661-64 (1983). From a pragmatic standpoint, it is difficult to square this standard with typical issuer/analyst exchanges.
The paucity of enforcement actions should not be equated with a lack of interest on the SEC’s part. In a speech last year, Chairman Arthur Levitt flagged the commission’s concern with the selective disclosure of material, nonpublic information in issuer/analyst contacts. Levitt pointedly warned that "it is very clear to me — and the SEC’s Enforcement Division — that issuers should not selectively disclose information to certain influential analysts, in order to curry favor with them and reap a tangible benefit, such as a positive press spin." Levitt, A Question of Integrity , Feb. 27, 1998.
Another source of potential liability is linked to private civil claims asserted by shareholders. As you know, any company that suffers a substantial drop in its stock price after a specific announcement is at risk of securities class actions alleging that earlier statements fraudulently misstated the company’s fortunes. It is not uncommon to see complaints that allege that statements made through what we have called the informal disclosure process were fraudulent. If, for example, the announcement of disappointing quarterly results was preceded by a statement to a recent investor conference that the company was "on target," our legal system provides ample incentive to private litigants to allege that this statement was fraudulent.
The practical reality is that most public companies feel compelled to assume these risks. A 1998 National Investor Relations Institute survey of 227 investor-relations managers at established public companies found that the majority made extensive use of informal contacts to supplement their disclosure. For one thing, four-fifths of the respondents reported making regular use of analyst conference calls.
It also is clear that, whatever the legal risk, a large majority are prepared to review analyst earnings models before they are disclosed publicly. Significantly, 86 percent of the respondents reported that they typically review draft analyst reports and 79 percent indicated that they review analyst earnings projections or models before they are disseminated. NIRI, A Study of Corporate Disclosure Practices: Second Measurement (May 1998).
The empirical data simply confirms what we have seen over the years. There is tremendous pressure on public companies to be more forthcoming in their "real time" disclosure to investors. The management of every public company must find a way to respond to these pressures.
In all this discussion of legal risks, it is easy to lose sight of the key objective: We want to tell the company’s story to the marketplace. Every senior manager would welcome an opportunity to tell analysts and investors how, collectively, we plan to increase shareholder value. Our legal advice has to be responsive to this desire. From our many discussions of these issues, we have developed guidelines for informal disclosure. These guidelines are intended to create a framework to contain the obvious risks without muzzling the messenger.
We have distilled our advice to 10 rules of thumb.
1. Limit the number of spokespersons. Because this disclosure is shaped through a continuous and countless series of oral statements, it is critical that the company be consistent in its responses. Every analyst who asks questions about the company’s current debt load should get the same answer. That consistency can be achieved only if the company limits who may speak on its behalf. At most companies, the day-to-day labors of the disclosure regimen are handled by one or two employees. That does not mean that other members of senior management do not participate in conference calls or one-on-one meetings. It simply suggests that the laboring oar with respect to daily contacts should be handled by a small cadre of officers.
To achieve that consistency, it is important that this principle be understood broadly within the company. The principle requires more than simply directing calls from securities analysts and the financial press to one source. It also means that employees will not speak for the company unless they are asked to do so.
To use a contemporary example, our company is the focal point of several "chat rooms" and "bulletin boards" on the Internet. These dialogues exchange information relating to the company. We have made clear to all our employees that nobody, however well-intentioned, is authorized to disclose sensitive information relating to the company in these discussions. In every aspect of its disclosure, the company must speak with one voice.
2. Invoke the safe harbor. One legacy of the Private Securities Litigation Reform Act of 1995 is a statutory safe harbor for forward-looking statements. Since the safe harbor provides us with a measure of protection, we should take the steps needed to put the company in the position to invoke this defense against any subsequent claims. It is particularly important as courts often have taken an expansive reading of the safe harbor.
For the informal disclosure process, two principles are important with respect to invoking the safe harbor. The first is that the safe harbor for oral forward-looking statements should be invoked in analyst conference calls and investor conferences. The safe harbor shields predictive statements if the speaker indicates that a statement is predictive and references a readily available written document that includes meaningful cautionary statements identifying important factors that might cause actual results to differ. This has led to what we have dubbed, "The Miranda warning." We begin each quarterly analyst conference call with some variation of the following:
Thank you for joining us today. In order to help you understand the company and its results, we will make some forward-looking statements. It is possible that our actual results might differ from the predictions we make today. Additional information regarding factors that could cause such a difference appear in the MD&A section of our Form 10-Q filed on [date].
Issuing this warning does not preclude us from identifying additional risk factors over the course of our presentation. But we should make the statement because the courts, to date, generally have rejected narrow interpretations of the safe harbor for oral forward-looking statements. See, for example, Wenger v. Lumisys Inc., 2 F. Supp. 2d 1231 (N.D. Cal. 1998).
Second, our periodic SEC filings now should include a good description of our risk factors. None of us can afford to regard this as routine legal "boilerplate." Instead, we must ensure that these risk factors address what we, personally, perceive as the primary risks. When we make our introductory statement at quarterly analyst conference calls, we rely on this cautionary language. Even if we make few, if any, predictive statements in our periodic reports, the safe harbor for oral statements makes it important to have an effective discussion of risk factors.
3. Disseminate material news broadly. Selective disclosure issues arise when a company provides material information to certain recipients in advance of its broad dissemination. An analyst conference call or a one-on-one meeting is not the right forum in which to disclose material information for the first time. Certain disclosures are clearly material, such as earnings announcements, significant transactions involving the company, dividend announcements. As a general practice, we have adopted a policy of distributing releases on such issues before they become the source of any informal discussions. Like many other companies, our quarterly analyst conference calls are preceded with press releases that detail financial results.
The 1998 NIRI survey suggests that our practice conforms with the philosophy adopted at most other public companies. Specifically, respondents were asked what they would do if they had previously provided guidance to the marketplace and actual results were expected to be significantly lower. Seventy percent responded that they would make the information public in a press release and then follow up with individual analysts. (As counsel, we found it disquieting that one quarter of the respondents would communicate this information to analysts).
It is important to remember that "materiality" is an amorphous concept that is always easier to assess after the fact. The less-than-illuminating legal test is whether the information would be considered significant by an investor making the decision of whether to buy, sell or hold our shares. A key measure of materiality is the reaction of investors to its disclosure.
To gauge the marketplace, part of our investor relations regimen involves maintaining a set of binders that include all of our SEC filings, press releases, analyst reports, analyst conference call transcripts, media coverage and other noteworthy items that form part of the mix of information relating to our company. This compendium allows us to develop an informed sense of what the marketplace considers to be significant and how our message is received. It also allows us a more informed basis to assess whether what we are planning to say may be considered "material."
4. Script the disclosure. Real-time disclosure involves a clash of perception and reality. The perception is one of a continuing dialogue that responds to marketplace concerns. That is not just a perception; it is what analysts and investors expect. The reality is that a record exists of these statements and they must be made with that record in mind. Real-time disclosure does not flitter into oblivion after the words are stated. For example, Internet bulletin board postings summarizing our analyst conference calls appear on-line within hours after their completion. Investors who do not participate in conference calls can dial in for several days after the fact and listen to the tape. These are not idle conversations.
Given the inherent difficulty of "thinking on your feet" with this audience, we script the primary presentations at analyst conference calls. We also anticipate the questions that will come from the participants and plan our responses. Beyond the structured presentation, we circulate internally a standing list of common questions from analysts and the response that has been provided. This is intended to limit the extent to which any one person is placed "on the line."
Having prepared such scripts, one question we have debated is whether we keep transcripts of analyst conference calls. Some lawyers argue that maintaining a transcript of an analyst conference call invites disaster in litigation since these documents are likely to be subject to discovery. We have made the other judgment. From a business perspective, having the transcripts provides us with a useful guide when we prepare for the next conference call. The transcript also is the best evidence that we did invoke the safe harbor and reflects what actually occurred over the course of the call. Discarding the transcript does not eliminate the statements that were made. If nothing else, the mere thought that your words are being transcribed has a disciplining effect.
5. "Manage" earnings expectations with great care. Virtually all discussions about informal disclosure ultimately come down to the issue of how far a company can go in "managing" marketplace expectations. On one hand, we see companies every quarter that report profitable results but nonetheless sustain the loss of a significant portion of their market capitalization because they failed to meet "consensus" expectations framed by analysts who follow the company. On the other hand, if managing expectations involves revealing true earnings data before a press release, that company has disclosed — selectively — its most important information
Whatever the risks, it is clear that many public companies struggle with the issue . . . and walk a fine line. As we noted earlier, nearly four-fifths of the respondents to the 1998 NIRI survey reported that they review analyst earnings projections or models before they are published. None of these companies wants to surprise the market. None of their senior management wishes to violate the federal securities law.
We consistently have recommended a simple rule of thumb — our policy is not to comment on earnings estimates unless we are prepared to do so in a press release. We are particularly careful to follow this principle if we feel our guidance will disappoint the market. If we do not believe that we will meet analyst expectations, we tell the marketplace as a whole, not just a "favorite" analyst.
This principle does not mean that we are precluded from a meaningful dialogue with analysts. It simply affects the way the process occurs:
• We review draft analyst reports but do not comment on earnings projections. For nearly two decades, courts have recognized that a company can become so "entangled" in the preparation of an analyst report that the report’s statements become those of the company. See Elkind v. Liggett & Myers, 635 F.2d 156, 162-64 (2d Cir. 1980). Despite that risk, as noted above, the vast majority of the respondents to the 1998 NIRI survey said that they "review drafts" of analyst reports. So do we. But our comments — oral or written — are qualified by an express statement that we are not commenting on the earnings projections.
• Analyst assumptions are discussed if a model or projection appears to be far off the mark. While we do not counsel any analyst to lower (or increase) an earnings estimate, we will review the assumptions that went into that model. By reviewing the variables that produced the result, it often is possible to address errors without discussing the specific earnings projection.
• We are consistent in our responses. We do not always get the same inquiries. Some analysts ask questions that are more focused and address the core of the company’s operations. By limiting the number of spokespersons, we heighten the likelihood that the company is providing a consistent response.
• We adhere to a "quiet period." For the two weeks prior to scheduled quarterly earnings announcements, our substantive contacts with analysts and investors cease. Three-quarters of the companies responding to the 1998 NIRI survey reported using quiet periods lasting an average of 21 days. By restricting contacts during this particularly sensitive time period, we limit the risk of an inadvertent disclosure.
There is no single formula that applies to all public companies. These exchanges are easier to control, however, if the company is consistent in its practices.
6. Prepare for "one-on-one" meetings with investors. All of the principles discussed above apply equally to "one-on-one" meetings or "company visits" by investors as well as quarterly conference calls with several dozen participants. At the same time, meetings with our most significant institutional investors are different. After all, these are investors who have backed their belief in our management vision in a tangible way. They are owners as well as analysts.
In some respects, the legal risks associated with selective disclosure can be more pronounced in these contacts. Our investors are different from "sell-side" analysts whose research is disseminated to the marketplace. Investors use their research for their own purposes. Both we and they could come under scrutiny if they trade our stock shortly after a "one-on-one" in which we said more than we intended.
We prepare for "one-on-one" meetings with these risks in mind. Since meetings with our largest investors can involve senior management who are not involved in the company’s day-to-day investor relations, we meet in advance with the managers scheduled to participate. These managers are briefed about the extent of our disclosure to date and the range of questions that are anticipated over the course of the meeting. While the hope is to foster an informal discussion, we take steps to ensure that the principles of our program are followed in the most casual discussion with investors.
7. Consider updating predictive disclosure. Few aspects of the securities laws are as muddled as the duty to update previous disclosure. The courts are so badly split on this issue that this topic is fodder for lengthy law review articles. We will limit ourselves to one paragraph and then outline the business imperative.
If we learn, after the fact, that a statement the company made previously was materially false when it was made, there is a generally recognized duty to correct that statement. If a statement that was true when made is rendered incorrect by subsequent events and the market continues to rely on that statement, some courts have indicated there may be a duty to update that statement. The operative word is "may." The outcome is very much a function of which federal circuit (and which judge within that circuit) considers the duty to update question.
As senior managers of a public company, you have a more immediate judge than those common to the protracted process of litigation. If we believe that the analysts and portfolio managers who follow the company are relying on a statement we now know to be incorrect, we should consider updating the statement for that reason alone. Most cases involving the duty to update do not address the fact that you have an audience that expects to be updated — and you face them every quarter.
8. Treat media contacts as a separate breed. In our discussions about the informal disclosure process, it is tempting to group the financial press with securities analysts. After all, that is because they are focused on the same thing — our company. While the financial press may be asking some of the same questions, it is important that we recognize that their audience is different. Securities analysts primarily tailor their written product — often in considerable detail — for sophisticated investors. The financial press must develop a short story aimed at a much broader audience.
When dealing with reporters, we keep in mind that they often are compelled to tell the company’s story in five paragraphs (or less). After pursuing the minutia of segment results with securities analysts, our mission with the financial press is to help them compress the information to that which is most critical and most topical. This process requires the same measure of care so that the "sound bites" that become one part of the company’s disclosure record meet the same levels of accuracy.
9. Think about Column 6 before you write anything. It is a helpful discipline to consider each of our written words and how they would appear if featured on the first page of the Wall Street Journal. The difficulty with the written word is that we cannot always control its use once it has been created. While this was always true of documents, it has become more so with the proliferation of electronic mail. By lulling us into a sense of intimate conversation while creating a time-stamped verbatim record, e-mail is a dream come true for any counsel trying to sue us or the company. Since the disclosure process — formal and informal — is laden with litigation risk, we must always be mindful of the record we are creating within the company.
10. Tell the truth. If you distill the legal analysis, one big question when a company’s disclosure is questioned is whether the company told the truth. Many of the potential legal issues we confront in the disclosure process can be minimized or avoided if we have a reasonable basis for all the statements we made. Having worked with you for years, we know that none of you would make a false statement. But the pressures of marketplace expectations and quarterly reporting affect all of us.
We all need to constantly assess whether they have colored our disclosure. We also need to constantly consider what kind of record we are creating through our daily disclosure efforts. While potential legal travails cannot (and should not) drive all of our daily activity, it behooves us to question how, for example, we would prove that there was a reasonable basis for the predictions made over the course of our last conference call.
In many respects, this advice would be easier if the informal disclosure process were covered by the same detailed rules that apply to Forms 10-Q and 10-K. The reality is that virtually none of that regulatory structure exists for analyst conference calls or "one-on-one" meetings with investors. In the absence of rules (and in the presence of constant legal risk), our best protections are good practices on a day-to-day basis. The guidelines we have developed are aimed at nurturing those good practices.
