ABA Section of Business Law

Business Law Today
September/October 2001 (Volume 11, Number 1)

Want that new FD to be easier
Try a projection template.

By Bruce Alan Mann

If you're into securities regulation, you've no doubt heard about the SEC's Regulation FD. Here's a way to deal with it.

The regulation has reduced selective disclosure of projections and other material inside information by requiring full and fair disclosure of that information. Although a few issuers greeted the adoption of Regulation FD by ceasing to provide guidance to securities analysts, most law firms concluded that this approach was not practical. Virtually every major law firm recognized that guidance will continue and recommended steps to assure that guidance as to future performance would not violate the regulation.

In adopting Regulation FD, the SEC concluded that the Internet makes it easier for issuers to disseminate information broadly and that "the market is best served by more, not less, disclosure of information by issuers." Issuers have therefore concluded that increased public disclosure is necessary and a growing number of companies are providing detailed information on their Web sites to assist investors and analysts to develop their own projections.

Increased Web site disclosure with adequate advance notice makes it possible for companies to continue to meet with analysts and respond to their questions without violating Regulation FD. The SEC interprets Regulation FD as permitting an issuer to selectively disclose to analysts information that is not important to the ordinary investor if all information that is independently material has been made public.

This selectively disclosed information may be important to the sophisticated investor, who recognizes its significance and uses it together with publicly disclosed material information to assemble a "mosaic" of information that is material.

Although issuers can discuss their business with analysts in more detail than exists in public filings so long as the information they provide isn't independently material, there is no clear line between what is material information and what is merely filling in the details. As a result, Regulation FD has placed "a high premium on restricting communications with analysts to information that a company has previously disclosed."

The more detailed the guidance given to the public, the less risk that additional information provided to analysts will be viewed by the courts or the SEC as being material rather than supplemental. Thus, issuers have been urged by their lawyers to consider expanding their periodic public disclosures to include line items that they expect to talk about with analysts and investors.

Detailed guidance also reduces the risk that an issuer will incur liability by entangling itself with an analyst's report to such a degree that a court will conclude that the issuer has endorsed the analyst's projection. Regulation FD added to concerns about "entanglement" and "adoption" because it gave the SEC a more direct enforcement route "where it suspects that a company has provided material, nonpublic information in the course of reviewing an analyst's draft or commenting on an analyst's assumptions or model."

Issuers have reached different conclusions as to whether they should review drafts of analysts' reports in light of the entanglement doctrine. Some issuers refuse to review draft reports, which avoids the risk of entanglement but increases the risk that the market will respond to erroneous assumptions or projections.

Some believe it is appropriate to review a proposed draft and correct matters of fact if those facts are already public. Still others have decided that the risk of a market surprise is greater than the risk of liability under the entanglement doctrine and go to greater efforts to make sure that analysts' projections are in line with the issuer's expectations.

Although all issuers want analyst coverage and most are willing to give guidance to obtain it, publication of detailed guidance is particularly important to smaller or newer issuers. Less well-known companies must work more closely with analysts to be sure that their business model is understood and to nurture a relationship that will result in analyst coverage. Since these more detailed discussions are risky for both the issuer and the analyst under Regulation FD, failure to give detailed public guidance will make it even more difficult for smaller issuers to get analyst coverage.

The decision to publish increased guidance as part of an issuer's efforts to comply with Regulation FD is sound, but it does not protect issuers from the risk of liability under other provisions of the federal securities laws. Indeed, issuers can inadvertently risk liability in an attempt to live up to their obligations under Regulation FD. Regulation FD deals only with selective disclosure and does not protect issuers from liability under Rule 10b-5 if the disclosures made contain material misstatements or omissions.

The Private Securities Litigation Reform Act of 1995 provides a safe harbor for "forward looking statements" identified as such if "meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward looking statement" accompany them. Thus, projections and other forward-looking information can be protected from liability under Rule 10b-5. However, the Reform Act only protects "statements" and offers no protection for omissions of material facts, which arguably includes material assumptions, necessary to make the statements made not misleading.

The risk of liability under Rule 10b-5 for material omissions places a premium on giving guidance with respect to all items that may be material in an investor. Whether an omission is material will be judged in part by what the company has commented on in prior guidance and what other similar companies comment on in their guidance.

Unfortunately, there is no consistency among issuers as to what items should be included in giving guidance, or the format in which it should be given. Some issuers limit guidance to a revenue range and target earnings per share. Others disclose projected earnings before taxes and intangible expenses (EBITDA), free cash flow, total debt and its components, effective interest and tax rates, and shares outstanding. Such disclosures may take the form of a specific target, a range, an expected growth rate, or a "soft" qualitative statement such as "slightly better" than last year.

Because there is no clear definition of what is a material omission for purposes of Rule 10b-5, issuers risk liability if they fail to include a discussion in their guidance of income-statement items, even if they do not discuss those items with analysts.
Thus, an issuer must try to accomplish multiple goals in giving guidance:

• Provide sufficient information to avoid liability under Regulation FD if an analyst asks about a line item that has not been discussed publicly.
• Establish a basis for analysts to prepare their own projections without the issuer reviewing drafts of the analysts' reports and risking entanglement in their projections.
• Allow analysts to meet with management to fill in the details necessary to create a mosaic without the analyst risking Rule 10b-5 liability.
  
• Make it easier for analysts and investors to prepare models in which they can substitute their assumptions for those used by the issuer.
  
• Avoid leaving out anything that could be viewed as a material omission under Rule 10b-5.

How can an issuer accomplish all of these goals? The answer is relatively simple. The issuer can publish a template that includes all material elements of the issuer's projected financial statement and sets forth the assumptions underlying the issuer's projections. The template should be supported by specific rather than qualitative assumptions. This will allow analysts and investors to develop their own models by modifying the issuer's assumptions, with a greatly reduced risk that guidance given by the company will be misunderstood and lead to mistaken assumptions.

Many companies provide detailed guidance in their quarterly press releases or on their Web sites, but few have adopted a template format. The use of a template, which could be downloaded as a spreadsheet together with the assumptions underlying the issuer's projections, would permit individual investors as well as analysts to develop their own earnings models before making an investment decision.

For example, if an issuer stated that in preparing its guidance it has assumed that sales would increase 10 percent each quarter and an investor would like to take a more cautious approach, the template could be downloaded, the assumptions could be modified, and the investor could create a model in which sales would only increase 5 percent each quarter.

What items should be included in the template? The answer will not be the same for all companies. However, a good starting point would be to include those items identified for discussion as part of the issuer's "Management's Discussion and Analysis" and any additional items, including balance sheet information, included as financial highlights in its annual report.

Should the template include specific targets for each line item or provide a range? In most cases, the safest course to follow would be to provide a range that reflects the issuer's best case and worse case assumptions, rather than publishing what the issuer considers to be the most likely scenario.

What time period should the template cover? That depends of course on the company's visibility of its business. It is unrealistic to provide guidance limited to the current year, particularly since capital spending and other commitments are regularly based on projections for a longer period. However, including periods in a template beyond those that are reasonably foreseeable will not only reduce investor confidence in the reliability of the information presented, but will increase the risk that the accompanying discussion of risk factors will not satisfy the "meaningful cautionary statements" standard of the Reform Act.

Finally, the template should be specifically identified as a "forward looking statement" for purposes of the Reform Act and accompanied by meaningful cautionary statements rather than boilerplate risk factors. Both the publication of the template on the issuer's Web site and publication of any changes in the template should be preceded by a press release or Form 8-K complying with Regulation FD.
If these steps are taken, a company can increase the ability of both analysts and investors to make investment decisions.

As a result, the company can expect to attract broader analyst coverage and investor interest, producing more realistic pricing for its common stock. This increased market efficiency will in turn reduce the risk of surprising the investment community with unanticipated, disappointing financial results, and the suits that frequently follow such surprises.

Mann is a partner at Morrison & Foerster LLP in San Francisco and is a senior managing director of WR Hambrecht + Co., a financial services firm that publishes its research over the Internet. His e-mail is bmann@mofo.com.