The SEC Raises The Stakes In Issuer-Analyst Communications

Under new SEC Regulation FD, a company disclosing material non-public information to investment professionals must also disclose such information to the public. To avoid violations, the author suggests that companies adopt conference calls, and exercise particular care when issuing Regulation FD press releases or 8-K Reports.

A new SEC rule has made it much riskier for companies to have private talks with securities analysts, let alone to do the things that were risky to begin with, like reviewing analysts' research reports before publication. In August the SEC adopted Regulation FD, which imposes strict disclosure obligations on a company when its senior officials or investor relations executives provide material information to an investment professional, like a securities analyst or an investment fund manager, or to any stockholder likely to trade on the basis of the information. All the SEC has to show to hold a company or an officer in violation of Regulation FD is that information changed hands, that the information was material, and that the information was not publicly disclosed on a timely basis or covered by an effective confidentiality agreement. The SEC's tight timing requirements heighten the prospect of liability. For example, if the SEC establishes that the leak is "intentional" or "reckless," Regulation FD would be violated unless the company made "simultaneous" public disclosure, which practically may be extremely difficult to do for communications that take place during one-on-one phone calls or meetings.

The SEC has tried to address concerns about expanded liability by providing that there is no private civil liability for violations of Regulation FD that do not of themselves constitute violations of the antifraud requirements of Rule 10b-5 or any other provision of the federal securities laws. This is helpful, but companies must recognize the possibility that aggressive private plaintiffs can turn a Regulation FD violation into a Rule 10b-5 violation simply by adding "scienter" and "personal benefit" allegations.¹. Moreover, the very act of complying with Regulation FD creates risks of its own. The SEC's tight deadline for putting out press releases or filing a Form 8-K -generally 24 hours and then only for "inadvertent" leaks -may pressure a company to do a hasty job in drafting and fact- checking press releases or disclosure statements on tricky topics like earnings forecasts or late-breaking business developments, with the result that the company may be walking into a minefield of class action liability under Rule 10b-5. As a result of Regulation FD, company officials must be much more careful when talking to analysts or shareholders and should err on the side of immediately disclosing publicly any information of arguable materiality that changes hands, but also must be careful to ensure that the disclosure is well drafted and well documented.

Let's take a closer look at Regulation FD and then address how companies should respond.

An Overview Of Regulation FD

In addition to securities analysts, Regulation FD applies to communications with broker dealers, investment advisors, institutional investment managers, hedge funds and other categories of investment companies, or their associated or affiliated persons, as well as to shareholders if it is "reasonably foreseeable" that the shareholder will use the information to buy or sell the company's stock. Regulation FD expressly does not apply to disclosures made: (1) to advisors who owe the company a duty of confidentiality, such as attorneys, investment bankers or accountants; (2) to anyone else who has agreed to hold the information confidential (like a prospective merger partner who has signed a confidentiality agreement); (3) to rating agencies; or (4) in connection with most securities offerings registered under the Securities Act.

The rule covers any company that files Exchange Act reports, including closed end investment companies (but not including other investment companies, foreign governments, or foreign private issuers), as well as individuals "acting on behalf of" the company, which includes any director, executive officer, or investor relations or public relations official, as well as any employee or agent who "regularly communicates" with market professionals or security holders. Disclosure of material information must be made "simultaneously" in the case of an "intentional" or a "reckless" disclosure and "promptly" (not after the later of 24 hours or the next opening of trading on the NYSE) in the case of any "inadvertent" disclosure. The disclosure can be made via a broadly disseminated press release or on a Form 8-K or by any other means reasonably designed to provide broad, non-exclusionary public disclosure. The SEC Release provides that companies may elect to use a new Item 9 of the 8-K Report that is "provided" rather than "filed" and thus avoids the automatic "incorporation by reference" of the information into the company's registration statements filed under the Securities Act of 1933.

Regulation FD gives companies an important alternative to disclosure of the leaked information. Under the rule, disclosure is not necessary if the recipient of the information agrees to hold the information confidential. The agreement to maintain confidentiality does not need to be in writing, but it must be express and may not be implied from expectations or conduct of the company and the recipient. For example, a company may not take advantage of this provision by asserting that the company and recipient had an implied agreement or understanding of confidentiality or that it was reasonable for the company to assume that the recipient would hold the information confidential. The agreement may be obtained after the disclosure is made but obviously not after the recipient of the information discloses or trades on it.

With respect to the key issue of materiality, the SEC Release states that companies should be especially careful when discussing the following categories of information: earnings information; mergers, acquisitions or tender offers; new products; customer or supplier developments, including the acquisition or loss of a contract; events regarding the issuer's securities, such as defaults, redemptions or future securities offerings; and bankruptcies or receiverships. Obviously, the SEC's list covers many topics that companies and analysts have traditionally discussed and effectively may heighten the risk that the SEC will view as material communications regarding these topics. The SEC has particularly singled out any sort of earnings "guidance" and warned that a company official takes on a "high degree of risk" and "likely will have violated" Regulation FD if he or she discusses earnings estimates privately with an analyst, even if the official just confirms this accuracy of the analyst's forecast.²

Companies that violate Regulation FD can face an SEC enforcement proceeding that seeks an injunction or civil money penalties. Moreover, the SEC may seek injunctions and civil money penalties from the responsible individual as the cause or the "aider and abetter" of the company's violation.

What Companies Are Doing

How Companies Should React

There is no one approach that is right for everyone, and company officials should design their own policy with a view to various factors, including both the role that analysts play in keeping their investors informed and the company's appetite for legal risk. In deciding what is right for your company, you should keep the following in mind:

Be Very Careful With Earnings "Guidance"

Earnings "guidance" refers to a range of practices, from explicitly discussing specific earnings targets to using an elaborate code to indirectly address earnings estimates. A company officer might say to the analyst: "I'm comfort able with your estimate" or "You won't be embarrassed by it." The tenuous theory for this verbiage is that it stops short of direct confirmation, which could impose on the company various legal duties, including the duty to publicly disclose its own estimate and to update the analyst's estimate once it is published ⁹. The SEC's dislike of this practice comes through loud and clear in its release adopting Regulation FD, which indicates that earnings guidance will be an enforcement priority under Regulation FD. Moreover, a practical problem with earnings guidance under Regulation FD is one of correction. It seems awkward, to say the least, for a company to publicly disclose that it has stepped over the line in "guiding" an analyst. The subliminal message of such a disclosure may be that the company's policy is to walk right up to the edge of Regulation FD in dealing with analysts and that it is putting out a public announcement because this time it went too far. Under Regulation FD, companies may continue to point analysts to publicly available information in order to help them to correct factual errors that have gone into their earnings estimates. Even this practice, however, might involve some additional risk in that it could draw heightened scrutiny from the SEC.

Keep Talking To Analysts But Invite The Public To Listen In

One of the best ways that a public company can continue to deal with analysts, while not violating Regulation FD, is to have a policy on analyst communication and make sure it is followed. The SEC itself said in its Regulation FD release that "[t]he existence of an appropriate policy, and the issuer's general adherence to it, may often be relevant to determining the issuer's intent with respect to a selective disclosure." ¹⁰. A sound policy might have the following elements:

Identify those individuals who are allowed to talk to analysts and shareholders. Warn all other employees that they may not do so and may not use company information for their own benefit or pass it along to others. Tell them that, if they do, they might face corporate sanctions and personal liability under the securities laws.

Make sure that those individuals whose job it is to talk to analysts are fully informed of important company developments, and know what information is public and what isn't. Make sure they understand the company's disclosure obligations, especially the law of materiality.

Consider placing some topics off limits, such as earnings estimates, M&A activity, and the like.

Have at least two persons on every important call, so that one person can act as a check on the other in deciding what was said (which oftentimes is unclear) and whether what was said was material.

Be sure experienced counsel is readily available to employees to give on-the-spot advice. Avoid reporting channels that slow down response time and garble facts and advice.

Keep a log of analyst communications, and possibly a recording (always advising the other party that the call is being recorded), so that the company will be in a good position to prove to the SEC when the call occurred, who was on it, and what was said.

Be Careful When Issuing Regulation FD Press Releases Or 8-K Reports

To avoid liability in case of a leak, a company must promptly put out a press release or an 8-K Report setting forth the material information leaked to the analyst. Although this may solve the company's problem under Regulation FD, the press release or 8-K Report, if false or misleading, can itself give rise to Rule 10b-5 class actions and therefore can create more liability than it eliminates. Even if the press release or 8-K Report is not misleading when issued, it can obligate the company to update any projections and other forward-looking information included in the press release ¹¹.

Issuing an accurate press release is often not as easy as it sounds when the topic is an earnings forecast, a financing proposal or another similarly complex corporate issue. First, companies should be careful not to hurry press releases out the door without adequate preparation or review just to observe Regulation FD's 24-hour or opening of trading time period for an "inadvertent" disclosure. Corporate officers and their counsel should make sure that all basic disclosure principles are observed. In particular, the company should have a reasonable basis for all statements ¹², and predictions should be qualified by all important factors that might make the prediction less likely to come true ¹³. In addition, companies should be sure to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act. Second, even if the press release is not misleading when issued, the company and its counsel should consider whether the press release imposes a duty to update earnings estimates, acquisition plans or other forward-looking information in the release.

Finally, if a company has a shelf registration statement on file with the SEC, filing an 8-K Report to address a concern under Regulation FD may impose liability on the company, as well as on its officers and directors, under Section 11 of the Securities Act. Companies can avoid this liability by putting out a press release rather than by filing an 8-K Report or by "furnishing" (rather than filing) the information under new Item 9 of the 8-K Report so that the information in the report is not incorporated into Securities Act filings. But it is possible that a company will want the press release or other information to be incorporated by reference because it contains material information. Each of these questions must be carefully assessed in the hurry to put out a press release after the regrettable analyst communication. For this reason, the SEC's tight deadlines may make it difficult for a company to do a thorough, careful job in checking the underlying facts and drafting the release.

If A Leak Occurs, Consider Obtaining A Confidentiality Agreement

Once material information has passed to a person covered by Regulation FD, a company may avoid the requirement to make disclosure by obtaining an express agreement of confidentiality from the recipient. As noted above, the agreement does not need to be in writing, but it must be an express, specific agreement addressed to the information that has passed.

Keep in mind that this approach has its own difficulties and is no panacea. First, the recipient of the information may not wish to incur the potential liability that comes with agreeing to hold material information confidential. Once doing so, the recipient becomes a "temporary insider" of the company with the result that he or she could incur significant personal liability under Rule 10b-5 if it is later established that he or she traded on the information or passed it along to someone who did. Second, securities analysts may view entering confidentiality agreements as contrary to the role they play in the marketplace. Analysts are not in the business of holding information confidential; quite the contrary, they see their job as ferreting out material information about the companies they follow so that investors (and particularly their clients) can make more informed investment decisions. Some difficult questions may arise. What happens, for example, if the information that the analyst has agreed to hold confidential affects the analyst's published earnings estimates or overall "buy," "hold" or "sell" recommendation on the stock? What does the analyst do if a routine discussion with a client turns to an information area covered by the confidentiality agreement? Because of this possibility, will analysts feel that they should not talk to clients about any topic relating to companies with which they have entered confidentiality agreements?

Shareholders who receive material information have similar disincentives. If they agree to hold material information confidential, they may well be precluded from buying additional shares of the company's common stock or from selling the shares that they own.

Another practical problem concerns how long the confidentiality agreement is to last. It is one thing for an analyst or a shareholder to agree to hold information confidential for a period of hours or days, until a company is ready to release the information publicly or reaches a natural reporting event like a filing of a Report on Form 10-Q. It is quite another thing to ask an analyst or shareholder to hold information confidential for a period of weeks or months, especially if doing so would hinder the analyst in covering the company or the shareholder in investing in the company. In sum, obtaining a confidentiality agreement may be very helpful in a particular case, but it is far from a perfect solution and may not be realistic in many situations.

Be Very Careful In Reviewing Analysts' Research Reports, If You Do So At All

Analysts sometimes ask companies to review drafts of their research reports prior to their publication. Companies must realize that the process of reviewing and commenting on a draft research report can communicate material non-public information just as surely as a phone call. This is obviously the case when the company confirms or corrects earnings estimates contained in the report. But a company official also can be accused of delivering material information just by reviewing the report and telling the analyst that it looks fine. For these reasons, the Second Circuit has said reviewing analyst reports "is a risky activity, fraught with danger." ¹⁴

Regulation FD makes review of research reports even riskier because it applies to this activity just as it applies to one-on-one phone calls or meetings. If a company official nevertheless elects to review a report, he or she should strongly consider delivering a written disclaimer to the analyst stating that the company's review is limited to historical factual information and does not include any review of earnings projections or other forward-Iooking information. The court in Elkind endorsed such a disclaimer as a way of limiting liability ¹⁵

Conclusion

By adopting Regulation FD, the SEC has equipped public companies and their officers with a formidable shield to fend off requests by analysts and major shareholders for the selective disclosure of material information. At least for awhile, Regulation FD should result in a sharp drop in selective disclosure practices. Whether the drop is permanent will depend in part on the SEC's ability to find and successfully prosecute violations of Regulation FD.

But victory over selective disclosure will remain elusive so long as companies are faced with the threat of huge liability resulting from private class actions based principally on sharp drops in stock prices following public disclosure of material adverse information. Some have argued that companies on occasion deliberately dribble material adverse information to selected analysts so that their stock prices drift down slowly, thereby avoiding the kind of abrupt stock price drop that frequently precipitates Rule 10b-5 class actions seeking multi-million dollar damage awards. In view of this perceived practical advantage of selective disclosure, some companies may feel that Regulation FD does little more than force them to pick between two evils -violating Regulation FD by selectively dribbling material information to avoid a sharp stock price drop, or publicly announcing the information in compliance with Regulation FD but in so doing precipitating a stock price drop and a barrage of private class actions. Two things could make the first choice seem dangerously seductive: (1) the chances for detection of an isolated case - of selective disclosure may seem small compared with the virtual inevitability of private class actions following a sharp stock price drop; and (2) the penalties for an SEC action under Regulation FD, although substantial, might seem pale in comparison with damages customarily alleged in stock drop cases, which easily can exceed the limits of D&O policies protecting the personal assets of the corporate officer involved.

There are, however, several problems with electing to violate Regulation FD on a "lesser of two evils" theory. First, it is clearly illegal. Second, leaking information to analysts can give rise to liability in SEC enforcement proceedings, which may involve penalties, cease and desist orders and fines and, in turn, may lead to embarrassing and career-Iimiting injunctions against serving as an officer of a public company in the future ¹⁶. Third, there is no guarantee that leaking information to analysts will not itself result in a sharp drop in the price of the company's stock as the information spreads into the marketplace. The very class actions that the company was trying to avoid may result anyway, with the exception that the litigation may be significantly more dangerous because of allegations that the stock price drop was precipitated by an intentional violation of Regulation FD. Ultimately, it seems that Regulation FD will reduce the incidence of selective disclosure but pressures for selective disclosure may remain until the SEC and the courts act to reduce the threat of frivolous securities class actions that indirectly can hinder the achievement of the SEC's primary goal, namely, a level playing field for all investors.

Now more than ever, public companies must be careful when talking to analysts. The guidelines set forth above should allow a company to maintain a relationship with the Wall Street community while complying with Regulation FD's restrictions on selective disclosure.

¹ See SEC v. Dirks, 463 U.S. 646 (1983).

² SEC Release at 8.

³. E.g., Michael Davis, et al., "SEC: Tell Everyone at Same Time: Full Disclosure Rules Approved," Houston Chron., Aug. 11, 2000, at Business 1; Tim Huber, "SEC Adopts Rule to Promote Fairness in Executive-Conversation Ruling," Knight-Ridder Tribune Bus. News, Aug. 11,2000; Jeff D. Opdyke and Aaron Lucchetti, "Mum's the Word in Wake of Discloure Rule," Wall St.J., Aug. 16, 2000, at Cl; Kathleen Pender, "SEC's Regulation FD Should Force Analysts To Do Homework," San Francisco Chron., Aug. 11,2000, at B1; Mary Vanac, "Companies Beginning To Clue In Average Investors -SEC's Proposed Fairness Regulation Already Being Felt," Newark Star-Ledger, Aug. 6, 2000, at Business 1.

⁴. At present, use of a company's own web site to make public discIosure is not by itself sufficient. This method might become sufficient as technology and use of the Internet evolve.

⁵ Pender, supra note 3.

⁶ Huber, supra note 3.

⁷ Opdyke and Lucchetti, supra note 3.

⁸ Vanac, supra note 3.

⁹ For a detailed discussion of this practice and cases addressing its legality, see junewicz, Handling Wall Street Analysts, 9 Insights 9,11-12(1995).

¹⁰ SEC Release at n. 90.

¹¹ Although the case law is less definitive, the SEC takes the view that a company is under a duty to update material information so long as it is reasonable to assume that investors are relying on the information in making investment decisions.

¹² See generally, Herskowitz v. Nutri/System, Inc., 857 F.2d 179, 184 (3d Cir. 1988) (opinion or projection actionable if without reasonable genuine belief or if it has no basis), cert. denied, 489 U.S.1054 (1989); Kirby v. Cu//inet Software, Inc., 721 F. Supp. 1444,1450 (0. Mass. 1989) (prediction must be made in good faith and with sound historical or factual basis).

¹³ See Goldman v. Belden, 734 F.2d 1059, 1068-69 (2d Cir. 1985) ("Given defendants' positive predictions and the allegations of knowledge of the undisclosed negative factors ... we conclude that the Complaint adequately stated a claim under § 10(b) and Rule 10b-5").

¹⁴ Elkind v. Liggett & Myers, Inc., 635 F.2d 156, 163 (2d Cir. 1980).

¹⁵ For further discussion of this approach, see Junewicz, supra note 9, at 14.

¹⁶ SEC v. Stevens, 91 Civ. 1869 (CSH), Litig. Rel. No.12, 813, 1991 SEC LEXIS 451 (Mar. 19,1991); SEC v. Rosenberg, 91 Civ. 2403 (SSH), Litig. Rel. No. 12,986, 1991 SEC LEXIS 2218 (Sept. 24, 1991).

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