United States: SEC Adopts Fair Disclosure Regulation

The Securities and Exchange Commission has adopted Regulation FD (for "fair disclosure") to address the problem of "selective disclosure" of material information by public companies. Securities Act of 1933 Rel. No. 7881 (August 15, 2000). The release also covers the adoption of two new insider trading rules, Rule 10b51 and Rule 10b52. Regulation FD and the new rules will become effective October 23, 2000.

Under Regulation FD, whenever:

• an issuer, or person acting on its behalf,
• discloses material non-public information about the issuer or its securities,
• to specified persons (in general, securities market professionals, or holders of the issuer's securities who are likely to trade on the basis of the information),
• the issuer must make public disclosure of that information

A number of key terms used above are defined in Regulation FD or are discussed in the adopting release.

Regulation FD applies to any issuer that has a class of securities registered under the Securities Exchange Act of 1934 or is required to file reports under Section 15(d) of that Act, including closedend investment companies but not other investment companies and excluding foreign governments and foreign private issuers as defined in Rule 405 under the Securities Act.

This phrase includes any senior official (i.e., any director, executive officer, investor relations or public relations officer or other person with similar functions) of the issuer or any other officer, employee or agent of an issuer who regularly communicates with securities professionals or with holders of the issuer's securities. Senior officials who direct lower level employees to make a selective disclosure would be responsible for having made the selective disclosure. Employees who do not routinely interact with securities professionals or shareholders would not otherwise be considered to have caused a violation of FD by disclosing such information. A person who communicates material, non-public information in breach of a duty to the issuer would not be considered to be acting on behalf of the issuer. These individuals would, of course, be subject to the usual insider trading laws.

The Commission has not defined materiality but refers to the definition, generally found in antifraud cases, that information is material if there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision or if the information would significantly alter the total mix of SEC Adopts Fair Disclosure Regulation available information. The Commission cites TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976) and Basic v. Levinson, 485 U.S. 224, 231 (1988), and the definition in Securities Act Rule 405 and Exchange Act Rule 12b2. The Commission also refers to Staff Accounting Bulletin No. 99 (August 12, 1999), which discusses the application of materiality thresholds to the preparation of financial statements filed with the Commission and the performance of audits of those financial statements. The SAB refers to the definition of materiality in TSC and emphasizes the importance of taking into account the "total mix" of information in judging materiality. In the context of financial statement items, this includes both the size in numerical percentage terms of the item as well as the factual context in which the user of financial statements would view the financial statement item. "The shorthand in the accounting and auditing literature for this analysis is that financial management and the auditor must consider both 'quantitative' and 'qualitative' factors in assessing an item's materiality."

The Commission recommends that the following types of information, while not per se material, should be reviewed carefully to determine their materiality:

• earnings information
• mergers, acquisitions, tender offers, joint ventures, or changes in assets
• new products or discoveries, or developments regarding customers or suppliers, such as the acquisition or loss of a contract
• changes in control or management
• changes in auditors or auditor notification that the issuer may no longer rely upon an audit report
• events regarding the issuer's securities, such as defaults on senior securities, calls of securities for redemption, repurchase plans, stock splits or changes in dividends, changes to the rights of security holders, and public or private sales of additional securities
• bankruptcies or receiverships.

Of particular importance, the Commission has highlighted its concern about earnings "guidance" provided to analysts, while at the same time encouraging continued discussions with analysts as long as no material information is selectively disclosed. The FD release states that issuers take on a "high degree of risk" and "likely will have violated" FD if they discuss earnings estimates privately with an analyst, even if the issuer just confirms the accuracy of the analyst's forecast. This will be true even if the guidance is provided indirectly through "guidance" jargon, the meaning of which is apparent though implied (for example, statements that management is "comfortable" with Street estimates). Similarly, an issuer cannot render material information immaterial simply by breaking it into ostensibly nonmaterial pieces.

FD applies to disclosures made to anyone in the following categories:

• brokerdealers and their associated persons
• investment advisers, certain institutional investment managers and their associated persons
• investment companies (including hedge funds and certain other categories of exempt investment companies) and affiliated persons as defined in the Investment Company Act of 1940
• any holder of the issuer's securities where the circumstances would make it reasonably foreseeable that such person would trade based on the information received.

The Commission points out that these are the types of persons most likely to be the recipients of improper selective disclosure, and that Regulation FD is not meant to cover persons engaged in ordinary-course business communications with the issuer, or to interfere with disclosures to the media or communications to government agencies.

Four specific exclusions from coverage are provided:

• the "temporary insider"—anyone who owes the issuer a duty of trust and confidence, such as an attorney, investment banker or accountant
• any person who agrees to maintain confidentiality and not to trade based on the information (the agreement must be express, but it need not be in writing and need not be entered into in advance)
• credit rating agencies
• disclosures made in connection with most offerings of securities registered under the Securities Act, with special rules to define when registered offerings are considered to begin and end for this purpose.

Unregistered offerings do not give rise to an exemption from FD, leaving the issuer with the choice of not disclosing any material non-public information in the offering, disclosing publicly any material information it discloses non-publicly, or obtaining a confidentiality agreement from the recipients of the non-public information. In the case of an issuer that is required by FD to release information publicly during an unregistered offering, the availability of the Securities Act exemption being relied upon may be affected by the required disclosure. The Commission suggests that these issues be carefully discussed in advance with issuer's counsel.

Issuers can make public disclosure by filing or "furnishing" a report on Form 8K, or by disseminating information through another method (or combination of methods) of disclosure reasonably designed to provide broad, non-exclusionary distribution of the information to the public. This must be done simultaneously, if the selective disclosure is intentional, or promptly, if the selective disclosure is unintentional.

• 8K Disclosure. To comply with FD, issuers may either file a report on Form 8K under Item 5, or furnish a report on Form 8K under a new Item 9 that has been added for this purpose and that will not be deemed to have been "filed." If the information is filed under Item 5 of 8K it will be subject to Exchange Act Section 18 liability and automatically be incorporated into the issuer's Securities Act shelf registration statements, which are subject to Securities Act Sections 11 and 12(a)(2) liability. If the information is merely furnished under Item 9, it would not be incorporated by reference into existing Securities Act registration statements and would not be subject to Securities Act Sections 11 and 12(a)(2) or Exchange Act Section 18 liability unless the disclosure is otherwise included in a filed report, proxy or prospectus. FD provides that filing or furnishing information on Form 8K for FD purposes will not, by itself, be considered an admission of the materiality of the information.
• Alternative methods of public disclosure. Acceptable alternative methods may include press releases distributed through a widely circulated news or wire service, and announcements made through press conferences or conference calls that interested members of the public can attend or listen to in person, by telephone or by other electronic transmissions, including the Internet. The public must receive adequate advance notice of the conference or call and the means of access. The choice of methods is left to the issuer, although sudden shifts in established methods of making public disclosures may be suspect. However, methods effective for some issuers might not be effective for others. For instance, if an issuer's press releases are routinely not carried by major business wire services, other or additional methods might be necessary.

The adopting release contains a model using a combination of methods for making a planned disclosure of material information, such as a scheduled earnings release:

• First, issue a press release, distributed through regular channels, containing the information.
• Second, provide adequate notice, by a press release and/or website posting, of a scheduled conference call to discuss the announced results, giving investors both the time and date of the conference call, and instructions on how to access the call.
• Third, hold the conference call in an open manner, permitting investors to listen in either by telephonic means or through Internet webcasting.

The Commission notes that this will allow an issuer to "discuss its release with analysts in the subsequent conference call, without fear that if it should disclose additional material details related to the original disclosure it will be engaging in a selective disclosure of material information," and that several issuers commenting on FD indicated that many companies already follow this or a similar model for making planned disclosures.

At present, the use of the issuer's own website to make public disclosure is not by itself sufficient, although, as technology evolves and more investors have access to and use the Internet, this method may be sufficient for larger issuers with websites that are followed widely by the investment community. The Commission intends to monitor this situation and might allow this alternative in the future.

• Intentional. A selective disclosure of material non-public information is intentional when the person making the disclosure either knows, or is reckless in not knowing, that the information being communicated is both material and non-public. "Reckless" describes a degree of negligence that is so egregious it constitutes scienter or bad faith, and would not include ordinary negligence. The Commission observes that, while judgments about materiality can be quite difficult, issuers making good faith attempts at compliance are not likely to have a problem. However, the Commission cautions that a pattern of "mistaken" materiality judgments would raise questions about whether mere negligence was involved.
• Promptly. To be disclosed promptly, disclosure must be made as soon as reasonably practicable, but in no event after the later of 24 hours or the commencement of the next day's trading on the New York Stock Exchange after a senior official of the issuer learns of the non-intentional disclosure by the issuer or a person acting on its behalf of information that the senior official knows (or is reckless in not knowing) was both material and non-public.

The Release notes that no private liability should result from an issuer's failure to file or otherwise make public disclosure as required by Regulation FD. FD is an issuer disclosure rule designed to create duties only under the reporting requirements of the Exchange Act and Investment Company Act, and it expressly provides that failure to make public disclosures required solely by FD does not violate the antifraud provisions of Exchange Act Rule 10b5. Issuers who violate FD could be subject to Commission enforcement proceedings including civil injunctive actions with monetary penalties and administrative proceedings including cease and desist orders and fines. Individuals employed by the issuer could be named in such proceedings for "causing" or aiding and abetting violations of FD. Advisers to closedend funds should be sensitive to the impact of these proceedings under Section 9 of the Investment Company Act. The usual antifraud rules would continue to apply to any false or misleading statements made to the public pursuant to FD or otherwise, and to trading or tipping while in possession of material undisclosed information. Conceivably an insider trading case could be combined with an injunctive or administrative proceeding alleging violation of FD or even criminal action under FD. However, failure to comply with FD will not deprive issuers of the ability to use the abbreviated Securities Act registration forms, or their affiliates and holders of restricted securities of the ability to use Rule 144 for their sales (although note that sellers under Rule 144 must represent that they do not know of any material non-public adverse information).

Issuers should review and, if necessary, amend their corporate disclosure and insider trading policies to reflect FD. While its adoption has apparently caused some issuers to cancel meetings with analysts and to cease conducting private conversations with analysts altogether, this seems to be an overreaction. FD nonetheless highlights the importance of the adoption of careful procedures in the area of communications with analysts and stockholders and in some respects will clearly change issuers' practices. Indeed, the release expressly states that "the existence of an appropriate policy, and the issuer's general adherence to it, might often be relevant to determining the issuer's intent with regard to selective disclosure."

The most important change is likely to be in the area of earnings "guidance." The Commission has clearly indicated its position that virtually any selective earnings guidance, whether express or indirect through guidance concerning particular components of earnings or through the use of the jargon that has flourished in this area, will violate FD. At the same time, the Commission has encouraged continued contact with analysts so long as they are not given material non-public information in the process. While materiality determinations are often quite difficult, the Commission has indicated that it is unlikely to second-guess good faith determinations by issuers in this area.

FD reemphasizes the importance of careful procedures with regard to dealings with analysts and the public regarding corporate information. Issuers should make certain that senior officials who are authorized to make disclosures or field inquiries from analysts, investors or the media are clearly identified and familiar with FD and related disclosure and insider trading law, as well as with all important issuer information. Other employees should be reminded that they are not authorized to provide any corporate information to anyone without specific authorization from a senior official, and that any unauthorized disclosures may result in disciplinary action and even in civil or criminal proceedings to the extent they involve tipping or trading.

Regarding contacts with analysts and investors, the Commission recommends that a record be kept of private communications, and that representatives of the issuer decline to answer questions raising materiality issues until clearance from counsel is obtained. The Commission recommends that in appropriate cases the issuer obtain the agreement of analysts not to use information until the issuer has had an opportunity to determine materiality. Care should be taken at all times to keep responses to analyst telephone calls or at analyst conferences consistent. Consideration should be given to

• placing some matters, such as earnings estimates, off limits in private discussions with analysts or individual shareholders
• requiring that more than one person be on important calls
• having a team of professionals, including lawyers and accountants, on call in case it is necessary to put out a press release.

Issuers holding analyst meetings should have scripts prepared and approved by counsel and appropriate executives and, in the event financial information becomes a disclosure issue, review by the issuer's auditors may be appropriate. Any related press releases should be prepared in advance and distributed just before the meeting at which it is intended to make any material non-public disclosures. Among other things, in appropriate cases counsel should consider use of the safe harbor for forward-looking statements in the Private Securities Litigation Reform Act of 1995 (Section 21E of the Exchange Act). Consideration should be given to recording the meeting. Issuers who have not already done so should consider allowing all interested parties to listen to any analyst meetings or conference calls and provide adequate notice and the necessary information to enable them to do so well ahead of the meeting or call. This will avoid an FD issue in the event that material information is disclosed at the meeting.

At the time the Commission adopted Regulation FD, but quite unrelated to FD, it also adopted two new insider trading rules—Rule 10b51, which would clarify whether "use," rather than just possession, of material information is necessary to establish a violation of the antifraud provisions of Exchange Act Section 10(b) and Rule 10b5; and Rule 10b52, which would clarify when a breach of a family or other non-business relationship violates those provisions. Of particular interest are the safe harbor provisions of Rule 10b51 that shelter trades pursuant to pre-existing contracts, instructions or plans meeting certain requirements, and trades where "wall" and similar procedures are in place, from attack under the antifraud provisions of Rule 10b5.

The Commission adopted Rule 10b51 in response to recent judicial decisions regarding whether a trader must be shown to have traded "on the basis of" material non-public information (the "use" standard), or whether it is sufficient to show that the trader was aware of material non-public information at the time of the trades (the "possession" standard). The rule provides that trading "on the basis of" material non-public information in violation of a duty of trust or confidence owed directly, indirectly or derivatively to the issuer, its shareholders or the source of the information constitutes a violation of the antifraud provisions of Exchange Act Section 10(b) and Rule 10b5, and then proceeds to define "on the basis of" to mean trading while aware of material non-public information, in effect codifying the "possession" standard.

The most interesting aspect of the Rule, however, is that it then provides two affirmative defenses to claims that trades were "on the basis of" material non-public information. The first requires a showing that, in good faith and before becoming aware of the material non-public information, the trader:

• entered into a binding contract to buy or sell the security
• instructed someone else to buy or sell the security for the trader's account; or
• adopted a written plan for the trades.

The contract, instruction or plan must:

• specify the amount (in units or dollars), price (including a market or limit price) and date (including a date on which a limit order is in force) of the trades;
• include a written formula or algorithm, or computer program, for determining the amount, price and date; or
• not permit the trader to exercise any subsequent influence over how, when or whether to trade (and anyone who does exercise such influence must not be aware of the material non-public information).

The trader cannot have altered or deviated from the contract, instruction or plan or entered into or altered a corresponding or hedging position.

A person other than a natural person may also establish an affirmative defense by showing that the individual making the trading decision on its behalf did not know of the material non-public information and that reasonable policies and procedures had been implemented to ensure that individuals making trading decisions would not violate insider trading prohibitions, either by prohibiting such transactions or by preventing the individual from becoming aware of such information. This provision acknowledges the legal effectiveness of socalled "Chinese Wall" procedures that banks and brokerage firms have used to preclude the legal attribution of knowledge of a particular fact by, for example, a bank's lending department from tainting trades by the bank's trust department.

New Rule 10b52 defines specified relationships as giving rise to a duty of trust and confidence for purposes of applying the "misappropriation" theory, under which persons who are not traditional corporate insiders can be found to have violated the Exchange Act antifraud provisions by trading while in possession of material non-public information or communicating it to others ("misappropriating" that information) in violation of an express or implied duty not to do so. The new rule essentially codifies a longstanding position of the Commission.

Under The Rule, This Duty Exists When:

• a person agrees to maintain information in confidence;
• the recipient and source have a history of sharing confidences such that the recipient should know that the source expects the confidentiality of the information to be maintained; or
• the source is a spouse, parent, child or sibling, unless the recipient can demonstrate that no such duty exists.

Copyright © 2007, Mayer, Brown, Rowe & Maw LLP. and/or Mayer Brown International LLP. This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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