United States: Federal Securities Law - Fair Disclosure [Regulation FD]

SEC's Regulation FD Enforcement Actions Bring Compliance Lessons to Light

You and your company might have forgotten about Regulation Fair Disclosure (Regulation FD) but the Securities and Exchange Commission (SEC) has not. Following a four year break in Regulation FD enforcement actions, the SEC has revamped its efforts in the area and is cracking down on selective disclosures. This could mean stiff penalties for companies and executives who have forgotten the old compliance lessons or failed to learn the new ones. The lessons demonstrated by the SEC's recent enforcement actions might surprise you.

When the SEC adopted Regulation FD in 2000 to prohibit selective disclosures of material corporate information, it quickly came under fire. Critics said the rule would have a chilling effect on issuers' communications and, thus, would negatively impact market efficiency. In an effort to assuage some of these fears, the SEC stated that its enforcement actions would "not be based on second-guessing reasonable judgments made in good faith by issuers," but instead would "be focused on clear violations."

As with most new rules, the SEC acted promptly after Regulation FD's passage to enforce the rule in seven actions between 2002 and 2005. In one of those actions, filed in 2004, the SEC brought a Regulation FD action against Siebel Systems, Inc. (Siebel Systems) and two of its executives for allegedly implicit statements about the company's positive outlook. The district court dismissed the complaint in 2005, stating that the alleged comments were not significantly different from those previously issued publicly by the company. Moreover, the court chastised the SEC for being "overly aggressive." The SEC laid low after the Siebel Systems ruling and did not bring another Regulation FD action for over four years.

Fast forward to September 2009. The SEC re-emerged in the area of Regulation FD enforcement and brought an action against the former CFO of American Commercial Lines, Inc. (ACL). The CFO, who was alleged to have emailed negative earnings guidance to select analysts, settled the charges. A few months later the SEC brought a similar action, this time against Presstek, Inc. (Presstek) and its former CEO. Presstek settled; the CEO, who allegedly commented on negative quarterly results in a conversation with an analyst, is still litigating. With this momentum and a renewed emphasis on Regulation FD, the SEC in October 2010 brought an action alleging that implicit communications by Office Depot, Inc. (Office Depot) executives violated Regulation FD.

What can companies learn about Regulation FD from this recent spate of actions? Surely the first lesson is never to assume the SEC has forgotten about any of its rules. While a drop in the number of a certain type of enforcement action, or even a span of years without any actions, might indicate that the SEC has shifted its focus, companies must be mindful that such inactivity may be temporary. Remaining vigilant in compliance with even rarely-enforced rules is certainly the most important lesson about Regulation FD that companies should take away from the SEC's recent actions. But how can a company, through its regular operations, remain compliant?

Regulation FD: Lessons and Practical Tips for Compliance

The SEC implemented Regulation FD in 2000. The rule was designed to prevent publicly traded companies from disclosing material information to analysts, select investors, or other entities prior to disclosing it to the public. Such "selective disclosures" provide undue market advantages to the entities receiving the information. In practice, the advantaged entities usually are large institutional investors, leaving smaller and individual investors excluded from access and, as a result, trading with less, or significantly delayed, information. The SEC intended Regulation FD to level the playing field by requiring companies to disclose material information to the public simultaneously with a disclosure to any private entity or individual.

Implicit communications and "signals to analysts or investors can violate Regulation FD.

In its 2004 complaint against Siebel Systems and two of the company's officers, the SEC alleged that Siebel Systems violated Regulation FD when one of the two charged officers, Kenneth Goldman, made statements at private conferences that materially contrasted public statements the company had previously made. According to the SEC, the earlier public statements included earnings warnings and conference calls in which Siebel Systems stated in part that the company's results for the prior quarter were poor due to the poor economy and that business would improve if the economy improved. In two private events just days later, Goldman commented that, among other things, the company's sales pipeline was "growing" or "building" and that the sales or business activity levels were "good" or "better." Goldman's statements did not condition performance on the economy as Siebel Systems' earlier statements had.

The United States District Court for the Southern District of New York dismissed the complaint, saying that the SEC scrutinized Goldman's statements down to the "tense of verbs and the general syntax of each sentence." The court refused to impose a standard on companies that it said would place an "unreasonable burden on a company's management and spokespersons to become linguistic experts." The court held that there was no Regulation FD violation where a private statement conveys the same material information that a public statement previously conveyed, and it found Goldman's statements provided the same information as was already generally available to the public. In a more direct blow to the SEC, the court accused the SEC of "nitpicking" and being "overly aggressive."

In October 2010, the SEC charged Office Depot and two of its executives with violations of Regulation FD for making statements to analysts that included implicit warnings about declining earnings. The SEC alleged that company executives made telephone calls to analysts in an attempt to encourage them to lower previous estimates, which company executives deemed no longer feasible. Three executives (one of whom was charged) developed a series of "talking points" for the calls that reminded analysts of the company's prior cautionary statements. The talking points also directed analysts to the earnings statements of similar companies that recently had experienced downturns due to the weakening economy. More than one analyst expressed concern that the company had not released the information to the public, and the executives noted that the analysts were lowering their estimates in response to the calls; nevertheless, the executives continued to encourage the calls. Office Depot and the executives settled the charges. The company agreed to pay a $1 million penalty and each of the executives agreed to pay $50,000 penalties and sign cease-and-desist orders.

While there are some obvious comparisons to Siebel Systems in the area of implicit communications, it appears to be the contrasting points that led Office Depot to settle despite the Siebel Systems holding. One significant distinction was that the evidence demonstrated that the Office Depot executives acted with the intent to change market evaluations— an element that seems to be missing from the Siebel Systems set of facts. Moreover, the Office Depot executives were alerted to the impact of their calls by the responses of the analysts.

One lesson from the Office Depot action is that the SEC believes indirect or implicit communications with select entities can serve as the basis for Regulation FD violations. However, there are steps executives at publicly traded companies can take to prevent or cure such violations.

Privately communicating with analysts or select investors is risky, and becomes more so towards the end of reporting periods or when the communications are outside of the company's normal business practices.

Office Depot was charged with violating Regulation FD when it did not, technically speaking, disclose any new material information. The timing of the calls, and because the company did not ordinarily make such calls, "communicated" something different to the analysts.

Office Depot might have been able to predict its trouble with the SEC. The SEC's Division of Corporate Finance offered guidance on inferences that may be drawn even when no new information is explicitly stated:

Indeed, the SEC quoted this language in its cease-anddesist proceedings against Office Depot.

In the strictest view, the only foolproof Regulation FD compliance policies would call for either (1) no private communications without a confidentiality agreement in place or (2) limiting private communications to simply restating prior statements verbatim. Of course, the former could be quite onerous as well as impractical. But the latter has its own problems. Not only would it be useless, but it could still result in violations. Depending on the context, tone, and timing, the SEC may view such communications as the same type of "hinting" it targeted in Office Depot.

Only time will tell whether the SEC intends to pursue actions arising from mere confirmations of earlier estimates, but companies are well-advised to assume that the SEC might do so. Understanding the inherent risk involved in private communications, especially those occurring at the end of reporting periods, can help companies develop policies and procedures to navigate through the risk.

Directors and officers may be charged even if they did not personally convey the messages.

The CEO and the then-CFO of Office Depot were charged in the SEC's action for their roles in the company's violation of Regulation FD. The SEC found that the two executives discussed how to cause analysts to revisit their estimates, developed talking points for the calls, and encouraged the calls to be made. Significantly, neither officer assumed the role of direct participant in any of the calls. However, the SEC's final rule release explicitly states:

As a result of the Office Depot action, there is now no doubt about the SEC's willingness to charge persons who did not personally disclose information.

The SEC may be more lenient toward companies that have vigorous training and other compliance policies in place prior to problems.

In 2009, the SEC brought an action against Christopher Black, the former CFO of ACL, based on much clearer violations of Regulation FD than Siebel Systems or Office Depot. Black had assisted in developing ACL's earnings guidance policy, which allowed for forward-looking guidance only once each year. Several months after its 2007 guidance, however, management recognized that annual earnings would be significantly lower than predicted and decided to issue a press release. The press release, issued on Monday, June 11, stated that the second quarter would be "similar" to the first. After the press release, and based on updated second quarter information Black received on Friday, June 15, Black sent an e-mail from his home to several analysts essentially advising them that the company's second quarter earnings per share would be around half of the level publicly announced.

The ACL scenario epitomized conduct that Regulation FD was designed to prevent. While the SEC did charge Black, it did not bring an enforcement action against the company itself. The SEC cited several reasons for this decision in its litigation release, including that the company had preventative measures in place, filed a Form 8-K the same day it discovered the disclosure, self-reported the violation, provided "extraordinary cooperation" to the SEC, and adopted additional controls afterward to prevent future violations.

Just months after it settled with Black, the SEC pursued an action for Regulation FD violations against Presstek and its former CEO, Edward Marino. During Presstek's "corporate silence" period at quarter-end, Marino participated in a call with an investment adviser whose funds held a large number of Presstek shares. The SEC's complaint alleged that Marino informed the adviser that the previous months had not been "as vibrant as [] expected" and that performance was a "mixed picture." This differed from the previous, more positive expectations issued to the public. In response, Presstek revised its corporate communications policies and corporate governance principles, replaced its management team, appointed new independent board members, and created a whistleblower's hotline. In the end, however, the company still paid $400,000 to settle the charges against it.

From a corporate perspective, Marino's conduct does not appear to be more egregious than Black's. In addition, Presstek appears to have been just as cooperative as ACL and to have implemented meaningful remedial measures similar to ACL's. Why, then, did ACL escape charges while Presstek did not? The answer may lie in the preventative measures ACL had in place prior to the problem. The SEC praised ACL for having "cultivated an environment of compliance" through controls such as training programs, but it made no mention of similar programs at Presstek. The SEC's action against Office Depot reinforces this "ounce of prevention" hypothesis, explicitly noting Office Depot's lack of any Regulation FD training or written compliance policies or procedures.

Even accidental disclosures should be remedied immediately as if they were intentional; the SEC likely will view most disclosures as intentional.

Regulation FD requires any material information that is disclosed privately also to be disclosed publicly. However, the state of mind behind the disclosure determines when the public disclosure must occur. If the selective disclosure is "intentional," the public disclosure must be simultaneous. If "non-intentional," the public disclosure must occur "promptly" after the issuer discovers the offending communication. When an issuer discovers a non-intentional disclosure, it should not assume it has already violated Regulation FD. "Prompt" disclosure in the face of a non-intentional disclosure requires public disclosure before "the later of 24 hours or the commencement of the next day's trading on the New York Stock Exchange."

It certainly is helpful to know how much time there is to cure non-intentional disclosures, but the important inquiry is whether a disclosure was non-intentional in the first place. The SEC states that an intentional disclosure occurs "when the issuer . . . either knows, or is reckless in not knowing . . . that the information . . . is both material and nonpublic." In the Presstek action, the CEO made the alleged material comments starting at about 10:40 a.m. on one trading day, and Presstek issued a public statement prior to the opening bell the next day. In its complaint, the SEC did not state that the disclosure was "intentional," but rather alleged that it occurred under circumstances in which it was "reasonably foreseeable" that the analyst would sell Presstek stock. The SEC charged Presstek despite the company's correction, stating that the disclosure to the public should have been made simultaneously with the analyst conversation. This serves as a reminder that the definition of "intentional" with respect to Regulation FD is not the same as common use. Because the SEC defines the term much more broadly, companies should remember that the SEC is likely to view questionable disclosures as intentional.

Companies should also presume that any non-public information conveyed to an analyst or institutional investor is material. In its action against Siebel Systems, the SEC relied heavily on the trading activity directly following Goldman's statements to show that the statements were material. While the court did not accept stock movement as sufficient to show materiality, it did find it to be a relevant factor. The SEC will almost certainly not abandon looking to trade activity to support materiality; it may even attempt to take it one step further and use such evidence, when dramatic enough, to demonstrate that a company was reckless in not knowing the information was material.

Conclusion

The SEC's renewed focus on Regulation FD, as demonstrated in three recent enforcement actions, should prompt companies to review their policies and procedures regarding disclosures of non-public information. A few simple compliance policies, based on lessons learned from the enforcement actions, can prevent Regulation FD violations in the first instance and can protect a company from SEC action even if violations occur.

Remedial actions, such as cooperating with the SEC and constructing after-the-fact compliance programs in response to a Regulation FD violation, are helpful but typically will not be sufficient for a company to escape SEC liability. Before problems arise, companies should implement preventative measures, such as formalizing or updating Regulation FD compliance policies and requiring authorized spokespersons and other executives to attend compliance training programs. Companies should avoid making non-routine calls to analysts and, when this is unavoidable, have counsel review a script or talking points before the calls. In addition, companies should evaluate whether, and to what degree, quiet periods and confidentiality agreements might be worthwhile. Finally, after any unplanned calls, consider the substance of any matters discussed to determine if non-public information was conveyed. While the reason for stock price movements may not always be identifiable, unusual movements directly following private communications might help companies identify where they have unintentionally disclosed material information. Identifying such occurrences will allow the company to remedy mishaps through prompt public disclosure. While not all of these tips are practicable for every company or in every situation, they offer a solid base for thinking about Regulation FD compliance. At a minimum, establishing such a compliance-minded environment has the potential for reducing, or avoiding altogether, penalties imposed on a company in an SEC action if the actions of a company official do violate Regulation FD.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.