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March 02, 2005

Reg FD and Earnings Projections Part 1

An article in the Wall Street Journal yesterday says that their survey shows a decline from 72% to 55% in the percentage of companies providing public earnings projections.  Today I’m blogging about Reg FD which created the current climate for investor communication; tomorrow I’ll blog about earnings projections specifically.

Securities and Exchange Commission (SEC) “Regulation FD” for Fair Disclosure went into effect in October of 2000.  The proclaimed target of the regulation was the cozy relationship between company managers and securities analysts at brokerage firms which, according to the SEC, existed prior to the issuance of the regulation.  These analysts were regularly briefed on a “confidential” basis by the company and given a “heads up” if there were significant changes from what they had been writing.

Each quarter just prior to the release of earnings many public companies held a “confidential” call with the analysts who covered them.  The stated purpose of the call, whose contents the analysts were not supposed to reveal until after the company issued its public press release, was to allow the analysts to ask questions and have their commentary on the company ready for issuance concurrent with  the company’s results.

What actually happened in some cases, as the SEC knew full well, was that analysts called their favored (read “big”) clients with the information before the information reached the general public.  This meant that the favored (read “big”) clients of the firms the analysts worked for could buy or sell or, at the very least, prepare to buy or sell on the basis of this information before it became generally known and affected the price of the stock.

Even under the law at the time, trading on insider information was illegal.  However, it was legal and common practice for companies to give this information confidentially to the analysts who covered them so long as the company didn’t know the information was being used illegally.

This advance information not only endeared the analysts to their firms and the firms to their clients, it also was powerful leverage that company management had with analysts.  In the unusually lucid words of the SEC:

“Selective disclosure also may create conflicts of interests for securities analysts, who may have an incentive to avoid making negative statements about an issuer for fear of losing their access to selectively disclosed information.”

It was certainly not unheard of for company management to stop returning phone calls from analysts who wrote negative things about them.

So Regulation FD says that top company management cannot make any material (“material” is legalese for “significant”) nonpublic information selectively available to people like security analysts or investors who may be able to trade or help others trade on that basis of that information.  If a company has something “material” to announce, it has to do it in a public forum like an SEC filing or a press release.  If material information is released or becomes known on a selective basis, the company has an obligation to make the information promptly available to the public.

I think Reg FD is a good thing.  As a company CEO at the time, I wrote a press release praising it (would have blogged in its favor if blogs had existed).  I believe the abuses of insider information the SEC cited were real.  I believe small investors were being disadvantaged by not having access to the same information as big investors.  The Internet, particularly, has made it possible to disseminate information widely and quickly so it is certainly practical to inform all who wish to be informed of material changes at the same time.

Reg FD made it possible for company management to tell analysts looking for inside information to take a hike.  “Nothing personal but we don’t want to go to jail.”  Public companies don’t offend securities analysts if they can help it.

However, although Reg FD makes information available more democratically, it also may result in less information being available.  Some companies immediately decided that Reg FD was a shield they could hide behind when they wished to disclose less.  Some were simply confused by the regulations and decided that staying mum was the better part of valor until some precedents were developed and the SEC gave more guidance.

The regulation was issued at a time when the end of the bubble was leading to a proliferation of class action suits against companies.  These suits, most but not all of which I think were unmerited concoctions by law firms, made companies very leery of communicating anything.  So studies which show less information available post FD than before are suspect.

However, FD does means that companies cannot communicate “indirectly” through analysts.  The biggest effect has been on projections of future financial information. See Part 2 of this blog for that.

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