The Disclosure Dichotomy Competing Models of IR

by Boris Feldman and Ignacio Salceda

Legal regulations and market dynamics are two elements that are omnipresent in any discussion of investor relations. Company executives and investor relations professionals need to comply with regulatory requirements as well as inform shareholders and analysts about their companies. Underlying discussions of the law and the marketplace are two competing schools of investor relations practice. One school urges communicating information with the modest investor in mind. This view, which we will call the Jeffersonian approach, holds that investor relations should tailor its methods of communications, as well as the substance of what is communicated, so as to reach individual investors. A second school, the efficient markets approach, maintains that companies should focus on securities analysts, who, in turn, are capable of informing the market. This view does not disdain small investors, but rather believes that their role in the efficient marketplace is largely irrelevant.

This article will discuss these competing models, which go to the heart of what companies should communicate and how they should do so. In the United States the Securities and Exchange Commission follows the Jeffersonian approach, while the courts have embraced the efficient markets perspective. Although we do not take a position as to which model is preferable, it is necessary for investor relations professionals to consider these differing models when formulating their IR practices. Before deciding on a particular IR question (e.g., should we let all investors participate in quarterly conference calls?), a company should determine which model is guiding its overall IR approach.

Models of IR and the Law

Who is the principal audience for a company's investor communications? In most companies the majority of stock is held by institutions, principally mutual funds and pension plans. For the typical public company, most of the information about it that enters the market comes from financial analysts, usually from large brokerage houses and investment banking firms, which issue reports about the company. Because the big money has been with the institutions and the opinion makers have traditionally been the analysts, companies tend to direct their investor relations efforts toward them.

This focus obviously affects the way companies communicate with the market. Public companies must file periodic reports with the SEC and announce material developments. But a substantial part of investor communications takes place outside of those formal legal requirements. Most public companies try to court analysts and institutions in more private settings. These include presentations at analyst conferences, road shows and one-on-one meetings with representatives from large institutions, as well as on-site visits from analysts and conference calls to discuss quarterly results or to make other major announcements.

It should be emphasized that most public companies do not focus on analysts and institutions out of ideological hostility to individual investors. Rather, over time, the views and actions of analysts have been seen as preeminent. In addition, by communicating with analysts who are knowledgeable about the company and who publish reports distributed to the market, a company can effectively communicate with the entire market. This affects the price of the stock for all investors, regardless of whether or not individual investors are aware of the information. It boils down to a cost-benefit decision: A company is able to communicate with a substantial share of the market for its stock when it hosts a conference call with analysts.

But there is an alternate model for communications with the market. This model views the role of investor relations less as responding to the needs of an efficient securities market than as communicating with all, including individual, investors. This view holds that companies have a responsibility to treat investors equally with respect to information, whether they own only a few or millions of shares, and that shareholders are equally entitled to information (and presumably equally capable of using it). The strongest proponent of this Jeffersonian perspective has been the SEC. In recent years the commission has repeatedly attempted to make the individual investor the focus of investor relations. This is not surprising for an institution born in the Depression, which gave life to the view that Wall Street needed more policing. Elements of this view live on to this day. The motto on the SEC's Web page is a quotation from its first chairman, William O. Douglas: "We are the investor's advocate."

Where the diverging models of investor communications are best examined is in questions of selective disclosure. There is no debate over whether insider-trading laws are good policy. Rather, the issue is the extent to which securities laws should be read to bar companies from informing the market through securities analysts. The SEC has consistently taken the view that all investors should have equal access to potentially material information and that analysts should not receive information beyond that already disclosed to the public. The courts, on the other hand, have viewed the issue less as one of fairness and more as one of economic efficiency: The law should not place obstacles in the path of lawful and productive information gathering by analysts. That does not mean that the courts have been deaf to complaints about insider trading; instead, they have shown greater concern than the SEC about how the expansion of the scope of liability for selective communication with the market may have a chilling effect on practices that are beneficial to the market.

A two-decades-old case involving selective disclosure shows these differing perspectives at work. In Securities and Exchange Commission v. Bausch & Lomb, Inc. (1977), the commission sought a permanent injunction against a company and its chairman, claiming that the chairman had improperly tipped securities analysts concerning earnings estimates and other nonpublic information. There was little question that the officer had in fact communicated this information to a number of the analysts, although he testified that he had done so in error. After extensive testimony the trial court denied the SEC's motion. This decision was later affirmed by the Second Circuit Court of Appeals. Both courts held that the chairman's actions had been an isolated incident that was not likely to recur, and therefore an injunction was unnecessary.

The Bausch & Lomb case can be read (and was regarded at the time) as the SEC's message to executives who might be giving analysts insider information. The decision also reveals the courts' skeptical approach to claims that the securities laws are intended to produce a level playing field for all investors. The decision deems it perfectly natural for a senior executive of a public company to discuss company matters with analysts, so long as the officer does not convey material nonpublic information. Yet even on this issue, the court took a much more limited view of what constituted material information, holding that most of the information conveyed by the insider "was either irrelevant or already publicly known."

The clearest example of the clash of the two perspectives is the case of Dirks v. Securities and Exchange Commission, decided by the Supreme Court in 1983. Raymond Dirks was a financial analyst who covered the insurance industry. In the course of his reporting, Dirks received information from an employee of Equity Funding that the company had overstated its financial results. Dirks investigated the claims and urged a reporter to write about the matter, to no avail. Dirks also told clients and investors of his investigation, who in turn sold their holdings in the company.

After Equity Funding collapsed, the SEC commenced an administrative action against Dirks, alleging that he violated the federal securities laws by communicating information he had received from an insider and thus aided and abetted the insider trading by his clients. The administrative proceeding ended in the SEC's favor. Ultimately, however, the Supreme Court reversed the findings and ruled in favor of Dirks.

Theoretical legal arguments aside, the SEC's position in the Dirks case appears to have been initiated by a concern that some investors would obtain information that was not generally available to the entire market. A majority of the Supreme Court rejected this view. The Court held on both legal and policy grounds that Dirks did not violate the securities laws. Apart from certain legal issues, the Court was emphatic in holding that the securities laws do not mandate a parity of information. Rather, the Court sought to encourage analysts and other market professionals to "ferret out and analyze information" and communicate that information to their clients. Unstated, but clearly implied, was the conclusion that by trading on that information, those clients thereby move securities prices to reflect that information and profit in the process. However, such trading also makes the market more efficient and reflective of all information – to the benefit of all investors.

The Dirks decision was anathema to the SEC. Having failed in an attempt to go after an analyst, the SEC set its sights on an executive in its most notable response to Dirks. In 1991, in Securities and Exchange Commission v. Stephens, the SEC charged an executive of a public company with tipping information to financial analysts, who then communicated that information to their clients. The executive consented to the entry of judgment against him and agreed to pay for the traders' avoided losses, plus penalties, so the commission's theory was never tested in the courts. Notably absent from the allegations, however, was any tangible personal benefit obtained by the executive. According to the SEC, his sole benefit was in having revived a good reputation with the analysts, which had suffered previously because of disappointing financial results. At the time, many commentators wondered whether such a benefit was sufficient under traditional insider-trading rules to establish liability. In any event, because the case was not litigated, the SEC did not obtain a judicial endorsement of its position. This issue is far from settled, and we expect that the courts will have the opportunity to deal with such allegations in the future. SEC chairman Arthur Levitt has stated in recent speeches that the commission believes companies may be tipping analysts and that it is contemplating bringing enforcement actions in appropriate cases. Any such actions would be heavily scrutinized by the free market, followed by the courts.

The Growth of the Jeffersonian Perspective

Over the past few years, there has been a growing debate about how public companies should communicate with investors and the market. Two interrelated developments – the number of active individual investors and technological changes in the equity markets – are principal drivers of these changes. With the advent of the Internet, it is easier than ever for individual investors to conduct research and obtain information previously available only to market professionals. Today anyone with a computer and Internet access can get real-time press releases, SEC filings, investment research and stock quotes as readily as a professional money manager.

Coupled with more accessible information has been the greater ease with which investors can act upon it. With on-line trading, transaction costs for individuals are lower. In effect, the yeoman investor can play the market very much like a money manager: Obtain information in real time and then trade instantaneously and for low cost.

As a result of these changes, there has been a substantial shift in the view of individual investors as to their ability to compete with (or beat) returns obtained by the institutions. Publications dedicated to helping individuals actively trade stocks are proliferating. And much attention has been given to the exploits of small individual investors, whether they are participants in investor clubs or day traders chasing the latest Internet stock. Indeed, the Internet bulletin board or chat room on a stock is the ultimate example of the belief that the little guy can play and win and provides every investor a megaphone to broadcast his views on a company.

Because of these changes, investor communications are at a crossroads. Many companies are considering whether (or how) they should change their investor relations practices to deal with these changes. For example, analyst conference calls have traditionally been limited to a select group of sell-side and buy-side analysts. There was no question about including individual investors. Today some companies get dozens of requests from individual investors clamoring to participate in conference calls, although most do not allow it. Some companies have opened up conference calls to individual investors or put a recording of the call on the Internet for play-back. The majority of companies and their legal advisers tend to view these developments with alarm.

From the financial perspective the rise of day trading by individuals, as well as the proliferation of Internet postings, appears to have increased volatility. Companies are spending more time than ever dealing with rumors circulated on the Internet by ill-informed (or ill-willed) individuals. Lawyers view these developments as potentially expanding the scope of a company's exposure to securities suits. If the quarter does not turn out as the company had predicted in a conference call, an analyst or institutional investor is unlikely to turn to the plaintiffs' class-action securities bar. The irate small investor is less likely to be restrained – and the Internet provides the shareholder plaintiffs' lawyer with greater information with which to craft a complaint.

Still, many companies feel pressure to open up their communications to individual investors. In essence, the Jeffersonian approach is gaining strength, although not as would have been expected. Companies may open up their conference calls, but those calls may also become less substantive, as less time is spent on issues of interest to analysts (e.g., the development of revenue earnings models) and more time is devoted to basic issues about the company. We suspect that this trend will continue and that, to the extent they open up analyst conference calls, companies will shift the avenues of providing guidance to presentations at analyst conferences or to one-on-one sessions with analysts.

The SEC has recently supported the views of individual investors wanting to listen in on conference calls with analysts. Although the SEC has never said that a company must let individuals participate in calls, the chairman recently warned that companies should not convey material nonpublic information on such calls, as that would constitute selective disclosure and expose the company to liability for insider-trading tipping. The Stephens case was eight years ago. We expect that the SEC will attempt to reiterate the message it sent in that case in the near future.

Beyond its usual concern about selective disclosure, the SEC has been active recently in expounding its view that shareholder communications should focus on the individual investor. The best recent example of this is the SEC's plain English rules, adopted in 1998. Under plain English, issuers are required to put substantial portions of registration statements (covers, summaries, risk factors) in intelligible English. By that the SEC means clear, concise disclosures, understandable to an average investor. Part of the goal of the initiative is to make offering documents easier to read for unsophisticated investors. Left open is the question of whether someone who is incapable of understanding an offering document that is not in "plain English" should be making an investment decision in the first place.

The plain English initiative is notable because it does not appear to take into account the question of whether the market is capable of absorbing complicated information without having it explained. For the past several decades, courts have held that, thanks to analysts and sophisticated institutions, the market can absorb complicated information and that this will be reflected in the price of a stock traded on an efficient market. Under this free market approach, plain English disclosures are unnecessary. Yet the SEC has given priority to plain English and has been active in getting issuers to change their offering documents. Clearly, the SEC is not satisfied with a market where unsophisticated individual investors are not able to understand the information contained in offering documents, even if it is reflected in the market price of the stock.

During the past two decades, some of the issues surrounding the obligations of companies in communicating with investors have reflected differing perspectives on the purpose of investor communications and the role of individual investors, financial analysts and institutions in the marketplace. These debates will continue. Indeed, as discussed above, we expect that they will intensify in the next few years as companies, the SEC and the courts deal with the changes in the marketplace. Until they receive further guidance from the SEC and the courts, public companies should consider these conflicting schools of thought in establishing their investor relations practices.

Boris Feldman and Ignacio Salceda are partners in the litigation department of Wilson, Sonsini, Goodrich & Rosati.

The views expressed in this article are those of the writers, and do not necessarily represent the views of the firm.