Selective Disclosure, Analyst Guidance, and the Duty to Update:

Building a Safer Safe Harbor

By Boris Feldman

One of the more ironic consequences of the shareholder class-action phenomenon is that it has led some public companies to give guidance with a nod and a wink. Of those public companies that guide the Street as to expected future financial performance, few do so in print. Particularly among smaller public companies, executives may be reluctant to publish their guidance, because they fear shareholder lawsuits if their expectations do not come about. Instead of promoting public disclosure of a firm's expectations for future operating results, therefore, Rule 10b-5 has driven guidance underground.

As a result, companies pursue a variety of conventions for guiding the Street. Some eschew guidance entirely, thereby enhancing the volatility of their stock, since many analysts are unable to model projections without help from management. Other companies provide guidance one-on-one with securities analysts, but not explicitly. For example, when queried regarding their expectations, some companies reply that they do not disclose their internal projections but then go on to point out to the analyst the range of estimates on the Street, implying that they are comfortable with the range. Analysts engage in spot checks with management during the later stages of the quarter, so they can attempt to deduce from voice stress or Druidic cues whether the quarter is "on track." And then the company enters "the quiet period" late in the quarter, clamming up entirely.

If the company misses the quarter, plaintiffs' lawyers circle, attributing all analysts' projections to management without having any idea whether they were, in fact, responsible for those projections.

Meanwhile, individual investors are screaming that "the big guys" get all the valuable information before they do.

It doesn't have to be that way.

Here is an alternative model. In the news release announcing quarterly earnings, the company includes the following disclosure:

With respect to the [next] quarter, the Company has set the following targets for its financial performance: revenue in the range of x to y and net income in the range of a to b. These are the Company's targets, not predictions of actual performance. Historically, the Company's performance has deviated, often materially, from its targets as of the beginning of a quarter. Given that the Company's sales occur disproportionately in the final weeks of a quarter, the Company often does not know whether it will achieve its targets until late in the quarter or even after the quarter has ended. Accordingly, the Company will not update these targets during the quarter. The Company will not report on its progress during the quarter, or comment on them to analysts or investors, until after it has closed the books on the quarter. Any statements by persons outside the Company speculating on the progress of the quarter will not be based on internal Company information and should be assessed accordingly by investors.

The foregoing statements regarding targets for the quarter are forward-looking information, and actual results may differ materially. Among the factors that could cause actual results to differ are the following: [list meaningful, not boilerplate, risk factors affecting that quarter].

On the conference call with analysts following the earnings release, management should decline to comment on expected results beyond the statements in the release. Ditto for the one-on-one calls by analysts following up on the conference call. Throughout the quarter, as analysts wheedle management for some - any - update on how the quarter's going, management should repeat its new mantra: "We will not comment on the progress of the quarter until we report actual results."

What are the likely consequences of adopting this model? First, analysts will have to do more of their own investigation. Then, if their channel checks suggest that the company is having a problem, they can publish their findings. If they conclude that market conditions make attainment of the initial targets unlikely, they can so warn their customers. What they will not be able to do is publish reports that say, "We visited with management last week, and they seem comfortable that the quarter is on track."

Second, all investors - institutions and individuals - will be on the same footing. Comments in the chat rooms along the lines of "I heard the CFO say that orders are strong" will eventually have less credibility, when the market comes to realize that the company really does not provide these kinds of temperature checks.

Third, pressure on the company to "walk the Street down" in the middle of a tough quarter will be gone. If the company realizes that it will miss by a mile, it may choose to issue a press release to that effect. But it will not adjust expectations by nudging the analysts with code words.

Fourth, the company must use correctly the Safe Harbor for forward-looking information created by the Private Securities Litigation Reform Act of 1995. In passing the reform act, Congress immunized from liability forward-looking statements that are accompanied by meaningful cautionary language. Even if the statements are not accompanied by appropriate risk disclosures, forecasts are not actionable unless they are made with actual knowledge of falsity. If the company misses the quarter and is sued, it should win the lawsuit at the outset on a motion to dismiss, pursuant to the Safe Harbor. Rather than seize upon analysts' statements that management was "comfortable" with the prior guidance, plaintiffs will have to allege, with compelling specificity, that when the company disclosed its initial expectations at the start of the quarter, it knew then that they were false. In the real world, that is almost never the case.

A paradigm shift is never uncomplicated.

The first wrinkle is stock sales by insiders. If internal tracking suggests that the company is likely to miss the quarter's projected results materially, management should close the trading window for executives immediately. Indeed, virtually all public companies already follow that practice.

A second wrinkle is whether the company has a duty to update the guidance, prior to issuing actual results, if it expects a miss. The reform act states explicitly, in connection with the Safe Harbor, that "[n]othing in this section shall impose upon any person a duty to update a forward-looking statement." In a statute renowned for its complexity, this is one of the few plain-English provisions. In my opinion, it enables a company that issues guidance pursuant to the model advocated here to forgo updating the market during the quarter, even if the company comes to believe that it is likely to miss. Others may disagree. In any event, however, the case for no duty to update is strongest where the company has expressly disclaimed updates in its sole guidance on future results.

A third challenge will be keeping management within the parameters set by this model. "No nudges" means no nudges. Executives accustomed to cheerleading will chafe at the muzzle. This does not mean that CEOs no longer can wax eloquent at investor conferences about their companies' prospects for the future. It does mean that they have to avoid comforting the audience by saying that the current quarter is on track.

Is this model foolproof? Of course not. Nothing is foolproof in the Lewis Carroll-like world of shareholder class actions. But this model does provide a method for reconciling the dual objectives that motivated Congress in adopting the reform act's Safe Harbor provisions: encouraging meaningful, evenhanded disclosure of a company's expectations for future results while shielding it from lawsuits by disgruntled investors when the crystal ball turns out to have been clouded.