Back to basics: Regulation Fair Disclosure

Thanks to Regulation Fair Disclosure, companies must learn to communicate with all their investors, and analysts must do research again. Now, there’s a concept.

Thanks to Regulation Fair Disclosure, companies must learn to communicate with all their investors, and analysts must do research again. Now, there’s a concept.

By Dan Colarusso
October 2001
Institutional Investor Magazine

In more than ten years as a transportation and shipping analyst, Credit Suisse First Boston’s Gary Yablon had never made the roughly five-mile trip from his Manhattan office to Port Elizabeth, the New Jersey piers that are among the busiest in the U.S.

But in May, Yablon chartered a bus and took 25 clients on a field trip to the gritty docks, redolent with the odors of rotting fish, tidal mud and oily seawater. They chatted up shipping company executives, employees and longshoremen and ferreted out enough information on slowing inbound and outbound shipments to make the determination that European business was “deteriorating” rapidly. As a result, Yablon says, CSFB lowered estimates on companies with European exposure, including FedEx Corp. and United Parcel Service, earlier than its competitors did. The port, he says, “was chock-full of information.”

For Yablon, such field trips - he also takes clients to the port at Long Beach, California - and surveys like his weekly “Shipper Comments” and monthly “Truckometer,” which monitor freight traffic, “have gone from being a luxury to a necessity. The information on the margins is more important because you have to take what you can get. The companies cannot hold your hand anymore.”

One year after the Securities and Exchange Commission enacted Regulation Fair Disclosure, analysts across Wall Street have gone back to the basics, digging for genuine research insights instead of just taking notes while CFOs speak. “I don’t mind it,” Yablon says. “It makes you roll up your sleeves to separate your work from competitors’.”


Yes, good analysts always did their own homework rather than take executives at their word. But during the bull market of the 1990s, some - let’s face it - got lazy. They may have masked their intellectual siestas with reams of statistics, but too often these were all but downloaded from the companies they covered. With stocks roaring almost inevitably upward, it was tempting for analysts to take “guidance” about company prospects from CFOs and investor relations executives. Doing so meant they would be more accurate in their earnings estimates - and less likely to offend the corporate clients of their investment banking colleagues.

Reg FD is changing all that. It prohibits companies from giving “material” information to selective parties, be they sell-side analysts or favored portfolio managers, before it’s made available to the general public and individual investors. Long-standing insider-trading laws have theoretically prevented investors from benefiting financially from nonpublic information, but analysts, with easy access to management, sometimes could give their major clients a bit of an edge.

No longer. The new rule carries a bite: Since October 23, 2000, the wrong kind of schmoozing can land a company or an analyst in court, as the defendant in a federal lawsuit. It is a violation of Reg FD for corporate employees who regularly communicate with securities market professionals to give an analyst “material” information ahead of the crowd and for the analyst to use it, even if the communicator is not a senior executive and does not stand to personally profit from disclosing information. But it’s not clear what is material.

Reg FD was promulgated by now-retired SEC chairman Arthur Levitt Jr., who wanted to put an end to selective disclosure of information as part of his effort to level the playing field for mom-and-pop investors. “When a market sells off the way this one has, the public is skeptical,” Levitt said even before the terrorist attacks on the U.S. sent the stock markets on a roller-coaster ride. “The belief grows that some people are being advantaged. The perception of fairness is important for confidence.”

Critics on Wall Street fiercely opposed Reg FD, claiming it would increase volatility in the market by depriving analysts of critical information and perhaps making companies reluctant to release information at all, even to the public, for fear of running afoul of the rule. Certainly, different companies have responded to the new regulation in different ways. Far from being afraid to provide any information, most publicly traded companies have chosen to send out waves of press releases and to host frequent Webcasts to make sure all investors get information - important or not - at the same time. But a few others have clammed up, except for making announcements required by law.

“There was a breakdown in the sense of what the responsibilities of analysts and companies were,” says Michael Hershey, manager of the Henlopen Fund, a Kennett Square, Pennsylvania-based money management firm. He points to the cozy relationships between analysts and the companies they covered and an investment climate that frowned on skepticism. “Now, with FD, we may be going back to something that had to be reinforced: that public companies have an obligation for wide dissemination of material information.”

With the major firms getting back to work doing real research again, at least one of Levitt’s objectives has been met. Smaller institutions and individual investors are getting more timely access than ever. They’re eagerly logging onto Webcasts and dialing into conference calls to listen to corporate executives and analysts and to glean any insights they can. CCNB, which provides live and archived Webcasts for companies, says that in the 12 months through August, the audience for live Webcasts increased from 110,000 to 1.2 million. The audience for archived Webcasts, which was already three times as large as that for live Webcasts, grew 25-fold in the same period.

Critics are quick to say that these changes have not been for the better. “Before Regulation FD it was clear: Giving out material information selectively was against the law,” says Wells Fargo & Co. CEO Richard Kovacevich. “I don’t understand FD. It seems to mean, ‘Don’t tell anybody anything.’”

Traders and money managers assert that in the year since it has been in force, the new rule has caused falling stocks to fall faster, widened the spread between different analysts’ earnings estimates and created both surfeits of information and news vacuums between earnings announcements.

In fact, in July Zacks Investment Research said it found that the difference between the high and low estimates for stocks in the Standard & Poor’s 500 index had grown by 40 percent in the past year, to 35 cents per share from 25 cents. That doesn’t surprise Chuck Hill, director of research at Thomson/First Call, which has not done a similar study. But Hill says that the widening spread of earnings estimates may be a good thing. “Some of the numbers on the extremes [of the estimates] may be on to something,” he says. “Too many analysts were not doing much more than parroting the companies.”

To be sure, the market over the past year has been one rocky place, filled with dozens of missed earnings estimates and corporate profit warnings. It’s hard to tell how much these disruptions in information flows can be blamed on Reg FD and how much stems from a weakening economy and the collapse of stock prices. Even some vocal critics of the rule have their doubts. “We’ve conceded the volatility issue, because we’re in a period of higher sustained volatility,” says Frank Fernandez, chief economist for the Securities Industry Association. “You couldn’t have picked a more difficult time to judge this.”

Indeed, there are indications that Reg FD has had little impact on trading. In July, K.R. Subramanyam, associate professor of finance at the University of Southern California’s Marshall School of Business, released a study stating that Reg FD had not made stocks more volatile around earnings announcements and that there had been an “increase in the quantity of firms’ voluntary forward-looking disclosure.” In other words, there had been more earnings preannouncements since Reg FD took effect.

Subramanyam’s study, which examined three time periods around quarterly earnings announcements, starting with the fourth quarter of 2000, concluded that stock price volatility during those periods had actually declined since Reg FD went live. “If the information was not there in the market, we should have seen big price swings,” Subramanyam says. “If anything, it came down.”

The offsetting factor, of course, is that earnings preannouncements had tripled in the same period. Subramanyam plans to address price volatility because of preannouncements in a follow-up study.

For years research analysts have depended on private meetings with the executives of the companies they cover for nuggets of information that could give them an edge over their analyst competitors and individual investors. Frequently, they met with their investor relations contacts to test their estimates of earnings prospects: sharing their assumptions, asking for comment - sometimes even going over their spreadsheets with IR people. Although they rarely offered specific earnings forecasts, IR managers skillfully nudged analysts in the direction the company desired, a point where neither the company nor the analyst would be embarrassed. “If you expect earnings to be $1.25 per share, you want analysts to have estimates between $1.10 and $1.30,” says one longtime IR specialist. “So you question the assumptions and comment on each one until you can say, ‘We can live with that.’”

This process was called “guidance” or, more cynically, “a wink and a nod.” The problem was that the guidance wasn’t available to everyone. Its principal beneficiaries were the big institutions that the sell-side analysts advised and the brokerage firms that employed the analysts and earned commissions based on their advice. Companies benefited because by managing the flow of information they could avoid missing unrealistic estimates - and protect their share price. Retail investors got left behind.

That didn’t sit well with Levitt’s activist SEC. What prompted the chairman to act when he did, in 1999, is unclear. Many point to an incident that year when Abercrombie & Fitch’s investor relations director, Lonnie Fogel, left a voice-mail message for Lazard Frres & Co. analyst Todd Slater and a handful of other buy- and sell-side analysts, letting them know that the retailer’s third-quarter sales would fall short of expectations. Five days passed before the company went public with that information; the time lapse provided ample opportunity to sell - or sell short - A&F shares. During that period the stock declined 15 percent. In the day after the announcement was finally made to the world at large, the stock fell a further 19 percent, eventually dropping a total of 43 percent in three weeks. A&F’s Fogel resigned his position. Lazard’s Slater declines to comment, citing lawsuits.

But although the A&F problem may have proved the last straw for Levitt, former SEC general counsel Harvey Goldschmid, who drafted Reg FD, says the regulation was already in the works. “For at least a year before the situation, Arthur Levitt had been increasingly concerned about selective disclosure,” says Goldschmid, now a professor at Columbia Law School.

Even inside the SEC, support for the provision wasn’t universal. Laura Unger, the commissioner and former interim chairwoman who made headlines lambasting analysts’ conduct in other areas, opposed FD because of concerns that the regulation would make companies less communicative. So, too, did recently confirmed chairman Harvey Pitt, formerly a partner at Fried, Frank, Harris, Shriver & Jacobson. Still, Regulation FD passed in a 3-1 vote of the SEC.

Pitt’s former opposition notwithstanding, Reg FD seems to be here to stay. Changing the rule isn’t on anyone’s list of legislative priorities in the wake of the terrorist attack on the World Trade Center. In fact, an argument can be made that Reg FD is exactly the kind of confidence-building measure that’s needed now, because it is all about assuring equal treatment of investors.

The policing of interchanges between companies and their favored investors and analysts has historically been so lax that many assumed that Reg FD would quickly become ineffectual. But that hasn’t been the case. To date, companies have been so gun-shy about lawsuits that both the spirit and the letter of the rule have remained relatively intact. “When FD was passed, people thought that after a few months things would go back to normal,” says Frank Bivona, chief financial officer of bond insurance giant Ambac Financial Group. “But that hasn’t happened.”

What has happened quite often is an information overload as some companies inundate the market with pronouncements big and small. “It used to be that if you changed your guidance three times in a year, your CEO got fired,” says an IR manager. “Now you change guidance because it was cloudy that morning.” The thinking is that you cannot get in legal trouble for providing investors with too much information.

“No company wants to be the poster child for Reg FD,” says Kevin McCaffrey, who heads U.S. equity research for Salomon Smith Barney. “What’s dangerous is when they say, ‘We have nothing more to say than what we said at our last public disclosure,’ and investors interpret that to mean everything’s okay.”

This has also affected the ability of companies to spin bad news. Before Reg FD, earnings expectations could be massaged downward through careful leaks. Filtered by analysts’ explanations and reassurances, stock prices would move only incrementally if earnings fell short. Now, with contact curtailed, earnings surprises really are surprises. When information is broadcast to one and all, and magnified by the Internet, earnings disappointments result in large sell-offs and plunging prices.

Bivona ran into a midquarter Reg FD, situation in the first quarter of 2001, when analysts began to interpret the impact falling interest rates would have on Ambac’s business. One, whom Bivona declines to identify, “was going a little too far” in estimating that impact. “Before FD, analysts could come up with a theory and ask us about it. Now they can’t do that, so the sell side makes its own expectations,” Bivona says. “And I was wondering, ‘Do I make a call to the analyst, or do I issue a press release?’”

He did neither: The first option would have been a violation of Reg FD, and he felt the second would have obligated Ambac to send out a press release every time an analyst went astray.

Two incidents within one week in July illustrated Reg FD’s potential pitfalls for many listed companies. First, a rumor about a possible SEC investigation of PeopleSoft, an enterprise software company, was sent as an online instant message from hedge fund manager Frank (Quint) Slattery to an analyst. PeopleSoft learned of the rumor and got its hands on the message, which it forwarded to the SEC for further investigation into the possibility that material information had been disclosed or that the rumor was started for profit. Just days later drugstore chain CVS Corp. announced that one of its executives had accidentally given earnings guidance to an analyst.

According to some market participants, the SEC has been aggressively pursuing suspected Reg FD violations, even, one securities attorney says, to the point of being “prickly.” Goldschmid says that concerns are overblown and that the rule clearly states that the government will take action only if a company is reckless - a high hurdle for the SEC - or intends to disclose information privately. “The rule was built to avoid cheap-shot cases,” Goldschmid says.

Still, SEC officials have said publicly that the agency’s enforcement division is examining ten potential Reg FD violations. The most widely publicized is that of Motorola. In March the company reviewed an earlier preannouncement with analysts; five cut their earnings estimates within 24 hours of each other. Although Motorola denies having given new guidance, the timing of the changed calls set off alarms at the SEC about selective disclosure.

Christian Mixter, a partner in the securities practice at New York law firm Morgan, Lewis & Bockius, says most of his clients struggle to determine what, exactly, constitutes material information and thus needs to be disclosed. “The SEC says it’s okay to give analysts one piece of the mosaic to help understand your company,” he says. “But you also don’t want to feed analysts big pieces of information to give them an advantage over anyone else. The question is, What’s the difference between those two?”

Goldschmid says some companies have been given overly cautious legal advice. “As everyone else provides nonmaterial information to analysts, the holdouts are realizing that if they don’t, they will pay a price in the market,” he says.

Ambac is typical of companies that have embraced compliance with Reg FD. Brian Moore, who heads investor relations at the $6.1 billion-in-revenues insurer, works closely with CFO Bivona in dealing with analysts. He says Reg FD has made his job easier. “You get calls during a quarter about pipeline or to find out whether you’re comfortable with estimates,” he says. “I used to be vague; now I know it’s off-limits. A year ago you’d get calls from sell-side analysts. Now you don’t. Whenever there’s a question, it’s easier to just put out a press release.”

But that creates its own problems: Sometimes a press release can make information “appear more material than it really is,” Moore says.

In early August coal company Massey Energy Co. planned to meet with a group of institutional money managers in suburban Pennsylvania. Going into that meeting, though, Massey started to see signs that it might fall short of its fourth-quarter expectations, because of the cost and time of training new miners and transportation delays in West Virginia.

Massey kept its September 26 lunch date with the buy-siders but not before squeezing off an earnings warning the previous evening. Those developments sheared 18.5 percent off the share price in one day but proved to the Henlopen Fund’s Hershey that the company was interested in a dialogue with investors, regardless of the short-term impact on the stock. Hershey’s fund and its affiliate, Landis Associates, which have $200 million under management, were among four institutions at the meeting.

“I think they made the right decision. They felt they still had a good story to tell, but they have some specific issues that are working against them right now,” Hershey says. “I thought [preannouncing and not canceling the meeting] was the thing to do, given the circumstances. They didn’t want to come to a small group and not be able to answer questions.”

Smaller companies, like financial services software outfit Sanchez Computer Associates, have different concerns. Followed by just five analysts, Sanchez can keep track of what it tells each of them. Still, the company began to give two quarters worth of revenue and earnings-per-share guidance in the fourth quarter of 2000; it tries to define its sales and product pipeline for investors as well as it can. Both were Reg FD-related decisions. “Reg FD sharpens your focus on the information you do publish,” says IR head Gregory Ryan. “It hasn’t affected the stock, certainly not in a negative way.”

The biggest issues for a company like Sanchez, with $250 million in revenues, are alliances with larger companies that may disclose information outside Reg FD guidelines. “It may not be material to them,” Ryan says, “but to us it can mean the difference between making the quarter or not making the quarter.” A casual comment by a large customer about Sanchez might be very material information indeed for the software company.

Although Sanchez Computer plays well with investors, some technology companies have felt the pangs of adjustment. “Some of our clients are worried, because their quarters can vary so much,” says Keith Eggleton, a partner at Silicon Valley law firm Wilson Sonsini Goodrich & Rosati. “What has changed is the amount of explicit guidance they give. But that also makes them feel, at the end of the quarter, compelled to preannounce if they’re not going to make estimates.”

Reduced guidance makes analysts work that much harder. But their output may end up being much better. “I think that Reg FD is forcing analysts to become analysts again,” says Maryann Keller, a former auto analyst who ranked No. 1 on Institutional Investor’s All-America Research Team from 1979-'82. “If I were to pursue being an auto analyst today, where would I go? Well, I’d go talk to car dealers and auto-parts companies, because they’re a window into the auto manufacturers. I’d really make friends with people in all of those businesses. I mean, it’s not that hard to do research. It really isn’t.”

But to avoid doing the same old research and depending upon the occasional selective-disclosure kiss, analysts have taken the offensive. Several major firms have freed up budget dollars for any analyst who wants to develop a proprietary study to offer a competitive edge.

James Moore, who covers software companies for Deutsche Banc Alex. Brown, says information he and other analysts are getting from management these days is “more carefully worded” than in the past. That, combined with vicious market conditions, has forced him to spend time visiting with corporate customers of the companies he covers - kind of a geeky, institutional version of the “mall walk” retail analysts take to see how shoppers are behaving.

Software spending has been reduced drastically, making it more important than ever for Moore to understand the mind-set of customers. “I visit with the chief information officers and try to get at their priorities, time frames and budget projections,” he says.

“This is forcing people to do more real research instead of simply trying to get information first,” says Joel Silverstein, a former sell-side analyst who’s now a money manager with Cohen, Klingenstein & Marks in New York. Midlevel managers are now basically off-limits to analysts, who once used them as valuable but naive sources, and the one-on-one meetings that are allowed tend to be watered down to general strategic discussions.

Smaller investors aren’t complaining. Paul Foster, a strategist for an options news service called who often plays the positions he reports (and ones he does not), says he enjoys the access Reg FD has given him. “Analysts were protecting companies. Now all of a sudden, I’m listening to conference calls and have access to the information myself,” he says. “By me listening to calls, I get ideas. I can hear the tone of voices of management. It makes a difference.”

Management and analysts must continue to adjust to the new boundaries of their relationship. “About six months ago analysts were saying companies were being difficult about giving forward-looking statements,” says a senior research executive at a major firm. “By now it’s just a minor irritant.”

Skepticism about Reg FD abounds. “A big question is whether the smart-money crowd is simply going to figure out new ways to get information ahead of other investors,” says John Maloney, CEO of M&R Capital Management, a New York money management firm with $300 million under management. “It’s far from clear that the reality before this was materially worse for the retail investor. Is this cure ultimately going to be worse than the disease?”

Others argue that Reg FD is an important part of adjusting to the new cynicism of investors about the market. Says David Martin, head of the SEC’s corporate finance division: “Do we want a market in which there’s no role for analysts? No. We do want a substantive and meaningful new policy around analysts. I think Reg FD is a way to get at that.”

To Levitt, however, the only proof he needs of the wisdom and power of Reg FD comes from individual investors. “People stop me in airports,” he says happily. “I can’t tell you how many people have complimented me on the rule or tell me they now listen in on conference calls.”