SEC Speech: Regulation FD - Enforcement Perspective (R. Walker)
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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Regulation FD –
An Enforcement Perspective

by  Richard H. Walker

Director, Division of Enforcement
U.S. Securities & Exchange Commission

Before the Compliance & Legal Division
of the Securities Industry Association
New York, N.Y.

November 1, 2000

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Walker and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

Good afternoon, and thank you, Jim, for your kind introduction. It's a pleasure to be here with you at this conference again this year.

I've always been a big supporter of the SIA's Compliance & Legal Division and of the men and women who are its members. You are our allies in our efforts to protect investors and our markets. I hope you will make your voices heard within the SIA and use your influence to ensure that the positions taken by the SIA on important issues are reflective of your views and not just those of the Association's staff.

I would like to share with you today some of my views, and they are only my views and not necessarily those of the Commission or its staff, about our new anti-selective disclosure rule, Regulation FD. The regulation became effective this past Monday and already I've witnessed its effect. For example, a friend of mine, who is a compliance officer at a large brokerage firm, played a tape for me of a recent conversation between one of his analysts, named Frank, and a company official, named Ernest. The conversation went like this:

(the analyst):

Hey Ernest, it's Frank.

(the co. official):

I'm really not allowed to say whether this is Ernest or not; the lawyers tell me I have to issue a press release first.


Come on Ernest, since when did you ever listen to what your lawyers said? If you had let your lawyers lead you around by the nose, you would never have made all that money on the Bonanza acquisition, I told you about.


Frank, I really don't think it's a very good idea to bring that up...


Ernest, all I'm looking for is a confirmation that you're still on track for the quarter.


I'm on my cell phone and I think we're breaking up. I can barely hear you.


Please, that's the oldest trick in the book. Look, this is no big deal. We've had these conversations every quarter for the past 3 years.


How about them Yankees?


Ernest, focus.


Did you see Piazza's face when Clemens threw the bat at him?


OK, let's try to do this in code. Cough if the numbers are high and sneeze if they are low.


I'd rather not; I prefer a germ-free work environment.


OK, no argument here. Do you speak pig Latin?


Give it a break Frank.


I don't seem to be getting through here.


Good to talk to you Frank; stay in touch.

Humor aside, while FD only became effective last week, it has been part of our collective lexicon for almost a year now. The rule proposal had its supporters – primarily investors and consumer groups. And it had its opponents, including members of the securities bar and this association.

While the SIA's strong opposition to the rule might have made one think that the rule was intended to regulate the conduct of its constituency, the good news is that, in fact, Regulation FD is not primarily about you, the broker-dealer community. As you know, Regulation FD speaks directly to issuers and their representatives, and requires that when they communicate material nonpublic information to securities industry professionals or shareholders, they do so publicly, not selectively. Regulation FD places the responsibility for avoiding selective disclosure, and the risks of engaging in it, squarely on the issuer.

This does not mean, of course, that Regulation FD will not affect the analyst community. You need look no farther than the daily news accounts of analyst conference calls to understand that the analysts' world also has changed and that analysts will no longer have the same direct access to material nonpublic information that they enjoyed before FD.

During the comment period, some opponents of FD argued that there was insufficient evidence of a widespread problem to justify the rulemaking. Now that the rule has been adopted, however, many of the same people are complaining about FD's far-reaching effects on disclosure practices and the markets. To me, this suggests that the problem of selective disclosure was even more widespread than we knew, and that retail investors were being disadvantaged more regularly than we reasonably believed.

Despite the securities industry's outcry against Regulation FD and the flood of alarmist client letters from law firms, Regulation FD was not intended to be revolutionary, though it was clearly drafted to change behavior and to end practices that were universally regarded as unfair.

In fact, Regulation FD was intended essentially to codify what we at the Commission understood to be the acknowledged best practices by issuers. NIRI (National Investor Relations Institute) and many others have said that issuers have always understood that they ought not reveal material nonpublic information on a selective basis. For this reason, and because of statistics showing dramatic improvement in issuer practices after the rule was first proposed, NIRI and others took the position that the rule wasn't necessary because there was no longer a problem.

Ironically, many prominent issuers supported the rule, in part for the same reason. Regulation FD, for them, simply represented business as usual.

I hope to convince you today there is no need for fear or hysteria, and you should not let the securities bar convince you otherwise. You also should be careful about some of the advice that has been circulating in client letters and various commentaries on the regulation. For example, some people have suggested that FD is satisfied by the filing of a "procedural 8-K" announcing that all future FD disclosures will be posted to the company's website. I can tell you the staff does not agree with this view.

Furthermore, Regulation FD was not designed as a trap for the unwary, as many law firms are counseling. In fact, the Commission took a number of steps in revising he final rule for the specific purpose of disarming many potential traps.

For example, under the express language of Regulation FD there is no liability under Rule 10b-5 for failure to make a public disclosure required by FD. This means that FD is not a fraud rule, and perhaps of greater importance, there is no exposure to private liability, which should go a long way in reducing anxiety levels.

In addition, the express language of the rule says that in order to violate Regulation FD, an issuer must have acted recklessly or intentionally in making a selective disclosure. What this means is that we're not going to second-guess close calls regarding the materiality of a potential disclosure. An issuer's incorrect determination that information is not material must represent an "extreme departure" from standards of reasonable care in order for us to allege a violation of FD.

Third, under Regulation FD, issuers are not responsible for selective disclosures made by mid-level management and junior employees. The revised rule carefully circumscribes the issuer employees and representatives for whose communications an issuer is accountable.

By eliminating these so-called traps, we minimized the risk that an issuer would inadvertently violate Regulation FD, and the consequences of so doing. Although I've heard industry spokespersons continue to claim that the rule has caused a "chilling effect" on communications, I personally believe that any such effect being observed is largely due to an over-abundance of caution, fed by the dire predictions of numerous law firms and others opposed to the rule.

In my own view, the market will reward companies that provide timely and reliable information to investors, and will treat more skeptically companies that do not. This should provide a powerful incentive for issuers to overcome any short-term apprehensions about communicating with the market for fear of running afoul of FD. I am confident that as issuers gain experience in dealing with FD, they will become increasingly comfortable with its requirements and will adjust their practices in conformity with the rule.

The fact that FD was drafted to avoid creating a trap for the unwary does not mean, however, that we will not enforce the rule. In this regard, I've heard enough speculation about how the SEC plans to enforce FD to fill the gossip page of any newspaper. Many believe that we are chomping at the bit to bring FD cases. One defense lawyer stated that when it comes to enforcing FD, SEC staffers will be "overzealous" because "they really want to push the envelope to make law and to make a name for themselves." I can assure you that this lawyer either needs cataract surgery or a new lens for his crystal ball.

Let me be clear. We are not looking to frustrate the purpose of the rule – which is to promote broader and fairer disclosure of information to investors – by second-guessing reasonable disclosure decisions made in good faith, even if we don't agree with them. Nor are we looking to test the outer limits of the rule by bringing cases that aggressively challenge the choices issuers are entitled to make regarding the manner in which a disclosure is made. There will be no FD Swat teams, and I do not envision any FD sweeps, unless, of course, there is widespread noncompliance with the rule, which I do not anticipate.

At the same time, however, you should understand that the Enforcement Division is not a toothless tiger. We expect issuers and others to conform their conduct to the requirements of the rule, and if they don't, we will take steps to make them do so.

In particular, we will be on the lookout for two types of violations. The first are egregious violations involving the intentional or reckless disclosure of information that is unquestionably material. This category includes the selective disclosure of information regarding mergers or acquisitions, earnings, or other matters that the courts or the Commission have long held to be material.

As you know, Reg FD draws a line in the sand separating material information, which cannot be selectively disclosed, from immaterial information, which can. A number of commentators and others have expressed concern that the line separating material from immaterial information, though sometimes clear and distinct (as in the categories previously mentioned), is often blurry. And these people fear that the SEC will second-guess difficult judgments on materiality. My response is twofold.

First, issuers are required to make difficult decisions on materiality every day. For the most part, they do so in a prudent and lawful manner. While FD may have added to the number of tough decisions that issuers must make, it has done so in an area where there already is substantial guidance available. The concept of materiality has been around since the inception of the federal securities laws over 65 years ago. Through case law, much of it in the area of insider trading, and staff guidance, there is a substantial, well-developed body of authority telling us the circumstances in which different types of information are and are not material.

Regulation FD's adopting release draws on this guidance and spells out seven items that should be reviewed carefully to determine whether they are material: earnings information; mergers and acquisitions; new products or developments regarding customers and suppliers; changes in control or management; change in auditors; a default or calling of securities; and bankruptcies.

This list puts the world on notice that an intentional or reckless selective disclosure of information falling into one of these categories is likely to draw the attention of the Enforcement Division. Of course, the list is not exhaustive. Nor does it suggest that information in these categories is always material. In addition, there still will be many situations that are not covered by the list and where good judgment will be required.

The second type of FD case I'd be interested in pursuing would be cases against those who deliberately attempt to game the system either by speaking in code, or stepping over the line again and again, thus diminishing the credibility of a claim that their disclosures were non-intentional.

The adopting release makes clear that selective disclosure of earnings information cannot come in the form of "indirect guidance, the meaning of which is apparent though implied." Providing a wink or nod, or a coded response calculated to convey indirectly information that cannot be disclosed directly is no different – and no more or less legal – than telling an analyst point-blank, "Our earnings will be down 10% this quarter."

In addition to winks and nods, we'll be on the lookout for situations involving multiple violations that an issuer claims were non-intentional. Regulation FD provides a delayed public disclosure for non-intentional violations. No violation will occur if the speaker did not act knowingly or recklessly and public disclosure is made within the later of 24 hours or the start of the next trading day on the NYSE. A pattern of "non-intentional" violations, however, surely will raise questions as to whether these were truly innocent slips.

The materiality of earnings guidance is the single item that has garnered the most attention and therefore is worth discussing today in somewhat greater detail. Numerous issuers, and others, have asked what they can say in this regard. It's appropriate for issuers to be concerned, and we have tried to provide guidance that is as responsive as reasonably possible to such concerns. The adopting release contains a sentence that I hope is by now familiar to everyone here. It states: "If the issuer official communicates selectively to the analyst nonpublic information that the company's anticipated earnings will be higher than, lower than, or even the same as what analysts have been forecasting, the issuer likely will have violated Regulation FD."

Many have asked, "does this mean we cannot walk the Street up or down?" and "under what circumstances can we confirm prior guidance?"

The first question is easier to answer than the second. In short, walking the Street up or down is almost certainly prohibited and can no longer be done privately. I'm hard-pressed to think of a scenario where the reasonable investor would not be interested in knowing whether an analyst's forecast is too high or low, if even by a penny, under current market dynamics.

Confirming prior guidance raises a tougher issue. The current views of our Division of Corporation Finance on this subject – and other FD-related subjects – were made public two weeks ago in guidance posted on our website. My own views are, not surprisingly, in accord with this guidance. In deciding whether such information is material, issuers need to start by asking themselves three related questions:

First, where are they in the earnings cycle? It is generally safer to confirm guidance in the first half of a quarter than in the second, unless intervening events have occurred since the last public disclosure that could reasonably raise a question whether earnings would be affected.

Second, how much time has passed since the public guidance was given? If an issuer privately confirms guidance an hour or a day after it has been given publicly, such a confirmation would not likely be material, unless perhaps the issuer is at the very tail end of the quarter.

Finally, issuers must ask whether anything important has happened in the interim between the initial estimate and the confirmation that would likely cause a reasonable investor to question the continued accuracy of the initial estimate. If so, a confirmation would be material.

I've spoken at length about conduct that violates FD. The good news for many in this room is that much of what I have said applies mainly to issuers and not analysts. Regulation FD, first and foremost, is designed and intended to address issuer conduct. Many of you may be wondering, what is the liability exposure of analysts and other of your colleagues?

At the outset, I should state that we understand an analyst cannot control what words a company official ultimately utters, and we don't want to discourage analysts from seeking all information that an issuer can legally provide. As a result, it would not be a common occurrence for the Division of Enforcement to charge an analyst with aiding and abetting, or causing, an unlawful disclosure by an issuer.

This does not mean, however, that analysts could never face some type of secondary liability under Regulation FD. One circumstance in which an analyst may be vulnerable is where an analyst and an issuer conspire or agree that the issuer will feed material nonpublic information to the analyst. I would also view as suspect comments by an analyst to an issuer along the lines of "you can tell me, the SEC will never find out." Comments of this sort raise red flags and convey an intention by the analyst to induce the issuer's violation of FD.

For analysts, there is also the risk that conduct intended to threaten an issuer into revealing information may draw our attention. I would caution analysts against trying to coerce information from an issuer by reminding the issuer that the analyst's firm took the issuer public, has issued favorable recommendations, or supports its stock by serving as a market maker. These statements imply that if the issuer doesn't give the analyst material non-public information, the analyst may take actions that will negatively impact the issuer's stock price. If the issuer succumbs to this kind of pressure and selectively discloses information to avoid economic harm, the issuer will have violated FD and the analyst may have caused or aided and abetted the issuer's violation. It is okay to be persistent and dogged; it is not okay to be abusive and threatening.

Apart from legal exposure, firms would be wise to consider the business risks created by their analysts' conduct in an FD world. If an analyst badgers an issuer into selectively disclosing information, and the issuer is charged with wrongdoing, the analyst may have gained a short-term victory in the quest for information, but lost the war by foreclosing any opportunity to obtain information from the issuer in the future. It's unlikely that an issuer led into a violation by an analyst will speak freely to that analyst again.

The prohibitions against insider trading also remain relevant for both issuers and analysts alike. Regulation FD supplements – but does not replace – insider trading prohibitions. We promulgated FD because selective disclosure was essentially the legal twin of insider trading. Like insider trading, selective disclosure enables recipients of material nonpublic information to profit based on access, rather than skill, acumen, and diligence.

Insider trading liability may arise in an FD world if an analyst breaches an agreement to keep confidential information supplied by an issuer under embargo. Under FD, an issuer is free to make a selective disclosure of material nonpublic information to an analyst if the analyst expressly agrees to maintain the information in confidence. If the analyst breaches such an agreement by disclosing information to a client, the analyst may be liable for illegal tipping if the client trades. Traditional insider trading liability will also be available where an official of an issuer intentionally or recklessly makes a selective disclosure of material nonpublic information to an analyst, who trades or tips, and the issuer official receives in return a benefit – either a pecuniary benefit or a benefit to his or her reputation.

While FD focuses primarily on communications between issuers and analysts, you should not lose sight of the fact that investment bankers have responsibilities under the rule as well. This follows from the fact that an issuer is liable for selective disclosures made by persons acting on its behalf, which specifically includes agents of the issuer. An investment banker working with an issuer in connection with an offering is an "agent" of the issuer. While generally speaking, FD does not apply to statements made in connection with a registered offering, broker-dealers should be aware that when serving as placement agents in private offerings, FD might apply to the statements of their investment bankers, who are in a position to cause an issuer to violate the rule. Moreover, investment bankers who enter confidentiality agreements with their issuer clients and then breach the agreement by disclosing material nonpublic information to potential investors place themselves at risk of illegal tipping and insider trading.

Firms employing analysts and investment bankers should also give careful consideration to their supervisory responsibilities in an FD environment. As you know, the law requires firms to maintain systems designed to prevent and detect insider trading. In light of FD, firms would be wise to re-evaluate their systems to make sure they appropriately address FD confidentiality agreements.

Specifically, broker-dealers should review their Chinese Wall policies to ensure proper safeguards against sensitive information passing between those who are subject to confidentiality agreements on the one hand, and the trading desk on the other. Regulation FD will increase the frequency with which one part of a firm may receive material nonpublic information – for instance on an embargoed basis – that another part of the firm is prohibited from knowing or acting upon. If an analyst received material nonpublic information under an embargo, and the information passed to the firm's proprietary trading desk, the analyst and the firm may be subject to insider trading liability.

Based on everything you've heard today, you may be asking yourself what information of value can issuers still share with analysts in one-on-one situations. In addition to information that already has been made public, the answer is what often is referred to as "mosaic information." By definition, mosaic information is not "material," but that does not mean it's not valuable to an analyst.

An issuer may convey to an analyst information that might seem inconsequential to the typical investor, but which a skilled analyst, knowledgeable about the issuer and the industry, may use to form a mosaic that reveals a material conclusion. An issuer may reveal this type of data even if, when added to the analyst's own fund of knowledge, it contributes to the analyst's ultimate judgments about the issuer.

Many of you may have seen a television commercial in which a mutual fund company boasts that it goes to greater lengths than its competitors to take care to invest its customers' money wisely. As an example of its diligence, the narrator relates that the fund investigated the type of fire-prevention system used by a computer company in which it was contemplating investing. As explained by the narrator, a traditional sprinkler system that would flood a warehouse could result in terrible damage to the company's products, and presumably to its bottom line. Instead, the fund determined that the computer company employed a dry, chemical-based fire prevention system that would not damage its products. That commercial is about mosaic information, pure and simple.

While disclosure practices will change, the role of the analyst remains valued and vital in our marketplace. I have no desire to see that role diminished through overly- aggressive enforcement of these new rules. My goal, which I stated at the outset, was to assure that Regulation FD was not designed as a trap for the unwary and to provide some level of comfort that we will be reasonable in enforcing Regulation FD. I hope I have succeeded in doing so. Thank you.