Comments of Douglas J. Clark
On Proposed Regulation FD
File No.: S7-31-99
I am a member of Wilson Sonsini Goodrich & Rosati, P.C., in Palo Alto, California (http://www.wsgr.com). I counsel public companies, primarily ones involved in various high technology industries, on disclosure obligations and I defend them in shareholder class action lawsuits. I submit these comments personally, not on behalf of any clients or my firm.
My comments address Proposed Reg FD's provisions concerning materiality and the distinction Reg FD makes between "intentional" and "non-intentional" selective disclosure.
Reg FD does not credit the difficulty inherent in talking to analysts. The Second Circuit has aptly characterized issuer/analyst communications as "a fencing match conducted on a tightrope." SEC v. Bausch & Lomb, Inc., 565 F.2d 8, 9 (2d Cir. 1977). As the Commission knows, analysts routinely call company officials to discuss the company's business. The analyst's goal, of course, is to obtain information that will give his firm's clients a leg up in the market. Analysts make these calls throughout a quarter, but the frequency of analyst calls increases toward the end of a quarter. Company officials perceive, correctly, that they must return these calls, lest the analyst punish the company by assuming something is amiss and publish unfounded speculation or criticism. So, a company official returns the analyst call and the fencing match begins. The outcome of the match is rigged, though, because the analyst publishes a report after the conversation and the company official has no control over that report.
I have set forth below a hypothetical that raises issues concerning both materiality and intent. The hypothetical is based on an actual events and, moreover, is representative of the types of contacts my clients have with analysts.
On March 15, 2000, Mega Software Company holds a software developer's symposium and announces that it will soon release a software program that performs a function previously performed only by software developed by Small Software Company. Small Software Company's CEO is deluged by analyst calls. Small Software Company's CEO knows why they are calling. He also knows he has to return the calls; the analysts will savage his company if he does not. He has two obvious responses to the question: how does this affect you? First, Mega's entry into his space will bring more attention to it. Not a bad thing. Second, R&D expenses will increase so Small can stay on the cutting edge and fend off Mega. Anyone who knows his company and its business would assume those two things. He returns two calls before the market opens on March 16. He states the obvious to both analysts. The first analyst, later that day, publishes a report discussing Mega's announcement and its impact on Small. He incorporates the two obvious points. The second analyst issues a note reducing estimates for the balance of the year, premised on increased R&D expenses. The second report is picked up by Dow Jones Newswire, which headlines its story, "Analyst 2 Firm Reduces Small Earnings Expectations after Discussion with Co. Management." Small's stock price plummets after the Dow Jones report.
Small's CEO did not disclose any material non-public information. He only stated two propositions obvious to anyone following his company or the industry it operates in. The analyst seized upon one of them, changed his model radically, and drove the stock price down. This is not unusual. "A skilled analyst with knowledge of the company and the industry may piece seemingly inconsequential data together with public information into a mosaic which reveals material non-public information." Elkind v. Liggett & Myers, Inc., 635 F.2d 156, 165 (2d Cir. 1980). The hypothetical analyst's conclusions may be something that a reasonable investor would consider important, but the information the company conveyed was pedestrian. The way the analyst disseminated the information will make investors, and the Commission, believe that the company gave the analyst more or different information than it actually did.
The attention drawn to Small as a result of the analyst's report will prompt the company, in light of Reg FD, to ask itself if the CEO's conversation with the analyst was an intentional or non-intentional disclosure. To the public, and the Commission, it may look intentional, but I submit that it is unintentional -- Small's CEO did not intend to discuss anything material. The communication, however, cannot be characterized as information "that was disclosed inadvertently through an honest slip of the tongue, or because the individual mistakenly (but not in reckless disregard of the truth) believed that the information had already been made public", to use the Commission's description of a non-intentional disclosure. Small's CEO intentionally identified two obvious market realities.
Small is in a bad position. The analyst has laid his material change in estimates at the Company's feet. Pursuant to Reg FD, the company has to determine whether the disclosure was intentional or not, and make the corresponding disclosure. Then, it has to come up with a disclosure. This presents an independent problem -- Small hasn't had time to quantify the additional R&D expenses. The market will expect management to say something concrete on the topic because the analyst said something very concrete. Doing this "simultaneously" is impossible and doing it within 24 hours is next to impossible.
Conclusion and Recommendations
The core problem with Reg FD is that the analyst's report or other dissemination of information can dictate, in the eyes of the public or the Commission, whether an issuer/analyst conversation contained a material disclosure. Reg FD then asks the issuer to make a difficult legal conclusion -- intentional versus non-intentional -- followed by a time-sensitive disclosure.
I recommend that the Commission abandon Reg FD. In the alternative, I recommend that the Commission revise Reg FD's implicit state of mind requirement to incorporate the scienter standard courts have applied in Rule 10b-5 selective disclosure cases. See, e.g., Elkind, 635 F.2d at 168 ("Absent evidence from which it may be inferred that the tipper knows or should certainly appreciate that the disclosure could reasonably be expected to be used by the tippee to his advantage, the essential state of mind for 10b-5 liability is lacking"). Finally, I recommend that Reg FD be revised to omit any disclosure obligation for non-intentional selective disclosures.
I appreciate the Commission's consideration of my views.