Writer's Direct Dial
June 30, 2000
Mr. Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Re: Proposed Regulation FD (File No. S7-31-99)
Dear Mr. Katz:
I am writing to set forth my views on proposed Regulation FD. This letter does not necessarily represent the views of my firm, my partners or any of my firm's clients.
I believe that the Commission would be making a grave mistake in adopting Regulation FD. The rule would greatly increase the likelihood of meritless litigation under Rule 10b-5. In addition, it would have a severe "chilling" effect on public companies' willingness to engage in dialogue with analysts and the financial press.
I also believe that the Commission lacks the statutory authority to adopt Regulation FD and that the rule will raise serious constitutional issues.
I. Proposed Regulation FD Represents Bad Policy.
The Commission justifies proposed Regulation FD by asserting that it will reduce "selective disclosure," which it describes as a "serious threat to investor confidence in the fairness and integrity of the securities markets."
As I have pointed out elsewhere, the term "selective disclosure" is nothing but a label invented by the Commission to describe a practice that it dislikes but that it cannot characterize as illegal.
As I have also pointed out elsewhere, the "investor confidence" argument is highly suspect. The equity markets are not far off record highs, and there have never been more investors in U.S. equities.
Indeed, if investor confidence has been harmed over the past year, there may be reason to believe that the cause is less from any actual occurrence of "selective disclosure" than from the Commission's relentless and highly vocal demonization of the practice (e.g., a "stain on our markets") and from its constant disparagement of the diligence and integrity of securities analysts and corporate financial and investor relations officers.
Let's look at the facts.
In 1983, the Supreme Court decided Dirks v. SEC, a decision that the Commission describes in the release as "affording considerable protection to insiders who make selective disclosures to analysts and to the analysts (and their clients) who receive selectively disclosed information." I personally advised analysts in 1983 that Dirks was a blessing for the research function because it reduced the danger that corporate officers could be "second-guessed" by the Commission for good-faith communications to analysts.1
At the same time, I advised analysts that it would be a mistake to use any and all material nonpublic information that a corporate officer might disclose. First, it was important to be sure that there was no "personal benefit" within the meaning of Dirks. Second, it was important for the sake of the corporate officer's reputation and career to be sure that he or she appreciated the material nonpublic nature of the information and that he or she was willing for the analyst to use the information (given the obvious dangers of appearing to "play favorites" among analysts).
In other words, there were built-in market-based incentives not to abuse the freedom that Dirks had granted. Properly applied, therefore, Dirks had not granted a license to "tip" or to take advantage of "tips" but had rather created a "buffer zone" for corporate officers who could engage in free and frank dialogue with analysts without fear of Commission action if they guessed wrong about the materiality of information or were unable to communicate simultaneously with all analysts following the company.
The resulting benefits to the securities markets were clearly understood in a recent authoritative description of the relationship among issuers, analysts and investors:
Investors acquire useful information regarding companies from sources other than Commission-mandated disclosure. One such source is analysts' research reports. As the Commission has long acknowledged and the Supreme Court recognized in Dirks v. SEC, analysts fulfill an important function by keeping investors informed. They digest information from Exchange Act reports and other sources, actively pursue new company information, put all of it into context, and act as conduits in the flow of information by publishing reports explaining the effect of this information to investors. ... Unlike small investors, analysts can arrange to interact with key company insiders and ask them pertinent questions. ...
... Analysts communicate with issuer representatives and then reflect their understanding about likely future results in the reports or updates they publish. The market's expectations of an issuer's future earnings can be gradually altered by issuers leading analysts away from incorrect predictions; less volatility in stock price would result.
The source of the foregoing statements is not any association of securities analysts but rather the Commission's own "aircraft carrier" release of November 1998 (Release No. 33-7606A) (text at and from note 333) (emphasis added).2
In other words, the Commission was quite comfortable at the time of the "aircraft carrier" release with:
- the ability of analysts to obtain information that was not available to small investors,
- the willingness of issuers to provide analysts with "guidance" on earnings expectations and
- the overall market benefits of the interaction between analysts and issuers.
What could account for the Commission's dramatic about-face in the course of a single year?
Could it be that there has been a remarkable increase in the past year in "selective disclosure"? The release refers to "many recent reports" of selective disclosure in the media, but it cites only two specific examples (neither of which is really on point). If other facts or empirical data exist to justify the Commission's change of view, they are not mentioned in the Regulation FD proposing release.
What has changed in the last year is the Commission's vocabulary. Indeed, even the casual reader of the Regulation FD proposing release and of various speeches that preceded it cannot help but be struck by the Commission's astonishing hostility towards securities analysts, principally the "sell-side" analysts employed by securities firms. Without hard evidence, members of the Commission (as well as the Chief Accountant) have in the last year accused analysts:
- of being the beneficiaries of "behind-the-scenes feeding",
- of being enmeshed in "a web of dysfunctional relationships,"
- of being "silenced by their employers,"
- of acting "more like promoters or marketers than unbiased and dispassionate analysts,"
- of tailoring reports more to selling a stock than to accurately reporting an issuer's financial performance,
- of having become addicted to corporate handouts,
- of being willing to "shade" their analysis to avoid being cut off from their source of supply.
It is regrettable enough that the Commission has chosen to disparage members of a profession without hard evidence to back up its charges. It is even more regrettable, however, that such disparagement should serve as the basis for an important Commission policy initiative, much less a policy initiative that runs a grave risk of disrupting channels of communication relied upon by the markets and (until recently) approved of by the Commission.
The type of analyst cross-examination of an issuer contemplated in Dirks and in the "aircraft carrier" release will no longer be possible if the Commission adopts Regulation FD. No investor relations or finance officer will want to take a chance that something that the officer might say will be perceived - by the analyst, by the markets or by the Commission - as "material," particularly with the Commission's recent issuance of SAB No. 99. Discussions with analysts will therefore be confined to quasi-public settings (e.g., the "analyst conference call") and other programmed or scripted venues. Q&A sessions will resemble a politician's press conference. Analysts would have no incentive to participate in such meetings. Indeed, many of the best analysts might find another role for themselves.
Commission representatives protest that none of this will happen because violations of Regulation FD will be treated as reporting violations not giving rise to a private right of action. The Commission is deluding itself if it believes that issuers, analysts or reporters will take comfort from this distinction.
First of all, as other commenters have noted, every responsible issuer takes seriously its responsibility to comply with the reporting rules. Among other things, no company officer wants to be the cause of the issuer's becoming subject to a Commission enforcement action or of losing the benefits, for example, of being able to use Form S-3.
Second, the Commission is disingenuous in stating that "no private liability will arise from an issuer's failure to file or make public disclosure" as called for by Regulation FD.3 To be sure, the release notes that an issuer's failure to "make a public disclosure" may give rise to liability under a "duty to correct" or "duty to update" theory, but liability on either of these theories already exists (or does not exist) independently of Regulation FD. The key issue is whether a failure to file or disclose pursuant to Regulation FD will supply the "duty to speak" that the Supreme Court referred to in Basic, Inc. v. Levinson, 485 U.S. 224, 239 n. 17 (1988), when it stated that "[s]ilence, absent a duty to speak, is not misleading under Rule 10b-5." The plaintiffs' bar will be immensely grateful for the opportunity to litigate this issue, as well as for the opportunity to wave a Regulation FD violation in front of a jury.
One further point: the Commission notes the possibility that issuers may seek to "abuse" Regulation FD disclosures by claiming that they are required by the rule to make what would otherwise be "gun-jumping" communications in violation of Section 5 of the 1933 Act. The Commission has surely also considered the possibility that issuers may abuse Regulation FD by making a large number of public disclosures and claiming that each of these is required by the rule as involving a communication to a third party of "material" and "nonpublic" information. The Federal Republic of Germany's Bundesaufsichtsamt fuer den Wertpapierhandel recently complained to companies listed in that country that it had observed a sharp increase in filings under that country's "ad-hoc publicity" requirements, that many of the filings appeared to be primarily for advertising or public relations purposes and that it was therefore becoming difficult for the markets to identify and assimilate "the really important information." 4
To summarize, the Commission has made no case about the occurrence or adverse effects of "selective disclosure" that would justify the potential increase in litigation and the "chilling" effect on corporate disclosure that would accompany the adoption of Regulation FD.
II. The Commission Lacks Legislative Authority to Adopt Regulation FD.
The Commission cites a number of statutory provisions as the basis for Regulation FD and the other proposals advanced in the Regulation FD proposing release, but the only apparent source of authority for Regulation FD is Section 13(a) of the 1934 Act. Indeed, no representative of the Commission at any public meeting has ever claimed any other basis for the proposed rule.
Section 13(a) confers on the Commission two types of authority in respect of publicly-held companies' reporting obligations:
Section 13(a)(2) authorizes the Commission to require the filing of such annual and quarterly reports as it may prescribe (emphasis added).
Section 13(a)(1) authorizes the Commission to require issuers to file such information and documents as it "shall require to keep reasonably current the information and documents required to be included in or filed with" a 1934 Act registration statement (e.g., a Form 10).5
These two provisions form the outward boundaries of the Commission's rulemaking authority in this area. That authority is not expanded by the references in Section 13's preamble to whatever may be "necessary or appropriate for the proper protection of investors."
Regulation FD's requirements are obviously not keyed to annual or quarterly periods as contemplated by Section 13(a)(2). The Commission must therefore be relying on Section 13(a)(1) as the source of its authority to adopt Regulation FD.
But the requirements of Regulation FD have nothing to do with the contents of a company's Form 10 or to the need to keep a Form 10 "reasonably current." Take, for example, the scenario that appears to cost the Commission the most sleep, that of a company's straightforward "heads-up" to analysts that they should lower their earnings expectations for the current quarter. Let's assume that the warning is both nonpublic and "material" within the meaning of SAB No. 99. On the other hand, it is safe to assume that none of the company's 1934 Act reports (generously viewing these in the aggregate as the equivalent of a Form 10 for Section 13(a)(1) purposes) contains an earnings projection of any kind. It is also safe to assume that the MD&A portion of these reports refers only (as required by Item 305 of Regulation S-K) to "trends or uncertainties" that may have an impact on future earnings. Requiring the company to make a public announcement of the "heads-up" communication (e.g., a lowering of expectations by a few cents a share) can therefore hardly be justified on the grounds that it is necessary to "keep reasonably current" its 1934 Act reports.
Since Section 13(a)(1) does not expand the Commission's power to require an issuer to file reports by reference to any act of the issuer, e.g., a communication by an issuer to a third party, then the Commission must be asserting the power under Section 13(a)(1) to require issuers to file a report simply because of the existence of material nonpublic information. In other words, the Commission is asserting the power to adopt a rule that includes, but extends far beyond, a "duty to correct" or a "duty to update." In fact, it is asserting the power to adopt a rule that requires issuers to make continuous disclosure of material information.
It will no doubt come as a surprise to Congress and to public companies that the Commission believes that it has this power. The last time that the Commission sought to assert such a power was during the deliberations that led to the ALI's publication of its Federal Securities Code in 1980. Section 602(a)(4) of the Code expanded Section 13(a)(1) of the 1934 Act to include reports that the Commission might require for the purpose of "keep[ing] investors reasonably informed with respect to the registrant." Comment 4 to Section 602 stated that the new language was broad enough to permit the Commission to require "instantaneous disclosure" through the issuance of press releases to be filed with the Commission. The comment also, to be sure, said that "[i]t may well be" that the Commission already had this authority under the existing Section 13(a)(1), but this genuflection may safely be regarded as one of the Code's many concessions to the Commission in exchange for its support of the Code.6
To summarize, the Commission lacks the statutory authority to adopt Regulation FD because it has not limited the disclosure required by the rule to that necessary to keep an issuer's Form 10 or similar document "reasonably current."
III. Regulation FD Will Raiser Serious Constitutional Issues
Regulation FD regulation would "compel speech" within the meaning of several Supreme Court cases construing the First Amendment, but the regulation's constitutional vulnerability probably lies more in (a) its "chilling" effect on a company's and its employees' ability to communicate truthful statements to third parties and (b) the likely resort by the Commission (and, possibly, by private plaintiffs) to subpoenas served on financial reporters and securities analysts for the purpose of obtaining evidence of a violation of Regulation FD.
"Chilling" Effect. As noted above, the practical effect of Regulation FD will be to discourage companies from talking to third parties such as analysts and the financial press for fear that an inadvertent disclosure of material nonpublic information will trigger a reporting obligation. Moreover, even if a company consciously wished to disclose material nonpublic information to a third party, the intended communication (which would indubitably constitute speech protected by the First Amendment) will be burdened by the procedural requirement of a simultaneous press release or other public disclosure. Whether these inhibitions amount to a constitutionally prohibited "prior restraint" is an interesting question that will undoubtedly be explored in the first Commission enforcement action under Regulation FD.
Regulation FD's principal "chilling" effect will most likely arise, however, as public companies seek to protect themselves against the occurrence of Regulation FD events (which might be followed by Regulation FD violations) by narrowing the circle of persons authorized to speak to anyone outside the company. In effect, employees (other than an authorized few) will be threatened with dismissal or other discipline if they speak to anyone outside the company without permission. The prohibition will undoubtedly extend to all communications by all employees (other than the authorized few) to all outsiders, and permission will probably rarely be granted. It is clear why companies will impose such a prohibition: they will not be willing to risk the occurrence of a Regulation FD event as a result of either (i) a miscalculation by an employee (particularly one not used to dealing with the media) on whether or not information is "material" or "nonpublic" or (ii) a wrong guess on whether the employee will be held to be speaking "within the scope of his or her authority."
A governmental employer that tried to impose these restrictions would be acting unconstitutionally unless it could carry the burden of demonstrating that the restrictions were reasonably necessary to protect the employer's efficient operations. See, e.g., Harman v. The City of New York, et al., 140 F.3d 111 (2d Cir. 1998). Government action that foreseeably leads a private employer to impose such restrictions should be equally vulnerable in the absence of a showing that the government action served an important purpose, and as seen above the Commission has not made out a persuasive case that Regulation FD is necessary.
Enforcement of Regulation FD. If a financial reporter or securities analyst were to publish an article or report that appeared to contain "material nonpublic information" about a public company, the Division of Enforcement's likely conclusion would be that the reporter's or analyst's source was a person covered by Regulation FD. It would then be the Division's likely response to request information from the issuer in an informal inquiry that could swiftly develop into a formal inquiry with the related service of subpoenas on the company and, not improbably, on the company's officers who customarily deal with reporters and with analysts. If the "guilty" party were not quickly discovered, the Division's likely next step would be to consider serving a subpoena on the reporter or analyst that published the article or report containing the "material nonpublic information."
It is important to keep in mind the range of persons who might publish such articles or reports and might therefore be in danger of receiving subpoenas from the Commission. The eligible universe presumably includes sell-side analysts, judging from the Commission's recent remarks about sell-side analysts referred to above. On the other hand, the eligible universe might also include:
- "buy-side" analysts to the extent that their views become known in the public or trade press, TV interviews and the like,
- rating agencies such as Moody's or S&P,
- financial reporters such as Floyd Norris or Alan Abelson,
- newsletter publishers such as David Tice,
- Internet or TV financial journalists,
- publishers of financial newsletters, whether hard-copy or electronic in format,
- web sites devoted to financial topics,
- persons expressing views in chat rooms.
Many of these sources of information are covered by the Department of Justice's policy statement, 28 C.F.R. 50.10, regarding the service of subpoenas on "members of the news media." I am not aware of any Commission position on whether it is bound by the DOJ policy.7 If the Commission believes that it is bound by the DOJ policy statement, it would be required among other things to negotiate with the member of the news media and then seek the express authorization of the Attorney General before serving a subpoena. If it believes that it is not bound by the DOJ policy statement, it should expect a challenge on this issue from the person on whom the subpoena is served. Whether or not the SEC is successful in convincing a court that it is not bound by the DOJ policy statement, it should still expect to be met with assertions from the person on whom it serves a subpoena that there is at least a qualified federal common law "journalist's privilege" - one that certainly has "constitutional underpinnings" -- to refuse to divulge the source of published information. Overcoming the privilege will regularly involve the Commission in lengthy, expensive and vexatious litigation.8
* * *
Members of the Commission's staff have been quoted in recent months to the effect that, for purposes of Regulation FD, "analysts analyze, and reporters report." The fact is that analysts, reporters and other "newsgatherers" all do a mixture of analysis and reporting. Even a columnist in a print newspaper often "sits" on information until he or she is ready to publish a story, and an analyst may sometimes disseminate news within minutes after receiving it. Moreover, in the securities area, all newsgatherers are in constant competition with one another. The Commission should proceed cautiously before acting on any belief that it can draw distinctions among newsgatherers for purposes of Regulation FD. Any attempt to do so will require it (at a minimum) to make new findings on the rule's anticompetitive effects and to repropose the rule for further public comment.
Very truly yours,
|1||My perception of this danger was not without foundation. See, e.g., the Commission's Javert-like pursuit of Bausch & Lomb Inc., its chief executive officer and a number of analysts only a few years before the Dirks decision, SEC v. Bausch & Lomb Inc., 565 F.2d 8 (2d Cir. 1977), and the proceedings referred to therein.|
|2||While the release noted the Commission's concern about research reports being used to "hype" a company's securities, this was in the context of explaining the Commission's efforts to seek a "balance" between the 1933 Act elements of this concern and the countervailing consideration of promoting the availability of current information.|
|3||The footnote supporting this statement is limited to the assertion that "[c]ourts have held that there is no implied right of action under Section 13(a)" of the 1934 Act. The note cites as support for this assertion two cases involving alleged violations of the Federal Corrupt Practices Act, not the reporting requirements..|
|4||Letter dated April 19, 2000, available at www.bawe.de/schr5.htm.|
|5||It should be noted that Section 13(a) only authorizes the Commission to require the filing of reports with the Commission. Nothing in the statute authorizes the Commission to require issuers to make "public disclosure" in any form other than a 1934 Act filing, e.g., by means of a press release or press conference, as contemplated by Regulation FD.|
|6||A 1985 law review note recommended that the Commission impose on issuers a "continuous duty to update." The note's argument that the Commission had authority to impose such a duty was based on its reading of Section 12(b)(1) and the MD&A requirements as already "imply[ing] mandatory across-the-board disclosure of all material information" (emphasis in original). Subsequent developments concerning MD&A make it clear that there is no such mandate.|
|7||There is one court decision holding that the NLRB is so bound. Maurice v. NLRB, 1981 U.S. Dist. LEXIS 16481 (S.D.W.Va. 1981), rev'd on other grounds 691 F.2d 182 (4th Cir. 1982).|
|8||In this connection, the courts have extended eligibility for the journalist's privilege beyond the traditional media to anyone who engages in newsgathering for the purpose of disseminating news to the public. Such persons have included documentary film-makers, securities analysts, and authors of technical publications, professional investigative books and articles in periodicals.|