SULLIVAN & CROMWELL
April 28, 2000
Jonathan G. Katz, Secretary,
Securities and Exchange Commission,
450 Fifth Street, N.W., Stop 6-9,
Washington, D.C. 20549.
Re: Selective Disclosure and Insider Trading--
File No. S7-31-99
Dear Mr. Katz:
We are pleased to submit this letter in response to the Commission's request for comments contained in Securities Exchange Act Release No. 42259 (Dec. 20, 1999).
Our comments primarily address proposed Regulation FD. Although we understand the concerns expressed by the Commission regarding the impact of selective disclosure on securities markets and investors, we question whether Regulation FD represents a wise approach to this long-standing issue of federal securities regulation. As discussed below, we believe that adoption of an immediate public disclosure requirement with respect to the release of material nonpublic information--one that would, in effect, supersede settled principles of anti-fraud law and established disclosure practices--may very well result in restricting, rather than enhancing, the flow of information to the public. We also offer specific comments on the scope and language of the regulation.
Following our comments on Regulation FD, we offer comments on proposed Rule 10b5-1.
As the Commission is aware, the application of the anti-fraud provisions of the federal securities laws to the selective disclosure of material nonpublic information by issuers to analysts, the media and investors was once the source of considerable uncertainty in the corporate, financial and legal communities. Commission pronouncements and existing case law offered little guidance as to when the disclosure of nonpublic information--for example, recent sales trends, an inventory build-up, a plant closing, an employee layoff or the introduction of a new product or service--merely "filled in the interstices" of information already in the public domain and when such disclosure crossed the line into fraudulent conduct. It was this uncertainty--almost invariably involving difficult and time-sensitive judgments about the "materiality" of an item of information--that led Judge Friendly to describe the relationship between a corporate spokesperson and a securities analyst to be akin to a "fencing match conducted on a tightrope."1 This situation plagued corporate public and investor relations activities for years.
Much of the uncertainty surrounding this issue was eliminated, however, with the Supreme Court's landmark 1983 decision in SEC v. Dirks.2 Without having to address a difficult issue of materiality (the information in Dirks was clearly material by any standard), the Court nevertheless clarified that liability could be imposed under Exchange Act Section 10(b) and Rule 10b-5 only where selective disclosure of material nonpublic information involves a breach of duty by a corporate official through the receipt of an improper personal benefit. By focusing the issue of liability not simply on materiality but also on the motivation of the insider in revealing the information, the Dirks decision effectively created a "safe harbor" for legitimate disclosures by issuers to analysts, media representatives and investors, undoubtedly encouraging greater openness and candor on the part of issuers in their dealings with the investment community.
We are, therefore, concerned that the Commission's initiative to implement--in the name of "parity of information"--an immediate public disclosure requirement with respect to the release of material nonpublic information will serve only to reimpose on issuers, analysts and investors the same uncertainties about line-drawing that prevailed prior to Dirks, and that this uncertainty may substantially constrict the flow of information to the public to the detriment of investors. The parity of information sought by the Commission may in fact become a parity of non-information (or perhaps even of misinformation).
For many issuers, it may be far easier to adopt a "policy" of avoiding analyst or investor meetings, rather than to decide whether a particular meeting "is reasonably designed to provide broad public access to the information" or whether, if it is not (or may not be) so designed, some remark by a corporate official could trigger an "immediate" obligation to issue a press release or to file an Exchange Act report. Further, some issuers could use Regulation FD as a "shield" to hide unfavorable information, citing the requirements of "parity of information" as an excuse for silence.
Regulation FD may also act as a significant disincentive for analysts to perform their obligations to, in the Commission's words, "ferret out and analyze" information. In this regard, proposed Regulation FD clearly discourages the kind of one-on-one contact between corporate officials and securities analysts that served to expose a massive fraud in Dirks (a fraud that for years had eluded the investigative efforts of others). Thus, an issuer sensitive to its responsibilities to be "fair" to investors under the federal securities laws might shun personal interviews and telephone conversations with analysts, reporters and investors, particularly in light of the inherent difficulty of making snap judgments about the "materiality" of matters discussed. To the extent the issuer held analyst meetings at all, it would be likely to either organize large gatherings or conference calls with public access at which in-depth questioning would be difficult due to the number of participants and time constraints involved, or else rigidly adhere to a pre-determined script in an effort to avoid disclosure of any item of information that could arguably be deemed "material." Although this result may advance some notion of financial democracy, it may also discourage enterprising analysts from digging as deeply into corporate affairs as they are permitted to do under current standards and practices. Why should a talented analyst spend time studying the business of the issuer if his or her only occasion to speak to management is a meeting or phone call with scores of other participants during which there may not be time to answer all questions and where the analyst's most important function may be the taking of notes? How does such an analyst distinguish himself or herself from others?
The potential "chilling effect" of Regulation FD on communications between issuers, on the one hand, and analysts, the media and investors, on the other, could also significantly impact the scope and quality of disclosures currently available to securities markets. For example, an increasing formalization, and decline in the number, of contacts between issuers and analysts could discourage discussion of forward-looking information by issuers--a practice that has been encouraged in recent years by both the Congress and the Commission. Proper understanding and analysis of such information often requires give-and-take discussion and communication of nuances that do not lend themselves to meetings open to the public, the issuance of a press release or the filing of a periodic report. The negative impact could be even more pronounced on communications made during the course of securities offerings, where concerns of issuer representatives of ensuring "parity of information" may inhibit the making of meaningful disclosures and the pursuit of due diligence.
Moreover, we note that Regulation FD--by forcing issuers to make broad public disclosures of information that often is of a "flash" or short-term nature--may inadvertently promote marketplace trends that the Commission may wish to discourage, such as excessive price volatility and undue reliance on near-term performance in assessing securities values. Although certain information disclosed under Regulation FD will undoubtedly have long-term impacts on securities prices, we suspect that many such disclosures will result only in short-term dips or spikes in market values that will correct themselves when the information is analyzed in depth. In addition, if, as discussed above, Regulation FD actually encourages issuers to withhold information from analysts, the press and investors, its delayed disclosure may itself result in exaggerated price movements. The Commission should, we believe, carefully consider whether the proposed disclosure requirement may be catering to market practices and trends that may be undesirable from a policy standpoint.
Finally, the Commission is, we believe, attempting to rewrite the law of insider trading. The policy underlying such law is that potential investors will be discouraged from investing in publicly-traded securities, and existing investors will be driven out of the market for securities, if they believe some market participants have an informational advantage over the general public that is unfair. Although stated in terms of fiduciary duties and misappropriation, the cases can also be viewed as drawing a line between what is regarded as a fair or an unfair informational advantage. Betting on a known outcome is unfair; profiting in the market through one's hard work, diligence and ingenuity is not. The Commission may believe that it is not changing insider trading law; however, Regulation FD would move the boundary line by saying that it is unfair if everyone does not have access to the same information, whether they earned it or not.
For the above reasons, we recommend that the Commission withdraw proposed Regulation FD. In this regard, we are particularly concerned whether the Commission has developed an adequate empirical basis for its stated belief that "it is unlikely, given the robust, active capital market, that the flow of information to the market will be significantly chilled." We believe that a new rule governing selective disclosure should not be based primarily on highly anecdotal "horror stories" or individual complaints by investors of "unfair" treatment without full consideration of the impact of the rule on the release of information to securities markets. We respectfully suggest that a notice of proposed rulemaking--which many would interpret as announcing the inevitability of some form of new rule--is not the best way to assess this impact. Rather, we suggest that the Commission first survey--perhaps by a statistically designed questionnaire--issuers, analysts and investors to determine how the rule would likely affect the availability of information to the marketplace. Only after satisfying itself that the "chilling effect" of a rule would not outweigh the perceived benefits of imposing a "parity of information" requirement should the Commission then proceed with a disclosure requirement along the lines of Regulation FD.
In addition to the fundamental concerns discussed above, we believe the scope and language of proposed Regulation FD presents a number of specific problems that the Commission should consider in deciding whether to adopt the regulation and, if it is adopted, its final provisions.
Issuers of Fixed-Income Securities. We believe Regulation FD should not apply to issuers subject to Exchange Act reporting requirements solely because they have registered non-convertible, fixed-income securities--i.e., issuers having no public equity. The current proposal would include, for example, wholly-owned finance or other subsidiaries of reporting companies that issue only nonconvertible debt securities or preferred stock to the public. Although it is theoretically possible that a selective disclosure of material nonpublic information by such an issuer could have an impact on the market for its securities, we do not believe that the remote possibility of such an occurrence warrants the imposition on such issuers of an obligation to implement policies and procedures to monitor compliance with Regulation FD. Accordingly, we recommend that any final rule be limited to issuers having equity securities (other than non-convertible preferred stock) registered under Section 12 or in respect of which reports are required to be filed under Section 15(d).
Foreign Governmental Issuers. Whether or not the Commission limits the issuers covered by Regulation FD as suggested above, the Regulation should expressly exclude foreign governments and their political subdivisions. Although such issuers are not required to file Exchange Act reports pursuant to Section 15(d) of the Act, those listing securities on a national securities exchange are subject to reporting requirements under Section 13. We assume that the Commission did not intend to subject foreign governmental issuers to Regulation FD, and that their inclusion was merely a drafting oversight.
Foreign Private Issuers. We believe that foreign private issuers should not be subject to Regulation FD, if adopted. Imposing an immediate disclosure obligation on non-U.S. issuers with respect to the release of material nonpublic information would represent a significant departure by the Commission from its existing disclosure policies that could have serious implications for the willingness of foreign issuers to enter the U.S. market.
For years, the Commission has exempted foreign private issuers from the current Exchange Act reporting requirements applicable to U.S. companies. Such issuers are not required to file Form 8-K and 10-Q Reports under Rules 13a-11 and 13a-13, but rather must file Form 6-K Reports under Rule 13a-16 disclosing information they otherwise make public in their own countries. Thus, foreign private issuers have not been required to establish policies and procedures to update annual disclosures in addition to those imposed upon them by local law and practice. We believe this policy--also evident in the exemption, pursuant to Rule 3a12-3(b), of foreign private issuers from the requirements of the proxy rules under Section 14 and the short-swing profits and reporting provisions of Section 16--represents a well-considered accommodation by the Commission to foreign laws and market practices to encourage foreign issuers to enter the U.S. market and to facilitate investment by U.S. investors in the securities of such issuers.
Applying the "immediate" disclosure requirement of proposed Regulation FD to foreign private issuers would, therefore, represent a radical shift in long-standing, soundly-based Commission policy. We believe that many foreign issuers would rightly view Regulation FD as an unwarranted intrusion by the Commission into the conduct of their day-to-day business operations. This would particularly be the case where the information triggering the immediate disclosure requirement was revealed by the issuer to a non-U.S. person outside of the United States. Moreover, foreign regulatory authorities--long accustomed to exercising primary jurisdiction with respect to required periodic disclosures by non-U.S. issuers--would be justified in objecting to the worldwide reach of Regulation FD, which may be inconsistent with their own requirements regarding selective disclosure, as an unjustified and offensive extension of U.S. jurisdiction.
Moreover, for the Commission to impose such an intrusive requirement on foreign private issuers after years of following a policy of relying on foreign rules and practices on matters of current disclosure might be seen as an act of bad faith. Application of the new regulation to issuers who have publicly offered or listed their securities in the United States in reliance on traditional Commission policies cannot help but to deter future entry of foreign issuers into our securities markets, to the detriment of U.S. investors.3
We believe that U.S. investors are prepared to accept certain differences in the disclosure requirements applicable to foreign issuers. Certainly, the long-standing exemption of foreign private issuers from current Form 8-K and 10-Q reporting obligations would indicate that domestic investors would be willing to accept something less than "parity of information" in the area of selective disclosure.
For these reasons, we strongly recommend that, if the Commission adopts Regulation FD, it exclude foreign private issuers from its scope.
Other Issuers. In its proposing release, the Commission requests comment on whether proposed Regulation FD should be expanded to apply to open-end investment companies and to issuers engaged in initial public offerings. We believe that any final regulation should apply to neither. Securities of open-end investment companies, which are subject to issuance and redemption on a daily basis at current net asset value, do not appear to us to be subject to any of the problems cited by the Commission with respect to inequality of access to information that would affect market prices of the issuer's securities. Similarly, issuers engaged in IPOs should not be subject to Regulation FD because their securities do not have an active trading market where informational disparities could be an issue.
"Person Acting on Behalf of an Issuer"
It is not clear why proposed Rule 100(a) refers to disclosures made by "an issuer, or any person acting on its behalf." (emphasis added) Because an entity can only speak through its representatives and agents, the reference to the issuer is confusing and, we believe, should be deleted in any final regulation, with the rule referring only to a "person acting on behalf of an issuer."
In its proposing release, the Commission states that the definition of "person acting on behalf of an issuer" encompasses only those "company officials, employees, or agents who are properly authorized or designated to speak to the media, the analyst community, and/or investors." Yet the text of proposed Rule 101(c) is far broader, encompassing any officer, director, employee, or agent "who discloses material nonpublic information within the scope of his or her authority."
The text of proposed Rule 101(a) would appear to pick up, say, a merchandising official of a garment manufacturer discussing the issuer's unannounced new fall line with a department store buyer, or a purchasing agent of that manufacturer discussing the same matter with a fabric supplier. Surely the Commission does not intend that statements made by such officials be the basis of a disclosure obligation under the Exchange Act and, therefore, that such officials must be instructed in the intricacies of "materiality" under the federal securities laws, consult with securities counsel prior to speaking to their counterparts about changes in company products or services, or obtain confidentiality agreements from such counterparts prior to discussing what, from their standpoint, are routine business matters.
Based on the concerns of the Commission as expressed in the proposing release, we believe that, if Regulation FD is adopted, two limitations should be built into the definition of "person acting on behalf of an issuer." First, we believe that it would be appropriate to limit that definition to "senior officials" of the issuer (see our discussion of this term below) and to those acting on behalf of or at the direction of "senior officials." Second, the term should cover only those senior officials (and persons acting for them) who are authorized or designated to speak to the financial media, securities analysts and/or professional investors. These two limitations would, in our view, ensure that the kind of informational advantages the Commission desires to eliminate (assuming arguendo that this is desirable) are addressed, while, at the same time, limiting the compliance burden and some of the unworkable aspects of the regulation on the issuer and its non-financial, non-management personnel.
"Person Outside the Issuer"
Given that the Commission's principal concern, as expressed in its proposing release, appears to be the unfairness to public securityholders of permitting selective disclosures to be made to "a small group of analysts or institutional investors," it is difficult to understand why proposed Regulation FD would impose a disclosure obligation whenever material nonpublic information is disclosed to anyone outside the issuer not bound by a duty of trust or confidence or a confidentiality agreement, whether or not the recipient of the information is engaged in the investment business.
Consistent with our suggestion to limit the scope of the definition of "person acting on behalf of an issuer," we believe that the Commission should, if it adopts Regulation FD, revise the language of the rule so that a public disclosure obligation is only triggered when material nonpublic information is disclosed to a financial professional. In our view, this would encompass a representative of the financial media, a securities analyst or an institutional or other professional investor not subject to a duty of trust or confidence or bound by a confidentiality agreement.
Our suggestion would, we believe, target the potentially favored recipients of selective disclosure identified by the Commission as being of concern to it. At the same time, however, it would limit the scope of the regulation so that it would not apply to situations the Commission is not seeking to regulate--for example, ordinary course disclosures of business information and developments made to customers, suppliers, joint venturers or potential merger partners. It would also clarify that Regulation FD does not apply to certain situations where it may be unclear whether a duty of trust or confidence exists--for example, disclosures made to rating agencies, to governmental bodies or to parties to litigation.
In addition to limiting "persons outside the issuer" for purposes of the regulation to financial professionals, we strongly recommend that the exclusion contained in the last clause of paragraph (b) of proposed Rule 100 be modified in any final regulation to refer to "a person who has agreed, expressly or impliedly, or is subject to an agreement, to maintain such information in confidence."
We believe that such a modification would clarify that persons who may receive material nonpublic information need not enter into written confidentiality agreements to avoid triggering a Regulation FD disclosure obligation on the part of the issuer. In this regard, even in circumstances involving discussions with financial professionals, written confidentiality agreements may be difficult, if not impossible, to obtain. For example, it is currently not the practice for an issuer or its agent to obtain written confidentiality agreements from potential institutional investors prior to the delivery of confidential disclosure materials in private placements or Rule 144A offerings. Rather, confidentiality is ensured by statements or legends in the materials themselves advising that the information being provided is confidential and must be treated as such by the recipient. Attempts to obtain written agreements would, we believe, result in a "battle of forms," unnecessarily slow down the offering process and, ultimately, constrict the flow of information in such private financings.
This modification would also, by referring to persons "subject to" a confidentiality agreement, permit disclosures to be made to employees and agents under the control of a party to such an agreement who have not individually signed or otherwise agreed to be bound by that agreement.
Timing of Public Disclosures
The proposed requirement for "immediate" public disclosure of information "intentionally" disclosed to a third party will undoubtedly lead to many practical difficulties of timing. Presumably, the Commission does not intend that an issuer seeking to comply with Regulation FD by filing an 8-K or 6-K report will be in violation of the regulation if it makes a selective disclosure during non-business hours at the Commission, but files its report at the opening of Commission business on the next business day.4 We also assume that the Commission does not intend to limit the current widespread practice of parties to a business combination or takeover transaction of granting interviews to the press--e.g., over a weekend--prior to the public announcement of the transaction at the opening of business on the next trading day. We believe the Commission should clarify these situations in any final rule and/or adopting release.
We agree with the Commission that, for purposes of determining when a public disclosure is required, a special rule should apply to distinguish "nonintentional" from "intentional" selective disclosures. Nevertheless, we believe this distinction--at least as explained by the Commission in the proposing release--does not go far enough to ensure fair treatment of issuers and their spokepersons in attempting to comply with the mandate of the regulation.
In our view, the most difficult issue that issuers and their advisors will face in complying with proposed Rule 100(a) will not be whether a particular disclosure has been made to a person outside the issuer, whether the disclosure was made on behalf of the issuer, or whether that disclosure was intentional or nonintentional. Rather, the most difficult issue will be that which plagued issuers, analysts, reporters and investors for years prior to the Supreme Court's decision in Dirks--whether the information conveyed was "material." Because, in its proposing release, the Commission does no more than refer to existing case law as the basis for resolving this issue,5 company officials will be in no better position to evaluate this often testy issue than they ever were.
This uncertainty could lead to blatantly unfair results under Regulation FD. Suppose, for example, a public relations employee of the issuer, without checking with his superiors, intentionally discloses in a telephone conversation with an analyst the company's most recent month-end backlog in the good faith, but, in hindsight, mistaken belief that it is not "material." It is possible that, because the employee knew he was communicating nonpublic information and was authorized to do so, this would be considered an "intentional"6 disclosure by a "person acting on behalf of the issuer," requiring that an "immediate" public disclosure be made by the issuer--an obligation that the issuer cannot conceivably meet because those officials charged with complying with the federal securities laws are unaware of the disclosure. Assuming this situation could be interpreted as involving a "nonintentional disclosure," what then happens if the employee's superior (a "senior official" for purposes of the rule), upon learning of the disclosure, also concludes in good faith that the backlog information is not material? If the Commission or a court ultimately finds this conclusion to have been incorrect, presumably the issuer has violated Rule 100(a).
In our view, situations like that discussed above will abound if Regulation FD is adopted in its present form. To mitigate, at least in part, the potential for an unjust result, we strongly suggest that the Commission, if it adopts Regulation FD, amend or clarify the language so that a good faith (i.e., non-reckless) determination by the person disclosing the information, or a senior official aware of the disclosure, that the information is not "material" will be treated as "nonintentional" and will not trigger a public disclosure so long as that belief is held.
In addition, also as a matter of fairness, we believe the Commission should, in any final rule, modify the definition of "senior official" to limit its scope to senior personnel having working knowledge of the disclosure policies and practices of the issuer. The term should cover only the CEO and other "executive officers" to the extent they are involved in investor or financial public relations functions for the issuer. We also believe that, to avoid imposing an unprecedented obligation on outside directors to monitor the issuer's compliance with periodic disclosure requirements, the term should exclude directors.
Manner of Public Disclosure
We agree with the Commission that issuers should be afforded flexibility in determining how to meet their obligations under Regulation FD, and that this should include any "method of disclosure that is reasonably designed to provide broad public access to the information and does not exclude any members of the public from access." This standard should permit the future development of alternative means of making public disclosures that may be made available by advances in technology.
Nevertheless, we believe that, if the Commission proceeds with the regulation, it should provide greater clarity--perhaps by a discussion of the concept in the adopting release--of what is meant by a means of communication "reasonably designed to provide broad public access." For example, although the text of Rule 101(e)(2)(ii) seems to provide a safe harbor for any "press conference to which the public is granted access (e.g., by personal attendance or by telephonic or other electronic transmission)," the proposing release states that "[i]n order to afford broad public access, an issuer must provide notice of the disclosure in a form that is reasonably available to investors." Does providing "notice of the disclosure" mean that the issuer must provide some sort of general notice of the press conference? If so, how should such a notice be communicated, and when?
In addition, we believe that the Commission should reconsider its position that a website posting of information by the issuer will not satisfy the requirements of Rule 101(e)(2)(ii). We believe that many investors--particularly those interested in obtaining the most up-to-date information about the issuer--do visit the issuer's website for news about recent developments. Further, permitting the issuer to disclose information on its website--as opposed to the more dramatic filing of an SEC report, issuance of a press release or calling of a press conference--should encourage issuers to be more open in providing information, particularly where its materiality may be in question. To ensure the effectiveness of this manner of disclosure, the Commission could condition its use on an annual undertaking by the issuer in its 10-K report that it will post, under appropriate, prominent and readily accessible captions, all disclosures made pursuant to Regulation FD on its website.
Liability Issues and Securities Act Implications
Use of Short-Form Registration. Given the proposed formulation of Rule 101(e)--that the issuer must file a report on Form 8-K or 6-K if it does not issue a widely-disseminated press release or use another method of public disclosure--it appears that a failure to comply with Regulation FD would result in loss to the issuer of the ability to use short-form Securities Act registration statements, such as Forms S-3 and F-3 (which require timely filing of Exchange Act reports), and the availability of "shelf" registration under Rule 415(a)(1)(x). Because Regulation FD would require the issuer to make "immediate" or "prompt" disclosures, and considering the time-sensitive nature, and the inherent difficulties, of judgments about selective disclosures and the apparent inability to "cure" violations, we believe this is a draconian result. Accordingly, we strongly recommend that, if the Commission adopts Regulation FD, it amend its registration forms to provide that a violation of the regulation will not affect the availability of short-form and shelf registration.
Rule 144. Reliance by holders of control and restricted securities on Securities Act Rule 144 is conditioned on the filing by the issuer of all Exchange Act reports required to be filed during the 12 months prior to the sale of the securities. As with short-form registration, we believe that loss of Rule 144 availability because of the failure of an issuer to make a disclosure under Regulation FD--a failure that may not be curable--would be an unnecessarily harsh result, both unfair to innocent securityholders and disproportionate to the harm the Commission identifies in selective disclosure. Accordingly, we strongly recommend that, if the Commission adopts Regulation FD, it amend Rule 144 to provide that a failure by the issuer to comply with the regulation does not affect the rule's availability to holders of its control and restricted securities.
Proposed Rule 181. We support the adoption of Rule 181 in the event the Commission adopts Regulation FD. However, we do not see any reason why it should only address potential Section 5 problems that may arise after a Securities Act registration statement is filed. It strikes us that the logic of the proposal also applies to potential "gun-jumping" prior to a registration statement filing. Therefore, we suggest that proposed Rule 181 be amended to provide that a disclosure under Regulation FD will not constitute an "offer" or a "prospectus" for purposes of Section 5(c) as well as Section 5(b).
In addition, the logic of proposed Rule 181 suggests that similar treatment should be accorded to Regulation FD disclosures under all provisions of the federal securities laws that impose filing or other obligations with respect to "offers," "solicitations" or the like. Thus, a Regulation FD disclosure should not be deemed to involve a "public offering" for purposes of Securities Act Section 4(2), a "general solicitation" for purposes of Regulation D, an "offer" to non-QIBs under Rule 144A, a "directed selling effort" for purposes of Regulation S or a "solicitation" for purposes of Exchange Act Section 14(a) or (c). We suggest, therefore, that, if Regulation FD is implemented, the Commission adopt appropriate amendments to its regulations with respect to these matters.
We question the Commission's authority to implement, by rulemaking, a "possession" rather than "use" test for fraud liability under Section 10(b) of the Exchange Act. Although the Supreme Court has not directly addressed this issue, there is a substantial likelihood that the Court would hold that an attempt by the Commission to impose insider trading liability based on the mere "awareness" of material nonpublic information by a purchaser or seller was inconsistent with, or ran afoul of, the requirement of "scienter" mandated by existing case law.
In the event the Commission nevertheless proceeds to adopt the "awareness" standard proposed in Rule 10b5-1, knowledge of material nonpublic information should do no more than establish a rebuttable presumption that can be overcome by evidence presented by the defendant that he or she did not in fact use the information in the transaction in question. This would address the Commission's concern about the difficulty of establishing evidence of use in Rule 10b-5 cases while, at the same time, mitigating the risk of innocent behavior violating the federal securities laws. Further, in our view, a "use" standard--with the burden of proof on the government--should continue to apply in criminal proceedings.
Consistent with the above suggestion, we believe the list of affirmative defenses proposed by the Commission should be treated as nonexclusive "safe harbors" from liability, permitting a defendant to establish facts showing that, in a particular case, the possession of inside information did not involve wrongful conduct.
We also recommend that the Commission adopt revisions to, or provide clarifications of, the enumerated affirmative defenses. First, the Commission should make it clear that the performance of an option to purchase or sell a security at a fixed price during a specified period of time constitutes a transaction pursuant to "a binding contract to purchase or sell the security in the amount, at the price, and on the date which the person purchased or sold the security" for purposes of Rule 10b5-1(c)(1)(i)(A). Because the option irrevocably binds the writer to perform, it should be considered a purchase or sale on the date it is written rather than on the date it is exercised.7
Second, we believe that the Commission should clarify the circumstances under which an order or instruction placed with a broker-dealer or other intermediary qualifies for the affirmative defense contained in proposed Rule 10b5-1(c)(1)(i)(B). We assume, for example, that a standing order with a broker-dealer to purchase or sell a stated number or dollar amount of shares "at the market" over a specified period of time is covered so long as the person placing the order relinquishes control over the specific dates on which, and the specific prices at which, transactions are executed. This is unclear given the language of the definition of "at the price(s)," which refers to "the market price for a particular date." (emphasis added) We assume the same analysis would apply to instructions by an issuer to the agent for a dividend reinvestment or employee stock purchase plan to make purchases in the market, or by a participant in any such plan to the agent to invest a specified amount pursuant to such plan.
The scope of proposed Rule 10b5-1(c)(1)(i)(C) is similarly unclear to us. Again, we believe that it should encompass a written plan to purchase or sell a specified amount or value of securities during a specified period of time so long as the purchaser or seller has no control over specific dates and times. We also assume--and request the Commission to confirm that--a memorandum in the files of a broker-dealer as to a customer's intentions would qualify as a "written plan."
Rule 10b5-1 raises particular problems for broker-dealers and others engaged in market-neutral, "dynamic" hedging transactions. Although some protection may be afforded by the "Chinese Wall" provisions of proposed Rule 10b5-1(c)(2)(ii), these may not provide protection in many instances where transactions are entered into pursuant to a pre-existing strategy to "lock in" a particular gain or to limit a particular exposure. In these cases, there is no attempt by the possessor of the information to either profit or avoid loss by its use. We therefore recommend that the Commission adopt an additional affirmative defense for transactions entered into in order to hedge the specific risk of a position or transaction, whether or not pursuant to a written plan, so long as the person engaged in the hedging can demonstrate the adoption of a strategy to hedge that specific risk prior to coming into possession of material nonpublic information.
* * *
We appreciate this opportunity to comment on the Commission's selective disclosure and insider trading proposals. We would be happy to discuss any questions the Commission may have with respect to this letter. We request that any questions be directed to William J. Williams, Jr. (212-558-3722) or John T. Bostelman (212-558-3840) in our New York office, or to Charles F. Rechlin (310-712-6680) in our Los Angeles office.
Very truly yours,
SULLIVAN & CROMWELL
|1||SEC v. Bausch & Lomb, Inc., 565 F.2d 8,9 (2d Cir. 1977).|
|2||463 U.S. 646 (1983).|
|3||In its proposing release, the Commission states that foreign private issuers having securities listed on the New York or American Stock Exchanges or admitted to trading on the Nasdaq Stock Market have already subjected themselves to disclosure obligations similar to proposed Regulation FD by reason of the listing standards of these markets. This statement ignores the fact that these requirements to make "prompt disclosure" of "material developments" not only do not have the force of law, but also, for years, have been administered so as to come into play only when the exchange or the NASD requests the issuer to explain the reasons for unusual market activity or to comment on a known rumor in the marketplace.|
|4||Presumably this situation is covered by Commission Rule 160, although it is not clear how the concept of a "period of time" meshes with an "immediate" disclosure requirement. Rule 160 should also apply where public disclosure under Regulation FD is made by press release or other permitted means.|
|5||And, we believe, attempts to rewrite the case law in the process. We do not agree with the Commission's statement that TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438,449 (1976), stands for the proposition that "information is material if 'there is a substantial likelihood that a reasonable shareholder would consider it important' in making an investment decision, or if it would have 'significantly altered the 'total mix' of information made available.'" (emphasis added) Rather than being alternative tests, as indicated by this language, the two elements of the Northway analysis were clearly intended to be part of a single, unified test of materiality.|
|6||It is unclear under what circumstances, if any, the Commission would treat a disclosure of information believed not to be material as "nonintentional." The only examples given in the proposing release are slips of the tongue and mistakes as to the nonpublic nature of the information.|
|7||Presumably, the exercise by a person of an option acquired at the time that person was not in possession of material nonpublic information would not give rise to liability under Section 10(b) and Rule 10b-5 because any subsequently acquired information would not be "material" to the writer, who is legally bound to perform the option in all events.|