26 April 2000
Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Re: Selective Disclosure and Insider Trading (File No. S7-31-99)
The Task Force on Selective Disclosure and Analyst Independence (Task Force) of the Association for Investment Management and Research1 (AIMR) is pleased to comment on the U.S. Securities and Exchange Commission's proposal on selective disclosure and insider trading. This rule proposal addresses several issues related to full and fair disclosure of information and insider trading law and includes three proposed rules: Regulation FD, Rule 10b5-1 and Rule 10b5-2. The AIMR Task Force is charged with addressing current practices and the existing ethical and professional standards in this important area. Our focus in responding to this rule proposal is on the role and importance of information in the investment process. We have also been charged with developing additional guidance for AIMR members on communication with issuers to ensure that investors maintain confidence in the ethics, as well as the expertise, of the investment professionals on whom they rely.
We are wholeheartedly in favor of increased and wide dissemination of information. Nevertheless, we are concerned that implementation of the rule as proposed will not accomplish that objective but have a negative impact on the research and investment decision-making process and the role that investment professionals play in information dissemination.
AIMR Task Force Recommendations
After careful review and analysis of the Commission's proposals, the AIMR Task Force recommends the following:
The AIMR Task Force fully supports the principles and sentiment that underlie this rule proposal. We understand, as well, that there is a perception in the market that some investors, specifically investment analysts and institutional investors, receive material information, on a regular basis, from companies in non-public forums. We believe, however, that this perception is false and is based on a misunderstanding of the role of investment professionals and the research process. Therefore, we object strongly to implementation of this rule proposal because we believe that the requirements of this rule will not increase information disclosed directly to the investing public. Rather, its implementation will have a negative effect on both the quality and quantity of information communicated by issuers to shareholders and other market participants, including investment professionals. The unprecedented flow of information to U. S. financial markets is due, by and large, to the diligent efforts of investment professionals to elicit more and better information from issuers. If issuers must be increasingly on their guard with respect to what they say and to whom they say it, they will soon hide behind this rule to avoid answering the hard questions or they will reduce their answers to "sound bites" and "boilerplate."
Even "[u]nder the existing regime, information does not bubble up from firms spontaneously...It emerges instead as various forms of processed public relations, administered by lawyers...What should be a steady outpouring of knowledge-some of it hype, some confusing, most of it ambiguous like business life itself-emerges instead as a series of media events that leave out everything interesting...Under these circumstances, markets are vulnerable to outside information. Deprived of knowledge, investors become paranoid and jump at every movement in the shadows."2 We have seen just such reactions in recent weeks and, therefore, can only agree with George Gilder that "[l]ess information about companies means more volatility and more vulnerability to outside events."3
In order to craft a rule that will truly increase communication between companies and investors, we recommend that the Commission create a Blue Ribbon Task Force, similar to the one the Commission formed to address auditor independence issues. This task force would consist of representatives of all market participants and examine current practices. The output of the task force work would be a narrow, operational definition of "materiality" and recommendations for "best practices" for communications with the investment community and the investing public. We would be happy to work with and support the Commission in this regard since developing such recommendations is our charge from AIMR.
The AIMR Task Force strongly supports efforts to prohibit and inhibit insider trading and supports the standard created under Rule 10b5-1 as an appropriate meld of the various theories of insider trading liability.
Although the AIMR Task Force generally supports the proposed rule, we are concerned that in gathering evidence to support misappropriation theory liability for personal relationships that are not "enumerating family relationships" the Commission's investigation will intrude unduly in areas that are not within its jurisdiction. Therefore, we recommend that the Commission base its rules solely on a trader's knowledge of material nonpublic information rather than on the source of that knowledge.
The AIMR Task Force's analysis of the rule proposals and bases for its recommendations follow.
AIMR prides itself on its full support for, and initiatives to ensure, full and fair disclosure of information needed for investment decision-making, investor protection and market integrity. In particular, we believe that the AIMR Code of Ethics and Standards of Professional Conduct (AIMR Standards of Practice) have served to create an environment within the investment industry that rewards and sustains high ethical standards for investment professionals who adhere to them. In addition, the efforts of AIMR volunteer advocacy committees have always been directed to achieving full and fair disclosure of corporate financial information to all market participants. Through its comments and recommendations to regulators and standard setters on financial disclosure initiatives, the AIMR Financial Accounting Policy Committee (FAPC)4 works to not only raise the quality and quantity of relevant information but to "level the playing field" between the investing public and investment professionals. The FAPC recognizes that, given their knowledge and expertise, investment professionals have a natural advantage over less sophisticated investors. Therefore, improvements in information content, form, and dissemination mechanisms are critical to providing all investors with the information they need to make sound investment decisions. For example, the FAPC opposed the Commission's proposal to only require issuers to provide abbreviated financial statements on the grounds that it would severely disadvantage individual investors. In Financial Reporting in the 1990s and Beyond, the FAPC publicly stated AIMR's long-standing position on the communication of information to the markets.
Obviously, financial markets and financial analysis thrive on information. Furthermore, information will eventually find its way to influence market prices, whether the avenues it takes are legitimate or not. As investment professionals who take pride in our ethical conduct, we need to have information that is frequent, reliable, and relevant. We need to have it disseminated even-handedly so that it becomes available to all market participants at the same time, rather than first to a privileged few.5
Other AIMR committees address investor protection issues. The AIMR Performance Presentation Standards Implementation Committee promulgates standards to ensure that investment management firms provide full and fair disclosure to their own clients and investors about the performance of the money that they manage. We firmly believe that "no matter how efficient or inefficient a financial market may be, information is its lifeblood" and the capital markets are best served when all market participants have equal access to, and a clear understanding of, the financial information necessary for investment pricing and decision-making. The Task Force on Soft Dollars has issued the AIMR Soft Dollar Standards that provide ethical principles and guidelines for investment managers in determining the proper balance between best execution and research needs. A newly formed Task Force on Best Execution will address the practical and ethical issues an investment manager must face in seeking to achieve best execution for clients.
AIMR has never, and will never, support a two-tier disclosure system. Such a disclosure system would have different disclosure requirements for different categories of investors. We would like to reiterate the AIMR FAPC's comments in its 1995 letter to the Commission concerning abbreviated financial statements: "We are concerned that by reducing the quantity and quality of information that is routinely delivered to some investors, the Commission is taking the first step down the "slippery slope" toward reducing the quantity and quality of information available to all investors."
Therefore, although the AIMR Task Force fully appreciates the Commission's sensitivity and objection to practices that are perceived to threaten investor protections, or might compromise the process by which investors are provided fair access to information, nevertheless, we question whether regulatory intervention is required or is the best method to curb perceived abuses in selective information dissemination. In fact, we are very concerned that the proposed regulations, rather than increase the information flow to investors, will curtail that flow because issuers will take the line of least resistance and disclose less. We believe that issuers will allow their concerns over meeting the spirit of the new rule or their fear of an enforcement action to inhibit their communications with investors. Although disclosure will still occur, the information disclosed will be sanitized: reduced to "sound bites" and "boilerplate." Such an outcome can only be detrimental, for it is not just the quantity of financial data that is important to investors, it is the quality, relevance and understandability of that data that transforms it into information.
To understand our position on this matter, the Commission must fully understand the role of financial analysts in the capital markets and the way in which the flow of information, and the information itself, is enhanced and increased through research, evaluation, and interpretation. These activities are the essence of financial analysis, and far from keeping relevant information from other investors, they decrease the amount of resources those investors must expend by repackaging "bits of data" into a "mosaic" that investors can use more readily to evaluate investment alternatives.
Therefore, in light of the specific concerns and recommendations that follow, we urge the Commission to reevaluate Regulation FD. If our comments are not persuasive and the Commission remains convinced that selective disclosure abuses are of such a magnitude that regulatory action is warranted, we ask the Commission to consider alternatives to the proposed regulation that will not undermine the current free flow of information that we believe is vital to the health of our financial markets. We recommend that the Commission form a Blue Ribbon Task Force consisting of representatives of all market participants to examine current practices and procedures and make recommendations about alternative measures to the Commission.
Role of the Financial Analyst in Information Dissemination and Enhancement
The financial markets in the United States are the most efficient in the world. Although this efficiency is primarily due to the depth and breadth of the information disclosed in corporate financial statements, regulatory documents, and other shareholder and investor communications, we firmly believe that well-educated and proficient investment professionals are a vital component in the development and maintenance of that preeminence. These investment professionals work in a wide variety of capacities in the investment industry and are employed by broker-dealers, investment advisors, mutual fund complexes, insurance companies, banks, and other financial institutions.
In all of these contexts, those who work as financial analysts gather and interpret large quantities of information, of varying quality, from a wide variety of sources: databases, written public documents such as financial statements and regulatory filings, the media, and people. Their success requires diligence and inventiveness in information gathering, as well as analytical skill, perception and a keen intuition. Analysts must often "ferret out" data that, to the average investor might appear insignificant or immaterial, but when aggregated with other data is highly informative and relevant to investment decision-making. This process might be likened to putting together a jigsaw puzzle, where the final picture is unknown, but whose outline begins to appear as the pieces are assembled.
Analysts with the most perception, intuition, or experience may "see" the whole picture before all the pieces are gathered, before less perceptive professional colleagues, and well before less sophisticated investors. Because of their work, they cannot help but recognize better than others when information provided in public documents or forums is internally inconsistent or "rings false" with information they have gathered by observation or other sources. These analysts often know just what question needs to be asked to complete the picture or reconcile discrepancies. As in every profession, this proficiency comes with experience. Because analysts can "see the big picture" better or more quickly, their research reports and recommendations are an important information source for other market participants. Both other investment professionals acting on behalf of their clients and employers and the investing public acting on its own behalf can use this higher level information together with their own investment experience and analyses to make better investment decisions.
The process analysts use to develop buy, hold, or sell recommendations on a particular security is a complex and lengthy one. It begins with analysis and judgments about the economy as a whole that must lead to an understanding of macroeconomic factors affecting the domestic and global economies. Next, analysts should examine and understand the factors affecting the industry or sector in which the company operates. Only when this environment is understood can an analyst begin to address company-specific variables such as "foreign exposure, competitiveness of product lines, pricing flexibility, efficiency, cost controls, tax rates, financial position, accounting practices and the historical financial record."6 Even developing an understanding of the history of a company is only a prelude to the analysts' real work: forecasting future earnings, dividends, and cash flows. Finally, these forecasted variables become the inputs to valuation models that the analyst will use to estimate the appropriate price for a particular security. When this estimated price is compared to the current price of the security, the analyst is in a position to make a buy, hold, or sell recommendation supported by a research report. This final product can only be as good as the information inputs to the process. It is clear why analysts spend so much time and energy gathering more and better information.
Analysts' tenacity and diligence in uncovering and procuring the information they need to develop well-supported recommendations have often turned the media and regulatory spotlight on them. Despite this, in its decision in Dirks v. SEC, the U. S. Supreme Court recognized the value of these activities and the analyst's important position in the marketplace:
Imposing a duty to disclose or abstain solely because a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market. It is commonplace for analysts to "ferret out and analyze information"...and this often is done by meeting with and questioning corporate officers and others who are insiders. And information that analysts obtain normally may be the basis for judgments as to the market worth of a corporation's securities. The analyst's judgment in this respect is made available in market letters or otherwise to clients of the firm. It is the nature of this type of information, and indeed of the markets themselves, that such information cannot be made simultaneously available to all of the corporation's stockholders or to the public generally.7 [Emphasis added.]
Recognizing the privileged position of the investment professional in the investment decision-making process, members of AIMR hold themselves to a higher standard than that required by Dirks.
A[n AIMR]] member should evaluate the materiality of any nonpublic information received to determine whether the disclosure of that information violates the communicator's fiduciary duty. If the member determines that the information is material and has been disclosed in a breach of duty, the member should make reasonable efforts to achieve public dissemination of the information. This effort usually means encouraging the issuer company to make the information public. If public dissemination is not possible, the member should communicate the information only to designated supervisory and compliance personnel within the member's firm and should take no investment action on the basis of the information.8
Therefore, in their conversations with issuers, AIMR members are not trying to elicit material nonpublic information. If corporate officials inadvertently disclose such material information to them, AIMR members must make every effort to have that information publicly disclosed and they cannot act on it.
The Commission itself has also recognized the analyst's crucial role in disseminating information to market participants and helping them understand financial information.
The value to the entire market of these efforts cannot be gainsaid; market efficiency in pricing is significantly enhanced by such initiatives [by analysts] to ferret out and analyze information, and thus the analyst's work redounds to the benefit of all investors.9
Therefore, it should be obvious to the Commission that the free flow of information is essential not only to professional analysts but also to the efficient and effective functioning of the financial markets. All investors, not just investment professionals, must have the freedom to seek the maximum amount of information possible to facilitate well-informed decisions about how and where to invest capital. The information sought and capable of discovery must go beyond that mandated by the financial reporting requirements of the federal securities laws. It must also extend to non-financial information specific to understanding a company's future growth, such as new products and services, new markets, capital projects, and the competitive environment. All investors, not just investment professionals, seek and use such information to compare and contrast investment alternatives.
Analysts cannot be passive in seeking new information about the companies that they follow. Their responsibility to their employers and their clients is to work hard to uncover information and interpret its relevance. These private efforts increase the amount of information available to the market as a whole and are an important supplement to the public disclosures required by the securities laws. To find this information, analysts listen to and question corporate officers and management, especially investor relations and finance personnel. They also read press releases and pore over financial statements and regulatory filings. They attend oral presentations by company executives, participate in analysts' meetings and conference calls, and visit company facilities. Analysts also go beyond company contacts and speak to customers, contractors, suppliers and competitors in order to find as many pieces of the puzzle as possible with the goal of developing the most accurate and complete picture of a company under review.
The picture that an analyst builds has often been described as a "mosaic." This analogy has developed into a "theory" about how analysts can develop a unique, and sometimes, market-moving picture of a company by accumulating bits of data. These data are insignificant in isolation, but through perceptive analysis, give the analyst a significantly different picture of the company than to others. Often other market participants could have gathered this information and drawn similar conclusions; but they did not, either because they could not, or did not want to, expend the necessary resources. In any event, analysts, as we would expect, probably do this more effectively than others, because of their education, experience, and incentives. They may be more apt to ask the right questions and draw the right conclusions because they can "fill in the gaps" better than less sophisticated investors.
To gain a better understanding of a company, analysts don't just talk to company representatives. They speak with everyone and anyone who might provide more pieces of the puzzle: customers, employees, competitors, and suppliers, to name a few. The more discussions analysts have about a company, the greater their ability to ask the right questions or fill in the gaps. For example, an analyst may discover something unusual or incongruous in a company's financial statements and look for someone to discuss this with. Questions about revenue generating ability or inventory problems, for example, might be addressed to key customers. In addition, just as a picture is composed of light and shadow, what is not said or uncovered in these interviews can be just as significant to the analyst in developing a complete picture of the company as what is said.
If there is so much information available and analysts can speak to so many people about a particular company, why are we so concerned that one-on-one communications with corporate executives will stop? We are concerned because through these discussions analysts gain insight about a company's activities, ambiguity and uncertainty is reduced, and more understandable and relevant information will reach the market. We see the process of analysis as having three components: disclosure of information, its use, and interpretation. Financial analysis starts with disclosure, the facts. Accounting data are part of those facts as are the number and location of company property, the number of employees, and the names and salaries of company executives. Analysts take those facts and make comparisons. They transform the data by developing trends over time, calculating ratios, and making adjustments based on other data. The real value-added, however, is the analyst's interpretation of the data and the transformations. Interpretation is the heart of the analytic process and it comes not only from "number crunching" but also from insight and understanding. Both buy- and sell-side analysts need access to one-on-one communications with corporate management in order to fully understand the company's background and culture, to gain perspective about trends and developments. The purpose of these discussions is not to gain material time-sensitive data or any other inside information. If such information is inadvertently disclosed, as discussed previously, an AIMR member is prohibited from trading on it.
We do not believe that analysts' efforts and their ability to use hard won expertise are either nefarious or unethical. Just as the investing public should not be disadvantaged by a lack of information, investment professionals should not be disadvantaged or penalized because they have spent time and other resources to develop expertise that others have not.
We believe that this debate over full disclosure is another example of the classic issue of the way markets work in general. Should order flow be aggregated in one place or should disparate market makers each be allowed to have their own order flow? In the disclosure context, on one hand, there could be rules that say issuers have to disclose everything to everybody at the same time; no one-on-one discussions allowed. On the other hand, if one-on-one discussions are allowed, certain players will have advantages over other players. Whether those advantages are "material" is a separate question. Regardless of the answer to the materiality question, because they have advantages, those players would be willing to invest in acquiring information, which makes the market more efficient. There is always tension between this efficiency and full transparency. We do not believe that it is obvious which of these two markets for information is the better one.
We also believe that there is a full spectrum of information that might be communicated about a company. There is information that a company has just invented a new technology. That's news. News is the type of information that can and should be disclosed to everybody at the same time. There are other kinds of information that cannot be conveyed to everybody at the same time: business strategies, for example. Business strategies are often very complicated. To understand a firm's strategy and its implications takes a lot of study, a deep knowledge of the industry, the firm's position in the industry, and the position of the industry in the general economy. We do not believe that it is possible for a firm to convey a sense of its strategy to all members of the investing public at the same time. We believe that to adequately communicate the implications of a business strategy takes research, consideration, interpretation, and dialogue. This is the kind of information that can only be elicited in one-on-one discussions. We strongly believe that these discussions are critical for the eventual dissemination of that information to the public in any meaningful way.
We urge the Commission to move carefully in making substantive changes in the current structure and process. If this rule proposal is enacted as proposed, the Task Force believes that analysts, who act as we have described and who rely and practice based on the ethical principles in the AIMR Standards of Practice, will be penalized for the hard work they perform. They will be penalized for the important interpretive information and investment advisory services that are provided to the very investors that the Commission seeks to protect.
Regulation FD (Fair Disclosure)
There is an unprecedented flow of information in the market today. Through the resource of the Internet, knowledge is more accessible than it has ever been before. Issuers had already begun to open conference calls to individual investors and are providing updated financial information on their websites. Analyst reports are also more readily available and from a wide variety of investment professionals and firms. The AIMR Task Force believes that Regulation FD has the potential to significantly alter this flow. We agree with the Commission's objective: "to the maximum extent practicable...all investors should have access to an issuer's material disclosures, at the same time [emphasis supplied]." However, rather than providing all investors with more information, we believe enactment of this proposal will result in less disclosure. The rule proposal shifts the burden of making the materiality determination to the issuer. We believe this is problematic and, as the Commission admits, "will require corporate officials to consider more thoroughly and precisely what to disclose." We believe that there is a real possibility that such consideration and deliberation will make issuers reticent about disclosure because they cannot always know what will be "material" to investors. Often it is the analyst who understands best when a disclosure is material. Analysts do have enough common sense that when an issuer says something to them that is material and nonpublic, they report it to both the issuer and their own compliance officer.
We believe this new "reticence to disclose" on the part of issuers is a function of several issues addressed in the rule proposal, materiality being the primary concern.
The Commission recognizes that without a bright-line test for materiality, "issuers or persons acting on their behalf" will need to make "instant materiality judgments" when communicating in a nonpublic setting, for example, responding to questions from individual shareholders, investors, or analysts. Given the difficulty of making these judgments, we strongly agree with the Commission's assessment that corporate officials will be more cautious and will often consult with legal counsel before issuing any statement. The fact that issuers will need to consult with counsel before responding to questions or unsolicited inquiries cannot help but inhibit or curtail their willingness to respond to any question, particularly in settings where the issuer must respond quickly and the question being asked was not anticipated. For example, when participating in conference calls with analysts, the issuer cannot put a question "on hold" until counsel can be reached. In fact, the very act of putting a question "on hold" would indicate that the answer is material. We believe that, to avoid these problems, issuers will not hold private meetings with analysts for fear they might disclose information that may be considered "material" after the fact.
We are also troubled by the Commission's ability to use a "Monday morning quarterback" approach to determining what disclosures by an issuer would be material. As drafted, Regulation FD appears to give the Commission broad latitude to deem information "material" in hindsight, based on an event that may be unrelated to the information disclosed. For example, will a change in stock prices immediately following a meeting with analysts be considered prima facie evidence that the issuer had disclosed material information (even if the issuer thought no such information had been conveyed)? We cite two examples. First, there is the recent case of ConAgra as reported by Stephen Barr in the March 2000 issue of CFO Magazine. Because issuers cannot be cognizant of the analysis that an analyst has already done, they will never know beforehand what piece of data is "material" to that analysis. The "straw that broke the camel's back" was immaterial in itself, but when added to all those other "straws" made all the difference.
The second example is more problematic. An issuer has a private conversation with a sell-side analyst confirming that prior public guidance on earnings expectations was still valid. Despite this confirmation, the analyst concludes, based on her own analysis, that the company would actually exceed these expectations and published that conclusion in her report. Not surprisingly, the issuer's stock price improves following the report's issuance. A buy-side analyst, reading the report and seeing the increased stock price, then accuses the company of providing material information selectively to the sell-side analyst, which the company denies. Unfortunately for the issuer, the sell-side analyst is correct in her analysis. The issuer knows that earnings will exceed expectations but has not yet disclosed that information. The issuer is unquestionably in a classic "Catch 22" situation. No one will believe that it did not disclose new, material information to the sell-side analyst. Consequently, we would be surprised if this issuer had any private discussions with analysts in the future. It would be much too dangerous.
The AIMR Task Force fully supports opening most communications venues, such as conference calls, to the general public, even if on a listen-only basis. We believe that this would be both cost-effective for issuers and support the Commission's objective of increasing the flow of information to the general public. Nevertheless, we do not believe that Regulation FD as proposed will accomplish that objective. The problem of determining materiality will not be mitigated as the Commission suggests. Instead, Regulation FD's effect on corporate behavior will be such that the general public will not gain access to the information now available to investment professionals. Instead, as described above, implementation of Regulation FD will both reduce the information disclosed and simultaneously change the nature of the dialogue that now takes place between investors and issuers. Therefore, we cannot support its implementation.
Increased Involvement of Legal Counsel in Investor Communications
The AIMR Task Force also believes that any increased involvement of legal counsel in investor communications activities, in itself, will significantly change both the form and substance of the information disclosed by issuers. With respect to public documents such as corporate annual reports or Form 10-K and other continuing reporting documents required by the Securities Exchange Act of 1934, we have already seen that increased involvement by legal counsel means increased use of "boilerplate" language despite the Commission's "plain English" initiatives.10 This severely reduces the amount of discriminating and relevant information communicated in written documents. We can only believe that increased involvement of legal counsel in oral or other communications with shareholders and investors, in public or private forums, will have the same effect. Counsel would most likely advise the use of formal, structured, and abbreviated disclosure in order to avoid any question about the information's materiality. Issuers will continue to speak, but no meaningful information will be communicated. We believe that such sanitized communications would continue until uncertainty about how the regulation will be enforced is diminished.
We also believe that once new patterns of communication are set, they will be particularly hard to change. After all, issuers by nature want to communicate as little information as possible to the market. This reluctance to communicate is usually couched in terms of cost-benefit, competitive disadvantage, and a desire not to "confuse investors." It is the continued, unrelenting pressure from the investment community on standard setters, regulators, and the companies themselves that has pushed them to provide as much information as they do currently. As proposed, Regulation FD would provide issuers with a strong defense against this pressure. The effect can only be both reduced and less relevant disclosure.
"Bright Line" Definition of Materiality
The AIMR Task Force believes that one way to reduce the involvement of legal counsel is to develop a "bright line" definition of materiality. At a minimum, this definition could include clear standards about what kind of information, such as earnings forecasts, would always be considered material. We believe that developing such a definition and standards could be one of the goals of the Blue Ribbon Task Force that we recommend be formed. Without such standards, whenever issuers speak in other than a public forum, they will always be "at risk" regardless of their ex ante materiality assessments. If the definition of materiality is too broad, there will be too high a burden on both the issuer and the financial markets in general. A narrow definition and list of standards could be reviewed on a regular basis and constantly updated.
Effect on Mosaic Theory
As discussed above, both the Supreme Court and the Commission have recognized the value of the "mosaic theory" of gathering and analyzing information that describes the process by which investment professionals form investment recommendations and security valuations. In a recent AIMR Disclosure Survey,11 the analysts who responded ranked public documents such as the annual report and other regulatory filings as the most important source of information for their analysis, followed closely thereafter by interactions with corporate executives. Without the ability to gather additional information from issuers to explain more fully the information provided in written documents, analysts will be less likely to make appropriate judgments about companies and to provide investors who rely on their expertise with the best information on which to base investment decisions.
An important source of information for many analysts is the company tour or plant visit. On these visits, analysts get information through both observation and discussion with company officials. These visits give analysts a better understanding of company operations and corporate culture and may or may not provide information that would materially change their current view of the company. Such a visit may provide the analyst with information that would change their view several years in the future. For example, consider that during a plant visit in 1995, analysts observed conditions that allowed them to judge production capacity at an issuer's only plant. Since this capacity was sufficient to meet both the company and the analysts' estimates of growth for several years, the analysts' consensus evaluation of the company was confirmed. Since the analysts did not change their recommendations, there was no effect on issuers' stock price at that time. It is now 2000 and the issuer has not increased capacity. No new plants have been built. At this point, the analysts who observed production capacity on the 1995 plant visit may question the issuer's ability to meet current growth targets as communicated in the Management Discussion and Analysis in the 2000 Annual Report and in corporate press releases. Therefore, analysts change their evaluations and lower their earnings estimates accordingly. This is the essence of the "mosaic theory." Information is gathered, analyzed and processed over time, by professionals with the time, resources and acumen to bring years' worth of analysis to bear on each investment recommendation and decision.
With this situation in mind, we ask whether the Commission would conclude that the issuer had inadvertently disclosed material information simply by conducting the 1995 plant tour. Could the issuer possibly have predicted that the information analysts gathered in 1995 would have a material effect on stock prices in 2000? Would the Commission's conclusion on materiality be different if the tour had been conducted in 2000? Or if during the tour, a plant manager had commented off-handedly that the issuer had no plans to build new facilities, even though analysts had observed no facilities being built?
Although some may claim that this scenario is unique or farfetched, we do not believe so. Information may be disseminated in conference calls or analyst meetings that will only be material when aggregated with other information that analysts have at their disposal. Questions that go unanswered and data that is withheld or avoided can also be informative when added to a "mosaic" of information that has been gathered over many months, if not years, of following a company.
In judging whether material information has been disclosed, we are concerned that issuers will always be "presumed guilty" if their stock price changes after any communication with investment professionals and that the burden of proof will always rest with the issuer. In the situation described above, the relevant information was disclosed five years before it became "material" to the analysts. If the company had any private communications with analysts before a change in recommendation, we are concerned that the company would be deemed to have communicated material nonpublic information. Without greater clarification how Regulation FD will be applied, we have no doubt that, initially, issuers will abbreviate plant visits and informal meetings with investment professionals. We are convinced that, if the Commission undertakes any enforcement actions following such meetings, companies will eliminate these important sources of information for analysts. If the work of analysts who "ferret out useful information" through these venues is harmed by Regulation FD, the AIMR Task Force questions the value that the regulation ultimately affords investors.
In addition, most analysts and their firms distribute research over the internet, on their firm's web pages, brokerage and independent web sites, and direct e-mails to clients and others. This provides wider and faster dissemination of analysts' reports to the investing public than existed prior to use of the internet.
Insider Trading Proposals: Rules 10b5-1 and 10b5-2
AIMR strongly supports efforts to prohibit and inhibit insider trading. The prohibition on insider trading has traditionally been justified on the grounds that it offends basic notions of fairness and jeopardizes the integrity of the open markets. The fairness notion rests on the belief that insiders and sophisticated institutional investors should not have an undue advantage over less sophisticated investors in the market. To this end, regulations curbing the misuse of privileged information help to create a "level playing field" among market participants, including small investors.
AIMR members must comply with the AIMR Standards of Practice. First promulgated in 1962, these standards are applicable to all AIMR members and prohibit the use of material, non-public information, including misappropriated information. The AIMR Standard of Professional Conduct V (A), Prohibition against Use of Material Nonpublic Information, states, in part:
[AIMR m]embers who possess material nonpublic information related to the value of a security shall not trade or cause others to trade in that security if such trading would breach a duty or if the information was misappropriated or relates to a tender offer. If members receive material nonpublic information in confidence, they shall not breach that confidence by trading in securities to which such information relates. Members shall make reasonable efforts to achieve public dissemination of material nonpublic information disclosed in breach of a duty.
The AIMR Task Force recognizes the need to clarify liability under Rule 10b-5 by establishing a "trading on the basis of" standard for insider trading. The fundamental goal of this rule is to eliminate the unfair informational advantage of those in possession of material nonpublic information. We can only agree with the Commission that the ability to trade on insider information hurts individual investors as well as the entire process of investment decision-making. Insider trading undermines investor confidence in the fairness and integrity of our markets.
Those in possession of material, inside information are perceived to have an advantage over other investors regardless of how such information is used. To effectively address investor perceptions and maintain market integrity, the AIMR Task Force agrees with the Commission that a rule that imposes insider-trading liability cannot be limited to only the use of such information. Common sense dictates that it would be impossible in practice for even the most ethical person to filter out of the analysis any material nonpublic information about a security when making a decision to trade. Therefore, we agree that imposing liability when a person trades with "awareness of" material nonpublic information is the only effective method to curtail insider trading and to maintain investor confidence in financial markets.
The AIMR Task Force also believes that the four defenses, proposed in Rule 10b5-1, that would exempt a person from insider-trading liability, are appropriate. Three of these defenses exempt persons from liability if they can establish that, at the time when they came into possession of the material non-public information, the trading decision had already been made through a pre-existing contract, trading instructions, or trading plan. Because the conditions were preexisting, the inside information did not affect the trading decision. The fourth defense, available to investors who "track an index," only applies to persons who essentially have no discretionary input into the trading decision since they are following a pre-established trading strategy that cannot be varied. Therefore, possession of inside information could not affect trading patterns. We believe that persons seeking to avail themselves of these defenses should be able to clearly establish that their trading plans, instructions, or index-tracking strategy were pre-existing. However, we do not believe that the Commission should set rigid rules about how investors might demonstrate these facts, such as requiring written plans or pre-clearance of plans with legal counsel. We recommend that the Commission judge each circumstance on a case-by-case basis. For example, the historical pattern of trades may be sufficient evidence that such a plan or strategy existed. We believe that enforcement in this manner will allow both the Commission and investors appropriate flexibility in applying this rule.
As noted above, the AIMR Standards of Practice already incorporate Rule 10b5-1 by requiring AIMR members to apply a "trading on the basis of" standard in determining their ability to trade when in possession of material non-public information. By requiring all investors to comply with Rule 10b5-1, the AIMR Task Force believes that the entire investment community will move to a uniform standard and set a "bright line" rule for insider-trading liability.
The AIMR Task Force generally supports the proposed rule. Under AIMR Standards of Practice, AIMR members, regardless of the type of confidential relationship by which the information was acquired, are prohibited from trading on information disclosed in a breach of duty or misappropriated. By enumerating specific close family relationships as sufficient in themselves for misappropriation theory liability, the Commission is attempting to set a "bright line liability rule." However, this list is not exclusive and other relationships may create a duty of trust and confidence.
It is with respect to these other personal relationships that the AIMR Task Force has concern. The Commission proposes that "relationships with a history, pattern, or practice of sharing confidences" would be subject to a "facts and circumstances" test for misappropriation theory liability. In these cases, the Commission will need to gather evidence regarding the type of confidences shared in order to establish the existence of a relationship that creates liability. Inquiries to secure this evidence will not be limited to business relationships and we question how these inquiries will be conducted. Particularly, we are concerned that this type of case-by-case inquiry regarding the history, pattern, or practice of non-business confidences may be unduly intrusive into investors' personal lives.
While the AIMR Task Force recognizes the need to prevent insider trading through misappropriation, we would encourage the Commission to focus on the knowledge of the trader under the circumstances of the trade rather than the relationship between the trader and the person supplying that information. If traders know or should have reason to know that the information is material and nonpublic and originated from an inside source, they should be prohibited from trading regardless of whether a confidential relationship with the person supplying the information exists. We believe that this type of bright line rule, which focuses on the knowledge of the trader, will best serve the purpose of eliminating insider trading.
With the caveats expressed above, the AIMR Task Force generally supports the Commission's proposed Rule 10b5-1 and Rule 10b5-2 that provide additional interpretation and guidance to investors in determining insider trading law violations. However, we cannot support the proposed Regulation FD. We strongly believe that implementation of Regulation FD will negatively impact both the quantity and quality of information currently available in U.S. financial markets. Consequently, our markets will be less efficient, securities will be less accurately priced and, rather than being better off, investors will be both informationally and economically worse off than they are today.
The AIMR Task Force appreciates the opportunity to comment on the SEC's proposals. Should you have any questions, need additional information, or would like to arrange a meeting with the Task Force, please do not hesitate to contact Patricia Doran Walters at 804.951.5315 or by e-mail at firstname.lastname@example.org.
|/s/ Arthur Zeikel
AIMR Task Force on Selective Disclosure and
| /s/ Thomas A. Bowman
Thomas A. Bowman, CFA
President & Chief Executive Officer
|Cc:|| Distribution List
AIMR Task Force on Selective Disclosure and Analyst Independence
Michael S. Caccese, Esq., Senior Vice President, General Counsel & Secretary, AIMR
Patricia Doran Walters, CFA, Vice President, Advocacy, AIMR
Linda R. Rittenhouse, Associate, Advocacy, AIMR
Maria J. A. Clark, Associate, Advocacy, AIMR
|1||The Association for Investment Management and Research is a global, not-for- profit organization of over 42,000 investment professionals in 95 countries. Through its headquarters in Charlottesville, Virginia and more than 94 Member Societies and Chapters throughout the world, AIMR provides global leadership in investment education, professional standards, and advocacy programs.|
|2||George Gilder, "The Outsider Trading Scandal," Wall Street Journal, April 19, 2000, p. A30, cols. 3-6. (Full article attached.)|
|4||The AIMR Financial Accounting Policy Committee is a standing committee of AIMR charged with maintaining liaison with and responding to the initiatives of bodies that set financial accounting standards and regulate financial statement disclosures. The FAPC also maintains contact with professional, academic, and other organizations interested in financial reporting|
|5||Peter S. Knutsen, for AIMR Financial Accounting Policy Committee, Financial Reporting in the 1990s and Beyond, AIMR, Charlottesville, 1993, p. 4. This position paper was published after first being issued for comment by AIMR members and then reviewed and approved by the AIMR Board of Governors.|
|6||"FAF Guidelines on Inside Information," Financial Analysts Journal, January - February 1974.|
|7||Dirks v. SEC, 463 U.S. 646, 658-59 (1983) (citations omitted).|
|8||Standards of Practice Handbook, AIMR, Charlottesville, VA, 1999, p. 147.|
|9||Dirks, op. cit., 659 n. 17.|
|10||The Commission has tried diligently to eliminate legal "boilerplate" disclosures. In August 1998, the Commission published A Plain English Handbook: How to Create Clear SEC Disclosure Documents. This Handbook was designed to help those who create disclosure documents to write in a style that would "highlight the important information investors need to make informed decisions. [The Handbook stressed that t]he legalese and jargon of the past must give way to everyday words that communicate complex information clearly." (Page 3)|
|11||During 1999, AIMR retained Fleishman-Hillard Research to conduct a survey of AIMR members to identify attitudes toward and perceptions about the factors that are most important in analyzing and evaluating a company's performance, the quality of disclosure by most publicly traded companies, the publicly traded companies that they perceive to be doing a good job of disclosing financial information to investors, and the information sources that are most important to the research and analysis process. The result of this survey was published in February 2000.|