Rogue on NIRI
Already broken some of your New Year's resolutions? Great, let me suggest one that will be both easy and fun to keep. It will also benefit everyone involved, even the tired old Wall Street institutions that are about to get seriously re- engineered. Every time you find that a company you've invested in has engaged in a wanton act of selective disclosure that leaves you, the shareholder, at the end of the information loop, raise hell.
Call the firm's Investor Relations office and politely ask why your company is failing to follow the "best practices" guidelines laid down by the National Investor Relations Institute (NIRI), the leading professional association of corporate officers and investor relations consultants. Ask if the company has adopted a written disclosure policy (like the NIRI has recommended) showing that corporate officials are committed to timely, orderly, and fair dissemination of information. Indicate that you are not only displeased that the firm is failing to communicate with shareholders in an ethical manner but that you are worried that such reckless policies may open your company up to lawsuits from some cretin who is even more upset than you are.
Calmly point out to your now besieged IR officer that the company's failure to practice equitable corporate communications may be detrimental to the stock's price, thus raising the company's cost of capital. That may mean the board is failing to live up to its fiduciary duties. Let the IR officer know that it's not hard to get a shareholder resolution on a proxy statement and that new online communities can facilitate such shareholder activism. Remind yourself that you are part owner of this company and that both you and the company stand to benefit from your own efforts at "relationship investing."
But do begin with the NIRI guidelines. Based in Vienna, Virginia, NIRI was founded in 1969 and now claims over 3,000 international members representing most of the largest publicly held U.S. corporations plus an increasing number of smaller companies. After looking over a survey produced in May of 1995, the association determined that its members needed some standards for conducting corporate communications. The result was the 30-page "Standards and Guidance for Disclosure" pamphlet released in April of last year.
The key issue in corporate disclosure is how companies handle material information. The legal definition for materiality as it pertains to the Securities and Exchange Commission's anti-fraud provision (Rule 10b-5) was established by the Supreme Court in Basic v. Levinson. To prove a violation of the materiality clause, the court decided that there "must be a substantial likelihood that the disclosure of an omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total' mix of information made available."
NIRI endorses the somewhat clearer definition offered by the 60,000 member Association for Investment Management and Research (AIMR), a group for investment analysts and portfolio managers that commented on NIRI's proposals. AIMR's definition states: "Information is 'material' if its disclosure would be likely to have an impact on the price of a security or if reasonable investors would want to know the information before making an investment decision."
Clearly, even that definition leaves room for doubt in determining materiality. Only case law can really spell out what constitutes a "reasonable investor." And there's already a sense that online access to investment information will raise this standard and thus broaden the definition of materiality. On the other hand, company officials can, within certain limits, withhold material information for business or competitive reasons.
But importantly, the NIRI guide argues that company officials should "err on the side of materiality" when trying to determine whether facts needs to be released to the public. "[I]f it is a borderline decision, the information should probably be considered material and released using broad means of dissemination." Broad dissemination means, at the very least, a press release that is distributed or covered by one or more major wire services.
Moreover, the NIRI guide is keenly concerned with the problem of selective disclosure of such material facts. It points out that "[d]ivulging important (material) nonpublic information in a private conversation with an institutional owner" is a clear example of selective disclosure. Also, "[d]ivulging the same information to a room full of securities analysts is also selective disclosure, unless followed immediately by a press release." The guide is emphatic on this point. Material information revealed in an analyst meeting or conference call "must be publicly disclosed immediately after the meeting." The goal is to "avoid anyone from taking action on selective information."
The same rules hold true for dealing with analyst earnings estimates. According to a 1995 NIRI survey, 69% of the companies queried always or usually provided guidance to analysts in formulating estimates. In NIRI's view, these companies are particularly obliged to make a "full public announcement using a press release" when officials determine that earnings won't meet estimates. "Under no circumstances should a company respond to an individual analyst's inquiry or conduct a conference call with analysts before making a public announcement."
Indeed, the association has offered a relatively enlightened view on conference calls in general. And given that NIRI's own surveys show more than 70% of companies are now employing such calls to discuss earnings or announce major changes, it's clear this is an increasingly important way of communicating with the investment community.
In NIRI's view, "The information from conference calls should be made available to all interested parties, including investors, analysts, and members of the media." The company can fulfill this obligation by making the call accessible in real-time "listen only" mode through an 800 number; providing access to a delayed tape version of the call; or by offering transcripts on request or publishing them on the company's own Web page.
The association argues that it's in a company's best interest to open up communications in this area since "the more people who participate by listening to a conference call, the less risk the company faces regarding charges of selective disclosure." The association has now started asking companies if they are allowing The Motley Fool onto conference calls, a move they are encouraging.
And NIRI has also made it clear that conference calls "should be preceded by press releases," and that the calls "should not divulge any new material information not contained in the press release." If they do, "the call should be followed immediately by an additional press release" stating the new information revealed during the call.
However, many companies remain hesitant to speak to the broad investment community. Some operate with the sense that only investment professionals (such as large shareholders, institutional investors, and analysts) can properly understand the details of a corporate balance sheet or the intricacies of management decisions. NIRI squarely addresses this concept of "differential disclosure."
Ordinarily, professional investors do require more detailed information to analyze a company than do most individual investors or reporters. But NIRI observes that this practice "can be a form of selective disclosure, which can be detrimental to the financial markets" if companies are unwilling to "provide the same level of information to the general public upon request." The group says that for individual investors and reporters who want detailed information, "the company should provide it."
There can be no mistaking these standards. They impose an awesome but completely justified obligation on American companies to communicate responsibly with all members of the investment community on an equal footing. Indeed, there's an implicit shareholder bill of rights embedded in the association's recommendations, and like The Clash said, "Know your rights. These are your rights." You have the right not to have your portfolio killed while someone else is being given a chance to save their skins. You also have the right to have a fair shot at making a killing without a bunch of institutional investors having an unfair jump on you.
Unfortunately, these rights are violated every day. Consider the recent debacle involving the comic book company Marvel Entertainment (NYSE: MRV). On Friday November 8th, representatives of the giant mutual fund companies Fidelity Investments and Putnam Investments chatted with Howard Gittis, vice chairman of the Andrews Group, the investment vehicle for millionaire financier Ronald Perelman. Directly after that little conference, the mutual funds dumped $70 million of Marvel junk bonds for 37 cents on the dollar.
The following Tuesday, the Andrews Group announced Perelman's new bailout plan to save Marvel. The proposal was such a complete betrayal of Marvel's investors that even though the stock had fallen in the preceding months from $13 to $4.62, the shares plummeted another 40%. And the stock continued to fall in the days to follow, reaching a low of $1.50 before its recent recovery to $2.50 per share. The company's bondholders didn't fare any better, with the Marvel bond prices more than cut in half, eventually sinking to a low of 16 cents on the dollar before they also made a modest recovery.
In effect, the conversation with Gittis had helped these two huge mutual fund companies save their investors about $14 million according to the calculations made by The Wall Street Journal . All those investors who didn't enjoy a similar opportunity suffered the common fate of the ill-informed: they lost a lot of money. Even in early December when the Journal revisited the story, Wall Street professionals were still fuming over these events. No one likes to be played for a sucker, especially when your rivals seem to have benefitted from special access to material nonpublic information.
At least in theory, such selective disclosure is against the law. But in practice, it's an area that goes almost wholly unpoliced aside from truly egregious violations. The problem is that the SEC's primary enforcement rights extend only to the mandatory disclosure associated with the public filings required by the Securities Act of 1934. Suspicious trading activity in connection with acts of voluntary disclosure really only interest the SEC when they appear to involve trading by insiders or their immediate family or associates.
Even in the seemingly obvious case of Marvel, the issues remain legally murky. For one thing, Gittis is not technically a Marvel insider, so his comments likely do not fall under the insider trading clause. In addition, neither he nor Perelman gained materially from the disclosure. And then there's the typically plausible exculpatory song-and-dance.
According to news reports, Andrews Group officials say that Gittis actually didn't even reveal nonpublic information to the fund managers. It was no secret that Marvel was in financial trouble. In fact, the Andrews Group had made two previous announcements cautioning that a restructuring of Marvel could prove detrimental to bondholders as well as shareholders. All Gittis did was "solicit ideas" from Putnam and Fidelity about how to structure the new financing plan. The mutual funds, in turn, just say they got a good offer for the bonds and decided to sell.
Yet, it's clear that whatever Gittis said to these fund managers helped them see the writing on the wall: Perelman's proposed restructuring would be more draconian than the overall market imagined. Marvel's market meltdown two trading days later proved that was indeed the case. The Marvel case offers a dramatic example of how such selective disclosure provides an unfair advantage to some investors while discriminating against others.
While such cases no doubt trigger some interest within the SEC, the more mundane and pervasive forms of selective disclosure are generally left to the self-regulatory organizations such as the New York Stock Exchange and the Nasdaq national market. And the NYSE and NASDR basically ignore these problems unless they become simply outrageous.
The NASD manual, for example, indicates that company officials should disclose through the news media "any material information which would reasonably be expected to affect the value of their securities or influence investors' decisions." The market will halt trading in a stock, if necessary, to allow material information to get out to the investing public. "This decreases the possibility of some investors acting on information known to them but which is not known to others."
Still, the NASDR has no power to censure or punish companies that violate the guidelines, according to Reed Walker, the NASD's associate director for media relations. The NASD's market surveillance department monitors real-time trading for unusual activity, but its goal is simply to get new information out in a timely and sensible fashion.
The NYSE guidelines and goals are remarkably similar to Nasdaq's. And NYSE spokesman Ray Pellecchia echoed Walker's comments, saying that legal action for those violating disclosure requirements would have to come from the SEC. The NYSE could ultimately delist a company that repeatedly or flagrantly violated these requirements, but Pellecchia said he could not think of a case in which that's happened.
None of this is particularly surprising. Public companies are essentially clients for the exchanges and markets. Thus these self-regulatory organizations not only have limited powers but limited incentive to ruffle corporate feathers by playing disciplinarian.
The unfortunate result is that some forms of selective disclosure are so common as to be essentially institutionalized. Consider the spark behind recent investor enthusiasm for the chip-making giant Intel (NASDAQ: INTC). On Wednesday December 11th, the company's shares jumped $7.75 to $136.87 on heavy volume of 21 million shares after analysts from First Boston, Merrill Lynch, and Montgomery Securities raised their 1997 earnings estimates by 5-15%.
As the Journal reported the next day, this sudden excitement may have had something to do with the fact that "Intel executives have been visiting in recent days with investment pros and analysts, with upbeat comments about demand for the company's microprocessors as well as profit margins. Yesterday, for instance, Gerald Parker, executive vice president of manufacturing, spoke at a Montgomery Securities conference, saying Intel plans to boost capacity 10% next year."
Indeed, the Journal reported that Merrill's analyst Thomas Kurlak met with Intel executives on Tuesday of that week. And that Monday, Robertson, Stephens & Co. analyst Dan Niles had raised his estimates by 12%, presumably after also meeting with Intel officials. The remarks made by Intel VP Parker no doubt contributed to the other revisions and to a buzz among institutional investors who attended Montgomery's prestigious but private technology conference.
The problem here is twofold. First, there can be no doubt that Intel's plan to boost capacity by 10% in 1997 constitutes material information. If Intel is going to release that information (and the company does provide guidance to analysts), then NIRI's recommendations suggest it should do so in the form of a press release that is widely distributed on the wires. A comprehensive search of the Dow Jones database revealed no such press release or wire report during this period. Intel's decision to release such data to a crowd of analysts and institutional investors without widely disseminating this information to the public constitutes a vivid but extremely typical example of a corporate policy of selective disclosure that discriminates against individual investors.
Second, it should be obvious that at least some of the information Intel shared in private meetings with analysts was material, since it led them to ratchet up earnings estimates by as much as 17%, or over a billion dollars. In theory, a company should only be making "soft disclosures" of non-material information in such private meetings with analysts. And the revisions in estimates that often follow such meetings then get chalked up to the "mosaic" theory, which suggests that analysts can essentially read more into such soft disclosures than would be apparent to non-professionals. That's because the analysts combine these data with that drawn from suppliers, distributors, and their other sources of information about the company.
This is a nice theory that may in some cases be true. It's also a brilliant way of rationalizing what in this Intel example would appear to be just another case of a company preferentially offering the professionals another trading advantage over the individual investor. (Indeed, this is one area where NIRI's guidelines seem to be too influenced by the input of the AIMR and by the fact that the task force drawing up the standards did not formally solicit the views of individual investors).
Still, individual investors should applaud NIRI for offering such a concise and powerful guide laying down ground rules for how companies should communicate with investors. And when individual investors are confronted with acts of selective disclosure that put them at a disadvantage, they should cite chapter and verse from the NIRI guide.
The bottom line is that neither the SEC, nor the markets, nor even the financial press seem particularly concerned with this problem. So unless individual investors make themselves heard on the issue, apology will remain policy, to paraphrase Dana Scully. But as owners of public companies, we all deserve more than apologies. We deserve equal access to whatever information the company offers other investors. If we can resolve to demand that access, 1997 is bound to be a happier year.
-- Louis Corrigan (RgeSeymour)
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