January 26, 1999

Investors' Rights

Why You Should Care

Louis Corrigan (TMF Seymor)

It's 10 a.m. October 8, 1997. Shares of Rational Software (Nasdaq: RATL) begin falling. They keep falling throughout the day. When trading is halted four hours later, the stock has dropped 19% on five times normal volume. And no news. A press release issued after the halt finally reveals the trouble: Revenue growth will be slower than expected.

Some investors obviously got the news early. According to Dow Jones, management warned some Wall Street analysts earlier in the day. Clients of these analysts were able to cut loose the shares before individual investors had any idea what was going on. These well-informed sellers were able to profit from less-informed buyers because they possessed material nonpublic information.

The Rational story captures the essence of a widespread problem known as selective disclosure. When companies fail to disseminate material news simultaneously to the broad investment community, a privileged few are often given the means to rob other investors. And they do.

Individual investors must learn that they have a right not to be abused in this way. At the same time, public companies must learn that such behavior is not just unethical but is also a potentially enforceable violation of the securities laws. Corporations should practice full and fair disclosure, and investors must come to expect it. When companies fail to meet this obligation, shareowners must speak up. It's simply in their interest to do so.

What Counts as Material Information?

In April of 1996, the National Investor Relations Institute (NIRI), the main international organization for investor relations professionals, published a booklet called Standards and Guidance for Disclosure. It outlines a set of "best practices" in this area. Crucially, NIRI adopted a definition of materiality that enlarges upon the one established by the Supreme Court in its interpretation of the Securities and Exchange Commission's (SEC) Rule 10b-5 anti-fraud provision.

The NIRI booklet concludes that 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." NIRI recommends that when management is in doubt about whether information is material, the information should be made public.

What Is Selective Disclosure?

Selective disclosure involves a company's release of material information to an individual or group prior to its broad public dissemination. If the information qualifies as "material," management should never privately divulge it to a prominent institutional shareowner, a favorite analyst, or a group of analysts. If by chance such disclosure occurs, a company should immediately issue a press release detailing the news. Or it should halt trading in its stock until such a press release can be issued. Rational Software's failure to take immediate corrective action confirmed and compounded the company's failure to abide by ethical disclosure practices.

What Constitutes Proper Public Disclosure?

Companies are obligated to disclose within 15 days certain major events such as a change in top management. Such "structured" disclosures must be made in a quarterly form 10-Q, annual form 10-K, or special form 8-K filing with the SEC. Companies have more leeway in releasing other types of material information. A corporation is only required to make prompt disclosure of such news when there's reason to believe insiders are trading on it or leaking it, or when new facts come to light that make a previous disclosure false or misleading.

When information is made public is certainly important. Plaintiffs' attorneys often argue that a company's top management profited while deceiving shareowners about a company's real prospects. Occasionally the attorneys are right. Yet what really concerns us here is how a company disseminates information when it decides to disclose it.

The essence of NIRI's recommendations is that companies should provide equal access to such information and should strive to release it "in a manner designed to reach the widest public audience possible, including the individual investor." The NIRI handbook notes that material news should be released to the exchanges and distributed electronically via the Business Wire or PR Newswire to "key media."

The handbook adds, "Companies should encourage the use of multiple technologies to disseminate information." It lists conference calls, broadcast fax and fax-on-demand services, e-mail, video conferences, Internet home pages, and Internet chat sites.

Conference Calls, for Example

Companies often use conference calls to elaborate on earnings releases or other major developments. These calls offer investors a special and quite important opportunity to hear from management and even to ask questions. Yet some companies still restrict access to the calls to Wall Street analysts and large institutional investors.

NIRI's guide warns against such restrictions, stating that "information from conference calls should be made available to all interested parties, including investors, analysts, and members of the media." Members of the media naturally should include members of the online media.

The NIRI booklet also insists that there "should be a widespread, broadcast notification of the conference call to ensure that all interested parties will be able to participate in the call, at least in listening mode." Moreover, the booklet indicates that such calls should occur before or after trading hours and should be preceded by a press release that includes the news. If in the course of the call management "modifies or expands upon" the information included in the press release, then the company should immediately issue a follow-up press release.

As these guidelines suggest, companies have an obligation to share information with all members of the broad investment community in a way that ensures that no party can trade on news before others have a fair chance to inform themselves about it. The guidelines go further, too, by insisting that companies be proactive in publicizing when and how this information will be communicated.

The SEC Is Watching

SEC Chair Arthur Levitt endorsed NIRI's guidelines in a February 1998 speech to a gathering of securities lawyers. He indicated that companies engaging in selective disclosure may be abetting conduct akin to classic insider trading. In fact, the example he used to illustrate the problem was strikingly similar to the Rational Software story. Levitt said that if these abuses don't stop, the SEC is "prepared to step in." He added that a "level playing field" on disclosure is crucial to ensuring the integrity of U.S. financial markets.

Though the legal issues are somewhat complicated, the SEC has in the past charged top managers as tipsters under the insider trading laws. For example, Phillip J. Stevens, CEO of Ultrasystems Corp., was successfully sued by the SEC in 1991 for offering analysts early warnings of an earnings shortfall. Stevens paid $126,455 in the settlement, the amount of losses avoided by those who were tipped off.

Former SEC Enforcement Division chief William R. McLucas told the National Law Journal early in 1998 that the Commission could become "more proactive," potentially charging something other than insider trading in such cases. Some attorneys think the SEC could pursue cases as violations of corporate disclosure obligations, suing companies rather than officers.

What You Should Expect

NIRI's guidelines were created by a special task force consisting of investor relations officers from major U.S. companies such as Bristol-Meyers Squibb (NYSE: BMY), Imation (NYSE: IMN), and Texaco (NYSE: TX). They were blessed by a professional organization comprised of 3,000 members. They have been unofficially blessed by the SEC.

There's simply no reason why these guidelines should not be endorsed and embraced by all public corporations. While investors reserve the right to quibble with any list of best practices created without their input, NIRI's recommendations provide a crucial baseline for good disclosure. Companies that fail to live up to these standards are also needlessly opening themselves up to potential lawsuits.

Ultimately, investor relations departments must become something more than a tool for public relations, the mere gatekeeping of corporate information, or the stroking of Wall Street analysts. Companies should strive to develop a community of informed investors by becoming more attuned to the opportunities for doing so. A firm's investor relations department should serve the interests of its shareholders. After all, these are the folks who own the business, and the IR staff is really working for them.

The payoff from a more knowledgeable and loyal shareowner base comes, in part, from a lower cost of equity capital. Since businesses are ultimately valued on the difference between their cost of capital and return on capital, lowering the cost of capital is just as important to a company's long-term prospects -- and to a shareowner's profits -- as increasing the return on capital. In this sense, shareowners have not just a right to expect timely, equitable, and helpful disclosure. They actually have a financial incentive, a right, even an obligation to demand it.

Highlights from NIRI's "Standards and Guidance for Disclosure"

Next -- Investor Relations Online

Related Links:
A Rogue Manifesto: Disclosure -- 09/19/97
Rational Investors Sue -- 11/07/97
Conference Calls -- 03/03/98
Analyst Trading Attacked -- 03/04/98
Arthur Levitt, A Question of Integrity