Selective Disclosure Exposed at EDS[Fool on the Hill] June 15, 2000

An Investment Opinion

Selective Disclosure Exposed at EDS

By Paul Commins (TMF Buster)
June 15, 2000

Boy, do I feel like a dope. Here I am, the wide-eyed newcomer at The Motley Fool, proudly shilling for the emerging investor revolution. You know the tune: the Internet has bestowed professional research and trading capabilities upon us little people. We have been empowered to compete with Wall Street insiders on a level playing field. Long live the revolution!

What a joke.

With an evening round of analyst-only phone calls last week, Fortune 100 computer solutions provider Electronic Data Systems (NYSE: EDS) slapped individual investors in the face, openly admitting what more seasoned investors have suspected all along -- that the traditional power structure hasn't changed all that much. I'm afraid to say that the onset of the real revolution may still lie ahead of us.

Our story begins on Thursday of last week, in the early morning hours, before markets opened for trading. In a private report to his clients, Merrill Lynch analyst Stephen McClellan warned that future EDS revenues will fall short of his standing estimates. So far, standard stuff, right? No big deal.

Maybe. Maybe not. Based on what unfolds over the next 18 hours, a rational person might form the opinion that McClellan's report is a big deal. But an EDS spokesman will later deny that McClellan had received any inside information from official EDS sources, prior to issuing his report, so it's tough to point fingers. It would just be speculation. We can only note, at this point, that EDS shares stepped down more than 8% at Thursday's opening bell and, relatively speaking, held steady for the remainder of the trading day. Shares closed down 8.5% to $57.81 (from Wednesday's $63.19 close).

So what does EDS make of this Thursday market debacle? Well, as EDS representative Reed Bynum would later reveal:

"[We were] certainly aware of McClellan's analysis and the market reaction to it. After the close of trading [on Thursday] we evaluated it and also our current revenue situation and made disclosure [Friday] morning."

To be clear, when Bynum uses the word "disclosure" here, he is referring to the public EDS warning of "softer than expected" revenues, which wasn't posted by PR Newswire until 10:06 a.m. on Friday morning.

Now, for the sake of argument, let's consider a hypothetical EDS shareholder, say H. Ross Doe. Ross bought EDS years ago. He bought to hold, not to trade, based on his evaluation of the long-term EDS business plan. But, lately, Ross has become increasingly concerned. The world of technology is about to change, again, and he's nervous that his old-guard EDS won't catch the B2B wave. Without a quick turnaround in the numbers, long-term EDS prospects just don't measure up, in his mind. In fact, he has made a decision: If second quarter 2000 results don't meet his expectations, he's going to sell.

Now, let's move ahead to Friday morning, and check in with Ross. He hears some dawn scuttlebut on CNBC regarding a potential EDS profit warning. Still stung by Thursday's big drop, he's nervous. So Ross jumps on his home computing device and leverages his awesome investor toolbox to view up-to-the-minute news on EDS. In the news, he sees more signs that something might be amiss but, still, nothing official from EDS. He decides to wait...

Bing! The EDS warning hits the wire. Ross jumps on his ready-to-go discount broker screen and fires off his sell order! Now that's using those revolutionary tools. You show 'em Ross! Viva la revolution!!

Ross is way too late.

In Thursday after-hours trading, it turns out, EDS had begun to drop again. And the sell-off had reached fever pitch before Friday's opening bell. The NYSE had done right by the individual investor, halting EDS trades from the opening bell until the EDS press release hit, thirty-six minutes later. But by the time Ross fires off his order, so many EDS sell orders are queued that trading opens around $43. Ross is out of luck. The price never recovers, closing Friday at $43.75, more than 30% below Wednesday's close.

His EDS wealth suddenly down by almost a third, a stunned Ross tries to make sense of what has just happened. It sure seems like a lot of people heard the EDS warning in advance, he wonders. Doesn't it? More precisely, it looks like the information got out some time Thursday evening. How did this happen? Very mysterious...

Nope. No mystery at all. The truth, this time, comes straight from the horse's mouth. Later on Friday, after some analysts had already spilled the beans, EDS's Bynum finally makes sense of it all, publicly, stating: "We talked to analysts last night, after the close of trade."

Some revolution.

Ironically, in his 1999 letter to shareholders, EDS chief Dick Brown says: "Shareholder value will remain foremost in everything we do. As we put our clients first, we put you first." I can only conclude that when Mr. Brown thinks of shareholders, he's thinking mostly about the ones with direct ties to Merrill Lynch, Goldman Sachs, Morgan Stanley Dean Witter, and Lehman Brothers, just to mention a few who admitted to Thursday night calls. Apparently, it's catch as catch can for the rest of us revolutionary dogs.

What's an EDS shareholder to do? Are you one of them? Well, given the importance of Q3 and Q4 earnings reports, in this critical year, I have a recommendation for you. You might want to open a full-service brokerage account. Normally, we Fools like to go it alone, but in this case, you might make an exception. You just never know when EDS might outsource its Investor Relations again.

Of course, there are always two sides to every story. BusinessWeek just published an alternate take on selective disclosure.

Also, today's Fool StockTalk with Infonet Services (NYSE: IN) covers a publicly traded company with its own strong opinion on selective disclosure.

Finally, if you're interested in more in-depth background on this topic, you can find it at the Fool's Help Stop Selective Disclosure area (note that the public comment period for the SEC has expired, but the content is still current).