Rogue Missives

Rational Investors Sue: What To Do About Selective Disclosure

By Louis Corrigan

On Oct. 8, Rational Software (Nasdaq: RATL) executives allegedly violated U.S. securities laws by providing a Cowen & Co. analyst with material nonpublic information and then failing to halt trading in Rational's stock or to disseminate that information to the general public until hours later. During that time period, Cowen officials allegedly violated securities laws by trading on that information, saving their clients millions of dollars as the stock collapsed, according to a class action lawsuit filed Oct. 10.

Based on the available evidence, the plaintiffs would appear to have a promising case. That could be good news for individual investors who are tired of seeing America's public corporations violate securities laws by giving Wall Street analysts special access to information while they, the owners, remain locked out of the loop. Well-deserved and public legal actionsfor selective disclosure might be exactly what's needed to convince corporate managers to start abiding by the law. Plus in this case, Rational investors who lost out in the debacle also stand a chance of getting their money back from Cowen and any others who defrauded investors by trading on insider information.

Headquartered in Santa Clara, California, Rational is the market leader in Automated Software Quality (ASQ) tools that support object-oriented and component-based software development. The company has nearly doubled revenue over the last two fiscal years to $145.4 million. Following the August acquisition of software developer Pure Atria Corp., Rational is now on course to double revenues yet again in the current fiscal year ending in March.

The company's stock, however, has had a rough ride this year. The shares stumbled badly on Sept. 22 following the announcement that Oracle Corp. (Nasdaq: ORCL) would soon enter the market of visual-modeling software, one of Rational's core markets. After losing $5 a share that day to close at $17 1/2, Rational's stock spent the next two weeks drifting lower as investors considered the new competitive challenges facing the company.

With these concerns apparently already figured into the stock price, trading in Rational shares began rather uneventfully on Oct. 8. After closing at $14 13/16 a share the previous day, Rational stock opened on an inside bid price of $15 1/16 and inside or lowest ask price of $15 1/8, according to Nasdaq trading records cited in the complaint. The inside ask price briefly fell below $15 at 9:53 a.m. only to recover. From 10:09 a.m. to 10:45 a.m., selling pressure began to hit the market, with the inside ask price dropping to $13 15/16. Beginning at 10:03 a.m., the first large block trades of the day starting crossing the tape. At 10:22 a.m., three block trades totaling 116,500 shares were executed.

From 11 am to 11:43 a.m., the inside ask dropped further, to $12 15/16, thanks to more heavy selling. A 100,000-share trade crossed at 11:06 a.m. Two minutes later, two more large blocks traded followed by seven large blocks at 11:09 a.m. and a 115,000-share block a minute later. Another 151,900 shares went through in two blocks during the next five minutes. By 11:50, the ask had dropped another dollar to $11 15/16, down 21% on the day.

As the complaint points out, there was no public explanation for what was suddenly causing Rational's stock to tank. There were no wire reports, no news pending. Commentary at the time on The Motley Fool'sRational message folder reinforces the fact that individual investors were clueless as to why they were losing so much money so fast. Around noon, poster "JdoMjoOD" summed up the general feeling: "What the hell is going on?... I cannot figure the collapse of this stock. Anyone with some insight to offer would be greatly appreciated."

The first explanation came at 2:03 p.m. from a Dow Jones headline: "Rational Off; Cowen Says Co. Tells Analysts to Lower Views." Nasdaq finally halted trading of the stock at 2:18, presumably at Rational's request. By then, the stock was off $2 7/8 to $11 15/16, a 19.4% decline for the day on 11.4 million shares traded, about five times normal volume for a full day. Then at 2:42 p.m., a Dow Jones story explained what had happened. The company "had advised analysts to lower revenue growth expectations for [the] fiscal year ending March 1998 and fiscal 1999, according to Cowen & Co. analyst Rehand Syed. Syed said Rational management told him that the company is not expecting to see its revenue rise as fast as analysts had estimated on account of 'additional competitive pressures.'"

Rational officials did not offer any public comment until 4:30 p.m. when management held a conference call with analysts. At 4:39 p.m., the company finally spoke to the general investing public in the form of a press release issued on the PR Newswire. The company said it would announce second quarter earnings Oct. 15 and that revenue would "be in line with current published analysts estimates and the company will report a net loss, as previously announced."

Then came the negative forecast that had already devastated the stock. For FY98, "while revenue will be generally in line with or slightly below published analysts' estimates, EPS will be somewhat lower due to increased expenses in R&D, sales, and marketing to address the increasingly competitive nature of the markets that the company serves."

As a result, the press release said, management now believes that revenue and earnings per share will fall below analyst estimates for FY99. The analysts got the message loud and clear, quickly downgrading the stock. In response, Rational shares fell another $2 a share to $9 15/16 the next day on volume of 36 million shares. In two days, Rational stock dropped 33%.

Rational's shareholders were no doubt stunned and dismayed by the disappointing earnings forecast. But from an individual investor's perspective, management's most egregious error pertained not to the forecast itself but to how Rational chose to convey that information to investors. After all, technology companies are especially susceptible to competitive pressure and earnings surprises. That goes with the territory. Yet it's appalling when a company's managers violate their legal obligations to shareholders by engaging in selective disclosure.

The events outlined in the lawsuit strongly suggest that Rational's management essentially gave one set of investors a chance to minimize their losses while other, less connected investors simply watched with fear as their investment dissipated by the minute. This is illegal. It also violates the very explicit guidelines for corporate disclosure established last year by the National Investor Relations Institute (NIRI), an international organization of investor relations officers. NIRI's handbook on disclosure offers clear guidance for what a company's management should do when they inadvertently reveal material nonpublic information to a research analyst:

"Companies should take caution to refrain from overstepping legal boundaries in providing an analyst with selective guidance, and absolutely refrain from disclosing material, nonpublic information on a selective basis. If material, nonpublic information is disclosed selectively, the company must take action immediately to achieve broad public dissemination of the information, to avoid anyone from taking action on selective information."

Rational's management had a legal obligation to either refrain from telling analysts that competition would pressure FY98 results or to use the available means, chiefly a press release, to disseminate that unhappy news to the overall investment community. Failing that, the company's management had a responsibility to balance the playing field as soon as possible by telling the world what had apparently been told the Cowen analyst and perhaps others. Rational should have immediately halted trading in its stock pending a news release via one of the business wires. The stock should not have re-opened until investors had some time, say 30 minutes, to learn of the revised outlook for the company.

That, at least, is what a management team dealing with its shareholders equitably and honestly would have done. It's what officials careful to avoid exposing the company and themselves to costly litigation would have done. Yet whatever other merits Rational's management might have, they apparently either don't understand their legal obligations to shareholders or they simply don't care. Toni Sottak, Rational's VP of corporate communications, said that the company had no comment on the pending lawsuit and that its attorneys would not allow her to say more.

While the actions of Rational's management are enough to incense any individual investor, Cowen's alleged involvement is also notable. Stock analysts cannot trade on nonpublic material inside information without violating the law under the so-called "misappropriation theory" of insider trading. Promulgated a decade ago by the Securities and Exchange Commission (SEC) to cover cases that did not fall under the classic theory of insider trading, the misappropriation theory was only recently upheld and broadened by the U.S. Supreme Court.

It's transparent from the Dow Jones news article following the trading halt that Cowen's Syed had been given such information before the company had made it public. If it can be proved that Syed or others at Cowen, or any others who were tipped, traded on this information during the day on Oct. 8, they will have broken the law. They could also be forced to essentially make good the losses suffered by investors caught on the other side of their trades, the folks who were buying Rational's stock even as it fell because they didn't know what the "smart money" knew.

The securities laws and the SEC do offer financial analysts a privileged role in disseminating information to the markets. According to the "mosaic theory," analysts are free from liability concerns when they combine public information with nonmaterial nonpublic information to reach an investment opinion. Given the new opportunities for disseminating information over the Internet to a growing community of online investors, it's arguable that the mosaic theory is dated, offering both unnecessary and undeserved privileges to professional analysts. It may in fact protect and reinforce a certain coziness between traditional Wall Street institutions and corporate America that actually diminishes confidence in America's markets.

In any case, the mosaic theory cannot apply to a disclosure of such specific and obviously material information as a forecast of lower-than-expected profits. And it's quite clear what an analyst presented with such information should do. The Association for Investment Management and Research (AIMR) is an international organization of investment analysts and portfolio managers that administers educational training under its three-year Chartered Financial Analyst (CFA) program. The AIMR's Standards of Practices Handbook notes that analysts in possession of inside information must tread carefully.

"Generally, the existence of an independent reason for an investment decision does not provide a valid defense against charges of insider trading. Thus, the mere possession of material nonpublic information about a security should trigger restrictions on investment actions related to that security."

The handbook goes on to say that "when a member deems selectively disclosed information to be material, the member must encourage the public dissemination of that information and abstain from making investment decisions on the basis of that information unless and until it is broadly disseminated to the marketplace."

Michael S. Caccese, AIMR's Senior VP and General Counsel, said that his organization can take disciplinary actions against a member who violates its code of ethics. He said that if an analyst traded on what he or she knew to be insider information, "We would look on that very gravely and consider it a serious violation."

In such a case, the AIMR could decide to take away the member's CFA charter and to strip the violator of membership in the organization.

But Caccese added that in his five years at the AIMR, only two members have faced allegations of trading on nonpublic material information. However, securities analysts are not required to join the AIMR, and only about 35% of its 30,000 current members are pure analysts rather than portfolio managers or other investment decision-makers. Based on the latest available records, Caccese said that Cowen's Syed is not a member of AIMR.

Cowen's Syed could not be reached for comment. Ken Hagan, Cowen's director of corporate communications, said that on advice of counsel, the company was not prepared to discuss the lawsuit or Syed's alleged involvement.

The lawsuit has been filed in U.S. District Court for the northern district of California by Los Angeles attorney Lionel Z. Glancy and associated lawyers. Glancy has experience in broker-dealer litigation and class action securities litigation. He also was among those attorneys who brought cases against Nasdaq's market makers for illegally conspiring to fix prices, a scandal that led Nasdaq to agree to a landmark settlement with the U.S. Justice Department two years ago.

Glancy said that the Rational case is "very rare" because it vividly showcases abuses that usually are difficult to tackle or substantiate. The 2:42 p.m. Dow Jones article that included Syed's comments was something of a smoking gun, pointing to the apparent disclosure that had triggered the selling. Glancy said he has already found other traders that knew of Cowen dumping shares. He's also heard from hundreds of shareholders, including some Silicon Valley executives, who were furious at Rational's handling of the disclosure.

The process from here won't be swift. Glancy said there will be a court hearing 60 days after the motion was filed to determine who will serve as the lead plaintiff and which counsel will control the litigation. From there, the defendants will likely file a motion for dismissal, which the judge could take months to rule on. If the judge denies this motion, a lengthy period of discovery, lasting anywhere from months to years, would ensue. Yet Glancy said the defendants have already been notified that they must not destroy any e-mail, voice-mail, or documents related to the matter.

The Rational debacle is yet another example of how many of the managers running America's companies exhibit a disregard for individual investors, particularly the individual investors who provide their hard-won savings to help these companies grow. While litigation is hardly the best way to get management to do the right thing, it appears to be necessary. It's surely time we saw lawsuits highlighting the abuses of selective disclosure. A few courtroom victories might be exactly the thing to force managers and investor relations officials to take their disclosure obligations seriously.