Risk & Compliance

Show and Tell

The SEC's efforts to end selective disclosure won't eradicate secrecy, but they could hasten the day when it no longer matters.
Stephen BarrMarch 1, 2000

James O’Donnell still isn’t sure what hit ConAgra Inc. When the Omaha-based food giant was preparing to release its third- quarter earnings last year, CFO O’Donnell invited analysts and portfolio managers to participate in a 9:00 a.m. conference call. He was eager to boast about the company’s 20 percent surge in earnings, which met Wall Street’s expectations to the penny, and he anticipated a bounce in the stock once the market opened.

Surprise! Most analysts trimmed their fourth-quarter estimates; the overall consensus estimates dropped by 3 cents, to 41 cents a share. “ConAgra hinted in ways that any analyst would understand that the next quarter would not be as strong,” recalls Nomi Ghez of Goldman, Sachs & Co.

But O’Donnell says he was dumbfounded to see the stock fall 9 percent that day. There was no clandestine effort to guide estimates down, he insists.

In any case, ConAgra would end up meeting that lowered consensus the following quarter–and doing away with the invitation-only conference call. Now on earnings-release day, after the market closes, analysts and the public alike can listen by telephone or the Internet to him and CEO Bruce Rohde discuss the quarterly results. Then anyone can phone the executives directly with questions.

“We are trying to find the fairest way to keep the story consistent and get information to everybody at the same time,” says O’Donnell.

As part of a new push to end selective disclosures, the Securities and Exchange Commission hopes to win over more executives to that kind of thinking. Under SEC regulations proposed in December, CFOs would not be penalized for feeding analysts material information about future performance if they also let the public listen to their quarterly earnings calls, as ConAgra has done.

These rules, which should be finalized this spring after a 90-day comment period, represent yet another front in the battle by SEC chairman Arthur Levitt to combat “misleading” financial reporting. Having campaigned for more than a year against companies that use accounting gimmicks to meet analysts’ earnings estimates, Levitt is now railing about those who manage estimates by covertly guiding analysts to earnings predictions that the company can meet, or preferably beat.

In a speech last October, Levitt excoriated corporate leaders and investment analysts for “a web of dysfunctional relationships” that he deemed “a stain on our markets.” He cited two primary concerns: that executives freely tip-off analysts about information that may spur an unusual amount of trading, without disclosing the news publicly; and that analysts are overly optimistic about the companies they cover in order to generate underwriting business with those firms.

The centerpiece of this crusade for more openness has been Levitt’s appeal to companies to make their quarterly conference calls accessible to the public and press. The new regulations don’t dictate this. Instead, they remind companies that they must divulge material information through an SEC filing or a press release, but also add the alternative of the open call. In addition, the SEC says, an accidental release of market-moving facts to a certain few could be corrected within 24 hours with a public statement.

“What we’re talking about will encourage opening things up…and discourage CFOs from trying to curry favor with analysts,” says Harvey Goldschmid, former SEC general counsel and now special senior adviser to the chairman, who wrote the new rules.

Broader consequences

The new rules won’t stop companies from talking privately with analysts and major shareholders, who may in turn detect nuances that could shape buy- and-sell decisions. “We get paid to question management,” says Goldman’s Ghez, “and that’s when we get the impressions we get.”

They also won’t disabuse CFOs of the widely held notion that they face peril every time they open their mouths. “It’s nice when Levitt gets up and says, ‘Be careful,’” observes Frank Borelli, a member of the office of the chief executive at Marsh & McLennan Cos. and its former CFO. “But you can’t always be perfect, particularly when someone is probing into a possible problem. If you back off, the conclusion they may reach is that there is a problem you don’t want to tell them about, and then they start selling your shares. You almost can’t win.”

But this move to thwart selective disclosures comes at a time when, thanks to the Internet, companies are already expanding their reporting practices and analysts are losing their monopoly on corporate information. “In the past, the analyst was the main conduit of information, and there was no need to talk to the general public,” says Scott Rosen, director of research at I/B/E/S International Inc., a market-data collection firm in New York. But with the explosive growth of self- investing online, more individuals investing in equities, and the approach of expanded trading hours, he adds, “the assumption now is that every investor should have access to the same information.”

What remains to be seen is whether CFOs clam up (as some predict) or are inspired to truly embrace the spirit of openness in ways that would reduce the need to manage expectations, earnings, or both.

What’s Your Preference?

Predictably, the strongest objections to the proposed rules have come from Wall Street, where analysts have long relied on access to executives as a way to gain an edge.

“Our concern boils down to the chilling effect that may result,” says James Spellman, a spokesman for the Securities Industry Association. “The SEC is making the process more cumbersome and complex,” he opines, adding that CFOs “may be more leery of giving analysts information.”

Then again, given the prospect of a huge sell-off when earnings fall short of expectations, some CFOs may prefer to open up rather than risk letting analyst pronouncements move the stock. Longtime analyst Bill Michalak recently quit the research business altogether out of frustration that companies were already moving in that direction. “The attitude is, you can’t tell anybody anything unless you tell everybody everything,” he gripes.

Last summer, before leaving Wachovia Securities Inc., he had built a model that led him to conclude that a company he covered would miss its earnings estimate. Before distributing his research, he called to present his thesis. The executives asked Michalak if they could get back to him in the morning, then used that window of a few hours to put out a press release pre- announcing that the next quarter’s earnings would be below expectations.

“My customers lost the value-added I gave them [of being able] to move before the market,” Michalak says. “My ability to differentiate was nil.”

For their part, few finance chiefs are inclined to come out against the kind of fairness the SEC is seeking. “The basic notion of driving toward greater openness is certainly on the side of the gods,” confirms Stephen Key, CFO of Textron Inc.

But in the long-running bull market, the CFOs who aren’t managing earnings have little choice but to spend more time than they would like managing expectations. And that’s where they can get into trouble with selective disclosure.

“We try to manage the consensus well,” Key concedes. “If we believe the analysts are getting ahead of what our earnings capabilities are, we have to tone them down. We frankly try to keep them below where we think we can come out. We’d rather be in a position of underpromising and overdelivering. And you never want to fall short.”

To most CFOs, however, nudging analyst models is legitimate, especially right after an earnings release, as long as you stick to picking out factual mistakes or pointing out faulty assumptions. “The only time I’d comment on a projection was if it were way off,” says Frank Gatti, CFO of privately held Educational Testing Service, based in Princeton, New Jersey.

Nevertheless, he urges caution: “Some [analysts] would do that intentionally to try to get you to give them the real number.”

Tails You Lose?

There’s no doubt that some CFOs like playing the selective disclosure game.

According to a CFOmagazine survey last year, 27 percent of CFOs acknowledged making disclosures to one analyst and not to others or the public at least once in the previous three years. One respondent had done so more than 10 times. “To go from massaging expectations to not telling the general public what you tell analysts is a big leap,” says Scott Rosen of I/B/E/S, who worked on the sell-side earlier in his career.

One of the most egregious cases ever came to light less than a week before Levitt’s speech in October. That’s when allegations surfaced that Abercrombie & Fitch Co. had told an analyst at Lazard Freres & Co. that quarterly sales growth was slower than expected. Lazard, which helped take the retailer public in 1996, allegedly then encouraged clients to unload their shares.

As the trading volume grew and the stock price began to fall, other analysts were told by the company that there was no adverse news to report. One went so far as to consider the slump a buying opportunity, and upgraded the stock. Over five days, Abercrombie’s shares lost 15 percent of their value before the company confirmed the sales shortfall in a press release.

More than two dozen lawsuits have been filed on behalf of investors who bought the stock during the five-day period in question.

But for most CFOs, the issue of selective disclosure is less black-and-white, and ultimately boils down to one question. As Rosen rhetorically puts it: “What information do you have to tell everybody equally?”

The law generally defines material information as news that “a reasonable investor would find important,” says the SEC’s Goldschmid. To underscore the point, the SEC has put out new guidance that expressly states that quantitative rules of thumb with respect to materiality–such as 5 percent of earnings, which have become increasingly acceptable to auditors–are not acceptable to the regulators. But Goldschmid’s definition leaves plenty of room for murky judgment calls, where companies argue, as Apple Computer Inc. did recently, that certain information was not material enough to warrant full disclosure in a press release.

Last September, in response to analyst questions about a recent earthquake in Taiwan, Apple executives warned that a halt in the production of notebook computers would likely cut revenue by about $50 million for the fiscal fourth quarter, which was just ending. Apple shares traded down about 7 percent over a three-day period, as the Street consensus fell to 45 cents a share, from 76 cents. But most investors had no clue what was going on at the company.

On October 13, Apple reported fourth-quarter earnings of 51 cents, 6 cents above the adjusted analyst forecast, and its stock shot up 14 percent in the next day’s trading. The episode serves only to confirm the cynic’s view that any guidance around the end of a quarter, whether done secretly or through a fully disclosed preannouncement, is meant to ensure that a company beats expectations.

The new SEC rules give companies like Apple the leeway to go straight to the public within 24 hours if a seemingly nonmaterial disclosure has triggered unusual trading activity. Unless they’d prefer to keep the average investor in the dark.

Online, and Off the Hook

But the SEC’s efforts will likely ensure that most companies will have opened their quarterly conference calls by the end of the year. Cost is no longer a factor–the price of Web-casting these calls on the Internet is a fraction of opening phone lines for all comers.

“Companies may not like people listening who may not have context for everything that’s said,” concedes Deb Kelly, a partner at Genesis Inc., a Denver-based IR consultancy. But, she adds, “the Web-cast is a way to open the call and take the company off the hook for selective disclosure.”

At least initially, the new rules are expected to increase the role of lawyers in making determinations about what information is material. “There will be pressure on people to make judgments in ways that they won’t get second- guessed,” says John Olson, a senior partner in the Washington, D.C., office of law firm Gibson, Dunn & Crutcher LLP. “That will introduce more lawyers in disclosure decisions.”

The SEC’s Goldschmid concedes that point, but notes that the SEC has provided plenty of wiggle room. Not only will companies have 24 hours to put out a press release if someone makes a nonintentional disclosure, but those caught making a selective disclosure would only face SEC enforcement action, unpleasant as that can be. The new rules, Goldschmid notes, lack a fraud provision that would open the door to “wild plaintiff litigation.”

Here the Abercrombie & Fitch case is instructive. It will likely proceed through the courts not because an executive allegedly tipped off an analyst about a sales slowdown. Rather, other analysts curious about the sell-off of the stock were told that nothing was wrong and that the market was overreacting.

“We’re not approaching this as a selective-disclosure case; this is garden-variety fraud,” says John Halebian, a partner at New York law firm Wechsler Harwood Halebian & Feffer LLP. “If the company hadn’t lied to the other analysts and just said ‘no comment,’ this would have been a difficult case. But we can show that they made a false and misleading statement, and knew they were lying, because they had made the selective disclosure.”

Other Venues

In the end, opening up conference calls will go only so far to curb selective disclosures. “The reality is that, when they’re on the line [during a conference call], analysts don’t ask the hardball questions seeking out information in an area that would give them advantage in their research,” says Gatti of Educational Testing Service.

In addition, the SEC has yet to review the rules around the road- show “quiet period,” and has said nothing so far about private investment conferences, to which the brokerage houses invite their best customers in hopes of generating trading commissions.

Any effort on that latter front will surely encounter stiff opposition. “The firms want to maintain the exclusivity, because that gives them something to sell,” says A. Gary Shilling, an independent economic consultant and investment adviser in Springfield, New Jersey, who once worked on Wall Street.

A number of securities firms have opened their meetings to the press–some fully, some partially. And many CFOs, presumably those who stick to the vetted script and don’t get suckered into making projections, would welcome having these sessions Web-cast in the same way that earnings conferences are. “I wouldn’t object to these conferences being open,” says Bill Porter, CFO of Cadence Design Systems Inc. “Most of these presentations are informational in nature anyway.”

Some media companies, like Dow Jones & Co. have recently refused to take part in conferences closed to the press, or threaten to do so. What disturbed The Washington Post Co. CFO John Morse about one recent gathering is that the brokerage firm “told us that companies wouldn’t present unless the press was not there and the conference was closed,” he says.

Morse isn’t alone in his outrage. “The broker-sponsored events are the next venue for the issue of openness,” predicts Louis Thompson, president and CEO of the National Investor Relations Institute. He adds that FedEx Corp. took the next step forward when, in late January, it Web- cast the audio portion of its annual New York meetings with analysts and investors.

Some observers see the SEC’s efforts on selective disclosure as helping pave the way, at least indirectly, for the development of “real-time” financial reporting over the Internet. That could ultimately render quarterly earnings reports irrelevant. Says Michael Young, a partner at the New York law firm of Willkie Farr & Gallagher: “What they are saying is that giving information to some is unfair to others, and that’s a baby step along the path to mass disclosure on a continuous basis.”

That’s a direction Textron’s Stephen Key is already inclined to move in: “I think what you’re going to see is a press release and [open] conference call that will be sanitized, followed by facts on the Internet.” On the Web, Key explains, would be “all of the junk the analysts need to update their models, and it would be freely accessible to anybody.”

Of course, Key will still need to have conversations with analysts to help them understand the trends that are most important in constructing their models. But with outsiders having access to the same basic data, those conversations would mean much less than they do now.