What's so Bad About Selective Disclosure?
Corporations, Securities & Antitrust Practice Group Newsletter - Volume 3, Issue 2, Summer 1999
August 1, 1999Joseph McLaughlin
The chairman of the SEC says that "selective disclosure" is tantamount to "cheating" and represents "a stain on our markets." one of his colleagues calls it "insidious." The SEC's general counsel announces that the SEC may pursue rulemaking to stamp out the practice.
Why is everyone so excited?
After all, "selective disclosure" is just a label. It has no legal content. It means simply that a public company tells particular persons about a new development before issuing a press release or other public announcement. Unless the company's disclosure is accidental, it is obviously "selective" in the sense that the company probably has a purpose in choosing the persons to whom it makes the disclosure — e.g., analysts.
You can be sure about one thing: if the SEC thought that the practice was illegal, it would be calling it "tipping" rather than "selective disclosure." In some parts of the country, they talk about "calling a dog a name and hanging it." that's about what the SEC and the financial press have done to "selective disclosure."
Again, why is everyone so excited?
A lot depends on where you sit. The SEC complains about "fairness" to small investors. The financial press and investor relations people complain about disclosure directed to sell-side (Wall Street) analysts. The buy-side analysts with responsibility to a single client complain about a company choosing to direct news to sell-side analysts who answer to thousands or millions of customers. Even some sell-side analysts don't like analyst-directed disclosure if it makes their job more difficult.
But isn't the key question whether selective disclosure can sometimes best serve the interests of investors? And isn't the next question whether public companies aren't in the best position to decide when this is the case?
A few years ago, for example, a large bank conducted a one-hour conference call with analysts before issuing a press release announcing a $350 million increase in reserves. As one might expect, it was reported that regulators were "troubled" and investors "infuriated" over the bank's "selective" disclosure to analysts.
Before condemning the bank (or any issuer in a similar position), let's examine two possible scenarios. In the first, the bank convenes a conference call to announce the reserve increase. It is fair to assume that the bank uses the hour consumed by the conference call to put the reserve increase into context for the benefit of the participants. For example, the bank might describe the move as responsive to a weaker economy rather than to factors unique to the bank.
After the call, analysts factor the increased reserve into their models and come up with some adjusted numbers. They then decide whether or not to change their rating on the stock. (What they obviously don't do is buy and sell for their own account.) After due consideration, they get on their firm's "squawk box" or similar system and inform the firm's sales force of the announcement and its significance for the stock. The brokers call their customers to inform them of these conclusions.
When the press release hits the tape, investors turn to brokers who are informed and knowledgeable about the news and its significance. Some of these investors sell. Others decide to hold.
Let's examine the alternative scenario, which the SEC and the financial press appear to prefer. The bank would put out a press release announcing a $350 million addition to reserves at the same time it starts its analyst conference call. While the bank is trying to put the reserve increase into context for the benefit of the analysts, anxious investors are calling their brokers in reaction to the press release.
With all expletives deleted, the discussion might proceed as follows:
Customer (to broker): What do you think, Bill?
Broker (to customer): I don't know, Bob. $350 million is a lot of money. It doesn't sound so good. I'll try to find out what Fred [the firm's analyst] thinks.
[Stock has not opened on NYSE because of order imbalance.]
Broker (to analyst's secretary): I need to talk to Fred. I've had six calls already from my customers who own 100,000 shares of this stock. I need to tell them what we think they should do when the stock starts trading.
Analyst's secretary (to broker): Fred is in a conference call. I can't disturb him.
[Stock opens on NYSE and it is down sharply from the previous close.]
Broker (to director of research): What kind of show are you running down there? I put a dozen customers into 200,000 shares of this stock on Fred's guarantee it couldn't miss, and here we are with a disaster! Get him out of that call now!
Director of research (to broker): I am sure Fred will have something for you as soon as the call is over. But I'll have a note put in front of him.
Note handed to Fred: You need to tell the sales force a.s.a.p. what you think about this announcement.
[Stock price continues to fall on heavy volume.]
Fred (to sales force, after leaving the call early and not having run any numbers): It's too soon to tell whether this announcement results from the weakening economy or from a more fundamental problem in the bank's credit standards. We would hold positions until there is more news.
Broker (to another broker): Did he say he was reducing his rating from "buy" to "hold"?
Other broker (to first broker): I wasn't listening, but I think that's what he said.
[Stock price is still falling; rumors are rampant.]
First broker (to customer): Fred seemed pretty uncertain on the call. Maybe you should get out now.
Customer (to broker): OK, sell my position. But forget about trying to sell me any more of Fred's good ideas.
[Stock price continues to fall until shortly after the end of the conference call, when several analysts put out encouraging view and reaffirm their ratings and estimates. The stock recovers most of its losses by the end of the day.]
Customer (to broker's voicemail): I really appreciate your help in getting me out at the lowest price of the day. Why don't you forget about trying to sell me any more good ideas from your firm, period.
It should be clear that the first scenario is better for small investors. A small investor is unlikely to be able to draw intelligent investment conclusions from a company's bare announcement that a reserve is being increased by a specific amount. He or she is more likely to be able to make a sound investment decision by relying on a broker who has access to an analyst's well-informed and well-considered reaction to the announcement.
More importantly, the Supreme Court also prefers the first scenario. It clearly held in Dirks v. SEC, 463 U.S. 646 (1983), that a company official could disclose material, nonpublic information to an analyst, who would then pass it on to customers, so long as the company official was not acting with a corrupt motive.
While the SEC has never fully accepted Dirks, it appears in the current debate to be willing to concede that selective disclosure is not fraud. But the SEC's jawboning is already having a chilling effect.
Let's make no mistake about it. The Supreme Court's decision in Dirks has constitutional underpinnings. Any SEC rulemaking in this area is going to have to meet First Amendment standards. And in the "age of information," it is going to be difficult for the SEC to make the case that public companies cannot decide for themselves how best to disseminate information to investors.
Joseph McLaughlin is a partner at Brown & Wood LLP in New York, NY. This article first appeared as a Guest Editorial in the April 1999 issue of Insights, the Corporate and Securities Law Advisor. We reprint here with the permission of Insights and the author, each of whom we thank for allowing us to do so.