What You Don’t Say Can Hurt You

Back when I was an attorney, I used to have to negotiate a fair number of documents.  When I was doing this, there was an unwritten rule that said that if you had the choice between drafting the document or reviewing it, you always elected to draft the document.  The reason for this was that in writing the document you could control what went in and what got left out.  The hardest thing in reviewing a document is figuring out what’s not in the document that should be there.  We always tend to focus on what’s said instead of what is not said. 

 

In the realm of investor relations, corporations start at an advantage over investors.  Corporations almost always control the flow of information, choosing what they will say and staying silent on many items that don’t favor them.  It then falls to investors to attempt to get the corporation to speak on those issues, if they are tuned in enough to realize that the corporation is staying silent.  Alternatively, investors can parse through oblique and obscure references contained in the company’s press releases, regulatory filings and other commentary to try and triangulate the data in order to figure out what’s going on.  Companies hate it when analysts do this and often claim the analyst has got the analysis wrong, but by trying to hide the data, companies get themselves into this pickle.

 

For example, let’s take a hypothetical example of a company that in a conference call talks about having “nearly 50,000 employees”.  Thinking this number sounds different, an analyst starts to dig back through records until he finds the next most recent reference to employee count, in a 10-K filing from a year ago, a reference to the company having 50,900 employees.  It would appear that the company has reduced their employee count by about 1,000 people over the course of the year, but have never mentioned layoffs, hiring freezes or reductions in force.  It may sound like a lot, something that the company should be forthcoming about, yet they have remained silent over the past year.  Have they fulfilled their obligation to disclose by the obscure reference to “nearly 50,000 employees”?  Maybe there is a good reason for the lower headcount – a facility or two may have been shut down or consolidated, more efficient operations, or something else, but the investors are purposely being kept in the dark, so the logical explanation is that the company is trying to hide something, and that something is bad news – layoffs and firings.

 

Now let’s have some more fun with this hypothetical and say that the company has recently opened a new distribution center in the last quarter, one of a series that is designed to change the manner that the company gets product to market.  But their quarterly press release doesn’t say anything about the new facility, which cost many millions of dollars, nor does it say anything about the remaining distribution centers to be built.  If an investor is savvy enough to notice this silence, how are they likely to interpret it?  That things are great, but the company just didn’t feel like talking about the project?  Possible, but not likely; it’s much more probable that an analyst will conclude that the company is hiding something they would rather not talk about.  Investors will assume that if the news was good, the company would naturally talk about it.  Even if the project is going great guns, the company, by remaining silent, puts a negative inference on it. 

 

Companies constantly accuse analysts and investors of having a short-term focus.  Yet companies themselves are extremely guilty of engaging in selective, short-term dissemination of information.  The process goes like this: “If it’s good news, we’re happy to talk about it until the cows come home.  If it’s bad news, you won’t hear a peep out of us unless someone is holding a gun to our heads and forcing us to disclose.”  In other words, good news is long term; bad news is short term.  I’ve written about this before in the context of Starbuck’s same –store sales; they didn’t stop disclosing them until they started to look weak. 

 

The investor relations profession needs to start thinking in terms of standards:  if something is important enough to talk about when the news is good, it is also important enough to talk about when the news is less than good.  If you have important projects or metrics by which you measure your business, then the only way to build credibility is to report on them when the news is both good and bad.  Silence is not golden.  It may be permissible within the cockamamie regulatory system we have, but it will not make the market more efficient, nor will it add to the long-term valuation of your firm.  

The Jumbled Mess Surrounding If and When to Disclose

Last week I wrote about the definition of materiality in the context of investor relations, and the case decisions wrestling with the concept.  When I boiled it all down, what I came up with is that an investor relations officer will determine something is material when, based on his experience dealing with investors who are interested in his company, he knows that the investors will think the information is important.  It’s not perfect, but it has the elegance of simplicity.  So now it’s time to take the next step on this slippery slope and ask ourselves; “OK, we know this information is material, now when do I have to disclose it?”  

On the face of it, this should be a simple problem.  Logic would dictate that if information is important, it should be disclosed as soon as possible, so that investors are not disadvantaged by the silence of the corporation.  If we had principle-based disclosure with continuous disclosure obligations on the part of the corporate issuers, this would be the case.  There would of course, be exceptions for sensitive issues such as merger negotiations, products under development, quarterly earnings and the like, but the general rule would be clear: Disclose as soon as possible.

Alas, we do not live in a world where the legalities surrounding investor relations are governed by logic.  We live in a world where investor relations is governed first, by statute, next by governmental regulation and third, by the case law arising out of the litigation caused by the first two.  The result is a jumbled mess when it comes to when the obligation to disclose begins and what happens thereafter.

In general, here’s how I understand all of this fits together.  (Note:  Although I am a lawyer, I am not your lawyer, and in writing this I am not expressing a legal opinion.  If this stuff is really important to you, get your own damn lawyer.)  The Securities Exchange Act of 1934 empowers the Securities and Exchange Commission (the “SEC”) to require companies to file periodic reports on their business, generally 10-Ks (annual) and 10-Qs (quarterly). These reports are designed to get companies to disclose all material information surrounding their companies.  Originally, if a material development occurred in between the filing of the periodic reports, a company had no obligation to disclose that development, but if they did choose to disclose it, they could do so on Form 8-K.  More recently, in 2004, the SEC came out with a release (SEC Releases Nos. 33-8400, 33-49424 (March 16, 2004)) that lists certain material events they deem so important they trigger the obligation to disclose on a form 8-K within four business days. These events include such things as entry into a material non-ordinary course agreement, departure of directors and officers, material impairments and many others. The list is lengthy, but not exhaustive.  So, if your company has a material development in between your periodic reporting cycle, and it’s not on the list, you may choose to remain silent on it, provided the company is not actively buying or selling the company’s securities. 

Not only may you choose to remain silent to the detriment of your investors, the regulatory and case law decisions push you in that direction, because once you say something, the anti-fraud provisions of Rule 10b-5 attach and you’ve got to be absolutely correct or you’ll get sued.  This might be difficult to do initially in situations where things are unfolding and you are uncertain of the magnitude.  Next, if you do say something, you will trigger a duty to correct in the event facts change, as they almost certainly will, and may also create a duty to update the information in the future.  Lawyers, who’s job it is to mitigate their client’s risks, will therefore almost always advise their clients to say nothing, and if you do have to say something, say as little as possible.  If fully informed investors lead to the most efficient markets, can this be good for the markets?

Let’s just take a hypothetical case.  Say you had a charismatic chairman who not only was the public face of the corporation, but was also viewed as having saved the company from ruin.  Let’s call him Steve Jobs.  The chairman, who has previously had a bout with cancer, makes a public appearance and looks like death warmed over, triggering speculation about his health.  Clearly, it’s something investors think is important, based on their reactions and questions.  The health of the chairman is not something the SEC has thought to put on its list of things that have to be disclosed within 4 business days.  The company could stay silent on it, triggering massive speculation.  Instead, a company spokesman states that the chairman had picked up a “common bug”.  Presumably the statement is correct, since if they knowingly made a misleading statement they would have violated the antifraud provisions of Rule 10b-5 and at some point they wil get the bejesus sued out of them.  Now however, they are saddled with a duty to correct, should things turn out differently and potentially, a duty to update.  And how long do these duties last?  This reminds me of the tar baby situation from Uncle Remus.  No wonder companies don’t want to say anything if they don’t have to.  (For a more complete, lawyer-like analysis of this situation, see Brock Romanek’s July 25^th post on the Corporate Counsel blog, link listed on the side.)

Which leads me back to what common sense tells me the underlying principle should be:  If it’s important, a company should disclose it as soon as possible, and continue to disclose as events unfold, except in very specific and narrow situations.  At the end of the day, the principle should be biased to favor the flow of information to investors, not to create additional liability and obligations if you do disclose.