Wednesday, March 25, 2009

A Gordian Knot – Investor Relations, Laws, Regulations and Case Laws

The academic part of my year is currently in full swing and that, combined with my other commitments, has caused me to fall behind on my musings. My apologies to those of you who have been eagerly awaiting yet another installment, but as a rational economic person, I’m going to do those things first which pay me, and frankly, this blog is never going to replenish my ravaged 401(K) account.  That being said, it was while I was preparing for one of this week’s classes that the idea for this post occurred to me.

One of my class topics this week focuses on the legal and regulatory framework surrounding investor relations.  It’s not a subject that business school students are naturally attracted to, but it is something that everyone involved in investor relations needs to master.  Back in the 60’s, there was a band by the name of Zager and Evans whose one and only hit was “In the Year 2525” which had the line in it, “Everything you think, do and say, is in the pill you took today”.  Which is a pretty good way to think about the laws and regulations surrounding investor relations – everything you think, do and say is governed by them.

One of the points I try to make in my class is that the laws and regulations surrounding IR are not the result of a coherent codification of the laws, cut from whole cloth.  Rather they have grown and evolved over time, from statutes, regulatory rule making and case law decisions.  The resulting Gordian Knot of laws, rules and case law is enough to send joy to the hearts of lawyers everywhere and give everyone else headaches.  Further, each is enacted from a different set of circumstances.

Statutes, for example, are usually enacted to stop some form of abuse.  This was true of the original securities protection acts, the state “Blue Sky” laws, and it continued to be true with the enactment of the Securities Act of 1933 and the Securities Exchange Act of 1934, which were enacted following the stock market abuses of the 1920s.  More recently, the Securities Litigation Reform Act of 1995 was enacted to curb abusive securities law class action claims and the Sarbanes-Oxley Act was passed by Congress in reaction to the Enron, Adelphia, MCI and Tyco scandals. Those of you who are looking for a common theme among these acts would do well to take up a different hobby. I suggest something much easier – say, along the lines of solving The New York Times Saturday crossword puzzle.

On the regulatory side, I find that the regulations that get enacted by the SEC tend to have a political background to them.  Take, for example, the disclosures surrounding executive compensation in the proxy statement.  As executive compensation has swelled, political pressure has built up, which has resulted in the SEC layering in more and more disclosure regulations surrounding executive pay.  Way back in the dark ages (the 1970s) when I was actually writing proxy statements, it was not unusual for them to be no longer than 8 – 12 pages.  Today, between tables, graphs, Compensation Committee and other reports, Proxy Statements routinely run 4 – 5 times that length.  It has to be extremely frustrating for politicians and the regulators, because the more disclosure they require, the bigger the pay packages seem to get. I have no doubt that if they could have enacted compensation limits, they would have. But the SEC’s regulatory authority only extends to disclosure, so they keep making companies say more and more about how they come up with their pay  schemes in the hope that shareholders will get outraged and rein in the pay packages.  Similarly, other disclosure regulatory requirements have waxed and waned depending on the political climate of the time.  As a result, any hope of consistency regarding how the regulations require you to act is a forlorn one. 

Finally, much of materiality and the definition of fraudulent behavior in the securities laws is the result of case law decisions.  These are instances where, except in the most egregious or fraudulent cases, reasonable people can differ. Yet this is how we come up with our definitions for materiality, how we interact with analysts, when we choose to disclose and a multitude of other things. 

I, for one, would like to see a comprehensive overhaul of the securities laws to bring some semblance of logic to them that would serve to eliminate much uncertainty (and billable law firm hours) from the process of being a public company. Like Alexander the overhaul would cut through the many strands of laws, regulations and case decisions that are tying us up in knots with a clear unified code of securities laws. Then again, given the current administration and the mood of Congress towards Wall Street, maybe its better to leave well enough alone…

Thursday, March 5, 2009

How to Use a Computer to Read Company Reports

It has come as somewhat of a shock to me, but I realized the other day that personal computers can actually perform some very useful roles when it comes to reviewing company SEC filings. This is welcome news to someone who labored through the early days of DOS based PCs where it felt like you spent more time trying to get the blasted things to work than you did in actually getting any productivity.  It’s nice to be getting some productivity payback, even if it is twenty years later.

I’ve found that when investors are following a company, what they care about are the changes that are happening on the margin, particularly as it compares with the same period in the prior year.  Companies, of course, are happy to tell them when good things are happening at the margin and will supply lots of reasons why smart management has made good things happen.  The bad things, however, either get buried in the fine print, or, more than likely, omitted.  It’s these omitted things that are toughest to spot.  After all, the previous period was a year ago and who can remember that far back?  I’m lucky if I can remember what I had for supper last night, so good luck spotting that omission. This is where reading the periodic filings of a company with the aid of a computer comes in really handy.

First, let me say that it really helps if you have a very large display monitor, or, better yet, dual screens.  I switched to dual monitors about two months ago and it feels as if I’m saving about 10% of my time because I no longer have to dig through and move around the multiple screens that I’m working on.  With a super-sized viewing area it is then easy to go the Securities and Exchange Commission’s website ( and search for the most recent filing by the company you’re interested in.  Once you’ve pulled that up, you then open a new window right next to it with the previous year’s filing for the same period in it.  So far, this is nothing you couldn’t do with paper on your desktop if you wanted to print out the documents and kill a lot of trees.  But now comes the cool part.  You can get the computer to search for the word or phrase you’re interested in.  Rather than parsing the document line by line to find out what’s missing, the computer can tell you exactly how many times a word or phrase was used in the company’s discussion.  Then you simply compare what you’ve found with the same search for the previous year’s filing.  If there is a big discrepancy, then a diligent investor will use it as a starting point to start asking questions. I’ve used this technique when writing some of my blog posts to look at the treatment of same store sales by Starbucks and the disclosure of the number of pharmacists working at CVS Drugstores (see Starbucks and Disclosure of Same Store Sales, December 5, 2008 and How to Read 10K and 10Q Reports, September 10, 2008).  My computer will tell me how many times the word or phrase is used in the document and take me right to the spot it’s used. 

 The system works because, by my estimates, 85% - 90% of the discussion material in the 10-K and 10-Q doesn’t change from period to period.  If you’ve ever sat in on a Disclosure Committee meeting, you know that the accountants and lawyers are trying to write the document by making as few changes as possible to the previous document.  Nobody has time to reinvent the wheel every quarter with a totally rewritten filing. So when they make a change, it’s usually because they have to make a revision due to changed circumstances.  Many times those changes, if they don’t favor the company, will get buried in the 10-Q or 10-K and it’s up to the intrepid investor to find them. 

And this is just the beginning of how computers can be used to analyze the textual discussion in company periodic reports.  Those of you who are intrigued by all of this should take a look at a site called Many Eyes ( to see how see how graphics can be used to analyze text and changes to text.

It’s a brave new world…