A Libretto for the Upcoming Legislative Changes

There is an old saying that goes “No man’s life, liberty or property are safe while the legislature is in session”. Recently we’ve been treated to a great example of this as the Obama administration introduced its proposals to overhaul the regulation of the financial industry and is revisiting a version of national mandates on health care. This being a blog on investor relations, I will focus on the process of changing the regulations in the financial industry, as eventually those of us involved in the equity markets will be impacted by such changes. Most aspects of the regulatory apparatus that oversees the financial industry, from the Securities and Exchange Commission, the Commodities Futures Trading Commission, the Federal Reserve, the Federal Deposit Insurance Corporation the Comptroller of the Currency and various and sundry other regulators have come under scrutiny. Nobody really knows how all of this will play out yet, but it makes great theatre, so I thought I would give everyone a guide to the proceedings.

Act One, Scene One: Capitalists will seek an investment edge that will allow them to reap profits. Once they find one that is legal, the early movers will become very rich. They will be followed by many more capitalists who, seeing the profits to be made, will expand the pool of money available for the investment in question. As more money chases a finite number of investments, standards will be lowered. See for example, the funding of start-ups in the dot .com boom, the prices paid for private equity deals in early 2008 and the sub-prime housing lending bubble. Eventually, when prices get crazy enough, the whole bubble collapses under its own weight. Investors lose tons of money. Everybody blames someone else for the collapse. There are outraged calls for Congress to act.

Act One, Scene Two: Enter the politicians and the bureaucrats. Sensing an opportunity to score easy points with the public, politicians begin to make proposals to protect investors, consumers or anyone else that can vote. After all, people vote, corporations don’t. The legislation that is proposed is designed to fix the immediate problem on hand and to demonstrate that Congress can act. Press conferences are held, laying out bold new initiatives to protect investors and consumers. Hearings are held, wherein the scapegoat du juor gets publicly flayed. While the politicians are preparing to act, the bureaucrats swing into action. This is where bureaucratic empires can be won or lost. Witness the recent struggles between the SEC and the CFTC. While it might make sense for one agency to regulate both securities and the derivatives that trade off them, neither the SEC nor the CFTC was going to submit to the other. Influence is wielded to protect regulatory turf and deals are cut.

Act One, Scene Three: Congress drafts legislation. In fact, they draft multiple versions of legislation. Nothing makes a Congressman or Senator feel better than to cosponsor legislation that will help them demonstrate to the folks back home that they are helping stamp out the evils of the flawed financial system that allows poor hapless consumers and investors to be sucked dry by rich bankers and hedge fund managers. Nobody pays any attention to the additional regulatory costs being layered onto the system. After all, corporations will pay that, and corporations don’t vote.

Act Two, Scene One: As the legislative process heats up, the fabled lobbying system swings into action. Lobbyists work on three basic premises: 1.) Time is their friend. The longer legislation can be delayed, the better the chance provisions can be inserted into it that benefit their organization. 2.) Every corporation resides in a home district or state of some Congressman or Senator and those corporations control jobs and investment spending in somebody’s home town, and those people do vote. 3.) While corporations don’t vote, their trade organizations control lots of money. And money is the mother’s milk of politics.

Act Two, Scene Two: Legislation finally gets passed. The President holds a bill signing ceremony and smiling legislators gather around him. The system works, sort of. The bill that gets enacted is usually far too long, with conflicting provisions and a very unclear legislative history. It will inevitably prove to have unintended consequences that will later require further legislative or regulatory fixes. Lawyers representing constituencies whose oxen are getting gored by the legislation are preparing to file lawsuits challenging the law even as the President is signing the bill.

Act Two, Scene Three: Capitalists begin combing through the legislation seeking an investment edge that will allow them to reap profits…

Email is Not Your Friend

Email is such an ubiquitous part of our lives today that we rarely think about the long-term implication of what sending an email involves. Recently we have been treated to the spectacle of the Securities and Exchange Commission bringing fraud charges against Angelo Mozillo, the former CEO of Countrywide, over statements he made in emails to his associates. The allegations are that in private emails he described one Countrywide product as “toxic” and another product’s performance so uncertain that they were “flying blind” while at the same time maintaining to the outside world that Countrywide was underwriting mainly prime mortgages using high underwriting standards. Of course, what we don’t know, and what will have to be decided in the courts, is whether such “toxic” products were significant enough to constitute a material impact on Countywide’s operations, thereby constituting securities fraud.

A lot of interesting things are at play here, not least of which is the SEC’s desire to appear tough following an era of lax enforcement. This is not very different from the description in Tom Wolfe’s “The Bonfire of the Vanities” of the desire of the district attorney to find a “great white defendant”. While I could devote my entire blog post to this topic, I’m going to focus on a much more mundane issue – the corporate use of emails.

It has been amazing to watch the explosive growth of emails, chat and twitter over the past few years. Back in the dark ages when I first started working, if you wanted to communicate with someone, you picked up the telephone and called them. Nowadays, many people make an appointment by email to make a phone call. When I was still in the corporate world, I would have people in the office next to mine email me rather than talk to me. Emails are such a part of business life that people don’t stop to think of the potential impact they may have using the 20/20 hindsight of litigation.

Once an email leaves your computer it takes on a life of its own. Not only does a copy go to the recipient, but a copy also goes to the corporate server, where your diligent IT department makes sure it gets stored forever. If you are sending the email to a corporate recipient, another copy gets stored on their corporate server. Not only that, but the electronic record is easily searchable for subject matter and key phrases. If that weren’t bad enough, your email is easily forwarded with the push of a button, so you’re never quite sure where it will wind up. Think about answering an analyst’s question and having your email forwarded to half a dozen hedge fund managers.

What all of this means for investor relations practitioners is, as the title of this post says, “Email is not your friend”. Investor relations people should never express opinions in emails that might come back to haunt the corporation at a later time. As a practical matter this means that things such as discussions about materiality of issues, concerns about business practices or other potentially controversial items should not be discussed in emails. The only exception is when the attorney-client privilege applies.

We work in a discipline that is fraught with legal liabilities. While it may seem as if it is taking a step backwards, when communicating with investors, or discussing potential disclosure issues, email should be used sparingly, if at all. You should write every email as if your email is being intercepted - because it is.

Stop the Earnings Guidance Madness

The subject of issuing earnings guidance is one for constant hand wringing by companies, analysts, commentators and even the National Investor Relations Institute.  Companies hate it, because their stock gets hammered if they miss their guidance by so much as a penny.  Analysts hate it because if they follow a company’s guidance and it turns out to be wrong, they feel duped.  On the other hand, if the analyst goes their own way and publishes an EPS forecast outside the company’s range, there is a good chance the company will either treat him as if he’s crazy, or nag him until he comes in line with the consensus. Reams of studies have been conducted about all of this, generally stating that the process puts too much focus on short-term quarterly results.

With all of this floating around, I thought that I would take a shot at bringing some light to the topic.  First, consider that analysts are not going to stop making estimates for quarterly earnings by companies just because companies stop giving earnings guidance.  Public companies in the United States report on a quarterly basis and, therefore, analysts will make earnings estimates on a quarterly basis, whether companies issue guidance or not. 

Further, whether or not a company issues earnings guidance has little to no effect on the pressure it feels to report good quarterly earnings.  To paraphrase one of my least favorite presidents, “It’s the earnings, stupid”. Companies that do not issue guidance feel pressure to hit the consensus earnings number that is every bit as intense as the pressure felt by companies to hit their guidance number. 

When the economy gets dicey, as it is now, issuing EPS forecasts becomes particularly hazardous.  When companies issue guidance, they almost never want to appear too downbeat, as it will act as an overhang on the company’s stock price for the foreseeable future.  So you usually get “cautiously optimistic” forecasts, which the company winds up revising downward as the year progresses.  Neither situation is good for the company.

So here’s my proposal – I call it “Less and More”.  Companies should give less in the way of specific EPS guidance; in fact, they should eliminate quarterly EPS guidance altogether.  In its place, I would suggest companies issue long term goals: revenue growth, key return criteria such as Return on Equity, Assets or Capital, the planned improvement in earnings growth and the manner in which they see achieving their goals, be it margin improvements, cost containment or simple growth.  These goals would be issued as target averages, with the explanation that any given year could vary from the goal, but over time, the expectation would be to achieve the target. 

On the other hand, companies should issue more short-term information in order to allow the market to work more efficiently.  This would involve companies releasing key performance metrics on a regular monthly basis.  This information would be along the lines of sales, order backlogs, customer mix, product mix and other key information that would allow investors to better assess the current state of business.  This would modestly increase a company’s reporting burden, but it’s not as if companies don’t already have this information – they run the businesses based upon it.  If they don’t have the information on at least a quarterly basis, they should.  Key metrics consistently reported monthly would increase transparency and help eliminate surprises.  By supplying what they consider to be important information on a monthly basis companies can eliminate the “black box” syndrome where investors have no idea what is happening at the company in between quarters.

It’s not a perfect solution for all concerned – some analysts will not be happy unless they have a direct feed from the reporting company’s mainframe computer, while many managements will groan at the thought of telling the street more.  What it will help to achieve is a better balance between allowing a company to focus on its longer-term goals, while supplying the market with timely short-term information that progress is being made towards those goals.