Looking Forward by Looking Back

The upcoming holiday season of Thanksgiving, Christmas and New Year’s is always cause to sit back and reflect on what has transpired over the course of the past year and what it portends for next year. I freely admit that my crystal ball is as fuzzy as the next person’s but we’ve had such an interesting year I can’t resist the temptation to extrapolate past events into future predictions in two areas, regulation/legislation and, the use of social media in investor relations.

Investor relations in the U.S. during 2009 was heavily impacted by the advent of a new administration in Washington, an administration that comes from a different political viewpoint than the previous administration, one that favors more regulation rather than less. The new Chairman at the Securities and Exchange Commission, under pressure to prove that the SEC was still relevant, made it very clear during the year that increased regulation of the securities markets and more vigorous enforcement of existing regulations were top priorities at the Commission. Thus during the year we had a flurry of regulatory actions that touch upon investor relations issues, including Reg. SHO, designed to cut down on “naked” short selling, approval of NYSE rules eliminating broker discretionary votes in director elections, proposals regarding the use of “dark pools” and updating the rules surrounding notice and access for proxy materials.

On the enforcement side, we had the first ever enforcement action under Reg. G, relating to abuse of Non-GAAP numbers, the first Reg. FD enforcement action since the SEC lost the Siebel II case in Federal court, and a series of high profile insider trading indictments.

And guess what? For next year I predict … more of the same. In large part, the continued regulatory onslaught will be driven by Congress. For months now, financial markets reform has been on the agenda of our august legislative body, but the bills being considered by the House and Senate are quite a bit different as they relate to how corporations deal with investors. The Senate version includes requirements for annual, non-binding say-on-pay voting, mandated proxy access, and elimination of staggered boards, among other things. My prediction is that most of these requirements will be negotiated out of the Senate version as the business community begins to focus on these items, but that won’t be the end of the process. The SEC, being a political animal, will pick up the ball and then attempt to do by regulation what Congress failed to do by legislation. Look for some of the aforesaid issues to pop up on the SEC agenda next year. It will continue the trend towards the federalization of state corporate law that has been ongoing over the past fifty years. On the enforcement side, the Commission will continue to try and bring actions so that they appear to be doing their job. After dropping the ball on Bernie Madoff, they’re desperate to prove there is a new sheriff in town.

On the more practical side of actually communicating with investors, the hot topic during the year gone by was the use of social media. Particularly during the last half of the year there have been a spate of commentators, myself included, discussing the issue. Generally, the arguments break down upon the following lines: For social media – “This is the dawn of a new era where everyone can communicate with everyone else without anyone getting in the way, and isn’t that great? And anyone who doesn’t get it is a troglodyte.” Those against social media – “You’re right – I don’t get it. This stuff tends to be a bunch of unfiltered junk and a huge waste of time.”

The truth, of course, is somewhere in the middle and I think that over the course of the next year we will continue to see modest use of social media by investor relations departments. Dell has shown that blogs can be done in a thoughtful manner and Southwest Airlines has successfully used Twitter to get the word out quickly during a crisis communications situation. But most corporations are conservative in nature, and have general counsels that lie awake at night worrying about securities litigation, so things will happen very slowly. In fact, by the time corporate legal departments get comfortable with, and figure out how to let investor relations people use Twitter safely, it will be old technology and social media will have moved on to something else.

Insider Trading Hurts Us All

There seems to be an epidemic of insider trading cases these days. First we started with the Galleon indictment alleging that Galleon profited from receipt of material nonpublic information from a variety of sources, including an investor relations firm working for Google, corporate executives at IBM and Intel, and a partner at the McKinsey consulting firm. This has been followed by criminal charges being brought against an additional fourteen people including hedge fund managers, a trader, a broker and a M&A lawyer, with five of them already agreeing to guilty pleas.

All of this raises some interesting questions ranging from, “Where have prosecutors been for the past several years?” to “What have compliance officers been doing at these firms?” but what I want to focus on is the bigger picture, insider trading itself. As you would expect, a number of commentators have expressed opinions about insider trading, and some people have gone so far as to suggest that the penalties for insider trading should be abolished because it’s common and impossible to police. Even beyond that, a number of noted academics have argued that insider trading is good for the markets because it makes the market more efficient.

Let’s start with the basics; the case law and the statutes surrounding he use of material non-public information are, with a few exceptions, pretty clear. To greatly oversimplify: If you are in possession of such information and you received it as a result of a duty to the corporation, or from someone who has such a duty, or if you have misappropriated the information in violation of a fiduciary duty, you can’t buy or sell that security.

The insider trading laws in the U.S. really get to the issue of fairness in our securities markets and go all the way back to the Pecora Commission hearings following the stock market crash of 1929. The result of those hearings was that the public was outraged that bankers and stock market insiders could manipulate company information for personal gain. The Securities Act of 1933 and the Securities Exchange Act of 1934 were a direct result of those hearings and the U.S. emerged with the most transparent market system in the world. The prohibition on dealing in insider information has served our markets well over the years.

In sum and substance, you cannot allow people to benefit from information simply because of their position, nor can you allow them to leak that information to a select few. To do so would mean that the markets were a rigged game, and people’s faith in the markets would take a severe blow.

Because of the large sums of money at stake over inside information that traders can benefit from, there will always be a few people willing to test the system, from Dennis Levine and Ivan Boesky in the 1980’s to the Roomy Khans of today. But let’s be clear – these are not close calls. Everything I have read about the current series of cases involves people who knew they were going beyond normal everyday information gathering and into the realm of the illegal. The use of disposable cell phones to avoid detection and payment to sources of information are not things one normally sees in the normal information gathering process of analysts.

This is not a victimless crime – activities that bring disrepute on the fairness of the markets impact all of us because people will be less willing to commit capital to unfair markets. I have absolutely no sympathy for this type of crime and hope that prosecutors continue to bring cases where appropriate. Fortunately, I think we will continue to see these cases, as good prosecutors can make their bones on them – after all, look at what it did for Rudy Giuliani.

Reg. FD and the Law of Unintended Consequences

It used to be in the good old days (some would say bad old days) stock analysts saw a goodly percentage of their job as talking to and cultivating relationships with management. The classic example of this is the analyst I refer to as the “Information Vampire” who would talk to management until they felt they had sucked every last drop of information from them. The thought process was that by building a relationship, the analyst would pick up enough tidbits of information to give them an advantage over the average investor, and because management liked them, they might let the analyst know something important before everyone else, either in a one on one meeting or by being the first phone call they made when news is breaking. On such things careers were built on Wall Street.

Then along came Regulation Fair Disclosure, in which the SEC mandated that if a company is going to say something important, it has to tell everyone at the same time. It doesn’t matter if you are best buddies with the analyst who has followed you through thick or thin or if a portfolio manager had been a loyal shareholder for many years. The reasoning was that the securities markets need to appear to be a level playing field for all concerned, regardless of whether you are a professional money manager with $50 trillion in assets or you are a retail investor looking to buy 100 shares of stock. (This is very much the same type of governmental thinking that gave us the Robinson-Patman Act prohibiting price discrimination between customers, but that’s a subject for another day.) The SEC then proceeded to announce a series of enforcement actions to drive home the point that you can’t just go off and blab to institutional investors. They never actually won a court case on the subject, but they made their point and companies toed the Reg. FD line.

This, of course, did not stop Wall Street’s desire for an information edge. We are, after all, talking about an industry with serious amounts of money at stake. It just meant that the quest for information went elsewhere. Hence today, courtesy of Reg. FD, we have at least two new types of information hunters on the scene.

The first of these is the “Channel Checker”. This is a person who specializes in cultivating a network of industry sources, be they lower level employees of the company, suppliers, customers and competitors. They usually don’t talk to the company very much, if at all. This type of analyst has always been around, but since the advent of Reg. FD have increased in number as they try to supply investors with they type of information edge they can no longer get from the company.

The second type of information provider that has gained more prominence since Reg. FD has been the expert network systems. These are organizations that have created data bases of people with expert knowledge on particular subjects. Then, when an investor needs to get up to speed quickly on a subject, whether it’s current inflationary trends in the footware industry in China or the likelihood of a drug getting through the FDA approval process, there is someone out there, that for a fee, will expound on the subject. (Disclosure: On occasions, I have been retained by expert networks to discuss things about which I have knowledge.)

Companies, of course, don’t like either one of these developments, as they can’t control the information being disclosed or put any spin on the story. In and of themselves, the channel checkers and expert networks are not a bad thing, they are just different sources of information. It’s just that the SEC shouldn’t kid themselves into thinking that Reg. FD has made the information the same for everybody. It just means that professional investors have to redirect their efforts as to how they get it and how they pay for it.