Nudge, Nudge, Wink, Wink: Office Depot and Reg. FD

Last week the Securities and Exchange Commission announced enforcement actions against Office Depot, its CEO and former CFO for violation of Regulation Fair Disclosure. After a four year quiet period following its Federal District Court loss in its second enforcement action against Siebel Systems, new leadership in a new administration seem to have resurrected Regulation Fair Disclosure from the regulatory dustbin, with three actions in the past year.

In the case of Office Depot it seems that management was concerned about analysts’ estimates for the second quarter of 2007 being too high. The CEO and the CFO directed people in the investor relations department to conduct calls with 18 analysts designed to remind the analysts of statements Office Depot made earlier in the quarter and that Office Depot’s competitors were having a tough time of it. The talking points used by the investor relations department were along the following lines:

"Haven't spoken in a while, just want to touch base.

At beg. of Qtr we've talked about a number of head winds that we were facing this quarter including a softening economy, especially at small end.

I think the earnings release we have seen from the likes of [Company A], [Company B], and [Company C] have been interesting.

On a sequential basis, [Company A] and [Company B] domestic comps were down substantially over prior quarters.

[Company C] mentioned economic conditions as a reason for their slowed growth.

Some have pointed to better conditions in the second half of the year – however who knows?

Remind you that economic model contemplates stable economic conditions – that is mid-teens growth"

In other words, Office Depot was attempting to imply that the economy was lousy, just as they had previously warned it might be and that their competitors had all been impacted by it. The logical inference then (nudge, nudge, wink, wink) is that Office Depot’s operations were also suffering. As might be expected, following the calls, analysts began to lower their estimates and the price of Office Depot shares began to fall. Six days after the calls began Office Depot filed a Form 8-K Report announcing that its sales and earnings would be negatively impacted by the softening economy.

This is the sort of thing that drives the Enforcement crowd at the SEC nuts and they went after Office Depot with a vengeance, eventually winning an agreement from the company to pay a $1,000,000 fine and $50,000 fines against both the CEO and former CFO.

The good news here is that the people actually making the calls, the investor relations staff, were not fined. Either the defense of “I was just following orders” works with the SEC or they figured that, given the salaries of most investor relations officers, there just wasn’t enough there to make fines worthwhile.

There are a number of lesson that can be drawn from all of this, the most obvious being that you shouldn’t try to do indirectly what the regulations do not allow you to do directly. This enforcement action will send shivers through any investor relations officer that has wrestled with an analyst over their estimates being out of line, as many of the same techniques are used to bring estimates into line.

But what I’m interested in is what did the management of Office Depot think they were going to accomplish? They clearly wanted to signal that business was not as robust as analysts were expecting, but to what purpose? So that the stock wouldn’t trade down when the earnings were announced? Surely they must have known that the stock would trade down when they began to contact analysts. So is it better to have the stock go down earlier? I don’t get it.

This is classic short term corporate thinking, worrying about the stock price over a period of a few weeks. Over the long haul, the stock price will reflect the intrinsic value of the stock, and management should be worried about how to drive that intrinsic value higher, not where the stock price is going over the next few weeks due to short term economic conditions.

Maybe They Thought It Wasn’t Important

There are several scenarios that are a company's publicity and investor relations nightmare. One of them is if a senior executive is arrested for drunk driving. That’s just the situation Walgreens found itself in recently when its CFO was arrested, not once, but for the second time in a little over a year for driving under the influence of alcohol. According to press reports, Wade Miquelon, Walgreens CFO, was first arrested in September of 2009 for having a blood alcohol level that was unacceptable under Illinois law. As a result of the first arrest, Miquelon paid a hefty fine and was placed under Court supervision. In September 2010 he was again stopped and charged with driving under the influence and driving on a suspended or revoked license. At the time of his second arrest he refused to submit to a breathalyzer test, resulting in an automatic suspension of his driving license for three years.

Walgreens response to all of this has been to have a company spokesman state, “We are aware of the situation. It's a personal matter, and we don't comment on personal matters related to our employees.”

This is a perfect example of adopting a regulatory approach to investor disclosure. If you just read the regulations, there is no requirement to make a disclosure under any of the filings. The instructions for filing a Form 8-K state that a company need only file a Form 8-K if someone like the CFO either resigns or is removed, not if he has done something criminal. Regulation S-K, which governs disclosures for periodic filings and proxy statements, states that with respect to certain legal proceedings, a company must disclose events during the past five years “that are material to an evaluation of the ability or integrity of any director, person nominated to become a director or executive officer of the registrant:…

(2) Such person was convicted in a criminal proceeding or is a named subject of a pending criminal proceeding (excluding traffic violations and other minor offenses);”

Driving under the influence of alcohol, even if it is a second arrest, would seem to fall under the exception for traffic violations, so that there is no specific requirement to file a disclosure of the event. So what one is left with is a standard materiality test, not unlike the situation when Steve Jobs of Apple was ill and the company was faced with a disclosure decision. (See my posts “The Weighty Issue at Apple", Jan. 6, 2009 and "Maybe Things Were Not So Simple and Straightforward", Jan. 15, 2009.) The legal analysis revolves around whether Mr. Miquelon, the Chief Financial Officer of the company who was specifically hired in to lead a restructuring effort called “Rewiring for Growth” was considered so key that effort that investors would deem it important to a decision to either buy or (more probably) sell the stock if he was shown to have a drinking problem. On this point, reasonable minds can differ, and when the subject of making a disclosure that might prove embarrassing to senior officers is concerned, it’s easy to see how a company might be able to get an opinion from counsel that you need not disclose.

The more interesting question is whether the company should have said something voluntarily. Clearly they have an officer, one of the most important in the company, who is either suffering from an illness or is exhibiting extremely poor judgment. According to reports in the press, if convicted for the second offence, Mr. Miquelon faces a high probability of doing some jail time, which will remove him from the company for a period of time. Additionally, I’m sure the questions crossed the minds of investors along the lines of “If Mr. Miquelon thinks so little of laws that affect him personally in the most direct way possible, what are we to think about the way he will choose to deal with the myriad laws and regulations that surround the accounting and investor disclosures he is in charge of for his company?” Yet Walgreens did not make any disclosure until the incident came to light. Wouldn’t it have been better to be proactive, acknowledge the problem and how they were addressing it?

You can’t tell me that the CEO and Board of Directors don’t think this series of incidents is not important. So it should be considered important to investors as well. Some well thought out disclosures should have been made for the benefit of the shareholders, the owners of the company.