Insider Trading – The More Things Change…

There’s an old French proverb, “plus ça change, plus c’est la même chose”, which translates into “the more things change, the more they stay the same” and that’s the way I feel about insider trading. Every few years, the topic seems to rear its ugly head long enough for prosecutors to make some headlines before moving on to other offenses.

In the past few weeks insider trading has come back into the news. Federal prosecutors recently unveiled a sweeping investigation centered upon the use of so called “expert networks” and involving subpoenas to SAC Capital, Janus Mutual funds, Fidelity Investments and Wellington Management. The current round follows about a year after the indictments announced in connection with the investigation of Galleon Hedge Fund and there appear to be a number of links between the two cases.

Insider trading issues are always going to be part of Wall Street as there is an inherent conflict of interests between our regulatory scheme and what motivates professional investors. The regulations seek to ensure fair and honest markets where all investors play on an even field. On the other hand, investors seek to gain an “investment edge” either through superior analysis or by figuring out insights to what may be happening at the company in question by piecing together disparate snippets of information. Given that there are significant amounts of money involved, Wall Street analysts are always going to push as hard as they can to gain an investment edge, up to, and sometimes over, the ethical line.

It doesn’t help matters that the current regulations and case law regarding insider information are not crystal clear. To greatly oversimplify things: If you are in possession of material, nonpublic 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 the securities of that company. However, the mosaic theory, first enunciated by the federal courts in Elkind v. Liggitt & Myers, Inc., holds that analysts can assemble seemingly disparate non-material information into a material piece of information; that is, information that leads to a decision to buy or sell the stock. Of course, if some of the mosaic of information was obtained as a result of violations of duty to the company discussed above, things become somewhat less clear.

And there we have what I believe to be the crux of the current crop of insider trading cases. If you listen to the defendant’s attorneys you hear a constant drumbeat of mosaic this and mosaic that, portraying their clients as simple analysts who gain insight into companies by dint of digging harder than anyone else. If you listen to the prosecutors, what you hear is a tale of misappropriation of information that was known to be from sources that had a duty not to disclose the information, even if the piece of information was not material in and of itself. To my knowledge, there is no clear case law that governs in such a situation. Judges and juries are going to have to figure this one out, followed by inevitable appeals.

If we’re lucky, there eventually may be some clarifying language that will help people understand what they can and cannot do - what lawyers like to refer to as a “bright line” test. If we’re really lucky, the courts will give it a handy catch phrase such as “fruit of the poisonous tree” or “clean hands doctrine” that will help investors know what they can and cannot do.

Goodness knows, the securities laws could use some simple, clear rules that everyone can understand.

Reg. FD - There’s a New Sheriff in Town

Regulation Fair Disclosure has had an up and down history in terms of enforcement. It would appear that we are currently in an up cycle and investor relations officers need to have an enhanced sense of awareness about Reg. FD so that they don’t find themselves in the SEC Enforcement Division’s crosshairs.

A bit of history is in order at this point. Reg. FD was enacted by the SEC in August, 2000 in order to prohibit companies from selectively disclosing material nonpublic information to market professionals under circumstances in which it would be reasonably foreseeable that the market professionals would trade on such information. In enacting the regulation, the SEC was attempting to level the investment playing field by assuring that all investors receive material nonpublic information at the same time. Of course, given that investors are constantly looking for an investment edge, usually in the form of information, there were bound to be some built in conflicts in the actual operation of the rule.

In the first years following the adoption of Reg. FD, the SEC brought a number of successful enforcement actions, as if to drive home their point. In these cases, companies had their knuckles rapped because they: told analysts (i) that earnings estimates were “too high” or “aggressive” (In re Raytheon Co., SEC Release No. 34-46897 (Nov. 25, 2002)), (ii) they were entering into a new material supply agreement (In re Secure Computing Corp., SEC Release No. 34-46895 (Nov. 25, 2002)), (iii) through a “combination of words, tone, emphasis and demeanor” indicated that next year’s earnings would decline significantly” (In re Schering-Plough Corporation, SEC Release No. 34-48461 (Sept. 9, 2003)).

During this period the SEC also brought not one, but two enforcement actions against Siebel Systems. After acquiescing in the first enforcement action, Siebel got their back up in the second enforcement action and litigated the issue in Federal District Court, where the SEC met their Waterloo. Basically, the District Court ruled that the SEC was being too aggressive on how they enforced selective disclosure and that companies could make statements in private conversations with analysts that vary from their public statements, so long as the statements were “equivalent in substance” (SEC v. Siebel Systems, Inc., 384 F.Supp.2d 694 (2005)). And there the matter stayed, with the SEC bringing no further enforcement actions.

Until recently, that is. Since September 2009, the SEC has brought three enforcement actions for Reg. FD. In addition to the high profile case against Office Depot which I wrote about several weeks ago (Nudge, nudge, wink, wink – Office Depot and Reg. FD, October 25, 2010), American Commercial Lines and Presstek have been taken to the regulatory woodshed. In September 2009 the SEC settled a civil action against Christopher Black, former CFO of American Commercial Lines for emailing 8 sell side analysts from his home on a Saturday, adding "additional color" to a previous company press release that had stated "2007 second quarter results to look similar to the first quarter". Black's email said that "EPS for the second quarter will likely be in the neighborhood of about a dime below that of the first quarter", which effectively cut in half the previously given guidance. That email cost Mr. Black $25,000, payable to the SEC.

In March of 2010, the SEC settled a Reg. FD enforcement action against Presstek, Inc. for selectively disclosing its poor earnings outlook to a single investment advisor in a phone conversation, who then sold his holdings of approximately 500,000 shares. Although Presstek issued a public announcement about 12 hours later, they still wound up paying a $400,000 fine.

I have no special insights into the inner workings of the SEC, but it appears to me that for whatever reason – new political administration, new head of the enforcement division of the SEC, desire to nail some scalps on the wall following a number of highly publicized enforcement failures – the SEC has decided that Reg. FD will receive renewed enforcement attention. In reality, the underlying reason doesn’t matter. Investor relations officers need to sit up and take notice that the SEC is once again taking a close look at fair disclosure situations. After all, receiving a Wells Notice letter can really ruin your day.

What Warren Buffett Can Teach Us About Investor Relations

In October, Jeff Matthews, the author of “Pilgrimage to Warren Buffett’s Omaha” came to our local Houston National Investor Relations Institute chapter meeting to talk about his book and to make observations about Warren Buffett and Berkshire Hathaway. It was an interesting talk and the Houston chapter gave everyone who attended copies of the book.

Normally I don’t read a lot of business books, as by the end of the work day I’m on information overload and prefer to pick up something kinder and gentler, such as a murder mystery. But in this case I already had the book and it looked as if it might be interesting, so I started to read it. I was pleasantly surprised. It’s an easy read and has more nuggets than the usual business book written by consultants or business school professors. (As someone who fills both roles, I am qualified to make that statement.) If you get a chance it’s worth the read.

The book itself is written around two visits Jeff Matthews made to the Berkshire Hathaway annual meetings in 2007 and 2008 and the bulk of the book is devoted to what was revealed through questions and answers at those sessions. But Matthews, a professional investor, is not content with merely acting as a reporter and uses the visits as springboards to examine a little bit about Buffett himself and a bit more about the businesses that make up Berkshire Hathaway.

There are a number of trenchant observations in the book, including the fact that most of Berkshire’s operating companies seem to prefer high profitability with okay growth to high growth with okay profitability, so that they can send all of their excess cash back to Omaha for further investment by Buffett. However, this is a blog about investor relations, so I want to focus on what I consider to be the most important IR takeaways from the book.

First, the bad news: Berkshire Hathaway does not have an investor relations department, nor do they have a fancy IR web site. Instead what they have is Warren Buffett and his annual letters to shareholders and appearances at the annual meeting. But this is more than enough. What Buffett tries to do is to get investors to understand the philosophy and culture of Berkshire Hathaway. He figures that if they understand what he is trying to do, he will get “high quality” investors that will stick with Berkshire Hathaway over the long term. Jeff Matthews illustrates this early in the book with a quote from the 1983 Chairman’s letter:

“We feel that high quality ownership can be attracted and maintained if we consistently communicate our business and ownership philosophy – along with no other conflicting messages – and then let self selection follow its course.”

In investor relations we all want to have “high quality” investors, but most of us spend our time discussing the latest 5 basis points of change in last quarter’s gross profit margins. As a result we tend to self-select towards those types of investors that are interested in the latest minute quarterly change as opposed to where the company is going to be five years down the road. So the first takeaway is that we get the shareholders we cater to. Focus on the long term and how you propose to increase value over time and you will be rewarded (assuming you execute well against your plans) with shareholders that are more patient and willing to overlook short-term bumps in the road. Focus on the current quarter and the short term and you will get investors that think that’s what’s important.

The second item for investor relations practitioners from the book is the immense amount of importance Buffett places on culture and reputation. I’ve written about this before in the context of investor relations (see “A “Cultured” Approach to Investor Relations” February 24, 2009) but it’s always nice to see that the world’s greatest investor agrees with you. In short, corporate culture and reputation matter, and it is important that investors understand these intangibles if they are going to understand how to value your company. And finally, and most importantly, it’s crucial that the actions of management conform to the culture that supports the reputation of your firm. To take another quote from Buffett in the book:

“We can afford to lose money – even a lot of money. We cannot afford to lose reputation – even a shred of reputation. Let’s be sure that everything we do in business can be reported on the front page of a national newspaper in an article written by an unfriendly but intelligent reporter.”

A short way to sum up these two key IR points is that you get the investors you deserve as a result of what you do and say. This is very typical of the way Buffett boils things down into powerful insights into the obvious that we often overlook.