Wednesday, May 25, 2011

The Infield Fly Rule and Disclosure

With the advent of Memorial Day and warm weather (down here in Houston we define warm weather by temperatures being above 90 degrees, where they will stay until late September), my thoughts have turned to baseball and what we in the investor relations profession can learn from it. After all, baseball is a deceptively simple game consisting of throwing a ball, hitting it with a stick and then catching the ball. This compares to investor relations, which on the surface is also deceptively simple, as it’s really just about talking to people about your company and how it’s doing.

In both instances however, what starts out to be simple, rapidly get complex as the result of rules. For example, in baseball, consider the infield fly rule. The infield fly rule is designed to eliminate a situation where a base runner might be damned if he does and damned if he doesn’t. That is, the purpose of the infield fly rule is to prevent the defensive team from turning a double play by intentionally dropping or not catching a fly ball hit to the infield. The rules of baseball define an infield fly as the following:

An INFIELD FLY is a fair fly ball (not including a line drive nor an attempted bunt) which can be caught by an infielder with ordinary effort, when first and second, or first, second and third bases are occupied, before two are out. The pitcher, catcher and any outfielder who stations himself in the infield on the play shall be considered infielders for the purpose of this rule. 
When it seems apparent that a batted ball will be an Infield Fly, the umpire shall immediately declare ”Infield Fly for the benefit of the runners. If the ball is near the baselines, the umpire shall declare Infield Fly, if Fair.” The ball is alive and runners may advance at the risk of the ball being caught, or retouch and advance after the ball is touched, the same as on any fly ball.

There are several interesting aspects to the rule, such as it requires the judgment of the umpire that the ball can be caught with ordinary effort, an outfielder can be an infielder for purposes of the rule, and it has exceptions for line drives and attempted bunts. And, in true regulatory fashion, this is just the definition. You have to go to another rule to discover the effect of the rule, which is that the batter is out. This is a rule that only a lawyer can love.

Next consider the rules and regulations surrounding disclosure of material non-public information. The rule here appears to be a little less complex than the infield fly rule (although technically speaking, it’s not a rule at all as it came out of court decisions), and goes as follows:

“Information is material if there is a substantial likelihood that a reasonable shareholder would consider it important in making an investment decision.” And “There must be a substantial likelihood that the disclosure of an omitted fact would have been viewed by the reasonable investor as having significantly altered the “total” mix of information made available.” (TSC Industries, Inc. v. Northway and Basic v. Levinson.)

There are several striking similarities between the disclosure of material information and the infield fly rule. First, the judgment of the umpire, or in this case the arbiter of fact such as a judge, jury or your securities law lawyer, is called for to figure out what is important and what a reasonable shareholder would think. Next, if you think about the cases handed down about people who have been caught using insider tips, you know that outsiders can be considered insiders. Also, just as with the infield fly rule, there are clear exceptions to the application of the rule. Just as base runners cannot be forced to leave their base in the case of an infield fly, companies can’t be forced to disclose if the disclosure would interfere with sensitive negotiations (for example, in the event of merger negotiations) or if the issue isn’t ripe (due to facts still being discovered). Finally, just as with the infield fly rule, you have to go to a different rule, in this case Rule 10 b-5, to learn that failure to disclose a material fact is unlawful. Coincidence? You decide. It’s enough to make me think that Casey Stengel would have made a great securities law lawyer.

So the next time you’re confronted with a disclosure issue, think of the infield fly rule and take comfort in the fact that very few people truly understand the way these things work, and even fewer can make the right calls under the pressure of the moment.

Friday, May 13, 2011

Expert Networks Following the Rajaratnam Verdict

There was a front page article in today’s New York times as part of the coverage of the guilty verdicts against Raj Rajaratnam, that was titled, “Next Up: A Crackdown on Expert Networks”. The gist of the article is that federal prosecutors were now going to focus their insider trading crackdown on the use of expert networks. In fact, there have already been a number of indictments and guilty pleas resulting from the government’s investigation.

Expert networks, in a classic example of the law of unintended consequences, sprang into being following the enactment of Regulation Fair Disclosure. The theory was Reg. FD was forcing companies to stick to a plain vanilla disclosure script, telling everybody at the same time, whereas investors would pay to get something more than plain vanilla before everyone else. It proved to be a good theory, as on Wall Street, time and information are money, and expert networks could help investors with both. If an investor needed to get up to speed on a new industry, a new drug or a new technology, paying an expert for an hour or two of their time could be much more efficient than spending a week researching the topic. And presumably the investor could get the information free of corporate spin with some insights into the topic that corporate management might be unwilling to discuss.

Alas, like all good ideas, abuses soon appeared. Some expert networks solicited people to act as experts on the companies they worked for, with the implied marketing pitch to investors that they would be able to get an insider’s perspective. And lo and behold, some of the experts actually gave out material, non-public information about their companies. Many of these “experts” were in technical fields, such as medicine or technology, and it would be easy to say that they might not be expected to know technical SEC regulations. However, when someone is paying a person large sums of money to tell them about things that are not generally known about their company, it’s fair to say that person knows he’s doing something wrong. At the very least they are violating their duty of confidentiality to their employer, at the worst, they are violating the federal securities laws.

So now that people are beginning to be sentenced, what does it mean for expert networks?First, they’re not going away. The desire of Wall Street for fast information that may give them an investment edge will insure that the expert networks will continue to be around. Costs will go up as more compliance is layered into the process, both by investors and the networks, but the demand for the product will not go away. Second, companies will strengthen their disclosure policies to prohibit employees from acting as experts. As I write this I am sure there are securities lawyers all over the country drafting memos advising their clients to update their disclosure policies to prohibit all employees from participating in expert networks. Third, maybe, perhaps, we hope, the bad actors will be forced out of the business.

I hate to sound like a cynic about the last point, but when you’ve hung around the industry as long as I have and witnessed Michael Milken, Dennis Levine, Martin Siegel, Ivan Boesky, R. Foster Winans (The “Heard on the Street” columnist from the Wall Street Journal), James McDermott (the former CEO of Keefe, Bruyette & Woods who gave tips to his adult movie star mistress) and Martha Stewart, you get just a bit jaded about the ability of regulations and compliance programs to overcome the lure of making a quick buck.