Whistle While You Work

If you look at the history of financial regulation in the United States, one of the things you notice is that almost all regulation of financial activity at the federal level comes as a result of some form of financial scandal or abuse. This goes all the way back to the Securities Act of 1933, which resulted from the stock market shenanigans brought to light by the Pecora hearings following the stock market crash of 1929. In more modern times, this trend has continued with the enactment of the Sarbanes-Oxley Act of 2002 in the wake of Enron, Tyco, and others, and the Dodd Frank Financial Reform Act of 2010 that was spawned by the housing and mortgage crisis.

These laws are usually enacted quickly, as legislators are anxious to demonstrate that they are doing something, but the resulting legislation lingers on for many years. Companies are left to deal with and adjust to murky legislative language and often burdensome regulations resulting from laws that are designed to prevent the last crisis. Often these laws have unintended consequences, such as the effect of Sarbanes-Oxley on the number of companies choosing to file their IPOs in the United States.

Now we have at least one provision tucked away in the Dodd-Frank law which may come back and bite public companies. I am referring here to the whistleblower provision in the financial reform act. Under this provision of the new law, if a whistleblower provides independent information of fraud to the SEC that results in a successful enforcement action that recovers at least $1 million in sanctions, the whistleblower is entitled to recover at least 10% and up to 30% of the recovered funds.

There are a couple of interesting twists to this legislation. The first is that the independent information regarding the fraud can come from independent analysis of public information. Thus, an outside analyst without any inside knowledge of the company’s books and records can blow the whistle on a company if their analysis shows that the company must be acting fraudulently. This was precisely what happened in the Madoff scandal, when Harry Markopolos went to the SEC with an analysis that showed the returns shown by Madoff were impossible to achieve. It doesn’t take a great leap of imagination to foresee a new subgroup of analysts devoted to looking for financial fraud with the thought of collecting a reward from the SEC.

It also doesn’t take a great deal of imagination to think that the plaintiff’s bar would be very interested in the new whistle blower rules. Now, instead of trolling through Form 4 filings to look for Section 16(b) short swing profits violations by insiders, aggressive attorneys can cultivate relationships with short sellers in the hopes of joining together to find companies engaged in fraudulent activities. Given that short sellers are almost always convinced that companies are defrauding the public and plaintiff’s lawyers never pass up an opportunity to turn a new legal provision into a revenue stream, this is a match made in heaven.

If nothing else, people involved in the disclosure of company information pursuant to the securities laws needs to take a close look at the whistleblower provisions of the Dodd Frank law. Under the current SEC proposed regulations, whistleblowers do not even have to first go through company channels before blowing the whistle. So the company needs to get their disclosures right on the first try, because if they don’t, there may not be a chance to remedy things before the SEC is notified. And the possibility of $100,000 or more in reward money can make it very tempting for whistleblowers to accuse first and verify later.

When is a CEO’s Illness Material?

There was an article in yesterday’s Wall Street Journal entitled “Investors Want Right to Know” which uses the recent announcement of Steve Job’s latest medical leave of absence to advance the argument that Boards of Directors need to disclose more about the health of their chief executive officer. I’ve written about Steve Job’s illness and the lack of disclosure surrounding it on a number of occasions before (see “The Weighty Issue at Apple”, Jan. 6, 2009 and “Maybe Things Were Not So Simple and Straightforward” Jan. 15, 2009) and I stick by what I wrote then. In short, this is a sensitive area where the privacy of an individual bumps up against the disclosure of material events.

Surprisingly, in light of the numerous other items executives must disclose, there is no SEC rule requiring that a company disclose or discuss the health of its CEO. On the other hand, there is no right to privacy under the federal disclosure laws and regulations, either. So what it boils down to, as it does in so many investor relations situations, is the materiality of the issue. If the fact that your CEO has a life threatening disease would be enough to create “a substantial likelihood that a reasonable shareholder would consider it important in making an investment decision” then you had better disclose it.

There are probably two lines of inquiry a Board needs to think about in considering disclosure; the corporate side and the health side of the issue. Factors to consider on the corporate side in making such a disclosure would include:

• How irreplaceable is the CEO perceived to be? People such as Sam Walton of Wal-Mart and Steve Jobs of Apple score highly on this test. Less visible CEOs might not be considered as important to the future of the company, particularly if there is a well publicized succession plan in place and the CEO is nearing retirement age.
• How much is the company paying the CEO compared to everyone else on the proxy compensation list? One of the most visible measures of how much the Board of Directors thinks the CEO is worth is how much they are paying him compared to the other important executives. If he’s making several multiples of the compensation of the next person on the list, then the logical assumption is that the Board views him as almost irreplaceable.
• Does the company have a risk factor in their 10-K report that talks about how unique and important their CEO is to their future? Obviously it’s difficult to argue that a life threatening illness to the CEO is not material if your risk factors say he’s very important to your future. (Apple in fact did this, but it sure doesn’t look good.)
• What is the fact situation surrounding the CEO? Does he portray himself as the sole identity of the firm or does he showcase other executives in public appearances, relations to investors, suppliers and customers?

On the health side of the equation, not to put too fine a point on it, we can all agree that the death of a CEO would be material. So the question Boards must wrestle with is how incapacitating, short of death, must an illness be before a Board has an obligation to disclose. Some commentators have been calling for more regulation by the SEC in these cases, but I think that is likely to be difficult, as hard and fast rules when dealing with health issues can prove a very slippery slope.

All of this sounds good in theory and it would work, except for one thing: Boards usually choose not to disclose a CEO’s illness. I can understand this from a couple of perspectives: the need for privacy in a very stressful situation and the Board’s sense of loyalty to the CEO. Further, when you go through the type of analysis I’ve outlined above, you can often find reasons not to disclose. So investors need to understand, and I think most do, that disclosure in these situations will be slower and more guarded than in a typical corporate situation.

As for the situation at Apple, I have very little sympathy for those who are now crying for more disclosure. If, after all the publicity surrounding Steve Job’s illness during the previous two episodes, an investor hasn’t gotten comfortable with an Apple after Steve Jobs, then they have been asleep at the switch.

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.

The SEC and Climate Change – What Are These Guys Thinking?

First, a brief reminder that my seminar “Fundamentals of Investor Relations” will be held February 24^th in Houston. The seminar blends real world experience with some of the tools we teach in business school such as valuation, decision tree analysis and efficient markets as they interact with the finance, capital markets, legal and communications issues of investor relations. If you’re interested, go to my website, www.palizzapartners.com and click on the seminars tab.

The Securities and Exchange Commission faces a daunting array of issues that need attention - we’re just recovering from the most severe financial crisis our country has faced since the Great Depression which severely tested the structure of our capital markets, credit rating agencies face a crisis of confidence based upon their performance in rating complex mortgage backed bonds and the inherent conflict of interest they face in being paid by the issuers of the bonds they rate, the proper regulation of derivative instruments needs to be addressed, and their enforcement division wasn’t able to identify the billions of dollars being stolen by Bernie Madoff in spite of receiving complaints against him on at least two occasions. So what pressing issue does the SEC choose to tackle first? CLIMATE CHANGE! In the words of Commissioner Kathleen Casey (a Republican who voted against adoption of the release) “our consideration of this release today sends a curious signal to the investment community about what we view as the most pressing issues facing the Commission”.

The interpretive release, which the SEC commissioners adopted in a 3 – 2 party line vote (guess which party voted in favor of the climate change release) and which as of this writing still hasn’t seen the light of day (how’s that for timely disclosure of a material event?) purports not to change disclosure requirements. The last time I checked the definition of materiality as set out by the Supreme Court in Basic v. Levinson, it was “Information is material if there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision”. In over thirty years of working in the field of investor relations I have never had an investor who owns, or is interested in owning shares, ask a climate change question. Could I have been dealing with unreasonable investors all these years? I have had questions from advocacy groups, but they are not investors, which is a crucial difference as far as disclosure requirements go.

Previous SEC interpretive releases have focused on areas such as analysis of long and short-term liquidity and capital resources, segment analysis, the effects of federal financial assistance on the operations of financial institutions, and the disclosure of preliminary merger negotiations. It seems to me that these are proper areas for the Commission to be concerned with; they are concrete, defined in scope and fairly immediate. Now we have a release, which according to the speeches of the SEC commissioners, requires companies to consider the reputational damage and its effect on their financial condition caused by their greenhouse gas emissions and requires them to disclose if their operations may be at material risk from the physical effects of climate change. So here are a couple of questions: How do you measure reputational risk in a meaningful and defined way? How do you know if your operations are at risk from climate change as opposed to normal weather shifts? Last time I checked hurricanes didn’t come with tags that say, “climate change related”. This is just bad regulation, requiring companies to engage in speculation about future events. In most other instances the SEC discourages speculation and requires you to make disclaimers about how the events may not come to pass, but this is an issue that is on the political agenda for the party with the majority of Commissioners on the SEC and so speculation is okay.

And just to remind you, the SEC also put out an interpretive release requiring companies to discuss Y2K issues, and we all know how material they turned out to be.

XBRL – Part Three, or, Son of the Return of XBRL

Back in January and February of this year, I wrote a couple of pieces about how I didn’t really get what all the whoopla surrounding XBRL was about. Those pieces generated a fair amount of comments and I even wound up talking to the folks at the SEC about XBRL. Not to put too fine a point on it, at the time I stated that I just couldn’t understand how XBRL was going to revolutionize the use of data by investors.

While I was doing research the other day on the SEC’s EDGAR database of filings, I noticed that reports are now beginning to be tagged as having “Interactive Data”. So I thought that I owed it to myself to go back and see how this XBRL stuff works in practice. Maybe the scales would fall from my eyes and I would see the error of my ways. Maybe I would be able to see how the data flowed seamlessly, enabling us to quickly reach investment decisions that were lost to us before. And maybe pigs would fly.

What I found when I went to the interactive data was that you could click on a heading such as Income Statement, and the P&L would come right up. I found the data had two properties: first, the headings were tagged. So for example, if you click on Revenues, you find that it’s US GAAP, the data type is monetary, the balance type is a credit and the period is the duration of the quarter. In other words, what you learn in Accounting 101. Secondly, you can grab the data and paste it into another document fairly easily. Also of note was the fact that the financials and notes are available as an Excel download, although everything I downloaded had a file name of “Financial_Report.xls”, so if you don’t rename the file right away, it becomes one of many with the same name.

After I had played with the data for a while, I sat back and thought about the cost /benefit analysis for what we’ve gone through with XBRL. On the benefit side we’ve gained a bit of functionality. I, for one, will welcome the ability to grab data off a downloaded spreadsheet rather than re-keying it when I want to do some analysis. But I don’t see a lot beyond that. The tagging of the data seems to merely tell me what I knew before. Further, professional investors have had the data in comparable and downloadable form for years. Systems such as Bloomberg and Telemet Orion (and I assume Reuters, although I have no experience with that system) already perform this function and a lot of other analytics as well. So my conclusion is that only relatively small investors are being helped. Against this we have to weigh the thousands of dollars spent and numerous man-hours invested by every company converting to XBRL.

To me this seems like another example of something that sounds good in theory, but the practical advantages just don’t seem to live up to the hype. In other words, it’s a governmental agency imposing a standard where the costs outweigh the benefits. The irony of it all is that the ultimate cost for all of this will be born by investors, because the cost of adopting to the new systems is a corporate expense, which lowers earnings, which will result in lower share prices.

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.

Keep Your Eyes on the Ball

The underlying premise of investor relations is simple: to the extent you can give investors a clear picture of what your company’s future earnings prospects are, the better they will be able to accurately assess the value of your firm and its stock price. This derives from the financial principle that the value of a firm is equal to the sum of its future cash flows, discounted back to a present value. Your past earnings history, even yesterday’s quarterly release, is germane only to the extent that it illuminates and gives confidence to estimates of future cash flows.

I bring this up because lately it seems to me that there are more distractions than ever to the discipline of investor relations. To start, it is the silly season in Washington and regulatory initiatives are in full swing. Every day seems to bring more news about SEC initiatives, whether it’s on flash trading or creating a new division of Risk, Strategy and Financial Innovation. They seem determined to prove that they can cure past ills by more regulations. Further, the industry association, NIRI, seems to be singularly focused on regulatory issues, which I guess makes sense as they are based in Washington and are creatures of their environment. Added to that we have whole new channels of communication opening up in the amorphous world of social media with twitter, facebook, linkedin and blogs. Then we have technical issues such as XBRL reporting and IFRS accounting to worry about. All of these are things that investor relations officers need to be aware of, have an opinion on and react to if it is their ox that is getting gored, but are not central to what they do.

With all of this going on, it’s very easy to forget the main function of investor relations: creating a clear and concise picture of what your firm’s prospects are and how you intend to get there. I will grant you that investor relations derives from regulation. Without specific regulatory guidelines most companies would be loath to tell investors anything, regardless of what the financial theory says. But the jumbled mess that we refer to as securities law regulation is a means to an end, not an end unto itself. Let the lawyers worry about the latest SEC staff interpretations; let the accountants worry about IFRS. What investor relations people should worry about is whether the market understands how what your company is doing leads to profits in the future. This means disclosing not only what happened in the past quarter; it also means helping investors gain insight into your markets, your industry and the trends, both long-term and short- term, that drive your business.

Likewise the social media that we are seeing today is nothing more than additional forms of communication. I’ve been around this business so long that I remember when conference calls were a novelty. Today conference calls are just another tool to get the company’s story to investors efficiently. Done well, they are helpful; done poorly they can be a disaster. Social media will eventually play out in a similar fashion.

So my advice is to let the hype and chatter pass you by. Keep your eyes on the goal of getting investors to understand your business and its prospects. Appropriate valuation in the form of stock price will follow.

A Dive Into Dark Pools

Earlier this week the luncheon topic for the NIRI Houston chapter was “Dark Pools”. This is a subject that has received much press lately, most of it with ominous overtones to accompany the rather sinister name, so I went with much anticipation, much like you’d go to a scary movie. I have to confess that I knew very little about all of this before I went, and when the luncheon was done, I was more confused than ever. So on the premise that I can’t be the only one who is confused, I decided to do a little more research and, at the expense of stretching a metaphor, try and shed some light on Dark Pools.

First, what are these things? As I understand it, a Dark Pool is an electronic crossing network that allows buyers and sellers of stock to place liquidity (an offer to buy or sell) into a pool anonomously and wait for execution while disclosing little, if any, information. Only when an order is executed is the information on the trade made public. To use a phrase from Bruce Springsteen, these market participants are “Dancing in the Dark”. This is in contrast to normal markets where public order flow allows market participants to judge supply and demand for a stock and adjust accordingly.

Second, are these things inherently good or bad? The ostensible purpose of Dark Pools is to allow holders of large blocks of stock to execute their buy or sell orders without indicating to the markets what they intend to do. Therefore Sellers can sell without driving the price down and buyers can buy without driving the price up. The pricing is done within the Best Bid or Offer context of the National Market System, so price discovery is occurring using normal market systems. This seems like a good thing if you are a large institution looking to move large blocks of stock. Additionally, if you are looking to buy or sell a relatively illiquid stock, dark pools can help you do so with a minimum of price disruption. If you are a company, it would seem that this balances itself out, especially when you consider that institutional investors trade approximately 80% of the stock volume in the U.S.

Third, why the big deal about all of this? Follow the money. The Exchanges – NYSE and NASDAQ, hate these things because they pull significant amounts of orders off the exchanges, which means less order flow and less earnings for them. Traders and specialists hate them because they obscure market information and eliminate trades that they would otherwise execute by putting it all into a machine. This eliminates both the lifeblood of traders – information – and jobs. So much volume has come off the floor of the NYSE that there are significantly fewer traders these days and they have been forced to close trading rooms.

Finally, are there things that should be of concern? If too much volume comes off of the visible Bid/Ask market system, the bids and offers shown on the publicly displayed market quotation system might not accurately reflect true supply and demand. This is why we are seeing rumblings by the SEC to regulate areas of dark pools if too much volume is traded in them. (The nature of regulators is to regulate.) While dark pools are good for large institutional investors moving large blocks of stocks and companies that trade using sophisticated algorithms, it is considerably less clear that they offer any benefit for anyone else.

I think what is happening here is that technology is opening up new channels for trading and moving things away from the old duopoly of the NYSE – NASDAQ. As they are the ones with the most to lose, they are also the ones that will yell loudest. At the end of it all, the lesson is that not all investors are equally suited to all markets. With the emergence of several new ways to trade stocks we are moving away from a “two markets fits all” approach to customized execution based upon the needs of the investor. Many permutations on order execution are bound to follow. The exchanges better figure out how they fit into all of this or they will be left behind.

Investor Relations and Social Media

Every generation has a point in the development of technology where they hit the wall. For my grandparents’ generation it was color TVs. My grandparents could never seem to be able to tune in their color TVs so that people looked normal – they always had a reddish or green tinge to their skins. For my parents’ generation, the people who were able to survive the Great Depression and World War II, cell phones have stopped them cold. Today’s seniors just don’t seem to be able to grasp what all those cool features on the phone are for – and why would you want a camera on your phone anyway? While I don’t claim to speak for my entire generation, for me, my technological Waterloo has been social media.

I don’t think of myself as a Luddite. After all, I write a blog, my business has a web site, I have an iPhone and I work on a computer most days. I’ve even learned how to send text messages on my phone, as it is the fastest way to get a response from my three college age children. But I confess that twitter and facebook have me stymied. I just don’t get it. Twitter because I’m incapable of saying anything in 140 characters or less and facebook because why would you want to put all that information out there in the public domain? And because I don’t get the social application of these services, I certainly don’t understand their application to investor relations.

First, let’s start with our friends at the Securities and Exchange Commission. The SEC has been very clear that all of the rules that apply to disclosure of information in other contexts also apply to social media. So I guess that means that if you inadvertently twitter a piece of material, non-public information, you must issue a press release as soon as possible thereafter. Of course, if you’ve taken the time to type out the information, I would question how “inadvertent” the disclosure was, which means that the press release should have been issued either before or simultaneously with the twitter. And how do you write a “Safe Harbor” disclaimer in less than 140 characters? These are the sorts of things that will drive your securities law lawyer to distraction, so they are quite possibly inclined to say that you would be better off not twittering about investor relations topics in the first place.

Secondly, who has the time? We all live days that are filled with lots of information flow, meetings, phone calls and other demands on our time. Do you really need another distraction, particularly one as unfiltered as social media tends to be? In a business context? I remember in the early days of email having a colleague extol the virtues of email because it bypassed all the filtering layers of a corporation, allowing anyone to communicate directly with you. These days I look at the constant stream of email that flows through my computer and sincerely wish for better filtering devices. And I don’t even work in a corporation, with its constant stream of emails from Human Resources, Security, IT, meeting and calendar reminders and notices of the annual golf outing, charity events and other odds and ends.

Finally, let’s not forget the primary mission of investor relations, which is relating to investors – making sure they understand your company and its prospects so that they can accurately value the company and its stock. Call me old fashioned, but I believe that this means that you actually have to talk to investors, listen to their questions and give them thoughtful responses. For that, the best, most efficient piece of technology that you have was invented in 1876. It’s called the telephone.

I suppose that over time social media will create a niche for itself in business, but for the present, to me, it seems over-hyped. I believe that truly sophisticated technology simplifies you life rather than adding more complications. And I don’t see how social media makes your life simpler.

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…

A Gordian Knot – Investor Relations, Laws, Regulations and Case Laws

The academic part of my year is currently in full swing and that, combined with my other commitments, has caused me to fall behind on my musings. My apologies to those of you who have been eagerly awaiting yet another installment, but as a rational economic person, I’m going to do those things first which pay me, and frankly, this blog is never going to replenish my ravaged 401(K) account.  That being said, it was while I was preparing for one of this week’s classes that the idea for this post occurred to me.

One of my class topics this week focuses on the legal and regulatory framework surrounding investor relations.  It’s not a subject that business school students are naturally attracted to, but it is something that everyone involved in investor relations needs to master.  Back in the 60’s, there was a band by the name of Zager and Evans whose one and only hit was “In the Year 2525” which had the line in it, “Everything you think, do and say, is in the pill you took today”.  Which is a pretty good way to think about the laws and regulations surrounding investor relations – everything you think, do and say is governed by them.

One of the points I try to make in my class is that the laws and regulations surrounding IR are not the result of a coherent codification of the laws, cut from whole cloth.  Rather they have grown and evolved over time, from statutes, regulatory rule making and case law decisions.  The resulting Gordian Knot of laws, rules and case law is enough to send joy to the hearts of lawyers everywhere and give everyone else headaches.  Further, each is enacted from a different set of circumstances.

Statutes, for example, are usually enacted to stop some form of abuse.  This was true of the original securities protection acts, the state “Blue Sky” laws, and it continued to be true with the enactment of the Securities Act of 1933 and the Securities Exchange Act of 1934, which were enacted following the stock market abuses of the 1920s.  More recently, the Securities Litigation Reform Act of 1995 was enacted to curb abusive securities law class action claims and the Sarbanes-Oxley Act was passed by Congress in reaction to the Enron, Adelphia, MCI and Tyco scandals. Those of you who are looking for a common theme among these acts would do well to take up a different hobby. I suggest something much easier – say, along the lines of solving The New York Times Saturday crossword puzzle.

On the regulatory side, I find that the regulations that get enacted by the SEC tend to have a political background to them.  Take, for example, the disclosures surrounding executive compensation in the proxy statement.  As executive compensation has swelled, political pressure has built up, which has resulted in the SEC layering in more and more disclosure regulations surrounding executive pay.  Way back in the dark ages (the 1970s) when I was actually writing proxy statements, it was not unusual for them to be no longer than 8 – 12 pages.  Today, between tables, graphs, Compensation Committee and other reports, Proxy Statements routinely run 4 – 5 times that length.  It has to be extremely frustrating for politicians and the regulators, because the more disclosure they require, the bigger the pay packages seem to get. I have no doubt that if they could have enacted compensation limits, they would have. But the SEC’s regulatory authority only extends to disclosure, so they keep making companies say more and more about how they come up with their pay  schemes in the hope that shareholders will get outraged and rein in the pay packages.  Similarly, other disclosure regulatory requirements have waxed and waned depending on the political climate of the time.  As a result, any hope of consistency regarding how the regulations require you to act is a forlorn one. 

Finally, much of materiality and the definition of fraudulent behavior in the securities laws is the result of case law decisions.  These are instances where, except in the most egregious or fraudulent cases, reasonable people can differ. Yet this is how we come up with our definitions for materiality, how we interact with analysts, when we choose to disclose and a multitude of other things. 

I, for one, would like to see a comprehensive overhaul of the securities laws to bring some semblance of logic to them that would serve to eliminate much uncertainty (and billable law firm hours) from the process of being a public company. Like Alexander the overhaul would cut through the many strands of laws, regulations and case decisions that are tying us up in knots with a clear unified code of securities laws. Then again, given the current administration and the mood of Congress towards Wall Street, maybe its better to leave well enough alone…