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.

Stand Up and Take It Like a Man

There’s been a bit of a kerfuffle lately about virtual, online annual shareholders meetings. It seems that Symantic Corporation recently held an audio only, virtual meeting where they took only two questions from shareholders. This angered a number of shareholders and Symantic came out of the process looking as if they lacked transparency, rather than looking as if they are on the cutting edge of technology. Gretchen Morgenson, the financial columnist for The New York Times, did a good job summarizing the meeting and the anger it engendered in its shareholders in her column on September 25^th.

The issue however, is not the efficacy of online annual meetings. There are some obvious efficiency and cost savings benefits to be realized by enabling people to link electronically rather than forcing everyone to come to a single physical location. With today’s technology there are ways that will enable shareholders to actively ask questions and see management’s responses in real time. In other words, companies can structure transparent online annual meetings if they want to; it’s just that many of them are less concerned with transparency than they are with controlling the agenda and message.

To be fair, corporations have reason to be concerned about controlling the agenda. Many special interest groups, if given the chance, would monopolize the question and answer sessions of annual meetings in order to promote their own agendas. In order to combat this, corporations put in place all sorts of limitations and devices to filter out dissenting voices, from the requirement to submit questions beforehand, to time limits, to limits on the number of questions, to arbitrarily cutting off questioners. The result is that usually management ends up looking arbitrary and controlling rather than open to the owners of the company. And when the controlling is done remotely and electronically it looks even worse that it does in person.

So the issue to me is not whether shareholder meetings occur virtually, in person or a combination of the two: the issue is how does management treat the shareholders, even if they don’t like the shareholders’ point of view. For this I take a page from Cork Walgreen, the former CEO of Walgreens.

One of my duties when I was working at Walgreens was to organize the Annual Shareholders Meeting. Attendance at the meeting during the time I ran it grew from around 400 people to over 3,000, and as you can imagine, the number and type of people attending ranged from retirees and employees to sophisticated investors and special interest groups. Questions at the meetings from shareholders at the meeting could be anything and often ranged from complaints about stores being out of merchandise to expansion plans in the State of Alaska to the use of non-union labor in certain construction sites.

The interesting thing about all of these questions was how Cork Walgreen handled them. First, let me say that public speaking was not one of Mr. Walgreen’s favorite things. In fact, he disliked it intensely and rarely appeared in public. But when it came to the annual meeting, he stood up there and took all the questions that time permitted. His attitude was that the shareholders paid him to be in charge and that included answering questions at the shareholders meeting, in good times and bad, no matter how uncomfortable that may have been. He may not have given everybody the answers they wanted – in a forum like the annual meeting you can’t please everyone – but he always gave them the courtesy of listening and responding to their questions. And the shareholders respected him for it.

So the takeaway from all of this is that when you’re conducting your next annual meeting, be it virtual, in person or a combination of the two, take the time to listen to and respond honestly to the shareholders’ questions. In short, “Stand up and take it like a man”. The pain may be intense, but it’s brief. And no one will write stories about how rude you were to shareholders in The New York Times the next day.

What Motivates Your Analyst?

The United States Court of Appeals for the Second Circuit once characterized the exchange of information between corporations and investment analysts as “a fencing match conducted on a tightrope”. If investor relations officers are going to be successful in such a treacherous environment, it helps to understand the analyst on the other side of the conversation and what motivates them. Different analysts have different approaches, and early on in this blog I wrote about “information vampires” (March 2007), “elephant hunters” (April 2007), and “channel checkers” (July 2007) as prime examples of the way some analysts approach things. Now comes a New York Times article published on September 12, 2010, entitled “The Loneliest Analyst” about Richard Bove, a banking analyst that offers some good insights about the way another type of analyst works.

The bulk of the article concerns the lawsuit brought by BankAtlantic, a Florida bank, against Bove for a report he issued about the banking industry in 2008, which ranked the bank’s holding company as among the most risky financial institutions based on financial ratios. The lawsuit was eventually settled without liability to Bove, but it left him the poorer by $800,000 in legal fees. While the drama surrounding the lawsuit is interesting to anyone who has ever listened to a CEO fume about what he thinks is unfair or inaccurate in an analyst’s report, the more interesting part of the article occurs when Bove speaks about his work.

The lead in the article talks about how Bove likes to take “extreme positions” which can occasionally move the markets, gaining him prestige and notoriety. It then cites as an example a recent opinion issued by Bove that government rules would curb mortgage profits and by implication, bank profits. When the share price of Wells Fargo, a large mortgage lender, begin to drop following the report, Mr. Bove’s phone lights up with calls and he states, “That’s what makes the game fun, right?”

According to the article, Bove’s work tends to focus on the big picture, because, as he puts it, “What’s the reason to pay me to be the 14^th guy to tell you what is going to happen in the second quarter at Citigroup? There’s just no utility for a guy at a boutique that operates pretty much on his own to replicate the work of other analysts.”

So one of the takeaways from the article come from learning that analysts at boutique firms may have an entirely different motivation in how they approach research. Without the resources of some of the bigger shops, their focus may be on hitting the home run as opposed to maintenance research, or on big picture, macro stories. Understanding if the analyst you are speaking with takes a differentiated approach will help you as an investor relations officer have a more meaningful discussion with that analyst.

In another interesting portion of the article, Andy Kessler, a former Wall Street analyst, is quoted as saying that it’s common for analysts to change their opinion styles in order to cater to their clients: “If your clients are mostly hedge funds, you’re going to give mostly short-term analysis”. Given that a large percentage of trading volume these days comes from hedge funds, it’s no wonder that we get mostly short-term analysis.

So two quick takeaways from the article: understand what motivates the analyst, and know who his clients are will help you understand his research approach. Sounds a lot like the old broker rule of “Know your client”, but this time reversed.

Proxy Access - Who Benefits?

There is a famous Latin saying, “Cui bono?” that was used in Roman trials to help determine the underlying truth of a matter. The phrase translates into “To whose benefit?” and is meant to suggest the possibility of a hidden motive or that the party responsible may not be who it appears to be at first. And so it is with proxy access, recently adopted by the Securities and Exchange Commission.

The thinking behind proxy access appears pure at first – to promote shareholder democracy by letting shareholders utilize the corporate proxy statement rather than go through the expense of mounting a proxy campaign of their own. But over the years, I’ve come to be suspicious of anything that drapes itself in motherhood and apple pie, whether it comes from the right or left side of the political spectrum, and so I started to think about who really benefits from proxy access.

As I understand the new rule, shareholders who have held at least 3% of a company’s stock for at least 3 years will be able to nominate up to 25% of a company’s board of directors using the company’s own proxy statement. So I guess this is a move to open up corporate boards to shareholders, but I wonder, which shareholders?

Retail? Certainly not retail shareholders; for the most part they don’t reach the 3% threshold.

Hedge Funds? Unlikely, as the turnover in their portfolios means that it is doubtful they will hold stock for 3 years.

What about activist investors – might this new rule inure to their benefit? Possibly, but not to a large extent. A paper entitled “Hedge Fund Activism, Corporate Governance and Firm Performance” suggests that the median holding period for activist hedge funds is 556 days, or 18.5 months. While this might be longer than you thought, it is still only half the time required by the new rule.

Mutual Funds? I suppose mutual funds might be a beneficiary of the new rule, but I’ve never known them to take an interest in nominating directors.

So who’s left? What entities have the financial muscle to hold 3% of a company’s stock for 3 years? What entities have exhibited a desire to use the proxy system to agitate for their own agendas? The answer is: Foundations and Pension Plans. Of these the bulk of the money is represented by pension plans. Add to that the fact that, according to The Wall Street Journal, four out of five for profit corporations have moved away from pension plans, while unionized employees both in the private sector and government, have fought to retain their fixed benefit pensions and the picture of who benefits starts to become clearer.

Least you were in doubt on the issue, consider also that the SEC adopted the rule in a party line vote, 3 democrats for and 2 republicans against. Suffice it to say that republicans don’t get many campaign contributions (or votes) from union members. Finally, consider two of SEC Chairwoman Shapiro’s key appointments to the Commission staff: senior advisor Kayla Gillian, former general counsel at Calpers, the California state workers pension fund, and Richard Ferlauto, former pension director at AFSCME, the union representing state and local government employees nationwide to the investor advocacy office.

Add it all up and it becomes clear that who benefits under the guise of shareholder democracy for all is really a limited number of unions. Now instead of spending union member’s dues in proxy contests they can lay that cost off on the corporations. It’s a nice deal if you can get it.

And Now for Something Completely Different

In the early part of the twenty-first century we all seem to lead time stressed lives. The press of business competes with the demands of ever increasing amounts of information that need to be absorbed. There never seems to enough time in the day to read everything that seems as if it might be important. So the question becomes, “How does one stay current with business thinking, or better yet, get ideas from some of the latest research?” Fortunately, technology has provided a solution.

Most people that work today spend significant time in commuting and this provides anywhere from thirty minutes to two hours a day when time is available to listen to podcasts. For those people who are not familiar with podcasts, they are electronic files that you can download to your computer, iphone and ipod and listen to anywhere, be it in the car or working out. There are an amazing variety of podcasts available, but here is a sampling of some of the better ones that that I have found that deal with business issues. Almost everything I list here is available through ITunes, and in the style of the ITunes store, I will sort them into Basics, Next Steps and Deep Cuts.

The Basics

HBR Ideacasts: Put together by the editors of the Harvard Business Review, I find this series particularly well done, with interesting topics that make me stop and think.

Freakonomics Radio: Produced by the authors of the Freakonomics books, these podcasts put an interesting spin on the dismal science.

Knowledge@Wharton Interviews: I’ve listened to relatively fewer of these as they have not been as well done as the HBR series, but there are occasional interesting interviews.

Wall Street Journal Editors Picks: Didn’t have time to read that interesting article in the Journal you saw at breakfast? You can usually get it here as the WSJ editors interview the authors of the article.

Next Steps

TED Talks: While not strictly speaking business podcasts, these speakers are engaging enough and knowledgeable enough on their subjects to get you thinking about things in a different light. Everyone engaged in business should occasionally be subject to new perspectives and these podcasts will give them to you.

BBC World Weekly with Gideon Rachman: A good way to get a non-U.S. perspective on the news events of the week, which often involve the world of business.

Stanford University Business Management: There are currently only 12 podcasts available in this series, but the ones available are quite good. (Stanford University also has a series on Business Leaders and Entrepreneurs which I have just begun listening to, which looks to be as good, but I haven’t heard enough to officially place it on the list.)

Deep Cuts

Yale Business & Management: Many of the podcasts in this series focus on very narrow topics, so you really have to hunt for what you think may be relevant to your situation, but when you find it, the speakers are quite good.

The Economist: Find the magazine too dense to read? Try the podcast.

The Bowery Boys History of New York: If you are going to deal with Wall Street, you need to understand New York and this delightful series gives you New York City history in bite-sized chunks.

And just to prove that it’s not all about business, here are some of my other favorites from my ipod.

A Prairie Home Companion’s News from Lake Wobegon: Comic genius (in a Midwestern sort of way) from Garrison Keillor.

The History of Rome: Want to know if the sex, sand and sandals in the HBO series are accurate? Listen to this podcast and catch up on your classical history.

Car Talk: Who doesn’t love Click and Clack, the Tappet brothers?

BBC In Our Time with Melvyn Bragg: Features erudite scholars being forced to speak in plain English about a variety of (sometimes) obscure topics.

Oxford Biographies: Catch up on your British history by hearing about people you’ve been told were important, but you don’t know why.

NPR Columns – Driveway Moments: Features the best human-interest stories from National Public Radio’s programming.

While everyone will have different tastes in what they want to listen to, the main point is that you don’t have to listen to that classical rock song for the 200^th time, you can actually put your brain to use and learn something useful.

Using Computers to Predict If a CEO is Lying

There is an interesting article in today’s Wall Street Journal discussing an academic paper by a couple of Stanford University Graduate School of Business professors. The article is entitled, “For Lying CEO’s, ‘Team’ Not ‘I’” and refers to a Paper entitled “Detecting Deceptive Conference Calls” available at http://www.gsb.stanford.edu/cldr/cgrp/documents/SSRN-id1572705.pdf. Obviously, for anyone involved in conference calls, either on the corporate or the investing side, this is required reading.

What the professors did was interesting: they examined the Question and Answer sessions of 29,663 earnings conference call transcripts between 2003 and 2007 for language features that predict “deceptive” reporting of financial statements. (Note that they were smart enough to ignore the carefully scripted section of the call.) In the professors’ words, “Our primary assumption is that CEOs and CFOs know whether financial statements have been manipulated, and their spontaneous and (hopefully) unrehearsed narratives provide cues that can be used to identify lying or deceitful behavior.” They then compared their predictive results to whether or not there was a later material financial restatement. And what they found was that their methodology had correctly predicted between 50% – 65% of the conference calls as “deceptive” by virtue of their having later resulted in an earnings restatement.

For those of you who want (or need) to know what the linguistic hot buttons are, here are some of the things to watch out for:

• CEOs that speak in terms of third person plural pronouns or impersonal pronouns are more likely to be deceptive. It seems in this case, honest CEOs tend to speak of I and me while dishonest CEOs prefer to refer to the company or team.
• Expressing extreme positive emotions with words such as fantastic is more likely while making a deceptive claim.
• Longer answers also are more likely to indicate that they are deceptive.
• Lack of hesitation – if a CEO is quick off the mark, the authors hypothesize that the answer is more likely one that he has rehearsed and wishes to answer quickly and move on.
• References to general knowledge such as “you know” also appear more frequently in deceptive responses.
• Lack of mention of shareholder value or value creation are also tip offs.

It will be interesting to see if investors pick up on any of this while parsing conference call answers. The Q & A session is already the portion of the call that gets the most scrutiny, and this research will only help to bring more focus to the area.