Proxy Advisory Services Regulation: What’s Good For the Goose…

As a commentator, one of the best things you can find to write about is when you come across someone being totally disingenuous; it’s almost as good as when companies do something really stupid (for which see “How Not to Run a Conference Call” December, 2007 and “What Was He Thinking, Whole Foods Version”, August 2007).

Which brings me to this week’s subject, the possibility of the Securities and Exchange Commission imposing regulations upon proxy advisory firms. Proxy advisory firms have grown in size and influence over the last twenty years. Their positions on corporate governance, compensation and proposed mergers and acquisitions have become important to both investors and corporations, creating in effect, de facto standards. Yet the manner in which the proxy advisory firms reach their recommendations and ratings, the formulas they use when looking at compensation and equity plans, and the process by which they make recommendations regarding merger and acquisition activity are considerably less than transparent. Further, the amount of research available to support their positions on corporate governance is less than overwhelming and far from conclusive. Finally, some firms, such as ISS, have actively worked both sides of the street, advising institutions how to vote and selling their consulting services to corporations to tell them how to structure things in order to get approval and high ratings from ISS.

So when the Securities and Exchange Commission asked for comments on the proxy process earlier this year it is not surprising that a number of comments came back suggesting that proxy advisory firms be subject to some regulation from the SEC, namely that proxy advisory firms should be subject to proxy rules and regulated as investment advisers, including mandated disclosure of specific conflicts of interest, transparency on how they develop their ratings and recommendations, and that they adopt procedures ensuring the accuracy of their reports and voting recommendations.

It seems as though the proxy advisory firms, which like more regulation for corporations, are not so happy when the shoe is on the other foot. Here’s Nell Minow, Chair of The Corporate Library and former general counsel and CEO of ISS in a comment letter to the SEC: “I would like to object in the strongest possible terms to the possible regulation of proxy advisory services.” Later in her comment letter, she goes on to explain how market forces will keep the proxy advisory services honest.

In other words, if we just let competition work without government getting in the way, everything should be fine. Of course this is exactly what they say doesn’t work for corporations when they want more regulation on say on pay, proxy access, compensation disclosure and a whole host of other corporate governance issues.

It does seem to make sense that these firms, which have a great deal of influence in how investment firms vote should at least be required to disclose the methodology by which they come to their ratings and recommendations, disclose any potential conflicts of interest (or better yet, be prohibited from conflicts of interest) and show they have stringent procedures in place to prevent inaccurate reports and recommendations.

After all, if increased disclosure and regulation is good for the goose (corporations), then it is certainly also good for the gander (proxy advisory firms).

Lawyers Gone Wild

To a certain degree, we are all governed by our experiences. In the case of Wal-Mart, that experience seems to include getting sued – a lot. While I was unable to get exact, recent numbers, a 2001 USA Today report had Wal-Mart stating that they were sued 4,851 times during the year 2000. Another source on the web reported that Wal-Mart was sued 845 times in federal court alone during 1999. The point here is not the preciseness of the numbers, but rather the magnitude, and the simple fact is that Wal-Mart finds itself on the receiving end of lawsuits with great regularity.

Having to deal with plaintiff’s lawyers on such a regular basis would warp the sensibilities of almost anyone and it appears that a bunker mentality regarding being prepared for lawsuits has crept into Wal-Mart’s investor relations pronouncements. How else can you explain the safe harbor language for forward-looking statements contained in their most recent earnings call?

A transcript of Wal-Mart’s third quarter earnings call shows that their safe harbor statement runs 1,316 words, or about 4 1/2 pages of dense, lawyer drafted prose. By my calculations using the transcript available on Seeking Alpha, this was slightly more than 10% of all the words spoken during the call. Interestingly, this was almost 300 words longer that their second quarter safe harbor statement, which came in at a mere 1,038 words. To get an idea of how things have escalated, their fourth quarter 2005 earnings call used a safe harbor statement containing 455 words. At this rate, pretty soon Wal-Mart’s entire earnings call will consist solely of a safe harbor statement.

I am fortunate enough that I don’t get sued with great regularity, so I may not be as sensitized to this issue as Wal-Mart is, but to me it seems like lawyerly overkill. Here’s an example:

“This call will contain statements that Wal-Mart believes are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, as amended, and intended to enjoy the protection of the safe harbor for forward-looking statements provided by that Act. These forward-looking statements generally are identified by the use of the words or phrases anticipate, are anticipating, are expecting, assume, could be, expect, forecasting, goal, guidance, guided, is expected, is planning, may affect, plan, will accelerate, will add, will be, could save, will drive, will ring, will be growing, will come, will continue, will cost, will experience, will generate, will grow, will improve, will not continue, will remodel, will see, will spend, will take, would represent, or a variation of one of those words or phrases in those statements or by the use of words and phrases of similar import. Similarly, descriptions of our objectives, plans, goals, targets, or expectations are forward-looking statements.”

The lawyer seems to have parsed through every verb that was going to be used in the call and labeled anything that could possibly be construed as future tense as forward looking. Of course, then for good measure, they throw in the phrase “or a variation of one of those words or phrases in those statements or by the use of words and phrases of similar import” which is legalese for “I can’t think of anything else, but if you can that’s excluded too”. Similarly, it appears as though a lawyer was determined to parse through every statement that Wal-Mart proposed to make during its earnings call, call out anything that could be deemed even slightly a forward looking statement, and specifically disclaim liability for it if things didn’t turn out as represented. That goes on for almost four pages. This is deadly stuff, and I don’t mean that in a positive way. I can’t image what Wal-Mart’s lawyers would do if the company actually took questions from analysts during the call.

All of this points out one of the central tensions of investor relations; the desire of IR practitioners to point out the road the company intends to pursue in order to earn future profits, versus the desire of lawyers to insulate the company from liability in a dangerous world where securities class action attorneys wait to pounce on any slight misstep. I’m not sure where the proper balance exists between these two desires, but management needs to recognize when lawyers are getting in the way of the message and tell them to cut back on the excess verbiage.

Certainly, if the lawyers are taking up over 10% of the message, things have gone too far.

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.

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.