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Source: The Harvard Law School Forum on Corporate Governance and Financial Regulation, May 23, 2017 posting

Private Investor Meetings in Public Firms: The Case for Increasing Transparency

Posted by Martin Bengtzen, University of Oxford, on Tuesday, May 23, 2017

Editor’s Note: Martin Bengtzen is a DPhil Candidate at the Faculty of Law and the Oxford-Man Institute of Quantitative Finance, both at the University of Oxford. This post is based on his recent article, published in the Fordham Journal of Corporate & Financial Law.

What are the consequences if a senior manager of a public firm selectively discloses valuable non-public information (NPI) about the firm (such as details of its next quarterly report) to curry favor with an investor who trades on the information and makes a substantial profit? In theory, they may both be in breach of the insider trading prohibition and the manager may have violated Regulation Fair Disclosure (Reg FD). In practice, however, my article argues, the development of insider trading law, the flawed design of Reg FD, the enforcement policy and practices of the SEC, and the preference and ability of both corporate managers and investors to keep such selective disclosures out of the view of the public and the regulator combine to allow such conduct to occur with impunity. As a result, selective disclosure provides an attractive method for extraction of private benefits from public firms to the detriment of investors without preferential access.

As an example of how managers may be able to distribute such valuable information, consider the Second Circuit decision in United States v. Newman: an investor relations manager at Dell (a large public firm at the time) selectively provided non-public information about its upcoming quarterly results that earned two investors trading profits of $62 million. The Second Circuit held that this activity did not constitute unlawful insider trading and the SEC did not even allege a Reg FD violation. Yet, the receipt of $62 million worth of information from a corporate manager would be a meaningful event for any investor and the potential availability of such awards could sway investors’ decisions on parallel matters where they can influence the manager’s position—such as when they vote on executive pay or in director elections.

The article argues that the current regime, which affords corporate managers significant discretion over the allocation of corporate information, requires increased transparency to prevent abuse.

The Unfulfilled Promises of Reg FD

The regulatory framework for tipping is primarily governed by the Supreme Court’s 1983 decision in Dirks v. SEC, which established that selective disclosure of material NPI is not prohibited if the insider does not receive a personal benefit from the disclosure. In the late 1990s, the SEC observed an increasing number of press and research reports documenting how public firms used selective disclosure of material NPI to curry favor with selected sell-side financial analysts—disclosures which did not involve a personal benefit to the disclosing insider but ostensibly to the firm itself—and decided to overlay Dirks with a new regulation, Reg FD, to deter such behavior. So as not to discourage corporate managers from speaking to investors, however, the SEC drafted Reg FD as a pure disclosure obligation, prohibiting intentional private disclosures without simultaneous disclosure to the market, while explicitly stipulating that failure to comply with the new regulation would not give rise to anti-fraud liability under the securities laws.

This article offers a detailed analysis of Reg FD and finds that both the original design of the regulation and subsequent developments cause it to fail to restrict many disclosures considered undesirable. Instead, the current Reg FD framework appears to have created an apparently unforeseen yet strong demand for private meetings with corporate managers. There are several reasons for this:

  1. Since Reg FD only applies to issuers, selective disclosure recipients are free to trade immediately after receiving private information, before other investors receive the information. Importantly, recipients can trade even if the information is material under the securities laws and even if the information was intentionally disclosed selectively to them.

  2. The SEC has explicitly acknowledged that, when managers evaluate whether a piece of information is material for purposes of establishing if it can be intentionally disclosed in private, it will apply a more lenient recklessness standard for disclosures made in unrehearsed private discussions than for prepared written statements. More disclosures can therefore be labeled unintentional under Reg FD if they take place within private meetings than in other settings, which means that they do not violate the regulation as long as they are eventually disclosed to the public.

  3. Reg FD creates a window for recipients of selectively disclosed material information to trade on it. This is because issuers are allowed up to twenty-four hours from when they become aware of an unintentional private disclosure of material information to rectify it by publicly disclosing the same information, but the recipients can trade in the meantime.

  4. The assessment of whether information disclosed in a private investor meeting is material is, as a practical matter, left to the disclosing insider. The regulation does not create any requirement or mechanism for oversight of the materiality determination, apart from possible SEC enforcement. This means that neither intentional nor unintentional disclosures of material information may ever be corrected and publicly disclosed.

  5. Reg FD does not require issuers to take any action to prevent recipients of mistaken disclosures of material information from trading. Issuers may even allow recipients to trade on such information, since they do not violate Reg FD as long as they disclose the information to the public within the stipulated window.

  6. Where an issuer has mistakenly disclosed material information in private, Reg FD only requires disclosure of the information to all investors. The regulation critically fails to provide any mechanism to inform shareholders or the regulator that a selective disclosure event has occurred; a design which makes it impossible to assess how frequently managers disclose material information in private and whether they repeatedly select the same beneficiaries for such disclosures.

A review of all Reg FD enforcement actions completes the picture. The SEC has taken action in thirteen cases, of which twelve resulted in negotiated settlements with low civil penalties, typically paid by the issuers. On the only occasion the SEC opted for court action over a negotiated settlement in relation to Reg FD, its complaint was dismissed—a defeat which appears to have reduced enforcement activity while demonstrating that it is difficult to prove materiality in cases of subtle private disclosures. Furthermore, the SEC enforces Reg FD so infrequently and imposes penalties of such a low magnitude that the regulation is unlikely to deter opportunistic selective disclosure in practice. In larger firms, managers may be able to confer billions of dollars’ worth of valuable information on preferred investors while facing little risk of paying civil penalties, which are low even when imposed.

Market participants may have taken advantage of this permissive regulatory environment to develop methods for profitable information trading that negate the purposes of the Dirks and Reg FD frameworks while superficially complying with them. Dirks’ protection of recipients who do not provide a personal benefit to insiders was built on the recognition that such selectively disclosed information at some point would benefit investors at large through improved market pricing of securities. However, as Dirks does not require that any such benefit actually materialize in order for the selective disclosure to be permitted, professional investors increasingly demand information in private forums and trade on such information in ways that may not provide benefits to investors other than themselves. Similarly, while Reg FD encourages firms that selectively disclose material information by mistake to publicly disclose it promptly, the SEC failed to recognize that this construction creates strong incentives among investors to pay for the necessary access to managers, in order to be the investors who receive such disclosures first.

The SEC’s design and enforcement of Reg FD may have contributed to the introduction of a new service offering—“corporate access”—that formalizes selective disclosure. Through this service, which has quickly become a billion-dollar industry, brokers charge professional investors to participate in private investor meetings with managers of public firms. The article analyzes potential problems that corporate access may create and argues that the introduction of Reg FD may not have achieved its purpose of reducing opportunistic selective disclosures to analysts preferred by corporate managers, but only caused this problem to transform so that disclosures that were previously made to supportive financial analysts are now instead made directly to the investors they designate.

Information as Property and Selective Disclosure as a Transaction

To place selective disclosure regulation in context, the article examines other mechanisms by which firms may deploy their non-public information to conduct information-based transactions and proposes a simple taxonomy. Senior managers of public firms have three private methods available to them for deployment of NPI: insider trading, firm trading, and selective disclosure followed by recipient trading, and one public method: full disclosure to the market. Following an analysis of these different methods for deployment of information, selective disclosure appears to be a comparatively lightly regulated way to monetize information. While this may create attractive opportunities for firms to effectively raise equity by selectively disclosing NPI to investors who can trade profitably and provide reciprocal value , it also leaves firms vulnerable to managerial opportunism.

The article considers how to improve selective disclosure regulation in light of the Supreme Court’s recognition that a firm’s non-public information is its property. The SEC should recognize that Reg FD is unnecessarily disjointed from the Supreme Court’s approach and instead embrace that approach to regulate selective disclosure as a transaction in firm property. As selective disclosure transactions resemble equity raisings with a significant risk of conflicted managerial interest, a transaction reporting requirement could then be introduced to require public firms to report all selective disclosure events as transactions. Under such a framework, firms would not need to disclose the actual information that is the subject of private investor meetings but general details about these private interactions, such as their dates, times, and counterparties. This would provide investors at large the opportunity to assess managers’ use of valuable firm information and the risk of conflicted managerial interest.

The new framework would deter behavior that shareholders find undesirable while rewarding beneficial transactions in information. Similar to the requirement that insiders report their own trading in their firms’ stock, the reporting of selective disclosure events would better enable investors and the SEC to assess the likelihood that insiders are using corporate information for personal gain. Enforcement of undesirable selective disclosure would thus be easier. This new approach would also have other beneficial effects. First, shifting the enforcement focus to transactions enables the SEC to verify that firms accurately disclose their transactions by requiring the typical counterparties to these transactions—professional investors and analysts—to also keep records of meetings, with penalties imposed for failures to do so. By enlisting the counterparty to these transactions, enforcement is more likely to be effective. Second, it allows for a new approach where firms are made answerable for their information transactions to their own shareholders.

The idea is simple: investors cannot be deceived if firms are fully transparent about their selective disclosure transactions, and with full transparency the SEC can shift its focus from undertaking complicated and expensive investigations into the details of private conversations (which at best result in miniscule penalties unlikely to produce deterrence) to ensuring that firms provide complete reporting of their selective disclosure transactions. This new framework could also improve the allocation of analyst resources, as it will be easier for them to find firms that are undersupplied by information traders. Importantly, the new framework would not curtail legitimate disclosure activities or require disclosure of the potentially sensitive details of private discussions, and would consequently not dissuade investors from taking part in private investor meetings. Investors would still be able to receive and trade on material NPI; the main difference is that other investors would be made aware of the extent of such activities in individual firms after the fact.

I also briefly consider systemic implications of the regulation of private investor meetings. By definition, only active investors take part in private discussions with corporate managers, and they require private information in order to outperform passive investment options over time to justify their fees. Active investors may consequently prefer private disclosures and may find it worthwhile to compensate obliging managers via the firm. Without oversight mechanisms, such as the new reporting obligation proposed in the article, there is a significant risk that selective disclosure of valuable information becomes a widespread phenomenon that systematically reallocates value from investors at large to active investors selected by corporate managers, with net costs to society.

The full article is available for download here.



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