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Banks are selling private discussions with corporate executives that could violate SEC rules

December 22, 2017

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All US investors are supposed to get information about publicly-traded stocks at the same time. If that’s so, then why do some hedge funds spend so much time and money on private meetings with executive management? The obvious reason is that they find it valuable. New research from Harvard Business School shows they’re asking for information that could indeed violate securities rules.

Previous research has shown that (surprise!) investors who frequently meet privately with executives—in the industry parlance, it’s called corporate access—tend to outperform the ones who didn’t. The meetings take place face-to-face or by phone and are often unrecorded, with analysts scribbling down notes. North American and European companies typically have 100 or so of these meetings a year, according to a 2016 survey by financial technology firm Ipreo.

To find out more about these closed-door meetings, Harvard Business School professors Jihwon Park and Eugene Soltes analyzed 1,200 questions that took place between investors and two companies between 2015 to 2016. The study was focused on 66 private discussions. They did this by placing a researcher—presented as a member of company management who was analyzing the firm’s practices—into the meetings. The academics didn’t disclose the names of the companies, one of which was a biotech firm and the other a defense contractor. The companies’ answers were also withheld.

In private meetings, they found that investors asked more questions, and that they were more aggressive and pointed than during public discussions. Some queries were philosophical in nature—”What keeps you up at night?”—but others were looking for information that was more timely than what was publicly available. Here are some examples:

The question about cash holdings—not the amount that was recently disclosed publicly, but rather the amount of cash at the time of the meeting—was especially popular: 26 separate investors asked the biotech firm’s management for an update on that metric. Answers to this question could give a helpful clue to the investors who can afford such meetings, while leaving everyone else out.

Back channel

When public companies in the US provide information, they’re supposed to do it widely so that no particular investor has an unfair advantage, on the basis of the Securities and Exchange Commission’s Regulation Fair Disclosure (Reg FD). Companies have conference calls to discuss earnings so that everybody, from investing giant BlackRock to day traders and journalists, can listen in and potentially ask questions. These conference calls about the companies’ strategy and results are easy to access online or over the phone.

But management also speaks with investors through corporate access meetings. One way this is handled is through bank analysts who provide buy or sell ratings on companies. Analysts facilitate these meetings—known as road shows—with the same companies that they provide ratings on. They arrange private discussions between executive managers and hedge funds, as well as pensions and other long-term investors. It provides a back channel through which investors can, among other things, look for body language or nonverbal clues.

Investors have traditionally paid for this service by sending some of their trading business to the bank brokerage that provided the corporate access they wanted. Though this method of payment is beginning to change, particularly in Europe where regulations are making brokerage payments more transparent, the corporate access channel remains popular. Investors around the world spend about $2 billion a year on these kinds of meetings, according to estimates from consulting firm Greenwich Associates.

Road shows are a major part of the analyst gig. An analyst with a top-tier bank told Quartz privately that bad ratings can jeopardize the broker’s chance to provide these meetings, while another bank analyst said a “sell” rating guarantees no road show with some companies.

Corporate jet analysis

The research showed that while company management was more interested in meeting with long-term investors, analysts often found ways to negotiate meetings with hedge funds. These firms also managed to get a “considerable” number of private phone calls.

Corporate access, like some of the scandals that have erupted in the financial industry, is a potential problem that’s been in plain sight (paywall) for years.

One 2015 academic report found evidence that these investors are more likely to buy a stock before it rises and to sell before it falls. Another showed that trading volumes in companies tend to go up when they’re having offline meetings. Researchers also examined hundreds of thousands of corporate jet flights—used as a proxy for road shows—and found ”greater abnormal stock reactions” during such these periods.

While it makes sense that an ambitious firm is more likely to seek out meetings and therefore should perform better, it also suggests that those who can’t participate in the meetings, because they can’t afford them or for some other reason, are getting left out of valuable conversations.

Yet, there are some good reasons for these meetings to take place. Fund managers may not want to tip their hand to others by publicly explaining their investment thesis. Harvard professor Soltes, who specializes in research on corporate misconduct, pointed out in an interview with Quartz that building a relationship between investors and managers can be a good thing. If a stock has a bad quarter, a money manager might have more patience (and not immediately sell) if she better understands the company’s executives. When it comes to hedge funds that trade frequently or bet against companies by shorting them, “keeping their enemies closer” can also make sense: Corporate management might at least like to know in advance what’s coming.

The optics of corporate access are suspect to say the least, but analysts say it’s common for companies to simply say they’re not comfortable answering certain questions in private meetings.

What could be done to help resolve some of the opportunities for abuse? Soltes suggested that publishing minutes of the discussions could help. That would at least help investors figure out whether there’s information being discussed in private meetings that they would like to know about. The names of the fund managers could be anonymized to help keep their trading plans private. Some independent companies like CorporateAccessNetwork offer these services, which could reduce the conflict-of-interest that emerges when brokerage analysts facilitate such meetings. Soltes is an advisor to Access Square, a firm that provides such services.

It’s worth remembering that markets have already come a long way. Conference calls between executives and analysts weren’t widely available before Reg FD was passed in 2000. If you go back 100 years, companies like Procter & Gamble published skimpy one-page earnings reports with a couple of financial metrics. If investors wanted more information, “accredited stakeholders” had to apply in-person in Cincinnati. When it comes to information disclosure, the field of play is probably much more level than even a few decades ago.

Even so, research like this latest report from Harvard Business School should be a warning, particularly for individual retail investors. While it’s admirable for regulators to try to even out the opportunities, these studies demonstrate that, one way or another, small players will almost always be outgunned.