E arlier this month, the Securities and Exchange persons - - PDF document

Corporate Finance Alert

September 2000

SEC Adopts Regulation FD to Combat Selective Disclosure of Material Non-Public Information to Market Professionals

By John D. Hogoboom, Esq., Steven M. Skolnick, Esq. and Michael W. Valente, Esq.

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arlier this month, the Securities and Exchange Commission adopted its controversial Regulation FD which is designed to eliminate the selective disclosure of material non-public information to market

• insiders. Regulation FD is likely to significantly change

the ways in which public companies communicate with analysts and other market participants. Regulation FD will be effective on October 23, 2000, although public companies would be well advised to alter the methods by which they disseminate material information immediately.

Overview of Selective Disclosure and Regulation FD

Overview

"Selective disclosure" occurs when an issuer voluntarily discloses material non-public information to a limited number of persons — typically analysts or other securities market professionals — prior to the release of such information to the general public. Selective disclosure is viewed by many investors as being indistinguishable from illegal "tipping." However, because of quirks in the development of insider trading law, the legality of selective disclosure has been unclear. Regulation FD is designed to address the most egregious instances of selective disclosure by requiring public companies to effect a broad general dissemination of material information that is disclosed to certain market professionals or to promptly publicize material information that has been selectively disclosed to such persons inadvertently. As discussed below, however, Regulation FD is likely to have far-reaching consequences for most communications by public companies.

The Rule

Regulation FD does not mandate the disclosure of material non-public information. However, Regulation FD requires issuers who intentionally disclose material non-public information to persons covered by the regulation to assure a simultaneous general disclosure of that information to the public. Regulation FD also requires issuers to cure promptly unintentional disclosures of such information to covered persons. Under Regulation FD, whenever: An issuer, or person acting on its behalf discloses material non-public information; to certain enumerated persons (in general, securities market professionals or holders of issuer’s securities who may well trade on the basis of the information; the issuer must make public disclosure of that same information:

• simultaneously (for intentional disclosure; or
• promptly (for non-intentional disclosure)

Regulation FD applies to all issuers with securities registered under Section 12 of the Securities Exchange Act of 1934, as amended, and all issuers required to file periodic reports under Section 15(d) thereof, subject to certain exceptions.

Disclosure of Material Non-public Information

Regulation FD applies to the disclosure of "material non-public" information. Under existing case law, information is material if "there is a substantial

“Under existing case law, information is material if "there is a substantial likelihood that a reasonable shareholder would consider it important" in making an investment decision.”

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discussions with the media, promotional activities and

• ther non-market communications, although such

communications were initially proposed to be covered by the regulation. Regulation FD specifically enumerates four categories of persons to which the regulation applies, absent an exclusion. Those persons are:

• broker-dealers and their associated persons;
• investment advisors, certain institutional

investment managers and their associated person;

• investment companies, hedge funds and

affiliated persons; and

• any holder of the issuer’s securities, under

circumstances in which it is reasonably foreseeable that the person would trade in the issuer’s securities on the basis of the information. Regulation FD excludes communications to "temporary insiders" (professionals, such as lawyers, accountants and investment bankers) who owe a duty of trust or confidence to the issuer. Regulation FD also excludes disclosures made to persons who expressly agree to maintain the disclosed information in

• confidence. Disclosures made to any entity whose

primary business is issuing credit ratings also are exempt, provided that the entity's ratings are publicly available and the information is disclosed solely for the purpose of developing a credit rating. Finally, as discussed more fully below, disclosures made in connection with registered offerings under the Securities Act of 1933, as amended, are not subject to Regulation FD. Regulation FD defines "any person acting on behalf

• f an issuer" as (i) any senior official of the issuer,

including any director, executive officer, investor relations or public relations officer, or other person with similar functions; and (ii) any other officer, employee, or agent of the issuer who regularly communicates with likelihood that a reasonable shareholder would consider it important" in making an investment

• decision. To fulfill the materiality requirement, there

must be a substantial likelihood that a fact "would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available." Information is "non-public" if it has not been disseminated in a manner making it available to investors generally. The lack of a bright line materiality test will make compliance with the regulation difficult for issuers because the determination of whether information is "material" is a judgment that is made on the basis of unique facts and circumstances. That determination can be highly complex and, unfortunately, is frequently reviewed with the benefit of hindsight. In order to aid issuers, the SEC included in the release discussing the adoption of Regulation FD the following non-exclusive list of information and events that are likely to be material:

• earnings information;
• mergers, acquisitions, tender offers, joint

ventures, or changes in assets;

• new products or discoveries, or developments

regarding customers or suppliers (e.g., the acquisition or loss of a contract);

• changes in control or in management;
• change in auditors or auditor notification that

the issuer may no longer rely on an auditor’s audit report;

• events regarding the issuer’s securities, such as

defaults on senior securities, changes in dividend policy, calls of securities for redemption, repurchase plans, stock splits, changes to the rights of security holders, public or private sales of additional securities; and

• bankruptcies and receiverships.

Scope of the Regulation

Regulation FD applies only to communications of information to those persons who would "reasonably be expected to trade securities on the basis of the information or provide others with advice about securities trading." As a result, it does not cover

“Information is "non-public" if it has not been disseminated in a manner making it available to investors generally.”

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market professionals or the issuer's security holders. In its adopting release, the SEC warns that issuers cannot avoid the reach of Regulation FD by having a non- covered person reveal the information. In such situations, the communication will be attributed to the senior official that directed the employee to make the

• disclosure. However, a person who breaches a duty to

the issuer and reveals material non-public information would not be considered to be acting on behalf of the issuer and, in such instances, the issuer would not be subject to liability under the regulation. As originally proposed, Regulation FD would have covered all selective disclosures made to a third party. In response to concerns that such a broad regulation would have had a "chilling effect" on corporate communications, the SEC revised Regulation FD to exclude disclosures made to non-market participants from the requirements of the regulation. However, given the SEC’s hostility toward selective disclosure, the policies underlying Regulation FD, and the likely effects of the regulation on corporate communications policies generally, we believe that any selective disclosure of material non-public information, regardless of the context, will become an increasingly likely source of potential liability for public companies. Accordingly, we believe that public companies will have to take steps to avoid all selective disclosures, regardless of whether they are subject to the requirements of Regulation FD. For example, issuers that have not already done so should appoint spokespersons to whom market inquiries are directed and such persons should be educated regarding the pitfalls of selective disclosure and the requirements of Regulation FD.

The Special Problem of Analyst Communications

In the adopting release, the SEC highlighted its concerns about communications between public companies and analysts, saying that analyst discussions raise "special concerns" regarding selective disclosure. The SEC noted that when an issuer official engages in private discussions with an analyst who is seeking guidance about earning estimates, he or she "takes on a high degree of risk" under Regulation FD. In the SEC’s view, if the official communicates selectively to the analyst regarding the company’s anticipated earnings (even if the official just confirms the analyst’s

• wn forecast), a violation of Regulation FD is likely to

have occurred. The SEC distinguishes this situation from one in which an issuer discloses non-material information to the analyst that the analyst views as significant because

• f other information in the analyst’s possession. In the

SEC’s view, a violation of Regulation FD does not occur where non-material information is disclosed to an analyst who then "discerns" the significance of the information. In practice, issuers will be hard-pressed to make the type of fine distinctions made by the SEC in the adopting release, especially when hindsight may call those judgments into question. Accordingly, we believe that private conversations with analysts should be avoided, absent compelling circumstances, because of the danger of an inadvertent disclosure of material

• information. Company officials, however, will likely

continue to face pressure from analysts to comment on corporate developments and to provide guidance on future prospects. Companies will have to decide whether continuing to have such discussions is worthwhile in light of the requirements of Regulation

• FD. Some may even find that the prospect of

Regulation FD applicability is an effective shield with which to fend off requests for information from analysts and other market professionals.

Intentional and Non-Intentional Disclosure and the Timing of Required Public Disclosure

Under Regulation FD, the timing of the required public disclosure differs depending on whether the disclosure is intentional or inadvertent ("non-

“Under Regulation FD, selective disclosure is intentional if the issuer or person acting on the issuer's behalf either knows, or is reckless in not knowing, prior to making the disclosure, that the information he or she is communicating is both material and non-public.”

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commencement of the next day’s trading on the New York Stock Exchange.

Public Disclosure Requirements

Regulation FD does not mandate the method of disclosing material information. The adopting release specifies that the public disclosure requirements of Regulation FD will be satisfied if the method or the combination of methods of disclosing the information to the general public is reasonably designed to provide "broad, non-exclusionary distribution of the information to the public." As part of its adoption of Regulation FD, however, the SEC also has adopted amendments to Form 8-K to allow issuers to disclose such information by filing or "furnishing" a report on Form 8-K. In response to concerns that filing an 8-K would be considered an admission that the disclosed information is material, the SEC will allow issuers to either "furnish" the information under a new 8-K Item 9 or to "file" such information under existing Item 5. Information furnished under Item 9 will not be deemed filed for purposes of the Securities Act or the Exchange Act and therefore, not subject to liability thereunder (other than for material misstatements or omissions). However, information furnished under Item 9 will not be deemed to be incorporated by reference into an issuer's registration statements filed under the Securities Act. As a result, issuers cannot utilize disclosures made under Item 9 to update such registration statements. The adopting release specifies that issuers can use methods other than the submission of a Form 8-K to comply with the disclosure requirements of Regulation

• FD. Such alternative methods include press releases

that are distributed through a widely disseminated news

• r wire service, and disclosures made in press

conferences or conference calls that members of the public may participate in, provided adequate notice of the conference or call is given. If press conferences or conference calls are used, adequate notice of and reasonable access thereto must be given to the public. The adopting release suggests the following model for making a planned disclosure of material information, such as quarterly earnings:

• First, issue a press release, distributed through

regular channels, containing the information; intentional" in the words of the adopting release). For intentional disclosure, the issuer is required to publicly disclose the same information simultaneously. In the case of a non-intentional disclosure, the issuer must "promptly" disclose the material information to the public.

Intentional Selective Disclosure

Under Regulation FD, selective disclosure is intentional if the issuer or person acting on the issuer's behalf either knows, or is reckless in not knowing, prior to making the disclosure, that the information he or she is communicating is both material and non-public. In the adopting release, the SEC emphasizes that the individual making the disclosure must know (or be reckless in not knowing) that he or she would be communicating information that was both material and non-public. Therefore, if an issuer erroneously determines that information is immaterial, liability will theoretically arise only if no reasonable person under the circumstances would have made the same

• determination. As a result, the context,

circumstances, and substance of the communication are important in determining whether the communication was intentional. For instance, the SEC indicates in the adopting release that a materiality judgment might be reckless in the context of a prepared written statement but may not necessarily be reckless in the context of an impromptu answer to an unanticipated question. However, given the difficulties inherent in determining the materiality of particular disclosures, this distinction is likely to be of little comfort to issuers.

Non-intentional Selective Disclosure

For non-intentional disclosures, the issuer must promptly make public disclosure of the information when a senior official learns that there has been a non- intentional disclosure of information by the issuer or person acting on behalf of the issuer which the senior

• fficial knows, or is reckless in not knowing, is material

and non-public. For purposes of Regulation FD, "promptly" means "as soon as reasonably practicable," but in any event before the later of 24 hours after becoming aware

• f

the disclosure

• r

the

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• Second, provide adequate notice, by a press

release and/or website posting, of a scheduled conference call to discuss the announced results, giving investors both the time and date

• f the conference call, and instructions on

how to access the call; and

• Third, hold the conference call in an open

manner, permitting investors to listen in either by telephonic means or through Internet webcasting. The SEC takes the position in the adopting release that the use of a bulletin or notice on the issuer’s website would not by itself be a sufficient method of public disclosure under Regulation FD. The SEC acknowledges, however, that such notice may, under some circumstances, be a component of effective

• disclosure. As in determining materiality, each issuer

will need to consider the relevant facts and circumstances surrounding its usual practices for publicly disclosing material information, such as the likelihood of the information being carried by a major news service. The adopting release makes clear that it is ultimately the issuer’s responsibility to choose methods that are reasonably designed to broadly distribute the information to the public.

Applicability to Securities Offerings

Compliance with Regulation FD raises special concerns for companies contemplating the sale of

• securities. In particular, Section 5 of the Securities Act

places restrictions on the disclosures that may be made at various intervals during a public offering. As a result

• f these concerns, the SEC has exempted public
• fferings from the requirements of Regulation FD, at

least during the offering period. No similar exemption exists, however, for private placements. In the SEC’s view, if a reporting issuer releases material information

• n a non-public basis during an unregistered offering

without assuring that the information will be kept confidential, public disclosure of the information will be required under Regulation FD, even if the disclosure could destroy the private placement

• exemption. Accordingly, issuers engaging in private

placements should consult with counsel on appropriate

• ffering mechanisms well in advance to assure that

selective disclosure will not take place. The SEC’s position will create significant difficulties for public companies contemplating a private placement. Although the SEC suggests in the adopting release that the use of appropriate confidentiality agreements would alleviate selective disclosure concerns in the private placement context,

• ur experience suggests otherwise. In some cases,

market professionals are likely to become aware of potentially material information (including the fact of the offering itself) at a time when they are not subject to a confidentiality agreement, for instance as initial indications of interest are being solicited. As a result, we believe that private placements will have to be approached carefully, unless the SEC, through its interpretive powers, provides relief to issuers.

Violations of Regulation FD

In the adopting release, the SEC takes great pains to characterize Regulation FD as an issuer disclosure rule and explains that Regulation FD is not intended to produce new duties for issuers pursuant to the antifraud provisions of the federal securities laws or private rights

• f action. To this end, Regulation FD expressly states

that a violation of Regulation FD is not deemed to be a violation of Rule 10b-5. Issuers that violate Regulation FD, however, will be subject to SEC enforcement action and to the possibility of civil money penalties, among

• ther remedies. Further, the release is silent on the

question of whether a selective disclosure violates Rule 10b-5 in appropriate circumstances. Interestingly, Regulation FD could lead to the anomalous result that a disclosure of non-public information to a market professional (presumably, the SEC’s main area of concern) results in no private right of action whereas disclosure of the same information to another outsider could form the basis of a private action under Rule 10b-5. Notwithstanding the SEC’s efforts to limit private rights of action for violations of Regulation FD, we believe that the SEC’s rulemaking initiative has focused attention on the problems inherent in engaging in selective disclosure. Further, the SEC’s hostility toward all forms of selective disclosure is likely to be adopted by the courts in analyzing private claims made under Rule

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10b-5 based on selective disclosures. As a result, we expect that companies engaging in selective disclosure will face increased scrutiny and potential liability, regardless of the applicability of Regulation FD. Accordingly, we believe that public companies should carefully review their communications policies and take appropriate steps to minimize the potential for selective disclosures to occur.

Conclusion

The effects of Regulation FD are likely to be far-

• reaching. For instance, we believe that Regulation FD

will significantly alter the nature of communications between public companies and analysts. In some ways, the changes in those relationships will be beneficial to

• investors. A public company will no longer have the

ability to "punish" analysts who publish negative comments about it by denying them access to company

• fficials. As a result, analyst reporting will, hopefully,

become more objective. In addition, we believe that the use of webcasting and open conference calls will increase dramatically, allowing investors to have first- hand access to the companies they invest in. At the same time, however, Regulation FD is likely to make issuers far more cautious about communications with

• utsiders than they have been in the past. As a result,

analysts and other market professionals are less likely to be informed about developments affecting the companies they cover or invest in and the occurrence

• f unanticipated events, such as earnings surprises,

may increase. ***********

Regulation FD is highly complex. As a result, public companies should carefully consider the requirements of Regulation FD before disclosing material information or communicating with market professionals. Should you have any questions or seek additional information regarding the application of Regulation FD, please feel free to contact Jack Hogoboom (973-597-2382), Steven Skolnick (973-597- 2475) or Mike Valente (973-597-6192) or any other member

• f our Firm's Corporate Finance/M&A Practice Group.

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