Investor relations officers routinely face communications issues triggered by major corporate events, such as acquisitions or disposals, significant new contracts, strikes, the loss of a major customer or supplier, or a runaway jury verdict. Proper communication of such events requires attention to important business factors, such as customer or employee relations, that may affect the desirability, form and timing of public disclosures. But such events also raise important legal issues, impacting the company’s obligations to file reports with the SEC, its ongoing relations with securities analysts, its ability to buy and sell company securities, and corporate insiders’ freedom to buy and sell securities.
Because every fact pattern is unique, experienced securities counsel should always be consulted on disclosure. And IROs should understand the legal issues so they can participate fully in the decision-making process as well as the execution of the disclosure plan.
Material developments
The first question is often the toughest: What constitutes a true big event, ‘a material development’? Under securities laws in the US this comes down to whether a particular development would be viewed by a reasonable investor as having significantly altered the mix of available information. Some developments are easy to categorize as material or not. But myriad transactions fall into a gray area, from the sale of a division to the serious illness of an executive officer.
The company must evaluate the materiality of each event as it arises and re-evaluate as developments unfold. What is immaterial one quarter may well be material later – and vice versa. Because the impact of being wrong can be so negative, lawyers tend to err on the side of giving conservative advice, in favor of the development being material.
Once a development is judged material, the company has to determine when it must be disclosed to the public. The basic principle is that the timing of the disclosure is defined by the company’s obligations under stock exchange requirements, by the registration of securities for public offering, or by the SEC’s requirements for periodic reports.
Exchange rules
Under NYSE or Nasdaq rules, many material developments must be disclosed immediately by a broadly-disseminated press release. Examples include annual and quarterly earnings, dividend announcements, mergers, acquisitions, tender offers, stock splits and major management changes.
Typically, press releases are issued either before the opening of trading or shortly after the close to avoid disruption in trading. But more urgent news, such as a tender offer, may – and often must – be released during trading. Some IROs believe all releases should go out during the day to avoid favoring traders in the after-hours market.
The violation of the exchange listing rules themselves usually would not give rise to criminal sanctions or private lawsuits, but in egregious cases can result in the exchange delisting the company’s securities. It is becoming common practice to follow up a press release by filing it as an attachment to an 8k report filed with the SEC to ensure inclusion in the company’s public disclosures.
Immediate disclosure is also required if the company has a live registration statement and is actively distributing securities to the public. Merely issuing a release will not suffice; the information must be added to the offering documents filed with the SEC. For many larger companies, this can be achieved through incorporation by reference to an 8k report.
When immediate disclosure is not required, the material development will need to be included in the next appropriate periodic report, with the timing dependent on the nature of the development. 10q quarterly reports contain only a few specified disclosures – financial statements, management’s discussion and analysis (MD&A), and legal proceedings – while the 10k annual report is more extensive. Thus changes in benefit plans typically are only discussed once a year, in the 10k and proxy statement, while material developments in legal proceedings are required to be updated quarterly.
Forward-looking MD&A
The most interesting disclosure issues arise with the MD&A, mandatory in each quarterly and annual report and each registration statement. The MD&A requires forward-looking disclosures of the impact of any ‘trend, event or uncertainty’ unless management can reasonably determine that the matter either is unlikely to occur or, assuming it does occur, is unlikely to be material to the company’s operating results, liquidity or financial position. So it’s vital all senior managers participate in creating the MD&A.
What happens if a disclosure proves to have been erroneous? In general, the company is obliged to correct these. So, for example, if an earnings release misstates results, the company must correct the release if the misstatement was material. Only trivial errors may safely be ignored.
What if an earlier statement was correct when made but subsequent events have changed the results? Most practitioners believe there is no duty to correct a prior statement unless it is a statement that investors could reasonably rely on as a continuing current statement of the company.
For example, a statement in January that ‘we plan to open 100 new stores this year’ probably does not need to be corrected if subsequent events make the new year less promising – unless the statement is ‘reissued’ through a subsequent distribution (the company probably will still want to update the information so the market is not disappointed later on). However, a statement made in a 10q MD&A projecting the year’s capital expenditures, when subsequently incorporated into a new registration statement, must be updated if material and no longer true.
Less certain under current law is the situation where the company makes a projection in September that is known by December not to be achievable. But even if there is no duty to update the projection, most sophisticated companies will try to correct perceptions. The cliche ‘the Street hates surprises’ governs.
Analyst maze
Securities analyst relationships frequently present disclosure issues. Telling an analyst about a material development before public announcement is ‘selective disclosure,’ and can create serious liability for the company and its officers. The SEC has been sending particularly clear signals lately about its concern with this practice.
The subject most often comes up in the context of quarterly analyst calls following an earnings release. If, during the call, management inadvertently tells the analysts about an undisclosed material development, the company must immediately issue a release to minimize the length of time during which the selective disclosure has time to affect securities trading.
To avoid the peril, the company should establish clear policies on dealing with analysts, which should at the minimum include the following: speak through a single, trained spokesperson; brief that person on all material developments; have a scripted and rehearsed response for all likely questions; know what has been said in the past; and have a press release prepared in case inadvertent disclosure occurs.
Company insiders privy to material non-public information are subject to an absolute prohibition against trading in the public markets while it remains undisclosed. Doing so can result in SEC enforcement actions against the individual, resulting in losses and legal costs that far outweigh any trading profits. Incidentally, the company’s trading activities in its own shares, whether by tender offer or open-market repurchase programs, must also stop while it has knowledge of non-public material developments. Under the Federal securities laws, the company and its senior management may also be liable for insider trading by its employees or agents if the SEC can demonstrate they failed to take steps to avoid it.
Of course, the biggest problem with any policy designed to prevent insider trading is that someone must make the determination of whether there is or is not material inside information. Given the extreme penalties, the cost of litigation and the embarrassment of headlines about employees snared in the SEC’s net, most companies choose to favor caution: when in doubt, don’t permit the trade.
To summarize, Investor relations officers should become alert to potentially material developments that may be required to be disclosed under exchange rules, or in registration statements and periodic reports. The occurrence of a material development may also affect what the company can say to analysts, shareholders or others. And the occurrence of a material development requires the company and its insiders to withdraw from all market activity until all of the news is properly disseminated.
David Porter is a partner in the Cleveland office of the international law firm, Jones Day Reavis & Pogue
