Regulation evolution

Having left his government job, former SEC chairman Arthur Levitt can once again actively invest. In doing so, he can peruse plain English prospectuses, view Edgar filings online, listen to analyst conference calls via the web and be reasonably assured he’s up-to-date on news. He may be somewhat less sure if he can trust auditors. Overall, however, he’ll be pretty confident in ‘the system’ (of course, only his broker will know for sure).

Similar trust by the American investing masses has made US equity markets the largest, deepest and most liquid in the world. That trust, many argue, has been engendered largely by a regulatory framework based on the premise that full and fair disclosure of a company’s business and financial status produces an honest market.

And, of course, not all disclosure is mandatory. Companies can gain lots of IR credibility by voluntarily disclosing a range of information – from performance measurements used to run the business to data about intangible assets not recognized in financial statements – on the premise that the more useful information investors have, the lower the company’s cost of capital.

Annuals and quarterlies, Form This and Regulation That. Investors clamoring for ever more information. Most IROs are intimately aware of the ever more complex striptease of disclosure requirements and restrictions. How did we get in this position?

1929: Crash sparks change

Widows and orphans lose their shirts – and faith in the fairness of US securities markets. Financial reporting said to lack credibility and standardization. Typical offering circulars ludicrously inadequate, containing little or no financial information or facts relating to the use of the proceeds. Thin people asking dangerous questions.

Response: Consensus emerges that the economy will recover once public faith in capital markets is restored. Restoration arrives via a raft of financial regulation including, in 1933, the Securities Act (or, Truth in Securities Law), ‘To require that investors are provided with material information concerning securities offered for public sale; and to prevent misrepresentation, deceit, and other fraud in the sale of securities.’

The Securities Act sets many registration requirements but it is only the following year with the Securities Exchange Act that a central authority is created – the Securities and Exchange Commission. The 1934 Act also regulates proxy solicitation and the information shareholders get with their proxies.

Previously, state securities laws (and most foreign laws) require a ‘merit’ test for registration. The state laws are known as ‘Blue Sky’ laws since, according to state securities laws specialist Richard Alvarez with Orrick Herrington & Sutcliffe, ‘Nothing but the blue skies of Kansas’ backed up the pretty but worthless paper swindlers peddled in the back roads of that state. The new ‘sunlight theory of regulation’ assumes that if investors are given all necessary information they will make wise decisions. It’s been said Congress did not deny a citizen his inalienable right to make a fool of himself. It simply attempted to prevent others from making a fool of him.

Effect: Wall Street less than thrilled with the new regulatory framework. Complaints subside, however, when former NYSE president Richard Whitney is jailed for dipping into the exchange’s pension fund.

Given wide discretionary authority, the SEC goes on to promulgate a slew of regulations. Investors go on to buy trillions of dollars worth of securities.

1980: MD&A intangibles

Through the 1960s, the SEC confines filed information exclusively to hard, objective ‘facts’, excluding forward-looking, subjective ‘soft’ information. Concerned about issuers hyping their stocks, the staff zealously seeks predictive meaning in relatively bland statements. But soft information, written and oral, oils securities markets.

Response: In the 1970s, the SEC allows ‘soft’ projections and creates a ‘safe harbor’ to encourage forward-looking information. This is not, however, required and the safe harbor provisions are largely ineffective.

Then, in 1980, the SEC adopts the Management Discussion and Analysis requirement. ‘It’s one thing to throw a bunch of numbers at you,’ notes Brian Lane, former head of the SEC’s corporation finance division and now a lawyer with Gibson Dunn & Crutcher. ‘It’s another to put it in context – here’s where we’ve been, here’s where we’re going. MD&A was precipitated by more calls for information on trends and uncertainties. The thought was soft information should be shared with the world.’

Effect: It’s a 180-degree turnaround by the SEC. Whereas soft information – particularly a rosy projection – was once banned, the SEC now requires filings to contain lots of soft and forward-looking information. A 1989 interpretive release makes it still clearer.

1982: Integration

For 50 years, the SEC takes the position that the differing objectives of the 1933 and 1934 laws made it difficult to implement common disclosure requirements. Each form has its own disclosure requirements and confusion reigns when different forms have different definitions (eg ‘issuer’, ‘executive officer’).

Response: In 1982 the SEC eventually adopts an integrated disclosure system, calling it Regulation SK – a blend of letters in 1933 and 1934 forms. Registration forms are streamlined and contain consistent definitions and disclosure requirements.

Effect: Lower legal bills trying to figure out how to fill out forms. Once assailed by confused investors, IROs no longer blame SEC for inconsistencies in their company disclosure documents.

1983: Edgar

Forests felled to provide paper SEC disclosure filings. Investor access difficult and expensive. The future was then when investors began frequenting SEC-designated reference rooms in the 1970s ‘microfiche era’. Technology marched on.

Response: In 1983, the Commission begins developing an Electronic Data Gathering and Retrieval (Edgar) system. A decade later, electronic filing becomes mandatory. In 1996, an ocean of information becomes publicly available with all SEC filings posted on its searchable web site.

Effect: Paper filings are history. Forests are spared. Revolutionary democratization for investors. A cottage industry of Edgar value-added web providers springs up.

1995: Safe harbor reform

While everyone wants ‘soft’ information, IROs remain loath to say anything not explicitly protected. By the early 1990s, corporate America is plagued by class-action suits from ‘predatory’ attorneys seeking a settlement rather than a jury verdict.

Response: In 1995, Congress passes the Private Securities Litigation Reform Act which beefs up ‘safe harbor’ protections for company executives making ‘forward-looking statements’ if accompanied by ‘meaningful cautionary language’.

Importantly, the law also requires plaintiffs to prove incorrect forecasts have been purposely misleading. ‘To win a lawsuit, plaintiffs would have to prove that management had actual knowledge that their forward-looking statement was false,’ notes Joel Seligman, dean of the Washington University School of Law and a renowned securities law expert. ‘The actual knowledge requirement is a much higher culpability standard than recklessness.’

Effect: Critics fear that with fewer civil remedies, confidence in the market will erode and executives will stretch the truth. The SEC reports in 1997 that the new law has had little effect on disclosure. While momentum is slow to gain, a Stanford School of Business study indicates the Act’s passage has led to increased and more detailed forward-looking disclosures that are no more optimistically biased than those issued previously. While ‘the race to the courthouse’ has slowed, investors still sue, but more cases are being dismissed rather than being settled for millions outside court.

1998: Aircraft Carrier

By the mid-1990s, a growing din rises from lawyers and Congress declaring that securities rules are outdated and a whole new system is needed to streamline capital raising and compete in global markets.

Response: In November 1998, the SEC publishes its vast Aircraft Carrier release proposing new registration forms for securities offerings by US and foreign issuers. It would also expand the types of communication issuers and underwriters could use before or during public offerings. Notably, the ‘quiet period’ would be ditched. Also permitted would be immediate public offerings by ‘seasoned’ issuers without having to register securities ahead of time on a ‘shelf’ basis.

Effect: Securities industry opposition forces the Aircraft Carrier to sail back to port for repairs. Some observers suggest it was unwise to cover the entire waterfront with the Aircraft Carrier, rather than focus on narrower problems. However, in light of recently enacted Regulations FD and MA, the SEC will likely re-float many of its communications aspects. Regulation MA allows free communications during M&As. ‘To be consistent, similar rules should be applied to capital raisings,’ says Brian Lane.

1998: Plain English

Impenetrable, legal techno-babble, suffocating prospectuses and other documents. Investors can’t understand what they are buying. SEC Chairman Levitt, not a lawyer, can’t understand either. SEC rules traced back to the 1969 Wheat Report require documents written in clear fashion but are forgotten and not enforced. The securities bar, insulted by intimations their prose is unreadable, argues plain English will expose clients to risk. ‘They thought by being clear, they might be misleading,’ comments Erik Sirri, a finance professor at Babson College and former SEC chief economist.

Response: In early 1998, the SEC’s ‘Plain English’ handbook published. Rule in effect later that year.

Effect: SEC strictly enforces plain English in prospectuses. Jargon and complex constructions rarer. Formerly grazing in rough pasture, investors and media applaud the new initiative. So do boards of directors. Billing rises from grumbling lawyers trying to write plainly. They ask IROs how to do it. Companies start using plain English in all sorts of documents. ‘People come to me all the time with complaints about the SEC,’ remarks Brian Lane, who helped push through the rule. ‘No-one ever complains to me about plain English.’

1990s and beyond: New media

New media: a reality. Everyone wants to post offering and other documents on the internet.

Response: Overall, the SEC embraces internet technology in facilitating corporate use as well as discharging its own responsibilities. Traditional disclosure requirements have been tailored for the new technology but not discarded. ‘The spirit has been to get more information to more people faster,’ says Babson’s Sirri.

Effect: Corporations rapidly expand internet use to fulfill SEC disclosure requirements and communicate with shareholders and other stakeholders. As investors become more computer literate, the costs for companies using the internet for annual reports, proxy statements, tender offer documents and the like, are reduced. Still, companies that once spent a bundle turning their annual report into a marketing piece, now spend a bundle turning their corporate web site into an IR resource. The printed annual report remains a critical communications tool and annual report designers learn web skills.

2000: Regulation FD

Where once institutional money called the tune, new technology empowers retail investors and changes the tenor of capital markets. Individual investors often note wild price moves in their stocks while only later getting access to the information responsible for the move. Once again, they wonder if Wall Street stacked the odds. Spurred by the media, thousands complain to the SEC about selective disclosure and receive a favorable ear from its populist chairman.

Commentators such as Niri and the Securities Industry Association express concern that proposed regulations will ‘chill’ casual contacts and actually result in less disclosure. Still, many wonder how this kind of selective disclosure has been tolerated at all.

Response: Following heated debate and compromise, the SEC enacts Regulation FD (fair disclosure) in October 2000. Issuers now must publicly disclose any material information to all audiences at once.

Effect: The symbiotic relationship between companies and analysts is altered. Issuers rarely review and revise analysts’ models. Much of the ‘gamesmanship’ is removed from quarterly earnings projections. Analysts are forced to work harder on their estimates and other research. The focus on earnings remains but whisper numbers all but disappear following strict SEC enforcement. For their part, institutions, who once could count on news about earnings updates, remain unimpressed. IR with analysts and large investors often strained. Despite warnings of a ‘chill’, companies don’t clam up. The market sees a deluge of earnings warnings – presumably because firms are not selectively disclosing or ‘guiding’ the market down slowly. With everyone reacting to news at once, volatility is exacerbated.

The web becomes even more important in the disclosure process. CEOs still brief their financial analysts, but interested investors of all kinds now listen in via phone or webcast. That which was once whispered confidentially to analysts is now part of public communication and calls become more detailed. Conferencing companies gear up for streaming internet webcasts. ‘We see significant interest by investor relations professionals in the use of web streaming technology,’ notes Michael Edwards, global sales director at conferencing provider Genesys. ‘It is a cost efficient method for complying with Regulation FD requirements.’

Meanwhile, despite IROs being forced to strictly control communications, investor conferences hosted by brokers remain mostly invitation-only. Executives still make exclusive comments. Analysts continue to proffer what passes for advice. Whether companies will take a cautious approach and release less information remains in question.

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Andy White, Freelance WordPress Developer London