Recent SEC Enforcement of Regulation FD: Lessons to be Learned
After a temporary lull in Regulation FD enforcement activity, recent cases, including the Office Depot action, are strong reminders that the SEC remains focused on Regulation FD compliance and of the value to public companies of having Regulation FD policies, procedures and training programs.
Office Depot Violations of Regulation FD
The SEC recently settled Regulation FD charges against Office Depot and its now former CEO and CFO alleging that they provided “signals” to analysts and select institutional investors that the company would not meet earning expectations. Both executives agreed to pay civil penalties of $50,000. Office Depot agreed to pay a $1 million penalty to settle the Regulation FD matter and other unrelated charges.
The Office Depot case is notable for two primary reasons. First, after a four-year period where the SEC brought no Regulation FD actions, the Office Depot action is the SEC’s third Regulation FD case in the last 13 months, indicating renewed enforcement emphasis on this regulation. Second, the charges were not based on overt statements, but rather Office Depot personnel were accused of merely “signaling” that the company would not meet further earnings expectations without directly saying so. They achieved this by directing analysts' attention to public announcements from its competitors and its own prior investor calls, hoping to indirectly get their point across while staying within Regulation FD parameters—a compliance strategy that was clearly rejected by the SEC.
Regulation FD is designed to “level the playing field” so that all investors receive material information at the same time. To this end, Regulation FD prohibits issuers or persons acting on their behalf from “selectively” disclosing material nonpublic information to securities analysts, institutional investors, or other enumerated persons without first or simultaneously disclosing that information to the general public. There are four, limited exclusions from Regulation FD coverage, including disclosures to “temporary insiders” and those made in most registered securities offerings. Regulation FD also provides that companies can “cure” an “unintentional” disclosure by making prompt public disclosure of the information after the selective disclosure is discovered.
Office Depot Actions
On the heels of significant earnings growth in 2005 and 2006, Office Depot executives set out in early 2007 to temper what they believed to be unsustainable earnings expectations. Early in the second quarter of 2007, company officials held two public conference calls, during which they attempted to set lower earnings expectations by discussing slower long-term earnings growth and warned investors that the company was experiencing softening demand. Most analysts lowered their earnings per share (EPS) estimates based on those calls.
Before the end of the second quarter in 2007, Office Depot executives determined that the company would probably not meet even these lower earnings estimates. The company was unable to issue a press release announcing internal estimates because the analysis was incomplete. The CEO and CFO, however, agreed that they needed to communicate something to get analysts to lower EPS estimates to avoid surprising the market. To accomplish this, the CEO and CFO agreed that the company should individually contact the 18 analysts covering the company. Their strategy was two-fold. They referred the analysts to earnings announcements by comparable companies whose earnings were impacted by the slower economy, and they also referred analysts to Office Depot’s prior public conference calls in which the company had discussed softening product demand and lower earnings growth.
The CFO and other company officials prepared the talking points for calls that included the following:
- “At beg. of Qtr we’ve talked about a number of head winds that we were facing this quarter including a softening economy, especially at small end.”
- “I think the earnings release we have seen from the likes of [Company A], [Company B], and [Company C] have been interesting.”
- “On a sequential basis, [Company A] and [Company B] domestic comps were down substantially over prior quarters.”
- “[Company C] mentioned economic conditions as a reason for their slowed growth.”
- “Remind you that economic model contemplates stable economic conditions—that is midteens growth."
The plan worked. After two days of calls, 15 of 18 analysts covering Office Depot lowered their EPS estimates to a level more consistent with internal estimates. Indeed, the message being conveyed was so clear that one of the analysts contacted expressed surprise to Office Depot’s director of investor relations that the company was not issuing a press release. Nevertheless, it was not until six days after the calls to analysts began that Office Depot publicly announced that earnings would be “negatively impacted due to continued soft economic conditions.” In the interim, between the day the analyst calls began and when the company publicly announced lower earnings, Office Depot’s stock price dropped about 7.7% with increased trading volume.
The SEC Enforcement Director concluded that “Office Depot executives selectively shared information with analysts and the company's largest shareholders in order to manage earnings expectations,” which “gave an unfair advantage to favored investors at the expense of other investors and . . . is illegal.”
First, the SEC does not limit its enforcement of Regulation FD to direct statements, but views indirect guidance—“signals”—and other implicit messages as communications that can violate Regulation FD.
Second, private calls with analysts, especially at the end of a reporting period, are inherently risky under Regulation FD.
Third, the SEC charged the CEO and CFO for directing their subordinates to engage in the wrongful conduct, even though these senior executives did not personally send the signals in issue to the analysts.
Fourth, the SEC emphasized that Office Depot did not have any formal written Regulation FD policies or procedures and had not conducted any formal training on Regulation FD, implying that such formal policies and training may have been helpful in the company’s defense of the Regulation FD violations. In light of these findings, companies that have in the past adopted Regulation FD policies or procedures, and/or conducted formal training, may want to review those steps; companies that have not yet adopted Regulation FD policies or procedures, or conducted formal training, may want to consider taking such actions.
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