Interesting read on F.D.
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Fri, 02 Feb 2001, 9:54am EST
The Secret Is Out
Despite howls of protest on Wall Street, the SEC's new disclosure rule will help
investors
By Chuck Carlson Bloomberg Personal Finance March 2001
For the first time in the company's charmed life, Cisco Systems was under attack.
Wall Street had mauled virtually every other technology stock during the
Nasdaq's free fall last December. Now it was Cisco's turn. The honey that
brought the bears out in force was concern about the shaky financial condition of
some Cisco customers. The selling escalated when the company's 10-Q filing
with the Securities and Exchange Commission showed Cisco setting aside $275
million for potential losses in the fiscal first quarter, a $200 million increase from
the same period just a year earlier.
Investors bailed out, sending the stock lower by 11 percent on December 18.
The following day, in what The Wall Street Journal described as a "highly
unusual" SEC filing, Cisco released the specifics of the $275 million set-aside
that was so troubling to investors. The details were made public in what's called
an 8-K filing. The document showed that Cisco allocated only $14 million of the
$275 million for "doubtful customer accounts," corporatese for deadbeats who
can't pay their bills. While that amount was up from the $5 million in doubtful
accounts recorded in the year- earlier quarter, it represented less than 1 percent
of Cisco's more than $6 billion in revenue in the period. The bulk of the set- aside
was to cover losses in its minority investments in other technology companies
and an increase in inventory reserves.
Cisco obviously filed the 8-K with the SEC to dispel fears that many of the
company's customers were going broke. What is most noteworthy about this
incident, however, is that Cisco felt compelled to make a public filing at all.
Indeed, if Cisco had found itself in a similar position six months earlier, the
company's chief financial officer or investor relations director might have just
picked up the phone and cleared the air by providing the details to four or five
influential analysts. But those days are history.
Reg FD, otherwise known as Regulation Fair Disclosure, is the SEC's attempt to
level the playing field between Wall Street and Main Street in terms of the
information flow from corporate America. In a nutshell, Reg FD, which went into
effect October 23, 2000, says that companies can't play favorites with a few Wall
Street cronies. If a company has something to say that might affect its stock
price, it must tell everyone at the same time. The rule should ensure that no one
is privy to important news and thus able to make a profit or avoid a loss at the
expense of those kept in the dark.
The new rule is intended to end selective disclosure, the long- standing practice
in which CEOs have routinely (and legally) provided sensitive financial
information to a handful of analysts. Regardless of how it's spun by corporate
executives and the players on Wall Street, this sort of channeled leaking leads
to sanctioned insider trading. After all, is there really a difference between a CFO
telling three buddies about the earnings hit his firm is going to take in the
upcoming quarter (clearly something most people would see as illegal) and a
CFO sharing the same information with three Wall Street analysts? In one sense,
the latter infraction is worse because of analysts' proximity to the financial
markets. And understand this--analysts are, in many cases, friends of the
company executives who feed them information. They can't help but be friends.
After all, sharing secrets is a form of intimacy.
Wall Street firms will never admit that their analysts are in bed with the
companies they cover. Nor will they admit that there's anything improper about
selective disclosure, a practice that's gained an undeserved legitimacy simply
because everyone was doing it. How widespread and how tight are these
relationships? According to surveys conducted by the National Investor
Relations Institute before Reg FD went into effect, 87 percent of the group's
corporate members review draft analyst reports at the request of the analysts.
The statistic is shocking. In effect, nearly 9 out of 10 companies can sign off on
the very same research reports that are supposed to provide an unbiased
evaluation of the companies' fiscal health.
The fact is that corporate executives and the analysts covering their
performance have been extremely chummy for many years. Arthur Levitt Jr.,
recently departed chairman of the SEC, described what each party got from the
relationship: "Today, as Wall Street analysts play an increasingly visible role in
recommending stocks, some in corporate management treat material
information as a commodity--a way to gain and maintain favor with particular
analysts. What's more, as analysts become more and more dependent on the
'inside word,' the pressure to report favorably on a company has grown even
greater, as analysts seek to protect and guarantee future access to selectively
disclosed information."
In Levitt's view, each side is equally guilty. Reg FD can be read as a rebuke to
analysts that they need to work harder. One not-so- subtle theme running
throughout the entire regulation is that analysts need to get off their haunches
and start doing rigorous shoe-leather equity research. Levitt clearly believes that
unbiased, independent research performed by many individuals will lead to
more efficient markets.
The regulation is also an indictment of corporate executives' role in the selective
disclosure game. The SEC understands how companies benefit from
maintaining close relationships with analysts. Companies have information.
Analysts want information. Thus, companies share information selectively to
curry favor--and favorable reviews--with analysts. In turn, analysts write positive
reviews in order to win favor and remain in the information loop. The SEC's new
rule is aimed at stopping this cycle of secrecy and favoritism. When any private
club is forced to open its doors to the general public, its members are likely to
bellow, and the outbursts concerning Reg FD have been boisterous. Beware of
Reg FD's many unintended consequences, warn analysts and CEOs alike,
citing most frequently an increased volatility in the markets and a chilling effect
on corporate disclosure.
Will Reg FD increase volatility? The defenders of the status quo argue the new
rule raises the likelihood that companies will report information that surprises
analysts. And surprises fuel market volatility. Hold on. It's not as if there weren't
earnings surprises and huge volatility before Reg FD. What happened to the
stock of any widely followed company that surprised Wall Street last year? In
many cases, the share price fell 5, 10, or even 20 percent in a single day. And
some of these companies were followed by 10 or 20 analysts. To be sure, the
stocks may have been sliding a bit prior to the earnings surprise, as analysts in
the know (benefiting from selective disclosure) were dumping shares ahead of
the news. Still, is a 30 percent decline in five days better than a 30 percent
decline in one day? The answer: Only for people who sell early, which is why
analysts like selective disclosure.
Also, investors need to understand that a certain amount of volatility comes with
markets that are more efficient. Reg FD actually increases the efficiency of the
market, since new information is processed more quickly precisely because it is
received by all market players simultaneously. Yes, that may mean more
volatility on a single day, but at least it's volatility that affects everyone equally.
Another point about volatility: Since companies will no longer be able to provide
earnings guidance, it stands to reason that the spread in analysts' earnings
estimates will widen. More variety in analysts' expectations is a key point. If
analysts don't unite around a single earnings estimate but instead are scattered
across a continuum of expectations, an earnings "surprise" by a corporation
may, in fact, surprise fewer players. And that may actually reduce volatility in the
stock price.
Will Reg FD have a chilling effect on company disclosure? There's a lot of
confusion about what it says concerning corporate revelations and whether the
regulation will curb the flow of information. For example, many investors (as well
as analysts) would probably be surprised to know that the rule doesn't entirely
preclude selective disclosure. In fact, Reg FD has an exclusion that allows
selective disclosure "to any person who expressly agrees to maintain the
information in confidence." Thus, companies don't necessarily have to stop
sharing information on a selective basis; recipients, however, must agree not to
disclose or trade on the information.
No doubt companies will likely reexamine the ways they disseminate
information on Wall Street, which may initially limit the flow. However, companies
also realize that ultimately it is in their best interests to communicate freely and
frequently. Investors want to own companies in which they feel confident they
know what's happening. Companies that clam up will lose investors to
competitors who are willing to tell their stories. Also, a company that uses Reg
FD as an excuse to say nothing is a company whose silence may send
unintended messages to Wall Street. Remember, in some cases, Wall Street
may fear what a company doesn't say as much as what it does say. Bottom line:
The belief that corporate America will become mute due to Reg FD is hogwash.
Once companies figure out the mechanics of how to break the news in a
widespread, simultaneous fashion, the level of disclosure may actually
increase. This is especially true in more difficult markets, when it is imperative
that companies get their information out to investors.
Of course, what really matters to investors is how Reg FD will affect them. Here
are some points to consider:
SEC filings, especially 8-Ks, are now must reading. Companies will increasingly
release material information more often via SEC filings, especially 8-Ks, in order
to meet Reg FD disclosure requirements. Investors need to develop ways to
access this information as it is released.
Wall Street will place an even greater premium on earnings consistency. In a
Reg FD world, analysts will have less faith in their own earnings projections. That
means a lot more "hold" recommendations. Analysts will give "buy" ratings only
to stocks in which they have a high degree of confidence. Therefore, more
institutional money will migrate to companies with consistent records of meeting
their numbers. That favors companies in steady- growth industries (drugs, for
example) and decreases the appeal of cyclical stocks, whose earnings are
highly volatile.
The value of original research increases. In a world where the information game
is not rigged, individual investors who do their homework should be rewarded. d
Chuck Carlson, CFA, is chief executive officer of Horizon Management Services
and author of Eight Steps to Seven Figures (Doubleday). -0- (BN ) Feb/01/2001
14:53 GMT
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