On October 21, the SEC announced the settlement of an enforcement action in which it charged Office Depot, Inc. and the company's chief executive officer and former chief financial officer with violating Regulation FD, or "Fair Disclosure," by selectively disclosing to analysts and institutional investors that the company would not meet analysts' earnings estimates. The SEC alleged that the company and the two executives had violated Regulation FD by "signaling," rather than expressly stating, that the company would not meet those estimates. The SEC's press release and complaint can be found at the SEC's website at www.sec.gov through the Litigation web page.
In another Regulation FD development, as mandated in the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC has repealed an exemption from Regulation FD formerly available for the disclosure by companies of material nonpublic information to credit rating agencies. The exemption had applied to credit rating agencies that make their credit ratings publicly available and to nationally recognized statistical rating organizations, including Moody's Investors Service, Inc., Standard & Poor's Ratings Services, and Fitch Ratings. The repeal of the exemption, which was effective on October 4, is described in Release No. 34-63003.
Regulation FD prohibits the selective disclosure, by companies and persons acting on their behalf, of material nonpublic information to securities market professionals and holders of the company's securities who reasonably can be expected to trade on the information. To promote its purposes, Regulation FD requires (1) simultaneous communication to the public of "intentional" disclosures of material nonpublic information made to a covered recipient, and (2) "prompt" communication to the public of "non-intentional" disclosures of such information after a senior official discovers the disclosures and realizes (or should realize) that the information was material and nonpublic. The methods of public disclosure must be "reasonably designed to provide broad, non-exclusionary distribution" of the information to the public. The methods may include disclosure in a Form 8-K report or other SEC filing, or through another method or combination of methods, such as a widely disseminated press release coupled with a conference call that is adequately publicized in advance and open to the public.
Office Depot enforcement action
The SEC has now brought ten enforcement actions under Regulation FD since its adoption in 2000. In its most recent enforcement action, the SEC charged violations of Regulation FD by Office Depot, Inc., an office products supplier listed on the New York Stock Exchange, and the company's chief executive officer and former chief financial officer. The SEC's complaint alleged that Office Depot selectively disclosed material nonpublic information to analysts and institutional investors in late June 2007 in an effort to "talk down" analyst estimates of the company's earnings per share (EPS) for the 2007 second quarter.
As described in the SEC's complaint, Office Depot's CEO and CFO decided to approach analysts covering the company after several months of increasing concern that the company's EPS results might fall short of analyst estimates. As a matter of company policy, Office Depot did not offer specific quarterly earnings guidance during the relevant period. In a publicly broadcast earnings conference call in February 2007, the CEO and CFO indicated that the company's business model contemplated EPS growth in the mid-to-upper teens over the long term. In another public conference call in April 2007, they warned investors that the company's largest business segments were facing a softening in demand that was continuing into the second quarter. In early May, shortly after the publication by analysts of lower EPS estimates for Office Depot, management reiterated these two messages at a publicly available investor conference.
On May 31, 2007, the CEO informed the board of directors that the company likely would not meet the consensus analyst EPS estimate of $0.48 per share for the second quarter, and that senior management was considering a strategy for advance communication of earnings to avoid an earnings surprise to the market. In early June 2007, the CFO instructed the director of investor relations and his supervisor to prepare a draft press release previewing second quarter earnings information. By mid-June 2007, some of the company's preliminary internal estimates forecast EPS of up to $0.44 for the quarter, which was $0.04 below the consensus analyst estimate. The CEO and CFO, however, decided not to announce publicly their internal estimates because those estimates remained incomplete.
On June 20, 2007, ten days before the end of the quarter, the CEO and CFO discussed how to encourage analysts to revisit and lower their EPS estimates for the company. The CEO proposed referring the analysts to recent earnings announcements by comparable companies that recently had publicly announced results which they said were affected by the slowing economy, and reminding the analysts of the cautionary statements about future earnings the company had made in the April and May calls. The SEC's complaint alleges that the two officers jointly decided to pursue this approach and that the CEO believed that if the analysts looked at Office Depot again in light of the planned communications, they likely would lower their EPS estimates.
The CFO, the director of investor relations and the IR director's supervisor drafted talking points based in part on the CEO's suggestions for use as a guide for discussions with analysts, which were to be conducted in "one-on-one" telephone calls. The scripted calls were to be prefaced by the IR director's statement that he wanted "to touch base" with the analysts, and were to include comments such as the following: "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." Another talking point would recall the company's earlier public statement about its expected EPS growth: "Remind you that economic model contemplates stable economic conditions – that is midteens growth."
On Friday, June 22, 2007, and the following Monday, June 25, 2007, the IR director spoke individually with all 18 analysts covering Office Depot and reviewed the talking points with each. The SEC noted that Office Depot did not regularly initiate calls of this type to all analysts covering the company. Word of the calls quickly spread among analysts, some of whom expressed the view that Office Depot was "talking down" analysts' earnings estimates. The calls apparently influenced many of the analysts to lower their EPS estimates for the second quarter, and 15 of the 18 had done so by the end of the second day of calls. When informed during the weekend between the first and second day of calls that the IR director had spoken to most of the company's analysts and that two had already reduced estimates, the CEO allegedly responded positively and encouraged continuation of the calls. The following Monday, the CEO urged the IR director to pursue additional conversations with analysts after reviewing an update on the calls that showed that the consensus analyst EPS estimate had declined only to $0.46.
The SEC highlighted in the complaint that on Friday, June 22, the IR director informed the CFO that one analyst had expressed concern that Office Depot had not publicly disclosed the information communicated on these calls, and that another analyst was informing his customers that he expected Office Depot's earnings to be down based on his call. On the following Monday, the IR director notified the CFO that another analyst had informed the director that the analyst and several of his clients were surprised at the absence of a press release. Late on Monday evening, the CFO instructed the IR director to call the company's top 20 institutional investors and relay the same talking points to them, which the director did the following day.
On June 28, 2007, six days after the calls to the analysts began, Office Depot filed with the SEC after the close of the market a Form 8-K report disclosing, among other things, that the company's earnings would be "negatively impacted due to continued soft economic conditions." Between June 22 and the last market close before the Form 8-K filing, the company's stock price had dropped by 7.7% on increased trading volume.
In the SEC's press release announcing the enforcement action, the director of the SEC's Division of Enforcement stated that the Office Depot executives "selectively shared information with analysts and the company's largest shareholders in order to manage earnings expectations," therefore providing "an unfair advantage to favored investors at the expense of other investors." The SEC's complaint noted that, although the CEO and CFO had not made the calls resulting in selective disclosure, both executives had encouraged the calls and both were aware of the decline in analyst EPS estimates while the calls were being made. In addition, the CFO assisted in preparing the talking points for the calls and was notified of the concern over lack of public disclosure expressed by some of the analysts. The company, its CEO and the now-former CFO settled the SEC actions without admitting or denying the SEC's allegations and consented to the entry of an administrative order requiring each to cease and desist from committing or causing any further violations of Regulation FD and Section 13(a) of the Exchange Act. The company also agreed to pay a $1 million civil penalty, while the two executives each agreed to pay a $50,000 civil penalty.
The Office Depot enforcement action offers a number of important compliance lessons:
- "One-on-one" discussions with analysts and security holders are inherently risky. The Office Depot enforcement action, like some earlier SEC enforcement actions, highlights the dangers to companies of permitting their representatives to engage in one-on-one discussions of financial results with securities market professionals and holders of the company's securities. In its Regulation FD adopting release, the SEC warned that "when an issuer official engages in a private discussion with an analyst who is seeking guidance about earnings estimates, he or she takes on a high degree of risk under Regulation FD." As shown by several SEC enforcement actions under Regulation FD, this warning is not to be taken lightly. For example, in November 2002, the SEC charged that Raytheon Company and its CFO violated Regulation FD by disclosing quarterly and semi-annual earnings guidance to analysts in private telephone calls. In another situation, involving Motorola, the SEC issued a report of investigation finding that the company had improperly disclosed in private telephone calls with selected analysts material information concerning the interpretation of a company announcement that it was experiencing a "significant weakness" in sales and orders.
- Company officials may incur a heightened risk of a Regulation FD violation if they address earnings estimates near the end of a fiscal period. The timing of Office Depot's calls to analysts may have been one focus of the SEC's enforcement interest. In its complaint, the SEC noted that Office Depot's CEO and CFO met ten days before the end of the 2007 second quarter to discuss how they might encourage analysts to revisit and lower their EPS estimates for the quarter, and then directed execution of the communications plan over the next few days. The SEC staff's interpretive advice under Regulation FD indicates that discussions of earnings forecasts by a company with analysts or security holders near the end of a fiscal period may be deemed to convey information about the company's actual, rather than expected, performance for the period, potentially resulting in improper selective disclosure of material information above and beyond the original forecast.
- Information may be selectively disclosed in violation of Regulation FD by "signaling" as well as by direct statements. In his conversations with analysts, the IR director of Office Depot never expressly stated that the company did not expect to meet analysts' EPS expectations. The SEC, however, indicated that indirectly communicating material information in a nonpublic manner is no more permissible than directly communicating the information. The SEC emphasized in its press release that "talking Wall Street down from its earnings projections whether done expressly or through signals is prohibited." On this basis, the SEC alleged that Office Depot violated Regulation FD even though it had communicated lower EPS expectations by reference to information already in the public domain.
- Formal Regulation FD training is an important feature of an effective compliance program. In its complaint, the SEC noted that while the Office Depot general counsel had occasionally distributed guidance and updates on Regulation FD to company officials, the company "did not have written Regulation FD policies or procedures at the time [and] had also never conducted any formal Regulation FD training prior to June 2007." The reference to Regulation FD training echoes statements on the importance of training made by the SEC in its 2009 enforcement action against the CFO of American Commercial Lines, Inc., which was noteworthy as the first Regulation FD enforcement action in which the SEC chose not to institute an action against the company whose employee was charged with a violation. The SEC in the earlier action highlighted the company's "environment of compliance," which included a program for training employees regarding the requirements of Regulation FD, as an important consideration in deciding not to charge the company.
Hogan Lovells US LLP acted as counsel to Office Depot and American Commercial Lines in connection with the matters discussed above.
Repeal of Regulation FD exemption for credit rating agencies
Effective on October 4, the SEC amended Regulation FD to repeal an express exemption for disclosures to credit rating agencies that make their credit ratings publicly available and to nationally recognized statistical rating organizations (NRSROs). The amendment was mandated by Section 939B of the Dodd-Frank Act.
It is questionable whether the elimination of the exemption will have a meaningful impact on the interaction of public companies with NRSROs. As explained above, Regulation FD applies only to the selective disclosure by companies of material nonpublic information to specified covered persons, including investment advisers and other securities market professionals. NRSROs, a category that includes all of the major credit rating agencies, were formerly investment advisers within the meaning of the Investment Advisers Act of 1940. The Credit Rating Agency Reform Act of 2006, however, removed NRSROs from the definition of "investment adviser" under the Investment Advisers Act, thereby eliminating them from the Regulation FD covered persons group.
Companies may address any uncertainty they have concerning the Regulation FD status of NRSROs by seeking to rely on the exemption in Regulation FD for material nonpublic information conveyed to a person who agrees to maintain the information in confidence. Moody's and Fitch Ratings are among the NRSROs that have stated they will consider entering into confidentiality agreements or including confidentiality provisions in their agreements with companies that request them to do so.