Remember Regulation FD? No one else seems to.

With increasing frequency, email blasts and update research reports are sent out to institutional equity investors that appear on the face to break the spirit, if not the letter, of Regulation FD (and its Canadian cousin).

Nortel and Air Canada are two high profile Canadian cases that stand out in my mind where “selective disclosure” led to major strife for all involved. Back in 2000, Oslers LLP put out a good summary that outlines why tighter rules were coming:

In its proposing release for Regulation FD the SEC expressed concern that “if corporate managers are permitted to treat material information as a commodity that can be parcelled out selectively, they may delay general public disclosure so that they can selectively disclose the information to curry favour or bolster credibility with particular analysts or institutional investors”. The SEC further noted:

“We are greatly concerned by reports indicating a trend toward less independent research and analysis as a basis for analysts’ advice, and a correspondingly greater dependence by analysts on access to corporate insiders to provide guidance and ‘comfort’ for their earnings forecasts. In this environment, analysts are likely to feel pressured to report favorably about particular issuers to avoid being ‘cut off’ from access to the flow of non-public information through future analyst conference calls or other means of selective disclosure. This in turn raises concerns about the degree to which analysts may be pressured to shade their analysis in order to maintain their access to corporate management.”

In practice, managers of public companies must be careful not to tell one analyst (or a conference of select portfolio managers) anything about their business that would likely be of interest to all investors and had not been otherwise disclosed; or available to all via a simultaneous webcast, for example.

At least that’s the theory.

I pasted one 2009-vintage research report below that serves as an example of what is now almost commonplace in certain corners of the brokerage world. At least 10% of daily research updates (excluding quarterly results blasts) are based upon a “live eye” corporate perspective; something the research analyst has gleaned from direct discussions with the public company’s management, a site visit, etc.

The language will be different, but it usually goes like this: “just got off the phone with ABC Co. management, and this is what they said.”

I’ve removed the identifier since I don’t want to single out the company or the analyst in question, but the report serves as a perfect example of this trend back to the days of pre-Regulation FD. It is indicative, and not unique:

“We met with ABC Co’s CEO…. Here are the highlights of the meeting:

• The US budget stimulus will fund approximately US$6 billion in XXX purchases, with 50% of the funds to be obligated by Sep 2009 (balance by Mar 2010).

• This will accelerate the exercise of existing options and hence the Company expects significant conversion in 2H/09. In this context,
management is totally focused on improving operational efficiency and dealing with bottlenecks.

• Current capacity is XX units per week and is ramping up to YY units. Management expects it can increase capacity by an additional ZZ units (AA units per week) without any material investment.

• Management is primarily focused on organic growth but is still interested in acquisitions in adjacent markets in the mid to longer term.

• Negotiations with the Union are on track and management expects a successful outcome.”

In one blast, we now know:

– the second half of the year will be strong for this company;
– the Obama Administration’s stimulus plan will help drive that revenue;
– widget production is increasing (which will increase revenue versus recent quarters);
– collective agreement negotiations with the union are going well, and no strike is expected.

Research Analysts have a tough job, and institutional portfolio managers pay a lot less to trade shares than they used to (maybe 2 cents/share vs. 5 cents 10 years ago). The brokerage business is no less competitive than ever, so analysts need to reach if they want to get the attention of their institutional clients. Reaching often requires unique product, which means channel checks, customer calls, demos, proprietary IP lawsuit research, etc. Most of all, industry competition puts pressure on the analyst to be in constant contact with their companies. And, if you find out something newsworthy, you must hit the keyboard immediately.

Getting your client the exciting, new datapoint on their portfolio holding is as important as a journalist being the first to break the news. But when does it cross the line and run afoul of Regulation FD? The rules are so subjective that anything interesting discussed between an analyst and a CFO could be called “selective” disclosure; even if it was only interesting with the benefit of hindsight.

Valerie Peck’s brutally unfair experience at Air Canada may no longer be at the forefront of folks’ minds, and there’s been sufficient turnover on Bay Street that some of the scars of the past may have been forgotten. In that case, she read a script that was said to have been reviewed by her outside lawyers, but that didn’t matter to the Ontario Securities Commission.

My fear is that someone, somewhere, will wake up one morning and find out they’re going to be made an example of by a regulator. Just like in the post-NASDAQ meltdown era. And it would be a shame if it were the research analysts, once again, who are generally the worst paid bunch of professionals at most brokerage firms (as compared to i-bankers, institutional salespeople and block traders).

Remarkably, more research analysts were pursued by the SEC this decade for their role in the tech wreck, than i-bankers who designed and structured the MBS/CDO/CLOs that laid to rest the U.S. brokerage industry and forced those who didn’t go bankrupt to turn themselves into commercial banks (GS, MS).

But justice isn’t always about fairness, and brokerage firm Compliance Departments need to reconsider these missives to understand if their analysts are sliding down the slippery slope.

Before someone gets hung from the yardarm.

MRM