04.11.2005

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Updates

In March 2005 the SEC announced its settlement of a Regulation FD enforcement action against Flowserve Corporation, the company's CEO and its director of investor relations (IR). In the Flowserve Regulation FD enforcement action, the SEC has, for the first time:

    • Asserted that a company violated Regulation FD by affirming, as opposed to announcing changes to, previous earnings guidance; and

    • Included enforcement against an IR professional.

This Update summarizes the key points of the SEC's enforcement action against Flowserve and offers practical advice.

Regulation FD

Regulation FD (Fair Disclosure) prohibits a public company from selectively disclosing material nonpublic information to shareholders or to market professionals (such as broker-dealers or analysts) before disclosing the information to the public generally. Information is material if there is a substantial likelihood that a reasonable investor would consider the information important when making an investment decision or if it would significantly alter the total mix of available information. See the SEC's Staff Accounting Bulletin No. 99 (http://www.sec.gov/interps/account/sab99.htm) for an excellent discussion of materiality.

Regulation FD distinguishes between intentional and unintentional selective disclosure.

    • Selective disclosure is "intentional" if the disclosing person knows (or is reckless in not knowing) that the information is both material and nonpublic. An intentional selective disclosure cannot be cured by subsequent public disclosure.

    • Unintentional selective disclosure may be cured by disclosing the material nonpublic information, such as on a Form 8-K or by a press release or other method that will provide broad public dissemination promptly after a senior official of the issuer becomes aware of the disclosure. Promptly means as soon as reasonably practicable and within 24 hours or the start of trading the next day, whichever is later.

In the proposing and adopting releases for Regulation FD, the SEC emphasized that earnings guidance was particularly likely to be considered material.

Trap for the Unwary

Private Reaffirmation of Earnings Guidance Is Dangerous.

Although in its interpretive guidance for Regulation FD (http://www.sec.gov/interps/telephone/phonesupplement4.htm), the SEC noted that a company can reaffirm previous earnings guidance without triggering Regulation FD, Flowserve makes it clear that this statement should be read with caution. The SEC interpretation notes that reaffirmations of earnings guidance may be considered material depending on, among other factors, how much time has passed between the public dissemination of the guidance and the private confirmation, and whether any intervening events have occurred. In light of the Flowserve action, companies should consider whether they should ever reaffirm earnings guidance privately before doing so publicly.

Flowserve Enforcement Action

In a series of publicly announced statements from February to September 2002, Flowserve reduced its full-year earnings projections by more than 30%. The company then reaffirmed its September guidance in its Form 10-Q filed on October 22, 2002.

During a private meeting on November 19, 2002, less than a month later, Flowserve's CEO responded to an analyst's question by reaffirming the company's October earnings projections. The CEO's response was contrary to the company's disclosure policy that earnings guidance was effective as of the date given and would not be updated until the company publicly announced updated guidance. Flowserve's director of investor relations, who was also present at the meeting, remained silent and did not attempt to explain the CEO's statement or reiterate the company's policy.

On November 20, 2002, an analyst who had attended the meeting issued a report highlighting the "no change" as news. The next day, Flowserve's stock rose approximately 6% on 75% greater volume. After the close of the markets, the company filed a Form  8-K with the SEC to furnish information acknowledging that the company had reaffirmed its earnings estimates earlier that week.

The SEC concluded that the CEO's reaffirmation was material information, specifically noting that Flowserve had a trend of lowering its earnings guidance during the course of 2002 (the October guidance represented a 30% decrease from the company's February 2002 guidance) and the reaction of the markets following the analyst's report. Under the settlement agreement, Flowserve and its CEO agreed to pay civil penalties of $350,000 and $50,000, respectively and, along with Flowserve's director of investor relations, were the subject of a cease-and-desist order.

Practical Tips

Hindsight Is 20/20. The SEC will carefully scrutinize with the full benefit of hindsight any discussions of earnings or projections in one-on-one meetings with analysts. The market (and maybe the analyst who publishes research) decides what is material. Although Flowserve reaffirmed information less than 30 days old, the market moved in reaction.

Enforce Your Regulation FD Policy.

Any senior officer who may speak publicly for the company should be familiar with the company's Regulation FD policy generally and its policy regarding statements on earnings guidance in particular. Companies should have a clear policy governing private communications with securities professionals or shareholders including a policy regarding reaffirmation of earnings guidance.

"IR" means "I'm Responsible" ― Know and Enforce Your Company's Regulation FD Policy. Private discussions of earnings were a core reason for the SEC adopting Regulation FD. The company's IR officer will do the CEO and other senior officers a favor by enforcing the Regulation FD policy. Script discussions with securities professionals or shareholders carefully, state the company's Regulation FD policy at the beginning of the meeting and set boundaries for these conversations, including "off limit" topics, such as statements regarding previous earnings estimates. Failure to follow an established policy makes it more likely that selective disclosure is considered intentional and therefore not curable by later public disclosure.

If a Selective Disclosure of Material Information Is Made, Speak Up and Publish, Promptly.

If a selective disclosure does occur, the IR professional or general counsel should immediately reiterate the company's Regulation FD policy, correct the statement and disseminate the material nonpublic information in a press release and/or a Form 8-K the same day. The SEC has indicated that its decision to take action against Flowserve's IR director was based on his silence following the CEO's reaffirmation.

When in Doubt, Seek Legal Counsel.

When making a decision on disclosing nonpublic information that could be material, seek advice from legal counsel. In an investigation involving Motorola, the SEC decided not to take enforcement action because the company had made a "good faith" effort to comply with Regulation FD.

Don't Lie to the SEC.

If the SEC calls, seek legal counsel and proceed honestly but cautiously. The lack of cooperation by Flowserve's CEO and IR director, specifically their initial denial that a reaffirmation had occurred, was a factor in the enforcement action.

Additional Information

This Update summarizes the key points of the SEC's enforcement action against Flowserve. You can find the SEC's announcement of the settlement at http://www.sec.gov/news/press/2005-41.htm and a description of previous Regulation FD enforcement actions at http://www.perkinscoie.com/content/ren/updates/corp/RegFD.htm. You can find discussion of other topics of interest to public companies on our website.

 

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