The Perils of Implied Messages for Reg FD

Annette Nazareth is a partner in the Financial Institutions Group at Davis Polk & Wardwell LLP. This post is based on a Davis Polk client memorandum by Michael Kaplan, William M. Kelly, Linda Chatman Thomsen and Janice Brunner.

The SEC recently announced settled Reg FD charges against Office Depot and its CEO and former CFO related to “signals” that Office Depot made in one-on-one conversations with analysts implying that it would not meet future earnings expectations. The Office Depot settlement, which is the SEC’s third Reg FD action in a little over a year after an approximately four-year hiatus, is distinctive because the challenged statements appear to have been crafted—unsuccessfully, as it turned out—to walk the FD compliance line by avoiding express references to changes in the company’s business.

The Communications with Analysts

As a result of softening business conditions in early 2007, and despite general cautions expressed publicly by the company, consensus estimates for Office Depot’s second quarter were still higher than internal forecasts. The CEO and CFO, in an effort to temper expectations, directed investor relations to contact each of the 18 analysts covering the company, using the following talking points:

  • “Haven’t spoken in a while, just want to touch base.
  • 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.
  • Some have pointed to better conditions in the second half of the year – however who knows?
  • Remind you that economic model contemplates stable economic conditions – that is mid-teens growth”

The predictable result of these calls was that almost all of the analysts lowered their estimates, and Office Depot’s share price significantly dropped on increased trading volume. Six days after the calls began, Office Depot filed a Form 8-K announcing to the market, among other things, that its sales and earnings would be negatively affected by the continued soft economy.

If You Can’t Say It, Don’t Imply It.

The SEC’s enforcement theory was that although Office Depot did not directly tell analysts privately that it would not meet their expectations (which would likely have been a textbook Reg FD violation), this message was “signaled” through its talking points. Aggravating factors included:

  • private calls with analysts, which carry a high degree of risk under Reg FD, and which were initiated by the company;
  • the statements were made at the end of the quarter, implying that they were based on real data rather than forecasts;
  • the direct role of the CEO and CFO in orchestrating the communications; and
  • the prompt reaction of the analysts and the market, which supports the materiality of the statements to analysts.

The Office Depot settlement is a reminder that implicit messages can be tantamount to explicit ones for Reg FD purposes, and that an overly clever approach may seem less so if the enforcement people decide to give you a call. Enforcement staff and the private bar have for many years talked about the risks of nods and winks and other forms of indirect communication. This is also a reminder that one-on-one communications with market professionals, particularly late in a reporting period, are inherently dangerous.

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