Implicit Communications and Enforcement of Corporate Disclosure Regulation

Ashiq Ali is the Charles and Nancy Davidson Chair in Accounting at the Naveen Jindal School of Management, University of Texas at Dallas; Jill Fisch is the Saul A. Fox Distinguished Professor of Business Law and Co-Director, Institute for Law and Economics at the University of Pennsylvania Law School; and Hoyoun Kyung is an assistant professor at the Trulaske College of Business at the University of Missouri. This post is based on their recent paper.

Corporate disclosure regulation and enforcement attempt to regulate the information publicly-traded corporations disseminate into the market. Although the federal securities laws focus primarily on explicit quantitative disclosures, corporations and corporate officials also make extensive use of implicit communications—qualitative information, tone and non-verbal cues. Thus, it is important to understand the extent to which information is communicated in an implicit manner. One of the key sources of implicit communication is private meetings in which there are only a select few market participants, providing the attendees with an opportunity to observe not just what is said, but how it is said. The scope of potential liability exposure that corporate officials face for such private communications has a critical effect on the effectiveness of corporate disclosure regulations in regulating implicit communications.

In our paper, we examine this issue in the context of Regulation Fair Disclosure (FD), which prohibits publicly-traded companies from disclosing material non-public information selectively. Specifically, we analyze empirically the effect of the federal court’s 2005 decision in SEC v. Siebel Systems on managers’ selective disclosure to financial analysts. Using a variety of tests, we provide evidence consistent with the conclusion that the court’s ruling led to a statistically and economically significant increase in selective disclosure. We posit that the market viewed the Siebel decision as a signal that the SEC could not effectively enforce Regulation FD against corporate officials who privately communicated information through positive or negative language, tone, and non-verbal cues.

The Securities & Exchange Commission (SEC)’s 2000 adoption and subsequent enforcement of Regulation FD provides a good empirical setting to evaluate the effectiveness of regulating implicit communications. At the time of Regulation FD’s adoption, the SEC was firmly of the view that managers could violate Regulation FD not just by what they say but also by how they say it. As Richard Walker, then-Director of the SEC Division of Enforcement explained, “selective disclosure of earnings information cannot come in the form of indirect guidance, the meaning of which is apparent though implied.” Subsequently, in 2002 and 2003, the SEC brought two enforcement actions against firms that it believed selectively disclosed non-public information through implicit communications. Both actions were resolved through settlement, so they did not involve judicial evaluations of the conduct at issue.

The SEC’s approach to addressing selective disclosure made through implicit communications was challenged, however, when in 2005 the U.S. Federal District Court for the Southern District of New York dismissed a civil lawsuit brought by the SEC against Siebel Systems, Inc. for violation of Regulation FD. The SEC alleged that Siebel CFO Kenneth Goldman selectively disclosed material non-public information by using positive statements and tone in private investor meetings. Rather than focusing on Goldman’s tone, the court focused on a close reading of the text of the official’s statements rather than the official’s tone and concluded that the SEC had been too demanding. In particular, the court reasoned that Goldman’s private disclosures were “equivalent in substance to the information publicly disclosed [by the company].” The court’s ruling in Siebel Systems revealed the difficulty associated with enforcing corporate disclosure regulations in the context of implicit communications. It thus reduced the enforcement risk faced by corporate officials who communicate material information implicitly through characterizations, tone or demeanor

We examine the impact of the Siebel decision by examining the information content of analyst outputs before and after the case. We study the effect of analyst information on stock returns for the sample period September 1, 2004, to August 31, 2006, the two-year period around the court’s ruling. We find that the information content of analyst information outputs is significantly greater in the one-year period after the court’s ruling than in the one-year period before the court’s ruling. This result suggests that the ruling led to a statistically and economically significant increase in firms’ selective disclosure to analysts. We also find that the increase is more pronounced for those analysts who tend to hold a more favorable view of the firm—precisely those analysts who are more likely to be the recipients of selective disclosures by corporate officials. We also conduct several analyses to mitigate concerns that our findings may be due to an unspecified time trend or other macro events during our sample period.

We infer that our results are due to officials’ increasing use of implicit communications in private meetings for two reasons. First, both explicit and implicit communications made through public disclosures subject corporate officials to potential liability under Rule 10b-5. This liability can be enforced by private litigants through class actions in addition to SEC enforcement actions. Indeed, studies have found that corporate officials’ use of optimistic tone in public disclosures can subject them to increased litigation risk. In contrast, corporate officials are unlikely to be subject to 10b-5 liability for statements made privately both because such communications are made to a limited audience and therefore unsuitable for a class action and because a private claim would require proof by the plaintiffs that the private communications materially altered the total mix of information available, proof that would implicitly concede that the plaintiffs had received material non-public information. Second, the Siebel opinion explicitly instructed corporate officials that, in evaluating their private disclosures, the courts would be focused on explicit statements and the extent to which those statements “add, contradict, or significantly alter the material information available to the general public.” Siebel thus provided assurance that implicit communications would not be subject to exacting judicial scrutiny.

Taken together, our findings suggest that implicit communications can limit the effectiveness of corporate disclosure regulation. The Siebel decision revealed the inherent difficulty associated with enforcing Regulation FD, when information can be conveyed through implicit communications. Our findings may also have implications for other corporate disclosure regulations such as laws that prohibit securities fraud and insider trading. Specifically, although managers may mislead investors not merely through explicit quantitative statements but also through qualitative statements and information conveyed through their tone and demeanor, enforcement efforts directed to these actions may face similar challenges. Corporate officials can further reduce the prospect of litigation by making optimistic statements in private rather than through public communications. Difficulties in enforcement may lead self-serving managers to become more aggressive in providing misleading information through implicit communications in private meetings.

The complete paper is available here.

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