Did the Siebel Systems Case Limit the SEC’s Ability to Enforce Regulation Fair Disclosure?

The practice of firms selectively disclosing nonpublic information to analysts and preferred investors has been a longstanding concern for regulators. The Securities and Exchange Commission (SEC) promulgated Regulation Fair Disclosure (Reg FD) in October of 2000 with the goal of mitigating the practice of firms selectively disclosing material nonpublic information. Although the initial wave of post-Reg FD academic studies found that Reg FD was effective in “leveling the playing field” for all investors, more recent studies find that private meetings with managers provide investors with significant trading advantages and possibly undermine the intent of Reg FD. In our paper, Did the Siebel Systems Case Limit the SEC’s Ability to Enforce Regulation Fair Disclosure?, we posit that the mixed evidence in the Reg FD literature could stem from the failed 2005 SEC enforcement action in SEC v. Siebel Systems, Inc. (hereafter Siebel), which challenged the SEC’s ability to subsequently enforce Reg FD. After this ruling, managers likely perceived a lower probability of Reg FD enforcement and had incentives to return to some degree of selective disclosure.

Prior to Siebel, the SEC pursued six enforcement actions related to Reg FD violations and all resulted in negotiated settlements with minor penalties. The 2005 Siebel case was the first and only instance in which the SEC pursued a Reg FD civil action and was largely based on indirect evidence that Siebel violated Reg FD. The district court judge dismissed the SEC’s charges with such force that legal commentators described it as a “public scolding” of the SEC. Following the Siebel defeat, the SEC did not bring another Reg FD enforcement action until 2007 and only initiated two enforcement actions in the following four years, neither resulting in significant penalties. Thus, the Siebel decision likely weakened the enforceability of Reg FD, resulting in managers reassessing the costs and benefits of private communications with investors.

We test whether the Siebel case is associated with the efficacy of Reg FD by examining informed trading by transient institutional investors. We replicate and extend the study of Ke, Petroni, and Yu (2008) who find significant abnormal selling by these institutions in the quarter preceding a major decline in earnings in the pre-Reg FD period (1995-1999) and no significant abnormal selling before major earnings declines in the post-Reg FD period (2001-2004), consistent with these institutions losing private information advantages due to Reg FD. However, when we extend these tests into the post-Siebel period (2005Q4-2009), we find that transient institutions again engage in abnormal selling prior to major earnings declines. Thus, the legal challenge to the SEC’s ability to enforce Reg FD has seemingly restored the ability of transient institutions to engage in private-information-based trading.

A possible alternative explanation for our results is that there was a secular increase in informed trading opportunities unrelated to the Siebel case. To address this possibility, we identify whether firms held open or closed conference calls prior to Reg FD and use the closed (open) call firms as a test (control) group with strong (weak) selective disclosure incentives. We find that transient institutions’ post-Siebel abnormal selling in the quarter preceding major earnings declines is only significant for closed-call firms. We also find no evidence of informed selling in the initial post-Reg FD period, which is consistent with Reg FD being effective prior to the Siebel case. As expected for a control group, we find no evidence of informed selling in the pre- and post-Siebel periods for open-call firms.

Another possible explanation for the results is that they reflect the “mosaic theory,” under which private communications of qualitative information were permitted both before and after Siebel, but the number of opportunities for such mosaic discussions simply increased over time. We address this concern by identifying firms that attend investor conferences. If our results solely reflect the mosaic theory, we should see informed selling for firms attending investor conferences before and after the Siebel case. However, we find significant abnormal selling by transient institutions before major earnings declines only in firms that attend investor conferences in the post-Siebel period, whereas there is no significant informed selling for firms attending conferences in the initial post-Reg FD period, or in firms not attending investor conferences during any period. This result suggests that managers perceived they had greater latitude to discuss material information privately at investor conferences after Siebel.

Prior work suggests that, when managers engage in selective disclosure (e.g., one-on-one meetings, private phone calls), they prioritize communications with large shareholders. We thus examine whether Siebel changed the diffusion of informed trading across institutional shareholders based on the magnitude of their stakeholdings. In the pre-Reg FD period, we find that both large and small transient institutional shareholders abnormally sell prior to major earnings declines. In the initial post-Reg FD period, we find no evidence of abnormal selling among large or small transient shareholders, consistent with Reg FD being initially effective. However, post-Siebel, we find that abnormal selling prior to major earnings declines is limited to transient institutions with large stakeholdings. This is consistent with Siebel changing the cost-benefit trade-off for private discussions with large shareholders, but not for small shareholders, where managers still appear less willing to risk violating Reg FD due to the lesser benefits of private interactions with small shareholders. These findings suggest a potential unleveling effect even among sophisticated investors due to selective disclosure practices becoming even more selective after Siebel.

To ensure the robustness of our inferences, we also examine the effect of Siebel on transient institutions’ fund-level stock-picking abilities following Bhojraj, Cho, and Yehuda (2012). Our tests show that transient institutions exhibit superior stock-picking ability in the pre-Reg FD period but not in the initial post-Reg FD period, consistent with Bhojraj et al. (2012). However, in the post-Siebel period, we find that transients again exhibit superior stock-picking ability, consistent with Siebel changing the private information flow between investors and managers.

This paper contributes to the literature on the effectiveness of Reg FD and to the literature on private meetings between managers and investors in the post-Reg FD period. We attempt to reconcile these literatures by showing that the Siebel case likely served as a shock to the enforceability of Reg FD, which changed managers’ cost-benefit trade-off of private information flows after 2005. Our evidence is consistent with the Siebel shock recreating an unlevel playing field that provides private information advantages similar to those predating Reg FD.  Our findings also add to the growing literature on securities law enforcement and highlight the important role of the enforcement of regulation. Finally, our findings suggest that researchers should exercise caution in assuming that Reg FD is effective in restricting private information dissemination in the post-Reg FD era.

The full paper is available for download here.