The challenge of reviewing analyst reports
Few and far between are the public companies that shun coverage by sell-side analysts. In fact, this coverage is so highly valued that IROs spend significant time cultivating relationships with analysts in the hope they will initiate and maintain coverage of their companies.
Why then do securities lawyers advise extreme care when dealing with analysts, especially when the issue of reviewing and commenting on analyst reports arises? The answer lies in the fact that too much involvement in the preparation of those reports can result in significant liabilities for both a company and its management. In recognition of the difficulties of dealing with securities analysts, in one court an analogy was made likening the process to 'a fencing match conducted on a tightrope.'
Highwire act
Armed with timely, complete and accurate information, investors are deemed well-positioned to make their own decisions regarding the investment merits of a particular security. Research reports issued by sell-side brokerage houses are an important source of information, widely used both by institutional investors and individuals. At first blush, it therefore seems logical for IROs to engage in pre-publication review of analysts' reports to ensure their accuracy.
Difficulties arise from the fact that the SEC in the US has argued and courts have held that under the 'pre-publication entanglement' theory, such review can make the company responsible for everything in the report, whether factual recitation or projections of future developments. And distribution of analyst reports by companies has been viewed as another form of adoption of the reports under a 'post-publication ratification theory' of liability, whether or not there was a pre-publication review.
It is clear that companies and individual members of management can be found liable for civil and even criminal violations of securities laws if they publish information containing material misstatements or omissions. Normally, this liability has not extended beyond company-issued documents. At times, however, public companies and members of management have been found guilty of violating the securities laws when the misinformation appeared in research reports authored by sell-side analysts.
The seminal case in this area was handed down in 1980 by the 2nd US Circuit Court of Appeals. The case, Elkind v Liggett & Myers Inc, centered on Liggett & Myers' review of a draft analyst report. The executives involved limited their review to factual details and did not comment on forecasts contained in the report. Liggett was absolved of liability when actual results did not live up to the forecasts, because it had taken care to clarify that it had not reviewed the analysts' forecasts.
In its opinion, however, the court in Elkind stressed that 'corporate pre-release review of the reports of analysts is a risky activity fraught with danger.' The court emphasized that if it is found that company officials have implied by their activities that the information in the analyst report is true or that it reflects the company's views, then the company will be found to have assumed liability for the report.
All tangled up
This concept of 'entanglement' was reaffirmed in 1991 when, in another case, SEC v Wellshire Sec Inc, the court stated that while in general a company has no duty to correct misstatements made by third parties, a duty to make such corrections may arise where a company 'sufficiently entangles itself with the analysts' forecasts to render those predictions attributable to it.'
Where sufficient entanglement is found, a company faces two serious burdens. First, it could be found liable for false or misleading statements or for projections which do not come to pass. In addition, the company may have assumed a legal obligation to correct and update any statement contained in an analyst report if subsequent developments cause certain statements to cease to be true; or it may face liability through failure to issue such an update.
The SEC's December 1997 'cease and desist' order against Presstek and two of its executive officers is a stark reminder that the concept of entanglement-related liability is still very much alive. Liability arose when two senior officers of Presstek commented extensively on a draft analyst report. The company did not, however, advise the analyst that its internal projections were substantially less positive than those in the report. The SEC concluded that Presstek was liable for the material inaccuracies in the published report, including the optimistic projections, because of its entanglement in the preparation of the report. Liability was also found under the 'post-publication adoption theory' since Presstek circulated the report.
Unfortunately, despite the passage of time since Elkind, no laws exist which lay down in black and white exactly what activity constitutes 'significant entanglement' to give rise to liability. Each case continues to be individually determined, based on its unique set of facts and circumstances.
Clearing the chasm
Despite the absence of clear law relating to the review of analyst reports, the practice is widespread. According to a survey conducted by Niri in 1995, over 95 percent of companies admitted to reviewing analyst reports.
Christine Marx, chairperson of the securities practice group at Edwards & Angell in New York, says, 'In the ideal world, none of my clients would review analyst reports. Abstention doesn't comport with reality, however, so I consider it important to do two things. First, I ensure that companies understand the legal risks surrounding the review process and next I counsel them on how to conduct a review in a way that minimizes the inherent risk.'
With respect to the risk assessment, Marx notes that as each company develops its policy on reviewing analyst reports, management must understand what follows from being named in an SEC proceeding or shareholder suit claiming fraud on the marketplace and must also assess its own tolerance for being named as defendants in such suits. The typical results include extensive negative media coverage; the expenditure of significant, and sometimes staggering, amounts of time and money to defend the company; and a decline, sometimes drastic, in the price of the company's stock.
Marx recommends some procedures to minimize risk when a company has determined
to review analyst reports:
* Strictly limit the number of individuals within a company authorized to speak with analysts;
* Ensure that each authorized spokesperson is well acquainted with disclosure responsibilities under the securities laws and that they stay current with legal developments in this area;
* Ensure that each authorized spokesperson is well acquainted with all of the company's public disclosures and fully briefed on subjects and financial statistics that are not to be publicly discussed;
lNever substitute alternative figures for an analyst's projections. Limit responses to commenting on inaccuracies in the factual assumptions underlying the projection or pointing out the variation between the projection and those issued by other analysts;
* Use extreme care to avoid engaging in 'selective disclosure' with one or more favored analysts;
* Respond to analysts in oral rather than written form and keep notes on the scope of guidance provided. In those cases where management insists on responding in writing, affix a disclaimer noting that the comments are limited to correcting factual inaccuracies and that no review was made of any projections or recommendations contained in the report;
* Deny permission for the report to attribute information to a named officer of the company or even to note that information was provided by an unnamed company spokesperson;
* Abstain from subsequent distribution of the analyst reports.
Crucial follow-up
Following any review of an analyst report, an investor relations officer should routinely engage in two follow-up activities. First, reflect on the subjects covered in the review to ascertain that no inadvertent disclosure of material non-public information occurred. If any such disclosure did occur, a press release containing such information should be issued as soon as possible. If the materiality of the information is in question, legal counsel should be consulted.
Second, the IRO must continually assess the accuracy of the guidance provided. Where it ceases to be accurate, and could still be considered to be material information, under Elkind, Presstek and other cases, it appears that a duty exists for the IRO to update the information.
Securities lawyers routinely caution clients to use extreme care when reviewing analyst reports. These warnings should not be dismissed as overly conservative or as unrealistically restrictive by those on the receiving end of analysts' demands for information. Given the absence of specific laws in this area, the absence of a safe harbor covering such reviews, and the imposition of liability by courts on companies and their managements falling into 'sufficient entanglement', such warnings are appropriate and should be well-heeded.
Marisa Jacobs is a director at Gavin Anderson & Co in New York