Wall Street Speech Police

Late last year, the Securities and Exchange Commission implemented Regulation FD, a restriction meant to guarantee “fair disclosure” of corporate information to investors in publicly traded securities. In the name of fairness, however, the rule is suppressing the freedom of speech of senior corporate executives and undermining a highly sophisticated mechanism for disseminating useful information about companies to the stock market.


Regulation FD requires that publicly traded firms must communicate “material” or potentially market-moving information to the public, rather than to securities investment analysts, portfolio managers, and institutional investors. Such information must be announced through a press release or through an open meeting, as opposed to the longstanding practice of leaking this information selectively to Wall Street pros.


The restriction takes away a popular method that firms once used to manage the expectations of the capital markets, and thus works to the detriment of firm shareholders. Rather than risk a sudden and pronounced investor reaction to good or bad news, firms could sift the information through knowledgeable research analysts at the major investment banks. The shock value of new news could be reduced by having the pros assess its overall impact on the companies’ prospects. Similarly, companies could try to disguise truly bad news with this tactic, but skilled analysts could also sniff out suspicious activity.


The immediate effect of the SEC’s mandate to broadcast all significant news has been to increase the volatility of the stock market, as more news comes as a surprise. Unfortunately, higher volatility alters the price-risk relationships that investors have grown accustomed to for many years. It will likely take some time for markets to adjust to the new regulatory environment.


The volatility effects pale in comparison with the havoc the disclosure restriction wreaks on the natural division of labor within the financial services industry. The stock market relies on experts to not only ferret out details that companies would rather not divulge, but offer informed interpretations of these details to their clients. Perversely, the government’s rule forces Wall Street research analysts to share their nuggets of wisdom with the world via conference call, and these specialists are less able to profit from utilizing their skills in the marketplace. Far from enhancing fairness, this is like preventing tall people from competing in basketball.


The SEC defends its restriction by arguing that small investors should be given equal access to all material information disclosed by a firm that could influence its stock price. But chat room prognosticators and internet day traders typically cannot utilize all of this information effectively anyway. Are such people capable of decoding embarrassing data buried deep within a financial statement? Can people without the requisite training be expected to assess the seriousness of the latest disclosure without overreacting one way or another? They don’t know the right questions to ask, and that’s the real reason they are not privy to the answers. Forbidding corporate officials from communicating with research analysts abridges their freedom of speech.


Wall Street analysts deserve much of the criticism they receive. Too often their recommendations are effected by the corporate finance relationships of their sell-side employers, the investment banks. However, the SEC goes even further, implying that it’s wrong for analysts to maintain close working relationships with the companies they cover. The agency’s position seems unduly harsh.


In practice, the best analysts work very hard to develop a detailed mosaic of each company they cover. This involves visiting the firm, contacting its suppliers, quizzing its key customers, etc. After distilling this information into a complex mathematical projection of the company’s future earnings stream, the analyst then asks the company’s executives for guidance on the fine details of his financial model. Getting answers to these questions–and determining the answers’ truthfulness–is not unfair to smaller investors in the marketplace. In contrast, it allows analysts to produce more accurate quarterly earnings estimates and other information that their clients rely on. The average investor does not have the capacity to ask such detailed questions in the first place.


In the name of protecting the small investor, the SEC is deliberately rendering Wall Street research less accurate. It’s like asking reporters to write stories without being able to interview their sources privately, via leaks or on background. A government agency should not be setting up roadblocks on the superhighways of financial information. Since Regulation FD was enacted last fall, many firms have simply refused to answer probing questions from Wall Street, citing the new rule to justify their “no comment.”


In the past, the courts have restrained the SEC’s meddling and may do so again. In the 1983 case Dirks v. SEC, the Supreme Court handed the SEC a major defeat in its ambitions, ruling that information may be released to anyone so long as the person disclosing it does not profit directly. That quite reasonable standard has governed the markets for some time. The activist regulators at the SEC may be violating the spirit of Dirks, making new law in this area without waiting for action from Congress, which properly possesses the constitutional power to legislate. The courts might also want to consider this rule’s infringement on corporate executives’ free speech.


Selective disclosure does appear unfair in some cases, and some firms have certainly tried to abuse the process. Yet the SEC has never shown that the abuses were so severe as to require drastic remedies. In situations where more open disclosure is suitable, the market had already begun to address the issue in measured ways. Many firms were making their analyst conference calls available on the Internet via webcasts. The markets were losing confidence in the more secretive firms, and competitive forces were forcing companies to broaden their information disclosure practices. Selective disclosures were also being disciplined naturally, as the markets tend to discount earnings forecasts made by brokerage firms that underwrote the company being analyzed. The SEC has short circuited these market processes, raising the cost of communicating all information–both material and irrelevant. Every disclosure must now be vetted with a firm’s lawyers in advance.


The SEC’s underlying goal with Regulation FD, parity of information, is utopian and unattainable. There can never be a process of information distribution that perfectly delivers market news to all interested parties simultaneously. Moreover, many investors and potential investors have widely differing interpretations regarding what type of information would cause them to buy or sell a stock. The SEC should stop pretending that it knows what information is material and what isn’t, in all situations. By stepping in to render judgment, the power-hungry regulators are preventing specialists from doing their jobs well and from being rewarded accordingly. The SEC should return to the modest legal standard set in Dirks, and allow competitive markets to sort out information on their own.


James M. Sheehan ([email protected]), an adjunct fellow with CEI, previously served as CEI’s Director for International Environmental Issues.