New SEC rules should favor small investors

But a certain form of insider trading has long been practiced, quite openly, in the securities industry. That's when a Wall Street analyst sits down to talk quietly with a corporate executive, then scurries back to his office to tell his company's traders to buy or sell on news that the general public won't learn for days. Obviously, those who get news first can trade at advantage, buying low before a stock goes up, or selling high before the price falls.

Last week, the Securities and Exchange Commission, in a rare split decision that underscored the momentous nature of its action, approved in a 3-1 vote a regulation to curtail this practice. Called Regulation FD, short for full disclosure, it requires that companies publicly disclose any information given to analysts or select investors such as the people who run mutual funds and pension funds. As companies adopt new practices, they are likely to give everyone telephone or Internet access to meetings and "conference calls" that traditionally have been closed communications between corporate executives and favored analysts and investors.

Small investors and many regulators, including SEC Chairman Arthur Levitt, have long criticized such "selective disclosure." It was Levitt who pushed for Regulation FD, which will take effect this fall. To many outsiders, it has long been hard to understand why selective disclosure did not violate laws against insider trading.

The key reason was a U.S. Supreme Court decision in a 1983 case known as SEC v. Dirks, says Wharton legal studies professor William C. Tyson. Raymond Dirks was a Wall Street analyst who in 1973 learned from an insider that Equity Funding of America, an insurance and mutual fund company, had overvalued certain assets. The insider was a whistle-blower who wanted this fraud revealed to the public, so Dirks took the story to a Wall Street Journal reporter.

When the reporter declined, feeling the story implausible, Dirks used the information to convince some of his firm's clients to sell their Equity Funding stock, which was likely to fall in value if the overvaluation of assets became known.

Later, the Journal did investigate the story, and Dirk's role became known. But then the SEC charged Dirks with an insider-trading violation, claiming he'd helped his firm's clients to profit on information that had not been publicly disclosed. Dirks fought back, and the case eventually went to the Supreme Court.

The Supreme Court ruled that insider trading had not occurred because the law required that the person who gave the inside tip had to have done it for personal benefit. In this case, the whistle-blower was acting not for personal benefit but in the public interest. Because the whistle-blower had not violated the insider-trading law, Dirks and the other recipients of the whistle-blower's information had not violated the law either, the court said.

With this ruling, companies were free to selectively disclose information to analysts and other recipients of their choosing, as executives do not make disclosures for personal benefit. In fact, the court said such disclosures served the public interest by providing a way for important information that affects stock prices to get into the marketplace.

But the SEC felt the practice gave an unfair advantage to a select few, and for the past 17 years the agency has been looking for a way to bar this practice, Tyson says. As a practical matter, he adds, the agency could not impose a selective disclosure ban that would defy the Supreme Court ruling. So Regulation FD was an ingenious way around that problem. Executives can continue having private meetings with analysts and favored investors but must immediately pass the same information to the public by press release or a filing with the SEC.

"The SEC used its rulemaking power to adopt issuer-disclosure rules," Tyson says. The agency specifically said it was not seeking to overturn the Dirks decision, and Regulation FD does not make violations criminal matters, merely administrative violations subject to fines and censure. Nonetheless, Tyson believes companies will take it seriously, as there is a great embarrassment associated with SEC accusations of rule violations.

Indeed, there was little objection to the proposed rule from corporate America. Securities firms, on the other hand, did object strenuously. The rule will undermine the special access they use to guide their own trading and to make their analysts' reports valuable to clients. The Securities Industry Association, the industry's trade group, argued the rule could backfire by making corporate executives reluctant to disclose information that otherwise would be made public.

Levitt was particularly concerned that analysts are too cozy with executives, refraining from issuing objective analyses for fear of losing their special access. Some academic studies have supported this view, demonstrating, for instance, that a typical analyst rarely issues a public recommendation for investors to sell stock in a company the analyst covers. A "sell" recommendation is often viewed as a vote of no confidence in a company's management, provoking executives' ire.

Small investors with long-term buy-and-hold strategies may feel they have little stake in matters like selective disclosure, but that is not necessarily true. If big investors with advance knowledge of bad news decide to sell their shares, the buyers are likely to be small investors who aren't in the know. The small investor would thus buy the stock, then suffer a loss when the bad news finally hits the market and the price falls. In another case, a small investor might sell a stock without knowing good news is coming, while the buyer might be the big investor with inside knowledge. The small investor would miss the gains that follow the release of good news; the big investor would get them.

Some students of the market believe Regulation FD will lead to a general improvement in analysts' reports. Because companies will not be able to use favoritism to reward selected analysts, the analysts will have no reason to sugarcoat their findings. The result: better, more candid analysis that will improve the information available to all investors.

 
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