Chapter 5
Investor relations is a highly regulated activity in most of the countries. In the United States, the primary agency responsible for oversight of the stock market is the United States Securities and Exchange Commission (SEC). On the agency’s website, the SEC states its main mission is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”1 To achieve these goals, the SEC oversees the federal securities laws, maintains the disclosure of financial information by publicly traded companies, and can bring enforcement actions against violators of the securities law. The SEC works in close cooperation with several other U.S. government agencies, such as the Federal Reserve Board of Governors and the Department of Treasury.
Prior to 1933, the United States did not have a comprehensive regulation of the securities markets on the federal level. Instead, individual states were left to enact their own laws to protect their citizens against investment fraud. These state laws, referred to as Blue Sky Laws, were enacted in response to a growing number of fraudulent speculative schemes targeted at general population. The schemes were not backed up by any assets or reasonable plans—all the fraudulent claims were “out of the blue sky.” Thus, these con artists were referred to as “blue sky merchants,” and the state laws protecting against these blue sky schemes were labeled Blue Sky Laws.
Nevertheless, in the early 1930s it became apparent that state laws alone cannot combat the securities fraud. The development of communication and transportation networks made interstate securities offering and trade easily accessible to both general public and con artists. State laws, however, were inadequate in dealing with interstate fraud. The Federal Government needed to step in and did so by creating a federal agency to provide an oversight over the securities markets—the SEC.
The SEC is headed by five commissioners. The commissioners are appointed by the President of the United States for a five-year term. The SEC must be a bipartisan body. In order to achieve this, no more than three commissioners can belong to the same political party. One of commissioners is designated by the U.S. President to be the Chair of the Commission. As of March 2009, the Chair of the Commission is Mary L. Schapiro—the first female to become the head of the agency. The four other representatives are: Kathleen L. Casey (R), Troy A. Paredes (R), Luis A. Aguilar (D), and Elisse B. Walter (D). Today the SEC employs almost 3,500 people. The Commission’s organization chart consists of four divisions and 19 offices. The Division of Corporate Finance is directly charged with overseeing corporate disclosure practices and making sure that all investors, from Wall Street financial analysts to retirees in rural Iowa, have equal access to the corporate financial information. The Division reviews required disclosure documents filed by companies planning to sell their securities to general public, as well as periodic disclosures by publicly traded corporations. The Division encourages corporations to provide extensive and timely information, both positive and negative, about a company’s business to ensure that investors can make an educated decision whether to buy, hold, or sell securities of the company.
The SEC also maintains EDGAR: Electronic Data Gathering, Analysis and Retrieval system. All publicly traded companies are required to submit their financial information to EDGAR, and that information becomes available to anyone who has a computer with Internet connection. EDGAR, however, is a noninteractive system—the information is presented simply as text. In early 2009, the SEC introduced new regulations that starting from a fiscal period ending on or after June 15, 2009, all large companies must use the new system—IDEA: Interactive Data Electronic Application. IDEA relies on the new interactive data format —eXtensible Business Reporting Language (XBRL). All other companies will start using IDEA by June 2011.
The key pieces of legislature that govern securities markets today are Securities Act of 1933, Securities Exchange Act of 1934, Regulation FD, and Sarbanes-Oxley Act of 2002.
Securities Act of 1933 requires any original interstate sale or offer of securities to be registered. The goal of the registration is twofold: first, it allows the government to make sure that there is no deceit or fraud behind such offer of securities. Second, it allows the authorities to ensure that the company fully discloses any relevant information pertaining to such offer and thus enables investors to evaluate this offer properly. The Act describes in detail the registration process and information that must be filed. In general, the company must file a document called prospectus that describes the specific types of securities offered, information about the company and its business, information about the management, and the financial statements certified by independent accountants.
The act also provides some exceptions for companies to avoid the process of registration. Two most common exceptions often used by foreign companies are Rule 144A and Regulation S. Rule 144A stipulates that foreign companies can be exempt from the registration process if they do not offer their securities to private individuals in the United States but only to large institutional investors. The SEC refers to such investors as QIBs—Qualified Institutional Buyers. QIBs have over $100 million in assets and typically employ financial analysts who can request the information from the issuer, analyze the offer of securities, and make qualified decisions on valuation of such securities themselves. As a result, the SEC believes that QIBs do not require the same protection as private investors or small institutional investors have under the Securities Act of 1933.
Regulation S also allows an issuer to be exempt from the registration if the securities do not have a connection to the United States—in other words, the company is located outside of the United States and issues securities outside of the United States. In addition, the company does not engage in direct selling efforts to U.S. investors. Many foreign companies also rely on Regulation S to avoid the registration requirement especially when issuing Depositary Receipts.
If the previously described Securities Act of 1933 regulates the initial offer of securities, the Securities Exchange Act of 1934 aims at regulating secondary trade of securities. The act provides regulation of brokerage firms, transfer agents, clearing companies, stock exchanges, and so on. The act establishes the guidelines for periodic reporting of major corporations with more than $10 million in assets and with more than 500 shareholders. In addition to corporate reporting requirements, the Securities Exchange Act of 1934 regulates proxy solicitation for shareholders’ meetings, offers to trade blocks of shares in excess of 5% of all outstanding shares, and trading of securities by people with connections to the company (so-called insider trading).
Although the Securities Act of 1933 and Securities Exchange Act of 1934 were primarily enacted to protect the interests of shareholders, it turned out that they do not protect all shareholders equally well. If we look back at the efficient market hypothesis discussed earlier in this book, one of the key assumptions of this hypothesis is equal access to information by all participants. However, quite often, the company would report the important information first to key analysts following its stock during a conference call or private meetings with institutional investors. Then, the information would trickle down the chain to smaller institutional investors, brokers, and private shareholders. Thus, large institutions such as Merrill Lynch, Wachovia, and Lehman Brothers would get access to any material information before other investors and would have a chance to receive higher returns on their investments by outperforming the market. The situation was unfair to private shareholders but there was no way to make information available to everybody from New York to California instantaneously.
The end of 1990s, however, brought the widespread adoption of the Internet. People became capable of accessing information themselves including directly from the SEC filings or companies’ websites. In addition, more and more people were engaging in self trading of securities using online brokerage firms. They needed to have access to information at the same time as large institutional investors did. The inequalities in the stock market became painfully obvious, and the government had to step in. As a result, the SEC adopted a new rule, Regulation FD (Fair Disclosure), in October 2000.
The key stipulation of Regulation FD was to eliminate the practice of “selective disclosure”—in other words, disclosure of information to some select parties (largely, institutional investors). Instead, Regulation FD requires the following:
The regulation provides that when an issuer, or person acting on its behalf, discloses material nonpublic information to certain enumerated persons (in general, securities market professionals and holders of the issuer’s securities who may well trade on the basis of the information), it must make public disclosure of that information.2
Such disclosure must also be done simultaneously to securities market professionals and everybody else, thus eliminating the opportunity for professional investors to “beat the market” by receiving information earlier. Regulation FD also provides provision for unintentional disclosure of information, in which case the company must follow up with the public disclosure in a very limited timeframe.
Although Regulation FD led to a significant improvement in the disclosure practices, it did not eliminate the problem completely. The competition among financial analysts pushes them to seek privileged information testing investor relations officers and executives almost daily through e-mails, phone calls, and one-on-one meetings. Regulators do not enforce the provision of Regulation FD very strictly either, creating a situation when it becomes an obligation of the investor relations officers to balance the demands of financial analysts and investors with the stipulations of the Regulation FD.
Finally, the most recent piece of legislature is the Sarbanes-Oxley Act. This new law, Public Company Accounting Reform and Investor Protection Act, was enacted July 30, 2002. It is often referred to by the name of its sponsors: Senator Paul Sarbanes (D-MD) and Representative Michael G. Oxley (R-OH), as Sarbanes-Oxley Act, or simply SOX. President George W. Bush, when signing the law, stated that Sarbanes-Oxley is “the most far-reaching reforms of American business practices since the time of Franklin D. Roosevelt.” Others also call SOX “a most welcome gift to shareholders”3
SOX primarily focuses on further improving the quality and quantity of financial disclosure. To some extent, SOX was a governmental response to a wave of corporate scandals that shook corporate America at the beginning of the twenty first century. Many of these scandals were directly related to senior management’s manipulation of information disclosed to investors and, as a result, the inability of investors, both private and corporate, to properly understand the company’s business and its value. In the chain of corporate scandals even the companies once believed to be among the leaders in their respective fields, such as Adelphia, Global Crossings, WorldComm, Tyco International, Kmart, and Waste Management, experienced significant drops in their share prices and some even bankruptcies. Of course, the largest scandal of all was Enron: “The collapse of energy giant Enron is the largest bankruptcy and one of the most shocking failures in U.S. corporate history.” Enron is referred to as “the Watergate of business.”4 The government had to restore the confidence of domestic and international investors in the very model of American capitalism.
SOX became the key step in restoring the investors’ confidence. First, SOX creates Public Company Accounting Oversight Board (PCAOB), an independent board charged with improving the audit process. As described earlier, in accordance with Securities Acts of 1933 and Securities Exchange Act of 1934, public companies must have their financials verified by an independent accountant. PCAOB’s goal is then to regulate the process of such audits and the companies that provide them. SOX creates specific requirements for auditing companies and explains what an auditor’s independence from the company means.
SOX also expands the scope of disclosure by public companies. The enhanced disclosure includes off-balance-sheet transactions, liabilities, and obligations. The company must also report on the transactions carried out by company’s executives.
SOX emphasizes the accuracy and completeness of the disclosure by public companies and introduces personal responsibility of the senior corporate managers for such disclosure. Specifically, Section 302 requires senior executives to certify the following:
- The signing officers have reviewed the report
- The report does not contain any material untrue statements or material omission or be considered misleading
- The financial statements and related information fairly present the financial condition and the results in all material respects
- The signing officers are responsible for internal controls and have evaluated these internal controls within the previous ninety days and have reported on their findings
- A list of all deficiencies in the internal controls and information on any fraud that involves employees who are involved with internal activities
- Any significant changes in internal controls or related factors that could have a negative impact on the internal controls5
The variety of other SOX provisions detail specific requirements for establishing internal structures to facilitate these new disclosure procedures, introduce corporate and criminal fraud accountability, and enhance white collar crime penalties.
Some of SOX’s critics point out to the significant expense of compliance with the new requirements that SOX introduced. Creating the internal control structures and hiring an expensive audit company might become a cost-burden for smaller, publicly traded companies. However, others claim that this is money well spent and that it is worth paying for enhanced understanding of the company’s business by shareholders and improved transparency of the market in general.