Legal/Regulatory | Deal Professor

As Information Flows, S.E.C. Faces Difficulty Bottling It Up

By STEVEN M. DAVIDOFF    May 27, 2014 6:06 pm

On Wall Street, information is “the most valuable commodity,” to quote a line from the 1987 movie “Wall Street.”

Since 2000, the Securities and Exchange Commission has sought to ensure equal access to that commodity through a rule known as Regulation FD. The rule generally requires that if a company disclosed material information to one person, it must do so to all.

Yet even with that requirement and with the flood of information that is out there, some investors still appear to be getting premier access. Indeed, Regulation FD may now be doing more harm than good.

You see it when the latest activist hedge fund takes a large position in a public company and calls for “dialogue.” Such an exchange of views, if it occurs, is supposed to cover only public information.

But when Carl C. Icahn has a three-and-a-half hour dinner with Apple’s chief executive, Timothy D. Cook, to persuade the company to engage in a $150 billion share buyback and then tweets that it was “cordial” and that “we decided to continue dialogue,” what do you think they were talking about?

In short, it is hard to police information, and with the rise of the activist hedge funds, Regulation FD is again in question.

The regulation was pushed by and adopted under the S.E.C. chairman Arthur Levitt. The proposed rule generated 6,000 comment letters. To some, the idea that all shareholders should have equal access to information was as natural as that Whitney Houston lyric that “children are our future.” These advocates argued that everyone should have all information released by the company, leading to better investing outcomes for all. It would also end the sense of unfairness that Mr. Levitt described in 1998 when he stated that “auditors and analysts are participants in a game of nods and winks.” Mr. Levitt argued that material information was being disclosed to these Wall Street analysts to guide stocks and manage earnings predictions.

Wall Street didn’t agree. The ability of analysts to get better information, or more “color,” from the companies they covered was what made the analysts worth employing. Investors would then want to do business with the brokers with the best analysts to get the best information. The business provided by these investors would also mean that the firms had an incentive to pay the analysts money and therefore provide both analyst coverage and services. The consequence would be reduced volatility in stock prices and companies getting more access to the capital markets. Regular investors who are in the market less and less these days anyway would gain because of this and the greater information provided to the market by these analysts.

Wall Street feared that Regulation FD would decimate research. The rule would cause Wall Street to lose incentives to provide analyst coverage, thus hurting investors. Companies, meanwhile, might simply stop disclosing information to the outside world instead of selectively disclosing it. The result would be that pricing in stocks could actually become worse.

But Mr. Pitt remained steadfast, asserting that the equal information goal was “unassailable.” Wall Street didn’t help its case as some analysts were clearly not only getting preferential, but absurdly preferential treatment. During this time, for example, Jack Grubman, the Citigroup analyst, attended the board meetings of WorldCom.

Regulation FD has not been the disaster that Wall Street predicted, but it had number of negative effects. Smaller companies experienced a higher cost of capital, and some lost analyst coverage. Surveys by Thomson Financial among others found that many companies simply chose to disclose less information. Still, some studies disagreed with these findings, instead asserting that Regulation FD had a positive effect on the market.

In any case, with the boom in use of social media and the rise of activist investors, Regulation FD has increasing problems.

The first is that trying to regulate information release in the media age is often a losing battle.

The S.E.C. investigated Reed Hastings, the chief executive of Netflix, after he disclosed on his personal Facebook page that Netflix had streamed one billion hours of content in a single month. The problem was that he personally disclosed it and the company released the information only a few hours later. The regulator used the investigation as a teachable moment on Regulation FD, saying that the rule applied to social media. But the S.E.C. also said that social media was appropriate provided that possible disclosure through this route was made by the company.

In essence, the agency is trying to tame the fire hose of the Internet with Regulation FD. But the truth is that information is getting even harder to control. With social media, there is simply too much out there to know what is being released as material or not without simply caging up all the top executives of every publicly traded company.

Activists and other investors, meanwhile, are continuing their dialogue with companies — and this conversation is impossible for regulators to monitor.

The S.E.C. is thus caught trying to control too much information and monitoring information it can’t even see or hear.

This is a difficult balance and is highlighted by the lack of enforcement cases. To date, the S.E.C. has brought less than a dozen enforcement actions over Regulation FD in the rule’s nearly 15-year history.

Perhaps it is time to reconsider what the agency is trying to do with information. Professor Joseph A. Grundfest of Stanford Law School has argued that Regulation FD may be unconstitutional because it unnecessarily restrains a company’s free speech. He contends that equal access to investors may be compelling, but it is not an interest of the securities laws.

Professor Grundfest’s argument may or may not prove to be correct, but he has a point that the rule seems to be there just for the sake of being there.

The S.E.C. should take a hard look at the rule and how it enforces Regulation FD. Is Regulation FD now honored more in the breach? Alternatively, do we even need such a broad rule anymore in today’s information age? If the rule was done away with, might not companies be much more willing to release information, information that would improve how markets trade. Given what is going on right now, it doesn’t seem like small investors are benefiting at all from this “equal access” to information, instead losing out because of small issuers being denied capital and analyst coverage.

The capital markets and information flows of 14 years ago when this rule was adopted are long gone. Perhaps it is time for the S.E.C. to recognize this fully and revisit Regulation FD.

Steven M. Davidoff, a professor at the Michael E. Moritz College of Law at Ohio State University, is the author of “Gods at War: Shotgun Takeovers, Government by Deal and the Private Equity Implosion.” E-mail: dealprof@nytimes.com | Twitter: @StevenDavidoff

This post has been revised to reflect the following correction:

Correction: May 31, 2014

The Deal Professor column on Wednesday, about a securities rule on corporate disclosure known as Regulation FD, referred incorrectly to the history of the rule. It was pushed by and adopted in 2000 under Arthur Levitt, then chairman of the Securities and Exchange Commission. It was not pushed by his successor, Harvey Pitt.

A version of this article appears in print on 05/28/2014, on page B5 of the NewYork edition with the headline: As Information Flows, S.E.C. Faces Difficulty Bottling It Up.

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