Reg FD cases rarely get to court, but here’s one that, barring a settlement, appears to be headed to trial. In a 129-page opinion in SEC v. AT&T, 9/08/22, the federal district court for the SDNY denied summary judgment for both sides in a case the SEC brought in March of 2021 against AT&T and three members of its Investor Relations Department for violations of Reg FD. (See this PubCo post.) The SEC alleged that, in March 2016, AT&T learned that, as a result of a “steeper-than-expected decline in smartphone sales,” AT&T’s first quarter revenues would fall short of analysts’ estimates by over a $1 billion. Given that AT&T had missed consensus revenue estimates in two of the three preceding quarters, AT&T, it was alleged, embarked on a “campaign” to beat consensus revenue estimates for Q1: the three defendant IR employees were asked by the CFO and IR Director to contact the analysts whose estimates were too high to “walk” them down. As part of that campaign, the SEC alleged, they selectively disclosed the company’s “projected or actual total revenue, and internal metrics bearing on total revenue, including wireless equipment revenue and wireless equipment upgrade rates.” The campaign worked. But—and it’s a big but—it also led the SEC to bring claims against AT&T for violating Reg FD, and against the three IR employees for aiding and abetting that violation. As to AT&T and the other defendants, the Court was not persuaded by their arguments that there was insufficient evidence to support the SEC’s claims of a Reg FD violation, nor did the Court agree that Reg FD was “invalid” under the First Amendment. And, as to the SEC, while the Court viewed as “formidable” the evidence showing that the information at issue was material, nonpublic and selectively disclosed, the question of scienter was a closer one, and a reasonable jury could find for the defendants on that point.
Reg FD prohibits selective disclosure of material, nonpublic information by public companies (or by its senior officials or specified other employees) to securities market professionals and shareholders reasonably likely to trade on the information. If a public company does make a disclosure of that kind, the company is required under Reg FD to disclose the information to the public. Information is considered “material” if there is “a substantial likelihood that a reasonable investor would consider the information important in making an investment decision or if the information would significantly alter the total mix of available information.” And that’s where the thorny part comes in. Judgments about materiality of disclosures are often complicated and muddy and frequently made in real time.
To be sure, as stated in SEC v. Bausch & Lomb, Inc., the “SEC, of course, does not maintain that the securities laws prohibit all disclosures of internal corporate information. The Commission itself has recognized that corporate management may reveal to securities analysts or other inquirers non-public information that merely fills ‘interstices in analysis.’” Similarly, the Second Circuit has recognized that the “corporate officer dealing with financial analysts inevitably finds himself in a precarious position, which we have analogized to ‘a fencing match conducted on a tightrope.’ ….A skilled analyst with knowledge of the company and the industry may piece seemingly inconsequential data together with public information into a mosaic which reveals material non-public information. (Elkind v. Liggett & Myers, Inc.)
As the SEC noted in the Reg FD adopting release, a company “is not prohibited from disclosing a non-material piece of information to an analyst, even if, unbeknownst to the issuer, that piece helps the analyst complete a ‘mosaic’ of information that, taken together, is material.” At the same time, a company “cannot render material information immaterial simply by breaking it into ostensibly non-material pieces.” Similarly, the SEC has said that, “since materiality is an objective test keyed to the reasonable investor, Regulation FD will not be implicated where an issuer discloses immaterial information whose significance is discerned by the analyst. Analysts can provide a valuable service in sifting through and extracting information that would not be significant to the ordinary investor to reach material conclusions.”
So when is information disclosed just filling in the interstices or providing fragments for a mosaic, and when is it material information disclosure of which could violate Reg FD? It’s a line that’s not always easy to discern. What’s more, whatever line-drawing takes place, it will always be evaluated by regulators with the benefit of hindsight.
As the Court in this case observed, since Reg FD’s issuance, the “SEC has enforced the regulation relatively sparingly,” focusing on more serious violations. According to the Court, “the SEC has signaled that it would not pursue ‘close calls’ in this area.”
In its opinion, the Court goes into great detail about the evidence, which occupies a major part of the opinion’s 129 pages. Generally, AT&T had been experiencing a decline in smartphone sales as a result of a number of factors, including primarily termination of customer subsidies for purchases as well as absence of new models. In the fourth quarter of 2015, the company’s revenue had substantially missed analysts’ estimates, leading the CFO to identify these trends on an earnings call with analysts in January 2016. In early March 2016, AT&T became aware of an especially steep decline in smartphone sales, including a potentially historic low rate at which existing customers purchased upgrades, and projected that its gross revenues would be well below the consensus estimate—not a particularly good place to be, especially since it would have been the company’s third consecutive quarterly miss. The company considered issuing a Form 8-K in early March that would have indicated that “wireless equipment unit sales [were] down year over year—impacting equipment revenues,” but ultimately ruled that out, deciding instead that the company’s CFO should discuss the issue at a scheduled investor conference on March 9, 2016. At the conference, the CFO referred back to his comments from AT&T’s fourth quarter 2015 earnings release regarding the decline in wireless equipment revenue and stated that he ‘would not be surprised’ to see that trend continue,” but did not provide any quantitative guidance for Q1, stating that he could “only talk about up through the fourth quarter.”
Those remarks were not enough, however, to induce analysts to lower the consensus revenue estimates sufficiently to be in line with AT&T’s internal estimates. To that end, a plan was developed for the IR Department to reach out to individual analysts to walk down the estimates, and these communications continued from March 9 through the eve of the earnings announcement on April 26, when AT&T announced results that beat consensus revenue by less than 1%. The SEC alleged that the plan was understood to be “a top priority at the company.” According to evidence from an AT&T employee, the CFO had said that he wanted to make sure that the IR Department was “working the analysts that still have equipment revenue too high” and was told that one of the defendants characterized it was a “top priority over the next few weeks.”
According to the Court, it was “undisputed that, before AT&T announced its 1Q16 financial results, the following data about AT&T’s Q1 performance was not publicly available: total consolidated revenue, wireless equipment revenue, and the wireless equipment upgrade rate.” The Court then painstakingly reviewed the testimony and other evidence reciting the specific disclosures of this data that were made to analysts , week by week, during that period. The Court also noted the SEC’s contention that, “of the 25 quarters since 2006 in which analysts’ estimates had initially been more than 0.5% higher than AT&T’s ultimate results, Q1 2016 was the only quarter in which these estimates were eventually revised to a figure lower than AT&T’s revenue, enabling it to exceed the consensus revenue forecast.”
Elements of Reg FD. On summary judgment, the parties’ dispute centered on the elements of materiality, selective disclosure of nonpublic information and scienter. With regard to materiality of the disclosures, the SEC contended that the information selectively disclosed to analysts was material because “the information (1) enabled AT&T to meet (and exceed) analysts’ consensus expectations for Q1 2016; and (2) alerted analysts in advance about three important performance metrics—all unexpectedly low—for that quarter: AT&T’s consolidated total revenue, wireless equipment revenue, and wireless upgrade rates.” The Court viewed the evidence supporting materiality to be “overwhelming.” In particular, there was “overwhelming evidence, both documentary and testimonial, on which a jury could find that in March and April 2016, AT&T undertook a campaign, choreographed at high levels of the company, to walk down analysts’ estimates….Insofar as the IR defendants’ disclosures were found to convey to analysts the fact that AT&T was on track to miss the then-consensus, ample authority—in both accounting literature and case law—supported that such information was material.” The defendants contended that it was not material because, previously, missed consensus estimates had not appreciably moved the stock price. But the Court concluded that, under the case law, that is “rarely dispositive of materiality.” In addition, the SEC observed that there was contemporaneous evidence that favorable news in the same announcement countered the bad news.
With regard to the materiality of the individual performance metrics that were alleged to have been disclosed, there was again “overwhelming evidence” of materiality, including identical data appearing in multiple analysts’ notes of calls with defendants, as well as evidence supporting the contention that the “March and April 2016 campaign was specifically undertaken to avoid missing analysts’ consensus as to total revenue,” one of the metrics allegedly disclosed. Although the metrics regarding AT&T’s wireless equipment revenue and wireless upgrade rates were “idiosyncratic and narrow such that they ordinarily would not form the basis of a finding of materiality, the evidence the SEC has adduced in this case would enable a jury to so find here.” Notably, the Court observed, those metrics appear to have driven the initial estimates as well as most of the lowered estimates of total revenue that enabled AT&T to meet and beat consensus. The Court did not find the defendants’ contention of quantitative insignificance to be persuasive, nor was evidence of profit neutrality. In addition, the Court noted that AT&T attributed significance to these metrics, discussing them in earnings calls, emails from C-suite executives and SEC filings. There was also evidence that these metrics mattered to analysts, who often addressed them in their reports to investors.
The Court also considered the evidence to be “overwhelming” that the IR defendants selectively disclosed nonpublic information to analysts. Defendants argued that analysts and investors could have extrapolated the information from public information. The Court, however, viewed that claim as “at odds with the evidence of the analysts’ behavior. The evidence does not reflect that any analyst, or other AT&T outsider, had performed such an exercise and arrived at this result.”
In addition, defendants argued that the IR defendants only directed analysts to the information the CFO had publicly disclosed at the March 9 conference. However, the CFO had spoken “at a high level of generality, that declines in equipment revenues and wireless upgrade rates were likely to continue.” The Court concluded that, as a “basis for summary judgment for the defense, this argument fails.” Although the CFO’s remarks were made at a public conference, they “self-evidently did not disclose the data which the SEC contends—and the analysts’ notes corroborate—was later selectively disclosed to individual analysts. They did not come close to doing so.” Rather, the evidence suggested that the CFO’s remarks failed to cause the analyst community to adjust their projections down sufficiently and that this failure “catalyzed the campaign of calls” beginning in mid-March. Analysts’ actions to further reduce estimates following the commencement of those calls “further undermines” the theory that the statements by the CFO at the conference “effectively disclosed the data” that the SEC contends the three IR employees selectively disclosed over the next six weeks”; as “the SEC notes, many analysts did update their models following the conference. But they updated these again—with materially worsened forecasts for Q1 2016’s revenue—after their conversations with an IR defendant.”
As opposed to the elements of materiality and nonpublic information, “as to which the evidence lopsidedly supports the SEC’s claim, there is substantial evidence on which a jury could find for either side as to the scienter element.” Scienter here “turns on whether the IR defendants knew, or were reckless in not knowing, that the data about AT&T’s Q1 2016 performance… was both material and nonpublic. Among the facts identified by the Court as favoring a finding a scienter were the number and duration of disclosures over the six-week period, the variety of internal data disclosed, the persistence of disclosure until the analyst consensus was brought into line, the training about Reg FD given to the IR employees (which “instructed them that no metric or number may be discussed with analysts unless the metric was already public, regardless whether it was material”) and their violations of internal rules. “A jury,” the Court suggested, “could also find incredible and abundantly contradicted by the record—and so risible as to support drawing negative consciousness-of-guilt inferences—defendants’ denials in testimony that they had ever disclosed quantitative metrics to the analysts,” and “discredit as clearly false” their contentions that their discussions with the analysts merely recapitulated the CFO’s statements. And, in the big picture, a jury could find that “these overall efforts were highly irregular and that it had been reckless (at a minimum) to participate without confirming that these complied with Reg FD.”
On the other hand, “the showing as to the defendants’ states of mind required of the SEC here, while short of criminal intent, is formidable….On multiple grounds, a jury here could find this state of mind not established. Most obviously, the jury could credit defendants’ uniform testimony that, in real time, they had not appreciated that the information they were disclosing was material and nonpublic. A jury could also note the absence of evidence that, in real time, any person within AT&T—including the defendants or the supervisors who had instigated the campaign to lower consensus—raised an alarm or expressed any hesitation or reservation about the legality of the ongoing disclosures.” Nor was there evidence that any analyst expressed a similar concern.
Accordingly, the Court denied summary judgment to both sides.
First Amendment. One of the more interesting aspects of the case, however, was not about the application of Reg FD, but rather the Court’s efforts to address—at great length—the defendants’ threshold challenge to Reg FD itself on the basis of the First Amendment. (The Court made quick work of other challenges by the defendants, not discussed in this post, under the due process clause of the Fifth Amendment, a contention that Reg FD was promulgated without statutory authority and a claim of logical inoperability.) The First Amendment issue has been raised in the past as a challenge to Reg FD, but, as the Court noted, “[n]o court has yet ruled, or opined, on Reg FD’s constitutionality.”
The defendants contended that Reg FD is “content based,” and, as a result, “must be narrowly tailored and advance a compelling government interest to satisfy the First Amendment.” Alternatively, they argued that it compels speech by “requiring companies to make a public disclosure following any private communication with an analyst made in violation of Regulation FD’s content-based restriction,” and is subject to strict scrutiny. Under either strict or intermediate scrutiny, they contended, Reg FD fails. According to the defendants, there “is no substantial or compelling government interest to be achieved by preventing companies from disclosing truthful information to analysts who are already prohibited from trading on material nonpublic information—and certainly no substantial or compelling government interest that would warrant prohibiting AT&T from disclosing the specific information that AT&T’s IR team allegedly selectively disclosed in this case.…. Companies have a legitimate interest in making sure analysts understand their business and prior public disclosures before publishing reports about them.” The SEC argued that Reg FD governs the selective manner, not the content, of disclosure and is subject to a rational-basis standard, requiring only that it be “reasonably related to an adequate interest and not be unduly burdensome.” The SEC said the Reg FD would survive that standard, as well as immediate scrutiny.
The Court, however, found that none of these standards provided a “satisfying match” for Reg FD. Although Reg FD is content-based, the Court was unpersuaded that strict scrutiny applied. Rather, “Reg FD is fairly viewed as a component of a broad regulatory disclosure scheme aimed at assuring that issuers inform investors on an evenhanded basis of material information about an issuer, and protecting investors against sharp practices, which here include slipping MNPI to favored audiences. The disclosure components of this body of law and regulations have not, historically, been subject to strict scrutiny.”
With respect to the contention that Reg FD compels speech, the Court determined that it is not political speech or opinion, subject to strict scrutiny, but rather is “more akin to the interest in avoiding consumer deception that underlies numerous statutory and regulatory disclosure requirements. These historically have been upheld provided they are reasonably related to preventing the deception of consumers.” The SEC contended that Reg FD was instead comparable to compelled commercial speech—“expression related solely to the economic interest of the speaker and its audience,” and subject to rational-basis review under SCOTUS’s decision, Zauderer v. Office of Disciplinary Counsel (1985). (For a discussion of the issue of compelled commercial speech in the context of the conflict minerals decision, see these PubCo posts of 7/16/14, 7/29/14, 9/14/14. ) However, although there were similarities, according to the Court, “case law to date has stopped short of equating the two.” While the commercial speech doctrine was a “closer fit,” in the Court’s view, it has “centered on advertisements or speech otherwise proposing a commercial transaction,” and is thus “ultimately also a mismatch for the speech covered by Reg FD.” Reg FD involves broader communications, the Court said, and rejected the SEC’s invocation of compelled commercial speech cases as “inapposite” or only “lightly instructive.” The Court concluded that “Reg FD’s idiosyncratic quality makes it an imperfect fit for any existing familiar First Amendment framework.”
Note that, in an en banc opinion in American Meat Institute v. U.S. Dept. of Agriculture, the D.C. Circuit upheld the USDA’s country-of-origin labeling rule, which AMI had argued compelled disclosure in violation of the First Amendment mandatory disclosure regulation at issue in that case. The Court held (with two dissents) that “Zauderer in fact does reach beyond problems of deception, sufficiently to encompass the disclosure mandates at issue here.” The Court observed that “Zauderer itself does not give a clear answer” and that the language regarding deception “could have been simply descriptive of the circumstances to which the Court applied its new rule, or it could have aimed to preclude any application beyond those circumstances.” In the end, however, consistent with the holdings of two other circuits, the Court concluded that the Zauderer language “sweeps far more broadly than the interest in remedying deception.” Moreover, specifically citing the National Association of Manufacturers conflict minerals case, the Court specified that “[t]o the extent that other cases in this circuit may be read as holding to the contrary and limiting Zauderer to cases in which the government points to an interest in correcting deception, we now overrule them.” (See this PubCo post.)
After concluding that strict scrutiny was clearly inapplicable, the Court examined Reg FD under the intermediate-scrutiny standard, and determined that Reg FD satisfied both that standard and the less demanding rational-basis standard. Applying intermediate scrutiny, the Court concluded that the speech at issue was lawful, the asserted government interest in combatting selective MNPI disclosures was substantial and directly advanced the government interest asserted—market integrity and protection of investors. Finally, the Court concluded, Reg FD did not burden substantially more speech than necessary to further its legitimate interests: it “does not prohibit speech. It does not compel speech containing any new content; its sole requirement, that MNPI be disseminated publicly, is limited to circumstances in which a corporation has already disclosed—selectively—the same MNPI. And, as the SEC explained, it is simple and inexpensive for a corporation to disseminate such information to the market.” Accordingly, the Court found that Reg FD, as applied in this case, “satisfies intermediate scrutiny—the most rigorous level potentially applicable to it—and does not violate the First Amendment.”
This post comes to us from Cooley LLP. It is based on the firm’s blog post, “SEC v. AT&T headed to trial—is Reg FD constitutional?” dated September 15, 2022, and available here.