He likes to chat.

Photographer: Peter Foley/Bloomberg

Sometimes Companies Meet With Their Owners

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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An important idea in modern corporate capitalism is that the shareholders are the owners of the corporation. If you believe this -- and most people mostly do, though you shouldn't take it too literally -- then you presumably also think that the managers work for the owners, that is, for the shareholders. The least the managers can do, then, is to meet with the shareholders sometimes, keep them posted on how things are going and listen to the shareholders' feedback. The shareholders, after all, are the bosses.

And so that happens: Lots of managers spend lots of time meeting with shareholders individually or in small groups, telling them how things are going and listening to what the shareholders have to say. Sometimes managers even go to Carl Icahn's apartment for dinner and a chat about buybacks. Here is an excellent Wall Street Journal article about the practice, which seems very sensible and straightforward if you think about it as corporate executives meeting with their bosses, but which is somewhat more worrying if you think about it as managers talking secretly with favored shareholders. These meetings, which tend to occur between managers and the bigger shareholders, are "a booming back channel through which facts and body language flow from public companies to handpicked recipients." If you are not a handpicked recipient, you might feel aggrieved.

These meetings sometimes seem like the sort of thing that works in practice but not in theory, though the theory is straightforward enough. There is a Securities and Exchange Commission rule called Regulation FD, which "provides that when an issuer discloses material nonpublic information to certain individuals or entities—generally, securities market professionals, such as stock analysts, or holders of the issuer's securities who may well trade on the basis of the information—the issuer must make public disclosure of that information." Companies can't selectively disclose material information to particular shareholders or analysts; material information must be disclosed to everyone simultaneously.  "Material" is a pretty vague term, but the classic statement in the law is that for a fact to be material, "there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available." 

How does this rule fit with the fact that companies have private meetings all the time with selected shareholders or analysts? The defense of these meetings is typically that the company never says anything material. But there is an obvious efficient-markets disproof of that, which is that if these meetings weren't significant for investors the investors wouldn't go. They're not, like, fun. 

Actually it's worse than that. Not only do the investors go to the meetings, they pay to go. From the Journal:

Invitations are doled out to money managers, hedge funds and other investors who steer trading business to the securities firms, which in turn provide the investors with a service called “corporate access.”

Investors pay $1.4 billion a year for face time with executives, consulting firm Greenwich Associates estimates based on its surveys of money managers. The figure represents commissions allocated by investors for corporate access when they steer trades to securities firms.

So it's a $1.4 billion a year industry that provides only useless trivial information.

To me the real upshot here is that U.S. securities law is built around the concept of "materiality," but there is no actual concept there. Companies must disclose "material" information broadly but can do whatever they want with "immaterial" information, and there is no clear distinction between the two. "Material" information is just, unhelpfully, information that a reasonable investor would consider significant.  In the olden days this worked more or less fine: Big things were material, little things weren't, and borderline cases went to court and the court made a judgment call. Judges assumed they could figure out which facts were significant and which weren't, just by looking at them. A merger was material, though there was debate about when exactly merger negotiations became material. The chief executive officer's body language in a private meeting was not material.  

Obviously investors were interested in the not-material stuff, but the law could just sort of wave that away. Here, for instance, is some garble that the SEC said in adopting Regulation FD:

An issuer 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. Similarly, 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. We do not intend, by Regulation FD, to discourage this sort of activity. The focus of Regulation FD is on whether the issuer discloses material nonpublic information, not on whether an analyst, through some combination of persistence, knowledge, and insight, regards as material information whose significance is not apparent to the reasonable investor.

What does that mean?  I think -- and hoo boy is this not legal advice -- it means that it's okay for companies to selectively disclose information to big sophisticated investors, as long as it's the sort of information that only big sophisticated investors are likely to find useful. A reasonable dentist who checks his stock portfolio once a week would be interested in knowing about an upcoming merger, but might not want to get into the details of a company's expected gross margin for the upcoming quarter, or the exact terms of a customer contract renewal. A hedge fund manager focused on the company might find those details very meaningful indeed. That SEC paragraph sort of hints that those details, which matter to hedge fund managers but not to "the ordinary investor," might not be material.

Now this is itself a weird standard: If companies can selectively disclose information as long as it is only useful to professional investors with keen knowledge, insight, etc., then that means that they can favor some professional investors over others. Which does not seem exactly, you know, fair.

But there's another problem. Since the development of the materiality standard, there have been major advances in computer technology and university finance departments, and we've just gotten better at figuring out how to isolate and quantify the value of information. In the olden days, courts could look at a "mosaic" of information and just see the big picture. Modern finance can examine each tile of the mosaic, sift out the ones that came from the company and determine their precise value. If that value isn't zero, it's gotten harder to argue that those tiles were immaterial.

So a judge could tell you that news of an impending merger is material, but he might not be able to tell you whether news of a customer contract renewal is material. A contract renewal sounds good, generically, but the actual impact depends on the pricing and terms and other things that it might take knowledge and insight to understand. But three academics -- Alma Cohen, Robert Jackson and Joshua Mitts -- went and looked at customer and supplier contract announcements and found "that a trading strategy of buying on the date such an agreement is struck and selling immediately before the agreement is disclosed yields, on average, abnormal returns of 35.4 basis points."  So if you met with a company, and it told you about an about-to-be-announced customer agreement, and you bought the stock, and sold as soon as the agreement was announced, you'd make a profit of 0.35 percent. Is that good? It hardly seems worth it for an ordinary investor; it might well be worth it for a hedge fund. But the point is that now we can quantify it, so it's harder to write it off as trivial. If you can put a number on it, it looks like an unfair advantage. "Insiders Beat Market Before Event Disclosure: Study," was the Wall Street Journal headline on this study. "'Trading the gap' gives insiders a big advantage in stock trades," said the Washington Post. The reasonable dentist might not want the details of a customer contract renewal, but he'd take the extra 0.35 percent, thanks.

Things get even weirder when you look at insider trading. Prosecutors tried to send two hedge fund managers, Anthony Chiasson and Todd Newman, to prison for 6 1/2 and 4 1/2 years, respectively, for getting nonpublic information from Dell and Nvidia insiders. For instance, one quarter, Chiasson and Newman apparently learned that Dell's "gross margin was 'looking at 17.5%' versus market expectations of 18.3%." Would that be material to an ordinary investor? I don't know. But prosecutors claimed that it was, and moreover that this sort of "detailed, pre-announcement earnings information" was so obviously material that Chiasson and Newman should have known it was obtained illicitly. If the insiders leaked that information illicitly and without corporate approval, and Chiasson and Newman knew about it, that would be illegal insider trading. 

But a federal appeals court reversed their convictions, finding that "the evidence showed that corporate insiders at Dell and NVIDIA regularly engaged with analysts and routinely selectively disclosed the same type of information." So the information that prosecutors thought was self-evidently material and illicit, a court found that Dell and Nvidia "regularly" and "routinely" gave to favored analysts. But whereas prosecutors wanted to put individuals in prison for years for getting that information from company insiders, no one seems interested in punishing the companies for giving it out themselves as a routine matter. Is it a violation of Regulation FD? I mean, if it was material enough that prosecutors and a jury thought it was criminal insider trading, and yet was disclosed selectively by the companies, then how could it not be? It sure seems like we lack a coherent theory of what companies are and are not allowed to selectively disclose.

Now of course you could imagine a simpler and more coherent rule. You could, for instance, just forbid companies from meeting with shareholders privately: Any shareholder communication would have to be in public and available simultaneously to all shareholders.  This seems to have been considered when Regulation FD was adopted, but the Journal says that "Companies and securities firms lobbied successfully to preserve the right to hold private meetings with investors."

As well they might! Of course companies want to have meetings with investors. Companies sometimes need money, for one thing, and it is much easier to persuade investors to buy your shares if you have built some sort of personal relationship with them, or at least looked them in the eye and shook their hand during a roadshow. And the shareholders are, more or less, the bosses: You want to build a good relationship with them, and listen to their suggestions, so they don't fire you and vote in new management.  The fiction that the stock market is supposed to be a level playing field conflicts with the fiction that the shareholders own the corporation and that the managers answer to them.

Both of those ideas have a bit of fiction to them, but the first is the most fantastical. Capital markets can never be fair, and professional investors who have the time and money and resources and clout to meet with companies will always have an informational advantage over day-trading hobbyists. And if we expect otherwise, our rules will always be a bit incoherent.

  1. I mean it is a useful fiction, or an approximate description of the state of affairs, or something. Shareholders don't literally own the corporation, come on. Here are Andrew Haldane and Lynn Stout

  2. Or as soon as possible, if the company accidentally gives it to selected shareholders. As happens. From the Journal:

    And it is easy for companies to trip over the legal line. In April, Bebe Stores Inc. told what it called a “select group of investors” that the retailer was “meeting our expectations.”

    The next day, Bebe, based in Brisbane, Calif., disclosed the same comment in a securities filing, saying it had made an “inadvertent disclosure.” 

  3. We talked last week about the value proposition that sell-side research offers to its customers, and this is a big part of it. There are people who dismiss the value of sell-side research, but of course the value of sell-side research departments is not just about their published research. If they help big clients in other ways -- by talking to them, or by getting them management access -- then analysts can earn their keep even if all their recommendations are wrong. I've mentioned before that "You could have a model where the best thing that a research analyst could do for his investing clients is put a 'buy' on every stock he covers, so as to get lots of management access and let his clients decide for themselves."

  4. I've written before about how the "reasonable investor" part of that definition makes no sense in an age of algorithmic trading: If you know information that has nothing to do with the company, that can still be significant to the dopey algorithms that trade its stock, and so can still move its price -- even if no reasonable investor would care.

    The example is that if you knew Nest was being acquired by Google, you could buy stock in Nestor (ticker: NEST), knowing that algorithms would see headlines to the effect of "Nest acquired by Google" and immediately cast about for the first thing to buy. Reasonable? No. Market-moving? Yes.

  5. I always assume "body language" is a euphemism for, like, "muttered stock tips," but you never know. The Journal article includes the examples of Regions Financial, which met with investors a few days before the 2013 stress test results, "appeared 'very confident'" at the meeting and passed the stress test a few days later; and of the weak "body language" of J.C. Penney's CEO at an investor breakfast the day before J.C. Penney announced a big share sale. And it quotes a hedge fund manager saying that "You can pick up clues if you are looking people in the eye."

  6. Right before that paragraph, the SEC says that "an issuer cannot render material information immaterial simply by breaking it into ostensibly non-material pieces," which sounds very precise and mathematical but which I don't think makes any sense? 

  7. More generally, they found that insiders often traded, profitably, between the time a company did something and the time, up to four days later, that the company disclosed it on a Form 8-K. (Form 8-K comes with its own materiality standards, incidentally; you'd think anything on an 8-K would be ipso facto material. But who knows.

  8. Really just before, but how would you know that? Just after would probably be fine.

  9. "And it’s perfectly legal," the Post headline goes on to say, though I'm not sure why. That's exactly what is up for debate here. It is at most imperfectly legal.

  10. One theory you could have is that the materiality standard in Regulation FD is much more permissive than the one in insider-trading law, because U.S. securities law is about protecting corporations rather than about fairness. So if someone misuses corporate information, the law will punish him hard; but if the corporation gives out the information illicitly, the law will look the other way. Remember, insider trading is about theft, not fairness. So the Journal notes:

    In the past 15 years, the SEC has brought 14 enforcement actions under Reg FD, according to Joseph Grundfest, a former SEC commissioner who now is a professor at Stanford University.

    The SEC brought more than 14 enforcement actions for insider trading in 2014 alone.

  11. And potential shareholders? Sure why not.

  12. It goes without saying that of course securities firms want to intermediate those meetings.

  13. Also, even if you really could ban all investor meetings, you couldn't ban companies from meeting with anyone who might buy their stock. If you need a bank loan, are you not allowed to meet with a bank because it might own your stock? Are you not allowed to meet with customers or suppliers who might buy your stock? 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
Zara Kessler at zkessler@bloomberg.net