Typically, the last act in a venture capitalist’s job is sitting on the board of a newly minted public company. Given the risks inherent in guiding the disclosure policies of an emerging company with a volatile stock price, while simultaneously realizing upon the VC’s investment in the company, this role often presents the greatest potential for liability to the venture capitalist. Recently, the Securities and Exchange Commission raised the stakes even higher for VCs by issuing Regulation FD (for Fair Disclosure) and two new insider trading rules.
Regulation FD is intended by the SEC to end the practice of selective disclosure by public companies to analysts and large investors in closed conference calls and one-on-one meetings. Under Regulation FD, public companies that intentionally disclose material inside information to a select group of analysts or investors must simultaneously disclose it to the public.
In the case of unintentional disclosures, public companies must disclose the information within 24 hours of the inadvertent disclosure or by the start of the next trading day. Failure to comply with Regulation FD can result in enforcement action by the SEC, the mere threat of which could threaten a company’s reputation and its market value.
The adoption of Regulation FD was controversial and the final rule contained several significant concessions in response to numerous comments to the rule as first proposed. For example, Regulation FD does not cover communications made in connection with most registered public offerings and violation of Regulation FD will not affect an investor’s ability to resell under Rule 144 or a company’s ability to use a Form S-3 short form registration statement. In addition, the rule does not apply to conversations with suppliers, customers, the news media or rating agencies. In the final rule, the SEC also exempted foreign issuers from its coverage.
Many commentators objected to the rule as unnecessary given that the current practices of most public companies are designed to avoid selective disclosures. Many companies provide advance notice of their quarterly earnings calls with analysts and allow the public to listen in via a Webcast on the Internet or by telephone. Moreover, Nasdaq and New York Stock Exchange listing requirements have mandated for years that public companies promptly disclose any material information. Nonetheless, the SEC adopted the rule in order to give the SEC enforcement powers, including injunctions and monetary penalties, to go after individuals and companies that engaged in selective disclosure. Although the rule expressly states that violations cannot in and of themselves be the basis for a securities class action, the specter of an SEC enforcement action has already had a significant chilling effect on the willingness of public companies to talk with analysts privately.
Regulation FD may not have a significant impact on large-caps such as General Electric or Intel that are covered by dozens of analysts and about which there is ample publicly available information, however small start-up, emerging companies are often in need of analyst coverage to tell their story to investors. The new rule will likely have a chilling effect on their ability to do that. Typically, these companies have a limited investor following, so there’s less incentive for analysts to cover them, and they are often in newer, emerging markets about which there is less publicly available information. As a result, analysts often require in-depth one-on-one meetings with management before they pick up coverage of these companies to develop the background information and knowledge they need. The potential for the new rule to disproportionally impact smaller, emerging companies will be a real concern for venture capitalists.
Insider Trading Rules
The two new insider trading rules (10b5-1 and 10b5-2) adopted by the SEC significantly expand the potential liability for insider trading and should be an even greater cover to VCs than Regulation FD. In essence, these new rules represent an effort by the SEC to sidestep well-established defenses to insider trading charges that have been developed by the federal courts.
New Rule 10b5-1 would create insider-trading liability for anyone who traded while aware of material inside information. This rule stands in stark contrast to federal court rulings that have required proof that a person charged with insider trading “used” material insider information. The new rule does provide a very narrow defense for trades made pursuant to binding contracts, instructions or written plans that are in place before an insider becomes aware of any material inside information. This defense, however, is only available if the arrangement expressly specifies the amount, price and date of any trades or gives some third party complete discretion over trading. In addition, the defense is lost to any person who alters or deviates from the contract or plan or who enters into or alters any hedging transactions.
For a number of years, securities lawyers have advised corporate insiders to dispose of their stock on a consistent, periodic basis to avoid allegations that a particular trade was motivated by material inside information. Indeed, a number of courts have held that a history of such trading will protect an insider from insider trading charges when they sell prior to a significant drop in their stock. Under the new rules, however, a regular pattern of trading is no protection unless it was conducted in strict accordance with a contract or written plan meeting the specific requirements of the rule.
New Rule 10b5-2, expands the circle of people who are liable for insider trading when they trade on the basis of a tip received from someone else. Under the new rule, people who received material inside information from their parents, spouses, children, siblings or others with whom they have a history of sharing confidences will now be liable for insider trading if they subsequently trade on the basis of that information.
Both Regulation FD and the new insider trading rules become effective on October 23, 2000, but public companies should begin compliance immediately.
In light of these new rules, VCs and their portfolio companies should consider some of the following actions:
* Increase Your IPO Co-managers. Recently, it has become common to have three co-managers on an IPO. For larger deals, it’s not unusual to have four or five co-managers. Given that Regulation FD does not apply to IPOs or most follow-up offerings, companies are well advised to have more co-managers and use the opportunity to tell their story to more analysts without fear of a Regulation FD violation. Managing the economics of such large syndicates will be a challenge, particularly for smaller deals, but it will probably be easier than attracting new analyst coverage after an IPO given the constraints of the new rule.
* Make Earnings Calls Public. As a matter of course, companies should open up their earnings calls to the public. In order for this approach to be effective, companies should provide advance notice of the call, together with information on how to listen to it live, via Webcast or by telephone. During the call management should not suggest that they will “get back” to analysts with more information at a later time, or make similar statements suggesting the possibility of selective disclosure.
* Adopt Quarterly Quiet Periods. Many companies already have a practice of avoiding analyst meetings or investor presentations at the end of their quarters in order to avoid giving any signals on where the current quarter is going to end up. In light of Regulation FD, all companies should adopt a policy of not communicating with analysts selectively beginning with the last month of a fiscal quarter and continuing until results for that quarter are announced.
* Update Disclosure Policies. Although Regulation FD only applies to senior management and investor relations professionals, the SEC has indicated that they will bring enforcement actions against companies that selectively disclose material information through junior-level personnel. Accordingly, companies should re-emphasize disclosure policies that restrict discussion with analysts and investors to senior management and preclude disclosure of confidential information in any circumstances.
* Adopt Written Disposition Plans. The new insider trading rules will apply to venture funds that have representatives on a public company’s board. Accordingly, VCs should consider adopting written disposition plans on the timing and amount of sales and distributions they make with respect to portfolio company securities. Care must also be given not to deviate or amend those plans or the protection of the safe harbor will be lost. In addition, general partners in venture funds should probably take similar precautions for their own disposition of portfolio company securities which they receive in distribution from their funds.
Company management should be counseled to establish similar written plans or arrangements, since insider trading allegations against management often results in securities class action suits against their companies. In addition, the new rules state that insiders can insulate themselves from liability by granting complete disposition discretion over their securities to a third party. Such “blind trusts” may be a good idea for managers and general partners with respect to the disposition of securities they own. For venture funds, however, such a delegation of authority is probably inconsistent with their fiduciary duties to their limited partners. t
John Egan III and David Cifrino are corporate partners in the Boston office of the international law firm of McDermott, Will & Emery.