Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

In a recent post (here), I discussed the recent work of two blue-ribbon groups focused on eliminating "short-termism" and recommending, among other things, the elimination of quarterly earnings guidance. The results of the National Investor Relations Institute's 2007 Earnings Guidance Practices Survey (press release here, survey results here) suggest that more companies are shifting away from quarterly earnings per share guidance. The survey results also appear to refute the suggestion that companies that eliminate guidance suffer adverse effects, as discussed further below.

The NIRI survey's results appear somewhat contrary to some recent academic research on related topics. An April 2007 paper by Joel Houston and Jenny Tucker of the University of Florida and Baruch Lev of New York University entitled "To Guide or Not to Guide? Causes and Consequences of Stopping Quarterly Earnings Guidance" (here) takes a look at a sample of 222 companies that ceased to provide quarterly earnings guidance during 2002 through the first quarter of 2005. The authors found that the "stoppers" ceased guidance for a variety of reasons, all suggesting operating weakness or other concerns, such as poor earning performance, poor record beating estimates, change in management, or difficulty in predicting earnings. The authors also found that "stoppers" experienced a relative decrease in analyst coverage and a relative increase in analyst forecast dispersion.

In summarizing their findings, the authors state:

In a nutshell, guidance cessation follows a poor operating performance and causes a deterioration in the information environment about the company. The major benefits claimed from stopping quarterly guidance - enhanced investment in the long-term and increased strategic disclosures - do not appear to materialize. Moreover, 31% of the stoppers in our sample subsequently resumed quarterly guidance, suggesting that it is rather difficult for firms to buck the trend and abstain from quarterly earnings guidance. Thus, we conclude that, consistent with economic theory, decreasing disclosure - stopping guidance in our case -does not seem to benefit investors or firms.

The 2007 NIRI survey report paints a different picture, perhaps because its survey reflects a later time period than the period the academics studied. The NIRI survey group also includes companies that never provided earnings guidance, as well as "stoppers," which may account for some of the differences in findings.

The NIRI survey found that only 51% of 2007 survey respondents provide earnings guidance of some kind, compared to 60% of 2006 survey respondents, and that only 47% of 2007 survey respondents provide revenue guidance, compared to 56% of 2006 survey respondents. Of the survey respondents that provide guidance of some kind, only 27% provide quarterly guidance. The 133 responding companies that provide quarterly guidance represents only 17.68% of the 752 survey respondents.

The NIRI survey's findings about the impact on "stoppers" who ceased providing earnings guidance in the last 24 months contrasts significantly from the findings in the academics' research. The NIRI survey results reflect an indifferent reaction from both the buy-side and the sell-side to the elimination of quarterly earnings guidance. The NIRI survey respondents reported that discontinued guidance had a neutral effect on their company's stock's valuation and volatility, and that their companies had not experienced unusual shareholder turnover. Moreover, only 11% of the companies that do not provide guidance were even considering providing guidance in the future.

Perhaps the later time period reflected in the NIRI survey compared to the time period reflected in the academics' research explains some of the differences between the two reports. A more cynical view might be that the NIRI study is a survey that depends on respondents' views, whereas the academics' analysis was based on the companies' actual performance.

In any event, the presence or absence of guidance may make less of a difference for companies' goals than is generally assumed. A July 23, 2007 Wall Street Journal article entitled "Numbers Game: Why 'Guidance' May Not Matter" (here, subscription required) reported on a recent study by Thomson Financial that took a look at company performance relative to guidance. Conventional wisdom holds that company executives use guidance to "manage expectations" by keeping analysts' estimates low ahead of earnings announcements, so that the reported numbers look better. But the Thomson Financial study found that between 2001 and 2006, the S & P 500 companies that issued guidance beat analysts' estimates 65% of the time, while companies that didn't issue guidance beat analysts' estimates 63% of the time.

But whatever companies' motivations may be for providing guidance, the NIRI survey suggests that fewer and fewer companies are doing it. I don't think the academics' research can be disregarded, but I think it may need to be updated. For example, if the class of "stoppers" were brought up to date and the early part of the academics' data set eliminated (say, data from years 2002 and 2003), the academics' research might well more closely resemble the NIRI survey's results.

In any event, the academics' analysis also represents a particular point of view. The academics expressly advocate the view that it is better if companies provide guidance, on their generalized economic theory that more information is better for the marketplace. But whatever the merits of this analysis in its own context, it is divorced from the practical effect that a public earnings prediction has on the behavior of company officials. Specifically, companies that have established a target will strain to meet it. As I have previously noted (most recently here), a short term orientation driven by earning estimates is frequently at the heart of problems that lead to shareholder claims. I am all in favor of complete disclosure about past performance. But whatever the arguable economic benefits from trying to make public predictions about the future, from a risk standpoint, companies will always be better off keeping their projections to themselves, particularly on quarterly projections.

A July 24, 2007 CFO.com article discussing the NIRI survey results and the academics' reserach can be found here.

Deeper Dive: In an earlier post (here), I took a look at the 2007 year-to-date securities lawsuits, and I also took a look (here) at the question whether the downturn in securities lawsuits may be temporary or is permanent. In the latest issue of InSights (here), I take a deeper look at both of these topics.

D & O Litigation Update Teleconference: On August 15, 2007, from 2:00 pm to 3:45 pm Eastern, I will be participating in a Mealey's sponsored D & O Litigation Update teleconference (here). My co-panelists are Marialuisa Gallozzi of the Covington & Burling law firm and Joe Monteleone of the Tressler, Soderstrom law firm. Topics to be discussed include the impact of global warming legal and regulatory issues on the board room and on D & O exposure; the impact of recent Supreme Court decisions, including Tellabs; D & O coverage issues arising from the subprime lending lawsuits; and problems with insurability of Section 11 settlements.

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As I have noted in prior posts (most recently here), there is a growing chorus of voices calling for the elimination of "short-termism," and specifically, for the elimination of quarterly earnings guidance. The recently issued reports of two blue-ribbon groups underscore the need for companies to develop and maintain a long-term orientation. More specifically, both reports also recommend the elimination of quarterly earnings guidance.

The first of the reports, called "The Aspen Principles" (here) was released on June 18, 2007 (refer here) and developed by the Aspen Institute, a group of corporate executives, business groups and labor unions, and endorsed by the Center for Audit Quality, a nonpartisan group affiliated with the AICPA. The Aspen Principles were "prompted by concerns about the short-term pressures on publicly traded companies and rising public sentiment against executive compensation." The Aspen Principles contain a number of specific recommendations, including that corporate boards communicate with "long-term oriented inventors" about executive compensation; that senior executives be required to hold at least some portion of company stock beyond their tenure with the company; and that senior executives be barred from hedging the risk of long-term stock compensation.

The Aspen Principles also specifically recommend that "companies stop providing quarterly earnings guidance to analysts" and that they "not respond to analyst estimates." A June 20, 2007 Law.com article discussing the Aspen Principles entitled "Biz Group Takes Aim at Short-Term Investors" can be found here.

A more detailed discussion of the ways to fight companies' short-term focus appeared in the June 27, 2007 report of the Committee for Economic Development (CED), entitled "Built to Last: Focusing Corporations on Long-Term Performance." The Report can be found here, and a press release summary of the Report can be found here. The CED is an independent research group of over 200 business leaders and academics. The Report was prepared by the CED's Corporate Governance Committee, which is chaired by former SEC Chairman, William H. Donaldson.

The CED prepared its report because of its view that "an increasingly short-term focus by many business leaders is damaging the ability of public companies to sustain long-term performance." The subcommittee specifically focused on the "role directors can play in changing culture and practices of corporations" because of their view that "directors are uniquely positioned to make a difference." The subcommittee has "no illusion" that directors "by themselves can solve all the problems," and the Report acknowledges that some investors, and in particular hedge funds, may be driving short-term expectations. However, the Report expresses the belief that long-term perspectives are in the best interests of the companies themselves and of the overall economy.

The Report contains a number of specific recommendations, including the suggestion that directors should support management's development of strategic plans with long-term objectives, and structure incentive compensation so that a significant portion of executives' income is tied to long-term objectives.

The Report also specifically recommends that "companies voluntarily refrain from issuing short-term guidance," which, the Report notes, represents "both symbol and substance of concerns over companies' lack of strategic focus on long-term performance." The Report observes that about half of listed companies continue to give quarterly guidance, but that "research studies indicate that quarterly guidance is at best a waste of resources and, more likely, a self-fulfilling exercise that attracts short-term traders." The report cites a study of over 4000 companies between 1997 and 2004, which found no evidence that guidance affected valuation multiples, improved shareholder returns, or reduced share price volatility. The study did find that the cost of management time and other resources of providing earnings guidance were significant.

The Report also notes that "the availability of information on short-term performance acts as magnet to those who trade based on such considerations," but that "market pressure to provide earnings guidance may be receding," since many companies are discontinuing the practice. A June 28, 2007 news article discussing the CED Report can be found here.

As I have noted in prior posts, the elimination of quarterly earning guidance would not only contribute to the reduction of a short-term orientation, but it would also discourage activity that frequently is at the center of shareholders' claims against companies and their directors and officers. The drive to make (or avoid missing) earnings projections is the root cause of many behaviors that drive shareholder claims. As the CED Report puts it, "companies that drop quarterly guidance have one fewer reason to manage earnings."

The elimination of quarterly earnings guidance is the first step for any company that is serious about managing its securities litigation risk. By the same token, as an increasing number of companies eliminate quarterly guidance, and as more and more thought leaders call for the elimination of guidance, companies that continue to provide quarterly guidance could increasingly be viewed with concern by D & O underwriters - and perhaps even by investors with a long-term orientation.

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Eliminate Quarterly Guidance? On July 24, 2006, the CFA Centre for Financial Market Integrity and the Business Roundtable Institute for Corporate Ethics issued a Report entitled "Breaking the Short-Term Cycle: Discussion and Recommendations on How Corporate Leaders, Asset Managers, Investers and Analysts Can Refocus on Long-Term Value," calling on corporate leaders, asset managers and others to break the "short-term" obsession and reform practices involving earning guidance, compensation and communication to investors.

The report is the product of a series of symposia the groups co-sponsored to address issues of "short-termism." The symposia participants included a number of widely respected individuals, including John Bogle of the Vanguard Group, Louis Thompson of the National Investor Relations Institute, and other representatives from companies, investor groups and securities analyst firms.

The report states that "the obsession with short term results by investors, asset management firms, and corporate managers collectively leads to the un-intended consequences of destroying long-term value."

The report's recommendations include the following actions:

• End the practice of providing quarterly earnings guidance;
• Align corporate executive compensation with long-term goals and strategies and with long-term shareholder interests;
• Improve disclosure of asset managers' incentive metrics, fee structures, and personal ownership of funds they manage; and
• Endorse the use of corporate long-term investment statements to shareowners that will clearly explain - beyond the requirements that are now an accepted practice - the company's operating model.

With respect to quarterly earning guidance, the report notes the following:

Although there may be certain benefits to providing earnings guidance, the costs and negative consequences of the current focused, quarterly earnings guidance practices are significant, including (1) unproductive and wasted efforts by corporations in preparing such guidance, (2) neglect of long-term business growth in order to meet short-term expectations, (3) a "quarterly results" financial culture characterized by disproportionate reactions among internal and external groups to the downside and upside of earnings surprises, and (4) macro-incentives for companies to avoid earnings guidance pressure altogether by moving to the private markets.

A prior D & O Diary post noted that these and other concerns increasingly are motivating companies to move toward annual earning guidance only or the elimination of earnings guidance altogether. The elimination of quarterly earning guidance would not only address the concerns noted in the recent Report, but also would discourage activity that frequently is at the center of shareholders' claims against companies and their boards. The drive to make (or avoid missing) guidance is the root cause of many of the behaviors that drive shareholders' claims. The D & O Diary believes that implementation of the Report's recommendations for companies -- especially the Report's recommendation about eliminating quarterly earnings guidance -- would be an important step for any company that is serious about managing its securities litigation risk.

The groups' press release describing the Report can be found here. A summary of the Report's recommendations can be found here. A July 25, 2006 cfo.com post discussing the report can be found here. An AAO Weblog post on the report can be found here.

Stanford Clearinghouse Mid-Year Report: On July 26, 2006, the Stanford Class Action Clearinghouse, in conjunction with Cornerstone Research, released their 2006 Mid-Year Class Action Securities Fraud Class-Action Filings Report, which can be found here. The report notes that the 61 class actions filed in the first half of 2006 represents a 45 percent decrease compared to the 111 filings observed in the first half of 2005. The 2006 mid-year numbers represent the lowest level of filing activity during a six-month period since 1996, just after the adoption of the PSLRA. The Report speculates that the decline is due to the passage of time from the Internet bubble of the late 1990s; to possible improvements to corporate governance owing to Sarbanes Oxley; and the overall absence of volatility in stock prices during recent periods. The press release that accompanies the report includes a quotation from a Cornerstone official that "[a]lthough there is no doubt that there has been a considerably lower level of filing activity over the last year, it is still too early to tell whether this is a permanent shift."

The D & O Diary agrees that it is way too early to conclude that the YTD numbers represent a fundamental change. Among other things that the D & O Diary thinks could still produce an uptick in class action securites activity this year is the options backdating scandal and the slow dissolution of the Milberg Weiss firm. Although the options backdating scandal has only produced limited class action securities litigation so far (as the Cornerstone mid-year Report duly notes), the string on the scandal still has a long way to run. The gradual out-migration of Milberg lawyers, including the spawn of new law firms, as well as the attraction of existing plaintiffs' firms (including firms traditionally associated with tobacco or asbetos litigation) to Milberg's space, create a population of plaintiffs' firms and attorneys that need to justify their existence. In addition, market causes, such as the low share price volatility, can change. Rising interest rates and energy prices, war in the Middle East, and the threat of terrorism and natural catastrophes all present the potential to generate volatility and undermine the generally stable business environment we have enjoyed for several good years.

The D & O Diary also notes that the class action securities lawsuits may not even be the shareholders litigation story for the first half of 2006. The real story may be the raft of shareholders' derivative suits that the options backdating scandal has generated (up to 49 cases at last count.)

State of the D & O Marketplace: On July 17, 2006, Advisen released its "Commercial Lines Expert Witness Report for D & O" which surveys the current state of play in the D & O insurance marketplace. The report contains the comments from 14 "thought leaders" in the D & O arena (including underwriters, reinsurers, brokers and attorneys). The commentators share their views on trends in D & O pricing and terms and conditions; the impact of the options backdating scandal and of Sarbanes Oxley on the D & O marketplace; and legal developments that the experts are following. The Advisen Report is a little repetitive, but there are a few nuggets that reward close reading, particularly with respect to policy terms and to legal trends. The comments of several underwriters that D & O pricing will (or at least should) rise in the second half of 2006 appear problematic in light of the statistics in the Cornerstone Report. The Advisen Report can be found here.

Some Healthy Options Backdating Skepticism: As observers and commentators have tried to get a handle on how widespread the options backdating scandal is, some pretty large numbers have gotten thrown around. For example, Professor Erik Lie and Randall Heron's latest study concludes that over 2,200 companies backdated options. Comes now Broc Romanek of the CorporateCounsel.net blog who solemnly declares in this July 24, 2006 post that "[m]y gut tells me there is something fishy" about these numbers. The basis for Romanek's skepticism is a fundamental disbelief that that many people are lying, coupled with a informed belief that many companies have already verified that their companies do not have a problem. Whether or not Romanek's gut is more reliable than Professors Lie's and Heron's analysis is for others to decide, but Romanek does have a point. The sheer magnitude of the Professors' numbers do create credibility tension. If the whole Y2K fiasco taught us nothing else, it surely taught us to be suspicious when the experts are announcing the arrival of Armageddon.

Head Case Redux: As a service to those for whom the Zidane head-butt controversy was the biggest story so far this year, The D & O Diary includes this link to a July 25, 2006 USA Today article (with video footage) entitled "Jockey apologizes for head-butting horse." (I am not making this up.) The jockey is sorry and assures everyone that this "will never happen again." I am sure the horse feels a lot better better about it now with that reassurance. The D & O Diary notes that, unlike Zidane, the jockey was wearing a helmet at the time of the head-butt. Is The D & O Diary the only one puzzled why anyone would ever use their head (which has numerous other important uses) as a weapon?

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The classic statement on the pitfalls of providing optimistic earnings guidance appeared in Warren Buffett's Letter to Shareholders in the 2000 Berkshire Hathaway Annual Report (only an excerpt is reproduced here, but the entire Letter warrants reading, especially in light of subsequent events):

The problem arising from lofty predictions is not just that they spread unwarranted optimism. Even more troublesome is the fact that they corrode CEO behavior. Over the years, Charlie [Munger, Berkshire's Vice Chairman] and I have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to "make the numbers." These accounting shenanigans have a way of snowballing: Once a company moves earnings from one period to another, operating shortfalls that occur thereafter require it to engage in further accounting maneuvers that must be even more "heroic." These can turn fudging into fraud. (More money, it has been noted, has been stolen with the point of a pen than at the point of a gun.)

Buffett didn't exactly predict the wave of corporate scandals that came in the years immediately after he wrote these words, but he sure wasn't surprised by it. He was prescient even if he wasn't prophetic.

The recent corporate scandals have produced a changed atmosphere and led to changed corporate practices, including changed practices regarding earnings guidance . A 2006 survey conducted by the National Investor Relations Institute found that fewer and fewer companies are providing quarterly earnings and revenue guidance. Among the survey's findings is that the number of companies providing earnings guidance declined to 66% from the 71% in the prior year's survey (and down from 79% in the 2001 survey), and that only 56% of companies provide revenue guidance, down from 60% in the prior year. The survey also found that only 52% of companies were providing quarterly earnings guidance, down from 61% in the prior year. Among the prominent public companies that are declining to provide guidance are: Coca-Cola, AT&T, McDonald's, Google, General Motors , Ford, Motorola, and Campbell Soup. A Wall Street Journal article discussing the 2006 NIRI survey appears here (via wsj.com, subscription required).

A thoughtful discussion of the issues surrounding earnings guidance appeared (via economist.com, subsciption required) in a recent issue of The Economist magazine. Among other things, the article presents data from an academic study showing that companies that actively guided met or beat analysts' estimate more often that occasional or nonguiders, but that the active guiders grew more slowly than occasional or nonguiders. On the other hand, the article quoted a different academic study analyzing 76 companies that have ended quarterly guidance since 2000 and concluded that poor performers were more likely to reduce guidance, suggesting that "ending guidance can be a fig leaf for companies in trouble." (While that certainly can't be said of Berkshire or Google, it might be an accurate statement about GM or Ford).

One thing is for sure; more and more companies are deciding that the best way to avoid missing guidance is to avoid giving guidance. A detailed discussion of the pitfalls of earning guidance and analyst communications -- and how to avoid them -- can be found here.

Accounting Discipline

A May 4, 2006 article on CFO.com reports that a former accountant for a heart-disease research foundation was sentenced to two to six years in prison for embezzling more than $237,000 from the foundation. The accountant apparently used the embezzled funds to pay for the services of Lady Sage, a dominatrix. He also allegedly charged purchases at stores such as Leather Creations, Victoria's Secret and Wicked Naughty Accessories. His attorney told the press that "It's just one of those things. I guess it was a midlife crisis." Apparently that explanation did not satisfy the accountant's wife, who, according to the article, "was so angry that she refused to pay for [his] $10,000 bail."

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