Last month, the SEC announced it was taking action regarding Netflix’ (NFLX) securities compliance based on a Facebook status update posted by CEO Reed Hastings. The move came as a shock to many in the tech business community, in which we’ve become accustomed to real-time disclosure by company executives through social media. What could be wrong with more transparency?
To understand the SEC’s point of view, it’s necessary to review the principles underlying securities law in the United States. Compressing 80 years of history into a paragraph, securities regulation here is fundamentally a disclosure-based system. With a few exceptions (notably corporate governance requirements imposed by the Sarbanes-Oxley Act in 2002), beginning with the original Securities Act of 1933, Congress and the SEC adopted a philosophy that financial markets work best when investors are free to make their own decisions based on timely, complete and accurate disclosure by publicly traded companies. Modern theories of economics and finance teach us that in a world of perfect information, the market will decide what a fair price is for any company’s stock at any point in time based on its current financial condition, results of past operations, analysts’ forecasts of future performance, industry conditions and so on.
The key words worth repeating here are “perfect information.” Like all forms of perfection in an imperfect world, it exists as an aspirational goal, not in reality. Certain people inside a company will always know more than the general public. This is why insider trading can be a criminal act: Trading on the basis of material nonpublic information that would affect the stock price is a form of cheating, taking advantage of those who lack access to the same information. The person or business on the other end of an insider trade is at an automatic disadvantage.
Public companies have dealt with financial disclosure in ways that evolved over time with markets and technologies. Before the commercial Internet, the primary tools of disclosure included:
- Prospectus and related registration statement (“S-1″) for an IPO
- Annual report (“10-K“) including audited financial statements with full footnotes and extensive disclosure about the company
- Proxy statement in connection with the annual meeting of stockholders
- Quarterly and annual earnings press releases giving financial results for the most recent period
- Quarterly and annual earnings calls in which chief executives discuss the contents of the press release and often field questions from investors and analysts
- Quarterly reports of financial results and other material information (“10-Q“)
- For extraordinary matters between quarters, an interim report (“8-K“), often with accompanying press release
There’s more, but unless you’re planning to become a securities lawyer, this list is a good overview. It should also make it clear why being a publicly traded company in the United States is a major undertaking that devours a decent chunk of financial, legal and senior executive resources. When it goes public, a company must adopt a raft of policies and measures designed to comply with insider trading rules and tightly control disclosure of financial and other material non-public information that, if disclosed, could significantly alter the total mix of information available to those making investment decisions.
In 2000, the SEC adopted Regulation FD in response to growing concerns regarding “selective disclosure.” Like it sounds, selective disclosure is the practice of supplying material non-public information to securities professionals or major investors before disseminating it to the general public. This doesn’t necessarily involve any sinister motives; a classic example is that quarterly earnings conference calls with the CEO and CFO were typically held with a few dozen participants, mostly stock analysts and financial journalists, with much of the time spent drilling down on specific issues and metrics that analysts rely upon in building their financial models to predict future performance. Nevertheless, selective disclosure could be said to unfairly benefit analysts and institutional investors at the expense of other stockholders, particularly individual investors, who lack access to the same information.
Regulation FD can be fairly summarized as requiring that if a company tells one (securities professional), it must tell all (“broad public disclosure”) at the same time if intentional, or “promptly” if unintentional. Although not specifically aimed at the Internet, it’s clear that online tools such as Webcasting and frequently updated investor relations pages make compliance with Reg FD much easier.
This brings us back to Mr. Hastings in the era of social media: On July 3, 2012, he posted to his Facebook page, which had more than 200,000 subscribers, the fact that Netflix had streamed a billion hours of video in the preceding month. Understanding the basis of Reg FD, this sounds like a ready-made law school exam question:
- Was the fact that Netflix had streamed more than a billion hours of video in June 2012, at the time Hastings disclosed it, material?
- Was posting this fact to his Facebook page on July 3, 2012 sufficient to satisfy the Reg FD requirement that it be broad public disclosure?
The first question is a fact-based analysis that involves reviewing Netflix’ public disclosures up until that time, determining the effects on revenue and earnings of the growth in hours streamed, etc. I won’t go down that rathole here, but will share that my advice to client executives in the past has been that when in doubt, if they’re going to cite any number related to company performance, either (1) make sure it’s been publicly disclosed already, or (2) determine with confidence that it’s immaterial.
The second question is where things get interesting as a cutting-edge issue of social media and securities law: Assuming the information was material, is posting a status update on the CEO’s Facebook page (when Hastings has 200,000+ subscribers, many of whom are presumably stock analysts and financial industry journalists) sufficiently public disclosure to satisfy the Reg FD requirement that the company use a platform “reasonably designed to provide broad, non-exclusionary distribution of the information to the public”? Quoting one commentator, Fortune’s Dan Primack:
Remember, this isn’t just limited to Facebook. What’s to stop Hastings from disclosing material information via his Twitter account. Or via Netflix’s Twitter account? Or via the company’s Pinterest account? Or its blog? Or maybe Hastings has a Tumblr. Could he record material info in an MP3 that only gets shared (freely) via iTunes? Would Wikipedia entries suffice?
The fact that the SEC decided to pursue this action suggests that these questions are at least debatable under current law. I wouldn’t jump to any conclusions of wrongdoing or violation of any law or regulation—the process gives Netflix and Hastings an opportunity to tell their side of the story, and the SEC to withdraw its Wells notice—but this case shines a spotlight on important, rapidly evolving issues that will increasingly come into play as public companies and their C-level executives embrace more and different forms of social media.