Investor Relations: Forward-Looking Statements (#58)
/In this podcast episode, we discuss the background for investor lawsuits against companies, and how the use of forward-looking statements and cautionary statements are designed to avoid those lawsuits. Key points made in the episode are noted below.
The Reason Why Public Companies Did Not Forecast Results
Public companies used to have a major problem with telling investors anything at all about their forecasted results. Until 1995, investors could sue a company to recover damages from a perceived securities fraud. What usually triggered such lawsuits was pretty much whenever the stock price dropped. As a basis for these lawsuits, investors used section 10b of the Securities Exchange Act of 1934. That section basically says that it’s unlawful to make an untrue statement of a material fact or omit to state one. So… if a company said anything at all about its future plans and then those plans didn’t come to pass – then you had a lawsuit on your hands.
If someone did file suit, the usual process was that the company then filed a motion to dismiss, on the grounds that the alleged facts were not sufficient to create a liability under Section 10b. This motion to dismiss was absolutely critical, because if the court allowed the case to proceed, then the investor could bury the company with demands for information, which is called the discovery process. Which could cost millions. At that point, the company usually settled out of court in order to avoid the cost of providing information.
Now if the company elected to take its chances in court, the investor could seek a class certification, which turned the case into a class action lawsuit. So, if the company lost the case in court, the verdict would apply to all of its stockholders. And then it would be really expensive.
You can see that investors could essentially point a double barreled shotgun at a company, and say “pay me now, out of court,” or “pay me a whole lot more in court.” So because of the way the system worked, there were lots of lawsuits, and companies usually paid up. Even if they hadn’t done anything wrong.
This was a bad state of affairs, because a key part of investor relations is to give the investment community some idea of what you intend to do in the future. But because of the risk of lawsuits, no one dared to say anything.
The Private Securities Litigation Reform Act
Luckily, Congress fixed the problem in 1995 with the Private Securities Litigation Reform Act. In brief, the Act forces a plaintiff to present a stronger case up-front. This makes it easier for a company to have a case dismissed.
But in addition to that, the new Act includes a nifty section called Safe Harbor for Forward Looking Statements, which is Section 102. As the name implies, it provides companies with a safe harbor from liability for forward-looking statements – but only if you identify them as forward-looking, and you add what the Act calls meaningful cautionary statements. These statements need to specify the most important factors that can cause actual results to differ from what you’re saying in the forward-looking statement.
This doesn’t mean that you can keep using the same boilerplate cautionary statements, because the company’s risk profile might change over time. Instead, you can refer to a complete set of identified risks, such as you’d find in a company’s annual 10K report.
This is obviously an important protection for a forward-looking statement, but that then brings up the question of what is a forward-looking statement? Well, according to the Act, it covers a half-dozen areas. The following four are the most important:
Projections of revenue, income, earnings per share, capital expenditures, dividends, or other financial items.
A statement of plans or objectives.
A statement of future economic performance.
Any statement about the underlying assumptions for those first three items.
You also need to know what is not covered by the Act. Not covered items include discussions about roll-up transactions, going-private transactions, tender offers, and initial public offerings.
The Nature of a Cautionary Statement
So, what does a cautionary statement look like? Well, let’s say you’re issuing a press release. After the main contents of the release, you should add text that is something like this:
“In accordance with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, the company notes that some statements in this press release look forward in time, and involve risks and uncertainties that may affect the company’s actual results of operations. The following important factors, among others that are discussed in company filings with the SEC, could cause actual results to differ materially from those set forth in the forward-looking statements.”
And at this point, you can add some company-specific factors, such as “we may be unable to hire a sufficient number of qualified technical personnel,” or “competing offers may cause us to lose projects that are competitively bid.”
Let’s face it, this is a great deal of butt-covering, but if it can prevent even a single lawsuit, then I’m all in favor.
Any by the way, you’ll find that the cautionary statement may quite possibly be as large as all of the other text in your press release, combined. So expect the cost of your press releases to go up.
And one last point about the Act. You’re under no obligation to keep updating forward-looking statements, even if the information in the last one has become obsolete. The Act specifically says, and I quote: “nothing in this section shall impose upon any person a duty to update a forward-looking statement.” Of course, if you want to build a decent long-term relationship with the investment community, you’d bloody well better keep updating your projections, but you don’t have to.
When preparing any kind of forward-looking statement, it really helps if you first clear it with the company’s attorneys. They’ll want to make dead certain that it complies with the Safe Harbor provisions of the Act. So don’t just copy forward the language you used in the last press release or speech, because it may need some updating. Don’t forget, the attorneys are there to keep you out of trouble, so use them.