Disclosure In The Modern Age

Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Netflix (NASDAQ: NFLX) chief executive officer Reed Hastings has been known to do some questionable things, like trying to force a massive price hike down customers' throats with virtually no notice. However, his Facebook (NASDAQ: FB) post about Netflix exceeding one billion hours of streaming shouldn't be counted as one of them. The government seems to disagree. That begs the questions of who these guys are supposed to be protecting?

The law
From the Securities and Exchange Commission (SEC) website about Regulation FD: “The regulation provides that when an issuer, or person acting on its behalf, discloses material nonpublic information to certain enumerated persons (in general, securities market professionals and holders of the issuer's securities who may well trade on the basis of the information), it must make public disclosure of that information. The timing of the required public disclosure depends on whether the selective disclosure was intentional or non-intentional; for an intentional selective disclosure, the issuer must make public disclosure simultaneously; for a non-intentional disclosure, the issuer must make public disclosure promptly.”

The logic behind Regulation FD is rock solid. It is inappropriate for companies to share information that could impact its stock price with a select person or individuals. That's called insider trading and it hurts investors of all sizes. Worse, it destroys trust in a financial system that relies on trust to operate properly. So, at its core, this rule makes complete sense. It even allows for “mistakes” (everyone makes them) by taking into consideration non-intentional disclosure.

The crime
In July of 2012, Hasting, Netflix's CEO, used a Facebook page to brag about a corporate milestone: "Netflix monthly viewing exceeded 1 billion hours for the first time ever in June."

While at first glance that sounds like releasing information to just a select group of people, the disclosure was made on the company's public Facebook page with over 200,000 followers. That's a pretty big audience and even if you look past the fact that it was a public page, Mr. Hastings, popular as he is, probably doesn't have that many close friends.

In December, the SEC sent Hastings and Netflix a so-called “Wells Notice” about the post. A Wells Notice is a letter from the agency informing the recipient that legal action may be brought against him, her, or it. This notice does not mean that a civil case will be opened, it just means the SEC may open one. No one is happy when they receive such a letter.

The big problem for Hasting and Netflix is that the stock jumped over 10% on the news. That said, the company had just a short time before the Facebook post noted that it was close to reaching that one billion milestone. So it shouldn't have come as any kind of shock to the marketplace.

Adjusting to a new world
Interestingly, Facebook's initial public offering was a public relations disaster with accusations of information being selectively disclosed. The claim, which hasn't been acted on, is that analysts at the company's underwriting banks had changed their expectations about the company's performance and only told major clients. Thus, the small fry were left to jump into an IPO that, effectively, tanked.

Facebook is part of a new breed of communication tool that includes such firms as privately held Twitter. Companies have Facebook pages and Twitter feeds, both of which allow for direct communication with “friends.” Making these sites and feeds public, however, allows anyone to follow a company or person. These are vital tools in the social media space and any public facing company not using them is putting itself at a competitive disadvantage.

The Hastings case brings up a topic that will have to be addressed, better it happen sooner than later. While hubris was a clear factor in the case, it is also clear that the CEO wasn't attempting to clue a select group of investors in on the chance to make big profits. That remains the case even though the shares jumped notably on the news.

Markets move fast
Interestingly, the government just dropped an investigation into select media companies selectively disclosing economic data just moments before it was publicly released. The accused included such household names as Bloomberg, Thomson Reuters (TRI), and Dow Jones. The reason for not following up on the case was that the SEC couldn't determine how much financial benefit was available from the disclosure of that information.

In a world where lightening fast computers are placed ever closer to stock exchanges so that investors can gain a millisecond's worth of time advantage, it's hard to believe that a dollar value can't be placed on the early disclosure of information. As an example, the Huffington Post highlighted the near collapse of Knight Capital (NYSE: KCG).

In 2012 something went horribly awry with that company's computer algorithms causing it to lose “$440 million in just over 45 minutes,” according to Eleazar David Melendez of Huffington. Regardless of the exact amount of money or the exact amount of time, Knight almost went belly up in a matter of minutes. The company's best hope for survival after getting a financial hand out is a takeover.

Time clearly has a value on Wall Street and it seems odd that the SEC isn't going after this issue but may chase down Netflix.

Repeat offender
Hastings recently told Bloomberg that he would continue to use Facebook to post information about his company. From a legal standpoint that's probably a mistake, but from a customer, and investor, relationship standpoint that's a good decision.

Regulation FD has done a great deal to level the playing field between the average Joe and large investors. It stopped some of the most egregious interactions, which sometimes included companies simply telling researchers and others what they expected to earn in a quarter or year. Now, everyone can see and hear what is going on. However, modern communication is changing and the SEC needs to change along with it or it will be hurting the small investor.

In a perfect world
Wouldn't it be nice if every company regularly posted information like what got Hastings in trouble? If you wanted to know, all you would need to do is “sign up” for the feed. That's not selective on the part of a company, but on the part of the participants receiving the information. That's what today's communication tools are all about. Taking control of your own news feeds, if you will.

While it may seem like a fine line for some, it's an important one to figure out because investors large and small could benefit.

Reuben Gregg Brewer 

Reuben Gregg Brewer has no position in any stocks mentioned. The Motley Fool recommends Facebook and Netflix. The Motley Fool owns shares of Facebook and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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