Corporate Disclosure and the Internet

I. INTRODUCTION

No one can deny the tremendous impact the Internet has had on communications generally. The Internet allows users to monitor world events in "real time." The benefits of instantaneous communications afforded by the Internet has not been lost on public companies and their investors. Companies routinely post selected SEC filings (such as proxy statements and annual reports) and press releases on their websites, and investors can use the Internet to efficiently retrieve a myriad of corporate information on the companies in their portfolios and even execute trades online.

Electronic communications can pose serious problems, however, where disclosure is inadvertent. For instance, on November 5, 1998, the Bureau of Labor Statistics inadvertently posted one day early its report on the number of jobs created the previous month. "Oops in Cyberspace, News Often Jumps the Gun," Wall Street Journal, Nov. 6, 1998, at B1. As a result of the inadvertent disclosure, no press release was issued contemporaneously by the BLS. (As discussed below, in the context of a public corporation.s communications, this could likely constitute selective disclosure.) A number of savvy investors located the posting and their trading temporarily propelled the bond market upwards.

Notwithstanding the dangers associated with electronic communications, the Securities and Exchange Commission has from the start strongly supported the use of the Internet to facilitate communications among corporations and investors. Its implementation of the Electronic Data Gathering and Retrieval (EDGAR) system has been quite successful -- never before has so much corporate information been so easily accessible to the common investor. However, due to the rising number of securities-related "cybercrimes," the SEC has recently increased its efforts to curb electronic abuses of the securities laws. For instance, in late October 1998, the SEC sued 44 companies and individuals for Internet-related securities violations, most of them related to illegal stock promotion.

II. GENERAL RULES REGARDING CORPORATE DISCLOSURE

The general rules regarding corporate disclosure have developed over the past few decades in the context of a paper-based environment. This section provides a general outline of those rules as they currently exist.

A. Duty to Disclose; Scope of Disclosure

The Supreme Court has observed that the fundamental purpose of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), was "to substitute a policy of full disclosure for a philosophy of caveat emptor." See, e.g., Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 477 (1977). No matter how material a development may be to a public company and its stockholders, however, absent an affirmative duty to disclose, a company will not be penalized for electing not to make a public statement disclosing the development. Generally, a public company has a legal duty to make a public announcement in three circumstances:

1. Statute or Regulation; Exchange Requirement; Common Law. If an applicable statute or regulation compels specific disclosures, a public company will be required to make such disclosures in accordance with such statute or regulation. An obvious example would be the disclosures required by the federal securities laws to be made in the company.s annual or quarterly reports to shareholders (e.g., MD&A). It is noteworthy that these periodic reporting requirements would not apply to a mid-quarter material development. And although Form 8-K requires prompt disclosure of a number of specified material items which might occur mid-quarter (including changes in control, material acquisitions or dispositions of assets, bankruptcy, etc.), disclosure of other non-enumerated events is optional (see Item 5 of Form 8-K). In addition, a public company may have an obligation to publicly announce a material development as a result of its listing agreement with its stock exchange. See, e.g., NYSE Listed Company Manual, Section 202.05 ("A listed company is expected to release quickly to the public any news or information which might reasonably be expected to materially affect the market for its securities."). Finally, it should be noted that courts have imposed a common law duty of disclosure upon private companies (i.e., companies not subject to the federal proxy rules) when seeking stockholder action. See, e.g., Stroud v. Grace, 606 A.2d 75, 84 (Del. 1992) (duty of candor/disclosure requires directors of Delaware corporations "to disclose fully and fairly all material information within the board.s control when it seeks shareholder action").

2. Insider Trading. When a public company or its insiders are trading in the company.s securities (e.g., during the course of an IPO or stock repurchase program), the company must disclose any material developments. Failure to make such disclosures could subject the company and/or its insiders to insider trading liability.

3. Previous Statement Incorrect When Made. Where a public company previously made a public statement which it later discovers was incorrect when made, the company is obligated to issue a public statement correcting the error. This is to be distinguished from the situation where a company.s statement is accurate when made, but changes in circumstances after the fact have rendered the original statement inaccurate. In such a situation, there is generally no obligation to correct the previous statement (but see Section II.C).

If a public company concludes that it has a duty to disclose, it only must disclose material facts. Whether a fact is "material" depends on a number of subjective factors. Many auditors (and their corporate clients) use a rule of thumb that considers an event material only if it positively or negatively affects revenues by anywhere from 3% to 10%. The SEC has stated that it is unwilling to assign a numerical value to "materiality" and that the quantitative implications of an event should be only one of a number of factors to be considered. The SEC has announced that it intends to issue a release on the concept of materiality by the end of 1998. In any event, the company must disclose all material facts or risk liability.

It is important to note that projections or other forward-looking statements are not "facts" for purposes of disclosure obligations. In no circumstances is a public company required to make projections or other forward-looking statements regarding future events or results. However, it should be noted that the SEC strongly encourages companies to make such disclosures. Congress supported the SEC.s position by enacting the Private Securities Litigation Reform Act of 1995 (the "PSLRA"), which established a "safe harbor" for certain forward-looking statements which are accompanied by meaningful cautionary language. If a company does make a public statement containing a projection, however, it may have an obligation to update or correct that statement if it later becomes untrue, even if it was true when made (see Section I.C). As discussed below, this is particularly true regarding forward-looking statements published on the Internet. Although Section 21E(d) of the Exchange Act provides that "[n]othing in this section shall impose upon any person a duty to update a forward-looking statement," practitioners should be mindful that the safe harbor does not apply in a number of situations (e.g., statements made in connection with IPOs or tender offers).

B. Selective Disclosure

Once a company has determined that it has an obligation to make a public disclosure, it must ensure that this disclosure is not "selective." Practitioners use the phrase "selective disclosure" to describe two different situations: (i) where a public company discloses only a portion of the material facts to the entire investing public (this is really an example of omitting a material fact) or (ii) where a public company discloses all of the material facts to only a selected portion of the investing public (usually favored analysts and financial media representatives). Each situation creates the opportunity for insider trading. The situation described in (i) could lead to insider trading by the company or its corporate executives who are (or are deemed to be) in possession of the full truth. The situation described in (ii) could lead to insider trading by the select group (usually analysts and their clients) who are in receipt of the material facts.

Public companies, particularly recent IPO companies, frequently engage in selective disclosure of the type described in (ii). From a practical standpoint, it is easy to understand why. Developing a following in the marketplace can be crucial to a young public company.s development. Therefore, it is in the best interests of that company that the company develop close ties to one or more analysts. Over the past decade, however, the total number of securities analysts has dropped while the total number of public companies has increased, meaning that the ratio of analysts to publicly-traded companies has dropped. This phenomenon has increased the fierce competition among young companies for analyst coverage, and has increased the leverage of analysts over those companies. Many analysts expect (and frequently demand) to receive material and comprehensive corporate information as quickly as possible, and in some cases will cease to cover those companies which are reluctant to selectively disclose such information in advance of its public dissemination.

Mindful of this practical problem, the SEC has recently become more outspoken. For instance, in his remarks at the "SEC Speaks" Conference this past February, SEC Chairman Levitt noted that the SEC is closely monitoring occurrences of selective disclosure. According to Chairman Levitt, the SEC has observed that selective disclosure to favored analysts frequently leads to unusual trading in the company.s stock in the period between the selective disclosure and the public disclosure. He further counseled that "issuers should not selectively disclose information to certain influential analysts, in order to curry favor with them and reap a tangible benefit, such as a positive press spin." Therefore, it is clear that, notwithstanding any benefits to be derived from selective disclosure, they are severely outweighed by the prospect of insider trading allegations.

C. Duties to Update or Correct - Quaker Oats

As noted earlier, a public company only has an obligation to correct previous statements which were incorrect when made. A recent controversial decision handed down by the Third Circuit, however, indicates that this may not always be true. In Weiner v. The Quaker Oats Company, 129 F.3d 310 (3d Cir. 1997), Quaker made multiple public statements to the effect that its future total debt-to-capitalization guideline would be approximately 60%. About a month after its last such statement, Quaker.s stock price tumbled after it announced that its acquisition of Snapple would increase its total leverage ratio to approximately 80%. The Third Circuit Court of Appeals reversed the district court, concluding that a fact-finder could determine that Quaker had a duty to update its public statements. The Court acknowledged the general rule that Section 10(b) of the Exchange Act does not impose a duty to correct statements which were true when made, but stated that ".there can be no doubt that a duty exists to correct prior statements, if the prior statements were true when made but misleading if left unrevised.." Id. at 316 (quoting In re Phillips Petroleum Securities Litigation, 881 F2d 1236 (3d Cir. 1991)) (emphasis added). The Quaker Oats court conceded that the Quaker statements were accurate when made, but nevertheless concluded that "a trier of fact could conclude that a reasonable investor . . . would have no ground for anticipating that the total debt-to-total capitalization ratio would rise as significantly as it did in fiscal 1995." Quaker at 317.

Numerous commentators have criticized the Quaker Oats decision as being an unreasonable extension of the Phillips holding, which related to a change of an investor.s intent in the context of a Schedule 13D filing. In Phillips, Mesa Partnership purchased about 5.7% of Phillips. stock in an attempt to take the company over. Mesa stated in its Schedule 13D and in several other public statements that it would not sell any shares owned by it back to Phillips except on an "equal basis" with all other shareholders. Mesa later sold its shares back to Phillips at a premium not available to all shareholders. In vacating the district court.s opinion, the Phillips court determined that the record contained evidence that supported a conclusion that Mesa.s statements of intent were either reckless or false when originally made. Phillips, at 1248. In other words, according to the court, Mesa either knew (fraud) or should have known (recklessness) that its statements were untrue when made. The implicit conclusion reached by the court was that Mesa.s statements were false when made, and that a duty to update therefore existed.

Although many commentators view Quaker Oats as an aberration, it remains good law and practitioners should be mindful of it when counseling clients regarding forward-looking disclosure. Importantly, the case hammers home that meaningful cautionary language should always accompany any such statements. Noting that the Third Circuit has adopted the "bespeaks caution" doctrine (the action arose prior to the PSLRA), the Quaker Oats court pointed out that Quaker.s statements were not accompanied by such cautionary language, implying that the inclusion of such language may have rendered the statements in question "immaterial" as a matter of law. Id. at 320.

D. Adoption and Entanglement

The concepts of "adoption" and "entanglement" pertain to a public company.s liability for statements made by a third party. A company is said to have become "entangled" with a third party.s statement where the company has had editorial input prior to the statement.s public dissemination. A company is said to have "adopted" a third party.s statement where the company adopts either explicitly or implicitly (e.g., through the distribution of an analyst report) the statements after they are published, regardless of whether the company had any editorial input.

Each of these concepts was involved in the December 22, 1997 settlement by two executives of Presstek, Inc. of charges by the SEC that they had distributed false and misleading information about Presstek. The SEC alleged that the Presstek executives reviewed and/or distributed copies of a market newsletter and an analyst report which contained earnings projections which the executives knew were materially overstated.

Although the case settled, it illustrates that public companies should be reluctant to (i) review and comment upon analyst reports prior to publication or (ii) distribute those reports after publication (this would include hyperlinks from their corporate websites). Moreover, any company which determines that prior review or post-publication distribution is in its best interests should take appropriate precautionary measures. For instance, it should adopt and distribute a written disclaimer that it does not endorse the statements made in the report. In addition, it should be careful not to selectively distribute analyst reports (i.e., it should distribute the good and the bad).

The principles discussed above regarding corporate disclosure pose a number of novel issues when applied to Internet communications. This section addresses some commonly asked questions.

Q. Does posting information on a company.s website satisfy its disclosure obligations?

A. No. If the company.s disclosure obligation stems from federal securities laws, it will generally be required to file such disclosure electronically with the SEC via EDGAR; posting such information on its website will not satisfy the company.s filing requirements (see generally Regulation S-T). If the obligation stems from stock exchange requirements, the company must disseminate the information via a press release through reputable newswire agencies (e.g., Dow Jones, Reuters, BusinessWire, PR Newswire). See, e.g., NYSE Listed Company Manual Section 202.06. It is noteworthy that most commercial wire services are able to embed a hyperlink to a company.s website in its press releases. As a result, online readers of the release will be able to directly access the company.s website through the hyperlink.

Moreover, where a company is required to deliver disclosure documents to its shareholders (e.g., proxy statements and annual reports) or to prospective investors (e.g., prospectuses), the SEC has stated that merely posting those documents on the company.s website is not enough because it is inappropriate to assume that each of those shareholders or prospective investors has access to the Internet. See "Use of Electronic Media for Delivery Purposes," Securities Act Release No. 33-7233, Examples 1 and 23 (Oct. 6, 1995) ("Electronic Media Release"). According to the SEC, electronic document delivery is only appropriate where (i) the recipients have notice that the documents are available on the website, (ii) the recipients have access to those documents and (iii) the issuer can show proof of delivery (usually through prior consent).

Q. If material information is posted on the website, but not disseminated in any other manner, could the company be exposed to liability for insider trading resulting from selective disclosure?

A. Probably. Selective disclosure can occur where material facts are disclosed to a select group. As noted earlier, the SEC has stated that a company may not assume that all investors have access to the Internet. Therefore, it may be argued that the posting of material information to the company website, absent any further general disclosure (e.g., press release or EDGAR filing), may subject the company to liability stemming from the selective disclosure because investors might trade on material information which has not been made available generally.

Q. Must a public company file with the SEC all information posted on its website?

A. No. The fact that information has been posted on the company.s website does not in and of itself mean that such information must be filed with the SEC. The company must only file information posted on its website with the SEC if that information is material and is of the type which is otherwise required by the federal securities laws to be included in an SEC filing.

Q. Does a company have a duty to update information contained on its website?

A. The SEC has clearly adopted the position that a company has the same duty to update electronic communications as traditional paper-based communications. Electronic Media Release, at n.20 ("Electronically delivered documents must be prepared, updated and delivered consistent with the provisions of the federal securities laws in the same manner as paper documents."). Therefore, to the extent that the law imposes a duty upon the company to update a particular statement, the company should assume that duty applies with at least equal force to the statement if it is on the company.s website. It might even be argued that an enhanced duty to update exists with respect to materials posted on a website because those materials are effectively "newly disseminated" each time the website is accessed. It cannot be stressed enough that a public company must employ stringent procedures for ensuring that materials on its website are current and accurate. In addition, companies should prominently display (i) the date each item was posted on its website and (ii) the last date on which the website was updated.

Q. How long is information contained on a corporate website considered "live"?

A. Incorporating material disclosure on a corporate website can be hazardous because, as mentioned above, the statements are essentially "refreshed" each time the website is accessed. Theoretically, this could lead to a continuous obligation to update (an onerous task). However, assuming historical data is accurate, the only data which must be continuously updated are forward-looking statements. As a result, in most circumstances companies should be loathe to incorporate forward-looking statements on their websites (even if such statements are accompanied by meaningful cautionary language and subject to the safe harbor). In addition, as discussed above, the website, and all documents posted thereon, should be prominently dated as a precautionary measure.

Q. What are the liability implications under the federal securities laws for hyperlinking to other sites? What if the hyperlinked site is a favorable analyst report?

A. The SEC has stated that "the hyperlink function provides the ability to access information located on another Web site almost instantaneously" and that the use of a hyperlink is therefore tantamount to the company disseminating the text located on the hyperlinked site. Electronic Media Release, n.16. The use of hyperlinks presents two problems. First, the company will likely be deemed to have "adopted" the statements contained on the hyperlinked site, and will therefore be subject to liability for such statements. Second, the statements on the hyperlinked site are subject to change without notice. Therefore, statements which were accurate when the company established the hyperlink may be rendered inaccurate over time or, more problematically, new statements may be added to the hyperlinked site without the company.s knowledge.

In addition to the foregoing issues, hyperlinking only to favorable analyst reports could lead to a selective disclosure problem. Such an action would be akin to disseminating favorable paper-based analyst reports (and thereby adopting the statements contained therein), but refraining from distributing unfavorable reports.

Companies should employ prominent disclaimer language in the form of a "gateway statement" which notifies the user when he or she is leaving its page (e.g., "You are now leaving XYZ Corporation.s corporate website. XYZ makes no representations concerning any endeavor to review or update any information or other content of other websites, and XYZ disclaims responsibility for the accuracy, copyright compliance or legality of materials contained on such websites."). Two benefits arise if the gateway disclaimer statement appears as a separate page (or text box) before the user is given access to the hyperlinked page: (i) the user is notified that he or she is leaving the corporate website and that the company is not responsible for materials on the linked website and (ii) access to the linked website is less "instantaneous," thereby (at least theoretically) decreasing the probability that the materials posted on the linked website would be attributed to the company.

Q. Should company executives participate in online "chat rooms" or "bulletin boards"? Could a public company be liable for statements made by its executives in this context?

A. An Internet "bulletin board" is a site that allows users to place messages which can be read by the general public. Those messages may be posted for an indefinite period of time. A "chat room" is an online forum (usually provided by commercial online services like America Online) where users gather and "chat" about a number of topics in real time. There are numerous such bulletin boards and chat rooms on the Internet and some estimate that they are frequented by millions of users. Bulletin boards and chat rooms are useful in that they provide direct insight into the views and expectations of a company.s retail investor base. This perspective can prove invaluable to companies with substantial retail shareholder bases, because retail shareholders (unlike institutional shareholders) rarely communicate directly with the company. So from a strategic standpoint, corporate executives would be well advised to at least visit bulletin boards and chat rooms.

Statements made by company executives during the course of their visits, however, would likely be attributed to the company. Therefore, company executives should be discouraged from actively participating in chat room discussions or utilizing bulletin boards in their executive capacities and should obviously be prohibited from disclosing material non-public information in such forums. Like website disclosures, bulletin board or chat room disclosures would (i) likely be considered to have been "selectively disclosed" and (ii) would be potentially subject to a continuous duty to update. Because these communications would likely be attributed to the company, it could in certain circumstances face insider trading (tipper) allegations. Moreover, statements made by company executives in this context would likely be "off-the-cuff," increasing the liability exposure to the company.

IV. PRACTICAL SUGGESTIONS

• Establish a group of high-level executives to review materials prior to their posting on the corporate website, and to remove or update materials which have already been posted but have become inaccurate or misleading.

• Don.t post material information on your website unless the information is (or has previously been) publicly disseminated through press releases and/or EDGAR filings. If you want to attract users to your website, instead embed a hyperlink to your website in your press release (e.g., "Further information on XYZ Corporation can be obtained at the corporate website located at http://www.xyz.com.").

• Avoid posting forward-looking statements on your website. If you determine otherwise, make sure it is accompanied by appropriate meaningful cautionary language.

• Each disclosure item posted on the corporate website, and the website itself, should be prominently dated so the reader knows how current the materials are.

• Never post analyst reports on your website.

• Don.t embed hyperlinks on your website to other websites which specifically discuss your company or its performance (especially analysts. websites). Try to keep all other hyperlinks on your site to a minimum. You should employ express disclaimer language notifying the user when he or she leaves your page in the form of a separate gateway page or text box.

• Although bulletin boards and chat rooms may prove useful for monitoring rumors and other corporate feedback, company executives should never actively participate in online chats or use online bulletin boards in connection with matters relating to the company.