Sunday, July 01, 2007

Quarterly Earnings Guidance and D & O Risk

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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