By Debbie Strickland

Associate Managing Editor

On Oct. 23, in the heart of the third-quarter earnings season, a new Securities and Exchange Commission rule will take effect banning material selective disclosures ­ valuable tidbits of information companies provide to analysts or large investors before making them public, potentially allowing those in the loop to make a profit or avoid a loss before a major move in stock price.

The agency also hopes the new rule, called Regulation FD, will make analysts' research more objective by taking away selective disclosures as a tool for corporate executives to reward analysts who write favorable reports and punish those who publish negative recommendations.

"The rule goes a long way toward somewhat radically changing existing practices," said Chris Matton, an attorney in the Raleigh, N.C., office of Kilpatrick Stockton LLC. "There has been a great deal of concern in the securities world, largely because the SEC is forcing many companies to effectively do a 180-degree turnaround on prior practices."

For an intentional selective disclosure, public disclosure must be simultaneous; for a non-intentional disclosure, the company must make the information public "promptly." The public disclosure may be made by filing a form 8-K with the SEC or by other public, non-exclusionary means such as press releases.

The rule has been in the making for a long time, said Jeffrey Baumel, a partner with Gibbons, DelDeo, Dolan, Griffinger and Vecchione in Newark, N.J. "As far back as 1990, representatives of the commission were expressing concern over the [sharing of information between] public companies and a select group of persons.

"The biotech companies over the last 10 years have been among the high-flying technology companies that have had dramatic swings in prices based upon specific developments," said Baumel. "To the extent that biotech companies are more subject to dramatic swings, those companies, along with some of the Internet companies, deepened the commission's interest in the issue."

The idea is to level the playing field for the small investor, the large investor and the investment bank market makers, but as yet attorneys say it's hard to tell exactly what the specific effects will be.

"We won't know the full impact of the regulation until the SEC decides how it's going to enforce it," said William Freeman, a partner at Cooley Godward LLP in Palo Alto, Calif. "We're telling our clients to be very careful, to make sure any news big enough to move the stock goes out as broadly as possible. Of course, we've been giving them that advice for a long time."

Such Wall Street traditions as the closed analyst conference call may become rarer, since a company would have to disseminate the information immediately to the public anyway. But, as Freeman noted, the rule merely accelerates a trend in this case, since "those calls are being opened up more and more frequently to all investors anyway.

"The SEC's real concern," he said, "is the one-on-one calls between companies and analysts."

Under the new rule, Matton noted, "If I'm a biotech executive, I can't call up my favorite analyst and say, 'By the way, I wanted you to know it looks like we're not going to hit our numbers.'"

The SEC has acknowledged concerns that the rule might have a "chilling" effect on communications with analysts, but maintains that analysts will continue to add value in the new environment by using their expertise and knowledge to analyze information available to everyone.

Materiality A Slippery Term

The definition of material information is superficially simple: Information is material, says the SEC, "if there is a substantial likelihood that a reasonable shareholder would consider it important in making an investment decision." But embedded in that straightforward statement are vague terms ­ "substantial," "reasonable," "important" ­ that make the determination vexing for both corporate executives and their attorneys.

"You can certainly look to a lot of cases for interpretations," Matton said, "but it ends up a judgment call as to whether information is material or not material. It's somewhat analogous to obscenity or pornography ­ you know it when you see it on a gut level."

Freeman agreed that, certainly in many cases after the fact, "you know it when you see it. You know something is material if the stock moved 10, 20 or 30 percent. But we don't always know [if the information was material] when the stock moves a small percentage. That's the kind of thing lawyers argue about incessantly."

Before the fact, determining materiality based on the likelihood of a stock move can be difficult. "It's hard to know what information moves the stock market until after the market moves," said Freeman. "It may be that a company shares a piece of information it thinks is minor, but an analyst may put several such pieces of information together and change the recommendation on the stock.

"In theory, if you provide several small bits of information that an intelligent and hardworking analyst puts together to create a story, you shouldn't have a problem," he said. "But in reality, it may not work out that way. That's the sticky situation companies are going to find themselves in. They're going to find themselves not being able to determine in advance what they can and can't say."

SEC Offers Guidance But No 'Bright Line' Standard

The SEC admits that no "bright line" standard or list of items can adequately address the range of situations that may arise. Yet the agency did provide a list of seven examples of information that "should be reviewed carefully to determine whether or not they are material":

*earnings information;

*mergers, acquisitions, tender offers, joint ventures or changes in assets;

*new products or discoveries, or developments regarding customers or suppliers (e.g., the acquisition or loss of a contract);

*changes in control or in management;

*change in auditors or auditor notification that the issuer (company) may no longer rely on an auditor's audit report;

*events regarding the issuer's securities (e.g., defaults on senior securities, calls of securities for redemption, repurchase plans, stock splits or changes in dividends, changes to the rights of security holders, or public or private sales of additional securities);

*bankruptcies or receiverships.

For biotech companies, many matters ­ clinical trial success or failure, earnings expectations, a CEO resignation ­ will be clearly material, but as Freeman noted, it's harder to determine the significance of "a lot of lesser events, such as the departure of a particular group or employee, an ambiguous clinical result, or a delay or postponement of agency action. Sometimes what happens depends on what's happening in the sector: On Monday, an event may move the stock, but on Thursday it won't."

Attorneys say it will take a high-profile case or two to cut through some of the uncertainty and provide more concrete guidance as to which behaviors the SEC is going to target.

"Clearly, you can put this kind of rule on paper and people don't really know how the SEC is going to interpret it," said Matton. "Once there have been a few people who've gotten the SEC's attention, there will be a much greater understanding of how it's going to be interpreted. We will also have to wait and see how much the SEC is going to make this an enforcement priority. To a certain extent, like all prosecutors, they have to set their own priorities."

Freeman agreed that until the agency initiates an enforcement action, "everyone's uncertain." A chilling effect on communications is "definitely a possibility" in the near term, he said.

Another open question is whether shareholders will be able to wield the new rule as a weapon in lawsuits against companies. The text of the regulation makes it clear that violation of the rule does not create liability for fraud; instead, the SEC will handle transgressions administratively, with such measures as a cease and desist order, or a civil action seeking an injunction and/or civil penalties.

"Presumably," said Baumel, "the rules are supposed to not provide a private right of action for violation of Regulation FD, but we'll have to wait and see what creative methods might be discovered by the plaintiffs' bar." The additional 8-K filings mandated might also provide an additional source of written records for use in suits, he said. *