Lux fiat. But will there be?: A diagnosis of the implications of SEC’s Proposed Draft Rule B4(3) on Earnings Guidance for corporate issuers on the Nigerian Stock Exchange

5th Sep 2009

Lux fiat. But will there be?: A diagnosis of the implications of SEC’s Proposed Draft Rule B4(3) on Earnings Guidance for corporate issuers on the Nigerian Stock Exchange

Posted by : Obi T. Onyeaso in Investor relations

Tags: analyst coverage, analysts, business strategy, Corporate Finance, corporate governance, Daisy Ekineh, Dotun Suleiman, Earnings guidance, Financial communications, Financial institutions, Investor relations, Nigerian investor relations, Nigerian Stock Exchange, NSE, Professor Ndi Okereke-Onyiuke, Reg FD, Regulation Fair Disclosure, SEC, Securities and Exchange Commission, Senator Udo Udoma, shareholder communications, Technical Committee for the Review of the Capital Market Structure and Processes

In the past year, there have been calls from several quarters for the Nigerian Securities and Exchange Commission (SEC) to carry out an overhaul of the regulations guiding the country’s securities market. In June 2009, the SEC, as part of its response to the challenges of regulating participant relationships on the Nigerian Stock Exchange released a set of proposed draft rules and amendments. Among these, draft rule B4(3) would require securities issuers to provide investors with earnings guidance. Oddly, there has been little public debate on the draft proposals, while comments, inputs and submissions on the proposals were limited to less than three weeks from the date of publication. This contrasts sharply with the lively exchanges in developed country markets over the utility and costs of earnings guidance. The SEC’s draft proposal is a curious one considering that even in the United States, securities law does not require companies to provide earnings guidance. In this post, we briefly examine the key arguments of both sides of the debate, and proffer suggestions and safeguards Nigerian companies can adopt to limit the risks and meet the demands of makings these types of anticipatory business performance statements.

In his 2000 annual letter to Berkshire Hathaway shareholders, Warren Buffett came down hard on the practice of providing earnings guidance. In his view, the expectations that these projections created were clearly unsustainable, at best, and viciously misleading, at its worst. In addition, it created a perverse incentive for CEOs to manage earnings so that they could always beat the Street.

It is both deceptive and dangerous for CEOs to predict growth rates for their companies. They are, of course, frequently egged on to do so by both analysts and their own investor relations departments. They should resist, however, because too often these predictions lead to trouble.

It’s fine for a CEO to have his own internal goals and, in our view, it’s even appropriate for the CEO to publicly express some hopes about the future, if these expectations are accompanied by sensible caveats. But for a major corporation to predict that its per-share earnings will grow over the long term at, say, 15% annually is to court trouble.

That’s true because a growth rate of that magnitude can only be maintained by a very small percentage of large businesses. Here’s a test: Examine the record of, say, the 200 highest earning companies from 1970 or 1980 and tabulate how many have increased per-share earnings by 15% annually since those dates. You will find that only a handful have. I would wager you a very significant sum that fewer than 10 of the 200 most profitable companies in 2000 will attain 15% annual growth in earnings-per-share over the next 20 years.

The problem arising from lofty predictions is not just that they spread unwarranted optimism. Even more troublesome is the fact that they corrode CEO behavior. Over the years, [we] have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to ‘make the numbers.’ These accounting shenanigans have a way of snowballing: Once a company moves earnings from one period to another, operating shortfalls that occur thereafter require it to engage in further accounting maneuvers that must be even more ‘heroic.’ These can turn fudging into fraud. (More money, it has been noted, has been stolen with the point of a pen than at the point of a gun).

[At Berkshire Hathaway we] tend to be leery of companies run by CEOs who woo investors with fancy predictions. A few of these managers will prove prophetic — but others will turn out to be congenital optimists, or even charlatans. Unfortunately, it’s not easy for investors to know in advance which species they are dealing with.

Such comments on earnings guidance, which is the practice of providing a specific or narrow band of earnings per share (EPS) for the next reporting season, from a man who is widely regarded as one of the world’s greatest investors would be alarming if they were not increasing shared by CEOs of several leading companies.

According to research by McKinsey, the management consultants, and the US National Investor Relations Institute (NIRI) more companies are abandoning the practice, and many more have started to question its usefulness. Candace Browning, president of Bank of America Merrill Lynch Global Research, who is widely regarded as one of Wall Street’s leading analysts, has spoken against the practice of guidance as well.

Companies offer earnings guidance for the following reasons:

Satisfy investment community demand for information
Maintain a channel of communication with investors
Intensifying management’s focus on meeting financial targets
Moderating the volatility of the share price
Achieving higher valuation
Building a wider shareholder base
Increasing liquidity.

As the global economy entered the economic crisis in 2007, it has become increasingly difficult for even companies like General Electric, which for several years have boasted predictable earnings to maintain earnings guidance.

Generally, those opposed to the practice of guidance list the following reasons:

Locks managers and managers into a vicious short-term focus
Litigation risks when managers fail to meet these expectations
Costly attention demand to meet the numbers

Yet, there is some evidence that the termination of guidance does not necessarily change the investment behaviour of companies as measured in increased spending on R&D or an improvement in other disclosure means. These findings contrast with research that companies that consistently provide earnings guidance invest significantly less than those that do so only occasionally. Such conclusions, in addition to laying the blame for a short-term focus on earnings guidance, urge companies to shift investor communication to a long-term focus as against the current practice of quarterly- horizon weighted communications. Ostensibly, this frames the argument in an either-or choice.

In the following video, Baruch Lev, one of the authors of the paper disputing the counter-long-term investment hypothesis against earnings guidance, explains his thesis, with the implication that managers with a clear view of the future and who are confident about their ability to deliver results have no qualms giving guidance. In other words, the termination of guidance is a symptom of endo-business challenges, and not exo-challenges imposed by analysts and institutional money managers.

In response to the charges of short-termism that opponents of earnings guidance issuance claim that it fosters, the CFA Institute Center for Financial Market Integrity in association with the Business Roundtable Institute for Corporate Ethics issued a paper titled ‘Breaking the Short-term Cycle: Discussion and Recommendations on how Corporate Leaders, Asset Managers, Investors and Analysts can refocus on Long-term Value’. The goal of the paper’s recommendations was to serve as a convergence-of-interests guide for companies, money managers and investors so that corporate and fund managers are not punished when companies miss their earnings targets without a broader understanding of the context of their performance and the progress of the companies with longer-term strategy objectives.

Notwithstanding the valid cases each side of the debate presents, it is important to remember that earnings guidance is just one of a number of means for companies to communicate their prospects, specifically cash-generating potential, to the investment community.

Yet, while we recognize the significance of the debate to executives and investors, we shall not be joining it here, since we cannot add anything new to the points already marshaled by both sides.

Instead, in this post, we have chosen to discuss the factors that Nigerian companies will need to consider before commencing the practice, if the proposed draft rule is eventually approved by the Securities and Exchange Commission.

Therefore, our intention in this post is to proffer recommendations on structures that corporates need to have in place prior to commencing earnings guidance. Before taking the leap of faith to provide earnings guidance, companies on the Nigerian Stock Exchange need to:

Determine the resources required to provide guidance in a timely manner
Determine the forecasting abilities of the company
Determine the processes required to provide guidance
Determine the conditions under which guidance will need to be updated
Demand legal and SEC protection from unmeritorious or frivolous but costly law suits that penalize (or extort) firms when they miss their guidance numbers or other forward-looking or future-oriented financial information
Situate communications about future performance in the wider context of the investor relations program and not simply as a regulator-imposed requirement
Develop a comprehensive disclosure policy according to leading practice principles, taking Reg FD as the model

Let us expatiate on each of the above.

1) Companies need determine the resources required to provide guidance in a timely manner

Whatever the merits of providing earning guidance, companies need to assess if they have the capacity to provide such information regularly and in a timely manner in the first place.

Typically, the release of guidance moves in a concurrent cycle with the periodic reports that companies provide.

On page 18 of the reproduced proposed draft rules below, one reads that:

Pursuant to Section 64, all public companies shall release [its] earnings forecast to the relevant Securities Exchange, the Commission, and the Investing Public within twenty (20) days of the commencement of a quarter.

In effect, as companies are reporting for the last period, they are also preparing to provide guidance on the next period.

This requirement will place new and heavy demands on the finance, strategy and operations functions of Nigerian companies to both prepare these estimates and manage them, where managing the numbers (EPS) is an implicit but critical part of earnings guidance.

The coincidence of the reporting and guidance cycles will also have reputational implications for the companies as disappointing results from the last period may and can have adverse credibility deficits including market under-reaction to future announcements. Cliche as it sounds, one does not build a reputation on future plans but on past performance.

Further, companies need to decide early on on the form and content of guidance. If a company decides to provide disaggregated guidance, that is, EPS as well as sales and operating costs plus other ancillary information, it will place greater demands on management time and resources.

2) Companies must make a frank assessment of their forecasting abilities

In a notoriously volatile economic environment like Nigeria’s where businesses are exposed to unpredictable and extreme foreign exchange and interest rate moves, government policy somersaults and costly operating demands, few businesses in Nigeria can confidently estimate EPS to a meaningfully thin band that has relevance to the models of analysts covering the company.

In other words, beyond a narrow strip of x points, ideally 20% range (e.g, EPS of N0.80 - N1.00), the informational value of EPS guidance is worthless. Companies need to be honest about both the business environment in which they operate and the nature of their businesses. For instance, it would be more challenging for an insurance company or bank to provide EPS guidance than for a company that sells fast moving consumer goods (FCMG) or other staple items. Guidance should be more than guesswork.

As a company wins the confidence of the investment community with accurate forecasting, the more credibility the market will give to future guidance and this trust will extend to the issuer’s cost of capital as the company is perceived to be less risky.

The case of John Holt Plc, a Nigerian conglomerate, provides a good example. The difficult operating environment the company faces is fully described in the Chairman’s statement in both the 2007 and 2008 annual reports. In a case like this, it will be a herculean task for John Holt to provide earnings guidance due to poor visibility and the harsh economic conditions.

3) Companies need to define unambiguous guidelines for the approval and release of guidance

It is not enough for the finance director or CFO to provide a number or range and then get a nod from the CEO. Failure to follow rules for approval may lead to abuse and expose the company to costly litigation by aggrieved investors.

Companies must ensure that they have strict and laid down procedure for approving the numbers. For instance, some companies may require the approval of the Audit Committee, while others require the approval of the executive committee and external auditors.

Companies must realize that guidance is supposed to serve as a strong signal to the market.

The SEC draft rule B4(3)II states that:

The forecast shall be certified by the Chief Executive Officer (CEO) and Chief Financial Officer (CFO) or [any] other officer performing similar functions.

Item 17 of the Internal and External Responsibilities of the Audit Committee Charter for the Xerox Company clearly specifies that it must approve any guidance before release.

4) Companies need to pre-identify circumstances which if they occur will trigger public notice of a change in guidance

Sometimes, events may occur which may put the earlier projections made at risk. When this happens, companies need to communicate to the market in as forthright a manner as possible the effects that the new events will have on the earlier guidance.

One Steel, the Australian manufacturer and distributor of steel products, provides a good example in its restatement of 2009 guidance of how a company can explain the reasons for the revision of guidance.

RJR, the US-based tobacco company, provides an even better example by describing the steps it is taking to cut costs, streamline operations and improve EPS.

5) Companies must ensure that the SEC and other regulatory authorities provide them with reasonable safe harbour protection against unmeritorious or frivolous law suits that seek to extort costly damages when they do not meet their guidance numbers or other forward-looking or future-oriented financial information

In the United States, companies providing earnings guidance or other future-oriented financial information are reasonably covered from securities fraud class actions by the Private Securities Litigation Reform Act of 1995 so that plaintiffs have to show good evidence that the intention of the guidance at the time it was given was to expressly mislead markets. The SEC must realize that it is not enough for companies to simply provide guidance, no matter the incentive. These companies could also face potentially costly risks from lawsuits if they miss their targets unless there are guidelines that offer them a measure of protection. Companies must request the SEC to define their potential liability exposure when they do not meet targets.

6) Companies should embed communications about future financial performance in the wider context of the investor relations program and not treat it as an isolated regulator-imposed requirement

Earnings guidance is not an end in itself. The release of guidance must be properly situated in the broader framework of bridging the gap between managers’ appreciation of the company’s prospects and the market’s. Providing earnings guidance should not be a check-box activity.

Companies must be understand that the provision of guidance is only one element, albeit an important one, among others which have the purpose of building the credibility of management in the capital markets.

Like the investor relations section of the website, analyst coverage, conference calls and non-deal roadshows, earnings guidance should be seen as just one item in the investor relations toolbox. Until companies adopt a strategic view of investor relations they will not reap the full benefits of any of tools.

Naturally, the assumption here is that companies that plan to provide earnings guidance already have a [robust] investor relations function headed by a senior professional with sound capital markets familiarity and a deep understanding of the investment’s community’s evolving information requirements. Since guidance is necessarily focused on the next reporting period, which critics emphasize makes it myopic, companies should balance this by providing information on their progress with longer-term plans and corporate strategy.

In fact, a more pressing issue for the Securities and Exchange Commission and the Nigerian Stock Exchange would be to require all corporate issuers to have an investor relations function as well as a regularly updated investor relations website with stringent fines for failure.

7) Develop a comprehensive disclosure policy according to leading practice principles, taking Reg FD as the model

Earnings guidance is a disclosure event. Like all corporate disclosure events, it is vital that a written policy exists to guide what can and cannot be disclosed. Regulation Fair Disclosure in the United States is a good model for companies to adopt when developing a disclosure policy. Needless to reiterate, earnings guidance, and past releases including financial statements, must be publicly disclosed and made available on the company website via an easily discoverable link with the least number of click-throughs from the Home page (Press>> News Releases or Investor Relations >> Earnings guidance).

Nigerian companies must recognize that disclosure practices have tangible valuation impact on their shares. Disclosure is not simply a best-practices adoption with negligible significance.

EMC Insurance Group, a US insurance company, has a disclosure policy that is both comprehensive and flexible enough to serve as a guide to other companies.

All the above points should be carefully considered by companies before issuing guidance, and by the securities markets regulator before making it mandatory for corporate issuers to provide such guidance. The provision of earnings guidance is not a trivial act. It has real costs for companies and unless a strong case for its benefits is made, it would be an exercise in futility to impose it on them.

The three week limit on public responses to the SEC raft rules and proposals did not only stifle public debate but curtailed sufficient public enlightenment by the regulator on the role of guidance in the capital markets with balanced coverage of its pros and cons.

We strongly feel that such haste and poor awareness can only lead to a still birth no matter the merits of guidance. The SEC should organize seminars for company IROs, finance directors, analysts, money managers and institutional investors as well as shareholders on the utility of guidance while stressing that such communications must form part of companies’ on-going communications on long-term plans and strategy milestones. Without such enlightenment, it is almost guaranteed that earnings guidance will not see the light of day in the Nigerian capital markets. No pun intended.