Investor Relations and Financial Press Regulations

Investor Relations and Financial Press Regulations

A business corporation is organized and carried on primarily for the profit of the stockholders.1


Introduction to Investor Relations

What Are Securities?

What Is a Corporation?

How Is a Corporation Organized and Administered?

Securities Exchange Commission Regulation

State Regulations and Actions

Practice Notes


Perhaps because communication is so important to establishing the price of securities, investor relations and financial reporting are two of the most lucrative areas of communication practice. Also, in the recent past the legal and ethical misconduct of practitioners in these areas has received significant public attention.

This chapter builds from the information on commercial speech presented in chapter 12. It begins with a very brief introduction to investor relations. It follows with a description of the structure and purpose of corporations and an explanation of how communication practitioners are central to the function and success of corporations. Of course, in this brief chapter we cannot begin to explain all the nuances of corporate structure. We limit the discussion to a brief introduction of corporate structure and an equally brief description of the corporate decision-making procedures that are most affected by mass communications. Continuing this focus on communication by and about corporations, we explain the anti-fraud provisions of the Securities and Exchange Commission’s (SEC’s) regulations and summarize recent changes in this area of law, particularly the Sarbanes–Oxley Act. In the practice note at the end of this chapter, we describe potential personal liabilities of financial reporters and practitioners in investment relations.

Introduction to Investor Relations

Stocks or shares of corporations, along with bonds and other records of investments, are called securities. Reporting about stocks, advertising the sale of bonds, and communicating about all kinds of securities are important tasks for communication practitioners because communication has an extraordinary impact on the value of the securities themselves. Stocks and bonds differ from most commodities that can be bought or sold because they have no intrinsic value. A purchaser or seller cannot look at a security instrument and decide how valuable it is. The buyer or seller must rely on information about the security to determine what it is worth. Most goods are produced and sold to be consumed and government regulation of communication about those goods is designed to protect consumers and enforce fair business practices. Securities instruments are created only to be sold and they cost virtually nothing to produce. A purchaser must have accurate information to even know what he or she is buying.

Accurate information about securities has a profound impact on their value but delivering accurate information about them is difficult because the language used to describe them is alien to many publics. The language of business is accounting and when describing stocks this language takes two major forms—the profit and loss (P & L) statement and the balance sheet. Grossly oversimplified, the profit and loss statement reports revenue, expenses, and income and is based on the mathematical formula:

Revenue – Expenses = Income

Equally simplified, the balance sheet describes assets, liabilities, and the net worth of a corporation or other business entity. The balance sheet is based on the formula:

Assets – Liabilities = Net Worth

Although the formulas of the profit and loss statement and balance sheet appear very simple they are subject to interpretation and manipulation and there is extraordinary temptation to misrepresent the information in them. For example, the revenue included in the profit and loss statement includes accounts receivable. Reporting large accounts receivable makes a company look more profitable and may positively influence its stock values. Accounts receivable are debts owed to the company and they may never actually be paid. The decision to include a debt in the profit and loss statement as an account receivable or to omit that debt is just one example of the many communication decisions that must be made by practitioners in investor relations.

What Are Securities?

Just like the Federal Trade Commission only regulates commercial communication, the Securities and Exchange Commission only regulates communication about securities. “Congress, in enacting the security laws, did not intend to provide a broad federal remedy for all fraud.”2 Therefore, before one can understand SEC regulation of communication, one must first be able to identify a security. A security is a document that shows a debt or financial obligation. Using this simple definition, think of a personal check written on a local bank account as a security. It is a document you created that shows your promise to pay the amount indicated when it is presented to your bank. However, most securities regulations only address securities that are both much larger than the typical bank check and that are created as a profit-making investment. Security is defined in the Securities Act of 1933 as:

any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas or other mineral rights, or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.3

Frankly, this is too much information to be useful. For our purposes, securities are stocks, stock options, stock futures, and investment contracts. Stocks are shares or proportionate ownership interests in a corporation.

Even when the security involved is the sale of an entire business, that sale is covered by security regulations if the business ownership was held in the form of shares or stocks in the business.4 The vast majority of regulated communication about securities addresses concerns about these stocks or shares.

One form of stock or note not considered a security is a note secured by a mortgage on a home. Other documents excluded from the definition of a security include currency and any note that becomes payable within 90 days.

Some of the confusion about what is and what is not a security was resolved by the U.S. Supreme Court in 1990. That year, in Reves v. Ernst & Young, the Supreme Court adopted a standard for defining securities that was originally proposed by the Court of Appeals for the Second Circuit.5 The Reves decision dealt with an investment scheme by a cooperative association in Arkansas. The investments were needed to acquire funding for a gasohol plant. The investments were described in the cooperative’s newsletter with the language:

YOUR CO-OP has more than $11,000,000 in assets to stand behind your investments. The Investment is not Federal [sic] insured but it is . . . Safe . . . Secure . . . and available when you need it.6

Despite these assurances, the cooperative filed for bankruptcy and left 1,600 investors holding $10 million in worthless notes. Bob Reves was one of several investors who lost money after investing in demand notes. The investors sued Ernst & Young accounting company, claiming the company had misrepresented the financial situation of the cooperative. Reves claimed Ernst & Young had violated provisions of the federal securities laws and Arkansas state securities laws. One of Ernst & Young’s defenses was simply to assert that the notes were not securities and therefore the securities regulations did not apply. After the appellate court granted Ernst & Youngs motion to dismiss, the U.S. Supreme Court reversed saying the notes did meet the definition of a security and therefore were covered by the securities regulations.

The test used by the Supreme Court to reach this decision, often called the family resemblance test, begins with the assumption that any note or document that can be sold or requires a payment more than 90 days beyond its issuance is a security. The test then offers a list of exceptions and says any note or paper that bears a “family resemblance” to something on the list is not a security. The test also includes four steps or questions to ask when trying to determine what is a security.7 These steps are explained in Exhibit 13.1.

Exhibit 13.1.  Family Resemblance Test to Determine What is a Security (From Bob Reves v. Ernst & Young, 494 U.S. 56 [1990] and Chemical Bank v. Arthur Andersen & Co. 726 F.2d 930 [1984]).

Begin with presumption that any note or paper with a term of more than 90 days is a security unless it is on. or resembles something on, this list:

Mortgage on a home

Short-term note secured by lien on a small business

“Character” or signature loan to a bank

Open account debt incurred in the ordinary course of business

To determine if an item resembles something on the list or should be added to the list ask four questions:


Item is a security if:

Item is not a security if:

What are the motives that would prompt a reasonable seller and buyer to enter into this agreement?

The seller’s purpose is to raise money for a business enterprise or to finance substantial investments and the buyer is interested primarily in profit

It is exchanged only to facilitate the purchase and sale of a minor asset or consumer good or to correct short-term cash flow problems

What is the plan for distribution of the instrument?

There is common trading and speculation among a large number of people

It is a private exchange between two people or a very small group of people

What is the reasonable expectation of the investing public?

The public expected it to be protected as a security and based their purchase decisions on such expectations

The public perceived the instrument as a private agreement and not as a security

Is there some factor that reduces the risk of investment and renders the protections of the Securities Acts unnecessary?

There is no factor that reduces the risk

There is a factor (or factors) that significantly reduces the risk to the investing public

Stock options, puts, and calls are all agreements addressing the future sale of stocks. Options are an agreement allowing one party to purchase shares at some future date at a specific price. A put is a privilege of delivering, or not delivering, the stock for sale and a call is a privilege of calling for or demanding the sale.8 These agreements are treated as securities and any proposal or offer to sell such agreements are controlled by the regulations we discuss in this chapter. Finally, investment contracts are regulated as securities and are defined as any agreement whereby a “person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”9

Some securities are exempt from regulation. Most notable among these exceptions are obligations issued or guaranteed by the U.S. government and securities that mature in less than 9 months. Therefore, if you are advertising or promoting the purchase of U.S. savings bonds, the communication regulations we discuss here do not apply.

What is a Corporation?

Most securities are stocks or ownership shares of a corporation so understanding securities requires some understanding of corporations. There are a number of misconceptions about the purpose and legal status of corporations. Knowing why corporations are formed and how they are structured is essential to understanding the need for legal restrictions on communication by and about corporations. Therefore, we present a brief history and description of corporations.

Business and trade organizations that are similar to corporations can be found as far back as the time of Hammurabi, in ancient Greece and in the Roman Empire. But the modern corporation really did not begin until the industrial and trade revolution. By the middle of the 18th century in Britain only the Crown could grant corporate status. This tradition of governmental license influenced the formation of corporate law in the United States, where states still control the formation and recognition of corporations. Early in U.S. history, individual states passed laws permitting incorporation by groups of investors. For example, North Carolina had such a law in 1795 and Massachusetts adopted one in 1799. Initially, these laws only allowed corporations to be formed for purposes beneficial to the public. Usually the corporations were formed to build a bridge, or operate a canal or toll road. In 1837, Connecticut adopted statutes permitting the formation of corporations for “any lawful purpose.” This statute is the forerunner of modern corporate structure.

Most corporations can be divided into three types: (a) corporations for-profit, (b) not-for-profit corporations, and (c) government-owned corporations, but there are some other forms of corporations. For example, most states require professionals like physicians and attorneys who want to incorporate to do so under professional corporation acts or as “limited corporations” and some industries such as banking and insurance are subject to special statutes. One other form is the close corporation that is only created when there is a very small number of shareholders. Each of these corporation types has its own legal idiosyncrasies and any communication professional reporting on or representing a corporation should consult legal counsel to identify the restrictions associated with specific forms of incorporation. For the purpose of this chapter, we focus on publicly held, for-profit corporations. These tend to be the largest corporations and are the ones subject to the greatest public interest and the most extensive communication regulation.

Simply put, the purpose of for-profit business corporations is to generate and protect wealth for their owners. They are not public interest organizations or quasi-governmental systems. The Supreme Court of Michigan best described the purpose of business corporations when it said:

In addition to generating income for the shareholders, another major reason for forming a publicly held, for-profit corporation is limiting the liability of shareholders for the corporation’s debts. As the individual states adopted and modified their corporate statutes, they gradually limited the liability of corporation owners or shareholders for the debts of the corporation. Today, there are very few instances wherein a shareholder can be held liable to pay any part of a corporate debt. The reciprocal is also true. The corporation cannot be sued or held liable for the personal debts of its shareholders. In effect, the corporation has become a legal “person” with a financial identity independent of its shareholder owners. This status as an independent legal “person” means that the corporation continues to exist even if a shareholder dies and that shareholders may sell their interests in the corporation without affecting the corporation’s ability to create contracts, collect obligations, and pay its debts.

Corporations differ from other forms of business enterprise and are attractive systems for organizing business because they insulate owners from business debt and because their shares are transferable. These advantages can be seen when corporation structures are compared to other forms of business. A sole proprietorship is a business run by an individual and a partnership is a business created and managed by a group of individuals who form their relationship through a formal or informal agreement among themselves. Sole proprietors and business partners are usually personally liable for the debts of their business and their business assets can be taken to pay their personal debts. It may be helpful to recall that in our discussion of agent-principal law we explained that partners are all agents of the partnership. In their status as agents of the partnership, partners can create debts and liabilities for the entire partnership. Furthermore, when a sole proprietor dies or leaves his or her business, that business ceases to exist. When any one partner dies or leaves a business, it often forces the other partners to dissolve the partnership and either leave business altogether or reorganize the enterprise.

Because corporations are more permanent than either sole proprietorships or partnerships, they are more attractive to customers and financers. Because corporations do not subject their individual shareholder owners to personal debt liability they are attractive to individual investors. Such individual investors are, of course, a major source of capital investment for the corporation. Because the corporation is a legal “person” and, perhaps, because it insulates its owners from some debts, it must be created by government license or charter and it is subject to extensive government regulation. These regulations not only cover how the corporation is organized, they also cover how the corporation can communicate. We focus on the regulations that limit how those of us in mass communications can talk or write about corporations. In order to understand the limitations on communication, it is necessary to have some basic understanding of how the corporation is owned and how its owners make decisions about how to run the corporation. The characteristics of a corporation are listed in Exhibit 13.2.

Exhibit 13.2.  Characteristics of Corporations.

  • Created by permission of government.
  • Legal “person.” It is legally independent of its shareholders and unaffected by retirement or death of owners.

    It can be sued and it can sue.

    It can buy, hold, and sell property in its own name.

    It has constitutional protection like equal protection and due process.

    It has a legal domicile and/or residence.

  • Individual shareholders have no right or duty to manage the corporation. Collectively, all of the shareholders do have the right to manage the corporation, but only through their actions as a group.
  • Ownership interest is transferable. Shareholders are free to buy and sell stock.
  • Limited liability of shareholders. Owners of shares are not obligated to pay the corporation’s debts from their private funds.
  • Tax liability. Since the corporation is a legal “person,” it is obligated to pay taxes on its income.

How is a Corporation Organized and Administered?

The person or group who forms a corporation is called a promoter. The promoter usually discovers a business or an idea that can be profitably developed. He or she recruits people willing to invest in the corporation, helps create the initial corporate bylaws, and arranges to have the corporation licensed. Those initial investors are the first shareholders. Shareholders own a “share” of the corporation in proportion to their investment in its creation. It is those shares that can later be purchased and sold as stock. The prices at which the shares are sold help determine the value of the corporation.

The shares not only determine how much of the corporation the individual shareholders own, they also determine the magnitude of control the individual shareholders have in the administration of the corporation. When the most important decisions are made in a corporation, the shareholders vote to make those decisions. In these corporate elections one share equals one vote, so the larger the number of shares or the larger portion of the corporation an individual owns, the greater his or her voice in the operation of the corporation. For the sake of simplicity, we limit our discussion here to common stock. Preferred stock and other classes of stocks may be treated differently.

Share ownership in a corporation is important for two reasons. First, owning a share entitles a shareholder to a portion of the corporation’s profits and second owning a share entitles a shareholder to a voice in the corporation’s decision making. Communication by and to shareholders, therefore, is important because it can influence both the distribution of money and the allocation of power. Money and power are the source of many disagreements and influencing the distribution of money and power creates extraordinary temptations to use communication to deceive and to manipulate others. Almost all regulation of communication about corporations is designed to control this temptation and to force accurate disclosure of information.

How Decisions are Made

The individual shareholders of the corporation do not have a right to manage the business of the corporation simply because they own shares of the enterprise. Having all the shareholders of a major corporation participate in all decisions would simply be too cumbersome and inefficient. Generally, the shareholders are only asked about major decisions that involve some change in their ownership interest like dissolution or merger and to select a board of directors. The day-to-day management of the corporation is entrusted to a board of directors so the selection of the board is one of the most important decisions in corporate management.

The shareholders make their collective decisions by “voting their shares” in special elections or at an annual meeting. The corporate elections are analogous to political elections except that they follow the principle of one share-one vote. The more shares a shareholder owns the more influential his or her vote in corporate decision making. It should also be noted that there are variations in how shares can be voted. Straight voting is common but many corporations also use a system called cumulative voting in which each shareholder may have multiple votes depending on how many members of the board of directors are being elected. There may also be variations in voting rights based on classes of shares, voting trusts, and voting agreements, none of which would be permissible in traditional political elections.

Because the shareholders must vote to decide how the corporation is administered and to choose the board that will manage the corporation, the availability of accurate information about corporate affairs is essential. Only well-informed shareholders are in a position to select the best board and to choose board members who reflect the shareholders’ views of how the corporation should be administered.

Typically, the board of directors is elected at annual shareholders’ meetings. At these meetings, the shareholders are also usually asked to approve the corporation’s independent auditors, to ratify stock option plans for management, and to vote on shareholder proposals. Most states follow the Model Business Corporations Act (MBCA), which specifies that annual shareholder meetings must be held at a time and place specified by the corporation’s bylaws. These meetings may be held anywhere permitted by the bylaws. Some corporations hold the meetings in the city where their headquarters are located. Some rotate the meeting locations for the convenience of the shareholders and some even hold meetings in deliberately inconvenient locations to discourage attendance. Under the MBCA, other meetings for elections can be called if 10% of the shareholders request the meeting. Such meetings are often called to remove a director or an entire board of directors when the shareholders are unhappy with the corporation’s performance. One function of communication in these elections is the distribution of notice that ensures all shareholders are given the opportunity to vote.

Obviously, not all shareholders can physically attend shareholder meetings to vote their shares. These individuals may not vote or they may select a proxy. A proxy is someone appointed by the shareholder to vote for him or her at the shareholder meeting. Often, the current board of directors will ask shareholders to allow them to vote their shares. These and similar requests, including requests by those who oppose the existing board, are called proxy solicitations. A major function of communication in shareholder elections is the solicitation of proxies. Communication regarding these solicitations is heavily regulated.

Those in mass communications may be called on to produce the documents and other communications used to encourage stock purchases, to report the activities of the corporation, and to influence the elections that determine how corporations will be managed. Both state and federal laws regulate these communications activities. Obviously, those in the subfields of investor relations or financial reporting must be familiar with these regulations.

Securities Exchange Commission Regulation

One of the most significant economic disasters in U.S. history was the stock market crash of 1929. Students of the crash have identified two major reasons for this breakdown in the economic fabric of the country. First, investors lacked the information they needed to make informed decisions about the purchase and sale of securities. Second, the claims about securities’ values being made by sellers were dishonest. These claims were so out of control that some sellers were even able to sell stock in companies that did not exist.

To prevent another economic collapse, the U.S. Congress considered two options. These options were called merit registration and the disclosure scheme. Merit registration