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Social Media in Action in the Securities Sector

Making Information Public

Recognizing that the availability of the Internet has broadened substantially, and that, for example, more than 80 percent of mutual fund share owners have Internet access, regulators have taken steps to permit (and even encourage) disclosures and other communication electronically.

While the majority of companies still distribute their earnings announcements and other investor disclosures through traditional paid public relations wire services, some large companies such as Expedia, Inc. and Google Inc. are taking advantage of the SEC guidance on using company websites for disclosure under Regulation FD, and moving toward exclusively providing this information through their websites.

Regulation FD governs the public disclosure of material information and requires that such information be disseminated by methods of disclosure “reasonably designed to provide broad, non-exclusionary distribution of the information to the public.” The SEC has recognized more channels of distribution for required and other public information disclosures (either to meet regulatory obligations or in connection with individual securities transactions), including a variety of electronic media, and the SEC has acknowledged that as technologies expand, it will continue to recognize new channels of distribution as appropriate for such disclosures. The SEC has already made it clear that companies can use their websites for disclosure if their websites are a “recognized channel” for investors. In time, other forms of social media may become such recognized channels. In the short term, however, it is likely that for the majority of companies, social media, coupled with traditional forms of shareholder communication, could provide the ability to more effectively reach more actual or potential customers, investors and/or shareholders. While social media presents an attractive channel of communication, care must be taken to assure that disclosures are appropriate and conform to a variety of applicable legal standards, and that those standards are understood and adhered to by a company’s employees and agents.

Failure to comply with Regulation FD could well result in an enforcement investigation or action. In addition, noncompliance with Regulation FD makes a company vulnerable to an SEC investigation or proceedings relating to trading violations if the recipients of the information disclosed by the company, trade their shares in a discriminatory manner ahead of a more fulsome public disclosure.

While application of the securities disclosure framework to social media continues to develop, issuers should be familiar with the current guidelines released by the SEC on August 7, 2008, and subsequent compliance and disclosure interpretations issued on August 14, 2009, relating to the use of company websites for such disclosures. These guidelines begin to outline boundaries applicable to sharing information through social media outlets, as well as the potential for issuer liability for information the company or its employees post on blogs, networks, communities and discussion forums. While it appears that issuers can utilize social media to disseminate information to the public, they need to proactively analyze the SEC guidelines and establish internal policies and frameworks to address these issues.

Advertising and Promotion

Social media also offers an opportunity to provide information in connection with a transaction or to promote a particular investment or investment strategy;, as such, it could be a very effective and attractive tool for investment advisors, investment companies and broker-dealers. However, if the promotion or disclosure is held to be inadequate or otherwise violative of regulatory requirements, it could result in an investigation or action by regulatory authorities. For example, numerous registered investment advisors (“RIAs”) use social media platforms such as Facebook, MySpace, LinkedIn, YouTube, Twitter and blogs for business purposes, because social media is an inexpensive and effective way for them to communicate with clients and prospective clients.

Investment advisers, investment companies, broker-dealers and other regulated persons and entities must take great care to assure that they obtain the proper approval before using social media tools. For registered representatives (“RR”) subject to the Financial Industry Regulatory Authority (“FINRA”) regulations, this means obtaining the approval from their broker-dealer compliance department before posting anything on the Internet. Postings are considered advertisements, and FINRA has published guidelines for use of the Internet by registered representatives of broker-dealers.

On January 25, 2010, FINRA, issued a regulatory notice giving guidance on how FINRA rules governing communication with the public apply to social media sites sponsored by a financial firm or its RRs. The goal of this notice was to ensure that as the use of social media sites increases over time, investors are protected from false or misleading claims and representations, and financial firms are able to effectively and appropriately supervise their associated persons’ participation in these sites. The key issues addressed in FINRA’s regulatory notice included:

• Recordkeeping responsibilities: Every firm that communicates through social media sites must retain records of any communications in order to comply with the Securities Exchange Act and NASD rules that require that broker-dealers retain electronic communications related to their business.
• Suitability responsibilities: If a firm recommends a security through a social media site, it is required to ensure that the recommendation is suitable to every investor to whom it is made under NASD Rule 2310. FINRA recommended that firms use those features of social media sites which limit access to information to a select group of individuals to meet this requirement. Further, communications that recommend specific investment products may trigger, for example, the FINRA sustainability rule and other requirements under federal securities laws, which may create substantive liability for a firm or a registered representative.
• Static versus interactive content in a blog: Whether content posted by a firm on a blog is “static” or “interactive” will determine which rules apply, as discussed below. If a blog enables users to engage in real-time interactive communications, FINRA will consider it to be an interactive electronic forum. FINRA does distinguish between interactive and static content within the same blog. For example, a Facebook site could have static content as well as interactive posts. The portion of these networking sites that provides for this interactive communication constitutes an interactive electronic forum.
• Approval or supervision of content posted on a social media site: If the content to be posted on a social media site is considered to be static, it must be pre-approved by a registered principal at the firm prior to posting. If the content to be posted is considered to be interactive and unscripted, the firm is not required to have a registered principal approve these communications prior to use, but must still supervise the communications to ensure that they do not violate the content requirements of FINRA’s communications rules. Static content on social media sites include profile, background, or wall information. Interactive content include such communications as interactive posts on Twitter or Facebook.
• Supervision of social media sites: A firm must adopt procedures and policies that are reasonably designed to ensure that electronic communications through social media do not violate FINRA or Security Exchange Act rules or laws. The supervisory system that will be optimal will be different for each firm; however, common themes of this system should include a mix of review by principal prior to use, and post-use review, depending on the nature of the communication. A firm must also ensure through its procedures and policies that its associated persons who participate in social media sites for business purposes are appropriately supervised, have the necessary training and background for such activities, and do not present undue risks to investors.
• Third-party posts: When a third party posts content on a social media site established by the firm or its personnel, FINRA generally does not treat such posts as the firm’s communication with the public, and thus the responsibilities described above do not apply to these posts. However, the third party content will be attributable as the firm’s communication if the firm has (1) involved itself in the preparation of the content or (2) explicitly or implicitly endorsed or approved the content.

The SEC has similar guidelines that RIAs must adhere to that govern advertisements, including postings to public Internet forums[1]. RIAs are generally responsible for self-supervision by chief compliance officers. In light of the foregoing, it seems RIAs not subject to FINRA regulations have quite a bit more flexibility when using the Internet and social media. However, common sense should always be used to avoid publishing security recommendations or any testimonials, both of which are explicitly prohibited by the SEC and state regulatory authorities. Even though communications with current clients are not usually viewed as advertisements, they might fall into that category if circumstances suggest that their purpose is to sell additional advisory services or to attract new clients. If an RIA’s use of social media is viewed by the SEC as an advertisement, it is subject to Rule 206(4)-1 under the Investment Advisers Act of 1940.

Certain types of social media, expressly or implicitly, violate Rule 206(4)-1(a)(1)’s prohibition of testimonials. A testimonial is a statement relating to a client’s experience with, or endorsement of, an RIA. LinkedIn profiles, for example, allow RIAs to accept and to publish professional recommendations from other individuals using the business-oriented social networking site. Any published recommendation that references the RIA may be construed as a testimonial, regardless of whether it was solicited, and it might violate Rule 206(4)-1 even if the person making the recommendation is not a client. These recommendations might be viewed as false or misleading, since an RIA may have solicited them from a friend, relative, or business associate. Regulators may see these recommendations as some sort of quid pro quo (e.g., an RIA recommends someone, and that person returns the favor). These recommendations also may paint a misleading picture of the RIA, since negative comments are unlikely to be published on the RIA’s profile.

In light of the foregoing, these recommendations might violate Rule 206(4)-1(a)(5), which bars any advertisement that is false or misleading in any way. Twitter and Facebook raise similar compliance issues.

Even if social media content is not considered to be a testimonial, a tweet or other communication can still violate Rule 206(4)-1. RIAs may send messages in haste, thereby increasing the risk of sending false or misleading information. Also, a tweet is limited to 140 characters, which leads to users increasingly using abbreviations, in turn raising the risk that the message could be misleading or difficult to understand. Finally, the space limitations of tweets may omit important information, including disclosures.

Profiles on LinkedIn, Facebook, and other social media platforms should be scrutinized to ensure they are not false or misleading, and should be consistent with the RIA’s advisory contract, and other advertisements, including websites. All references to performance may be subject to the guidance in the Clover Capital no-action letter. The Clover Capital no-action letter requires that performance results be presented on a net-of-fees basis, and that advisers make numerous disclosures when providing performance results. In addition, RIAs may inadvertently be violating Rule 206(4)-1(a)(2) under the Investment Advisers Act, which restricts advertisements referring to specific recommendations made by an RIA that were, or would have been, profitable to any person.

RIAs should revise their compliance manual to incorporate policies and procedures regarding the use of social media by their employees. RIAs have three options: (1) allow employees to post information about the advisory firm but require pre-approval by a firm’s compliance officer or a designee for all such business-related postings using social media (a supervisory nightmare); (2) a limited prohibition against allowing any information to be posted to the public profile portion of any social media; or (3) an absolute prohibition against employees communicating any information about the advisory firm (other than the name of their employer) on a social media site.

RIAs should make all employees aware that posting any information about their advisory firm on a social media site is considered advertising and, as such, is subject to SEC prohibitions and firm policies and procedures. An advisory firm should also require that all employees attest to the fact that they are in compliance with the firm’s rules regarding advertising and electronic communications. The firm’s chief compliance officer should also periodically visit the more common social media sites to check for violations of either Rule 206(4)-1 or the firm’s own policies and procedures.

The fact that the SEC is now on Twitter should be of additional concern. One of the SEC’s very first tweets discussed a recent enforcement action against an RIA. It stands to reason that if the SEC is on Twitter, then it certainly is capable of finding compliance violations in social media.

Insider Trading

Social media’s “stock in trade” is the communication of information. Thus, there is an obvious likelihood that some of the information that might be conveyed via social media could be material, non-public information. The transmission of such information, if it breaches a duty to the company or to the person who shared the information, may itself be a violation of the securities laws, and if you trade on such information, you very likely have committed insider trading. This conduct is regulated largely through the antifraud provisions, but most often Section 10(b) of the Securities Exchange Act and Rule 10b-5 thereunder.

Underscoring its recent announcements that insider trading remains a high priority, the SEC has entered into an agreement with the New York Stock Exchange’s regulatory arm (NYSE Regulation, Inc.) and FINRA to improve detection of insider trading across the equities markets by centralizing surveillance, investigation, and enforcement in these two entities. In addition, the SEC’s new organizational structure, announced in 2009 and put into place this year, includes specialized subject-matter Enforcement units, including a Market Abuse Unit, focused on investigations involving large-scale market abuses and complex manipulation schemes by institutional traders, market professionals, and others. The Market Abuse Unit relies heavily on computers, cross-checking trading data on dozens of stocks with personal information about individual traders, such as where they went to school or where they used to work, looking for patterns by traders across multiple securities, to see if there are any common relationships or associations between those traders. Suffice it to say, social media will be crucial in making some of these connections for this specialized team.

These changes, together with recent pressure brought to bear on U.S. regulators by high-profile enforcement failures, are likely to result in increased enforcement in this area. This is true because insider trading cases, specifically, are comparatively easy for regulators to identify and investigate and, in light of public pressure, regulators have a substantial interest in bringing higher numbers of cases. At the same time, we have seen an increase in insider trading investigations and prosecutions worldwide, as well as an unprecedented level of international cooperation among securities regulators to pursue violations across jurisdictions. In particular, the Financial Services Authority in the UK has put the identification and punishment of insider trading at the top of its enforcement agenda.

Thus, social media is of particular importance when considering insider trading issues because of the volume of information traffic, the fact that the traffic crosses borders, and the ability of regulators to locate the source of the information, since social media postings—like everything on the Internet—never really disappear.

Other Potential Liability—Market Manipulation, False Rumors

Wrongly used, information posted in social media can expose companies to regulatory investigations and legal claims, and expose companies’ securities to manipulation by those who would intentionally exploit the media for unlawful activity. Companies should assure that sites, pages and other outlets for discussion and dispersal of information are being properly and lawfully used.

In much the same way that companies protect their trademarks and trade dress, they should protect their company names and their information, or risk finding themselves on the receiving end of an investigative subpoena, even in circumstances where the company itself had no involvement whatsoever. The SEC has announced its intention to pursue “false rumor” cases. This is just one variety of market manipulation, and social media is the perfect place for such rumors to grow and eventually impact stock prices. Although companies will not be able to ameliorate all such activity, reporting such conduct to regulators (and to website hosts) in the first instance is just one consideration that should be discussed with counsel.

Current Legal and Regulatory Framework in the Securities Sector

Three recent cases brought by the SEC offer cautionary tales. Although none involved the use of social media, any of the conduct for which the defendants were charged—and settled with the SEC—could have been accomplished using social media.

Violation of Regulation FD

InSEC v. Black[2], the defendant, the designated investor relations contact of American Commercial Lines, Inc. (“ACL”), acting without authority and without informing anyone at ACL, selectively disclosed material, nonpublic information regarding ACL’s second quarter 2007 earnings forecast to a limited number of analysts without simultaneously making that information available to the public, in violation of Regulation FD. Specifically, after ACL had issued a press release projecting second quarter earnings would be in line with its first quarter earnings, the defendant sent e-mail from his home to eight analysts who covered the company, advising that second quarter earnings “will likely be in the neighborhood of about a dime below that of the first quarter,” thus cutting ACL’s earnings guidance in half. The resulting analysts’ reports triggered a significant drop in the company’s stock price—9.7 percent on unusually heavy volume. Although this selective disclosure occurred via e-mail, it could just have easily been accomplished on the defendant’s Facebook page.

The SEC determined not to bring any action against ACL because it acted appropriately, cooperating with the investigation and taking remedial steps to prevent such conduct in the future. In its release announcing the case, the SEC noted that, even prior to defendant’s violative disclosure, “ACL cultivated an environment of compliance by providing training regarding the requirements of Regulation FD and by adopting policies that implemented controls to prevent violations.” In addition, the SEC highlighted that the defendant had acted alone, and that ACL, on learning of the selective disclosure, immediately publicly disclosed the information by filing a Form 8-K with the SEC.

More recently, the SEC filed a civil injunctive action against Presstek, Inc. and its former President and CEO, Edward J. Marino, for violations of Regulation FD and Section 13(a) of the Securities Exchange Act.[3] The SEC charged that Marino took a call from Michael Barone, the managing partner of Sidus, an investment adviser, whose funds held substantial positions in Presstek. The call between the two is documented in Barone’s notes and text messages that he sent to colleagues at Sidus during and after the call.

According to the SEC’s complaint, and Barone’s notes, Marino revealed during the call that “[s]ummer [was] not as vibrant as [they] expected in North America and Europe,” and while “Europe [had] gotten better since [the summer]… overall a mixed picture [for Presstek’s performance that quarter].” During the course of these disclosures from Marino, Barone sent a text to a Sidus colleague, “sounds like a disaster.” That colleague inquired as to whether he should be buying Presstek puts, and Barone confirmed. After the call ended, Sidus began selling, and Barone sent a text to the Sidus trader “sell all prst,” which he did. Coincident with those sales, Presstek’s stock dropped 19 percent. Presstek accelerated disclosure of its poor quarterly earnings numbers, issuing the report the next day, with the result that the stock dropped another 20 percent.

Presstek settled with the SEC without admitting or denying liability, agreeing to pay a $400,000 civil penalty. The Commission acknowledged substantial remedial measures taken by the company, including the replacement of its management team. Marino continues to fight the charges.

The case is interesting on a number of levels, particularly since there are probably many who would wonder whether the statements attributed to Marino rise to the level of material non-public information, which is likely why the matter is charged solely as a Regulation FD violation, with no insider trading charges. But there is no question that the comments cited are the sort of vague generalities that just might show up in a tweet or a Facebook newsfeed.

False Rumor

In SEC v. Berliner[4], the defendant, a trader himself, was charged with disseminating a false rumor concerning The Blackstone Group’s acquisition of Alliance Data Systems Corp. (“ADS”) via instant messages to other traders at brokerage firms and hedge funds. In short order, the news media picked up the story, resulting in heavy trading in ADS stock. Within 30 minutes, the defendant’s false rumor caused the price of ADS stock to plummet 17 percent, causing the New York Stock Exchange to temporarily halt trading in ADS stock. Later that day, ADS issued a press release announcing that the rumor was false; by the close of the trading day, the stock price had recovered. On the day of the rumor, more than 33 million shares of ADS were traded, representing a 20-fold increase over the previous day’s trading volume. Although the defendant sent the false rumor by instant message, he could have disseminated it through social media. One could easily imagine how a false rumor could spread even faster via Twitter, wreaking havoc with an issuer’s stock price.

Insider Trading

Although the misappropriated disclosures in SEC v. Gangavarapu[5] were made during telephone calls between siblings, the facts disclosed are exactly the sort of details you could find on someone’s Facebook page: “my husband is working all hours,” “my husband is traveling a lot for business,” “things are crazy at work for my husband,” “thank goodness, after tomorrow, things will calm down for my husband at work!”

According to the SEC’s complaint, the defendant misappropriated material non-public information from his sister, whose husband was an executive officer at Covansys Corporation, and purchased $1.4 million in stock based on the misappropriated material non-public information. Covansys was in discussions with Computer Sciences Corporation (“CSC”) and another company about their interest in acquiring Convansys. During that time period, the defendant often spoke with his sister by telephone and they discussed matters such as her husband’s work activities and whereabouts. For example, the defendant’s sister told him that her husband was in closed-door meetings, that he was working a lot and that he had traveled overseas for work. Then, after learning from her husband that the Covansys’ board of directors would vote the next day on which acquisition offer to accept, she told the defendant “by tomorrow, it’s a relief, it will be over.” Based on these details of his brother-in-law’s working life, the defendant purchased more than 54,000 shares of Covansys stock over eight days. When the public announcement came that CSC would acquire Covansys, the next day, the price of Covansys’ stock rose 24 percent, resulting in trading profits for the defendant totaling more than $361,761.

Bottom Line—What You Need to Do

Before you decide to adopt social medial as a form of communication and disclosure, you must ensure that the proper controls are in place. Whether it be material disclosures, advertising, or everyday business disclosures, you must be certain that your communications meet the regulatory requirements. For material disclosures, that means compliance with Regulation FD. For advertising of transactions or services, this means assuring that you obtain the proper approval before using social media, and that you are not in violation of any regulations, such as the Investment Adviser’s Act. You should verify that all mandatory disclaimers regarding forward-looking statements and financial measures are included with any electronic disclosure.

The spontaneity of social media presents a number of risks. Regularly monitoring your websites and social media presence to assure that the discussion is appropriate, the dispersal of information is compliant with the securities laws, and more simply, that these vehicles are being properly and lawfully used, is a good dose of preventive medicine. In addition, conduct routine searches for the use of your company’s name and corporate logo or other image, so as to assure that false rumors or other manipulations are not occurring.

Insider trading policies, together with good training programs that animate the dry rules and place employees into the types of real-life situations where information can be inadvertently shared, and strict controls on material non-public information, are really the only ways that companies can protect themselves. Employees must understand the importance of Regulation FD’s prohibitions on selective disclosure and know to keep the company’s most important confidential information internal to the company. They need to know what information they can and cannot communicate electronically in order to stay within the limits of compliance. Such programs, together with meaningful and well-circulated corporate policies, will help to prevent violations in the first instance; and, if a problem should arise, the fact that your company has undertaken these steps may tip the balance in your favor when the SEC is deciding whether or not to bring an enforcement action.

Finally, social media is new territory and the rules are constantly evolving. You will have to make a decision whether it is necessary to use social media at this moment for your company to stay ahead of the curve. If so, then carefully plan, execute, and periodically revisit a strategy that ensures that your use of social media is compliant with securities laws, and that you are protected against its abuse..