Client Alert

The SEC recently issued a cease and desist order against IBM that arose out of allegedly misleading statements made by IBM during and in connection with a conference call with analysts. The takeaway: Public companies should be careful to ensure that their Form 8-K disclosures are materially complete, not misleading and able to withstand scrutiny of the SEC in light of contemporaneous business developments.

On June 5, 2007, the SEC issued a cease and desist order against IBM under Section 21C of the Exchange Act for allegedly making materially misleading statements in its public filings.¹ This proceeding was based on IBM's April 5, 2005 conference call with analysts to announce IBM's decision to expense employee stock options beginning with the first quarter of 2005, and a transcript of the call and a supplemental chart that IBM filed that day on a Form 8-K. The main purpose of the call and the Form 8-K filing was to disclose the impact of stock option expensing on IBM’s earnings.

During the call, IBM's Chief Financial Officer specifically quantified the pro forma impact of option expensing on IBM’s 2004 earnings. However, the CFO did not quantify the impact on 2005 earnings. Instead, he emphasized that the accounting change had nothing to do with IBM's underlying business and advised the analysts to update their expectations for 2005 to reflect the same level of year-to-year profit improvement as current estimates. The CFO's statements, and the supplemental chart included in IBM’s Form 8-K that was consistent with those statements, led analysts to reduce their quarterly and full year earnings per share estimates for 2005 by amounts equal to the pro forma adjustments applicable to 2004. About a week later, however, IBM announced its first quarter 2005 results, which, due to adverse business developments, were materially less than the amount many analysts were expecting. Moreover, the actual impact of option expensing on IBM’s earnings for the quarter was substantially less than the analysts had expected, which made the gap between actual and estimated earnings per share even more troubling to the analysts. IBM’s stock price dropped 8% that day.

The basis for the SEC's enforcement action against IBM was that, at the time of the conference call, IBM had an internal forecast that showed the impact of option expensing on 2005 earnings per share would be materially lower than for 2004, apparently due to some steps IBM was taking to reduce equity compensation expense. The SEC alleged that IBM wanted the analysts to use the higher 2004 expense numbers in building their 2005 estimates and thereby arrive at a lower earnings forecast for 2005. Why? According to the SEC’s findings, the action was taken to avoid an earnings per share hurdle that IBM believed would be difficult to achieve in view of an expected increase in year-over-year pension costs.

The SEC found that IBM’s Form 8-K was materially misleading (and violated Rule 12b-20, the SEC’s anti-fraud rule applicable to Exchange Act filings) because the report created the impression that IBM’s stock option expense for the first quarter of 2005 would be greater than IBM actually expected it to be. While the SEC’s order is narrow in its findings and conclusions, the facts suggest that on the day of the call IBM knew that later in the month it would announce a disappointing first quarter 2005.

This timing raises the question whether IBM's less than complete disclosures concerning the impact of option expensing on 2005 earnings, or even the timing of the decision to adopt option expensing in the first place, were motivated by a desire to make the expected earnings shortfall appear less severe than it actually was. On the other hand, IBM can point to statements made during the call and in the Form 8-K to put the analysts on notice that the company had taken steps to reduce its stock option expense for 2005, which in turn might have led the analysts to ask questions designed to quantify the expense reduction. Unfortunately, however, the CFO elected not to entertain questions during the call.

The SEC's enforcement action against IBM reinforces that public companies must strive for transparency in their financial disclosures.

If you have any questions regarding the enforcement action or its implications, please contact either the Womble Carlyle attorney with whom you usually work or one of our Corporate and Securities attorneys here.

 ¹ The SEC press release regarding the settlement of the enforcement action may be found here. The SEC Order Instituting Cease-and-Desist Proceedings, Making Findings, and Imposing a Cease-and-Desist Order Pursuant to Section 21C of the Securities Exchange Act of 1934 may be found here.