A PRACTICE WORTH ENDING: EPS GUIDANCE HARMING LONG-TERM GROWTH.

• Author: Millet, Rachel G.

INTRODUCTION

Public companies are often praised for their efforts to facilitate transparency among investors. (1) Federal securities laws were constructed around a single concept: the more information provided by companies, the better protected their investors would be. (2) However, in the summer of 2018, President Donald J. Trump challenged this longstanding approach and urged the Securities and Exchange Commission (SEC) to investigate the potential for changing the financial reporting requirement for publicly held corporations from quarterly reporting to semiannual. (3) The request comes off the coattails of many prominent business leaders, including Warren Buffett, Jamie Dimon, and Indra Nooyi, encouraging public companies to move away from current practices resulting in an unhealthy focus on short-termism and to instead focus on long-term strategy and sustainability. (4)

Following the stock market crash of 1929, investors not only lost then-investments, but also their confidence in the market. (5) The Securities Exchange Act of 1934, (6) along with other measures taken by Congress, "was designed to restore investor confidence in our capital markets by providing investors and the markets with more reliable information and clear rules of honest dealing." (7) Almost forty years later, in 1970, federal securities laws began requiring public companies to issue quarterly reports. (8) The purpose of creating Form 10-Q, the form companies use to file quarterly reports, was primarily to provide investors with summarized financial information within forty-five days after the end of each of the first three fiscal quarters. (9) Such information would ensure investors received adequate financial information to make informed decisions regarding their investments.

During the late 1990s, many companies began a new practice of issuing earnings guidance. (10) Earnings guidance is broadly defined as comments and financial projections management makes regarding its company's future earnings. (11) Companies that issue earnings guidance usually provide the guidance in the form of quarterly or annual earnings per share (EPS) guidance. (12) This guidance can be provided as an exact estimate or a range of what the company is forecasting its EPS to be for the upcoming quarter. (13) This shift toward companies providing additional forward-looking guidance on what management expects next quarter's earnings to be became an instrumental approach resulting from the Private Securities Litigation Reform Act of 1995 (PSLA). (14) The PSLA included many protections to shield companies from liability for statements regarding their projected performance. (15)

In addition to management providing its own EPS guidance, analysts working outside the company also calculate and project next quarter's earnings forecasts. (16) Both management's and analysts' calculations of EPS guidance provide investors with hard-and-fast projections used to evaluate the company. It has become a common perception that if a company meets or exceeds its EPS guidance, the company is in good financial health, and if the company misses its guidance, the company must be struggling. Regardless of whether a company misses its own EPS guidance or misses the consensus estimate provided by analysts, a company will likely face a sharp decline in its stock price. Therefore, management is greatly incentivized to prevent missing the guidance. Indeed, a number of studies have shown that it is common for companies to defer long-term investments to meet short-term earnings targets. (17) One of the earliest studies found that eighty percent of CFOs would reduce discretionary spending on value-creating activities, such as marketing and research and development, in order to meet the company's short-term earnings targets. (18)

The desire to meet EPS guidance forces management to think solely in terms of short-term Financials and has led many companies to avoid or minimize thinking about long-term strategy. This focus on short-termism is harming investors--likely without many knowing it--as they are made to believe that if a company meets its short-term earnings, it is in their best interest. Short-termism refers to the practice of corporate decisionmaking based on short-term earnings expectations rather than focusing on long-term value creation. (19) When management provides quarterly EPS guidance, the company overemphasizes the need to meet short-term Financial goals and minimizes the need for long-term growth, resulting in diminished returns for the company's long-term investors. (20) The current practice of issuing quarterly earnings guidance has caused management to focus solely on short-term incentives rather than to pursue long-term growth investments. Moreover, it is not the frequency of reporting that is causing short-termism, but rather management's behavior resulting from the company's issuance of EPS guidance. This Note argues that there should not be a reduction in reporting requirements, as the frequency and content of Form 10-Q disclosures are not the source of short-termism. However, short-termism does result from the voluntary practice of companies issuing earnings guidance to investors--which wrongly incentivizes myopic management decisions--and such practice should be halted to encourage long-term growth and investment. Investors need timely and accurate information in order to make informed investment decisions, but they do not need forward-looking quarterly EPS guidance to make those decisions.

On December 18, 2018, the SEC requested comments on how to maintain or enhance investor protections provided by the current periodic reporting system while reducing potential burdens on reporting companies. (21) The request also sought comments relating to potential changes to the frequency of periodic reporting, as well as on whether the current system of periodic reports and earnings guidance foster an excessive emphasis on short-term considerations. (22) The comment period ended March 21, 2019, and the SEC must now determine how to proceed and what action may be appropriate regarding quarterly reports and EPS guidance. (23)

This Note focuses on one factor--EPS guidance--that contributes to myopic behavior and short-termism within public companies. Part I discusses the history of the shareholder primacy norm and the need for management to act in the best interest of its shareholders. Additionally, this Part provides background on EPS guidance and the notion of short-termism. Part II lays out a framework for quarterly reporting and argues that the current disclosure requirements should remain intact. This Part addresses the importance of frequency in quarterly reporting and provides two examples--the United Kingdom and Regulation A--of practices with longer reporting frequencies that demonstrate longer interim periods on their own do not deter short-termism. Further, Part II discusses the content of the required disclosures, including the disclosure of forward-looking information, as well as possible implications, including a reduction in transparency and potential for insider trading, that may occur if the SEC decreases the reporting requirements. Part III examines quarterly forward-looking earnings guidance and argues that when management provides EPS guidance, it incentivizes short-term behavior that is suboptimal for investors. Part III additionally discusses in detail earnings reports and EPS guidance, including a discussion on analysts' role in calculating EPS and the ability for continued calculation. This Part is designed to demonstrate that it is how management reacts to EPS guidance that leads to short-termism. Further, this Part provides two examples of companies that provide annual EPS guidance and quarterly EPS guidance illustrating how, regardless of frequency, management still behaves myopically. Part IV explores specific ways management manipulates and deters long-term growth to ensure the company meets or exceeds their EPS guidance. This Part seeks to demonstrate that management's myopic behavior occurs as a result of issuing EPS guidance. Part V argues that by preventing companies from issuing EPS guidance the company will be better equipped to focus on long-term growth initiatives, which are in the shareholders' best interests. This Note concludes by suggesting companies will better align their interests with investors and provide management with the flexibility needed to pursue long-term goals by replacing EPS guidance with long-term roadmaps, overall reducing short-termism.

1. BACKGROUND

   Officers within a publicly held corporation arc faced with many daily challenges that occupy both their time and energy. It is a rare occasion when management is forced to rethink whether they are truly acting in the best interests of its shareholders--the owners of the corporation. This Part seeks to provide context to this Note by discussing the obligation management of publicly held companies has to act in the best interests of the company's shareholders. Additionally, this Part will provide a brief overview of EPS guidance and the short-termism that results.

   1. Shareholder Primary Norm

      Shareholder primacy has long dominated corporate governance literature as a fundamental norm that corporate managers should act to maximize shareholder wealth. (24) In 1919, the Supreme Court of Michigan decided Dodge v. Ford Motor Company--a case commonly cited in support of shareholder primacy (25)--where it upheld the shareholder primacy norm stating that "[a] business corporation is organized and carried on primarily for the profit of the stockholders." (26) The court established that "it is not within the lawful powers of a board of directors to shape and conduct the affairs of a corporation for the merely incidental benefit of shareholders and for the primary purpose of benefiting others." (27) Thus, the court clarified that managers must not only act in the best...