December 3, 2023

Deal Professor: In Netflix Case, a Chance to Re-examine Old Rules

Deal ProfessorHarry Campbell

Netflix is in the Securities and Exchange Commission’s sights over a post on Facebook by Reed Hastings, its chief executive, saying that the video streaming company’s monthly viewing had reached a billion hours. Yet, the case is more convincing as an illustration of how the regulator clings to outdated notions of how markets work.

In July, Mr. Hastings posted three lines stating that “Netflix monthly viewing exceeded 1 billion hours for the first time ever in June.”

While his comments may have seemed as innocuous as yet another Facebook post about cats, for the S.E.C., it was something more sinister, a violation of Regulation FD.

Regulation FD was the brainchild of Arthur Levitt, a former chairman of the commission. During Mr. Levitt’s time, companies would often disclose earnings estimates and other important information not to the markets but to select analysts. Companies did so to preserve confidentiality and drip out earnings information gently to the markets, and in that way avoid the volatility associated with a single announcement.

For Mr. Levitt, this was heresy. He believed not only in disclosure, but in the principle that all investors should have equal access to company information. Regulation FD was the answer.

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In general, Regulation FD says that when a public company gives material nonpublic information to anyone, the company must also publicly disclose that information to all investors. Regulation FD in that way prevents selective leaks and, according to the S.E.C., promotes “full and fair disclosure.”

It seems so simple. How can more disclosure be bad? But both public companies and investment banks argued that the rule would actually reduce the flow information, as companies, now forbidden from disclosing only to analysts, would simply choose not to release the information. And because analysts would no longer have that advantage in knowledge, their value would be harder to justify, resulting in fewer analysts. Stockholders would be worse off as less information was in the market.

The S.E.C. disputed these arguments, and Regulation FD went into effect over a decade ago.

Subsequent studies of Regulation FD’s effects have shown that the critics may have been right. One of the most-cited studies found that analyst coverage of smaller companies dropped. And since there was now less information in the market about these smaller companies, investors subsequently demanded a bigger premium to invest, increasing financing costs. Another study found that the introduction of Regulation FD increased market volatility because information was no longer informally spread. In fairness, some studies found different results, but the bulk of findings are that Regulation FD is at best unhelpful.

Despite these studies and companies’ complaints about the costs of compliance, the S.E.C. has stuck to the rule. Until the Netflix case, however, the agency appeared to try to keep the peace by seeking redress in only the most egregious cases.

In all, there have been only about a dozen Regulation FD cases since its adoption, including one against Office Depot in 2010, for which it was fined $1 million for hinting its earnings estimates to analysts. But while enforcement actions have been rare, it has required that companies fundamentally change the way they disclose information.

Then Netflix came along.

The S.E.C.’s case appears to be rest on much weaker grounds than previous ones involving Regulation FD. To make a Regulation FD claim, the agency must show the information was released privately and that it was material. But neither element seems certain here.

Mr. Hastings’s announcement that the milestone of one billion hours was achieved seems more like a public relations stunt than a disclosure of material information. And Netflix had previously said that it was close to this milestone, so followers knew it was coming.

But while it seems like this information was a nonevent, this post occurred as Netflix’s stock was beginning to rise, and by two trading days later, it had jumped almost 20 percent. While some may view this as proof of the post’s materiality, it is hard to read too much; Netflix shares can be volatile, and a Citigroup analysts’ report released during that time could have also moved the stock.

Then there is the issue of whether this was privately disclosed information.

Some have seized on this requirement to claim that the S.E.C. is in essence saying that Facebook is not a “public” Web site. This is laughable; after all, Mr. Hastings is popular — he has more than 200,000 subscribers to his Facebook account. It is certain that more people read this comment on Facebook than if it had been in an S.E.C. filing.

But the S.E.C.’s argument is likely to be more technical than saying Facebook is private. In a 2008 release on Web site disclosure, the S.E.C. asserted that a Web site or a blog could be public for Regulation FD purposes but only if it was a “recognized channel of distribution of information. ”

In other words, a public disclosure is not about being public but about being made where investors knew the company regularly released investor information.

So the S.E.C. is likely to sidestep the issue of Facebook’s “public” nature and simply argue that Netflix never alerted investors that Facebook was the place to find Netflix’s investor information. Mr. Hastings appeared to concede this, and in a Facebook post last week, he argued that while Facebook was “very public,” it was not where the company regularly released information. If this dispute goes forward, expect the parties to spend thousands of hours arguing about whether the post contained material information rather than whether Facebook is public.

But it all seems so silly and technical and shows the S.E.C.’s fetish of trying to control company disclosure to the nth degree. It’s easy to criticize the agency for not understanding social media, but I would argue that in trying to bring a rare Regulation FD enforcement action, it truly missed an opportunity. Rather than focus on technicalities that few people understand, it could have used this case to examine what it means to be public and how social media results in more, not less, disclosure.

If the idea behind Regulation FD is to encourage disclosure, then allowing executives to comment freely on Facebook and Twitter, recognizing them as a public space akin to a news release, is almost certain to result in more disclosure, not less, and reach many more people than an S.E.C. filing would. The agency’s position will only force executives to check with lawyers and avoid social media, chilling disclosure.

And this leads to the bigger issue. Regulation FD was always about principles of fairness that belied the economics of the rule. If the S.E.C. really wanted to encourage disclosure, then it might want to take a step back and consider whether after a decade, Regulation FD is worth all the costs. Perhaps shareholders would even prefer more disclosure on Facebook and fewer regulatory filings. I suspect they might, if it meant more information and generally higher share prices.

In any event, this case still has a way to go. Netflix disclosed only the receipt of a Wells notice, which meant the S.E.C. staff was recommending to the commissioners that an enforcement action be brought. It is now up to the commissioners to decide. Given the issues with this case, they may decide it isn’t worth it. It would still leave Netflix with substantial legal fees, but perhaps save the agency from another embarrassing defeat.

But while that may end the matter, it shouldn’t. The regulator could use the Netflix case to rethink its disclosure policies in light of not only the rise of social media but how the market actually works. After all, even the S.E.C. has a Twitter account these days.

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Media Decoder Blog: The Quick Demise of Qwikster

7:19 p.m. | Updated

The New Coke experiment lasted less than three months. Qwikster did not even make it make it out of the bottle.

In a swift reversal, Netflix said Monday that it had decided to keep its DVD-by-mail and online streaming services together under one name and one Web site, abandoning the breakup it had announced three weeks earlier.

The company, which will keep a recent 60 percent price increase in place, declared that it had moved too fast when it tried to spin-off the old-fashioned DVD service into a new company called Qwikster, angering many subscribers. “We underestimated the appeal of the single Web site and a single service,” Steve Swasey, a Netflix spokesman, said in an interview, before quickly adding: “We greatly underestimated it.”

Some reacted on Monday by teasing Netflix and its chief executive, Reed Hastings, for being topsy-turvy, but many praised the company for, as Ingrid Chung of Goldman Sachs put it in an analysts’ note, “listening to its customers (finally) and working to fix its relationship” with them. On Monday morning, Netflix e-mailed people who recently canceled their accounts to tell them about the reversal.

Maybe, some said, after a season of spectacular missteps, Netflix has finally figured out how to communicate effectively about its future. Or maybe now the company is just saying what its subscribers want to hear — that those who want both online streams and DVDs won’t have to manage two accounts and pay two bills each month, after all.

Netflix stock, which has lost almost two-thirds of its value in the last three months, rose on the news on Monday morning, but declined in the afternoon, closing down 4.8 percent at $111.62.

Richard Greenfield, a media analyst for BTIG Capital, said in an e-mail message that Monday’s announcement was the “necessary reversal of a bad decision.”

“The key remaining question,” he said, “is ‘Why did they make the Qwikster decision in the first place?’ ”

Netflix said it never actually separated the services or started Qwikster. But the planned breakup was rooted in Mr. Hastings’ belief that DVDs and online streams have different cost structures and different consumer demographics.

In July, to address the structural underpinnings of the business, he announced that the company would start charging $8 a month for both its streaming service and its DVD service, a total of $16 a month for the combination. Previously, DVDs were a $2 add-on to the $8 streaming service. Of course, subscribers who only wanted one service or the other — most new subscribers only want the online streams — saw no price hike, but that fact was drowned out by the outcry.

Netflix expected some of its 25 million subscribers to cancel in the wake of the price change, but the cancellation rate exceeded expectations. The company said on Sept. 15 that it expected to report a quarterly decline of about one million in the third quarter, which ended on Sept. 30.

Still, it pressed forward, announcing the breakup plan the night of Sept. 17. “Companies rarely die from moving too fast, and they frequently die from moving too slowly,” Mr. Hastings wrote in a blog post that night. His implication then was that Netflix had to act aggressively to expand its fast-growing streaming service by severing its older, slower DVD-by-mail arm.

In a sentence that now seems like a bit of foreshadowing, Mr. Hastings also wrote, “It is possible we are moving too fast — it is hard to say.”

Tens of thousands spoke out against the plan on Netflix’s Web site and others, and Netflix stock slid sharply. Three days after the announcement, Mr. Hastings wrote in a Facebook status update, “In Wyoming with 10 investors at a ranch/retreat. I think I might need a food taster. I can hardly blame them.”

Then came the flip-flop, announced Monday. Mr. Hastings declined interview requests, but he said in a statement that “there is a difference between moving quickly — which Netflix has done very well for years — and moving too fast, which is what we did in this case.”

Mr. Swasey declined to comment on any involvement by the Netflix board in the decision to keep the two services together.

Some of the details of the reversal are still being deduced. Netflix’s plan for Qwikster to rent video games may or may not move forward; Mr. Swasey said that it was “to be determined.”

On Netflix’s blog on Monday, some subscribers called for Mr. Hastings’ ouster, but others called him courageous for owning up to his mistakes. Wrote Sean Michael McCord, a systems engineer, “I was ready to call the whole thing ‘Quitster’ for me, but now I may just stick around for awhile longer.”

Some analysts suspect that Netflix’s third-quarter losses exceeded the company’s already-lowered expectations, but the company declined to comment Monday. It will report earnings and subscriber figures on Oct. 24.

Despite the turnaround, online streaming remains the core business for Netflix going forward. A lack of compelling films and TV shows on the streaming service is a frequent lament, and it is likely to grow louder next winter: that’s when Sony and Disney films are expected to be removed, the result of a failed negotiation with Starz.

But Netflix is trying to stock up on more streaming content; last month it announced a deal with DreamWorks Animation to stream that studio’s films starting in 2013, and last week it announced a deal with AMC Networks to stream old episodes of TV shows like The company also remains interested in paying for the production of new TV shows. Earlier this year it ordered its first original drama, which is expected to have its premiere in late 2012.

It is now in talks to distribute new episodes of two canceled TV series, formerly of the Fox network, and “Reno 911,” formerly of Comedy Central. The past seasons of both shows can be streamed via Netflix — and can be rented on DVD, too.

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Netflix Sees Angry Clients Cutting Profit

Just two weeks after announcing a price adjustment that angered many customers, Netflix came out Monday with a weaker-than-anticipated earnings outlook.

While the entertainment distributor reported a 52 percent rise in second-quarter revenue, it also reaffirmed a temporary slowdown in subscriber growth and said that its third-quarter revenue would be hampered by reactions to the price change. Netflix stock, which peaked above $300 earlier this month, dropped 10 percent in after-hours trading Monday, after closing at $281.53 earlier in the day.

Netflix posted second-quarter revenue of $789 million, up 52 percent from the same quarter last year. It said its profit for the quarter was $68 million, up 55 percent.

For the third quarter, Netflix said it expected revenue to be $799.5 million to $828.5 million, which was lower than previous projections on Wall Street.

The price adjustment, announced July 12, takes Netflix’s DVD-by-mail service, which was a $2 add-on to its $8-a-month online streaming service, and makes it a separate $8 package. For Netflix, the online streaming service, which remains $8, is growing much faster than DVD-by-mail. But some customers were outraged by what was effectively a 60 percent price increase for the combined service.

The price change “doesn’t take effect until the very end of the third quarter,” the Netflix chief executive, Reed Hastings, said in an interview Monday. “So we have to face those subscribers who are upset by the increase this quarter.” While he said he expected only “a few” to cancel or downgrade service, “that means less revenue than we otherwise would have had.”

The price change will benefit Netflix in the fourth quarter and beyond, he said, expressing no misgivings about the change in strategy. He said that Netflix intended to spend the increased revenue on its online streaming service, keeping its domestic operating margin for the year around its target of 14 percent. In the second quarter, its domestic margin was 16.3 percent.

“As our subscriber base continues to grow, we’re able to spend more on improving that service, both on the R. D. side and on the content availability side,” Mr. Hastings said, using shorthand for research and development.

Keeping online streaming customers satisfied is a critical task for Netflix, which is vulnerable to the licensing decisions of Hollywood studios. Netflix has indicated that it is confident that it can pay what is necessary to license enough content from studios.

Mr. Hastings declined to comment on a Bloomberg News report that it was in talks to license the exclusive streaming rights to DreamWorks Animation films, replacing DreamWorks’ pact with HBO. An executive with knowledge of the deal, who spoke on condition of anonymity because no announcement had been made, said that HBO had offered DreamWorks an early departure from its contract with the premium cable company.

Netflix said that it remained in talks with its single biggest supplier of films, Starz. That agreement comes up for renewal in the first quarter of 2012.

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