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Listing & Public Offers


Prospectus Regulation and the Credit Crunch

Contributed by: Alasdair Steele, Nabarro LLP The process by which companies can issue or sell shares or other securities to investors has long been regulated in the UK and EU. As a general rule, whenever shares or other securities are offered "to the public" or a company listed on an EU regulated market issues a certain number of new securities of a listed class, a prospectus, containing prescribed information, is required to be published. Immediately before and during the credit crunch, a number of companies prepared prospectuses which contained statements which ultimately turned out to be wrong in view of subsequent events. This article considers the effectiveness of prospectus regulation in the UK and EU generally, in light of the events that have occurred over the past 18 months. Background In 2005, the UK implemented Directive 2003/71/EC (Prospectus Directive) through amendments to the Financial Services and Markets Act 2000 (FSMA) and by replacing the previous listing rules with a combination of the Prospectus Rules (PR), Listing Rules (LR) and Disclosure & Transparency Rules (DTR) which were issued by the Financial Services Authority (FSA). The Prospectus Directive applies across all EU Member States and has been largely repeated in the relevant UK legislation. As is often the case with UK financial services legislation, the UK has in some instances adopted more stringent requirements than are strictly required by the Prospectus Directive. The Prospectus Directive, FSMA and PR dictate when a prospectus is required to be published, who is required to approve it, how it must be published and what it must contain: When Is a Prospectus Required? A prospectus is generally required whenever a company or other entity (the issuer) wants to issue or sell securities to the public or for securities to be admitted to trading an EU regulated market (such as the Official List of the FSA and London Stock Exchange's main market for listed securities) (section 85, FSMA). There are a number of exemptions which may be available (section 86(1), FSMA), the most common ones being: · Where the securities are offered to less than 100 people in each EEA state (note that the test applies to the number of people to whom the securities are offered, not to the number who actually take up the securities); Where the securities are only offered to "qualified investors" (generally speaking, regulated financial services entities and other sophisticated investors); and Where the securities have a minimum price or denomination of 50,000 (usually relied on in bond or other debt issuances). Who Is Required to Approve a Prospectus? Each EU Member State must designate a competent authority to approve prospectuses under the Prospectus Directive. In the UK, the FSA is the designated competent authority. How Must a Prospectus Be Published? According to Article 14 Prospectus Directive and PR 3.2, the prospectus must be: · Made available to the public, free of charge, at specified locations, including the registered office of the issuer or the offices of the regulated market where the securities will be traded;

· ·

· ·

Inserted in a newspaper with wide circulation in the EEA State(s) to or from which the securities are being offered or issued; or Published on the issuer's website. What Must a Prospectus Contain?

A prospectus is made up of three components (the requirements are set out in section 87A FSMA, PR 2 and Articles 5, 25 and 26 Prospectus Directive): · · · A summary; A registration document containing information about the issuer; and A securities note containing information about the securities being offered or admitted to trading.

In the majority of cases, these three parts will be bound into one document though they may be prepared as three separate, physical documents. Where they are combined in one document, the summary must always appear at the beginning as a separate section though the remaining content requirements for the registration document and securities note may be combined into one section. Articles 3 to 23 and Annexes I to XVIII Prospectus Directive specify the minimum information to be included in the registration document and securities note with different requirements for different types of securities (the share disclosure requirements being considerably more than the disclosure requirements for high denomination (50,000) debt securities, for example). However, there is an overriding, general requirement that the prospectus contain all information necessary to enable investors to make an informed assessment of a) the assets and liabilities, financial position, profits and losses, and prospects of the issuer and b) the rights attaching to the securities to which the prospectus relates (section 87A(2) FSMA). Prospectus Preparation The process of preparing a prospectus involves a number of advisers as well as the issuer itself. In the UK, the practice is for the corporate finance adviser (usually also working as the issuer's sponsor for the purposes of the UK's LR) to project-manage the preparation of the prospectus, delegating or taking responsibility for the preparation of the different parts. Typically, the corporate finance adviser and the issuer will prepare the information on the issuer's business, the issuer and its accountants, information on the issuer's financial history and the issuer's lawyers, information on the issuer's constitution, share capital, the terms of the securities being issued, material agreements and other legal matters. As the directors of the issuer take personal responsibility for the accuracy of the information contained in the prospectus, various processes are undertaken to ensure that the information contained in the prospectus is both accurate and not misleading by omitting relevant information. In the UK, this is done by preparing verification notes, where the issuer's lawyers will prepare a file which verifies the accuracy of every statement in the prospectus by reference to either underlying supporting documentation (such as a copy of an agreement or a report) or the rationale for a certain opinion being reached. In other jurisdictions, the issuer's lawyers may take more responsibility for preparing the prospectus and then provide an opinion to the issuer as to its accuracy (similar to a 10b5 opinion in U.S. securities offerings). In addition, the issuer would also expect to receive a number of comfort letters from its advisers confirming that so far as that adviser is aware, the prospectus is correct and does not omit any important information. For some of the more important or complicated information contained in a prospectus, a separate report may be required. For example, every prospectus relating to shares must contain a description of any significant change in the financial or trading position of the issuer since the date at which the last audited or interim financial statements were prepared (para. 20.9, Annex I, Prospectus Directive). As there will not be any audited information to support the updating information included in the prospectus (or, if there has not been any significant change, the statement to that effect), the issuer's

accountants will typically be engaged to report on the issuer's financial performance during that period by reviewing its internal records (though this will not be an audit standard review). Forward-looking Statements in Prospectuses Although much of the information contained in a prospectus relates to existing matters and circumstances, there are a number of areas where some form of forward-looking statement is required. These can range from fairly generic trend statements about the state of a particular market and future risks to the issuer's business if generic events were to occur (e.g., if the company required further funding, that may not be available and therefore this could have a material effect on its business). These statements are relatively simple to justify and are often supported by independent industry or market reports or publications by competitor businesses. The directors of the issuer will need to make an informed decision based on their knowledge of the market as to what is material for inclusion and, ultimately need to decide what is not material and therefore does not merit inclusion. Regulators are particularly keen to ensure that only material facts and matters are included and not every possible theoretical risk, no matter how small. The inclusion of a profit forecast (however worded) in a prospectus is generally optional. The exception would be if the issuer has already published or made public a profit forecast which is still relevant, in which case the general disclosure requirement (see above) would almost certainly require its inclusion. Where a profit forecast is included, the issuer's accountants must include a report in the prospectus to the effect that it has been properly compiled and has been compiled on a basis consistent with the issuer's accounting policies (para. 13, Annex I, Prospectus Directive). As these reports are often complex, time-consuming and expensive to produce, issuers generally prefer to avoid including profit forecasts in prospectuses. The statement which probably causes most concern in terms of forward-looking statements in a prospectus is the statement that, in the opinion of the issuer, its working capital is sufficient for its present requirements (para. 3.1, Annex III, Prospectus Directive). For these purposes, "present requirements" is regarded as being at least 12 months from the date of publication of the prospectus, i in line with guidance issued by the Committee of European Securities Regulators (CESR). This requirement has existed in the UK for many years and the practice has developed of the issuer's accountants reviewing and reporting on the issuer's conclusion that it has sufficient working capital. The review period reported on will usually extend from 18 to 24 months after the expected publication date for the prospectus and involves the accountant reviewing the working capital projections prepared by the issuer and then stress-testing them against a number of sensitivities. These sensitivities will be determined based on the risks to the business model which are reasonably foreseen by the issuer's directors, the reviewing accountants and the issuer's corporate finance adviser, drawing on their general market and industry expertise as well as specific knowledge of the issuer. Prospectus Standards The basic standard to which a prospectus must be prepared is set out in the responsibility statement which is given on a personal basis by the issuer's directors ("having taken all reasonable care to ensure that such is the case, the information contained in the [prospectus] is, to the best of their knowledge, in accordance with the facts and contains no omission likely to affect its import." See para. 1.2, Annex I, Prospectus Directive. The standard is therefore that those responsible must take "all reasonable care" in preparing the prospectus and that its contents are "to the best of their knowledge" accurate and not misleading. This is reflected in the working capital statement being given "in the opinion of the issuer." The important point to note is that nothing in the prospectus is a guarantee that any future state of events will or will not exist, only that based on current opinions and understandings regarding the future, the position stated in the prospectus is a reasonable one to adopt.

The Impact of the Credit Crunch Between April and June 2008, a number of banks, including Royal Bank of Scotland, HBOS and UBS, raised capital through equity issues, producing prospectuses in the process. Each of these institutions was able to give a clean working capital statement; namely that, in its opinion, it had sufficient working capital for at least the following subsequent 12 months. In addition, each updated its financial position since its last audited financial statements (e.g., Royal Bank of Scotland wrote down its investments by £5.9 billion in the period April to June 2008). History however reflects an altogether different picture. Following the collapse of Lehman Brothers in September 2008, many of these banks have been supported by significant State aid. For example the UK government holds somewhere in the region of 70 percent of Royal Bank of Scotland and Lloyds Bank, having first "rescued" and becoming a significant investor in HBOS. Following the events that transpired, a number of people ranging from small shareholders to politicians have asked the question as to why the banks are not being sued for the statements contained in those prospectuses, which were issued within a few months of the near collapse of the issuing bank. Interestingly, very few calls for action have come from institutional and sophisticated investors, who were the ones who invested significantly in the summer 2008 fundraisings. Where Next for Prospectuses? The fact that no action has been taken and been successful against any of the issuers of prospectuses based on the credit crunch suggests, to a large extent, that the standard of disclosure in prospectuses is already at a sufficiently high level. Prospectus regulation has always operated on the principle of ensuring that investors receive all the information they require to make a proper investment decision ­ it is a disclosure-based process. There is a risk that by increasing the disclosure requirements to reflect every possible risk and consequence, prospectus preparation becomes a box-ticking process, where issuers simply include every possible fact, circumstance and risk which may affect their business. Whilst some may argue that this would increase transparency for investors, in practice it would be more likely to obscure the true position of a business as it would not be clear what is and is not a real risk to the business. For example, would it become necessary for every issuer to state that if its bank failed (something unthinkable two years ago) it may have an adverse effect on its business? Even following the credit crunch, regulators are keen to ensure that prospectuses contain qualitative discussions of the issuer's business and the risks facing it, not a mass of irrelevant information. In addition, issuers generally engage highly qualified professional advisers to help them prepare the prospectus, usually with extensive knowledge and experience of the securities markets and laws generally ­ HBOS' 2008 rights issue was led by two global investment banks, two "Magic Circle" law firms and one of the "Big Four" firms of accountants, all with significant equity capital markets expertise. Given the quality of the advice which a well-advised issuer is receiving, it is difficult to see how an investor could realistically argue that the directors of that issuer did not take "all reasonable care" in preparing the prospectus and that its contents are not, "to the best of their knowledge," accurate and not misleading. It is unlikely therefore that we will see significant changes to the prospectus disclosure requirements. As has been the case since prospectus disclosure standards were introduced many years ago, disclosures have evolved to reflect market conditions and practices. For example, as a result of the credit crunch, issuers and their advisers will now at least consider whether a failure of their main bank is both a reasonable possibility and a material risk to the issuer's business. Not every issuer however will conclude that it is a material (and realistic) risk which would require disclosure. For issuers and investors, the rules on preparing prospectuses are unlikely to change significantly ­ they will still require to be prepared to the highest standards (arguably beyond the required legal standard). Issuers will look critically at the standard and quality of their advisers to ensure that they are

receiving the best and most up to date advice. What may become more common is investors taking into account the quality of the issuer's advisers as part of their investment decision. Alasdair Steele is a Corporate Partner at Nabarro LLP, specialising in UK and cross-border corporate finance, including primary and secondary equity issues, public and private M&A and strategic investments, as well as regularly advising on consortia and corporate joint venture arrangements. He regularly advises quoted companies and financial intermediaries on the UKLA Listing Rules and Disclosure Rules, the Prospectus Rules, the AIM Rules, the Takeover Code and general company law. Telephone: +44 20 7524 6422; Email: [email protected]

© Bloomberg Finance L.P. 2009. permission

Originally published by Bloomberg Finance L.P. Reprinted by


See para. 108 of CESR's recommendations for the consistent implementation of the European Commission's Regulation 809/2004 on prospectuses, CESR/05-054b.


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