On 30 March 2011, the Australian Securities and Investments Commission (ASIC) updated its Regulatory Guides on expert reports, namely:
- Regulatory Guide 111 (RG 111) – Content of expert reports (click here for a copy)
Provides guidance on the content of expert reports and how experts can help security holders make informed decisions about transactions.
- Regulatory Guide 112 (RG 112) – Independence of experts (click here for a copy)
Explains how ASIC interprets the requirement that an expert is independent of the commissioning party and others.
ASIC has stated that the aim of the updated guides is to enhance "the reliability and quality of expert reports that are commissioned to assist security holders and others to make major decisions, including on takeover bids, schemes of arrangement and related party transactions." The changes appear to be partly driven by some of the corporate collapses of the global financial crisis (GFC), and a review of certain transactions which were implemented before the GFC by companies which subsequently collapsed.
Key changes to RG 111 - Content of expert reports
The main principles in RG 111 have not changed. These include the meanings of "fair" and "reasonable", the test for a "best interests of shareholders" report, the range of methodologies which can be used, encouragement to use concise reports with full reports made available separately, and appropriate use of disclaimers. The principal changes to RG 111 are described below.
Related party transactions are now covered
RG 111 now applies to expert reports prepared for related party transactions under Chapter 2E of the Corporations Act or ASX Listing Rule 10. This was an expected development given media and regulatory scrutiny of pre-GFC related party transactions and ASIC's recent revision of Regulatory Guide 76 (Related Party Transactions). ASIC requires the expert to consider the overall effect of a related party transaction, rather than focussing on individual or some component parts of a transaction.
Assessing whether a related party transaction is "fair" and "reasonable"
It is clear from RG 111 that ASIC expects significantly more than a comparison of the advantages and disadvantages of a related party transaction. Experts are required to express separate opinions on whether the transaction is "fair" and whether it is "reasonable" from the perspective of non-associated members, in the same way as for a takeover bid.
What is "fair" and "reasonable" for a distressed target?
The fair value of the target's securities in a scheme of arrangement or takeover bid should be determined on the basis of a knowledgeable and willing but not anxious seller who is able to consider alternative options to the scheme or bid (such as an orderly asset sale). Although a scheme or takeover bid for a financially distressed company is unlikely to be "fair", as a bidder will set its offer price on the basis that the target is distressed, RG 111 confirms that such an offer may still be reasonable if the alternatives available to the target (often winding up or a fire sale) are likely to be less attractive to the target than the proposed scheme or bid.
Reasonableness of forward-looking information
RG 111 extends the caution on including prospective financial information in expert reports to "any other statements or assumptions about future matters". Such statements will run the risk of being misleading or deceptive, unless they are made on reasonable grounds. Where forward-looking information is included, certain information must be made available to readers to assess the reasonableness of the methodology and assumptions used.
RG 111 recognises that an expert may use a discounted cash flow methodology when valuing a start up project where there is a long lead time until cash will be generated, provided the expert has reasonable grounds for using the forward-looking information in it. This will often be a challenge for the expert to satisfy, which may drive the expert to use other methodologies, particularly for its primary valuation methodology.
Maintaining working papers
RG 111 emphasises that experts should be able to readily draw on their working papers to demonstrate that their opinions are reasonably based. It requires experts to maintain adequate records of the work undertaken to prepare the expert report. Keeping such working papers will also be necessary to demonstrate independence in the way the engagement has been managed, for the purposes of RG 112.
This change to RG 111 may indicate that experts will increasingly be required to provide information to ASIC where ASIC is conducting a review or an investigation of a transaction which has been the subject of an expert's report.
Key changes to RG 112 - Independence of experts
RG 112 now contains additional requirements directed at parties commissioning and appointing experts and guidance for experts on when they should decline an engagement and how they should manage the engagement to maintain their independence. These additional requirements are described below.
Commissioning an expert
Before engaging an expert, a commissioning party must be satisfied that the expert is independent and has sufficient expertise and resources to provide a thorough report, having regard to a list of factors ASIC considers relevant. In this context, the short time frame often available for preparation of an expert's report will be relevant.
A commissioning party must also ensure that any pre-engagement discussions with the expert do not compromise the expert's independence. This could occur where the expert gives its views on the merits of the transaction, the deal value or the proposed methodologies as that may allow a commissioning party to pick the expert which it believes will give the desired outcome.
RG 112 recommends that commissioning parties ensure that the method by which an expert is appointed is consistent with concepts of independence and perceived independence of the expert. For example, it may be appropriate for a non-executive director to oversee the appointment process, where management has a strong interest in the outcome of the transaction. The non-executive director may also need to oversee the timely provision of material information to the expert.
Pre-releasing conclusions of expert reports
RG 112 discourages commissioning parties from releasing any conclusions contained in an expert report in advance of the final report as it may cause confusion or uncertainty. It is common practice for an entire report to be released, rather than just the conclusions, because of the potential for the conclusions, taken alone, to mislead rather than inform readers. However, leaks to the market or press speculation about the conclusions may require a company to make some announcement to the ASX to comply with its continuous disclosure obligations. To avoid this problem, commissioning parties should take steps to ensure confidentiality is maintained over the conclusions until the whole report is available for release.
Experts - time to review your processes
The updated Regulatory Guides will impact the process of engaging experts and preparing an independent expert's report for a transaction as they impose additional requirements on both experts and commissioning parties. Experts should review their current processes relating to acceptance of engagements, conflicts management, valuation processes and record keeping, against the Regulatory Guides' recommendations. This will minimise the risk of a report being found to be misleading or deceptive and the reputation damage that would flow from such a finding, and ensure the expert is able to answer any queries from ASIC arising from its reports.