In recent days the FSA has issued two substantial fines against two listed companies for failing to disclose inside information to the market as soon as possible. These cases are a timely reminder to listed companies that disclosure of inside information should be made promptly to the market, and that negative news cannot be withheld from disclosure on the basis that positive matters could offset it.
- Issuers cannot withhold disclosure of negative news on the basis that positive matters are likely to offset it
- Customer confidentiality agreements with third parties are no justification for withholding price-sensitive information
- Concerns that the market will overreact to bad news is not relevant in deciding whether to disclose negative information Business impact on listed companies
- Ensure internal processes are in place to identify, in a timely fashion, the need to consider whether information is inside information
- Act with urgency when considering whether inside information must be announced – a delay of only a few days could be detrimental
- Seek professional advice on disclosure obligations – advice from investor relations advisers is not appropriate
- Disclose both negative and positive information and allow the market to determine whether they cancel each other out
In June 2008, we reported that the FSA had taken its first enforcement action in respect of failing to disclose information to the market in a timely manner, since the Disclosure Rules and Listing Principles came into force in July 2005. The FSA has recently taken action for the same infraction in two similar cases. This briefing considers these cases and the lessons that can be gleaned.
On 10 March 2008 Wolfson Microelectronics plc was advised by a major customer, which generated approximately 18% of Wolfson’s revenue, that Wolfson was not required to supply parts for future editions of two of the customer's products. This represented a loss of $20m to Wolfson: 8% of Wolfson’s forecast revenue for the year. At the same meeting, Wolfson was advised of positive news, which was to expect increased demand for Wolfson's supply of parts for another of the customer's products, and that Wolfson’s overall revenues would increase. After increasing the forecast revenue attributable to the new product, and revenues expected from other clients, Wolfson calculated that it would still meet market revenue expectations for 2008.
Wolfson's initial reaction was that a public announcement should be made "fairly soon". However, Wolfson's investor relations advisors advised that an announcement was not necessary, because the revised 2008 revenue forecast remained close to the average market expectations and there would be no material change to the source of the revenue. This advice was incorrect. The following week, Wolfson sought the opinion of its legal advisers. The following day it consulted its corporate finance advisers. Both advised that a public announcement should be made and on the following day, 27 March 2008, a public announcement was made. As a result, Wolfson waited 16 days (10 trading days) after it became aware of the news, before the announcement was made. On the day the announcement was made, Wolfson's share price fell by 18%.
On 29 December 2006 Entertainment Rights plc and its subsidiary Gold Key Home Video Inc, entered into an agreement with Genius Products LLC for the distribution of DVDs in the US. On 10 July 2008 a variation to the agreement took effect, resulting in lower royalty margins and future payments to Entertainment Rights being phased over a longer period, which would reduce Entertainment Rights’ profits by $13.9 million. Further, certain intellectual property rights reverted back to Entertainment Rights from Genius. This reduction in profits represented a significant percentage of Entertainment Rights’ estimated profits for the financial year ending 31 December 2008.
Between 4 June and 31 July 2008, the board considered whether an announcement should be made. It concluded that there would be various opportunities over the course of the year to mitigate the negative impact of the variation, and that the existence of these opportunities permitted the deferral of any announcement of the variation. However, at a board meeting on 25 September 2008, it was thought that the variation had a clear impact on profitability and cash flow, since it resulted in a shortfall of approximately £8 million against market consensus, and that the announcement could not be delayed. Accordingly, on 26 September 2008 the board made an announcement to the market about the variation – which was a deferral of 78 days from the date the variation took effect. On that day, the share price fell by 55%.
In both cases, the FSA found that the listed companies had breached Disclosure and Transparency Rule (DTR) 2.2.1, namely the obligation to disclose inside information to the market as soon as possible, and Listing Principle 4, to avoid the creation or continuation of a false market in listed securities. Substantial penalties were imposed: Wolfson received a fine of £140,000, and Entertainment Rights, a fine of £245,000. Both had agreed to settle the FSA’s investigation and qualified for a 30% discount under the FSA’s executive settlement procedures thereby reducing the penalties.
One of the questions that the FSA had to determine in both cases was whether the negative news (i.e. the variation of the agreement in the case of Entertainment Rights, and the loss of the supply business in Wolfson's case) constituted inside information. To amount to inside information, the information must, if generally available, be likely to have a significant effect on the share price. Under s118C(6) of the Financial Services and Markets Act 2000, information would be likely to have a significant effect on price if and only if it is information of a kind which a reasonable investor would be likely to use as part of the basis of his investment decisions.
In both cases, the FSA found that the negative news was inside information. The FSA found in the case of Wolfson: that the information constituted inside information, on the basis of the significance of the business relationship with the customer, the lost supply business and the related impact on revenue. In the case of Entertainment Rights: the FSA considered that due to the size of reduction in profit in comparison to the anticipated profits, the information about the variation was inside information. As a result, disclosure obligations arose under DTR 2.2.1, when Wolfson became aware of the news on 10 March 2008, and when the variation to Entertainment Rights' contract took effect on 10 July 2008.
Justifications for non-disclosure
The key issue in both cases was whether the boards of the issuers were justified in delaying disclosure of the negative news, on the basis that other or future events may mitigate the impact of the financial consequences. In the Entertainment Rights case, the board sought to justify the delay on the basis that there would be various opportunities over the course of the year to mitigate the negative impact of the variation. In Wolfson, the investor relations adviser had said that the board was justified in withholding disclosure on the basis that (1) previously unavailable revenues would offset the loss and therefore negate the need to announce, (2) it would cause a fall in the share price or result in the share price not representing the ‘true’ value of the company, and (3) confidentiality agreements with the customer meant that they could not announce the increased demand in parts for the other product. The FSA rejected these arguments in both cases.
In both cases, the FSA considered that the seriousness of the breaches warranted a financial penalty. The common aggravating factors in both cases factors were:
- The extensiveness of the delays (78 days in the case of Entertainment Rights, and a substantially fewer 16 days in the case of Wolfson).
- The justifications for non-disclosure being inappropriate, in particular the hope of mitigating the loss with positive news. This was seen to be particularly serious given previous enforcement cases on this issue and that the FSA has published guidance in this area.
- Failure to consult professional advisers in a timely manner: in the Wolfson case, the board did not make the decision to consult its legal advisors until 10 days after it received the news, and it was not until a number of days later that Wolfson received the advice.
- The impact of the negative news on profits was substantial. In the Entertainment Rights case, an aggravating factor was that the company's internal processes failed to identify, in a timely fashion, the need to consider whether the effect of the variation was inside information. This was even though the board was made aware of the potential impact shortly before the variation was executed and considered the issue on a number of occasions without appreciating the need to make an announcement.
The two cases provide listed companies with a reminder of their disclosure obligations on receipt of negative news, and reinforce the position that issuers cannot withhold disclosure of negative news on the basis that positive matters are likely to offset it.
The circumstances in which disclosure of inside information can be delayed are very limited and are set out in DTR 2.5. This rule states that an issuer may delay the public disclosure of inside information, such as not to prejudice its legitimate interests (for example where the outcome of negotiations would be affected by public disclosure), provided that:
- such omission would not be likely to mislead the public;
- any person receiving the information owes the issuer a duty of confidentiality; and
- the issuer is able to ensure the confidentiality of that information.
The cases provide guidance on the circumstances in which delay of disclosure is not warranted. In relation to the offsetting of the negative news with positive, the cases highlight that listed companies should disclose both negative and positive information and allow the market to determine whether they cancel each other out. This is in line with previous FSA action: for example the case against MyTravel Group in July 2005 in which a £240,000 fine was imposed for the company's failure to disclose a change in expectation as to its performance, in the anticipation that the impact would be offset by gains; and the FSA's April 2004 UKLA List! publication. Other lessons to be learnt include that customer confidentiality agreements with third parties, and concerns that the market will overreact to bad newssuch that it would cause a fall in the share price or result in the share price not representing the ‘true’ value of the company, are not justifications for withholding inside information.
Other key messages are that listed companies should ensure that internal processes are in place to identify, in a timely fashion, the need to consider whether information is inside information and whether public disclosure is necessary. A deferral of disclosure of even a few days could be detrimental. Finally, listed companies should seek advice from legal or corporate advisers on disclosure obligations expeditiously. In the Wolfson case, the board initially consulted its investor relations advisers and the FSA stated that it was inappropriate for the company to rely on this advice given that it was not legal advice, nor advice from its corporate brokers.
Breach of disclosure obligations by listed companies is currently a hot topic for the FSA, and further enforcement action on this may be expected. Even though year end is approaching for many companies, listed companies may not simply defer announcement of inside information until publication in their Annual Reports. In current market conditions, listed companies may be reluctant to publish negative news in circumstances where trading may have already substantially deteriorated. However, in November 2008 Mike Knight, FSA Manager for Company Monitoring gave a speech in which he warned firms that the current market conditions were no excuse for avoiding disclosure obligations. Even if disclosure of a particular issue may impact on share price and on confidence in the company, it is important that companies continue to recognise their continuing disclosure obligations. Further, in the UKLA's January 2009 publication of List!, the FSA reminded listed company directors that in the current difficult economic climate, directors will need to bear in mind their obligation to inform the market about any inside information in accordance with the DTR.