Continuous Disclosure Part 1

Continuous Disclosure in Context

One of the basic tenets of a market economy is that market valuation and the resultant commitment of resources in response to such valuation will operate most efficiently when all of the market participants are fully informed. If not all participants are fully informed (known as information asymmetry), the value of the items traded on the market may not reflect their true value based upon what a fully informed buyer and seller would agree. The consequences of information asymmetry in a marketplace (and particularly the share markets) can be quite serious at the ‘macro’ level. Markets which are not fully informed may result in allocative inefficiency in that investors will make investment decisions which may be different from the most beneficial decision had full information been known.

On an individual participant’s level, those who trade without full information will eventually see the value of their investment change when full information becomes available to the market as a whole. Further, once it is known that a market is not operating efficiently, investor confidence may be eroded. In consequence, investors may seek alternative investment opportunities either locally or internationally.

Market operators and governments both understand the value of fair and efficient markets as a way of encouraging market participation, thus assuring that capital will be efficiently allocated.¹ While some commentators have argued that the best way to allow information to be disseminated to the market is to allow those with information to trade, the more enlightened view is that those with an informational advantage should not profit thereby (which has led to the longstanding prohibition on insider trading). In order to prevent the opportunity to profit from informational asymmetry (insider trading), mandatory continuous disclosure has been accepted, at least in Australia, as the most appropriate method to protect the less-informed investors by expeditiously making available price-sensitive information upon which they can make a more informed investment decision.²

Originally, only the market operator required companies listed on the exchange to comply with continuous disclosure through its listing rules. Listed companies agreed contractually to comply with the ASX listing rules, which provide, in Listing Rule 3.1:

Once an entity is or becomes aware of any information concerning it that a reasonable person would expect would have a material effect on the price or value of the entity’s securities, the entity must immediately tell ASX that information.

This continuous disclosure rule is subject to the ‘carve outs’ in Listing Rule 3.1A. Under these ‘carve outs’, the rule is not applicable if:

1. a reasonable person would not expect the information to be disclosed, and

2. the information is confidential and ASX has not formed the view that the information has ceased to be confidential, and

3. one or more of the following applies:

(a) a law would be breached if the information were to be disclosed

(b) the information concerns an incomplete proposal or negotiation

(c) the information comprises matters of supposition or is insufficiently
definite to warrant disclosure

(d) the information is generated for internal management purposes of the
entity

(e) the information is a trade secret

The difficulties with relying only upon contractually based continuous disclosure resulted in consideration of alternatives by the (then) Companies and Securities Advisory Committee (CASAC) in 1991. Its report³ recognised the difficulties with using only contractually based continuous disclosure and indicated that, in its view, statutory reinforcement of the continuous disclosure obligation could effectively address those deficiencies.

Following CASAC’s recommendation, the Corporate Law Reform Act 1994 (Cth) implemented a statutory regime of continuous disclosure to support the listing rules. Under s 1001A of the Corporations Law, if a disclosing entity was required to comply with ASX Listing Rule 3.1, then it must not contravene those provisions:

… by intentionally, recklessly, or negligently failing to notify the securities exchange of information:

(a) that is not generally available; and

(b) that a reasonable person would expect if it were generally available would have a material effect upon the price or value of ED securities of the entity.

According to the statute introduced in 1994, failure to comply with the continuous disclosure obligation was an offence if reckless or intentional.⁴

Providing criminal sanctions and civil penalties for failure to comply with the ASX listing rules was an improvement on the former listing rules’ enforcement by contractual obligation alone. However, the new provisions were themselves somewhat flawed, requiring either lengthy criminal proceedings or pursuit of a civil penalty order. Since timely and accurate disclosure of price sensitive information is the goal of the continuous disclosure provisions, neither regulatory enforcement mechanism was considered effective, particularly for less serious failures. As a result of ASIC’s inability to pursue minor breaches of the continuous disclosure regime, it was perceived that there was a need to create an improved culture of compliance with the continuous disclosure provisions.⁵ The consequences of such failures was indicated to be:

This problem has a significant impact because continuous disclosure is fundamental to the integrity of the Australian securities markets. It is important that all investors should have equal and timely access to price sensitive information released by disclosing entities. Inadequate disclosure has the potential to discourage confident investor participation in securities markets. This in turn could reduce liquidity of these markets and hence the efficiency of the price discovery process.⁶

Although the basic concept related to continuous disclosure has remained relatively constant (promoting an efficient market through provision of full information) the mechanisms by which failure to comply can be sanctioned have gradually been modified. The continuous disclosure obligations have, since 1994, seen the application of the civil penalty provisions to both companies and individuals involved in the contravention through Corporations Act s. 1317E; 674(2A) and 6752(B), the introduction of an express ‘due diligence defence’ in Corporations Act s. 674(2B) and 675(2b), and introduction of the infringement notice provisions in Corporations Act Part 9.4AA. Before turning to the systems which companies might employ to avoid difficulty with continuous disclosure obligations, we should first review developments in relation to enforcement of these provisions.

Recent Developments in Enforcement

Although continuous disclosure has been around for some time, the enforcement policies of ASIC and the market operator, ASX, have, in recent times seen some significant activity. These developments indicate not only how the standard for disclosure is being interpreted, but what steps should be taken by companies to avoid falling foul of the requirements.

The approaches of the regulators to continuous disclosure depend upon the significance of the disclosure failure, and as a result, I would like to consider the continuous disclosure obligations by referring to the three levels of enforcement response:

(a) infringement notices;

(b) company contraventions (recent developments); and

(c) potential director liability

The Infringement Notice Provisions and Procedures – Observations

Because of the difficulties of enforcing minor contraventions, ASIC was provided with a new tool, the infringement notice in 2004. The Explanatory Memorandum to the Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 summarised the justification for a new regulatory tool in the following way:

It remedies a significant gap in the current enforcement framework by facilitating the imposition of a relatively small financial penalty and requiring information disclosure in relation to relatively minor contraventions of the continuous disclosure provisions of the Corporations Act that would not otherwise be pursued through the courts.⁷

As the Explanatory Memorandum to the Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 indicates, the amendments made by that act affirm that the purpose of the new infringement notice provisions, as with continuous disclosure generally, is to assure an efficient and informed market so as to maintain investor confidence and thus assure market liquidity. With this legislation, Parliament attempted to rectify certain gaps in the continuous disclosure framework.

The Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 made three significant changes to the continuous disclosure landscape:

(a) it broadened the scope of the civil penalty provisions, applying them to individuals who were ‘involved in the listed entity’s contravention’ (see Corporations Act s. 674(2A);

(b) it increased the civil penalties applicable to such contraventions to $1 million for a body corporate and $200,000 for an individual (see Corporations Act s. 1317G (1B); and

(c) it introduced a new administrative penalty provision through the insertion of a new Part 9.4AA into the Corporations Act.

According the Explanatory Memorandum, the three changes would have the potential:

…to provide improved incentives towards compliance with the continuous disclosure framework by increasing the likelihood that contraventions would be penalised. The proposal for the introduction of an infringement notice mechanism may also benefit ASIC by reducing the costs of pursuing less serious contraventions of the regime. This benefit would accrue if entities elect to pay the applicable penalty rather than continuing to pursue the matter in court.⁸

Perhaps the most controversial of the changes was the new ‘infringement notice’ provision now found in Part 9.4A of the Corporations Act. This Part enables ASIC to issue infringement notices proposing penalties for contraventions of the continuous disclosure provisions (sections 674(2) and 675(2) of the Corporations Act) whenever it has reasonable grounds to believe that a disclosing entity has contravened those subsections. The amount of the penalty varies with the size of the company (in terms of market capitalisation) and any previous failure to give proper notice. The penalties under the notice may be $33,000, $66,000 or $100,000, significantly less than the maximum pecuniary penalty that could be imposed by a court under Part 9.4B of the Corporations Act for the same contraventions ($1 million for bodies corporate).

ASIC has indicated in Regulatory Guide 73 Continuous disclosure obligations: infringement notices (updated June 2012) that it uses the infringement notice provision to assure compliance with the continuous disclosure obligations

ASIC’s key role in administering Ch 6CA is to ensure that listed and unlisted disclosing entities disclose material information on a timely basis and comply with any relevant listing rules. Our approach is based on the principle that the continuous disclosure obligations are fundamental to maintaining the integrity of the market by ensuring transparency and equal access to information. (RG 73.5).

In its administration of the infringement notice provisions, the procedures which it follows is a relatively straightforward ten step process once a breach has been alleged. ASIC indicates that it has a number of mechanisms for identifying alleged breaches. Once it has identified an alleged breach the procedures which it then follows are indicated in Regulatory Guide 73. Prior to the issuance of the infringement notice, the first seven steps ASIC will follow are:

The administrative determination to issue an infringement notice is based upon a number of criteria. These are disclosed by ASIC to be based upon the seriousness of the breach:

In determining the seriousness of an alleged breach, ASIC will have regard to a number of different factors depending on the circumstances of the matter. The impact of the alleged breach on the market for the entity’s securities may be a relevant consideration (including, for example, any change in price of the securities and/or the number of securities traded during the period of the alleged breach). ASIC may also have regard to the materiality of the information the subject of the alleged breach, such as whether the information went to the heart of the entity’s continued operations. The factual circumstances giving rise to the alleged breach (such as whether the conduct giving rise to the alleged breach was negligent, reckless or deliberate) will be considered by ASIC in determining its seriousness. The adequacy of the entity’s internal controls, and whether they were complied with, may be a relevant consideration. The conduct of the entity before the alleged breach (including whether the entity sought and followed professional advice in relation to disclosure) and after the alleged breach (for example whether the entity took immediate steps to correct the failed disclosure) will be considered by ASIC in most cases. RG 173.10

Despite the indication of the criteria to be applied, a number of criticisms of the process have arisen. In particular, the use of an ASIC delegate rather than an external agency (such as the Takeovers Panel) has been raised by critics. Given the non-financial prejudice which could be faced by the infringement notice process, these concerns have some merit. On the other hand, the ease with which ASIC can act so as to maintain an informed market has its advantages.

Once ASIC has issued and served the infringement notice, the Reporting Entity is faced with three possible outcomes (as indicated in the eighth step in ASIC’s Regulatory Guide):

Disregarding the request of extension of time, the disclosing entity is faced with three choices:

a. comply with the notice and pay the penalty

If the company decides to comply with the infringement notice, this will resolve the issue as far as it relates to the company alone. This could be a favourable outcome for the company as far as possible regulatory action is concerned because ASIC cannot take civil or criminal proceedings against the company in respect of the breach alleged in the notice. Nevertheless, the company may face negative publicity in relation to the notice (ASIC may publish details of the infringement notice), and shareholder class actions seeking compensation might be based upon the actions which the company has arguably tacitly admitted by complying with the notice.

Further, individuals knowingly concerned in the alleged breach (e.g. directors or senior executives) may still face ASIC action since the infringement notice regime does not apply to them. As the James Hardie case has shown, this can also involve serious ramifications for directors if the company’s failure to comply with its continuous disclosure obligations has subjected it to injury as a result of the directors’ failure to exercise care and skill under s. 180(1) Corporations Act.

Finally, with the growth of shareholder class actions and litigation funders, the admission that continuous disclosure failures have occurred might also subject the disclosing entity to civil litigation. According the Law Council of Australia,⁹ shareholder class actions now account for approximately 25% of all class actions now filed in Federal Court. This implication of complying with an ASIC infringement notice cannot, consequently, be ignored.

b. seek withdrawal of the notice by ASIC (s. 1317DAH)

The company may attempt to persuade ASIC to withdraw the notice by making written submissions to ASIC. ASIC may withdraw the notice if it is satisfied that it is appropriate to do so. ASIC would normally hold a hearing before issuing an infringement notice (see Continuous Disclosure Obligations: Infringement Notices, an ASIC guide, June 2012, para 16-17). It is consequently difficult to see how, having failed to dissuade ASIC from issuing the notice at a hearing, ASIC would be convinced to withdraw the notice at a later stage by written submission.

c. choose not to comply with the notice and face further regulatory action by ASIC

The consequences of failing to comply with an infringement notice are indicated in Corporations Act s. 1317DAH. These depend upon the requirements in the compliance notice itself. If the notice requires payment of a penalty, failure to pay that penalty may result in proceedings under Corporations Law Part 9.4B for a declaration of contravention and a pecuniary penalty in relation to the alleged contravention. Failure to notify a relevant market or lodge a required document with ASIC as required in a notice may result in proceeding under Corporations Act s. 1324B.

Once the reporting entity has made its response, ASIC indicates that it will then respond in the following ways:

With so much fanfare at the time of its introduction, it is quite interesting that ASIC has successfully imposed infringement notices only eighteen times since 2005. The list of entities and their penalties is listed in the Chart below:

It is not clear why these particular entities were chosen for imposition of infringement notices. Further, the inability of ASIC to publicise unsuccessful attempts to impose infringement notices means that a full understanding of ASIC’s decisions can never be appreciated by reference to the public record alone.

Despite these limitations, academic authors have attempted to establish why certain continuous disclosure failures have led ASIC to use to infringement notice provisions rather than more significant prosecutions. Aakash Desai and Ian Ramsay reviewed ASIC’s practice in using infringement notices in their article, ‘The use of infringement notices by ASIC for alleged continuous disclosure contravention.’¹⁰ Five factors and trends in the analysis of ASIC’s practice through 2010 were observed.

These five factors were:

1. The industry sector

Desai and Ramsay summarised that the following sectors were represented
frequently in the above list:

(a) Material (43%)

(b) Health Care (29%)

(c) Financials (14%); and

(d) Information Technology (14%).

The four new inclusions since 2010 continue the trend with further representation from Materials, Information Technology, and Health Care. Only the most recent inclusion, Leighton Holdings, falls outside of these sectors.

2. Penalty quantum

While the penalties meted out indicate that the larger entities have the greater penalties imposed (as contemplated by the legislation), Desai and Ramsay conclude that the fact that large entities are included within the infringement notices publicised is merely indicative of the fact that minor infractions of continuous disclosure obligations can occur irrespective of the size of the disclosing entity^.11

3. Year of issuance

Although it is clear that the issuance of infringement notices are more frequent in particular years than others, there may be no particular reason for this ‘clumping.’ Desai and Ramsay hypothesise that particular events which might have a consequence on an entire market sector or variations in ASIC enforcement behaviour could explain this. They, however, indicate that it is difficult to make any meaningful observation with such a small sample.¹²

4. Time to issuance

Somewhat surprisingly, Desai and Ramsay observed that through 2010, the time taken between the continuous disclosure breach occurring and ASIC issuing the infringement notice was significantly longer than ASIC’s self-identified target of ninety days. For the examples in their study, the average time it took for ASIC to issue an infringement notice was 248 days. The authors consequently question whether one of the justifications for the continuous disclosure infringement notice (that being the ability of ASIC to respond quickly to disclosure failures) can be sustained by reference to actual experience. In none of the examples was the infringement notice issued within ninety days, with the shortest period being 133 days.¹³

5.  Time to announcement

While the length of time from the alleged contravention to the issuance of the infringement notice is quite significantly longer than perhaps is optimal, the additional period of time attributable to the decision making by the recipient of the notice of how to deal with the notice and by ASIC once that recipient’s decision is communicated is only 32.5 days, according to Desai and Ramsay. The authors conclude that the time required must indicate that disclosing entities often seek extensions of time to reply, but that otherwise there is no discernible variation among industry sectors or the size of the company involved.

In concluding their study, Desai and Ramsay observed that the infringement notice provisions have been narrowly applied as far as industry sectors involved; that they are not as efficient or responsive as intended, that they have been applied to failure to disclose both positive and, and that ASIC has used the infringement notices in relation to entities of all sizes based upon market capitalisation.¹⁴

Company continuous disclosure failures: Fortescue Metals; James Hardie etc.

Over the past few years there have also been numerous prosecutions of companies for continuous disclosure failures. Two recent cases indicate just how prejudicial the failure to comply properly with continuous disclosure obligations can be. These cases, ASIC v. Hellicar¹⁵ (concerning James Hardie) and ASIC v. Fortescue Metals Group Ltd,¹⁶ have been dealt with extensively in the press and by other speakers today, but I shall mention them because they do shed light on the potential consequences for directors through Corporations Act s. 180(1), discussed in more detail below.

James Hardie resulted in sanctions against all of its executive directors as a result of breach of directors’ duties arising from a misleading media release to the ASX concerning ‘fully funding’ a foundation to meet asbestos related liabilities. Likewise, the CEO of Fortescue Metals also was considered as having breached his director’s duty as a result of Fortescue’s failure to properly inform the market about ‘binding’ contracts with Chinese firms in the development of a mining project in the Pilbara.

Finally, several lesser profile cases point out some of the difficulties in determining whether information should be disclosed and how quickly that disclosure should take place.

James Hardie

In the highly publicised case of James Hardie, the James Hardie Group embarked upon a restructure in early 2001. One feature of the restructure was the expulsion of two companies within the group and the formation of the Medical Research and Compensation Foundation, funded by the James Hardie Group.

As a result of the restructure and formation of the foundation, James Hardie was required to notify the market (ASX) of those developments under its continuous disclosure obligations. An announcement to ASX was therefore made in February 2001. In this announcement, the new foundation was described as ‘fully funded’ with ‘sufficient funds to meet all legitimate compensation claims.’ As it transpired, the foundation actually faced a significant shortfall in funding.

The case proceeded on the basis that James Hardie had failed in its continuous disclosure obligations by announcing that the foundation was fully funded. As a result, the High Court agreed that the non-executive directors of James Hardie failed in their duty of care to the company by approving the announcement with the misleading description of a ‘fully funded’ foundation without assuring themselves that such a statement was accurate.

Fortescue Metals

In 2004 and 2005, Fortescue Metals planned a mining project in the Pilbara region, including a mine, a port at Port Hedland, and a railway to connect the mine to the port. In early 2004, Fortescue Metals entered into negotiations with three Chinese companies in relation to the construction of the mine, port and railway. The negotiations led to the execution of three framework agreements with China Metallurgical Construction (Group) Corporation, China Harbour Engineering Company (Group), and China Railway Engineering Corporation. In August and November 2004 Fortescue gave information about the project to the Australian Stock Exchange, stating that it had executed binding agreements with the Chinese companies to build, finance and transfer the railway, port and mine for the project.

In March 2005 Australian Financial Review asserted that the framework agreements did not impose any legally binding obligations on the Chinese contractors. Copies of all of the agreements were provided by Fortescue to ASX on 29 and 30 March 2005.

In March 2006, ASIC brought proceedings alleging that Fortescue had engaged in misleading and deceptive conduct by falsely representing to the investing public that the framework agreements were enforceable agreements. Only declaratory relief was sought against Fortescue, but the contraventions of the continuous disclosure obligations and the assertion that the disclosures which were made were misleading and deceptive were used as stepping stones toward the conclusion that Forrest contravened his director’s duties to the company under Corporations Act s. 180(1). These assertions were upheld by the Full Federal Court in 2011.

As an observation in this case Keane CJ discussed the requirement of materiality, found within Corporations Act s. 677. That section explains:

A reasonable person would be taken -to expect information to have a material effect on the price or value of ED securities of a disclosing entity if the information would, or would be likely, to influence person who commonly invest in securities in deciding whether to acquire or dispose of the ED securities.

Chief Justice Keane, with whom Emmett and Finkelstein JJ agreed, observed that s. 677 did not invite an inquiry as to whether any change in the price of securities has occurred. Further, it does not require that one be entirely certain that a price change has been caused by an announcement. The ‘likely influence’ test provided by Corporations Act s. 677 does not provide a high threshold. However, what has happened in the market, in terms of movements in share price, may assist the court in applying the ‘likely influence’ test.

Both James Hardie and Fortescue Minerals involved a misdescription of events which was revealed to the market. The sanctions imposed upon the companies and their directors are noteworthy more for the severity of the sanctions than for any consideration of the essential obligation of disclosure. Nevertheless, ASX has decided to reconsider its guidance note 8 explaining the continuous disclosure obligations, and the reworked guidance note is likely to be released after the High Court has heard the appeal in Fortescue Mining.

As part of the consultation process, ASX has consulted with a number of industry bodies. The Law Council of Australia included in its submissions several issues which it viewed as lacking certainty. When the ASX releases the new version of guidance note 8, there is anticipation that it will deal with a number of issues of some concern including materiality (as discussed in Fortescue, above) and immediacy.

Other examples

In the last six years, there have been a number of examples of continuous disclosure failures. Even though some of the following examples were not litigated, they nevertheless give a feeling for the enforcement policy which ASIC applies.

One of the most difficult issues in continuous disclosure concerns the requirement that continuous disclosure should be made immediately. ASX Guidance Note 8 (2005) currently indicates:

ASX acknowledges that it is important to strike an appropriate balance between encouraging timely disclosure of material information and preventing premature disclosure of material information of incomplete or indefinite matters (GN 8.12)

Despite the pragmatic words in the guidance note, three incidents of failure in this regard can show just how critical a short period of time can be in the proper context (all of the following resulted in infringement notices):

(a) In 2006, the Promina Group failed to inform ASX of the receipt of a takeover proposal (to acquire all the ordinary shares of the company) for approximately 20 hours (during which time the market was open for less than four hours — 3 ½ hours).

(b) In 2007, Rio Tinto Limited failed to notify ASX immediately of information about its acquisition of Alcan which, though originally confidential, had ceased to be so. Rio Tinto notified the ASX approximately 1 hour 12 minutes after this occurred.

(c) In 2008, Commonwealth Bank of Australia failed to notify ASX about a significant deterioration in its expected loan impairment expense ratio and its expected acceptances ratio for the financial year ending 30 June 2009. This failure to notify occurred for a period of approximately 4 hours and 10 minutes (during which time the market was open for approximately 45 minutes).

Because of the uncertainties raised by these cases (concerning immediacy) and the difficulty with ascertaining materiality (as discussed in Fortescue Mining), ASX has indicated that it intends to issue a new Guidance Note on Continuous Disclosure, clarifying how it intends to administer Listing Rule 3.1. This new Note is expected only after the High Court rules on the appeal in Fortescue Minerals. Hopefully, it will further clarify aspects of the ‘carve outs’ such as what is meant by an incomplete proposal, confidentiality, and the reasonable person test in this context.

Continued in part 2