FSA probes profit warnings

In its concerns over the rising number of profit warnings, the Financial Services Authority is probing large companies over possible failure to disclose key trading data to the markets. But lawyers say the watchdog’s focus on disclosure could lead to disputes with companies over what information should have been revealed and when, especially given the wider circumstances surrounding many decisions during the credit crisis. The FSA’s probes could lead to fines for companies that break the listing rules and criminal prosecution of executives for “market abuse”.

The FSA has always scrutinised sharp share price movements after profits warnings ­ the regulator carries out more than 200 “enquiries” a year (although many are routine checks). But the credit crunch is seeing a higher volume of cases than normal and a larger number involving multinationals that would not normally expect trading difficulties.

For example, Rentokil’s share price fell more than 30% last summer following a profits warning. On 12 January this year Land of Leather saw its share price plummet to three pence ahead of a suspension in trading and the company’s entry into administration.

Last year saw the highest number of UK company profit warnings since 2001, according to research by Ernst & Young, totalling 449 ­ a rise of 17% on the previous year. Of these, more than 40 FTSE-250 companies experienced share price falls of more than 10% on profit warnings.

It is in this context that the FSA has warned companies of its intention to strictly police the rules on disclosure to the market and making profit warnings. The regulator appears acutely aware of the temptation for companies to hold back bad news from the market, particularly when their survival is at stake.

The FSA’s disclosure regime does recognise that some information can be kept confidential until developments are at a stage when an announcement can be made without prejudicing the legitimate interests of the issuer. However, it adds that the ability to delay disclosure of inside information is “conditional, not absolute” and such a delay should not “mislead” investors.

False markets
David Southern, senior corporate partner at law firm Marsden Rawsthorn, says the FSA’s concern is the creation of false markets that such dramatic fluctuations in share price can cause. “It is likely that further adverse news is on the horizon for many listed companies and the FSA has stated it intends to investigate all instances where a share price fluctuation of more than 10% occurs following a profits warning,” says Southern.

“Whether the FSA has the resources to implement such a policy will depend on the severity of the recession and the number of companies that struggle as a result.

However, company directors should be in no doubt as to the serious implications of withholding share-price sensitive information and must inform the market as soon and as comprehensively as is practicable,” he says.

The penalties for companies failing to comply with these obligations are severe. The FSA has the power to impose unlimited fines, order a company to pay compensation to victims and publicise its infringement. These warnings are more than empty rhetoric. In July last year the FSA fined Woolworths £350,000 for failing to disclose promptly a likely drop in earnings following renegotiation of a key contract.

Paul Henty, senior associate at solicitors firm Shadbolt, says the Financial Services and Markets Act 2000 and Market Abuse Directive impose a basic obligation on LSE-listed companies to ensure all information which is likely to have a significant effect on the price of shares is made known to the market as soon as possible. But complying with the obligation often involves fine judgments.

For example, a company only needs to divulge information which is sufficiently precise, such as probable events and circumstances, and to judge whether this information would have a significant effect on the share price. “These are not easy decisions at the best of times, but even less so in today’s rapidly moving market,” he says.

“Directors owe a duty of skill and care to the company and this could expose them to civil actions where an unnecessary disclosure was made which had an adverse effect on shares,” says Henty. “Shareholders could attempt to sue directors for a loss in value in the shares if they unnecessarily harmed share value through needless or inaccurate statements. As a result, companies will feel they could do without the extra challenge presented by this increase in regulatory enforcement.”

Changing circumstances
Richard Weaver, partner in the capital markets group at PricewaterhouseCoopers, says the FSA’s position is not new: what is unprecedented is the backdrop against which directors have to make judgements as to what information to disclose ­ and when.

“The FSA’s definition requires that the information to be disclosed should be of ‘a precise nature’. What is different now is the range of potential outcomes that the directors face in making a forecast,” says Weaver.

“Directors need to consider if the information would be likely to have a significant effect on the share price. Normally, news of poor trading would depress the share price, but this is 2009. Some companies’ share prices are so depressed that even worse-than-expected trading news may have little effect,” says Weaver.

“The news in the next few months will be full of profit warnings. Directors will be hoping that these difficult decisions are not judged by the market (or the regulator) with the wisdom of hindsight,” he adds.

Useful links
Read a recent FSA speech at http://tinyurl.com/fsa-psi

http://tinyurl.com/ey-warnings