Need to know:
In the second half of 2017, there were a number of key developments in the area of equity capital markets. These include:
- the release of draft product design and distribution legislation;
- a warning from ASIC regarding the need to consider whether an initial coin offering is the offering of a financial product, and the release of updated Information Sheet 225, Initial coin offerings and crypto-currency;
- a consultation paper from the Takeovers Panel on rights issues;
- the release of a guidance report on seller-side research by ASIC; and
- changes to the ASX Listing Rules.
Draft product design and distribution legislation
In December 2017, Treasury released the exposure draft of the legislation which will implement product design and distribution obligations and ASIC’s product intervention power for consultation with stakeholders.
The draft legislation is in response to recommendations made by the Financial System Inquiry which were accepted by the Government in its Government Response, Improving Australia’s Financial System, which was released in 2015.
The obligations generally apply to offers of financial products that require disclosure under the Corporations Act 2001 (Cth) (Corporations Act) or which are exempt from such disclosure under a mutual recognition scheme. Financial products covered will include insurance products, agribusiness schemes, contracts for differences and other managed investment schemes marketed to retail investors.
Ordinary shares will generally be exempt from the new regime unless the company’s constitution provides that ordinary shares may be converted into preference shares; or a company issues ordinary shares to carry on a business of investing in financial products or other investments. The Explanatory Memorandum indicates that ordinary shares are excluded because they are fundamental to corporate fundraising and “because there is a level of understanding regarding such securities among consumers”.
The design obligations are to:
- make a target market determination in relation to the product;
- review the target market determination as required to ensure it remains appropriate;
- keep records of the person’s decisions in relation to the new regime; and
- notify ASIC of any significant dealings in a product that are not consistent with the product’s target market determination.
The target market determination for a product must be made before making an offer and before a person provides financial product advice in relation to that product. It must also be “appropriate” for the product, be in writing and set out: (1) the class of persons who comprise the target market for the product; and (2) any conditions and restrictions on dealings in, or providing financial product advice in relation to, the product (“distribution conditions”).
A determination is “appropriate” if it is reasonable to conclude that, if the product were issued in the target market in accordance with the distribution conditions, the product would generally meet the likely objectives, financial situations and needs of the persons in the target market.
The review obligations require:
- an issuer to review a target market determination as necessary to ensure it remains appropriate;
- a person who makes a target market determination to, at the same time:
- identify events and circumstances that would reasonably suggest that the target market determination is no longer appropriate; and
- determine the maximum period between reviews of the target market determination which must be reasonable in the circumstances.
The distribution obligations are:
- not to deal, or provide financial product advice, in relation to a product unless a target market determination has been made;
- not to deal, or provide financial product advice, where a target market determination may no longer be appropriate;
- to take reasonable steps to ensure that products are distributed in accordance with the target market determination;
- to collect information related to the distribution of a product; and
- to notify the issuer of a product of any significant dealings in the product that are not consistent with the product’s target market determination.
A contravention of each new obligation is both a civil penalty provision and an offence. A person who suffers loss or damage because of a relevant contravention may recover that loss or damage by civil action. The court may also make an order declaring that the contract is void.
Initial coin offerings
An initial coin offering (ICO) is a new form of funding in which a business or individual raises funds from investors through the internet. Investors use cryptocurrency to purchase coins or tokens (also called “crypto-assets”) via the internet for a set period of time. The ICOs are often global offerings which can be created anonymously and/or accepted anonymously.
Significantly, crowd funding using an ICO is not the same as the ‘crowd-sourced funding’ regime that is regulated by the Corporations Act and commenced on 29 September 2017. Under that regime, a provider of crowd-sourced funding services must hold an Australian financial services licence with authorisation to provide the service.
On 3 May 2018, ASIC updated Information Sheet 225, Initial coin offerings and crypto-currency, which, amongst other things, offers guidance in relation to the legal status of ICO tokens and when an ICO could be an offer of a financial product.
In summary, an ICO could be subject to the Corporations Act depending on how the ICO is structured and operates. If the rights attached to an ICO mean that the promoters are offering a “financial product” which is regulated by the Corporations Act, then there are a range of disclosure, registration and licensing obligations that must be complied with. A statement that an ICO is not a financial product is not sufficient to eliminate the possibility that it is a financial product. Likewise, the fact that a token is described as a digital currency does not mean it is a financial product. Whether an ICO is a financial product will turn on what rights are associated with the tokens issued under the ICO.
An ICO is likely to be a managed investment scheme if:
- people contribute money or assets (such as digital currency) in exchange for tokens;
- the contributions are combined or used in a common enterprise to produce financial benefits or interests in property, and
- the contributors do not have day-to-day control over the operation of the scheme but, at times, may have voting rights or similar rights.
It is likely that an ICO will be an offer of shares if the ICO is created to fund a company and the rights attached to the token are similar to rights attached to shares.
An ICO could be a derivative if the price of a token issued under the ICO is based on another financial product, market index or asset price. ASIC gives an example of a self-executing smart contract which is represented in the token itself.
It is unlikely that tokens will be a non-cash payment facility, but if the ICO allows payments to be made to a number of payees using tokens, or converted from token form to fiat currency to enable completion of the payment, it may be a non-cash payment facility.
ASIC advises that in relation to proposals that expose consumers to crypto-assets, or propose to invest in crypto-assets, businesses may require a new licence or licence variation (such as a new product authorisation) to provide financial services involving the proposed product.
ICOs will be subject to the misleading and deceptive conduct provisions in either the Corporations Act (if it is a financial product) or the Australian Consumer Law. Examples of misleading and/or deceptive conduct in the context of ICOs includes:
- using social media to exaggerate public interest in an ICO;
- undertaking or arranging for a group to engage in trading strategies which create the appearance of greater buying and selling activity for an ICO or a crypto-asset;
- failing to disclose adequate information about the ICO, and
- suggesting that the ICO is a regulated product or has been approved when that is not the case.
ASIC is now able to take action under the Australian Consumer Law in relation to misleading or deceptive conduct relating to crypto-assets, regardless of whether they are financial products. ASIC has already issued inquiries to ICO issuers and their advisers where it identified misleading or deceptive conduct and statements, and has taken action against an unregulated scheme.
ASIC also continues to monitor for unlicensed ICO-related activity.
ASX have indicated that any applicant seeking to list a business investing in, or making ICOs of, bitcoin or other cryptocurrencies will need to satisfy ASX that its business is bona fide; that it has a structure and operations that are appropriate for a listed entity; that it complies with applicable laws; and that proper disclosure has been made to investors of the risks involved.
The following updates are summarised in ASIC’s recent report: Report 567: ASIC regulation of corporate finance: July to December 2017 February 2018.
Restrictions on advertising
ASIC continues to monitor the advertising of fundraising offers and will intervene in circumstances where advertising is potentially misleading and will expose investors to a risk of making uninformed decisions.
In November 2017 a securities firm paid an infringement notice penalty of $358,000 for providing price support to a company in the first 2 weeks of its backdoor listing on the ASX. The firm had acted as lead manager and underwriter to the company in its capital raising. The firm’s action was in breach of the ASIC Market Integrity Rules 2010 which:
- prohibit a market participant from making bids on its own behalf with the intention, or having the effect, of creating a false or misleading appearance with respect to the price of shares; and
- require a market participant to notify ASIC, as soon as practicable, if the market participant has reasonable grounds to suspect that bids have been made that have, or are likely to have, that effect.
Underwriters’ obligations and opportunity
ASIC has identified several instances where the underwriter for a fundraising offer was not authorised under an Australian Financial Services (AFS) licence to provide underwriting services.
ASIC advises that, in order to provide underwriting as part of a financial service, an underwriter must either hold an AFS licence that expressly permits underwriting, or act as an authorised representative. Underwriters must be actively involved in the preparation of disclosure documents and undertake due diligence.
The Takeovers Panel issued a Consultation Paper in February 2018 on Guidance Note 17 – “Rights issues” and asked for submissions by 6 April 2018. The main changes proposed to the Guidance Note relate to how the potential control effects of a rights issue might be mitigated, including:
- making a rights issue renounceable where an active market for the rights is likely;
- having a dispersion strategy to deal with the shortfall;
- offering a shortfall facility where:
- shareholders and others can apply for extra shares before the shortfall is determined;
- shortfall shares will be allocated in proportion to their respective shareholding; and
- directors do not exercise their discretion in a manner likely to exacerbate a potential unacceptable control effect.
These changes and comments reinforce the role of professional underwriters to assist in capital raisings by a rights issue strategy. The Takeover Panel notes that the exception to the requirement to comply with the takeover provisions of the Corporations Act for rights issues may not apply to protect an acquisition under a dispersion strategy unless the acquisition is by an underwriter or sub-underwriter (i.e. one who facilitates a capital raising by contracting to subscribe for the shortfall before the offer is made).
What is underwriting? – a reminder
Certain exceptions to the general prohibition (which restricts a person’s ability to acquire further voting power above a 20% threshold) apply to an acquisition by a person in their capacity as an underwriter or sub-underwriter.
In Regulatory Guide 6: Takeovers: Exceptions to the general prohibition, ASIC said (at [6.142]:
“Under the form of underwriting traditionally employed in Australia, the underwriter legally assumes the shortfall risk by agreeing to subscribe for, or procure subscriptions for, securities not otherwise subscribed for under a public offer”.
A sub-underwriter assumes some or all of the obligations of the underwriter.
ASIC notes that the following will not be regarded as underwriting:
- where a person agrees to take firm a specific number of securities that are the subject of a public offer;
- where the underwriter has the ability to terminate the underwriting in its discretion or if an event occurs which is in the control of the underwriter; or
- where an underwriter can terminate on the basis of an event that is certain, or near certain, to occur (such as a small fall in a relevant market index).
In December 2017, ASIC released Regulatory Guide 264: Sell-side research (RG 264) which focuses on how to manage conflicts of interest and “inside information”.
“Inside information” is defined by the Corporations Act to mean:
- information that is not generally available; and
- if the information were generally available, a reasonable person would expect it to have a material effect on the price or value of a particular financial product.
ASIC has observed that some Australian financial service licensees do not have appropriate arrangements to manage situations where staff, including research analysts, come into possession of inside information. ASIC also observed that there are inconsistent practices which indicate a lack of research independence.
To reduce conflicts of interest and protect the integrity of research, ASIC recommends that licensees:
- provide their staff with training to ensure that staff have the necessary skills and experience to be able to determine whether information they receive contains inside information;
- implement policies and processes to verify whether information is publicly available, and what to do if inside information has been received; and
- implement information barriers and wall-crossing procedures.
ASIC advises that if a research analyst becomes aware of insider information they should follow the licensee’s “wall-crossing” procedure. Then on the private side of a deal the research analyst should be subject to controls on their trading and publication of reports to minimise the risk that inside information is inappropriately passed to others or acted on.
ASIC further notes that the business model and organisational structure of some licensees can potentially result in an actual or apparent lack of research independence; for instance, where research remuneration is funded by corporate advisory revenues. As such, RG 264 also addresses ways to minimise conflicts associated with:
- research analyst interactions with corporate advisory during pre-solicitation;
- research analyst interactions with the issuing company during the pitching stage;
- preparation of investor education reports; and
- discretionary incentive fees for the licensee managing the transaction.
If the conflict in providing both research and corporate advisory services cannot be managed by a licensee, ASIC advises that the licensee should only do one or the other.
The most frequent disclosure concerns ASIC raised during the second half of 2017 were:
- inadequate risk disclosure;
- inadequate business model disclosure;
- insufficient details regarding proposed use of funds;
- lack of clear, concise and effective disclosure;
- unbalanced disclosure; and
- insufficient information about directors’ history.
In ASIC’s 2017-2018 business plan it is noted that ASIC will be analysing forecasts, particularly those in IPO prospectuses, and identifying:
- the proportion of companies that miss their forecasts; and
- the reasons why forecasts are missed.
Changes to the ASX Listing Rules
Recent changes to the ASX Listing Rules include:
- expansion upon what ASX regards as “artificial” means of obtaining security holdings for the purpose of counting towards minimum spread;
- additional guidance on ASX’s disclosure expectations for material contracts; and
- guidance to address the new insolvent trading safe harbour for directors in section 588GA of the Corporations Act; and what should be disclosed when an entity in financial difficulty requests a voluntary suspension to complete a transaction necessary for its survival.
Disclosure of customer contracts
ASX has expressed concern about the number of incidents where the disclosures by listed entities about their contractual arrangements with customers failed to meet the required standards. Examples include:
- announcing a contract with a major global customer without providing any details of the nature or substance of the contract or its significance;
- announcing a material customer contract without disclosing that it is subject to a trial period or other conditions and therefore may not proceed;
- not disclosing when a material customer contract does not proceed;
- disclosing revenue projections for customer contracts that do not have a proper basis or that do not state the material assumptions or qualifications underpinning them; and
- representing a customer contract as being “material” when it is not.
Listing Rule 3.1 requires a listed entity to immediately disclose “market sensitive” information to ASX. In March 2018, ASX revised its Guidance Note to require that “wherever possible, an announcement under Listing Rule 3.1 should contain sufficient detail for investors or their professional advisers to understand its ramifications and to assess its impact on the price or value of the entity’s securities.”
ASX recommends that an announcement about the signing of a market sensitive contract with a customer include information about:
- the customer’s name;
- the term of the contract;
- the nature of the products or services to be supplied to the customer;
- the significance of the contract to the entity;
- any material conditions that need to be satisfied before the customer becomes legally bound to proceed with the contract; and
- any other material information relevant to assessing the impact of the contract on the price or value of the entity’s securities.
Good fame and character
ASX may now require good fame and character checks from persons who are not currently, or proposed to be, directors of the entity but who are likely to be involved in its management. This is in order to capture persons who do not join the board in order to avoid the good fame and character requirements.
In October 2017, the ASX released Reverse takeovers: Final listing rule amendments to regulate the treatment of reverse takeovers (RTOs).
An RTO is defined as a takeover bid, or a merger by way of scheme of arrangement, where:
- an entity is proposing to acquire securities of another body by takeover bid or scheme; and
- the aggregate number of equity securities issued or to be issued by the entity – under the takeover bid or scheme and/or to fund the cash consideration payable under the takeover bid or scheme – is equal to or greater than the number of fully paid ordinary securities on issue in the entity at the date of announcement of the takeover bid or scheme.
The Listing Rules were amended with effect from 1 December 2017 so that:
- shareholder approval is now required for the issue of securities by a bidder in the context of a reverse takeover;
- a notice of meeting to approve an issue of securities under, or to fund, a reverse takeover must disclose information ‘in relation to the reverse takeover’ (see Guidance Note 12, revised in March 2018); and
- for issues under, or to fund, a reverse takeover, the requirement under Listing Rule 7.1 to issue those securities within 3 months after shareholder approval has been extended from 3 months to 6 months.