Avoiding stop orders on your prospectus

Monday, 01 July 2002

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Richard Cockburn

    This financial year, ASIC has issued more than 80 stop orders on prospectuses issued by Australian companies seeking to raise funds.

    How can you avoid an ASIC stop order on your prospectus? Let's look at your legal obligations, our role and powers, and some common problems of prospectuses we've taken action against, and how to avoid them.

    Your legal obligation

    The Corporations Act places the onus on you as a company director, to ensure that the would-be investor and their professional adviser have all the information they reasonably require and expect to find in the fundraising document. This information must enable them to understand the financial position, performance and prospects of the company, as well as the rights and liabilities attaching to the particular securities or shares being offered.

    What we're looking for

    Contrary to some public perceptions, we don't review fundraising documents before they become publicly available, nor do we pronounce judgment on the merits of a particular business enterprise. Instead, we aim to ensure that the prospectus has adequate information so that investors themselves can decide on the merits of investing in the company. To illustrate, we would not stop a fundraising to develop a business making concrete life jackets, provided the company's disclosure about the risks and prospects, etc complies with the law. What we do is review a number of selected prospectuses to ensure the disclosure is adequate. Prospectuses are selected using risk criteria developed from our experiences in this area.

    Our power to make stop orders

    When we identify a company prospectus that doesn't comply with the law, we will usually issue an Interim Stop Order. We issue stop orders to protect investors from making an inadequately informed investment decision. Stop orders prohibit further distribution of the prospectus and any allotment of the securities. Interim stop orders last for 21 days. The most frequent outcome is that the company issuing the prospectus (the issuer) will use that period to negotiate with us, and produce a supplementary or replacement prospectus to address our concerns. If our concerns are not addressed, a formal hearing must be started within the 21-day period. Sometimes, the issuer will seek to adjourn that hearing while they work on a supplementary prospectus, although a further interim stop order is commonly made, which lasts until the hearing is concluded. The hearing provides the issuer with an opportunity to argue why the prospectus is not defective, although few issuers proceed this far. Less than 15 percent of interim stop orders proceed to a final order because our concerns are usually addressed in a supplementary prospectus.

    Our experience tells us that prospectuses offering higher risk investments are more likely to have aspects that don't comply with the law. We discuss some of these aspects below.

    Forecasts of future earnings

    The single most common problem with prospectuses throughout most of the 1990s was forecasting, usually about future earnings. The Australian market places a heavy emphasis on earnings multiples as a means of valuing the shares being offered. This drives those promoting the companies, particularly those seeking to list on the Stock Exchange, to make favourable predictions about the future earnings in the prospectus. Most studies over the last decade concluded these forecasts were very frequently overly optimistic.

    To comply with your legal obligations as a director, you must ensure that all material assumptions that form the basis of the prediction are explained. This explanation must:

    • enable an investor to form their own view about the appropriateness of the assumption and,

    • to the extent they may not agree with it, to work through the effect a different assumption may have on the predicted future earnings.

    To guide the market, we issued Information Release 01/05 in 2001, on the use of hypothetical assumptions in predicting future earnings. This was followed by draft Policy Statement 170 Prospective financial information [PS 170]. Get copies of these documents from www.asic.gov.au.

    [PS 170] requires that assumptions in forecasts have a reasonable basis, and effectively bans hypothetical assumptions unless they don't have a significant impact on the forecast. The policy provides a non-exhaustive list of how the requirement to have a reasonable basis may be achieved. Most commonly, this can be achieved by either:

    • an investigating accountant's report that complies with Australian Auditing Standard (AUS) 804 or

    • by having appropriate independent experts' reports verifying the reasonableness.

    Capital raisings

    Another common problem that has come to the fore, particularly in the past year or so, has been with capital raisings that are not underwritten and have no minimum subscription. Many issuers are reluctant to have a minimum subscription because if that amount is not raised within four months, the moneys must be refunded. A minimum subscription is the smallest amount you need to raise to ensure the proposed fundraising can go ahead. Many companies have been going to the market seeking smaller non-underwritten fundraisings, typically $5 million or less. Commonly, such raisings are for additional working capital or smaller asset acquisitions. In many cases, companies prepared the document without direct assistance from professional advisers. Or, companies didn't explain the possible impact of a lesser sum raised, on the proposed use of the funds.

    A good example is a proposed raising of $5 million to buy new plant and equipment. If say only $1 million were raised, we would expect the prospectus to cover things like:

    • whether the acquisition would be scaled down, and if so, the impact on the profit and loss, and future balance sheet of the company, or

    • whether the company intends to simply borrow more money to finance the acquisition, or buy less or different assets, and if so, the impact of these options on the prospects of the company.

    The prospectus should address these issues to ensure investors understand the range of outcomes that may follow the fundraising.

    Experts' reports

    The third most common problem is with the use of experts' reports. Many companies use experts' reports in their prospectus to provide greater comfort to investors about a particular proposal. Our policy in this area requires the expert to explain why they reached the conclusion in their report. The explanation will typically require a discussion about the assumptions, alternative methodologies and why they used the method they ultimately chose. A simple test to determine the adequate level of detail in such reports is that an investor must be able to track the reasoning process and so be able to decide if they agree with the expert's reasoning.

    Non-compliant financial statements

    Another problem we encounter is where the company uses pro forma balance sheets that don't use accounting standards that would apply if the company were a listed entity. We take the view that to use say, special purpose accounts in a prospectus seeking listing on the ASX, where those accounts would be materially different if the entity had to fully comply with the Corporations Act, is misleading to investors. This is because the first set of financial reports the shareholders receive will be those that comply with the Act and relevant accounting standards. The Act also prohibits paying dividends other than out of profits. The courts have interpreted this to mean profits determined by the Corporations Act mandated accounting principles, so that any other profit figure may mislead investors to assume their potential returns will be greater than those they will actually receive.

    What do you need to do?

    So, if you want to avoid an ASIC stop order on your prospectus, it pays to take the time to ensure your prospectus complies with the law, especially on the issues discussed above. For copies of draft PS 170, and more about prospectuses, go to the Fundraising page of www.asic.gov.au


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