A recent decision of the Supreme Court provides an interesting case-study of what standards of disclosure are required in prospectuses and what happens to companies that do not meet that standard.
The Supreme Court of New South Wales made orders by consent compelling a debenture issuer (the Company) to make corrective disclosure and ordering it to offer a full refund to those investors who invested in the Company’s high-yield debenture product between 17 February and 9 September 2005. Legal action was instigated by the Australian Securities and Investments Commission (ASIC), on the basis that the Company’s 2004 prospectus that was seeking to raise $75 million was misleading and it failed to make full disclosure as required by the Corporations Act 2001 (the Act).
The 2004 prospectus stated that the Company’s funds were invested in a variety of residential and commercial mortgages, however the vast majority of the funds were actually invested in property development activities carried on by parties related to the Company. The Company consented to a court declaration that its prospectus did not adequately disclose information concerning the security and risks associated with the property development loans, which were made to related parties.
In commenting on the Company’s failure to provide full disclosure in an ASIC media release, ASIC Deputy Chairman Mr Jeremy Cooper said, “This is a case where investors could not get a proper understanding of the security they were getting and the risks they were taking, because the Company's prospectus wasn't up to scratch. If you are in the business of lending for property developments then your prospectus has got to say so."
ASIC became aware of the Company’s conduct through its high-yield debenture surveillance campaign. “High-yield" debenture prospectuses generally include those prospectuses offering debentures that return 3 per cent or more above the bank term deposit rate. As a result of the debenture campaign, ASIC issued a final stop order on the Company’s 2004 prospectus, which prevented the Company from issuing securities under the prospectus.
ASIC accepted an enforceable undertaking from the Company that it would publish corrective advertising in major metropolitan newspapers which would clarify statements made about the security of the debentures. The Company had previously published newspaper and radio advertisements which invited investors to invest in the debenture product and used slogans such as “Invest with certainty!" and “First ranking investors can enjoy peace of mind through a First Ranking Charge". ASIC was concerned that the advertisements were misleading in that they endorsed the security of the investment and certainty of a return, without the use of any qualifications or disclaimers.
Current legislative requirements
Section 710 of the Act outlines a “general disclosure test" in relation to the type of information that a prospectus must contain.
Generally, a prospectus must contain all of the information that investors and their professional advisers would reasonably require to make an informed assessment of the rights and liabilities attaching to the securities being offered and the assets, liabilities, financial position and performance, profits, losses and prospects of the issuer of the debentures. The information that is required to be contained in the prospectus is limited to that information which investors or their professional advisers would reasonably expect to find in the prospectus.
Section 728 of the Act is a general offence provision to complement the general disclosure standard under section 710 of the Act, and provides that a person must not offer securities under a disclosure document if:
- there is a misleading or deceptive statement in the disclosure document
- any of the information required by Chapter 6D of the Act is omitted, or
- a new circumstance has arisen since the document was lodged which would have been required to be disclosed pursuant to Chapter 6D.
ASIC’s powers - issuance of stop orders
Where ASIC is satisfied that a prospectus contravenes section 728 of the Act because it is misleading, deceptive or it omits material information, ASIC has the power to issue an interim stop order under section 739 of the Act, which prevents the issue of securities under the prospectus until the problem has been rectified and a full disclosure has been made by a supplementary or replacement prospectus. In those circumstances where ASIC is not satisfied that the problem has been rectified by the issue of the replacement or supplementary prospectus, it may proceed to obtain a final stop order preventing the issue of securities under the prospectus.
Recommendations
ASIC’s published surveillance report entitled “High-yield Debentures" identifies four key areas of concern in relation to prospectuses and advertising for debentures:
1. aggressive or misleading advertising
2. poor disclosure about property developments
3. related-party transactions, and
4. bad and doubtful debts.
In light of these findings, issuers of debentures must ensure that their prospectuses which offer securities meet all disclosure standards and that investors are notified of the additional risks of investing in them.
ASIC has issued a warning to the industry that, in line with the action taken against the Company, it will continue its intense scrutiny of companies involved in the high-yield debentures market that provide insufficient disclosure and promote misleading advertising. They stated that, “it is fair to say that the high-yield debenture market continues to be an area of concern and focus for us. The actions we have taken against the Company should convey a clear message to other participants that we want this industry to get its act together sooner rather than later. That means sensible advertising and proper disclosure of what is on offer, including what the business really is and what risks are involved. Investors must be able to properly price the risk they are taking on."
Conclusion
ASIC recommends that issuers of securities should ensure that prospectuses contain all the information that is required for investors to make an informed decision about the merits of the offer, including the risk levels associated with the investment.
Section 710 of the Act is worded very widely, and not in the form of a comprehensive checklist for issuers of debentures. As a best practice guideline, issuers of debentures should adopt a conservative approach to disclosure to avoid the risk of being issued with a stop order from ASIC. The issuance of a stop order will likely cause time-consuming delays and additional costs as a consequence of having to answer issues raised by ASIC, and the requirement to prepare a supplementary or replacement prospectus will further delay the offer.
