Post-Transparency Directive - Liability for Reports and Statements

01 September 2007

Nick Eastwell, global head of capital markets, Linklaters LLP

Previous law and Impact of the Transparency Directive (TD)

As the implementation date of the TD approached, serious concerns were expressed that the liability of directors would be affected by the implementation of its periodic financial reporting requirements. The objective of these requirements, as stated in the recitals of the Directive, is to allow investors to make an “informed assessment” of an issuer’s position and to increase investor protection within the EU. In this context, periodic financial information must be made generally available throughout the EU and, for annual and half-yearly reports, a statement of responsibility must be given by the “persons responsible”.

In the absence of legislative intervention, it is likely that the effect of the TD would have been to extend the scope of liability under English law for annual accounts and other financial reporting to investors and the public in general across the EU. Fortunately, while member states must impose liability for information published under the TD on “at least the issuer or its directors”, the TD allows member states to determine the extent of that liability.

The UK government therefore took the opportunity to include two provisions in the Companies Act 2006 (the Companies Act) to clarify the liability of directors for narrative reports and issuers for periodic financial information (which also includes narrative reports). Both provisions operate so as to define the limited circumstances in which liability will arise, and to exclude liability in all other circumstances.

Liability of Directors to their Company for Narrative Reports

The first provision (section 463 of the Companies Act) is designed to meet concerns about directors’ liability for forward-looking statements in narrative reports, in particular the enhanced business review that listed companies are now required to produce under the Companies Act. However, the provision also relates to the whole of the directors’ report (not just the business review), the directors’ remuneration report and information in summary financial statements derived from either of these reports. It provides that:

• a director will be liable to compensate the company for any loss it suffers as a result of any untrue or misleading statement in, or omission from, such a report, but only if he knew (or was reckless as to whether) the statement was untrue or misleading, or knew the omission to be dishonest concealment of a material fact; and

• no director, auditor or other person will have any liability to anyone other than the company resulting from reliance on information in these reports.

The provision thus limits the liability of directors in relation to directors’ reports (including the business review) to the company only. Directors will not be liable to shareholders or other third parties for such reports – unless they take some action beyond publishing their reports in accordance with company law. For example, if a director were to send a copy of the company’s annual report and accounts to a bank in connection with the negotiation of an overdraft facility, he might still, as now, be liable to the bank as a result of an express or implied representation to the bank as to the accuracy of the contents of the report.

The provision applies to directors’ reports published after 20 January 2007, the date of implementation of the TD.

Liability of Issuers for Reports and Statements Published under the Transparency Rules

The second provision inserted new sections 90A and 90B into the Financial Services and Markets Act 2000 (FSMA) and deals with liability in relation to annual and half-yearly reports and interim management statements published under the Disclosure and Transparency Rules by issuers with securities traded on a regulated market in the UK (or on a regulated market outside the UK where the UK is the home state). It also extends to preliminary announcements of results, where issuers choose to publish them under the new voluntary regime, but only to the extent that the information contained in the preliminary announcement is of a kind appearing in the subsequent annual report.

The provision imposes on an issuer of securities liability to pay compensation to an investor who acquired securities of the issuer and suffered loss:

• as a result of an untrue or misleading statement in, or omission from, a report;

• but only if a “person discharging managerial responsibilities” within the issuer knew or was reckless as to whether the report was untrue or misleading, or knew the omission to be dishonest concealment of a material fact.

Perhaps more significantly, the provision exempts the issuer and any other person from any other liability, subject to limited exceptions described below.

The existing power under FSMA for a court or the Financial Services Authority (FSA) to require restitution to be paid to investors or others who have suffered loss resulting from a breach of FSA rules is not affected by the new provision. Although never yet used in the context of a breach by an issuer or director of the Listing, Disclosure and Transparency or Prospectus Rules, this power does leave open at least a possibility of personal liability to investors on the part of directors. Similarly, the provision does not exclude civil or criminal liabilities such as under the market abuse regime, penalties for Listing Rule breaches or criminal acts under section 397 of FSMA.

Section 90A of FSMA applies to periodic financial information and preliminary announcements of results for financial years commencing on or after 20 January 2007.

Effect of the New Liability Regime – A Sword and a Shield

The combined effect of these two provisions is to preclude investors from having a direct right of action against directors; but they could claim against the company, if they can show that they have suffered loss, and that there was knowledge or recklessness, or dishonest concealment, on the part of one or more directors regarding the defect in the report. The company could then claim its own loss (compensation paid to an investor) against an individual director whose knowledge, recklessness or dishonest concealment gave rise to that loss.

The new provisions have been generally welcomed by issuers and market participants as creating a reasonable balance between responsibility and the ability to report in an open and forward-looking manner without undue fear of litigation. The fear that, in the context of liability, the UK was going to get its own version of the United States’ Sarbanes- Oxley Act proved, happily, unfounded.

However, the new regime does give rise to the following couple of issues.

Existing shareholders: an issuer is potentially only liable to persons who acquire securities and suffer loss as a result of an untrue or misleading statement or omission. It is not subject to any other liability, including liability to its existing shareholders (who may, for example, decide not to sell their securities on the basis of a misleadingly positive statement). Existing shareholders therefore lose whatever common law rights they may have had, although, in the light of Caparo, these may be limited to exercising governance rights.

Other disclosures: there is a somewhat arbitrary division between disclosures that are within the regime and those that are not. The liability regime, as originally proposed, covered periodic financial reporting under measures implementing the TD, namely annual and half-yearly reports and interim management statements, but not preliminary announcements of results, price-sensitive announcements such as profit warnings, or announcements of significant transactions under the Listing Rules. Following a consultation in the summer of 2006, the government extended the regime to cover preliminary announcements of results but concluded that any further extension was inappropriate as the issues were too complex to be resolved quickly.

Because of the controversy caused by the new statutory liability regime for issuers, the government was prompted to initiate a further review of whether a statutory liability regime for other financial disclosures would be necessary and commissioned Professor Paul Davies QC to carry out the review. The UK Treasury published the conclusion of the review on 4 June 2007 (the ‘Davies Report’). The Davies Report has recommended, inter alia, that the standard of liability should be fraud (rather than a less demanding standard of negligence) and on this basis recommends the exercise of the powers conferred by the new section 90B of FSMA to extend the existing statutory liability regime in section 90A of FSMA as follows:

• to cover ad hoc as well as periodic disclosures, so as to include all information announced to the market via a Regulatory Information Service (“RIS”);

• to apply to disclosures by issuers with securities traded on exchange-regulated markets including AIM and PLUS; and

• to confer rights on both buyers and sellers of shares, but to exclude those who continue to hold (or not to buy) shares from suing in respect of misstatements in RIS announcements.

The Davies Report also recommends that the statutory compensation regime should be extended to encompass liability for dishonest delay.

The government has taken a reserve power to amend the Companies Act 2006 by secondary legislation if changes recommended by the review are supported by subsequent consultation.

Jurisdictional Scope of Liability

Neither of the new liability provisions protects issuers or directors from being sued in other EU jurisdictions under laws implementing the TD. During negotiations on the TD, the government attempted to introduce a provision that would have required crossborder civil liability disputes to be resolved within the civil liability regime of the issuer’s home state, but this was not accepted. Certainty and a relatively benign regime in the UK has, therefore, to be balanced by the risks of legal action taken elsewhere where liability regimes may be more onerous and far-reaching.

The review considered the potential for issuers to be subject to claims made by investors resident in different jurisdictions. Although outside the review’s terms of reference, the Davies Report concluded that it would be best if a single legal regime were to apply to investor claims.

Practical Implications

Issuers will want to consider whether any additional verification procedures on narrative and periodic reporting are required to limit the risk of their liability to investors. However, the existing statutory obligations and sanctions, coupled with the high standard of care required for information released to the market by both the existing Disclosure and Transparency Rules and Listing Rules, should mean that existing procedures do not need to be adjusted to take account of the new regime. The level of verification should take into account the fact that the trigger for liability is high, requiring knowledge, recklessness or dishonest concealment rather than mere negligence.

Issuers will also want to meet their auditors to discuss whether additional processes are required in relation to forward-looking statements in the business review or interim management report.

Issuers will also need to consider who will give the responsibility statement in relation to annual and half-yearly reports. This is most likely to be the board of directors. Whilst directors may not have any liability to investors under the new statutory liability regime as a matter of English law, they may be liable to the issuer. Furthermore, there may be additional consequences for directors as a result of being named in the responsibility statement, for example, under local securities laws if the issuer’s shares are traded on exchanges outside the UK. Such issuers and their directors will want to investigate with their legal advisers whether it is possible to include a disclaimer in the responsibility statement such that neither are liable except to the extent that they would be under English law.

And, finally, in this increasingly overregulated and risk-averse world in which we live, companies will also need to discuss with their insurance brokers whether the insurance cover for directors and officers needs to be adjusted to reflect the new liability and responsibility regime.

It is not possible to buy entry into Who's Who Legal

terms and conditionscontact us