The Refinancing Disclosure Trap... And How To Avoid It

Key Point

• Directors of a listed entity need to ensure that, when faced with a spectrum of challenging issues, including the actual solvency and financial viability of an organisation, disclosure obligations are not overlooked.

Market disclosure of debt positions is now a major issue for many listed entities.

As the economic downturn leads to the withdrawal of capital from underperforming sectors, debt refinancing risk has resulted in significant devaluations of many leveraged entities. With monotonous regularity this devaluation has then resulted in those entities' being unable to raise capital through the equities market without further deep discounting. Market disclosure of an entity's debt position has therefore become the subject of intense scrutiny by analysts and investors and, in some cases, the target of shareholder class actions.

This elevation of debt positions to a major market disclosure issue is still catching some entities unawares - and the next six to 12 months will see many boards still struggling to manage this issue, at the same time as they focus on maintaining the solvency and financial future of their organisations.¹

Disclosure risks

Listed entities' disclosure obligations are simple to recite, but applying them in the current market conditions is not so straightforward.

(1) The continuous disclosure obligation

As everyone knows, immediately it becomes aware of any information that a reasonable person would expect to have a material effect on the price or value of its securities, a listed entity is required under the ASX Listing Rules and the Corporations Act to disclose that information to the ASX.

Disclosure is not required if:

• a reasonable person would not expect the information to be disclosed;

• the information is confidential; and

• among other things, the information concerns an incomplete proposal, comprises matters of supposition, is insufficiently definite, or is generated for the internal management purposes of the entity.

Even if these conditions are met, ASX can still force disclosure if it forms the view that disclosure is necessary to prevent the market trading on rumours or speculation^.2

Just as the factors relevant to an investor's investment decision change with market conditions, so too do a listed entity's disclosure obligations. When considering the application of the continuous disclosure regime, ASIC and the ASX have recently emphasised that "the expectations of a reasonable person evolve over time"³ The concept of what should be considered "material" is, therefore, a dynamic one that depends upon continuously changing market conditions.

While debt refinancing obligations may have once been immaterial, they have become very material to investors, and hence "material" for the purposes of the continuous disclosure regime. This is recognised by the ASX and ASIC, who have noted that, "In a falling market where loan funds are tight, and banks are sceptical, the fact of a rollover to a financial institution is more likely to be price sensitive, certainly where discussions are clearly difficult. In that instance the markets should be informed."⁴

The fact that alternative sources of capital, in the nature of equity, are also very difficult to raise in the current market only enhances the materiality of an entity's ability to obtain and maintain access to debt finance.

(2) Classification of debt in financial reports

A market downturn can place significant pressure on a listed entity's classification of debt for the purposes of its financial reports. A market collapse can cause liabilities which were once comfortably considered non-current (such as long-term financing arrangements) to become current (as review clauses, material adverse change clauses or insolvency acceleration event clauses are triggered).

Listed entities' financial reports must comply with accounting standards⁵ Financial reports must correctly identify liabilities as current or deferred. Under AASB 101 an entity must classify a liability as "current" when:

• it is expected to be settled in an entity's normal operating cycle;

• it is held primarily for the purpose of trading;

• it is due to be settled within 12 months after the end of the reporting period; or

• the entity does not have an unconditional right to defer the settlement of the liability for at least 12 months after the reporting period.

A central allegation in the current investor class action against Centro Retail Group is that Centro engaged in misleading and deceptive conduct by failing to correctly classify an interest bearing liability as a current liability in its financial reports for the year ending 30 June 2007.

(3) Refinancing risk and forecasts

As both external market and internal company circumstances change, entities need to continually assess the risks associated with the refinancing of any debt facilities. If an entity forms the view that there is a material risk that a debt facility:

• will not be able to be refinanced; or

• will only be able to be refinanced at a greater cost than the costs used to underpin any forecasts,

it may breach its continuous disclosure obligations and mislead the market if it fails to disclose that information.

The relationship between refinancing costs and forecast financial information is fundamental. Entities need to continually reassess their financial forecasts in light of potential increases in financing costs, as the cost of funding is often a central assumption underpinning forecasts.

Even here, the current economic conditions have shifted the goalposts. ASX's longstanding Guidance Note 8 refers to a need to disclose material variations in previously released forecasts or expectations. It says that "as a general rule a variation in excess of 10% to 15% may be

considered material". In a recent speech, ASIC Commissioner Belinda Gibson urged entities to adopt a more conservative approach: "In this volatile market, I believe that variations at the lower end of the scale might reasonably be expected to impact price materially and should be disclosed."⁶

A forecast is deemed to be misleading unless the entity has reasonable grounds for the forecast. Further, the onus of proof in relation to an alleged misleading forecast is reversed, so that an entity is taken not to have reasonable grounds unless it provides evidence to the contrary.⁷ One of the allegations in the current class action against Centro Retail Group is that it engaged in misleading and deceptive conduct by (among other things) failing to disclose the likely impact on its forecasts of likely increased costs of financing. It is also worth noting that Australia's largest securities class action settlement ($144.5m) related to proceedings which included allegations that Aristocrat Leisure Ltd had failed to disclose that it would not meet earnings forecasts.

When considering the likelihood that refinancing will be obtained and the potential costs of that refinancing, listed entities should not assume that all the lenders in their banking syndicate have identical motivations. Some lenders may have entered credit default swaps, meaning that their risk profile in relation to the loan may not be what it appears. It is also possible that the bank may even profit by the borrower going into administration. A lender may even have passed its risk to a vulture fund which actually wants a borrower to fall into external administration so that it can profit from cheap asset sales.

The consequences of getting refinancing risk disclosure wrong

Entities which fail to properly disclose their debt position in accordance with their continuous disclosure obligations or in financial reports, or that fail to revise forecasts in light of their changing debt position may be subject to investigation and possible sanction by ASIC. Directors and executives may also face individual sanctions.

Directors also need to be aware that failure to disclose, or disclosure of incorrect information, can give rise to shareholder damages claims for misleading and deceptive conduct in relation to the entity's securities.⁸ Such allegations have been the basis of several shareholder class actions, including those currently on foot against Allco Finance Group and Centro Retail Group.

Oz Minerals

The recent example of Oz Minerals Limited illustrates the difficulty faced by directors in determining how the continuous disclosure regime applies to debt refinancing obligations.

In February 2008, Oxiana Limited entered into debt facilities which were to be refinanced on 8 August 2008. This date was extended to 30 November 2008.⁹ In June 2008, Oxiana's interim financial statements classified these debt obligations as a deferred liability rather than a current liability.¹⁰ Oz Minerals took this approach because a clause in the relevant loan agreement allowed Oz Minerals to request an extension to the refinancing date and obliged the lenders not to unreasonably withhold consent to the extension as long as Oz Minerals had used its best endeavours to refinance the facilities.¹¹

On 18 November 2008, Oz Minerals shares fell from 83c to 73c over two trading days. In response to an ASX query, Oz Minerals stated that it was not aware of any information that had not been announced that could be an explanation for the fall in price of its securities.¹²

On 25 November 2008, Oz Minerals informed the market that it was in the process of negotiating refinancing of its debt facilities, and required an extension of time on its current facilities to enable negotiations continue.¹³

On 28 November 2008, Oz Minerals obtained a trading halt from the ASX as negotiations with its current lenders continued.

On 1 December 2008, trading in Oz Minerals was suspended at the request of the company as negotiations continued, with Oz Minerals accepting an extension of the debt facilities to 29 December 2008, with the possibility, subject to certain conditions, of an extension to 31 January 2009. Oz Minerals requested the suspension to ensure that the negotiations were not jeopardised by potentially extreme share price volatility.¹⁴

On 2 December 2008, the ASX asked Oz Minerals why it had not released information about the refinancing to the market in response to the ASX's Price Query on November 18.¹⁵ Oz Minerals responded that, at the time of the Price Query, negotiations were confidential and incomplete, and that it believed both that the debt facilities would be extended and that it had contractual grounds (referred to above) for requiring lenders to grant the extension.¹⁶

This case illustrates the challenges which boards can face in managing their debt financing disclosure obligations in rapidly changing economic circumstances.

Conclusion – best practice in the current market

Listed entities clearly need to err on the side of caution in the market environment - at the same time being mindful not to mislead the market through premature disclosure. If a listed entity finds that a review event has already been triggered or its debt financing facilities are unable to be extended, and it has not previously disclosed sufficient information to the market regarding such a possibility, it is at serious risk of allegations that it has breached its continuous disclosure obligations. Directors of a listed entity need to ensure that, when faced with a spectrum of challenging issues, including the actual solvency and financial viability of an organisation, disclosure obligations are not overlooked.

The approach which listed entities need to take can be summarised as follows:

• When a new material financing arrangement is entered into: Disclosure should include information about important terms such as the amount borrowed or available, and when it is due to be repaid or refinanced.
• Existing financing arrangements: Listed entities should be confident that existing financing arrangements have been sufficiently disclosed in the context of changing market conditions. They should regularly review and carefully monitor any terms that may be activated on the occurrence of certain events (particularly events beyond the control of the entity, such as market events). Such events may be obvious ones, such as market capitalisation triggers, or less obvious, such as the potential triggering of leverage or interest covenants as a result of movements in exchange rates applicable to foreign currency loans.¹⁷ Further disclosure may be required when the term becomes likely to be activated.¹⁸
• Refinancing risk: An entity should seriously consider disclosure if it becomes apparent during the term of a debt facility that:

• Classification of debt in financial reports: Listed entities should ensure that the terms of all of their financing agreements are carefully reviewed and accurately reflected in the classification of those financing arrangements as current or non-current liabilities in accordance with AASB 101.
• Address refinancing as early as commercially feasible: It goes without saying that all listed entities would be taking a "call your bank manager before he calls you" approach in the current market, if their circumstances allow it. The benefits of engaging in refinancing early can be illustrated by that fact that, when Crown Limited recently completed major refinancing almost two years ahead of the expiry date of its existing debt facility, its shares rose 10 percent in a day.¹⁹

Thanks to Holly McDonell for her help in writing this article.

Footnotes

1 A Deutsche Bank report noted this month that $84 billion worth of corporate debt is to be refinanced in Australia over the next two years, quoted in "Big Four poised to take over commercial lending", The Australian, December 11 2008

2 See ASX Listing Rules 3.1, 3.1A and 3.1B, Corporations Act 2001 (Cth) Chapter 6CA, sections 674-678.

3 See, for example, ASX Companies Update 02/08, "Important Information for Listed Entities", 29 February 2008.

4 Belinda Gibson, ASIC, "Lessons learnt from market volatility and sub-prime" speech delivered to Innovate 08 IFSA Conference, 7 August 2008

5 Corporations Act, section 296

6 Belinda Gibson, ASIC, "Capital Markets Updated" speech presented to the Australasian Investor Relations Association 2008 Annual Conference, 27 November 2008

7 Corporations Act sections 670A(2), 728(2) and ASIC Act section 12BB(1).

8 Sections 1041H of the Corporations Act and 12DA of the ASIC Act prohibit misleading and deceptive conduct in relation to financial services and financial products (including shares and other listed securities). Section 1041I of the Corporations Act and 12DA of the ASIC Act provide that a person who suffers loss or damage as a result of the contravention may recover that loss or damage from the entity that contravenes the section.

9 Oz Minerals Limited, ASX Release, Response to ASX Price Query, 3 December 2008

10 Oz Minerals Limited, ASX Release, "Updated Financial Information", 4 December 2008

11 Ibid

12 Oz Minerals Limited, ASX Release, Response to ASX Price Query, 19 November 2008

13 Oz Minerals Limited, ASX Release - "Oz Minerals to defer projects and cut operating costs", 25 November 2008

14 Oz Minerals Limited, ASX Release, - Request for Voluntary Suspension, 1 December 2008

15 ASX letter to OZ Minerals Limited- "OZ Minerals Limited - Debt refinancing" ,2 December 2008

16 ASX Release, Oz Minerals Limited, Response to ASX Debt Refinancing Query, 3 December 2008

17 See for example, ING Office Fund, ASX Release, "Capital management presentation", 5 December 2008

18 See ASX Companies Update 02/08, "Important information for ASX Listed Entities", 29 February 2008

19 Crown Limited, ASX Release: "Crown completes major refinancing", 4 December 2008

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.