UK: The Davies Review: Issuer Liability For Misstatements To The Market

The Final Report by Professor Paul Davies QC on "Issuer liability for misstatements to the market", following up the March 2007 Discussion Paper, was published on Monday 4 June 2007. The Report, and copies of the submissions on the points raised in the Discussion Paper, is available at http://www.hm-treasury.gov.uk/davies.

The Report, and the earlier Discussion Paper, follow the Treasury’s promise in October 2006 to re-consider the new statutory compensation regime imposing liability on issuers in respect of damage or loss suffered as a consequence of inaccurate, false or misleading information disclosed by issuers to financial markets, as set out in Section 90A of the Financial Services and Markets Act 2000 ("FSMA"). This liability regime took effect on 20 January 2007 (for financial years beginning on or after that date), and gives investors the right to claim compensation for losses caused by untrue or misleading statements in (or omissions from) "periodic (ie financial reporting) disclosures" where these are made knowingly or recklessly. Perhaps more significantly, Section 90A eliminates any other liability (save for civil/criminal penalties) in respect of the same losses.

The Section 90A regime was introduced in part to satisfy the requirements of the EU Transparency Directive on liability for financial reporting disclosures pursuant to the Directive, and in part to allay the fears of issuers and their advisers that the effect of implementation of the Transparency Directive in the UK would be to undermine long-established principles of common law that, as a general rule, issuers, directors and auditors have no liability to investors for inaccurate or misleading disclosures in annual accounts. The purpose of such disclosures is to assist shareholders in exercising their "stewardship" rights, not to provide a basis for claims by investors.

Consultation on the proposed regime in July/August 2006 elicited concerns to the effect that the regime, although helpful in many respects, failed to deal with the issues comprehensively. A key criticism raised by respondents to the 2006 consultation was that it would often be a matter of chance as to whether financial reporting disclosures were made under the umbrella of the statutory compensation regime (ie within documents produced pursuant to the requirements of the Transparency Directive) or under the wider and less certain common law liability regime for "ad hoc" market announcements. This presented a confusing and illogical framework for both issuers and investors.

When Section 90A was inserted into the FSMA, therefore, a power was taken to make adjustments by statutory instrument to the statutory compensation regime it introduced, following completion of the promised review. We can therefore assume that, after some time is taken to consider and digest Professor Davies’ recommendations, the Treasury will consult on proposals to adjust the Section 90A statutory compensation regime in line with Professor Davies’ recommendations.

The key recommendation – fraud or negligence?

The key question, the answer to which determines the answer to a number of the other questions addressed in the Discussion Paper, is whether issuers should have liability under the compensation regime for untrue or misleading statements (or the omission of material information) on the basis of fraud only, or whether the threshold for liability should be set at negligence.

Professor Davies also floated the idea of a "half way house" – in the form of "gross" negligence, although dismisses this as "a new and untested standard", which would "create legal uncertainties and risk the same problems of defensive reporting and speculative litigation as simple negligence". The recommendation is that the threshold for liability should remain fraud – knowingly or recklessly making an untrue or misleading statement – for three principal reasons:

• the Financial Services Authority’s enforcement regime for directors and issuers, which is set at the negligence threshold, already acts as a significant deterrent to careless reporting;

• negligence is a ‘’fact dependent’’ standard of liability, which would make general guidance difficult, leading to the inevitable consequence of defensive and bland reporting;

• a civil liability regime based on negligence would risk a multitude of "unmeritorious claims" for large sums – which a fraud-based regime would not (on the basis that fraud is significantly more difficult to establish than negligence).

The concern of many who responded to the Discussion Paper was that, by adopting the fraud threshold for liability to investors, existing rights of shareholders to claim for negligence would be prejudiced. Davies strongly recommends that existing shareholder rights should remain unaffected by the new regime – except to make it clear, to the extent necessary, that this is the case. This would go some way to appease those investor bodies who feel that the threshold for liability is set too high under the statutory regime.

The key recommendations from the Report, following on from the overriding principle described above, are as follows:

Ad hoc disclosures: The statutory compensation regime should be extended to cover "ad hoc disclosures’’ (announcements of "inside" and other information made to the market by issuers through their Regulatory Information Service (RIS) on the basis that:

• some ad hoc disclosures will later appear in periodic reporting disclosures required by the Disclosure and Transparency Rules (DTRs);

• it is confusing to have different liability regimes for what is effectively the same disclosure, depending on the means by which it is made available to the market; and

• issuers and investors alike see no reason to draw a distinction between ad hoc and periodic disclosures in terms of liability.

The overwhelming view of respondents to the Discussion Paper was that the regime should extend to all (and not some only) of an issuer’s RIS announcements, regardless of the obligation (if any) which leads to the disclosure. Professor Davies has accepted this issue in making his recommendations.

Disclosures by issuers on exchange-regulated markets (eg AIM and PLUS): The statutory compensation regime should be extended so as to apply to financial and ad hoc reporting disclosures by issuers of securities trading on exchange-regulated markets, including AIM and PLUS – and even beyond that, to all other trading platforms for securities. This is on the basis that, whilst investors in these markets should accept the risk of lower levels of disclosure than on the main market, they should nevertheless be protected from dishonest disclosure.

Liability for dishonest delay: Despite the majority of responses (22 out of 29) being against this proposal, Davies recommends that the statutory compensation regime should be extended to encompass liability for dishonest delay in making RIS statements, on the basis that where the purpose of the delay is fraudulent, this should be subject to claims for damages by investors. Davies acknowledges that the need to define dishonesty appropriately is the key requirement of this proposal, and draws a parallel with Section 397 of FSMA, which imposes criminal liability for dishonest concealment of material facts but only if the concealment is "for the purpose of inducing someone to take, or not to take, a certain course of action". He also suggests that the concept could be refined further, so that the prohibited purpose could be defined as "making a profit on behalf of the defendant or inflicting a loss on the person who acquired the security during the period of delay". This relatively narrow definition of dishonesty will provide some comfort to the many respondents who voiced concerns that liability for delay – even if only on a dishonesty basis – could expose issuers to a risk of litigation where investors had purchased shortly before the publication of an announcement and were able to show deliberate delay by the issuer and its directors. Respondents feared that the consequence of such potential liability would be either to reduce the level of disclosure, or to degrade the quality of disclosure as issuers sought to avoid accusations of delay by releasing less complete information prematurely.

Protection for sellers: At present, the compensation regime is only available for investors who buy shares or other securities in reliance on false or misleading statements. Professor Davies proposes the extension of the statutory regime to sellers as well as buyers, on the basis that sellers, in principle, should not be excluded from claiming for losses suffered in circumstances where buyers would be able to claim. However, although acknowledging the difficulty of the issue, Professor Davies recommends the exclusion of those who continue to hold (or do not buy) shares or securities from suing in respect of misstatements in RIS announcements.

Areas where Professor Davies recommends no change to the statutory compensation regime under Section 90A at present are:

• confining statutory liability to issuers only, so that no statutory liability to third parties will be imposed on directors in respect of misstatements in RIS announcements – on the basis that this is not necessary, for deterrent purposes, to encourage appropriate behaviour by directors;

• leaving the assessment of damages to the Court, on the grounds that it is too difficult to formulate effective rules in statute which would not tie the Court’s hand in an undesirable way in handling particular cases;

• the question of subordination of investors’ claims under the compensation regime to those of unsecured creditors – the Government is encouraged to review this issue at a later date, in part because of the ramifications outside the area of securities legislation.

Professor Davies also considered the potential for UK issuers to be subject to claims by investors in jurisdictions other than the UK – the current liability regime addresses only the position so far as claims brought by investors in the UK are concerned. Professor Davies suggests that there should be a single legal regime applied to investor claims (he does not specify whether he thinks this should be across Europe, or globally) – possibly the law of the jurisdiction where the issuer is incorporated, or the law of the jurisdiction where the issuer has its primary listing. On the basis that this is outside Professor Davies’ terms of reference, he does not deal with this in any detail, but raises a flag for the Government that this point should be addressed in the context of a pan- European securities market. However sophisticated – and fair – the UK liability regime following implementation of Professor Davies’ recommendations, it would be disappointing if the resulting regime was seriously undermined by the possibility of litigation initiated against UK issuers in other EU Member States.

Professor Davies’ recommendations are likely to be welcomed by issuers, directors and investors – with some reservations (on the part of issuers and directors) in respect of the prospect of liability for dishonest delay in making RIS announcements. However, Professor Davies has gone to some lengths to make even this proposal palatable to its opponents by significantly narrowing the circumstances in which liability may arise.

The recommendations recognise many of the valid criticisms expressed in relation to the regime that has now found its way into FSMA. However, the basic elements of the regime remain unaffected, which suggest that, in principle, the Government nearly got it right with its first attempt and these fine tuning adjustments should result overall in a better and more acceptable regime, within which issuers and investors can feel comfortable operating in the future. The next step is likely to be draft Regulations implementing some or all of Professor Davies’ recommendations, although it seems unlikely that these will materialise before the Autumn at the earliest.

This article is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts at Linklaters.