Changes to the Continuous Disclosure requirements

The Federal government is planning to introduce permanent changes to the continuous disclosure obligations in the Corporations Act 2001.  These changes will affect all ASX-listed entities and unlisted disclosing entities.[1]

Broadly, the disclosure rules require regulated entities to disclose materially price sensitive information to the market.   This was a ‘reasonable person’ or objective test.  In May 2020, the government introduced temporary changes to these rules, to address the economic uncertainty accompanying the COVID pandemic.   These temporary changes introduced a fault based element.  Namely, to incur a civil penalty for failure to disclose information, the entity must know, or be reckless or negligent as to whether that information is materially price sensitive. These changes principally affect legal liability for forward looking statements such as profit forecasts.  The regulatory intention was to shield companies from liability where targets are not achieved, relevantly as a result of the pandemic.

The government now proposes to make these changes permanent.  It also proposes to introduce parallel and consequential changes to the general law relating to misleading and deceptive conduct.  These laws were not modified in the existing temporary amendments.  They will now change to require the same fault element to make out misleading or deceptive conduct in connection with a breach of the continuous disclosure obligations.

However, companies may still incur ASIC-issued infringement notices and non-financial penalties for contravention of the disclosure obligations on a no-fault basis.  This is intended to ensure that there is no change in the standard required of companies and officers.

Effectively, companies and officers will need to comply with both the reasonable person test and the fault elements.  In practice, we believe there will probably be no major changes to best practice in relation to continuous disclosure obligations, in particular with respect to the practical steps which company officers take when releasing earnings guidance or other forward looking statements (see Takeaways below).  The new laws are intended to deter class actions.  There is vigorous debate about the changes’ ramifications in this respect: some fear that they water down corporate responsibility and accountability; others believe the changes will reduce defensive administrative costs and discourage a burgeoning suite of class actions.  Additionally, there may be a shift towards ASIC relying more on its infringement notices powers than pursuing court action.

 What is new?

Prior to May 2020, civil penalties applied if an entity failed to disclose information that was not generally available, and that a reasonable person would expect to have a material effect on the price or value of the securities of the entity.

Under the amendments, civil penalties only apply if there is also a proven element of “state of mind” i.e. the person or entity must also be shown to:

• know;
• be reckless; or
• be negligent

as to whether the information is materially price sensitive.

As above, the requisite mental elements (knowledge, recklessness or negligence) must now be proven in a charge of misleading and deceptive conduct based on contravention of the continuous disclosure obligations.

State of mind will be considered for both civil and criminal penalties.

How to establish each of the fault elements

The Bill’s Explanatory Memorandum clarifies the legal approach to establishing each of these fault elements.

Knowledge

An entity knows information would have a material effect on the price or value of its …securities if it knows that the information would, or would be likely to, influence persons who commonly invest in securities in deciding whether to acquire or dispose of [those] securities.[2]

Recklessness or negligence

An entity is reckless or negligent with respect to whether the information would have a material effect on the price or value of its enhanced disclosure securities if it is reckless or negligent with respect to whether the information would, or would be likely to, influence persons who commonly invest in securities in deciding whether to acquire or dispose of the enhanced disclosure securities.[3]

What hasn’t changed:  infringement notices and non-financial penalties

Infringement notices issued by ASIC will not require consideration of the mental element.  ASIC may issue infringement notices or take non-financial enforcement actions on a ‘no-fault’ basis.

The government asserts that advantages of retaining the no-fault standard for ASIC to pursue include that the insurance premiums should not rise in response to fault-based penalties, and that ASIC will be able to penalize and deter minor infractions of the continuous disclosure rules without undertaking lengthy procedures.  Further, having two regimes operating should effectively create a sliding scale of penalties, which should be proportionate to the severity of the infringement.

Effectively, there has been no change in the standard that companies and officers are expected to uphold, and ASIC retains in its toolkit means of engaging with, fining, and publicly rebuking, companies and officers without proving a fault element.

Table 1:  Comparison of previous, current and proposed provisions for Continuous Disclosure obligations

Legislation	Provisions	Source
Previously	If a listed disclosing entity has information that those provisions require the entity to notify to the market operator; and that information is not generally available; and is information that a reasonable person would expect, if it were generally available, to have a material effect on the price or value of ED securities of the entity; the entity must notify the market operator of that information in accordance with those provisions.	Corporations Act 2001 (Cth) s674(2)
	(= “objective test”)
Current temporary (and proposed permanent) changes)	If a listed disclosing entity has information that those provisions require the entity to notify to the market operator; and the information is not generally available; and the entity knows, or is reckless or negligent with respect to whether, the information would, if it were generally available, have a material effect on the price or value of ED securities of the entity; the entity must notify the market operator of that information in accordance with those provisions.	Corporations (Coronavirus Economic Response) Determination (No. 4) 2020 Treasury Laws Amendment (2021 Measures No.1) Bill 2021
	(= “objective test” + “fault elements”)

 

Why are these changes being made permanent?

Initially, the changes to the continuous disclosure obligations were temporary modifications to counteract economic uncertainty during the pandemic, to provide some protection against class actions for directors and entities who might have “got it wrong” during such unpredictable times.

Subsequently, the Parliamentary Joint Committee on Corporations and Financial Services completed a report on litigation funding and regulation of the class action industry (PJC Report). The PJC Report recommended permanent legislation of the temporary measures.  The reasons underlying this recommendation included:

• to halt the trend of increasing frequency of securities class actions, which are often based on allegations of contraventions of the continuous disclosure obligations. Class actions (effectively) transfer funds from shareholders to third parties, including by payment of legal costs and settlement costs.  Entities can also face increased insurance premiums as a result of class actions.  There is a trend to an increasing number of class actions in Australia, but interestingly absolute numbers remain relatively low;
• to reduce the compliance burden, in terms of cost and time, on entities and directors;
• to more closely align Australian legislation with the UK and US approaches;
• to address the conjunctive aspects of the continuous disclosure obligations and misleading and deceptive conduct: i.e. failure to disclose must have a proven element of “fault” (knowledge, recklessness or negligence) to lead to a charge of misleading and deceptive conduct.

The government has adopted the recommendations to make permanent the state of mind, or fault, element, and the Bill is currently before parliament.

Will the legislation achieve its aims?

There is presently a clear division between the response from businesses and those who regulate them and class action litigators.

Proponents for these changes point out that, during the 6 months in which the continuous disclosure changes were temporarily in place, there the number of material announcements to the market increased relative to the previous year.  However, this isolated data probably does not reflect how permanent legislation will affect disclosure rates.

Will the changes achieve their stated aim of reducing class actions?  Under the previous rules, a successful action required the person bringing it to demonstrate what a reasonable person should have done in those circumstances.  This is essentially an objective test.  Under the new rules, there is now no basis for a claim for either unless a fault element (i.e. one of knowledge, recklessness or negligence) can be demonstrated.

At a superficial level, it is clear the requirement to show a fault element will require additional work make out a case.  Whether this will change the results in litigated cases is however less certain.  For example:

• As regards misstatements of present fact – we suspect legal outcomes will be more or less the same despite these changes. For example, if a regulated entity incorrectly reports it has signed a key contract without any basis for asserting this, it is difficult to see how this could be excused. [5]
• We believe the main intended impact of these changes is on liability for forward looking statements, for example, where a regulated entity releases a forecast of its projected financial performance which it then fails to meet. Such cases are likely to turn on whether those responsible for the statement were reckless or negligent in the first place.
• Opponents express concern that the legislation encourages “honest ignorance”. Instead of motivating directors to probe for information of which they should be aware (as per the current provisions), critics say superficial diligence will suffice and possibly protect them from incurring civil penalties. Some claim these changes will effectively shield entities from responsibility for these misstatements.
• A related concern is that “negligence” has not been legally defined in this context, and is untested, (yet extremely important in preventing the potential development of willful ignorance).

Takeaways

ASIC has previously provided some helpful guidance on when prospective financial information should be disclosed.[6]    ASIC stresses that prospective financial information should be issued only when that information is based on reasonable grounds.  Factors that may indicate reasonable grounds are very much contextual, but include:

• independent industry expert reports;
• reasonable short-term estimates;
• identification and assessment of the reasonableness of all material assumptions.

An opinion, or subjective state of mind, is generally considered inadequate for this purpose. In our view, this guidance should remain best practice notwithstanding the changes above.  First, if the entity rigorously checks and verifies the assumptions underlying its projections, the chances of being wrong must be lower than otherwise.  No harm, no foul.  Secondly, we find it difficult to imagine how an entity can be said to have been negligent or reckless if it takes these steps.

Whatever these concepts may ultimately prove to mean in this context, we believe that the standard expected of officers and companies is unchanged.  Strict liability deterrents (infringement notices and non-financial enforcement actions by ASIC) remain, with concomitant risk of damage to a company’s public perception for any failure in compliance with the continuous disclosure obligations.

[1] ASIC Regulatory Guide 198 provides information about unlisted disclosing entities.   They include bodies (mostly companies) with 100 or more members holding securities as a result of issues under a disclosure document, or as consideration for an acquisition under an off-market takeover bid or Pt 5.1 compromise or arrangement; and disclosing entities whose securities are quoted on a prescribed financial market but where the issuer itself is not admitted to that market’s official list.

[2] Source: Treasury

[3] Source: Treasury

[4] Enhanced disclosure

[5] Interestingly, in the recent Federal Court case ASIC v Big Star, the Court took the position that the director should have known and disclosed certain information to shareholders.  This was based on the objective test that a reasonable person would have been influenced by the information, and the director should have realized this.  Under the new provisions, a director would have to be found negligent or reckless in failing to disclose the information (i.e a fault element would have to be proven).

[6] ASIC Regulatory Guide 170