Issues for financial intermediaries on equity capital markets transactions in the present environment
Stressed issuers need access to capital quickly, with the minimum of process and disruption. At the same time as meeting issuer’s objectives, financial intermediaries have to contend with duties to regulators, reputational issues and maintaining relationships with the buy-side, as well as a myriad of internal policies and procedures. In one sense, those challenges are no different from those faced in a normal capital markets environment but the current situation throws them into sharper relief.
This article explores some areas that financial intermediaries should consider particularly carefully in the current environment and covers:
- working capital;
- financial position and prospects procedures;
- underwriting and placing agreements; and
- advising clients on fundraising structures.
The Covid-19 pandemic has made forecasting cash flows highly challenging. Without knowing when lockdown and social distancing measures are going to be eased and in what form, it is difficult for many issuers to make working capital statements where they are required to do so. A similar challenge exists for sponsors, who on an application for listing/for the production of a class 1 circular are required to give a working capital confirmation to the Financial Conduct Authority (FCA) in their sponsor’s declaration.
The FCA has recognised the current difficulty and, in a technical supplement released on 8 April 2020, confirmed that on a temporary basis issuers may, in certain circumstances, disclose in an unqualified working capital statement their key assumptions in relation to business disruption during the coronavirus crisis underpinning the “reasonable worst case scenario” that must be modelled in support of the working capital statement.
In light of the FCA technical supplement sponsors should, when reviewing working capital statements and their supporting models, among other things:
- consider carefully with the issuer whether any coronavirus related assumptions need to be made in relation to the reasonable worst case scenario;
- if such assumptions are made:
- appropriately challenge and interrogate the reasonableness of those assumptions and any
- sensitivities applied;
ensure that there is no language included in the assumptions which:
- does not relate to the uncertainty around coronavirus assumptions in the reasonable worst-case scenario and which appears to qualify or disclaim the working capital statement; or
- are otherwise prohibited by the technical supplement;
- ensure that the form of wording on the basis of preparation set out in the technical supplement follows the working capital statement; and
- consider whether a negative or qualified working capital statement would be more appropriate.
In all circumstances, early engagement and consultation with the FCA is recommended.
In addition, financial intermediaries should be aware that it is likely to be more difficult for reporting accountants to give working capital comfort in the present environment. Situations may arise where reporting accountants cannot provide working capital comfort on transactions where they normally would, as well as comfort (whether in reports or comfort letters) being provided in a more qualified or caveated form than would be customary.
Although on a secondary issue a sponsor is not (in the sponsor’s declaration) required to give a confirmation in relation to financial position and prospects procedures of the issuer, sponsors should , not least from a reputational perspective, nonetheless ensure that the issuer’s financial position and prospects procedures remain appropriate.
The Covid-19 pandemic has resulted in many issuers working in a different way from previously. Certain procedures may not be capable of being operated outside of the office.
Adjustments to procedures may need to be made to cover unusual situations, such as the absence of large swathes of the workforce, and different aspects of the business may need to be monitored on a more regular or different basis. Accordingly, sponsors should consider stress-testing the financial position and prospects procedures of issuers and consider whether they need revised comfort, whether from the issuer or, more formally, from reporting accountants.
Although financial intermediaries are not specifically “persons responsible” for the formal disclosure documents published in connection with capital markets transactions, or otherwise accept responsibility for them, they have a keen interest in ensuing that disclosure is accurate, not least because:
- the investors they have procured will rely on such information, with the attendant reputational consequences if that disclosure is incorrect or misleading; and
- a sponsor has to make a declaration in the sponsor’s declaration on an application for listing that it has come to a reasonable opinion, after having made due and careful enquiry, that the issuer has satisfied all applicable requirements set out in the prospectus rules.
The Covid-19 pandemic most obviously affects disclosure in relation to risk factors, use of proceeds and forward-looking statements, such as current trading and outlook and use of proceeds. First, in relation to risk factors, the FCA has said in its technical supplement on working capital that, in most cases, it would expect issuers and their advisers to conclude that a risk factor on coronavirus-related disruption is necessary, perhaps addressing risks due to uncertainty as to duration and severity of impact. The ESMA guidelines on risk factors under the Prospectus Regulation, applicable from 4 December 2019, make clear that, among other things, risk factors must be drafted specifically as regards the issuer and must not be generic. In order to satisfy themselves as to the adequacy of disclosure in the disclosure document in coronavirus related risk factors (and other coronavirus related disclosure), financial intermediaries should consider asking issuers to produce a coronavirus risk assessment addressing the key areas of risk to the business and likely impact.
Forward-looking statements are particularly challenging in times of great economic and social uncertainty. Financial intermediaries should therefore challenge issuers on statements that appear too categorical and make sure they are appropriately drafted: the verification exercise conducted by issuer’s counsel and reviewed by the financial intermediaries’ counsel will be particularly important in relation to these statements.
Finally, financial intermediaries should consider carefully with issuers the use of proceeds language in the disclosure documents. For example, if the proceeds of the raise are for a non-coronavirus related purpose, does the issuer want to reserve the right to use some of the proceeds for a different purpose if a coronavirus related risk materialises? Those discussions will also need to be factored in to discussions on working capital.
Financial intermediaries will need to consider their total risk exposure when underwriting, as it will have an impact on their regulatory capital position. That is particularly true at a time when banks are exposed to quality of capital issues resulting from Covid-19 issues in other parts of their business, such as loan repayment holidays. We expect step-up rights (in the event of an underwriter default) to be a commonly debated point on underwriting agreements in the next few months where there is an underwriting syndicate. Similarly, sub-underwriting is likely to be a significant feature of the market, as banks seek to off-lay risk at a time where they are exposed to genuine and considerable market risk.
Although seldom exercised, the termination rights in underwriting agreements should be considered very carefully in the light of the current pandemic. In addition to any issuer-specific provisions (for example if applicable, shareholder approval for the transaction), the “typical” suite of termination rights includes a market MAC, an issuer MAC, a right to terminate for misstatements in disclosure documents, upon an obligation arising to publish a supplementary prospectus, for breach of the agreement and of warranty and where there is a refusal of the application for admission. While these rights are widely drawn, they in reality may be more difficult to exercise than may appear on their face. In particular, financial intermediaries should be aware that:
- while certain of the termination rights in underwriting agreements are expressed to be exercisable in the opinion of the banks, there is usually a requirement in exercising the provision for the financial intermediary to act in good faith. Case law suggests that the exercise of good faith is not wholly subjective: it contains both subjective and objective elements. For example, in CPC Group v Qatari Diar Real Estate Investment Company  EWHC 1535, commentary on the use of the term “good faith” suggested that parties must “observe reasonable commercial standards of fair dealing, and to be faithful to the agreed common purpose, and to act consistently with the justified expectations of [the other parties].”;
- the factual circumstances surrounding the exercise of termination rights are likely to be relevant to the assessment of acting in good faith. For example, if a development relating to the Covid-19 pandemic was in fact reasonably foreseeable at the time of entry into the underwriting agreement, it will make it more difficult for a financial intermediary to argue that it is acting in good faith if it then relies on that development to terminate the underwriting agreement;
- financial intermediaries may, therefore, depending on the circumstances find themselves in a position where they cannot be absolutely sure that the exercise of a termination right will be held to be valid by a court. The invalid exercise of a termination right could have very serious reputational issues (as well as legal costs and damages); for example, if the consequence of the purported exercise of the termination right for the issuer were to be insolvency (there will be a significant number of issuers in the present environment who will need to raise capital for viability reason); and
- termination rights that are precise and objective are more likely to be capable of valid exercise than generally expressed ones. In that context, financial intermediaries could consider setting out more specific, objective circumstances in which they would have a termination right. In addition, given that breach of warranty typically gives rise to a termination right (albeit generally qualified by some form of materiality), financial intermediaries should consider whether the warranty package contains sufficient specific and objective warranties and whether additional warranties should be added to address not only the particular nature of the issuer’s operations but also the prevailing circumstances.
Financial intermediaries may also wish to consider the length of lock-ups in underwriting agreements: uncertain markets, it may be particularly important for investors to know that issuers will not be coming back to the market for longer periods.
In current times, speed of execution and costs minimisation are particularly important to clients. The following may assist financial intermediaries in devising structures that achieve the same.
Non pre-emptive offers
While the Pre-emption Group (PEG) has been a strong advocate over the years for the safeguarding of pre-emption rights, it has recognised (in an announcement made on 1 April 2020) that, in these exceptional times, investors clearly want the companies in which they are invested to have access to the capital they need in order to maintain their solvency.
In that announcement, PEG recommended (on a temporary basis until 30 September 2020) that investors consider, on a case-by-case basis, supporting issuances by companies of up to 20 per cent. of their current issued share capital (being the annual look-back threshold below which a prospectus is not required). That, on its face, would seem to make securing support for structures such as cashbox placings (which are structured as issues for non-cash consideration, so statutory pre-emption rights are not applicable) more straightforward where such cashbox placings do not exceed 20 per cent of issued capital. Issuers typically take authority to allot over one-third of their issued share capital at annual general meetings and so such a cashbox placing could be effected without the need for further shareholder approval.
PEG has set out its expectations if this additional flexibility is sought, which is likely to affect the approach taken by financial intermediaries, particularly as regards wall-crossing and allocations, and possibly provisions in the underwriting/placing agreement. PEG expects:
- the particular circumstances of the issuer to be fully explained, including how they are supporting their stakeholders;
- proper consultation to be undertaken with a representative sample of the issuer’s major shareholders;
- the issue to be undertaken as far as possible on a soft pre-emptive basis; and
- management of the issuer to be involved in the allocation process.
The €8m exemption
Fully pre-emptive offerings will typically require a prospectus. However, section 86(1)(e) of the Financial Services and Markets Act 2000 (FSMA) provides for an exemption to the requirement to produce a prospectus under section 85(1) FSMA (public offers). The exemption applies where the total consideration for the transferrable securities being offered does not exceed €8m (or an equivalent amount). In circumstances where a prospectus is not otherwise required under section 86(2) of FSMA (application for admission to trading on a regulated market), the €8m euro exemption could either be used to make a fully pre-emptive offer up to that amount or be reserved to the financial intermediary to satisfy demand from investors who are not qualified investors (known as a broker option).
The United States has the largest, deepest pools of capital in the world. It is therefore frequently desirable for UK issuers to make some form of US offering. The Rule 10b-5 (anti-fraud) opinion often required by underwriters on Rule 144A offerings is, however, time-consuming, expensive and invasive for management. Recently however, in (typically smaller) UK offerings financial intermediaries have more frequently relied on private placing exemptions, such as under Section 4(a)(2) of the Securities Act of 1933, which provides an exemption for an issuer not involving any public offering. Financial intermediaries are more easily able to get comfortable that they do not need a 10b-5 opinion largely on the basis that these transactions not involve re-sales and by obtaining so-called “big-boy” letters from US investors.