The Guidelines on Risk Factors under the new Prospectus Regulation that were published by the European Securities and Markets Authority (ESMA) earlier this year have now come into force on 4 December 2019. The Guidelines are to be used by the Financial Conduct Authority (or other relevant competent authority) when considering the specificity and materiality and of the presentation of risk factors across categories in a prospectus being submitted to it for its approval.
ESMA has noted that, in recent years, prospectuses have suffered from "size inflation" which "may be directly attributable to the inclusion of large quantities of information surrounding each risk factor…which may obscure the comprehensibility of a prospectus". Issuing companies have tended to follow a trend of seeking to make disclosure in a prospectus of all potential risks that may be relevant to the company and/or the transaction, no matter how obtuse or inconsequential, in order simply to limit its perceived exposure to liability. However, as specified in Recital 54 of the new Prospectus Regulation, the real purpose of including risk factors should be to ensure that investors can assess the relevant risks related to their investment and that they can, therefore, make informed investment decisions in full knowledge of the facts. Risk factors should therefore be limited to those risks which are material and specific to the issuer and/or its securities and which are corroborated by the content of the prospectus.
With a view to tackling this issue, ESMA prepared a set of guidelines under the powers granted to it under the new Prospectus Regulation for competent authorities to take into account as part of their prospectus review and approval process.
Following its review of a submitted prospectus, the FCA may request amendments where the standards envisaged by the Guidelines are not met and ultimately, it can choose to reject the prospectus. As such, risk factors will need to be drafted in accordance with the contents of the Guidelines and practitioners will therefore need to take note of them.
Reflecting Article 16(1) of the Prospectus Regulation, ESMA's guidelines are set out in six key headings and are supplemented by a number of explanatory paragraphs, which are as follows:
In its guidelines, ESMA noted that there is currently a culture of including generic risk factors which fail to serve any purpose in terms of identifying legitimate risks faced by the issuing company. ESMA is of the opinion that the wording detailing such risks is often extracted from other documents. As such, generic risks are deemed to act only as disclaimers, thus cause lengthy, non-specific risk factor sections which obscure the genuine risks faced by the company. In order to cure this drafting habit, ESMA recommends that prospectuses are now drafted so that there is a "clear and direct link between the risk factor and the issuer".
The relevant competent authority should consider the materiality of risk factors contained in the prospectus. Whilst it is not required to assess the level of materiality per se, the FCA must ensure that the materiality of the risk factor is apparent from the disclosure. In order to achieve this outcome, ESMA's guidelines recommend that any potential negative impact associated with the risk factor should be disclosed. To achieve this, issuers could provide quantitative or qualitative information to clearly demonstrate how material a risk factor is.
It is further noted that the inclusion of mitigating language in a risk factor may compromise materiality and should therefore be avoided, save for in instances where it is "used to illustrate the probability of occurrence or expected magnitude of negative impact". In the guidelines, ESMA has sought to explain this through the use of the following example: when an issuer has adopted a set of risk management policies, an issuer should assess the materiality of the risk (taking into account the risk management policies).
Corroboration of the materiality and specificity
The importance of the materiality and specificity should be corroborated by the overall picture presented by the prospectus. Whilst the guidelines state that this is not necessarily required in all cases, in practice one would expect consistent language used throughout and therefore this requirement should be satisfied.
Presentation of the risk factors
Consistent with the theme of risk factors being made clearer for investors, the fourth guideline notes that risk factors should be presented in a way to aid investors in navigating the risk factor section of the prospectus. In order to achieve this, risk factors should be:
- a grouped and categorised and within each category; and
- b ordered in a manner to support comprehensibility.
When grouping the risk factors, appropriate headings should be included which "reflect the nature of the risk factor". Sub-categories can be included but they should be appropriate and not disproportionate to the size and complexity of the transaction. Categories should not be included where they are not relevant and category headings should be limited to no more than ten in number (unless there is fair justification as to why more are required).
Focused/concise risk factors
Historically, there has been a trend of drafting lengthy risk factors which often include an unnecessary level of detail and background information, neither of which add to the understanding of the risk in question. As such, guidelines now suggest that risk factors should be drafted concisely.
Risk factors in the summary
As a drafter might expect, any risk factors mentioned in the summary section of the prospectus must be consistent with the risk factor section in the main body of the prospectus. This is not to say that all the risk factors have to be repeated in the summary section; only those which are deemed particularly noteworthy.
Conclusions and observations
ESMA's Guidelines will certainly address the issue of over-lengthy risk factors that have historically been creeping into the prospectus. It will be interesting to see how the interplay of issuers wishing to reduce their liability through the inclusion of widely and extensively drafted risk factors with the FCA's approach under the new Guidelines plays out. From our own team's experience from working on current Main Market listings, Risk Factors are under much greater focus now by the FCA when undertaking their review and approval of a prospectus. As such, we recommend a careful review of risk factors in light of the ESMA Guidelines before the draft prospectus is submitted to the FCA.