The new Prospectus Regulation (EU) 2017/1129 came into full force in July 2019. Among its many features, the New Prospectus Regulation sets out requirements for the disclosure of risk factors in a prospectus.
Risk factor disclosures
It is widely acknowledged that prospectuses have undergone substantial “size inflation” in recent years, reducing their overall comprehensibility. With the objective of making prospectuses more reader-friendly and targeted to the situation of the issuer and its securities, the New Prospectus Regulation requires risk factor disclosures to be limited to material risks that are specific to the issuer and its securities. In addition each material risk factor must be corroborated by the content of the prospectus and be presented in a limited number of categories. In each category, the most material risk factor must be mentioned first.
ESMA was mandated to develop guidelines for competent authorities in reviewing risk factor disclosures, particularly their specificity and materiality and presentation across categories.
The new disclosure standards pose a challenge to securities lawyers, many of whom have ingrained habits acquired from long experience drafting prospectuses in a style where more was better when it came to risk factors. These habits include copying generic risk factors from issuers in the same sector or including extensive mitigating language that leaves a reader uncertain whether any risk remained. The new standards leave no room for lazy or misleading drafting. They also give issuers the confidence to present a simplified and comprehensible picture of the risks they face.
New ESMA guidelines
In accordance with its mandate, ESMA has published guidelines that are addressed to the competent authorities of Member States. The competent authorities are required to incorporate them into supervisory frameworks and consider them when carrying out their duties of prospectus review.
The ESMA Guidelines are organised into twelve specific guidelines covering the following six categories::
Guideline 1 implements the principle that risk factors should be specific to the issuer and its securities by requiring competent authorities to ensure that the specificity of each risk factor is clear from its disclosure.
As with the other guidelines, a competent authority is required to challenge the persons responsible for the prospectus where a disclosure does not establish a clear and direct link between the risk factor and the issuer or its securities.
A risk factor will also be challenged if it appears that it has not been tailored specifically for the issuer. Generic disclosures will no longer be permitted. Even in instances where issuers operating within the same industry and are exposed to similar risks, it is expected that the disclosure will reflect the differences in how those risks affect the issuer. The practice of duplicating “industry standard” risk factors is no longer permitted where it does not additionally reflect an individual assessment of the impact on the issuer in question. The Appendix to the Guidelines provides a couple of illustrative examples of how this requirement can be met in practice.
The principle of specificity is amplified by Guideline 2 which requires competent authorities to challenge the inclusion of risk factors that merely serve as disclaimers. The purpose of risk factors is not to shield the persons responsible for the prospectus from liability. This type of disclosure is rarely issuer or security specific.
The new materiality threshold is intended to limit disclosure to the risk factors that are material for taking an informed investment decision. Guideline 3 requires that, where the materiality of a risk factor is not apparent, the disclosure should be amended to include a clearer explanation of the reasons why it is material to the issuer or its securities.
Guideline 4 emphasises that the potential negative impact of a risk factor should be disclosed where it is not otherwise evident. The Guideline states that the potential negative impact should be illustrated, where possible, using quantitative information, such as by reference to the issuer’s published financial reports. Where quantitative information is unavailable, the materiality of the risk can be described in qualitative terms. This description can include presentation using the low/medium/high materiality scale.
Competent authorities are required by Guideline 5 to challenge the inclusion of mitigating language in disclosures; for example where the mitigating language limits the perception of risk to the extent that the reader is not clear whether there is any remaining risk. In principle, a risk factor should not be rendered obscure or immaterial by mitigating language. At the risk of providing new prospectus boilerplate, ESMA has included an illustration of the kind of mitigating language that might be acceptable in the Appendix to the Guidelines.
Guideline 6 addresses the requirement for any risk factor disclosure to be corroborated by the overall picture presented in the prospectus. This does not mean that each risk factor must be supported by specific corresponding information elsewhere in the prospectus. In some cases, it is sufficient that materiality and specificity can be identified by reference to the overall picture in the prospectus.
The categorisation and ordering of risk factors is supported by Guideline 7 which requires competent authorities to ensure that the sorting of risk factors into categories reflects their nature and supports their overall comprehensibility. It is clarified that risk factors that cross two or more categories should only appear once, and in the most appropriate category.
As required by the New Prospectus Regulation, the most material risk factors must be presented first in each category. However, the Guideline clarifies that it is not mandatory for all the remaining risk factors within each category to be ranked in order of their materiality.
The Guidelines present sample categories for risk factors (which will inevitably become the prospectus drafting default).
The sample categories for risks that relate to the issuer are:
- Risks related to the issuer's financial situation
- Risks related to the issuer's business activities and industry
- Legal and regulatory risk
- Internal control risk, and
- Environmental, social and governance risks
The sample categories for risks that relate to the securities are:
- Risks related to the nature of the securities
- Risks related to the underlying
- Risks related to the guarantor and the guarantee, and
- Risks related to the offer to the public and/or admission of the securities to trading on a regulated market
Guideline 8 clarifies that the presentation of the category headings should appropriately reflect the nature of the relevant risk factors.
Competent authorities are required by Guideline 9 to challenge the number of categories and sub-categories where they are disproportionate to the size or complexity of the transaction and risk to the issuer. The rule of thumb specified here is that competent authorities should challenge the presentation of risk factors across more than ten categories and sub-categories in the case of a single issuer, single security prospectus. Guideline 10 states the circumstances in which sub-categories are justified, following the same principles as for categorisation generally.
Guideline 11 requires competent authorities to challenge risk factor disclosures that are not presented in concise form. A competent authority is required to challenge the length of disclosures to ensure that the materiality and specificity of each risk factor is clear and its presentation is appropriate and focused.
Where a summary has been included in a prospectus, Guideline 12 requires that there should be consistency in presentation between the summary and the risk factors themselves. It is clarified that the summary is not required to include risk factors from all of the categories in the prospectus.
The New Prospectus Regulation puts a renewed focus on limiting risk factor disclosures to those risks that are specific to the issuer or the securities and which are material for making an informed investment decision. The Guidelines implement this objective by requiring competent authorities to challenge the inclusion of generic or immaterial risk factors. Ultimately, the success of this effort will depend on the final judgements of issuers and their directors in assessing their responsibilities and potential liabilities to investors for the accuracy and completeness of the prospectus.
For more information on drafting prospectuses with compliant risk factor disclosures, contact a member of our Equity Capital Markets team.
The content of this article is provided for information purposes only and does not constitute legal or other advice.