22 April, 2017
On 10 April 2017, the Market Misconduct Tribunal (“MMT”) issued its report on CITIC Limited (“CITIC”, formerly CITIC Pacific Limited), and concluded that there was no market misconduct within the meaning of section 277(1) of the Securities and Futures Ordinance (“SFO”).
On 20 October 2008, CITIC issued a profit warning announcement (“Profit Warning”) in respect of losses arising from target redemption forward contracts (“TRF contracts”) and stated that it had been aware of such exposure since 7 September 2008. This appears inconsistent with a circular published on 12 September 2008 which contained a statement that the directors were not aware of any material adverse change in the financial position of the Group since 31 December 2017.
The MMT sets out their first interpretative guidance on the meaning of “no material adverse change”:
- The obligation to announce whether there has been any “material adverse change” under Chapter 14A of the Listing Rules is distinct from the obligation to publish “price sensitive information” under Rule 13.09 of the Listing Rules applicable then.
- The question is whether there has been a material adverse change in the financial circumstances of the company of such deep significance that it has undermined the financial integrity of the company for an enduring period.
Background
The background of this case is familiar to many. In 2006, CITIC acquired mining rights in Western Australia to secure a reliable source of iron ore for its mills in the Mainland. The project to mine and ship iron ore (the “Sino Iron Project”) was budgeted in US dollars but a substantial portion of the capital expenditure required Australian dollars. To hedge its foreign exchange risk, from 2007, CITIC employed a combination of financial instruments, including TRF contracts, referred to in the market as “accumulators”.
In the summer of 2008, the global financial crisis hit and the Australia dollar collapsed, losing 37% of its value in three months commencing in late July 2008 through until October that year. The collapse in the Australian dollar meant that CITIC was obliged to purchase increasing multiples of Australian dollars under the TRF contracts, way beyond what was needed for the operation of the Sino Iron Project, at prices materially higher than prevailing market rates.
On 20 October 2008, CITIC published the Profit Warning, informing the public of the severe losses sustained through the TRF contracts. Based on the valuations then, the mark-to-market loss on that date under the outstanding leverage foreign exchange contracts (of all currencies) was HK$14.7 billion, which was significantly in excess of its actual exposure. CITIC’s share price dropped 55% on the first trading day after the announcement (from $14.52 to $6.52).
The issue
On 12 September 2008, a listed subsidiary of CITIC published a circular in relation to a disclosable and connected transaction (“Circular”). In accordance with the Listing Rules, the Circular contained a “no material adverse change statement” in this language:
“Save as disclosed in this Circular, the directors are not aware of any material adverse change in the financial … position of the Group since 31 December 2017…”
On the other hand, CITIC disclosed in the Profit Warning that it had been aware of the exposure arising from the TRF contracts since 7 September 2008.
This apparent contradiction between the Circular and the Profit Warning led to the MMT enquiry as to whether there was market misconduct within the meaning of section 277(1) of the SFO in the publication of the Circular containing the “no material adverse change statement”. Under this section, market misconduct would be committed if:
- a person, whether in Hong Kong or elsewhere, disseminates or is concerned in the dissemination of information (“the Publication Element”);
- the information is likely to induce dealing in securities in Hong Kong or is likely to maintain, increase, are due or stabilise the price of securities in Hong Kong (“the Market Effect Element”);
- the information is false or misleading as to a material fact or is false or misleading through the omission of a material fact (“the False or Misleading Element”); and
- the person in question knows that, or is reckless or negligent as to whether, the information is false or misleading (“the Fault Element”).
MMT’s findings
The MMT concluded that there was no market misconduct within the meaning of section 277(1). In particular, only the Publication Element, which was undisputed, was established. We look at each of the elements in more detail.
The Publication Element
On 5 September 2008, CITIC’s Company Secretary sent a memorandum to the directors on CITIC’s board requesting them to consider and approve the Circular. In response, all the directors signed and returned the relevant documents. It is not disputed that each of the specified persons in their capacity as directors authorised the publication of the Circular containing the “no material adverse change statement”. On this basis, the MMT found that the publication element was satisfied.
The Market Effect Element
To establish the Market Effect Element, what is required to be demonstrated is that the “no material adverse change statement” was likely to “maintain, increase, reduce or stabilize” the share price of CITIC. The MMT explained that the test is a predictive one, and the question is whether it is probable that the information would have a causative effect in that it would induce the investing public to deal in securities of the listed company and thereby undermine and/or distort the open and honest workings of the market.
In the CITIC case, there was no evidence that the market was waiting on some assurance that the setbacks already identified would not materially affect CITIC’s financial or trading position. Evidence suggested that in the weeks before the publication of the Circular, CITIC shares had largely kept pace with the HSI and continued to do so for at least three weeks after publication. Accordingly, the publication of the “no material adverse change statement” had no influence at all on CITIC’s share price.
The MMT concluded that it had not been demonstrated that the “no material adverse change statement” would have had the effect of maintaining or stabilising the price of CITIC shares.
The False or Misleading Element
To prove the False or Misleading Element, two matters have to be demonstrated: (a) on an objective basis, there was in existence a material adverse change in CITIC’s financial position, not simply a threatened or likely material adverse change but an actual change; and (b) the directors of CITIC were aware of that change.
In determining what constitutes a “material adverse change” in the financial position of a company, the MMT emphasised the distinction between the obligation imposed by the then applicable Rule 13.09 of the Listing Rules for listed companies to announce “price sensitive information” and the obligation to announce whether there has been any “material adverse change” under Chapter 14A of the Listing Rules. The MMT made the following observations:
- The fact that information is price sensitive information does not necessarily mean that it represents a material adverse change to the financial position of a company.
- Price sensitivity is to be viewed through the eyes of an ordinary reasonable investor, whilst the concept of material adverse change is to be determined objectively by looking to the available financial and other relevant information.
- For a material adverse change to a company’s financial position to be demonstrated, the change must be “one of deep significance to that company’s existing financial position, a change that has undermined its financial integrity… it must be demonstrated to be a change that is not merely temporary but is one that, judged in all the circumstances, is a change that will endure, certainly (in the present instance) over a matter of months or longer.” (emphasis added)
- The concept of “material adverse change” is therefore a far more ominous matter than one of price sensitivity. The question is whether there has been a material adverse change in the financial circumstances of the company of such deep significance that it has undermined the financial integrity of the company for an enduring period.
- A “no adverse material change statement” describes an existing state of affairs and not a prospective state of affairs. Although unrealised losses may be shown to constitute an existing material adverse change, with reference to the present case, the losses were prospective and there was no question of imminent crystallisation.
On analysis, the MMT concluded that there was insufficient objective evidence of an actual material adverse change in CITIC financial position on 9 September 2009, being the last practicable date of the Circular. The mark-to- market losses facing CITIC then was entirely unrealised losses. It had to be reported in the Group’s profit and loses accounts but was not an actual imminent crystallisation of capital loss. There was no evidence for any compulsion to sell or any need to terminate the TRF contracts no matter what the loss. Instead, CITIC was actively investigating and considering the overall remedial measures at that time.
The MMT therefore found that while there were sufficient data that by 9 September 2008 the TRF contracts posed a major threat to the financial integrity of the CITIC Group which could result in an actual material adverse change in the financial position of the Group, it was not demonstrated that such change had already occurred. Even if a material adverse change had already occurred, it was not demonstrated that it would clearly endure.
The Fault Element
The final element to be established is that the specified person had knowledge of the material adverse change (if demonstrated) as at 9 September 2008. In this respect, the MMT went into details of a meeting held on 7 September 2008 attended by the five executives of CITIC. Although CITIC’s then CFO tried his best to explain the losses arising from the TRF contracts to the meeting, evidence was that what he said was confusing and occasionally contradictory.
The five executives were therefore in no position to come to the conclusion that a material adverse change has occurred, not until they had been able to accurately analyse the exact nature and extent of the exposure.
Commentary
The MMT has provided helpful guidance on the distinction between the obligation to announce a “material adverse change” and the obligation to publish “price sensitive information”. In deciding whether to make a “no material adverse change” statement in company communications, executives should ask whether, objectively, there has been a material adverse change in the financial circumstances of the company of such deep significance that it has undermined the financial integrity of the company for an enduring period.
For further information, please contact:
Melvin Sng , Partner, Linklaters
melvin.sng@linklaters.com
