Maybe IPO prospectuses should discuss governance issues too
PICK up any prospectus for an initial public offering and on its cover you will see this line in capital letters: “There are certain risk factors which prospective investors should consider.” Then you’re asked to turn to the section in the prospectus that discusses these risk factors.
The statement is there because it’s a requirement of the Securities Commission’s prospectus guidelines. The section on risk factors is also a must.
“A prospectus should contain information about risk factors which are specific to the corporation/group and its industry, and to the securities being offered.
“These are risk factors which had or could materially affect, directly or indirectly, the business, operating results, and financial condition of the corporation/group,” says the SC in the guidelines.
The regulator encourages the issuers to list the risk factors in order of priority and reminds them that disclaimers on the risk factors should not be so wide that the risk disclosures are of little or no beneficial use to investors.
This reflects the central criterion for a prospectus. “Information given to investors must be presented in a manner that can be easily understood to enable them to assess and make an informed investment decision,” says the SC.
It’s all about helping investors to make up their minds whether to invest in the shares and warrants that are being offered in the IPO. So how informative are the sections on risk factors?
In terms of volume and depth, there isn’t much to complain about. Typically, the section on risk factors takes up at least 10 pages of the prospectus, with the issuer listing well over a dozen risks. In a recent large IPO, the company highlighted 45 risks and needed 26 pages to talk about them.
When done well – that is, when the company is generous with relevant and important information – the section on risk factors provides insight into how the company’s business and industry work. And that does matter when making investment decisions.
However, when there’s a reliance on generic factors and boilerplate language, the investor will probably learn little from reading the section.
For example, for risks associated with the securities being offered, just about every company will bring up possibilities such as price and trading volatility; a postponement or abortion of the listing; the company’s failure to pay dividends; and the lack of an active market for the securities.
Only novice investors are unlikely to know such things. But we get it – the issuer has to cover all the bases and that includes reminding people of the risks, even those that are obvious and familiar.
In that spirit, maybe there should be another category of risks relating to governance. People often invest in an IPO with the cheerful belief that the company’s directors and top managers are competent and upright.
The reasoning here is that the authorities wouldn’t have otherwise allowed the IPO to proceed.
But that’s flawed thinking because regulatory screening isn’t designed to detect moral weakness and well-disguised conceit.
The many cases of corporate malfeasance here and abroad should be enough to tell us that some IPOs will lead to dead ends. But we are often forgetful or overly optimistic. That’s why we should consider identifying governance risks in prospectuses.
Since templates are popular among those responsible for disclosures, here are several samples on how a company can address these risks in its prospectus:
>We may be tempted to undertake dodgy deals
There are so many ways to rob a company blind. We can buy assets at inflated prices or sell crown jewels when we absolutely do not have to. We can do mergers that will excite the market in the short term – thus allowing some people to benefit from the spike in the share price – but will destroy value in the long run.
We can diversify and promote the move as us broadening our revenue base or getting an early start on to the next big thing, but it is actually a ruse for a pump and dump scam.
We are not saying any of these will happen in this company, but you cannot say we have not alerted you on this possibility.
> Our controlling shareholders may not act in your best interests
Be warned that it is no fun to be a minority shareholder. The controlling shareholders have overwhelming, well, control of the company.
They often decide who sit on the board and who make up the management. They can put together related-party transactions and smooth the path for the proposals to go through, although they are not allowed to vote on the matter during shareholder meetings.
Controlling shareholders can choose to sit back and allow the company’s share price to sink, and then privatise the business at a cost lower than the value of the assets.
> Our auditors may one day discover what we have been hiding all these years
We believe that what you do not know will not hurt you. But the law says we have to issue audited accounts.
The auditors will come in once a year to audit our financial statements. We cannot guarantee that they will not find anything that will compel them to issue a qualified audit opinion.
We can remove troublesome auditors or they themselves can opt to quietly resign, but that is a risk for another day.
> It is possible that the business is peaking and that this IPO is our majority shareholders’ plan for cashing out
This IPO can only work if we paint a rosy picture of the company’s strong business growth in the years to come. However, our controlling shareholders are privately less confident that there is much room for expansion. In fact, they may be looking for the exit door. If that is true, kindly disregard any optimism that you come across in this prospectus.
> Boardroom tussle(s) may happen in this company and you will never get the full story
Companies have been known to suddenly see bids by shareholders to remove directors and to replace them with nominees. Seldom are such developments properly explained and yet, shareholders are asked to vote on these proposed boardroom changes. It is confusing and worrying. We do not know if such a thing will occur in this company, but you ought to be ready for it anyway.
Executive editor Errol Oh wonders how a prospectus would look like if truth serum is liberally used when the document is being drafted.
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