Annual accounts/ going concern statement
Companies need to prepare themselves to thoroughly explain the impact of supply chain disruptions, sanctions and general market volatility on the company's future.
Considerations for prospectus drafting
Investors and securities regulators, including the AFM in the Netherlands, are taking great interest in the potential impact of the war in Ukraine on (future) issuers.
Annual accounts are drawn up on the basis of a going-concern principle unless discontinuity is unavoidable. For a company, this means that it has to reasonably foresee that it will be able to meet its future obligations. The auditors will approve the going-concern basis only if the company is likely able to meet its obligations in the upcoming 18 months. This will usually be the case, even with declining profits or when impairments are required.
However, in times of material uncertainty on key financial drivers, the going concern assumption may be put to the test. Typically, the concern lies in one of two triggers. The first big issue occurs where there is either a foreseeable shortness in cash or too little headroom in bank facilities, resulting in uncertainty about the availability of sufficient financing. The second big issue occurs where a refinancing is due in less than 18 months, resulting in the questionable ability to find financiers willing to commit sufficient amounts of refinancing capital. Especially if a substantial impairment must be made or EBITDA drops, the debt ratio will outweigh the assets or EBITDA, thus endangering the upcoming refinancing.
To make matters worse, these two big issues not seldomly occur simultaneously. Regarding reporting, continuity is open to serious doubt as soon as the company's future depends – to a greater or lesser extent – on the cooperation of third parties such as financiers. If the required cooperation has not been obtained when the annual accounts are drawn up, the material uncertainty has to be thoroughly explained on in the annual report.
In times of uncertainty, a solution-focused approach has many benefits over trying to understand the root causes. Our clients typically start identifying various scenarios and design a plan A, plan B, plan C to have readily available to put against those scenarios, should they occur. The management board will have to discuss with its financial and legal advisers the feasibility of the different scenarios, the required financing of each of the scenarios and the feasibility of such financing. In most cases, the auditor will be satisfied with such discussions and a detailed and sufficiently long-term planning for continuous monitoring of the scenarios and their feasibility. Sometimes, an auditor requires an indicative heads of terms with the bank syndicate, shareholders, or other financiers; a commitment tends not to be needed at this stage. In any of these, the key is in a company's ability to convince its financiers and its auditors that the company has prepared itself for a number of outcomes, that the future of the company is not on the line and that the co-operation of third parties as required, may be assumed without material doubt.
Although many equity and debt capital markets transactions have been delayed or suspended as a result of the Russian invasion of Ukraine, recent experience with crises shows that, when the impact of the war crystallizes and becomes "familiar" to market participants generally, activity could resume quickly. The potential significant negative effect on issuers, and the information provided by them to investors, is of particular interest to the AFM. Companies that are either considering to start a prospectus approval process, or that have already started this process, should examine the impact, actual and potential, of all aspects of the Ukraine war on their business and financial situation carefully, and ensure that these (potential) consequences are adequately disclosed in their prospectus or offering memorandum. Issuers should consider that even if their business is not directly affected by the war, meaning that no operations have to be halted in either Russia or Ukraine, nor any materials are directly supplied from these countries, its indirect consequences can still have a material negative impact that requires adequate disclosure.
The impact of the Ukraine war must be described in both a general and a specific way. General disclosure can regard the impact of sanctions imposed by the United States, the European Union, the United Kingdom and other jurisdictions on Russia, Russian individuals and Russian financial institutions, market volatility and increased inflation. More specific disclosure could focus on the impact of higher raw material costs, raw material shortages, cyber disruptions or attacks, higher manufacturing costs, higher energy costs and higher supply chain costs for an individual issuer.
In our experience, the regulator will ask companies to quantify, were reasonably possible, the potential negative impact of the Ukraine conflict in their prospectuses. If the disclosure does not contain a quantification, or if there is no narrative at all, the regulator is likely to request (future) issuers to explain why such disclosure would not be material to investors. Developments in the conflict should be closely monitored during the prospectus drafting and approval process, and the prospectus should be updated, if necessary, for each filing. Once a transaction has launched and the prospectus published, material developments prior to closing may trigger a prospectus supplement and an obligation to extend or re-open the subscription period with two business days.
Regarding Dutch capital markets transactions, material inaccurate or incomplete statements in the prospectus that could influence the behavior of investors, can be qualified as misleading. If the text of the prospectus is deemed misleading due to a material omission, the causal link between the misleading text and the investment decision of the investor will be assumed. This shifts the burden of proof from the investor to the issuer and the underwriting banks. In this light, (future) issuers are to carefully consider and disclose the full negative impact of the Ukrainian war on their business and financial position. The potential negative impact of the Russian – Ukraine conflict must be closely monitored during the prospectus approval process and shall be updated, if necessary, with each filing.
We believe the most logical place to add disclosure on the conflict and its consequences is in the risk factor section of the prospectus, in recent developments, and in the operating and financial review to the extent that developments have found their way (or not) in historical financial information for financial periods that have ended. Issuers should also consider the continued validity of any guidance that may be outstanding. Over time, if operations should be adjusted because of the conflict or its indirect consequences, disclosure in the business section may be warranted as well.