This article was written by David Gewer (Director, Werksmans Attorneys).
Foreign investors looking to enter South Africa's local market often choose to do so by acquiring an established local business. Before taking the plunge, a prospective buyer would generally wish to conduct a due diligence investigation ("DD") on the target.
When the target company is listed on the Johannesburg Stock Exchange however, the Financial Markets Act (the "FMA") regulates the disclosure of inside information, and an acquiring company needs to put a mechanism in place as early as the DD phase to regulate the exchange of information which could potentially be inside information. Inside information is defined in the FMA as information which, if disclosed or made public, would have a material effect on the share price of the shares in question.
What an acquirer should be concerned about from an early stage is the possibility that it (and the target) may have to disclose, to the shareholders of the target, certain information received by the acquirer in the course of conducting the DD, before the transaction may proceed. The disclosure of such information may in turn affect the prospects of success of the proposed transaction.
On the other hand, the acquiring company requires a certain level of information in order to evaluate the viability of the proposed transaction, and it must acquire this information in a manner that will still enable it to transact later. It is this dilemma and the relevant provisions of the FMA, compared with the now repealed Security Services Act 36 of 2004 (the "SSA"), that are considered further below.
Disclosure of inside information
Disclosure of potentially inside information was previously governed by the SSA, which provided that a person who knowingly disclosed inside information was guilty of an offence unless it could be shown that it was:
"necessary to do so for the purpose of the proper performance of the functions of his or her employment, office or profession in circumstances unrelated to dealing in any security listed on a regulated market and that he or she at the same time disclosed that the information was inside information".
This defence conceivably covered employees and agents of a target company who provided information to a prospective acquirer prior to a possible takeover, although the wording of the now repealed act was nevertheless unclear.
Despite the change in legislative regime (by virtue of the SSA being replaced by the FMA), the law applicable to the disclosure of inside information in the DD phase remains unchanged - and there lies the problem – the justification of “necessity” in disclosing inside information in the performance of one's so called duties is vague at best. Is the necessity of a disclosure measured by an enforcement agency in hindsight by the relevant persons or at the time the decision was made? Is the enquiry objective or subjective? None of these issues are clarified by the FMA.
Dealing in securities affected by inside information
The SSA regulated the dealing in securities and provided that an insider, who possessed inside information and dealt in affected securities for himself, or on behalf of another, was guilty of an offence. An insider could however justify such dealings provided they were "in pursuit of the completion of an affected transaction as defined in section 440A of the [then] Companies Act [61 of 1973]". An affected transaction included the acquisition of shares of a listed target company above a certain threshold, and would apply in the typical takeover of a listed company.
This defence relating to completing affected transactions has been replaced in the FMA by a more narrow defence, which requires an insider to be acting "in pursuit of a transaction in respect of which –
- All parties to the transaction had possession of the same inside information
- Trading was limited to the parties to the transaction
- The transaction was not aimed at securing a benefit from the exposure to movement in the price of the security, or a related security, resulting from inside information.
The effect of the new defence is that an acquiring company which has received inside information during a DD can no longer proceed with a transaction or deal in affected securities under the umbrella justification that it was acting in pursuance of an affected transaction. The FMA now requires all parties to the transaction (which, in the case of a transaction involving the acquisition of all the shares in a company, would mean the acquirer and all the shareholders from whom shares are being acquired) to have the same information and for the transaction to be limited to those parties.
The consequence of an acquirer having received inside information is that it will contravene the FMA if it deals in the securities of the target company (which includes "dealing" for the purposes of completing the transaction) unless it can fulfil the requirements of the defence set out in section 78 of the SSA. To ensure compliance, inside information received by the acquirer must be disclosed to all shareholders of the target company, whether by SENS announcement or by circular to the shareholders, before the transaction may proceed which is potentially troublesome given the confidential nature of a public takeover and the need for utmost secrecy.
Handling of information which is potentially inside information during a DD
Parties involved in a DD process typically seek to maintain and regulate the confidentiality of information through the conclusion of a non disclosure agreement ("NDA"). Although, at this stage, the parties are primarily focused on preventing any confidential information from being disclosed, the impact of the FMA on the exchange of inside information and the consequences that follow must be borne in mind.
The acquirer naturally wants access to confidential information to assess the prospects of the proposed transaction, but because inside information received will have to be disclosed to the target's shareholders, the acquirer and/or the target may prefer not to receive or provide certain inside information. The FMA not only requires the disclosure of inside information to be necessary but also requires the disclosing party to inform the recipient of the nature of the information.
It must be borne in mind that not all confidential information will be inside information. To be inside information, it will need to be information which, if disclosed, would have a material effect on the price of the securities in question. The NDA should therefore regulate the exchange of information and stipulate that, before any inside information is exchanged, the target is obliged to advise the acquirer of the nature of the information. The acquirer may then decide whether or not it wants access to this information, having regard to the fact that dissemination of this information to the target's shareholders will be required, in order to enable the acquirer to complete the proposed transaction. This could be problematic as even being aware that such information exists could be viewed as inside information.
The specific obligations of the parties in the NDA may differ depending on the transaction. The acquirer may require the NDA to oblige the target to disclose all information required by the acquirer, provided that the target advises the acquirer beforehand of the nature of the information and the acquirer elects to receive the information. On the other hand, a target may seek to protect itself by stipulating in the NDA that it will disclose only that information which, in its sole discretion, is necessary to conduct the DD. The target may further require the NDA to stipulate that, if the transaction proceeds, inside information exchanged in the DD be disclosed to all its shareholders, however, as mentioned above, this may be tactically difficult.
Since the target company may not be able to easily determine what information constitutes inside information (as defined in the FMA), a practical approach to the handling of information which is potentially inside information and which is proposed to be provided by the target to the acquirer, is required. A possible approach is for the target to provide such information to the parties' legal and financial advisors, on the basis that the advisors jointly assess and determine whether, in their view, the information constitutes inside information.
This arrangement would then entail the acquirer's advisors keeping the information confidential and not disclosing it to the acquirer itself until and unless the acquirer confirms that it is prepared to receive such inside information (knowing the nature of the information and that disclosure thereof to the target's shareholders will be required prior to completion of the proposed transaction). Advisors will need to carefully consider their obligations to their clients if material information is obtained in this manner.
Such an approach reduces the likelihood of inside information slipping through the cracks in a DD, and a disclosure requirement being unintentionally triggered.
Acquiring companies need to be aware that certain information received ahead of a proposed transaction will likely have to be disclosed to the target's shareholders before the transaction may proceed. It is therefore essential to put precautionary measures in place as early on as the DD phase to prevent the acquirer from inadvertently obtaining inside information which it may not be viable to disclose to the target's shareholders ahead of the transaction.
Section 77 of the FMA
Sections 73(3)(a) and 73(2)(b) of the SSA
Section 73(1)(b)(i), Section 73(2)(b)(ii) of the SSA
Section 440A of the Companies Act 61 of 1973 (now repealed)