Brian Gaynor: Warning signs disclose problems

The continuous disclosure rules, which came into force on December 1, are having major teething problems.

The Stock Exchange, market surveillance panel, listed companies, investors and analysts are all complaining about the way the regulations are being implemented and enforced.

The issue came to a head on Thursday when Vertex announced an ebit (earnings before interest and tax) downgrade from $10.1 million to the $9.2-to-$9.6-million range for the March 2003 year. This was the company's second downgrade and was due to the strong New Zealand dollar, rising raw material prices, weak domestic consumer demand and the loss of a contract. It came after a period of hectic trading in its shares.

This included the purchase of a 10.3 per cent holding by George Gould on February 11 at $1.46 a share and a further 9.5 per cent on February 19 at $1.67. The latter included 7.6 per cent acquired from Sir Selwyn Cushing.

Why did Vertex take so long to announce its second downgrade when most of the characteristics that have affected its earnings have been in place for some time?

The Stock Exchange defines continuous disclosure as "the requirement for timely advice to the market of information required to keep the market informed of events and developments, as they occur".

Under the old listing rules information was an asset of the company that needed to be released only under certain circumstances, whereas under the new regime all material information (that may affect security values or influence investment decisions) must be released to the market immediately.

Issuers are now required to release the following information as soon as possible:

* A change in financial forecast or expectation.

* The appointment of a receiver, manager or liquidator in respect of any of the company's activities.

* Any transaction that represents 5 per cent or more of the issuer's total assets.

* Any information regarding dividend payments.

* The undersubscription or oversubscription of an issue.

* Any agreement between the issuer and a director.

The problem with the listing rules is that they are vague, particularly regarding the definitions of "immediately" and "a change in financial forecast or expectation".

No company runs exactly to budget - all have good months and bad months.

Three bad months can be followed by three good ones, with results for the six-month period in line with budget. Should a company announce a profit downgrade after one or two bad months when it expects to make up the lost ground and hasn't changed its full-year budgets?

Most companies do not make regular changes to their year-end forecasts and they don't believe they should make any announcement to the exchange until a new pattern has been clearly established and they can specify its impact on earnings.

There are a number of other reasons why companies are either reluctant or slow to announce profit revisions:

* Investors have been particularly harsh on companies that have announced downgrades. There is a natural inclination for directors to hold back bad news because of the huge impact it can have on a share price. They also live in the hope that a positive turnaround can be achieved.

* Sometimes it is hard to specifically identify the impact of a particular event. A rural-based company may take some time to determine the bottom line impact of a downturn in commodity prices or a long dry spell. Most companies hold back downgrades until they can specifically identify the dollar impact.

* Many companies wait until directors have signed changes in forecasts at their monthly board meeting. This can cause delays of up to four weeks.

* Many New Zealand companies are still on the six-month reporting cycle and find it difficult to deal with issues relating to budgets and forecasts outside this cycle.

Problems with the enforcement of the continuous disclosure regime are causing friction between the Stock Exchange and its market surveillance panel. Mark Weldon, the exchange's chief executive, wants the panel to restore investor confidence by rigorously enforcing the listing rules.

The panel is sympathetic to this view, but it often has to face a bevy of QCs, representing public issuers, who argue that their clients have adhered to the continuous disclosure regime and/or the rules are vague or impracticable.

To resolve this issue, the exchange needs to change its listing rules to include specific definitions of a number of terms including "immediately" and "a change in financial forecast or expectation". It should also encourage companies to give indicative profit revisions.

An indicative revision is when an issuer tells the market that certain events are likely to have an impact on its earnings but it is too early to identify the impact in terms of actual numbers. This would give the market an early warning and would not require a board meeting and formal approval of a revised budget.

The issuer would then be obliged to issue a specific profit revision within a given time and would be prohibited from having any contact with analysts or investors until the new forecasts had been released to the market.

An indicative profit revision should have been given by Vertex before Thursday. It would have enabled investors to be more fully informed and reduced the criticism directed at the company.

Vertex was listed last July after the issue of 29.8 million shares to the public at $2.05 each. Pacific Equity sold 29.3 million existing shares and the company issued 500,000 new shares.

Pacific Equity is an Australian investor that sold 62.6 million Frucor shares, representing 49.9 per cent of the company, to the public in 2000. Frucor reported net earnings of only $11.7 million for the June 2001 year, well short of its prospectus forecast of $20.4 million.

In view of this, Vertex's independent directors should have made sure that the prospectus forecasts were realistic and could be achieved.

On September 4, just two months after listing, Vertex reduced its ebit forecast for the March 2003 year from $11.2 million to $10.1 million. On November 27 directors stated that the revised forecasts should be achieved, but on Thursday the ebit projection was lowered again from $10.1 million to $9.2-$9.6 million.

Why was this revision not released earlier, particularly in view of the heightened share-trading activity since February 11?

Vertex has decided that a revision should be announced when expected earnings are 5 per cent higher or lower than previously expected (a number of listed companies have a 10 per cent benchmark).

To determine this, Vertex has to collate its latest monthly figures and make year-end projections based on these. Its complete January figures were not available until mid-February and the profit revision was announced shortly after.

The obvious alternative to this delayed announcement was for Vertex to have made an indicative revision in January or early February as a number of assumptions used in its forecasts, particularly the New Zealand dollar, raw material prices and domestic demand, had turned negative at that stage.

It could have said that a more specific revision would be announced later when a more accurate assessment could be made.

That would have kept investors better informed, particularly George Gould, and appeased analysts. Many analysts are finding it difficult to operate under the new regime because they are no longer receiving early indications of a profit revision.

Vertex is under scrutiny from the Stock Exchange and Securities Commission for its prospectus forecasts, and this week's developments will not have helped its cause. It will be a major surprise if the company escapes the wrath of the two enforcement agencies.

But the Stock Exchange also has an obligation to ensure that its listing rules are clearly defined and practical. In this regard, its continuous disclosure regulations need to be clarified.

* Disclosure of interest: none.

* Email Brian Gaynor