Market practice in acquisition announcements made by companies listed on the London Stock Exchange is that future contingent consideration obligations, and any cap that applies to them, are disclosed in the acquisition announcement. Estimates of liability pursuant to those obligations are sometimes disclosed – more often where the consideration relates to stock or other assets, and rarely where the consideration is an earn-out, to be calculated on the basis of future results of the target business.
A recent decision of the Financial Services Authority ("FSA") may suggest that market practice should lean more towards disclosure of these estimates. The acquiror in the relevant investigation in fact failed to disclose that it had any obligation to pay the future contingent consideration, and it is this that the FSA determined to be a breach of the Disclosure and Transparency Rules ("DTRs"). In its ruling on the issue, however, the FSA suggested that the acquiror's estimates of the amount of future contingent consideration that it expected to pay also amounted to inside information, and that a failure to disclose them could therefore constitute a breach of the DTRs in and of itself.
On 25 January 2011 the FSA issued a Final Notice in its investigation of JJB Sports Plc ("JJB"). The ruling was that JJB, an LSE-listed company, had breached the DTRs and the principles set out in the Listing Rules in relation to its acquisitions of Original Shoe Company Limited ("OSC") and Qubefootwear Limited ("Qube"). JJB was fined £455,000 for failure to disclose future contingent consideration arrangements in the purchase agreements.
JJB agreed the acquisition of OSC for consideration comprising a £5 million fixed payment, plus 97% of the cost price of OSC's stock as at close of business on a date four months later (the "Stock Amount"). In JJB's announcement of the acquisition, there was no indication that the Stock Amount would be payable. The Qube acquisition agreement similarly provided for an up-front payment of £1, and the paying off of Qube's overdraft as at the day before completion (the "Overdraft Amount"). Again, the public announcement of the acquisition referred only to the up-front payment. The Stock Amount was eventually determined to be over £10 million and the Overdraft Amount was approaching £6,500,000. When these payments were disclosed to the market (alongside other negative statements) in JJB's 2008 Interim Results, JJB's share price fell from 104p to 52p.
The FSA's view was that the failure to announce the obligations to pay the Stock Amount and Overdraft Amount, and that those liabilities were not capped, created and sustained a false market in JJB's shares in breach of Listing Principle 4. Further, the obligations to pay the Stock Amount and the Overdraft Amount were held to constitute inside information, and JJB's failure to disclose them to the market therefore amounted to breaches of DTR 2.2.1. Given that these liabilities were not disclosed at all, and the magnitude of the Stock Amount and Overdraft Amount relative to the up-front payments, this decision was generally expected.
The Final Notice also makes some remarks in respect of the estimates of the Stock Amount and the Overdraft Amount that JJB had available at the time they made their announcements. The position stated is that both were "capable of estimation", and that therefore the total estimated acquisition costs (including the estimates of the Stock Amount and Overdraft Amount) should have been disclosed to the market as part of the inside information disclosable under the DTRs. The definition of inside information requires that information be "precise", which is explained in the legislation as meaning that it is (among other things) "specific enough to enable a conclusion to be drawn as to the possible effect of those circumstances or that event on the price of [the listed shares]".
The FSA's view that JJB's estimates of the Stock Amount and Overdraft Amount were inside information, whilst not formally part of the decision given in the Final Notice, may have implications for the market practice around disclosure of future consideration. The estimates that JJB had available at the time of their announcements were not particularly accurate – the Stock Amount was estimated at around £8,000,000, compared to the finally-determined amount of over £10,000,000. It therefore seems that there is a degree of tolerance in the FSA's view of information that is specific enough to enable the market to form a view as to the effect on the acquiror's share price.
This view may have implications for the disclosure of earn-out consideration as well as stock or asset-based future contingent consideration payments. Acquirors will usually, of course, have an internal estimate of the future results of a target's business over the period covered by the earn-out. On the basis of that estimate, an estimated level of earn-out consideration could, clearly, be calculated. Acquirors should therefore give careful consideration as to how reliable they believe their estimate to be, and whether it therefore might constitute information that is specific enough to amount to inside information – and therefore require disclosure.
While there will tend to be a greater degree of uncertainty over a business's future results than over its levels of stock, where an earn-out relates to the results of the current financial year (and the estimate will therefore be extrapolated from existing part-year management accounts) it may well be considered that the estimate is sufficiently precise as to constitute inside information for disclosure. The reliability of the estimate will almost certainly decrease where the earn-out relates to periods that are further off in time, but it is possible that it could still be considered to be sufficiently precise if, for example, the target business derives a substantial proportion of its revenue from a limited number of long standing customers.
If estimates are disclosed to the market, further issues of liability for the disclosing companies and their directors will arise. Companies will be obliged to issue follow-up announcements where the finally-determined consideration differs materially from the estimate (as the difference will, in itself, constitute inside information) and should specifically state that this announcement is a correction of the estimated amount. JJB's failure to draw attention to the inaccuracies of its acquisition announcements when the Stock Amount and Overdraft Amount were disclosed was cited by the FSA as an aggravating factor in this decision . In arriving at any estimates which are to be disclosed, companies should take care to ensure that the models used make fair and reasonable assumptions – where the estimated amount differs materially from the final amount, the FSA may decide to investigate the basis for the estimate.