Financial Services Authority takes action for breach of Listing Rules

Introduction

The Financial Services Authority has for the first time used powers that it acquired under the Financial Services and Markets Act 2000 to publish a statement censuring a company for breach of the UKLA's Listing Rules. The statement concerns SFI Group plc, which operates pubs and restaurants in the UK, including the Slug and Lettuce and Litten Tree chains.

On 11 December 2003 the FSA issued a public statement censuring SFI for failing to take reasonable care that an announcement of its preliminary results for the year ended 31 May 2002 was not misleading or false. Listing Rule 9.3A requires a company to take all reasonable care that any statement, forecast or other information it announces is not misleading, false or deceptive and does not omit anything likely to affect the import of such statement, forecast or other information. The FSA said that, were it not for certain matters, it would have been appropriate to impose a significant financial penalty.

This is the first time that the FSA has used these powers to discipline a company since they came into force on 1 December 2001. Section 91(1) FSMA allows the FSA to impose a financial penalty of such amount as it considers appropriate where it considers that an issuer of listed securities has contravened any provisions of the Listing Rules. In addition, a penalty can be imposed on any director who is knowingly concerned in the breach. Alternatively, where the FSA is entitled to impose a penalty on any person it may instead publish a statement censuring that person.

Description of the facts as found by the FSA

SFI operates a number of chains of pubs and restaurants throughout the UK. Between 1996 and 2002 the number of outlets owned by SFI increased significantly from 24 to 186 as a result of acquisitions and a planned opening programme. SFI's results for the five years to 31 May 2001 showed a steady increase in turnover, profit before tax and net assets. The preliminary results announcement on 30 July 2002 for the year to 31 May 2002 showed profit before tax of £19.5m, an increase of 30% on the previous year, and net assets of £85m. The profits before tax were broadly consistent with the most up to date market consensus and there was no significant movement in SFI's share price on the day.

The preliminary results announcement was regarded by the FSA as positive in its import, referring to "11 years of continuous growth and another successful year" with the company's key performance indicators all positive, although it did say, "gearing is higher than we would like. Many shareholders are rightly concerned that the balance sheet needs to be strengthened. We have acknowledged their concerns and are taking appropriate action."

In August 2002, SFI appointed external advisers to assist with the restructuring of its debt and in September 2002 a research note published by an external analyst stated that SFI was failing to pay its creditors. SFI's share price fell 20%. SFI made an announcement in response noting that trading in the first quarter continued to be positive with returns meeting its expectations and referring to a number of new sites that it had opened. Although it referred to short-term pressure on creditors, the announcement said that the group was actively managing the situation and continued to trade within its existing bank facilities, although it was in the process of making amendments.

In October 2002, on the day of its annual general meeting, SFI released an announcement explaining problems that had made it necessary to ask for, and be granted, temporary waivers of certain breaches of existing banking facilities and stating that as a consequence of the company's cash position further openings would be limited and that the board could not recommend payment of the proposed final dividend. The share price fell 67%.

In November 2002 SFI announced the suspension of its shares following the discovery of accounting irregularities and said that a full review of SFI's financial position was ongoing.

The review found, on the basis of an unaudited estimate of the effect of the net current asset accounting discrepancies, that the preliminary announcement of results for the year ended 31 May 2002 overstated profit before tax by 31.3% and net assets by 27%. These discrepancies were primarily the result of accounting errors attributed in part to SFI's rapid growth, which put pressure on the resources of the finance department. There were also said to be serious failures in management of cash flow and capital expenditure due to both inaccurate forecasting and process shortcomings.

FSA's decision and sanction

The FSA censured SFI for breaching Listing Rule 9.3A in relation to the preliminary results announcement. The FSA concluded that the announcement was misleading and false, in that the profits before tax were overstated by 31% and net assets were overstated by 27%. It also concluded that SFI's statement that it was in a strong position, and that strong earnings growth would continue, was not correct.

The FSA also considered whether, in assessing compliance with Listing Rule 9.3A, SFI took reasonable care to ensure that the preliminary results announcement was not misleading or false. The FSA concluded that SFI failed to take such reasonable care because its accounting systems and controls had not allowed it reliably to determine its current and historical financial position as a whole. Also, that its accounting systems and controls were not, and had for some time not been, appropriate to its business or growth strategies, and were not robust enough to support internal forecasts and projections that proved misleading and false.

The FSA said that, were it not for certain factors, it would have considered imposing a significant financial penalty. Its reasons for not doing so included the fact that there was no evidence to suggest that the contravention was deliberate, or that SFI had knowingly failed to have proper regard to its obligations under the Listing Rules. Additionally, regard was had to SFI's financial means (its facilities were almost fully drawn down and neither current or projected trading were sufficient to support repayment of that debt, and it was likely that its equity value was completely eroded). It was also significant that SFI notified the UKLA as soon as it became aware of the overstatement and its shares were immediately suspended.

Conclusions

It is well known that the FSA attaches great importance to the Continuing Obligations requirements of Chapter 9 of the Listing Rules, which it sees as a fundamental protection for investors. Information must be timely, sufficient and relevant. Information must also not be misleading, false or deceptive or omit information likely to affect its import. The FSA has now shown that it will use its considerable powers to sanction companies which do not comply. In this case, the FSA did not impose financial penalties. Among the factors which led to censure rather than a financial penalty was the fact that there was no evidence to suggest that the Listing Rules were deliberately or knowingly breached and that SFI had acted responsibly in notifying the UK Listing Authority as soon as it became aware of the overstatement in the accounts and instructed solicitors to undertake a full investigation into its accounting position and the accounting discrepancies.

The statement is also a salutary reminder of the importance of internal controls and that, far from being exclusively the province of corporate governance and the "comply or explain" regime, failure to maintain a sound system of internal control may well cause of a breach of the Listing Rules.

For further information, please contact Peter Smith (Corporate partner) by telephone on +020 7 367 2816 or by email at peter.smith@cms-cmck.com.