Directors' risk: revealing the truth

Directors often use their shareholdings as security against a personal loan,
but such arrangements are subject to complex disclosure rules that can trip up
the unwary.

These dangers were dramatically highlighted at the end of last year, with
David Ross’ high-profile resignation from the boards of Carphone Warehouse and
other companies over just such a loan. This was rapidly followed by hasty
announcements by other directors.

Early responses to these stories revealed a troubling confusion, among
directors and professional advisers alike, over requirements for notifying the
company and the market when company shares are used as security in this way. As
a result, the disclosure rules, which are different for companies on the main
market of the London Stock Exchange and for AIM companies, have been thrust into
the heart of the spotlight.

Requirements for main market companies are set out in the model code on
directors’ dealings in securities, found in Chapter 9 of the listing rules, as
well as in the disclosure and transparency rules (DTRs). The requirements affect
directors and other ‘persons discharging managerial responsibilities’ (PDMRs).
They may also affect other shareholders with a significant stake.

Using company shares as security is expressly included in the definition of
‘dealing’ for the purposes of the model code. Therefore, directors and other
PDMRs of main market companies must seek permission from the company before
using their shares in this way.

The model code also prohibits all forms of dealing during a close period in
the run up to an announcement of results or when there is inside information
relating to the company. In addition, directors must take reasonable steps to
prevent dealings by any person connected to them during a close period.

Under DTR 3, PDMRs and those connected to them are required to notify the
company of all transactions conducted on their account in the company’s shares.
This must be done within four business days of the transaction. The company must
then notify the market, via a regulated information service, no later than the
end of the business day following receipt of notification from the PDMR.

Some legal advisers have argued a grant of security over shares is not a
relevant transaction under the rules. This interpretation was largely based on
the fact that the market abuse directive ­ which DTR 3 implements ­ clearly
intends notification to prevent market abuse around the acquisition or disposal
of shares. Therefore, the argument went, granting security over a share by
creating a pledge, mortgage or charge would not be regarded as a disposal.

However, the FSA put paid to this on 9 January 2009 when it confirmed grants
of security interests over shares are covered by DTR 3 and should be disclosed
to the market. Recognising the confusion, the FSA declared an amnesty in
relation to prior failures to disclose and imposed a deadline of 23 January for
disclosures that should already have been made by relevant people.

The regulator also conceded the directive has not been implemented
consistently across member states and it is seeking a common understanding with
the European Commission and its fellow national regulators.

In addition to DTR 3, it is possible a grant of security over shares will
need to be disclosed under another of the transparency rules ­ DTR 5. This
requires notification where a person’s voting rights in the company reaches,
exceeds or falls below certain percentage thresholds, as a result of an
acquisition or disposal of shares or financial instruments.

This will only be an issue where the terms of the security granted over the
shares involves a loss of voting rights. Where DTR 5 applies, the shareholder
must notify the company no later than two trading days after the obligation
arises. The company ­ assuming it is a UK company ­ must then notify the market
no later than the end of the next trading day.

The DTRs do not generally apply to AIM companies, as opposed to companies on
the main market, but DTR 5 is an exception. Aside from DTR 5, the disclosure
rules for AIM companies are set out in the AIM rules for companies.

While the model code in the listing rules is not directly applicable to AIM
companies, each company will probably have its own share dealing code. Like the
code, this may well require a director, and possibly senior and other employees,
to obtain permission from the company before using company shares as security
for personal loans.

Rule 21 of the AIM rules prohibits any dealing in company shares by directors
­ or their families and family trusts and companies ­ or applicable employees
during a close period in the run up to an announcement of results, or any other
period when the company has unpublished, price-sensitive information. In this
context, ‘applicable employees’ include any employee who is likely to have such
information.

A deal is defined as any change whatsoever to the holding of shares. There is
no specific reference to granting security over shares, but a holding is defined
as any legal or beneficial interest in shares. As a deal is so widely defined,
the prudent view is that it covers using shares as security. The restrictions on
dealing during a close period will therefore apply.

Rule 17 of AIM similarly requires the market to be notified of any deals in
company shares (again, including using shares as security) by directors, their
families and family trusts and companies.

The market must also be notified of significant shareholder disclosures.

Media attention and the FSA’s action to eradicate any uncertainty about the
application of the rules have highlighted this issue for all quoted companies
and their directors and significant shareholders. The regulators will not look
kindly upon any future failure to disclose the use of company shares as security
for personal loans.

Directors’ responsibilities in brief

• A director should notify the company when he grants security over his
  shares, and the company should notify the market.
• A significant shareholder should notify the company – and the company should
  notify the market – if a grant of security over his shares reduces his voting
  rights through a relevant threshold.
• Directors and certain senior employees are prohibited from granting security
  over company shares during a close period.
• Outside of close periods, directors and certain senior employees of
  companies on the main market must seek permission in accordance with the model
  code in advance of granting security over their shares. Directors of AIM
  companies should check and comply with the requirements of any share dealing
  code adopted by their company.