What Constitutes Inside Information for Corporate Bond Issuers?

2.1. Article 7

Article 7.1 of MAR defines inside information as information (italics added) “of a precise nature, which has not been made public, relating, directly or indirectly, to one or more issuers or to one or more financial instruments, and which, if it were made public, would be likely to have a significant effect on the prices of those financial instruments or on the price of related derivative financial instruments”. Two of the elements precise nature and significant price effect, are further qualified in two auxiliary rules (Article 7.2 and 7.4). Article 7.1 thus contains four cumulative elements – precise nature, non-public information, directly or indirectly related to the issuer, and significant price impact – which determines whether a piece of information constitutes inside information. These elements are addressed in the sections below, focusing on the precise nature and significant price impact elements, which are the key elements in the subsequent analysis of what information can be assumed to constitute inside information for bond issuers.

2.2. Article 17 and the duty to disclose inside information

When information is deemed to constitute inside information under Article 7 of MAR, Article 17 imposes an obligation on the issuer to “inform the public as soon as possible of inside information which directly concerns that issuer”, by disclosing the information “in a manner which enables fast access and complete, correct and timely assessment of the information by the public”. The meaning of “as soon as possible” is not further defined in MAR or related legal acts. However, it seems clear that the requirement is to be understood as a qualitative requirement for prompt disclosure “without undue delay” rather than a quantitative requirement for disclosure immediately, within a certain timeframe, and that the assessment must also be made on a case-by-case basis.^[25] Although the assessment must be made on a case-by-case basis, the issuer is presumed to have an organisation that allows for the prompt and efficient handling of information. Deficiencies in procedures or decision-making structures, such as the need to obtain the approval of the board of directors or the CEO or the lack of manoeuvrability, are not taken into account when assessing whether the information has been disclosed as soon as possible.^[26] Whether the trading venue on which the issuer’s instruments are traded is closed or open does not in principle affect the assessment either.

In summary, the requirements for issuers to disclose inside information are far-reaching. The threshold for what constitutes inside information is at least relatively low, and once inside information has arisen it must be disclosed promptly. However, such a regime without exemptions would be unreasonable in practice, as in many situations the issuer may have a strong legitimate interest in keeping inside information confidential. An exception to the disclosure obligation is therefore provided for in Article 17.4 of MAR, according to 226which an issuer may delay the public disclosure of inside information if the following cumulative conditions are met:

1. immediate disclosure is likely to prejudice the legitimate interests of the issuer or emission allowance market participant,

2. delay of disclosure is not likely to mislead the public,

3. the issuer or emission allowance market participant is able to ensure the confidentiality of that information.

ESMA has issued guidelines on how these conditions are to be interpreted in guideline 2016/1478. It should also be mentioned that MAR has been reviewed within the EU Listing Act, and the duty to disclose inside information has become at least slightly less demanding. This applies to inside information related to intermediate steps in a protracted process as referred to in Article 7(2) and 7(3), and condition (b) for delayed disclosure (delay of disclosure is not likely to mislead the public) has been changed to a condition requiring that the delay is not in contrast with previously disclosed information the same topic.^[27]

3.1. What affects the price formation of equities

A classical legal perspective on the limited liability company is to consider it, in Jensen and Meckling’s terminology, a nexus of contracts.^[28] The implication of such a perspective is that the limited liability company becomes a form of financing and organising certain activities, or put differently, a set of explicit and implicit “contracts” between the company and its stakeholders. From this perspective, it can be stated that the vast majority of contracts between a company 227and its various stakeholders – its creditors, employees, management and board of directors, customers, suppliers, etc. – are “closed contracts” in terms of economic claims, in the sense that the economic rights and obligations arising from the contracts are predefined. Employees are entitled to a specific salary for certain tasks, customers may buy a product or service for a certain amount, and the same applies to suppliers who sell a product or service to the company. Even variable remuneration contracts normally follow certain pre-defined criteria that make the contract “closed”. The same applies in particular to the company’s creditors, where a bank, for example, lends a certain amount of money to the company for a certain period of time at a certain predetermined interest rate.

However, one of the company’s contracts is different, namely that between the company and its shareholders. This “contract” can be characterised as open-ended, in the sense that the shareholders, in exchange for the capital injection at the time of formation or issue, are not given any specific right to a return, but only a right to the residual assets of the company without any time limit. In other words, they receive a return on their investment only after the company has fulfilled its obligations towards other stakeholders.

The fact that the share is an open contract means that, in principle, the economic value of a share is a function of the performance of the company’s business as a whole, both now and in the future. If the company does business that increases its margins or size and thus the prospects or expected size of future profits, the shares (in theory) increase in value. The same is true if the company’s financial situation strengthens so that the future need to retain profits in the company decreases (and the scope for dividends thus increases). And if the company incurs unforeseen costs or the economic situation becomes more uncertain for one reason or another, the value of the shares will (again, in theory) fall. These are probably fairly uncontroversial statements, but they are nonetheless an important starting point for recognising that, in principle, any information about a company’s economic development or the conditions for it can influence the valuation of its shares. The same generally applies to other share or share price related instruments, such as warrants, convertible bonds, and equity derivatives.

3.2. What affects the price formation of corporate bonds

However, the situation is different for corporate bonds. In general, a corporate bond is as a debt instrument with a nominal amount that falls due at a certain point in time, where the return consists of an interest rate determined by the terms of the bond, either fixed or linked to a reference rate (and in the context of this article, where the loan cannot be converted into shares, since that would 228make it an equity instrument). Corporate bonds as a contract can therefore, as far as the right to compensation is concerned, be considered a closed contract. The firm-specific uncertainty in a bond can thus be said to be limited to the risk that the debtor cannot fulfil its financial obligations to the creditor (default). Thus, the information that can be assumed to be relevant for the valuation of a corporate bond is more limited than for equities.

The basis for the pricing of a bond is, of course, the terms of the bond, and the rights on which bondholders base their investment. In addition, the fundamental value of a bond is determined by the risk of default. This risk is a function of two components: the probability that the issuer will fail to honour its financial obligations under the bond, and the expected loss if default occurs. The components are often described with the terms probability of default (PD) and the loss given default (LGD).^[29] For example, if the issuer’s probability of default is 1 per cent,^[30] and the loss given default for a particular bond is estimated to be 50 per cent due to the fact that the loan is secured, the credit risk is thus 0.5 per cent of the remaining debt at the time of default.^[31] Thus, for disclosure purposes, information from which new conclusions about an issuer’s probability of default can be drawn should be assumed to be price-sensitive information. The implication of this is that if the probability of default is already zero or close to zero per cent (as is normally the case, for example, for bonds rated A-AAA), then information that the issuer’s business has developed in a positive direction cannot be assumed to be price-sensitive for a bond issuer, but information that the business has developed in a negative direction to the extent that it actually leads to an increased probability of default is another matter. The same must apply to information from which conclusions can be drawn about loss given default and changes in seniority impacting loss given default (see further below).

229However, credit risk as such is not only related to the probability of the issuer’s default. A similar effect may arise in the context of mandatory redemptions, mandatory exchanges of securities, and also in the event of a change in the bond terms in such a way that it results in a credit loss for the bondholders. This type of risk is sometimes referred to as documentation risk or event risk and, in the case of early redemption etc. call risk.^[32]

The value of a bond is also affected by factors other than the risk of credit loss. One such factor is interest rate risk. If the interest rate on a bond with a AAA rating is 2.2 per cent, and the central bank raises the policy rate from 2.0 to 2.25 per cent, this means that the value of the bond will fall and the bond will trade below par to compensate for the relatively low interest rate. The opposite would apply if the central bank were to cut its interest rate from 2.0 to 1.75 per cent. The longer the maturity of a bond, the greater the interest rate risk. A related risk, especially for bonds with longer maturities, is inflation risk. External factors such as interest rate risk, inflation risk and the economic outlook have a greater impact on the pricing of a bond the lower the firm-specific risk.^[33] Thus, whether it is mainly the company-specific credit risk or interest rates and inflation that influence the pricing of a bond varies depending on the creditworthiness of the issuer.

Another factor affecting the pricing of a corporate bond is liquidity risk. In simple terms, this risk can be described as the risk that an investor wishing to sell a bond will not receive a price that reflects the bond’s value in terms of interest rate and credit risk, and it is well documented that low liquidity has a negative effect on the value of bonds in the secondary market.^[34] The liquidity of a corporate bond can be affected by, for example, the size of the issue, the 230credit rating, the currency, the industry in which the issuer operates, how often the issuer issues bonds in the market, etc.

4.1. Changes in credit risk

If an issuer’s financial situation changes to such an extent that it affects the likelihood of the issuer being able to fulfil its obligations under the bond, there is no doubt that information thereof must be deemed to constitute inside information as a starting point. The question is thus rather how large a change must be for it to be regarded as having a “significant price effect”, and whether it matters whether the change in credit risk is positive or negative.

The following section concludes that the available empirical data clearly indicate that downgrades of credit ratings (which are in principle a measure of credit risk) normally have a significant negative impact on bond prices, and that a downgrade of credit ratings must therefore generally be assumed to constitute inside information, especially when the credit rating is already in the lower range of investment grade or non-investment grade from the outset. Thus, in the case of a negative change in an issuer’s financial situation, a rule of thumb could be that if the change is of such magnitude that it would have led to a downgrade of the credit rating, then information about the change should be considered inside information.^[35] If an adverse change in the economic situation, while significant, is not of such magnitude that it has caused or would have caused a downgrade, the assessment may be different, given the granularity of the credit rating scale. If the issuer or its bonds are rated at the higher end 231of the investment grade segment of the credit rating scale, a deterioration in the economic situation that is not of such magnitude that it has caused or would have caused a downgrade of the credit rating should not be assumed to have a price impact on the issuer’s bonds, and thus not constitute inside information.^[36] If the issuer is at the lower end of the scale, and in particular in the non-investment grade segment, the issuer should probably be more vigilant, and perhaps rather assume that even a minor negative change in the economic situation constitutes inside information.^[37]

For positive changes in an issuer’s financial situation, the price impact appears to be smaller. In some studies, a credit rating upgrade has been shown to have a positive effect on bond pricing,^[38] and in others not.^[39] Nevertheless, it is reasonable to assume that a price change resulting from a rating change from, for example, BBB+ to BBB should (pricing wise) mirror a corresponding change from BBB to BBB+, ceteris paribus.^[40] Thus, a positive change in the financial situation of an issuer should be considered as inside information, provided that 232a change in the opposite direction could be assumed to have a an effect on the bond price. Again, however, a favourable change in the financial position of the issuer, where the issuer was already in a good financial position before the change, should be considered less relevant to price formation (if at all) than a change where the issuer was in a worse financial position to begin with.

4.2. Changes in credit ratings

Related to the assessment of when a change in credit risk should be considered inside information, as discussed in the previous section, is the assessment of when information about changes to an issuer’s credit rating constitutes inside information. From a theoretical point of view, it seems obvious that information about a change in credit rating must be viewed as inside information, as it means by definition that an independent credit rating agency has assessed that the issuer’s creditworthiness has changed to such an extent that the change has a material impact on the risk of the issuer becoming insolvent. That this is the case in practice is also well documented empirically in relation to equity price formation. As far as can be judged, it is now in principle clear from the empirical literature that a negative change in credit ratings has a significant impact on the price of shares and credit default swaps.^[41] Furthermore, the price effect seems to be greatest in the case of credit rating downgrades when the credit rating is already relatively low to begin with.^[42] It does not seem to be clear 233whether credit rating upgrades have any significant price impact on equity prices if the issuer had a relatively good credit quality to begin with.^[43]

The price impact of credit rating changes on corporate bonds has not been studied to the same extent as equities. However, in the studies that have been conducted, the results appear to be essentially the same: when an issuer’s credit rating is downgraded, this has a significant price impact on outstanding corporate bonds, and the price impact is in principle greater the lower the issuer’s initial credit rating.^[44] As regards the impact on bond prices, rating upgrades have been shown to have a significant price impact in some studies, but not in others.^[45]

234Against this background, the following conclusions can probably be drawn regarding when changes in an issuer’s credit rating should be considered as inside information under Article 7 of MAR. As a general rule, if the issuer’s credit rating is downgraded, this information should be considered as inside information.^[46] To the extent that the issuer’s credit rating prior to the downgrade is at the lower end of investment grade or below, this general rule can probably be applied without further ado. However, if the downgrade is from AAA to AA+, there may be room in the individual case to claim that the information does not constitute inside information with reference to available empirical evidence. On the other hand, since a difference between AAA and AA+ credit ratings represents a not insignificant difference in the risk of default, it seems likely that this is information that a reasonable investor would be interested in utilising as part of the basis for his or her investment decision given the discussion in section 2, and great caution seems to be called for here.^[47]

If, on the other hand, the issuer receives a credit rating upgrade, there is less clear empirical support for the impact on the bond price, and whether such information should be considered inside information is unlikely to be answered in general terms. However, it seems sensible to assume that a reasonable investor would use information about a credit rating upgrade as part of the basis for his or her investment decision, mirroring what applies in downgrades (see above). It also seems likely, subject to the lack of firm empirical support, that it should matter whether the issuer is, for example, upgraded from BB to BBB or whether it is an upgrade from AA+ to AAA.^[48]

235In the case of both upgrades and downgrades, there is probably also reason to consider the remaining maturity of outstanding bonds in each individual case. For example, if an issuer receives a downgrade of its credit rating but the only outstanding bond matures in one month and it is clear that the bond will be repayable under the circumstances prevailing at the time, the information is unlikely to be of significance for the pricing of the bond. Consideration may also need to be given to whether a change in the rating was widely expected.^[49]

4.3. Buy-backs and voluntary security exchange offers

A relatively common phenomenon in the bond market is for an issuer to repurchase outstanding bonds in order to reduce its outstanding debt (a buy-back), which can be attractive when the bonds are trading below par or when the issuer is able to reduce its interest costs through repurchases. Such repurchases can be made either directly in the market or through the use of a public tender offer. The issuer may also launch a (voluntary) exchange offer for refinancing purposes, whereby bondholders are given the opportunity to subscribe to new bonds of the issuer in full or in part in exchange for their outstanding bonds.

A first question that needs to be asked regarding whether information about a buy-back offer or a voluntary exchange of securities constitutes inside information is how the value of the offer relates to the price at which the bonds are traded. Unless the premium paid is negligible or the buy-back or exchange programme is so small that it cannot be assumed to affect the market price, the information about it must be considered inside information, since it sends the signal that the issuer believes the bond is under-priced and since the buy-back programme in itself will likely affect the bond price. However, even in cases where the premium is relatively low or where it is difficult to determine what constitutes the market price of the bonds, there is reason to be cautious in assessing whether the information constitutes inside information, if the liquidity of the bond before the offer is limited (which would often be the case in the 236many times illiquid bond market) and if a public offer is so extensive that it can be assumed to have a positive impact on liquidity.^[50] Moreover, it probably cannot be ruled out that information that the outstanding volume of a particular bond is substantially reduced may in itself constitute inside information. Where this threshold lies must be assessed in each individual case, but given what has been said above regarding the threshold for what information should be considered to have a significant price effect under MAR, some caution is probably required. It is probably not possible to set a general percentage threshold for when the size of a public repurchase or securities exchange offer should be considered to constitute inside information, and the assessment must take into account the factors affecting the liquidity of the bond, such as the issuer and the size of the bond, as well as the investor base in the bond.

4.4. Mandatory security exchanges

If the bond terms contain provisions for mandatory security exchanges, this normally requires that a proposal to this effect is approved at a bondholders’ meeting, making the decision binding for all bondholders. A mandatory exchange of securities is an almost expropriation-like procedure which is typically used when the issuer is in a difficult financial situation, and which normally involves the bondholders making not insignificant concessions on the financial terms of the bonds in order to avoid the issuer falling into financial crisis. It is therefore nigh self-evident that information that the bondholders’ meeting has approved a proposal for a mandatory exchange of securities is one that a reasonable investor would use as part of the basis for his or her investment decision, unless the exchange of securities does not in principle affect the position of the bondholders (which in practice would be exceedingly rare). The same is likely to apply when an issuer decides to propose a mandatory exchange of securities, irrespective of the likelihood of the bondholders’ meeting approving the proposal, since the fact that the issuer has concluded that such a measure is necessary should in itself be information of a precise nature that can be assumed to have a significant impact on the price, and an investor can draw conclusions about credit risk and possibly also default depending on the terms of the exchange of securities.

4.5. 237Changes in terms and breaches

The fundamental conditions for an investment in bonds are governed by the bond terms, and change of terms should in principle always be considered as inside information. However, some distinction must be made regarding the type of terms that are changed. An issuer whose bonds are admitted to trading on a regulated market must also observe the disclosure requirement regarding changes in the rights attached to the bond.^[51]

With reference to what has been said in section 3, changes affecting credit risk should likely always be considered as inside information, for example with regard to interest rate and interest payment, nominal amount, maturity and acceleration, collateral, and risk management mechanisms such as covenants. A change of this nature can reasonably only be considered as not having an effect on the bond price if it is so marginal that it is clear that it does not matter from an investor perspective. In other words, an issuer should assume that information about such a change in terms constitutes inside information, given how central the terms are to an investment decision and how difficult it would generally be to determine where a reasonable investor would draw the line as to when a term is not considered material to an investment decision. With reference to what has been said above regarding securities exchanges and repurchases, the same should, as a starting point, also apply with regard to changes to any conditions on repurchase, early redemption and voluntary and mandatory exchanges of securities. In line with what has been said in the previous section regarding proposals for mandatory exchanges, it is likely that the information should also be considered as inside information not only when a change of terms is approved by the bondholders, but also when the issuer decides to propose such a change, provided that the information about the change, if implemented, is deemed to constitute inside information.

What has been said about changes to the terms of the bond must also reasonably apply, mutatis mutandis, if the issuer breaches the terms.^[52]

4.6. 238Actions affecting seniority

As discussed, credit risk is a fundamental component in the calculation of the value of a corporate bond. One factor in this calculation is the risk of default, which is relevant for disclosure purposes in relation to changes in credit risk and credit ratings. Another factor is the loss given default. For the calculation of the loss suffered by bondholders in a default event, the seniority of the bonds is, of course, essential.^[53]

Thus, as a starting point, actions by the issuer that affect the seniority of bonds should likely be considered to constitute inside information. This includes the case where the seniority of a bond is directly altered, for example through a change in terms and conditions that reduces the bond’s priority in the event of default, and when (importantly) changes in an issuer’s company group are carried out that results in a structural subordination. The seniority of bonds is also affected by whether the issuer’s other creditors obtain a stronger position than the relevant bondholders, for example by providing security for another bond or a bank loan. Such information could therefore normally also be assumed to constitute price-sensitive information, and may constitute inside information depending on the impact on the relevant bonds.

4.7. Changes of control and delisting

Two final examples of when inside information is likely to arise in the bond market to be addressed concerns changes of control and delistings. The bond terms often contain provisions regarding changes of control of the issuer, providing that in the event of a change of control, the issuer must inform the bondholders and the market of the event.^[54] However, it is debatable whether infor239mation about a major change in the company’s ownership structure should be considered inside information.^[55]

There is empirical evidence that the value of corporate bonds in the secondary market drops significantly when a bond issuer is subject to a change of control if the new owner’s credit rating (or unrated credit quality) is lower than that of the issuer, and vice versa.^[56] Thus, information about an acquisition of at least all the shares in the company could be assumed to constitute inside information. However, the studies that have been carried out on the effects of changes of control on the value of corporate bonds are relatively few and the results do not seem to be unequivocal, so a general recommended stance is probably difficult to present (other than erring on the side of caution).

The case is clearer regarding delistings. The terms and conditions of the bonds will often require that the bonds be listed, and sometimes also contain specific mechanisms for what happens if the bonds are delisted for one reason or another, including requirements for the issuer to publicly disclose information on listing failure. However, even if such a requirement does not follow from the terms of the bond, information about an impending delisting of the bond must categorically be considered inside information for a variety of reasons, including impact on liquidity, change in holding conditions, and how the legal requirements on the issuer changes.