Non-director participants in significant capital raisings need to be alert to their risks under the Financial Markets Conduct Act (FMCA), but also to know that the sky is not about to fall in.
The FMCA will fail if, rather than promoting confident and informed participation in New Zealand’s capital markets, it ties up offers in unnecessary bureaucracy and process. This will be particularly unfortunate if excessive caution is based on an alarmist reading of the liability provisions in the Act.
This paper seeks to provide an informed and balanced analysis of the legal exposure which applies to investment banks, trustees, auditors and other expert advisers under the FMCA.
Three bases for civil liability
The FMCA provides for three bases of civil liability – direct liability, which applies to issuers (normally companies); deemed liability, which applies to directors in cases of defective disclosure; and accessory liability, which can capture wider participants.
Accessory liability in this sense applies only to the civil remedies. For crimes, which now require knowledge or recklessness, participant liability would need to be established under the general provisions in section 66 of the Crimes Act 1961.
The limits of accessory liability
For accessory liability to be established, three layers of proof are needed.
- Underlying contravention: that the principal party – either the issuer or a director of the issuer – has committed the underlying breach (although it is not a pre-condition that proceedings be brought against the primary violator).
- Connection to the contravention: that the participant did some act (such as counselling, procuring or abetting) that connects him or her to the contravention – known as the actus reus in conventional criminal terms.
- Mental element: that the non-director participant knew the essential facts of the contravention (e.g. knew that a statement in the PDS was materially misleading) – the mens rea in criminal law terminology.
Meaning of “involved in a contravention” – the connecting factor
Section 533 FMCA specifies that a person is "involved in a contravention" if the person:
- has aided, abetted, counselled, or procured the contravention, or
- has induced, whether by threats or promises or otherwise, the contravention, or
- has been in any way, directly or indirectly, knowingly concerned in, or party to, the contravention, or
- has conspired with others to effect the contravention.
The conventional meanings of these elements are as follows:
Click here to view the table.
Settled meanings and significant jurisprudence
The FMCA definition of involvement in a contravention uses very familiar concepts from the criminal law and is also substantially the same test as has long applied in the pecuniary penalty provisions of section 43(1) of the Fair Trading Act, section 80(1) of the Commerce Act 1986 and Part 5 of the Securities Markets Act 1988. As a result, the meanings of the terms used are settled and are well supported by case law.
Also, although the application of these provisions in a securities offering context is novel in New Zealand, they are practically identical to provisions in the Australian Trade Practices Act and in the Australian Corporations Act, so there is a wide jurisprudence and academic commentary from Australia for the New Zealand courts to draw on.
And the Commerce Committee commentary on the Bill, indicating the intention of Parliament, is clear:
For a person to be involved in a contravention, it would need to be proved that he or she was an intentional participant in the primary contravention with knowledge of all the essential facts.
But, there’s always a but…
The more difficult issue arises in relation to what Arnold J has described as “evaluative assessments” in which the essential facts that establish the underlying breach do not speak for themselves and are not incontrovertible, but instead are in the nature of conclusions, predictions and judgements on which reasonable people may disagree.
This will often be the case in relation to disclosure where decisions commonly involve an element of business judgement or opinion, legal conclusions, matters of degree, questions of materiality – or some combination of these. Consider both theNathans and Lombard cases, where the courts agreed that the directors honestly believed the statements in their offer documents were true – a finding that will be much more relevant in an FMCA setting, where criminal liability (although not civil) will require proof of knowledge or recklessness.
The difficulties around issues of materiality will be amplified by the word limits on PDS imposed in the FMC Regulations and the challenge laid down by the Financial Markets Authority (FMA) to move away from generic, all-encompassing disclosures to a more specific and considered focus on the true prospects and vulnerabilities of the business.
Defences for accessories under the FMCA
In addition to the first line of defence of getting it right, further inoculation against liability lies in the due diligence defences provided in the FMCA. Those available to persons "involved in a contravention" are summarised in the table below.
Click here to view the table.
Although the FMCA does not require the FMA or a private litigant to proceed against persons with direct liability (i.e. issuers) or deemed liabilities (i.e. directors for defective disclosure or defective financial statements) before pursuing an accessory, the prospect of a claimant succeeding against an accessory, but not the persons primarily responsible, is practically unlikely. Defences available to an issuer include:
- the person made all inquiries that were reasonable under the circumstances and, after doing so, believed on reasonable grounds that the statement was not false or misleading
- the contravention was due to the act or default of another person (excluding some people, such as employees of the issuer), or to an accident or to some other cause beyond the person’s control and the issuer (or its directors) took reasonable precautions and exercised due diligence to avoid the contravention (this defence does not apply to defective disclosure of regulated disclosure documents, but does apply to "advertisements").
Where a director can demonstrate that the issuer, or he or she personally, undertook reasonable investigations we think a Court would likely be satisfied an accessory took all reasonable and proper steps to ensure that the issuer complied.
Implications for due diligence procedures
The most intensive due diligence is required for an initial public offer of shares. An equity IPO ‘gold standard’ should typically involve:
- preparation of a formal Due Diligence Planning Memorandum, setting out:
- any potential securities law and other liabilities relating to the offering
- the objectives and scope of the due diligence process, including any materiality thresholds
- the identity of the Due Diligence Committee (DDC)
- the due diligence process that will be undertaken and the responsibility of its various participants, including any due diligence questionnaires or interviews with management and others that will be required
- the required outputs of the DDC, including written reports, minutes, advice, sign-offs and back-up materials, and
- bring-down and ongoing monitoring processes to ensure that the due diligence is maintained throughout the offering period and, in particular, at its key milestones (registration of offering documents, offer launch, and allotment/listing)
- regular meetings of the DDC to carry out this work programme and to consider progressive drafts of the offering documents, and
- the presentation of reports and materials to the board of the issuer and other relevant persons (e.g. selling shareholders) for approval of the offering documents and go-ahead of the offer.
The DDC will generally comprise independent directors and/or members of the audit committee and, at a minimum, the issuer’s chief financial officer and general counsel. Other participants will typically include the external auditors, representatives of the arrangers/joint lead managers, the issuer’s external legal counsel (and sometimes counsel to other parties, including any ‘promoter’ of the securities or the arrangers/joint lead managers). Others (for example line managers) may be asked to attend on an ad hoc basis (There has been a practice of distinguishing between “members of” and “observers at” the DDC. This distinction is unlikely to be helpful to anyone under the FMCA, under which accessory liability will depend on the substance of a person’s involvement rather than their title).
One or more members (often a director) will be appointed chair, with responsibility for producing agendas and minutes, and for the conduct of the meetings generally.
Reports and sign-offs from a variety of officers and advisers should be fed into the DDC, usually including:
- wider management personnel or staff (who are often asked to fill in a due diligence questionnaire and/or verify parts of the offering documents)
- issuer's counsel, who will normally provide an opinion on formal securities law compliance (assuming the truth of the underlying information)
- the auditor (currently in the form of its opinion required under the Securities Act) and any other specific non-audit engagements required by the issuer, and
- tax and other specialist advisers.
The process will often involve an ongoing feedback loop between the DDC and the working group involved in preparing the offering documents, with issues lists to ensure that appropriate action is taken (and documented) and that disclosure of key matters is satisfactory.
The basis for participation in a due diligence process, and particularly membership of a DDC, is that each member makes reasonable inquiries (particularly related to their respective areas of specialist expertise), brings an inquiring and independent mind, ensures all matters requiring investigation are raised and followed through, and participates in decision-making.
The above is substantially the due diligence process that was undertaken by the directors and other participants in the 2004 Feltex IPO, which was the result of the proceedings that have this week culminated in the High Court decision in Saunders v Houghton. See Chapman Tripp’s commentary here.
Although, having found that there were no material misstatements in the prospectus, it was unnecessary for the Court to rule upon the due diligence defence under the Securities Act 1978, Dobson J observed that the process undertaken was “very thorough” and “conforming to best practice” and concluded:
“[A]ll relevant components of the process by which the prospectus was settled were undertaken sufficiently thoroughly, and with the application of genuine consideration by those involved, so as to justify findings that the defendants could indeed prove that they had reasonable grounds for belief in the accuracy of what was produced”.
Adapting the due diligence process to the circumstances
The above process is very exhaustive and expensive and, as a result, is likely to be adapted for the circumstances. For example, in a follow-on offer by an existing issuer, it is possible that the exercise can be conducted for the most part on a “bring down” basis, looking at proposed changes in the disclosure and developments in the business since the last offering was undertaken.
Financial product manufacturers and other continuous issuers have evolved their own largely in-house procedures for addressing the verification and due diligence requirements.
Offers under exclusions, such as of same class quoted financial products, can and should be subject to much more focused and streamlined verification processes.
Processes for verification
- identify all factual, statistical and other data in the offering documents and verify these against reliable (ideally third party) sources
- be subject to objective scrutiny claims and opinions about material matters (including, for example, as to the standing of the issuer or its business)
- evaluate whether any discussion of technical or industry matters (including any use of financial or industry-specific metrics, concepts and jargon that need to be included for relevance reasons) merits further explanation in plain English, and
- ensure that the disclosure to be presented to investors (taking into account any graphics, images or formatting) conveys an adequate and accurate overall impression of the offer and provides a balanced disclosure of the benefits and risks.
In order to evidence these procedures, a ‘verification book’ may be prepared showing the steps that were taken and including any relevant sign-offs.
The position with respect to material omissions is more difficult and relies on the involvement of engaged and knowledgeable participants both from within and outside the issuing entity. This can be informed by the preparation of questionnaires and/or undertaking management interviews, but ultimately it requires a rigorous analytical approach which is capable of testing assumptions and where participants are encouraged to play a ‘devil’s advocate’ role.
This Brief Counsel was drawn from the paper Ross Pennington prepared on the FMCA for the 2014 conference of the Banking and Financial Services Law Association.