Untrue statements and prudent investors
Due diligence defence
Precluding Fair Trading Act claims and retrospectivity
The Court of Appeal recently reviewed important aspects of liability under New Zealand securities legislation. Houghton v Sanders and Ors ( NZCA 493) was an unsuccessful appeal against a High Court decision dismissing claims brought by subscribers for shares in the 2004 Feltex Carpets initial public offering against:
- the company's directors, the vendor and the issuer of the shares; and
- the vendor, the listed promoter and two other parties (who had been organising participants and joint lead managers of the initial public offering) as promoters.
Feltex went into receivership in September 2006 and liquidation in December 2006, rendering the shares worthless. An action was brought by a large number of investors. To streamline determination of the claims, it was ordered that Houghton's claim be tried first and that, in addition to being a judgment on that claim, the decision would result in a binding determination of a number of identified issues common to the other claims.
The High Court had dismissed claims under the Fair Trading Act 1986 (as its application was excluded by the Securities Act) and negligence (as the relationship between the initial public offering investors and defendants did not result in a duty of care). Under the Securities Act, while some criticisms of the prospectus were justified, none were held to be materially misleading and, in any event, the defendants would have been able to avoid liability by applying a statutory due diligence defence.
The appeal challenged the High Court decision in the following respects:
- the interpretation and application of the Securities Act as creating liability for untrue statements in public offering documents (and the related concept of a 'prudent investor');
- the interpretation and application of the term 'promoter';
- certain key factual findings;
- the availability of the due diligence defence;
- the Securities Act's exclusion of the Fair Trading Act; and
- the findings on reliance and loss.
This update focuses on the aspects of the decision with potential application in other cases, rather than those mainly concerned with the particular facts of the case.
Untrue statements and prudent investors
Section 55 of the Securities Act provides that statements are untrue if they are misleading in form or context or by reason of any material particular being omitted. Civil liability to those who subscribe for securities on the faith of a prospectus which contains an untrue statement is imposed on the issuer, its directors and the promoters of the securities (Section 56).
The Court of Appeal rejected arguments that Section 55 was not an exhaustive statement of the basis of liability, and that the plaintiff need not show that any particular statement was untrue (so that an entire prospectus could be treated as a misleading statement by reason of the absence of some relevant information). As a matter of policy, the court agreed with the trial judge that New Zealand securities legislation does not seek to limit risk which investors may face, but rather to require adequate and accurate disclosure of matters relevant to risk.
Adequate disclosure is that which conforms to the detailed disclosure regime set out in the Securities Act and the regulations made there under. Legitimate risk, even if substantial, does not create liability if adequately disclosed.
In addition to confirming the exhaustive nature of Section 55 for both civil and criminal liability, the court also confirmed that Section 56 civil liability requires an untrue statement to be material. Under Section 56, a plaintiff must establish that the investment was made "on the faith of" the prospectus. The court suggested that the resulting connotation of reliance is the first reason that the untrue statement must be material. The second is that, under Section 56, the plaintiff must also establish that it suffered loss "by reason of such untrue statement".
The court set out its view on how the materiality requirements of Section 56 should be approached. It suggested that the courts first ask whether the notional investor's decision to invest was more likely than not to have been influenced by the untrue statement. If so, materiality would be established unless evidence established that the particular investor had not relied on the untrue statement (eg, by knowing the true position). The test thus combines objective and subjective elements.
The court also agreed with the trial judge's characterisation of a 'notional investor' – a non-expert with a basic understanding of the prospectus's narrative content, who was not qualified to analyse financial data but could recognise content not understood and was likely to have sought advice if that content was material to the investment decision.
After rejecting the grounds of appeal relating to factual findings, the court considered the so-called 'due diligence defence' set out in Section 56(3)(c), which provides that Section 56 liability can be avoided by establishing a belief on reasonable grounds that a statement is true. Although finding no untrue statements, the trial judge went on to hold that the process by which the prospectus's content was settled would justify findings that the defendants could show reasonable grounds for belief in its accuracy.
The Court of Appeal confirmed that the defence would be unavailable to parties that knew that a statement was untrue, but failed to correct it because they believed it to be immaterial. It agreed with the plaintiff that it was critical to focus on what the defendants knew and the steps taken to satisfy themselves about the truth of a particular statement, but held that the evidence established a thorough process in which the defendants had engaged with genuine consideration. In the absence of a proved material untruth, no closer analysis was possible.
Section 2 of the Securities Act contains a statutory definition of a 'promoter'. The appellants argued that three parties, none of whom had been named in the prospectus as a promoter, were promoters (and that the trial judge had been wrong to find otherwise). Two of the three parties had been engaged to provide the sort of investment banking and brokering services typically required for an initial public offering transaction, including the provision of stock market listing services. They had agreed to take a firm allocation of shares and had made a commitment to make up a shortfall if bondholders did not elect to convert bonds to shares or to subscribe for shares at the prescribed rate. In exchange, they received fees, brokerage and a discretionary incentive fee.
The trial judge had held that the term 'promoter' involved a close measure of personal involvement and a level of authority, enabling the promoter to share control over the offer. Those who had participated at the direction of others and whose advice may have been rejected were unlikely to have been instrumental in formulating a plan for an initial public offering, which the definition requires. The plaintiff argued that:
- the statutory definition turned on instrumentality, not the power to make decisions;
- instrumentality does not require power or control; and
- the role of the two firms was critical both to the design of the structure and in giving the commitment to acquire shares and their partial underwrite.
For that reason, they exercised de facto control through the threat of withdrawal.
Although acknowledging that the issue was primarily one of statutory interpretation, the Court of Appeal reviewed the development of the concept of a promoter under common law and concluded that the statutory definition must be read in the light of its common law antecedents. It also reviewed the legislative antecedents of the applicable Securities Act definition.
The court concluded as follows:
- A person may be a promoter even though not named as such in the prospectus.
- A promoter is someone who brings a plan into existence by taking an active part in its formation to issue securities and is a party to the preparation of the prospectus.
- A decision-making role may be good evidence that a person is a promoter, but it is not essential. The main prospectus decision makers, namely the issuer and its directors, are separately liable for misstatements in a prospectus.
- There is insufficient potential for the imposition of unwitting criminal liability to justify the narrow interpretation of a promoter adopted by the trial judge.
The members of the court differed on whether the nature of the firms' roles brought them within this broad definition, with the majority considering that it did. As a result, the court also considered whether the statutory professional capacity exclusion applied to them. The plaintiff's argument that the exclusion did not extend to corporates was rejected in light of the broad Securities Act definition of a 'person'. Because the issue was not dispositive (and the governing act no longer imposes similar liabilities), the court declined to express a view on the more difficult issue of whether the extent of the firms' financial interests took them outside the scope of the exception. The court noted that the roles in the case under appeal were different from those in earlier cases which had discussed the underlying policy justification, and that engagement on standard industry terms did not preclude the possibility that the industry regularly strayed beyond acting in a purely professional capacity and became a risk participant.
The third alleged promoter was the group's holding entity, which held the shares in Feltex. Another group entity had administered and directed it. The latter group was named as a promoter, but the issuing shareholder was not. While only individual issuers are liable under Section 56, corporates can be liable as promoters. The appellant argued that the holding entity had had "total control" through its ownership and, in the alternative, through its corporate relationship with the named promoter. It was suggested that the named promoter was effectively appointed to act as promoter by the issuer to protect the issuer from liability.
The court agreed with the trial judge's analysis; it was only the named promoter that had participated in the formulation of the plan and played an active role. Agency is not an element of the statutory definition, which focuses on the role played, not ownership. The suggested agency loophole did not exist because, if an issuer were a corporate, the issuer's directors would have potential liability for untrue statements under Section 56.
Precluding Fair Trading Act claims and retrospectivity
The trial judge held that two pleaded causes of action under the Fair Trading Act were precluded by the Securities Act and the Fair Trading Act. Section 63A of the Securities Act precludes liability under the Fair Trading Act for conduct regulated by the latter if there is no liability for the conduct under the Securities Act. The Securities Act contains transitional provisions which require it to be applied as if not amended for existing offences or contraventions thereof. Section 5A of the Fair Trading Act duplicates the effect of Section 63A. The Feltex prospectus was issued before either provision came into force. The proceeding was issued after Section 63A, but before Section 5A, came into force.
The plaintiff argued that the transitional provisions preserved the application of the Fair Trading Act to the conduct at issue in the proceeding and that, in any event, applying either provision would deprive investors of rights accrued under the Fair Trading Act retrospectively, contrary to Section 7 of the Interpretation Act 1999.
Retrospectivity arises when a statute effects some change to the legal nature or effect of a past act or omission, something which is not easy to discern. The rationale for opposing the presumption against retrospectivity in Section 7 is an assumption that Parliament does not intend statutes to create unfairness. A majority disagreed with the trial judge's view that applying Section 63A would not have retrospective effect by depriving claimants of accrued rights – it was no answer to the appellant's argument to say that a claim could be brought, but no remedy given, as removal of a remedy removes substantive rights. Parliament may provide for statutes to have retrospective effects either expressly or by implication, but the greater the apparent unfairness created by retrospective application, the more clearly the expression of such an intention is expected.
The majority found no indication in the statute of an intent that Section 63A would have retrospective effect. In their view, if conduct occurred before the 2006 Securities Act amendment, neither Section 63A nor the later Section 5A of the Fair Trading Act operated to deprive claimants of rights of action and associated remedies. When the transitional provisions preclude the application of enhanced rights and remedies under the Securities Act, it would be unfair to deprive claimants of any accrued cause of action under the Fair Trading Act.
The minority agreed with the trial judge that Section 63A precluded a successful Fair Trading Act claim and took the view that, as the provision applied only to conduct regulated by the Securities Act, no unfairness arose.
Notwithstanding the majority's view, the court did not consider the Fair Trading Act claims because, to obtain a Fair Trading Act remedy, the plaintiff had to establish that the misleading or deceptive conduct was an effective cause of some loss or damage. As the court had already held that only one matter was capable of being held to be misleading or deceptive, but that such matter was immaterial, the majority considered the Fair Trading Act claims to be untenable.
Although the trial judge, having found no material untruths in the prospectus, did not address loss definitively, the appellant challenged the observations that he had made.
The plaintiff had not called any evidence on loss, asserting that, if there had been full disclosure, he would not have invested in the initial public offering and it would not have proceeded. Therefore, he claimed that his loss was the full price of the shares. The trial judge had disagreed, holding that the shares clearly had substantial value at the time of purchase and that the plaintiff had overlooked his obligation to mitigate loss. Once aware of the matters of concern, the plaintiff could have minimised his loss by selling the shares.
The plaintiff's final fall back – a suggestion that questions of loss could be reserved for a subsequent hearing – was problematic because the staged hearing orders required full resolution of the plaintiff's claim, including loss, at the trial.
The Court of Appeal referred to its earlier conclusions on the questions of reliance and causation and the need, as a result of the pre-trial directions, for the plaintiff to produce evidence to substantiate the loss claimed.
While Section 56 removed the need to prove fraud regarding prospectus misstatements, it did not dispense with the need to prove reliance and quantification of loss. Compensatable loss should be quantified as the difference between the price paid and the estimated value of the securities if proper disclosure had been given. To that extent, the Court of Appeal agreed with the approach that the trial judge had indicated. In such an approach, no duty to mitigate arises.
The decision is a useful confirmation of a number of securities law liability issues which have been gradually clarified through a series of cases following the collapse of most of New Zealand's finance companies during the global financial crisis.
Those involved in public offerings will be relieved to receive confirmation that:
- liability is limited to material untrue statements (a concept which excludes treating a prospectus as a whole as a statement);
- materiality is primarily measured objectively against a notional non-expert but prudent investor;
- conscious and diligent participation in a robust due diligence examination of a prospectus is likely to provide a defence to participants who believe its contents to be true;
- the concept of a promoter is limited to those actively involved in planning and undertaking a public offer (without extending to associated parties); and
- loss must be proved on a diminution of value basis.
The decision also offers useful guidance on the approach to retrospectivity, a concept which is notoriously difficult to apply in many cases.
However, there are matters to which those involved in public offers, particularly as investment bankers and brokers, should pay careful attention. The Court of Appeal expressly left open the issue of whether those who become risk participants in a public offering can rely on the professional adviser exclusion (and explicitly rejected an argument that showing that participation is on "standard industry terms" will be sufficient to come within the exclusion). The court also confirmed that the due diligence defence is unavailable to defendants who knew that a statement was untrue, but doubted its materiality.
For further information on this topic please contact Chris Browne at Wilson Harle by telephone (+64 9 915 5700) or email ([email protected]). The Wilson Harle website can be accessed at www.wilsonharle.com.