The importance of robust due diligence processes in significant capital raisings is a key take-out from the High Court decision this week clearing the former Feltex directors from liability for shareholder losses.
The Court found that the company’s 2004 IPO document was not misleading under the Securities Act.
Even had misleading statements been made, the Court considered the process by which the prospectus had been settled was so thorough that the directors could prove they had reasonable grounds to believe in the accuracy of its contents.
The directors and others associated with the Feltex IPO were being sued by Eric Houghton on behalf of 3,689 former Feltex shareholders for losses they claimed arose from their reliance on misleading disclosure.
The prospectus, issued in May 2004, identified a number of risks to the company’s future performance but generally portrayed an improving financial position. The end of year results for 2004 permitted a dividend above forecasts, but, by 1 April 2005, the company was issuing a profit downgrade. In September 2006, the bank appointed receivers, over the board’s objection. In October its assets were sold to Godfrey Hirst and, in December, it was placed in liquidation, its shares worthless.
The Securities Commission conducted an inquiry into the adequacy of the disclosure and concluded in October 2007 that it was not misleading in any material respect.
The High Court decision
The Court found there was “some justification” for a number of the criticisms brought by the shareholders, but that they had not demonstrated that there were any materially misleading statements or omissions in the prospectus that would trigger liability under the Securities Act 1978 (SA).
In response to the submission that the prospectus overall conveyed an impression that the investment was less risky than it turned out to be, Dobson J found that argument “appeared stronger when invoked with the benefit of hindsight, than it did as a reconstruction of the position as reasonably apprehended by the defendants at the time”.
The Court also found that, because the relevant behaviour was regulated by the SA, overlapping liability under the Fair Trading Act (FTA) would not arise. This finding confirms the effect of amendments made in 2006. The Financial Markets Conduct Act 2013 (FMCA) likewise overrules the application of the FTA in relation to financial products and services and goes further, by requiring that the Commerce Commission get the FMA’s permission before proceeding with an FTA misleading conduct claim in the financial services sector.
Similarly, the Court found that there is no place for any cause of action for negligent misstatement in these circumstances.
The Court had no difficulty finding that the Joint Lead Manager role fell within the ambit of the professional adviser exclusion to promoter liability, as has been widely assumed in practice. The FMCA takes a different approach by focusing secondary liability on those knowingly involved in a contravention, regardless of the nature of their role.
Much of the interest in the judgment sits outside the substantive findings of fact. Because it was said during the proceedings that appeals would be “inevitable”, Dobson J thought it appropriate to record his views on other issues which could arise on appeal.
Two matters of particular relevance to directors and others responsible for document preparation to support a capital raising are:
- the level of reliance required to trigger liability for civil compensation, and
- the due diligence defence.
Level of reliance
One of the major reforms introduced by the FMCA is a presumption of loss provided for in section 496 (reflecting “fraud on the market” theory). This provides that if an investor sustains a loss, and there has been a disclosure contravention in an offer document, the loss will be attributed to the defect in disclosure unless it can be demonstrated that it was due to something else.
This is much more investor-friendly than the equivalent provision in the SA, and essentially turns the test on its head. But there is a two year transition to the FMCA, and the SA will continue to apply to those cases which predate its application, of which there are several in the pipeline.
Section 56 of the SA provides that civil liability for losses will be established if the person bought the securities “on the faith of” an untrue statement in an advertisement or registered prospectus. At issue was what this meant.
The shareholders argued that it “contemplated no more than investing in the knowledge that a prospectus existed.”
The defendants cited the Court of Appeal1, stating that an investor must:
“…show reliance on a particular item or items in the [financial statements] which were inaccurate… For, if the inaccurate material was not an influence…., how can it be alleged that the investor would not have gone ahead with the investment”.
They also drew on the explanatory note to the Financial Markets Conduct Bill explaining that, under the SA, it was difficult for investors to obtain compensation due to “the need for each investor to prove actual reliance on the misstatement that caused the loss”.
But Dobson J went down the middle, saying that the legislative intention in the SA was to create a materiality threshold and that:
“There has to be a nexus between the loss sustained and the untrue statement, but not to the extent that requires the claimant to prove reliance directly on the untrue statement”.
Due diligence defence
Under the due diligence defence, which has been carried through to the FMCA (along with two new defences), where there has been a defect in disclosure, directors can avoid civil liability if they can establish that they had reasonable grounds to believe that the documents were accurate at the time they were issued to the public.
Application of this defence would require a case-by-case consideration of the reasonableness of the belief claimed by each director in relation to any particular content that was found to be misleading.
Dobson J said that he did not need to go through this exercise as he had already found that the materiality test was not triggered. However, he made the general observation that the rigour of the due diligence applied in the IPO, which he described as “very thorough” and “conforming to best practice”, would put the Feltex directors into a position of relative safety:
“[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”.
Features of the due diligence approach which the Court commented on included:
- responsibility for the preparation of the various components in the prospectus being allocated to the people best qualified to make those contributions
- each of the three law firms involved being required to complete legal due diligence
- Ernst & Young as the company’s auditors being contracted to provide not only the usual statutory report but also a review of the manner in which the prospective financial information had been prepared (according to the Court, this second step was “novel” in 2004)
- members of Feltex senior management specifically considering and signing off on the accuracy of how those aspects of the business in which they had particular expertise were described
- the conducting of 11 further interviews with senior Feltex managers to test the reasonableness of statements for inclusion in the prospectus, and
- Forsyth Barr and First New Zealand Capital, as Joint Lead Managers of the IPO, having representatives attend the due diligence committee meetings and being invited to comment as the content evolved.
For an in-depth analysis of how and where the FMCA departs from the SA, refer to the paper Ross Pennington prepared for the Banking & Financial Services law Association conference in August.