The recent High Court decision of
Houghton v Saunders1 (the
Feltex case) offers important insights for issuers, directors, advisers and investors in a public offer of securities. It is the first judgment in New Zealand dealing with a compensation claim brought by a group of investors alleging misleading statements or omissions in a securities offer document. The judgment provides guidance as to how the key provisions of securities law – both under the Securities Act and the new Financial Markets Conduct Act (FMCA) – will be interpreted and applied by the courts.
Most of the recent decisions on these issues have involved criminal prosecutions of directors of finance companies. Those cases have resulted in convictions for directors and have naturally caused some concern for directors and others as to the standard of liability which now applies. Feltex arose from the very different factual context of an IPO with a full due diligence process. The Judge dismissed the plaintiff’s claims of untrue statements in the prospectus and indicated that, even if those claims had succeeded, the directors would have had a complete defence based on the thoroughness of the due diligence they undertook. He also found that the plaintiff had, in any event, failed to prove any loss.
The judgment is likely to be welcomed by many directors and corporates as confirmation of the principle that directors are entitled to rely in good faith on information and advice provided by management. It applies the same legal test as was applied in the finance company cases, but does so in the very different factual context of a properly managed corporate with a careful due diligence process. The judgment also provides important guidance on issues such as forward looking statements, prospective financial information, the tests for reliance and loss, and the tests for liability of advisers to an IPO.
Bell Gully was involved both as advisers in the IPO and defending the directors in the High Court proceeding.
Feltex had been owned by the private equity division of Credit Suisse. It was sold by a public offer with a combined investment statement and prospectus issued in May 2004. The company traded profitably during 2004 and the share price remained at or about the float price for 10 months or so after the float. But the company’s fortunes then deteriorated rapidly. Feltex issued a profit downgrade on 1 April 2005 and a further profit downgrade in June 2005. On 22 September 2006, Feltex’s bank appointed receivers and on 13 December 2006 the company was placed in liquidation.
The Securities Commission conducted an inquiry into the prospectus and released a report finding it was not misleading in any material respect. Nonetheless, in early 2008, one of the investors in the IPO commenced proceedings as a representative of other IPO investors. By the time of the trial the investor group had grown to 3,689 and the total claim, including interest, was said to be in the vicinity of $200 million. The claim sought damages against the former directors, Credit Suisse, and the two joint lead managers (First NZ Capital and Forsyth Barr). The plaintiff alleged breaches of the Securities Act and Fair Trading Act, and liability under the tort of negligent misstatement, for what he said were misleading statements and omissions in the prospectus. The case was slow to proceed to trial, at least in part due to the novel procedural issues it presented with a single representative of many investors (to all intents and purposes a “class action”) and two litigation funders standing behind the plaintiff. The case finally went to trial between March and June of this year before Justice Dobson, with the judgment delivered in mid-September. The plaintiff has since filed an appeal.
Eight key lessons from the Feltex case
Investors must act prudently to protect their own interests
When deciding whether a prospectus is misleading, the courts apply the test of the “prudent but non-expert investor”. This test can be difficult to apply to information which is, by its nature, technical. For example, what does the prudent but non-expert investor do when confronted by technical financial information which the investor may not understand? This issue had particular relevance in Feltex because of the way the plaintiff presented its case. The plaintiff complained that information which was correct – such as EBITDA figures or normalised profit figures – was nonetheless misleading because an unsophisticated investor may be confused by it. It was alleged, for example, that an unsophisticated investor may be misled by a normalised profit figure, even if clearly labelled, and may wrongly assume it to be the statutory profit figure. The Judge found that it was not appropriate “to test the content of the prospectus as it would appear to cursory or careless readers”. He also said that prospectuses need not be “dumbed down” to avoid the risk that some readers may not understand them. To the extent that an investor does not understand information in a prospectus, the prudent investor would seek expert advice. Thus financial information such as EBITDA and normalised profit figures are not misleading to a “prudent but non-expert investor”.
Directors are entitled to rely in good faith on advice
This has been one key area of concern following the recent finance company cases. Some passages in those judgments can, divorced from their context, be read to question the long-standing principle that directors can rely in good faith on information and advice provided by management. The Court in Feltex confirmed that directors can indeed rely on management. They are not required “to conduct all relevant research personally”, but can “seek and receive information and advice from those reasonably assessed by directors as being competent to provide it”. On the facts of the Feltex case, the Court found that the directors reasonably relied on the information provided to them by the company’s senior management.
Directors must, however, exercise their own judgement and form their own view (as the Feltex directors did)
The entitlement to rely on others does not, however, mean that directors can simply delegate responsibility for a prospectus. There must also be a “genuine individual assessment of the accuracy of the prospectus”. This requires every director to read the prospectus and the due diligence report and to apply an inquiring mind to satisfy himself or herself that the prospectus was correct. In the Feltex case, every director gave evidence on their personal inquiry into the accuracy of the prospectus. Every director was cross examined on that, and the Judge found that each of them had genuinely and thoroughly tested the content of the prospectus to satisfy themselves that it was accurate.
A thorough due diligence process is likely to provide a defence
A key factual difference between Feltex and the finance company cases was the thoroughness of the due diligence process followed in the Feltex IPO. This involved a formal due diligence committee, minuted meetings, management interviews, a detailed written due diligence report and supporting expert advice from accountants, economists and lawyers. This due diligence process represented best practice in 2004 and was, in substance, the same as the best practice model that we follow in today’s IPO market. This was described in the judgment as a “very thorough” process on which the directors were entitled to rely. It is important to note, however, that it is not the due diligence process itself which provides the defence. Rather, the reports produced by that process allowed the directors to make their own individual assessment and so reasonably satisfy themselves as to the accuracy of the prospectus.
Prospective financial information should be rigorously tested and carefully presented
The Feltex case illustrates the focus which falls on prospective financial information where a company falls short of its projected performance. The judgment warns against analysing forecasts with the benefit of hindsight and instead analyses the issue by asking whether “the directors had reasonable grounds for forming the opinions they did”. The Judge said that the assumptions used in the prospective financial information must be realistic but must not be construed as anything in the nature of a warranty:
Many of the assumptions related to matters entirely beyond Feltex’s control … and were inherently likely to be wrong. That did not make them invalid, and certainly not misleading. Their purpose was to define the parameters of the exercise undertaken to produce the forecast and projection.
The judgment also shows the importance of presenting prospective financial information carefully and in a way that will not mislead the “prudent but non-expert investor”. The plaintiff had focussed particularly on a normalised profit figure, which the plaintiff referred to as a “second bottom line”. The Judge found that this was not misleading, but added that some commentary or an explanatory footnote might have been useful for some readers of the prospectus.
Risks should be disclosed clearly and frankly
The case also illustrates the importance of full and frank disclosure of risks. Some of the plaintiff’s claims alleged that Feltex failed because of changing market conditions – increased competition from imports and unfavourable exchange rate movements – and that these risks should have been more fully explained in the prospectus. In each case, the defendants were able to point to the due diligence inquiry into the relevant risk and to the corresponding disclosure of that risk in the prospectus. This is a useful illustration of the benefits for directors (and others potentially liable under a prospectus) of frankly disclosing the risks facing the business.
A plaintiff seeking compensation must prove reliance and loss – though this will change under the FMCA
The plaintiff had sought to rely on a concept of “indirect reliance” so that an investor need show only that he or she relied on the fact that there was a prospectus rather than on the specific content of the prospectus. The plaintiff also claimed that it was unnecessary to prove any loss attributable to an untrue statement and that he was simply entitled to reimbursement of his full subscription price. The Judge rejected both those arguments. Although not going so far as to require direct proof of reliance on individual statements, the Judge found that the “untrue statement … must be sufficiently material that, if correct, it would then have been more likely than not that the investment would not have been made”. He also found that the plaintiff would need to show the actual loss attributable to any untrue statement and had failed to do so.
On these issues of reliance and loss, the legal test will change under the FMCA. The effect of the new regime is to create an assumption of loss whenever a financial product has declined in value since the date of contravention of the Act. That assumption can be rebutted by the defendants, but nonetheless the plaintiff will no longer need to prove reliance on the misleading statement or loss arising from it.
Joint Lead Managers are not “promoters” – though the law in this area also changes under the FMCA
The judgment also confirmed that investment banks acting as joint lead managers are not “promoters” for the purposes of the Securities Act. This finding was consistent with the accepted view, though there had not previously been any authority directly on point. This is another area where the law will change under the FMCA. The liability of advisers such as joint lead managers will no longer depend on their status as “promoters” (and that concept disappears under the new regime), but rather on whether they satisfy the test for liability as an “accessory”. This in turn depends on the adviser’s degree of involvement in any false statement and, most relevantly, on the adviser’s level of knowledge about any statement found to be untrue.
For further information about the FMCA please contact your Bell Gully adviser.
This publication is necessarily brief and general in nature. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.