Supreme Court brings final clarity to prospectus liability
Houghton v Sanders ( NZSC 74) was a partially successful appeal, which considered the liability of those associated with the 2004 Feltex Carpets initial public offering (IPO) of shares under NZ securities legislation (for further details please see "Appeal comprehensively clarifies prospectus liability").
Feltex went into receivership in September 2006 and was placed in liquidation in December 2006, meaning that the shares were essentially worthless. Mr Houghton brought a representative claim on behalf of himself and other investors, alleging that the IPO prospectus had been misleading and that this had caused loss to the investors. To streamline the process, the High Court ordered a split trial, with a stage one hearing to deal with all of Houghton's claims on the basis that the resolution of issues common to all members of the class represented by Houghton would be binding on all. The stage two hearing was to determine issues such as reliance and loss, which might not be common to all. The
appeal concerned issues raised in the stage one hearing.
The High Court dismissed claims brought by Houghton against the company's directors, the listed promoter and two other parties (who had been organising participants and joint lead managers for the IPO) as promoters. The trial judge found that Houghton's claims under the Fair Trading Act 1986 had failed because the conduct in question was regulated by the Securities Act 1978, that Houghton had failed to prove the prospectus contained any materially misleading statements or omissions that would give rise to liability under the Securities Act and that, in any event, the defendants could establish a statutory due diligence defence.
The trial judge also rejected Houghton's contention that he would be entitled to a full refund on his investment plus interest if he established that the defendants were liable.
The Court of Appeal upheld the High Court's judgment on all but one point. Contrary to the trial judge's finding, the Court of Appeal held that the forecast of revenue for the year ending 30 June 2004 (the FY04 revenue forecast) was an untrue statement. This was because the Feltex directors had known at the time of the allotment of shares that the forecast would not be achieved – they had been advised that there was a likely revenue shortfall of between NZ$7.5 and NZ$9 million, amounting to approximately 10% of the forecast for the final quarter of FY04 or 2.8% for the year.
However, the Court of Appeal found that the untrue statement was not material and therefore did not lead to liability under the Securities Act for the respondents. The Court of Appeal also considered whether the due diligence defence would have applied if there had been liability, finding that it would have been unavailable to parties that had known a statement was untrue even if they reasonably believed that it was immaterial. The majority found that liability under the Fair Trading Act was not precluded, but the court found no liability on the part of the respondents under the Fair Trading Act.
On appeal, the Supreme Court considered:
- the interpretation and application of the Securities Act as creating liability for untrue statements in public offering documents and whether the prospectus contained an untrue statement;
- the assessment of loss;
- the availability of a due diligence defence;
- liability under the Fair Trading Act; and
- the interpretation and application of the term 'promoter' for the purposes of the Securities Act.
This article focuses primarily on the aspects of the decision with potential application to other cases, rather than those mainly concerned with the particular facts of the case.
Section 55(a) of the Securities Act provides that statements in an advertisement or registered prospectus are untrue if they are misleading in form and context or by reason of the omission of a material particular. Under Section 56, issuers, their directors and the promoters of securities are civilly liable to persons who subscribe for any securities on the faith of an advertisement or registered prospectus which contains any untrue statement.
The Supreme Court held that the definition of 'untrue' in Section 55(a) is broad and that a broad interpretation of the term 'misleading' is appropriate. Because of the breadth of the definition in Section 55(a), the Supreme Court considered that it made no difference (at least in the present appeal) whether it is seen as an exhaustive definition or not, and therefore treated the definition as exhaustive for the purposes of the judgment.
The Supreme Court noted that the term 'untrue statement' and the definition in Section 55(a) must be interpreted in the context of the act and its investor protection purpose. Accordingly, to be an untrue statement in terms of Section 56(1), a statement must be on a topic that may be relevant (either on its own or in combination with other considerations) to a decision to invest. The court also noted that a claim that a prospectus is, in its entirety, an untrue statement will be able to be substantiated only if it can be shown that statements in (or omissions from) the prospectus have a cumulative effect, making the overall document misleading. Realistically, such a claim would be unsuccessful unless supported by identified misleading statements or omissions.
Similar to the Court of Appeal, the Supreme Court did not consider that there is any requirement that an untrue statement be misleading to a material extent to be untrue; rather, all that is required is that the statement is misleading in the form and context in which it is included in a prospectus. The Supreme Court unanimously upheld the Court of Appeal's finding that the FY04 revenue forecast was an untrue statement – even an anticipated shortfall of 2.8% for the year was significant enough to render the forecast untrue in the context of Feltex's history and the cyclical nature of the carpet market.
Meaning of 'on the faith of' and 'by reason of' – loss assessment
The liability imposed on issuers, directors and promoters under Section 56(1) of the Securities Act is a liability to compensate investors who invested 'on the faith of' an untrue statement for any loss or damage that they may have sustained 'by reason of' such untrue statement.
The Court of Appeal found that there is a materiality requirement in Section 56 (ie, a plaintiff must prove that a statement is untrue, that they have read and considered the prospectus and that a notional investor's decision to invest was more likely than not influenced by the particular untrue statement unless the evidence establishes that the particular plaintiff did not rely on the untrue statement). It found that the FY04 revenue forecast was not capable of causing loss because it could not have influenced any decision to invest.
The Supreme Court disagreed. 'On the faith of' under Section 56 means in reliance on the truth of the publicly registered document which informs the market. This does not require that investors have seen or read the prospectus – there is an inference that investors who subscribe for shares invest on the faith of the prospectus assuming that its contents are true. This inference would be displaced if the investors knew the truth and invested anyway.
As to whether loss or damage was sustained 'by reason of' an untrue statement in a prospectus, the court must determine whether the effect of the untrue statement was such that the market value of the securities for which the investor subscribed would have been lower than the price paid if the misleading statement had not been made (ie, if the prospectus had complied in all respects with the Securities Act and the Securities Regulations).
In the present case, and contrary to the Court of Appeal's view, the Supreme Court held that the untrue statement in the FY40 revenue forecast was capable of causing loss. However, the court rejected Houghton's case that, once an untrue statement is proved, loss equal to the value of the investment automatically follows. Whether the untrue statement caused loss for investors other than Houghton was left for determination at the stage two hearing.
Section 56(3) of the Securities Act provides that Section 56 liability can be avoided by establishing a belief on reasonable grounds that a statement is true.
The Supreme Court affirmed the Court of Appeal's finding that the Section 56(3) due diligence defence is unavailable to parties that know that a statement is untrue, but consider the inaccuracy in the statement to be immaterial. Section 56(3) refers to a belief that a statement is true, not a belief that a statement is untrue but only to an immaterial extent, and it is not possible to claim reasonable grounds for believing that a statement is true when it is known that it is not.
The Supreme Court also noted that the unavailability of the Section 56(3) due diligence defence did not prevent parties found to be in breach of the Securities Act from arguing that Section 63(1) should be applied to relieve them from liability. That section gives the court power to excuse from liability a person who might be liable in respect of negligence, default, breach of duty or breach of trust in connection with an offering to the public or allotment of securities.
Liability under 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 said conduct under the Securities Act. Section 5A of the Fair Trading Act duplicates the effects of Section 63A. The Securities Amendment Act contained transitional provisions requiring the Securities Act to be applied as if it were not amended by the Amendment Act for existing offences or contraventions. The Feltex prospectus was issued before either Section 63A or Section 5A came into force, and the Feltex proceeding was issued after Section 63A, but before Section 5A, came into force.
The trial judge held that two causes of action under the Fair Trading Act were precluded by Sections 63A and 5A and that no retrospectivity issues arose, as neither section prevented a claim being made under both the Securities Act and the Fair Trading Act even if the court could be deprived of jurisdiction to make a finding under the Fair Trading Act by a finding that the conduct in question was regulated by the Securities Act.
The majority in the Court of Appeal disagreed, noting that it was no answer to say that a claim could be brought, but no remedy given, as removal of a remedy removed substantive rights. Applying Section 63A and Section 5A was to give these provisions retrospective effect and there was no legislative indication that the sections were intended to have retrospective effect. It was unfair to apply Section 63A retrospectively. However, the Court of Appeal found that the untrue statement in the FY04 revenue forecast did not breach the Fair Trading Act.
The Supreme Court upheld the majority's finding that Section 63A of the Securities Act and Section 5A of the Fair Trading Act had no retrospective effect. The Supreme Court noted that it would be an odd outcome if Section 63A applied to Houghton's claim when none of the substantive provisions introduced into the Securities Act by the Securities Amendment Act applied. The Supreme Court also agreed that applying Section 63A or Section 5A in the present case would unfairly deprive Houghton and the other plaintiffs of a remedy for a breach of the Fair Trading Act that they would have otherwise had. In the absence of language indicating that the section should apply retrospectively, the correct approach is to treat Section 63A as applying only to conduct occurring after it came into force.
The Supreme Court noted that, in terms of Section 56 of the Securities Act, the prospectus contained an untrue statement in the FY04 revenue forecast. It followed that the company's directors and the listed promoter were in breach of Section 9 of the Fair Trading Act, which prohibits engaging in conduct that is misleading or likely to mislead or deceive. However, the Supreme Court dismissed the Fair Trading Act claim against the joint lead managers, as Houghton had failed to prove that the untrue statement in the FY04 revenue forecast was attributable to the joint lead managers as primary parties.
The issues of causation and appropriate remedy under the Fair Trading Act were left for resolution at the stage two hearing.
Section 56(1) of the Securities Act imposes civil liability for misstatements in a registered prospectus on the issuer (if an individual), directors of the issuer and "every promoter of the securities". Section 2(1) of the Securities Act defines a 'promoter' as "a person who is instrumental in the formulation of a plan or programme pursuant to which the securities are offered to the public" and "where a body corporate is a promoter, includes every person who is a director thereof", but "does not include a director or officer of the issuer of the securities or a person acting solely in his or her professional capacity".
Houghton argued that the joint lead managers on the Feltex IPO were promoters.
The joint lead managers were share brokers and investment bankers and were not named in the prospectus as promoters. They were engaged to provide investment banking and share brokering services, including the provision of stock market listing services and advised on regulatory requirements, the content and structure of the prospectus and offering and the due diligence process.
The joint lead managers agreed to take a specific share allocation and made a commitment to make up the shortfall if bondholders did not elect to convert bonds to shares or subscribe for shares at the prescribed rate. In exchange for this and other services supplied, the joint managers received fees, brokerage and a discretionary incentive fee.
The trial judge held that the term 'promoter' involved a close measure of personal involvement and a level of authority enabling the promoter to have or share control over the offer. Those whose advice had been rejected were unlikely to be instrumental in formulating a plan for the IPO as required by the statutory definition. In addition, the trial judge held that the joint lead managers fell within the exception in Paragraph (c): "a person acting solely in his or her professional capacity".
The Court of Appeal took a different view on the interpretation of promoter in the Securities Act and was divided on the application of principle to the facts. Adopting a lower threshold, the Court of Appeal found that 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. While a decision-making role in formulating a plan may be evidence that someone is a promoter, this is not a necessary element.
The members of the Court of Appeal differed on whether the joint managers fell within the definition of a promoter, with the majority finding that they did because they were actively involved in the formulation of the plan to offer the securities. As the issue was not dispositive of the appeal and in the absence of full argument, the Court of Appeal did not express a concluded view on whether the joint lead managers' services were undertaken solely in their professional capacity.
On appeal, the Supreme Court considered the meaning of promoter in the Securities Act, whether the joint lead managers were promoters and whether the professional capacity exception in Section 2(1) (c) applied.
It held that the definition of 'promoter' in Section 2 emphasises three considerations:
- distinctness from the issuer; and
- the exclusion of a person acting "solely in his or her professional capacity".
The Supreme Court noted that it was a matter of debate whether Parliament's alteration of the statutory definition in 1978 from 'party to the preparation' to 'instrumental in the formulation' was intended to contract or extend the level of a person's involvement in a public offering of securities in order to come within the definition of promoter and declined to resolve the point as it was not dispositive in the present case. In the factual context of the case, and putting aside the exception in Section 2(1)(c), the Supreme Court found that the joint lead managers had been instrumental to the formulation of the plan pursuant to which the shares were offered to the public. Their role had involved more than just taking an active part in the formulation of that plan – the joint lead managers had also had the capacity to significantly influence the form of the prospectus and exercised that opportunity, albeit having no determinative powers and being overruled on some recommendations. They had been neither bystanders nor bit part players.
As to whether the professional capacity exception in Section 2(1)(c) applied, the Supreme Court noted that it agreed with the characterisation of the exception given by Darville and Clarke in Securities Law in New Zealand:
...[A]n underwriting or stockbroking firm managing a flotation or issue on a normal retainer basis will be within para (c). But if the firm is itself responsible for initiating the
float, or it receives remuneration more akin to a profit on a venture than normal professional charges, the exception will probably not apply.
Applying this to the facts, the Supreme Court held that the joint lead managers had not been promoters for the purposes of Section 56, as their role had fallen within the professional capacity exception in Paragraph (c) of the definition of promoter in Section 2(1) of the Securities Act. The role of the joint lead managers had been ultimately ministerial and advisory in character and had not exceeded the normal professional responsibilities of an organising participant broker acting in a professional capacity. Although it was accepted that an unusually high level of reward-based remuneration might take a broker outside the exclusion in Paragraph (c), that was not the case on the
The Supreme Court's decision is a useful determination of a number of securities law liability issues in the NZ context. It clarified as follows:
- An untrue statement for the purposes of Section 56 of the Securities Act need not be misleading to a material extent to be untrue – all that is required is that the statement is misleading in the form and context in which it is included in the prospectus.
- In considering whether an investor invested on the faith of the prospectus, the term 'on the faith of' gives rise to an inference that investors invested in reliance on the truth of the publicly registered document; it does not require investors to have seen or read the prospectus.
- The untrue statement need not be misleading to a material extent to be causative of loss but causation and loss must be proven – it is insufficient to argue that once an untrue statement is proven, loss equal to the value of the investment automatically follows.
- Loss is likely to be reflected on the effect of an untrue statement on the market value of the securities.
- The Section 56(3) due diligence defence is not available to parties that knew a statement was untrue but considered that the inaccuracy in the statement was immaterial – it is not possible to claim reasonable grounds for believing that a statement is true when it is known that it is not.
- The unavailability of the Section 56(3) due diligence defence does not prevent parties found to be in breach of the Securities Act from arguing that Section 63(1) should be exercised to relieve them from liability.
- The Fair Trading Act is not precluded from applying – Section 63A of the Securities Act has no retrospective effect.
- A person who is instrumental to the formulation of the plan pursuant to which securities are offered to the public, and who has the capacity to significantly influence the form of the prospectus, may be a 'promoter' unless their role falls within the professional capacity exclusion.
- Brokers and investment bankers involved in securities offerings must be aware that the professional capacity exclusion will not invariably apply to them – it will depend on whether they have exceeded the normal professional responsibilities of a participant broker acting in a professional capacity. An unusually high level of reward-based remuneration may take such parties outside the professional capacity exclusion.
(1) Houghton did not lead evidence on the loss that he had suffered in the High Court, instead relying on the argument that his loss equalled the whole of his investment. As an alternative, he sought an inquiry into damages. The trial judge rejected both arguments, finding that Houghton's loss needed to be established in the stage one hearing. This was upheld by the Court of Appeal and the Supreme Court. The Supreme Court noted that, having failed to prove loss at the stage one hearing, Houghton's Securities Act claims would fail in the normal course, unless he successfully applied to the High Court to allow his participation at the stage two hearing. The court made no comment on whether such an application should be allowed.
For further information on this topic please contact Hannah Yiu at Wilson Harle by telephone (+64 9 915 5700) or email ([email protected]). The Wilson Harle website can be accessed at www.wilsonharle.com.