Unpicking the weft of the Feltex decision

22 October 2014

Unpicking the weft of the Feltex decision

Introduction

The decision of Dobson J. in the High Court last month marks an important milestone in the long-running litigation battle following the Feltex IPO. At the end of last week it was announced that the decision is to be appealed.

This was (effectively) a representative action brought against the directors of Feltex on behalf of investors who bought shares in the 2004 IPO against the (then) directors of Feltex for liability for alleged disclosure failings in the IPO prospectus.

The headline element of the decision is that the former directors were cleared. Although the judge found a number of the criticisms of the content of the prospectus had some justification, he found that none of them were materially misleading (as to content or omissions from that content) that would trigger liability on the test as applied under the Securities Act 1978. In addition, the judge decided that because relevant conduct is regulated by the Securities Act, the prospect of liability does not arise under the Fair Trading Act 1986. Nor are the circumstances of any relationship between the directors and other defendants on the one hand, and investors in the IPO on the other, such as to give rise to the prospect of a duty of care in tort being imposed.

The judge also cleared two Credit Suisse entities, as well as First New Zealand Capital and Forsyth Barr (as the Joint Leads Managers (“JLMs”) of the IPO) of any liability relating to claims alleging misleading statements.

The judge noted that, whilst those findings would be sufficient to determine the claims – because he was told repeatedly during the hearing that appeals would be inevitable, it is appropriate to record findings on numerous other issues which were the subject of extensive evidence and argument, and which would become relevant in the event that an appeal court finds that he was wrong to dismiss the claims of misleading content in, or omissions from, the prospectus.

These additional findings provide interesting reading and some important lessons.

Background

Feltex was a long-established carpet manufacturer of carpets. It was acquired by the private equity arm of Credit Suisse which, in 2004, sold down its holding via an IPO. (Note: unlike many IPOs – a significant element of the IPO was the selldown of shares by an existing shareholder – rather than raising new money for the listed company).

The offer document (a combined investment statement and prospectus) was dated 5 May 2004 and the IPO closed on 4 June 2004 – with the share price being set at $1.70 through a book-build process.

Feltex reported difficulties about 10 months after the IPO when, at beginning of April 2005, it issued a profit downgrade. This was followed by another profit downgrade in June 2005. Receivers were appointed by Feltex’s banks at the end of September 2006 – and the company went into liquidation in December 2006.

In October 2007 the Securities Commission released a report on an inquiry it had conducted into the IPO prospectus and the company’s compliance with financial reporting and continuous disclosure obligations in the period between the IPO and liquidation. It concluded that the prospectus was not misleading in any material respect – but noted that the company failed to disclose certain material information to the market concerning changes to its banking facility agreement with ANZ in October 2005 as well as a breach of its banking covenants and did not properly classify its debt in its half-year financial statements at the end of 2005.

In 2008 a representative action was commenced on behalf of IPO investors – seeking damages against the former directors, the Credit Suisse vendor entity, and the JLMs for alleged breaches of the Securities Act (and Fair Trading Act) for alleged misleading statements and omissions in the IPO prospectus.

Findings

As noted above, the primary finding was that none of the criticisms of the content of the prospectus met the threshold test to be materially misleading (as to content or omissions from that content) under the Securities Act.

Misleading in form and context?

To meet the threshold test under the Securities Act, a statement in a prospectus must be shown to be misleading in the form and context in which it is included. The judge rejected the submission that this required the prospectus to be considered on the whole. Instead, he found that the relevant passages in the prospectus that are alleged to be (materially) misleading must be identified – and tested on a statement-by-statement basis, having regard to the context in which they appear. However, he added that if the context that renders any one or more statements misleading is reflected in numerous other passages in the prospectus, then a determination of whether the statement complained of is misleading requires an assessment of the sense reasonably conveyed by that statement, where the subject matter is addressed elsewhere in the prospectus.

In the case of omissions, again a particular statement must be identified that is rendered misleading because of the omission of additional information which would be material to understanding that statement in the form and context in which it appears in the prospectus.

As a result, the judge concluded that the relevant provisions in the Securities Act reflect a policy that the preparers of offer documents are to be held to account on a “relatively specific” basis, not at an abstract level that prejudices their ability to consider the criticism and respond to it.

In this case, one of the more general criticisms was that the prospectus, overall, gave an unjustifiably positive impression of Feltex’s business and its prospects. But the judge pointed out that, unless related to a specific statement or omission from an identified statement, such generalised criticisms are difficult to evaluate objectively.

Therefore, he continued that, to the extent that the approach of the Court in Nathans Finance suggested a more liberal evaluation of the impression given by a prospectus than that of Bridgecorp, it may well be that the Court in Nathans Finance considered it appropriate in the context of that prospectus to reflect the overall impression conveyed by the offer document as part of the context, whereas the judge in Bridgecorp was focusing on the statement or omission that was the subject of complaint. (In Nathans Finance, the judge assessed a number of particular passages that were found to be misleading and, after doing so, it was appropriate to reflect on their combined impact.)

Perspective of notional investor

Next, the judge noted that the test of whether a particular statement or omission is misleading is an objective one. The standard to be applied is the effect the statements would have on a ‘notional investor’ (using the “prudent but non-expert person” benchmark established by the investment statement regime – which is carried through into the FMC Act). The profile of the notional investor has been considered in failed finance company cases – such as Bridgecorp and Lombard.

In this case, Dobson J. accepted that there was a material difference between the notional investor in relatively simple, fixed-term investment in debt securities offered by a finance company and an investor in a more complex equity security offered under an IPO. The latter would be regarded as likely to seek advice on aspects of the prospectus that they did not understand.

The notional investor test can be difficult to apply where the information is technical (in this case there was much discussion of technical financial information such as ‘normalised’ profit figures). The plaintiff complained that some of this information, even if correct, was misleading because a non-expert person may be confused by it. For example, that they might assume that a normalised profit was an achieved/reported outcome. Dobson J. found that the relevant benchmark was not that of a cursory review or that prospectuses needed to be dumbed down to avoid misleading investors. Instead, he concluded that a prudent but non-expert investor would not understand such information (and would seek expert advice).

And in order to sheet home a claim under the Securities Act based on a misstatement in a prospectus, a claimant must prove that they:

• subscribed for the securities on the faith of the prospectus; and
• suffered loss “by reason of” the untrue statement.

By reason of/on the faith of (reliance)

Whilst he did not need to make a finding on this issue, because of his decision that there was no material misstatement or omission, Dobson J. added that he did not treat the requirement that an investment had been made “on the faith of” a prospectus as requiring reliance on specific passages (which would be required to prove negligent misstatement).

The plaintiff argued that it did not have to establish reliance on the specific content of the prospectus that was found to be misleading. Instead, subscribing for securities “on the faith of” a prospectus contemplated no more than investing in the knowledge that a prospectus existed. This is described as “indirect reliance”.

Alternatively, the plaintiff argued that it would be sufficient to establish that they relied on the prospectus as a whole.

In an early interlocutory appeal, the Court of Appeal recognised that subscribing “… on the faith of a prospectus” may refer to reliance generally on the prospectus, rather than on specific passages.

The test was not before the Court, and the point was not fully argued. However, Dobson J. concluded that the legislative intent was to create liability in respect of misleading content or omissions where that content materially contributed to a claimant’s decision to invest. He continued that the untrue statement/s must be sufficiently material that, if corrected, it would then have been more likely than not that the investment would not have been made. That proposition assumes that the claimant makes out reliance on the prospectus in general, and that their assessment of the risks of investment would more likely than not have been reversed if the untrue statement/s were corrected. As a result, the judge rejected the broader claim that indirect reliance, merely on the existence of a prospectus, would be sufficient.

Absence of recoverable loss

The judge also added that, had he found misleading content or omissions, it is unlikely that he would have found the claimant to have established that they had suffered a recoverable loss. Specifically, they would have been required to establish that the market remained unaware of the true position in relation to the relevant aspects of Feltex’s business, for the period of 9+ months until there was a significant drop in the market price of the shares below the IPO issue price. Otherwise, noting that a plaintiff had a duty to mitigate their loss, he the judge found that they had an adequate opportunity to avoid or minimise their loss by selling when the market was informed, and for that period of 9+ months, did not treat the further information about Feltex as materially affecting its share price.

Interestingly, the directors’ analysis on loss (which the judge regarded as “tenable” but which he did not need to rule on) was that, either:

• the market became aware of the impact of any material matters that were either misstated or omitted from the prospectus, so as to factor those changes into the price; or
• given that Feltex’s shares were the subject of publicised analyst comment, and that the share price largely reflected the then current assessment of value – any misstatement or omission in the prospectus would have lost its impact over 9 months, and was therefore no longer relevant to the market price for Feltex shares.

Lessons / Takeaways

Directors’ good faith reliance on advice

Some commentators have identified a pattern from some of the finance company cases that calls into question the ability of directors to rely on information and advice.

Dobson J. reaffirmed that directors can rely in good faith on information and advice from management. And he found that they are not required to conduct all relevant research personally. Instead, they must undertake due inquiry but in doing so can seek and receive information and advice from those whom they reasonably consider are competent to provide it.

In this case, the judge found that the directors had established that they reasonably relied on the information provided to them by the company’s senior management.

Directors must exercise their own judgement

Reasonable reliance does not entitle directors to simply delegate responsibility for the content of a prospectus. Whilst the judge noted that the suggestion that directors did not genuinely participate in considering the accuracy of the content of the prospectus was not squarely put to any of the directors – he thought it would be invidious to attempt any ranking of the directors in terms of the genuineness or thoroughness of their testing of the content of the prospectus through the course of its preparation.

This does not remove the need for directors to demonstrate that they undertook a rigorous and genuine individual assessment of the material. In this sense, the finding is in keeping with similar findings in Australia about the need to be able to point not only to a comprehensive due diligence process – but also to an active participation in that process to be personally satisfied as to its outcome.

The due diligence defence

The due diligence defence provides a defence from liability (even if a statement is misleading) if the relevant defendant proves he or she had reasonable grounds to believe, and did believe, the relevant statement was true.

Unlike a number of the failed finance companies, Feltex undertook a comprehensive due diligence process for the IPO. Evidence was provided about its thoroughness and that the process was of a standard that met with best practice.

Whilst it can be said that such a process provides the platform on which the directors’ (due diligence) reliance defence is built – it is important to note that it is the product of that process to which the directors must apply their own assessment in order to be satisfied as to the accuracy of the offer document.

Even though he found that the prospectus did not contain any untrue statements, Dobson J. set out his views on the availability of the due diligence defence to each defendant.

In the case of directors of the issuer, they were not required to undertake the due diligence personally. Instead, their investigation was limited to making due inquiry (of the material provided to them). And whilst the thoroughness of the process would, of itself, satisfy the test to uphold a due diligence defence, in this case the judge was satisfied that the relevant parts of the process were undertaken sufficiently thoroughly, and with the application of genuine consideration.

Again, because he held that no statements in the prospectus were untrue, Dobson J. was not required to determine whether the due diligence defence was made out. However, he did say that the defendants would be likely to be able to prove they had reasonable grounds for belief in the accuracy of what was produced – and therefore would be able to rely on the defence.

Who is a promoter?

The JLMs of the IPO, and the private equity arm of Credit Suisse, as the vendor of the shares, were held to not to be promoters in terms of the IPO.

In terms of the Securities Act, a promoter is “…a person who is instrumental in the formulation of a plan or programme pursuant to which the securities are offered to the public…”. One description is a person who acts as “midwife to the offer” . Dobson J. saw the statutory definition and the use of “instrumental” as requiring both a close measure of personal involvement in the process and a level of authority enabling any promoter to have, or at least share, a measure of control over decisions as to the form and terms on which the offer of securities is made. He considered those who participate at the direction of others unlikely to be instrumental in formulating the plan for the IPO if their advice on material points of the plan can be rejected by the vendor or the issuer.

In this case, the JLMs could make suggestions which could be (and at times were) rejected. In the case of the Credit Suisse entity, its role was that of passive owner. Its manager, another Credit Suisse entity, had declared itself to be a promoter. And the judge was not persuaded that the limited role the selling shareholder played in the IPO in its own name was sufficient to attribute to it the status of a promoter. Also, he did not consider that it be attributed with that status by virtue of the work undertaken in its interests by its manager, when that entity had the status in its own right as a promoter.

Fair Trading Act liability

Dobson J found that the provisions of the Securities and Fair Trading Acts prevent a finding of liability under the Fair Trading Act where the claim relates to conduct that is regulated by the Securities Act and no liability has been found under the Securities Act.

Negligent misstatement?

When dealing with the alternative claim of negligent misstatement, Dobson J. followed the commentary that where, as here, the source of an obligation is in statute and the statute prescribes a specific regulatory regime for the conduct, an additional claim in negligence has limited use. The Securities Act provides investors with a remedy for the conduct complained of – therefore a claim based in negligent misstatement would not provide investors with enhanced rights or remedies.

Also, to the extent that any relationship can be imputed between the JLMs and investors in the IPO by virtue of their reliance on the prospectus – he found it is not of a type that justifies the imposition of a novel tortious duty of care. A similar outcome was reached in relation to the Credit Suisse private equity arm that was the vendor of the shares in the IPO.

Historic and prospective financial information

Prior to its demise, Feltex had announced two profit downgrades – when it became clear that it was going to fall short of its projected performance. However, rather than seeking to focus on analysing forecasts with the benefit of hindsight, the judgment notes that liability should only be imposed for representations about future events if they were not made in good faith, or if it is shown that there were no grounds on which they could reasonably have been made. Also, that the assumptions applied (in making those projections) must be realistic in light of all the experience and knowledge possessed by those responsible for them at the time, but this does not involve anything in the nature of a warranty that they are the assumptions that are most likely to be proven correct on any empirical basis.

Dobson J. continued by noting that there would always be a real prospect that any given assumption will be wrong, but those considering the projection need to know the terms of the assumptions on which it was based. In this case he said, many of the assumptions related to matters entirely beyond Feltex’s control (for example that there would be no new entrants in the market) and were inherently likely to be wrong. In his decision, 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 the projection.

Importantly, the judge also accepted some criticisms advanced on behalf of the plaintiffs about the presentation of (prospective) financial information with the inclusion of a normalised profit projection (labelled by the plaintiffs as a second bottom line) and the risk of confusing the target audience of “prudent but non-expert investors”. Ultimately, whilst this was not found to be misleading, the judge said that its inclusion would have been made much clearer by a footnote describing what had been done and why.

Risks disclosure

In keeping with the FMA’s recent guidance on effective disclosure, the judgment provides more guidance on risks disclosure in offer documents and the need for clarity and not just breadth of coverage. In this regard, the judge noted that he had some sympathy for the plaintiff’s concern that the cautionary signals, and description of the risks of investing in Feltex, which were “buried” near the end of the document at a point where a proportion of prudent readers would have given up.

However, the risks disclosure was comprehensive and the drafters of the prospectus signalled both the inclusion and the importance of risks near the outset of the document. This, said Dobson J. is not a case in which the lack of balance in the manner of presentation of the risks, where they are otherwise adequately expressed, requires their impact to be discounted in assessing the content of other passages that are the subject of criticism.

And the defence was able to point, in the case of specific risk items, to the evidential trail provided by the due diligence process inquiring into each risk item and to a corresponding disclosure in the prospectus.

Different outcome under the FMC Act?

Although the FMC Act heralds a sea change in a number of areas affecting capital-raising, a number of key concepts are being brought from the Securities Act into the new regime. These include the perspective of the notional investor – with the stated purpose of a PDS being to:

“…provide certain information that is likely to assist a prudent but non-expert person to decide whether or not to acquire the financial products.”

and the availability of a due diligence defence.

However, there are some important changes, including:

• Reliance (and proof of loss): The civil liability provisions in Part 8 provide that a person must be treated as having suffered loss or damage because of the (disclosure) contravention unless it is proved that the decline in value was caused by a matter other than the relevant statement, omission, or circumstance. That presumption then places the onus of proof on the defendant – to prove otherwise. Importantly, its effect will be to overcome some of the difficult hurdles faced by the plaintiff in Feltex to prove both their reliance – and the losses that flowed from such reliance.

• The demise of the promoter: The concept of the promoter has always been an oddity – a sort of unique hangover from the Victorian (English) underpinnings of our securities law. With the advent of the FMC Act, the concept disappears – to be replaced by accessory liability such as that found in trade practices law. As a result, advisors , such as the JLMs and others involve in the teamwork that is a feature of any IPO, will only be liable for a breach where they can be shown to have been an accessory to the offending. This will depend on both the degree of involvement and their knowledge.

Further information

The High Court decision is important and there is some important learning to be taken from it. However, Dobson J. noted that he was told repeatedly during the hearing that appeals would be inevitable. As a result it will be interesting for those of us who are not directly involved to see what an appeal court makes of the judge’s findings.

If you would like more information about any of the matters discussed in this note, please contact me.