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Liability under the Financial Markets Conduct Act

31 October 2014

A key area where the Financial Markets Conduct Act (FMCA) improves on its predecessor legislation is in the liability regime, in particular:

  • the greater reliance on, and access to, civil redress

  • the insistence that criminal sanctions require some element of knowledge and fault, and

  • the clear delineation between the roles of the issuer (generally a company), directors of the issuer and non-director participants in relation to liability.

Civil liability

The FMCA provides a variety of instruments to enforce civil liability: declarations of contravention; compensation, damages and other relief; and pecuniary penalties, which can be very substantial. It also facilitates class actions through the introduction of a “presumption of loss” such that, if there has been a contravention and the investor has lost money, the loss will be deemed to be a result of the contravention unless some other cause can be proven.

Criminal liability

Criminal liability for serious offences requires proof of knowledge or recklessness and is punishable by imprisonment for up to ten years and a fine not exceeding $1 million (or $5 million for a non-individual), or both.

Infringement notices for lesser offences are punishable by fines. These can only be levied against the issuer, supervisors and other generally corporate entities, rather than individuals carrying out the relevant functions.

The offence in the FMCA that carries the most significant sanctions relates to misstatement (including by omission) in a PDS, register entry or ongoing disclosure document where the offeror knows, or is reckless to whether, the statement is false or misleading or is likely to mislead.

Lesser offences, although still serious, include: failure to provide a PDS if the offer requires disclosure (section 53 FMCA); insider trading and tipping (section 244 FMCA); making a misleading statement or disseminating misleading information (section 264 FMCA), and creating a false or misleading appearance of trading (section 269 FMCA).

Liability for these offences is restricted to the issuer (when a corporate entity) and to the directors of the issuer where the offer, or the continuing of the offer, takes place with the director’s authority, permission or consent (which normally will be the case where, as required, the board has provided its consent to lodgement of documents).

Participant or non-director liability

The FMCA provides for three bases of civil liability – direct liability, which applies to issuers (normally companies); deemed liability, which applies to directors of the issuer in cases of defective disclosure; and accessory liability, which applies only to civil remedies and can capture wider participants.

Section 533 FMCA specifies that a person is “involved in a contravention” if the person:

  • has aided, abetted, counselled, or procured the contravention, or
  • has induced, whether by threats or promises or otherwise, the contravention, or
  • has been in any way, directly or indirectly, knowingly concerned in, or party to, the contravention, or
  • has conspired with others to effect the contravention.

Although the application of these provisions in the context of primary securities offers is novel in New Zealand, the meanings of the terms used are settled and are well supported by case law. Because they are practically identical to longstanding Australian trade practices and corporations law provisions, there is a wide jurisprudence and academic commentary from Australia for the New Zealand courts to draw on.

Shades of grey

The more difficult issue arises in relation to what a New Zealand Court of Appeal Judge has described as “evaluative assessments”, in which the essential facts that establish the underlying breach do not speak for themselves and are not incontrovertible but instead are in the nature of conclusions, predictions and judgements on which reasonable people may disagree.

This will often be the case in relation to disclosure where decisions commonly involve an element of business judgement or opinion, legal conclusions, matters of degree, questions of materiality – or some combination of these. Consider recent prosecutions of finance company directors, such as the Nathans and Lombard cases, where the courts agreed that the directors honestly believed the statements in their offer documents were true – a finding that will be much more relevant in an FMCA setting, where criminal liability (although not civil) will require proof of knowledge or recklessness.

The difficulties around issues of materiality will be amplified by the word limits on PDS imposed in the FMC Regulations and the challenge laid down by the Financial Markets Authority (FMA) to move away from generic, all-encompassing disclosures to a more specific and considered focus on the true prospects and vulnerabilities of the business.

The due diligence safety net

The safety net for all participants in a securities offering is to ensure a robust due diligence process which produces relevant and high quality information for investors. The FMCA appropriately recognises that a by-product of this process should be liability protection for its participants.

To take the example of an equity IPO, where information asymmetry is presumptively the greatest, a ‘gold standard’ due diligence process should typically involve:

  • preparation of a formal Due Diligence Planning Memorandum, setting out:
    • any potential securities law and other liabilities relating to the offering
    • the objectives and scope of the due diligence process, including any materiality thresholds
    • the identity of the Due Diligence Committee (DDC)
    • the due diligence process that will be undertaken and the responsibility of its various participants
    • the required outputs of the DDC, including written reports, minutes, advice,
      sign-offs and back-up materials, and
    • bring-down and ongoing monitoring processes to ensure that the due diligence is maintained throughout the offering period and in particular at its key milestones (registration of offering documents, offer launch, and allotment/listing)
  • regular meetings of the DDC to carry out this work programme and to consider progressive drafts of the offering documents, and
  • the presentation of reports and materials to the board of the issuer and any other responsible parties for approval of the offering documents and go-ahead of the offer.

The DDC will generally comprise independent directors and/or members of the audit committee and the issuer’s chief financial officer and general counsel. Other participants will typically include the external auditors, representatives of the arrangers/joint lead managers, the issuer’s external legal counsel (and sometimes counsel to other parties, including any ‘promoter’ of the securities (under previous terminology) or the arrangers/joint lead managers). Others (for example line managers) may be asked to attend on an ad hoc basis.

One or more members (usually a director) will be appointed chair, with responsibility for producing agendas and minutes, and for the conduct of the meetings generally.

Reports and sign-offs from a variety of officers and advisers should be fed into the DDC, usually including:

  • wider management personnel or staff (who are often asked to fill in a due diligence questionnaire and/or verify parts of the offering documents)
  • issuer’s counsel, who will normally provide an opinion on formal securities law compliance (assuming the truth of the underlying information)
  • the auditor, and
  • tax and other specialist advisers.

The process will often involve an ongoing feedback loop between the DDC and the working group involved in preparing the offering documents, with issues lists to ensure that appropriate action is taken (and documented) and that disclosure of key matters is satisfactory.

The basis for participation in a due diligence process, and particularly membership of a DDC, is that each member makes reasonable inquiries (particularly related to their respective areas of specialist expertise), brings an inquiring and independent mind, ensures all matters requiring investigation are raised and followed through, and participates in decision-making.

This is substantially the due diligence process that was undertaken by the directors and other participants in the 2004 Feltex IPO, which were ultimately considered in the substantive proceedings in the Houghton v Saunders class action.

Having found that there were no material misstatements in the prospectus, it was unnecessary for the Court to rule upon the due diligence defence under the Securities Act. However, Dobson J concluded:

“[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”.

Adapting the due diligence process to the circumstances

The above process is very exhaustive and expensive and, as a result, is likely to be adapted for the circumstances. Indeed, a key point of the FMCA changes is to provide the conditions for more targeted, and less costly, verification procedures according to the circumstances of the offer, issuer and investment.

For example, in a follow-on offer by an existing issuer, it is possible that the exercise can be conducted for the most part on a “bring down” basis, looking at proposed changes in the disclosure and developments in the business since the last offering was undertaken. Offers under exclusions, such as of same class quoted financial products, can and should be subject to much more focused and streamlined verification processes.

Financial product manufacturers and other continuous issuers have evolved their own largely in-house procedures for addressing the verification and due diligence requirements.

These should:

  • identify all factual, statistical and other data in the offering documents and verify these against reliable (ideally third party) sources
  • subject to objective scrutiny claims and opinions about material matters (including, for example, as to the standing of the issuer or its business)
  • evaluate whether any discussion of technical or industry matters (including any use of financial or industry-specific metrics, concepts and jargon that need to be included for relevance reasons) merits further explanation in plain English, and
  • ensure that the disclosure to be presented to investors (taking into account any graphics, images or formatting) conveys an adequate and accurate overall impression of the offer and provides a balanced disclosure of the benefits and risks.

In order to evidence these procedures, a ‘verification book’ may be prepared showing the steps that were taken and including any relevant sign-offs.

The position with respect to material omissions is more difficult and relies on the involvement of engaged and knowledgeable participants both from within and outside the issuing entity. This can be informed by the preparation of questionnaires and/or undertaking management interviews, but ultimately it requires a rigorous analytical approach which is capable of testing assumptions and where participants are encouraged to play a ‘devil’s advocate’ role.

This article is drawn from an analysis Ross Pennington prepared for the Banking & Financial Services Law Association 2014 conference.

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