The Securities Amendment Act 2004 has recently expanded the categories of persons to whom offers of securities can be made without the need for a prospectus and investment statement. While helpful, last-minute changes at select committee stage have delivered less than was anticipated, and resulted in some conceptual confusion in this area of the law.
In this Counsel, Frank McLaughlin and Jim Sullivan take a closer look at the new changes and their implications for private funding.
A (not so) imaginary background
Imagine a law that –
- prevented offerors from “market testing” prior to offering securities to the “public”, to assess whether a proposed offer will have sufficient public demand
- imprecisely defined those categories of persons excluded from the Act’s protections so that offerors cannot proceed with certainty with offers intended for private subscription only
- imposed significant penalties on offerors who offered (even unintentionally) securities intended for private subscription to the public
- automatically “voided” incorrectly allotted securities, even if the allotment was unintentional – an outcome with immensely disruptive consequences for both the offeror and, potentially, investors (the very persons the law sought to protect).
This background has been the reality of securities regulation in New Zealand since the enactment of the Securities Act 1978. Policy-makers and market participants alike have been aware of these problems for some time, and the recently enacted Securities Amendment Act 2004 (“Amendment Act”) was intended to ameliorate some of the above effects. Unfortunately, its success has been somewhat mixed. We review the key amendments to the Securities Act below.
Pre-prospectus publicity – seeking expressions of interest
Historically, the Act provided offerors with a limited ability to advertise without triggering the disclosure requirements.The Amendment Act repealed the previous pre-prospectus regime and replaced it with a significantly broader regime. The key change is that issuers can now seek non-binding expressions of interest from the public. This will be a useful mechanism for issuers to test the market prior to embarking on the expense of preparing and circulating a prospectus and investment statement.
The regime also clarifies that an offeror can pick and choose which of the prescriptive listed information to include in pre-prospectus publicity (such as a description of the securities and applicable interest rates, if any). However, the amendment has not done the full job adequately: the listed information still does not allow issuers to include a description of their business in pre-prospectus publicity. While the existing list of permitted information allows some scope for business descriptions, on the whole it is inadequate and it’s likely that issuers will continue to seek exemption for pre-prospectus publicity on this basis.
Expanding private placements
Under section 3(2)(a) of the Act, an offer made only to specified “private” persons does not constitute an offer of securities to the public, and falls outside the Act entirely (avoiding the need to comply with the requirement to prepare a prospectus and investment statement). The Amendment Act expanded the categories of private persons (indicated by the bold text) to:
- relatives or close business associates of the issuer or of a director of the issuer
- persons whose principal business is the investment of money or who, in the course of and for the purposes of their business, habitually invest money
- persons who are each required to pay a minimum subscription price of at least $500,000 for the securities before the allotment of those securities
- any other person who in all the circumstances can properly be regarded as having been selected otherwise than as a member of the public.
When considering these exclusions, it is important for issuers to note that one bad apple spoils the entire barrel: while an offeror can make an offer to multiple categories of private persons (say, to both habitual investors and to relatives of the issuer’s directors), the inclusion of just one member of the public will trigger the Act’s disclosure obligations.
Relative and close business associates
The Amendment Act extended this narrow exception to relatives or close business associates of directors of the issuer, recognising that many issuers are corporate entities. However, this exception is likely to remain of little benefit for issuers (especially corporates) seeking significant private funding.
Key changes to the Securities Act
New pre-prospectus publicity regime (s5(2CA))|
Enables issuers to test the market prior to embarking on expense of preparing disclosure material
Incomplete: The ability to test the market will be useful, but an issuer is still prevented from describing its business in pre-prospectus publicity
Consider whether market testing will be of benefit prior to preparing offering documents, but note limits on what can be said about the issuer’s business, the product and other matters
Expansion of categories of private placements (s3(2), which are not offers to the public)
Introduces a new $500,000 minimum subscription exclusion – an easy to determine bright line test for issuers seeking private funding
Allows corporate issuers to offer to relations/close business associates of directors of issuer
Fair: The $500,000 bright-line test may prove useful to many issuers. But not much use for issuers seeking investment on a smaller scale, and other exemptions remain narrow and difficult to interpret
Consider whether existing capital-raising strategies should be reviewed in light of broadened private placement exclusions
Continue to exercise caution around existing exclusions, which are difficult to interpret
New category of exempt “eligible persons” (s5(2CB), which are still offers to the public)
No need to prepare offering documents if subscribers are “wealthy” or “experienced”. These new exemptions are broader than private persons, and easier to determine
Note that these are not subject to restrictions on secondary trading, but still subject to scrutiny of Securities Commission as an “advertisement”
Fair: The threshold tests for the new exemption are easier to ascertain than for private persons. But shifting the exemption from section 3(2) to section 5 has rendered its effectiveness less than optimal
Consider whether existing private placement processes and marketing should be reviewed in light of new “eligible person” exemption, and consider procedures around certification requirements
Don’t bundle offers to “eligible persons” with offers to private persons – this is currently prohibited
New relief regime to deal with voidable allotments (ss 37AA to 37AL)
Provides the courts with the power in certain circumstances to order that the allotment is not void when an offer is made to the public without a registered prospectus or investment statement
Incomplete: The court’s discretion to ameliorate void consequences in certain circumstances is useful, but the changes fail to address whether void consequences are still appropriate for modern offers
Seek legal advice from Chapman Tripp on steps that can be taken to address incorrectly allotted securities
Historically, the “habitual investor” exception has been the most utilised section 3(2) category, and is routinely relied on to issue securities to share-broking or fund management businesses. While there has been no change to the habitual investor category, the Amendment Act has introduced a new category of exempt (but not excluded) “eligible persons” in section 5(2CB), which includes persons “experienced in investing money” (a broader category than “habitual investors”: see “Experienced Persons” below).
$500,000 minimum subscription
The $500,000 exception introduces a new bright-line test for private placements, and replicates a similar provision from the equivalent Australian legislation. Now, an offer where subscribers must pay $500,000 or more prior to the allotment of securities falls outside the Act.
Importantly, the subscription price must not be issuer funded. Section 3(8) requires that any amount paid or loaned by the issuer or offeror (or any associated person) must be disregarded in calculating the price to be paid for securities.
Interestingly, this exclusion, together with the new section 5(2CB) “wealthy persons” exemption (discussed below), indicates a general policy shift in the Act. There is now explicit Parliamentary recognition that wealthy investors do not require the same level of protection as less affluent investors. While these changes are well-intentioned, their joint impact is unlikely to advance wealth mobility. Offers may be structured to target those deemed affluent, disenabling participation by those not deemed affluent – a surprising outcome for a Labour-led government, which historically has been committed to the belief that a railwayman’s daughter should have the same opportunities as a doctor’s son.
Persons selected otherwise than as members of the public. The last category of private persons (known as “selected individuals”) is notoriously difficult to interpret. Unfortunately the Amendment Act did not attempt to clarify its application. The exception has, however, recently been considered by the Court of Appeal in Lawrence v Registrar of Companies (2004) 9 NZCLC 263,480 which confirmed its very narrow scope (see the box on page 9 below).
The new “eligible persons” exemption
The most dramatic amendment to the Securities Act is the introduction of the “eligible persons” exemption under section 5(2CB). This section provides that if subscription to an offer is restricted to “eligible persons” (which are persons who are either “wealthy” or “experienced” – see the boxes below), the offer is exempt from nearly all of the disclosure obligations under the Act and Regulations.
Unfortunately, the vagaries of the select committee process have rendered the new exemption much less effective than originally intended, and its utility to investors seeking private capital is less than optimal. Initially proposed as an extension to the section 3(2) exclusions, the “eligible persons” exemption was moved to section 5 during the passage of the Bill. This shift has generated a number of unforeseen difficulties for the new amendment.
The key requirement for eligibility as a “wealthy person” is certification by an “independent chartered accountant” that the person has:
- net assets of $2,000,000, or
- $200,000 annual gross income for each of the last two financial years.
Independence of chartered accountant
Importantly, certification can only be provided by an “independent” chartered accountant. While it is likely “independence” will be approached objectively, it is not defined in the Act, and it is unclear whether it means independent of the issuer, the offeree, or both. Of course, until the courts have had an opportunity to consider the “independence” threshold, issuers and accountants should proceed conservatively. The Institute of Chartered Accountants’ Code of Ethics specifies industry standards for objectivity and independence; compliance with the Code is likely to satisfy the independence requirement under section 5(2CB).
Section 5(2CF) allows the Governor-General to make regulations by Order-in-Council prescribing how the value of net assets is to be determined, and how gross income is to be calculated (either generally, or in specific circumstances). Accountants should utilise standard accounting methods unless and until such regulations are gazetted.
An allotment to a “wealthy person” must occur within six months of certification by the chartered accountant. After that period has elapsed, a person will need to be re-certified in order to subscribe for securities as a “wealthy person”.
Same person as subscriber and allottee
Issuers should also note that “eligible persons” must be both the subscriber and the allottee. For example, a “wealthy” subscriber could not require that the securities were registered in, say, the name of a family company (unless the company also complied with the “wealth” criteria). This requirement also applies to “experienced” persons.
Importantly, the “experienced” exemption is much broader than the “habitual investor” exclusion. There are two categories of “experienced person”:
experienced in investing money, or
experienced in the industry or business to which the security relates.
The key requirement for “experience” is a written statement from an independent financial service provider that the person to whom the offer is made, as a result of having relevant “experience”, can assess the following criteria:
- the merits of the offer
- the value of the security
- the risks involved in accepting the offer that person’s own information needs, and
- the adequacy of the information given by the person making the offer.
The “experienced person” must also sign a written acknowledgement that the financial service provider has not provided them with a prospectus or investment statement in respect of the securities.
Independence of financial service providers
As with “wealthy persons”, “independence” is key for financial service providers. Unlike accountants, there is no registration requirement for financial service providers (although there is limited self-regulation and certain disclosure obligations under the Investment Advisors (Disclosure) Act 1996). Accordingly, independence for such providers may be more difficult to establish. Moreover, there is a subjective element to assessing the “experienced” criteria (unlike the bright-line “wealth” test), which could increase the risk of rogue providers.
As a starting point, any provider who has provided strategic advice to the offeror, or who could benefit financially from the offer, or who has an ongoing advisory role to the offeror, would be unlikely to be sufficiently “independent”. Certainly, issuers should take statements from financial providers on their face, and should not look behind them unless put on notice. In addition, issuers should avoid activities that might compromise independence, such as paying commissions to financial service providers for delivering capital from eligible investors.
No temporal limitation
Unlike the “wealthy” certification, there is no temporal limitation on the statement provided for “experienced” persons. Accordingly, a person could be certified as experienced in investing money for an extended offer without the need for
re-certification. However, it is likely that fresh certification will be required for each new offer, because the criteria contemplate offer-specific certification.
Difficulties with “eligible persons”
Importantly, there is a conceptual distinction between private persons under section 3(2)(a) and the “eligible persons” exemption under section 5(2CB). An offer to a private person falls outside the Act entirely, whereas an offer to an “eligible person” is still an “offer of securities to the public”, and remains subject to certain aspects of the Act. In particular, offers exempted under section 5(2CB) are treated as advertisements for the purposes of the Act (and as such are subject to certain restrictions).
This distinction arises from a suggested change to the Bill by the Securities Commission during select committee stage. The Commission submitted that the “eligible persons” exemption should be moved from section 3(2)(a) to section 5, to ensure that offers to “eligible persons” remain subject to the Act’s restrictions on advertisements. There was no similar submission that the other categories of person under section 3(2)(a) be subject to the advertisement restriction. Nor was the suggested change necessary to achieve this outcome; the “eligible persons” exemption could have been made subject to the restrictions on advertising without the move.
There is a danger in approaching issues solely from an enforcement perspective. While the Commission’s concerns are understandable, the result creates a number of unfortunate (and no doubt unintended) implications for “eligible persons”, and leaves the policy underlying the exemption confused.
Bundled offers are prohibited
The conceptual disconnect between section 3(2) and section 5 (unintentionally) prohibits bundled offers. In other words, an issuer cannot make a single offer both to “eligible persons” and to private persons, because section 5(2CB) is only available if the only persons who are able under the terms of the offer to subscribe for the security are “eligible persons”.
By way of example, an offer made to persons “experienced in investing money” under section 5(2CB) could only be accepted by “habitual investors” if they first made the necessary acknowledgement and obtained the necessary statement from a financial service provider. This is inconvenient, and seems completely unnecessary for a person who Parliament has deemed not to be a member of the public (and therefore not to require the Act’s protections).
Secondary trading and “warehousing”
The second unintended consequence arises in the context of secondary trading. Because an offer to “eligible persons” is an offer of securities to the public, it is not subject to the general prohibition on secondary trading in section 6(2). That section is designed to prevent the practice of “warehousing” securities. Warehousing is where a large number of securities are issued to a financial intermediary (such as a merchant bank) without a prospectus or investment statement, and then on-sold to the public without the usual disclosure protections.
Because “eligible persons” are members of the public, the amendment effectively allows them to acquire large numbers of securities and subsequently offer them at a premium for re-sale without triggering any of the disclosure obligations under the Act. While we think that a court would seek to avoid this (potentially disastrous) outcome by reading in a restriction on the basis of the policy underlying section 6(2), the plain wording of that section would make such an approach difficult.
Not an offer to the public
Offers under s3(2)(a) are not “offers to the public” for the purposes of the Act, and are excluded from the requirements of the Act in its entirety.
Exempt from prospectus and investment statement
Offers to “eligible persons” under s5(2CB) are still offers to the public, but are exempted from Part 2 of the Act and the Regulations (including the requirement to have prospectus and investment statement).
Not subject to “advertisement” regime
Because offers to private persons are not subject to the Act, the only content requirements are those specified in the Fair Trading Act and the Contractual Remedies Act.
Subject to “advertisement” regime
Offers to “eligible persons” are explicitly subject to the Act’s advertisement regime (secs 38B and 58), the Act’s penalty regime, and the scrutiny of the Securities Commission
General restriction on secondary trading
Offers to private persons are subject to the general prohibition on secondary trading under s6(2).
No general restriction on secondary trading
Offers to “eligible persons” are not subject to general prohibition as secondary trading under s6(2). Theoretically, an “eligible person” could “warehouse” securities.
Offer restricted to private persons
To fall within the excluded categories, an offer can only be made to private persons specified in s3(2)(a). If an offer is made to even one member of the public, then the offeror must comply with the disclosure requirements.
Subscription restricted to “eligible persons”
Offers to eligible persons can be made to the public at large so long as only “eligible persons” can subscribe to the offer. However, offers cannot be bundled with offers to private persons unless those private persons are also “eligible persons’’.
The key justification for moving “eligible persons” to section 5 was to ensure offers made to “eligible persons” complied with sections 38B and 58. Those sections prohibit advertisements from being likely to deceive, mislead, or confuse as to any material particular, or from containing any untrue statements.But the restrictions on advertising add little to the existing requirements on all issuers under the Fair Trading Act and the Contractual Remedies Act. The only significant difference is to subject such offers to the Securities Act’s harsher penalty regime and the scrutiny of the Securities Commission. Even if this were a sufficient rationale, it is unclear why the restriction was not also imposed on habitual investors, as the distinction between the two categories is not obvious.
In short, the disconnect between private persons and “eligible persons” is unprincipled and may limit the appeal of the new exemption for many issuers. The slight benefits arising from subjecting the exemption to the Act’s restrictions on advertisements are outweighed by the unintended consequence of the shift.
Relief for those who get it wrong
Getting it wrong was historically very painful for issuers and subscribers alike: an offer made without a prospectus, where it transpired that even just one of the subscribers was a member of the public, resulted in the securities deemed “void” (non-existent). Directors were liable to repay the subscription price plus interest to the subscriber. Similarly, the failure to prepare an investment statement rendered the securities “voidable” at the option of the subscriber (within a prescribed period).
Voiding securities is inevitably a blunt instrument – especially when the subscriber has no say in the matter – and can create unjust and unforeseen consequences. Often, subscribers have acted in reliance on the (well-founded) belief that the property in question existed: shares may have been transferred or pledged, dividends received, and taxes paid.
The recent amendments to the Act attempt to provide a more targeted remedy when issuers get it wrong. The court now has the power to issue relief orders in certain circumstances, effectively validating void securities, where to do so is just and equitable.
These new relief amendments were “triggered” by the recent issues facing the managed fund industry (and investors in the managed funds) as a result of compliance failures under certain Securities Commission Exemption Notices. Accordingly, the amendments are largely a pragmatic response to an immediate problem. They do not address the more fundamental question of whether an automatic “void” outcome is appropriate at all (see the discussion on further law reform below).
Time for an overhaul?
The changes to the Securities Act are on the whole helpful, and represent a positive step towards striking a balance between investor protection and efficient capital-raising. But tinkering with the Act is no longer a sustainable response.
The reality is that New Zealand’s capital-raising laws need a complete overhaul. The Ministry of Economic Development is currently contemplating a review of the Securities Act – the final stage in the Government’s four-step securities law reform programme. But change is not likely before the next election. A number of problems indicate that the Act is past its use-by date:
- The compliance requirements for capital-raising assume that an issuer can “stand still” for a substantial period (practically anywhere between six weeks and six months) while it satisfies its compliance obligations before raising further capital. But fast-growing companies seeking to raise capital for further acquisitions often cannot afford this luxury. The Act needs to recognise that capital-raising, like other commercial activities, now operates within a fast-moving world where decisions are able to be made and implemented promptly to retain competitive advantages.
- The Securities Act was initially drafted on the basis that the main disclosure document was the registered prospectus. Amendments in 1996 introduced the (shorter) investment statement as the main disclosure document. But the investment statement regime was crudely “grafted” onto the Act, rather than integrated into it. Any reform process should assess:
- whether there are more effective and efficient means of enabling investors to make informed investment choices
- whether both a registered prospectus and an investment statement are still required
- what the respective roles of both are, and
- whether the current penalty and compliance regimes properly reflect the different roles of those documents.
- Listed companies are subject to a comprehensive continuous disclosure regime, which has statutory recognition and enforcement mechanisms. Any re-think of the Act needs to assess the relevance of the current capital-raising disclosure requirements for issuers already subject to continuous disclosure obligations.
- While the impact of the “void” and “voidable” consequences have been ameliorated by providing the courts with discretionary relief in certain circumstances, any re-think needs to consider whether the void and voidable remedies are still appropriate. A number of comparable jurisdictions around the world have eschewed or moved away from such remedies (for example the UK, Canada and Australia).
- In light of recent amendments and judicial consideration of the Act, it is clear the Act assumes that those who are “wealthy”, “experienced”, or who habitually invest, do not require the Act’s protections. This may have a longer-term consequence of tilting the playing field in favour of private placements, and away from public offers. Any reform of the Act needs to consider the long-term impact of security regulation on wealth mobility. A law initially designed to protect the public may now end up restricting middle New Zealand from the same wealth investment opportunities as those who are deemed “wealthy”, “experienced”, or who habitually invest. Any significant shift in this area should be of concern for a society that has a strong egalitarian ethos.
Lawrence and the policy underlying private placementsThe Court of Appeal has provided the clearest consideration of private placements to date in Lawrence v Registrar of Companies (2004) 9 NZCLC 263,480, where the question arose as to the scope of the “selected individual” exclusion under section 3(2)(a)(iii). In considering its scope, the Court examined the underlying policy of section 3(2), noting that the key to the exceptions is the ability to self-protect:
In any particular relationship it will be indicative of exclusion if those selected can objectively be seen to be in a category of persons able to protect themselves either by being able to require the issuer to provide them with relevant information or because of general sophistication in investment matters. (Paragraph 33)
The Court’s approach indicates that only those capable of protecting themselves will fall into the “selected individual” exception (such as “experienced” persons). Unfortunately, the Court did not have the benefit of considering the new “eligible persons” regime prior to its decision. But the judgment indicates that “eligible persons” may well already fall within the “selected individual” category. Accordingly, the Court’s decision may leave the way open for offers to be made to “experienced persons” under section 3(2)(a)(iii) without the need for obtaining the relevant exemptions under section 5(2CB).
On the other hand, the decision to shift “eligible persons” to section 5 may indicate that those persons are members of the public by definition. Accordingly, the judicial bar for the “selected individual” category may have been raised by the Amendment Act. But to what? Once individuals who can self-protect are eliminated from the category, is there anyone else left?