Supreme Court’s Decision in Feltex Litigation

The decision was a partial victory for the shareholders.

A financial forecast was an untrue statement in circumstances where it was known there would be a 2.8% shortfall of the forecast sales.

Reliance could be established even if a shareholder had not read the prospectus containing the untrue statement.

There will now be a stage 2 hearing with a number of issues still to be decided such as causation and loss.

On 15 August 2018, the Supreme Court delivered its judgment in the long-running Feltex litigation.¹ This was a representative action brought by Eric Houghton on behalf of approximately 3,600 shareholders. The claims concerned alleged misleading statements and omissions in a prospectus issued for an Initial Public Offer (IPO) in 2004. The defendants were Feltex’s former directors, Credit Suisse (the private equity vendor of the shares) and the two joint lead managers for the IPO, First NZ Capital and Forsyth Barr Ltd (JLMs).

Mr Houghton’s claims were brought under the Securities Act 1978 (SA), the Fair Trading Act 1986 (FTA) and the tort of negligent mis-statement.² The Supreme Court’s judgment dealt with “stage 1” of the proceeding, which was to determine Mr Houghton’s claim in its entirety and issues common to the represented shareholders.

The shares in Feltex were sold by the IPO in May 2004 at a price of $1.70 per share. More than $250m was raised. Unfortunately, the company’s fortunes rapidly deteriorated about a year later. The company was placed into liquidation on 13 November 2016.

At first instance, Mr Houghton was wholly unsuccessful. He appealed. The Court of Appeal upheld Dobson J’s High Court judgment, but it differed in one respect. It found that the forecast of revenue set out in the prospectus for the financial year ending 31 June 2004 (the FY04 revenue forecast) was an untrue statement. However, the Court found it was immaterial. Therefore, it did not lead to liability under s56 SA. Mr Houghton appealed once more. Mr Houghton’s cause of action under s56 SA required him to prove:

• There was in an untrue statement in the prospectus;
• He invested on the faith of the prospectus; and
• He suffered loss by reason of the untrue statement.

The principal focus of the appeal was on the FY04 revenue forecast and, in particular, the Court of Appeal’s finding that, although this was untrue and misleading, it did not lead to liability under s56 SA.

After the offer period had closed but prior to the allotment of shares, Feltex’s managing director, Mr Magill, advised Feltex’s due diligence committee that Feltex might not meet its sale forecast for YE 30 June 2004. The shortfall was around 2.8% of the forecast annual sales. However, the committee was told the market was lifting and there was a high level of confidence that Feltex would achieve the forecast EBITDA and forecast net surplus. The committee decided no material adverse circumstances had arisen from when the prospectus was issued on 5 May. This view was reported to and accepted by Feltex’s Board at its meeting on 2 June 2004.

The Supreme Court upheld the Court of Appeal’s finding that the FY04 revenue forecast was an untrue statement. In its view, the sales shortfall of 2.8% was sufficiently significant to render the FY04 revenue forecast untrue in the circumstances.

Mr Houghton’s appeal in relation to other parts of the prospectus which he argued amounted to untrue statements was dismissed.

In the High Court, Dobson J found there could be no liability under s56 unless a statement was misleading in the sense that it materially contributed to an investor’s decision to invest. The Court of Appeal also found the investors had to show reliance was placed on the untrue statement before they could establish that it caused them to suffer loss. The Supreme Court, however, decided an investor could prove he or she had relied on an untrue statement without even having read the prospectus. It held that, “on the faith of” means in reliance on the truth of the publicly registered document, which informs the market, but does not require that an investor has seen or read the prospectus. The Court said it could be inferred that if a prospectus contained a misleading statement, an investor invested on the faith of the prospectus assuming the statement was true. This inference could be displaced if the investor knew the truth and invested anyway. The Supreme Court acknowledged that its test of “on the faith of” under s56 would not be a difficult test for an investor to satisfy but considered that was consistent with the investor protector objective of the SA.

The Supreme Court confirmed an investor is required to establish that he or she had sustained loss by reason of the untrue statement. There must be a causal nexus between the untrue statement and the loss. This requires a determination of 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.

Contrary to the Court of Appeal’s view, the Supreme Court held that the untrue statement in the FY04 revenue forecast was capable of causing loss. Whether in fact it did cause loss for the investors other than Mr Houghton³ would be a matter for determination at a stage 2 hearing. The Court indicated that the normal measure of loss would be the difference between the price paid of $1.70 for each share and the value of the shares if the untrue statement had not appeared in the prospectus.

The Court held that the statutory “due diligence” defence in s56(3)(c) SA cannot apply in circumstances where the untruth of a statement is known, even if the defendants reasonably believe that the statement is only untrue to an immaterial extent. However, it left open the argument (which is to be determined at the stage 2 hearing) whether the defendants could be relieved of liability pursuant to the Court’s discretion under s63(1) SA, which allows relief from liability for those who have acted honestly and reasonably in all the circumstances.

The Supreme Court found that the inclusion of the untrue statement in the revenue forecast also amounted to misleading and deceptive conduct under s9 FTA. In doing so, it upheld the Court of Appeal’s finding that the FTA applied, as the provisions in the SA and FTA precluding a party from being liable under the FTA for conduct regulated by the SA and
which came into effect after the events in issue, did not have retrospective effect.

The appeal against the JLMs was dismissed in its entirety.

In relation to the FTA cause of action, Mr Houghton failed to prove that the FY04 revenue forecast statement could be attributed to the JLMs as primary parties (having abandoned an allegation that they were parties to that statement).

Mr Houghton alleged that the JLMs were “promoters” which meant they attracted liability under s56(1) of the SA. “Promoter” was defined in section 2(1) SA. There were two issues. First, were the JLMs instrumental in the formulation of the plan or programme pursuant to which the shares had been offered to the public (limb (a) of the definition). Second, were the JLMs exempt from liability because they had acted solely in a professional capacity (limb (c) of the definition).

The Supreme Court said that if limb (c) was disregarded, the JLMs might legitimately be said to be persons instrumental in the formulation of the plan pursuant to which the shares were offered to the public. However, the Court found that the ‘professional capacity’ exception applied.

The Supreme Court’s decision has not brought finality to this long-running litigation. There will now be a stage 2 hearing with a number of issues still to be decided. Those issues include whether each investor suffered loss “by reason of” the untrue statement and the quantum of loss. The extent to which the investors suffered loss by reason of the untrue statement will most likely be determined by expert evidence regarding whether the price the investors paid ($1.70 per share) was higher than would have been the case if the prospectus had not contained the untrue statement. This is likely to be a contentious issue. The judgment may raise some concerns for directors and their insurers who are involved in offers of financial securities due to the low threshold for reliance under s56 SA. However, as the SA has now been repealed and replaced by the Financial Markets Conduct Act 2013, the significance of the Supreme Court’s judgment for future cases is questionable.

1.  Houghton v Saunders [2018] NZSC 18.  
2.  The negligent mis-statement claim failed in the High Court and was subsequently abandoned on appeal.  
3. The Court found Mr Houghton had failed to prove loss at the stage 1 hearing. This meant the end of his personal claim under the SA, unless the High Court allowed him to participate in the stage 2 hearing  

For any further information regarding this please contact Darren Turnbull or Andrea Challis