In depth: Financial regulation reaches its high water mark
- Download the article 367 kB PDF
The government's securities law reform agenda is in full swing. The Financial Markets Conduct Bill (FMCB) is currently proceeding through its parliamentary stages (the Commerce Select Committee is due to deliver its report on the FMCB on 7 September), and with it comes an overt focus on consumer protection. Meanwhile, the Companies and Limited Partnerships Amendment Bill proposes to criminalise certain breaches of directors' duties, something that has until now been a civil matter.
However, we do not have to wait for Parliament to see change in this area. The Courts have recently delivered two important securities law decisions Hickman & Ors v Turner and Waverley Limited ( NZSC 72) (Blue Chip) and R v Douglas ( NZHC 1467 and  NZHC 1746 – the two cases were dealt with in parallel) (Capital + Merchant). These decisions may well represent the high water mark for an expansive approach to consumer protection under New Zealand's financial regulation laws. These decisions will potentially have a sweeping impact on the New Zealand business environment, and their significance is likely to carry through to the new legislative regime. The implications of Capital + Merchant are not limited just to issuers and financial service providers. It would appear to extend to borrowers, lessees and purchasers under terms of trade.
Blue Chip: It's the vibe
The Supreme Court has recently delivered a unanimous judgement in Blue Chip. The issue the Court considered was whether Blue Chip, through marketing of its investment products, had offered securities to the public within the meaning of the Securities Act, and if so, whether the offer was exempt. If the investments were securities, Blue Chip had failed to comply with the requirements of the Securities Act. Both the High Court and Court of Appeal (and, it seems, the Financial Markets Authority (FMA)) had concluded that the products did not fall within the scope of the legislation. However, on appeal, the Supreme Court had no difficulty ruling that the products conferred on the investors the right to be paid money and obligations that were otherwise owing to them by Blue Chip (i.e. were "investments"), thus making the products debt securities. The requirements for issuing debt securities to the public had not been complied with (namely, there was no registered prospectus or a trustee for the debt securities) and no exemptions were available. Therefore the investors were entitled to relief under the Securities Act against Blue Chip and, importantly, the developers as co-issuers. The sale and purchase agreements were deemed unenforceable.
The Supreme Court's decision is no doubt a welcome relief to investors faced with the prospect of losing their own homes for the sake of apartments that they never intended to buy. However, the decision appears to have increased the ambit of the Securities Act to an uncertain extent, raising the question of what, exactly, is a "debt security".
The investment schemes
At issue were three Blue Chip investment products and three property developments. The common theme of these products was that the Blue Chip customer entered into a sale and purchase agreement (SPA) with the property developer and therefore became bound to pay a deposit or bond, and to purchase the apartment once completed. The customer also entered into a variety of agreements with Blue Chip that provided for income streams to the customer relating largely to either a return on deposit monies or rental from the apartments once complete. The customers were under the impression that they would never actually have to settle the purchases – Blue Chip was to find a subsequent purchaser for each apartment – although the documents they entered into did not provide for this. Using the SPAs as security, the developers raised capital to construct the apartments (for which Blue Chip then acted as an underwriter and received fees).
When Blue Chip collapsed in February 2008 the investors were left bound by the SPAs, obliged to settle but lacking the funds to do so. Consequently, many of the investors risked losing their own homes.
The Supreme Court, ultimately holding that the Blue Chip arrangements fell within the intended regulatory scope of the Securities Act, favoured a broad interpretation of the Securities Act so as to encompass "less usual types of securities". Throughout the decision, the Court places strong emphasis on the language used in, and policy underlying, the Securities Act and takes a more expansive view of the Securities Act than has occurred previously. This may be explained in part by the nature of the case but the principles discussed have consequences for other transactions.
The first question for the Court was whether the Blue Chip products were "securities". The Court held that they were. "Debt security" is defined as "any interest in or right to be paid money that is, or is to be, deposited with, lent to, or otherwise owing by, any person ..." The phrase "otherwise owing" is to be given its plain meaning and the investors, in providing consideration for the allotment of the securities by entering into the SPAs (money's worth) and any payments made under them (money), subscribed for debt securities. The Court went on to observe that Blue Chip's obligations to the investors were indeed "rather like" those owed by a borrower to a lender and saw the "Blue Chip products as providing mechanisms by which Blue Chip sought and obtained financing from the public".
Prior to the Blue Chip judgment, the generally held view was that a sale of a property with a guaranteed financial return fell within the exemption in section 5(1)(b) of the Securities Act. This exemption effectively provides that "ordinary" agreements for sale and purchase of land are not caught by the various definitions of securities. However, the Court found that the exemption did not apply in relation to the Blue Chip model. The exemption was intended to apply only to an "ordinary purchase of land" or arrangements that are "an unexceptional term ancillary to the purchase of an interest in land". In the Supreme Court's view, this meant that the investor's entry into an SPA must be looked at as a whole, along with any related transactions. In Blue Chip, the investors had no intention of occupying the apartments, nor were they to receive any rent from them. The apartments had a limited function in the whole transaction, acting as a form of security for the investors against Blue Chip's promise to reimburse investors. The SPAs and Blue Chip products were inextricably linked in the eyes of the investor, so the exemption was not available to either.
The Court found that, in receiving what was provided by the investors to Blue Chip as consideration for the allotments, the developers were caught by the definition of "issuer" in the Securities Act (along with Blue Chip). Further, the developers either had complete or substantial knowledge of the detail of the investment products. Looking at the transaction as a whole and in light of the Securities Act's "consumer protection focus", it was therefore appropriate "to attribute to the developers the actions and knowledge of Blue Chip". Therefore the SPA and the other arrangements were all caught by the Securities Act. The Securities Act had not been complied with, so the SPAs were of no effect. The developers were ordered to refund all deposits held in relation to the SPAs to the investors.
Where to from here?
Other than the unenforceability of the SPAs, the immediate consequence for the developer and Blue Chip is that they are now potentially liable for civil and criminal offences under the Securities Act. An FMA spokesperson has said that the FMA will be considering whether it can take steps to assist Blue Chip investors.
Our initial view of the Supreme Court judgment is that it has potentially expanded the kind of transactions that will be caught by the Securities Act. The case suggests that banks and other lenders now need to be careful in relying on SPAs as part of any presale requirement, and reliance on these types of agreements as a matter of course should be reviewed.
Questions must also be asked about the general scope of the Securities Act and debt securities. The approach of the Supreme Court was very much based on whether something could reasonably be said to be an "investment", with only those matters specifically carved out of the Securities Act excluded from its scope (e.g. the section 5 exemptions). However, the approach of relying on specific carve outs from the Securities Act equally raises queries about other rights to receive money or money's worth (i.e. debt securities). Is a cell phone pre-paid balance a debt security? What about gift vouchers? Gym and other club memberships paid in advance? Insurance? None of these matters are expressly excluded from the Securities Act either.
The FMCB, which will replace the Securities Act in the near future, deals with these issues in a slightly different manner (the land carve out is now limited to managed investments, according to Financial Markets Conduct Bill, clause 9(2)). However, the Supreme Court decision was based on the definition of debt security, which is largely the same in the FMCB, and so the Blue Chip decision may be an important authority in this area for the foreseeable future.
Capital + Merchant: Theft by a person in a not so special relationship
While Blue Chip was a civil matter, Capital + Merchant involved a criminal prosecution against the directors of a failed finance company. Unlike many other finance company prosecutions, the decisions in Capital + Merchant did not involve allegations of breaches of the Securities Act (although such charges are likely to come), rather breaches of the company's trust deed. The (perhaps surprising) effect of the High Court decision seems to be to criminalise even immaterial breaches of a trust deed (and potentially loans, leases and other contracts). Moreover, the findings establish that a breach of a director's Companies Act duties may already give rise to criminal liability in certain circumstances, even ahead of the enactment of the Companies and Limited Partnerships Amendment Bill.
While there is unlikely to be a lot of sympathy for the Capital + Merchant directors, the broader implications of the decision are more concerning.
In essence, the Judge found three directors of the company guilty of theft in a special relationship (under section 220 of the Crimes Act 1961) in respect of various related party transactions (other charges were not proven). The elements of this offence required that:
- The directors had control of property which they knew they were required to deal with in accordance with the requirements of another person (here, under the trust deed)
- They intentionally dealt with the property otherwise than in accordance with those requirements.
Specifically, the Judge found the following:
- The directors had control of the investors' funds. On the facts, it was clear that they had control over the company and that "they guided and controlled its affairs". The company was the "alter ego" of the directors1. However, Justice Wylie's approach is not limited to directors; control of funds seems to be sufficient and therefore may include non-directors with actual control over funds
- The directors clearly knew that the funds were held subject to the requirements of the trustee as set out in the trust deed. It seems, therefore, that if control over the funds is found and there is a trust deed governing those funds, the “requirements” element of the offence will be met
- A bare breach of the trust deed in those circumstances could give rise to criminal liability under section 220 irrespective of whether the breach was material, or remediable, or whether it was a breach that would entitle the trustee to take enforcement action: "A breach was a breach whether or not it resulted in enforcement action being taken by the trustee"
- The directors intentionally dealt with the funds other than in accordance with the trustee's requirements. This was based on three separate breaches of the trust deed (as discussed below). It sufficed that the directors “voluntarily and deliberately breached the requirements contained in the debenture trust deed” – dishonesty was not required.
The breaches found by the Judge were in respect of clauses of the trust deed prohibiting related party transactions (except within permitted exceptions, which, among other things, required the transaction to be in the ordinary course of business), requiring the company to carry on its business in an efficient, prudent and business-like manner, and requiring the company to comply with applicable law – i.e. standard clauses that appear in almost all debenture trust deeds and loan and security agreements. The finding of a breach of the covenant requiring compliance with applicable law was based on a breach by the directors of their duties to act in good faith and what the director believes is in the best interests of the company (section 131) and for a proper purpose (section 133). Even disregarding the fact that the trust deed clause did not seem to require directors to comply with these duties (but rather required compliance by the company with all laws), the effect of the finding is to criminalise a breach of the Companies Act duties, which otherwise have civil consequences only.
In summary, the effect of the decision appears to be that directors (and others) who are in a position where they effectively control funds invested in a company may be criminally liable if they breach the trust deed under which those funds are invested, even if:
- There is no dishonesty
- The breach is immaterial, or a technical or minor breach that a trustee would ordinarily waive
- The breach is one that would traditionally be dealt with as a civil matter (e.g. an action for negligence or breach of directors' duties).
It seems that there is a real risk that directors could be liable on matters of business judgement – such as whether a transaction is in fact in the “ordinary course of business” and on arm’s length consideration, or whether the company’s business is being carried on in a prudent-like manner. Moreover, it is only a small step to extend the reasoning to breaches of loan and security agreements, leases, trade terms of supply and other contracts under which requirements are imposed as to how a person may deal with property. Few would expect breaches of these types of agreements to lead to criminal liability, yet that appears to be the position after Capital + Merchant.
Putting the case in context – legislative changes
As noted, the Companies and Limited Partnerships Amendment Bill proposes to also criminalise certain breaches of directors' duties. This is, however, limited to sections 131 (duty to act in good faith and the best interests of the company) and 135 (reckless trading) of the Companies Act. The proposed offences also require a degree of actual knowledge of the breach (Companies and Limited Partnerships Amendment Bill, clause 4). In contrast, knowledge was not a precondition to liability in Capital + Merchant. Further, one of the criminalised breaches found in Capital + Merchant was in relation to section 133 of the Companies Act (duty to exercise powers for a proper purpose) – a provision that the Companies and Limited Partnerships Amendment Bill leaves as a civil matter.
More generally, the FMCB will (at least as currently drafted) alter the thresholds for establishing criminal liability. Other than for infringement offences (which do not lead to a conviction), criminal liability is essentially reserved for knowing or reckless breaches of the disclosure requirements. This is a significant departure from the current approach, where liability for untrue statements is strict, subject only to defences of immateriality or an honest and reasonable belief in the truth of the statement. Moreover, there will be a greater degree of emphasis on civil liability for contraventions of the Financial Markets Conduct Bill, as opposed to criminal liability. In particular, the Financial Markets Authority will be able to bring civil pecuniary penalty proceedings against directors in a wide variety of circumstances. In that context, it seems the government has recognised that criminal liability should be reserved for the most egregious breaches. There would seem to be some inconsistency between that approach and a finding that criminal liability can ensue from an (albeit intentional) immaterial breach of a trust deed.
1. There were some differences between the three defendants. Messrs Nicholls and Douglas were involved from the outset (and the owners of the company via a series of companies and trusts), while Mr Tallentire became a director later, although had earlier been a senior officer of the company.
In two decisions, delivered within weeks of each other, the Courts have increased both the scope of New Zealand's financial regulation regime and the consequences for breaching that regime. These decisions may well represent the high water mark for an expansive approach to consumer protection under New Zealand's securities laws, while Capital + Merchant may have more far-reaching implications, as it is not limited to securities law.
Of course, all decisions necessarily reflect the facts of the particular cases before the Court, and it must be said that, in our view, the Courts reached the "right" decision based on moral grounds. However, care needs to be taken not to upset commercial certainty for the sake of consumer protection – both are specific objectives set out in the Financial Markets Conduct Bill, clause 3.
In our view, any expansion of the scope of financial regulation or any movements towards criminalising directors' duties should be considered carefully to ensure that any changes strike the right balance between protecting stakeholders' interests and commercial imperatives. While failed finance companies are usually fairly unsympathetic parties in any proceeding, it is also necessary to recognise that directors' roles entail the exercise of business judgement in respect of which reasonable people can differ (especially in hindsight). While we are all expecting big things from the FMCB (including the FMA, who is "looking forward with glee" to enforcing it, see article here), based on its current drafting there are still a number of uncertainties about its application and the consequences for breach. The government should therefore consider the impact of the Blue Chip and Capital + Merchant decisions very carefully in its ongoing financial sector law reform.
In the meantime, these cases serve as yet further reminders that directors, issuers and financial service providers need to be vigilant in the discharge of their duties under financial regulation laws, while property developers, investors, borrowers, lessees and purchasers of goods subject to ongoing terms of trade, also need to tread more carefully.