As seen in the Otago Daily Times, July 6th 2015.
This year we have seen well publicised success stories of businesses funding expansion through crowd funding and other new initiatives made possible by the passing of the Financial Markets Conduct Act (known as the FMCA) in 2013. The FMCA has clarified previous exceptions and also created new exceptions to disclosure requirements that would otherwise apply when a company issues shares to the public. With all this new development, there has been a lot of focus on the new exceptions and how they can benefit businesses. It is useful then to remind ourselves just why these exceptions are important.
A recent High Court decision illustrates the consequences of failing to comply with the disclosure requirements when a company issues shares to the public. The applicant, Frimley, issued shares to a number of individuals including Ms Fog to fund a subdivision of a large block of land near Hastings.
Under the Securities Act (the predecessor to the FMCA which applied at the time), Frimley was required to provide investors with a registered prospectus unless an exception applied. The prospectus would have contained extensive information about the shares and the company to allow an investor to make an informed decision. Frimley had no registered prospectus. The subdivision was not an overall success and Ms Fog sought to have her investment cancelled and repaid.
Ms Fog was introduced to Frimley by her financial advisor who was also a director of Frimley. Over a period of years Ms Fog contributed cash totalling $149,400 in return for shares in Frimley. The issue of shares without a registered prospectus in breach of the Securities Act meant that Ms Fog could require Frimley to repay the amount that she had invested plus interest. If Frimley failed to repay Ms Fog’s investment then the directors of Frimley would be personally liable to repay Ms Fog.
Frimley applied to the High Court for relief under the Securities Act so that it would not be required to repay Ms Fog’s investment. The High Court considered two key points. Firstly, whether Ms Fog was truly a “member of the public” or whether an exception applied, and secondly, whether Frimley qualified for relief.
Frimley asserted that Ms Fog was a “close business associate” of the director (an exception under the Securities Act) and therefore did not need to be provided with a prospectus. The High Court was not persuaded that the investor/advisor relationship between Ms Fog and the director of Frimley amounted to a close business relationship, stating “… Ms Fog could not be assumed to have all the relevant knowledge of Frimley, or know what to ask [the director]. The relationship did not overcome the inequality that existed between [the director] as promoter of a complex risky development project and Ms Fog as a passive investor.” Ms Fog was not a close business associate which meant that Frimley should have provided Ms Fog with a registered prospectus.
The High Court listed the material information that should have been provided to Ms Fog such as details of trading prospects and risks, statement of financial position, and an explanation that the share capital of the directors was not paid up. The High Court concluded that the contravention of the usual disclosure requirements was serious, and not a minor or technical breach. Had Ms Fog received the information that she should have, she may have had significant reservations about her investment in Frimley. This breach had materially prejudiced Ms Fog and therefore relief was not available.
If Frimley had relied on the “close business associate” exception in the FMCA then the result is likely to have been the same. However, if Frimley was carrying out the same offer under the FMCA then they may have had a range of other exceptions open to them, notably the “small offer” exception. Under this exception, a company could issue up to $2 million of shares to a maximum of 20 investors over 12 months without needing to satisfy the usual disclosure requirements.
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