Raising capital: how well do you know your investors?

It's easy to assume that investments made in exchange for shares in a company by a few acquaintances and friends of the issuer are not subject to the Securities Act requirements for offers to the public. But an offer of securities does not have to be "to the world at large" in order to fall within the scope of the Act. In this article, solicitor Julian Benefield discusses a recent case which provides a useful illustration of the type of smaller offers caught by the Act and a reminder of the consequences for those who get it wrong.

In the life of a small business there will often be a need for a cash injection to assist with the expansion and growth of the business. This can come from a variety of sources, including from private investors willing to provide funding in exchange for shares or other securities.

The problem with this type of funding is that it can easily be caught by the requirements of the Securities Act 1978 (the Securities Act) relating to "public offers" unless the offer is structured to bring it within one or more of the exceptions available.

The Securities Act provides, in broad terms, that no security can be "offered to the public" for subscription by or on behalf of an issuer without being accompanied by an investment statement and a registered prospectus, unless the offer falls under one of the four categories of "private" offers.

Under section 3(2) of the Act, a "private" offer (or placement) is one made only to one or more of the following:

• relatives or "close business associates" of the issuer, or a director of the issuer, of the securities being offered;

• persons whose principal business is the investment of money or who, in the course and for the purposes of their business, habitually invest money (known as "habitual investors");

• persons who each pay a minimum subscription price of at least $500,000 for the securities¹; or

• any other person who in all the circumstances can properly be regarded as having been selected "otherwise than as a member of the public".

The case

In the recent High Court decision of De Alwis & Ors v Luvit Foods², it was unclear whether the defendant, Mr Chean, had section 3(2) in mind as he went about raising capital for the expansion and development of his manufacturing business, Luvit Foods International Limited (Luvit Foods). Between March 2000 and September 2001, Mr Chean gathered together seven individual investors who together contributed a total of $1.68 million in funds in exchange for shares in the holding company of Luvit Foods.

On the facts, it appeared that none of the investors selected by Mr Chean (the sole director and shareholder of Luvit Foods) were known to Mr Chean, or knew anything about Luvit Foods and its business prior to their respective investments. All of the investors had been persuaded to invest in Luvit Foods on the strength of an information memorandum and various oral representations made by Mr Chean at meetings held at the business premises and elsewhere.

The claims

In addition to several claims made under the Fair Trading Act 1986, the investors sought recovery of their investments on the basis that the shares issued to them should not have been offered without a registered prospectus complying with the Securities Act and that, in the absence of such a prospectus, the allotment of the shares was void and of no effect. If successful, this Securities Act claim would likely result in a refund of the investors' subscription monies.

The decision

On the evidence in De Alwis, Justice Courtney found that the representations made in the information memorandum and the various oral representations made by Mr Chean amounted to misleading and deceptive conduct for the purposes of the Fair Trading Act.

In terms of the claim under the Securities Act, the court had to consider whether the offers of shares to the individual investors constituted a "public offer", or an offer made only to specified persons (taking the offers outside the requirements of the Securities Act to register a prospectus by virtue of one or more of the section 3(2) exceptions).

Other than the "close business associates" exception, the judgment provides little analysis of the categories of private offers set out in section 3(2) of the Securities Act.

Justice Courtney noted that the purpose behind the Securities Act was the protection of members of the public who might be participating in the purchase of securities. He referred to one case which stated that the broad statutory goal of the Securities Act was to "facilitate the raising of capital by securing the timely disclosure of relevant information to prospective subscribers for securities", with the protection of investors being paramount. This purpose was said to be achieved by regulating the conduct of issuers of securities and by providing sanctions for infringements by those issuers and their directors and officers.

In Justice Courtney's discussion on the "close business associates" exception, he referred to Securities Commission v Kiwi Co-operative Dairies Ltd³. In that case, the Court of Appeal considered the meaning of the close business associates exception, concluding that close business associates must be:

" sufficiently closely connected on a personal basis with the issuer that the assumption could be made that they would each have sufficient relevant knowledge of their relative's affairs or the means of readily obtaining that knowledge".

To Justice Courtney, it was clear that none of the investors in De Alwis enjoyed a relationship with Luvit Foods or Mr Chean that came near the description from Kiwi Co-operative Dairies. None of the investors had known Mr Chean prior to the 2000-2001 investing period, and apart from their investment in Luvit Foods, none had had any other previous business or personal dealings with Mr Chean.

Accordingly, Justice Courtney concluded that the relationship between Luvit Foods, Mr Chean and the investors fell well short of that required by section 3(2) of the Act for close business associates. As a result, a registered prospectus should have accompanied the offers of shares.

Relief provided by the Securities Act

The consequence of not complying with the Act's requirements for a registered prospectus resulted in the allotment of shares in Luvit Foods to the investors being deemed void and of no effect under section 37 of the Act. In this event, the Act requires the investors to be refunded in full for their subscription, and since this was not done, the court found both Luvit Foods and Mr Chean jointly and severally liable to repay the investment monies plus interest to all of the investors.

Conclusion

As noted at the outset, this case provides a clear illustration of what can go wrong if the provisions of the Securities Act are not taken into account when embarking on a capital raising exercise. Potential issuers and promoters of an offer of shares or other securities (regardless of the size of the offer or the number of investors) should consider the application of the Securities Act and obtain legal advice before soliciting outside investors for a (intended) private placement. This is especially so where the placement is attempted or intended to be made under the "close business associate" exception.

It is also important to remember that when making an offer of shares to a select few, it only takes one of the potential investors to fall outside the private offer exceptions to trigger the requirement for the offer to be accompanied by a registered prospectus.

¹ It should be noted that at the time the offers of shares were made in De Alwis there were only the three other categories for private offers, with the close business associates exception being more limited. Under the Securities Amendment Act 2004, the category of offers to relatives or close business associates was expanded to include the reference to "a director of the issuer" and the category referring to offers to persons required to pay a minimum $500,000 subscription was introduced.

² De Alwis & Ors v Luvit Foods (Unreported, High Court, Auckland, CIV-2002-404-1944 15, 23 May 2007)

³ [1995] 3 NZLR 26

Enquiries and information

For more information on any of the cases, articles and features in Commercial Quarterly, please email Diane Graham or call her on 64 9 916 8849.