On 30 June 2022 the High Court upheld a Financial Markets Authority (‘FMA’) direction order against property development and investment companies Du Val Group NZ Limited and Du Val Capital Partners Limited (‘Du Val’), dismissing all of Du Val’s grounds of appeal.

In this Financial Law Insight we take a look at the key findings from the decision, and what they mean for entities that offer and market non-retail investments.

Background

On 4 October 2021, the FMA issued Du Val with a direction order requiring the removal of promotional material the FMA felt was likely to mislead or deceive potential investors.

High security and high return

The FMA asserted that Du Val’s promotion of its Mortgage Fund Limited Partnership (‘Fund’) contravened the fair dealing provisions of the Financial Markets Conduct Act (‘FMC Act’). The marketing material, which appeared on Du Val’s website and social media channels, included phrases such as “high security and high return”, “the best of both worlds in terms of security and return”, and “the highest-ranking security that is available.” The FMA viewed this as creating the impression Du Val’s Fund was low risk when, in reality, the risks associated with early stage finance for a property development project are not low.

No fees

The FMA also claimed that Du Val was not transparent about the fact it retained all profit above the 10% fixed return provided to investors. The FMA characterised this as effectively being a performance-based fee and considered Du Val’s advertising was misleading because investors may not have realised the general partner kept all profit above 10%. The FMA directed Du Val to ensure they no longer use the phrases “we do not charge fees”, “no management or performance fees” and “no administration fees.” Alternatively, if Du Val continued to the refer to ‘no fees’ then the FMA directed Du Val to qualify that statement by clarifying that they “retain any profit in excess of the 10% p.a. return to investors.”

Eligible investors

Du Val relied on the wholesale offer exclusions in Schedule 1 of the FMC Act to offer the Fund. A product disclosure statement was not required as any such offer was not a ‘regulated’ one. The offer was instead made via a Private Placement Information Memorandum.

It appears most investors in the Fund were ‘eligible investors’. This is a subset of the broad wholesale investor category. To be classed ‘eligible’ an investor must self-certify as having some experience and ability to assess the investment, and have that certification confirmed by a financial adviser, qualified statutory accountant or lawyer.

Small offer

Du Val also offered the Fund via the small offer exclusion in Schedule 1 of the FMC Act, and advertised the offer. Of course, small offers cannot be advertised. Du Val had already conceded to the FMA that it had made errors regarding the small offer exclusion and was repaying investors who had invested under that exclusion. Oops.

Appeal by Du Val

Under section 532(g) of the FMC Act an enforcement order decision by the FMA can be challenged on the basis that it is wrong in law. Du Val appealed to the High Court (the first appeal in relation to a direction order that has made it to a full court hearing) on the basis that the FMA erred in its application of the fair dealing provisions and failed to consider that wholesale investors are inherently more sophisticated than retail investors. Du Val also argued that the FMA incorrectly characterised the right to retain any profits as a ‘fee’.

Takeaways from the High Court’s decision

Gault J’s judgment confirmed that whether representations are likely to mislead or deceive in the particular circumstances must be examined objectively and involves questions of fact. When determining if there is a breach of section 19 of the FMC Act (misleading and deceptive conduct generally), the correct approach is to identify who the representations are targeted at (whether to the public at large or to a class specifically targeted) and in either case to exclude outliers. Here Gault J accepted that the correct test to apply is the one set out in the Court of Appeal’s Godfrey Hirst NZ Ltd v Cavalier Bremworth Ltd decision (with section 19 of the FMC Act clearly analogous to section 9 of the Fair Trading Act).

Gault J also recorded that whether representations are likely to mislead or deceive involves a factual assessment to be determined objectively (rather than according to a subjective view). This aligns with the Supreme Court’s Red Eagle Corporation Ltd v Ellis decision.

Targeted v public at large

Du Val contended that its advertisements were only targeted at wholesale investors and that, in any event, only wholesale investors could take up the offer. The FMA considered the advertisements targeted the ‘public at large’ and that an ‘inexperienced audience’ was ‘exposed’ to the representations made.

Gault J found that although the FMA did not specifically state that Du Val was targeting the public at large, the FMA did find that by virtue of the distribution channels used the representations targeted inexperienced investors and therefore had identified the relevant class of potential investors – a key finding for the validity of the FMA’s actions.

Interestingly, Gault J commented that “it may not be feasible to advertise in a way that targets only wholesale investors.” Wholesale offerors should therefore consider the characteristics of the actual audience likely to see their advertisements and be transparent in all marketing material, regardless of the channels used. At the very least a prominent statement that the offer is ‘limited to wholesale investors and not suitable for retail investors’ is a must (but not a cure all).

Not inherently sophisticated

The FMA had previously stated that it did not agree with Du Val’s contention that wholesale investors are inherently more sophisticated.

Running a rule over the various wholesale categories, Gault J affirmed the FMA’s contention that wholesale does not equate to sophisticated. An investor may have simply inherited a large sum of money, own various properties, or sold a business or farm. None of those forms of wealth reflect any special skill or experience in investing. Such investors are no more capable of evaluating the merits of an offer or accessing necessary information than so-called ordinary ‘mum and dad’ retail investors.

Wholesale investors come in varying degrees of experience and sophistication. And the FMC regime is clear. The fair dealing provisions apply to all offers, regulated or otherwise, and are intended to protect all investors.

Whether the bright-line tests in Schedule 1 of the FMC Act need an overhaul is another question. They certainly seem to set a low bar in the current scheme of things and were perhaps even out of step when the FMC Act was enacted. The Du Val decision adds further fuel to those flames.

The ability for investors to self certify certainly has the potential to be exploited, or to exploit investors, if not applied in a robust manner. As Gault J noted, even though the Du Val offer was only available to wholesale investors, the nature of the representations made could incentivise potential investors to complete a wholesale or eligible investor certificate.

Is retained profit a fee?

Gault J could not rein in the FMA’s expansive concept of ‘fee’. Not because the FMA was necessarily correct in its categorisation, but rather because it was a point of fact and not law, and thus outside the scope of the appeal.

The FMA readily states that it takes a broad interpretation of the term ‘fee’. In the case of Du Val, the FMA considered that any payment to the general partner by the fund was a fee. Although stating the reference to a fee was ‘inapt’, Gault J decided it was not a completely insupportable position, hence the position was left ‘as is’.

At some stage the FMA will need to offer more nuanced guidance as to what it considers a ‘fee’ (the guidance note for managed fund fees is several years old). This includes drawing a clear line between the concepts of fee and profit. Offerors can make a profit or margin (such as the difference between deposit and lending sides of a venture). This is the reason to be in business. Not every benefit an offeror gains is a fee.

Appeal dismissed

In summary, the High Court found that although some of the FMA’s reasoning was questionable, there were no material errors of law in the direction order. The appeal was dismissed and the direction order against Du Val stands.

FMA actions

As part of the appeal, Gault J accepted that direction orders are at the lower end of the FMA’s enforcement spectrum. They are intended to be a “flexible and efficient enforcement tool.” Despite this, Gault J has stated that the FMA must still give sufficient reasons when issuing an order. This serves the principle of open justice “which is essential to public confidence and the rule of law by ensuring that the decision can be scrutinised.”

While it ‘won’ the appeal, there are lessons for the FMA from the judgment. On occasion, we have observed that FMA feedback letters, notices and orders contain material inaccuracies, both factual and legal, and lack clear details to enable an understanding of the crux of the FMA’s concerns. The FMA needs to be wary of acting as judge, jury, and executioner. Whether or not you agree with Du Val’s methods and marketing, at least they had the gumption to challenge. All FMA decisions about market service licences are able to be challenged (on fact and law). And enforcement orders can be appealed on grounds of law.

Concluding thoughts

The FMA has signalled it is taking a close look at the wholesale sector. Late last year it asked wholesale offerors for extensive information, including investor certifications and promotional material. The FMA intends to release a report on the sector later this year. Whether or not its report raises policy points about the design of the ‘unregulated’ part of the regime remains to be seen. As the tide goes out, we may see a repeat of the old finance company failures. If that happens reform will be inevitably follow.

In the meantime, the FMA’s view is clear. Retail investors should stay away from markets and products they do not understand. With this in mind, wholesale offerors need to tighten up their practices. This includes ensuring advertised returns do not underplay the risks involved. Offerors must also be clear about fees. If some profit is retained, then that needs to be clearly disclosed. Adopting some ‘best practice’ approaches may also help. Fund-type structures, in some cases, could benefit from supervisor involvement. Wholesale offerors can distinguish themselves from others in the sector by maintaining high quality, transparent initial and ongoing disclosure and reporting.

With regard to advertising, the FMA’s guidance note on Advertising of financial products under the FMC Act sets outs out clear requirements, and regulator expectations. This includes for offers made to wholesale investors. Offerors are strongly recommended to follow this useful guidance, regardless of the perceived sophistication of their intended target audiences. The wholesale offer regime is not a get out of jail free card!

Start a conversation

If you would like to discuss any other aspect of the Du Val decision or wholesale offers, please contact Catriona Grover on +64 4 498 0816, David Ireland on +64 4 498 0840, Mark Schroder on +64 9 375 1120, Keegan Toft on +64 4 915 0785 or email the team at bankingandfinancialmarkets.nz@dentons.com.