ESG Updates – The Bank of England Climate Biennial Exploratory Scenario

The Bank of England (BoE) has published the results of the Climate Biennial Exploratory Scenario (CBES), which explores the financial risks posed by climate change for the largest banks and insurers operating in the UK. In line with the findings of other central bank stress tests across the globe, the CBES found that while the financial system might be adequately capitalised to absorb the shocks of climate change scenarios, the sector would suffer losses across each scenario, with the greatest quantifiable losses suffered in a No Action and Late Action scenario. This reaffirms the BoE’s drive to an early and orderly transition to a net-zero economy.

  • In June 2021 the BoE launched the CBES, seeking to explore and better understand the financial risks posed by climate change to the UK financial system, and to ensure that real change is effected to help with systemic resilience.
  • Following the submission of participants’ initial responses in October 2021, we looked at the CBES in the context of other central bank initiatives and stress tests across the globe, to understand the scope of the CBES as part of our November 2021 Global Banking Review, which focussed heavily on the issues facing financial institutions in connection with Climate Change.
  • Just over six months later the BoE has published the results of the CBES, and we consider here what it has learnt, where will the focus fall, and what will come next?

Summary of key findings – Banks

The climate risks captured in the CBES scenarios are likely to create a drag on the profitability of both UK banks and insurers. Loss projections varied across participating firms and the three different climate scenarios but equated to an annual drag on profits of around 10-15% on average. Projections suggested (unsurprisingly) that the overall costs will be lowest in scenarios with early, well-managed actions to transition to a net-zero economy.

However, the CBES found that there was substantial uncertainty as to the magnitude of climate risks. The figures identified in the BoE report were heavily caveated to allow for various acknowledged limitations, with this, its first CBES, including:

  • The banks’ projections were focused on credit risk, and did not yet fully take into account possible impacts resulting from market risk;
  • The data used to populate responses from firms was incomplete and inconsistent in its approach – for example, loss estimates on the same corporate customers differed substantially in participating firms’ responses;
  • The ‘No Action’ scenario would likely incur losses past the time horizon selected for the CBES projections, and as such projections for this scenario were likely partial; and
  • The BoE acknowledged the limitations of the fixed balance sheet approach adopted for the CBES.

Despite these, and other limitations, the CBES included a number of interesting observations for market participants:

Quantitative findings – calculating the risk

  • Projected climate risk impacts were highest for banks’ wholesale and mortgage exposures, and projected climate-related consumer credit losses were relatively low.
  • Institutions which relied upon third-party modelling and data without sufficient internal capability to challenge and scrutinise often gave rise to materially lower loss projections than those institutions which had invested in and developed their own internal models. The development of internal models was more established in the insurance than the banking sector.
  • Limitations caused by data gaps and inconsistent data provision from third parties such as clients and counterparties were again noted. In particular, the lack of available data regarding corporates’ current value chain emissions and future transition plans was a common issue affecting firms. The BoE also recommends that banks act to encourage remediation of data limitations and gaps to help firms meet the PRA’s supervisory expectations, as set out in SS3/19. Firms’ efforts in this area will be supported by initiatives currently in train to resolve some of these data gaps.

Qualitative findings – planning ahead

  • Responses to the qualitative secondary part of the CBES, which focused on transition planning, suggested that some banks, in particular, were not considering their transition plans holistically: they were failing to take into account the likelihood of similar management actions from competitors or adjusting for different macro scenarios.
  • Transition plans suggest that banks intend to divest from energy-intensive sectors. The BoE sounded a note of caution in relation to these suggestions and to the idea that capital requirements could be used to target investment towards “green” sectors and away from energy-intensive sectors. The BoE noted the systemic risk inherent in depriving energy-intensive sectors from the funding they would need to transition towards net-zero, and also the economic repercussions of mass divestment from providing finance to carbon-intensive sectors ahead of the expansion of renewable energy supply.
  • Capital adequacy remains at the forefront of the BoE’s mind, but in the context of developing (along with other central banks) Solvency II to better accommodate the nuances of climate change risk, rather than using the BoE’s prudential regulation as a pseudo-governmental arm seeking to drive policy change.
  • While participating firms were making good progress in some aspects of climate risk management, they all had more work to do to improve their climate risk management capabilities.

Climate Litigation Risk 

As part of the CBES, the BoE engaged with members of the London Insurance Market to understand the extent to which existing policies would cover climate-related litigation. Following the trend of increasing climate-related litigation (particularly in the United States, which is ahead of many European jurisdictions in this regard), the BoE wanted to look at the impact of this development in the contentious landscape. The BoE identified seven ‘types’ of climate-related litigation, these are set out in full below:

  • Direct causal contribution: a corporate is found liable for its representative contribution to manmade climate change.
  • Violation of fundamental rights resulting in cessation or reduction of operations: a corporate is prevented from practising carbon-intensive activities that violate fundamental human and dignity rights, this has a significant impact on financial revenues.
  • Greenwashing: a corporate is found to be misleading customers (e.g. false advertising, mislabelling as ‘environmentally friendly’, underreporting disclosures) and must pay out compensation to customers/investors.
  • Misreading the transition: a corporate is sued on the basis that it continued to sell a carbon-intensive product while in knowledge it would become redundant due to government net-zero policy, they must refund and compensate customers.
  • Indirect casual contribution (related to exposure to Utilities sector only): utilities are sued for their indirect contribution to climate change which amplifies physical risks due to inadequate or negligent preparation.
  • Directors’ breach of fiduciary duties (related to cover against asset managers only): investors of an asset manager allege that the entity’s directors have understated the physical and/or transition risk to their assets in their disclosures. Investors seek payment for damages from the directors’ breach of fiduciary duty.
  • Indirect causal contribution (financing): a case is brought against financiers of carbon-intensive activities, as they have contributed indirectly to manmade climate change through financing activities of carbon majors.

                                                  Taken from Table 1 of Box C of the CBES Results

Following engagement with members of the insurance market, the BoE identified that (in aggregate) just under half of the D&O insurance policies currently in place would cover these types of litigation risk; while approximately a quarter of the professional indemnity policies would cover climate related litigation. The respondents noted that this figure may not reflect coverage of the defendant’s own legal costs, which could often be high, particularly where the claims were investor-led.

While the focus of these questions was on the impact to the insurance industry of the developing trend, the analysis should focus the minds of banks and asset managers: have they sufficiently considered their litigation risk? Have they considered whether their policy coverage is adequate? As we move forward, have they budgeted for the increasing cost of Profin and D&O insurance which may arise from developing trends in this area?

What next

  • The BoE’s work on climate scenario analysis, including that done as part of the CBES, provides a key tool supporting firms and policymakers as they navigate uncertainty over future climate policy and climate change, enabling assessment against a range of possible outcomes.
  • As set out in the PRA’s October 2021 Climate Change Adaptation Report, the PRA and the BoE are undertaking further analysis to determine whether changes need to be made to the design, use, or calibration of the regulatory capital frameworks.
  • To support this work on the capital framework, the BoE will host a research conference on the interaction between climate change and capital in Q4 2022, and has already put out a ‘Call for Papers’. The BoE will publish follow-up material on the use of capital, including on the role of any future scenario exercises, informed by the conference and the findings of the CBES.
  • While no future CBES has been announced, it is clear that more work is needed before the BoE and market participants understand the stress that they may soon be under as a result of climate risks.
Simon Clarke
Simon Clarke
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Sousan Gorji
Sousan Gorji
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Eleanor Dole Sheaf
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Herbert Smith Freehills contributes chapter to The Securities Litigation Review (8th Edition)

Herbert Smith Freehills have contributed the England and Wales chapter of The Securities Litigation Review. Now in its eighth edition, The Securities Litigation Review is a guided introduction to the class action regimes for securities claims in the key jurisdictions across the globe, providing a valuable resource for corporates and financial institutions who might face such claims.

Download chapter

Reproduced with permission from Law Business Research Ltd. This article was first published in May 2022. For further information please contact Nick.Barette@thelawreviews.co.uk.

Previous Editions:

7th edition 2021

6th edition 2020

5th edition, 2019

4th edition, 2018

3rd edition, 2017

Harry Edwards
Harry Edwards
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Jon Ford
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How to navigate the Autonomy judgment: guidance for corporate issuers defending Section 90A / Schedule 10A FSMA shareholder claims

The High Court has handed down its long-awaited judgment in the US$5 billion civil fraud action brought by the Hewlett Packard group in connection with its acquisition of the UK software company Autonomy Corporation Limited in 2012: ACL Netherlands BV & Ors v Lynch & Ors [2022] EWHC 1178 (Ch).

The judgment follows a previously published Summary of Conclusions, in which the High Court confirmed that the claimants “substantially succeeded” in their claims against two former Autonomy executives (see this post on our Civil Fraud and Asset Tracing Notes blog, which sets out the background facts to the dispute and summarises the outcome).

The successful claims were brought under s.90A of the Financial Services and Markets Act 2000 (FSMA), common law misrepresentation and deceit, and the Misrepresentation Act 1967, as well as claims for breach of the defendants’ management duties.

The 1657-page judgment is significant, not only because the case is one of the longest and most complex in English legal history, but also because it is the first s.90A FSMA case to come to trial in this jurisdiction.

As a reminder, s.90A (and its successor, Schedule 10A FSMA) is the statutory regime imposing civil liability for inaccurate statements in information disclosed by listed issuers to the market. It imposes liability on the issuers of securities for misleading statements or omissions in certain publications, but only in circumstances where a person discharging managerial responsibilities at the issuer (a PDMR) knew that, or was reckless as to whether, the statement was untrue or misleading, or knew the omission to be a dishonest concealment of a material fact. The issuer is liable to pay compensation to anyone who has acquired securities in reliance on the information contained in the publication, for any losses suffered as a result of the untrue or misleading statement or omission, but only where the reliance was reasonable.

In recent years, there has been a noticeable uptick in securities litigation in the UK, in particular in claims brought under s.90A/Sch 10A FSMA. The purpose of this blog post is to distil the key legal takeaways on s.90A FSMA arising from the judgment, which may be relevant to such claims.

Scope of s.90A / Sch 10A FSMA

The court accepted the defendants’ “general admonition” that the court should not interpret and apply s.90A/Sch 10A FSMA in a way which exposes public companies and their shareholders to unreasonably wide liability.

It emphasised that, in considering the scope of these provisions (and in particular in considering the nature of reliance which must be shown and the measure of damages), the history of the s.90A regime is relevant. The court highlighted the following background to the provisions of FSMA, in particular:

  • Prior to s.90A, English law did not provide any remedy (statutory or under the common law) for investors acquiring shares on the basis of inaccuracies in a company’s financial statements (in contrast to the long-established statutory scheme of liability for misstatements contained in prospectuses). The rationale for the different treatment of liability for misstatements in prospectuses and those in other disclosures was because an untrue statement in a prospectus can lead to payments being made to the company on a false basis, but the same cannot be said of an untrue statement contained in an annual report, for example.
  • The ultimate catalyst for the introduction of a scheme of liability was the Transparency Directive (Council Directive 2004/1209/EC), which included enhanced disclosure obligations and the requirement for a disclosure statement. This gave rise to concerns that the English law’s restrictive approach to issuer liability would be disturbed and that issuers (and directors and auditors) might be made liable for merely negligent errors contained in narrative reports or financial statements.
  • The regime for issuer liability was introduced in this jurisdiction in a piecemeal fashion, recognising the historical tendency against liability. The government was aware that the scheme would involve a balance between: (a) the desire to encourage proper disclosure and affording recourse to a defrauded investor in its absence; and (b) the need to protect existing and longer-term investors who, subject to any claim against relevant directors (who may not be good for the money), may indirectly bear the brunt of any award against the issuer.
  • The original s.90A provisions introduced by the government were subsequently extended with effect from 1 October 2010 as follows: (a) to issuers with securities admitted to trading on a greater variety of trading facilities; (b) to relevant information disclosed by an issuer through a UK recognised information service; (c) to permit sellers, as well as buyers, of securities to recover losses incurred through reliance on fraudulent misstatements or omissions; and (d) to permit recovery for losses resulting from dishonest delay in disclosure. However, liability continued to be based on fraud and no change was suggested or made to the limitations that: (i) liability is restricted to issuers; and (ii) liability can only be established through imputation of knowledge or recklessness on the part of PDMRs of the issuer. Further, no specific provisions to determine the basis for the assessment of damages were introduced.

Two-stage test for liability under s.90A /Sch 10A FSMA

The court confirmed that the provisions of s.90A / Sch 10A FSMA make clear that there is an objective and a subjective test, both of which must be satisfied to establish liability:

  • Objective test: the relevant information must be demonstrated to be “untrue or misleading” or the omissions a matter “required to be included”.
  • Subjective test: a PDMR must know that the statement was untrue or misleading, or know such omission to be a “dishonest concealment of a material fact” (referred to in the judgment as “guilty knowledge”).

Each of these tests is considered separately below.

The objective test (untrue or misleading statement or omission)

The court said that the objective meaning of the impugned statement, is “the meaning which would be ascribed to it by the intended readership, having regard to the circumstances at that time”, endorsing the guidance provided in Raiffeisen Zentralbank Osterreich AG v The Royal Bank of Scotland plc [2010] EWHC 1392 (Comm).

The court gave some further guidance as to how to establish the objective meaning of a statement for the purpose of a s.90A/Sch 10A FSMA claim, including the following:

  • The content of the published information covered by s.90A/Sch 10A will often be governed by certain accounting standards, provisions and rules, which involve the exercise of accounting judgement where there may be a range of permissible views. The court confirmed that a statement is not to be regarded as false or misleading where it can be justified by reference to that range of views.
  • Where the meaning of a statement is open to two or more legitimate interpretations, it is not the function of the court to determine the more likely meaning. Unless it is shown that the ambiguity was artful or contrived by the defendant, the claim may not satisfy the objective test.
  • The claimant must prove that they understood the statement in the sense ascribed to it by the court.

The subjective test (guilty knowledge)

As in the common law of deceit, it must be proven that a PDMR “knew the statement to be untrue or misleading or was reckless as to whether it was untrue or misleading”; or alternatively, that they knew that the omission of matters required to be included was the dishonest concealment of a material fact. The court noted that for both s.90A and Sch 10A, the language used shows that there is a requirement for actual knowledge.

The court clarified several key legal questions as to what will amount to “guilty knowledge” for the purpose of the subjective test, including the following:

  • Timing of knowledge. In the context of an allegedly untrue/misleading statement, a party will be liable only if the facts rendering the statement untrue were present in the mind of the PDMR at the moment the statement was made. In the case of an omission, the PDMR must have applied their mind to the omission at the time the information was published and appreciated that a material fact was being concealed (i.e. that it was required to be included, but was being deliberately left out).
  • Recklessness. In the context of s.90A/Sch 10A FSMA, recklessness bears the meaning laid down in Derry v Peek (1889) 14 App. Cas. 337, i.e. not caring about the truth of the statement, such as to lack an honest belief in its truth.
  • Dishonesty
    • Even on the civil burden of proof, there is a general presumption of innocent incompetence over dishonest design and fraud, and the more serious the allegation, the more cogent the evidence required to prove dishonesty.
    • For deliberate concealment by omission, dishonesty has a special definition under Sch 10A (although s.90A contained no such special definition), which represents a statutory codification of the common law test for dishonesty laid down in R v Ghosh [1982] 1 QB 1053 (although in a common law context, that test has been revised by Ivey v Genting Casinos (UK) Ltd [2018] AC 391). Under the Sch 10A definition, a person’s conduct is regarded as dishonest only if:

“(a) it is regarded as dishonest by persons who regularly trade on the securities market in question, and (b) the person was aware (or must be taken to have been aware) that it was so regarded.”

    • Any advice given to the company and its directors from professionals will be relevant to the question of dishonesty (see below).
  • Impact of advice given by professionals on the subjective test
    • The court emphasised that, where a PDMR receives guidance from the company’s auditors that a certain fact does not need to be included in the company’s published information, then the omission of that fact on the basis of the advice is unlikely to amount to a dishonest concealment of a material fact (even if the disclosure was in fact required).
    • Similarly, where a PDMR has been advised by auditors that a particular statement included in the accounts was a fair description (as required by the relevant accountancy standards), it may be unlikely that the PDMR had knowledge that the statement was untrue/misleading or was reckless as to its truth (unless the auditor was misled).
    • However, in the court’s view, directors are likely to be (and should be) in a better position than an auditor to assess the likely impact on their shareholders of what is reported, and (for example) to assess what shareholders will make of possibly ambiguous statements. Accordingly, the court said “on matters within the directors’ proper province, the view of the company’s auditors cannot be regarded as a litmus test nor a ‘safe harbour’: auditors may prompt but they cannot keep the directors’ conscience”.
    • Accordingly, narrative “front-end” reports and presentations of business activities cannot be delegated by directors, as their purpose/objective is to reflect the directors’ (not the auditors’) view of the business and require directors to provide an accurate account according to their own conscience and understanding.
  • Subjective test to be applied in respect of each false statement. The court confirmed that liability is only engaged in respect of statements known to be untrue. If a company’s annual report contains ten misstatements, each of them relied on by a person acquiring the company, but it can only be shown that a PDMR knew about one of those misstatements, the company will only be liable in respect of that one, not the other nine.

Reliance

Reasonable reliance is another necessary precondition to liability under s.90A and Sch 10A, although the precise requirements of reliance are not defined in those provisions. In the Autonomy judgment, the court considered the question of reliance in further detail, providing the following guidance:

  • Reliance by whom? The court held that reliance must be by the person acquiring the securities, and not by some other person.
  • Individual statements vs published information. The court held that reliance must be upon a statement or omission, rather than, in some generalised sense, on a piece of published information (e.g. the annual report for a given year).
  • Express statements vs impression. The court suggested that statements and omissions may in combination create an impression which no single one imparts and, if that impression is false, that may found a claim (subject to the “awareness” requirement below).
  • Awareness requirement. The court held that, in order to demonstrate reliance upon a statement or omission, a claimant will have to demonstrate that they were consciously aware of the statement or omission in question, and that it induced them to enter into the transaction. The requirement for reliance upon a piece of information will not be satisfied if the claimant cannot demonstrate that they reviewed or considered the information: “it cannot have been intended to give an acquirer of shares a cause of action based on a misstatement that he never even looked at, merely because it is contained, for example, in an annual report, some other part of which he relied on”. Further, the relevant statement “must have been present to the claimant’s mind at the time he took the action on which he bases his claim”, i.e. made his investment decision.
  • Standard of reliance. The court held that a claimant must show that the fraudulent representation had an “impact on their mind” or an “influence on their judgement” in relation to the investment decision.
  • Presumption of inducement. The court held that the so-called “presumption of inducement” applies in the context of a FSMA claim to the same extent as it does in other cases of deceit. This is a presumption that the claimant was induced by a fraudulent misrepresentation to act in a certain way, which will assist the claimant when proving reliance. The presumption is an inference of fact which is rebuttable on the facts. In addition, for the purposes of s.90A and Sch 10A, any reliance must be “reasonable”, and that reasonableness requirement mitigates the effect of the presumption by introducing an additional test for the claimant to satisfy. The court also made clear that the presumption of inducement is subject to the “awareness” requirement above, i.e. the presumption of inducement will not arise if the claimant was not consciously aware of the representation.
  • When is reliance reasonable? The court held that “the test of reasonableness is not further defined, but is plainly to be applied by reference to the conditions at the time when the representee claimant relied on it. Circumstances, caveats or conditions which qualify the apparent reliability of the statement relied on by the claimant are all to be taken into account. The question of when reliance is reasonable is fact-sensitive.”

Loss in the context of FSMA claims

The court expressed its provisional view on some “novel and difficult issues” in the context of loss. In particular, it said that it is for the court to decide, and not for the defrauded party to make an election, as to whether “inflation” damages (i.e. if the truth had been known the claimant would have acquired the shares at a lower price) or “no transaction” damages (i.e. if the truth had been known, the claimant would not have purchased the shares in question) are available. The court will return to this question when addressing issues of quantum (the present judgment considered liability only).

Future use of s.90A / Sch 10A claims in M&A disputes

In the present case, the alleged liability of Autonomy under s.90A/Sch 10A was used as a stepping-stone to a claim against the defendants. This was described by the court as a “dog leg claim” because Autonomy (now under the control of HP) accepted full liability to its shareholder, and Autonomy sought to recover in turn from the defendants as PDMRs of Autonomy at the relevant time. The court said that there was no conceptual impediment to this, but that it was right to bear in mind that in interpreting the provisions and conditions of liability, the relevant question was whether the issuer itself should be liable.

This may open the door for future M&A disputes to be brought by way of a s.90A FSMA claim by disgruntled purchasers against the target company in order – ultimately – to pursue a claim against former directors of the target company (i.e. the vendors), based on breach of their duties owed to the target company.

Simon Clarke
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Ceri Morgan
Ceri Morgan
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Rupert Lewis
Rupert Lewis
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Chris Bushell
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High Court clarifies meaning of “PDMR” in s.90A FSMA claims

The High Court has clarified what is meant by “person discharging managerial responsibilities” (PDMR) in the context of Section 90A and Schedule 10A of the Financial Services and Markets Act 2000 (FSMA), a key element of the test for statutory liability for statements made by UK listed companies in periodic publications: Various Investors v G4S Limited (formerly known as G4S plc) [2022] EWHC 1081 (Ch).

The statutory regime

Pursuant to Schedule 10A FSMA, paragraph 3(1), an issuer will be liable to pay compensation to a person who acquires, continues to hold or disposes of securities in reliance upon published information and suffers loss as a result of any untrue or misleading statement in (or omission of a “matter required to be included” from) that published information. An issuer will also be liable to pay compensation to a person who acquires, continues to hold or disposes of the securities and suffers loss in respect of the securities as a result of delay by the issuer in publishing information (paragraph 5(1)).

An issuer will only, however, be liable in the following circumstances:

  • in respect of an untrue or misleading statement, if a PDMR within the issuer knew the statement to be untrue or misleading or was reckless as to whether it was untrue or misleading (paragraph 3(2));
  • in respect of omissions, if a PDMR within the issuer knew the omission to be a dishonest concealment of a material fact (paragraph 3(3)); and
  • in respect of delays, if a PDMR within the issuer acted dishonestly in delaying the publication of the information (paragraph 5(2)).

Paragraph 8(5) defines PDMR for the purposes of Schedule 10A as follows:

  1. any director of the issuer (or person occupying the position of director, by whatever name called);
  2. in the case of an issuer whose affairs are managed by its members, any member of the issuer;
  3. in the case of an issuer that has no persons within paragraph (a) or (b), any senior executive of the issuer having responsibilities in relation to the information in question or its publication.

The meaning of “director”

In the case of G4S, which is a company with directors, it was common ground that the relevant paragraph was 8(5)(a), and that only directors of G4S would constitute PDMRs. However, the parties differed in relation to what was meant by “director”.

The claimants contended that terms such as “director” take colour from their context and that the term should be interpreted broadly for the purposes of paragraph 8(5)(a). They highlighted the use of the term PDMR in EU market abuse legislation, and the broader definition that applies there:

“…a person within an issuer…who is (a) a member of the administrative, management or supervisory body of that entity; or (b) a senior executive who is not a member of the bodies referred to in point (a), who has regular access to inside information relating directly or indirectly to that entity and power to take managerial decisions affecting the future developments and business prospects of that entity”.

The claimants suggested that the term “director” in paragraph 8(5)(a) ought to be interpreted so as to align the Schedule 10A definition with the market abuse definition, extending the concept of “director” beyond the three currently recognised categories in English law (i.e. de jure, de facto and shadow directors), to also include “senior executives with control over substantial business units, or who were responsible for managerial decisions affecting the future developments and business prospects of the issuer and/or those business units”.

By way of contrast, the defendant contended that the statutory definition of PDMR in Schedule 10A was clear and unambiguous. The term “director” is well-known and established in UK law. The drafter used recognised concepts of domestic company law and there is no reason to adopt another meaning.

The court rejected the claimants’ argument, holding that Schedule 10A clearly stipulates that where an issuer has directors the PDMRs are the directors (including persons occupying the position of director, by whatever name called), and that the term “director” in that context should be given its usual, well-established legal meaning.

De facto directors

For the purposes of this application, the defendant did not contest the claimants’ position that a de facto director might constitute a PDMR for the purposes of paragraph 8(5)(a). The defendant did, however, contest that, if de facto directors can be PDMRs for the purposes of paragraph 8(5)(a), this had been properly pleaded by the claimants. Mr Justice Miles held that the claimants had pleaded that the individuals they alleged to be PDMRs were de facto directors of G4S. However, he encouraged the claimants to do so more fully, holding that “it is to my mind undesirable for the pleadings to be left in their somewhat ambiguous and uncertain state.”

Chris Bushell
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Sarah Penfold
Sarah Penfold
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Holly McCann
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Reform of the UK prospectus regime – update on securities litigation risk

HM Treasury (HMT) has published a response setting out its policy approach to reforming the UK’s prospectus regime, in the biggest shake up since 2005. The response follows the initial consultation published in July 2021.

HMT’s intention is to proceed with the reforms broadly as proposed in its initial consultation. The next step is for HMT to make the necessary legislative changes to the Financial Services and Markets Act 2000 (FSMA), to create the framework for the new regime when parliamentary time allows.

The idea behind these changes is to simplify regulation in this area, as well as facilitating wider participation in the ownership of public companies and improving the quality of information investors receive. As part of this, HMT will delegate a greater degree of responsibility to the Financial Conduct Authority (FCA) to set out the detail of the new regime through rules. The full suite of reforms will take effect after the FCA has consulted on, and is ready to implement, new rules under its expanded responsibilities. HMT is keen to return responsibility for designing and implementing financial services regulatory requirements to regulators. For more information on the reforms themselves, please see this detailed briefing produced by our Capital Markets team.

From a securities litigation perspective, in light of the ever-evolving statutory and regulatory landscape, it is important issuers continue to monitor the impact of any changes to their disclosure requirements. HMT’s reforms of the UK’s prospectus regime are likely to have a potential impact on claims under s.90 FSMA for liability for prospectuses and listing particulars. For more information on this impact, please see our previous blog post: HMT reform of prospectus regime: the potential impact on securities litigation.

Ceri Morgan
Ceri Morgan
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Nihar Lovell
Nihar Lovell
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High Court strikes out shareholders’ claim barred by the reflective loss rule

The High Court has struck out a claim by the former shareholders of a dissolved company against an investor on the basis that all the losses claimed were barred by the reflective loss principle: Burnford & Ors v Automobile Association Developments Ltd [2022] EWHC 368 (Ch).

As a reminder, the Supreme Court in Sevilleja v Marex Financial Ltd [2020] UKSC 31 confirmed (by a 4-3 majority) that the reflective loss principle is a bright line legal rule, which prevents only shareholders from bringing a claim based on any fall in the value of their shares or distributions, which is the consequence of loss sustained by the company, in respect of which the company has a cause of action against the same wrongdoer (see our blog post).

Although the company in the present case had been dissolved, the High Court found that the claimants’ claim fell within the ambit of the reflective loss principle.

The decision is of interest because of the High Court’s consideration of the question as to the time at which the reflective loss rule falls to be assessed. In Nectrus Ltd v UCP plc [2021] EWCA Civ 57, Flaux LJ (as he then was) sitting as a single judge of the Court of Appeal refused permission to appeal and in doing so held that the claim of an ex-shareholder was not barred by the reflective loss principle, finding that the rule should be assessed at the time the claim is made. However, in Primeo Fund v Bank of Bermuda (Cayman) Ltd [2021] UKPC 22 the Board of the Privy Council (comprising five of the seven judges who had heard the Supreme Court appeal in Marex) concluded that Nectrus was wrongly decided. The Board confirmed that the rule falls to be assessed as at the point in time when a claimant suffers loss and not at the time proceedings are brought (see our blog post).

Notwithstanding the ruling of the Board of the Privy Council in Primeo, the High Court in the present case considered that it was bound by the decision in Nectrus, even though Flaux LJ’s decision in Nectrus was made as a single member of the Court of Appeal on an application for permission to appeal, and would therefore not normally have any precedent value.

In spite of this, the High Court then concluded that the present case was distinguishable on its facts from Nectrus and did, therefore, follow the Board of the Privy Council’s decision in Primeo. As such, even though the company in the present case was dissolved, the claimants’ claims were barred because their losses were suffered in the capacity of shareholders, in the form of a diminution in the value of their shareholdings, which was the consequence of loss sustained by the company in respect of which the company had a cause of action against the same wrongdoer.

This case suggests a judicial reluctance to follow Nectrus, which is not surprising given its uncertain precedent value and the Privy Council’s comments in Primeo. This may lead to further attempts to distinguish Nectrus in future cases, until the Court of Appeal has the opportunity to reconsider the issue properly.

We consider the decision in more detail below.

Background

The claimants were former shareholders in a company called Motoriety (UK) Ltd (Motoriety), whose business was the exploitation of two software-based products for the motoring industry. In 2015, Motoriety wished to expand its customer base and entered into negotiations with Automobile Association plc (better known as “the AA”), on the basis that the AA could invest in the company. Motoriety and the claimants subsequently entered into an investment agreement with the defendant subsidiary company of the AA. The defendant agreed to subscribe for 50% of the share capital of Motoriety and the defendant had a call option for the remaining 50%, for consideration produced by a formula contained in the agreement. On the same day, Motoriety granted the defendant a licence to use its software and associated intellectual property rights. In 2017, Motoriety went into administration and was bought from its administrators by another company in the AA group.

The claimants subsequently brought a claim against the defendant for fraudulent or negligent misrepresentation and/or for breach of contract. The claimants alleged that they had entered into the investment agreement and the licence agreement in reliance on false representations by the defendant. The claimants also alleged that the defendant breached implied terms of the investment agreement by pursuing a course of conduct that undermined the basis of the arrangements between the claimants, Motoriety and the defendant. The claimants alleged that this led to Motoriety going into administration. The claimants also pleaded an alternative breach of contract claim that, had it not been for the defendant’s breach of contract, the defendant would have exercised the call option and paid the consideration due.

The claimants sought damages for losses incurred as a result of the fraudulent/negligent misrepresentation and/or breach of contract. On the claimants’ misrepresentation claim, losses were claimed on the basis that, had the alleged misrepresentations not been made, the claimants and Motoriety would not have done the deal with the defendant, but would have entered into a venture with a third party company and the value of the claimants’ shareholdings would have increased accordingly. Similarly, in relation to the original breach of contract claim, the claimants claimed that if the contract had been properly performed, Motoriety would have thrived and the value of the claimants’ shareholdings would have increased. Alternatively, had it not been for the defendant’s breach of contract, the defendant would have exercised its call option, so that the claimants would have been entitled to the consideration provided for by that option. Three of the claimants also claimed for the loss of their initial investments in Motoriety.

The defendant denied the claim and brought an application to strike out the claim or for reverse summary judgment on the basis that all the losses claimed by the claimants were barred by the reflective loss principle.

Decision

The High Court found in favour of the defendant and granted its application to strike out the claim.

The key issues which may be of interest to financial institutions are set out below.

Developing area of the law

The claimants argued that it was inappropriate to deal with the reflective loss principle in a strike out application because this is a “fiendishly complex area of the law” which is “uncertain and developing”. However, the High Court did not accept this and, on the contrary, considered that Marex had restated and recast the principle. Even the “timing issue” (referred to below) which was raised by the decision in Nectrus was quickly resolved by the Privy Council in Primeo.

The High Court stated that Lord Reed’s judgment in Marex had made clear that claims by shareholders against third parties fell foul of the reflective loss rule where (and only where):

  • The shareholder suffers loss,
  • in the capacity of shareholder,
  • in the form of a diminution in share value or in distributions,
  • which is the consequence of loss sustained by the company,
  • in respect of which the company has a cause of action,
  • against the same wrongdoer.

All of these conditions needed to be satisfied for a claim to be barred by the reflective loss rule and, conversely, if any of them were not satisfied, the claim was not barred.

Independent wrongs

The claimants argued that their losses were caused by independent wrongs committed against them by the defendant. Their losses did not simply follow on from the loss of the company, reflected through their shareholdings in it. The representations were made to them personally and they were separate parties to the contract, such that they had “separate and distinct” losses from that of Motoriety.

However, the High Court noted that, as per Prudential Assurance Co v Newman Industries Ltd [1982] 1 Ch 204, shareholders may not recover a loss caused to the company by breach of the duty owed to the company. To allow otherwise, would subvert the rule that no shareholder can bring a claim on behalf of the company (as per Foss v Harbottle (1843) 2 Hare 461). With the above in mind, the High Court considered that the claimants had to show that Motoriety had not suffered the same loss. In fact, the claimants’ alleged losses were entirely derived from the claimed losses of Motoriety. They may have had a direct claim, but they only had an indirect loss.

The “timing” point

The claimants argued that the reflective loss rule did not apply because Motoriety had been dissolved before the commencement of the claim, and therefore they were no longer shareholders in it. In the claimants’ view, the reflective loss rule must be applied by reference to the time when the claims commenced, and not when the loss was suffered. The claimants relied on Nectrus in which Flaux LJ (as he then was) sitting as a single judge of the Court of Appeal, refused permission to appeal. In doing so, he held that the claim of an ex-shareholder was not barred by the reflective loss principle, finding that the rule should be assessed at the time the claim is made. The claimants argued that, although the Board of the Privy Council in Primeo (comprising five of the seven judges who had heard the Supreme Court appeal in Marex) found that Nectrus was wrongly decided and confirmed that the rule falls to be assessed as at the point in time when a claimant suffers loss and not at the time proceedings are brought, this decision was not binding on the High Court. Conversely, the defendant argued that Nectrus was not binding on the High Court and was distinguishable in any event.

The High Court highlighted that Flaux LJ’s decision in relation to permission to appeal in Nectrus contained no express statement that it was establishing a new principle or extending the current law. It should therefore not ordinarily be cited before a court or bind another court. However, in Allianz Global Investors GmbH v Barclays Bank plc [2021] EWHC 399 (Comm), Sir Nigel Teare (sitting as a High Court judge) while acknowledging that remarks made when refusing (or granting) permission to appeal are ordinarily of no weight, stated that he had been informed that Flaux LJ’s intention was that his ruling may be cited. As such, the High Court in the present case proceeded on the basis that that was correct and therefore Flaux LJ’s decision was binding.

The High Court noted that, as per Willers v Joyce, it was obliged to follow an otherwise binding decision of the Court of Appeal in preference to a decision of the Privy Council. The High Court considered whether the “timing” point was merely obiter dicta and therefore not strictly binding, but concluded that Flaux LJ’s decision in Nectrus was based on four separate grounds which were all part of the binding ratio decidendi. One of the grounds was that it was “unarguable” that the reflective loss rule applied to a claimant who had ceased to be a shareholder at the date of the claim and the High Court was therefore bound by this part of the decision unless it could be distinguished.

The High Court did, however, find that Nectrus was distinguishable. In that case the shareholder had sold its shareholding at a reduced price, which meant that the company’s loss had in effect been “passed on” (pro rata) to the shareholder so the company could no longer claim that share of the loss. As per Allianz, it was clear that in such circumstances there was no risk of: (a) the rule in Foss v Harbottle being subverted as there would be no concurrent claims; and (b) double recovery. In the present case, there had been no sale of the shares at a reduced price, and no “passing on” of any part of the loss of the company. If Motoriety was restored to the register, the loss would still be in the company. As such, the High Court determined that it was not bound to follow Nectrus and was free to follow the decision in Primeo in finding that the reflective loss principle did bar the claimants’ misrepresentation and original breach of contract claim.

Alternative claim for breach of contract

The claimants argued that the alternative breach of contract claim fell outside the scope of the reflective loss rule because the loss consisted of the formula set out in the investment agreement to calculate the consideration due under the call option and because only the claimants, not Motoriety, had rights to the consideration under the call option. Therefore Motoriety never had a cause of action to claim compensation in respect of this head of loss.

The High Court found that this claim was also barred by the reflective loss rule. The claim satisfied all six of the conditions set out in Lord Reed’s judgment in Marex. The fact that the measure of the claimants’ loss was by reference to a contractual formula and different to the measure of the loss of the company was beside the point.

The initial investments claim

The claimants who claimed for the loss of their initial investments in Motoriety argued that this head of loss fell outside of the reflective loss rule because it did not reflect a diminution in the value of their shares.

The High Court agreed with the defendant’s argument that this was simply a “less ambitious” version of the same claim. Instead of claiming the difference between what the values of their shareholdings should have been and what they now were, the claimants were claiming the much smaller difference between what they paid for their shareholdings and what they now had. The High Court found that even though the claims were limited to the amounts paid for the shares, the loss suffered by the claimants was still the loss of their value and the loss of their value was still reflective of the loss to Motoriety.

Accordingly, for all the reasons above, the High Court found in favour of the defendant and granted its application to strike out the claim.

Julian Copeman
Julian Copeman
Partner
+44 20 7466 2168
Ceri Morgan
Ceri Morgan
Professional Support Consultant
+44 20 7466 2948
Nihar Lovell
Nihar Lovell
Professional Support Lawyer
+44 20 7466 2529
Claire Nicholas
Claire Nicholas
Senior Associate
+44 20 7466 2058

LIBOR transition risks: the brave new world of RFRs

In previous blog posts, we have considered the risks of LIBOR transition for legacy LIBOR referencing contracts. For new transactions, LIBOR has almost been consigned to history, although there are still some areas relating to the use of near risk free rates where the market has not yet settled.

In this briefing, our colleagues in the Finance team provide a status update for LIBOR in 2022 through a transactional lens, including the current market practice for new USD debt and a helpful explanation of the purpose and proposed use of “synthetic LIBOR”.

COVID-19 market disclosures and managing the associated litigation risks

Herbert Smith Freehills have published an article in the Journal of International Banking Law and Regulation: COVID-19 market disclosures and managing the associated litigation risks.

Since the start of the pandemic many listed companies have sought to strengthen their balance sheet by raising additional capital from shareholders. This article considers the types of disclosures relating to COVID-19 that have been made to the market when doing so, the potential litigation risks that may be faced in the context of increased securities class actions activity in this jurisdiction, and how those risks may be appropriately managed.

The article can be found here: COVID-19 market disclosures and managing the associated litigation risks. This material was first published by Thomson Reuters, trading as Sweet & Maxwell, 5 Canada Square, Canary Wharf, London, E14 5AQ, in the September 2021 edition of JIBLR and is reproduced by agreement with the publishers.

Alternatively, please contact Nihar Lovell if you would like to request a copy of the full article.

Rupert Lewis
Rupert Lewis
Partner, Head of Banking Litigation
+44 20 7466 2517
Michael Jacobs
Michael Jacobs
Partner
+44 20 7466 2463
Daniel May
Daniel May
Senior Associate
+44 20 7466 7608
Sarah Ries-Coward
Sarah Ries-Coward
Senior Associate
+44 20 7466 2268

Privy Council confirms that the so-called “reflective loss” principle applies to ex-shareholders

The Board of the Privy Council has allowed an appeal in relation to the application of the so-called “reflective loss” principle, confirming that the rule falls to be assessed as at the point in time when a claimant suffers loss and not at the time proceedings are brought Primeo Fund v Bank of Bermuda (Cayman) Ltd & Anor (Cayman Islands) [2021] UKPC 22.

As a reminder, the Supreme Court in Sevilleja v Marex Financial Ltd [2020] UKSC 31 confirmed (by a 4-3 majority) that the reflective loss principle is a bright line legal rule, which prevents only shareholders from bringing a claim based on any fall in the value of their shares or distributions, which is the consequence of loss sustained by the company, where the company has a cause of action against the same wrongdoer (see our blog post: Untangling, but not killing off, the Japanese knotweed: Supreme Court confirms existence and scope of “reflective loss” rule).

On the facts of the present case, the claimant suffered loss arising from a breach of obligation by a wrongdoer before it became a shareholder in a company. However, by the time the claimant brought its claims, it had become a member of the relevant company, which had its own claim for the same loss against the same wrongdoer. It was common ground that if the company succeeded in its claims, it would fully restore the value of the shares in the company held by the claimant. However, the Board found that the claimant’s claims were not barred by the reflective loss principle. It emphasised that the reflective loss rule is not a procedural rule, concerned only with the avoidance of double recovery, but must be applied as a substantive rule of law, focusing on the nature of the loss, which must be assessed at the time the loss is suffered.

This is a helpful clarification of the correct approach to the issue of timing. Since Marex, there have been conflicting decisions as to whether the rule against reflective loss will apply to a former shareholder, who is no longer a shareholder in the relevant entity at the time the claim is commenced. In particular, there has been a lot of focus in some quarters on a decision by Flaux LJ as a single judge of the Court of Appeal in relation to an application for permission to appeal in Nectrus Ltd v UCP plc [2021] EWCA Civ 57. In Nectrus, Flaux LJ held that the claim of an ex-shareholder was not barred by the reflective loss principle, finding that the rule should be assessed when the claim is made.

The decision of the Board in Primeo Fund has put this question beyond doubt, expressly confirming that a shareholder which suffers a loss in the form of a diminution in value of its shareholding which is not recoverable as a result of the application of the reflective loss rule, cannot later convert that loss into one which is recoverable simply by selling its shareholding. The Board said that to find otherwise would lead to very “odd results”. While decisions of the Privy Council are not binding on English courts, they are regarded as having great weight and persuasive value (unless inconsistent with a decision that would otherwise be binding on the lower court). Given the questionable precedent value of Nectrus  and the constitution of the Board of the Privy Council in Primeo Fund, it is highly likely that the decision in Primeo Fund will be followed by the Court of Appeal the next time this issue arises in an English case.

The decision is considered in further detail below.

Background

The appellant (Primeo), was an open-ended mutual investment fund set up in 1994 and registered in the Cayman Islands, but now in liquidation. The respondents acted as Primeo’s custodian and administrator from 1993.

From inception, Primeo placed a proportion of funds raised from investors with Bernard L Madoff Investment Securities LLC (BLMIS) for investment. Over time, Primeo increased the proportion of its fund which invested with BLIMIS until, by 1 May 2001, the whole of its fund was invested in this way either directly, or indirectly through two feeder funds called Herald Fund SPC (Herald) and Alpha Prime Fund Limited (Alpha).

On 1 May 2007, Primeo’s direct investments with BLMIS were transferred to Herald, in consideration for new shares in Herald (the Herald Transfer). From that date, Primeo no longer had any direct investments with BLMIS, all investments were held indirectly via Herald or Alpha.

On 11 December 2008, the Ponzi scheme operated by Mr Madoff and BLMIS collapsed. Mr Madoff surrendered to the authorities in the United States and was charged with fraudulently operating a multi-billion dollar Ponzi scheme. Primeo was placed into voluntary liquidation on 23 January 2009.

Primeo brought claims in the Cayman Islands against its administrators and custodians, alleging breaches of duty.

Decisions of the Grand Court and Court of Appeal of the Cayman Islands

The Grand Court held that the administrators and custodians owed relevant duties to Primeo and breached those duties. However, the Grand Court dismissed Primeo’s claims on the grounds that they infringed the reflective loss rule, on the basis that Herald and Alpha also had claims against the same defendants which covered the same loss, and if they made recovery on those claims that would eliminate any loss suffered by Primeo.

Each side appealed to the Court of Appeal of the Cayman Islands (on various issues), which dismissed Primeo’s appeal against the Grand Court’s finding that its claims were barred by the reflective loss rule.

Appeal to the Privy Council

The Board of the Privy Council gave directions to hear and determine the discrete issue as to the operation of the reflective loss rule (with another hearing to follow, dealing with other issues on appeal). The parties were agreed that Cayman Islands law regarding the reflective loss rule, was the same as English law.

The specific issues for the Board of the Privy Council to determine were as follows:

  1. What is the relevant time to determine whether the reflective loss rule applies? Is it the time when the relevant claimant (here, Primeo) issued proceedings (by which time Primeo was a shareholder in Herald), or is it the time when the claimant acquired its causes of action (when Primeo was not a shareholder in Herald)?
  2. If the time to determine whether the reflective loss applies is when the claimant acquired its causes of action, did Primeo nonetheless lose its right to claim for the losses it suffered and become subject to the reflective loss rule by reason of the Herald Transfer, by which it ceased to be a direct investor in BLMIS and became an indirect investor via its replacement shareholding in Herald?
  3. The reflective loss rule operates where there is a common wrongdoer whose actions have affected both the claimant shareholder (Primeo) and the company (Herald/Alpha) – must the claims against the common wrongdoer be direct claims, and what degree of overlap between the claims of the shareholder and the company is required?
  4. Were the Grand Court and Court of Appeal correct to say that the reflective loss rule is brought into operation where the company has a realistic prospect of success, as opposed to being likely to succeed on the balance of probabilities?

Decision of the Board of the Privy Council

The Board of the Privy Council concluded that Primeo’s appeal in relation to the application of the reflective loss rule should be allowed. Each of the issues considered by the Board are discussed further below.

1. The timing issue

The Board confirmed that the reflective loss rule falls to be assessed as at the point in time when the claimant suffers loss arising from some relevant breach of obligation by the relevant wrongdoer, and not at the time proceedings are brought. On the facts of the present case, at the time Primeo suffered loss, it was not a shareholder in Herald and therefore its claim was not barred by the reflective loss principle.

The Board emphasised that the reflective loss rule is not a procedural rule, concerned only with the avoidance of double recovery, and must be applied as a substantive rule of law. In this context, the majority in Marex said that the focus of the reflective loss rule is on the nature of the loss, which involves consideration of the capacity in which the claimant suffered the loss and the form of the loss. The Board concluded that the issue is one of the characterisation of the loss, which depends on its status (i.e. whether or not it is recognised by the law) at the time it is suffered.

In the Board’s view, Nectrus Ltd v UCP plc [2021] EWCA Civ 57 was wrongly decided. In Nectrus, Flaux LJ presided as a single judge of the Court of Appeal over an application for permission to appeal. Flaux LJ held that the claim of an ex-shareholder was not barred by the reflective loss principle, finding that the rule should be assessed when the claim is made, at a time when the loss claimed has crystallised.

As a consequence of its decision, the Board confirmed that a shareholder which suffers a loss in the form of a diminution in value of its shareholding which is not recoverable as a result of the application of the reflective loss rule, cannot later convert that loss into one which is recoverable simply by selling its shareholding. The Board said that to find otherwise would lead to very “odd results”.

2. The Herald Transfer issue

Having found that the reflective loss principle was not engaged following analysis of the timing issue above, the Board considered whether the outcome was affected by the Herald Transfer.

In Marex, Lord Reed and Lord Hodge explained the justification for the reflective loss rule as based on the fact that, by becoming a member of the company, the shareholder agrees to “follow the fortunes of the company” in relation to losses suffered by it as a result of wrongs done to the company, and agrees that the company will have the right to decide whether claims should be brought in respect of such wrongs.

The question then was whether the Herald Transfer precluded Primeo from pursuing the causes of action it had already acquired before the Herald Transfer, because of the “follow the fortunes” bargain.

The Board considered that this argument was unsustainable, because the “follow the fortunes” bargain is forward-looking, not backward-looking. It is directed to characterisation of loss suffered by a claimant after they become a shareholder in the company (and they then suffer loss of the requisite type arising as a consequence of a wrong done to the company), and is directed to limiting the ability of a shareholder to acquire a right of action from that time on.

In the Board’s view, to apply the reflective loss rule to preclude a new shareholder from enforcing rights of action which had already accrued to them before they became a member of the company would be an unwarranted extension of the reflective loss rule. The Board noted that the issue of possible double recovery by Primeo on the one hand, and Herald and Alpha on the other, would have to be managed by a procedural mechanism.

3. The common wrongdoer issue

Primeo submitted that the Court of Appeal was wrong to apply the reflective loss rule in respect of claims against its former administrator, because neither Herald nor Alpha had any claim against the same corporate entity (different entities in the same group were involved in the provision of administration and custody services over the years to the various parties). Primeo made the same argument in relation to certain claims against its former custodian.

The Board agreed with Primeo, saying that it is an inherent part of the reflective loss rule that it only applies to exclude a claim by a shareholder where what is in issue is a wrong committed by a person who is a wrongdoer both as against the shareholder and as against the company. It noted that the separate legal identity of the administrator and custodian were of critical importance in the application of the reflective loss rule. The Board commented that to extend the reflective loss rule in these circumstances would be contrary to the decision in Marex, which was directed to keeping the operation of the rule within narrow parameters.

4. The merits issue

Given the Board’s other findings, it was not necessary to decide whether the Grand Court and Court of Appeal were correct to say that the reflective loss rule is brought into operation where the company has a realistic prospect of success, as opposed to being likely to succeed on the balance of probabilities.

However, the Board observed that those judgments were reached without the benefit of the decision in Marex, and adopting a materially different approach to the Supreme Court in that case. Accordingly, the Board warned that what the Grand Court and Court of Appeal said about this issue should not be treated as authoritative.

Julian Copeman
Julian Copeman
Partner
+44 20 7466 2168
Ceri Morgan
Ceri Morgan
Professional Support Consultant
+44 20 7466 2948

HMT reform of prospectus regime: the potential impact on securities litigation

HM Treasury (HMT) has published an initial consultation on fundamental reforms promising the biggest shake up of the prospectus regime since 2005. The consultation follows the conclusions of the Hill Review of the UK listing regime published in March 2021.

In this blog post, we consider HMT’s consultation paper through a securities litigation lens, highlighting the potential impact on claims under s.90 of the Financial Services and Markets Act 2000 (FSMA) for liability for prospectuses and listing particulars.

For an overview of all the key proposals in HMT’s consultation paper, please see our Capital Markets team’s briefing paper: UK Prospectus Regime review – bold reform ahead?

1) Liability for forward-looking information in a prospectus

The most important reform to highlight in the context of s.90 FSMA claims is the proposed new statutory standard of liability for forward-looking information published in a prospectus.

We examine below the rationale behind this proposal, the current standard of liability for information published in a prospectus, HMT’s proposed approach to liability standards and also consider what this will mean for issuers in terms of litigation risk for claims under s.90 FSMA.

The rationale

In Lord Hill’s view, the existing prospectus regime deters issuers from including forward-looking information in their prospectuses. This is due to the level of liability attached to a prospectus under the current legislative framework in respect of untrue or misleading statements or omissions relating to both past and future events. Issuers have some certainty over past events, but less so when considering their future plans and trajectory. As a consequence, issuers typically provide very little forward-looking information directly to investors. In order to improve the quality of information that investors receive directly, Lord Hill recommended an adjustment to the current statutory standard of liability for forward-looking information in a prospectus.

The current standard of liability

The current standard of liability under s.90 FSMA for information published in a prospectus is, essentially, a negligence standard with a reverse burden of proof. S.90 FSMA provides that any person responsible for the document is liable to pay compensation to a person who has suffered loss as a result of any untrue or misleading statement in the document, or any omission from the document of “necessary information” (see section (3) below in relation to this disclosure requirement and the proposed reforms to it). Schedule 10 FSMA sets out exemptions to liability under s.90, including that liability does not arise where a person reasonably believed that the statement was true and not misleading or that the omission was properly made. It is generally accepted that it is for Claimants to prove that they have suffered loss as a result of the untrue or misleading statement, or omission, but it is for Defendants to prove the reasonableness of their belief. [1]

By way of contrast, the fault standard under s.90A FSMA, for untrue or misleading statements in information published by an issuer via a recognised information service, is one of recklessness: there is liability where the relevant person (a PDMR or “person discharging managerial responsibilities”) within the issuer either knows the statement to be untrue or misleading or is reckless as to whether it is untrue or misleading. In respect of omissions of a matter which is required to be included in information published by an issuer, the fault standard is effectively one of dishonesty: the PDMR must know the omission to be a dishonest concealment of a material fact. It is generally accepted that the burden of proof is on Claimants to prove recklessness or dishonesty. The same liability standard as under s.90A FSMA also applies under s.463 of the Companies Act 2006 (CA 2006) to directors of companies in respect of their potential liability towards the company for untrue or misleading statements in, or omissions from, the directors’ report and certain other reports and statements included in a company’s annual report.

HMT’s proposed standard of liability

HMT is minded to apply the same recklessness standard of liability to forward-looking information in, and to omissions from, prospectuses.

HMT’s view is that this standard of liability should only apply in respect of statements in a prospectus which project or predict a future state of affairs. It would not be applicable to statements of fact (e.g. any statement on the state of affairs at the date of the documents or any statement of historic fact), or the working capital statements in a prospectus. An issuer who wishes to be subject to the proposed lower standard of liability for forward-looking information will be required to identify that information explicitly.

Impact on s.90 FSMA litigation risk

Recklessness is a higher fault standard than negligence. Therefore, if the proposals are introduced, it will be more difficult for an investor to bring a successful claim for breach of s.90 FSMA on the basis of alleged untrue or misleading statements in or omissions of necessary information from a prospectus, where those allegations arise in relation to forward-looking statements. The practical impact (and the rationale underpinning the change, as discussed above) is that this should encourage greater disclosure of forward-looking information in prospectuses.

HMT’s proposals are yet to have legislative force, but they indicate the likely direction of travel in respect of liability for forward-looking statements in prospectuses for issuers. It will be important for issuers to continue to monitor regulatory developments. It appears, at this stage, that there will be a further Government consultation and a review and consultation by the FCA.

2) Threshold for when a prospectus will be required

The Government consultation suggests a number of other bold reforms, which may lead to a reduction in the number of prospectuses published in the UK. Although prospectuses will remain a key feature of an IPO in the UK, the Government suggests that a prospectus may not be needed in all instances where an admission occurs, such as during a secondary issuance of new securities. The consultation proposes to grant the FCA discretion as to when a prospectus is needed for the admission of securities to a UK regulated market. At present, the FCA cannot amend the UK Prospectus Regulation which governs the requirement to produce a prospectus, and its format and contents – only Parliament can. The consultation proposes to put those powers back into the hands of the FCA (which held them prior to the implementation of the EU Prospectus Directive in the UK in 2005).

A reduction in the number of prospectuses published would result in fewer opportunities for claims under s.90 FSMA. However, this would not remove the securities litigation risk for a prospectus-exempt issuance altogether, since s.90A claims may be available for any untrue or misleading statements made to the market, or omissions or delays in publishing required information.

3) Disclosure requirement

The general disclosure requirement for prospectuses in the UK is the “necessary information” test, which includes an express materiality standard and is found currently at Article 6(1) of the UK Prospectus Regulation: “…a prospectus shall contain the necessary information which is material to an investor for making an informed assessment of: (a) the assets and liabilities, profits and losses, financial position, and prospects of the issuer and of any guarantor; (b) the rights attaching to the securities; and (c) the reasons for the issuance and its impact on the issuer.”

The consultation suggests that, for now, the substance of the necessary information test should be retained, thus maintaining the overall disclosure standard for prospectuses. From a litigation perspective, this preserves the status quo for s.90 FSMA claims.

However, the consultation identifies two potential future changes:

  • The Government is considering amending the test to better accommodate further issues and non-equity securities. At present, a simplified prospectus content regime exists for secondary offerings contained in Article 14 of the UK Prospectus Regulation. This simplified regime sets out a separate standard with reduced information requirements. The consultation asks for feedback as to whether this revised separate standard has clarified matters. The Government is proposing not to include a separate test for secondary issuances but instead to make clear that a factor considered will be whether an issuer’s securities are already admitted to the market.
  • The consultation proposes to give the FCA responsibility for making detailed rules on the contents of a prospectus, where one is still required. Theoretically this could mean a change to the general disclosure requirement at some later date, if the rules are altered by the FCA using its new powers.

If either of these changes are implemented, there may be a corresponding impact on s.90 FSMA claims. For example, if the FCA believes that the level of detail required by the current regime is too high, it could downgrade the disclosure threshold, leading to a reduction in the volume of disclosure, which may limit the scope for s.90 FSMA claims.

For more information

Our Capital Markets colleagues have prepared an overview of all the key proposals in HMT’s consultation paper.

If you have any specific queries in relation to the impact of the proposals on s.90 FSMA claims, please get in touch with one of the contacts below or your usual HSF contact.

[1] It is also worth noting that the need to show reasonableness applies to the Defendant’s specific belief and whether that belief was based on reasonable enquiries rather than a broad assessment of the Defendant’s conduct as a whole.

Simon Clarke
Simon Clarke
Partner
+44 20 7466 2508
Ceri Morgan
Ceri Morgan
Professional Support Consultant
+44 20 7466 2948
Nihar Lovell
Nihar Lovell
Professional Support Lawyer
+44 20 7374 2529
Sarah Penfold
Sarah Penfold
Senior Associate
+44 20 7466 2619