Who bears the liability for IPO shortcomings?

Partner, Morten Schwartz Nielsen writes in Commercial Dispute Resolution (www.cdr-news.com) about liablity in conncetion with Initial Public Offering shortcomings:
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LIABILITY IN CONNECTION WITH AN IPO


In spring of 2014, the Initial Public Offering (IPO) of the Danish company OW Bunker was completed with a listing at the Nasdaq OMX Nordic Copenhagen Stock Exchange in Denmark. The company had an impressive revenue of approximately DKK 92 billion.


However, on 7 November 2014, the company was taken into bankruptcy proceedings. The move can be seen as one of the most spectacular Danish insolvency cases, given the bankruptcy occurred so soon after its IPO, particularly as prior to the IPO, the company was owned by a well-renowned international private equity fund.


The bankruptcy gave rise to several investigations regarding the differing possibilities for imposing liability. Scope for such liability can be wide, including questions over the personal liability of board members and the daily management.


There are several possibilities for the imposition of liability on the basis of an inadequate prospectus; liability can even be considered if the listing at the stock exchange is a sale of the company, and if the professional private equity fund is liable based upon a more traditional seller's liability.


LIABILITY IN REGARD TO A PROSPECTUS


An IPO always entails that a prospectus is drafted to present the company’s strategy, risk and financial information. The process includes advice from corporate finance advisors, lawyers and accountants among others. The prospectus must contain detailed financial information about the company and its future objectives and strategies, and the company's risk management strategies. The latter was part of the downfall of OW Bunker.


The bankruptcy process later showed that while risk management was an essential part of the company’s strategy in relation to distribution of oil, the management of its risk did not secure the possibilities of adverse changes in oil price, and risks connected with a subsidiary in Singapore were not adequately secured.


Investing in a company is always associated with risk. If the risk is fairly stated in the prospectus, the investor must evaluate the risk and rewards, in accordance with the ‘buyer, beware’ principle of caveat emptor. But even if an investor agrees to take a commercial risk, it must be presumed that the prospectus is correct and provides sufficient information to give investors an idea of how real the risk is.


Under Danish law, liability may be incurred if the prospectus contains errors or omissions which are relied upon by investors in making their decision to purchase the shares. The drafting of prospectuses is governed by detailed regulations. The regulations are in essence a manifestation of the seller’s duty of loyalty and disclosure. Liability in relation to a prospectus revolves around the question of whether the prospectus can be deemed accurate, or inadequate in terms of disclosing items of material significance to the buyer’s risk assessment of the company. After a Supreme Court case from 2002, which made the possibility for claiming damages due to inadequacies in the prospectus in the shape of untrue or lacking information a conditional one, that issue in question – in the light of the other information in the prospectus – is of material significance to the assessment of the company.


The risk associated with an investment is thus a pivotal point, when examining the question of potential liability. The use of a prospectus cannot exempt an investor from conducting a proper examination of the prospectus and consider his or her investment. This has been the historical starting point for any case involving potential liability for a prospectus.


The most recent precedent on prospectus liability in Denmark is from 2013, and relates to the bankruptcy of a bank called BankTrelleborg. The Supreme Court analysed the prospectus and found that there were three discrepancies and included an element that verification was opted out. In that case it was confirmed by the Supreme Court that the information given in a prospectus had to be correct and that a verification process could have uncovered the inadequacies. In relation to the calculation of loss, predictability and causation, the court established a rule of assumption as to when a prospectus is materially inadequate. 


The assumption is that the investor would not have invested, had the prospectus contained the complete information. The legal position can thus be summarised as: when an equity investment in a company is made on the basis of a prospectus with nonconformities in the form of incorrect and missing information, and which an overall assessment is essential for evaluation of the company, there is a presumption that the investment would not have been made if the prospectus had provided correct and complete information. The ruling created a new legal standard.


The bar is set very high in terms of what is required in order to invalidate the assumption. The fact that the investors had not read the prospectus is not enough to invalidate the assumption, as investment decisions are not made solely based on the prospectus, but just as much on the basis of advice and a general market assessment. 


In OW Bunker, a report drafted by the administrators of the bankrupt estate asserted that the initial draft for the prospectus contained detailed information in relation to the risk management, as well as the use of financial instruments and hedging on the market. More essentially, a subsidiary in Singapore was mentioned, which, at the time of drafting the prospectus, was responsible for more than 11% of the revenue of the OW Bunker group of companies in Financial Year 2013. A total of 53% of the groups’ financial income came from the subsidiary in Singapore alone.


The details relating to the subsidiary were deleted from the final prospectus, and a report showed that the credit policies were not fulfilled in relation to the subsidiaries dealing with one customer, representing more than 85% of the turnover in the subsidiary. If the relevant credit policies had been applied, it is arguable that the credit to OW Bunker given would have been substantially less, and any later bankruptcy would have been likely to have been avoided.


The report also states that a correct assessment of the outstanding debtors in the company would have led to a large write-off by the end of FY 2013. The result being negative for the annual report, which most likely would have meant the company, could not have been able to complete an IPO.


SELLER’S LIABILITY IN A SALES TRANSACTION


The sale of stocks and shares is regulated by the Danish Sale of Goods Act. The Act provides that the seller is obligated in good faith to give all relevant information relating to the asset being sold. It can be argued that this obligation is manifested in the prospectus. It can also be considered that a listing in a traditional sense is not a sale of goods, and therefore only regulated by the relevant rules for listing of companies on the stock exchange.


In the case of OW Bunker, a report published in December 2015 established that a private equity fund had tried to sell the company before the listing to a buyer within the industry. This process did not lead to a sale, as the potential buyers were not willing to pay more than DKK 1.2 to 2.3 billion.


On that basis, it seems that the listing of the company was chosen as a better exit strategy, which in itself is, of course, acceptable. The end result was that the seller acquired approximately DKK 5.2 billion. It is suggested that the listing therefore could be seen as a sale of the company and that the listing was merely a technical tool in that regard. The sale – through an IPO – requires that the seller gives all necessary information in good faith in relation to the object being sold.


Under these circumstances, the seller will be subject to a traditional seller’s liability, meaning that the fact that the prospectus lacked information in relation to risk management, observance of credit policies and the assessment of debtors, and associated consequences for their statement in the annual accounts could be held up against the seller's general obligation to give all relevant information relating to the asset. A decision on these aspects will be new to Denmark.


LIABILITY FOR BOARDS OF DIRECTORS AND MANAGEMENT


Under Danish law the management and board of directors can be found liable if the conduct of the business has been negligent or otherwise conducted in a manner which is contradictory to normal business conduct.


Under the so-called business judgement rule, management or board of directors will not be liable if it has taken a decision that later turns out to be wrong or non-profitable, as long as the decision was taken on a well-informed basis. In these circumstances it is difficult to assert liability. In other words, mistakes in business are accepted without legal liability.


However, the rule differs when a company is taken into bankruptcy proceedings. In this situation, liability is possible if it is proven that the company should have been closed at a much earlier point in time, i.e. it was trading when insolvent.


This principle is known as the ‘hopelessness point’. It must be recognised that it is difficult to prove the occurrence of the exact point in time when the management and/or board of directors should have abandoned ship and stopped the business.


Other scenarios involve situations where managers or owners have neglected their duties, for instance their duty to ensure correct organisation and risk management, and to ensure that the company does business within its purpose, as set out in the articles of association.


As the report made by the trustee in bankruptcy shows that the management knew of the business in Singapore and neglected to observe the credit policies, there is sufficient information to suggest management could be held liable; this topic is to be addressed in the upcoming legal proceedings ensuing the fall of OW Bunker.


LIABILITY FOR OTHER ADVISERS IN THE IPO PROCESS


An IPO process also includes many different advisers. These may also be subject to liability if it is proven that they had knowledge about the relevant risk factors in a company, and that they had advised the company to omit these risk factors in the IPO. 


At this point in time a large number of legal proceedings are expected, both in Denmark and abroad. The results of these cases will clarify the different possibilities under Danish law and determine the legal ramifications of a sale of a company through the use of an IPO through future rulings.


Morten Schwartz Nielsen is a partner in Lund Elmer Sandager law firm and attorney at law with the right of audience before the Supreme Court of Denmark. He works on corporate matters, including litigation and arbitration. Morten specialises in cases involving corporate law, M&A and financial law, especially leasing, where he is recognised as one of the leading experts in Denmark. Morten is chairman for the association of OW Bunker Investors representing approximately 3,700 members that lost their investment."


Source: "https://www.cdr-news.com/categories/expert-views/6357-what-lies-beneath-who-bears-the-liability-for-initial-public-offering-shortcomings" 

If you have any questions to this article or other questions, feel free to contact Morten Schwartz Nielsen, msn@lundelmersandager.dk (+33 300 271).