Can the reasonable steps defence save the integrated PDS and incorporation by reference?

The superannuation industry is still not convinced about the value of some of the recent changes to disclosure law, particularly the use of incorporation by reference and ‘integrated product disclosure statements’¹.  Treasury and the regulators are encouraging product issuers to make product disclosure shorter and more effective.  The problem for issuers, and those that advise them, is embedded in the legislation. 

Any person involved in the preparation of a defective product disclosure statement (PDS) is potentially liable for civil action brought by an investor who has suffered loss by reason of the defect in the PDS².  This ‘scattergun’ approach to civil liability for defective disclosure has made both product issuers and their advisers risk averse, particularly given the willingness of litigation funders to back class actions involving thousands of investors alleging defective disclosure.

Another problem is in the prescribed information that must be included in a PDS.  Treasury opted for a ‘principles’ based approach to drafting the product disclosure provisions in Chapter 7 of the Corporations Act, rather than a ‘prescriptive’ approach, as an acknowledgement that a wide variety of financial products would be regulated under the provisions of Chapter 7.  The difficulty with a ‘principles’ based approach to drafting legislation is often a lack of certainty for those trying to comply with the law.

And so it is with the product disclosure requirements in Part 7.9 of the Corporations Act.  A number of the ‘main content requirements’³ are quite wide (eg ‘information about any significant risks associated with holding the product’⁴), but the biggest concern is the scope of the ‘general content requirement’⁵ that a PDS contain ‘any other information that might reasonably be expected to have a material influence on the decision of a reasonable person, as a retail client, whether to acquire the product’.  As the legislation is still relatively new, issuers do not have the benefit of decided cases, and there has been little guidance from ASIC, on what information might reasonably be expected to have a material influence on a reasonable person seeking to acquire the financial product.

Despite all the discussion about shorter and more concise disclosure documents, the guidance from ASIC in relation to financial product disclosure has also been ‘principles’ based⁶, rather than in a practical form that issuers can apply to their documents (such as a ‘model’ PDS).  And the recent enforcement action taken by the regulators against licensees for alleged breaches of the law is not encouraging.  Although they do not relate to disclosure, in both the Citigroup⁷ and VBN⁸ cases, the regulators - unsuccessfully - took action for alleged breach of the law in circumstances where the licensees and their representatives had made substantial efforts to put procedures in place to prevent those breaches (in a particularly fraught area of the law - conflict of interest - in both cases). 

In any event, the final decision on whether the disclosure made in a product disclosure statement is defective will not be made by the regulators, it will be made by the courts.

The solution might lie in the use of the ‘reasonable steps’ defence in section 1022B(7) of the Corporations Act.  The extent to which this statutory defence to civil liability gives some comfort to issuers will, in turn, depend on how reasonable the courts are willing to be when deciding what constitutes ‘reasonable steps’.  Most issuers use a structured process in the preparation of a PDS to ensure the information contained in the PDS is accurate and there are no material omissions.  A good process will establish materiality thresholds and provide for verification of the material information that is included in the PDS.  This process is useful on a practical level, because it allows the issuer and its advisers to give proper consideration to all the information that may be included in the PDS, and to determine what information is material and how that information should be presented.  The process also establishes a basis for relying on the ‘reasonable steps’ defence.

The terms of reference for the ‘reasonable steps’ process generally extend beyond the issue of the PDS, and requires those involved to give consideration to any material information that comes to light after the issue of the PDS that might render the PDS defective.

There is no reason why this ‘reasonable steps’ process cannot be applied to information incorporated by reference into a PDS, or where a trustee prepares an ‘integrated PDS’ on the conditions set out in Regulatory Guide 184 in order to comply with section 1012IA.  The difficulty for the issuer (and its advisers) is being assured of the quality of the information it is receiving, and making sure it remains up to date, in circumstances where the information is sourced from outside the organisation.  It is difficult enough authenticating information from within the organisation (business, compliance, marketing, etc); controlling the quality of information from outside the organisation adds another layer of complexity. 

However, the ‘reasonable steps’ process can be extended to information sourced from third parties that is going to be incorporated into the PDS.  Provided there is sufficient rigour in the assessment of the information, and good lines of communication are established (so the third party notifies the issuer when the information changes, or periodically verifies to the issuer that the information has not changed), information from external sources is covered by the ambit of the ‘reasonable steps’ defence⁹.

The important next step, however, is for the regulators and the courts to accept that an issuer has taken ‘reasonable steps’ where such a process was implemented, and the process was sufficiently robust.  There are good public policy reasons for encouraging incorporation by reference and the use of integrated PDSs - everyone has an interest in disclosure documents being shorter - but issuers will not take on the associated risks unless they can be assured they will be given due credit for doing so. This will require the regulators to avoid the application of hindsight - which has been a strong undercurrent in recent enforcement action - and for the courts to follow suit.

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