The High Court has again found that the directors of a failed finance company are guilty of breaches of the Securities Act. As was widely reported, on 24 February 2012 the directors of Lombard Finance and Investments Ltd (Lombard) were found guilty of charges arising from untrue statements made in offer documents: R v Graham  NZHC 265 (the Lombard decision).
The decision does not set a new benchmark for directors, as some commentators have suggested. However, the verdict of Justice Dobson contains important reminders and lessons for directors as they seek to comply with securities laws and their duties as directors.
Key lessons for directors
- Liability under the Securities Act is not limited to misleading statements. Directors may also be liable if offer documents contain a material omission.
- Directors may be criminally liable under the Securities Act even if they acted honestly and were not reckless. The offence is a "strict liability" offence, with no form of mental intent required.
- The purpose of offer documents is to give investors adequate information on material matters so that they can make decisions for themselves. Directors cannot escape this responsibility by arguing that investors instead "relied on the directors to make commercial judgments".
- Offer documents must disclose "everything of relevance that is likely to be material to the investment decision".
- If a discernable pattern emerges revealing information that is important to investors – such as the company repeatedly missing key management forecasts – this should be disclosed, notwithstanding its potentially damaging effect on the marketability of an offer.
- Although directors can generally rely on information provided by management, they must adequately monitor and test the competence of management, and investigate further if put on notice of any issues.
- Directors cannot rely on the absence of any red flags raised by professional advisers in substitution of their own duty to review the offer documents.
- Directors' obligations in relation to the accuracy of offer documents are "non-delegable". Directors ultimately must exercise their own judgment about the documents.
- Directors must ensure that they receive draft offer documents in sufficient time to properly review them (this is consistent with Australian case law: see our article Directors' Liability for Mistakes in Financial Statements).
- If there is a tension between downplaying risk to protect existing investors and shareholders and complying with the Securities Act, the Securities Act prevails.
Lombard predominantly raised money from the public to lend to property developers. By late 2007, the finance company sector was under significant stress, with receivers appointed to Bridgecorp and Nathans Finance. In December 2007, Lombard distributed an amended prospectus and three investment statements (the offer documents), and raised NZ$10.5 million from the public.
However, Lombard's position deteriorated, and in April 2008 receivers were appointed. The Crown subsequently charged the directors of Lombard in relation to the contents of the offer documents.
Under section 58 of the Securities Act, the Crown was required to prove beyond reasonable doubt that each document (1) included an untrue statement (such as a misleading statement or material omission); (2) was distributed; and (3) that the director signed the prospectus or was a director at the time of distribution of the investment statement.
In assessing whether the offer documents contained untrue statements, Justice Dobson ruled that the documents must disclose "everything of relevance that is likely to be material to the investment decision", rejecting a defence argument that this "set the bar too high". The court also said that the target audience for the documents is a "prudent but non-expert person". Such an investor includes someone who understands technical words and financial jargon, but who may have "less than a complete understanding of all content" and who may not seek financial advice.
The Crown was not required to prove that the directors were dishonest or reckless, or any other form of mental intent. Section 58 creates what the law calls a "strict liability" offence. However, this does not mean that if an offer document is misleading, the directors must be convicted, as one commentator has asserted. The directors have a defence if they prove on the balance of probabilities that the misstatement or omission was immaterial, or that they believed – and had reasonable grounds to believe – that the statement was true.
The Crown alleged that the offer documents were misleading or contained material omissions in three relevant respects for present purposes, concerning: (1) liquidity risk; (2) loan impairment; and (3) adherence to lending and credit policies.
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The directors' defence
The directors raised the defence that they believed – and had reasonable grounds to believe – that the documents were true.
The directors first argued that they were required to balance their obligations under the Securities Act with their commercial obligations to existing investors and shareholders not to be overly pessimistic about risks which might jeopardise Lombard's business. The court promptly dismissed this argument.
The directors also argued that they properly relied on management and external professional advisers, such as the auditors, the trustee and solicitors. Justice Dobson held that such reliance was not a two-way street. A director cannot ignore an issue with an offer document raised by a professional adviser. But the same relevance cannot "be attributed in the positive sense to the absence of warning signals from competent external advisers". The absence of such warnings may make it "marginally easier" for directors to make out reasonable belief, but ultimately "directors' obligations in relation to the accuracy of content of offer documents are non-delegable".
The same is true for reliance on management. The court ruled that as long as directors adequately monitor management, and there is nothing to put the directors on notice of the need for further inquiry, "reliance on information provided by management in their delegated areas of authority will generally be appropriate". However, the court also observed that "Directors are appointed to exercise judgment and that extends to testing the competence of management within areas in which managers are relied upon".
Justice Dobson concluded that the directors had not shown on the balance of probabilities that their belief in the accuracy of the statements in the offer documents concerning liquidity was reasonable.
The Lombard case is the second in a trilogy of finance company cases to come before the court in the past year. In the Nathans Finance case, one director pleaded guilty and the other three directors were found guilty under the Securities Act. (See our earlier article: Further clarity for directors' duties: The Moses case and the Steigrad case (aka Nathans and Bridgecorp).) The Bridgecorp case is still before the court, with two directors having pleaded guilty and three directors defending charges under the Securities Act.
In contrast to Lombard, the Nathans Finance case involved significant related-party lending, a board that failed to meet, and less reliance on external advisers. Although the Crown achieved convictions in both cases, the differences in culpability between the directors may well be reflected in sentencing.
New Zealand's securities legislation is in the process of a substantial overhaul with the Financial Markets Conduct Bill currently making its way through Parliament. The Bill removes strict liability for defective disclosure and adds an element of mental intent – under the proposed law, directors will only be guilty of a criminal offence if they know or are reckless as to whether the disclosure is defective. If passed, these changes will provide further protections to directors facing criminal charges arising from the contents of offer documents.