Findings last week of criminal liability in the Nathans Finance case echo the Centro ruling from the Australian Federal Court last month and make it clear that directors must apply their own judgement in the exercise of their duties rather than simply relying on management and expert advice.
The Nathans prosecution (R v Moses) is the first in a series of prosecutions now making their way through the New Zealand courts involving the directors of failed finance companies.
This Brief Counsel looks at the decision and considers its implications for directors generally. Chapman Tripp’s commentary on the Centro case is available here.
Nathans Finance NZ Limited (Nathans) collapsed in August 2007, owing $174 million to roughly 7000 investors. The charges against the three directors - Mervyn Ian Doolan, Kenneth Roger Moses and Donald Menzies Young – relate to misleading statements made in the company’s registered prospectus and investment statement of December 13 2006, a subsequent prospectus extension statement on March 30 2007, and two letters to investors sent in July and August 2007 (the documents).
A fourth director, John Hotchin, pleaded guilty to three breaches of the Securities Act in relation to the prospectus in February this year. Hotchin is currently serving eleven months home detention for his part in the collapse, and testified against his former fellow directors at the trial.
Nathans Finance had loaned considerable sums to parent company VTL to fund an ultimately unsuccessful attempt to break into the US vending machine market. Key issues, in terms of inadequacy of disclosure, were the extent of this related party lending, the quality of Nathans loan-book, and the company’s governance practices and liquidity.
The charges related to s 58 of the Securities Act 1978 (the Act), under which every director of a company that distributes a prospectus or advertisement (including an investment statement) that contains an “untrue statement” commits a criminal offence, punishable by a term of imprisonment of up to five years or a fine of $300,000.
The Act deems a statement to be “untrue” where it is “misleading”, either affirmatively or by omission of a material particular. A defence is available where the director can prove, on the balance of probabilities, that “he or she had reasonable grounds to believe, and did, up to the time of the distribution of the prospectus, believe that the statement was true”.
The directors argued that, in a strict literal sense, no untrue statements were made in the documents. They also relied in the alternative on the defence that they had a reasonable belief in the truth of the statements when made. Justice Heath was not persuaded by either of those arguments.
The test under the Securities Act is an objective one – how would the documents (as a whole) be read by a notional “prudent but non-expert investor”? Justice Heath characterised this as someone “not expected to be financially literate (in the sense of being able to read financial statements…)” but as having “sufficient ability to comprehend competent advice” and appreciate the correlation between risk and return.
He found that:
- while the documents acknowledged a “significant proportion” of Nathans lending was to VTL, the impression given was that those loans were arm’s-length transactions on normal commercial terms, usually for no more than 12 months. In reality, loans to VTL were consistently rolled over, and interest on them capitalised. Furthermore, from at least June 2006, the directors knew that there was no reasonable prospect that those inter-company debts could be repaid without VTL selling all or some of its business, and that not even the interest on those debts could be paid out of VTL’s income
- statements about good governance were misleading, as “by 13 December 2006, Nathans had effectively delegated strategic decisions about its future to the board of VTL” (which had included, at various times, all of Messrs Doolan, Moses and Young). Decisions about loans to VTL were therefore clearly not approached in the same manner as loans to other parties, and
- the liquidity profile of the prospectus indicated inter-company indebtedness was to be paid within 12 months, which was not the case. Statements that Nathans’ liquidity was supported by VTL were also clearly erroneous as “VTL did not (and could not) support Nathans; Nathans supported VTL.”
Justice Heath therefore accepted that the Crown had proved beyond reasonable doubt that the statements were misleading.
He also rejected the directors’ claim that they were entitled to believe, on reasonable grounds, that the statements were true because they had relied on advice to this effect from other parties, including external advisors and senior management.
Justice Heath considered that the directors “failed, on all material occasions, to give sufficient personal attention to the content of the relevant offer document” and that this was “not a delegable duty”.
“There was a fundamental failure, on the part of all directors, to review the content of the offer documents and to ask themselves whether the information conveyed presented, to a prudent but non-expert person, an accurate impression of Nathans‘ business and the associated risks. That exercise should have been undertaken by excluding their own insider knowledge. That is one of the reasons why a collective approach at a board meeting would likely have resulted in a different outcome. A discussion among the directors, properly led by the chairman, was likely to tease out a number of issues of concern.
While it was fair for the directors to rely on the auditors to check aspects of the company‘s financial statements and to ensure that technical standards were fully met in relation to accounting policies, the accounts remained those of the directors and they had their own obligation to be satisfied of their content when signed.”
“[E]ven a cursory analysis of the narrative of the investment statement and prospectus should have led the directors to the view that the impression conveyed by it was at odds with the real position, as they knew it to be.”
The broader context and implications
These cases always turn on their own, often complex, factual circumstances. By way of illustration, as part of assessing the directors’ defence of reasonable belief, Justice Heath traverses considerable detail regarding the state of VTL’s business interests in the US and Australia. So the precedential impact of the decision should not be overstated.
Some broader points of interest do, however, arise.
Australian Securities and Investments Commission v Healey  FCA 717
Justice Heath’s overall approach, including his view that independent consideration of the accuracy of financial statements is a non-delegable duty of the directors of a finance company, is consistent with that of the Australian Federal Court in the Centro case.
Both decisions were welcomed by the relevant regulator in each jurisdiction. The Australian Securities and Investments Commission described Centro as a “landmark decision” and the Financial Markets Authority said that the Nathans judgment “reinforced the responsibility that every director of an issuer has to provide truthful and complete information to investors”.
Such regulatory successes on both sides of the Tasman are likely, once again, to remind directors of their statutory responsibilities, and cause them to ensure they have appropriate processes in the discharge of those responsibilities.
In comparison with Judge Doogue in MED v Feeney, Justice Heath places little emphasis on external advice received by the directors, including from their solicitors. This seems to be driven largely by the circumstances of the case, as it appears that legal advisers were not fully involved in the final discussions before the prospectus and investment statement were approved.
Justice Heath notes that some advice from the solicitors was not forwarded to the directors by Nathans' in house lawyer, and observes that
"The quality of any advice is only as good as the information provided to the professional, on the basis of which he or she is asked to advise. In considering the extent to which directors are entitled to rely on external advice, some assessment must be made of the prime information on which the adviser acted and whether he or she was on inquiry as to the accuracy of that information."
This is consistent with other recent decisions, such as the James Hardie litigation in Australia, which has emphasised that the reasonableness of reliance on experts depends very much on what those experts have been told.
In Justice Heath’s view, directors of finance companies must be financially literate:
“It is axiomatic that a director of a finance company will be assumed to have the ability to read and understand financial statements and the way in which assets and liabilities are classified… Such requirements are not unduly oppressive; nor could they be said to act as a disincentive to qualified persons acting as directors of finance companies. They represent no more than the basic level of understanding needed to run a finance company, which any investor would expect a director to have”.
At first sight, this approach might seem inconsistent with Judge Doogue’s decision in MED v Feeney (Feltex). But Feltex concerned a specific issue (characterisation of liabilities as term or current) in the context of Feltex’s transition to new accounting standards. Justice Heath’s comments, in contrast, are directed more generally to the requirement for all finance company directors to have sufficient general financial literacy properly to monitor the company’s business.
Justice Heath cites with approval similar comments from Justice Miller earlier this year in Davidson v Registrar of Companies. Justice Miller said:
“A director must understand the fundamentals of the business, monitor performance and review financial statements regularly. It follows that a degree of financial literacy is required of any director of a finance company. Without it, Mr Davidson could scarcely understand the business, let alone contribute to policy decisions.”
It should not be assumed that directors of companies which are not finance companies need not bother about being so financially literate. The point, rather, is that the courts will expect every director to have sufficient financial literacy to understand, monitor and guide the business of his or her company. Exactly what that means may depend on the nature of the business. But it is now clear, if it wasn’t before, that any director who thinks “I don’t really understand financial statements, but am here to contribute in other areas” needs to think again. Law reform
One of the major focuses of the Government’s ongoing Securities Law Review is on liability for directors in situations such as this. While criminal sanctions continue to be contemplated in the area, current proposals are to limit this to “the most egregious breaches” of directors’ duties, and to deal with lesser offences through civil penalties. The extent to which these policy debates will influence the sentencing of the Nathans directors, due in September, remains to be seen.