In its decision released last week, the Court of Appeal not only upheld the convictions of the former directors of Lombard Finance, but has ruled that their sentences should be increased. The Lombard directors' appeal – and the subsequent cross-appeal by the Crown against sentencing – has therefore left the directors in a worse position than they would have been had the High Court verdict not been challenged.
The Court of Appeal's decision against conviction does not set any new legal precedent, but it reinforces the important lessons for directors set out in the High Court decision.1 The case shows that directors can be guilty of no more than a "material misjudgement" as to what should be included in a prospectus, yet can be criminally liable and potentially imprisoned. This is a legal test that will change under the new Financial Markets Conduct Bill, but that is a change that will come too late for the Lombard directors.
Guidance for directors
Liability for directors under the Securities Act is not limited to incorrect statements. Directors may also be liable if offer documents contain material omissions, i.e., where the statements in the offer document are misleading in the absence of further information.
Offer documents must disclose everything of relevance that is likely to be material to the investment decision. It may not be enough to simply mention potential risks, directors may be obliged to "bring home the imminence" of those risks (notwithstanding that the directors may themselves be of the opinion that the company can survive).
Investors are entitled to make their own judgement on whether to invest and to make that decision on the basis that statements in the offer documents are true and not materially misleading. Directors cannot justify omitting reference to material information on the basis that the analysis of that information is properly for the judgement of the directors rather than investors.
A director's duty to ensure that statements in an offer document are true "overrides the duty directors owe to the company to act in its best interests (where those duties conflict)."
If directors cannot be satisfied that the statements contained in the offer documents are true and are not misleading by omission, the offer should not be made "irrespective of the consequences that might flow".
The obligations of directors under the Securities Act are non-delegable and cannot be avoided by reliance on information supplied by management. Whether or not the directors believe the information supplied by management to be reasonable, they must ultimately exercise their own judgement about the offer documents.
While directors are entitled to delegate management responsibilities (not the review of offer documents) to company executives, if they are aware of material matters such as unfavourable market conditions or potential issues with cash flow, then they ought to test information received from management and are "obliged to take a much more direct personal interest in the company's affairs than might have been the case in a more favourable market."
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 content of the offer documents. The charges were brought under section 58 of the Securities Act. Section 58 imposes criminal liability on directors where they sign a prospectus which contains an untrue statement (such as a misleading statement or a material omission).
High Court decision
The High Court found the directors guilty in relation to a failure to express concerns about Lombard's existing liquidity risk. Justice Dobson held that for the months prior to December 2007, Lombard management had consistently and substantially overstated projected loan recoveries. By December 2007, Lombard's cash reserves were approximately $8 million, compared with projections in the preceding months of between $15 and $30 million. The chairman of Lombard (Sir Douglas Graham) had in fact acknowledged in an email that Lombard was now "sailing very close to the wind." Despite this, the offer documents expressed no concern about existing liquidity issues.
Justice Dobson imposed sentences of community work on all directors and that two of the directors pay $100,000 each in reparations.
Court of Appeal decision
The directors appealed the convictions on a number of grounds. We discuss the two most important grounds.
Click here to view table.
The Crown also brought a cross-appeal, arguing that the sentences that Justice Dobson imposed on the directors were "manifestly inadequate". The Crown asked the Court of Appeal to substitute sentences comprising a combination of home detention and community work. The Court of Appeal agreed and held that Justice Dobson had erred by adopting a starting point for sentencing which was short of imprisonment. The Court of Appeal has indicated it will substitute sentences of home detention for the directors (combined with community work), following receipt of reports from the Crown.
There is a tendency in the media to lump all the cases against finance company directors together. However, to do so paints a misleading picture. For example, the Court of Appeal in the Lombard case recognised that:
There were a much greater number of omissions in the offer documents of Nathans Finance, that the Nathans Finance directors had had opportunities to correct the untrue statements, and that the case against the Nathans Finance directors involved substantial related-party lending.
The cases against the Bridgecorp and Capital + Merchant directors involved more serious offending and that substantially greater losses were suffered by investors.
The Court of Appeal's view that most of the cases against finance company directors to date "reflect more serious circumstances and degrees of culpability than the [Lombard] case", will be of little comfort to the Lombard directors. Moreover, they may wonder if the outcome would have been different under the new Financial Markets Conduct Bill (which looks likely to be passed by Parliament shortly). The Bill removes strict criminal liability for defective disclosure and adds an element of mental intent. Under the new law, directors will only be guilty of a criminal offence if they know or are reckless as to whether the disclosure is defective (which the Crown will have to prove). There is room for debate as to whether the Lombard case would have had a different outcome had the directors been tried under this new standard. That is something the Lombard directors will be left wondering.