On 8 July, a High Court Judge found three directors of Nathans Finance, Roger Moses, Mervyn Doolan and Donald Young, guilty of offences under the Securities Act. A fourth director, John Hotchin, had earlier pleaded guilty and was sentenced to eleven months home detention. Nathans Finance was placed in receivership in August 2007, owing investors $174 million. The company raised capital by issuing secured debenture stock to the public, primarily in order to fund activities carried out by its parent company, a vending machine franchise business.

Justice Heath found that the Nathans directors signed off on statements in the public offer documents which were misleading. He found that the directors, although they acted honestly, did not have reasonable grounds on which to think the misleading statements were true.

Why is the decision important?

This was the first defended case in a number of prosecutions of finance company directors, making the verdict important for future cases. The decision is also of general relevance to directors as it sets out the standards the courts will expect them to meet when signing off on documents designed to solicit funds from the public.

Contact us if you would like to discuss the decision, and its implications, in more detail.

What were the charges against the directors?

The directors faced six charges under section 58 of the Securities Act, in relation to documents distributed by Nathans Finance. These included the prospectus and investment statement distributed by the company, and various letters to investors.

Section 58 makes directors liable for distributing a prospectus or advertisement that includes an untrue statement. The penalties for a breach of section 58 are imprisonment of up to 5 years, and a fine of $300,000.

The Crown alleged that the various offer documents contained a number of untrue statements, including: whether loans made to the related party parent company were on commercial arms length terms; whether there should have been disclosure that loans to the parent were rolled over and capitalised; whether there should have been disclosure of the deteriorating liquidity profile of the company and misleading statements on corporate governance and credit management processes.

What is meant by 'untrue' statement?

The directors argued that the statements contained in the offer documents were true. The Court rejected this and found that the statements were misleading.

The Court took a contextual, rather than a literal, approach to assessing whether the statements were untrue. It was accepted that some statements, while literally true on their face, were misleading to potential investors. The Court also interpreted the statements in light of the offer documents as a whole, rather than looking at them in isolation.

What is the significance of this approach by the Court?

It is important that directors consider the overall impression created by an offer document, when assessing the truth of the document. While a statement may be 'literally true' it may still be misleading to a potential investor.

In reaching his verdict the Judge said: "It was the combination of statements and material omissions that conveyed a false impression to investors about the true nature of Nathan's business, the actual state of its financial health and the risks of the investment."

What defences are available to directors under section 58?

It is a defence to section 58 if the director can prove either that the statement was immaterial or that they had reasonable grounds to believe, and did believe, that the statement was true.

The Court held that "reasonable grounds to believe" should be assessed from the perspective of each individual director, based on the information available to them at the relevant time. The Judge deliberately took a 'boardroom' rather than a 'courtroom' approach to this assessment.

The Judge held that while there was no doubt that the directors believed the statements were true, these beliefs were not based on reasonable grounds.

What did the Court say about the role of directors?

The directors argued that they were entitled to rely on the advice and information given to them by others involved in the preparation of the documents. They argued that they relied on management, the auditors, external professional advisers, the Trustee and the Registrar of Companies, who all had input into the offer documents.

Justice Heath discussed the different roles that directors and management play in a company and stated that "Directors direct; managers manage". He went on to say that directors establish the policy or rules that are to be implemented by management and put systems in place to ensure their instructions are carried out. Directors must act in good faith in the best interests of a particular company and must exercise the "care, diligence and skill that a "reasonable director" would exercise in the same circumstances."

Directors are entitled to rely on information provided by management, however this is fact specific and directors must take into account their obligations and responsibilities and the nature of the tasks delegated to management.

In relation to financial statements, directors are entitled to rely on the auditors to check technical standards were fully met, but they have their own obligation to be satisfied of their content.

What role must directors take in the preparation of a prospectus or other advertisement?

The decision in Nathans makes it clear that directors cannot simply rely on others to prepare offer documents and sign off on them without turning their minds to the statements that they contain.

The responsibility for ensuring that an offer document is not misleading rests with directors. This is a non-delegable duty to form their own opinions on whether any of the statements are misleading, in reliance on information provided by others that they have no reason to suspect may be wrong.

The Court noted that non-executive directors have the same obligations as executive directors. While non-executive directors may not be involved in the day-to-day operations of a company, they must still ensure that they have enough information on which to make an informed decision, when carrying out duties as a director.

In the Nathans case, the directors delegated to senior management the task of determining whether the investment statement and prospectus were "compliant", and failed to bring independent minds to this issue.

Directors should ask themselves whether the information contained in an offer document, conveys to a prudent but non-expert person, an accurate impression of the company and the associated risks.

The Judge was critical of the fact the directors had not had a board meeting before the prospectus and investment statement were finalised. He considered that a formal discussion between the directors, led by the Chairman, would have allowed the directors to properly tease out any issues.

What happens next?

The directors will be sentenced on 2 September 2011. We will provide an update after that.