By Sarah Kerr
What was the case about?
The case related to alleged breaches of the Securities Act 1978 (the "Securities Act") by the directors of Lombard Finance & Investments Limited ("LFIL"). LFIL was a finance company which periodically raised money from the public to on-lend to borrowers who were predominantly property developers. As part of its periodic fundraising, and to comply with the requirements of the Securities Act, LFIL issued prospectuses and distributed investment statements. These offer documents contained information for investors who were encouraged to invest in debenture stock and unsecured notes of LFIL.
In April 2008, receivers were appointed to LFIL by Perpetual Trust, the trustee for the debenture stockholders of LFIL. According to the High Court judgment, the likely projected return for secured investors is less than 24 cents in the dollar whilst unsecured investors in LFIL may lose the entirety of their investments.
The Lombard case has garnered significant media attention, not only because of the imposition of criminal liability on directors but also because of the high profile directors involved. The directors found guilty of criminal charges under the Securities Act included the Right Honourable Sir Doug Graham (a former Minister of Justice, Attorney General and Minister in charge of the Serious Fraud Office) and the Honourable Bill Jeffries (a former Cabinet Minister whose portfolios included Justice and Transport). The two other directors involved were Michael Reeves (also CEO of LFIL) and Lawrence Bryant.
What were the charges against the directors?
The charges against the directors were brought under section 58 of the Securities Act (criminal liability for mis-statement in advertisement or registered prospectus). The five charges under that section related to allegedly untrue statements in an amended prospectus issued by LFIL in December 2007, allegedly untrue statements in three investment statements issued in December 2007 and an allegedly untrue statement in a DVD that was apparently distributed between March and April 2008. (The DVD constituted an "advertisement" for the purposes of the Securities Act).
The Crown's arguments that untrue statements were made in the prospectus were centred around five key matters, as follows:
- LFIL's liquidity;
- The impairment of major loans made by LFIL to borrowers;
- The existence of, and adherence to, lending and credit policies as a means of limiting risks;
- The absence of adverse change in LFIL's financial position since 31 March 2007; and
- An assurance that there were no other matters material to the offer of securities, beyond those referred to in the amended prospectus.
What did the Crown have to prove?
Because the offences under section 58 of the Securities Act are strict liability offences, the issue of whether or not the directors intended to distribute offer documents that were false or misleading is irrelevant. The Crown merely had to prove that:
- the offer documents contained untrue statements (which could either be an affirmative statement or a material omission of information);
- the offer documents were distributed (as regards the prospectus); and
- the accused directors signed the prospectus, or it was signed on their behalf.
In relation to the DVD, the Crown needed to show that the directors were directors at the time of its distribution.
What defences were available to the directors?
The directors could escape liability under section 58 by arguing that, on the balance of probabilities, the untrue statements were immaterial, or that they had reasonable grounds to believe, and did, up to the time of distribution of the prospectus/investment statements/DVD, believe that the statements were true.
An additional defence available in relation to the distribution of the DVD was the defence of total absence of fault, which, as a settled legal principle, is open as a defence to parties accused of certain strict liability offences.
What did the Court find?
The Court found that the directors made untrue statements in the prospectus and investment statements in relation to two out of five matters alleged by the Crown to have been untrue.
The key respect in which the Court found untrue statements had been made was as regards the liquidity of LFIL (i.e. the ability of LFIL to meet its payment obligations). Specifically, the court found that "... there was a material discrepancy between the liquidity squeeze confronting LFIL in December 2007, and the more confident comments on liquidity conveyed in the offer documents."
The court noted that on 15 November 2007, Sir Doug Graham had commented in an email to Mr Reeves (the CEO) that LFIL was "sailing very close to the wind now and the next two or three months will be critical". The court also placed emphasis on the fact that predictions given to the Board by management since September 2007 in relation to projected repayment of loans had been consistently out by more or less than half the predicted repayments in each month and that this had not been accurately reflected in the prospectus and investment statements.
Although the judge was satisfied that the directors "genuinely believed in the accuracy and adequacy of the content of the offer documents when they were issued" he held that they could not establish, on the balance of probabilities, that it was reasonable for them to omit further details in relation to liquidity issues facing LFIL that were known to them but not acknowledged in the prospectus and investment statements.
The second key matter in which the court found (by extension) that the directors were guilty of making an untrue statement was in connection with the statement in the prospectus that "There are no other material matters relating to the offer of securities offered under this Prospectus other than those set out in this Prospectus".
For various reasons, the court found that all directors could invoke the defence of total absence of fault in relation to the distribution of the DVD.
Important "lessons" for directors arising from the Lombard decision
- The buck stops with you, as director: Directors cannot delegate their directors' duties. Even where advisers such as lawyers and auditors sign off on offer documents or where offer documents appear to be "market standard" this does not instantly absolve you from liability as a director of a public issuer in relation to the content of those offer documents. You need to closely review and consider the content of offer documents yourself and ensure those offer documents do not contain any untrue statements. As the Court said: "The directors' obligations in relation to the accuracy of content of offer documents are non-delegable".
- Beware of over-reliance on management: You can rely on the advice of management but only up to a point. If you have any concerns about the information provided by management or, more generally, about the ability of management to perform their duties, you must enquire further and resolve these concerns. In particular, if you are relying on management projections or reports which have ultimately turned out to be materially inaccurate more than once, serious questions need to be asked before continuing to rely on such information. As the Court said: "Neither sections [2B (Meaning of "due enquiry") of the Securities Act or 138 (Use of information and advice) of the Companies Act] can be read in a way that would relieve a director of the obligation to check on the competence of a delegate, in any circumstances where a signal occurs that would put a reasonable director on notice of the need to do so... By the time of the February 2008 Board meeting, the pattern of errors in the projections of performance by borrowers over the preceding six months should have caused the Board to question the adequacy of management of the major loans."
- Err on the side of disclosure: If, as a director, you are making an important judgement call which may be crucial to the ongoing financial health of the company of which you are a director (e.g. where management forecasts are being relied upon and such forecasts have previously been proven unreliable) disclose that judgement call in the offer documents.
- Don't let a fear of being unduly pessimistic hinder disclosure: The law requires directors to disclose in offer documents all material matters, including those which might adversely affect the value of securities previously issued by the company. A fear of "upsetting" the market or negatively impacting the value of existing securities is no excuse for holding back on disclosure of material information in offer documents.
What is the relevance of the Financial Markets Conduct Bill ("FMC Bill") to charges of a similar nature?
The FMC Bill is currently before Parliament. It was introduced to Parliament on 12 October 2011 and had its first reading on 7 March 2012. It has been referred to the Commerce Select Committee who are due to report back on 7 September 2012.
The broad purpose of the FMC Bill is "to provide an enduring financial market conduct regulatory regime that promotes confident and informed participation in New Zealand's financial markets". Amongst other things, the FMC Bill repeals in its entirety the Securities Act. The equivalent of section 58 of the Securities Act (which is the relevant section in the Lombard case) in the FMC Bill is clause 259 (criminal liability for false or misleading statement or information). The maximum penalty for an offence under that section is, for an individual, imprisonment for a term of not exceeding five years and a fine not exceeding $500,000 or both and, in any other case, a fine not exceeding $2.5 million.
The explanatory note to the FMC Bill explains that serious criminal offences which provide for the possibility of imprisonment are targeted at "egregious violations of the law, such as where the conduct in question involved knowledge or recklessness".
Under the new regime, it is unlikely that the Lombard directors would have been the subject of criminal charges or at risk of being subject to criminal penalties. They would, however, likely still have been the subject of civil charges. In a similar vein, the proposed criminalisation of certain directors' duties in the Companies Act (the duty to act in good faith and the best interests of the company and the duty to avoid carrying on the business of the company in a manner likely to create a substantial risk of serious loss to the company's creditors) will require knowledge on the part of the accused. The Companies and Limited Partnerships Amendment Bill which is the vehicle for these changes prescribes a maximum penalty of five years imprisonment or a fine of $200,000 for breach of these directors' duties.
Sentencing of the Lombard directors
Sentencing of the Lombard four is set down for 29 March and, although the charges are criminal and criminal penalties apply, it is likely that the sentences imposed on the directors will take the form of fines and community-based sentencing because the Court did not find the directors were dishonest or negligent (and acknowledged that it was not part of the Crown's case that the directors' conduct was anything but honest). This may well cause a media uproar, with those who do not have a full understanding of the case perhaps taking the view that the directors have been let off lightly and inadequately punished. The long term consequences of the decision could mean that it is much harder for companies (particularly those who are issuing prospectuses and investment statements) to attract good quality directors onto boards. Directors' fees will likely also increase to reflect the heightened risks associated with assuming a directorship.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.