Brian Gaynor 's Opinion

Investment columnist for the NZ Herald

Brian Gaynor: Rulings have raised the bar for directors

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Lombard Finance directors Sir Douglas Graham, Michael Reeves, Bill Jeffries and Lawrence Bryant in the High Court at Wellington. Photo / Supplied
Lombard Finance directors Sir Douglas Graham, Michael Reeves, Bill Jeffries and Lawrence Bryant in the High Court at Wellington. Photo / Supplied

The criminal conviction of two former Justice Ministers, Sir Douglas Graham and Bill Jeffries, clearly indicates that the bar has been lifted as far as disclosure to investors is concerned.

Graham was chairman of Lombard Finance & Investments and Jeffries a fellow director along with Michael Reeves and Lawrie Bryant. The latter two were also found guilty on four of the five charges.

The successful prosecutions raise, and clarify, a number of issues in relation to prospectuses, investment statements, advertising and the role of directors.

The High Court case revolved around a 12-month period, from May 2007 to April 2008, as outlined in the accompanying table.

Justice Robert Dobson noted that one of the first signs of problems occurred in May 2007 when "concerns about the concentration of lending led auditors to recommend to the audit sub-committee of the board that Lombard establish a separate sub-committee including one or more independent directors, to monitor the larger loans".

At the end of May the auditors, KPMG, signed off Lombard's accounts for the year ended March 31.

Bridgecorp was placed in receivership on July 2 and was quickly followed by Nathans Finance on August 20 and Five Star Consumer Finance on August 29.

These receiverships indicated that the finance company sector was in trouble, particularly companies exposed to property developers.

The Bridgecorp, Nathans Finance and Five Star Consumer Finance collapses meant that other finance companies would have problems in attracting new investments and convincing existing depositors to reinvest their money when it matured.

At the end of August, Lombard had cash holdings of $39.6 million and its lending was dominated by exposure to five major property development groups.

Lombard's trustee, Perpetual Trust, was concerned about the company's liquidity situation and encouraged it to obtain outside advice from KordaMentha (then called Ferrier Hodgson).

KordaMentha reported on September 19 and noted that the finance company sector was under considerable stress as reinvestment rates had plummeted from historical levels.

According to the minutes of the September 26 board meeting chief executive Michael Reeves expressed "his concern at the future viability of finance companies which relied on funding from the issue of debenture stock".

"He said that he believed the lack of investor confidence following the failure of so many finance companies over the past 12 months was serious and unlikely to be restored for some time."

Lombard's cash position had declined to $24 million at the end of September.

On November 15, Graham wrote an email to Reeves stating that Lombard was "sailing very close to the wind now and the next two or three months will be critical. Some of our exposures are difficult and depend on a number of positive events occurring.

"If they do not, or there are delays, we run the risk of running out of cash."

At the December 19 board meeting directors were told that the cash position at the end of November had plummeted to just $9.5 million and the December 31 cash forecast was $8.8 million.

This compared with KordaMentha's earlier projections that Lombard would have up to $30 million of cash at the end of December.

One of the issues facing Lombard was that a public issuer can only use a prospectus to issue new securities for up to nine months from the end of the period to which audited financial statements accompanying the prospectus relate.

However, a prospectus can be amended and extended if directors certify within nine months after the date of the financial statements contained in the prospectus that the issuer's financial position has not changed materially and adversely from that reflected in the financial statements published in the prospectus.

The extension certificate must also confirm that the prospectus is not false or misleading in a material way.

It is important to note that a prospectus can be misleading if it omits or fails to emphasise adverse circumstances.

As Lombard's audited accounts were for the year ended March 31, 2007, it needed to lodge an amended prospectus before December 31 if it wanted to continue to attract investors' money after that date.

This amended prospectus was signed by all directors at the December 19 board meeting and lodged with the Companies Office five days later.

The four directors were charged on five counts: count one, allegedly untrue statements in respect of Lombard's amended prospectus dated December 24, 2007; counts two, three and four, allegedly untrue statements in each of the investment statements in respect of unsecured subordinated notes, unsecured subordinated capital notes and secured debenture stock, dated December 28, 2007; count five, allegedly untrue statements in a promotional DVD the Crown alleged was distributed between March 3, 2008 and April 3, 2008.

Graham and the other three directors were found guilty in respect of counts one, two, three and four but not guilty in respect of count five.

Justice Dobson wrote: "I am satisfied there was a material difference between the liquidity squeeze confronting Lombard in December 2007, and the more confident comments on liquidity [in the amended prospectus]".

He made note of comments by Graham in his November 15 email that the company was sailing close to the wind and the next two to three months would be critical.

According to Justice Dobson: "This comment (in Graham's November 15 email) was justified at the time, and liquidity conditions continued to tighten thereafter."

One of the problems was that the directors relied heavily on management's optimistic loan repayment forecasts even though these forecasts had been far too optimistic in the past.

Justice Dobson wrote: "I am satisfied that the accused genuinely believed in the accuracy and adequacy of the content of the offer documents when they were issued" but "the alleged offences are ones of strict liability so the Crown is not required to prove any form of mental intent to distribute documents that were false or misleading".

This is consistent with the Nathans Finance decision and clearly demonstrates that the bar has been substantially lifted as far as the content of prospectuses and investment statements are concerned as well as the duties of directors.

One of the arguments used by the defendants was that the amended prospectus could not be too pessimistic because they had obligations to existing investors and any negative comments might jeopardise Lombard's ongoing business.

This is an argument used by financial institutions because any material negative news can seriously impact on investor confidence and lead to a run on these organisations.

Justice Dobson rejected this on the basis that "the standard imposed by s58 of the act is absolute in the sense that criminal liability will follow from the issue of documents containing untrue statements or omissions".

This is a clear message to directors of financial entities.

Lombard went downhill after December 24, 2007, and was placed in receivership on April 10, 2008.

According to the latest receiver's report Lombard's major asset is the property loan book which consisted of 27 loans with a total book value of $136.7 million.

Gross realisations of $65 million have been recovered but Lombard has received only $18 million of this because it often held only second- or third-ranking mortgages.

Lombard's secured debenture holders have received 11.5c in the dollar to date and their total return is forecast to be between 15c and 22c for every dollar invested.

Unsecured subordinated noteholders and unsecured subordinated capital noteholders are expected to receive nothing.

Brian Gaynor is an executive director of Milford Asset Management.

- NZ Herald

Brian Gaynor

Investment columnist for the NZ Herald

Brian Gaynor has written a weekly investment column for the Weekend Herald since April 1997. He has a particular passion for the NZX and its regulation. He has experienced - and suffered through - the non-regulated period prior to the establishment of the Securities Commission in 1978 and the Commission’s weak stewardship until it was replaced by the FMA in 2011. He is also a Portfolio Manager at Milford Asset Management.

Read more by Brian Gaynor

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