Lombard's directors were found guilty not for what they said - but for what they left unsaid. Chris Barton reports.
It's a modern-day morality tale of financial ruin. A fall from grace. A story of how some 4400 New Zealanders entrusted $127 million to honourable men who loaned that money to property developers who didn't repay the loans. Most of the money - often people's life savings - was lost.
It happened at the start of the global financial crisis. There were many local parallels with the global events. An interplay of valuation and liquidity problems in the United States banking system in 2008 sparked the crisis. Liquidity and valuation were also problematic for the company at the centre of this story: Lombard Finance and Investments Limited (LFIL), which went into receivership in April 2008.
The crisis went hand in hand with the US housing bubble, which peaked in 2007, then burst, damaging financial institutions the world over. New Zealand's property bubble burst around the same time, playing a big part in obliterating this country's finance companies.
Since May 2006, 65 companies have failed and some 205,000 investors are expected to lose half of the $8.65 billion invested. But macroeconomic factors were not the only cause of the local crisis. An inquiry by Parliament's commerce select committee last October found the failures were mostly the result of human fallibility: poor governance and management, criminal misconduct, deficiencies in disclosure and investors' understanding, and inadequate supervision.
The men in charge of Lombard Finance - former justice ministers Sir Douglas Graham and Bill Jeffries, plus fellow directors Lawrence Bryant and Michael Reeves - were called to account. All faced criminal charges in the High Court, were found guilty on some counts and received modest sentences of community service, with Graham and Bryant paying $100,000 each in reparations.
Meanwhile, Lombard investors learned this week that they will get back another 1.5c in the dollar on their investment, bringing the total return so far for secured creditors to 13c in the dollar. The receivers estimate that at best investors will get back 22c in the dollar; at worst 15c.
The story doesn't end there. The directors have appealed their convictions, claiming they did not mislead investors and did everything they could to look after investors' money, but were overwhelmed by forces beyond their control. "I couldn't stop a global property crash. Sorry, but I couldn't," Sir Douglas told the TV programme 60 Minutes.
While the appeal, due to be heard in September, may defer planned civil proceedings by the Financial Markets Authority, which brought the criminal case, it's unlikely to stop civil action by the receiver. "We are waiting for some final legal opinions, but it is likely we will take claims against the directors and potentially other parties as well," says PricewaterhouseCoopers receiver John Fisk. "We would be looking at a claim that would be for the benefit of all creditors." Other targets may be auditors and valuers.
So it's a battle on two fronts: directors fighting to restore their shattered reputations and the receiver fighting to recover creditors' lost investments - battles which may take years.
Fisk's action would be taken under the Companies Act 1993, which allows for personal liability claims against directors who breach their duty of care obligations to act in the best interests of the company. Such as? "Not to incur debts without a reasonable prospect of being able to pay them and various other things," Fisk tells the Herald.
How did it come to this? Some say Lombard's problems can be sheeted home to a scrub-covered 7.9ha hillside property in Brooklyn, Wellington. The land was part of a grandiose subdivision begun in 2004 by property developer Lance James - initially for 90 houses on an area dubbed "Brooklyn Rise", to be followed by another 500 houses on the adjoining "Brooklyn Views". The first part of the subdivision, including roads, infrastructure and six nearly complete houses, sold in 2010 for just $2.25 million.
The Brooklyn project, which was taken over by Auckland developer Tim Manning in 2007, had an outstanding loan of $42.6 million when Lombard went into receivership. "We'll get back something like 10-15 per cent of that," says Fisk, who is selling the remaining Brooklyn Views land.
Brooklyn was the largest loan of the Manning Group, which at the start of April 2008 owed Lombard $54.69 million. Next was the Austin Group, with developments in the Auckland suburb of Bayswater and Mahia, owing $22.42 million, then Blue Chip ($15.39 million), George Group ($9.6 million) and De Rohe Group ($8.29 million). Collectively the five borrowers owed $110.38 million out of a total loan book of $136.71 million.
A report by registrar of companies Neville Harris for the commerce select committee highlighted the Brooklyn loan as accounting for almost 30 per cent of Lombard's loan book. "The significantly impaired $42 million Brooklyn Rise loan was part of a loan book of which 80 per cent was lent to just five borrowers," said Harris.
Harris' point was that many of the largest companies that failed between 2006 and 2008 had a concentration of loan risk - often relying on the success of one industry or a very small group of borrowers. "The exposure of these finance companies was such that they had no choice but to continually roll over poor performing loans until the borrower's development project could be completed."
Harris' view about the impairment of the Brooklyn loan was the opposite of Justice Robert Dobson, who in the High Court last year examined whether Lombard's amended prospectus of December 2007 was "untrue" in that it "omitted material adverse matters relating to impairment of major loans".
In his verdict this February, he found the Brooklyn loan was not impaired and nor were Lombard's other loans, except for one. The one loan the judge agreed was impaired was for a development in Bayswater, Auckland, which sold in March 2008 leaving an outstanding balance of $11.95 million. Despite the loss, the judge found the impairment of just one loan was not material to the overall case against Lombard.
Justice Dobson devoted considerable analysis to what constituted impairment of a loan in light of what was disclosed in Lombard's prospectus, and how the company managed its loans: "The focus was on the ultimate capacity to completely repay, in light of analyses of the prospects of bringing the projects to successful conclusions."
The judge noted that in preparation for the 2008 audit, the company's auditors KPMG had flagged with Lombard "that recoverability of large loans, and more generally the ability to confirm the going concern status" of Lombard for the ensuing 12 months, would be important audit issues.
The auditors were also concerned about Lombard's exposure to Brooklyn because of its size and its history. KPMG audit partner Ross Buckley, called by the Crown as a witness, told the court his concerns about Brooklyn were not just about Lance James "as the inappropriate developer attempting to run it", but also about the feasibility of such a large subdivision. "He saw it involving a huge amount of initial investment in infrastructure and roading, with a staged development that made it more difficult to assess the overall feasibility," said Justice Dobson. He also noted that Buckley and another KPMG partner Andrew Dinsdale had visited the Brooklyn site and that Dinsdale found it "a little surprising" the directors had not.
There was also recognition, based on reviews by investigating accountants Ferrier Hodgson (now KordaMentha), that most of the major loans "were clearly impaired by the end of March 2008". But as the judge pointed out, that wasn't relevant to what Lombard was saying in its amended prospectus.
"Once the influence of hindsight is removed, I am not satisfied that as at December 2007, there was any sufficient pattern of delayed sales or drop off in activity affecting developments of the type over which LFIL had security, for it to require the recognition of impairment affecting all, or a majority, of the major loans." In other words, the directors didn't mislead investors about the state of the company's loans.
On the face of it, Justice Dobson's finding squares with what Sir Douglas told 60 Minutes: "Lombard was in my view a very well-run little, profitable company until things started to go haywire in the latter part of '07."
But if the loans weren't impaired, as Justice Dobson found, what prospect does the receiver have in its proposed civil claim against the directors under the Companies Act? Those claims would have to show the company suffered as a result of the way its loans were made and administered.
Fisk points out that the standard of proof in criminal cases - beyond reasonable doubt - is much higher than it is for civil cases - more likely than not. Fisk also believes the court didn't receive sufficient evidence regarding the loans. He says almost all the loans to the five main borrowers had impairment issues. "I think probably only two loans in that loan book that were repaid in full."
Fisk sees a loan as impaired if the loan terms have been breached so the maturity date has passed and the loan hasn't been repaid or has been rolled over. He says the receivers are aware the directors had insurance to cover civil proceedings, which isn't available for criminal proceedings. "We wouldn't take action unless there was a benefit in it for the investors."
How long does he think the Lombard loans were impaired? "We think they were certainly impaired by December '07. How far back they go I wouldn't like to say at the moment," he says. "A lot of the loans were rolled over for a considerable period of time going back two years and really all that did was avoid the crystallisation of what was an inherent loss in each of the loans." "
While Justice Dobson found the directors not guilty on the counts of misleading investors regarding the impairment of Lombard's loans and on the counts involving breach of the company's lending policies, he did find them guilty on four counts of making untrue statements regarding Lombard's liquidity.
But like so much about this case, it was complicated. The "untrue" statements involved not what was said in Lombard's amended prospectus of December 2007 and its offer documents, but in what was unsaid - an act of omission.
The guilty verdicts were particularly galling because, the directors argued in their defence, Lombard had done everything it could to warn investors of the difficult conditions it was facing by issuing a new prospectus highlighting new risks. What's more, it had gone to considerable effort in seeking the best advice about the right thing to do. That included seeking a review of its loans from investigative accountants Ferrier Hodgson in September 2007 and taking advice from top commercial lawyer Paul Foley of Minter Ellison on the appropriate wording of the new prospectus.
"When we sat at the board table and looked at it, we said, 'God if you'd read this, you'd never invest in the company in a million years'," Sir Douglas told 60 Minutes. He and Jeffries declined to speak to the Herald.
Despite the warnings, some people did invest in Lombard in the period between the end of December 2007 and early April 2008 - in total, some $10.45 million, of which $8.7 million was reinvestment and $1.7 million new money. "The majority are retired people who were critically reliant on getting their money back, if not the interest they anticipated earning," said Justice Dobson in his sentencing notes. "The crushing impact of the financial losses, and the emotional stresses caused by it, should not be underestimated."
Lombard had sensibly been holding onto cash in order to make payments to investors. In August 2007 Jeffries described the strong cash balance ($39.6 million) as "... Good assets in this Darwinian liquidity contest which has begun". The judge found that what Lombard hadn't told investors was that the cash was declining rapidly, and had been for some time. By the end of September Lombard's cash position had dropped to $24 million. At the December 19 board meeting directors were told the cash position at the end of November had fallen to just $9.5 million and the December 31 cash forecast was $8.8 million. As it turned out, the actual amount of cash on December 24, 2007, the date of the prospectus, was $8.133 million.
Justice Dobson found it relevant that the directors knew "liquidity conditions would be tight, and potentially very tight, for a period in early 2008". He referred to an email from Sir Douglas to Reeves on November 15, 2007, indicating 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."
The company had also received cashflow projections from the Ferrier Hodgson/KordaMentha review in September 2007. "The essence of our report was to say you've got cash in the bank and that's great, but you've got four or five critical loans which, if you don't achieve certain milestones on these, you'll be out of cash and there'll be a point where you'll completely run out of cash and fail," KordaMentha principal Grant Graham told the Herald. "One of the issues was the Brooklyn development. That was a massive thing - they were going to need fair winds to get a successful outcome on that."
Justice Dobson found that not telling potential investors about its liquidity squeeze, especially the declining trend in the cash position, was misleading.
What really caught the Lombard directors was Section 58 of the Securities Act 1978. As Justice Dobson pointed out, the alleged offences are ones of strict liability, meaning the Crown is not required to prove any form of intent to distribute documents that were false or misleading.
"Nor is it any part of the Crown's case that the conduct by the directors in issuing the offer documents was other than honest. In the relevant respects, the law has created criminal liability for what may be no more than a material misjudgement about the accuracy and adequacy of the description of the state of financial health of the company, as directors authorise it in offer documents."
The absolute standard imposed by Section 58 of the Act - that criminal liability follows from the issue of documents containing untrue statements or omissions - will be a key part of the appeal. David Hurd, counsel for Bill Jeffries, told the Herald, "We say [the judge's approach to Section 58] was incorrect, essentially because he misconstrued the threshold for criminal liability and effectively set that too low."
There'll also be a challenge to the judge's substantive finding on liquidity - largely around the reliance placed on a calculation that "was conceptually misconceived and was arithmetically badly flawed" involving the recovery of loan repayments. Hurd is referring to a document shown to Sir Douglas during cross examination, showing delays in repayments on Lombard's major loans. It showed that cumulatively, repayments over those four months from September to December were 46 per cent of the amounts projected.
Sir Douglas told 60 Minutes he had never seen the document before and it was incorrect. The true figure, he said, was "at least 62 per cent recovery and probably a lot higher."
A further aspect of the appeal relates to a statutory defence - whether each of the accused had reasonable grounds for their belief that what was in the offer documents was true. In his sentencing Justice Dobson said while this part of the securities law is about to change - restricting criminal conduct to cases involving deliberate or reckless misstatements - he could only deal with the law as it stands. And that since 1978 the law has placed high importance on adequate disclosure by making it a criminal offence to issue offer documents that did not provide that.
But Justice Dobson also put the offending into the context of other finance company collapses - from the most serious offending involving dishonesty with the intent to mislead; to conduct that is reckless or grossly negligent; to cases like Lombard "involving innocent misrepresentation arising out of greater or lesser degrees of carelessness".
The judge was at pains to point out that, despite the victim impact statements, the convictions did not reflect any dishonesty by the directors. He did, however, refer to the "personal reputations" that meant Lombard was trusted by many small investors above other finance companies. The judge also mused on "the harm done in an institutional sense to the New Zealand community's confidence in savings and investment" by the industry-wide failure of so many companies.
Fisk makes a similar observation. "It will be a long time before investors consider putting money into finance companies again. What it has done is changed the dynamics for property developers and their sources of funding.
"That's probably for the better. There is much less speculation in the market now and much more focus on the fundamentals of developments. Unfortunately a lot of people got burnt on the way."
How much warning is enough warning?
What Lombard said:
Lombard's December 2007 prospectus included these warnings (the final paragraph in bold type):
"In the event that Lombard Finance failed to manage its liquidity, due to mismanagement of its own borrowings (deposits from investors) or matured loans failed to repay on time and should such loss of liquidity be of a magnitude to cause Lombard Finance to become insolvent, there could be insufficient funds to repay investors.
"... Lombard Finance is currently experiencing a reduced level of reinvestment by borrowers that applied 12 months ago.
"The Board remains confident that, based on a range of conservative scenarios, Lombard Finance will have the required cash resources to fund full repayments to investors when due and that are not reinvested.
"There is a risk that a further loss of confidence in the finance sector could result in investors materially reducing their level of reinvestment below that assessed by Lombard Finance. If that was extreme, Lombard Finance would not be able to fund its repayment obligations unless other funding was available or asset realisations/borrower repayments were accelerated."
The judge's version:
Justice Dobson said these words would have given investors a clearer picture of Lombard's situation:
"Since mid 2007 LFIL has sought to build and maintain cash reserves to guard against the reduced investment and reinvestment rates likely to be caused by the loss of investor confidence in the finance company market. The company's cash reserves reached a high of approximately $40 million in August 2007, and although the amounts fluctuate, the downward trend during December 2007 has been to around 22-18 per cent of that high point. A substantial majority of the cash reserves have been applied to repay maturing investments.
"The adequacy of LFIL's cash resources is a source of concern to the directors. The company's ability to meet its obligations to investors in the coming months depends upon receipt of loan repayments as forecast. The directors are dependent on the respective loan managers for projections as to the timing and amount of loan repayments. Since September 2007 there has been a substantial extent of over-estimation in the projected loan repayments, month by month. However, the directors continue to have confidence in the competence of the loan managers and provided there is a material improvement in the accuracy of their projections, LFIL will be able to continue meeting its obligations as they fall due."