The Ralec/NZX High Court decision gives a fascinating insight into the risks associated with acquisitions, particularly the purchase of offshore start-ups.
It also raises serious questions about the NZX's disclosure to investors and whether the stock exchange operator should set higher standards in this area. NZX's annual reports contained positive statements about the newly acquired Australian business yet the High Court judgment clearly shows that its performance was well below forecasts.
The story begins in 2002, when Mark Weldon was appointed New Zealand Stock Exchange chief executive with the company listing on its own exchange a year later.
By mid-2009 NZX had acquired a number of New Zealand agriculture-based news services and publications. Weldon's vision was to use these publications as a foundation for an electronic online trading platform for agricultural commodities.
In July 2009, NZX identified a Melbourne-based business operating in this area and three months later, on October 6, announced it had purchased Clear Group from Ralec for A$6.4 million ($6.7m) cash.
The vendors would receive additional payments if certain targets were reached, the first of which was 1.5m tonnes of grain traded in the June 2010 year season.
Clear had two main principals, Grant Thomas and Dominic Pym, and its main businesses were:
• Clear Interactive, which designed and wrote software for electronic agriculture markets.
• Clear Commodities, an embryonic electronic grain exchange enabling farmers and commercial entities to trade grains and wheat.
The exchange was launched in the 2008/09 season but had failed to generate significant revenue. It had accumulated losses of A$4.2m at the time of the NZX purchase.
The volume of grain traded on the exchange in the 2009/10 season was only 204,052 tonnes, representing just 14 per cent of the targeted 1.5m tonnes.
Weldon's view was that Clear needed to capture around 15-20 per cent of the Australian grain trade but it only attracted 0.75 per cent in the 2009/10 season, 0.94 per cent in the 2010/11 season and about 1.5 per cent in each of the next three seasons.
The relationship between Weldon and Thomas appears to have deteriorated quickly.
Thomas was given an adverse performance review in April 2010 and resigned. He and Weldon agreed terms for his severance but the Australian subsequently sued NZX for failing to honour its commitments. NZX conceded the claim. Pym continued in a reduced executive role at Clear until June 2011 when his employment was terminated.
The NZX made a number of claims against Ralec including: alleged pre-contractual misrepresentation; misleading and deceptive conduct by Ralec and by Thomas and Pym personally; and alleged breach by Ralec of contractual warranties as to the truth, completeness and accuracy of information provided in the due diligence process, and non-disclosure of material circumstances.
NZX made separate claims against Thomas and Pym about guarantees of vendors' liabilities and for damages.
Justice Dobson's 172-page judgment outlines a complicated story of a willing buyer and willing seller, with Weldon keen to expand his agriculture offering. Weldon and Thomas saw eye to eye at first but they quickly fell out. NZX claimed it had relied heavily on projections made by Thomas and Pym and these had not been achieved.
Justice Dobson found that Ralec is "liable for actionable misrepresentations" and "the same outcome of liability applies to the Claims under the Fair Trading Act".
He also found "that Ralec has breached terms of warranties provided by it" under the sale and purchase agreement.
However, he wrote: "I defer any analysis on whether NZX can make out recoverable loss until I have made determinations as to liability on Ralec's counterclaims."
Ralec's main counterclaim was that NZX had breached its obligation to fund and resource Clear Group after the acquisition.
The vendor's argument was based on the principle that its upfront payment of A$6.7m was about one-third of its total potential payment. The additional two-thirds was payable if certain targets were met, particularly the 1.5m tonnes per annum. Accordingly, Ralec claimed that it had an agreement with the NZX that the latter would resource and finance Clear to an extent that was appropriate having regard to the targets that would trigger additional payments to the vendors.
Justice Dobson found that NZX had breached its contractual obligation to resource and finance Clear Group but that all of the other counterclaims made by Ralec had failed.
NZX made two claims: one for an actual loss of $13.76m and another for a projected profit between $33.5m and $44.2m if "Clear's representations had turned out to be accurate".
Ralec's counterclaim was for $14m, being the additional amount it would have received if the NZX had resourced and financed Clear's potential growth.
Justice Dobson rejected both sides' claims for recoverable damages and called his decision "a nil-all draw".
He wrote: "Both parties embarked extremely willingly on the deal between them, and must be taken to have appreciated the significant risks involved. The team on each side was led by strong and combative personalities, and there can be no question of inequality of bargaining power. Both sides retained professional advisers."
As far as the NZX is concerned Justice Dobson wrote: "This was a new endeavour in an industry where it had no experience, but was one which it hoped would be a critical component of a much larger new venture. Despite a detailed due diligence analysis, the lack of experience, the novelty of the proposition and the embryonic state of the grain market inevitably meant it was a high-risk venture."
Justice Dobson made the following comments regarding Ralec: "Its shareholders had effectively exhausted their own prospects of transforming their novel idea into a business generating viable levels of revenue" and "they were paid at a rate substantially in excess of the value recently attributed to the business."
The High Court decision raises serious questions about NZX's board decisions, the company's disclosure and its decision to pursue a hugely expensive and unsuccessful legal claim.
As far as disclosure is concerned, NZX's annual reports had this to say about Clear:
• "Clear Grain Exchange in Australia is demonstrating real momentum, with trading currently tracking at four times the levels reached in the previous harvest" (2010 report released in March 2011).
• "NZX Clear met its second-half forecast for tonnes traded on the grain exchange platform" (2011 report released in March 2012).
• "Our grain trading platform, Clear Grain Exchange, and dairy derivatives businesses are now on a much firmer footing" (2012 report released in March 2013).
These comments did not fully reflect Clear's poor performance.
Two weeks ago NZX announced, under the euphemistic heading "NZX reduces exposure to NZ & Australian agri sector", that it had agreed to sell the Clear Grain Exchange to Nathan Cattle, the head of that business. The sale price wasn't disclosed, nor was the total loss on the investment.
I would estimate this loss may have been close to $25m, including legal costs.
The Clear Grain Exchange investment has had a negative impact on the NZX's reputation, as well as its share price.
The NZX made a high-risk investment in an Australian start-up and decided to take hugely expensive legal action against the vendors, which has not been successful.
Hopefully, the NZX will now focus on improving the performance of the domestic sharemarket. The market needs a major revamp because its rules and regulations best serve the interests of brokers, rather than the investors who use the market as a trading platform.