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Brief Counsel

The Feltex decision – and its import for other directors

06 August 2010

Judge Jan Doogue’s vigorous defence of a director’s right to rely on specialist advice in MED v Feeney and Ors has drawn sharply different responses with some seeing it as a source of comfort for directors and others as a source of concern.

This Brief Counsel summarises the key points of the decision, samples some of the reactions it has provoked and gives Chapman Tripp’s assessment of the decision’s broader significance.

He said, they said, we said

Professor Martin Devlin, programme adviser for Massey University’s Master of Business Administration, considers that the decision will deter people from taking up directorships:

“Many directors will be concerned that they can, individually, find themselves in court on such charges as faced by the Feltex directors, even after relying upon experts for advice and guidance”. 

The New Zealand Shareholders’ Association Chairman John Hawkins seemed to take the opposite position, saying: "If directors can rely entirely on outside advisers then that begs the question of why directors have to be paid so well for exercising their judgement”.

Our view:  We consider that, on balance, the judgment should be a source of considerable reassurance for New Zealand directors.  While directors must always give appropriate consideration to material placed before them, they are entitled to trust those advising them, so long as such trust is warranted and there are no reasons to suspect that it may be misplaced. 

In situations, such as under sections 36 and 36A of the Financial Reporting Act 1993 (FRA), where only directors, and not the company, are exposed to liability, the law appropriately acknowledges that those directors are justified in relying on expert advice.

The charges

All five directors faced two charges under s 36A relating to the accuracy of Feltex’s interim financial statements for the half year to 31 December 2005.  The statements were one of the first in New Zealand to be prepared for compliance with new financial reporting standards, the New Zealand International Financial Reporting Standards (NZIFRS).

Both breaches arose as a consequence of the statements being prepared in a way that would have complied with the old standards (GAAP), but did not comply with NZIFRS.  This led to a loan facility that Feltex had with ANZ being classified as a “non-current liability” when, under the new standards, it was in fact a “current liability”.  It was not disputed by the defendants that the statements breached s 36A.  Instead, they relied on section 40 of the FRA, which provides a complete defence for directors who have taken “all reasonable and proper steps” to ensure their company complied with the FRA. 

The Judge was also guided by what she regarded as a codification of common law principles relating to appropriate delegation, contained in s 138 of the Companies Act (CA).  This section provides that directors are entitled to rely on information and advice received from their employees or professional advisers.  Section 138 only applies, however, if a director “acts in good faith, makes proper inquiry where the need for inquiry is indicated by the circumstances, and has no knowledge that such reliance is unwarranted”.

The result

Judge Doogue’s decision is an emphatic dismissal of all charges, holding that the directors’ behaviour was entirely appropriate in the circumstances.  She found that the directors had taken a number of prudent steps in relation to the change-over of accounting standards, including: 

  • commissioning Ernst & Young to prepare an IFRS assessment identifying the key areas that had to be addressed in the change-over

  • establishing a steering committee comprising Feltex’s own financial management, supervised by Ernst & Young to review the IFRS standards applicable to Feltex, and

  • engaging Ernst & Young to review the interim financial statements in question to ensure they complied with the IFRS. 

“A reasonable director having read Ernst & Young’s review report and attended the (board) meeting on 16 February 2006 would have been left in no doubt that the interim financial statements complied fully with the IFRS,” the Court said.

On that basis, the Judge held that the further steps submitted as necessary by the Ministry for Economic Development – that the directors ought to have considered themselves how the new reporting standards applied to Feltex, and whether the financial statements complied with IFRS – were not necessary.  In light of the highly complex and technical nature of the new accounting standards, it was entirely reasonable for the directors to rely on the specialist advice of Ernst & Young.

The intersection between the FRA and the CA

Sections 36 and 36A of the FRA endeavour to ensure a reporting entity’s financial statements are accurate by imposing liability on directors (and directors alone), where those statements are inaccurate.  Such a legislative approach must necessarily allow directors a measure of protection where they have established appropriate mechanisms to ensure reporting compliance.  The “reasonable and proper steps” test in s 40 does so.

In this case, it is clear that such steps had been taken.  It is important to recall, however, that what is “reasonable” turns largely on the particular circumstances at hand.  Directors must remain vigilant in ensuring that their company’s finances are managed prudently and professionally.  As long as this is done, however, it is clear that the law will respect the fact that this requires the delegation of responsibility in certain specialised areas.

It is also interesting to note that Judge Doogue is quite explicit that “as a matter of law the directors are entitled to the benefit of s 138 of CA 93”, holding that s 138 applies directly to directors’ responsibilities under the FRA, not just the CA.  In so holding, Judge Doogue rejected the argument that as part of Part 8 of the CA, s 138 applies only as a defence to the civil charges possible for a breach of ‘directors’ duties’ contained in that Part.

Instead, the Judge considered that as the two Acts passed through Parliament together, they are properly considered “companions”.  In her view, s 128 of the CA, which grants directors “all the powers necessary for managing, and for directing and supervising the management of, the business and affairs of the company”, extends to the powers exercised in ensuring compliance with the FRA.  On that basis, directors are entitled to the benefit of s 138.

In the final analysis, it is questionable whether an explicit reading-in of s 138 was required in this case.  In considering what amounts to “all reasonable and proper steps” under s 40 of the FRA, a court will necessarily refer to the broader principles of company law, including the CA and the common law relating to reliance on specialist advice.  As such, it may be that s 138 is better considered a guide to interpreting s 40 than an explicit defence in and of itself, as the judgment seems to imply.

Our thanks to Michael Dobson, Law Clerk, for writing this Brief Counsel. For more information please contact the lawyers featured.

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