The conviction last month of four former Lombard finance company directors for misleading the market have sent a frisson of unease into New Zealand boardrooms.
This was a high profile case, involving two former Ministers of Justice one of whom was knighted for his contribution to the Treaty of Waitangi settlement process. The calibre of the people involved, and the fact that there was never any suggestion that they had been other than honest, has reinforced to directors exactly how vulnerable they are under a strict criminal liability test. Many are expressing reservations about the burdens recent court decisions are imposing on even the diligent, well-intentioned director.
This case is similar to the Centro case concluded in the Australian Federal Court last year where the Judge also accepted that, although there had been a failure to disclose material information, there had been no intention deliberately to mislead the market. The important difference between the two cases is that the Centro case was a civil proceeding only. Hence the Centro directors were never at risk of a criminal conviction and the Judge was able to issue declarations of contravention with no further penalty.
Of course directors must be held accountable for their decisions. But the Lombard judgment is one of a series in recent times which have underlined the risk associated with being a director and there is a concern that good people may be discouraged from taking up directorships or that boards will become too risk averse to pursue growth opportunities.
To some extent, the New Zealand Government has already acknowledged this risk. The Financial Markets Conduct Bill, now winding its way through Parliament, reserves criminal sanctions for misconduct which is deliberate or reckless. Where there has been no intent to mislead, liability will be restricted to civil remedies in the form of compensatory orders and civil pecuniary penalties, unless recklessness can be proven.
The Bill also creates a ‘due diligence’ defence for directors in the context of compensatory orders, incorporating an equivalent test used under some Australian statutes and the New Zealand Insurance (Prudential Supervision) Act. As articulated in Universal Telecasters (Qld) Ltd v Guthrie, this will mean that it is sufficient to prove that a proper system for compliance was in place and that it was adequately supervised. The fact that a problem occurred would not be damning of itself as “even the best systems may break down due to human error”.
In the Lombard case the only defences available to the directors, in the context of criminal liability, were that they had “reasonable grounds to believe” and did believe that all of the information contained within the relevant prospectus and investment statements was correct and that any omissions were immaterial.
They argued reasonable belief, pointing out that none of the external professional advisers on which they relied had raised the red flag. But Justice Dobson said that although this defence would have been “adversely” affected had the directors been advised by a professional adviser to make a content change, the “absence of warning signals” did not support a finding that there were reasonable grounds for their belief that the documents were accurate.
External advice is of itself insufficient to justify a reasonable belief defence, if on the facts a reasonable belief could not independently exist. And he cited Justice Heath in the Nathans decision of July 2011, saying that the directors’ obligations in relation to the accuracy of offer documentation were “non-delegable”.
The many similarities between the Nathans and Lombard cases – both proceedings were criminal, both involved finance companies and both concerned breaches of disclosure requirements – ensured that the Nathans judgment would loom large in the Lombard litigation.
Counsel for the defence sought to persuade Justice Dobson that Justice Heath had set the bar too high in two respects but in both, Justice Dobson reaffirmed Justice Heath’s position.
The first related to the degree to which directors can rely on the advice of others.
Justice Heath ruled:
Subject to adequate monitoring of management by the directors or anything that may put a director on notice of the need for further inquiry, reliance on information provided by management in their delegated areas of authority will generally be appropriate. But every reliance inquiry will be fact specific, taking into account both the obligations and responsibilities of particular directors and the nature of the tasks delegated to members of the management team.
The defence argued that this interpretation was unreasonably narrow and that directors should be able to rely on the judgement of managers until they were put on notice that something of substance had gone wrong. But Justice Dobson said this would put “permissible reliance too highly”.
He also declined to accept that Justice Heath had been excessive in expecting that offer documents should be exhaustive, disclosing “everything of relevance that is likely to be material to the investment decision”.
Having concluded that the amended prospectus and three investment statements signed off by the board in December 2007 were misleading in relation to the severity and imminence of the liquidity squeeze confronting Lombard and that, on the facts, the “reasonable belief defence” could not exist, the Court had no option but to issue convictions against the directors.
The Court will, however, have more discretion when it comes to the sentencing hearing on 29 March. Already Justice Dobson has been clear that the level of offending is “a material step away from the seriousness required for a custodial sentence” and that he will be looking at community sentences and financial penalties only.
Whether the Court would have held that the directors were reckless as to the content of the prospectus under the approach in the FMC Bill is open to question. It is possible, however, that history will consider the Lombard directors were simply in the wrong place at the wrong time.
John Holland is a partner at Chapman Tripp specialising in securities law, energy law, mergers and acquisitions, construction law and competition law issues.