First published in NZ Lawyer, 4 May 2012.
The spectacular collapse of dozens of finance companies continues to play out in the courtroom, this time in the form of criminal prosecutions of directors for allegedly defective disclosures in prospectuses, investment statements and advertisements (offer documents).
As has been widely reported, in February 2012 Dobson J found the directors of Lombard Finance and Investments Ltd (Lombard) guilty on charges arising from untrue statements made in offer documents: R v Graham  NZHC 265. The case has attracted a high level of media attention, not only because it involved a failed finance company, but also because two of the directors were former Ministers of Justice.
Key lessons for directors
The Lombard verdict contains important reminders and lessons for directors as they seek to comply with securities laws and their duties as directors:
Liability under the Securities Act is not limited to misleading statements. Directors may also be liable if offer documents contain a material omission.
Directors may be criminally liable under the Securities Act even if they acted honestly and were not reckless. The offence is a strict liability offence, with no form of mental intent required.
The purpose of offer documents is to give investors adequate information on material matters so that they can make decisions for themselves. Directors cannot escape this responsibility by arguing that investors instead relied on the directors to make commercial judgments.
Offer documents must disclose everything of relevance that is likely to be material to the investment decision.
If a discernable pattern emerges revealing information that is important to investors – such as the company repeatedly missing key management forecasts – this should be disclosed, notwithstanding its potentially damaging effect on the marketability of an offer.
Although directors can generally rely on information provided by management, they must adequately monitor and test the competence of management, and investigate further if put on notice of any issues.
Directors cannot rely on the absence of any red flags raised by professional advisers in substitution of their own duty to review the offer documents.
Directors' obligations in relation to the accuracy of offer documents are non-delegable. Directors ultimately must exercise their own judgment about the documents.
Directors must ensure that they receive draft offer documents in sufficient time to properly review them.
If there is a tension between downplaying risk to protect existing investors and shareholders and complying with the Securities Act, the Securities Act prevails.
Lombard predominantly raised money from the public to lend to property developers. By late 2007, the finance company sector was under significant stress, with receivers appointed to Bridgecorp Ltd and Nathans Finance NZ Ltd. In December 2007, Lombard distributed an amended prospectus and three investment statements (the offer documents), and raised $10.5 million from the public.
Over the next few months, Lombard's position deteriorated, and in April 2008 receivers were appointed. The Crown subsequently charged the directors of Lombard under section 58 of the Securities Act in relation to the contents of the offer documents.
Under section 58, the Crown must prove beyond reasonable doubt that: (1) each document included an untrue statement (such as a misleading statement or material omission); (2) the offer document was distributed; and (3) the director signed the prospectus or was a director at the time of distribution of the investment statement. The Crown need not prove any form of mental intent.
In assessing whether the offer documents contained untrue statements, Dobson J ruled that the documents must disclose "everything of relevance that is likely to be material to the investment decision", rejecting a defence argument that this "set the bar too high" (). The court also said that the target audience for the documents is a "prudent but non-expert person". Such an investor includes someone who understands technical words and financial jargon, but who may have "less than a complete understanding of all content" and who may not seek financial advice ().
Although the Crown is not required to prove mental intent, directors have a defence if they prove on the balance of probabilities that the misstatement or omission was immaterial, or that they believed – and had reasonable grounds to believe – that the statement was true.
The Crown alleged that the offer documents were misleading or contained material omissions in relation to loan impairment and adherence to lending and credit policies. Dobson J found in favour of the directors on these particulars, ruling that he was not prepared to decide the allegations on the basis of hindsight.
However, Dobson J found the directors guilty in relation to one particular – the offer documents' description of Lombard's liquidity risk. The documents described that risk conditionally – that is, if the company failed to manage its liquidity, problems could arise – but did not express a concern about an existing liquidity risk.
Dobson J found that there was an existing liquidity risk that should have been described in the offer documents. For the four months prior to the offer documents, management had consistently and substantially overstated projected loan recoveries. Cash balances were very low, and the chairman had said in an email that Lombard was now "sailing very close to the wind" ().
In his judgment, Dobson J ruled that the offer documents should have disclosed that "there has been a substantial extent of over-estimation [by management] 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, [Lombard] will be able to continue meeting its obligations as they fall due" ().
Dobson J recognised that "marketing advisers might suggest that there was little point in issuing a prospectus in such cautionary terms". However, he ruled that these considerations "cannot influence the analysis of what was required to provide adequate and accurate disclosure" ().
The directors' defence
The directors raised the defence that they believed – and had reasonable grounds to believe – that the statements were true.
The directors first argued that they were required to balance their obligations under the Securities Act with their commercial obligations to existing investors and shareholders not to be overly pessimistic about risks which might jeopardise Lombard's business. The court promptly dismissed this argument.
The directors also argued that they properly relied on management and external professional advisers, such as the auditors, the trustee and solicitors. Dobson J held that such reliance was not a two-way street. A director cannot ignore an issue with an offer document raised by a professional adviser. But the same relevance cannot "be attributed in the positive sense to the absence of warning signals from competent external advisers". The absence of such warnings may make it "marginally easier" for directors to make out reasonable belief, but ultimately "directors' obligations in relation to the accuracy of content of offer documents are non-delegable" ().
The same is true for reliance on management. The court ruled that as long as directors adequately monitor management, and there is nothing to put the directors on notice of the need for further inquiry, "reliance on information provided by management in their delegated areas of authority will generally be appropriate" (). However, the court also observed that "Directors are appointed to exercise judgment and that extends to testing the competence of management within areas in which managers are relied upon" ().
Justice Dobson concluded that the directors had not shown on the balance of probabilities that their belief in the accuracy of the statements in the offer documents concerning liquidity was reasonable.
The level of offending by the Lombard directors can be contrasted with two other recent cases concerning finance companies under the Securities Act. In R v Moses  NZCA 542, which concerned the directors of Nathans Finance, the Court of Appeal upheld sentences of imprisonment of up to 2 years 4 months. And in R v Urwin  NZHC 715, a director of Bridgecorp who pleaded guilty to charges under the Securities Act charges was sentenced to 2 years in prison. The former managing director of Bridgecorp, Rod Petricevic, has been sentenced to 6 and a half years in prison, although he also faced charges of making a false statement under the Crimes Act:  NZHC 785.
By contrast, the Lombard directors have been sentenced to between 300 and 400 hours community work, and to pay up to $100,000 in reparations: R v Graham  NZHC 575. These differences in sentencing show that the Lombard directors' offending was at the lower end of the scale.
However, Dobson J's verdict will not be the last word on the matter. The Lombard directors have said that they will appeal both the verdict and the sentence.
Finally, New Zealand's securities legislation is in the process of a substantial overhaul with the Financial Markets Conduct Bill currently making its way through Parliament. The Bill removes strict liability for defective disclosures and adds an element of mental intent – under the proposed law, directors will only be guilty of a criminal offence if they know or are reckless as to whether the disclosure is defective.
As a matter of principle, the law should be slow to impose criminal liability on individuals without the need to prove any mental element. The Bill strikes a better balance by requiring the Crown to prove that a director knew or was reckless that a disclosure was defective.
This publication is necessarily brief and general in nature. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.