Brian Gaynor: Feltex ruling revives familiar debate

Feltex directors (from left) John Hagen, Peter Thomas, Tim Saunders, Peter David Hunter and John Feeney. Photo / Sarah Ivey

This week's district court decision, which dismissed all charges against the five Feltex directors, has reignited the debate about corporate responsibility in New Zealand.

There have been a large number of corporate collapses in recent years yet no single group seems to be responsible; the buck doesn't stop anywhere.

As far as the failed finance companies are concerned it has yet to be established whether the directors, auditors, trustee companies, Securities Commission, Companies Office or other parties were at fault.

No specific group has stood up and accepted the blame because lines of corporate responsibility are extremely blurred in this country.

On the other hand there are strong arguments that investors have to accept that companies do fail.

That is true, but the finance company debacle and Feltex failure were more than normal commercial failures, there were clear signs that governance and regulatory issues played major roles in the huge losses suffered by investors.

The Feltex IPO, which was one of the largest in the past 15 years, was clearly an exercise of dressing up mutton to look like lamb. Institutional and sophisticated investors largely shunned the issue and, as a result, it was aggressively sold to individual investors.

These investors lost over $200 million yet we are no closer to understanding why Feltex collapsed, even after the latest expensive and unsuccessful district court process.

The Ministry of Economic Development took the case under Section 36A of the Financial Report Act. The charges were:

That the directors failed to disclose the breach of a loan agreement (the ANZ Bank debt facility) that had not been remedied on or before the December 31, 2005 balance sheet date.

This ANZ Bank debt facility was classified as "non-current" when it should have been classified as "current".

The MED believed that these breaches were material to the understanding of the company's report to shareholders for the six months ending December 31, 2005.

The annual report for the year ended June 2005 showed that Feltex had total borrowings of $106.4 million, mainly from the ANZ Bank, compared with the prospectus projection of $102.4 million. All the debt was classified as "non-current" although a note to the accounts showed that $27.4 million was due to be repaid to the ANZ Bank on July 1, 2006.

This "non-current" classification of the $27.4 million facility was correct because liabilities due within 12 months are "current" while this was due one year and one day after the June 2005 balance date.

The interim report for the six months ended December 31, 2005 showed that total borrowings had increased to $116.8 million and all of this was classified as "non-current". Based on this it would have been reasonable to assume that the $27.4 million security had been extended beyond the original July 2006 maturity date.

This was not the case and at this point we must enter the complex world of accounting policies and the use of outside experts.

Feltex adopted the new IFRS accounting standards for the first time for the six month reporting period ended December 2005. This meant that the company was moving from an old to a new accounting regime and from one based on substance to one based on form.

A substance-based regime is one where directors can classify a loan as "non-current", even if it is "current", if they believe that the lender will extend this loan for a longer period.

Under the new IFRS rules, which are based on form, directors have to classify a loan as "current" even if the directors believe that it will be extended.

In the interim statement for the six months ended December 2005 Feltex did not disclose that the $27.4 million loan was still due in July 2006 and it also failed to reveal that it had breached a loan agreement with ANZ Bank.

The directors accepted that the interim report had failed to comply with the new IFRS accounting standards but they claimed they had received poor advice from the company's auditors, Ernst & Young.

Judge Jan Doogue's 59-page judgment has extensive coverage of Ernst & Young's advice regarding the adoption of the IFRS standards.

She wrote that directors are entitled to accept outside advice under the Companies Act 1993 and they cannot be found guilty if they took all reasonable steps to ensure that they complied with the law.

She quoted evidence by a Feltex director where he asked the Ernst & Young audit partner whether you "can assure me that the accounts comply with IFRS?" The director told the court that the reply was "yes".

The last six pages of the judgment are highly critical of Ernst & Young. Judge Doogue wrote that "Ernst & Young's IFRS assessment report was completely wrong" and the auditors did not query ANZ Bank about the important loan issues.

She concluded: "If Ernst & Young had performed the review to a proper professional standard as the directors were entitled to expect they would have identified and advised Feltex and the directors of the need to classify the bank debt as a current liability and to refer to the covenant breach in the explanatory notes".

The directors were found not guilty on the MED charges but what about their obligations to keep investors fully informed?

Feltex was already in trouble by late 2005 with shareholders pleading for better disclosure from the company.

At the December 2005 annual meeting the directors faced a ferocious three pronged attack from Ross Dillon, Des Hunt and Bruce Sheppard of the Shareholders' Association.

At this stage the company's share price had plunged from the IPO price of $1.70 to 50 cents.

Chairman Tim Saunders rejected repeated requests at the meeting to give up-to-date financial information and projections for the June 2006 year. This column wrote after the meeting: "Why are companies willing to give detailed financial forecasts when they are selling shares to the public but are reluctant to supply forward-looking figures once investors have paid their money?"

Even though investors were crying out for greater transparency the Feltex directors chose not to disclose that the company was in breach of a bank covenant and had major bank loans which were "current" in the interim report released in February 2006.

This is something they could have, and should have, done under the old substance rules or the new form based IFRS standards as most investors, with the notable exception of the Feltex directors, realised that the company had serious problems.

Only directors can be prosecuted under Section 36A of the Financial Report Act. But hypothetically one could be tempted to conclude from Judge Doogue's judgment that Ernst & Young would be found guilty if they could have been prosecuted regarding these inadequate accounting disclosures.

However that would probably not be the case because the auditors have covered themselves quite carefully.

The interim report for the six months to December 2005 was not audited and an attached letter from Ernst & Young had a large number of disclaimers.

These included; "The directors are responsible for the preparation of interim consolidated financial statements" and "Our review is limited primarily to enquires of group personnel and analytical procedures applied to financial data and thus provides less assurance than an audit".

In other words all the parties in the corporate reporting process are well remunerated but none of them accept responsibility, the buck is passed around and around and around.

This lack of responsibility has been a major problem with the finance company sector as well as Feltex.

It will continue to be a drag on the performance of our public issuers until clear lines of responsibility are established under statute and through regulatory guidelines.

Disclosure of interest; Brian Gaynor is an executive director of Milford Asset Management.