Judge tells directors how to stay out of jail

In a rare move for the High Court, Justice Paul Heath came out from behind his bench this week to speak to professional directors about their roles - and offer advice on how to keep out of jail.

Taking the stage at the Institute of Directors conference in Auckland, he had just been praised by insolvency specialist Michael Stiassny for locking up the first finance company directors – Nathans Finance’s Roger Moses and Mervyn Doolan.

The benchmark-setting 2011 decision, which found them guilty of misleading of investors, had set the template for the major finance company trials to follow, Mr Stiassny said.

“History will show it was a landmark.”

Justice Heath said he was at the conference to point out areas in which directors’ performance had been “less than optimal” and give a judge’s insight about compliance with legal requirements.

“Sadly, many of those who need to be here are probably not,” the judge said.

Since the Nathans Finance trial, there has been a number of other finance company trials in which investors lost money through failures on the part of directors. Justice Heath categorised the cases under three categories:

1. Where directors were dishonest and their frauds were not detected or reported

2. Where directors were completely indifferent to the decisions that they made. Even though they turned their collective minds to issues that they needed to address, they did not do so with sufficient rigour.

3. ‘Turn your brain on’ cases where directors “turned their brains off”, failing to understand their own obligations to consider and determine issues and provide direction for the company. Instead, they relied uncritically on work of others, in discrete areas.

Puzzling comment on honesty explained

Justice Heath said he considered Nathans Finance trial as in the “turn your brain on” category, which helped explain his puzzling finding the Nathans trio, although guilty of misleading investors, had “acted honestly throughout”.

“Nobody turned their brain on sufficiently to realise that the information coming from different sources had to be collated and analysed before decisions were made,” the judge said.

In that way material misstatements appeared in offer documents on which individual investors might have relied.

“The only reason these people were not dishonest is because they did not even think about the issues,” said.

Roger Moses slams judge for blagging

The suggestion Nathans’ directors “turned their brains off” and relied “uncritically” on the work of others in the company, later drew the ire of Nathans chairman Roger Moses, who completed his two-year, two month jail sentence last year.

“One wonders why he deems it necessary to continue to justify his decisions in the case,” Moses told NBR ONLINE.

“To quote Justice Hammond, “there is still a real force to the old adage that the less that is seen of a judge off the bench the better. Judges’ are not celebrities.”

Problem of wearing two business hats

Despite Moses’ criticism, Justice Heath, in his address, had painted a human picture of the directors in Nathans Finance.

“The Nathans’ prosecution revealed a stark conflict of interest that blinded the Nathans’ directors from seeing and understanding the impact of their decisions on those who invested money in Nathans.

“The conflict arose out of common directorships that most of them held in the parent company of Nathans, VTL,” Justice Heath said.

“VTL carried on an entrepreneurial business, while Nathans was a finance company taking deposits form members of the public.

Members of the public were entitled to believe they could rely on Nathans’ directors to deal prudently with the money they had invested. Instead, because of their unswerving belief in the VTL business model, the directors of Nathans were prepared to continue lending significant sums of money to VTL in the face of cogent evidence that they might not be repaid.”

It was understandable Nathans directors wished to procure funds to advance the VTL business model, Justice Heath said.

“But, as directors of Nathans, they were obliged to look at the prudence of the loans and to ensure they would be repaid on time. Instead, the inter-company borrowings were rolled over with capitalised interest, contrary to the overall impression to be gained from the narrative and financial statements to the relevant prospectus.

Defence of honest belief

Justice Heath said the conflict facing Nathans directors led to what he perceived to have been a fundamental misunderstanding of directors' obligations when issuing a prospectus.

A defence to a charge of issuing a prospectus containing a misleading statement is that the director honestly believed on reasonable grounds that the statement was true, he said.

“Yet, throughout the [Nathans] trial, the directors’ focus seemed to be on whether each had an honest belief on reasonable grounds that VTL would succeed.”

There was a disconnect between the two concepts, the judge said.

“A director could have a honest belief that the parent company, to which moneys were being advanced, would succeed and, ultimately, repay the debt without holding an honest belief on reasonable grounds that the statements made to members of the public in the relevant prospectus were true.”

General duties of directors

“As I said in Nathans, directors direct and managers manage,” Justice Heath said.

“In larger companies, directors will necessarily delegate management responsibility to executives, who are employees of the company. In that situation, the board’s primary responsibility is to provide strategic direction and to supervise the way in which its directions are carried out.

Justice Heath recognised directors operate in a dynamic business environment in which they can be required to respond to sudden and unexpected market shifts.

“A standard of near perfection is both undesirable and unattainable. In all cases it will be necessary to view decisions taken by directors from the perspective of the boardroom, at the time they are made.”

The challenge for judges

Judges needed to be alive to the problems inherent in making decisions with the benefit of hindsight after undertaking an extensive financial autopsy of the corporate corpse, Justice Heath said.

The Companies Act allowed directors a wide discretion in matters of business judgment, while at the same time providing protection for shareholders and creditors generally against abuse of management power, he said.

Legal requirements of directors

Directors were required to act in good faith in what they believed to be the best interests of the company and to exercise the care, diligence and skill that a reasonable director would exercise in the same circumstances.

“He or she must not act recklessly or incur an obligation in the absence of a belief, on reasonable grounds, that it will be performed on due date.”

In specified circumstances, a director was entitled to rely on any other director in performing his or the duties, the judge said.

In most instances, management can be relied on for information too, but the judge gave caution.

“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.

“The appropriateness of any particular reliance is measured by reference to the adequacy of actual inquiries made, the information on which the directors relied and the reasonableness of any such reliance.”

The blame game played out during the Nathans trial, where directors blamed the auditors, lawyers and trustees, demonstrated abdication of directors’ responsibilities, not reliance on others, Justice Heath said.

Directors reassured

Although these obligations were cast on directors, the Act recognises that, in certain circumstances, directors may rely on information from others, he said.

“The appropriateness of any particular reliance is measured by reference to the adequacy of actual inquiries made, the information on which the directors relied and the reasonableness of any such reliance.”

“Directors who do their work conscientiously and make rational decisions will almost invariably avoid appearing before the courts in cases such as these.”

gbond@nbr.co.nz