Corporate Advisory

05 Aug 2010

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Feltex case reinforces "reasonable reliance" defence

Former directors of Feltex Carpets have successfully defended all charges brought against them by the Ministry of Economic Development. In finding the directors "not guilty" of offences under the Financial Reporting Act (FRA), the District Court has reinforced an important defence for directors. Judge Doogue found that the Feltex directors could invoke a provision of the Companies Act which allows directors to rely on information and advice they receive, so long as they are acting reasonably.

Although the decision is unsurprising, it serves as a useful reminder that our corporate law is not blind to the realities of management, and the need for the board to delegate.

The case concerned a failure to disclose a breach of bank covenants, and correctly classify liabilities to ANZ as current liabilities, in Feltex's 31 December 2005 interim financial statements. With these errors, the financial statements did not comply with NZIFRS, and the directors were guilty of an offence under the FRA, unless they could show that they took "all reasonable and proper steps" to ensure compliance.

The 2005 interim financial statements were the first which Feltex prepared under NZIFRS, and in fact Feltex was one of the first companies to report under NZIFRS as an "early adopter".

As would be expected, the Feltex directors placed significant reliance on Feltex's finance team and its auditors, in securing compliance with the new accounting standards. The Court found that the directors:

• placed reliance on a qualified, competent and well resourced management team;
• established a comprehensive transition process from GAAP to IFRS;
• engaged a highly reputable accounting firm to prepare an IFRS assessment report identifying key areas and issues that needed to be addressed in the transition;
• created and established a steering committee comprising Feltex's own financial management and supervised by the auditors;
• engaged the auditors to conduct a review of the relevant accounts;
• obtained declarations by the CEO and CFO in relation to Feltex's compliance with the FRA; and
• used an appropriately constituted audit committee.

In the face of this evidence, it might well be asked "what more could be done"? The prosecution answered this question with a number of suggestions, including that "the directors themselves should have looked at the accounting standards".

Judge Doogue correctly pointed out that this suggestion was "utterly unrealistic" and contrary to the longstanding principle that "directors are entitled to rely on advice where appropriate conditions are satisfied". The directors did not "have to do it themselves".

The Judge found that, by properly delegating the task of compliance, and obtaining expert advice on the outcome, the directors had made out the defence of "all reasonable and proper steps" towards compliance under the FRA. In doing so, the Judge confirmed that the directors were entitled to rely on employee and expert advice, so long as the conditions set out in the Companies Act were met:

• the advice must be from:
  • an employee reasonably believed to be competent; or
  • an expert on a matter reasonably believed to be within their expert competence; and
• the directors must act in good faith, make proper enquiries where the need is indicated and have no knowledge that reliance is unwarranted.

The main message here is that directors can place reliance on experts, particularly when dealing with complex matters beyond their personal expertise. In doing so they must, however, act reasonably and in good faith.

The more subtle legal point is that the Judge has applied the general "reliance" provisions of the Companies Act to an offence under the FRA. This suggests the "reliance" defence should be available whenever a director's actions are being considered, but whether it will be extended beyond the FRA (which was effectively a twin birth with the Companies Act) remains to be seen.

Authors

Shelley Cave

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Peter Hinton

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Don Holborow

Partner - Corporate & Commercial

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Kevin Jaffe

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Robert McLean

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Michael Pollard

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