Feltex directors clear hurdle but there may be more ahead

By TIM HUNTER - The Dominion Post

Last updated 10:20 06/08/2010

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OPINION: The Feltex directors have been cleared on a narrow point of law but a wider picture may yet emerge, writes Tim Hunter .

For all their outrage, bluster and talk of compensation claims, Feltex directors should not consider themselves vindicated by the ruling of Judge Doogue which let them off the hook this week.

For one thing, her judgment shows a relaxed view of what might reasonably be expected of professional directors. For another, their achievement in obliterating a substantial listed company matches some of the finance company debacles in its destructive impact on investors.

And, like the finance companies, the records of Feltex's rise and fall are smudged with the spoor of dubious disclosures.

It's such a long time since Feltex collapsed that it's worth reminding ourselves what an impact it made.

The company was floated amid the usual broker-fuelled optimism in May 2004. In total, investors paid about $247 million for it, with $193m of the public's money going straight to the previous owner, a Credit Suisse First Boston private equity fund.

Two years later the shares were worth diddly squat.

So what went wrong? The court case concluding in this week's acquittal of five former Feltex directors revolved around $116m of debts owed by Feltex to ANZ bank - in particular, whether a breach of bank covenants should have been disclosed in the interim report of December 2005, along with a reclassification of the debt as due within one year.

But this prosecution, despite its legal gravitas and wider implications for other directors, has only a bit part to play in the overall Feltex story. After all, it wasn't omissions from the interim report that caused Feltex's failure. So before returning to the issue of the judgment, let's consider some details that help put it in context.

First up, Feltex has already been subject to a Securities Commission probe, triggered by widespread outrage that a secretive private equity fund walked away with millions while Kiwi investors were left with trash.

THE commission's report, released in October 2007, found no fault in the 2004 prospectus - therefore investors were not misled about the state of the company. This conclusion has always rankled with some investors, but in law it's hard to challenge - mostly.

Perhaps the most shocking thing for investors was the speed of Feltex's demise. How could a market-leading company fall apart so quickly?

The commission noted: "The reasonableness of the [prospectus] assumptions and the projection figures were supported by FTX's actual performance for the six month period ended December 2004." This performance was a net profit of $13m on revenue of $160m - a healthy result.

A closer look at the figures, however, suggests this outcome should not have been reassuring. In fact, based on the company's prior and subsequent performance, there was something unusual about it.

Publicly available figures show it to be the biggest six-month profit Feltex ever recorded. The only previous one in double figures was the half-year profit to December 2003 - $11.4m - the most recent period to feature in the prospectus.

A look at the cashflows reveals a more startling anomaly - in the six-month period to June 2004 operating cashflow was $22m, a remarkable outlier since Feltex had never generated operating cash in double figures in the two years prior.

Indeed, the most operating cash it had managed in a six-month period was $5.5m in the six months to December 2002. The most it managed subsequently was $9.3m.

That this blip should occur around the time of the float is a curious coincidence. A cynic might conclude it warranted a forensic accounting probe and that there were deeper concerns about Feltex's financial reporting.

Whether the commission delved into such matters is not clear, but it is obvious that the law at the time limited its ability to hold directors and advisers to account.

Unlike this week's ruling, three years ago the commission found directors had breached continuous disclosure requirements of the Securities Markets Act and stock exchange listing rules.

But "the securities laws did not attach liability to directors for continuous disclosure violations". They now do, but it meant the only sanction against directors for their failure was to refer the case to the Registrar of Companies and its enforcement powers under the Companies Act and Financial Reporting Act.

This week, directors were cleared of breaking those laws. Does that mean they conducted themselves with the diligence and judgment required of directors?

Not according to the commission.

This is what directors failed to tell their shareholders.

In October 2005, ANZ Bank was so concerned about the security of its money it changed the terms of its loans to Feltex, increasing the interest rates significantly (the effect added more than $1m to the company's annual interest bill) and allowing the bank to review the lending at any time.

This gave it the right to declare all the money repayable on 30 days notice, even if Feltex was not in breach of loan covenants.

This was a huge change and should have left directors in no doubt that the company's debts were effectively on call. By this time, let's remember, Feltex was already deeply unpopular with shareholders, having failed to deliver the profits offered in its prospectus. It had also been attacked for poor disclosure leading up to a profit warning in April 2005 - a failure that led to a stock exchange fine.

HAVING raised money in the 2004 float to pay down debt to $87m, the board allowed it to balloon just six months later back to $107m, partly because shareholders received an $18m dividend - the last they were paid.

This debt was a huge burden on Feltex, making it utterly reliant on continued support from ANZ. In the circumstances, most would have expected the debt issue to loom large in directors' minds, especially since they knew in August or September 2005 that Feltex was likely to breach its banking covenants come December.

Yet directors failed to tell shareholders of the changed loan terms and the increased interest rates as required by the Securities Markets Act and stock exchange listing rules. Nor did they reveal the breach of bank covenants.

Directors have since admitted their error, but in their defence argue they took all proper steps to ensure the 2005 report was accurate and they were entitled to rely on the expert advice they commissioned from Ernst & Young.

This argument is allowable in law and was accepted by the judge. But it is interesting to look at prosecution suggestions that directors could have done more to ensure the debt was properly disclosed.

They could, for example, have specifically asked Ernst & Young how the ANZ debt should be disclosed in new accounting standards. They could have checked the matter with their own management team. They could have asked ANZ to provide a written waiver.

Yet the judge dismissed all these suggestions out of hand, arguing that even though directors hadn't asked Ernst & Young to look at the debt specifically, this was implied by their general questions. The judge was particularly reassured that, at a key audit committee meeting in February 2006, director Peter Thomas asked an EY partner "can you assure me that these accounts comply with IFRS?" Receiving the answer "yes", that was the end of the matter.

The judge may be reassured. Others may find it extraordinary that Mr Thomas did not ask about the debt. Rather than a central concern, it seems to have been the elephant in the room.

So where does this all leave us?

Directors have been acquitted. The court has spoken. But this has simply satisfied a narrow legal question. With further action to come from liquidators and an investor lawsuit, a wider picture may yet emerge.

Qualifying shareholders can still elect to opt-in to the class court action relating to the Feltex public issue in June 2004. 

Senior counsel for the plaintiff and the qualifying shareholders he represents has confirmed that 2 June 2010 is not necessarily an absolute cut-off date.