Directors’ reliance on professional advice – the Apple Fields litigation

Directors’ reliance on professional advice – the Apple Fields litigation

A search of the FMA website yielded an update on the FMA’s prosecution of the directors of Apple Fields under the Financial Reporting Act 1993 with failing to deliver financial statements and an auditor’s report to the Registrar of Companies for the financial years ending 2011, 2012 and 2013.

The most recent (and possibly final) step in the litigation sheds some light on the ability of directors to rely on professional advice in relation to their duties to oversee compliance by the company with its statutory obligations.

The key elements of the “reasonable and proper steps” (to oversee compliance) are relevant not only to financial reporting obligations but also those under the Companies Act 1993 and (perhaps most significantly) the Financial Markets Conduct Act 2013.

Whilst the judge at first instance in the District Court declined to follow Feltex, on appeal the High Court distinguished the position of the directors of Apple Fields with those of Feltex – on the basis that the Feltex directors relied on advice that they were compliant. By contrast, the Apple Fields directors knew (on the basis of their professional advice) that Apple Fields was in breach of its financial reporting obligations. As a result, they were obliged not only to take all practical steps to ensure compliance but also to explore (i.e. take advice on) the options available to them. By not following up the accountant’s advice – and seeking legal advice, they had not met the test.

Timeline

The timeline for the case is noteworthy on its own:

11 January 2016 The High Court issued a decision dismissing the directors’ appeal.
29 September 2015 The appeal hearing was held in the Christchurch High Court. The Judge’s decision was reserved.
16 June 2015 The directors filed an appeal against both the substantive decision and the sentence.
25 May 2015 The directors were fined $30,000 each at the Christchurch District Court for failing to deliver financial statements to the Registrar of Companies for the years ending 2011, 2012 and 2013.
20 February 2015 The Judge issued a decision in the Christchurch District Court and found that the directors had breached the Financial Reporting Act.
24 July 2014 A hearing date was allocated for this matter in the Christchurch District Court.
12 June 2014 First appearance by the directors in the Christchurch District Court – each pleaded not guilty to all charges.

The details

The factual background to the prosecution is a long and complicated one involving the former orchardist turned property developer Apple Fields, the death of its driving force (Tom Kain), problems with appointing and retaining auditors, a complicated arrangement with a ‘deemed subsidiary’ and the difficulties with obtaining information from that deemed subsidiary to enable Apple Fields’ financial statements to be completed.

At its simplest, the failure to have the financial statements completed, audited and filed with the Registrar hinged on the advice of Apple Fields’ external accountant as to whether the deemed subsidiary needed to be consolidated. That advice was not tested when the relevant information was not made available.

The District Court Judge held that, given Apple Fields’ issues (including question marks about its going concern status) the directors must have known the critical need for shareholders and investors to be provided with audited accounts. That, together with the clear obligations on the directors, should have brought home to them the need to enquire further than the accountant’s advice (even if they considered it was correct).

Noting that the requirement under is for the directors to have taken “all reasonable and proper steps” to ensure compliance, the District Court Judge considered that this precludes passive acceptance of such critical advice without corroboration. The District Court judge also determined that there were alternatives means of securing compliance (without the deemed subsidiary’ accounts). This part of the decision is a little surprising.

Consequently, because the Financial Reporting Act is designed to ensure timely and transparent audited financial statements, from which investors and shareholders are able to be apprised of the exact circumstances of the company, Apple Fields could not continue to a non-compliant issuer on an indefinite, ongoing basis. Therefore, by failing to submit the financial statements to the auditors (without seeking to secure alternative means of compliance) they had failed to take “reasonable and proper steps”.

Appeal

At the heart of the appeal to the High Court was whether, in reliance on the 2010 decision in the Feltex case, that section 138 of the Companies Act 1993 is relevant to the question of whether directors have taken all reason able and proper steps to ensure compliance with the Financial Reporting Act. And, as the District Court Judge found that the defendants considered the advice from the accountant was to be taken seriously, and had an honestly held belief in its veracity and accuracy, they should be brought within the protection of section 138(1)(b) which entitles directors to rely on “a professional adviser or expert in relation to matters which the director believes on reasonable grounds to be within the person’s professional expert competence”.

In support of their argument, the appellants referred to the Feltex case. In Feltex, the directors were charged under section 36A of the Financial Reporting Act for issuing a statement containing interim financial information for its half-year results which failed to comply with applicable reporting standards. The directors accepted that the statements failed to comply with the applicable reporting standards but relied on the “reasonable and proper steps” defence. The directors’ evidence was that they had relied on specialist advice from a reputable accounting firm to review Feltex’s compliance, and obtained assurances from those reviewers that the accounts did comply with the applicable standards.

The judge in Feltex accepted the directors could rely on the section 40 defence, saying:

“… if the advice is professional or expert advice and the directors act in good faith, make proper enquiry where the need for the enquiry is indicated by the circumstances, and no knowledge that such reliance is unwarranted, they are entitled to rely on the professional expert advice which they have received. They will then have taken “reasonable and proper steps” to ensure that the applicable requirements of the FRA would be complied with.”

“Does this mean that they will also have taken “all” reasonable and proper steps? Given the terms of [section 138 of the companies Act] it is difficult to see how they will not be held to have taken “all” reasonable and proper steps.”

However, in Apple Fields, the District Court Judge rejected the approach in Feltex, saying that:

• While section 40 was referred to, the Feltex directors were charged [under section 36A] in relation to the accuracy of Feltex’s interim financial statement. That section required the statements comply with any applicable financial reporting standard – and the Feltex statements did not.
• Whilst the Feltex decision gave weight to section 138 of the Companies Act, and imported it into the Financial Reporting Act to allow directors to honestly rely on information and advice received from their professional advisers and employees – there are specific statutory defences provided in the Financial Reporting Act (i.e. section 40) and not only is there no need, it is improper to import the Companies Act into the Financial Reporting Act.

There is academic support for this approach – and the rejection of the Feltex approach.

Outcomes

In the High Court, the judge found a distinction from the situation of the directors – to those in Feltex. Specifically, the judge accepted that section 138 does not constitute an express statutory defence under the Financial Reporting Act. However, the judge went on to say that, where a director of the company is charged under the Financial Reporting Act, the fact that a director is entitled to rely on reports, statements and financial data, in the circumstances spelt out under section 138, must be relevant to the Financial Reporting Act enquiry. Consequently:

• There will be circumstances where (as per Feltex), reliance on professional advice may be sufficient to establish the defence.

• (But), in every case where the ‘reasonable reliance’ defence is used, there must be a fact-specific enquiry to see whether the obligation to take all “reasonable and proper steps” to ensure compliance with the Act – has been met. Taking professional advice will be part of, but not necessarily a complete answer to, that enquiry.

The judge then distinguished Apple Fields from Feltex, by saying that the circumstances were different. In his view:

• The reliance on professional advice was not, as in Feltex, directly in relation to compliance, but rather was advice as to their obligations which led to the directors knowingly not complying with the Financial Reporting Act. The question is therefore whether, given their understanding that they had to include the deemed subsidiary’s accounts in their group financial statements before they could sign them and submit them to audit – whether they then took all reasonable steps to comply with their obligations under the Financial Reporting Act.

• In this case the directors did not take legal or accounting advice on the issue of whether there was anything more they could do to achieve compliance. The accounting advice did not go so far as to advise the directors that they had taken “all reasonable and proper steps” to ensure the requirement to have financial statements audited and filed with the Registrar had been complied with. (And the directors had conflated the advice as to what was required to properly complete the financial statements (and the defence under section 40) when in fact these represent two distinct stages in the directors’ obligations.

As a result, the judge concluded that taking “all reasonable and proper steps” to ensure compliance requires the directors to both:

• take all practical steps to ensure compliance (such as the efforts to appoint auditors and to obtain the deemed subsidiary accounts); and

• to seek comprehensive legal and/or accounting advice as to the range of options available to them when those practical steps did not bear fruit.

And the High Court judge concluded that the directors were happy to accept the accountant’s advice without further enquiry – because it suited them (on the basis that they did not want to file financial statements that that excluded the potential profits from subsidiary).

As a result, he concluded that, when faced with the consequence of being in breach of the Financial Reporting Act for the failure to file audited financial statements, directors could not demonstrate that they did all that was possible to comply with the Act. Instead, it was clear that they knew they were in breach, but failed to seek any further advice on what they should do.

In his conclusion, when faced with that dilemma, the most obvious step would have been to seek legal advice on whether the subsidiary could be compelled to provide the information. That, in turn, would have been likely to demonstrate whether the accountant’s advice was correct or not and, if it was, what options the directors had to compel the provision of the accounts from the deemed subsidiary. That was a reasonable step to take – which was not taken.

Therefore, the issue of reliance on section 138 of the Companies Act simply did not arise. The directors took no legal advice on whether they had any alternative ways to obtain the subsidiary’s accounts (when that was unable to be achieved through request and negotiation). As a result, they could not demonstrate they relied on professional advice to that effect, and so the question of section 138 is irrelevant to whether the section 40(a) defence is satisfied.

Concluding comments

Apple Fields was able to be distinguished from Feltex, on the basis that the Feltex directors’ had obtained (and relied on) advice that the interim financial statements complied with the relevant financial reporting standards. By contrast, the Apple Fields directors’ reliance on the accountant’s advice led to them being in a position of knowing that there was a failure to comply with the company’s financial reporting obligations.

Neither the District Court judge at first instance, nor the High Court judge on appeal, outlined what steps the Apple Fields directors should have taken once they had obtained the “comprehensive” advice. However, it seems that armed with that advice (as to non-compliance), in order to establish their defence, the directors would need to point to evidence that any reasonable options identified in that advice had been exhausted.

Further information

If you would like more information about any of the matters discussed in this note, please contact me.