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New Zealand Securities Commission |
Last Updated: 12 November 2014
Feltex Carpets Limited
IPO Prospectus, Financial Reporting
and Continuous Disclosure
TABLE OF CONTENTS
Glossary of Abbreviations and
Terms
Part I
Executive Summary
Part II
The Commission's Review
Procedure
Part III
Chronology
Part IV
The IPO
Financial Information
Assumptions
Risk Disclosures
Historical Financial Statements
Directors' Interests
Conclusions
Part V
Changes
to the Banking Facility Agreement
Conclusions
Part VI
Financial
Reporting of the Breach of Banking Covenants in the December 2005 Half-Year
Financial Statements
Conclusions
Part VII
Classification
of Debt in the 31 December 2005 Half-Year Financial Statements
Conclusions
Part VIII
Board Issues
Conclusions
Part IX
Auditor Conduct
IFRS Impact Assessment
December 2005 Review
Conclusions
Part X
Other Issues
Responsibility For Audit Working
Papers
Other Matters Considered
Part
XI
Conclusions and Referrals
GLOSSARY OF ABBREVIATIONS AND TERMS
ANZ
Australia and
New Zealand Banking Group Limited
ASRB
Accounting Standards
Review Board
CFO
FTX Chief Financial Officer
CPM
Corporate Portfolio Management ANZ
CSFB
Credit
Suisse First Boston
CSFBAMP
Credit Suisse First Boston Asian
Merchant Partners, L.P.
EBIT
Earnings Before Interest and Tax
EBITDA
Earnings Before Interest, Tax, Depreciation, and
Amortisation
Facility Agreement
Loan agreement among ANZ, FTX,
and certain affiliated companies
Fourth Restatement
Fourth Deed
of Amendment and Restatement of Facility Agreement 27 October 2005
FRA
Financial Reporting Act 1993
FTX
Feltex
Carpets Limited
IPO
Initial Public Offering
NZ
IAS
New Zealand Equivalents to International Accounting Standards
NZ IFRS
New Zealand Equivalents to International Financial
Reporting Standards
NZICA
Institute of Chartered Accountants of
New Zealand
NZX
New Zealand Exchange Limited
NZSX
New Zealand Stock Exchange
NZ RS
New Zealand
Statement of Review Engagement Standards
Prospectus
2004 FTX IPO
Prospectus
Shaw
Shaw Industries Australia Pty Limited
Part I EXECUTIVE
SUMMARY
1.
The Commission has inquired into the 2004 IPO
Prospectus of Feltex Carpets Limited (in Liquidation) ("FTX"), and FTX's
compliance
with financial reporting and continuous disclosure obligations in the
period between its listing in 2004 and the appointment of liquidators
to the
company in late-2006.
2.
The Commission's inquiry has concluded
that:
3.
The Commission has determined that it
should report on the findings of its inquiry. It has found a failure to disclose
material changes
to the banking facility in October 2005, a failure to disclose
the breach of banking covenants, and a failure to properly classify
the
company's debt in the December 2005 half-year financial statements. These
matters variously raise issues about the governance
of the company by the FTX
Board and about the conduct of FTX's auditors, Ernst & Young.
4.
FTX is now in liquidation and its shares are
no longer trading on the NZSX. As liability for continuous disclosure breaches
lies only
against the issuer concerned, there is no realistic chance of taking
enforcement action in these circumstances. Under the law in
force in 2005
directors and officers of companies could not be held liable for continuous
disclosure breaches. Therefore, no question
arises of action against any
individuals.
5.
In late 2005 it was widely known
that FTX was in difficulty. At that time FTX was dependent upon the continued
support of its bank,
ANZ. It appears that the FTX directors failed to comprehend
the significance of changes made to the debt facility agreement that
were
designed to protect the position of the bank, and so failed to adequately inform
the market of these.
6.
The FTX board's failure
to disclose the breach of FTX's banking covenants in its 31 December 2005
half-year financial statements raises
questions of compliance with the Financial
Reporting Act 1993. Certain defences may be available to the directors,
including that
they "took all reasonable and proper steps to ensure that the
applicable requirement of this Act would be complied with." The Commission
found
that the directors did take certain steps, as described herein. Nevertheless,
the Commission is of the view that the FTX board
failed to pay sufficient
attention to the breach and failed to consider whether there were financial
reporting obligations arising
from the breach. The Commission refers this matter
to the Registrar of Companies.
7.
Questions of
liability under the Financial Reporting Act arise only in regard to the conduct
of the directors of a company. Therefore,
the Commission is not able to refer
this matter to the Registrar of Companies in regard to the conduct of FTX's
auditors, Ernst &
Young.
8.
FTX's failure to
properly classify the debt in its 31 December 2005 half-year financial
statements has highlighted that the classification
of debt in interim financial
statements is not expressly addressed by an applicable financial reporting
standard. The Commission
refers this matter to the ASRB to consider whether any
guidance or other action is necessary.
9.
The improper
classification of debt was a breach of New Zealand Generally Accepted Accounting
Practice ("NZ GAAP"), but it was not
a breach of an applicable financial
reporting standard. Questions of liability under FRA arise only where there is a
breach of an
applicable financial reporting standard. Therefore, the Commission
will not refer this matter to the Registrar of Companies in regard
to the debt
classification issue.
10.
The Commission is of
the view that the work undertaken by Ernst & Young New Zealand in relation
to the review of the December
2005 financial statements failed to meet the
standards required for such an engagement. The Commission refers this matter to
NZICA.
11.
While the issues referred to above
raise questions about the performance of the FTX Board and its auditors, the
Commission is not
suggesting that these issues are the reason that FTX failed.
The Commission has heard from witnesses that the collapse of FTX was
due to a
combination of factors. Such factors included the high fixed costs inherent in
the carpet manufacturing industry and those
particular to FTX, the need for
restructuring, the decline in the Australian housing market, and the competition
from Asian carpet
manufacturers. It is the Commission's view that the FTX
collapse was not caused by securities or financial reporting matters, and
accordingly, the Commission will not comment on the FTX collapse.
Part II THE COMMISSION'S REVIEW
12.
The
Commission conducted a review of the prospectus dated 5 May 2004 and FTX's
compliance with financial reporting and continuous
disclosure obligations in the
period between its listing in 2004 and the appointment of liquidators to the
company in late-2006.
This review has been carried out under section 10(c) of
the Securities Act 1978, which provides that it is a function of the Commission
"[t]o keep under review practices relating to securities, and to comment
thereon to any appropriate body."
13.
The
Commission considers that the matters under review raise issues of securities
law and practice upon which it is appropriate for
the Commission to comment. The
Commission has decided to comment by way of this report.
Procedure
14.
The
Commission determined the procedures for this review.
15.
In a
formal inquiry, the Commission heard evidence from the following:
(a)
Mr Timothy Saunders, former Chairman of the Board of FTX;
(b)
Mr Peter Thomas, former Chief Executive Officer and Director
of the Board of FTX;
(c)
Mr David Hunter, former Director of the
Board of FTX;
(d)
Mr John Hagen, former Director of the Board of
FTX;
(e)
Former Chief Financial Officer FTX;
(f)
Head of Corporate Portfolio Management ANZ "CPM";
(g)
Chief
Risk Officer ANZ;
(h)
Head of Diversified Industrials ANZ;
(i)
Mr Gordon Fulton, Partner, Ernst & Young, New Zealand;
(j)
Mr Stuart Painter, Partner, Ernst & Young, Australia;
(k)
Mr Kevin Simpkins, Kevin Simpkins Advisory Services Limited
(Commission's retained accounting expert); and
(l)
Mr Charles
Cable, Deloitte, Auckland (FTX Directors' retained expert).
16.
The Commission reviewed documents
received from:
(a)
FTX, FTX receivers, and FTX liquidators, which
included board papers, reports provided to ANZ; and financial documents;
(b)
ANZ which included loan agreements, memoranda,
correspondence, and reports; and
(c)
FTX auditors which included
reports; memoranda; correspondence; and working papers.
17.
The Commission retained a market analysis
expert; an accounting expert; and analysts to examine various financial matters.
18.
Confidentiality and privacy orders were in
place throughout the inquiry.
19.
All parties to
the inquiry were afforded an opportunity to be represented by counsel. Oral
evidence was recorded and transcripts were
provided to the witnesses.
20.
After receiving evidence, the Commission
prepared a confidential consultative report and invited comment from affected
parties. These
parties were given a full opportunity to respond with submissions
and to provide further evidence to the Commission.
21.
The Commission has carefully considered all
evidence and submissions before publishing this report.
Part III CHRONOLOGY
22.
FTX had been
operating in Australia and New Zealand since the 1920's. FTX produced a full
range of woven and tufted carpets and wool
and man-made fibre carpets, under a
range of well recognised name brands.
23.
Originally
manufacturing footwear, FTX expanded into manufacturing industrial felts, floor
coverings, and then carpets in the 1940's.
Since that time FTX had acquired
several entities including rubber companies and other carpet manufacturers and
in 1988 was ultimately
sold to an Australian company named BTR Nylex.
24.
In 1996, Credit Suisse First Boston Asian
Merchant Partners, L.P. "CSFBAMP", purchased FTX from BTR Nylex. CSFBAMP was a
member of
a group of companies which operated the private equity business of
Credit Suisse Group, a Switzerland-based international financial
institution.
25.
In May 2000, FTX acquired Shaw to become one
of the two largest Australasian carpet manufacturers. As a result of the Shaw
acquisition,
FTX significantly increased in size and gained a stronger position
in Australia.
26.
In 2003, FTX issued $60
million of bonds.
27.
In 2004 FTX offered $50
million of new shares to members of the public in New Zealand and institutions
in New Zealand and Australia.
FTX intended to use the proceeds from the issue of
the $50 million in new shares along with additional drawings under the bank
facility
to redeem the bonds issued in 2003. There was a secondary sale by
CSFBAMP of 113,523,100 shares ($193 million) to members of the
public in New
Zealand, bondholders with New Zealand addresses, and institutional investors in
New Zealand and Australia. First NZ
Capital and Forsyth Barr Limited were the
joint-lead managers in the IPO. The offer closed on 21 May 2004 and on 4 June
2004, FTX
shares began trading on the NZSX at $1.70 per share, which was the
subscription price for members of the public in the IPO.
28.
The offer of shares to the public was made
by FTX in a combined investment statement and registered prospectus dated 5 May
2004. In
the same offer document FTX presented the company's prospective
financial information consisting of forecast financial information
for the year
ending June 2004 and projected financial information for the year ending June
2005.
29.
In October 2004, FTX engaged Ernst
& Young to conduct an impact assessment of the NZ IFRS requirements on FTX
to assist FTX in
its conversion of financial reporting to NZ IFRS.
30.
For the six months ending 31 December 2004
the company's interim report made reference to the fact that "EBITDA was
$24.6 million, up 6.9%, supported by an increased EBITDA margin, which improved
to 15.4% from 13.4%. Revenue of $160 million
was down 7.4% as the company
maintained its focus on the higher margin segments of the market."
31.
The company also mentioned that "despite the Group not
meeting the projected sales and the likelihood of a continuing strong New
Zealand dollar, EBITDA and net profit
projections for the year remain
achievable."
32.
Up until late February 2005 the company had
maintained the above position saying that it was on track to meet prospectus
earning projections.
The projected net profit after tax for the full year was
$23.9 million.
33.
However, on 1 April 2005, FTX announced to
the market that it expected its net profit after tax for the financial year
ending 30 June
2005 to fall significantly below the previous projections. FTX
downgraded its earnings projection to $15 - 16 million. FTX announced
that its
sales for the full year were projected to be $295 million to $305 million which
was below the previous guidance provided
in the interim report of between $310
million to $315 million. Net profit after tax was projected to be between $15 to
$16 million
for the year ending 30 June 2005 which was between $8 million and $9
million less than the previous projection.
34.
FTX announced that the key reasons for their
revised projections were that the market environment in Australia and New
Zealand was
more difficult than expected in the first quarter of the calendar
year; their commercial retailers and contractors experienced a
delay in projects
due to a shortage of laying contractors; there was continued low store traffic
in the first quarter of the calendar
year, which reduced the retailers'
confidence for the remainder of the financial year; increased price competition
in the market
primarily due to synthetic imports being higher than projected;
and the decline in the Australian residential market. FTX also announced
that
the price competition had impacted FTX's ability to fully pass on additional
first quarter synthetic raw material cost increases;
the declining Australian
market was frustrating FTX's ability to reach its projected market share
increases; and the ongoing strength
of the New Zealand dollar continued to
adversely affect FTX's performance.
35.
NZX
Regulation investigated whether the 1 April 2005 announcement was made in a
timely manner in compliance with NZX Listing Rules.
36.
NZX Regulation considered that FTX
management had material information that should have been disclosed to the
market prior to the
actual announcement of 1 April 2005.
37.
FTX disputed this view, but settled this
matter with NZX and paid a sum of $150,000 consisting of $85,000 for NZX
Regulation's and
NZX Discipline's costs arising from the inquiry and a $65,000
contribution to the NZX Discipline Fund.
38.
On
20 June 2005, FTX further revised its earnings guidance to announce that the net
profit after tax for the 2005 financial year would
be between $11.5 million and
$12 million (as compared with the projection of between $15 million to $16
million announced on 1 April),
prior to restructuring costs associated with the
review of management and operations. FTX also projected the fourth quarter
earnings
to be between $200,000 and $700,000 prior to restructuring costs,
compared to the third quarter loss of $880,000, noting that this
was a small
turnaround which fell below expectations in April. FTX also announced that in
response to unsatisfactory financial performance,
the FTX Board of Directors was
making senior management changes, undertaking a review of FTX's operations, and
Chief Executive Sam
Magill was to step down. Further, FTX explained that there
were external factors impeding its ability to maintain and improve average
selling prices and margins, such as the increasing competitive conditions in
Australia, less favourable market conditions in New
Zealand, and the increasing
competition by imported carpet against locally manufactured carpet.
39.
During the period from prior to the 1 April
2005 announcement to after the 20 June 2005 announcement, the FTX share price
fell approximately
68%.
40.
Also, in June 2005,
Godfrey Hirst, a rival carpet manufacturer, acquired a 5.83% shareholding in
FTX.
41.
In July 2005, Godfrey Hirst made a
proposal to FTX to merge the two businesses.
42.
In October 2005, FTX rejected Godfrey
Hirst's offer to combine their businesses.
43.
FTX had a number of loans from ANZ bank
dating back to the early 1990's. In October 2005, ANZ reduced one of FTX's loans
by A$5,000,000
and loaned FTX A$10,000,000 as a short-term facility. FTX and ANZ
also amended the terms of their loan facility agreement. The revised
agreement
was reflected in the Fourth Deed of Amendment and Restatement of Facility
Agreement ("Fourth Restatement").
44.
In
December 2005, FTX engaged Ernst & Young to conduct a review of FTX's 31
December 2005 half-year financial statements.
45.
As at the 31 December 2005 calculation date,
FTX had breached certain of its banking covenants. In August or September 2005,
the FTX
directors apprised ANZ that FTX anticipated breaching certain of its
banking covenants.
46.
In February 2006, the FTX
Board approved the 31 December 2005 interim half-year financial statements in
which FTX classified most
of its debt with ANZ bank as "non-current."
47.
In March 2006, FTX notified ANZ that FTX had
breached certain of its banking covenants.
48.
In May 2006, ANZ formally notified FTX that
ANZ had waived its rights in regard to FTX's breach and ANZ imposed certain
reporting
obligations upon FTX.
49.
In June
2006, ANZ formally notified FTX that ANZ had withdrawn its waiver of rights in
regard to FTX's breach.
50.
In June 2006, FTX
announced to the market that it was seeking a cornerstone stakeholder.
51.
FTX considered offers to purchase from
several companies prior to the ANZ placing FTX in receivership on 22 Sept 2006.
ANZ appointed
the firm of McGrath Nicol as receiver.
Part IV THE IPO
52.
Offers of securities to the
public must be made in compliance with the Securities Act 1978. The Act requires
issuers to register a
prospectus which must contain all of the material
information in regard to an offer of securities.
53.
The Commission reviewed the prospectus for
compliance with the Securities Act and to consider whether the prospectus was
misleading
in any material particulars.
Financial
Information
54.
The Commission assessed prospective
financial information in the prospectus to determine whether the prospective
financial information
was consistent with the assumptions presented and whether
the assumptions were consistent with the requirements of FRS 29.
55.
The methodology underlying FTX's preparation
of the detailed sales forecasts and projections was similar to the process
followed for
the preparation of the annual budget.
56.
Financial Reporting Standard No. 29
("FRS-29"): Prospective Financial Information was the applicable financial
reporting standard
for the FTX prospectus. FRS-29 states that prospective
financial information can be presented either as a forecast or as a projection.
57.
FRS-29 defines the terms as follows:
(a)
"'A forecast' means prospective financial information
prepared on the basis of assumptions as to future events that the governing
body
reasonably expects to occur associated with the actions the governing body
reasonably expects to take as at the date that the
information is prepared
(best-estimate assumptions).
(b)
'A projection' means
prospective financial information prepared on the basis of one or more
hypothetical but realistic assumptions,
(or 'what-if' scenarios), that reflect
possible courses of action for the reporting periods concerned as at the date
that the information
is prepared."
Assumptions
58.
FRS-29
requires that the assumptions used in preparing forecasts "shall be
reasonable, supportable, consistent among themselves and with the strategic
plans of the entity, and be applied consistently."
FRS-29 also states that a
forecast is based on assumptions which the governing body reasonably expects to
occur while a projection
is based on one or more hypothetical but realistic
assumptions.
59.
FRS-29 does not require
projection assumptions to be supportable, although they must be reasonable.
60.
FRS-29, paragraph. 5.21, states:
"To be reasonable, best-estimate assumptions are to be consistent with the
strategic plans of the entity. Assumptions are consistent
with the plans of the
entity if they reflect the expected economic effects of anticipated strategies,
programmes and actions, including
those being planned in response to expected
future economic conditions."
61.
The
Commission found that most of FTX's assumptions presented a largely "no change"
scenario. Some of the critical assumptions were:
(a)
that the carpet
market in Australia and New Zealand would continue to grow by 1% (total market
sales), which is stated to be below
the average growth rate over the past 10
years; and
(b)
that new products would increase in line with
expectations; and
(c)
that FTX would successfully implement the
strategies described in the prospectus under "Business Description," which would
result
"in Feltex's market share increasing by approximately 1% over the
projected period."
62.
The Commission
received information and explanations supporting the 1% growth assumption
regarding FTX's market share.
63.
Due to the
process involved, FTX's assumptions were consistent with the strategic plans of
the entity.
Risk
Disclosures
64.
The Commission notes that the
prospectus outlined the risks specifically related to the carpet industry and to
the business of FTX,
such as competition in the floor coverings industry;
changes in the building industry; exchange rate fluctuations; effect of imports
on the market; and performance-related risks. The prospectus also specifically
outlined the risks associated with forward-looking
statements and with choosing
an investment advisor.
Historical Financial
Statements
65.
The prospectus contained
summary financial statements and audited financial statements for June 2003 and
December 2003. The Commission
reviewed the financial statements in the
prospectus. This review did not find evidence of any breach of disclosure
required under
the securities laws and financial reporting standards.
Directors'
Interests
66.
The Commission also notes that
the prospectus contained disclosures concerning the risks associated with
investing in FTX, the directors'
and vendor's interests; shares held by
directors and senior managers outside of the offer and the shares they would
obtain from the
executive share option plans, Peter Thomas's relationship with
CSFBAMP, and annual fees.
Conclusions
67.
The
Commission concluded that the underlying management process around the
preparation of the PFI in the prospectus appears to have
been robust, that FTX
undertook a rigorous process to decide how the PFI should be labelled, and that
FTX made reasonable assumptions
upon which it based its projection figures.
68.
The reasonableness of the assumptions and the projection
figures were supported by FTX's actual performance for the six month period
ended 31 December 2004.
69.
The Commission concluded that there
was no information available to the directors at the time of the IPO to suggest
that the directors
of FTX could or should have foreseen that the projections
would not be reasonable.
70.
The Commission
concluded that the assumptions met the standard of reasonableness required in
respect of projections by FRS-29.
71.
The
Commission concluded that the risk disclosures, historical financial statements,
and disclosure of directors' and vendor's interests
were adequate in terms of
securities law.
72.
The Commission concluded
that the prospectus did not breach securities law and was not misleading in any
material particulars.
73.
The Commission will
take no further action with regard to the prospectus.
Part V CHANGES TO THE BANKING
FACILITY
74.
FTX had a loan facility agreement with
the ANZ bank which reflected the terms and conditions of FTX's obligations to
ANZ arising from
FTX's debt.
75.
There were four
relevant changes to this agreement which were finalised on 27 October 2005.
76.
The amendment regarding
the annual review process specifically articulated that ANZ would conduct a
review of each facility on or
about 30 November 2005 and thereafter on or about
1 September of each year. If ANZ did not conduct the review on or about 30
November,
ANZ could conduct the review at any time thereafter.
77.
Previously, the loan agreement allowed for
ANZ to call the debt immediately due and payable only if an event of default
occurred.
The amendments gave ANZ the enhanced power to call the debt
immediately due and payable without the previous requirement that FTX
default
upon its loan. The ANZ was able to call the debt, upon review and with at least
thirty (30) days notice.
78.
The annual margin
interest rates for the various loans increased as follows:
(i)
0.77% to
1.95% - Money Market,
(ii)
0.70% to 1.95% - Cash Advance,
(iii)
0.85% to 1.95% - Term Loan,
(iv)
1.05% to
1.95% - Leasing, and
(v)
0.65% to 1.95% - Supplier Finance
(vi)
2.75% - Short -Term Loan
79.
The Commission saw a report prepared by
Feltex management at the time of the changes to the facility agreement
reflecting a projected
annual cost of the increase in the margin interest rates
of $1,746,890. The Commission also heard that the FTX directors believed
that
correct calculation of the costs of the inquiries in the margin interest rate
was $1,155,105. The directors believed that the
figure of $1,746,890 included
increases in interest margin that occured prior to the changes to the facility
agreement and is based
on the assumption that all of the facilities were fully
drawn, which they were not. The Commission also heard that the directors
expected FTX's actual interest costs to decrease because the anticipated
restructuring would result in asset sales and repayments
of debt.
80.
The Commission is of the view that to appropriately fulfil
its continuous disclosure obligation FTX should have disclosed the increase
in
the margin interest rates, the projected costs of this increase, and the board's
broader expectations in relation to these costs
and any anticipated
savings.
81.
No disclosure was made to the market
at the time the facility agreement was renegotiated.
82.
Section 19 of the Securities Markets Act
1988 and the NZX Listing Rules govern the question of what information must be
disclosed
to the public by a public issuer. Specifically, Section 19B requires a
public issuer, such as FTX to disclose material information
to the public that
is not generally available to the market. Also a public issuer must disclose
such information in accordance with
the listing rules of the exchange on which
it is registered.
83.
Material information is
information that a reasonable person would expect to affect the price or value
of listed securities if the
information were generally available to the market
and relates to particular securities or a particular public issuer(s) rather
than
to securities generally or public issuers generally. Information would have
a material effect on the price or value of listed securities
of a public issuer
if the information would, or would be likely to, influence investors in their
decision to buy or sell those securities.
84.
In
the Commission's view, both the projected increased interest costs and the
changes to ANZ's review and cancellation rights under
the facility agreement
were likely to have been material to the market in terms of the Securities
Markets Act and section 10 of the
NZSX Listing Rules.
85.
The
Commission considered the information available to the market about FTX's
financial condition at the time of these changes in
the Fourth Restatement. The
April and June 2005 earnings downgrades would have created uncertainty for FTX's
potential earnings.
The projected increased interest costs were material to
FTX's expected earnings. While some savings might have been expected from
the
restructuring that could occur as a result of the increase to the facility, it
seems unlikely that any such cost savings would
have been apparent in the short
term. The interest cost increases, by contrast, were effective immediately. In
the Commission's view
these increased costs would have been expected to have a
material and negative effect on the company's profit forecasts, and should
have
been disclosed to the market.
86.
The other
material effect of the Fourth Restatement was to tighten the review requirements
under the facility agreement. The renegotiated
agreement gave ANZ the right to
review all facilities on 30 November 2005, or at any time thereafter if not done
at that time, and
to call all amounts due and payable on 30 days notice
following such a review. The bank could take this step even if FTX was not
in
breach of any of its loan covenants. These additional rights were added to the
agreement by ANZ in order to provide extra protection
for its own position.
87.
In the Commission's view these changes to
the facility materially changed the terms of FTX's debt funding arrangements.
They reduced
the company's expectation concerning the longer-term outlook for
its debt facility. This would, in the Commission's view, have been
likely to be
viewed by the market as a sign of significant concern on the part of the bank
about the company's prospects, and would
have been likely to affect market
confidence in the company, leading to a fall in the share price.
88.
The FTX directors, as reflected in the
opinion of their retained expert, stated that the amendments to the facility
agreement would
not have materially impacted the FTX share price because at the
time:
89.
Further, the directors' expert stated that
ANZ's right to call the facilities due and payable after the review date of 30
November
only advanced the bank's right to call the facilities by one month,
because the bank would have been able to call the facilities
at the covenant
breach on 31 December 2005.
90.
The Commission
has considered the expert's opinion. Notwithstanding that there may have been
market discounting, the Commission considers
that the facility amendment which
allowed ANZ to call the debt immediately due and payable with 30 days notice was
a significant
change in the relationship between FTX and its banker. Since FTX's
financial stability depended upon the continued support of ANZ,
the information
about the change in that relationship was material and should have been
disclosed to the market.
Conclusions
91.
The Commission finds that these
changes were material information that a reasonable person would expect to
affect the price or value
of listed securities, if the information were
generally available to the market, and would have been likely to influence
investors
in their decision to buy or sell FTX shares.
92.
Therefore, FTX should have disclosed the
changes to the market on 27 October 2005. Under the Securities Markets Act any
failure to
comply with the continuous disclosure provisions of the NZX Listing
Rules incurs civil liability for a company. The changes had not
been disclosed
to the market at 22 September 2006, the date that FTX was placed into
receivership. The company's business assets
were subsequently sold, and the
company was placed in liquidation by order of the High Court. FTX shares are not
trading on the NZX,
and the company currently has no material assets. Since
there is essentially no company against which to take an action, the Commission
will not pursue an action against FTX for its failure to disclose the changes to
the facility agreement.
93.
The Commission makes
no criticism of ANZ for its actions. As a significant creditor, ANZ was
concerned about the position of FTX and
was taking steps to protect ANZ's
position.
94.
At the time of the FTX directors'
conduct in failing to disclose the changes to the facility agreement, the
securities laws did not
attach liability to directors for continuous disclosure
violations. Since the time of this conduct, the securities laws have been
changed to include liability against the directors of a company for failing to
disclose material information. In the near future,
these changes will take
effect. However, the Commission must deal with the state of the securities laws
as they were at the time
of this conduct. Therefore, no further action will be
taken as to this matter.
Part VI FINANCIAL REPORTING OF THE BREACH OF BANKING COVENANTS IN THE 31
DECEMBER 2005 HALF-YEAR FINANCIAL STATEMENTS
95.
The
Commission addressed the financial reporting matter of whether FTX should have
disclosed that it breached its banking covenants
in its 31 December 2005
half-year financial statements.
96.
As at the
calculation date of 31 December 2005, FTX breached the interest cover and debt
cover ratios of its banking covenants. In
August or September 2005, the FTX
directors apprised ANZ that FTX anticipated breaching its banking covenants at
31 December 2005.
97.
FTX did not disclose this
breach of covenants in its 31 December 2005 half-year financial statements.
98.
New Zealand entities which are required to
comply with New Zealand Generally Accepted Accounting Practice (NZ GAAP) under
the Financial
Reporting Act 1993 are required to apply New Zealand Equivalents
to the International Financial Reporting Standards and Interpretations
(NZ IFRS)
issued by the International Accounting Standards Board (IASB) for financial
reports that cover the annual reporting period
of 1 January 2007. Early adoption
of these standards was allowed beginning 1 January 2005.
99.
FTX
chose to adopt NZ IFRS for the financial year ending June 2006 which therefore
required FTX to file its half-year financial statements
for 31 December 2005
under the NZ IFRS standards.
100.
FTX further
chose to have their auditors, Ernst & Young, conduct a review of the 31
December 2005 half-year financial statements
for compliance with NZ IFRS.
101.
The applicable financial reporting standard
is New Zealand Equivalent to International Accounting Standard 34 (NZ IAS 34),
paragraphs
16 & 17. This standard requires an entity, in the notes of its
interim financial statements, if material and if not disclosed
elsewhere in the
interim financial report, to disclose any loan default or breach of a loan
agreement that has not been remedied
on or before the balance sheet date.
102.
IFRS defines material in the context of
omissions and misstatements, which are material if they could influence the
economic decisions
of users taken on the basis of the financial statements.
103.
The Commission's view is that information
about FTX's breach of banking covenants was material information that should
have been disclosed
in the interim financial statements as required by NZ IFRS.
104.
The breach was an event of default, as a
result of which ANZ had a right to declare the debt immediately due and payable.
105.
Section 36A of the Financial Reporting Act
1993 requires that interim accounts comply with any applicable financial
reporting standards.
The FRA imposes criminal liability for offences under
section 36A. Every director who commits an offence under FRA section 36A is
liable on summary conviction to a fine not exceeding $100,000. This raises the
issue of possible criminal liability of the directors.
106.
Under section 40 of the FRA, there are
certain defences available to the directors, if the directors prove that they
"took all reasonable
and proper steps to ensure that the applicable requirement
of this Act would be complied with."
107.
The
directors took the following actions in their preparation of the 31 December
2005 financial statements:
108.
Nevertheless, the Commission
is of the view that the FTX board failed to pay sufficient attention to the
breach. They further failed
to appreciate FTX's financial reporting obligations
arising from the breach, which required FTX to disclose its breach in its 31
December 2005 financial statements.
109.
Directors of a company are primarily
responsible for the company's financial reporting. However, they are entitled,
in terms of fulfilling
their more general duties under the Companies Act 1993
section 138, to rely to a degree on professional advisers such as auditors.
The
role of the auditors in providing assurance about a company complying with its
financial reporting obligations is crucial.
110.
The FTX
directors submitted that they relied on the advice of Ernst & Young that the
31 December 2005 interim financial statements
complied with NZ IFRS. Ernst &
Young takes the view that an accounting firm (whether conducting an audit or a
review engagement)
does not provide advice to the to the directors of a company.
111.
At the hearings Stuart Painter, Ernst
& Young Australian partner, testified that during the course of the review,
he was aware
that FTX would breach its banking covenants and the process for a
review would be to make inquiries as to whether the bank was taking
action. He
stated that if FTX had breached its covenants and the bank wrote a no action
letter, then the breach would not need to
be disclosed. The Commission asked Mr
Painter, in relation to the disclosure requirements of NZ IAS 34 paragraphs 16
and 17, why
FTX did not disclose the breach of covenants in its 31 December 2005
half-year financial statements even though Ernst & Young
was aware that such
breach existed. Mr Painter testified that FTX had failed to make the disclosure
and that Ernst & Young did
not pick it up.
112.
There was no waiver letter from the bank
on or before balance date. It does not appear that Ernst & Young sought
evidence of a
formal waiver of the breach. Rather, they seem to have relied on
information provided by the company about FTX's banking relationship.
In this
regard, the failure of the company's directors to give sufficient weight to the
legal effects of the breach of covenants
and the changes to the facility
agreement appears to have been compounded by the auditors' failure to identify
financial reporting
errors. Regardless of the opinions held by the directors,
the auditors should have, upon learning that there had been a breach of
banking
covenants, sought verification that the breach had been formally waived,
otherwise the breach should have been disclosed.
113.
In its submission, Ernst & Young took
the position that a formal waiver of the breaches was not required from the ANZ,
because
ANZ was fully aware of the breach and was prepared to lend FTX
additional funds without exercising any rights of enforcement. Ernst
& Young
asserted that ANZ's conduct must have varied the covenant ratios which were
breached, or at the very least waived the
breaches of those ratios, by advancing
additional funds which would have themselves created breaches.
114.
According to the Fourth Restatement, "[n]o
failure to exercise and no delay in exercising any right, power or remedy under
any Financing
Document operates as a waiver."
Conclusions
115.
FTX should have disclosed the
breach of the banking covenants in its 31 December 2005 half-year financial
statements, because the
breach was material and could have influenced the
economic decisions of the users of the financial statements. The Commission has
determined that if the directors were confident of the bank's continuing
support, it would have been appropriate for the company
to seek a waiver of the
31 December covenant breach on or before the balance date of 31 December 2005.
Since there was no waiver
on or before 31 December 2005, the breach was not
remedied and under NZ IAS 34, paragraphs 16 & 17, the breach should have
been
disclosed.
116.
The failure to disclose
the breach of banking covenants was a breach of NZ IAS 34, an applicable
financial reporting standard.
117.
As outlined above, the
Commission is of the view that the FTX directors failed to pay sufficient
attention to the breach and failed
to consider whether there were financial
reporting obligations arising from the breach. The Commission notes that the
directors,
in their preparation of FTX's 31 December 2005 financial statements
took certain steps to ensure compliance with NZ IFRS. These steps
may provide
defences for the directors.
118.
It is not the
Commission's role to assess criminal liability and defences to such liability.
Therefore, the Commission refers this
matter to the Registrar of Companies for
that Office to determine whether to pursue criminal prosecution of the FTX
directors.
119.
Questions of liability under the Financial
Reporting Act arise only in regard to the conduct of the directors of a company.
Therefore,
the Commission is not able to refer this matter to the Registrar of
Companies in regard to the conduct of FTX's auditors, Ernst &
Young.
120.
The Commission views the failure of the FTX directors to
disclose to the markets the changes to the banking facility agreement as
a
significant and ongoing continuous disclosure breach. Had these changes to the
facility agreement been disclosed, this would have
informed the market of the
breach of the banking covenants. Therefore, the Commission has not specifically
considered the breach
of banking covenants as at 31 December 2005 as a
continuous disclosure issue.
Part VII CLASSIFICATION OF DEBT IN THE 31 DECEMBER 2005 HALF-YEAR
FINANCIAL STATEMENTS
121.
The changes to the ANZ
facility agreement and the 31 December 2005 breaches of banking covenants also
raised a question of whether
FTX properly classified its debt in its 31 December
2005 half-year financial statements.
122.
In
its 31 December 2005 half-year financial statements, FTX classified $116,842
million of its debt to ANZ as "non-current."
123.
NZ IAS 1 paragraph 60 changed, from prior
requirements under NZ GAAP, to require that a liability be classified as
"current" in the
balance sheet when the entity does not have an unconditional
right to defer settlement of the liability for at least twelve months
after the
balance sheet date.
124.
NZ IAS 1, paragraph 3,
which refers to the scope of the standard, states that certain parts of NZ IAS 1
do not apply to the structure
and content of interim financial statements as
they do to annual financial statements.
125.
Ernst & Young put forward an argument
as FTX's auditors that FTX did not need to classify its debt in the 31 December
2005 half-year
financial statements as it would have to under NZ IAS 1, because
the principles for classification of debt contained in NZ IAS 1
did not apply to
interim financial statements.
126.
However, NZ
IAS 34, paragraph 28, requires an entity to apply the same accounting policies
in its interim financial statements as
are applied in its annual financial
statements.
127.
When NZ IAS 1 paragraphs 60
and 3 are read together, there appears to be no applicable reporting standard
regarding the classification
of debt for interim financial statements as there
is for full-year financial statements. For matters where there is no provision
made in an applicable financial reporting standard, a reporting entity must look
to accounting policies that are appropriate to the
circumstances of the
reporting entity and that have authoritative support within the New Zealand
accounting profession. NZ IAS 1,
paragraph 60 provides appropriate authoritative
support for the choice of an accounting policy for classification of debt in
interim
financial statements.
128.
In the
Commission's view, it would be inconceivable to accept that different accounting
treatments can apply for interim and full-year
financial statements, because
such an interpretation would allow for two different classifications for the
same debt.
129.
The fact that FTX did not have
an unconditional right arises from the changes in the terms of the Fourth
Restatement and that ANZ
did not give FTX a formal waiver of the breach until
May 2006. Prior to May, FTX may have inferred from ANZ's conduct that no action
would be taken in consequence of the bank's right. However, after 27 October
2005, ANZ had the power, based on the terms in the Fourth
Restatement, to
conduct a review and to call the loan due and payable. This meant that FTX did
not have an unconditional right to
defer settlements of its loans for the twelve
months.
130.
The enhanced power given to ANZ in the Fourth
Restatement regarding the bank's ability to call the loan due and payable meant
that
FTX did not have an unconditional right to defer settlement of its debt for
twelve months. Without this unconditional right, FTX
should have classified its
debt as current.
131.
In addition, the breach of banking
covenants as at 31 December 2005, as discussed in the previous section, was an
event of default.
This gave ANZ an additional ground on which it could call the
loan immediately due and payable. Under NZ IAS 1, this right on the
part of the
bank required FTX to classify its debt as current, unless a formal waiver had
been delivered by ANZ to FTX no later than
31 December 2005.
Conclusions
132.
The Commission concludes that
FTX incorrectly classified its debt as non-current in the 31 December 2005
half-year financial statements,
because FTX did not have an unconditional right
to defer settlement of its debt for twelve months at 31 December 2005 and FTX
was
in breach of its banking covenants. We view FTX's incorrect classification
of debt as a breach of NZ GAAP, not a breach of an applicable
financial
reporting standard. Since the debt was not properly classified, the market was
uninformed about the status of FTX's debt.
133.
Questions of liability under FRA arise
only where there is a breach of an applicable financial reporting standard.
Therefore, the
Commission will not refer this report to the Registrar of
Companies in regard to the debt classification issue.
134.
The Commission is strongly of the view
that the classification of debt adopted by FTX in the December 2005 financial
statements was
incorrect and misleading. The changes brought about by NZ IFRS,
required that FTX's debt should have been classified as current.
However, it
appears that the classification of debt in interim financial statements may not
be expressly addressed by an applicable
financial reporting standard. As such,
the Commission refers this question to the ASRB to consider whether any guidance
or other
action is necessary.
Part VIII BOARD ISSUES
135.
Company directors
are responsible for corporate governance. High standards of corporate governance
provide accountability to shareholders
and enhance corporate performance.
136.
The Commission's inquiry has identified
several failures in FTX's financial reporting and continuous disclosure
compliance in 2005
and 2006. These are described above.
137.
The Commission has considered the
circumstances of the breaches identified in this report in terms of their
implications for the governance
of FTX. In the Commission's view these breaches
highlight corporate governance failures on the part of the Board of this
company.
138.
The matters discussed in this
report have a common feature - all concern FTX's debt facility agreement with
ANZ, changes to this facility,
and breaches by FTX of covenants under the
facility, and an apparent failure on the part of FTX's board and advisers to
fully understand
the implications of these matters.
139.
The Commission considered what steps the
FTX directors took to inform themselves of the changes to the facility agreement
required
by ANZ as a condition of the further funding. The evidence provided to
the Commission showed the following:
(a)
in early October 2005, the
board members had access to the ANZ Credit Approved Term Sheet which outlined
the increase in margin rates,
the facility review date of 30 November 2005, and
ANZ's ability to require repayment of the facilities; and
(b)
prior to the 25 October 2005 board meeting during which the board discussed
entering into the Fourth Restatement, board members were
sent a summary of
amendments prepared by the CFO, a solvency representation letter prepared by the
CFO, and a letter prepared by
FTX's external lawyers explaining the key changes
to the facility.
140.
The summary of amendments
prepared by the CFO showed the increase in margin rates for the facilities, the
proposed facility review
date of 30 November 2005, and the ability of ANZ, upon
review, to declare all sums immediately due and payable.
141.
The solvency document prepared by the CFO
advised that FTX could pay its debts as they fell due in the ordinary course of
business.
142.
The letter from FTX's counsel
advised the following changes to the facility agreement:
"1.
the
reduction of the Working Capital Facility commitment by A$5 million to A$35
million;
2.
incorporating an additional facility
to be provided by ANZ for A$10 million being a Short Term Facility to assist
funding the implementation
of Project Blue [a restructuring project]; and
3.
a requirement that all Facilities are to be
reviewable as of 30 November 2005. The effect of this means that the Facilities
may be
cancelled, amended or continued.
In relation to Item 3, if the facilities are to be cancelled, no less than 30
days notice must be given at which time the Facilities
are to be repaid. If the
Borrowers do not agree to the terms of any proposal to amend or continue the
Facilities within 15 days of
receiving the revised terms the Facilities can be
cancelled."
143.
It appears to the Commission
that the Board members were given sufficient information advising them of the
changes to the facility
agreement. They sought and obtained legal advice, which
also highlighted the key changes.
144.
Notwithstanding this, it appears that the
directors failed to recognize the significance of these changes, and failed to
consider
the changes in the context of the company's continuous disclosure
obligations.
145.
The Commission recognises
that at the time the FTX directors would have been most focussed on the
immediate need to obtain further
funding to carry out restructuring needed to
reduce costs for the company. The Commission has learned that consideration of
continuous
disclosure was a standing agenda item at every board meeting. The
directors of public issuers must recognise that at all times they
have an
obligation to the market, and to investors, to maintain appropriate standards of
continuous disclosure.
146.
The Commission
notes that the legal advice obtained by the FTX Board concerning the Fourth
Restatement did not address continuous
disclosure obligations. The Commission
has seen no evidence that the FTX Board sought advice on whether the changes to
the restatement
and the resultant increases in interest costs for the company
raised continuous disclosure issues. The Commission has not seen any
evidence
that the directors turned their minds to this question.
147.
The Commission heard from ANZ
representatives that the bank considered FTX to be a valuable customer, and that
the bank sought to
maintain a positive relationship. Notwithstanding this, the
directors should have been alert to the changes to the facility agreement
obtained in exchange for the further restructuring advance, the effect these had
in strengthening ANZ's rights under the agreement,
and the effects of this for
FTX and its disclosure obligations.
148.
From
the evidence it has seen, the Commission is of the view that the FTX directors
failed to give sufficient emphasis to the changes
to the terms of the facility
agreement largely because of the strong belief, shared by all directors from
whom the Commission heard,
that the company's relationship with ANZ was strong
and supportive.
149.
This continuing belief,
shared by the entire Board, that the bank's attitude to FTX was entirely
supportive, appears also to underlie
the disclosure failures in the December
2005 interim financial statements. As described earlier in this report the
Commission has
found that FTX should have disclosed the breach of its banking
covenants in its interim financial statements. It should also have
classified
debt owed to ANZ under the facility agreement as current debt. The Commission
questioned the FTX directors about these
matters. Their evidence demonstrated
that the focus of the Board was on the apparent strength of the banking
relationship. None of
the company's directors appear to have contemplated that
ANZ might act on the 31 December 2005 covenant breaches. This belief was
based
on ongoing discussions with ANZ personnel, and the fact that in August or
September 2005, the FTX directors apprised ANZ that
FTX anticipated breaching
certain of its banking covenants.
150.
It can
be appropriate for a company's directors, when considering issues such as
whether a company is able to pay its debts as they
fall due, to take into
account the commercial substance of its arrangements, including the attitude of
creditors. However, the starting
point of any assessment of a company's debt
position must be the legal rights of creditors. This is even more important
where a company
is in a difficult financial position, or has significant
vulnerability to the actions of a single creditor.
151.
In the Commission's view the FTX directors
failed to give due weight to the legal effects of the changes to the facility
agreement
and the 31 December covenant breach. When FTX breached its facility
covenants this gave ANZ a further ability to call debts due and
payable. The FTX
directors clearly had no expectation that this would be done in the short term,
but their belief did not change
the rights held by ANZ, and the effects of this
on the status of FTX's debt for the purpose of New Zealand equivalents to the
International
Financial Reporting Standards. Had FTX's directors given
sufficient weight to the legal position of ANZ this may have led them to
ask
more pressing questions about the impact of the covenant breach and the restated
review and call-in rights of the bank on the
company's financial reporting
obligations.
152.
If the debt had been properly
classified as current in FTX's 31 December 2005 half-year financial statements,
the Commission believes
that there would have been significant market focus on
ANZ's ability to declare the debt immediately due and payable, resulting in
negative consequences for FTX.
153.
The FTX directors at this
time placed a great deal of weight on the continuing support of ANZ. This in
itself may have been a reasonable
judgement at the time. However, in so doing
the directors failed to sufficiently consider the changes that were taking place
to the
bank's legal rights as a creditor of FTX. The 31 December 2005 covenant
breach should have been disclosed in the interim financial
statements. The debt
should have been classified as current. Neither of these things was done,
largely it appears because the directors
failed to appreciate the legal rights
of the bank which determined the company's financial reporting obligations.
Instead, the directors
relied on an expectation that in practice the bank would
continue to support the company, whatever the legal position.
Conclusions
154.
On the evidence it
has heard, the Commission concludes that the FTX directors were, generally,
sufficiently aware of the financial
position of the company in late 2005 and
early 2006. They were aware that the company was in difficulty, and took steps
to attempt
to address this. Notwithstanding this, the directors gave
insufficient attention to the continuous disclosure ramifications of the
October
2005 facility restatement. They failed to seek specific advice on the continuous
disclosure implications of the restated
agreement. They gave insufficient
attention to the enhanced powers of the bank, despite clear legal advice on the
point.
PART IX AUDITOR CONDUCT
155.
The
Commission has assessed Ernst & Young's conduct in regard to their advice
regarding the transition to NZ IFRS and their review
engagement of the FTX 31
December 2005 financial statements.
156.
In the
period leading up to the preparation of its first NZ IFRS accounts, FTX engaged
Ernst & Young for the following services,
and paid fees for such services:
a.
Impact assessment of FTX's NZ IFRS transition;
b.
Review of the 31 December 2005 FTX financial statements; and
c.
Audit of the FTX opening balance sheet as at 1 July 2004 and
the restatement of the 30 June 2005 results in accordance with NZ IFRS.
IFRS Impact Assessment
157.
FTX appropriately
commissioned Ernst & Young to conduct a specific project to address its
transition to NZ IFRS. This project
was intended to provide an assessment of the
significant impacts of NZ IFRS for FTX.
158.
This work done by Ernst & Young in
October 2004 did not identify for FTX, the different basis upon which debt is
classified under
NZ IFRS, in contrast to previous NZ GAAP. It did not highlight
the requirement for non-current debt that there be an unconditional
right to
defer payment for twelve months.
159.
The
Commission recognises that in October 2004 FTX did not have a precarious debt
position and therefore the classification of debt
issue was not as significant
for FTX as it was in 2005.
December 2005 Review
160.
FTX engaged Ernst
& Young to carry out a review of its 31 December 2005 interim financial
statements. A review is not an audit.
It provides a lesser degree of assurance,
and is based primarily on information given to the reviewer by the client,
rather than
an independent verification of information provided.
161.
NZ RS-1 Statement of Review Engagement
Standards sets out review standards applicable to a review engagement.
162.
In accordance with Review Standard 3 of
New Zealand RS-1: Statement of Review Engagement Standards: a review
engagement should be performed and its report prepared with due care by persons
who have adequate training, experience and
competence in the review of financial
information.
163.
The reviewer is required to
obtain sufficient and appropriate evidence, primarily through inquiry and
analytical procedures, to be
able to express a negative assurance opinion in the
review report.
164.
Furthermore, the New
Zealand Review Engagement Guideline (RG-1) paragraph 3 requires that if,
based on enquiry and analytical review procedures, the auditor has reason to
believe that the financial statements
being reviewed may not give a true and
fair view, then the auditor has a duty to carry out additional and more
extensive procedures
to enable a negative opinion to be expressed on the report
or to conclude that that such an opinion cannot be given.
165.
The 31 December 2005 review failed to pick
up the non-disclosure of the covenant breaches, and failed to pick up the
incorrect classification
of debt by the company. In the Commission's opinion an
adequate review would have identified both of these issues. The Commission
believes that Ernst & Young, had it carried out the review engagement
appropriately, would have enquired further into the company's
debt arrangements,
and read the Fourth Restatement. Even without doing this Ernst & Young
should have considered the impact of
a known breach of banking covenants on the
company's financial statements. The breach of banking covenants should also have
prompted
Ernst & Young to enquire further about proper debt classification
in terms of NZ IAS 1.
166.
Gordon Fulton, an
Ernst & Young partner, was the audit partner in charge of the review
engagement for FTX's 31 December 2005 interim
financial statements, although
most of the field work was carried out by Ernst & Young Australia in
Melbourne. He told the Commission
that classification of debt was not
specifically addressed as part of the review engagement by Ernst & Young and
that Ernst &
Young did not give FTX any specific advice regarding the
classification of debt.
167.
Stuart Painter,
the partner of Ernst & Young Australia who led the work done by Ernst &
Young Australia on the review engagement
of FTX's 31 December 2005 interim
financial statements, also gave evidence to the Commission. He testified that
there was no specific
guidance given to FTX by Ernst & Young and that FTX
did not seek advice from Ernst & Young in regard to classification of
debt
in the 31 December 2005 financial statements. He stated that Ernst & Young
expressed a negative assurance opinion to FTX
regarding those financial
statements; the classification of debt as a non-current liability was part of
the financial statements;
and nothing came to Ernst & Young's attention
during the course of the review which suggested that the classification should
be changed.
168.
Mr Painter stated that FTX had
failed to make the disclosure and that Ernst & Young, although aware of the
covenant breaches,
did not pick it up.
169.
In
accordance with Review Standard 7 of New Zealand RS-1: Statement of Review
Engagement Standards, where the reviewer has cause to doubt the assertions
provided to it by management, the reviewer should seek evidence to substantiate
the assertions of management.
170.
From its
history as FTX's auditor, Ernst & Young had a thorough knowledge of FTX's
business given that FTX was a long term audit
and business client of Ernst
&Young.
171.
With such an in-depth
knowledge of FTX, events such as the breach of banking covenants, changes to the
Fourth Restatement and the
new disclosure requirements arising from changes from
NZ GAAP to NZ IFRS, should have prompted Ernst & Young to enquire further.
It should have been apparent to Ernst & Young, as an accounting expert, to
see the relationship between these matters and therefore
conduct their review to
ensure FTX's financial statements complied with NZ IFRS.
172.
In its submission to the Commission, Ernst
& Young, New Zealand asserts there was not a significant change in the
requirements
for classification of debt from previous NZ GAAP to NZ IFRS.
173.
The Commission believes that Ernst & Young should have
appreciated the significance of the change in requirements as a result
of the
change to NZ IFRS in terms of how this affected disclosure of the breach of
banking covenants and the classification of FTX's
debt.
174.
Ernst & Young should have, upon
learning that there had been a breach of banking covenants, sought confirmation
that the breach
had been formally waived, regardless of the opinion held by the
directors about the banking relationship.
175.
Ernst & Young relied on information
provided by the company about FTX's banking relationship. In this regard, the
failure of the
company's directors to give sufficient weight to the legal
effects of the breach of covenants and the changes to the facility agreement
appears to have been compounded by Ernst & Young's failure to identify
financial reporting errors.
176.
The failures of the FTX board
and Ernst & Young to appreciate the NZ IFRS requirement regarding the debt
resulted from a lack
of understanding of the NZ IFRS requirements by all
parties. The directors assessed the company's debt primarily by reference to
the
bank's continuing, but informal, support for the company, not by reference to
the rights of the bank under the Fourth Restatement.
Ernst & Young relied,
in the context of a review engagement, on FTX's views about the banking
relationship. This reliance was
misplaced, in view of the information available
to the auditors concerning the fragility of the company's financial position,
its
dependence on the ANZ facility, the restatement of that facility in October
2005, and the breach of covenants in December 2005.
177.
Review
Standard 6 Documentation of NZ RS-1 requires the reviewer to document
matters which are important in providing evidence that the review was carried
out in
accordance with the Review Engagement Standards and support the level of
assurance provided.
178.
The Commission would
have expected Ernst & Young's working papers to discuss the basis for their
conclusions; e.g.:
(a)
details of discussions with FTX staff and the
questions they asked;
(b)
reasons as to why they believed that
the breach had been remedied as at 31 December 2005; and
(c)
the
basis on which they believed that the debt was unconditional as at 31 December
2005.
179.
In reviewing Ernst & Young's
working papers, the Commission has concerns that Ernst & Young did not ask
the right questions.
180.
Ernst & Young's
main working paper on loans payable that addressed compliance with loan
agreement provisions does not mention
the 31 December 2005 breach, how the
breach had been remedied, or whether the loans classified as non-current were
unconditional.
This is surprising given the known existence of a breach and the
requirements of both NZ IAS 1 and NZ IAS 34.
181.
A checklist completed in the course of the
review included an item for noting whether there had been any loan default or
breach of
a loan agreement, not remedied on or before the reporting date. Ernst
& Young marked this item "not applicable". There is nothing
recorded on the
checklist or otherwise in the review working papers that explains how this
conclusion was reached.
182.
In a separate
going concern checklist that Ernst & Young completed for the review they
responded as follows:
(a)
"ANZ facilities have been renegotiated and
there is no indication from the bank that they will not support Feltex".
(b)
For the question "[a]re the entity's borrowing and bank
facilities approaching maturity with uncertainty as to the prospects of renewal
or repayment?" they responded "[n]o" then went on to say "[n]o indication of no
bank support."
(c)
For the question "[i]s the entity having
difficulty in complying with the terms of loan agreements or the need to
restructure debt?"
they responded "[y]es. Company has renegotiated ANZ loan
facilities."
183.
The Commission cannot see how
negotiation of the Fourth Restatement in October meant that no issue remained in
respect of the breach
given that the breach occurred some months later on 31
December 2005.
184.
It is difficult, if not
impossible, in the context of a review engagement for the reviewer to rely
simply on a "no indication of no
bank support" when seeking to gain sufficient
evidence that a breach has been remedied and that an unconditional right existed
as
at 31 December 2005. The nature of the assertions being made, i.e. the breach
has been remedied and the facility is unconditional,
should have prompted a
reviewer to ask more questions, and in all likelihood seek access to relevant
documentation or else seek independent
assurances.
185.
The Commission notes that there is
differing evidence in regard to whether FTX provided a copy of the Fourth
Restatement to Ernst
& Young. Ernst & Young personnel indicated that FTX
failed to provide to Ernst & Young a copy of the Fourth Restatement
and a
member of FTX's management team asserted that he did provide such a copy.
186
The Commission's conclusions regarding Ernst &
Young's responsibilities do not turn on whether or not Ernst & Young was
provided
a copy of the Fourth Restatement.
Conclusions
187.
It is particularly important
for both companies and auditors to understand the terms of any review engagement
which they enter into.
The Commission takes the view that notwithstanding the
particulars of a review engagement, auditors are reasonably viewed as advisers.
It is reasonable under section 138 of the Companies Act for the directors of a
company to rely on the accounting firm (whether their
advice is given pursuant
to an audit or a review engagement). The Commission believes that this view is
widely shared by company
directors in New Zealand.
188.
In its submission to the Commission, Ernst
& Young New Zealand asserts that an accounting firm (whether conducting an
audit or
a review engagement) is not an adviser to the directors of a company.
189.
Ernst & Young, New Zealand takes the
position that it is not appropriate for them to comment on whether directors
might be able
to assert a legitimate defence that they were relying on the
advice of auditors.
190.
The Commission
considers that Ernst & Young failed in its professional responsibility by
not recognising the change in the classification
of debt from NZ GAAP to NZ IFRS
and how this change affected FTX in December 2005.
191.
The Commission does not consider that work
done by Ernst & Young and the responsible partner Gordon Fulton, in their
review of
FTX's 31 December 2005 financial statements, met the required
standards of a review engagement. Ernst & Young and the responsible
partner
failed to inquire sufficiently about the status of FTX's debt to ANZ, failed to
identify that breaches of banking covenants
were required to be disclosed, and
failed to review the Fourth Restatement in order to understand the status of the
banking relationship.
The Commission believes that the work of Ernst & Young
New Zealand and the responsible partner Gordon Fulton fell below the standards
required by NZ RS-1 Statement of Review Engagement Standards. The
Commission will refer Ernst & Young New Zealand and the responsible partner
Gordon Fulton to the NZICA.
192.
Since
questions of liability under FRA do not arise in regard to the conduct of
auditors of a company, the Commission is not able
to refer Ernst & Young to
the Registrar of Companies in regard to FTX's failure to disclose the breach of
its banking covenants
in its 31 December 2005 interim financial statements.
PART X OTHER ISSUES
Responsibility For Audit Working
Papers
193.
From 2003 to 2006, Ernst & Young
provided audit and review engagement services to FTX. Ernst & Young New
Zealand was the contracting
party with FTX for these services. However, Ernst
& Young New Zealand had Ernst & Young Australia conduct some of the work
because FTX had its headquarters in Australia. When the Commission requested
working papers prepared by Ernst & Young Australia,
Ernst & Young New
Zealand took the position that it was a separate entity from Ernst & Young
Australia and that Ernst &
Young New Zealand did not have control over any
working papers produced by Ernst & Young Australia.
194.
Ernst & Young New Zealand told the
Commission that the work carried out by Ernst & Young Australia was carried
out pursuant
to a subcontracting relationship in accordance with Ernst &
Young's standard terms and conditions which reflect current market
practice.
195.
The Standard Terms and Conditions of
Business as articulated by Ernst & Young New Zealand's contract with FTX for
the review engagement
of the 31 December 2005 FTX financial statements state
that, at times, Ernst & Young New Zealand may use the partners or staff
of
other member firms of Ernst & Young Global Limited and Ernst & Young
International Limited, wherein the other members
are deemed to be acting as
servants or agents of Ernst & Young New Zealand and Ernst & Young New
Zealand is liable for the
activities of partners or staff of other members as if
they were the partners or staff of Ernst & Young New Zealand.
196.
Ernst & Young New Zealand submitted to
the Commission that it is a separate legal entity from Ernst & Young
Australia and
that, pursuant to New Zealand Auditing Standard 602, Ernst &
Young New Zealand does not have control over the working papers
of Ernst &
Young Australia in regard to the FTX review engagement.
197.
New Zealand Auditing Standard 602, Using
the Work of An Other Auditor, states that "[u]nless otherwise agreed, the
working papers
of the other auditor shall remain the property of the other
auditor."
198.
The Commission concludes that
under Ernst & Young New Zealand's Standard Terms and Conditions of Business,
the work undertaken
by Ernst & Young Australia was done on an agency basis
for Ernst & Young New Zealand.
199.
Notwithstanding that the working papers
are the property of Ernst & Young Australia under New Zealand Auditing
Standard 602, the
Commission considers it is unacceptable for the auditor of a
New Zealand issuer not to retain control of the full records of its
audit (or
review), which would include the records of the work done by any agent, even
though considered the property of such agent
under New Zealand Auditing Standard
602.
200.
We refer this matter to NZICA to
consider whether the New Zealand Auditing Standards should be reviewed in this
regard.
Other Matters
Considered
201.
The Commission reviewed the IPO
allocations of the joint-lead IPO managers, Forsyth Barr Limited and First New
Zealand Capital and
the institutional and investor participation in the IPO. The
Commission found no unusual activity.
202.
The
Commission reviewed trading in the FTX shares of two companies, Forsyth Barr
Limited and First New Zealand Capital, including
their employees, officers, and
directors during time periods surrounding certain of their market announcements.
The Commission found
no unusual trading activity.
203.
The Commission considered the trading
activity of FTX directors and officers. The Commission found that the executive
officers of
FTX properly disclosed their transactions to the NZX.
204.
The Commission also considered the
disclosure of information by FTX to analysts relating to the breach of banking
covenants around
the time of FTX's second profit downgrade on 20 June 2005.
Three analysts who forecast in research reports the possible breach by
FTX of
its banking covenants were interviewed. The Commission found that there was no
indication that the analysts had access to
non-public information from FTX when
they forecast the possible breach of banking covenants.
Part XI CONCLUSIONS AND REFERRALS
205.
The
Commission has concluded that:
206.
The Commission has
concluded that the disclosure breaches show that the FTX Board failed to pay
sufficient attention to the continuous
disclosure and financial reporting
compliance issues arising from changes to the facility agreement and the breach
of banking covenants.
207.
Since FTX is in liquidation and
liability for continuous disclosure breaches lies only against the issuer
concerned, there is no realistic
chance of taking enforcement action in these
circumstances. The Commission will take no further action in regard to FTX's
failure
to disclose to the market the changes to the facility agreement.
208.
The Commission refers this report to the
Registrar of Companies to consider whether any action should be taken against
the FTX directors
under FRA.
209.
The
Commission has concluded that the work undertaken by Ernst & Young New
Zealand and the responsible partner Gordon Fulton in
their review of the 31
December 2005 half-year financial statements failed to meet the standards
required for such an engagement.
210.
The
Commission refers this report to NZICA to consider whether any action should be
taken against Ernst & Young New Zealand and
the responsible partner Gordon
Fulton.
211.
FTX's failure to properly classify
the debt in its 31 December 2005 half-year financial statements has highlighted
that the classification
of debt in interim financial statements may not be
expressly addressed by an applicable financial reporting standard. The
Commission
refers this matter to the ASRB to consider whether any guidance or
other action is necessary.
212.
The Commission
considers it is unacceptable for the auditor of a New Zealand issuer not to
retain control of the full records of its
audit or review. We refer this matter
to NZICA to consider whether the New Zealand Auditing Standards should be
reviewed in this
regard.
213.
Since questions
of liability under FRA do not arise in regard to the conduct of auditors of a
company, the Commission is not able
to refer Ernst & Young to the Registrar
of Companies in regard to FTX's failure to disclose the breach of its banking
covenants
in its 31 December 2005 interim financial statements.
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