Opi Pacific Finance Limited (in liquidation and in receivership) v Sherwin Chan & Walshe

[2014] NZHC 449

IN THE HIGH COURT OF NEW ZEALAND WELLLINGTON REGISTRY

CIV-2013-485-3914 [2014] NZHC 449

BETWEEN  OPI PACIFIC FINANCE LIMITED (IN LIQUIDATION AND IN RECEIVERSHIP)

Plaintiff

ANDSHERWIN CHAN & WALSHE Defendant

Hearing:                   27 February 2014

Counsel:                  S A Shortall, O J Meech and A C Payne for defendant/applicant

M J Tingey and T B Fitzgerald for plaintiff/respondent

Judgment:                12 March 2014

RESERVED JUDGMENT OF DOBSON J (Defendant’s application to strike out parts of the claim)

[1]      This judgment deals with an application on behalf of the defendant (SCW) to strike out components of the claims brought against it in the proceedings.   The claims relate to alleged breaches of contractual and tortious obligations owed by SCW to the plaintiff in relation to SCW’s audit of the plaintiff’s financial statements for the year ended 31 March 2007.   The claims also allege breaches of additional responsibilities arising in the course of that audit to discharge certain statutory obligations imposed under the Securities Act 1978 on the completion of an audit for a company that is the issuer of a prospectus for the raising of money from the public.

[2]      The ground for the strike out application is that there is no tenable basis on which the plaintiff could make out that any of the errors or omissions alleged against SCW could have been causative of certain components of the losses that have been

claimed.

OPI PACIFIC FINANCE LTD (IN LIQ AND IN REC) v SHERWIN CHAN & WALSHE [2014] NZHC 449 [12 March 2014]

Factual circumstances

[3]      From at least 2000 and possibly earlier, the plaintiff was in business as a finance company that offered both secured debenture stock and unsubordinated, unsecured debt notes to the public.  At the time of events relevant to this claim, the company was called MFS Pacific Finance Limited.   Subsequent to the relevant events, it has had  a change of  name to  OPI Pacific Finance  Limited.   (In this judgment, it will be referred to as MFS Pacific.)

[4]      In the usual way for finance companies of its type, MFS Pacific had entered into  a  debenture  trust  deed  with  Perpetual  Trust  Limited  (the  trustee)  dated

12 November  1999  that  regulated  the  relationship  between  the  plaintiff  and  the trustee for debenture holders.  It then periodically issued prospectuses in reliance on which investors placed money with the company.

[5]      MFS Pacific was, at the relevant time, a less than wholly owned subsidiary of an Australian listed entity that was then MFS Limited.  The parent company changed its  name  to  Octaviar  Limited  in  early  2008  (Octaviar).    Octaviar  provided  a somewhat unusual form of support for MFS Pacific by means of a put option that obliged Octaviar to buy any of MFS Pacific’s loan advances that were more than three months in arrears, for the then face value of such loans (the put option).

[6]      In  mid  January 2008,  Octaviar  announced  the  separation  of  its  financial services business from travel and tourism businesses conducted by other members of the group.  It appears that was treated by financial markets as a signal that the parent company was in difficulties.  The statement of claim pleads that, by 30 April 2008, MFS Pacific was in breach of its trust deed and had a shortfall to creditors of some

$334.8 million.  At that time, MFS Pacific proposed a moratorium designed to allow a less pressured realisation of assets.   That proposal was agreed to in May 2008. However, in September 2009, receivers were appointed to MFS Pacific at the instigation of the trustee.

[7]      SCW was the auditor of the financial statements for MFS Pacific for its financial  years  ended  31 March  2000  to  2007.    SCW’s  audit  of  the  financial statements for the year ended 31 March 2007 was completed on 16 August 2007.  It

resulted in the auditors providing to the shareholders an unqualified report on the financial statements and, in addition, a report to shareholders, debenture holders and the trustee as required under provisions of the Securities Act and the Securities Regulations 1983.

[8]      In the first cause of action, the statement of claim particularises numerous breaches of contractual duties owed to MFS Pacific in relation to the conduct of its audit.   The second cause of action pleads negligent misstatement in breach of a common law duty to exercise the care, diligence and skill of a reasonable auditor in the same circumstances.  Negligent misstatements are alleged to have arisen from the terms of the reports completed by SCW at the conclusion of its audit, and in complying with the requirements under the Securities Act and Regulations.

[9]      The  statement  of  claim  alleges  that  if  SCW  had  completed  the  audit competently, the terms of its inevitably different audit report would have caused MFS Pacific to cease trading by 14 September 2007.  In reliance on that proposition, MFS Pacific claims to have suffered loss in two respects.   First, it quantifies the resulting loss as the net loss incurred in respect of advances (including re-advances) made after that date, and up until MFS Pacific ceased trading when receivers were appointed in September 2009 (the lending claim).

[10]     Second,  it  pleads  a further loss  on  the  basis  that,  if  the  audit  had  been completed competently, then the directors would have exercised the put option requiring Octaviar to pay MFS Pacific the face value of loans then in arrears for three months or more.  The statement of claim alleges that was some $61.6 million. Instead, the only payment subsequently received under the put option was some

$23.1 million.  The loss is calculated as the difference between those two amounts realised out of the put option (the put option claim).

[11]     The principal criticism of SCW’s performance of the 2007 audit relates to their acceptance of the proposed mode of valuing MFS Pacific’s loan book, which comprised its major asset.  The claim is that SCW failed to assess even a sample of major loan  exposures  to test  whether they were impaired  so  that  there was  no consideration of whether the value of the loans should be written down as an asset in

the financial statements.   The case for MFS Pacific will be that numerous of the major loans were seriously impaired, so that the auditors should not have accepted the loans being included at their face value in the financial statements.

[12]     The claim is on the basis that SCW should not have accepted the approach urged on them by management and/or the board of MFS Pacific, to the effect that all loans could be treated as having their full face value because of the existence of the put option.  The company reasoned at the time that MFS Pacific was not exposed to any risk that it would not recover the full amounts owed on any of its loans because once there had been a default on any particular loan for a period of three months, the company could require Octaviar to buy the loan at its face value, thereby passing the credit risk for non-recoverability of the loan to Octaviar.  At the time, Octaviar was supposedly  in  a  strong  financial  position,  so  that  there  was  no  credit  risk  that Octaviar would not be able to honour its commitments under the put option.

[13]     It will be argued for MFS Pacific that the manner of accounting for the value of loan assets by taking into account the existence of the put option (as accepted by SCW) breached relevant accounting standards and caused incorrect or misleading reporting to the trustee on various of the criteria and ratios provided for in the trust deed.  Those deficiencies in the reporting allegedly impaired the trustee’s ability to monitor the risk of loss to the investors in debenture stock.

[14]     There are other strands to MFS Pacific’s case. The receivers will argue that if the audit had been done competently, SCW would either have refused to provide an unqualified audit report, or would have required re-casting of the accounts to an extent that showed the company was insolvent.   The receivers will argue that, in either event, the trustee would have stepped in and appointed receivers.  Somewhat less drastically, if the auditors had insisted on the loan book being valued correctly, then (even if the dire financial position did not provoke the appointment of receivers) the financial position would have been shown to be sufficiently weak that there would  have  been  no  point  in  issuing  a  prospectus  to  raise  further  funds  from investors.

[15]     The provisions in the Securities Act and Regulations governing the content of lawful prospectuses require that a prospectus relies on audited financial statements for a period ending no  more than nine months earlier.   However, an  extension certificate for an existing prospectus can extend the life of a prospectus in reliance on more recent unaudited financial statements.   Such an extension certificate requires two directors to confirm certain details to the effect that there has been no material adverse change.

[16]     In MFS Pacific’s case, it issued a prospectus on 14 September 2007 that relied  on  the  financial  statements  to  31 March  2007  as  audited  by SCW.    The prospectus therefore needed an extension certificate before the end of December, or it  would  expire  at  that  time.    On  21 December  2007,  two  of  the  MFS  Pacific directors completed such a certificate enabling the September prospectus to be extended.   In accordance with the statutory requirements, the certificate stated the opinion of all the directors of the company that:

…  after  due  enquiry  by  them  …  the  financial  position  shown  in  the statement of financial position contained in the registered prospectus has not materially and adversely changed during the period from the date of that statement of financial position (being 31 March 2007) to the date of this certificate.

[17]     The other element of the certificate  was to the effect that the registered prospectus was not, at the date of the certificate, “… false or misleading in a material particular by reason of failing to refer, or to give proper emphasis, to adverse circumstances”.   The unaudited financial statements for the six month period to

30 September 2007 accompanied the certificate.

Relevant law on causation

[18]     There have been  numerous attempts to strike out claims brought against auditors on the ground that any negligence that might be made out could not be causative of the types of loss claimed.  Mr Meech could not identify a case that was

analogous to the arguments he presented in this case, in which a strike out has been successfully maintained.1

[19]     There have been numerous cases in which claims have been brought against auditors on the basis that a competent audit would have identified insolvency or sufficient financial difficulties to have caused a halt in the company’s trading.  The extent of increased losses incurred from the point at which a competent audit ought to have brought trading to a halt has been claimed on the basis that that is the loss caused by the negligent audit.

[20]     Perhaps  the  high-water  mark  of judicial  opinions  doubting the necessary causative link between a negligent audit permitting a company to continue trading, and the losses resulting from continuation of trading, comes from the judgment of Mahoney JA in the Court of Appeal of New South Wales:2

But allowing the company to remain in existence does not, without more, cause losses from anything which is, in that sense, a danger incident to existing.

[21]     That  observation   on   causation   was   cited   with   apparent   approval   by Glidewell LJ in the English Court of Appeal decision in Galoo,3 and via that source by McKay J in the New Zealand Court of Appeal decision in Sew Hoy.4

[22]     A somewhat similar caution about the need for a causative link between an auditor’s breach of duty and losses of this type was signalled in the judgment of Henry J in Sew Hoy:5

The question which arises is whether a bare allegation that trading continued as a result of the breach is sufficient to link the breach with the trading loss subsequently incurred.   It is this step in the plaintiff’s case which I think causes difficulty.  Profits and losses from trading are not caused by the fact that trading is undertaken, which does no more than present the opportunity to make profits or incur losses.  Profits and losses result from, and adopting a

1      The decisions Mr Meech suggested were closest to the arguments he advanced were Sew Hoy & Sons Ltd (in rec and in liq) v Coopers & Lybrand [1996] 1 NZLR 392 (CA) [Sew Hoy] and Belgrave Finance Ltd (in rec and in liq) v Schofield [2012] NZHC 2916.

2      Alexander v Cambridge Credit Corporation Ltd (1987) 9 NSWLR 310 at 334.

3      Galoo Ltd (in liq) v Bright Grahame Murray (A Firm) [1994] 1 WLR 1360 at 1371, [1995]

1 All ER 16.

4      Sew Hoy, above, n 1, at 398.

5      At 404.

commonsense  viewpoint are caused by,  the incidents  of trading and the circumstances which affect it.

[23]     Both parties focused on the decision in Sew Hoy.  In that case, the allegation was that the auditors had confirmed an overvaluation of stock, resulting in an overstatement of the surplus of assets over liabilities and the resulting net profits. The claimant alleged that a competent audit would have caused the company to cease trading, when in fact it continued trading, eventually suffering greater losses, the extent of which was the subject of the claim.

[24]     The  High  Court  had  struck  out  the  statement  of  claim,  subject  to  the entitlement for the company to re-plead the nature of causative links between the allegedly negligent audit, and losses subsequently incurred.

[25]     The  Court  of Appeal  reversed  that  decision,  finding  that  the  nature  and closeness of the link between allegedly negligent components of an audit, and losses subsequently incurred by the company, were dependent on a full analysis of the facts to an extent that untenability of the alleged causative link could not be decided without evidence at trial.

[26]     Decisions on causation in this area reject the notion that causation on a “but for” basis is adequate.6   In other words, it is not enough for the plaintiff to claim that a  competent  audit  would  have  stopped  the  company trading,  so  that  the  losses incurred as a result of continued trading are caused by the negligent audit.   The causative link has to be stronger than that, in that the losses claimed from subsequent trading have to have been caused by the negligent elements of the audit.

The lending claim

[27]     The partial strike out application on the lending claim was pursued on the

basis that the directors’ conduct in issuing the extension certificate on 21 December

2007 brought to an end any reliance there might have been, up to that point, on the audit work and audit reports that SCW had completed some months earlier.

6      For example, Sew Hoy, above n 1, at 395/25.

[28]     Mr Meech also argued that any residual relevance to the audit confirmation that might usually have continued was eliminated by a change in accounting standards.  The full year accounts to the end of March 2007 were the last prepared in compliance with New Zealand Generally Accepted Accounting Practice (GAAP), and  the  six  month  financial  statements  to  30 September  2007  were  the  first completed  in  compliance  with  New Zealand  International  Financial  Reporting Standards (IFRS).

[29]     After it completed the 2007 audit, SCW were given notice that they would not be re-appointed as the company’s auditors.  SCW were reasonably led to believe that Ernst Young were being appointed.  An additional factor in the break between reliance on the audited financial statements to 31 March 2007, and the more recent picture of the company’s financial position as presented in the unaudited statements to 30 September 2007, was arguably the expectation that the company would have taken external advice on how matters were to be re-cast in the first set of financial statements pursuant to the new accounting standards.

[30]     Because the directors had sole responsibility for the financial statements to

30 September 2007, SCW argued that they had “taken ownership” of the content of the financial statements.   This included comments in their report illustrating the significance of the put option, its importance to MFS Pacific’s business model and their view that the state of affairs of the company was “satisfactory”.  In addition, the directors provided a summary of the position regarding security over the loan portfolio, including the ratios of the loan book secured by first, second and third mortgages, the proportion of unsecured loans, and the position in respect of past due loans.  The directors expressed the opinion that they did not consider any past due loans were impaired.  The distinction was made between “impaired” and “past due”, in that the directors had control over whether loans were categorised as past due, and using that status gave them the ability to exercise the put option.

[31]     The aspect of the strike out relating to the lending claim was brought on the basis that any further lending after 21 December 2007 could not be attributed to the audit work SCW had done in relation to the financial statements to 31 March 2007. Arguably, the impact of the audit report was effectively overtaken or “spent” by the

issue of the more recent half-yearly financial statements.  It was submitted that the most recent accounts and most recent opinion of the directors would be the obvious source of reliance once those were available.  The directors must have known that they took full responsibility for those financial statements and the accompanying commentary.  Accordingly, there was no tenable basis to claim that the audit opinion in  relation  to  the  prior  accounts  was  causative  of  any  loss  occasioned  by MFS Pacific’s decision to continue making advances after 21 December 2007.

[32]     Substantial affidavits were filed in support of, and in opposition to, the strike out application.  These were provided first by an audit partner with SCW, Mr Foy, in his affidavit in support and one in reply, and secondly by Mr McCloy, one of the receivers whose analysis is relied on in advancing the claim.  Given my view on the scope  of  the  relevant  analysis,  and  the  outcome,  it  is  neither  necessary  nor appropriate to analyse the contrasting views of liability and causation.

[33]     However, Mr Meech did place substantial reliance on the matters deposed to by Mr Nigel Lane, as providing a factual basis for the arguments denying causation, on the basis of a lack of relevant reliance on the auditors’ work.  Mr Lane was the chief financial officer of MFS Pacific and other New Zealand entities owned by Octaviar.  He held the position from 2004 until approximately May 2007.  Mr Lane was advised of the existence of these proceedings by the receivers who requested his assistance.   Having considered Mr Foy’s first affidavit in support of the strike out application, he contacted Mr Foy to offer SCW his assistance in defending the claim.

[34]     Mr Lane disputed the reconstruction of events at MFS Pacific provided in Mr McCloy’s affidavit.  He deposed that the company’s directors were well aware of the extent of non-performing loans in the company’s loan book, and their deterioration over time.  Mr Lane described MFS Pacific as being “… increasingly utilised as a depository for non-performing loans from another fund under the MFS umbrella …”.  He considered the directors’ views as to whether to exercise the put option in relation to non-performing loans were conflicted by their position as either executives  and/or  directors  of  Octaviar  or  other  entities  linked  with  the  parent. Mr Lane insisted that, had the auditors requested different accounting treatment for

the valuation of the loans and the impact of the put option on their valuation, this would not have altered the course of conduct pursued by the directors.

[35]     If Mr Lane comes up to brief and his version is not discounted after cross- examination, then his evidence may well create some real difficulties for the plaintiff’s claims.

[36]     However, that is not the test on a strike out. The tenability of causes of action is to be tested on the basis that the plaintiff will make out the allegations in the statement of claim.7   Mr Tingey submitted that Mr Lane’s views would be contested, that Mr Lane was no longer with the company when the audit report was produced, and that this was not a circumstance in which the untenability of the causation aspect of the cause of action could be determined pre-trial.

[37]     In this case, the plaintiff will argue that the auditors ought to have brought a stop to the practice of relying on the put option when valuing the company’s loan book.  If the auditors had insisted on assessing major loans on their own terms in the conventional way, then it would have required a quite different course to be charted for the company’s business.   Arguably, the impact of that alleged error persisted because the same approach continued to apply.  On this approach, the directors could not have completed the financial statements to 30 September 2007 on the terms that they did if the auditors had rejected the company’s form of reliance on the put option as at 31 March 2007.

[38]     As in Sew Hoy, that contention is sufficiently fact-dependent to be incapable of determination to the standard required for a strike out application, in the absence of contested evidence.

The put option claim

[39]     Mr Meech advanced a different range of arguments to dispute the tenability of MFS Pacific’s claims that allegedly negligent performance of the audit materially

contributed to or caused the directors’ decision not to exercise the put option.   A

7      Attorney-General v Prince [1998] 1 NZLR 262 (CA) at 267.

majority of the MFS Pacific directors were either executives in, or directors of, the parent  company or Australian  affiliates.    There  were  relatively obvious  adverse consequences  for  Octaviar  in  assuming  liability  for  impaired  loans.    Mr Meech invited the inference that the governing factor in the board’s decision not to exercise the put option in respect of any particular loans was the conflict of interest affecting the directors’ judgement.  In this regard, the submission relied on Mr Lane’s affidavit that firmly expressed the opinion that that was so.

[40]     Further, Mr Meech cited the fact that in December 2006 the directors had decided not to deal with past due loans by exercising the put option, and took the same course when there were past due loans at the 31 March 2007 balance date of some $6.3 million.   Subsequent to the auditors’ involvement, the directors again decided not  to  exercise  the put  option  on 31 March  2008  when  past  due loans exceeded $43 million.

[41]     Mr Meech also invited the inference that, quite independently of the audit, the directors would have a clear idea of the status of overdue or impaired loans. Again,  such  an  inference  is  supported  by  Mr Lane’s  affidavit  which  states unequivocally that the directors were fully informed of the state of non-performing loans.

[42]     Countering these arguments that challenged the existence of a causative link, Mr Tingey submitted that, until the evidence is tested at trial, there is no sufficient basis for a finding that the directors  would not have approached a decision on exercising the put option differently if the auditors had insisted that the major loans be valued without relying on the put option.  Inferentially, he suggested that it was easier for the board to defer decisions on exercising the put option in relation to particular loans when the auditors approved financial statements that confirmed the face value of the loans.  The directors’ duties to the company would arguably have been in starker relief if they had persisted with a decision not to exercise the put option in the face of the auditors’ insistence on a substantial write-down in the value of major loans.

[43]     Beyond that influence on the directors’ own conduct, Mr Tingey argued that in causation terms a competent audit report that required the financial statements to value the loan book without regard to the put option would create the prospect for the trustee, or even receivers, to take the decision on exercise of the put option out of the directors’ hands.

[44]     The context in which a sufficient causative link is pleaded is different from that considered in Sew Hoy and other cases.  However, the same approach to striking out is to be applied.  I cannot be satisfied that there is no tenable prospect for MFS Pacific to make out a sufficient causative link between any alleged negligence in the auditors’ approval of the treatment of the valuation of loans, and the deferral of a decision to exercise the put option in relation to major loans  that were then in arrears.

[45]     The argument has identified difficulties for this part of the plaintiff’s claim, but none of them can be determined in the context of a strike out application as existing to the level that renders the pleaded causative link to be untenable.

Outcome

[46]     The application for partial strike out of the causes of action is dismissed.

Costs

[47]     The plaintiff is entitled to costs on a 3B basis, together with disbursements as approved by the Registrar.

Dobson J

Solicitors:

Bell Gully, Wellington for plaintiff

Minter Ellison, Wellington for defendant