Caution Danger Ahead: A snow flakes Chance in Hell

I've been thinking a lot recently.

Mainly about the three afflictions that confronted the young prince that left the palace on his journey to enlightenment.

His first excursion from the palace confronted him with three great human travails: illness; old age, and death. The Princes innocence, had a snow flakes chance in hell of surviving any real time, once he was in the real world.

My recent engagement with a very good hospital, and all the panoply of human suffering and experience that are concentrated in hospitals bought this to my mind: thank goodness my reveries on these melancholy themes were bought to a halt by the musings of an old friend and colleague in relation to an exceptional story of a journey of corporate affliction that may well end up mirroring the Buddha's story, but this time without the happy ending of enlightenment.

Business is a happy distraction of mine: it's more of a pleasant calling than work, but my sense of calm, like the Princes innocence, had little chance of reaching equanimity, in this real world story of good intentions competing with ignorance and incompetence in matters of capital raising, governance and the law.

Let me start out by saying that this is supposed to be more than mere narrative: it is to serve as a cautionary tale - but as I want to protect the innocent as well as shedding light on the incompetent, I will only refer to the parties tangentialy: and the numbers I use will only be directionally accurate, so that even the cleverest of you will still only be able to guess in the most proximate way, to the people and businesses to whom I actually refer.

The Beginning

In the beginning was the word, and the word was with God, and the word was God, according to John: but in the world of Company's the beginning is often associated with capital, or more accurately, capitalisation.

All company's require capital.

In recent years many company's have turned to the exciting world of crowd funding, using regulations that exempt small issuers, and their directors, from some of the "consumer" type protections normally provided to retail investors under the FMCA legislation. But there are times when people just 'Get things wrong': both the Issuer and the entities that are facilitating the capital raise.

Without being an insider it's hard to say who, is responsible: so let's deal with the issues that a professional indemnity insurer would be familiar with, contributory negligence. To crash an airliner it takes three or four mistakes, from several parties, coming together in an unfortunate sequence to create a fiery disaster, so it is with Company disasters.

Take company X, a successful, established, profitable and solvent business that used one of NZ's most prolific Crowd funding organisations to raise capital.

The raise was successful: alongside the founders, there were other directors with grey and no hair, they looked the part, and the offer of equity was accompanied by subscribing shareholders receiving an annual reward of the company’s goods and services, to bolster loyalty to the product or service. All wrapped up in a nice little bow.........well no actually.

Milestones and Gallstones

One of the first milestones of any company is its inaugural AGM: well passing this milestone was more like passing a gallstone for this little business: painful, unprepared, a complete muddle.

The notice of meeting was inadequate; it provided no financials for approval; there was no resolution of an opt out of the audit, a requirement under the Companies Act. The directors claimed to be unpaid, but there was a suggestion that they received shares in lieu of salary, no-one could clarify if income tax was paid, on the income (shares), or indeed if they were ever issued. The Board couldn't even answer if dividend (& imputation credit) statements for those that received their rewards would be available, after all either the company or the shareholders needed to pay tax on the reward. In this world, much like the Buddha's, there are two certainties in life: death and taxes.

There were no new board candidates; no discussion on the remuneration of directors, other than the unanswered questions; no mention even of directors and officers insurance. And the Crowd funding advisor seemed to think that the meeting was a success!?! Perhaps in his own little parallel universe, it was. But then again he had thought the capital raise a success as well.

Doctor Who and the Tardis

Doctor Who has always been one of my characters of fiction. A Time Lord, he can travel backward and forwards in time with his Tardis, allowing him to ameliorate previous awful outcomes, by changing events the past. I wish I had the Doctors lanky good looks, and his time travelling Tardis, alas I only have his penchant for scarves.

Company X seem to fancy themselves as Time Lord's. Fast forward 18 months, and the annual in Annual General Meeting (AGM) seems to be more of a suggestion, than to have been mandated by the Companies Act, as having to occur within 15 months of the last AGM.

Only the founder directors remain: the three other directors have all resigned, but the shareholders are not told why.

The real surprise is in the 2016 accounts (that are now 12 months old and out of date), but at least they are now compliant with the Financial Reporting Act provisions and the Companies Act - YES - they are audited. Alas, it's not all good news.

Apparently, the business has more liabilities than assets: for the legal eagles amongst you, yes it has breached one of the two limbs of the solvency test.

But what happened? It was a great business, it was profitable, it successfully raised capital, it generated loyalty through rewards, what on earth could have happened? And importantly, who is liable, accountable, responsible for this cock-up?

The Gift that never Ends

The gift that never ends, like Midas' touch, is not a gift: it is of course, a curse.

The reward itself was the issue: Poorly worded; poorly executed, the auditors have determined that it created a perpetual creditor relationship, outside of the equity relationship defined in the equity subscription agreement.

Let's say the company raised circa $400,000 in equity - well the perpetual reward has been valued as a liability of say circa $400,000.

It's really a Clayton's capital raise: the capital raise you have when you raise no new net capital at all!

Why, I here you say, they got the cash didn't they? Well yes, but they also created a perpetual liability of about the same amount! Add a small operational loss and BOOM, you're prima facie insolvent.

To add insult to injury, not only was the new so-called AGM (which the shareholder's could chose to call the Annual and a Half General Meeting) rushed through, but the notice included no annual report from either the Chair or the CE, and no scheme or suggestion to replace any of the directors that resigned.

Instead, one of the agenda items attempts to get the shareholders to consent to amending the form of the reward.

Of course, this is just not possible. At least not after the General Meeting approved the accounts.

As soon as that occurs, the Company resolves that it recognises that it actually has a valid debt obligation, to creditors. The accounts are signed by the directors, signed off by the auditors, and are now approved as a true and accurate statement of the directors by the shareholders of the company, it's now an incontrovertible fact that the company created a perpetual contract for a liability parallel to the shares, for those parties that qualified for the reward defined in the subscription agreement.

So whilst the shareholders can agree all sorts of things, the company needs to reach a compromise with this class of creditors, all of whom are comprised of shareholders, but here's the rub, not all the shareholders are creditors for the reward.

Creditors are creditors: shareholders are shareholders, despite a large overlap in the Venn diagram they are nonetheless different beasts. That's where Part 14 of the Companies Act comes in. The creditors need to be asked to compromise their rights. It's just not within the competence of a General Meeting of Shareholders to do this.

So unlike Dr Who, its more like deja Vue! Going backwards and forwards in time not to change outcomes, but to repeat all the same mistakes again and again in glorious technicolor. So who is to blame?

Well my colleague and I are outsiders, we can't possibly know; but if I'd been a director of an entity that is trading insolvently and therefore exposing my personal assets as a director for over 12 months, I'd be wanting to get some other balance sheets on the hook to protect my own position: I'd start with lawyers, accountants and capital advisers, they all have juicy Professional Indmentity insurance and from my perspective they all look pretty incompetent.

I'd also have a crack at the 'retired' directors, they should only have served after due diligence, if they were present when the information memorandum was signed, then they are also on the hook.

The end of the Affair?

So what happens next?

Well probably nothing, small powerless shareholders and reward creditors don't have any money to take this to court, the directors seem to feel they are beyond rapproach, and the capital advisor seems to think all is just peachy.

Well actually, it's a complete and unmitigated mess!

I hope the Companies Office, or the FMA, get involved. They have a mandate in these matters, and there are sanctions that can be applied to former and current directors, and licensed advisers who either advised for, or failed to advise against, such structures.

You don't need to be an accountant or a lawyer to understand basic accounting and statutory principles, and you shouldn't be advising on capital raising if you can't get some basic things right. Perhaps, actual expertise might be become a requirement in new Crowd funding licence applications, rather than merely a rosy view of the world, a belief in goodness, and a dose of fairy tale naivety?

But whatever comes of this, it might well harm the future reputation of Crowd funding for issuers, and if it's reputation is damaged by the actions of some of its players, then they won't stand a snow flakes chance in hell, if they screw things up for Companies raising capital.

New Zealand only hates one thing more than success, and that is failure and incompetence.

Pip pip Pierpont, Hurrah!