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Report on aspects of the initial public offering of Vertex Group Holdings Limited in 2002

CORPORATE GOVERNANCE MATTERS

Several corporate governance issues arose during the inquiry. These are discussed below.

Information available to the Vertex Board for IPO Planning

During the period under review, Vertex management prepared financial information for inclusion in the monthly board meeting papers. The board papers included a monthly management pack containing the following financial information:
- a management report (presented jointly by the Managing Director and Chief Financial Officer) describing and explaining financial and operating performance by business unit and for Vertex as a whole, including revenues, EBIT, cash flow; forecasts, and treasury issues;
- a financial report containing operating performance key performance indicators (KPIs), a financial performance summary for Vertex as a whole, various detailed schedules, and an executive summary; and
- a treasury report.

The information sets included in the monthly management pack for Vertex board meetings at which Vertex's financial and operating performance and position were discussed, varied somewhat in content between April and June 2002. Mr Clark informed the Commission that as a consequence of the restructuring of the business, the form and content of management reports changed for Vertex board meetings held from June onwards.

Detailed financial information concerning business unit operating profitability (as distinct from levels of customer sales) was not included in the management report presented at board meetings in the period before the offer document was registered. For board meetings held up until 28 May 2002 (including the April 2002 results) management reports included business unit level information in a sales and marketing report, which showed sales by customer for each business unit. For board meetings held from June onwards (including the May 2002 results) the management report to the Board included detailed financial information at the individual business unit level, and in particular the actual sales and EBIT/EBITDA of each business unit against plan on a monthly and year to date basis, with an analysis of variance.

The minutes of the May board meeting (at which results were presented for April 2002) recorded that discussions were held about the profitability (EBITDA) of individual business units. The Commission's view is that, given the lack of documented figures showing all of the revenue, expenditure and earnings figures of each business unit against plan in the May management reporting pack, the directors may not have had a full opportunity to properly understand the earnings performance of each business unit in terms of both revenues and operating costs and earnings. The documented figures presented at that board meeting only covered the April sales, by customer.

Mr Clark confirmed to the Commission that the first time the full Vertex Board saw the detailed business unit performance, analysed by sales and operating earnings, was on 25 June, when the May Vertex results were presented to the board.

The May management report presented to the board on 25 June 2002 indicated a significant cumulative negative variance in the Technical Injection unit's EBITDA against plan (i.e. negative 25% on the full year budgeted operating EBITDA and negative 148% on the unit's cumulative budgeted operating EBITDA for the months of April and May 2002).

It is apparent that the quality of business unit level information communicated to the board improved from the June board meeting (at which the May results were presented). The Commission is, however, of the view that the information about the actual financial performance of the individual Vertex business units was critical to the board's understanding and knowledge of Vertex's actual underlying operating profitability, at the commencement of the 2002/2003 financial year and before the prospectus was registered and the shares allotted.

In the Commission's view, the business unit level information would have been relevant to the board's assessment of the prospective financial information included in the offer document. The sales information by itself (which was all that was made available to the board prior to June) was not sufficient to provide directors with an indication of the performance of the individual business units, as it took no account of costs.

It appears that the directors were aware of the negative variance in operating profitability in some of the business units during the months prior to registration of the offer document. After the June board meeting, when the extent of the problems in Technical Injection became apparent, the board did call for an in-depth review of Technical Injection's operations and financial performance to be presented at the July board meeting.

The Commission considers that the fact that the information provided to the board in the period leading up to the IPO was incomplete is a matter of concern from a corporate governance perspective. This was an IPO of a company with diverse business units, where the IPO was promoted on the strengths of some of those units. In these circumstances, the Commission considers it is important that the board has complete information about the performance of individual units in the period leading up to the registration of a prospectus. If such information is not available, and the decision is taken to proceed with an IPO, directors need to satisfy themselves that the content of the prospectus accurately reflects of the amount of information that is available. For example, if the information available to the Board is not sufficient to support the inclusion of forecasts in the prospectus, then forecasts should not be used.

Understanding of forecasts and projections

The evidence provided to the Commission demonstrated that some of the directors were not aware of the difference between forecasts and projections, and did not understand what form the prospective financial information in the offer document was required to take. Some thought that securities law required the prospective financial information for the period to 31 March 2003 (i.e. to the end of Vertex's financial year) to take the form of a forecast.

When asked to describe the material differences between a projection and a forecast, Mr McKay replied as follows:

"I'm not sure which way round legally we're talking, from projection versus forecast, but what goes into a prospectus has to be the very best estimate of what we believe is achievable, and based on a rigorous due diligence process."

Mr McKay was then asked:

Q:   "The Vertex prospectus had a forecast for the 12 months to March 03, and then a projection for the following six months. Were you conscious in your input into the prospectus of the difference between the two?"

A:  "Yes, I was"

Q:  "And how did you see that difference?"

A:  "Well, I saw those forecasts as absolutely-you know, that-I was very aware of the importance of getting those forecasts as accurate as possible."

When asked whether he thought the Vertex Board had the option of treating the prospective financial information as all being projections rather than forecasts, Mr McKay replied:

"Oh no. No, no. No, we were aware of our responsibilities in the prospectus in terms of the forecasts."

Mr McKay was then asked whether he treated those responsibilities as including a mandatory requirement to have a forecast for the next 12 months, to which Mr McKay replied:

"Yes. We were required to have a forecast for the next 12 months..."

It also appears from Mr McKay's evidence that no discussion took place with Vertex's advisers about the distinction between a forecast and a projection, and whether forecasts or projections should be presented in the offer document.

However, Mr Foliaki's evidence indicates that some informal discussion took place at an early stage between PwC and George Clark, Vertex's CFO, about the characterisation of the prospective financial information. Mr Foliaki was asked:

Q: "Was there any discussion between you and the CFO on the content of FRS-29 and what the different requirements were for forecasts and projections?"

A: "No, I pointed out to him where those requirements were and left it to him to consider based on our discussions whether that was appropriate..."

If the prospective financial information is to consist of a forecast, directors must be able to assess whether the assumptions underlying the prospective financial information are sufficiently supportable for the prospective financial information to properly qualify as a forecast in terms of FRS-29, or whether it would be more appropriate to present the information as a projection. To make this assessment, directors need be fully aware of the different requirements of forecasts and projections.

It seems that in practice PwC went some way towards satisfying itself that presenting the prospective financial information as forecasts for all business units for the period to 31 March 2003 was appropriate. However, this judgment was not part of its formal engagement, and PwC did not take any legal responsibility for the quality of the forecasts. In his evidence, Mr Foliaki said:

"[I] took the view that the forecasts for the 12 months to March 2003 were forecasts, and beyond that they were projections because they were based on high level assumptions."

Mr Foliaki was then asked:

Q: "And what were the criteria on which you decided that what they were putting in for the 12 months to March 2003 qualified as forecasts?"

A: "Primarily because it was based on their detailed bottom-up budgetary process which had started some time before the IPO process; and also, because it was the actions that the directors and management were in the process of completing, if you like. They had clearly identified 'this is our plan forward, these are the actions we need to achieve that plan' and they were, you know, moving ahead on that basis."

The Commission is of the view that directors of companies offering shares to the public should obtain advice from professional advisers about obligations under securities law, including the difference between forecasts and projections, and the quality of the information supporting the assumptions underlying the prospective financial information. This does not appear to have happened in Vertex's case.

PwC's Role

PwC and Vertex had two relevant engagement letters. One related to PwC's engagement for the due diligence work. This letter did not extend to due diligence regarding the prospective financial information in the prospectus. The other engagement letter described PwC's statutory role as auditor in respect of the financial information appearing in the offer document. This letter limited the scope of PwC's duties in relation to the prospective financial information. PwC was required to check the numerical accuracy of the calculations and computations included in the prospective financial information, and to express an opinion as to whether the prospective financial information had been properly compiled on the footing of the assumptions in the offer document, and was consistent with the accounting policies normally adopted by Vertex.

It should be noted that an auditor's statutory role in respect of prospective financial information in a prospectus is limited. He or she is not required to verify the information the company used to prepare the prospective information in a prospectus, or to go behind the assumptions used to seek information about their validity.

The Commission notes that there was previously an Auditing Guideline (AG 20, issued in 1990) that provided guidance on the role of an auditor in the examination of prospective financial information. This guidance was subsequently withdrawn. The Commission notes that professional standards and/or guidelines have been issued in other jurisdictions, such as Australia and the US, that deal with an auditor's role in the examination of prospective financial information. The Commission notes, however, that the role of the auditor in those jurisdictions may differ from the auditor's statutory role in New Zealand.

The paragraph headed "Basis of Opinion on the Prospective Financial Information", contained in the Auditors' Report appearing on page 64 of the offer document, reflects the limited nature of PwC's opinion on the prospective financial information as set out in its engagement letters. This limited opinion is consistent with the requirements of the Securities Regulations 1983.

The engagement letters specified that PwC's role did not extend to testing the prospective financial information. However, there appears to have been some confusion between the parties on the scope of PwC's role in the IPO. Mr Clark had signed off the PwC engagement letters on the delegated authority of the board. It appears that the engagement letters were not sighted by the Vertex Board, and at least some directors were of the view that PwC was testing the assumptions underlying the prospective financial information.

In his witness statement, Jon Hartley said:

"The budget figures and the underlying assumptions were subjected to rigorous review and testing by the DDC, independent advisers, observers and the Board. Specifically, I understand that PwC undertook detailed analysis of the forecasts."

When questioned by the Commission where this understanding derived from, Mr Hartley replied:

"The amount of time spent by PwC in the offices of Vertex would be an anecdotal indication of the work they were doing. Secondly, the conversations that were had between management and PwC in terms of, for example, the change in revenue number that took place as we came towards the final process. Management specifically met with PwC to make sure that they were satisfied, and management reported back to the Board that they were satisfied with the changes that were being recommended. So, implicit in that is, for PwC to be satisfied about something that is a change, they should be satisfied about what it's changing from in order to be able to form a view about their satisfaction".

PwC asked Vertex management some very detailed questions regarding the basis of the prospective financial information. This may have contributed to Vertex's belief that PwC's engagement was wider in scope than was set out in the engagement letter. Also, it was PwC who suggested to the DDC that the assumptions regarding the exchange rate ought to be reconsidered. The foreign exchange rate used in the prospective financial information was then altered and reflected in the net $1.2 million revenue adjustment made on 28 May 2002.

The following questions were put to Mr Foliaki:

Q:  "In terms of the due diligence work, could you just briefly describe exactly what tasks PwC saw itself undertaking, relative to the prospective financial information?"

A:  "As I say, we didn't do any due diligence work. In terms of their letter, the engagement for due diligence services, we didn't do any work on the prospective information. The prospective information work was covered under our statutory role, so we simply carried out all the tasks we believe we're required to do to fulfil that role."

Q:  "Well did that, for example, extend to testing the validity of the assumptions on which the directors relied in making the projections of revenue in the prospective financial information?"

A:  "No."

Q:  "We've heard evidence that PwC initiated the debate, for example, about the exchange rates that had been used. Do you recall how that came about?"

A:  "Yes, I do. I raised that specific issue because the rate that they had included in the forecast that was represented to us, it started to be different from the spot rate at the time, and I said, that's your assumption but I question-I said that difference, it's materially different. What do the directors want to do about that? And I raised the question."

Q:  "And embarking on that issue, were you not questioning one of the assumptions underlying the prospective financial information?"

A:"Not in my perspective. I was just saying that there's an assumption here that you've presented to us and we've checked the mathematical accuracy which is, you know, correct but it seems factually flawed if I look at the spot rate today."

It appears to the Commission that by questioning the exchange rate PwC went beyond the stated limited role in respect of the prospective financial information set out in the engagement letter. The Commission does not criticise PwC for asking this question, and notes that PwC may even have had a professional duty to do so under the Code of Ethics that applies to all members of ICANZ. However, the Commission also notes that PwC asking the question may have contributed to a confusion about PwC's role. It appears from the evidence that while PwC did not consider it had any due diligence role in respect of the prospective financial information (and in terms of its engagement letter, at least, in fact had no such role), this was not the view of Vertex's directors.

As already noted, Buddle Findlay advised the Commission that questions in the due diligence information request list relating to the prospective financial information were not contained in a due diligence report. Rather they were addressed by the DDC, which sought further reports from management where necessary, and recorded outcomes in the "key issues log". Buddle Findlay's due diligence report stated that PwC were taking responsibility for reporting on the prospective financial information due diligence. The evidence of the Vertex Board indicated that they were under the impression that PwC had tested the prospective financial information. It appears that the DDC did not communicate to the Vertex Board the fact that the DDC itself, and not an independent adviser, had carried out the due diligence in respect of the prospective financial information.

Evidence from Vertex directors indicated to the Commission that they drew comfort from the due diligence carried out by PwC, which they thought included due diligence on the prospective financial information. This raises the question of whether the board would have drawn the same level of comfort in respect of the prospective financial information due diligence if they had known that the DDC, and not PwC, had taken responsibility for it.

Vertex's legal advisers submitted that there was no misunderstanding or confusion about PwC's role, stating:

"Although the letters of engagement may have set out a defined role for PwC, the reality of the situation is that they took this role further, thereby assuming shared responsibility for the prospective financial information, which the directors relied upon."

and

"PwC was intimately involved in all aspects of the development and finalisation of the forecasts".

Counsel for PwC submitted that:

"These directors and their legal advisers are sophisticated and experienced. PwC relied on them to understand the engagement letters and the nature and scope of services PwC was providing. Neither market practice nor professional duty expand the scope of work being undertaken by PwC beyond the carefully worded engagement letters."

and

"PwC says it was not intimately involved in 'all aspects of the development and finalisation of the forecasts'. It observed them to the extent necessary to give the opinion required by the Securities Regulations 1983. This means that it ensured that it
1. understood the prospective financial information;
2. understood the nature and extent of the assumptions on which that. information was based.
However, PwC did not form a view about whether
1. the assumptions were themselves appropriate;
2. the risks associated with the assumptions had been accurately described."

It is not for the Commission to reach a conclusion on the scope of the contract between Vertex and PwC, and the Commission makes no comment on that. However, the Commission is of the view that there was confusion surrounding the scope of PwC's role, and is concerned with the potential effects of such confusion.

It is important that the role of independent advisers in an IPO is well understood by the company's board and management and the advisers themselves, so that there is no doubt about the responsibilities and expectations of the parties. Directors who sign a prospectus do so in part relying on the due diligence carried out by its advisers. If their reliance is to have a proper basis, the directors must have a clear understanding of the roles of their professional advisers. Any uncertainty about these matters increases the risk of serious flaws in the due diligence process and in the resulting offer document.

The Commission also notes an irregularity in that the directors' representation letter (a standard document prepared by PwC for Vertex to sign on Vertex letterhead confirming the basis on which the company prepared the prospective financial information) was signed by a director who had retired at the time of signing.

Having noted at paragraph 192 the absence of guidance concerning an auditor's examination of prospective financial information, the Commission refers to ICANZ the question of whether such guidance is desirable.

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