Feltex Carpets Limited
IPO Prospectus, Financial Reporting and Continuous Disclosure

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.

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.

FTX did not disclose this breach of covenants in its 31 December 2005 half-year financial statements.

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.

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.

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.

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.

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.

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.

The breach was an event of default, as a result of which ANZ had a right to declare the debt immediately due and payable.

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.

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."

The directors took the following actions in their preparation of the 31 December 2005 financial statements:

• organized in 2004 an in-house staff team to address FTX's transition to IFRS;
• commissioned Ernst & Young in October 2004 to conduct a specific project to address FTX's transition to NZ IFRS by providing an assessment of the significant impacts of NZ IFRS for FTX;
• engaged Ernst & Young to carry out a review of its 31 December 2005 interim financial statements;
• engaged Ernst & Young to audit the FTX opening balance sheet as at 1 July 2004 and the restatement of the 30 June 2005 results in accordance with NZ IFRS; and
• the FTX Audit Committee (which included a director with significant accounting experience) invited Stuart Painter to the Audit Committee Meeting wherein the directors asked Mr Painter for assurance that the 31 December 2005 financial statements were compliant with IFRS and according to the directors, Mr Painter indicated that the financial statements were in compliance with IFRS.

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.

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.

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.

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.

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.

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.

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."

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.

The failure to disclose the breach of banking covenants was a breach of NZ IAS 34, an applicable financial reporting standard.

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.

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.

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.

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.