Feltex Carpets Limited
IPO Prospectus, Financial Reporting and Continuous Disclosure

Company directors are responsible for corporate governance. High standards of corporate governance provide accountability to shareholders and enhance corporate performance.

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.

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.

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.

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:

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.

The solvency document prepared by the CFO advised that FTX could pay its debts as they fell due in the ordinary course of business.

The letter from FTX's counsel advised the following changes to the facility agreement:

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."

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.