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The art of law, - company directors can incur criminal liability, either at common law or under the Companies Act

The criminal liability of company directors

Of the many duties and concomitant liabilities of company directors, their civil liability often captures centre stage.

Of particular note is the potential liability of company directors to be declared by a court to be personally liable for the company's debts in terms of section 424(1) of the old Companies Act of 1973 (and it is noteworthy that this section remains in force, despite the repeal of the Companies Act 1973, in circumstances where a company is wound up on the grounds that it is insolvent) and the numerous provisions of the new Companies Act 2008 in terms of which a director can incur a liability in damages to the company, or to other persons.

There is an important distinction between a director's incurring personal liability for the company's debts, and incurring personal liability for damages, not least because damages have to be proven, and that a causal link has to be shown to exist between the director's misconduct and the damages in question.

Modern Company Law has moved away from using the criminal law to compel compliance

Generally, modern company law has moved away from criminalizing corporate misconduct. There are sound reasons for this trend.

Firstly, the criminal justice system moves very slowly, and it may take years for the matter to come to court, by which time evidence may have been lost and witnesses may have died or disappeared. Secondly, overworked prosecutors may give greater priority to crimes against the person, particularly crimes of violence, than to so-called "white-collar" crime. Thirdly, the onus of proof that rests on the prosecution in a criminal case is high - the guilt of the accused has to be proved "beyond a reasonable doubt", and not merely on a balance of probabilities as in a civil matter. Fourthly, many corporate accused have the financial means to brief a high-powered legal team whose expertise and experience outweigh that of the prosecution.

It should be borne in mind, however, that "white-collar" crime can devastate peoples' lives no less than physical violence, as for example, when people are misled into investing their life savings in hopeless companies, or are duped into making other disastrous investments.

The decision of the Supreme Court of Appeal in Levenstein v The State

In South Africa, the criminal prosecution of high-profile business personalities is relatively rare, and for this reason the judgment of the Supreme Court of Appeal in The State v Levenstein, in which judgment was handed down on 1 October 2013, is currently a talking point in business circles.

In this case, Levenstein, a well-known businessman, was appealing against his conviction in the South Gauteng High Court on several counts, including common law fraud and breaches of the now-repealed Companies Act 1973.

His appeal was partially successful, with his conviction on some counts being set aside, and on other counts confirmed.

His appeal against sentence was also partially successful, with the sentence on certain counts being reduced.

Overall, though, the effective sentence, as finally determined by the Supreme Court of Appeal, was one of eight years imprisonment (reduced from the fifteen year sentence imposed by the High Court), reflecting the serious view taken by the court of his misconduct.

Background events

The charges against Levenstein, a qualified accountant and auditor, related to events that occurred whilst he was an executive director of a bank and its holding company that collapsed in 2001.

In 1995, he and his brother-in-law had founded a new company called Rand Treasury Ltd, of which Levenstein was the de facto chief executive officer, and the Reserve Bank had granted the company a banking licence. The company's name was thereafter changed to Regal Treasury Private Bank Ltd (for brevity, "Regal") which became a registered bank.

It was decided to establish a group structure so as enable the banking business to be conducted in an entity separate from non-banking business, and in February 1999 the holding company was listed on the Johannesburg Stock Exchange.

The controversial valuation of company assets - the branding dispute

From the outset, Regal was enmeshed in controversy, but its troubles began in earnest in the financial year ended February 2000, when the company came into conflict with its own auditors, Ernst &Young, in regard to the valuation of a certain unlisted investment held by it.

The valuation of that investment was controversially published in Regal's financial statements and then corrected a few days later. Further audit issues arose in the following year. Levenstein was removed as the CEO of Regal, and within months he retired.

A cautionary announcement was published regarding the holding company and this triggered a run on Regal, with the result that it was unable to pay its depositors the money they had invested. Regal never recovered and in February 2004, it was placed into final liquidation.

As the judgment recounts, "So much for the sad story of the life and death of Regal. In the aftermath of these unhappy events, [Levenstein] was charged and convicted "

The valuation of the branding income

At the centre of the controversy was the fact that, in the preparation of Regal's financial statements for the year, a valuation had to be made of a particular asset of the company, namely the company's right to receive a percentage of the total issued shares of a company to which Regal had given a licence to use Regal's brand name and trademark.

The valuation of this asset, which Regal proposed to adopt in its financial statements for the year, was an amount derived from a valuation model that was based on potential rather than actual income. This, (as the judgment recounts at para [17]) flew in the face of what is usually known as GAAP (Generally Accepted Accounting Standards) which is the standard recognized by the Reserve Bank for banks under its supervision.

The company's auditors declined to approve the value determined by Regal

The company's auditors, Ernst & Young, were unable to approve the value that Regal had arrived at by this method.

The gulf between the two methods of valuation was substantial - Regal was pushing for a valuation of branding income for the year of R55 million, but Ernst & Young were not prepared to go beyond R5.5 million.

Ernst & Young were of the view that, until the branding scheme actually realized income, it could not be taken into account in assessing Regal's profits. Ernst & Young made clear that, if Regal would not alter its stance on the issue of valuation, they would qualify the company's financial statements - and everyone involved realized that this could lead to a run on the bank, leading to its collapse.

Levenstein bowed to the inevitable and instructed Regal's Chief Financial Officer to redraft the company's financial statements so as to reflect only R5.5 million as the value of Regal's shareholding in the branding companies. However, in order to inflate Regal's apparent profits, Levenstein instructed the Chief Financial Officer to defer R6 million in expenditure for the year and to prepare the final financial reports on that basis. This was duly done.

At Levenstein's instruction, the foreshadowed press announcement was amended to say that the company's branding income had been deferred, but an additional statement was tacked on, to the effect that expenses of R18 million relating to the branding income had already been written off - which was untrue, or at least a gross exaggeration.

Regal's financial results were published in a form not approved by its auditors

In the result, Regal's financial results were, on 16 May 2000, published in a form that had not been seen and approved by the company's auditors, first on the Johannesburg Stock Exchange News System ("SENS") and in the popular press the following day.

The publication of Regal's financial statements in this form brought an immediate and indignant response from Ernst & Young who demanded that a correction notice be published immediately, and this was done.

The publication of Regal's financial results in the form they were in on 16 May 2000 was the basis of the charge against Levenstein, in which it was averred that the announcement contained misrepresentations of fact that were not only factually incorrect, but had been fraudulently made in order to induce persons using the financials to act to their actual or potential prejudice.

The term fraud in the charge sheet reflected the prosecution's contention that untrue statements of fact had been made by Levenstein, with conscious and deliberate dishonesty, including the statement that the company's results for the year ended 29 February 2000 had been audited, plus an untrue statement that approximately R18 million in branding expenditure had been written off.

The charge sheet averred that these untrue statements were to the prejudice or potential prejudice of Regal's shareholders and other persons who made use of its financial statements.

In its judgment, the Supreme Court of Appeal made the crucial point (emphasis added) that -

"[Levenstein] knew that the financial statements contained figures that did not bear the auditors' approval. But that does not in itself justify a conviction of fraud. For that to result, he must have knowingly misrepresented the truth with the intention to induce persons embarking on a course of action to their actual or potential prejudice."

The court accepted (see the judgment at para [38]) that Levenstein felt passionately that his method of valuing the branding income was correct, although the method was "ahead of its time", that GAAP was inadequate for this purpose, and that Ernst & Young should have placed a far higher value on Regal's branding income.

However, the court pointed out that, "the fact remains that he knew that E&Y, as well as the other accountants and the Reserve Bank, firmly disagreed with his methodology" and that Regal's results had consequently been manipulated. The court pointed out (at para [39]) that -

"the inescapable reality is that the figures as ultimately published did not bear the auditor's approval. [Levenstein] not only knew that to be so but orchestrated their misrepresentation in order to make Regal appear more attractive to investors and depositors than would otherwise have been the case. The inference is inescapable that [Levenstein] intended to influence investors and depositors by setting out information that he knew had not been approved by the auditors and he must have appreciated that they could act to their actual or potential prejudice if they relied on financial statements falsely declared to have been audited."

The Supreme Court of Appeal concluded that, on this basis, the High Court had been correct in finding Levenstein guilty of fraud.

A company's financial statements must give a true and fair view

A core principle, accepted internationally, is that a company's financial statements must give "a true and fair view" or, in the language of section 29(1)(b) of the new South African Companies Act 2008, must "present fairly the state of affairs and business of the company".

However, this uncontested principle conceals many difficulties. Thus, for example, in the case discussed above, Levenstein believed ("passionately" said the court) that the orthodox or traditional way of valuing the prospective so-called "branding income" - that is to say, the value of the shares of the "branded company" that Regal was to receive from the agreement in terms of which Regal gave a licence to certain companies to use its brand name or trade mark - was inadequate, and that the value would be more accurately reflected by valuing potential income, rather than income already derived.

However, the court was able to sidestep any argument that Levenstein had not put forward a valuation that he knew to be false by focussing instead - and basing its finding of fraud - on the fact that he knew that the company's auditors, Ernst & Young, and the Reserve Bank, disagreed with the methodology of his valuation and that he had knowingly manipulated Regal's financial position by deferring R6 million in expenditure.

The basis of the fraud conviction

The basis on which the finding of fraud rested was (see para [39]) that Levenstein -

"intended to influence investors and depositors by setting out information that he knew had not been approved by the auditors despite the claim that the financials had been audited; and he must have appreciated that they could act to their actual or potential prejudice if they relied on financial statements falsely declared to have been audited".

Levenstein's conviction on this particular count was based on common law fraud, but it is significant that, in terms of section 29(6) of the new Companies Act 2008, a person is guilty of an offence if he is party to the preparation or publication of any financial statements, knowing that those statements fail in a material way to present fairly the state of affairs and business of the company.


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