Aussie judge overturned in Digitech case twist

By Deborah Hill Cone

Thursday 8th April 2004

Down-on-his-luck Digi-Tech svengali John Reid has had much of his dramatic $A44 million ($NZ51 million) Australian court win, handed down two years ago, overturned.

Mr Reid has been found to have misled and deceived Digi-Tech investors by a three-judge bench of the Australian Appeal Court, which turned the 777-page Supreme Court ruling by Justice Clifford Einstein ruling exonerating him on its head.

"This judgment throws Einstein out of the window," one investor said.

Of 11 questions posed in the appeal, the judges answered five in favour of the investors, three in favour of Digi-Tech (upholding the Supreme Court ruling) and sent three back to be re-tried in the Supreme Court.

The key finding was a criticism of Digi-Tech's projections estimating the potential profit to be made by its products.

The whole investment scheme turned on the valuation of the intellectual property to Digi-Tech's products, known as Freerider and Terminal Adapter (TA.)

Digi-Tech had carried out its own valuation of its products and using its gross margin figures commissioned a report from Deloitte, which put the value of the products at $A67-74 million.

These figures look very different in hindsight, given only 33 units of the Freerider gizmo were ever sold.

The valuation depended on a projection of 50% market penetration but in the judges' opinion Digi-Tech and Mr Reid did not show reasonable grounds that this figure was achievable.

Under a clause of Australia's Trade Practices Act if a corporation makes a claim about the future of a product without reasonable grounds, they are deemed to have been misleading which is what the Court of Appeal found in this case.

Now the issue which goes back to the lower court is: did the investors rely on Digi-Tech's representations about the product?

The background to the case: On the evening of June 30, 1997 until 4am the next morning Sydney lawyers worked like "a madhouse" to sign up investors to a complicated tax-driven transaction involving Freerider and the TA, the products owned by Digi-Tech.

Freerider was a software system that allowed a data network to be used simultaneously for multiple functions; the TA allowed the logging on of a number of functions fax, phone, email and Eftpos on a single phone line at the same time.

How the transaction worked: Digi-Tech would assign the intellectual property relating to the products to a partnership. The partnership would promote the products.

The investors were required to make payments each quarter of $350,000 to Digi-Tech over three years followed by a larger "balloon" payment in September 2000.

But as part of the scheme the investors had an option to get out relieving them of the balloon payment.

They had the chance to take up that option any time in the 15 months before August 2000 and sign over their obligations to another Digi-Tech subsidiary, Digi-Tech Equities (DTEL) to take up their rights and duties under the scheme.

The idea was that unless the partnerships were highly successful Freerider and the TA turned out to be the hottest technology invention since sliced bread the options would be exercised so the liability for the balloon payment would fall on Digi-Tech itself rather than the investors.

In the meantime the investors could claim tax deductions for the capital they had spent buying the IP to Freerider and TA.

But the steps for the investors to exercise their option to get out and hand over their obligations to DTEL were complex, with many technical hoops to jump through depending on whether the entity used was a corporate body or natural person.

This is where some investors ran into trouble.

In his 777-page judgment, with a further 100 pages of appendices, Justice Einstein found some investors had correctly exercised options to back out of their contracts but others had not.

The four investor companies which had invalid grounds for exercising their options, Kalifair, Kalinick, Mclean Pty and A.I.McLean Pty, were ordered to pay money owing and interest totalling $A44 million.

Kalifair and Kalinick are companies linked to Andrew Banks and Geoff Morgan, founders of the Morgan & Banks recruitment agency.

The McLean companies are linked to electrical engineer Ian McLean.

Although they had been ordered to make this huge payment to Digi-Tech, it was unlikely Mr Reid would see any of the money.

The Supreme Court heard how Kalifair and Kalinick were $2 shelf companies that would be unable to pay large sums of damages.

Another investor who has been battling over whether his company had exercised its options correctly was Chris Kelliher, a technology specialist and former managing director of Microsoft New Zealand.

In an interesting twist to the case, the three judges of the Appeal Court delivered a stinging rebuke to Justice Einstein, devoting two pages of their pithy 57 page judgment to a tirade, phrased in seemingly polite legal terms, against "overly lengthy judgments" the legal equivalent of giving him a serve.

"It is generally unnecessary and undesirable to express every line of thought, including that have proved to be unhelpful in the judge's chain of reasoning."

The case had been particularly complex with appeal books containing exhibits numbering 4803 pages but it was still not necessary to have written such a long document, they harrumphed.

"While genuine tribute must be paid to the judge for the industry and dedication manifest from his extensive reasons, it has to be said that their length and form have not facilitated the discernment and understanding of the significant issues in the appeal," the Appeal Court said.

The investors may be less than pleased that Justice Einstein is likely to be assigned to the matters which have been sent back to the Supreme Court for a re-hearing.

Meanwhile, in a separate criminal, rather than civil, case Mr Reid and three others John Currie, Peter Russel and Peter Connolly are preparing for a Serious Fraud Office hearing in the High Court at Auckland in September.

The foursome are facing fraud and money laundering charges over a separate Digi-Tech investment scheme in New Zealand.

The New Zealand scheme was structured so investors signed up for sale and purchase agreements to buy shares in Wellington-based Digi-Tech with the bulk of the price payable 10 years in the future.

Investors also took out an insurance policy guaranteeing the shares' value would treble in that time and received a loan to pay for the insurance premium.

The key plank of the SFO's case is that the insurance company was fictional and the transaction was circular and a sham.

Speaking to NBR this week Mr Reid said he expected the Australian court action could take "easily another two years, or even longer." to resolve.

Mr Reid said what was argued on appeal by the investors had not been made out at trial so that was why Digi-Tech had not explained it had reasonable grounds for its representations about the products.

Asked about the cost of funding the litigation, on top of his SFO case, Mr Reid said: "It's something we cope with."

He declined to answer questions about whether he was continuing to work but said self-styled merchant bank Milloy Reid Wong & Co was still in existence.

"Obviously litigation takes up a lot of time."

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