Australian Securities and Investments Commission v Cycclone Magnetic Engines Inc & Ors [2010] QCA 71

SUPREME COURT OF QUEENSLAND CITATION: Australian Securities and Investments Commission v Cycclone Magnetic Engines Inc & Ors [2010] QCA 71 PARTIES: AUSTRALIAN SECURITIES AND INVESTMENTS COMMISSION (applicant/respondent) v CYCCLONE MAGNETIC ENGINES INC (first respondent/first appellant) MICHAEL PETER NUGENT (second respondent/second appellant/) STEVEN VINCENT FOSTER (third respondent/not party to appeal) ROBERT GEORGE MCCLELAND (third respondent/not party to appeal) FILE NOS: Appeal No 9427 of 2009 SC No 2655 of 2007 DIVISION: Court of Appeal PROCEEDING: General Civil Appeal ORIGINATING COURT: Supreme Court at Brisbane DELIVERED ON: 26 March 2010 DELIVERED AT: Brisbane HEARING DATE: 17 March 2010 JUDGES: Holmes, Muir and Fraser JJA Separate reasons for judgment of each member of the Court, each concurring as to the order made ORDER: The appeal be dismissed with costs CATCHWORDS: TRADE AND COMMERCE – TRADE PRACTICES ACT 1974 (CTH) AND RELATED LEGISLATION – CONSUMER PROTECTION – MISLEADING OR DECEPTIVE CONDUCT OR FALSE REPRESENTATIONS – MISLEADING OR DECEPTIVE CONDUCT GENERALLY – MISLEADING OR DECEPTIVE: WHAT CONSTITUTES – where primary judge found appellants had engaged in conduct that was misleading or deceptive, or likely to mislead or deceive, in breach of s 12DA Australian Securities and Investments Commission Act 2001 (Cth) – where first appellant a company engaged in the development of an engine powered by magnets – where second appellant director of first appellant company and author of company’s Business Plan – -- 1 of 11 -- 2 where Business Plan made representations regarding proposed "Research and development" expenditure – where accountant gave evidence that none of appellants' actual expenditure fell within the Business Plan's definition of "Research and development" – where accountant utilised Australian Accounting Standards definitions – where appellants argued "Research and development" had been given a particular meaning in the Business Plan – whether primary judge erred in holding that appellants engaged in conduct that was misleading or deceptive, or likely to mislead or deceive, in breach of s 12DA Australian Securities and Investments Commission Act 2001 (Cth) Australian Securities and Investments Commission Act 2001 (Cth), s 12BB(1), s 12BB(2), s 12DA Australian Securities and Investments Commission v Cycclone Magnetic Engines Inc & Ors [2008] QSC 58, considered COUNSEL: R Perry SC, with J Rolls, for the appellants S Keim SC, with E Longbottom, for the respondents SOLICITORS: Garland Waddington for the appellants Australian Securities and Investments Commission for the respondents [1] HOLMES JA: I agree with the reasons of Muir JA and the order he proposes. [2] MUIR JA: Introduction The appellant first and second respondents in these proceedings brought by the respondent, Australian Securities and Investments Commission, appeal against the declarations in paragraphs 2(b)(ii) and 3 and the orders in paragraphs 4(c) and 5(b) of the Order made in the proceedings on 31 July 2009, on the grounds that the primary judge erred in holding that the appellants engaged in conduct in breach of s 12DA of the Australian and Securities and Investments Commission Act 2001 (Cth) ("the Act"). [3] The orders appealed against are injunctions restraining the first appellant (paragraph 4(c) of the Order) and the second appellant (paragraph 5 of the Order) from engaging in specified conduct. The declarations are as follows: "2. It is declared that the First [Appellant]: (a) … (b) in breach of section 12DA of the Australian Securities and Investments Commission Act 2001 (Cth) … has in trade or commerce, engaged in conduct in relation to financial services that was misleading or deceptive, or likely to mislead or deceive, in that the First [Appellant]: … (ii) in the Business Plan, when there were no reasonable grounds to do so, represented that it -- 2 of 11 -- 3 would use the proceeds available to it in the following way: A. $50,000 on tooling, being certain plant and equipment in its tooling-up process, required for the assembly of its fully functioning prototype; B. $300,000 on 'research and development', a term expressly defined as comprising general administrative expenses, components, raw materials, tooling (other than capital equipment), insurances and promotional costs; and C. $100,000 on salaries and wages ("the Expenditure Representation"); … 3. It is declared that the Second [Appellant], in breach of section 12DA of the ASIC Act, in trade or commerce, has engaged in conduct in relation to financial services that was misleading or deceptive, or likely to mislead or deceive in that the Second [Appellant] created and provided to prospective investors the Business Plan which, when there were no reasonable grounds to do so, made the Expenditure Representation." [4] The second appellant, Mr Nugent, was a director of the first appellant, Cycclone Magnetic Engines Inc ("CME") at relevant times. CME prepared a document dated 2 February 2005 entitled "Business Plan" for use in soliciting members of the public to acquire preference shares in CME. The primary judge found that Mr Nugent was "the prime force behind CME" and "the author of most of the Business Plan". The Business Plan explained that CME was engaged in the development of a commercially viable engine which, deriving its power solely from magnets within the engine, would have no need for fuel of any kind. The respondent claimed and the primary judge declared that, in representing to potential investors that such a machine could work, CME engaged in conduct which was misleading or deceptive, or likely to mislead or deceive, in breach of s 12DA of the Act. [5] The declaration just mentioned was not appealed against. I will digress to quote part of the primary judge's reasons which encapsulates his conclusions on the merits of the appellants' proposed magnetic engine. Referring to the engineers who gave expert evidence, he said:1 "… Dr Walker and Mr Potts agreed that: (a) The proposed permanent magnet motor would comprise a perpetual motion machine. (b) The aim of using permanent magnets to produce power, to propel motor vehicles or conventional industrial machines cannot be achieved. In his final report, Mr Potts concluded: 1 Australian Securities and Investments Commission v Cycclone Magnetic Engines Inc & Ors [2008] QSC 58 at [112]- [113]. -- 3 of 11 -- 4 '6.3 The hope of making an engine that will operate purely on magnets is forlorn. That is irrelevant to the potential success of the company and examples can be found readily of successful firms based upon futile flagship inventions. 6.4 The faith in an engine operated purely by magnets has been founded on quasi scientific reports that give an illusion of being erudite but never quite close the loop on being comprehensible.' I am confident that Dr Walker would agree with the gist of those expressions. They adequately summarise my understanding of the effect of all the scientific evidence. (citations omitted)" The Business Plan [6] The Business Plan relevantly provides: "… CME is seeking Seed Capital in first round funding, in the form of convertible preference stock. The intended reinvestment and use of these proceeds is as follows; Use of Proceeds CAPITAL EXPENDITURES Tooling $ 50,000 Debt Retirement (Purchase Agreement) $ 140,000 Total proceeds for capital expenditures $ 190,000 WORKING CAPITAL Salaries and wages $ 100,000 Lease Commitments $ 25,000 Professional services $ 50,000 Research & development expenses $ 300,000 Reserve $ 235,000 Total Proceeds for working capital $ 710,000 and reserve Total Uses $ 900,000 Summary of Significant Accounting Policies Employed The projection has been prepared using generally accepted accounting principles that CME expects to use when preparing its historical financial statements. … Tooling CME expects to acquire certain plant and equipment in it's (sic) tooling-up process required for the assembly of it's (sic) fully functioning prototype. … -- 4 of 11 -- 5 Research and development The principal types of expenses within this category are general administrative expenses, components, raw materials, tooling (other than capital equipment), insurances and promotional costs. The projections herein are the responsibility of the officers and founders of Cycclone Magnetic Engines as identified in the business plan, and, to the best of management's knowledge and belief, are in conformity with generally accepted accounting principles. CME believes all of the assumptions underlying the projections are reasonable and appropriate. Management further represent that these projections were not complied (sic) or examined by a (sic) an independent public accountant and should not be viewed as if so compiled or examined." [7] The explanation under the heading "Research and development" of the types of expenditure which might come within the category of research and development was described in argument as a "definition" (“the Definition”). I will adopt that convenient, although not entirely accurate, description. The relevant findings of the primary judge [8] The primary judge held, implicitly, that it was represented in the Business Plan that CME intended to use $300,000 of the moneys invested in the acquisition of its shares on research and development ("the Representations"). [9] The Representations were held to be misleading and deceptive by application of ss 12DA, 12BB(1) and (2) of the Act on the basis that, as the Representations were as to a future matter and the appellants had not adduced evidence that CME had reasonable grounds for making the Representations, CME must "be taken not to have had reasonable grounds for making" them. [10] Under s 12BB(1), a representation about a future matter by a person who has no reasonable grounds for making it is taken to be misleading. Section 12DA of the Act provides, inter alia, that "a person must not, in trade or commerce, engage in conduct in relation to financial services that is misleading or deceptive or likely to mislead or deceive". There was no challenge to the findings that the Representations were made "in trade or commerce" and were "in relation to financial services". The primary judge held that Mr Nugent had also engaged in misleading and deceptive conduct, or in conduct likely to mislead or deceive, in breach of s 12DA of the Act, in that he, being the "prime force behind CME" and the author of most of the Business Plan, "engaged in … the creation and provision to prospective investors of the Business Plan". [11] The primary judge found it unnecessary to decide whether, as the respondent contended, it was possible to infer from the evidence of Mr Hellen, an accounting expert called by the respondent, that no money had been spent by CME on research and development, that it was never proposed by CME or Mr Nugent that $300,000 be spent in that regard. The appellants' contentions [12] Counsel for the appellants accepted that the primary judge accurately stated the relevant argument advanced on behalf of the appellants in the following passage from the reasons: 2 2 Australian Securities and Investments Commission v Cycclone Magnetic Engines Inc & Ors [2008] QSC 58 at [206]. -- 5 of 11 -- 6 "The [appellants] argued that such an approach [Mr Hellen's] is irrelevant given that the particular items of expenditure are the subject of separate definitions in the business plans. In other words, the [appellants] argue that, whatever a term such as 'research and development' might mean in the Australian Accounting Standard, it has been given a particular meaning in the business plan and that is all that is relevant." [13] The same argument was advanced on appeal. [14] The appellants’ counsel also submitted that the primary judge erred in concluding that Mr Hellen, who provided a report in which he compared the expenditure actually incurred with the proposed expenditure in the Business Plan, did "… form a view about the expenditure that was incurred under the terms as defined in the business plan".3 It was asserted that instead of considering and applying the Definition, Mr Hellen utilised Australian Accounting Standards definitions. [15] Apart from those matters, the appellants' case was that there was nothing misleading or deceptive about the Representations, as all that was represented about research and development was that there would be expenditure of $300,000 on one or more of the categories in the Definition and that there was no reason to suppose that such expenditure was not intended or likely at the time the Representations were made. In that regard it was submitted that, as the sole object or purpose of CME was the development of a commercially viable magnetic engine, it followed that expenditure by CME on salaries, wages and in meeting general overheads should be seen as expenditure on research and development. Mr Hellen's evidence was also referred to in an attempt to show that if the appellants' view of the meaning of the Representation was accepted, there was some evidence that money had been spent on "general administrative expenses" and "promotional costs". The expert accounting evidence Mr Hellen expressed opinions on whether expenditure in the following categories could be properly said to relate to research and development: "General Administrative Expenses; Components; Raw Materials; Tooling (other than capital equipment); Insurances and Promotional costs." [16] He concluded that "there appears to be no expenditure by CME that should be properly included in the business plans' (sic) definition of research and development expenditure". [17] The primary judge noted:4 "[205] The analysis conducted by Mr Hellen concentrated on the actual expenditures by CME and how they should, in his view, be categorised. This is a further point of departure for the parties. Mr Hellen examined the expenditure of CME and, by using the Australian Accounting Standard for 3 Australian Securities and Investments Commission v Cycclone Magnetic Engines Inc & Ors [2008] QSC 58 at [208]. 4 Australian Securities and Investments Commission v Cycclone Magnetic Engines Inc & Ors [2008] QSC 58 at [205]. -- 6 of 11 -- 7 Intangible Assets, arrived at the conclusion that no money had been spent on research and development." (citation omitted) [18] Before proceeding further, I should explain that although the arguments advanced by counsel for the appellants at first instance and on appeal relied heavily on challenging the validity of Mr Hellen's opinions, success in that regard by no means ensures the appellants' success on the appeal. The appellants must demonstrate that the primary judge erred in making the findings summarised in paragraph [8] above. Discussion of the expert evidence, however, is of utility in that it highlights the general improbability of the case advanced on behalf of the appellants. [19] Included in Mr Hellen's explanation of his methodology in Section 7 of his report, headed "7.1 Methodology Adopted in Assessing Allocation of Expenditure", is the following: "7.1.4 I have examined documentation supporting the expenditure to determine the nature of the expenditure and I have categorised that expenditure as far as possible in accordance with the categories listed in the 'Use of Proceeds', by reference to the definitions used in the CME business plans." [20] Section 9 of the Report, which deals with research and development expenditure, provides: " Section 9 EXPENDITURE RELATING TO RESEARCH AND DEVELOPMENT 9.1 Summary 9.1.1 In my opinion there appears to be no expenditure by CME that should be properly included in the business plans' (sic) definition of research and development expenditure. 9.2 Business Plans' (sic) Definition of Research and Development 9.2.1 The business plans' (sic) definition of research and development expenditure includes the following categories:- • General administrative expenses; • Components; • Raw materials; • Tooling (other than capital equipment); • Insurances; and • Promotional costs. 9.2.2 I have been requested to assess whether the CME's expenditure in the categories above could properly be said to relate to research and development. 9.3 Australian Accounting Standard AASB 138 - Intangible Assets 9.3.1 The Australian Accounting Standard AASB 138 - Intangible Assets discusses the accounting treatment of costs and defines research and development activities. -- 7 of 11 -- 8 9.3.2 In relation to research the standard discusses expenditure incurred in research activities examples of which are:- a) Activities aimed at obtaining new knowledge; b) The search for, evaluation and final selection of, applications of research findings or other knowledge; c) The search for alternatives for materials, devices, products, processes, systems or services; and d) The formulation, design, evaluation and final selection of possible alternatives for new or improved materials, devices, products, processes, systems or services. 9.3.3 In relation to development the standard discusses development costs incurred in development activities examples of which are:- a) The design, construction and testing of pre-production or pre-use prototypes and models; b) The design of tools, jigs, moulds and dies involving new technology; c) The design, construction and operation of a pilot plant that is not of a scale economically feasible for commercial production; and d) The design, construction and testing of a chosen alternative for new or improved materials, devices, products, processes, systems or services. 9.4 Methodology Adopted in Assessing Research and Development Expenditure 9.4.1 I have applied the examples of research and development activities from the Australian Accounting Standard AASB 138 - Intangible Assets to expenditure incurred by CME. 9.4.2 I noted no expenditure on:- • Components; • Raw Materials; and • Tooling (other than capital equipment) 9.4.3 I consider the following categories of expenditure by CME would be appropriately described as overhead expenses, and based on the information available to me this expenditure could not properly be said to relate to research and development:- • General Administrative Expenses; and • Insurances. 9.4.4 In order to properly be said to relate to research and development this expenditure should be directly -- 8 of 11 -- 9 related to the research and development activities undertaken by the company. 9.4.5 I consider promotional costs are more appropriately described as overhead expenses, which could not properly be said to relate to research and development." [21] Except to the extent described under the previous heading, there was no criticism of Mr Helen's report or of the methodology used in it. Consideration [22] Sections 7.1 and 7.2 of the Report explain that Mr Hellen has adopted the categories of expenditure listed in the "Use of Proceeds" part of the Business Plan and that this was done "by reference to the definitions used in the business plan". [23] Specifically in relation to the assessment of research and development expenditure, Mr Hellen explained in paragraph 9.4.1 that he "applied the examples of research and development activities from the Australian Accounting Standard AASB 138 - Intangible Assets to expenditure incurred by CME". [24] Referring to expenditure by CME under the headings "General Administrative Expenses" and "Insurances", he formed the view that based on "the information available", the expenditure was more appropriately described as "overhead expenses". The explanation in paragraph 9.4.4 shows that in relation to these categories of expenditure, Mr Hellen, although having regard to the Business Plan's definitions, considered that the application of conventional accounting standards required that the subject expenditure not be regarded as research and development expenditure. Mr Hellen's evidence in cross-examination, which will be discussed shortly, makes it plain that, subject to a possible exception in the case of "promotional costs", he was prepared to regard expenditure within one of the categories listed in the Definition as expenditure on research and development only if that expenditure was properly referable to research and development. [25] I do not accept the contention that in making an appropriate comparison of represented with actual expenditure, Mr Hellen was unable to take "generally accepted accounting principles" into account. The Business Plan asserted that it had been prepared using "generally accepted accounting principles" and that the projections "to the best of management's knowledge and belief, are in conformity with generally accepted accounting principles". It was therefore appropriate that such principles be applied when comparing actual with projected expenditure. [26] Of course, it did not require the application of any accounting standard to compel the conclusion that on any sensible reading of the Business Plan, expenditure would fall within a type of expense listed in the Definition only if it could be regarded properly as expenditure on the research and development of the magnetic engine. The list of "types of expenses" is not exhaustive and the "types of expenses" are expenses "within this category", namely, the category of "Research and development". The words of the Definition must be construed with regard to their context. They are located in a document, the purpose of which is to persuade potential investors to fund the development of what the primary judge and the expert witnesses regarded as a perpetual motion machine, so as to share in the embarrassment of riches which would inevitably flow from the project's success. -- 9 of 11 -- 10 [27] If Mr Hellen's unchallenged professional opinion that "promotional costs are more appropriately described as overhead expenses, which could not properly be said to relate to research and development" is correct, the Business Plan was not prepared "using generally accepted accounting principles". That may well constitute a further example of misleading and deceptive conduct but it was not conduct on which the respondent relied in the proceeding. The object of Mr Hellen's exercise was to compare actual expenditure with projected expenditure, applying the same principles to each. Because of the Definition, Mr Hellen had to treat "promotional costs", which could be properly said to relate to research and development, as capable of coming within "Research and development" even if to do so was to contravene generally accepted accounting standards. It is arguable that if he did not do so, the comparison he made in that respect would not have been a true one. [28] In cross-examination by counsel for the appellants at first instance, Mr Hellen, referring to what he described as "the Business Plan's definition of Research and Development expenditure", said that, "… while expenditure in those categories at times may well be considered Research and Development, when I went through the expenditure of the companies there was nothing that I saw there that should qualify, in my view, as Research and Development expenditure". It was put to him that expenditure on bank fees was a general administrative cost and thus within the Business Plan's definition of research and development. Mr Hellen accepted the first part of the proposition but not the second on the basis that it had not been shown that the bank fees "were relevant for [the] purpose" of research and development. Consequently, it seemed plain enough that Mr Hellen was prepared to treat expenditure as coming within the Definition as long as it was properly referable to research and development. [29] After the evidence just discussed, counsel for the appellants asked, "Well, you say that some bank fees could have been allocated if the accounts were used for Research and Development purposes, is that what I understand your evidence to be?" [30] Senior counsel for the third and fourth respondents, who are not parties to this appeal, objected to the question on the basis of lack of relevance. The point made was that Mr Hellen's understanding of the meaning of the Business Plan, based on his professional knowledge and experience, was not relevant to the question of whether the document was misleading or deceptive to potential investors. After some exchanges with the primary judge, counsel for the appellants elected not to ask any further questions. In oral argument on appeal, counsel for the appellants flirted with the contention that the primary judge had made a ruling preventing the appellants' counsel at first instance from pursuing a permissible line of cross- examination. The argument was not within any ground of appeal, lacked merit and was not pursued. [31] It is unnecessary to determine whether Mr Hellen's evidence in cross-examination should be taken as qualifying his statement in paragraph 9.4.5 of his report concerning promotional costs, although I rather think it does make plain that in that paragraph he was saying, in effect, that he could not see any reasonable connection between research and development and the "promotional costs" incurred by CME. The use the respondent made of Mr Hellen's report was to found the submission that it was possible to infer from the complete absence of expenditure on the matters listed in the Definition, or on anything which could be conventionally regarded as research and development, that there never had been an intention to spend $300,000 or anything like it on research and development. -- 10 of 11 -- 11 [32] The respondent's argument would have substance even if Mr Hellen's approach was that "promotional costs", regardless of their nexus with research and development, could not be regarded as research and development expenditure. But this challenge to Mr Hellen's evidence lacks factual foundation. The analysis of CME's expenditure extracted from Mr Hellen's report and provided to the primary judge by counsel for the appellants identified no expenditure by CME on "promotional costs". The appellants' argument in this regard was entirely hypothetical. [33] As I have already said, the primary judge did not rely on any inferences to be drawn from the failure of CME to spend money on anything which was recognisable as research and development in order to establish misleading or deceptive conduct. The primary judge held that the Representations were deemed to be misleading and deceptive by operation of sub-sections (1) and (2) of s 12BB of the Act. The argument advanced by counsel for the appellants failed to reveal any flaw in the primary judge's reasons in this regard. To do so would have required advocacy of a singularly high order. [34] Mr Nugent was called as a witness in the respondent’s case. He was not cross- examined by counsel for the appellants at all, let alone with a view to showing that there were reasonable (or even any) grounds for making the subject representations. No other witness was called for that purpose or gave evidence that went towards showing the existence of such reasonable grounds. In the circumstances, the primary judge was plainly correct in concluding that the representors must be "taken not to have had reasonable grounds for making the [Representations]". 5 Conclusion [35] For the above reasons, I would dismiss the appeal with costs. [36] FRASER JA: I have had the advantage of reading the reasons for judgment of Muir JA. I agree with those reasons and with the order proposed by his Honour. 5 Australian Securities and Investments Commission Act 2001, s 12BB(2). -- 11 of 11 --