A tale of two matters Law Reporter

How much power should corporate regulators be allowed to have?

Recently the newspapers have been full of stories concerning the inability of corporate regulator ASIC, to properly deal with issues of continuous disclosure involving some of our largest companies. But at the same time the newspapers have carried the story of the New South Wales Supreme Court decision in Australian Securities and Investments Commission v Adler and Four Others ([2002] NSWSC 171).

The two sets of stories are in one respect not linked at all. In another respect they are very closely linked and deserve very close attention by all directors and their companies.

Our Corporations Act contains some of the most far-reaching and significant rules relating to the regulation of companies and the way they do business. There are rules in relation to the raising of capital; rules relating to the carrying on of business as investment advisers (recently added to the legislation by the Financial Services Regulation legislation); rules which set out what is in effect a code of conduct (in very broad terms) for company directors and officers; rules relating to the registration of company charges; rules relating to accounts and auditing of those accounts; rules relating to the internal management of com-panies; and rules relating to liquidation, voluntary administration, and receiverships. And the list goes on!

Indeed, the Corporations Act is a complex and very large piece of legislation. Under this legislation and related legislation the regulators (including ASIC) are given enormous powers. And yet, many of these regulators want more power, not only in this area, but in other areas. They argue that the laws are inadequate to enable them to carry out their particular tasks; and that Parliament should vest in them quite extraordinary powers to do things which even the police can not when dealing with breaches of the general law.

All members of society must behave themselves within the confines of the regulatory regimes. Indeed, unless we have that kind of regulatory structure, we can find ourselves quickly facing anarchy. So, this writer, who has been a regulator himself and has exercised considerable power in running one of Australia's most powerful agencies, recognises that there are at times deficiencies in the way in which our legislative framework is structured and in the way in which the courts administer the laws.

But there are also failures in the way in which administrators carry out their obligations. There are lawyers who sometimes cut corners in providing advice to their clients. There are some lawyers who may even encourage their clients to take shortcuts which cause difficulty and frustration. In each case where there is a breach of the relevant law, it is appropriate and important that the regulator has the power and the necessary resources to pursue that breach. But, if the regulator finds, for whatever reason, that it cannot establish that there is a breach of the law then the regulator should be very careful in what it says publicly. It is inappropriate, and mischievous in my view, for the regulator to say: "If we had more evidence in relation to this matter or if this person or that company did certain other things in relation to the events that were proscribed, we would have brought proceedings in the courts and obtained a judgment against the company and perhaps the directors and even the advisers."

It is also unfair for the regulator to suggest that in certain circumstances a company which did certain things and persons who did certain things would have been guilty of certain laws if it could have had a different law in place. It is inappropriate to say that those persons were "almost guilty", but "we just did not have enough evidence or the right law to get a verdict from the court".

What are those persons named by those regulators supposed to do in these circumstances? Do they come out and say: look, this is outrageous, you have named us in these reports and we will sue you for defamation? Do they run the risk of pursuing that course of conduct so the regulator can then defend its position by claiming that the evidence was not quite there but it was nearly there and sufficient to warrant prosecution? There have recently been examples of such statements made by our corporate regulators, including ASIC which were followed by a request for more powers and a strengthening of the law. It is quite proper for the regulator to canvass changes to the law but not in the context of a set of circumstances that have not been tested in a court, in my view. Certainly they should not be seeking changes to the law because someone "was almost guilty" in their view.

Because there have been a number of major corporate collapses and billions of dollars have been lost by investors and others as a result of those corporate collapses it might be seen by many as fair game for regulators to come out and make such statements and seeking a change in the law or more powers to deal with the particular issue. I for one have no difficulty with the regulator seeking clarification of the law. I do have many difficulties with the regulator suggesting that the particular company and particular circumstances (and perhaps some directors and others involved) may have breached the law if the facts had been different.

In my view, the laws we have are what we deserve. We elect parliament-arians on the basis of policies that they put forward in election campaigns and they deal with these matters in the Parliament. If we are dissatisfied with the laws that they pass then we should vote out those who we elect to represent us. We should give the new members (through our voting patterns) clear indications of how we want particular matters dealt with. But, we should not allow the Parliament to abdicate its responsibilities of passing appropriate laws to deal with particular matters by vesting additional and unfettered powers on regulators simply because "things were a bit difficult to establish in this particular case."

This point is absolutely clear as a result of the recent decision in HIH referred to earlier. This arise in the so-called difficult area of establishing that directors breached their duties in general terms. In Australian Securities and Investments Commission v Adler and Four Others Justice Kim Santow handed down his judgment within four months of the case first being argued in the court.

His decision makes it clear that if the right evidence is presented to the court appropriate findings will be made. No doubt certain persons will seek a review of those decisions and we may have to wait for a Court of Appeal to deal with certain aspects of the particular matter. But the judge, whose judgments have been treated with great respect by appeal courts and by commentators, had little difficulty in reaching certain conclusions about the alleged breaches of duty in relation to certain matters involving HIH Insurance Ltd (HIH). The facts of this particular case and the charges levelled against various directors are complex and quite technical. It is impossible to canvass all the relevant facts but the judgment of Santow J contains the following brief overview of the facts which we repeat without comment.

"The First Defendant Mr Adler, is sued as a non-executive director of HIH, the parent company. He is also sued as an alleged officer (non-executive) of its wholly owned subsidiary HIHC. Mr Adler denies he is a director or officer of HIHC. Mr Adler is being sued for alleged breaches of his statutory duties owed to HIH and HIHC and also, in his case only, as a director of the trustee company of a unit trust, the Australian Equities Unit Trues ('AEUT'), in which HIHC invested, namely Pacific Eagle Equity Pty Limited ('PEE'). Adler Corporation, also joined as a Defendant for accessory liability, at all material times controlled PEE and (with two others) acquired the majority of the units in AEUT. Those alleged contraventions relate to the first transaction constituted by HIHC's investment of $10 million in the trust ('the trust transaction').

Then they relate to two further sets of transactions by the trust. Thus the second set of transactions involves a substantial purchase of HIH shares by AEUT contemporaneously with and made from the $10 million investment ('the HIH share transaction'). Later there is the third set of transactions relating to the sale by Adler Corporation to AEUT of certain unlisted share investments bought by AEUT from Adler Corporation at the latter's cost ('the unlisted investment transaction'). Finally there is the fourth set of transactions comprising AEUT's loans (unsecured save in two cases by unsecured guarantees) to entities associated with Mr Adler and Adler Corporation ('the unsecured loan transactions'). Proceedings against Mr Adler and Adler Corporation are in respect of all four sets of transactions.

Proceedings against the other two directors, Messrs Williams and Fodera, are in respect of the first two sets of transactions only. This is clear from the declarations sought and the material facts pleaded, though the pleaded Particulars are similar.

The directors against whom action is brought include two of the executive directors of HIH, Mr Williams, chief executive officer of HIH and Mr Fodera, HIH's finance director. They are the Second and Third Defendants respectively. There is no dispute that both are directors of HIHC as well as HIH." (paragraph 4)

Further allegations were made against Williams and Fodera on the basis that they were liable for accessory liability under section 79 of the Corporations Act. Santow J then described in paragraphs 11 through to 19 of his judgment the relevant "breaches" in what he described as "neutral terms". It is not intended to go into the detail of the relevant transactions described in the above quote but in essence, and taking only the first transaction as an example of the complexities of the issues raised Santow J's description is reproduced for the benefit of readers.

"The first transaction (the trust transaction) relied upon by ASIC as giving rise to the relevant contraventions proceeded by a payment by cheque of $10 million on 15 June 2000 by HIHC to PEE, controlled by Mr Adler. This payment followed earlier correspondence commencing 9 June 2000 between Mr Adler and Mr Williams and later steps involving various officers of HIH and HIHC. PEE either contempor-aneously or shortly thereafter became the trustee of AEUT. Control of AEUT was vested in Adler Corporation with two others. Adler Corporation enjoyed an entitlement to 10 percent of all distributable income via A class units issued at an issue price of $25,000. The remaining units being B class units, were issued to HIHC at a price of $10 million, thus appropriating the $10 million earlier paid over. Those B class units conferred an entitlement on HIHC to receive 90 percent of AEUT's 'distributable income'. The characterisation of that payment of $10 million initially as an unsecured loan (as the Plaintiff prefers) or as throughout impressed with a trust (as alleged by the Defendants) and, if so, its precise legal character, is a matter of dispute. It is the Plaintiff's view (disputed by the Defendants) that there would be no difference in result, under either characterisation; that is to say, the same contraventions would occur.

That payment of $10 million by HIHC to PEE, was, according to ASIC (but disputed by the Defendants):

(a) made at the instigation of Mr Adler, with Adler Corporation 'involved' so liable as an accessory;

(b) with the agreement of and under the direction of Mr Williams;

(c) with the assistance of Mr Fodera in implementing the payment and who (it is alleged) failed, with Messrs Adler and Williams to bring that transaction and the HIH share purchases to the attention of other directors of HIH or to its investment committee so that neither were approved or authorised as required by applicable investment guidelines by HIH's Investment Committee, or by the Board;

(d) employed under a deed for AEUT that unduly favoured Mr Adler and Adler Corporation and lacked basic safeguards, permitting as it did self-dealing with no requirement for independent appraisal;

(e) was made and invested by AEUT without the necessary Board or Investment Committee approval."

After setting out the broad overview the judge goes on to describe how the relevant alleged payments were utilised in relation to the purchase on the stock market of shares in HIH over an approximate two-week period commencing 15 June 2000. Further payments were later utilised to make other purchases described in paragraphs 16 to 17 of the judgment. Because of the complexity of the relevant matters we will not go into those facts in detail. Indeed, it is not intended to comment on the factual scenario but simply to deal with the detailed description of the breaches of the law that were relevant and the judge's approach to the analysis of the relevant provision of the Corporations Act.

It is now appropriate to briefly discuss the conclusions that he reached in this case to confirm the fact that we do have a very powerful piece of legislation in place in our Corporations Act. It is not proper nor appropriate for the law to be changed on the basis that there have been the odd failures on the part of the regulator because that may well be due to a lack of evidence in the particular case. The three directors charged were a non-executive director and two executive directors as well as a company linked to one of the non-executive directors. ASIC sought declarations that the various allegations had been committed and sought relief against each individual director of compensation as well as civil penalties and banning orders. The major allegations were that each of the directors breached duties owed to HIH and a certain subsidiary company arising out of the related party provisions of the Corporations Act. One set of provisions related to obtaining certain benefits without shareholder approval; another set of allegations related to the giving by the relevant company of financial assistance for the purchase of its shares.

The other major allegations were breaches of statutory duties of care and diligence in relation to the carrying out of the obligations in relation to the company, a breach of the duty to act in good faith and for a proper purpose and also breaches of the duties requiring directors not to use their position improperly or to use information improperly. At paragraph 372 of the judgment in this case Santow J sets out in brief but very easy to follow form a broad summary of the duties of directors to act with appropriate care and diligence, to act in good faith and to avoid misusing either their position or information. It is unnecessary to set out the first two paragraphs of that part of the judgment. They simply recite the traditional position which has been set out in the pages of this journal many times in the past. However, there are certain other statements made by Santow J which I found particularly useful in explaining some of the duties of directors. I therefore repeat them for the benefit of readers. In describing the obligations, especially of a non-executive director or directors that may not be engaged in the front line of decision making, Santow J, relied on the decision in the AWA case (Daniels v Anderson (1995) 37 NSWLR 438 at 666-667) where these comments were highlighted.

Basic duties

"Directors are required to take reasonable steps to place themselves in a position to guide and monitor the management of the company. That is to say:

(a) a director should become familiar with the fundamentals of the business in which the corporation is engaged;

(b) a director is under a continuing obligation to keep informed about the activities of the corporation;

(c) directorial management requires a general monitoring of corporate affairs and policies, by way of regular attendance at board meetings; and

(d) a director should maintain familiarity with the financial status of the corporation by a regular review of financial statements. Indeed, he or she will be unable to avoid liability for insolvent trading by claiming that they had never learned to read financial statements." (paragraph 372)

Special expertise

Santow J then examined the position of a director with special expertise and suggested that such a person "is not relieved of the duty to pay attention to the company's affairs which might reasonably be expected to attract inquiry, even outside that area of expertise." (Citing Re Property Force Consultants Pty Ltd (1995) 13 ACLC 1051 at 1061.)

Reliance on others

Santow J next noted that while a director is entitled to rely without verification on the judgments, information and advice of management and other officers appropriately so entrusted, such reliance would be unreasonable where directors know, or by exercise of ordinary care should have known any facts that would deny reliance on others (referring to Daniels case again for support of this proposition).

He made these very useful comments about reliance and how far reliance or delegation can be taken.

"(11) Although reasonableness of the reliance or delegation must be determined in each case, the following may be important in determining reasonableness:

(a) the function that has been delegated is such that 'it may properly be left to such officers': Re City Equitable Fire Insurance Co Ltd [1925] Ch 407 per Romer J.

(b) the extent to which the director is put on inquiry, or given the facts of a case, should have been put on inquiry: Re Property force Consultants Pty Ltd (1995) 13 ACLC 1051 per Derrington J at 1060.

(c) the relationship between the director and delegate, must be such that the director honestly holds the belief that the delegate is trustworthy, competent and someone on who reliance can be placed. Knowledge that the delegate is dishonest or incompetent will make reliance unreasonable: Biala Pty Ltd v Mallina Holdings Ltd (1994) 15 ACSR 1 at 62.

(d) the risk involved in the transaction and the nature of the transaction: Permanent Building Society v Wheeler (1994) 14 ACSR 109 (although in this case the Chief Executive Officer in question also had a conflict of interest).

(e) the extent of steps taken by the director, for example, inquiries made or other circumstances engendering 'trust'.

(f) whether the position of the director is executive or non-executive: Permanent Building Society v Wheeler per Ipp J, though in Daniels v Anderson (1995) 37 NSWLR 438, the majority have moved away from this distinction." (paragraph 372)

Delegation

After referring to these common law "evaluations" of the position, Santow J noted that under section 198D of the Corporations Act directors may delegate any of their powers to a committee of directors or to other persons. But, the directors will be responsible for the exercise of that power and if the director did not believe that the exercise was appropriate the director should take steps to correct the situation. Santow J made some sensible and very helpful comments about avoiding conflicts of duty and interest and then turned to deal with the business judgment rule.

Business judgment rule

As readers of this journal will appreciate, the business judgment rule was introduced to provide protection to directors from liability where, even though they may have made a mistake, their actions were such as to warrant excuse or relief because of the circumstances surrounding the particular matter. In one of the rare decisions in which the business judgment rule has been evaluated, Santow J noted as follows:

"(15) In order for the safe-harbour 'statutory business judgment rule' to be relied upon, the director must first have made a business judgment. Then that business judgment must satisfy the following requirements, namely made in good faith for a proper purpose' after the director has informed himself as to the subject matter of the judgment to the extent he reasonably believes to be appropriate; in circumstances where the director does not have a material personal interest in the subject matter of the judgment and rationally believes that the judgment is in the best interests of the corporation: section 180(2). The director's believe that his or her judgment is in the best interests of the corporation is a rational one unless the belief is one that no reasonable person in that position would hold: section 180(2)." (All of the references are to the Corporations Act.) (paragraph 372)

In the final summing up of the findings made by Santow J in this case he held that the non-executive director was in breach of sections 180 and 181 of the Corporations Act. He also held that Mr Williams was in breach of section 180 because:

"Mr Williams was not entitled to rely on Mr Adler to make investments, which conformed with the law and were not detrimental to the interests of HIH, without at the least making sure there were put in place proper safeguards including independent appraisal of the investments made by way of proper due diligence and by ensuring that before the arrangements were put in place, the terms of the mandate were approved by the Investment Committee, if not the Board. Mr Williams simply did not do this either when making the original commercial deal or by instructing Mr Howard. It is nothing to the point to say that he hoped that the investment would turn out profitably or he would not have made it. The fact of the matter was that Mr Williams did not ensure that the company complied with its own safeguards laid down for approval of such a mandate by its Investment Committee _ Accordingly, I conclude that Mr Williams was in breach of s180 of the Corporations Act in failing to exercise the degree of care and diligence that a reasonable person would have exercised as a director in the circumstances and occupying the office held by Mr Williams. Mr Williams is not able to invoke the business judgment rule in the circumstances where he either failed to make a business judgment at all or to the extent that he did, failed to establish that he made it in good faith for a proper purpose, and in any event, where he had a material personal interest in the subject matter of the judgment and had failed to inform himself to the extent he could reasonably believe to be appropriate." (paragraph 453)

Similar findings (but not quite as extreme) were made against another director, a Mr Fodera.

High threshold to establish a breach of duty to act in good faith

It is interesting to note in dealing with Mr Fodera's case under section 181 of the Corporations Act the judge did not find that either Mr Williams nor Mr Fodera had breached section 181 of the Corporations Act which requires the directors to act in good faith and for proper purposes. In doing so, the judge noted that there was a stringent standard required to be established for a breach of section 181. Perhaps in that context the regulator is right and the law needs to be changed to make the standards a little less stringent especially in civil proceedings. The judge was also asked to consider whether the directors should obtain relief under the terms of section 1318 or section 1317S of the Corporations Act. He declined to consider the matter until he had heard more evidence on questions of penalty and related matters.

Some other observations

There will be many who argue that the HIH case is such a special case on its facts that not many conclusions should be taken from it. But, at a time when there is a continual outcry against corporate collapses and the actions of company directors, if we have judgments which clearly find that there has been a breach of the law (and after all the law has only recently been redrafted to provide significant defences as well as codifying other parts of it) then there is a clear indication that the law can and does work in cases where the evidence is properly presented. It is quite inappropriate for society to continue to claim that people should be convicted of breaches of the law if they in fact do not breach the law. The law is stated in such a way that it provides an opportunity for people to act within the law, the fact that some in the community (and indeed it may be the majority at a particular time) feel outraged by what is going on is not sufficient. Otherwise we might have to go out there and hang those who we think are breaking the law whether they have broken it or not.

We should not allow the passion that sometimes is generated by unfortunate and tragic collapses to warrant vigilante squads of citizens or regulators to go out and carry out a public justice campaign. Our Corporations Act does work. It of course contains flaws. I have been critical of some of these flaws. But, the way in which to overcome those flaws is to continue to press for changes to the law; some of those flaws can be overcome. In my view, we should not at any time, or under any circumstances, leave the responsibility of Parliament to enact changes to the law to those who feel that because they are given certain additional responsibilities and power to administer the law without maintaining proper "boundaries". That would be a dangerous and unacceptable course for us to take. I believe our regulators do a quite remarkable job in enforcing our laws. At times they are frustrated by inadequate resources and by technical reasoning. One sympathises with them (I experienced similar frustrations when I was a regulator) in some cases.

If the decisions of the court show that the provision is inadequate to deal with a certain type of conduct the Regulator should seek appropriate changes to the law. That means ensuring that the law is drafted in such a way so that it can be interpreted by a court following the production of appropriate evidence and information. To allow the law to be applied without reference back to these critical and central criteria of our judicial system would be to take a very big step backwards indeed. The recent events show that our laws do work. The fact that some of them may be flawed and there can be technical breaches occur (which I do not concede) is a matter than can be dealt with through appropriate channels and parliamentary reform. They cannot and should not be dealt with by vesting sweeping and very draconian powers on regulators who want to take shortcuts that are unacceptable to society.

Disclaimer

The purpose of this database is to provide a full-text record of all articles that have appeared in the CDJ since February 1997. It is aimed to assist in the research and reference process. The database has a full-text index and will enable articles to be easily retrieved.It should be noted that information contained in this database is in pre-publication format only - IT IS NOT THE FINAL PRINTED VERSION OF THE CDJ - therefore there might be slight discrepancies between the contents of this database and the printed CDJ.