The Australian Securities and Investment Commission (ASIC) recently commenced civil proceedings against a number of former directors and former executives of James Hardie. This case will undoubtedly raise – and hopefully answer – many questions in relation to directors’ duties and responsibilities. Kevin Forde reports.
In February, ASIC filed civil proceedings in the Supreme Court of New South Wales relating to disclosures by James Hardie Industries Limited (JHIL) concerning the adequacy of the funding of the Medical Research and Compensation Foundation (MRCF). This case is likely to consider several fundamental questions concerning the duties and roles of company directors. There are five central issues that will certainly be examined by these proceedings, namely:
- What are the standards of care and diligence required by directors?
- To what extent can directors rely on management and the information provided by management to satisfy this duty of care?
- To what extent can directors rely on advice of outside experts in carrying out their duties?
- Directors’ obligations to ensure public disclosures are made by listed companies are not misleading; and
- How applicable ‘safe harbour’ defences are for directors who are charged with breaches of the Corporations Act.
ASIC’s proceedings are against seven non-executive directors and three executives of James Hardie who worked for the company at the time of its 2001 restructure, alleging they failed to act with requisite care and diligence. The regulator is also asking the court to consider imposing fines and banning individuals from acting as company directors.
Care and diligence
According to Professor Thomas Clarke, Director of the Centre for Corporate Governance at the University of Technology, Sydney: “These proceedings will be of great importance in terms of deciding the level of care and diligence expected of modern directors. Were James Hardie board members entitled to rely on the information provided by management or should they have conducted further independent investigations?
“There are also some basic issues such as the extent to which directors can trust information provided to them by management and their ability and willingness to ask the right questions at the appropriate time.”
Central to ASIC’s allegations is that James Hardie’s ASX announcement of 16 February 2001, and related press conference statements in relation to the establishment of the Medical Research and Compensation Foundation (MRCF), were misleading. ASIC claims the relevant directors failed in their duties to the company because they knew, or ought to have known, that the press announcement was misleading and that, if the misleading nature of the statement was revealed, it would be harmful to the company’s reputation.
In this context, the duty of care and diligence requires that directors exercise independent business judgement and do not rely blindly on the judgement of others. Moreover, if a director knows, or should know, any facts which would make a prudent person suspicious, then the director must take care to ensure that information provided by management or others is properly tested. These principles derive from the AWA case.
Paul Redmond, Sir Gerard Brennan Professor in the Faculty of Law at the University of Technology, Sydney says: “ASIC’s proceedings focus on the ASX announcement rather than the company’s separation and funding decisions themselves. They seek to extend the liability net beyond Peter MacDonald (the former chief executive of James Hardie) to the non-executive directors who approved the announcement.”
Says Redmond: “ASIC alleges the non-executive directors breached their duty of care by failing to query the draft announcement since they neither believed as individuals that funding was sufficient nor had adequate information before them to justify such a belief.
Duty of care
“Further, ASIC says the non-executive directors should have known that the ASX announcement was false or misleading since it relied upon a cash flow model whose dubious assumptions were not tested in the limited external scrutiny it was given. They breached their duty of care, ASIC claims, by failing to inquire as to the nature and limits of the external scrutiny and the model’s suitability.”
Most of the former directors and executives are being charged under Section 180(1) of the Corporations Act – apart from Peter MacDonald who is also being charged under S181 (1) which relates to a director exercising their powers and discharging their duties in good faith in what they believe to be in the best interests of the corporation, and for a proper purpose.
Peter Shaw, partner at Clayton Utz, says: “Most of the alleged contraventions are of s180, which relates to a directors duty of care and diligence. In particular the contraventions relate to the level of inquiry into the truth or otherwise of information that the company released to the market. ASIC’s argument is that the directors knew, or ought to have known, that if misleading information was released to the market the company would suffer.”
Shaw continues: “One of the core issues of this case is likely to be the effectiveness of the business judgment rule. There have been numerous cases testing the diligence rule but no real test of the business judgment rule. For non-executive directors in particular it will be important – they must make inquiries that are reasonable in the circumstances. But what exactly is a ‘reasonable inquiry’ and how will the court interpret the making of a judgment ‘in good faith’ in this case?”
Clarke agrees: “The civil proceedings do not hang on the overall legality of the restructuring but on the misleading nature of the statements made by the company and endorsed by the board. It is somewhat ironic that the company’s public relations spin, designed to ward off trouble, has become the cornerstone of proceedings against its officers.”
Information from management
Another crucial aspect of the case is likely to be how much a non-executive director should enquire about or challenge the information presented by management. Ideally, the proceedings against James Hardie directors may define how much non-executive directors may rely on information from management and advisers, in addition to that provided by the company. It would be a significant issue if the courts found that directors needed separate advice to that received by the company.
Clarke believes that non-executive directors reviewing external advice need to ask two questions:
- Have the external advisers been given the correct information by management?
- Do the external advisers have a conflict of interest in providing this advice – ie is there an incentive for the external advisers to provide opinions that will please management?
These questions could also lead the court to turn its attention to the behaviour of James Hardie’s outside advisers. Over the past decade the first response to a corporate crash is usually to blame the directors. But Professor John C. Coffee, Adolf A. Berle Professor of Law at Columbia Law School, believes the behaviour of other corporate governance ‘gatekeepers’ warrants greater scrutiny.
It is Coffee’s view that a number of ‘gatekeeping’ professions – auditors, lawyers, securities analysts, credit-rating agencies – exist to help guard against corporate governance failures. He says: “Yet clearly these watchdogs did not bark while corporations were looted and destroyed. Why not? To answer this question, a more detailed investigation is necessary that moves beyond journalism and easy scapegoating, and examines the evolution, responsibilities, and standards of these professions.”
The James Hardie case is also likely to analyse whether the directors involved may be able to avail themselves of a ‘safe harbour’ defence, which effectively is an exception to the duty to act with due care and diligence. Even if, prima facie, there were a breach of a duty of care and diligence, directors will not be liable if they can establish a safe harbour defence. Relevant safe harbours are in section 189 (Reliance) and section 180(2), the business judgement rule (BJR) of the Corporations Act.
Shaw agrees that section 189 of the Corporations Act is likely to be relevant in this case. “In my view the qualification that a director may rely on information provided by an expert or employee only after making an independent assessment of the advice cannot mean that a director must second guess the expert. I think that this case will test how robust the BJR is and exactly what the second part of section 189 of the Corporations Act really means.
“For the non-executive directors whose knowledge is imperfect the question is how much inquiry do I have to make? As a director you cannot be meddling in the business. But at the very least non-executive directors must bring an inquiring mind to the boardroom,” Shaw says.
Safe harbour defence
To establish the ‘reliance’ safe harbour under section 189, directors need to show that they relied on an external person or employee and that (a) they believed on reasonable grounds that the adviser was reliable and competent, (b) they acted in good faith; and (c) they made an independent assessment of the information or advice provided to them.
Directors also could seek to rely on the business judgement rule in section 180(2). This is applicable if the directors exercise a business judgement. The conditions of this safe harbour are that (a) the directors acted in good faith and for a proper purpose, (b) they had no material personal interest in the matter, (c) they reasonably believed their actions were appropriate, and (d) they rationally believed their actions were in the company’s best interest.
According to Redmond, non-executive directors are likely to claim the safe harbour of the business judgement rule. That rule protects directors who make a judgement they rationally believe is in the best interests of their company. The rationality standard is deemed satisfied unless the belief is one that no reasonable person in their position would hold.
“However, access to this safe harbour is conditional, says Redmond. “The condition that will be tested on the first claim is the requirement that the directors were adequately informed in their decision, the very issue that ASIC is contesting. The condition of director good faith and proper purpose might be tested on the second.
“ASIC’s action does not appear to open new vistas of non-executive directors’ liabilities. It is likely, however, to provide a welcome exploration of the business judgment rule’s protection,” Redmond says.
Thus far virtually all the discussion surrounding the James Hardie case has concentrated on the behaviour of the company’s directors and senior management. But what about the outcomes for the asbestos victims? Clarke research concludes that: “When compared to some of the settlement trusts set up in the US and UK, it seems that Australian asbestos victims have got a relatively good outcome, even if it has taken a lot of time and effort to achieve.”
The Law Reporter column in this issue (page 38) also discusses aspects of the James Hardie case.
Harsh light may shine on executives
John Story, Chairman of AICD, says that on any view, the saga of James Hardie is an unhappy chapter in Australian corporate history. The role of an independent board includes providing an effective check and balance with respect to the management of the affairs of a company, particularly having regard to prudential and ethical considerations. In the case of James Hardie, the events that have transpired may bring into question the issue as to whether or not the board of the day failed to fulfil that role.
However, failure on one occasion does not mean that our system of corporate governance is broken. During the past 15 years, Australia has experienced a period of sustained economic growth, combined with vigorous corporate activity. There are examples, including HIH and One-Tel, of corporate governance failures during this period, but what is striking is how few there have been. By and large, Australian companies are well managed, and our standards of corporate governance compare favourably to those of any of our global competitors. Australia’s model of independent non-executive directors has served it well.
The civil penalty actions allege various breaches of duties under the Corporations Act, including:
1. JHIL’s ASX announcement of 16 February 2001 and related press conference statements in relation to the establishment of the MRCF. ASIC alleges these communications were misleading.
2. The failure to disclose the existence of the Deed of Covenant and Indemnity between the MRCF and JHIL, which created, amongst other things, an ongoing asbestos-related liability of JHIL.
3. The Information Memorandum (IM) for the 2001 Scheme of Arrangement that proposed a restructure of the James Hardie group. The restructure had the effect of JHIL (the then-ASX listed company) becoming a subsidiary of JHINV, a Netherlands company. ASIC alleges the IM was misleading in failing to disclose pertinent information relating to the meeting of JHIL’s future liabilities.
4. A series of presentations by a senior executive to institutional investors in 2002. ASIC contends these presentations contained misleading information about the adequacy of the funding of the MRCF and the James Hardie group’s asbestos liabilities.
5. The cancellation of the partly paid shares in JHIL, which were held by JHINV and represented as having been issued for the purpose of JHIL meeting any future liabilities. ASIC alleges that JHINV failed to act with the requisite care and diligence in requesting JHIL to cancel these shares. ASIC also alleges that JHINV failed to disclose certain important information to the ASX regarding the cancellation. ASIC has also sought orders that JHINV execute a deed of indemnity up to a maximum of $1.9 billion, or such amount as JHIL or its directors consider is necessary to ensure that JHIL remains solvent. However, if the conditions precedent to the Final Funding Agreement (referred to in the JHINV’s announcement to the ASX dated 1 December 2005) are satisfied, ASIC will not pursue the claim of indemnity against JHINV.
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