Domini Stuart examines whether a legal defence proposed by Company Directors will benefit the majority of directors who are committed to doing the right thing.
In 2010, Steven Cole FAICD had the job of explaining Australia’s director liability regime as part of the Walton Business School Certificate in Governance.
“There were people in the class from North and South America, Africa, Asia and Europe and their universal response was ‘you’ve got to be joking’,” says Cole, non-executive director of Matrix Composites & Engineering and managing director of consultancy firm Cole Corporate. “That was a serious comment from senior directors and it confirmed my belief that Australia has a significant competitive disadvantage compared with its international peers. If I’m a CEO or director of a company with $5 billion to invest, am I going to say ‘let’s put it into Australia where I can go to jail and be personally sued for making a well-considered business decision?’”
Research by the Australian Institute of Company Directors also suggests that personal and reputational risks are deterring some very able people from taking up directorships.
“It’s easy to counter that by pointing to the people queuing up to join boards, but the real problem is that many of our best directors are reluctant to leave the comparative security of the S&P/ASX 50 companies,” continues Cole. “In most professions, younger people learn by working alongside their more senior colleagues, but many directors feel too vulnerable at the junior end of the market. Yes, we have some excellent mentoring programs, but that’s still not the same as sitting in the boardroom with a top director and learning at his or her feet. The flow-on effect from that can affect our national wellbeing. ”
The business judgment rule (BJR)
In 2000, then Treasurer Peter Costello inserted the BJR into the Corporate Law Economic Reform Program (CLERP) Bill. This was a response to concerns that the NSW court of appeal had gone too far in rejecting the boards’ right to rely on expert advice.
“Justice Andrew Rogers had ruled that the non-executive directors in the AWA case were not liable for duties of care and diligence because they had taken advice from management and experts,” says Professor Bob Baxt AO FAICDLife, emeritus partner at Herbert Smith Freehills. “The court of appeal overturned him two to one and that decision attracted a lot of criticism.”
The BJR was designed to provide a defence for directors who may have breached their duty of care as long as they made the judgment in good faith, for a proper purpose, did not have a material personal interest, appropriately informed themselves about the subject matter and rationally believed that the decision was in the best interests of the company. But it has never been used successfully.
“Courts are very conservative in this country and the focus here is on legislation that makes it easier for regulators to prosecute rather than harder,” says Baxt. “This is a very different situation to the US where, if a director is being sued for breach of care and diligence, the BJR requires the prosecution to prove that he or she did not exercise appropriate business judgment.”
The court also has the power to forgive directors for a breach of duty if they have acted honestly and reasonably but, again, it has failed to exercise that discretion. The Centro case is a notable example.
“Justice Middleton said that the directors had been in breach of a duty to comply with the accounting rules as well as a breach of duty of care, so the Australian Securities and Investments Commission (ASIC) sought to disqualify and penalise them,” says Baxt. “When Justice Middleton heard the case, he made the powerful statement that the directors had, in fact, done everything that was asked of them, but I was disappointed and surprised when he decided not to exercise his right to forgive them. That’s a very confusing message to be sending to the community.”
A narrow approach
Cole dismisses the BJR as having so many limitations that it is almost worthless. It is also very narrow in its approach.
“There are so many places where directors are in fear of liability that it was never intended to cover,” he says. For example, there is no incentive for directors to attempt to save a company which is experiencing financial difficulties.
“If they get it wrong, and the company becomes insolvent during a rescue mission, directors commit an offence and can lose their homes,” says Bruce Cowley FAICD, chairman of law firm Minter Ellison. “No wonder the first thing that directors of a financially troubled company do is call in the administrators rather than looking at options for helping it to survive.”
There is also a lack of clarity around the continuous disclosure rules that apply to listed companies.
“ASIC has no idea of how far to go and how strongly to pursue this,” says Baxt. “It tends to rely on issuing infringement notices – you agree to pay a fine of, say, $100,000 and it reports quietly to the market that the issue has been resolved. Usually it also asks for an enforceable undertaking – a promise to behave in future – and, while paying the fine is not an admission of breaking the law, it is often a trigger for a class action. So companies are having to settle multi-million dollar law suits when ASIC should be taking cases like this to court to establish what really happened and then responding appropriately.” (For more on infringement notices, see p52.)
Honest and reasonable director defence
Company Directors has developed an honest and reasonable director defence which could be inserted into the Corporations Act 2001 to improve the regulatory environment. The proposed defence would be available in circumstances where a director conducts himself or herself honestly, for a proper purpose and with the degree of care and diligence that the director rationally believes to be reasonable in the circumstances.
“I think the beauty of this is that it can be applied equally to all contraventions of the Corporations Act and the ASIC Act 2001 whether they be in respect of insolvency, forward-looking statements, continuous disclosure or anything else – a different defence is not required for each offence,” says Cowley. “The proposed defence is an important contribution to the debate and given the ease with which it could be introduced, I encourage the government to give it serious consideration.”
Some commentators have suggested it would be easier to extend coverage of the existing BJR.
“That would involve multiple interventions right across the Corporations Act,” says Cole. “Company Directors’ approach is much simpler and easier to implement.”
Another concern is that the defence fails to address state laws.
“It’s true that there are 700 pieces of state-based legislation imposing liability on directors,” continues Cole. “Work is being done to decriminalise some of these offences, but there is still civil liability in cases related to the environment, occupational health and safety and many other areas. I believe this to be a secondary fight that needs to be taken up with the states under each piece of legislation, and that having a clear position at a federal level would make it much easier to pick these off.”
On the issue of state liability provisions Rob Elliott FAICD, general manager of policy and advocacy at Company Directors, states: “Company Directors has done a significant amount of work on the issue of state director liability reform. In 2011, in response to lagging COAG reforms, we developed a set of principles and a model provision which directly addressed the specific flaws evident in state criminal liability provisions applying to directors. As a result of our engagement efforts with state and territory governments, there has been significant reform on this issue, particularly in Queensland, NSW and Victoria. In Queensland, for example, around 90 per cent of the director liability provisions which failed to uphold the presumption of innocence for directors have now been amended or repealed with further reform anticipated. While our work on state issues continues, the honest and reasonable director defence is designed to improve federal corporations legislation.”
There could also be limited benefit in the so-called “stepping stone” cases where ASIC alleges that directors have breached their duty of care and diligence by failing to prevent a contravention by their company, or exposing their company to a risk of contravention, of the Corporations Act or other laws.
“In the stepping stone cases, the defence will be considered only when the court has found that the company has contravened the law, or was at serious risk of doing so, and that the directors have failed to exercise the degree of care and diligence required under section 180,” says Tim Bednall, managing partner at King & Wood Mallesons. “The onus will then be on the directors to prove that they rationally believed at the relevant time that they had exercised a reasonable degree of care and diligence. In my view, welcome as it would be, the defence would be unlikely to deter ASIC from pursuing these cases as long as directors remain liable to civil penalties and disqualification for a breach of the duty of care and diligence under section 180. As a practical matter, it would need to be clear from the evidence that directors considered the relevant issues and acted on a reasonable basis, even though the court has found that they acted without the degree of care and diligence that a reasonable person would have exercised. That would be difficult.”
A different focus
Cole believes that the current focus on director liability is a distraction from the real impact of both the current regime and the prevailing culture. “I think we’ve lost sight of what business is about,” he says. “Corporations are not purely economic. They provide employment, pay taxes and produce goods and services which are of use to society. Out of that we build prosperity throughout our community.
“Culturally, when something goes wrong we’re looking for someone to blame. When you choose to invest in a company you are accepting an element of risk yet much of our regulation is based on the notion that we should punish people for failure. Instead of reflecting a healthy balance between performance and risk management, the standard board agenda these days is bogged down in compliance. And this discourages innovation and entrepreneurship which, in turn, has a negative impact on productivity, investment, new market entrants, international competitors and the community; we’ve all seen what happens to communities in times of recession.”
A sigh of relief
Cowley believes that the honest and reasonable director defence would elicit a huge sigh of relief from the vast majority of Australia’s 2.3 million directors who are committed to doing the right thing. “They could feel confident in the knowledge that, as long as they do act honestly and reasonably, they will be free from liability and able to get on with the business of growing the wealth of their shareholders and the prosperity of Australia as a whole,” he says.
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