A landmark US court case has raised the question of when the knowledge and motives of individual employees should be attributed to the company itself, writes Professor Pamela Hanrahan.

    Before 2020, few people outside the healthcare sector thought much about medical PPE — the personal protective equipment like facemasks, gloves, and gowns that have been an important part of infection control for more than 150 years. Now, of course, PPE is big business and its reliability is more important than ever.

    Problems with PPE were indirectly behind the decision of the US Court of Appeals for the Second Circuit in Jackson v Abernathy (2020), delivered in New York in May. In it, the court dismissed a shareholder class action against PPE manufacturer Kimberly-Clark and its subsidiary, Avanos Medical. The companies were sued for failing to disclose problems with their “MicroCool Breathable High Performance Surgical Gown”, a PPE product designed to protect against highly infectious diseases such as HIV and Ebola. The plaintiff shareholders alleged the companies and their senior executives had made fraudulent representations to the market that the gowns met applicable quality and safety standards.

    MicroCool gowns had been the subject of a separate consumer protection case in California in 2017. Key executives of Kimberly-Clark testified in California that the problems with the gown were well known at the companies and had been communicated to then CEO Thomas Falk. Witnesses in the California proceedings included the president of the healthcare division (a direct report to the CEO) and the companies’ former and current global directors of strategic marketing for surgical and infection protection. The jury in the California action found, likely based in part on this testimony, that the companies had intentionally misled consumers about the gown’s protective qualities in violation of California’s strict consumer protection laws. But in New York in 2020, the appeal court found the plaintiffs had not met the high liability threshold for shareholder suits.

    The facts in Jackson illustrate two issues of ongoing concern to Australian directors. One is the disposition of shareholder class actions arising out of failure to disclose bad news — including about key product lines — to the market. The second is the way in which knowledge of problems deep inside the company, for example among technical and operational staff, can be attributed to the company itself for the purposes of determining corporate blameworthiness.

    Disclosure failures

    In Jackson, the shareholders alleged that the companies contravened sections 10(b) and 20(a) of the US Securities Exchange Act of 1934 and SEC Rule 10b-5, which deal with representations relating to corporate securities.

    US securities law forbids a company or an individual from making a materially misleading statement to shareholders. But, as the appeal court in Jackson points out, liability for such a statement in the US “requires proof that it was made with fraudulent intent”. The court observes that where a defendant is an individual, demonstrating such intent is often straightforward, however, “where the defendant is a corporation… a plaintiff must show that the misstatement was not a case of mere mismanagement, but rather the product of collective fraudulent conduct. As a result, a plaintiff must plead facts that raise a strong inference of collective corporate scienter”. Scienter here refers to malintent — intent or knowledge of wrongdoing at the corporate rather than individual level.

    The liability settings for disclosure failures in Australia are, of course, quite different. As a string of Australian shareholder class actions have demonstrated, a company that engages in misleading conduct in connection with market announcements here is exposed to a shareholder class action, even where the company did not intend to mislead the market and where it did not (and could not) know that its statements were untrue. Added to this, Australian listed and unlisted “disclosing entities” have a positive obligation to disclose price-sensitive information under sections 674 and 675 of the Corporations Act 2001 (Cth), meaning that failure to say anything at all can be misleading in some circumstances. The Jackson decision shows the different liability risk faced by Australian companies and their directors in connection with disclosure failures from their US counterparts.

    The Australian government’s temporary adjustment of the continuous disclosure rules, announced in May in response to the COVID-19 crisis, touches this issue. The adjustments have been hotly debated, including as to whether they should be made permanent. The government’s stated intention is that continuous disclosure failures should not attract liability under section 674 unless those responsible knew, or were reckless or negligent as to whether, information not disclosed was price-sensitive. But they are an incomplete answer to the risk of claims for misleading or deceptive conduct under Australian law, which remains unmodified.

    Corporate intent

    The Jackson decision also raises the perennially difficult question of when the knowledge and motives of individuals in a company should be attributed to the corporate entity itself. In Jackson, the liability question came down to whether the fact that individual executives knew and communicated that there were problems with the MicroCool gowns meant that Kimberly-Clark and Avenos had the necessary “collective corporate scienter” — in other words, whether the corporation itself intended to deceive, manipulate, or defraud.

    As the appeal court observes, “Ascribing a state of mind to a corporate entity is a difficult and sometimes confusing task. This is true ‘not because ‘collective intent’... is an oxymoron’, but because ‘the hierarchical and differentiated corporate structure’ often muddies the distinction between a deliberate fraud and an unfortunate (yet unintentional) error caused by mere mismanagement”.

    Corporate scienter is not a consideration in cases dealing with disclosure failure in Australia. But it does arise in other contexts, particularly in corporate criminal prosecutions where a fault element must be proved. The Jackson decision says that the knowledge of the three executives who gave evidence in California was not enough to show that the corporation itself had the requisite intention to defraud. The claim “sets forth allegations that three employees knew of problems with the MicroCool gown, but it provides no connective tissue between those employees and the alleged misstatement”.

    In Australia, deciding whether the knowledge and intentions of individual executives and employees should be attributed to the company is often a matter for statute, rather than judge-made law as in the US. And the Australian statutes are inconsistent. The Australian Law Reform Commission had this issue squarely in its sights in its recent inquiry into corporate criminal liability and we wait to see how it will be resolved.

    The Jackson decision reminds us that problems of transparency and corporate accountability arise everywhere.

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