1. What are directors' duties?
1.1 The duties of directors can be found in the common law, in equity, under the Corporations Act 2001 (Cth) (Corporations Act) and a company's constitution.
1.2 Common law and equitable/fiduciary duties include:
(a) the duty to act bona fide in the interests of the company as a whole
(b) the duty not to act for an improper purpose
(c) the duties of care and diligence
(d) the duty to retain discretion
(e) the duty to avoid conflicts of interest, although this duty may be qualified by express provisions in a company's constitution or by full disclosure and approval
(f) the duty not to disclose confidential information, and
(g) the duty not to abuse corporate opportunities.
1.3 The duties that can be found under the Corporations Act include:
(a) the duty of care and diligence (s 180)
(b) the duty of good faith (s 181)
(c) the duty not to make improper use of position or information (ss 182-183)
(d) duty not to trade while insolvent (s 588G)
(e) disclosure of material personal interests (ss 191-195)
(f) the requirement to obtain shareholder approval for financial benefits to related parties (ss 208 - 210), and
(g) duties of care and diligence specifically in relation to financial reporting obligations (ss 285 -318).
1.4 Section 184 of the Corporations Act provides a series of criminal offences which arise when directors act in a reckless or intentionally dishonest way and fail to carry out their duties in good faith, gain an advantage for themselves or someone else, or cause detriment to the corporation.
1.5 According to section 140(1)(b) of the Corporations Act, a company's constitution has the effect of a contract between the company and each director or secretary and, consequently, it may also contain specific obligations for directors.
2. Areas of concern
Two current and major areas of concern are insolvent trading and continuous disclosure obligations.
2.1 Insolvent trading
(a) Directors have a duty to prevent insolvent trading under section 588G of the Corporations Act.
(b) Under section 588G Corporations Act, a director of a company may be liable for debts incurred by the company at such time as:
(i) the person is a director of the company, and
(ii) the company is insolvent at the time the debt is incurred, or becomes insolvent by reason of incurring that debt, and
(iii) at that time, there were reasonable grounds for suspecting that the company was insolvent, or would become insolvent.
(c) Commonly, when a company is placed into external administration, unsecured creditors do not get paid in full. The company is by definition insolvent, so the recriminations start: "What were the directors doing ...?"
Knowing when to stop trading a company and/or to appoint an external administrator is not an exact science. Even with the best of intentions, directors often do not get it right. The law, in recognition of this, provides a number of defences to an insolvent trading action.
Section 588H of the Corporations Act includes the following defences:
(d) The expectation of solvency based on reasonable grounds.
(e) "Reliance on competent person" defence, having three elements:
(i) Belief, based on reasonable grounds, that a competent and reliable person was providing adequate information as to the company's solvency, and
(ii) Actual provision of information by that competent and reliable person, and
(iii) Expectation of solvency based on the information provided.
2.2 Continuous disclosure obligations
(a) The need for corporations to make timely disclosure of market-sensitive information has been highlighted by the recent global financial turmoil.
(b) It is especially important for companies whose share price or operations have been significantly impacted by this turmoil to ensure that the market is up-to-date with material changes to their businesses and financial status.
(c) Continuous disclosure obligations have been a focus of the media and regulatory authorities following the Federal Court's recent approval of the largest class action settlement in Australia's history ($144.5 million) which involved claims that Aristocrat leisure failed to comply with these obligations.
(d) Continuous disclosure obligations can be found in ASX Listing Rule 3.1 which requires an entity that becomes aware of any information concerning it that a reasonable person would expect to have a material effect on the price or value of the entity's securities, to immediately tell the ASX that information.
(e) ASX Listing Rule 3.1 is given legislative support by s 674 of the Corporations Act, which imposes statutory liability in circumstances where a listed company fails to disclose information that it is required to disclose under the Listing Rules, and the information is not generally available and is information that a reasonable person would expect, if it were generally available, to have a material effect on the price or value of the company's listed securities.
(f) Information that is required to be disclosed under ASX Listing Rule 3.1 must be disclosed notwithstanding that an entity may be subject to a contractual restraint not to disclose that information.
(g) The question whether a reasonable person would expect information to have a material effect on the price or value of securities is taken to be affirmatively answered if the information would, or would be likely to, influence persons who commonly invest in securities in deciding whether or not to acquire or dispose of those securities (s 677 of the Corporations Act).
(h) Examples of circumstances where disclosure may be required include:
(i) where there is a change in an entity's financial forecasts
(ii) the recommendation or declaration of a dividend
(iii) the commencement of material litigation against the company
(iv) the giving or receiving of a take over notice, or
(v) a proposal to acquire or dispose of an asset.
(i) The requirement for disclosure may also extend to matters such as a proposal to change auditor or a change in the company's accounting policy, if material.
(j) Exceptions: Disclosure under ASX Listing Rule 3.1 is not required where (these are cumulative):
(i) a reasonable person would not expect the information to be disclosed
(ii) the information is confidential and ASX has not formed the view that the information has ceased to be confidential, and
(iii) either
(A) it would be a breach of law to disclose the information
(B) the information concerns an incomplete proposal or negotiation
(C) the information comprises matters of supposition or is insufficiently definite to warrant disclosure
(D) the information is generated for the internal management purpose of the entity, or
(E) the information is a trade secret.
(k) However bringing oneself within the exception to the requirement to continuously disclose price-sensitive information may not necessarily protect an entity from civil liability when information provided is literally true but is misleading and deceptive.
(l) Sections 1041E and 1041H of the Corporations Act provide that a person must not make a statement or engage in conduct that is false, misleading or deceptive or is likely to mislead or deceive.
(m) Similarly, section 12DA(1) of the ASIC Act also provides that a person must not engage in conduct in relation to financial services that is misleading or deceptive or likely to mislead or deceive.
3. Indemnities and Insurance
3.1 Directors and officers face significant exposure to claims arising from allegations for breach of these director's duties.
3.2 In addition, directors may also be found personally liable for breaches under the Australian Consumer Law (previously known as the Trade Practices Act 1974), occupational health and safety laws, tax laws and environmental protection laws.
3.3 A company may attempt to shield its directors and officers from some aspects of their potential liability by including indemnities in favour of directors and officers in the company constitution.
(a) However, protection by this means is limited by section 199A of the Corporations Act which severely
restricts the types of liabilities that can be indemnified by a corporation and forbids indemnification in relation to legal costs incurred in defending an action for liability where the officer is found to be guilty
in criminal proceedings or the grounds for making the order are found by the court to be established.
(b) Indemnification is also limited if the corporation becomes insolvent as the indemnity will bear no fruit.
3.4 The limitations on the protection afforded by indemnities explains the need for directors' and officers' insurance (D&O Insurance).
3.5 Although a company is not required to provide its directors and officers with D&O liability insurance, it is common for directors of large public companies to insist upon the availability of D&O insurance before taking office.
3.6 A standard Australian D&O insurance policy contains two separate parts:
(a) a direct cover component which indemnifies directors and officers for wrongful acts committed by them in the conduct of their duties (known as side A cover), and
(b) a company reimbursement component which reimburses the corporation for any (lawful) indemnity which the corporation may grant to its directors and officers for their liability for alleged wrongful acts undertaken in their capacity as directors and officers (known as side B cover).
3.7 D&O policies for listed corporations may also contain cover for the corporation's own liability for claims made against it in relation to matters concerning the corporation's securities, such as the issue or transfer of securities. This is known as side C cover.
3.8 As D&O policies can vary a great deal, each policy must be scrutinised to ensure that it meets the needs of the directors and officers concerned. The insurance policy is a contract and must be negotiated to provide adequate coverage for the directors and officers. The nature and extent of the coverage required will also depend on the industry in which the company is operating.
3.9 D&O insurance cover may include civil proceedings, successful defence of criminal proceedings, trade practices actions, occupational health and safety, official investigations, and employee actions. A policy may be endorsed to extend coverage to outside directorships, pre-acquisition liability, prospectus liability and joint venture liability.
3.10 As the insurance policy is in reality a specialised contract, it is generally possible to negotiate certain policy extensions.
3.11 There are a number of standard exclusions in a D&O policy. Some of these include:
(a) deliberate or fraudulent omission
(b) prior known circumstances
(c) insider trading exclusion
(d) claims brought by shareholders
(e) insolvent trading.
4. Safe harbour rule
4.1 The Business Judgment Rule (s180(2))
(a) The business judgment rule as it currently exists offers a protection from liability, a ‘safe harbour', for
directors who make a business decision to take action or not to take action regarding the business operations of a company.
(b) Under s 180(2) of the Corporations Act, a director will be taken to have met the requirements of the duty
of care and diligence contained in s 180(1) in respect of making a business judgment if the relevant judgment is made:
(i) In good faith and for a proper purpose
(ii) While acting on an informed basis to the extent they reasonably believed to be appropriate
(iii) Without material interest, and
(iv) Holding a rational belief that the decision is in the best interests of the corporation.
(c) The difficulty for directors and officers is that in effect, the defence does not stipulate a less exacting
standard than that required by the prescribed duty. Accordingly, a rational decision which satisfies all of
the requirements of the business judgment rule is unlikely to constitute a contravention of the duty of care and diligence in the first place.
(d) Hence, in practice directors rarely obtain the benefit of the business judgment rule.
4.2 Reforms
(a) On 19 January 2010, Chris Bowen, then Minister for Financial Services, Superannuation and Corporate Law announced the release of a discussion paper on the operation of Australia's insolvent trading laws in the context of attempts at business rescue outside of external administration.
(b) This discussion paper put forward three possible options:
1. No change to the existing laws
2. Introducing a business judgment rule for insolvent trading - this would provide relief to directors who discharge their duties of due care and diligence in seeking a work-out, but in doing so breach the duty not to trade while insolvent.
3. Invoking a moratorium on the prohibition against insolvent trading while an informal workout is attempted.
(c) The Federal Government called for submissions on these proposals which were due by 2 March 2010 but as yet the government has not introduced any reforms.
5. Class actions
There has been a remarkable proliferation of shareholder and other class actions in recent years. These class actions have become increasingly commonplace as the global financial crisis forces asset prices down, and investors look for someone to blame.
5.1 Litigation funders
(a) The increased use of litigation funding has certainly been the catalyst for a number of high profile cases, and an increase in the number and value of class actions. For example, the value of class actions led by IMF (the biggest litigation funder in Australia) increased from $400 million in 2007 to $1.2 billion by the end of 2009.
(b) While there are restrictions on lawyers engaging in fee arrangements whereby the lawyer would share in a proportion of any judgment, no such restrictions apply to non-lawyer litigation funders.
(c) The arrangement is straightforward. The litigation funder identifies the potential claim and enters into agreements with the potential claimants. Under these agreements the funder receives an agreed percentage of any moneys received by the claimants whether by way of settlement or judgment. The funder retains a lawyer who agrees to conduct the litigation on a normal basis.
(d) Shareholder litigation is relatively new in Australia, however with the emergence of litigation funders willing and able to fund these claims it is gaining momentum.
(e) Most, if not all, of the shareholder class actions commenced in the Australian courts since 2005 are being funded by litigation funders.
6. Liquidators' investigations and examinations / insolvent trading
6.1 The powers contained in Part 5.9 of the Corporations Act give a liquidator, administrator, ASIC or a person authorised by ASIC, being an eligible applicant, the ability to apply for a summons to publicly examine persons regarding the conduct and examinable affairs of companies (ss 596A - 597).
6.2 The broad function of the provisions as they apply to liquidators (s 596A and s 596B), is to enable the liquidator to be better informed about the company's examinable affairs so that the winding-up of the company may be more effectively administered.
6.3 Examinable affairs are defined as (s 9):
(a) The promotion, formation, management, administration or winding up of the corporation
(b) Any other affairs of the corporation, or
(c) The business affairs of a connected entity of the corporation in so far as they are relevant to the corporation or to anything included in its examinable affairs because of (a) or (b) above.
6.4 Quite often examinations are used specifically to obtain books of account, records or other information which will assist, particularly to recover antecedent transactions or amounts to be recovered from directors. The Court may direct that such books of account be produced for the purposes of inspection (s 597(9).
6.5 The examination itself is inquisitorial in nature and the information obtained can be used in later proceedings providing the written record is signed (s 597(14).
6.6 The use of the examination record is subject to a limited form of protection of the examinee against self incrimination (s 597(12A) such that a person is excused from providing a self incriminating answer but if, before answering the question the person claims privilege, the answer may not be used in evidence against him or her in a criminal proceeding or a proceeding for the imposition of a penalty other than a proceeding in respect of the falsity of the answer.
6.7 The Corporations Act recognises that, in certain circumstances, the liquidator may not need an examination and that information could as usefully be obtained by affidavit evidence. A liquidator can apply to court for it to require examinable officers to supply evidence by affidavit instead of, or in addition to, attending an examination (s 597A).
6.8 Directors should be aware that the investigative powers of liquidators into the affairs of the company (including the examination process) will subject their conduct to close scrutiny in respect of any breaches of duty and in particular a director's duty to prevent insolvent trading of a company, discussed further at paragraph 2.
7. ASIC
Two recent decisions have provided insight on directors and their duties:
7.1 Centro (ASIC v Healey & Ors [2011] FCA 717)
(a) In June this year, a decision was handed down that sent a clear message to directors: that they must scrutinize company accounts.
(b) In this case, ASIC argued that Centro's directors had breached their duty of care and diligence (under s 180) and their obligation to keep financial records and financial reporting duties, because its 2007 annual accounts had not complied with the Corporations Act and the accounting standards:
(i) The accounts had misclassified a number of borrowings as non-current liabilities when they were actually current
(ii) Centro did not disclose some guarantees that should have been disclosed as they were material post balance date events
(iii) The board had not ensured that the CEO and CFO had provided the declaration of compliance required by s 295A.
(c) The directors denied these allegations.
(d) The court found, in favour of ASIC, that the directors had breached these duties.
(e) While the court appeared to say that it was not imposing a general financial literacy standard for directors, it was clear that the Court did believe that a certain level of financial literacy is an essential qualification for directors.
(f) The Court also said that the importance of the annual accounts and the fact that the Corporations Act places specific responsibilities upon directors in relation to the accounts means that directors cannot delegate those responsibilities.
(g) "Directors cannot substitute reliance upon the advice of management for their own attention and examination of an important matter that falls specifically within the Board's responsibilities as with the reporting obligations."
(h) The Court held that overload of information was no excuse for failing to read and understand information provided to them where directors have specific statutory duties such matters relating to takeovers and dividends.
(i) The decision highlights the need for boards to carefully manage the information they receive and to focus on the information provided to them. Boards need to ensure that they receive meaningful information rather than mere data.
7.2 Westpoint
(a) In 2006, the Westpoint Group collapsed resulting in losses to investors of around $310 million.
(b) ASIC commenced compensation actions in 2007 and 2008 which included:
(i) a claim brought against KPMG, the former auditors of the Westpoint Group
(ii) a claim brought against the directors of certain companies in the Westpoint Group
(c) The claims against the directors related to the way they handled money invested in the Westpoint mezzanine companies. Claims were also made against companies associated with one of the directors for unlawfully receiving commissions. The claims solely against the directors were in the order of $273 million.
(d) ASIC settled its proceedings with several directors and KPMG in February 2011. This settlement resulted in an additional recovery for the benefit of investors through the liquidation process of up to $67.45 million but was subject to a number of confidential conditions.
(e) In June this year, the former CFO of Westpoint, Graeme Rundle, was found guilty by a jury of two criminal offences of making a false or misleading statement with intent to gain a financial advantage for Scots Church Development Limited. The charges related to statements made to a financial institution in relation to obtaining a $71 million construction finance facility to complete a project at York Street, Sydney.
(f) He later received a sentence of 18 month's imprisonment with the sentence to be suspended upon him entering into an 18 month good behaviour bond.
(g) In response to this decision, ASIC Chairman stated that CFOs, as an officer of a corporation, must take their responsibilities seriously, and discharge their legal duties to the company and comply with the law carefully. He also stated that: "CFOs must ensure that any representations made by them to financiers, on behalf of companies, are accurate".
(h) This decision highlights that care and caution must be taken in relation to all financial statements made by officers of a corporation.
8. Conclusion
Nothing should detract from the fact that by becoming a director of a company, an individual is assuming a significant number of obligations and duties. That having been said, if you are a competent person acting honestly, history tells us that you will have nothing to fear.
Australia is not a jurisdiction which "shoots first and asks questions later". Australian Company Law is in fact a relatively friendly regime. ASIC provides a significant amount of material for directors which will provide a full and complete road map on what being a director is all about and what a director must and must not do. I recommend that if you are planning to become a company director you should consult the ASIC website and download the excellent papers which will cover most questions a director should have.
If, in the discharge of your duties as a director, issues arise which are not clear or which give rise to concern, then you should obtain your own legal advice as soon as possible.