Although the James Hardie, Fortescue and Centro cases may not have changed the law on directors’ duties in any significant way, they serve as potent reminders of the standards that apply to directorial decision-making, particularly relating to the duty of care and diligence.
An overview
The proceedings against James Hardie Industries Limited, its directors and a number of its executives, and against Fortescue Metals Group Ltd and one of its directors, Andrew Forrest, both involved announcements to the Australian Securities Exchange (ASX) that the Australian Securities and Investments Commission (ASIC) argued were misleading and deceptive.
In the case of James Hardie, the company’s announcement said that a foundation that had been set up to compensate asbestos victims was fully funded, while the Fortescue case revolved around announcements that called various agreements with Chinese companies binding agreements.
The trial judge in James Hardie agreed that the statement that the foundation was fully funded was misleading and deceptive, and found that the James Hardie directors had approved the statement, in breach of their duty of care and diligence to the company.
While the James Hardie directors successfully appealed the trial judge’s decision, the NSW Court of Appeal overturned the trial judge’s ruling, largely because of ASIC’s failure to call a material witness, and not because the appellate court disagreed with the trial judge’s legal analysis of the statement to the ASX.
In Fortescue, the trial judge found in favour of the company and Mr Forrest, on the basis that the characterisation of the agreements as binding was a statement of opinion as to their legal effect and that that opinion was honestly and reasonably held. The full Federal Court reversed the decision, however, finding that an ordinary and reasonable reader of the statements to the ASX would have taken the references to binding agreements to be statements of fact, not of opinion.
The Court also found that, when viewed objectively, the agreements were not binding. As a result, calling those agreements binding was misleading and deceptive, and Mr Forrest, in being intimately involved in the execution of the agreements and the formulation of the company’s disclosures relating to them, breached his duty of care and diligence and was involved in a contravention of the company’s continuous disclosure obligations.
The James Hardie and Fortescue decisions have both been appealed to the High Court.
Failing to flag the misclassification of debt
In another recent case, ASIC brought proceedings against the directors and certain executives of Centro Properties Group and Centro Retail Group, stemming from (among other matters) the misclassification in their 2007 financial statements of $1.5 billion in debt as non-current (that is, payable in more than 12 months) rather than current.
Under section 295(4) of the Corporations Act, directors are required to declare that, in their opinion, a company’s financial statements are in accordance with the Act, and section 344 requires them to take all reasonable steps to comply with, or to secure compliance with, the financial reporting sections of the Act.
The misclassification of the debt stemmed from a change in the Australian accounting standards to conform to the International Financial Reporting Standards. Under A-IFRS, the standard for classifying debt as non-current had become more stringent, but Centro management had failed to apply the new standard in classifying Centro’s debt (and Centro’s auditors failed to flag the mistake). Several of the Centro directors relied heavily on management, the company auditors and the Board Audit and Risk Management Committee in signing off on the financial statements.
The Court’s view was that directors, in fulfilling their statutory duty to approve a company’s financial statements, cannot rely solely on experts and just ‘go through the motions’. Instead, directors must apply their attention diligently to the information provided to them, bringing to bear everything they know about the company and its business, and ask questions when further enquiries are warranted.
The Court found that, in failing to do this, the Centro directors had breached both section 344 and their duty of care and diligence. In assessing penalties, however, the Court took into account all of the circumstances of the case and chose not to impose any ban or penalties on the directors (other than a requirement to pay ASIC’s costs).
Minimum standard of competence
While each of these three cases turned on their particular facts, a number of principles can be gleaned from them to guide boards of directors going forward.
First, directors must meet a minimum standard of competence, which includes at least a normal level of intelligence, a general understanding of their company’s affairs, an enquiring mind, and an element of financial literacy.
Although the Centro case has raised questions about the level of financial literacy that is required, the Court made it clear that directors do not need to have an intimate knowledge of the accounting standards. Directors do need to have a basic knowledge of conventional accounting concepts, however, particularly as they relate to the company’s business.
Get good advice
Directors must keep in mind that good advice matters. While a key message from Centro is that directors cannot rely blindly on the advice of experts (at least in the context of approving financial statements), if management and the company’s auditors had focused more closely on the characterisation of Centro’s debt, the misclassification might never have happened.
The Court in Fortescue also recognised the importance of obtaining appropriate advice (in that case, legal advice on whether the agreements were binding) to show that a director has taken reasonable steps to ensure compliance with the company’s continuous disclosure obligations.
Scrutinise information and manage the overload
Directors must bring an appropriate level of scrutiny to matters that are important to a company and exercise independent judgement, knowing what they know about the company and its business and applying common sense. Information overload also needs to be controlled. The Centro Court’s response to the directors’ complaint about the volume of information (thousands of pages) that had to be reviewed was that a board can control the information it receives.
Directors need to take the time to consider matters with the requisite care and attention. If reviewing thousands of pages is unavoidable, the approval timetable needs to include enough time for directors to be able to review them. Directors also need to keep a clear record of what they are (and are not) considering. The James Hardie case turned on whether the directors had in fact approved the ASX announcement in question (the minutes of the meeting said the directors had approved it, but several of the directors testified to the contrary). Boards are not required to approve the text of announcements to the ASX, so they should make a conscious choice whether to review documents of that kind.
While these principles in many ways are just common sense, the James Hardie, Fortescue and Centro cases remind us that all too often, common sense can be overlooked.
Fines and jail for OHS slip-ups
In another context where exercising the necessary care and diligence is essential, under the model Work Health and Safety laws all company directors (executive and non-executive) must be active and diligent in ensuring their company complies with its workplace health and safety duties and obligations. Failing to exercise “due diligence” may expose directors to considerable penalties – up to $600,000 and/or imprisonment of five years.
The obligation on directors to exercise due diligence is a key feature of OHS reform being introduced around Australia.
What does it mean to exercise due diligence?
To exercise due diligence, an officer must, among other things, take reasonable steps to:
- acquire and maintain their knowledge of work health and safety matters
- gain an understanding of the hazards and risks associated with the nature of the company’s operations
- ensure that the company has appropriate resources and processes to enable hazards to be identified and risks eliminated or minimised
- ensure that the company has appropriate processes for receiving and considering information about incidents, hazards and risks and responding in a timely way
- ensure that the company implements processes for complying with its safety duties and obligations.
In practical terms, directors need to make sure that appropriate reporting, consultation, audit and training procedures are implemented that place them in a position to know about and understand their own, and the company’s duties and obligations and the health and safety matters that affect the company.
This will include matters such as the nature of hazards and risks arising out of the company’s operations, the measures for eliminating or minimising hazards and risks, measures undertaken by the company to promote OHS compliance, and when safety incidents arise.
The bottom line to due diligence is that a director is now required to focus on managing health and safety in the workplace in an active way.
What do directors need to do now?
Directors should be thinking about whether they are in a position to satisfy their due diligence obligations under the health and safety laws and, if not, what needs to occur to ensure they can meet their obligations.
The reputational fallout from James Hardie, Fortescue and Centro, not to forget the heavy financial burden of contesting litigation and possible penalties and directorial bans, serve as stark reminders to directors of what can happen if they fail in their compliance measures or, indeed, any of their duties and responsibilities when serving on a company’s board.
