Legal Briefing

Number 38

9 October 1997


Corporate governance has come to embrace a very wide range of issues. At its core, it deals with the way in which management is composed and the mechanisms which are put in place to ensure that executive management is accountable to the board and that the board is accountable to shareholders. The issues raised include the independence of directors, the separation of the roles of CEO and Chairman of the Board and the use by the company of audit(1) and other committees.

Implications for Clients

Under the Corporations Law, responsibility for the management of the company lies with the board. Directors must be aware that their performance will be assessed both in relation to compliance with the Law (where sanctions for non-compliance may be civil or criminal, monetary or penal) and by reference to corporate governance 'best practice' (where the sanctions may come in the form of shareholder intervention, particularly where large institutional investors are involved).

Commonwealth Authorities and Companies Bill 1997

Enhanced levels of responsibility in relation to the governance of Commonwealth-owned companies and Commonwealth authorities are provided for in the Commonwealth Authorities and Companies Bill 1997 and the Auditor-General Bill 1996 which are expected to replace Part XI of the Audit Act from November 1997.

Some key features of these Bills, as they apply to Commonwealth companies, include:

  • the establishment of a standard financial reporting and accountability framework
    which applies to wholly-owned
    Commonwealth companies
  • the provision for the Auditor-General to be the external auditor for Commonwealth companies and their subsidiaries, and
  • the requirement of regular reporting to the Finance Minister including the preparation of interim financial statements and estimates of receipts and expenditures.

Corporations Law Changes Since 1992

Since 1992 a number of major amendments to the Corporations Law have affected the duties imposed on directors.

The Corporate Law Reform Act 1992 (the 1992 Act) introduced an objective duty of care, requiring a company officer to exercise the degree of care and diligence that a reasonable person in a like position in a corporation would exercise in the corporation's circumstances (discussed below).

The 1992 Act also introduced a new Part 3.2A dealing with 'related party transactions'. The provisions regulated the financial relationship between the company and its directors and related corporations. Part 3.2A broadened the class of financial transaction subject to regulation, prohibited loans by a company to its directors (subject to some exceptions requiring shareholders' approval) and restricted certain transactions with related companies.

The Part also provided for enhanced disclosure relating to conflicts of interest by directors. The 1992 Act also contained sweeping reforms to the insolvency provisions of the Law.

The Corporate Law Reform Act 1994 (the 1994 Act) introduced a regime of continuous disclosure. The regime provides remedies to persons who suffer loss as the result of negligent or reckless breach of certain ASX listing rules, resulting in non-disclosure of information by an entity to the ASX which if generally available, could be expected to have a material effect on the price or value of the securities of the entity.

The 1994 Act also introduced a continuous disclosure regime for certain unlisted entities with 100 or more holders of securities, requiring such entities to lodge with the ASC, as soon as practicable, information which, if generally available, would be likely to have a material effect on the price or value of those securities.

The First Corporate Law Simplification Act 1995 contains amendments dealing with share buy-backs, proprietary companies and company registers.

The proposed Second Corporate Law Simplification Bill (which was to have dealt with share capital, accounts and audits, deregistration of companies, company meetings and company formation and a form of statutory derivative action) is currently being reviewed.

Corporate Governance

In 1995, as part of an increased emphasis on self regulation, the ASX promulgated a listing rule which requires listed companies to detail in their annual report the corporate governance practices followed by each company. The sort of practices contemplated by the listing rule include:

  • the mix between executive directors and non- executive directors (NEDs)
  • the independence of NEDs
  • the use of audit, remuneration and nomination committees, and
  • the existence of codes of ethics.

The impetus for an examination of corporate governance practices had been growing strongly over the previous four years:

  • In 1992 Rogers J handed down his decision in AWA Ltd v Daniels (1992) 10 ACLC 933; the Cadbury Committee in the UK reported on the control and reporting functions of boards, and the role of auditor; the American Law Institute published its Principles of Corporate Governance - Analysis and Recommendations; and there was wide public discussion following the release of the exposure draft of the 1992 Act.
  • In 1993 the Strictly Boardroom report was released by the Sydney Institute and the second edition of Corporate Practices and Conduct was prepared by a committee headed by Mr Henry Bosch AO.
  • In 1994 the Parliamentary Joint Committee on Corporations and Securities released an issues paper 'Inquiry Into the Role and Activities of Institutional Investors in Australia'; the Toronto Stock Exchange made its final Report 'Guidelines for Improved Corporate Governance in Canada'.
  • In 1995 the Australian Investment Managers Association promulgated a Corporate Governance Guide and the Supreme Court of NSW (Court of Appeal) handed down its decision in Daniels v Anderson (1995) 13 ACLC 614.

The Mix of Executive and Non-executive Directors

One of the features of the corporate collapses of the 1980s was a perceived lack of accountability by management to the board. The role of NEDs in overcoming this apparent lack, is seen as:

  • bringing an independent view to the
    board's deliberations
  • helping the board provide the company with effective leadership
  • fostering the continuing effectiveness of the executive directors and management.

The Bosch Committee considered that best practice required that the majority of directors on a board need to be NEDs, and at least one third of a board should be genuinely independent of management and any other external influence that could detract from their ability to act in the best interest of the company as a whole.

In the UK, the Cadbury Committee recommended that there be sufficient NEDs 'for their views to carry significant weight in the board's decisions', and also a majority of whom are independent from management and free from any business or other relationship which could materially interfere with the exercise of independent judgement.

In Canada, the Toronto Stock Exchange Report recommended that every board should be constituted with a majority of unrelated directors.

The Independence of NEDs

The independence of a director is widely seen as ensuring that there is an absence of relationships and interests which could compromise or be perceived to compromise the ability of a director to exercise judgement in the best interest of the corporation. In some cases the lack of strong independent voices on the board has led to serious problems for a company, particularly where a holding company has dominated the board of a subsidiary.

The Bosch committee considered that independence is more likely where a director:

  • is not a substantial shareholder of the company
  • has not been employed by the company in any executive capacity in the recent past
  • is not retained as a professional adviser by
    the company
  • is not a significant supplier or customer of
    the company
  • has no significant contractual relationship with the company, other than as director.

Company Directors' Duties

Although the acts of directors are generally held to be the acts of the company, directors may be held personally liable when:

  • they breach the general law duties which they owe to the company
  • they are subject to specific statutory liability
  • they act beyond the scope of their authority to act for the company and the company has not ratified that act, or
  • they commit a tortious act (for example, give negligent incorrect advice, make a defamatory statement or interfere with contractual relations).

General Law Duties of Directors

The director's relationship with the company is of a fiduciary nature and, accordingly, a director is required to act honestly and in good faith, and to avoid actual and potential conflicts of interest. As a general principle, directors should not put themselves in a position where their duty to the company conflicts with their own interests, for example, where the director contracts with the company or where the company contracts with another company of which he or she is also a director or substantial shareholder.

A director must also avoid exploiting information acquired through their position as a director. Any profit made from such exploitation must be accounted for to the company. The liability to account will arise where a director has exploited an opportunity whether or not the company was not in a position to do so.

The general law is reinforced by the Corporations Law, which imposes on a director who is in any way, whether directly or indirectly, interested in a contract or proposed contract with the company, a duty to declare the nature of their interest at a meeting of the directors.

In addition, a director is required to disclose to the first meeting of directors after their appointment, full details of any other office held which might directly or indirectly create duties or interests which might conflict with their duties as a director of the company.

Statutory Duties of Directors - Section 232

Section 232 of the Corporations Law requires an officer, including a director of a corporation, to act honestly in the exercise of his or her powers and the discharge of the duties of the office.

Subsection 232(4) also sets out the test for the standard of care and diligence required of an officer. 'In the exercise of his or her powers and the discharge of his or her duties, an officer of a corporation must exercise the degree of care and diligence that a reasonable person in a like position in a corporation would exercise in the
corporation's circumstances.'

The words 'in a like position' are intended to allow the court to consider the distribution of functions among members of the board (for example, between executive and non-executive directors) and any special expertise that a particular director might possess (for example, a geologist on the board of a mining company). The words 'in the corporation's circumstances' are intended to allow the court to have regard to any special circumstances surrounding the corporation (such as, for example, its solvency).

These subjective elements recognise that there is no objective standard of the reasonably competent company director. Further, the diversity of companies and the variety of business endeavours do not allow a uniform standard, see AWA Ltd v Daniels (1992) 10 ACLC 933 at 1015.

Section 232 also prohibits an officer or former officer of a corporation from making improper use of information acquired by virtue of their position and prohibits an officer or employee of a corporation from making improper use of their position to gain an advantage for themselves or for any other person or to cause detriment to the corporation.

In Practice…

In Australia, courts have rarely found directors in breach of their duty except in the most extreme cases of neglect of their responsibilities or in cases involving fraud. In assessing whether a director has been sufficiently diligent, a court might expect the following:

  • that the directors of a large company would ensure that among their number there should be one or more who are competent in the field of corporate financial management
  • that the directors of a large company should read, be able to understand and seek any necessary clarification of the key financial information put before the board, such as a balance sheet and a profit and loss statement
  • that the board would ensure that appropriately skilled people are engaged to carry out the company's accounting functions
  • that the board would require relevant accounting information to be supplied ahead of regular board meetings at which key financial decisions are to be made, and that, where a significant borrowing is to be undertaken, the management should supply the board with a statement of the company's current financial position as well as the particulars of the way in which the principal, interest and other charges are to be serviced over the anticipated term of the loan, and
  • where the nature of the business may expose the company to a high risk of sudden liquidity restriction, or the company is known by the director to be in a delicate financial position, that extra care and more rigorous safeguards should be adopted.

Indemnifying and Insuring Company Directors

The changes to section 241 and the new section 241A contained in the 1994 Act enable companies to:

  • provide insurance for their officers, including directors, except in cases where they wilfully breach their duty to the company or gain an improper advantage, and
  • indemnify their officers in respect of liability to persons other than the company (or a related company), provided the liability does not arise out of conduct involving a lack of good faith.

Section 241 does not allow a director to contract out of their liabilities to the company. Contracting out is permitted in relation to the director's tortious liability to third parties provided that the liability does not arise out of conduct involving a lack of good faith. Section 241 also does not remove the common law prohibition on a company indemnifying its officers against criminal liability.

Section 241A prohibits a company or a related body from paying a premium in respect of an insurance policy indemnifying a director against liability arising out of conduct involving a wilful breach of duty in relation to the company or a contravention of subsection 232(5) or (6). The term 'wilful' has been defined to mean intentionally and in this context, wilful breach could be taken to mean intentional breach of the director's contractual duty or their duty of care.

This means that a company, even though precluded from directly giving an indemnity to the director by virtue of the new section 241, will still be able under section 241A to take out an insurance policy for its director to indemnify that director against liability to the company in situations where the director has not wilfully breached his or her duty to the company or where they have not been guilty of misusing their position or misusing confidential information, whether wilfully or not.

Directors against whom a claim has been made for negligence, default, breach of duty or breach of trust in their capacity as director may apply to the court for exculpation and if it appears to the court that the director has acted honestly and ought fairly to be excused, the Court has the power, under subsection 1318(1), to relieve them from liability. Directors who have reason to believe a claim might be made may similarly apply to the court for relief.

Civil Penalty Orders

The 1992 Act inserted into the Law a new Part9.4B entitled 'Civil and Criminal Consequences of Contravening Civil Penalty Provisions'. Part 9.4B applies where a person has contravened a 'civil penalty provision' (defined to include section 232 (honesty, care diligence etc.); section 243ZE (related party transactions); subsection 318(1) (financial statements); and subsection 588G(1) (insolvent trading)).

An application for a civil penalty order will usually be made by the Australian Securities Commission, must be made within six years of the contravention, and will be determined using the civil rules of evidence and procedure and standard of proof.

A Court may, if it is satisfied that the contravention is serious, order that the person pay a penalty of up to $200,000 to the Commonwealth and may also disqualify the person from managing a corporation for such period as it thinks fit. A person who contravenes a civil penalty provision with a dishonest intent commits an offence punishable by a maximum fine of $200,000 or five years jail, or both.

1 See the recent Australian National Audit Office paper 'Applying Principles and Practice of Corporate Governance to Budget Funded Agencies'.

ISSN 1448-4803 (Print)
ISSN 2204-6283 (Online)

The material in this briefing is provided for general information only and should not be relied upon for the purpose of a particular matter. Please contact AGS before any action or decision is taken on the basis of any of the material in this briefing.

Back to Legal Briefing Index