Legal Briefing No. 38

Number 38

9 October 1997

DUTIES OF DIRECTORS AND
CORPORATE GOVERNANCE

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.

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