Under the Corporations Act 2001 (Cth) directors and other officers of a company must exercise their powers and discharge their duties with the degree of care and diligence that a reasonable person would exercise if he or she:
- were a director or officer of a company in the company's circumstances; and
- occupied the same office held by, and had the same responsibilities within the company, as the relevant director or officer.(1)
The act also contains a rebuttable presumption of reasonableness where a director has relied on information or advice given or prepared by a professional adviser in relation to matters that a director reasonably believes to be within a person's professional or expert competence, provided that the reliance is in good faith and the director has independently assessed the information or advice.(2) This defence is complemented by other, subject-specific provisions in the act which provide that directors or other officers will not contravene certain sections if reasonable steps are taken.
Three recent landmark Australian court decisions on directors' duties - Fortescue,(3) James Hardie(4) and Centro(5) - have involved, among other things, consideration of when directors are entitled to rely on the advice of advisers in the context of an allegation of a breach of their duty of care and diligence. Despite their different factual circumstances, these cases demonstrate some common threads that are emerging on the reliance issue, which are worthy of closer scrutiny.
The Fortescue case
In Fortescue the Australian Securities and Investments Commission (ASIC) alleged that a director of a publicly listed company had failed to discharge his duty of care and diligence because of his involvement in the company's contravention of the continuous disclosure requirements of the act. The company's contravention of the continuous disclosure obligations related to the release of market announcements, which the ASIC alleged were misleading because they referred to certain supply contracts as being legally binding, when they were not.
The director sought to rely on the statutory defence that he had taken all reasonable steps to ensure that the company had complied with its disclosure obligations, and believed on reasonable grounds that the company was complying. A legal adviser who became the company's in-house counsel after the first of the announcements was made had been involved in reviewing and drafting the supply contracts to which the announcements related and reviewing the contracts after the announcements were made. The director's defence included an argument that he was entitled to rely on the work undertaken by the in-house counsel.
On appeal, the full Federal Court held that there was no evidence that the director had consulted the in-house counsel (or any other adviser) on the question of whether the supply contracts were binding before the announcements were released.(6) Accordingly, it was impossible to establish the reasonableness of reliance.
The James Hardie case
In James Hardie, the ASIC alleged that the chief executive officer (CEO) (who was also a director of the company) and the company secretary (who also acted as general counsel) had breached their duties of care and diligence as a result of the board approving the release of a market announcement which stated that a foundation established to manage and pay asbestos claims against group companies would have sufficient funds to meet all present and future legitimate claims.(7) The ASIC alleged that the announcement was false and misleading because it contained unequivocal statements about the adequacy of the foundation's funding. The ASIC also alleged that the company had breached its continuous disclosure obligations by failing to disclose a deed in respect of certain related group indemnities and covenants.
The likely funding required by the foundation had been the subject of an actuarial report prepared by external advisers engaged by the company, and a cashflow model which was the subject of limited review by other external advisers.
The trial judge in the New South Wales Supreme Court found that the emphatic nature of the announcement, together with the fact that it was in clear English, meant that the CEO was not entitled to rely on outside experts in relation to the estimated financial position of the foundation and the announcement's content. The CEO also argued that he had relied on the advice of the company secretary and external legal advisers, and therefore had acted reasonably for the purposes of the act in respect of the non-disclosure of the deed.
However, the trial judge found that, as in Fortescue, there was no evidence that the CEO had relied on advice from either of these quarters about whether the deed should be disclosed and, in any case, there was no evidence of any independent assessment of that advice by the CEO (thereby failing one of the statutory elements that must be established in relation to the reasonableness of the reliance).(8)
The Centro case
Centro related to a breach of duty of care and diligence by a board that resulted from the erroneous classification of material short-term debt as long-term liabilities in the company's financial statements and the failure to disclose various material intra-group guarantees in the financial statements. The financial statements were required to be signed off (and were signed off in their erroneous form) by the directors under the act.
Uniquely, the court accepted that the errors in respect of the classification of the short-term debt were made by the company's auditors in the audited accounts, which were subsequently approved by the company's audit committee, before final approval and sign-off by the board. Unsurprisingly, the directors argued that they were entitled to rely (and had exclusively relied) on the work undertaken by the auditors and management in respect of the financial statements and related advice, and therefore had not breached their duty of care and diligence in signing off the financial statements.
The Federal Court found that because the act places a specific responsibility on the board and each of the directors to approve the accuracy of the financial statements, the directors could not substitute reliance on the auditors and management for their own examination of a matter which fell squarely within the realm of their own statutory responsibilities. Rather than accepting that the sole and exclusive reliance that the directors placed on the company's external auditors was acceptable, the court found that each director had failed to take all reasonable steps to focus on and consider for himself the content of the financial statements so far as they related to the short-term debt and intra-group guarantees.
There are a number of common threads running through the Fortescue, James Hardie and Centro decisions in relation to reliance by directors on advice and the guidance that directors can take from these cases in determining the limits of reliance for the purposes of properly discharging their duty of care and diligence. Although reliance on advisers (to varying degrees) was a feature of the defence against allegations of a breach of the duty of care and diligence in all three cases, in each case the reliance argument failed. This, at the very least, suggests that courts will approach the issue of reasonableness of reliance conservatively and in a way that may be less generous to directors than they may expect.
The fact that advisers may have been involved at some point in time in the general subject matter of a board decision that triggers an alleged breach of the duty of care and diligence does not necessarily equate to reasonable reliance by a director on that advice - both Fortescue and James Hardie show that evidence must be established of specific reliance on advice that directly relates to the board decision and, at least in the case of the formal reliance defence under the act, it must also be shown that directors have engaged in an independent assessment of that advice. This is easier said than done when considered in the context of specific decision-making by boards on significant matters that are mixed with the challenges of monitoring and guiding ordinary business.
Ideally, even where there is reliance, a board should still be able to point to a process whereby material components of what was relied on were subject to some testing by directors for veracity and accuracy. The problem that the directors faced in Centro was that the court found that this did not occur when the directors approved and signed off the financial statements; instead, the exclusive reliance that was placed on the auditors' work became self-defeating as it demonstrated that each of the directors had failed to bring an independent, inquiring mind to the subject matter at hand. While this aspect of the result in Centro has been subject to the criticism that it places an 'unreal' burden on directors given time constraints and the complexity of the technical and commercial issues faced by boards, the court rejected this as an excuse for the directors failing to bring an inquiring mind to the accuracy of the financial statements.
Directors must also consider the circumstances under which their ability to rely on advice might be curtailed because of the specific matter under consideration by the board. Centro clearly shows that where there is a statutory obligation on a board to sign off on financial statements, exclusive reliance will be curtailed. However, the decision in James Hardie may be indicative of a wider set of circumstances inhibiting reliance, instead suggesting that where the board's decision relates to a more significant approval of, for example, a market announcement and the subject matter of the decision is such that it should be capable of being understood by a director without specific reference to any underlying expert advice, it will be particularly difficult to establish the reasonableness of reliance on advisers.
Both Centro and James Hardie demonstrate that in order to succeed with a reliance defence, the circumstances must be such that the court considers that the matters under consideration by the board were capable of delegation to (and thereby reliance on) others. Accordingly, the duty imposed on every director of a board to take the necessary steps to enable him or her to guide and monitor the company in circumstances where delegation is not appropriate will typically require directors to apply their own independent, enquiring minds to the subject matter of significant decisions, and not to delegate to or rely exclusively on others.
(4) Australian Securities and Investments Commission v Macdonald (No 11)  NSWSC 287, involving 10 former James Hardie employees; see also the Court of Appeal decision of Morley v Australian Securities and Investments Commission  NSWCA 331.
whether the appellate court considered all the evidence that the trial judge had examined;
clarification of whether the business judgment rule applied; and
whether the announcement was infact misleading and deceptive.
(7) The non-executive directors of the company were also held to have breached their duties, although this finding was overturned on appeal on the basis that the ASIC had failed to establish that the non-executive directors had, as a matter of fact, approved the market announcement. This issue is the subject of a High Court appeal brought by the ASIC which is yet to be heard. Leave to appeal has also been granted to the company secretary (and general counsel) regarding the issue of whether he was acting in his capacity of general counsel in respect to his dealings with the board, and was therefore not acting as an officer bound by the statutory and common law duty of care and diligence.
(8) The further finding that the company secretary (and general counsel) had also breached his duty to the company by failing to either himself advise or obtain advice for the CEO and directors regarding the deed was not overturned on appeal, but will be challenged before the High Court.
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