Principles of Contemporary Corporate Governance [2 ed.] 0521138035, 9780521138031

Principles of Contemporary Corporate Governance, Second Edition, provides a concise presentation of vital topics and eme

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Table of contents :
01.0_pp_i_iv_Frontmatter
02.0_pp_v_xiv_Contents
03.0_pp_xv_xvi_Contributors
04.0_pp_xvii_xx_Table_of_cases
05.0_pp_xxi_xxii_Table_of_statutes
06.0_pp_xxiii_xxiv_Preface
07.0_pp_xxv_xxvi_Preface_to_the_first_edition
08.0_pp_1_2_BASIC_CONCEPTS_BOARD_STRUCTURES_AND_COMPANY_OFFICERS
08.1_pp_3_19_The_concept_corporate_governance_and_essential_principles_of_corporate_governance
08.2_pp_20_70_Stakeholders_in_corporate_governance_and_corporate_social_responsibility
08.3_pp_71_100_Board_functions_and_structures
08.4_pp_101_130_Types_of_company_directors_and_officers
09.0_pp_131_132_CORPORATE_GOVERNANCE_IN_AUSTRALIA
09.1_pp_133_155_Corporate_governance_in_Australia_background_and_business_initiatives
09.2_pp_156_178_Regulation_of_corporate_governance
09.3_pp_179_197_The_role_of_the_regulators_ASIC_and_ASX
09.4_pp_198_218_Accounting_governance
09.5_pp_219_239_Auditors_and_audits
09.6_pp_240_278_Directors_duties_and_liability
09.7_pp_279_296_Enforcement_of_directors_duties
10.0_pp_297_298_CORPORATE_GOVERNANCE_IN_INTERNATIONAL_AND_GLOBAL_CONTEXTS
10.1_pp_299_336_Corporate_governance_in_the_USA_the_UK_and_Canada
10.2_pp_337_416_OECD_Principles_of_Corporate_Governance_and_corporate_governance_in_Germany_Japan_and_China
11.0_pp_417_418_BUSINESS_ETHICS_AND_FUTURE_DIRECTION
11.1_pp_419_445_The_ethical_obligations_of_corporations
11.2_pp_446_468_Reflections_on_contemporary_corporate_governance_and_its_future_direction
12.0_pp_469_482_Index
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Principles of Contemporary Corporate Governance Second edition Jean Jacques du Plessis Anil Hargovan Mirko Bagaric Contributors Vivienne Bath Christine Jubb Luke Nottage

cambridge university press Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, S˜ ao Paulo, Delhi, Dubai, Tokyo, Mexico City Cambridge University Press 477 Williamstown Road, Port Melbourne, VIC 3207, Australia Published in the United States of America by Cambridge University Press, New York www.cambridge.org Information on this title: www.cambridge.org/9780521138031  c Cambridge University Press 2011

This publication is copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published by Cambridge University Press 2005 Reprinted 2007, 2009 Second edition 2011 Cover design by Jeni Burton, Divine Design Typeset by Aptara Corp. Printed in China by Everbest Printing Co. Ltd. A catalogue record for this publication is available from the British Library. National Library of Australia Cataloguing in Publication data Du Plessis, Jean J. Principles of contemporary corporate governance / Jean Jacques du Plessis, Mirko Bagaric, Anil Hargovan. 2nd ed ISBN 9780521138031 (pbk.) Includes index. Corporate governance–Law and legislation. Corporate governance–Australia. Directors of corporations–Australia. Bagaric, Mirko. Hargovan, Anil, 1962– 346.94066 ISBN 978-0-521-13803-1 paperback Reproduction and communication for educational purposes The Australian Copyright Act 1968 (the Act) allows a maximum of one chapter or 10% of the pages of this work, whichever is the greater, to be reproduced and/or communicated by any educational institution for its educational purposes provided that the educational institution (or the body that administers it) has given a remuneration notice to Copyright Agency Limited (CAL) under the Act. For details of the CAL licence for educational institutions contact: Copyright Agency Limited Level 15, 233 Castlereagh Street Sydney NSW 2000 Telephone: (02) 9394 7600 Facsimile: (02) 9394 7601 E-mail: [email protected] Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external or third-party internet websites referred to in this publication and does not guarantee that any content on such websites is, or will remain, accurate or appropriate.

Contents

Contributors xv Table of cases xvii Table of statutes xxi Preface xxiii Preface to the first edition

xxv

PART ONE BASIC CONCEPTS, BOARD STRUCTURES AND COMPANY OFFICERS 1 1 The concept ‘corporate governance’ and ‘essential’ principles of corporate governance 3 1.1 The meaning of corporate governance 3

1.2 1.3 1.4 1.5

1.1.1 Generally 3 1.1.2 Origins of the corporate governance debate and the stakeholder debate 5 1.1.3 Definition of ‘corporate governance’ 10 ‘Essential’ principles of corporate governance 11

Is ‘good corporate governance’ important and does it add value? Are corporate governance models converging? 18 Conclusion 19

14

2 Stakeholders in corporate governance and corporate social responsibility 20 2.1 Introduction 20 2.2 Stakeholders in the corporation: An overview 22 2.2.1 What is a stakeholder? 22 2.2.2 Discussion of different stakeholders 24 2.2.2.1 Shareholders 25 2.2.2.2 Employees 25 2.2.2.3 Creditors 29 2.2.2.4 Customers 30 2.2.2.5 The community 31 2.2.2.6 The environment 31 2.2.2.7 Government 35 2.2.2.8 All stakeholders have vested interests in the sustainability of corporations 35

v

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CONTENTS

2.3

Stakeholders’ interests and the corporation: The role of the law 36 2.3.1 The Australian position 36 2.3.2 Overseas position: A snapshot 40 2.3.2.1 OECD 40 2.3.2.2 European Union (EU) 41 2.3.2.3 United States 43 2.3.2.4 United Kingdom 45 2.3.2.5 Canada 49 2.3.2.6 New Zealand 49 2.3.2.7 South Africa 51

2.4

2.5 2.6

Stakeholder interests, good governance and the interests of the corporation: A mutual relationship 53 2.4.1 General analysis 53 2.4.2 Case study of James Hardie’s asbestos compensation settlement CSR and directors’ duties 65 Conclusion 69

56

3 Board functions and structures 71 3.1 Higher community expectation of directors

3.2 3.3 3.4 3.5

3.6

71 3.1.1 Initially low standards of care, skill and diligence expected of directors 71 3.1.2 Legal recognition of changed community expectation of directors The organs of governance 75 Board functions 77 Board structures 83

Board structures in the broader context of a good corporate governance model 90 3.5.1 Overview 90 3.5.2 Effective board structure 91 3.5.3 Effective support mechanisms to assist the board in properly fulfilling its functions 93 3.5.4 Effective statutory provisions 93 3.5.5 Effective regulators 94 3.5.6 Effective charters, policies and codes of best practice and conduct 96 3.5.7 Corporate governance rating systems for companies 98 Conclusion 100

4 Types of company directors and officers 101 4.1 Overview 101 4.2 Definition of ‘director’ 102

4.3

73

4.2.1 De jure and de facto directors covered 102 4.2.2 Shadow director 103 4.2.3 Nominee directors 104 Definition of ‘officer’ 106 4.3.1 Statutory definition 106 4.3.2 Senior employees and senior executives as ‘officers’ 4.3.3 Middle management as ‘officers’? 108

107

CONTENTS

4.4

vii

Types of company officers 109 Executive and non-executive directors 109 Independent non-executive directors 110 Connected non-executive directors 116 Lead independent directors or senior independent directors 117 The managing director, managing directors, the chief executive officer and executive directors 117 4.4.6 Chairperson 118 4.4.7 Alternate director 120 4.4.8 Secretary 120 Training and induction of directors 122 4.5.1 Training 122 4.5.2 Induction of new directors 124 Ethical behaviour by directors 125 Remuneration of directors and executives 127 4.4.1 4.4.2 4.4.3 4.4.4 4.4.5

4.5

4.6 4.7

(with contributions by Christine Jubb)

4.8

4.7.1 A controversial issue 127 4.7.2 Disclosure of remuneration and emoluments in Australia 128 4.7.3 Investigations into excessive remuneration of directors and executives 128 Conclusion 129

PART TWO CORPORATE GOVERNANCE IN AUSTRALIA 131 5 Corporate governance in Australia – background and business initiatives 133 5.1 Background to the corporate governance debate in Australia 133 5.2 The Bosch Report 136 5.2.1 5.2.2 5.2.3 5.2.4

5.3 5.4

Background 136 The Bosch Report (1991) The Bosch Report (1993) The Bosch Report (1995)

Divergence from UK practice: 1995 to early 2003 142 The Hilmer Report 142 5.4.1 Background 142 5.4.2 The Hilmer Report (1993) 5.4.3 The Hilmer Report (1998)

5.5 5.6 5.7 5.8

137 139 141

144 145

The virtues of good corporate governance in Australia between 1991 and 1998 146 The IFSA Blue Book 146 Standards Australia 152 Conclusion 154

6 Regulation of corporate governance 156 6.1 Overview 156 6.2 Regulation generally 157 6.3 Objectives in regulating corporate governance

159

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CONTENTS

6.4

Sources of regulation in Australia 161 6.4.1 ‘Hard law’ 162 6.4.1.1 Statutory regulation – corporate law 162 6.4.1.2 Statutory regulation – other than corporate law 165 6.4.1.3 ‘Corporate governance and the judges’ – the place of judge-made law 165 6.4.2 ‘Hybrids’ 166 6.4.2.1 ASX Listing Rules 166 6.4.2.2 ASX Corporate Governance Principles and Recommendations 168 6.4.2.3 Accounting standards 169 6.4.2.4 Auditing standards 169 6.4.3 ‘Soft law’ 170 6.4.4 The role of market forces 172

6.5

Towards an effective supervision of financial markets regulatory framework in Australia – analysis 174

6.6

6.5.1 OECD’s guidelines for achieving an effective governance framework 174 6.5.2 Division of responsibilities between ASX and ASIC 176 Conclusion 178

7 The role of the regulators: ASIC and ASX 179 7.1 Introduction 179 7.2 The Australian Securities and Investments Commission

180 Overview 180 Statutory powers under the ASIC Act 181 The role of ASIC in corporate governance 182 ASIC enforcement patterns 185 The Australian Securities Exchange Ltd 187 7.3.1 Slow to get out of the blocks 187 7.3.2 Rapid change in attitude since the end of 2002 189 7.3.3 ASX Corporate Governance Council’s Principles of Good Corporate Governance and Best Practice Recommendations 190 7.3.3.1 Changes in 2007 190 7.3.3.2 Structure 190 7.3.3.3 Recommendations 191 7.3.3.4 The roles and relationship between ASX and ASIC 193 Conclusion 195 7.2.1 7.2.2 7.2.3 7.2.4

7.3

7.4

8 Accounting governance 198 8.1 Overview 198 8.2 Background to the Corporate Law Economic Reform Program and some later developments 199 8.3 The Corporate Law Economic Reform Program 200 8.4 Impetus for CLERP 9: Responding to corporate collapses 202 8.5 Explanation of key CLERP 9 reforms 205 8.5.1 Audit reform

205

CONTENTS

8.6 8.7

ix

8.5.2 Corporate disclosure 206 8.5.2.1 Remuneration of directors and executives 206 8.5.2.2 Financial reporting 207 8.5.2.3 Continuous disclosure 208 8.5.2.4 Shareholder participation 209 8.5.2.5 Whistleblowers 209 8.5.2.6 Disclosure rules 211 8.5.3 Miscellaneous 213 8.5.3.1 Managing conflict by financial services licensees 213 8.5.3.2 Register of relevant interests 213 8.5.3.3 Officers, senior managers and employees 214 8.5.3.4 Enforcement 214 8.5.3.5 Proportionate liability 214 Accounting standards 215 Conclusion 216

9 Auditors and audits 219 (with contributions by Christine Jubb) 9.1 Introduction: The audit role and where it fits into corporate governance 219 9.1.1 Overview of the audit role 219 9.1.2 The link between the audit role and corporate governance 221 9.2 CLERP 9 changes to audit role 222 9.3 Auditor independence 224 9.3.1 Overview of rationale behind independence requirement 224 9.3.2 General requirement for auditor independence 225 9.3.3 Meaning of ‘conflict of interest situation’ 225 9.3.4 Disclosing and resolving conflicts 226 9.3.5 Specific independence requirements – minimising conflict of interest through employment and financial restrictions 226 9.3.6 Auditor rotation 228 9.3.7 Disclosure of non-audit services 228 9.4 Auditors and the AGM 229 9.5 Auditors’ duties 229 9.6 Reducing the legal exposure of auditors 231 9.6.1 Overview of auditors’ liability 231 9.6.2 Registration of audit companies 232 9.6.3 Proportionate liability 233 9.7 Qualification of auditors 235 9.8 Uniform auditing standards 235 9.9 Audit oversight 236 9.10 Audit committees 237 9.11 Conclusion 239

10 Directors’ duties and liability 240 10.1 Introduction 240

x

CONTENTS

10.2 Part 9.4B – civil penalty provisions or pecuniary penalty provisions 243 10.2.1 Overview 243 10.2.2 The civil penalty provisions in particular 244 10.2.2.1 Section 180: Duty of care and diligence – civil obligation 244 10.2.2.2 Section 181: Duty of good faith – civil obligation 247 10.2.2.3 Sections 182 and 183: Duty not to use position or information to gain personally or cause detriment to the corporation 248 10.2.2.4 Part 2E: Duty relating to related party transactions 249 10.2.2.5 Part 2H: Duty relating to share capital transactions 250 10.2.2.6 Part 2M.2 and 2M.3: Duty relating to requirements for financial reports 251 10.2.2.7 Part 5.7B: Duty to prevent insolvent trading 251 10.2.2.8 Part 5C: Duties relating to managed investment schemes 254 10.2.2.9 Chapter 6CA: Duty relating to continuous disclosure 255 10.2.2.10 Part 7.10: Duty not to be involved in market misconduct and other prohibited conduct relating to financial products and financial services 255 10.2.2.11 Subclause 29(6) of Schedule 4: Duty relating to disclosure for proposed demutualisation 258 10.2.2.12 Relief from civil liability 258

10.3 Case studies regarding civil penalty provisions or pecuniary penalty provisions 260 10.3.1 Overview 260 10.3.2 ASIC v Adler [2002] 41 ACSR 72 260 10.3.2.1 Summary of the facts 260 10.3.2.2 Contraventions of civil penalty provisions 261 10.3.2.3 Court orders 264 10.3.3 ASIC v Macdonald (No 11) (2009) 256 ALR 199 – James Hardie litigation 265 10.3.3.1 Background and summary of the facts 265 10.3.3.2 Legal issues 266 10.3.3.3 Decision and significance of the decision 267 10.3.3.4 Court orders 271 10.3.4 ASIC v Rich [2009] NSWSC 1229 272 10.3.4.1 Background and basic facts 272 10.3.4.2 Legal issue 273 10.3.4.3 The decision and its significance 273 10.4 Conclusion 277

11 Enforcement of directors’ duties 279 11.1 Introduction 279 11.2 The statutory derivative action: Part 2F.1A

281

CONTENTS

xi

The case to introduce a statutory derivative action 281 Eligible applicant 282 Cause of action 283 Leave of court required to institute the statutory derivative action 283 Oppressive conduct of affairs: Part 2F.1 284 11.3.1 Type of conduct covered by Part 2F.1 284 11.3.2 Who may apply for relief under Part 2F.1? 285 11.3.3 Nature of relief available under Part 2F.1 286 Section 1324 injunctions 287 11.4.1 Introduction 287 11.4.2 Section 1324(1) 287 11.4.3 The court’s discretion 288 11.4.4 Remedies in particular 289 Criminal liability of directors 290 11.5.1 The importance of the criminal sanction in the corporations law 290 11.5.2 Selected criminal offences directors and other officers can commit under the Corporations Act 293 11.5.2.1 General 293 11.5.2.2 Specific offences for breaches of duties 294 Conclusion 294 11.2.1 11.2.2 11.2.3 11.2.4

11.3

11.4

11.5

11.6

PART THREE CORPORATE GOVERNANCE IN INTERNATIONAL AND GLOBAL CONTEXTS 297 12 Corporate governance in the USA, the UK and Canada 299 12.1 Introduction 299 12.2 United States 300 12.2.1 Background to the corporate governance debate in the USA 300 12.2.2 The American Law Institute’s involvement in the corporate governance debate 301 12.2.2.1 Basic aims of the project 301 12.2.2.2 Impact and importance of the project 301 12.2.2.3 Some of the key aspects addressed 302 12.2.3 The Securities Exchange Commission 303 12.2.4 The Sarbanes-Oxley Act of 2002 – the US response to collapses such as Enron and WorldCom 304 12.2.4.1 Backdrop 304 12.2.4.2 Aims and objectives 305 12.2.4.3 Some perspectives on SOX and its effect 307 12.2.5 NYSE: Sections 303 and 303A – corporate governance rules 309 12.2.5.1 Background 309 12.2.5.2 Summary of the most important NYSE corporate governance rules 310 12.3 United Kingdom 312 12.3.1 Background to the corporate governance debate in the UK 312 12.3.2 The Cadbury Report and the unfolding of the concept of ‘corporate governance’ in the UK 312

xii

CONTENTS

12.3.2.1 Context of the Cadbury Report 312 12.3.2.2 Code of Best Practice 313 12.3.2.3 Further developments 314 12.3.3 The Greenbury, Hampel, Smith and Higgs reports 316 12.3.3.1 The Greenbury Report (1995) 316 12.3.3.2 The Hampel Report (1998) 316 12.3.3.4 The Higgs Report (2003) and the Smith Report (2003) 317 12.3.4 The 2008 UK Combined Code and the 2010 UK Corporate Governance Code 317 12.4 Canada 320 12.4.1 Overview 320 12.4.2 Regulatory environment 321 12.4.3 Proposed National Policy 58–201: Corporate governance principles 323 12.4.4 Current National Policy 58–201: Corporate governance guidelines 330 12.4.5 National Instrument 58–101: Disclosure of Corporate Governance Practices 330 12.4.6 National Instrument 52–110 and Companion Policy 52–110CP Audit Committees 331 12.4.7 Future direction 334 12.5 Conclusion 336

13 OECD Principles of Corporate Governance, and corporate governance in Germany, Japan and China 337 13.1 Introduction 337 13.2 OECD Principles of Corporate Governance 338 Background 338 Broad aims and application 338 Structure 339 Ensuring the basis for an effective corporate governance framework 339 13.2.5 Disclosure and transparency 341 13.2.6 Conclusions on OECD corporate governance principles 342 13.3 Germany 342 13.3.1 Background to the corporate governance debate in Germany 342 13.3.2 The German Corporate Governance Code 345 13.3.2.1 Background to its adoption 345 13.3.2.2 Structure and explanatory nature of the German code 347 13.3.3 Employee participation at supervisory board level – co-determination 348 13.3.4 The German board structure 351 13.3.5 Conclusions on Germany 351 13.4 Japan 352 13.2.1 13.2.2 13.2.3 13.2.4

(by Luke Nottage) 13.4.1 Introduction

352

CONTENTS

13.4.2 Japan and debates on comparative capitalism and corporate governance 353 13.4.3 Historical transformations in Japanese corporate law and practice 359 13.4.4 Japanese corporate forms and internal governance mechanisms 363 13.4.4.1 Overview 363 13.4.4.2 Companies with committees versus companies with boards of auditors 365 13.4.4.3 Directors’ duties and derivative actions 369 13.4.5 Shareholder versus bank finance 373 13.4.5.1 Overview 373 13.4.5.2 Share-class diversification 374 13.4.5.3 Takeovers regulation 375 13.4.5.4 Main banks 379 13.4.6 Core employees 382 13.4.7 Conclusions on Japan 385 13.5 China 386

(by Vivienne Bath) 13.5.1 Introduction 386 13.5.2 Government and legislation in China 387 13.5.3 Corporate entities in China 390 13.5.3.1 State-owned enterprises 390 13.5.3.2 Foreign-investment enterprises 392 13.5.3.3 Companies under the Company Law 393 13.5.4 Corporate governance – issues and resolutions 395 13.5.5 Controlling the board of directors and the managers – the supervisory board 397 13.5.6 Increasing the duties of directors 398 13.5.7 Independent directors 401 13.5.8 Committees 402 13.5.9 The issue of the controlling shareholder – protection for minority shareholders under the Company Law 403 13.5.10 Improved disclosure requirements 406 13.5.11 Imposing additional requirements on the sponsors of public offerings 408 13.5.12 Higher standards of accounting 408 13.5.13 Direct intervention – the case of dividends 409 13.5.14 Enforcement 410 13.5.15 Consequences of breach 410 13.5.16 Conclusions on China 413 13.6 Conclusion 415

PART FOUR BUSINESS ETHICS AND FUTURE DIRECTION 417 14 The ethical obligations of corporations 419 14.1 Introduction – the nature of morality 419 14.2 The threshold issue: Is there a role for ethical considerations in business? 424

xiii

xiv

CONTENTS

14.2.1 A brief look at the short history of business ethics 424 14.2.2 The disunity between business and ethics argument 427 14.2.3 Morality applies to business because moral judgments are universalisable 427 14.2.4 Exception to universalisation – activities with internal settled rules? 428 14.2.5 Are moral norms too vague to apply to business? 429 14.2.6 Promise to shareholders to maximise profits as a basis for rejecting application of moral principles to business? 430 14.2.7 Summary of the general link between business and ethics 431 14.3 Application of moral principles to a business setting 432 14.3.1 Types of duties imposed on corporations – proscriptions against causing harm, lying and environmental damage already legally enforced 432 14.3.2 Additional duties imposed on corporations – a duty of benevolence? 434 14.3.2.1 Acts and omissions doctrine serves to minimise obligations on corporations 434 14.3.2.2 Principal duty is for corporations to comply with law – business is morally neutral 436 14.3.2.3 A more elaborate duty – extreme wealth and a maxim of positive duty 437 14.3.2.4 Requirement to pay social dividend 439 14.3.3 Extreme wealth and duty to not frustrate access to justice 441 14.3.4 Is corporate social responsibility the answer? 442 14.4 Conclusion 444

15 Reflections on contemporary corporate governance and its future direction 446 15.1 Introduction 446 15.2 Regulatory pyramid and the cycles of regulation: A perspective on contemporary corporate governance regulation 447 15.3 Interaction of cycles of regulation and ‘law and norms’ discourse 451 15.3.1 The significance of norms 451 15.3.2 Norms, corporate governance and the utility of behavioural analysis 457

15.4 Conclusion: The future of corporate governance regulation Index 469

465

Contributors

Jean Jacques du Plessis is Professor in the School of Law at Deakin University.

He is an Alexander von Humboldt Scholar, and since 2004 he has assisted with the South African Corporate Law Reform Program as a member of the International Reference Group for the South African Corporate Law Reform Program. He is a member of the Executive Committee of the Corporate Law Teachers Association and was the President of this Association in 2008 and 2009. Anil Hargovan is Associate Professor in the School of Business Law and Tax-

ation at the University of New South Wales. His research interests are in the area of corporate and insolvency law, a discipline in which he has presented many conference papers and published widely in refereed Australian and international law journals. He has recently edited a volume of the Australian Journal of Corporate Law dedicated to the legal and policy issues arising from the Sons of Gwalia litigation, concerning the treatment of shareholders as creditors in corporate insolvencies. Anil has authored and co-authored several books, including Australian Corporate Law (2008). He is a member of the Executive Committee of the Corporate Law Teachers Association and convenor of the Company Law Interest Group for the Australasian Law Teachers Association. Anil teaches corporate governance in the MBA program at the AGSM at the University of New South Wales, and is a member of the Corporate Governance Subject Advisory Committee for Chartered Secretaries, Australia. Mirko Bagaric is Professor in the School of Law at Deakin University. He has

published several articles with James McConvill on policy issues and future developments in corporate governance. He also researches very actively in such fields as criminal law, the law of evidence, privacy and family law. Mirko has already published on his own or as co-author of textbooks or monographs in each of these areas. He is also a practising lawyer. Vivienne Bath is Associate Professor in the Faculty of Law at the University of

Sydney. She has first class honours in Chinese and in Law from the Australian National University, and a Master of Laws from Harvard University. Prior to joining the Faculty of Law, she was a partner in international firm Coudert Brothers, working in the Hong Kong and Sydney offices and specialising in commercial law, with a focus on foreign investment and commercial transactions in the People’s Republic of China. Vivienne has published widely in the area of xv

xvi

CONTRIBUTORS

Chinese law and is a frequent participant in conferences and seminars focusing on developments in international economic law and the Chinese legal regime. Christine Jubb is Research Fellow in the Australian National Centre for Audit and Assurance Research at the Australian National University. She was formerly Professor of Accounting at the Deakin Business School, Deakin University. She was appointed, by the Financial Reporting Council, to the Australian Auditing and Assurance Standards Board in 2005 and reappointed for a second three-year term to the Board in 2008. Christine has taught auditing and financial reporting at undergraduate and postgraduate levels, supervised auditing-related research at Honours, Master and PhD levels and published articles and textbooks on Auditing and Assurance. She is a member of the CPA Australia Exam Policy Advisory Committee and the Exam Special Consideration Committee. She is an author for the Assurance and Auditing CPA segment. Luke Nottage is Associate Professor in the Faculty of Law at the University of Sydney, Associate Director (Japan) at its Centre for Asian and Pacific Law, Program Director (Comparative and Global Law) at the Sydney Centre for International Law and founding Co-Director of the Australian Network for Japanese Law. He specialises in comparative and transnational commercial and consumer law, and has published more than 100 works, including Nottage, Wolff & Anderson (eds) Corporate Governance in the 21st Century: Japan’s Gradual Transformation (2008). Luke is qualified in New South Wales and New Zealand, has worked closely with law firms in Japan since 1990, and is a Director of Japanese Law Links Pty Ltd. He has served as expert witness and consulted for many law firms worldwide, as well as for the Organisation for Economic Co-operation and Development (OECD), the European Commission, Japanese Cabinet Office and the United Nations Development Programme.

Table of cases

Re a Company [1989] BCLC 13 104 Adler v ASIC & 4 Ors [2002] NSWSC 483 264 Airpeak Pty Ltd v Jetstream Aircraft (1997) 15 ACLC 715 287; 720 290 Alexander v Cambridge Credit Corp Ltd (1987) 9 NSWL 310 231 Allen v Atalay (1993) 11 ACSR 753 287 ASIC v Adler [2002] 41 ACSR 72 246, 260; NSWSC 483 (30 May 2002) 244, 260; (2002) 41 ACSR 72 245, 247, 250, 268; 42 ACSR 80 75 ASIC v Dawson Nominees Pty Ltd (2008) 169 FCR 227 211 ASIC v Elliot (2004) 48 ACSR 621 75 ASIC v Fortescue Metals Group Ltd [No 5] [2009] FCA 1586 186 ASIC v Macdonald and Others (No 11) [2009] NSWSC 287 (23 April 2009) 80, 83; (2009) 256 ALR 199 56, 57, 59, 65, 183; 256 ALR 199 75, 102, 245, 247, 265 ASIC v Macdonald (No 12) [2009] NSWSC 714 56, 265, 271; (2009) 259 ALR 116 75, 265

ASIC v Maxwell (2006) 59 ACSR 373 75, 245, 268 ASIC v Murdaca (2008) 68 ACSR 66 103 ASIC v Plymin (No 1) (2003) 175 FLR 124 254; 46 ACSR 126 251–2 ASIC v Rich (2003) 44 ACSR 44 75; 44 ASCR 341 171; [2009] NSWSC 1229 186, 245, 246, 272; [7193] 241; [7203] 109 ASIC v Triton Understanding Insurance Agency Pty Ltd and Others (2003) 48 ACSR 244, 256 289–90 ASIC v Vines (2005) 55 ACSR 617 75; 56 ACSR 528 259 ASIC v Vizard (2005) 145 FCR 57 75, 241, 249; 219 ALR 714 186 Australian Securities and Investments Commission v Mauer-Suisse Securities Ltd (2002) 42 ACSR 605 289 AWA Ltd v Daniels (Trading as Deloitte Haskins & Sells & Ors) (1992) 7 ACSR 759 77, 80, 142, 268; 9 ACSR 983 231; 867 109, 143; 10 ACLC 933 87

Re AWB Ltd (No 10) [2009] VSC 566 186 Barnes v Andrews 298 Fed 614 (1924) 73 Bateman v Newhaven Park Stud Ltd (2004) 49 ACSR 454 168 BGJ Holdings Pty Ltd v Touche Ross & Co (1987) 12 ACLR 481 220–1 Re Brazilian Rubber Plantation and Estates Ltd [1911] 1 Ch 425 72 Brunninghausen v Glavanics (1999) 46 NSWLR 538 240 Campbell v Backoffice Investments Pty Ltd [2009] HCA 25 285 Canadian Aero Service Ltd v O’Malley (1973) 40 DLR (3d) 371 107 xvii

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TABLE OF CASES

Re Cardiff Savings Bank (Marquis of Bute’s case) [1892] 2 Ch 100 242 Chahwan v Euphoric Pty Ltd (2008) 65 ACSR 661 283 Charterhouse Investment Trust Ltd v Tempest Diesels Ltd [1986] PCLC 1 262 City Equitable Fire Insurance Co Ltd [1925] Ch 407 73 Re City Equitable Fire Insurance Co Ltd [1925] Ch 407 72, 74, 241, 245 Columbia Coffee & Tea Pty Ltd v Churchill t/as Nelson Parkhill (1992) 29 NSWLR 141 231

Commonwealth Bank of Australia v Friedrich (1991) 5 ASCR 115, 187 80, 242, 253, 259; 9 ACLC 946 74, 259 Re Damilock Pty Ltd (In Liq); Lewis and Carter as Liquidators of Damilock Pty Ltd (In Liq) v VI SA Australia Pty Ltd (2009) 252 ALR 533 251–2 Daniels v Anderson [1995] 13 ACLC 614 109; (1995) 13 ACLC 614 80, 143, 144, 242; 16 ACSR 607 (CA (NSW)) 72, 73, 74, 241, 268; 37 NSWLR 438 244, 247, 259

DCT v Clarke [2003] NSWCA 91 254; (2003) 57 NSWLR 113 254 Re Denham and Co (1883) 25 CH D 752 242 Dodge v Ford Motor 170 N.W. 668 (Mich. 1919); (1919) 204 Mich. 459 6 Dodrill v The Irish Restaurant & Bar Co Pty Ltd [2009] QSC 317 285 Edwards v ASIC [2009] NSWCA 424 251, 252 Edwards v Attorney General (NSW) [2004] NSWCA 272 60; (2004) 50 ACSR 122 Elliot v ASIC (2004) 48 ACSR 621 254 Esanda Finance Corp Ltd v Peat Marwick Hungerfords (1997) 188 CLR 241 231 Re Faure Electric Accumulator Co (1888) 40 Ch D 141 72 Fiduciary Ltd v Morningstar Research Pty ltd (2005) 53 ACSR 732 283 Fire and All Risk Insurance Ltd v Pioneer Concrete Services Ltd (1986) 10 ACLR 760 168

Re Forest of Dean Coal Mining Co (1878) 10 Ch D 450 72 Frankston & Hastings Corp v Cohen (1960) 102 CLR 607 231 Furs Ltd v Tomkies (1936) 54 CLR 583 241 Gambotto v WCP Ltd (1995) 182 CLR 432 51 Goozee v Graphic World Group Holdings Pty Ltd [2002] NSWSC 640 (25 July 2002) 282

Group Four Industries Pty Ltd v Brosnan (1992) 8 ACSR 463 268 Hall v Poolman (2007) 65 ACSR 123 252, 253, 259, 260 Harman v Energy Research Group Australia Ltd (1985) 9 ACLR 897 168 Harris v Sheperd (1975) 1 ACLR 50 (on appeal) [1976] ACLC 28, 614 104 Hawkins v Bank of China (1992) 7 ACSR 349 252 Hely-Hutchinson v Brayhead Ltd [1968] 1 QB 549 118 Ho v Akai Pty Ltd (in liq) (2006) 24 ACLC 1526 104 Hospital Products Ltd v United States Surgical Corporation (1984) 55 ALR 417 248

Industrial Equity Ltd v Blackburn (1977) 13 CLR 567 58 Insurances Ltd v Pioneer Concrete Services Ltd (No 2) (1986) 10 ACLR 801 169

TABLE OF CASES

xix

John J Starr (Real Estate) Pty Ltd v Robert R Andrew (A’asia) Pty Ltd (1991) 6 ACSR 63 285 Katz v Oak Industries, Inc., 508 A.2d 873, 879 (Del. Ch. 1986) 6 Kenna & Brown Pty Ltd v Kenna (1999) 32 ACSR 430 259 Re Kingston Cotton Mill (No 2) [1896] 2 Ch 270 220–221 Kuwait Asia Bank v National Mutual Life Nominees Ltd [1991] AC 187 105 Lagunas Nitrate Company v Lagunas Syndicate [1899] 2 Ch 392 72; 435 241 Lennard’s Carrying Co Ltd v Asiatic Petroleum Co Ltd [1915] AC 705, 713 75 Manpac Industries Pty Ltd v Ceccattini (2002) 20 ACLC 1304 254 McLellan (in the matter of The Stake Man Pty Ltd) v Carroll [2009] FCA 1415 253, 254, 259

Metropolitan Fire Systems v Miller (1997) 23 ACSR 699 253 Metyor Inc v Queensland Electronic Switching P/L [2002] QCA 269 (30 July 2002) 281

Morley v Statewide Tobacco Services Ltd, (1992) 14 Syd LR 504 74 Murdaca v ASIC [2009] FCAFC 92 102 Natcomp Technology Australia Pty Ltd v Graiche [2001] NSWCA 120 (30 April 2001) 104

Re National Bank of Wales Ltd [1899] 2 Ch 629 72 Re New Mashonaland Exploration Co [1892] 3 Ch D 577 72 Niord Pty Ltd v Adelaide Petroleum NL (1990) 8 ACLC 684 286 Northumberland Insurance Ltd (in liq) v Alexander (1988) 13 ACLR 170 231 Oates v Consolidated Capital Services Ltd (2009) 72 ACSR 506 283 Overend, Gurney & Co. v. Gibb (1872) LR 5 HL 480 72 Pacific Acceptance Corporation v Forsyth (1970) 92 WN (NSW) 29 220–1 Parke v Daily News Ltd [1962] Ch 927 46 Percival v Wright [1902] 2 Ch 421 240 Permanent Building Society v Wheeler (1994) 14 ACSR 109 268 Playspace Playground Pty Ltd v Osborn [2009] FCA 1486 252 R v Dytham [1979] QB 722 436 R v Pittwood (1902) 19 TLR 37 436 Ragless v IPA Holdings Pty Ltd (in liq) (2008) 65 ACSR 700 283 Regal (Hastings) Ltd v Gulliver [1942] UKHL 249; [1967] 2 AC 134 241, 249 Revlon, Inc v McAndrews & Forbes Holdings, Inc 506 A.2d 173 (Del. 1986) 43 Rich v ASIC [2004] HCA 42 134, 146 RTP Holdings Pty Ltd v Roberts [2000] SASC 386 (8 November 2000) 284 Salomon v Salomon & Co Ltd [1897] AC 22 58 Sandell v Porter (1966) 115 CLR 666 251–2 Scottish Co-operative Wholesale Society Ltd v Meyer [1959] AC 324 105, 285 Somerville v ASIC (1995) 131 ALR 517 280 Spies v R (2000) 201 CLR 603 29, 68

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TABLE OF CASES

Statewide Tobacco Services Ltd v Morley (1990) 2 ACSR 405 242, 253, 254, 268; 8 ACLC 827 74 Strategic Minerals Corp NL v Basham (1996) 15 ACLC 1155 231 Swansson v Pratt (2002) 42 ACSR 313 283 Re Tasbian (No 3) [1992] BCC 358 104 Tekinvest Pty Ltd v Lazarom [2004] NSWSC 940 (11 October 2004), [21]-[22] 289–90

Tesco Supermarkets v Nattrass [1971] 2 All ER 127 291 The Australian Metropolitan Life Assurance Co Ltd v Ure (1923) 33 CLR 199 241 The Bell Group Ltd (in liq) v Westpac Banking Corporation (No 9) [2008] WASC 239 (28 October 2008) [4362] 5, 75; (2008) 70 ACSR 1 29 Tourprint International Pty Ltd v Bott (1999) 32 ACSR 201 253 Turquand v Marshall (1869) LR 4 Ch App 376 72, 74, 242 United States v Arthur Young, 465 US 805, 817–18 (1984) 224 Unocal Corp. v Mesa Petroleum Co. 493 A.2d 946 (Del. 1985) 43 Vanmarc Holdings Pty Ltd v PW Jess & Associates Pty Ltd (2000) 34 ACSR 222 289–90

Vines v ASIC (2007) 62 ACSR 1 75, 259, 268 Vrisakis v ASC (1993) 11 ACSR 162 268 Walker v Wimborne (1976) 137 CLR 1 58 Wayde v NSW Rugby League Ltd (1985) 180 CLR 459 285 Western Areas Exploration Pty Ltd v Streeter [No 3] (2009) 73 ACSR 494 241 Whitlam v Australian Securities and Investments Commission (2003) 21 ACLC 1259 118

Williams v ASIC (2003) 46 ASCR 504 264 Williams v Scholz [2007] QSC 266 254; [2008] QCA 94 259

Table of statutes

China Company Law 1993 387–8, 390, 391, 393–5, 397–401, 403–7, 409–11, 414

Criminal Law of the People’s Republic of China 1997 387–8 Enterprise State-owned Assets Law of the People’s Republic of China 2009 391–2

General Principles of Civil Law 1987 392

Law of the People’s Republic of China on Chinese-foreign Cooperative Joint Ventures 1988 392 Law of the People’s Republic on Foreign Capital Enterprises 1986 392 Law of the People’s Republic of China on Industrial Enterprises owned by the Whole People 1988 390–1 Law on Securities Investment Funds 2003 387–8 Securities Law of the People’s Republic of China 1998 387–8, 393, 396, 407, 410

Corporate Law Economic Reform Program Act 1999 201 Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 94, 108, 159, 160–1, 169, 170, 171, 198–9, 219, 293, 448, 456 Corporations Act 2001 26, 30, 50, 51, 59, 60, 67, 75, 76, 94, 102, 103, 104, 105–7, 109, 117–20, 121, 128, 134, 144, 147, 160–1, 162–5, 167, 169, 182, 193, 199, 206–7, 209, 220, 225–30, 232–3, 235, 236, 242–60, 262–4, 266–7, 268–78, 281–95 Criminal Code Act 1995 290–2 Cross-Border Insolvency Act 2008 201

Environment Protection and Biodiversity Conservation Act 1999 32 Fair Work Act 2009 26 Financial Services Reform Act 2001 184, 201

Public Interest Disclosure Act 2003 210

Trade Practices Act 1974 30, 232, 235

Commonwealth

Germany

Audit Reform and Corporate Disclosure Act 2004 128, 147 Australian Prudential Regulation Authority Amendment Act 2003 95 Australian Securities and Investments Commission Act 2001 26, 181–2,

Stock Corporation Act 1937 360

207, 233–5, 236, 237

Australian Securities and Investments Commission Amendment (Audit Inspection) Act 2007 237 Company Law Review Act 1998 229

Japan Child Care and Family Care Leave Law 2004 384 Companies Act 2005 363–5, 372 Equal Employment Opportunity Law 1997 384 Equal Employment Opportunity Law 2006 384

xxi

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TABLE OF STATUTES

New Zealand

United States

Companies Act 1993 49

Model Business Corporations Act 2002

United Kingdom

Sarbanes-Oxley Act 2002 94, 97, 159,

Companies Act 1985 46, 49 Companies Act 2006 45, 46, 67, 68,

168, 205, 218, 304–9, 317, 448, 456 Securities Act 1933 303–4, 449 Securities Exchange Act 1934 303–4, 309–10, 449

78

121, 280

Companies (Audit, Investigations and Community Enterprise) Act 2004 47

Preface

Corporate governance has increased in prominence over the past 30 years or so. It has long been an area of rapid development and, in some instances, following dramatic corporate collapses, drastic measures were required to ensure adherence to good practice in corporate governance. Since the appearance of the first edition of Principles of Contemporary Corporate Governance in 2005, developments have not only gained velocity, but the volume of materials on corporate governance has grown exponentially. This made the appearance of a second edition inevitable. In addition, the global financial crisis that emerged in 2008 and global financial uncertainties related to some worrying revelations in the first half of 2010 about the financial stability of several European Union member countries make it easy to predict that the discipline of corporate governance will retain its prominence in future. In this second edition of Principles of Contemporary Corporate Governance, the basic approach was again to extract the fundamental and contemporary principles of corporate governance. The majority of authors have a legal background, which reflects an emphasis on legal aspects of corporate governance. However, care has been taken also to focus on managerial and accounting perspectives of corporate governance. It should be emphasised that this book deals primarily with corporate governance of large public corporations. It does not focus separately on small and medium-sized enterprises (SMEs), non-government organisations (NGOs) or public-sector corporate governance. It goes without saying that many of the good principles in corporate governance that are generally applicable to large public corporations are transplantable to other enterprises, organisations and governmental agencies. Although grounded in Australian corporate governance, it will be apparent to the reader that international perspectives are interwoven throughout the book. In addition, there is a prominent multi-jurisdictional focus in Part Three, where the OECD Principles of Corporate Governance are discussed and where specific chapters address corporate governance debates in the USA, the UK, Canada, Germany, Japan and China. Readers familiar with the first edition will notice that separate parts on corporate governance in Canada, Japan and China have been added. The second edition provides an extensive and comprehensive update, and expands the areas covered in the first edition. In the current Chapter 8 there is a broader focus on ‘accounting governance’, replacing the narrower focus on xxiii

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PREFACE

CLERP 9 in the first edition. The chapter on business ethics (Chapter 14) has been expanded and greater attention devoted to the importance of business ethics. In Chapter 10 (Directors’ duties and liabilities), recent Australian cases (up to May 2010) in the area of corporate law and directors’ duties are included. We have also updated all references, including discussions of the most recent corporate governance reports and codes in Australia and in the other jurisdictions covered. The chapter on accounting and auditing (Chapter 9) has been expanded and updated to position the Australian jurisdictional characteristics in an international context. There are five distinctive parts in Principles of Contemporary Corporate Governance, each carrying through a consistent theme: Part One introduces the reader to basic concepts on different types of board structures and company officers. Part Two focuses on corporate governance in Australia; Part Three adds an international perspective to corporate governance. Basic corporate governance principles in selected jurisdictions, including the USA, the UK, Canada, Germany, Japan and China are discussed, while the OECD Principles of Corporate Governance are also covered in some detail. Part Four deals with business ethics and possible future developments and trends in corporate governance. We are confident that this edition will again broaden the perspectives and understanding of all people interested in corporate governance and corporate regulation and management, including company secretaries, compliance officers, judicial officer, lawyers, accountants, academics and students of law and business management. We would like to thank James McConvill, second author of the first edition, for giving us permission to use the parts he prepared for the first edition, in this second edition of Principles of Contemporary Corporate Governance. Although several parts were changed extensively, there are still parts that we adopted in the second edition that we have not changed. We would also like to recognise James’ considerable input in the first edition. Circumstance beyond James’ control made it impossible for him to be an author of the second edition. THE AUTHORS May 2010

Preface to the first edition

Corporate governance concerns the manner in which corporations are regulated and managed. Corporations control a significant portion of the world’s wealth and other resources. The dominance of the corporation as the central agent in the market economy is increasing. Corporate behaviour impacts on every individual – often in very profound and significant ways. A fundamental tension in the corporate governance debate is balancing the profit making objective of corporations and company officers against broader social responsibilities owed to the wider community. This tension has not been adequately resolved. Thus, corporate governance is a very complex and controversial area of the law. This book sets out to demystify corporate governance regulation. It explains the rules and principles that regulate corporate behaviour in Australia and a number of other jurisdictions, including the United States, the United Kingdom and Germany. As well as dealing with corporate governance regulation today, the book provides an extensive analysis of the wider moral and policy considerations underpinning corporate governance. It evaluates existing standards pertaining to corporate governance, makes proposals for change and suggests ways in which this area of law and practice can be made more coherent and principled. The book argues that corporate governance regulation and management is in need of fundamental reform and explains in detail the direction that these reforms should take. The primary aim with Principles of Contemporary Corporate Governance is to extract and evaluate the core principles of this subject area. However, it also gives context to these principles by way of to-the-point discussions and explanations as well as through carefully selected diagrams, case studies and real-life examples of corporate governance practices. The book is written for all people who have an interest in corporate regulation and management, including company officers, judicial officers, lawyers, accountants and students. There are five distinct parts in Principles of Contemporary Corporate Governance, but they carry a consistent theme through the book. In Part One the reader is introduced to some of the most basic aspects regarding corporate governance, namely the meaning of the concept ‘corporate governance’; corporate stakeholders and participants; board structures (in particular the unitary and two-tier board structure); and types of company officers (executive and nonexecutive directors; alternate director; secretary, etc). xxv

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Part Two focuses on corporate governance in Australia, covering the ASX Corporate Governance Council’s Principles of Good Corporate Governance and Best Practice Recommendations (applicable to listed companies), other corporate governance guidelines and recommendations, the main governance and accountability mechanisms under the Australian Corporations Act 2001 and the recent Corporate Law Economic Reform Program 9 (CLERP 9) reforms to the Act. Part Three considers corporate governance in practice. Specific topics covered include board and committee structures and risk management policies; auditors and audits; and an overview of directors’ duties and liabilities. Part Four adds an international perspective to corporate governance. Basic corporate governance principles in selected jurisdictions such as the USA, UK and Germany are dealt with; the OECD Principles of Corporate Governance are also covered in some detail. Part Five deals with some policy issues, and likely future developments and possible corporate governance trends. We trust that our readers will find as much satisfaction in reading Principles of Contemporary Corporate Governance as we did in writing it. Jean Jacques du Plessis, James McConvill and Mirko Bagaric May 2005

PART ONE BASIC CONCEPTS, BOARD STRUCTURES AND COMPANY OFFICERS

1 The concept ‘corporate governance’ and ‘essential’ principles of corporate governance It is necessary only for the good man to do nothing for evil to triumph. – Attributed to Edmund Burke (18th-century English political philosopher) – The Australian, Monday 6 December 2004, 4, reporting on the most favoured phrase of quotation-lovers, as determined by an Oxford University Press poll

1.1 The meaning of corporate governance 1.1.1 Generally Corporate governance is as old as the corporate form itself,1 although Tricker correctly points out that the phrase ‘corporate governance’ was scarcely used until the 1980s.2 In the first edition (2005) of this book we pointed out that there is no set definition for the concept of corporate governance. This has not changed. Commentators still speak of corporate governance as an indefinable term, something – like love and happiness – of which we know the essential nature, but for which words do not provide an accurate description. Many have attempted to lay down a general working definition of corporate governance, yet one definition varies from another, and this often leads to confusion. Early attempts to define the concept of corporate governance appear in the United Kingdom Cadbury Report (1992) and the South African King Report (1994), defining corporate governance as ‘the system by which companies are directed and controlled’. That seems not particularly helpful in clarifying the meaning of corporate governance. Over the past decade or so, there have been further attempts at a definition, bringing in additional aspects or elements under the term ‘corporate governance’.

1 J J du Plessis, ‘Corporate law and corporate governance lessons from the past: Ebbs and flows, but far from “The end of History . . . : Part 1” ’ (2009) 30 Company Lawyer 43 at 44. 2 Bob Tricker, Corporate Governance: Principles, Policies and Practices, Oxford, Oxford University Press, (2009) 7.

3

4

BASIC CONCEPTS, BOARD STRUCTURES AND COMPANY OFFICERS

In a background paper published prior to the Report of the HIH Royal Commission (the Owen report) on the collapse of HIH Insurance Ltd – one of Australia’s largest corporate collapses – a clearer definition began to emerge: Corporate governance refers generally to the legal and organisational framework within which, and the principles and processes by which, corporations are governed. It refers in particular to the powers, accountability and relationships of those who participate in the direction and control of a company. Chief among these participants are the board of directors, and management. There are aspects of the corporate governance regime that have an impact on the relationship between shareholders and the company.3

In this report, Justice Owen considered the meaning of the term ‘corporate governance’ in two instances. In the introductory part of the Report, under the heading, ‘Corporate governance: A poor role model’, he reflected that the term ‘corporate governance’ was used so widely and so generally that the term ‘corporate governance’ was potentially meaningless. Justice Owen then provided some substance to the concept: Corporate governance – as properly understood – describes the framework of rules, relationships, systems and processes within and by which authority is exercised and controlled in corporations. Understood in this way, the expression ‘corporate governance’ embraces not only the models or systems themselves but also the practices by which that exercise and control of authority is in fact effected.4

This description of corporate governance focused on specific elements or aspects of corporate governance. The trend to define corporate governance more precisely continued in 2003 with the appearance of the Australian Securities Exchange’s (ASX) Principles of Good Corporate Governance and Best Practice Recommendations.5 The description used in 2003 was slightly different from the description of corporate governance contained in the 2007 ASX’s Principles of Good Corporate Governance and Best Practice Recommendations: Corporate governance is ‘the framework of rules, relationships, systems and processes within and by which authority is exercised and controlled in corporations’. It encompasses the mechanisms by which companies, and those in control, are held to account. Corporate governance influences how the objectives of the company are 3 Background Paper 11 (HIH Royal Commission) Directors’ Duties and Other Obligations under the Corporations Act (November 2001) 27 para 76. 4 Report of the HIH Royal Commission (Owen Report), The Failure of HIH Insurance – Volume I: A Corporate Collapse and its Lessons, Canberra, Commonwealth of Australia (2003) xxxiii. 5 ASX, Principles of Good Corporate Governance and Best Practice Recommendations (March 2003) 3, available at . ‘What is corporate governance? Corporate governance is the system by which companies are directed and managed. It influences how the objectives of the company are set and achieved, how risk is monitored and assessed, and how performance is optimised. Good corporate governance structures encourage companies to create value (through entrepreneurism, innovation, development and exploration) and provide accountability and control systems commensurate with the risks involved.’

CONCEPT AND ESSENTIALS

5

set and achieved, how risk is monitored and assessed, and how performance is optimised. Effective corporate governance structures encourage companies to create value, through entrepreneurialism, innovation, development and exploration, and provide accountability and control systems commensurate with the risks involved.6

It is useful to quote another, realistic and open-ended description of corporate governance from a United States perspective, but the absence of a reference to stakeholders as part of this definition and the focus on shareholder primacy (see below), is conspicuous: Simply defined, corporate governance consists of all people, processes, and activities in place to help ensure the proper stewardship over a company’s assets. Corporate governance is the implementation and execution of processes to ensure that those managing a company properly utilize the time, talents, and available resources in the best interests of absentee owners. These processes include all aspects of a company’s performance including risk management, operational and marketing strategies, internal control, conformance with applicable laws and regulation, public relations, communication, and financial reporting.7

While a closer description of corporate governance was required, the concept ‘corporate governance’ remains one that does not lend itself to a single, specific or narrow definition. Several differences remain, sometimes only subtle ones, but in other instances they are more fundamental. In 2008, Justice Owen made the following comments in The Bell Group Ltd v Westpac Banking Corporation (No 9):8 [D]irectors are in control of the assets of a corporation but they do not own those assets. They control the assets on behalf of the corporation and, through the corporation, others having an interest in the wellbeing of the entity. There are no hard and fast rules that constitute ‘corporate governance’. But there are some basic underlying principles that help to explain the guidelines and legal principles that have developed over time and now dictate how a director is expected to carry out her or his responsibilities.

Before we attempt to give our own definition, it is important to consider the origins of both the corporate governance and the stakeholder debates.

1.1.2 Origins of the corporate governance debate and the stakeholder debate It is difficult to determine exactly when the corporate governance debate started.9 However, there is little doubt that there were many factors that brought the corporate governance debate to prominence: the separation of ownership and control 6 ASX, Principles of Good Corporate Governance and Best Practice (2nd edn, August 2007) 3, available at . 7 K Fred Skousen, Steven M Glover and Douglas F Prawitt, An Introduction to Corporate Governance and the SEC, Mason, Thomson South-Western, (2005) 7. 8 [2008] WASC 239 (28 October 2008) [4362]. 9 See John Farrar, Corporate Governance: Theories, Principles and Practice, Melbourne, Oxford University Press (3rd edn, 2008) 8–120.

6

BASIC CONCEPTS, BOARD STRUCTURES AND COMPANY OFFICERS

(so pertinently illustrated in 1932 by Berle and Means in their book, The Modern Corporation and Private Property), which resulted in the so-called ‘managerial revolution’10 or ‘managerialism’;11 the pivotal role of the corporate form in generating wealth for nations; the huge powers of corporations, and the effects of these on our daily lives; the enormous consequences that flow from collapses of large public corporations;12 and what we would like to call the ‘boardtorial revolution’ or ‘directorial revolution’, based on what Stephen Bainbridge recently identified as ‘the director primacy model of corporate governance’ (see discussion below and Chapter 3). We are, indeed, as Allan Hutchinson describes it so appropriately, living in an age of corpocracy.13 It is also beyond dispute that the corporate governance debate became particularly prominent when the basic perception of the company changed. At first the only real concern for a company was the maximisation of profits.14 Profits for whom? – the shareholders.15 This was confirmed in 1919 in the case of Dodge v Ford Motor16 and is a view many commentators adhered to for a considerable period of time, with a further confirmation of the Dodge theory in 1986 in the case of Katz v Oak Industries17 . According to this view, the shareholders are the ‘owners of the company’, the primary stakeholders and most important providers of capital to enable the company to conduct business. Gradually this perception changed, and the company, especially the large public company, came to be seen in a different light. People realised that there were other stakeholders in a company, too; that if the only purpose of a company was ‘the maximisation of profits for the shareholders’, the society as such could suffer tremendously – poor working conditions for workers, exploitation of the environment, pollution and so on. Then came the realisation that: enterprise, private as well as public, because it both contributes to and benefits from society (local, national and larger), can be said to have rights and duties vis-` a-vis that society in somewhat the same way as has an individual;18 10 See, for example, Klaus J Hopt, ‘Preface’ in Institutional Investors and Corporate Governance. Theodor Baums, Richard M Buxbaum and Klaus J Hopt (eds), Berlin, W de Gruyter (1994) I; and OECD Principles of Corporate Governance (April 2004) 12. 11 Stephen M Bainbridge, The New Corporate Governance in Theory and Practice, Oxford, Oxford University Press (2008) 9, 19–20 and 155 et seq. 12 See generally Roberta Romano, The Genius of American Corporate Law, Washington, DC, AEI Press (1993); and David S R Leighton and Donald H Thain, Making Boards Work, Whitby, Ontario, McGraw-Hill Ryerson (1997) 9–10. 13 Allan C Hutchinson, The Companies We Keep, Toronto, Irwin Law (2005) 8. 14 Adolf A Berle, ‘The Impact of the Corporation on Classical Theory’ in Thomas Clarke (ed.), Theories of Corporate Governance: The Philosophical Foundations of Corporate Governance, London, Routledge (2004) 45, 49 et seq. 15 Margaret M Blair, ‘Ownership and Control: Rethinking Corporate Governance for the Twenty-First Century’ in Thomas Clarke (ed.), Theories of Corporate Governance: The Philosophical Foundations of Corporate Governance, London, Routledge (2004) 175, 181. See also Bainbridge, above n 11, 53. 16 Dodge v Ford Motor 170 N.W. 668 (Mich. 1919) at 684; (1919) 204 Mich. 459 at 507: ‘A business corporation is organized and carried on primarily for the profit of the stockholders The powers of the directors are to be employed for that end. The discretion of directors is to be exercised in the choice of means to attain that end, and does not extend to the change of the end itself, to the reduction of profits, or to the nondistribution of profits among stockholders in order to devote them to other purposes.’ 17 Katz v Oak Indus., Inc., 508 A.2d 873, 879 (Del. Ch. 1986). 18 Charles de Hoghton (ed.), The Company: Law, Structure and Reform in Eleven Countries, London, Allen & Unwin (1970) 7.

CONCEPT AND ESSENTIALS

7

and [t]he limited liability company does not simply represent one interest. It represents an arena in which there is a potential clash of many interests. We may identify the interests underlying it as: (1) investors – share capital/loan capital; (2) outside creditors – commercial finance/trade creditors; (3) employees; (4) consumers; (5) the public.19

The concept of ‘managing the corporation’ then came to be expressed in terms of these other interests: The balancing of the company’s responsibilities – to workers as members of the company, to consumers of the goods and services it provides, and to the community of which it is a citizen – with its primary one of operating at maximum efficiency and lowest cost, so as to make profits and discharge its obligations to its shareholders, represents the full scope of management.20

Thus, the concept of ‘corporate governance’ began to adopt this new articulation of ‘managing the corporation’, with a central focus on the interrelationship between internal groups and individuals such as the board of directors, the shareholders in general meeting, employees, managing directors, executive directors, non-executive directors, managers, audit committees and other committees of the board. However, outside interests are also at stake; for example, those of creditors, potential investors, consumers and the public or community at large (so-called stakeholders). Traditional wisdom regarding shareholder primacy21 versus other stakeholders began to be challenged with statements like ‘managerial accountability to shareholders is corporate law’s central problem’,22 ‘corporate law is currently in the midst of crisis, because of the exhaustion of the shareholder primacy model’23 and ‘[s]hareholder dominance should be questioned’.24 Nowadays, it is fairly generally accepted that ‘in future the development of loyal, inclusive stakeholder relationships will become one of the most important determinants of commercial viability and business success’;25 that ‘recognition of stakeholder concern is not only good business, but politically expedient and morally and ethically just, even if in the strict legal sense [corporations] remain directly accountable only to shareholders’;26 and that ‘[t]he corporation as a legal entity grew out of its ability to protect not only the shareholders but also other 19 John J Farrar et al., Farrar’s Company Law, London, Butterworths (1991) 13. 20 George Goyder, The Responsible Company, Oxford, Blackwell (1961) 45. 21 See generally on the theory of ‘shareholder primacy’ Irene-Mari´ e Esser, Recognition of Various Stakeholder Interests in the Company Management: Corporate Social Responsibility and Directors’ Duties, Saarbr¨ uken, VDM Verlag Dr M¨ uller, (2009) 19–23. 22 David Millon, ‘New Directions in Corporate Law: Communitarians, Contractarians, and the Crisis in Corporate Law’ 1993 (50) Washington & Lee Law Review 1373, 1374. 23 Ibid, 1390. 24 Morten Huse, Boards, Governance and Value Creation: The Human Side of Corporate Governance, Cambridge, Cambridge University Press (2007) 29. ¨, The Stakeholder Corporation, London, Pitmann (1997) ix. See further 25 David Wheeler and Maria Sillanp¨ aa James E Post, Lee E Preston and Sybille Sach, Redefining the Corporation: Stakeholder Management and Organizational Wealth, Stanford, Stanford Business Books (2002), 1–3; and Mark J Roe, ‘Preface’ in Margaret M Blair and Mark J Roe (eds), Employees & Corporate Governance, Washington, DC, Brookings Institute (1999) v. 26 Leighton and Thain, above n 12, 23.

8

BASIC CONCEPTS, BOARD STRUCTURES AND COMPANY OFFICERS

stakeholders’.27 This, in turn, made the concepts of ‘corporate social responsibility’ (the CSR debate) and ‘corporate citizenship’ highly prominent. Entire books are dedicated to discussion of corporate citizenship and the importance of companies being good corporate citizens. Examples include Mervyn King’s The Corporate Citizen28 and Corporate Citizenship, Contractarianism and Ethical Theory, edited by Jes´ us Conill, Christoph Luetge and Tantjana Sch¨ onw¨ alder-Kuntze.29 Also, a spate of books have been published recently on the CSR debate.30 It seems as though we have truly and inevitably moved away from the view that the primary aim of corporations is ‘to make a profit’, towards a view that corporations, especially large public corporations, should primarily strive ‘to build a better society’.31 The stakeholder debate, the CSR debate and ‘corporate citizenship’, therefore, are integral and prominent in most of the recent corporate governance discussions and reports. We consider stakeholders in greater detail in Chapter 2, but it is useful to refer at an early stage to some of the most prominent statements on the role and importance of stakeholders. The importance of stakeholders was clearly illustrated in the European Union Report, Comparative Study of Corporate Governance Codes Relevant to the European Union and its Members (January 2002),32 the South African King Report on Corporate Governance (March 2002)33 and the ASX Corporate Governance Council’s Principles of Good Corporate Governance and Best Practice Recommendations (March 2003)34 . 27 Huse, above n 24, 29. 28 Mervyn King, The Corporate Citizen: Governance for All Entities, Johannesburg, Penguin Books (2006). 29 Jes´ us Conaill, Christoph Luetge and Tanjanna Sch¨ onw¨ alder-Kuntze (eds), Corporate Citizenship, Contractarianism and Ethical Theory: On Philosophical Foundations of Business Ethics, Burlington, Ashgate (2008). 30 G¨ uler Aras and David Crowther (eds), Global Perspectives on Corporate Governance and CSR, Farnham, Gower Publishing Ltd (2009); Frank den Hond, Frank G A de Bakker and Peter Neergaard, Managing Corporate Social Responsibility in Action: Talking, Doing and Measuring, Aldershot, Ashgate Publishing Ltd (2007); Ana Maria D´ avila G´ omez and David Crowther (eds), Ethics, Psyche and Social Responsibility, Aldershot, Ashgate Publishing Ltd (2007); Wim Vandekerckhove, Whistleblowing and Organizational Social Responsibility: A Global Assessment, Aldershot, Ashgate Publishing Ltd (2006); David Crowther and Lez Rayman-Bacchus (eds), Perspectives on Corporate Social Responsibility, Aldershot, Ashgate Publishing Ltd (2004). 31 Hutchinson, above n 13, 326. 32 Comparative Study of Corporate Governance Codes Relevant to the European Union and its Members (hereafter referred to as European Commission Comparative Study) (January 2002) 4: ‘Although the comparative corporate governance literature and popular discussion tend to emphasise “fundamental” differences between stakeholder and shareholder interests, the extent to which these interests are different can be debated. The majority of corporate governance codes expressly recognise that corporate success, shareholder profit, employee security and well being, and the interests of other stakeholders are intertwined and co-dependent. This co-dependency is emphasised even in codes issued by the investor community.’ 33 Executive Summary – King Report on Corporate Governance (King Report (2002)), Parktown, South Africa, Institute of Directors in Southern Africa (March 2002) para 5.3: ‘The inclusive approach recognises that stakeholders such as the community in which the company operates, its customers, its employees and its suppliers need to be considered when developing the strategy of a company. The relationship between a company and these stakeholders is either contractual or non-contractual.’ 34 Principles of Good Corporate Governance and Best Practice Recommendations (2003), above n 5, 59: ‘There is growing acceptance of the view that organisations can create value by better managing natural, human, social and other forms of capital. Increasingly the performance of companies is being scrutinised from a perspective that recognises these other forms of capital. That being the case, it is important for companies to demonstrate their commitment to appropriate corporate practices.’

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A particularly good summary of the importance of the stakeholder debate, as an integral part of the corporate governance debate, appears in the Organisation for Economic Cooperation and Development (OECD) Principles of Corporate Governance (April 2004): A key aspect of corporate governance is concerned with ensuring the flow of external capital to companies both in the form of equity and credit. Corporate governance is also concerned with finding ways to encourage various stakeholders in the firm to undertake economically optimal levels of investment in firm-specific human and physical capital. The competitiveness and ultimate success of a corporation is the result of teamwork that embodies contributions from a range of different resource providers including investors, employees, creditors, and suppliers. Corporations should recognise that the contributions of stakeholders constitute a valuable resource for building competitive and profitable companies. It is, therefore, in the long-term interest of corporations to foster wealth-creating co-operation among stakeholders. The governance framework should recognise that the interests of the corporation are served by recognising the interests of stakeholders and their contribution to the long-term success of the corporation.35

Thus, since 2004, the OECD Principles of Corporate Governance has referred to corporate governance as ‘a set of relationships between a company’s management, its board, its shareholders and other stakeholders’.36 Also, because of the prominence of the stakeholder debate in recent times and the realisation that stakeholders form an integral part of any corporation’s existence and longterm prosperity, some commentators have moved away from the traditional ‘ownership-orientated’ definition of the corporation to a broader ‘stakeholderorientated’ definition. James E Post, Lee E Preston and Sybille Sach offer the following definition of a corporation: The corporation is an organisation engaged in mobilising resources for productive users in order to create wealth and other benefits (and not to intentionally destroy wealth, increase risk, or cause harm) for its multiple constituents, or stakeholders.37

We deal with this expanded definition in much greater detail in Chapter 2. However, it is worthwhile pointing out that over time these developments have made commentators and researchers pick up some definite trends, and increasingly theories and models of the corporation and of corporate governance have been identified.38 Until very recently, the ‘shareholder primacy model’ and ‘stakeholder primacy model’ of corporate governance have been the most prominent models, but Stephen Bainbridge, in his excellent work, The New Corporate Governance in Theory and Practice, analyses these theories and provides some exciting new perspectives on corporate governance models by expanding on the ‘director primacy model’ that he developed recently. Bainbridge began to develop 35 OECD Principles of Corporate Governance, above n 10, 46. 36 Ibid, 11. See also Etsuo Abe, ‘What is Corporate Governance? The historical implications’ in The Development of Corporate Governance in Japan and Britain (edited by Robert Fitzgerald and Etsua Abe), Aldershot, Ashgate Publishing Ltd (2004) 1. 37 Post, Preston and Sach, above n 25, 17. 38 See Esser, above n 21, 19–36 for a useful summary of these theories.

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this model with his research paper ‘Director Primacy: The Means and Ends of Corporate Governance’ in 2002 and in a comprehensive article, titled ‘Director Primacy and Shareholder Disempowerment’, published in the Harvard Law Review in 2006.39 We discuss the ‘director primacy model’ in greater detail in Chapter 3, but it can be summarised here: It is boards of directors, and not the shareholders, other stakeholders or managers in large corporations, that actually control the corporation and ‘have the ultimate right of fiat’.40 This, in our view, could be described as the ‘boardtorial revolution’ or ‘directorial revolution’, in a similar vein to what has been identified as the ‘managerial revolution’ (see reference above) several years ago.

1.1.3 Definition of ‘corporate governance’ If one takes into consideration recent developments, corporate governance could be defined as follows: The system of regulating and overseeing corporate conduct and of balancing the interests of all internal stakeholders and other parties (external stakeholders, governments and local communities – see Chapter 2) who can be affected by the corporation’s conduct, in order to ensure responsible behaviour by corporations and to achieve the maximum level of efficiency and profitability for a corporation.41

Thus, the most important components of this definition are that corporate governance: ● is the system of regulating and overseeing corporate conduct ● takes into consideration the interests of internal stakeholders and other parties who can be affected by the corporation’s conduct ● aims at ensuring responsible behaviour by corporations ● has the ultimate goal of achieving the maximum level of efficiency and profitability for a corporation. A comparison with the definition provided in the first edition of this work will reveal that we have changed the first part of the definition from ‘a process of controlling management’ to ‘the system of regulating and overseeing corporate conduct’. This adjustment was required to reflect a widening of the corporate governance debate and the prominence that regulating and overseeing corporate conduct has gained since 2005. The global financial crisis (GFC) of 2008–9 provided further impetus to view corporate governance in an even wider context. Although views differ on this,42 it is important to note that the GFC was 39 Stephen M Bainbridge, ‘Director Primacy and Shareholder Disempowerment’ (2006) 119 Harvard Law Review 1735. 40 Bainbridge, above n 11, 11. 41 For other useful definitions of corporate governance, see Ken Rushton, ‘Introduction’ in The Business Case for Corporate Governance (Ken Rushton, ed.), Cambridge, Cambridge University Press (2008) 2–3; Huse, above n 24, 15 and 18–24; Bob Garratt, Thin on Top, London, Nicholas Brealey Publishing (2003) 12; John Farrar, ‘Corporate Governance and the Judges’ (2003) Bond Law Review 49; and G¨ uler Manisali Darman, Corporate Governance Worldwide: A Guide to Best Practices and Managers, Paris, ICC Publishing (2004) 9–11. 42 See Thomas Clarke and Jean-Francois Chanlat, ‘Introduction: A new world disorder?’ in European Corporate Governance (Thomas Clarke and Jean-Francois Chanlat, eds), London, Routledge (2009) 1 and

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no indication of a total failure of corporate governance. This is explained in the King Report (2009) from a South African and United Kingdom perspective, but it rings true much wider: The credit crunch, and the resulting crisis among leading financial institutions, is increasingly presented as a crisis of corporate governance. However, although current problems are to an extent indicative of shortcomings in the global financial architecture, they should not be interpreted as reflecting dysfunction in the broader South African and UK corporate governance models where values-based principles are followed and governance is applied, not only in form but also in substance.43

What we need to establish is how the principles of contemporary corporate governance contribute towards ensuring better governance of large public companies. This will become clear in the following chapters of this book.

1.2 ‘Essential’ principles of corporate governance In recent years there have been several attempts to identify and explain what are the ‘essential’ principles of corporate governance. Although there are several examples,44 it will be seen that different principles are identified as ‘essential’ and, over time, views have changed on what could be considered as ‘essential’ corporate governance principles. There is nothing wrong or inconsistent with this evolutionary process. Corporate governance is a subject area that grows and expands, and it adjusts according to new insights and new challenges. As Mervyn King puts it, ‘good governance is a journey and not a destination’45 or, as Bob Tricker puts it: Overall, corporate governance continues to evolve. The metamorphosis that will determine the bounds and the structure of the subject has yet to occur. Present practice is still rooted in the 19th century legal concept of the corporation that is totally inadequate in the emerging global business environment.46

A good illustration of this is provided by the various South African King Reports. In the King Report (2002), seven ‘essential’ principles of corporate governance were identified, namely: 1. discipline 2. transparency 3. independence 13–18. See generally, and for a more radical plea for a total overhaul and new perspectives on the state of health of corporate governance, Hutchinson, above n 13, 12–19 and 203 et seq. 43 King Report on Governance for South Africa 2009 (King Report (2009)), Johannesburg, Institute of Directors (2009) 9 . 44 See, for example, OECD Principles of Corporate Governance, above n 10, and The Combined Code on Corporate Governance (UK Combined Code (2008)), available at . 45 King, above n 28, 4. 46 Tricker, above n 2, 22.

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4. accountability 5. responsibility 6. fairness 7. social responsibility. In the King Report (2009), the emphasis shifted slightly towards some ‘key aspects of the report’, which are explained as follows: The philosophy of the Report revolves around leadership, sustainability and corporate citizenship. To facilitate an understanding of the thought process, debate and changes in the Report, the following key principles should be highlighted: 1. Good governance is essentially about effective leadership. Leaders should rise to the challenges of modern governance. Such leadership is characterised by the ethical values of responsibly, accountability, fairness and transparency and based on moral duties . . . Responsible leaders direct company strategies and operation with a view to achieving sustainable economic, social and environmental performance. 2. Sustainability is the primary moral and economic imperative for the 21st century. It is one of the most important sources of both opportunities and risks for businesses. Nature, society, and business are interconnected in complex ways that need to be understood by decision-makers. Most importantly, current, incremental changes towards sustainability are not sufficient – we need a fundamental shift in the way companies and directors act and organise themselves. 3. The concept of corporate citizenship which flows from the fact that the company is a person and should operate in a sustainable manner . . .

Another illustration of changing views on ‘essential’ principles of corporate governance is revealed by comparing the 2003 and 2007 Principles of Good Corporate Governance and Best Practice Recommendations of ASX Corporate Governance Council. In 2003, 10 essential principles of good corporate governance were identified: 1. Lay solid foundations for management oversight – recognise and publish the respective roles and responsibilities of board and management. 2. Structure the board to add value – have a board of an effective composition, size and commitment to adequately discharge its responsibilities and duties. 3. Promote ethical and responsible decision making – actively promote ethical and responsible decision making. 4. Safeguard integrity in financial reporting – have a structure to independently verify and safeguard the integrity of the company’s financial reporting. 5. Make timely and balanced disclosure – promote timely and balanced disclosure of all material matters concerning the company. 6. Respect the rights of shareholders – respect the rights of shareholders and facilitate the effective exercising of those rights. 7. Recognise and manage risk – establish a sound system of risk oversight and management and internal control. 8. Encourage enhanced performance – fairly review and actively encourage enhanced board and management effectiveness.

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9. Remunerate fairly and responsibly – ensure that the level and composition of remuneration is sufficient and reasonable, and that its relationship to corporate and individual performance is defined. 10. Recognise the legitimate interests of stakeholders – recognise legal and other obligations to all legitimate stakeholders. The 2007 Principles of Good Corporate Governance and Best Practice Recommendations contains only eight principles. According to the ‘Comparative Table of Changes to the Principles and Recommendations’ the two principles deleted were Principle 8, ‘Encourage enhanced performance’ and Principle 10, ‘Recognise the legitimate interests of stakeholders’. However, although these principles seem to have disappeared, they were in fact incorporated into other principles. Principle 8 has been incorporated into principles 1 and 2, while Principle 2 has been incorporated into principles 3 and 7. Principle 9 became Principle 8. The current eight principles of corporate governance promoted by ASX’s Corporate Governance Council are the following:

Principle 1 – Lay solid foundations for management and oversight. Companies should establish and disclose the respective roles and responsibilities of board and management. Principle 2 – Structure the board to add value. Companies should have a board of an effective composition, size and commitment to adequately discharge its responsibilities and duties. Principle 3 – Promote ethical and responsible decision making. Companies should actively promote ethical and responsible decision making. Principle 4 – Safeguard integrity in financial reporting. Companies should have a structure to independently verify and safeguard the integrity of their financial reporting. Principle 5 – Make timely and balanced disclosure. Companies should promote timely and balanced disclosure of all material matters concerning the company. Principle 6 – Respect the rights of shareholders. Companies should respect the rights of shareholders and facilitate the effective exercise of those rights. Principle 7 – Recognise and manage risk. Companies should establish a sound system of risk oversight and management and internal control. Principle 8 – Remunerate fairly and responsibly. Companies should ensure that the level and composition of remuneration is sufficient and reasonable and that its relationship to performance is clear.

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The ASX Corporate Governance Council specifically recognises the evolving nature of corporate governance by stating that ‘[c]orporate governance practices will evolve in the light of the changing circumstances of a company and must be tailored to meet those circumstances’.47 Corporate governance practices will naturally evolve in the context of developments, both in Australia and internationally.

1.3 Is ‘good corporate governance’ important and does it add value? When corporate governance was raised in conversation and commentaries a few years ago, there were often references to the need for corporations to implement and maintain ‘good governance practices’. However, there has been a continuing debate as to whether a focus on governance practices comes at the expense of what is really important to the company and its shareholders – the bottom line! Did providing attention to ‘conformance’, in terms of adhering to corporate governance rules and principles, come at the expense of ‘performance’? Was implementing practices in good corporate governance a necessary ingredient for corporate success, or merely a distraction from the real business of the company? Naturally, given that there is still debate and uncertainty as to what ‘corporate governance’ means, there are varying perspectives on what constitutes good practice in corporate governance, and whether good corporate governance is indeed important to the company and actually adds value or ‘makes a difference’.48 Nowadays, however, these questions seem almost rhetoric, as it is easy to find numerous very good reasons – and even empirical proof – that good corporate governance is important to companies and that it does add value and it makes a difference. We are, however, of the opinion that it is still important to at least provide some indications as to how the debate in favour of the importance of good corporate governance gained momentum over recent years. In the Report of the HIH Royal Commission, Justice Owen opined that to achieve good practice in governance in Australia’s companies, corporate governance must not succumb to a ‘one size fits all’ approach, which involves heavy regulation of companies and does not give companies much opportunity to implement practices that are best for the company. Rather, good governance naturally develops within companies by setting down voluntary guidelines, which can be used by companies to develop a model that best suits their particular circumstances. Justice Owen stated that: For me, the key to good corporate governance lies in substance, not form. It is about the way the directors of a company create and develop a model to fit the circumstances of the company and then test it periodically for its practical effectiveness. 47 Principles of Good Corporate Governance and Best Practice Recommendations (2007), above n 6, at 3. 48 See generally Jonathan Charkham, Keeping Better Company, Oxford, Oxford University Press, (2nd edn, 2005) 23–4; Sir Geoffrey Owen, ‘The Role of the Board’ in The Business Case for Corporate Governance (Ken Rushton ed.), Cambridge, Cambridge University Press (2008) 10 at 11.

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One thing is clear though. Whatever the model, the public must know about it and how it is operating in practice. Disclosure should be a central feature of any corporate governance regime.49

Given that some of the companies involved in the recent international spate of corporate collapses actually had in place generally good governance practices, the question has also been raised as to whether good practices in governance are important in terms of ensuring company success. In Australia, the adherence to corporate governance principles was, in the late 1990s, considered as placing an unnecessary burden on Australian businesses. Strict corporate governance rules have even been blamed for the under-performance of Australian companies.50 Nowadays, the general consensus (at least in Australia, New Zealand, South Africa and the United Kingdom)51 appears to be that while heavy regulation and ‘one size fits all’ approaches to corporate governance should be avoided,52 it is at the very least important that companies are good corporate governance citizens. In an article entitled ‘The Changing Face of Corporate Governance’, which appeared in a special symposium edition of the University of New South Wales Law Journal53 dedicated to corporate governance, former Chairman of the National Companies and Securities Commission, Henry Bosch, made the following useful remark about the importance of good corporate governance: Good corporate governance is desirable and important for two reasons. First, in a well-governed company, the risks of fraud and corporate collapse are reduced, and there are mechanisms which reduce the likelihood of company controllers enriching themselves at the expense of investors. Considerable evidence has emerged in the hearings of the HIH Royal Commission, and from the court cases involving One.Tel and Harris Scarfe, that governance practices in those companies were poor and accountability lax . . . Good governance is desirable and important for a second reason: it can increase the creation of wealth by improving the performance of honestly managed and financially sound companies.54

Similarly, Justice Owen noted, in the Report of the HIH Royal Commission, the economic benefits that arise from good corporate governance: There is continuing debate about the existence or otherwise of a correlation between good corporate governance and successful performance. Good governance processes are likely in my view to create an environment that is conducive to success. It does not follow that those who have good governance processes will perform well or be immune 49 Owen Report, above n 4, 133 para 6.6. 50 Rick Sarre, ‘Responding to Corporate Collapses: Is There a Role for Corporate Social Responsibility’ (2002) 7 Deakin Law Review 1; David Knott, ‘Protecting the Investor: The Regulator and Audit’, Address to the CPA Congress 2002 Conference, Perth, Western Australia, 15 May 2002 (Publications / Speeches / 2002) 4. The pdf version of Knott’s speech is available at: . 51 See, for instance King Report (2009), above n 43, 9 Peter Montagnon ‘The Role of the Shareholder’ in The Business Case for Corporate Governance (Ken Rushton, ed.), Cambridge, Cambridge University Press (2008) 81 at 83–4. 52 Sir Bryan Nicholson, ‘The Role of the Regulator’ in The Business Case for Corporate Governance (Ken Rushton ed.), Cambridge, Cambridge University Press (2008) 100. 53 Henry Bosch, ‘The Changing Face of Corporate Governance’ (2002) 25 University of New South Wales Law Journal 270. 54 Ibid 271.

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from failure. Risk exists to some extent at the heart of any business. Risks are taken in the search for rewards. No system of corporate governance can prevent mistakes or shield companies and their stakeholders from the consequences of error.55

These sentiments are also echoed internationally. The South African King Report (2002) relied on an Investment Opinion Survey by McKinsey & Co (June 2000) and a study by Stanford University (March 2001) to illustrate the profound implications of adhering to good corporate governance practices. By developing good governance practices, managers can add significant shareholder value; institutional investors are willing to pay a premium for shares in well-governed companies; and good corporate governance practices are now widely recognised as part of international financial architecture and make countries, especially in the emerging markets, a magnet for global capital.56 This conclusion has been confirmed by later research,57 and there is now little doubt that a good business case could be made for following good practice in corporate governance.58 In fact, as Durnev and Kim point out, companies who rely more heavily on external finance can use a reputation for effective governance to raise global equity and debt at lower costs, effectively increasing a company’s value by reducing its cost of capital59 and boosting investor confidence.60 In an interesting chapter, in the book, The Business Case for Corporate Governance, Colin Melvin and Hans-Christoph Hirt analyse the link between corporate governance and performance. They discuss and evaluate most of the research undertaken indicating that it is inconclusive that there is a direct link between good corporate governance and good company performance. However, they point out that, at the very least, sensible corporate governance activities may prevent the destruction of value. They then conclude that they are convinced that active ownership based on good corporate governance is an investment technique that effectively improves performance and ultimately increases the value of a portfolio of investee companies.61 The contrary, bad corporate governance practices, combined with some other factors, have exactly the opposite effect, as was illustrated by the East Asia experience in the late 1990s.62 55 Owen Report, above n 4, 104–5 para 6.1.2. 56 King Report (2002), above n 33, 12–14 paras 19–23. See also Richard Smerdon, A Practical Guide to Corporate Governance, London, Sweet & Maxwell (2nd edn, 2004) 16; Low Chee Keong, ‘The Corporate Governance Debate’ in Low Chee Keong (ed.), Corporate Governance: An Asian-Pacific Critique, Hong Kong, Sweet & Maxwell (2002) 1, 8–10 – other contributions in this collection confirm the same point (see 49–50 and 57 et seq). 57 See Donald H Chew and Stuart L Gillan, ‘Introduction’ in Global Corporate Governance (Donald H Chew and Stuart L Gillan eds), New York, Columbia Business School (2009) IX; and Ren´e M Stulz, ‘Globalization, Corporate Finance, and the Cost of Capital’, in Global Corporate Governance (Donald H Chew and Stuart L Gillan eds), New York, Columbia Business School (2009) 106 at 108 et seq. 58 Ken Rushton (ed.), The Business Case for Corporate Governance, Cambridge, Cambridge University Press (2008). 59 Art Durnev and E Han Kim, ‘Explaining differences in the quality of governance among companies’, in Global Corporate Governance (Donald H Chew and Stuart L Gillan, eds), New York, Columbia Business School (2009) 52 at 53–4. 60 Ibid 54 and 63. 61 Colin Melvin and Hans-Christoph Hirt, ‘Corporate Governance and Performance’ in The Business Case for Corporate Governance (Ken Rushton, ed.), Cambridge, Cambridge University Press (2008) 201 at 217. 62 See King Report (2002), above n 33, 12–14 para 22.

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Evidence of the significance of good practice in corporate governance also comes from the OECD Principles of Corporate Governance (2004). The OECD found that corporate governance was a key element in improving economic efficiency and growth, as well as in enhancing investor confidence.63 It also observed that if countries were to reap the full benefits of the global market, and attract long-term ‘patient’ capital, corporate governance arrangements had to be credible, well understood across borders and adhere to internationally accepted principles. Even if corporations did not rely primarily on foreign sources of capital, adherence to good practice in corporate governance would help to improve the confidence of domestic investors, reduce the cost of capital, underpin the good functioning of financial markets and, ultimately, induce more stable sources of financing.64 The OECD pointed out that companies with a good corporate governance record were often able to borrow larger sums and on more favourable terms than those that had poor records or operated in non-transparent markets.65 In Chapter 5 we expand on the important link between effective corporate governance and healthy global capital markets. More recently, there has been more hard evidence suggesting that there is indeed a correlation between good corporate governance, operating performance and share-price returns. In the United Kingdom, between 2003 and 2007 a comprehensive survey was conducted on listed companies by Selvaggi and Upton. They tested the strength and direction of any potential link between the good corporate governance and operating and share-price returns. They found a direct and robust link between good corporate governance and superior company performance.66 The study shows that good corporate governance leads to better performance, and that the impact of governance on performance was long-term in nature. It should, however, be pointed out that Bagat, Bolton and Romano identified some shortcomings in the study.67 In an interesting 2009 Treasury Working Paper, Corporate Governance and Financial Performance in an Australian Context, Rebecca Brown and Tue Gørgens referred to several studies that found evidence for good corporate governance adding financial value to a company.68 Rebecca Brown and Tue Gørgens summarised their findings as follows, focussing on the top 300 Australian listed companies: 63 OECD Principles of Corporate Governance, above n 10, 11. 64 Ibid 13. 65 Ibid 48. See generally also Darman, above n 41, 12–13 and 31 for more positive spin-offs from following good corporate governance practices. 66 M Selvaggi and J Upton, Governance and Performance in Corporate Britain: Evidence from the IVIS colourrating system ABI Research Paper 7, Report from ABI Research and Investment Affairs Department (February 2008). 67 Tricker, above n 2, 221. Note that some shortcomings in the Selvaggi and Upton research and surveys were identified by Sanjai Bhagat, Brian J Bolton and Roberta Romano, ‘The Promise and Peril in Corporate Governance Indices’ ECGI Working Paper No 89/2007, Yale Law & Economics Research Paper no. 367, Social Science Research Network (2007) . 68 Rebecca Brown and Tue Gørgens, Corporate Governance and Financial Performance in an Australian Context, Treasury Working Paper 2009 – 02 (March 2009) 8–9. See also Xavier Vives, ‘Corporate Governance: Does it Matter?’ in Corporate Governance: Theoretical & Empirical Perspectives (Xavier Vives, ed.), Cambridge, Cambridge University Press, (2000) 1 at 12–13.

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We find that companies with better corporate governance outperform poorly governed companies, particularly in relation to earnings per share and return on assets. Furthermore, we find that companies that are fully compliant with the ASX Corporate Governance Principles perform better than companies that are only partially compliant. Our results also indicate that companies may find it beneficial to focus their efforts on improving corporate governance in the areas of board composition, remuneration, the formation of committees (that is, board, audit and remuneration committees), and those principles related to the structure of the company.69

1.4 Are corporate governance models converging? The question of the convergence of corporate governance models was seriously debated after publication of an article with the provocative title ‘The End of History for Corporate Law’ by two leading United States academics, Hansmann and Kraakman.70 It was to be expected that their proposition that all corporate governance models in actual fact converged into the United States corporate governance model would be challenged. Douglas Branson wrote an article titled, ‘The Very Uncertain Prospect of “Global” Convergence in Corporate Governance’71 and many other articles followed that challenged Hansmann and Kraakman’s hypothesis. This debate is still alive, with part of Thomas Clarke and Jean-Francois Chanlat’s (eds) European Corporate Governance dedicated to the question of convergence or diversity of corporate governance systems.72 Tricker correctly pointed out that cultural differences will always play a role in development of the most appropriate corporate governance model for a particular country – such differences will almost guarantee that there will always be differences in the corporate governance principles and corporate governance models of different countries and jurisdictions.73 Tricker lists the forces that could lead to convergence of corporate governance principles, and also those that accentuate divergence, or at least cause differentiation among corporate governance principles applied in different countries and jurisdictions: Converging forces:74 • corporate governance codes of good practice • securities regulation • international accounting standards • global concentration of audit practices 69 Brown and Gørgens, above n 68, at 3–4. 70 Henry Hansmann and Reiner Kraakman, ‘The End of History for Corporate Law’ (2001) 89 Georgetown Law Journal 439. Also see Jeffrey N Gordon and Mark J Roe (eds), Convergence and Persistence in Corporate Governance, Cambridge, Cambridge University Press (2004). 71 Douglas M Branson, ‘The Very Uncertain Prospect of “Global” Convergence in Corporate Governance’ (2001) 34 Cornell International Law Journal (Cornell Int’l LJ) 321. 72 Thomas Clarke and Jean-Francois Chanlat (eds), in European Corporate Governance, London, Routledge (2009) Part 3, 141–97. 73 Tricker, above n 2, 183. See also Chew and Gillan, ‘Introduction’ in Global Corporate Governance (Donald H Chew and Stuart L Gillan, eds), above n 57, X; Huse, above n 24, 103–4. 74 Tricker, above n 2, 208–9.

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• globalisation of companies75 • raising capital on overseas stock exchanges • research publications, international conferences and professional journals. Diverging forces:76 • legal differences • standards in the legal process • stock market differences • ownership structures • history, cultural, and ethical groupings.

1.5 Conclusion There are various definitions of corporate governance. We believe, however, that the most realistic approach to corporate governance is the so-called inclusive approach – to view all stakeholders as part of the corporate governance debate. At the end of the day, corporate governance deals with the system of regulating and overseeing corporate conduct, balancing the interests of all internal stakeholders and other parties who may be affected by the corporation’s conduct in order to ensure responsible behaviour by corporations and to achieve the maximum level of efficiency and profitability for a corporation. There is ample evidence that there are real economic benefits in following good practice in corporate governance – by doing so, managers potentially will be able to add significant shareholder value and investors will be prepared to pay a premium for investments in companies in which good corporate governance practices are followed. There are some powerful forces responsible for the convergence of corporate governance principles and models. However, there are also several forces and factors that will almost guarantee that there will always be differences in the corporate governance models for different countries and jurisdictions. We agree with Bob Garratt’s convincing arguments about the increasing importance of corporate governance.77 75 Globalisation’s impact on university governance is well illustrated in Simon Markinson and Mark Considine, The Enterprise University, Cambridge, Cambridge University Press (2000) 41, 45–51. 76 Tricker, above n 2, 209–10. 77 Garratt, above n 41, Chapter 2, 29–64.

2 Stakeholders in corporate governance and corporate social responsibility It is conceivable, indeed it seems almost essential if the corporate system is to survive, that the ‘control’ of the great corporations should develop into a purely neutral technocracy, balancing a variety of claims by various groups in the community and assigning to each a portion of the income streams on the basis of public policy rather than private cupidity. Berle and Means, The Modern Corporation and Private Property (1932), 356.

What we are witnessing is a shift in the content of the shareholder value norm, so that it comes to represent the idea that shareholders exercise their powers not as representatives of the market, but as agents of society as a whole. The corporate governance of the future will be centrally concerned with how this idea is worked out in practice. Simon Deakin, ‘The Coming Transformation of Shareholder Value’ (2005) 13 Corporate Governance: An International Review 11, 16.

2.1 Introduction Contemporary commentary on corporate governance can, in general terms, be divided into two main camps, between those who consider corporate governance as being about building effective mechanisms and measures to satisfy either: (1) the expectations of the variety of individuals, groups and entities (collectively ‘stakeholders’) that inevitably interact with the corporation;1 or (2) the narrower expectations of shareholders (shareholder primacy).2 This chapter focuses on the first of these objectives,3 with attention being given to the stakeholders of the company, how the law influences corporations to recognise and protect the interests of these stakeholders, and the relationship 1 E M Dodd, ‘For Whom are Corporate Managers Trustees?’ (1932) 45 Harvard Law Review 1145. 2 A Berle, ‘Corporate Powers as Powers in Trust’ (1931) 44 Harvard Law Review 1049; A Berle, ‘For Whom Corporate Managers Are Trustees: A Note’ (1932) 45 Harvard Law Review 1365. 3 For a broader discussion on competing corporate law theories and the public and private dimensions of corporate law, see Stephen Bottomley, The Constitutional Corporation – Rethinking Corporate Governance Ashgate, England (2007).

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between these stakeholders and the underlying objective of companies of achieving and maintaining good corporate governance. Letza, Sun and Kirkbride explain the difference between the two corporate governance paradigms, ‘shareholding’ and ‘stakeholding’ as follows: Such a division hinges on the purpose of the corporation and its associated structure of governance arrangements understood and justified in theory. On one side is the traditional shareholding perspective, which regards the corporation as a legal instrument for shareholders to maximise their own interests – investment returns. A three-tier hierarchical structure, i.e. the shareholder general meeting, the board of directors and executive managers, is given in company law in an attempt to secure shareholders’ interests . . . On the other side is the stakeholding perspective newly emerged in the later 20th century, which positions itself on the contrary to the traditional wisdom and views the corporation as a locus in relation to wider external stakeholders’ interests rather than merely shareholders’ wealth. Employees, creditors, suppliers, customers and the local community are major stakeholders often mentioned and emphasised within a broad definition of stakeholding.4

The central place of non-shareholder stakeholders in corporate governance has been explicitly recognised by the Organisation for Economic Co-operation and Development (OECD) in the preamble to the revised 2004 OECD Principles of Corporate Governance: Corporate governance involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined.5 (emphasis added)

Also contained in the OECD Principles of Corporate Governance is the following statement, recognising three key non-shareholder stakeholders (creditors, employees and government): Corporate governance is affected by the relationships among participants in the governance system. Controlling shareholders, which may be individuals, family holdings, bloc alliances, or other corporations acting through a holding company or cross shareholdings, can significantly influence corporate behaviour. As owners of equity, institutional investors are increasingly demanding a voice in corporate governance in some markets. Individual shareholders usually do not seek to exercise governance rights but may be highly concerned about obtaining fair treatment from controlling shareholders and management. Creditors play an important role in a number of governance systems and can serve as external monitors over corporate performance. Employees and other stakeholders play an important role in contributing to the long-term success and performance of the corporation, while governments establish the overall institutional and legal framework for corporate governance.6 4 See Steve Letza, Xiuping Sun and James Kirkbride, ‘Shareholding versus Stakeholding: A Critical Review of Corporate Governance’ (2004) 12 Corporate Governance: An International Review, Oxford, Blackwell 242, 243. 5 OECD Principles of Corporate Governance (April 2004) 11. 6 Ibid 12.

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The OECD Principles of Corporate Governance, a non-binding statement of what the OECD believes to constitute best practice in corporate governance, is discussed extensively in this book. The structure of this chapter is as follows. Section two below commences by acknowledging that there is no fixed definition of what a ‘stakeholder’ is; however, it provides some useful examples of definitions that have been adopted in mainstream literature, and which can be used for the purposes of this chapter. This section then proceeds to identify, and provide a brief explanation of, the nature and corporate governance role of each ‘stakeholder’ recognised by the OECD Principles of Corporate Governance. Having provided this general understanding of what is meant by ‘stakeholder’ and to whom this concept applies, section three then explains whether and how the law requires – or at least encourages – companies and their directors and executives to take into account the interests of these stakeholders. The principal focus of this section is the requirement for listed companies to have in place a ‘code of conduct’ specifying how the company intends to deal with its stakeholders – particularly employees. The section also discusses similar obligations for nonlisted companies, as well as legal obligations applying to companies (both listed and non-listed) – outside of company law and corporate governance – requiring that they protect and respect the interests of stakeholders. Having considered how the law requires or encourages companies, both listed and non-listed, to take into consideration and protect the interests of a variety of stakeholders, section four then discusses why a stakeholder-orientated approach to management (known as the ‘stakeholder model’) is considered to be important from the perspective of good corporate governance. This includes discussion (albeit brief) on emerging trends and issues in relation to the role of particular stakeholders in the corporation from the perspective of good corporate governance, particularly employees, in maintaining a sound internal governance framework. The concluding section revisits the debate on the interaction of the ‘shareholder primacy’ approach to corporate decision-making with the ‘enlightened self-interest’ approach.

2.2 Stakeholders in the corporation: An overview 2.2.1 What is a stakeholder? The definition of ‘stakeholder’ is not set in stone7 . Indeed, there are almost as many varying definitions of what a ‘stakeholder’ is and who can be characterised 7 The Social Responsibility of Corporations Report (December 2006), Corporations and Markets Advisory Committee (Australian Government) at [2.4] notes that the notion of ‘stakeholders’ has no precise or commonly agreed meaning. See Further, B Horirigan, ‘Fault Lines in the Intersection between Corporate Governance and Social Responsibility’ (2002) 25 University of New South Wales Law Journal 515.

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as a stakeholder as there are individuals who have written about stakeholders in corporate governance. Christine Mallin provides the following explanation: The term ‘stakeholder’ can encompass a wide range of interests: it refers to any individual or group on which the activities of the company have an impact.8

According to Mallin, apart from shareholders, ‘stakeholder’ encompasses employees, suppliers, customers, banks and other creditors, the government, various ‘pressure groups’ – in fact, anyone upon whom the activities of the company may have an impact. This is a useful definition, although it fails to include within the realm of ‘stakeholder’ those individuals or entities whose activities have impact upon the company. Perhaps a better definition of stakeholder, which does recognise such a mutual relationship between stakeholders and the corporation, is that provided in Redefining the Corporation: Stakeholder Management and Organizational Wealth by James E Post, Lee E Preston and Sybille Sachs9 (who have also established a ‘Redefining the Corporation’ website with information and links on stakeholder management).10 They define ‘stakeholder’ as follows: The stakeholders in a corporation are the individuals and constituencies that contribute, either voluntarily or involuntarily, to its wealth-creating capacity and activities, and that are therefore its potential beneficiaries and/or risk bearers.11

The authors go on to explain: The fundamental idea is that stakeholders have a stake in the operation of the firm, in the same sense that business partners have a common stake in their venture or players on a team a common stake in the outcome of a game. Stakeholders share a common risk, a possibility of gaining benefits or experiencing losses or harms, as a result of corporate operations.

In developing a ‘stakeholder model’ of the corporation, Post et al. posit that there are a series of flows running through the corporation, with stakeholders holding a central position: The flows between the firm and its stakeholders run in both directions; each stakeholder is perceived as contributing something and receiving something from the corporation (even involuntary and essentially passive stakeholders contribute by tolerating the existence and operation of the firm, and receive some combination of benefits and harms as a result).12

Another important perspective on stakeholders and the corporation is contained in the scholarly article, ‘Corporate Governance: A Stakeholder Interpretation’, by R E Freeman and W M Reed, published in 1990.13 Freeman and Reed refer 8 Christine Mallin, Corporate Governance, Oxford, Oxford University Press (2nd edn, 2007) 49. 9 J E Post, L E Preston and S Sachs, Redefining the Corporation: Stakeholder Management and Organizational Wealth, Stanford, CA, Stanford Business Books (2002). 10 . 11 Post, Preston and Sachs, above n 9, 19. 12 Ibid 22. 13 See Journal of Behavioural Economics 19 (1990) 337.

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to the organisation as being a ‘multiple agreement’ between the enterprise and its stakeholders, and suggest that there are ‘external’ and ‘internal’ stakeholders. The ‘internal’ stakeholders include employees, managers and owners. Employees are included because management depends upon employees to fulfil strategic intentions. ‘External’ stakeholders include customers, suppliers, competitors and ‘special interest’ groups – with each relationship constrained by formal and informal rules. Finally, governments and local communities set the legal and formal rules within which businesses must operate. Due to the quite broad, and to some degree ‘vague’, definition of stakeholder that has been put forward in various ways by commentators, the question has been raised – mainly in management and finance literature – about who the stakeholders in the corporation actually are, with this flowing on to further questions about the practice of stakeholder management. Perhaps the most inclusive definition of stakeholders, as recognised by the Corporate and Markets Advisory Committee (CAMAC) report on The Social Responsibility of Corporations,14 is the following:15 those groups or individuals that: (a) can be reasonably be expected to be significantly affected by the organisation’s activities, products and/or service; or (b) whose actions can reasonably be expected to affect the ability of the organization to successfully implement its strategies and achieve its objectives.

This broad definition can therefore include all of the constituents discussed earlier, as well as pressure groups or non-government organisations (NGOs), usually characterised as public interest bodies that espouse social goals relevant to the activities of the company. It is important to note that different attitudes towards the place of stakeholders in corporate governance are evident in different jurisdictions, and are influenced by differences in tradition and culture. Mallin, for example, notes that: In the UK and the US, the emphasis is on the relationship between the shareholders (owners), and the directors (managers). In contrast, the German and French corporate governance systems, which view companies as more of a partnership between capital and labour, provide for employee representation at board level, whilst banks (providers of finance) may also be represented on the supervisory board.16

2.2.2 Discussion of different stakeholders This section provides a general and necessarily brief account of the role of some of the key stakeholders in the context of the governance of a company. The explanation provided for each stakeholder draws heavily on Mallin’s book, which contains a clear and concise description of the place of stakeholders in contemporary corporate governance. 14 The Social Responsibility of Corporations Report above n 7, at [2.4] 15 Global, 40 . 16 Mallin, above n 8, 57.

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What is emphasised below in the discussion of the different stakeholders is that, apart from shareholders, discrete areas of legal regulation operating independently of company law and corporate governance principles have a direct and significant impact on the relationship between particular stakeholders and the company. 2.2.2.1 Shareholders As stakeholder management is often discussed as an alternative to the traditional shareholder-oriented approach to corporate governance (emphasising wealth maximisation), shareholders are regularly excluded from the definition of ‘stakeholder’. Mallin includes shareholders as part of her concept of ‘stakeholder’, but deals with shareholders separately to all the other constituents that are also stakeholders. She defines ‘shareholder’ as ‘an individual, institution, firm, or other entity that owns shares in a company.’17 As Mallin appreciates, however, the reality of shareholding is more complex than this definition suggests, once beneficial ownership and cross-holdings are considered. Mallin treats shareholders differently from other stakeholders for two reasons: ‘[F]irst, shareholders invest their money to provide risk capital for the company and, secondly, in many legal jurisdictions, shareholders’ rights are enshrined in law whereas those of the wider group of stakeholders are not.’18 Mallin goes on to say that a rationale for privileging shareholder interests over the interests of other stakeholders is that they are ‘the recipients of the residual free cash flow (being the profits remaining once other stakeholders, such as loan creditors, have been paid). This means that the shareholders have a vested interest in trying to ensure that resources are used to maximum effect, which in turn should be to the benefit of society as a whole’.19 Justice Owen, in the Report of the HIH Royal Commission, articulates a similar conception of corporate governance when explaining the ‘organs of governance’: [P]rimary governance responsibility lies with the board of directors. In formal terms the directors are appointed by, and are accountable to, the body of shareholders . . . The role of the shareholders is to exercise the powers that are reposed in them by the Corporations Act and the constitution of the corporation. The perceived wisdom is, I think, that shareholders play a passive role as the objects of corporate governance rather than an active role as part of it.20

2.2.2.2 Employees Following is a summary of the explanation given by Mallin of the role of employees as stakeholders in the corporation: 17 Ibid 49. 18 Ibid. 19 Ibid. 20 Report of the HIH Royal Commission (Owen Report), The Failure of HIH Insurance – Volume I: A Corporate Collapse and its Lessons, Canberra, Commonwealth of Australia (2003) 103 para 6.1.1.

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The employees of a company have an interest in the company as it provides their livelihood in the present day and at some future point, employees would often also be in receipt of a pension provided by the company’s pension scheme. In terms of present day employment, employees will be concerned with their pay and working conditions, and how the company’s strategy will impact on these. Of course the long-term growth and prosperity of the company is important for the longer term view of the employees, particularly as concerns pension benefits in the future . . . Many companies have employee share schemes which give the employees the opportunity to own shares in the company, and feel more of a part of it; the theory being that the better the company does (through employees’ efforts, etc), the more the employees themselves will benefit as their shares increase in price . . . Companies need to also consider and comply with employee legislation whether related to equal opportunities, health and safety at work, or any other aspect. Companies should also have in place appropriate whistle-blowing procedures for helping to ensure that if employees feel that there is inappropriate behaviour in the company, they can ‘blow the whistle’ on these activities whilst minimizing the risk of adverse consequences for themselves as a result of this action.21 (emphasis added)

It is important to note that Australia has in place a sophisticated array of legislation and regulations, both at state/territory and federal levels, which are designed to protect the interests of employees in relation to their interaction with the employer and the workplace. At the state/territory level, there exists equal opportunity legislation, occupational health and safety legislation (the obligations under which also operate to preserve the well-being, health and safety of contractors and customers, in addition to employees), as well as general regulations and criminal laws to protect employee rights. At federal level, the principal legislation designed to uphold and protect the interests of employees is the Fair Work Act 2009 (Cth), which regulates workplace conditions, wagesetting arrangements and the conciliation and arbitration of workplace disputes over pay and working conditions. Australia has also recently introduced new rules, both under the Corporations Act 2001 (Cth) (the Act) and as part of the Australian Securities Exchange (ASX) Revised Corporate Governance Principles and Recommendations (August 2007, discussed throughout this book), to provide protection for genuine ‘whistleblower’ employees. Part 9.4AAA of the Act (effective from 1 July 2004) operates to prohibit employers from victimising whistleblowers when they have acted in good faith and on reasonable grounds, and also provides the whistleblower with qualified privilege when information regarding a suspected breach of the law (being the Act or the Australian Securities and Investments Commission Act or regulations made under either Act) has been reported to the Australian Securities and Investments Commission (ASIC) or another person specified in the Act. Principle 3 of the ASX Revised Corporate Governance Principles and Recommendations states that public companies should establish a code of conduct for directors 21 Mallin, above n 8, 51.

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and senior executives to, among other things, encourage the reporting of unlawful/unethical behaviour by employees and others, and to identify measures the company follows to protect whistleblowers who report violations in good faith.22 Another useful explanation of the role of the employee in the corporation, and the significance of this role in terms of contemporary corporate governance, comes from the HIH Royal Commission’s Final Report. In the part of the report discussing ‘Organs of governance’, Justice Owen states: It is difficult to define with precision the part that employees play in corporate governance. It will depend on the extent to which the employee is involved in or can influence the decision-making process. Senior management is more likely to have such a role. But in large corporations or complex groups it may be that employees further down the corporate hierarchy have a decision-making function that involves elements of control in the process. There is a danger in the current emphasis on the role and responsibilities of boards of directors. It may cause to be overlooked the reality of the necessarily greater part that executives and other employees play in the day-to-day running of many corporate businesses.23

As to how employees can become important stakeholders in the corporation, again the OECD Principles of Corporate Governance provides a useful discussion: The degree to which employees participate in corporate governance depends on national laws and practices, and may vary from company to company as well. In the context of corporate governance, performance enhancing mechanisms for participation may benefit companies directly as well as indirectly through the readiness by employees to invest in firm specific skills. Examples of mechanisms for employee participation include: employee representation on boards; and governance processes such as works councils that consider employee viewpoints in certain key decisions. With respect to performance enhancing mechanisms, employee stock ownership plans or other profit sharing mechanisms are to be found in many countries.24

The topic of employee participation, and more generally the role of employees as stakeholders, has been written about and commented upon a great deal over the past decade, and is still heavily debated and returned to regularly when considering reform options to improve corporate regulation and the governance practices of corporations.25 In the Anglo-American, or ‘outsider’ system of corporate governance (which loosely describes Australia’s system of corporate governance), neither employees nor shareholders have a particularly prominent role in the dayto-day governance arrangements of the corporation. However, in some European countries, most notably Germany, employees (as well as shareholders) are central to a company’s governance practices through a two-tier board structure and 22 For guidance on the provision of a whistleblowing service, ASX recommends the Australian Standard on Whistleblowing Protection Programs for Entities (AS 8004). 23 Owen Report, above n 20, 104 para 6.1.1. 24 OECD Principles of Corporate Governance, above n 5, 47. 25 See Irene Lynch-Fannon, ‘Employees as Corporate Stakeholders: Theory and Reality in a Transatlantic Context’ (2004) 4(1) Journal of Corporate Law Studies 155 (which contains a fresh analysis of what is meant by ‘ownership’ in order to argue for a central relationship between the corporation and employees in the corporate governance mix), and a collection of essays, Howard Gospel and Andrew Pendleton (eds), Corporate Governance and Labour Management, Oxford, Oxford University Press (2005).

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a legislated system of ‘co-determination’ (see further Chapter 13 for a discussion of Germany’s system of corporate governance). An ‘insider’ system of corporate governance reigns supreme. In the United States, in particular, a lot of attention has been given over the past decade to the concept of ‘wealth creation’, which embodies a view that a long-term focus on wealth, rather than a short-term focus on returns to shareholders, is truly in the best interests of the company. Respect for employees is central to this emerging perspective on corporate governance, as the development of firm-specific skills by loyal and happy employees is considered an integral ingredient of ‘wealth creation’. In the leading work to date on wealth creation, Ownership and Control: Rethinking Corporate Governance for the 21st Century, published in 1995, Margaret Blair argues that corporations should not be regarded as ‘bundles of assets’ being the sole property of shareholders, but rather as institutional arrangements governing the relationship between all parties contributing firm-specific assets – embracing not only shareholders, but also employees who develop specialised skills being of value to the enterprise. Blair explains that the idea of ‘wealth creation’ for the corporation extends beyond short-term profit taking by shareholders to include the corporation’s long-term interests, and thus includes employees, customers, creditors etc. as integral to ensuring the best interests of the corporation from the perspective of wealth creation. Blair strongly associates achievement of wealth creation with recognition and respect for human capital; that is, employees. According to Blair: [I]n the 1990’s, fewer and fewer publicly traded corporations actually look like the factory model. Much of the wealth-generating capacity of most modern firms is based on the skills and knowledge of the employees and the ability of the organization as a whole to put those skills to work for customers and clients. Even for manufacturing firms, physical plant and equipment make up a rapidly declining share of the assets, while a growing share consists of intangibles . . . such as patent rights, brand reputation, service capabilities, and the ability to innovate and get the next generation product to market in a timely manner.26

Another emerging area of discourse that emphasises the importance of employee involvement in the overall governance framework of the corporation is the ‘participatory management’ philosophy. Commentators have referred to participatory management as the most important industrial relations phenomenon of the past three decades.27 According to Stephen Bainbridge, there are two basic forms of participatory management – operational participation and strategic participation: 26 Margaret Blair, Ownership and Control: Rethinking Corporate Governance for the 21st Century, Washington, DC, Brookings Institute (1995) Ch 1 (Primer on Corporate Governance). 27 Stephen M Bainbridge, ‘Corporate Decision-Making and the Moral Rights of Employees: Participatory Management and Natural Law’ (1998) 43 Villanova Law Review 741.

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Operational participation refers to programs in which employee involvement is limited to day-to-day issues of productivity and working conditions at the plant level . . . Strategic participation refers to programs in which employees participate in major policy decisions, such as those traditionally viewed as falling within the realm of corporate governance.28

2.2.2.3 Creditors Creditors always rate a mention as one of the key stakeholders in the corporation. Apart from the rapidly increasing literature on corporate governance, over the years many commentators have examined whether company directors can29 and should owe a duty to act in the best interests of creditors while serving the company.30 In discussing the place of creditors as company stakeholders, Mallin separates creditors into two categories: ‘providers of credit’ and ‘suppliers’.31 As to the former: Providers of credit include banks and other financial institutions. Providers of credit want to be confident that the companies that they lend to are going to be able to repay their debts . . . It is in the company’s best interest to maintain the confidence of providers of finance to ensure that no calls are made for repayment of funds, that they are willing to lend to them in the future, and that the company is able to borrow at the best possible rate.

As to the latter: Suppliers have an interest in the companies which they supply on two grounds. First, having supplied the company with goods and services, they want to be sure that they will be paid for these and in a timely fashion. Secondly, they will be interested in the continuance of the company as they will wish to have a sustainable outlet for their goods and services.

The OECD Principles of Corporate Governance also discusses the significant place of creditors in contemporary corporate governance, and the various ways by which creditor interests may be, or in fact are, protected by law. Importantly, rather than requiring the internal governance arrangements of corporations to recognise and embrace creditor interests, reference is made to the discrete area 28 Ibid 742. 29 Directors have no direct fiduciary duties to creditors: Spies v R (2000) 201 CLR 603. 30 For a discussion of the much-vexed issue of director’s duties to creditors following the High Court decision in Spies, see the scholarly debate between James McConvill, ‘Directors’ Duties towards Creditors in Australia after Spies v The Queen’ (2002) 20 Company and Securities Law Journal 4; in reply Anil Hargovan, ‘Directors’ Duties to Creditors in Australia after Spies v The Queen – Is the Development of an Independent Fiduciary Duty Dead or Alive?’ (2003) 21 Company and Securities Law Journal 390; James McConvill, ‘Geneva Finance and the “Duty” of Directors to Creditors: Imperfect Obligation and other Imperfections’ (2003) 11 Insolvency Law Journal 7; in reply Anil Hargovan, ‘Geneva Finance and the “Duty” of Directors to Creditors: Imperfect Obligation and Critique’ (2004) 12 Insolvency Law Journal 134. The debate appears to be resolved: Justice Owen in The Bell Group Ltd (in liq) v Westpac Banking Corporation (No 9) (2008) 70 ACSR 1 at [4398] held that the question was ‘determined authoritatively’ by the High Court in Spies. For comprehensive examination of this topic, see Andrew Keay, Company Directors’ Responsibilities to Creditors, London, Routledge-Cavendish (2006). 31 See Mallin, above n 8, 51–2.

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of insolvency law (which generally includes directors’ duties to creditors) to protect creditors in their relationship with the corporation. Especially in emerging markets, creditors are a key stakeholder and the terms, volume and type of credit extended to firms will depend importantly on their rights and on their enforceability. Companies with a good corporate governance record are often able to borrow larger sums and on more favourable terms than those with poor records or which operate in non-transparent markets. The framework for corporate insolvency varies widely across countries. In some countries, when companies are nearing insolvency, the legislative framework imposes a duty on directors to act in the best interests of creditors, who might therefore play a prominent role in the governance of the company. Other countries have mechanisms which encourage the debtor to reveal timely information about the company’s difficulties so that a consensual solution can be found between the debtor and its creditors. Creditors’ rights vary, ranging from secured bond holders to unsecured creditors. Insolvency procedures usually require efficient mechanisms for reconciling the interests of different classes of creditors. In many jurisdictions provision is made for special rights such as through ‘debtor in possession’ financing which provides incentives/protection for new funds made available to the enterprise in bankruptcy.32

2.2.2.4 Customers Mallin provides the following very brief explanation of how a company’s customers also fit the description of ‘stakeholder’ from a corporate governance perspective: Increasingly customers are also more aware of social, environmental, and ethical aspects of corporate behaviour and will try to ensure that the company supplying them is acting in a corporately socially responsible manner.33

As will be explained below, under the 2007 ASX Revised Corporate Governance Principles and Recommendations, listed entities are advised to have a code of conduct that identifies the company’s core values and they should consider the reasonable expectations of their stakeholders. Furthermore, under Chapter 7 of the Corporations Act (dealing with financial services and markets), retail clients of a financial product must receive a ‘product disclosure statement’, which must provide an explanation, among other things, of the extent to which labour standards or environmental, social or ethical considerations are taken into account in the selection, retention or realisation of an investment if the product has an ‘investment component’ (see s 1013D(1)(l) of the Act). Australia’s Trade Practices Act 1974 (Cth) is also important in ensuring that the interests of customers are a central consideration of the corporation in its day-to-day activities. The Act contains an extensive number of rules under Part V, ‘Consumer Protection’, including the general prohibition on misleading and deceptive conduct, and further aims to protect and uphold the interests of 32 OECD Principles of Corporate Governance, above n 5, 48. 33 Mallin above, n 8, 52.

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consumers through rules on product recalls, defective goods and anti-competitive conduct (Part IV). These requirements (as well as a number of others) work together so that, in Australia, the role of customers in corporate governance is neatly aligned with Mallin’s description above. 2.2.2.5 The community A great deal has been written about whether society as a whole is also a specific stakeholder of the modern corporation, and the implications for directors’ duties and corporate regulation more generally if society is, indeed, a stakeholder. Referring to ‘society’ as a whole as being a stakeholder presents some difficulties, as this makes it very difficult to provide any meaningful conception of what obligation this imposes on the corporation. Mallin’s approach of examining society at the micro-level of the ‘local community’ seems useful and workable. According to Mallin: Local communities have a number of interests in the companies which operate in their region . . . companies will be employing large numbers of local people and it will be in the interest of sustained employment levels that companies in the locality operate in an efficient way. Should the company’s fortunes start to decline then unemployment might rise and could lead to part of the workforce moving away from the area to seek jobs elsewhere . . . However, local communities would also be concerned that companies in the area act in an environmentally-friendly way as the last thing they would want is pollution in local rivers, in the soil or in the atmosphere generally. It is therefore in the local community’s interest that companies in their locality continue to thrive but do so in a way that takes account of local and national concerns.34

2.2.2.6 The environment In the first edition of the book, it was noted that ‘just as contentious as the question of whether “society” is a stakeholder of the corporation is whether “the environment” can be considered to be a stakeholder. Perhaps this is because the implications of both, in terms of how a company must structure its affairs and do business, are enormous’. The call for environmental change has progressed rapidly since then with a growing sense of urgency35 that negates the need for the ‘contentious’ claim made earlier. Following the launch of the Kyoto Protocol in 2005,36 managing greenhouse gas emissions has become a routine part of doing business in key global 34 Ibid. 35 For example, see Intergovernmental Panel on Climate Change, Climate Change 2007: The Physical Science Basis – Contribution of Working Group 1 to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change, Cambridge, Cambridge University Press (2007). 36 The Kyoto Protocol was adopted at the Third Session of the Conference of the Parties to the United Nations Framework Convention on Climate Change in 1997, in Japan. Countries signatory to the Protocol undertook legally binding commitments to reduce greenhouse-gas emissions in the commitment period 2008 to 2012.

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trading markets, and shareholders and financial analysts increasingly assign value to companies that prepare for and capitalise upon business opportunities posed by climate change – whether from greenhouse-gas regulations, direct physical impacts or changes in corporate reputation.37 In a recent report on climate change and corporate governance, the following observations were made:38 For corporations, climate change is a financial problem that presents significant economic and competitive risks and opportunities. Corporate boards, executives and shareholders simply cannot afford to ignore it39 . . . Given the sweeping global nature of climate change, climate risk has become embedded, to a greater or lesser extent, in every business and investment portfolio.40

In Corporate Governance, Mallin speaks not just of the ‘environment’ as being a stakeholder, but also the various environmental lobby groups that operate both on the domestic level and the international level to ensure that companies meet environmental standards. These standards comprise self-imposed standards and standards derived from obligations under environment protection and other legislation (for example, the Environment Protection Act 1970 (Vic) and the Environment Protection and Biodiversity Conservation Act 1999 (Cth)).41 Tied in with the concept of ‘wealth creation’ discussed above is the concept of ‘sustainability’. That is, growth can only be maintained over the long term if the manner in which resources (both natural and human) are used and treated is sustainable. Thus, attention must quickly turn to the environment and the ways in which it is being used and protected, with a view to maintaining long-term growth. Put simply, if the manner in which resources are being used to achieve growth now cannot be sustained, then long-term growth is not achievable. What is needed is long-term, sustainable growth. According to Mallin, for companies to promote sustainability, they must be environmentally responsible. Mallin explains that an environmentally responsible company must not subject its workers to potentially hazardous processes without adequate protection, must not pollute the environment and should, where possible, use recyclable materials and engage in a recycling process. Mallin states that: ‘Ultimately all of these things will benefit society at large and the company itself.’42 37 This account is drawn from Douglas Cogan, ‘Corporate Governance and Climate Change: Making the Connection’ (March 2006) at 1 – Report commissioned by Ceres from the Investor Responsibility Center. 38 Ibid at 11. The report is the first comprehensive examination of how 100 of the world’s largest corporations are positioning themselves to compete in a carbon-constrained world. 39 For an interesting discourse on the corporate and securities law obligations on United States companies in the context of climate change, see Perry Wallace, ‘Climate Change, Fiduciary Duty, and Corporate Disclosure: Are Things Heating Up in the Boardroom?’ (2008) 26 Virginia Environmental Law Journal 293. 40 ‘Between 1994 and 2002, 62 shareholder resolutions on global warming issues were filed with the SEC in the US and 26 of them came to votes’: E Hancock, ‘Corporate Risk of Liability for Global Climate Change and SEC Disclosure Dilemma’ (2005) 17 Georgetown International Environmental Law Review 233 at 249. 41 The Australian Government’s Carbon Pollution Reduction Schemes Bill (2009) was rejected by the Senate in December 2009. See further, ‘Garnaut Climate Change Review: Emissions Trading Scheme Discussion Paper’ (March 2008) available at . 42 Mallin, above n 8, 53.

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In an excellent contribution to his 2004 collection of essays, Thomas Clarke emphasises the importance of protecting ‘the environment’ from a stakeholder– management perspective. According to Clarke: It is time for the principal-agent problematic to be reinforced with the environmenttrustee problematic in both theory and practice. The competitive struggle to grow business and accumulate capital (whether measured by shareholder value or not) has disturbed the natural balance of the earth and threatened essential life-support systems . . . 43

Clarke discusses how, incrementally, management philosophy and practice has embraced the concept of sustainability, rather than remaining focused purely on profit maximisation. The literature stresses that the way in which economic activity has recently been organised is not sustainable – which (as explained above) sits uncomfortably with a more long-term perspective of growth. According to Clarke: In the past, companies did not recognize or acknowledge the environmental or social effects of their operations . . . The environmental context in which business must operate in the future suggests the following imperatives which all corporations will face, and all corporate governance systems will need to resolve: maintaining a licence to operate via transparency and accountability; generating more value with minimum impact; preserving the natural resource base, and doing business in a networked, intelligent multi-stakeholder world.44

With a more long-term approach to management, based on a wealth-creation perspective of corporate governance, it is clear that the environment is a central stakeholder of the corporation – in terms both of what the environment offers the corporation (being long-term growth) and of the risk to the environment as a result of corporate activities. From a practical perspective, the place of the environment as a principal stakeholder of the corporation has been emphasised not only in company codes of conduct and ethics that have become a recent feature of Australian corporate governance arrangements (as discussed in greater detail below), but also through discrete environmental policies that companies have adopted. These are designed to ensure that companies fulfil their core environmental obligations, and require employees and managers to act in an environmentally sensitive manner when at work and utilising the company’s resources. Indeed, some companies have gone even further and implemented ‘environmental procurement policies’ requiring that, in order for suppliers to maintain business with the company, they need to maintain certain environmental ‘KPIs’ (key performance indicators). 43 See Thomas Clarke, ‘Theories of Governance – Reconceptualizing Corporate Governance Theory after the Enron Experience’ in Thomas Clarke (ed.), Theories of Corporate Governance – The Philosophical Foundations of Corporate Governance, London, Routledge (2004) 25. 44 Ibid.

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One of the progressive listed companies in Australia, in terms of expressing a commitment to the environment, is the National Australia Bank (NAB). NAB has a Group Environment Policy that sets a global reference point for its environmental commitments and management practices. In responding to climate change as a large global company, NAB states that ‘it is our responsibility to play a part in addressing the unprecedented challenges of climate change, and to help our employees, customers and suppliers do the same’.45 Furthermore, ‘our aim is to ensure environmental considerations are integrated throughout the organisation’.46 To encourage sustainable travel, NAB states that an interest-free public transport loan is available to employees based in Melbourne and Sydney, and that some 800 bike racks are installed across Australia.47 In 2002, NAB became a signatory to the United Nations Environment Programme Statement for Financial Institutions on the Environment and Sustainable Development, which promotes sustainable development and environmentally sustainable business practices in the international financial services sector. In 2007, NAB announced its intention to become a carbon neutral organisation by September 2010. According to NAB, ‘these are both clear signals that as a global provider of financial products and services, we recognise the pivotal role financial institutions play in environmental management and the sustainability of the communities in which we operate’. In 2007, NAB agreed to a global social and environmental benchmark for financing projects greater than US$10 million by adopting the Equator Principle, a voluntary set of guidelines to assess and manage social and environmental project financing risk, especially in emerging markets.48 In terms of the company’s environmental policy statement, NAB states that it offers the following commitments to its customers:49 • Reviewing and continuously improving lending policy which includes where appropriate, environmental risk assessment to assist in the consideration and management of indirect environmental impacts; • Wherever possible supporting the investment choice of customers to invest in Socially Responsible Investment products; • Looking for opportunities to offer customers ‘green’ choices in financial products and services; • Wherever possible assisting business and corporate clients to operate their businesses in an environmentally sustainable manner, by providing appropriate banking and risk management products and services.

The commitment accorded to environmental issues is reflected in the Group Chief Executive Officer (CEO) having ultimate responsibility for the environmental performance of the NAB Group, with the Group’s Environmental Management 45 NAB Enviroment policy, available at . 46 Ibid. 47 Ibid. 48 The Equator principles can be found at . 49 NAB Enviroment policy, n 45.

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Committee being responsible for the implementation of the environment policy throughout the organisation. 2.2.2.7 Government As noted earlier, Mallin’s account of the place of stakeholders in contemporary corporate governance identifies government as a key stakeholder. In discussing the role of government as stakeholder, Mallin states: The government has an interest in companies for several diverse reasons. Firstly, as with the local and environmental groups – although not always with such commitment – it will try to make sure that companies act in a socially responsible way taking account of social, ethical, and environmental considerations. Secondly, it will analyse corporate trends for various purposes such as employment levels, monetary policy, and market supply and demand of goods and services. Lastly, but not least, it will be looking at various aspects to do with fiscal policy such as capital allowances, incentives for investing in various industries or various parts of the country, and of course the taxation raised from companies!50

2.2.2.8 All stakeholders have vested interests in the sustainability of corporations At the end of the day, it is not difficult to conclude that all stakeholders have vested interests in the sustainability of corporations.51 The shareholders want to maximise returns on their investment, not only by receiving good dividends, but also by making profits when they sell securities in a corporation. The employees are dependent on the company, not only to support themselves and their families, but in some cases also as holders of employee benefits, including securing retirement benefits from the company. The creditors also have a strong interest in the sustainability of the company as their expectation is that they are paid in accordance with the conditions agreed upon with the corporation, while supplier–creditors are of necessity dependent upon corporations to continue manufacturing products and services. Customers want to continue trading with corporations that provide excellent goods and services, and they will deal with the company to enforce guarantees and warranties against suppliers. The communities in which corporations do business, manufacture their goods or deliver their services gain by corporations providing job opportunities and creating wealth that leads to the improvement of living conditions, as long as the corporations adhere to good practice in corporate governance and do business in an environmentally friendly manner. The environment is our ‘pearl’ and is highly dependent on sustainable and environmentally friendly corporations. The government has an interest in the sustainability of corporations, as not only do they provide job opportunities to citizens, also are responsible for the majority of governmental income through taxes, levies, licenses etc., which income is eventually re-invested into 50 Mallin, above n 8, 53. 51 Mervyn King, The Corporate Citizen, Johannesburg, Penguin Books (2006) 63.

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a country’s infrastructure, health, education etc. to ensure prosperity for its citizens.

2.3 Stakeholders’ interests and the corporation: The role of the law A major work titled The Anatomy of Corporate Law: A Comparative and Functional Approach, produced by seven leading corporate law and corporate governance scholars,52 emphasises the important role of company law (including rules of corporate governance) in protecting stakeholder interests. Indeed, recognition and protection of stakeholder interests is regarded as one of the key functions of company law. The underlying thesis of this work is that in every jurisdiction (whether it be a developing country in Europe, or a developed country such as the United States) the central issue for corporate law is how to mediate three different kinds of ‘agency conflicts’: between managers and shareholders; between majority and minority shareholders; and between the firm and third parties (that is, stakeholders). In this section we extend beyond the rules of company law to look at how corporate governance regulation, in general, manages and protects stakeholder interests. We begin by examining a recent development in corporate governance regulation in Australia that has ensured a more prominent place for stakeholders in contemporary corporate governance, particularly in relation to listed companies. We also illustrate issues in corporate social responsibilities (CSR) arising from a September 2004 report of the Special Commission of Inquiry into the James Hardie asbestos compensation case. A short discussion of the overseas position with respect to the recognition and protection of stakeholder interests is also provided in this section.

2.3.1 The Australian position Since 1 July 2004, listed companies in Australia have been required, in order to comply with ASX Best Practice Recommendations (as it was originally titled in 2003), to have in place and posted on their websites a code of conduct and ethics indicating how they intended to deal with stakeholder concerns and interests. As explained in Chapter 7, the now revised ASX Corporate Governance Principles and Recommendations (2007) represent Australia’s attempt to develop a regulatory framework that promotes adherence to best practice in corporate governance, in response to a series of corporate collapses in the earlier part of this decade. From an international perspective, the treatment of stakeholders through the sophisticated development of a model code of conduct is quite 52 Reiner Kraakman, Henry Hansmann, Edward Rock, Paul Davies, Gerhard Hertig, Klaus Hopt and Hideki Kand all made contributions to The Anatomy of Corporate Law: A Comparative and Functional Approach, Oxford, Oxford University Press (2004).

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progressive – with neither of the recent reform ‘movements’ in the United States or the United Kingdom directly dealing with stakeholders’ interests in terms of how to achieve best practice in corporate governance. Rather, the USA and the UK movements were focused on more specific aspects of corporate governance – financial reporting and audit in the USA, and the role of non-executive directors in the UK. As explained in greater detail in Chapter 7, ASX Corporate Governance Principles and Recommendations operate according to a ‘comply or explain’ regime: pursuant to Listing Rule 4.10.3, listed companies must either comply with each recommendation, or clearly explain the reasons for their non-compliance in the annual report of the company. The recommendations build upon eight core principles, with each principle explained in detail and with commentary about implementation in the form of Recommendations. For the present discussion, Principle 3 (Promote ethical conduct and responsible decision-making) is most relevant. Recommendation 3.1 states that, in order to actively promote such conduct and decision making, listed companies need to ‘take into account their legal obligations and reasonable expectations of their stakeholders’. The commentary attached to Principle 3, designed to provide assistance (but does not give rise to a reporting obligation) advises that companies should not only comply with their legal obligations, but ‘should also consider the reasonable expectations of their stakeholders, including: shareholders, employees, customers, suppliers, creditors, consumers and the broader community in which they operate. It is a matter for the board to consider and assess what is appropriate in each company’s circumstances.’ Recommendation 3.1 then goes on to provide that to achieve this, listed companies should establish and disclose a code of conduct to guide compliance with legal and other obligations, in order to meet the reasonable expectations of stakeholders. Box 3.1 goes further in setting out some comprehensive guidelines as to the type of content that should be included in a code of conduct: 1. Clear Commitment by Board and Senior Executives to the Code of Conduct – This is often linked to statements about the aspirations or objectives of the company; its core values; and its views about the expectations of shareholders, employees, customers, suppliers, creditors, consumers and the broader community. 2. Responsibilities to Shareholders and the Financial Community Generally – This might include reference to the company’s commitment to delivering shareholder value and how they will do this, the company’s approach to accounting policies and practices, and disclosure. 3. Responsibilities to Stakeholders (identified above) – This might include reference to standards of product quality or service, commitments to fair value, fair dealing and fair trading, and the safety of goods produced. 4. Approach to Community – This might include environmental protection policies, support for community activities, and donation or sponsorship policies.

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5. Responsibilities to the Individual – This might include the company’s privacy policy, and its policy on the use of privileged or confidential information. 6. Employment Practices – This might include reference to occupational health and safety; employment opportunity practices; special entitlements about the statutory minimum; employee security trading policies; training and further education support; policies and practices on drug and alcohol usage and on outside employment. 7. Approach to Business Standards – Policies on the company’s approach to business courtesies; bribes, facilitation payments, inducements and commissions. This might include how the company regulates such conduct and prevents the misuse of company assets and resources. 8. How the Company Complies with Legislation Affecting Its Operations – For company operations outside of Australia, particularly in developing countries, the code of conduct should state whether those operations comply with Australian or local legal requirements regarding employment practices, responsibilities to the community and responsibilities to the individual, particularly if the host country adopts lower standards than those prescribed by Australian law or international protocols. 9. Approach to Conflicts of Interests – Specify how the company handles actual or potential conflicts of interest. This might include reference to how the company manages situations where the interests of a private individual interferes or appears to interfere with the interests of the company as a whole, and how the company prevents directors, senior executives and employees from taking improper advantage of property, information or position, or opportunities arising from these, for personal gain or to compete with the company. 10. Promotion of Ethical Behaviour – Identify measures the company follows to encourage the reporting of unlawful or unethical behaviour and to actively promote ethical behaviour. This might include reference to how the company protects those, such as whistleblowers, who report violations in good faith, and its processes for dealing with such reports.53 11. How the Company Monitors and Ensures Compliance with its Code

The ASX Corporate Governance Principles and Recommendations state that Box 3.1 contains some suggestions for the content of the corporate code of conduct, and therefore, of course, companies have flexibility to include or exclude some of the above matters, or include others that may be more specifically relevant to their business. The explanatory text accompanying the original ASX Best Practice Recommendations (2003), indicates that codes of conduct are intended to state the values and policies of the company, in order to ensure adequate public or social accountability by corporations. 53 For guidance on the provision of a whistleblowing service, ASX recommends the Australian Standard on Whistleblowing Protection Programs for Entities [AS 8004].

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Highlighting the role of areas outside company law rules and corporate governance principles in accounting for the interests of stakeholders, the 2003 explanatory text states that codes of conduct ‘should address matters relevant to the company’s compliance with its legal obligations to stakeholders’. Further, ‘the company should have a system for ensuring compliance with its Code of Conduct and for dealing with complaints’. The compliance aspect of the code of conduct should complement the company’s risk management practices. Principle 7 of ASX Corporate Governance Principles and Recommendations, dealing with the recognition and management of risk, recommends that listed companies structure their affairs to ensure compliance with legal obligations – therefore complementing Principle 3, given that many of the legal obligations imposed on listed companies have a direct bearing on the interests of stakeholders. Principle 7 states that good corporate governance can be achieved through establishing ‘a sound system of risk oversight and management and internal control’. Recommendation 7.1 then states that ‘the company should establish policies for the oversight and management of material business risks and disclose a summary of those policies’. Further explanation is provided in the accompanying recommendations (7.2–7.3), that the policies should include the following components: oversight, risk profile, risk management, compliance and control, and assessment of effectiveness. Commentators, focusing on a range of empirical studies demonstrating that while an increasing number of companies since the mid-1990s have adopted policies consistent with the concept of CSR, have made the following observation:54 the studies conducted to date suggest that the ‘Australian approach’ to CSR is still largely characterized by tentative and short term initiatives of a philanthropic nature. While there are exceptions, most businesses in Australia have not yet sought to integrate the precepts of CSR or corporate citizenship into their strategic approach or corporate culture.

In 2004, the question of whether corporate governance, and more specifically rules concerning the duties of company directors, should be oriented towards protecting the interests of stakeholders, became a heavily debated issue in Australia. This debate resulted from a major scandal involving manufacturer James Hardie and that company’s under-funding of an entity set up to compensate claimants of asbestos-related illnesses who had come into contact with James Hardie building products. More details of the James Hardie asbestos compensation affair are discussed later in this chapter. The potential for future asbestos victims to go uncompensated due to the arrangements set up by James Hardie led to calls for company law reform so that directors of the James Hardie parent company, and directors in the future under similar circumstances, could be made personally 54 H Anderson and I Landau, in ‘Corporate Social Responsibility in Australia: A Review’ Corporate Law and Accountability Research Group Working Paper No. 4, Monash University (October 2006).

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liable for claimant (that is, stakeholder) debts. In light of this, in March 2005 the Australian Government asked its Corporations and Markets Advisory Committee to consider and report on whether the statutory duties of directors should be amended to clarify the extent to which directors can take into account stakeholder interests, or require directors to take into account stakeholder interests.55 The findings of the report, and its implications for stakeholders, are considered later in the chapter with reference to the debate on the interaction of the ‘shareholder primacy’ approach to corporate decision making with the ‘enlightened self-interest’ approach.

2.3.2 Overseas position: A snapshot What follows is a brief discussion of the approaches of the OECD, the European Union, the USA, Canada, the UK, New Zealand and South Africa, to recognising and protecting the interests of company stakeholders, through corporate governance principles and/or company law rules.56 2.3.2.1 OECD The OECD Principles of Corporate Governance is very useful when considering how the regulation of corporate governance has recognised the importance of companies accommodating stakeholder interests. The OECD principles state that: The corporate governance framework should recognise the rights of stakeholders established by law or through mutual agreements and encourage active co-operation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises.57

More specifically, the OECD principles recommend that OECD countries adhere to this principle: (a) Laws and mutual agreements with stakeholders are to be respected. (b) Where stakeholder interests are protected by law, stakeholders should have the opportunity to obtain effective redress for violation of their rights. (c) Performance-enhancing mechanisms for employee participation should be permitted to develop. (d) Where stakeholders participate in the corporate governance process, they should have access to relevant, sufficient and reliable information on a timely and regular basis. 55 See further The Social Responsibility of Corporations Report (December 2006), above n 7. 56 For insights into CSR in different European countries, see Andre Habisch, Jan Jonker, Martina Wegner and Rene Schmidpeter (eds), Corporate Social Responsibility Across Europe, Germany, Springer (2005). 57 OECD Principles of Corporate Governance, above n 5, 16 – 17.

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(f)

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Stakeholders, including individual employees and their representative bodies, should be able to freely communicate to the board their concerns about illegal or unethical practices, and their rights should not be compromised for doing this. The corporate governance framework should be complemented by an effective, efficient insolvency framework and by effective enforcement of creditor rights.58

2.3.2.2 European Union (EU)59 The EU Green Paper, Promoting a European Framework for Corporate Social Responsibility (2001), described CSR as ‘a concept whereby companies integrate social and environmental concerns in their business operations and in their interaction with their stakeholders on a voluntary basis’. Although the emphasis on the voluntary nature of CSR did not find favour with some of the respondents to the Green Paper,60 this definition was reaffirmed by the European Commission (the executive arm of the EU) in its policy communication in 200661 and remains current. The philosophical approach behind this definition, which integrates social and environmental concerns with business, was described as follows:62 It is essentially about companies being prepared to take the lead, and illustrate to the Commission and to their stakeholders voluntarily that they take CSR seriously. CSR is always about going beyond the law. Ideally, CSR is a win-win scenario, whereby companies increase their profitability and society benefits at the same time.

In July 2002, the Commission commented on the conflict between maximising short-term profits and achieving shareholder value by noting:63 the growing perception among enterprises that sustainable business success and shareholder value cannot be achieved solely through maximising short-term profits, but instead through market-oriented yet responsible behaviour.

In May 2003, the European Commission released a communication titled ‘Modernising Company Law and Enhancing Corporate Governance in the European Union: A Plan to Move Forward’. This document outlines the approach that the 58 Ibid 46–8. 59 For a description of the development of CSR in the EU, see Sorcha Macleod, ‘Corporate Social Responsibility Within the European Union Framework’ (2005) 23 Wisconsin International Law Journal 541. For a broader perspective, see Sorcha Macleod, ‘Reconciling Regulatory Approaches to Corporate Social Responsibility: The European Union, OECD and United Nations Compared (2007) 13 European Public Law 671. 60 For a summary of criticisms directed to this definition in the Green Paper by trade unions and NGOs, see Sorcha Macleod, ‘Corporate Social Responsibility Within the European Union Framework’, (2005) 23 Washington International Law Journal 541, 545–7. 61 Implementing the Partnership for Growth and Jobs: Making Europe a Pole of Excellence on CSR, COM (22 March 2006). 62 See EU Corporate Social Responsibility Briefing (16 March 2009), available at . 63 The Commission Communication Concerning Corporate Social Responsibility: A Business Contribution to Sustainable Development, COM (2 July 2002), at 5.

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Commission intends to follow specifically in the area of company law and corporate governance. Importantly, the Commission’s position is that member states of the EU should provide for an inclusive approach – recognising and protecting the interests of key corporate stakeholders – as a priority in moving forward with reforming company law and corporate governance regulation. The Communication states: Ensuring effective and proportionate protection of shareholders and third parties must be at the core of any company law policy. A sound framework for protection of members and third parties, which properly achieves a high-degree of confidence in business relationships, is a fundamental condition for business efficiency and competitiveness. In particular, an effective regime for the protection of shareholders and their rights, protecting the savings and pensions of millions of people and strengthening the foundations of capital markets for the long term in a context of diversified shareholding within the EU, is essential if companies are to raise capital at the lowest cost.64

This general communication on company law and corporate governance follows the communication on CSR of 2002. The document addressed the social and environmental aspects of doing business in the global economy, and led to the setting up by the EU of a European Multi-Stakeholder Forum with a view to promoting voluntary social and environmental practices of business – linked to their core activities. Indeed, a stakeholder-oriented approach to corporate governance is heavily emphasised and promoted in EU countries, with the MultiStakeholder Forum (formed in 2002) bringing together employers, employees, NGOs, academics and socially responsible investors every two years to discuss further steps for the EU to raise awareness of CSR, to encourage its adoption and to facilitate exchange of best practices across Europe.65 In addition, the European Coalition for Corporate Justice (ECCJ) was formed in 2006. A renewed EU strategy on CSR of the European Union was launched in 2006, leading to the creation of the European Alliance for CSR, which is viewed as an important pillar of European policy on CSR. The CSR Alliance lays the foundation for the partners to promote CSR in the future around the following three areas of activity:66 ● Raising awareness and improving knowledge on CSR and reporting on its achievements ● Helping to mainstream and develop open coalitions of cooperation ● Ensuring an enabling environment for CSR. 64 European Commission, Modernising Company Law and Enhancing Corporate Governance in the European Union: A Plan to move Forward COM (2003) 284 (May 2003) at 8 (emphasis added). 65 Other EU initiatives include, inter alia, a High-Level Group of Members States’ representatives, which meets every six months to share different approaches to CSR and encourage peer learning. A Commission inter-service group on CSR has the task to ensure a coherent approach across the different Commission services concerned. It involves the following policy areas: environment, justice, liberty and security; internal market; health and consumer affairs; and external affairs. 66 For identification of the several priority areas, inspired by the European Roadmap for Businesses launched by CSR Europe in March 2005, which reflect the wide-ranging nature of CSR – see the mission statement of the Alliance available at .

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2.3.2.3 United States In the USA,67 a concept of ‘corporate constituency’ – by which the interests of stakeholders have been recognised – has been embedded in the takeover laws of the various states (corporate law in the USA is predominantly regulated at state level) since the 1980s,68 in response to strong hostile takeover activity during that decade.69 By 1998, over 30 state legislatures had introduced ‘corporate constituency’ laws, designed to protect companies in their local economies from hostile takeovers by enabling or requiring directors to consider the impact of their activities (including decisions whether to accept or reject a takeover offer) on constituencies other than shareholders – including employees, customers, suppliers and the community. For example, the statute in Illinois provides:70 in discharging the duties of their respective positions, the board of directors, committees of the board, individual directors and individual officers may, in considering the best interests of the corporation, consider the effects of any action upon employees, suppliers, and customers of the corporation, communities in which offices or other establishments of the corporations are located and all other pertinent factors.

Hence, while in Australia the notion of directors owing a duty to stakeholders is not stated explicitly in statute law, in the USA it is the norm, at least in relation to takeovers regulation. According to Margaret Blair in Ownership and Control: Rethinking Corporate Governance for the 21st Century, the constituency statutes make it legal for directors to consider other interests in addition to those of shareholders when making major decisions. Typically, the statutes require directors to consider the ‘best interests of the corporation’ as a whole, and then to identify a specific set of stakeholders, including employees, creditors, suppliers and the community in general, whose interests are tied to the corporation. However, the exact nature and scope of these provisions are still uncertain71 – see also discussion in Chapter 12. It is worth noting that Australia considered the pluralist approach in the USA and rejected any move to introduce legislation obliging directors to have regard to the interests of groups other than shareholders in making decisions.72 67 For an overview of the development of CSR in the USA, see C A Harwell Wells, ‘The Cycles of Corporate Social Responsibility: An Historical Perspective for the Twenty-first Century’ (2002) 51 Kansas Law Review 77. 68 For a summary of the USA state statutes, see K Hale, ‘Corporate Law and Stakeholders: Moving Beyond Stakeholder Statutes’ (2003) 45 Arizona Law Review 823. For criticism of corporate constituency statutes, see S Bainbridge, ‘Interpreting Nonshareholder Constituency Statutes’ (1992) 19 Pepperdine Law Review 971. 69 See, for example, decisions of the Delaware Supreme Court in Unocal Corp. v Mesa Petroleum Co. 493 A.2d 946 (Del. 1985); Revlon, Inc v McAndrews & Forbes Holdings, Inc 506 A.2d 173 (Del. 1986). 70 For a listing of the states that have enacted non-shareholder constituency statutes, see Alissa Mickels, ‘Beyond Corporate Social Responsibility: Reconciling the Ideals of a For-Benefit Corporation with Director Fiduciary Duties in the US and Europe’ (2009) 32 Hastings International and Comparative Law Review 271. For an analysis of the corporate constituency statutes, see E Orts, ‘Beyond Shareholders: Interpreting Corporate Constituency Statutes’ (1992) 61 George Washington Law Review 14. 71 Bayless Manning, ‘Principles of Corporate Governance: One Viewer’s Perspective on the ALI Project’ (1993) 48 The Business Lawyer 1319. 72 The Report of the Senate Standing Committee on Legal and Constitutional Affairs, Company Directors’ Duties: Report on the Social and Fiduciary Duties and Obligations of Company Directors (November 1989).

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Similarly, more recent Australian reports have adopted a similar approach,73 and are considered later in the chapter. According to some commentators,74 ‘the US is in the process of moving beyond the traditional conception of society as divided neatly into three sectors – business, non-profit, and government – and is witnessing the emergence of a new fourth sector that encompasses elements of both the business and non-profit sectors’.75 Some USA states have recently introduced a new corporate structure, known as the ‘low-profit limited liability company’ (L3C), for business entities whose primary goal is to achieve a socially beneficial objective.76 This is a new hybrid structure for profit-making ventures that have profits as a secondary goal of the entity; hence, they are called ‘low-profit’ companies. The L3C is a variation of the limited liability company (LLC) that currently exists in the USA and shares many of its characteristics. The L3C is a for-profit entity and is treated like an LLC for tax purposes, rather than a not-for-profit entity, and its members enjoy limited liability.77 L3Cs can distribute their profits to shareholders, a major distinction from non-profit companies. In order for an entity to qualify as a L3C, it must be established to significantly further one or more charitable or educational purposes. Furthermore, it must not have as a significant purpose the production of income or the appreciation of property (though it is permissible to earn profits). Additionally, the entity must not be organised to accomplish any political or legislative purposes. These three characteristics of L3Cs mirror the Program-Related Investment (PRI) requirements under the United States federal tax laws, which allow private foundations to invest in business entities without triggering tax penalties.78 This new company structure is designed to make it easier for social enterprises to attract capital and offer investors a financial return. It is envisaged that the L3C could create new jobs by supporting social enterprises that otherwise could not exist, and the timing of its introduction has been opportune given the credit 73 See further, The Social Responsibility of Corporations Report, above n 7; The Commonwealth of Australia, Parliamentary Joint Committee on Corporations and Financial Services Report, Corporate Responsibility and Managing Risk and Creating Value (June 2006), available at . 74 See, for example, Thomas Billitteri, Mixing Mission and Business: Does Social Enterprise Need a New Legal Approach? (2007), available at (Report of an Aspen Institute Round Table Discussion). Google.org is a celebrated example of a for-profit organisation formed largely for the purpose of providing social benefit. 75 Thomas Kelley, ‘Law and Choice of Entity on the Social Enterprise Frontier’ (2009) 84 Tulane Law Review 337. 76 See further, James Austin Roberto Guti´ errez, Enrique Ogliastri and Ezequiel A Reficco, ‘Capitalizing on Converge’, (2007) 24 Stanford Social Innovation Review 24 – available at ; Andrew Wolk, ‘Social Entrepreneurship & Government: A New Breed of Entrepreneurs Developing Solutions to Social Problems’ (2007), available at . 77 Acumen Law Group, ‘The Low-Profit LLC: A New Entity in Illinois’ (9 December 2009), available at . 78 ‘Illinois Recognizes New Business Entity that Mixes For-Profit and Nonprofit Elements’, Tax Law Centre, Practitioners’ Corner, State Taxation (28 August 2009), available at .

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crunch and global financial crisis.79 On 1 January 2010, Illinois became one of five states to recognise such a structure (and joins the states of Michigan, Wyoming, Utah and Vermont, which passed the first law on 30 April 2008 and lists about 60 L3Cs in the state database). The United States legislatures’ creation of a new type of corporate structure for blended enterprise (cross between a non-profit and for-profit corporation) demonstrates the bridging of the gap and a movement away from the traditional boundary between for-profit and non-profit organisations, and is in line with the development of the community interest company (CIC) in the UK, designed to meet community needs, discussed below. It remains to be seen whether this interesting development ‘holds particular promise for responding to the legal needs of the emerging fourth sector’,80 particularly beyond the time when the stimulus funds supplied to communities by the United States government (arising from the global financial crisis) are exhausted. 2.3.2.4 United Kingdom The embodiment of the concept of ‘enlightened shareholder value’ is a key aspect of the new corporate law regulatory environment in the United Kingdom.81 Section 172 of the Companies Act 2006 (UK) adopts the ‘enlightened shareholder value’ approach to directors’ duties, which is described under the Act as ‘a duty to promote the success of the company’.82 According to the Department of Trade and Industry, this will ensure that ‘regard has to be paid by directors to the long term as well as the short term, and to wider factors where relevant such as employees, effects on the environment, suppliers and customers’.83 This will principally be achieved through the high-level ‘statement of directors’ duties’ set out in the Act (reproduced below) to clarify the duties and responsibilities of directors. The genesis of section 172, discussed below, can be traced to the work of the UK Company Law Steering Group, which viewed the ‘enlightened shareholder value’ as being different from the pluralist approach (in the USA) and explained the concept as follows:84 There will inevitably be situations in which the interests of shareholders and other participants will clash, even when the interests of shareholders are viewed as longterm ones. Examples include a decision whether to close a plant, with associated 79 ‘New Corporate Structure Could Give Social Entrepreneurs New Funding Stream’, Chicago Tribune (10 August 2009). 80 Kelley, above n 75, at 342. 81 For critical appraisal, see Andrew Keay, ‘Tackling the Issue of the Corporate Objective: An Analysis of the United Kingdom’s “Enlightened Shareholder Value”’ (2007) 29 Sydney Law Review 577. See also I Esser and J J du Plessis, ‘The Stakeholder Debate and Directors’ Fiduciary Duties’ (2007) 19 South African Mercantile Law Journal 346 at 355–6. 82 See generally Esser and Du Plessis, ibid, at 351–6. 83 Press Release of 17 March 2005, ‘Draft Company Law Reform Bill Puts Small Business First’, available at . 84 UK Company Law Steering Group Consultation Paper, Modern Company Law for a Competitive Environment: The Strategic Framework (February 1999) at para 5.1.15.

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redundancies, or to terminate a long-term supply relationship, when continuation in either case is expected to make a negative contribution to shareholder returns. In such circumstances, the law must indicate whether shareholder interests are to be regarded as overriding, or some other balance should be struck. This requires a choice . . . between the enlightened shareholder value and pluralist approaches. An appeal to the ‘interests of the company’ will not resolve the issue, unless it is first decided whether the ‘the company’ is to be equated with its shareholders alone (enlightened shareholder value) or the shareholders plus other participants (pluralism).

In line with the above philosophical approach, section 172 of the Companies Act 2006 (UK) makes it clear that directors owe their fiduciary duty only to the shareholders generally, rather than a range of interest groups, but seek to provide a broader context for fulfilling that duty. Section 172 (in effect from October 2007) sets out a non-exhaustive list of matters to which directors must have regard and provides as follows:85 Duty to promote the success of the company (1) A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to: (a) the likely consequences of any decision in the long term, (b) the interests of the company’s employees,86 (c) the need to foster the company’s business relationships with suppliers, customers and others, (d) the impact of the company’s operations on the community and the environment, (e) the desirability of the company maintaining a reputation for high standards of business conduct, and (f) the need to act fairly as between members of the company. (2) Where or to the extent that the purposes of the company consist of or include purposes other than the benefit of its members, subsection (1) has effect as if the reference to promoting the success of the company for the benefit of its members were to achieving those purposes. (3) The duty imposed by this section has effect subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company.

Two principal reasons for the law reform, closely linked with one another, are identified by Davies:87 85 See further, Andrew Keay ‘Section 172(1) of the Companies Act 2006: An Interpretation and Assessment’ (2007) 28 Company Lawyer 106. For some critical views on the UK approach, see Esser and Du Plessis, above n 81, at 355–6. 86 This provision replaces the repealed s 309 of the Companies Act 1985 (UK), which recognised the interests of company employees in a manner similar to the position in Parke v Daily News Ltd [1962] Ch 927. Furthermore, under the repealed provision, employees were expressly denied the ability to enforce s 309. The current provision does not appear to be an improvement on the employees’ position under the 1985 Act. Note that s 247 of the current Act, similar to its predecessor, confers power upon the company to make provisions for the benefit of employees on cessation or transfer of its business – notwithstanding the provisions of s 172. 87 Paul L Davies, Gower and Davies Principles of Modern Company Law, London, Sweet & Maxwell (8th edn, 2008) at 507–8.

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The first . . . was that the existing common law duty was thought to be insufficiently precise in the guidance it gave to directors about whose interests should be promoted in the exercise of their discretion . . . the [old formulation] that directors must act in the interests of ‘the company’ comes close to being meaningless. This is because the company is an artificial legal person and it is impossible to assign interests to it unless one goes further and identifies with the company the interests of one or more groups of human persons. [The second] . . . the statutory formulation clearly rejects the ‘pluralist’ approach to the law of directors’ duties . . . however, the rule of shareholder primacy was not intended by the Government to be adopted in an unsophisticated way. Instead, the degree of overlap between the interests of the members and those of other stakeholders is emphasised through the directors’ duty to ‘have regard’ to the interests of other stakeholders . . . [giving rise to] adopting a modernised version of shareholder primacy . . .

According to the then UK Trade and Industry Secretary, Patricia Hewitt: ‘The proposals [now law] are part of a wide programme of action to boost enterprise, encourage investment and promote long-term company performance.’ Express recognition of the importance of stakeholders, and stakeholder interests, within the general business community is also reflected in a major initiative introduced in the UK in 2005. Under the Companies (Audit, Investigations and Community Enterprise) Act 2004 (UK), which received royal assent on 29 October 2004 (and came into force in July 2005),88 a new type of company called the CIC may be established. The CIC is a limited liability business form designed for enterprises that wish to use their profits and assets for the ‘public good’. The CIC is similar to the European Economic Interest Grouping (EEIG), a specialised form of incorporation facilitated by European Community law and based on the model of the French Groupement d’Int´erˆet Economique.89 According to Davies, this form of incorporation is designed to enable existing business undertakings in different EU member states to form an autonomous body to provide services ancillary to the primary activities of its members.90 The EEIG has not been popular in the UK, with as few as 185 set up there by 2006.91 The reason for the unpopularity of EEIGs, and what distinguishes the new CIC business form from the EEIG, is that members of an EEIG are not protected by limited liability; meaning that members are – personally – jointly and severally liable for its debts. Under the 2004 Act, an enterprise that wishes to be a CIC can choose one of three company forms: (1) private company limited by shares; (2) private company limited by guarantee, or (3) public limited company. Social enterprises tackle a wide range of social and environmental issues and operate in all parts 88 For proposed amendments, see Department for Business Enterprise & Regulatory Reform: Amendments to the Community Interest Company Regulations 2005 – Summary of Responses and Government Response to Consultation (2009), available at . 89 European Council Regulation 2137/85, [1985] 0.J. L199/1, Art. 16. 90 See Davies, above n 87, 27. 91 Ibid 28.

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of the economy. The introduction of CICs came about because of the UK government’s belief that social enterprises have a distinct and valuable role to play in helping create a strong, sustainable and socially inclusive economy. While CICs will provide the same certainty and flexibility as a standard company, they will be subject to a unique requirement – a so-called ‘asset lock’, limiting the ability of CICs to distribute profits to members in the form of dividends, or to distribute assets to members. This is to ensure that (subject to certain exceptions and exemptions) the assets and profits of CICs will be used for the community interest, rather than for private gain. It is intended that CICs will be subject to less formal legal requirements than charities, but will not enjoy the same tax benefits as charities. An organisation cannot be both a CIC and a charity. According to the Act, CICs are overseen by an independent regulator. The regulator has responsibility for considering CICs’ constitutions (including proposed changes) and for providing ‘general guidance’ to CICs and their stakeholders, and generally aims to maintain public confidence in CICs. As an overview, the new regulatory regime has been designed so that CICs will be: ● easy to set up, subject to adopting a suitable constitution and satisfying an objective and transparent ‘community interest’ test (the test is whether a reasonable person would consider the CIC’s activities to benefit the community) ● able to issue shares to raise investment, but the dividends paid on those shares would be capped (by the independent regulator, after consultation), to protect the ‘asset lock’ ● required to produce annual ‘community interest’ reports (which will be made publicly available) on how they have pursued their social or community objectives and how they have worked with their stakeholders. This requirement is to ensure that the community served by the CIC will have easy access to the key information on its activities ● allowed to transfer assets to other suitable organisations, such as other CICs or charities.92 It is considered that a CIC may be a suitable vehicle for an enterprise engaging in social purposes, so that shareholders, financial backers, customers and other stakeholders are clear that the enterprise is working principally for the benefit of the community rather than private gain, thus avoiding potential liability for breaches of directors’ duties, oppression or other action, for not focusing on commercial objectives and maximising profits and dividends for shareholders.93 Thus, while the UK common law continues to uphold the traditional principle that directors owe their duty to the company, and that this requires directors to 92 See ‘New Corporate Governance Laws for UK’, Corporate Law Electronic Bulletin, Lawlex, November 2004, 1.12; Department of Trade and Industry (UK), ‘An Introduction to Community Interest Companies’, December 2004, available at . 93 As at 26 April 2010, some 3630 CICs had been registered – see .

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focus on maximising profits, the recent introduction of the CIC has changed the landscape somewhat by enabling this form of company to give priority to social objectives – with non-shareholder stakeholders being the principal beneficiaries. 2.3.2.5 Canada Operators of social or community enterprises have been creatively working with the available patchwork of legal structures in Canada under provincial or federal legislation (partnerships, companies, cooperatives, non-profit organisations, registered charities) with ‘virtually no corresponding legislative or regulatory innovation’94 comparable to the position in the UK (CICs) and the USA (L3Cs). Researchers at the British Columbia Centre for Social Enterprise have made, inter alia, the following law reform recommendations in an effort to modernise the organisational infrastructure that applies to social enterprise to better enable it to flourish:95 That the Government of Canada enact a Community Enterprise Act, which ● draws upon the best of the recent legislative innovations in the UK (CICs) and the USA. That this Community Enterprise Act enable new organisations to incorpo● rate as ‘Community Enterprises’ – similar to CICs in the UK. They should have the capacity to issue shares to investors, subject to limitations on scope of activities and on investment returns, and a capital lock to ensure that assets remain primarily for community benefit. That this Community Enterprise Act should define ‘community benefit’ ● and provide a mechanism for entities incorporated under other federal or provisional legislation that meet that test to be eligible for favourable tax treatment and other incentives the government may decide to establish. The impetus for the above call to law reform comes from the global financial crisis of 2008 and the preceding fundamental economic changes in Canada (such as the potential collapse of the automotive manufacturing industry) which, according to Bridge and Corriveau,96 underscores the urgency of the need to adopt and redesign the ways in which the economy and communities function. In their view, as the old industrial model will not return in its old form, social enterprise should be at the forefront of this redesign. 2.3.2.6 New Zealand New Zealand has, under its Companies Act 1993, a provision similar to the nowrepealed section 309 of the Companies Act 1985 (UK), although it is expressed slightly differently. Section 132(2) of the New Zealand Act states: 94 Richard Bridge and Stacey Corriveau, Legislative Innovations and Social Enterprise: Structural Lessons for Canada, BC Centre for Social Enterprise (February 2009) 3, available at . This article provides a useful overview of legal structures available for blended enterprise in North America. 95 Ibid, 12–13. 96 Ibid, 2.

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The constitution of a company may provide that a director may, when exercising powers or performing duties as a director, act in a manner which he or she believes on reasonable grounds is in the best interests of a shareholder or group of shareholders, or any other entitled persons, notwithstanding that such action may not be in the best interests of the company. (emphasis added)

Section 132(2) is expressed such that ‘any other entitled persons’ could presumably include creditors, employees, charitable organisations, perhaps even society at large or the environment, depending on how the relevant provision in the company’s constitution is framed. The section therefore appears to embrace a wider range of stakeholders, and is not limited to employees. Like the repealed section 309 of the UK Act, section 132(2) may appear at first glance to transcend the narrow confines of the common law and provide directors with a licence to place stakeholder interests ahead of the interests of the company and its shareholders. But, again, a closer analysis demonstrates otherwise. Section 132(2) does not establish fresh directors’ duties towards the ‘entitled persons’ that come within the section, but simply makes it clear that the interests of these ‘entitled persons’ can be taken into account by directors as part of their function of administering the company in the company’s best interests (meaning, with a view to achieving profits). That is, section 132(2) is only a clarification of the existing position at common law, rather than an alteration of the law. Similar confirmation of the interests that directors can take into account when performing their functions could be obtained through reference to judicial decisions. Furthermore, the reference in section 132(2) to the ability of companies to specify in the constitution the manner in which directors can exercise their duties provides no additional power to companies, but again simply confirms the position at common law, reinforced by statutory provisions. In Australia, at common law and supplemented by general statutory provisions,97 the company has tremendous freedom (subject to approval by shareholders via a special resolution) to structure its constitution to determine the corporate governance rules and procedures it will follow, and in doing so shape the nature and content of the duties of directors98 – see Chapter 4. The company’s constitution can set out the manner in which the duties of its directors shall be performed, and whose interests may be be considered when performing these duties, even if this departs from the traditional conception of how the particular duties are to be exercised99 – although the company and 97 See s 136 of the Corporations Act 2001 (Cth), which sets out that the company’s constitution can be adopted or modified, and does not expressly prohibit any particular clauses or matters being dealt with by the company in its constitution. 98 See Robert Baxt, Keith Fletcher and Saul Fridman, Corporations and Associations: Cases and Materials, Sydney, LexisNexis Butterworths (10th edn, 2009) 299: ‘ . . . by and large a company may control its own destiny by the terms of its constitution’. 99 See R P Austin and I M Ramsay, Ford’s Principles of Corporations Law, Chatswood, LexisNexis (14th edn, 2010) 459 para 8.370: ‘It is a central principle of the law of fiduciaries that the principal may authorise the fiduciary to engage in conduct which would otherwise be a breach of fiduciary duty, and may condone or ratify

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its directors must refrain from conduct that may be considered oppressive or unfairly prejudicial to a particular shareholder or class of shareholders (see Part 2F.1 of the Corporations Act, and Chapter 12 of this book).100 Indeed, there is an inherent logic in allowing modification of directors’ duties through the provisions of the company constitution. As the duties are owed to the company, the company (through the general body of shareholders passing a special resolution to support a constitutional amendment) should be allowed some say as to how these duties will apply (if at all) to their directors. Confirming that the company can use its constitution to determine how directors may act when performing their duties, which section 132(2) does, could be described as legislative overkill.

2.3.2.7 South Africa In September 2009, a new King Report was released, also known generally as the King III Report.101 The King Report (2009) is accompanied by a separate volume, ‘King Code of Governance Principles for South Africa 2009’. The main difference between King Report (2002)102 and the King Report (2009) is that the latter is much shorter and concentrates more on the principles of corporate governance than by comprehensive discussion of the principles. Most of the principles discussed in the King Report (2002) still form part of the King Report (2009). The King Report (2002) is a comprehensive document that sets in place guidelines for best practice in corporate governance in South Africa. The King Report was first released in 1994, and then revised in 2002 and, as mentioned, it is the King Report (2009) that will apply in South Africa in future. When first released, the King Report was revolutionary, in providing a very clear and extensive explanation of how companies in South Africa should account for the interests of stakeholders, and articulating the benefits that such an ‘inclusive approach’ to governance could provide companies. Indeed, so-called ‘integrated sustainability reporting’ was recognised over and above the financial and regulatory aspects of corporate governance. The King Report (2002) acknowledged a shift away from the single ‘bottom line’ (meaning, the approach of businesses focusing on generating profits for shareholders) to a triple bottom line, which embraces the economic, a breach which has already occurred.’ Also, in the specific context of the duty of directors to avoid conflicts of interests, it is noted that in large companies it is common for a company to alter the content of the duty to avoid conflicts so that conflicts do not need to be put to the general meeting for a vote: [9.120]. However, [8.385] of Ford’s Principles of Corporations Law notes that there are arguments as to why the equivalent statutory duties should not be as easy to ‘opt out’ of, although case law in Australia has not endorsed these arguments. 100 See also Gambotto v WCP Ltd (1995) 182 CLR 432; Ian Ramsay (ed.), Gambotto v WCP Limited: Its Implications for Corporate Regulation, Melbourne, Faculty of Law, The University of Melbourne (1996). 101 King Report on Governance for South Africa 2009 (King Report (2009)), Johannesburg, Institute of Directors (2009), available at . 102 King Report on Corporate Governance (King Report (2002)), Parktown, South Africa, Institute of Directors in Southern Africa (March 2002).

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environmental and social aspects of a company’s activities. The concepts of ‘sustainability’ and the ‘triple bottom line’ are used interchangeably in the report. In accommodating the interests of stakeholders, by ‘recognising the importance of the relationship between an enterprise and the community in which it exists’, the revised Report states that integrated sustainability reporting is to be achieved as follows: 2.1: Every company should report at least annually on the nature and extent of its social, transformation, ethical, safety, health and environmental management policies and practices. 2.2: The board of directors should, in determining what is relevant for disclosure, take into account the environment in which the company operates. 3.1: A company should demonstrate its commitment to organisational integrity by qualifying its standards in a code of ethics. 3.2: Each company should demonstrate its commitment to its code of ethics by: ● creating systems and procedures to introduce, monitor and enforce its ethical code; ● assessing high level individuals to oversee compliance with the ethical code; ● assessing the integrity of new appointees in selection and promotion procedures; ● exercising due care in delegating discretionary authority; ● communicating with and training all employees regarding enterprise values, standards and compliance procedures; ● providing, monitoring and auditing safe systems for reporting of unethical or risky behaviour; ● consistently enforcing appropriate discipline; ● responding to offences and preventing reoccurrences. Chapter 8 of the King Report (2009) deals extensively with ‘governing stakeholders’ relationships. In Chapter 9 of the King Report (2009) the important issue of ‘Integrated reporting and disclosure’ is discussed. The King Report (2009) deals with ‘emerging governance trends’ incorporated in the Report, focusing on:103 ● Alternative dispute resolution; ● Risk-based internal audit; ● Shareholders and remuneration; and ● Evaluation of board and director performance. The new issues included in the King Report (2009) are:104 ● Information technology governance; ● Business rescues; and ● Fundamental and affected transactions. 103 King Report (2009), above n 101, 11–14. 104 Ibid 14–17.

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2.4 Stakeholder interests, good governance and the interests of the corporation: A mutual relationship 2.4.1 General analysis How does taking into account, and protecting, the interests of stakeholders contribute towards good corporate governance? Can taking into account a broad constituency of interests actually lead to poor corporate governance? Whether or not an integrated approach to managing the corporation is consistent with good corporate governance, and in the best interests of the corporation, is a question upon which divergent views are held, and upon which – especially recently – there has been a great deal of commentary. While the virtue of protecting the interests of the collection of stakeholders is generally acknowledged, there are some who believe that any approach to corporate governance that departs from a strict wealth-maximisation view is simply unworkable. For example, Mallin contends: Another very important point is that if the directors of a company were held to be responsible to shareholders and the various stakeholders groups alike, then what would be the corporate objective? How could the board function effectively if there were a multiplicity of different objectives, no one of which took priority over the others? . . . This could actually lead to quite a dangerous situation where directors and managers were not really accountable.105

In a similar vein, Thomas Clarke writes that: The difficulty is whether in trying to represent the interests of all stakeholders, company directors simply slip the leash of the only true restraint that regulates their behaviour – their relationship with shareholders. In apparently seeking to become the arbiter of the general interest, all that occurs is that executives become a selfperpetuating group of princes.106

In our view, an integrated approach to corporate governance, by which directors and management not only consider the impact that company decisions will have on the bottom line but also the broader social, political and economic impacts of the decision, is desirable and is the most effective way to ensure that a company achieves long-term, sustainable growth. This section of the chapter briefly explores the importance of ‘redefining the corporation’ by integrating stakeholder interests as a component of managing the corporation. The recent James Hardie asbestos scandal in Australia, in which James Hardie’s parent company ultimately agreed to provide compensation to asbestos victims (who could be viewed as employees, creditors or both) even though there was no clear 105 Mallin, above n 8, 58. 106 Thomas Clarke, ‘The Stakeholder Corporation: A Business Philosophy for the Information Age’ in Theories of the Corporation: The Philosophical Foundations of Corporate Governance, London, Routledge (2004) 189, 193.

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legal obligation to do so, is used as a case study highlighting how adoption of an integrated approach to management is more in tune with the best interests of the corporation over the long term than taking a short-term, narrow focus on the company’s share price and what is best for shareholders. In Redefining the Corporation – perhaps the most important work so far this decade on the role of stakeholders in corporate governance, and mentioned earlier in this chapter – the authors explain that: The modern corporation is the center of a network of interdependent interests and constituents, each contributing (voluntarily or involuntarily) to its performance, and each anticipating benefits (or at least no uncompensated harms) as a result of the corporation’s activities.107

Indeed, a field of ‘stakeholder management’ has emerged as a distinctive component of strategic management, out of recognition of how so-called ‘stakeholder linkages’ can contribute to organisational wealth and to the overall well-being and success of the corporation. Most of the constituents in the corporation are essential to the operations of the corporation because they contribute inputs, receive outputs, or – whether actively or passively – provide its ‘license to operate’ as an institution within the economy and society.108 Post, Preston and Sachs express the positive interrelationship between respect for stakeholder interests and the best interests of the corporation, as follows: Although the ultimate justification for the existence of the corporation is its ability to create wealth, the legitimacy of the contemporary corporation as an institution within society – its social charter, or ‘license to operate’ – depends on its ability to meet the expectations of an increasingly numerous and diverse array of constituents. The modern, large, professionally managed corporation is expected to create wealth for its constituents in a responsible manner (that is, not by theft or deception). The connection between wealth and responsibility has been stressed by both business leaders and critics for more than a century, and if the corporation can continue to survive and succeed today it must continue to adapt to social change.109

In presenting the case for a ‘stakeholder model’ of the corporation, based on their wider definition of ‘stakeholder’110 (discussed earlier in this chapter), Post and colleagues argue that there are two principal reasons to reassess and redefine the large, well-established corporation to accommodate or integrate stakeholder interests: 1. Size and socioeconomic power – Leading global corporations have access to vast resources (including specialised knowledge), overwhelming bargaining power with respect to most of their constituents, and extraordinary ability to influence their environments. They are not microscopic economic actors at the mercy of market forces and omnipotent governments. 107 108 109 110

Post, Preston and Sachs, above n 9, 8. Ibid 229. Ibid 9. Ibid 10.

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2. Inaccuracy of the ‘ownership’ model and its implications – Shareowners hold securities, but they do not own the corporation in any meaningful sense, nor are they the only constituents vital to its existence and success. The notion that shareowner interests should dominate those of all other corporate constituents is inconsistent with the observed behaviour of successful firms. Therefore, the conventional shareowner-dominant model of the corporation is unrealistic, as well as normatively unacceptable.111 In light of the above reasons, Post, Preston and Sachs then emphasise the commercial imperative of stakeholder management, stating: The corporation requires and receives inputs, some of them involuntary, from multiple sources, and has an impact on many constituents, favourable or otherwise. The corporation cannot – and should not – survive if it does not take responsibility for the welfare of all of its constituents, and for the well-being of the larger society within which it operates.112

And further: In democratic political systems, which are uniquely hospitable to market-oriented economic arrangements, no business activity that causes substantive negative impact on any significant group of people or interests can be expected to survive, unless it offers conspicuous and broadly distributed offsetting benefits.113

In addition to the significant work undertaken by the ‘Redefining the Corporation’ project in alerting interested observers to the important link between recognition of stakeholders and good corporate governance and performance, the OECD Principles of Corporate Governance is another excellent source in this area. See discussion above and in Chapter 1. The article by Steve Letza, Xiuping Sun and James Kirkbride114 explains that this consequentialist view of stakeholder management, stressing the important connection between protecting stakeholder interests and good corporate governance and performance, is referred to in the management literature as ‘instrumental stakeholder theory’ – as distinct from social entity theory (a general theory that the company should serve multiple stakeholder interests).115 According to Letza and colleagues, rather than justifying stakeholder interests on the basis of moral value and fundamental human rights, the ‘instrumental stakeholder theory’ legitimises stakeholder value on the grounds that stakeholder management is an effective means to improvement of efficiency, profitability, competition and economic success. 111 112 113 114 115

Ibid 10–11. Ibid 16. Ibid 21. Letza, Sun and Kirkbride, above n 4, 242. Ibid 251.

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2.4.2 Case study of James Hardie’s asbestos compensation settlement116 The James Hardie asbestos scandal – which filled Australian newspapers in 2004 and was the subject of a Special Commission of Inquiry117 – and the company’s historic settlement with claimants just before Christmas 2004 is an excellent case study supporting what has been stated above about the positive link between respect for stakeholder interests and good corporate governance and performance. The lessons from the James Hardie experience are not purely legal ones.118 One salient lesson concerns the need for ethical standards and increased social responsibility.119 The strategy embarked upon by James Hardie, to divest itself of its asbestos liabilities, has been described by the Australian Council of Trade Unions as ‘one of the most morally and legally repugnant acts in Australian corporate history’.120 Although the actions of James Hardie (discussed below) is not unprecedented,121 the conscience of the former directors of James Hardie, in relation to its strategic behaviour in the separation plan and the limited funding of claims by its asbestos victims, has been found to be sorely wanting.122 Some background on James Hardie and the 2004 asbestos scandal is required in order to appreciate the significance of the agreement negotiated in December 2004, and its direct relevance to the present discussion on the relationship between stakeholders and corporate governance and performance. Companies in the James Hardie group were major participants in the manufacture of asbestos products, in the 1920s, which were used extensively in Australia during the major part of the past century, particularly in building products and insulation materials. James Hardie had been responsible for 70 per cent of Australian asbestos consumption.123 Asbestos, however, is injurious to health and its fibres can give rise to asbestosis, lung cancer and mesothelioma, which is often fatal. The disease may not manifest itself immediately, and it is not uncommon for a severe medical condition to arise some decades after exposure to the asbestos fibre. Asbestosis was common in the 1920s, and the insidious effect of asbestos and its link to mesothelioma was established in 1960.124 116 The following discussion draws largely from Anil Hargovan, ‘Corporate Governance Lessons from James Hardie’ (2009) 33 Melbourne University Law Review (forthcoming). 117 David Jackson, ‘Report of the Special Commission of Inquiry into the Medical Research and Compensation Foundation’ (Jackson Report) (September 2004), available at . 118 See Chapter 10 (Directors’ duties and liability) for discussion on the legal lessons that emerged from the decisions in ASIC v Macdonald (No 11) (2009) 256 ALR 199; ASIC v Macdonald (No 12) [2009] NSWSC 714. 119 For the views of the leading advocate on corporate goals and social responsibilities, see Dodd, above n 1, 1145. 120 ABC 7.30 Report Transcript, ‘James Hardie Executives Accused of Fraud’ (29 July 2004), available at . 121 For a critical and valuable examination of the use of the limited fund strategy by the largest manufacturer and supplier of asbestos products in the USA, see Peta Spender, ‘Blue Asbestos and Golden Eggs: Evaluating Bankruptcy and Class Actions as Just Responses to Mass Tort Liability’ (2003) 25 Sydney Law Review 223. 122 Peta Spender, ‘Weapons of Mass Dispassion: James Hardie and Corporate Law’ (2005) 14 Griffith Law Review 280. 123 Jackson Report, above n 117, 59. 124 Ibid at 18.

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James Hardie Industries Ltd (now ABN 60 Pty Ltd) manufactured asbestos products until 1937, whereupon this activity was taken over by its subsidiary, James Hardie & Coy Pty Ltd (now Amaca Pty Ltd), which became a substantial producer until it ceased this business activity in the 1980s. Another business arm of the corporate group manufactured brake-lining products (formerly Jsekarb Pty Ltd, now Amaba Pty Ltd) until its sale to an independent party in 1987. These three companies in the James Hardie Group were the main participants in the manufacture and distribution of asbestos products. These companies, together with Mr Macdonald as its CEO, Mr Shafron as the company secretary and general counsel and Mr Morley as the chief financial officer (CFO), were to form the dramatis personae in the corporate reconstruction of James Hardie125 and the subsequent litigation in ASIC v Macdonald (No 11) (2009) 256 ALR 199 discussed in Chapter 10. Impetus for corporate restructure A switch in business focus to the USA, and the development of new, non-asbestos products in the 1980s proved successful for the James Hardie Group and provided the impetus to separate the accruing asbestos liabilities in Australia from the Group’s core business in the USA. The impetus to divest itself of its asbestos liabilities also came from the desire of the Group to remove what it perceived as an obstacle to its aspirations to access the capital market in the USA. An aborted attempt to issue 15 per cent of the shares of a related Dutch company (JH NV) on the New York Stock Exchange added to the impetus for a corporate restructure to ‘fully realise the value of JHIL, and for its growth prospects to be realised’126 by adopting the USA as the Group’s base. Without separation of the asbestosrelated liabilities on its balance sheet, it was thought that listing in the USA was commercially unrealistic.127 Three other influential factors impacted on the momentum towards corporate reconstruction and its timing. The first factor included the desire to avoid the impact of a proposed new Australian Accounting Standard, due to come into force in October 2001, which would require disclosure of the total of the Group’s estimated asbestos liabilities.128 The second factor was the desire to capitalise on the timing of the announcement of the Group’s third quarter results to the market on 16 February 2001.129 It was envisaged that simultaneous announcement of the Group’s profits, together with the corporate restructure plan, would deflect from a controversial issue that might otherwise attract undesirable publicity. The third factor related to the effluxion of time and the Group’s new business and stewardship of the business. Within this context, the James Hardie Group’s 125 There have been many changes in the identity and names of the James Hardie companies over the years. This chapter, however, refers to the three companies relevant for purposes of this discussion as James Hardie Industries Ltd (JHIL), Amaca and Amaba. 126 Jackson Report, above n 117, 24. 127 Ibid 340. 128 Ibid 25. 129 Ibid 26, 351.

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asbestos liabilities were treated as ‘non-core issues’,130 a source of ‘management distraction’131 and regarded as ‘legacy issues’132 that formed ‘part of the rump’.133 Against this backdrop of corporate aspiration and apparent indifference to the fact that the James Hardie Group remained accountable for negligence in the manufacture or distribution of asbestos products over the past century, notwithstanding cessation of that business, the Group marched forward with a separation plan that was poorly executed, as illustrated below.

Key features of the separation plan In the period from 2000 to 15 February 2001, management of JHIL worked on a plan (known as Project Green) to divest the Group of its asbestos liabilities through the use of a trust structure in the following way. Amaca and Amaba were to remain responsible to claimants for asbestos-related liabilities, to the extent of their existing assets, but ownership of both these companies would pass from JHIL to a new company unrelated to JHIL, known as the Medical Research and Compensation Foundation Ltd (Foundation) which would operate as a trust. The Foundation, a company limited by guarantee, became the trustee of the Foundation trust. New directors were appointed to the trust and to Amaca and Amaba. The structure adopted sought to exploit the benefits of the separate legal entity rule134 and limited liability ordinarily conferred on companies by the corporate veil and extended to corporate groups.135 Furthermore, as part of the concerted effort to quarantine JHIL from its asbestos liabilities, the following arrangements were put in place. In return for payments to be made over time by JHIL to each of Amaca and Amaba, JHIL was to be indemnified by both these companies against any asbestos-related liabilities that JHIL might have. Moreover, both these companies agreed to forego any claims against JHIL arising from any past dealings with it, including the payment of dividends or management fees. Recovery of such intra-group payments

130 Ibid 19. 131 Ibid. 132 Ibid. 133 Ibid. 134 Salomon v Salomon & Co Ltd [1897] AC 22. 135 Walker v Wimborne (1976) 137 CLR 1; Industrial Equity Ltd v Blackburn (1977) 13 CLR 567. The question whether existing laws concerning the operation of limited liability or the corporate veil within corporate groups requires reform is explored in a wealth of literature. See, for example, F Easterbrook and D Fischel, ‘Limited Liability and the Corporation’ (1985) 52 University of Chicago Law Review 89; P Blumberg, ‘Limited Liability and Corporate Groups’ (1986) 11 Journal of Corporation Law 573; P Blumberg, ‘The Transformation of Modern Corporation Law: The Law of Corporate Groups’ (2005) 37 Conn L Rev 605; K Strasser, ‘Piercing the Veil in Corporate Groups’ (2005) 37 Conn L Rev 637; James McConvill, ‘Revisiting Holding Company Liability For Subsidiary Company Debts in Australia: A Response To The James Hardy Controversy’ (2005) 7 The University of Notre Dame Australia Law Review 23; Anil Hargovan and Jason Harris, ‘Piercing the Corporate Veil in Canada: A Comparative Analysis’ (2007) 28 The Company Lawyer (UK) 58; P Prince, J Davidson and S Dudley, ‘In the Shadow of the Corporate Veil: James Hardie and Asbestos Compensation’ (2004), available at . The deficiencies in Australian corporate law concerning the operation of limited liability within corporate groups were noted in the Jackson Report, above n 118, 571–3.

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was barred by a deed of covenant and indemnity (DOCI) entered into by the contracting parties.136 Public announcement of the separation The events surrounding the public announcement of the separation were also germane to the litigation in ASIC v Macdonald (No 11) (2009) 256 ALR 199. The draft ASX announcement media, which ASIC alleged was before the board on 15 February 2001137 and which was subsequently released to the public on 16 February 2001, was an integral part of the public relations planning in relation to the separation. The theme of certainty of sufficient funding pervaded this, and future, media statements that became the focus of attention in the Macdonald litigation, discussed further in Chapter 10. The final ASX announcement included, inter alia, the following statements, which ASIC alleged to be false or misleading and the basis of the directors’ breach of the statutory duty of care and diligence in section 180(1) of the Corporations Act 2001 (Cth):138 The Foundation has sufficient funds to meet all legitimate compensation claims . . . Mr Peter Macdonald said that the establishment of a fully-funded Foundation provided certainty for both claimants and shareholders . . . In establishing the Foundation, James Hardie sought expert advice . . . James Hardie is satisfied that the Foundation has sufficient funds to meet anticipated future claims . . .

Scheme of arrangement and relocation to The Netherlands After the establishment of the Foundation in February 2001, steps were implemented in October pursuant to a scheme of arrangement139 to substitute a new Dutch company (JHI NV) for JHIL as the holding company of the Group – with JHIL becoming a wholly owned subsidiary of JHI NV. The impetus for the move to the Netherlands centred on the prospect of further international growth for the Group, as well as being in the best interests of the shareholders as a whole due also to the improvement in the after-tax returns to shareholders.140 A brief overview of the mechanics of the scheme is relevant to the legal issues subsequently raised in ASIC v Macdonald (No 11) (2009) 256 ALR 199. One of the main features of the scheme involved JHI NV subscribing for partly paid shares in JHIL. Consequently, JHIL could call on its holding company to pay any or all of the remainder of the issue price of those shares at any time in the future. Significantly, the amount callable under the partly paid shares would be equal to the market value of the James Hardie Group less the subscription monies already 136 The events surrounding the execution of the separation plan were relevant to the litigation in ASIC v Macdonald (No 11) (2009) 256 ALR 199. 137 This point was contested, unsuccessfully, by the 10 former directors and officers who claimed that they had no recollection of this document being tabled at the board meeting. See further, Macdonald (2009) 256 ALR 199, 239–44. 138 Ibid 229–30. 139 Corporations Act 2001 (Cth) s 411. 140 Jackson Report, above n 117, 33. James Hardie, ironically, offered a similar reason for its plan to move its corporate domicile from the Netherlands to Ireland following approval by the Federal Treasurer, but subject to approval of a meeting of shareholders anticipated in early 2010. ‘James Hardie Cleared for Ireland Move’ Sydney Morning Herald (22 September 2009).

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paid up. This sum was considerable and was likely to be in the region of $1.9 billion.141 The significance of this feature of the scheme was underscored when JHIL assured Justice Santow, during the application for approval of the scheme in the New South Wales Supreme Court in October 2001, that JHIL had the ability to satisfy any asbestos-related liabilities by calling upon the partly paid shares.142 The cancellation of the partly paid shares, and the formation of a new foundation in March 2003 to acquire the shares in JHIL, ensured the complete removal of JHIL from the James Hardie Group. The subsequent failure to inform the public immediately of this development also became the focus of attention in the Macdonald litigation. It is against this background of the very large discrepancy between the initial funding of the Foundation and the actuarial assessments of its liabilities that gave rise to controversy and the appointment of the Commission of Inquiry. Concerns above the adequacy of arrangements available to the Foundation to meet its liabilities were also underscored by its application to court143 to seek relief that would permit payments to claimants in full, notwithstanding statutory provisions that prohibit insolvent trading.144

Jackson Report and its significance Because of the emerging crisis facing the Foundation and asbestos victims, in February 2004 the New South Wales Government set up a Special Commission of Inquiry, chaired by David Jackson QC, to put on the record how the crisis had developed, who was responsible, what had gone wrong and why, with a view to determining whether imposing liability on the ultimate holding company of James Hardie was an appropriate and reasonable course of action to take. Specifically, Commissioner Jackson was to report on: 1.1 the current financial position of the Foundation, and whether it was likely to meet its future asbestos related liabilities in the medium to long term 1.2 the circumstances in which the Foundation was separated from the James Hardie Group, and whether this may have resulted in or contributed to a possible insufficiency of assets to meet its future asbestos-related liability 1.3 the circumstances in which any corporate reconstruction or asset transfers occurred within or in relation to the James Hardie Group prior to the separation of the Foundation from the James Hardie Group, to the extent that this may have affected the ability of the Foundation to meet its current and future asbestos-related liabilities 141 Ibid 34. 142 Management of JHIL did not alert the court of the Foundation’s concerns over the inadequacy of the initial funding and the Foundation’s fears of being unable to meet the claims of all asbestos victims that were expressed by the Foundation in a director’s letter dated 24 September 2001. Justice Santow approved the scheme under these circumstances. 143 Edwards v Attorney General (NSW) (2004) 50 ACSR 122; [2004] NSWCA 272. 144 Corporations Act 2001 (Cth) s 588G.

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1.4

the adequacy of current arrangements available to the Foundation under the Corporations Act to assist the Foundation to manage its liabilities, and whether reform is desirable to those arrangements to assist the Foundation to manage its obligations to current and future claimants.145 The first, and most important, term of reference dealt with in the Report related to ‘the circumstances in which MRCF [the Foundation] was separated from the James Hardie Group and whether this may have resulted in or contributed to a possible insufficiency of assets to meet its future asbestos-related liabilities’. Commissioner Jackson explained in his report that the restructuring of the James Hardie Group and the separation of the asbestos-liable subsidiary companies – Amaca and Amaba – from the Group was not illegal, and indeed was a valid arrangement by the company, with a view to elevating its share price and attracting capital from the USA. Commissioner Jackson did find, however, that the separation from the Group was a cause of the Foundation’s dilemma, and that on the facts the Group did bear some responsibility for this. The Commissioner remarked incredulously: ‘ . . . I find it difficult to accept that management could really have believed that the funds of the Foundation would have been sufficient . . . yet that was the message that JHIL propounded . . . the day after separation, to the Australian Stock Exchange (ASX), to government, the media, its shareholders, unions, plaintiffs’ solicitors, asbestos victims and anybody else it felt the need to convince.’146

Later in the Report, Commissioner Jackson stated that: . . . there was no legal obligation on JHIL to provide Amaca and Amaba, on separation, with any funds in addition to the assets of those companies. Amaca and Amaba were not stripped of assets; they retained them. Indeed they obtained more than those assets by reason of the additional periodic payments . . . But in practical terms, separation was, in my opinion, likely to have an effect of that kind. If separation had not taken place in February 2001, it seems likely that, for the indefinite future, the asbestos liabilities would have been treated, as they had been for years, as one of the annual expenses of the Group.147

After the wide-ranging enquiry on the financial position of the Foundation, its likelihood to meet its asbestos-related liabilities into the future and the circumstances of the corporate reconstruction of James Hardie, Commissioner Jackson came to the following conclusions that are relevant for the purposes of this discussion and the litigation in ASIC v Macdonald (No 11) (2009) 256 ALR 199, discussed in Chapter 10: ● As at 30 June 2004, liabilities of the Foundation were estimated at not less than $1.5 billion. Against that, the value of the total assets acquired by the Foundation was $293 million;148 145 146 147 148

See Jackson Report, above n 117, Part A, 1. Ibid [1.1.4]. Ibid [1.23] (emphasis added). Ibid, 8.

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There was no prospect of the Foundation meeting the liabilities of Amaca and Amaba in either the medium or long term due to the rapid depletion of the funds used in the payment of current claims149 and that the life of the Foundation was about three years or a little less;150 ● The actuarial report produced by Trowbridge (February 2001) provided no satisfactory basis for the assertion that the MRCF [the Foundation] would have sufficient funds to meet all future claims;151 ● The evidence demonstrated that the February 2001 estimates of future liabilities were ‘far too low and that the results of the financial modelling were wildly optimistic’;152 ● The public announcements made by JHIL at the time of separation (16 February 2001) emphasised that JHIL had provided for a Foundation which had sufficient funds to satisfy all future legitimate asbestos-related claims;153 ● The media release sent to ASX, conveying the idea of ‘certainty’ with respect to the Foundation’s funding, was seriously misleading and also conveyed the misleading impression that the funding amount JHIL arrived at was checked by independent experts;154 ● Contrary to the claims in the media release sent to ASX, the Foundation was not ‘fully-funded’. It was massively under-funded;155 and ● The JHIL board meeting of 15 February 2001 approved ASX announcement to be made by JHIL.156 This view, however, was unsuccessfully challenged by the board in Macdonald despite the absence of direct evidence of board approval. The company’s patent failure to observe CSR norms was crystallised in the Jackson Report with the following observation:157 ●

The notion that the holding company would make the cheapest provision thought ‘marketable’ in respect of those [asbestos] liabilities so that it could go off to pursue its other more lucrative interests insulated from these liabilities is singularly unattractive. Why should the victims and the public bear the cost not provided for?

Aftermath Despite the fact that it was made clear in the Special Commissioner’s report that James Hardie had no legal obligation to make up for the shortfall of funds in the Foundation, the company was pressured to do so by a sliding share price and the implementation of government bans on the purchase of James Hardie products, as well as by the threat of specific legislation being introduced to, in effect, unwind 149 150 151 152 153 154 155 156 157

Ibid 7. Ibid 63. Ibid 9. Ibid 12. Ibid 8. Ibid 10. Ibid 356. Ibid 351. Ibid 13.

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the company’s 2001 restructure so that liability could be imposed on the parent company. Accordingly, over a period of 13 weeks following the handing down of Commissioner Jackson’s report, James Hardie entered into negotiations with the New South Wales Government and the Australian Council of Trade Unions (ACTU) to find a mutually satisfying way to resolve the impending funding crisis. The willingness of James Hardie to agree to negotiations was significant, given that the predominant reason for its move to the Netherlands in 2001 was, allegedly, to avoid having to fund the asbestos claims. On 21 December 2004, an agreement between James Hardie, the ACTU and the New South Wales Government was announced. The agreement detailed the way in which James Hardie would compensate asbestos victims for at least 40 years. James Hardie agreed to make annual payments to a special-purpose fund, capped at 35 per cent of its free cash flow. Initially, James Hardie agreed to inject into the special-purpose fund three years’ worth of funding (approximately $240 million).158 The total value of the agreement was estimated to be as high as $4.5 billion.159 The decision by James Hardie to negotiate a settlement was obviously designed with shareholder interests in mind, with the agreement seen as a way to improve the company’s economic and share price performance – indeed, on the day of the announcement the company’s share price rose by 6 per cent and a number of boycotts on James Hardie products were lifted. It was, in effect, the lesser of two evils (the other option being specific legislation). Nevertheless, commentators emphasised that there was also a moral element to the agreement. One commentator described the James Hardie episode as ‘one of Australia’s most protracted and bitter fights for moral justice [by] James Hardie Industries signing the nation’s largest compensation settlement, worth up to $4.5 billion’.160 Indeed, James Hardie’s CEO, Meredith Hellicar, described the agreement as a ‘compassionate’ outcome.161 Another commentator stated: This year’s Special Commission found there was ‘no fundamental legal impediment’ to what Hardie did before it moved offshore; divorce itself from subsidiaries that had manufactured building products and brake linings containing the deadly fibre. Hardie therefore gets some credit for negotiating a new funding deal and not relying on the letter of the law to try to avoid its moral responsibility. Only some, however, because it had next to no choice.162

As alluded to above, James Hardie provides a significant recent case study of a large corporation recognising and embracing the importance of stakeholder 158 See Anthony Marx, ‘Accord Fires Up Hardie’, The Australian (Sydney) (22 December 2004). 159 See ‘James Hardie Signs Compo Deal’, The Australian (Sydney) (21 December 2004). 160 See Roz Alderton, Bianca Wordley and Kaaren Morrissey, ‘Hardie Agrees to $4.5bn Payout’, The Age (Melbourne) (22 December 2004). 161 In response, Peta Spender, above n 122, 292 makes the following observation: ‘I suppose I have a different understanding of compassion as a spontaneous response to the human condition rather than one based on institutional pressure.’ 162 Malcolm Maiden, ‘Cost of Asbestos Exposure Does Not End Here’, The Age (Melbourne) (22 December 2004).

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management from the point of view of corporate performance and good governance. Through the historic agreement reached in December 2004, the interests of some of the company’s stakeholders – the increasing number of claimants who had contracted asbestos-related diseases from James Hardie products – were placed above the short-term interests of shareholders. Reference to the historic agreement being a ‘moral’ development emphasises the point that James Hardie has aligned itself with a stakeholder model of governance; a consistent theme in stakeholder literature is that there is considered to be an ‘intrinsic moral value in business operation’.163 As a result of the agreement, the company’s performance and future prospects have improved. The company’s share price gained ground after deteriorating to historic lows during the course of the Special Commission inquiry; the September 2004 bans on the purchase of company products have been lifted; and representatives of union organisations appear to be prepared to deal with the company. It is hoped that the James Hardie affair will generate a genuine change of culture within organisations.164 This historic agreement, the largest personalinjury settlement in Australian history, could potentially represent – or at least heavily influence – a turning of the tide in the attitude of management towards stakeholder interests, with companies genuinely appreciating the intrinsic value of an integrated approach to management – as opposed to regarding recognition of stakeholder interests (through codes of conduct etc.) as a mere compliance burden. It is an important case study that highlights how embracing a stakeholderoriented approach to management can ultimately be more beneficial to shareholders than a narrowly focused approach of maximising wealth in the short term. As Robert E Wood, CEO of Sears in the 1980s, once said, in explaining why his company adhered to a stakeholder model of governance, ‘shareholders’ long-term project [can] be enhanced by satisfying the needs and expectations of other stakeholders’.165 The Commissioner’s Report (2004) had a direct bearing on ASIC’s decision to launch civil penalty proceedings in February 2007 against James Hardie, its directors and officers. The Jackson Report was used as a springboard to launch further investigations into the activities of the James Hardie Group. ASIC investigated the conduct of JHIL and that of both executive and non-executive directors, and sought court declarations that a range of directors and officers had breached their duties owed to JHIL.166 The practical application of the scope and content of directors’ and officers’ duties, particularly the statutory duty of 163 Letza, Sun and Kirkbride, above n 4, 253. 164 For an exploration of the concept of corporate responsibility and its relationship with international human rights law, see Justine Nolan, ‘Corporate Responsibility in Australia: Rhetoric or Reality?’ (2007) University of New South Wales Faculty of Law Research Series 47. 165 Ibid 252–3. 166 The investigation spanned three countries (the USA, the UK and Australia) and it involved about 348 billion documents, 72 examinations and the issuing of 284 notices to obtain evidence: ASIC, ‘ASIC Commences Proceedings Relating to James Hardie’ (Media Release 07–35, 15 February 2007), available at .

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care and diligence, was one of the essential tasks requiring judicial determination in ASIC v Macdonald (No 11) (2009) 256 ALR 199, which is addressed in Chapter 10.

2.5 CSR and directors’ duties This part of the chapter addresses general concerns when seeking to achieve the correct balance in corporate governance regulation and then focuses, in particular, on the key issue of whether Australian law reform is desirable in order to clearly articulate the duties of company directors. The ASX Best Practice Recommendations document itself recognises that there are different sources of legal obligations – apart from company law rules and corporate governance principles – designed to ensure that corporations are obliged to take into account the interests of stakeholders other than shareholders: Most companies are subject to a number of legal requirements that affect the way business is conducted. These include trade practices and fair dealing laws, consumer protection, respect for privacy, employment law, occupational health and safety, equal employment opportunities, superannuation, environment and pollution controls. In several areas, directors and officers are held personally responsible for corporate behaviour inconsistent with these requirements, and penalties can be severe.167

The OECD Principles of Corporate Governance recognise the danger in seeking to over-use corporate governance regulation in order to achieve corporate governance objectives: Corporate governance requirements and practices are typically influenced by an array of legal domains, such as company law, securities regulation, accounting and auditing standards, insolvency law, contract law, labour law and tax law. Under these circumstances, there is a risk that the variety of legal influences may cause unintentional overlaps and even conflicts, which may frustrate the ability to pursue key corporate governance objectives. It is important that policy-makers are aware of this risk and take measures to limit it.168

Indeed, as explained by the Corporations and Markets Advisory Committee (CAMAC) in its May 2005 discussion paper, ‘Personal Liability for Corporate Fault’, in addition to companies, company directors can be personally liable by virtue of their position as directors under a raft of federal and state/territory legislation (in relation to, inter alia, environmental regulation, occupational health and safety, hazardous goods and fair trading). This complex area of the law, concerning ‘derivative liability’ of directors, is subject to ongoing review. The repeated call for law reform over the years to extend the duties of company directors was quickly countered by commentary from some of Australia’s leading corporate lawyers. For example, soon after the Special Commission of Inquiry 167 ASX, Principles of Good Corporate Governance and Best Practice Recommendations, (March 2003), available at . 168 OECD Principles of Corporate Governance, above n 5, 31.

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examining the James Hardie affair handed down its report, Bob Baxt wrote in The Australian Financial Review: . . . from time to time we have flirted with allowing wider interests to be taken into account by directors in running the company (for example, in takeovers). But, in fact, those obligations are already imposed on them and their companies in a different form. Directors of companies must obey the laws relating to environmental protection, taxation, occupational health and safety, trade practices and consumer protection as well as many others. Failure to comply with these laws not only exposes companies to potential fines but, in appropriate cases, directors and officers to potential fines or even jail. Directors who act negligently in such cases run the added risk that they will be liable for a breach of duty to act with appropriate care and diligence and may be sued by the company.169

The basic point made by Baxt and others is that if (in light of recent developments) corporate governance is to be taken seriously as a sophisticated and discrete area of legal regulation, then what is required is an examination of where corporate governance fits into the overall jigsaw of rules and regulations – rather than continuing to accept the commonly held perception that corporate governance is an intangible, ‘airy fairy’ (or what Justice Owen in the HIH Royal Commission Final Report referred to as ‘hortatory’170 ), amorphous concept that is allowed to overlap and intrude into areas already well and truly covered by discrete, self-contained areas of law. As alluded to earlier, the James Hardie scandal was the catalyst for the topic of CSR to receive renewed popular and government interest. This is not surprising, as recognised by CAMAC,171 given the prominence of corporate enterprises in contemporary society, the considerable power and influence of particular companies, the ways in which companies conduct themselves and the extent to which they are perceived to be taking responsibility for the consequences of their actions can be expected to attract continuing scrutiny. Against this backdrop, in March 2005 CAMAC was requested by the government to consider and report on a range of matters, including: Should the Corporations Act be revised to clarify the extent to which directors may take into account, or be required to take into account, the interests of specific classes of stakeholders or the broader community when making corporate decisions?

The Annotations to the OECD Principles of Corporate Governance also recognise the need to consider the interests of a range of stakeholders: 169 ‘Corporations Law a Fragile Structure’, The Australian Financial Review (19 November 2004), 55. See also Ian Ramsay, ‘Pushing the Limits for Directors’, The Australian Financial Review (Sydney) (5 April 2005), 63. Angus Corbett and Stephen Bottomley, ‘Regulating Corporate Governance’ in Christine Parker, Colin Scott, Nicola Lacey and John Braithwaite (eds), Regulating Law, Oxford, Oxford University Press (2004) 60, 65: ‘There are many different regulatory schemes which affect the conduct of directors and the system of corporate governance adopted by companies.’ 170 Owen Report, above n 20, 102 para 6.1. 171 The Social Responsibility of Corporations Report, above n 7, at [iii].

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In all OECD countries, the rights of stakeholders are established by law (e.g. labour, business, commercial and insolvency laws) or by contractual relations. Even in areas where stakeholder interests are not legislated, many firms make additional commitments to stakeholders, and concern over corporate reputation and corporate performance often requires the recognition of broader interests.172

The traditional position in Australia, as we explore further in Chapter 10, dealing with directors’ duties and liability, is that the overriding duty of directors is to act in the best interests of the company – a separate legal entity – to which they have been appointed and which they are meant to be representing. There are very limited circumstances in which Australian courts have held that directors owe a duty to creditors or individual shareholders, but almost always the expression of such a duty is qualified or followed by a statement that the ultimate loyalty of directors is to the company. Prior to the issuance of the CAMAC Report in December 2006, a parallel inquiry by the Parliamentary Joint Committee on Corporations and Financial Services (PJC) reported in June 2006 and recommended no changes to the provisions concerning directors’ duties.173 Similarly, the CAMAC Report did not support revision of the Corporations Act to either clarify or increase its width of coverage, for the following reasons:174 The Committee considers that the current common law and statutory requirements on directors and others to act in the interests of their companies . . . are sufficiently broad to enable corporate decision-makers to take into account the environmental and other social impacts of their decisions, including changes in societal expectations about the role of companies and how they should conduct their affairs . . . a non-exhaustive catalogue of interests to be taken into account serves little useful purpose for directors and affords them no guidance on how various interests are to be weighted, prioritised or reconciled.

CAMAC was also of the view that the current legal requirements for directors to act in the ‘best interests of the company’ can assist in aligning corporate behaviour with changing community expectations.175 Given this, CAMAC considered it unnecessary to amend the Corporations Act 2001 (Cth) to comport with section 172 of the Companies Act 2006 (UK) (discussed earlier) because ‘no worthwhile benefit is to be gained’.176 In fact, CAMAC thought alignment with the ‘enlightened shareholder value’ approach in the UK could be ‘counterproductive’ because in the Committees’ view ‘there is a real danger that such a provision would blur rather than clarify the purpose that directors are expected to serve. In so doing, it could make directors less accountable to shareholders without significantly enhancing the rights of other parties.’177 172 173 174 175 176 177

OECD Principles of Corporate Governance, above n 5, 46 Corporate Responsibility: Managing Risk and Creating Value, above n 73. Ibid at 3.12. Ibid. Ibid. Ibid.

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Justice Austin, writing in a non-judicial capacity, was critical of the findings in both Australian law reform reports.178 In particular, his Honour was struck by the disparities in the reasoning of both reports when compared with the depth of analysis under by the UK law reform bodies in the lead up to the passage of section 172 of the Companies Act 2006 (UK), which embodies the ‘enlightened shareholder value’ approach to directors’ duties discussed earlier.179 His Honour queried why the existing approach in Australia (for directors to act in the ‘best interests of the company’) was preferable to declaring a duty of directors to take stakeholder interests into account in the course of promoting the success of the company for the benefit of its members as a whole (as the UK Act does).180 According to his Honour:181 The ‘flexibility’ that [CAMAC] wishes to maintain [in relation to the traditional formulation of directors’ duties] is really . . . a profound lack of clarity; and I see no good reason for giving directors a discretion to do or not to do something which, on any rational public policy basis, they should be duty-bound to do . . . [CAMAC] has not given sufficient weight to the argument that a provision like s 172 will clarify the law for the benefit of everyone concerned, including directors themselves182 , fortifying them to resist the pressures of short-termism.

These contrasting perspectives on the question of whether Australian directors may or must take into account the interests of non-shareholder stakeholders continues to be a vexed issue183 and, except as regards the interests of creditors,184 there is no authoritative pronouncement at the appellate level, as noted by Justice Austin. Section 172 of the UK Act rejects a pluralist approach in favour of the ‘enlightened shareholder value’ approach, which retains the overall objective to promote the success of the company for the benefit of its shareholders. To that extent, it is arguably a better approach to the current position in Australia for the reasons proffered by Justice Austin185 – if it is accepted that the UK approach is devoid of uncertainty.186 That caveat, however, will only be known when the boundaries 178 Robert Austin, ‘Remarks on the Launching of Company Directors and Corporate Social Responsibility: UK and Australian Perspective’ (16 March 2007), available at . 179 Ibid. 180 Ibid. For exploration of directors’ duty to act in the best interests of the company, see Ian Ramsay, ‘The Duty to Act in the Best Interests of the Company (Including Creditors)’ in Directors in Troubled Times: Monograph 7 (R P Austin and A Y Bilski, eds) Sydney, Ross Parsons Centre of Commercial, Corporate and Taxation Law (2009) at 24. 181 Ibid. 182 Cf, above n 81, 577. 183 For a wide-ranging discussion on shareholders as the conduit of CSR and the capacity of the board to integrate the interests of stakeholders into corporate decision making, see the book review essay by Angus Corbett and Peta Spender, ‘Corporate Constitutionalism’ (2009) 31 Sydney Law Review 147. 184 Spies v R (2000) 201 CLR 603. 185 Cf Particia Dermansky, ‘Should Australia Replace Section 181 of the Corporations Act 2001 (Cth) with Wording Similar to Section 172 of the Companies Act 2006 (UK)?’, available at . 186 For identification of some of the uncertainties that may be associated with the construction of s 172, see The Social Responsibility of Corporations Report, above n 7, at [3.9.2].

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and operation of section 172 of the UK Act are fully tested with the passage of time.

2.6 Conclusion The inherent tension remains between the shareholder primacy theory and the stakeholder theory, famously identified in the public debate in the 1930s in the Harvard Law Review between Berle and Dodd.187 The alignment of CSR concerns with legal duties continues to be a vexed issue, particularly in light of the credit crunch, which has transformed into the global financial crisis. According to one commentator,188 ‘in the current market-based economy, directors all over the world are questioning whether corporations should exist solely to maximize shareholder profit’ and that ‘many corporate directors no longer abide by Milton Friedman’s famous declaration that a corporation’s only social responsibility is to provide a profit for its owners’. Despite the sweeping nature of these claims, which are incapable of precise measure, it is suspected that they do, however, embody some measure of truth. The stress of the current global economic crisis, and the emergence of of the ‘fourth sector’189 of the USA, UK and other economies (the ‘for-benefit’ companies that measure profitability by financial and social components) highlights the importance of CSR initiatives as a means to promote economic prosperity via long-term business expectations. The impact of this innovative development in the USA and UK on the existing business landscape (dominated by large, forprofit corporations), however, remains to be seen. In the wake of the global financial crisis, the United States government’s entanglement (or temporary partial nationalisation) of industries within the financial190 and automobile sectors191 and President Obama’s mandate for a new era of responsibility,192 Janet Kerr explores how the long-standing BerleDodd theory of the corporations debate might play out in the distressed economic climate.193 In the commentator’s view:194 187 See, for instance, Esser and Du Plessis, above n 81, at 347–51. 188 Mickels, above n 70, at 272. 189 For a description of over 20 different names used to describe activity within the fourth sector (such as ‘hybrid organisations’, ‘corporate citizenship’, ‘social enterprise’, ‘social business’ and ‘entrepreneurship’), see Mickels, above n 70. 190 IndyMac, a major mortgage lender with US$34 billion in assets, was government-owned for six months in 2008. Citigroup, one of the largest financial institutions in the world, agreed to convert US$25 billion worth of preferred stock to common stock, giving the United States government 36 per cent of the total shares in the bank. In 2008, the United States government invested US$150 billion in insurance gaint AIG and acquired almost 80 per cent ownership rights of the company. These facts are drawn from Janet Kerr, ‘A New Era of Responsibility: A Modern American Mandate for Corporate Social Responsibility’ (2009) 78 UMKC L. Rev. 327 at 336–8. 191 Ibid at 338: ‘Detroit Auto Manufacturers Received More than 17 billion dollars in Loans and Increased Government Oversight.’ 192 Barack Obama, President of the USA, Inaugural Address (20 January 2009), available at . 193 Janet Kerr, ‘A New Era of Responsibility: A Modern American Mandate for Corporate Social Responsibility’, n 189. 194 Ibid at 365.

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the interconnectedness of world economies, and the current economic crisis, [makes] it necessary to advance a new plane of discussion surrounding the debate of CSR. This discussion must not only encompass the historic debate between shareholder primacy and constituency concerns, but it must also reflect the pragmatic reality that as corporations provide services traditionally administered by governments, society will expect that boards of directors will consider non-shareholder interests.

The global financial crisis raises the pertinent question as to whether CSR, and the interests of stakeholders, are still relevant during hard economic times. On one view, in the line with the shareholder primacy model, the corporate focus should be exclusively on survival and shareholder interests. An alternate view, as espoused by the European Commission, is that CSR remains relevant during times of economic crisis and should not be jettisoned in times of economic hardship. According to the Commission, ‘overcoming the economic recession and finding solutions to our environmental and social problems must not be a zero sum game. If we make the right decisions, we can show that European leadership on social and environment issues will contribute to our competitiveness’.195 As the global financial crises plays out, it remains to be seen in which direction the pendulum will swing with regard to the conundrum over shareholder versus stakeholder interests.196 195 V P Verheugen, Speech at CSR Alliance event, 4 December 2008, available at . For a similar proposition, where it has been argued that corporate decision-making is not a ‘zero sum’ game in which the interests of one group can only be advanced at the expense of another group, see Orts, above n 70, 14. 196 For a discussion on the pivotal role of shareholder primacy in corporate law, Stephen Bottomley, The Constitutional Corporation – Rethinking Corporate Governance Ashgate, Aldershot (2007); Andrew Keay, ‘Shareholder Primacy in Corporate Law: Can it Survive? Should it Survive?’ 1 (November 2009), available at .

3 Board functions and structures There is now overwhelming evidence that the board system is falling well short of adequately performing its assigned duties. Without fundamental improvement by individual boards, the entire board system will continue to be attacked as impotent and irrelevant and the boards of troubled and failing companies will, with good reason, increasingly become the targets of not only aggrieved and angry shareholders but also employees, creditors, suppliers, governments, and the public. David SR Leighton and Donald H Thain, Making Boards Work (1997) 3.

Until they served on a board, people may well imagine that directors behave rationally, that board level discussions are analytical, and that decisions are reached after careful consideration of alternatives. Not often. Experience of board meetings, or of the activities of any governing body for that matter, shows that reality can be quite different. Directors’ behaviour is influenced by interpersonal relationships, by perceptions of position and prestige, and by the process of power. Board and committee meetings involve a political process. Bob Tricker, Corporate Governance: Principles, Policies and Practices (2008) 241.

3.1 Higher community expectation of directors 3.1.1 Initially low standards of care, skill and diligence expected of directors Directors’ statutory duties and liability are discussed in greater detail in Chapter 10. It is, however, important first to make a few observations regarding the higher community expectations of directors. Based on English precedents, it has been accepted that directors are not liable for a breach in their duty of care, skill and diligence if they merely acted negligently. One of the first indications that more than ordinary negligence was required is found in an English case decided in 1872, where it was held that directors are liable only for a breach in their duty of care, skill and diligence if they acted with crassa negligentia (gross negligence).1 This rule was confirmed

1 Overend & Gurney Company v Gibb [1872] LR HL 480 at 487, 488, 489, 493, 496 and 500.

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in a later case (1899) by Lord Lindley MR, one of the most famous English commercial Lords: The inquiry, therefore, is reduced to want of care and bona fides with a view to the interests of the nitrate company. The amount of care to be taken is difficult to define; but it is plain that directors are not liable for all the mistakes they may make, although if they had taken more care they might have avoided them: see Overend, Gurney & Co. v. Gibb (1872) LR 5 HL 480. Their negligence must be not the omission to take all possible care; it must be much more blameable than that: it must be in a business sense culpable or gross. I do not know how better to describe it.2

These sentiments were repeated in several later English cases,3 and the fact that negligence alone was not enough to hold directors liable for a breach of their common law duties or equitable duties, was also recognised in the leading Australian case, Daniels v Anderson.4 In Daniels v Anderson the majority (Clark and Sheller JJA) referred to the concept of ‘negligence’ as used in context of equitable remedies, and concluded that ‘[t]he negligence spoken of was something grosser or more culpable determined by subjective rather than objective tests’.5 The subjective test referred to by Clark and Sheller JJA alludes to the test that a director was to exercise only the care which can reasonably be expected of a person of his knowledge and experience. The combined effect of a higher requirement than ordinary negligence and the fact that subjective elements were used to judge whether a particular director was in breach of her or his duty of care, skill and diligence, ensured that it was very rare to find cases in which directors were held liable for a breach of their duty of care, skill and diligence. In Daniels v Anderson6 the court referred to the low standards of care, skill and diligence expected of directors in the past and observed that ‘[h]owever ridiculous and absurd the conduct of the directors, it was the company’s misfortune that such unwise directors were chosen’.7 There were several reasons given by the courts and commentators as to why in the past the courts were reluctant to expect high standards of care, skill and diligence of directors. Or, to 2 Lagunas Nitrate Company v Lagunas Syndicate [1899] 2 Ch 392 at 435. 3 Re National Bank of Wales Ltd [1899] 2 Ch 629 at 672; In re Brazilian Rubber Plantation and Estates Ltd [1911] 1 Ch 425; In re City Equitable Fire Insurance Company Limited [1925] 1 Ch 407 at 427. 4 (1995)16 ACSR 607 (CA (NSW)) at 657. 5 Ibid. 6 (1995) 16 ACSR 607 (CA(NSW)). 7 Ibid 658–9, which is in actual fact a reference to what was said in Turquand v Marshall (1869) LR 4 Ch App 376 at 386: ‘It was within the powers of the deed to lend to a brother director, and however foolish the loan might have been, so long as it was within the powers of the directors, the Court could not interfere and make them liable . . . Whatever may have been the amount lent to anybody, however ridiculous and absurd their conduct might seem, it was the misfortune of the company that they chose such unwise directors; but as long as they kept within the powers of their deed, the Court could not interfere with the discretion exercised by them.’ The Cooney Report Senate Standing Committee on Legal and Constitutional Affairs, Company Directors’ Duties—Report on the Social and Fiduciary Duties and Obligations of Company Directors (Cooney Report) (1989) at 20 para. 3.3 fn 2, also cites the following cases for similar sentiments: ‘Re New Mashonaland Exploration Co [1892] 3 Ch D 577 at 585 per Vaughan Williams J; Re Forest of Dean Coal Mining Co (1878) 10 Ch D 450 at 453 per Jessel MR; Re Faure Electric Accumulator Co (1888) 40 Ch D 141 at 152 per Kay J. See J Dodds, ‘New Developments in Directors Duties – The Victorian Stance on Financial Competence’ (1991) 17 Monash University Law Review 133 at 133 and 134–6.

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put it differently, why the courts were reluctant to scrutinise closely the business decisions taken by directors. Some of the reasons given were that: ● taking up a position as non-executive director on a part-time basis was simply ‘an appropriate diversion for gentlemen but should not be coupled with onerous obligations’8 9 ● ‘directors are not specialists, like lawyers and doctors’ ● directors are expected to take risks and they are dealing with uncertainties, which would be compromised if too high standards of care were expected of directors ● courts are ill-equipped to second-guess directors’ business decisions ● the internal management of the company is one that companies can arrange as they wish, and courts should be reluctant to interfere with internal company matters etc. As will be seen below, the scene has changed considerably, and nowadays there are much higher expectations of directors to act with due care and diligence, and these higher expectations are reflected in several court cases decided since the early 1990s.

3.1.2 Legal recognition of changed community expectation of directors That the scene has changed considerably for directors in recent years was strikingly illustrated by the case of Daniels v Anderson.10 Although the court specifically recognised the potential tension between expecting objective professional standards of all directors in all types of companies, the court did not hesitate to conclude that community expectations of the standards of performance of directors have increased since the case of City Equitable Fire Insurance Co Ltd (decided in 1925). Thus, the court held that it is the modern law of negligence that should be used to determine whether a director was in breach of his or her duty of care, skill and diligence.11 In actual fact, the court held that the modern law of negligence (also called the tort of negligence) can cope with the potential tension between expecting objective professional standards of all directors in all types of companies. The court adopted the general principles of the tort of negligence and the duty of care after drawing attention to three very important things. First, there were historic reasons why directors’ duty of care, skill and diligence were viewed in a particular manner by the English courts of the late 1800s and early 1900s. Referring to the article by Jennifer Hill,12 the court made the following observation: 8 RBS Macfarlan, ‘Directors’ Duties after the National Safety Council Case: Directors’ Duty of Care’, (1992) 3 Australian Bar Review 269 at 270. See also Dodds, above n 7, at 134. 9 P Redmond, ‘The Reform of Directors’ Duties’ (1992) 15 UNSWLJ 86 at 98, quoting from Barnes v Andrews 298 Fed 614 (1924) at 618. 10 (1995)16 ACSR 607 (CA (NSW)). 11 at 664–5. 12 J Hill, ‘The Liability of Passive Directors: Morley v Statewide Tobacco Services Ltd’, (1992) 14 Syd LR 504.

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The nature and extent of directors’ liability for their acts and omissions developed as the body corporate evolved from the unincorporated joint stock company regulated by a deed of settlement and was influenced by the partnership theory of corporation whereunder shareholders were ultimately responsible for unwise appointment of directors.13

Second, in embracing the tort of negligence as the basis of liability for a breach of a director’s duty of care, skill and diligence, the court took into consideration that ‘the law about the duty of directors’ had developed considerably since the decision in Re City Equitable Fire Insurance Co (1925).14 The court then, in roughly seven pages,15 painstakingly quoted from contemporary cases before reaching the conclusion that the tort of negligence and the modern concept of a duty of care now forms an acceptable basis for liability of directors’ breach of their duty of care.16 Third, the court mentions the law of negligence has developed considerably in the 70 years (Daniel’s case was decided in 1995) since the decision in Re City Equitable Fire Insurance Co.17 Daniels v Anderson represents the pinnacle in Australia (and probably also in other jurisdictions influenced by English law!) of the development of directors’ duty of care, skill and diligence, which only began to emerge in greater detail in about 1869, with the case of Turquand v Marshall. Daniels v Anderson was decided in 1995, and since then it can safely be stated that the standards of care expected of Australian directors under the common law has reached new heights – Daniels v Anderson brought an abrupt end to the notions that directors’ duty of care, skill and diligence should be judged subjectively and that their negligence ‘must be in a business sense culpable or gross’. Although Daniels v Anderson represents the pinnacle of developments in this regard, there were at least two earlier cases that sent a wake-up call to sleeping or dormant directors in Australia – they were the cases of Statewide Tobacco Services Ltd v Morley18 and Commonwealth Bank of Australia v Friedrich,19 which served as the catalysts for the development of contemporary standards in this area of the law. Similar developments, and the fact that there are nowadays higher expectations of directors, are neatly summarised by Tricker, with reference to international developments: Once upon a time a directorship was a sinecure – an occasional meeting between friends, maybe a few supportive questions, then a fee and probably lunch. Not now. Today more is expected of company directors, indeed the members of all governing bodies, than ever. The work of governing corporate entities has become demanding, 13 Daniels v Anderson (1995) 16 ACSR 607 (CA (NSW)) at 657. 14 Ibid at 661. See also The Honourable Sir Douglas Menzies ‘Company Directors’ (1959) 33 The Australian Law Journal 156 at 156–8 and 163–4; Macfarlan, above n 8, 272–3. 15 Daniels v Anderson (1995) 16 ACSR 607 (CA (NSW)) at 661–7. 16 Ibid at 668. 17 Ibid at 661. 18 (1990) 8 ACLC 827. 19 (1991) 9 ACLC 946. See generally A S Sievers ‘Farewell to the Sleeping Director—The Modern Judicial and Legislative Approach to Directors Duties of Care, Skill and Diligence’ (1993) 21 Australian Business Law Review 111.

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often difficult, and open to challenge. Nevertheless, the work and responsibility is often crucial and can be rewarding, both financially and personally.20

As will be seen in Chapter 10, director liability in Australia is dominated by liability for a breach of their statutory duties. Also, it will be seen that it is the primary corporate regulator (the Australian Securities and Investments Commission (ASIC)) that takes a lead role in instituting actions against directors for a breach of their statutory duties.21 However, as was illustrated above, also in terms of case law based on the breach of directors’ common law duties or equitable duties, the standards of skill, care and diligence expected of directors have risen considerably over the past two decades, and the statutory standards of care found under section 180(1) of the Corporations Act 2001 (Cth) (the Act) reflects the common law standard.22

3.2 The organs of governance The Report of the HIH Royal Commission (Owen Report)23 summarises very well the concept of organs of a corporation in the context of corporate governance.24 Justice Owen explained that a corporation is a legal entity separate and apart from its board of directors (one of the primary organs of a corporation) and shareholders (the other primary organ of a corporation), and that the corporation can only ‘act through the intervention of the human condition’.25 The classic statement of this principle is to be found in Lennard’s Carrying Co Ltd v Asiatic Petroleum Co Ltd per Lord Haldane: My Lords, a corporation is an abstraction. It has no mind of its own any more than it has a body of its own; its active and directing will must consequently be sought in the person of somebody who is really the directing mind and will of the corporation, the very ego and centre of the personality of the corporation.26

In 2008, Justice Owen again explained as follows in The Bell Group Ltd v Westpac Banking Corporation (No 9):27 There are various organs that influence the decision-making processes of a corporation and which are involved in corporate governance. But primary governance responsibility lies with the board of directors. In formal terms the directors are appointed by, and are accountable to, the body of shareholders. As a general rule it is the directors who 20 Bob Tricker, Corporate Governance: Principles, Policies and Practices, Oxford University Press, Oxford (2009) 17. 21 See, for example, ASIC v Adler (2002) 42 ACSR 80; ASIC v Rich (2003) 44 ACSR 44; ASIC v Elliot (2004) 48 ACSR 621; ASIC v Vines (2005) 55 ACSR 617; ASIC v Vizard (2005) 145 FCR 57; ASIC v Maxwell (2006) 59 ACSR 373; ASIC v Macdonald (No 11) (2009) 256 ALR 199l; ASIC v Macdonald (No 12) (2009) 259 ALR 116. 22 Vines v ASIC (2007) 62 ACSR 1; ASIC v Macdonald (No 11) (2009) 256 ALR 199. 23 Report of the HIH Royal Commission (Owen Report), The Failure of HIH Insurance – Volume I: A Corporate Collapse and its Lessons, Canberra, Commonwealth of Australia (2003). 24 Ibid 103 (Ch 6, s 6.1.1). 25 Ibid. 26 [1915] AC 705, 713. 27 [2008] WASC 239 (28 October 2008) [4365].

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are ‘the directing mind and will of the corporation, the very ego and centre of the personality of the corporation’: Lennard’s Carrying Co Ltd v Asiatic Petroleum Co Ltd, at 713. The power to manage the business of the company has been delegated to the directors. The delegation arises as part of, or by virtue of, the contract between the shareholders and the company represented by the Articles of association.

Historically, the power to manage the business of all companies and corporations was conferred upon the board of directors. The practical reality that it was impossible for a board of directors to manage the day-to-day business of large public corporations was realised only quite recently (see discussion under ‘Board functions’, below). Nowadays, the board of directors is seen as the primary governance or supervisory organ. The 2007 Australian Securities Exchange (ASX) Principles of Good Corporate Governance and Best Practice defines the term ‘board’ as: the directors of a company acting as a board and, in the case of listed trusts and externally managed entities, references to ‘boards’ and ‘directors’ are references to the boards and directors of the responsible entity of the trust and to equivalent roles in respect of other externally managed entities.28

The powers conferred upon shareholders are primarily conferred upon them by the Act. The powers to appoint directors and to remove directors are some of the most important powers of shareholders, but there are also several other decisions in a company that cannot be taken without the approval of the shareholders by way of a special resolution (a 75 per cent majority of the shareholders present at a shareholders’ meeting in person or by proxy).29 Justice Owen commented on the legal status of the two primary organs of a corporation: In formal terms the directors are appointed by, and are accountable to, the body of shareholders. The board will usually be constituted (and in the case of HIH was constituted) by a chair, executive directors and non-executive directors.30

One of the most interesting aspects revealed by the Owen Report was that employees, falling in the group of middle management, have considerable powers in large public corporations and often take decisions that may have huge consequences for the corporation. Justice Owen explained this as follows: It is difficult to define with precision the part that employees play in corporate governance. It will depend on the extent to which the employee is involved in or can influence the decision-making process. Senior management is more likely to have such a role. But in large corporations or complex groups it may be that employees further down the corporate hierarchy have a decision-making function that involves elements of control of the process. There is a danger in the current emphasis on the role and 28 ASX, Principles of Good Corporate Governance and Best Practice (2nd edn, August 2007) 39, available at . 29 One of the most important powers that the shareholders have is to change the company’s constitution (if any) by way of a special resolution – see s 136(2) of the Corporations Act 2001 (Cth). 30 Owen Report, above n 23, 103 para 6.1.1.

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responsibilities of boards of directors. It may cause to be overlooked the reality of the necessarily greater part that executives and other employees play in the day-to-day running of many corporate businesses.31

3.3 Board functions32 AWA Ltd v Daniels (Trading as Deloitte Haskins & Sells & Ors)33 is one of the very few cases in which an attempt was made to explain the division of functions between the board of directors and management; non-executive directors and the chief executive officer (CEO) or managing director; and the chairman and the board of directors.34 Rogers CJ explained that, apart from statutory ones, a board’s functions are said to be normally four-fold, namely ‘(1) to set goals for the corporation; (2) to appoint the corporation’s chief executive; (3) to oversee the plans of managers for the acquisition and organisation of financial and human resources towards attainment of the corporation’s goals; and (4) review, at reasonable intervals, the corporation’s progress towards attaining its goals’.35 Rogers CJ pointed out the practical limitations on the ability of the board of a large public corporation to manage the day to day business of the corporation: The Board of a large public corporation cannot manage the corporation’s day to day business. That function must of necessity be left to the corporation’s executives. If the directors of a large public corporation were to be immersed in the details of the day to day operations the directors would be incapable of taking more abstract, important decisions at board level . . . 36

This distinction is nowadays also widely accepted in legislation. In the past the power ‘to manage the business of the company’ was invariably conferred upon the board of directors by way of the model set of articles of association (Table A) that accompanied most of the Companies Acts that preceded the Act. The current statutory recognition reflecting the practical reality that in large public corporations the business of the corporation is not done by the board as such, but under the direction of the board, is contained in section 198A(1) (replaceable rule – see Chapter 6 for the meaning of the term ‘replaceable rule’) of the Act, providing that ‘[t]he business of a company is to be managed by or under the direction of the directors’. In proprietary companies, the business of the 31 Ibid. 32 For some interesting reflections on the gap between what directors in fact do and what the business literature professes they should do, see Myles L Mace, ‘Directors: Myth and Reality’ in Thomas Clarke (ed.), Theories of Corporate Governance: The Philosophical Foundations of Corporate Governance, London, Routledge (2004) 96 et seq, based on his book, Myles L Mace, Directors: Myth and Reality, Boston, Division of Research, Graduate School of Business Administration, Harvard University (1971). For a more theoretical analysis, distinguishing between ‘board tasks’ and ‘board functions’, see Morten Huse, Boards, Governance and Value Creation, Cambridge, Cambridge University Press (2007) 33 and 38–40. 33 (1992) 7 ACSR 759. 34 At 865–8. 35 At 865–6. 36 At 866.

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company will be managed ‘by’ the board, but in large public corporations it will be managed ‘under the direction’ of the board. A similar recognition of the practical realities in large public corporations is found in the American Law Institute’s (ALI) Principles of Corporate Governance and Structure where § 2.01(a) provides that ‘[t]he management of the business of a publicly held corporation should be conducted by or under the supervision of such principal senior executives as are designated by the board of directors’.37 § 8.01(b) of the American Model Business Corporations Act captures this by providing that ‘[a]ll corporate powers shall be exercised by or under the authority of the board of directors of the corporation, and the business and affairs of the corporation shall be managed by or under, and subject to the oversight, of its board of directors’.38 Stephen Bainbridge refers to § 141(a) of the Delaware General Corporation Act, which provides that ‘[t]he business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors . . . ’ and mentions that this power conferred upon the board is enshrined in every piece of state legislation, except in Missouri. He then calls the statutory recognition of directors powers ‘the director primacy mode’39 and points out that this ‘director primacy model’ he has developed ‘has been recognised by several other commentators’.40 This is, indeed, a new and clever way to contrast that model with what has been called the ‘shareholder primacy model’ and the ‘stakeholder primacy model’ (see discussion in Chapters 1 and 2) for many years. Bainbrige’s ‘director primacy model’ is based on the simple reality that even though it is said that the shareholders ‘own’ the corporation, they have virtually no power to control either its day-to-day operation or its long-term policies. Instead, Bainbridge argues, the corporation is controlled by its board of directors.41 It is the boards of the directors, and not the shareholders, other stakeholders or managers, in large public corporations that actually control the corporation and ‘have the ultimate right of fiat’.42 This, in our view, could be described as the ‘boardtorial revolution’, or ‘directorial revolution’, in similar vein to what has been identified as the ‘managerial revolution’ (see reference in Chapter 1). The distinction between managing and directing the business of a corporation is nowadays well accepted in managerial circles. As early as 1997, Bob Garratt explained as follows: But there is a vast difference between ‘directing’ and ‘managing’ an organisation. Managing is literally, given its Latin root, a hands-on activity thriving on crisis action. On the operations side of an organisation it is a crucial role. Directing is different. 37 ALI, Principles of Corporate Governance: Analysis and Recommendations, St Paul, American Law Institute Publishers (1994) 82. 38 American Bar Association, Model Business Corporations Act: Official Text with Official Comments and Statutory Cross-References Revised through June 2005, Chicago, American Bar Association (2005) 8–4. 39 Stephen M Bainbridge, The New Corporate Governance in Theory and Practice, Oxford, Oxford University Press, (2008) ix. 40 Ibid, xi-xii. 41 Ibid, 3. 42 Ibid, 11.

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Directing is essentially an intellectual activity. It is about showing the way ahead, giving leadership. It is thoughtful and reflective and requires the acquisition by each director of a portfolio of completely different thinking skills.43

He repeated these sentiments in 2003: We seem to rely excessively on an ill defined and weakly assessed notion called ‘experience’ to get by. Unfortunately such experience is rarely directoral. It is usually managerial and professional, and so concerned with the day-to-day operations of a business – these are not directoral roles and there is a big difference between managing and directing an organization.44

Because of the different role of the modern board, it is often difficult for managers who are promoted internally as directors to properly fulfil their directorial responsibilities. There is a natural tendency for directors promoted internally ‘to ensure that their managerial successor does not mess up what they have so painfully achieved’.45 These newly appointed directors also naturally have a tendency to ‘sit on their [successors’] shoulders’, and that can lead to considerable friction.46 That is also a forceful argument against the CEO of a company becoming the same company’s chair of the board. As John B Reid, AO, former CEO of BHP Ltd, puts it: I think it can be argued that everything is working against CEOs in asking them to detach themselves from thinking like an operational manager and to change their thought process vis-a-vis every senior executive in the operation and to focus on the issues that are the responsibility of the chairman. Not only that, but directors would be asking the CEO to deliberately walk away from thinking about the matters that were his or her earlier managerial responsibilities and to be detached from them. There are not many people who can rejig their processes so easily and it is even harder in a familiar environment where colleagues assume that the CEO has not changed very much. They are probably right.47

The argument in favour of allowing a retiring CEO to become the chairperson is based upon the notion of continuity and the desire to retain the experience and intimate knowledge of the retiring CEO within the company. It is, however, submitted that from a corporate governance perspective this is not a good enough reason to allow this to happen. At the most, the retiring CEO can become a nonexecutive director, but he or she will not be considered to be an independent, non-executive director. A better practice probably is to agree, under specific conditions that are clarified with the new CEO and the board, that the retiring 43 Bob Garratt, The Fish Rots from the Head, London, Harper Collins Business (1997) 4. See also Robert AG Monks and Nell Minow, Corporate Governance, Oxford, Blackwell (3rd edn, 2004) 195 and 202–3; J B Reid, Commonsense Corporate Governance, Sydney, Australian Institute of Company Directors (2002) 22; Stephen M Bainbridge, Corporation Law and Economics, New York, Foundation Press (2002) 194–5. 44 Bob Garratt, Thin on Top, London, Nicholas Brealey Publishing (2003) 69. 45 Garratt, above n 43, 3; Nigel Kendall and Arthur Kendall, Real-World Corporate Governance, New York, Foundation Press (1998) 8. 46 Garratt, above n 43, 3; Kendall and Kendall, above n 45, 15. 47 Reid, above n 43, 31. See also Tricker above n 20, at 60.

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CEO can be consulted by the new CEO or the board. In this way he or she has no continuing involvement with the company as a director who is expected to attend all board meetings, but the experience and knowledge of the retiring CEO could be retained as an ‘external’ consultant. ASX’s Principles of Good Corporate Governance and Best Practice Recommendations48 summarises the responsibilities of the board slightly more elaborately than did Rogers CJ in the AWA Ltd case: ● overseeing of the company, including its control and accountability systems ● appointing and removing the CEO (or equivalent) ● where appropriate, ratifying the appointment and the removal of senior executives49 ● providing input into and final approval of management’s development of corporate strategy and performance objectives ● reviewing, ratifying and monitoring systems of risk management and internal control, codes of conduct and legal compliance ● monitoring senior executives’ performance and implementation of strategy ● ensuring appropriate resources are available to senior executives ● approving and monitoring the progress of major capital expenditure, capital management, and acquisitions and divestitures ● approving and monitoring financial and other reporting. The board’s responsibility ‘to guide and monitor the management of the corporation’ has been emphasised in several Australian cases.50 The OECD, in its Principles of Corporate Governance, considers it an important attribute of an effective corporate governance framework that the board should ‘ensure the strategic guidance of the company’; should ensure ‘effective monitoring of management’; and should be ‘accountable to the company and the shareholders’.51 Functions such as ‘reviewing’, ‘monitoring’ and ‘overseeing’ are mentioned repeatedly in the OECD Principles of Corporate Governance as core functions of the board.52 The board is indeed ‘the centre of the enterprise – “business brain” or central processor – monitoring and coping with the results of the external and internal processes of the whole enterprise’.53 The UK Institute of Directors identifies the key purpose of the board as being to seek to ensure the company’s prosperity by collectively directing the company’s affairs, while meeting the appropriate interests of its shareholders and relevant stakeholders.54 Bob Garratt explains that 48 Principles of Good Corporate Governance and Best Practice (2nd edn, August 2007), above n 28, 13. 49 Senior executives include all officers and employees who have the opportunity to materially influence the integrity, strategy and operation of the company and its financial performance. 50 Commonwealth Bank v Friedrich (1991) 5 ASCR 115, 187; AWA Ltd v Daniels (Trading as Deloitte Haskins & Sells & Ors) (1992) 7 ACSR 759, 864; Daniels v Anderson (1995) 13 ACLC 614, 614; ASIC v Macdonald (No 11) [2009] NSWSC 287 (23 April 2009), available at at paras 101 and 255 et seq. 51 OECD Principles of Corporate Governance (April 2004), available at 22. 52 Ibid 60–3. 53 Garratt, above n 43, 9. 54 UK Institute of Directors, Standards for the Board: Improving the Effectiveness of Your Board, London, Institute of Directors (2001) 4, 28.

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boards are responsible for strategic decisions and, in order to direct strategically, boards must agree on three things:55 ● In which direction are we going? ● On which ideas are we working to get us there? ● On which information sources will we rely? Taking all these aspects together, the board’s functions and responsibilities could be summarised as to ‘direct, govern, guide, monitor, oversee, supervise and comply’. The literature on management and managerial strategy makes a distinction between two primary roles of the board, namely a ‘performance role’ and a ‘conformance role’. Robert I Tricker classifies ‘contributing know-how, expertise and external information’; and ‘networking, representing the company and adding status’ as being part of directors’ performance role. Under their conformance role he includes ‘judging, questioning and supervising executive management’; and a ‘watchdog, confidant and safety-valve role’.56 Bob Garratt sees accountability (for quality of thinking, high ethical standards and values, to obey the law and to treat stakeholders in a consistent way) and supervision of management (conformance to key performance indicators, cash flow, budgets and projects) as part of the board’s conformance task.57 Under its performance task he lists policy formulation and foresight and strategic thinking.58 The distinction between the board’s ‘performance’ and ‘conformance’ tasks seems a realistic explanation of directors’ roles and mirrors the primary functions of the board. However, the problem lies in the practical application of these roles or, to put it differently, to strike the right balance. As Tricker puts it: [E]very board faces a challenge to strike a reasonable balance between formulation and policy making, the performance roles, on the one hand, and executive supervision and accountability, the conformance roles on the other . . . The problem is that the more a board concentrates its efforts on the conformance activity – management supervision and accountability – the more that board comes to see its work as ensuring compliance with the corporate governance requirements of respective codes, regulations, and the law . . . The formulation of strategy and policy making is then largely delegated to top management. By focusing on compliance, such boards tend to see corporate governance activities as an expense and wonder whether it is cost-effective.’59

From a more practical point of view, the members of the board should not only concentrate on the formal responsibilities they have, as explained above, but should also ask some fundamental questions about their performance, accountability, effectiveness, the governance risks they face and improving their effectiveness. Bob Garratt argues for a change in directoral mindset; directors should 55 Garratt, above n 44, 124. 56 Robert I Tricker, International Corporate Governance, London, Prentice-Hall (1994) 98–100. See also Bob Tricker, ‘From Manager to Director: Developing Corporate Governors’ Strategic Thinking’ in Developing Strategic Thought: Rediscovering the Art of Direction-giving (Bob Garratt, ed.), London, McGraw-Hill Book Company (1995) 11 at 16–18. 57 Bob Garratt, The Fish Rots from the Head, London, P Profile Books (2003) 109 et seq and 131 et seq. 58 Ibid, 57 et seq and 88 et seq. 59 Tricker above n 20, 139. See also Ken Rushton, ‘Introduction’ in The Business Case for Corporate Governance (Ken Rushton ed.), Cambridge, Cambridge University Press (2008) 5.

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not see themselves as sitting at the apex of a pyramid, but rather should see themselves as the centre of the enterprise, the ‘business brain’ or central processor that monitors and copes with the results of the external and internal learning processes of the enterprise.60 Leighton and Thain suggest that the board should ask itself the following fundamental questions:61 1. How satisfied are our shareholders, and other stakeholders, with the performance and accountability of the company and its board? 2. How effective is the board? 3. What are the governance risks and problems we face? 4. What exactly should we be doing to anticipate and avoid the embarrassing and costly mistakes in governance that have plagued so many other companies? 5. What should we be doing to make our board more effective and how should we do it? From the discussion above it will be apparent that the board’s role is a complex one. This is neatly illustrated by the UK Institute of Directors: In pursuing its key purpose, a board of directors faces a uniquely demanding set of responsibilities and challenges, the complexity of which can be seen in some of the seemingly contradictory pressures it faces: • The board must simultaneously be entrepreneurial and drive the business forward while keeping it under prudent control. • The board is required to be sufficiently knowledgeable about the workings of the company to be answerable for its actions, yet to be able to stand back from the day-to-day management of the company and retain an objective, long-term view. • The board must be sensitive to the pressures of short-term issues and yet be informed about broader, long-term trends. • The board must be knowledgeable about ‘local’ issues and yet aware of potential and actual non-local, increasingly international, competitive and other influences. • The board is expected to be focused upon the commercial needs of its business while acting responsibly towards its employees, business partners and society as a whole.62

Directors need to have some practical guidelines to ensure that they fulfil their duties and responsibilities diligently. Mervyn King, in his book, The Corporate Citizen, provides some excellent guidelines to directors in taking decisions or making business judgments. He suggests that directors, taking decisions or making business judgments, must ask 10 questions: 1. Do I as a director of this board have any conflict in regard to the issue before the board? 2. Do I have all the facts to enable me to make a decision on the issue before the board? 60 Bob Garratt, The Fish Rots from the Head, P Profile Books, London (2003) 4. See also Bob Tricker (Developing Strategic Thought: Rediscovering the Art of Direction-giving) above n 56, 11. 61 David S R Leighton and Donald H Thain, Making Boards Work, Whitby, Ontario, McGraw-Hill Ryerson (1997) 34. 62 UK Institute of Directors, above n 54, 4–5.

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3. Is the decision being made a rational business decision based on all the facts available at the time of the board meeting? 4. Is the decision in the best interests of the company? 5. Is the communication of the decision to the stakeholders of the company transparent, with substance over form, and does it contain all the negative and positive features bound up in that decision? 6. Will the company be seen as a good corporate citizen as a result of the decision? 7. Am I acting as a good steward of the company’s assets in making this decision? 8. Have I exercised the concepts of intellectual honesty and intellectual naivety in acting on behalf of this incapacitated company? 9. Have I understood the material in the board pack and the discussion at the boardroom table? 10. Will the board be embarrassed if its decision and the process employed in arriving at its decision were to appear on the front page of the national newspaper? Bearing in mind the realities of decision-taking processes as described by Bob Tricker in the second opening quote to this chapter, some may say it is unrealistic to expect of directors, taking decision ‘on the run’, to ask all these questions. On the other hand, especially as far as Australian directors are concerned, there is very little doubt that if all the directors of James Hardie did ask all these 10 questions and could answer ‘no’ on questions 1 and 10 and ‘yes’ on questions 2–9, they would not have been held liable.63 Also, the names of the directors of Centro Properties Group would not have been mentioned so prominently in the media during October 2009 when ASIC announced that it would institute action against the directors for a breach of their statutory duty of care and diligence64 if those directors had asked the 10 questions Mervyn King suggests and could answer ‘no’ on questions 1 and 10 and ‘yes’ on questions 2–9.

3.4 Board structures Generally speaking, there are two types of board structures, namely the unitary board and the two-tier board. It is, however, not easy nowadays to make an exact distinction between these two board structures, as most developed countries have moved away from the traditional ‘unitary board’ structure in the case of large public corporations. In most developed countries, board structures for large corporations have some characteristics that are reminiscent of the more traditional ‘two-tier board’. A good way to illustrate this point is to start with a very basic 63 See ASIC v Macdonald (No 11) [2009] NSWSC 287 (23 April 2009), available at . 64 See ‘ASIC Commences Proceedings Against Current and Former Directors of Centro’, ASIC Media Release 09–202 AD (21 October 2009), available at .

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Board Governance

Management organization

Management

Figure 3.1 [2.1]: The board and management differentiated

Figure 3.2 [2.2]: All-executive board

Figure 3.3 [2.3]: Majority executive board

distinction drawn by Tricker in his books International Corporate Governance65 and Corporate Governance: Principles, Policies and Practices66 between a so-called ‘managerial pyramid’ and a ‘governance circle’, and illustrates this by way of five figures (reproduced with Tricker’s original numbering in square brackets, figures 3.1–3.4 reproduced from International Corporate Governance and 65 Tricker (International Corporate Governance), above n 56, 44–5. See also Tricker, above n 20, 35–6 and 61–4. 66 Tricker, above n 20, 35–6 and 61–4.

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Figure 3.4 [2.4]: Majority outside board

Figure 3.5 [2.5]: Two-tier board

figure 3.5 reproduced from Corporate Governance: Principles, Policies and Practices): Figure 3.2 portrays the typical board structure for proprietary companies and also, in the past, the board structure of most public corporations. However, with the drive to have objective checks on management and to bring independence into the board, the move has clearly been towards the board structure depicted in Figure 3.3. More recently there have been several moves to have a majority of non-executive directors and, in particular, a majority of independent nonexecutive directors (Figure 3.4). The German system is perhaps best described by Figure 3.5, with the governance circle representing the supervisory board and the managerial pyramid representing the management board. The most recent trends towards independent non-executive directors will be explained in greating detail in Chapter 4, while the German two-tier board will be discussed in Chapter 13. Figure 3.6 illustrates a board with no executive director.

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Figure 3.6 [3.4]: The all non-executive director board

1-10 individuals

Figure 3.7: The statutory arrangement for South African close corporations

It is rare to find this in listed public companies, but Tricker points out that it is sometimes the board structure for not-for-profit entities such as charitable organisations, arts, health and sports organisations, and ‘qualgos’ (quasi-autonomous non-government organisations)’.67 Figure 3.7 depicts the South African close corporation, where the statutory presumed or default arrangement is based on the premise that there is a complete overlap between the governance circle and the managerial triangle in small businesses.68 Tricker’s basic models could be used to further refine and explain board structures and an effective corporate governance model (see discussion and illustrations). There are several indications that traditional common law jurisdictions recognise the distinctive roles of ‘the board’ and ‘management’. The primary 67 Ibid, 64. 68 See further Jean J du Plessis, ‘Reflections and Perspectives on the South African Close Corporation as Business Vehicle for SMEs’ (2009) 15 (4) New Zealand Business Law Quarterly 250 at 252–3 and 257 for some of the reasons for having separate legislation applying to SMEs.

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function of ‘the board’ is to ‘direct, govern, guide, monitor, oversee, supervise and comply’, and ‘management’s’ function is to ‘manage the day-to-day business of the corporation’. This becomes clear if one looks at what is nowadays understood under the ‘functions of the board’, as explained above. There is no longer a place in large corporations for the board to ‘manage the business of the corporation’, but to provide strategic direction to the corporation and the development and implementation of risk management policies are key functions of the board. For these reasons, these days it is misleading to express a preference for ‘a unitary board’ or ‘a two-tier board’ without clarifying what is meant by these terms.69 It is also unfounded to make a prediction of a ‘convergence towards a unitary board approach’, without defining what is meant by a ‘unitary board’.70 Where the business of the corporation is not managed by the board but is ‘under the direction of the directors’71 – with a majority of independent (or outside) non-executive directors, a senior independent director, an independent non-executive director as chair and several sub-committees72 – it can hardly be said that such a corporation has a ‘unitary board’ comparable to the ‘unitary board’ (see again Figure 3.3 above) that was the focus of attention of many studies over many years.73 It is nowadays beyond dispute that the contemporary – or should we say, reinvented – ‘unitary board’ has much more in common with the traditional ‘two-tier board’ than some would be prepared to admit.74 The modern ‘unitary board’ does not look as one-dimensional as some would have us believe. On the other hand, the modern German ‘two-tier board’ is not as two-dimensional as it has been made out to be.75 Due to the way in which the traditional ‘unitary board’ has been reinvented, the score would probably be slightly in favour of the ‘two-tier board’76 if a winner had to be selected in the ‘unitary board’ 69 For a typical example of such a misleading approach, which seems to have been perpetuated over time in the various South African King Reports, see King Report on Governance for South Africa 2009 (King Report (2009)), Institute of directors (2009) 9, available at at 39 para 62. 70 Cf Garratt, above n 43, 42–3. 71 See s 198A(1) of the Corporations Act. See further AWA Ltd v Daniels (Trading as Deloitte Haskins & Sells & Ors) (1992) 10 ACLC 933. 72 See Financial Reporting Council, The Combined Code on Corporate Governance (UK Combined Code (2008)) (June 2008), available at ; and ASX, Principles of Good Corporate Governance and Best Practice (2nd edn, August 2007) 3, available at . See also Review of the Role and Effectiveness of Non-Executive Directors (Higgs Report), (January 2003), available at . 73 See Tricker (International Corporate Governance), above n 56, 44–5. 74 See Comparative Study of Corporate Governance Codes Relevant to the European Union and its Members (hereafter ‘European Commission Comparative Study’) (January 2002) 4–5; The German Corporate Governance Code (hereafter ‘the German Code’) (May 2003), available at 1; Sir Geoffrey Owen, ‘The Role of the Board’ in The Business Case for Corporate Governance (Ken Rushton, ed.), Cambridge, Cambridge University Press (2008) 10 at 21–2. 75 See Carsten Berrar, ‘Die zustimmungspflichtigen Gesch¨ afte nach § 111 Abs. 4 AktG im Lichte der Corporate Governance-Diskussion’ (2001) 54 Der Betrieb (Zeitschrift) 2181, 2185–6. 76 Garratt, above n 43, 187 has no hesitation in stating that United States boards are ‘closer to the German twotier board’, while John L Colley (Jr), Jacqueline L Doyle, George W Logan and Wallace Stettinius, Corporate Governance, New York, McGraw-Hill (2003) 43, state that ‘[t]he committee of outside directors is somewhat similar to the European two-tiered model of governance, in which there is a supervisory board and an executive board’. See also Alistair Howard, ‘UK Corporate Governance: To What End a New Regulatory State?’ in

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versus ‘two-tier board’ contest, but at the end of the day it is perhaps best to accept that the so-called ‘fit-all board structure’ does not – and probably never will – exist.77 The frequent overstatement of the differences between the contemporary ‘two-tier board’ and the contemporary ‘unitary board’ is neatly summarised by Weil, Gotshal and Manges (on behalf of the European Commission, Internal Market Directorate General) in their report, Comparative Study of Corporate Governance Codes Relevant to the European Union and its Members:78 Another major corporate governance difference embedded in law relates to board structure – the use of a unitary versus a two-tier board. However, notwithstanding structural differences between two-tier and unitary board systems, the similarities in actual board practices are significant. Both types of systems recognise a supervisory function and a managerial function, although the distinctions between the two functions tend to be more formalised in the two-tier structure. Generally, both the unitary board of directors and the supervisory board (in the two-tier structure) are elected by shareholders although . . . in some countries employees may elect some supervisory body members as well. Typically, both the unitary board and the supervisory board appoint the members of the managerial body – either the management board in the two-tier system, or a group of managers to whom the unitary board delegates authority in the unitary system. In addition, both the unitary board and the supervisory board usually have responsibility for ensuring that financial reporting and control systems are functioning appropriately and for ensuring that the corporation is in compliance with law. Each board system has been perceived to offer unique benefits. The one-tier system may result in a closer relation and better information flow between the supervisory and managerial bodies; however, the two-tier system encompasses a clearer, formal separation between the supervisory body and those being ‘supervised’. With the influence of the corporate governance best practice movement, the distinct perceived benefits traditionally attributed to each system appear to be lessening as practices converge.

In various reports, such as the Cadbury Report (UK), King Report (South Africa) (1994, 2002 and 2009), Higgs Report (UK), and Owen Report (Australia), the ‘unitary board’ structure was preferred to the ‘two-tier structure’ but, as mentioned above, these so-called alternative board structures are not really alternative in the strict sense of the word, but rather have some similarities and some differences. Another problem with simply accepting the ‘unitary board’ as the preferred structure is that it does not open up consideration of other possibilities, nor does it stimulate debate on the best possible board structure or on the relative merits of alternative board structures. There were some indications European Corporate Governance (Thomas Clarke and Jean-Francois Chanlat, eds), London, Routledge (2009) 218 at 226. 77 As Paul Davies, ‘Employee Representation and Corporate Law Reform: A Comment from the United Kingdom’ (2000) 22 Comparative Labor Law and Policy Journal 135, 137, points out, ‘there is no one bestsystem of corporate governance’. 78 European Commission Comparative Study, above n 74, 4–5.

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that the Hampel Committee (UK) was at least prepared to compare other board models with the ‘unitary board’,79 but in the end nothing came of it. The resistance even to discussion of alternative board structures is probably directly linked to the vested interests of groups such as the shareholders and current directors, who may fear that a ‘two-tier board’ would open the door for other stakeholders, such as employees, to gain representation on the board. However, a two-tier board does not equate to co-determination or, to put it differently, does not have to embrace the concept of co-determination (employee participation at supervisory board level: see Chapter 13 for further discussion of this concept). Even in Germany there is currently considerable debate surrounding co-determination and the actual advantages of employee participation at supervisory board level.80 This debate is continuing within the context of the two-tier board, which is accepted as the norm in Germany for large public companies. The German two-tier board has been considerably improved over the past 10 years or so,81 but there are strong indications of mounting pressure in Germany against co-determination or employee participation at supervisory board level. It is not the German two-tier system as such that is in danger, but co-determination.82 We do not propose that one board structure is superior to the other, but rather that a ‘unitary board structure’ could not simply be rejected in favour of a ‘twotier board structure’ or vice versa. Deciding on a particular board structure will depend on many variables (for example, the size of the company, the quality of persons sitting as non-executive directors, the corporate culture within a particular corporation etc). As Justice Owen put it: I think that any attempt to impose governance systems or structures that are overly prescriptive or specific is fraught with danger. By its very nature corporate governance is not something where ‘one size fits all’. Even with companies within a class, such as public listed companies, their capital base, risk profile, corporate history, business activity and management and personnel arrangements will be varied. It would be impracticable and undesirable to attempt to place them all within a single straitjacket of structures and processes. A degree of flexibility and an acceptance that systems can and should be modified to suit the particular attributes and needs of each company is necessary if the objectives of improved corporate governance are to be achieved.83

Promoting the concept of objective overseers or outsiders (that is, independent non-executive directors) in a unitary board structure is nothing but a move 79 Kevin Keasey and Mike Wright, ‘Introduction: Corporate Governance, Accountability and Enterprise’ in Kevin Keasey and Mike Wright (eds), Corporate Governance: Responsibility, Risks and Remuneration, New York, Wiley (1997) 17. 80 See Otto Sandrock and Jean J du Plessis, ‘The German Corporate Governance Model in the Wake of Company Law Harmonisation in the European Union’ (2005) 26 Company Lawyer 88–95; Jean J du Plessis and Otto Sandrock, ‘The Rise and the Fall of Supervisory Codetermination in Germany?’ (2005) 16 International and Commercial Law Review 67–79. 81 Jean J du Plessis, ‘Reflections on Some Recent Corporate Governance Reforms in Germany: A Transformation of the German Aktienrecht?’ (2003) 8 Deakin Law Review 389. 82 Jean J du Plessis, ‘The German Two-Tier Board and the German Corporate Governance Code’ (2004) 15 European Business Law Review 1139, 1164. 83 Owen Report (2003), above n 23, 105 para 6.12.

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towards a quasi – or perhaps even a de facto84 – two-tier board structure; namely, the managers and executive as one tier and a board consisting of a majority of non-executive directors as the second tier. Recognising that the board of directors cannot manage the day-to-day business of a large public corporation, and that the business of the corporation could at most be managed ‘under the direction of the board’85 is another indication that the division between managerial and supervisory functions is becoming a practical reality in large public corporations. It is for these reasons that the ‘two-tier board structure’ has been studied with renewed interest, and has even gained some ground in certain circles.86 The Japanese Suzuki Report also stated unequivocally that the ‘functions of the board of directors and any management board should be separate so that corporate decision-making and business execution are clearly distinguished’.87 It is, however, to be expected that – depending on one’s understanding and definition of a ‘unitary board’ – strong support for such a board system will continue to be expressed in certain circles.88

3.5 Board structures in the broader context of a good corporate governance model 3.5.1 Overview Good corporate governance practices require more than just effective board structures. The view presented here is that corporate governance, and in particular a good corporate governance model for any specific country, should be judged against several other criteria. The South African King Report (2002) argued as follows:89 22.

. . . In East Asia, in 1997 and 1998, it was demonstrated that macro-economic difficulties could be worsened by systematic failure of corporate governance, stemming from: 22.1 weak legal and regulatory systems; 22.2 poor banking regulation and practices; 84 John C Shaw, ‘The Cadbury Report, Two Years Later’, in K J Hopt, K Kanda, M J Roe, E Wymeersch and S Priggle (eds), Comparative Corporate Governance: The State of the Art and Emerging Research, Oxford, Clarendon Press (1998) 21, 22. 85 An author like Huse, above n 32, 106 generalises that ‘[i]n the Anglo-American model there is one board, which also has direct responsibility for the day-to-day running of the firm’. The statement may be correct in so far as he refers to ‘one board’ and also if the statement is applied to the majority SMEs, but it is not correct in so far as large public companies are concerned, where ‘the board’ nowadays will not and cannot run the day-to-day business, as was pointed out above. 86 Thomas Sheridan and Nigel Kendall, Corporate Governance, London, Pitman (1992) 161; John Brewer, ‘Hong Kong Society of Accountants’ Report on Corporate Governance’ (1996) (June) The Corporate Governance Quarterly 10, 12. 87 Corporate Governance Committee of the Corporate Forum of Japan, Corporate Governance Principles: A Japanese View (Final Report) (Suzuki Report), 26 May 1998, 48 (Principle 7A). 88 See Garratt, above n 43, 42–3 and 210. 89 Executive Summary–King Report on Corporate Governance (King Report (2002)), Parktown, South Africa, Institute of Directors in Southern Africa (March 2002) para 22. See also G¨ uler Manisali Darman, Corporate Governance Worldwide: A Guide to Best Practices and Managers, Paris, ICC Publishing (2004) 30.

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22.3 inconsistent accounting and auditing standards; 22.4 improperly regulated capital markets; 22.5 ineffective oversight by corporate boards, and scant recognition of the rights of minority shareowners.

Justice Owen in the HIH Royal Commission Report adopted a highly realistic and broad approach to corporate governance, observing that: The relevant [corporate governance] rules include applicable laws of the land as well as the internal rules of a corporation. The relationships include those between the shareholders or owners and the directors who oversee the affairs of the corporation on their behalf, between the directors and those who manage the affairs of the corporation and carry out its business, and within the ranks of management, as well as between the corporation and others to whom it must account, such as regulators. The systems and processes may be formal or informal and may deal with such matters as delegations of authority, performance measures, assurance mechanisms, reporting requirements and accountabilities.90

It will be clear from the quotes above that several factors play a role in determining the effectiveness of a good corporate governance model for any particular country. We are of the opinion that the following criteria will all, to a greater or lesser extent, play a role in ensuring good corporate governance practices: ● effective board structures, recognising the supervisory role of the board and the managerial role of management ● effective support mechanisms to assist the board in fulfilling its functions properly; for instance, board committees (appointment, remuneration, audit, risk management, shareholders etc.) and the company secretary ● effective statutory provisions, in particular in the areas of corporations law, banking law, regulating capital markets and ensuring auditing standards ● effective regulators, in particular in the areas of corporations law and capital markets ● effective codes of best practice and conduct. We will now discuss each of these criteria in turn.

3.5.2 Effective board structure As explained above, the ‘fit-all board structure’ does not exist, but that does not mean that sound corporate governance principles to ensure an effective board structure could not be extracted generally. As has already been pointed out, the board’s functions to ‘direct, govern, guide, monitor, oversee, supervise and comply’ should be distinguished from management’s function to ‘manage the day to day business of the corporation’. This could be illustrated by using Tricker’s ‘governance circle’ and ‘managerial pyramid’, but placing them at an equal level rather than having the ‘governance circle’ on top of the ‘managerial 90 Owen Report (2003), above n 23, 101–2 para 6.1.

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Figure 3.8: Separation and interaction of management and governance

pyramid’ – they function ‘side-by-side’.91 There should be a healthy interaction between the ‘governance circle’ and the ‘managerial pyramid’. The functions of the ‘governance circle’ and the ‘managerial pyramid’ should be separated, as illustrated by the perforated vertical line in Figure 3.8, but there should be a healthy interaction between those who fulfil the respective functions, as illustrated by the horizontal arrow pointing in both directions. Exchange of information, consultation and collaboration should be key features of the division between the function to ‘direct, govern, guide, monitor, oversee, supervise and comply’ and the function to ‘manage the day to day business of the corporation’. The composition of the ‘governance circle’ and the ‘managerial pyramid’ may differ considerably, depending on the corporations law of a particular country. At one extreme is the German system, where the ‘governance circle’ consists of one-third or one-half employee representatives and two-thirds or one-half shareholder representatives, with no overlap between the ‘governance circle’ and the ‘managerial pyramid’. At the other end of the scale is a model in which there is considerable overlap between the ‘governance circle’ and the ‘managerial pyramid’, but with at least some (not the majority) of the members not part of the ‘managerial pyramid’. The position preferred by several recent corporate governance reports, which could probably be described as roughly the middle position, would have a majority of independent members in the ‘governance circle’. Some reports suggest that at least half of the ‘governance circle’ should consist of independent members. This has been the recommendation in the earlier UK Combined Code and ASX’s Corporate Governance Council in Australia. The South African King Report (2009) is currently one of the only leading corporate governance reports not requiring a majority independent non-executive directors to fill the board. The requirement is only that there should be majority non-executive directors and that the majority of them should be independent.92 The argument has consistently been that the

91 Kendall and Kendall, above n 45, 53. 92 Principle 2.9, King Code of Governance Principles for South Africa, Johannesburg, Institute of Directors in South Africa (2009) 25.

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board should comprise a balance of power – ‘[n]o one individual or block of individuals should be able to dominate the board’s decision-making’.93 In theory this approach makes sense, but the practical reality is that the potential is there in any case that a majority non-executive director (even if not all of them are ‘independent’), can dominate the board’s decision making. However, as will be seen in Chapter 4, the expectation of having a majority independent directors on the board to ensure independence is open for criticism.

3.5.3 Effective support mechanisms to assist the board in properly fulfilling its functions The idea that the board should be assisted by several standing board committees in fulfilling its primary functions to ‘direct, govern, guide, monitor, oversee, supervise and comply’, has gained considerable support over recent years. In this regard, appointment committees, nomination committees, remuneration committees, audit committees, risk management committees and shareholder committees have become particularly prominent. Some of these committees were pertinently mentioned in the American Law Institute’s Principles of Corporate Governance: Analysis and Recommendations; some were also promoted in the Cadbury, Hampel, Greenbury, King and Higgs Reports. One key feature of most of these committees is that they are supposed to fulfil their tasks independently of management, and ensure that they bring some objectivity to the tasks they fulfil. Another key position mentioned in several recent reports as being able to assist the board in fulfilling its tasks properly is the company secretary. The company secretary can play a vital role, not only in assisting the board to fulfil its tasks, but also in ensuring a healthy and free flow of information between the ‘governance circle’ and the ‘managerial pyramid’. If these aspects are taken into consideration, our corporate governance model can be illustrated as shown in Figure 3.9.

3.5.4 Effective statutory provisions It is important that effective legislation exists to ensure a proper corporate governance model for any country. The areas of most importance are those of corporations law, banking law, regulating capital markets and ensuring auditing standards. It is necessary to have effective legislation, not only to ensure that certain abuses and misuses are identified, but also to provide for effective remedies and penalties. The remedies and penalties should be civil as well as criminal and should be aimed at punishing corporations contravening the legislation and the individuals who are responsible for the acts of corporations. The list of possible 93 King Report (2009), above n 69, at 39 paras 62–5.

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Company secretary Appointment or nomination committees Compensation or remuneration committee Audit committee Risk management committee Shareholder committee Figure 3.9: Support mechanisms to assist the board

remedies and penalties is far too long to include here,94 but in Australia there has been considerable success in using disqualification orders, compensation orders and civil penalties orders against directors of several corporations that collapsed after 2001.95 There have in recent years been considerable changes to legislation in several countries to ensure proper audit standards. The main impetus for better regulation in this area came from collapses such as those of Enron, WorldCom, Tyco, HIH, One.Tel etc. Perhaps the most far-reaching reforms in this area were implemented in the USA through the Sarbanes-Oxley Act of 2002. In Australia, the Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 (the so-called CLERP 9 Act) introduced into the Corporations Act some drastic changes to regulation of the audit profession and new provisions regarding continuous disclosure and protection for whistleblowers. These developments will be discussed in greater detail in later chapters.

3.5.5 Effective regulators As was pointed out in the King Report (2002), effective regulation in the areas of corporations law and the capital markets is essential to ensure good corporate governance. The importance of this principle was again emphasised in Australia 94 See Mirko Bagaric and Jean J du Plessis, ‘Expanding Criminal Sanctions for Corporate Crimes – Deprivation of Right to Work and Cancellation of Education Qualifications’ (2003) 21 Company and Securities Law Journal 7–25. 95 See Jean J du Plessis, ‘Reverberations after the HIH and other Recent Australian Corporate Collapses: The Role of ASIC’ (2003) 15 Australian Journal of Corporate Law 225, 225–45.

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with the collapse of the HIH group of insurance companies. The Australian Prudential Regulatory Authority (APRA) has been heavily criticised for not reading the signs of doom for HIH sooner and for not stepping in earlier.96 There were serious allegations that APRA had been made aware of financial difficulties in HIH at least six months before HIH went into provisional liquidation in March 2001.97 Although the Report of the HIH Royal Commission (Owen Report) did not go so far as to blame APRA for not picking up earlier on financial difficulties experienced in HIH, or suggest that it could have prevented the collapse, Justice Owen did not hesitate to explain the reasons for APRA’s inaction, and mentioned that ‘[i]n many instances – even taking account of the constraints it was under – APRA did not react appropriately’.98 Amendment of the legislation to improve the effectiveness of APRA followed this criticism.99 The importance of effective regulators has again been emphasised with the 2008–9 global financial crisis, and it is to be expected that there would be an increasing expectation of regulators to regulate effectively and perform their regulatory duty properly. There is little doubt that, globally, increasing regulation of the financial markets and corporate law began to emerge100 and at the end of 2009 there were predictions that in Australia more regulation can be expected.101 With the collapse of the Geelong-based Chartwell Enterprise Group, there were some serious speculations that the Australian Tax Office (ATO) did not fulfil its duty to inform ASIC earlier that Chartwell Enterprises had not paid taxes for a considerable period of time before it eventually collapsed. During this time, several investors invested in Chartwell Enterprises, believing that the company was just going through a natural downturn, rather than experiencing serious financial problems. These investors argued that they would not have invested if ASIC had been informed by the ATO of the company’s taxation status, and ASIC had begun an investigation. ASIC itself was criticised for not acting sooner. There were some speculations that ASIC was made aware of serious problems in Chartwell Enterprises long before the company actually collapsed. Thus, an area that will have to receive serious attention in future is the nature of the respective duties of all the corporate regulators and how their regulatory tasks and roles can be coordinated to make the regulatory environment as effective as possible without restraining business unnecessarily. It is accepted that it is a formidable task and that striking the right balance would require careful consideration, 96 M De Martinis, ‘Do Directors, Regulators, and Auditors Speak, Hear, and See No Evil? Evidence from Enron, HIH, and One.Tel’ (2002) 15 Australian Journal of Corporate Law 66 at 72–3; Rick Sarre, ‘Responding to Corporate Collapses: Is There a Role for Corporate Social Responsibility’ (2002) 7 Deakin Law Review 1. 97 Stephen Bartholomeusz, ‘After Enron: The New Reform Debate’ (2002) 25 University of New South Wales Law Journal 580, 581. 98 Owen Report (2003), above n 23, li. 99 See the Australian Prudential Regulation Authority Amendment Act 2003 (Cth) – an important amendment was the replacement of the APRA Board and CEO with a full-time executive governing body. 100 See in particular Stilpon Nestor, ‘Regulatory Trends and Their Impact on Corporate Governance’ in The Business Case for Corporate Governance (Ken Rushton, ed.), Cambridge, Cambridge University Press (2008) 176 et seq. 101 Kate Gibbs, ‘General Counsel Prepare for Regulation Onslaught’, TheNewLawyer, 17 December 2009 at 3, available at .

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but it is something that cannot be postponed indefinitely. It is, therefore, to be welcomed that ‘the role of the regulator’ becomes more prominent, also in other books dealing with corporate governance.102 However, it is a case ‘of finding the right balance’. As Sir Bryan Nicholson puts it: While comply-or-explain and the market-based approach to raising standards are preferable to prescriptive regulation, they nonetheless have to be backed up by a supportive regulatory framework. Government and regulators should not act as a substitute for the market, but they do have an important role to play in making sure that the market works effectively.103

Since the first edition of Principles of Contemporary Corporate Governance, we have emphasised the importance of effective regulators as part of the complete picture of developing an effective corporate governance system.

3.5.6 Effective charters, policies and codes of best practice and conduct Since the Cadbury Report in 1992, the idea of self-imposed, good practices in corporate governance through codes of good practice has become prominent. Huse explains that most of the recent reports on corporate governance have contributed to developing and formalising structures and norms by way of codes of conduct, but he explains that in fact, ‘[c]odes are important when other mechanisms attempting to improve governance fail’.104 He then asks some very pertinent questions: Which problems do codes solve? Should there be the same codes for all kinds of firms – small as well as large – and all kinds of ownerships? Should family firms and firms listed on stock exchanges have the same codes?105

Just as with corporate governance generally, the one-size-fits all code of conduct is not achievable. In the UK, the UK Code of Corporate Governance sets the corporate governance standards for listed corporations; comparable standards are required of corporations listed on ASX through the ASX Corporate Governance Council’s Principles of Good Corporate Governance and Best Practice Recommendation. However, the King Report (2009) has now gone further. It recommends that the so-called ‘King Code of Governance Principles’ should apply much wider: In contrast to the King I and II codes, King III applies to all entities regardless of the manner and form of incorporation or establishment and whether public, private sectors or non-profit sectors. We have drafted the principles so that every entity can apply them and, in doing so, achieve good governance.106 102 Sir Bryan Nicholson, ‘The Role of the Regulator’ in The Business Case for Corporate Governance (Ken Rushton, ed.), Cambridge, Cambridge University Press (2008) 100. 103 Ibid, at 106. 104 Huse, above n 32, 176 and 181. 105 Ibid, 182. 106 King Report (2009), above n 69, at 17.

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A common feature of these codes is that it is not mandatory to follow the principles of the code. Some form of explanation is, however, required if a core principle or recommendation is not followed. This approach has been called the ‘comply or explain principle’, ‘if not, why not?’ principle, or, as has more recently become fashionable, the principle of ‘apply or explain’. The problem identified with the principle of ‘comply or explain’ was that it could lead to ‘mindless compliance’, rather than acceptable appliance with good corporate governance principles. Thus, there was a move by the United Nations to promote the principle of ‘adopt or explain’, which was refined slightly in the Netherlands code, referring to ‘apply or explain’. This is also the current principle adopted in the King Report (2009). The approach followed in the USA after the adoption of the Sarbanes-Oxley Act 2002 (see discussion in Chapter 12) has been described as the ‘comply or else’ approach.107 In recent years it has become apparent that a code of best practice could be used just as effectively in a jurisdiction in which a traditional two-tier board structure is the norm for large corporations. Thus, in 2002 Germany adopted a Corporate Governance Code for listed corporations. The ‘comply or explain principle’ was also introduced, showing that there are several principles of good corporate governance that can be superimposed upon a traditional ‘unitary board’ as well as on a traditional ‘two-tier board’.108 Lately, it has also been recommended that companies should develop internal codes of conduct. In this regard, ASX’s Principles of Good Corporate Governance and Best Practice Recommendations sets an excellent example. It requires companies to have a code of conduct. Recommendation 3.1 expects companies to establish a code of conduct and disclose the code or a summary of the code as to: ● the practices necessary to maintain confidence in the company’s integrity ● the practices necessary to take into account their legal obligations and the reasonable expectations of their stakeholders the responsibility and ● the responsibility and accountability of individuals for reporting and investigating reports of unethical practices. The purpose of a code of conduct is explained as follows: The board has a responsibility to set the ethical tone and standards of the company. Senior executives have a responsibility to implement practices consistent with those standards. Company codes of conduct which state the values and policies of the company can assist the board and senior executives in this task and complement the company’s risk management practices.109

It is interesting to note that under the 2007 ASX Principles of Good Corporate Governance and Best Practice it is specifically provided that it is not necessary for companies to establish a separate code for directors and senior executives. It is explained that, depending on the nature and size of the company’s operations, 107 Ibid, at 6 and 7. Also see Peter Montagnon, ‘The Role of the Shareholder’ in The Business Case for Corporate Governance (Ken Rushton, ed.), Cambridge, Cambridge University Press (2008) 81 at 83–4. 108 See Du Plessis, above n 81, 389–404. 109 ASX Principles of Good Corporate Governance and Best Practice (2nd edn, August 2007), above n 28, 21.

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the code of conduct for directors and senior executives may stand alone or be part of the corporate code of conduct.110 It is also interesting to note the difference from the 2003 ASX Principles of Good Corporate Governance and Best Practice; the 2007 ASX Principles of Good Corporate Governance and Best Practice does not require a separate code on ethical and legal conduct or a code of conduct towards stakeholders. This is unfortunate as these different codes were considered to be useful instruments to accentuate the importance of ethical and legal behaviour and also to recognise the importance of stakeholders other than shareholders in the corporation. They were also seen as promoting an inclusive approach to corporate governance, as reflected in the definition of corporate governance set out in Chapter 1. Building upon the previous illustrations, a good corporate governance model would, therefore, look as follows:

Effective legislation

Effective regulators Duties Remedies

Charters, policies and codes of best practice and conduct

Company secretary Appointment or nomination committees Compensation or remuneration committee Audit committee Risk management committee

Shareholder committee

ASX Legal and ethical behaviour Stakeholders: Employees Clients Customers Consumers Community

Figure 3.10: Complete corporate governance model

3.5.7 Corporate governance rating systems for companies Over recent years it has become increasingly important for companies to achieve financial ratings as an indicator of their financial credibility. A few problems were 110 Ibid, 22.

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identified with the system of financial rating.111 First, there is only a limited number of companies and institutions that provides this rating, most prominently, Standard and Poor which, to a large extend monopolises the market. Second, over time the independence of these financial rating institutions or organisations could be compromised because they do not provide these services free of charge. A poor financial rating will almost inevitably lead a client to attempt to get a better financial rating from another company or organisation.112 Third, different criteria are used for such ratings. All these factors together led to situations in which companies and, in particular financial institutions, received AA or even AAA financial ratings, but the global financial crisis revealed that several of them were not as financially stable as what the ratings indicated.113 Another rating system that has become popular in recent times is corporate governance rating systems. It goes almost without saying that most of the problems identified with the financial ratings apply to corporate governance ratings. For current purposes it suffices to list some of the corporate governance rating agencies:114 ● Standard and Poor’s ● The FTSE Group in collaboration with International Shareholder Services (ISS) 115 ● RiskMetrics Group (RMG) ● GovernanceMetrics International (GMI) ● Deminor corporate governance ratings ● Thai Rating and Information Service (TRIs) ● The International Finance Corporation (IFC) . 111 For a more comprehensive discussion on the failure of credit-rating agencies as gatekeepers, see John Coffee, ‘Understanding Enron: It’s About the Gatekeepers, Stupid’ (2002) 57 Business Law 1403; Claire Hill, ‘Rating Agencies Behaving Badly: The Case of Enron’ (2003) 35 Connecticut Law Review 1145; Claire Hill, ‘Regulating the Rating Agencies’ (2004) 82 Washington University Law Quarterly 43; John Hunt, ‘Credit Rating Agencies and the “Worldwide Credit Crisis”: The Limits of Reputation, the Insufficiency of Reform and a Proposal for Improvement’ (2008), available at . 112 Patrick Boltion, Xavier Freixas and Joel Shapiro, ‘The Credit Ratings Game’, Working Paper (February 2009), available at . 113 See, for example, Marco Pagano and Paolo Volpin, ‘Credit Ratings Failures and Policy Options’, Centre for Studies in Economics and Finance, Working Paper no. 239 (November 2009), available at . For law reform proposals, see ‘Joint Report by the Treasury and ASIC: Review of Credit Rating Agencies and Research Houses’ (October 2008), available at ; Technical Committee of International Organisation of Securities Commissions (IOSCO), ‘Code of Conduct Fundamentals for CRAs’ (revised May 2008), available at ; US Securities and Exchange Commission, ‘SEC Votes on Measures to Further Strengthen Oversight of Credit Rating Agencies’, (September 2009), available at . See generally Thomas Clarke and Jean-Francois Chanlat, ‘Introduction: A New World Disorder?’ in European Corporate Governance, London, Routledge (2009) 1 at 15–16. 114 See Tricker, above n 20, 322–4 for a short explanation of all these agencies and organistions. 115 In March 2010, RMG announced a comprehensive review of its corporate governance rating system and introduced several new Governance Risk Indicators (GRIds). This was done in direct response to the global financial crisis and unreliable past governance risk indicators.

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3.6 Conclusion We started this chapter by focusing on the organs of a company and then discussed the main functions of a board of directors. It was pointed out that although there is no ‘one-size-fits’ all governance model, there are certain general criteria that can be used to judge whether a particular country has a good corporate governance model. Effective board structures, effective support mechanisms to assist the board in fulfilling its functions properly, effective statutory provisions and effective regulators have all been identified as elements from which it could be judged whether a country adheres to a good corporate governance model. At the end of the day, a good corporate governance model will translate into well-governed corporations. This in turn, will ensure that investors will see the benefits of investing in well-governed companies to maximise the return on their investments. An additional advantage is that all of this leads to the creation of wealth, which will stimulate a country’s economy and improve the living standards of its citizens. Because of these factors, Durnev and Kim have established that often corporations in countries with weak investor protection mechanisms in place and only requiring minimum corporate governance standards, will do more than just the minimum to adhere to good corporate governance practices. In fact, they were surprised by the number of high-quality governance firms in such countries.116 Also, increasingly, more research is being done and studies undertaken on the key elements of an effective corporate governance system. This ensures that investors are able to quantify the benefits that they get from investing in wellgoverned companies, also called ‘private benefit of control’ by economists.117 In our view, together, all these factors will ensure that corporate governance as a subject area will remain of considerable importance in future. 116 Art Durnev and E Han Kim, ‘Explaining Differences in the Quality of Governance Among Companies’, in Global Corporate Governance (Donald H Chew and Stuart L Gillan, eds), New York, Columbia Business School (2009) 52 at 53. 117 Alexander Dyck and Luigi Zingales, ‘Control Premiums and the Effectiveness of Corporate Governance Systems’, in Global Corporate Governance (Donald H Chew and Stuart L Gillan, eds), New York, Columbia Business School (2009) 73. See also Sir Bryan Nicholson, ‘The Role of the Regulator’ in The Business Case for Corporate Governance (Ken Rushton, ed.), Cambridge, Cambridge University Press (2008) 100 at 101–3.

4 Types of company directors and officers As the cigar smoke in the boardrooms clears, the comfortably reclining figures are instantly revealed as being of two types: the executive directors who run the business and take the rap, and the non-executive directors who, having read their papers carefully for the pre-lunch board meeting, asked their statutory question, and enjoyed a reasonable rib of beef, are ready to depart blamelessly to their bank, chambers, farm or villa for another two months. PLR Mitchell, ‘Non-executive Directors’ (1985) Business Law Review 173

The key directors on our board all know what I have done to make our company perform. They made me the CEO because I was the best candidate they could find. I have worked my butt off at great sacrifice to my family and personal life to transform this company and make it perform better than it ever had before. I don’t need any of their penetrating questions or second-guessing. Thanks to my own tough bargaining, I am financially secure and set for life. If they can get someone better than me to do the job, then that’s what they should do. Until then let them back off and stay out of my way. David SR Leighton and Donald H Thain, Making Boards Work, Whitby, Ontario, McGraw-Hill Ryerson Ltd (1997) 6 (quote from an anonymous, skeptical Canadian CEO)

We trained hard – but every time we were beginning to form up into teams, we would be reorganised. I was to learn later in life that we tend to meet any new situation by reorganising, and [what] a wonderful method it can be for creating the illusion of progress while producing confusion, inefficiency and demoralisation. The famous words of Roman writer Gaius Petronius: Petronii Arbitri Satyricon, 66 ad, as quoted by Nigel Kendall and Arthur Kendall, Real-World Corporate Governance, London, Pitman Publishing (1998) 212

4.1 Overview Comparing the first two opening quotes to this chapter with current realities illustrates very well how things have changed over a relatively short period of 101

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time. In the previous chapter we have seen that there are nowadays much higher community expectations that all types of directors fulfil their duties of care and diligence meticulously. No longer may directors hide behind ignorance or inaction, nor are the duties of non-executive directors seen as being of an intermittent nature. All directors have a positive duty to challenge, enquire and investigate when controversial or potentially risky matters are discussed at board level, as was illustrated by the 2009 case of ASIC v Macdonald (No 11).1 In this chapter it will also become clear that the traditional and simplistic distinction between executive and non-executive directors no longer holds true, although as a general rule it can be said that the legal duties of all types of directors are the same.

4.2 Definition of ‘director’ The identification of who is a director has practical significance for the law on directors’ duties and sanctions for breach under the Corporations Act 2001 (Cth) (the Act), with particular reference to the civil penalty provisions (pecuniary penalty, compensation and disqualification orders) discussed in Chapter 10. The court in Murdaca v ASIC2 reminds us that a person who is not, strictly speaking, a director may nevertheless be disqualified from managing a company if that person is involved in management in ways that are considered to constitute directing or controlling the affairs of that company, either alone or jointly with others. The expansive definition of director also has significant ramifications for those people who occupy the position of director and cause the company to trade while insolvent. Section 588G of the Act, discussed in greater detail in Chapter 10, imposes personal liability upon those persons who occupy the office of director or who discharge functions attaching to that office of the kind normally performed by a director.

4.2.1 De jure and de facto directors covered The corporations laws of most common-law jurisdictions contain a definition of ‘director’. Although there are some differences in the respective definitions, a common feature is that each aims to define the term quite widely in order to ensure that those who fulfil directorial functions do not escape the provisions of the corporations legislation. Thus, the definition of a ‘director’ will typically include a reference to the fact that a person could still be considered to be a director irrespective of the fact that the person is not called a director,3 but is known by a name such as ‘governor’, ‘executive’, ‘manager’ etc. The definitions of ‘director’ will also, as a general rule, not only cover those individuals who were 1 [2009] NSWSC 287 (23 April 2009), available at . 2 [2009] FCAFC 92. 3 See also Robert I Tricker, International Corporate Governance, London, Prentice Hall (1994) 42.

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validly appointed to the position of ‘director’ (de jure directors), but also extend to those acting as a ‘director’ (de facto directors). A recent trend in legislation was also to include so-called ‘shadow directors’ under the definition. These are individuals who are neither appointed to the position nor directly act as directors, but who manipulate the board ‘from behind the scenes’. Section 9 of the Act contains a typical definition of ‘director’, which includes all the features of the definition mentioned above: ‘director’ of a company or other body means: (a) a person who: (i) is appointed to the position of a director; or (ii) is appointed to the position of alternate director and is acting in that capacity, regardless of the name that is given to their position; and (b) unless the contrary intention appears, a person who is not validly appointed as a director if: (i) they act in the position of a director; or (ii) the directors of the company or body are accustomed to act in accordance with the person’s instructions or wishes. Subparagraph (b)(ii) does not apply merely because the directors act on advice given by the person in the proper performance of functions attaching to the person’s professional capacity, or the person’s business relationship with the directors or the company or body.

The labels accorded to directors, as ‘de facto’ or ‘shadow’ directors are intended to be prescriptive. In expressing caution on becoming fixated with labels, Justice Gordon in 2008 in ASIC v Murdaca4 warned: Such descriptions can, at times, be misleading. Names and labels aside, what is required is a critical assessment of the way in which a corporation is managed and then an assessment as to whether the conduct of the person concerned falls with one or more of the categories identified.

4.2.2 Shadow director Subparagraph (b)(ii) covers so-called ‘shadow directors’, but the proviso to subparagraph (b)(ii) (last paragraph quoted above) was included in order to exclude from its parameters those persons in accordance with whose directions the directors usually act, where that advice is given by the outsider in that person’s professional capacity (for example, solicitor or accountant) or because of their business relationship with the directors or company (for example, as the company’s banker). The expanded definition of ‘director’ has caused concern among banks, financial institutions and business and professional advisers. These institutions and persons clearly have a strong interest in the company’s affairs, especially when companies are in financial difficulty and steps are being taken to send representatives to the board to investigate affairs and make suggestions on how to 4 (2008) 68 ACSR 66 at [11].

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overcome the company’s financial difficulties. The problem is succinctly stated by Vinelott J in Re Tasbian (No 3):5 The dividing line between the position of a watchdog or adviser imposed by an outsider investor and a de facto or shadow director is difficult to draw.

The use of the plural, ‘directors’, in subparagraph (b)(ii) suggests that the board, rather than a single director, must be accustomed to acting in accordance with the shadow director’s directions or instructions before the subsection is satisfied. While such an interpretation has been adopted with respect to the equivalent to subparagraph (b)(ii) of the definition in other jurisdictions (Re a Company6 ) the treatment of the subsection in Harris v Sheperd7 suggests that the court believed it sufficient for a single director, there the managing director, to be accustomed to acting on the outsider’s directions. That ‘accustomed to act’ is a tough threshold to satisfy is highlighted further in the recent case Natcomp Technology Australia Pty Ltd v Graiche,8 in which Stein JA said that in order for directors to be ‘accustomed to act’ on the instructions or directions of an outsider for the purposes of the Act, it must be established that the outsider is involved in the principal aspects of the company’s business. This threshold, nonetheless, is not insurmountable, as evidenced in Ho v Akai Pty Ltd (in liq)9 where it was found that the directors or officers of Akai Australia (a company in financial difficulty) were accustomed to acting in accordance with the instructions and wishes of Grande Holdings (a Singaporean company) – the latter being held to be a shadow director and therefore exposed to liability under the insolvent trading provisions in section 588G of the Act.

4.2.3 Nominee directors The term ‘nominee director’ is sometimes loosely used to refer to a director who has been nominated to the board by a majority shareholder or other stakeholder.10 This practice is common in company groups in which the holding company appoints directors to the boards of its subsidiaries. Conflicts of interest may easily arise for these so-called ‘nominee directors’, putting them in an unenviable position where they need to consider their duties towards the company upon whose board they serve or the shareholder (another company in the group context) that appointed them, and in groups of companies they will often be senior managers or executives of the holding company. The law is very clear. A director owes his or her duties to the company upon whose board he or she serves, not to the shareholder or stakeholder who nominated the person to be a 5 Re Tasbian (No 3) [1992] BCC 358 at 363. 6 [1989] BCLC 13. 7 (1975) 1 ACLR 50 (on appeal) [1976] ACLC 28, 614. 8 [2001] NSWCA 120 (30 April 2001). 9 (2006) 24 ACLC 1526. 10 See Bob Tricker, Corporate Governance: Principles, Policies and Practices, Oxford, Oxford University Press, (2009) 53.

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director.11 Thus, the director will be in breach of his or her statutory, common law or equitable duties if he or she does not act in good faith and the best interest of the company upon whose board he or she serves, but in the best interests of the nominator or appointer. There is one exception, and that is provided for in section 187 of the Act. In terms of this section, a director of a corporation that is a wholly owned subsidiary of a body corporate is taken to act in good faith in the best interests of the subsidiary if the following three conditions apply: ● the constitution of the subsidiary expressly authorises the director to act in the best interests of the holding company; and ● the director acts in good faith in the best interests of the holding company; and ● the subsidiary is not insolvent at the time the director acts and does not become insolvent because of the director’s act. Apart from the obvious dilemma for the ‘nominee director’ as far as conflicts of interests are concerned, there are also other dangers involved for the nominator or appointer. First, the nominator or appointer could be considered to be a ‘shadow director’ (see discussion above), thus owing duties similar to other directors towards the company (the holding company in the group context).12 Second, if the ‘nominee directors’ are controlled and manipulated by the nominator or appointer, the nominator or appointer could be held liable vicariously for the acts and conduct of the ‘nominee directors’.13 Although the term ‘nominee director’ is not used in the Act, there is, in the concluding sentence of section 203D(1), a recognition of the practice that directors may be appointed by specific shareholders or debenture holders: 203D(1) If the director was appointed to represent the interests of particular shareholders or debenture holders, the resolution to remove the director [under s 203D(1)] does not take effect until a replacement to represent their interests has been appointed.

A few additional, general observations can be made regarding so-called ‘nominee directors’. It should be noted that in fact all non-executive directors are ‘nominee directors’ in the strict sense of the word, as they are all nominated by the board of directors or by shareholders to be appointed by the general meeting. Although these provisions can be replaced by provisions in a company’s constitution, if a company has a constitution, two sections in the Act confirm the practice that non-executive directors are nominated by the board of directors or by shareholders and then appointed by the shareholders in general meeting. Section 202G provides that ‘[a] company may appoint a person as a director by resolution passed in general meeting’, while section 203H provides as follows: 11 Scottish Co-operative Society v Meyer [1959] AC 324 at 367 per Lord Denning. 12 Standard Chartered Bank of Australia v Antico (1995) 18 ACSR 1. 13 Kuwait Asia Bank v National Mutual Life Nominees Ltd [1991] AC 187.

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(1) The directors of a company may appoint a person as a director. A person can be appointed as a director in order to make up a quorum for a directors’ meeting even if the total number of directors of the company is not enough to make up that quorum. (2) If a person is appointed under this section as a director of a proprietary company, the company must confirm the appointment by resolution within 2 months after the appointment is made. If the appointment is not confirmed, the person ceases to be a director of the company at the end of those 2 months. (3) If a person is appointed by the other directors as a director of a public company, the company must confirm the appointment by resolution at the company’s next AGM. If the appointment is not confirmed, the person ceases to be a director of the company at the end of the AGM.

Thus, whether their appointment was approved by one majority shareholder or two minority shareholders in concert, or by several shareholders as associates voting for their appointment, all non-executive directors are normally appointed by the general meeting if the company did not replace sections 202G and 202H by way of custamised appointment provisions in its constitution. Furthermore, it is often the board of directors, through appointment or nomination committees, that nominates non-executive directors to be appointed by the general meeting. In fact, if the term ‘nominee director’ is the correct description of a director nominated by and appointed by a majority shareholder, such a director will not pass the common test of ‘independence’ contained in most codes of practice. Under the first guideline (Box 2.1) of the 2007 Australian Securities Exchange (ASX) Principles of Good Corporate Governance and Best Practice it is expected that the board, in order to determine the ‘independence’ of a non-executive director, has to consider whether the director is ‘associated’ with a ‘substantial shareholder’. It is inevitable that there will be such ‘an association’ between the director and the ‘substantial shareholder’ if the director was appointed by the ‘substantial shareholder’.14 It will be noted that the discussion regarding ‘nominee directors’ has been limited to non-executive directors. The reason is that the appointment of managing or executive directors is governed by section 201J of the Act, which is discussed below.

4.3 Definition of ‘officer’ 4.3.1 Statutory definition The provisions of the Act often extends beyond directors to any ‘officer’. The aim with such a definition is to ensure that other individuals in the company, 14 ASX, Principles of Good Corporate Governance and Best Practice, (2nd edn, August 2007) 3 at 17 fn 13, defines ‘substantial shareholder’ as ‘a person with a substantial holding as defined in section 9 of the Corporations Act’. S9 of the Corporations Act 2001 (Cth) basically classifies a ‘substantial holding’ as a holding by a person and associates of ‘5% or more of the total number of votes attached to voting shares’ in a body corporate.

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not appointed as directors or acting as directors or shadow directors, are also covered by certain provisions of the Act and that they cannot escape liability if they are in breach of certain provisions. Under section 9 of the Act, ‘officer of a corporation means’: (a) a director or secretary of the corporation; or (b) a person: (i) who makes, or participates in making, decisions that affect the whole, or a substantial part, of the business of the corporation; or (ii) who has the capacity to affect significantly the corporation’s financial standing; or (iii) in accordance with whose instructions or wishes the directors of the corporation are accustomed to act (excluding advice given by the person in the proper performance of functions attaching to the person’s professional capacity or their business relationship with the directors or the corporation); or (c) a receiver, or receiver and manager, of the property of the corporation; or (d) an administrator of the corporation; or (e) an administrator of a deed of company arrangement executed by the corporation; or (f) a liquidator of the corporation; or (g) a trustee or other person administering a compromise or arrangement made between the corporation and someone else. Note: Section 201B contains rules about who can be a director of a corporation: (1) Only an individual who is at least 18 may be appointed as a director of a company. (2) A person who is disqualified from managing corporations under Part 2D.6 may only be appointed as director of a company if the appointment is made with permission granted by ASIC under section 206F or leave granted by the Court under section 206G.

4.3.2 Senior employees and senior executives as ‘officers’ The aim with the broad statutory definition of ‘officer’ is also to ensure that there is no doubt that certain duties imposed by the corporations law apply to a group of people who will not necessarily fall under the definition of ‘director’. It is a well-established principle that senior employees or senior officers of a corporation owe duties similar to those of directors towards the company. The clearest expression of this principle, adopted in most common-law jurisdictions, is the case of Canadian Aero Service Ltd v O’Malley:15 I do not think it matters whether O’Malley and Zarzycki were properly appointed as directors of Canaero or whether they did or did not act as directors. What is not in doubt is that they acted respectively as president and executive vice-president of Canaero for 15 (1973) 40 DLR (3d) 371.

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about two years prior to their resignations. To paraphrase the findings of the trial Judge in this respect, they acted in these positions and their remuneration and responsibilities verified their status as senior officers of Canaero. They were ‘top management’ and not mere employees whose duty to their employer, unless enlarged by contract, consisted only in respect for trade secrets and for confidentiality of customer lists. Theirs was a larger, more exacting duty which, unless modified by statute or contract (and there is nothing of this sort here), was similar to that owed to a corporate employer by its directors.16

4.3.3 Middle management as ‘officers’? In the HIH Royal Commission Report, Justice Owen was struck by the role of middle management as a component of a company’s governance systems. He observed that it is customary to focus upon the role of senior or executive level management when the organs of governance are discussed. However, Justice Owen observed that ‘middle management’ had played a significant role in HIH and that they were involved in undesirable practices. He was frustrated by the disinclination of those persons to accept responsibility in relation to such practices. Justice Owen then observed as follows regarding middle management: I have therefore had occasion to review the current legal regime governing the duties imposed upon persons other than directors. These issues seem to me to be of considerable significance, because it is clear that in larger companies many significant decisions are made by management without reference to the board. It follows that any legal regime for the enforcement of corporate governance standards which does not extend to the acts or omissions of at least some levels of management is unlikely to be wholly effective. The evidence I have heard also suggests that it is common for management decisions to be made on a collective or collegiate basis, or at least after interaction with other managers. There is therefore an opportunity for the law significantly to influence the mind-set or culture of those managers, and reinforce their obligations to the company and its shareholders.17

As part of the CLERP 9 amendments to the Act in 2004 (see Chapter 8) the term ‘employee’ was included in several of the provisions of the Act.18 However, the legislature did not accept Justice Owen’s suggestion to make the primary duties imposed upon directors and officers applicable to middle managers. The question of reform in this area was, however, referred to the Corporations and Markets Advisory Committee (CAMAC) for consideration. In May 2005, CAMAC released a discussion paper titled Corporate Duties Below Board Level. In that paper, CAMAC put forward preliminary proposals to, inter alia, (i) extend the duties in section 180 (due care and diligence), and section 181 (good faith 16 At 381, para. 22. 17 Report of the HIH Royal Commission (Owen Report), The Failure of HIH Insurance – Volume I: A Corporate Collapse and its Lessons, Canberra, Commonwealth of Australia (2003) 122 para 6.4. 18 See the Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 (the so-called CLERP 9 Act), amending inter alia the following sections to include ‘employees’ – ss 411, 418, 422, 436 etc.

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and proper purpose) to apply to ‘any other person who takes part in, or is concerned, in the management of that corporation’, and (ii) extend the prohibitions in section 182 and section 183 (regarding improper use of company position or information) to apply to ‘any other person who performs functions, or otherwise acts, for or on behalf of that corporation’. CAMAC sought comments as to whether ‘management’ should be defined and, if so, whether it should be defined along the lines of activities that involve policy and decision making related to the business affairs of a corporation, to the extent that the consequences of the formation of those policies or making of those decisions may have some significant bearing on the financial standing of the corporation or the conduct of its affairs. It is still unclear whether these proposals would be adopted and, if so, when.

4.4 Types of company officers 4.4.1 Executive and non-executive directors19 It will be clear from the discussion above that the Act makes no distinction between ‘executive’ and ‘non-executive’ directors. All ‘directors’ fall under the same definition and, as general rule,20 have the same duties. That this is the correct interpretation of the Act as confirmed in Daniels v Anderson.21 Although there is, as general rule, no difference in the duties expected of ‘executive’ and ‘non-executive’ directors in the Act, the distinction between ‘executive’ and ‘non-executive’ directors is nowadays a very important one in practice.22 This distinction has become progressively more important with the emphasis on the board’s role to ‘direct, govern, guide, monitor, oversee, supervise or comply’, as explained in greater detail in the previous chapter. The more prominent role of ‘independent non-executive directors’ has further accentuated this practical distinction between ‘executive’ and ‘non-executive’ directors.23 Executive directors wear two hats. On the one hand, they are executives working full-time in the corporation, and in this capacity they will normally have a contract of service with the corporation.24 On the other hand, executive directors 19 In the USA, the term ‘outside director’ is used rather than ‘non-executive director’. 20 The words, ‘as general rule’ are emphasised, because there is a clear recognition in s 180(1) of the Act that although all directors or other officers of a corporation ‘must exercise their powers and discharge their duties with the degree of care and diligence that a reasonable person would exercise’, the specific type of corporation (for instance a small proprietary company or a large multinational, listed public company) in which the director fulfilled his or her duties and the specific position the person occupied and the specific responsibilities allocated to the person (for instance an independent non-executive director or the chief financial officer or CEO, who are also board members) will be taken into consideration in determining whether there was a breach of a particular director’s duty of care and diligence under s 180(1) of the Corporations Act 2001. 21 [1995] 13 ACLC 614. 22 ASIC v Rich [2009] NSWSC 1229 [7203]. 23 See generally Murray Steele ‘The Role of the Non-executive Director’ in The Business Case for Corporate Governance (Ken Rushton, ed.), Cambridge, Cambridge University Press (2008) 50. 24 See AWA Ltd v Daniels (Trading as Deloitte Haskins & Sells & Ors) (1992) 7 ACSR 759, 867.

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are office-bearers of the company, falling under the statutory and commonlaw duties expected of a ‘director’. The 2007 ASX Principles of Good Corporate Governance and Best Practice simply defines ‘executive director’ as ‘a director who is an executive of the company’.25 Non-executive directors have the same statutory and common-law duties as executive directors, but they do not work in the company on a full-time basis. Their labour is first and foremost directed toward the matters dealt with at board meetings. They serve on the board, and the board’s functions and responsibilities are to ‘direct, govern, guide, monitor, oversee, supervise and comply’. In this sense their duties and responsibilities are of a continuing nature. The 2007 ASX Principles of Good Corporate Governance and Best Practice simply defines ‘non-executive director’ as ‘a director who is not an executive of the Company’.26

4.4.2 Independent non-executive directors It has been realised for several years that non-executive directors can play an important role on boards, in particular, of larger corporations, because they ‘bring to bear a broader perspective, more background, a wider range of skills on a particular issue or indeed on the management of the company . . . ’27 Thus, apart from any expertise they may bring to the company, non-executive directors often provide a beneficial objective/independent viewpoint and thus a crucial check on self-interest and abuse within corporate management. Tricker explains the shift away from boards controlled by inside directors and also the reason for this shift: In the last several decades there has been a dramatic shift away from boards dominated by inside directors towards boards dominated by outside directors . . . A principal reason for this change has been the growing concern that inside directors (ie corporate employees) tend to be self-serving.28

In 1992, the Cadbury Report emphasised the important role of non-executive directors in bringing an ‘independent judgment’ into the boardroom.29 However, the committee responsible for the Report stopped short of recommending that the majority of the board should consist of ‘independent non-executive directors’. The only recommendation was that there should be at least three nonexecutive directors on the boards of listed companies and that the majority of non-executive directors should be ‘independent of the company’.30 The Cadbury 25 Principles of Good Corporate Governance and Best Practice (2007), above n 14, 39. 26 Ibid. 27 Evidence presented to the Senate Standing Committee on Legal and Constitutional Affairs, Report on the Social and Fiduciary Duties and Obligations of Company Directors (1989) 618. 28 Tricker, above n 3, 15. 29 Committee on the Financial Aspects of Corporate Governance, Report of the Committee on the Financial Aspects of Corporate Governance (Cadbury Report (1992)) (1992) para 4.10 et seq. 30 Ibid para 4.11 and 4.12.

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Report only defined independence as ‘independent of management and free from any business or other relationship which could materially interfere with the exercise of their independent judgment’.31 The Hampel Committee (1998), ‘after careful consideration’, observed that it ‘[does] not consider that it is practicable to lay down more precise criteria for independence’;32 and in 2002, it was stated that there were in the United Kingdom only minimal indications of what is meant by ‘independence’ and that it was primarily for the board to set standards regarding the definition of independence.33 Subsequently, however, there has been a considerable change of heart in the UK. The Higgs Report (2003) not only recommended that at least half of the board (excluding the chair) should be ‘independent non-executive directors’,34 but also defined ‘independence’ in great detail.35 These recommendations were accepted and formed part of the 2008 UK Combined Code (see further Chapter 12 and note that a new UK Corporate Governance Code will become effective from 29 June 2010 – also discussed further in Chapter 12). A person may only be considered to be an ‘independent non-executive director’ if the following criteria are met: Code Principle A.3.1 The board should identify in the annual report each nonexecutive director it considers to be independent. The board should determine whether the director is independent in character and judgement and whether there are relationships or circumstances which are likely to affect, or could appear to affect, the director’s judgement. The board should state its reasons if it determines that a director is independent notwithstanding the existence of relationships or circumstances which may appear relevant to its determination, including if the director: • has been an employee of the company or group within the last five years; • has, or has had within the last three years, a material business relationship with the company either directly, or as a partner, shareholder, director or senior employee of a body that has such a relationship with the company; • has received or receives additional remuneration from the company apart from a director’s fee, participates in the company’s share option or a performance-related pay scheme, or is a member of the company’s pension scheme; • has close family ties with any of the company’s advisers, directors or senior employees; • holds cross-directorships or has significant links with other directors through involvement in other companies or bodies; • represents a significant shareholder; or • has served on the board for more than nine years from the date of their first election.

31 Ibid para 4.12. 32 Committee on Corporate Governance, Final Report (Hampel Report (1998)), para 3.9, available at . 33 Stephen M Davis, ‘Leading Corporate Governance Indicators’, in Low Chee Keong (ed.), Corporate Governance: An Asian-Pacific Critique, Hong Kong, Sweet & Maxwell (2002) 57, 61. 34 Review of the Role and Effectiveness of Non-Executive Directors (Higgs Report), (January 2003), available at para 9.5. 35 Ibid para 9.11 and box following para 9.13 on 37. See also Richard Smerdon, A Practical Guide to Corporate Governance, London, Sweet & Maxwell (2nd edn, 2004) 67 et seq.

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In Australia, it is now expected that listed companies must explain if they do not have at least half of the board (excluding the chair) consisting of ‘independent directors’; there are now also extensive guidelines in the ASX Principles of Good Corporate Governance and Best Practice Recommendations for assessing whether a non-executive director is ‘independent’.36 These guidelines were originally (2003) adapted from the Investment and Financial Services Association (IFSA) Blue Book (2002):37 Assessing the independence of directors An independent director is a non-executive director (ie is not a member of management) and: 1. is not a substantial shareholder of the company or an officer of, or otherwise associated directly with, a substantial shareholder of the company; 2. within the last three years has not been employed in an executive capacity by the company or another group member, or been a director after ceasing to hold any such employment; 3. within the last three years has not been a principal of a material professional adviser or a material consultant to the company or another group member, or an employee materially associated with the service provided; 4. is not a material supplier or customer of the company or other group member, or an officer of or otherwise associated directly or indirectly with a material supplier or customer; 5. has no material contractual relationship with the company or another group member other than as a director of the company; 6. has not served on the board for a period which could, or could reasonably be perceived to, materially interfere with the director’s ability to act in the best interests of the company; 7. is free from any interest and any business or other relationship which could, or could reasonably be perceived to, materially interfere with the director’s ability to act in the best interests of the company.

These guidelines were simplified, and the 2007 ASX’s Principles of Good Corporate Governance and Best Practice Recommendations currently contains the following guidelines: Box 2.1: Relationships affecting independent status When determining the independent status of a director the board should consider whether the director: 1. is a substantial shareholder of the company or an officer of, or otherwise associated directly with, a substantial shareholder of the company 2. is employed, or has previously been employed in an executive capacity by the company or another group member, and there has not been a period of at least three years between ceasing such employment and serving on the board 3. has within the last three years been a principal of a material professional adviser or a material consultant to the company or another group member, or an employee materially associated with the service provided 36 ASX, Principles of Good Corporate Governance and Best Practice Recommendations, (March 2003), available at . 37 Guidance Note No. 2.00: Corporate Governance: A Guide for Fund Managers and Corporations (hereafter referred to as ‘IFSA Blue Book (2002)’), (December 2002), 18 – see ASX, Principles of Good Corporate Governance and Best Practice Recommendations (March 2003) above n 36, 20 fn 5.

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4. is a material supplier or customer of the company or other group member, or an officer of or otherwise associated directly or indirectly with a material supplier or customer 5. has a material contractual relationship with the company or another group member other than as a director.

The shift towards expecting a majority of the directors of listed corporations to be ‘independent non-executive directors’ went hand-in-hand with a considerable expansion of the role envisaged for independent non-executive directors over recent years. Perceptions of what an ‘independence director’ is has also changed rapidly over recent times.38 As recently as 1998, Kendall and Kendall explained as follows: An independent director may represent particular key stakeholder groups, such as shareholders, employees or a major trading partner, or he or she may have a more general purpose, representing all interested parties.39

It will be apparent from both the 2008 UK Combined Code and the ASX’s Principles of Good Corporate Governance and Best Practice Recommendations, quoted above, that such a director (called ‘connected independent director’ (CNED) – see discussion below) will no longer pass the test of independence. Companies will nowadays have to explain why they consider a director to be ‘independent’ if he or she represents the interest of a stakeholder such as a ‘significant shareholder’ or is himself or herself ‘a substantial shareholder of the company or an officer of, or otherwise associated directly with, a substantial shareholder of the company’. Only time will tell whether non-executive directors can live up to the huge expectations for them not only to ‘bring to bear a broader perspective, more background, a wider range of skills on a particular issue or indeed on the management of the company . . . ’,40 but also to fulfil their newly acquired monitoring or supervisory roles. It should be kept in mind that several factors or barriers may stand in the way of non-executive directors fulfilling their role effectively: the appointment processes for non-executive directors are often inadequate – nomination by the board based on close personal relationships with board members, the chief executive officer (CEO) or the chairperson of the board etc;41 some are still too closely allied with management; they rely of necessity on information prepared by and received from management to fulfil their monitoring or supervisory functions;42 there is no guarantee that they will challenge the CEO; 38 See generally Robert AG Monks and Nell Minow, Corporate Governance, Oxford, Blackwell (3rd edn, 2004) 227 et seq. 39 Nigel Kendall and Arthur Kendall, Real-World Corporate Governance, London, Pitman (1998) 107. 40 Evidence presented to the Senate Standing Committee on Legal and Constitutional Affairs, Report on the Social and Fiduciary Duties and Obligations of Company Directors, Canberra, AGPS (1989), 618. 41 See generally Tricker, above n 10, 57. 42 For some very skeptical, but enlightening, views of the role of boards by young CEOs in Canada, see David Leighton and Donald H Thain, Making Boards Work, Whitby, Ontario, McGraw-Hill Ryerson (1997) 6–7. Also see Lawrence Mitchell, ‘Structural Holes, CEOs and the Informational Monopolies: The Missing Link in Corporate Governance’, (2005) 70 Brook Law Review 1313.

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they lack detailed knowledge of the company’s business; they have limited time to spend on their directorships;43 ‘independence’ is a state of mind, rather than something to be determined by ticking a few boxes to illustrate that the person is ‘independent’;44 there are different meanings attached to ‘independence’;45 the more ‘involved and engaged’ non-executive directors become, the less independent they become; lack of time commitment to the company; and a lack of knowledge and understanding of the company46 . Murray Steele summarises the challenges for non-executive directors very well: [A]s a result both of their responsibilities and of the rapidly changing environment in which companies operate, the NED role today is complex and demanding. It requires skills, experience, integrity, and particular behaviours and personal attributes. NEDs have to deal with interesting dilemmas: they need both to challenge and support the executive directors; be both engaged and non-executive; and both independent and involved.47

We will also have to wait and see whether the role and effectiveness of independent non-executive directors will improve corporate governance practices and make corporations more responsible, efficient and profitable (see the definition of ‘corporate governance’ in Chapter 1). There are widely diverging views on what the actual effect of ‘independence’48 is on directors’ perceptions of their role and functions. It has been argued that all directors should have an interest in the corporation through shareholdings;49 that ‘the best boards consist of directors who are also substantial, as opposed to nominal, shareholders’;50 and that it ‘has [been] proven [to be] hollow at best’ to expect outside directors with little or no equity stake in the company to effectively monitor and discipline the managers who selected them.51 It seems to us that the ‘monitoring, overseeing, supervisory and compliance’ roles (see Chapter 3) – and the fulfillment of these roles through independent non-executive directors – have become so dominant that the other roles of the board (‘directing, governing and guiding’) could suffer as a result. This trend could be described as the dominance of responsible corporate behaviour over 43 Bonnie Buchanan, Tom Arnold and Lance Nail, ‘Beware the Ides of March: The Collapse of HIH Insurance’ in Jonathan A Batten and Thomas A Fetherston (eds), Social Responsibility: Corporate Governance Issues, London, JAI (2003) 199, 213; John C Shaw, ‘The Cadbury Report, Two Years Later’ in K J Hopt, K Kanda, M J Roe, E Wymeersch and S Priggle (eds), Comparative Corporate Governance: The State of the Art and Emerging Research, Oxford, Clarendon Press (1998) 21, 27–9; and Tricker, above n 3, 15. 44 See also Bob Tricker, above n 10, 51. 45 See in particular Donald Clarke, ‘Three Concepts of the Independent Director’, (2007) 32 Delaware Journal of Corporate Law 73. 46 Steele, above n 23, 50 at 56–9. 47 Ibid, 50 at 65. 48 Leighton and Thain, above n 42, 64–5, give good reasons for their belief that ‘director independence is a myth’. 49 See further Mirko Bagaric and James McConvill, ‘Why All Directors Should be Shareholders in the Company: The Case Against “Independence” ’ (2004) 16 Bond Law Review 40. 50 John L Colley (Jr), Jacqueline L Doyle, George W Logan and Wallace Stettinius, Corporate Governance, London, McGraw-Hill (2003) 78. 51 Jensen, as quoted by Mahmoud Ezzamel and Robert Watson, ‘Executive Remuneration and Corporate Performance’ in Kevin Keasey and Mike Wright (eds), Corporate Governance: Responsibility, Risks and Remuneration, New York, Wiley (1997) 61, 70.

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corporate performance,52 and one wonders whether the scale has not perhaps tilted too far in favour of responsible corporate behaviour.53 We are of the opinion that the role and effectiveness of independent nonexecutive directors has been over-emphasised in recent years or, to put it differently, there is an unrealistic expectation of what non-executive directors can achieve.54 We agree with Justice Owen, who had some difficulty in accepting the wisdom of the current trend to expect listed companies to have a majority of independent non-executive directors: The weight of current opinion is that it is desirable to have a majority of independent directors on a public company board. The board of HIH had several ‘independent’ directors but this provided little protection against the folly of management. I am not convinced that a mandatory requirement for boards to have a majority of non-executive directors is either necessary or desirable. In most cases it will be desirable (assuming the non-executive directors are truly independent) but flexibility ought to be maintained to enable corporations to be structured in a way that best suits their circumstances. Nonetheless, the trend in the prescription of codes of conduct seems to assume the premise. My recommendations have been developed accordingly.55

It is also particularly noteworthy that the 2010 UK Corporate Governance Code moved away from the requirement that the boards of listed UK companies should comprise a majority independent, non-executive directors. The current requirement reads as follows: The board should include a strong presence of executive and non-executive directors (and in particular independent non-executive directors) such that no individual or small group of individuals can dominate the board’s decision taking (Supporting Principle to B.1).56

With their monitoring role in mind, and the huge potential of personal liability, in future will there be any real incentive for ‘independent non-executive directors’ to work and see the company through difficult times rather than just abandoning ship at the earliest possible time when the corporation goes through troubled times? There is a risk that in future ‘independent non-executive directors’ will become no more than professional whistleblowers in order to fulfil their monitoring role and to avoid the danger of huge personal liability. The upshot of this is that it will lead to a reality check – the current over-emphasis on the role and effectiveness of ‘independent non-executive directors’ is creating an unrealistic 52 See generally Thomas Clarke, ‘Risks and Reform in Corporate Governance’ in 3R’s of Corporate Governance, Kuala Lumpur, Malaysian Institute of Corporate Governance (2001) 116, 116. 53 See also Leighton and Thain, above n 42, 23–4; and Sir Geoffrey Owen, ‘The Role of the Board’ in The Business Case for Corporate Governance (Ken Rushton, ed.), Cambridge, Cambridge University Press (2008) 10 at 22–3 and 28; Sanjai Bhagat and Bernard S Black, ‘Non-correlation Between Board Independence and Long-term Firm Performance’ (2002) 27 Journal of Corporate Law 231. 54 Ken Rushton, ‘Introduction’ in The Business Case for Corporate Governance (Ken Rushton, ed.), Cambridge, Cambridge University Press (2008) 1 at 6–7. 55 Owen Report, above n 17, 112 para 6.2.6. 56 FRC, Consultation on the Revised UK Corporate Governance Code (December 2009), available at at 22.

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expectation, a rapidly widening ‘expectation gap’. Over time, that has the potential to cause the demise of the ‘independent non-executive director’ as one of the useful devices invented to ensure that corporations adhere to good corporate governance practices. Although we do not deny there is a definite place in the complete corporate governance picture for independent non-executive directors, it is barking up the wrong tree to over-emphasise their role and effectiveness. Time, energy and money would, in our view, better be spent in adopting an open-minded and inclusive approach to corporate governance (see the definition of corporate governance in Chapter 1) rather than taking a narrow approach that focuses only on selected areas such as the financial aspects of corporate governance or the role and effectiveness of independent non-executive directors. As Rodrigues justly points out, recent corporate history and corporate scandals (Enron, Hewlett Packard and United Health) teach us that the ‘independent board’ can be of cold comfort and that we should guard against over reliance on independence. The argument is that to expect independence in order to achieve more, to require super majority independent boards and expect them to make better business decisions and govern the corporation better is to misconceive the role of the independent director and to fetishise independence.57 Another danger emphasised by Mitchell is that on boards in which there is a super majority of independent board members, the function of the board shifts, of necessity, to the monitoring role of the board. In addition, with so few insiders on the board, the CEO becomes the main avenue for providing internal information, which increases the risk of fraud.58

4.4.3 Connected non-executive directors Tricker uses the term ‘connected non-executive directors (CNEDs)’ in reference to categories of directors who are not part of the company’s management but have some relationship with the company.59 CNEDs are also called ‘affiliated directors’.60 In other words, they are the non-executive directors who do not meet one or more of the criteria stipulated to classify them as ‘independent non-executive directors’. These directors will, therefore, have to be disregarded when a company wants to determine whether it complies with the expectation in several international voluntary codes of best practice that the boards of listed public companies must have a majority ‘independent non-executive directors’. Alternatively, a company will have to explain why it considers a person still to be ‘independent’ irrespective of the required connections with the company. 57 Usha Rodrigues, ‘The Fetishization of Independence’ (2008) 33 Journal of Corporate Law 447. 58 Lawrence Mitchell, ‘Structural Holes, CEOs and the Informational Monopolies: The Missing Link in Corporate Governance’, (2005) 70 Brook Law Review 1313. 59 Tricker, above n 10, 51. 60 Stephen M Bainbridge, The New Corporate Governance in Theory and Practice, Oxford, Oxford University Press, (2008) 188.

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4.4.4 Lead independent directors or senior independent directors The 2010 UK Corporate Governance Code requires that the board appoint one of the independent non-executive directors to be ‘the senior independent director’. It is expected of the senior independent director to provide a sounding board for the chairman and to serve as an intermediary for the other directors when necessary. The senior independent director should also be available to shareholders if they have concerns about which contact through the normal channels of chairperson, CEO or other executive directors has failed to resolve or for which such contact is inappropriate.61 The Code further provides that the annual report should identify ‘the senior independent director’.62 It also requires that ‘the senior independent director’ should lead a meeting with all the non-executive directors at least annually, without the chairperson, in order to appraise the chairperson’s performance, and on such other occasions as are deemed appropriate.63 This performance evaluation of the chairperson should take into account the views of executive directors.64 Furthermore, the senior independent director should attend sufficient meetings with a range of major shareholders to listen to their views in order to develop a balanced understanding of the issues and concerns of major shareholders.65 The ASX Corporate Governance Council’s Principles of Good Corporate Governance and Best Practice Recommendations contains no specific recommendation for a ‘senior independent director’ to be appointed and identified. However, there is a suggestion that where the chairperson is not an independent director, it may be beneficial to consider the appointment of a ‘lead independent director’.66

4.4.5 The managing director, managing directors, the chief executive officer and executive directors In terms of section 201J (replaceable rule) of the Australian Corporations Act 2001 (Cth), the directors of a company may appoint one or more of themselves to the office of managing director for such period, and on such terms (including remuneration), as the directors may think fit. Section 198C (replaceable rule) specifically allows the directors to confer on a managing director any of the powers that the directors may exercise. Note that there is no definition of ‘managing director’ in the Act. The term has also been used, especially in the past, to indicate all those directors involved in managerial functions. There is also no definition of ‘executive director’ in the Act. Thus, it is only by inference that it could be concluded that a board 61 62 63 64 65 66

FRC, above n 56, Code Provision A.4.1. Ibid, Code Provision A.1.2. Ibid, Code Provisions B.6.3. Ibid. Ibid, Code Provision E.1.1. Principles of Good Corporate Governance and Best Practice (2007), above n 14, 17.

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will, under sections 201J and 198C of the Act have the power to appoint one or more of themselves to the office of ‘executive director’ and confer on an executive director any of the powers the directors may exercise. The reason for this inference is that it is less common to use the terms ‘managing directors’ or ‘the managing director’ in public companies. Under the influence of the USA, it is nowadays common to use the terms ‘executive directors’, ‘chief executive officer’ or ‘principal executive officer’ rather than ‘managing directors’ or ‘the managing director’.67 In most large Australian corporations, the CEO will also be a director, but listed companies will have to explain (under the ‘if not, why not’ principle) if the CEO is also the chair of the board.68 It is interesting to note that there is no reference to ‘the managing director’ or ‘managing directors’ in the 2007 ASX Principles of Good Corporate Governance and Best Practice. The term ‘senior executives’ is used and defined as ‘the senior management team as distinct from the board, being those who have the opportunity to materially influence the integrity, strategy and operation of the company and its financial performance’.69

4.4.6 Chairperson Section 248E (replaceable rule) of the Act allows the board to appoint one director to chair their meetings. This section further provides that the directors must elect a director present to chair a meeting, or part of it, if: (a) a director has not already been elected to chair the meeting; or (b) a previously elected chair is not available or declines to act for the meeting or part of the meeting. It is unclear, however, whether the chairperson has any implied authority beyond the usual authority of a single director. This was doubted in Hely-Hutchinson v Brayhead Ltd.70 If a director is the chairperson of a meeting, he or she is still acting in his or her capacity as a director of the company. If, however, the chairperson is acting as a proxy (an agent for the member), the chairperson owes duties to the individual members who directed their proxies to him or her. Accordingly, in such circumstances a chairperson owes duties distinct from the duties owed by a director – they are not mutually exclusive – both sets of duties must be complied with: Whitlam v Australian Securities and Investments Commission.71 As pointed out in Chapter 3, it is considered not to be a good corporate governance practice to combine the role of CEO and chairperson of the board. The reasons are, firstly, roles of management and the board are considered to be different and it is almost impossible for the same individual to properly fulfil the respective roles of the most senior manager of the company and the 67 J B Reid, Commonsense Corporate Governance, Sydney, Australian Institute of Company Directors (2002) 68. 68 Principles of Good Corporate Governance and Best Practice (2007), above n 14, Recommendation 2.2. 69 Ibid, 39. 70 [1968] 1 QB 549. 71 (2003) 21 ACLC 1259.

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role as chairperson of the board, with an expectation that the board should ‘direct, govern, guide, monitor, oversee, supervise and comply’ – see discussion in Chapter 3. Second, it is also considered to be too much of a concentration of power vested in one person to combine the roles of CEO and chairperson.72 However, it should be pointed out that whether or not the CEO is also the chairperson, it is unlikely that other executive directors serving on the board will challenge the CEO on managerial decisions taken by the CEO at board level. The reason for this is simply that such a challenge will probably result in them having to face the wrath of the CEO the next day, when they will again be seen as the subordinates of the CEO, who is after all their boss as far as line management is concerned. One can also imagine that executive directors will normally not like their internal differences to be displayed at board level, as that can easily get in the way of an harmonious and collegial way in which the business of the company is run by the senior executives. Having a different person as chairperson of the board provides a mechanism through which sensitive issues can be discussed with the chairperson on all executive matters, rather than taking up these matters at board level. Mervyn King, in his book, The Corporate Citizen, devotes a chapter to the role of the chairperson. Some of the key aspects that chairpersons should keep in mind could be extracted from this chapter:73 ● A good chairperson will be able to prepare a meeting in such a way that it will finish within two to three hours; ● Because body language is important, members of the board need to be in a place where they can not only hear each other clearly but can see each other as well. ● The chairperson needs to prepare for the meeting by ensuring that he or she has read all the documents carefully, understands them, and, in addition has spent time with senior management prior to the meeting. ● The chairman has to ensure that the board does not get involved in management – he or she has to remember that the board’s role is a reflective one; strategy rather than activity. ● A good chairman is also a good listener. ● It is important for the chairperson to liaise with the chairperson of every board committee (especially the audit committee) and have an understanding between them in regard to the presentation of any matter with which the respective subcommittees is concerned. ● While the chairperson has to be collegiate, he or she has to be at arm’s length (which is impossible if the role of CEO and chairperson is combined) because at some time the chairperson is going to be called upon 72 See generally Ken Rushton, ‘The Role of the Chairman’ in The Business Case for Corporate Governance (Ken Rushton, ed.), Cambridge, Cambridge University Press (2008) 29. 73 Mervyn King, The Corporate Citizen: Governance for All Entities, Johannesburg, Penguin Books (2006) at 39–45. For another discussion of the practical importance of the chairperson, see Bob Tricker, above n 10, 255–9.

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to arbitrate issues, dismiss a senior executive or call on a colleague to resign. The chairperson should try to meet at least twice a year with the nonexecutive directors so that a discussion without management present can be held about, inter alia, issues such as the ability of the management team and succession planning. The chairperson must endeavor to find ways in which bad news will reach the top more quickly and he or she must become an expert in asking a critical intellectually na¨ıve question when he or she does intervene in a debate. A chairperson needs to know that the members of the board have done their homework by sometimes asking any of the board members to summarise an issue and motivate why he or she voted in a particular way on an issue.

4.4.7 Alternate director Section 201K (replaceable rule) of the Act empowers a director to appoint an alternate director to exercise some or all of the director’s powers for a specific period. This power is useful when a director is unable to be present at meetings. The appointment of an alternate director must be in writing74 and must be approved by the other directors.75 This approval will presumably be by way of a resolution of the board. If so requested by the appointing director, the company must give the alternate director notice of directors’ meetings.76 When an alternate exercises the appointing director’s powers, it is just as effective as if the powers were exercised by the appointing director.77 Although the alternate director may be appointed to act as agent of the appointing director, the alternate is nevertheless a director in the eyes of the law, with the same rights, duties and responsibilities of a director.78 The appointing director may terminate the alternate’s appointment at any time.79 It is important to note that the Australian Securities and Investments Commission (ASIC) must be given notice of the appointment and termination of appointment of an alternate director.80

4.4.8 Secretary The Cadbury Report (1992) dealt with the vital role the company secretary should play in ensuring that correct procedures and good corporate governance practices 74 Section 201K(5) of the Corporations Act. 75 Section 225K(1). 76 Section 201K(2). 77 Section 201K(3). 78 Business Council of Australia, Corporate Practices and Conduct (hereafter referred to as the ‘Bosch Report (1993)’), Melbourne, Information Australia (1993) 18. 79 Section 201K(4). 80 Section 205B(2) and (5).

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are followed.81 This has been confirmed by the Hampel Report (1998).82 In the Cadbury Report, the role of the company secretary was explained as follows: 4.25 The company secretary has a key role to play in ensuring that board procedures are both followed and regularly reviewed. The chairman and the board will look to the company secretary for guidance on what their responsibilities are under the rules and regulations to which they are subject and on how those responsibilities should be discharged. All directors should have access to the advice and services of the company secretary and should recognise that the chairman is entitled to the strong and positive support of the company secretary in ensuring the effective functioning of the board. It should be standard practice for the company secretary to administer, attend and prepare minutes of board proceedings (original emphasis).83

In Australia, a public company must have at least one secretary.84 A proprietary company is no longer required to appoint a secretary, but if it does have one or more secretaries, at least one must ordinarily reside in Australia.85 Section 188(2) of the Act serves as an encouragement for even proprietary companies to appoint a secretary, by providing that the directors of such a company will be liable if sections 142, 145, 205B or 345 are contravened. The power to appoint a company secretary rests with the board86 and the appointee holds office on the terms and conditions (including remuneration) that the directors determine.87 The secretary must be a natural person who is at least 18 years old, and no person disqualified to be a director may be a secretary without the approval of ASIC.88 The secretary, or one of the secretaries, must be ordinarily a resident in Australia.89 The company secretary may also be a director of the company. Unlike in the UK,90 there is no requirement in Australia that the company secretary should have any relevant business experience or formal educational qualifications. As pointed out in the previous chapter, we are of the opinion that the company secretary should play a vital role, not only in assisting the board to fulfil its tasks, but also in ensuring a healthy and free flow of information between the board and management.91 The importance of the company secretary is recognised in the Australian legislation by way of section 300A(1B)(a) of the Act, stating clearly that ‘a person is a company executive of the company if the person is a secretary or senior manager of the company’. 81 Cadbury Report (1992), above n 29, paras 4.25–4.27. 82 Hampel Report (1998), above n 32, para 1.7. 83 Cadbury Report (1992), above n 29, para 4.25. See generally Smerdon, above n 35, 93 et seq. 84 Section 204A(2) Corporations Act 2001. 85 Section 204A(1). 86 Section 204D. 87 Section 204F (replaceable rule). 88 Section 204B(2). 89 Section 204A(2). 90 Section 273 Companies Act 2006 (UK). This section applies to secretaries of public companies. 91 See further David Jackson, ‘The Role of the Company Secretary’ in The Business Case for Corporate Governance (Ken Rushton, ed.), Cambridge, Cambridge University Press (2008) 67.

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4.5 Training and induction of directors 4.5.1 Training After the collapse of the HIH Insurance company, Trevor Sykes, one of the leading commentators on corporate collapses and the impact they have on society, commented as follows: The whole [HIH] episode underlines the long-established lesson that whatever structures are devised to impose corporate honesty, they won’t work unless you have the right people in them.92

This is almost stating the obvious as, in practical terms, the real difficulty is to find the right people and, once they have been found, to train them and then to monitor, over time, that they perform efficiently and adhere to good corporate governance practices. Whether the task of ensuring proper performance and adhering to good corporate governance practices is one for the company itself on a voluntary basis or for a regulator is a controversial issue. After the HIH collapse there were suggestions that a regulator such as ASIC should assume some responsibility for monitoring companies to detect the signs of possible corporate collapses at the earliest possible time, but it was acknowledged that it would indeed be challenging to assume such a role.93 The importance of training directors was emphasised in the Cadbury Report. Training was considered to be ‘highly desirable’ because directors come from different backgrounds and their qualifications and experience may vary considerably.94 It was also emphasised that the training of directors is a very important way to ensure that directors adhere to good corporate governance practices.95 The simple reality is that directors should be trained so that they can be adequately prepared to understand and discharge their duties as directors.96 Bob Garatt, however, exposed a serious problem with director training in the past; that is, that the training was based upon a managerial training at a higher level, or a type of ‘mini-MBA’ training. Garratt argues that the distinction between ‘managing’ and ‘directing’ requires a completely different type of training.97 Thus, to get the directors in the mindset of what they really need to do, namely to ‘direct, govern, guide, monitor, oversee, supervise or comply’ as pointed out in Chapter 3. Kendall and Kendall emphasise the need for director training in at least the following areas:98 92 Trevor Sykes, ‘Cocktail of Greed, Folly and Incompetence’, The Australian Financial Review, 14 January 2003. 93 Jean J du Plessis, ‘Reverberations after the HIH and other Recent Australian Corporate Collapses: The Role of ASIC’ (2003) 15 Australian Journal of Corporate Law 225, 245. 94 Cadbury Report (1992), above n 29, para 4.19. 95 Ibid. 96 Shaw, above n 43, 27. 97 Garratt, Thin on Top, London, Nicholas Brealey Publishing (2003) 214–15. 98 Ibid 9.

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their statutory and regulatory obligations; their ethical obligations; and ● what constitutes good operational practice. Tricker provides a useful list of types of director training:99 ● Formal external training courses on aspects of the director’s work; ● In-house board development programmes designed specifically for the entire board; ● Updating and briefing sessions for the board, or individual directors; ● Relevant higher degree courses in corporate governance, corporate strategy and other board related topics; ● Experiential sponsorship programmes; ● Mentoring, with a one to one personal trainer; ● Self-directed learning and continuous self-development; and ● Board experience itself provides one of the best learning experiences. The need for formal director training has led to the prediction that ‘a director accreditation and registration process’, at least for directors of listed companies, is inevitable.100 This in turn may ‘turn directing into a profession’.101 As Bob Garratt puts it in one of his later works (2003): ● ●

Directing will become a recognized profession internationally over the next two decades. The pressure for improving board performance . . . are growing too strongly for them to be stopped. What is now obsolescent, and will soon be obsolete, is the all-too-common notion that a few amateur friends of the chief executive and chairman can enjoy some good food and wine, lots of golf, and somehow fit in a bit of time to give guidance to the company and add value for the owners in the long term.102

We agree with these sentiments. Not only have the rights, duties and responsibilities of directors been defined in much greater detail over recent years, but the principles of contemporary corporate governance are now also being extracted with much greater clarity. We are indeed very close to the recognition of a ‘directors’ profession’, no different from the legal, accounting and medical professions. With such recognition will come a greater emphasis on the rights, duties and responsibilities associated with the position of director, and that will necessarily increase adherence to good corporate governance practices. However, we are also of the opinion that the ‘professionalisation’ of the position of director will not guarantee adherence to good corporate governance practices, stop malpractices or miraculously prevent corporate collapses. However, the recognition of the directors’ profession will ensure that professional standards for directors will become even more formalised, prominent and accentuated, and that will be another positive step in enhancing corporate governance. 99 100 101 102

Bob Tricker, above n 10, 295–6. Garratt, above n 97, 208–9. Ibid 207. Ibid.

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4.5.2 Induction of new directors As part of the training process for directors, they should be properly introduced to the company, especially independent outside directors. This is important as the ways in which companies conduct their business may vary considerably or, to put it differently, ‘corporate cultures’ may be hugely different among corporations. Appointment of directors will normally be based upon their proven skills, experience, qualifications and past track record, but they may know nothing about the ‘corporate culture’ of their new corporation or about the other directors and senior executives of the corporation. A good induction process for non-executive directors was considered to be of great importance by a large number of the non-executive directors surveyed two years after the Cadbury Report.103 Probably the most useful and comprehensive guidelines regarding a proper induction program are to be found in the 2003 UK Combined Code, based on the recommendations of the Higgs Committee (2003). These suggest that the induction process should aim at achieving the following:104 1. Building an understanding of the nature of the company, its business and the markets in which it operates. For example, induction should cover: ● the company’s products or services; ● group structure/subsidiaries/joint ventures; ● the company’s constitution, board procedures and matters reserved for the board; ● summary details of the company’s principal assets, liabilities, significant contracts and major competitors; ● the company’s major risks and risk management strategy; ● key performance indicators; and regulatory constraints. 2. Building a link with the company’s people including; ● meetings with senior management; ● visits to company sites other than the headquarters, to learn about production or services and meet employees in an informal setting. It is important not only for the board to get to know the new non-executive director, but also for the non-executive director to build a profile with employees below board level; and ● participating in board strategy development. ‘Awaydays’ enable a new non-executive director to begin to build working relationships away from the formal setting of the boardroom. 3. Building an understanding of the company’s main relationships including meeting with the auditors and developing a knowledge of, in particular: ● who are the major customers; ● who are the major suppliers; and 103 Shaw, above n 43, 30. 104 The Combined Code on Corporate Governance (UK Combined Code (2003)) (July 2003), available at 75–6; Higgs Report, above note 34, 111–12. See also Smerdon, above n 35, 38–40.

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who are the major shareholders and what is the shareholder relations policy – participation in meetings with shareholders can help give a first hand feel as well as letting shareholders know who the non-executive directors are.

4.6 Ethical behaviour by directors Ethical behaviour by directors is one of the most important cornerstones of good corporate governance, as it sets the tone for the ethical behaviour of the corporation and that, in turn, goes a long way to ensure that the corporation adheres to good corporate governance practices. We have dedicated a whole chapter (Chapter 14) to the ethical behaviour of corporations. It is, however, necessary at an early stage to make a few general observations about the ethical behaviour of directors. As was pointed out in Chapter 1, Principle 3 of the 2007 ASX’s Principles of Good Corporate Governance and Best Practice Recommendations states that ethical behaviour by the corporation should be promoted. The expectation that a corporation must have ‘ethics, morals and values’ became prominent with the recognition of the corporation as a person and of the ‘social responsibilities of corporations’.105 It is primarily a responsibility of the board of directors to promote ethical decision making in the corporation.106 The 2003 ASX’s Principles of Good Corporate Governance and Best Practice Recommendations was one of the first corporate governance reports to deal specifically with the ethical behaviour of directors. It recommended that corporations should establish a code of ethical and legal conduct to guide the board and executives as to: (a) the practices necessary to maintain confidence in the company’s integrity; and responsibility; and (b) accountability of individuals for reporting and investigating reports of unethical practices.107 The current expectation in the 2007 ASX Principles of Good Corporate Governance and Best Practice is that these aspects are dealt with in the code of conduct. The importance of ‘ethics, morals and values’ was also commented on by Justice Owen in the HIH Royal Commission Report, under the heading ‘The Royal Commission: A personal perspective’: Right and wrong are moral concepts, and morality does not exist in a vacuum. I think all those who participate in the direction and management of public companies, as well 105 Kendall and Kendall, above n 39, 17 and 139 et seq. See also Batten and Fetherston, above n 43, 1, 5–6; Philip T N Koh, ‘Responsibilities of Corporate Governance and Control of Corporate Powers’ in 3R’s of Corporate Governance, Malaysian Institute of Corporate Governance, Kuala Lumpur (2001) 1, 5–6; and Monks and Minow, above n 38, 17–18 and 77 et seq. 106 Principles of Good Corporate Governance and Best Practice (2007), above n 14, 3: ‘There is a basic need for integrity among those who can influence a company’s strategy and financial performance, together with responsible and ethical decision-making.’ 107 Ibid, 25.

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as their professional advisers, need to identify and examine what they regard as the basic moral underpinning of their system of values. They must then apply those tenets in the decision-making process.108

We are of the opinion that in future ‘ethics, morals and values’ for corporations will become increasingly important considerations for corporations. As we pointed out in Chapter 1, just as good corporate governance adds value to a corporation, so also does ‘ethical behaviour’: [A] highly ethical operation is likely to spend much less on protecting itself against fraud and will probably have to spend much less on industrial relations to maintain morale and common purpose.109

Corporate collapses happen for many reasons, but there is little doubt that unethical behaviour plays some part in contributing towards such collapses.110 We accept that it is difficult to define ‘business ethics’: it is often very closely linked to concepts like ‘business culture’ and ‘cultural values generally’, as well as to perceptions about business in a particular country or community. Some would say that business ‘is all about business’, and that ethics has little place in the hard business world (in Chapter 14 we comment in greater detail on ‘The disunity between business and ethics argument’ and why some would argue that business and ethics should be separated). Others would simply say that the ways in which people view ethics differ so much that we will never be able to find common ground on what is meant by ‘ethical behaviour’ – what is seen as a good and sound business deal or a clever business strategy by some would be considered by others to be ‘unethical behaviour’. However, as Kendall and Kendall illustrate, there are certain general guidelines against which ‘ethical behaviour’ can be judged, and which will assist in detecting ‘unethical behaviour’. They list the following aspects:111 1. General views on ethics – what and how important the issues are, such as: ● consideration and protection of the environment; ● fair trading, especially with poor countries; ● defending human rights, for example non-exploitation of workers in poor countries; ● not investing in countries with unacceptable regimes; ● supporting local communities; ● fair treatment of staff. 2. Particular stakeholder views/angles, such as: ● customers’ beliefs when purchasing – how much do ethical issues actually affect their buying behaviour? 108 Owen Report, above n 17, lxiii. 109 Kendall and Kendall, above n 39, 139. See also Stephen Cohen and Damien Grace, ‘Ethics and the Sustainability of Business’ in Collapse Incorporated: Tales, Safeguards & Responsibilities of Corporate Australia, Sydney, CCH Australia (2001) 99, 105–6. 110 Cohen and Grace, ibid, 99–100. 111 Kendall and Kendall, above n 39, 142.

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employees’ moral values – how important is it for them to work in an ethically sound company? ● shareholders’ feeling of responsibility – to what extent do they feel obliged to enforce ethical behaviour? ● local community’s interest – how much are they interested in the company’s active involvement in the community? The internationalisation and globalisation of business make it imperative that we strive to find common ground on what is meant by ‘ethical behaviour’ by corporations, and that we promote such behaviour as a core practice in good corporate governance. ●

4.7 Remuneration of directors and executives 4.7.1 A controversial issue The debate on excessive executive remuneration became particularly sensitive politically as a result of the global financial crisis, but it is not a new topic. In 1995, in the UK the Greenbury Report was one of the first corporate governance reports promoting transparency and disclosure of executive remuneration. This was taken further in the 1998 UK Hampel Report, and Australia followed suit by repeating sentiments of disclosure of executive remuneration in the Bosch and Hilmer Corporate Governance Reports (see Chapter 12). As a result of this legislation was introduced to ensure disclosure in both jurisdictions. However, because of the global financial crisis, director and executive remuneration caused a renewed public outcry and politicians were quick to pick up on this. The nexus between pay and performance and the role of short-term versus long-term incentives built into compensation packages to better align managerial and shareholder interests112 has been to the fore recently in particular. It is not remuneration of directors and executives as such that caused angst among the public and politicians, but ‘excessive’ remuneration. In addition, the huge differences between remuneration of executives and that of other employees, which has been illustrated by disturbing statistics, has been of concern.113 In the wake of the global financial crisis, public outrage at the level of remuneration paid to executives heightened, particularly in relation to banking personnel at a time when countries across the Western world were propping up banks using taxpayer funds. The perception was, justly or unjustly, that these executives had ‘milked’ staggering corporate cows, and eventually taxpayers’ money was used to bail out the banks. As recently as 2004, the Business Council of Australia (BCA) 112 See, for instance, Michael C Jensen and Kevin J Murphy ‘Performance Pay and Top Management Incentives’, (1990) 98 Journal of Political Economy 225–64. 113 See John Shields, 2005, ‘Setting the Double Standard: Chief Executive Pay the BCA Way’, Journal of Australian Political Economy, Edition 56, 2005, 299 at 302, available at .

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warned against additional regulation of executive remuneration,114 but it was clear in 2009 that the BCA had conceded that steps needed to be taken to curb excessive executive remuneration.115 In early 2009, the Australian Institute of Directors (AIOD) issued some new guidelines for boards on executive remuneration as a result of the global financial crisis.116 In short, the global financial crisis drew the attention of the public, politicians and business to excessive executive remuneration.

4.7.2 Disclosure of remuneration and emoluments in Australia Australia has one of the most extensive disclosure regimes in the world in relation to the remuneration of directors and key management personnel. The Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 introduced section 300A into the Corporations Act 2001 (Cth), which requires enhanced disclosures, either in the directors’ remuneration report or the financial report, which are audited. These disclosures include: i) the board’s remuneration policy [s 300A(1)(a)]; ii) the relationship between remuneration policy and company performance [s 300A(1)(ba)]; iii) details of remuneration of key personnel [s 300A(1)(c)]; iv) reasons for failing to subject to performance conditions any remuneration made via shares or options [s 300A(1)(d)]; v) the relative proportion of remuneration related to performance, value of options granted and aggregate and percentage values of remuneration via options [s 300A(1)(e)]. Additionally, a non-binding advisory resolution must be put to shareholders [s 250R(2) & (3)]. Further major reforms to both disclosure of and accounting for share-based payments have occurred since 2004. In particular, Accounting Standard AASB 2 Share-based Payment requires calculation of the ‘fair value’ of options granted under remuneration packages and expensing of this value, along with disclosures around the method and assumptions involved in calculating the fair value.

4.7.3 Investigations into excessive remuneration of directors and executives In Australia, the Federal Government requested the Australian Prudential Regulation Authority (APRA), which regulates entities in the insurance, superannuation and authorised deposit-taking industries, to produce 114 BCA. Executive Remuneration: A Position Paper Prepared by the Business Council of Australia. June 2004, available at . 115 For example, the BCA’s submission of 2 September 2009 to the Australian Parliamentary Senate Economics Legislation Committee re the Corporations Amendment (Improving Accountability Termination Payments Bill) 2009, available at . 116 AIOD, ACID Issues New Guidelines for Boards on Executive Remuneration. Media Release 12 February 2009, available at .

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best-practice guidelines for both the design and disclosure of executive remuneration. On 28 May 2009, APRA released a consultation paper117 with draft proposals released on 7 September 2009.118 On 30 November 2009, Prudential Practice Guide PPG 511 – Remuneration was released by APRA. Briefly, the governance standards require the establishment of remuneration committees and the design of remuneration policy that, in rewarding individual performance, is designed to encourage behaviour that supports the risk management framework of the regulated institution (para. 43). Further, in designing remuneration arrangements, the board remuneration committee will need to consider, among other matters: ● the balance between fixed (salary) and variable (performance-based) components of remuneration. Performance-based components include all short-term and longer-term incentive remuneration, payable with or without deferral; and ● whether cash or equity-related payments are used and, in each case, the terms of the entitlements including vesting and deferral arrangements (para. 44). The Federal Government also, in March 2009, initiated a review into the Regulation of Director and Executive Remuneration in Australia by the Productivity Commission. The Productivity Commission’s final report119 was released publicly in January 2010. Perhaps the most noteworthy120 conclusion in the Report is that if 25 per cent or more of shareholders at two successive annual general meetings vote negatively on the board’s pay report there should be an immediate vote on whether the entire board should face re-election. If this is carried by a majority of those voting at the meeting, all board positions would be up for election, one by one, at a special meeting held within three months. This is referred to as the ‘two-strikes plus a resolution to “spill” the board’ approach.121 Currently, under section 250R of the Act, shareholder votes on remuneration reports are not binding and have no other legal consequences. At the time of writing, it is not known which, if any, of the conclusions in the report will be acted upon by the Federal Government.

4.8 Conclusion There is no doubt that nowadays there are much higher community expectations of company directors and company officers than in the past. These higher 117 Discussion Paper, Remuneration – Proposed extensions to governance requirements for APRA-regulated institutions, 28 May 2009. 118 Response to Submissions, Remuneration – Proposed extensions to governance requirements for APRAregulated institutions, 7 September 2009. 119 Productivity Commission, Executive Remuneration in Australia, Report No. 49, Final Inquiry Report, Melbourne, Commonwealth of Australia (December 2009), available at . 120 See, for instance, Allan Fels, ‘Shareholders Can Turn Up the Heat on Executive Pay’, Sydney Morning Herald, 5 January 2010, 20. 121 See Productivity Commission, above note 119, at XXXII and 296–301.

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expectations do not apply only to the exercise of directors’ and other officers’ general duties, but also their ethical behaviour – company directors’ and company officers’ conduct is under constant scrutiny not only by the media and the general public, but also the regulators. As a corollary, there is constant pressure on politicians to ensure that the law is adequate to be able to enforce these higher community expectations of company directors and company officers. In this chapter we have seen that there are various types of company directors and officers that can be identified, although the basic understanding is that the law will expect the same duties of all directors and that senior employees and senior executives owe duties to the company comparable to that of directors. The discussion in this chapter also reveals that the practical distinction between, and expectations of, the various types of directors (for example, independent nonexecutive directors, executive directors, senior or lead independent directors), are becoming increasingly important. Also, the roles, functions and expectations of CEOs and chairpersons have become more easily identifiable over time. This is the case not only because various corporate governance reports have begun to accentuate the various responsibilities associated with these positions, but also because the courts have begun to focus on the higher responsibilities associated with, and higher standards expected of, persons occupying certain key positions in large public corporations. Three specific topics have been identified as particularly important in so far as different types of directors are concerned. They were the training and induction of directors; the ethical behaviour of directors; and the remuneration of directors and executives. It is submitted that these topics will become of increasing importance in future.

PART TWO CORPORATE GOVERNANCE IN AUSTRALIA

5 Corporate governance in Australia – background and business initiatives At some point over the last several years the debate about what boards of directors ought to do and be responsible for took a wrong turn. In almost every other area of economic life the debate has been about how various participants can improve the quality and volume of their productive contributions. For example, workplace reforms, management developments and financial deregulation are all about increasing competitiveness and productivity and achieving standards of best practice. In contrast, the debate about directors has become preoccupied with criminality, fraud, negligence and minimum standards. The worry about the rotten apple – and there have been a number – has deflected attention from the main game of wealth creation which is, in turn, the driver of new investment and job creation. Frederick G Hilmer, Strictly Boardroom: Improving Governance to Enhance Company Performance (Hilmer Report (1993)), Preface

5.1 Background to the corporate governance debate in Australia1 John Farrar reflects as follows on perceptions regarding corporate governance and corporate law in Australia: Every country approaches corporate governance from the background of its own distinctive culture. New Zealand has tended in the past towards a pragmatic adaptation of the UK model but has recently adopted a more North American approach. In the case of Australia one sometimes has the impression that this is based on either Ned Kelly or his jailer. We love a larrikin and are a little too tolerant of corruption but we are inclined to come down heavily on ‘tall poppies’ and to be excessively penal in our approach. The attitude to the excesses of the 1980s and their aftermath reflects this. We also have a tendency to over-legislate and the result is obese and user-unfriendly legislation.2 1 This part is based on Jean J du Plessis, ‘Reverberations after the HIH and other Recent Australian Corporate Collapses: The Role of ASIC’ (2003) 15 Australian Journal of Corporate Law 225, 227–30. 2 John Farrar, Corporate Governance in Australia and New Zealand, Melbourne, Oxford University Press (3rd edn, 2008) 6–7.

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The ‘excesses of the 1980s’ were also emphasised in corporate governance reports in the early 1990s.3 Having some knowledge of the ‘excesses of the 80s’ is indeed essential in understanding and explaining many of the statutory provisions in the Australian Corporations Act 2001 (Cth) (the Act) and in appreciating prevailing perceptions regarding corporate governance in Australia. Trevor Sykes’ fascinating account of the abuses of the 1980s in his book, The Bold Riders,4 reveals much of the evils that flourished then and is a good starting point from which to obtain a deeper insight into the current Australian corporate law and corporate governance. Names like Christopher Skase, Alan Bond, John Friedrich and Abe Goldberg are often mentioned in discussions of corporate law5 and, as though these characters are omnipresent, names like Ray Williams, Rodney Adler, Dominic Fodera, Brad Cooper, Jodee Rich, Brad Keeling, John Greaves, Rene Rivkin, Bill Howard and John Elliott had been mentioned regularly in the financial and other press in the period 2001–4. The importance of interpreting legislation in a broader context – and in particular in context of the ratio for the legislation and the abuses it aims at preventing – was recently emphasised by Kirby J in his minority judgment in Rich v ASIC.6 With specific reference to the abuses of the 1980s, Kirby J reiterated that the legislation was intended to address the negative consequences of those abuses and to improve the standards of corporate governance in Australia. He argued, therefore, that remedies such as disqualification orders and civil penalty orders should not be interpreted narrowly, but rather in the context of the intention of the legislature, and in particular as remedies aimed at particular evils.7 With spectacular corporate collapses like those of HIH, Harris Scarfe, One.Tel, Pasminco, Centaur, Ansett, Westpoint, Fincorp, Opes Prime, Chartwell Enterprises, Kleenmate etc. (the list has grown considerably since the 2005 edition of this book) in mind, it is obvious that it is not the existence of ‘obese . . . legislation’ that prevents corporate collapses, and that it was a misconception to rely on Corporate Law Simplification or Corporate Law Economic Reform Programs to provide the answer to the ‘excesses of the 80s’.8 There is also very little use in governments constantly acting on an ad hoc basis to deal with specific problems. This makes the law ‘too cumbersome’ and, as Bob Baxt also points out fittingly, ‘make[s] it more and more difficult to discern a clear theme underpinning the legislation, and to provide a clear message to the courts in deciding cases that are

3 Frederick G Hilmer, Strictly Boardroom: Improving Governance to Enhance Company Performance, Melbourne, Business Library (1993), 1 and 4. 4 First published in 1994; Sydney, Allen & Unwin (2nd edn, 1996). 5 See Rick Sarre, ‘Responding to Corporate Collapses: Is There a Role for Corporate Social Responsibility’ (2002) 7 Deakin Law Review 1. 6 [2004] HCA 42 (9 September 2004), [62]. 7 [117]–[118]. 8 See generally HIH Royal Commission (Owen Report), The Failure of HIH Insurance – Volume I: A Corporate Collapse and its Lessons, Canberra, Commonwealth of Australia (2003) xiii–xiv and F Clarke and G Dean, ‘Corporate Collapses Analysed’, in Collapse Incorporated: Tales, Safeguards & Responsibilities of Corporate Australia, Sydney, CCH Australia (2001) 72, 89.

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brought before them’.9 It is true that the breadth and depth of the provisions in the Act covering directors’ duties and responsibilities – and the remedies available for breaches of these – are impressive. The Act has imbedded in it a very finely woven legislative net that will catch even the smallest fish, but it would be very interesting to conduct research to establish whether the bulky Australian corporations legislation is more foolproof than core Corporations Acts such as those of New Zealand or Canada.10 In Australia corporate governance was, in the late 1990s, considered to be almost an unnecessary burden upon Australian businesses. Strict corporate governance rules have even been blamed for the under-performance of Australian companies.11 David Knott, the then-Chairman of the Australian Securities and Invesments Commission (ASIC), neatly captures the prevailing mood of the late 1990s: ‘Directors started to question [corporate governance’s] relevance. Corporate governance became formalistic, even ritualistic. It lost momentum as an effective program for corporate risk management. We probably paid a price for that.’12 But in the early 2000s corporate governance was once again on the front pages of newspapers and uppermost in the minds of directors and most regulators in Australia.13 This has been an international trend and one explained well by Morten Huse in 2007: A governance revolution seems to be taking place . . . The recent scandals now give us the opportunity to ask if there is need for a new paradigm for governance. Governance reforms now ranks high on the priority list of policy-makers and regulators.14

The corporate collapses in Australia between 2000 and 2003 also brought a sudden end to the complacency that had prevailed on corporate governance in Australia after many years of sustained growth and Australia’s remarkable survival of the Asian financial crisis.15 Solutions to ‘bad corporate governance’ were sought along a broad and varied front, including continuous disclosure; codes of good practice; disqualification of auditors; and the role and functions of the auditor, audit committees, independent directors, and non-executive directors.16 Most recently, the focus has been on excessive executive remuneration (see also 9 Robert Baxt, ‘The Necessity of Appropriate Reform’ in Collapse Incorporated: Tales, Safeguards & Responsibilities of Corporate Australia, Sydney, CCH Australia (2001) 325, 329 (see also Baxt’s critical comments on several recent pieces of legislation at 329–34). 10 It is promising to note that there seems to be some mention of a core and modern corporate law – Baxt, above n 9, 335. 11 Sarre, above n 5, at 1; Rick Sarre, ‘Risk Management and Regulatory Weakness’ in Collapse Incorporated: Tales, Safeguards & Responsibilities of Corporate Australia, Sydney, CCH Australia (2001) 291, 295. 12 David Knott, ‘Protecting the Investor: The Regulator and Audit’, Address to the CPA Congress 2002 Conference Perth Western Australia, 15 May 2002, available at 4. 13 See David Knott, ‘Corporate Governance: The 1980s Revisited?’ Monash Law School Foundation Lecture, 23 August 2001, available at 3–4; Jillian Segal, ‘Corporate Governance: Substance over Form’ (2002) 25 University of New South Wales Law Journal 320. 14 Morten Huse, Boards, Governance and Value Creation, Cambridge, Cambridge University Press (2007) 26–7. 15 Knott, above n 12, 11. 16 For an excellent address covering almost all relevant aspects of good corporate governance, see Pat Barrett, ‘Corporate Governance – More Than a Passing Fad’, Alfred Deakin Club Luncheon, 12 June 2002.

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Chapter 4) and the Australian Government is seriously considering legislation to cap executive regulation – again a knee-jerk reaction, focusing on one aspect rather than seeing corporate governance reform in its totality. Many of these mechanisms to curb poor corporate governance practices were implemented in 2000–4, with CLERP 9 probably being the best example with its aims of restoring confidence in the accounting profession, improving disclosure and financial reporting, and protecting those who reveal and report contraventions of the Act (see discussion of CLERP 9 in Chapter 8). Almost ‘forgotten’ debates have been reopened, including the debate on board structures – in particular the two-tier board system versus the unitary board system (see discussion in Chapter 3) – and it is clear that, as in the ‘old days’, the strong preferences for the one or the other board structure still exist among commentators.17

5.2 The Bosch Report 5.2.1 Background In or around 1990 a Working Group, chaired by Henry Bosch (AO) (former chairman of the National Companies and Securities Commission (NCSC)), was established by several leading players in the financial markets. They included the Australian Merchant Bankers Association, the Australian Stock Exchange Ltd, the Australian Institute of Company Directors and the Securities Institute of Australia. In June 1990 this Working Group released a paper on ‘Corporate Practices and Conduct’, which was widely discussed before its first report was published in 1991 under the same title.18 There are often references to ‘the Bosch Report’, but in fact there were three Bosch Reports: the original one in 1991, and two reviews of the 1991 report, in 1993 and 1995 (with a 1996 reprint). Although all deal with ‘Corporate Practices and Conduct’ or corporate governance as it is now more generally known, the three reports differ considerably in detail and it could lead to confusion if the particular year of the report is not mentioned. We will refer to the original Bosch report as the Bosch Report (1991) and to the 1993 and 1995 reviews as respectively the Bosch Report (1993)19 and the Bosch Report (1995).20 17 Cf Jillian Segal, ‘The Future of Corporate Regulation in Australia’, Address to the 18th Annual Company Secretaries’ Conference, Surfers Paradise, 19 November 2001, available at 3; Jillian Segal, ‘Everything the Company Director Must Know about Corporate Financial Disclosure and Continuous Disclosure’, Address to the Australian Institute of Company Directors Conference, Governance & Disclosure – A Forum for Company Directors, Sydney 31 October 2001, available at 11–12; and Knott, above n 13, 4–7. 18 Business Council of Australia (BCA), Corporate Practices and Conduct, Melbourne, Information Australia (the Bosch Report (1991)), (1991). 19 BCA, Corporate Practices and Conduct (the Bosch Report (1993)), Melbourne, Information Australia (2nd edn, 1993). 20 BCA, Corporate Practices and Conduct (the Bosch Report (1995)), Melbourne, Pitman (3rd edn, 1995).

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5.2.2 The Bosch Report (1991) The Bosch Report (1991) stated that it represented ‘wide consensus in the corporate community of the substantive issues’ and attempted ‘only to set out general principles of practice and conduct’. A strong call was made for the corporate sector to establish its own framework for acceptable standards of behaviour, irrespective of existing or prospective regulatory and legislative rules.21 Four aspects of the Bosch Report (1991) deserve special mention. First, with its release in 1991 the Bosch Report was ahead of the United Kingdom: the UK Cadbury Committee was established in May 1991, and released its draft report in May 1992 and its final report in December 1992.22 Second, although the abuses of the 1980s surely contributed to the establishment of the Working Group, it does not seem that it was specific scandals – such as Maxwell and BCCI23 in the UK – that triggered this self-regulatory move by the business community in Australia. However, the Working Group’s main and general aim with its report, namely ‘to improve the performance and reputation of Australian business by encouraging and assisting the general adoption of the highest standards of corporate conduct’,24 suggests at least that there were concerns about the ‘underperformance’ and ‘bad reputation’ of Australian businesses. The last-mentioned aspect could surely be traced back to the abuses of the 1980s. Third, the term ‘corporate governance’ appears as only one of three main headings (the other two headings being ‘Company Code of Ethics’ and ‘Guidelines for Conduct of Directors’) in the Bosch Report (1991). There is, however, little doubt that what was then understood as ‘Corporate Practices and Conduct’ (the full title of the Bosch Report (1991)), would nowadays sit comfortably under the title ‘Corporate Governance’. One wonders what the impact of the Bosch Report would have been if the term ‘corporate governance’ had been used – as was the case with the Cadbury Report in the UK. Fourth, whereas the Cadbury Report is hailed for its clarity of expression,25 it would not be an overstatement to say that the Bosch Report (1991) should receive recognition not only for its clarity of expression but also for its brevity and for being at the forefront in introducing several principles of good corporate governance that became the standard of good corporate governance practices in other countries only several years later. For example, the Bosch Report (1991):

21 Bosch Report (1991), above n 18, ‘Foreword’. 22 Committee on the Financial Aspects of Corporate Governance, Report of the Committee on the Financial Aspects of Corporate Governance (‘Cadbury Report’), UK, (1992). 23 John C Shaw, ‘The Cadbury Report, Two Years Later’ in K J Hopt, K Kanda, M J Roe, E Wymeersch and S Priggle (eds), Comparative Corporate Governance: The State of the Art and Emerging Research, Oxford, Clarendon Press (1998) 21, 23; Stanley Christopher, ‘Corporate Accountability: Cadbury Committee: Part 1’ (1993) 11 International Banking and Financial Law 104. 24 Bosch Report (1991), above n 18, ‘Foreword’. 25 Owen Report, above n 8, 102 para 6.1.

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recommended that the annual reports of all public companies should include a statement by the directors that the company supports and has adhered to the principles set out in the ‘Corporate Practice and Conduct Paper’ recommended that any departures from the principles set out in the Corporate Practice and Conduct Paper (that is, the Bosch Report (1991)), ‘should be noted and the reasons for them given’ – in other words, one of the first corporate governance reports relying on the principle of ‘if not, why not?’ or ‘comply or explain’26 identified the most important functions of the board recommended that the roles of chairman and chief executive should be separate recommended that each public company’s board should appoint an audit committee with at least a majority of non-executive directors identified the primary functions of audit committees without over-emphasising the monitoring role of non-executive directors, recognised that they should bring an independent view to the board’s deliberations and help the Board provide the company with effective leadership recognised the importance of independent non-executive directors, but defined ‘independence’ quite generally by reference to ‘a contractual relationship’ or ‘any relationship with the company which could affect the exercise of independent judgment’ rather than recommending any particular number of ‘independent nonexecutive directors’ to be appointed to the board, suggested that ‘it is a useful safeguard to appoint to the Board at least two directors who have no [personal or professional association with the company]’ recommended that the company auditor should attend the board or audit committee meetings at which the statutory accounts and directors’ reports are approved for issue, and should have the right of access to the board where appropriate recommended the development, publication and enforcement of company codes of ethics provided guidelines for conduct of directors to assist them to carry out their duties and responsibilities recognised that directors should be provided with expert advice, particularly on legal and financial matters, to assist them to properly discharge their fiduciary duties.

26 See further Ian Ramsay and Richard Hoad, Disclosure of Corporate Governance Practices by Australian Companies, Research Paper, Centre for Corporate Law and Securities Regulation, University of Melbourne (1997), available at 3 – also published as Ian M Ramsay and Richard Hoad, ‘Disclosure of Corporate Governance Practices by Australian Companies’ (1997) 15 Company and Securities Law Journal 454.

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5.2.3 The Bosch Report (1993) The foreword to the Bosch Report (1993) makes immediately apparent the impact of the UK Cadbury Report (1992), as well as the huge impression that the concept ‘corporate governance’ has made upon the Working Group.27 ‘Corporate governance’, rather than being used only once as a main heading, is now pivotal: it appears four times in the foreword, and the heading ‘Corporate Governance’ has been supplemented with a definition of corporate governance – ‘the system by which Companies are controlled’ – and with a very specific message, that ‘[t]he essence of any system of good corporate governance is to allow Directors the freedom to drive their Companies forward but to exercise that freedom within a framework of effective accountability’.28 The desire to keep adherence to good corporate governance practices within the realm of self-regulation is again expressed in no uncertain terms: [T]he corporate sector is making a significant effort to create its own framework of acceptable standards of behaviour irrespective of existing or prospective legislation . . . 29 The second edition of the Corporate Practices and Conduct booklet represents a continuing commitment by Australia’s leading business and professional organisations to lift the standards of corporate governance which will enhance investor confidence both here and overseas.30

The order in which the organisations that produced the booklet were listed has also changed slightly since the previous report. The Australian Institute of Directors, mentioned third last in 1991, has now moved to the top of the list. The Australian Investment Managers’ Group has been added to the list, and the Australian Merchant Bankers Association has been replaced by the International Banks and Securities Association of Australia. The following aspects could be listed as the core differences between the Bosch Report (1991) and the Bosch Report (1993): ● The Bosch Report (1993) is longer by 17 pages (22 in 1991, 39 in 1993). ● The functions of the Board are explained in much greater detail (six bullet points in 1991, 17 points in 1993). ● There is a toning down of the 1991 expectation that ‘all public companies’ should comply with the Corporate Practices and Conduct Paper. The Bosch Report (1993) makes certain recommendations just for ‘listed public companies’; others ‘for public companies, and in particular companies listed on the Australian Stock Exchange’; and others for ‘public companies, of sufficient size’ (emphasis added). ● The role of non-executive directors has been expanded in the Bosch Report (1993). Not only is their role to bring an independent view to the board’s 27 28 29 30

Bosch Report (1993), above n 19, 1–2. Ibid 9. Ibid 1. Ibid 2.

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deliberations and help the board provide the company with effective leadership, but they are now also ‘[t]o foster the continuing effectiveness of Executive Directors and management’31 – a pertinent expansion of their monitoring role. Independent non-executive directors have become more prominent – it is now suggested (not recommended) that ‘preferably the majority of NonExecutive Directors should be independent, not only of Management but of any external influence that could detract from their ability to act in the interest of the Company as a whole’.32 What is actually meant by ‘independence’ has begun to emerge – ‘independence’ is now considered to be ‘more likely to be assured when the Director’ does not have any of the following five affiliations with the company: – a substantial shareholder of the company – employed in any executive capacity by the company within the last few years – a professional adviser of the company (either personally or through his/her firm) – a significant supplier or customer of the company – a significant contractual relationship with the company other than as a director. The influence of the UK Cadbury Report (1992) (see discussion in Chapter 12) is clearly noticeable, for instance in the suggestion that boards should include ‘sufficient directors who are generally independent in their views to carry significant weight on the Board’,33 and the recognition of the important role of the company secretary.34 It is now recommended that companies disclose in their annual reports any material contracts, other than memberships of the Board, that directors have with the company.35 Although not specifically recommended to do so, public companies, ‘in particular [those] listed on the Australian Stock Exchange’, are urged that they ‘should consider’ the appointment of compensation committees and nomination committees.36 Apart from ‘non-executive directors’, the roles and functions of three other types of directors – ‘executive directors’; ‘nominee directors’; and ‘alternate directors’ – are described in general terms.37 Two new parts have been added to the booklet, namely ‘Company Accountants and Auditors’; and ‘Shareholders’ – clearly also under the influence of the UK Cadbury Report (1992).

Ibid 15. Ibid 16. Ibid 16. Ibid 18. Ibid 17. Ibid14–15. Ibid 17–18.

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5.2.4 The Bosch Report (1995) It is not necessary to say much about the Bosch Report (1995), as in substance little has been added since the Bosch Report (1991) and the Bosch Report (1993). Although the objectives of the report were now specifically articulated,38 there is little doubt that these same objectives underlie the two prior reports. The Bosch Report (1995) grew in size (now 58 pages, in comparison with the 22 pages of the Bosch Report (1991) and 39 of the Bosch Report (1993)); the formatting and presentation improved slightly (probably because of the involvement of a commercial publisher); and the Report became more tiresome to apprehend because further explanations and specific ‘considerations’, ‘beliefs’ and ‘general comments’ were added by the Working Group by way of paragraphs highlighted using horizontal lines in the page margins. The ‘considerations’, ‘beliefs’ and ‘general comments’, in particular, leave some impression of tugs-of-war taking place between influential role players in the financial and securities markets. It is interesting to note that of the nine organisations that contributed to the Bosch Report (1993), only six remained in 1995 – the Australian Investments Group, Australian Stock Exchange Ltd, and International Bankers and Securities Association of Australia have disappeared from the list. The Bosch Report (1995) has some hallmarks of a report that has lost its original focus on core principles of corporate practice and conduct – probably because the work evolved over a period of approximately six years (1990–5). It has also attempted to accommodate and reflect rapidly changing and expanding international developments in the area of corporate governance.39 The Working Group seems to have been overwhelmed by development in the area of corporate governance: ‘[s]ince the first edition of this book was published in 1991, there have been many new laws and regulations, and many court judgments, that have made the task of governing corporations more complex and difficult’.40 Several of the recommendations, suggestions and proposals of the Bosch Report (1991) and Bosch Report (1993) have either disappeared from the Bosch Report (1995) or have been modified to such an extent that it is difficult to recognise them or trace them back to the original report. It is also interesting to note that ‘the Bosch Report’ nowadays receives only scant attention in most of the leading Australian corporate governance and corporate law textbooks.41 This said, there is no doubt that the Bosch Report (1995) was another wellintended effort to promote good corporate governance practices in Australia and to keep corporate governance self-regulated.

38 Ibid 1. 39 See Bosch Report (1995), above n 20, 4–5. 40 Ibid 1. 41 Cf (for example) Farrar, above n 2, 381–2; R P Austin, H A J Ford and I M Ramsay, Company Directors: Principles of Law and Corporate Governance, Sydney, LexisNexis (2005) 15–17.

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5.3 Divergence from UK practice: 1995 to early 2003 On 1 July 1995 a rule (originally Rule 3C(3)(j) and later Rule 4.10.3, and applying to reporting periods ending on or after 30 June 1996) was introduced into the Australian Securities Exchange (ASX) Listing Rules,42 requiring listed companies to disclose in their annual reports the main corporate governance practices that they had had in place during the year. An appendix to the Listing Rules (originally Appendix 33 and later Appendix 4A) listed typical matters (a so-called ‘indicative list of corporate governance matters’) that companies could take into consideration in complying with Listing Rule 3C(3)(j)/4.10.3.43 Phillip Lipton explains the differences, at that stage, to the UK approach and also what the Australian approach was intended to achieve: The Australian approach does not require specific corporate governance practices to be adopted by listed companies. Rather, there is a list of indicative practices and it is up to individual companies to establish their own effective system of governance and disclose it to the market. This approach seeks to ensure that corporate governance practices evolve and improve over time to meet the needs and expectations of the market and companies. Best practice does not become rigid and formulaic and it is hoped that thought is given by boards as to what is appropriate and why, rather than a checklist approach involved in ticking off prescribed practices in a non-analytic way. A prescriptive approach could discourage innovation and development of better practices by setting a minimum standard. A non-prescriptive approach also tries to ensure that smaller companies do not have unrealistic compliance burdens imposed upon them.44

It was only after the establishment of ASX’s Corporate Governance Council in August 2002 and the release of its Principles of Good Corporate Governance and Best Practice Recommendations in March 2003 that the corporate governance practices in the UK and Australia again converged – see discussion in Chapter 7.

5.4 The Hilmer Report 5.4.1 Background The case of AWA Ltd v Daniels (Trading as Deloitte Haskins & Sells & Ors)45 caused considerable anxiety among directors in Australia. In AWA Ltd v Daniels Rogers CJ was required to consider, in a practical context and in a complicated factual context, what the duties and responsibilities of directors really were. Rogers CJ himself admitted that the theories regarding directors’ duties and responsibilities 42 Bosch Report (1995), above n 20, 3; Phillip Lipton, ‘The Practice of Corporate Governance in Australia: Regulation, Disclosure and Case Studies’ in Low Chee Keong (ed.), Corporate Governance: An Asian-Pacific Critique, Hong Kong, Sweet & Maxwell (2002) 105, 131. 43 See Lipton, above n 42, 132–3 for the matters listed in Appendix 4A. 44 Ibid 131–2. 45 (1992) 7 ACSR 759.

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were not always easy to apply in practice. For this reason he approached the Sydney Institute to facilitate discussions on corporate governance. The outcome of these discussions, by a working group under the chairmanship of Fredrick G Hilmer, was the release in 1993 of a report, Strictly Boardroom: Improving Governance to Enhance Company Performance (the Hilmer Report (1993)).46 In hindsight, the Hilmer Report (1993) was particularly appropriate, as the appeal of AWA Ltd v Daniels, namely Daniels v Anderson,47 emphasised that the Australian courts expected high standards of care and diligence of directors, including non-executive directors. In AWA Ltd v Daniels Rogers CJ had suggested that non-executive officers may only be expected to pronounce on matters of policy and may rely on management to inform them of anything important. The Royal Commission into the Tricontinental Group of Companies48 believed such was not sufficient to satisfy the director’s duty of care, asserting that the director must provide an independent enquiring mind. For this reason, the Commission questioned the authority of AWA Ltd v Daniels, suggesting that subsequent ‘courts are likely to examine critically any failure by directors to be sufficiently wellinformed about matters affecting the financial performance and health of their corporations, even if they are non-executive directors’. This proved to become the norm. In Daniels v Anderson, Clarke and Sheller JJA specifically referred to Rogers CJ’s views on the duties of non-executive directors. They considered, among others, Roger CJ’s comments that ‘a director is justified in trusting [officers of the company] to perform duties that, having regard to the exigencies of business, the intelligent devotion of labour and the articles of association, may properly be left to them’; and that ‘a director is entitled to rely on the judgment, information and advice of the officers so entrusted and on management to go through relevant financial and other information of the corporation and draw to the board’s attention any matter requiring their consideration’. Clarke and Sheller JJA said in no uncertain terms that they did not think that these statements ‘accurately state the extent of the duty of directors whether non-executive or not in a modern company’.49 Their own views – that there is a positive duty on directors to investigate and to query management, especially when there is notice of mismanagement, and that directors are under a continuing obligation to keep informed about activities of the corporation50 – caused alarm bells to ring, especially for non-executive directors. Rogers, commenting on Clarke and Sheller JJA’s decision in a paper included as part of the Hilmer Report (1998), said that they had ‘struck out a radically different direction’ as far as directors’ duties were concerned generally, and in particular their view that no distinction should be drawn between the obligations of executive and 46 Frederick G Hilmer, Strictly Boardroom: Improving Governance to Enhance Company Performance (Hilmer Report (1993)) Melbourne, Business Library (1993) 1–3. 47 (1995) 13 ACLC 614. 48 Final Report of the Royal Commission of Inquiry into the Tricontinental Group of Companies, Melbourne, Business Library (1992), vol 2, ch 19, paras 19.53–19.56. 49 Daniels v Anderson (1995) 13 ACLC 614 at 663. 50 Ibid 663–4.

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non-executive directors.51 Following the concerns raised by the New South Wales Court of Appeal’s approach in Daniels v Anderson, amendments to the Corporations Act were required to make it clear under which circumstances directors could delegate powers to others and when they would be protected for relying on the information provided to them by those to whom they had delegated certain powers.52

5.4.2 The Hilmer Report (1993) The Hilmer Report (1993) deals primarily with the following three questions:53 ● What is the principal contemporary concern about the roles of the board, directors, management and auditors? ● What are the key functions of a board that require greater emphasis if this concern is to be addressed? ● To carry out these functions, what should be the responsibility of directors and other parties involved in corporate governance and what other changes are needed in board composition and processes? One of the key aspects emphasised by the Hilmer Report (1993) was that poor corporate performance, not fraud or misconduct, should be the main contemporary concern of corporate governance.54 For this reason a chapter was dedicated to the functions of the board55 and another chapter to improving governance.56 Some notable aspects of the ‘summary of recommendations’ in the Hilmer Report (1993) are that: 1. The board’s key role is to ensure that corporate management is continuously and effectively striving for above-average performance, taking account of the risk. 2. Each board should clearly define what is meant by sustainable, aboveaverage performance in its particular situation. 3. Each board should monitor performance in terms of performance so defined: in each case the extent and type of monitoring should reflect the strength of the board’s reasons for scrutinising performance on an issue, as well as the importance of the issue to the corporation. 4. Boards should define their roles in each of the following five areas in a way that reflects the prime responsibility for setting and monitoring achievement of performance goals and management’s responsibility for formulating proposals and monitoring implementation in a way that enhances managerial accountability: 51 Andrew Rogers, ‘Update’, in Frederick G Hilmer, Strictly Boardroom: Improving Governance to Enhance Company Performance, Melbourne, Information Australia (2nd edn, 1998) 77. 52 See Explanatory Memorandum to the CLERP Bill 1998, paras 6.98–6.105; and the current ss 189–190 and 198D of the Corporations Act 2001 (Cth). 53 Hilmer Report (1993), above n 46, 3. 54 Ibid 4. 55 Chapter 3 of the Hilmer Report, above n 46. 56 Chapter 4, ibid.

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appointment of the chief executive officer (CEO) and human resources issues ● strategy and policy ● budgeting and planning ● reporting to shareholders and regulatory compliance ● ensuring own effectiveness. Non-executive directors should concentrate on keeping the board’s primary performance responsibility at the top of the agenda. The non-executive chair has a critical additional responsibility in ensuring that the agenda, information flow, time spent and processes of the board maintain a performance emphasis while not losing sight of conformance responsibilities. Executive directors have a special responsibility to inform the board on issues about which the executive has special and relevant knowledge. Each company should have an audit committee comprised of nonexecutive directors, with the chair of the committee and the majority of its members also independent in the sense of not having a business relationship with the company that might interfere with their judgment. The appointment of an independent and properly qualified external auditor is also a critical responsibility of the [audit] committee and the board. Boards should consider a number of mechanisms that would build the cohesiveness of the non-executives as a group. Boards should pay greater attention to the calibre as well as mix of directors, recognising that effective board membership requires high levels of intellectual ability, experience, soundness of judgment and integrity. Boards should look favourably at remuneration packages that include incentive elements for senior management. ●

5. 6.

7. 8.

9. 10. 11.

12.

5.4.3 The Hilmer Report (1998) Several international developments in the area of corporate governance after 1993 resulted in a second Hilmer report in 1998 under the same title: Strictly Boardroom: Improving Governance to Enhance Company Performance.57 There were no radical changes in approach between the 1993 and 1998 Hilmer Reports. The same sentiments underpinned the Hilmer Report (1998)58 and there were very few changes to the 12 numbered paragraphs under the heading ‘Summary of Recommendations’.59 However, an extract of a publication by Frederick G Hilmer and Lex Donaldson on ‘The Fallacy of Independence’ was included as Appendix 1 to the Hilmer Report (1998). This article makes it clear that the real 57 Frederick G Hilmer, Strictly Boardroom: Improving Governance to Enhance Company Performance, Melbourne, Information Australia (2nd edn, 1998) (Hilmer Report (1998)), i–ii. 58 Ibid 1–7. 59 Frederick G Hilmer and Lex Donaldson, ‘The Fallacy of Independence’ in Hilmer Report (1998), above n 57, 81.

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challenge for boards is not independence, but performance.60 It also points out that research has failed to support the idea that a large number of independent directors leads to fewer illegal acts by corporations.61 This conclusion seems to be supported by several corporate collapses in Australia and other parts of the world: there were several independent directors serving on the boards of the majority of these companies, but poor corporate governance practices and contraventions of the corporations laws still thrived – the corporate governance watchdogs, the outside and non-executive directors, as well as the independent outside and non-executive directors were obviously all still fast asleep at that stage.

5.5 The virtues of good corporate governance in Australia between 1991 and 1998 The excellent intentions of the Bosch Reports (1991, and the 1993 and 1995 reviews) and the Hilmer Reports (1993 and 1998) to promote good corporate governance principles did not, unfortunately, pay the dividends one would have expected of them – as was so cruelly illustrated by the investigations into and court cases dealing with the spate of collapses of large Australian public corporations between 2000 and 2003. Several reasons could be given for the poor corporate governance practices identified in reports and court cases following these collapses: for example, the lack of vigorous scrutiny of whether professed good corporate governance practices were actually followed; poor accounting standards; lack of independence of auditors; lack of proper disclosure of material; price-sensitive information; and lack of statutory protection for those who knew about poor corporate governance practices to encourage them to bring those practices to light. However, it is probable that complacency about corporate governance, after many years of sustained growth in Australia in the middle to late 1990s and early 2000s, was one of the biggest contributing factors in allowing poor corporate governance practices62 to thrive again in an environment in which there was surely no lack of appreciation of the virtues of good corporate governance – as is so strikingly illustrated by the commendable recommendations of the Bosch and Hilmer reports released between 1991 and 1998.

5.6 The IFSA Blue Book In 1995, the Australian Investment Managers’ Association (AIMA, or IFSA (Investment and Financial Services Association Ltd) as it is now known), 60 Hilmer Report (1998), above n 57. 61 Hilmer and Donaldson, above n 59, 86. 62 See Du Plessis, above n 1, 229 and Rich v ASIC [2004] HCA 42 (9 September 2004), [117].

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published a guide on good corporate governance practices for investment managers, under the title Corporate Governance: A Guide for Investment Managers and a Statement of Recommended Corporate Practice.63 A second edition of the guide appeared in July 1997.64 This guide was revised and was re-released in July 1999 (3rd edition) under the name IFSA Guidance Note No. 2.00: Corporate Governance: A Guide for Investment Managers and a Statement of Recommended Corporate Practice.65 It was republished in December 2002 (4th edition) as IFSA Guidance Note No. 2.00: Corporate Governance: A Guide for Fund Managers and Corporations – commonly known as the IFSA Blue Book.66 The 5th edition was released in October 2004.67 Several significant changes were made to the IFSA Blue Book (2004), as a result both of amendments to the Corporations Act 2001 effected by the Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 and of the release in March 2003 of the ASX’s Principles of Good Corporate Governance and Best Practice Recommendations.68 The current, 6th edition of the IFSA Blue Book (2009) was released in June 2009.69 It was not until 2002 that the IFSA Blue Book included a definition of ‘corporate governance’.70 The definition IFSA uses is, understandably, very much focused on shareholders and management: Corporate Governance concerns the conduct of the board of directors and the relationships between the board, management and shareholders. The transparency of major corporate decisions and accountability to shareholders is at the core of governance issues. Shareholders should be treated equitably and there should be the appropriate distribution of risks and rewards between shareholders and company management.71

Interestingly, the term ‘stakeholder’ is only used twice in the IFSA Blue Book (2009). In the IFSA Blue Book (2004) there was only one such a reference under Guideline 10. Currently it is explained in Part 3 (Guidelines for Corporations), under Guideline 1 (Annual Disclosure) that poor management of the environment and social risks facing a company can significantly detract from community and stakeholder support of the company. This was probably added because of the James Hardie case as well as the case of the Australian Wheat Board (AWB case). The second reference occurs also in Part 3 (Guidelines for Corporations), under 63 As referred to in Ramsay and Hoad, above n 26, 10 fn 25. 64 Guidance Note No. 2.00: Corporate Governance: A Guide for Investment Managers and A Statement of Recommended Corporate Practice (IFSA Guidance Note No. 2.00 (1999)), 3rd edn, (July 1999) 5, para 8.3 – available at . 65 Ibid 1. 66 Guidance Note No. 2.00: Corporate Governance: A Guide for Fund Managers and Corporations (December 2002) (IFSA Blue Book (2002). 67 Guidance Note No. 2.00: Corporate Governance: A Guide for Fund Managers and Corporations (October 2004) (IFSA Blue Book (2004)) – available at . 68 IFSA Media Release, ‘Enhanced Corporate Governance Guidelines Issued by IFSA: Proxy Voting Summary to Appear on Member Company Websites’, 21 October 2004, available at . 69 Guidance Note No. 2.00: Corporate Governance: A Guide for Fund Managers and Corporations (June 2009) (IFSA Blue Book (2009) – available at . 70 IFSA Blue Book (2002), above n 66, 9, para 9.2.1. 71 Ibid, 10, para 9.2.1.

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Guideline 10 (Performance Evaluation), where it is stated that ‘the board should also determine policies where the interests of shareholders and other stakeholders require them to limit the discretion of management to act in particular areas such as legal compliance and environmental policy’ (emphasis added).72 Since 1999, the IFSA Guidelines have been divided into two parts. First, some guidelines are given specifically for ‘Fund Managers’ regarding their approach to corporate governance, voting and other issues proposed by public companies in which they invest. Second, there are some general guidelines for ‘Corporations’. In this part, IFSA outlines what it believes are best practice corporate governance standards for companies in which its fund manager clients have invested. There were four guidelines presented under the first part from 1999–2004. They were presented in the following order: communication (Guideline 1); voting scope (Guideline 2); corporate governance policy and procedures (Guideline 3); and reporting to clients (Guideline 4). Currently there are five guidelines under the first part and they are presented in the following order: Guideline 1 – Corporate Governance Policy and Procedures Fund Managers should have a written Corporate Governance policy which is made available on their website. The policy should be approved by the board of the Fund Manager and should note the general principles underpinning formal internal procedures to ensure that the policy is applied consistently. Guideline 2 – Communication with Companies Fund Managers should establish direct contact with companies in accordance with their Corporate Governance Policy. Engagement with companies should include constructive communication with both senior management and board members about performance, Corporate Governance and other matters affecting shareholders’ interests. Guideline 3 – Voting on Company Resolutions Fund Managers should vote on all Australian company resolutions where they have the voting authority and responsibility to do so. An aggregate summary of a Fund Manager’s Australian proxy voting record must be published at least annually and within 2 months of the end of the financial year. Guideline 4 – Reporting to Clients Wherever a client delegates responsibility for exercising proxy votes, the Fund Manager should report in a manner required by the client. Reporting on voting and, where required, other corporate governance activities, should be a part of the regular reporting process to each client. The report should include a positive statement that the Fund Manager has complied with its obligation to exercise voting rights only in the client’s interest only. If a Fund Manager is unable to make the statement without qualification, the report should include an explanation.

72 Ibid 26, para 11.11.

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Guideline 5 – Environmental and Social Issues and Corporate Governance Fund Managers should engage companies on significant environmental and social issues that have the potential to impact on current or future company reputation and performance.

The second set of guidelines (Guidelines for Corporations) numbered 14 in 1999, but this was expanded to the 17 in 2004 and there are currently 18 in the IFSA Blue Book (2009): Guideline 1 – Annual Disclosure The board of directors of a listed company should prominently and clearly disclose, in a separate section of its annual report, its approach to Corporate Governance. This should include an analysis of the Corporate Governance issues specific to the company so that shareholders understand how the company deals with those issues. If the particular circumstances of a company warrant departure from these guidelines, the company should clearly explain the reason for an alternative approach. A company should also disclose its policies and performance regarding other issues, including its risk management framework and material environmental and social issues. Guideline 2 – Composition of the Board of Directors: Competency The board of directors of a listed company should be comprised of competent individuals who have the requisite skills and experience to fully discharge their directors’ duties. It is important to ensure that the board as a whole has the necessary breadth of experience and diversity of skills to enable it to discharge its functions. The board should review and disclose in the annual report its required mix of skills, experience and other qualities, including the core competencies that each director brings to the board. Guideline 3 – Composition of the Board of Directors: Independence The board of directors of a listed company should be constituted with a majority of individuals who qualify as independent directors as defined in this Guideline. Guideline 4 – Number of Permissible Directorships an Individual May Hold Individual directors must commit an appropriate amount of time to board matters and, where appointed, to relevant board committees. It is appropriate to limit the number of board positions held in order to ensure that the individual fulfils their duties to each particular company. Guideline 5 – Chairperson to be an Independent Director The Chairperson should be an independent director. Guideline 6 – Board Committees Committees of the board of directors should: • generally be constituted with a majority who are independent directors, although all members of the Audit Committee should be independent directors (see Recommendation 4.2 of ASX Principle 4: Safeguard integrity in financial reporting); • be entitled to obtain independent professional or other advice of their choice at the reasonable cost of the company; and

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• be entitled to obtain such resources and information from the company, including direct access to employees and advisers to the company. Guideline 7 – Key Board Committees The board should appoint a nomination committee, an audit committee, a remuneration committee and such other committees required by law. These committees should be constituted as defined in this Guideline. Guideline 8 – Election of Directors The method for electing directors must be fair and transparent. Guideline 9 – Appointment of Non-executive Directors Before accepting appointment, non-executive directors should be formally advised of the reasons they have been asked to join the board and given an outline of what the board expects of them. They should be advised of their rights as a director, including their access to company employees and access to information and resources. Additionally, they should be advised of their entitlement to obtain independent professional or other advice of their choice at the reasonable cost of the company. The terms of any pre-nuptial agreement73 should not diminish shareholder rights. Guideline 10 – Performance Evaluation The board should develop a formal performance evaluation process for the regular review of its performance, the performance of individual directors, the company and management. As a key part of that process, the independent directors should meet on their own at least once annually to review performance. Guideline 11 – Equity Participation by Non-executive Directors The board should establish and disclose in the annual report a policy to encourage non-executive directors to invest their own capital in the company or to acquire shares from an allocation of a portion of their fees. Guideline 12 – Trading by Directors and Senior Management [added in 2009] Companies must develop, enforce and monitor policies on director and executive trading in accordance with the Corporations Act 2001, and which reflect their own circumstances. This should include monitoring, enforcement and reporting on trading within any trading windows and ‘blackout’ trading periods. The policy should include appropriate restrictions and disclosure regarding margin lending arrangements over the company’s stock. Guideline 13 – Respective roles of the Board and Management The board should, at least annually, review the respective roles and the allocation of responsibilities between the board and management. Guideline 14 – Board and Executive Remuneration Policy and Disclosure The board must disclose in the company’s annual report its policies on, and the quantum and components of, remuneration for all directors and each of the five highest 73 For a discussion of ‘pre-nuptial’ agreements entered into between the board and a director, see James McConvill, ‘Removal of Directors in Public Companies Takes Centre Stage: An Exploration of the Contemporary Corporate Law and Governance Issues’ (2005) 1 The Corporate Governance Law Review 1.

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paid executives. Where consolidated financial statements are required, remuneration details of each of the five highest paid group executives must be provided. The disclosure should be made in one section of the annual report in tabular form with appropriate explanatory notes. Guideline 15 – Company Meetings – Format of resolutions Notices of meeting and company resolutions should be in plain English and made in a manner that permits shareholders to make informed decisions. Notices of meeting should be posted on the company website or be accessible electronically. Separate issues should not be combined and presented as a single motion for shareholder vote. – Form of proxies Companies should adopt the Model Proxy Form in APENDIX B (with appropriate modifications). Additionally, companies should take steps to implement facilities for the electronic submission and authentication of proxy forms. – Notification Period for Shareholder Meetings The annual report, notice of meeting and other documents for all shareholder meetings should be sent to shareholders at least 28 days prior to the meeting. – Method of Voting Voting should generally be conducted by poll only on the conclusion of discussion of each item of business. Appropriate forms of technology should be utilised to facilitate the proxy voting process. – Disclosure of voting results In announcing to the ASX the decisions made by shareholders at a general meeting, a listed company must report the aggregate proxy votes validly received for each item of business in the notice of meeting. The report should disclose, in the case of a resolution passed on a show of hands, the aggregate number of proxy votes received in each voting category (‘For’, ‘Against’, ‘Left to Proxy’s Discretion’ and ‘Abstain’). In the case of a resolution submitted to a poll, the report should disclose both the information specified in the preceding sentence and the aggregate number of votes cast ‘For’ and ‘Against’ on the poll. – Access to Minutes Shareholders should be able to authorise an agent to inspect or obtain copies of minutes of shareholders’ meetings. Guideline 16 – Disclosure of Beneficial Shareholder Information Information about beneficial shareholdings obtained by companies in response to their inquiries should be disclosed to the market. Guideline 17 – Major Corporate Changes Major corporate changes, which in substance or effect may impact shareholder equity or erode share ownership rights, should be submitted to a vote of shareholders. Sufficient time and information (including a balanced assessment of relevant issues) should be provided to shareholders to enable them to make informed judgements on these resolutions. Guideline 18 – Company Codes of Ethics and Conduct Listed companies should have a company Code of Ethics and Conduct that is adopted by the board and is available to shareholders on request.

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5.7 Standards Australia Standards Australia was founded in 1922, but then called the Australian Commonwealth Engineering Standards Association. It is a non-government organisation that aims to ensure high standards of Australian product and business standards that meet Australia’s need for contemporary, internationally aligned standards and related services. The work of Standards Australia enhances the nation’s economic efficiency and international competitiveness, and contributes towards community demand for a safe and sustainable environment. It is committed to the following:74 ● Work for the Net Benefit of the Australian community; ● Provide national leadership and public access to Standards development; ● Represent Australia’s interests internationally; ● Promote Standardisation; ● Use good regulatory principles and behave legally and ethically; ● Engage with all stakeholders; ● Ensure balance on committees and transparency of interests; ● Adhere to consensus and governance processes; ● Accredit other Standards development organisations; and ● Continuous improvement. One of its divisions is called Business and Management. This sector develops, in response to the needs of business, best-practice solutions to assist businesses to perform more effectively in highly competitive markets. The focus is on a diversity of areas, including:75 ● business governance ● risk management ● knowledge management ● earned value management ● market research ● business continuity management ● personal financial planning ● Quality and Environmental Management Systems (AS/NZS ISO 9001 and 14001) ● conditions of contract. In 2003, Standards Australia sold its commercial businesses to SAI Global Limited and this company was floated on ASX.76 It means that if standards developed by Standards Australia are to be viewed or used, they need to be bought commercially.

74 Available at . 75 See . 76 See and – this address leads the user to a site from which a print copy or electronic (pdf) version of the standards may be purchased.

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In 2003, Standards Australia launched the AS 8000 Corporate Governance series of Standards.77 Supporting these standards, two guides were published in March 2004: a guide to corporate governance; and the other elaborating on applications of corporate governance principles. The guides were developed in collaboration with Victoria University. The AS 8000 series of corporate governance standards provide guidance to businesses in the following areas:78 ● good governance principles (AS 8000) ● fraud and corruption control (AS 8001) ● organisational codes of conduct (AS 8002) ● corporate social responsibility (AS 8003) ● whistleblower protection programs for entities (AS 8004). AS 8000 promotes principles of good corporate governance and is designed to assist members of boards, chief executive officers and senior managers to develop, implement and maintain a robust system of governance that fits the particular circumstances of the entity, provide the mechanisms for an entity to establish and maintain an ethical culture through a committed, self-regulatory approach and provide shareholders, or stakeholders, as the case may be, with benchmarks against which to gauge the entity’s performance. The object of good corporate governance principles is to:79 ● Enhance organisational performance. ● Understand and manage risks to minimise the negative aspects and maximise the opportunities. ● Increase investor confidence in the integrity and efficiency of capital markets and also enhance the competitiveness of the economy. ● Strengthen shareholder and/or community confidence in an entity, particularly in areas that are not formally regulated. ● Enhance the public reputation of an entity through enhanced transparency and accountability. ● Allow entities to demonstrate how they are discharging their legal, shareholder and ethical obligations. ● Provide a mechanism for benchmarking accountability. ● Assist in the prevention and detection of fraudulent, dishonest and/or unethical behaviour. AS 8000 consists of four main parts, dealing respectively with the scope, application and objectives of the AS 8000 standards; developing and implementing a system for achieving good governance; good governance principles; and three appendices. Different to the ASX Principles of Good Corporate Governance and Best Practice that apply to listed companies, AS 8000s also aims to set appropriate good governance standards for private companies, government entities, trustee companies and not-for-profit organisations. It also covers a wider range 77 Standards Australia, Good Governance Principles, AS 8000–2003 (Incorporating Amendment No 1 – November 2004), Standards Australia International Ltd, Sydney (2003). 78 See . 79 See .

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of elements including structural elements (government policy and continuous improvement), operational elements (identification of governance issues, operating procedures for governance and dealing with governance breaches and complaints) and maintenance elements (education and training, communication, monitoring and assessment of governance practices). The part dealing with good governance principles includes guidance on the role, powers and responsibility of the board, board composition and board appointment. The concept of board independence is prominent.80 In this part entities are encouraged to develop codes of conduct; there are also guidelines dealing with board and shareholder meetings and board committees and their composition. Part 3.6 captures the important role of stakeholders in corporate governance. The three appendices are important in a practical sense: Appendix A deals with ‘board roles’ and includes summaries of the role of the chairperson, individual directors, the CEO and the company secretary. Appendix B spells out the underlying ethical values that entities should promote, while Appendix C deals with special issues for consideration in the governance of not-for-profit entities.

5.8 Conclusion Whereas the ‘excesses of the 80s’ ensured ‘diligent awareness of good corporate governance practices during the 90s’, none of these factors seems to have stopped poor corporate governance practices in the 1990s and early 2000s. As mentioned, many reasons could be given for this, but the complacency that prevailed about corporate governance after many years of sustained growth in Australia in the middle to late 1990s and early 2000s was one of the biggest contributing factors in poor corporate governance practices thriving once again, in an environment in which there was surely no lack of appreciation of the virtues of good corporate governance practices. With the 2008–9 global financial crisis, it was again realised that good corporate governance principles are pivotal in maintaining financial stability. Thus, the importance of corporate governance grows steadily as a subject area. We can, however, expect that aspects of total transparency, risk management and increasing regulations will become even more prominent over the next decade or so. The next chapter will illustrate that Australia clearly received a wake-up call. It was realised, quite late in the day, that poor corporate governance practices were lurking below the surface in an environment in which a ‘less prescriptive’ approach was chosen. Several other jurisdictions had more drastic measures in place to ensure corporate governance compliance at least a decade before Australia adopted a similar approach. And, as David Knott observed in 2000, ‘[w]e probably paid a price for that’.81 However, it is remarkable that as far as riding the 80 Ibid, para 3.2.4. 81 Knott, above n 12, 4.

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storm of the global financial crisis is concerned, Australia did remarkably well. It is to be hoped that this will not lead to complacency as far as the importance of good corporate governance principles and practices are concerned. The financial stimulus, combined with adhering to good corporate governance practices were probably, in that order, responsible for Australia doing better than most other developed countries during the global financial crisis.

6 Regulation of corporate governance The impetus for considering the impact of regulation on law is the growing importance of regulation. There is a broad and general move in the community to manage or regulate risk. This focus on regulation and risk management is, in turn, part of a broader interest in using a range of governance mechanisms to directly and indirectly ‘influence the flow of events’. Angus Corbett and Stephen Bottomley, ‘Regulating Corporate Governance’ in Christine Parker, Colin Scott, Nicola Lacey and John Braithwaite (eds), Regulating Law, Oxford, Oxford University Press (2004) 60

6.1 Overview It will be clear from Figure 3.10 in Chapter 3 that we consider regulation of corporate governance to be prominent in a good corporate governance model. This chapter builds upon that model by focusing on the regulation of corporate governance in particular. It deals specifically with the various mechanisms, legislative and non-legislative, which regulate the corporation and which set in place, collectively, a framework by which good governance can be achieved. Overall, this collective body of mechanisms forms part of what has recently been described as an emerging ‘law of corporate governance’. The regulation of corporate governance in Australia is achieved through both binding and non-binding rules, international recommendations and industry specific standards, commentaries of scholars and practitioners and the decisions of judges. The legislature acts to facilitate the fulfillment of good corporate governance by refining the rules encompassing corporate law, and indirectly through the entire panoply of rules and regulations enacted, which have an impact on the corporation and its activities in a variety of ways. But there are other agencies, apart from the legislature, that assume a role in the regulation of corporate governance. Section two of this chapter provides a working definition of ‘regulation’, to clarify what is meant by references to the ‘regulation’ of corporate governance throughout this chapter. It also introduces the influential ‘pyramid’ of regulatory compliance developed by Ayres and Braithwaite. Section three explores the common and unifying aims and objectives of regulation, with reference in 156

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particular to the Organisation for Economic Co-operation and Development’s (OECD) Principles of Corporate Governance (2004), and similar statements made when recent corporate governance reforms were introduced in Australia (namely the CLERP 9 Act (2004), and the Australian Securities Exchange (ASX) Corporate Governance Principles and Recommendations (2007)). These sources emphasise the strong financial objectives underpinning the recent formalisation of corporate governance regulation. Section four explains the various mechanisms (or ‘sources’), both traditional and more recent, which encompass the regulation of corporate governance in Australia. These mechanisms are categorised as being examples of ‘hard law’, ‘hybrids’ or ‘soft law’. Finally, section five assesses whether, in general terms, there is an effective corporate governance with reference to the financial markets regulatory framework in Australia. This assessment is based on the guidelines contained in the OECD’s Principles of Corporate Governance (2004) on what it perceives to be an effective corporate governance regulatory framework.

6.2 Regulation generally Regulation is a topic of significant and increasing interest in a wide range of disciplines, from politics and economics to sociology, psychology and history. There is, therefore, a variety of different definitions of ‘regulation’ used in the literature, with some commentators referring to a ‘definitional free-for-all’.1 One of the best and most useful definitions of ‘regulation’ is provided by Simon Deakin and Jacqueline Cook of the University of Cambridge, in an August 1999 Research Paper prepared by the United Kingdom’s Company Law Review Steering Group. The paper, ‘Regulation and the Boundaries of the Law’ provides some general considerations relating to the debate about the appropriate form of corporate regulation, and usefully explores the present structure of company law and corporate governance in the UK. Deakin and Cook state: In the present context the term ‘regulation’ may be taken to refer to the control of corporate and commercial activities through a system of norms and rules which may be promulgated either by governmental agencies (including legislatures and courts) or by private actors, or by a combination of the two. The direct involvement of the state is not a necessary condition for the existence of regulation in this sense, since rules may be derived from the activities of industry associations, professional bodies or similarly independent entities. This is because the rules of contract, property and tort are seen as empowering commercial actors to enter into and enforce transactions, whereas regulatory interventions 1 See Helen Bird, David Chow, Jarrod Lenne and Ian Ramsay, ASIC Enforcement Patterns, Research Report, Melbourne, Centre for Corporate Law and Securities Regulation (2004), 5 referring to Julia Black, ‘Decentring Regulation: Understanding the Role of Regulation and Self Regulation in a “Post-Regulatory” World’ (2001) 54 Current Legal Problems 103, 129. For a general discussion of regulation in a legal context, see Christine Parker, Colin Scott, Nicola Lacey and John Braithwaite (eds), Regulating Law, Oxford, Oxford University Press (2004). In this edited work, Angus Corbett and Stephen Bottomley have written a chapter on ‘Regulating Corporate Governance’ (at 60).

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are seen as more often controlling the terms of contracts and imposing obligations of various kinds regardless of the intentions of the parties.2

A similarly broad working definition of regulation is used in the recent research report of the Centre for Corporate Law and Securities Regulation at The University of Melbourne, entitled ‘ASIC Enforcement Patterns’. The authors of the report, state that: Three broad ‘textbook’ definitions or approaches to regulation are commonly identified, ranging from the narrowest to widest sense of the term. First, regulation as (government-determined) legal rules backed by mechanisms for monitoring and enforcement. Secondly, in a more encompassing variation of the first, regulation includes any form of deliberate state intervention in the economy or other fields of social activity. Thirdly, regulation, in its widest reading, includes all mechanisms of social control or influence, from whatever source and whether intentional or not.3

The report goes on to discuss the ‘pyramid’ of regulatory compliance developed by Ayres and Braithwaite in their influential book, Responsive Regulation, published in 1992. The report’s authors explain that the ‘pyramid’ aligns itself to a self-regulatory approach to regulation (as opposed to enforced, mandatory regulation), by highlighting the purpose and limits of self-regulation. The ASIC Enforcement Patterns report provides a useful explanation of how Ayres and Braithwaite perceive the pyramid as operating, and the significance of the pyramid in illustrating their theory of responsive regulation. Bird, Chow, Lenne and Ramsay describe the operation of the pyramid as follows: Sanctions are structured in such a way as to combine persuasion in the majority of cases with direct enforcement in a smaller number. At the base of the pyramid, most actors are persuaded to comply through indirect intervention; full sanctions, such as criminal penalties or the withdrawal of a licence to operate, are reserved for the few cases at the top.4

In terms of the purpose of the pyramid in illustrating Ayres and Braithwaite’s theory, the authors of the report go on to explain: The purpose of the pyramid is to provide regulatees with maximum incentives for early compliance. This is an acknowledgement that, where ‘persuasive’ strategies are used, the regulator and the regulatee are, in effect, engaged in bargaining over the terms and timing of compliance, and that without the threat of escalating sanctions, the regulatee may have incentives to hold out in the expectation of being able to negotiate a better deal.5 2 Paper prepared by the ERSC Centre for Business Research, University of Cambridge (1999), for the Department of Trade and Industry’s Review of Company Law. 3 Bird, Chow, Lenne and Ramsay, above n 1, 4. 4 Ibid. In ‘Responsive Regulation’, Ayres and Braithwaite explain that (at 39): ‘Firms that resist initial compliance will be pushed up the enforcement pyramid. Not only escalating penalties, but also escalating frequency of inspection and tripartite monitoring by trade unions . . . can then negate the returns to delayed compliance.’ 5 Ibid 5. See also John Braithwaite, Restorative Justice and Responsive Regulation, Oxford, Oxford University Press (2002).

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Another useful explanation of Ayres and Braithwaite’s pyramid of regulatory compliance is provided by Simon Deakin in the research note, ‘Economic Effects of Criminal and Civil Sanctions in the Context of Company Law’.6 Ayres and Braithwaite’s model of regulatory compliance and enforcement has received widespread support, and indeed was endorsed by the authors of ASIC Enforcement Patterns.7 This research report, published in 2004, details the findings of an empirical study of court-based enforcement activities undertaken by ASIC during the period 1997–9. One of the key aims of the study was to determine whether ASIC’s enforcement activities during this time were consistent with the findings of past sociological studies of legal regulation and enforcement. According to the report, sociological theories contend that the effectiveness of laws as forms of regulation depends on the process by which those laws are received, interpreted and responded to by the participants in the regulatory process. ‘Those participants include ASIC, the Commonwealth Director of Public Prosecutions (DPP), and the pool of persons and companies influenced and controlled by company and financial services laws.’8 What we will see below is that Ayres and Braithwaite’s pyramid of regulatory compliance provides an important context within which to understand the extensive and exciting recent developments in the regulation of corporate governance,9 enabling one to engage in an informed assessment of why corporate governance regulation has reached the point that it has, and where things may head in the future.

6.3 Objectives in regulating corporate governance The impetus for recent corporate governance regulatory reforms both domestically and internationally (such as Sarbanes-Oxley in the USA, and CLERP 9 and the ASX Corporate Governance Principles and Recommendations in Australia) has been spurred on by a series of corporate collapses and the perceived need to restore confidence in the market. As a result, financial objectives are expressed to be the driving factor underpinning contemporary corporate governance regulation. Most, if not all, contemporary corporate governance reports, guidelines, commentaries and legislative packages strongly emphasise the link between sound corporate governance practices and success within the corporation and throughout the economy. For example, the OECD Principles of Corporate Governance states that: 6 Simon Deakin, ‘Economic Effects of Criminal and Civil Sanctions in the Context of Company Law’, Research Note July 2000, DTI Company Law Review, United Kingdom, 5, available at . 7 See Bird, Chow, Lenne and Ramsay, above n 1. 8 Ibid xiii. 9 For application of the pyramid in the enforcement of directors’ duties, see Commonwealth of Australia, Review of Sanctions in Corporate Law (2007), available at .

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The presence of an effective corporate governance system, within an individual company and across an economy as a whole, helps to provide a degree of confidence that is necessary for the proper functioning of a market economy. As a result, the cost of capital is lower and firms are encouraged to use resources more efficiently, thereby underpinning growth . . . 10 The degree to which corporations observe basic principles of good corporate governance is an increasingly important factor for investment decisions. Of particular relevance is the relation between corporate governance practices and the increasingly international charter of investment. International flows of capital enable companies to access financing from a much larger pool of investors.11

In discussing the OECD Principles of Corporate Governance, Janis Sarra has usefully described the link between effective corporate governance and healthy global capital markets, as follows: Corporate governance is only one aspect of the larger framework of macroeconomic policies, competition and tax policy, global capital, products and labour markets, cultural norms and ethics, and diverse state regulatory systems. The growth of global capital markets has created the potential for greater access to a larger investor pool. Key to the attraction of long-term ‘patient capital’, whether it is domestic or international, is the ability to offer corporate governance systems that are clearly articulated and adhered to, within regulatory and legal frameworks that support contractual and ownership rights.12

At the domestic level, in Australia, important sources of recent corporate governance regulatory reform – the CLERP 9 amendments to the Corporations Act 2001 (Cth) (the Act), the ASX Corporate Governance Principles and Recommendations and the recently revised IFSA Blue Book on corporate governance – all emphasise the financial objectives underlying contemporary regulation of corporate governance. The CLERP 9 amendments to the Act, the majority of which came into effect from 1 July 2004, contain the bulk of corporate governance-related reforms, including enhanced mandatory rules dealing with auditor independence, financial reporting, executive remuneration, continuous disclosure and shareholder participation.13 CLERP 9 represented the 9th stage of the Howard Government’s Corporate Law Economic Reform Program, which was strongly driven by economic objectives for law reform. In the Second Reading Speech of the CLERP 9 Bill, delivered in the House of Representatives on 3 December 2003, Treasurer Peter Costello said: 10 OECD Principles of Corporate Governance (April 2004), available at 11. 11 Ibid 13. 12 See Janis Sarra, ‘Convergence Versus Divergence: Global Corporate Governance at the Crossroads’ (2001) 33 Ottawa Law Review 177, 186–7. 13 See generally James McConvill, An Introduction to CLERP 9, Sydney, LexisNexis (2004); R P Austin, H A J Ford and I M Ramsay, Company Directors: Principles of Law and Corporate Governance, Sydney, LexisNexis (2005); John Farrar, Corporate Governance: Theories, Principles and Practice, Melbourne, Oxford University Press (3rd edn, 2008).

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The draft Bill continues the work of the Government’s Corporate Law Economic Reform Program, to modernise business regulation and foster a strong and vibrant economy, progressing the principles of market freedom, investor protection and quality disclosure of relevant information to the market.

Importantly, however, as suggested in the above statement by the then-Treasurer Costello, the CLERP 9 reforms are not only driven by a narrow financial objective, but are also seeking to protect and enhance the rights of shareholders, by confirming their position as the central and most significant stakeholder in the modern corporation. The ASX Corporate Governance Principles and Recommendations (2007) are also expressed to be driven by financial objectives – it notes the importance of good corporate governance from the perspective of achieving a sound economy and maintaining market confidence. Two statements in the ASX Corporate Governance Principles and Recommendations (2007) illustrate this point: [G]ood governance structures and practices continue to be important in determining the cost of capital in a global capital market. Australian companies must be equipped to compete globally and to maintain and promote investor confidence both in Australia and overseas.14

and The Recommendations are not prescriptions, they are guidelines, designed to produce an outcome that is effective and of high quality and integrity. This document does not require a ‘one size fits all’ approach to corporate governance. Instead, it states suggestions for practices designed to optimise corporate performance and accountability in the interests of shareholders and the broader economy.15

Finally, the IFSA Blue Book on corporate governance (Corporate Governance: A Guide for Fund Managers and Corporations),16 providing guidance for IFSAmember fund managers as to how they may influence companies in which they invest to achieve and maintain corporate governance best practice standards, explains that the guidelines and standards in the IFSA Blue Book, if followed, will provide ‘positive benefits to all shareholders and the economy as a whole’.17

6.4 Sources of regulation in Australia The key definitions of ‘regulation’, as quoted above, highlight some of the main sources of regulation. We now apply this background discussion to a specific context of corporate governance in Australia, and provide an account of the 14 ASX, Corporate Governance Council, Corporate Governance Principles and Recommendations (2nd edn) (August 2007) at 4, available at . 15 Ibid 5. 16 Guidance Note No. 2.00: Corporate Governance: A Guide for Fund Managers and Corporations (June 2009) (IFSA Blue Book (2009) – available at . 17 Ibid 4.

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various mechanisms, both traditional and more recent, which encompass the regulation of corporate governance in Australia. John Farrar has engaged in a very useful task of categorising the various sources of corporate governance regulation in Australia – into ‘hard law’, ‘hybrids’ and ‘soft law’.18 Although Farrar does not provide a working definition of any of these categories, it could be said that ‘hard law’ means ‘traditional black-letter law’; ‘soft law’ includes voluntary sources of corporate governance standards that companies have the freedom to adopt or not; and ‘hybrids’ fall somewhere between the two: neither mandatory nor purely voluntary. Below we identify the main sources of corporate governance regulation under the category headings provided by Farrar. We also detail our perspective on each of these sources and add to Farrar’s analysis our own viewpoint on corporate governance regulation.

6.4.1 ‘Hard law’ 6.4.1.1 Statutory regulation – corporate law Australia’s primary companies legislation, the Corporations Act 2001 (Cth), contains a number of provisions that influence, both directly and indirectly, all aspects of a company’s governance arrangements. The provisions range from director’s duties and liabilities19 and shareholder rights and remedies,20 which influence the relationship between directors, management and shareholders, to the financial reporting provisions under Chapter 2M,21 which are intended to ensure that the financial aspects of a company’s governance practices are characterised by transparency and accountability, and to the comprehensive provisions under Chapter 2G governing company meetings (both directors’ meetings and meetings of members). Many of these provisions are mandatory rules, with sanctions imposed for non-compliance. While there are many important corporate governance ‘mandates’ under the Act, this does not mean that all of the corporate governance rules that stem from the Act are prescriptive in nature. Indeed, the opposite is the case. The Act provides companies with a great deal of say on the internal arrangements and management of their company. Most of the rules governing a company’s internal arrangements and management may be contained in the company’s constitution (if the company has one); this is specifically drafted by each company to meet its particular needs and therefore in essence may contain whatever rules the company desires (subject to a special majority of the company’s shareholders approving the changes). Instead of a constitution, a company’s internal management may be governed by a set of ‘replaceable rules’ (that is, rules that the company may abide by or ‘opt out of’ by adopting alternative arrangements in 18 John H Farrar, ‘Corporate Governance and the Judges’ (2003) 15 Bond Law Review 65. 19 For discussion, see Jason Harris, Anil Hargovan and Michael Adams, Australian Corporate Law, Sydney, LexisNexis (2nd edn, 2009) Chapters 16–19. 20 Ibid, Chapter 20. 21 Ibid, Chapter 21.

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its constitution – see discussion below) contained in the Act (see list in section 141 of the Act). A company may also use a combination of constitution and replaceable rules. While the constitution (if any) is drafted independently by each company, it is appropriate to discuss the constitution in the context of regulation under the Act. This is because the Act contains some important provisions relating to company constitutions. Most importantly, section 140(1) provides that a company’s constitution (if any, as well as any replaceable rules that apply to the company) has effect as a contract between: (a) the company and each member (b) the company and each director and company secretary (c) a member and each other member. Due to s 140(1), the company’s constitution has the status of a ‘statutory contract’, which means that it has certain features which depart from ordinary principles of contract law. With an ordinary contract, only initial parties to the contract are bound by it. This would typically be the company and the shareholders who purchased shares in the company when it was first formed. The statutory contract, however, has a reach beyond the current corporate membership. It extends to, and binds, any person who acquired membership after the company was formed. An important implication of the company constitution having the status of a statutory contract is that it offers remedies beyond damages if the contract is breached. An injunction or declaration is also available to enforce compliance with the constitution.

Another reason for the constitution ultimately being a creature of the Act, rather than being an entirely separate initiative of companies, is that the Act sets out the procedure that companies have to follow in order to adopt or amend a constitution. Section 136(1) provides that a company may adopt a constitution in one of three ways: (a) a new company is considered to adopt a constitution upon registration if those persons who are named in the company’s registration application as consenting to become members, agree in writing to the terms of the constitution before the application is lodged; (b) by passing a special resolution (defined below) of members if a company is already registered but does not have a constitution; (c) if a court order is made under s 233 (finding oppressive conduct under Part 2F.1) requiring that the company adopt a constitution.

Under section 136(2) of the Act, a special resolution of members is required to modify or repeal a constitution or a provision of a constitution. Section 9 of the Act defines ‘special resolution’ as being a resolution passed by at least 75 per cent of the votes cast by members entitled to vote on the resolution. Most companies, and probably all larger companies, have a constitution. The main reason, in practice, for adopting a constitution is to displace one or more of the so-called ‘replaceable rules’ under the Act that would otherwise apply to the company. This is implied in section 135(2) of the Act – replaceable rules are

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‘replaceable’ because they can be modified or displaced by adopting a constitution with alternative procedures. The replaceable rules regime was introduced in 1998. The key objective behind this move was to provide a simplified procedure for setting up and running a company. It is explained in the Explanatory Memorandum to the Company Law Reform Bill 1997, that: The concept of memorandum of association will be abolished (the memorandum of existing companies will be treated as part of their constitution). Also, the adoption of a constitution will be optional. The basic rules that are available to the internal management of companies (Table A of the Law) will be updated and moved into the main body of the Law as replaceable rules. Companies will be able to adopt a constitution displaying some or all of these rules. These reforms will reduce the cost of registering a company for the approximately 80,000 new companies that are registered each year.22

With this amendment to the Act, 41 provisions regulating the internal affairs of the company became replaceable rules. The replaceable rules, listed in section 141 of the Act,23 essentially reflect the rules contained in the old Table A to the Corporations Law, and are divided into provisions dealing with officers and employees, inspection of books, directors’ meetings, meetings of members, shares and transfer of shares. The replaceable rules apply only to companies that were incorporated after the introduction of the replaceable rules regime on 1 July 1998, and to companies incorporated before 1 July 1998, which repeals their existing constitution.24 As companies are no longer required to have a constitution, the replaceable rules may entirely govern the internal affairs of a company if the company so chooses.25 Ford and colleagues explain that it is possible for a company’s internal arrangements and management to be governed entirely according to the replaceable rules contained in the Act. The authors state, however, that in practice companies find some or all replaceable rules to be inappropriate or inadequate, and will therefore adopt a constitution to supplement, or entirely replace, the replaceable rules. Commonly, therefore, companies will be governed by a constitution, or a mix of constitutional provisions and replaceable rules.26 The significance of the company constitution in shaping the corporate governance practices of companies is recognised in the leading corporate law textbooks: Gower and Davies’ Principles of Modern Company Law in the UK, and Ford’s Principles of Corporations Law in Australia. Gower and Davies refer to the company constitution as being the key source of governance arrangements, including 22 Explanatory Memorandum, Company Law Reform Bill 1997, paragraph 10. 23 Section 141 of the Act sets out a list of 41 provisions that apply as replaceable rules, which companies may use as their internal governance arrangements. 24 See s 135(1) of the Act. 25 See further James McConvill and Mirko Bagaric, ‘Opting Out of Shareholder Governance Rights: A New Perspective on Corporate Freedom in Australian Corporate Law’ (2005) 3 De Paul Business and Commercial Law Journal (USA) 401. 26 R P Austin and I M Ramsay, Ford’s Principles of Corporations Law, Sydney, LexisNexis Butterworths (14th edn, 2010) 188–9 para 6.11.

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the division of powers between shareholders and the board, and the composition, structure and operation of the board.27 Ford’s Principles of Corporations Law uses ‘corporate governance rules’ and the company’s ‘constitution’ as almost interchangeable terms, with the authors noting: The provision of the constitution which deals with the power to manage the company’s business is obviously of critical importance. The constitution of many companies will contain a provision that the directors may exercise all the powers of the company except any powers that the Corporations Act or the company’s constitution requires the company to exercise in general meeting.28

6.4.1.2 Statutory regulation – other than corporate law As already explained in Chapter 2, the manner in which the internal arrangements and management of companies is achieved, and the relationship between the company and its various stakeholders operates, is also influenced by legal rules operating outside of company law. These rules derive from areas of law such as industrial relations, tax, environmental law, and banking and finance. 6.4.1.3 ‘Corporate governance and the judges’ – the place of judge-made law Regulation encompasses the making of laws, the interpretation of laws to determine what is required to comply with them and, in turn, the actions taken to enforce these laws in cases of non-compliance.29

In Australia, ‘company law’ (including the rules of corporate governance) as a collective body of rules has traditionally been statute-based, unlike in the UK, where much of company law – including directors’ duties and shareholder rights – principally has been governed by common law and equitable principles (although this is progressively changing as a result of company law reform). Within this statute-based regulatory framework, as the above statement suggests, judges have an important role in developing and applying the principles of the law through their role as interpreters (particularly when provisions are vaguely expressed or overly complex). Thus, while the common perception is that regulation of corporate governance comes in the form of black-letter rules – legislative or quasi-mandatory codes and principles – it is important to understand the significant role that judges continue to play.30 Probably the best recent account of the important role that judicial determinations have in the context of corporate governance regulation in Australia comes from Farrar. He states as follows: 27 Paul L Davies, Gower and Davies’ Principles of Modern Company Law, London, Sweet & Maxwell (8th edn, 2008) 62. 28 Austin and Ramsay, above n 26, 223 para 7.091. 29 From Bird, Chow, Lenne and Ramsay, above n 1, 2, citing Robert Baldwin and Martin Cave, Understanding Regulation, New York, Oxford University Press (1992) 1–2 (emphasis added). 30 See Davies, above n 27, 61. See also Corbett and Bottomley, above n 1, 60.

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If we turn to corporate governance consisting of statutory rules and case law rules and principles [they have] traditionally been regarded as justiciable [that is, capable of being determined by a court acting judicially]. Indeed, it was left to the courts to fill in the substantial gaps left by the legislation in terms of director’s fiduciary and other duties, and shareholder remedies . . . Court proceedings of any sort are expensive and occasion delay. ASIC prefers to avoid them if possible for these reasons and uses its administrative powers wherever possible and is seeking to impose its own penalties . . . This needs to be considered as does the question whether the courts have a role in respect of self-regulation.31

Farrar also discusses in detail three high-profile recent cases in Australia (relating to the HIH and One.Tel collapses, and the ongoing saga associated with NRMA) to highlight the importance of the continuing role of the courts in corporate governance where self-regulation fails. He gives the following explanation of the important role of Australian courts in relation to the regulation of contemporary corporate governance: What these situations demonstrate is that self-regulation sometimes fails and there is no alternative to court involvement. Self regulation lacks an effective system of sanctions which can only be provided by the courts. In the case of HIH, retribution has been swift. There was not time and perhaps inclination for minority shareholders to seek redress. ASIC took prompt action.32

6.4.2 ‘Hybrids’ ‘Hybrid’ mechanisms of corporate governance regulation have been described in the literature from a broader theoretical context as constituting a strategy of ‘enforced self-regulation’. According to Ayres and Braithwaite in Responsive Regulation, enforced self-regulation occurs where the law delegates to privatesector bodies (such as self-regulatory organisations, which loosely describes ASX) the task of formulating substantive rules, to which certain legal sanctions are then attached. 6.4.2.1 ASX Listing Rules ASX provides a market for trading in securities. ASX engages in market surveillance in relation to securities issued by entities that are accepted onto the official list of the ASX (‘listed entities’). One way that ASX does this is through setting the standards of behaviour for listed entities, which are contained in ASX Listing Rules. According to ASX, the Listing Rules ‘govern the admission of entities to the official list, quotation of securities, suspension of securities from quotation and removal of entities from the official list. They also govern disclosure and some aspects of a listed entity’s conduct’. Compliance with the Listing Rules is a requirement for admission to the official list. Non-compliance is a ground for 31 Farrar, above n 13. 32 Ibid 80.

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removal from the official list. The corporate governance rules in the Listing Rules typically require a listed entity to disclose to the market and/or shareholders certain information, or to obtain shareholder approval for a particular transaction or arrangement. Some of the corporate governance-related Listing Rules include: ● LR 3.1 (dealing with continuous disclosure of information upon discovering the information’s ‘materiality’) ● LR 7.1 (requiring shareholder approval if a company issues more than 15% worth of its securities over a 12 month period) ● LR 10.1 (requiring shareholder approval for, among other things, certain related party transactions) ● LR 11.1 (requiring provision of details to ASX if an entity proposes to make a significant change, either directly or indirectly, to the nature and scale of its activities) ● LR 11.2 (requiring shareholder approval if the significant change involves the entity disposing of its main undertaking). At first blush, it appears curious that Farrar included the ASX Listing Rules under the ‘hybrid’ category when they are mandatory rules, given statutory force under section 793C of the Corporations Act (meaning that an application may be made by ASIC, ASX or an aggrieved person for a court order that the operating rules of the market be complied with or enforced).33 However, an explanation for categorising the Listing Rules as hybrids is that they are different from traditional legislation – rather than being enacted by Parliament, they are developed and implemented by ASX, subject only to disallowance by the relevant Minister.34 Another plausible reason for treating the listing rules as hard–soft law (hybrid), which we accept, can be explained with reference to the approach to enforcement of corporate governance principles by ASX. The attitude of ASX towards enforcement of the Listing Rules also offers support to the categorisation of the Corporate Governance Principles and Recommendations (2007) as soft law – despite the elevation of the Listing Rules to a statutory importance. The paradoxical position, and difficulty with labelling, is best explained with reference to the introduction to the ASX Listing Rules and judicial attitude to its enforcement. The former explicitly rejects a perspective approach to enforcement:35 ASX has an absolute discretion concerning the admission of an entity to the official list (and its removal) and quotation of its securities (and their suspension). ASX also has discretion whether to require compliance with the Listing Rules in a particular case (ie, apart from waiving the rules). In exercising its discretion, ASX takes into account the principles on which the Listing Rules are based. 33 Furthermore, s 1101B of the Act provides that the court may make a wide range of orders to ensure compliance with legislation, operating rules and other requirements which relate to dealing in financial products, providing financial services or operating a licensed market. An application may be brought by ASIC, a market licensee or a person aggrieved by a contravention of the operating rules. 34 See s 793E(3) of the Act. 35 See .

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ASX may also waive compliance with a listing rule, or part of a rule, unless the rule in question says otherwise. The Listing Rules necessarily cast a wide net. However, ASX does not want to inhibit legitimate commercial transactions that do not undermine the principles on which the Listing Rules are based.

There is a line of judicial authority that is sympathetic to the nature and intent of the listing rules, as envisaged above by ASX.36 In Bateman v Newhaven Park Stud Ltd, Barrett J rejected counsel’s submission that the views of ASX as to the construction of its listing rules (reproduced above) ‘are essentially beside the point’37 and reinforced the explicit power ASX reserves to itself to decide whether to require compliance. Herein lies the complication and tension in trying to fit ASX Corporate Governance Principles and Recommendations (2007) easily into the slots of ‘hybrid law’ and ‘soft law’. The discussion illustrates, at the least, that it is not easy to find a strict classification that is necessarily decisive. 6.4.2.2 ASX Corporate Governance Principles and Recommendations Farrar includes the ASX’s Corporate Governance Principles and Recommendations (2007) under the category of ‘soft law’.38 The rationale for this is that the Best Practice Recommendations differ from the Listing Rules in that they are not strictly mandatory rules backed up by statutory force; rather, as was explained in greater detail in Chapter 5 of this book, ASX Corporate Governance Principles and Recommendations (2007) operate under a ‘comply or explain’ regime: ASX-listed companies must either comply with each of the recommendations, or clearly explain why not in their annual report. Notwithstanding the caveat expressed above on strict classifications, we believe that ASX Corporate Governance Principles and Recommendations (2007) should come under the ‘hybrid’ category for the reasons discussed above. The ‘comply or explain’ regime stems from Listing Rule 4.10.3, which expressly states that listed entities must comply with the recommendations (constituting benchmarks for corporate governance best practice in relation to a range of different matters) or explain why not in their annual report. Hence, while the benchmarks contained in ASX Corporate Governance Principles and Recommendations (2007) are not prescriptive rules – as exist in the USA with the Sarbanes-Oxley Act of 2002 and the New York Stock Exchange corporate governance rules – neither are they purely voluntary – as are the other standards and guidelines expressing corporate governance benchmarks, discussed below under ‘soft law’. Listed companies do not have complete freedom (as they do, say, with the replaceable rules in the Corporations Act) to decide whether or not to comply with the recommendations: to depart from any one of the 27 recommendations contained in 36 For example, see Harman v Energy Research Group Australia Ltd (1985) 9 ACLR 897; Fire and All Risk Insurance Ltd v Pioneer Concrete Services Ltd (1986) 10 ACLR 760; Bateman v Newhaven Park Stud Ltd (2004) 49 ACSR 454. 37 (2004) 49 ACSR 454 at 456. 38 John Farrar, Corporate Governance: Theories, Principles and Practice, Melbourne, Oxford University Press (3rd edn, 2008) 384 et seq.

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ASX Corporate Governance Principles and Recommendations (2007), companies need to justify their action by clearly explaining why they have done so. Failure to do this technically constitutes a breach of Listing Rule 4.10.3, and sanctions (including even removal from the official list of ASX) are available. The following judicial remarks by Kirby P (as his Honour then was) in FAI Insurances Ltd v Pioneer Concrete Services Ltd (No 2),39 in support of a wide construction on the enforceability of ASX Listing Rules are relevant to this debate:40 [Section 793C of the Corporations Act] permits the protective intervention of the court to ensure that breaches of listing requirements, which, for whatever reason, are not pursued by the Commission or a securities exchange, can be brought to notice of the court by a person aggrieved . . . Making every allowance . . . for the ‘absolute discretion’ reserved to the securities exchanges by the foreword to the official listing requirements [reproduced above], the overall scheme of [Chapter 7 of the Act], as enacted by the Parliament, appears to be one which elevates the listing requirements to a statutory importance which they did not previously have. They are now more than the private rules of a private body. By [s 793C], as by]s 1101B] of the [Act], they are given statutory significance . . . (emphasis added)

6.4.2.3 Accounting standards The importance of having in place proper procedures and policies to ensure accurate and transparent financial reporting within a company (which involves complying with standards of accounting and auditing practice) was highlighted by the accounting scandals in the early part of this decade, which led to the collapse of Enron and World.Com in the USA and HIH in Australia. Farrar distinguishes accounting standards from the Corporations Act, categorising accounting standards as ‘hybrids’ rather than ‘hard law’. For similar reasons to those given for ASX Listing Rules above, we understand why Farrar has done this, but believe that accounting standards are in fact ‘hard law’. Accounting standards, essentially a collection of generally accepted accounting practices, are set by the Australian Accounting Standards Board under the supervision of the Financial Reporting Council, rather than being enacted by Parliament. However, they are given statutory force under the Act (see sections 296 and 304), and therefore failure to prepare a financial report in accordance with the accounting standards may be enforced under the Act. But, again, nothing major turns on the accounting standards being characterised as ‘hybrids’ rather than ‘hard law’. 6.4.2.4 Auditing standards Since the implementation of the CLERP 9 reforms in 2004, we can now similarly refer to auditing standards (standards of proper auditing practice which, 39 (1986) 10 ACLR 801. 40 Ibid at 812. In this case, Street CJ commented on the enforceability of listing rules and also supported a wide construction of the relevant statutory provisions. For application of this broad view, see FAI Traders Insurance Co Ltd v ANZ McCaughan Securities Ltd (1990) 3 ACSR 279.

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if adhered to, assist auditors in satisfying their duty to use reasonable care and skill) as ‘hard law’. Section 307A of the Act, introduced by CLERP 9, provides that if an individual auditor, audit firm or an audit company conducts: (a) an audit of the financial report for a financial year; or (b) an audit or review of the financial report for a half year the individual auditor or audit company must conduct the audit or review in accordance with the auditing standards.

6.4.3 ‘Soft law’ Corporate governance objectives are also formulated in voluntary codes and standards that do not have the status of law or regulation. While such codes play an important role in improving corporate governance arrangements, they might leave shareholders and other stakeholders with uncertainty concerning their status and implementation. When codes and principles are used as a national standard or as an explicit substitute for legal or regulatory provisions, market credibility requires that their status in terms of coverage, implementation, compliance and sanctions is clearly specified.41

Soft law involves the purely voluntary (that is, no formal sanctions arise from noncompliance) codes and guidelines articulating benchmarks for what is considered best practice in corporate governance, as well as scholarly and trade writings (in the form of books, reports and articles) that have had some role in influencing companies to shape their internal arrangements and management to achieve best practice. Recent examples of these codes/guidelines include the IFSA Blue Book on corporate governance for fund managers (discussed above, and in Chapter 5) and Standards Australia’s series of corporate governance standards (released in 2003), which contain similar benchmarks for a number of governance matters to ASX Best Practice Recommendations (2003) and Revised Principles (2007), but are used mostly by public sector bodies, non-listed entities and non-profit organisations. In terms of reports and other writings, a plethora of such material has been produced and published in Australia (mainly since the early 1990s) – as in other jurisdictions – contributing towards a rich and valuable collection of corporate governance ‘soft law’. While there were obviously some company law rules and voluntary standards in Australia prior to the introduction of ASX Best Practice Recommendations and the rules on corporate governance in CLERP 9, the conception of what best practice in corporate governance meant was primarily shaped by the contents and recommendations of a number of well-publicised reports by committees chaired by prominent directors and business persons. The first of these was the Bosch Report (officially titled Corporate Practices and Conduct), first released in 1991 (with subsequent editions published in 1993 and 1995), followed closely by Fred Hilmer’s Strictly Boardroom, first published in 1993 by the Sydney Institute – see Chapter 5 for further discussion of these reports. In the UK, the first such report 41 OECD Principles, above n 10, 30.

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was the Cadbury Report, published in 1992 by the Committee on Financial Aspects of Corporate Governance. Bob Baxt, Keith Fletcher and Saul Fridman explain that: These various committees looked at many aspects of corporate governance such as the use of committees by boards of directors, the practice of having one individual act as both chairman of the board as well as chief executive officer, the use of independent directors and the proper role and working of a good board.42

Since the Bosch Report (1991) – the first attempt in Australia to capture and express in written form what was considered to be corporate governance best practice at the time – the focus of corporate governance in Australia was on selfregulation. However, since CLERP 9, the focus has shifted towards a more formal regulatory approach. Nonetheless, the various reports and writings (including books, journal articles etc.) which preceded this shift continue to have an important place in the regulation of corporate governance. For example, in the 2003 New South Wales Supreme Court case of ASIC v Rich,43 ASIC presented as evidence three books on corporate governance (including Sir Adrian Cadbury’s A Company Chairman (2nd edn, 1995), and John Harper’s Chairing the Board (2000)) to support its argument that a company chairperson has greater responsibilities than an ordinary director, and therefore should be required to exercise and maintain a higher standard of care. In accepting ASIC’s use of this evidence, Austin J stated: Much of the literature of corporate governance is in the form of exhortations and voluntary codes of conduct, not suitable to constitute legal duties. It is sometimes vague and less than compelling, and must always be used with caution. Nevertheless, in my opinion this literature is relevant to the ascertainment of the responsibilities to which Mr Greaves was subject.44

And later in the judgment: [Over the last decade] there has been an enormous outpouring of literature concerning corporate governance, and there has been much debate in the Australian commercial community as to the effects the new thinking should have in practice. The court must perform the difficult task of articulating a standard of care by reference to community expectations, in an area not frequently traversed in litigation. It seems to me preferable for the court to embark upon this task with a measure of assistance from the kind of evidence the commission proposes to advance, than to choose the only other alternative, namely to rely on unassisted armchair reflection.45

A fourth category of regulation that Farrar refers to is ‘business ethics’. In this book, we deal with business ethics separately to regulation in Chapter 14. 42 See Corporations and Associations: Cases and Materials, Sydney, LexisNexis Butterworths (9th edn, 2003) 264. 43 (2003) 44 ASCR 341. 44 Ibid 358. 45 Ibid 359.

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6.4.4 The role of market forces Another important source of influence, and perhaps control, over the internal arrangements and management of the company, but one that does not sit comfortably under any of the categories of regulation above46 is ‘market forces’. In their 1997 book, Making Boards Work, David S R Leighton and Donald H Thain interestingly referred to common examples of market forces as ‘alternatives to self-motivated board improvement’, which lends support to our approach in this chapter of including market forces as a form of regulation. It is perhaps difficult for some to envisage how market forces, being the natural forces of an intangible entity, could actually be said to be a form of regulation; however, the label ‘alternatives to self-motivated board improvement’ could be useful in easing in market forces as part of the dialogue on corporate governance regulation.47 The significant role of market forces in contributing towards good corporate governance and strong corporate performance has for some time been emphasised in economic literature on the corporation and corporate law.48 In fact, many consider the influence of market forces to be an effective substitute for formal legal regulation.49 Ford’s Principles of Corporations Law gives an excellent summary of how the significance of market forces as a regulatory mechanism is presented in the economic literature on corporate law and governance – or ‘law and economics’, which underlie the ‘contractarian’ view of the corporation (that the corporation is an abstract entity consisting of a ‘nexus of contracts’, rather than having separate legal personality).50 In approaching regulation of corporate governance, the focus on contractual theory would suggest that market forces – probably best fitting into the category 46 In reference to ‘hard law’, ‘hybrids’ and ‘soft law’, it could perhaps be argued that market forces are ‘hybrids’, in that they cannot be described as traditional black-letter law, but neither are they purely voluntary – market forces exist and have an important influence on governance practices regardless of the wishes of the company and its management. 47 In their book, Leighton and Thain discuss five such ‘alternatives’ (some of which are often discussed as market forces, some of which are not): (1) takeovers [ineffective boards leave companies wide open for takeovers]; (2) proxy contests [use voting powers to remove inefficient directors and appoint more effective directors]; (3) ‘power investing’ [investment bankers, who pool their money with pension funds and other institutional investors to take control of major corporations]; (4) shareholder activism [self-explanatory]; and (5) legal action [e.g. class action; oppressive remedy etc.]. See David S R Leighton and Donald H Thain Making Boards Work, Whitby, Ontario, McGraw-Hill Ryerson (1997), 10–12. 48 See Frank H Easterbrook and Daniel R Fischel, The Economic Structure of Corporate Law, London, Harvard University Press (1991); more recently, consider, for example, Larry E Ribstein, ‘Market vs Regulatory Responses to Corporate Fraud: A Critique of the Sarbanes-Oxley Act of 2002’ (2002) 28 Journal of Corporation Law 1. 49 The classic article on the role of market forces as an alternative regulatory mechanism to traditional legal regulation is L A Bebchuk, ‘Federalism and the Corporation: The Desirable Limits on State Competition in Corporate Law’ (1992) 105 Harvard Law Review 1437 (which examines the operation of the various markets that may affect the decisions of managers); another significant contribution is by J C Coffee, ‘Regulating the Market for Corporate Control: A Critical Assessment of the Tender Offer’s Role in Corporate Governance’ (1984) 84 Columbia Law Review 1145. Bebchuk’s article ultimately contends that there are limits to the effectiveness of market forces and that, at least in the USA, there remains a strong place for traditional legal rules in corporate law, if corporate law is truly to maximise shareholder value. 50 The alternative view of the corporation discussed in Ford is the ‘managerialist’ view. Managerialists place greater weight on the hard law, hybrids and soft law as regulatory mechanisms by which to achieve positive outcomes than on the role of market forces. This theory is further discussed in the text above.

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of ‘soft law’, due to constituting a form of corporate control, but control arising without any form of threat of direct legal sanction – are more significant than legal rules. This is in contrast to an alternative theory discussed in Ford’s Principles – the managerialist theory, which suggests that strong legal rules are needed to temper the enormous power that corporate managers wield, and to ensure that this power is exercised consistently with the interests of shareholders. According to the contractual theory, competitive markets are more important than mandatory legal rules in providing managers with appropriate incentives to maximise shareholder wealth. These markets include the product market, the market for corporate control and the managerial labour market [often described in the USA as the ‘factors market’]. The contractual theory does not imply the absence of legal rules. Rather, the theory asserts that market forces require managers to act in the interests of shareholders . . . Clearly the validity of the contractual theory depends upon the efficiency of the markets.51

Ford’s Principles of Corporations Law valuably deals with each of the market forces separately, and the impact of each in terms of influence and control: (i) Products market With respect to the products market, adherents to contractarian theory argue that management must ensure that the company competes effectively in the market for the company’s goods and services. Otherwise the company will lose business and may be forced into liquidation.

(ii) Market for corporate control If a company is operating inefficiently this should be reflected in the company’s share price. This creates an opportunity for a raider to take over the company, install more efficient managers and therefore profit. Yet there are limits on the effectiveness of the market for corporate control. If the inefficiency in the management of the company results in only a minor reduction in the company’s share price, this means that the likelihood of a takeover is increased to only a limited degree.

(iii) Labour force market Another market force which may operate to discipline management is the managerial labour market. Any reduction in shareholder value because of management inefficiency may have a detrimental effect on the employment opportunities of managers.52 51 Austin and Ramsay, above n 26, 25 para 1.380. As an example of the attitude of ‘contractarians’ towards the role of market forces in corporate governance (and more specifically, the influence of market forces on board composition), see for example Donald C Langevoort, ‘The Human Nature of Corporate Boards: Law, Norms, and the Unintended Consequences of Independence and Accountability’ (2001) 89 Georgetown Law Journal 797, 800: ‘Notwithstanding the longstanding legal interest in board independence, I share the sense of many commentators that the law has played a relatively minor role in the evolution of board structure and behaviour; market and other social forces are far more important. Indeed, I suggest leaving the matter of board independence and accountability largely to these extralegal incentives.’ 52 Austin and Ramsay, above n 26, 25–6 para 1.380.

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The OECD Principles of Corporate Governance (OECD Principles) also recognises the role of market forces in influencing the decisions of directors and managers in relation to the internal arrangements of the company. Its preamble states that: Corporate governance is affected by the relationships among participants in the governance system . . . The role of each of these participants and their interactions vary widely among OECD countries and among non-OECD countries as well. These relationships are subject, in part, to law and regulation and, in part, to voluntary adaptation and, most importantly, to market forces.53

The OECD Principles explain that, in order to achieve the most efficient deployment of resources, policy makers in OECD countries need to undertake analyses of the impact of key variables that affect the functioning of markets, such as incentive structures, the efficiency of self-regulatory systems and dealing with conflicts of interests. According to the OECD Principles: The corporate governance framework should be developed with a view to its impact on overall economic performance, market integrity and the incentives it creates for market participants and the promotion of transparent and efficient markets.54

6.5 Towards an effective supervision of financial markets regulatory framework in Australia – analysis 6.5.1 OECD’s guidelines for achieving an effective governance framework We have already explained in Chapter 1 and above in this chapter why, in order to maintain international money market confidence in the domestic economy and local companies, it is important that Australian companies are perceived to be operating according to best practice corporate governance standards – ‘good corporate governance’ is important and it does add value! For our companies to meet best practice in corporate governance, any corporate governance regulatory framework that is in place needs to be effective. In this section, we discuss the criteria for an effective corporate governance regulatory framework set out in the OECD’s Principles, and assess whether Australia’s regulatory framework meets the criteria for effectiveness. As previously mentioned, the OECD Principles are intended to assist OECD (and non-OECD) governments to evaluate and improve the legal, institutional and regulatory frameworks for corporate governance in their countries, and to provide guidance for stock exchanges, investors, corporations and other parties having a role in developing good corporate governance.55 53 OECD Principles, above n 10, Preamble (emphasis added). 54 Ibid 30. 55 See OECD Principles, above n 10, 11.

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One of the key principles contained in the OECD Principles is: ‘Ensuring the Basis for an Effective Corporate Governance Framework’. For a regulatory framework to be effective, the OECD Principles states that: The corporate governance framework should promote transparent and efficient markets, be consistent with the rule of law and clearly articulate the division of responsibilities among different supervisory, regulatory and enforcement authorities.56

Thus, according to the OECD Principles, whether or not a corporate governance regulatory framework is effective depends on whether the following three criteria are satisfied: – promotion of transparent and efficient markets – consistency with rule-of-law principles (namely accountability, accessibility and clarity)57 – clear articulation of the division of responsibilities among the different supervisory, regulatory and enforcement authorities. In our view, Australia’s regulatory framework for corporate governance easily satisfies the first two criteria. Most developed economies with strong democracies do so as a matter of course. That is why Australia is considered to be an attractive place for international investment and why it has enjoyed a long period of strong economic growth, whereas some countries in Asia – with regulatory frameworks that traditionally have not been consistent with Western democratic principles, and generally do not allow markets to operate free of unnecessary controls – have struggled over the past decade. We believe, however, that the third OECD criterion highlights a weakness in Australia’s existing regulatory framework with respect to corporate governance. We believe there are currently some issues to do with the dual roles of ASIC and ASX in the supervision of Australia’s financial markets framework. The forthcoming discussion in Chapter 7 on the roles of ASX and ASIC finds that their respective roles are far from clear, and that there is some friction between the primary corporate regulator (ASIC) and ASX. As contemporary corporate governance further matures into a sophisticated area of corporate regulation, it is crucial that the key regulators have a clear vision as to how they contribute towards good corporate governance practices in Australian corporations. Achieving an effective corporate governance regulatory framework by international standards is not merely an exercise of adding more red tape to an already burdensome framework of corporate governance regulation; it is also about ensuring (as already emphasised in this chapter) that Australia maintains a positive reputation in the international money markets – thereby providing strong benefits for the economy. In order to ensure that Australia does satisfy the third criterion, and can be seen to have an effective corporate governance regulatory framework, it is essential to address shortcomings in the current regulatory 56 Ibid 29. 57 For a discussion of rule-of-law principles in the context of corporate law, see James McConvill and Mirko Bagaric, ‘Related Party Transactions under Part 2E of the Corporations Act: Time for Reconsideration’ (2002) 15 Australian Journal of Corporate Law 19.

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structures (as the Federal Government has recently done,58 discussed below) and avoid a general lack of confidence in the market due to perceived conflicts of interest arising from having a private-sector entity (ASX) with supervisory powers over brokers.59

6.5.2 Division of responsibilities between ASX and ASIC There is presently (December 2010) a memorandum of understanding (MOU) between ASIC and ASX, which seeks to minimise overlap and to increase cooperation in relation to market supervision.60 Traditionally, the role of the ASX has been limited to market surveillance and supervision, with ASIC also having some responsibility in this area as part of its general role of enforcing the Corporations Act. The subsequent privatisation of the ASX and its retention of supervisory powers over the financial market have long given rise to accusations of conflicts of interest. In a recent interview, the Minister for Financial Services (Chris Bowen) made the following concessions when explaining the reasons for the proposed important structural change to market supervision:61 . . . we don’t believe it’s appropriate any longer for a private-sector entity (ASX) to have supervisory powers over brokers. So this is important in terms of the perception of conflict of interest, to ensure there’s no perception that there’s a conflict of interest . . . I think it’s more appropriate going forward that [supervision] be done by a single, unified supervisor. I think there are issues where wherever there’s a perception of a conflict of interest, I think that’s a real problem . . . there are concerns about things falling through the cracks; about grey areas.

A common theme in the recent corporate governance reform movement has been the desire to instill a culture of transparency and accountability in the governance practices of Australian companies. We believe that the parameters should naturally be extended so that the regulators themselves set in place guidelines for a transparent and accountable approach to their own regulation of corporate governance. There is no reason the regulators should operate outside the more intense regulatory arena – indeed, they should set the lead. The OECD Principles make this point very strongly, emphasising that a ‘clearly defined’ division of responsibilities between corporate governance regulators constitutes one of the three key criteria underpinning an effective corporate governance regulatory 58 The Government announced on 24 August 2009 its intention to install ASIC as the new regulator of market supervision of brokers. See ASX submission to Treasury Consultation Paper: Reforms to the Supervision of Australia’s Financial Markets Framework (22 December 2009), available at . 59 For example, see Adele Ferguson, ‘Query on ASX’s Supervisory Power’, The Australian (17 September 2007); Danny John, ‘ASX Cited for Conflict of Interest’, Sydney Morning Herald Business Day (5 April 2008). 60 ASIC also has entered into MOUs with a number of other regulators and organisations, including the Australian Competition and Consumer Commission (ACCC). In December 2004, ASIC and the ACCC revised their MOU – believing this was necessary due to the closer relationship that has developed of late in their respective actions in addressing wealth-creation seminars and get-rich-quick schemes, as well as misconduct in debt collection. 61 Australian Broadcasting Corporation, Interview with Minister for Financial Services on Lateline Business, Transcript, (24 August 2009), available at .

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framework. The OECD Principles express the importance of this clearly defined division of responsibilities as follows: Effective enforcement also requires that the allocation of responsibilities for supervision, implementation and enforcement among different authorities is clearly defined so that the competencies of complementary bodies and agencies are respected and used most effectively. Overlapping and perhaps contradictory regulations between national jurisdictions is also an issue that should be monitored so that no regulatory vacuum is allowed to develop . . . and to minimise the cost of compliance with multiple systems by corporations.62

At the time of writing (December 2010), the Federal Government is proposing that ASIC will become responsible by late 2010 for both supervision and enforcement of Australian market participants, with progress scheduled as follows:63 Date

Steps

September/October 2009 November 2009 December 2009/January 2010

Drafting of exposure draft legislation Public consultation on exposure draft Additional drafting (to take account of public consultation) and preparation of accompanying document Amending legislation introduced in 2010 autumn sittings of Parliament Amending legislation passed in 2010 winter sittings of Parliament ASIC prepares systems for supervision and begins customising SMARTS system (ASIC’s new trade surveillance system) ASIC begins supervision of Australia’s financial markets

February/April 2010 May/June 2010 July/September 2010 Third quarter 2010

Should the proposed reforms be enacted in its current form, the main implications64 are that licensed financial market operators, such as ASX, will no longer self-supervise trading on their own markets. As a result, brokers and other trading participants in those markets will be subject to the direct supervision and enforcement powers of ASIC in relation to market misconduct. However, market operators will retain responsibility for supervising the entities listed on those markets. We also discuss the proposed changes of the regulatory functions of ASX further in Chapter 7. The Federal Government notes that the proposed reforms:65 ● will enhance the integrity of Australia’s financial markets ● support other initiatives implemented by the Federal Government that are aimed at reinforcing Australia as a credible and significant financial services hub in this region ● bring Australian markets into line with other leading jurisdictions that have, or are in the process of moving to, centralised or independent regulation. 62 OECD Principles, above n 10, 31. 63 The timeline and schedules are extracted from Allens Arthur Robinson, ASIC Market Regulation (24 August 2009), available at . 64 Ibid. 65 Ibid.

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6.6 Conclusion We have seen in this chapter that there has been a recent formalisation in the regulation of corporate governance. Increasingly, where companies once had complete freedom (from a regulatory perspective) to adopt benchmarks of corporate governance best practice, or to choose alternative arrangements, they now have to abide by formal rules (consider the series of corporate governance rules introduced under CLERP 9 in Australia) or provide a clear explanation in their annual report justifying why they are departing from them (consider the ‘if not, why not?’ regime underpinning the ASX Best Practice Recommendations and now under the revised ASX Corporate Governance Principles and Recommendations). The formalisation of corporate governance regulation has been considered a necessary response to high-profile corporate collapses and poor stock market performance, which were perceived as being attributable to less-than-desirable corporate governance practices. While corporate governance practices may have been a cause of the problems we have recently witnessed, this does not necessarily mean that formalising the regulation of corporate governance is the appropriate solution. Indeed, many commentators stress that a focus on conformance rather than performance will not resolve the recent problems, which were expressly raised as the impetus for the recent tranche of reforms. In Chapter 15, we engage in a detailed theoretical and normative analysis of the recent shift towards a formal corporate governance regulatory framework, and reflect on the desirable future direction of regulation. In the next chapter we will focus on the role of ASX and ASIC as two of the main corporate regulators in Australia.

7 The role of the regulators: ASIC and ASX [HIH Insurance Ltd’s collapse] is a tale of scoundrels – crooks even, who jockey and grasp and concoct the most ingenious ways to pocket HIH’s cash while they still can. Well-placed mates help well-placed mates . . . Mortgages are forgiven, bonuses awarded, dodgy invoices are fast-tracked and cheques are somehow cleared after the banks have closed. But policy-holders get nothing because that is the new policy, and shareholders might as well not exist. The Australian, Wednesday, 15 January 2003

Directors of Australian public companies have a dual challenge in seeking to navigate their companies through the heavy seas of the global financial services. They must set strategies to deliver long-term profitable performance in a manner that responds to the difficult circumstances. And they must ensure conformance by their companies and themselves with all applicable legal and regulatory requirements. Hard economic times are enhancing the challenge to directors in both their performance and conformance roles. Robert Austin and Aaron Rathmell, An Introduction to the Conference Theme, Directors in Troubled Times (R P Austin and A Y Bilski, eds, Ross Parsons Centre of Commercial, Corporate and Taxation Law Monograph 7, Sydney, 2009) at 22

7.1 Introduction This chapter highlights the role and relationship between the twin regulators, the Australian Securities and Investments Commission (ASIC) and the Australian Securities Exchange (ASX) in the Australian corporate governance regime. The exercise of ASIC’s powers are reviewed and enforcement patterns are commented upon. The chapter sketches the role of ASX in corporate governance and concludes with remarks addressing the broad philosophical debate on the role of the regulator in light of the carnage (the widespread corporate collapses or near collapses)1 arising from the global financial crisis and the pressure on ASIC to be more proactive and to perform to a higher standard. 1 Opes Prime Stockbroking Ltd, Tricom Equities Ltd, Chimaera Capital Ltd, Allco Finance Group Ltd, Babcock & Brown Ltd, Storm Financial Ltd, ABC Learning Ltd, Timbercorp Ltd, Great Southern Ltd, to name a few.

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7.2 The Australian Securities and Investments Commission2 7.2.1 Overview ASIC was first called the National Companies and Securities Commission (NCSC) and later the Australian Securities Commission (ASC).3 The Wallis Report (released in April 1997) recommended several regulatory changes, including the establishment of ASIC, which occurred on 1 July 1998: [The Wallis Report] proposed a regulatory system based around three regulatory agencies: the Reserve Bank as central bank, but without the role of bank supervision; APRA [the Australian Prudential Regulation Authority], as a new prudential regulator; and ASIC, a new single regulator for conduct and disclosure, responsible for administration of the Corporations Law, ensuring market integrity and consumer protection.4

In recognition of this new role, ASIC is Australia’s corporate, markets and financial services regulator. ASIC regulates companies, financial markets, financial services organisations and professionals who deal and advise in investments, superannuation, insurance, deposit taking and credit. ASIC’s work covers consumers, investors and creditors of corporations and other businesses, including, an estimated:5 ● 16.9 million people who have a deposit account ● 11.8 million who invest in superannuation or annuities ● 10.8 million who have a major card credit, debit or charge ● 6.7 million who have a loan ● 3.9 million who directly hold shares ● 2 million who have invested (managed investment/superannuation) through a financial planner/adviser ● 1 million who invest in managed investments. As the market regulator, ASIC assesses how effectively authorised financial markets are complying with their legal obligations to operate fair, orderly and transparent markets6 . As the financial services regulator, ASIC licenses and monitors 2 This part is based on part of the following article: Jean J du Plessis, ‘Reverberations after the HIH and other Recent Australian Corporate Collapses: The Role of ASIC’ (2003) 15 Australian Journal of Corporate Law 225, 230. 3 This chapter focuses on contemporary developments following the rebadging of ASC to ASIC. For an exellent study on the many complexities (political, legal, social and institutional) that have influenced, motivated and constrained the development of the present system of Australian companies and securities regulation, see Bernard Mees and Ian Ramsay, Corporate Regulators in Australia (1961–2000): From Companies’ Registrars to the Australian Securities and Investments Commission’ Research Report (Melbourne: Centre for Corporate Law and Securities Regulation, University of Melbourne, 2008); Bernard Mees and Ian Ramsay, ‘Corporate Regulators in Australia (1961–2000): From Companies’ Registrars to ASIC’ (2008) 22 Australian Journal of Corporate Law 212. 4 A Cameron, ‘Not Another Regulator!!!’, 1998 Suncorp-Metway Bob Nicol Memorial Lecture, Brisbane, 10 November 1998, available at 6–7, 10. 5 ASIC Annual Report 2008–09 at 59, available at . 6 ASIC, ‘Our Role’, available at .

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financial service businesses to ensure that they operate efficiently, honestly and fairly.7 As the corporate regulator, ASIC is responsible for ensuring that company directors and officers carry out their duties honestly, diligently and in the best interests of the company8 . This chapter focuses on ASIC’s traditional role as corporate watchdog.9

7.2.2 Statutory powers under the ASIC Act10 ASIC is a Commonwealth Government body, led by five full-time commissioners who are accountable to the Minister for Financial Services, Superannuation and Corporate Law and the Parliament under the Australian Securities and Investments Act 2001 (the ASIC Act). The objects of the ASIC Act are described in general terms in section 1 of the Act. Section 1(2) of the ASIC Act provides, in part, that in performing its functions and exercising its powers, ASIC must take whatever action it can take, and is necessary, in order to enforce and give effect to the laws of the Commonwealth that confer functions and powers upon it.11 In order to ensure compliance with the law, ASIC is vested with special powers of investigation and information gathering. These powers are set out in Part 3 of the ASIC Act. Where ASIC decides to undertake an investigation, it can require any person to render to it all necessary assistance in connection with the investigation. ASIC is authorised to initiate an investigation if it suspects, on reasonable grounds, that: ● a contravention of the corporations legislation (other than the excluded provisions)12 may have been committed (ASIC Act section 13(1)(a)) ● a contravention of a law of the Commonwealth, state or territory concerning the management of the affairs of a body corporate or managed investment scheme may have been committed (ASIC Act section 13(1)(b)(i)) ● a contravention of a law of the Commonwealth, state or territory which contravention involves fraud or dishonesty in relation to a body corporate, managed investment scheme or financial products may have been committed (ASIC Act section 13(1)(b)(ii)) 7 Ibid. 8 Ibid. 9 For an interesting perspective of ASIC’s role as a regulator, see F Assaf, ‘What will Trigger ASIC’s Strategies?’ (2002) Law Society Journal (May 2002) 60, 60–1. 10 For fuller discussion, see Jason Harris, Anil Hargovan and Michael Adams, Australian Corporate Law (2nd edn, LexisNexis, 2009, Chapter 2 ‘ASIC: Role and Powers’). 11 See also George Gilligan, Helen Bird and Ian Ramsay, ‘Civil Penalties and the Enforcement of Directors’ Duties’ (1999) 22 University of New South Wales Law Journal 417, 433–6; George Gilligan, Helen Bird and Ian Ramsay, ‘The Efficiency of Civil Penalty Sanctions Under the Australian Corporations Law’ (1999) 136 (November) Trends and Issues in Crime and Criminal Justice 1. 12 The excluded provisions are s 12A of ASIC Act, which deals with ASIC’s other functions and powers, and Div 2 of Pt 2 of the ASIC Act, which deals with unconscionable conduct and consumer protection in relation to financial products: ASIC Act s 5.

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unacceptable circumstances within the meaning of the provisions of the Corporations Act dealing with takeovers may have occurred (ASIC Act section 13(2)) ● a contravention of the consumer protection provisions (Division 2 of Part 2) of ASIC Act may have been committed (ASICA section 13(6)). Following an investigation or examination conducted, ASIC may, if it is in the public interest to do so, commence proceedings under section 50 of the ASIC Act seeking civil remedies from the court. In these proceedings, based on public interest considerations, ASIC may take legal action in the name of a company without the need for the company’s consent. In such circumstances, ASIC may seek damages for fraud, negligence, default, breach of duty, or other misconduct committed in connection with a matter to which the investigation or examination related. It may also seek to recover property on behalf of individuals. It is disappointing to note that Section 50 has not been used to great effect, with only 21 actions being taken since 1991.13 Much of the recent litigation instituted by ASIC, after the most recent spate of corporate collapses, was instituted in response to ASIC’s obligations associated with these responsibilities – specifically, and most prominently, its powers under the Corporations Act 2001 (Cth) (the Act). ●

7.2.3 The role of ASIC in corporate governance Jillian Segal (former Deputy Chair of ASIC), in addressing the role of the regulator, captures the complex and multifaceted role that ASIC plays in Australia with the following observation: ‘the regulator’s role is a continuum of responses. It is bounded by enforcement at one end and education at the other, with policy guidance, industry support and disclosure guidelines in between.’14 ASIC has clearly accepted that it should play an important role in corporate governance in Australia. In a speech on 27 November 2002 at a Corporate Governance Summit, Berna Collier (a former commissioner of ASIC) outlined the role of ASIC in corporate governance as follows: So what exactly is our role in corporate governance? What do we do on a daily basis to improve corporate governance in Australia? Essentially, ASIC’s role in corporate governance is threefold: 1. monitors, enforces and administers compliance with the broad range of corporate governance provisions in the Corporations Act; 2. has a public education or advocacy role; and 3. contributes to law reform in relation to corporate governance.15 13 ASIC Media Release 07–291, ‘ASIC to Pursue Compensation for Westpoint investors’ (8 November 2007), available at . For the major reported instances of s 50 actions taken by ASIC, see Janet Austin, ‘Does the Westpoint Litigation Signal a Revival of the ASIC s 50 Class Action?’ (2008) 22 Australian Journal of Corporate Law 8. 14 Jillian Segal, ‘Corporate Governance: Substance Over Form’ (2002) 25 University of New South Wales Law Journal 1 at 5. 15 Berna Collier, ‘The Role of ASIC in Corporate Governance’, Corporate Governance Summit (27 November 2002) 5, avalailable at .

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The first of these roles, and in particular enforcing compliance, was prominent in ASIC’s dealings with the corporate collapses in Australia in 2001 and 200216 and the recent failures of corporate governance.17 There is no doubt that in the aftermath of the massive corporate collapses in 2001–2, ASIC fulfilled its role as the primary Australian corporate regulator with assiduousness, and it has remained highly active since then, with several actions instituted against directors, albeit with a mixed record of success in 2009 (discussed below). David Knott, former Chair of ASIC, was reported as saying that the orders against the three HIH directors acted as a warning to company directors and ‘highlighted the serious consequences that could flow from the failure of good corporate governance’.18 Berna Collier observed that ‘it is important to note that all [the recent] enforcement action [by ASIC] does more than target individuals who breached the law. It has an education and market confidence impact’.19 Or, as Assaf puts it, ‘the above matters [civil proceeding against HIH and One.Tel directors] sent out a strong signal to directors of public companies – comply with your statutory obligations or else[!]’.20 Stewart Wilson, executive officer of the Australian Shareholders Association, made his views on the deterrence value of possible jail sentences for white-collar crime known in no uncertain terms – ‘the threat of being locked up is perhaps the most effective deterrent for white-collar crime’.21 ASIC’s successful civil penalty proceedings in the case of ASIC v Macdonald and Others (No 11)22 against seven former non-executive directors and three former executives of James Hardie was hailed by ASIC as a landmark decision in Australia as far as corporate governance is concerned. The impact-value and aims of ASIC with this litigation was explained by ASIC’s current Chairperson, Tony D’Aloisio: I encourage Boards to carefully consider this decision and assess what improvements they can make to their decision making processes, the way they convey decisions to the market and in the way they conduct investor briefings and so called road shows . . . The decision is another important step in improving corporate governance in Australia and that improvement will add confidence to the integrity of our markets. This confidence will be particularly important as we emerge from the financial crisis and companies come to the market to raise funds for new investments, much needed for the recovery of the real economy.23

16 For discussion of enforcement actions against officers of GIO Insurance Ltd, HIH Insurance Ltd, One.Tel Ltd and Water Wheel Holdings Ltd, see Jason Harris, Anil Hargovan and Michael Adams, Australian Corporate Law (2nd edn, LexisNexis, 2009, Chapters 16–19 on Directors and Officers Duties). 17 For example, see ASIC v Macdonald (No 11) (2009) 256 ALR 199 – discussed in Anil Hargovan, ‘Corporate Governance Lessons from James Hardie’ (2009) 33 Melbourne University Law Review (forthcoming). 18 The Australian, Friday 31 May 2002. 19 Collier, above n 15 6. 20 Assaf, above n 9, 63. 21 Stuart Wilson, ‘Jail Best Deterrent for Corporate Crims’ The Australian, 22 February 2005, 25. 22 (2009) 256 ALR 199. 23 ASIC Media Release 09–69, ‘James Hardie Proceedings’, 23 April 2009, available at .

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How afraid some greedy corporate cowboys will be after the spate of litigation against delinquent directors since 2002 is an open question, especially in light of ASIC’s recent failures in complex litigation (discussed below).24 There was some speculation that because of the active role ASIC plays in bringing civil penalty actions against directors, that Australian directors are becoming risk-averse due to a fear of personal liability. This, in turn, led to Treasury commencing a review of criminal and civil sanctions, with a view to possibly widening the protection of directors against civil sanctions and considering whether there are not too many criminal sanctions that expose directors to criminal liability.25 There have, however, been strong views expressed in the media and by investor groups that there is no real need to protect directors further because there is no evidence that directors are over-exposed to liability. Also, there was no evidence that indicated that directors who were held liable following ASIC’s enforcement actions since 2000 should in fact not have been held liable. Finally, it was argued that there are no facts backing the claim that Australian directors are indeed risk-adverse because of the wide range of legal sanctions in Australia. At the end of 2008, Treasury released some interesting results of a survey undertaken among directors.26 The results of this survey indicated that there is little substance in the claim that directors are influenced by the high risks of personal legal liability when taking business decisions. Only 27.7 per cent of 101 respondents said they felt a high degree of risk of being found personally liable (under any law) for decisions they or their boards have made in good faith. A further 65.3 per cent of respondents said that they had only ‘occasionally’ taken an overly cautious approach to business decision making because of the risk of personal liability (under any law). The areas of law indicated as the areas most likely to cause an overly cautious approach to business decisions seem to be ‘derivative liability’ laws. This was described as laws under which the director may be found liable for the misconduct of his or her company due to being a director. The examples given of such laws were ‘occupational health and safety laws, environmental laws and/or building laws’. Of the 94 respondents, 35.1 per cent indicated that these laws caused overly cautious business decisions. However, it is comforting to know that there are also other strategies in place to control the financial markets, apart from focusing on director liability and ASIC attempting to scare directors by instituting actions against high-profile directors who allegedly did not fulfil their statutory duties under the Corporations Act. The Financial Services Reform Act 2001 and other reforms in the insurance industry should be seen as part of a broader strategy to ensure good corporate governance and to act proactively in the battle to prevent spectacular corporate collapses. 24 Stuart Washington, ‘Academics Question ASIC’s Ability’, The Age Business Day (26 December 2009). 25 See Commonwealth of Australia, The Treasury, Corporate and Financial Services Division, Review of Sanctions In Corporate Law (2007), available at and . 26 See .

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The words ‘spectacular corporate collapses’ are used specifically, as it is impossible for any regulator, legislature or the market to prevent corporate collapses completely. ASIC’s view is that there will always be company failure because of the simple reality of competitiveness and economic forces.27 The role of the law and the regulators is rather to manage the problem and to ensure, as diligently as possible, that signs of financial difficulties are detected as soon as possible and, where there is still hope, to take struggling companies by the hand through voluntary or external administration or similar supportive arrangements.28

7.2.4 ASIC enforcement patterns The Centre for Corporate Law and Securities Regulation at the University of Melbourne has undertaken some interesting research on ASIC’s enforcement patterns.29 This research has revealed that ASIC was more likely to pursue courtbased enforcement against individuals (rather than companies), and against men (rather than women) aged 41–50 years in their capacity as directors of companies working in the finance and insurance industries. It was also discovered that more actions are instituted against directors of private companies than against directors of public companies.30 This is perhaps understandable, as there are far more private companies than public companies and directors of public companies will often also be directors of subsidiary private companies of the public company – see the case study on the HIH Insurance Ltd collapse (ASIC v Adler) in Chapter 10. During the period from January 1997 to December 1999, where 1438 courtbased ASIC enforcement actions were examined, the research showed that ASIC predominantly used penal enforcement actions rather than civil enforcement action. ASIC was more likely to pursue penal enforcement in relation to laws that were mandatory (rather than enabling) in nature, and to laws orientated towards social (rather than economic) regulation. ASIC would predominantly use settlements – rather than the court processes – as outcomes for civil enforcement. ASIC preferred to focus on laws with an ethical foundation, addressing conduct that is widely condemned because it exploits and defrauds shareholders and creditors.31 27 Segal, above n 14; Jillian Segal, ‘Institutional Self-regulation: What Should be the Role of the Regulator?’ Address to the National Institute for Governance Twilight Seminar, Canberra, 8 November 2001, available at ; Knott, ‘Corporate Governance: The 1980s Revisited?’ Monash Law School Foundation Lecture, 23 August 2001, 3. Several causes can potentially play a role in any business failure, see J Adams and N Jones, ‘Distressed Businesses – Preventing Failure’, in Collapse Incorporated: Tales, Safeguards & Responsibilities of Corporate Australia, Sydney, CCH Australia (2001) 205–10. 28 See Adams and Jones, above n 27, 210–16. 29 Helen Bird, Davin Chow, Jarrod Lenne and Ian Ramsay, ASIC Enforcement Patterns Research Paper No 71, Melbourne, Centre for Corporate Law and Securities Regulation, University of Melbourne (2003). See also Helen Bird, Davin Chow, Jarrod Lenne and Ian Ramsay, ‘Strategic Regulation and ASIC Enforcement Patterrns: Results of an Empirical Study’ (2005) 5 Journal of Corporate Law Studies 191. 30 Ibid xiv. 31 Ibid xiv–xv.

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During 2008–9, in collaboration with the Commonwealth Director of Public Prosecutions, ASIC completed 39 criminal proceedings, with 34 convictions, including 19 jail terms.32 ASIC, in that period, also completed 35 civil proceedings and obtained over $14.5 million in recoveries, costs and fines.33 A recent study argues that ASIC’s perceived failure to use criminal sanctions in cases of serious corporate misconduct (for example against Vizard,34 the directors and officers of James Hardie Ltd35 and AWB Ltd) threatens to undermine its reputation as an effective regulator36 – notwithstanding data showing that during the period 2001–6 the number of criminal prosecutions commenced by ASIC outnumbered the civil penalty proceedings issued.37 Vicky Comino, although supportive of ASIC’s strategic regulation theory, is critical of the implementation of this approach to enforcement for a variety of reasons, including the following:38 ASIC . . . should focus its efforts to rigorously enforcing the law rather than continue to allow itself to be exposed to the criticism that it fails to do so, as happened under the [previous] chairmanship . . . The view that ASIC fails to adequately enforce the law is also borne out by the results of the stakeholder survey . . . to help it identify what it did well and where improvements were needed. One of the ways in which ASIC can overcome criticisms is to ensure that it uses the criminal law in the enforcement pyramid underlying Pt 9.4B more, to punish corporate misconduct in serious cases, especially against high profile wrongdoers, and thus prove that it is a serious regulator crucially portraying an ‘image of invincibility’.

ASIC’s reputation for law enforcement took a severe blow in 2009, when it lost three high-profile civil cases against the directors of One.Tel Ltd (Jodee Rich and Mark Silbermann),39 former AWB Ltd managing director Andrew Linberg40 and Fortescue Metals Group Ltd’s chairman and chief executive officer, Andrew Forrest.41 Critical comments on ASIC’s litigation strategy by each of the judges, 32 ASIC Annual Report (2008–2009) at 16. 33 Ibid. 34 ASIC successfully launched a civil penalty proceeding against Vizard (director of Telstra Ltd) for breach of director’s duties, resulting in the defendant being banned for 10 years from managing a corporation and ordered to pay pecuniary penalties of $390 000. Nothwithstanding the judge in ASIC v Vizard (2005) 219 ALR 714 making critical comments on the director’s dishonesty and ‘gross breach of trust’ and the defendant’s admission of insider trading to ASIC, a criminal offence was never pursued by ASIC in this case. 35 See ASIC Media Release, ‘James Hardie Group Civil Action’ (5 September 2008). 36 See further, Vicky Comino, ‘The Challenge of Corporate Law Enforcement in Australia’ (2009) 23 Australian Journal of Corporate Law 233. 37 Michael Welsh, ‘Civil Penalties and Strategic Regulation Theory: The Gap Between Theory and Practice’ (2009) 33 University of Melbourne Law Review (forthcoming). 38 Vicky Comino, above n 36, at 260. 39 ASIC v Rich [2009] NSWSC 1229: Justice Austin of the NSW Supreme Court held that ASIC failed to prove any facet of its pleaded case against either defendant. 40 Re AWB Ltd (No 10) [2009] VSC 566. The court found that Mr Lindberg, who was accused of bribery and breach of director’s duties arising from the delivery of wheat by AWB to the Government of Iraq contrary to United Nations sanctions, will be unjustifiably vexed and oppressed and manifestly denied a fair trial by the existence of a pending second proceeding – the latter which would also bring the administration of justice into disrepute in the minds of right-thinking people. ASIC’s civil action, which followed an initial case in the courts on a similar issue, which is still continuing (at the time of writing), was therefore held to be an abuse of process. 41 ASIC v Fortescue Metals Group Ltd [No 5] [2009] FCA 1586. ASIC unsuccessfully alleged, inter alia, that Andrew Forrest breached his duty as a director to exercise care and diligence as required by s 180(1) of the Act by failing to ensure that the company both complied with its disclosure obligations and did not engage in misleading or deceptive conduct and, as a result, he exposed the company to a risk of serious harm.

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made independently in the three different jurisdictions, painted a disturbing picture of the regulator’s litigation strategy. A hostile media humiliated ASIC, questioned its ability to carry out complex litigation and commented upon its flawed sense of judgment.42 Ian Ramsay, director of the Centre for Corporate Law at The University of Melbourne, commented on the need for a review on the manner in which ASIC conducts complex litigation.43 It is hoped that ASIC’s success in the James Hardie litigation (if not overturned on appeal) will provide the template for future success.

7.3 The Australian Securities Exchange Ltd 7.3.1 Slow to get out of the blocks ASX was slow in following the examples of other securities exchanges in the world to develop and promote good corporate governance through a code of good corporate governance practices and to promote compliance with such a code by including a provision in its Listing Rules that companies that did not comply with such provisions should explain non-compliance in their annual reports. By the early 1990s, both the London Stock Exchange and the Johannesburg Stock Exchange had already included a Listing Rule to ensure compliance or an explanation of non-compliance with a code of best practice. Until early 2003, ASX chose to be ‘less prescriptive’,44 and resisted any change in its approach, despite being criticised by ASIC for not following the example of several other securities exchanges.45 Prior to 2003, ASX Listing Rule 4.10 (originally introduced on 1 July 1996 as Listing Rule 3C(3)(j))46 provided as follows: 4.10 An entity must include the following information in its annual report. The information must be current at a date specified by the entity which is no more than 6 weeks before the report is sent to security holders . . . 4.10.3 A statement of the main corporate governance practices that the entity had in place during the reporting period. If a practice had been in place for only part of the period, the entity must state the period during which it had been in place.

In 1997, there was vigorous debate between the Australian Investment Managers’ Association (AIMA) (or IFSA, as it is now known) and ASX as to whether listed 42 For example, see Matthew Stevens, ‘Laughter and Jeers over ASIC Failure’, The Australian (31 December 2009). Jennifer Hewett, ‘Three Strikes Prove Regulator is out of Touch’, The Australian (24 December 2009). 43 Stuart Washington, ‘Academics Question ASIC’s Ability’, The Age Business Day (26 December 2009). For the complexities involved in litigation concerning civil penalty proceedings, see judgment of Justice Austin in ASIC v Rich. See further, Tom Middleton, ‘The Privilege Against Self Incrimination, the Penalty Privilege and Legal Professional Privilege under the Laws Governing ASIC, APRA, the ACCC and the ATO: Suggested Reforms’ (2008) 30 Australian Bar Review 282. 44 See Paul Redmond, Companies and Securities Law, Sydney, LBC information Services (3rd edn, 2000) 268, and Phillip Lipton, quoted at n 42 in Chapter 5. 45 Phillip Lipton and Abe Herzberg, Understanding Company Law, Sydney, Law Book (11th edn, 2003) 296. 46 Business Council of Australia, Corporate Practices and Conduct, Melbourne, Pitman (3rd edn, 1995) (the Bosch Report (1995)), 3.

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companies were actually complying with the Rule. ASX alleged that every one of the largest 150 companies listed on the Exchange complied with Listing Rule 4.10.3, while AIMA showed that very few of the listed companies had a clear understanding of what really should be disclosed.47 Whether ASX or AIMA was right in its claims is to a large extent irrelevant today, but it required several huge corporate collapses between 2000 and 2003 to cause ASX to realise that its ‘less prescriptive’ approach was probably not the right one. Under the ‘less prescriptive’ arrangement – in place until March 2003 – listed companies had to rely on the ‘indicative list in Appendix 4A (originally Appendix 33) to the Listing Rules to guide them in the types of matters considered to be corporate governance practices upon which they had to report. Guidance Note 9 of ASX, issued in September 2001, provided guidance on the disclosure of corporate governance practices under Listing Rule 4.10.3. Guidance Note 9 cited Listing Rule 4.10 and then explained several aspects, such as the role of ASX; disclosure in annual reports; corporate governance matters generally; and the way in which the indicative list should be used to comply with the disclosure required under Listing Rule 4.10.3.48 On 4 August 2009, ASX released its first review of corporate governance disclosures since the Principles were updated in 2007. It should be noted that the statistics were based on only a small sample of 168 companies whose reporting period ended on 31 December 2008. Only 75 per cent of disclosures were ‘good’ or ‘very good’. In relation to Principle 7 (recognise and manage risk, an issue that became crucial during the global financial crisis), ASX identified a number of areas with ‘room for improvement’ including disclosure of risk-management policies, information about board evaluations and how responsibilities are delegated between the board and management.49 Until March 2003, listed companies were assisted in two other ways (apart from the indicative list) in complying with Listing Rule 4.10.3. First, the 1996 reprint of the Bosch Report (1995) specifically mentioned the introduction of the disclosure requirement on corporate governance practices in Listing Rule 4.10.3 and also discussed the corporate governance matters to be reported upon in Part II.50 Second, listed companies could use the AIMA Guidelines and later the IFSA Blue Book as a guide for good corporate governance practices to comply with Listing Rule 4.10.3 – see discussion in Chapter 6.

47 Ian Ramsay and Richard Hoad, Disclosure of Corporate Governance Practices by Australian Companies, Research Paper, Melbourne, Centre for Corporate Law and Securities Regulation, The University of Melbourne (1997), available at 1–2; also published as Ian M Ramsay and Richard Hoad, ‘Disclosure of Corporate Governance Practices by Australian Companies’ (1997) 15 Company and Securities Law Journal 454. 48 ASX Guidance Note 9, ‘Disclosure of Corporate Governance Practices: Listing Rule 4.10’, Issued September 2001, available at . 49 ASX, ‘Analysis of Corporate Governance Disclosures in Annual Reports for Year ended 31 December 2008’, available at . 50 Bosch Report (1995), above n 46, 3.

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7.3.2 Rapid change in attitude since the end of 2002 The entire face of corporate governance in Australia changed rapidly with the collapses of HIH, Harris Scarfe, One.Tel, Pasminco, Centaur and Ansett during 2000–3 and the establishment by ASX of the Corporate Governance Council (CGC) on 15 August 2002.51 The CGC is composed of representatives of the most important players in the financial markets.52 Its first task was to produce a set of consolidated and up-to-date standards of best practice. The CGC developed these guidelines with great speed, approving the Principles of Good Corporate Governance and Best Practice Recommendations in March 2003. Even before the approval of this document by the CGC, Listing Rule 4.10.3 was amended on 1 January 2003 to read as follows: 4.10 An entity must include the following information in its annual report. The information must be current at a date specified by the entity which is no more than 6 weeks before the report is sent to security holders . . . 4.10.3 A statement disclosing the extent to which the entity has followed the best practice recommendations set by the ASX Corporate Governance Council during the reporting period. If the entity has not followed all of the recommendations the entity must identify those recommendations not followed and give reasons for not following them. If a recommendation had been followed for only part of the period, the entity must state the period during which it had been followed. Introduced 1/7/96. Origin: Listing Rule 3C(3)(j). Amended 1/1/2003. Note: The corporate governance statement may be given to ASX as a separate report but must be given to ASX at the same time as the annual report and be clearly identified as the corporate governance report.

In March 2003, a new Guidance Note 9A on ‘Corporate Governance – ASX Corporate Governance Council – Principles of Good Corporate Governance and Best Practice Recommendations’ was issued.53 Guidance Note 9A was reissued in December 2007 and that is the current document guiding companies to comply with Listing Rule 4.10.3.54 It cites the current Listing Rule 4.10.3; explains that any deviation from the CGC’s Principles of Good Corporate Governance and Best Practice Recommendations should be explained on the basis of the principle of 51 The CGC had its 5th meeting on 20 February 2003 – Alan Kohler, ‘Directors Face D-day as Old Rules go by the Board’, The Australian Financial Review, 20 February 2003. 52 The Council consists of representatives of 21 business and investor groups: Association of Superannuation Funds of Australia Ltd; Australasian Investor Relations Association; Australian Council of Superannuation Investors; Australian Financial Markets Association; Australian Institute of Company Directors; Australian Institute of Superannuation Trustees; Australian Securities Exchange; Australian Shareholders’ Association; Business Council of Australia; Chartered Secretaries Australia; CPA Australia Ltd; Financial Services Institute of Australasia; Group of 100; Institute of Actuaries of Australia; The Institute of Chartered Accountants in Australia; Institute of Internal Auditors Australia; Investment and Financial Services Association;Law Council of Australia; National Institute of Accountants; Property Council of Australia; and Securities & Derivatives Industry Association. 53 See . 54 See .

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‘if not, why not?’; and contains a condensed version of the Principles of Good Corporate Governance and Best Practice Recommendations.

7.3.3 ASX Corporate Governance Council’s Principles of Good Corporate Governance and Best Practice Recommendations 7.3.3.1 Changes in 2007 As mentioned in Chapter 1, the 2003 ASX Principles of Good Corporate Governance and Best Practice Recommendations were amended in 2007. The 2007 ASX Principles of Good Corporate Governance and Best Practice Recommendations now only contains eight principles as a result of the merger of two principles (Principle 8, ‘Encourage enhanced performance’ and Principle 10, ‘Recognise the legitimate interests of stakeholders’), now incorporated into other principles.55 7.3.3.2 Structure Apart from the Foreword, the 2007 ASX Principles of Good Corporate Governance and Best Practice Recommendations consists of the following parts: a description of corporate governance in Australia; disclosure of corporate governance practices (following the ‘if not, why not’ approach); a summary of the eight core corporate governance principles and recommendations; an explanation of the eight core corporate governance principles and recommendations; and glossary. The explanatory part of the document is contained under the heading ‘Corporate Governance Principles and Recommendations’. This part consists of the eight core corporate governance principles, followed typically by the following: ● a short explanation of the principle ● recommendations on the essential principles ● commentary, guidelines and application on the core principle ● boxed paragraphs giving practical guidance on what the content of certain documents should contain ● suggestions on how the recommendation should be implemented or how certain aspects should be assessed (for example, assessing the independence of directors). In a speech to launch the revised ASX corporate governance principles, the Parliamentary Secretary to the Treasurer made the following observations on the nature and role of these governance principles:56 Initiatives [such as these below] are an integral part of Australia’s corporate governance framework. This framework consists of a mixture of regulation, co-regulation and encouragement of industry best practice. It is an approach that has served us well. In fact, Australia’s corporate law has been recognised as world class . . . The government’s approach to improving corporate governance in Australian companies is to steer well 55 Principle 8 has been incorporated into current Principles 1 and 2, while Principle 2 has been incorporated into current Principles 3 and 7. Principle 9 became Principle 8. 56 The Honourable Chris Pearce MP, ‘Speech to Launch the Revised ASX Corporate Governance Principles’ (2 August 2007), available at .

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away from imposing arbitrary ‘black letter rules’ that prescribe detailed governance practices that companies must adopt . . . The ASX corporate governance principles are consistent with this framework. In fact, they are a good example of a flexible marketbased solution.

7.3.3.3 Recommendations There are 27 specific recommendations in the 2007 ASX Principles of Good Corporate Governance and Best Practice Recommendations: Principle 1 – Lay solid foundations for management and oversight Recommendation 1.1: Companies should establish the functions reserved to the board and those delegated to senior executives and disclose those functions. Recommendation 1.2: Companies should disclose the process for evaluating the performance of senior executives. Recommendation 1.3: Companies should provide the information indicated in the Guide to reporting on Principle 1. Principle 2 – Structure the board to add value Recommendation 2.1: A majority of the board should be independent directors. Recommendation 2.2: The chair should be an independent director. Recommendation 2.3: The roles of chair and chief executive officer should not be exercised by the same individual. Recommendation 2.4: The board should establish a nomination committee. Recommendation 2.5: Companies should disclose the process for evaluating the performance of the board, its committees and individual directors. Recommendation 2.6: Companies should provide the information indicated in the Guide to reporting on Principle 2. Principle 3 – Promote ethical and responsible decision-making Recommendation 3.1: Companies should establish a code of conduct and disclose the code or a summary of the code as to: ● the practices necessary to maintain confidence in the company’s integrity ● the practices necessary to take into account their legal obligations and the reasonable expectations of their stakeholders ● the responsibility and accountability of individuals for reporting and investigating reports of unethical practices. Recommendation 3.2: Companies should establish a policy concerning trading in company securities by directors, senior executives and employees, and disclose the policy or a summary of that policy. Recommendation 3.3: Companies should provide the information indicated in the Guide to reporting on Principle 3. Principle 4 – Safeguard integrity in financial reporting Recommendation 4.1: The board should establish an audit committee. Recommendation 4.2: The audit committee should be structured so that it: ● consists only of non-executive directors ● consists of a majority of independent directors ● is chaired by an independent chair, who is not chair of the board ● has at least three members.

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Recommendation 4.3: The audit committee should have a formal charter. Recommendation 4.4: Companies should provide the information indicated in the Guide to reporting on Principle 4. Principle 5 – Make timely and balanced disclosures Recommendation 5.1: Companies should establish written policies designed to ensure compliance with ASX Listing Rule disclosure requirements and to ensure accountability at a senior executive level for that compliance and disclose those policies or a summary of those policies. Recommendation 5.2: Companies should provide the information indicated in the Guide to reporting on Principle 5. Principle 6 – Respect the rights of shareholders Recommendation 6.1: Companies should design a communications policy for promoting effective communication with shareholders and encouraging their participation at general meetings and disclose their policy or a summary of that policy. Recommendation 6.2: Companies should provide the information indicated in the Guide to reporting on Principle 6. Principle 7 – Recognise and manage risk Recommendation 7.1: Companies should establish policies for the oversight and management of material business risks and disclose a summary of those policies. Recommendation 7.2: The board should require management to design and implement the risk management and internal control system to manage the company’s material business risks and report to it on whether those risks are being managed effectively. The board should disclose that management has reported to it as to the effectiveness of the company’s management of its material business risks. Recommendation 7.3: The board should disclose whether it has received assurance from the chief executive officer (or equivalent) and the chief financial officer (or equivalent) that the declaration provided in accordance with section 295A of the Corporations Act is founded on a sound system of risk management and internal control and that the system is operating effectively in all material respects in relation to financial reporting risks. Recommendation 7.4: Companies should provide the information indicated in the Guide to reporting on Principle 7. Principle 8 – Remunerate fairly and responsibly Recommendation 8.1: The board should establish a remuneration committee. Recommendation 8.2: Companies should clearly distinguish the structure of nonexecutive directors’ remuneration from that of executive directors and senior executives. Recommendation 8.3: Companies should provide the information indicated in the Guide to reporting on Principle 8.

Compared to the UK formulation of ‘comply or explain’ adopted in the UK Corporate Governance Code, ASX–CGC approach to enforcement is based on an ‘if not, why not?’ precept. It would appear to be an identical approach; however,

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Alan Cameron argues that there is a subtle difference between the two, based on the following considerations:57 ‘Comply or explain’ connotes an assumption, a presumption, that you should be doing it and you have to explain if you are not doing it. ‘If not, why not?’ . . . is, and ought to be, morally neutral. It simply says, in effect, ‘If you are not doing this, tell us why you are not doing it’, but there is no presumption. Despite the use of the word ‘recommendation’ in the Corporate Governance Guidelines, it is clear that there is not a presumption in favour of compliance in the Australian rules.

In the first review of corporate governance reporting under the revised principles, conducted by the ASX Markets Supervision, overall reporting levels was 93.4 per cent for all entities and 98.3 per cent for top-500 entities, including trusts.58 7.3.3.4 The roles and relationship between ASX and ASIC Currently (December 2010), an MOU59 governs the relationship between ASIC and ASX, but as will be seen below, changes are envisaged. The MOU aims to minimise duplication of activity and promote cooperation, effective communication and mutual assistance between ASIC and ASX. Under the MOU, ASX is expected to:60 ● Monitor and enforce compliance by Participants and listed entities with its Operating Rules. ● Undertake regular education of Participants and listed entities to promote compliance with the Rules. ● Maintain a close working relationship with ASIC to avoid unnecessary duplication of investigation and enforcement work. ● Consult with ASIC before making public any information in relation to a current or possible future ASIC investigation or enforcement action. ● Maintain ongoing and effective communication in accordance with agreed procedures. Under the existing legislative framework (proposed structural changes are discussed below), as discussed in Chapter 6, ASX is the ‘front line’61 regulator of participants’ conduct in relation to its market, and both ASX and ASIC have separate and complementary roles in the supervision of the markets.62 In addition, ASIC also supervises ASX. ASIC is obliged, under the Corporations Act, annually to assess the extent to which ASX group licensees have complied with their obligations to, to the extent that it is reasonably practicable to do so; do all things necessary to ensure that 57 Alan Cameron, ‘How Do Directors Sleep at Night?’ in Directors in Troubled Times (R P Austin and A Y Bilski, eds, Ross Parsons Centre of Commercial, Corporate and Taxation Law Monograph 7, Sydney, 2009) 115 at 118. 58 ASX, ‘Analysis of Corporate Governance Disclosures in Annual Reports for Year ended 31 December 2008’ (3 August 2009), above n 49 at 3. 59 See . 60 See . 61 ASIC Report 168, Market Assessment Report (28 August 2009) at 17. 62 For further information, see ASX, ‘ASX’s Role in Australia’s Financial Regulatory Framework’, (June 2008).

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the markets operated by ASX group are fair, orderly and transparent.63 In the 7th Market Assessment Report released by ASIC, for the period 1 January 2008 to 31 December 2008, the regulator identified the following nine areas in which ASIC and ASX concluded that changes and improvements were needed by ASX:64 1. increase in resourcing levels within ASX Capital Monitoring Function 2. enhanced focus on the overall internal supervision culture of participants 3. increase in resourcing initiatives relating to the Enforcement and Tribunal functions 4. improvements in ASX’s real-time surveillance practices and complaint handling procedures in relation to trading activities 5. greater consideration to be given by ASX to requesting on a more regular basis, insider lists from listed entities, to assist in insider trading investigations 6. report to ASIC, by 31 March 2010, on the effectiveness of recent changes to the resourcing and procedures of ASX’s real-time surveillance function 7. during 2008, three entities were admitted to the list without meeting the spread requirements. ASX was to report to ASIC, by 31 March 2010, on effectiveness of measures to prevent a repeat occurrence 8. report to ASIC, by 31 March 2010, on a review of effectiveness of ASX group’s measures to monitor and deal with software capacity issues following two technology outages during 2008 caused by software error 9. report to ASIC after the Error Resolution Policy is invoked on the basis of the rationale for the Fair Price Value determination, which is used to identify trades that are to be cancelled. The current regulatory regime under which ASX operates does not preclude the existence of conflicts of interest as operator and watchdog. There is no per se prohibition on ASX having conflicts of interest65 but ASX must manage any conflicts it does have so as not to allow its commercial interests to prevail over its supervisory role. ASIC’s view is that whether or not there should be such a per se prohibition is a policy matter for government66 and continues to discharge its role to assess if ASX has adequate arrangements in place to manage conflicts of interest. Despite ASIC’s conclusion in its seven most recent reports that ASX’s arrangements for managing conflicts were adequate (that is, met the statutory standard),67 ASX has been continually dogged by allegations of inherent conflicts of interest from operating a money-making business alongside its regulatory duties.68 Proposed Structural Changes to Supervision of Financial Markets The MOU will continue to govern the relationship between ASIC and ASX, but only until the third quarter of 2010. In a joint media release of the Federal 63 Sections 792A, 794C and 821A. 64 ASIC Report n 61, at 9–11. 65 Ibid at 20. 66 Ibid. 67 Ibid. 68 For example, see Adele Ferguson, ‘Query on ASX’s Supervisory Power’, The Australian (17 September 2007); Danny John, ‘ASX Cited for Conflict of Interest’, Sydney Morning Herald Business Day (5 April 2008).

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Treasurer Wayne Swan and The Hon. Chris Bowen,69 it was announced that the supervisory responsibility of ASX will be transferred to ASIC in the third quarter of 2010. The main aim is to ‘enhance the integrity of Australia’s financial markets and take another step towards establishing Australia as a financial services hub in the region’.70 Transferring this supervisory role will ensure that in future Australia will have only ‘one whole-of-market supervisor’. The transfer of powers will be done in stages to ensure that it is done in an orderly fashion. There were some individuals in ASIC that were vehemently opposed to the regulatory powers of ASX to be transferred to ASIC.71 Taking away the regulatory powers of ASX will end a long and sometimes stinging attack on ASX being a regulator and player on the securities market, which led to obvious conflicts of interests.72 ASX is one of only a few major exchanges with such dual functions.73 It is submitted that transferring all the regulatory powers to ASIC is a development that should be welcomed as one that is in line with good regulatory corporate governance principles. Whether ASIC, however, has the resources and expertise to discharge these additional duties more effectively than ASX remains to be seen. ASIC itself has commented upon the pressure and stress on resources put upon ASX in 2008 when policing real-time surveillance of the market.74 Ian Ramsay also raised issues that are relevant for the future assessment of ASIC’s new role:75 The big question now is will ASIC put in sufficient resources? Will it receive sufficient resources from the Government to do an adequate job? Also, there’s a second major question, will ASIC have the required expertise? The argument in favour of ASX doing it is that it’s close to the market, close to the brokers, knows what the brokers are doing.

7.4 Conclusion Fundamental questions remain about the scope of ASIC’s prudential supervision, powers and responsibilities. There are some differences in opinion as to how far the powers of a regulator should be extended. David Knott touched on some of these issues in a public address: 69 Treasurer Wayne Swan and Minister for Financial Services, Superannuation and Corporate Law, Chris Bowen, ‘Reforms to the Supervision of Australia’s Financial Markets, joint media release (24 August 2009), available at . 70 See . 71 See Henry Davis York Lawyers, for a good summary of the intended changes and consequences for the financial markets. 72 Gill North, ‘The Corporate Disclosure Co-regulatory Model: Dysfunctional and Rules in Limbo’ (2009) 37 Australian Business Law Review 75, 80–1. 73 The Australian, 25 August 2009 – ‘Securities Exchange had Conflicting Roles’. 74 ASIC Report 168, above n 61, at 51. 75 Australian Broadcasting Corporation, ‘ASX Stripped of Key Supervisory Powers’, Lateline Business Transcript (24 August 2009). For similar queries, see Allens Arthur Robinson, ASIC Market Regulation, (24 August 2009), available at .

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Is the traditional approach leaving responsibility for corporate governance and compliance with boards, shareholders and auditors still valid? Or should we be thinking about extending the scope of prudential supervision more pervasively throughout the business community? Should the corporate regulator, for example, have rights to enter, inspect and even seize records without cause? Should the regulator have powers to prescribe and enforce governance standards? These would be radical notions for a corporate regulator and would represent a major shift in managing governance responsibilities. I am not necessarily advocating such change, merely making the point that if you are not in control of governance, you cannot prevent failure.76

One could be forgiven for detecting from this a hint that ‘failure’ may well be ‘prevented’ if ASIC’s powers are extended along the line David Knott alluded to in 2002. That notion may nowadays find favour among the general public,77 who have suffered greatly from the recent corporate collapses, and among politicians, who will surely see the political gain in ‘protecting’ and ‘coming to the rescue’ of the voters. There are, however, also views that such drastic powers are unwarranted and that further regulation may just stifle corporate initiative.78 Corporate governance is again high on the corporate law agenda in Australia. Challenging economic times, associated with the global financial crisis during 2008–9 has, however, laid bare the shortcomings of the Australian regulators (ASIC and ASX) in protecting investors who lost millions of dollars following the collapse of managed investment schemes like Timbercorp Ltd and Great Southern Ltd, financial planners like Storm Financial Ltd and Opes Prime Ltd, and other companies like Babcock & Brown Ltd and Allco Finance Group Ltd. These events raise the fundamental question as to whether the regulators in Australia should be acting as an early warning system? ASIC Chairman Tony D’ Aloisio addressed the regulatory framework in reply to this question posed by the media and, in turn, posed a number of challenging questions in a lengthy reply that is worth reproducing:79 . . . as a community, is the regulatory framework one where the role of an ASIC is to actually prevent collapses of companies, or is it as it’s been traditionally that you really oversight the markets and you come in and you deal with issues as they unfold? I think what you’re seeing is we’re not having clear debate about that. I mean, traditionally a regulator such as ASIC has had roles of enforcement, compliance . . . investigations . . . it’s never extended to the fact that an ASIC is the guarantor of last resort, or that it actually has the resources to be able to go into every boardroom and every chief executive to make sure that things are being done properly. If that’s where the community wants to go, then clearly there would be a need for quite substantial resources. Philosophically 76 David Knott, ‘Corporate Governance – Principles, Promotion and Practice’ Inaugural Lecture – Monash Governance Research Unit (16 July 2002), available at 8. 77 See Jillian Segal, ‘Institutional Self-regulation’, above n 27 at 13. 78 Robert Baxt, ‘The Necessity of Appropriate Reform’ in Collapse Incorporated: Tales, Safeguards & Responsibilities of Corporate Australia, Sydney, CCH Australia (2001) 326. 79 Australian Broadcasting Corporation, ‘ASIC Chairman Defends Role as Corporate Regulator’ (Transcript, Lateline, 22 May 2008).

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in a free enterprise system, I think the community also has to take into account the fact that failures in companies are part of the free enterprise system, as well as success. And I think you need to . . . have a debate on whether ASIC should be preventative or whether it should remain in its traditional role of really oversighting the market and coming in and dealing where there’s been excesses that should be dealt with.

The quote raises rich questions on policy settings and whether the time is ripe for a review of the philosophical considerations currently underpinning the regulatory system, as identified by the ASIC Chairman. It is reasonable to presume that, given a choice, the community will prefer the regulatory framework to be amended to facilitate ASIC’s monitoring rule to become more prominent in future, as a way of detecting the signs of potential huge corporate collapses as soon as possible, rather than cleaning up after such collapses.80 It is interesting to note that the proportion of the adult population of Australia that owns shares is one of the highest in the world, with approximately 46 per cent (some 7.3 million people) of adult Australians owning shares.81 Many of these shareholders, as well as the thousands of creditors and those who lost their insurance cover in the HIH collapse, are likely to support any suggestion of extending ASIC’s powers that may prevent future spectacular corporate failures. If so, the challenge for ASIC will be to play a far more active role in ensuring that signs of corporate collapses are detected at the earliest possible time. This will probably mean a much greater focus on monitoring companies, rather than strictly on its role as regulator and enforcer. Fulfilling this role will likely be a far greater challenge than that of picking up the leftovers on behalf of affected corporations and individuals after the corporate cowboys and bold riders have left the corporations they have ruined financially. Only time will tell whether ASIC will be allowed to take up this challenge and live up to public expectations in this regard. As part of a preventative approach, the education and advocacy roles of ASIC will also have a prominent role to play. But, as Jillian Segal points out, the success of this approach will also depend on the willingness and commitment of the corporate sector to embrace ethical standards.82 80 See generally regarding the role of governments in risk minimisation: Rick Sarre, ‘Risk Management and Regulatory Weakness’, in Collapse Incorporated: Tales, Safeguards & Responsibilities of Corporate Australia, Sydney, CCH Australia (2001) 319–21. 81 Speech by Prime Minister of Australia, Kevin Rudd, ‘Australia’s Economic Future’ to Confederation of British Industry and Australian Business in London (4 April 2008), available at . 82 Jillian Segal, ‘Corporate Governance: Substance Over Form’ (2002) 25 University of New South Wales Law Journal 1 at 21.

8 Accounting governance The CLERP 9 Act amends a number of Acts, including the Corporations Act 2001, to give effect to reforms aimed at restoring public confidence in corporate Australia after a number of significant instances of misconduct and corporate failure. The BDW Guide to CLERP 9 (Blake Dawson Waldron, July 2004) 22

8.1 Overview No matter which corporate code of conduct or corporate governance framework is used, the issue of ‘transparency’ is referred to either directly or by implication. The application of ‘transparency’ to the reporting to the public by companies of their financial and non-financial conduct and performance for a period has come under increasing scrutiny of corporate stakeholders. The single most significant reform in this area in Australia came in response to the high-profile corporate collapses of the early 2000s. On 1 July 2004, the Corporate Law Economic Reform Program (Audit Reform & Corporate Disclosure) Act 2004 (Cth) came into effect. This Act is now commonly referred to as the ‘CLERP 9 Act’, or simply ‘CLERP 9’, since it was the ninth such Act under the Government’s Corporate Law Economic Reform Program (CLERP). This Act, together with an Australian Securities Exchange (ASX) Listing Rule change (2003) with respect to the establishment of audit committees for certain companies (see Chapter 9) and ASX Best Practice Recommendations of 2003, and as amended in 2007, together represent one of the most significant packages of corporate law reform, and by far the most significant effort at regulating the corporate governance practices of companies in Australian history. Since then, other important reforms in Australia have been the adoption of International Financial Reporting Standards and International Standards on Auditing based on those promulgated by the International Accounting Standards Board (IASB) and the International Auditing and Assurance Standards Board (IAASB) respectively (see Chapter 9). No book on corporate governance in Australia could do justice to its topic without devoting at least some discussion to accounting governance in terms 198

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of the CLERP 9 and accounting and auditing standard-setting reforms and their place in the broader context of corporate governance, and in the regulation of corporate governance in particular. The effects of the CLERP 9 reforms have been significant, with considerable parts of the Corporations Act 2001 (Cth) (the Act) now devoted to mandatory ‘corporate governance rules’ (especially in relation to the financial aspects of corporate governance, with substantial reforms in the area of audit and financial reporting). Prior to CLERP 9, many of the best-practice requirements that are now prescriptive rules forming part of the Act (dealing with, for example, executive remuneration, shareholder participation and financial reporting) were either part of a self-regulatory approach to governance and standard setting overseen by professional bodies (for example, the Australian Auditing and Assurance Standards Board), or merely aspirational standards. CLERP 9 accelerated the shift in the way that corporate governance operates and is perceived, as well as the actual role of the regulators and quasi-regulators such as ASX, in shaping corporate governance best practice and the behaviour of companies. The CLERP 9 Act was designed, with some minor exceptions, to be consistent with and to complement ASX Best Practice Recommendations (2003) over the range of corporate governance matters to which they both applied (from board structure and auditing to shareholder participation and continuous disclosure). The aim was to have these two measures work to promote both good corporate governance practices within Australian listed companies and achieve effective regulation. Some of the initiatives introduced under CLERP 9, however, go further than the 2003 and 2007 ASX Best Practice Recommendations: they apply also to non-listed companies, and non-compliance with CLERP 9 potentially attracts formal penalties, whereas (as already mentioned in Chapter 7), the Best Practice Recommendations operate under an ‘if not why not?’ (‘comply or explain’) regime notwithstanding the Corporations Act requirement to comply. This chapter draws on the explanation of the background to, and contents of, each of the key CLERP 9 reforms provided by James McConvill in his 2004 book, An Introduction to CLERP 9.1

8.2 Background to the Corporate Law Economic Reform Program and some later developments The CLERP was announced by then-Federal Treasurer Peter Costello in March 1997, and involved a review of key areas of regulation affecting business and investment activity. According to the then-Government, the objective of CLERP was to ensure that business regulation was consistent with promoting a strong and vibrant economy and provided a framework which assisted business in adapting to change. 1 James McConvill, An Introduction to CLERP 9, Sydney, LexisNexis (2004).

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The establishment of CLERP is said to have been a consequence of the decision to transfer responsibility for legislation on corporations and securities from the Office of the Attorney-General to the Department of Treasury. The perception was that this transfer of responsibility would generate a shift from an emphasis on legal regulation to economic regulation, and would result in a focus on the economic impact of corporations law. Since the election of the Labor Government in 2007, regulatory reform has continued, particularly in standardising state and Federal requirements in an effort to reduce the regulatory burden on business2 , but these reforms have not occurred under the CLERP title3 . As pointed out in Chapter 7, one particularly important, recently proposed reform is the re-balancing of responsibilities for monitoring of the capital market in favour of the Australian Securities and Investments Commission (ASIC), at the expense of ASX. ASX is itself a listed company and, as such, it has been argued that it has an inherent conflict of interest since it has historically regulated and monitored the exchange upon which it selflists. The global financial crisis of 2007, which did not affect the Australian stock market severely until 2008, highlighted issues associated with margin lending to directors, share trading by directors during ‘black out’ periods and other matters, which prompted reform proposals not implemented at the time of writing.4 Another area that has received attention is executive remuneration, particularly after generous bonuses were paid in the aftermath of the downturn caused by the global financial crisis.5 Chapter 4 provides detail of activities in relation to director and executive remuneration.

8.3 The Corporate Law Economic Reform Program The CLERP reform program was developed with the benefit of consultation with the Business Regulatory Advisory Group, which was formed in 1997 with the intention of providing quality feedback to the government on business and corporate law reform. The Business Regulatory Advisory Group consists of representatives from key business groups. Since 1997, nine policy proposal papers were released as part of CLERP, comprising: Paper 1 – Accounting Standards (1997) Paper 2 – Fundraising (1997) Paper 3 – Directors’ Duties and Corporate Governance (1997) Paper 4 – Takeovers (1997) Paper 5 – Electronic Commerce (1997) 2 See, for example, the Treasury project on Standard Business Reporting, available at . 3 See Corporations and Markets Advisory Committee, Aspects of Market Integrity (June 2009), available at . 4 Ibid. 5 See Productivity Commission, Executive Remuneration in Australia, Report No. 49, Final Inquiry Report, Melbourne, Commonwealth of Australia (December 2009), available at .

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Paper 6 – Financial Markets and Investment Products (1997) Paper 7 – Simplified Lodgment and Compliance Procedures with ASIC (2000) Paper 8 – Cross-Border Insolvency (2002) Paper 9 – Audit Reform and Corporate Disclosure (2002). The first four papers, and part of the fifth, were reflected in the Corporate Law Economic Reform Program Act 1999 (Cth). The sixth paper led to the Financial Services Reform Act 2001 (Cth), which took full effect from March 2004, and introduced Chapter 7 of the Corporations Act, dealing with financial products, financial markets and providers of financial services.6 Paper seven was adopted with a series of reforms taking effect from 1 July 2003, and CLERP 9 was largely adopted with reforms taking effect from 1 July 2004. The proposals contained in paper eight were implemented by way of the Cross-Border Insolvency Act 2008 (Cth), which commenced on 1 July 2008. In a document titled CLERP – Policy Framework, released in 1997, the Department of Treasury indicated that the key factors driving changes to corporate regulation in Australia were: (1) globalisation and market behaviour; and (2) that the law had not kept pace with change. This document identified six ‘key principles’ to be applied under CLERP. Under the heading ‘Economic Approach to Business Regulation’ these principles are: 3.1 Market Freedom Competition plays a key role in driving efficiency and enhancing community welfare. However, free markets do not always operate in a sufficiently competitive, equitable or efficient manner. Business regulation can and should help markets work by enhancing market integrity and capital market efficiency. At the same time, the regulatory framework needs to be sufficiently flexible so that it does not impede market evolution (for example, new products and technologies) and competition. 3.2 Investor Protection With an increasing number of retail investors participating in the market for the first time, business regulation should ensure that all investors have reasonable access to information regarding the risks of particular investment opportunities. Regulation should be cognisant of the differences between sophisticated and retail investors in access to information and the ability to analyse it. 3.3 Information Transparency Disclosure is a key to promoting a more efficient and competitive marketplace. Disclosure of relevant information enables rational investment decision making and facilitates the efficient use of resources by companies. Disclosure requirements increase the confidence of individual investors in the fairness and integrity of financial markets and, by fostering confidence, encourage investment. Different levels of disclosure may be required for sophisticated and retail investors. 6 R P Austin and I M Ramsay, Ford’s Principles of Corporations Law, Sydney, LexisNexis, Butterworths (14th edn, 2010) 52.

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3.4 Cost Effectiveness The benefits of business regulation must outweigh its associated costs. The regulatory framework should take into account the direct and indirect costs imposed by regulation on business and the community as a whole. What Australia must avoid is outmoded business laws which impose unnecessary costs through reducing the range of products or services, impeding the development of new products or imposing system-wide costs. The regulatory framework for business needs to be well targeted to ensure that the benefits clearly exceed the costs. A flexible and transparent framework will be more conducive to innovation and risk taking, which are fundamental elements of a thriving market economy, while providing necessary investor and consumer protection. 3.5 Regulatory Neutrality and Flexibility Regulation should be applied consistently and fairly across the marketplace. Regulatory distinctions or advantages should not be conferred on particular market structures or products unless there is a clear regulatory justification. The regulatory framework should also avoid creating incentives or opportunities for regulatory arbitrage. The regulatory framework should be sufficiently flexible to permit market participants to respond to future changes in an innovative, timely and efficient manner. Regulation should be designed to facilitate predictability and certainty. 3.6 Business Ethics and Compliance Clear guidance regarding appropriate corporate behaviour and swift enforcement if breaches occur are key elements in ensuring that markets function optimally. The Government is committed to the strong and effective enforcement of corporate law and will continue to provide substantial resources to the Australian Securities Commission [now the Australian Securities and Investments Commission (ASIC)] to enforce the law. Fostering an environment which encourages high standards of business practice and ethics will remain a central objective of regulation, as will effective enforcement. These principles provide a useful tool for developing or critiquing corporate law and governance reforms. As discussed briefly in the concluding remarks to this chapter, subjecting the CLERP 9 reforms to the key principles provides another basis from which to evaluate the efficacy of shifting towards further formalisation of corporate governance regulation in Australia.

8.4 Impetus for CLERP 9: Responding to corporate collapses As is discussed in various parts of this book, renewed international attention to corporate governance resulted from the collapse of two of America’s largest

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companies, Enron and WorldCom in 2001. The collapse of HIH Insurance Ltd – Australia’s largest-ever corporate collapse – followed soon thereafter. Regulators were quick to focus their attention on any role of those companies’ auditors in contributing to the collapses due to poor audit oversight, lack of transparency and accountability, or the relevant audit firms being too close to their audited clients. In the USA, it was discovered that the global accounting firm Arthur Andersen & Co (Andersen), which subsequently also collapsed under the weight of the ensuing scandal, had signed off on Enron financial reports, which overstated the company’s earnings by US$586 million over five years, and had allegedly shredded a large volume of Enron’s documents – this was later found on appeal not to have been the case. It was argued that Andersen’s negligence and, indeed, dishonest practices, were due to its dependence upon fees paid to the firm by Enron for non-audit services (such as consultancy and legal services). As other audit firms similarly depended on non-audit fees, lack of ‘auditor independence’ was considered to be a major problem that required attention.7 Auditor dependence is a problem from a corporate governance perspective, because if a company involves the same firm in the provision of both audit services and non-audit services, such as consulting or legal services, the auditor will possibly be reluctant to provide an unfavourable audit report to management if the result is a loss of the audit engagement, and the subsequent loss of substantial fees arising from non-audit services. Despite the limited role that auditors actually perform and their very narrow obligations under law, the renewed focus on corporate governance and the importance of the auditor’s role in ensuring the reliability of a company’s half-year and full-year accounts warranted serious attention being given to the regulation of auditors. In Australia, the same problem of potential auditor dependence on audit clients was found to be rife. This was due mainly to the large accounting and audit firms establishing multidisciplinary practices (with consulting, legal and tax practices) in an attempt to offer a ‘one-stop advisory shop’ for their clients, and thereby to maximise client fees. An important study of Australia’s 100 largest companies, conducted by ASIC in January 2002, revealed that a large majority of these companies retained their audit firm to provide non-audit services, and that non-audit fees accounted for nearly 50 per cent of the total fees paid to the audit firm.8 Also raising the issue of auditor independence in Australia was the fact that two board members of the collapsed HIH Insurance group were ex-partners of Andersen, the firm that had performed HIH’s last audit.9

7 See generally Melissa Fogarty and Alison Lansley, ‘Sleepers Awake! Future Directions for Auditing in Australia’ (2002) 25 University of New South Wales Law Journal 408. 8 See ASIC, ‘ASIC Announces Findings of Audit Independence Survey’ (Press Release 02/13, 16 January 2002). Not surprisingly, the concept of multidisciplinary practices is now considered to be pass´e and anachronistic, rather than a real opportunity for fee maximisation. 9 See Michael De Martinis, ‘Do Directors, Regulators, and Auditors Speak, Hear and See No Evil? Evidence from the Enron, HIH and One.Tel collapses’ (2002) 15 Australian Journal of Corporate Law 66, 67.

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It is not difficult to see why the problems that were believed to be behind these high-profile corporate collapses became the focus of CLERP. Corporate law reform – particularly in the area of corporate disclosure – was seen as a possible solution to restoring market confidence, addressing the cause of those collapses and preventing further collapses from occurring. Prior to developing proposals for corporate law reform to address corporate disclosure and corporate governance more generally, the Federal Government commissioned Ian Ramsay to review audit independence regulation in Australia. Ramsay was commissioned in August 2001, soon after the collapse of HIH Insurance Ltd, and at a time when auditor independence was a hot topic in the financial press and among law-makers and regulators. Ramsay handed his report, titled ‘Independence of Australian Company Auditors: Review of Current Australian Requirements and Proposals for Reform’, to the government in October 2001. The report contained seven key reform recommendations: 1. Introduction of a general requirement for auditors to be independent under the Corporations Act. 2. Incorporation in the Corporations Act of the best-practice position regarding the employment of auditors, and the financial relationships between the audit firm and the firm’s clients to ensure independence. 3. Enhancement of the disclosure requirement for non-audit services (for example, consulting, legal) performed by the audit firm (so that the type of service and the monetary amount paid is transparent). 4. Prohibition of audit firm partners who were directly involved in an audit from becoming directors of the audited client within two years of the auditor resigning from the audit firm. 5. Introduction of a requirement that all listed companies have an audit committee. 6. Establishment of an auditor independence ‘supervisory board’. 7. Introduction of measures to improve the operation of the Companies Auditors and Liquidators Disciplinary Board. Following the HIH collapse, the Australian Government also established a Royal Commission to investigate the collapse and, among other things, raise proposals for possible corporate law and governance reforms. Justice Owen of the Western Australian Supreme Court was appointed as Commissioner. Following the endorsement of the Ramsay Report by the Federal Government, a less-publicised review of audit reform was also conducted by the Federal Parliament’s Joint Committee of Public Accounts and Audit. In a 144-page report titled ‘Review of Independent Auditing by Registered Company Auditors’, released in September 2002, the Joint Committee made 13 recommendations for reform.10 Also in September 2002, the Federal Government released its discussion paper, ‘Corporate Disclosure: Strengthening the Financial Reporting 10 A pdf version of this report is available at .

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Framework’, which comprehensively explained its proposals for law reform in relation to audit and financial reporting in particular, but also in other areas drawn together by a strong objective of ensuring good corporate governance practices. The discussion paper drew heavily on the Ramsay Report in relation to auditor independence, and was also influenced by the United States SarbanesOxley Act of 2002, which had been quickly drafted and implemented to respond to the large collapses in that country. In October 2003, the Australian Government released its draft Corporate Law Economic Reform Program (Audit Reform & Corporate Disclosure) Bill (the so-called ‘CLERP 9 Bill’), and accompanying commentary, for public consultation. The CLERP 9 Bill was introduced into Parliament on 4 December 2003, incorporating some amendments to the draft Bill and immediately sent to the Joint Parliamentary Committee on Corporations and Financial Services for further review. That Committee released its report in June 2004. The Committee was generally supportive of the initiatives contained in the CLERP 9 Bill; however, it suggested a number of important reforms, particularly in relation to the proposed whistleblowing provisions, and shareholder participation (including a recommendation that all individuals appointed as proxy for company meetings be required to vote as directed, with CLERP 9 otherwise being limited to reforms pertaining to electronic proxy voting). We return to the Committee’s report below in this chapter, when we discuss the possibility of further corporate governance-related law reform, post-CLERP 9. On 25 June 2004, Parliament approved the CLERP 9 Bill. It came into effect as the Corporate Law Economic Reform Program (Audit Reform & Corporate Disclosure) Act 2004 (Cth) on 1 July 2004, as intended with most provisions applying from that date.

8.5 Explanation of key CLERP 9 reforms In this section, we identify each of the key CLERP 9 reforms implemented. The explanation is divided into three parts: (a) audit reform, (b) corporate disclosure, and (c) miscellaneous. Note that ASIC has released a number of policy statements, practice notes and other policy documents indicating its intentions in administering different aspects of CLERP 9. Where relevant, we include reference to these policy documents, but readers are encouraged to visit the CLERP 9 section of ASIC’s website: .

8.5.1 Audit reform As noted earlier, Chapter 9 of this book is devoted to explaining the role of auditors in corporate governance, and the reforms to auditing and audit regulation introduced under CLERP 9. This section merely identifies the main initiatives relating to audit reform that were made as part of CLERP 9.

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A key area for reform as part of CLERP 9 was auditor independence. CLERP 9 enhanced auditor-independence requirements through a number of reforms including general and specific independence rules embedded into the Corporations Act, new audit–partner rotation rules (requiring listed companies to essentially replace their external audit partner every five years), the imposition of ‘cooling off’ periods for ex-auditors before being able to take up a position with a former audit client, and requirements for disclosure of the dollar value of nonaudit services by category11 provided by auditors (the value of auditor-provided non-audit services purchased had long been a required disclosure under accounting standards) with an explanation in the directors’ report of how the provision of these services did not compromise independence. Other changes increased auditor accountability by requiring that auditors of listed company clients attend the clients’ annual general meeting to answer shareholder questions; extended the duty of auditors to report unlawful conduct occurring within an audited body; gave auditing standards the force of law similar to accounting standards, which had long enjoyed this requirement; reconstituted the previous professional body that sponsored the Auditing and Assurance Standards Board (AUASB) as a statutory authority under the guidance of the Australian Financial Reporting Council (FRC); allowed registration of audit companies (previously only sole practitioners or partnerships were permitted); formalised auditor competence requirements; and provided jurisdiction to the FRC to supervise and guide auditors regarding independence requirements. ASIC set out its policy in relation to audit reform in Policy Statement 180, ‘Auditor Registration’, and Policy Statement 34, ‘Auditors’ Obligations – Reporting to ASIC’.

8.5.2 Corporate disclosure 8.5.2.1 Remuneration of directors and executives CLERP 9 introduced enhanced disclosure requirements for listed companies in relation to the disclosure of informing shareholders regarding the rates of director and executive remuneration, and in particular of the link between levels of executive pay and company performance. The major changes were to section 300A of the Corporations Act, requiring much greater disclosure by listed companies of director and executive remuneration (both the level of remuneration, and the company’s policy in determining remuneration) – including the preparation of a specific ‘remuneration report’ to be included as a section in the directors’ report (which is intended to clearly explain board policy in relation to remuneration and demonstrate to shareholders that levels of executive pay were based on company performance and how this was determined), and disclosure of the remuneration of each director and the five highest-paid key managerial personnel in the company and in the 11 Refer AASB 101 Presentation of Financial Statements para AUS 138.1.

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group (if applicable)12 . Other CLERP 9 initiatives in relation to remuneration included: ● a requirement (under section 250R) for listed companies to provide shareholders with a non-binding ‘advisory’ vote on the designated ‘remuneration report’ prepared by the directors ● a tightening of the termination payment rules, with shareholder approval generally being required for all termination payments (including payments arranged pursuant to pre-employment contracts, and damages for breach of contract due to early termination of contract), which are the greater of the relevant person’s average remuneration for the last three years multiplied by the number of years the person has held an office in relation to the company (up to a maximum seven years) or the person’s remuneration for the last 12 months (see section 200F). Under the Act, a ‘company executive’ is defined to mean a company secretary or senior manager of the company (see section 300A(1B)). A ‘senior manager’ is defined under section 9 as a person, other than a director or company secretary, who makes, or participates in making, decisions that affect the whole, or a substantial part, of the business of the corporation; or has the capacity to affect significantly the corporation’s financial standing. 8.5.2.2 Financial reporting CLERP 9 introduced some significant financial reporting reforms requiring that further information be provided in the directors’ report or financial report (which is included in the annual or half-yearly report of the company). Another important financial reporting-related initiative introduced under CLERP 9 involved the establishment of the Financial Reporting Panel, which has jurisdiction to hear and determine disputes between ASIC and companies (or other entities) regarding accounting treatments in annual reports.13 In terms of the compliance-based reforms, the three key changes made under CLERP 9 were: ● that listed companies must include in the directors’ report a declaration by the directors that they had received a chief executive officer (CEO) and chief financial officer (CF) joint declaration that the company’s financial records have been properly maintained, that the financial statements and accompanying notes have been prepared in accordance with accounting standards, and that the financial statements and notes for the financial year provide a ‘true and fair’ view of the company’s position (see sections 295(4)(e) and 295A) ● that the directors’ report for a listed company must include a ‘management discussion and analysis’ (a so-called ‘MD&A’), which contains sufficient information that investors would reasonably require to make an informed 12 See also AASB 2 (accounting standard), Share-based Payment for other required disclosures and accounting treatments. 13 See Part 13 of the Australian Securities and Investments Commission Act 2001 (Cth) which established the Panel; also Part 2M.3, Division 9 of the Corporations Act.

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assessment of the company’s operations and financial position, as well as business strategies and prospects for future financial years (see section 299A) that if additional information is included in an entity’s full year or half-year financial report to ensure a ‘true and fair’ view (of the financial performance and position of the company – satisfying the existing requirement under the Act (see sections 297 and 305)), then the directors’ report must set out the reasons for the directors forming the view that the inclusion of this information was necessary and the location of this additional information in the financial report (see section 298(1A)), and the auditor’s report must include a statement as to whether the auditor believes the inclusion of this additional information was necessary to provide a ‘true and fair’ view (see section 306(2)).

8.5.2.3 Continuous disclosure One of the most controversial areas of reform under CLERP 9 was the changes made to the continuous disclosure regime. The continuous disclosure regime (under the Corporations Act and ASX Listing Rules) requires that listed companies (and non-listed ‘disclosing entities’) immediately release to the market information that could have a material effect on the price or value of affected companies’ securities. There were two key changes relating to continuous disclosure under CLERP 9: ● introduction of personal liability for individuals who are deemed to be ‘involved’ in an entity’s contravention of the continuous disclosure provisions (which essentially ‘pick up’ the continuous disclosure rules under ASX Listing Rules). This personal liability provision is subject to a ‘due diligence’ defence14 ● providing ASIC with the power to issue so-called ‘infringement notices’ against an entity (but not against an individual ‘involved’ in a contravention) if ASIC considers that the entity has not met its continuous disclosure obligations. The infringement notice power was introduced with a view to enabling ASIC to take action in relation to less serious contraventions of the continuous disclosure provisions, where court action would not be justified. An infringement notice may only be issued within 12 months of an alleged contravention. The size of the monetary penalty contained in the infringement notice depends on the offending entity’s market capitalisation and whether it has previously been convicted of contravening the continuous disclosure provisions. The maximum possible penalty for each offence (at the time of writing) was $100 000. Complying with an infringement notice by paying the specified monetary penalty within the specified time period is not an admission of guilt, and bars ASIC from commencing civil or criminal proceedings in relation to the alleged contravention. 14 See Corporations Act s 674(2A).

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Importantly, in relation to publicity, ASIC may not issue any public release relating to an infringement notice being issued against a company. ASIC may only publish a statement when an entity complies with an infringement notice, and this statement must include a note clearly stating that compliance is not an admission of the entity’s guilt, and that the entity is not regarded as having contravened the continuous disclosure provisions.15 8.5.2.4 Shareholder participation CLERP 9 introduced some important amendments to the Act, designed to facilitate and promote the exercise by shareholders of important governance rights: being informed of company activities, as well as participation in and voting at general meetings of the company. The key amendments in this area were designed to: ● encourage companies to embrace technology (particularly the internet and e-mail) and forms of electronic communication (such as web-casting) to improve communication with shareholders, particularly facilitating the distribution of notices of meeting and annual reports through electronic means16 ● encourage shorter and more comprehensible notices of company meetings so that shareholders can fully understand the contents of the notices (see section 249L(3), which introduced a requirement that notices are worded and presented in a ‘clear, concise and effective manner’) ● improve shareholder access to general meetings by facilitating proxy voting (in particular, to facilitate electronic proxy voting (by permitting regulations to prescribe so-called ‘authentication mechanisms’), which authenticate proxy appointments provided electronically)17 ● better inform shareholders, by requiring that listed company directors disclose other directorships held in the three years prior to the end of the financial year to which the report relates,18 and the qualifications and experience of the company secretary be included in the directors’ report.19 8.5.2.5 Whistleblowers Part 9.4AAA of the Act introduces a new regime providing protection from victimisation for ‘whistleblowers’ (officers, employees, contractors and employees of contractors) who report contraventions (or suspected contraventions) of the ‘Corporations legislation’ (defined to include the Corporations Act, the Australian Securities and Investments Commission Act, and regulations under either Act) to ASIC, the company’s auditor, a director or other authorised person. Victimisation 15 See Part 9.4AA of the Act, and ASIC’s policy document, ‘Continuous Disclosure Obligations: Infringement Notices – An ASIC Guide’ (released in May 2004), which sets out ASIC’s processes for administering the infringement notice regime, including how hearings are to be conducted and notices issued. 16 See Corporations Act, ss 249J and 314. 17 See Corporations Act, s 250A(1A) and reg 2G.2.01 of the Corporations Regulations. 18 Corporations Act, s 300(11)(e). 19 Corporations Act, s 300(10)(d).

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may occur in a number of ways, including actual dismissal, demotion, bullying or constructive dismissal. In order for the whistleblower to obtain protection under Part 9.4AAA, there are three pre-conditions that need to be satisfied: (i) The person has reasonable grounds to suspect the disclosure highlights that there has been a contravention of the Corporations legislation. (ii) The disclosure is made in ‘good faith’. (iii) Prior to making the disclosure, the person provides their name to the person to whom they are reporting (for example, ASIC, the company’s auditor, a director or another authorised person). Part 9.4AAA contains a number of useful provisions, including section 1317AB, which states that whistleblowers are not subject to civil or criminal liability, or the enforcement of contractual rights and remedies, simply on the basis of the disclosure they made, and sections 1317AC and 1317AD, which prohibit victimisation (this offence carries a fine of $2750 and/or imprisonment for six months), and enable whistleblowers to claim compensation where they have suffered loss as a result of victimisation. The House of Representatives: Standing Committee on Legal and Constitutional Affairs released a report titled Whistleblower Protection: A Comprehensive Scheme for the Commonwealth Public Sector on 25 February 2009.20 It contains wide-ranging discussions on the need for whistleblower protection, including comparative approaches with respect to other jurisdictions. A key recommendation of the report was the enactment of a new law, the Public Interest Disclosure Act, to facilitate public interest disclosures and strengthen legal protection for whistleblowers in the federal public sector. Due to concerns that the existing protections for corporate whistleblowers contain ‘fundamental shortcomings’,21 the Federal Government released an options paper in October 2009, exploring strategies for improving protections for corporate whistleblowers.22 Issues include: ● who is allowed to qualify for protection as a whistleblower – former employees currently do not qualify ● whether motive should affect protection – currently an individual with malicious motives cannot be protected even if the information they disclose is genuine ● whether anonymity should affect protection ● when a court may order the production of documents that reveal a whistleblower’s identity – there is concern that whistleblowers will be discouraged from coming forward unless there is further guidance on this issue. 20 See Commonwealth of Australia, Whistleblower Protection: A Comprehensive Scheme for the Commonwealth Public Sector (Report of the House of Representatives: Standing Committee on Legal and Constitutional Affairs), (25 February 2009). 21 The Minister for Financial Services, Superannuation and Corporate Law, the Hon Chris Bowen, Media Release No.032 of 22 October 2009. 22 Commonwealth of Australia, Improving Protections for Corporate Whistleblowers: Options Paper, (October 2009), available at .

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To date, however, there are no court decisions clarifying the scope of the provisions23 and there is no evidence of any enforcement activity involving the provisions by ASIC.24 Janine Pascoe’s research on the literature on business ethics and compliance suggests that the introduction of whistleblower laws, without corresponding changes in organisational ethical values, will not work.25 In order to be effective, Pascoe argues that legal and regulatory initiatives require a shift in corporate culture and ethical values. Similarly, a significant research project based on case studies and quantitative and qualitative analyses produced two key messages:26 (1) organisations can and should adopt a policy of ‘when in doubt report’ to encourage the reporting of wrongdoing (2) organisations need to improve their performance in supporting and protecting persons who come forward with reports of wrongdoing. The need to provide an environment free from recriminations and victimisation, as noted by ASIC,27 is essential if senior management and the board are to adequately manage risk and cultural issues within their company.

8.5.2.6 Disclosure rules A less-publicised component of CLERP 9 involves the series of important reforms made in relation to the disclosure requirements for prospectuses (under Chapter 6D of the Act) and product disclosure statements (PDSs) (under Chapter 7 of the Act). The objective underlying the reforms was to improve the quality of information provided to investors in securities and financial products. There were four key reforms in this area, as follows: ● Information in prospectuses and other Chapter 6D disclosure documents under which securities are offered must be worded and presented in a ‘clear, concise and effective manner’ under new section 715A. This provision was based on section 1013C(3) of the Act, introduced in 2002, which contains an equivalent presentation requirement in relation to the content of PDSs – issued under Part 7.9 of the Act for certain offers of financial products other than securities. ● Introduction of section 1013FA under Chapter 7 (dealing with financial services and products), which enabled so-called ‘transaction specific’ PDSs in relation to ‘continuous quoted securities’. This provision was based on existing section 713, under Chapter 6D of the Act, which allows for ‘transaction 23 ASIC v Dawson Nominees Pty Ltd (2008) 169 FCR 227 raised issues concerning the availability of publicinterest immunity for the regulator from the need to surrender documents and transcript arising form its investigation of Multiplex Ltd. In affirming such protection, the court did not directly address the statutory provisions. 24 Janine Pascoe ‘Corporate Sector Whistleblowing in Australia: Ethics and Corporate Culture’ (2009) 27 Company and Securities Law Journal 524 at 525. 25 Ibid. 26 Peter Roberts, Jane Olsen and A J Brown, Whistling While They Work – Towards Best Practice Whistleblowing Programs in Public Sector Organisations (Draft Report, July 2009), available at . 27 ASIC, Whistleblowers: Corporate Culture of Compliance, available at .

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specific’ prospectuses. A ‘transaction specific’ document is shorter than usual, as information that investors may require but has recently been made available to investors through another forum (for example, the company’s most recent annual or half-yearly report, or a continuous disclosure notice issued after the company report but before the date of the PDS), does not need to be included – thus avoiding ‘doubling up’ of disclosure. With respect to continuous disclosure notices, information contained in the notice may be only validly excluded if the PDS states that as a disclosing entity the issuer is subject to regular reporting and disclosure obligations, and informs people of their right to obtain a copy of the notice. Importantly, ASIC may determine that section 1013DA does not apply to the offer of particular continuously quoted securities if the regulator is satisfied that the issuer has in the previous 12 months contravened: (a) the provisions of Chapter 2M of the Act dealing with financial reporting; (b) the continuous disclosure provisions; (c) section 1012DA(9), which requires financial product issuers to correct defective notices; or (d) section 1308 (false and misleading statements).28 The introduction of section 708A provides exemptions for some secondary sales of securities originally issued without a disclosure document under Chapter 6D of the Act. The basis of this amendment was that no further disclosure is required if at the time securities are issued investors have the benefit of information that is comparable to the information that would otherwise be available in a prospectus. Section 708A is considered to essentially enact the exemptions that ASIC formerly provided under categories 1 and 2 in Schedule C of ASIC Class Order 02/1180. The basic gist of the provision is it exempts a person offering to sell an entity’s securities, within 12 months of the securities having been issued without disclosure provided under Chapter 6D of the Act, from having to provide disclosure in the form of a prospectus or some other disclosure document. The exemption only applies if the relevant securities are in a class of securities that were ‘quoted securities’ at all times in the 12 months before they were issued. Further, the exemption is not available if the company that originally issued the securities did so with the purpose that the purchaser would then sell or transfer the securities (or otherwise grant, issue or transfer an interest in, or option over, the securities). As with section 1013DA, ASIC is able to make a determination disallowing the exemption in section 708A from applying if the issuer of the securities has in the previous 12 months contravened certain disclosure obligations under the Act (for example, continuous disclosure, financial reporting). Section 1012DA was introduced, which is consistent with section 708A in terms of exempting some secondary sales of financial products from PDS requirements. The provision also extends the existing relief that was

28 See s 1013FA. ASIC applies Practice Note 66, ‘Transaction Specific Prospectuses’ to transaction-specific PDSs.

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available under ASIC Class Order 02/1180 for secondary sales of financial products so that relief is available for all quoted financial products, not just managed investment products.29

8.5.3 Miscellaneous 8.5.3.1 Managing conflict by financial services licensees CLERP 9 introduced section 912A(1)(aa), which provides a condition on the licence of financial services licensees (‘AFS licensee’), under Chapter 7 of the Act, that they have in place adequate arrangements to manage conflicts of interest that may arise, either wholly or partially, from the activities undertaken by an AFS licensee or their representatives in the context of providing financial services in a financial services business. This reform was directed mainly at addressing conflicts of interest faced by so-called ‘sell-side’ research analysts working for full-service investment dealers who have not clearly separated research and investment banking businesses. This potential for conflict became a focus for reform after a series of Wall Street scandals in 2001 that revealed a very close dependence between research and other areas of large investment banks.30 This same issue has been raised in the context of the global financial crisis.31 8.5.3.2 Register of relevant interests CLERP 9 introduced s 672DA into the Act, requiring listed companies and listed management schemes to establish a register of ‘relevant interests’, recording the information that is obtained under Part 6C.2 of the Act (which sets up a procedure to enable ASIC or a listed public company or scheme to trace the true beneficial ownership of a company’s shares). Section 608 of the Act provides that a person has a ‘relevant interest’ in securities if they are the holder of the securities, or have the power to exercise (or control the exercise of) a right to vote attached to the securities, or have power to dispose of (or control the exercise of a power to dispose of) the securities. Section 609 of the Act outlines a number of situations (including holding of securities by financial services licensees, and shares covered by buy-backs) which do not give rise to a relevant interest for the purposes of section 608. Section 672DA(1) provides that a listed company (or the responsible entity for a listed managed investment scheme) must keep a register of information that it receives under Part 6C.2 (whether the information is received pursuant 29 In relation to the operation of ss 708A and 1012DA, see ASIC’s Policy Statement 173, ‘Disclosure for On-sale of Securities and Other Financial Products’ (revised in December 2004). 30 ASIC set out its policy for dealing with this obligation to manage conflicts in Policy Statement 181, ‘Licensing: Managing Conflicts of Interests’ (August 2004) and ‘Managing Conflicts of Interests: An ASIC Guide for Research Report Providers’ (November 2004). 31 John Kehoe, ‘ASIC Targets Independence of Auditors, Analysts’, Australian Financial Review (Sydney), (13 October 2009), 1.

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to a direction the company, or responsible entity, itself gives under s 672A, or is received from ASIC under section 672C). 8.5.3.3 Officers, senior managers and employees Prior to CLERP 9, the Act contained two different definitions of ‘officer’ – one in section 82A, which included employees within the definition, and one in section 9. This anomaly was discussed in detail by Justice Owen in the HIH Royal Commission Final Report and was eventually addressed in the CLERP 9 Act, which repealed section 82A to leave only one definition of ‘officer’ in section 9. CLERP 9 also introduced a new definition of ‘senior manager’ under section 9, being a person (other than a director or company secretary) who (a) makes, or participates in making, decisions that affect the whole, or a substantial part, of the business of the corporation, or (b) has the capacity to affect significantly the corporation’s financial standing. The concept of ‘senior manager’ is mainly used in sections of the Act introduced by CLERP 9 on executive and director remuneration and audit services. 8.5.3.4 Enforcement The CLERP 9 Act introduced a number of important measures to strengthen the enforcement provisions of the Act, such as increased penalties,32 providing courts with the power to extend the period of ‘automatic disqualification’ of directors managing a corporation, upon application by ASIC, for a further 15 years.33 8.5.3.5 Proportionate liability The CLERP 9 Act introduced a proportionate liability approach in relation to claims for misleading conduct regarding economic loss or property damage under three provisions: section 1041H of the Act, section 12DA of the ASIC Act and section 52 of the Trade Practices Act 1974 (Cth). This change in approach facilitated apportionment between a plaintiff and a defendant according to their respective level of blame (similar to the rules of ‘contributory negligence’ in torts), and between two or more defendants based on their respective levels of blame. The change to proportionate liability was principally designed to protect auditors, but applies to all professional advisers. Prior to the CLERP 9 reforms, audit partners in firms were jointly and severally liable for professional default within the firm, thus exposing each partner to unlimited liability. Auditors had traditionally protected themselves from unlimited liability through professional indemnity insurance, but the cost of insurance premiums had skyrocketed as a result of the collapse of HIH Insurance. 32 See Corporations Act, s 1308 and s 1309. 33 See Corporations Act s 206BA and s 206B(1).

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8.6 Accounting standards The Australian Financial Reporting Council directed the Australian Accounting Standards Board (AASB) to adopt international financial reporting standards (IFRS) issued by the International Accounting Standards Board in July 2003. Previously there had been a policy of harmonisation with IFRS but not outright adoption. The AASB issued the suite of Australian Equivalents to International Financial Reporting Standards (AIFRS) by May 2004 for implementation by all reporting entities for periods beginning on or after 1 January 2005. For 31 December balancers, this gave little time for implementation. Further, since financial statements had to provide comparative numbers from the previous year, these numbers needed to be re-worked according to IFRS too, and certain reconciliations between the previous and new treatments were required. Many other countries (for example, in Europe) that adopted IFRS did so only for consolidated financial reports. Hence, the transition was a monumental task and not without cost. As justification for the reform, the then-Government argued that ‘in a globalised economy with large and growing cross-border capital movements, high quality, internationally accepted accounting standards will facilitate crossborder comparisons by investors and enable Australian companies to access international capital markets at lower cost’.34 However, the initial policy of amending the wording of the original IFRS meant there was still uncertainty internationally over compliance with IFRS, and in 2007 the AASB was given a strategic direction by the Australian Financial Reporting Council to the effect that auditors should attest to compliance with IFRS where companies in their annual reports made this claim.35 One important difference between IFRS and the previous accounting standards is the emphasis on the use of ‘fair value’ to value assets, particularly investments in securities. In the illiquid market for many securities in the aftermath of the global financial crisis, this valuation method has come under enormous scrutiny and even blame.36 The IASB was forced to compromise on its standard on financial instruments when European banks found themselves at a disadvantage with United States banks on recognition of losses on poorly performing loans. Indeed, the struggle for supremacy between accounting standards issued by the IASB and the United States standard setter, the American Financial Accounting Standards Board (FASB), has been highlighted by the financial crisis. The USA had laid out a roadmap itself to adopt IFRS by 2014 but at the time of writing this timetable, and even whether there is still appetite for this reform in the USA, is under a cloud.37 34 CLERP 9 Proposals (2002), 6.2. 35 For detail see C A Jubb and K A Houghton, ‘The Australian Auditing and Assurance Standards Board after the Implementation of CLERP 9’, (2007) 22 Australian Accounting Review. 688–715. 36 See, for instance, Tim McCollum, ‘Fair Value Under Fire’ (2008) 65(6) The Internal Auditor, 13. 37 See, for instance, Stephen Barlas, Lance Thompson, Dave Topp and Kathy Williams, ‘Slowdown on IFRS’ (2009) 90(9) Strategic Finance 61.

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8.7 Conclusion We have recently witnessed a major change in the mode of corporate governance regulation: from a ‘disclosure’ based approach, which preferred companies to disclose the corporate governance policies and practices they implemented in accordance with their particular needs, to an ‘interventionist’ approach – with CLERP 9 contributing to the formalisation of best-practice governance benchmarks by introducing (or significantly enhancing) substantive corporate governance mandates under the Corporations Act. Considerable debate still exists as to whether many of the compliance-related requirements under CLERP 9 (particularly in relation to audit reform, financial reporting – for example, CEO/CFO declarations and the MD&A discussion in the directors’ report – and executive remuneration) were necessary to improve the governance practices and general performance of companies, and therefore to ‘fireproof’ companies from collapse, or whether they merely imposed additional burdens on the company. We believe that returning to the ‘key principles’ of the CLERP program, discussed in section two above, is an important project (and one that has not been carried out to date) to properly assess the efficacy of the post– CLERP 9 regulatory framework. In particular, we repeat the fourth key principle, ‘cost effectiveness’, supporting a cost–benefit approach to assessing the efficacy of corporate regulation, which states: The benefits of business regulation must outweigh its associated costs. The regulatory framework should take into account the direct and indirect costs imposed by regulation on business and the community as a whole. What Australia must avoid is outmoded business laws which impose unnecessary costs through reducing the range of products or services, impeding the development of new products or imposing system-wide costs. The regulatory framework for business needs to be well targeted to ensure that the benefits clearly exceed the costs. A flexible and transparent framework will be more conducive to innovation and risk taking, which are fundamental elements of a thriving market economy, while providing necessary investor and consumer protection.

The costs need to include an evaluation of the adoption of IFRS and of giving auditing standards the force of law, among other things. Do the benefits of moving towards more substantive corporate governance mandates outweigh the additional costs (both time-based and financial) of compliance? Does the post– CLERP 9 regulatory landscape represent a flexible and transparent framework that is conducive to innovation and risk taking, or is the overriding objective of contemporary corporate regulation in Australia now ‘conformance’ rather than ‘performance’? We leave you to come to your own conclusion with the assistance of the overview of the CLERP 9 and other reforms provided in this chapter. Both the key principle extracted above, and the remaining five key principles comprising the CLERP policy framework, provide an excellent source for

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engaging in a systematic evaluation – importantly, against criteria which the Government has itself set and continues to endorse (with every CLERP discussion paper it releases) in its attitude to effective corporate regulation – as to the effectiveness of the increasing shift towards substantive corporate governance mandates as part of CLERP 9. Is the general trend towards formalisation of corporate governance, of which CLERP 9 forms a significant component, in harmony with the Government’s present framework of corporate regulation as reflected in the key principles? What are the implications if inconsistencies can be identified? It may be that the government needs to either reassess the efficacy of the regulatory momentum it has influenced, or go back and review whether the key principles underlying CLERP are in fact in line with its contemporary thinking on corporate regulation. But there may be, and in fact are, many recent reforms (for example, the changes to the continuous disclosure regime, and the reforms in the area of shareholder participation and information – both promoting investor protection and information transparency) that align with the CLERP key principles. How would these changes be affected by such a review? If the package of substantive corporate governance mandates introduced by CLERP 9 is not considered to be efficacious, one possible option for reform – which perhaps is more aligned with the CLERP key principles and the economic philosophy underpinning the government’s approach to corporate regulation – may be to convert the relevant provisions from mandatory rules to optional terms or at least to make them differentially applicable (for example, requiring audit–partner rotation for companies in other than Australian Prudential Regulation Authority (APRA)-regulated industries because of the rigorous experience requirements for auditors to be accepted by APRA as ‘approved auditors’ in that sector).38 In Australia, this could be achieved by converting many of the compliance reforms into ‘replaceable rules’ under the Corporations Act (see section 141), thereby providing companies with greater freedom to tailor their governance procedures and practices by including an alternative procedure in the company’s constitution if this is considered to better suit their organisational needs. Alternatively, ASIC could be given powers of exemption and modification, to provide relief to companies from one or more of the provisions by establishing to ASIC that such relief would be in the best interests of the company.39 Another option would be to adopt an ‘opt in’ procedure, whereby the corporate governance rules under the Act would only apply to a company if the company’s constitution is amended (by special resolution of shareholders) to confirm that 38 This was a recommendation of an extensive study of, among other things, auditors’ perceptions of the CLERP 9 reforms in the period post their implementation. See chapters 10–12, K C Houghton, C Jubb, M. Kend and J. Ng, The Future of Audit: Towards a National Strategy in Keeping Markets Efficient, Canberra, ANU E-Press (2009), available at . 39 For a discussion of the potential expansion of ASIC’s exemption and modification powers under the Corporations Act, see James McConvill and Mirko Bagaric, ‘Opting Out of Shareholder Governance Rights: A New Perspective on Contractual Freedom in Australian Corporate Law’ (2005) 3 De Paul Business and Commercial Law Journal (USA) 401.

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the company ‘opts in’ to the rules, rather than the rules applying to the company unless it opts out.40 Such a proposal would certainly find favour with advocates of a law and economics conception of corporate law and the corporation (who perceive corporate-law rules to be default terms designed to fill ‘gaps’ in the series of exchanges forming the ‘nexus of contracts’ – see discussion above), and would be compatible with other key principles underlying the CLERP policy framework (promoting market freedom, innovative decision making and regulatory neutrality and flexibility). A similar proposal was raised recently by Yale Law Professor Roberta Romano in the context of discussing the formalisation of corporate governance in the USA as a result of the Sarbanes-Oxley Act of 2002. Romano argues that imposing corporate-governance requirements in relation to independent audit committees, provision of non-audit services, executive loans and executive certification of financial statements through prescriptive rules under the Act is misguided and ineffective. There are alternative means available to achieve the ends sought by law-makers in the USA in relation to the Sarbanes-Oxley Act. According to Romano: The analysis of the empirical literature and political dynamics relating to the [SarbanesOxley Act] (‘SOX’) corporate governance mandates indicates that those provisions were poorly conceived, as there is an absence of a factual basis to believe the mandates would be efficacious. Hence there is a disconnect between means and ends. The straightforward policy implication of this chasm between Congress’s action and the learning bearing on it is that the mandates should be rescinded. The easiest mechanism for operationalizing such a policy change is to make the SOX mandates optional, serving as statutory default rules that firms choose whether or not to adopt.41 (emphasis added)

In section five of this chapter, we discussed some additional corporategovernance reform proposals that may form part of the next wave of corporate law reform in Australia – ‘CLERP 10’. But further into the future, the very mode of regulating corporate governance – disclosure-based or prescription-based – may need to be subjected to review by law-makers and regulators. 40 There is a debate, particularly in the USA, where competition exists between states to adopt managementfriendly corporation law (so-called ‘chartermongering’), as to whether default terms in corporate law should be phrased as ‘opt out’ or ‘opt in’ provisions. The predominant view appears to be that ‘opt out’ provisions favour management as managers can block the necessary charter (constitutional) amendment to achieve opting out. See, for example, Lucian Bebchuk and Assuf Hamdani, ‘Optimal Defaults for Corporate Law Evolution’ (2002) 96 Northwestern University Law Review 489. 41 Roberta Romano, ‘The Sarbanes-Oxley Act and the Making of Quack Corporate Governance’ (2005) 115 Yale Law Journal; also available as Yale Law School Centre for Law, Economics and Public Policy, Research Paper No. 297, 205–6, available online at .

9 Auditors and audits Audited financial statements are an important part of the financial information that is available to the capital markets and an important part of effective corporate governance. Ian M Ramsay, Independence of Australian Company Auditors: Review of Current Australian Requirements and Proposals for Reform, Report to the Minister for Financial Services and Regulation, Canberra, Department of Treasury, October 2001 [4.01]

9.1 Introduction: The audit role and where it fits into corporate governance 9.1.1 Overview of the audit role Auditing is defined as an assurance service that objectively gathers evidence and communicates it to third parties.1 Companies that are required to prepare a financial report for a financial year must have their financial report audited and obtain an auditor’s report.2 Thus, all large proprietary companies and public companies must appoint an auditor. Small proprietary companies in normal circumstances are not required to prepare a financial report and hence need not appoint an auditor.3 However, they must do so in a limited range of circumstances, namely where shareholders holding at least 5 per cent of voting shares require preparation of accounts and ask for an auditor.4 Broadly, the function of an auditor is to conduct an audit on the financial affairs of the company and to ascertain whether the financial report provided by the company complies with relevant legal requirements and accounting principles, and gives a true and fair account in all material respects of the company’s financial affairs. The audit role has several objectives. The main one is to provide 1 C Jubb, S Topple, P Schelluch, L Rittenberg and B Schwieger, Assurance and Auditing: Concepts for a Changing Environment, Sydney, Thomson,(2nd edn, 2008), 4 of 681. 2 Section 301(1) Corporations Act 2001 (Cth). 3 On 4 December 2009, the Australian Government released the Draft Corporations Amendment Corporate Reporting Reform Bill 2010. Among other things, the Draft Bill proposed a three-tiered, differential reporting framework that exempts small companies limited by guarantee from reporting and auditing requirements (subject to the same current safeguard for small proprietary companies) and providing other companies limited by guarantee with streamlined assurance requirements (review rather than audit) and simplified disclosures in the directors’ report. 4 Section 293 of the Act.

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reasonable assurance that the financial information reported by the company is free from material misstatement. In the process, auditors provide a barrier of protection against careless or dishonest company officers. In order to fulfil this role, the auditor must have suitable skills and expertise, and must be independent of the company. The main auditing requirement is to provide an audit report to the members in the financial report for a financial year.5 This is laid before the annual general meeting and lodged with the Australian Securities and Investments Commission (ASIC).6 It is important to note that the auditor’s role is essentially procedural, not substantive in nature. More particularly, pursuant to sections 307 and 308 of the Corporations Act 2001 (Cth) (the Act), the auditor’s report to members must set out a number of matters in relation to the financial report for a financial year. These include: ● whether the financial report is in accordance with the Act, including compliance with accounting standards, and whether the report provides a true and fair view of the financial position and performance of the company7 ● if the auditor is of the opinion that the financial report does not comply with an accounting standard, the auditor’s report must, to the extent it is practicable to do so, quantify the effect that non-compliance has on the financial report. If it is not practicable to quantify the effect fully, the report must state why ● whether the auditor has been given all information and assistance for the conduct of the audit ● any defect or irregularity in the financial report ● whether the company has kept financial records sufficient to enable the conduct of the audit ● whether the company has kept other records required by the Act. The Act specifically states that if the auditor is of the opinion that the financial report does not comply with an accounting standard, the auditor’s report must indicate the effect that this has on the financial report. In addition to this, the auditor’s report must describe any defect or irregularity in the financial report and any other relevant deficiencies or shortcomings regarding the record keeping of the company.8 The auditor’s role does not extend to commenting or passing judgment on the soundness of the business and financial decisions of the directors and other officers.9 5 Disclosing entities may have their half-year financial report audited or reviewed (s 309 of the Act). A review provides limited rather than reasonable assurance. A review consists of making enquiries, primarily of persons responsible for financial and accounting matters, and applying analytical and other review procedures. A review may bring significant matters affecting the financial information to the assurance practitioner’s attention, but it does not provide all of the evidence that would be required in an audit. Refer to the Auditing Standard on Review Engagements, ASRE 2410 Review of a Financial Report Performed by the Independent Auditor of the Entity. 6 Sections 308, 317, 319 of the Act. Other audit report circumstances are detailed in R P Austin and I M Ramsay, Ford’s Principles of Corporations Law (14th edn, 2010) 663–4 para 10.470. 7 See also ss 296 and 297 of the Act. 8 Section 308 of the Act. 9 BGJ Holdings Pty Ltd v Touche Ross & Co (1987) 12 ACLR 481.

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9.1.2 The link between the audit role and corporate governance The audit role in the context of corporate governance needs some explanation, as the role is largely external to that of company decision makers. Auditors do not prepare company reports. Their role is one of ‘checking’, or verifying. In this respect, it has been noted that an auditor is ‘a watch dog, but not a bloodhound’.10 This audit function is, however, integral to the activities and affairs of a company. Although the audit role can be defined relatively easily, it is a role that at various junctures has been perceived not to have been fulfilled well. Indeed, doubts about audit quality in the context of high-profile corporate collapses led to CLERP 9 reforms of the audit function so far as it relates to public companies. The audit role is now regarded as being so central to the activities of a company that, despite the fact that it is in essence a monitoring role performed by parties outside the corporate structure, it is considered by some commentators to be a definitional and cardinal aspect of corporate governance. In looking at the nexus between external audit and corporate governance, the Report of the HIH Royal Commission (Owen Report) notes that: Auditors play a significant role in corporate governance. This is not surprising given the emphasis placed on integrity and on the need for financial reporting that is honest and that presents a balanced picture of the state of the company’s affairs. Again, I refer to the Cadbury report: The annual audit is one of the cornerstones of corporate governance . . . the audit provides an external and objective check on the way in which the financial statements have been prepared and presented, and it is an essential part of the checks and balances required. The question is not whether there should be an audit, but how to ensure its objectivity and effectiveness.

Irrespective of whether the audit function is viewed as being internal or external to corporate governance, there is no doubt that it is a crucial activity. This, too, is a point emphasised by Justice Owen in the HIH Report: The point of an audit is to provide independent assurance of the integrity of the way in which the company has reported. It follows that shareholders in particular have an interest in the proper functioning of the audit process as it provides them with comfort in making investment decisions. This element of assurance is of course also relevant to the directors themselves, so far as they rely on management in the preparation of the accounts as well as to others with an interest.11

Similar comments were made by Treasury in its Explanatory Memorandum outlining the CLERP 9 proposals: Audited financial statements are an important part of the financial information that is available to the capital markets and an essential element of effective corporate governance. Auditor independence is fundamental to the credibility and reliability of auditors’ reports and in turn independent audits perform an important function 10 See Lopes LJ in Re Kingston Cotton Mill (No 2) [1896] 2 Ch 270. For a more expansive view of the duty of an auditor, see, for example, Pacific Acceptance Corporation ν Forsyth (1970) 92 WN (NSW) 29. 11 Report of the HIH Royal Commission (Owen Report), The Failure of HIH Insurance – Volume I: A Corporate Collapse and its Lessons, Canberra, Commonwealth of Australia (2003), 162 para 7.2.

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in terms of capital market efficiency. There has been widespread concern about the efficacy of the audit function, including the independence of auditors, as a result of major corporate collapses in Australia and overseas, including HIH. Over recent years there have been a number of corporate collapses which have called into question the degree of independence of auditors. These cases have demonstrated that while a company’s actual financial position may have been poor, the financial statements and the audit report did not reflect the true condition of the company. This has impaired the ability of shareholders and the market more generally to adequately assess the financial health of their investment. Whilst the Global Financial Crisis (GFC) has not to date resulted in major criticisms of auditors,12 regulatory action against auditors is underway in connection with several corporate failures including ABC Learning, Babcock and Brown, Centro Properties and Allco Finance Group. Often there is a time lag between corporate collapses and actions against the auditing profession. For instance, the Westpoint collapse in 2006 resulted in ASIC banning three auditors for up to two years in August 2009.13 Similarly, ASIC accepted enforceable undertakings not to practice as registered auditors for 12 months from the auditors of the failed Estate Property Group in January 2010, some three and a half years after the lead auditor signed an unqualified audit opinion for the company’s financial report for the year ended June 30, 2006.14 It is also to be expected that here will be ramifications also for the auditors flowing from ASICs intended litigation against 8 directors and officers of Centro Properties Group (CNP) and Centro Retail Group (CER).15 ASIC alleges that the financial reports of the companies did not comply with the relevant accounting standards and regulations. In addition the contention is that the financial reports did not give a true and fair view of the financial position and performance of the entities because they failed to classify, or failed to correctly classify, a significant amount of interest-bearing liabilities of the relevant entities as current liabilities, as required by the relevant accounting standard, AASB 101 Presentation of Financial Statements.

9.2 CLERP 9 changes to audit role The role and regulation of auditors underwent significant changes following the CLERP 9 reforms. As noted by James McConvill: The CLERP 9 reform movement emerged principally due to an international debate on corporate governance, and the role and regulation of auditors more specifically, as a result of a concentrated period in 2001 and 2002 when a number of very large companies, in the United States (Enron and World.Com), and Australia (HIH Insurance, One.Tel principally, as well as Ansett and Pasminco) collapsed.16 12 For further detail, refer to the concluding chapter in K C Houghton, C Jubb, M Kend and J Ng, The Future of Audit: Towards a National Strategy in Keeping Markets Efficient (2009), ANU E-Press, available at . 13 S Washington, ‘Westpoint Collapse: ASIC Imposes Ban on Three Auditors’, The Sydney Morning Herald (18 August 2009), 21. 14 B Wilmont, ‘Auditors Under ASIC Review’, The Australian Financial Review (6 January 2010), 7. 15 See ASIC Media Release 09–202AD of 21 October 2009, ‘ASIC Commences Proceedings Against Current and Former Officers of Centro’, available at . 16 James McConvill, Introduction to CLERP 9, Chatswood, Lexis Nexis Buttterworths (2004) 1.

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In the Enron audit it was discovered that the accounting firm Arthur Andersen & Co (Andersen) had signed off on Enron’s financial reports, which had overstated the company’s earnings by US$586 million over five years, and had shredded a large volume of Enron’s documents. Although the finding in relation to shredding of documents subsequently was overturned, Andersen had already collapsed in March 2003. It was argued that Andersen’s negligence and dishonest practices were due to its dependence on fees that Enron had paid the firm for non-audit services, such as consultancy and legal services. Thus, the absence of ‘auditor independence’ was seen as a significant factor that had contributed towards the collapse of Enron. In Australia, the lack of independence of auditors was also rife. This was due in large part to the major accounting and audit firms establishing multidisciplinary practices (with consulting, legal and tax practices) in an attempt to offer a ‘onestop advisory shop’ for their clients, and maximise client fees. A study conducted in January 2002 by ASIC of Australia’s 100 largest companies revealed that a large majority of these companies retained their audit firms to provide non-audit services, and that non-audit fees accounted for nearly 50 per cent of the total fees paid to the audit firm.17 Given the circumstances leading to these high-profile collapses, the principal CLERP 9 audit reforms related to enhanced auditor oversight and independence. These included: 1. Introducing a general requirement for auditors to be independent under the Act. 2. Incorporating in the Act the best-practice position regarding the employment of auditors and the financial relationships between the audit firm and the firm’s clients to ensure independence. 3. Enhancing the disclosure requirement for non-audit services (for example, consulting, legal) performed by the audit firm (so that the type of service and the monetary amount paid is transparent). 4. Prohibiting audit firm partners who were directly involved in an audit from becoming directors of the audited client within two years of the auditor resigning from the audit firm. 5. Establishing an auditor independence ‘supervisory board’. It had been proposed initially that CLERP 9 introduce a requirement that all listed companies have an audit committee. This requirement was subsequently taken up by ASX, which introduced Listing Rule 1.13, effective 1 January 2003, mandating audit committees for only the top 500 companies on the basis of disproportionate cost for smaller companies. In the remainder of the chapter we analyse the audit role in so far as it relates to companies, and focus particularly on some of the above reforms. As noted in Chapter 8, the role and operation of auditors was drastically reformed by CLERP 17 See ASIC, ‘ASIC Announces Findings of Audit Independence Survey’ (Press Release 02/13, 16 January 2002), available to .

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9. For a detailed discussion of the background and effect of the changes, readers are referred to chapters 2, 3, 4 and 5 of McConvill’s An Introduction to CLERP 9.18

9.3 Auditor independence 9.3.1 Overview of rationale behind independence requirement A central aim of the CLERP 9 audit reforms was to ensure greater auditor independence. Prior to the CLERP 9 changes, the Act dealt with auditor independence in only a piecemeal fashion. The importance of auditor independence was underlined in the HIH Final Report, where Justice Owen stated: Auditor independence is a critical element going to the credibility and reliability of an auditor’s reports. Audited financial statements play a key role promoting the efficiency of capital markets and the independent auditor constitutes the principal external check on the integrity of financial statements. The Ramsay report recognised the following four functions of an independent audit in relation to capital market efficiency: • adding value to financial statements • adding value to the capital markets by enhancing the credibility of financial statements • enhancing the effectiveness of the capital markets in allocating valuable resources by improving the decisions of users of financial statements • assisting to lower the cost of capital to those using audited financial statements by reducing information risk.

In addition to the above functions noted in the Ramsay Report, an independent audit contributes to capital market efficiency by enhancing the consistency and comparability of reported financial information. It is widely accepted that the auditor must be, and be seen to be, free of any interest that is incompatible with objectivity. For an audit to fulfil its functions, there must be public confidence in the auditor. The responsibility of auditors to maintain independence in the carrying out of their function was stated by the United States Supreme Court: The independent public accountant performing this special function owes allegiance to the corporation’s creditors and stockholders, as well as the investing public. This public watchdog function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.19

In the absence of a competently and independently performed audit, there is increased risk to the efficiency of capital markets. There is a danger that the audit report will lure users into a false sense of security that there has been an independent scrutiny of the financial report when there has not.20 18 McConvill, above n 16 – much of the foregoing chapter is derived from these chapters. 19 United States ν Arthur Young, 465 US 805, 817–18 (1984). 20 Owen Report, above n 11, 163 para 7.2.1.

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It seems striking that an ‘independent’ auditor could, in relation to another aspect of its business, be ‘dependent’ upon the fees paid by the company being audited. Human nature dictates that an auditor is likely to be less impartial in assessing a corporation’s financial reporting, such that an unfavourable audit report may jeopardise substantial fees arising from provision of non-audit services. CLERP 9 attempted to address this issue by introducing a range of reforms, which aimed to improve both actual, and perceived, independence, and led to greater confidence in the credibility and reliability of audited financial statements – as noted in discussion of the Ramsay Report in Chapter 8, part 8.3.

9.3.2 General requirement for auditor independence The CLERP 9 amendment to include section 324CA of the Corporations Act established a general requirement for auditor independence. Section 324CA(1) applies to auditors21 and prohibits an individual auditor or audit company from engaging in ‘audit activity’22 in relation to an audited body at a particular time if: ● a ‘conflict of interest situation’ exists in relation to the audited body at that time ● the individual auditor or the audit company are aware that the conflict of interest situation exists ● the individual auditor or the audit company does not take all reasonable steps to ensure that the conflict of interest situation ceases to exist, as soon as possible after the relevant person (referred to in section 324CA(1)(b)) becomes aware that the conflict of interest situation exists.

9.3.3 Meaning of ‘conflict of interest situation’ The CLERP 9 amendment to section 324CD(1) provided that a ‘conflict of interest situation’ exists in relation to an audited body at a particular time, if circumstances exist at the time which: ● impair, or might impair, the ability of the auditor, or a professional member of the audit team, to exercise objective and impartial judgment in relation to the conduct of an audit of the audited body (section 324CD(1)(a)) ● would give a person, with full knowledge of the facts and circumstances, reasonable grounds for concern that the ability of the auditor, or a professional member of the audit team, to exercise objective and impartial judgment in relation to the conduct of an audit of the audited body is, or might be, impaired (section 324D(1)(b)). 21 A general independence requirement for members of audit firms and directors of audit companies, mirroring s 324CA, is contained in ss 324CB and 324CC of the Act, respectively. 22 See the definition of ‘engage in audit activity’ under s 9 of the Act.

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In determining whether a conflict of interest situation exists, section 324CD(2) goes on to provide that regard is to be had to circumstances arising from any relationship (that either exists, has existed, or is likely to exist) between: ● the individual auditor ● the audit firm or any current or former member of the firm ● the audit company, any current or former director of the audit company or any person currently or formerly involved in the management of the audit company and any of the following persons and bodies: – a company (including a person currently or formerly involved in the management of the company) – a disclosing entity (including a person currently or formerly involved in the management of the entity) – a registered scheme (including a person currently or formerly involved in the management of the responsible entity).

9.3.4 Disclosing and resolving conflicts Section 324A(1A) provides that if a ‘conflict of interest situation’ exists in relation to an audited body while an individual auditor or audit company is the auditor of that audited body, the individual auditor or audit company must notify ASIC in writing of the conflict of interest within seven days from the day they became aware of the conflict of interest. If the auditor or audit company does not then notify ASIC within 21 days subsequent to the notification (or such other period as ASIC determines) that the conflict has been removed, then the audit appointment will terminate pursuant to section 327B(2A) if the audit is of a public company.23

9.3.5 Specific independence requirements – minimising conflict of interest through employment and financial restrictions Prior to the CLERP 9 reforms, section 324 of the Act included a limited number of specific restrictions on auditors to ensure independence. There are now specific independence requirements applying to: ● individual auditors: section 324CE ● audit firms: section 324CF ● audit companies: section 324CG. For example, section 324CE(1) provides that an individual auditor must not engage in audit activity at a particular time if a ‘relevant relationship’ outlined in the table in section 324CH(1) (which applies to each of sections 324CE, 324CF 23 Section 324CA(2) of the Act deals with circumstances in which a ‘conflict of interest situation’ exists in relation to the audited body but the individual auditor, or the audit company, is not aware that the conflict of interest exists. An audit in such circumstances is prohibited where the individual auditor or audit company would have been aware of the existence of the conflict of interest situation if they had in place a quality control system reasonably capable of making them aware of such a conflict of interest. An individual auditor is not in breach of s 324CA(6) if they have reasonable grounds to believe that they have in place a quality control system providing reasonable assurance that the audit company and the company’s employees complied with the general independence requirements. A similar ‘quality control’ defence is provided for audit companies under s 324CA(5).

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and 324CG) applies at that time to a person or entity specified in the table in section 324CE(5). This means, as an example, that an individual auditor (subsection 324CE(1) – table item 1) cannot engage in ‘audit activity’ (as defined in section 9) if the individual is an officer of the audited body (subsection 324CH(1) – table item 1). There are separate but similar tables in the legislation outlining specific independence requirements for members of audit firms (see section 324CF) and authorised audit companies (see section 324CG). If a relevant item of the table in subsection 324CH(1) applies to a person or entity listed in the table of persons in any of sections 324CE, 324CF or 324CG, then the individual auditor, audit firm or audit company must notify ASIC of this specific conflict within seven days: see sections 324CE(1A), 324CF(1A), or 324CG(1A) (there is also a provision applying to directors of audit companies under section 324CG(5A)). If this initial notification is not followed up within 21 days (or in such other period as ASIC decides) by another notice to ASIC, indicating that the conflict of interest is removed, then pursuant to section 327B(2A) (individual auditors), 2B (audit firms) or 2C (audit companies), the audit appointment terminates.24 CLERP 9 also introduced a cooling off period concerning the involvement of auditors with firms they have audited. Under the Act, a person is prohibited from becoming an officer of an audited body for two years if the person: ● ceases to be a member of an audit firm or director of an audit company and was a professional member of the audit team25 engaged in an audit of the audited body (section 324CI) 26 of the auditor if the person was a ● ceases to be a professional employee ‘lead auditor’ or ‘review auditor’ for an audit of the audited body (section 324CJ). Under the Act, a ‘lead auditor’ is the registered company auditor who is primarily responsible to the audit firm or audit company that is conducting the audit. A ‘review auditor’ is the registered company auditor (if any) who is primarily responsible to the individual auditor, the audit firm, or audit company for reviewing the conduct of the audit (section 324AF). Additionally, CLERP 9 requires that a person who has been a member of an audit firm or director of an audit company cannot become an officer of an audited body if another person who is, or was, a member or director of the auditor at a time when the auditor undertook an audit of the audited body is also an officer of the audited body: section 324CK. 24 It should also be noted that similar to the general independence provisions discussed above, for each of ss 324CE, CF and CG there is a ‘quality control’ defence, so that the individual auditor, member of an audit firm or audit company is not taken to have contravened the relevant section if there are reasonable grounds to believe that a quality control system was in place to provide reasonable assurance that the auditor, firm or company was complying with its specific independence requirements. 25 Section 324AE of the Act defines ‘professional members of the audit team’ as any registered company auditor who participates in the conduct of the audit, any other person who in the course of doing so exercises professional judgment regarding the application of or compliance with accounting or auditing standards and legal requirements, and any other person who is in a position to directly influence the audit outcome. 26 Section 9 of the Act provides that a ‘professional employee’ of an auditor participates in the conduct of audits and in the course of doing so exercises professional judgment regarding the application or compliance with accounting or auditing standards or legal requirements.

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9.3.6 Auditor rotation Prior to the CLERP 9 changes, there was no legislative requirement for audit partner rotation. The requirement for audit partner rotation instead formed part of the self-regulatory Joint Code of Professional Conduct of the ICAA and CPAA27 (which recommended rotation after seven years). While these two professional bodies encompass most auditors, it was considered necessary to set this rotation requirement in legislation so that it applied to the entire auditing profession and was enforceable. The legislative framework for auditor rotation applies where either an individual auditor, an audit firm or authorised audit company has been appointed as auditor of a listed company or registered scheme. The provisions rely on the concept of an auditor having ‘played a significant role’, which is defined under section 9. Where an individual plays a significant role in the audit of a listed company for five successive financial years, the individual cannot play a significant role in the audit of that company for at least another two successive financial years: section 324DA. Section 324DA(2) goes on to provide that a person may not play a significant role as auditor for more than five out of any seven successive financial years. According to the Explanatory Memorandum to the CLERP 9 Bill: This approach recognises that auditors may not necessarily audit a body in consecutive years however the relationship between the auditor and the audited body can still give rise to a threat to independence.

This is also intended to prevent an auditor from avoiding the rotation obligation in section 324DA: . . . where an auditor plays a significant role for four successive years, resigns from the audit for only one year and then resumes a significant role for another four successive years.28

9.3.7 Disclosure of non-audit services The HIH Royal Commission Final Report noted that non-audit services by auditors to audited bodies raised two threats to audit independence: ● self-review threats – these situations arise when the auditor may need to review work performed either by the auditor or the auditor’s firm ● the sacrifice of audit integrity in order to procure more lucrative non-audit work. 27 These two professional bodies subsequently initiated a more independent body for the setting of ethical standards, the Accounting Professional Ethical Standards Board (APESB), and were later joined by a third professional body – the National Institute of Accountants (NIA). APES 110 Code of Ethics for Professional Accountants superseded the Joint Code of Professional Conduct. 28 There is a range of possible offences for breaching the rotation requirement: see ss 324DC, 324DD of the Act. It should be noted that pursuant to s 342A, ASIC has been given the power to extend the period before rotation of an auditor is required, if the general rotation requirements are considered too burdensome for a particular company.

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In response to this, following CLERP 9, the board of directors of a listed company must provide a statement in the company’s annual report identifying non-audit services29 that have been provided, and a declaration that the provision of these services does not compromise the auditor’s independence: see section 300(11B). Where the company has an audit committee, this statement must be made in accordance with advice provided by that committee: section 300(11D).

9.4 Auditors and the AGM A good way to look beyond the often superficial nature of audit reports is to ask questions of the auditors. Shareholders traditionally have had little meaningful opportunity to probe deeper into audit reports. Since the Company Law Review Act 1998 (Cth) came into effect, company shareholders have been entitled to ask questions of the auditor concerning the conduct of the audit and the contents of the audit report. However, this right was somewhat limited as it depended on shareholders actually attending the annual general meeting (AGM, which most do not), and on the company’s auditor attending the meeting. CLERP 9 introduced section 250PA, which allows a shareholder of a listed company to submit questions to the auditor about the contents of the audit report or the conduct of the audit. Importantly, section 250PA(5) allows auditors to ‘filter’ questions according to their relevance to the audit report or conduct of the audit. While the filtering exercise is the task of the auditor, the company can express its opinion to the auditor regarding the relevance of individual questions. Section 250PA(7) requires the company to make the list of questions provided by the auditor reasonably available to members attending the AGM. The list could be provided through distribution of printed copies to shareholders or by other means. Section 250RA of the Act requires auditors of a listed company to attend the company’s AGM at which the audit report is to be considered. Where the auditor is an individual auditor and is unable to attend the AGM, the auditor can instead be represented by a member of the audit team who is ‘suitably qualified’, and is in a position to answer questions regarding the audit: section 250RA(1)(b).30

9.5 Auditors’ duties Another change introduced by the CLERP 9 package of reforms involved expanding auditors’ reporting obligations to ASIC to include a much wider range of 29 The Act does not include a definition of ‘non-audit services’; however, it is intended that non-audit services will include any services that are provided by an auditor but not included in the terms of the audit engagement. 30 As auditors of listed companies are now required to attend company AGMs, s 1289(3) makes it clear that qualified privilege applies to answers to questions asked before or during a company AGM. Section 1289(4) of the Act also extends qualified privilege to a person representing the auditor at the AGM in cases where the auditor is not present.

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suspected or actual malfeasance. Section 311 requires individual auditors conducting an audit31 to notify ASIC in writing within 28 days after they become aware of any circumstances that: ● they have reasonable grounds to suspect what amounts to a contravention (either a significant contravention, or a contravention that the auditor believes has not been or will not be adequately dealt with by commenting on it in the auditor’s report or bringing it to the attention of the directors) of the Act ● amount to an attempt, in relation to the audit, by any person to unduly influence, coerce, manipulate or mislead a person involved in the conduct of the audit ● amount to an attempt, by any person, to otherwise interfere with the proper conduct of the audit: section 311(1). Section 311(4) provides that in determining whether a contravention of the Act is a ‘significant’ one, regard is to be had to: (a) the level of penalty provided for in relation to the contravention (b) the effect that the contravention has, or may have, on: (i) the overall financial position of the company, registered scheme or disclosing entity (ii) the adequacy of the information available about the overall financial position of the company, registered scheme or disclosing entity (iii) any other relevant matter. Section 311(7) defines ‘a person involved in the conduct of the audit’ to mean the auditor, the ‘lead auditor’32 for the audit, the ‘review auditor’33 for the audit, a professional member of the audit team34 for the audit or any other person involved in the conduct of the audit. Where an audit firm or audit company is conducting an audit, section 311(2) imposes an obligation equivalent to that under section 311(1) on the lead auditor. If there is a failure to comply with section 311(2), the lead auditor of either the firm or the company will have contravened the section: section 311(3). The audit company is also taken to have contravened section 311(2) if the lead auditor fails to adhere to their obligations. Section 601HG, which contains similar obligations for auditors of managed investment schemes, was amended to reflect the extended reporting obligations placed on auditors under section 311. CLERP 9 also amended section 990K(2) of the Act through the addition of a requirement that an auditor must give a report to ASIC in relation to any matter that, in the opinion of the auditor, constitutes an attempt to unduly influence, coerce, manipulate or mislead the auditor in the conduct of the audit: section 990K(2)(c).

31 32 33 34

Defined under s 9 of the Act to include a review of a half-year financial report. Defined under s 324AF of the Act. Ibid. Defined under s 324AE of the Act.

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9.6 Reducing the legal exposure of auditors 9.6.1 Overview of auditors’ liability Like all parties, professional or otherwise, auditors may be legally liable where they do not properly discharge their legal duties.35 This liability can arise in three main ways. First, the auditor is engaged to perform an audit pursuant to a contract (which is normally in writing) by a company. The auditor can be liable for breach of contract if the audit function is not performed adequately. Parties to a contract are always free to agree to any express terms in the contract; however, in relation to audit services, the implied duties of an auditor include an undertaking by the auditor to use reasonable skill and care in the conduct of the audit.36 As result of the operation of the ‘privity’ doctrine, only the company may sue the auditor for breach of contractual promise. Other potentially affected parties, such as shareholders, are not a party to the contract and hence have no standing to sue under the contract. Second, the law on negligence provides that the auditor will be liable to parties to whom they owe a duty of care, if they do not complete the audit to the standard required of a professional auditor and the other party suffers loss as a result of the negligent audit.37 To this end, it is noteworthy that existing case law has held that not only do auditors owe a duty of care to the company, but in some cases the duty may also extend to shareholders38 and potentially also to other third parties, such as financiers of the company, where the financiers made the auditors aware of the fact that the information received from the auditors will be used to determine whether or not finance should be provided to the audited person or entity.39 Finally, auditors can be held liable for breach of statutory duties. Where an auditor breaches duties imposed on the auditor by statute (such as section 311), the company may sue for damages for breach of this duty.40 In these circumstances, only the company may sue, given that the statutory duties are

35 For a detailed discussion regarding the legal liability of auditors, see Austin and Ramsay, above n 6, 666–8 paras 10.530–10.540. 36 Frankston & Hastings Corp ν Cohen (1960) 102 CLR 607. 37 For example, see Alexander ν Cambridge Credit Corp Ltd (1987) 9 NSWL 310; Northumberland Insurance Ltd (in liq) ν Alexander (1988) 13 ACLR 170. 38 Columbia Coffee & Tea Pty Ltd ν Churchill t/as Nelson Parkhill (1992) 29 NSWLR 141; Strategic Minerals Corp NL ν Basham (1996) 15 ACLC 1155; but cf Esanda Finance Corp Ltd ν Peat Marwick Hungerfords (1997) 188 CLR 241. 39 The circumstances in which an auditor could owe a duty of care to third parties was most recently examined by the High Court in Esanda Finance Corp Ltd ν Peat Marwick Hungerfords (1997) 188 CLR 241. In this case, it was held that an auditor did not have a duty of care to a financier of the company. The High Court, however, did not state that auditors could never be liable to third parties. McHugh J, at 285, stated that: ‘The position in Australia to date with respect to liability for pure economic loss caused by negligent misstatement is that, absent a statement to a particular person in response to a particular request for information or advice or an assumption of responsibility to the plaintiff for the statement, it will be difficult to establish the requisite duty of care unless there is an intention to induce the recipient of the information or advice, or a class to which the recipient belongs, to act or refrain from acting on it. Mere knowledge by a defendant that the information or advice will be communicated to the plaintiff is not enough.’ 40 AWA Ltd ν Daniels t/as Deloitte Haskins & Sells (No 2) (1992) 9 ACSR 983.

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enacted in order to protect the company.41 There are a range of other statutory actions that might also be available to a company. The main one is the misleading and deceptive conduct cause of action pursuant to s 52 of the Trade Practices Act 1974 (Cth). Often, the causes of action will be overlapping. Thus, it will be open to a company to pursue all of the causes of above action against an auditor who has not competently audited the company’s records. The manner in which damages are assessed will often differ. In relation to proceedings based in contract, the general rule is that damages are assessed on the basis of one’s ‘expectation loss’. This means that the successful party may recover the amount that is necessary to put it in the same position as if the audit was conducted properly. Damages in the tort of negligence are assessed on the basis of the amount that it takes to put the plaintiff in the position prior to the negligent conduct. The quantum of damages for breach of statutory duty is often similar to that for breach of contractual duty.42 As a result of the operation of normal contract – and, particularly, negligence principles – auditors potentially might be burdened with a legal liability beyond their level of fault. A moment of inattention in checking company records can result in an auditor failing to observe a significant problem or defect with a company’s finances. If the defect had been detected by the auditor this may have enabled the company to, say, stave off insolvency and thereby save many millions of dollars. In order to redress this issue, changes introduced as part of CLERP 9 reduced the potential liability of auditors. Two key changes that were introduced were (i) to enable audit firms to incorporate (so that liability is restricted to the auditor(s) actually responsible); and (ii) to introduce a system of ‘proportionate liability’ in relation to damages actions involving (but not limited to) auditors concerning economic loss or property damage stemming from misleading and deceptive conduct.

9.6.2 Registration of audit companies Prior to the CLERP 9 changes, only natural persons could be registered as an auditor under the Corporations Act 2001; companies could not be registered as auditors. Because of this, partnerships were the main business structure employed by auditing firms. The consequence of this, given that audit partners were subject to unlimited joint and several liability for professional default, was that all partners in an audit firm could be liable for losses caused by another partner in the firm, even if they had no involvement in the particular conduct causing loss. Giving audit firms the option to incorporate was considered to be the best way to overcome this liability issue. Section 1299A requires companies to apply to ASIC for registration as an ‘authorised audit company’. Section 1299B states that a company may only be 41 Ibid. 42 Ibid.

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registered as an authorised audit company if all of the following conditions are met: ● each of the directors of the company is a registered company auditor and is not disqualified from managing a corporation under Part 2D.6 ● each share in the company is held and beneficially owned by a person who is an individual or the legal representative of an individual ● a majority of the votes that may be cast at a general meeting of the company attach to shares in the company that are held and beneficially owned by individuals who are registered company auditors ● ASIC is satisfied that the company has adequate and appropriate professional indemnity insurance ● the company is not an externally administered body corporate.

9.6.3 Proportionate liability Prior to the CLERP 9 reforms, audit partners in firms were jointly and severally liable for professional default within the firm, thus exposing each partner to unlimited liability. Auditors had traditionally protected themselves from unlimited liability through professional indemnity insurance. However, as a result of the collapse of HIH, insurers in Australia adopted much tougher risk-selection protocols, which meant that many auditors found it extremely difficult to obtain adequate insurance, or were paying much higher premiums to get the level of professional indemnity insurance they wanted. As a consequence of this, many auditing firms reduced the scope of the audit and other services provided to their clients, in order to be able to obtain insurance, or obtain it at a reasonable rate. In response to these problems, the CLERP 9 legislation implemented a regime of ‘proportionate’ liability to all professional advisers, including auditors. The basic thrust of the provisions is that for claims not involving dishonesty or deliberate breaches, the liability of financial advisers would be commensurate with their degree of wrongdoing. Section 12GP(1) of the ASIC Act provides that Subdivision GA (‘Proportionate Liability for Misleading and Deceptive Conduct’) applies to a claim for damages if: 43 for eco● the claim is made under section 12GF (action for damages) nomic loss or damage to property caused by conduct that contravenes section 12DA (misleading or deceptive conduct in relation to financial services) ● the economic loss, or the damage to property, was not caused intentionally or fraudulently. 43 Section 12GF of the ASIC Act 2001 (‘Action for Damages’) was amended to complement the addition of Subdivision GA by adding a new subsection (1B), which provides that if a person makes a claim for damages under s 12GF(1) in relation to economic loss or property damage, caused by a defendant in contravention of s 12DA, and the claimant suffered loss or damage as a result of the claimant’s failure to take reasonable care, and the claimant suffered loss (economic loss or property damage) both as a result partly of the claimant’s own failure to take reasonable care, and as a result of the defendant’s action, which was neither intentional or fraudulent, the damages are to be reduced to the extent to which the court thinks just and equitable having regarding to the claimant’s share in the responsibility for the loss or damage.

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Section 12GP(3) goes on to provide a definition of ‘concurrent wrongdoer’. For the purposes of these provisions, a ‘concurrent wrongdoer’ is one of two or more persons whose acts or omissions, independently of each other or jointly, caused the damage or loss that is subject to the claim. Then section 12GP(4) provides that ‘apportionable claims’ are limited to those claims specified in subsection 12GP(1) above. Section 12GQ(1) provides that the liability of a concurrent wrongdoer in proceedings involving an apportionable claim (that is, a claim that fits within section 12GP(1)) is limited to an amount reflecting that person’s responsibility for the loss or damage in question. It also provides that the court may give judgment against the defendant for not more than that amount. As a matter of clarification, section 12GR(2) states that when a matter involves an apportionable claim and some other claim, then only the apportionable claim is to be determined in accordance with Subdivision GA. Existing law continues to apply to the non-apportionable claim (for example, involving wrongdoers who intended to cause or fraudulently caused the plaintiff’s loss or damage). Section 12GR(3) goes on to state that when apportioning responsibility between defendants: ● the court is to exclude that proportion of the loss attributable to a plaintiff’s contributory negligence under any relevant law ● the court may have regard to the comparative responsibility of any concurrent wrongdoer who is not a party to the proceedings. Section 12GR(4) provides that the section applies in proceedings involving an apportionable claim whether or not all concurrent wrongdoers are parties to the proceedings. Section 12GS states that when a defendant has reasonable grounds to believe that a particular person may be also be a concurrent wrongdoer in a claim, and fails to give the plaintiff written notice about the identity of the person as soon as practicable, the court may order the defendant to pay all or any of the costs that the plaintiff has incurred in the proceedings. A defendant against whom a judgment is given cannot be made to contribute to any damages or contribution recovered from another wrongdoer in respect of an apportionable claim and cannot be required to indemnify any such wrongdoer: section 12GT. Section 12GT of the ASIC Act states that a plaintiff is entitled to bring an action against a concurrent wrongdoer even though the plaintiff previously brought an action against another concurrent wrongdoer relating to the same damage or loss. Importantly, however, the plaintiff cannot recover damages if this would mean that the plaintiff receives compensation greater than the loss or damage actually sustained by the plaintiff. Section 12GV provides that certain matters are not affected by the changes. This means, in particular, that: ● a person may still be held vicariously liable for a proportion of any apportionable claim

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a partner may still be held severally liable with another partner for the proportion of an apportionable claim for which the other partner is liable ● any other statutory provisions imposing several liability will not be affected. Similar provisions to Subdivision GA of the ASIC Act outlined above have been introduced in the Corporations Act 2001 (Cth) and the Trade Practices Act 1974. ●

9.7 Qualification of auditors The audit role can only be fulfilled properly if auditors have high-level skills and expertise. Prior to the CLERP 9 reforms, the law required prospective auditors to have completed a three-year degree course in accountancy from an Australian university, or to have other qualifications and experience which, in the opinion of ASIC, was equivalent to such a degree. In addition to this, professional accounting bodies required completion of an advanced training course in auditing; however, this was not mandatory in order to become an auditor. CLERP 9 introduced minimum competency, standard-based practical experience for all auditors in order to enhance public confidence in auditors. The specific CLERP 9 amendments to the Corporations Act in this regard included: ● providing that the practical experience requirements for registration may be satisfied by completion of all the components of a competency standard in auditing44 ● revising the education requirements for registration to include completion of a specialist course in auditing45 ● making an auditor’s continued registration subject to compliance with any conditions that may be imposed by ASIC in accordance with the regulations (with new Corporations Regulations introduced to deal with this) ● replacing the requirement for auditors to lodge a triennial statement with a new requirement to lodge an annual statement46 ● revising the matters that may be referred to the Companies Auditors and Liquidators Disciplinary Board (CALDB) in light of the above.47

9.8 Uniform auditing standards CLERP 9 amended the Corporations Act to give auditing standards the force of law, a status long enjoyed by accounting standards. All registered company auditors, not just professional accounting members as had been the case 44 See ss 1280A and 1280(2)(b) of the Act. New Reg 9.2.01 sets out the practical experience that is prescribed for the purposes of subparagraph 1280(2)(b)(ii). Regulation 9.2.01 provides the applicant will have to have had at least 3000 hours work in auditing, including at least 750 hours spent supervising the audits of companies, during the five years immediately before the date of the application. The expression ‘work in auditing’ means work under the direction of a registered company auditor, which includes appraising the operations of companies and forming opinions on the matters specified in ss 307 (Audit), 308 (Auditor’s report on annual financial report) and 309 (Auditor’s report on half-year financial report) of the Act. 45 See ss 1280(2A), 1280(2B) of the Act. 46 Section 1287A of the Act. 47 Section 1292(1) of the Act.

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previously, are required to use auditing standards when performing auditing work to meet the requirements of the Act. Division 2A in Part 12 of the ASIC Act, inserted into the legislation under CLERP 9 provisions related to: 48 ● the interpretation of auditing standards 49 ● powers of the AUASB to make auditing standards ● requirements that the AUASB must comply with when making standards ● the giving of directions to the AUASB by the Financial Reporting Council (FRC, see below for more information on this body) and the Minister. Section 307A of the Corporations Act requires audits of a financial report for a financial year and audits or reviews of a financial report for a half-year period to be conducted in accordance with auditing standards. Sections 308 (Auditor’s report on annual financial report) and 309 (Auditor’s report on half-year financial report) have been amended to require auditors to include in their reports any statements or disclosures required by the auditing standards: see sections 308(3A) and 309(5A). The pre-CLERP 9 suite of auditing standards were deemed unenforceable due to their many implied obligations (for example, use of phrases such as ‘the auditor considers . . . ’) and ASIC agreed not to take action on force-of-law standards before 1 July 2006. By that date, all of the auditing standards relevant to statutory audits had been revised and rewritten to ensure enforceability.50

9.9 Audit oversight Prior to CLERP 9, there was little genuine oversight of the auditing profession. The oversight that existed was largely self-regulatory in nature, undertaken to a large part by the professional accounting bodies. This obviously carried a serious risk that professional bodies would champion the interests of their members rather than broader community interests, thereby potentially undermining the quality and independence of the audit process. Following CLERP 9, the role of the FRC, a statutory body created to oversee the accounting standard-setting process, was expanded to include responsibility for overseeing auditor-independence requirements and audit-standard setting. As part of this change in audit oversight, a reconstituted Auditing and Assurance Standards Board51 came under the auspices of the FRC, with an expanded, 48 See s 234A of the ASIC Act. 49 Section 336 of the Corporations Act provides AUASB with the authority to make auditing standards for the purposes of the Act. An auditing standard must be in writing and must not be inconsistent with the Corporations Act or the Corporations Regulations. See also s 1455. 50 Auditing standards are available at . 51 Sections 227A and 227B of the ASIC Act establish the AUASB as a statutory body, and set out its functions and powers. The AUASB has a number of important functions: these include the power to make an Australian auditing standard by issuing the text of an international standard with any minimum modification to ensure that the standard operates effectively, having regard to the existing Australian legislative framework and institutional regulatory arrangements. The AUASB, when performing its functions, must follow the broad strategic direction determined by the FRC under ss 225(2A)(c), 225(7), 234C. In relation to auditing standards, see also, especially, s 234D(3).

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more representative membership and government-appointed chairperson (to overcome criticisms of the body lacking independence). These arrangements bring together, under a single oversight body – the FRC – policy advice and oversight functions for the key elements of the financial reporting framework. It is assumed that having policy direction coming from a single overarching body will lead to better oversight, while at the same time protect the independence of the two technical boards within the structure. In order to allow it to fulfil its role, the FRC was given sweeping powers. Section 225 of the Australian Securities and Investments Commission Act 2001 (Cth) was amended to state that the FRC is formally responsible for overseeing both the AASB and the AUASB. The FRC’s functions in relation to auditor independence are set out in section 225(2B) of the ASIC Act. These include: ● monitoring and assessing the nature and overall adequacy of: – the systems and processes used by auditors to ensure compliance with auditor independence requirements – professional accounting bodies for planning and performing quality assurance reviews of audit work – the investigation and disciplinary procedures of the professional accounting bodies monitoring overall compliance by companies and other entities with audit● related disclosure requirements ● giving the Minister and professional accounting bodies reports and advice about the above matters ● promoting the teaching of professional and business ethics by the professional accounting bodies, universities and other tertiary institutions. Despite the FRC’s extensive role in ensuring auditor independence, enforcement of auditor-independence requirements is the responsibility of either ASIC or the professional accounting bodies (depending on whether the independence requirement is contained in the Corporations Act or in APES 110 Code of Ethics for Professional Accountants), rather than of the FRC. ASIC’s audit firm inspection powers were strengthened in 2007 with passage of the Australian Securities and Investments Commission Amendment (Audit Inspection) Act 2007 No. 1, 2007.52

9.10 Audit committees An effective audit committee, a committee of the board of directors, can play a critical role in financial reporting by overseeing and monitoring the management’s and the auditor’s participation in the financial reporting process. They can increase the credibility of the financial reporting process by monitoring 52 This Act followed release by Treasury on 30 September 2005 of a consultation paper entitled Audit Inspection Powers of the Australian Securities and Investments Commission. The proposals related to the ability of ASIC to cooperate with overseas audit regulators and to ASIC’s domestic audit-inspection powers.

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the opportunistic selection of financial accounting policies, and meeting regularly with internal and external auditors, at least occasionally in the absence of management. Originally proposed to be part of the CLERP 9 reforms was a requirement for all listed companies to establish an audit committee. However, ASX took charge of this proposal since it coincided with ASX taking charge of corporate governance best-practice recommendations, originally also proposed to be part of CLERP 9. ASX introduced a Listing Rule effective 1 January 2003, mandating audit committees for the top 500 companies. A subsequent review of ASX governance guidelines reduced the requirement for compliance with ASX Corporate Governance Guidelines (2003) on committee composition and other matters to only the top 300. Prior to this, although many listed companies had audit committees, their formation was entirely voluntary. Currently, ASX Listing Rule 12.7 requires that an entity included in the S&P All Ordinaries Index at the beginning of its financial year have an audit committee during that year. If an entity is in the top 300 of that Index, the composition, operation and responsibilities of the audit committee must comply with the relevant recommendations found in ASX Corporate Governance Principles and Recommendations (2007). For an audit committee to be effective and not merely a cosmetic construct, research has shown that it should be composed of independent or non-executive directors entirely, at least some of whom have financial expertise; should have issued an audit committee charter; and should meet frequently.53 Consistent with these findings, Recommendation 4.2 of ASX Corporate Governance Principles and Recommendations (2007) states that: ‘The audit committee should be structured so that it consists only of non-executive directors, consists of a majority of independent directors, is chaired by an independent chair, who is not chair of the board and has at least three members.’ In terms of expertise, the Commentary to this recommendation states that: ‘The audit committee should include members who are all financially literate (that is, be able to read and understand financial statements); at least one member should have relevant qualifications and experience (that is, should be a qualified accountant or other finance professional with experience of financial and accounting matters); and some members should have an understanding of the industry in which the entity operates.’ Recommendation 4.3 states that the audit committee should have a formal charter. The Commentary states that: ‘The charter should clearly set out the audit committee’s role and responsibilities, composition, structure and membership requirements and the procedures for inviting non-committee members to attend meetings. The audit committee should be given the necessary power and resources to meet its charter. This will include rights of access to management, rights to seek explanations and additional information and access to auditors, 53 For a review of this research see F T DeZoort, D R Hermanson, D Archambeault and S A Reed, ‘Audit Committee Effectiveness: A Synthesis of the Empirical Audit Committee Literature’,’ (2002) Journal of Accounting Literature 21 at 38–75.

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internal and external, without management present.’ In terms of responsibilities the Commentary states that: ‘The audit committee should review the integrity of the company’s financial reporting and oversee the independence of the external auditors.’ In terms of the frequency of meetings, the Commentary states that: ‘The audit committee should meet often enough to undertake its role effectively.’ One would expect that to be at least twice a year, in line with the formal reporting requirements for disclosing entities. Research has provided evidence consistent with increased financial reporting and/or audit quality in association with effective audit committees. For instance, reduced manipulation of accounting numbers,54 greater willingness to issue appropriately modified auditor’s reports,55 a lower incidence of fraudulent financial reporting and financial restatements,56 lower incidence of auditor switching and following an unfavourable auditor’s report,57 lower incidence of auditor resignation58 and a higher frequency of engagement of industry specialist auditors.59

9.11 Conclusion It will be clear from this chapter not only that auditors and audits are nowadays pivotal to corporate governance, but that the threshold of what is expected of auditors and audits has been raised considerably in recent times. There is now an expectation that auditors should be independent, that they should report breaches of the law and that if they do not do so, action will be taken against them – either by private suit or by the corporate regulator. The ultimate objective with the CLERP 9 reforms and the audit committee ASX Listing Rule change, as is the case with similar reforms in several other countries, is to ensure that financial statements better reflect the true financial position of corporations. This will enable investors to make sound investment decisions, based on the financial statements reflecting the true financial position of corporations. These reforms will not ensure that corporations do not collapse in future, but they should, it is hoped, ensure that the signs of a collapse are detected as early as possible. 54 A Klein, ‘Audit Committee, Board of Director Characteristics, and Earnings Management’ (2002), Journal of Accounting and Economics 33, 375–400. 55 J V Carcello and T L Neal, ‘Audit Committee Composition and Auditor Reporting’ (2000), Accounting Review 75 at 453–67. 56 L J Abbott, S Parker and GF Peters, ‘Audit Committee Characteristics and Restatements’ (2004), Auditing: A Journal of Practice and Theory 23 at 69–87. 57 J V Carcello and T L Neal, ‘Audit Committee Characteristics and Auditor Dismissal Following “New” Going Concern Reports’ (2003), The Accounting Review 78 at 95–117. 58 H Y Lee, V Mande and R Ortman, ‘The Effect of Audit Committee and Board of Director Independence on Auditor Resignation’ (2004), Auditing: A Journal of Practice and Theory 23 at 131–46. 59 Y M Chen, R Moroney and K Houghton, ‘Audit Committee Composition and the Use of An Industry Specialist Audit Firm’ (2005), Accounting and Finance 45 at 217–39.

10 Directors’ duties and liability Typically a director’s working (office) days were short and lunches long, collegial, and often alcohol fuelled. How things have changed. The mindset now is meant to be all numbers, regulation by law only, self-interest, ruthlessness, over-long hours, and mineral water and sandwiches at your desk. The levels of client service and comfort are now sufficient, but no more, to do the deal just within the law. Bob Garratt, Thin on Top, Nicholas Brealey Publishing, London (2003) 30

Those responsible for the stewardship of HIH ignored the warning signs at their own, the group’s and the public’s peril. The culture of apparent indifference or deliberate disregard on the part of those responsible for the well-being of the company set in train a series of events that culminated in a calamity of monumental proportions. Report of the HIH Royal Commission (Owen Report), Volume I, Department of the Treasury (2003), xiii–xiv

10.1 Introduction As a general rule, directors owe their duties to the company as a whole, not to individual shareholders.1 Historically, directors’ duties and liability were discussed under general law duties (duties at common law or in equity) and, more recently,2 were supplemented under statutory duties. Under general law duties, most courts and commentators usually draw a distinction between fiduciary duties and the duty to act with due care and diligence. The following duties are generally recognised as directors’ fiduciary duties: ● directors’ duty to act honestly and in the company’s best interests ● directors’ duty not to fetter discretion ● directors’ duty to avoid a conflict of interests ● directors’ duty to exercise powers for their proper purpose. These duties are considered to be strict duties at common law or in equity, and the courts have held on numerous occasions that directors can be in breach of these 1 Percival v Wright [1902] 2 Ch 421. For an example of recognised exception, see Brunninghausen v Glavanics (1999) 46 NSWLR 538. 2 For discussion on the rationale and development of directors’ statutory duties in Australia, see Jason Harris, Anil Hargovan and Janet Austin, ‘Shareholder Primacy Revisited: Does the Public Interest Have Any Role in Statutory Duties?’ (2008) 26 Company and Securities Law Journal 355.

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duties irrespective of the fact that they acted without fault, either in the form of negligence or intent. It has also been held that, as a general rule, the fact that directors acted in what they believed to be in the best interests of the company as a whole will not serve as a general defence for a breach of these duties. It also does not matter whether the company suffered any damages.3 As long as one of these duties are breached, several remedies are available to the company:4 it can claim back any profits the directors made as a result of the breach of their duties;5 it has, as a general rule,6 the option to avoid any transaction (including contracts) concluded in breach of any of these duties; or it can force directors to rectify what they had did in breach of any one of these duties.7 In contrast with the judicial approach to directors’ fiduciary duties, in the case of directors’ duty to act with due care and diligence the courts originally insisted that directors would only be in breach of this duty if they acted with gross negligence and only if the company suffered damages because the directors acted negligently.8 There are, however, some interesting recent decisions that illustrate that it is not easy to classify directors’ duty of care simply as a common law duty, an equitable duty, a fiduciary duty or a general duty of care as part of the tort of negligence.9 In addition, under the statutory duty of care, damages suffered by the company need not be proven, so long as there is a foreseeable risk or harm to the company.10 Directors’ duty of care and diligence was, for many years, considered to impose remarkably low standards on directors as the courts expected gross negligence11 as the yardstick for liability and judged a breach of these duties against subjective standards – ‘[a] director need not exhibit in the performance of his duties a greater degree of skill than may reasonably be expected from a person of his knowledge and experience’.12 The idea that the shareholders were ultimately responsible for the unwise appointments of directors led to the duty of care, skill and diligence being characterised as remarkably low.13 Historically, directors were viewed as country gentlemen and were not expected to realise the

3 Regal (Hastings) Ltd v Gulliver [1967] 2 AC 134; ASIC v Vizard (2005) 145 FCR 57. 4 For a useful discussion on the remedies available for breach of fiduciary duty, see Western Areas Exploration Pty Ltd v Streeter [No 3] (2009) 73 ACSR 494. 5 Regal (Hastings) Ltd v Gulliver [1967] 2 AC 134; Furs Ltd v Tomkies (1936) 54 CLR 583. 6 The exceptions were if the company affirmed the transaction with knowledge of its right to avoid it; innocent third parties would be prejudiced by the election to avoid the transaction; the company unduly delayed acting to exercise its right to avoid the transaction (a form of estoppel); or it became impossible for the parties’ rights to be restored to the position obtaining before (restitutio in integrum) the transaction was entered into. 7 In The Australian Metropolitan Life Assurance Co Ltd v Ure (1923) 33 CLR 199 at 215–16 and 220, a shareholder was unsuccessful in an action to force the directors to register a particular shareholder, as the court held that in this case they had used a power conferred upon them for a proper or permissible purpose. 8 ASIC v Rich [2009] NSWSC 1229 [7193]. 9 See in particular Daniels v Anderson 16 ACSR 607 at 652 et seq; and ASIC v Rich [2009] NSWSC 1229 [7193]. 10 ASIC v Rich [2009] NSWSC 1229 [7193]. 11 Lindley MR in Lagunas Nitrate Co v Lagunas Nitrate Syndicate Ltd [1899] 2 Ch 392, 435. 12 Re City Equitable Fire Insurance Co Ltd [1925] Ch 407. 13 For example, see Turquand v Marshall (1869) LR 4 Ch App 376.

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significance of certain information in the financial accountants14 or to be aware of the company’s affairs.15 This laidback approach to directors’ duties changed after the landmark decision in Daniels v Anderson,16 emphasising that the Australian courts are now prepared to expect high standards of care and diligence of directors, including non-executive directors.17 Nowadays, the statutory duties of directors in Australia are far more prominent than their duties at common law or in equity.18 Under contemporary law, the discussion of directors’ duties and liability can be adequately based on statutory provisions in the Australian Corporations Act 2001 (Cth) (the Act), notwithstanding the fact that most of the primary statutory duties imposed upon directors ‘have effect in addition to, and not in derogation of, any rule of law relating to the duty or liability of a person because of their office or employment in relation to a corporation’.19 In other words, directors’ statutory duties are most prominent irrespective of the fact that the legislature did not intend to codify directors’ duties at common law and in equity. We have adopted the approach of explaining directors’ duties and liability primarily by way of the statutory provisions. Not only are these provisions comprehensive, but in more recent times they form the basis of most of the litigation in this area due largely to the introduction of the civil penalty provisions since 1993 and the lower standard of proof (balance of probabilities) to establish breach of directors’ duties under the civil penalty provisions. The enforcement of directors’ duties is of particular importance. Enforcement of the civil penalty provisions, with reference to case studies (HIH Insurance Ltd, James Hardie Ltd and One.Tel Ltd), are discussed below. The first part of this chapter will demonstrate that enforcement by the Australian Securities and Investments Commission (ASIC) of civil penalty provisions has been most prominent in recent years. However, in Chapter 11 we will also touch upon the enforcement of directors’ duties by the corporation under the statutory derivative action (Part 2F.1A) and the rights of minority shareholders to apply for various 14 For example, see Re Denham and Co (1883) 25 CH D 752. 15 In Re Cardiff Savings Bank (Marquis of Bute’s case) [1892] 2 Ch 100, in dismissing a claim of negligence against the Marquis, who had become the president of the board of the bank at the age of 6 months and held that position for over 40 years (during which time he attended only one board meeting), the court said that the Marquis was entitled to rely on the bank’s managers to perform their duties properly and could not be liable for their neglect. 16 (1995) 13 ACLC 614. 17 For discussion on the development of the modern law in this area, see Anil Hargovan, ‘Corporate Law’s New Love: Section 232(4) and the Director’s Duty of Care’ (1994) Asia Pacific Law Review 20; Sally Sievers, ‘Farewell to the Sleeping Director – The Modern Judicial and Legislative Approach to Directors’ Duties of Care, Skill and Diligence – Further Developments’ (1993) 21 Australian Business Law Review 111; ‘Directors’ Duty of Care: What is the New Standard?’ (1997) 15 Company and Securities Law Journal 392; Julie Cassidy, ‘An Evaluation of Corporations Law s 232(4) and the Directors’ Duty of Care, Skill and Diligence’ (1995) 23 Australian Business Law Review 184. 18 This was not always the case. Prior to the insolvent trading cases in the late 1980s and early 1990s (such as Statewide Tobacco Services v Morley (1990) 2 ACSR 405; Commonwealth Bank of Australia v Friedrich (1991) 5 ACSR 115), which articulated higher standards of care, there was a dearth of reported cases on the directors’ statutory duty of care and diligence. See further, Anil Hargovan, ‘Corporate Law’s New Love: Section 232(4) and the Director’s Duty of Care’ (1994) Asia Pacific Law Review 20. 19 Section 185(a) of the Act.

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remedies in the case of unfairly prejudicial or unfairly discriminatory or oppressive conduct by the corporation or its directors (Part 2F.1). Finally, we will deal with injunctions under section 1324 of the Act, allowing ASIC or ‘a person whose interests have been affected’ by a contravention of the Act to stop such conduct and to obtain damages suffered because of such conduct.

10.2 Part 9.4B – civil penalty provisions or pecuniary penalty provisions 10.2.1 Overview As far as directors’ duties and liabilities are concerned, the Act is based on the premise that the most important duties of directors are listed under the ‘civil penalty provisions’.20 This basically means that if a breach of any of these provisions is proven, the court will make a declaration of contravention, which is then considered to be conclusive evidence of the following matters:21 ● the court that made the declaration ● the civil penalty provision that was contravened ● the person who contravened the provision ● the conduct that constituted the contravention ● if the contravention is of a corporation/scheme civil penalty provision – the corporation or registered scheme to which the conduct related. Once such an order of contravention is made, there are primarily three further orders that ASIC may seek: disqualification orders; pecuniary penalty orders (called civil penalties in the case of corporations/scheme); or compensation orders. The relevant corporation (or responsible entity of a registered scheme) may also apply for a compensation order,22 and the corporation/scheme is also entitled to intervene in any proceedings for a disqualification order or pecuniary penalty (which may only be initiated by ASIC) and is entitled to be heard on all matters other than whether the declaration or order should be made.23 It is important to emphasise that a declaration order must be made before a pecuniary penalty or disqualification order can be sought by ASIC. A declaration of contravention is not, however, a necessary prerequisite to a compensation order being sought. We have already dealt with disqualification orders, pecuniary penalty orders (called civil penalties in the case of corporations/scheme) and compensation orders in some detail in Chapter 7. 20 This is confirmed in para 5.3 of Part 1.5 (Small Business Guide) of the Act, listing most of the civil penalty provisions as ‘some of the most important duties’ of directors of proprietary companies. 21 Sections 1317F and 1317E(2) of the Act. 22 See s 1317(2) of the Act. 23 See s 1317(3) of the Act. In relation to ‘financial services civil penalty provisions’ (see s 1317E(1)(ja) to (jg)); any person who suffers damage in relation to a contravention, or alleged contravention, of such a provision can also apply for a compensation order (see s 1317(3A)).

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As far as pecuniary penalty orders are concerned, a court may order a person to pay the Commonwealth up to $200 000 as a pecuniary penalty or a civil penalty – except for so-called ‘financial services civil penalty provisions’ (including, for example, continuous disclosure, false trading, market manipulation and insider trading) – where the maximum penalty is $1 million following amendments under CLERP 9 – see section 1317G). It should be noted that civil penalty orders have nothing to do with orders to cover damages suffered by the company because of a breach of the civil penalty provisions. Civil penalties are statutory penalties paid to the Commonwealth simply for a breach of what are considered to be some of the most important provisions of the Act, namely the civil penalty provisions mentioned in section 1317E of the Act. The main aim of these socalled pecuniary penalty or civil penalty provisions is to highlight some of the core provisions relating to directors’ duties in the Act and to serve as a serious warning to all directors and officers not to contravene these provisions. This was explained as follows in ASIC v Adler:24 It is well established that the principal purpose of a pecuniary penalty is to act as a personal deterrent and a deterrent to the general public against a repetition of like conduct.25

10.2.2 The civil penalty provisions in particular 10.2.2.1 Section 180: Duty of care and diligence – civil obligation26 Directors’ duty of due care and diligence are captured in section 180 of the Act. This section provides that a director or other officer of a corporation must exercise their powers and discharge their duties with the degree of care and diligence that a reasonable person would exercise if they: (a) were a director or officer of a corporation in the corporation’s circumstances and (b) occupied the office held by, and had the same responsibilities within the corporation as, the director or officer. The fact that this duty is judged against objective standards (‘a reasonable person’) means that the standards of this duty have been raised considerably and is consistent with its common law counterpart established in Daniels v Anderson27 . No longer can directors escape a breach of this duty by relying on the fact that subjectively they lacked the knowledge or experience to take a certain decision. In other words, they would not be able to rely on the fact that in the performance of their duties they did not exhibit ‘a greater degree of skill than may reasonably 24 [2002] NSWSC 483 (30 May 2002), available at . 25 ASC v Donovan; Trade Practices Commission v CSR Limited [1991] ATPR 52–135 at 125. Compare George Gilligan, Helen Bird and Ian Ramsay, ‘Civil Penalties and the Enforcement of Directors’ Duties’ (1999) 22 University of New South Wales Law Journal 417, 438–9. 26 For a fuller discussion, see Jason Harris, Anil Hargovan and Michael Adams, Australian Corporate Law, Sydney, LexisNexis (2nd edn, 2009), Chapter 18. 27 (1995) 37 NSWLR 438.

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be expected from a person of [their] knowledge and experience’.28 In order to ensure consistency in the application of this duty, two provisos were included: that the duty of care and diligence be judged against the standards expected of directors or officers in corporations comparable to the corporation in which the accused director or officer held office; and that they occupied the office and had the same responsibilities within the corporation as directors in comparable corporations. The expression ‘same responsibilities’ in section 180(1)(b) requires a consideration of the work in fact undertaken by the relevant director or officer and requires a consideration of the whole of the position occupied. If a director or officer has dual roles as, for example, a company secretary and in-house counsel, both roles are to be taken into account.29 The courts adopt the following test to determine breach of section 180(1): In determining whether a director has exercised reasonable care and diligence one must ask what an ordinary person, with the knowledge and experience of the defendant might have expected to have done in the circumstances if he or she was acting on their own behalf.30

The precise degree or standard of care and diligence required is to be determined with reference to the particular circumstances of the company. These include a host of circumstances such as:31 ● the type of company ● the size and nature of the company’s business ● the composition of the board ● the director’s and officer’s position and responsibilities within the company ● the particular function the director or officer is performing ● the experience or skills of the particular director or officer ● the circumstances of the specific case. The application of section 180(1) to directors (executive and non-executive) and officers (company’s general counsel and chief financial officer (CFO)) is demonstrated in Part 10.3.3 below with reference to the decision in ASIC v Macdonald (No 11).32 The content of the directors’ duty of care, skill and diligence is also discussed in Part 10.3.4 below with reference to the collection of the contemporary case authorities and legal principles in ASIC v Rich.33 Business judgment rule There is, however, some protection for directors against a breach of duty of care claim in a safe-haven provision, called the ‘business judgment’ rule34 – ‘business 28 Re City Equitable Fire Insurance Co Ltd [1925] Ch 407. 29 ASIC v Macdonald (No 11) (2009) 256 ALR 199. 30 ASIC v Adler (2002) 41 ACSR 72. 31 ASIC v Maxwell (2006) 59 ACSR 373. 32 (2009) 256 ALR 199. 33 [2009] NSWSC 1229. 34 For discussion on the origins of the business judgment rule and its operation at common law, see Paul Redmond, ‘Safe Harbours or Sleepy Hollows: Does Australia Need a Statutory Business Judgment Rule? In

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judgment’ means any decision to take or not take action in respect of a matter relevant to the business operations of the corporation.35 It is assumed that directors and other officers acted with the required degree of care and diligence if, in exercising a business judgment, they meet four standards (section 180(2)): (a) they must have made the judgment in good faith for a proper purpose (b) they must not have had a material personal interest in the subject matter of the judgment (c) they must have informed themselves about the subject matter of the judgment to the extent they reasonably believed to be appropriate (d) they must have rationally believed that the judgment was in the best interests of the corporation. As far as the last requirement is concerned, it is provided that the director’s or officer’s belief that the judgment is in the best interests of the corporation is a rational one unless the belief is one that no reasonable person in their position would hold. It should be noted that this provides considerable protection to directors as the requirement is not the ordinary objective requirement that ‘a reasonable person in their position will hold’, but that ‘no reasonable person in their position will hold’. This ensures that only in extreme circumstances, where they blindly believed something that ‘no other person in their position’ would believe, will a court withhold the protection of the business judgment rule based on the fact that it was not a rational belief that their business judgment was in the best interest of the corporation. The operation of the business judgment rule is discussed further in Part 10.3.4 below with reference to its application in ASIC v Adler36 and to the judicial views on its meaning expressed by Austin J in ASIC v Rich37 – see Part 10.3.4 below. It is of considerable importance to note that the business judgment rule will only provide protection to directors when the courts must consider whether they acted with the required care and diligence. It does not operate in relation to duties under any other provision of the Act; for example, the duty to act in good faith (section 181); the duty not to use their position to gain personally or cause detriment to the corporation (section 182); the duty not to use information to gain personally or cause detriment to the corporation (section 183); or the duty to prevent insolvent trading (section 588G). To illustrate this with an example: directors will still be liable under the insolvent trading provision (section 588G) if they incurred a debt when the company was insolvent or if there were reasonable grounds to suspect that the company was insolvent, irrespective of the fact that they based that decision on what could be considered to be a sound business judgment under section 180(2) of the Act. They may well be protected under section 180(2), but since that protection applies only to their duty of care and diligence, the protection will not be extended to the insolvent trading provisions as the law stands at I Ramsay (ed.), Corporate Governance and the Duties of Company Directors, Melbourne, Melbourne University Centre for Corporate Law and Securities Regulation (1997). 35 Section 180(3) of the Act. 36 [2002] 41 ACSR 72. 37 [2009] NSWSC 1229.

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the time of writing. The Australian Government in January 2010 has, however released a set of possible options for law reform that includes the prospect of a business judgment rule as a safe harbour from directors’ personal liability for insolvent trading (see further, Treasury, Insolvent Trading: A Safe Harbour for Reorganisation Attempts Outside of External Administration). Meanwhile, the director will have to rely on the statutory defences to insolvent trading contained in section 588(H), which is discussed in Part 10.2.2.7 below. Delegation and reliance The ability to delegate responsibilities and rely on subordinates to carry out a task is an essential part of effective management. The general law (ASIC v Adler (2002) 41 ACSR 72) and sections 198D and 189 of the Act permit directors to delegate powers and to reasonably rely on others for information or advice. In order to obtain the benefit of the reliance defence, the director’s reliance on others must be reasonable, which is to be determined on the facts of each case. Justice Santow, in ASIC v Adler,38 collated the judicial authorities on this issue and offered the following general legal principles in determining reasonableness: ● The function that has been delegated is such that it is proper to leave it to the delegate. ● The extent to which the director is put on enquiry, or given the facts of a case, should have been put on enquiry. ● The relationship between the director and the delegate must be such that the director honestly holds the belief that the delegate is trustworthy, competent and someone upon whom reliance can be placed. Knowledge that the delegate is dishonest and incompetent will make reliance unreasonable. ● The risk involved in the transaction and the nature of the transaction. ● The extent of steps taken by the director; for example, inquiries made or other circumstances engendering trust. ● Whether the position of the director is executive or non-executive (although, as noted by Justice Santow, the majority judges in Daniels v Anderson (1995) 37 NSWLR 438 moved away from this distinction). The reliance defence is unavailable when management specifically brings a matter before the board for attention and the task for consideration is not an onerous one, as illustrated in ASIC v Macdonald (No 11),which is discussed further in Part 10.3.3 below. 10.2.2.2 Section 181: Duty of good faith – civil obligation39 A director or other officer of a corporation is also expected to exercise their powers and discharge their duties: (a) in good faith in the best interests of the corporation and (b) for a proper purpose. 38 (2002) 41 ACSR 72. 39 For a fuller discussion, see Harris, Hargovan and Adams, above n 26, Chapter 16.

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This duty is a slight extension of the fiduciary duty of directors that they must always act bona fide in the best interests of the corporation. The part that has been added is that they must also act for a ‘proper purpose’. This part was included because of several court cases in which it was held that if directors based their decisions primarily or substantially within the purpose for which a particular power was conferred upon them, a court would not set such decisions aside irrespective of the fact that partially or incidentally the power might have been exercised for an improper or impermissible purpose. On the other hand, if the decision was primarily or substantially taken for an improper or impermissible purpose (for example, issuing shares with a view to defending a hostile takeover of the company), a court will set such a decision aside irrespective of the fact that partially or incidentally the power might have been exercised for a proper purpose. Once the court has determined that primarily or substantially the power was misused, it will not help the directors to allege that they had not gained personally, that the company had benefited from the conduct or that they had acted honestly – the conduct of the directors under attack will then be set aside because of the breach of their strict fiduciary duty to exercise their powers for the purpose for which the power was conferred upon them.40 10.2.2.3 Sections 182 and 183: Duty not to use position or information to gain personally or cause detriment to the corporation41 These two duties are discussed together because they deal with basically the same situation. They cover typical conflict of interests situations. Because directors occupy a unique position and have access to lots of information about the corporation’s business, they may not use their position or the information they obtain as directors to gain personally; or to gain an advantage for someone else; or use their position or the information they obtain as directors to the detriment of the corporation. This duty will also cover situations in which directors use a corporate opportunity to make a secret profit or to allow someone else to gain from a corporate opportunity. It originates from the strict fiduciary duty on directors to act in the best interests of the corporation and to prevent a conflict between their duty to the corporation and their own self-interest. In the High Court decision of Hospital Products Ltd v United States Surgical Corporation,42 Dawson J described a fiduciary duty in the following terms: Inherent in the nature of the fiduciary relationship itself is a position of disadvantage or vulnerability on the part of one of the parties which causes him to place reliance upon the other and requires the protection of equity acting upon the conscience of that other. From that springs the requirement that a person under a fiduciary obligation shall not put himself in a position where his interest and duty conflict or, if conflict is unavoidable, shall resolve it in favour of duty and shall not, except by special arrangement, make a profit out of his position. (emphasis added) 40 See Jean J du Plessis, ‘Directors’ Duty to Use their Powers for Proper or Permissible Purposes’ (2004) 16 South African Mercantile Law Journal 308, 320. 41 For a fuller discussion, see Harris, Hargovan and Adams, above n 26, Chapter 17. 42 (1984) 55 ALR 417 at 488.

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The following rationale for the no-conflict rule and its codification was offered by Justice Finkelstein in ASIC v Vizard:43 [Sections 182 and 183] bear the stamp of ‘regulatory offences’. On a daily basis, a director of a large public company will come across information that is not available to the public or even to the company’s shareholders. According to the common law a director is denied the ability to use such information for his or her own purposes. It does not matter that the director’s action causes no harm to the company or does not rob it of an opportunity which it might have exercised for its own advantage: Regal (Hastings) Ltd v Gulliver [1942] UKHL 1; [1967] 2 AC 134. This rule admits of few exceptions. Parliament realised that the common law was too often ignored. The temptation to make an improper profit was too great. So Parliament decided to act. The Companies Acts were amended to create an offence if a director misused information obtained by reason of his fiduciary position. It is in this sense that the sections are regulatory in character, directed to avoiding the potential harmful consequences of a particular type of conduct. [Section 183 has] another equally important purpose. [It] seek[s] to establish a norm of behaviour that is necessary for the proper conduct of commercial life and so that people will have confidence that the running of the marketplace is in safe hands. For this reason a contravention of . . . s 183 carries with it a significant degree of moral blameworthiness. There is moral blameworthiness because a contravention involves a serious breach of trust.

It should be noted that the duties in sections 182 and 183 also apply to the company’s employees. 10.2.2.4 Part 2E: Duty relating to related party transactions Part 2E stems from the recommendations made by the Companies and Securities Advisory Committee (CSAC) in its Report on Reform of the Law Governing Corporate Financial Transactions in 1991. The Committee’s draft legislation was intended to introduce ‘detailed procedures to monitor and control those matters which [are] otherwise vulnerable to abuse by corporate controllers’, including loans to directors, inter-corporate loans, asset transfers and excessive remuneration.44 The underlying principle introduced by the legislation was that financial benefits given to persons who are in a position to significantly influence the decision to give the benefit should be subject to shareholder approval unless they are on commercial terms. The legislation is based on the notion that ‘uncommercial’ transactions with related parties should be referred to disinterested shareholders before the transactions take place. These sentiments are currently echoed in Section 207, which states the object of Part 2E as being to protect the interests of a public company’s members as a whole, by requiring member approval for giving financial benefits to related parties that could endanger those interests. 43 (2005) 145 FCR 57 at [28]–[29]. 44 CSAC, Report on Reform of the Law Governing Corporate Financial Transaction, Canberra, The Committee (1991) 11–12.

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Part 2E prohibits a company from giving a financial benefit to a related party of the company, unless:45 (a) the giving of the financial benefit falls within one of several exceptions to the provision or (b) prior approval is obtained from shareholders to the giving of the financial benefit. For the purposes of Part 2E, each director of a public company is considered to be a related party of the public company. ‘Financial benefit’ is given a very wide meaning. In order to determine whether a transaction is a ‘financial benefit’, the economic and commercial substance of the transaction will be considered, and it is as a general rule irrelevant whether the related party delivered services or paid something (consideration given) to receive the financial benefit. ‘Giving a financial benefit’ includes things like making an informal agreement, oral agreement or agreement that has no binding force. It can be considered to be giving a financial benefit even if it does not involve paying money, but only conferring a financial advantage on the related party. The following examples are given of financial benefits:46 (a) giving or providing the related party finance or property (b) buying an asset from or selling an asset to the related party (c) leasing an asset from or to the related party (d) supplying services to or receiving services from the related party (e) issuing securities or granting an option to the related party (f) taking up or releasing an obligation of the related party. Two of the main exceptions, where members’ approval is not required when a financial benefit is given to a related party, are arm’s-length transactions47 and reasonable remuneration and reimbursement of expenses incurred by directors and other officers.48 The civil penalty provisions will be contravened if a financial benefit is given to a related party without prior approval of the general meeting or without it falling under one of the statutory exceptions.49 The operation of these provisions is illustrated below in Part 10.3.2 with reference to the decision in ASIC v Adler.50 10.2.2.5 Part 2H: Duty relating to share capital transactions Part 2H covers several prohibitions regarding share capital transactions. For instance, a corporation may reduce its share capital only if it is permitted or if it complies with the specific provisions for such a reduction in the Act.51 A corporation may only acquire its own shares under the limited circumstances provided for in the Act.52 Furthermore, a corporation may only give financial assistance to 45 46 47 48 49 50 51 52

Sections 208–29 of the Act. S 229 of the Act. S 210 of the Act. S 211 of the Act. S 1317(1)(b) of the Act. (2002) 41 ACSR 72. Section 256B of the Act. Sections 259A and 259B of the Act.

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a person to acquire shares in that corporation under the limited circumstances provided for in the Act.53 All the prohibitions are listed as civil penalty provisions, and will expose the directors or officers of corporations contravening these provisions to any of the orders described above.54 10.2.2.6 Part 2M.2 and 2M.3: Duty relating to requirements for financial reports Part 2M.2 and 2M.3 contain detailed provisions regarding keeping of financial records, financial reporting and directors’ reports. As part of the CLERP 9 amendments (2004), discussed in greater detail in Chapter 8 of this book, several of these provisions were refined, and new obligations added to ensure that sound financial and other information is available to the public regarding the corporation’s financial performance and financial practices. These provisions require directors to take all reasonable steps to comply with or to secure compliance with Part 2M.2 and 2M.3. This is quite an important civil penalty provision, especially in light of the corporate collapses in Australia between 2000 and 2003.55 10.2.2.7 Part 5.7B: Duty to prevent insolvent trading56 Section 588G of the Act imposes a positive duty on directors to prevent insolvent trading by the corporation. The statutory purpose of this section was recently considered by the New South Wales Court of Appeal in Edwards v ASIC:57 [It] is to discourage and provide a remedy for a particular type of commercial dishonesty or irresponsibility . . . [which] occurs when a company that is at or approaching insolvency obtains a loan, or obtains property or services on credit, and either there is a director who knows or suspects the insolvency or approaching insolvency, or a reasonable person in the director’s position would know or suspect it. In that situation, any director . . . can be made personally liable . . . The section aims to encourage directors to carry out their duties properly if the company is at or approaching insolvency, and provides a sanction if they do not.

This section applies to a person who is a director of a company at the time when the company incurs a debt; and the company is insolvent at that time, or becomes insolvent by incurring that debt, or by incurring at that time debts including that debt; and at that time, there are reasonable grounds for suspecting that the company is insolvent, or would so become insolvent, as the case may be.58 It is important to note that the extended definition of director under section 9 of the Act discussed earlier in Chapter 4, which includes de facto and shadow directors, applies to this provision. 53 Section 260A of the Act. 54 Section 1317(1)(c) of the Act. 55 The duty relating to the requirements for financial reports is made a civil penalty under ss 344(1) and 1317E(1)(d) of the Act. 56 For a fuller discussion, see Harris, Hargovan and Adams, above n 26, Chapter 19. 57 [2009] NSWCA 424 at [3] per Cambell JA. 58 For a list of relevant factors that may be used to determine whether there are reasonable grounds to suspect insolvency, see ASIC v Plymin (2003) 46 ACSR 126; Re Damilock Pty Ltd (In Liq); Lewis and Carter as Liquidators of Damilock Pty Ltd (In Liq) v VI SA Australia Pty Ltd (2009) 252 ALR 533.

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Section 95A of the Act provides that a company is insolvent if, and only if, the company is unable to pay all the company’s debts, as and when they become due and payable. A temporary lack of liquidity does not mean there is insolvency.59 The practical difficulties in assessing insolvent trading, and some of the indicia of insolvency, is recognised by Justice Palmer in the following passage in Hall v Poolman:60 The law recognises that there is sometimes no clear dividing line between solvency and insolvency from the perspective of the directors of a trading company which is in difficulties. There is a difference between temporary illiquidity and ‘an endemic shortage of working capital whereby liquidity can only restored by a successful outcome of business ventures in which the existing working capital has been deployed’ . . . The first is an embarrassment, the second is a disaster. It is easy enough to tell the difference in hindsight, when the company has either weathered the storm or foundered with all hands; sometimes it is not so easy when the company is still contending with the waves. Lack of liquidity is not conclusive of insolvency, neither is availability of assets conclusive of solvency. (emphasis added)

Section 588E of the Act assists in proving insolvency under section 588G by allowing for the following rebuttable presumptions to be made: ● Continuing insolvency – if it can be proved that a company was insolvent at a particular time during the 12 months ending on the ‘relation-back day’ (as defined in section 9 of the Act as the date of filing the application for a compulsory winding up), it is presumed that the company remained insolvent thereafter ● Absence of accounting records – if the company has contravened either section 286(1) or (2) by failing to keep or retain adequate financial records for seven years (except for a minor or technical breach), it is presumed that the company is insolvent during the period of contravention. The Act does not contain a definition of ‘debt’. What, then, is a debt for purposes of the insolvent trading provisions? Section 588G captures trading debts61 (including contingent debts such as guarantees)62 and a range of ‘deemed debts’ under section 588G(1A) linked to certain share capital transactions undertaken by the company. For example, when the directors make a decision to pay dividends, the debt so incurred will be considered to be when the dividend is paid or, if the company has a constitution that provides for the declaration of dividends, when the dividend is declared. Another example is that when directors incur a debt by providing financial assistance to a person, within the circumstances permitted for such assistance (see discussion above), the debt will be considered 59 Sandell v Porter (1966) 115 CLR 666. The authorities in relation to determining whether a company is insolvent are exhaustively analysed by Mandie J in ASIC v Plymin (2003) 46 ACSR 126 at [370]-[380]. 60 (2007) 65 ACSR 123 [at 266]. 61 For consideration of the question ‘when does a company incur a debt?’, see collection of authorities discussed in Playspace Playground Pty Ltd v Osborn [2009] FCA 1486; Edwards v ASIC [2009] NSWCA 424 held that quantum meruit liabilities are debts for purposes of s 558G. 62 Hawkins v Bank of China (1992) 7 ACSR 349.

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to be incurred when the agreement to provide the assistance is entered into or, if there is no agreement, when the assistance is provided. It is by failing to prevent the company from incurring the debt that the person contravenes this civil penalty provision. There are certain further requirements for a contravention, namely that: (a) the person was aware at that time that there were grounds for suspecting that the debt would render the company insolvent or (b) a reasonable person in a like position in a company in the company’s circumstances would be so aware. Directors need to be vigilant about this duty as it has the potential to make them liable for huge amounts.63 A non-executive, honorary, director of a company limited by guarantee in Commonwealth Bank of Australia v Friedrich64 was found personally liable (under the predecessor provisions to section 588G) for a substantial corporate debt of $97 million owed to the bank. Apart from civil liability, where insolvent trading is accompanied with a dishonest intent, there is a separate criminal offence that may result in a fine and/or imprisonment (up to five years). Section 588H contains a number of defences to insolvent trading and a director is entitled to rely on any one or more of the following statutory defences. Reasonable expectation of solvency (s 588H(2))65 The courts require evidence greater than a mere hope or possibility that the company will be solvent. In explaining the concept of ‘expectation’, Austin J in Tourprint International Pty Ltd v Bott (1999) 32 ACSR 201 at para. 67 held: Expectation . . . means a higher degree of certainty than ‘mere hope or possibility’ or ‘suspecting’ . . . The defence requires an actual expectation that the company was and would continue to be solvent, and that the grounds for so expecting are reasonable. A director cannot rely on complete ignorance of or neglect of duty . . . and cannot hide behind ignorance of the company’s affairs which is of their own making of, if not . . . has been contributed to by their own failure to make further necessary inquiries.

Palmer J in Hall v Poolman66 offers guidance on the approach required to discharge the defence in section 588H(2): There comes a point where the reasonable director must inform himself or herself as fully as possible of all relevant facts and then ask himself or herself and the other directors: ‘How sure are we that this asset can be turned into cash to pay all our debts, present and to be incurred, within three months? Is that outcome certain, probable, more likely than not, possible, possible with a bit of luck, possible with a lot of luck, remote, or is there is no real way of knowing?’ If the honest and reasonable answer is 63 Insolvent trading is made a civil penalty under ss 588G(2) and 1317E(1)(e) of the Act. 64 (1991) 5 ACSR 115. 65 For case examples on the operation of this defence, see Statewide Tobacco Services v Morley (1990) 2 ACSR 405; Metropolitan Fire Systems v Miller (1997) 23 ACSR 699; Tourprint International Pty Ltd v Bott (1999) 32 ACSR 201; Hall v Poolman (2007) 65 ACSR 123; McLellan (in the matter of The Stake Man Pty Ltd) v Carroll [2009] FCA 1415. 66 Hall v Poolman (2007) 65 ACSR 123 [at 269].

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‘certain’ or ‘probable’, the director can have a reasonable expectation of solvency. If the honest and reasonable answer is anywhere from ‘possible’ to “no way of knowing”, the director can have no reasonable expectation of solvency.

Reasonable reliance on others providing the information on the solvency of the company (s 588H(3))67 Directors will not be able to rely on section 588H(3) where they are put on enquiry as to whether the delegate was fulfilling their responsibilities and they do not make enquiries and receive reasonable assurances that the duties are being performed.68 Distrust of the person relied upon for financial information will also negate the defence.69 Illness or some other good reason resulting in absence from management (s 588H(4))70 The law’s intolerance of ‘sleeping, or passive, directors or a director who is absent from management because of their total reliance on their spousal director due to their love and faith is captured in the following passage by Chief Justice Spigelman in DCT v Clarke:71 Sections 588G and 588H was based on the assumption that a director would participate in the management of the company. This assumption strongly suggests that a total failure to participate, for whatever reason, should not be regarded as a ‘good reason’ for failing to participate at a particular time . . . it is a basal structural feature of corporations legislation in Australia that directors are expected to participate in the management of the corporation.

Reasonable steps to prevent the company from incurring any debts (s 588H(5)) This defence may be established if the director has acted swiftly in their decision to appoint a voluntary administration to take over the management of the company: section 588H(6). If the director is unable to persuade the board to pass a written resolution to appoint a voluntary administrator, the director should either seek to wind up the company or resign to protect themselves from personal liability.72 10.2.2.8 Part 5C: Duties relating to managed investment schemes Part 5C of the Act contains provisions regarding the registration of a managed investment scheme; the corporate form it must use; its constitution; and how it must be administered. This part contains several duties for directors of these managed investment schemes. There is also a special requirement that if less 67 For case examples on the operation of this defence, see Manpac Industries Pty Ltd v Ceccattini (2002) 20 ACLC 1304; Williams v Scholz [2007] QSC 266; McLellan (in the matter of The Stake Man Pty Ltd) v Carroll [2009] FCA 1415. See further, Anil Hargovan, ‘Relevance of Directors’ Unsecured Borrowings, Guarantees and Honesty in Determining Liability for Insolvent Trading’ (2009) 17 Insolvency Law Journal 36. 68 ASIC v Plymin (No 1) (2003) 175 FLR 124; affirmed Elliot v ASIC (2004) 48 ACSR 621. 69 Williams v Scholz [2007] QSC 266; affirmed [2008] QCA 94. 70 For case examples on the operation of this defence, see DCT v Clarke (2003) 57 NSWLR 113; Williams v Scholz [2007] QSC 266. 71 [2003] NSWCA 91 at paras. 114 and 116. 72 Statewide Tobacco Services Ltd v Morley (1990) 2 ACSR 405; affirmed [1993] 1 VR 423.

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than half of the directors of the responsible entity (a public company) are external directors, the responsible entity must establish a compliance committee.73 Section 601 imposes duties, similar to the duties on directors, on the members of the compliance committee, who are expected: (a) to act honestly and (b) to exercise the degree of care and diligence that a reasonable person would exercise if they were in the member’s position and (c) not to make use of information acquired through being a member of the committee in order to: i. gain an improper advantage for the member or another person or ii. cause detriment to the members of the scheme and (d) not make improper use of their position as a member of the committee to gain, directly or indirectly, an advantage for themselves or for any other person or to cause detriment to the members of the scheme. A breach of any of these duties will expose the members of the compliance committee or the directors to any of the orders a court may make under the civil penalty provisions.74 10.2.2.9 Chapter 6CA: Duty relating to continuous disclosure We have already dealt with the introduction of the continuous disclosure provisions: in Chapter 8 as part of the CLERP 9 amendments to the Act and when discussing the Australian Securities Exchange (ASX) Best Practice Recommendations and the recommendation that listed companies have in place a ‘trading policy’ to ensure compliance with their continuous disclosure obligations. Suffice here to point out that non-compliance with the continuous disclosure provisions is considered to be a contravention of a ‘financial services civil penalty provision’, in which a higher maximum penalty applies (as mentioned above).75 10.2.2.10 Part 7.10: Duty not to be involved in market misconduct and other prohibited conduct relating to financial products and financial services Market manipulation A person must not take part in, or carry out (whether directly or indirectly and whether in this jurisdiction or elsewhere)76 a transaction that has or is likely to have, or two or more transactions that have, or are likely to have, the effect of creating an artificial price for trading in financial products on a financial market operated in this jurisdiction; or maintaining at a level that is artificial (whether or not it was previously artificial) a price for trading in financial 73 Section 601JA(2) of the Act. 74 The duty relating to managed investment schemes is made a civil penalty under ss 588G(2) and 1317E(1)(e) of the Act. 75 The continuous disclosure provisions are made civil penalty provisions under s 1317E(1)(ja) of the Act. 76 Section 1041A of the Act.

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products on a financial market operated in this jurisdiction. All these forms of market manipulation are considered to be contravention of a ‘financial services civil penalty provision’.77 False trading and market rigging A person must not do, or omit to do, an act (whether in this jurisdiction or elsewhere) if that act or omission has or is likely to have the effect of creating, or causing the creation of, a false or misleading appearance of: (1) active trading in financial products on a financial market operated in this jurisdiction; or (2) the price for trading in financial products on a financial market operated in this jurisdiction.78 A person is taken to have created a false or misleading appearance of active trading in particular financial products on a financial market if the person enters into, or carries out, either directly or indirectly, any transaction of acquisition or disposal of any of those financial products that does not involve any change in the beneficial ownership of the products; or makes an offer (the regulated offer) to acquire or to dispose of any of those financial products in the following circumstances: the offer is to acquire or to dispose of at a specified price; and the person has made or proposes to make, or knows that an associate of the person has made or proposes to make, if the regulated offer is an offer to acquire – an offer to dispose of; or if the regulated offer is an offer to dispose of – an offer to acquire; the same number, or substantially the same number, of those financial products at a price that is substantially the same as the price referred to above. An acquisition or disposal of financial products does not involve a change in the beneficial ownership if a person who had an interest in the financial products before the acquisition or disposal, or an associate of such a person, has an interest in the financial products after the acquisition or disposal. A transaction of acquisition or disposal of financial products includes a reference to the making of an offer to acquire or dispose of financial products; and a reference to the making of an invitation, however expressed, that expressly or impliedly invites a person to offer to acquire or dispose of financial products. The Act also prohibits a person (whether in this jurisdiction or elsewhere) from entering into, or engaging in, a fictitious or artificial transaction or device if that transaction or device results in the price for trading in financial products on a financial market operated in this jurisdiction being maintained, inflated or depressed; or fluctuations in the price for trading in financial products on a financial market operated in this jurisdiction.79 Any such false trading, market rigging and artificial price maintenance are contraventions of ‘financial services civil penalty provisions’.80 77 78 79 80

Section 1317E(1)(jb) of the Act. Section 1041B of the Act. Section 1041C of the Act. Section 1317E(1)(jc) and (jd) of the Act.

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Dissemination of information about illegal transactions A person must not (whether in this jurisdiction or elsewhere) circulate or disseminate, or be involved in the circulation or dissemination of, any statement or information to the effect that the price for trading in financial products on a financial market operated in this jurisdiction will, or is likely to, rise or fall, or be maintained, because of a transaction, or other act or thing done, in relation to those financial products, if the transaction, or thing done, constitutes or would constitute a contravention of inter alia the prohibitions regarding false trading, market rigging and artificial price maintenance described above; and the person, or an associate of the person, has entered into such a transaction or done such an act or thing; or has received, or may receive, directly or indirectly, a consideration or benefit for circulating or disseminating, or authorising the circulation or dissemination of, the statement or information.81 Any such dissemination of information about illegal transactions is a contravention of a ‘financial services civil penalty provision’.82 Insider trading83 Part 7.10 – Division 3 contains the general prohibition on a person trading in financial products (defined in Division 3; for instance, securities, derivatives and debentures) when that person is in possession of inside information. ‘Inside information’ is defined as information that is not generally available or, if the information were generally available, a reasonable person would expect it to have a material effect on the price or value of a particular financial product.84 A person with inside information (the insider) may not apply for, acquire, or dispose of, any of the defined financial products, or enter into an agreement to apply for, acquire, or dispose of, such financial products or procure another person to apply for, acquire, or dispose of such financial products, or enter into an agreement to apply for, acquire, or dispose of such financial products.85 ‘Procuring’ is defined as inciting, inducing or encouraging an act or omission of another person by a person in possession of inside information.86 The insider must also not, directly or indirectly, communicate the inside information (so-called ‘tipping’), or cause the information to be communicated, to another person if the insider knows, or ought reasonably to know, that the other person would or would be likely to apply for, acquire, or dispose of, the defined financial products, or enter into an agreement to apply for, acquire, or dispose of, such financial products or procure another person to apply for, 81 Section 1041D of the Act. 82 Section 1317E(1)(je) of the Act. 83 See Gregory Lyon and Jean J du Plessis, The Law of Insider Trading in Australia, Sydney, Federation Press (2005) for a comprehensive analysis of all legal aspects pertaining to insider trading. 84 Section 1042A of the Act. 85 Section 1043A(1) of the Act. 86 Section 1042A of the Act.

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acquire, or dispose of such financial products, or enter into an agreement to apply for, acquire, or dispose of such financial products.87 Any contravention of the insider trading provisions is a contravention of a ‘financial services civil penalty provision’.88 10.2.2.11 Subclause 29(6) of Schedule 4: Duty relating to disclosure for proposed demutualisation Clause 3 of Schedule 4 to the Act provides for some transitional arrangements for the registration of transferring financial institutions or friendly societies as companies. Subclause 29(6) of Schedule 4 lays down several rules regarding modification of the constitution of such unlisted companies. For instance, if such modification would have the effect of varying or cancelling the rights of members, or a class of members, to the reserves of the company; or varying or cancelling the rights of members, or a class of members, to the assets of the company on a winding up; or varying or cancelling the voting rights of members or a class of members etc., the following rules will apply: (a) The notice of the meeting of the company’s members at which the proposed modification is to be considered must be accompanied by certain documents listed in subclause 29(4) of Schedule 4 (namely a disclosure document estimating the financial benefits to members if the proposed modification occurs, and an expert’s report indicating whether the proposed modification is in the best interests of the company as a whole) and (b) The notice of the meeting may not be shortened under subsection 249H(2) of the Act and (c) The company must lodge with ASIC the notice and the documents referred to in paragraphs (4)(a) and (c) within seven days after notice of the meeting is given. A substantially similar procedure applies if the unlisted entity proposes to issue shares. A contravention of any of these rules is considered to be a contravention of a ‘financial services civil penalty provision’ and will expose those involved in such contraventions to any of the orders discussed above.89 10.2.2.12 Relief from civil liability90 Section 1317S gives the court discretion to relieve from liability persons, either wholly or partly, held liable to pay compensation if it appears that the person acted honestly and having regard to all the circumstances of the case ought fairly to be excused. Section 1318 provides similar relief against breaches of civil penalty provisions. The purpose of these sections are ‘to excuse company officers from liability in situations where it would be unjust and oppressive not to do 87 Section 1043A(2) of the Act. 88 Section 1317E(1)(jf) and (jg) of the Act. 89 Section 1317E(1)(k) of the Act. 90 This discussion draws upon Michael Adams, Jason Harris and Anil Hargovan, Chapter 13 ‘Officers’ in Australian Corporation Practice, LexisNexis Loose-leaf Service.

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so, recognising that such officers are businessmen and women who act in an environment involving risk in commercial decision-making’: Daniels v Anderson (1995) 37 NSWLR 438 at 525. Acting honestly, which underpins both sections, means to act ‘without moral turpitude’.91 In Hall v Poolman,92 Justice Palmer considered the following factors as relevant in assessing honesty: whether the person has acted without deceit or conscious impropriety, without intent to gain improper benefit or advantage for himself, herself or another, and without carelessness or imprudence to such a degree as to demonstrate that no genuine attempt at all has been to carry out the duties and obligations of his or her office imposed by the Corporations Act or the general law.

There have not been many successful cases in which the directors have benefited from the operation of these discretionary provisions. The recent decisions in Hall v Poolman and in McLellan (in the matter of The Stake Man Pty Ltd) v Carroll93 are, however, a notable exception to the trend of judicial reluctance in this regard. In the former case, a director was partially absolved from liability for debts incurred during insolvent trading in breach of section 588G, discussed earlier. Significantly, the latter case is the first in which a director has been fully exonerated from personal liability through the exercise of judicial discretion. The court in Hall v Poolman was influenced by the commercial conduct of the director, who was found to have acted in a reasonable manner, for a limited time, when attempting to save the business while negotiating over a large debt with the Australian Taxation Office. In adopting an approach widely regarded by commentators as commercially realistic, Justice Palmer in Hall v Poolman94 made the following observations: Experienced company directors . . . would appreciate that, in some cases, it is not commercially sensible to summon the administrators or to abandon a substantial trading enterprise to the liquidators as soon as any liquidity shortage occurs. In some cases a reasonable time must be allowed to a director to assess whether the company’s difficulty is temporary and remediable or endemic and fatal. The commercial reality is that creditors will usually allow some time for payment beyond normal trading terms, if there are worthwhile prospects of an improvement in the company’s position.

Honesty, by itself, is insufficient to justify relief.95 In Williams v Scholz,96 the Court of Appeal in Queensland declined to exercise judicial discretion under section 1318 and excuse the directors from liability for insolvent trading on the basis of their knowledge of deterioration financial conditions, suspicions of mismanagement and their failure to take remedial steps. Under these circumstances, despite the honest conduct of the directors, it was held that the function of section 1318 is not to subvert the operation of the insolvent trading laws. 91 Commonwealth Bank Ltd v Freidrich (1991) 9 ACLC 946; 5 ACSR 115 at 198; ASIC v Vines (2005) 56 ACSR 528; affirmed Vines v ASIC (2007) 62 ACSR 1, at [568] per Ipp JA and at [797], [800] per Santow JA. 92 (2007) 65 ACSR 123 at [325]. 93 [2009] FCA 1415. For commentary, see Anil Hargovan, ‘Director’s Liability for Insolvent Trading, Statutory Forgiveness and Law Reform’ (2010) Insolvency Law Journal (forthcoming). 94 (2007) 65 ACSR 123 at [331]. 95 Kenna & Brown Pty Ltd v Kenna (1999) 32 ACSR 430. 96 [2008] QCA 94.

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It is an irrelevant consideration, for the exercise of judicial discretion for relief, that directors do not have directors and officers’ liability insurance to meet any judgment debt and has to rely on their own resources. In Hall v Poolman,97 Justice Palmer considered this issue and held: The fact that a director has no insurance to meet a judgment debt arising from an insolvent trading claim cannot, without more, play a part in the consideration of discretionary defences under s.1317S and s.1318. Most creditors are not insured against the insolvency of their debtors. The Court should not, in the exercise of discretion under s.1317S or s.1318, hold accountable only a director whose insurer will absorb the pain of a judgment.

10.3 Case studies regarding civil penalty provisions or pecuniary penalty provisions 10.3.1 Overview ASIC v Adler98 remains one of the best cases to illustrate how the civil penalty provisions or pecuniary penalty provisions are used by ASIC in practice, because of both the lucid judgment of Justice Santow and the fact that the case involved multiple breaches of statutory duties and civil penalty provisions. However, there were several other significant cases that ASIC brought against directors and officers that either clarified or demonstrated the operation of the statutory duties of directors. There is only space to provide brief overviews of the key legal issues in ASIC v Adler,99 ASIC v Macdonald (No 11)100 and ASIC v Rich.101

10.3.2 ASIC v Adler [2002] 41 ACSR 72 10.3.2.1 Summary of the facts This case deals basically with four different sets of transactions in the lead up to the collapse of HIH Insurance Ltd. The main defendants were Rodney Adler (director and shareholder in HIH), Ray Williams (chief executive officer (CEO), shareholder and founder of HIH) and Dominic Fodera (director and CFO of HIH). 1. Transfer of funds: The first transaction took place on 15 June 2000 when an amount of $10 million was transferred from one of HIH Insurance Ltd’s (HIH) subsidiaries, Casualty & General Insurance Company Limited (HIHC), to a company, Pacific Eagle Equity Pty Limited (PEE), controlled by Rodney Adler. This payment followed earlier correspondence commencing 9 June 2000 between Rodney Adler and Ray Williams and later steps involving various officers of HIH and HIHC. This transfer was executed by Dominic Fodera, the CFO of HIH and HIHC and also a director of both 97 98 99 100 101

(2007) 65 ACSR 123 at [342]. (2002) 41 ACSR 72; [2002] NSWSC 483 (30 May 2002). Ibid. (2009) 256 ALR 199. [2009] NSWSC 1229.

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companies, after Rodney Adler requested such a transfer and the CEO of HIH, Ray Williams, concurred with it and also directed the transfer. 2. Purchase of HIH shares: The second set of transactions took place between 16 and 30 June 2000, when PEE began to purchase shares in HIH to the extent of $3 991 856.21. All these purchases were instigated by Rodney Adler. This was in circumstances in which, according to ASIC, but disputed, the stock market was led to believe by Rodney Adler that the purchases were made by Rodney Adler or family interests associated with Rodney Adler in order to shore up the HIH share price. On 7 July 2000, the Australian Equities Unit Trust (AEUT) was established, by execution of a Trust Deed, with PEE as trustee. Units of different classes were issued to HIHC and Adler Corporation, a company controlled by Adler. The $10 million investment by HIHC, including the HIH shares purchased with it, then became part of this trust (AEUT).102 The HIH shares were subsequently sold by AEUT at a loss of $2 121 261.11 on 26 September 2000 – barely three months after they had been purchased. 3. Purchase of unlisted investments: The third set of transactions relates to AEUT buying three unlisted investments (unlisted technology and internet companies), from Adler Corporation Pty Ltd (Adler Corp). Adler Corp was a company in which Rodney Adler was the sole director and he and his wife the only shareholders. AEUT bought dstore Limited (dstore) on 25 August 2000 for $500 002, Planet Soccer International Limited (Planet Soccer) on 25 August 2000 for $820 748 and Nomad Telecommunications Limited (Nomad) on 26 September 2000 for $2 539 000 – collectively called ‘the unlisted investments’. These sales were all financed with the funds still available (after the purchase of the HIH shares) from the original $10 million payment by HIHC, which became AEUT’s after the execution of the Trust Deed. AEUT suffered a loss on all three transactions totalling $3 859 750 (without interest taken into consideration) from these transactions. 4. Making of unsecured loans: The fourth set of transactions deals with unsecured loans. Between 26 July 2000 and 30 November 2000, Rodney Adler caused three unsecured loans totalling $2 084 345 to be made by AEUT, without adequate documentation, to companies or funds associated with him and/or Adler Corp, to the latter’s advantage and allegedly to the disadvantage of AEUT. 10.3.2.2 Contraventions of civil penalty provisions103 Related party transactions (Chapter 2E) It was held that the payment of $10 million by HIHC to PEE on 15 June 2000 amounted to ‘giving of a financial benefit’ to PEE, Adler Corp and Adler within 102 Jason Lang and Giselle McHugh (Mallesons Stephen Jacques) in Corporate Law Electronic Bulletin (Bulletin No 55, March 2002), available at . 103 This part is based on the excellent summary of the findings of Santow J by Lang and McHugh, ibid, and the headnote to the Australian Corporations and Securities Reports–ASIC v Adler (2002) 41 ACSR 72–7.

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the meaning of section 229 of the Act. Thus, HIH and HIHC had contravened section 208 of the Act. The transaction was not an ‘arms length’ transaction under section 210. The subsequent entering into of the trust deed was also not held to fall within the ‘arms length’ exception in section 210 because the trust deed lacked proper safeguards in circumstances in which Adler had a potential conflict of interest and was significantly one-sided against HIHC. It was also held that the transaction was carried out at Adler’s request and with Williams’ concurrence and direction. Both of them were ‘involved’ in giving of a financial benefit within the meaning of section 79. Both contravened section 209(2) by being ‘involved’ in the contravention of section 208 by HIH and HIHC. Fodera was also in breach of section 209(2). He had sufficient knowledge of the essential elements of the contravention, and his attempts to subsequently distance himself from the transaction by referring matters to others did not alter this. Financial assistance (Part 2J.3) HIHC suffered material prejudice as a result of financially assisting PEE to acquire shares in HIH and, in so doing, contravened section 260A of the Act. The material prejudice arose from the fact that the rights that HIHC obtained from PEE were of a materially lesser value than the cash handed over. In other words, HIHC was ‘impoverished’ by this transaction. The court relied on Charterhouse Investment Trust Ltd v Tempest Diesels Ltd [1986] PCLC 1, looking ‘at all interlocking elements in a commercial transaction as a whole’. The material prejudice for HIHC resulted from the fact that there was no security or documentation and no control over the disposition of the funds. The AEUT Trust Deed was also one-sided and did not include safeguards to protect against Adler’s potential conflict of interest. A loss on the HIH shares traded by PEE was inherently likely from the inception, and did in fact occur. It was held that Rodney Adler and Ray Williams were sufficiently involved in the contravention of section 260A to have breached section 260D(2). They knew that HIHC was providing assistance for the purchase of HIH shares, but it was not necessary for them to have actual knowledge of material prejudice. Dominic Fodera’s involvement was more remote and, on the facts, Santow J was not able to conclude that Fodera, while having knowledge that financial assistance was given, also had knowledge that it would materially prejudice HIHC. However, as the onus lay on the defendants to prove that giving the financial assistance was not materially prejudicial, this element of section 260A was essentially a defence, and proof of knowledge of material prejudice was therefore not necessary for section 260D(2). Accordingly, Fodera was also found to have breached section 260D(2).104 In making these findings, Santow J stated that ‘a combination of suspicious circumstances and the failure to make appropriate enquiry when 104 Lang and McHugh, above n 102.

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confronted with the obvious, makes it possible to infer knowledge of the relevant essential matters’.105 Duty of care and diligence (s 180) It was held that a reasonably careful and diligent director or officer in the position of Adler would not have caused the payment of $10 million by HIHC to PEE to be applied in part to purchasing HIH shares. Adler failed to follow authorised practices relating to investments made by HIH/HIHC and to ensure that safeguards were in place to protect HIH or HIHC. In fact, Adler’s object was to support the HIH share price (doing so for his own substantial shareholding in HIH), rather than to enable HIH to obtain, through its interests in AEUT, the benefit of a quick profit on the resale of the HIH shares. In the case of Ray Williams, he was aware the $10 million was to be used in whole or in part to pay for shares in HIH, and permitted that amount to be paid in advance of any documentation and with no stipulation of any necessary safeguards to deal with Adler’s potential conflicts of interest, which is a circumstance requiring special vigilance. While the primary responsibility will fall on the director proposing to enter into the transaction, this does not excuse other directors or officers who become aware of the transaction. It was only common sense that a reasonably careful and diligent director would have brought the issue of a $10 million payment being made to a director, to be used at his discretion, before the board or at least the HIH Investment Committee. Similarly, Fodera was found to be in breach of section 180.106 The directors’ attempt to rely on the protection of the business judgment rule (see section 180(2)) failed. In Adler’s case, there was no ‘business judgment’; moreover, Adler clearly had a material personal interest in the ‘subject matter of the judgment’. Williams failed to establish that he had made the decision in good faith for a proper purpose, and failed to inform himself to the extent that he could reasonably believe that the decision was a proper business decision. Duty of good faith (s 181) Rodney Adler was the only director found to be in breach of section 181. This was because Adler, quite apart from failing to make proper disclosure, promoted his personal interest by making or pursuing a gain (of maintaining or supporting the HIH share price) when there was a substantial possibility of a conflict between his personal interests and those of the company in pursuing a profit. The interests of HIH and HIHC were put at risk by illegality under sections 208 and 260A, and by concealing from the market that HIHC, not Adler or his interests, was funding the purchase of HIH shares.107 105 ASIC v Adler (2002) 41 ACSR 72, 163. 106 Lang and McHugh, above n 102. 107 Ibid.

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Use of position to gain advantage for oneself or another or to cause detriment to the corporation (s 182) Santow J concluded that both Adler and Williams were in breach of section 182. Adler’s conduct evinced his improper purpose in supporting the share price in HIH. This included passing up an early opportunity for AEUT to make a profit on the sale of HIH shares, as well as maximising the ultimate loss for AEUT by selling his own interests in HIH ahead of AEUT’s when the market was falling. Williams likewise breached section 182 in authorising the $10 million payment without proper safeguards and without the knowledge or approval of the HIH Investment Committee. More generally, Adler was also found to have breached his duties under sections 180 to 182 in relation to PEE’s acquisition of the three unlisted technology and internet investments from Adler Corp. No reasonable director in Adler’s position and possessing his knowledge would have committed PEE to acquiring investments in Nomad, dstore and Planet Soccer at the prices Adler Corp paid for them. The known radical change in market conditions relating to technology stocks, the lack of any due diligence and the misleading statements and omissions made by Adler in relation to the on-sale of these investments all supported this conclusion. Despite being clearly aware of the financial dire straits of these investments, Adler and Adler Corp extricated Adler Corp from its position, at no loss to Adler Corp, but to the disadvantage of PEE, HIH and HIHC. Adler was in further breach of sections 180 to 182 in relation to the three unsecured loans from AEUT to entities associated with Adler. These loans were not adequately documented and not one of them was even within the scope of the vaguely sketched mandate for AEUT, as discussed by Adler and Williams, to pursue investment in ‘venture capital’ or ‘share trading’.108 Improper use of information (s 183) Adler was also found by Santow J to have breached his obligations under section 183, in relation to both the acquisition of the three unlisted investments from Adler Corp and the loans to Adler-associated entities. Adler had improperly used information obtained by him to gain an advantage for himself.109 It must be noted, however, that this part of Santow J’s judgment was overturned on appeal. The New South Wales Court of Appeal held that neither Adler’s disregard of HIH’s investment guidelines and procedures, nor his knowledge of Williams’ susceptibility, amounted to an improper ‘use’ of information for the purposes of section 183.110 10.3.2.3 Court orders Santow J ordered that Rodney Adler should be disqualified for a period of 20 years and that he and Adler Corp should pay pecuniary penalties of $450 000 each (totalling $900 000). Ray Williams was disqualified for a period of 10 years 108 Ibid. 109 Ibid. 110 See Adler v ASIC; Williams v ASIC (2003) 46 ASCR 504.

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and was ordered to pay pecuniary penalties of $250 000. Dominic Fodera was not disqualified, but was ordered to pay pecuniary penalties of $5000. In addition, Rodney Adler, Ray Williams and Adler Corp were ordered to pay aggregate compensation of $7 958 112 to HIH Casualty and General Insurance Limited (subject to verification of the calculation of interest).111 Criminal proceedings were later brought against Rodney Adler and Ray Williams in relation to their activities prior to the collapse of HIH, and both pleaded guilty – see discussion later in this chapter.

10.3.3 ASIC v Macdonald (No 11) (2009) 256 ALR 199 – James Hardie litigation112 10.3.3.1 Background and summary of the facts This case sheds light on the practical application of the scope and content of directors’ and officers’ duties in a large, publicly listed company. The case illustrates the standard of care expected by management and the board when considering strategic company decisions and market-sensitive information. It offers guidance on the standards expected under section 180(1), with particular reference to non-executive directors, executive directors, CFOs, company secretaries and in-house counsel. In Chapter 2 we have already used the James Hardie litigation as a case study in context of the importance of stakeholders and how stakeholders and pressure groups are able to influence corporate behaviour and influence corporate governance practices. The irony is that the agreement by James Hardie to establish a fund to cover future medical claims led to further litigation, resulting in the reported cases ASIC v Macdonald (No 11)113 and ASIC v Macdonald (No 12).114 As will be recalled, James Hardie Industries Limited (JHIL) faced significant liability for damages claims for asbestos-related conditions resulting from the use of its products since 1920. JHIL was the holding company of the James Hardie group. In order to separate JHIL from this liability, the board decided to establish the Medical Research and Compensation Foundation (MRCF) which would manage and pay out asbestos claims against JHIL. At a board meeting of JHIL held on 15 February 2001, the board decided to constitute JHIL as trustee of the MRCF. At the same meeting, a draft announcement to ASX was approved. Although this event was disputed by the 10 defendants (directors and officers), the judge rejected the chorus of non-recollection. This draft announcement explained that MRCF would be ‘fully funded’ (to meet the outstanding liability). At the same meeting, the board also agreed to execute the Deed of Covenant and Indemnity (DOCI), which dealt with liability between 111 Lang and McHugh, above n 102; Jillian Segal, ‘Corporate Governance: Substance over Form’ (2002) 25 University of New South Wales Law Journal 320, 328. 112 Parts of this discussion is based on Anil Hargovan, ‘Corporate Governance Lessons from James Hardie’ (2009) 33 Melbourne University Law Review (forthcoming). 113 (2009) 256 ALR 199. 114 (2009) 259 ALR 116; [2009] NSWSC 714.

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JHIL and MRCF. The seven non-executive directors attended this meeting (two by phone from the USA), as did the CEO (Peter Macdonald), the board secretary and general counsel (Peter Shafron) and the CFO (Phillip Morley). The minutes of the board meeting contained an entry to the effect that the company had explained the impact of the resolution passed at the meeting to approve an ASX announcement and to execute the ASX announcement and send it to ASX. The minutes of the meeting were signed by the chairman at the following board meeting, held on 4 April 2001. On 7 April 2001, the minutes of the meeting of 15 February 2001 were sent to the secretary of the company. The evidentiary value of the minutes, however, was negated by the company’s non-compliance with the relevant statutory provisions governing minutes and thereby precluded the court from reliance on the minutes to establish the events that transpired at the board meeting. ASIC alleged that the draft ASX announcement was approved at the board meeting of 15 February 2001 and that it stated that the MRCF would commence operations with assets of $284 million. The draft ASX announcement also contained a number of statements to the effect that MRCF would have sufficient funds to meet all legitimate asbestos claims; that it was fully funded; and provided certainty for people with legitimate asbestos claims. The final ASX announcement included, inter alia, the following statements: The Foundation has sufficient funds to meet all legitimate compensation claims . . . Mr Peter Macdonald said that the establishment of a fully-funded Foundation provided certainty for both claimants and shareholders . . . In establishing the Foundation, James Hardie sought expert advice . . . James Hardie is satisfied that the Foundation has sufficient funds to meet anticipated future claims . . .

10.3.3.2 Legal issues Based on the facts discussed above, ASIC alleged in Supreme Court hearings in September 2008 that JHIL, its officers and the board breached several civil penalty provisions of the previous Corporations Law and the current Corporations Act 2001 (Cth), which attracted civil penalties.115 In particular, ASIC argued that: 1. The draft ASX announcement approved at the board meeting on 15 February 2001 was false or misleading. The approval by the non-executive directors,116 the CEO (Mr Macdonald), the company secretary and general counsel (Mr Shafron), and CFO (Mr Morley) was in breach of the duty of care in section 180(1) 2. JHIL’s failure to disclosure information, in relation to the DOCI, to ASX was in breach of section 1001A(2)117 115 ASIC concluded that there was insufficient evidence to refer any matter to the Commonwealth Director of Public Prosecution for criminal prosecution of the company’s officers: ASIC, ‘James Hardie Group Civil Action’ (Media Release 08–201, 5 September 2008), available at 116 Mr Brown, Ms Hellicar, Mr Wilcox, Mr O’ Brien, Mr Terry, Messrs Gillfillan and Koffel. 117 Section 1001A(2) of the Corporations Law, carried over into the Corporations Act until its repeal in 2002, dealt with breach of continuous disclosure obligation.

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3. Failure by the CEO and company secretary and general counsel to advise the board that the DOCI information should be disclosed to ASX was in breach of section 180(1) 4. The CEO had breached section 180(1) for failure to advise that the final ASX announcement on 16 February 2001 should not be released or that it should be amended to cure the defect 5. Statements made by the CEO at a press conference concerning the adequacy of funding for asbestos claims were false or misleading and involved a breach of section 180(1) 6. A release to ASX on 23 February 2001 by the CEO, which contained false or misleading statements, was in breach of section 180(1); the approval of an announcement released to ASX on 21 March 2001 by the same officer, which contained false or misleading statements was in breach of section 180(1) and the good faith provisions in 181(1)118 7. The publication of the final ASX announcement, the press conference statements and the further ASX announcements, referred to in (6) above, JHIL contravened sections 995(2)119 and 999120 8. The representations made by the CEO with respect to JHI NV at roadshows in Edinburgh and London and in slides for these United Kingdom presentations, lodged with ASX, were false and misleading and in breach of sections 180(1) and 181. On the same facts, it was argued that JHI NV was in breach of s 1041E121 and, in making ASX representations, breached s 1041H;122 and 9. JHI NV failed to notify ASX of JHIL information in accordance with Listing Rule 3.1 and thereby contravened disclosure obligations in section 674(2).123 10.3.3.3 Decision and significance of the decision124 The following discussion centres on the findings made against the directors and officers of JHIL. We focus on the significance of the case for different types of directors and officers. Non-executive directors The court addressed the question of whether the law differentiated in the standard of performance expected between executive and non-executive directors. 118 Section 181 requires directors and officers of a corporation to exercise their power and discharge their duties in good faith in the best interests of the corporation and for a proper purpose. 119 Section 995(2) of the Corporations Law, carried over into the Act until its repeal in 2002, was modelled on s 52 of the Trade Practices Act 1974 (Cth) and prohibited misleading or deceptive conduct in connection with securities. A similar provision to s 995 exists in s 1041H (1) of the Corporations Act. 120 Section 999 of the Corporations Law, carried over into the Act until repealed in 2002, prohibited false or misleading statements in relation to securities. 121 Section 1041E of the Act prohibits false or misleading statements that induce persons to, inter alia, apply for or dispose of financial products. 122 Section 1041H of the Act prohibits misleading or deceptive conduct in relation to a financial product. 123 Section 674(2) of the Act deals with a listed disclosing entity’s continuous disclosure obligations. 124 This part is based on Hargovan, above n 112; Anil Hargovan, ‘Directors’ and Officers’ Statutory Duty of Care Following James Hardie’ (2009) 61 Keeping Good Companies 590.

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Justice Gzell referred to the divergent judicial views expressed by Rogers CJ in AWA Ltd v Daniels t/as Deloitte Haskins & Sells,125 who appeared to show readiness to accept a lower standard of care for non-executive directors,126 and the Court of Appeal in Daniels v Anderson127 wherein Clarke and Sheller JJA held that the approach of Rogers CJ on this issue did not represent contemporary company law128 and that all directors are required to take reasonable steps to guide and monitor the management of the company.129 After reviewing the case law on this point,130 Gzell J reiterated the analysis of Justice Santow in ASIC v Adler131 and held that a director should become familiar with the fundamentals of the company’s business and is under a continuing obligation to keep informed about the company’s activities. Satisfied that the same standards of care are imposed on all directors, Justice Gzell focused on the test to determine breach of section 180(1) and relied on ASIC v Adler132 to adopt the following test: In determining whether a director has exercised reasonable care and diligence one must ask what an ordinary person, with the knowledge and experience of the defendant might have expected to have done in the circumstances if he or she was acting on their own behalf.133

Justice Gzell commented on the failure of the non-executive directors to discharge their monitoring role as part of the statutory duty of care and diligence:134 . . . it was part of the function of the directors in monitoring the management of the company to settle the terms of the draft ASX announcement to ensure that it did not assert that the foundation had sufficient funds to meet all legitimate compensation claims.

The court held that the directors’ conduct thereafter, in releasing the defective ASX announcement, fell short of the standards expected to discharge obligations under section 180(1) for the following reasons:135 The formation of the foundation and the [restructure of the relevant entities described earlier] from JHIL were potentially explosive steps. Market reaction to the announcement of them was critical. This was a matter within the purview of the board’s responsibility: what should be stated publicly about the way in which asbestos claims would be handled by the James Hardie group for the future. (emphasis added) 125 (1992) 7 ACSR 759 (AWA). 126 Ibid 867. 127 (1995) 16 ACSR 607. 128 Ibid 668. 129 Ibid 664. 130 Statewide Tobacco Services Ltd v Morley (1990) 2 ACSR 405; Group Four Industries Pty Ltd v Brosnan (1992) 8 ACSR 463; Vrisakis v ASC (1993) 11 ACSR 162; Permanent Building Society v Wheeler (1994) 14 ACSR 109; ASIC v Adler (2002) 41 ACSR 72; ASIC v Maxwell (2006) 59 ACSR 373; Vines v ASIC (2007) 62 ACSR 1. 131 (2002) 41 ACSR 72. 132 (2002) 168 FLR 253. 133 Macdonald (2009) 256 ALR 199, 247. 134 ASIC v Macdonald (No 11) (2009) 256 ALR 199 at [332]. 135 Ibid at [333].

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Although two of the non-executive directors attended the relevant board meeting by telephone, and claimed that the draft ASX announcement was not provided nor read to them, the court, nonetheless, held that both directors had breached section 180(1) by voting in favour of the resolution. Gzell J, unimpressed with the conduct of both directors in such circumstances, found liability on the following basis:136 Neither [non-executive directors] raised an objection that [they] did not have a copy of the draft ASX announcement at the . . . meeting. Nor did they ask that a copy be provided to them. Nor did they abstain from approving the . . . announcement.

The entire board’s reliance upon, and delegation to, management and experts were held to be inappropriate on the facts of this case for these key reasons:137 This was not a matter in which a director was entitled to rely upon those of his codirectors more concerned with communications strategy to consider the draft ASX announcement. This was a key statement in relation to a highly significant restructure of the James Hardie group. Management having brought the matter to the board, none of them was entitled to abdicate responsibility by delegating his or her duty to a fellow director. (emphasis added)

Chief executive officer The court found that Mr Macdonald, as a director and CEO of JHIL with reporting duties directly to the board, had ultimate responsibility for planning the separation proposals and was the driving force. Furthermore, he was appointed to make public statements on behalf of JHIL on these matters and, in keeping with his position, was responsible for dealing with the board on this issue. As a result of these responsibilities, Gzell J concluded that the CEO bore a high standard of care. In voting in favour of the resolution to approve the draft ASX announcement, the court applied an objective test and found liability under section 180(1) based on similar reasons applicable to the non-executive directors. The court also found that the negligent conduct of the CEO resulted in multiple breaches of the statutory duty of care and diligence under section 180(1). These included the failure of the CEO to: ● advise the board of the limited nature of the reviews on the cash-flow model undertaken by external consultants. The review was restricted to issues concerning logical soundness and technical correctness. According to Justice Gzell,138 a reasonable person with the same responsibilities would have informed the board that the external consultant had been specifically instructed not to consider the key assumptions adopted by the cash-flow model – namely, the fixed investment earnings rates, litigation and management costs and future claim costs 136 Ibid at [233]. 137 Ibid at [260]. 138 Ibid at [363].

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advise the board that the draft ASX announcement was expressed in too emphatic terms and, in relation to the adequacy of funding, was misleading and deceptive ● correct the misleading statements on the adequacy of funding when making representations during international roadshows in Edinburgh and London to promote the company and ● advise the board of the company’s continuous disclosure obligations to release price-sensitive information in a timely manner. The court, however, rejected ASIC’s allegation that the CEO had breached section 180(1) through failure to enquire of each director as to whether they had formed an opinion on the adequacy of the quantum expressed to meet all present and future asbestos claims. The imposition of such a duty, according to Gzell J, was unwarranted because a director is not obliged to analyse the basis upon which fellows directors intend to vote before determining his or her own course.139 The CEO failed to offer oral evidence to substantiate all of the statutory criteria under the business judgment rule in section 180(2) (discussed earlier in Part 10.2.2.1). This strategic decision proved to be fatal to the successful discharge of the defence. It is not easy, as recognised by the court, to rely on documentation alone to discern, for example, if the director had a rational belief that the business judgment was in the best interests of the company. ●

General counsel Mr Shafron, the company secretary and in-house counsel, was held to be a company officer due to his expansive role in the affairs of JHIL and, significantly, attracted the stringent statutory duties applicable to officers under sections 180– 183 of the Act, which includes the duty of care and diligence. Mr Shafron’s failure to advise the board of the limited nature of the reviews on the cash-flow model undertaken by external consultants also constituted a breach of section 180(1), for the same reasons discussed earlier with respect to the conduct of the CEO. Similarly, Mr Shafron’s failure to advise the CEO and the board of the company’s continuous disclosure obligations, in relation to the failure to release price-sensitive information to the market in a timely manner, constituted breach of section 180(1). The court rejected Mr Shafron’s argument that he had no duty to warn the board of the emphatic statements in the draft ASX announcement because, according to the defendant, a reasonable director would be capable of assessing the statement as false and misleading. On the contrary, according to the court, there was a compelling duty to speak in such circumstances:140 . . . [general counsel] had a duty to protect JHIL from legal risk and if the directors were minded to approve the release of the draft ASX announcement in its false and misleading form, there was the danger that JHIL would be in breach . . . [of the statute]. 139 Ibid at [351]. 140 Ibid at [402].

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Against that harm it was [the] duty [of Mr Shafron] to warn the directors that [such an] announcement should not be released in its too emphatic form.

Chief financial officer Mr Morley, the CFO of JHIL, was also held to be an officer due to his participation in far-reaching decisions of the board. The CFO was responsible for all of the finance, audit, tax and treasury aspects of the James Hardie Group of companies. Engaging in a similar analysis on this issue with respect to the conduct of the CEO and general counsel described earlier, it was held that section 180(1) was breached by Mr Morley for identical reasons concerning the failure to address the limitations of the cash-flow model and its key assumptions and to communicate this to the board.141 As CFO, Mr Morley was responsible for verifying the sufficiency of financial information. The court held that a reasonable CFO would have known that the range of limited assumptions meant that the press release could not state with certainty that the Foundation was fully funded. 10.3.3.4 Court orders In a separate judgment dealing with the civil penalty consequences of breach of the law, Justice Gzell in ASIC v Macdonald (No 12)142 dismissed the defendants’ claims to be exonerated from their contravention pursuant to section 1317S or section 1318 of the Act – the latter provisions confer judicial discretion to grant relief from liability upon the basis that the defendants had acted honestly and, in the circumstances, ought fairly to be excused for their contravention. Significantly, the court adopted a rigorous approach to the application of the duty of care and diligence, and held that the defendants could not be excused from liability despite the existence of the following circumstances surrounding the decision making at the key board meeting on 15 February 2001 – namely: ● The board meeting was attended by JHIL management and a number of external advisers who did not raise concerns. ● JHIL was in receipt of legal advice on issues surrounding the separation plan, which addressed directors’ duties (but not the resolution to approve the draft ASX announcement). ● There was contravention of standard practice, which required the approval of a draft press release by line management and senior executives prior to its placement before the board. ● It was a busy board meeting and the approval of the draft ASX announcement by the non-executive directors, who had lengthy and accomplished careers of service on other boards, was an isolated act. In denying relief under such circumstances, his Honour was influenced by the following key features of the case:143 141 Ibid at [454]. 142 [2009] NSWSC 714. 143 ASIC v Macdonald (No 12) [2009] NSWSC 714 at [104].

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This was a serious breach of duty and a flagrant one. The non-executive directors were endorsing JHIL’s announcement to the market in emphatic terms that the Foundation had sufficient funds to pay all legitimate present and future asbestos claims, when they had no sufficient support for that statement and they knew, or ought to have know, that the announcement would influence the market.

Furthermore, while this event may have been an isolated one, it was nonetheless held to be a very significant event in the life of the company, which demanded attention. Justice Gzell was also influenced by the fact that reliance on advisors was inappropriate on the facts of this case. According to the court, the task before the board involved ‘no more that an understanding of the English language used in the document’.144 In light of these findings, Gzell J made the following disqualification orders under section 206C and imposed the following pecuniary penalties under section 1317G(1) of the Act, payable to the Commonwealth of Australia: ● Mr Macdonald banned from management for a period of 15 years and liable to pay a pecuniary penalty of $350 000. ● Mr Shafron banned from management for a period of 7 years and liable to pay a pecuniary penalty of $75 000. ● Mr Morely banned from management for a period of 5 years and liable to pay a pecuniary penalty of $35 000. ● All of the seven former non-executive directors banned from management for a period of 5 years each and liable to pay a pecuniary penalty of $30 000 each. ● JHI NV liable to pay a pecuniary penalty of $80 000. It should be noted that this case is subject to appeal, scheduled for hearing in 2010.

10.3.4 ASIC v Rich [2009] NSWSC 1229 10.3.4.1 Background and basic facts ASIC launched civil penalty proceedings against some directors and officers of One.Tel Ltd (One.Tel) for breach of the statutory duty of care and diligence under section 180(1) of the Act. The proceedings initially brought by ASIC were against four defendants, arising out of the collapse in May 2001 of One.Tel and its local subsidiaries, and the collapse or on-sale of overseas subsidiaries. After a settlement was reached with Bradley Keeling and John Greaves and disqualification orders made against them, they were not included in the further litigation against Jodee Rich and Mark Silbermann. ASIC sought relief against the defendands, Jodee Rich and Mark Silbermann. Jodee Rich was a director and joint chief executive of One.Tel at all relevant times up to 17 May 2001, and Mark Silbermann was finance director of One.Tel at all relevant times. 144 Ibid at [77].

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ASIC alleged that the defendants did not disclose the true financial position of the company to the board, and that they knew or should have known the true financial position of their company. The central allegation was that the financial position of the Group and the Australian and international businesses within it, in terms of cash, cash flow, creditors, debtors, earnings and liquidity, was much worse during the months of approximately January to March 2001 than the information provided to the board of directors revealed. It was also alleged by ASIC that forecasts of those matters provided to the board, particularly for the period to June 2001, had no proper basis. In addition, ASIC contended that the defendants were aware of the poor financial position of the Group, or ought to have been, and failed to make proper disclosure to the board. 10.3.4.2 Legal issue In essence, ASIC’s case was based on a breach by Jodee Rich and Mark Silbermann of their duty of care and diligence under section 180(1) of the Act. In other words, in not disclosing the true financial position of the company to the board, while they knew or should have known the true financial position of their company, they did not act with the required care and diligence expected of directors under section 180(1). 10.3.4.3 The decision and its significance On 18 November 2009, in a decision of more than 3000 pages, Justice Austin held that the defendants were not in breach of their duty of care and diligence as required under section 180(1). In short, that ASIC failed to prove its pleaded case against either Jodee Rich or Mark Silbermann. The case is particularly significant because of the observation Justice Austin made on directors’ duty of care and diligence and the business judgment rule as contained in sections 180(2) and (3) of the Act. However, almost as significant as these aspects is the fact that this is one of very few prominent and high-profile cases lost by ASIC. Justice Austin’s criticism of the way in which ASIC conducted its case is particularly interesting and will probably change the way ASIC handles similar cases in future. Directors’ duty of care and diligence and the business judgment rule Since this part of the case alone stretches over 55 pages, it is hardly possible to discuss it in detail in a book dealing primarily with general principles of corporate governance, but a few of the most important points made will be highlighted. Justice Austin confirmed that the statutory duty of care and diligence under section 180(1) of the Act is essentially the same as the duty of care and diligence of a director under general law. Directors will only be held in breach of this duty if the risk or potential harm was reasonably foreseeable. This basically means that directors will only be in breach of this duty if they did not foresee, but objectively other directors in a similar situation would have foreseen the risk or harm and would have taken steps to prevent it. In judging a breach of directors’ duty of

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care and diligence, a ‘forward looking’ approach should be adopted by the courts and that requires the defendants’ conduct to be assessed with close regard to the circumstances existing at the relevant time, without the benefit of hindsight.145 Justice Austin pointed out that section 180(1) incorporates a minimum standard of diligence, requiring every director or officer, including a non-executive director:146 (i) to become familiar with the fundamentals of the business or businesses of the company (ii) to keep informed about the company’s activities (iii) to monitor, generally, the company’s affairs (iv) to maintain familiarity with the financial status of the company by appropriate means, including (in the case of a director) review of the company’s financial statements and board papers, and to make further inquiries into matters revealed by those documents where it is appropriate to do so (v) in the case of a director, and at least some officers, to have a reasonably informed opinion of the company’s financial capacity. Although it was pointed out that they have somewhat different consequences for executive and non-executive directors, Justice Austin accepted the following submissions of ASIC: (i) the statutory duty in terms of section 180(1) encompasses a duty of competence, measured objectively (ii) compliance with the duty is determined by reference to what a reasonable person of ordinary prudence would do; a duty that is enhanced, where the directorial appointment is based on special skill, by an objective standard of skill referable to the circumstances (iii) the statutory standard of skill includes a standard of competence in reading and understanding financial material, which is not dependent on the director’s subjective inexperience or lack of skill (iv) it follows that directors and officers cannot escape liability on the basis that they did not read financial material made available to them for the purposes of their office, and at least to that extent, the statutory duty of care and diligence imports an objective standard of skill irrespective of the directors’ or officers’ subjective inexperience or lack of skills (v) the legislative history of section 180 confirms that the provision was intended to impose an objective standard of skill (vi) whatever particular skills an individual director or officer actually possesses, or inexperience the individual may suffer from, the director or officer is accountable to a core irreducible requirement of skill, measured objectively. An interesting, and possibly controversial, point made by Justice Austin is that there are in actual fact two layers of protection for directors against liability. In his view, directors are automatically protected against liability for mere errors of 145 ASIC v Rich [2009] NSWSC 1229 [7242]. 146 Ibid at [7203].

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judgment. For mere errors of judgment, they do not need to rely on the protection provided by the statutory business judgment rule (also called the ‘safe-habour rule’) contained in section 180(2) and (3) of the Act. However, if it was not a mere error of judgment, they may still be protected by the statutory business judgment rule:147 If the impugned conduct is found to be a mere error of judgment, then the statutory standard under s 180(1) is not contravened and it is unnecessary to advert to the special business judgment rule in s 180(2). In the view that I have taken of it, explained below, s 180(2) provides a defence in a case where the impugned conduct goes beyond a mere error of judgment, and would contravene the statutory standard but for the defence.

The reason the distinction is perhaps controversial is that there is little guidance for when a matter will be considered to be a mere error of judgment. Can a director simply aver that whatever went wrong was simply an error of judgment and would the plaintiff (ASIC, but could also be the shareholders – see discussion below regarding statutory derivative actions) then have to provide evidence that it was not merely an error of judgment? Or, is the onus from the beginning on the plaintiff to make out a prima facie case that the alleged breach of the duty of care was not a mere error of judgment? Also, there has been a general understanding that there is a presumption that directors will be protected against liability if they have made proper business judgments, even if the judgments are proven, in hindsight, to be wrong. In short, there seems to be confusion between the protection that Justice Austin describes as mere errors of judgment and the protection provided by the business judgment rule. Closely linked to this controversial distinction is Justice Austin’s finding on who carries the burden of proof to establish that the criteria listed under section 180(2)(a)-(d) of the Act were met. In order to rely on the protection of the statutory business judgment rule, it has to be shown that a ‘business judgment’148 was made and that, in respect of such a ‘business judgment’, a director or office: (a) made the judgment in good faith for a proper purpose and (b) did not have a material personal interest in the subject matter of the judgment and (c) informed themselves about the subject matter of the judgment to the extent they reasonably believe to be appropriate and (d) rationally believed that the judgment was in the best interests of the corporation. An unresolved issue was whether there is a presumption that directors exercise business judgment by following the four criteria. Thus, that the plaintiff (usually ASIC, but could also be the shareholders – see discussion below regarding statutory derivative actions) carries the burden of proof to rebut these presumptions. 147 ASIC v Rich [2009] NSWSC 1229 [7242]. 148 Under s 180(3) of the Act a ‘business judgment’ is defined as follows: ‘business judgment means any decision to take or not take action in respect of a matter relevant to the business operations of the corporation.’

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In other words, should a court accept that directors exercised their business decision in such a manner unless it is proven not to be the case by the plaintiff? The alternative approach would be that these criteria are not presumptions, but that the defendants (directors or officers) need to prove each one of these aspects in order to be protected by the statutory business judgment rule under sections 180(2) and (3) of the Act. The statutory business judgment rule was supposed to create a presumption in favour of directors and the way in which the presumption in favour of directors was supposed to work, was explained as follows in the Explanatory Memorandum before section 180(2) was introduced: Provided directors or other officers fulfil the requirements of proposed subsection 180(2) paragraphs (a) to (d): • such directors have an explicit safe-harbour, being effectively shielded from liability for any breach of their duty of care and diligence; and • the merits of directors’ business judgments are not subject to review by the Courts.149 Proposed subsection 180(2) acts as a rebuttable presumption in favour of directors which, if rebutted by a plaintiff, would mean the plaintiff would then still have to establish that the officer had breached their duty of care and diligence150 (emphasis added).

Whether this has, in fact, been achieved with the way the statutory business rule is currently worded in the Act has been questioned by at least one commentator.151 A leading commercial law judge, Justice Santow, has also pointed out that it was uncertain152 whether or not the directors carried the burden of proof at least to establish that they have met the standards set out in section 180(2)(a)–(d). Justice Austin has now determined that the matter will have to be revisited (‘at the appellate level’) as the language is ‘profoundly ambiguous’, but for the moment, and as the provision is currently worded, it will be the defendants (directors and officers) who will carry the burden to proof that they have exercised their business judgments meeting the criteria set out in section 180(2)(a)–(d) in order to rely on the protection of the statutory business judgment rule:153 The question whether the plaintiff or the defendant bears the onus of proving the ingredients of s 180(2) is an important one that will eventually need to be resolved at the appellate level. With some hesitation in light of the US approach, I have reached the conclusion that the Australian statute casts the onus of proving the four criteria in s 180(2) on the defendants [director or officers against whom it is alleged that they have breached their statutory duty of care and diligence under s 180(1)] . . . As revealed in the Explanatory Memorandum, paras 6.1–6.10, the purpose of the introduction of a 149 The Parliament of the Commonwealth of Australia – House of Representatives, Explanatory Memorandum to the Corporate Law Economic Reform (CLERP) Bill 1998 (ISBN 0642 37879 7) para 6.9. 150 Ibid at para 6.10. 151 See D DeMott, ‘Legislating Business Judgment – A Comment from the United States’ (1998) 16 Company and Securies Law Journal 575, commented on by R P Austin and I M Ramsay Ford’s Principles of Corporations Law, Chatswood, LexisNexis Butterworths (14th edn, 2010) 438 para 8.310. 152 G F K Santow, ‘Codification of Directors’ Duties’ (1999) 73 The Australian Law Journal 336 at 348–9 and 350. 153 ASIC v Rich [2009] NSWSC 1229 [7269]–[7270].

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business judgment rule was (generally speaking) to ensure that directors and officers are not discouraged from taking advantage of opportunities that involve responsible risk-taking. Casting the onus of proof of the elements of the defence on the director or officer is not necessarily incompatible with that purpose, because it may happen in practice that the evidential burden can be shifted to the plaintiff relatively easily, if the defendant addresses the statutory elements in his or her affidavit, though the price to be paid is that the defendant is exposed to cross-examination on those matters.

Judicial criticism of ASIC’s case management Justice Austin was quite critical about the way in which ASIC had conducted the case. For instance, he observed that ASICs contentions had ‘a superficial appeal, but time and again they were shown to be unpersuasive when the underlying financial detail was investigated’.154 He observed that a very large number of documents were presented to the court, and that ASIC’s case was primarily based upon documentary evidence. However, when those documents were scrutinised in detail, they were found to be, wholly or in part, too unreliable to form the basis for financial findings. Also, there were ‘unexplained problems’ with the documents, adding to ‘a serious flaw in ASIC’s case’.155 Perhaps the most serious indication that Justice Austin was not impressed with the way in which ASIC ran the case, is his serious consideration that in addition to ordering ASIC to pay the defendants’ costs of the proceedings as agreed or assessed, he gave close consideration to the question of whether this was not an appropriate case for ordering costs assessed on the indemnity basis. In other words, not only the actual legal costs, but also additional costs associated with a long, drawn-out court case. It was with some hesitation and unassertiveness that Justice Austin eventually concluded that it was not warranted to impose indemnity costs.156 ASIC, and other Australian regulators as well, should take serious note of his observations when running cases in future, especially stark criticism like this: According to my observation, ASIC doggedly pursued an extremely large case because of its conviction, erroneously in my view but not reckless or totally groundless, that the evidence would support its contentions.157 (emphasis added)

10.4 Conclusion This chapter confirms the view of Lord Hoffman that it is far from easy to succinctly extract the duties expected of directors.158 For two reasons we have chosen to use the statutory duties, and in particular the civil penalty provisions in the 154 155 156 157 158

Ibid at [7319]. ASIC v Rich [2009] NSWSC 1229 [7319]. Ibid at [7325]–[7330]. Ibid at [7330]. Lord Hoffman, ‘Duties of Company Directors’ (1999) 10 European Business Law Review 78.

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Australian Corporations Act 2001, as the starting point for explaining directors’ duties and their potential liability. First, the Australian Corporations Act 2001 covers directors’ general law duties (duties at common law and in equity) very comprehensively, and provides a neat extraction of most of these. Second, the litigation in recent years, dealing with breaches of directors’ duties, almost exclusively has been based on breaches of the statutory duties and not on breaches of the duties at common law and in equity.

11 Enforcement of directors’ duties There are no qualifications for being a company director. Even directors of listed companies do not have to take any examinations . . . In principle, anyone can become a director. One might therefore think that the duties of an office so unexacting in its qualifications would be simple and easy to ascertain. In fact, this is far from the case. In fact, the duties of directors can be discovered only by examining at least three different sources which lie like strata one above the other. The bedrock is the duties which directors owe at common law, or more precisely in equity, simply because they are managing other people’s property. Over that layer has been imposed a number of specific statutory duties intended to reinforce the duties at common law. And over that layer has been imposed still further duties under various self-regulatory codes, which are also intended to reinforce the common law duties in areas not thought suitable for legislation. Lord Hoffman, ‘Duties of Company Directors’ (1999) 10 European Business Law Review 78

The governance of a public company should be about stewardship. Those in control have a duty to act in the best interests of the company. They must use the company’s resources productively. They must understand that those resources are not personal property. The last years of HIH were marked by poor leadership and inept management. Indeed, an attitude of apparent indifference to, or deliberate disregard of, the company’s underlying problems pervades the affairs of the group. Report of the HIH Royal Commission (Owen Report), Volume I, Department of the Treasury (2003), xiii–xiv

11.1 Introduction The Australian Securities and Investments Commission (ASIC), as the primary corporate regulator, has played such an active role in enforcing the civil penalty provisions over recent years that it has been questioned whether there is any real incentive left for corporations themselves to enforce directors’ duties.1 In fact, nowadays the single most distinctive factor between the Australian and 1 Jean J du Plessis, ‘Reverberations after the HIH and Other Recent Australian Corporate Collapses: The Role of ASIC’ (2003) 15 Australian Journal of Corporate Law 225, 240–3.

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United Kingdom corporations law models is the extent to which the primary Australian regulator, ASIC, has been prepared to use its extensive powers to enforce directors’ and officers’ duties under the civil penalty provisions of the Corporations Act 2001 (Cth) (the Act), albeit with mixed results (as discussed earlier in Chapter 6). In the UK it is still primarily the shareholders, and not the primary regulators, that will enforce directors’ duties. The UK Companies Act 2006 now makes it easier for individual shareholders to bring actions against directors, based on new and closer-defined statutory duties contained in the UK Companies Act 2006. However, it will still be the shareholders, not the regulators that will bring these actions against directors in breach of their statutory duties.2 In this respect, the fundamental duty of shareholders to enforce these duties did not change from the traditional common law position in the UK, explained by Johnstone and Chalk: [O]wing largely to the fact that [directors’ duties] are owed to the general body of shareholders taken as a whole, and enforceable against the directors only by the company acting on their behalf, these duties have not historically played a prominent role.3 (emphasis added)

In Australia, there is an array of actions available for private parties to institute actions against directors or to enforce their rights internally,4 but they are not used very often nowadays, and it is submitted that the reason for this is the active role that ASIC plays in enforcing civil penalty provisions against directors and officers.5 As noted by one commentator,6 ASIC has shown a marked reluctance in recent years to use its power under section 50 of the ASIC Act to bring civil action in the name of the company, or a class action for shareholders or investors for the recovery of damages for corporate misconduct. The purpose of section 50 has been captured by Justice Lockhart in Somerville v ASIC:7 An evident function of s 50 is to permit the commission, acting in the public interest, to cause proceedings to be taken where persons or corporations have suffered loss or harm arising from fraud, negligence or misconduct, but do not have the resources to maintain expensive and complicated litigation . . . In the case of a company, the commission may cause the proceedings to be begun and carried on the company’s name whether it consents or not.

The focus of this chapter is to provide an overview of the enforcement actions available to shareholders and some other parties. It deals briefly with the 2 Keith Johnstone and Will Chalk, ‘What Sanctions are Necessary?’ in The Business Case for Corporate Governance (Ken Rushton, ed.), Cambridge, Cambridge University Press (2008) 146 at 151–2 and 163–7. 3 Ibid at 151. 4 See Michael Duffy, ‘Shareholder Representative Proceedings: Remedies for the Mums and the Dads’ (2001) 75 Law Society Journal 54. 5 For some of the literature on the growth of civil penalties and its use, see Robert Baxt, ‘The Expansion of Civil Penalties under the Corporations Act’ (2002) 30 Australian Business Law Review 61; Michael Welsh, ‘Eleven Years On – An Examination of ASIC’s Use of an Expanding Civil Penalty Regime’ (2004) 17 Australian Journal of Corporate Law 175; Vicky Comino, ‘The Enforcement Record of ASIC Since the Introduction of the Civil Penalty Regime’ (2007) 20 Australian Journal of Corporate Law 183. 6 Janet Austin, ‘Does the Westpoint Litigation Signal a Revival of the ASIC s 50 Class Action?’ (2008) 22 Australian Journal of Corporate Law 8 at 8. 7 (1995) 131 ALR 517 at 523.

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statutory derivative action (Part 2F.1A); actions aimed at unfairly prejudicial, discriminatory or oppressive conduct by the corporation or its directors (Part 2F.1); and injunctions under section 1324 of the Corporations Act.8 The chapter also canvasses the criminal liability of directors and selected types of criminal offences under the Corporations Act 2001.

11.2 The statutory derivative action: Part 2F.1A 11.2.1 The case to introduce a statutory derivative action These provisions [statutory derivative action] basically make it easier for shareholders and others to institute proceedings (including proceedings against directors) where the directors refuse to do so. These provisions obviously increase the exposure of directors, as there is now greater potential for actions to be brought against directors in the name of the company.9

In many respects, the derivative action is unique. It allows an individual to bring an action that belongs to another (it should be remembered that directors owe their duty to the corporation and that the corporation is thus the proper plaintiff in the case of any breach of these duties). Furthermore, the benefit of this action, brought by the shareholder, will not directly advantage that member; rather, it will accrue to the corporation, which has, for whatever reason, decided not to pursue the matter. Thus, it allows the shareholder to usurp the authority that the corporate entity has vested in the board of directors. Significantly, it also allows the minority shareholders of the corporation to act as some sort of corporate watchdog over the majority, and to set the company in motion to establish their rights in situations in which the majority shareholders oppose the company doing so.10 The main difficulties associated with the common-law derivative action, which preceded the introduction of the statutory derivative action under Part 2F.1A, were summarised as follows in the Explanatory Memorandum to the CLERP Bill 1998 (which became the CLERP Act 1999):11 ● the effect of ratification of the impugned conduct by the general meeting of shareholders (if effective, the purported ratification by a majority of shareholders could deny the company as a whole, and hence minority shareholders, any right of action against the directors) ● the lack of access to company funds by shareholders to finance the proceedings (where a shareholder seeks to enforce a right on behalf of a company, they are likely to be disinclined to risk having costs awarded against them 8 For a fuller discussion, see Jason Harris, Anil Hargovan and Michael Adams, Australian Corporate Law, Sydney, LexisNexis (2009, 2nd edn), Chapter 20. 9 Emilios Kyrou, ‘Directors’ Duties, Defences, Indemnities, Access to Board Papers and D&O Insurance Post CLERPA’ (2000) 18 Company and Securities Law Journal 555, 561. 10 See Metyor Inc v Queensland Electronic Switching P/L [2002] QCA 269 (30 July 2002). 11 Explanatory Memorandum to the CLERP Bill 1998, para 6.15.

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in a case which will ultimately benefit the company as a whole, not just individual shareholders) and ● the strict criteria that need to be established before a court may grant leave. The current statutory derivative action allows an eligible applicant, which includes shareholders and directors, to commence proceedings on behalf of a company, including for breaches of directors’ duties under sections 180–4, where the company is unwilling or unable to do so. Proceedings may be commenced in respect of wrongs done to the company, with the company thereby benefiting from successful actions.12

11.2.2 Eligible applicant Section 236(1), outlining who is entitled to apply to bring a statutory derivative action, provides as follows: (1) A person may bring proceedings on behalf of a company, or intervene in any proceedings to which the company is a party for the purpose of taking responsibility on behalf of the company for those proceedings, or for a particular step in those proceedings (for example, compromising or settling them), if: (a) the person is: (i) a member, former member, or person entitled to be registered as a member, of the company or of a related body corporate or (ii) an officer or former officer of the company and (b) the person is acting with leave granted under section 237. Thus, an application for leave can be made by: ● members of the company (including those with a present entitlement to be registered) ● former members of a company or related body corporate and ● directors and officers, present and former, of the company. Under the common law, only members may institute derivative proceedings on behalf of a company. Former members were included under the statutory provision because they may have been compelled to leave the company in view of the dispute potentially giving rise to the litigation on behalf of the company. Members and former members of a related body corporate are also included as they may be adversely affected by the failure of the company to take action and therefore may have a legitimate interest in applying to commence a derivative action. This will be particularly relevant in a corporate group scenario where subsidiary companies wish to take action against the directors of the holding company; for example, the New South Wales Supreme Court decision in Goozee v Graphic World Group Holdings Pty Ltd.13 In this case, however, leave to institute a derivative action was refused, as the court held that the applicant was not acting in good faith, and the derivative action would not be in the best interests of each 12 Ibid, para 6.17. 13 [2002] NSWSC 640 (25 July 2002).

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immediate holding company. The conferral of standing on officers recognises that they are most likely to be the first to become aware of a right of action that is not being pursued by the company.14 ASIC is not included as an eligible applicant. The motivation of this rule is discussed as follows in the Explanatory Memorandum to the CLERP Bill 1998:15 [A]s the basic policy objective of derivative proceedings is to provide an effective remedy for investors and to overcome the difficulties in Foss v Harbottle – there is no proper role for ASIC to bring such proceedings. In particular, the statutory action is not intended to be regulatory in nature, but to facilitate private parties to enforce existing rights attaching to the company – effectively, the action is designed to be a self help measure. In this regard, a statutory derivative action has the potential to remove some of the regulatory burden from ASIC by making it easier for investors themselves to protect the interests of a company. (There are other means by which ASIC may commence actions on behalf of investors, for example, under s 50 of the ASIC Act.)

11.2.3 Cause of action The statutory derivative action may be used in respect of a cause of action that a company has against either: ● a director of the company for breach of duties owed to the company or ● a third party for a breach of contract or in respect of a tortious act committed by that third party (it is however presumed that where proceedings involve a third party, granting leave is not in the best interests of the company unless the contrary is proved (section 237(3)).16 The provisions allow a person to intervene in proceedings to which a company is a party, on behalf of the company, for the purpose of taking responsibility on behalf of the company for those proceedings, or for a particular step in those proceedings. This includes continuing, defending, discontinuing, compromising or settling the proceedings on behalf of the company.17

11.2.4 Leave of court required to institute the statutory derivative action It was realised that appropriate checks and balances should be provided in the legislation to prevent abuse of the proceedings and to ensure that company managements are not undermined by vexatious litigation and that company funds are not expended unnecessarily. This is done by requiring in section 237 that a court should only grant leave to proceed with the action if:18 14 Explanatory Memorandum to the CLERP Bill 1998, paras 6.26–6.28. 15 Ibid, para 6.30. 16 Ibid, para 6.20. 17 Ibid, para 6.21. 18 For discussion of the legal principles surrounding the operation of s 237, see Swansson v Pratt (2002) 42 ACSR 313; Fiduciary Ltd v Morningstar Research Pty Ltd (2005) 53 ACSR 732; Ragless v IPA Holdings Pty Ltd (in liq) (2008) 65 ACSR 700; Chahwan v Euphoric Pty Ltd (2008) 65 ACSR 661; Oates v Consolidated Capital Services Ltd (2009) 72 ACSR 506.

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there is inaction by the company: section 237(2)(a) the applicant is acting in good faith: section 237(2)(b) ● the action appears to be in the best interests of the company: section 237(2)(c) ● there is a serious question to be tried: section 237(2)(d) and ● the applicant gave written notice to the company of the intention to apply for leave, and of the reasons for applying, at least 14 days before making the application, or circumstances are such that it is appropriate to grant leave in any case: section 237(2)(e). Upon the applicant establishing each of the five ingredients of section 237(2) to the court’s satisfaction, the court is required to grant the application for leave under section 237(1). There is no residual discretion.19 In one of the first cases to interpret Part 2F.1A, RTP Holdings Pty Ltd v Roberts,20 Lamer J explained why leave of the Court is necessary for a derivative action: ●



There are good reasons why leave should first be obtained. If any former member or officer was able to cause the company to commence proceedings before leave was granted, a multiplicity of suits might arise. Moreover a member or officer could usurp the proper functions of the company. A company is entitled to decide for itself whether it wishes to bring, defend or intervene in legal proceedings. Where a company will not itself bring, defend or intervene in proceedings it is necessary that there be some filtering system such as the requirement for leave before proceedings are commenced in the name of the company.21

Empirical evidence suggests that it is a moot point whether the introduction of the statutory derivative action, as framed in Part 2F.1A,22 has served as an effective watchdog by empowering shareholders to litigate on behalf of the company to redress wrongs done to the company.23

11.3 Oppressive conduct of affairs: Part 2F.1 11.3.1 Type of conduct covered by Part 2F.1 Section 232 of the Corporations Act specifies the grounds for a court order under Part 2F.1. It provides that a court can make any order under section 233 (see discussion below) if certain specified conduct by the corporation is either contrary to the interests of the members as a whole; or oppressive to, unfairly 19 Chahwan v Euphoric Pty Ltd (2008) 65 ACSR 661. 20 [2000] SASC 386 (8 November 2000). 21 Ibid [14]. 22 For criticisms of law reform proposals leading up to the introduction of Part 2F.IA, see Anil Hargovan, ‘Under Judicial and Legislative Attack: The Rule in Foss v Harbottle’ (1996) 113 South African Law Journal 631. 23 See further, I Ramsay and B Saunders, Litigation by Shareholders and Directors: An Empirical Study of the Statutory Derivative Action, Melbourne, Centre for Corporate Law and Securities Regulation, The University of Melbourne (2005).

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prejudicial to, or unfairly discriminatory against, a member or members whether in that capacity or in any other capacity. Three specified forms of conduct are listed: (a) the conduct of a company’s affairs or (b) an actual or proposed act or omission by or on behalf of a company or (c) a resolution, or a proposed resolution, of members or a class of members of a company. The oppression remedy is frequently relied upon, especially by members in proprietary companies whose commercial interests may be exploited and who may be unable to sell their shares to exit the company. The Corporations Act does not define oppression. The courts have defined oppression widely to mean conduct that is ‘burdensome, harsh and wrongful’.24 In the leading decision on the operation of section 232, the High Court in Wayde v NSW Rugby League Ltd25 held that there is no need to establish any irregularity or breach of legal rights to succeed. Thus, conduct that is legal may still be oppressive.26 Furthermore, mere prejudice or discrimination is insufficient to establish a breach of section 232, as the wording in that section requires the prejudice or discrimination to be unfair. Oppression may occur even though all members of a company are treated equally.27 There is no requirement to prove that the company or its officers intended to cause harm to the members.28 The broad nature of this provision, together with the wide nature of relief available (identified below), makes it an important remedy for minority shareholders.29

11.3.2 Who may apply for relief under Part 2F.1? Section 234 allows the following parties to bring an application under Part 2F.1: ● a member of the company, even if the application relates to an act or omission that is against: (i) the member in a capacity other than as a member or (ii) another member in their capacity as a member or ● a person who has been removed from the register of members because of a selective reduction or ● a person who has ceased to be a member of the company if the application relates to the circumstances in which they ceased to be a member or ● a person to whom a share in the company has been transmitted by will or by operation of law or 24 Scottish Co-operative Wholesale Society Ltd v Meyer [1959] AC 324. 25 (1985) 180 CLR 459. 26 For recent application of these legal principles, see Dodrill v The Irish Restaurant & Bar Co Pty Ltd [2009] QSC 317. 27 John J Starr (Real Estate) Pty Ltd v Robert R Andrew (A’asia) Pty Ltd (1991) 6 ACSR 63, 28 Campbell v Backoffice Investments Pty Ltd [2009] HCA 25. 29 See further, Ian Ramsay, ‘An Empirical Study of the Use of the Oppression Remedy’ (1999) 27 Australian Business Law Review 23.

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a person whom ASIC thinks appropriate having regard to investigations it is conducting or has conducted into: (i) the company’s affairs or (ii) matters connected with the company’s affairs. The discretion of ASIC under section 234(e) is, however, now wide enough to allow any person to have standing if ASIC thinks it to be appropriate after the investigation conducted into the company’s affairs or matters connected with the company’s affairs. This, obviously, may include a creditor. ‘Member’ was defined in the former section 246AA(5) as including a legal personal representative of the member and others to whom a share has been transmitted under a will or by operation of law. It was, however, required that the shareholder be a ‘registered’ shareholder.30 It will be apparent from the above that this is no longer a requirement. Even a person removed from the register or who ceased to be a member, if the application relates to the circumstances in which they ceased to be a member, could bring the application. ●

11.3.3 Nature of relief available under Part 2F.1 Section 232(1) confers upon a court a broad discretion to make ‘any order under this section that it considers appropriate in relation to the company’. Apart from this very wide discretion, section 232(1) lists 10 specific orders the court could consider, namely: ● that the company be wound up ● that the company’s existing constitution be modified or repealed ● that conduct of the company’s affairs be regulated in future ● for the purchase of any shares by any member or person to whom a share in the company has been transmitted by will or by operation of law ● for the purchase of shares with an appropriate reduction of the company’s share capital ● for the company to institute, prosecute, defend or discontinue specified proceedings ● authorising a member, or a person to whom a share in the company has been transmitted by will or by operation of law, to institute, prosecute, defend or discontinue specified proceedings in the name and on behalf of the company ● appointing a receiver or a receiver and manager of any or all of the company’s property ● restraining a person from engaging in specified conduct or from doing a specified act and ● requiring a person to do a specified act. 30 Niord Pty Ltd v Adelaide Petroleum NL (1990) 8 ACLC 684.

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It is clear that the judicial discretion afforded under section 233 may be exercised to mould a remedy appropriate to each particular case. Section 233(2) ensures that the general law applying to winding up will apply if the court orders that the company be wound up. Previously, the court’s discretion was limited in that it could not order that a company be wound up if it would unfairly prejudice the oppressed member(s): former section 246AA(4). This limitation has now been removed. Where a court’s order effects a change to the company’s constitution the company cannot, without leave of the court, alter the constitution in a manner that is inconsistent with the order, unless the order states that the company does have the power to make such a change: section 232(3)(a). The company could, alternatively, obtain the leave of the court to repeal or modify its constitution if it was modified by the court in terms of section 233(1)(b).

11.4 Section 1324 injunctions 11.4.1 Introduction Strangely, the injunctive relief provided for under section 1324 has only rarely been used. Subsection 1324(1) allows ASIC or a person ‘whose interests have been, are or would be affected by the conduct’ to apply for an injunction or interim injunction (section 1324(4)) restraining a person who engages in conduct which, in essence, directly or indirectly involves a contravention of the Corporations Act 2001 (Cth). Under section 1324(2), the court may require a person who fails or refuses to do an act required by the Act to do such an act. We emphasise that section 1324 applies to the entire Act.

11.4.2 Section 1324(1) In essence, section 1324(1) provides that where a person has engaged, is engaging or is proposing to engage in conduct that constituted, constitutes or would constitute a contravention of the Act, the court may, on the application of ASIC or of ‘a person whose interests have been, are or would be affected by the conduct’, grant an injunction, on such terms as the court thinks appropriate, restraining the first-mentioned person from engaging in the conduct and, if in the opinion of the court it is desirable to do so, requiring that person to do any act or thing. Importantly, the phrase ‘a person whose interests have been, are or would be affected’, has been interpreted broadly to apply to creditors, employees, shareholders and other stakeholders31 – even though, as discussed earlier, directors owe their duties first and foremost to the company. Accordingly, while the general duties of directors (for example, due care and diligence, good faith, proper 31 See, for example, Airpeak Pty Ltd v Jetstream Aircraft (1997) 15 ACLC 715; Allen v Atalay (1993) 11 ACSR 753.

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purpose) under Chapter 2D of the Act are owed to the company, and only ASIC or the company (if seeking a compensation order – see section 1317(2)) has standing to initiate action for breach as the duties are civil penalty provisions, if a shareholder or a creditor, for example, suffers some loss or damage due to a breach or potential breach of a Chapter 2D duty, they may utilise section 1324 to have the particular conduct stopped, and/or to obtain damages (under section 1324(10), discussed below). This also applies, for example, to the insolvent trading provisions, which is particularly relevant for creditors who may be affected by a director incurring debts at a time when the company is insolvent or faces pending insolvency. Without section 1324, stakeholders affected by corporate misconduct, but without standing, would be dependent on ASIC to take action. This highlights the power of section 1324 as a remedial tool for stakeholders, and explains why commentators are frustrated by the fact that it has to date been under-utilised.32 For example, Baxt has commented: Section 1324 has, in my view, been rather surprisingly little used in trying to make directors accountable to a broader range of persons. The section creates a statutory right in shareholders and others who may establish that they have a relevant interest in pursuing a claim to have the directors comply with the duties imposed on them by the Corporations Act.33

With the statutory derivative action under Part 2F.1A now also available to shareholders and others, and with ASIC’s active role as litigating regulator, the use of section 1324 may become even rarer in future.

11.4.3 The court’s discretion Section 1324 provides the court with a broad discretion to make orders on such terms as it thinks appropriate and to discharge and vary such at any time: section 1324(1), (2) and (5). The court may also order the person to pay damages to any other person in lieu or in addition to an order under section 1324(1) and (2): section 1324(10). Moreover, the court may order relief under section 1324(1) or (2) whether or not it appears that: ● the person will continue to engage, or refuse/fail to engage, in that conduct ● the person has previously engaged, or refused/failed to engage, in that conduct and 32 See James McConvill, ‘Part 2F.1A of the Corporations Act: Insert a New s 242(2) or Give it the Boot?’ (2002) 30 Australian Business Law Review 309; James McConvill, ‘Australian Securities and Investments Commission’s Proposed Power to Issue Infringement Notices: Another Slap in the Face to s 1324 of the Corporations Act or an Undermining of Corporate Civil Liberties?’ (2003) 31 Australian Business Law Review 36; James McConvill, ‘Geneva Finance and the “Duty” of Directors to Creditors: Imperfect Obligations and other Imperfections’ (2003) 11 Insolvency Law Journal 7; James McConvill, ‘Directors’ Duties to Creditors in Australia After Spies v The Queen’ (2002) 20 Company and Securities Law Journal 4; James McConvill and Martin Joy, ‘The Interaction of Directors’ Duties and Sustainable Development in Australia: Setting off on the Unchartered Road’ (2003) 27 Melbourne University Law Review 116; James McConvill, ‘Ensuring Balance in Corporate Governance’ (2001) 12 Australian Journal of Corporate Law 293; Robert Baxt, ‘A Body Blow to Section 1324 of the Corporations Law?’ (1996) 14 Company and Securities Law Journal 312. 33 Bob Baxt, ‘Directors’ Duty of Care and the New Business Judgment Rule’ in Ian Ramsay (ed.), Key Developments in Corporate Law and Trusts Law, Sydney, LexisNexis Butterworths (2002) 164.

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there is an imminent danger of substantial damage to any person if that person engages, or refuses/fails to engage, in that conduct: section 1324(6) and (7). In Australian Securities and Investments Commission v Mauer-Suisse Securities Ltd,34 Palmer J held that when exercising its discretion under section 1324, a court is not strictly confined by the considerations that would be applicable if it were exercising its equitable jurisdiction to grant injunctions (that is, whether there is a serious question to be tried, where the balance of convenience lies, and whether damages would be an adequate remedy). Rather, according to Palmer J, while the approach to determining an application under section 1324 will be virtually the same as an application for an injunction in equity, the ‘broad’ question the court must consider in an application for a section 1324 injunction is ‘whether the injunction would have some utility or would serve some purpose within the contemplation of the Act’.35 This approach accords with the universal view now held by academics and judges that section 1324 should be accorded an expansive interpretation.36 Later cases have applied the Mauer-Suisse approach, and in doing so have emphasised that equitable considerations (in particular the balance of convenience) still represent a sound basis for undertaking a preliminary assessment of what factors should be reviewed against ASIC’s statutory role in determining whether to grant an injunction, and are applied when considering applications for interim injunctions under section 1324(4) as to whether it is ‘desirable’ (the wording used in section 1324(4)) for the injunction to be granted.37 ●

11.4.4 Remedies in particular The main force of section 1324 is to provide restraining and mandatory injunctive relief. However, section 1324(9) widens the relief available under section 1324 to include the Mareva-type relief provided for under section 1323 of the Act. Section 1323 gives power to the court to prohibit payment or transfer of money, securities, futures contracts or property. Section 1324(10) provides that where the court has power under this section to grant an injunction restraining a person from engaging in particular conduct, or requiring a person to do a particular act or thing, the court may, either in addition to or in substitution for the grant of the injunction, order that person to pay damages to any other person. In Vanmarc Holdings Pty Ltd v PW Jess & Associates 34 (2002) 42 ACSR 605. 35 Ibid 609. 36 See discussion in James McConvill and Martin Joy, ‘The Interaction of Directors’ Duties and Sustainable Development in Australia: Setting off on the Unchartered Road’ (2003) 27 Melbourne University Law Review 116, 135. 37 See ASIC v Triton Understanding Insurance Agency Pty Ltd and Others (2003) 48 ACSR 244, 256; Tekinvest Pty Ltd v Lazarom [2004] NSWSC 940 (11 October 2004), [21]–[22].

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Pty Ltd,38 it was confirmed that damages are available to complainants under section 1324(10) even if an injunction is not sought under section 1324(1).39

11.5 Criminal liability of directors 11.5.1 The importance of the criminal sanction in the corporations law The sanctions explained above could be described as civil sanction based on statutory provisions. We have chosen not to deal with non-statutory civil sanction (for example, action against directors or other personnel for common law negligence or breach of trust in equity) because of limited space and the fact that the statutory sanctions are so prominent nowadays. The criminal sanction is, however, also a very prominent one in the Australian corporations law and some mention should be made of potential offences directors and officers can commit under the Act. A comprehensive discussion of possible offences for corporations, directors and other officers falls outside the scope of this work. Appendix G to the Report of the HIH Royal Commission provides a very useful summary of the offence provisions of several Acts. This appendix also contains an excellent explanation of the differences between the corporations law before and after 13 March 2000. The relevance of this date is that significant amendments were made to the Corporations Act with effect from 13 March 2000.40 We deal here with only some of the most important criminal offences that directors and officers can commit, and only with those mentioned in the Act. There are numerous other offences, in particular in the areas of occupational health and safety and environmental law, and, of course, under general criminal law (for example, theft, complicity and a range of deception offences)41 that could be committed by directors and officers, but also that fall outside the scope of this work. Subject to the provisions of the Act, the Criminal Code Act 1995 (the Code) applies to all offences against the Act.42 The Code clarifies the operation of general principles of criminal liability by setting in place the ‘physical’ element (what traditionally was the actus reus or physical act of the offence) and the ‘fault’ element of an offence (traditionally the mens rea). To briefly explain, the Code provides that the physical elements of an offence are: (a) conduct or (b) the circumstances in which conduct occurs or (c) a result of conduct. 38 (2000) 34 ACSR 222 at 227. 39 See also Airpeak Pty Ltd v Jetstream Aircraft (1997) 15 ACLC 715, 720 (Einfeld J). 40 Report of the HIH Royal Commission (Owen Report), Volume I, Department of the Treasury (2003) 321–30. 41 See, for example, James McConvill and Mirko Bagaric, ‘Criminal Responsibility Based on Complicity Among Corporate Officers’ (2004) 16 Australian Journal of Corporate Law 172. For a general discussion of these offences, see Mirko Bagaric and Ken Arenson, Criminal Laws of Australia, Melbourne, Oxford University Press (2004), Chs 9 and 10. 42 Section 1308A of the Act.

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Under the Code, the prosecution has the onus of proving each physical element contained in the offence. Along with the physical element(s), the prosecution is also required to prove the fault element of the offence. The Code sets down four so-called ‘default’ fault elements: intention, knowledge, recklessness and negligence. The Code operates such that an offence can have its own fault element specific to the physical element of the offence; however, where there is no specified fault element, the Code expressly states that a default fault element will apply to determine liability. The Code provides that for the ‘conduct’ part of an offence (for example, improper use of company information), the default element is ‘intention’; for ‘circumstances’ or ‘result’ (for example, causing detriment to the corporation) the default element is ‘recklessness’. Part 2.5 of the Criminal Code is particularly significant, in that it expresses how the Code applies to bodies corporate. It explains how the principles of criminal responsibility in the Code apply to bodies corporate in relation to offences against Commonwealth laws (including the Corporations Act). Thus, to determine whether the company will be criminally liable for intentional offences of directors or other officers under the Act, Part 2.5 needs to be consulted (unless the relevant provision states that the principles of criminal responsibility under the Code do not apply). Part 2.5 provides that the physical element of an offence will be attributed to a body corporate where it is committed by an agent or officer of the body corporate acting within the actual or apparent scope of their authority. This is, in essence, a codification of the traditional common law principle attributing criminal liability to the company when a criminal act is committed by the ‘directing mind’ of the company.43 In relation to the fault element, Division 12.3(1) provides that where ‘intention, knowledge or recklessness’ is a fault element of an offence, that element can be attributed to the company if the company ‘expressly, tacitly or impliedly authorised or permitted the commission of the offence’. Division 12.3(2) of the Code is crucial here, as it provides that ‘authorisation or permission’ may be established by a number of means including: (a) proving that a corporate culture existed within the body corporate that directed, encouraged, tolerated or led to non-compliance with the relevant provision or (b) proving that the body corporate failed to create and maintain a corporate culture that required compliance with the relevant provision. ‘Corporate culture’ is defined under Part 2.5 (section 12.3(6)) of the Code as an ‘attitude, policy, rule, course of conduct or practice existing within the body corporate generally or in the part of the body corporate in which the relevant activities take place’. The effect of Part 2.5, therefore, is that the intention of a company will be equated with its ‘corporate culture’. It is generally accepted that Part 2.5 of the Code, by embedding the concept of corporate culture, will have a significant impact on the approach to determining criminal liability of companies

43 See Tesco Supermarkets v Nattrass [1971] 2 All ER 127.

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for the actions of their directors as well as their employees and agents.44 Part 2.5 may, indeed, impose a direct duty on companies to implement a compliance system to avoid systematic contravention of federal legislation, including the Act.45 It is pertinent to note that there is often very little, if any, substantive difference between conduct that is a criminal or a civil wrong. As a result of the huge expansion over the past few decades in the types of conduct that are now proscribed by the criminal law, it is not tenable to provide a coherent rationale to distinguish between criminal and civil wrongs. It is certainly not the case, for example, that criminal liability is now reserved for the most heinous or harmful types of conduct. A large amount of very trifling conduct – such as littering and incorrectly parking a motor vehicle, and in some jurisdictions even flying a kite to the annoyance of others – is a criminal offence.46 Thus, as a general rule, few inferences, in terms of the seriousness of the proscribed conduct, can be drawn merely from whether a director or officer is guilty of a civil or a criminal penalty. Whether conduct is made a criminal or civil offence often turns on matters such as the (actual or perceived) public sentiment, at the time the offence was created, in relation to the relevant conduct. Given the increasing amount of public disillusionment in recent years regarding corporate behaviour and collapses, it is not surprising that progressively we are seeing a range of new corporate criminal offences being enacted. This, however, does not necessarily mean that the conduct prohibited by these provisions is objectively particularly serious or damaging. Despite the fact that there is no coherent distinction between civil and criminal wrongs, there are significant differences in the manner in which the respective breaches are treated. Criminal offences tend to result in stigmatisation and subject the agent to a range of coercive measures, including imprisonment. Civil wrongs do not generally involve moral censure, and the harshest measure is generally in the form of a monetary extraction. Thus, whether conduct is dealt with by means of civil or criminal liability often seems arbitrary. In addition, the conduct covered by the civil and criminal wrongs is often very similar, and in fact can often be dealt with under either regime. In such circumstances, prosecution authorities effectively may elect to pursue the director or officer in either the civil or the criminal jurisdiction. Faced with such a choice, it might seem most appropriate to elect to go down the criminal stream in order that the defendant is held fully accountable for their conduct. However, there are often compelling reasons for instead pursuing a civil remedy. First, it is generally easier to establish civil wrongdoing, where the burden of proof is on the balance of probabilities, instead of the higher standard of beyond 44 See James McConvill and John Bingham, ‘Comply or Comply: The Illusion of Voluntary Corporate Governance’ (2004) 22 Company and Securities Law Journal 208, 213–14. 45 See Christine Parker and Olivia Conolly, ‘Is there a Duty to Implement a Corporate Compliance System in Australian Law?’ (2002) 30 Australian Business Law Review 273, 282–3. 46 For further discussion regarding the convergence between criminal and civil offences, see Mirko Bagaric, ‘The “Civil-isation” of the Criminal Law’ (2001) 25 Criminal Law Journal 197.

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reasonable doubt. The rules of evidence in relation to civil proceedings are also far more liberal and hence prosecution authorities (including the Commonwealth Department of Public Prosecutions in relation to the Act) can normally tender a greater amount of evidence in support of a civil case.47 Second, people charged with criminal offences are likely to more fiercely contest such allegations than allegations that have only a civil dimension. This is because criminal offences carry a greater stigma and often involve a risk of imprisonment – which is the harshest penalty in our system of law. Thus, the prospect of reaching an agreed settlement with a director or officer is diminished if criminal proceedings are pursued. Prosecution authorities should not be unduly influenced by seeking to finalise matters as expeditiously as possible. Ultimately, the most important objective is to ensure that all people are held fully responsible for their transgressions. It would be remiss of prosecution authorities not to give considerable weight to the likely cost to the public of a long criminal trial – which can readily blow out into millions of dollars – in deciding whether they should launch civil or criminal proceedings against a director or officer. In some cases, where the evidence is particularly strong, even the most powerful and well-resourced directors or officers may plead guilty to criminal offences. The advantage to them in doing so is that a plea of guilty, which spares the community significant costs in the form of legal costs and is viewed as evidence of contrition by the accused person, entitles the accused to a significant penalty reduction.

11.5.2 Selected criminal offences directors and other officers can commit under the Corporations Act 11.5.2.1 General Schedule 3 to the Act contains all the penalties (criminal as well as civil) and maximum periods of imprisonment for each of the criminal offences created by the Act. After the amendments effected by CLERP 9 (after 1 July 2004) there are 590 different offences for which penalties are prescribed in Schedule 3. These offences can be committed by a wide variety of persons, but they are primarily offences that can be committed by the company, directors and officers and employees of the company. Since we have concentrated on the civil penalty provisions as far as directors’ duties are concerned, we will also only give an overview of the offences directors can commit in relation to those provisions. Apart from section 180 (duty of care and diligence) and sections 674(2A) and 675(2A) (continuous disclosure), all the other civil penalty provisions are also made offences under the Act. 47 For a discussion of evidence law and the different rules that apply in the criminal and civil jurisdiction, see Ken Arenson and Mirko Bagaric, Understanding Evidence Law, Sydney, LexisNexis Butterworths (2002).

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11.5.2.2 Specific offences for breaches of duties Whereas sections 181–3 reflect directors’ civil obligations, section 184 lays down the requirements for when directors will commit criminal offences in contravening their duties of good faith, use of position and use of information. Under section 184(1) a director or other officer of a corporation commits an offence if they are reckless, or are intentionally dishonest, and fail to exercise their powers and discharge their duties in good faith in the best interests of the corporation, or for a proper purpose. Section 184(2) provides that a director, other officer or employee of a corporation commits an offence if they use their position dishonestly with the intention of directly or indirectly gaining an advantage for themselves, or someone else, or causing detriment to the corporation; or recklessly as to whether the use may result in themselves or someone else directly or indirectly gaining an advantage, or in causing detriment to the corporation. In terms of section 184(3), a person who obtains information because they are, or have been, a director or other officer or employee of a corporation commits an offence if they use the information dishonestly with the intention of directly or indirectly gaining an advantage for themselves, or someone else, or causing detriment to the corporation; or recklessly as to whether the use may result in themselves or someone else directly or indirectly gaining an advantage, or in causing detriment to the corporation. A director who fails to perform his or her duties under these sections may be guilty of a criminal offence with a penalty of $200 000 or imprisonment for up to five years, or both.48 The most common penalty for directors who commit the offences comparable to the civil penalty provisions is a penalty of $200 000 (or $1 million for financial services civil penalty provisions) or imprisonment for five years, or both.49 The offences associated with insider trading are, however, more serious. A person who commits the insider trading criminal offences faces fines of up to $2 million, or imprisonment for five years, or both.50

11.6 Conclusion In this chapter we have shown that there are several ways of enforcing the provisions of the Corporations Act 2001 (Cth). Although ASIC plays a dominant role in this regard, shareholders, directors and officers, and creditors are also given standing to enforce directors’ duties either on behalf of the company or on their own behalf. The statutory derivative action (Part 2F.1A) and oppressive remedies (Part 2F.1) are the most important remedies available to shareholders. 48 Item 30 of Schedule 3 to the Act; Para 5.3 of Part 1.5 (Small Business Guide) of the Act. 49 See Items 50, 80, 86, 89–90, 117, 138, 163A–163C, 164A and 309B–310B of Schedule 3 to the Act; and subclause 29(7) of Schedule 3 to the Act. 50 See Items 311C and 312A of Schedule 3 to the Act.

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Section 1324 injunctions and damages provide powerful remedies to any person affected by conduct of the company in contravention of provisions of the Act, but its use in practice is disappointing. It will also be apparent that there are numerous criminal sanctions for contraventions of the Act. As pointed out in Chapter 7, several criminal charges have already been brought against several directors of the large corporations that have collapsed since 2000, leading to the imprisonment of people like Ray Williams, Rodney Adler, Brad Cooper and others. There are also criminal proceedings pending against the directors of Chartwell Enterprises (Ian Rau and Graeme Hoy) and the directors of Opes Prime.51 It is highly likely that further civil and criminal proceedings will follow the collapses of Westpoint, Centro Properties, Storm Financial,52 Fincorp and Kleenmaid. 51 See ‘Chartwell Officer Arrested on Criminal Charges’ ASIC Media Release 09–139AD (11 August 2009), available at ; ‘ASIC Brings Charges Against Opes Prime Directors’, ASIC Media Release 10–05AD (11 January 2010), available at ; Chris Zappone, ‘Opes Prime Directors Charged by ASIC’, Sydney Morning Herald (11 January 2010), available at . 52 See ASIC Media Centre, ‘Update for Former Clients of Storm Financial, available at .

PART THREE CORPORATE GOVERNANCE IN INTERNATIONAL AND GLOBAL CONTEXTS

12 Corporate governance in the USA, the UK and Canada Two features can be considered to describe the modern world – globalization and the free market. It is widely accepted – almost unquestioningly – that free markets will lead to greater economic growth and that we will all benefit from this economic growth. G¨ uler Aras and David Crowther ‘Convergence: A Prognosis’ in G¨ uler Aras and David Crowther (eds), Global Perspectives on Corporate Governance and CSR, Farnham, Gower Publishing Ltd (2009) 314–15

12.1 Introduction In this chapter we give a brief overview of corporate governance in the USA, the UK and Canada, while we deal with the OECD principles of corporate governance and corporate governance in Germany, China and Japan in Chapter 13. In the first edition of this book we dealt with the OECD principles of corporate governance and corporate governance in the USA, the UK and Germany in one chapter (Chapter 12). As we decided to add China and Japan as two new and important jurisdictions, the chapter became too long. The reason for the split is that corporate governance in the USA, the UK and Canada is classified as Anglo-American models. The OECD principles include traditional Anglo-American corporate governance principles, but it also goes wider – spanning across principles applying to a traditional unitary board structure and principles applying to a typical two-tier board structure. Germany has always been seen as the prime example of a jurisdiction that adopted a true two-tier board structure for public corporations and larger proprietary companies, while Japan has been influenced by this. China has a unique corporate governance model because of the political model adopted in that country.

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12.2 United States 12.2.1 Background to the corporate governance debate in the USA Corporate governance has been a topic for discussion in the USA for a very long time, and the materials on corporate governance in the USA are extensive. In such a dominant world economy, United States debates on corporate governance will almost invariably influence corporate governance debates in other jurisdictions. It is, therefore, important to deal with corporate governance debates in the USA to lay the basis for understanding corporate governance models in other parts of the world. The debate on corporate governance in the USA had started as early as 1932, when Berle and Means published their book, The Modern Corporation and Private Property.1 The importance of this debate was emphasised further by Mace’s book, Directors: Myth and Reality, published in 1971, but the discussion became really heated in 1982 with the publication by the American Law Institute (ALI) of its Principles of Corporate Governance and Structure: Restatement and Recommendations. This project, which had started off quite modestly, resulted in a stream of publications on the topic of corporate governance in the USA. The Proposed Final Draft (later termed Principles of Corporate Governance and Structure: Analysis and Recommendations) was only approved in May 1992. However, publications on this topic did not stop there. In 1993 alone, 73 articles published in American law review journals dealt directly with the topic of corporate governance. One commentator justly alluded to ‘The Emergence of Corporate Governance as a New Legal Discipline’;2 while another remarked that between 1990 and 1993 ‘events have moved at lightning speed for the world of corporate governance’.3 That speed has accelerated considerably since the huge corporate collapses of Enron,4 WorldCom, Global Crossing, Tyco, Adelphia and others. Studying corporate governance developments in the USA is important, since some people apparently became aware of the corporate governance debate only when the Cadbury Report was published in 1992 in the UK, and, there are still some who wrongly believe that corporate governance was an invention of the Cadbury Report.5 It is also noteworthy that the Cadbury Report dealt only with a limited area of corporate governance, namely ‘Financial Aspects of Corporate Governance’. 1 Klaus J Hopt, ‘Preface’ in Institutional Investors and Corporate Governance, New York, W. de Gruyter (1994) i. 2 E Norman Veasey, ‘The Emergence of Corporate Governance as a New Legal Discipline’ (1993) 48 The Business Lawyer 1267. 3 Irna M Millstein, ‘The Evolution of the Certifying Board’ (1993) 48 The Business Lawyer 1485, 1489. 4 For a summary of the circumstances that led to the collapse of Enron, see K Fred Skousen, Steven M Glover and Douglas F Prawitt, An Introduction to Corporate Governance and the SEC, Mason, Thomson South-West, (2005) 3–5. 5 See generally Nigel Kendall and Arthur Kendall, Real-World Corporate Governance, London, Pitman (1998) 22; Bob Garratt, The Fish Rots from the Head, London, P Profile Books (2003) 140.

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In the USA, the theories of shareholder primacy and profit maximisation are still dominant in expressing ‘the objective and conduct of the corporation’. This is clearly set out in the ALI’s Principles of Corporate Governance: The objective and conduct of the corporation § 2.01(a) Subject to the provisions of Subsection (b) . . . a corporation should have as its objective the conduct of business activities with a view to enhance corporate profit and shareholder gain. (b) Even if corporate profit and shareholder gain are not thereby enhanced, the corporation, in the conduct of its business: 1. Is obliged, to the same extent as a natural person, to act within the boundaries set by law; 2. May take into account ethical considerations that are reasonably regarded as appropriate to the responsible conduct of business; and 3. May devote a reasonable amount of resources to public welfare, humanitarian, educational, and philanthropic purposes. The only qualifications to shareholder primacy and profit maximisation are that these aims should be achieved within the boundaries of the law; taking into account ethical considerations; ensuring responsible conduct of business; and that a reasonable amount of resources should be given to public welfare, humanitarian, educational, and philanthropic purposes.

12.2.2 The American Law Institute’s involvement in the corporate governance debate 12.2.2.1 Basic aims of the project In its project, Principles of Corporate Governance and Structure: Restatement and Recommendations, the ALI aspired to extract from the corpus of United States law of corporations a set of generalised propositions that would instruct managers and directors about their duties, and to provide criteria for judgment by courts in cases involving allegations of improper conduct by managements and directors.6 It was hoped to extract the basic corporate governance principles applicable in the USA from court cases and other sources and to restate the law.7 12.2.2.2 Impact and importance of the project The project was supposed to be finished within two years, but eventually took 15 years because of the sensitivities involved in the topics discussed and the huge vested business interests involved in the discussion.8 One commentator observes that ‘it is fair to say that the successive drafts of the Principles received more intensive review, by a greater number and wider variety of persons and over 6 Bayless Manning, ‘Principles of Corporate Governance: One Viewer’s Perspective on the ALI Project’ (1993) 48 The Business Lawyer 1319, 1320. 7 Ibid 1319, 1324. 8 Ibid 1319, 1325.

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a longer period of time, than any other project in the history of corporate law’,9 while another states that ‘the Project’s work . . . has occupied the time and effort of leaders of the corporate bar and respected academicians for over a decade of intense work, debate, and drafting.’10 One thing is certain, and that is that the ALI project on corporate governance shaped views on corporate governance and laid the foundations for many of the current discussions and debates regarding corporate governance in the rest of the world. This area is of great complexity and many issues discussed by the ALI are still considered to be quite controversial.11 12.2.2.3 Some of the key aspects addressed The key topics addressed by the ALI were: ● the objectives and conduct of the corporation ● the structure of the corporation ● the duty of care ● the duty of fair dealing ● tender offers ● remedies. The topic of the objectives and conduct of the corporation has already been dealt with above. It is, however, necessary to emphasise that the stakeholder debate was to a large extent ignored by the ALI. The reason for this is that the theories of shareholder primacy and profit maximisation were adopted by the ALI as its point of departure. There are certain statutes in some states of the USA that allow corporations specifically to consider the interests of other stakeholders such as employees, suppliers and customers, but the exact nature and scope of these provisions are still uncertain.12 It is very interesting to study the part of the ALI report dealing with the structure of the corporation, as it illustrates clearly how the corporate governance debate in the USA has shaped corporate governance debates in several other jurisdictions. § 3.01 covers ‘Management of the corporation’s business’. It provides that ‘the management of the business of a publicly held corporation should be conducted by or under the supervision of such principal senior executives as are designated by the board of directors, and by those other officers and employees to whom the management function is delegated by the board or those executives, subject to the functions and powers of the board in § 3.02 [see below]’.13 This description clearly provides for a differentiation between the ‘governance circle’ and the ‘managerial pyramid’ we described in Chapter 3 of this book. In fact, it provides for 9 Melvin Aron Eisenberg, ‘An Overview of the Principles of Corporate Governance’ (1993) 48 The Business Lawyer 1271, 1295. 10 Veasey, above n 2, 1267. 11 See in particular Stephen M Bainbridge, Corporation Law and Economics, New York, Foundation Press (2002) at 218; Eisenberg, above n 9, 1273–4; and Manning, above n 6, 1319, 1321, 1328–9. 12 Manning, above n 6, 1278. 13 § 8.01(b) of the Model Business Corporations Act (1984 and Supplement) reads as follows: ‘All corporate powers shall be exercised by or under the authority of, and the business affairs of the corporation managed by or under the direction of, its board of directors . . . ’

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dual ‘managerial circles’, namely ‘principal senior executives’ and ‘other officers and employees’. The last-mentioned group receives its managerial powers either from the board or from the principal senior executives. This description also clearly recognises the ‘supervisory role’ of the board and is in accordance with the principle explained in Chapter 3 that the board’s function is primarily to ‘direct, govern, guide, monitor, oversee, supervise and comply’. It differs from the traditional formulation of the board’s function, namely that the business of the corporation ‘shall be managed by [its] board . . . ’14 The new description of the board’s functions provides another indication that it is impossible for the board of a large corporation to manage the day-to-day business of the corporation. That task must of necessity be left to senior executives and other employees of the corporation. § 3.02 deals with ‘Functions and powers of the board of directors’. § 3.02(a) allocates five primary functions to the board: (1) select, regularly evaluate, fix the compensation of, and, where appropriate, replace the senior executives (2) oversee the conduct of the corporation’s business to evaluate whether the business is being properly managed (3) review and, where appropriate, approve the corporation’s financial objectives and major corporate plans and actions (4) review and, where appropriate, approve major changes in, and determinations of other major questions of choice respecting, the appropriate auditing and accounting principles and practices to be used in the preparation of the corporation’s financial statements (5) perform such other functions as are prescribed by law, or assigned to the board under a standard of the corporation. It is once again clear that the board’s functions of ‘directing, governing, guiding, monitoring, overseeing, supervising and complying’ are foremost.

12.2.3 The Securities Exchange Commission The Securities Exchange Commission (SEC) is the primary securities markets regulator in the USA. It was formed in 1934 after the passing of Federal legislation in the form of the Securities Exchange Act of 1934. This legislation followed the passing of the Securities Act of 1933. The intent of Congress in establishing the SEC is summarised in the following SEC statement: Congress, in establishing the securities laws, created a continuous disclosure system designed to protect investors and to assure the maintenance of fair and honest securities markets. The Commission, in administering and implementing these laws, has sought to coordinate and integrate this disclosure . . . 15 14 Bainbridge, above n 11, 195. 15 As quoted by Skousen, Glover and Prawitt, above n 4, 48.

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This Securities Act of 1933 and the Securities Exchange Act of 1934 aimed to restore the integrity and reliability of information provided to investors. The stock market crash of 1929 and the fraud, deceit and excesses of the 1920s were arguably major factors leading to the Great Depression.16 The Securities Exchange Act of 1934 gave the SEC extensive powers to police, oversee and regulate the financial markets and also gave it considerable power to investigate contraventions of the law and civil as well as criminal sanctions to enforce the law. The SEC experienced slow growth until 1945, but the there were rapid expansions of powers after almost every market crash or market break, in particular in 1962 and 1977.17 As will be seen in the next part, the expansion of powers and overseeing role of the SEC were not enough to prevent several abuses, as became apparent in the early 2000s with the scandals associated with Enron and other scandals involving corporate giants (Tyco, WorldCom, Xerox, Adelphia, Ahold etc.), brokage firms (for example, Merrill Lynch), stock exchanges (for example, the New York Stock Exchange), the large public accounting firms (like Arthur Anderson and others) and managers of mutual funds (for example, Piper Jaffray). The reaction to this was another piece of draconian legislation, the Sarbanes-Oxley Act of 2002 (SOX).18 The organisational structure of the SEC is impressive. It consists of five commissioners and five different divisions (Corporation Finance; Enforcement; Investment Management; Marker Regulation and Compliance Inspections & Examinations), an executive director and general counsel. The principal Acts defining the SEC’s mandate and legal framework are the Securities Act of 1933, the Securities Exchange Act of 1934 and SOX.19

12.2.4 The Sarbanes-Oxley Act of 2002 – the US response to collapses such as Enron and WorldCom 12.2.4.1 Backdrop The passing of SOX should be seen against the backdrop of several huge corporate failures in the USA. These collapses, in particular Enron and WorldCom, caused serious concern and became such a political issue that the United States government of the day (at that stage the Bush Administration) saw no option but to act quickly and radically. It was thought by the Bush Administration to be the best way to deal with the issue, but there are those who saw it as a political knee-jerk reaction to an immediate crisis rather than a carefully considered and integrated set of responses to wider and underlying corporate governance problems.20 As was explained by Commissioner Paul Atkins of the SEC: 16 17 18 19 20

Ibid 2–3 and 31–2. Ibid 35–6. Ibid 5. Ibid 39 and 40–4 and 49 et seq. Bob Garratt, Thin on Top, London, Nicholas Brealey Publishing (2003) 20.

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Last year, in fact, the market decline and large corporate failures led to just such a general sense that politicians should ‘do something’. The impending November 2002 congressional elections, which had been said to be very close, gave added urgency to legislative action. Because these corporate failures stemmed from lax accounting and corporate governance practices, ‘Corporate Responsibility’ became an important political issue in the United States, for the first time in perhaps 70 years. In late July of 2002, Congress passed the Sarbanes-Oxley Act, with only 3 members voting ‘no’. Corporate responsibility is still a critically important political issue in America. Just last week in his State of the Union address, the President, referring to Sarbanes-Oxley, said that ‘tough reforms’ were passed to ‘insist on integrity in American business’.21

12.2.4.2 Aims and objectives The SEC’s summary of SOX22 very clearly set out the aims and objectives of the Act soon after it became law: restoring confidence in the accounting profession ● improving the ‘tone at the top’ ● improving disclosure and financial reporting ● improving the performance of ‘gatekeepers’ and ● enhancing enforcement tools. ● SOX is indeed a blunt statutory instrument, with heavy civil and criminal sanctions for contraventions. The passing the SOX Act has been described as ‘enormously consequential’.23 A look at some of its provisions illustrates these points: Section 3(b)(1): A violation by any person of this Act, any rules or regulation of the Commission issued under this Act or any rule of the Board shall be treated for all purposes in the same manner as a violation of the Securities Exchange Act of 1934 or the rules and regulations issued thereunder . . . Section 102: Beginning 180 days after the determination by the Commission it shall be unlawful for any person that is not a registered public accountant firm to prepare, or issue, or participate in the preparation or issuance of, any audit report with respect to any issuer. Section 105(4): If the Board finds, based on all of the facts and circumstances, that a registered public accounting firm or associated person thereof has engaged in any act or practice, or omitted to act, in violation of this Act [or any other relevant rule or regulation] . . . the Board may impose such disciplinary or remedial sanctions as it determines appropriate, subject to applicable limitations under paragraph (5), including– (D) A civil money penalty for each violation, in an amount equal to not more than $100,000 for a natural person or $2,000,000 for any other person; and in any case to which paragraph (5) applies, not more than $750,000 for a natural person or $15,000,000 for any other persons. 21 The Sarbanes-Oxley Act of 2002: Goals, Content and Status of Implementation, address delivered at the University of Cologne (5 February 2003), available at . 22 See . 23 Skousen, Glover and Prawitt, above n 4, 5.

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Under section 101 a five-member Public Company Accounting Oversight Board, with extensive powers, was established. This Board has regulatory and enforcement powers comparable to the SEC itself. The tentacles of SOX stretch all over the world, as no distinction is made between United States and non-United States ‘Issuers’ (§ 106). Foreign companies issuing securities on United States markets are brought under the umbrella of SOX through the definition of ‘Issuer’ in § 2 – basically meaning companies that issue securities on United States markets. As was explained by Commissioner Paul Atkins: Of course, Sarbanes-Oxley generally makes no distinction between U.S. and non-U.S. issuers. The Act does not provide any specific authority to exempt non-U.S. issuers from its reach. The Act leaves it to the SEC to determine where and how to apply its provisions to foreign companies. The SEC is well aware that new U.S. requirements may come into conflict with home-country requirements on non-U.S. issuers. As we move forward to implement Sarbanes-Oxley, we have tried and we will continue to try to balance our responsibility to comply with the Act’s mandate with the need to make reasonable accommodations to our non-U.S. issuers.24

Paul von Nessen explains as follows: The passage of the Sarbanes-Oxley Act itself would have had minimal impact upon corporations outside the United States were it not for the fact that a number of Australian and other foreign corporations have sought to raise capital on the stock exchanges of the United States. As a result of this, the US legislation and the rules for corporate governance implemented by the US exchanges in response to the requirement of Sarbanes-Oxley Act necessitate that Australian corporations which are listed on US exchanges comply with the listing rules requirements, including requirements relating both to corporate governance generally and to accounting and auditing standards specifically.25

The wide application and consequences of SOX were also explained thus by Commissioner Paul Atkins: Over 1,300 non-U.S. corporations from 59 countries file reports with the SEC, as compared with approximately 400 issuers from less than 30 countries in 1990. Most of our non-U.S. issuers are from Canada. The second largest number are from the U.K. Currently, approximately 30 German corporations report to the SEC – the largest ones being DaimlerChrysler AG, E.ON AG, Deutsche Bank, and SAP. In our efforts to create a global marketplace, we want to encourage more German corporations to participate in the U.S. securities markets, and we always welcome your comments and advice as to how we might improve the situation.26

Given this wide application of SOX, at the time of completing this book, the Australian Securities and Investments Commission (ASIC) was in negotiations 24 The Sarbanes-Oxley Act of 2002: Goals, Content and Status of Implementation, address delivered to the International Financial Review (25 March 2003), available at . 25 Paul von Nessen, ‘Corporate Governance in Australia: Converging with International Developments’ (2003) 15 Australian Journal of Corporate Law 189 at 194–5. 26 The Sarbanes-Oxley Act of 2002: Goals, Content and Status of Implementation, above n 21.

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with the SEC and the Public Company Accounting Oversight Board in the USA to confirm arrangements for overseeing compliance of Australian ‘issuers’ (and auditors of Australian issuers) with the SOX rules.27 Title II of SOX attempts to ensure ‘auditor independence’ by prohibiting auditors from delivering certain non-audit activities to entities they audit, including (§201(a)): legal services and expert services unrelated to the audit ● management functions or human resources ● book-keeping or other services related to the accounting records or finan● cial statements of the audit client. Section 303 of SOX aims to prevent improper influence on the audit process by making it ‘unlawful . . . to fraudulently influence, coerce, manipulate, or mislead any auditor engaged in the performance of an audit for the purpose of rendering the financial statements materially misleading’. This overview provides more than enough evidence of the evils SOX aims to prevent28 or, to put it differently, the misuses and abuses related to audits that occurred in the past. These misuses and abuses of the audit process were the main reasons many of the recent corporate collapses occurred and why the actual (poor!) financial position of these corporations could not be detected by investors. 12.2.4.3 Some perspectives on SOX and its effect In the first edition of this work it was pointed out that whether SOX was an overreaction or not, was open to debate and depended on one’s personal political views on how far a regulatory system of corporate governance should go or whether one favoured a self-regulatory corporate governance model or not.29 In fact, as Bob Tricker observed, SOX will go down in history as an important turning point, as SOX made it clear that United States and UK corporate governance no longer share similar foundations – that they were, from the passing of SOX, based on fundamentally different foundations. The United States’ approach was, from the passing of SOX, based on a prescriptive, rule-based legal approach to governance, while the UK approach is still based on a non-prescriptive, principlesbased, self-regulatory approach.30 Since 2002, several additional perspectives began to emerge regarding the regulatory or hard-law approach adopted with SOX. The principle underlying SOX is ‘comply or else’. In other words, as seen above, there are legal sanctions 27 See, for example, Fiona Buffini, ‘ASIC May Help US Regulator’, The Australian Financial Review (17 February 2005), 9. 28 See also Robert A G Monks and Nell Minow, Corporate Governance, Oxford, Blackwell (3rd edn, 2004) 248–9; Richard Smerdon, A Practical Guide to Corporate Governance, London, Sweet & Maxwell (2nd edn, 2004) 364–6. 29 For a similar view expressed later, see Sir Bryan Nicholson, ‘The Role of the Regulator’ in The Business Case for Corporate Governance (Ken Rushton, ed.), Cambridge, Cambridge University Press (2008) 100 at 103–6 and 118; Keith Johnstone and Will Chalk, ‘What Sanctions are Necessary?’ in The Business Case for Corporate Governance (Ken Rushton, ed.), Cambridge, Cambridge University Press (2008) 146 at 154. 30 Bob Tricker, Corporate Governance: Principles, Policies and Practices, Oxford, Oxford University Press (2008) 19. See also Nicholson, above n 29, 100 and 107–8.

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for non-compliance that could lead to people being convicted of crimes and being sent to jail for long periods or huge fines imposed for non-compliance. The irony of SOX is that despite such a draconian piece of legislation already being in place, several poor corporate governance practices related to risk management and excessive executive remuneration were lurking beneath the surface. As far as executive remuneration is concerned, it is somewhat perplexing that the abuses were well-known and commented upon within the United States before the global financial crisis.31 However, it seems as though greed and a highly competitive corporate environment ensured that these poor corporate governance practices could be perpetuated, and even flourished, amid severe criticism of excessive executive remuneration. These poor corporate governance practices were, to a large extent, if not exclusively, responsible for the global financial crisis – sparked-off by a melt-down of the United States economy in 2008 and early 2009, especially in the banking and financial sectors. The ripple effect this caused is well-known and was well covered in the media. It was, therefore, to be expected that the proponents of a self-regulatory corporate governance model, who criticised the regulatory hard-law approach of SOX, would say that the global financial crisis illustrates that such an approach does not work.32 Some have also used the global financial crisis to challenge the contention that the European, relationship-based corporate governance systems are inherently less efficient than the Anglo-American, market-based systems.33 In addition, it has been pointed out that the compliance or agency cost of SOX far outweighs its efficiency. It has, for instance, been said that the ‘total cost to the American economy of complying with SOX is considered to amount to more than the total write-off of Enron, WorldCom and Tyco combined’.34 On the other hand, some United States companies report benefits from SOX compliance, including better accountability of individuals, reduced risk of financial fraud and improved accuracy in financial reports.35 The causes of the global financial crisis are complex and wide-ranging, and it would be preposterous to state that it was caused by SOX or even that it proves that SOX did not ensure better corporate governance practices, or that SOX was ineffective in preventing corporate collapses – it should be remembered that if several banks were not bailed-out by the United States Government, they would surely have collapsed in a similar fashion to Enron, WorldCom and Tyco. What is, however, reasonably safe to conclude is that the one-size-fits-all corporate governance does not work. Also, the most sensible approach to corporate governance is still to tackle corporate governance problems along a broad front and in a 31 Commentators like Skousen, Glover and Prawitt, above n 4, 6 provide a very clear picture of unacceptable compensation practices in the USA, especially as far as compensation by way of overvalued stock was concerned. 32 King Report on Governance for South Africa 2009 (King Report (2009)), Institute of Directors (2009) 9, available at at 6 and 9. 33 Thomas Clarke and Jean-Francois Chanlat, ‘Introduction: A New World Wisorder?’ in European Corporate Governance, London, Routledge (2009) 1. 34 KingReport (2009)), above n 32, at 6. 35 Tricker, above n 30, 158.

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flexible way. In fact, aspiring to strike a balance between sensible self-regulatory arrangements and a rigid regulatory corporate governance model is still the best approach to corporate governance. As was pointed out by Duncan Niederauer, chief executive officer (CEO) of the New York Stock Exchange on 15 June 2009, the regulatory framework in the USA is under strain and requires reform.36 He identifies four core principles that should guide modern and proactive regulatory reform: ● Financial regulatory reform must protect investors and restore investor confidence. ● Financial oversight must be rationalised and harmonised. ● New systems must bring complex financial instruments out of the shadows. ● A new regulatory system must stress smarter regulation, not overregulation. These guiding principles, and corporate law and corporate governance regulation generally, will be high on the agenda for the United States’ Government and regulators in the USA.

12.2.5 NYSE: Sections 303 and 303A – corporate governance rules 12.2.5.1 Background The SEC approved the New York Stock Exchange (NYSE) rules on corporate governance on 4 November 2003. Some amendments were made on 3 November 2004, primarily dealing with the definition of independence. All listed companies (with a few exceptions) must comply with certain standards regarding corporate governance as codified in section 303A.37 The most important exception is that foreign private issuers (defined in Rule 3b-4 under the Exchange Act) are permitted to follow home country practice in lieu of the provisions of section 303A, except that such companies must comply with the following rules: ● They must have an audit committee that satisfies the requirements of Rule 10A-3 under the Exchange Act.38 ● They must disclose any significant ways in which their corporate governance practices differ from those followed by United States companies under the NYSE listing standards.39 The following commentary is included in section 303A.11 as far as this requirement is concerned: Foreign private issuers must make their United States investors aware of the significant ways in which their corporate governance practices differ from those required of domestic companies under NYSE listing standards. However, 36 ‘Principles that Must Guide Financial Regulation’ (15 June), Financial Times, available at . 37 NYSE Section 303A: Corporate Governance Standards (31 December 2009), available at . 38 Ibid s 303A.06. 39 Ibid s 303A.11.

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foreign private issuers are not required to present a detailed, item-byitem analysis of these differences. Such a disclosure would be long and unnecessarily complicated. Moreover, this requirement is not intended to suggest that one country’s corporate governance practices are better or more effective than another. The NYSE believes that United States shareholders should be aware of the significant ways that the governance of a listed foreign private issuer differs from that of a United States listed company. The NYSE underscores that what is required is a brief, general summary of the significant differences, not a cumbersome analysis. Each listed company CEO must promptly notify the NYSE in writing after any executive officer of the listed company becomes aware of any material non-compliance with any applicable provisions of this section 303A.40 Each such company must submit an executed Written Affirmation annually to the NYSE. In addition, each listed company must submit an interim Written Affirmation each time a change occurs to the board or any of the committees subject to Section 303A.41 The annual and interim Written Affirmations must be in the form specified by the NYSE. This form was updated on 25 November 2009 and became effective from 1 January 2010.42

12.2.5.2 Summary of the most important NYSE corporate governance rules43 ●



● ●

● ●

Listed companies must have a majority of independent directors, and ‘independence’ is defined in detail in section 303A.02 of the NYSE Listed Company Manual.44 In order to empower non-management directors to serve as a more effective check on management, the non-management directors of each listed company must meet at regularly scheduled executive sessions without management. Listed companies must have a nominating/corporate governance committee composed entirely of independent directors. Listed companies must have a compensation committee, with a minimum of three members, composed entirely of independent directors (as defined in section 303A.02). Each listed company must have an internal audit function. Listed companies must adopt and disclose corporate governance guidelines, addressing the following subjects: – director qualification standards – director responsibilities

40 Ibid s 303A.12(b). 41 Ibid s 303A.12(c). 42 See for the ‘Foreign Private Issuer Annual Written Affirmation Form’. The form is available at . 43 See for the full text to the NYSE Listed Company Manual. 44 Ibid.

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– director access to management and, as necessary and appropriate, independent advisers – director compensation – director orientation and continuing education – management succession – annual performance evaluation of the board. ● Listed companies must adopt and disclose a code of business conduct and ethics for directors, officers and employees, and promptly disclose any waivers of the code for directors or executive officers. Each listed company may determine its own policies, but all listed companies should address the most important topics, including the following: – conflicts of interest – corporate opportunities – confidentiality – fair dealing – protection and proper use of company assets – compliance with laws, rules and regulations (including insider trading laws) – encouraging the reporting of any illegal or unethical behaviour. ● Listed foreign private issuers must disclose any significant ways in which their corporate governance practices differ from those followed by domestic companies under NYSE listing standards. ● Each listed company CEO must certify to the NYSE each year that he or she is not aware of any violation by the company of NYSE corporate governance listing standards, qualifying the certification to the extent necessary. ● Each listed company CEO must promptly notify the NYSE in writing after any executive officer of the listed company becomes aware of any material non-compliance with any applicable provisions of section 303A. ● Each listed company must submit an executed Written Affirmation annually to the NYSE. In addition, each listed company must submit an interim Written Affirmation each time a change occurs to the board or any of the committees subject to section 303A. The annual and interim Written Affirmations must be in the form specified by the NYSE. ● The NYSE may issue a public reprimand letter to any listed company that violates a NYSE listing standard. NASDAQ and the American Stock Exchange (AMEX) have also amended their corporate governance listing requirements by including, inter alia, the following:45 ● Require that a majority of the members of the board of directors of most listed companies must be independent of management. ● Define independence using very strict bright-line rules. ● Expand the duties and powers of the independent directors. 45 Stephen M Bainbridge, The New Corporate Governance in Theory and in Practice, Oxford, Oxford University Press (2008) 177.

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Expand the duties and powers of the audit committee of the board of directors.

12.3 United Kingdom 12.3.1 Background to the corporate governance debate in the UK Corporate governance in the UK became a prominent issue after the release of the Cadbury Report in 1992. The report was a response to the Maxwell and Polly Peck scandals of that period.46 As mentioned above, the Cadbury Report had a rather narrow focus on the financial aspects of corporate governance. The Cadbury Report was followed by several other corporate governance reports, such as the Greenbury Report (1995), the Hampel Report (1998), the Smith Report (2003) and the Higgs Report (2003). It is interesting to note that, unlike the ALI’s comprehensive investigation of corporate governance within the context of corporate law generally, all the UK reports dealt only with specific aspects of corporate governance – including the disclosure of remuneration of directors and executive officers, audit committees and the role and effectiveness of nonexecutive directors.

12.3.2 The Cadbury Report and the unfolding of the concept of ‘corporate governance’ in the UK 12.3.2.1 Context of the Cadbury Report The Cadbury Committee was set up by the Financial Reporting Council, the London Stock Exchange (LSE) and the accountancy profession in May 1991 in order to address the financial aspects of corporate governance.47 The main reason for conducting such an inquiry was to take action in respect of the perception that the UK was slipping down the league table of international business competitiveness. The second reason was to show the financial community that some of the major parties involved in the financial markets were greatly concerned about unexpected company failures and cases of fraud in England, particularly after the Maxwell and BCCI scandals.48 The draft report was issued for public comment on 27 May 1992, and the final report49 was released on 1 December 1992. 46 Peter Montagnon, ‘The Role of the Shareholder’ in The Business Case for Corporate Governance (Ken Rushton, ed.), Cambridge, Cambridge University Press (2008) 81. 47 The Financial Aspects of Corporate Governance: Draft Report (hereafter Cadbury Report (Draft)), Committee on the Financial Aspects of Corporate Governance, UK (1992) 7 para 2.1; Charlotte Villiers, ‘Draft Report by the Cadbury Committee on the Financial Aspects of Corporate Governance’ (1992) 13 Company Lawyer 214. 48 John C Shaw, ‘The Cadbury Report, Two Years Later’ in K J Hopt, K Kanda, M J Roe, E Wymeersch and S Priggle (eds) Comparative Corporate Governance: The State of the Art and Emerging Research, Oxford, Clarendon Press (1998) 21, 23; Stanley Christopher, ‘Corporate Accountability: Cadbury Committee: Part 1’ (1993) 11 International Banking and Financial Law 104. 49 Report of the Committee on the Financial Aspects of Corporate Governance (hereafter Cadbury Report (1992)) Committee on the Financial Aspects of Corporate Governance, UK (1992).

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The essence of a system of good corporate governance was explained as follows: The country’s economy depends on the drive and efficiency of its companies. Thus the effectiveness with which their boards discharge their responsibilities determines Britain’s competitive position. They must be free to drive their companies forward, but exercise that freedom within a framework of effective accountability. This is the essence of any system of good corporate governance.50

These objectives are not unique to the UK. They are, indeed, essential for any country seriously striving to be competitive in international business. 12.3.2.2 Code of Best Practice At the heart of the committee’s recommendations was a Code of Best Practice, designed to achieve high standards of corporate behaviour.51 While the Code sets out the general principles,52 the committee also made various recommendations on specific aspects: the composition of the board of directors,53 the establishment of auditing committees54 and the role of a company’s shareholders.55 The committee believed that had a Code of Best Practice been in existence, a number of unexpected company failures and frauds, which had occurred in the UK, could have been avoided.56 The principles upon which the Code is based are those of openness, integrity and accountability.57 It is basically aimed at all listed companies,58 with compliance to be ensured by the LSE, thus making acceptance of the Code one of its listing requirements.59 However, the committee specifically encouraged as many other companies as possible to aim at meeting the Code’s requirements.60 The Code of Best Practice was published as a separate document accompanying the final report. It deals with general aspects concerning the board of directors, non-executive directors, executive directors and financial reporting. It is clear that the basic aim is to promote useful checks and balances within the corporate structure. According to the Code of Best Practice, there should be a clearly accepted division of responsibilities at the head of a company, which will ensure a balance of power and authority, such that no single individual has unfettered powers of decision. The role of the non-executive director is to bring an ‘independent judgment’ on issues of strategy, performance, resources, key appointments and standards of conduct. Concerning executive directors, the Code makes it clear that they should, in principle, not be protected against removal by long-term 50 51 52 53 54 55 56 57 58 59 60

Cadbury Report (Draft), above n 47, 5 para 1.1. Cadbury Report (1992), above n 49, 11 para 1.3. Ibid 58 et seq. Ibid 20 et seq. Ibid 36 et seq. Ibid 48 et seq. Ibid 12 para 1.9. Ibid 16 para 3.2. Ibid 16 para 3.1. Ibid 17 paras 3.7–3.9. Ibid 16 para 3.1.

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service contracts. Their contracts of service should not exceed three years without shareholders’ approval. Disclosure of the emolument of executive directors constitutes an important part of the Code, which also provides that executive directors’ pay should be subject to the recommendations of a remuneration committee made up wholly or mainly of non-executive directors. The Code also contains various reporting controls. It notes that it is the responsibility of the board of directors to present a balanced and understandable assessment of the company’s position, to maintain an objective and professional relationship with the auditors and to establish an audit committee, consisting of at least three non-executive directors, with written terms of reference dealing clearly with its authority and duties. A set of ‘Notes’ accompanied the Code of Best Practice; it was explicitly stated that these notes did not form part of the Code, but only ‘included further recommendations on good practice’. Note 5, aiming to ensure the independence of non-executive directors, is of particular interest: ‘The Committee regards it as good practice for non-executive directors not to participate in share option schemes and their services as non-executive directors not to be pensionable by the company, in order to safeguard their independent position.’ The presumption of the Committee was clearly that share-option schemes and pension schemes for non-executive directors may tend to make the non-executive director dependent on the company and this will jeopardise the basic role of the non-executive director; that is, to bring an ‘independent judgment’ on issues of strategy, performance, resources, including key appointments, and standards of conduct. The four primary principles promoted by the Cadbury Report were summarised as follows by John C Shaw:61 1. A clear division of responsibilities at the head of a company to ensure a balance of power and authority, such that no single individual has unfettered powers of decision. 2. Every board should include non-executive directors of sufficient calibre and number for their views to carry significant weight in decisions. 3. Institutional investors should take a positive interest in the composition of boards of directors, with particular reference to avoiding unrestrained concentration of decision making. 4. The board structure should clearly recognise the importance and significance of the financial function. 12.3.2.3 Further developments The Financial Reporting Council (FRC) is the UK’s independent regulator for corporate reporting and governance. It has ultimate responsibility for maintaining and updating the so-called ‘UK Combined Code’,62 which will in future be 61 Shaw, above n 48, 24. 62 See .

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called the UK Corporate Governance Code.63 In June 2004, the FRC committed to conducting a regular review of the Combined Code,64 and has since established several operating bodies to achieve its goals.65 In November 2006, the FRC issued an important policy statement, ‘The UK Approach to Corporate Governance’.66 In December 2006, the FRC also released a ‘Draft Updated Regulatory Strategy and Plan & Budget 2007/08’.67 The FRC has set six objectives to achieve its primary aim of promoting confidence in corporate reporting and governance. The six objectives are: 1. high-quality corporate reporting 2. high-quality auditing 3. high-quality actuarial practice 4. high standards of corporate governance 5. the integrity, competence and transparency of the accountancy and actuarial professions 6. its effectiveness as a unified independent regulator.68 The functions that the FRC exercises, in pursuit of its six objectives, are summarised as follows: ● promoting high standards of corporate governance ● setting, monitoring and enforcing accounting and auditing standard ● setting actuarial standards ● statutory oversight and regulation of auditors ● operating an independent investigation and discipline scheme for public interest cases ● overseeing the regulatory activities of the professional accountancy and actuarial bodies.69 The basis upon which the Government reached its decisions about the role of the FRC was set out in two reports, that from the Consultative Group on Audit and Accounting (CGAA)70 and the Government ‘Review of the Regulatory Regime of the Accountancy Profession’.71 In the past, the FRC amended the UK Combined Code after investigations and reports by specialised committees. The Greenbury Report (1995), the Hampel Report (1998), the Smith Report (2003) and the Higgs Report (2003) are examples of such reports that led to some amendments to the UK Combined Code. The FRC is still considered to be a better form of self-regulation and market-driven 63 See . 64 See . 65 See . 66 See . 67 See . 68 These objectives are set out in the FRC Regulatory Strategy, May 2006, Version 2.1 at p. 2, available online at . 69 Ibid. 70 See . 71 See .

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regulation of corporate governance than a full-on regulatory regime following SOX in the USA.72

12.3.3 The Greenbury, Hampel, Smith and Higgs reports 12.3.3.1 The Greenbury Report (1995) Richard Smerdon points out that no subject in recent years has aroused more controversy than the question of remuneration, and that commentators sometimes portray it as the only issue of concern in governance.73 The Greenbury Report (1995) had a very specific focus on executive remuneration: its recommendations dealt primarily with the establishment of remuneration committees for listed companies and the role and function of the remuneration committee.74 It also made several recommendations regarding the disclosure of executive remuneration75 and the remuneration policy that listed companies should adopt.76 The final part of the Greenbury recommendations dealt with service contracts and what entitlements directors would have in the event of early termination.77 This investigation was considered to be necessary because of concerns that executive remuneration was excessive and that shareholders should know exactly what executives earned and what a company’s liability would be if executive directors were removed or if an executive contract were to be terminated prematurely. 12.3.3.2 The Hampel Report (1998) This report was to a large extent a continuation of the work already done by the Cadbury and Greenbury reports. The Hampel Report is probably one of the most balanced UK reports on corporate governance, in the sense that it concentrated on broad trends and commented on some incorrect perceptions on corporate governance. One of its main aims was, as Kendall and Kendall point out, ‘to calm the situation down’.78 A few examples will illustrate the point. It was one of the main aims of the Hampel Committee ‘to restrict the regulatory burden on companies’, and to ‘substitute principles for detail wherever possible’.79 This particular focus was possible because the Hampel Committee was established to focus not on poor corporate governance practices, but rather on the positive contribution that good corporate governance could make.80 The focus was thus on corporate governance guidelines and principles, rather than ‘box-ticking’ to determine whether or not good corporate governance practices identified in 72 Nicholson, above n 29, 108–9. 73 Smerdon, above n 28, 115. 74 Code Recommendations – Para A. 75 Code Recommendations – Para B. 76 Code Recommendations – Para C. 77 Code Recommendations – Para D. 78 Kendall and Kendall, above n 5, 23. 79 Committee on Corporate Governance, Committee on Corporate Governance: Final Report (Hampel Report (1998)) London, Gee (1998), para 1.6. 80 Ibid para 1.7.

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Cadbury and Greenbury were being followed.81 The Hampel Report is also one of the few UK corporate governance reports to recognise the importance of the stakeholder debate.82 Perhaps one of the most controversial aspects of the Hampel Report was its contention that the monitoring role of the board had become ‘over-emphasised’ because of the focus on the role of non-executive directors and in particular the role of ‘independent non-executive directors’. Hampel saw the role of nonexecutive directors as clearly linked to ‘a strategic and monitoring function’ and as ‘mentors to relatively inexperienced executives’.83 12.3.3.4 The Higgs Report (2003) and the Smith Report (2003) The Higgs Report (2003) had a primary focus on the role and effectiveness of non-executive directors. The most significant aspects of this report were the recommendations that at least half of the board of directors (excluding the chairman) should be independent non-executive directors, and the very detailed definition of the term ‘independence’. At the same time as the Higgs Committee was conducting its work, the Smith Committee (2003) was investigating accounting standards. Both the Higgs Report and the Smith Report were to some extent a result of collapses such as Enron and WorldCom, and of the USA’s reaction to these collapses – the Sarbanes-Oxley Act of 2002. The factor that most clearly distinguishes the UK and United States approaches, however, is that the SOX Act is a statutory instrument that makes several accounting standards and practices compulsory. In the UK, good corporate governance practices are still primarily self-enforced arrangements that are promoted through the listing rules for listed public companies. In particular, the Code Provisions contained in the UK Combined Code set the standards for good corporate practices.

12.3.4 The 2008 UK Combined Code and the 2010 UK Corporate Governance Code Since 2003 the UK Combined Code was revised and refined on several occasions, with the last refinements, before proposals to rename it to the UK Corporate Governance Code in December 2009,84 done in June 2008 (2008 UK Combined Code).85 As pointed out above, the UK Combined Code is ultimately the responsibility of the FRC. The Combined Code represents the combined wisdom of the reports discussed above and currently serves as the norm for good corporate governance practices for listed public companies in the UK. Voluntary compliance 81 Hampel Report (1998), above n 79, paras 1.12–1.14. See also Smerdon, above n 28, 17–18. 82 Hampel Report (1998), above n 79, para 1.16. 83 Ibid paras 3.7–3.8. 84 FRC, 2009 Review of the Combined Code: Final Report (December 2009) . 85 See .

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with the Combined Code is ensured through the Listing Rules of the LSE, which require that as a general rule listed public companies must comply with the Code or explain why they are not complying – the so-called principle of ‘comply or explain’.86 The effect of this approach, although classified as ‘soft-law’, is not insignificant as there are powerful market forces at work to ensure compliance rather than allowing listed public companies to explain why they are not complying. It is, therefore, not uncommon still to find strong support for a market-based or self-regulatory approach to promoting good corporate governance practices in the UK.87 Apart from the Listing Rules, additional requirements have been added through the Directors’ Remuneration Report Regulation 2002 and a requirement to introduce a business review, following the implementation of the EU Accounts Modernisation Directive.88 On 1 December 2009 the FRC published a final report on the findings of its review of the impact and effectiveness of the Combined Code.89 At the same time the FRC released a report explaining the consultation processes that preceded the recommendations to change the 2008 UK Combined Code.90 The final report also sets out the actions that the FRC propose to take as a result of the review. The main findings and actions are explained in the ‘Executive Summary’ section of the report.91 It is proposed that the UK Combined Code should be called the UK’s Corporate Governance Code in future. The Code has been revised regularly since 2003 to ensure it reflects changing governance concerns and practices and economic circumstances. The latest proposals take into account those lessons of the 2008–2009 global financial crisis that are relevant to all companies. The FRC expected to announce its final decision and publish the revised Code in May 2010. In December 2009 it was anticipated that the revised Code would apply to reporting periods beginning on or after 29 June 2010.92 Some of the main changes proposed to the 2008 UK Combined Code by the FRC in December 2009 were explained as follows by the FRC in its final report:93 ● Proposed new Code principles on: the roles of the chairman and nonexecutive directors; the need for the board to have an appropriate mix of skills, experience and independence; the commitment levels expected of directors; and the board’s responsibility for defining the company’s risk appetite and tolerance. 86 This is ensured through the LSE Listing Rule 12.43A – see generally Smerdon, above n 28, 19–20. 87 Sir Nicholson, above n 29, 103–6; Keith Johnstone and Will Chalk, ‘What Sanctions are Necessary?’ in The Business Case for Corporate Governance (Ken Rushton, ed.), Cambridge, Cambridge University Press (2008) 146 at 168–70; Simon Low, ‘Is the UK Model Working?’ in The Business Case for Corporate Governance (Ken Rushton, ed.), Cambridge, Cambridge University Press (2008) 222 at 240–1. 88 Nicholson, above n 29, 100 at 107. 89 FRC, above n 84. 90 See FRC, Consultation on the Revised UK Corporate Governance Code (December 2009) . 91 See . 92 See . 93 FRC, above n 84 at 3.

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Proposed new ‘comply or explain’ provisions including: board evaluation reviews to be externally facilitated at least every three years; the chairman to hold regular development reviews with all directors; and companies to report on their business model and overall financial strategy. ● Changes to the section of the Code dealing with remuneration to emphasise the need for performance-related pay to be aligned with the long-term interest of the company and to the company’s risk policies and systems and to enable variable components to be reclaimed in certain circumstances. It was proposed by the FRC that the 2010 UK Corporate Governance Code consists of five different parts, dealing with leadership, effectiveness, accountability, remuneration and communication. Some of the main provisions of the 2010 UK Corporate Governance Code regarding board composition can be summarised as follows: ● The chairman should be an independent non-executive director (Code Provision A.3.1). ● The board and its committees should consist of directors with the appropriate balance of skills, experience, independence and knowledge of the company to enable it to discharge its duties and responsibilities effectively (New Principle B.1). ● The board should include a strong presence of executive and non-executive directors (and in particular independent non-executive directors) such that no individual or small group of individuals can dominate the board’s decision taking (Supporting Principle to B.1). It is of considerable importance to note that there is no longer a requirement that at least half of the board (excluding the chairman) should be independent non-executive directors (2008 UK Combined Code Provision A.3.2). However, the board should identify in the annual report each non-executive director it considers to be independent (Code Provision B1.1). ● The board should appoint one of the independent non-executive directors to be the senior independent director to provide a sounding board for the chairman and to serve as an intermediary for the other directors when necessary. The senior independent director should be available to shareholders if they have concerns which contact through the normal channels of chairman, chief executive or other executive directors has failed to resolve or for which such contact is inappropriate (Code Provision A.4.1). ● The annual report should identify the chairman, the deputy chairman (where there is one), the chief executive, the senior independent director and the chairmen and members of the board committees. It should also set out the number of meetings of the board and those committees and individual attendance by directors (Code Provision A.1.2). ● There should be at least three committees of the board, namely an audit committee (Code Provision C.3.1), a nomination committee (Code Provision B.2.1); and a remuneration committee (Code Provision D.2.1). ●

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No one other than the committee chairman and members is entitled to be present at a meeting of the nomination, audit or remuneration committee, but others may attend at the invitation of the committee (Supporting Principle to B.1). The average board size for FTSE 100 companies in 2002 was just under 12; for FTSE 250 companies, 8.5; and for other listed companies, six directors.94 It is possible to appoint two types of non-executive directors: ‘independent nonexecutive directors’, who meet the criteria laid down for independence; and non-executive directors, who do not meet these criteria, called connected nonexecutive directors in Chapter 4 (CNEDs). The executive directors serving on the board will typically include the managing director or CEO and the chief financial officer (CFO). We have stated in Chapter 4 our opinion that the role and effectiveness of independent non-executive directors are over-emphasised, and that requiring a majority of the board to consist of independent non-executive directors may have a detrimental impact on the performance of the corporation. ●

12.4 Canada 12.4.1 Overview In an increasingly globalised world economy, competition is intense and good corporate governance can make a difference to how Canadian companies are viewed. There are benefits to being recognised as a country where excellence in corporate governance receives a high priority; these benefits accrue to individual Canadian companies when operating abroad, as well as to the entire Canadian capital market as viewed by international investors.95

Broadly speaking, in common with the general approach to corporate governance in the UK and Australia, Canada also places great emphasis on guidelines rather than prescriptive rules.96 There is, to some degree, a basic level of congruence in the principles governing the corporate governance framework in international jurisdictions. In particular, there are similar themes in Canada, Australia and the UK on the guidelines relating to, inter alia, board composition, the establishment of independent audit, nominating and compensation committees and the operation of the disclosure regime of corporate governance practices (‘comply or explain’ system). 94 Review of the Role and Effectiveness of Non-Executive Directors (Higgs Report (2003)), (January 2003), available at 18. 95 Beyond Compliance: Building a Governance Culture – Final Report Joint Committee on Corporate Governance (November 2001) at 7 (Sponsored by the Canadian Institute of Chartered Accountants, the Canadian Venture Exchange, Toronto Stock Exchange and chaired by Guylaine Saucier). 96 Exceptions to this general categorisation arise, however, when the influential impact of the rules-based approach under SOX on Canadian corporate governance is considered. The Canadian response to SOX is dealt with later in this chapter.

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12.4.2 Regulatory environment In focusing on the Canadian securities regulatory framework, it is worth noting that Canada is the only developed country that does not have a national securities regulator.97 Each Canadian province (of which there are 10) and territory (of which there are three) has its own securities regulator responsible for administering the province’s or territory’s securities act and formulating its own set of rules and regulations. The difficulties and concerns arising from the current patchwork approach to securities regulation are captured in the recent report issued to the Canadian Government by the Expert Panel on Securities Regulation in Canada:98 The Expert Panel heard repeated . . . concerns about the cost and confusion caused by our fragmented system of thirteen separate securities regulators . . . While the terminology has differed over the years – single, common, Canadian, national, or federal – the conclusion of virtually every study [over the years] has been the same: Canadians are ill-served by such a balkanized system . . . The lack of a national Canadian securities regulator also raises wider concerns about systemic risk, as there is no national entity accountable for the stability of our national capital markets.

The Expert Panel viewed Canada’s fragmented system of 13 regulators as a serious shortcoming in Canada’s system of financial regulation, and recommended the establishment of a single securities regulator administering a single securities act for Canada.99 The report and draft Securities Act make a number of recommendations to improve securities regulation and investor protection. These include: ● establishing a single, comprehensive system to measure the performance of securities regulation in Canada to promote greater accountability ● establishing the Canadian Securities Commission to administer a single securities act for Canada ● advancing a principles-based approach to securities regulation ● promoting fairness in the adjudication of regulatory matters by establishing an independent adjudicative tribunal ● establishing an investor panel and an investor-compensation fund to better serve the needs of investors. The philosophical approach adopted by the Expert Panel to securities regulation is captured in the following extract from the report:100 97 Chair’s Foreword to Final Report and Recommendations: Creating an Advantage in Global Capital Markets (12 January 2009), available at . 98 Ibid. For earlier reports warning of similar dangers and advocating a single national securities regulator in Canada, see Wise Person’s Committee to Review the Structure of Securities Regulation in Canada, It’s Time (December 2003), available at ; Crawford Panel on a Single Canadian Securities Regulator, Blueprint for a Canadian Securities Commission (June 2006), available at . 99 This criticism was made despite the existence of passport, which is a regulatory system designed to aid harmonised laws and provides market participants with streamlined access to Canada’s capital markets. Although a major step forward, the passport system has been criticised as being limited in application and too slow, cumbersome and expensive. See further, Chair’s Foreword to Final Report and Recommendations: Creating an Advantage in Global Capital Markets (12 January 2009), available at . 100 Ibid.

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We recommend Canadian securities regulators should focus less on process and more on outcomes; relying more on articulating principles than on multiplying rules. We believe that regulation should be grounded in guidance and rules on a bedrock of wellformulated principles. This will help reduce unnecessary compliance costs, improve regulatory outcomes, and give Canada a competitive edge.

Only seven provinces and three territories agreed to support these law reform proposals, with Quebec threatening to launch a constitutional challenge on the federal legislation, which is seen as an encroachment on Quebec’s jurisdiction over property and civil rights.101 The situation remains fluid (at the time of writing). In October 2009, the federal Minister of Justice announced the Canadian Government’s next step – its plan to submit in 2010 a draft bill for a Federal Securities Act, to the Supreme Court of Canada for an advisory opinion on its constitutionality.102 Although the recent financial crisis has added impetus to the latest push for securities law reform, it remains to be seen if these latest initiatives will also succumb to political forces and jurisdictional competition among the provinces. Currently, the Canadian Securities Administrators (CSA) is working to achieve harmonisation of the 13 separate securities regime. The CSA is an umbrella organisation representing all 13 Canadian securities regulators and provides a coordinating function.103 In the wake of the passage of SOX in 2002 in the USA, the Canadian securities and corporate governance landscape has changed. Similar to the USA’s experience with the collapse of Enron and WorldCom, Canada was not immune to failures in corporate governance and also had its share of financial scandals such as Nortel, Livent and Cinar Corporation.104 The combination of internal failures and pressure from the USA to implement reforms, due to the existence of the Multi-Jurisdiction Disclosure System that allows Canadian issuers to list in United States markets, resulted in significant debate and eventual action on the part of Canadian securities regulators to implement corporate governance reforms.105 The CSA adopted and modified certain aspects of SOX, which has the effect of ensuring that the Canadian securities regulatory environment remains closely aligned in principle with that in the USA.106 101 Existing provincial regulatory regimes are based on their ‘property and civil rights’ jurisdiction conferred under s 92(13) of the Constitution Act 1867. 102 Ken Dickerson, ‘Reference Case to Confirm Constitutionality of Federal Securities Regulation’, Centre for Constitutional Studies, University of Alberta (16 October 2009), available at . 103 For an examination of Canadian securities regulation, see Task Force to Modernise Securities Regulation in Canada, Canada Steps Up (2006), available at . 104 Stephanie Ben-Ishai, ‘Sarbanes-Oxley Five Years Later: A Canadian Perspective’ (2008) 39 Loyola University Chicago Law Journal 469 at 476. 105 Ibid. 106 Susan Jenah, ‘Commentary on a Blueprint for Cross-Border Access to U.S. Investors: A New International Framework’ (2007) 48 Harvard International Law Journal 69 at 78. For a critique on the Canadian approach to regulatory policy initiatives, see Ronald Davis, ‘Fox in S-Ox North, A Question of Fit: The Adoption of United States Market Solutions in Canada’ (2004) 33 Stetson Law Review 955. For a brief comparison of the Canadian and United States regulatory schemes, see Ben-Ishai, above n 104, 481.

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The key instruments and policies, covering a broad range of subjects, impacting on Canadian corporate governance practices are: ● National Instrument 58–101: Disclosure of Corporate Governance Practices ● National Instrument 51–102: Continuous Disclosure Obligations ● National Instrument 52–109: Certification of Disclosure in Issuers’ Annual and Interim Filings (CEO and CFO Certifications)107 108 ● National Instrument 52–110: Audit Committees ● Companion Policy 52–110CP: Audit Committees 109 ● National Instrument 52–108: Auditor Oversight ● National Policy 51–201: Disclosure Standards ● National Policy 58–201: Corporate Governance Guidelines. On 30 June 2005, the CSA introduced a key policy document, National Policy 58–201: Corporate Governance Guidelines, which is recommended as a guide to best practice for issuers to follow. At the time of writing, it was envisaged that the current National Policy 58–201 would be replaced with the proposed National Policy 58–201, discussed below. These recent initiatives aimed to review and improve the current corporate governance regime;110 however, they have been shelved until the 2011 proxy season, at the earliest.111 The proposed reforms, which the CSA is now reconsidering due to the concern that ‘issuers are currently focused on business sustainability issues in a challenging economic climate’,112 contemplated significant changes to Canada’s corporate governance regime. Despite this setback to law reform, the chapter focuses on the law reform proposals given the similarities to the current guidelines, except where indicated below.

12.4.3 Proposed National Policy 58–201: Corporate governance principles The proposed National Policy 58–201 articulates nine core principles addressing corporate governance issues (similar to the current guidelines), discussed 107 This instrument covers the certification requirements of section 302 of SOX. It requires each CEO and CFO of an issuer company to file a separate annual certificate stating that he or she has reviewed annual filing, has no knowledge of any material misrepresentation and that he or she is responsible for establishing and maintaining disclosure controls and procedures and internal control over financial reporting for the issuer. 108 This instrument covers, with some