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

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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

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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

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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

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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

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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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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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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

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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.

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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.’

CONCEPT AND ESSENTIALS

9

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 modification, the independent audit committee requirements of section 302 of SOX. Unlike the United States position, Canadian audit committees are not required to have a financial expert – however, similar to the position in the USA, each member must be financially literate. 109 This instrument is influenced by sections 101 to 105 of SOX, which deals with the audit requirements of public companies. 110 See CSA Staff Notice 58–304 Review of NI 58–1–1 Disclosure of Corporate Governance Practices and NP 58–201 Corporate Governance Guidelines, available at . 111 See CSA Staff Notice 58–305 Status Report on the Proposed Changes to the Corporate Governance Regime (13 November 2009), available at . In December 2008, the CSA published for comment proposed changes to the corporate governance regime entitled Proposed Repeal and Replacement of National Policy 58–21– Corporate Governance Guidelines, National Instrument 58–1–1 Disclosure of Corporate Governance Practices, and National Instrument 52–110 and Companion Policy 52–110CP Audit Committees. 112 Ibid CSA Staff Notice 58–305.

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below, that are not fully covered in other corporate governance instruments. Each principle below is accompanied by commentary explaining those principles. In addition, it includes examples of corporate governance practices that can be used to achieve the objectives in the principles. In supplying examples, an innovative feature compared to the current National Policy 58–201, the CSA aims to assist issuers in crafting their own corporate governance regime that is appropriate in the circumstances.113 As stated by the CSA, they are not meant to create obligatory practices or minimum requirements.114 In adopting a flexible, principles-based approach, the purpose of the CSA’s policy is designed to:115 (a) provide protection to investors and foster fair and efficient capital markets and confidence in those markets (b) reflect the realities of the large number of small issuers and controlled issuers in the Canadian market and (c) take into account corporate governance developments around the world. The nine core corporate governance principles are: Principle 1: Create a framework for oversight and accountability An issuer should establish the respective roles and responsibilities of the board and executive officers. The commentary under Principle 1 identifies the following tasks as being the usual responsibilities of the board: (a) developing the issuer’s approach to corporate governance, including a set of corporate governance practices that are specific to the issuer (b) recruiting and appointing the CEO and evaluating his or her performance, based on clear objectives (c) satisfying itself that the executive officers have integrity (d) empowering the CEO, and other executive officers, to create a culture of integrity throughout the organisation, and satisfying itself they have done so (e) adopting a strategic planning process and approving, at least annually, a strategic plan (f) identifying the principal risks of the issuer’s business and ensuring that appropriate systems are in place to manage these risks (g) ensuring that a system for succession planning is in place (h) adopting a communications policy for the issuer and (i) adopting measures for receiving feedback from stakeholders. The national policy document recognises that the objectives of this principle can be achieved in a number of ways, including by: 113 Request for Comment: Proposed Repeal and Replacement of National Policy 58–201 Corporate Governance Guidelines, National Instrument 58–101 Disclosure of Corporate Governance Practices and National Instrument 52–110 and Companion Policy 52–110CP Audit Committees (19 December 2008), Appendix B, National Policy 58–201 Corporate Governance Principles, available at . 114 Ibid. 115 Ibid.

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adopting a written mandate or formal board charter that details the board’s roles and responsibilities and that of each standing committee of the board, if any having the board develop clear position descriptions for the chair of the board and the chair of each board committee having the board together with the CEO, develop a clear position description for the CEO, which may include delineating management’s responsibilities and providing directors with the terms and conditions of their appointment.

Principle 2: Structure the board to add value The board should be comprised of directors that will contribute to its effectiveness. The commentary under Principle 2 recognises that the board’s role is to provide strategic leadership and to supervise the performance of executive officers. It recommends that an effective board is to be structured in a way that allows directors to (a) fully and effectively carry out their fiduciary duties; and (b) add value to the issuer with a view to its best interests. To this end, each director should: ● have skills that will contribute towards the effective functioning of the board ● competencies appropriate to the issuer’s business ● demonstrate integrity and high ethical standards ● exercise independent judgment when making decisions and carrying out their other duties. This includes reviewing and challenging how executive officers discharge their duties and achieve their goals, where appropriate ● be able to provide sufficient time and commitment to their role ● be able to act collectively and interact in a manner that facilitates effective decision making. No individual or small group should dominate the board’s decision making. The national policy document recognises that the objectives of this principle can be achieved in a number of ways, including by having the board (or a committee of the board) regularly review its size and composition, and by encouraging directors to limit other external board commitments so as not to affect their ability to fulfil their duties to the board. The national policy document identifies the following related principles dealing with board composition: (a) having a majority of independent directors on the board116 (b) having an independent director chair the board or act as a lead director117 116 This recommendation is the same as Part 3.1 of the current National Policy 58–201. A director is independent if he or she has no direct or indirect material relationship with the issuer. A ‘material relationship’ is a relationship that could, in the view of the issuer’s board of directors, be reasonably expected to interfere with the exercise of a member’s independent judgment. This definition, located in the current Audit Committee Instrument, is subject to proposed amendment. Such law reform proposals are discussed later in the chapter. The current law reform process has, however, been temporarily suspended. See further, CSA Staff Notice 58–305 Status Report on the Proposed Changes to the Corporate Governance Regime (13 November 2009), available at . 117 This recommendation is the same as Part 3.2 of the current National Policy 58–201.

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having an appropriate number of independent directors who are unrelated to any control person or significant shareholder separating the roles of chair and CEO creating committees with an appropriate number of independent directors for specific purposes giving independent directors an opportunity, both at the board and committee level, to hold regularly scheduled meetings at which other directors and the executive officer are not present118 and giving the board the authority to engage and compensate any internal and external advisor that it determines necessary to carry out its duties, including advice from outside advisors.

Principle 3: Attract and retain effective directors A board should have processes to examine its membership to ensure that directors, individually and collectively, have the necessary competencies and other attributes. The commentary under Principle 3 recognises that while the shareholders elect directors, the board plays an important role in selecting candidates for the shareholders’ consideration. The board should be satisfied that appropriate procedures are in place for selecting candidates so that it can maintain a balance of competencies and other attributes. The national policy document recognises that the objectives of this principle can be achieved in a number of ways, including by: (a) having procedures for: (i) evaluating the competencies of directors (ii) identifying any gaps that exists on the board (iii) nominating directors to fulfil the needs of the board and (iv) developing and reviewing board succession plans (b) establishing a nomination committee to carry out, or make recommendations with respect to, some or all of these procedures. The national policy document identifies the following design principles dealing with the nomination committee: (a) having a majority of independent directors119 (b) having directors with the necessary competencies to fulfil the committee’s mandate (c) being chaired by an independent director (d) adopting a charter that sets out its roles and responsibilities, composition, structure and membership requirements and (e) having authority to engage and compensate any advisor that it determines necessary to permit it to carry out its duties. Principle 4: Continuously strive to improve the board’s performance A board should have processes to improve its performance and that of its committees, if any, and individual directors. 118 Ibid, Part 3.3. 119 This recommendation is a departure from Part 3.10 of the current National Policy 58–201, which states that the board of the nomination committee should be composed entirely of independent directors.

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The commentary under Principle 4 recognises that a board’s performance is dependent upon directors having the requisite knowledge, information and abilities to fulfil their obligations. It recommends that the board should provide its new directors with a comprehensive introduction to the company’s business and culture, and that continuing education should be provided for all directors. The subject matter to be covered should include the roles and responsibilities of the board, committees, directors and officers. On a broader level, it should also cover the issuer and its business, including its financial condition, strategy operations and risk management practices, the industry within which the issuer operates and its competitive position.120 The national policy document recognises that the objectives of this principle can be achieved in a number of ways, including by: (a) having appropriate orientation procedures in place for new directors121 (b) ensuring that all directors are provided with continuing education opportunities relevant to their duties on the board122 (c) having procedures in place regarding the timely provision of relevant information to the board by executive officers (d) allowing directors to request additional information or independent advise at the issuer’s expense, if the directors consider it necessary to fulfil their duties (e) creating opportunities for directors to interact with executive officers and (f) assessing the board, any board committees and each individual director on a regular basis regarding his, her or its contribution against established criteria and acting upon results.123 Principle 5: Promote integrity An issuer should actively promote ethical and responsible behaviour and decisionmaking. The commentary under Principle 5 recognises that the board has a responsibility to set the ethical standards applicable to the issuer’s directors, executive officers and employees. It acknowledges that investor confidence can be enhanced if the board clearly articulates ethical practices that are acceptable to the issuer. Executive officers are given the responsibility to implement and enforce those standards for behaviour and decision making. The national policy document recognises that the objectives of this principle can be achieved in a number of ways, including by: (a) supporting the issuer’s standards of ethical behaviour with appropriate training, monitoring, reporting, investigating and addressing unethical behaviour and (b) adopting a code of conduct.

120 121 122 123

This recommendation is similar to Part 3.6 of the current National Policy 58–201. Ibid. Ibid, Part 3.7. Ibid, Part 3.18.

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The commentary under Principle 5 identifies the following matters as being the usual content addressed by a code of conduct:124 (a) conflicts of interest, including transactions where a director or executive officer has a significant interest (b) protection and proper use of corporate assets and opportunities (c) confidentially of corporate information (d) the issuer’s responsibilities to security holders, employees, those with whom it has a contractual relationship and the broader community (e) compliance with laws, rules and regulations (f) reporting of any illegal or unethical behaviour and (g) monitoring and ensuring compliance with the code. Principle 6: Recognise and manage conflicts of interest An issuer should establish a sound system of oversight and management of actual and potential conflicts of interest. The commentary under Principle 6 recognises that conflicts of interest may arise in various situations (apart from those identified above under Principle 5), for example, when there is a significant divergence of interests among shareholders or their interests are not completely aligned or when a director cannot be considered impartial in connection with a proposed decision to be made by the board. The national policy document recognises that the objectives of this principle can be achieved in a number of ways, including by: (a) having practices for: (i) identifying, reviewing and assessing situations, decisions, contracts, arrangements or transactions where an actual or potential conflict of interest could arise (ii) submitting to the board the prior declaration by directors of their conflicts of interest (iii) keeping records of conflicts of interests and (b) establishing an ad hoc or standing committee made up of independent directors to carry out these practices and (c) obtaining paid independent advice on conflict of interest situations. Principle 7: Recognise and manage risk An issuer should establish a sound framework of risk oversight and management.125 The commentary under Principle 7 recognises that risk oversight and management include the culture, processes and structures that are directed towards taking advantage of potential opportunities while managing potential adverse effects. It acknowledges that risk oversight and management is most effective if it is embedded into the issuer’s practices and business processes rather than if it is viewed or practised as a separate activity. While a risk management committee 124 Ibid, Part 3.8. 125 Compare the guidance herein with the more specific recommendation contained in Principle 7 in Australia’s Corporate Governance Principles and Recommendations.

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can assist in identifying and managing risks, the responsibility for risk oversight and management rests with the full board. The national policy document recognises that the objectives of this principle can be achieved in a number of ways, including by: (a) developing, approving and implementing policies and procedures for the oversight and management of principal risks that: (i) reflects the issuer’s risk profile (ii) take into account its legal obligations and (iii) clearly describe the roles and accountabilities of the board, audit committee, or other appropriate board committee, management and any internal audit function. (b) regularly reviewing and evaluating the effectiveness of these policies and procedures and requiring the CEO and other executive officers to regularly report to the board on these matters. Principle 8: Compensate appropriately An issuer should ensure that compensation policies align with the best practices of the issuer. The commentary under Principle 8 recognises that compensation should be set and structured to attract and retain executive officers and directors and motivate them to act in the best interests of the issuer. This includes a balance pursuit of the issuer’s short-term and long-term objectives. It acknowledges that transparency of compensation can promote investor understanding and confidence in the process. The national policy document recognises that the objectives of this principle can be achieved in a number of ways, including by: (a) having procedures for: (i) establishing and maintaining goals related to executive officers’ compensation (ii) regularly evaluating executive officers’ performance in light of these goals (iii) determining the compensation of executive directors and directors and (iv) having the board review executive compensation disclosure before the issuer publicly discloses it and (b) establishing a compensation committee to carry out, or make recommendations to some or all these procedures. The national policy document identifies the following design principles dealing with the compensation committee: (a) have all independent directors126 (b) have directors with the requisite competencies to fulfil the mandate of the committee (c) have a charter that clearly sets out its roles and responsibilities, composition, structure and membership requirements 126 This recommendation is the same as Part 3.15 of the current National Policy 58–201.

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have the authority to engage and compensate any advisor have procedures to ensure that no individual is directly involved in deciding his or her own compensation.

Principle 9: Engage effectively with stakeholders The board should endeavour to stay informed of shareholders’ views through the shareholder meeting process as well as through ongoing dialogue. The commentary under Principle 9 recognises that an issuer’s relationship with its shareholders is an important aspect of corporate governance. To this end, within the parameters of corporate and securities law, it recommends that the board should promote a voting process that is understandable, transparent and robust, and that facilitates the board obtaining meaningful information on shareholder views. The national policy document recognises that the objectives of this principle can be achieved in a number of ways, including by: (a) posting on the issuer’s website a clear description of the voting process for registered and beneficial shareholders (b) giving shareholders the option of voting electronically, for example, through telephone or internet voting and (c) giving shareholders or proxy holders the option of attending meetings through electronic means.

12.4.4 Current National Policy 58–201: Corporate Governance Guidelines The current governance policy also sets out corporate governance guidelines, grouped under nine main topics. Similar to the proposed National Policy 58–201, these guidelines are not mandatory. The proposed governance policy is, however, broader in scope since the current governance policy does not expressly address the subject matter of principles 6 (Recognise and manage conflicts of interest), 7 (Recognise and manage risk) and 9 (Engage effectively with stakeholders) discussed above.127 Furthermore, the proposed governance policy will have a wider application and extends to all issuers. The current governance policy applies to all reporting issuers (both corporate and non-corporate entities), other than investment funds.

12.4.5 National Instrument 58–101: Disclosure of Corporate Governance Practices Currently, this instrument requires a reporting issuer (other than an investment fund) to include in its information circular, annual information form or 127 For criticisms directed to principles 7 and 8, see submission by the Institute of Corporate Directors to CSA based on the report developed by the Independent Task Force on the Canadian Securities Administrators’ Proposed National Governance Policy Regarding Revisions to NP 58–201 and NI 58–101 (17April 2009).

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equivalent document disclosure regarding its corporate governance practices. Issuers must disclose whether their practices are consistent with those recommended under current National Policy 58–201 Corporate Governance Guidelines. This approach is consistent with the ‘comply or explain’ disclosure regime in other jurisdictions, such as Australia and the UK.128 The proposed National Instrument 58–101129 will significantly revise disclosure requirements to comport with the contents of the proposed National Policy 58–201 Corporate Governance Principles. In particular, the disclosure requirements will no longer be based on a model of ‘comply or explain’ against governance guidelines. Instead, issuers will be required to disclose their governance practices that achieve the objectives espoused in the nine core governance principles. The proposed adoption of an ‘explain’ model has been criticised for taking Canada in a different direction from other jurisdictions and, more significantly, running the risk that unsophisticated investors in governance practices will be reading and evaluating the issuer’s disclosures in a vacuum due to the absence of a common benchmark.130

12.4.6 National Instrument 52–110 and Companion Policy 52–110CP Audit Committees As a response to major corporate fraud and misconduct in the USA, Canada reformed the audit function to enhance the quality of the audit process by adopting the following measures: ● establishing the Canadian Public Accountability Board (CPAB), which parallels the creation of the Public Company Accounting Oversight Board (PCAOB), seen as the centerpiece of SOX131 ● creating an Auditing and Assurance Standards Oversight Council (AASOC) ● promulgating new auditor independence standards ● passing a national instrument on auditor oversight. In line with international trends, which has concentrated attention on audit committees in fulfilling their oversight responsibilities with respect to the integrity of financial statements and reporting,132 Canada has also focused on the expanded 128 Since 1995, companies listed on the Toronto Stock Exchange (TSX) have been required to disclose on an annual basis a ‘Statement of Corporate Governance Practices’. Although the TSX guidelines (set out in the TSX Company Manual) were not prescriptive, it was predicated on the ‘comply or explain’ disclosure regime. For examples of disclosure of Canadian corporate governance practices, see disclosure documents of public companies, which are available at . 129 See earlier discussion on the status of this law reform measure. 130 See submission by the Institute of Corporate Directors to CSA based on the report developed by the Independent Task Force on the Canadian Securities Administrators’ Proposed National Governance Policy Regarding Revisions to NP 58–201 and NI 58–101 (17April 2009). 131 For a useful discussion on the role of the audit profession in corporate governance and an account of developments in the regulation of the audit function in both Canada and the USA, see Paul Paton, ‘Rethinking the Role of the Auditor: Resolving the Audit/Tax Services Debate’ (2006) 32 Queen’s Law Journal 135. 132 See, for example, Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, published by the New York Stock Exchange and The National Association of Securities Dealers (1999).

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role of audit committees. Similar to section 301 of SOX, this national instrument requires every reporting issuer to have an audit committee composed of independent directors, unless otherwise exempted, which is responsible for the oversight of the external auditor and for reviewing the company’s financial statements. The national instrument establishes requirements for the responsibilities, composition and authority of audit committees.133 The companion policy provides information regarding the interpretation and application of the instrument. In the case of a non-venture issuer, an audit committee must be composed of a minimum of three directors who must be, subject to limited exceptions, independent and financially literate.134 For purposes of the instrument, a director is financially literate if he or she has the ability to read and understand a set of financial statements that present a breadth and level of complexity of accounting issues that are reasonably comparable to the breadth and complexity of the issues that can reasonably be expected to be raised by the issuer’s financial statements.135 Furthermore, issuers disclose the education and experience of each audit committee member that is relevant to the performance of his or her responsibilities as an audit committee member.136 The definition of ‘independent director’, which is also applicable to the corporate governance guidelines discussed earlier, is contained in National Instrument 52–110 and is determined with reference to the following specific ‘bright-line’ tests: ● an individual who is, or with the prior three-year period has been, an employee or executive officer of the issuer ● an individual whose immediate family member is, or within the prior threeyear period has been, an executive officer of the issuer ● an individual who is, or has been, or has an immediate family member who is, or has been, a partner or employee of a current or former internal or external auditor of the issuer, or personally worked on the issuer’s audit within the past three years as a partner or employee of that audit firm ● an individual who is, or has been, or whose immediate family member is, or has been within the past three years, an executive officer of an entity if any of the issuer’s current executive officers serve or served at the same time on that entity’s compensation committee ● an individual who received, or whose immediate family member who is employed as an executive officer of the issuer received, more than $75 000 in direct compensation from the issuer during any 12-month period within the past three years and ● for purposes of this definition, an ‘issuer’ includes any parent or subsidiary entity. The definition above is extended for audit committee composition purposes. In addition, an individual will not be treated as independent if he or she: 133 The instrument applies to a reporting issuer other than an investment fund, an issuer of asset-backed securities, a designated foreign issuer and an SEC foreign issuer. 134 Part 3.2 of National Instrument 52–110. 135 Part 4.1 of Companion Policy 52–110CP to National Instrument 52–110 Audit Committees. 136 Ibid.

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Accepts, directly or indirectly, any consulting, advisory or compensatory fee from the issuer, other than as remuneration for acting as a board member or as a part-time chair or vice-chair of the board or ● Is an ‘affiliated entity’ of the issuer or any of its subsidiary entities. Proposed law reform to National Instrument 52–110, which is currently stalled for reasons discussed earlier, contemplates redefining when a director can be considered independent of the company. The ‘bright-line’ tests, identified above, may no longer apply if the proposed reforms are implanted in 2011 (at the earliest).137 Instead, the proposed redefinition states than an independent director is a director of an issuer who: (a) is not an employee or executive officer of the issuer and (b) does not have, or has not had, any business or other relationship with the issuer or its executive officers which could, in the view of the issuer’s board having regard to all relevant circumstances, be reasonably perceived to interfere with the exercise of his or her independent judgment. The CSA has proposed a ‘perceptions’ test because it believes that the concept of perception is broader and more appropriate in view of the proposed removal of the ‘bright-line’ tests. The revised definition has been attacked by the Alberta Securities Commission (ASC) over concerns the clause (b) above may remove the discretion of the board to determine whether or not a director who is not an employee or executive offer is independent.138 The ASC has queried whether the reasonable person litmus test to judge independence is appropriate and whether it is desirable for issuers to identify directors as being ‘not independent’ and to offer an explanation for such a label.139 The concern for the ASC is that the best available directors may not become members of the boards because of the application of the revised definition of independence.140 Another concern expressed is that the primacy of independence has caused many boards to operate with directors who are entirely independent but who lack the skills, attributes and industry knowledge that would be most valuable to the issuer’s business.141 The responsibilities of the audit committee are set out in Part 2.3 of the National Instrument 52–110, which states: (1) An audit committee must have a written charter that sets out its mandate and responsibilities. (2) An audit committee must recommend to the board of directors (a) the external auditor to be nominated and (b) the compensation of the external auditor. ●

137 See CSA Staff Notice 58–305 Status Report on the Proposed Changes to the Corporate Governance Regime (13 November 2009), available at . 138 Request for Comment: Proposed Repeal and Replacement of National Policy 58–201 Corporate Governance Guidelines, National Instrument 58–101 Disclosure of Corporate Governance Practices and National Instrument 52–110 and Companion Policy 52–110CP Audit Committees (19 December 2008), Appendix A, National Policy 58–201 Corporate Governance Principles – available at . 139 Ibid. 140 Ibid. 141 See submission by the Institute of Corporate Directors to CSA based on the report developed by the Independent Task Force on the Canadian Securities Administrators’ Proposed National Governance Policy Regarding Revisions to NP 58–201 and NI 58–101 (17 April 2009).

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An audit committee must oversee the work of the external auditor engaged for the purpose of preparing or issuing an auditor’s report or performing another audit, or attest services for the issuer, including the resolution of disagreements between management and the external auditor regarding financial reporting. An issuer or any of its subsidiary entities must not obtain a non-audit service from its external auditor unless the service has been approved by the issuer’s audit committee. An issuer must not publicly disclose information contained in or derived from its financial statements, Management Discussion and Analysis (MD&A) or annual or interim earnings news releases, unless the document has been reviewed by the audit committee. An audit committee must be satisfied that adequate procedures are in place for the review of the issuer’s public disclosure of financial information extracted or derived from the issuer’s financial statements and must, on a reasonably frequent basis, assess the adequacy of those procedures. An audit committee must establish procedures for: (a) the receipt and retention of and reasonable attempts to resolve complaints received by the issuer regarding accounting, internal accounting controls, or auditing matters and (b) the confidential, anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters. An audit committee must review and approve the issuer’s hiring policies regarding partners, employees and former partners or employees of the present or former external auditor of the issuer.

12.4.7 Future direction The following section highlights some of the key concerns expressed on the future direction of corporate governance in Canada. A common concern, echoed by various commentators,142 deals with the tendency for Canadian corporate and securities law reform to move lockstep with the USA despite considerable differences in the Canadian capital markets from those in the USA. The key major difference between the USA and Canada lies in the fact that most United States companies are widely held, unlike the Canadian position where half of the top firms have controlling shareholders (wealthy families, other firms, or large financial institutions).143 Those controlling shareholders usually dominate the board, giving rise to governance problems whereby controlling shareholders are either 142 See, for example, Sukanya Pillay, ‘Forcing Canada’s Hand? The Effect of the Sarbanes-Oxley Act on Canadian Corporate Governance Reform’ (2004) 30 Manitoba Law Journal 285; Davis, above n 106, 990; Paton, above n 131, 135; Edward Waitzer, ‘Paradigm Flaws: An Agenda for Corporate Governance Reform’ (2007) Banking & Finance Law Review 405. 143 Randall Morck and Bernard Yeung, ‘Research Study: Some Obstacles to Good Corporate Governance in Canada and How to Overcome Them’, commissioned by the Task Force to Modernise Securities Legislation in Canada, Canada Steps Up (18 August 2006) at 293–300.

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unsophisticated or wield control without owning very many shares through control-magnifying devices such as super-voting shares and pyramiding.144 Morck and Yeung note that much empirical research links these problems to weak performance.145 In their view, current corporate governance reforms in Canada are ill-suited for the following reasons:146 Canadian corporate governance laws, regulations and best practices must attend to controlling – versus public-shareholder disputes in firms with controlling shareholders, and to shareholder-manager disputes in firms without them. This requires a fundamentally broader focus that in the United States and the United Kingdom, where controlling shareholders are relatively rare and good governance is mainly about preventing or solving shareholder-manager disputes.

The following questions posited by a Canadian commentator illustrate the fierce debate about the future direction of Canadian corporate governance reform:147 ● Should Canada harmonise its securities laws with SOX? ● Since Canada has traditionally employed a principles-based model of corporate governance, is it necessary for Canada now to shift its corporate governance culture to adopt a rules-based model in order to harmonise with SOX? ● Given that Canada does not have a federal securities regulator like the USA’s SEC, can Canada even achieve domestic harmonisation let alone external harmonisation with SOX? An unanswered question, posed by Ronald Davis,148 is whether the importation of the SOX regulatory requirements will adversely affect the culture of Canada’s corporations by encouraging the abandonment of a ‘culture of compliance’ for a loop-hole conscious, rules-based culture. Answering this question merits scholarly research and empirical evidence into corporate governance practices. It is noted with some irony by one commentator149 that the current calls to roll back section 404 of SOX (dealing with internal controls) due to the high cost of compliance (in particular for smaller public companies) and the United States reforms150 suggests that the USA may be moving in the Canadian direction. The contemplated change in philosophy, from a set of recommended governance practices to a principles-based approach to corporate governance in 144 Ibid. 145 Ibid at 295. 146 Ibid at 296. For similar concerns, see Janis Sarra, ‘The Corporation as Symphony: Are Shareholders First Violin or Second Fiddle?’ (2003) 36 University of British Columbia Law Review 403, who notes that corporate law reforms shift oversight power to large investors and their ability to influence corporate governance. 147 Pillay, above n 142, 285; 148 Davis, above n 106, 990. 149 Ben-Ishai, above n 104, 490. 150 SEC Press Release (13 December 2006), ‘SEC Votes to Propose Interpretive Guidance for Management to Improve Sarbanes-Oxley 404 Implementation’, available at ; SEC Press Release (23 May 2007), ‘SEC Approves New Guidance for Compliance with Section 404 of Sarbanes-Oxley’, available at ; and see John W. White, SEC’s Proposed Interpretive Guidance to Management for Section 404 of Sarbanes-Oxley Act (23 May 2007), Washington, DC.

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National Policy 58–201, will bring with it opportunities and risks151 for those at the coal-face who are familiar with the current governance culture. The proposed replacement of the current system of corporate governance with nine broad principles designed better to protect investors and make Canadian business more competitive is yet to be tested, and therefore its workability is yet to be judged.152 In an effort to be less prescriptive by removing the ‘bright-line’ tests to determine director independence, the proposed amendment of the definition of independence to a more principles-based definition brings with it a range of concerns discussed earlier. It remains to be seen, as forewarned,153 if on the path to transition Canada loses the generally accepted baseline of governance practices that currently exists should the principles-based approach be implemented.

12.5 Conclusion There were considerable developments in the area of corporate governance in all three jurisdictions discussed in this chapter. Although signs of convergence of corporate governance models were identified and still exist, it is far from certain that all corporate governance systems will converge. Cultural differences and other factors listed in this chapter will almost certainly ensure that there will always be differences in the corporate governance systems adopted by different countries, irrespective of globalisasion generally. An interesting illustration of this is the strong divergence that occurred between the USA and UK corporate governance models with the adoption of SOX – it has put the two jurisdictions on different corporate governance paths, with a self-regulatory aspiration still dominant in the UK, while the United States model is far more prescriptive and regulatory in nature. Also, the differences between models relying on the principle of ‘comply and explain’ or ‘comply or else’ or ‘apply or explain’, also commented on in Chapter 3, illustrate that variety will probably remain the spice of ‘corporate governance’ (‘life’)! 151 For a comprehensive discussion on the costs and benefits of rules and principle-based regulatory systems, see Cristie Ford, Principles-Based Securities Regulation: A Research Study Prepared for the Expert Panel on Securities Regulation (12 January 2009), available at . For critique on the use of such labels, see Lawrence Cunningham, ‘A Prescription to Retire the Rhetoric of “Principle-Based Systems” in Corporate Law, Securities Regulation, and Accounting’ (2007) 60 Vanderbilt Law Review 1411. 152 British Columbia introduced a bill to create an innovative principles-based Securities Act (Bill 38), which was assented to in May 2004 but is yet to come into force. 153 See submission by the Institute of Corporate Directors to CSA based on the report developed by the Independent Task Force on the Canadian Securities Administrators’ Proposed National Governance Policy Regarding Revisions to NP 58–201 and NI 58–101 (17 April 2009). Cf Erinn Broshko and Kai Li, ‘Playing by the Rules: Comparing Principles-based and Rules-based Corporate Governance in Canada and the U.S.’ (2006) Canadian Investment Review 18.

13 OECD Principles of Corporate Governance, and corporate governance in Germany, Japan and China Nothing so concentrates the mind as an urgent and complex problem. Frederick G Hilmer, Strictly Boardroom: Improving Governance to Enhance Company Performance (Hilmer Report (1993)) 1

13.1 Introduction In Chapter 12 we discussed corporate governance in the USA, the UK and Canada. We have mentioned that although they are considered to be the major traditional Anglo-American corporate governance jurisdictions, there are among them some fundamental differences in approach. In this chapter the focus is on the OECD principles of corporate governance, and corporate governance in Germany, Japan and China. The OECD principles cover board structures. Germany adheres to a two-tier board structure with employee representatives forming part of the supervisory board. Elements of the German corporate governance model influenced the original Japanese corporate governance model, but Anglo-American influence emerged after World War II. China has a unique corporate governance model because Chinese corporations were traditionallyare state-owned and many major corporations are still either state-owned or state-controlled. Nevertheless, elements of both the German model and the Anglo-American model, especially as far as independent, non-executive directors for listed companies are concerned, have influenced the Chinese corporate governance model.

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13.2 OECD Principles of Corporate Governance 13.2.1 Background The Organisation for Economic Co-operation and Development (OECD) consists of a group of 30 member countries who share a commitment to democratic government and a market economy. It shares expertise and exchanges views with more than 100 other countries, non-government organisations and civil societies. The OECD brings together the governments of countries committed to democracy and the market economy from around the world to:1 ● support sustainable economic growth ● boost employment ● raise living standards ● maintain financial stability ● assist other countries’ economic development ● contribute towards growth in world trade. One of the OECD’s early projects was to develop a set of principles of corporate governance. The first such set was completed in 1999 under the title OECD Principles of Corporate Governance.2 These principles provided minimum requirements for best practice and were not aimed at promoting a single corporate governance model for all OECD countries, but rather at promulgating principles that could be applied in all OECD and non-OECD countries. On 22 April 2004, the 30 OECD countries approved the 2004 OECD Principles of Corporate Governance.3 These principles confirm several sound corporate governance practices already identified and explained in the 1999 Principles, but they also contain some refinement in light of the corporate scandals of the late 1990s and early 2000s: The OECD Principles of Corporate Governance were originally developed in response to a call by the OECD Council Meeting at Ministerial level on 27–28 April 1998, to develop, in conjunction with national governments, other relevant international organisations and the private sector, a set of corporate governance standards and guidelines. Since the Principles were agreed in 1999, they have formed the basis for corporate governance initiatives in both OECD and non-OECD countries alike. Moreover, they have been adopted as one of the Twelve Key Standards for Sound Financial Systems by the Financial Stability Forum. Accordingly, they form the basis of the corporate governance component of the World Bank/IMF Reports on the Observance of Standards and Codes (ROSC).4

13.2.2 Broad aims and application The OECD Principles aimed to assist governments in their efforts to evaluate and improve the legal, institutional and regulatory framework for corporate 1 See ‘About OECD’, at . 2 OECD Principles of Corporate Governance (1999). 3 OECD Principles of Corporate Governance (2004), available at . 4 Ibid 9.

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governance, and to provide guidance and suggestions for stock exchanges, investors, corporations and other parties that have a role in the process of developing good corporate governance.5 One of the unique aspects of the OECD Principles is that they operate across borders and without preference for any particular corporate law system or board structure6 – they focus, in the true sense of the word, on ‘the principles of corporate governance’. Thus, an open-minded approach to corporate governance is adopted: Corporate governance is one key element in improving economic efficiency and growth as well as enhancing investor confidence. 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. Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and its shareholders and should facilitate effective monitoring.7

13.2.3 Structure The document containing the OECD Principles is divided into two parts: the first comprises the core principles, while the second part presents the principles with annotations and are intended to help readers understand their rationale. The annotations also provide descriptions of dominant trends and offer alternative implementation methods and examples that may be useful in making the principles operational. The principles presented in the first part of the document cover the following areas: I) Ensuring the basis for an effective corporate governance framework; II) The rights of shareholders and key ownership functions; III) The equitable treatment of shareholders; IV) The role of stakeholders; V) Disclosure and transparency; and VI) The responsibilities of the board. Each of the sections is headed by a single principle that appears in bold italics and is followed by a number of supporting sub-principles.8 In this discussion we focus only on the principles not dealt with specifically in any other chapter of this book, namely those in Part I and Part V.

13.2.4 Ensuring the basis for an effective corporate governance framework The basic principle is expressed as follows:9 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. 5 6 7 8 9

Ibid 11. Ibid 13. Ibid 11. Ibid 14. Ibid 17.

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Four specific aspects are mentioned to ensure the implementation of this principle:10 A. 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. B. The legal and regulatory requirements that affect corporate governance practices in a jurisdiction should be consistent with the rule of law, transparent and enforceable. C. The division of responsibilities among different authorities in a jurisdiction should be clearly articulated and ensure that the public interest is served. D. Supervisory, regulatory and enforcement authorities should have the authority, integrity and resources to fulfil their duties in a professional and objective manner. Moreover, their rulings should be timely, transparent and fully explained. Many of the aspects discussed in this part of the OECD Principles of Corporate Governance have already been mentioned in Chapter 3 under the heading ‘3.5 Board structures in the broader context of a good corporate governance model’. As was discussed in Chapter 5, the OECD Principles emphasise the point that a corporate governance framework typically comprises elements of legislation, regulation, self-regulatory arrangements, voluntary commitments and business practices that are the result of a country’s specific circumstances, history and tradition. One of the specific dangers warned against is over-regulation. The costs and benefits of laws and regulations should be considered carefully before they are implemented, otherwise the result will be over-regulation, or even the creation of unenforceable laws. Any corporate governance model should support the exercise of entrepreneurship.11 It is stressed that the regulatory and legal environment within which corporations operate is of key importance to overall economic outcomes. A corporate governance model is typically influenced by several legal arrangements such as company law, securities regulation, accounting and auditing standards, insolvency law, contract law, labour law and tax law. However, these laws will require effective enforcement. The allocation of responsibilities for supervision, implementation and enforcement among different authorities should be clearly defined so that the competencies of complementary bodies and agencies are respected and used most effectively. If this is not done, overlaps can occur or, even worse, ‘regulatory vacuums’ can be created.12 We have argued in Chapter 6 that this is one of the aspects where the Australian corporate governance model lags behind, especially as far as the respective roles of the Australian Securities Exchange (ASX) and the Australian Securities and Investments Commission (ASIC) are concerned. 10 Ibid. 11 Ibid 29. 12 Ibid 29–31.

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13.2.5 Disclosure and transparency The basic principle is expressed as follows:13 The corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company.

Four specific aspects are mentioned to ensure the implementation of this principle:14 A. Disclosure should include, but not be limited to, material information on: 1. the financial and operating results of the company 2. company objectives 3. major share ownership and voting rights 4. remuneration policy for members of the board and key executives, and information about board members, including their qualifications, the selection process, other company directorships and whether the board regards them as independent 5. related party transactions 6. foreseeable risk factors 7. issues regarding employees and other stakeholders 8. governance structures and policies, in particular, the content of any corporate governance code or policy and the process by which it is implemented. B. Information should be prepared and disclosed in accordance with highquality standards of accounting and financial and non-financial disclosure. C. An annual audit should be conducted by an independent, competent and qualified auditor in order to provide an external and objective assurance to the board and shareholders that the financial statements fairly represent the financial position and performance of the company in all material respects. D. External auditors should be accountable to the shareholders, and owe a duty to the company to exercise due professional care in the conduct of the audit. The OECD Principles note that most OECD countries already have in place both mandatory and voluntary disclosure arrangements. The main advantage of a strong disclosure regime is that it promotes transparency, ensures effective monitoring of companies and is central to shareholders’ ability to exercise their ownership rights on an informed basis. Disclosure is also a powerful tool with which to influence the behaviour of companies and protect investors.15 The advantages of an effective disclosure regime versus the disadvantages of a poorly developed disclosure regime are summarised neatly as follows: 13 Ibid 22. 14 Ibid. 15 Ibid 49.

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A strong disclosure regime can help to attract capital and maintain confidence in the capital markets. By contrast, weak disclosure and non-transparent practices can contribute to unethical behaviour and to a loss of market integrity at great cost, not just to the company and its shareholders but also to the economy as a whole . . . Insufficient or unclear information may hamper the ability of the markets to function, increase the cost of capital and result in a poor allocation of resources.16

It is, however, important that disclosure requirements should not place unreasonable administrative or cost burdens on enterprises or require of companies to disclose information that may endanger their competitive position. The principle adopted in most OECD countries to ensure that the right kind of information is disclosed is the principle of ‘materiality’: ‘material information can be defined as information whose omission or misstatement could influence the economic decisions taken by users of information’.17

13.2.6 Conclusions on OECD corporate governance principles As was pointed out, one of the unique aspects of the OECD Principles is that they operate across borders and without preference for any particular corporate law system or board structure– they focus, in the true sense of the word, on ‘the principles of corporate governance’. It is, therefore, of particular importance to take note of these principles and to adopt the ones most appropriate for a specific country. It also provides some of the most convincing arguments for why good corporate governance is important and why adhering to good corporate governance adds value to a corporation.

13.3 Germany18 13.3.1 Background to the corporate governance debate in Germany The German corporate governance debate is particularly interesting and relevant, since the German corporations law makes a two-tier board system (supervisory board and management board) compulsory for all public corporations. This system, and in particular the role and effectiveness of the supervisory board as institutional supervisor or overseer of the management of the business of the corporation, has been highly prominent in Germany since the middle 1990s. In the past, the German two-tier system has been criticised for: the ineffectiveness of supervisory boards generally; the practical difficulty in distinguishing between the managerial and supervisory functions of the management board 16 Ibid. 17 Ibid 49–50. 18 For a more comprehensive discussion of the German corporate law and governance models, see J J du Plessis, B Großfeld, C Luttermann, I Saenger and O Sandrock, German Corporate Governance in International and European Context, Heidelberg, Springer Verlag (2007).

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and supervisory board respectively; the practical difficulties associated with the relationship between the supervisory and management boards; the defects in the composition of supervisory boards; and, in particular, employee participation at supervisory board level.19 Many of the original criticisms against the German board system have been addressed pertinently since the middle of the 1990s. These aspects are refreshing and can hardly be ignored as far as the worldwide debate on corporate governance is concerned. The German corporate governance debate, and in particular the debate on the functions of the supervisory board, has for many years been considered to be of academic interest only.20 This perception has changed significantly over recent years. The supervisory board has been a focus of attention for the German government; it formed the central theme of discussion of several seminars and symposiums; German industry committed itself to finding solutions; trade unions made recommendations; and eminent German academics participated keenly in this debate.21 The debate on corporate governance in Germany was closely linked with the relatively difficult economic conditions experienced there during the middle and late 1990s,22 and in particular with the difficulties experienced in the German iron and steel industry.23 Difficulties in some of the large German industries were blamed upon failure and neglect of management and those overseeing the business of large corporations, particularly the supervisory boards.24 The recent global financial crisis took a particular toll on the German economy, which has always been heavily dependent on export of expensive and sophisticated commodities such as luxury cars; during a financial crisis, naturally purchases of luxurious items are cut first.25 The official reaction to the corporate governance debate of the middle 1990s came in November 1996, with a Ministerial Draft Bill dealing with issues relating to more transparency in corporations and the powers of control of the various organs of public corporations26 – generally known as the Aktienrechtsreform 19 See Detlev F Vagts, ‘Reforming the “Modern” Corporation: Perspectives from the German’ (1966) 80 Harvard Law Review 23, 76–8 and 87–9; Mark J Roe, ‘Some Differences in Corporate Structure in Germany, Japan, and the United States’ (1993) 102 Yale Law Journal 1927, 1995–1997; Jean J du Plessis, ‘Corporate Governance: Reflections on the German Two-tier System’ (1996) Journal of South African Law 20, 41–4; Jean J du Plessis, ‘Corporate Governance: Some Reflections on the South African Law and the German Two-tier Board System’ in Fiona Macmillan Patfield (ed.), Perspectives on Company Law: 2, London, Kluwer Law (1997) 131, 139–43. 20 Marcus Lutter, ‘Defizite f¨ ur eine effiziente Aufsichtsratst¨ atigkeit und gesetzliche M¨ oglichkeiten der Verbesserung’ (1995) 159 Zeitschrift f¨ ur das gesamte Handelsrecht und Wirtschaftsrecht 287, 288–9. 21 See Jean J du Plessis, ‘Reflections on Some Recent Corporate Governance Reforms in Germany: A Transformation of the German Aktienrecht?’ (2003) 8 Deakin Law Review 381, 384–5 and references in footnotes 19–23. 22 This fact has been mentioned by quite a few chairmen of management boards in their yearly reports – see Klein-Gunnewyk (Chairman’s Statement: PWA AG) 1994.06.24. See also Carsten P Claussen, ‘Aktienrechtsreform 1997’ (1996) 41 Die Aktiengesellschaft (Zeitschrift) 481. 23 Marcus Lutter, ‘Deutsche Corporate Governance Kodex’ in Reform des Aktienrechts, der Rechnungslegung und der Pr¨ ufung, Stuttgart, Sch¨ affer-Poeschel Verlag (2003) 68, 69. 24 Claussen, above n 22, 481. 25 See generally Anatole Kaletsky, ‘Europe Needs Rescue Act from Germany’, The Australian (19 May 2009) at 21; and ‘Thomas Cook Up for Grabs After Retailer Folds’, The Australian (11 June 2009) at 20. 26 Referentenentwurf eines Gesetzes f¨ ur Kontrolle und Transparenz im Unternehmensbereich (KonTraG) – Dokumentation, 1997 (Special Edition) Die Aktiengesellschaft (AG) 7.

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1997.27 The 1997 Draft Bill dealt with several fundamental aspects pertaining to the duties, responsibilities and liability of members of supervisory boards; proxies; financial statements and disclosure; votes by the banks on behalf of shareholders; and financial instruments and capital markets.28 This Draft Bill was widely discussed in 1997,29 and several amendments were made before it became law in May 1998.30 The proposed changes were described by some as comprehensive and akin to the reform of the German corporations law in the 1960s.31 Others were more skeptical and described the changes as no more than cosmetic,32 or done piecemeal instead of by way of a comprehensive review of the German corporations law.33 Some of the more fundamental questions asked during the reform process were how the German corporations law could be modified to ensure the improvement of the state of businesses in Germany and how to create more jobs.34 Nowadays several items, such as the role and functions of the management board and general meeting, and removing some unnecessary bureaucratic provisions from the corporations law, are mentioned as items on the long-term reform agenda of the German corporations law.35 It was realised at an early stage of the German corporate governance debate that most of the changes in the Draft Bill could be achieved without the need for statutory changes36 – in other words, through voluntary or self-imposed good corporate governance practices. Some commentators warned specifically against the dangers of over-regulation by the legislature, and that such regulation often causes more damage than advantages.37 Following the changes in 1998, a government commission, chaired by Theodor Baums, was appointed by the German Chancellor on 29 May 2000.38 The Baums Commission made 150 recommendations in its report, released on 10 July 2001.39 27 Heinz-Dieter Assmann, ‘AG-Sonderheft: Die Aktienrechtsreform 1997’, Die Aktiengesellschaft (Zeitschrift) (Special Edition, 1997) 3. 28 See Michael Adams, Die Aktiengesellschaft (Zeitschrift) (Special Edition,1997) 9 ff for a most comprehensive discussion of the issues dealt with in the Draft Bill. 29 See Adams, above n 28, 9 ff for detailed commentary by some of the most eminent corporate law academics in Germany. 30 Gesetz zur Kontrolle und Transparenz im Unternehmensbereich (KonTraG) – Bundesgesetzblatt Teil I (BGBI. I. 1998 786 ff). 31 See Claussen, above n 22, 494. 32 Ekkehard Wenger, Die Aktiengesellschaft (Zeitschrift) (Special Edition, 1997) 57. 33 Ulrich Seibert, ‘Aktienrechtsreform in Permanenz?’ (2002) 45 Die Aktiengesellschaft (Zeitschrift) 417. However, at 419–20 the author explains that such piecemeal reform was necessary as comprehensive corporate law reforms take a long time and there was simply not enough time to wait for comprehensive corporate law reform in Germany. 34 Claussen, above n 22, 481. 35 Seibert, above n 33, 419. 36 Conrad Berger, Die Kosten der Aufsichtsratst¨ atigkeit in der Aktiengesellschaft, Frankfurt, Peter Lang (2000) 10. 37 Claussen, above n 22, 481, 487. 38 Until about 2007 available at ‘Corporate Governance – Unternehmensf¨ uhrung – Unternehmenskontrolle – Modernisierung des Aktienrechts’. Press Release 3 August 2001 at 3 – for a copy of the press release, contact first author Jean du Plessis. 39 Ibid.

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The work of the Commission was described as follows by the State Minister to the Chancellery, Hans Martin Bury, when the report was delivered to the German Chancellor: The work of the Government Panel on Corporate Governance has laid the foundation for a comprehensive reform of German company law. The Panel’s recommendations aim to improve corporate management and supervision, transparency and competition. They improve the protection of stockholders and strengthen Germany’s financial market. The Government Panel not only has accomplished its mission of formulating recommendations to correct undesirable past trends, but has also developed proposals with well-reasoned future orientation to strengthen the German system of Corporate Governance and eliminate potential shortcomings.40

The recommendations dealt with the introduction of a corporate governance code for listed German corporations; intensifying the control over directing the business of the corporation and increasing the powers of supervisory boards; improving the rights of shareholders; improving protection for investors; improving provisions for the disclosure of information; improving accounting standards and financial reporting; and the use of modern information and communication technology.41 For current purposes the focus will be on the first two aspects.42

13.3.2 The German Corporate Governance Code43 13.3.2.1 Background to its adoption In Germany, the introduction of a code of good corporate governance practices was always seen in the context of the broader definition of corporate governance. The approach to such a definition was a realistic one, with two aspects being highlighted: first, that corporate governance cannot ignore the stakeholder debate; and second, that the concept of corporate governance encompasses more than just the creation of legal structures for decision making and supervising the corporation. It was, furthermore, realised that because of the peculiarities of the German corporations law, in particular the prescriptive nature of the German Corporations Act (Aktiengesetz (AktG)) regarding a two-tier board, no international code would fit the German situation perfectly. Even in the European 40 Translation by Shearman and Sterling, ‘German Government Panel on Corporate Governance’, Summary of Recommendations (Translation) (2001) 1 – translation kindly provided by Professor Theodor Baums. Also see . 41 Press Release, above n 38, 3–8. 42 As far as the supervisory board in particular is concerned, see the comprehensive and excellent article by Jan Lieder, ‘The German Supervisory Board on Its Way to Professionalism’ (2010) 11 German Law Journal 115 et seq. For some of the more general issues dealing with the German corporate governance model, see Christel Lane, ‘Changes in Corporate Governance of German Corporations: Convergence to the AngloAmerican Model?’ in European Corporate Governance (Thomas Clarke and Jean-Francois Chanlat, eds), London, Routledge (2009) 157. 43 This part is partly based on extracts from the following two articles – Du Plessis, above n 21, 381 et seq; and Jean J du Plessis, ‘The German Two-tier Board and the German Corporate Governance Code’ (2004) 15 European Business Law Review 1139 et seq.

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Union context, the vast differences between the OECD Principles of Good Corporate Governance and the UK Combined Code served as a clear illustration that no international code could really serve as an example for Germany. Soon after the release of the Baums Report it was made known that a group of experts would be appointed to draft a code of best practice for Germany that would apply to all listed German corporations, and that the code should follow the ‘comply or explain’ principle adopted in the UK. This task was given to the German Corporate Governance Commission under the chairmanship of Gerhard Cromme (the Cromme Commission), who was appointed in September 2001. Although there were some private initiatives to introduce a code of best practice for Germany in 2000, the official German code was only adopted on 26 February 2002. Since 2005, the code has been amended and adjusted slightly on an annual basis in June of each year.44 Several of the amendments have been influenced by international developments and after the publication of several corporate governance reports based on conferences held under the auspices of the Cromme Committee. The papers of these conferences were published in German and in English.45 The current code is one dated 18 June 2009.46 One of the main aims of the code was to improve corporate governance practices relating to managing, directing and overseeing listed corporations. The code adopted the two basic principles referred to above, namely that in essence it would apply only to listed corporations and that it would not be mandatory, but that listed corporations must disclose if they did not follow certain specific recommendations of the code (the ‘comply or disclose’ principle). What is, however, different from most other systems with which voluntary corporate governance codes were adopted is that the obligation to comply with the German code or to explain non-compliance was introduced into the German law through a statutory provision, section 161 of the Aktiengesetz (AktG). Section 161 basically puts a statutory duty on supervisory boards and management boards of all listed German corporations, either to state that they ‘comply’ with the German code as published electronically by the Standing Corporate Governance Commission, or to ‘disclose’ if they do not comply with the code. The ‘comply or disclose’ statement must be done on an annual basis and must also be made available to the shareholders at all times. Such a voluntary corporate governance model provides the advantage of being able to respond quickly and effectively to the continuously changing needs of business – something that cannot be achieved if corporate governance practices are formalised through legislation, especially because of the tediousness involved in amending legislation. Klaus J Hopt describes the basic aims of a first-class 44 See . 45 See for instance Gerhard Cromme (ed.), Corporate Governance Report 2006: Vortr¨ age und Diskussionen der 5. Konferenz Deutscher Corporate Governance Kodex, Stuttgart, Sch¨ affer-Poeschel Verlag (2006); Gerhard Cromme (ed.), Corporate Governance Report 2007: Vortr¨ age und Diskussionen der 6. Konferenz Deutscher Corporate Governance Kodex, Stuttgart, Sch¨ affer-Poeschel Verlag (2007); Gerhard Cromme (ed.), Corporate Governance Report 2008: Vortr¨ age und Diskussionen der 8. Konferenz Deutscher Corporate Governance Kodex, Stuttgart, Sch¨ affer-Poeschel Verlag (2008). 46 See .

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corporate governance code as brevity, certainty, allowance for individualisation and flexibility,47 and it seems that most of these aims are achieved by the German code. 13.3.2.2 Structure and explanatory nature of the German code The Code consists of seven distinct parts. The first part, the foreword, explains the purpose of the Code and how its provisions should be interpreted. Part 2 deals with shareholders and the general meeting; Part 3 with the cooperation between the management board and the supervisory board; Part 4 with the management board; Part 5 with the supervisory board; Part 6 with information that should be disclosed to ensure transparency; and Part 7 deals with aspects such as financial reporting, audits and financial statements. The foreword explains that there are basically three types of provision in the Code. The first group is identifiable by the use of the word ‘shall’ (soll). These provisions contain the core recommendations of the Code and are the ones to which the principle of ‘comply or disclose’ will apply – if a company does not comply, the nature of non-compliance needs to be disclosed annually. The second set of provisions is identifiable by the words ‘should’ (sollte) or ‘can’ (kann). These provisions are considered to be good corporate governance principles, although not really the core ones. Corporations are encouraged to follow them, but no explanation is required if they do not. All remaining provisions of the Code, not identifiable by any one of the words used above, are considered to be provisions confirming the requirements under the current German law relating to public corporations. In other words, they simply serve as a general and userfriendly way of explaining the most basic existing corporate law and corporate governance rules under the German corporations law. This serves a so-called communications function. These provisions are quite useful, as it is one of the most basic explanations of the German two-tier board system and the relationship among the various corporate organs that exist in the German literature. Almost half of the provisions of the Code are of an explanatory nature. At the heart of the Code is the improvement of the supervisory and overseeing functions of the supervisory board. Thus, the Code explains in some detail the relationship between the supervisory board and the management board, as well as the respective roles and functions of the supervisory and management boards. It is interesting to note that the first two parts of the Code primarily serve the purpose of explaining the current law. These parts consist of three pages, but there are only six ‘comply or explain’ provisions in them. There is also a good deal of explanation of the existing law in Part 4, dealing with the management board. In contrast, there are only a few articles in Parts 5–7 that do not contain ‘comply or explain’ provisions. 47 Klaus J Hopt, ‘Unternehmensf¨ uhrung, Unternehmenskontrolle, Modernisierung des Aktienrechts – Zum Bericht der Regierungskommission Corporate Governance’ in Corporate Governance: Gemeinschaftssymposion der Zeitschriften (ZHR/ZGR) Verlag Recht und Wirtschaft GmbH Heidelberg (2002) 27, 49–51.

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Most of the amendments affected in June 2009 deal with the remuneration or compensation of members of the management board and the disclosure of their remuneration and compensation. Also, it is now specifically provided that performance incentives should be included as part of the remuneration of management board members. In this regard, Provision 4.2.3 (second paragraph) of the 2009 German Corporate Governance Code provides as follows: The compensation structure [of Management Board Members] must be oriented toward sustainable growth of the enterprise. The monetary compensation elements shall comprise fixed and variable elements. The Supervisory Board must make sure that the variable compensation elements are in general based on a multi-year assessment. Both positive and negative developments shall be taken into account when determining variable compensation components. All compensation components must be appropriate, both individually and in total, and in particular must not encourage to take unreasonable risks. For instance, share or index-based compensation elements related to the enterprise may come into consideration as variable components. These elements shall be related to demanding, relevant comparison parameters. Changing such performance targets or the comparison parameters retroactively shall be excluded. For extraordinary developments a possibility of limitation (cap) must in general be agreed upon by the Supervisory Board.

13.3.3 Employee participation at supervisory board level – co-determination48 Any discussion of the German corporate governance system would be incomplete without at least a brief discussion of one of its outstanding features, which has captured the imagination of those who view the German corporate governance model from abroad.49 This is, of course, the German system of employee participation at supervisory board level – or co-determination, as it is more commonly known. This is also a theme that regularly pops up in the European Union context, often with direct or indirect reference to the German corporations law and corporate governance model. It was, indeed, because of conflicting views on the two-tier board and employee participation in the supervisory board that the Draft Fifth Directive has had such a stormy history and has little chance of ever being implemented.50 Rose explains the opposing approaches succinctly: The German co-determination system and the UK shareholder primacy model represent contrasting poles on an EU governance continuum. Given the deep structural and cultural differences that exist between EU Member States, convergence will entail significant expense. Convergence costs may include not only regulatory structure 48 For a more comprehensive discussion of employee participation at supervisory board level, see J J du Plessis, B Großfeld, C Luttermann, I Saenger and O Sandrock, German Corporate Governance in International and European Context, Heidelberg, Springer Verlag (2007) 111–144. 49 See Margaret M Blair and Mark J Roe (eds), Employees and Corporate Governance, Washington, DC, Brookings Institution (1999); and sources quoted in Du Plessis, above n 21, 381–2. 50 See J J du Plessis and J Dine, ‘The Fate of the Draft Fifth Directive on Company Law: Accommodation Instead of Harmonisation’ [1997] The Journal of Business Law 23, 25–7.

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costs – the costs required to develop a new regulatory regime or alter an existing regime – but also cultural costs.51

Co-determination by employees at supervisory board level has recently also been the focus of renewed attention in Germany, after a relatively long period during which such co-determination was simply accepted as part of the German corporate governance model without any serious challenge to the real attributes of such co-determination as a good corporate governance practice. This reflection on co-determination was triggered in particular because of several cases in the European Court of Justice.52 Germany has a long legislative history of support for industrial democracy. While this was initially reflected in the creation of elected worker committees and worker councils, which gave employees a voice on the shop floor, later legislation introduced employee representation at supervisory board level. The main impetus for supervisory co-determination by employees actually came from the determination of British occupation authorities and German trade unionists to ensure that the nation would never again fall into the dictatorial pattern of the Third Reich.53 The specific method invented was to make it compulsory for labour and management to work together at the level of the supervisory board (co-determination!). This was supposed to ensure that the very strict class distinction that had existed in Germany would not emerge again.54 The government of the day campaigned for a one-third employee representative regime, but the trade unions got their way after a strike in the mining, iron, coal and steel industries.55 The system of electing the employee representatives is a very complicated one. Furthermore, the number of employees who are appointed to the supervisory board varies from industry to industry, but also depends on the size of the corporation. However, there are basically only two systems: on certain supervisory boards one-third of the board is made up of employees, and in other supervisory boards half of the membership consists of employees. This is sometimes called parity co-determination by employees, in that shareholders and employees can appoint an equal number of representatives to the supervisory board. There is also mention of quasi-parity co-determination in certain industries. This refers to the arrangement whereby shareholders and employees can appoint an equal number of representatives on the supervisory board, but the right to appoint 51 Paul Rose, ‘EU Company Law Convergence Possibilities after CENTROS’ (2001) 11 Transnational Law and Contemporary Problems 121, 133. See also Jonathan Charkham, Keeping Better Company, Oxford, Oxford University Press (2nd edn, 2005) 28–9. 52 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; 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. 53 Brian Robinson, ‘Worker Participation: Trends in West Germany’ in Mark Anstey (ed.), Worker Participation (1990) 49. 54 Hellmut Wißmann, ‘Das Montan-Mitbestimmungs¨ anderungsgesetz: Neuer Schritt zur Sicherung der Montan-Mitbestimmung’ (1982) Neue Juristische Wochenschrift (Zeitschrift) 423. 55 Ibid.

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the chair belongs to the shareholders – thus tilting the power balance slightly in favour of the shareholder representatives.56 Recently, employee participation at supervisory board level has come under severe criticism, as illustrated by several articles in leading law review journals – including an editorial by an eminent academic, Peter Ulmer, in one of the leading academic commercial and business law journals57 and two articles in perhaps the leading corporate law journal in Germany.58 Moreover, other legal scholars and managers experienced in co-determination matters have published many comments during the past few years that point to several shortcomings of parity co-determination.59 Despite these shortcomings, members of management and shareholder representatives generally have been reluctant to openly challenge the legitimacy and usefulness of parity co-determination during recent decades, seeking to avoid confrontations with the powerful German trade unions – confrontations that could also have provoked strikes. Further, for fear of losing general elections at the level either of federal German unions or of the important federal industrial states, most of the political parties have not lent any support to modifications, not even the most moderate ones. The German system of co-determination was therefore characterised as a matter of taboo60 or as a ‘dinosaur model’.61 It is only during the past few years that some voices from management and political parties have been willing, in this respect, to call a ‘spade a spade’. Although it is far too soon to draw any definite conclusions from these developments, it is clear that the topic of co-determination has once again become a subject for lively political debate, and it will be difficult to keep co-determination off the political agenda for much longer.62 It is interesting to note that the German Corporate Governance Code reinforced and modernised the two-tier board system, and will probably ensure that it will remain the board system for public corporations in Germany for the foreseeable future.63 The most controversial aspect of the German two-tier board 56 Du Plessis and Sandrock, above n 52, 67 at 70. 57 Peter Ulmer, ‘Editorial: Parit¨ atische Arbeitnehmermitbestimmung im Aufsichtsrat von Großunternehmen – noch zeitgem¨ aß?’ (2002) 166 Zeitschrift f¨ ur das gesamte Handels-und Wirtschaftsrecht 271. See also Peter Ulmer, ‘Der Deutsche Corporate Governance Kodex – ein neues Regulierungsinstrument f¨ ur b¨ orsennotierte Aktiengesellschaften’ (2002) 166 Zeitschrift f¨ ur das gesamte Handels-und Wirtschaftsrecht 150, 180–1. 58 Martin Veit and Joachim Wichert, ‘Unternehmerische Mitbestimmung bei europ¨ aischen Kapital¨ berseering” und “Inspire Art”’ (2004) 49 Die gesellschaften mit Verwaltungssitz in Deutschland nach “U ¨ ber Aktiengesellschaft (Zeitschrift) 14, 17–18; and Otto Sandrock, ‘Geh¨ oren die deutschen Regelungen u die Mitbestimmung auf Unternehmensebene wirklich zum deutschen ordre public?’ (2004) 49 Die Aktiengesellschaft (Zeitschrift) 57 et seq. See also Sandrock and Du Plessis, above n 52, 88 et seq; Du Plessis and Sandrock, above n 52, 67 et seq. ¨ berlagerungstheorie’ (2003) 102 Zeitschrift f¨ 59 Otto Sandrock, ‘Die Schrumpfung der U ur Vergleichende Rechtswissenschaft 447, 490–3; Sandrock and Du Plessis, above n 52, 88 et seq; Du Plessis and Sandrock, above n 52, 67 et seq. 60 Expression used by Maximilian Schiessl, ‘Leitungs- und Kontrollstrukturen im internationalen Wettbewerb – Dualistisches System und Mitbestimmung auf dem Pr¨ ufstand’ (2003) 167 Zeitschrift f¨ ur das gesamte Handels-und Wirtschaftsrecht 235, 237. 61 Expression used by Theodor Baums, an eminent German company law expert, according to a note in the Frankfurter Allgemeine Zeitung (nation-wide German daily newspaper) of 27 June 2003. 62 See in particular Ulmer, above n 57, 272; and Hopt, above n 47, 42–6 and 66–7. 63 See in particular Lieder, above n 42, 115 et seq, but also K Pohle and A v. Werder ‘Die Einsch¨ atzung der Kernthesen des German Code of Corporate Governance (GCCG) durch die Praxis’ (2001) 54 DB 1101,

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system is still employee participation at supervisory board level. This is something that will have to be debated in Germany, especially after several recent decisions of the European Court, and the skepticism that exists about employee participation in practice. Employee participation at supervisory board level has the potential, once again, to become one of the most challenging political issues in Germany in the near future.64

13.3.4 The German board structure If we use Tricker’s ‘governance circle’ and ‘managerial pyramid’, as explained in Chapter 3, the typical German two-tier board structure will look as follows.

Employees

Shareholders

13.3.5 Conclusions on Germany There have been considerable developments in the areas of corporate law and corporate governance in Germany over recent years. The first wave of developments focused on the role and effectiveness of supervisory boards. Since the adoption of the German Corporate Governance Code in February 2001, the focus has been on promoting good corporate governance practices through the Code. This has enabled the German corporate governance model to remain relevant and to reflect international best corporate governance practices. Co-determination or employee participation at supervisory board level is still one of the most controversial and most debated issues in Germany. There are not only increasingly critical views expressed by German commentators on codetermination, but there are powerful market forces that put strain on the system of co-determination. It is not difficult to predict that, with globalisation and internationalisation, where the financial markets of all countries become more and more accessible, it will lead to further pressure on the German system of codetermination. With the global financial crisis of 2008–9 still fresh in the minds of all entrepreneurs, it will be difficult for German entrepreneurs to continue 1103 ff, 1107 for an interesting survey demonstrating that the majority of German public corporations are largely satisfied with the two-tier board system and co-determination, but that modernisation of the system was considered to be imperative. 64 See Sandrock and Du Plessis, above n 52, 88 et seq; Du Plessis and Sandrock, above n 52, 67 et seq.

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to cling to a governance model that is viewed with skepticism by many other entrepreneurs from other countries. The more options investors have to move their money around internationally, the more pressure there will be on the German corporate law and corporate governance models to become as flexible as possible if they want to remain competitive and to ensure that the German economy attracts more international investments.

13.4 Japan 13.4.1 Introduction Corporate law and practice in Japan have long attracted considerable attention among foreign commentators, and an extensive literature in Western languages.65 Much of the commentary increasingly refers to ‘corporate governance’, reflecting the emergence of this broader term world-wide since the 1980s (outlined in Chapter 1) and indeed generating another neologism in the Japanese language: ‘kopureto gabanansu’.66 But contemporary corporate law analyses and discussions focused on Japan have long tended to adopt a broader perspective. This reflects an awareness of the pervasive but typically informal role in firms of stakeholders other than shareholders, especially core ‘lifelong’ employees, ‘main banks’ and ‘keiretsu’ corporate groups. Before examining such stakeholders in more detail (especially in Parts 13.4.4– 13.4.6), alongside an account of corporate law topics conventionally covered in accounts of Japanese law, this chapter locates Japan within the broader context of debates about comparative capitalism and corporate governance (Part 13.4.2). It also presents a brief historical introduction to the development of modern corporate law, initially based mainly on German law when Japan reopened to the world in the late 19th century (Part 13.4.3).67 Corporate and securities law elements derived from the USA were superimposed during the Allied Occupation (1945–51). Arguably, broader Anglo-American as well as European Union law 65 Harald Baum and Luke Nottage, Japanese Business Law in Western Languages: An Annotated Selective Bibliography, Littleton, F B Rothman (1998); Harald Baum and Luke Nottage ‘Auswahlbibliographie [Selected Bibliography]’, in Harald Baum (ed.), Handbuch des japanischen Handels- und Wirtschaftsrechts [Japanese Business Law Handbook], Cologne, Carl Heymanns Verlag, (2010). Much of the commentary has been in German, reflecting the German influences on developments in this field of Japanese law that are sketched below. But a growing literature is in English, both practitioner-oriented (parallelling the emergence of English as the main language of international financial markets) and academic (reflecting a longstanding tradition within the USA of focusing on business law topics when studying Japan, as well as the particular popularity of corporate governance as a field of study in the USA). 66 A search of the NACSIS Webcat database aggregating most university library catalogues in Japan gave 266 books in Japanese containing this neologism in the title, available at . See also, for example, TSE-Listed Companies White Paper on Corporate Governance 2009 (and its Japanese-language original), available at . 67 For a succinct overview of Japanese legal history and institutions, see Masaki Abe and Luke Nottage, ‘Japanese Law’, in Jan Smits (ed.), Encyclopedia of Comparative Law, Cheltenham, Edward Elgar, (2006), p. 357, updated under the reference M Abe and L Nottage, ‘Japanese Law: An Overview’ [2008] JPLRes 1, available online at .

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developments have influenced a ‘third wave’ of corporate law reforms underway since the 1990s, in conjunction with that ‘lost decade’ of economic stagnation. This part therefore takes seriously the ‘five ways forward’ proposed for navigating through and assessing often diverse interpretations of contemporary corporate governance in Japan (and indeed elsewhere).68 Particularly when considering the ‘convergence’ debate (outlined in Chapter 1), we need always to be attentive to: 1. timing or the historical periods selected for analysis (with longer timespans often suggesting that major transformations are underway) 2. both ‘black-letter law’ or the ‘law in books’ (which also tends to emphasise change) and socioeconomic context or the ‘law in action’ (tending to emphasise continuities) 3. multiple points of comparison (comparing just two legal systems being risky, as this often results in assessments of either great differences or great commonalities and hence convergence) 4. normative preferences (even when commentators – inevitably influenced by their own backgrounds or eras – profess to have none) and 5. processes of law creation and enforcement, not just outcomes (even when legal rules or their impact in practice appear to display limited change, the processes by which this occurred may have been very different from past experience – in turn creating a greater possibility of more far-reaching changes in outcomes from future iterations).

13.4.2 Japan and debates on comparative capitalism and corporate governance A longstanding tradition of comparing Japanese corporate governance in full socioeconomic context connects to a wider debate about the nature of Japanese capitalism itself. One issue has been whether it was and remains another ‘coordinated market economy’ (CME, similar to Germany, for example), rather than a more arm’s-length ‘liberal market economy’ (LME, epitomised by the USA).69 Political scientists have also tried to combine that distinction, developed primarily by economists and organisational theorists, with the extent of ‘minority shareholder protections’ (MSPs) offered by various national corporate law systems in order to explain the extent of diffuse shareholdings. In this model, Japan’s CME plus weaker MSPs help to explain a significant blockholding tradition and hence a stakeholder system of corporate governance. Perhaps to a somewhat 68 Luke Nottage, ‘Perspectives and Approaches: A Framework for Comparing Japanese Corporate Governance’ in Luke Nottage, Leon Wolff and Kent Anderson (eds), Corporate Governance in the 21st Century: Japan’s Gradual Transformation, Cheltenham, Edward Elgar (2008) 41–51. 69 See generally Peter A Hall and David W Soskice, Varieties of Capitalism: The Institutional Foundations of Comparative Advantage, Oxford, Oxford University Press, (2001). For some longstanding difficulties in locating Japan at the ‘coordinated’ end of this spectrum, let alone more recently, see Luke Nottage, ‘Japanese Corporate Governance at a Crossroads: Variation in “Varieties of Capitalism”’ (2001) 27 The North Carolina Journal of International Law & Commercial Regulation 255.

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lesser extent than Germany nowadays, Gourevitch and Shinn argue that this system is underpinned by a political system that has tended to favour compromise rather than majoritarian approaches, and preferences of management and workers that have dominated those of shareholders.70 Again, however, Japan is hard to fit within this analysis. It could be argued that they have underestimated the extent of blockholding in Japan. A more far-reaching critique of their analysis is that Japan has developed significantly more pervasive LME elements and MSPs, certainly since its ‘lost decade’ and concomitant waves of corporate law reforms since the 1990s. This would explain or predict (widely observed) decreases in blockholdings. Yet, the model would therefore demand a different explanation for the political backdrop in Japan than that provided by Gourevitch and Shinn.71 A major problem with their approach is its considerable reliance on aggregate quantitative data. They compare many countries’ shareholding diffusion indices (often difficult to assess) against the extent of LME and MSP policies (also hard to quantify, especially over time). This then frames their more qualitative analyses of specific countries like Japan. That risks over-simplification and the possibility that the country of interest may not quite fit the overall model – even though the model itself is robust enough to survive because it fits other countries better. An alternative methodology is to begin with more qualitative comparative research, connecting up with (possibly looser) quantitative studies and overarching theory.72 This is indeed the approach taken in an important recent book by Milhaupt and Pistor on law and capitalism.73 They begin with empirically based skepticism about theories that effective property rights – especially MSPs, often also linked to ‘common law’ rather than ‘civil law’ tradition countries – contribute towards shareholder diffusion, and hence active share markets and improved economic growth.74 The dichotomy between ‘common law’ and ‘civil law’ arguably understates differences within countries within the same ‘legal family’ and how they 70 See Peter Alexis Gourevitch and James Shinn, Political Power and Corporate Control: The New Global Politics of Corporate Governance, Princeton, Princeton University Press (2005). 71 Nottage, above n 68, at 47–8. For example, rather than the ‘corporatist compromise’ characteristic of Germany and especially Japan, according to Gourevitch and Shinn (above n 70), Japanese politics may be generating more of an ‘investor’ coalition, where owners and managers prevail over employees. They give Korea as an example of that political configuration, which predicts pressures towards more diffuse shareholdings and a decline in blockholders. 72 As an example of a small-scale empirical analysis that nonetheless confirms some very significant transformations, see the comparison of key features of Japan’s top 40 listed companies in 1988 compared to 2008: Souichirou Kozuka, ‘Conclusions: Japan’s Largest Companies, Then and Now’, in Luke Nottage, Leon Wolff and Kent Anderson (eds), Corporate Governance in the 21st Century: Japan’s Gradual Transformation, Cheltenham, Edward Elgar (2008) 228. 73 Curtis J Milhaupt and Katharina Pistor, Law and Capitalism: What Corporate Crises Reveal About Legal Systems and Economic Development around the World, Chicago, University of Chicago Press (2008). 74 Compare especially Rafael La Porta, Florencia Lopez-de-Silanes et al., ‘Law and Finance’, (1998) Journal of Political Economy 106, 1113. For a tongue-in-cheek, empirical critique of the ‘corporate law matters’ thesis, see also one the most popular papers downloadable via SSRN.com: Mark D West, ‘Legal Determinants of World Cup Success’, Michigan Law and Economics Research Paper, 02–009 (2002), available at . More seriously, see Dan W Puchniak, ‘In the Company We Trust: Japanese Lifetime Employment Redefines Why Law Matters’ (manuscript available on request from Assistant Professor Dan Puchniak at the National University of Singapore, Faculty of Law), Part II.

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develop over time. Conventional theories also run up against the fact that marketsupportive legal systems do not reveal a strongly uniform set of characteristics, and crises in corporate governance do not appear to stem from some obvious legal ‘defect’ (such as lack of MSPs). Their detailed case studies of contemporary crises across seven major economies show instead that: the problems typically stemmed from deep-seated conflicts over the allocation of control and decision-making rights in society and from often equally deep-seated controversy about the very role that law should play in the country’s economic governance system. Conversely, [they] often saw importation of new legal rules patterned after law in more advanced legal economies (typically the United States) had ambiguous, unintended, or delayed consequences. These findings defy attempts to fix governance problems according to the simple algorithm of importing legal rules from more advanced economies to plug holes in the legal systems of less advanced economies. More generally, they defy attempts to associate a particular type of legal system with higher economic growth or other attractive economic outcomes such as larger capital markets.75

Accordingly, Milhaupt and Pistor develop an alternative classification depending primarily on whether or not (a) an economy’s legal system is decentralised regarding the involvement in actors in both the making and enforcement of law, and (b) the main function of the law is protection of individual rights (as in the USA) rather than the coordination of socioeconomic relationships and activity. From this perspective, they roughly locate Japan as follows.76 Coordinative Centralised

Protective

Russia Singapore

China Korea

Japan Germany

Decentralised

United States

Thus, there is no single way to organise an effective corporate governance regime, and each exhibits considerable static tendencies. However, they argue, for example, that ‘a legal regime that protects individual investors’ interests will be produced in response to growing demand, provided that the system is sufficiently 75 Milhaupt and Pistor, above n 73, 175. 76 Reproduced from ibid 183 (Figure 9.1). See also 28–37. That gives, as a major example of an emphasis on coordination over rights protection, Germany’s requirement for employee representation on the supervisory boards of large corporations (see also discussion above in this chapter). Milhaupt and Pistor (above n 73) also mention, but unfortunately do not explore so much, two other functions of law: signalling and credibility enhancement.

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decentralised at that point to foster contestation of governance structures’.77 Such contestation may involve widespread political participation in producing and enforcing law as a device for governance, but can also include access to politicians, courts or bureaucrats or even business elites. Focusing on this aspect, determining the demand for legal governance helps explain how the overall governance structure may change despite no formal legal change, as new constituencies can make use of existing but dormant rules. Conversely, simply transplanting new legal rules is unlikely to change the governance structure.78 Indeed, Milhaupt and Pistor anticipate that ‘internally developed’ legal systems will support markets better than those developed through transplantation, as law should be broadly responsive to local demands (good ‘micro-fit’) and political economy (good ‘macro-fit’). Similarly, legal transplants are more likely to work if local (legal and other) communities adapt the law to local circumstances. This depends largely on the motivation for the transplant (practical utility – that is, ready availability at low cost – being more powerful than colonial necessity or a broader ‘signaling’ effect), the legal community’s familiarity with the transplant, and consistency with the wider political economy and other existent governance mechanisms.79 A good example is the belated activation of directors’ duty of loyalty imposed on directors (now Article 355 of the Companies Act), independently from the more venerable duty of care, from the late 1980s.80 Overall, therefore, Milhaupt and Pistor caution against both evolutionary accounts of strong-form convergence on shareholder primacy in corporate governance, and path dependency underpinned by efficiencies or rent-seeking. Foreign institutional investors, developments in information technology and efforts abroad by reform advisors from international and domestic bodies promote greater formal convergence (in the ‘law in books’). But that may have only limited functions even in signalling potential broader shifts or credibility enhancement, depending for example on the country’s track record in actually using and enforcing new legislative provisions. A key element for actual convergence (changes in the ‘law in action’) is likely to lie in broader developments such as the structure and education of the legal profession around the world.81 In Japan, for example, since the 1970s in-house corporate counsel have steadily gained influence both within firms and as a lobby group promoting broader judicial system reforms.82 And a package of reforms unveiled in 2001 has added significant flexibility into the profession and legal education, as well as another round of changes to criminal justice and the civil dispute resolution 77 Milhaupt and Pistor, above n 73, 175. 78 Ibid, 203–4. 79 Ibid, 211. 80 Hideki Kanda and Curtis Milhaupt, ‘Re-Examining Legal Transplants: The Director’s Fiduciary Duty in Japanese Corporate Law’ (2003) 51 American Journal of Comparative Law 887. See further part 13.4.4 (Japanese corporate forms and internal governance mechanisms) below. 81 Milhaupt and Pistor, above n 73, 214–5. 82 Toshimitsu Kitagawa and Luke Nottage, ‘Globalization of Japanese Corporations and the Development of Corporate Legal Departments: Problems and Prospects’ in William Alford (ed.), Raising the Bar, Cambridge, Massachusetts, Harvard East Asian Legal Studies Program, Harvard University Press, (2007) 201.

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system. Yet results remain very mixed, with the jury mostly still out (quite literally).83 Adaptable but embedded communities continue to reassert themselves vis-` a-vis the formal legal system.84 Thus, applying the analytical insights of Milhaupt and Pistor – but assessing shifts in the legal profession to be somewhat more limited – suggests that we are likely to find more of a ‘gradual transformation’ in contemporary Japanese corporate governance.85 Even their ‘institutional autopsy’ of a mini-crisis has been occasioned by novel hostile takeovers in Japan this century, described further in Part 13.4.3. Thus, Milhaupt and Pistor join a growing group of analysts comparing corporate governance and capitalism more generally in Japan who perceive significant but gradual changes especially since the 1990s, reflecting some broader socio-economic developments. Specifically, as in other advanced industrial democracies such as Germany, we perceive incremental change yet some clear discontinuities (the shaded category [3] below):86

Continuity Process of change

Result of change Discontinuity

Incremental

[1] Reproduction by adaptation

[3] Gradual transformation

Abrupt

Survival and return

[2] Breakdown and replacement

Japan’s system has only partly adapted to new ‘macro-fit’ and ‘micro-fit’ in many respects, so reproduction does not mean continuity (cf category [1]). This differs from the view of a few theorists who perceive almost no change in allegedly fundamental features of institutional organisation and, therefore, corporate governance in Japan.87 Yet, nor has there been an abrupt breakdown resulting in 83 On civil and criminal justice reforms, see respectively, for example, Luke Nottage, ‘Civil Procedure Reforms in Japan: The Latest Round’ (2005) 22 Ritsumeikan University Law Review 81–86; and Kent Anderson and Mark Nolan, ‘Lay Participation in the Japanese Justice System’ (2004) 37 Vanderbilt Journal of Transnational Law 935. On legal education reforms, see for example, Luke Nottage, ‘Build Postgraduate Law Schools in Kyoto, and Will They Come – Sooner and Later?’ (2005) 7 Australian Journal of Asian Law 241 (with a parallel Special Issue [No 20] of the Journal of Japanese Law partly reproduced at ). Japan retains a much stronger ‘gatekeeper’ role for the state: see Luke Nottage’s ‘Japanese Law and the Asia-Pacific’ blog at . But the market for legal services in Tokyo has certainly begun to change extensively this century: Bruce Aronson, ‘The Brave New World of Lawyers in Japan’ (2008) 21 Columbia Journal of Asian Law 45. 84 Takao Tanase (Luke Nottage and Leon Wolff, trans and eds), Law and the Community: A Critical Assessment of American Liberalism and Japanese Modernity, Cheltenham, Edward Elgar (2010). 85 Luke Nottage, Leon Wolff and Kent Anderson (eds), Corporate Governance in the 21st Century: Japan’s Gradual Transformation, Cheltenham, Edward Elgar (2008). 86 Reproduced from Nottage, above n 68, 39 (Table 2.1). That in turn derives primarily from Wolfgang Streeck and Kathleen Ann Thelen, ‘Introduction’ in Wolfgang Streeck and Kathleen Ann Thelen (eds), Beyond Continuity: Institutional Change in Advanced Political Economies, New York, Oxford University Press (2005) 9. 87 John Haley, ‘Japanese Perspectives, Autonomous Firms, and the Aesthetic Function of Law’ in Klaus Hopt et al. (eds), Corporate Governance in Context: Corporations, State, and Markets in Europe, Japan, and the US, Oxford, Oxford University Press (2005) 205. Sanford M Jacoby, The Embedded Corporation: Corporate Governance and Employment Relations in Japan and the United States, Princeton, Princeton University (2005) – drawing primarily on research around 2001; and even Ronald Dore, Stock Market Capitalism, Welfare Capitalism: Japan and Germany Versus the Anglo-Saxons, New York, Oxford University Press, (2000) (but backtracking quite considerably for example, in Ronald Dore, ‘Shareholder Capitalism Comes to Japan’ (2007) 23 Journal of Japanese Law 207). Others also suggest that there has been no change in Japanese (corporate) governance: Yoshiro Miwa and J. Mark Ramseyer, The Fable of the Keiretsu: Urban Legends of the

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C on

Su

s

pp

lie

er m

rs

su

Managers Shareholders

Employees

Creditors

nt

me

ern ov

G

N on

- g o v er

n m e n t o r g a n i s a ti

ons

= Changing influence Figure 13.1

replacement of stakeholder governance by a system based on shareholder primacy and market forces, as proclaimed (and often acclaimed) by some commentators within the financial press.88 The picture is instead more complex. Shareholders have become more central in corporate governance, especially since the mid-1990s; banks certainly less so (while still remaining important); employees probably less so (but with some major fissures emerging), and with more complex shifts underway regarding the impact of suppliers and consumers or the state and non-government organisations (see Figure 13.1).89 Japanese Economy, Chicago, University of Chicago Press (2006). But this involves the radical assertion that everyone else has overlooked that Japan already operates on free-market principles, thus rendering governance mechanisms like ‘main banks’ and keiretsu groups an unnecessary ‘myth’. For critiques of that revisionist account, see, for example, Craig Freedman and Luke Nottage, ‘You Say Tomato, I Say Tomahto, Let’s Call the Whole Thing Off: The Chicago School of Law and Economics Comes to Japan’ in Centre for Japanese Economic Studies Research Papers (2006), available at . Dan W. Puchniak, ‘A Skeptic’s Guide to Miwa and Ramseyer’s: “The Fable of the Keiretsu”’ (2007) 12 Journal of Japanese Law 273 and Takeo Hoshi, ‘The Fable of the Keiretsu [Book Review]’ (2008) 11 Social Science Japan Research 344. 88 Cf for example, Gillian Tett, Saving the Sun: A Wall Street Gamble to Rescue Japan from Its TrillionDollar Meltdown, London, Random House Business (2004). After the global financial crisis of 2008–9, she confesses to ‘eating humble pie’ (quoted in Luke Nottage, ‘Economics, Politics, Public Policy and Law in Japan, Australasia and the Pacific: Corporate Governance, Financial Crisis, and Consumer Product Safety in 2008’ (2009) 26 Ritsumeikan Law Review, 49 at 67). Indeed, her recent enthnological account critically assesses ‘innovation, perversion and disaster’ linked to Wall Street financial institutions and weak regulatory oversight: Gillian Tett, Fool’s Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe, London, Little Brown (2009). 89 Reproduced from Nottage, above n 68, 29 Figure 2.2, in turn adapted from Luke Nottage and Leon Wolff, ‘Corporate Governance and Law Reform in Japan: From the Lost Decade to the End of History?’ in Rene Haak and Markus Pudelko (eds), Japanese Management: In Search of a New Balance between Continuity and Change, New York, Palgrave Macmillan (2005) 133.

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Such disparate results pose challenges for theories of convergence on shareholder primacy, and also (perhaps to lesser extent) of path dependency. But the phenomenon of different aspects of corporate governance pulling in seemingly different directions has been observed elsewhere.90 It is much less surprising from the perspective of Milhaupt and Pistor because of the weight they give to politics (in a broad sense), in addition to economics.

13.4.3 Historical transformations in Japanese corporate law and practice The importance of politics to corporate law and practice has long been evident in modern Japan. When Japan reopened fully to the world in 1868, after twoand-a-half centuries of almost complete isolation under Tokugawa rule, it had to agree to ‘unequal treaties’ with the USA and European imperial powers. A precondition to renegotiation was the establishment of a modern legal system, and the Meiji government decided to enact comprehensive codes along European lines, including a commercial code containing corporate law provisions to support both smaller enterprises and large-scale industrialisation.91 Company law provisions drafted in 1875 were rejected as excessively based on English law, so a German advisor (Roesler, central also to the Meiji Constitution of 1889) led a wide-ranging, comparative study to generate a draft Commercial Code over 1881–4. The first part came into effect in 1893, regulating company law, insolvency and commercial bills; the rest came into effect in 1898. This was quite French in form, but in substance more German (drawing especially on 1861 legislation). It inaugurated the kabushiki kaisha (KK) form, the joint stock company or company limited by shares, with limited liability for shareholders. The KK was governed especially by its general meeting (sokai), with unlimited competence and powers to appoint directors (torishimariyaku). The third governance body comprised statutory auditors (kansayaku). They were charged with checking whether directors’ activities were not only lawful (as nowadays), but also in the interests of shareholders. However, they could not dismiss directors (unlike the Aufsichtsrat in contemporary German law) and initially could even act as directors. 90 For example, comparing Australia, see Luke Nottage, Corporate Governance and M&A in Australia: An Overview for Assessing Japan and the ‘Americanisation’ (2008) – 08/28 Sydney Law School Research Paper, available at . See also a recently published overview of a joint research project noting continuing managerial control coupled with growing shareholder influence, and ‘the appearance of new forms of corporate governance which are hybrids in the sense of combining institutional mechanisms with different origins and/or functions’: Simon Deakin and D Hugh Whittaker, ‘On a Different Path? The Managerial Reshaping of Japanese Corporate Governance’ in Simon Deakin and D Hugh Whittaker (eds) Corporate Governance and Managerial Reform in Japan, Oxford, Oxford University Press (2009) 1 at 23. They conclude (at 21) that while the Japanese corporate governance ‘system’s reaction could be described as one of resistance to external change, we think that it is better characterised as one of adjustment and adaptation to a changing institutional environment, with legal reforms acting as a trigger or stimulus’ along with the changing competitive environment. 91 The following summary, through to the early 1990s, is based on the detailed analysis of corporate law reforms in full economic and political context provided by Harald Baum and Eiji Takahashi, ‘Commercial and Corporate Law in Japan: Legal and Economic Developments after 1868’ in Wilhelm R¨ ohl (ed.), History of Law in Japan since 1868, Leiden, Brill (2005) 330.

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This legislation was replaced by the Commercial Code of 1899, which followed German law more closely (including 1884 legislation on stock companies), except for the insolvency law provisions, which remained in effect until separate legislation was enacted in 1922. Auditors were no longer allowed to serve simultaneously as directors, and the licensing scheme for promoters and subscribers was abolished in favour of a registration system for new companies. After another wave of corporate scandals, amendments in 1911 added strict liability for promoters. They also clarified that the relationship between directors and the company was an agency contract (implicating a high duty of care: see Part 13.4.4.3 below) and established personal liability in damages. Reform to the Code in 1938 was more comprehensive, again largely based on Germany’s Stock Corporation Act of 1937, with both countries attempting to address the emerging separation from ownership and control. Non-shareholders became entitled to serve as directors or auditors, for example, and minority shareholders gained better rights to enforce liability and obtain corporate information. Unlike Germany, however, the Japanese reform also enlarged the competence of the sokai but expanded transactions requiring prior consent of shareholders. The reform also introduced some English concepts for corporate reorganisation (seiri) and special liquidation (tokubetsu seisan). Also in 1938, Japan belatedly enacted separate legislation for a private limited liability company (yugen kaisha or YK), similar to the GmbH already found in the German Code of 1897. This legislation (containing many cross-references to the Japanese Code) also included some elements from the English law designed for closely held companies, such as a limit of 50 shareholders. Japanese policy makers, initially through academic studies, were also aware that France had addressed such issues through legislation in 1925. By the end of World War II, there were nearly half as many YKs as KKs, although many closely held companies persisted in incorporating as KKs (see Part 13.4.4 below). The United States-led occupation (1946–51) not only inaugurated securities regulation and anti-monopoly law, but also significant reforms to the Commercial Code, all based this time on United States law. The Code amendments first aimed to redistribute corporate powers. The sokai’s jurisdiction was limited to matters set in law or articles of incorporation, ushering in the institution of the board of directors to collectively hold and exercise powers and managerial functions. Corporate auditors were restricted to auditing financial statements and reporting to the sokai. Counterbalancing this shift, a second set of reforms strengthened individual or minority shareholder rights. Voting restrictions in the articles of association were abolished, cumulative voting was introduced, inspection rights were enhanced, a new ‘director’s duty of loyalty’ and derivative shareholder actions were added. However, many of these changes had little effect in practice until the 1990s (see Part 13.4.5.3), or were expressly rolled back. For example, 1966 amendments reinstated the capacity for companies to restrict share transferability through articles of association, and in 1974 the auditors were once again allowed

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to supervise the legality (but not, expressly, the appropriateness) of directors’ business activities. (In 1993, auditors were provided an extended term and the statutory minimum number was raised to three in large companies required to have a supervisory board – kansa yakkai.) Reforms in 1981 also addressed the deterioration of sokai into a mere formality due to the Occupation amendment shifting power to the board of directors, as well as the emergence of sokaiya (criminals extorting money from companies by threatening to disrupt meetings or reveal negative information). On the one hand, the revised Code prohibited the granting of benefits to anyone related to (non-)use of shareholder’s rights – although sokaiya practices did not die out quickly. On the other hand, it required directors and auditors to explain sokai agenda items, and gave shareholders rights to propose matters for discussion. Minority shareholders also gained more rights to call meetings or propose resolutions. The four decades from the Occupation through to the collapse of Japan’s asset ‘bubble economy’ in 1990 thus witnessed the emergence of a new hybrid corporate governance regime, intertwined with other economic institutions of the era. One central pillar was the ‘main bank, the largest lender as well as a principal shareholder (although each bank’s holding was subject to a statutory 5 per cent cap). Main banks provided diverse financing, monitoring (usually ex ante but ex post if borrowers get into difficulty, through organising acquisitions or the creditors’ committee), and information and management support (see Part 13.4.5.4). Cross-shareholding was a second feature, with about two-thirds of listed company shares held by ‘stable’ shareholders in the early 1990s. The epitome were the keiretsu, ‘historically derived clusters of affiliated firms held together by stable cross-share ownership, interlocking directorates, extensive product market exchanges, and other linkages that enhance group identity and facilitate information exchange’.92 Six major post-war ‘horizontal’ keiretsu were centered on main banks (for example, Mitsubishi); ‘vertical’ keiretsu brought together groups of production and investment chains (for example, Hitachi). A third significant practice in larger firms (and an ideal for many others) was ‘lifetime employment’, whereby workers implicitly traded initially below-market wages for continuous employment and above-market wages in the second half of his or (to lesser extent) her career (Part 13.4.6). Fourth, government–business relations involved considerable ‘administrative guidance’ (informal enforcement of regulatory objectives), with bureaucrats – and the long-reigning Liberal Democratic Party (LDP) – promoting consensus-based, private ordering through repeated informal contacts with firms and industry associations. The first three features, in particular, reduced the need for the active board monitoring function promoted by Occupation reformers and, indeed, for the disciplinary effect of hostile takeovers.

92 Curtis J Milhaupt and Mark D West, Economic Organizations and Corporate Governance in Japan, Oxford, Oxford University Press (2004) 14 (also outlining this system of main banks, employment relations and government–business relations).

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This system was never universal or completely stable, of course, and began to fray when larger firms turned increasingly from bank to shareholder finance from the 1980s. Bigger challenges came from the collapse of asset prices in 1990 and Japan’s consequent ‘lost decade’ of economic stagnation, including failures of major financial institutions and ‘Big Bang’ deregulation of financial markets from 1997. Almost in desperation, domestic policy-making elites embarked on major reforms to commercial regulation generally, and corporate law in particular. Main objectives, long sought also by Anglo-American investors and governments, included greater flexibility in corporate law rules – moving away from the German tradition of detailed mandatory provisions – and greater focus on the interests of shareholders vis-` a-vis other stakeholders such as core employees, trading partners and main banks. Space precludes detailed analysis here concerning all the corporate (and related securities) law reforms undertaken from the early 1990s.93 In short, by the time the consolidated Companies Act was enacted in 2005, in rough chronological order the legislator had: ● strengthened supervision by shareholders and statutory auditors (including derivative suits) and liberalised corporate bond financing ● relaxed restrictions on share buy-backs, and introduced stock options ● introduced measures to facilitate creation of holding companies (the year after the Anti-Monopoly Act restriction was lifted in 1998) and for splitting up companies ● diversified types of shares and voting rights ● allowed companies a new governance form aimed at large companies, without statutory auditors, and ● allowed paperless shares and electronic announcements. Overall, therefore, Japan has experienced three major waves in developing corporate law, linked to similar shifts in other fields of legislation, at roughly halfcentury intervals. The Meiji-era Code around the turn of the 20th century was followed by United States-inspired (even ‘United States-imposed’) reforms during the post-war Occupation, then the much more wide-ranging reforms from around the turn of the 21st century. Even in terms of formal legislative changes, the trajectory has not been one of straightforward ‘Americanisation’, and the overall position now reached is also very different from United States law, as evidenced by the persistence of the statutory auditor governance form.94 Also evident are some influences from – or at least parallels with – aspects of English 93 See further, for example, the summary Appendix in Luke Nottage, Leon Wolff and Kent Anderson (eds), Corporate Governance in the 21st Century: Japan’s Gradual Transformation, Cheltenham, Edward Elgar (2008) 13–20, based on the detailed descriptions in Tomotaka Fujita, ‘Modernising Japanese Corporate Law: Ongoing Corporate Law Reform in Japan’ (2004) 16 Singapore Academy of Law Journal 321; the summary Table 11.1 (and accompanying text) in Hiroshi Oda, Japanese Law, Oxford, Oxford University Press (3rd edn, 2009) 219; and more theoretically Curtis J. Milhaupt, ‘A Lost Decade for Japanese Corporate Governance Reform?: What’s Changed, What Hasn’t, and Why’, in Magnus Blomstrom and Sumner LaCroix (eds), Institutional Change in Japan, Abingdon, Routledge (2006) 97. 94 Cf R Daniel Kelemen and Eric C Sibbitt, ‘The Americanization of Japanese Law’ (2002) 23 University of Pennsylvania Journal of International Economic Law 269 (focusing, however, on securities law and product liability in Japan).

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law, epitomised recently in listing requirements (Part 13.4.4.2 below) but also a tendency in takeover regulation to give priority to decisions of shareholders rather than directors (Part 13.4.5.3). The impact of German law, filtered sometimes nowadays through European Union law, also remains important. Japan’s complex corporate law landscape is also matched by persistently distinctive features of contemporary corporate governance practice, even though this, too is undergoing a gradual transformation.

13.4.4 Japanese corporate forms and internal governance mechanisms 13.4.4.1 Overview The regime prior to the Companies Act of 2005 provided for four types of corporation: (i) the KK, (ii) the YK, (iii) the limited partnership company (goshi kaisha) and (iv) the partnership company (goshi kaisha). The last-mentioned made all partners jointly and severally liable, and gave them the obligation and right to manage the company’s affairs as well as the right to represent the company. Admitting a new member required unanimous consent to modify the articles of incorporation. The goshi kaisha applied similar provisions, but some partners could have limited liability with different provisions regarding management and representation of the company, and there were also differences regarding transfers of equity interests. However, even the goshi kaisha form was infrequently used. The YK form proved much more popular and was intended for smaller, closely held businesses. It involved limited liability for 50 or less shareholders who had to provide less paid-in capital than the KK form. Differences in governance structures included no statutorily recognised board of directors, with significant business decisions instead requiring a shareholders’ resolution. Yet many small businesses chose the KK form, often for its prestige, despite the latter being designed for large public companies raising funds through securities markets. By 2005, there were about 1.5 million YK companies and 2.5 million KK companies, but of the latter 86.7 percent had capital of less than 20 million yen. Most of these small companies were not among the less than 4000 listed companies, and instead restricted share transferability through articles of association.95 This growing gap between the ‘law in books’ and the ‘law in action’ had led to problems, such as minority shareholder ‘squeeze-outs’ and other oppressions characteristic of family run businesses that lacked directly applicable relief provisions. Yet legislation drafted by a study group in 1990 was not adopted.96 95 Oda, above n 93, 221–3 (comparing also the numbers of differently capitalised companies in the forms provided now under the Companies Act). 96 Zenichi Shishido, ‘Problems of the Closely Held Corporation: A Comparative Study of the Japanese and American Legal Systems and a Critique of the Japanese Tentative Draft on Close Corporations’ (1990) 38 American Journal of Comparative Law 337.

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Instead, regulators enacted more general legislation in 1974 and 1993 that imposed stricter auditing requirements for ‘large’ companies (with capital of 500 million yen or more, or debts of 20 billion yen or more). In 1990, they also increased the differential in paid-in capital required for YK as opposed to KK forms. However, following the credit crunch of the 1990s, from 2003 the capital was allowed to be paid in over five years following incorporation. And in 2005, the new Companies Act abolished minimal paid-in capital requirements altogether. Indeed, the law abolished YK companies altogether, subsuming them into the KK form, instead of forcing the smaller KK companies to adopt provisions like those that existed for smaller companies. The Companies Act also provided multiple options within the KK rubric, including simplified governance structures very suitable for smaller companies, as part of a broader shift away from narrow mandatory rules and towards greater choice for businesspeople. This leaves the risk of large companies also selecting a simplified structure that may be dangerous for corporate governance, but that was thought to be justified given other governance rules and practices. These range from potential liability of directors to third parties in certain situations through to a doctrine of ‘piercing the corporate veil’ (albeit quite limited97 ) and the monitoring mechanisms provided by core employees or main banks (described further from Part 13.4.5.4 below). Furthermore, the Companies Act of 2005 does restrict governance options depending on whether or not the company is ‘large’ and/or ‘public’ (meaning that transferability of any class of shares is unrestricted – to be a listed public company, by contrast, exchanges require that all shares be fully transferable). The law’s somewhat complex rules can be interpreted to provide for these four KK subcategories:98 (i) For non-public and non-large companies: there exist nine possible structures, of which the most practicable is likely to involve just one or several directors (but no requirement for a board). Shareholders seeking to add a governance mechanism likely to appeal to banks might also add a statutory auditor (but who may be restricted through the articles of association to assessing accounting matters, not the legality of directors’ actions). (ii) For non-public but large companies: there are four possible structures. All require accounting auditors. Three involve statutory auditors (with full powers), with the two not requiring a board of auditors likely to be most popular; the other structure involves a ‘company with committees’ (explained in Part 13.4.4.2 below). (iii) For public but not large companies: there are five structures, all involving a board of directors, with four also involving statutory auditors (two with boards) and the other a ‘company with committees’. The most practicable 97 See for example the judgments translated in Yukio Yanagida, Daniel H Foote, Edward Stokes Johnson Jr, J Mark Ramseyer and Hugh T. Scogin Jr (eds), Law and Investment in Japan: Cases and Material, Cambridge, Massachusetts, Harvard University Press, (2000) 336–41. 98 Keiko Hashimoto, Katsuya Natori and John C Roebuck, ‘Corporations’ in Gerald McAlinn (ed.), Japanese Business Law, The Hague, Kluwer (2007) 102–5.

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is likely to involve a board of directors plus one statutory auditor (but no board). (iv) For public and large companies: there are only two options. One is the ‘company with committees’ (iinkai setchi kaisha), which always requires one or more accounting auditors. The other is ‘a company with a board of statutory auditors’ (kansayakukai setchi kaisha), including a board of directors and one or more accounting auditors. It remains to be seen whether this much-expanded menu of options that businesspeople can select for smaller companies will lead courts to become even more reluctant to police oppression of shareholders, on the theory that they or legal advisors should have chosen a more sophisticated form to improve governance from the outset. This issue is complicated because some forms of oppression, such as share issuance, raise issues covered by provisions that are also creating problems and court precedents in takeover disputes involving large listed companies (reviewed in Part 13.4.5.3 below). Yet Japanese courts may make allowance for the fact that the government has enacted the new Companies Act with a considerable element of ‘policy push’ – trying to channel behaviour, rather than the more usual ‘demand-pull’ approach, whereby legislation tends instead to reflect already emergent practices. They may also take into account that smaller businesses still lack access to sophisticated legal advice, despite the parallel effort to reform the legal profession and justice system more generally.99 13.4.4.2 Companies with committees versus companies with boards of auditors Much of the discussion about this new menu of corporate governance structures has instead focused on the two provided for public and large companies. In fact, the option of substituting a (more Anglo-American) ‘company with committees’ for the (German) statutory auditor board form was created through legislative amendment in 2002.100 This ‘elective corporate governance reform’ partly reflects a compromise among Japan’s major corporate law reform institutions.101 99 Tomoyo Matsui, ‘Open to Being Closed? Foreign Control and Adaptive Efficiency in Japanese Corporate Governance in Luke Nottage, Leon Wolff and Kent Anderson (eds), Corporate Governance in the 21st Century: Japan’s Gradual Transformation, Cheltenham, Edward Elgar (2008) 197, applying the distinction between the two approaches developed by Zenichi Shishido, ‘The Turnaround of 1997: Changes in Japanese Corporate Law and Governance’ in Masahiko Aoki, Gregory Jackson and Hideaki Miyajima (eds), Corporate Governance in Japan: Institutional Change and Organizational Diversity, Oxford, Oxford University Press (2007) 310. In other areas such as contract law, moreover, Japanese case law has developed a more flexible (German rather than French) approach to protecting the weaker party in a long-term relationship: Luke Nottage, ‘Form and Substance in US, English, New Zealand and Japanese Law: A Framework for Better Comparisons of Developments in the Law of Unfair Contracts’ (1996) 26 Victoria University of Wellington Law Review 247. 100 Dan W Puchniak, ‘The 2002 Reform of the Management of Large Corporations in Japan: A Race to Somewhere?’ (2003) 5 Australian Journal of Asian Law 42. 101 Ronald Gilson and Curtis Milhaupt, ‘Choice as Regulatory Reform: The Case of Japanese Corporate Governance’ (2005) 53 American Journal of Comparative Law 343 at 353–4; Luke Nottage and Leon Wolff, ‘Corporate Governance and Law Reform in Japan: From the Lost Decade to the End of History?’ in Rene Haak and Markus Pudelko (eds) Japanese Management: In Search of a New Balance between Continuity and Change, New York, Palgrave Macmillan (2005) 133.

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The Ministry of Justice (MoJ) – traditionally charged with reform through its Hosei Shingikai deliberative council, chaired by leading professors – had initially favoured the imposition of a United States-style, committee-based form. Yet the MoJ’s leadership in this field had been challenged by private members’ bills since 1997 (beginning with one liberalising stock options). Such bills and other corporate law initiatives (like the guidelines on takeovers introduced in Part 13.4.5.4 below) were also supported by the Ministry of Economy, Trade and Industry (METI). Its responsibility for industrial policy has involved a significant shift since the 1990s away from outright interventionism and towards pragmatic market liberalisation in many respects. METI and big business lobbies objected to forcing companies to adopt United States-style committees. So did the Ministry of Finance (MoF), against the backdrop of its responsibility for stock exchanges – with the Tokyo Stock Exchange (TSE) subsequently emerging as another ‘competing’ regulator in Japan’s broader corporate governance universe.102 Such mixed messages from various constituencies help explain both limited uptake of the committee-based form in the first round (2003 general meetings, mostly in June) as well as statistically insignificant share-price effects among the subset of listed companies that did adopt that form. Only 71 firms (45 listed), or three per cent, took this option, including the Nomura financial holding company together with 13 privately held subsidiaries, plus Hitachi with 21 affiliates. These two major corporate groups are not traditional bank-centred keiretsu, and many of the other adopting firms diverge from conventional patterns of Japanese industrial organisation (such as Orix) and have high foreign ownership (such as Sony). In fact, existing and budding corporate groups seem to be using the ‘United States-style’ form in a quite a German way – to entrench control over the group rather than (directly) advancing interests of shareholders in individual firms. They can do this because the 2002 amendment requires a majority of directors on the committees to be ‘outside’ directors, defined not to encompass employees of parent companies or of sibling firms with a common parent. A large majority of Nomura and Hitachi firms in fact fell into the latter categories of ‘grey’ outside directors. Gilson and Milhaupt acknowledge that these patterns may reflect and promote efficiency gains, with appointment of outside directors driven by industrial organisation needs of particular industries or firms. However, they are concerned that the capacity to appoint directors from other group members may end up encouraging ‘stakeholder tunnelling’ (firms advancing interests of core employees and other stakeholders, over dispersed shareholders) and managerial entrenchment, especially if Japanese courts cannot or do not scrutinise directors’ decisions carefully in takeover contests.103 102 See further Hideki Kanda, ‘What Shapes Corporate Law in Japan?’ in Hideki Kanda, Kon-sik Kim and Curtis J Milhaupt (eds), Transforming Corporate Governance in East Asia, Abingdon, Routledge (2008) 60 and Part 13.4.5 below in this chapter. 103 Ronald Gilson and Curtis Milhaupt, ‘Choice as Regulatory Reform: The Case of Japanese Corporate Governance’ (2005) 53 American Journal of Comparative Law 343.

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A subsequent qualitative study shows that lawyers and statutory auditor respondents, in particular, were worried about the loss of monitoring potential from appointment of ‘grey outside directors’ to the parent’s subsidiaries. Respondents focused on the possibility of monitoring improvements only in the parent company if that itself adopted the committee form, because then the outside directors would tend also to be independent, and there was relatively little appreciation of the group cohesion and flexibility benefits of appointments to subsidiaries. Respondents were also unimpressed by the new form’s creation of an executive officer system, designed to encourage managerial flexibility in conjunction with stronger mechanisms for monitoring. The problem here was that legislation still allowed directors to serve concurrently as executive officers, allowing for the perpetuation of a tradition of executive directors. A sharper distinction between monitoring and management can therefore be maintained through the statutory auditor board corporate form. Unsurprisingly, therefore, only a further 39 companies had adopted the committee-based form in October 2006, after three more rounds. Lawley concludes that the new system has the potential to generate stronger and more transparent corporate governance, and has been perceived in this way, but the empirical reality so far does not meet these expectations. Nonetheless, rather than tightening legislative requirements, he suggests that:104 the committee system’s monitoring mechanisms might be improved by encouraging companies with the committee system to appoint truly independent outside directors in greater numbers, and to create environments in which grey outside directors will monitor effectively. The adverse effect this strengthened monitoring would have on managerial freedom might also indirectly encourage companies with the committee system to separate officers from directors more strictly.

In fact, the Japan Pension Fund Association did try to encourage such developments by publishing principles calling for greater independence, and other calls came from individual investors in Japan and especially from abroad. The Financial System Council (advising the FSA) established a ‘Study Group on the Internationalization of Japanese Financial and Capital Markets’, which met eight times from October 2008, presenting on 17 June 2009 a report entitled ‘Toward Stronger Corporate Governance of Publicly Listed Companies’. The report urged stock exchanges to promote a corporate governance model that would include greater independence of statutory auditors and directors within companies with committees, and would require listed companies to disclose details of their corporate governance systems and reasons for selecting them. The report hoped that this would improve uptake of such companies, comprising only 2.3 per cent of firms listed on the TSE as of August 2008.105 104 Peter Lawley, ‘Panacea or Placebo? An Empirical Analysis of the Effect of the Japanese Committee System Corporate Governance Law Reform’ in Luke Nottage, Leon Wolff and Kent Anderson (eds), Corporate Governance in the 21st Century: Japan’s Gradual Transformation, Cheltenham, Edward Elgar (2008) 129 at 154. 105 Available at 11–12. The chair of this FSA Study Group was Keio University Professor of Economics Kazuhito Ikeo. For more statistics on companies with

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Another hope was for improvement of governance in statutory auditor companies, which must have outside auditors but not necessarily outside directors – and with 55 per cent of TSE-listed companies currently lacking such directors. The report noted that some companies had already appointed highly independent outside directors who then collaborated closely with the statutory auditors (who must include outsiders) as well as officers in charge of internal audits and control now required by legislation, thereby addressing two problems remaining with the statutory auditor model. Responsibility for internal audits and internal control lies with directors, and systems are therefore not directly reportable to the auditors; the auditors lack voting rights at directors’ meetings (including regarding election of officers) and their audits are generally confined to whether the directors acted legally (as opposed to appropriately). A report of the ‘Corporate Governance Study Group’ established by METI in December 2008, also released on 17 June 2009, concluded more specifically that a listed company should have at least one truly independent director or auditor, as well as improve disclosure about its corporate governance system, through listing rules rather than legislative reform.106 This Group’s members considered that this would provide a better trade-off between minimising the risk of conflicts of interests and maximising effectiveness in corporate governance and performance. The report also recommended either (a) at least one outside director and disclosure about the company’s corporate governance system, or (b) disclosure of the system ‘using the company’s own original method’.107 By 29 September 2009, the TSE had released a ‘Listing System Improvement Action Plan’. ‘Matters for prompt implementation’ included a requirement for independent directors/auditors unlikely to give rise to conflicts of interest vis`-vis general shareholders. Progress reports released on 29 October clarified a that these were to be selected from among the outside directors or auditors. The requirement was included, along with disclosure as to the independent directors’ or auditors’ names and reasons for being so designated, as ‘Items to be observed’ in the TSE’s Code of Corporate Conduct (which must be complied with in order to avoid delisting) with effect from 30 December.108 In addition, following the FSA Study Group’s recommendations, the action plan proposed new ‘Items desired to be observed’ for the TSE’s Principles of Corporate Governance for Listed Companies to support statutory auditors. Companies are encouraged to provide them with sufficient human resources, including for cooperation with internal audit and control divisions; to appoint highly committees (and many other corporate governance matters, compared to 2007) see TSE-Listed Companies White Paper on Corporate Governance 2009, above n 66). 106 See 4. The chair was University of Tokyo Professor of Law Hideki Kanda. 107 Ibid, 5. The report noted other existing innovations within statutory auditor companies, such as executive directors (who by definition can never be ‘outside’ directors) who had nonetheless been engaged from outside the company and had never previously worked for it, or looser ‘advisory boards’ comprised of outside experts providing input into management decision making. 108 The agreed changes can be found at . The Code is available at .

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independent outside auditors; and appoint auditors with in-depth knowledge of finance or accounting. The Principles were unveiled in 2004 as purely voluntary, ‘not to require companies to adopt minimum standard policies or models for corporate governance, nor to demand companies that do not adopt the best policies or models to explain why’.109 But the TSE has now revised listing rules and its ‘Guidelines for descriptions in corporate governance reports’ to require firms to describe measures taken to enhance statutory auditor functions. Likewise, the TSE has presented corporate governance models deemed suitable for most listed companies, namely in the ‘remarks’ column following its Principles of Corporate Governance. Each firm must now disclose its current governance system and reasons for it, referring to the models added to the principles. In other words, Japan has recently moved to a significantly more prescriptive approach, at least for companies listed on the main stock exchange. The TSE demands a stricter standard than the Companies Act in one respect: at least one independent (not just outside) director or statutory auditor. This adopts one major recommendation of the METI Study Group’s Report, but not directly the other regarding outside directors. In addition, following the FSA Study Group the TSE also encourages further independence and other corporate governance enhancements through a regime not too dissimilar to the ‘comply or explain’ approach found in the UK and (arguably more loosely) in Australia.110 13.4.4.3 Directors’ duties and derivative actions Minimum numbers and qualifications as an ‘outside’ or ‘independent’ director (or auditor) provide ex ante protection for shareholders and even other stakeholders. Once appointed, directors also owe specified duties that can operate as ex ante or ex post controls. From a comparative and historical perspective, another intriguing development in Japan has been the superimposition of a duty of loyalty (chujitsu gimu) providing relief if directors turn out to have acted dishonestly or unfairly.111 The Commercial Code added Article 254–3 (now Article 355 of the Companies Act) during the Occupation in 1950, reflecting the central role played by the duty of loyalty in (Anglo-)American corporate law. It sat uneasily alongside the duty of care provided in Article 254(3) (now Article 330), which incorporated – following German law – the high standard set out in the Civil Code (Article 644: zen kan chui gimu). In 1970 the Supreme Court of Japan held that it clarifies and restates the duty of care. Article 254–3 also played no practical independent role for other important reasons, too. Unlike in common law systems, breach of the duty of loyalty provided for the same relief: damages, not disgorgement of profits or other often flexible remedies originally derived from courts of equity. Developing a new, independent form of ex post relief would have put additional 109 Preface to the 2004 edition, 4, available at . 110 Nottage, above n 90. See also Chapter 1 of this book. 111 Kanda and Milhaupt, above n 80.

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strain on a judiciary used to working within a corporate law containing many narrower mandatory provisions. Relatedly, the Commercial Code contained specific ex ante procedural rules governing many situations. In particular, Article 264 (now Article 356(1)(1)) restricts transactions by a director on his or her behalf or for another that competes with the company’s business. Article 265 (now Article 356(1)(2) and (3)) regulates self-dealing, also requiring prior board approval. However, in 1989, the Tokyo High Court awarded damages against a director solely under Article 254–3. Poaching key employees for his new firm may have been seen as beyond the scope of Article 264.112 But a few subsequent judgments have also applied Article 254–3 (and Article 355) independently of the duty of care in other contexts. Kanda and Milhaupt argue that this reflects new patterns of ‘micro-fit’ and ‘macro-fit’, reflecting broader shifts in Japanese economic institutions, sharp reductions in cost barriers to shareholder derivative suits from 1993, and growing familiarity with the duty of loyalty.113 As in Anglo-American law, it may even yet come to play a role in contests for corporate control (outlined in Part 13.4.5.3 below) or more generally in underpinning independence of directors. Article 355 of the Companies Act also requires directors to obey all laws, articles of association and resolutions of general shareholders’ meetings. The Supreme Court (7 July 2000) has ruled that ‘laws’ should be interpreted broadly. The Daiwa Bank judgment (Osaka District Court, 20 February 2000) held it extended to relevant foreign law, namely United States law, which had been breached by a locally hired New York employee causing huge losses to the Bank and its shareholders. The judgment also held that the board must establish a system for internal control, with non-executive directors obliged to monitor its effectiveness. Generally, the latter must also monitor activities of the other directors, and creditors of small to medium-sized companies have quite often successfully claimed damages against non-executive directors. The board of directors also must supervise executive directors and the appointment or dismissal of representative directors (Article 362); and must supervise executive officers within companies with committees (Article 416(1)(2)). Directors are also liable if they negligently allow dividends and the company becomes insolvent by year-end (Article 465), or the dividends exceed a statutory formula (Article 462). The emergence of derivative suits in Japan since the 1990s has been even more striking, enlivening and interacting with these directors’ duties. The issue was highlighted by the 80 billion yen awarded at first instance in the Daiwa Bank case, although a 250-million yen settlement was reached during the appeal.114 Under the German-inspired Commercial Code of 1899, shareholders holding at least 10 per cent of the company’s capital could require the auditors to sue directors, 112 See also the Tokyo High Court judgment of 24 June 2004, cited in Souichirou Kozuka and Leon Wolff, ‘Commercial Law’ in Luke Nottage (ed.), CCH Japan Business Law Guide: Looseleaf, Singapore, CCH Asia (2007), para. 16–320. See also their paras 16–300 through 16–380 and 15–360 for further key details about all directors’ duties, including non-competition duties and others described in the ensuing text above. 113 See also Part 13.4.2 (Japan and debates on comparative capitalism and corporate governance), above. 114 See generally Bruce Aronson, ‘Reconsidering the Importance of Law in Japanese Corporate Governance: Evidence from the Daiwa Bank Shareholder Derivative Case’ (2003) 36 Cornell International Law Journal 11.

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but this was little used.115 Occupation reforms in 1950 included a United Statesstyle, derivative suit mechanism, but it, too, generated only a few dozen cases. Shareholder plaintiffs typically had to pay attorneys an up-front fee, and even if successful remained liable for further ‘success fees’ beyond what the court might find ‘reasonable’. Regarding court costs, they also faced the ‘loser pays’ rule standard in civil litigation in Japan and, most importantly, had to pay significant amounts upon filing, which were based on the amount claimed. Courts liberally construed a provision, modelled on Californian law, allowing defendants to seek security for costs if it was credible that the suit was brought in bad faith; and could also invoke the ‘abuse of rights’ doctrine. Only plaintiffs holding at least 10 per cent of shares (3 per cent after 1993) could access company financial information through rights to examine its books or (only upon showing cause) to appoint an inspector. Suits burgeoned after the Code was amended from mid-1993, primarily to fix the court filing fee at the flat rate of 8200 yen, by deeming derivative actions to be non-property claims (Article 267(4)). This followed the new interpretation given by the Tokyo High Court (30 May 1993).116 Yet, statistical analysis of suits filed between 1993 and 1999 found very low success rates and quite limited settlements for plaintiffs, as well as negligeable indirect benefits reflected in share price ‘event studies’ – not unlike findings from the United States. Milhaupt and West therefore conclude that suits persist primarily because of various financial advantages to Japanese attorneys. But they also acknowledge some influence from (a) non-monetary motives for some plaintiffs, (b) piggybacking on information disclosure ensuing from white collar crime prosecutions, (c) proliferating professional indemnity insurance (although settlements remained few and low), and (d) new-generation sokaiya.117 Fujita identifies other empirical work suggesting that the 1993 reform nonetheless may have enhanced monitoring over misbehaving managers, but ultimately finds the evidence to be ambiguous, particularly as other major changes ensued for the management liability regime overall.118 One set of procedural law changes focused on procedural rules in derivative actions themselves. Japanese law had no express provisions to limit litigation that might be ‘abusive’ vis-` a-vis non-plaintiff shareholders, as opposed to directors themselves. Thus, for example, courts could not dismiss suits likely to succeed even if shareholders 115 Milhaupt and West, above n 92, 18, speculate that this was because such large shareholders could enforce rights informally anyway, or were deterred by strict rules on security for costs and liability for damages to the company if the shareholders failed. 116 The Supreme Court (10 October 2002) eventually upheld this interpretation of the old Code provision. Derivative suits pending in District and High Courts rose to 86 by the end of 1993 to around 200 from 1997: Tomotaka Fujita, ‘Transformation of the Management Liability Regime in Japan in the Wake of the 1993 Revision’ in Hideki Kanda, Kon-sik Kim and Curtis J. Milhaupt (eds), Transforming Corporate Governance in East Asia, Abingdon, Routledge (2008) 15 at 17. 117 Milhaupt and West, above n 92, 22–37. For more on the (arguably diminishing) roles of sokaiya as well as Japanese organised crime more generally see ibid, 109–78. However, subsequent empirical analysis presents persuasive evidence against their ‘rational attorney’ explanation, and instead emphasises nonmonetary motives and various heuristics as driving burgeoning lawsuits. See Dan Puchniak, ‘Japan’s Love for Derivative Actions: Revisiting Irrationality as a Rational Explanation for Shareholder Litigation’, 2nd Annual NUS–Sydney Law School Symposium, Singapore, 15–16 July 2010. 118 Fujita, above n 116.

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as a whole might suffer (for example, due to the directors having insufficient assets). Article 847(1) of the draft Companies Act of 2005 added a provision clearly extending court powers in this respect, creating a version of the United States law requirement that plaintiffs ‘fairly and adequately’ represent shareholder interests, but this was not enacted due to fears of undermining monitoring incentives. However, the Act did clarify that the company has standing to intervene or participate in the derivative action – indeed, it does away with certain conditions imposed by a Supreme Court judgment (30 January 2001). Reforms to the Commercial Code in 2001 had already provided a detailed procedure by which the company could intervene and assist director defendants. In particular, the statutory auditor(s) must decide within 60 days of a request from shareholders whether or not to sue, and provide written reasons for not suing (see now Articles 386(2) and 847(3) of the Companies Act). Procedural rules for exonerating management were also amended from 2001. Liability may be exempted beyond specified limits (for example, two years’ remuneration for outside directors) if a director has acted in good faith and without gross negligence. This requires approval by the shareholders’ meeting (Article 425), or by the board of directors if provided in the articles of association and 3 per cent of shareholders (or less if so provided in the articles) do not subsequently override the board’s decision (Article 426). Statutory auditors (or members of the audit committee in a Company with Committees) also approve the exemption. Fujita suggests that partial exemptions may have some psychological effect on judges considering judgment against directors. However, he suggests that relatively few companies have amended their articles of association because exemption by means of the board is further limited to where exemption is ‘particularly necessary taking into account the relevant circumstances including, but not limited to, the details of the facts that caused the liability and the status of execution of duties’ (Article 426(1)). Further, even if exemption is by means of a shareholders’ meeting, there must be disclosure of ‘the facts giving rise to the liability and its amount’ (Article 425(1)) – normally after the first-instance judgment. Lastly, there are also few cases in which courts impose liability without evidence of ‘gross negligence’, anyway. This last point ties into a third set of developments: transformations in the substantive law on directors’ duties. In particular, a Japanese version of the ‘business judgment rule’ has become more prominent since the late 1980s. Japanese courts do check that the substance of directors’ decisions was not markedly inappropriate or not based on detailed fact findings, even if they find no problems with decision-making or information-gathering processes in general. But increasingly, judgments begin by expressly referring to the rule and proclaiming limited scope for reviewing substantive business judgments, before examining and ruling on the facts. In addition, the Companies Act now applies negligencebased rather than strict liability regarding illegal distributions or self-dealing, extending 2002 revisions to the Commercial Code, which had restricted liability only for companies with committees.

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Fujita concludes that the 1993 change to the filing fee issue and rapid growth of derivative suits pose problems for path-dependence theory (including his own earlier work with Kanda), which had predicted change only where complementarities with other rules had been weak, or where strong complementarities could be overturned through comprehensive reforms in extraordinary political circumstances. He now suggests that where strong complementaries do exist and persist, the narrow reform will lead to further changes to the overall system – like the more recent sets of changes to Japan’s management liability regime. Alternatively, the perspective of Milhaupt with West or Pistor may provide a better explanation for the emergence of the 1993 change itself – namely, broader transformations in Japanese economic institutions and hence corporate governance as a whole – but their views then sit rather uneasily with the evidence of ‘backlash’ tentatively identified by Fujita. Japan’s gradual transformation may be considerably more gradual than they believe.

13.4.5 Shareholder versus bank finance 13.4.5.1 Overview Greater choice of governance form and enhanced MSPs such as derivative suit mechanisms were aimed at expanding capital-raising from shareholders. This consolidated a trend that had accelerated since the 1980s, as companies turned to bond and share markets. It also acknowledged the growing role of foreign investors, holding around 20 per cent of TSE-listed shares by the early 2000s, compared to just 4 per cent in 1990. Shareholder finance also became crucial as banks accumulated huge, non-performing loan portfolios and a credit crunch persisted throughout Japan’s ‘lost decade’ and into the early 2000s. Relatedly, corporate law was liberalised to allow companies to offer many new types of shares. This has moved Japan away from a system of limited options that left uncertainty about the legality of other possibilities, even though crossborder joint ventures and some bolder companies in Japan sometimes used those other options anyway. Since 2001, Japanese corporate law has expressly made available a much more diverse menu of share type offerings to investors (Part 13.4.5.2). Yet, this has highlighted more possibilities for abuse by incumbent managers and other stakeholders in the face of actual or potential hostile takeovers, resulting in complex and ongoing developments in takeovers regulation. Japan has been influenced by United States law in allowing certain defensive measures such as ‘poison pills’ – shares or warrants (‘rights’ to subscribe to shares, in Anglo-Australian parlance) that dilute the hostile bid. But there are echoes of Anglo-Australian law in the greater role accorded to approval by target shareholders rather than directors (Part 13.4.5.3). This may further undermine the ‘main bank’ system over the long term, but that did survive the lost decade, and indeed cross-shareholdings have been increasing more generally in recent years (Part 13.4.5.4).

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13.4.5.2 Share-class diversification One striking liberalisation regarding shares relates to new types of shares available since the 2001 amendments to the Commercial Code. Previously, other than ordinary shares there could only be preference shares in respect of dividends or interest or distribution of assets upon insolvency, with the possibility of limiting voting rights. Now, under Articles 107 and 108 of the Company Law, there may be classes of shares with different rights regarding: ● distribution of surplus or residual assets (including now ‘tracking stocks’ linked to performance of subsidiaries, for example) ● restrictions on assignment (even now for a specific class of shares) ● no or limited voting rights (for example, voting restricted to profit distributions – with the maximum for such shares with limited rights raised, for public companies, from one third to one half of issued shares: Article 115) ● rights of shareholder to require companies to acquire the shares (‘shares with a put option’) ● rights of the company to acquire the shares (‘shares with a call option’, with the acquisition price payable in other classes of shares, bonds etc.) or an entire class of shares (now by qualified majority, subject to the squeezed out shareholders being able to get the court to determine the price: Article 172(1)) ● a veto for the class regarding certain corporate actions (‘golden shares’) ● rights of a class to appoint directors or auditors (except for public companies and ‘Companies with Committees’: Article 347). These provisions allow management additional flexibility to raise capital from shareholders with different investment needs. However, many may also be used as defensive measures against actual or potential hostile takeovers and thus entrench incumbent management for its own interest rather than maximising benefits for all shareholders and the company as a whole.119 In addition, even without shareholder approval directors may now issue share purchase warrants with a call option (share options or shinkabu yoyaku-ken) exercisable if a certain proportion of shares is acquired (Article 236(1)(7)). A company can also 119 See Oda above n 93, 232–7, including a summary of the UFJ Trust Bank case. In 2004 it issued preferred shares to Mitsubishi Tokyo Bank as the preferred suitor, with rights of veto and to appoint a certain number of directors, and with no voting rights unless for example the merger was approved by UFJ. Since 2006, however, the TSE has indicated that issuing shares requiring class approval for director appointment or dismissal can lead to delisting. (In another remarkable development for Japan, the disappointed Mitsui Sumitomo Banking Corporation pursued a contract law claim against UFJ all the way to the Supreme Court: see Koji Takahashi, ‘Walford v Miles in Japan: Lock-in and Lock-out Agreements in Sumitomo v UFJ’ (2009) 2009 Journal of Business Law 166. The issue of ‘golden shares’ can become acute where the government retains them in partly privatised public utilities and foreign investors are involved, although Japan has not yet witnessed litigation as in the European Union. Compare Souichirou Kozuka, ‘Foreign Direct Investment, Public Interest and Corporate Governance: Japan’s Recent Experience’ (2009), Paper presented at the 6th Asian Law Institute Conference, Hong Kong, 29–30 May 2009 (analysing cases in which foreign investors – TCI from the UK, and Macquarie from Australia – faced difficulties instead from Japan’s FDI regulation framework) and Kenichi Osugi, ‘Transplanting Poison Pills in Foreign Soil: Japan’s Experiment’ in Hideki Kanda, Kon-Sik Kim and Curtis J Milhaupt (eds), Transforming Corporate Governance in East Asia, Abingdon, Routledge (2008) 36 at 40 (discussing the float of Inpex Corporation with a golden share for the government, but in 2004 and without controversy so far for foreign investors). More generally, see Christopher Pokarier, ‘Open to Being Closed? Foreign Control and Adaptive Efficiency in Japanese Corporate Governance’ in Luke Nottage, Leon Wolff and Kent Anderson (eds), Corporate Governance in the 21st Century: Japan’s Gradual Transformation, Cheltenham, Edward Elgar (2008) 197.

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discourage takeovers by increasing the voting requirements, pursuant to the articles of association, for resolutions of all shareholders to approve dismissal of directors or M&A transactions (Article 309).120 Since the Companies Act took effect from 2006, the TSE has developed momentum to impose additional restrictions on defensive measures – thereby not only transforming corporate governance outcomes, but also complicating the process by which law and practice are being transformed in Japan.121 13.4.5.3 Takeovers regulation Hostile takeovers had been very rare in post-war Japan due to substitute means for monitoring incumbent managers: keiretsu or broader cross-shareholding relationships, main banks, stable core employees and informal relationships with the economic ministries. However, Milhaupt and Pistor argue that these and other economic institutions had come under prolonged stress since the 1990s, leading to great controversy surrounding the February 2005 bid aimed at a Fuji Television subsidiary by internet firm Livedoor. Led by maverick entrepreneur Horie, the bid pitted the new against the old. It also arose in the context of growing concern about increased foreign investment into Japan, facilitated by new entrants to deregulated financial markets – illustrated by Lehman Brothers’ financing of Horie’s bid. In addition, Livedoor aggressively used the legal framework. It found a securities law loophole (closed in 2006) to accumulate a 38 per cent shareholding off-market but after-hours, thus circumventing tender-offer rules that required purchases beyond one-third to be open to all shareholders. (Drawing again on United States law, tender-offer provisions were added in 1971 to the Securities Exchange Law – broadened into the Financial Instruments Exchange Act in 2007.122 ) When the target’s board issued shinkabu yoyaku-ken warrants to Fuji that would dilute this stake, Livedoor invoked a provision in the 2001 Code amendments that allowed injunctions if such warrants were ‘substantially unfair’. All three levels of the courts enjoined Fuji in March 2005, extending earlier case law that had interpreted the issuance of actual shares (to white knights or the like) as not unfair if its ‘primary purpose’ was to raise capital rather than entrench the management against hostile bidders.123 But the courts recognised exceptions 120 Keiko Hashimoto, Katsuya Natori and John C Roebuck, ‘Corporations’ in Gerald McAlinn (ed.), Japanese Business Law, The Hague, Kluwer (2007) 91 at 139–41 (including useful diagrams). 121 See generally Hideki Kanda, ‘What Shapes Corporate Law in Japan?’ in Hideki Kanda, Kon-sik Kim and Curtis J Milhaupt (eds), Transforming Corporate Governance in East Asia, Abingdon, Routledge (2008) 60 at 63–6; and the introduction and Part 13.4.4.2 (Companies with committees versus companies with boards of auditors), above. 122 For a detailed analysis, see Hiroshi Oda et al., ‘Securities Law (the Financial Instruments and Exchange Law)’ in Luke Nottage (ed.), CCH Japan Business Law Guide: Looseleaf, Singapore, CCH Asia (2009). 123 For details on that case law, based on Code Article 280–10 (effectively restated in Article 210 of the Companies Act), see Souichirou Kozuka, ‘Recent Developments in Takeover Law: Changes in Business Practices Meet Decade-Old Rule’ (2006) 22 Journal of Japanese Law 5. Injunction in that context is also possible where the share issuance breaches other statutory provisions (respectively Article 280–2(2), now Articles 199(2) and 201(2)). Courts and a 2003 amendment interpreted that aspect to require a price linked to the market price – typically reflecting the bid offered by the acquirer. To that extent, namely incumbent management having to re-evaluate their firm’s value in response to bidders, Kozuka believes that the market for corporate control was operative.

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for specified ‘abusive motives’ (such as greenmail or scorched earth policies) by the bidder that would clearly harm other shareholder interests, provided the measures then were proportionate.124 Milhaupt and Pistor join other commentators in highlighting strong parallels with Delaware case law on similar ‘poison pills’ decided in the 1980s. The influence of United States law is even more apparent in the first report of METI’s Corporate Value Study Group, established in September 2004 to clarify whether and how Japan’s new legislative provisions could be used to provide defensive measures against takeovers. The report was released on 27 May 2005, with significant additions to the Summary Outline (published on 7 March, shortly before the first Livedoor judgment). But one professor who served on that Group instead points out that (non-binding but influential) guidelines agreed between METI and MoJ also on 27 May:125 ‘had virtually no trace of Delaware rules and developed native legal thoughts instead. In the beginning, the Guidelines indicated three fundamental principles: 1. adoption, activation, and abolition of the defensive plan shall be made for maintaining or improving corporate value and eventually shareholders’ collective interests; 2. a defensive plan shall disclose its purpose, contents, etc. when it is adopted and be dependent on the rational will of shareholders; and 3. a defensive plan shall be allowed only when it is necessary and proper to prevent [inadequate] takeovers. Subsequently, the Guidelines issued various legal structures for rights plans and the legal procedures for adopting them. The Guidelines did not mention what constituted an appropriate standard that would help adjudicate a target board’s activation of a defensive plan during a control contest. This was probably because the authority to interpret statutes was vested only with the judiciary. Compared to the Delaware rules, the METI Report and to a larger extent the Guidelines laid greater emphasis on shareholders’ power to adopt and/or abolish a defensive plan.

Subsequent case law in Japan, beginning with the Nireco and Yumeshin-JEC judgments in 2005 (involving instead pre-bid or ‘peace-time’ measures, unlike the Livedoor case) and including the Supreme Court’s ruling in the 2007 Bulldog Sauce case, has developed in conjunction with two subsequent Group reports (in March 2006 and June 2008) to further emphasise the importance of shareholder approval.126 The TSE, continuing its emergence as a major policy setter, has recently reiterated this, too.127 124 Milhaupt and Pistor, above n 73, 90–8. 125 Osugi above n 119, 39. Oda above n 93, 265 also notes parallels to German law’s ‘balance of powers doctrine’ in the context of the primary purpose rule. 126 See also Mitsuhiro Kamiya and Tokutaka Ito, ‘Corporate Governance at the Coalface: Comparing Japan’s Complex Case Law on Hostile Takeovers and Defensive Measures’ in Luke Nottage, Leon Wolff and Kent Anderson (eds), Corporate Governance in the 21st Century: Japan’s Gradual Transformation, Cheltenham, Edward Elgar (2008) 178; Luke Nottage, Leon Wolff and Kent Anderson, ‘Introduction’ in ibid; and Nottage above n 93 (especially the Appendix comparing the subtly changing membership of the Group, chaired also by Professor Kanda, from 2004–8: see also Luke Nottage, ‘The Politics of Japan’s New Takeover Guidelines’ (31 August 2008), available at . 127 TSE Report of 17 June 2009 above n 66, 4 (and 6 on squeeze-outs). Recall also Kanda above n 121.

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However, there remains diversity even within the most popular ‘advance warning’ poison pills – loosely inspired by the Yumeshin-JEC case – that over 500 companies had implemented by June 2009.128 These generally require the bidder to present an acquisition plan and other information, and to give the target shareholders time to assess the bid and decide to have directors seek out white knights. They usually also provide for directors to deploy defensive tactics such share warranty issuance, discriminating against a non-compliant bidder. Such schemes were often set up without shareholder approval. But this was usually obtained if the schemes also provided for tactics triggered more broadly, such as judgments that the bidder is abusive or even that the bid will be detrimental to the company. (Most schemes also had some type of independent committee to advise the directors, although the final say was reserved for the board.) In addition, reflecting concern about heightened conflict of interests with the incumbent directors, a minority of schemes envisaged that only the shareholders could approve deployment on the broader grounds such as abusive motive.129 The relative emphasis on shareholder interests is also consistent with developments at several levels regarding Management Buyouts (MBOs), where the managers seeking to take their company private (often with private equity financing, at least before the global financial crisis) have an incentive to take actions diminishing the market price. Already on 13 December 2006, amendments to the securities law required bidders to disclose any written evaluation from third parties that had influenced the tender offer price, for example. METI ‘Guidelines on Increasing Corporate Value and Ensuring Regulatory Compliance in the Context of MBOs’, released in September 2007 under the chairmanship of the ubiquitous Professor Kanda, also emphasise the need for an appropriate price (for example, through longer tender-offer periods or avoiding ‘no shop’ agreements between the bidders and the company). They further recommend means to promoting fairness within the target company’s processes for evaluating the offer, including obtaining independent advice about the process and reports from third parties about price.130 The Guidelines appear to have influenced the concurring decision of Justice Tahara in the Supreme Court’s judgment in the Rex Holdings minority squeeze-out case (29 May 2009), as both emphasise transparency and appropriate valuation.131 128 See Oda, above n 93, 266. (He notes that this represents less than 20 per cent of listed companies but suggests that this ‘demonstrates the perception of the companies of the uncertainties involving the permissibility of such measures’.) 129 Osugi, above n 119, at 42–3. 130 Soichiro Fujiwara and Masanori Tsujikawa, ‘New Procedures for Fair MBOs’ (2008) Supplement: The 2008 Guide to Japan International Financial Law Review, available at . 131 Squeeze-outs for cash became possible under the new Company Law, but subject to court appraisal if the price is unfair. The Court upheld the Tokyo High Court’s judgment (of 12 September 2008) that the offer price should be around 120 per cent of the six-month average market price before the tender offer. See Wataru Kamoto et al., ‘Rex Holdings – Supreme Court of Japan Requires “Fair Price” to be Paid to Minority Shareholders’, Allen and Overy Knowledge (19 June 2009), available at . For

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Already in 2007, Kanda had observed that regarding defensive measures against takeovers, ‘the scope of permitted discretion of a target board seems much narrower in Japan than in the US’.132 Indeed, this seems more consistent with many substantive rules under Anglo-Australian law. There are even some parallels between the emergence of Guidelines and the way Takeovers Panels in the UK and Australia issue guidance notes for market participants and observers. But one difference from Japan is that these panels (more informal in the UK than Australia) also issue the binding rulings in takeover disputes, in lieu of regular courts. Another is that poison pills per se – as opposed to other measures that can also impede takeovers – are effectively outlawed altogether through a combination of panel decisions, listing rules and directors’ fiduciary duties.133 Thus, Japan continues to develop its own hybrid regime. As Milhaupt and Pistor point out, taking Delaware law as a major starting point, rather than the UK’s City Code requirements for ‘strict neutrality’ from target managers and hence shareholder approval of defensive measures, promised a system more protective of those managers and thus more politically acceptable. It also offered a new business opportunity to United States law firms and financial advisors, as well as elite Japanese lawyers increasingly found with United States law training.134 Accordingly, they concede that one outcome may be reinforcement rather than transformation of management entrenchment, substituting for now-lower mutual or stable shareholdings. But they also consider the possibility of adaptive responses including more use of proxy fights to remove directors (still rarely used) and the legal profession’s growing familiarity with corporate control issues, resulting in much stronger convergence on the United States experience, particularly over the 1980s. Overall, they suggest that Japan will fall somewhere in between, however, as the METI Takeover Guidelines derive from a comparatively ‘rapid, top-down process of law reform’ and Delaware law generates very ‘unpredictable ex post decision making’ even in its native environment. Milhaupt

another example where an MBO failed, after a whistleblower suggested the founding family had maneouvered to lower the market price, involving appraisals that were not sufficiently independent: see ‘Charle MBO Bid Collapses on Opaque Share Pricing’, NikkeiNet Interactive (20 January 2009). 132 Hideki Kanda, ‘Hostile Takeovers, Defenses and the Role of Law: A Japanese Perspective’ (10 July 2007), available at 9. 133 Nottage, above n 68 (referring especially to the respective studies of Emma Armston and Jennifer Hill). Another Australian urges Japan to establish a takeovers panel: Geread Dooley, ‘Streamlining the Market for Corporate Control: A Takeovers Panel for Japan?’ in Luke Nottage, Leon Wolff and Kent Anderson (eds), Corporate Governance in the 21st Century: Japan’s Gradual Transformation, Cheltenham, Edward Elgar (2008) 155. But this might create the worst of both worlds: an informal body struggling to apply a still-flexible, substantive test (rather than the more bright-line Anglo-Australian rules): Nottage et al., above n 93, 8. 134 Milhaupt and Pistor, above n 73, 99–100. They also remark that at least one-third of the (original) Corporate Value Study Group’s members had extensive exposure to Delaware corporate law. Less convincing, however, is their argument that the City Code alternative would have required introducing a UK-style mandatory bid rule, ‘which would require major changes to the tender offer provisions of the securities law, which may have been politically problematic given the lack of cooperation between METI and the financial services agencies’. In fact, amendments in 2006 anyway introduced a requirement for bidders to bid for all outstanding shares if seeking two-thirds of more of the shares: Kanda, above n 132, 5. Nonetheless, that threshold is comparatively high and anyway ‘the acquirer always has the option of going to the market and exempting themselves from the obligations of a tender offer’.

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and Pistor still view Japanese courts as ‘inclined to stake out a key role for themselves as arbiters of contests for control, not unlike the Delaware courts’, with ‘the Livedoor case and its aftermath [being] symptomatic of a broad shift in the use of law to support market activity in Japan’.135 That may be putting it too strongly, but another gradual transformation does seem evident already in this field. Mergers and acquisitions burgeoned after the late 1990s, including now a considerable proportion involving foreign acquirers.136 And the possibility of hostile takeovers is no longer a negligeable part of the corporate governance landscape. Puchniak justifiably objects to those who have proclaimed already a more drastic reconfiguration, but tends to overstate his case when arguing for de minimus change and impact.137 For example, he takes a conventional but quite narrow view of what constitutes a hostile takeover. Even if a target board does not directly object to a bid, it can indicate a preference for another. Things have also changed compared to the 1980s, in that the blue-chip companies are now launching hostile bids too, turning bids into a recognised business tactic.138 A major firm admittedly has not yet succeeded in such a bid, but upward share valuations are occurring and so in that sense the market for corporate control is operating in Japan. The growing numbers of companies issuing poison pills should also be counted beyond 2006, alongside survey evidence that many managers nowadays continue at least to feel threatened by the possibility of a hostile takeover. The numbers may still be proportionately fewer than in the USA, but that could be due to some ongoing (or even new) uncertainties.139 It is also the explanation for the persistence of greater stable shareholdings still in Japan; indeed, companies continued to sign up to more poison pills despite a recent rise again in cross-shareholdings noted by Puchniak and others. 13.4.5.4 Main banks Japan’s M&A market remains quite distinctive because of the continuing importance of bank finance for listed firms, although that peaked during the highgrowth 1960s and 1970s. As the yen appreciated and the stock market boomed over the 1980s, companies expanded overseas and diversified corporate finance, especially bond and new share issuance. The collapse of the ‘bubble economy’ from 1990 drastically reduced the raising of capital through shares, with public offerings in 2007 constituting less than a tenth of the amount in 1989. But third-party issuance has grown steadily since 1991, and in 2000 overall 135 Milhaupt and Pistor, above n 73, 104. 136 Milhaupt and West, above n 92, 179–206; Robert Grondine and Brian Strawn, ‘Corporate and Project Finance’ in Gerald McAlinn (ed.), Japanese Business Law, The Hague: Kluwer (2007) 515 at 535–45. 137 Dan W Puchniak, ‘Delusions of Hostility: The Marginal Role of Hostile Takeovers in Japanese Corporate Governance Remains Unchanged’ (2009) 28 Journal of Japanese Law 89. 138 As in the case of Oji Paper: cf Oda, above n 93, 262. 139 See respectively, Kozuka, above n 123; Osugi, above n 119; Milhaupt and Pistor, above n 73, 92; Oda, above n 93. The takeovers story also needs to be read in the context of other evidence that managers are placing greater weight on shareholder interests: see even the recent work by Ronald Dore and more cited in Nottage, above n 68.

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equity finance (shares plus bonds – mostly now convertible warrant bonds) surpassed borrowing from banks. They struggled throughout the 1990s with non-performing loans and the capital adequacy ratios required by the Bank of International Settlements, and a banking crisis from late 1997 through to 1998. On the other hand, equity finance has declined from 2006, including issues of bonds with pre-emption rights for new shares, with some commentators pointing to concerns about exposing companies to hostile takeovers.140 Central to post-war bank finance in Japan has been the ‘main bank’, the primary lender and provider of many other services to the firm. The firm would disclose information extensively to its main bank, usually assisted by the bank becoming a major shareholder (albeit subject to a 5 per cent statutory limit), and with retiring bank officials often becoming its senior finance officers. If the borrower nonetheless got into difficulties, the main bank would try to tide it over or restructure it through new loans or refinancing, guaranteeing other firm debts or sending officials to assist as managers or directors. However, this constituted an implicit promise to attempt a rescue instead of relying on often higher-priority security interests. It depended on main banks being able to take a long-term view of the relationship, which would include possibilities for more extensive profits on other business provided to the firm compared to the other banks. Main bank rescue ex post, and its role as an important ex ante and interim monitoring mechanism for corporate governance of firms in Japan, also relied on borrowers retaining quite extensive intangible value. Another premise was informal relationship with the government, promising long-term advantages (for example, more approvals for new branches) if main banks supported economic stability by informally supporting firms with desirable long-term prospects. Logically, the system is challenged by deregulation of financial markets particularly since the 1990s and a general shift towards more arms-length relationships, including the government now occasionally allowing banks to fail and a more accessible formal bankruptcy law regime.141 But there is still scope to debate the precise impact, now and in the foreseeable future, on main banks. Experienced Tokyo practitioners have argued, for example, that:142 In the last 10 years this main bank system has seriously declined, especially as the 20 major Japanese city and long-term credit banks have consolidated into basically only four main banking conglomerate groups that are now competing more actively for good new customers . . . In the past if a company sough financing from a bank which was not its main bank, the first impression at this new bank would very likely have been that the company must be in severe trouble because its main bank would not lend for the particular project. Now this occurrence has become relatively common and the new bank will often welcome this opportunity to develop a new customer at the expense of its rivals. 140 Oda above n 93, 270–2 (citing Egashira and Moden). 141 See generally Kent Anderson, Stacey Steele and Shoichi Tageshira, ‘Insolvency Law’ in Luke Nottage (ed.) CCH Japan Business Law Guide: Looseleaf, Singapore, CCH Asia (2009). 142 Grondine and Strawn, above n 136, 519.

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For Kozuka, one of the most striking transformations among Japan’s 40 largest companies in 2008 compared to 1998 is that banks have virtually disappeared as major shareholders, with a corresponding rise in institutional investors (including many foreign investors). Further, although equity ratios have remained almost unchanged on average, there is now much greater variance.143 On the other hand, although large firms continued to lessen ties with banks in favour of bond issuance over the 1990s, smaller listed firms continued borrowing and firms already carrying high levels of bank debt relied on main banks for a growing proportion. Empirical studies suggest that the banking crisis did not result in a credit crunch at least among firms with strong growth opportunities, while:144 debt did play a disciplinary role in the 1990s, but a high concentration of loans with the main bank tended to delay the corporate restructuring. This suggests that banks facing financial distress engaged in soft-budgeting and followed an ‘evergreen’ policy of rolling over loans. This situation made the threat of bank intervention in poorly performing firms less credible. Thus, close ties with a main bank no longer the positive disciplinary role of ‘contingent governance’ in Aoki’s sense. Relationship banking in Japan is not likely to disappear, but it will play a more limited role. Roughly, one-third of all listed firms now depend on capital markets for external finance, but these mostly large firms constitute approximately 70% of total firm value and over 50% of total employees among all firms on the First Section of the Tokyo Stock Exchange in 2002. For these firms, bank loans are now based on an explicit and arms-length contract (eg credit line or loan syndication). For these firms, market pressure through institutional investors and bond ratings are now playing a major role in corporate governance and banks are unlikely to regain their monitoring role. Meanwhile, the majority of smaller firms continue to depend on bank borrowing. Here banks have continued advantages through private information, which can help overcome difficulties in raising finance. Whether banks can once again effectively monitor these firms depends very much on their financial health.

Puchniak therefore seems to overstate the position in suggesting that ‘the main bank system dramatically increased its influence over the Japanese economy throughout the lost decade’.145 But he convincingly shows how evergreening 143 Kozuka, above n 72, 234–5. 144 Gregory Jackson and Hideaki Miyajima, ‘Introduction: The Diversity and Change of Corporate Governance in Japan’ in Masahiko Aoki, Gregory Jackson and Hideaki Miyajima (eds), Corporate Governance in Japan: Institutional Change and Organizational Diversity, Oxford, Oxford University Press (2007) 1, 18–19, summarising Yasuhiro Arikawa and Hideaki Miyajima, ‘Relationship Banking in Post-Bubble Japan: Coexistence of Soft- and Hard-Budget Constraints’ in Masahiko Aoki, Gregory Jackson and Hideaki Miyajima (eds), Corporate Governance in Japan: Institutional Change and Organizational Diversity, Oxford, Oxford University Press (2007) 51 and referring to Masahiko Aoki, Towards a Comparative Institutional Analysis, Cambridge, MIT Press (2001). They also note research showing how Japanese banks have increasingly used private equity funds to strengthen their role in corporate restructuring: Noriyuki Yanagawa, ‘The Rise of Bank-Related Corporate Revival Funds’ in Masahiko Aoki, Gregory Jackson and Hideaki Miyajima (eds), Corporate Governance in Japan: Institutional Change and Organizational Diversity, Oxford, Oxford University Press (2007) 205. However, greater formalisation through lines of credit and such like does not automatically mean that main banks will shelter behind them when the going gets tough for borrowers, who can still appeal to an implicit promise for assistance in restructuring. 145 Dan W Puchniak, ‘Perverse Rescue in the Lost Decade: Main Banks in the Post-Bubble Era’ in Luke Nottage, Leon Wolff and Kent Anderson (eds), Corporate Governance in the 21st Century: Japan’s Gradual Transformation, Cheltenham, Edward Elgar (2008) 81 at 106.

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and perverse lending (to more poorly performing borrowers, usually with no interest-rate premium) were facilitated particularly through main banks and thanks to a new informal government policy regime aimed at supporting the banking system overall. That analysis certainly undercuts Miwa and Ramseyer, who assert that market forces and arms-length enforceable rules are all that matter in the Japanese economy, thus rendering the main bank system another pernicious ‘myth’ about Japanese corporate governance.146 The continued but arguably diminished existence of the main bank system is also consistent with a broader revival of cross-shareholding and stable shareholding in recent years, also involving banks. But that has also now attracted concern from the TSE, including the possibility of mandating disclosure of such shareholdings and related agreements, which some companies are now doing voluntarily.147 Overall, therefore, it does seem that:148 corporate finance in Japan is increasingly characterized by the co-existence of two different, and in ways competing logics – a pattern rather similar to Germany or Italy . . . While the main bank system has not disappeared, it has been institutionally displaced and its scope limited to a more specific niche segment of firms than in the past.

13.4.6 Core employees Significant ‘displacement’ is also evident in Japan’s lifelong employment system, although the transformation is arguably even more gradual. The implicit promise of a job for life – combined with related practices such as seniority based wages and promotions, cooperative industrial relations, entry level hiring followed by job rotations (and hence generalist or firm-specific skills training), and a relatively weak external labour market – have long been identified as a further key monitoring mechanism distinguishing post-war corporate governance in Japan. Indeed, Puchniak argues that career management incentivised by lifelong employment was essential to efficient main bank monitoring, making the system the most important element for trust in the market and hence the expansion (and dispersion) of shareholdings in post-war Japan.149 Yet, a range of new strategies since the 1990s aimed at:150 promoting ‘shareholder value’ may provoke a number of conflicts with employees around the issues of corporate disclosure, business portfolios, equity-oriented performance targets and the use of performance-oriented pay, such as stock options. Shareholder value creates pressure for more market responsiveness in employment through reducing excess employment, divesting from less profitable businesses and decentralizing bargaining to match wages with productivity. 146 See for example Miwa and Ramseyer, above n 87; cf also Curtis J. Milhaupt, ‘On the (Fleeting) Existence of the Main Bank System and Other Japanese Economic Institutions’ (2002) 27 Law and Social Inquiry 425 and the further critiques by Puchniak above n 87 and Nottage and Freedman above n 87. 147 Financial System Study Group, above n 105, 8. 148 Jackson and Miyajima, above n 144, 19. 149 Puchniak manuscript, above n 74. 150 Jackson and Miyajima, above n 144, 24–5.

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Nonetheless, the ideal of the lifelong employment system has always been more important than its reality. Already by the 1990s, lifelong employment applied:151 to less than 10 percent of all corporate entities, barely 20 percent of all workers, and only 8 percent of working women. Even if lifelong employment were dying, this is hardly a strong basis to project major shifts in Japan’s corporate governance system or capitalist configuration. Nor, given the enormous powers management have to command labour even for core workers, is lifelong employment the radical departure from at-will employment that are said to define more liberal market economies.

In predicting the system’s present and likely future influence, moreover, Wolff stresses the importance of determining its main causes. A cultural theory seems implausible in light of the limited reach of lifelong employment in practice, for example. The neo-classical market theory sketched by Miwa and Ramseyer asserts that the system survives only due to strict restraints on dismissals developed quite creatively by Japanese courts, but that development occurred after the system emerged soon after the War. The ‘institutional complementarities’ theory emphasised by Aoki and others struggle to explain how those institutions arose, why they become associated with (seemingly endogenous) economic stagnation over the 1990s, and other dark sides to the lifelong employment system (for example, for women).152 For example, data from the late 1990s mostly show only small or statistically insignificant shifts towards more market-oriented human resource management (HRM) practices, as predicted by a model emphasising complementarities with more readily observed transformations in corporate finance.153 Data from 2003 indicate that such practices – especially major shifts towards completely or partly merit-based pay – are not significantly impacted by foreign ownership, but they are by more outside board executives or by managerial stock options as an emergent form of remuneration.154 Overall, ‘changes in corporate governance have affected the role of employees but, in fact, some elements of Japanese-style HRM may be compatible with a wider range of corporate governance institutions than suggested by some theories of complementarity’.155 The best explanation for the lifelong employment system therefore appears to be a political account, acknowledging the post-war agreement among at least some major interest groups that established a ‘flexicurity’ mode of regulation – balancing security of tenure with extensive flexibility in the working conditions that managers can impose. Tensions are apparent within this 151 Leon Wolff, ‘The Death of Lifelong Employment in Japan?’ in Luke Nottage, Leon Wolff and Kent Anderson (eds), Corporate Governance in the 21st Century: Japan’s Gradual Transformation, Cheltenham, Edward Elgar (2008) 53 at 60. 152 Ibid, 61–4. 153 Masahiro Abe and Takeo Hoshi, ‘Corporate Finance and Human Resource Management in Japan’ in Masahiko Aoki, Gregory Jackson and Hideaki Miyajima (eds), Corporate Governance in Japan: Institutional Change and Organizational Diversity, Oxford, Oxford University Press (2007) 257. 154 Gregory Jackson, ‘Employment Adjustment and Distributional Conflict in Japanese Firms’ in Masahiko Aoki, Gregory Jackson and Hideaki Miyajima (eds), Corporate Governance in Japan: Institutional Change and Organizational Diversity, Oxford, Oxford University Press (2007) 282. 155 Jackson and Miyajima, above n 144, 26.

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mode of regulation, but until it becomes subject to a new political settlement, the main trend is an intensification of flexicurity for a diminishing core group, culminating in:156 (i) preserving job security for incumbent core workers, (ii) squeezing out older and younger workers from the benefits of permanent tenure (they now join women on the ‘outside’ of the system), (iii) disproportionately burdening the SME sector with the fixed cost of surplus labour, and (iv) encouraging greater casualisation of the Japanese workforce. A crisis in Japanese industrial relations is now in train.

Intensification has nonetheless been underpinned by a continuation or expansion of legal rules. A judgment of the Tokyo District Court (2 January 2000) only slightly relaxed unfair dismissals requirements even for larger companies, and in 2003 the legislature confirmed the overarching ‘abuse of rights’ doctrine. Employment security for women has been promoted through amendments to the Equal Employment Opportunity Law (1997 and 2006) and the Child Care and Family Care Leave Law (2004), while whistleblowers gained protection through a new statute in 2004. In exchange, since the late 1990s flexibility has been enhanced to allow managers to (re)direct labour even more efficiently, including lifting of the holding companies prohibition and Commercial Code amendments facilitating for spin-offs and such like, and to outsource labour more easily.157 It remains to be seen how the new government led by the Democratic Party of Japan (DPJ) will respond to the present tensions within the lifelong employment system, following its August 2009 election victory, which displaced the conservative Liberal Democratic Party (LDP) from power for only the second time since 1955. The DPJ may be more sensitive to the challenges faced by disadvantaged groups such as women and at least some SMEs (although the LDP has also traditionally sought out votes from small business). It may therefore introduce measures resulting in further displacement (or even ‘exhaustion’158 ) of the system in favour of HRM practices more focused on the external labour market, albeit with a more generous social safety net than under the LDP. But others are likely to call instead for the security promised by the system – even at the cost of managerial flexibility, especially nowadays – to be extended to increasingly marginalised groups. Much will depend on the economic constraints placed on 156 Wolff, above n 151, 74. 157 Wolff above n 151, 75–8. See also Nottage and Wolff above n 89. However, whistleblower protection can serve to promote broader shareholder interests, for example (see the Charle case cited above n 131), or the interests of consumers – more prominent outside stakeholders these days – rather than conventional insiders. 158 Wolff (above n 151, 79) agrees with Nottage, (above n 68, 41) that ‘exhaustion’ (the slow withering away of lifelong employment) may be the closest description from among the five modes of ‘gradual transformation’ proposed by Wolfgang Streeck and Kathleen Ann Thelen, ‘Introduction’ in Wolfgang Streeck and Kathleen Ann Thelen (eds), Beyond Continuity: Institutional Change in Advanced Political Economies, New York, Oxford University Press (2005) 1 although ‘displacement’ (emergence of hitherto subordinate institutions and norms) is also a possible description given the declining core of lifelong employees. But Wolff (above n 151) observes that within this core, the system’s core feature of flexicurity is in fact intensifying. This pattern may represent a sixth mode of gradual transformation, which may also be found outside Japan.

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the new government by the global financial crisis, in addition to those built up over the ‘lost decade’, as well as the performance and potential of Japanese firms – large and small.159

13.4.7 Conclusions on Japan This brief introduction to two still-important and quite distinctive monitoring mechanisms in Japanese corporate governance – the lifelong employment system and main banks – reminds us that government policy and the vicissitudes of politics are as important as economics and broader social or cultural context in explaining and predicting trajectories. Nonetheless, a gradual transformation seems to be underway even along these two dimensions, in parallel with more significant changes in the relationship between shareholders and directors or managers. Among those who examined Japanese corporate governance from the 1970s, some (like Haley) still emphasise continuities – especially in relation to employment relationships – and indeed tend to acclaim such features of Japan’s more coordinated market economy. A very few revisionists (notably Ramseyer) instead now proclaim Japan to be already a liberal market economy, just like the USA – and that it has been so already for many decades. A much younger generation of foreign commentators who have tracked developments since the late 1990s (such as Kelemen and Sibbitt) tend to perceive drastic shifts towards ‘Americanisation’ and LMEs. But some now (especially Puchniak) see very little significant change, impressed for example by the renewed economic growth enjoyed by Japan over 2002–7 – albeit belatedly, at low rates, and thanks to considerably pump-priming. A third group (including Nottage, Wolff and Anderson as well as Deakin, Whittaker and their co-researchers, and Milhaupt especially over recent years) have tracked aspects of Japanese corporate governance from the 1980s and tend to see significant but gradual transformations. A key feature has been growing diversification – of processes generating law and policy (especially over the last decade), of comparative law borrowings or adaptations, and of corporate practices and norms. This growing and admittedly sometimes messy diversity,160 especially 159 In particular, Japanese firms and governments may become more generally skeptical about the benefits of deregulation following the global financial crisis debacle, yet both quite desperately need capital, at least in the short-term, and renewed scepticism may not be as widely shared abroad. In other respects, for example in its declared intention to pursue FTAs, the DPJ does not seem particularly ‘anti-market’; a very rough analogy might be ‘New Labour’ in the UK. On the DPJ and possible policy developments more generally, see Luke Nottage, ‘The New DPJ Government in Japan: Implications for Law Reform’ (1 September 2009), available at . 160 See the critique of Japan’s current diversity in generating rules for ‘Cross-Border M&A’, by Ken’ichi Osugi and Yoshihisa Hayakawa in their Keynote Report for Toshiyuki Kono et al., ‘Koko ga Hen da yo – Nihon-Ho [Is Japanese Law a Strange Law?]’ (2009) 28 Journal of Japanese Law 229 at 242–3. For a more positive appraisal of hybridisation more generally in contemporary Japanese corporate governance, see Deakin and Whittaker, above n 90.

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in organisational forms, itself may be evidence of a move from CME-type institutions (demanding high levels of mutual investment in relationship-specific assets) towards LME-type institutions.161 But Japan’s experience confirms some indications from other jurisdictions that such changes do not necessarily occur at the same rates along all dimensions – and the political aspects reinforce the possibility of such complexity or even some ‘reverse course’. Evidence from two surveys (in 2003) indicate considerable support even among managers for employees being as important as shareholders and for a stakeholder model of corporate governance more generally.162 Japan, therefore, continues to offer a fascinating reference point in comparative corporate governance debates, in addition to its continued practical importance within the world economy.

13.5 China 13.5.1 Introduction Corporate law and corporate governance in China have been influenced by a variety of factors: the traditional dominance of the state-owned sector and the continuing ideological commitment by policy makers to the ‘socialist market economy’; the decision by the government to attract foreign capital by encouraging the establishment of foreign-invested companies in China and subsequently to encourage the development of a corporatised private sector in order to develop the Chinese economy and the use of the stock markets, in China and overseas; and the decision to capitalise upon and expand first state-owned and then private Chinese companies. Chinese decision makers have adopted selected concepts and ideas from a wide range of legal systems in attempting to construct a corporate and securities legal system that will be appropriate and effective in China. Corporate governance is of concern to Chinese companies of all kinds – state-owned, foreign-invested and private, domestically owned corporations. It became an issue of concern for foreign and domestic investors because of government-backed efforts by state-owned enterprises from the early 1990s to raise money first on Chinese and then on international markets from foreign and domestic investors while maintaining control over the listed vehicle. Indeed, the issue of the controlling shareholder (generally the state) and its activities in diverting assets and business advantages from its listed subsidiary continues to be a major problem in Chinese corporate governance. Corporate governance is also concerned with providing adequate protection for investors in other listed 161 Mari Sako, ‘Organizational Diversity and Institutional Change: Evidence from Financial and Labor Markets in Japan’, in Masahiko Aoki, Gregory Jackson and Hideaki Miyajima (eds), Corporate Governance in Japan: Institutional Change and Organizational Diversity, Oxford, Oxford University Press (2007) 399; and more generally Jackson and Miyajima, above n 144. Cf for example Jacoby above n 87 (suggesting, from mostly earlier data, that Japanese companies have shown little or no expansion in HRM and corporate governance diversity between 1980 and 2004, only a shift on average – smaller than in the USA – towards market-based forms over that period). 162 Wolff above n 151, 70.

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companies and in the fast-growing private sector in China. It is also of interest to the wholly state-owned sector: the Chinese government has stated its commitment to the principle of corporate social responsibility and better standards of enterprise internal controls for state-owned enterprises.163 A variegated system of controls and controllers has been developed in China to deal with these different types of entities and issues. Although principles of corporate governance imposed on listed companies have attracted much of the scholarly attention devoted to corporate governance in China and are obviously important indicators of how Chinese regulators approach the various issues, it is important not to overlook other Chinese companies and corporate entities, the regulation of which is also clearly causing concerns for investors, other stakeholders and regulators. This part of the chapter begins by examining the legislative structure in China, particularly as it relates to corporate governance. It looks briefly at the different kinds of corporate entity in China and the different issues these varied types of entities present, and examines the regulatory structure relating to corporate governance. It then considers the main problems for corporate governance in China, the varying methods that have been used to resolve these issues and the consequent development of corporate governance principles and rules, and concludes with a brief discussion of the efficacy of these methods and likely future developments.

13.5.2 Government and legislation in China The National People’s Congress (NPC) is the premier law-making authority in China. Only the NPC (and its Standing Committee when the NPC itself is not in session) is able to make laws (fal¨ u).164 The Constitution, as implemented by the 165 Law on Legislation, makes it clear that the right to legislate on important issues such as criminal law, deprivation of a citizen’s right to liberty, civil institutions and fundamental economic systems (including tax, customs, finance and trade) belongs solely to the NPC or its Standing Committee. Thus, the principal items of legislation in the corporate area, the Company Law, the Securities Law,166

163 National People’s Congress, 2005, Company Law of the People’s Republic of China (29 December 1993; subsequently amended on 28 August 2003 and 27 October 2005, effective 1 January 2006), (‘Company Law’), Article 5: ‘When engaging in business activities, a company must abide by laws and administrative regulations, observe social morals and business ethics, act in good faith, accept supervision by the government and the public, and bear social responsibilities.’ Ministry of Finance, China Securities Regulatory Commission, National Audit Office and China Insurance Regulatory Commission, Basic Internal Control Norms for Enterprises (2008); State-Owned Assets Supervision and Administration Commission of the State Council, Guiding Opinions Concerning Fulfillment of Social Responsibility by Central Enterprises (29 December 2007). 164 NPC, Constitution of the People’s Republic of China (adopted 4 December 4, 1982; amended 12 April 1988, 29 March 1993, 15 March 1999 and 14 March 2004), Art 62. 165 Standing Committee of the NPC, Law on Legislation of the People’s Republic of China (15 March 2000, effective 1 July 2000), Art 8. 166 NPC, Securities Law of the People’s Republic of China (29 December 1998, amended 27 October 2005, effective 1 January 2006).

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the Securities Investment Fund Law167 and the Criminal Law168 were all passed by the NPC or its Standing Committee. The State Council, the highest level of executive authority in China, under the Premier, may issue administrative regulations (xingzheng guiding) on important matters.169 These often include detailed implementing regulations that clarify areas in the laws that are vague or are felt to need further elaboration. China is not a federal system. Thus, although provincial, municipal and other lower-level governments have the power to issue rules and decrees, the provinces and other governments do not have distinct areas of responsibility that belong specifically to them. They do, however, have the power to issue implementing legislation and legislation on ‘local matters’.170 The central government has maintained strict control over companies and securities law, and regulation in China and local legislation have been permitted only limited impact.171 Thus, although Shenzhen and Shanghai had introduced experimental corporate law regimes in the early 1990s in order to underpin their budding stock markets,172 these rules were replaced in their entirety by the Company Law and the national corporate law regime. The various ministries, administrations and other bodies under the State Council may issue rules, decrees and other instruments with legislative impact.173 The State Administration for Industry and Commerce (SAIC) is the company registration body174 and its rules and activities have some impact on corporate issues such as governance. The State-owned Assets Supervision and Administration Commission of the State Council (SASAC) is responsible for centrally administered, state-owned enterprises and plays a regulatory, legislative and supervisory role in relation to those enterprises.175 Similar, state-owned assets administrations play a role in relation to locally administered, state-owned enterprises. The Ministry of Commerce, which is responsible for internal and external trade, is the authority primarily responsible for foreign-owned enterprises.176 The primary regulator for listed companies is the China Securities Regulatory Commission

167 Standing Committee of the NPC, Law on Securities Investment Funds (28 October, 2003, effective 1 June, 2004). 168 NPC, Criminal Law of the People’s Republic of China (adopted 14 March 1997, amended 25 December 1990, 31 August 2001, 29 December 2001, 28 December 2002, 28 February 2005, 29 June 2006 and 28 February 2009). 169 Law on Legislation, note 165, Chapter 3. 170 Law on Legislation, Chapter 4. 171 Standing Committee of the NPC, Law on Administrative Licensing of the People’s Republic of China (27 August, 2003, effective 1 July 2004), Art 15, for example, makes very clear that local authorities may not impose pre-qualification or other requirements upon entities seeking to incorporate under the Company Law. 172 Standing Committee of the Shenzhen Municipal People’s Congress, Regulations on the Shenzhen Special Economic Zone on Companies Limited by Shares (26 April 1993); Standing Committee of the Shenzhen Municipal People’s Congress, Regulations of the Shenzhen Special Economic Zone on Limited Liability Companies (26 April 1993); Shanghai People’s Municipal Congress, Shanghai Municipality Tentative Provisions on Companies Limited by Shares (18 May 1992); see also Bath, ‘Introducing the Limited Company’, China Business Review (1993) 1–2, 50–54. 173 Law on Legislation, Art 71. 174 See website at . 175 See website at . 176 See website at .

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(CSRC), another body under the State Council.177 The CSRC is a prolific issuer of rules and documents in the securities area. In the corporate governance area, a significant step recognising the importance of corporate governance standards was taken with the issuance of the Code of Corporate Governance for Listed Companies in China in 2001,178 which was followed by the Guidelines on Introducing the Independent Director System in Listed Companies.179 The importance of corporate governance was again emphasised by the CSRC in 2005180 and in 2007 with the issuance of the Notice on Matters concerning Carrying out a Special Campaign to Strengthen the Corporate Governance of Listed Companies,181 followed in 2008 by the jointly issued Basic Internal Control Norms for Enterprises.182 The CSRC has also issued a number of regulations on important corporate governance issues such as rights of shareholders of public companies183 and requirements for public disclosure of information.184 The China Insurance Regulatory Commission, however, has primary responsibility for insurance companies, and the China Banking Regulatory Commission has primary responsibility for banks and financial institutions. These two commissions thus have overlapping responsibilities with the CSRC to the extent that insurance and financial companies are listed or engage in securities transactions.185 The Supreme People’s Court and the Supreme People’s Procuratorate also issue opinions, interpretations and regulations on the application of particular laws or the handling of particular matters. Opinions of the Supreme People’s Court restricting the ability of shareholders to bring actions in securities cases, for example, have been an important reason for the relatively slow growth of shareholder litigation.186 The Listing Rules and other regulations of stock exchanges upon which the securities of Chinese companies are listed and traded, both inside and outside China, also have an impact on corporate governance and behaviour of listed companies. Although the Communist Party plays a ‘leadership’ role under the Preamble to the Constitution and is given no formal legislative role, it has a continuing and highly significant role in administration, implementation of policies and 177 See website at . The primary activities of the CSRC are described in China Securities Regulatory Commission, CSRC Annual Report (2008), English version available at: . 178 CSRC, Code of Corporate Governance for Listed Companies in China (7 January 2001). 179 CSRC, Guidelines on Introducing the Independent Director System in Listed Companies (16 August 2001). 180 State Council, Circular of the State Council on Approving and Forwarding the Opinions of the China Securities Regulatory Commission on Improving the Quality of Listed Companies (19 October 2005). 181 CSRC, Notice on Matters Concerning Carrying out a Special Campaign to Strengthen the Corporate Governance of Listed Companies (9 March 2007). 182 Ministry of Finance, China Securities Regulatory Commission, National Audit Office and China Insurance Regulatory Commission, Basic Internal Control Norms for Enterprises (issued 22 May 2008, effective 1 July 2008). 183 For example, CSRC, Several Regulations concerning Reinforcement of Protection of Public Shareholders’ Rights and Interests (7 December 2004); CSRC, Rules on Shareholders’ Meetings of Listed Companies (16 March 2006). 184 CSRC, Measures on Administration of Information Disclosure of Listed Company (30 January 2007). 185 See websites at ; . 186 See Wallace Wen-Yeu Wang and Jian-Lin Chan, ‘Reforming China’s Securities Civil Actions: Lessons from PSLRA Reform in the U.S. and Government-Sanctioned Non-Profit Enforcement in Taiwan’ (2008) 21 Columbia Journal of Asian Law 21 at 115–60.

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policy making itself. Indeed, Article 19 of the Company Law provides for the establishment of a party organisation in each company set up under the law.187 This influence may extend to the issuance of influential policy documents but also operates through less obvious and formal means. Senior officials of government derive power from their positions in the Communist Party, and power may be in the hands of persons who have a relatively insignificant role in the government hierarchy. This flows through to state-owned enterprises, universities, courts and other entities, where the Communist Party structure effectively takes priority over the formal structure and where senior officials may be appointed by sources outside the organisation.188 In the corporate governance context, the fact that there may be a dual organisation within the entity, or that important decisions about managers and management may be taken by sources outside the organisation, has a potential impact on the effectiveness of measures taken to improve the internal management structures and activities.

13.5.3 Corporate entities in China There are three main categories of companies and corporate entities in China, including foreign-investment enterprises, state-owned enterprises and companies, and privately owned companies. 13.5.3.1 State-owned enterprises Until the introduction of foreign-investment enterprises in 1979, the Chinese economy was dominated by state-owned enterprises, which were under the control of various parts of government and administered as a part of government rather than as autonomous corporate entities.189 The dominance of the state-owned enterprise in the economy was not, however, accompanied by an equivalent level of efficiency or productivity.190 The 1980s and 1990s saw a concerted effort by government to reform state-owned enterprises by a combination of means, including reorganisation, mergers and takeovers, privatisation and mergers. An important step forward in terms of the formalisation of the structure of state-owned enterprises was the promulgation of the 1988 Law on Industrial Enterprises owned by the Whole People.191 This law gave substantial power to 187 See also Sonja Opper and Sylvia Schwaag-Serger,‘Institutional Analysis of Legal Change: The Case of Corporate Governance in China’ (2008) 26 Washington University Journal of Law & Policy 245 at 253 and 261. 188 For a more detailed discussion, see Nicholas Howson, ‘China’s Restructured Commercial Banks: Nomenklatura Accountability Serving Corporate Governance Reform?’ in Cai Zhu and Avery (eds), China’s Emerging Financial Markets: Challenges and Global Impact, Singapore, John Wiley & Sons, (2009); Fang Hu and Sidney Leung, Appointment of Political Top Executives and Subsequent Performance and Corporate Governance: Evidence from China’s Listed SOEs (March 17, 2009), available at . 189 Chao Xi, Corporate Governance and Legal Reform in China, London, Wildy, Simmonds and Hill Publishing (2009) 6 et seq. 190 Wallace Wen-Yeu Wang, ‘Reforming State Enterprises in China: The Case for Redefining Enterprise Operating Rights’ (1992) 6 Journal of Chinese Law 89, 92. 191 NPC, 1988, Law of the People’s Republic of China on Industrial Enterprises Owned by the Whole People (13 April 1988, effective 1 October 1988, amended 27 August 2009). See also Xi, above n 189, 6–35, for a description of the historical development of management and structure of state-owned enterprises.

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the factory director, who was appointed by the relevant level of government or elected by the workers,192 acted as the legal representative of the enterprise193 and assumed overall responsibility for the work of the enterprise.194 He (or she) acted as the chief executive officer (CEO) of the enterprise, assisted by a management committee that was chaired by the factory manager and comprised employee representatives and ‘leading persons’ in charge of parts of the enterprise (Article 47). A board of directors or shareholder structure was not required in the Law on Industrial Enterprises Owned by the Whole People, even though the Chinese-foreign Equity Joint Venture Law,195 which required a board of directors and a chairman, had been in effect since 1979. The role of the relevant local government in relation to the enterprise was to formulate policies, coordinate relationships with other enterprises, provide information, protect state assets and improve public facilities (Article 56). The Communist Party was guaranteed a role in the enterprise, supervising the implementation of the guiding principles of the Party.196 This was succeeded by a policy requiring the corporatisation of state-owned enterprises.197 Thus, the Company Law contains a chapter198 that deals specifically with wholly state-owned companies. In addition, many listed companies have substantial amounts of state ownership. There are still, however, a number of different kinds of state-owned enterprises in existence, the corporate organisation of which varies depending on the history of the entity. An examination of the list of centrally controlled, state-owned enterprises administered by the SASAC, for example, shows that many of these state-owned enterprises, although corporations, have not been converted into corporations under the Company Law and do not have corporate structures including a board of directors or board of supervisors as required under the Company Law.199 For example, the website of China National Offshore Oil Company (CNOOC) sets out a list of management, which does not mention a board of directors; instead, the chief officer of the company (Fu Chengyu) is both President of CNOOC and Party Leadership Group Secretary.200 The fundamental principles relating to the management and governance of state-owned enterprises are reflected in the recently promulgated Enterprise State Assets Law, which states that the relevant entity of the State should act as the 192 Article 44. 193 Article 45. 194 Article 7. 195 NPC, Law of the People’s Republic of China on Chinese-Foreign Equity Joint Ventures (1 July 1979; amended 4 April 1990 and 15 March 2001). 196 Article 8. 197 Cindy Schipani and Junhai Liu,‘Corporate Governance in China: Then and Now’, (2002) 1(1) Columbia Business Law Review 1, 22–8. 198 Company Law, Articles 65–71. 199 See list of central enterprises on SASAC website at . 200 CNOOC website . The continuing role of the Communist Party in state-owned enterprises should not be forgotten. An example of the relative importance attached to these positions can be seen in the contrast between the English and Chinese websites – on the English site, the positions held by the President are listed as ‘President: Party Leadership Group Secretary’. On the Chinese site, the position of Party Secretary is listed first.

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investor in state-owned enterprises ‘in accordance with the separation of government from enterprises, the separation of public administrative functions from the functions of state-owned asset investors and respecting the lawful and independent operation of enterprises’.201 The Enterprise State Assets Law also requires that state-owned enterprises accept social responsibilities and establish corporate governance systems.202 Although the number of state-owned enterprises in China has been reduced since 1979 by a concerted policy of privatisations, planned bankruptcies and consolidations, the state-owned sector continues to be strong. Government policy is to continue state dominance of ownership and control in certain sectors203 and to protect ‘state assets’ generally. The challenge for regulators and companies alike is to maintain the separation of the roles of managers, investors and regulators in entities that are essentially guaranteed a dominant place in the market and to improve the corporate governance regimes within companies that do not have a diverse group of shareholders monitoring the performance of the company and the behaviour of its executives. 13.5.3.2 Foreign-investment enterprises Modern corporate law in China can be said to date from 1979, with the promulgation of the Chinese–Foreign Equity Joint Venture Law. This was followed in 1986 by the Wholly Foreign Owned Enterprise Law204 and subsequently by the Cooperative (or Contractual) Joint Venture Law.205 These three laws and their associated implementing regulations, notices, decrees and other subordinate legislation still define the shape of foreign-investment enterprises, which generally take the form of Chinese legal persons with limited liability, issuing registered capital rather than shares. It was not until the promulgation of the General Principles of Civil Law in 1986,206 however, that there was a serious attempt to provide a definition for the concept of legal personality. The Company Law applied to foreign-investment enterprises in a limited fashion. After the promulgation of the amendments to the Company Law in 2005, a concerted attempt was made by the government department in charge of company registration, the SAIC, to bring foreign-investment enterprises into line with wholly 201 NPC, Enterprise State-owned Assets Law of the People’s Republic of China (2008, effective 1 May 2009), Article 6. 202 Art 17: ‘State-invested enterprises that engage in operating activities shall abide by laws and regulations, strengthen their operating management practices, enhance their profitability, accept the administration and supervision of the government and relevant departments and organs, as well as the supervision of the general public, and shall assume responsibilities to both society and investors. State-invested enterprises shall establish and improve sound legal entity corporate governance practices, in addition to internal supervision and risk control systems, in accordance with the law.’ 203 General Office of the State Council, State-Owned Assets Supervision and Administration Commission of the State Council, Circular of the General Office of the State Council Concerning Transfer of the Opinions of the SASAC on Guidance for Promotion of Adjustment of State-owned Assets and Restructuring of State-owned Enterprise, (5 December 2006). 204 NPC, Law of the People’s Republic on Foreign Capital Enterprises (adopted 12 April 1986, amended 31 October 2000). 205 NPC, Law of the People’s Republic of China on Chinese-foreign Cooperative Joint Ventures (adopted 13 April 1988, amended 31 October 2000). 206 NPC, General Principles of Civil Law (12 April 1986, effective 1 January 1987, amended 27 August 2009), Chapter 3.

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Chinese-owned companies and to apply the corporate structure rules (such as the requirement to have a supervisory board) set out in the Company Law to foreign investment enterprises.207 The foreign-investment laws and regulations set out only basic rules relating to corporate management structures, but do not contain detailed provisions relating to corporate governance. The investors may, however, impose corporate governance standards themselves through their constituent documents or company policies and codes. The structure of joint-venture companies, in particular, does not fit neatly into the management structure contemplated by the Company Law, since joint ventures are not required to have meetings of shareholders. Instead, directors are appointed by the parties and may be removed only by the party that appointed them.208 An advantage offered by the joint-venture structure, however, is that the joint-venture contract sets out in considerable detail what the relationship between the investors is and how it should operate. The minority party in a joint venture therefore has considerable scope when it negotiates the joint-venture contract to incorporate the protections it considers necessary and acceptable. 13.5.3.3 Companies under the Company Law Companies set up under the Company Law may be privately owned, partly privately owned or wholly state-owned, and are able to take the form of either limited liability companies or companies listed on a Chinese stock exchange or outside China. The number and value of both private and listed companies have grown considerably. On 5 November 2009, for example, there were 868 listed companies on the Shanghai Stock Exchange, with a total market capitalisation of 17.3 trillion RMB (AUD 2.7 trillion).209 Xinhua attributes a 15.8 per cent increase in the number of privately owned enterprises in 2006 to the amendments to the Company Law, which facilitated the establishment of small private companies.210 The Company Law was followed by the Securities Law in 1998. Both laws were significantly amended in 2005 in order to provide additional protection to shareholders and to provide a higher degree of protection to shareholders, particularly minority shareholders. In addition, a substantial number of regulations, notices, decrees and codes of conduct have also been issued largely by the State Council and the CSRC in order to improve the system and the standards of corporate governance in Chinese companies. These apply mainly in relation to listed companies, although the Basic Internal Control Norms for Enterprises,211 207 See Vivienne Bath, ‘The Company Law and Foreign Investment Enterprises in China – Parallel Systems of Chinese-Foreign Regulation’ (2007) 30 UNSW Law Journal 774. 208 Equity Joint Venture Law, Art 6. 209 Shanghai Stock Exchange website . By way of contrast, on 10 November 2009, there were 2198 companies listed on the Australian Stock Exchange, with a market value of AUD 1.09 trillion – see the ASX website at . 210 Xinhua, New Corporate Law Drives Growth of China’s Private Sector in 2006 (24 April 2007), available at . 211 Basic Internal Control Norms for Enterprises (issued 22 May 2008, effective 1 July 2008).

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which were issued in 2008, are also aimed at large and medium-sized unlisted enterprises. The Company Law provides for a three-tier structure of management: a shareholders meeting, a board of directors and a supervisory board. The roles and functions of these different levels of management are prescribed in some detail in the Company Law itself. Each company must have articles of association, and some leeway is provided in the Company Law for the shareholders to modify the relationship between them through the medium of the Articles. The main difference between a limited liability company and a joint stock company (or company limited by shares) is that a limited liability company has registered capital (that is, a specified sum of capital that may be paid in cash and/or in kind) and a joint stock company has shares. Only joint stock companies may be listed – a limited liability company or other entity must be converted into a joint stock company if the shareholders wish to conduct a public offering.212 Most features of the management and corporate governance regime for the two types of companies as set out in the Company Law are, however, identical. The vast majority of foreign-investment enterprises with legal personality are limited liability companies. Corporatised state-owned companies will be either limited liability companies or, if listed, joint stock companies. There are, however, some differences between the form of these companies and a standard limited liability company under the Company Law. A joint venture, as noted above, does not have a shareholders’ meeting; a private company with only one shareholder does not hold a shareholders’ meeting but makes decisions by written memorandum (Article 62). A wholly state-owned company with one investor effectively does not hold shareholders’ meetings either, and may delegate a large amount of its authority to the board of directors, although the consent of the relevant government authority acting as investor is required for certain actions.213 Generally, however, the shareholders’ meeting is the organ of authority of a company (Articles 37 and 99) and has, at least in theory, power over most of the major management decisions of a company, including the ability to approve business plans and budgets, elect and remove directors and supervisors, approve dividend distribution plans, review and approve reports of directors and supervisors, changes to the company’s corporate plan and so on (Articles 38 and 100).214 Decisions of the shareholders are generally taken by a majority vote, with the exception of decisions on amendments to the articles of association, changes to the registered capital and decisions on merger, division, dissolution or change of the corporate form of the company, for which a two-thirds vote of the shareholders is required (Articles 44 and 104). In theory, Chinese companies issue 212 Company Law, Arts 9, 96. 213 Company Law, Art 67. 214 See Charles Qu, ‘The Representative Power of the Shareholders’ General Meeting under Chinese Law’ (2008) 17 Pacific Rim Law & Policy Journal 295 at 300–2; Xi, above n 189, 36–42. See also Sandra Kister, ‘China’s Share-structure Reform: An Opportunity to Move Beyond Practical Solutions to Practical Problems’ (2007) 45 Columbia Journal of Transnational Law 312.

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only one class of shares. In practice, there have been many different types of shares, ranging from state shares (held by the state); legal person shares (often held by legal persons in which the state had a controlling interest); employee shares; ‘A’ shares (listed on Chinese exchanges and available only for sale to Chinese investors, with some exceptions); ‘B’ shares (listed on Chinese exchanges and traded in foreign exchange); ‘H’ shares (traded on the Hong Kong Stock Exchange) and so on.215 Voting rights of shareholders are, in principle, equal (Articles 49 and 104). The board of directors is elected by the shareholders and acts as the executive of the company. It is responsible for developing the budget and plans presented to the shareholders, establishing management structure and appointing and dismissing the managers, convening shareholders’ meetings and so on (Articles 47 and 109). The supervisory board (or supervisor, in the case of a small company) has essentially a monitoring role. It should include employee representatives as well as supervisors elected by the shareholders (Articles 52 and 118), and is responsible for examining the financial affairs of the company, supervising the activities of the directors and requiring them to rectify wrongful actions and, if necessary, instituting litigation to protect the shareholders (Articles 54 and 119). In addition to these three tiers, a limited-liability company, a wholly stateowned company and a joint-stock company should each have a manager whose powers are also specified in the Company Law (although subject to the provisions of the articles of association), including responsibility for operations and production and internal management (Articles 50, 69 and 149). The two main Chinese stock markets are the Shanghai Stock Exchange and the Shenzhen Stock Exchange.216 Shares of Chinese companies are listed outside China, principally on The Stock Exchange of Hong Kong.

13.5.4 Corporate governance – issues and resolutions The main problem relating to Chinese listed companies arises from the number of companies that are listed, but have one principal or controlling shareholder – often the Chinese state in one form or another. Chinese government policy originally promoted the idea of listing on the basis that it would be a useful way to raise additional capital from outside shareholders without giving away significant amounts of control. Companies could not initially list at all without obtaining government approval, and this approval was given to state-owned enterprises

215 Chenxia Shi,‘Protecting Investors in China Through Multiple Regulatory Mechanisms and Effective Enforcement’ (2007) 24 Arizona Journal of International and Comparative Law 451 at 455–6. 216 There is a number of other securities exchanges, however, namely the Dalian Commodity Exchange, the Shanghai Futures Exchange, the Zhengzhou Commodity Exchange and the China Financial Futures Exchange. The CSRC’s policy is to develop a three-tiered market, involving the main board, a Growth Development Board and an over-the-counter share transfer system. CSRC Annual Report (2008), above n 177, 17.

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that were in need of new capital, rather than companies with a strong commercial track record that could attract enthusiastic investors.217 In the Chinese market, which initially had very few companies in which potential shareholders could invest, there seemed to be (and still seems to be) no difficulty in attracting shareholders to buy shares in initial public offerings.218 This enthusiasm for shares, however, has been accompanied by a series of major scandals, in China and in Hong Kong, relating primarily to the major problem of ‘tunnelling’ – that is, the use by the controlling shareholder of its position to divert cash, assets and business advantages from the listed company to itself – but also to such issues as fraud, false accounts, faulty disclosure, insider trading and other forms of market manipulation.219 Chao Xi220 comments that the two major problems in corporate governance can be summarised as the conflicts between the owners of a company and the managers, who may misuse their power to disadvantage the shareholders, and the conflict between the majority shareholders, who may misuse their position to disadvantage the minority shareholders. In China, it is the second of these problems; that is, the domination of listed companies by state-owned enterprises, that has been the main problem. China is not, however, free from problems related to management capture. A recent report on corporate governance in China led by the China Academy of Social Science,221 for example, reported that corporate remuneration in the top 100 listed companies in China increased substantially in 2008, notwithstanding the global financial crisis and the loss of profitability of many of these companies. Insider trading and market manipulation were specifically addressed in the 2006 amendments to the Criminal Law, and the 2005 revisions to the Securities Law provided for the establishment of a special fund to protect investors.222 The Chinese legislature and regulators (including the stock exchanges) have attempted to deal with the issues of corporate governance by a variety of means, including mandating and encouraging the adoption of internal management and governance mechanisms, direct intervention in relation to particular corporate 217 Xi, above n 189, 42–51. 218 For example, Ran Zhang ‘Overseas Fever of Tsingtao Beer, 8 September 2008’, available at regarding over-subscription of Tsingtao Beer shares in 1993; Trippon, ‘Shanghai Stock Exchange – World’s Hottest Stock Market Scores Another Hit’ (29 July 2009), available at regarding 30 times over-subscription for Sichuan Expressway. 219 Examples include Guangdong Kelon Electrical Holdings Co (executives accused of fraud and inflating profits, a scandal in which Deloitte also became the subject of an investigation), see Zhang Ran, ‘Deloitte Faces Double Trouble in China’, China Daily (31 March 2006), available at . See also Hongming Cheng,‘Insider Trading in China: The Case for the Chinese Securities Regulatory Commission’, (2008) 15 Journal of Financial Crime 165. 220 Xi, above n 189, 51–2. 221 Centre for Corporate Governance, Chinese Academy of Social Sciences, Centre for Research on Assessment of Leaders, China National School of Administration & Protiviti Consulting, Corporate Governance Assessment; Summary Report on the Top 100 Chinese Listed Companies for 2009, Beijing (2009), available at 16–17. 222 China Securities Regulatory Commission, 2006, Circular Concerning Deepening Study of Criminal Law Amendment (6) by Listed Companies (12 July, 2006); Securities Law, Art 116.

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governance issues, public sanctions, education and administrative and criminal penalties. Although the focus has been on listed companies, private (including foreign) and state-owned companies are also included in this comprehensive effort to establish a functional corporate governance regime in China.

13.5.5 Controlling the board of directors and the managers – the supervisory board As discussed above, Chinese companies under the Company Law have three organisational bodies, with roles and responsibilities allocated under the Company Law. Legislators and regulators have looked at all three, the shareholders, the directors and the supervisors, with a view to adjusting their powers in order to improve standards of corporate governance. The Company Law envisaged that the board of supervisors would play a monitoring and supervisory role in a Chinese company. The supervisory board, a body composed of representatives elected by the shareholders and employee representatives,223 should investigate the financial affairs of the company, supervise acts of the directors and managers that breached laws, regulations or the articles of association and order rectification of any acts that were harmful to the company. The Company Law as passed in 1993, did not, however, give the supervisors any power to obtain information or to enforce their decisions. It became clear that the supervisory board had very little impact on the activities of the board of directors or in improving the corporate governance of companies. Indeed, given that the majority of the supervisors were appointed by the same shareholders who appointed the directors, it seemed unlikely from the outset that the supervisors would have a real effect on the operations of the board.224 Under Articles 52 and 53 of the amended Company Law, supervisors were given more power – they may investigate the company’s financial affairs, supervise the directors and officers and recommend their removal, require a misbehaving officer or director to ‘rectify’ their misbehaviour, propose that shareholders’ meetings be convened and convene a meeting themselves if the directors fail to do so, and initiate litigation against directors for breach of duty if so requested to do so by at least 1 per cent of the shareholders. They do not have the power, however, to institute litigation at their own volition. In order to back up these obligations, supervisors may attend board meetings as non-voting members and conduct investigations (including by hiring outside accounting firms) into the affairs of the company (Article 55), with all costs and expenses to be paid by the company (Article 57). Supervisors are subject to the same requirements as directors and officers of the company in relation to qualification to act as a director (discussed below in relation to the duties of directors), and are also required to comply with the law, 223 Company Law 1993, Arts 52 and 54. 224 Xi, above n 189, 151–6.

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administrative regulations and the articles of association and to compensate the company for any losses due to their failure to do so (Articles 148 and 150); may not take bribes or otherwise take advantage of their position and are subject to duties of fidelity to the company and diligence (Article 148), on the same basis as the directors and officers. The 2005 amendments did not, however, change the basic method by which supervisors are selected nor did they impose any obligation that supervisors be independent of the company or, in particular, of the controlling shareholder (if there is one).225 There is, however, a requirement in Article 52 that at least one-third of the supervisors be democratically elected representatives of the workers.226 In addition, supervisors of joint stock companies, like directors, may be elected on a cumulative voting system (Article 106) if the company’s articles of association so provide. If implemented, this provision would give minority shareholders the opportunity to elect supervisors in a number proportionate to their total voting power.227 Nevertheless, the lack of any requirement that the supervisors be independent is likely to mean that the supervisory board will continue to be a relatively ineffective check upon the powers of the board. Indeed, in relation to listed companies, although the role of the supervisory board continues to be included by regulators as an essential part of a coherent corporate governance regime,228 more emphasis has been put on improving the board of directors itself than in turning the supervisory board into an effective mechanism for monitoring and control. Unlisted companies, however, are not required to have independent directors under the Company Law. Monitoring of these companies, therefore, still relies on the supervisory structure, which is required for foreign-investment enterprises established from the beginning of 2006,229 and wholly state-owned companies.230

13.5.6 Increasing the duties of directors The 2005 amendments to the Company Law significantly expanded the duties of directors, supervisors and officers of the company and, for the first time, gave shareholders a direct remedy in relation to breaches of duties by these various officers. The Company Law allowed for the confiscation of unlawful 225 See comments in Xi, above n 189, 175–8 on issues of independence of the supervisory board. 226 See Chao Xi, ‘In Search of an Effective Monitoring Board Model: Board Reforms and the Political Economy of Corporate Law in China’ (2006) 22 Connecticut Journal of International Law 1 at 21–2. 227 It appears that at least some listed companies do elect supervisors by this means. See China COSCO Holdings Company Limited, Announcement of the Resolutions Passed at the Annual General Meeting: Amendments to Articles of Association (2009); Payment of 2008 Final Dividends; Appointment of supervisors (9 June 2008), available at , which refers to the election of supervisors by cumulative voting. 228 For example, see CSRC, Notice on Matters concerning Carrying out a Special Campaign to Strengthen the Corporate Governance of Listed Companies, Annex (2007). 229 State Administration for Industry and Commerce, Ministry of Commerce, General Administration of Customs, State Administration of Foreign Exchange, Opinion on Several Issues on the Application of Laws on the Administration of the Examination and Approval and the Registration of Foreign-Funded Companies (26 April 2006), Art 18, see also, Bath, above n 207. 230 Company Law, Art 71.

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proceeds, punishment of the guilty director or officer by the company or, in extreme cases, criminal prosecution (Articles 214 and 215). It also provided that a director, supervisor or manager who caused loss to the company as a result of breaching the Company Law or the company’s articles of association should compensate the company (Article 63). The significant weakness in these provisions, however, was that there was no mechanism clarifying the way in which the ‘company’ as an entity should impose punishment on its erring officers, or enforce its claim for compensation. In a case in which the director or manager involving in defrauding the company was not acting alone, or was collaborating with a majority shareholder, the minority shareholders did not have adequate remedies through the medium of the Company Law to take the appropriate action. The Company Law now, through Part 6, sets out much more concrete provisions relating to the duty of directors, supervisors and officers, and to the ways in which action can be taken against infringing parties. Article 147 follows the previous law in setting out the qualifications for directors, supervisors and officers. Generally, a person may not serve in such a position, and his election to such a position is invalid, if he has no or limited capacity for civil acts;231 he has a criminal conviction for a crime of dishonesty such as corruption and no more than five years has elapsed since his sentence ended; he held a position within the past three years as director, factory director or manager of an enterprise liquidated in a bankruptcy for which he was personally responsible, or of an enterprise that has had its business licence revoked for a violation of law for which he was responsible, or he is a person with a comparatively large amount of personal debts which are due and unsettled.232 The Company Law does not otherwise provide for the concept of a person being disqualified to serve as a director. It does, however, provide that directors, supervisors and senior officers all have duties to the company in which they serve. These duties are the same for both limited-liability companies and for joint-stock companies. Article 148 requires that directors, supervisors and senior officers comply with the provision of laws, administrative regulations and the articles of association of the company, and that they have in addition duties of fidelity and diligence to the company (Article 148).233 Although the concept of the duties of fidelity and diligence (zhongshi yiwu he qinmian yiwu) are often construed as fiduciary duties, the Chinese system is a civil law system and it is not at all clear that equitable concepts relating to fiduciaries can to be imported into these expressions.234 The law does not attempt to define the exact scope 231 General Principles of Civil Law, Chapter 2. 232 The Enterprise Bankruptcy Law does not deal with personal bankruptcies – only with the bankruptcy of enterprises. NPC, Enterprise Bankruptcy Law of the People’s Republic of China (adopted 27 August 2006, effective 1 June 2007). 233 By contrast, Article 33 of the Code of Corporate Governance provides that directors shall ‘faithfully, honestly and diligently perform their duties in the best interests of the company and all the shareholders’. 234 See comments on the borrowed concept of ‘fiduciary’ duties by Donald C Clarke, ‘Lost in Translation? Corporate Legal Transplants in China’ (2006) GWU Law School Public Law Research Paper No. 213, available at and in Xi, above n 189, 77–86 in the context of takeover legislation in China.

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of these duties, although Article 149 sets out a list of actions in which directors may not engage, which ends with the expression ‘other acts in breach of his duty of fidelity to the company’ and may therefore be construed to constitute a list of actions that are in breach of the duty of fidelity. These acts focus on financial misbehaviour and revealing business secrets, and include encroaching on the property of the company (Article 148) or misappropriating funds of the company; depositing company funds in a personal account; lending the funds of the company or providing security over company property for the benefit of a third person without the consent of the shareholders or directors;235 entering into a contract with the company in violation of the articles of association of the company or without the consent of the shareholders; taking for himself commercial opportunities that belong to the company; taking secret commissions or disclosing the secrets of the company without authorisation. As a result, it is not clear whether the scope of the duty extends beyond financial misfeasance to, for example, such acts as causing the company to trade while insolvent, or whether the duty extends beyond the company to the shareholders themselves. Article 153 gives the shareholders the right to bring action against directors, supervisors or officers who harm the interests of shareholders in violation of the law, administrative regulations or the provisions of articles of association. It is not, however, clear how and to what extent this concept of harm to the shareholders extends beyond the more clearly spelled out concept of harm to the company itself. A major development in the 2005 amendments was the creation of a regime whereby direct action can be taken against infringing officers by the supervisors (at the behest of the shareholders) or by the shareholders themselves. Article 150 provides that a director, supervisor or member of senior management who violates ‘provisions of laws, administrative regulations or the articles of association of the company in the execution of company duties and thereby causes losses to the company’ will be liable to pay compensation. Under Article 152, in such a case, shareholders holding at least 1 per cent of the voting rights in the company may require the supervisors or, if the action complained of was an act of the supervisors, the directors, to take action; and if they fail to do so, the shareholders may take court action themselves ‘for the interests of the company’. The Supreme People’s Court, in its Second Interpretation on the Company Law, has extended the right of the shareholders to bring a suit under Article 152 to the right to institute an action against members of the liquidation group when the company is in liquidation (Article 23).236 This provision, not surprisingly, has attracted a considerable amount of attention, due to its similarity to the Western concept of a derivative action,237 although the sparse content of the 235 Article 16 of the Company Law provides that the grant of security for a third-party debt must be authorised by either the board or the shareholders as set out in the articles of association. 236 Supreme People’s Court, Provisions of the Supreme People’s Court on Some Issues about the Application of the Company Law of the People’s Republic of China (II) (12 May 2008, effective 19 May 2008), Art 23. 237 Hui Huang, ‘The Statutory Derivative Action in China: Critical Analysis and Recommendations for Reform’ (2007) 4 Berkeley Business Law Journal at 227–50, available at .

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provision has raised a number of significant issues about its practical implications. It should be noted that this provision applies to limited-liability companies as well as to joint-stock companies and may well prove to be a valuable tool for oppressed minorities in private companies, as well as for shareholders in listed companies.238 The issues relating to this provision are discussed in greater detail below.

13.5.7 Independent directors The Code of Governance for Listed Companies in China, issued by the CSRC in 2001,239 provided that listed companies should introduce independent directors to the board (Article 49). This was followed by the Guidelines for Introducing the Independent Director System in Listed Companies later that year,240 which required that by 2003 at least one-third of the directors on the board of a listed company should be independent (Article 1). More than half of the membership of remuneration, audit, nomination and other committees should also be independent, if the listed company has such committees (Article 5(4)). Under the Guidelines, an independent director must have substantial professional work experience (Article 2) and must not be related to officers of the company or its subsidiaries, shareholders holding 1 per cent or more of the shares of the company and certain shareholders of subsidiaries or persons providing professional services to or holding office in organisations providing services. An independent director cannot be removed without cause unless he or she ceases to be independent (Article 4(5)), and if he or she resigns must provide an explanation for such resignation to the shareholders and creditors of the company (Article 4(6)). Independent directors are given specific rights and functions, including the right to engage an agency to provide an independent consulting report on major transactions submitted to the director, and to propose that meetings of the shareholders or directors be convened. The importance of ensuring that the independent directors are able to carry out their functions of independent review was reiterated by the CSRC in 2007,241 when it made clear that a company should review whether an independent director had played a role in overseeing the operations of the company and, in particular, if the performance of his functions had been affected by the actions of the principal shareholder or if he had been improperly removed from office (Annex 2(1)). 238 Interestingly, one reported case under Article 152 involves the Chinese party of a Chinese–foreign joint venture taking action against the manager appointed by the foreign party. See sino-Link Consulting, ‘The First Case on Foreign Shareholder Representative Litigation in China’, available at (no date). Huang notes that it is easier for shareholders in a limited liability company to obtain standing to sue under the Company Law (above n 237, 236). 239 This followed provisions in Art 112 of the 1997 CSRC, Guidelines on the Articles of Incorporation of Public Listing Companies (issued 16 December 1997), which provided that a company could have independent directors and the State Economic & Trade Commission, China Securities Regulatory Commission, Proposal on Accelerating Standardized Operation of Companies Listed Overseas and Deepening their Reforms (29 March 1999), Arts 5 and 6, which required at least two independent directors on the board of a company listed outside China. See also Xi, above n 189, 373–6. 240 CSRC, Guidelines on Introducing the Independent Director System in Listed Companies (16 August 2001). 241 CSRC, Notice on the Matters Concerning Carrying out a Special Campaign to Strengthen the Corporate Governance of Listed Companies (9 March 2007).

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There are a number of stated purposes in requiring a company to have independent directors,242 including the need for independent directors to represent smaller shareholders, to monitor related party transactions, to act as an independent consultant and advisor and to serve the public interest on the board. Both the desirability of these functions and the extent to which the independent directors serve these purposes can be disputed. (A related question is the overlap between the functions of the supervisory board and the role to be played by the independent directors.) Questions have been raised as to the competence and experience of the persons selected as independent directors, as well as their ability to act effectively and independently, and the willingness of the board and its managers to incorporate and utilise independent directors effectively. The selection of independent directors appears to be dominated by the majority shareholders through their control of the board of directors and supervisory board.243 Studies suggest that the majority of independent directors have tended to be academics and government officials rather than experienced businessmen and women. In addition, with some exceptions, the independent directors have not fulfilled the expectation that they would be active and if necessary controversial members of the board of directors. As a result, some commentators have concluded that the effect of independent directors on the performance of listed companies is minimal.244

13.5.8 Committees The Code of Corporate Governance (Articles 52 to 58) provides that the board of directors of a listed company may establish a number of specialist board committees – a corporate strategy committee, an audit committee, a nomination committee, a remuneration and appraisal committee and other special committees.245 Pursuant to the Guidelines on Independent Directors (Article 5(4)), if such committees are established, independent directors must form more than half of the members. The 2005 Opinions of the China Securities Regulatory Commission on Improving the Quality of Listed Companies246 provided that a listed company should establish an audit committee and a remuneration and assessment committee, and this was further reiterated in the 2007 CSRC Notice on Matters concerning Carrying out a Special Campaign to Strengthen the Corporate

242 See discussion in Donald C Clarke,‘The Independent Director in Chinese Corporate Governance’ (2006) 31 Delaware Journal of Corporate Law 125 at 169 et seq. 243 Xi, above n 189, 168–75; see also Jie Yuan, ‘Formal Convergence or Substantial Divergence? Evidence from Adoption of the Independent Director System in China’ (2007) 9 Asian-Pacific Law and Policy Journal at 71–104, available at . Clarke, above n 242. 244 Ibid. 245 This chapter does not discuss the requirements of stock exchanges outside China that may require Chinese companies listed there to establish audit and other committees. 246 See State Council, Circular of the State Council on Approving and Forwarding the Opinions of the China Securities Regulatory Commission on Improving the Quality of Listed Companies (19 October 2005), Annex, Item 3.

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Governance of Listed Companies.247 Article 13 of the Basic Internal Norms for Enterprises,248 requires companies subject to the standard to set up an audit committee as part of the requirement for companies to establish a sound system of corporate governance. The question, of course, is the extent to which listed companies have adopted the committee system. A recent study by the Centre for Corporate Governance, Chinese Academy of Social Sciences, on the top 100 listed companies, shows that major listed companies in China have made substantial improvements in the establishment of board committees, particularly audit committees.249

13.5.9 The issue of the controlling shareholder – protection for minority shareholders under the Company Law The major issue for Chinese listed companies has been the role of the major shareholder, which is generally, although not always, a Chinese state-owned enterprise.250 As a consequence, the regulatory authorities, the stock exchanges and the legislature have all focused on the role of the controlling or majority shareholder in Chinese companies. The issue of abuse of power by the majority shareholder is not, however, confined to listed companies, and the 2005 amendments to the Company Law therefore placed considerable emphasis on protecting the position of minority shareholders in limited liability companies as well. Thus, the Company Law sets out not only provisions of general application but provisions that are specifically designed to provide protection for shareholders in limited liability companies. Article 21 of the Company Law applies to all companies and forbids controlling shareholders, de facto controlling persons, directors and senior management of a company from using ‘their affiliation’ with another enterprise that they control in order to harm the interests of the company. The concept of affiliation 247 CSRC, Notice on Matters Concerning Carrying out a Special Campaign to Strengthen the Corporate Governance of Listed Companies (9 March, 2007). 248 Note 163. On 26 April, 2010, the Ministry of Finance, SCRC, National Audit Office, China Banking Regulatory Commission and China Insurance Regulatory Commission issued the Application Guidelines for Enterprise Internal Control, Guidelines for Assessment of Enterprise Internal Control and Guidelines for Audit of Enterprise Internal Control, which will be implemented in stages from 1 January 2011. For a summary, see KPMG, China Boardroom Update: Internal control regulatory developments advisory (2010) issue 2, available at . 249 Centre for Corporate Governance, Chinese Academy of Social Sciences, Centre for Research on Assessment of Leaders, China National School of Administration & Protiviti Consulting, Corporate Governance Assessment; Summary Report on the Top 100 Chinese Listed Companies for 2009, Beijing (2009), available at 13–16. 250 The continued dominance of the state-owned sector in China should not be under-estimated. See Xiao Geng, Xiuke Yang and Anna Janus, ‘State-owned Enterprises in China, Reform Dynamics and Impacts’, in Ross Garnaut, Ligang Song and Wing Thye Woo (eds), China’s New Place in a World in Crisis, Chapter 9, (2009) published ANU e-press, available at , noting that in 2007 state-owned enterprises comprised 70 per cent of the top 500 Chinese enterprises, owning 94 per cent of the assets, p. 158; Standard & Poors, S&P Transparency and Disclosure Survey by Chinese Companies 2008 (2009), available at , including 237 SOEs (central and local) in the top 300 Chinese companies in 2007; Chinese Academy of Social Science survey, above n 221, counting 31 out of the 100 top listed Chinese companies in 2008 as state-owned.

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includes a relationship that may lead to the transfer of shares in the company (Article 217).251 If they do use their affiliation in such a manner, they are liable to compensate the company. The Second Interpretation of the Company Law252 (Article 23) places obligations on controlling shareholders or de facto controllers of listed companies in relation to failures to act properly in the liquidation process. A ‘controlling shareholder’ is generally a person with 50 per cent of the voting rights, but also includes a person with a substantial interest (Article 217). A ‘de facto controlling person’ is defined quite broadly as a person capable of controlling the company through agreements or some other means (Article 217). Under Article 20, any shareholder of the company who abuses ‘shareholder rights’ to ‘harm the interests of the company or other shareholders’ is liable to pay compensation to the company or the other shareholders. If it ‘abuses the independent status of the company legal person and the limited liability of shareholders’ to evade debts and seriously harm the interests of the creditors of the company, it may also be jointly liable with the company to the creditors. Although this provision is not restricted to controlling shareholders, it seems likely that a majority or controlling shareholder would be the most likely to be in a position to abuse its shareholder rights. Although it can be assumed that the purpose of this provision is to provide a legal basis for the piercing of the corporate veil on a suitable occasion, the basis upon which a court might make such a decision is not at all clear from the language of the section.253 It seems, however, that together with Article 64, which provides creditors with a remedy in circumstances in which the shareholder of a single shareholder company intermingles his or her assets with company assets, an important purpose of this provision is the protection of creditors, not just other shareholders or the company itself. The Company Law also provides two further protections for shareholders. The first of these applies only to limited liability companies. Article 75 gives a dissenting shareholder the right to require the company to buy it out in certain limited circumstances: when there has been no distribution of dividends for five years, the company is about to merge or transfer major property, or the other shareholders vote to extend the term of a limited operation company. The Article is vague on the mechanism and procedures for the buy-out, which is a concept that sits uncomfortably with the limited liability company, an entity having only registered capital. Presumably, the shareholders of the company must vote to reduce the registered capital of the dissenting shareholder and to pay the shareholder an agreed amount, which may be greater or lesser than the paid-in amount of registered capital. It does, however, provide an enforcement mechanism, since if the company and the dissenting shareholder do not agree 251 It should, however, be noted that Art 217(4) provides that there is no affiliation between two state-owned enterprises merely by virtue of the fact that the state controls both enterprises. 252 Supreme People’s Court, Provisions of the Supreme People’s Court on Some Issues about the Application of the Company Law of the People’s Republic of China (II) (12 May 2008, effective 19 May 2008). 253 Mark Wu,‘Piercing China’s Corporate Veil; Open Questions from the New Company Law’ (2007) 117 Yale Law Journal 329.

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upon a price within 60 days of the date of the shareholders’ resolution, the shareholder has a 30-day period within which it may institute proceedings in a people’s court. It is not clear what the court will do to resolve the dispute. Article 183 applies to both limited-liability companies and joint-stock companies. It gives shareholders holding 10 per cent of the voting rights of a company the right to petition the court for dissolution of the company where ‘there are serious difficulties in the operation and management of the company and the continued existence will cause major losses to the rights and interests of the shareholders, and they cannot be resolved through other means’. The Second Interpretation of the Company Law fleshes out this provision and clarifies that it will apply in circumstances in which operation or management of the company is dysfunctional; that is, when the company has been unable to hold a shareholders’ meeting for two years, it has not been possible to form a quorum for two years, there is a longstanding dispute between the directors, which the shareholders cannot resolve, or there are other major difficulties in the company’s operation or management causing material losses to the interests of the shareholders (Article 1). In addition to these specific provisions, it should be noted that the institution of the supervisory board, as well as the requirement for a listed company to have independent directors, is intended to have some impact on the controlling shareholder issue. The requirement in the Code of Corporate Governance that a company with a controlling shareholder holding more than 30 per cent of the equity should institute a system of cumulative voting,254 as well as the provision in Article 106 of the Company Law that a listed company may institute cumulative voting for directors and supervisors, is designed to ensure that minority shareholders have representation on the board of the company. The major issue has, however, been the listing of companies that were converted or created from state-owned enterprises and in which the majority shareholder is the state. The Code of Corporate Governance sets out the basic requirement that the corporate governance structure of a listed company ‘shall ensure equal treatment toward all shareholders, especially minority shareholders’ (Article 2). Chapter 2 of the Code deals with the question of restructuring companies that propose to list, and was clearly directed at the issue of state-owned enterprises being restructured into listed companies. Thus, it requires the stripping out of social functions and non-operational assets (Articles 15 and 16) and the conversion of other units into specialised companies that may provide services to the listed company (Article 17). Separation of the listed company from the controlling shareholder is mandated by Articles 22 to 24. Article 21 provides that the controlling shareholder must not interfere with the company’s decisions or business activities, or impair the interests of the company or the other shareholders. Article 27 provides that a controlling shareholder must not engage in the same or similar business to the listed company and that a controlling shareholder must adopt measures to avoid competition with the listed company. 254 Article 31.

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The stock exchanges have also included provisions in their listing rules to deal with the conflicts of interest that arise when a listed company has a controlling shareholder or de facto controller.255 For example, the Shanghai Stock Exchange Rules require a lock-up for shares of a controlling shareholder for a set period after listing.256 They also control transfers of shares by the controlling shareholder or de facto controller of the company.257 Other detailed requirements deal with the disclosure and handling of related party transactions, including preventing a related director from voting on the transaction in a board meeting and preventing related shareholders from voting in a shareholders’ meeting. Similarly, disclosure must be made of guarantees granted to related parties.258 A more comprehensive solution to the controlling shareholder issue, at least in relation to state-owned shares, would be for the state to cease holding majority interests in major listed companies.259 In this respect, the decision by the State Council260 to end the distortions in the market caused by the distinction between tradable and non-tradable shares provides a possible answer by allowing for the reduction of the stakes held by controlling shareholders. In practice, however, it is unlikely that this will be the effect. Under the key pillars policy,261 the government intends to maintain state control over certain sectors of the economy, such as oil, gas and telecommunications, and in many of these sectors there are listed companies in which shares have been sold to the public.262 The effect of the key pillars policy will be that the public will continue to hold a minority of shares.

13.5.10 Improved disclosure requirements Chinese legislators and regulators have recognised that access to current and reliable information is essential for shareholders of all kinds. Thus, the Company 255 The definition of these terms follows the Company Law, although ‘control’ is defined in more detail. Shanghai Stock Exchange Listing Rules, Art 18.1, English version available at . 256 Shanghai Stock Exchange Listing Rules, Art 5.1.5 (36-month lock up). 257 Shanghai Stock Exchange Listing Rules, Chapter 9. 258 Shanghai Stock Exchange Listing Rules, Chapter 10. ‘Related party’ is defined widely, but it should be noted that two parties are not considered to be related merely because they are under the same state assets administration, unless the chairperson, general manager or more than half of the directors serve as directors, supervisors or senior officers of the listed company (Chapter 10.1.4). 259 See, for example, recommendation by Geng et al., above n 250, recommending the reduction of state ownership to less than 30 per cent, p169. 260 State Council, 9 Opinions on Expediting Reform and Development of Capital Markets (4 February 2004). See Kister, above n 214. 261 State Council, Circular of the General Office of the State Council Concerning Transfer of the Opinions of the SASAC on Guidance for Promotion of Adjustment of State-owned Assets and Restructuring of State-owned Enterprises (5 December 2006). 262 These include such companies as CNOOC Ltd (Zhongguo Haiyang Shiyou Youxian Gongsi), listed on The Stock Exchange of Hong Kong and the New York Stock Exchange, indirectly 64.41 per cent owned by CNOOC as of May 2009 (see CNOOC Ltd, Explanatory Statement relating to General Mandates to Issue Securities and Repurchase Shares and Re-election of Directors and Amendment to the Articles of Association, available at ); China Telecom Corporation Ltd (China Telecom, Zhongguo Dianxin), listed on The Stock Exchange of Hong Kong and the New York Stock Exchange, 70.89 per cent owned by China Telecommunication Corporation (see ).

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Law and the Securities Law provide for the disclosure of information – to shareholders in the case of the Company Law and to the public and hence investors in the case of the Securities Law. The 2005 amendments to the Company Law expanded the ability of the shareholders to obtain access to information. Article 34 gives shareholders in limited liability companies rights to see the articles of association, minutes of shareholder meetings and supervisors’ meetings, resolutions of the directors and the financial and accounting reports of the company, as well as the right to see the account books (under some conditions). Article 98 gives shareholders in joint stock companies the right to examine the articles of association of the company, the register of shareholders, counterfoils of corporate bonds, minutes of shareholders’ general meetings, minutes of the meetings of the board of directors, minutes of the meetings of the supervisory board, and financial and accounting reports, as well as the right to offer suggestions in relation to or inquire about the operation of the company. Under Article 125, the secretary of a joint stock company is required to handle the provision of information as required under the Company Law. The Securities Law not only provides for specific disclosures of information, but also requires continuing disclosure of information (Chapter 3). All such information must be authentic, accurate and complete (Article 63). Chapter 3 also requires annual reports, interim half-yearly reports and the disclosure of major events that may affect the trading price of a listed company’s shares (Article 67), including changes in business scope, major investments or assets purchases, major contracts, the incurrence of or failure to pay major debts, major losses, major changes in circumstances, changes in directors or one-third of the supervisors or managers, major changes in shareholdings (by shareholders holding 5 per cent or more of the company’s shares), changes in capital or an application for bankruptcy, major litigation, criminal investigation of the company or its officers and so on. Failure to disclose information, or to disclose it accurately, may result in the imposition by the CSRC of a fine and an order to correct the information, on the issuer, a person responsible for disclosure and a controlling shareholder or de facto controller who is responsible for the omission or provision of incorrect information (Article 193). These requirements are further fleshed out in the 2007 Measures on Administration of Information Disclosure of Listed Companies263 and the stock exchange rules. A 2009 survey on transparency and disclosure in 2008 by the top 300 Chinese companies264 criticises disclosure by these companies, particularly in the areas of business operations, director nominations (which continue to be controlled by the majority shareholder) and information on remuneration, although disclosure on ownership concentration was considered to be relatively good. Interestingly, disclosure by state-owned enterprises, particularly centrally controlled 263 CSRC, Measures on Administration of Information Disclosure of Listed Companies (30 January 2007). 264 S&P Survey, above n 250.

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state-owned enterprises, was of a higher standard than that of private companies (other than joint ventures or university owned companies).265

13.5.11 Imposing additional requirements on the sponsors of public offerings Another way in which the CSRC has attempted to deal with the question of corporate governance is to impose additional obligations on the sponsors of a listing. The 2008 Measures for the Administration of the Sponsorship of the Offering and Listing of Securities266 replace and strengthen the previous legislation.267 The Measures require issuers to engage a qualified securities company to act as its sponsor for a public offering or offering of new shares or bonds (Article 2). A securities company proposing to act as a sponsor must be approved by the CSRC (Article 3). In order to qualify, the company must submit, among other things, evidence of its own corporate governance and internal control systems (Article 10). The sponsor’s duties include conducting a full investigation of the issuer (Article 24); providing guidance and training to the issuer and its directors, supervisors, senior managers and shareholders holding more than 5 per cent of the shares (Article 25) and satisfying itself that the issuer complies with laws, administrative regulations and CSRC provisions before it sponsors the offering (Article 28). The sponsor is also responsible for post-initial public offering guidance for a period of at least two years (Articles 35 and 36), during which its responsibilities include the implementation of internal control systems in the issuer, including a system guarding against the controlling shareholder, de facto shareholder or other affiliated persons from appropriating the issuer’s resources. If the sponsor subsequently believes that the issuer may have violated laws or committed another ‘improper act’, it must procure an explanation and a rectification and, if the matter is serious, report it to the CSRC and stock exchange (Article 57). The sponsor and its officers may be subject to penalties ranging from an order to rectify, warnings, being declared ‘persona non grata’, administrative penalties or criminal penalties, and suspension from qualification to act as a sponsor (Articles 66 and 67 et seq).

13.5.12 Higher standards of accounting Efforts have also been made to improve the accounting standards of listed companies, by requiring independent audits and by moving towards the adoption of standards that are closer to international standards from the beginning of 265 Ibid. 266 CSRC, Measures for the Administration of the Sponsorship of the Offering and listing of Securities (17 October 2008, effective 1 December 2008, amended 13 May 2009, effective 14 June 2009). 267 CSRC, Tentative Measures for the Sponsorship System for Issue and Listing of Securities (28 December 2003); CSRC, Measures for the Provision of Guidance for Initial Public Offerings of Shares (16 October 2001).

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2007.268 The CSRC has been engaged in a process of supervising the annual reports of listed companies to review compliance with the new accounting standards.269

13.5.13 Direct intervention – the case of dividends The multifaceted approach to regulation outlined above focuses on general principles of corporate governance, with a strong emphasis on the implementation of adequate internal control and corporate governance systems. The question of how best to enforce these requirements, however, continues to present difficulties. An interesting example of the issues presented by the many methods of regulation and enforcement is presented by the issue of the declaration of dividends, which has proved to be a longstanding issue for shareholders, and which has apparently not been resolved by compelling Chinese companies to adopt better internal systems of management or corporate governance. Many Chinese companies historically have been reluctant to pay dividends. The division of functions between the board of directors and the shareholders’ meeting set out in the Company Law does not address this issue, since although the shareholders have the power to approve the plan for distribution of profits, it is the responsibility of the directors to formulate the plan in the first place (Articles 38 and 47). The Company Law recognises that this can be a problem in the case of a limited-liability company by giving the dissenting shareholder a right to be bought out where a profitable company has not distributed profits for five years (Article 75). Shareholders in a joint-stock company do not have a similar right under the Company Law. The Chinese Academy of Social Science report on corporate governance in the top 100 Chinese listed companies in 2008270 notes that only about 10 per cent of Chinese listed companies pay dividends regularly. In 2008, only 13 of the top 100 listed companies paid dividends at all, and of those only two paid more than 10 per cent of their profits in the form of dividends – well below world-market norms. In response, the CSRC has imposed a number of additional requirements on listed companies to compel them to declare and pay dividends. These include requiring listed firms that apply to make a new share issue to have paid out dividends in cash equal to not less than 30 per cent of distributable profits over the previous three years and requiring companies to disclose in their annual report their profit distribution plan, with an explanation for any decision 268 For reasons of space, these requirements are not discussed in detail here. See, however, Noelle Trifiro ‘China’s Financial Reporting Standards: Will Corporate Governance Induce Compliance in Listed Companies?’ (2007) 16 Tulane Journal of International and Comparative Law 271. See also CSRC Report 2008, 78 et seq. 269 See, for example, CSRC, ‘Answers by Principal of CSRC Accounting Department to Questions by Correspondent on Supervision over Listed Companies’ Annual Reports of 2008’ (22 August 2009), English version available at . 270 Above n 221, 12.

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not to distribute dividends.271 A similar issue in relation to unlisted state-owned enterprises was dealt with in 2007 by the Implementing Regulations on the Management of Income and Receipts from the State-owned Assets of Central Enterprises,272 which required the centrally controlled, state-owned enterprises to pay a specified percentage of their profits as dividends. The need to address this issue directly strongly suggests that the efforts made in the Company Law and by the CSRC and the stock exchanges to promote corporate governance through a variety of efforts is having only mixed success.

13.5.14 Enforcement A major issue in relation to corporate governance in China is the question of enforcement – whose responsibility it is and should be, how effective it is and how enthusiastically breaches of relevant legislation are pursued. As noted above, there are a variety of different remedies for breaches of corporate governance requirements and a variety of entities that have responsibility for enforcement. Penalties may include warnings, reprimands, public criticisms, bannings, the imposition of fines and administrative penalties and criminal prosecution. Civil remedies may be sought by aggrieved shareholders through the courts under the Company Law and the Securities Law. Cases involving state-owned and other enterprises may involve action by the SASAC or an equivalent state-owned asset administration and, where they involve Communist Party members and government interests, it can be expected that the Communist Party and other parts of government will become involved in investigation and the ultimate determination of cases.273

13.5.15 Consequences of breach The Chinese system has traditionally not relied on shareholders or the courts to enforce systems of corporate governance. Indeed, historically the legislature and the courts generally have been reluctant to encourage shareholder litigation against listed companies in particular.274 The amendments to the Company Law in 2005 opened up various possibilities in relation to shareholder litigation, although as discussed above, the preference is clearly for action to be taken by the directors or supervisors of a company rather than by the shareholders. The shareholders are, however, empowered to sue directors or officers for actions contrary to law or the articles of association that harm the interests of 271 CSRC, The Decisions on Amending Some Provisions on Cash Dividends by Listed Companies (7 October, 2008, effective 9 October 2008); see also Bi Xiaoning, ‘State Firms Urged to do More Dividend Spread’ (2 July 2009), China Daily, available at . 272 Ministry of Finance and State-owned Assets Supervision and Administration Commission of the State Council, Implementing Regulations on the Management of Income and Receipts from the State-owned Assets of Central Enterprises (21 December 2007). 273 See Cheng, above n 219. 274 Wang, above n 186. See also Marlon Layton, ‘Is Private Securities Litigation Essential for the Development of China’s Stock Markets?’ (2008) 83 New York University Law Review 1948.

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shareholders under Article 153. Under Article 22, a shareholder may institute litigation to have declared void a resolution or action of the company where the procedure or method of voting contravenes laws, regulations or the Articles of the company, although the court may require the shareholder to provide security for the action. For shareholders in limited-liability companies, in fact, few remedies other than litigation are available in the absence of a regulator with overall responsibility for shareholders in companies of this kind. The concept of enforcing shareholder rights through litigation by shareholders in listed companies is often attractive to Western commentators, who see in the provisions of Articles 152 and 153 of the Company Law275 an opportunity for the development of shareholder activism.276 There is, however, little evidence that these provisions have been effective in encouraging shareholder actions. In the period 2001 to 2003, the Supreme People’s Court severely restricted the ability of shareholders to bring actions (limiting the types of cases that could be brought and requiring that the CSRC should first have made a determination on corporate wrongdoing before the shareholders could seek compensation).277 A circular issued by the Supreme People’s Court and other regulatory and judicial bodies in 2008 acknowledges the right of shareholders to seek compensation from the courts, but focuses on investigation and punishment of illegal securities action by regulatory authorities rather than on the question of compensation of victims.278 At this stage, therefore, it does not seem likely that court action will become a major method of enforcement of shareholder rights, at least in the near future.279 A major way in which China deals with cases of corporate malfeasance of various kinds is through the criminal system, although it is questionable whether the emphasis on criminal prosecutions rather than civil actions provides an adequate remedy to the shareholders. The use of criminal law is, however, a basic tool in dealing with securities and companies in China. In particular, the Criminal Law (as amended in 2006 and 2009)280 includes detailed provisions imposing 275 See also the Securities Law. Article 47 gives shareholders the right to institute suit in their own name in the interests of the company if a director, officer or major shareholder breaches the six-month lock up on the sale of shares and the directors fail to take action to confiscate the proceeds. Article 235 gives a concerned party the right to appeal against a decision of the CSRC or other administrative body, either by way of administrative review or litigation. 276 See Jiong Deng, ‘Building an Investor-Friendly Shareholder Derivative Lawsuit System in China’ (2005) 46 Harvard International Law Journal 347; Wang, 2008, above n 186. 277 Layton, 2008, above n 274. For an interesting illustration of a Chinese securities case, see Chao Xi, ‘Case Note: Private Enforcement of Securities Law in China: Daqing Lianyi Co v ZHONG Weida and Others (2004), Heilongjiang High Court’ (2006) 1 Journal of Comparative Law 492. 278 Supreme People’s Court, Supreme People’s Procuratorate, Ministry of Public Security and China Securities Regulatory Commission, Circular on the Relevant Issues on the Suppression of Illegal Securities Activities (2 January 2008). Article 6 provides that victims of securities crimes should seek compensation through criminal procedures for recovery; victims of general legal violations may seek compensation as set out in the Civil Procedure Law. 279 See Randall Peerenboom, ‘Between Global Norms and Domestic Realities: Judicial Reforms in China’, available at for a thoughtful discussion of the development of the judicial system in China. 280 Standing Committee of the NPC, Criminal Law of the People’s Republic of China, Amendment No. 6 (19 June 2006); Standing Committee of the NPC, Criminal Law of the People’s Republic of China, Amendment No. 7 (28 February 2009).

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penalties of up to 10 years’ imprisoment for serious cases of insider trading (Article 180), three years for false or misleading disclosure of financial information (Article 161) and three to seven years for market manipulation by a director, supervisor, officer or controlling supervisor causing serious harm to a listed company (Article 169), as well as other crimes of management malfeasance by such a person, and up to five to 10 years for serious cases of market manipulation (Article 182). The 2008 Supreme People’s Court Circular referred to above focuses on the transfer of shares to the public without approval; issuing securities without approval and unlawful operation of securities business as matters of the greatest concern. The CSRC is primarily responsible for pursuing these cases, in conjunction with other bodies such as the procuratorate and the public security bureau, although its ability to do so effectively is arguably limited not only by resources but the difficulty for Chinese regulators in pursuing government officials and businesspeople with strong connections to government.281 The CSRC is able to investigate and issue administrative sanctions282 (including orders for rectification, confiscation of illegal proceeds and fines) and to impose a ban on persons or organisations from entering the securities market. According to its 2008 report,283 107 new cases were registered in 2008 involving insider trading (34 cases), market manipulation (12 cases), fraudulent disclosure (15), illegal investment advice (19 cases) and other misconduct (27 cases). In the course of the year, the CSRC closed 130 cases, placed 157 under informal investigation, transferred 210 to public security authorities and imposed 77 administrative penalties or market entry bans. RMB 320 million was confiscated (of which RMB 250 million was actually collected or frozen).284 The courts pronounced judgments in approximately 20 cases of illegal securities activities. The stock exchanges also have powers in relation to listed companies, including the ability to suspend trading and issue other sanctions in the form of suspension, delisting and other warnings or sanctions. However, the stock exchanges are essentially still subordinate to the CSRC, even though they are notionally independent.285 It is, of course, difficult to make an accurate assessment from these statistics of how effective securities enforcement is in China, and opinions vary widely.286 It has been argued that reputational sanctions such as public criticisms issued by the 281 See Cheng, above n 219. 282 Securities Law, Art 179. 283 CSRC Annual Report 2008, 34–6. 284 By way of comparison, the Australian Securities and Investments Commission 2008–2009 reports the completion of 39 criminal cases, 35 civil proceedings, the recovery of AUD 14.5 million and the freezing of AUD 13.8 million in assets (a total of approximately RMB 176 million). See ASIC Annual Report 08-09 on the ASIC website at , 16 et seq. 285 See Shi, above n 215 on the relationship between the CSRC and the stock exchanges in China. See also Benjamin Liebman‘Reputational Sanctions in China’s Securities Market’ (2008) 108 Columbia Law Review 929 at 945. 286 See Peng Sun and Yi Zhang, ‘Is There Penalty for Crime: Corporate Scandal and Management Turnover in China’, available at , casting doubt on the effectiveness on punishment of managers in Chinese companies; Gong-meng Chen, Michael Firth, Ning Daniel Gao and Oliver M Rui, ‘Is China’s Securities Regulatory Agency a Toothless Tiger? Evidence from Enforcement Actions’, available at concluding that CSRC enforcement is effective.

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stock exchanges are effective in encouraging listed companies to improve their standards of corporate governance, due to the impact on the share price and on such matters as access to financing.287 It is also important not to under-estimate the greatly increased availability of information on the internet in China, through government websites and blogs, and the reporting of business and economic issues as a result of which information on the stock markets and the behaviour of companies and their executives is published more rapidly and read more widely.288 Finally, the role of publicity, education and training should also not be underestimated. The existence of regular studies and surveys on corporate governance of Chinese companies puts pressure on listed companies to implement corporate governance systems. Websites of listed companies include information on corporate governance and corporate social responsibility systems.289 Continued emphasis on corporate governance in the form of regulations and notices from all relevant regulatory authorities also impose continuing pressure on companies to improve their systems of internal management and control.

13.5.16 Conclusions on China Legislative and regulatory authorities in China have made extensive efforts to formulate and implement an adequate system of corporate governance. There continue to be a number of pervasive issues, however, in relation to corporate governance in China. These include the questions of clarity and internal consistency in the corporate governance system (of which the conflicting role of the supervisory board and the independent directors is a good example), the involvement of multiple enforcement authorities, primarily the CSRC, the stock exchanges, the public security bureau, police and procuratorate (in relation to criminal prosecutions) and the courts (in relation to private enforcement actions) and inconsistent enforcement. In particular, the close relationship between the state and its instrumentalities and corporate entities in China continues to cause difficulties in establishing a functioning system of corporate governance and in enforcing the system that has been established. Suggestions as to the best way in which to resolve these various issues and create a workable and comprehensible system range from privatisation,290 encouraging private enforcement,291 following the Taiwanese example by establishing a government-sanctioned non-profit organisation to support shareholder litigation292 and providing additional resources to the CSRC to strengthen its 287 See Liebman, above n 285. 288 See also comments in Colon Hawes and Thomas Chiu, ‘Flogging a Dead Horse? Why Western-style Corporate Governance Reform Will Fail in China and What Should be Done Instead’ (2006) 20 Australian Journal of Corporate Law 20 at 25–54. 289 Although note that the S&P survey suggested that information from regulatory sources and annual reports is considerably more comprehensive than information on company websites. Above n 250, 2. 290 Geng et al., above n 250. 291 Huang, above n 237. 292 Wang, above n 186.

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enforcement efforts,293 to changing the entire approach to corporate governance and focusing instead on increasing public scrutiny, executive qualifications and business ethics.294 The Chinese government will not, it is clear, resolve the issue of state control of major companies by simply engaging in massive privatisation programs. Government policy is that state-owned enterprises will continue to be a participant in the marketplace for some time to come, despite the structural reforms that have resulted in state shares becoming tradable and therefore theoretically disposable.295 It also seems doubtful at this stage that private enforcement through the court system will become an important method of enforcing accountability on major enterprises. For shareholders in small, privately held companies, however, in the absence of a regulator with an interest in minority rights within small companies, stronger and more active courts, willing and able to enforce the rights granted to shareholders under the Company Law, are vital and the Supreme People’s Court has shown some willingness to expand the activities of the court in order to assist smaller companies with claims under the Company Law.296 However, until the courts are prepared to accept and deal with major and complex securities cases in ways that may be generally unpopular with major companies, private litigation is unlikely to have a major impact on the wider market for tradable shares. It is also questionable whether reputational sanctions and a focus on business ethics alone, without the strong threat of investigation, sanction or prosecution, would be more effective than the current system, which combines all of these different methods of dealing with corporate governance issues. Overall, it must be a major element in corporate governance implementation and reform to convince company management that good corporate governance is good for the company and for their own future. Improving the resources available to the CSRC, allowing CSRC regulators greater independence in aggressively and publicly297 enforcing securities laws against offenders and giving the stock exchanges more power to deal with offences and offenders is, in our opinion, essential in dealing with egregious offenders. The experience of securities and financial markets world-wide in the course of the global financial crisis has made abundantly clear that there are no simple answers to the issue of corporate governance. Despite the recurring problems in the system and the shortcomings in such corporate structures as the supervisory board and the independent director system, the multifaceted approach taken by legislators, regulators and company management in China has resulted in 293 Cheng, above n 219. 294 Hawes, above n 288. Hua Cai, ‘Bonding, Law Enforcement and Corporate Governance in China’ (2007) 13 Stanford Journal of Law, Business and Finance 82. 295 See Kister, above n 214, on the share reform program pursuant to which government-owned shares have been converted into shares that are tradable (at least in theory). 296 See, for example, Supreme People’s Court, Provisions of the Supreme People’s Court on Some Issues about the Application of the Company Law of the People’s Republic of China (II) (2008), which expands the ability of the court to order a winding up in situations of management breakdown or deadlock. 297 See Liebman, above n 285, on the significance of public sanctions.

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considerable progress in persuading Chinese companies of the importance of a stronger corporate governance regime.298 The continuing stresses in the system due to the continuing role of state-owned enterprises in the economy and the market, the influence of government and Party in the judicial and enforcement system and the competitiveness of the markets, however, mean that the implementation of a strong corporate governance system will continue to present challenges for the future.

13.6 Conclusion In this chapter we have dealt with the OECD principles of corporate governance as guiding principles spanning across unitary and two-tier board structures, and also across various jurisdictions. In short, these principles apply internationally and they are based on international best practices in corporate governance, irrespective of which particular company law model is followed. The German corporate governance system is unique because of the very specific and rather rigid requirements for public companies and large proprietary companies. They must have a two-tier-board system (management board and supervisory board) and there must be employee representatives on the supervisory board, although the number varies from industry to industry and also depends on what type of company is involved. The introduction of the German Corporate Governance Code in 2001 added a new dimension to German law by expecting listed companies to comply or disclose if they do not comply. It ensures that contemporary and international best practices in corporate governance have been able to be identified and promoted for listed companies through the German Corporate Governance code that has been updated and refined annually since 2005. There is little doubt that the issue of employee participation at supervisory board level, or co-determination, is still one of the most controversial issues facing German corporate law and corporate governance. As far as Japan is concerned, we have pointed out that corporate law and practice have long attracted considerable attention among foreign commentators. Much of the commentary increasingly refers to ‘corporate governance’, reflecting the emergence of this broader term world-wide since the 1980s (outlined in Chapter 1). Contemporary corporate law analyses and discussions focused on Japan have long tended to adopt a broader perspective. This reflects an awareness of the pervasive but typically informal role of stakeholders in firms other than shareholders, especially core ‘lifelong’ employees, ‘main banks’ and ‘keiretsu’ corporate groups. The two still-important and quite distinctive monitoring mechanisms in Japanese corporate governance also remind us that government policy and the vicissitudes of politics are as important as economics and broader social or cultural context in explaining and predicting trajectories. Nonetheless, a gradual 298 As indicated by the Academy of Social Sciences Report, above n 221.

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transformation seems to be under way even along these two dimensions, in parallel with more significant changes in the relationship between shareholders and directors or managers. We have seen that corporate law and corporate governance in China have been influenced by a variety of factors: the traditional dominance of the stateowned sector and the continuing ideological commitment by policy makers to the ‘socialist market economy’; the decision by the government to attract foreign capital by encouraging the establishment of foreign-invested companies in China. The adoption of the Companies Law 1993 can be seen as a highlight in the corporate law and corporate governance developments in China. In 2005, there were considerable amendments to the Companies Law 1993, in particular as far as the duties of directors were concerned and also the role and function of independent directors. Elements of the German two-tier board system and outside or independent directors from the Anglo-American corporate governance model can be identified for certain types of Chinese companies. It has been pointed out that legislative and regulatory authorities in China have made extensive efforts to formulate and implement an adequate system of corporate governance. There continues to be a number of pervasive issues, however, in relation to corporate governance in China. These include the questions of clarity and internal consistency in the corporate governance system (of which the conflicting role of the supervisory board and the independent directors is a good example), the involvement of multiple enforcement authorities, primarily the CSRC, the stock exchanges, the public security bureau, police and procuratorate (in relation to criminal prosecutions) and the courts (in relation to private enforcement actions), and inconsistent enforcement. In particular, the close relationship between the state and its instrumentalities and corporate entities in China continues to cause difficulties in establishing a functioning system of corporate governance and in enforcing the system that has been established. Overall, it remains a major element in corporate governance implementation and reform in China to convince company management that good corporate governance is good for the company and for their own future. It was also observed that the continuing stresses in the Chinese corporate system, due to the continuing role of state-owned enterprises in the economy and the market, the influence of government and Party in the judicial and enforcement system and the competitiveness of the markets, mean that the implementation of a strong corporate governance system in China will continue to present challenges for the future.

PART FOUR BUSINESS ETHICS AND FUTURE DIRECTION

14 The ethical obligations of corporations The social responsibility of business is to increase profits. Milton Friedman, The New York Times, 13 September 1970

Ethics deals with values, with good and bad, with right and wrong. We cannot avoid involvement in ethics for what we do – and what we don’t do – is always a possible subject of ethical evaluation. Anyone who thinks about what he or she ought to do is, consciously or unconsciously, involved in ethics. Peter Singer, A Companion to Ethics, Oxford, Blackwell (1991), v

14.1 Introduction – the nature of morality Until now, this book has focused on the legal rights and duties of those involved in the governance of companies. This chapter examines not what the law stipulates as expected of those involved in corporate governance, but the ethical responsibilities of company officers.1 These levels of inquiry, though often overlapping, are quite different. The ultimate aim of the law is to guide and coordinate human behaviour, normally through the threat of coercive measures for violations of legal norms. In order to be effective at shaping human conduct, legal norms must be clear and knowable. Morality is less prescriptive than the law – there is no official sanction or censure involved with breach of moral norms. It is also generally more openended and less clear. This, however, should not stifle the search for moral truths or consensual moral norms. Despite the high level of disagreement about the precise content of moral norms, an important paradigm of moral judgments is that they are (apparently) used in the same manner as factual judgments. We 1 The terms ‘ethics’ and ‘morals’ are normally used interchangeably to mean ‘what people ought to do’. Some writers distinguish between the two terms. In making this distinction, some maintain that morality has a religious connotation, whereas ethics does not, Further, morality is sometimes used to refer to the particular, subjective preferences of people and groups, as opposed to an objective field of inquiry. These distinctions are misguided. Morality, like ethics, is not a localised custom or etiquette. Its rules and principle apply equally to all people. Hence, the distinction between ethics and morality is illusory and is not adopted in this book. The terms are used interchangeably. See further, Peter Singer, Ethics (1994) Chapter 1.

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engage in moral reflection, correction and argument and, as with other areas of human knowledge, there appears to be a slow but evident convergence in our moral judgments. We engage in moral dialogue and thinking in order to evaluate and improve on our own behaviour, and in an endeavour to persuade others to behave in an appropriate manner. Moral norms are also the cornerstone of our legal rules and principles. In this chapter we examine the moral norms that apply to corporations. If it is established that corporations are morally bound by certain norms, this will not, of course, compel company officers to adhere to those norms. They may yet choose to flout morality and be guided solely by their legal rights and duties. However, the law is often driven by moral considerations and, hence, if it is established that certain moral norms clearly apply to corporations, these norms may form the basis for future law reform. While not all laws have a moral foundation (some are purely for coordination purposes, such as driving on the left or right-hand side of the road), it is not easy to provide examples of laws in developed nations that are clearly immoral. Prior to considering the role of ethics in business, we provide a brief overview of the nature of morality. At its most basic level, morality consists of the principles that dictate how serious conflict should be resolved.2 Not every aspect of our lives is governed by morality. As an empirical fact, morality does not dictate what colour shirt we should wear, who gets to watch a television show, or what career we should choose. Morality is not concerned with trivialities. Further, it relates only to situations in which there is an actual or potential conflict of interest between two or more parties – it assesses and weighs the respective interests. In a perfect world, consisting of unlimited resources and no possibility of clashes of interests, morality would be redundant. In a book of this nature it is not possible to provide a systematic or detailed analysis of moral theory. More ink has been spilt on moral theory – perhaps because of its cardinal status in evaluating human conduct – than probably any other social issue. However, it is necessary to make some broad observations regarding the meaning and nature of moral discourse and imperatives. There has been a proliferation of normative moral theories that have been advanced over the past four or five decades. These theories can be divided into two broad groups. Consequentialist moral theories claim that an act is right or wrong depending on its capacity to maximise a particular virtue, such as happiness. Non-consequentialist (or de-ontological) theories claim that the appropriateness of an action is not contingent upon its instrumental ability to produce particular ends, but follows from the intrinsic features of the act.3 The leading contemporary non-consequentialist theories are those that are framed in the language of rights. Following the World War II, there has been 2 Mirko Bagaric, ‘A Utilitarian Argument: Laying the Foundation for a Coherent System of Law’ (2002) 10 Otago Law Review 163. 3 Another normative theory, termed ‘virtue ethics’ focuses on moral character or promoting certain ideals as opposed to duties and obligations.

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an immense increase in ‘rights talk’,4 both in number of supposed rights and in total volume. Rights doctrine has progressed considerably since its original aim of providing ‘a legitimisation of . . . claims against tyrannical or exploiting regimes’.5 There is now, more than ever, a strong tendency to advance moral claims and arguments in terms of rights.6 Despite the dazzling veneer of de-ontological rights-based theories, when examined closely such theories do not provide convincing answers to central questions such as: what is the justification for rights? How can we distinguish real from fanciful rights? Which right takes priority in the event of conflicting rights? Arguably, such intractable difficulties stem from the fact that contemporary rights theories lack a coherent foundation. Attempts to ground rights in ideals such as dignity, concern or respect are unsound and fail to provide a mechanism for moving from abstract ideals to concrete rights.7 A non-consequentialist ethic provides no method for distinguishing between genuine and fanciful rights claims, and is incapable of providing guidance regarding the ranking of rights in the event of a clash. Due to the great expansion in rights talk, rights are now in danger of being labelled as mere rhetoric, and are losing their cogent moral force. Or, as Sumner points out, rights become an ‘argumentative device capable of justifying anything [which means they are] capable of justifying nothing’.8 Therefore, in attempting to uncover the scope and content of corporate ethics it is unhelpful to consider it purely from the perspective of a de-ontological, rights-based normative theory. Against the background of such a theory, consumers coherently are able to declare that their right to essential goods (such as medicines) should be subsidised by companies; shareholders are able to assert that their right to maximise the return on their shares should trump other interests, while directors are able to assert that their right to high salaries for their labour should prevail over other competing interests. Unfortunately, there is no underlying ideal that can be invoked to provide guidance on the issue. As with many rights, the victor may unfortunately be the side that simply yells the loudest. This may seem to be unduly dismissive of rights-based theories and pays inadequate regard to the considerable moral reforms that have occurred against the backdrop of rights talk over the past half-century. There is no doubt that rights claims have proved to be an effective lever in bringing about social change. As Campbell correctly notes, rights have provided ‘a constant source of inspiration 4 See Tom Campbell, The Legal Theory of Ethical Positivism, Brookfield Vermoth, Darmouth Publishing Company (1996) 161–88, who discusses the near-universal trend towards bills of rights and constitutional rights as a focus for political choice. 5 S I Benn, ‘Human Rights – For Whom and For What?’ in E Kamenka and A E Tay (eds), Human Rights, London, Edward Arnold (1978) 59, 61. 6 Almost to the point at which it is not unthinkable to propose that the ‘escalation of rights rhetoric is out of control’: see L W Sumner, The Moral Foundation of Rights, Oxford, Clarendon Press (1987) 1. 7 See Mirko Bagaric, ‘In Defence of a Utilitarian Theory of Punishment: Punishing the Innocent the Compatibility of Utilitarianism and Rights’ (1999) 24 Australian Journal of Legal Philosophy 95, 121–43. 8 Sumner, above n 6, 8–9.

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for the protection of individual liberty’.9 For example, recognition of the (universal) right to liberty resulted in the abolition of slavery; more recently, the right of equality has been used as an effective weapon by women and other disenfranchised groups. For this reason, it is accepted that there is a continuing need for moral discourse in the form of rights. This is so even if de-ontological, rights-based moral theories (with their absolutist overtones) are incapable of providing answers to questions regarding, for example, the existence and content of proposed rights, and even if rights are difficult to defend intellectually or are seen to be culturally biased. There is a need for rights-talk, at least at the ‘edges of civilisation and in the tangle of international politics’.10 Still, the significant changes to the moral landscape for which non-consequentialist rights have provided the catalyst must be accounted for. There are several responses to this. Firstly, the fact that a belief or judgment is capable of moving and guiding human conduct says little about its truth – the widespread practice of burning ‘witches’ being a case in point. Secondly, at the descriptive level, the intuitive appeal of rights claims, and the absolutist and forceful manner in which they are expressed, has heretofore been sufficient to mask fundamental logical deficiencies associated with the concept of rights. Finally, and perhaps most importantly, we do not believe that there is no role in moral discourse for rights claims. Simply, that the only manner in which rights can be substantiated is in the context of a consequentialist ethic.11 A more promising tack for providing concrete guidance regarding competing rights and interests in constructing and justifying a ladder of human rights is to ground the analysis in a consequentialist ethic. The most popular consequentialist moral theory is utilitarianism. Several different forms of utilitarianism have been advanced. In our view, the most cogent (and certainly the most influential in moral and political discourse) is hedonistic act utilitarianism, which provides that the morally right action is that which produces the greatest amount of happiness or pleasure and the least amount of pain or unhappiness. This theory selects the avoidance of pain, and the corollary, the attainment of happiness, as the ultimate goals of moral principle. We are aware that utilitarianism has received a lot of bad press over the past few decades, resulting in its demise as the leading normative theory. Considerations of space and focus do not permit us to fully discuss these matters. This has been done elsewhere.12 The key point to note for the purpose of the present discussion is that for those with a leaning towards rights-based ethical discourse, utilitarianism is well able to accommodate interests in the form of rights.13 Rights 9 Campbell, above n 4, 165. 10 Ibid. 11 See also John Stuart Mill, who claimed that rights reconcile justice with utility. Justice, which he claims consists of certain fundamental rights, is merely a part of utility. And ‘to have a right is . . . to have something which society ought to defend . . . [if asked why] . . . I can give no other reason than general utility’: J S Mill, ‘Utilitarianism’ in M Warnock (ed.), Utilitarianism, Fontana Press (1986, first published 1981) 251, 309. 12 Bagaric, above n 7. 13 Mill, above n 11.

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not only have a utilitarian ethic, but in fact it is only against this background that rights can be explained and their source justified. Utilitarianism provides a more sound foundation for rights than any other competing theory. For the utilitarian, the answer to why rights exist is simple: recognition of rights best promotes general utility. Their origin accordingly lies in the pursuit of happiness. Their content is discovered through empirical observations regarding the patterns of behaviour that best advance the utilitarian cause. The long association of utilitarianism and rights appears to have been forgotten by most. However, over a century ago it was John Stuart Mill who proclaimed the right of free speech, on the basis that truth is important to the attainment of general happiness, and this is best discovered by its competition with falsehood.14 Difficulties in performing the utilitarian calculus regarding each decision make it desirable that we ascribe certain rights and interests to people – interests that evidence shows tend to maximise happiness, even more happiness than if we made all of our decisions without such guidelines. Rights save time and energy by serving as shortcuts to assist us in attaining desirable consequences. By labelling certain interests as rights, we are spared the tedious task of establishing the importance of a particular interest as a first premise in practical arguments.15 There are also other reasons that performing the utilitarian calculus on each occasion may be counter productive to the ultimate aim. Our capacity to gather and process information and our foresight are restricted by a large number of factors, including lack of time, indifference to the matter at hand, defects in reasoning, and so on. We are quite often not in a good position to assess all the possible alternatives and to determine the likely impact upon general happiness stemming from each alternative. Our ability to make the correct decision will be greatly assisted if we can narrow down the range of relevant factors in light of pre-determined guidelines. History has shown that certain patterns of conduct and norms of behaviour, if observed, are most conducive to promoting happiness. These observations are given expression in the form of rights that can be asserted in the absence of evidence that adherence to them in the particular case would not maximise net happiness. Thus, utilitarianism is well able to explain the existence and importance of rights. It is just that rights do not have a life of their own (they are derivative not foundational), as is the case with de-ontological theories. Due to the derivative character of utilitarian rights, they do not carry the same degree of absolutism or ‘must be doneness’ as those based on de-ontological theories. However, this is not a criticism of utilitarianism; rather, it is a strength since it is farcical to claim that any right is absolute. The broader matter to note for the purposes of this book is that as far as implications for corporate ethics are concerned, similar conclusions are reached 14 Ibid. 15 See Joseph Raz, Morality of Freedom, New York, Oxford University Press (1986) 191. Raz also provides that rights are useful because they enable us to settle on shared intermediary conclusions, despite considerable disputes regarding the grounds for the conclusions.

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irrespective of which ethical theory one chooses. While at the foundational level ethical theories often diverge enormously, they often share similar premises concerning the nature of morality and key moral principles. As we shall see below, the view that moral principles are universalisable transcends most moral theories. So, too, does the existence of some core moral principles. Consequentialist and non-consequentialist theories alike place considerable importance on values such as life, liberty and property – although they differ in terms of the absoluteness with which such principles apply. However, the exact points of departure in this regard are not critical for the purposes of the present discussion. The discussion below emphasises a number of moral principles, and in particular ‘the maxim of positive duty’. Thus, we argue that the conclusions we reach concerning the moral obligations of companies follow irrespective of which moral theory is adopted. This chapter is about discovering which, if any, moral duties apply to corporations. Corporate ethics concerns the intersection between corporate activity and normative ethics. This, of course, assumes that ethics and corporate activities do in fact overlap. A tenable argument can be mounted that ethics and corporate activities are parallel areas of human endeavour, which do not intersect. In the next part of this chapter, following a brief history of business ethics, we consider whether the fusion between business and ethics belongs in the realm of reality, as opposed to wishful or ‘virtual’ thinking. In section three we examine the moral rules that govern business in general. The ultimate aim of most corporations is to make money, and hence there would not seem to be a relevant distinction between the ethical constraints that bind the business world in general and the corporate world in particular. Thus, in considering the ethical duties that bind those involved in corporate decision making, we examine the ethical constraints that bind businesses in general. However, in section four we shall see that very successful businesses, which normally operate under a corporate structure, have additional moral duties.

14.2 The threshold issue: Is there a role for ethical considerations in business? 14.2.1 A brief look at the short history of business ethics The notion that businesses have moral duties is becoming increasingly widespread. This has been partly as a result of what appears to be an increasing number of corporate scandals. As noted by Scott Mann: The scandals of Enron, WorldCom, Xerox and Merck are in the headlines: massive accounting frauds involving many billions of dollars of fabricated and inflated profits, assets and revenues through which these corporations with the help of their accountants, have maintained share prices far above those justified by their true financial status, to increase the wealth of existing shareholders (including company executives)

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and to attract new investors. These companies have responded to the public revelations of such practices by sacking thousands of workers to ‘reduce their costs’ (17,000 in the case of WorldCom alone).16

In a similar vein, Gordon Clark and Elizabeth Jonson note that during the past two decades there has been a considerable degree of interest, at least at the theoretical level, in the concept of business ethics. The topic of business ethics has been elevated to the front pages of the mainstream media as a result of events going back to the 1980s, including the 1987 stock market crash (as a result of which billions of dollars were wiped from the resource base of investors); the recession of the early 1990s; the apparent corruption in business, leading to the collapse of personal leveraged empires in Australia, the UK and Canada; 17 and the ruin of once-iconic symbols of the free market such as Lehman Brothers and Bear Stearns during the 2007–9 global financial crisis. Springboarding from this are concepts such as ‘corporate social responsibility’18 (which is discussed further below) and ‘obligations to stakeholders’.19 Laura Nash correctly notes that ‘the topic of business ethics is acknowledged to pervade every area of the corporation just as it is a recurrent theme in media. Corporate codes of conduct are now the norm rather than the exception’.20 However, the link between business and ethics has a very short history. It has been recognised as a genuine form of applied ethics for little more than the past few decades. According to Aristotle, the practice of chrematisike, or trading for profit, was devoid of virtue and engaged in only by ‘parasites’. As is noted by Robert Solomon, this view prevailed until the 17th century.21 Thereafter the attitude towards business quickly changed: John Calvin and then the English Puritans taught the virtues of thrift and enterprise, and Adam Smith canonized the new faith in 1776 in his masterwork, The Wealth of Nations . . . The general acceptance of business and the recognition of economics as a central structure of society depended on a very new way of thinking about society that required not only a change in religious and philosophical sensibilities but, underlying them, a new sense of society and even of human nature. This transformation can be partly explained in terms of urbanization, larger more centralized societies, the privatization of family groups as consumers, rapidly advancing technology, the growth of industry and the accompanying development of social structures, needs and desires.22 16 Scott Mann, Economics, Business Ethics and Law, Sydney, Lawbook (2003) 13. 17 See Gordon Clark and Elizabeth Jonson, ‘Introduction’ in Clark and Jonson (eds), Management Ethics, Sydney, Harper Educational (1995), 11. 18 See for example, Simon Longstaff, ‘About Corporate Social Responsibility’ (2000) 40 City Ethics 1. See more generally list of articles by St James Ethics Centre at . 19 See, for example, Otieno Mbare, ‘The Role of Corporate Social Responsibility (CSR) in the New Economy’ (2004) Electronic Journal of Business Ethics and Organization Studies, available at . 20 Laura Nash, ‘Why Business Ethics Now’ in Clark and Jonson (eds), above n 17, 25. 21 Robert C Solomon, ‘Business Ethics’ in Peter Singer (ed.), A Companion to Ethics, Oxford, Blackwell (1991) 354, 355. 22 Ibid.

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While business has became an acceptable activity it is only recently that a ‘more moral and more honourable way of viewing business has begun to dominate business talk’.23 Although business ethics has a very short and patchy history, Laura Nash notes that some trends have apparently emerged regarding the changing focus of business ethics. In the 1950s, the two major concerns were price-fixing and dehumanisation in the workforce. In the 1960s, constraints were placed on environmentally and socially destructive activities. The 1970s witnessed concerns about bribery following the shift to internationalism, in particular to markets in Asia and the Middle East.24 In the 1980s, the focus shifted from institutional responsibility to the moral capacity of individuals. Thus, there was considerable concern over activities such as insider trading and hostile takeovers, which were marked by a high degree of greed and dishonesty.25 In the early 21st century, greed, sprinkled with an unhealthy dose of dishonesty, is still the major constant that underpins public disillusionment with the corporate governance of many large public companies. This disillusionment has been fuelled by a string of corporate collapses, wiping out billions of dollars of shareholder investment – notable instances being that of Enron, HIH and One.Tel; 26 and a suite of financial institutions that either folded or were subject to government takeover or bail out, including Fannie Mae, Merrill Lynch, Ford, General Motors Chrysler, Freddie Mac, Washington Mutual and AIG during the global financial crisis of the late 2000s. This is nothing new. It seems to be a cyclical event. In the Australian context, about a decade ago even middle Australia was taken aback by the collapses of the Quintex group and the Pyramid Building Society. Company managers continue to be criticised for their apparent inability to look beyond the bottom line of the profit-and-loss statement and, in particular, how this impacts on their personal fortunes. There is also increasing disquiet regarding the huge sums paid to corporate directors, in the form of both salary and wages and severance payments. This reached its peak at the height of the global financial crisis. The USA alone injected nearly $1 trillion in 2008 and 2009 in two stimulus packages designed to improve liquity and confidence in the market. A large portion of these funds were used to prop up crumbling private financial institutions. The community and many world leaders, including United States President Barack Obama and Australian Prime Minister Kevin Rudd, tapped into widely held community sentiment that it is indecent for officers of these failing institutions to be receiving massive sums of public money for (anti-) managing instutions to the brink of financial ruin. Despite the anger and dismay at burgeoning corporate salaries, governments have yet to put in place effective mechanisms to rein in these excesses.27 23 Ibid, 356. 24 For a discussion of the similarities between bribery and networking, see Mirko Bagaric and Leigh Johns, ‘Bribery and Networking: Is There a Difference?’ (2002) 7 Deakin Law Review 159. 25 Nash, above n 20. 26 See, for example, Henry Bosch, ‘The Changing Face of Corporate Governance’ (2002) 25 University of New South Wales Law Journal 270. 27 In January 2010, the Productivity Commission in Australia recommended that directors should be required to stand for re-election if a majority of shareholders reject remuneration reports. The report can be found at .

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14.2.2 The disunity between business and ethics argument Despite the emerging popularity of the notion of business ethics, there is little convergence in opinion regarding the precise moral duties owed by company managers.28 In light of this, and the infancy of the concept of business ethics, many commentators continue to maintain that ethics does not have a role in the corporate world. The duty of a company director, so the argument runs, is to maximise corporate profits within the bounds of the law – no more, no less. The most famous exponent of this argument is Nobel Prize-winning economist Milton Friedman who, in an article in the New York Times over three decades ago titled ‘The Social Responsibility of Business is to Maximise Profits’, stated that company directors are the employees of shareholders and therefore have a fiduciary duty to maximise profits. Directing resources to charities or other social causes is akin to stealing from shareholders. He called business people who defended the notion of corporate responsibility ‘unwitting puppets of the intellectual forces that have been undermining the basis of a free society’. He also accused them of ‘pure and unadulterated socialism’.29 The notion that there may be a contradiction between commercial realities and moral norms has been noted (though not endorsed) more recently in the context of legal practice by Justice Kirby, who ‘has speculated about whether it is possible to maintain noble ideas while practising in the world of commercial realities’.30 Thus, before launching into a discussion of business ethics, the threshold issue that must be addressed is this: does ethics have any role in guiding the decision making of company managers?

14.2.3 Morality applies to business because moral judgments are universalisable A counter to the separateness of business and ethics argument is that it violates a fundamental paradigm of morality. The surface nature of moral language suggests that moral principle is applicable to all forms of human conduct, whether public or private,31 and provides the ultimate evaluative framework by which our behaviour is judged. The notion of contracting out of morality seems untenable. A key feature of moral judgments is that they are universalisable. A judgment is universalisable if the acceptance of it in a particular situation entails that one is logically committed to accepting the same judgment in all other similar situations. Accordingly, whenever one judges a certain action or thing (situation) as having a particular moral status then one is logically committed to 28 For an overview of some of the different theories so far as they apply to business, see Mann, above n 16. 29 As cited in Solomon, above n 21, 360. 30 As cited in J Cain and K Hammond, ‘Tending the Bar: Lawyers are Expected to Act Ethically. Whose Job is it to Ensure They Do?’, The Age (Melbourne), 18 August 2002, 16. 31 For the difference between particular and public reasons, see Stephen Freeman, ‘Contractualism, Moral Motivation & Practical Reason’ (1987) 88 Journal of Philosophy 281.

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the same judgment about any relevantly similar action or situation.32 If an action is morally good or bad, then it is so in all relevantly similar situations in which that action is performed. The context in which an action is performed does not appear to constitute a relevant difference. Deliberately lying to another person is wrong irrespective of whether it is done in private or in the context of sport, politics or other fields of human endeavour. So too, it would seem, in the case of (corporate) business activities. In order to justify the independence thesis, it is necessary to identify a relevant difference between business activities and other activities that are subject to moral evaluation.

14.2.4 Exception to universalisation – activities with internal settled rules? A possible basis for distinguishing business from most other human endeavours – which are clearly subject to moral evaluation – is that business is a ‘self-contained’ activity. That is, it is already governed by relatively settled and clear principles and standards. Moral rules appear to apply most acutely to govern conduct between private individuals, which is largely unregulated by other norms. Thus, it is morally reprehensible to lie, break promises or cheat on our partners, and so on. Business, on the other hand, has its own settled rules and, hence, so the argument goes, there is no scope to evaluate the morality of activities conducted within the scope of business. The boxer who intentionally injures an opponent is immune from moral blame, even though his or her conduct would be clearly reprehensible if performed in a different setting. Corporate and business activities are regulated by extensive and complex legal rules and principles. Hence, just like boxing, the activities performed by corporations should be immune from moral evaluation. This attempt to excise corporations and business from the sphere of moral evaluation fails because it places too much weight on the importance of the existence of established rules. The level of sophistication, organisation or system that underlies an area of human endeavour is generally irrelevant to its amenability to moral evaluation. This is shown by the fact that activities that produce undesirable outcomes – such as drug trafficking, people smuggling and child pornography – do not attract moral immunity irrespective of their level of internal regulation and organisation. There certainly may be instances in which following the rules of an existing rule-governed practice may provide a general immunity from moral blame. Tackling another player in conformity with the rules of soccer, refusing to pass a weak student, serving the first person in a queue are all perfectly justifiable 32 It has been suggested that numerical differences are irrelevant. This refers to specific descriptions of the person, relation or situation. Thus, the fact that the judgment relates to a particular person (such as John Smith), place (such as Melbourne), relation (John’s mother) is irrelevant. Also irrelevant are generic differences: tastes, preferences and desires: see John L Mackie, Ethics: Inventing Right and Wrong, Harmondsworth, UK, Penguin (1977) 83–102.

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actions. However, this has nothing to do with the fact that forms of conduct are regulated by rules (of sport, academia or etiquette), but rather occurs because the rules have been designed in light of pre-existing moral norms, or at least are not morally objectionable in themselves. Similarly, the only reason that boxing is morally acceptable is because the good consequences from it outweigh the bad – the need to respect the autonomy of the boxers weighs more heavily in the moral calculus than the possible harm that might occur as a result of condoning fighting in a controlled environment. Further, those involved in generally non-offensive, rule-governed activities never acquire an absolute indemnity from moral censure. For example, it is reprehensible for organisers of a boxing context to pit a skilled professional fighter against a rank amateur, or for a referee to permit a fight to continue after one boxer clearly has been rendered defenceless. Hence, even in relation to rulegoverned practices that are generally regarded as being morally acceptable, moral norms continue to play a supervisory role. This role is so cardinal that morality remains a constant catalyst for rule changes to the practices – to ensure that they continue to conform to changing, increasingly enlightened, moral standards. It follows that the mere fact that corporations have well-settled rules, procedures and protocols for all aspects of their activities does not provide them with immunity from moral norms. The important question is whether corporations conform to minimal moral standards.

14.2.5 Are moral norms too vague to apply to business? A further rationale that has been advanced in support of the separateness of business and ethics is that morality has no role in business because it is too subjective and, given its indeterminate nature, is incapable of providing guidance concerning business practice.33 To this, there are three counters. First, as one of the authors has previously argued, moral principles are in fact objective, capable of logical proof.34 The mere fact that it is sometimes difficult to find moral answers does not derogate from this – in the same way that difficulties in finding cures for many physical illnesses do not mean that there are not necessarily better forms of treatment. Second, for sceptics who are unconvinced about the objectivity of moral judgments, even if we accept that moral judgments are by their very nature imprecise and often indeterminate, this has not limited their application to other human endeavours and activities, such as politics, law, or even sport. Why then should the situation be any different in the case of corporate business activities? Third, the fact that the moral status of an activity has not been resolved, and the application of moral principles to it has not produced clear standards of 33 Milton Friedman, as cited in Solomon, above n 21, 361. 34 Bagaric, above n 2, 163; Mirko Bagaric ‘Internalism and the Part-time Moralist: An Essay about the Objectivity of Moral Judgments’ (2001) 2 Journal of Consciousness and Emotion 255.

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conduct pertaining to that activity, generally results in increased moral reflection and assessment upon the matter, rather than an abandonment of such discourse. For example, the fact that activities such as abortion and cloning are morally equivocal has proved a catalyst for further moral dialogue and debate on such issues – not less, or none at all. Accordingly, since there is no relevant difference between corporate and business activities and other activities that are regulated by moral principles, the business world is not outside the sphere of morality.

14.2.6 Promise to shareholders to maximise profits as a basis for rejecting application of moral principles to business? A third possible justification for excluding the operation of moral principles to business is the argument that businesses ‘owe’ it to their shareholders and investors to make profit maximisation the cardinal objective.35 ‘Owe’ in this context is used in a normative sense, implying that investors and shareholders invest in businesses in the reasonable expectation that they will be profit-focused and hence it would be morally reprehensible for businesses to act contrary to this – it would violate the moral prescription that one should keep one’s promises. This argument fails for several reasons. First, few investors who put their finances into a business receive an express promise that their funds will be used only to maximise profit.36 It could be claimed that although investors do not receive an express promise as to the manner in which their funds will be used, there is widespread knowledge in the community that the sole aim of business is to maximise profit and hence there is at least a tacit promise to this end. However, even if businesses did promise to investors to use the funds solely to advance profit, this does not justify the harmony thesis. Promise-keeping is not the highest-order moral requirement. It is undoubtedly morally permissible and necessary to break a promise in circumstances in which keeping it would result in significant harm to another person. For example, there is no question that it is appropriate to break a promise to meet a friend or colleague in order to attend to an emergency. Business, too, would be justified in breaking a ‘profit promise’ to shareholders where keeping the promise would violate higher-order moral ideals. In order to get at least some mileage out of the promise to shareholders argument, it could be contended that while the existence of a promise does not absolutely justify the harmony thesis, it goes at least part way to doing so 35 Milton Friedman, as cited in Solomon, above n 21, 354. 36 Christopher Stone, Where the Law Ends: The Social Control of Corporate Behaviour, New York, Harper & Row (1975). Moreover, an increasing number of people want corporations to focus on matters beyond profit making. Mbare, above n 19, notes that: ‘The Millennium Poll on Corporate Social Responsibility, September 1999 conducted by Mitsubishi Corporation found “two in three citizens want companies to go beyond their historical role of making profit, paying taxes, employing people and obeying all laws; they want companies to contribute to broader societal goals”.’

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by providing a prima facie reason that profit maximisation should be the main business goal. However, even this less-ambitious form of the argument fails. It is not true that one always has even a prima facie obligation to uphold a promise. The content of a promise often can affect the reason for keeping it.37 Implicit in the term ‘prima facie’ is the notion that the act it relates to should be done unless there are other more compelling considerations. If even in the absence of other more compelling considerations, the act still should not be performed, due to its abhorrent nature, then the use of the term ‘prima facie’ is not only redundant, but also incorrect. Thus, a corporate officer would not have an obligation to approve the sale of dangerous goods, no matter how profitable the arrangement was to the corporation.

14.2.7 Summary of the general link between business and ethics In all other areas of life, moral principles are the ultimate standards by which we evaluate and assess activities and actions. Business is a label describing one of many types of human activities. Irrespective of how desirable an activity is felt to be, the universalisability and pervasiveness of morality is such that it applies to properly regulate the actions performed within the relevant activity. This is so even in relation to practices such as medicine, law and charitable services. The fact that corporate activities are not different in any relevant sense from the range of activities to which moral principles are applicable means that they too are caught within the sphere of moral evaluation. As such, moral principles are the ultimate evaluative standard of business conduct and should prevail where there is tension between them and business principles. Having dispelled the argument that there is no role for ethics in business, we now turn our attention to the content of the ethical norms that apply in the business setting. Before we discuss business ethics, it is important to note that business ethics is not a stand-alone moral construct, but that it forms part of normal ethics. Fundamental moral principles and major moral theories – already discussed by Bagaric38 – should always be kept in mind when business ethics are considered. As a reminder, there is general consensus that, irrespective of which of the mainstream normative theories one adopts, the following list represents the core moral principles: 1. Do not kill or otherwise violate the physical integrity of others. 2. Do not steal the property of others. 3. Do not lie (this includes keeping promises). 4. Assist others who are in serious trouble, when assistance would immensely help them at no or little inconvenience to oneself (the maxim of positive duty). 37 Chin Liew Ten, ‘Moral Rights & Duties in a Wicked Legal System’ (1989) 1 Utilitas 139. 38 Bagaric, above n 2, 163.

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14.3 Application of moral principles to a business setting 14.3.1 Types of duties imposed on corporations – proscriptions against causing harm, lying and environmental damage already legally enforced According to some commentators, the managers of corporations have extensive moral obligations to all those affected by corporate activities. Robert Solomon believes that ‘managers of corporations have obligations to their shareholders and all other stakeholders as well. In particular, they have obligations to consumers and the surrounding community as well as to their employees’.39 More elaborately, he defines the stakeholders in a company ‘as all those who are affected and have legitimate expectations and rights regarding the actions of the company, including employees, consumers and suppliers as well as the surrounding community and society at large’ – see further our discussions in Chapter 2.40 The content of this obligation to all stakeholders is unclear. Nevertheless, the view that corporations have wide-ranging ethical obligations is shared by a growing number of commentators and members of the public. It is an increasingly popular conception that institutions should be ‘good corporate citizens’ and that they have widespread ‘social responsibilities’. While the exact meaning of such phrases has not been defined, the connotation is clear. Corporations should be managed in such a way that they are socially responsible and do not engage in activities that adversely impact on the interests of others. There are a myriad ways in which companies can damage the interests of others. The most obvious is where a corporation sells or otherwise distributes unsafe products or engages in unsafe practices that place at risk the lives and physical safety of employees. Less extreme, but potentially just as damaging, are practices that are not conducted in a sustainable manner; for example, where corporations exhaust finite resources or destroy culturally or environmentally valuable assets. It has also been suggested that corporations have a duty of candour to all people who may be inclined to invest in them. Finally, it has been suggested that corporations should not only avoid committing harmful acts, but that they have a positive duty to engage in activities that promote desirable social ends. Thus, there are broadly four levels of expectations or duties that can be imposed on corporations: 39 Solomon, above n 21, 361. 40 Ibid, 360. See also Kenneth Goodpaster, who defines a stakeholder in an organisation as (by definition) ‘any group or individual who can affect or is affected by the achievement of the organization’s objectives’. As examples of such stakeholder groups Goodpaster mentions employees, suppliers, customers, competitors, governments and communities: as cited in Marjaana Kopperi, ‘Business Ethics in a Global Economy’ (1999) 4 Electronic Journal of Business Ethics and Organization Studies, available at .

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(i) not to directly harm people (ii) not to engage in activities that are socially or environmentally unsustainable (iii) not to lie or otherwise misrepresent the activities of the corporation and (iv) to engage in activities that are socially desirable – for brevity, we shall call this the duty of benevolence. In determining the nature and scope of moral duties that apply to corporations, the starting point, as we have seen, is that all agents are subject to moral norms and evaluation. Corporations are ultimately a group of people acting towards a common goal. There is no doubt that moral liability applies not only to individual, but also to group actions. Individuals cannot opt out of moral liability by engaging in activities with others. Thus, we see that each individual in a group or ‘gang’ of people that harms others is morally liable for the conduct. This applies irrespective of the size of the group – in some cases even entire nation states can be held to account for the conduct of individuals or groups within the state. The best example of this is the censure that is typically cast upon nations that engage in unjustified war against other states, such as Germany during both world wars, Japan during World War II, Iraq during its occupation of Kuwait and most recently the USA for its ‘coalition of the willing’ invasion of Iraq in 2003. Thus, the collective decision-making and action-taking nature underpinning corporate activities do not provide a relevant basis for limiting the scope of moral duties that apply to corporate agents. Against this background, we see that the first three duties are not highly controversial. All agents have a moral duty not to engage in activities that physically harm others, and not to lie to others. There is also a widespread consensus that we have a moral duty not to damage the environment.41 These duties apply universally and there is no tenable argument for carving out a business exemption in relation to them. In relation to each of these areas, Australia and all developed economies have wide-ranging and settled laws. Developed economies have highly developed and comprehensive product liability laws (to protect consumers) and labour laws (to protect employees), and in most circumstances these operate effectively to discourage corporations from distributing goods that place at risk the physical safety of consumers or from engaging in work practices that imperil the safety of their workers. As we have seen in earlier chapters, there are also strict duties on directors to accurately report on the activities of the corporation and to flag any material changes to the activities of the corporation. In addition, there are widerranging laws, often imposing criminal sanctions (which are often strict liability in nature), that proscribe or limit activities that damage the environment or risk exhausting finite resources. Underpinning and justifying these laws are the moral principles adverted to above. While the overlap between moral and legal duties that apply to companies 41 Although the precise content of this duty is less well developed, see Mirko Bagaric, ‘Environmental Ethics and the Fallacy of Kyoto’ (2005) 12 Buffalo Environmental Law Journal 195.

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relating to dishonesty and activities that cause direct harm to others or that damage the environment is probably not complete, it is certainly extensive. It may be the case that there are some moral gaps in laws proscribing; for example, the sale of dangerous goods; however, these gaps are not evident. If commentators wish to impose a moral duty above and beyond the legal duties that already exist in these areas it is important to note that these must be established by reference to the above theories and principles, and not merely asserted as abstract and standalone claims. Given that there is already extensive legal regulation prohibiting the first three forms of harm listed above42 against all agents, including corporations, the focus of the rest of this chapter is on moral norms that are not legally enforced.

14.3.2 Additional duties imposed on corporations – a duty of benevolence? 14.3.2.1 Acts and omissions doctrine serves to minimise obligations on corporations The fourth and most controversial duty that potentially applies to corporations is a positive duty to be a ‘good corporate citizen’. This imposes on corporations a duty to do more than to simply obey the law. It seeks to impose on corporations an obligation to engage in activities that promote the welfare of the community, including company stakeholders, beyond providing high-quality and safe goods and services. The content of such a duty can vary enormously. A modest expression of the duty would require corporations to treat all their employees with concern and respect; for example, by paying performance-based and end-of-year bonuses. A far more extravagant requirement is in the form that corporations have a positive duty to enhance community and social capital by either directly engaging in benevolent activities or indirectly doing so – by, for example, donating to worthy charities or social causes.43 A duty of benevolence 42 This is obviously not the case in all countries, thus there is a need to carefully consider the moral obligations of businesses in these areas. Such considerations also arise where Australian companies operate internationally. For a discussion about business ethics in the global environment, see Kopperi, above n 40. A particularly important issue in global business ethics concerns the so-called ‘race to the bottom’. This is the view that corporations are forced to compete with lower salaries, taxation, safety regulations and standards for environmental protection. In this kind of system, it has been argued that it is very difficult or even impossible to act in a way that would benefit not only the shareholders but all the stakeholders and the society on the whole. Given the highly regulated trading and labour market in Australia, this is not a problem at the domestic level. 43 The uncertainty relating to the meaning of corporate social responsibility is also noted by Mbare, above n 19, who states: ‘[C]orporate social responsibility is an issue that has dominated many executive discussions in recent times. Indeed, there are differing perspectives on CSR. At one extreme it is argued that CSR is achieved as long as an organization does not disobey the law. At the other extreme it is argued that an organization has a duty to ensure a “good society”.’ He also notes the lack of convergence that exists in relation to this concept: ‘[C]oncepts of the business-society relationship have evolved and expanded over the past five decades – from social obligation and stewardship, to social responsibility and social responsiveness and finally, as Frederick (1994, 1998) suggests, to social consciousness. The literature is replete with theories and models which seek to describe, to explain, and to institutionalize the relationship (Preston and Post, 1975; Frederick, 1984; Steiner, 1997). Brennan suggest that this scholarship has resulted in less business defensiveness, more emphasis on managerial techniques for responding to social issues, and more empirical research on corporate social roles, responsibilities and constraints (see also, Frederick, 1994; Clarkson, 1995). As pointed out earlier, the efforts to adequately define and circumscribe corporate social responsibility have been characterized, at times, by acrimonious and frustrating debate and disagreement (Friedman, 1970; Chamberlain, 1973; Perrow, 1972; Preston & Post, 1975; Frederick, 1994, 1998).’

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is perhaps the most extreme form of a positive duty that can be imposed on corporations. Thus, a duty to be a good corporate citizen can obviously be framed in many different ways. It is not feasible to consider each such manifestation of this duty. For the purposes of this chapter we consider the most extreme expression of this duty – that of benevolence.44 Recognition of such a duty is not in keeping with contemporary corporate practice. While many corporations are certainly in the business of making donations, often this is clearly grounded in self-interest (the clearest example of this being donations to political parties); otherwise it is considered to be an expression of extreme generosity, rather than the fulfilment of a pre-existing obligation. Additionally, given the mountain of legal rules that now apply to corporations, it may seem pragmatically unrealistic and theoretically untenable to expect corporations in a highly regulated environment (where the regulation is already driven by basic moral norms, such as proscriptions against lying – hence, duties of disclosure and the like – and harming others) to do more than pursue profits and comply with the law. As a general observation, this is correct. At the individual level, as we have seen, there are very few positive moral obligations imposed upon us. This is also the case as far as the law is concerned. Thus, it is rare that individuals are required to positively do an act (as opposed to refraining from engaging in conduct) to assist another. This stems from a fundamental distinction that is entrenched in most common law jurisdictions: the acts and omissions doctrine, which is the view that one is only responsible and liable for one’s positive acts, as opposed to events that one fails to prevent (omissions). The acts and omissions doctrine maintains that there is a relevant distinction between performing an act that has a certain consequence and omitting to do something that has exactly the same outcome. Essentially, it is the view that provided we do not do anything contrary to accepted norms or rules we cannot be legally culpable. The widespread recognition of this doctrine does not, however, necessarily entail that there are sound normative reasons supporting it. It may be that the distinction is grounded in pragmatism as opposed to principle. Distinguishing between acts and omissions provides a simple method for demarcating lawful and unlawful conduct. This makes it easier to adhere to the rule-of-law virtues of consistency, uniformity and certainty.45 Adhering to these virtues is important if laws are to be effective in guiding conduct. Laws are framed 44 The duty described this way accords with the meaning of corporate social responsibility adopted by the European Commission. A useful summary of the Commission paper on the topic is provided by Mbare, above n 19: ‘According to the European Commission’s Green Paper entitled “Promoting a European Framework for Corporate Social Responsibility” (July 2001), CSR is defined as a “concept whereby companies integrate social and environmental concerns in their business operations and in their interactions with their stakeholders on a voluntary basis”. On a simpler note, CSR are actions, which are above and beyond that required by the law. Frederick (1986: 4) summed up the position as follows: “The fundamental idea of ‘corporate social responsibility’ is that business corporations have an obligation to work for social betterment”.’ 45 For a discussion of the rule-of-law virtues, see John Finnis, Natural Law and Natural Rights, Oxford, Clarendon Press (1980) 270–6; Joseph Raz, The Authority of Law, New York, Oxford University Press (1979) Ch 11.

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in terms of rules (which are precise guides to certain actions, and apply conclusively to resolve an issue) rather than in terms of principles (which are general considerations that carry a degree of persuasion and form the underpinnings of the rules).46 In light of the need for certainty the common law has shown a bias towards individual liberty. Hence we may do as we wish unless it is clearly wrong. The acts and omissions doctrine is simple and readily comprehensible and, accordingly, provides a basis for guiding conduct. As a general rule, omissions are not unlawful, even if motivated by harmful intent, if no pre-established duty is owed to the other person. Adherence to the acts and omissions doctrine no doubt allows some reprehensible behaviour to go unpunished. However, it is felt that the ground lost here is more than made up in terms of the certainty that the doctrine provides and the harm that would arise if criminal sanctions were to be imposed on the basis of rules formed retrospectively. Despite this, there are some circumstances in which people are legally liable for their omissions. Thus, parents have a duty towards their children, and a positive duty to act has also been imposed upon those employed in areas having implications for public safety,47 such as police officers.48 The acts and omissions doctrine has also attracted widespread appeal because it supposedly prevents our lives being intolerably burdened by demarcating the extent to which we must help others. It is the reason, so the argument runs, that we do not feel obliged to devote more resources to assisting people who are worse off than us, and why we feel less responsible for the deaths and tragedies we fail to prevent than for those we directly cause. The doctrine is one source of justification for why failing to feed the starving people in other nations is not on a par with shooting our neighbour.49 Given the deep roots of the acts and omissions doctrine, there seems little scope to assert that corporations do in fact have a positive duty to engage in social and community building activities. This view is supported by the observations of Solomon, who states that ‘the purpose of a corporation, after all, is to serve the public, both by way of providing desired products and services and by not harming the community and its citizens’.50 While Solomon proposes that corporations should serve the public, this duty is supposedly discharged merely by providing quality goods and services and not harming people. But cannot we ask more from corporations? 14.3.2.2 Principal duty is for corporations to comply with law – business is morally neutral From the above, it follows that the starting point so far as the moral obligations of corporations are concerned is that corporations must abide by the law in 46 For a fuller discussion on the distinction between rules and principles, see Ronald Dworkin, Taking Rights Seriously, London, Duckworth (1984). 47 For example, see R v Pittwood (1902) 19 TLR 37. 48 For example, see R v Dytham [1979] QB 722. 49 See Helga Kuhse, ‘Euthanasia’ in Peter Singer (ed.), A Companion to Ethics, Oxford, Blackwell (1991) 297. 50 Solomon, above n 21, 361.

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their pursuit of profit. It is necessary to emphasise that engaging in business and seeking to make profits is a legitimate form of conduct, and that people – acting individually or collectively – should be given the opportunity to pursue such activities. Corporate managers in the pursuit of profits do not, at least prima facie, need to keep one eye on the bigger moral picture in their pursuit of profits. They may without any moral embarrassment or guilt go about seeking to make as much money as is legally possible. While we might hope that people would engage in somewhat more virtuous activities than chasing the next dollar, it is not easy to identify a concrete basis from which to impose such a duty. A good Samaritan duty has not been justified. The pursuit of profits – like watching television, writing books, walking in the park, dining with friends, playing or watching sport and driving a car – is ultimately a break-even or neutral moral activity. It does not harm the agent or the wider community, nor does it necessarily either promote or diminish any person’s relevant interests. Moreover, profit chasing will never be able to fully exhaust the ambit of one’s morally relevant behaviour. Each person engages in an infinite range of activities. Some are purely for pleasure, such as watching television and playing tennis; others are functional, such as working and cleaning the house and buying shares; some are spiritual, such as attending church or meditating; others are sourced in kindness, such as babysitting the neighbours’ children and engaging in volunteerism. The point to note is that even if engaging in business is a morally neutral activity, moral worthiness (if in fact we should be looking to more than breaking even morally) can yet be readily acquired through the myriad of other activities in which a person engages. So far as business (and other non-inherently harmful activities) is concerned, people should be given as much space and freedom as possible in terms of how they go about their activities and projects. This means that corporate managers should at every point in the process be permitted to keep their eye firmly fixed on the bottom line of the profit-and-loss statement in making their business decisions. Business decisions can thus be made along business lines. Corporate managers are entitled to pay employees and directors market wages, they can pursue efficiency at the expense of ‘propping up’ an inefficient workforce, and when they close down unsound branches they do not need to pay above-market severance packages. 14.3.2.3 A more elaborate duty – extreme wealth and a maxim of positive duty Despite this, there are two (related) reasons that can be advanced to assert that corporations have a positive duty of benevolence. The first is that the acts and omissions doctrine is, in fact, unsound. Despite its intuitive appeal, it is unclear whether the doctrine withstands close scrutiny. The first criticism of the doctrine is that, as a general rule, there is no

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morally relevant difference between acts and omissions – sometimes morality requires us to perform a positive act. Morality makes very few positive demands of us. It is essentially a set of negatively framed rules proscribing certain behaviour. However, it is premature to conclude that so long as we do not violate these negative rules we have discharged our moral obligations. There are occasions when acting morally requires us to do more than merely refraining from certain behaviour; when we must actually do something. Morality defined exhaustively as a set of negative proscriptions fails to explain why it is morally repugnant for a techno-billionaire to refuse to give his loose change to the starving peasant whose path he crosses, or why it is wrong to decline to save the child drowning in a puddle in order to avoid getting our shoes wet, or to refuse to throw a life rope to the person drowning beside the pier. While the situations in which morality demands performance of a positive action are infrequent, when they do arise the obligations can be so clear, pronounced and unwavering that it would be implausible to postulate an account of morality that is not consistent with and explicable of such observations. As is discussed below, in addition to the negative postulates of morality, is one very important positive one: we must assist others in serious trouble, when assistance would immensely help them at little or no inconvenience to ourselves51 – the maxim of positive duty.52 The acts and omissions doctrine is incapable of explaining why we are understandably appalled on becoming aware of clear breaches of this maxim. The public loathing directed at the witnesses of the Kitty Genovese murder is a practical illustration of the operation of the maxim.53 Whether harm ensues as a result of an act or omission is in itself irrelevant to the moral appraisal of an action. The critical issue is whether one is responsible for the harm, where responsibility is assessed from the perspective of all of the norms and rules of morality including the maxim of positive duty. Arguably, the principle of positive duty provides a far more accurate and coherent basis upon which we can reject intolerable demands on our time and resources than does the acts and omissions doctrine. The doctrine is not necessary to explain why we should not work solely to assist others, since there is simply no pre-existing moral obligation to help everyone we possibly can. As is adverted to above, morality is essentially a set of negative constraints plus the maxim of positive duty. The proviso to the maxim, when there is little or no inconvenience to oneself, readily explains why our duty to assist others is extremely limited. 51 There are some who would deny that any such duty exists (for example, see Edward Mark, ‘Bad Samaritans and the Causation of Harm’ (1980) Philosophy and Public Affairs 1). However we agree with John Harris, who in The Value of Life, London, Routledge & Kegan Paul (1987) 31 labels the denial of such a duty as ‘very odd’. 52 A similar principle is articulated by Peter Singer, in Practical Ethics, Cambridge, Cambridge University Press (2nd edn, 2002), 229–30. 53 Kitty was beaten and stabbed by her assailant in Kew Gardens, Queens, New York City, over a 35-minute period in front of 38 ‘normal’, law-abiding citizens who did nothing to assist her; not even call the police, or yell at the offender. When finally a 70-year-old woman called the police it took them only two minutes to arrive, but by this time Kitty was already dead: Louis P Pojman, Ethics: Discovering Right and Wrong, Belmont, CA, Wadsworth (1990) 1–2.

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The second reason that the acts and omissions doctrine may not provide corporations with a shield to defend themselves against a positive duty to contribute to socially worthy enterprises stems from a relatively rare trait that is disproportionately enjoyed by corporations. Corporations are often funded by thousands, and in some cases millions, of individuals. As a result they have an enormous resource base. This allows them to compete very effectively in the market place as the preferred provider of goods and services. This often leads to the generation of enormous profits. Thus, a distinction between many corporations and individuals is that corporations control more wealth. This raises for consideration the issue of whether extreme wealth generates additional or special moral duties. Generally speaking, wealth is not regarded as being morally relevant in demarcating the scope of an agent’s moral rights and responsibilities. Gifts to charity and other altruistic forms of behaviour are regarded as virtuous conduct, but there is no expectation on individuals to donate a portion of their resources to the more needy. While altruism can elevate the moral status of an individual it is not a necessary requirement for an individual to be a morally fit and complete agent. This is so, arguably, irrespective of the capacity of the agent to donate money and other resources. On this view, a strong argument can be made that corporations, no matter how large and wealthy, do not have an obligation to promote the betterment of the community. Corporations are, ultimately, a collection of individuals and the profits belong to the shareholders. Their duty to assist others should not be elevated merely because their wealth derives, at least in part, from shareholding – as opposed to, say, income derived from personal services. 14.3.2.4 Requirement to pay social dividend However, there are perhaps two fallacies associated with the view that corporate wealth does not attract a benevolence duty. First, it is not the case that money derived by collections of individuals is necessarily disaggregated when assessing whether there is a duty to assist others in need. The ultimate group enterprise involved in the accumulation of wealth is the nation state. Each nation has a bottom-line profit-and loss-statement, which is largely measured by its gross national income (GNI). There is a well-established international custom that wealthier nations will donate a portion of their wealth (currently the United Nations has set a target of 0.7 per cent of GNI) to developing countries. This was pledged nearly 40 years ago in a resolution to the General Assembly. To date, only five countries have met or surpassed this target: Luxembourg, Denmark, Norway, Sweden and the Netherlands.54 Australia commits about 25 per cent of its GDP; the USA 22 per cent and the UK 48 per cent. This money could, of course, be distributed to the citizens of the donating countries, but the argument that the money actually belongs to the individuals does not seem to overcome the strong expectations on rich countries to donate 54 See .

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their wealth. Thus, at least in relation to very large institutions, there seems to be a relatively well-settled moral expectation that very rich institutions should donate part of their wealth to the more needy. Second, even at the individual level it can be argued that there is an obligation on the extremely rich to redistribute a portion of their wealth. It is not necessarily accurate to assert that the parameters of our moral obligations are circumscribed by an obligation not to engage in activities that harm others.55 This is an obligation that Australians increasingly seem prepared to fulfil. A study by the Australian Council of Social Service (ACOSS), published in December 2004, into the level of donations made by Australians revealed a growth in the collective sympathy gland of the community. The key findings were: ● $867.7 million was claimed in tax deductible donations in 2001–2, up by 3.5 per cent from the previous year. This builds on a 16.2 per cent increase in the year before that. ● 3 595 391 taxpayers – 34.8 per cent of all taxpayers – made and claimed tax deductible donations in 2001–2; 148 828 more people than the previous year. ● Since 1996, the amount donated by individual Australians as a proportion of total income has been rising and is at an average of 0.25 per cent. It is now at its highest level since 1992–3. ● The average tax-deductible donation in 2002 was $241.35. ● The average tax deductible donation made and claimed by Australian males in 2002 was $280.38 compared to $197.23 for Australian females.56 Thus, a strong argument can be made that corporations do in fact have a moral responsibility to contribute towards the improvement of the communities in which they operate. This obligation only crystallises when a corporation is highly successful in achieving its wealth-generating objective. In dollar terms it is not feasible to draw a bright line indicating at what point this is reached. Any figure will be challenged as being arbitrary; however, we suggest that the threshold is reached once a company (or group of companies) makes a billion-dollar annual profit. It should then pay a ‘social dividend’ of 5 per cent for each profit dollar exceeding this amount. A billion dollars is so large a sum that it is unlikely that anyone could seriously argue that ‘it is not enough’. Five per cent is sufficiently large to be meaningful, yet small enough to not discourage innovation and merit. The obvious counter to this proposal is that it is the government’s role to fund such matters and programs. However, as Peter Singer has commented (in the context of international aid), there is no evidence that an increase in private donations will diminish the amount of government support to such areas – in fact 55 According to Peter Singer, people in the developed nations who are on average or above-average incomes should be donating about 10 per cent of their income to reducing poverty: Practical Ethics, Cambridge, Cambridge University Press (2nd edn, 2002) 246. For an argument in favour of an even more egalitarian system, see Kai Nielson, ‘Radical Egalitarianism’ in James Sterba (ed.), Morality in Practice, Belmont, CA, Wadsworth (3rd edn, 1991) 37. 56 ACOSS, ‘Facts Reveal Record Generosity of Australians at Xmas’, Media Release 13 December 2004, available at .

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it might even result in an increase.57 Additionally, the two processes of giving and society building are not mutually exclusive. In terms of how this social dividend is delivered, there are obviously a multitude of causes and projects that could be described as ‘worthy’. To remove doubt the money should be applied to basic human needs, such as health and shelter. Thus, we propose that the social dividend should be paid directly to public hospitals and other non-profit health providers or institutions involved in providing housing to destitute members of the community. Food is obviously another fundamental human need, but the absence of people dying of malnutrition in developed countries indicates that the provision of this important service is already satisfied. It should be noted that the duty cast in this manner can be reconciled with the non-interventionist approach to corporate management set out earlier. As noted above, corporations are not required at every step to do more than is legally necessary in their pursuit of profits. However, if they are spectacularly successful in achieving this goal, they must then donate a portion of their profits. The proposal being advanced here is analogous to the duties imposed on individuals. Tiger Woods does not have to break into his golf round to visit the elderly or staff a soup kitchen, but if he keeps producing outstanding golf rounds and in the process derives millions of dollars, some of the proceeds should be (and may well be) donated to worthwhile social causes. Framing the duty in this manner allows corporate managers and individuals to focus on what they do best, without constantly being required to have their routine and processes disrupted by pursuing socially desirable aims, which they may not have appropriate skills and judgment to identify and implement. At the same time, the community benefits if they are successful at achieving their prior orientated objectives.

14.3.3 Extreme wealth and duty to not frustrate access to justice Wealth also confers other advantages upon agents in our legal system. At the substantive level, there is widespread consensus that the principles underpinning the legal systems of most developed nations are relatively just and fair – as noted earlier, certainly it is not easy to identify laws that are demonstrably unjust. However, this is largely meaningless if parties cannot obtain access to the law in order to assert and enforce their legal rights. The rights to be free from assault or to own property would be largely vacuous if muggers and thieves were never charged and prosecuted. As far as the civil law is concerned, laws of contract and negligence would be empty if people could not sue when their economic or physical interests were harmed by others. In any legal system – such as that in Australia – where the losing party is normally liable for the other party’s costs, the relative wealth of the potential litigants plays a crucial role in a rational assessment of whether a party should pursue 57 Singer, above n 55, 241–2.

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their legal rights. Corporations often have an invisible barrier of protection from legal accountability for their unlawful acts because it is not economically viable for consumers to seek legal redress against them. It is not financially viable to issue proceedings for a $50 over-charging for a phone, electricity or health-care bill. Even a ‘win’ in court will result in a net loss. While this is the situation even in cases in which the defendant is another individual, the problem is even more acute where the defendant is a wealthy corporation, which has the capacity to financially exhaust the resources of the plaintiff through interlocutory proceedings even before the substantive claim is determined, or to engage an army of lawyers to fend off a relatively modest claim. Thus, corporations have an obligation not to frustrate access of others to the courts. This obligation can be discharged in a number of different ways. The first is to have an efficient and open internal complaints system, whereby customer complaints are handled promptly, courteously and fairly, and which involves providing written reasons to customers regarding the company’s response to complaints. This complaints-resolution process should be publicised to customers. For matters that cannot be resolved at this level, and which end up in the courts, corporations should undertake not to initiate unnecessary interlocutory steps or engage legal counsel beyond that which is commensurate with the complexity of the matter and the monetary sum involved. To do otherwise is to use their size and wealth to achieve unjustified outcomes.

14.3.4 Is corporate social responsibility the answer? An alternative to these clear and defined (albeit modest) corporate reforms is to adopt a more wide-ranging mode of corporate regulation that aims to encourage corporations to become more responsible institutions. The past two decades have seen a distinct move towards this end. This has manifested most acutely in the notion of ‘corporate social responsibility’ (CSR), which has gained traction – at least at the conversational and theoretical levels – in recent times. There is no settled meaning of CSR; however, in essence it is a concept that corporations and businesses should look beyond the interest of their immediate stakeholders and give weight to the public interest as a whole in their policies and practices. CSR encourages corporations to inject into their decision making important social and moral objectives and principles. These include the interests of the immediate community in which a corporation operates as well as more distant and wider objectives such as environmental concerns. There are no legal rules compelling CSR. Instead, it is a form of self-regulation, which despite its vagueness has become synonymous with what is termed the ‘triple bottom line’ of people, planet and profit. Despite the open-ended nature of CSR, there have been some attempts to more precisely define its mandates. A number of reporting guidelines or standards

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have been developed by which to measure and encourage corporations in a CSR-compliant manner. For example, the United Nations Global Compact has set out 10 standards that corporations should observe. The Global Compact is the world’s largest corporate citizenship and sustainability program. Its participants include more than 5200 businesses in more than 130 countries. Participating corporations are expected to make the relevant CSR principles part of the organisation’s business and set out in their annual reports the manner in which these principles are implemented, and encourage others to advance the Global Impact. The core requirements of the Global Impact are: Human rights ● ●

Principle 1: Businesses should support and respect the protection of internationally proclaimed human rights. Principle 2: Businesses should make sure that they are not complicit in abuses of human rights.

Labour standards ● ● ● ●

Principle 3: Businesses should uphold the freedom of association and the effective recognition of the right to collective bargaining. Principle 4: Businesses should uphold the elimination of all forms of forced and compulsory labour. Principle 5: Businesses should uphold the effective abolition of child labour. Principle 6: Businesses should uphold the elimination of discrimination in respect of employment and occupation.

Environment ● ● ●

Principle 7: Businesses should support a precautionary approach to environmental challenges. Principle 8: Businesses should undertake initiatives to promote greater environmental responsibility. Principle 9: Businesses should encourage the development and diffusion of environmentally friendly technologies.

Anti-corruption Principle 10: Businesses should work against corruption in all its forms, including extortion and bribery.58 The FTSE4Good Index Series measures the performance of companies against CSR standards, to enable investors to make more informed choices about their investment decisions.59 The aspiration driving the move towards CSR is commendable. However, there are two deep problems with the concept. First, the principles are vague and ●

58 See . 59 See .

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often not apposite to corporations operating within developed nations. Principles 1 to 6 and 10 of the Global Compact are legal requirements in any event in most developed countries – compliance with these adds nothing to existing corporate duties. Principles 7 to 9 are drafted in aspirational language and contain no objective measures or defined targets or processes. Moreover, degradation of the environment has become a universal problem and ownership of this problem has effectively been assumed at the government level. There is a recognition that the only way to improve and deal with pressing environmental problems is through collective global action, driven initially by international agreement and then prescribed by government action that forces corporations to implement specific and concrete environmental measures. The United Nations Climate Change Conference, held in Copenhagen, Denmark in 2009, reached an understanding that climate change needs to be addressed and that nations need to ensure that any temperature increase does not exceed 2◦ C. The Copenhagen Accord is not, however, legally binding. There is some prospect that legally binding targets and measures may be set at the next climate change conference, scheduled for Mexico in late 2010. In any event, it seems that there is widespread acceptance of the fact that corporations acting unilaterally and voluntarily will not achieve meaningful improvement to the environment. The second main disadvantage of CSR is that the principles are voluntary. No country has passed laws mandating compliance with CSR. Denmark requires corporations to include CSR information in their annual reports, such as setting out the corporation’s policies for CSR; however, it is not mandatory for corporations to have CSR policies or practices.60 Thus, while CSR is a desirable ideal, its utility in terms of driving more responsible and ethical corporate conduct and outcomes will continue to be limited until clearer objectives are set and these objectives are mandated by legal requirements. Certainly, there is no evidence to show that corporations in the current CSR environment are behaving more responsibly than at any other time.

14.4 Conclusion Corporations, like all agents, have moral duties and responsibilities. The content of the moral obligations of corporations, however, must be established, not asserted. It is empty merely to claim that corporations must be good citizens, without defining the source of such a duty. We have seen that the moral duty owed by corporations must be grounded in a verifiable, normative ethic. Business ethics is the application of normal ethical principles to the business setting. An application of moral theory to a business 60 New Danish Law Requires CSR Disclosure: .

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setting in which there is extensive legal regulation broadly based on enforcing basic moral proscriptions, such as the duty not to harm others or lie, reveals that company managers have relatively few moral duties over and above those to obey the law. Corporate managers are free to base their business decisions on business criteria without having to add moral considerations into the decision-making calculus. However, when they are spectacularly successful in achieving their profit-making goal, the maxim of positive duty mandates that they pay a social dividend. At what profit level this duty crystallises is unclear. We suggest that the threshold is an annual profit of one billion dollars, in which case corporations should be required to donate 5 per cent of each profit dollar exceeding this amount to worthwhile social causes. In addition to this, corporations should not use their wealth to effectively prevent or discourage individuals from pursuing and enforcing their legal rights. If companies observe these two duties (and do not breach any laws) they can then claim to be good corporate citizens.

15 Reflections on contemporary corporate governance and its future direction If society is to improve itself and make good on its democratic promises, large corporations must be reformed so that they better fit and square with democratic theory and vision. The undertaking is immense, but it is entirely worthy of our collective energies. Accordingly, if we are to work towards good corporate governance, we must implement a sea change in how we think about corporations, how we constitute them, how we regulate them, and what we expect of them. Allan C Hutchinson, The Companies We Keep, Toronto, Irwin Law (2005) 316

The [global] financial crisis has reminded the world of the extreme dangers of unregulated markets and institutions, and of the eternal importance of transparency, disclosure, risk management, effective regulation, and robust governance. Thomas Clarke, ‘Recurring Crisis in Anglo-American Corporate Governance’ (2010) Contributions to Political Economy (Oxford University Press) 1,3

. . . ethics and norms are not only more potent means to achieve compliance with the law than deterrence is, but in fact also delimit the relevance of deterrence. Michael Wenzel, ‘The Social Side of Sanctions: Personal and Social Norms as Moderators of Deterrence’ (2004) 28 Law and Human Behavior 547, 549

15.1 Introduction This chapter builds on the discussion in Chapters 5 and 6 of this book, which dealt with how corporate governance is regulated in Australia (both the sources of regulation and the regulatory bodies), and introduced the so-called ‘pyramid’ of regulation developed by Ian Ayres and John Braithwaite in their 1992 book, Responsive Regulation. Reflecting on this material, in this chapter we make reference to a variety of sources of research (both in law and management), many 446

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of which are at the cutting edge, to identify recent and historical trends in the context of corporate governance regulation, and determine where regulation of corporate governance should be directed in the future.1 In this chapter, when discussing the ‘regulation of corporate governance’, in the Australian context we mean the Australian Securities Index (ASX) Principles of Good Corporate Governance and Best Practice Recommendations and the various formal corporate governance benchmarks now contained in the Corporations Act 2001 – mainly as a result of CLERP 9. We do not include other areas of law, such as taxation law, which may impact on the governance practices of companies.

15.2 Regulatory pyramid and the cycles of regulation: A perspective on contemporary corporate governance regulation We believe that Ayres’ and Braithwaite’s pyramid of regulatory compliance is very useful and relevant to the discussion in this chapter. Analysing developments in corporate governance regulation (the shift towards a formalisation of benchmarks of best practice in corporate governance, often accompanied by prescriptive rules) with reference to the regulatory pyramid displays an historical logic and rationale that underlies what on the surface appears to be (using a phrase adopted by Yale Law Professor Roberta Romano) ‘quack’ regulation enacted amidst a free-falling stock market (particularly in the USA) and media frenzy over corporate scandals in the early 2000s.2 Although Ayres’ and Braithwaite’s ‘pyramid’ of regulatory compliance (underpinning their theory of responsive regulation) has already been discussed in some detail in Chapter 5, the following summary of their thesis, derived from the Centre of Corporate Law and Securities Regulation’s research report, ASIC Enforcement Patterns, is useful in providing some context for the following discussion. The key elements of Ayres’ and Braithwaite’s model of regulation . . . relates to their prescriptions for twin pyramids of enforcement strategies and sanctions. In these hierarchies, the least intrusive interventions (such as promoting voluntary compliance through education and persuasion) constitute the base level approach, but the regulator’s actions will respond ‘up’ the relevant pyramid to more intrusive and punitive approaches . . . depending on the regulatee’s behaviour.3 1 See James McConvill, ‘Of Surfboards, Stewards and Homo Sapiens: Reflections on the Regulation of Contemporary Corporate Governance’ (1 February 1, 2005), available at . 2 See Roberta Romano, ‘The Sarbanes-Oxley Act and the Making of Quack Corporate Governance’, NYU Law and Economics Research Paper 04–032 (September 2004), available at . An abridged version of this article was published in (May 2005) 114 Yale Law Journal 1521. 3 See Helen Bird, David Chow, Jarrod Lenne and Ian Ramsay, ASIC Enforcement Patterns, Research Report, Melbourne, Centre for Corporate Law and Securities Regulation, The University of Melbourne (2004), 29. As Ayres’ and Braithwaite’s ‘strategic’/‘responsive’ approach to regulation provides the basis for the analysis of corporate governance regulation that follows in the rest of this chapter, we should at least recognise that there has been some criticism levelled at this approach. For example, in the ASIC Enforcement Patterns

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The Ayres and Braithwaite pyramid of regulation is useful in showing that we have experienced neither the beginning of the regulation of corporate governance, nor an ‘explosion’ in corporate governance regulation (as some commentators have suggested), since the Enron and WorldCom collapses in the USA, the HIH collapse in Australia and the raft of other failings that occurred during the global financial crisis in the late 2000s, discussed earlier in this book. Rather, with the increasing formalisation of benchmarks for corporate governance best practice (often through prescriptive rules – see CLERP 9 in Australia and the Sarbanes-Oxley Act in the USA), what we have witnessed is a shift up the ‘pyramid’ of corporate governance regulation. Indeed, the reason for the shift fundamentally accords with Ayres’ and Braithwaite’s explanation of the need for a hypothetical shift to respond to a perceived abuse of a more voluntary, disclosure-based approach to corporate governance regulation. It was perceived that the series of recent corporate collapses reflected an abuse of the voluntary regime, and emphasised the need for formal rules. Indeed, complementing this approach of applying Ayres’ and Braithwaite’s ‘pyramid’ to corporate governance regulation, a number of commentators have recently written that the formalisation of best-practice benchmarks and enactment of corporate governance ‘mandates’ in the post-Enron regulatory environment simply constitutes the most recent wave in a longstanding and easily identifiable ‘cycle of regulation’. The general consensus is that, to a large extent, the cycles of regulation roughly follow cycles in the stock market. When the bubble of the stock market bursts as a result of corporate collapses and a general lack of confidence in the market, statutory intervention invariably occurs, to restore confidence in the market. When confidence is restored and the market is characterised by exuberance, the focus shifts from conformance to performance – companies are allowed to do essentially whatever they want, so long as the strength in the market is maintained. United States law professor Larry E Ribstein has described this phenomenon in corporate governance regulation as the ‘boom–bust–regulate’ cycle. Ribstein has explained that: A boom encourages unwarranted trust in markets, leading to the speculative frenzy of a bubble and then to the inevitable bust. The bust, in turn, leads first to the disclosure of fraud and then to the mirror image of the bubble – a kind of speculative frenzy in regulation.4 report mentioned above, it is noted of Ayres’ and Braithwaite’s thesis that (at 30): ‘[T]his approach has been critiqued on the basis that by focusing primarily on the use of punishment in enforcement it remains trapped in the compliance/deterrence dialectic [citing Julia Black, ‘Managing Discretion’, Conference Paper to ALRC Conference, ‘Penalties: Policy, Principles and Practice in Government Regulation’ (June 2001) 21)] . . . Indeed, it has been argued that the continued examination of general regulatory strategies with punish/persuade as the basic elements of analysis has distracted academics’ and policy-makers’ attention from the development of particular, post-regulatory strategies for enforcement (such as education, consultation, capacity-building and meta-evaluation) [citing Black, above, 22].’ In our view, this critique can be dismissed as irrelevant to our analysis, given that we are in fact supporting a move away from strict formal regulation of corporate governance, rather than focusing on punishment and ‘command and control’. 4 See Larry E Ribstein, ‘Bubble Laws’ (2003) 40 Houston Law Review 77, 78.

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According to Ribstein, this boom–bust–regulate cycle can be traced as far back as the 17th century, but has been particularly noticeable since the Wall Street stock market crash of 1929, which led to the introduction of two major pieces of corporate legislation in the USA in the early 1930s – the Securities Act 1933 and the Securities and Exchange Act 1934. While this is undoubtedly important legislation, many have argued (and carried out a variety of empirical studies to support their opinion) that this legislation was not in fact necessary to achieve its stated objectives: in other words, that the regulatory heavy hand was not the appropriate response to corporate collapse. As Ribstein explains: Lawmakers rushing to regulate following the 1929 crash focused on the supposed defects of markets while failing realistically to assess the costs and benefits of regulation. Accordingly, they reduced the opportunity of precisely the sort of innovative firms that were needed to fuel the next boom.5

In an exciting piece (published in 2005) titled, ‘The Inevitable Instability of American Corporate Governance’, Mark J Roe adopts a similar perspective to Ribstein’s boom–bust–regulate approach to understanding the recent spate of corporate collapses and the subsequent emphasis on formal regulation. According to Roe: The recent business crisis seems new and different from what has gone on before. But at their core, they are not. The core fissure in American corporate governance is the separation of ownership from control – distant and diffuse stockholders, with concentrated management – a separation that creates both great efficiencies and recurring breakdowns. True, some of the Enron-class scandals’ specific problems are new, or exaggerated forms of what’s come before – special purpose vehicles with complex funding arrangements, unusually high executive compensation with stock options a dominating component, failure at a venerable accounting firm, some inattentive boards of directors – but the specifics still derive from the core structure of American corporate governance. We will solve the current issues – or, more plausibly, reduce them to manageable proportions – but then sometime later, somewhere else, another piece of the corporate apparatus will fail. We’ll have another corporate governance crisis and it will emanate from the same basic source: that ownership has separated from control in large firms. We’ll patch it up, we’ll move on, we’ll muddle through. That’s what will happen this time, and that’s what will happen next time.6

Thomas Clarke, of the UTS Centre for Corporate Governance, has also stressed the importance of approaching corporate governance regulation with a sound understanding of history and an appreciation of the cycle of regulation and the natural inclination towards prescriptive rules following on from a major corporate collapse. In an article titled ‘Cycles of Crisis and Regulation: The Enduring Agency and Stewardship Problems of Corporate Governance’, Clarke recognises the operation of the cycle thus: 5 Ibid. 6 Mark J Roe, ‘The Inevitable Instability of American Corporate Governance’ in Jay W Lorsch, Leslie Berlowitz and Andy Zelleck (eds), Restoring Trust in American Business, Cambridge, Mass, MIT Press (2005) Chapter 1 at 9.

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Corporate governance crisis and reform is essentially cyclical. Waves of corporate governance reform and increased regulation occur during periods of recession, corporate collapse and re-examination of the viability of regulatory systems. During long periods of expansion, active interest in the conformance aspects of governance diminishes, as companies and shareholders become again more concerned with the generation of wealth, rather than in ensuring governance mechanisms are working appropriately for the retention of wealth, and its use for agreed purposes . . . Complacency concerning corporate governance during confident times compounds enduring crises.7

Clarke also makes the important statement that: . . . the historical development of corporate capitalism has been punctuated by periodic crises and it is at these points of critical inflexion that minds are concentrated on the need for regulation.8

This historical context suggests that, over time, it is possible that we may see a shift back down the ‘pyramid’ of corporate governance regulation. This may be particularly so if, once a formal corporate governance regulatory regime has been operating over some time, corporate collapses and lack of market confidence occur to the same or a similar extent as when corporate governance regulation consisted primarily of voluntary principles and guidelines. Indeed, over the coming decade what is likely (indeed inevitable, based on past trends) is that we will experience another wave of high-profile corporate collapses. At this point, the inevitable question will then be asked: why continue with a highcost system of compliance when there is the same or similar risk of corporate collapse? Why not revert to a voluntary, self-regulatory approach to corporate governance? The recent spate of corporate collapses led to calls for the formalisation of corporate governance regulation. The next spate of corporate collapses may be the impetus for a gradual process of de-formalisation – based on the acknowledgement that formal rules are not effective in achieving their stated corporate governance objectives. In other words, to again use the phraseology of Roberta Romano, we may come to realise the disconnect between means and ends.9 Thus, rather than corporate regulation representing a reaction to corporate collapses, efforts should be directed towards considering what is the best approach to the regulation of corporate governance for the greater majority of businesses in operation. Painting this picture of corporate governance regulation as being similar to other areas of legal regulation – its direction being influenced by similar factors to traditional regulation, rather than being a unique and recent intervention and sui generis in nature, as popular commentary would suggest – is very useful. With this understanding of corporate governance regulation we can engage in 7 See Thomas Clarke, ‘Cycles of Crisis and Regulation: The Enduring Agency and Stewardship Problems of Corporate Governance’ (2004) 12 Corporate Governance: An International Review 153–4. 8 Ibid 153. On this point, see also Stuart Banner, ‘What Causes New Securities Regulation?’ (1997) 75 Washington University Law Quarterly 849, 850. 9 Romano, above n 2, 209.

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a far more reflective analysis of factors that may influence the development and direction of regulation over the long term, and engage in an informed, normative analysis of where corporate governance regulation should be heading. Relying on the bulk of recent commentary on corporate governance – which is heavily focused on accounting scandals, collapses and regulatory interventions – would make this endeavour much more difficult, if not impossible. Accordingly, rather than regulation theory and the ‘cycle of regulation’ as it applies to corporate governance being discussed in isolation, it in fact has an important role in this chapter in providing the basis upon which we can engage in a fresh, open-minded analysis of the regulation of corporate governance and its future direction.

15.3 Interaction of cycles of regulation and ‘law and norms’ discourse As mentioned above, over time it is possible that the trend towards greater formalisation of corporate governance regulation will place its legitimacy at risk. Due to the corporate collapses, corporate misconduct and falling stock market prices, which inevitably will occur in the future, we believe the attention of mainstream corporate governance commentary will naturally turn to dealing with the following question: if the post-Enron formalisation of corporate governance regulation is not as effective as thought in really improving governance practices and preventing collapse and associated problems, why not let the forces of the market have greater influence? That is, should not attention turn to the performance of companies, as opposed to conformance by companies? In dealing with this question, we believe it is useful to draw upon commentary that has entered into corporate law discourse, in relation to ‘law and norms’ and behavioural law and economics, to mount an argument that having a formal approach to corporate governance regulation is not necessary to achieve and maintain sound corporate governance practices, and indeed is not the appropriate regulatory approach. Rather than approach regulation with the focus being on ‘form’, we should instead turn our attention to the intended ‘function’ of regulation, and consider how best this function can be performed.10

15.3.1 The significance of norms Richard Posner, a prominent commentator on law and economics in the USA, defines a ‘norm’ as: 10 For a discussion of the distinction between ‘form’ and ‘function’ and the relevance of this discussion to corporate law and governance, see David A Skeel, ‘Corporate Anatomy Lessons’ (2004) 113 Yale Law Journal 1519. Of relevance to the discussion that follows in this chapter, Skeel explains that according to legal realists, a ‘functional analysis’ of a particular matter or area of law ‘encompasses not only legal rules, but also norms, history and social context’ (at 1522).

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. . . a rule that is neither promulgated by an official source, such as a court or a legislature, nor enforced by the threat of legal sanctions, yet is regularly complied with . . . 11

Another useful definition comes from The New Palgrave Dictionary of Economics and the Law, where the distinction between ‘law’ and ‘norms’ is emphasised: [L]aws can be adopted through acts of parliament, even if (at times) only to codify what is already accepted by custom. Social norms, on the other hand, almost always emerge gradually. Repeated patterns of behaviour gradually ossify into custom and then into a social norm, the violation of which causes eyebrows to be raised and is seen as an aberration.12

It is explained in the literature on ‘law and norms’ that what distinguishes a norm from a regulation is that non-legal sanctions attach to the contravention of a norm. Nazer refers to there being three types of sanctions: first, second and third-party sanctions. First-party sanctions are administered by the primary actor; second-party sanctions are administered by the person acted upon; and third-party sanctions are administered by other individuals or groups.13 Corporate law scholars, particularly in the USA, have turned their attention to identifying norms operating inside the corporation, and exploring the implications of cataloguing and understanding these norms from the perspective of corporate regulation.14 While it is recognised that there are differences from firm to firm and between cultures and jurisdictions as to the norms that shape the internal arrangements and management of corporations, collectively a common theme that emerges is that the norms are naturally oriented towards what we would now consider corporate governance best practice (subject to the needs of each individual company), with participants in the corporation focused on the continued adherence to, and satisfaction of, these norms. At a Symposium on Norms and Corporate Law, held at the University of Pennsylvania Law School in 2000, Edward B Rock and Michael L Wachter had the following to say about ‘norms’ in the context of corporate law (and, by implication, the regulation of corporate governance): Norms are an essential element of human conduct. We have always known that they guide behavior and that they are important in this role. They represent those behavioral rules and standards that are primarily, if not exclusively, enforced by the parties 11 R A Posner, ‘Social Norms and the Law: An Economics Approach’ (1997) 87 American Economic Review 365–9. Norms are divided into ‘organisational norms’; that is, norms in and between organisations, and ‘societal norms’. In relation to corporate governance regulation, we are more concerned with the former than with the latter. 12 See Kaashik Basu, ‘Social Norms and the Law’ in Peter Newman (ed.), The New Palgrave Dictionary of Economics and the Law, London, Macmillan (1998), available at . 13 Daniel Nazer, ‘The Tragicomedy of the Surfers’ Commons’ (2004) 9 Deakin Law Review 655, 663. 14 See, for example, the comments of Robert C Ellickson, ‘Law and Economics Discovers Social Norms’ (1998) 27 Journal of Legal Studies 537, who suggests that founders of classical law and economics exaggerated the role of law in the overall system of social control (which encompasses corporate regulation), and in doing so under-estimated the importance of socialisation and the informal enforcement of social norms.

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themselves. But until recently, writing about legal rules and standards was of much greater interest to the legal academy. In recent years, the legal academy’s interest in norms has reawakened . . . Much of [the] literature deals with societal norms, the norms of atomistic actors interacting with other individual actors, or with the non-legal behavioral norms of parties who are contracting with each other. The interest in norms is now being felt in corporate law. Changing the context to a corporate setting changes the role that norms play . . . Corporate norms are distinctive because they do not deal with third parties colliding with each other in a societal context or second parties interacting with each other in a contracting context. Thinking about the role of norms in a corporate setting is critical for several reasons. Inside the corporation second-party relationships reign, but the relationships are importantly, indeed primarily, non-contractual. For example, behavioural rules and standards for corporate actors are provided by corporate culture and are essentially norm-based. Much of what goes on in the corporate boardroom varies among companies and follows corporate-specific practice. . . . With great latitude, corporations can still follow their own norms and still do it ‘right’.15

Based on one particular perspective or ‘theory’ of the corporation – the so-called ‘transaction cost’ theory – rather than norms existing alongside the panoply of other sources of corporate regulation, it can be said that ‘corporate norms’ are in fact central to the operation of the corporation, providing the basis/rationale for the corporation as a business form existing in the first place. Transaction cost theorists view the corporation as principally being a mechanism to save the costs involved in engaging in sequential specific contracts: the participants to these continuing contracts (employers and employees being the best example) use the corporation as the basis for their relationship, with a view to replacing the formal rules that would otherwise apply (for example, the law of contract and so on), with informal governance arrangements inside the corporation – namely, the norms by which the corporation is structured and organised, and the relationship with participants is managed.16 Transaction-cost theory derives from Ronald Coase’s seminal 1937 paper, ‘The Nature of the Firm’, in which he characterised the ‘bounds of the firm’ (a different specimen to the market) as the range of exchanges over which the market system was suppressed, and resource allocation was accomplished instead by authority and direction. 15 Edward B Rock and Michael L Wachter, ‘Norms & Corporate Law: Introduction’ (2001) 149 University of Pennsylvania Law Review 1607, 1608. 16 Consider the following explanation by Edward B Rock and Michael L Wachter in ‘Islands of Conscious Power: Law, Norms and the Self-Governing’ (2001) 149 University of Pennsylvania Law Review 1619, 1632: ‘When transaction costs are low, the parties can write contingent state contracts to protect the integrity of their transactions. Transactions can thus be left in the market, with the market providing the parties with unequaled high-powered incentives for joint maximizing behavior . . . When transaction costs are high, the relationships are brought inside the firm where they are governed by the intrafirm, hierarchical governance structure. From the perspective of the transaction cost theorists, the decision to bring relationships within the firm is just the decision to opt for the intrafirm governance structure over market governance.’ Available at .

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According to Edward Rock and Michael L Wachter in their article, ‘Islands of Conscious Power: Law, Norms and the Self-Governing’: according to an emerging consensus among theorists of the firm, the raison d’etre of firms is to replace legal governance of relations with non-legally enforceable governance mechanisms.17

Transaction-cost theorists would accordingly support the preservation and elevation of norms as part of the regulation of corporate governance – a favourable alternative to the continued shift towards more formal rules and thus a greater compliance burden for companies. This is because the trend towards formalisation of corporate governance regulation, with benchmarks of corporate governance best practice increasingly influenced through mandatory or quasimandatory rules rather than through voluntary principles and commentaries, works against the underlying rationale for the corporation (to avoid formal rules), rather than being a measure to protect the corporation and improve performance. If transaction costs become too high pro rata due to an added compliance burden, contracting within the market – without the protection and benefits that the corporation provides – may become more feasible. As Rock and Wachter explain: The high transaction costs that bring certain transaction costs inside the boundary of firms also create the ideal grounds for developing governance arrangements that are self-enforcing, encouraging good play and discouraging opportunistic play. For them to function properly, the ability to punish opportunistic play is important, and the highfrequency/long-duration interactions among the parties operating together inside the firm allow ample opportunity to sanction bad play and encourage good play.18

In the specific context of corporate governance regulation, the percolation of norms inside the corporation is important. If we can identify a systematic body of norms operating inside the corporation, and also between the corporation and its stakeholders, backed by non-legal sanctions, then in areas where norms are operating effectively it can be argued that formal rules are not necessary. It could be asked, applying a simple cost–benefit analysis, why formal regulation in relation to a particular matter should be introduced, whether it be board structures, executive compensation, the responsibilities of auditors or whatever else. Why should these matters be regulated if substantially the same, or exactly the same, outcome can be achieved through enabling norms of best practice to operate independently? Regulating these matters and ensuring compliance with it is, after all, costly and time-consuming. Norms began as the predominant form by which internal arrangements and management in companies developed, and over time a commonality in the norms operating from company to company could be discovered, setting in place an early standard of corporate governance best practice. Naturally, it is the case that before everything else must be the norms, as the norms have provided 17 Ibid 1622. 18 Ibid 1649.

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the foundation upon which the guidelines and reports subsequently have been developed and revised, and by which mandatory rules setting in place formal benchmarks for corporate governance best practice could be enacted. Indeed, in the 1993 version of the Bosch Report, the importance of corporate norms in influencing and shaping governance practices was expressly acknowledged: The corporate sector is making a significant effort to create its own framework of acceptable standards of behaviour irrespective of existing or prospective legislation.19

The natural development of best practice governance arrangements within corporations over time by way of norms, independently (or with little involvement) of formal legal rules, is supported by the concept of ‘firm routine’, discussed by Timothy F Malloy in his piece, ‘Regulation, Compliance and the Firm’.20 Malloy notes: Organizational theory teaches us that in many instances, firm behaviour is driven more by the firm’s routines than by economic rationality or normative values . . . The term ‘firm routine’ is used broadly here, referring to a wide range of formal and informal regular patterns of behaviour that coordinate the activities of the firm members. This includes communication routines that channel information through the firm, standard operating procedures that control production activities, budgeting and resource allocation procedures, and a multitude of other procedures. Because they coordinate the actions of individuals within the firm and allocate resources to them, firm routines are basic components of organizational activity.21

Further support for the view that corporate governance was predominantly and effectively regulated by informal norms, which later influenced the development of corporate governance reports and guidelines and subsequently mandatory rules, comes in an article by E Norman Veasey, Chief Justice of the Delaware Supreme Court, which was written and published prior to the post-Enron formalisation of corporate governance regulation. In that article, Justice Veasey identified seven ‘aspirational ideals of good corporate governance practices’, operating outside the requirements of the law, which he suggested boards of directors should implement. According to Veasey, those aspirational ideals ‘reflect some developing norms of corporate behavior’ and constitute ‘the reasonable expectations of stakeholders’.22 The seven ‘aspirational ideals’ were: (a) There should be a heavy majority of purely independent directors on every board. (b) The board should be engaged in actual governance, and not merely act as advisers to the chief executive officer (CEO). It means directors are in control of the policy of the firm, and the managers work for them. 19 Business Council of Australia, Corporate Practices and Conduct, Melbourne, Information Australia (2nd edn, 1993) 2. 20 (2003) 76 Temple Law Review 451. 21 Ibid 458 (emphasis added). 22 E Norman Veasey, ‘Should Corporation Law Inform Aspirations for Good Corporate Governance Practices – Or Vice Versa?’ (2001) 149 University of Pennsylvania Law Review 2179, 2189.

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(c)

Directors should meet face-to-face frequently throughout the year and spend a minimum of at least 100 hours per year attending to routine matters on each board. (d) Directors should limit to a reasonable number the major boards upon which they serve. What is a reasonable number depends on the extent to which each director is able to carry out his or her responsibilities to each board in a professional manner. (e) The board should have audit, compensation and nominating committees consisting solely of independent directors. Moreover, independent directors should regularly evaluate the CEO, and they should meet with each other alone on a regular basis. (f) The board should establish and monitor reasonable law-compliance programs. (g) The board should carefully review disclosure documents for which it has direct responsibility, to ensure that all material information reasonably available is disclosed to the relevant audience.23 Most, if not all, of these ‘aspirational ideals’, based on developing norms inside the corporation, have since been transformed into formal benchmarking ‘rules’ in Australia and the USA (included in the ASX Best Practice Recommendations or CLERP 9 reforms in Australia, the Sarbanes-Oxley Act and NYSE corporate governance rules in the USA), even though these ideals reflected standard practice inside most corporations at the time of the Enron and WorldCom collapses in the USA, and the HIH and One.Tel collapses in Australia. The fact that corporate governance best practice has traditionally been the product of norms operating within the corporation has also been recognised by John Farrar. In his article, ‘Corporate Governance and the Judges’, Farrar states: In its narrower, and most useful, sense [corporate governance] refers to control of corporations and to systems of accountability by those in control. It refers to the companies legislation but it also transcends the law because we are looking not only at legal control but also de facto control of corporations. We are looking at accountability, not only in terms of legal restraints but also in terms of systems of self-regulation and the norms of so-called ‘best practice’.24

The overriding objective guiding contemporary corporate governance regulation, and more specifically the shift towards more formal rules, is a desire to restore confidence in the market by ensuring that corporations and their participants adhere to good governance practices. In other words, the rationale for the reforms is that without prescriptive regulation in this area, directors and managers would naturally depart from standards of corporate governance best practice, due to a preference for more self-interested transactions and arrangements. Presumptions that traditionally underpinned agency theory and the rational 23 Ibid 2190–1. 24 John Farrar, ‘Corporate Governance and the Judges’ (2003) 15 Bond Law Review 65, 66 (emphasis added).

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choice model of the corporation – that directors and managers are self-interested actors who need to be controlled – have a very strong role here. A reliance on norms and voluntary principles is considered to be undesirable in the post-Enron environment – the common assumption is that Enron and other high-profile corporate collapses across the world have shown us that enforced self-regulation is not sufficient; it has been ‘abused’ and hence (so the argument goes) tougher regulation is required. In other words, recent events have required us to take the next step up the ‘pyramid’ of regulatory compliance as a means to ensuring effective corporate governance.

15.3.2 Norms, corporate governance and the utility of behavioural analysis Relatively recent literature on so-called ‘behavioural law and economics’ and associated theories in management has, however, again cast doubt on the efficacy and appropriateness of formalising the regulation of corporate governance to ensure directors and executives act consistently in the best interests of the corporation rather than their own self-interest. Literature shows that the selfinterested actor does not present an entirely accurate view of how corporate participants behave. These studies and theories present corporate actors as being individuals with very human desires, with ‘other-regarding preferences’ and wanting to behave not only in the best interests of the corporation, but also to be perceived as trustworthy. ‘Behavioural law and economics’ leads on from the ‘law and economics’ movement, which was particularly prominent between the 1970s and 1990s. Law and economics scholars embraced a neo-classical, economic conception of human behaviour, with humans perceived as rational actors in search of the most efficient outcomes.25 Efficiency was generally equated with wealth maximisation.26 Based on this rational-actor model of human behaviour (also referred to as ‘homo economicus’), law and economics scholars believed that legal rules and legal institutions could be understood from an efficiency rationale; that is, a rule or institution can be said to maintain its legitimacy only if it enhances efficiency in the way rights and obligations are dealt with.27 25 According to Becker, the standard economic principles, which were adopted by law and economics scholars as providing an accurate representation of human behaviour and decision-making processes, were that human beings are participants who: (1) maximise their utility; (2) form a stable set of preferences; and (3) accumulate an optimal amount of information and other inputs in a variety of models. See Gary Becker, The Economic Approach to Human Behavior, Chicago, University of Chicago Press (1976) 14. 26 See in particular Richard A Posner, Economic Analysis of Law, Boston, Mass, Little, Brown (5th edn, 1998). 27 As an example, in Frontiers of Legal Theory, Cambridge, Mass, Harvard University Press (2001), Richard Posner explains how the ‘fair use’ doctrine in copyright law, which allows anyone to make ‘fair use’ of a copyrighted work without having to make payment to the holder of copyright, can be justified by applying economic analysis. According to Posner, the fair use doctrine is an example of the law allocating legal rights efficiently where large transaction costs (which are ordinarily assumed not to exist in neo-classical analysis) prevent the market from doing so naturally. Posner’s thesis is best explained by Robert T Miller, ‘Posner’s Laws of Pragmatism’ (2001) 118 First Things 54–6. See also Richard A Posner, Law, Pragmatism and Democracy, Cambridge, Mass, Harvard University Press (2003).

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While the economic analysis of law dominated legal scholarship in the USA for many years, it was obvious that there were some limitations to the ‘rational actor model’ of human behaviour, which provided the basis for strict law and economics analysis. Even though human beings cannot accurately be described as irrational creatures, nor are we machines programmed to pursue the most efficient outcome in every possible situation.28 Accordingly, in the second half of the 1990s, a trend gradually emerged of legal scholars seeking information from outside neo-classical economics to better understand how human beings really behave.29 Studies in other fields, primarily behavioural economics, had shown that rather than being rational self-actors at all times, people frequently are unselfish. So began the ‘behavioural law and economics movement’, or what is often referred as the ‘second synthesis’ of law and economics.30 Behavioural analysis of the law is increasingly standing on its own as a field of inquiry outside law and economics scholarship. Legal scholars now feel confident enough to apply findings on human, social cognitive and emotional biases, which are central to behavioural analysis, without framing the analysis in economic terms. Corporate law scholars have applied understandings about real, personal human traits such as trust and sensitivity to dismantle the self-interested actor model of the individual.31 Further supporting the view that norms are just as capable as formal rules of satisfying the objectives of contemporary corporate governance regulation, and capable of operating as a self-contained source of regulation independent of external legal rules encouraging compliance through the threat of sanctions, is the stewardship theory of the corporation. While there are many similarities between the findings and policies of members of the behavioural law and economics school and stewardship theorists,32 ‘stewardship theory’ as a discrete area of study has yet to attract the attention of legal commentators.33 To date, discussion of the stewardship theory of corporate governance has primarily been confined to the pages of management journals and books – with 28 See, for example, the collection of papers in Daniel Kahneman and Amos Tversky, Choices, Values and Frames, New York, Russell Sage Foundation (2000). 29 See Christine Jollis, Cass R Sunstein and Richard Thaler, ‘A Behavioral Approach to Law and Economics’ (1998) 50 Stanford Law Review 1471. 30 See generally Cass R Sunstein (ed.), Behavioral Law & Economics, New York, Cambridge University Press (2000). 31 See Margaret Blair and Lynn Stout, ‘Trust, Trustworthiness and the Behavioral Foundations of Corporate Law’ (2001) 149 University of Pennsylvania Law Review 1735. 32 Indeed, leading legal scholars in the field of corporate governance Lucian Bebchuk, Jesse Fried and David Walker have come to similar conclusions as stewardship theorists through their studies on ‘internalised incentives’. See Bebchuk and Walker’s Working Paper, ‘Executive Compensation in America: Optimal Contracting or Extracting Rents?’, available at . This research is also included in Lucian Bebchuk and Jesse Fried’s recently released book, Pay Without Performance: The Unfulfilled Promise of Executive Compensation, Cambridge, Mass., Harvard University Press (2004). 33 A study by the authors of law review articles on Westlaw, LexisNexis, AGIS and CaseBase in 2004 found that reference was made to ‘stewardship theory’, in the context of corporate law and governance, in only one article, and that article only dealt with stewardship theory in passing. The article is Shann Turnbull, ‘Corporate Charters with Competitive Advantages’ (2000) 74 St John’s Law Review 89.

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a handful of commentators being particularly prolific in the early 1990s in exploring the potential implications of the theory. Stewardship theorists have utilised psychological studies (as well as studies in sociology) into human motivation to dispel the mainstream view that the company’s directors and executives are driven purely by self-interest and personal economic gain (that is, agency theory). According to Thomas Clarke, in a commentary on theories of corporate governance published in 2004: Stewardship theory acknowledges a larger range of human motives including orientations towards achievement, altruism and the commitment to meaningful work.34

At the core of stewardship theory is a ‘model of man’ directed towards selfactualising behaviour rather than purely economic behaviour (which was the model of ‘man’ presented and accepted by agency theorists), with the motivation (drawn from psychology and psychological mechanisms) being ‘higher order’ needs (growth, achievement, self-actualisation) rather than lower order/economic needs. This more humanistic model of ‘man’ has been explained by stewardship theorists as representing the instinctive desire of humans to ‘grow beyond their current state and reach higher levels of achievement’. Deeply rooted in psychological studies and theory relating to motivation and choice, stewardship theory suggests that managers can be organisational, as well as individualistic. That is, managers who are ‘stewards’ are just as (if not more) motivated to make decisions that are in the best interests of the organisation as to act for their own self-interest, as that will provide them with pure economic benefits. To use the jargon, their ‘utility functions’ are maximised through a cooperative relationship with the shareholders, rather than a relationship of control, in which shareholders are distanced from the corporation so that management can rationally pursue what is in their own self-interest. According to Australian Lex Donaldson, one of the main commentators on stewardship theory since its emergence into mainstream commentary on corporate governance at the end of the 1980s,35 studies into human behaviour support this deeper understanding of managerial motivation: Students of human behaviour have identified a much larger range of human motives, including needs for achievement, responsibility, and recognition, as well as altruism, 34 Thomas Clarke, ‘Introduction to Part Four’ in Thomas Clarke (ed.), Theories of Corporate Governance: The Philosophical Foundations of Corporate Governance, London, Routledge (2004) 117. 35 One of the first major contributions exploring the potential significance of stewardship theory as a perspective on corporate governance was in 1989 by Lex Donaldson with James Davis, ‘CEO Governance and Shareholder Returns: Agency Theory or Stewardship Theory’, a paper presented at the annual meeting of the Academy of Management in Washington, DC. While it can be said that stewardship theory has entered into mainstream literature on management and received significant support, it is probably incorrect to describe this theory as a dominant perspective of corporate governance. Obviously, the relatively short time in which the theory has been discussed is a reason for this, but many commentators also point to a limitation of the theory, which prevents overwhelming support – it rests on shareholders being prepared to take the risk (through accepting the ‘relaxed’ governance structures that stewardship theorists support) that management will act as ‘stewards’ as opposed to being purely opportunistic. See James H Davis, F David Schoorman and Lex Donaldson, ‘Towards a Stewardship Theory of Management’ in Thomas Clarke (ed.), Theories of Corporate Governance: The Philosophical Foundations of Corporate Governance, London, Routledge (2004) 118, 121.

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belief, respect for authority, and the intrinsic motivation of an inherently satisfying task.36

A consequence of stewardship theory is the argument that there is not the same imperative to separate the roles of chairman and chief executive in the corporation; rather it is considered favourable that boards have a majority of specialist executive directors rather than a majority of independent directors, as managers who are entrenched in the corporation (and ‘identify’ with the corporation, according to stewardship theorists) are naturally drawn to pursue what is best for the corporation. This view stands in contrast with that held by law and economics proponents, who argue for a separation of the roles of chairman and chief executive, and for a majority of independent directors on the board, as this is considered necessary in order vigilantly to monitor management and to limit their individualistic opportunism.37 The point about ‘stewards’ coming to ‘identify’ with the corporation(s) they are managing is again important in supporting the view that norms shaping the internal arrangements and management of the corporation can be allowed to operate on their own without the interference of formal legal rules. If the directors/executives ‘identify’ themselves with the corporation, any adverse consequences for the corporation and its general performance as a result of departing from the norms of good governance would actually impose a form of ‘sanction’ on the individual personally. This form of sanction is described in literature on norms as a ‘first-party sanction’, and – at least in relation to social norms (which are not considered to be different to organisational or corporate norms) – is considered to be the most effective of the sanctions in ensuring compliance with norms. Even without accepting this form of sanction to be truly effective, commentators on law and norms also refer to the ability of a person or group to ‘internalise’ norms and choose to abide by them even when external sanctions are unlikely.38 Director and manager behaviour that is consistent with the best interests of the company is therefore likely to continue as a predominant ‘corporate norm’, without any need for formal rules, because disservice to the corporation from departing from ‘good governance’ is likely to be considered a sanction in itself. Overall, the stewardship theory has important implications for the future regulation of corporate governance, particularly if one is to take a step back and reflect on why it is considered necessary for corporations to be the subject of formal regulation. It can be said that the primary reason that regulation of corporate governance is considered necessary is the existence of a ‘separation of ownership 36 Lex Donaldson, ‘The Ethereal Hand: Organizational Economics and Management Theory’ (1990) 15 Academy of Management Review 369, 372. 37 See Lex Donaldson and James H Davis, ‘Stewardship Theory or Agency Theory: CEO Governance and Shareholder Returns’ (1991) 16 Australian Journal of Management 49, 50–2. 38 See, for example, Amitai Etzioni, ‘Social Norms: Internalization, Persuasion and History’ (2000) 34 Law and Society Review 157 (arguing that most of the power of social norms comes from internalisation and first-party based incentives); also Mark West, ‘Legal Rules and Social Norms in Japan’s Secret World of Sumo’ (1997) 26 Journal of Legal Studies 165.

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and control’39 in the contemporary public corporation.40 Directors and managers are given overwhelming power with little accountability to the dispersed group of shareholders, and regulation of a corporation’s internal arrangements thus has been considered vital to ensuring that directors and executives do not abuse this power for personal gain.41 Economists refer to the divergence between ownership and control in the corporation as the ‘agency problem’, and similarly suggest that external incentives be implemented in order to confine this divergence.42 Kahan provides a useful explanation from a legal perspective: The effective management of a public corporation requires the separation of ownership and control. Multiple, dispersed share-holders cannot themselves make the many dayto-day management decisions that it takes to run a public company. The corporate form solves this problem by delegating the power to manage the company to the board of directors, which further delegates the power to the corporate officers. The resulting separation of ownership and control, however, creates an agency problem: since managers do not own all of the corporation’s equity – indeed, they often own only a trivial portion – their interests diverge from those of the shareholders as a group. The main issue in corporate governance is therefore to create incentives for managers to run the company in the interest of shareholders.43

Lipton and Herzberg also make it quite clear that regulation of corporate governance is based entirely on the presumption that directors and managers of modern public corporations need to be kept accountable: Corporate governance best practice seeks to provide the mechanisms which align the interests of management with those of shareholders. The development of increased interest in corporate governance reflects higher expectations by the public and investment community that greater efforts be made by listed public companies to develop structures and procedures so as to ensure management is effective and 39 See Adolph Berle and Gardiner Means, The Modern Corporation and Private Property, New York, Macmillan (1932, rev. 1967). The classic statement in this text regarding the ‘separation of ownership and control’ is as follows (at 116): ‘In examining the break up of the old concept that was property and the old unity that was private enterprise, it is therefore evident that we are dealing not only with distinct but often with opposing groups, ownership on the one side, control on the other – a control which tends to move further and further away from ownership and ultimately lie in the hands of the management itself, a management ultimately capable of perpetuating its own position. The concentration of economic power separate from ownership has, in fact, created economic empires, and has delivered these empires into the hands of a new form of absolutism, relegating “owners” to the position of those who supply the means whereby the new princes may exercise their power.’ 40 For a recent reflection of the significance of the separation of ownership and control in the history of corporate USA and corporate governance, see Roe, above n 6 : ‘Technology changes, crises arise, and the problems in one decade differ from those of another decade. But the principal problems arise from ownership separation, and ownership separation is with us to stay . . . To say that our problems derive from separation isn’t to say that we can do better by giving up separation. It just says that we have to deal repeatedly with separation’s derivative problems. Thus we fix up each current problem, and we muddle through.’ 41 See Robert Baxt, Keith Fletcher and Saul Fridman, Corporations and Associations: Cases and Materials, Sydney, LexisNexis Butterworths (9th edn, 2003) 264. 42 See the classic article, Michael C Jensen and William H Meckling, ‘Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure’ (1976) 3 Journal of Financial Economics 305. 43 Marcel Kahan, ‘The Limited Significance of Norms for Corporate Governance’ (2001) 149 University of Pennsylvania Law Review 1869, 1877–8 (emphasis added).

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acts in the interests of shareholders and adopts appropriate standards of corporate behaviour.44

In a paper written by seven leading corporate law and governance scholars – Reiner Kraakman, Henry Hansmann and Ed Rock of the USA; Paul Davies of the UK; Gerhard Hertig of Switzerland; Klaus Hopt of Germany and Hideki Kanda of Japan – titled ‘The Anatomy of Corporate Law: A Comparative and Functional Approach’,45 the same point about the rationale for corporate law is made, although the authors contend that agency costs go beyond management and shareholders. They argue that the centre issue for corporate law, in every jurisdiction, 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. The research presented by stewardship theorists shows, however, that in the great majority of cases, directors, managers and others in positions of power within the corporation will have personal incentives to do what is best by the corporation and its stakeholders, without the need for additional incentives in the nature of formal rules and principles. Accordingly, the longstanding foundation upon which the regulation of corporate governance rests is questionable. Directors and managers will naturally operate the corporation, including its relationship with stakeholders, in a manner that is consistent with best practice standards due to their role as stewards in the corporation, with a comprehensive body of ‘corporate governance’ norms developing as a result. It is submitted that these norms, in setting in place a routine by which directors and managers are focused on the best interests of the corporation, provide (and should be accepted as) an effective substitute for formal legal rules. An alternative argument that could be made to justify a role for formal rules in the regulation of corporate governance is that even if there are behavioural/psychological factors guiding directors and executives towards naturally doing what is best for the corporation, formal rules are still necessary so that participants take into account interests other than purely those of the corporation (such as the environment, local communities and employees – see further the discussion in Chapter 2 on stakeholders). However, two responses can be given to this argument. First, it can be said that this represents an overly narrow view of the corporation, failing to embrace the more ‘enlightened’ view, which sees the corporation as an entity dependent on its stakeholders in order to create wealth and achieve long-term, sustainable growth. Second, there is empirical evidence, 44 See Phillip Lipton and Abe Herzberg, Understanding Company Law, Sydney, Law Book (11th edn, 2003) 295. Indeed, this view on the significance of agency costs to corporate regulation derives from (or at least is commonly attributed to) F L Easterbrook and D R Fischel’s classic treatise on the law and economics of corporate law, The Economic Structure of Corporate Law, Cambridge, Mass., Harvard University Press (1991). Easterbrook and Fischel argued in this work that corporate law (at least in the USA) is designed to limit agency costs by providing a menu of default rules that parties can alter by contract if they so choose. 45 Reiner Kraakman et al., The Anatomy of Corporate Law: A Comparative and Functional Approach, Oxford, Oxford University Press (2004).

CONTEMPORARY CORPORATE GOVERNANCE

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utilised in some of the material on behavioural law and economics, showing that experiments involving so-called ‘prisoner’s dilemmas’46 (one of the key tools used in game theory47 ) demonstrate that ‘other-regarding preferences’ is a strong and common characteristic in human beings. Furthermore, it could be said that the value we place on trust, and our desire to be perceived as trustworthy, extends to corporate participants’ relationships with non-shareholder stakeholders. The first point is dealt with in Chapter 2 of this book, which is devoted to the topic of stakeholders. Some discussion here is, however, warranted for the second point. Lynn Stout, together with Margaret Blair, has been particularly prominent in exploring the implications of research into trust and trustworthiness for corporate law and governance. Both have explored and analysed important empirical evidence derived from social dilemma games, which lend support to the proposition that there are many ways in which we – as homo sapiens – act as though we care about the costs borne and the benefits enjoyed by others, as opposed to being driven purely by economic self-interest. Consider, for example, the following statement by Stout: Extrinsic empirical evidence supports the claim that most people shift freely between self-regarding and other-regarding models of behaviour, depending on their perceptions of social context and relative personal cost. This phenomenon is neither rare nor capricious. To the contrary, it is endemic and predictable. And as a result, it will often be of vital importance to a sound understanding of many phenomena, including norms.48

The existence of other-regarding preferences, as well as the importance of the phenomenon of ‘trust’ and ‘trustworthiness’ (and the related concept of ‘altruism’) to corporate law and governance have been emphasised by Stout and Blair 46 The prisoner’s dilemma is defined as a ‘situation in which the non-cooperative pursuit of self-interest by two parties makes them both worse off’ (see – A W Tucker, Contributions to the Theories of Games (2001), Princeton, NJ, Princeton University Press; William Poundstone, Prisoner’s Dilemma, Oxford, Oxford University Press (1993). In the prisoner’s dilemma, in each game the prisoner has to decide whether to ‘cooperate’ with an opponent, or otherwise defect. The prisoner and the opponent must make a choice, and then their decisions are revealed. The prisoner’s dilemma demonstrates that the ‘rational’ choice in each instance is not the one that maximises personal self-interest as neo-classical economists suggest, but rather the one that maximises the collective good of the two or more persons who are each making the decision. In other words, the most rational decision or strategy is the one that promotes competition between the participants in the game. Thus, the prisoner’s dilemma is studied in a range of different contexts to try to find, and understand, strategies that promote cooperation. 47 Game theory encompasses an interdisciplinary approach (covering, for example, mathematics, economics, sociology and information technology) to the study of the behaviour of humans. A ‘game’ in this context is a scientific metaphor for a wide range of human interactions between two, or more than two, persons, such persons possessing opposing (or at least mixed) motives. In constructing these games, game theorists contend that the rational choice of game participants involves maximising the rewards of the group of decision makers involved in the game. See Morton Davis, Game Theory: A Non-Technical Introduction, London, Constable (1997); Oskar Morgenstern and John von Neumann, The Theory of Games and Economic Behavior, Princeton, NJ, Princeton University Press (1944). 48 See Lynn A Stout, ‘Other-regarding Preferences and Social Norms’, Georgetown Law and Economics Research Paper No. 265902 (March 2001), available at .

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BUSINESS ETHICS AND FUTURE DIRECTION

in a number of articles.49 For example, in a collaborative piece, Stout and Blair note: Economic theory has yielded great insights into the nature of the business form and the role the law plays in shaping it. At the same time, conventional economic analysis has proven inadequate to resolve a number of important debates and questions in corporate law . . . Our approach does not reject economic reasoning. It does, however, re-examine one of its standard assumptions: the assumption that people always behave like homo economicus. We argue to the contrary that people often behave as if they care about costs and benefits to others. In support of this claim, we review the extensive empirical evidence that has been developed on human behaviour in social dilemma experiments. This evidence demonstrates that most people shift readily from purely self-interested to other-regarding modes of behaviour depending on past experience and social context.50

Stout has also noted in an individual piece: [I]f we want to understand the business judgment rule, we must begin by recognizing that the social institution of the board of directors is premised on the belief that directors are motivated, at least in part, by altruism, in the form of a sense of obligation to the firm and its shareholders.51

This literature on other-regarding preferences, and on the concepts of ‘trust’ and ‘altruism’, importantly emphasises that one consequence of moving away from the strict ‘homo economicus’ model of human towards a more realistic model of behaviour is that there is a reduced role for formal rules.52 According to Blair and Stout: Mistaken assumptions about the role and importance of external incentives in furthering cooperative behavior can lead not only to mistaken descriptions but also to mistaken prescriptions. In particular, the experimental evidence warns that attempts to provide external motivations for cooperative behavior can instead reduce cooperation by undermining corporate participants’ internal motivations.53

Our discussion above, particularly in relation to ‘law and norms’ suggests that over time (as advocated above) the ‘cycle of regulation’ in corporate governance may settle at voluntary principles and guidelines as ultimately the most effective 49 In fact, these concepts (trust, in particular) are integrated into Stout and Blair’s widely disseminated and accepted ‘team production’ theory of the corporation. Margaret Blair and Lynn Stout, ‘A Team Production Theory of Corporate Law’ (1999) 85 Virginia Law Review 247. Blair and Stout’s team-production theory has generated a great deal of interest in academic circles as it challenges the dominant view of shareholder primacy, by suggesting that the role of the corporation is not limited to maximising economic returns for shareholders, but rather is intended to resolve team production problems. As a result, neither shareholders nor other stakeholders are the primary concern; rather, the corporation and the legal rules regulating corporations treat shareholders and stakeholders as a ‘team’, each contributing to the corporation in different ways. 50 Blair and Stout, above n 31, 1807. 51 Lynn A Stout, ‘In Praise of Procedure: An Economic and Behavioral Defence of Smith v Van Gorkom and the Business Judgment Rule’ (2002) 96 Northwestern University Law Review 675, 677. 52 It must be remembered that adherence to principles and standards of behaviour consistent with good corporate governance practices has also been considered to be achievable through various market forces (product, labour, corporate control), as a substitute for formal regulation – although the role of markets in contributing to corporate practices and behaviour is strongly associated with law and economics analysis and the conception of corporate participants as self-interested actors, which loses some contemporary relevance due to the growing role of behaviouralism in legal analysis. 53 Blair and Stout, above n 31, 1808–9.

CONTEMPORARY CORPORATE GOVERNANCE

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method of ‘regulating’ corporate governance practices.54 This is because the principal reason for introducing formal legal rules – to impose sanctions in the form of penalties for non-compliance and hence encouraging compliance ‘by stealth’ – is unwarranted: sanctions are inherent in norms, and adherence to these norms is achieved through mechanisms other than legal rules. Indeed, as Stout explains: [T]here are a variety of tools available to internalize externalities. These include the legal sanctions imposed by a coercive state; voluntary exchanges in the market; the threat of retaliation in repeated dealings . . . 55

15.4 Conclusion: The future of corporate governance regulation It is plausible to predict that corporate norms, as an evolutionary source of corporate governance practices, will be the ultimate driver of the ways in which corporate governance develops and changes over the long term.56 That said, there is still a role for voluntary principles and codes in emphasising and ‘reinforcing’ the norms so that they are adhered to (through an educational, pressure or incentive function), and so that formal regulation of corporate governance can be avoided.57 Further, as we discussed in Chapter 8, a range of areas of law (such as banking law, employment law and environmental law) will still impact on company activities and encourage good governance. Thus, what may be required is a different approach to the increasing formalisation of corporate governance regulation that we have witnessed over the past decade. Best-practice benchmarks in corporate governance may be achieved by allowing corporate norms to operate independently; minimising the need to turn these benchmarks into mandates. Corporate collapses and downward 54 See David Charny, ‘Norms and Corporate Governance’ in Jeffrey Gordon and Mark Roe (eds), Convergence and Persistence in Corporate Governance, Cambridge, Cambridge University Press (2004) Ch 8. See also Roberta Romano’s recent working paper, in which she argues for a return to a voluntary regulatory framework for corporate governance in the USA, arguing that there is no justification for prescriptive rules (with the principal focus of the paper being on the federal Sarbanes-Oxley Act) mandating corporate governance practices. See Romano, above n 2. 55 Stout, above n 48, 6. 56 For a contrary position, see Kahan, above n 43, who suggests (at 1899) that norms only have a limited significance for corporate governance, and really only have a role when more ‘high-powered incentive devices’ are absent. This causes Kahan, at 1900, to disagree with the prediction of Robert Ellickson that ‘the newly found appreciation of norms is likely to cause the significant redirection of law and economics’. 57 We should acknowledge at this point that there is a debate in ‘law and norms’ discourse about whether there remains a role for formal regulation if a particular matter or area is or can be effectively regulated by norms. That is, if norms can be said to embody an ‘informal contract’ between the participants, what is the justification for supplanting this with ‘formal contracts’ in the form of legislation and other rules? In a Working Paper prepared for Harvard University (Harvard Institute of Economics Research Paper no. 1923), entitled ‘Norms and the Theory of the Firm’, May 2001, Oliver Hart suggests that ‘it is hard to draw clear-cut conclusions about whether formal contracts will make it easier to sustain self-enforcing contracts (ie formal and informal contracts are complements), or more difficult (ie formal and informal contracts are substitutes)’ A copy of the Hart paper is available online at . See also Rock and Wachter, above n 16.

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BUSINESS ETHICS AND FUTURE DIRECTION

trends in the market will occur over the course of time, as we have discussed above, regardless of whether regulation of corporate governance predominantly consists of formal rules or voluntary principles. The collapses and misconduct we witness in the corporate world from time to time can be said to be the work of a few ‘rotten apples’,58 and that therefore there is no benefit in imposing an increasing compliance burden on companies, which comes from further formalising corporate governance regulation, when the overwhelming majority of companies have sound internal governance arrangements in place. This compliance burden can distract companies from concentrating on performance, and places in jeopardy the flow-on effects for our society and economy that come from having companies perform strongly. While for the immediate, and perhaps medium, term following the global financial crisis, we must deal with a heavy handed regulatory approach to corporate governance, in the future advisers, law-makers and general commentators may experience a natural shift back towards a voluntary regulatory framework for corporate governance, once an informed historical perspective can be drawn on whether a formal or voluntary approach to corporate governance regulation is ultimately more effective. Empirical studies, and the natural course of events (with collapses continuing to occur, corporate misconduct still arising, and markets continuing to rise and fall), is likely to demonstrate that a voluntary approach to corporate governance regulation is desirable. On this point, the comments of Thomas Clarke are again useful: Despite the strenuous efforts at reform, the cyclical pattern of stock market booms encouraging and concealing corporate excesses is likely to continue. When recession highlights corporate collapses, statutory intervention invariably occurs. To avoid mandatory restrictive over-regulation, active voluntary self-regulation – particularly in terms of confidence and growth – is necessary.59

The view that self-enforced regulation is the most desirable approach in relation to corporate governance finds support in the writings of John Braithwaite on responsive regulation. In a book chapter titled ‘Responsive Regulation in Australia’,60 Braithwaite identifies three key obstacles (‘myopias’) to a more constructive regulatory culture in Australia. These are ‘regulatory legalism’, deregulatory rationalism and knee-jerk opposition to self-regulation. ‘Regulatory legalism’, which essentially describes support for the enactment and enforcement of black-letter law, aptly characterises the present mindset of regulators and lawmakers enacting specific corporate governance rules, beyond the series of other legal obligations imposed on companies, to influence good governance practices and restore and maintain confidence in the market.61 Furthermore, in ‘Responsive Regulation’ (co-authored with Ayres and discussed earlier in this chapter), 58 Frederick G Hilmer, Strictly Boardroom: Improving Governance to Enhance Company Performance (Hilmer Report (1993)), Melbourne, Business Library (1993) Preface. 59 Clarke, above n 7, 160. 60 In Peter Grabosky and John Braithwaite (eds), Business Regulation and Australia’s Future, Canberra, Australian Institute of Criminology (1993). 61 Ibid 81–4.

CONTEMPORARY CORPORATE GOVERNANCE

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Braithwaite contends that the most effective system of regulation provides a framework that facilitates a high proportion of willing compliance in response to persuasion, supported by high expectations of appropriate but inevitable enforcement. The relatively recent movement towards the formalisation of corporate governance regulation (at least since SOX in 2002) over time may become seen as misguided. This position, is supported by the present shift (at least in academic commentary) away from – or at the very least the slowdown in the move towards – a United States-style ‘outsider’ model of corporate governance (characterised by diffuse shareholdings, the separation of ownership and control, and a shareholder-value based objective) following the collapses of Enron and WorldCom. In the mid-to-late 1990s, there was growing momentum for jurisdictions such as Germany and France – along with other European and Asian countries (including Japan) – who, for reasons of tradition, culture and perceived effectiveness adhered to an ‘insider’ style of governance, to model their systems more along United States lines, thereby causing an international ‘convergence’ in corporate governance.62 This was due to the enormous growth, and strong corporate performance, that the USA was experiencing relative to other countries. However, over the course of time, as we have experienced large-scale collapses and a general slowdown in economic performance in the USA, the ‘conventional wisdom’ of convergence is now being questioned.63 Post-Enron, commentators are focusing on what is wrong with United States corporate governance, and are reviewing the role and direction of convergence in contemporary corporate governance, rather than continuing to advocate a convergence strictly in accordance with the United States system of governance.64 The global financial crisis has provided added impetus to the questioning of the United States model. Clarke has observed that ‘the apparent ascendancy of the Anglo-American markets and governance institutions was profoundly questioned by the scale and contagion of the 2008 global financial crisis.’65

62 On convergence generally, see Mark J Roe, Political Determinants of Corporate Governance, Oxford, Oxford University Press (2003). 63 See, for example, Douglas Branson, ‘The Very Uncertain Prospects of “Global” Convergence in Corporate Governance’ (2001) 34 Cornell International Law Journal 321; and G¨ uler Manisali Darman, Corporate Governance Worldwide: A Guide to Best Practices and Managers, Paris, ICC Publishing (2004) 137–40. See also Paul MacAvoy and Ira Millstan, The Recurrent Crisis in Corporate Governance, Basingstoke, UK, Palgrave Macmillan (2004), in which the authors examine the implications of the Enron scandal and the bursting of the ‘dot.com bubble’, which has required commentators to re-examine the effectiveness of United States corporate governance. Indeed, a recent work by Harvard law professor Reiner Kraakman and six other leading commentators, The Anatomy of Corporate Law: A Comparative and Functional Approach, Oxford, Oxford University Press (2004), looks beyond path dependence and convergence as the emerging trend, and instead approaches company law from a globally integrated perspective. The authors frame company law as a body of rules designed to address three ‘agency problems’ – managerial opportunism, controlling shareholder opportunism, and the opportunism of shareholders vis-` a-vis other stakeholders. 64 See in particular Gordon and Roe, above n 54, which contains a series of essays considering, among other things, the very point of whether the Enron scandal, and the subsequent corporate governance reform movement (with the extra compliance costs now involved in properly maintaining a compliant ‘outsider’ public corporation) will halt the trend towards convergence. 65 Thomas Clarke, ‘Recurring Crisis in Anglo-American Corporate Governance’ (2010) Contributions to Political Economy (OUP) 1, 3.

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Meanwhile, in the context of the global financial crisis, the next wave of corporate governance commentary could very much relate to regulators insisting upon a more formal and prescriptive approach to corporate governance regulation. President Nicolas Sarkozy of France recently proclaimed, in the context of the global financial crisis, that ‘self-regulation as a way of solving all problems is finished’.66 Such sentiments only serve to guarantee that the cycle of regulation in this boom–bust period, prefaced in the opening remarks of this chapter, will continue into the future. This will remain the case, notwithstanding the findings of one study, which refutes the popular belief that corporate governance ‘failed’ during the global financial crisis and that justification exists for sweeping corporate governance reforms.67 Cheffins concluded, after analysing the removal of 37 firms from the S&P 500 index during the market meltdown in 2008, that corporate governance functioned tolerably well in those companies, implying that the case has not yet been made for fundamental reform of current arrangements in corporate governance. However, the next chapter in the evolution of corporate governance reform is yet to be written. The wait is unlikely to be long, following the urge of lawmakers around the world to shine the law-reform spotlight upon corporate governance issues, yet again. The challenge of regulating unethical corporate behaviour will remain, however. 66 Quoted in Clarke, ibid 1, 2. 67 Brian Cheffins, ‘Did Corporate Governance “Fail” During the 2008 Stock Market Meltdown? The Case of the S&P 500’ ECGI Law Working Paper No: 124/2009 (July 2009), available at http://ssrn. com/abstract=1396126.

Index

11–12, 81–82, 144, 176–7, 206, 324–5, 461–2 accounting governance 198–218 accounting standards 57, 152–4, 169, 215 acts and omissions doctrine 434–6, 437–8 accountability principle

AIOD see Australian Institute of Directors Alberta Securities Commission (ASC)

333 American Law Institute (ALI) involvement in corporate governance debate 301–3 Principles of Corporate Governance and Structure 78, 300–1 aims 301 impact and importance 301–2 key topics 302–3 American Model Business Corporations Act

78 Anatomy of Corporate Law: A Comparative and Functional Approach, The 36 APRA see Australian Prudential Regulation Authority ‘arms length’ transaction 262 ASC see Alberta Securities Commission ASIC see Australian Securities and Investment Commission ASIC v Adler [2002] 41 ACSR 72 260–5 contraventions of civil penalty provisions

261–4 court orders 264–5 summary 260–1 ASIC v Macdonald (No 11) (2009) 256 ALR 199 (James Hardie litigation)

265–72 court orders 271–2 decision and significance 267–71 legal issues 266–7 summary and background 265–6 ASIC v Rich [2009] NSWSC 1229 272–7 background and facts 272–3 decision and significance 273–7

judicial criticism of ASIC’s case management 277 legal issue 273 ‘asset lock’ requirement (of CICs) 48 Assets Supervision and Administration Commission of the State Council (SASAC) 388, 391 ASX see Australian Securities Exchange ATO see Australian Taxation Office auditing/auditors audit committees 237–9, 333–4 audit oversight 236–7 audit reform 205–6 audit role 219–22 auditing standards 169–70,

235–6 auditor dependence 203 auditor independence 206, 223,

224–9, 307, 367–8 auditor rotation 228 disclosure of non-audit services

228–9 general requirement 225 auditors and the AGM 229 CLERP 9 changes 222–4 Companion Policy 52—110CP Audit Committees 331–4 and conflict 225–7 cooling off period 227 duties 229–30, 231–2 Enron audit 223 Hilmer Report (1993) 144–5 liability of auditors 231–2 qualification of auditors 235 Ramsey Report—reform recommendations 204, 224 reducing legal exposure of auditors

231–5 role in corporate collapses 203–5 Australian Institute of Directors (AIOD)

128 Australian Prudential Regulation Authority (APRA) 128–9

469

470

INDEX

Australian Securities and Investments Act 2001 (ASIC Act) 181–2, 280 Australian Securities and Investments Commission (ASIC) 75, 95,

180–7, 229–30, 232–3 158–9, 185–7, 447 approach 186

ASIC Enforcement Patterns

litigation strategy comments

186–7 use of penal enforcement actions 185 Australian Securities and Investments Commission Act 2001 (ASIC Act)

181–2, 220 civil penalty enforcement 279–80 corporate governance role 182–5 disclosing and resolving conflict 226 enforcement of civil penalty provisions

243–60 financial markets framework role

175,

176–7 FRC’s functions 237 infringement notice power 208–9 injunctive relief 287–8 notification of conflict 227 orders ASIC may seek 243–4 and proportionate liability 233–5 relationship between ASIC and ASX–MOU

193–5 role of 179–95, 197 and SOX 306 transfer of ASX’s supervisory role to ASIC

194–5, 200 Australian Securities Exchange (ASX)

187–95 areas of required improvement

194 ASX Listing Rules

142, 166–8, 187–8,

198, 223 Best Practice Recommendations (2003)

36–40, 65, 170, 198, 199, 456 changes since 2002 189–90 conflicts of interest 194–5, 200 Corporate Governance Council 92, 142,

189 corporate governance definition 4 Corporate Governance Principles and Recommendations (2007) and audit committees 238–9 financial objectives in regulating corporate governance 161 ‘soft’ law category 168–9 financial markets framework role 175,

176–7

Principles of Good Corporate Governance and Best Practice (Recommendations)

96–8, 106, 110, 118, 142, 147, 189, 190–5 2007 changes 190 assessment of independence

112–13 board responsibilities 80 CGC approach versus Combined Code approach 192–3 ethical behaviour by directors 125 recommendations 191–3 structure 190–1 privatisation and conflicts of interest accusations 176 Revised Corporate Governance Principles and Recommendations 26–7, 170 codes of conduct 30, 36–40 Principle 3 37–9 Principle 7 39 roles 179–95, 197 transfer of supervisory role to ASIC

194–5, 200 Australian Taxation Office (ATO)

95

36–40, 65, 76, 96–8, 313–14 boards (of directors) 395, 397–8, 455–6 accountability 81–2 ASX definition 76 board committees 149–50 company meetings 151 the company secretary 93, 120–1 competency 149 and continuous improvement 326–7 effectiveness of 81–2 best practice

employee participation at supervisory board level 348–51 functions 77–83, 86–7, 93, 303 German two-tiered board 85, 87, 92,

342–5 Hilmer Report (1993) 144–5 integrity 327–8 legislation 93–4 organs of governance 75–7 performance of 81, 144–6, 150 responsibilities 80, 150 structures 83–99, 136, 325–6 supervisory role 303 UK Institute of Directors (purpose and roles of board) 80, 82 see also independence principle; shareholders

471

INDEX

boardtorial revolution 6, 78 body corporate 291, 292 Bosch Reports 136–41, 170–1, 455 background 136 Bosch Report (1991) (original)

137–8 Bosch Report (1993) 139, 140 Bosch Report (1995) 141, 188 core differences between 1991 and 1993 reports 139–40 Working Group 136, 137, 139, 141 British Columbia Centre for Social Enterprise

49 burden of proof 275–7 business ethics concept 424–31 business judgement rule 245–7, 263,

270, 273–7, 372 Business Regulatory Advisory Group

community interest company (CIC)

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

47 Companies Act 1993 (NZ) Companies Act 2006 (UK)

49–51 46, 67, 68–9,

280 company law see corporate law comparative capitalism 353–9 compliance ASX Listing Rules 166–7, 187–8 and the auditor’s report 220 and the Bosch Report 139 compliance with law—corporations

436–7 compliance-based reforms of CLERP

200

207–8 ‘comply or disclose’ principle

88, 96, 110, 120–1, 122, 137, 170–1 and ALI principles 300 code of best practice 313–14 context 312–13 and corporate governance 312–16 influence on Bosch Reports 139, 140 call options 374 Cadbury Report (UK)

CAMAC see Corporations and Markets Advisory Committee Canadian Securities Administrators (CSA)

322–3 capitalism 353–9 CGC see Corporate Governance Council Chartwell Enterprise Group 95 chief executive officers (CEOs) 34, 79–80,

113, 117–19, 269–70 chief financial officer (CFO) 271 China Securities Regulatory Commission (CSRC) 388–9, 401–3, 408,

412 CIC see community interest company citizenship see corporate citizenship civil liability 258–60 climate change 31–2, 34–5, 444 codes of conduct 30, 33, 36–9, 40,

96–8 co-determination concept 89, 348–51 Combined Code (UK) 92, 96, 111,

124–5, 192–3 common-law derivative action 281–2 communication 148–9, 347 Communist Party 389–90, 391, 410 community 31, 35–6, 45, 47–9,

71–5

45,

47–9

346,

347 ‘comply or else’ principle 307–8 ‘comply or explain’ regime 168–9,

346 corporate governance 37–9 regulatory compliance ‘pyramid’

158–9, 447–51 conduct 284–7, 291, 292–3 conflict 213, 225–6, 248–9, 264, 396, 420 conflicts of interest 104–5, 176, 194–5, 200, 226–7, 328, 406 consequentialist moral theories

420 contracts 231, 283 corporate citizenship 8, 12, 443 ‘corporate constituency’ concept 43–5 corporate disclosure 206–13 Corporate Disclosure: Strengthening the Financial Reporting Framework 204 corporate governance accounting governance 198–218 Anglo-American models 300–12 aspirational ideals (of good corporate governance practices) 455–6 ASX Revised Corporate Governance Principles and Recommendations 4,

26–7, 30, 36–40 audit role – corporate governance link

221–2 in Australia 131–55 1991–1998 146 background 133–6 Bosch Reports 136, 137–8, 139–40,

141, 170–1

472

INDEX

corporate governance (cont.) divergence from UK practice (1995–2003) 142 Hilmer Report 142–5, 146,

170–1 IFSA Blue Book 146–51 Standards Australia 152–4 and board structures 90–9 in Canada 320–36 future direction 334–6 National Instrument 52 –110

331–4 National Instrument 58 –101

330–1 National Policy 58 –201 323–30 regulatory environment 321–3 charters, policies and codes of best practice and conduct 96–8 in China 386–415 committees 402–3 Communist Party 389–90, 391,

410 391, 392–5, 397–401, 403–8, 409 and conflict 396 consequences of breach 410–13 Company Law 1993

controlling shareholder issue

403–6 corporate entities 390–5 direct intervention—dividends

409–10 enforcement 410 foreign-investment enterprises

392–3 government and legislation 387–90 improved disclosure requirements

406–8 398–401 independent directors 401–2 issues and resolutions 395–7 key pillars policy 406 Law on Industrial Enterprises owned by the Whole People 390–1 National People’s Congress (NPC)

387–8 requirements of sponsors of public offerings 408 Securities Law 393–4, 406–8 standards of accounting 408 state-owned enterprises 390–2,

410 405

356 convergence of corporate governance models 18–19, 353, 356, 357,

359 97, 111, 115–16, 117, 345–8, 402–3, 405 cultural differences 18–19 debate origins 5–10 definitions 3–11 employee participation 27–9 framework 339–40 in Germany 342–52 background 342–5 Baums Commission 344–5 Corporate Governance Code

Draft Bill (Aktienrechtsreform 1997)

343–4 German Code – structure and nature

347–8 IFSA Blue Book definition 147 implications of trustworthiness research

463–4 in Japan 352–86 Commercial Code

359–60,

369–70 companies – committees versus boards of auditors 365–9 comparative capitalism and corporate governance debates 353–9 core employees 382–5 corporate law and practice transformations 359–63 Daiwa Bank judgement 370 derivative suits 370–2, 373 directors’ duties and derivative actions

369–73

increasing duties of directors

supervisory boards

compliance 37–9 contestation of governance structures

395, 397–8,

economic stagflation 362 ‘five ways forward’ proposal

353 German influence 359, 360 ‘grey’ outside directors 366–7 human resource management (HRM) practices 383, 384 Japanese corporate forms and internal governance mechanisms 363–73 kabushiki kaisha (KK) company

363–5 lifetime employment practice

361,

382–5 main banks 361, 379–82 Meiji-era Code 359 ‘micro-fit’ and ‘macro-fit’ of law

370

356,

INDEX

Occupation period 360–1, 371 partnership company (goshi kaisha)

363 share-class diversification 374–5 shareholder versus bank finance

373–82 yugen kaisha (YK) company

360,

363–4 and the judges 165–6 managerial pyramid/governance circle distinction 91–3, 447–51 ‘managing the corporation’ concept 7 and market forces 172–4 norms and behavioural analysis

457–65 OECD Principles of Corporate Governance

9, 17, 21, 27, 29–30, 40–1, 65, 66, 338–42 OECD-recognised stakeholders 22–35, 36 community 31, 35–6 creditors 29–30, 35–6 customers 30–1, 35–6 employees 25–9, 35–6 environment 31–6 government 35–6 shareholders 25, 35–6 organs of governance 25, 27, 75–7 paradigms 21 and performance 16 policy guidelines 148 principles 11–14 public disillusionment 426 rating systems for companies 98–9 regulation of 94–6, 156–61, 178, 465–8 role of ASIC 182–5 and share-price (or share-price returns)

17 significance 14–18 solutions to ‘bad corporate governance’

135–6 stakeholders 24, 53–65 statutory provisions 93–4 ‘stewardship theory’ 458–61 systems 27 in the United Kingdom 312 in the United States 300–12 background 300–1 Securities Exchange Commission

303–4 and the wealth creation concept 28 Corporate Governance Council (CGC) 92,

142, 189

corporate law

473

36, 52, 162–5, 198, 199,

359–63 Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 (CLERP 9 Act)

94, 108–9, 128, 135–6, 198–9, 202, 448 auditing standards 169–70 auditor rotation obligation 228 auditors’ duties 229–30, 231–2 CLERP reform program 200–2, 456 audit reform explanation 205–6 background 199–200 changes to audit role 222–4 disclosure of remuneration and emoluments in Australia 206–7 impetus – responding to corporate collapses 202–5 initiatives 207 key principles 201–2 miscellaneous 213–14 policy proposal papers 200–1 common-law derivative action difficulties

281–2 see also statutory derivative action Corporations Act 2001 amendments and IFSA Blue Book 147, 160–1 design 199 effects of CLERP 9 reforms 199 enforcement 214 independence requirements 226–7 self-regulation to formal regulatory approach shift 171 corporate social responsibility (CSR) 8, 24,

39, 41–2, 442–4 and directors’ duties 65–9 European Alliance for CSR 42 relevance during hard economic times

70 corporations acts and omissions doctrine

434–6,

437–8 ‘agency problem’ 461–2 application of moral principles to business

432–44 application of the Code to bodies corporate

291 codes of conduct 151 company constitution 50–1,

162–5 company dissolution 405 company secretary 93, 120–1 complaints-resolution process 442

474

INDEX

corporations (cont.) corporate collapses

95, 126, 134–6, 169, 183, 185, 426, 450 as CLERP 9 impetus 202–5 investigations into 146 corporate culture 291–2 corporate entities in China 390–5 corporate social responsibility 8, 24, 39, 41–2, 442–4 duties benevolence duty 434–41 compliance with law 436–7 extreme wealth and duty not to frustrate access to justice 441–2 extreme wealth and maxim of positive duty 437–9 levels 432–3 proscriptions against causing harm, lying and environmental damage

432–4 ethical obligations 419–45 Japanese corporate forms 363–73 judgment in the best interest of the corporation (directors) 246 ‘managing the corporation’ concept

7 managing versus directing 78–9 regulator – ASIC 180–7 replaceable rules 162–5, 217 requirement to pay social dividend

439–41 size and socioeconomic power 54–5 and stakeholders 22–3, 36–52,

53–65 sustainability of 35–6 ‘transaction cost’ theory 453–4 see also corporate citizenship; corporate governance; corporate social responsibility Corporations Act 2001 (Cth) 26–7, 30, 51,

67, 76, 77, 94, 102, 163 amendments and the IFSA Blue Book

147, 160–1 and the auditor’s report 220 Case Studies – civil/pecuniary penalty provisions 260–77 Chapter 2D 287–8 Chapter 6CA – continuous disclosure

255 civil liability relief 258–60 CLERP 9 reforms – mandatory corporate governance rules 199 corporate governance – excesses of the 80s

134–5

corporate law 162–5 criminal liability of directors

290–4 criminal offences – directors and officers

293–5 disclosure of remuneration and emoluments in Australia 128 duties of directors 109, 242 general requirement for auditor independence 225 and managing directors 117–18 Part 2E – related party transactions

249–50, 261–2 Part 2F.1 – oppressive conduct of affairs

284–7 applicants for relief 285–6 nature of relief 286–7 type of conduct covered 284–5 Part 2F.1A – statutory derivative action

281–4 case to introduce 281–2 cause of action 283 eligible applicant 282–3 leave of court required to institute

283–4 Part 2H – shares 250–1 Part 2J.3 – financial assistance

262–3 Part 2M.2, 2M.3 – financial records and reporting 251 Part 5.7B – insolvent trading 251–4 Part 5C – managed investment schemes

254–5 Part 7.10 – market misconduct

255–8 Part 9.4B 243–60 s 180: Duty of care and diligence

244–7, 263, 272–7 s 181: Duty of good faith

247–8,

263 s 182, s 183: Duty not to use position or information to gain personally or cause detriment 248–9, 264 Schedule 4, Subclause 29(6) – disclosure for proposed demutualisation 258 Section 188(2) 121 Section 201K – replaceable rule 120 Section 1324 – injunctions 287–90 court’s discretion 288–9 remedies 289–90 Section 1324(1) 287–8 Corporations and Markets Advisory Committee (CAMAC) 65, 66–9,

108–9

INDEX

crassa negligentia (gross negligence)

71–3 creditors 29–30, 35–6 categories 29 creditor interests and insolvency law

29–30 Criminal Code Act 1995 290–2 application to bodies corporate

291 corporate culture 291–2 ‘default’ fault elements 291 establishing ‘authorisation/permission’ (offence) 291–2 criminal liability 290–4 and the Code 290–2 criminal offences – directors and officers

293–5

business judgement rule

475

245–7, 263,

270, 273–7, 372 continuous disclosure duty 255 corporate governance and the Hilmer Report 142–4 and CSR 65–9 delegation and reliance 247,

271–2 disclosure for proposed demutualisation

258 due care and diligence

241–2,

244–7, 263, 272–7 duty not to be involved in market misconduct 255–8 duty of good faith 247–8, 263 duty to prevent insolvent trading

251–4

importance of criminal sanction in corporations law 290–3 CSA see Canadian Securities Administrators CSR see corporate social responsibility CSRC see China Securities Regulatory Commission customers 30–1, 35–6

enforcement 281–94 fiduciary duties 240–1, 248, 399 financial records and reporting duties

debt 251–4 Delaware General Corporation Act

no-conflict rule 248, 249, 264 related party transaction duties

251 increasing duties of directors

398–401 managed investment schemes duties

254–5 78 demutualisation 258 derivative action see statutory derivative action director primacy model 9, 78 directorial revolution 78 directors 124–5, 367–8, 455–6 alternate directors 120, 140 chairperson 113, 118–20, 149 chief executive officers 34, 79–80, 113,

117–19, 269–70 competency 326 connected non-executive directors (CNEDs) 116 and ‘corporate constituency’ laws

43–5 criminal offences under the Act

293–5 definition 102–3, 106 de jure and de facto directors

102–6 nominee directors 104–6, 140 shadow directors 103–4 duties 45–6, 49–51, 67, 68–9,

240–78, 369–73 ASIC enforcement 279–80 breach of duties 245–7, 283

249–50, 261–2 share capital transactions duty

250–1 statutory duties 242 election and appointment 150 equity participation 150 ethical behaviour by directors 125–7 executive and non-executive directors

109–10, 139, 140, 267–9 ‘grey’ outside directors (Japan)

366–7 higher community expectations of directors 71–5 Hilmer Report (1993) 144–5 independent non-executive directors

110–16, 140, 145, 149, 314, 319–20, 332–3, 401–2 judgement- and decision-making guidelines 82–3 lead/senior independent directors

117 liability 39–40, 184, 240–78, 290–4 managing versus directing 78–9 and mere errors of judgement 274–5 permissible directorships 149 remuneration 127–9, 206–7,

307–8

476

INDEX

directors (cont.) trading 150 training of 122–3 types of company directors and officers

101–30

151, 206, 272–7 166–7,

187–8 Australian Accounting Standards 57 and CLERP 201, 211–13 ‘comply or disclose’ principle 346,

347 continuous disclosure 208–9, 255 corporate disclosure 206–13 disclosing and resolving conflict 226 National Instrument 58 –101 (Canada)

330–1 of non-audit services 228–9 for proposed demutualisation 258 of remuneration and emoluments in Australia 128 and transparency 341–2 dividends 409–10, 439–41 duty of benevolence 434–41 duty of care 73–4, 263 development – relevant cases 73–4 director protection – business judgement rule 245–7, 263, 270, 273–7,

372 directors and the Act: Section 180

244–7, 272–7 247–8, 263

duty of good faith

EEIG see European Economic Interest Grouping employees 35–6, 248–9 and CLERP 9 amendments 108–9 employee participation 27–9,

348–51 Japan’s lifetime employment practice

361, 382–5 legislation and regulations protecting

26–7 Mallin’s theories 25–6 nature and corporate governance role

25–9 powers within corporations 76–7 and the wealth creation concept 28 ‘whistleblower’ employees 26–7 ‘enlightened shareholder value’ 45–6, 67,

68–9

304–9 Enterprise State Assets Law (China)

391–2

see also boards (of directors); shareholders discipline principle 11–12 disclosure 39, 52, 94, 127–8, 140, 149, and ASX Listing Rules

Enron collapse 203, 223, 317, 448 US response – Sarbanes-Oxley Act (2002)

environment 31–6, 148–9 Environment Protection Act 1970 (Vic)

32 Environment Protection and Biodiversity Conservation Act 1999 (Cth) 32 equal opportunity legislation 26 Equator Principle, the 34 ethics business ethics and compliance principle (CLERP) 202 business ethics concept 424–31 application of moral norms to business

429–30 business–ethics link 431 business/ethics argument disunity

427 history 424–6 internal settled rules 428–9 justification for excluding moral principles 430–1 universalisability of moral judgements

427–9 codes of conduct

30, 33, 36–9, 40,

151 ethical behaviour by directors 125–7 ethical obligations of corporations

419–45 and justice 441–2 European Economic Interest Grouping (EEIG) 47 European Union (EU) 41–2 inclusive approach to protecting stakeholders’ interests 42 Expert Panel on Securities Regulation

321–2 Fair Work Act 2009 (Cth) 26 fairness principle 11–12, 215 false trading 256 financial markets framework 174–7 financial ratings systems 98–9 financial reporting 207–8, 251 Financial Reporting Council (FRC) 236–7,

314–16 financial services 184, 213, 255–8 first-party sanction 460 ‘for-benefit’ companies 69 Ford’s Principles of Corporations Law [publication] 172–3

INDEX

general counsel 270–1 global economic crisis 69 global financial crisis (GFC)

10–11, 49, 69–70, 95, 127–8, 154, 308, 343 Global Impact program (UN) 443 governance see corporate governance government 35–6, 387–90 Greenbury Report (1995) 316 greenhouse gas emissions 31–2 gross negligence (crassa negligentia)

71–3 Hampel Committee (1998) 111 Hampel Report (1998) 316–17 Higgs Report (2003) 88, 111, 124–5,

317 HIH Royal Commission HIH Insurance Ltd collapse

203, 204, 260–5, 448 Owen Report 4, 14–16, 25, 27, 88, 91, 95 importance of auditor independence

221, 224 observations of middle management

108 offence provisions in Acts 290 and organs of governance

75–7 Hilmer Report 142–6, 170–1 background – AWA Ltd v Daniels; Daniels v Anderson 142–4 Hilmer Report (1993) 144–5 summary of recommendations aspects

144–5 Hilmer Report (1998) 145–6 Appendix 1 – ‘The Fallacy of Independence’ 145 IAASB see International Auditing and Assurance Standards Board IASB see International Accounting Standards Board IFRS see International Financial Reporting Standards IFSA see Investment and Financial Services Association Ltd IFSA Guidance Note No. 2.00: Corporate Governance: A Guide for Fund Managers and Corporations (IFSA Blue Book) 146–51 indemnity 58, 233 independence principle 11–12, 112–13,

140, 145, 149, 314

477

206, 223, 224–5, 228–9, 307, 367–8 insider trading 257–8, 396 insolvency 29–30, 251–4, 288 defences to insolvent trading 253–4 rebuttal presumptions (the Act) 252 intention (‘default’ fault element) 291 auditor independence

International Accounting Standards Board (IASB) 198 International Auditing and Assurance Standards Board (IAASB) 198 International Financial Reporting Standards (IFRS) 198, 215 ‘fair value’ emphasis 215 International Standards on Auditing 198 Investment and Financial Services Association Ltd (IFSA) and ASX Listing Rules 187 IFSA Blue Book 146–51, 161, 170,

188 James Hardie asbestos scandal

39–40,

53 ASIC’s proceedings 183 Case Study – James Hardie’s asbestos compensation settlement 56–5 aftermath 62–5 background 56–7 impetus for corporate restructure

57–8 Jackson Report and its significance

60–2 key features of the separation plan

58–9 public announcement of the separation

59 scheme of arrangement and relocation to The Netherlands 59–60 judicial discretion 288–9 Mauer-Suisse approach 289 key performance indicators (KPIs) 33 King Reports, the (1994, 2002, 2009)

11–12, 16, 88, 90–1, 92, 96–7 291

knowledge (‘default’ fault element) Kyoto Protocol 31–2

L3C see ‘low-profit limited liability company’ law behavioural analysis 457–65 compliance with law – corporations

436–7 36, 52, 162–5, 290–3, 359–63, 391

corporate law

478

INDEX

law (cont.) criminal law (China) 411–12 framing of laws in terms of rules ‘hard’ law 162–6 ‘hybrid’ regulation mechanisms

proportionate liability

435

166–70

see also James Hardie asbestos scandal litigation 283–4, 410–13 ‘low-profit limited liability company’ (L3C)

44–5

accounting standards 169 auditing standards 169–70 implications of trustworthiness research

463–4 insolvency law 29–30 judge-made law 165–6 law and norms discourse 451–65 legal recognition of expectations of directors 73–5 ‘soft’ law 168–9, 170–1 takeover laws 43–5, 373, 375–9 see also legislation law of negligence 71–4, 231 development – relevant cases 73–4 negligence as ‘default’ fault element

291 leadership 12 legislation corporate governance and statutory provisions 93–4 equal opportunity legislation 26 Fair Work Act 2009 (Cth) 26 government and legislation (China)

387–90 interpretation (excesses of the 80s context) 134–5 occupational health and safety legislation

26 protecting employees’ interests 26–7 statutory regulation 162–5 see also Corporations Act 2001 (Cth) (the Act); law liability 44–5, 47–9, 83, 208, 404 of auditors 231–2 breach of statutory duties 231–2 and contract 231 law of negligence 231 civil liability 258–60 concurrent wrongdoer 234 criminal liability 290–4 of directors 39–40, 71–5, 184,

240–78 disclosure of liabilities 57 and insolvency 253 limited liability companies 394,

404–5 for mere errors of judgement moral liability 433

214, 232,

233–5

274–5

Making Boards Work [publication] 172 managed investment schemes 254–5 management of the corporation’s business – ALI

302–3 IFSA corporate governance definition

147 Management Buyouts 377 management discussion and analysis (MD&A) 207–8 managerial pyramid/governance circle distinction 84–6, 91–3, 447–51 middle management as ‘officers’

108–9 register of ‘relevant interests’ 213–14 stakeholder management 8–10, 23,

54–5 strategic management 54–5 supervision of management – boards

81 three-tier structure of management (China) 394 Management Buyouts (MBOs) 377 managerialist theory 172–3 market rigging 256 markets Corporations and Markets Advisory Committee (CAMAC) 65, 66–9,

108–9 financial markets framework 174–7 market forces 172–4 market freedom principle (CLERP) 201 market misconduct 255–8 dissemination of illegal transactions information 257 false trading and market rigging 256 insider trading 257–8, 396 market manipulation 255–6 regulator – ASIC 180–7 material prejudice 262–3 MBOs see Management Buyouts Ministry of Commerce (China) 388 Ministry of Economy, Trade and Industry (METI) 366, 368, 369, 376, 377 Ministry of Justice (MoJ) 366 minority shareholder protections (MSPs)

353–5, 373

479

INDEX

morality 419–24, 437–8 application to business 429–30,

432–44 core moral principles

431,

109–10

433–4

independent non-executive directors

moral liability 433 moral neutrality of business 436–7 promise-keeping and the harmony thesis

430–1 universalisability of moral judgements

427–9

110–16 lead/senior independent directors

117 managing director(s), chief executive officers and executive directors

117–18

utilitarianism 422–3 see also ethics MSPs see minority shareholder protections nation state 439–40 National Australia Bank (NAB) 34–5 National People’s Congress (NPC)

387–8 negligence see law of negligence New York Stock Exchange (NYSE)

309–12 background 309–10 corporate governance rules

310–12,

operational participation 29 oppressive conduct (of affairs) 283–7 Organisation for Economic Cooperation and Development (OECD) OECD effective governance framework guidelines 174–6 OECD Principles of Corporate Governance

9, 17, 21, 27, 29–30, 40–1, 65, 66, 338–42 aims and application 338–9 background 338 board responsibilities 80 corporate governance framework

339–40

456 no-conflict rule (the Act)

connected non-executive directors (CNEDs) 116 executive and non-executive directors

213–14, 248,

264 non-consequentialist moral theories

420–2 norms 451–65 development 454–5 significance 451–7 NPC see National People’s Congress NYSE see New York Stock Exchange occupational health and safety legislation

26 OECD see Organisation for Economic Cooperation and Development officers (company) chief executive officers 34, 79–80, 113,

117–18, 269–70 definitions CLERP definition of ‘senior management’ 214 middle management as ‘officers’

108–9 senior employees and senior executives as ‘officers’ 107–8 statutory definition 106–7 types 101–21, 130 alternate directors 120 chairperson 113, 118–20 company secretary 93, 120–1

disclosure and transparency

341–2 division of responsibilities (ASX and ASIC) 176–7 financial objectives in regulating corporate governance 159–60 recognition of market forces role 174 structure 339 OECD-recognised stakeholders 25–35 recognition of stakeholders in corporate governance 21, 40–1 Owen Report 4, 14–16, 75–7, 88, 91,

95 Appendix G – offence provisions 290 audit role – corporate governance link

221, 224 observations of middle management

108 ‘organs of governance’ discussion

25,

27 Parliamentary Joint Committee on Corporations and Financial Services (PJC) 67 participatory management philosophy

28–9 pluralist approach (to shareholders’ interest)

43–5, 68 376, 377, 378, 379

‘poison pills’

480

INDEX

policy 406 compensation policy 329–30 corporate governance policy 96–8,

148

307–8, 316, 348

‘prima facie’ 430–1 Productivity Commission 129 profit(s) 57, 436–7 ‘low-profit limited liability company’ (L3C)

44–5 maximisation of 6, 427, 430–1 Program-Related Investment (PRI) 44 Project Green 58 proportionate liability 214, 232,

233–5 recklessness (‘default’ fault element)

291 Redefining the Corporation: Stakeholder Management and Organizational Wealth [publication] 23, 54–5 regulation Australian sources 161–74 ‘hard’ law 162–6 ‘hybrid’ regulation mechanisms

166–70 role of market forces 172–4 ‘soft’ law 168–9, 170–1 Australia’s regulatory framework ‘boom–bust–regulate’ cycle 448–50 of corporate governance 94–6,

202, 216 ‘cycle of regulation’ 448–50 definitions 157–8 financial markets regulatory framework – analysis 174–7 division of responsibilities (ASX and ASIC) 176–7 OECD guidelines 174–6 neutrality and flexibility principle (CLERP)

202 protecting employees’ interests 26–7 regulatory compliance ‘pyramid’ 158–9,

447–51

439 responsibility principle 11–12 rights doctrine 420–3 risk 39, 328–9 governance risks 81–2 investor protection principle (CLERP)

201 risk-aversion and directors 184 Royal Commission into the Tricontinental Group of Companies 143 ‘safe-harbour rule’ see business judgement rule SAIC see State Administration for Industry and Commerce Sarbanes-Oxley Act (2002) (SOX) 94, 97, aims and objectives 305–7 and collapse 304–9, 317, 448 and formalisation of corporate governance perspectives 307–9 SASAC see Assets Supervision and Administration Commission of the State Council Securities Act 1933 449 Securities and Exchange Act 1934 449 Securities Exchange Commission (SEC)

303–4 shadow directors 103–4 share capital transactions 250–1 shareholder primacy model 78 shareholders/shares 35–6, 432 actions against directors 280, 281–94,

400–1

role of regulators 179–97 self-regulation 166, 171, 442–4 enforced self-regulation 166–70 pivotal role of corporate governance

139

see also law; legislation

135–6 replaceable rules 162–5, 217 reporting 148–9, 207–8, 251 resources 32–3, 54–5, 174,

218

156–61, 178, 465–8 cost effectiveness principle (CLERP)

137, 139, 141

disclosure of remuneration and emoluments in Australia 128 excessive remuneration debate 127–9,

456

36–40

Working Group – Bosch Report

related party transaction 249–50, 261–2 reliance defence 247, 271–2 remuneration 127–9, 150, 206–7,

136,

auditors and the AGM 229 call options 374 controlling shareholder issue

403–6 and dividends 409–10 and the Dodge theory 6 ‘enlightened shareholder value’

67, 68–9

45–6,

INDEX

IFSA corporate governance definition

147 Mallin’s theories 25 and ‘members’ 286 minority shareholder protections (MSPs)

353–5, 403–6 models 78 nature and corporate governance role

25 and ‘ownership’ model inaccuracies

54–5 powers conferred upon by the Act

76 share-class diversification 374–5 shareholder participation 205, 209 shareholder versus bank finance (Japan)

373–82 shareholders’ meeting 394–5 shareholders versus stakeholders 21 share-price (or share-price returns) 17 ‘tunnelling’ problem 396 and the wealth creation concept 28 see also boards (of directors); stakeholders Smith Report (2003) 317 social dividend 439–41 social responsibility principle 11–12, 24,

432 corporate social responsibility

8, 24, 39,

41–2, 442–4 stakeholder management 8–10, 23, 54–5 ‘instrumental stakeholder theory’ 55 stakeholders 5, 147–8, 302, 330, 432,

462 corporate governance role 24 definitions 22–4 ‘external’ and ‘internal’ stakeholders 24 importance of 8–10 models 23, 53–65, 78 OECD recognition 21, 25–35 shareholders versus stakeholders 21 stakeholder debate origins 5–10 stakeholders’ interests – role of the law

36–52, 65 Australian position 36–40 Canadian position 49 EU position 41–2 New Zealand position 49–51 OECD position 40–1 overseas position 40–52 South African position 51–2 UK position 45–9 USA position 43–5 and sustainability of corporations 35–6,

52

481

see also shareholders Standard and Poor (rating agency) 99 Standards Australia 152–4, 170 AS 800 Corporate Governance series

152–4 parts and appendices 153–4 State Administration for Industry and Commerce (SAIC) 388, 392 statutory derivative action 281–4 ‘stewardship theory’ (of corporate governance) 458–61 implications 460 stock market 448–50 strategic participation 29 Strictly Boardroom: Improving Governance to Enhance Company Performance (Hilmer Report) 142–6, 170–1 supervisory boards 395, 397–8,

405 actions against directors 400–1 see also boards (of directors) sustainability 12, 32–3 of corporations 35–6, 52 Global Impact program (UN) 443 Suzuki Report (Japan) 90 ‘tipping’ 257 Tokyo Stock Exchange (TSE)

366, 368–9,

373 tort of negligence 73–4 Trade Practices Act 1974 (Cth)

30,

232 ‘transaction cost’ theory (corporations)

453–4 transparency principle

11–12, 176–7,

201, 341–2 ‘triple bottom line’ concept 52 TSE see Tokyo Stock Exchange ‘tunnelling’ problem 396 two-tier board structure 83–90, 136 UK Combined Code 314–16, 317–20 unitary board structure 83–90, 136 United Nations Environment Programme Statement for Financial Institutions on the Environment and Sustainable Development 34 universalisation (of moral judgements)

427–8 exception 428–9 utilitarianism 422–3 victimisation 209–11 voting 148–9, 209, 394–5, 398

482

INDEX

wealth creation 28, 32–3, 437–9 extreme wealth and duty not to frustrate access to justice

441–2 nation state 439–40 redistribution of wealth

‘whistleblowers’

26–7, 115, 205,

209–11 Working Group (Bosch Report)

136, 137,

139, 141 WorldCom collapse

440

448

203, 304–9, 317,