Corporate governance: lessons from the James Hardie decision

The decision of the New South Wales Supreme Court in Australian Securities and Investments Commission v Macdonald¹ (the James Hardie decision) in April last year has generated substantial interest across the Tasman. The decision is also noteworthy here, particularly for the guidance it provides on the responsibilities of directors and senior executives, the conduct of board meetings and the release of market sensitive information .

In this article, partner Glenn Joblin discusses the key aspects of ASIC's claims and the court's decision with commentary on the relevance of the decision under New Zealand's statutory regime.

For a summary of corporate governance recommendations arising from the decision, see the corporate governance tips section at the end of the article.

In brief

The James Hardie decision of the New South Wales Supreme Court relates to civil proceedings brought by the Australian Securities and Investments Commission (ASIC) against former directors and certain senior executives of the former parent company of the James Hardie group. The court found that these individuals breached their statutory duty of care as a result of false or misleading stock exchange announcements, press releases and public statements made about the adequacy of the funding of a foundation established to meet asbestos-related claims against companies in the James Hardie group.

ASIC also succeeded in claims against companies in the James Hardie group for breaches of Australia's market manipulation provisions and ASX's continuous disclosure obligations.

In a subsequent penalty hearing, the court issued various penalty orders against all of the directors and the three executive officers, and banned them from acting as directors or being involved in the management of a corporation for periods ranging from five to fifteen years.

The facts of the case highlight the importance of following best practice corporate governance procedures in relation to:

• the formal conduct of board meetings;

• the responsibility of senior management and in-house legal counsel to be proactive on the information they put before a board; and

• the appropriate procedures and authorisations surrounding the drafting and release of public announcements.

Background to the James Hardie decision

The case arose out of the restructuring of the James Hardie group of companies initiated in 2001. The restructuring's principal objective was to separate the group's operating assets from the legacy of asbestos liabilities associated with James Hardie Industries Limited (JHIL), the listed parent company of two group companies which manufactured asbestos products in Australia (the subsidiaries). As part of the restructuring, a trust company was established as the new parent company of the subsidiaries and as trustee to a foundation which was intended to assume the responsibility for the group's asbestos-related compensation claims.

As Justice Gzell noted in his decision, the proposal to restructure the James Hardie group and establish the foundation represented "a most significant event in the life of the James Hardie group" and was an event that the board of JHIL "were at pains to ensure was well received by the market".

When JHIL announced the establishment of the foundation in February 2001, it stated that the foundation would have "sufficient funds to satisfy all future legitimate claims", was "fully funded", and "provided certainty for both claimants and shareholders" (the ASX Announcement). The ASX Announcement also stated that expert advice from a number of firms had been sought and this "formed the basis of determining the level of funding required to meet all future claims". These statements were repeated in subsequent ASX announcements, press statements, investor "road-show" presentations and various accompanying documents.

None of the ASX announcements referred to a deed of covenant and indemnity which JHIL had entered into with the subsidiaries (the DOCI) as part of the separation arrangements. Under the DOCI, JHIL was afforded additional protection from various asbestos-related claims which could have been made by the subsidiaries (and other potential third parties) against JHIL. The DOCI also contained a put option which required one of the subsidiaries to purchase all of JHIL's shares if certain conditions arose.

Later the same year, the next stage of the restructuring of the James Hardie group was implemented by means of a scheme of arrangement. The information memorandum sent to JHIL's shareholders included a statement that partly paid shares issued by JHIL to James Hardie Industries NV (the new Dutch holding company for the group under the proposed restructuring) would enable JHIL to call on James Hardie Industries NV if it required funds to meet any further liabilities JHIL had for asbestos related claims. JHIL was entitled to cancel the partly paid shares at any time and in 2003, JHIL was transferred out of the James Hardie group and the partly paid shares were cancelled. However, James Hardie Industries NV did not announce to the market the board's decision to proceed with the 2003 changes relating to JHIL and the cancellation of the partly paid shares.

Shortly after the completion of the restructuring of the James Hardie group it became apparent that the foundation was significantly underfunded. In 2004, the New South Wales government established a special commission of inquiry to review the foundation's ability to meet future asbestos-related liabilities and to determine the effect the restructuring of the James Hardie group had on the foundation's insufficiency of assets to meet its liabilities.

The inquiry concluded that although there was likely to be a shortfall of AU$1.5 billion in the funding of the foundation, there was nothing improper with the transactions leading to the establishment and separation of the foundation from the James Hardie group and, further, JHIL was under no legal obligation to provide greater funding to the foundation. Its findings however were very critical of JHIL's board and its management, particularly with regard to misleading statements made on behalf of JHIL at the time of the establishment of the foundation and during the restructuring of the group (noted above). It concluded that there was no satisfactory basis for the assertions made in the ASX Announcement and in other subsequent statements to the effect that the foundation would have sufficient funds to meet all future claims.

In 2008, after investigating matters arising from the inquiry, ASIC commenced civil proceedings against JHIL, James Hardie Industries NV and certain former directors and officers of those companies.

ASIC's claims and their relevance to New Zealand's securities and corporate legislative regimes

Statutory duty of care

The majority of ASIC's claims were based on establishing that the seven surviving JHIL directors and the CEO, the company secretary and general counsel, and the CFO had failed to discharge their duties with due care and diligence to ensure that JHIL did not contravene its obligations under the Corporations Act with respect to the disclosures made concerning:

• the adequacy of funding to be made available in 2001 for the foundation (with particular reference to a draft of the ASX Announcement approved by the board of JHIL in February 2001); and

• future plans relating to JHIL and the partly paid shares issued by JHIL.

In Australia this case is seen as significant partly because it is one of the few cases where ASIC has brought proceedings against both executives and directors of a company for breaches of the same obligations. The case highlights significant differences between New Zealand and Australian legislation in this area. Under New Zealand legislation, the duty of care obligation (section 137 of the Companies Act 1993) only applies to directors and not to a company's executive officers (unless they are deemed directors). In addition, ASIC has power under the Corporations Act to bring a civil action against directors and officers of a company for breach of their duty of care. There is no equivalent statutory power under New Zealand law.

Nevertheless, the difference between the statutory regime in each country does not lessen the importance of the case for New Zealand directors and from a best practice standpoint the court's findings on the responsibilities of senior executives in this case remain noteworthy.

Market manipulation and continuous disclosure obligations

ASIC also brought civil proceedings against JHIL for engaging in misleading or deceptive conduct, providing false or misleading statements to the market and breaching its continuous disclosure obligations (through failing to disclose the DOCI and certain further information in relation to the subsequent restructuring of the James Hardie group). The findings of the court on these aspects of the case are relevant to New Zealand listed companies, their directors and senior executives because the underlying obligations of New Zealand's market manipulation and continuous disclosure rules are the same as under Australian law.

New Zealand's market manipulation rules were introduced in 2008 in the Securities Markets Act 1988. The New Zealand equivalent provisions of those which ASIC claimed had been breached by JHIL prohibit a person from:

• engaging in conduct in relation to any dealing in securities that is misleading or deceptive or that is likely to mislead or deceive;

• making a statement or disseminating information which is materially false or misleading which is likely to induce a person to trade in securities or have the effect of increasing, reducing, maintaining or stabilising the price for trading in those securities.

New Zealand's continuous disclosure obligations arise under Part 2 of the Securities Markets Act and the NZX Listing Rules. A breach of the continuous disclosure obligations can result in a fine or other penalty imposed by NZX Discipline on an issuer under the NZX Listing Rules. In addition, since an amendment to the Securities Markets Act in early 2008, liability for such a breach can extend to any person who aids, abets, counsels or procures any other person (including the issuer) to contravene a listed issuer's continuous disclosure obligations or any person who is in any way, directly or indirectly, knowingly concerned in or a party to the contravention by any other person . This allows the Securities Commission to bring proceedings against directors and key senior executives in the event of a breach by a listed company of its continuous disclosure obligations. (For further details of this change see the article "Expanded liability under the continuous disclosure regime" in the Winter 2007 issue of Commercial Quarterly.)

The decision

February 2001 board meeting

One of the key issues in the case was whether the JHIL board as part of their deliberations on the foundation proposal at a board meeting on 15 February 2001, had considered and approved a draft of the ASX Announcement prior to its release the following day.

Minutes of the meeting, which had been drafted by JHIL's solicitors prior to the meeting and signed-off as correct at the next board meeting (without objection), indicated that these events had taken place. However, each of the directors claimed that they had no recollection of the draft ASX Announcement being tabled at the February meeting, nor of its terms being discussed, nor could they recall giving their approval for it to be released.

Evidence given in support of the directors' positions included the following:

• the draft ASX Announcement was not included in the board papers for the meeting and there was no mention of the ASX Announcement in the agenda of the meeting;

• it was JHIL's standard practice in relation to ASX announcements, other than those of a financial nature, for the announcement to be approved by the CEO, the CFO, general counsel and JHIL's external legal advisers prior to an announcement being put to the board in its final form, whereas in this instance none of these individuals recalled seeing a copy of the ASX Announcement prior to the board meeting and there was no evidence given confirming they had been sent copies of the announcement;

• two of the directors had participated in the meeting by teleconference from the United States and there was no evidence to show that those directors had been sent a copy of the draft ASX Announcement;

• each of the directors indicated that if they had seen the draft ASX Announcement they would either not have approved it or would have made comments seeking to modify its terms;

• none of the directors recalled reading the entry in the minutes relating to the approval of the ASX Announcement, (with some acknowledging that they had not read the minutes in full); and

• there were a number of inaccuracies recorded in the minutes (in addition to the alleged inaccurate entry referring to the ASX Announcement).

On the facts, the minutes were not given any special evidentiary value by the court. Under the Corporations Act there is a statutory presumption that the minutes are a correct record of a meeting, but the court held that the presumption did not apply in this case given that the minutes were not recorded in JHIL's minute book within the one-month time period stipulated in the Act. Nevertheless, the court found as a matter of fact that the entry in the minutes relating to the ASX Announcement was accurate. The court found that the directors were mistaken in their recollections of the proceedings at the meeting, and inferred from copies of the draft ASX Announcement retained by a JHIL officer (who attended the meeting), a corporate shareholder of JHIL (who had directors on the board) and JHIL's lawyers that a draft of the ASX Announcement had been circulated to the directors present at the 15 February board meeting. The court also relied on oral evidence given by one director who had acknowledged that someone might have outlined what was to be in the ASX Announcement, including the wording relating to the foundation being sufficiently funded.

The court concluded that it followed from this finding that the draft ASX Announcement had been approved by the board, even though the directors did not recall a formal vote being taken. T he court noted that the practice of the JHIL board was not to formally put a matter to a meeting as a resolution. The practice was for the chair to summarise the position and directors indicated their approval or remained silent.

The ASX Announcement

Breach of duty of care by the directors

Having found that the draft ASX Announcement was circulated and approved by the board for release to the market at the 15 February meeting, the court went on to find that each of the seven directors had breached their statutory duties to exercise due care under section 180(1) of the Corporations Act.

By giving their approval to the draft ASX Announcement with its overstatement of the situation as to the level of funding of the foundation, the court found that the directors had failed in their duty to JHIL to protect it from the harm it potentially faced upon publication of the ASX Announcement, including legal action for publishing false or misleading or deceptive statements, damage to its reputation and market reaction.

The court reached this decision despite a finding that JHIL's executive officers had failed to advise the board appropriately on key aspects of the content of the ASX Announcement (see the discussion below). Based on the material provided to the board which, in addition to the independent expert reviews referred to in the ASX Announcement, included a number of earlier presentations to the board on the uncertainty of prediction of asbestos claims, the court concluded that the directors, if they had exercised their duty with the appropriate level of care and skill, could not have been satisfied that JHIL had a proper basis for making the assertions of sufficient funding, or approved the ASX Announcement or authorised the release of the ASX Announcement.

The court also rejected the argument that the approval of the ASX Announcement was a matter that the board could delegate to directors with particular expertise or to JHIL's management. In the court's view the nature of the announcement made it appropriate for management to ask the board to approve the content of the draft ASX announcement. Justice Gzell noted that i t was a "key statement in relation to a highly significant restructure of the James Hardie group" and given that management brought the matter to the board, the directors were not entitled "to abdicate responsibility by delegating his or her duty to a fellow director." In Justice Gzell's opinion, t he emphatic nature of the draft ASX Announcement was not something that was a matter for reliance upon management or outside experts. 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.

In the case of the two US directors, the court found both directors to be in breach of their duty of care in failing to request that they be provided with a copy of the draft ASX Announcement, in failing to familiarise themselves with its terms, or in failing to abstain from voting in favour of the announcement "as a reasonable person in their shoes with their responsibilities would have done".

Breach of duty of care by the executive officers

Although the court found that the directors were not entitled to rely on management in relation to the approval of the ASX Announcement, the court still found that the three executives had duties to bring certain matters to the attention of the directors. In particular the court found that the CEO (who was also a director of JHIL), the general counsel (who was also the company secretary) and the CFO had failed in their duty to act with due care and skill (in breach of section 180(1)) by not bringing to the board's attention that there were important limitations to the reviews of the foundation undertaken by two independent experts.

The CEO and the general counsel were also found to be in breach of the same duty for not advising the board that the language used in the ASX Announcement was expressed in too emphatic terms concerning the adequacy of funding to meet all legitimate present and future asbestos claims and in that respect the ASX Announcement was false or misleading. Justice Gzell noted that the general counsel had a "high degree of responsibility to protect JHIL from legal risks associated with the proposed publication" of the ASX Announcement and he had failed to warn the board of those risks.

In reaching these findings, the court noted that all three executives had played a significant role in the implementation of the restructuring proposal. The CEO was the leader of the restructuring proposal. The general counsel and the CFO regularly participated in decision-making that affected the whole or a substantial part of the business of JHIL, including the decision taken by the board on the foundation at the February 2001 meeting. Given their respective roles in JHIL, they were party to all relevant information which would have led to a reasonable person holding similar positions to theirs to realise that the statements were false and misleading and that they would be harmful, or potentially harmful, to JHIL.

However, the court did not agree that the CEO's duty of care extended to a duty to monitor the individual bases upon which his co-directors voted on the issue. To quote Justice Gzell: "A director is not obliged to analyse the basis upon which fellow directors intend to vote before determining his or her own course. Bearing in mind the calibre of the JHIL board members, it would be insulting for the [CEO] to ask each board member whether he or she really meant what they were about to do."

Additional allegations of breach against the CEO

The CEO was also found to be in breach of his statutory duty of care for:

• approving for release the ASX Announcement, or in failing to advise that the ASX Announcement not be released, or that it be amended before being released, to remove the matters that were false or misleading; and

• failing to ensure statements he made at subsequent press conferences and road-shows, in his role as CEO of JHIL and later as CEO of James Hardie Industries NV, relating to the funding of the foundation were not false or misleading.

However, the court found that ASIC had not established that the CEO through his actions had failed to exercise his statutory duty to act in good faith, in the best interests of JHIL and for a proper purpose. The court noted that the CEO may have been misguided in the extent to which he sought to sell the restructuring proposal, but in doing so there was no conflict between his personal interest and that of JHIL. The court pointed out that he did not take advantage of his position to make a secret profit, nor did he misappropriate the company's assets for himself. He was "overzealous, but he was overzealous in the interests of JHIL".

Market manipulation contraventions by JHIL

In addition to the breaches by the directors and the executives, the court also found that JHIL had, in releasing the ASX Announcement and certain other announcements and as a result of statements made in press conferences:

• engaged in conduct that was misleading or deceptive, or was likely to mislead or deceive; and

• released information that was likely to induce other persons to sell or purchase the shares of JHIL, or likely to have the effect of increasing, reducing, maintaining or stabilising the market price of shares of JHIL,

in contravention of the market manipulation provisions in the Corporations Act. The court concluded that the CEO used over-emphatic terms of certainty in his endeavour to sell the restructuring announcement (which he knew or ought to have known were false or misleading in a material particular). The natural effect of those statements was likely to induce listeners to purchase JHIL shares and was likely to increase the market price of those shares.

Executives' personal liability for breach of continuous disclosure obligations

The court found that JHIL breached its continuous disclosure obligations for failing to disclose the DOCI in February 2001 on the basis that a reasonable person would have expected the publication of the DOCI to have a positive material effect on the price of JHIL's shares. JHIL had acted negligently in that it did not obtain any legal advice as to whether it should disclose the DOCI and in that neither the board nor management of JHIL considered whether disclosure of the DOCI was required. The court also found that James Hardie Industries NV was in breach of its continuous disclosure obligations for failing to disclose, among other things, that the partly paid shares were cancelled as part of the transfer of JHIL from the James Hardie group.

Two of the executive officers were also found to be in breach of their duty of care in respect of the non-disclosure of the DOCI. The CEO was found to be in breach of his duty to exercise due care for:

• failing to advise the chairman of the board of JHIL whether or not the DOCI was required to be disclosed to the ASX;

• failing to seek and consider advice to satisfy himself in relation to that question;

• failing to determine that JHIL would disclose the DOCI to the ASX; and

• failing to raise with the chairman or the board of JHIL that the issue needed to be considered and determined.

Similarly, the general counsel was found not to have exercised due care through:

• failing to advise either the CEO or the board that it needed to consider whether JHIL was required to disclose the DOCI under the continuous disclosure obligations;

• failing to obtain advice for the CEO or the board or provide his own advice as to whether disclosure was required; and

• failing to advise the CEO or the board to determine that JHIL would disclose the DOCI.

As general counsel he should have noted that the disclosure issue was not an item on the agenda for the board's consideration at the February 2001 meeting and taken appropriate steps to ensure that the CEO and the board were aware that non-disclosure could result in JHIL being in breach of its continuous disclosure obligations. The general counsel was aware that if any failure to disclose material information was exposed, JHIL would suffer harm to its reputation with the prospect of adverse market reaction. The court reiterated its earlier comment made in relation to the terms of the ASX Announcement that "the core of [the general counsel's] responsibility was to protect JHIL from legal risk".

In New Zealand, the Securities Commission (like ASIC) now has the power to bring civil proceedings against directors, executives, and other individuals who are involved in a contravention by a listed issuer of its continuous disclosure obligations. This power, however, is based not on a breach of duty of care as under the Corporations Act but under recent changes to the Securities Markets Act (discussed further above). A due diligence defence is available if a person can establish on the balance of probabilities that:

• they took all steps (if any) that were reasonable in the circumstance to ensure that the issuer complied with its continuous disclosure obligations; and

• after doing so, they believed on reasonable grounds that the issuer was complying with its obligations.

Although there has been no case law on this new provision, the defence is likely to apply where directors and senior executives of an issuer have sought and relied on advice from a qualified expert who was provided with all relevant information.

Penalties

The court issued penalty orders in August 2009². The CEO was banned from managing a corporation (including acting as a director) for 15 years and fined AU$350,000. The general counsel was banned for seven years and fined AU$75,000. Smaller fines were imposed on the CFO and the other seven directors, who were each banned from managing a corporation for five years. Six of the directors and the general counsel have since appealed the court's first instance decision. The appeal is scheduled to be heard in April 2010. Of the remaining three, two have filed notices of intention to appeal with only the CEO deciding not to appeal.

In New Zealand, the Securities Markets Act provides a number of statutory consequences for non-compliance with the market manipulation provisions and continuous disclosure obligations (depending on the nature of the breach or the offence). These include:

• a prohibition order or a corrective order issued by the Securities Commission;

• a pecuniary penalty order of up to $1 million per person;

• a compensatory order for loss or damage suffered by any person; and

• other civil remedy orders (for example, restraining the exercise of voting rights or the acquisition or disposal of securities).

Additional consequences for non-compliance with the market manipulation provisions include:

• a management banning order for a term of up to 10 years; and

• criminal penalties (imprisonment of individuals for up to five years and/or a fine of up to $300,000 and a fine for a body corporate of up to $1 million).

Concluding comments

The James Hardie decision illustrates the high level of scrutiny that is required from directors when considering strategic matters and the limitations on their ability to delegate to or rely on others. In particular, directors should:

• obtain all information they need from management and ensure they read all relevant board papers before making a decision;

• ensure that they sign-off on the company's public communications on strategic decisions and that those communications are accurate and not misleading; and

• review all draft board meeting minutes before they are adopted to ensure they are an accurate record of the meeting.

In the case of senior executives, the decision reinforces the importance of fully briefing the board about significant public announcements and ensuring that the board is provided with all relevant information.

 

Corporate governance practice tips Board meetings Directors should take responsibility for obtaining all information they need from management and ensure that they are familiar with the content of any material provided to the board prior to voting on a board resolution. The practice of the JHIL board not to put matters requiring a decision of the board in the form of a formal resolution may have been a contributing factor to the board not giving the requisite attention to the ASX Announcement. Adopting a formal resolution procedure, especially for matters of significance, is more likely to ensure that directors apply the appropriate degree of consideration to all matters. Directors attending a meeting by teleconference or other electronic means must exercise the same standard of care as those directors physically present at a meeting. In particular, they should ensure that they are able to hear what is being said at the meeting and are in possession of the same information and documentation provided to other directors at the meeting. If a director does not wish to vote on a matter, he or she should abstain from the vote rather than simply expressing no opinion either way on a matter. A director's abstention (and the reasons for the abstention) should be noted in the minutes of the meeting. A complete set of all documents provided at or prior to a meeting should be kept by the company so there is clear evidence of what has, and has not, been seen by the board. Directors should also keep copies of documents provided to them. Although New Zealand is not subject to the same statutory minute requirements as under the Corporations Act, it is good practice for a draft of the minutes of a board meeting to be circulated and reviewed by all directors in a timely manner with directors raising any objection to the content of those minutes before they are approved. Ideally the final version of the minutes should be put before a meeting of the directors as part of the formal sign-off process. Delegation and reliance An important limitation on a director's statutory duty of care is the ability of a director to rely on information or advice prepared by certain persons (see section 138 of the Companies Act), including officers, professional advisers and fellow directors. However, as under the equivalent Corporations Act provision, the New Zealand limitation is subject to the director acting in good faith, making "proper enquiry" and having no knowledge that such reliance is unwarranted. The James Hardie decision provides an example of a situation where the court considered it inappropriate for a director to rely on the particular skills of his co-directors, management or expert advisers. In the court's opinion the content of the draft ASX Announcement "involved no more than an understanding of the English language used in the document." Role of senior executives The James Hardie decision illustrates the importance of executives taking particular care when briefing the board about significant public announcements. The information they are required to provide will reflect their level of expertise, their position and their knowledge of the matter being discussed. Making public announcements In circumstances where a company is implementing a major transaction or becomes aware of a matter of strategic importance to the company, and the company is to make public statements on the matter, directors should not abdicate responsibility for approving and releasing public statements by delegating responsibility to other directors, to management or to advisers even if they have greater expertise in relation to the substance of the matter. Establish and follow internal protocols around the release of public statements. In the James Hardie decision, evidence was given suggesting that JHIL's standard practices were not followed leading up to the presentation of the ASX Announcement to the board. Company announcements should be balanced and objective. The same standard should be applied to statements and presentations made for investor and press briefings. Continuous disclosure obligations Review the company's communication policies to ensure clear responsibilities for continuous disclosure and identification of price sensitive information have been established. Ensure senior management is aware of and understand the company's continuous disclosure obligations and their potential personal liability under the Securities Markets Act. Maintain records in order to establish a due diligence defence if the company's internal policies fail, resulting in a breach of the continuous disclosure provisi ons.

 

¹ (No.11) [2009] NSWSC 287

² ASIC v Macdonald (No 12) [2009] NSWSC 714

Enquiries and information

For more information on any of the cases, articles and features in Commercial Quarterly, please email Diane Graham or call her on 64 9 916 8849.