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Brief Counsel

The importance of being frank (with the board)

08 March 2011

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The New South Wales Appeal Court recently upheld penalties for breach of directors’ duties against two former executives of James Hardie Industries Limited (JHIL).  Although, unlike Australia, New Zealand law does not expressly impose directors’ duties on company “officers”,  it would be a mistake to think that the judgment is therefore not relevant to New Zealand. 

In particular, chief executives and members of board committees should understand its implications – and ensure that they provide the board with all information material to its decisions.

The context

JHIL was under intense pressure at the start of the new millennium to insulate the company’s asbestos-related exposure from the rest of the business because proposed accounting standard changes would have required JHIL to include in its balance sheet a provision for future asbestos claims.

Senior management had been exploring restructuring options for some time and were under direction from the board that they needed to be able to satisfy the market and asbestos victims that there would be sufficient funding to meet present and future claims.

The final proposal, approved by the board on 15 February 2001, was to create a trust - the Medical Research and Compensation Foundation – in which the shares of the two subsidiary companies responsible for the group’s historic asbestos production would be vested, together with other assets to a net value of $293 million.  In return, a Deed of Covenant and Indemnity (DOCI) would be entered into, indemnifying JHIL from any further liability.

However, the strategy bombed spectacularly.  Within two years of implementation, the Foundation was reporting a serious shortfall in funds.  Within four years, JHIL was the subject of a judicial Commission of Inquiry.  Within nine years, disqualification orders and penalties had been awarded against the CEO, the CFO, the General Counsel and the seven non-executive directors who participated in the 15 February board meeting.

All parties except the CEO appealed.  The breaches against the non-executive directors were discharged by the Appeal Court but the appeals by the CFO, Phillip Morley, and the General Counsel, Peter Shafron, largely failed. 

Appeal Court findings against Morley and Shafron

Shafron was found to have contravened his duty of care and diligence on two counts:

  • failure to advise the CEO and the board that the DOCI should be notified to the market under the continuous disclosure requirements, and
  • failure to inform the board that the actuarial assessment underpinning the funding allocation to the Foundation was not based on the most recent data and had only a 50% probability of being achieved.

Morley was found in contravention for failing to advise the board that the reviews of the cash flow modelling by external experts were restricted to the logical soundness and technical correctness of the model and explicitly excluded consideration of the model’s key assumptions, including an assumed 11.7% return on investments.

Implications for New Zealand

The Australian Corporations Act places the same duties of care and diligence on “officers” of the company as on directors.  The New Zealand Companies Act does not.  But this does not mean the case can be ignored on this side of the Tasman.  In particular, it is relevant to chief executives and directors who sit on board committees.

  • Chief executives.  Under the New Zealand Companies Act, “director” includes (for the purposes of core directors’ duties) “a person to whom a power or duty of the board has been directly delegated ... with that person’s consent or acquiescence”.  This will typically be the chief executive (and may sometimes include others, such as the CFO).  A chief executive who is required to play a role in relation to a transaction (analysis, negotiation, entry under delegated authority) might be regarded as a “deemed director” and accordingly required to exercise the care, diligence and skill of a reasonable director in respect of that role.
  • Board committees.  Under the Companies Act, a director must exercise the degree of care, diligence and skill which a reasonable director would exercise in the circumstances taking into account (amongst other things) “the nature of the responsibilities undertaken” by him/her.  A director who has agreed to sit on a board committee – for example, an ad hoc committee established to play the lead governance role for a major transaction – may well have more extensive obligations than those which apply to non-committee members.

In either case, failure by the chief executive or committee members properly to inform the main board of all matters material to the decision might mean they are found liable for breaching their duty of care (as directors), even if the other board members (who relied on them) were not.

Take-outs

As with most (all?) other recent cases involving liability for alleged breach of disclosure obligations, this case is very fact-specific.  It nonetheless provides some useful lessons/reminders for directors (and direct board delegates).

  • Ensure that you understand the full extent of your responsibilities.  (Shafron sought to use as a defence the fact that he had not actually participated in the decision-making, but the Court found that “it is a reality of corporate life that board and other important decisions involve many persons other than the ultimate decision-makers”.)
  • For important or sensitive decisions, err on the side of caution – even to the extent of telling the board things you think are obvious or that they already know.  (Shafron failed to advise the board that a draft ASX release was “too emphatic” regarding the sufficiency of the Foundation’s funding.  He argued that this was not necessary as he had told the board many times that the actuarial estimates were subject to qualifications and uncertainty.  In the event, no contravention was made against him for this lapse, but only because the Court of Appeal found that the board had not approved the statement.)
  • Do not rely blindly on the presence of external advisers.  (The Court of Appeal rejected Shafron’s argument that an external law firm represented at the board meeting should have advised that the DOCI came within the continuous disclosure rules, saying that the obligation did not apply as JHIL had not explicitly sought the firm’s advice on the issue.)
  • As a corollary, carefully consider the information and advice received as a whole and ensure that any “gaps” (such as untested assumptions or material limitations on advice) are identified to the board for it to consider.

Other commentaries

An earlier, more general Chapman Tripp commentary on the Appeal Court decision is available here

We have also written an article for the Institute of Directors on the implications of the case for non-executive directors. 

For further information, please contact the lawyers featured.

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