On Wednesday 20 October 1999, the Minister for Financial Services and Regulation announced that the major provisions of the Corporate Law Economic Reform Programme Act 1999 would commence on 13 March 2000. The Act implements a number of significant changes to the Corporations Law ("the Law") and the Australian Securities and Investments Commission Act 1989, among them:

• Chapter 2D of the Law has been re-written. A "Business Judgment Rule", the stated purpose of which is to offer directors a "safe harbour" in relation to honest, informed and rational business judgments, has been introduced
• A new Chapter 6A introduces a new regime with respect to takeovers and compulsory acquisitions.
• A new Chapter 6D aims to make prospectus disclosure requirements more flexible, particularly with respect to "sophisticated investors".
• Part 12 of the ASIC Act, inter alia establishes the Financial Reporting Council and the Australian Accounting Standards Board.

The focus of this paper is upon the changes to the provisions of the Corporations Law with respect to the statutory duties of directors. It is perhaps a trite point that breaches of duty by directors (and, in particular, breaches of the statutory and general law duties of care) often come to light when a company is in financial difficulty. Accordingly, I propose to focus upon aspects of the changes to the Law that are likely to have implications for companies in liquidation.

The New Chapter 2D

To this can be added, the duty of directors to prevent insolvent trading (s588G) and the fiduciary duties of a director to act, in broad terms, in the best interests of the corporation. Section 232 was a "Civil Penalty Provision" and both civil and criminal consequences could flow from its breach.

The new Chapter 2D represents a significant re-write of these provisions. Notably:

• The statutory duty to exercise due care and diligence has been clarified. A failure to exercise due care and diligence does not, under the new section 180 result in potential criminal consequences; further s180 (2) provides for a Business Judgment Rule, with a view to promoting "entrepreneurial flair" on the part of directors.
• Section 189 provides that a director is presumed to have acted reasonably, if he or she has relied, in certain stated circumstances, upon the advice of an appropriately qualified professional or expert adviser.
• Section 190, when read in conjunction with the (new) section 198D provides limited protection for directors who delegate their functions to a committee of directors, another director, an employee of the company, or any other person. Such delegation will be permitted unless the company’s constitution provides otherwise.
• Section 187 allows directors of wholly owned subsidiaries to act (in certain circumstances) in the best interests of the subsidiary’s holding company, even when that may not necessary be in the best interests of the subsidiary itself.

The Business Judgment Rule

The Business Judgment Rule enacted by the new section 180 is best understood in the context of the historical development of the duty of care owed by directors and other officers to companies controlled by them.

The duty of care imposed upon directors by the general law during the late 19th and early 20th century has been described as "extraordinarily undemanding". Suffice it to say that the courts, and in particular, the English courts, were reluctant to impose liability upon directors for anything short of gross negligence. For example:

…A director is not bound to give continuous attention to the affairs of his company… (3) In respect of all duties that, having regard to the exigencies of business, and the articles of association, may be properly left to some other official, a director is, in the absence of grounds for suspicion, justified in trusting that official to perform such duties honestly."

The law, as applied in Australia, did not much change until the early 1990s.

However, the AWA cases (AWA v Daniels , Daniels v Anderson) and the case of Mistmorn Pty Ltd (in liq.) v Yasseen, have been widely (and correctly) interpreted as increasing the burden placed upon directors by the law of negligence. The law now requires that directors take reasonable steps to place themselves in a position to guide and monitor the management of the company.

Whilst it is true to say that the Courts have traditionally been reluctant to interfere with bona fide business decisions, some of the cases, such as Mistmorn evince a judicial willingness to depart from this position.

In distinguishing between acceptable and unacceptable commercial risk, the judgment of Davies J has become quite well known as the high-water mark of directors’ liability in negligence. The company in liquidation operated a duty free shop and had purchased $196,000 of duty free cigarettes. Yaseen, who was held to be a shadow director of the company, directed the company to make the purchase in circumstances where he knew that the company’s business was virtually uninsurable because of a series of three thefts. He did so because, he said, the price of duty free cigarettes was depressed. He was held liable, notwithstanding that this was ostensibly a commercial risk, taken with a view to profiting from an opportunity to purchase stock at a discount.

That is the historical background against which the Commonwealth Government commented, in its explanatory memorandum to the CLERP Bill that:

[t]he Courts have failed to provide clear guidance to directors on the level of skill and care expected of them, particularly in relation to the responsibilities and liability of executive and non executive directors.

 

The Elements of the Rule

The Business Judgment Rule applies only to:

• the statutory duty of due care and diligence imposed by the "new" section 180
• the equivalent duties at common law and in equity.

It follows, then that the requirements or elements of the rule are analogous to, or include, most of the ordinary statutory, common law and fiduciary duties owed by directors to their companies. A director or officer of a corporation who makes a business judgment is taken to meet the requirements of those duties if:

1. Good Faith And Proper Purpose

The director or officer concerned makes the relevant judgment in good faith and for a proper purpose.

There is a fair degree of overlap between this element of the duty and the other duties imposed upon directors by the Corporations Law.

2. No Material Personal Interest

The director or officer has no "material personal interest" in the subject matter of the judgment.

This component of the rule is derived from the familiar concept of a director’s duty, at common law, to avoid conflicts of interest.

3. Duty to Inform Oneself

The director or officer informs him or herself about the subject matter to the extent that he or she reasonably believes to be appropriate.

It is possible to draw an analogy between this duty and the duty of a director to inform him or herself as to the solvency or otherwise of the company, imposed by implication, and in practice by section 588G and its predecessors. By way of elaboration, the trend in judicial decisions upon the question of insolvent trading has been towards the imposition of a positive duty to take an active interest in the affairs and financial position of the company. That trend is evident from the cases decided pursuant to the former section 592 and also from the reported applications of section 588G.

Clearly, the courts do not interpret the Corporations Law in a vacuum, but rather, its provisions are applied in the context of the judicial view of the proper scope of an offiicer’s responsibilities.

The main difference, as a matter of statutory interpretation, between the duty to be informed that applies under section 588G, and the duty to be informed under the new section 180 is that:

• the business judgment rule appears to be subjective – that is, the focus is on what the officer believes is appropriate
• the duty under sections 588G and 588H is, in effect, to form an an objectively reasonable view of the company’s financial position.

4. The Best Interests of the Company

The director or officer rationally believes that the judgment is in the best interests of the company.

The director or officer’s belief that the judgment is in the best interests of the company is a rational one unless the belief is one that no reasonable person in their position would hold.

The question of how this definition of rationality is to be applied is, of course, yet to be answered. It is not altogether clear whether any genuinely-held belief that is not manifestly foolish will be rational, whether something akin to a "reasonable person" test (would the ordinary, reasonable person have held the belief?) will be applied, or whether the courts will adopt some test somewhere in between these two extremes. The latter test, in the context of an action for, in effect, negligence, would appear to be somewhat otiose.

Whatever test is applied, it appears that the parliament has added a further objective element to the law of directors liabilities. The courts will have to make an assessment of whether, in all the circumstances, conduct is objectively reasonable. It remains to be seen whether or not the test applied will be an exacting one.

The Consequences for Corporate Groups

The new section 187 provides that a director of a corporation that is a wholly owned subsidiary of another corporation is taken to have acted in the best interests of that subsidiary, notwithstanding that he or she acted in the best interests of the holding company. This principle applies in the following circumstances:

1. the constitution of the subsidiary expressly authorises the director to act in the interests of the holding company, and
2. the director acts in good faith and in the best interests of the holding company
3. the subsidiary is not insolvent at the time, or immediately after, the director acts.

This may be regarded as a departure from the law’s traditional insistence upon a conception of companies as separate legal entities, best exemplified by the decision of the High Court in Walker v Wimbourne. That case involved a director of a several companies in a loose "group" of companies which was in financial difficulty. He was prosecuted, in effect, because he attempted to "juggle" funds between the various group companies in an attempt to keep the group as a whole afloat. The High Court refused to adopt a "commercially realistic" or "broad brush" approach to the director’s duties in these circumstances. Rather, it held that the director owed a duty, to consider the individual interests of each separate group company. Moreover in the context, at least, of a company in financial difficulty, the directors owed a duty to consider the interests of the companies’ creditors.

It is, however, a limited departure. This much should be evident from the specific circumstances listed above, and from:

• the confinement of the "exception" to wholly owned subsidiaries
• the emphasis upon the solvency of the subsidiary both before and after the transaction in question (although the effect of this remains to be seen, particularly in circumstances where a course of conduct that has the effect of gradually running down the subsidiary is engaged in).

Conclusions

In the final analysis, it may be concluded that, despite the publicity that has accompanied these changes, in practice, their effect is unlikely to permanently alter the way we think about directors’ duties and their liability for bad decisions.

Certainly, the business judgment rule and the changes with respect to the liability of directors of corporate groups represent, from a director’s perspective at least, a welcome "codification" of the principles that the Courts will apply.

That said, it is hard to see that the substantive principles to be applied by the Courts will greatly change. The courts have been always been reluctant to interfere with decisions made in good faith by honest directors who take an active and diligent interest in the affairs of their company. That the modern cases impose certain minimum standards upon all directors is not something to be deplored, and, with respect, it is not something that the new Chapter 2D has radically altered.