Australian Court Of Appeal’s Highly Anticipated Decision In The James Hardie Civil Penalty Case Regarding Directors’, Executives’ Responsibilities

On December 17, 2010, the New South Wales Court of Appeal handed down judgment in the much anticipated James Hardie civil penalty appeals.

In brief:

• The seven non-executive directors (NEDs) were successful in their appeals, and the Court of Appeal set aside the declarations of contravention, the pecuniary penalties and disqualification orders against them (each had been fined A$30,000 and disqualified for five years). The appeal judges also ordered the Australian Securities and Investments Commission (ASIC) to pay the NEDs’ costs.

• Central to the Court of Appeal’s decision was its conclusion that ASIC did not prove that the NEDs passed a resolution approving a draft announcement to the ASX (Australian Securities Exchange). The Court of Appeal held that, in civil penalty proceedings, clear and cogent evidence is required to discharge the onus of proof. ASIC’s failure to call a material witness who likely had relevant evidence was a breach of ASIC’s obligation of fairness. This undermined the cogency of ASIC’s case.

• The appeal by the former general counsel and company secretary, Mr. Shafron, succeeded in part.

• The former chief financial officer, Phillip Morley, was unsuccessful in his appeal.

• The trial judge’s findings that the former general counsel and chief financial officer were “officers” within the meaning of the Corporations Act 2001 (Cth) and, therefore, subject to the duties in Section 180(1) were upheld.

• The appeal by the company James Hardie Industries NV was also unsuccessful.

• Peter Macdonald, the former chief executive officer (CEO), did not appeal.

• The decision places the spotlight squarely on the duties owed by general counsel, chief financial officers (CFOs) and potentially other executives in a disclosure context and limitations on the ability of directors and executives to rely on others such as external advisers.

• While the findings of contravention by the NEDs were overturned, many of the findings of the trial judge remain intact.

The Court of Appeal (comprised of Spigelman CJ, Beazley and Giles JJA) published two decisions — one in respect of the former directors and executives (Morley & Ors v Australian Securities and Investments Commission [2010] NSWCA 331) and a second in respect of the company (James Hardie Industries NV v Australian Securities and Investments Commission [2010] NSWCA 332). Both were unanimous.

Implications for Directors, General Counsel, CFOs and Other Non-Director Executives

This case was contested primarily on a factual basis (i.e., whether the Draft ASX Announcement was approved by the board). Both the first instance and appeal decisions, however, indicate the high level of scrutiny that is required of major transactions and the potential limitations on the ability of directors to delegate to, or rely on, others. In our view, the Court of Appeal’s decision suggests that:

• Directors need to be vigilant in reading and approving minutes of meetings. ASIC’s investigation and decision to bring the proceedings were largely based on the content of the minutes, which inaccurately recorded that the board had passed the Draft ASX Announcement Resolution.

• There may be limitations on the ability of directors to rely upon others, including management, external advisors and fellow directors.

• Not all press releases or ASX announcements require board approval. However, where an announcement does go before the board, a director exercising due care and diligence could not accept the announcement for approval without applying his or her mind.

For general counsel, CFOs and other non-director executives, the Court of Appeal’s decision illustrates that:

• Non-director executives may be under an obligation to advise boards of certain issues — even if those issues may appear obvious. The former general counsel was found to have a duty to advise even on matters he considered obvious to the board. The Court commented that a reasonable person with the general counsel’s responsibilities would have raised with the board an issue which was obvious but was either not being appreciated or was being ignored by the board.

• General counsel and CFOs participating in company decision-making are likely to be acting as officers of the company and are subject to the standards of care and diligence set out in Section 180(1) of the Corporations Act. It is not necessary to have ultimate control of decision-making. Advising decision makers will likely be sufficient to establish participation in the decision-making process and satisfy the definition of “officer”.

• Although this case concerned ASX announcements, general counsel should be mindful that the Court’s reasoning as to the duties of general counsel applies generally.

• For CFOs, the decision is a useful reminder that, even when dealing with a commercially experienced and intelligent board, it is necessary to ensure that all matters are explained fully and accurately.

Finally, the decision has important implications for ASIC and the manner in which it conducts civil penalty proceedings, to ensure that it complies with its duty of fairness.

Background

In 2001, James Hardie implemented a corporate restructure which included transferring the asbestos liabilities of two of its subsidiaries to the Medical Research and Compensation Foundation, a vehicle it established to compensate asbestos victims and to fund medical research. Market reaction to the announcement of these steps was critical to the company, the board and management.

At first instance, ASIC succeeded in establishing contraventions of the duty of care and diligence under Section 180(1) of the Corporations Act against the seven former NEDs and three former company executives — Peter Macdonald, the former CEO; Peter Shafron, a former company secretary and general counsel; and Phillip Morley, the former CFO.

Gzell J imposed the following banning orders and pecuniary penalties:

• each of the NEDs was fined A$30,000 and disqualified from acting as a company director for five years;

• Peter Macdonald, the CEO and Managing Director, was fined A$350,000 and disqualified for 15 years;

• Phillip Morley, the CFO, was fined A$35,000 and disqualified for five years; and

• Peter Shafron, the general counsel and company secretary, was fined A$75,000 and disqualified for seven years.

(see WSLR, May 2009, page 23).

Appeal Grounds

The NEDs and executives, with the exception of Peter Macdonald, appealed against the decision of Gzell J.

The legal principles relating to the duty of care and diligence under Section 180(1) of the Corporations Act were not significantly contested by the parties on appeal. However, the application to the facts was strongly disputed. The central issues on appeal were:

• ASIC’s failure to call relevant witnesses;

• whether, on the evidence properly available, the NEDs had approved a Draft ASX Announcement; and

• so far as the former general counsel/company secretary and the CFO were concerned, the definition of “officer” under the Corporations Act and their ability to rely on external advisers.

Court of Appeal’s Findings — NEDs

The trial judge found that each of the NEDs and the CEO contravened Section 180(1) of the Corporations Act by voting on February 15, 2001, in favour of a resolution to approve the Draft ASX Announcement and authorise its execution and lodgement with the ASX. Because of the emphatic and unqualified statements as to the certainty of funding provided to the foundation in the announcement, Gzell J held the directors ought to have known that it was misleading.

ASIC’s Failure to Call Relevant Witnesses

The central issue bearing on the Court of Appeal’s reasoning in finding that the Draft ASX Announcement was not passed by the board was ASIC’s failure to call relevant witnesses.

ASIC chose not to call relevant advisers from UBS and Allens who had attended the board meeting in question. ASIC had indicated that it would call these witnesses, but in the course of the hearing at first instance it announced that it no longer intended to do so. This gave rise to three issues:

1. Jones v Dunkel Inference

First, it was submitted that the trial judge erred in declining to draw a Jones v Dunkel inference against ASIC (i.e., an inference that the evidence of the witnesses would not have assisted ASIC’s case). Gzell J considered that the Allens and UBS witnesses were not in ASIC’s camp — they were witnesses who were equally available to the NEDs.

The Court of Appeal disagreed with the trial judge’s assessment and found that the Allens witness, Mr. Robb, could not be categorised as a witness who was equally available to both sides. For the reasons set out below, the Court of Appeal said ASIC had an obligation to call Mr. Robb.

2. Prosecutorial Duty

Secondly, it was submitted that ASIC had an obligation akin to that of a prosecutor in criminal proceedings (i.e., a duty to call all material witnesses). Gzell J found that he was bound by the decision of the Court of Appeal in ASIC v Adler to reject that submission because that case held that prosecutorial fairness as it applies in criminal jurisprudence has no application to civil penalty proceedings.

The Court of Appeal agreed with the trial judge and did not accept that ASIC was under a prosecutorial duty in civil penalty proceedings, nor that ASIC v Adler should be overturned.

3. Duty of Fairness

Thirdly, it was submitted that ASIC had a duty of fairness which required it to call relevant witnesses.

The appeal judges accepted that Mr. Robb (an Allens partner deeply involved in advising on legal issues about the foundation and who attended the relevant board meeting) was an important material witness available to ASIC. The Court noted that, when ASIC decided not to call Mr. Robb, it was with the knowledge that the NEDs disputed approving the Draft ASX Announcement and maintained Mr. Robb was an important witness of fact material to this issue. However, the judges’ views differed as to the importance of the UBS witnesses.

ASIC accepted that it had an obligation to act fairly with respect to the conduct of the proceedings. However, it contended that the obligation did not oblige it to call Mr. Robb or the UBS witnesses.

The Court of Appeal found that failure to call a witness could constitute a breach of the obligation of fairness. ASIC had breached that obligation in the particular circumstances of this case. The serious nature of civil penalty proceedings, the wide ranging scope of ASIC’s powers and the public interest dimensions of its functions meant that ASIC could not be regarded as an ordinary civil litigant. These circumstances required it to call a witness of such potential importance — even if only to show that the witness could not recall relevant factual issues and to be available for cross examination by the appellants.

The reasoning of the Court of Appeal diverged in respect of ASIC’s failure to call the UBS witnesses. However, that did not affect the result. Spigelman CJ and Beazley JA said what was required was some basis for an inference that there was a significant degree of probability that the witness would have relevant knowledge. They found a regulator is under no duty to call every bystander or eyewitness who could give relevant evidence, and considered that the UBS witnesses had only a tangential involvement.

Giles JA disagreed, finding it was apparent that the UBS witnesses “had a real involvement” in relevant matters and the obligation of fairness would require that they be called in addition to Mr. Robb.

The consequence of ASIC’s failure to call Mr. Robb contrary to the obligation of fairness was that it significantly undermined the cogency of ASIC’s case on the approval by the board of the Draft ASX Announcement.

Approval of the Draft ASX Announcement

The case against the NEDs turned on whether or not they had been provided with the Draft ASX Announcement at a board meeting on February 15, 2001, and passed a resolution approving its release to the ASX.

The Court of Appeal found that, in order to reach the requisite standard of proof, clear and cogent evidence was required of the necessary facts that needed to be established. There needed to be actual persuasion that these facts were proved (known as the Briginshaw principle).

Despite ASIC submitting that there were grounds to infer that the board had considered and approved the Draft ASX Announcement, such as:

• the communication of full funding in order to quell stakeholder opposition,

• the company’s usual practice for approving ASX announcements,

• the minutes of the meeting on February 15, 2001, and

• the absence of protest from the directors after the announcement was made,

the appeal judges did not consider these matters of great force.

The changes made to the Draft ASX Announcement after the board meeting called into question the conclusion that the announcement was approved at the meeting. Further, the company’s practice of approving ASX announcements did not support ASIC’s case, but undermined it. The failure to comply with this practice, including the absence of prior vetting, advice and consents tended against the definitive approval alleged by ASIC.

These factors, combined with the undermining of the cogency of ASIC’s case due to its breach of the obligation of fairness, meant that ASIC failed to discharge its burden of proof in establishing that the Draft ASX Announcement Resolution was passed at that board meeting. As a result, the contraventions could not stand.

Hypothetical Assumptions and Breach of Section 180

The Court of Appeal went on to consider whether, assuming the directors had voted in favour of the Draft ASX Announcement Resolution, they would have contravened the Corporations Act.

The Court of Appeal agreed with the trial judge’s conclusions in this regard, finding that if the NEDs had voted in favour of the Draft ASX Announcement at the February board meeting, they would have been in breach of their duty of care and diligence, as the draft announcement was misleading.

Although the Court of Appeal rejected the key factual finding of approval of the Draft ASX Announcement on which Gzell J’s decision turned, the Court did not overturn his other findings.

Delegation and Reliance

The appeal judges concluded that the NEDs were not reasonably relying on management and management procedures in this case. This was because:

• the NEDs were intelligent and commercially experienced and could be expected to bring their skills to the exercise of their duties;

• the board had long been considering a restructure of James Hardie and the risks associated with this, including risks relating to asbestos liabilities. They were aware of the importance of the resolution;

• the NEDs were aware of the uncertainty in the modelling that was being relied on; and

• the NEDs considered that the draft announcement was too emphatic and a number of them gave evidence that they would not have approved it in that form.

Attending Board Meetings by Telephone

Messrs. Gillfillan and Koffel attended the board meeting by telephone from the United States. It was common ground that they did not have a copy of the Draft ASX Announcement.

The appeal judges said that if they had found that the Draft ASX Announcement Resolution had been approved, they would have found that:

• by remaining silent, the directors joined in the informal resolution;

• if the directors did not abstain, they were under a duty to familiarise themselves with the resolution, even if they were participating over the telephone;

• if the directors did not abstain, they could not rely on the other directors to “craft an announcement”; and

• on the hypothetical facts, their conduct was a failure to exercise their due care and diligence.

General Counsel and CFO

The appeal by the former general counsel and company secretary, Mr. Shafron, was allowed in part. The former CFO, Phillip Morley, was unsuccessful in his appeal against the finding that he failed to advise the board of the limited nature of the reviews of the cashflow analysis.

At first instance, Gzell J found Mr. Shafron had a duty to protect the company from legal risk. Gzell J found Mr. Shafron breached his duty in Section 180(1) of the Corporations Act by failing to advise the board:

• that the language of the Draft ASX Announcement was too emphatic regarding the adequacy of funding and was therefore misleading. The Court of Appeal overturned this contravention in light of its finding that the board had not approved the Draft ASX Announcement;

• that the cashflow model was reviewed by PwC and Access Economics for logical soundness and technical correctness only — the key assumptions in the cashflow model had not been verified. The Court of Appeal also overturned this contravention because it had not been proven that Mr. Shafron knew of the limited nature of those reviews; and

• that the board needed to consider whether the company was required to disclose to the ASX information about various indemnities and other covenants provided by James Hardie entities relating to the establishment of the foundation (DOCI Information). The Court of Appeal upheld this finding of contravention. The Court’s reasoning provides useful guidance to general counsel in relation to reliance on external advisers, which is considered in further detail below.

In addition, the Court of Appeal upheld part of ASIC’s cross appeal, finding that Mr. Shafron failed to advise the board about aspects of the actuarial estimates of asbestos liability exposure.

Unlike Mr. Shafron, Mr. Morley did not challenge the finding that he knew of the limited nature of the reviews of the cashflow analysis undertaken by the external advisers. Instead, his primary argument was that his presentation at the board meeting and his statement that the cashflow model was “logically sound and technically correct” made clear to intelligent and commercially experienced board members that the external review had not extended to a review of the assumptions underlying the model. The Court of Appeal rejected this argument.

Because the Court of Appeal’s findings differed from the trial judge’s in respect of Mr. Morley and Mr. Shafron, it is necessary for the penalties imposed against them to be reconsidered. Their proceedings were stood over to February 4, 2011, for further directions regarding relief from liability, pecuniary penalties and disqualification.

Definition of ‘Officer’

Neither Mr. Shafron nor Mr. Morley was a director. A necessary element in the contravention findings against them was the trial judge’s conclusion that they were “officers” within the meaning of Section 9 of the Corporations Act. This issue became central to their appeals.

Section 9 provides:

“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 a corporation; or

(ii) who has the capacity to affect significantly the corporation’s financial standing; …

Mr. Shafron argued that he was not an officer for the purposes of ASIC’s allegations, even though he jointly held the role of company secretary and general counsel. He argued that, in relation to the matters alleged, he was acting as general counsel. He also argued that he did not make or participate in making any relevant decision. He said that he had no power to make a decision, and did not purport to do so; rather he gave advice and assistance, upon request from those who made the decision.

Mr. Morley argued that he was not acting as an officer in presenting the cashflow model. He contended that it was the board that was making or participating in making the decision — the board was not acting in accordance with his instructions or wishes. His role was limited to presenting the cashflow model so the board could make a decision.

The Court of Appeal found that both Mr. Shafron and Mr. Morley were “officers”, given the nature of their roles, the tasks they generally performed, and the level of participation they had in the decision-making process. In reaching this conclusion, the appeal judges rejected submissions that:

• Section 180(1) required the Court to “determine whether the impugned conduct is conduct that would render a person an officer”. The appeal court said that what is to be determined is whether a person has the statutory status of an officer. Section 180 is then applied to the particular exercise of power or performance of duties being carried out.

• Upholding the trial judge’s findings on this issue would unduly open the floodgates to management or advisers being officers within the definition. The appeal court said that it is a reality of corporate life that board and other important decisions involve many persons, other than the ultimate decision-makers.

The appeal judges also considered that Mr. Morley was an “officer” under another limb of the definition because he had the capacity to significantly affect the corporation’s financial standing. The appeal judges emphasised this was because of his individual capacity and role, rather than the role and capacity of an abstract CFO.

Reliance by General Counsel upon External Advisers

In respect of the finding that he failed to advise the board regarding the disclosure of the DOCI Information, Mr. Shafron argued that:

• the directors and CEO were all intelligent, sophisticated business people who did not require general counsel to point out the obvious; and

• the company had retained high calibre professional advisers. It was not reasonable to expect the general counsel to undermine or second guess their advice.

Mr. Shafron did not claim that Allens gave express advice that the disclosure of the DOCI Information was not required. Rather, he submitted that he was entitled to rely on Allens to provide advice and, as that advice was not forthcoming, he was entitled to assume that disclosure was not required.

The Court of Appeal held that Mr. Shafron’s submissions that he was under no duty to point out the obviousness of the need to disclose the DOCI Information were “particularly unattractive”:

• The Court considered there was a stark inconsistency between this position and his submission that he was entitled to rely on the silence of Allens to imply that no disclosure was necessary.

• Furthermore, the appeal judges were not satisfied that the continuous disclosure obligations were so obvious as to make it unnecessary to advise. The Court of Appeal commented that this was the very kind of matter upon which a NED could well have been entitled to rely on the silence of both Allens and the company secretary and general counsel — even though the general counsel may not be entitled to rely on the silence of the external legal advisers.

Ultimately:

• The Court of Appeal concluded that there was no evidence of a request for advice about disclosure of the DOCI Information, nor did Allens have a general retainer that would have required them to provide such advice.

• The Court of Appeal found that Mr. Shafron had undoubted responsibilities to ensure compliance with regulatory requirements and that he did in fact give advice on such issues from time to time. The Court noted ASIC’s submissions that Mr. Shafron was not a “mere conduit for the advice of external solicitors”.

• The appeal judges pointed out that they were not suggesting Mr. Shafron’s duty to protect the company from legal risk was a non-delegable duty — however, there had to be some evidence that consideration was given to the need for advice, and there was none.

James Hardie Industries NV

The appeal by James Hardie Industries NV against the finding by the trial judge — that it had made misleading statements likely to affect market behaviour and failed to make disclosures — was unsuccessful. The Court of Appeal found no error in the trial judge’s findings of contravention.

In considering the company’s challenge to the trial judge’s finding that its breach was flagrant, the Court of Appeal said that, contrary to being an error of judgment, the company’s strategy in not disclosing certain information was well thought through. What it told the market and when it did so was deliberate. The appeal judges found its contravening conduct demonstrated a significant disregard for honesty and transparency and a subjective willingness to interpret its statutory obligations to suit its own corporate purposes.

The Court of Appeal commented that the penalty imposed by Gzell J was light given the seriousness of the company’s conduct, but noted ASIC had not challenged the penalty imposed. Accordingly, the penalty imposed at first instance stands.

ASIC has filed applications in the High Court for special leave to appeal the Court of Appeal’s judgment, in so far as the decision concerns the former NEDs and Mr. Shafron. Mr. Shafron and Mr. Morley also have filed special leave applications.

Blake Dawson acts for Mr. Greg Terry, one of the former non-executive directors, in the proceedings.

Elspeth Arnold is a Partner in the Melbourne office, Angela Pearsall is a Partner in the Sydney office, and Penelope Kelton is a Senior Associate in the Sydney office, of Blake Dawson. The authors may be contacted at elspeth.arnold@blakedawson.com, angela.pearsall@blakedawson.com, and penelope.kelton@blakedawson.com.