Corporations and the Business Judgment Rule - recent lessons for all company directors

Some recent well publicised cases, have resulted in significant adverse consequences for directors. In this bulletin, we draw some conclusions to assist directors in their ability to rely on the business judgment rule.

Fortescue Case: Background

On 18 February 2011, the Full Federal Court of Australia handed down its appeal decision in the case of Australian Securities and Investments Commission v Fortescue Metals Group Ltd (FMG).

In early 2004, FMG and one of its directors, Andrew Forrest (Forrest), entered into negotiations with three Chinese companies in relation to the construction of a mine, port and railway as part of a mining project known as the Pilbara Infrastructure Project. These negotiations led to the execution of three agreements.

FMG then made disclosures to the ASX and issued media releases stating that FMG had executed binding agreements to build, finance and transfer the railway, port and mine.

In or about March 2005 (almost a year later), it became known that these agreements were merely framework agreements. The agreements did not bind the Chinese companies to build the infrastructure and provide finance. The agreements only obliged the Chinese companies to enter into further negotiations with FMG.

ASIC commenced proceedings against FMG and Forrest alleging breaches of provisions of three sections of the Corporations Act 2001 (Cth) (being, sections 674 (continuous disclosure), 1041H (prohibiting misleading or deceptive conduct in relation to a financial product) and 180(1) (imposing a duty on directors to act with care and diligence)) together with section 52 of the Trade Practices Act.

Allegations

It was alleged that:

• FMG had engaged in misleading and deceptive conduct by falsely representing to the investing public that the framework agreements were enforceable agreements to build, finance and transfer the infrastructure.

• FMG breached its continuous disclosure obligations to the ASX.

• Forrest was involved in the above contraventions as he authorised the disclosures to the ASX and the media releases and breached his duty as a director of FMG to act with care and diligence.

Defence

As part of Forrest's defence to the claim that he had breached his duty of care and diligence to FMG, he sought to rely on section 180(2) of the Corporations Act which is also known as the 'business judgment rule'.

Section 180(2) of the Corporations Act provides as follows:

A director or other officer of a corporation who makes a business judgment is taken to meet the requirements of subsection (1), and their equivalent duties at common law and in equity, in respect of the judgment if they:

(a) make the judgment in good faith for a proper purpose; and

(b) do not have a material personal interest in the subject matter of the judgment; and

(c) inform themselves about the subject matter of the judgment to the extent they reasonably believe to be appropriate; and

(d) rationally believe that the judgment is in the best interests of the corporation'.

Decisions

At the first hearing before a single judge, the judge found in favour of FMG and Forrest and dismissed ASIC's claim.

On appeal, the Full Federal Court overturned the decision of the trial judge.

The Full Federal Court found that:

• Statements made by FMG were 'likely to' mislead and deceive ordinary and reasonable members of the investing public who read the announcements into believing that the framework agreements were binding.

• Each of FMG and Forrest (in his capacity as an officer of FMG) had breached its and his continuous disclosure obligations under the listing rules of the Australian Securities Exchange.

• Forrest had also breached his duty as a director of FMG to act with diligence and care as he knowingly participated in events leading up to FMG's misleading conduct.

• Forrest could not rely on the 'business judgment rule' - as:

• he was not able to provide sufficient evidence to show:

  • that he made the judgement in good faith and for a proper purpose;

  • his shareholding in FMG did not amount to a material personal interest in the subject matter of the judgment;

• his decision did not relate to the business operations of FMG but, instead, to FMG's compliance with the requirements of the Act.

The court was of the view that Forrest could not rely on the business judgement rule to avoid liability for a decision that the Company should not comply with a provision of the Corporations Act.

Penalties are yet to be decided. FMG has announced that FMG and Andrew Forrest intend to apply for special leave to appeal to the High Court.

James Hardie Case: Background

In February 2001, an announcement was published by James Hardie Industries Limited (JHIL)on the Australian Securities Exchange to the effect that an asbestos compensation trust had been established that was "fully funded" to manage and pay all future legitimate asbestos claims made against companies forming part of the James Hardie corporate group.

Subsequently, this statement was found to be untrue and that there would be a significant shortfall in the fund. A NSW Government inquiry was then conducted which found that the shortfall could be up to $2 billion.

Allegations

ASIC commenced proceedings against 10 former executive and non executive directors and officeholders of James Hardie Industries Limited for breach of section 180(1) (duty to act with care and diligence) of the Corporations Act on the basis that, in approving the release of the misleading ASX announcement, breached his or her duty of care and diligence to the company.

In the case of Mr Peter McDonald, Chief Executive Officer, ASIC also alleged that he had breached section 181(1) (duty to act in good faith) of the Corporations Act as Mr Macdonald knew, or was reckless as to the truth, that if he made the above statements on behalf of JHIL that were false or misleading, that was harmful, or potentially harmful, to JHIL in that it might contravene, or risk contravening, sections 1041E and 1041H of the Corporations Act and section 52 of the Trade Practices Act 1974 (Cth).

Defence

Each of the defendants argued that they had not acted in breach of their duty of care to the company under section 180(1) of the Corporations Act as none of them approved the wording of the ASX Announcement.

Mr McDonald also sought to rely on section 180(2) (business judgment) as a defence to ASIC's allegation that he had acted in breach of section 181(1) of the Corporations Act.

Decisions

At first instance:

• In respect of ASIC's allegations of the directors breach of section 180(1) of the Corporations Act, the court found in favour of ASIC and each of the executive and non executive directors and officeholders was issued a fine and/or disqualified from acting as director or manager for certain periods.

• However the court rejected ASIC's allegations that Mr McDonald breached section 181(1) of the Corporations Act on the basis that it was not satisfied that Mr McDonald deliberately engaged in conduct that was not in the best interest of the company.

• Although ASIC was not successful in its allegation of breach of section 181(1) against Mr McDonald, the court did note, however that Mr McDonald was not able to rely on section 180(2) as a defence to a breach of section 181(1) as there was no evidence that Mr McDonald rationally believed that a business judgment was in the best interest of JHIL.

On appeal:

• The court held that ASIC had not proved that the non executive directors had approved the release of the misleading ASX Announcement and set aside the findings made against those non executive directors.

• While the court also overturned some of the findings of breach of duty of care by the company's general counsel and company secretary, he was still found guilty of some breaches of the Corporations Act.

• The court upheld the trial judge's findings in respect of Mr Morley (chief financial officer).

On 11 May 2011, it was announced that ASIC's application to the High Court for special leave to appeal the NSW Court of Appeal decision had been granted.

Lessons

While these decisions are obviously important for listed companies and their directors (which are subject to more onerous disclosure obligations than those imposed on proprietary limited companies), all directors should take note of the following:

• Directors should take care when making a statement on which someone is going to rely. Public announcements ? particularly pertaining to matters of public interest ? should be treated in a similar way to representations made in a contract. There may be many instances where, with an established system, such statements can be reviewed and approved by a delegate of the board. However, on some occasions, the matter will be serious enough for the board to insist on directly reviewing and approving the proposed statement prior to publication.

• If a director becomes aware of an error or omission in a statement that has been made public, prompt action should be taken by the board to correct the misstatement.

• Ignorance of the law is no excuse. If in doubt, the better course is to take professional advice. Advice can be sought collectively by the board or by directors individually. Even if the advice ultimately proves incorrect, the fact that advice was sought should assist with the mitigation of penalties.

• A director should be aware of what he or she is being asked to decide and whether he or she is being asked to make a decision on a matter that involves compliance with the law (where a director will not be able to rely on the business judgment rule).

• A director seeking to rely on the business judgment rule will be greatly assisted if he or she is able to demonstrate that each component of the rule has been satisfied. To achieve this, a director should:

  • ensure an accurate written record of all decisions made by the board is kept - so there is no doubt about what the decision was;

  • if the director wants to demonstrate he or she did not join in the decision, ensure that the record of the decision includes any votes against the resolution and any abstentions;

  • ensure that he or she has all of the information (including any appropriate professional or technical advice) required to make a decision;

  • ensure, having reviewed available information in respect of the decision, that he or she has an honest belief that approval of the decision will be in the best interest of the company.