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Can Directors challenge Management?

10/09/2019 1:35 PM

Sep19 Newsletter - Can Directors Challenge Management?

CAN DIRECTORS CHALLENGE MANAGEMENT?

The 2019 Governance Institute of Australia’s National Conference was fortunate in having to deliver the keynote address, Sir Winfried Bischoff, former chair of Lloyds Banking Group and Citi and current Chairman of JP Morgan Securities plc as well as Chairman of the Financial Reporting Council UK. Sir Win, as he often was referred to, raised matters which are now important for boards to be addressing.

These include:

1. the risks of climate change
2. awareness of diversity and
3. the importance of boards challenging the CEO and company.

According to Sir Win “Boardrooms shouldn’t be too ‘comfortable’”. I think reading into that comment comes a message that unfortunately not only does it occur; but, maybe far more frequently than boards and directors alike openly acknowledge. He also commented that boards therefore need to challenge management and hold executives to account, otherwise it is easy for the boardrooms to become comfortable environments which support cosy chatter without the necessary rigour of analysis and pushback.

In fact, he “strongly” supported “robust” challenge of management by boards, while also acknowledging that this was a theme of the Hayne royal commission.

Another issue calling for our attention included the dangers of “groupthink” on boards.

It is worth reflecting whether that has ever been our experience; or, if it has been generally our experience of boards, past and present.

For those who have some experience and length of service as directors; and who read widely about governance, one aspect this raises is – as this topic is not knew, why has it not been effectively resolved by now?

Is it that too many directors remain unsure of what are their roles and responsibilities?

That seems too silly to consider as being the situation. Yet Sir Win felt it necessary, on an international stage, with many hundreds in the audience from a broad range of business including, ASX listed companies and overseas guests, to include it as an important aspect of his plenary address.

A reasonable conclusion must therefore be that it is both widespread and damaging for present corporate governance practices.

So how should the question of a director’s role and responsibilities be answered?

The Australian Institute of Company Directors comments in one of its Director Tools, headed “General duties of directors and Duties of directors” as follows:

“The role of a company director is to govern a company on behalf of the shareholders or members of that company.

…..

What are the four basic directors’ duties?

The Corporations Act 2001 specifies four main duties for directors:

Care and diligence – This duty requires a director to act with the degree of care and diligence that a reasonable person might be expected to show in the role (s 180).

A very similar duty is also imposed on directors at common law. Recent court cases have emphasised this duty in relation to the approval of financial statements (Centro case) and board approval of statements issued by a company (James Hardie cases).

There can also be a breach of this duty by causing a company to enter into risky transactions without any prospect of producing a benefit or where a managing director fails to inform the board of matters which clearly should have been brought to the board’s attention. The business judgment rule (discussed below) provides a “safe harbour” for a director in relation to a claim for a breach of care and diligence at common law or under s180.

Good faith – This duty requires a director to act in good faith in the best interests of the company and for a proper purpose (s 181), including to avoid conflicts of interest, and to reveal and manage conflicts if they arise.

This is a duty of fidelity and trust, known as a ‘fiduciary duty’ imposed by common law and a duty required in the Corporations Act 2001.

Not to improperly use position – This duty requires directors to not improperly use their position to gain an advantage for themselves or someone else, or to the detriment to the company (s 182).

Not to improperly use information – This duty requires directors to not improperly use the information they gain in the course of their director duties to gain an advantage for themselves or someone else, or to the detriment to the company (s 183).”

The ASIC website is helpful in that it clearly asks and responds to that question concerning small proprietary companies, as follows:

Key responsibilities of company directors

As a director, you are responsible for oversight of the affairs of the company. You must comply with your legal obligations as a director under the Corporations Act 2001. This is the case even if you appoint an agent to look after your company’s affairs.

As a director, you must be fully up-to-date on what your company is doing, including its financial position, question managers and staff about how the business is going and take an active part in directors’ meetings.

You must not [mis]use your position as a director of a company – or information obtained because you are or have been a director, officer, or employee of a company – to cause detriment to the company or to gain an advantage for yourself or someone else.

When you make a business decision as a company director, you must, amongst other things, ensure that you:

• make the decision in good faith and for a proper purpose

• do not have a material personal interest in the decision and make it in the best interests of the company

• find out and assess how any decision will affect your company’s business performance, especially if it involves a lot of the company’s money or could have a material impact on the company’s reputation

keep informed about your company’s financial position and performance, ensuring your company can pay its debts on time

get trusted professional advice when you need assistance to make an informed decision

• make full and frank disclosure about any material personal interests you do have

There are penalties and consequences – including civil penalties, compensation proceedings and criminal charges – for directors who fail to comply with their obligations under Australian law.

All the duties and responsibilities listed on this page are the minimum obligations for directors and officers of small propriety companies.

What is to be our take-out message from this information?

1. Care and diligence involves –

a. Oversight
b. fully up-to-date on what your company is doing
c. make business decisions that are up to date and informed
d. question managers and staff
e. take an active part in directors’ meetings

2. Good Faith

a. Comply with your legal obligations
b. must not [mis]use your position as a director – [conflict of interest]
c. must make business decisions

i.   in good faith and for a proper purpose
ii.  with the best interests of the company
iii. that assesses how the decision will affect the company’s business performance
iv. that considers including trusted professional advice
v.  which involves full and frank disclosure

Turning to one issue in particular – directors challenging management prior to relying on management information – how is this best to be achieved?

On 31 May 2019, Justice Nicholas handed down a judgement in ASIC v Vocation Limited (in liquidation) [2019] FCA 807.  The case concerned civil penalty proceedings commenced by ASIC against Vocation Ltd (In Liquidation) (“Vocation”) and some of its officers, Mark Hutchinson (CEO), John Dawkins (Chair), and Manvinder Gréwal (CFO).

This case emphasised the importance of directors challenging management on information being presented to the board. Directors, in this case, were unable to justify the failure to disclose price sensitive information to the ASX, based on advice received from management. The issue concerned a key customer withholding payment on a major contract due to a dispute. Vocation responded to media queries with the advice that the dispute had no material impact on the company.

ASIC started proceedings against three of Vocation’s directors alleging that they had failed to ensure full disclosure of the correct information when it was available to them. The directors defended their actions on the basis that they relied on information from management in updating the market, which showed the withholding of payments was not material.

The Court rejected the directors’ defence, finding that if they had properly tested the management information, they would not have relied on it. The Court considered that the management information was poor and should have been questioned by the directors. The failure to exercise proper care and diligence in assessing this information constituted a breach of their directors’ duties.

Take out message is that directors must be prepared and must act by testing the accuracy of information provided to them by management. If subsequently it is found that the quality of the management information is poor, then what were the directors thinking? What didn’t they challenge?

It seems that maybe too many independent board members are too easily captured by the Siren spell of a company’s success. Looking for the rocks and then under them is a good practice in both the good and not so good times. In other words, be prepared for the worst and pleased when it does not occur.

Sir Win also said that “Boards, of course, should regularly challenge the CEO and his executive committee’s views. Groupthink occasionally does, but should not, influence how key decisions are made,”. In his words – “Successful boards should not be comfortable places all the time. Only through effective debate can issues be resolved”.

The Hayne royal commission likewise explored the board’s role in challenging management, with CBA chairman Catherine Livingstone at the time saying “quite surprised by the lack of challenge” under the previous chairman David Turner. There was no doubt serious cultural problems inside banks. The chairman also said that the bank’s board only rarely challenged management. Hence for the public it is not a surprise that serious misconduct issues were overlooked. Directors need to be confident about challenging any management assertions and/or assumptions.

The Australian Prudential Regulation Authority (APRA) likewise recognised how important it is for boards to challenge management in its 2018 Final Report dealing with the Prudential Inquiry of the Commonwealth Bank of Australia. APRA commented “For much of the period under review, the Board did not demonstrate rigour of oversight and challenge to CBA management. The tone at the top was unclear. The Board did not have the right balance of both summarised and detailed reporting in these risk areas, and nor did it, until recently, insist on improvement.”

So, what is expected?

In an April 2019 AICD article, by Tony Featherstone, “How effective boards challenge management”, Steven Cole, FAICD, chairman of Neometals, Perth Markets and the Queen Elizabeth II Medical Trust, and a non-executive director of Matrix Composites & Engineering was quotes as saying “inexperienced directors can misunderstand the board’s role and inappropriately challenge management. … The board’s role is to be part of a team, support management and give wise counsel. Directors, of course, should be probing, constructively challenge the executive team on issues where required, and call out inappropriate behaviour. But the board is not a headmaster with a cane that spends its time trying to pick up errors in management’s work and dish out punishment.”

So, it seems there is a need for directors to adopt a balanced approach.

The objective is for each director to have a clear understanding of each issue, which may mean seeking out how management reached their view and gaining more assurance around management’s capability and judgment. Where this is done openly and respectfully and with the right spirit it can add value for all concerned.

This is not only preferable but essential for optimal continuing cohesiveness of the directors and management working relationship.

DISCLAIMER: This article is general ONLY in nature and is not advice

For more information contact Damien Smith on smithdj@enterprisecare.com.au or 0418 325 781.

 

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