The new fault element in continuous disclosure s674A and the directors’ duty of care

This note summarises the main points of a more detailed paper on this topic. Please email damian.reichel@jws.com.au if you would like a copy.  

Introduction

Overall, the new s674A will not materially alter the approach that directors should adopt in seeking to have the company comply with its obligations and discharge the directors’ own duties. It is timely though to review the directors’ duty of care and diligence under s180 in its application to the continuous disclosure obligation under the new s674A,  including in light of the Federal Court’s decision in GetSwift on 10 November 2021.

The new fault element in s674A

The new s674A of the Corporations Act provides that the company is liable for damages for breach of the continuous disclosure obligation in ASX Listing Rule 3.1 only if the company knows, or is reckless or negligent with respect to whether, a reasonable person would expect the information to have a material effect on the price or value of the company’s shares.

Section 674 which has no fault element continues to apply but only as an offence provision.

Despite the controversy that accompanied the passage of the reform, there is a real question as to whether s674A actually changes anything materially, in that section 674 has always effectively had a reasonable person test (the touchstone of negligence liability) to be applied when considering the materiality of information to be disclosed, and it is hard to point to a decided case where the new fault element of at least negligence on the part of the company could not have been made out on the facts.  That said, the new s674A will at least require that the fault element be pleaded by those making a claim – but it may be the requisite fault can claimed to be inferred from the circumstances of a failure to disclose.  Whether the fault element will give rise to new fronts for pre-trial skirmishes in class actions for strike out applications, requests for particulars and discovery remains to be seen.

However, the question that we address is whether and how the new fault element will affect directors in discharging their duty of care and diligence.

Directors’ accessorial liability

Directors have only ever been liable as accessories to a breach by the company of s674 (that is, “involved” in a contravention) if they knew that the company should have disclosed the information at the time. Even in cases of what appear in hindsight to be a serious breach, that degree of culpability on the part of a director has not been found. The GetSwift decision on 10 November 2021[1] is the first time directors have been found liable for involvement (other than some cases where directors have admitted culpability).  

The introduction of a fault element for civil liability makes directors’ involvement in a contravention even less likely – they will now be liable only if they know the company knew or was reckless or negligent as to whether disclosure was required.

Directors’ duty of care and diligence – relationship with s674A

The directors’ duty of care and diligence under s180 has, however, been used successfully by ASIC on a number of occasions as a “side door” to make directors personally liable for breach of s674 – on the basis that their lack of care exposed the company to liability, even though they have not been found liable as an accessory.

The directors’ duty of care and diligence under s180 remains unchanged.  But under the new s674A, generally if the directors discharge their duty of care, they will not be liable - and neither will the company.

What approach should directors take in discharging their duty of care to ensure the company’s compliance with Listing Rule 3.1 and s674A?

Central question – material effect on price or value

The central question directors need to consider with due care under the new s674A and in discharging their s180 duty is whether the information the company has would have a material effect on the price or value of the company’s shares. That is defined to mean that the information would, or would be likely to, influence persons who commonly invest in securities in deciding whether to acquire or dispose of the securities. There is no need to show necessarily any actual effect on the market price of the company’s shares, although (as noted below) that will usually be the case.

A failure by the company apply the proper materiality test could be an indication of a failure to use reasonable care.

The “persons who commonly invest in securities”

Case law has established that persons who commonly invest in securities can include investors both sophisticated and unsophisticated, large and small, frequent and infrequent, and investors in any securities, not just shares in the type of company in question, whether as to size or sector.

The “common investor’s” value assessment

But case law has also established that the hypothetical “person who commonly invests” is someone who makes an assessment of whether to buy or sell securities on the basis of a company’s earnings or potential earnings and the potential return the investment offers after making an allowance for risk – those who invest on an assessment of the company fundamentals. Speculators and day traders trading on rumour or momentum, or hedge funds who are not making investment decisions based on company fundamentals, or irrational investors, are not included.

So whilst there are various sub-classes of persons who “commonly invest”, that does not mean that directors need to assume different value assessment criteria or methodologies by each sub-class.

It was held in the Myer case[2] that the question is not necessarily whether information would likely cause the market price to move up or down. But in Myer there was found to be an information imbalance between institutional investors and retail investors – specifically that the former had access to broker analysts’ reports but the latter did not. Whether that finding was correct is questionable, and in any case it was said that the retail investors when they were appraised of the information (changes in Myer’s internal forecasts, which were generally in line with the analyst consensus) at least “might” have moved the share price. Anyway it was held that the retail investors could not claim to have suffered loss because the information was already incorporated into the share price. It is only theoretically possible that if information would not move the share price at all, a claim of breach of s674A would be made in the first place, let alone succeed, unless there is some collateral reason to undertake the proceedings. An example is the James Hardie case[3] in which the company was found to have breached s674 by failing to make timely disclosure of a transaction under which a new entity was created that effectively assumed the company’s asbestos liabilities and limited its future financial exposure – a good news or at least neutral story (from a financial point of view at least) that when later disclosed had no material impact on the share price. 

Be that as it may, where there is no information imbalance, the rational assessment based on company fundamentals – future cash flows – can be assumed to be reflected in the market price.

Material effect on future cash flows

The question then is whether the information (the relevant event or development) would have a material effect on the company’s future cash flows – reading “cash flows” as reflecting measures of earnings such as NPAT, EBIT, EBITDA, or dividend maintenance etc, the measure that directors reasonably consider to be the main driver of the market’s value assessment.

A material change in the company’s forecast is likely to influence the hypothetical “person who commonly invests”.  After Myer and more recently Masters v Lombe,[4] it would be prudent for a company to consider announcing any material change in its forecast, even where the analysts’ consensus forecast is already in line with the company’s.

As for what percentage is material, a rule of thumb is between 5% and 10% or more, although in Myer itself a 5% change was found to be enough. ASX Guidance Note 8 at section 7.2 has a useful discussion of the appropriate percentage to be applied, which will depend on the characteristics of the individual company.

Where the effect of a potential development is uncertain

The most difficult continuous disclosure assessments are those that require predictions as to the effect of an adverse development (call it “X”) on a company’s forecast. The ultimate impact of X may be difficult to assess. Or there may be an X in one part of the business but another part has good prospects of over-performing expectations such that the forecast should not change, but there is no guarantee of the over-performance.

An answer that the ASX and ASIC would give is that if in doubt about the impact of X, the company should disclose what it knows, including all relevant qualifications and uncertainties. Or go into a trading halt followed if necessary by a suspension from trading – never a desirable course for shareholders or the company.

But what of a situation where disclosure will make the development so much worse? This is often the assessment where the effect of the X development depends on the outcome of a negotiation with a counterparty – for example, a financier or major customer or essential supplier. Premature disclosure, or a trading halt that starts a clock ticking, will give the counterparty much greater leverage in the negotiation. If the company says that it expects the counterparty to back down, that will have the likely effect that the counterparty’s attitude will harden.

Potential conflict of duty

If the directors consider that the negotiation will likely lead to a materially adverse outcome with or without immediate disclosure, they have no choice but to cause the company to disclose even though disclosure will likely make the outcome worse.

But where the directors reasonably expect the outcome of X to be immaterial as long as the issue is not made public, they will have competing considerations – pre-X shareholders would rather no disclosure and for management to get on with resolving the issue. But there is the prospect of shareholders coming in post-X and they could suffer damage (pay more for their shares than what they are considered in hindsight to have been worth at the time) if the directors’ expectation is not realised.

It should not necessarily follow that where a company is ultimately found to be in breach of the Corporations Act, a breach by the directors of s180 will be found. Directors may consider with due care and expect on reasonable grounds that the outcome of an X development will be immaterial, but appreciate that their assessment may be challenged if their expectation is not realised. Directors in these circumstances can and should balance the foreseeable risk of harm to the company (here, that a breach of s674A may later be found if their expectation is not realised and is successfully challenged) against the potential benefit of delaying disclosure to allow X to be resolved with immaterial consequences for the company.

An opinion reasonably held is included in the information that the company has

Case law has established that an opinion of the directors reasonably held is included in the information that is to be assessed for materiality. 

So for example if a junior gold exploration company finds out from assay results that there is a deposit of nickel on one of its tenements, but decides that the results are not sufficiently prospective to spend money on determining whether the deposit is economic, the positive information is in effect neutralised by the company’s opinion that it is not worth pursuing (Jubilee Mines v Riley[5]). Another example, a board may be aware of financial difficulties confronting the company that could mean the company is insolvent, but forms the opinion that the strategies to address the difficulties are likely to succeed and so the company is not insolvent (Grant-Taylor v Babcock & Brown[6]). That is so in each example even if the opinion is disputable and even if it turns out to be wrong, but if it is reasonable (based on reasonable grounds), it forms part of the information that the company “has”.

Accordingly, subject to our comments below, if the directors form the opinion on reasonable grounds that X will be resolved with immaterial consequences to the company, that can neutralise what would otherwise be a material X – if investors knew what the directors know, including the directors reasonably held opinions, they would not consider that X will have a material impact on the company’s future cash flows.

But that said, it needs to be borne in mind that if the opinion turns out to be incorrect or over optimistic, the directors’ opinion will be picked over by a Court with the unavoidable colouring of hindsight. 

The spectre of hindsight

This is starkly illustrated by the Vocation decision[7]. Vocation was negotiating with its major source of income - a Victorian Government department (the DEECD) who provided funding for Vocation’s training courses - over issues raised by the DEECD about whether Vocation was enrolling the right kind of students and the quality of the courses. The directors expected that the issues would be resolved with immaterial consequences but their expectation was not realised. Vocation later went into liquidation and a claim was made by ASIC for breach of s674 against Vocation and against the Chairman (and the CEO) for involvement in the contravention and breach of s180. The claim centred on the information available to Vocation at a point in time (a 3 week period before the negotiation was complete). The Court reviewed what the DEECD was claiming in correspondence with Vocation at that time, and looked at the precise terms of the DEECD funding agreements, and determined that the Chairman (who had taken on a quasi-executive responsibility for resolving the issues) should have appreciated that what the DEECD could do would be much worse than what the Chairman foresaw – and what he DEECD could do was material information that should have been disclosed. 

Of course, the posture that a counterparty in a negotiation adopts at a point in time and the terms of its contractual rights are not the only factors to be taken into account. What the counterparty could do (that is, in the worst case) is not necessarily what it will do or should be expected to do. But in this case the counterparty (the DEECD) subsequently did do more of what it could do than the Chairman expected.  The Chairman was found to have acted in breach of the s180 duty of care by not undertaking the same point-in-time deep dive risk assessment that the Judge undertook on the available information, and also by relying without sufficient scepticism on management – despite that management were experienced in dealing with the DEECD and were expressing confidence that the issue would be resolved without material impact.

If directors are to seek to rely on their opinion in these circumstances, it may be vital to document carefully their considerations in detail, including their assessment of the characteristics and drivers of the counterparty which may not otherwise be apparent from correspondence and contractual documents. It would not go too far to say that a form of “due diligence” (analogous to the process adopted for a capital raising) can and should be undertaken in this sort of instance, and this, done properly, could go a long way to assisting a director to resist a claim that they have failed to discharge their duty.

Reliance on management

Despite Vocation, it remains open to directors in discharging their duty of care to rely on apparently reliable management assessments of the potential outcome of an “X” development, unless they are put on notice that management is not providing reliable information - as was found in Vocation.  In that case there was no claim of lack of care made against the NEDs. As noted the Chairman had assumed a quasi-executive function in personally seeking to resolve the issues with the DEECD and so was held to have the responsibility that an executive would have in assessing the risks and likely outcomes.

Where management does not disclose material information

ASX listed companies have continuous disclosure policies which require executives responsible for the management of a particular major part of the company’s business (we will use the term “division managers”) to alert a particular executive (eg the CEO, CFO or General Counsel) of material developments - what we have termed an “X”. The company’s continuous disclosure policy will typically provide that the information must then be assessed for ASX disclosure by a committee charged with that responsibility (we will call it the “CD committee”) and if appropriate, the matter is elevated by the CD committee to the board for its consideration.

What if a division manager fails to comply with the company’s continuous disclosure policy – fails to alert the CEO, CFO or General Counsel of an “X” development?

Generally, a company is taken to be aware of information if it comes to an executive within the area of the executive’s responsibility. In terms of ASX Listing Rule 3.1, the company would be “aware” of the information.

If the division manager (in this example) is not a member of the CD Committee, the failure to disclose as required by the company’s policy will probably be a breach by the division manager of s180.  But the upper management and directors are unlikely to be liable for breach of s180 – except perhaps if they have not properly disseminated the company’s continuous disclosure policy within the company or have not required compliance with it.

But will the company will be liable for breach of s674A?

Section s1317QE of the Corporations Act provides that if an element of a civil penalty provision (s674A is a civil penalty provision) is done by an employee, agent or officer within actual or apparent scope of their employment or within their actual or apparent authority, the element is to be attributed to the body corporate.

But in this example, the division manager is not a member of the CD committee and has no responsibility for disclosure decisions, so their decision not to disclose “up the line” is not “an element” of s674A but is in effect anterior to the application of that section.

Those who do have responsibility for making the disclosure decision under s674A (the CD committee and ultimately the board) cannot be considered at fault for failing to consider whether the information would have a material effect on price under s674A because they were not made aware of the information. 

It remains to be seen, but it may be difficult to find the company at fault for failing to comply with s674A in these circumstances.

Conclusion

As can be seen from the discussion above, the position of directors has not been changed fundamentally by the introduction of a new s674A fault element. Under the former “no fault” s674, directors had to exercise reasonable care and diligence to ensure that the company complied with s674. Under the new regime, they have to exercise the same care and the addition of a fault element does not alter the substance of what the directors must do to discharge their duties. The accessorial liability of directors for involvement in a contravention of s674 was already largely a “dead letter” and the new fault element has simply confirmed that.

All that said, if the directors take the necessary steps to discharge their duties under s180, there is every chance that the company will be considered to have complied with s674A. The other side of that coin is that if the company fails to use reasonable care, it will be a short step to find that the directors have likewise failed to use reasonable care – but again this is nothing terribly new or earth shattering.

Important Disclaimer: The material contained in this article is comment of a general nature only and is not and nor is it intended to be advice on any specific professional matter. In that the effectiveness or accuracy of any professional advice depends upon the particular circumstances of each case, neither the firm nor any individual author accepts any responsibility whatsoever for any acts or omissions resulting from reliance upon the content of any articles. Before acting on the basis of any material contained in this publication, we recommend that you consult your professional adviser. Liability limited by a scheme approved under Professional Standards Legislation (Australia-wide except in Tasmania).