What future for Australian manufacturing and why should you care?

The question of whether manufacturing has a future in Australia has been hotly debated for some time. This year, the debate has reached fever pitch fuelled by the usual Hanrahans spouting their own versions of “We'll all be rooned.”

The media is full of stories of failing Australian manufacturers and government bail outs. The Executive Chairman of Manufacturing Australia recently stated that, “manufacturing is severely threatened unless steps are taken to maintain global competiveness”.

But is Australian manufacturing really on a road of no return or is it merely reshaping itself, albeit not without some pain, for the 21^st century and why does it matter?
Firstly, why manufacturing matters. As Professor Roy Green has commented, Australian manufacturing is important because of the strong connection between manufacturing and developing a knowledge-based economy. True we may no longer be competitive in textiles, garments and footwear given the competition from low-wage economies. But we can be competitive in fashion and design, as well as in technical textiles and smart fabrics for industrial purposes.
That’s why it is important to preserve and assist our manufacturers. There is plenty of scope for Australia to lead the world through ingenuity and research.
Manufacturing Australia is advocating a reform agenda focused on lowering regulatory and energy costs for manufacturers and strengthening Australia’s anti-dumping system.
While these are sound reforms and may be beneficial, are they really addressing the core reasons why we need a manufacturing sector? How do these responses address the trends that are reshaping global manufacturing?
As discussed, many products previously manufactured in Australia are now being manufactured in low-wage economies like China, Thailand, Vietnam and Malaysia. Typically these are commodity products that attract relatively low margins and rely on volume to generate revenue.
The move to shift manufacturing commodity products to low cost countries is not unique to Australia and has been happening for some time as developing countries expand their industrial base. Calls for stronger anti-dumping protection will not address the underlying economic reason why these products are manufactured in these countries.
There is a more recent phenomenon occurring globally that could ultimately support more a sustainable manufacturing sector in Australia. That is, the move away from manufacturing products at an end-to-end factory located in a single country and then selling those products.
Rather, what is now occurring, particularly in developed countries, is the “unbundling” of the various manufacturing stages of a particular product across borders. Components and subsystems for a particular product are produced in two or more countries that have a comparative advantage in making those components and subsystems. They are then shipped to a third country to be assembled into the end product, which is then sold world-wide.
The benefit of “unbundling” is that each stage of the manufacturing process, including final assembly, is conducted in the country that has (theoretically) the best comparative advantage for its particular part in the process.
Large businesses, particularly multinational corporations, are not only “unbundling” and geographically dispersing the manufacture of products to reduce costs and enhance competitiveness; they are also “unbundling” and outsourcing services, such as back office administration.
What determines which country or countries have the best comparative advantage? For assembly of a product, it’s primarily access to labour at low cost. For the production of components and subsystems, it will depend on the intellectual property content in the product. Countries with strong intellectual property protection will be favoured where components and subsystems contain unique intellectual property.
Australia thus needs to focus not on the low value aspects of the production chain but rather on what Professor Green calls “our capacity to compete in knowledge-based activities worldwide as part of international markets and supply chains”.
An example of “unbundling” is the manufacture of passenger trains. Components and subsystems are manufactured in a variety of developed countries where intellectual property protection is strong. Those components and subsystems are then shipped to a developing country, where low cost labour is abundant. There they are assembled into either the finished passenger train or a partially complete passenger train. In the latter case, the partially complete train is shipped to a developed country where further high end manufacturing, such as installation of the computer and communication systems, occurs to complete the train.
Other examples using this global production technique are motor vehicles, mobile phones, computers and televisions to name but a few.
This move towards globalised manufacturing has occurred in parallel with another, related trend – the rise of preferential and free trade agreements between countries. Significantly for manufacturers, these trade agreements address more than the usual border issues such as tariffs and customs procedures. They also encompass “behind the border” issues such as investment, intellectual property and competition.
Why are these issues important? Breaking apart a manufacturing process and dispersing it across multiple jurisdictions results in a complex web of:-

• trade in components and subsystems across borders;
• investment in factories in multiple jurisdictions and associated investment in training, technology, OHS, etc; and
• infrastructure to manage the logistics involved in both the production of goods at each stage of the manufacturing process and then marketing the final product in export markets.

The threats to such a globalised manufacturing network are clear. For example, weak intellectual property and foreign investment rules in a jurisdiction will work against establishing manufacturing or assembly operations in that jurisdiction. The solution? Enter into preferential trade agreements that address those ‘behind the border’ issues and, thereby, facilitate the establishment of manufacturing operations in those jurisdictions.
In its 2011 World Trade Report the World Trade Organisation found that for cross-border production networks to operate efficiently, certain national policies (e.g. intellectual property, foreign investment, etc.) need to be harmonised and rendered mutually compatible. This generates the need for “deep” preferential agreements either on a bilateral basis or on a regional basis.
Since June 2008, Corrs has been involved in this process through (our CEO) John Denton’s role as government-appointed business representative on the regional trade and investment body, the Asia-Pacific Economic Co-operation forum and APEC's Business Advisory Council.
Corrs is eager that we shift from an old-style trade debate, where the objective is to crash through to one about economic integration. As John Denton has previously commented: “The world economic crisis has underscored just how connected markets are in an era of globalisation, yet all kinds of unhelpful nuts-and-bolts barriers remain behind borders. At the macro-level we need to flip the discussion from protection and market access to market integration”.
What does this mean for Australian manufacturing? The sector continues to be important to our collective wealth. Much can and has been done by successive governments to improve the competitive position of Australian manufacturing by moving into higher-value activities and identifying new areas of manufacturing, like manufacturing using lasers and 3D, where we have world-class scientists and a proud tradition of innovation through organisations like CSIRO and the world class work done by, amongst others, its Manufacturing, Materials & Minerals Division. At the same time we need to be vigilant in ensuring our network of trade agreements addresses any behind the border issues that might hold us back.

New SASAC rules signal greater transparency and accountability

There has been some suggestion that there is a “crackdown” by Chinese authorities on outbound foreign direct investment (OFDI) by Chinese State-owned Enterprises.

I have seen no evidence to suggest that the new rules announced by China’s State Assets Supervision and Administration Commission (SASAC) are anything more than the legitimate and reasonable wish of the Chinese government to get greater comfort about the quality of the investment decisions to maximise the benefits of the transactions. They do not signal an end or decline in OFDI which is largely driven by a readjustment of China’s economic growth model.

The new measures come into effect from May 2012. They restrict an SoE from making any OFDI in non-core business areas except in special circumstances as approved by SASAC. The measures also provide that SoEs must report to SASAC prior to making major OFDI related to their core businesses with details of an investment plan and financing sources. If an SoE breaches the rules and suffers a major loss, SASAC has reiterated that the enterprise and related persons will be held accountable.
Despite first impressions, these new rules are no more than a step in the evolution of SASAC’s current OFDI rules. Significantly, the 2011 Interim Measures require SoEs to procure feasibility studies and due diligence for all OFDI.

In particular where:

• state-owned assets located in the PRC are used as consideration for an overseas investment, an appraisal conducted by a domestic valuation institution is required; and
• an off-shore subsidiary of an SoE is to purchase overseas assets, a professional institution of sufficient expertise and reputation must be engaged to conduct a valuation or appraisal of the transaction.

The transaction price must then be based on these appraisals.
As a package, the 2011 and 2012 measures reflect a desire to strengthen the investment processes and accountability of SoEs. Statements from Chinese officials have indicated the aim of the new rules is to prevent SoEs from blindly diversifying into high risk sectors or making speculative investments abroad.

The new measures reflect a growing sophistication of Chinese authorities in managing risks associated with OFDI. They do not signal an end or decline in OFDI. Indeed, China’s accumulative OFDI is forecast to grow by 17% between 2011-15 reaching US$560 million by 2015.
Earlier this year MOFCOM reaffirmed China’s commitment to its “Going Out Policy”, stating the Government will guide and encourage local companies to enhance cooperation and invest abroad in manufacturing, energy, culture and engineering. MOFCOM has also stated that China will promote outbound investment in service sectors including finance, architecture, tourism, education and telecommunications. This reflects a logical shift in Chinese OFDI toward commercial operations in advanced economies like Australia.

The scale of businesses operated by SoEs abroad has grown exponentially as has the range of sectors in which they are investing and the complexity of the investment transactions.
While the direct effect of the new rules cannot be measured, the rules may imply a shift in the nature of Chinese OFDI in Australia with a focus on joint ventures or minority stakes in quality proven assets. This is a trend that we have already seen emerging.

The message for Australian vendors is they must understand and appreciate a SoE’s investment criteria and structuring requirements to formulate a successful deal. SoE’s will be focused on thorough due diligence, careful structuring and negotiation of the transaction to maximise synergies and benefits. Where JVs are the chosen investment method, management of relationships between the two partners will be critical to success.

I welcome SASAC’s strengthening oversight of Chinese OFDI. Ultimately, the new measures encourage accountability and transparency, two of the key principles underpinning investment by government related entities in Australia’s Foreign Investment Policy.

New rules for M&A in the PRC

Commencing 1 September 2011, China has a new ‘security review’ system for mergers and acquisitions of domestic enterprises by foreign investors.

 

Far from being a new hurdle for foreign investors to jump over, the new regime is intended to "increase the transparency and predictability of China's reviews of foreign investment and promote more ordered mergers and acquisitions in China."

Interestingly, the new procedures bear some similarities to Australia’s Foreign Investment Review Board (FIRB), which has ruled on planned Chinese investments in Australia and which can block deals it deems not to be in the national interest. FIRB advises Australia's treasurer, who has the final say.

China’s new ‘security review’ rules have established an Interdepartmental Committee system to review acquisitions of domestic enterprises.

The Interdepartmental Committee will be led day to day by the National Development and Reform Commission (NDRC) and Ministry of Commerce (MOFCOM) under the guidance of the State Council.

Like the FIRB, the Interdepartmental Committee is expected to involve other departments as required for information or to build consensus in the government but it will not necessarily invite those departments to take an active role in the review process.

National interest

Determining what is considered ’in, or not in, the national interest’ is dependent upon the way that foreign investor is controlled in China.
Under Chinese rules all foreigners and acquisitions are regulated according to industry groupings that are either encouraged, permitted, restricted or prohibited. Some economic sectors that are restricted or prohibited are analogous to areas of mandatory review under Australia's foreign interest rules (eg aviation and telecommunications) and some have no equivalent (eg the processing of traditional green tea).
In almost all cases the threshold for security review will be that the foreign investor must acquire “actual control” of the enterprise. ‘Actual control’ includes situations where any foreign investor or combination of investors will hold more than 50% of an enterprise’s equity, or where voting rights give a foreign investor significant influence over shareholder meetings or board meetings.
It seems that Chinese regulators are to be given a broad mandate when reviewing transactions. The Interdepartmental Committee will examine the transaction’s influence on national defence, economic stability, basic societal order and research and development capacity related to national security.
In the Chinese context, "national security” appears to be a more embracing and complex concept than would be typically found in a western definition, but one that is not totally inconsistent with what has been applied in Australia.
In Australia the equivalent national interest test has been described as “… something that is defined by the Australian Government and the Australian people. It is not static and cannot be defined in a mechanical way.”
Like the PRC model Australia’s foreign investment legislation does not provide a mechanical definition or guidelines against which to measure the national Interest. FIRB, as the advisory body to the Treasurer, is not obliged to reveal either how it arrived at a decision or what it recommends to the Treasurer.
It is in fact rare for the Treasurer to issue formal reasons for the approval or prohibition of transactions. Earlier this year the Treasurer took the unusual step of providing some insight into his thinking in prohibiting the acquisition of ASX by SGX. However, this is far from the norm.
In Australia the national interest includes:

• preserving of national security;
• preserving of Government revenue;
• evidence that the participant will respect Australian law and business practices;
• avoiding of inappropriate levels of competition or excessive concentration;
• consistency with Government policies; and
• the character of the investor.

Much like China the most ambiguous and difficult to predict is the national security test. This test has on occasions been applied to prohibit acquirers from purchasing mining assets that were considered too close to the Woomera prohibited area and in the SGX transaction it was considered by reference to the systemic security of Australia’s financial system.
In the SGX takeover there is no doubt the Treasurer formed the view that a takeover of ASX may have meant a loss of “full regulatory sovereignty” that might have impacted on Australian regulatory authorities’ capacity to protect the system from financial crisis.

OECD’s view

Australia’s regulatory regime sits in the mid-point of OECD countries in terms of its relative level of restrictiveness. The OECD’s FDI Regulatory Restrictiveness Index (FDI Index) measures statutory restrictions on foreign direct investment in 49 countries, including all OECD and G20 countries, and covers 22 sectors. Australia’s score is held back by the fact that the national interest test is seen as a “discriminatory screening requirement”.

Australia ranks seventh among the 34 advanced nations on an index measuring the height of the barriers countries put in front of international companies wanting to invest. This is despite Australia being decidedly pro-investment and the fact that the national interest test to reject foreign investments is rarely invoked.
The OECD’s annual Going for Growth found that screening might create uncertainties that limit foreign direct investment. Indeed the review suggested that:

Transparency would be enhanced by more information on the criteria applied in government decisions and by involving specialist agencies (e.g. national securities) in the review process of FDI approval.

China’s foreign investment regulatory regime is currently ranked as the second most restrictive on the FDI Index. However, with the introduction of a transparent set of rules and procedures governing security reviews of cross-border M&A transactions, we would hope to see China improve its score in future versions of the FDI Index.

Conclusion

Both the Australian and Chinese governments have chosen a model that allows them to retain the flexibility to be able to deal with the consequences or externalities that may arise from a foreign takeover.
As noted by the OECD there is potentially great merit in both governments providing greater transparency around the assessment process so that there is more certainty for foreign investors. Communicating how and why decisions to approve or prohibit transactions would be one way to provide transparency by which others could judge how the process operated.

A win for common sense not a blow to continuous disclosure but perhaps its time for a new way forward...

In 2004 and 2005 the Australian Securities & Investments Commission alleged Fortescue had failed to properly inform the market about contracts with a Chinese group concerning the development of rail infrastructure.
The Federal Court did not accept that proposition, later the Full Federal Court overruled that decision and now they in turn have been overruled by a unanimous decision of the High Court.
ASIC is considering the impact of the High Court's decision on the continuous disclosure requirements. It seems they are concerned that the market is unclear what companies need to disclose about the nature and content of an agreement, and “what is necessary to ensure that the market is properly informed for the purposes of making investment decisions.''
For a number of years commentators including (Greg Golding and Ronald Barusch) have expressed concern that the continuous disclosure regime was developing in a way where there was a substantial gap between what companies thought was appropriate and what the courts expected of them. The Fortescue case demonstrates that the High Court (at least) is much closer to the market’s perspective of what is required than their brothers on the Full Federal Court.
Indeed, the High Court decision suggests that directors involved in companies dealing with continuous disclosure have more scope to manage their announcements than had previously been thought. But maybe it also says something about whether ASIC is really the right body to be making decisions about market expectations concerning continuous disclosure.
The case is a win for commonsense. The 46 page judgment demonstrates the High Court’s commerciality and understanding of the nature of the cut and thrust of commercial life. But unfortunately very few of the companies or directors who need to consider their disclosure obligations are in a position to have the damning allegations of a regulator hang over them for a long period and the resources to seek the wisdom of the High Court.
Indeed, the case underscores the fact that the continuous disclosure announcements are often made in difficult circumstances where directors are trying to strike the right balance between the need to disclose too much and not enough. Justice Dyson Heydon seems to have recognised the difficulties faced by directors when he described in his separate judgment that the comments in relation to Fortescue’s contracts with Chinese China Railway Engineering Corp, China Harbour Engineering Corp and the China Metallurgical Construction Corporation were not directed to the public as a whole.

They were directed to a section of the public. It comprised superannuation funds, other large institutions, other wealthy investors, stock brokers and other financial advisers, specialised financial journalists, as well as smaller investors reliant on advice. This was not a naive audience. It was not an audience in whom the adjectives "Western Australian", "mining" and "Chinese" would excite a sudden certainty about the imminent creation of wealth beyond the dreams of avarice.

The majority decision of four judges also found that “the parties’ stated intention of making a legally binding agreement was genuinely shared by them”. In the end what we see is a judgment where the High Court has focussed on the underlying question of what is required in order for a statement not to constitute misleading or deceptive conduct. Because the High Court found there was no misleading or deceptive conduct, they did not explore other issues like directors’ obligations under the continuous disclosure laws or the application of the business judgement defence.
Clearly each case turns on its facts and the High Court was at pains to point out that its reasons in this case did not establish any general proposition to the effect that any public statement that company A has made a contract with company B necessarily conveys to its audience a message only about what the contractual document contains.
We can only hope that when the ASX and ASIC settle down to resolve the new wording of the proposed revised Guidance Note 8 that commonsense will also prevail. The meanings of words such as “immediately”, “aware” and “materiality” need to be construed with the same sensible approach as the High Court adopted and with due regard to commonsense and the environment in which the market and continuous disclosures operate.
But maybe the issue is bigger than this case. In 2002 (Making Continuous Disclosure Work – Outcomes v. Enforcement, JASSA, Spring 2002) I and others (see H Corlett, R da Silva Rosa and T Walter Corporate Executives’ Experiences of Continuous Disclosure) argued the need for our system of regulating continuous disclosure to leverage off the significant and measurable success of the Takeovers Panel and to introduce a “Disclosure Division” of that body to perform a non-judicial function related to disclosure misconduct.
Since 5 September 1994 continuous disclosure by Australian listed companies has been the foundation upon which much of our scheme for the efficient regulation of markets has been based. Our system of compulsory immediate release of information is based on an assumption that investors should be able to make investment decisions in the light of the best possible information and the powerful disinfecting quality of sunlight. That high-quality disclosure, in as near to real time as possible, will ensure that share prices better reflect value enhancing market accuracy. In that sense, the requirement of continuous disclosure is based on the market information principle, an assumption that the efficiency of a capital market depends on the amount of information available to and its distribution, among investors. But it also requires real time solutions to disclosure issues.
It is important to remember the nature of the problems that have emerged in this field. These issues are largely about the requirements of ASX Listing Rule 3.1 a provision that is somewhat aspirational in its terms. Like all the ASX Listing Rules, Rule 3.1 needs to be read (whatever its detail) by reference to the spirit, intention and purpose of the ASX Listing Rules and by looking beyond form to substance. As long ago as 1986 Young J. said:

"One falls into error if one treats the requirements of the listing rules as a technical document for construction in the same way as a statute. To my mind the listing requirements are a flexible set of guidelines for commercial people to be policed by commercial people. They are in the same category as guidelines or standards laid down by administrative bodies who are administering an Act of Parliament. These guidelines or standards are never intended to be inflexible rules, but rather principles to be administered and applied by an expert body in accordance with the prevailing ethos of those chosen to administer them.” see Fire & All Risks Insurance Co Ltd v Pioneer Concrete Services Ltd (1986) 10 ACLR 760 noted on appeal 10 ACLR 801 at 806.

Clearly the court is supporting the view that the ASX Listing Rules are not the kind of rules that ought to be enforced by a regulator like ASIC or that are traditionally associated with offences the subject of penalty notices or similar judicial processes.
While the current arrangements work satisfactorily there is scope to improve the provisions, not through penalty provisions or enforceable undertakings, but rather through the establishment of a new Disclosure Division of the Takeovers Panel.
The Disclosure Division would be designed to act with speed, it could apply a uniform standard based on experience and peer review of questions of compliance with continuous disclosure obligations. The Disclosure Division could determine whether there had been any “unacceptable disclosure practice” having regard to the spirit of the market misconduct provisions. A new approach could provide a considerable enhancement to the existing continuous disclosure regime. It may be an idea whose time has come.

A view from the trenches


In my experience most directors and executives expect their lawyers to act independently, ethically and with integrity but not as a gatekeeper. The suggestion that gatekeeper rules ought to apply to a wide sweep of participants in the financial markets is a problematic idea and may miss the point.

Gatekeeper theory might seem like an idea for our times, but as with Coffee’s post-Enron formulations of the idea; it is an idea that has some serious limitations. Would more gatekeepers have helped JP Morgan to better manage risk (and their oversight) or have helped the Centro shareholders?

It seems that everyone from Commonwealth members of parliament to ASIC is looking for a set of rules that will deliver better ethical behaviour by holding individuals to account. Unfortunately the theory might not deliver the ethical outcome that they seek. Do we really think a focus on responsibility alone will achieve the right outcome? The debate thus framed is a bit one dimensional and would benefit from a more integrated approach to risk management as suggested by O’Brien.

It’s too easy to suggest an “indisputable duty of corporate lawyers to act as officers of the legal system” as a reason for corporate lawyers to be characterised as gatekeepers. To characterise corporate lawyers as gatekeepers is to impose upon them an inappropriate standard that does not address the matrix of relationships in which they operate. As Dubnick recognises these the trusting and accountable relationships which underlie current practices are at the heart of how the system actually works.

The complex relationship between commercial lawyers and their clients and the overwhelming recognition by commercial lawyers of their role as guardians means at least in this jurisdiction there is not a systemic failure as some claim took place in other places during the GFC.

Corporate lawyers are more usefully thought of as guardians than gatekeepers, they generally operate conscious of our strong ethical obligations and obligations to our clients, the courts of which we are officers and to the community that depends on the strength of our legal and financial institutions. Unlike auditors or security analysts (who have independent duties as objective providers of external assurance) corporate lawyers do not and can not have imposed on them duties to the wider market beyond their general ethical duties. Corporate lawyers provide advice to the company that is seldom if ever designed to be relied upon anyone outside the company. Lawyers are fiduciaries of their client who operate within a broader environment and who are governed both by the specific laws and by the grundnorm.

In general terms there are different levels of intensity proposed by the advocates of the corporate lawyer as a gatekeeper. These range in intensity from nothing to an annual certification obligation.

Unfortunately, the gatekeeper’s exponents fail to adequately account for the economic incentives and cognitive biases that systemically influence the behaviour of market participants like corporate lawyers. Even beyond the economic incentives, if lawyers were aware of material information of misdeeds (and it is questionable whether they would be aware in such black and white terms) their cognitive bias makes it unreasonable to impose gatekeeper obligations on them.

Advances in behavioural and social psychology have demonstrated that corporate lawyers and financial advisers (like everyone else) are prone to deeply embedded behavioural biases. People are affected by unconscious biases that can affect the rigour that they bring to the roles expected of them and the accuracy of their judgements. Because the corporate lawyer’s primary audience is their client and because they owe their client fiduciary duties, studies into accountability and audience bias strongly suggest it is simply unrealistic to expect them not to avoid all alignment pressure in the way that we expect of an auditor or analyst. If we want better outcomes from market participants we need to understand and manage these behavioural biases.

Corporate lawyers have a professional duty to maintain independence; for corporate lawyers this means:

• avoiding formal and informal conflicts of interest;

• remaining independent from government, this is not accepting government policy blindly without regard to the rule of law or specific legislative requirements;

• being independent from our personal views; and

• a degree of independence from the client but being independent from our clients is not the kind of independence the community expects from auditors. For corporate lawyers independence is more complex and multifaceted: at its simplest it requires that we preserve our overriding duties as officers of the court and at its most complex it requires that we are zealous proponents of arguments that we might feel uncomfortable making on our own behalf.

In 1998 Sir Gerard Brennan reminded commercial lawyers that: because the moral purpose of much commercial law is known to commercial lawyers alone, the lawyer becomes by default the moral as well as the legal advisor. The commercial lawyer’s duty cannot be restricted to legal advice, for then the moral decision – what ought to be done as distinct from what can lawfully be done – will not be addressed.

The corporate lawyers must ensure that our profession has the structural features to permit a degree of commercialism commensurate with meeting the challenges of the growth of national and transnational legal practice without detracting from the underlying essential elements of the goodwill of that “business market” – the faithful administration of justice based on adherence to professional standards and ethics and to the required ethical standard.

Wasserman suggests that it is not hard to articulate what we the ethical standard should be, we can just go back to the “golden rule”. This is the philosophical maxim common to almost all of the world’s great religions, holds that you should treat others as you would like to be treated (a useful maxim for dealing with everyone from five year old boys upwards). In many ways this is as simple as asking the question “Am I acting as a good agent? Am I helping my client to be a good fiduciary for the parties to whom she owes fiduciary duties? Am I acting as a good agent of my society and the legal, financial and regulatory system?” How different would the circumstance of James Hardie or Centro have been if those questions had been asked?

Even as a mere “transaction engineer”, the corporate lawyers keeps in mind that they are hired to provide independent and critical judgement. There is a place for ethics to help the lawyer help our client company, its executives and directors act as a good agents. That same benchmark can help the securities lawyer be a good member of society and our legal, financial and regulatory system.

In my experience most directors and executives expect their lawyers to act independently, ethically and with integrity but not as a gatekeeper. Maybe the answer is not as simple as better rules.

What is good corporate governance?

What is good corporate governance?
Corporate governance is the system by which corporations are directed and controlled:

The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs.

The subject of corporate governance is wide and varied. Even though good corporate governance can mean different things to different people, essentially it is an extended partnership between a company and a range of other groups including its shareholders, its management, its employees, the regulators, the markets and the wider community. It also regulates the relationship between a company's members.

Good corporate governance is at least:
o a system of checks and balances to promote fairness, accountability and transparency;
o part of an overall risk management program;
o founded on the premise that the board is charged with the role of agent for the shareholders to ensure the organisation is managed in the shareholder's best interests;
o about protecting the organisation's reputation; and
o capable of responding to the tension between ensuring managerial accountability and enhancing per-formance.

Good corporate governance is applicable to public, private, government and not-for profit organisations alike.

Good governance and good risk management have many similar features. Both identify and determine the amount of acceptable risk; establish a regime to measure and monitor risk, separate risk management from management; and develop a strong corporate risk culture so that the rewards, as well as the risks, are always considered.

Responsibility for corporate governance commonly falls on the board. Any governance standard adopted by a board is likely to be used as a benchmark in assessing whether a board or individual directors have applied a reasonable degree of care and diligence in exercising their powers and discharging their duties, as is required by law. One key element of the governance of a corporation is its constitution, the relationship between the governance matters and the constitution is a very interesting area and one I plan to wite on further: see The 2010 McPherson Lectures Series by Dr Robert P Austin, Adjunct Professor and Challis Lecturer in Corporate Law, the University of Sydney (formerly a Judge of the Supreme Court of New South Wales - three one-hour lectures in the Series under the topic, 'The Role and Duties of Australian Company Directors: a Restatement'.


In Australia there are many sources of corporate governance rules, including the Corporations Act 2001, common law and the company's constitution. The Australian Standards, "Good Governance Principles", and the ASX Corporate Govern-ance Council's Principles and Recommendations also provide a sound approach to corporate governance for many different types of entities.

The area of corporate governance on the whole is premised on self-regulation. Self-regulation is flexible, able to evolve to meet specific and changing circumstances, utilises the expertise of those it regulates and has the ability to enlist the support and input of stakeholders within the industry to create an effective culture of performance.

A beginners blog of governance, corporate and securities stuff: Photo

A beginners blog of governance, corporate and securities stuff: Photo

Centro decision

I think there is an interesting question emerging for directors and officer from the decision in Centro.

What is the nature of the "certification" obligations? Is 295(4), 344(1) different from other Corporations Act requirements?

How does this impact on takeover documents, prospectuses etc. What are the effective limitations of "reasonable reliance"?

It seems that as regards the accounts they could not delegate or "abdicate" that responsibility to others. Middleton J said that:
…directors cannot substitute reliance upon the advice of management for their own attention and examination of an important matter that falls specifically within the Board’s responsibilities as with the reporting obligations.

In Middleton J's view:
the whole purpose of the directors’ involvement in the adoption and approval of the accounts is to have the directors involved in the process at a level and responsibility commensurate with their role.

In other words, a reasonable step would be to delegate various tasks to others, but this does not discharge the entire obligation upon the directors.

A further step is required, which involves the directors taking upon themselves the responsibility of reading and understanding the financial statements in light of an understanding of basic accounting concepts.

The same reasoning applied in respect of reliance by directors on the audit committee. Middleton J held that whilst an audit committee has an important role in monitoring and oversight, this cannot be to the exclusion of the role of a director to consider the financial accounts.

The “national interest test” and Australian foreign investment laws

Introduction

The national interest test is by its nature opaque. The decision of the Treasure to publish his reasons is a welcome trend.

Published reasons ought to be encouraged in all major FIRB approvals and rejections.
The availability of reasons will lead to an overall better system one less likely to be criticised as being “a “protectionist relic” that does not fit with the Australian Government’s free markets principles”. The national interest test has always been an opaque standard. The test was introduced in 1986. It was intended to reflect a changed bias towards foreign investment but it has been the subject of substantial criticism.

In a sense, the test is both a strength and the weakness of Australia foreign investment policy. The recent decision by the Treasurer to reject the takeover of ASX Limited by the Singapore Exchange emphasises many the test including the difficulty of pinning down what exactly is “the national interest”.

The decision of the Treasurer to publish his reasons is an unusual but welcome step towards transparency in the FIRB process.

Background
Australia is a subscriber to the OECD Declaration on International Investment and Multinational Enterprises. Australia’s regulatory regime sits in the mid-point of OECD countries in terms of its relative level of restrictiveness. Australia’s score is held back by the fact that the national interest test is seen as a “discriminatory screening requirement”. Even though the onus of proof that a foreign investment proposal is “contrary to the national Interest” rests with the Government and not with the investor. Indeed the OECD’s annual Going for Growth found that screening might create uncertainties that limit foreign direct investment. Indeed the review suggested that: Transparency would be enhanced by more information on the criteria applied in government decisions and by involving specialist agencies (e.g. national securities) in the review process of FDI approval.

Australia’s investment policy is decidedly pro-investment. Australia rarely invokes the national interest test to reject foreign investments.

In the case of the ASX SGX deal one inherent problem was that the transaction was never seen as a merger of equals. It was always characterised as an SGX takeover. In this sense no matter what concessions were made, there were deep seated concerns that the deal would not give ASX a sufficient voice. This point is expressly acknowledged in the Treasurer’s reasons:
To diminish Australia's economic and regulatory sovereignty over the ASX could only be justified if there were very substantial benefits for our nation, such as greatly enhanced opportunities for Australian businesses and investors to access capital markets. Given the size and nature of the SGX –which is a smaller exchange with a smaller equities market than the ASX – the opportunities that were offered under the proposal were clearly not sufficient to justify this loss of sovereignty.

The Government and FIRB have consistently been reluctant to approve foreign acquisitions which might result in parties who have lower levels of interest in developing Australian assets ahead of other global interests. In the case of Woodside Petroleum in 2011 there were substantial concerns that the proposed new owners (Royal Dutch Shell) would not have an interest in developing the Australian asset ahead of their other global assets. Again the Treasurer’s reasons point to this feature:
It is in the national interest for Australia to maintain the ongoing strength and stability of our financial system, and ensure it is well placed to support the Australian economy into the future. It is important that we continue to build Australia's standing as a global financial services centre in Asia to take best advantage of the benefits of our superannuation savings system. I had strong concerns that the proposed acquisition would be contrary to these objectives.

While there have been calls for the national interest test to be more precisely defined and to replace the role of the Treasurer with an independent body that would not achieve the same functional purpose as is provided by the existing test. What is then the existing test and how is it applied?

So what is Australia’s national interest?
In many respects the national interest is “a bit like an elephant”. Hard to describe but you know one when you see one. As Ashton Calvert commented in 2003 “The Australian national interest is something that is defined by the Australian Government and the Australian people. It is not static and cannot be defined in a mechanical way.”

The legislation does not provide a mechanical definition or guidelines against which to measure the national Interest. FIRB as the advisory body to the Treasure is not obliged to reveal either how it arrived at a decision or what is its recommendation to the Treasurer that is entirely consistent with usual general principles of advice from Treasury to its minister. The Treasurer is not compelled to provide justification or clarification as for the reasons for his or her decision. This has resulted in accusations of political expediency and of failing tests of transparency and openness that no one would expect in a democracy like Australia.

In the case of the SGX merger it is helpful that the Treasurer has provided insight into his thinking in prohibiting the acquisition of ASX by SGX. In March 2009 the Treasurer issued statements in connection with the Oz Minerals Ltd and has issued details of conditions attaching to transactions but he has not previously issued formal reasons.

The National Interest includes the following:
* preserving of national security;
* preserving of Government revenue;
* evidence that the participant will respect Australian law and business practices;
* avoiding of inappropriate levels of competition or excessive concentration;
* consistency with Government policies; and
* the character of the investor.

Of these, the most ambiguous is the national security test. This test has on occasions been applied to prohibit acquirers from purchasing mining assets that were considered to close to the Woomera prohibited area and in the SGX transaction it is being considered by reference to the systemic security of the Australian Financial System.

That said that the Treasurer’s decision took in to account the “importance of maintaining the effectiveness of Australia’s regulatory framework and the Government’s objective of building Australia’s standing as a regional financial services centre.”

Apparently the decision was also based on “the importance to Australia and its long term economic well being of the development of the ASX as primary equities and derivatives exchange and sole clearing house.”

There is no doubt that the Treasurer formed the view that the role that ASX played in the Australian financial system was such that the takeover by SGX may have meant a loss of “full regulatory sovereignty” that might have a negative effect on Australian regulatory authorities capacity to protect the system from financial crisis.

The ASX also operates infrastructure that is critically important for the orderly and stable operation of Australia's capital markets. Both the Reserve Bank of Australia (RBA) and the Australian Securities and Investments Commission (ASIC), carefully review the operations of the ASX on an ongoing basis and have been satisfied that it is meeting its obligations and remains a robust operation. However, FIRB's recommendation, which incorporated advice from ASIC, the RBA and the Australian Treasury, was that not having full regulatory sovereignty over the ASX-SGX holding company would present material risks and supervisory issues impacting on the effective regulation of the ASX's operations, particularly it’s clearing and settlement functions. Australia's financial regulators have advised me that reforms to strengthen our regulatory framework should be a condition of any foreign ownership of the ASX to remove these risks.

This analysis is not surprising. The Australian clearing and settlement system has been the subject of a number of enquiries following the global financial crisis including the Review of Settlement Practices for Australian Equities in May 2008.

The Treasurer found that the clearing and settlement system operated by ASX was critical to the smooth functioning of the Australian financial system. FIRB advised him that there was a genuine concern that the wider role of Government as a regulator meant that he ought to be careful before he agreed to give up flexibility over the market mechanism. In part is an acknowledgement that the rules are never going to be perfect and they do not necessarily anticipate all the consequences or “externalities” that may arise.

The Treasure asked the Council of Financial Regulators to establish a working group to consider measures which to protecting the interests of Australian issuers, investors and market participants. Clearly there was a perceived need to preserve the ability of our financial supervisors to maintain “robust oversight in all market conditions, including in the event of a future commercial arrangement between the ASX and another exchange”.

Conclusion
In 2005 the Financial Times described the national interest test as a “protectionist relic” that does not fit with the Australian government’s free markets principles. The Times argued that screening foreign investments was common among countries but the few countries “operate regimes that are more opaque, unaccountable or open to political and bureaucratic manipulation”.

While some of the criticism meted out by The Times is warranted this ought not to be a reason to abandon the test. The test serves a useful function for the Government as a macro economic regulator of the economy.

The Government ought to retain the flexibility to be able to deal with the consequences or externalities that may arise from the foreign takeover. That said, as noted by the OECD there is great merit in greater transparency around the process and this would be enhanced by a regular process of providing detailed decisions by which others could judge how the process operated.

Corporate lenders – a new focus for insider trading?

The Australian Securities and Investments Commission's enthusiasm for insider trading cases and the difficulties of managing Chinese walls ought to give hedge and private equity fund managers pause. In the United States the growth of activity by private equity and hedge funds in the debt and quasi-equity market has resulted in the Securities Exchange Commission reviewing one situation and it's unlikely to be unique.

Like the SEC, it is likely that ASIC will be closely watching private equity and hedge funds. These funds have become active lenders in the Australian market, offering alternative sources of debt and quasi-debt funding to companies such as Advance Healthcare Group Limited, Nylex Limited and PBL Media. Often, the debt will be structured to provide a yield as well as an opportunity to participate in increased equity value via the ability to convert debt into shares.

Apart from the funding structure itself, one of the key differences between being a debt provider and being a shareholder is the level of information the borrower is required to provide. Typically, a lender will receive more frequent and more detailed financial information than anyone outside of the key management team. Generally, this information will be material and price sensitive.

Of course, being in possession of inside information is not of itself a problem. The difficulty arises when someone with inside information deals in those securities. Where lenders who possess inside information are also in the business of trading the debt or trading the company’s securities, or where the debt instrument itself can be converted into securities, the potential for trading on the basis of inside information is significantly increased.

In the case of the US movie rental chain company, Movie Gallery it is currently receiving attention by the SEC. In early March of this year, Movie Gallery held a private conference call with its lenders, most of whom were hedge funds, to discuss the company’s poor results for 2005. Over the 2 day period following the call, Movie Gallery’s shares were heavily traded and its share price fell by 25%. However, the company didn’t announce its earnings results to the public until nearly two weeks after the private call with its lenders. The SEC is now investigating whether any of the lenders traded on the basis of their inside knowledge of the company’s poor trading results.

If there are Chinese walls in place a fund will not breach the insider trading rules merely because one of its employees has inside information and another employee trades. What they need to establish is that the person with inside information is not involved in trading decisions and there are adequate arrangements in place to ensure that inside information is not communicated to those who are and that therefore no benefit has been unfairly obtained by having the inside information.

The critical question is how effective are the Chinese walls? Do they really prevent the inappropriate use of inside information? To have any effect the arrangements need to be established with clear protocols and those protocols must adhered to and monitored. There needs to be a clear separation between those who possess or have access to inside information and those who make trading decisions.

While it may be possible to implement such arrangements within large organisations that can physically separate different work groups, clearly this is much more difficult to achieve for organisations operating with small teams, as is often the case with private equity/hedge funds.

Even where Chinese walls can be established, they do not provide absolute protection from liability. It is virtually impossible to prevent staff members from coming into contact with each other and potentially communicating inside information. If you possess inside information at the time of making a transaction, it is no defence to say that you did not use or rely on that information at the time.

For the majority of private equity/hedge funds, the ‘pared back’ styles of doing business will create a real problem when they need to show effective Chinese walls. A two person team sitting next to each other are never going to be effectively separated by a wall, let alone a Chinese wall.

Take me to the limit one more time: how far do disclosure obligations go?

The recent leak of New Zealand cabinet papers to Telecom NZ and the now infamous CD-ROM found in a Qantas lounge raise interesting questions about the limits of the obligation to disclose under ASX Listing Rule 3.1.

Are companies bound to disclose all materially price sensitive information irrespective of how it’s obtained? On its face the only relevant test is whether a reasonable person would expect to have a material effect on the company’s share price.

We normally expect that information that is disclosed to the market is produced according to the highest standards to ensure we have a fair and well-informed market. But are there circumstances where information that is defamatory, illegal or obtained in breach of confidence must be disclosed to the market?

To avoid the disclosure requirement, the information must meet three criteria. Firstly, a reasonable person would not expect the information to be disclosed. Secondly, the information is confidential. Thirdly, one of the following criteria apply: it would be a breach of a law to disclose the information or the information concerns an incomplete proposal or negotiation, the information is insufficiently definite, generated for internal management or the information is a trade secret.
But what if the information fits the first and third criteria, but is not considered confidential under the Listing Rule?

In the ASX’s view ‘confidential’ is a matter of fact. For example, confidentiality is retained when information is given to third parties in the ordinary course of business, but is lost once, whether inadvertently or deliberately, the information becomes known by others, in circumstances where the company loses control of the information (the recipient is not under an obligation to keep the information confidential). An example is a rumour circulating or media comment about the information where that rumour or comment is “reasonably specific.”

In a submission to ASX in 2002, The Australian Institute of Company Directors’ questioned the suitability of ASX to determine confidentiality as a fact, and stated that this should be a matter for the company to determine, after taking advice where necessary.

Of course this is not how the law would generally look at the question of confidential information. A lawyer will tell you that confidentiality is largely a question of the nature of the information and how it is obtained, largely regardless of whether it is known to others.

So, on the one hand ASX Listing Rule 3.1 states that information known by others over which the company has no control is not confidential. On the other hand, under the general law where confidential information has been knowingly obtained in breach of confidence the information remains confidential, even if it has been disclosed by the recipient. So clearly ASX Listing Rule 3.1 and the general law doctrine of confidential information cannot be easily reconciled.

The problem of ASX’s interpretation of confidential information being different to that under the general law is that there are serious consequences under the Corporations Act for failure to comply with the ASX disclosure obligations.
A listed company receiving significant material even illegally or improperly is faced with a dilemma, as no doubt the cabinet paper proved to be to the board of Telecom NZ. Either breach the disclosure rules or be sued or possible prosecuted; a rock and a very hard place!

It would seem the existing listing rules left as is create a strange situation where information illegally or improperly obtained, which by its nature cannot be verified to ensure its accuracy, must be disclosed to ensure a ‘fair and well-informed market’.

Thanks to Belinda Coombs for her assistance with this piece.

Remuneration committees - “in the line of fire”

The courtroom battles between shareholders and directors are seldom the stuff of “Vanity Fair” magazine. However, if the subject matter is the Disney company, the directors include Sydney Poitier and the matter revolves around the tale of two Hollywood titans, then expect the unusual.
Shareholders of Disney are claiming against the Disney directors and the compensation committee in particular for their role in the employment and severance agreements of former president Michael Ovitz. The compensation committee approved the dismissal of the president and the payment of a US$140 million severance package after Mr Ovitz was less than 15 months in the job.
The recently concluded trial, and the SEC orders (settling inadequate "related party transaction" disclosure issues), are part of a continuum for the Walt Disney Company that included a very difficult shareholder meeting in 2004 that resulted in the board separating the positions of chairman and chief executive. Last year, nearly 45% of shareholders voted against CEO Michael Eisner's re-election to the board. In response, the board stripped Eisner of his role as chair and elevated former U.S. Senator George Mitchell to that post. Eisner later announced that he would retire by September 2006.
This case is interesting because it examines a claim around excessive compensation for people other than interested directors in question and because the case explores the duty of directors and directors on the remuneration committee in particular, to act in good faith.
The US and Australian formulations of the business judgment rule provide that directors have the right and duty to decide where the company's interests lie. Directors are entitled to have regard to a wide range of practical considerations and their judgment is not open to review in the courts.
It is a prerequisite of the business judgment rule that directors have acted in good faith and for a proper purpose. The elements of the rule are good faith, disinterest, exercise of judgment, proper information and reasonable belief. Thus, although the board of directors is entitled to a presumption that it exercised proper business judgment, the board will need to be able to demonstrate:
 the decision was made in good faith and for a proper purpose (ie in the best interests of the corporation as a whole);
 they had no material personal interest in the matter;
 they informed themselves of available material information by, for example:
 considering an appropriately selected expert’s opinion;
 providing all board members with adequate and timely notice of the matter , of its purpose and all relevant information for the purpose of considering the transaction; and
 inquiring adequately into the reasons for, or terms of, the transaction.
The duty of good faith requires that directors must: exercise their powers in the interests of the company, not misuse or abuse their power, avoid conflict between their personal interests and those of the company, not take advantage of their position to make secret profits, account to the company for business opportunities which come to them by reason of or in the course of holding office as a director and exercise an independent judgment in relation to proposals put before the board.
Executive compensation (as opposed to that of directors) is a matter of business judgment. Good corporate governance requires that boards take responsibility for the remuneration of the business’ key executives. In the US it has been suggested that if directors say that they base compensation decisions on some performance measure and then don't do so, or if they are disingenuous or dishonest about it, this could amount a breach of the directors duty of good faith.
The question is what type of conduct must a director engage in to be found to have not acted in good faith and thereby allow a court to review the board (or the committee’s) business judgment? Courts have traditionally had some difficulty in divining the subjective motivation (good faith or bad faith) of officers from objective facts; generally conduct must be fairly egregious in order to rise to the level of "bad faith".
The standard of behaviour required is not complied with by subjective good faith or by a mere belief by a director that his or her purpose was proper, rather it involves a determination of whether a reasonable director could have reached that conclusion.
In the first Disney case the Court refused to dismiss a complaint seeking to hold the directors of The Walt Disney Company personally liable for damages arising out of the hiring and termination of Michael Ovitz as Disney's President. The complaint suggested complete abdication of authority by the directors. It was alleged that, when Ovitz was hired, the compensation committee and the directors paid little attention to the terms of his employment, leaving the arrangements to be negotiated by Mr. Ovitz and his "close friend," Michael Eisner, Disney's Chief Executive Officer.
The board's alleged neglect will be key to the Court's decision. While the business judgment rule might have applied if "the board had taken the time or effort to review [its] options, perhaps with the assistance of expert legal advisors," the allegations, if found made out, "imply that the defendant directors knew that they were making material decisions without adequate information and without adequate deliberation, and that they simply did not care if the decisions caused the corporation and its stockholders to suffer injury or loss."
The duty of good faith requires that a director act in the best interests of the corporation. While the Court's review requires it to examine the board's subjective motivation, the Court will utilise objective facts to infer such motivation. The analysis will focus on the process by which the board reached the decision under review. That said however, Australian courts are likely to remain extremely reluctant to impose liability on disinterested directors who make genuine efforts to fulfil their duty to make informed decisions regarding matters of importance like executive compensation.
The good faith obligation includes an obligation to penetrate beyond the superficial whilst this is a more onerous obligation than that held by a director generally because a specific responsibility has been assigned to the committee it is consistent with the obligation to exercise a level of care and diligence having regard to the circumstances of the director the office held.
In the Australian context the good faith test will probably cross similar ground to the statutory requirement of the business judgment rule that the committee members have informed “themselves about the subject matter of the judgment to the extent they reasonably believe appropriate”, that is, the committee came to an informed decision.
In this context committee members need to be able to establish they conducted themselves in a manner that enabled them to reach an informed business judgement about the remuneration/compensation issue. The committee needs initiative, diligence and independent thought. Unfortunately this might mean a proliferation of external advice designed to protect the members of the committee from liability.
For Disney it will be interesting to see whether without the harsh glare of shareholder criticism the company will maintain its interest in shareholder rights and whether the Delaware court is willing to open the board room door and analysis the appropriateness of the Ovitz termination and employment arrangements.
Remuneration/ compensation committee
Remuneration/compensation committees used to be considered relatively innocuous, but the rules of the game are about to change, if they haven’t already, the Corporations Act now includes specific references to the work of the remuneration committee, if not committee itself. The ASX corporate governance principles recommend the establishment of a remuneration committee the majority of whom should be independent and who should be lead by an independent chair.

The committee will usually be responsible for remuneration policies and practices, it will to take control of the disclosure obligations relating to executive remuneration and the adoption of the remuneration report.
Takeaway – satisfying the business judgment ‘defence
To rely on the business judgment rule members of the remuneration committee need to be able to demonstrate five things:
1. That a decision was taken.
2. No personal interest in the matter that could be seen to have a capacity to influence the individual’s vote.
3. The decision was made for a proper purpose (in the best interests of the company) without misuse or abuse of power and exercising independent judgment.
4. That members reasonably informed themself of all material information concerning the matter by, for example:
 considering an expert’s opinion;
 adequate and timely notice of the to allow proper consideration of the matter; and
 demonstrate inquiry.
5. That members rationally believe the decision is in the best interests of the company.
In general a systematic approach to the transaction will help committee members substantiate that they took reasonable steps to inform themselves and that their belief that the transaction was in the best interests of the company was reasonable.

Corporate Social Responsibility: the case for a self regulatory model

The limited liability corporation is one of the greatest inventions of all time. The corporation is an integral part of our society yet it would seem that society is raising some pretty challenging questions about the role of the corporation in our society. Is there is a need to find a way to enable corporate managers to abandon rules designed in the 1800’s in favour of a more modern concept that recognises the wider role of corporations in our community?

Recently, the Parliamentary Secretary to the Commonwealth Treasurer, the Hon Chris Pearce MP, referred the question of corporate social responsibility to the Corporations and Markets Advisory Committee for consideration and advice. Reflecting these concerns, the Australian Financial Review has editorialised that: “Modern capitalism has many strengths but one big weakness. Some executives are so driven to achieve legitimate corporate goals bigger profits, more shareholder value, a critical restructuring that they are able to justify any technically legal means of pursuing them. The risk is that management and board lose sight of a fundamental question: is this just? In the vast majority of cases their duty to the company and the law is not in conflict with any wider duty, and society as a whole benefits from the wealth created. In rare cases, what is legal and what is just are at such odds that strict legal justifications crumble before community outrage and the threat of legislative action.

In part this is a response the report the Special Commission of Inquiry into the circumstance surrounding James Hardie’s corporate reconstruction. Interestingly, in March 2005, James Hardie’s chair, Meredith Hellicar, called for: “a safe harbour for directors to be able to integrate corporate social responsibility into their decision making without fear that they are going to be sued both personally, and as a company, by their shareholders. “.

To what extent is this concern real? Does Australian corporate regulation need to reflect ‘modern business needs and wider expectations of responsible business behaviour’, that ‘the basic goal for directors should be the success of the company for the benefit of its members as a whole’ and that to reach this goal, directors should be able to ‘take a properly balanced view of the implications of decisions over time and foster effective relationships with employees, customers and suppliers, and in the community more widely’?

There is advantage in providing a reasonable level of protection for those that want to take the ‘long view’. However, many commentators believe that the existing duties of managers, especially the overriding duty to act in the best interests of the company, already accommodate consideration of wider interests by directors and officers if the decision is justifiable as being in the company’s best interests.

Yet, it seems that managers have concerns about how to take a properly balanced view of the implications of their decisions as well as foster effective relationships with employees, customers and suppliers, and the community more widely, whilst at the same time not leave themselves open to complaint from shareholders.

The increased community calls for some form of corporate social responsibility cannot simply be ignored; these are the ‘cultural norms’ that shape the way corporations are allowed to operate. In Canada a significant number of Canadians, and a significant percentage of Canadian shareholders, have been found to want business executives of corporations "to take into account the impact their decisions have on employees, local communities and the country as well as making profit," but can they do so if it at the expense of making profit?

To simply introduce provisions such as those suggested in the UK could lead to greater uncertainty and more capacity for people with only a tangential interest in the company to sue mangers for failing to sufficiently consider their interest or more likely the interests they purport to represent.

The question of whether such a provision is strictly necessary can be avoided by simply including a replaceable rule that will give managers some comfort if they prefer the long view over the short.

The use of a default provision of the constitution giving the managers the freedom to include matters such as employees, customers and suppliers, and the community as being in the interest of the company should provide managers with some comfort.
TIME FOR THE CORPORATIONS ACT TO INCLUDE A NEW REPLACEABLE RULE?
Self regulation is appropriate for complex and difficult issues like corporate social responsibility that do not necessarily require an industry wide solution. A self regulatory model allows a solution tailored to each entity’s circumstances. If there was genuine community agreement about the value of corporate ethics then such provisions affirming their place in the life of the company would quickly gain acceptance as best practice.

Is it necessary for corporate social responsibility to be enforceable? Probably not, as calls for corporate social responsibility have largely been along the lines of the need for a permissive model so, to this extent then there would seem to be no basis for criticising a self-regulation model on the basis of enforcement difficulties.

A self regulatory model will also ensure that only those companies with a genuine interest/need take the issue forward and this is less likely to result in an approach to corporate social responsibility that is a process focussed “tick the box” approach.

A replaceable rule also provides flexibility providing scope for efficiency improvements and innovation. Additionally, such a rule would recognise that many small and micro businesses use the corporate form and do not have the resources to comply with a prescriptive set of rules.

The corporation is create of statute designed for investors to collect together for a common business pursuit through a legal entity that provided the benefits of limited liability, continuity of existence and simplicity in contractual dealings. As part of the bargain, investors should be able to regulate the general nature of their bargain with the other investors and management through the constitution.

The Corporations Act provisions dealing with the constitution could have a default setting that provided that in the absence of an alternative provision in the constitution of a company the board as the agent of the investors were entitled have regard to their a social responsibility the board would be entitled to do more than adhere to the rules and doing “whatever you can get away with”.

The provision would thus form part of the contract between the members and management and it would be theirs to consider, modify if necessary and reject if they wished. It would not be open to regulators, “stakeholders” or anyone who was not a member or officer to enforce against mangers.

A replaceable rule would also lessen the risk of litigation against the corporation by tangential ‘stakeholders’. A statutory proscription to consider social issues, could mean that section 1324 of the Corporations Act could be used to enable the “stakeholders” to seek remedies against managers for not having, say, proper regard to “the community and the environment”. Whilst little use has been made of this provision in developing the view that officers might owe duties to others in addition to their company that is not to say it could not be. The future battle ground for lawyers looking for ways of representing people like the landholders surrounding the BHP mine in Papua New Guinea, Ok Tedi, might be based around the injunction and corporate social responsibility provisions.

In practice, a constitutional provision of this type would not fundamentally alter the circumstances where a board had somehow failed to properly consider, corporate social responsibility type matters in circumstances where it would have been in the best interests of the company to do so. Those directors would still be liable for failing to satisfy their duty of care and diligence. However, if the directors had taken a decision favouring the long term sustainability of the company which resulted in financial detriment to the current shareholders the directors could argue the existence of the replaceable rule was a relevant factor in determining the ‘corporation’s circumstance’ or the office held and the ‘responsibilities within the in the corporation’.

A replaceable rule would also be consistent with the Principle 10 of the ASX recommendations. Compliance with this recommendation was originally contemplated by a code of conduct but a replaceable rule would be entirely consistent with the recommendation. A replaceable rule would also give managers more certainty than a code of conduct, in terms of their duties to the company and the availability of business judgement defences.

An interesting related development might include combining accreditation and self-regulation. A voluntary accreditation scheme might also be adopted to try to ensure consistencies in corporate social responsibility standards across different sectors. Self-regulation of the type discussed could mean that companies are defining their own corporate social responsibility standards and therefore some entities will be taking on far greater corporate social responsibility obligations than other entities.

As with other corporate governance reforms, a self regulatory approach to corporate social responsibility is the surest way to get meaningful approach to this issue. There is a case for reforming directors and officers’ duties; the changes needed should not be revolutionary. A self regulatory model together with a scheme for accreditation provides a better model for influencing behaviour by institutionalising a change that is permissive and reflective of each company’s own circumstances.

If the social norm has shifted, and there is ample evidence it has, then that pressure can be accommodated in the proposed model. The self regulatory model suggested will allow company’s to create wealth on a sustainable basis, but subject to the requirements of responsible business conduct.

Sources: Letter of referral by The Hon Chris Pearce MP to CAMAC, available at http://www.camac.gov.au/CAMAC/camac.nsf/byHeadline/Whats+NewDirectors%27+duties+and+corporate+social+responsibility?openDocument; Parliamentary inquiry into Corporate Responsibility, see online at http://www.aph.gov.au/Senate/committee/corporations_ctte/corporate_responsibility/index.htm; AFR article 22 September 2004, pg 62; UK White Paper on Modernising Company Law available on the UK Department of Trade and Industry's website at http://www.dti.gov.uk/cld/WhitePaper.htm; James McConvill “Directors’ duties to stakeholders: A reform proposal based on three false assumptions” (2005) 18 Australian Journal of Corporate Law 88, see also - Ian Ramsay, ‘Pushing the Limit for Directors’, The Australian Financial Review, 5 April 2005, 63; R. Baxt, “Directors’ Duty of Care and the New Business Judgment Rule in the 21st Century Environment”, Seminar Paper, Seminar on Key Developments in Corporate Law & Equity, Melbourne, March 2001 cited in Saul Fridman “Corporations Law in the courts and the academy: a dangerous malaise?” Butterworths Corporation Law Bulletin No 23 December 1996; ASX Principles of Good Corporate Governance and Best Practice Recommendations.