Few governance debates are more important – or controversial – than the need for a stronger statutory business-judgement rule. Ensuring directors are fairly protected against personal liability from board decisions is critical for innovation and risk-taking.
Nearly 70 per cent of directors in the latest AICD Director Sentiment Index believe there is a risk-averse culture on boards. Lack of certainty on director protection hinders decision making and can lead to governance conformance rather than performance. Personal liability risks can also deter people from serving on boards.
Deakin University researchers have proposed a new reform option to offer wider protection for directors against personal liability that extends beyond “business judgements” to all board decisions.
The authors, Professor Jean du Plessis and Jim Mathiopoulos, believe their “All-Inclusive Directors and Other Officers Decisions Defence” removes the need for larger reforms proposed separately in recent years by the Australian Institute of Company Directors and Dr Robert Austin, a former Judge of the Supreme Court of New South Wales and one of Australia’s most distinguished corporate law experts.
Their paper, “Defences and Relief from Liability for Company Directors: Widening Protection to Stimulate Innovation,’” was published in the Australian Journal of Corporate Law.
Du Plessis and Mathiopoulos argue that directors should not be in breach of any duties if it is proven they:
- acted in good faith for a proper purpose
- did not have a material personal interest in the subject matter when they acted
- informed themselves about the subject matter when they acted, to the extent that they reasonably believed to be appropriate
- rationally believed that the act was in the best interests of the corporation.
The main change from the current wording in the Corporations Act 2001 under their proposal would be the move away from ‘business judgement’, and the replacement of the word ‘judgement’ by ‘act’.
Although the changes appear limited, the authors’ argue that moving from ‘business judgement’ would expand the protection for directors and inserting ‘act’ (in part D above) would mean that directors may have a stronger defence if is it is proven that other directors would have acted in the same way, in the same or similar circumstances.
“Our proposed business-judgement rule provides an appropriate balance between the need for better director protection, and the best interests of the public,” says Du Plessis. “It gives directors wider protection and greater certainty about personal-liability protection, while ensuring high standards of conduct required of directors are maintained.”
Du Plessis argues that their proposal is more practical than competing proposals. “We do not rely on subject elements such as director ‘honesty’. And the burden of proof remains with directors to prove they met the four tests in our approach. We propose a simple approach that can fix the business-judgement rule once and for all.”
Problems with business judgement rule
The business-judgement rule is a longstanding governance problem. Its introduction in 2000, through section 180(2) of the Corporations Act 2001, was initially welcomed by the business community. But the protection directors hoped for through the safe-harbour provision proved illusory.
A 2015 study by researchers at Cornell Law School and the University of Sydney found only two of 21 cases up to 2009 had successfully raised the business-judgement rule.
Although considered in a number of cases, the Du Plessis and Mathiopoulos argue that the application of the rule has been rejected by the courts because of a conflict of interest for the defendant director or because the act of the director or decision the director made was not considered to be a business judgement in respect to the corporation’s “business operations”.
“It appears the business judgement rule exists purely as an enthusiastic ideal,” write Du Plessis and Mathiopoulos.
The authors argue the current business-judgement rule is complex and uncertain for two reasons. First, protection is strictly limited to directors’ duty of care and due diligence. The rule as a defence (a form of safe harbour) is not available to directors for breaches of duties such as continuous disclosure, financial reporting or insolvent trading.
Second, business judgement is narrowly defined as only applying to the “business operations” of the corporation. That puts directors in the difficult position of having to determine if something is a business judgement, and potentially protected through the business-judgement rule, or a non-business judgement. Board approval of a capital restructure, for example, might be considered a non-business judgement because it does not relate to normal “business operations”.
“These are two very big drawbacks,” says Du Plessis. “Directors should be protected for every decision they make, provided they meet the four tests we propose. We believe boards should almost be conditioned to apply the four tests in every decision made. It should become second-nature.”
He argues that it is neither impractical, nor unfair, to expect of directors to consider all four aspects for all acts and decisions they take. “The defence should also be available under circumstances where the current business judgment rule is not available, for instance, in the area of insolvent trading. The Australian insolvent trading provisions are unique and make directors particularly risk-averse because of the narrow protection provided in the Corporations Act.”
Du Plessis claims that the All-Inclusive Directors and Other Officers Decisions Defence solves this problem and argues it is unnecessary to try and develop separate protective rules or defences for special situations. “Directors and officers need an overall and all-inclusive defence to enhance certainty and assure a consistent approach to all director acts and decisions” he says.
A different approach
Other groups have previously offered different approaches for dealing with the challenges of the business-judgement rule. The AICD in August 2014 proposed a better defence for directors who act honestly through “A Proposal for Reform: The Honest and Reasonable Director Defence.”
The AICD’s Honest and Reasonable Director Defence (HRDD) provided an over-arching defence for all director decisions, not only business judgements, similar to the All-Inclusive Directors and Other Officers Decisions Defence proposal by Du Plessis and Mathiopoulos.
Other similarities between the HRDD and the Du Plessis and Mathiopoulos proposals include the burden of proof remaining with directors and the defence applying to positive acts as well as omission. The main point of difference is the HRDD’s reliance on “honesty and reasonableness” to protect directors, claim the Deakin researchers.
“Our four tests do not include any subjective elements, such as ‘honesty’,” says Du Plessis. “It has been shown many times that honesty is a difficult concept to prove in court and is fraught with complexities, such as cultural connotations of the meaning of honesty. It’s a mistake to go back to the past and attempt to use honesty as a legal defence.”
In contrast, the author’s argue that Dr Austin’s proposal only protects directors in their exercising of their director’s capacity to make business decisions. The proposal broadens the definition of the term ‘business judgement’ to include “any decision to take or not to take action in respect of a matter relevant to the business operations of the company.”
The distinguishing feature of Austin’s proposal is the reversal of the onus of proof, according to Du Plessis and Mathiopoulos. The party alleging the breach of duty or exposure to liability must prove that:
- there was no business judgement, or
- there was a business judgement but the director:
- was dishonest;
- had an undisclosed material interest;
- or the business judgement was one that no reasonable person in the director’s position could have made.
The reverse of onus of proof is an interesting twist. A recurring concern among directors is the time and cost of them having to prove their innocence against any allegations that they have breached their duties. Putting the onus on the opposite party addresses some key anxieties directors have around the application of the business-judgement rule.
However, Du Plessis says Austin’s proposal, while a valuable contribution to the business-judgement rule debate, may prove hard to apply in practice.
“Our regulators are not sufficiently resourced to have the onus of proof reversed on to them. It’s almost impossible for third parties to prove what is required in the Austin model and bringing in the element of ‘dishonesty’ provides similar challenges than proving ‘honesty’”.
The Du Plessis and Mathiopoulos proposal seeks to broaden the defence to all board decisions, but the authors argue that it does not rely on subjective elements and keeps the onus of proof on directors.
“We believe the business-judgement rule should be changed in smaller increments than the models [previously] proposed by AICD and Dr Austin,” says Du Plessis. “I understand why both models want to give directors greater protection, but the risk is you go too far, too soon, and end up with law that does not meet the community’s high expectations for director behaviour.”
Du Plessis argues: “Our model sensibly protects directors and investors; encourages risk-taking and innovation, while respecting the needs of the community; and is legally simple and workable. We want protection but not overprotection for Australian directors, based on objectivity rather than subjectivity.”
Du Plessis has called on the Commonwealth Government to recognise the urgency of upgrading the business-judgement rule, by initiating a comprehensive consultation process with key stakehodlers. “We need a forum where people can bring ideas on the business-judgement rule and have them tested, for the good of the governance community, business community and wider community. It’s too important a rule to leave as it is.”
The views expressed in this article represent those of the research authors and not the AICD’s position on this issue.
Read the academic article here: