The recent decision of the Federal Court in Vocation1 provides further clarity for directors on the nature of the continuous disclosure obligation and, perhaps more importantly, the responsibility of officers and directors to ensure that the listed entities they manage meet those obligations.
These were civil penalty proceedings commenced by ASIC against Vocation Ltd (In Liquidation) (Vocation) and its officers, Mark Hutchinson (CEO), John Dawkins (Chair), and Manvinder Gréwal (CFO). As such, the proceedings explored the range of duties of corporate players from the chair of the board to executives reporting to the board.
The Court found that the Chair and CEO had breached their statutory duty of care and diligence by causing or permitting Vocation to breach its continuous disclosure obligations. The Court reiterated the limitations of an officer's reliance on others in the discharge of their statutory duty, and provided further guidance on the test for knowing involvement in a breach of a company's continuous disclosure obligations.
In this case, the proceedings explore a relatively short period from July to October 2014. Vocation provided vocational education, training and assessment under a contract with the Victorian Department of Education and Early Childhood Development (Department).
From about July 2014, Vocation was aware that the Department was concerned about the way Vocation was managing its contract with the Department to provide education services. However, it was not until late October 2014 that Vocation fully explained to the ASX the nature, extent and seriousness of the Department's concerns and the materiality of the consequences to Vocation and importantly its shareholders.
It finally emerged that Vocation had lost almost $20 million in government funding and relinquished funding contracts from the Department. This triggered a significant fall in Vocation's share price, its earnings and market value. Liquidators were appointed to Vocation in late 2015.
The claims against Vocation and its officers related to the proper disclosure of the nature and extent of the impact of the Department's concerns about its arrangements with Vocation, including the withholding of payments and suspension of enrolments (Withholding and Suspension Information). The case concerns the disclosure of those matters to the market generally, and the underwriter specifically, under the continuous disclosure rules and the general Corporations Act obligations not to mislead or deceive.
ASIC's case was that the Withholding and Suspension Information had the potential to materially negatively impact Vocation's earnings by upwards of about 9% of EBIT and quite possibly upwards of 16% of EBIT.
ASIC put forward that these matters should have been made known to the market as they were matters that "would, or would be likely to, influence persons who commonly invest in securities in deciding whether to acquire or dispose of" Vocation's securities. The Court agreed that Vocation had failed to properly update the market on these circumstances on a number of occasions during the relevant period.
When the additional risk of impairment of revenue growth in the future due to reputational damage was weighed alongside the the potential earnings and cash flow impact of the contractual measures, the Court considered it fanciful to think that investors would not be influenced by the Withholding and Suspension Information. Indeed, the Court was satisfied that the cash flow impact of the contractual measures was so significant in the circumstances (i.e. the lenders were extremely concerned about the actions of the Department) that Vocation had no alternative other than to undertake a capital raising.
The Court explored in some detail whether the information was material and which of the officers knew or should have known about its materiality. The Court found that the assessment of materiality takes place based on what a board thinks will be the future state of affairs rather than actual results. Hence, the Court found that a company might be required to disclose the existence of a lawsuit that would, if decided against the company, substantially reduce its earning capacity notwithstanding that the outcome of the lawsuit is not known at the date of its commencement. That is not to say that disclosure would be required if such a lawsuit could reasonably be characterised as bound to fail.
The Court was satisfied that the Withholding and Suspension Information was material in that it would likely have influenced persons who commonly invest in securities in deciding whether to acquire or dispose of Vocation shares. Accordingly, the Court held that Vocation contravened s 674(2) of the Corporations Act 2001 (Cth) (Corporations Act) by not notifying the ASX of the Withholding and Suspension Information.
The Court followed the disappointing conclusion reached in the Full Federal Court Fortescue decision that the continuous disclosure decisions are not business judgments. In that case, the court suggested that a decision not to make accurate disclosure of the terms of a major contract is not a decision related to the 'business operations' of the corporation. Rather, it is a decision related to compliance.
The decision to cause or permit Vocation not to disclose the Withholding and Suspension Information to the market, or to provide the due diligence questionnaire (DDQ) to UBS in connection with a placement, were not business judgments.
The Court acknowledged the alternative view in the Mariner decision but the Court found a difference between a continuous disclosure decision and a decision to cause the company to make a takeover offer and a related ASX announcement. In any event, the Court found that even if the decisions taken by the CEO were business judgments, the CEO had failed to inform himself to the extent that he could reasonably have believed to be appropriate.
To some extent, this exposes the weakness of the business judgment defence and suggests that for most officers (especially in the continuous disclosure area), the defence will have limited utility for directors facing stepping stone liability as a consequence of a continuous disclosure decision that has gone wrong. We prefer the view of Justice Heydon who saw that in the Fortescue circumstances that "... the binding quality of an alleged contract is an inherently controversial matter of professional judgment."
The Court accepted that exercising a director's duty requires balancing the foreseeable risk of harm to the company (including the magnitude of the risk and the probability of its occurrence) against the potential benefits that could reasonably be expected to accrue to the company from the conduct in question, along with the expense and difficulty of taking alleviating action and any conflicting responsibilities. However, that balancing exercise did not tilt the scales in favour of the CEO or Chair.
The Court found that the CEO, in breach of his duty under s 180(1) of the Corporations Act, failed to exercise the degree of care and diligence that a reasonable person would have exercised in his position during the relevant period in his consideration of the Withholding and Suspension Information and the question of whether Vocation was required to disclose such information pursuant to Listing Rule 3.1.
The Court was also satisfied that the Chair breached his duty to exercise care and diligence on the basis that a person in his position exercising reasonable care and diligence would have appreciated that the Withholding and Suspension Information would be likely to affect Vocation's share price. This was not merely due to the potential earnings impact of the Department's contractual measures, but also due to their cash flow impact, resulting in a situation which, were it not for the capital raising that was undertaken on 10 September 2014, was likely to have resulted in Vocation running out of cash.
This is another example of what is known as ' stepping stone' liability. First, Vocation breached the Corporations Act (i.e. failing to make adequate disclosure). Second, by exposing Vocation to that breach, the Chair and CEO are then found to have breached their duty of care in failing to 'prevent a foreseeable risk of harm to the interests of the company'.
Both the CEO and Chair sought to excuse their breach on the basis of their reliance on external lawyers and management. The Court did not accept this position, and found that although a director is entitled to rely without verification on the judgment, information and advice of management and other officers, that reliance would be unreasonable where the directors know, or by the exercise of ordinary care should have known, any facts that would deny reliance on others. Here, the Court found that the CEO and Chair's reliance upon advice provided to them by management and Vocation's lawyers was unreasonable. In the case of the lawyer's advice, the Court was satisfied that the CEO and Chair were aware, or ought to have been aware, that the advice was based upon a number of important assumptions that the lawyers were asked to make, and that the lawyers were not in a position to independently assess or verify the validity of those assumptions or the veracity of any other pertinent information provided to them by management.
Although the Court found that the Chair and CEO breached their duty to exercise care and diligence in respect of the continuous disclosure contravention, it did not find that they were liable as accessories to Vocation's contravention of s 674(2). The Court rejected ASIC's contention that knowledge of the underlying facts, as opposed to knowledge that the Withholding and Suspension Information was material in the relevant sense, was sufficient to establish liability under s 674(2A) of the Corporations Act.
The DDQ signed by the CEO and CFO was given to the underwriter as part of the underwriting process for the placement. The Court held that the DDQ contained misleading or deceptive statements in contravention of s 1041H of the Corporations Act. The Court found that both the CFO and CEO breached their duty by providing the DDQ to the underwriter in circumstances where a person in their position exercising reasonable care and diligence would have understood that it conveyed the misleading or deceptive statements.
Lessons to be learned
- Companies must have in place rigorous processes to ensure that management provides the board with timely and quality information that will enable the board to form a view as to the materiality of the relevant information to the market.
- Boards need to test materiality and the veracity of information provided by management. The board cannot necessarily rely on external advice or the mere presence of external advisors in board meetings. The value of external advice is only as good as the assumptions on which it is based. Directors need to understand and test those assumptions.
- Directors have to make an independent assessment of the company's disclosure obligations for the purpose of complying with their duty to the company to exercise care and diligence.
- Documents like a due diligence questionnaire will be explored and read as a whole and in context to understand the impression conferred on a theoretical reasonable reader. Boards, executives and the company will be liable for their contents both in contract but more importantly under the Corporations Act.
- There exists serious doubt about the availability of the business judgment defence for continuous disclosure decisions, especially if the directors have failed to properly inform themselves about the underlying issues.
- In order to be an 'accessory' in a company's continuous disclosure contraventions, the officers must have knowledge that the information was likely to influence an investor in making a decision to acquire or dispose of shares, as opposed to mere knowledge of the underlying facts. This may focus claims against officers based on breach of duty.
- In considering this case and the continuous disclosure obligations, directors should be aware of new, stronger penalties, including an increase in the maximum penalties payable for this type of claim that could be $1.05 million per contravention for individuals or $10.5 million for companies.
1 Australian Securities and Investments Commission v Vocation Limited (In Liquidation)  FCA 807 (31 May 2019).
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