Shocks in the Stock Market - Essay Example

Running Head: Corporate Law Corporate Law Name Course Lecture Date Question 1 Recent shocks in the stock market show the exposure of investors to weak corporate leadership. In Australia, a number of superannuation funds lost millions they had invested in companies whose stock value vanished overnight. The ending economic crisis was caused by excessive risk taking by executives1. In order to restore public trust and confidence in public traded companies the corporate governance framework needs to be strengthened and revised. Good corporate governance is the cornerstone of effective operation in free markets and plays a huge role in wealth creation. Australia tries to encourage free trade with as little regulation as possible2. The Australian regulation of corporate governance is more principle based rather than rule based3. However, the recent case of the Australian Securities and Investments Commission v Healey [2011] FCA 717 show the need to strengthen and revise Australian corporate governance frameworks4. In this case, the directors failed to disclose the true position of the company’s debt. In my view, a better corporate governance framework will reduce the need for regulation5. The role of regulators like the ASIC is to ensure compliance with these good standards of behavior. Revised and strengthened corporate governance frameworks would ensure a more stable trade in securities. The rules and procedures needed to regulate corporate governance are likely to increase the cost of doing business, constrain business practice and stifle business innovation6. Pressure to increase regulation of corporate governance continues, but this must be done cautiously. However, regulation should be part of the new governance framework with the principle aim being economic growth and the need to prevent further financial crisis. If regulations become too stringent, then the spirit of entrepreneurship in most Australian companies will die. Revised and strengthened corporate governance is the key to avoiding another stock market problem and economic. Shareholder and boards should scrutinize how the affairs of their company are being run more closely. Transparency and accountability should be the main principles that are reinforced in corporate governance to ensure companies remain stable in the long-term. 1 B. Financial Reporting requirements Part 2M. 3 of the Corporation Act 2001 require Companies in Australia to prepare an annual financial and director’s report. An independent audit of the annual report is also required and an accompanying audit report is a must. For listed companies, the director’s report must give information about the observance of national auditing standards and the impact of auditor independence on the final report7. Disclosing entities are also required to prepare half-year directors and financial reports; the financial report should also be audited and accompanied by an auditor’s report. An auditor is under legal obligation to form an opinion of matters outlined in section 307. If the auditor is of the opinion the financial report is not in accordance with the Corporations Act he must inform members. The auditor also reports whether the report conforms to accounting standards and it is a true and fair view of the company’s position. If he thinks otherwise, he must state his reasons. A declaration of independence from the lead director is also required. According to Jennings, Pany and Reckers, contravention of the Auditor’s independence declaration is a strict liability offence. According to the ASIC, gatekeepers, including auditors are an important part of the Australian financial regulatory system8. While auditors are supposed to be self-regulatory or co-regulatory but they sometimes fail to live by their code of ethics. However, as seen in some cases, the incentives for maintaining professional reputations and independence are not enough in ensuring ethical conduct of gatekeepers. Cases handled in Australian courts show that auditors can contribute to market failure when they collude with unethical corporate managers. Caparo Industries plc v. Dickman and Ors (1989) 1 ACSR 636 asserted that an auditor owes a duty of care to shareholders of a company while conducting his work9. The role of the auditor in corporate disclosure is very significant. As observed in the Australian reporting requirements an auditor can play a great role in detecting fraud and illegalities in the conduct of a business. However, some Australian regulation regarding the relationship between the auditors and reporting entity seem to be lax. The introduction of Mandatory Audit Firm Rotation (MAFR) can improve auditor independence in the Australian business environment. According to Jennings, Pany and Reckers, excessive cosiness between auditor and client is a threat to auditor independence10. Therefore, the application of MAFR and other stringent disclosure requirements can restore investor confidence and trust in Australia’s publicly traded companies. Question 2 The business judgement rule as provided for in s180 (2) of the Corporations Act 2001 (Cth) provides a defence to directors for any business judgement that is made in good faith, for a proper purpose, in the interest of the corporation and where the person has no material interest in the judgment11. Some feel the business judgment rule provides an escape for directors who run the affairs of their company negligently12. In my opinion the business judgment rule provides little protection to directors and thus it discourages entrepreneurial risk taking in corporations. The Corporations Act 2001 is a complex legislation by nature and has numerous legal duties set out for directors make for business. In the views of Rosenberg, the corporation Act contains extensive and sometimes unintelligible duties13. Most of the duties hamper enterprise and prevent logical risk taking and are thus anti-business. Similar views were expressed by the majority in Daniaels vs Anderson before the NSW Supreme Court of Appeal who stressed the role of risk taking in business: “Great risks will be taken in the hope of commensurate rewards. If such ventures fail, how is the undertaking of it to be judged against an allegation of negligence by the entrepreneur?”’ (1995) 13 ACLC at pages 662-66314. According to Chapter 2D-Part 1- Division 1 of the Corporation Act, the primary duty of directors is to act in the best interest of the company and for a proper purpose15. Therefore, it would be fair to allow directors to take reasonable risk as long as it is in the interest of the company. However, the courts approach shows greater consideration to the degree of care and diligence a directors shows in the conduct of the company affairs. Little regard is shown to the benefit that the company could have accrued had the risky venture succeeded. Justice Ipp in Vrisakis v Australian Securities Commission criticized the conventional approach noting that risk was inherent in industry and commerce16. In the views of Justice Ipp, any venture that shows much promise is also fraught with equal risk. It is therefore unfair to punish directors for undertaking unsuccessful ventures that would clearly benefit the company if they succeed. In contrast, directors are strictly liable for any corporate losses and the business judgement in its present forms does not provide any protection to enterprising directors. According to Justice IP in Vrisakis vs Australian Securities Commission, the penalties to directors for failing to observe their duties is not meant to make other overly overcautious in their business judgement17. However, these penalties force directors to result to conservative risk taking and therefore the company misses the opportunity to enhance value for its shareholder. Young advances five policy basis for having a statutory business judgement defence18. First, qualified and competent directors are unlikely to serve as directors in Australia as the law they feel exposed to liability for their business decisions. In survey, a third of qualified individuals were likely to refuse appointment to the board of directors because of the risk of personal liability19. While 22 per cent of directors had quit because of fear of being found personally liable for decisions made in running a company. The second rationale stresses the need for informed risk-taking which is the foundation for survival and prosperity of any company. Thirdly, courts are not in a position to thoroughly analyze the merits of financial decisions that are under dispute. According to Sheller JJA in Daniels v AWA Ltd (1995) 13 ACLC 614 decisions are made on the basis of incomplete information, managerial intuition, and managerial knowledge among a horde of these factors20. Assembling and analyzing these factors in court would be an insurmountable task. Even if this was possible no court would be in the unique position of director while making the decision cannot be replicated. Lastly, the Business Judgement Rule can be used to dismiss complex cases at the motion or pre-trial stage therefore achieving judicial economy. Australia should thus adopt a general defence for directors based on the business judgement rule. This would ensure directors who make informed decisions in the best interest of the company are not punished for their entrepreneurial risk taking, if such decisions are in error. With such reforms, competent and qualified individual will no longer be afraid to join boards of directors. Furthermore, directors will be able to take reasonably calculated risk and thus ensure shareholder value is enhanced Question 3 The House of Lords in Regal Hastings v Gulliver [1942] 1 All ER 378, decided that directors where in breach of their fiduciary duty to the corporation, if they benefit from conflict of interest with the company, regardless of whether the they acted honestly or the company gained benefit from the transaction21. In the views of Edmunds and Lowry the judgement in Regal Hastings v Gulliver seeks to make sure that the trustee does not make any personal benefit from the fiduciary22. However, the central principle of equity is that the fiduciary and the trustee should not have conflicting interest. In contrast, both the directors of Regal and company had similar interest in capitalizing the subsidiary to acquire the lease. Therefore, I do not agree with the judgement in Regal Hastings v Gulliver as it departs from the central tenet of equity law and is too harsh on directors who act honestly in the full interest of the corporation. In English and commonwealth company law, the fiduciary duty of a director expressly prohibits them from exploiting company opportunities on behalf of themselves23. The rationale of the Regal Hastings v Gulliver judgement is to discourage directors from competing against the company and causing detriment for the company by diverting company opportunities. However, it fails to address situations where it is to the benefit of the company for directors to exploit the available opportunities. It also fails to cater for situations where the corporation rejects the opportunity. In addition, the approach fails to consider whether the directors’ breach harmed the company or whether the company would have exploited the opportunity. Edmunds and Lowry suggest the “corporate opportunity doctrine” to address the issues the problems noted with the English approach to fiduciary breach by directors24. Developed through US case law for over 60 years, the doctrine serves to prevent directors from being engaged in the same line of business as the company he/she holds directorship in25. However, the US doctrine is not based on equity’s protectionist instinct and is now a separate legal principle. The US approach seeks to balance between shareholder protection and director’s freedom, and does not prejudge accrual of benefit as evidence of wrongdoing on the part of the director. The shortcoming of the judgement in Regal Hastings v Gulliver [1942] 1 All ER 378 is more pronounced when compared to cases decided in the US on similar issues26. In Guth v. Loft, Inc., 5 A. 2d 503 (Del. Ch. 1939), the Delaware Supreme court decided Guth was in breach of his fiduciary duty for diverting for himself an opportunity offered to his company when he was president of Loft Foods27. However, the reasoning in the case was completely different from the Regal Hastings v Gulliver judgement. While Regal Hastings v Gulliver maintains a director is liable to account for profits gained through knowledge obtained by virtue of being director, Guth v Loft took a different approach in determining liability. In Guth v Loft, the director is only prohibited from taking advantage of corporate opportunity: if the corporation was in a position to undertake the venture; if the opportunity is of practical advantage to the company or the corporation has an actual or expectant interest in the opportunity28. Guth v Loft went on to outline guidelines that were applied in later cases to decide whether directors had breached their fiduciary duties by diverting corporate advantage for themselves29. According to Guth v Loft, a director was not in breach of his fiduciary duty if: a), he had been presented the opportunity in his individual capacity and not as a director of a company; b), the opportunity is non-essential to the company; c, the company lacks interest in the opportunity; d), the director has not wrongfully used the company’s resources in exploiting the opportunity. In Broz v. Cellular Information Systems, Inc. 673 A.2d 148 (Del.1996), the guidelines listed were used to decide if Broz had breached his fiduciary duty by diverting an opportunity to a company where he was sole shareholder and director30. The Delaware Supreme Court decided that Broz did not breach his fiduciary duty by taking the opportunity for himself. The court reasoned that the opportunity had been presented to Broz personally and the company had lacked the financial means to exploit the opportunity. In contrast, the strict English and commonwealth approach would have found Broz guilty. The reliance of equity principle’s in deciding whether directors have breached their fiduciary duties is faulty as it presupposes guilt if the director accrues any personal benefit. In contrast, the US approach considers whether the fiduciary conduct was honest and whether it caused detriment to the organization. Therefore, the directors of Regal should not have been vindicated for taking advantage of an opportunity their organization lacked the financial means to exploit and which in the end brought financial benefit to the corporation. Question 4 In Sons of Gwalia v Margaretic; ING Investment Management v Margaretic (2007) 232 ALR 232 (Sons of Gwalia) overturned the commonly held principle that shareholder claims are subordinate to those of unsecured creditors when distributing the assets of a company when winding-up31. Provided shareholder relied on false or misleading information about the financial state of the company, their claims would be on equal footing with those of unsecured creditors. The judgement followed in the footsteps of the House of Lords in Houldsworth v City of Glasgow Bank (1880) 5 AC 317 which has decided that a person’s claim for damages was dependant on the manner he obtained his shares32. The decision in Sons of Gwalia was seen by most as upsetting the balance between shareholder protection against corporate fraud, and the need to ensure creditors are justly compensated for debt advanced to companies under administration. However, in November 2010, the Australian parliament passed the Corporations Amendment (Sons of Gwalia) Act 2010 (Cth) (Sons of Gwalia Act) reversing the effects of Sons of Gwalia ruling33. Under the Act, all shareholder claims would remain subordinate to those of unsecured creditors. The sons of Gwalia Act introduced three important amendments34. First, shareholder would not be precluded from bringing claims against the company because they were shareholders. Secondly, under s563A, the claims of shareholder were subordinated to those of shareholders, but would be settled before any distribution to general shareholders. Thirdly, the act empowered shareholders whose claim were postponed under section 563A to participate in running the affairs of the liquidated company through receipt of copies of notices to creditors and a right to vote on some matters as creditors. In my view, it was right for parliament to subordinate the claims of shareholder who have been duped into acquiring company shares to those of unsecured creditors. First, it is unfair to reduce the rights of creditors to the assets of a company under liquidation because the company had misled the public into buying its shares. Liability for misleading potential shareholders lies with the company directors and thus they should pay for the investor’s losses. As in insolvent trading, courts should pierce the corporate veil and find the people who are culpable for providing false information about the company’s financial position35. Secondly, having shareholders compete against creditors is against well established economic principles. Creditors feel more exposed to risk if ordinary shareholders are at equal footing while winding up companies. According to Di Lernia, the sons of Gwalia ruling had caused a rise in the cost of lending and the availability of credit in Australia36. However, shareholders argue that the equity risk that they take in investing should be based on misrepresented information. Despite the Corporations and Markets Advisory Committee’s (CAMAC) recommendation the government went ahead to Corporations Amendment (Sons of Gwalia) Act 2010 (Cth) (Sons of Gwalia Act)37. The government preference of creditors’ rights over shareholders’ was based on sound economic principles. In order for economic growth to continue, Australian businesses require cheap and readily available credit, thus the need to create a less risky economic environment for lenders38. While stringent disclosure requirement were necessary after the Global Financial Crisis, it was not the intention of the legislature to promote the rights of shareholder over creditors in case a company breached this regime. According to Marshall, the Australian economy will benefit from the amendments in number of ways39. First, Australian companies will be able to access unsecured credit more easily, as the risk for creditors is reduced. Secondly, investors will feel more comfortable in rescuing distresses companies through injection of capital. Thirdly, formal insolvency proceedings will become more efficient. Overturning the sons of Gwalia ruling through the amendment was necessary to maintain Australia’s economic wellbeing. Targeted at controlling the rising cost of lending in Australia, the move will guarantee credit availability for Australian companies. With better debt financing, Australia will experience growth and more employment opportunities will be created. Furthermore, Australia needs to retain its image as favourable investment destination for financial organizations. Bibliography A. Articles/Books/Report Australia Security Exchange, Corporate Governance Principles and Recommendations with 2010 Amendments, 2nd Edition ( 2011,ASX Corporate Governance Council) Australian Institute of Company Directors, ‘Liability laws damaging the economy director survey reveals’Media Release, 01 Nov 2010, < http://www.companydirectors.com.au/General/Header/Media/Media-Releases/2010/Liability-laws-damaging-the-economy-director-survey-reveals> Australian Securities and Investments Commission v Healey [2011] FCA 717 Buffini, F. ‘Auditors Under ASIC Microscope.’ (2006) 15 Australian Financial Review 7. Byrne, Mark, Directors to hide from a sea of liabilities in a new safe harbour, (2008) 22 Australian Carcello, Joseph V., Dana R. Hermanson, and Zhongxia Ye. ‘Corporate governance research in accounting and auditing: Insights, practice implications, and future research directions.’ (2011) 30 (30) Auditing: A Journal of Practice & Theory 1, 31. Collett, Peter, and Sue Hrasky. ‘Voluntary disclosure of corporate governance practices by listed Australian companies.’ (2005) 13(2) Corporate Governance: An International Review 188, 196. Di Lernia, Cary. "Implications of the Sons of Gwalia decision’ (2008) 7 (1) Journal of Law and Financial Management 8-17. Edmunds, Rod, and John Lowry. ‘The no conflict–no profit rules and the corporate fiduciary: challenging the orthodoxy of absolutism.’ (2000) 3 Journal of Business Law 122, 142. Jennings, Marianne Moody, Kurt J. Pany, and Philip MJ Reckers. ‘Strong corporate governance and audit firm rotation: Effects on judges' independence perceptions and litigation judgments.’ (2006) 20 (3) Accounting Horizons 253, 270. Journal of Corporation Law 255 Lumsden, Andrew, and Katrina Sleiman ‘Corporate Law: Government Introduces Draft Legislation to Effect Reversal of Sons of'Gwalia'Decision’ (2010) 62 (6), Keeping Good Companies 350. Marshal James, Sons of Gwalia: the right response, The Australian Financial Review (Sydney), 22 January 2010, < http://www.afr.com/p/markets/dealbook/sons_markets_gwalia_decision_the_RNd8hQoB8f3ojHiqKRU6NP> Securities Law Journal 216 Securities, Australian. ‘Investment Commission (ASIC)(2003a).‘ASIC: Policing acceptable standards of auditing and accounting practices’, Speech by Berna Collier, ASIC Commissioner, 20 May.’ Stapledon, Nigel. ‘Housing and the global financial crisis: US versus Australia’ (2009) 19 (2)The Economic and Labour Relations Review 1-16 Van den Berghe, L. A. A., and Abigail Levrau. ‘Evaluating boards of directors: what constitutes a good corporate board?.’ (2004) 12(4) Corporate Governance: An International Review 461, 478. Vrisakis vs Australian Securities Commission (1993) 11 ACSR 162 Ying, Jennifer. ‘Guth v. Loft: The Story of Pepsi-Cola and the Corporate Opportunity Doctrine.’ Loft: The Story of Pepsi-Cola and the Corporate Opportunity Doctrine (May 8, 2009) (2009). Young, Neil, Has Directors Liability gone too far or not far enough?, (2008) 26 Company and Di Lernia, Cary. "Implications of the Sons of Gwalia decision’ (2008) 7 (1) Journal of Law and Financial Management 8-17. B. Cases Broz v. Cellular Information Systems, Inc. 673 A.2d 148 (Del.1996) Caparo Industries plc v. Dickman and Ors (1989) 1 ACSR 636 Daniaels vs Anderson (1995) 13 ACLC at pages 662-663 Daniels v AWA Ltd (1995) 13 ACLC 614 Guth v. Loft, Inc., 5 A. 2d 503 (Del. Ch. 1939) Houldsworth v City of Glasgow Bank (1880) 5 AC 317 Regal Hastings v Gulliver [1942] 1 All ER 378 Regal Hastings v Gulliver [1942] 1 All ER 378 Sons of Gwalia v Margaretic; ING Investment Management v Margaretic (2007) 232 ALR 232 C. Legislation Corporations Act 2001 (Cth) CORPORATIONS AMENDMENT (SONS OF GWALIA) ACT 2010 (NO. 150, 2010) Read More