Memorandum of Advice

TO: Sharon Strezleki, PartnerMonash LawyersFROM: Shyna ChowSUBJECT: The implications of the recent reforms to the Corporations Act DATE: 15th August 16, 2011

Fact

The recent reforms to the Corporations Act 2001 (Cth) in Australia introduced the ‘two strikes and you’re out rule’; rule on declaration of the use of remuneration consultants; rule prohibiting the key management personnel and their closely relate parties from voting on remuneration reports and in the resolution to spill the board; rule prohibiting the key management personnel and their closely related parties from hedging their incentive on remuneration; and a requirement to obtain shareholder’s approval for declarations of “no vacancy” at an Annual General Meeting, (Alembakis 2011)

Implications of the reforms to executive remuneration

The introduced ‘two strike’ rule requires directors of public listed companies to stand for a re-lection if they fail to respond to shareholders’ concerns on remuneration report for two consecutive years. This equips shareholders and stakeholders with a big axe which will enable them to wield against boards who disregard their unhappiness with regard to remuneration practices, (Lamont, 2011). Also, the directors of listed companies have to disclose information related to remuneration consultants. This implies that there exist criminal liabilities where directors get advice from remuneration consultants. Further, the presence of rules on remuneration voting exclusion implies that any vote cast by key management personnel or their closely related parties will not be counted in determination of whether a resolution has passed,. Finally, the “no vacancy” rule leads to increased diversity among board members in listed companies, (Government of Australia, 2010). Generally, the implications of these amendments are summarized in a speech by Parliamentary Secretary David Bradbury that, “This bill will ensure that we have an internationally competitive system of executive remuneration that is transparent and accountable and that gives shareholders more power over the pay of company executives and directors,” (Alembakis 2011). However, as AICD (2010) points out, thee are loopholes in these new rules. For example, AICD notes that directors are already conversing with share holders in case their remuneration reports receive more than 25% votes against it. In addition, the mechanisms adopted under the “no vacancy” rule may hinder other market-led initiatives that are likely to be more effective in increasing diversity on boards. In this regard, it is advisable for the boards to retain the power to govern their practices which will enable them to act in the best interest of companies, (AICD, 2010).

The Centro and Fortescue decisions

Facts

In both the Centro and Fortescue cases, the federal court of Australia ruled that the directors of Centro properties group (CPG) had failed to take reasonable care and to show diligence in their approval of the financial statements which contained errors.

Implications to the current governance practices of Tractors and Trucks Ltd

The decision held in the above cases conveys a clear message to the directors of Tractors and Trucks Ltd not to rely fully on the information provided to them by the management as well as to the opinions of the auditors while approving financial statements. Rather, they should apply their judgement while reviewing financial statements provided to them for approval in order to determine whether the information contained in them and the opinions of auditors regarding that information are consistent with what they know and that material matters are not omitted. This stems from the fact that directors have an obligation to protect and promote a fair and reliable market for shares in the company. In other words, they owe fiduciary obligation to apply their knowledge and skills to the financial statements of the company before they are presented to the market.

Implications to the future desirable composition of the Board and key Committees

The decisions held in the two cases imply that in the future, the non-executive directors of Tractors and Trucks Ltd will really need to be independent from the management and free from any other business relationship that will be likely to materially interfere with the exercise of independent and unfettered judgement. As Austin and Ramsay argue, “non-executive directors can bring an independent and broad view to the board’s decision making as well as specialized experience and ability to review the performance of the company’s full-time managers.” Also, In order to safeguard the integrity of financial reporting, Tractors and Trucks Ltd will need to ensure that the company’s audit committee will be composed of independent persons with a range of qualifications, expertise and experience to discharge their mandate effectively. This will ensure compliance with disclosure rules in the Corporations Act that financial statements should be presented in a clear, precise and concise manner.

The implications of Centro decision to Tractors and Trucks

The Centro decision puts limits to the extent to which the directors of Tractors and Trucks can rely on external advisers and on the management while approving financial statements. The decision reinforces the fact that directors need to demonstrate a high degree of financial literacy, which they should extend as far as conventional accounting practices and basic accounting concepts are concerned. Further, if the directors of Tractors and Trucks Ltd notice any error in draft financial statements brought to them for approval, they must question the management or the external advisors before making any approval. To ensure that these goals are attained, Tractors and Trucks need to ensure that directors of this company meet the minimum requirements of basic concepts and financial literacy to be in a position to question errors in financial statements brought to them for approval.

Recent reforms on responsibilities and knowledge of non executive directors

According to Harrisch, a non-executive status does not give leeway to perform duties at a lesser standard than the executive status. . In other words, as Austin and Ramsay argue, it would be unreasonable to expect all directors to have equal knowledge and experience of all activities of a company, but that does not mean that a lower standard of care should apply to non-executive directors than to executive directors. Rather, under the amended Corporations Act 2001 (Cth), all directors are obligated to provide standard care regardless of whether one is an executive or a non-executive director. Therefore, all non-executive directors (like the executive directors) owe the basic obligation of monitoring the affairs of the company by maintaining high levels of awareness of the company’s activities and financial status. As Harrisch asserts, “such knowledge is a necessary component of the director’s appraisal of and agreement to the company’s annual reporting requirements.”

Relevant law

Various changes were made to Corporations Act 2001 (Cth), leading to introduction of the new rules. The first change involved subsections 250R (2), and 250V (1) and section 250U of the act which introduces first ‘two strike’ rule. Sections 206K, 206L and 206M require listed companies to declare the use of remuneration consultants. Section 250R (4)-(10) prohibits key management personnel and also their closely related parties from voting on a spill resolution.

The Centro decision was in accordance with section 344 (1) of the Corporations Act 2001 (Cth), which provides that directors should take all necessary steps to ensure compliance with, or to comply with the financial reporting obligations stipulated by the Act. In the Fortescue case, the federal court established that FMG contravened section 674(2) of the Corporations Act which stipulates that public companies should notify the market of any information that is not generally available for disclosure. In addition, the company contravened section 1041H which prohibits an individual or a company from engaging in deceptive or misleading conduct in relation to a financial service or product. In both cases, the omissions were in violation of sections180 (1) and 601FD (1) (b) of the Act which require directors and other officers in governance to demonstrate a high degree of care and diligence in making approval to statements or reports of a company

Conclusion

In conclusion, the recent reforms to the Corporations Act 2001 (Cth) have led to increased corporate credibility and transparency in and increases the voice of shareholders and stakeholders the process of executive remuneration. However, there are still loopholes in the amendments which may affect effective application of the new rules, which may be resolved by giving boards power to govern their practices which will enable them to act in the best interest of companies. As noted in the above argument, the Centro and Fortescue decisions demonstrate that directors can establish and supervise processes within companies but unavoidably, they are part of the process and thus, still have a fiduciary obligation to exercise reasonable care and diligence. The decisions held in both cases send a clear message to Tractors and Trucks Ltd regarding the importance of the fundamental legal requirement that financial statements and reports must present fair information with high regard to their impact on the decisions of the users, especially the shareholders.

Letter of advice to Tractor and Trucks Ltd

Shyna ChowLawyers and Notaries131 Wellington RoadVIC 3113Ph +61433932206Email: mary.dean@tractorsandtrucks.comName of DirectorDirectorTractor and Trucks Ltd.AddressDear Sir/ Madam,Re: The possible legal ramifications of a recent decision of the board

Fact

The recent decision of the board of Tractors and Trucks Ltd to approve a $2 million payment to Jian Fu Tractors Ltd in response to a recommendation by Mr. Alphonse Pennyweather, the Technical Manager of the company involves a breach on fiduciary obligations. Given that this took place after the Centro case, the decision of the board of Tractors and Trucks Ltd has possible regal ramifications to the board and to Mr. Pennyweather.

Legal issue

Two legal issues arise in this case. The first pertains to the possible legal liability of the non-executive directors concerning their move to approve the proposal at face value. A second issue which is evident in this case concerns the potential regal liabilities of Mr. Pennyweather under the aforementioned circumstances.

Regarding the possible legal liability of the non-executive directors, Tractors and Trucks Ltd need to understand that the non-executive owe fiduciary duty to demonstrate care and diligence in their work similar to the standard required of the executive directors as provided for under the Corporations Act 2001 (Cth). Further, the Act provides that company directors should make independent and informed assessment in the context of the director’s position and the complexities of a company’s operations before approving financial statements. In this case, the non-executive directors relied on the judgement of the Technical Manager, Mr. Alphonse Pennyweather and approved the recommended proposal at face value. This explains the fact the non-executive directors of Tractors and Trucks Ltd breached the law of fiduciary obligations by approving the contract at face value.

Similarly, Mr. Pennyweather’s engagement clearly contravened the law of fiduciary obligations embodied in the amended Corporations Act 2001. This law provides that the key management personnel have a fiduciary duty to avoid engagements that may result into conflict of one’s interest and with the interests of those that one is bound to protect. In this case, the Technical Manager of Tractors and Trucks Ltd Mr. Pennyweather received an ex-gratia payment of US $ 250, 000 from Jian Fu Tractors Ltd in order to put forward the proposal and recommend it to the board. That way, he intended to make an undisclosed profit out of the company’s dealings. In this regard, it would be appropriate to say that Mr. Pennyweather contravened the law of fiduciary obligations.

Application of law to facts

Several laws are applicable to this case. To start with, sections 181 of the amended Corporations Act 2001 (Cth) stipulate that all officers of a company owe the fiduciary duty to demonstrate care and diligence in their dealings with company matters. This section is relevant to the actions of the non-executive directors who demonstrated lack of care and diligence while approving the proposal by the technical manager. On the other hand, Section 183 of the act stipulates that an officer or an employee of a company must not use their positions improperly so as to gain profit themselves or to damage the company. The engagement by Mr. Pennyweather violated this rule since it leads to a conflict of interest between him and Tractors and Trucks Ltd.

Conclusion and options

In conclusion, the move by the non-executive directors of Tractors and Trucks Ltd the $2 million to approve the contract with Chinese registered company, Jian Fu Tractors Ltd amounted to violation of fiduciary duty of care and diligence provided for under the Corporations Act 2001 (Cth). By approving the proposal from the technical manager without checking its merits, the directors violated the principle that they ought to make informed judgement based independent and informed assessment of the proposal. Mr. Pennyweather also violated the law of fiduciary obligations by acting in self-interest at the expense of the company.

Recommendations

The only option of Tractors and Trucks Ltd is to find the best remedy to the issue as provided for under the fiduciary law. In this case, one of the best remedies would involve rescission of the contract. Another option is to hold the non-executive directors liable make compensation to the company should any damage arise from this contract. Regarding Mr. Pennyweather, Tractors and Trucks Ltd has an option to strip him of the secret payment from the Chinese company regardless of whether the company makes profits or losses.

Yours sincerely,

Shyna Chow

References

Articles/ Books/ Reports

Alembakis, R., (2011), “two strikes” policy for directors over executive remuneration, [Accessed

9 september 2011], HYPERLINK “http://www.thesustainabilityreport.com.au/two-strikes-policy-for-directors-over-executive-remuneration/27/” http://www.thesustainabilityreport.com.au/two-strikes-policy-for-directors-over-executive-remuneration/27/

Austin R. P. & Ramsay, I. M, (2010), Ford’s Principles of Corporations Law (14 edition), LexisNexis Butterworths, Australia.

Australian Institute of Company Directors (AICD, (2010), AICD welcomes improvement in two strikes policy, [Accessed 9 September 2011] HYPERLINK “http://www.companydirectors.com.au/General/Header/Media/Media-Releases/2010/AICD-welcomes-improvement-in-two-strikes-policy” http://www.companydirectors.com.au/General/Header/Media/Media-Releases/2010/AICD-welcomes-improvement-in-two-strikes-policy

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Fletcher, G., (2011), ASIC v Fortescue Metals Group Ltd [2011] FCAFC 19, [Accessed 15 August 2011] http://www.bransgroves.com.au/corporations/asic-v-fortescue-metals-group-2011-fcafc-19.html

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Lowry, J., (2004), The Recognition of Directors Owing Fiduciary Duties to Creditors – RePantone 485 Ltd and Colin Gwyer & Associates Ltd v London Wharf (Limehouse) Ltd, International corporate rescue journal, 1(1), available from, http://www.chasecambria.com/site/journal/article.php?id=83

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Australian Securities Exchange (ASX), (2004) Principle 4: Safeguard integrity in financial reporting, [Accessed 15 august 2011] http://asx.ice4.interactiveinvestor.com.au/ASX0701/Corporate%20Governance%20Principles/EN/pdf_pages/page_0027.pdf

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HYPERLINK “http://www.austlii.edu.au/au/legis/cth/consol_act/ca2001172/s250u.html”http://www.austlii.edu.au/au/legis/cth/consol_act/ca2001172/s250u.html

Commonwealth of Australia (1998), Corporate Law Economic Reform Program, Paper No. 3

(Directors’ Duties and Corporate Governance: Facilitating Innovation and Protecting Investors, 1997 [Accessed 15 august 2011]HYPERLINK “http://www.treasury.gov.au/documents/264/PDF/clerp.pdf”http://www.treasury.gov.au/documents/264/PDF/clerp.pdf

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http://www.oup.com/uk/orc/bin/qanda/sample_chapters/judge_ch02.pdf

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Director and Executive Remuneration) Bill 2011, [Accessed 15 august 2011], HYPERLINK “http://www.aph.gov.au/library/pubs/bd/2010-11/11bd083.pdf” http://www.aph.gov.au/library/pubs/bd/2010-11/11bd083.pdf

Parliament of Australia, (1998), Explanatory Memorandum, Company Law Review Act (1998) (Cth), [Accessed 15 august 2011] http://www.aph.gov.au/library/pubs/bd/1997-98/98bd133.htm

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[Accessed 15 august 2011] HYPERLINK “http://www.lexisnexis.com.au/pdf/austin-black-sample-” http://www.lexisnexis.com.au/pdf/austin-black-sample-annotation_s180.pdf

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