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OPINION: Corporate Governance watershed looming

March 18, 2019

Contacts

Partners Michael Pollard, James Hawes, Don Holborow, Andrew Matthews, Robert McLean, Michael Sage, Cath Shirley-Brown, Simon Vannini

Corporate governance

As corporate lawyers, we try not to be melodramatic, and particularly about subjects which seem unlikely to yield melodrama, or anything like it. But sometimes this is justified, and this is one such situation.

In the world of corporate governance there is a courtroom debate looming that may have ramifications for every business that runs on a group model.

The forum is the long-running James Hardie litigation. This is a series of class actions brought against James Hardie Industries Plc (JHI) and its relevant operating companies concerning defective cladding products. The property owners are seeking recovery from the UK parent company, as well as the local entity that supplied the products. The latest instalment is from the NZ Court of Appeal.[1] This was a pre-trial hearing at which JHI was seeking to have itself removed from the proceedings on the basis that there was no way in law that it could be held responsible for the acts of its subsidiary.

On one level it is completely understandable for a property owner to ask the parent company to stand by the actions and products sold by its subsidiary - it’s all one business, right?

But that is not how company law works. The basic principle is that a company has its own legal identity, separate from its shareholders, and if things go wrong the company is liable for any losses, not its shareholders. In a group context, each company in the group is a separate legal entity, with its own legal rights and obligations, independent from one another. There is no presumption that a subsidiary company acts as the agent of its parent (shareholder), or that a parent owes a duty of care - the basis of a claim in negligence - to third parties who suffer loss from the acts of its subsidiaries.

This case required the Court of Appeal to consider when a parent company might be liable for defective products made and sold by its subsidiary company. JHI argued along legal orthodoxy lines (ie JHI couldn't be liable), and the property owners said that JHI had acted in such a way that the orthodox position should not apply (ie and so JHI could be liable).

That JHI’s argument was rejected, and the reasons why, is what makes this case so very important to the NZ corporate governance world.

The Court of Appeal made it clear that the issue was not one of “piercing the corporate veil” - so, as a matter of company law, looking behind the company and requiring the shareholder to take responsibility for the acts of the company. A more general proposition is at issue - whether, by its actions in the circumstances, JHI had created a duty of care to third parties who had bought the building products from JHI’s NZ subsidiary.

The Court recognised that there is no generally recognised duty of care in relation to a holding company and the acts of its subsidiary, but that such a duty could arise in some circumstances.

Having canvassed law developing in Australia, the UK and Canada, it identified three instances where a holding company could face potential liability for the acts of its subsidiary:

  • Where the parent takes over the running of the relevant part of the business of the subsidiary.
  • Where the parent has superior knowledge of the relevant aspect of the business of the subsidiary, the subsidiary relied upon that knowledge, and the parent knew or ought to have foreseen the alleged deficiency in process or product.
  • More generally, where the parent takes responsibility (irrespective of superior knowledge or skill) for the policy or advice which is linked to the wrongful act or omission.

(We quite appreciate that any director of a corporate group’s holding company who is reading this, may be getting a little anxious as they read, and we can understand why.)

The Court was not required to decide whether such a duty of care definitely existed in relation to JHI. The question was whether, in the circumstances, such a duty of care definitely did not apply. The Court felt there was enough evidence to show that the duty of care might exist, and very little presented by JHI to show that it didn’t. Thus, JHI’s request was refused, and - pending whether the Supreme Court allows JHI to appeal further - the matter proceeds to a full trial.

The question of whether such a duty of care existed, in the circumstances, will be a focal point in that trial. On the one hand we have the “orthodox incidents of a group structure” - the conclusion drawn by Peters J, the judge in the High Court proceeding, on the evidence concerning the operation of JHI and its subsidiaries. On the other, we have the Court of Appeal’s view that JHI’s activities potentially give rise to liability by JHI for the acts of its subsidiary.

The ultimate judgment in this saga could have far-reaching consequences for companies operating in a group structure. The Court of Appeal’s decision seems to infer that accepted forms of management of complex organisations could increase the risk of parent company liability for subsidiaries’ conduct. There are many groups that operate with multiple subsidiaries, with at least some of the portion of the subsidiary structure being put in place to “ring-fence” potential liability. The Court of Appeal’s comments suggest that accepted corporate governance structures for complex organisations could worsen the risk profile of a holding company at the top of the structure.

It seems unlikely that accepted group management and corporate governance structures can be adapted to reduce the risk:

  • Investors expect a strong board and senior management team with oversight of the whole business, along with reporting structures that reflect this.
  • The board will generally delegate authority to a group CEO to run “the business”, with all other management authority emanating from there. It is hard to run a group business otherwise.
  • Group-wide policies and reporting structures are essential for group corporate governance. It would be hard to have effective oversight without a consistent approach on basic behaviours and regular reporting against consistently applied requirements.
  • Centralisation of management and resources is part of the synergistic values that corporate groups seek to maximise.
  • Complex businesses tend to be managed, operated and reported along “business” or “division” lines, not along “corporate” lines.
  • If things go wrong within a group business, to a material extent, then the board will generally take action to solve the problem from the point of view of ultimately preserving shareholder value.

Investors expect the business to be run as efficiently as possible, so as to maximise returns. The operation of groups in accordance with accepted corporate governance principles is essential, and particularly for groups with a listed parent. For a board to run a business any other way can create unacceptable risks.

So what will happen?

Will the ultimate James Hardie decision require a board to make impossible decisions? Leading to attempts to avoid the duty of care burden associated with the conduct of its operating subsidiaries by ‘watering down’ corporate governance activities?

Or will a board come to the conclusion that the greater risk associated with potential liability for the conduct of group subsidiaries (in such a way that a duty of care might arise) is the price to pay for the group’s operational efficiency? We assume not, and hope that the final decision will provide guidance to the corporate world in light of practical realities.

We will continue to follow this important precedent as it develops.

 

[1] James Hardie Industries PLC v White [2018] NZCA 580

Contributors charlotte.mcloughlin@simpsongrierson.com