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In response to widespread public concern about systemic misconduct in the banking and financial services sector in Australia, a Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry was established in December 2017 by the Australian government. The Commission met throughout 2018 presided over by Commissioner Kenneth Hayne, a former High Court judge.
The final report of the Commission was released to the public on Monday 4 February 2019. As predicted by many, Hayne delivered a detailed report containing a comprehensive set of recommendations across the Australian banking, financial advice, superannuation and insurance sectors (FS sectors) as well as recommendations on the key areas of organisational culture, governance and remuneration (CG&R) and on the conduct of regulation over the industry.
For the insolvency industry, Hayne’s final report raises important matters in the areas of corporate governance (and the executive responsibilities that administrators and liquidators assume as statutory insolvency officials and as “gatekeepers” over the financial services industry); of directors’ duties (in particular, the grounds for making claims against former directors on behalf of creditors); and the impact of a more aggressive enforcement culture adopted by regulators.
To understand Hayne’s recommendations and link them to the specific context of insolvency, you have to understand the Commissioner’s principled ‘building block’ approach in the way he has set out his report. His central objective in the final report is to examine what can be done to avoid the misconduct in the FS sectors being repeated.
He starts with some key observations that have guided the Commission’s work. In the context of CG&R, he observes that:
- The misconduct was driven by the relevant entity’s pursuit of profit and also by the individual’s pursuit of gain, whether in the form of remuneration for the individual or profit for the individual’s business (effectively, a feature of prevailing culture and governance)
Hayne identifies a number of important questions that will be the basis of any policy response to the misconduct and shortcomings in the FS sectors exposed during the Commission’s hearings. On the subject of CG&R, he asks:
- What more can be done to achieve effective leadership, good governance and appropriate culture within financial services firms so that firms comply with six basic norms of conduct?
- Obey the law
- Do not mislead or deceive
- Be fair
- Provide services that are fit for purpose
- Deliver services with reasonable care and skill
- When acting for another, act in the best interests of that other
Hayne sees these six “very simple ideas” as being the real basis for the proper conduct of financial service entities. They also support a number of general rules that he outlines including, in the CG&R space, that "culture and governance practices (including remuneration arrangements),
both in the industry generally and in individual entities, must focus on non-financial risk1, as well as financial risk."
The Report’s recommendations all relate to one or more of his key questions and reflect one or more of the six simple ideas. This is especially so in his commentary and recommendations on CG&R.
In light of the above, Hayne’s recommendations and supporting commentary are relevant not only, of course, to professionals working within FS sectors but also to other professionals including the insolvency practitioner (IP).
Insolvency practitioners' assumption of management responsibilities
An IP (such as an administrator) will take over responsibility for the running of an insolvent entity and in doing so owe a primary duty to creditors. The IP, in an administration or liquidation, has all the powers of the company and its directors.
In managing the entity, the IP will be principally assessing the entity’s ability to operate as a going concern on a long-term basis. The focus will accordingly be on the financial or business aspects of the entity’s activities (in other words, its financial risks). However, an IP cannot lose sight of the need for proper management of an entity’s non-financial risk, as this will be important for the business’ future sustainable life where reputation, brand value, recruitment capabilities and regulatory relationships (to name only a few) will play a big part in the entity’s activities.
IPs therefore need to keep in mind Hayne’s recommendations on CG&R and specifically his Recommendation 5.6: all financial service entities should, as often as reasonably possible, take proper steps to assess the entity’s culture and governance, identify any problems with that culture and governance, deal with those problems and determine whether the changes it has made have been effective.
Hayne reiterated in his final report that directors (and by implication IPs) should ask:
- Is there adequate oversight and challenge of emerging non-financial risks?
- Is it clear who is accountable for risks and how they are to be held accountable?
- Are issues and risks identified quickly, referred up the management chain and then managed and resolved urgently? Or does bureaucracy get in the way?
- Is enough attention being given to compliance? Or is it just ”box ticking”?
Although the time period may be short during which an IP is controlling an entity for the purposes of the administration or other insolvency process, this does not lessen the importance an IP should apply to matters of non-financial risk, accountability, good management practices and compliance generally.
Indeed, a focus on these matters as part of its investigation of the affairs of the insolvent entity may well give rise to information that could form a ground for making claims against former directors for dereliction of their duty.
Directors' duties and claims for breach
An IP will assess, on behalf of the creditor group, whether the former directors of the entity have complied with their legal responsibilities, and whether a claim for breach of director’s duties might be feasible as part of the asset/cash recovery process within an administration or liquidation.
The ability to identify a potential breach in director’s duties and the extent to which creditors may potentially benefit from a claim against the directors of an insolvent organisation is therefore an important element in the work of an IP.
When looking specifically at examples of directors’ flawed behaviour in the conduct of their duties, Hayne honed in on two very practical features of governance that are critical to managing risk and that were particularly lacking in a number of financial services entities:
I. The need for boards to get the right information about emerging non-financial risks. This requires the board to:
- seek further or better information if what they have is deficient; and
- use that information properly in order to robustly challenge management’s approach to managing these risks.
If the board does not have the right information, it simply cannot effectively challenge management and properly discharge its functions.
Hayne notes that the evidence before the Commission showed that boards frequently did not get the right information about emerging non-financial risks. He also emphasises the need for the right information and not more information—quality not quantity.
Hayne firmly lays the responsibility for getting the right information on boards and senior management.
II. The need for boards and senior management to be clear who within the financial services entity was accountable for what
The evidence before the Commission showed frequent uncertainty or ignorance within financial service entities as to who was responsible for what actions or tasks. Such uncertainty destroys any form of effective accountability.
Clear accountability is intrinsic to good governance. It ensures that problems are resolved effectively. It fosters a culture where risks are managed soundly. It is accountability that determines what consequences must follow when things go wrong (and where credit is due where things go right).
These are matters of importance for any corporate entity. The consequences of not properly addressing these two needs can be, and were in the case of certain financial services entities, particularly adverse.
It follows, therefore, that where directors have failed in these particular fundamental responsibilities, then the question should be asked as to whether a breach of directors’ duties has occurred.
Hayne's limited analysis of legal basis of directors' duties
Interestingly, Hayne does not spend much time in a detailed analysis on whether what happened in the FS sectors amounted to a series of breaches of directors’ duties. Hayne did refer a number of examples of misconduct to the regulators for consideration as to whether criminal or civil proceeding should be pursued. Claims for breach of directors’ duties may ensue as that consideration progresses.
This lack of legal analysis in the final report is, however, in keeping with Hayne’s approach in his final report. Hayne distrusts any supposed benefit of additional complication in an already cluttered financial services law. In general, he has helpfully pointed out practical omissions and related circumstances that have led to significantly adverse outcomes for banks and their customers. But he has generally avoided advocating for extensive law changes as a solution which suggests he sees more practical, behavioural-based solutions as being relevant to the problems in the FS sector (e.g., adherence to the six norms which, he says, are a necessary aspect of any good culture).
Hayne considers the legal duties of directors in a fairly brief section of the report that looks at the question of to whom directors’ duties should be owed. In Australia, a key duty of a director is to exercise his/her powers “in good faith in the best interests of the corporation and for a proper purpose” and to exercise his/her powers with reasonable care and skill. In line with Hayne’s view that the prudent management of non-financial risk is of equal importance to that of financial risk, he considers who the beneficiaries of those duties should be. He concludes that this is the corporation and that financial returns to shareholders, though important, are not the only matter to be considered. The interests of customers, employees and others associated with the company may also require consideration as well, depending on the circumstances.
Hayne concludes this piece by saying that the interests of key stakeholders (shareholders, customers, employees, etc.) are more likely to converge with the company’s long-term financial advantage. And that long-term financial advantage is more likely to follow if the company conducts its business according to proper standards, treats its employees well and seeks to provide its shareholders with results that in the long run compare favourably with similar competitors.
Change in enforcement culture
Hayne has been critical of the financial regulators’ approach and attitude towards the enforcement of laws that they administer.
The entrenched culture within the corporate regulator—the Australian Securities & Investments Commission (or ASIC)—of seeking to resolve conduct issues by agreement or negotiation (and, in particular, approaching that negotiation from the perspective of what the regulated entity is prepared to give) draws particular fire. This “cannot be the starting point for a conduct regulator” and Hayne continues by pointing out that “compliance with the law is not a matter of choice.” Public denunciation and punishment for wrongdoing is important as a deterrent and to clearly signify the community’s views of, and position on, that wrongdoing.
Hayne therefore recommends that ASIC’s approach to enforcement should start with the question of whether a court should determine the consequences of a breach—in other words, “Why not litigate?” ASIC has accepted this recommendation and is now in the process of adopting this changed attitude within its enforcement division.
Financial service entities can therefore expect, for the time being, a more aggressive approach on enforcement from regulators who are now displaying a stiffened resolve to apply and enforce the law. This will mean more claims and the possibility of financial damage and possibly even insolvency, especially where public denunciation through enforcement leads to the abandonment of the entity by its customers.
The recent passage in Australia of penalty legislation reflects the seriousness being applied to stiffening regulatory resolve. The new law increases maximum prison penalties for the most serious offences to 15 years. It significantly increases civil penalties for companies, now to
be capped at AU$525 million, with maximum civil penalties for individuals increasing to AU$1.05 million. Significantly, the law also introduces, for the first time, a civil penalty (capped at AU$525 million) for breach of the primary obligation banks and other financial services licensees owe to all of their customers, that is ‘to do all things necessary to ensure the financial services covered by the licence are provided efficiently, honestly and fairly.'
Relevant to this trend and as part of its response to Hayne’s recommendations, ASIC has announced a set of five principles for litigating and which will guide the approach of its new (and ring-fenced) Office of Enforcement:
- Where a possible breach of law is known to ASIC, ASIC will undertake an assessment and, if appropriate, conduct an investigation by reference to the facts and law. Once ASIC is satisfied that breaches of law are more likely than not, it will ask itself: why not litigate?
- Any public interest in pursuing a (non-court) negotiated outcome is weighed against the clear benefits of a judgment and imposition of a prison sentence, civil penalty or other court-based outcome with a negotiated outcome pursued only where objective assessment weighs in favour of the negotiated outcome.
- There is a focus on both corporate accountability and individual accountability particularly at executive and board level for breaches of the legislation administered by ASIC.
- Emerging technologies are employed to enhance ASIC’s enforcement capabilities and these technologies are monitored so ASIC keeps pace with advances in these technologies.
- There is careful monitoring of, and an endeavour to pre-empt, budgeting and resourcing requirements.
In light of the change in approach reflected in these new principles, IPs need to be alive to the greater possibility of enforcement action leading to adverse consequences for an entity, especially when the IP has taken control of an entity, for example in an administration.
Enforcement action by a regulator may indeed be the precursor to directors’ duties claims by an IP based on the behaviour that is itself the basis of the regulator’s action.
In the final analysis, Hayne’s recommendations and observations should make for compulsory reading by participants in the FS sectors and the professionals (such as IPs) that serve the sector. The position of IPs, at least in Australia, as “gatekeepers” who have a responsibility for the honest and efficient operation of the wider system, means IPs cannot ignore the implications of Hayne’s views on the proper conduct of corporate governance, that conduct’s effect on the enforcement of directors’ duties and the greater likelihood of enforcement action by the financial regulators.