Directors, how can you ensure the information you get from management is reliable?

Directors must be able to rely on assessments and information made by management about matters of legal and regulatory compliance, says Professor Pamela Hanrahan.

The $700 million collapse of vocational education and training (VET) provider Vocation Ltd in November 2015 was one of the most spectacular of recent years. It is unsurprising that both the class action lawyers and the Australian Securities and Investments Commission (ASIC) quickly began the search for blame.

First cab off the litigation rank was ASIC’s civil proceedings against the company (now in liquidation), its CEO Mark Hutchinson, CFO and company secretary Manvinder Gréwal, and non-executive chair the Hon John Dawkins AO, a former federal treasurer. The lengthy trial ran from October 2017 to February 2018. It examined in detail an investigation conducted by the funding body — the Victorian Department of Education and Early Childhood Development — into training quality and student recruitment in the business and the disclosures made by Vocation to the market and its share underwriters in that investigation between July and October 2014.

The ASIC case turned on the failure of Vocation to appreciate the materiality of the VET funder’s investigation, and to disclose it to the market and its underwriters in a timely way. As is increasingly common in these circumstances, ASIC sought to sheet home responsibility for the disclosure failure not just to the company, but also to key individuals involved.

The decision in ASIC v Vocation Ltd (in liquidation) [2019] FCA 807 was handed down by Justice John Nicholas in the Federal Court in Sydney on 31 May 2019, 15 months after the trial concluded. His Honour found Vocation had contravened relevant provisions of the Corporations Act 2001 (Cth) dealing with the continuous disclosure obligations of listed entities and with misleading or deceptive conduct in relation to a financial product. Importantly, he also found that the CEO, CFO and non-executive chair had contravened s 180 of the Act — the statutory duty of care — by causing or permitting Vocation’s contraventions.

At the time, his Honour reserved his decision on whether the officers should be subject to a penalty or disqualification, or excused from liability under the general exoneration provisions in the Act.

The decision in Vocation raises significant issues of law and policy for non-executive directors that extend beyond the disclosure framework for listed entities. These include the relationship and flow of information between boards and management, and the liability assumed by non-executive directors who involve themselves in the resolution of regulatory or commercial matters affecting the company. It also provides a clear example of the difficulties directors face when decisions involving matters of commercial judgment, made in real time and against a shifting factual background, are picked apart forensically by regulators and courts years later.

In hindsight, the disclosure failures by Vocation look like a slow train wreck. An investigation by the VET funder that began in June 2014 led to the suspension of payments to a Vocation subsidiary in mid-July, pending resolution of the funder’s concerns. Quickly those concerns widened to other matters and other subsidiaries. The fact of the investigation came to the board’s attention later in July — management’s advice was that the investigation was not material. On 21 August 2014, the CEO and the CFO gave an investor briefing which, in the words of Justice Nicholas, “effectively committed Vocation to the position that changes to the… funding arrangements since 30 June 2014 were not material”. Management then stuck with that view, even after Vocation’s non-disclosure was questioned by the VET funder, the financial press, the ASX, its underwriters and members of its banking syndicate. As a result, Vocation breached its continuous disclosure obligation. And when Vocation undertook a fully underwritten $75m capital raising on 10 September 2014, it did not make adequate disclosure in its answers to the underwriter’s due diligence questionnaire or in the cleansing notice issued under s 708A of the Act.

ASIC sought to hold the individual defendants to account for being “involved in a contravention” by Vocation of the continuous disclosure requirements, and for negligence. There was no allegation that they deliberately set out to conceal information or were wilfully blind to its significance. Instead, ASIC proceeded on the basis that the defendants did not “know” the information was material in the relevant sense. The three other non-executive directors were not pursued by ASIC. Justice Nicholas found against ASIC on the involvement case because it did not prove that the defendants knew the information withheld was price-sensitive. However, ASIC succeeded in important aspects of its “stepping stones” negligence case.

Three findings are significant. The first is that the CEO was negligent in not understanding the potential impact of the investigation on the company, including not obtaining proper legal advice on the VET funder’s rights under the funding contracts. The CEO’s decisions about the materiality of events as they unfolded were not protected by the business judgement rule, with Justice Nicholas concluding decisions about corporate disclosure matters are not “decisions relevant to the business operations of Vocation” covered by the rule.

The second is that, as a result of the failures of management, the information flowing up to the board was “of very poor quality and… the product of a serious failure on [the CEO’s] part to provide the board with any organised or coherent information or analysis which the board could draw upon for the purposes of determining whether or not further disclosure should be made”. The company had formal disclosure and governance policies in place, and the board met frequently during the relevant period and took legal advice on the disclosure point. However, ultimately the non-executive directors and legal advisers were reliant on management’s assessment of the likely impact of the VET funder’s actions.

The third concerns the position of the non-executive chair. In mid-August, attempting to resolve matters with the VET funder, the company organised a high-level meeting that included the chair and the deputy secretary of the relevant government department. Justice Nicholas found that Dawkins was then “provided with all relevant correspondence with” and “assumed direct responsibility for the negotiations” with the department. From then on, given what he knew, “he accepted what he was told by management too uncritically and without challenging the correctness of the advice or the assumptions on which that advice was based”. His Honour concluded, “In doing so, he failed to exercise... reasonable care and diligence.”

The Vocation saga still has some distance to run — all the non-executive directors have been joined by PwC as cross-respondents in the class action. In the meantime, it is an important reminder of the difficulties all non-executive directors face in relying on information and assessments made by management about matters of legal and regulatory compliance.