Criminalisation of directors’ duties – again

27 November 2013

Criminalisation of directors’ duties – again

Introduction

On Friday, the office of Commerce Minister Craig Foss sent out another press release announcing that the Minister had tabled another Supplementary Order Paper (“SOP”) to the Companies and Limited Partnerships Amendment Bill. Under guise of lifting confidence, the SOP (the second such SOP on this topic) represents yet another go at criminalising “egregious” breaches of certain directors’ duties.

It continues by stating that these changes have been made after consultation and (a bold claim) further work to strike the right balance between holding directors to account and not criminalising legitimate risk-taking.

In a nutshell, the provisions that are the subject of the SOP are a solution in search of a problem. Subpart 1 of the Companies and Limited Partnerships Amendment Bill includes proposals for offence provisions that would criminalise directors’ duties in relation to not acting in good faith and the best interests of the company and so-called ‘reckless trading’. The latest bandaid seems destined to fail and I think that, no matter how well intentioned, the Minister should abandon his quest.

A solution in search of a problem?

The solution the Bill seeks to impose is, at least in part, a response to the series of finance company failures that occurred during the GFC. There is no disputing that the losses suffered by investors in failed finance companies were catastrophic for those affected and caused a loss of confidence that has rippled across capital markets matters.

In some quarters, an absence of punishment in the form of lengthy jail terms, is seen a solution. This has taken the form, in the Bill, of criminalisation of “egregious” breaches of certain directors’ duties.

However, one of the key lessons from the finance company failures, is that the ordinary criminal law did apply where there was criminal offending – notably fraud. However, by extending criminal penalties into business decision-making processes, there is a high degree of risk that the legislature will simply frighten off good candidates who might otherwise be willing to take up a governance role. The Minister is aware of this potential for such a chilling effect and his Department has been working to find ways to manage it. After all, if good candidates will not take up board roles, the net outcome is likely to be that an absence of good governance heightens the risk of loss.

Others describe this is undermining one of the central planks of the concept of the limited liability company – namely to provide a vehicle for doing what business does (and must do) namely take (calculated) business risks.

As a result, the Minister and his Department have now had three goes at coming up with something that works. None of this creative thought and detailed drafting appear to have made the underlying case any stronger – namely that the existing law, to the extent that applies to (blameworthy) offending acts or omissions in a corporate context, has not been shown to be materially deficient.

Primary duty

The duty in section 131 of the Companies Act, to act in good faith and in the best interests of the company is sometimes referred to as the primary duty of a director. The Bill, as amended by the SOP, proposed a new criminal offence of acting or omitting to act, in breach of that primary duty if the director knows that the conduct is seriously detrimental to the interests of the company.

In the latest iteration, the SOP requires that (to provide the offence) it must be shown that, in relation to the act or omission, the director:

• acted in bad faith towards the company; and
• believed the conduct is not in the best interests of the company; and
• knowing, or being reckless as to whether, the conduct will cause:
o serious loss to the company; or
o benefit or advantage to a person who is not the company (including, for example, to the director).

This seems, to me, to be a pointless add-on to the existing law. Put simply, any director who checks all of these boxes must be guilty of fraud – an offence that presently has a small number of directors of failed finance companies practicing their golf swing at Her Majesty’s pleasure.

However, absent the instances of fraud, a number of finance company failures have resulted in successful prosecutions for offences where there was no actual dishonesty. Instead, the other offence provisions, particularly in the Securities Act, have been shown to work.

So there is no net gain from the proposals to ‘backstop’ the primary duty of a director with a criminal offence. Indeed, it seems far more likely to have exactly the chilling effect that the Minister has been warned about – by further discouraging good candidates to become company directors.

Reckless trading

The second string to the proposals for criminalisation is in relation to ‘reckless trading’. However, rather than fix the existing problems with section 135 of the Companies Act and attempt to stiffen it with a criminal penalty, the Bill proposes an extension to section 380 of the Companies Act (Carrying on business fraudulently).

In its latest incarnation under the SOP, an offence would be committed if:

• a director agrees to, or causes or allows, the business of the company to be carried on in a manner that causes serious loss to 1 or more of the company’s creditors; and
• the director knows that a serious loss will be suffered by 1 or more of the company’s creditors as a result of the business being carried on in that manner (whether or not the director knows the full extent of the loss or the identity of the creditors concerned); and
• 1 or more of the creditors that suffered the serious loss did not give their prior consent to carrying on the business in that manner.

but the SOP provides a defence (that is aimed at protecting legitimate work outs) if, at the time that the business of the company is being carried on, the director:

o believes on reasonable grounds that all the creditors that will suffer serious loss as a result of the business being carried on in that manner have been identified; and
o believes that all those creditors have consented to the business being carried on in that manner.

The difficulties with the drafting are lengthy. And there is no guidance about what amounts to a “serious loss”. This creates a vacuum for director and their advisers. For example, what about a benchmark against good governance, or good industry, practices?

One of the criticisms of the experience of the GFC in Australia is that the penalties for directors found guilty of reckless trading caused too many salvageable businesses to be put under too early – because the directors were advised not to risk exposure to personal liability. The Bill seems to amplify that risk and remove any prospect of directors rolling their sleeves up to save the business (and the jobs of employees as well as the interests of other stakeholders such as suppliers and customers).

Concluding comments

I remain firmly of the view that the criminal law, where used in a business context, should be confined to criminal offending such as actual fraud. In all other cases, the penalties and remedies should be civil and have as their focus, compensation for the financial losses suffered as a result of the conduct. This is largely the pattern adopted in the other limbs to the reform of our capital markets sector – notably the Financial Markets Conduct Act.

In this case, the Minister should stick to that pattern. Time for a re-think.

Further information

If you would like more information about any of the matters discussed in this note, please contact me.