Directors’ duties – breach of law by company

Introduction

Across the Tasman, a number of commentators have been pointing to the significance of a decision arising out of ASIC’s legal battle in the aftermath of the failure of Storm Financial – one of the high profile collapses of the GFC. The central issues flow from the so-called ‘mass harm’ to a large number of clients as a result of being encouraged by a network of financial planners to adopt aggressively-geared financial models.

In the latest round (#8) the Federal Court has found that the directors of Storm Financial breached their directors’ duties, by breaching their duty of care and diligence, under the equivalent of section 137 of the Companies Act 1993. They were found to have done so by permitting / failing to prevent the Storm Financial model being applied “indiscriminately” to a wide range of clients. The key (worst) examples being clients who were retired or near retired with limited income and few assets – with the Storm model involving clients borrowing against their homes and obtaining margin loans to invest in index funds.

Specifically, the Court found that a reasonable director would have realised that there was a strong likelihood that it would be inappropriate for retired or near-retired clients to use their homes as security for such an investment. As a result, the directors were found to have contravened their duty of care and diligence under the Corporations Act 2001 (Australia) by exercising their powers in a way which caused or “permitted” (by omission to prevent) inappropriate advice to be given to the relevant clients.

The judge found that a reasonable director with the responsibilities of the directors of Storm would have known that the Storm model was being applied to clients within the retired / nearly retired class and that its application was likely to lead to inappropriate advice. The consequences of that inappropriate advice would be catastrophic for Storm (the entity to whom the directors owed their duties). It would have been simple to take precautionary measures to attempt to avoid the application of the Storm model to this class of persons.

The decision involved an exploration of a number of concepts arising in respect of the directors’ duty of care and diligence. In particular, the decision is regarded as noteworthy because it confirms that, in exercising care and diligence, directors must think beyond the financial consequences of a particular action or approach and consider all of the possible harmful effects that may arise – including reputational harm and potentially, the failure of the company’s business (in this case by the loss of a financial services licence) arising from the failure by the company to comply with the law.

Also of note is the discussion about whether a breach of this duty gives rise to both a private and public wrong.

Is company misconduct a necessary stepping stone to a directors breach?

ASIC’s case relied on an actual breach by the company as a “stepping stone” for a finding that the directors breached their duty of care and diligence. Although an actual breach was found to have occurred – the judge queried whether the prosecution had set itself an (unnecessarily) high bar, and that there must be some doubt as to whether a contravention by the company was a necessary stepping stone in order to find breach by a director. (If so, a director might escape liability for an acts or omissions which were highly likely to involve a serious breach of the law, if (by chance) no actual breach occurred).

Accessory liability – by the back door?

Accessory liability or “aiding and abetting” is a key issue in matters such as breaches of consumer protection legislation but is only starting to be explored in the context of Companies Act matters – including under the heading of criminalisation of certain breaches of directors’ duties.

In the Storm case, the judge rejected the idea that the directors’ duty of care and diligence can be used to create liability for directors simply because the company had breached another provision of the Corporations Act (labelled “back door accessory liability”). In doing so, he rejected ASIC’s submission that directors were under a general duty to ensure that the company met its statutory obligations.

This part of the judgment seems quite orthodox – but the judge went on to add that contraventions or the risk of contraventions by the company are circumstances to be taken into account in assessing whether a director exercised care and diligence. However, they are not the only circumstances, and they are not conditions of liability.

The Court also considered the concept that any breach of the directors’ duty of care and diligence must be “founded on jeopardy to the interests of the corporation”. This was described as shorthand for the idea that, if the interests of the company are not threatened (or foreseeably harmed), there cannot be any breach. Where, as in the Storm case, the issue is a breach of law by the company, the relevant jeopardy is the (reasonably foreseeable) threat of damage to the interests of the company – such as fines and penalties. That is, the risk of exposure to liability for fines and penalties must be clear to the directors.

Is the directors’ duty of care and diligence limited to financial harm?

In order to discharge their duty of care and diligence, directors need to balance the (foreseeable) risk of harm against the potential benefits. Because business itself is all about balancing risks and potential rewards, it does not follow that just because a course of action involves a foreseeable risk (of harm to the interests of the company) does not mean that a director has failed in their duty (to exercise care and diligence).

However, the judge noted that harm is not limited to financial harm. It covers harm to any of the interests of the company, including its reputation and interests which relate to compliance with the law (e.g. the potential loss [in Storm’s case] of a financial services licence).

The judgment also notes that the balancing exercise to be undertaken in determining whether the duty has been breached is not simply an exercise of examining costs and benefits – so that a finding of a breach of duty could not be avoided by showing that the likely financial cost (fines and penalties) of a breach of the law was exceeded by the potential profit from the breach.

Is a breach of directors’ duties a public wrong?

Another aspect of the Storm judgment that has attracted the attention of commentators is its exploration of a question as to whether a breach of the directors’ duty to exercise care and diligence is both a private and a public wrong.

For the Storm directors it was argued that the duty is “private” owed only to the company – with any “public” element being ASIC’s ability to pursue fines and penalties. (It was also argued that, in the case of a solvent company, the only stakeholders of the company are its shareholders.)

By contrast, ASIC argued that the directors’ duty of care and skill creates an independent public duty requiring consideration of a “general norm of conduct” which is not limited to the interests of the company – and also requires the public interest to be taken into account.

Whilst the judge concluded that he did not need, in the context of the case, to resolve this issue, he did explore the possibility that the wording of the relevant provision in the Corporations Act and other contextual matters might indicate that a public duty is owed.

Concluding comments

Some commentators have suggested that current trends, including the approach indicated by regulators use of such buzz phrases as “setting the tone from the top” and “culture is the new black” and even statements by the new British PM about rebuilding trust in business and making boards more accountable, hint at the possibility of a broader public duty. This raises the possibility that directors might be at risk, regardless of the impact on shareholders, for the failures of the company and its employees.

Further information

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