Directors’ exposure to liability – some further thoughts

17 November 2014

Directors’ exposure to liability – some further thoughts

Introduction

Recently, a lot of time and attention has been focused on issues relating to directors’ personal responsibilities for the actions of their companies. The issue of personal exposure has been addressed in a variety of contexts.

Primarily, because of the shape of our economy and the impact of the GFC, the focus has come in the context of the various claims that have followed the finance company collapses. As well as a monetary or financial context, sadly a number of recent events involving loss of life and/or serious injury – have brought about an increased focus on the concept of backstopping public order legislation with sanctions against those in control of corporates. And, most recently, we have seen a drive to criminalise so-called egregious breaches of directors’ duties.

Jim Farmer’s comments

A recent article by Jim Farmer QC, one of New Zealand’s leading commercial litigation lawyers as well as someone who has significant experience as a company director, on the subject of corporate governance and directors’ liability, highlights the predicament facing many company directors.

Whilst a number of Mr Farmer’s observations are relevant in a wide variety of contexts in which the role of directors are a focal point, he begins by making the observation that (in the context of the FMA’s desire for shorter and simpler offer documents) that highlights a concern for many:

“Having defended the directors of Lombard in their unsuccessful appeals in the Court of Appeal and Supreme Court (except as to sentence in the latter), I find that objective and, generally, the cry for less time on compliance one that has a major disconnect with the views of the Judges, which can be broadly summarised as a need for more, not less, detail.”

Mr Farmer continues by noting that this may be an “inevitable outcome” of the combined effect of the wording of specific pieces of legislation (particularly the Securities Act) and the judiciary having to deal with the aftermath of corporate collapses and the sense that someone must be held accountable.

He then provides a brief recital of the benefits of limited liability, the manner in which the law has recognised that those who control a company (i.e. the board) must perform their duties with competence and integrity and the competing tensions that have brought about the present state of the law on directors’ duties. To emphasise his concern that Courts not view the actions of directors with too much of an eye on the rear-view mirror, Mr Farmer cites authority for the need to make such an assessment on the basis of foreseeability – balancing the risk of foreseeable harm against the benefits that could reasonably have been expected to accrue to the company from the conduct (decision) in question. And this he adds needs to be measured against the environment in which the company operates.

Here, two points are relevant:

• the ‘noisiness’ of the environment in which the business operates will often determine the impact that can be made by management / governance; and
• in assessing that ‘noisiness’ – a distinction should be made between (internal) risks specific to the relevant business and external matters beyond its control – to which it can only react intelligently.

Mr Farmer then notes that these points were raised in the Court of Appeal in Lombard

“without judicial reaction. Indeed, that Court was unwilling to examine the causes of Lombard’s collapse.”

Mr Farmer concludes with his own take on the concern that making the legal environment too tough will frighten off exactly those who would make good directors. In this regard he notes that the part-time nature of the job exacerbates directors’ vulnerability as does the combination of public and media behaviours following corporate collapses and the role of judges who he says have little commercial knowledge or experience. He concludes by saying that whilst value enhancement is a worthy goal for a board – directors downplayed the custodial role at their peril.

The business judgement rule

Other commentators in this area have highlighted the pressures that have brought about a focus on compliance seemingly almost to the exclusion of directors’ primary role. Here we see an increasing number of references to important subjects such as the need for adequate due diligence being described in provocative terms such as “rituals”. This label is used to demonstrate:

• not only the difficult task being faced by directors in light of a series of recent court cases that seem to requires the Board to oversee the activities of management in an increasingly fine detail
• but also the problem created by the one-sidedness of directors risk exposure (i.e. they do not share in the upside of a profitable decision but “wear” the risk of getting it wrong) with the result that they will rationally choose to overinvest in precautions at the cost of the company and its shareholders.

This line of reasoning seeks to limit the erosion of the so-called ‘business judgement rule’ whereby courts should not seek to second-guess business judgements made by directors in good faith.

On my reading, the proponents of this view would support, at least in part, the final resting place of the recent efforts to criminalise egregious breaches of directors’ duties. In particular, knowing breaches made in bad faith along with those made fraudulently or dishonestly would continue to be penalised. However, they would rather not leave it to the courts to undertake a balancing act when examining the Board’s conduct – an enquiry that (arguably) the courts are ill-equipped to conduct. Instead, they would prefer a clear bright line test with the result that honest mistakes by directors, particularly when viewed against the backdrop of external matters largely beyond their control (significant noise), should just be one of the categories of risk assumed by investors.

In this regard, the differences in company law in Australian appear to put Australian company directors at a significant advantage to their New Zealand counterparts. Specifically, the basic duty provided by section 180 of the Corporations Act (Australia) that:

• Directors exercise their powers and discharge their duties with the care and diligence that a reasonable person would exercise, taking into account the company’s circumstances, the offices occupied by the person and their responsibilities within the company.
• A director will have been taken to have discharged their obligations if they:
o makes a ‘business judgment’ in good faith and for a proper purpose;
o do not have a material personal interest in the subject matter;
o inform themselves to the extent that they reasonably believe to be appropriate; and
o rationally believe that the judgment is in the best interests of the corporation.

In the One.Tel case (ASIC v Rich (2009)) a ‘business judgment’ was held to be any decision to take or not to take action in relation to a matter relevant to the company’s business operations, which included decisions in planning, budgeting and forecasting. The NSW Supreme Court found that the question to be asked is: “whether the director or officer has turned his or her mind to the matter.” ASIC had sought to say that the defence was not available to the CEO and Finance Director on the basis that inaction and omissions could not be spun into “conscious and considered acts involving the exercise of judgment”.

The argument was rejected, on the basis that [the directors] had turned their minds to the matters in issue and made decisions – ASIC just did not agree with them. Whilst the defence provided by the business judgement rule does not extend protection to a failure of oversight where there is a complete lack of decision-making, the Court noted that the defence seeks to ensure that directors and officers are not discouraged from taking advantage of opportunities that involve responsible risk taking. Instead, in their decision-making, [the Board] may have protection from the consequences of its decision where it can demonstrate that they have taken the steps required by the statutory defence.

By contrast, the New Zealand lawmakers shied away from introducing a defence for directors based on the business judgement rule. Instead, the Companies Act 1993 addresses only one narrow aspect of the rule – relating to directors’ self-interested transactions. The absence of such a defence, when coupled with the uncertainty highlighted by Jim Farmer and others, and other worrying developments such as the present state of the law relating to insolvent transactions, leave a nagging doubt about whether the right balance has been struck (and why we are out-of-step with Australia).

Further information

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