You have probably seen lots of articles and webinars hammering on about directors’ duties.
You are left feeling slightly depressed about the idea of becoming a director. Or maybe you are one already and wondering if it’s really worth it.
There are recurring topics when it comes to risks of being a Director. You will have heard about the Mainzeal case [1] and perhaps also Debut Homes [2]. In both cases, directors were held to be in breach of their duties under the Companies Act 1993. They were, as you probably know, pinged heavily for their failures.
Like much media reporting, the headlines can be scarier than the detail. So perhaps it’s time for some good news.
Make no mistake, recent law tells us that we need to be fully alert when carrying out our duties as directors. There is no excuse for not being well aware of the law (and if you haven’t read these cases, then at least find a good summary and get on with it.)
However the good news is that the Companies Act itself provides some relief from what some of the doom merchants are saying.
The good news starts by having a closer look at the long title of the Companies Act which says:
An Act to reform the law relating to companies, and, in particular,—
- to reaffirm the value of the company as a means of achieving economic and social benefits through the aggregation of capital for productive purposes, the spreading of economic risk, and the taking of business risks; and
- to provide basic and adaptable requirements for the incorporation, organisation, and operation of companies; and
- to define the relationships between companies and their directors, shareholders, and creditors; and
- to encourage efficient and responsible management of companies by allowing directors a wide discretion in matters of business judgment while at the same time providing protection for shareholders and creditors against the abuse of management power; and
- to provide straightforward and fair procedures for realising and distributing the assets of insolvent companies.
If you look at the underlined bits, you will see that Parliament itself has affirmed the value of the company as an essential engine to carry out “economic and social” policy in our country. It accepts the taking of “business risks”. If you are a director you are allowed “a wide discretion in matters of business judgement”.
But it’s a balancing act: This policy and the latitude allowed must be held in clear tension and balance with the “protection for shareholders and creditors against the abuse of management power”.
Why is this good news? Fundamentally, it gives a strong direction to Courts to allow for sensible business risk. But at the same time it strongly indicates what is not sensible. It prescribes boundaries, beyond which you as a director ought not to go. If you are in danger of heading over a boundary line, then you will have some clear choices to make.
The comfort this gives is that it will ensure that Courts are not quick to find small discrepancies and whack the directors too readily – otherwise the fundamental purpose of the Act is undermined and a major policy for the successful operation of business and social enterprise is undermined. There is and must be scope for risk taking.
What are the reasonable limits to the scope of risk?
Now this is where it might get a bit dull, but it is important.
Solvency is the issue – the touchstone.
Section 4 of the Act sets out two types of solvency:
- Trading solvency – the requirement that the company is able to pay its debts as they become due in the normal course of business;
- Balance sheet solvency – the requirement that the value of the company’s assets must be greater than the value of its liabilities, including contingent liabilities.
You as a director must have a “sober assessment” on an ongoing basis as to the company’s likely future income and prospects. Not all directors are financially minded or trained (some are there for other skills). Such directors need to make sure they are getting reliable and current summaries from those who are financially literate.
The three key duties that you have as a director are:
- You must act in good faith in what you believe to be the best interest of the company (section 131);
- You must not agree to cause or allow the company’s business to be carried on in a manner that is likely to create a substantial risk of serious loss to the company’s creditors (section 135);
- You must not agree to the company incurring an obligation unless you believe at that time, on reasonable grounds that the company will perform the obligation when it is required to do so (section 136).
In a nutshell here is what the Act is trying to put the brakes on:
- Directors making decisions (or avoiding decisions) that are likely to result in people beyond the shareholders suffering loss e.g. creditors. Its one thing for the company to put its own funds at risk (including shareholders contributions), but it’s quite another for the company to begin to put third parties at risk. The law may accept the former as a reasonable “business risk”. But it may view the latter as an “abuse of management power”.
- Directors making decisions to avoid their own personal guarantees being called on. As a director you may have entered into a personal guarantee to support the company borrowings or other commitments e.g., a lease. Again the law takes a dim view of any action you take as a director which is more about you protecting your guarantee and less about protecting third party creditors or even shareholders.
If you are facing a doubtful situation what should you do?
- Resign? That may be your only option. Merely voting against a dodgy proposition may not be enough in the longer term. Raising issues at a board level and giving the board a reasonable time to change its stance may be a reasonable position. However if the company continues to sail on into troubled waters, contrary to your views, then you must act.
- Trigger insolvency regimes? That may well be the alternative to the above but is fairly rarely done by directors in New Zealand. It is more common to hear the view that a director continued on the board in the hope of “rescuing” its direction. Again, this is a doubtful strategy.
Directors’ and Officers’ liability insurance.
This sort of insurance is highly advisable for most trading companies. (You can’t have any such insurance if you don’t have a constitution – this is discussed more here).
As a director you may be well aware that you have a policy and may even know what the total cover is. But are you aware of other essential details such as:
- The notice provisions and how soon the insurer must be notified for the policy to be effective?
- Whether the defence costs under that policy are adequate in today’s climate? In particular make sure the defence costs, of any action that you are relying on, are separate from the liability costs – something that some directors have in the past found out wasn’t applicable – to their considerable cost.
- What is covered and what is not? This seems obvious, but finding out after an insurable event arises, is not the best time to become more acquainted with your policy.
Conclusions
- Company law accepts that business risk is a reality. The Company structure permits a certain degree of freedom;
- Balanced with that, the same law guards against over extending the use of that freedom to trade with other people’s money and not just your own company’s, or to be trading in a way that is more with an eye to protecting your own personal interests (e.g. personal guarantee protection) than that of the company and its creditors;
- So you should take all reasonable steps to be alert and knowledgeable about your company’s financial position and prognosis, put in place appropriate insurance and have the courage to take appropriate steps when you think the company is getting into difficulty.
- Being a director can be a valuable contribution to our country’s economic and social well- being. Don’t be put off by the headlines only. Make your decision to ‘sign up’ based on a bit of solid research-and if you do become a director, maintain that approach throughout.
We have a lot of experience helping Directors, Boards and Companies – if there is something you would like to discuss then let us know.
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DISCLAIMER: This article is of a general nature and cannot be relied on as specific legal advice. If you are thinking about becoming a director, or are a director facing a difficult decision, you should take advice specific to your fact situation.
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[1] Yan v Mainzeal Property and Construction Limited (in liquidation) [2021] NZCA 99.
[2] Debut Homes Limited (in liquidation) v Cooper [2020] NZSC 100.
