New Zealand’s Companies Act 1993 and common law impose duties and liabilities on the directors of a company.
Who is a director?
Many of the following duties are not limited to those actually on the board of directors. A director can also include “shadow directors” who instruct the directors how to act, and persons who exercise powers of the board by delegation.
Who are duties owed to?
In general, these duties are owed directly to the company, giving it (and not individual shareholders or creditors) the right to sue a director for breach of duty. However, there do exist a number of provisions by which shareholders and creditors may pursue directors – these will be examined at the end of this article.
- Duty to Act in Good Faith and in the Best Interests of the Company (s131)
Good faith implies acting with a proper motive – without any malice or dishonesty. It also means avoiding acts which promote a director’s own interests at the expense of the company’s (historically termed “conflicts of interest”).
Acting in the best interests of the company
This is a subjective test – that is, directors must only act in what they perceive to be the best interests of the company – not what an “ordinary” or “reasonable” director might do. This gives directors a certain amount of discretion to use their own business judgment, without fear of every decision being open to scrutiny. Although, the Courts may find section 131 has been breached when a director does not take into account the company’s interests before acting.
Exceptions to best interests rule
If the company is a joint venture company or a wholly (i.e. 100%) owned subsidiary of a parent company, a director may act in the best interests of his or her appointing shareholder or parent company – even if this is not in the company’s best interests. This recognises that these are unique entities – whose operation depends on directors having liberty to carry out the wishes of their (often conflicting) shareholders.
Given the duty to avoid conflicts of interest, can directors have any interest in a transaction or use any information gained by virtue of their position? The short answer is “yes” – provided they are willing to jump through the fairly arduous hoops of disclosure imposed by the 1993 Act – these will be discussed shortly.
Don’t get too comfortable with the notion that as long as you believe a decision is in the best interests of the company, you’ll be fine. If your decision is one which any director with any appreciation of fiduciary responsibilities would see as being inconceivable, it is likely a Court would view this as a breach of section 131 – despite its subjective appearance. There is also an independent duty on directors to exercise reasonable care and skill – read on ….
- Duty to Exercise Powers for a Proper Purpose (s133)
At its simplest, this duty could be said to cover the situation where a director strays beyond the limitations intended for their office and acts out of an ulterior motive. Unfortunately, it seems impossible to define in advance exactly what situations fall within this definition. It may be that it is not until a Court reviews the exercise of a power that it can be determined whether or not that power was exercised for a proper purpose. Often the Courts consider whether section 131 has been breached and then rely on that rationale to determine that the director has also breached section 133. Some examples from case law include where a director has acted for personal purposes, has withdrawn funds to the company and Inland Revenue’s detriment, or has engaged in a Ponzi scheme.
Be aware that this duty is not related to the duty to act in good faith – that is, a director could act in what he or she thought was the best interests of the company, but still be acting for an improper purpose. A clear example of this would be the directors issuing shares solely for the purpose of diluting a particular (and probably troublesome) shareholder’s shareholding. While this may be in the best interests of the company as a whole (and even applauded by the other shareholders), it will nevertheless be an improper motive for issuing shares.
- Duty to Comply with Companies Act 1993 and Company Constitution (s134)
It is obvious that by not complying with the Act or the Company Constitution, a director would be acting outside of his or her mandate.
But wait, there’s more …
However, this duty may be more onerous than it first appears. The Act imposes numerous responsibilities on directors, of which failure to discharge may result in criminal liability (discussed later). For example, under section 87(1), a share register must be maintained by the company. Failure to do this would mean that the Act is not being complied with and, for a director, would be a breach of the section 134 duty. This breach will be actionable by the company as against the director, which means that not only does so simple an omission as failure to maintain a share register constitute a criminal offence, it exposes directors to potential civil liability for breach of section 134.
And more …?
Our advice: Make sure you are also aware of obligations under other statutes, such as the Privacy Act, Health & Safety in Employment Act and Resource Management Act… – because if you cause the company to act in contravention of any statute, this would almost certainly amount to acting for an improper purpose or not acting in the best interests of the company.
- Reckless Trading (s135)
Don’t be so reckless …
A director must not agree to, cause or allow the business of the company to be carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors. This duty is aimed at preventing conduct by the directors which could jeopardise the company’s solvency. It is not designed to curtail the directors’ ability to take risks – as long as the company is able to bear the loss from complete failure.
Unlike the best interests duty, the directors’ personal opinion as to the company’s ability to continue trading is irrelevant. Instead, a Court is likely to ask: “Was there something in the financial position of the company which would have alerted an ordinary prudent director to the real possibility that continuing to carry on the business of the company would cause serious loss to the creditors?”
Arise from your slumber
The situation of a director who “allows” reckless trading may include the “sleeping director” who has little or no actual knowledge of the company business, but is content to abdicate his or her responsibilities to more active members of the board. This can be especially relevant where spouses are each directors of a company, but only one works in the business.
Make sure you have a sound knowledge of goings on no matter what your level of involvement in the company. If you miss a board meeting, make sure you find out what happened from another director – even obtain a copy of the minutes to ensure no major decision was made – which you might have “allowed” by your absence.
- Duty in relation to Obligations (s136)
A director must not agree to the company incurring an obligation unless he or she believes on reasonable grounds when the obligation is incurred that the company will be able to perform the obligation when required to do so.
This will apply to such transactions as the company giving a guarantee.
Cramping their style?
It has been suggested that this duty will prevent directors taking commercial risks. However, as long as the directors’ decision is based on reasonable inquiries, research or information, it is less likely to be scrutinised later.
Our advice: When making a decision of this kind, the board should leave a “paper trail” – detailing not only their decision, but also their reasons. Better still, obtain professional advice. This will go toward showing that you acted on “reasonable grounds”. Also, do your homework early on – note the test is applied “at the time the obligation is incurred” – that is, when the transaction is entered into.
- Director’s Duty of Care & Skill (s137)
Directors are required, when exercising powers or performing duties, to exercise the care, diligence and skill that a reasonable director would exercise in the same circumstances, taking into account:
- the nature of the company;
- the nature of the decision;
- the position of the director; and
- the nature of responsibilities undertaken by him/her.
Therefore, it seems each director is judged on his or her role in each decision made. If a director is appointed to a specific task, he or she may be liable if they do not bring the required skills to that task. However, it appears that a director is not ordinarily supposed to have special skills – so there may be differing levels of skill and care expected from executive and non-executive directors (but note that any difference between these directors applies to this duty only).
Don’t go down these roads …
Examples of the Courts finding directors to have breached this duty include:
- where they acted before becoming fully acquainted with the company’s affairs.
- where loans were made to a company connected to a director with no possible benefit to the company.
- where cheques were signed in blank and the conduct of the business left entirely to another director.
- where directors unquestionably trusted (subsequently dishonest) employees with the management of the company.
A Higher Standard?
Many people believe that this duty places a greater burden and more stringent standard of care on directors than was previously the case. At the very least, it would seem that shareholders’ greater awareness of a statutory duty of care on directors will lead to higher expectations and increased vigilance of directors’ actions.
Our advice: It is vital to understand that it is no longer acceptable to sit back and let others run the show. It is clearly established that even directors who are scarcely involved in management of the company can still be held liable when financial difficulties arise. Evaluate your position as a director – are you familiar with the ins and outs of the business? Do you read (and understand) the financial accounts? Do you attend board meetings? Do you have a hand in business decision-making? If the answer to these is generally “No”, it may well be that you shouldn’t be a director at all!
- Use of Information and Advice (s138)
Relief from Omniscience?
In today’s commercial environment, directors cannot be expected to know everything about their company, or possess all the skills necessary for business decision making (although based on the foregoing, you could be forgiven for thinking otherwise!) Section 138 provides a (limited) form of relief for directors. It entitles directors, in the course of decision making, to rely upon reports, statements and financial data, as well as professional/expert advice given to them by:
- an employee of the company who is believed by the director (reasonably) to be reliable and competent in the matters concerned – this could be another director.
- a professional adviser/expert on matters within their competence.
- another director or committee of directors regarding a specific area of designated authority.
There is a catch: In doing so, directors must act in good faith, make proper inquiry where the circumstances indicate a need for this, and have no knowledge that their reliance on the information is unreasonable.
Our advice: Again, documentation of decisions is the key – whenever you rely on someone else’s advice, record that fact. And don’t just blindly rely on others – as a director, you should be capable of reaching a reasonably informed opinion of the company’s financial capacity. If there are grounds for suspicion arising from another’s advice – act appropriately.
- Director’s Interests (ss139-144)
Traditionally, if a director had an interest in a contract made with the company, he or she had to account to the company for any profits they might make (unless the company’s Articles or shareholders permitted otherwise). This was seen as a unduly harsh rule, and has now given way to a more permissive – but also more controlled – regime under the disclosure provisions of the Companies Act 1993.
Cards on the Table
Where a director has (or may obtain) a direct or indirect financial benefit in a transaction, he or she must disclose their interest in the transaction as soon as they become aware of it.
Disclosure is made by way of entry in the “interests register”, which must be kept by the Company. Disclosure is also required to be made to the board.
Avoidance by the Company
A transaction in which a director is interested may be avoided by the company any time within three months after the transaction is disclosed to the shareholders (whether by annual report or otherwise) – unless it is proved that the transaction is for fair value.
Our advice: Err on the side of excess when it comes to disclosure. While failure to disclose an interest in the register doesn’t affect the transaction’s validity, it could open you up to a $10,000 fine or an action from shareholders for breach of duty.
Also, disclose interests to the shareholders early – don’t leave it until the annual report – this could be months away and extend the timeframe in which the transaction can be overturned by the company.
- Use of Company Information (s.145)
Pssst! …… (Don’t) Pass it on!
As with director’s interests, directors have traditionally been prohibited from using company property (including confidential information and trade secrets) for their own purposes. However, once again this blanket prohibition seems to have been abandoned in favour of regulating the use of information by directors.
Section 145 of the Act provides that a director who possesses confidential information must not disclose that information to any person, nor make use of it or act on it, subject to the following exceptions:
- If disclosure is made solely for company purposes.
- If disclosure is required by law.
(a) The director has entered particulars of the disclosure in the interests register; and
(b) the board has authorised the director to make disclosure; and
(c) the disclosure will not prejudice the company.
· If disclosure is made by a nominee director to his or her appointer, provided this is not prohibited by the Board.
What is confidential information? It could be anything, but definitely includes trade secrets, technical know-how, lists of customers, internal financial reports, feasibility studies, and specific information concerning ongoing transactions between the company and its clients.
It is important to note that the section does not directly cover the use of company information by a former director. Here, the company would probably need to rely on the common law relating to breach of confidence.
Our advice: While section 145 would seem to provide reasonable protection, if your company’s operation is such that directors are often privy to large amounts of confidential information and/or have outside interests in similar spheres, it may be prudent to have the directors sign a confidentiality/restraint of trade agreement which expressly binds them during and beyond their term of office.
- Further Liability
While the above synopsis sets out the primary duties a director must uphold (which, in essence, place the quality and integrity of their decisions under the spotlight), liability for breach of these duties is by no means the only way a director can be called to account. What follows is a whistle-stop tour (or steeple-chase) of further provisions contained in the Companies Act 1993 which could cause a director to stumble:
- A director owes duties directly to shareholders to supervise the share register, disclose interests in contracts with the company (as discussed above), and disclose any interest they have in share dealings. A breach of these duties entitles a shareholder to bring a personal action against a director (s169).
- A shareholder could also bring an action to either restrain a director from acting in a manner which breaches the Act or the company constitution (s164), or to force them to act in accordance with these (s170).
- Directors may be personally liable if a distribution is made to shareholders when the company is insolvent – to the extent that the distribution is not able to be recovered from the shareholders (s56).
- Directors may be personally liable to liquidators or creditors for the debts of the company if they participate in the management of a company when they have been disqualified (by the Court or the Registrar) from doing so (ss384,386).
- Directors may be liable to the company if they receive an unauthorised payment or have unauthorised insurance effected – to the extent they are unable to prove these are fair to the company (ss161,162).
- If, on the liquidation of the company, it appears to the Court that a director has misapplied company money or property, or has been guilty of negligence, default or breach of trust, he or she may be liable to repay or restore the money or property, or contribute an amount to the assets of the company by way of compensation (s301).
Note that a creditor is entitled to apply for an order under this section and could allege breach of any duty as grounds for an order that money or property be paid directly to the creditor. If a company is in liquidation and the failure by the company to keep proper accounting records has contributed to its inability to pay its debts or impedes an orderly liquidation, a Court can order that any directors or former directors are personally responsible for all or any part of the debts of the company – unless they can show they took reasonable steps to ensure compliance (s300).
- Criminal Liability: There are over 100 sections of the Act a breach of which can constitute a criminal offence. In almost all of these sections, criminal liability is imposed on the directors personally, in addition to the company (there do exist limited defences relating to reasonableness on the part of directors). Penalties can be up to $10,000 depending on the offence. Far more serious, dishonesty offences can carry up to 5 years imprisonment or a fine of $200,000 (ss373,374).
- Liability in tort: A director can be liable for a tort (for example, negligence) committed primarily by the company, but through their agency – if they have assumed personal responsibility for their actions.
- A directors who trades shares using inside information is liable to account to the buyer to the extent that the shares are sold for more or less than their fair value (s149).
- Directors should also be aware of both the company’s and their own obligations under any other legislation – which also have the potential to fix personal liability on directors. These include, but are not limited to the Financial Reporting Act, Fair Trading Act, Health & Safety in Employment Act, Resource Management Act, Commerce Act, Privacy Act, Human Rights Act, and Building Act.
It will hopefully be apparent by now that the significance and potential consequences of these duties and liabilities are not to be sneezed at. Unfortunately, it seems that at present directors are either largely ignorant of these standards or do not take them sufficiently seriously. Perhaps more unfortunate is that it is usually not until a company fails that the extent of these duties becomes relevant – when a director’s decision is reviewed by the Court.
It is imperative to get things right at the time each decision is made. If you have any doubt as to the wisdom of any decision or act either of your own or your fellow directors, seek legal advice.
Because the implications of these duties are potentially severe, companies are increasingly availing themselves of the indemnity and insurance provisions of the 1993 Act as part of a risk management strategy designed to avoid personal liability on the part of directors.
This article is not a substitute for legal advice and you should talk to a lawyer about your specific situation. Should you need any assistance with this, or with any other Commercial matter, please contact Tim Rankin at Parry Field Lawyers (348-8480) firstname.lastname@example.org