Richard Simpson and Tim Downes of Grant Thornton New Zealand explain.
In a recent speech, Securities Commission chairwoman Jane Diplock stated that “fundamentally, the global financial crisis is taking us into uncharted waters.” The comment has particular resonance for company directors, who may find their abilities tested, and actions scrutinised, to a degree not previously encountered. While it would probably be going too far to describe these new forces as a perfect storm, they do reflect a fundamental shift in the business environment. On the one hand, financial uncertainty means directors are more likely to be involved in decisions that may expose them to liability. On the other, the same environment is creating greater expectation that breaches will be punished. In addition, directors’ statutory obligations have not changed and neither are they widely nor well understood.
Companies and shareholders have limited liability, but the liability of directors is unlimited. This means they can be found personally liable for negligent actions. The sums involved are not trivial.
In 2005, the Court of Appeal upheld a judgment of the High Court that had imposed damages of $8.4 million on a director of South Pacific Shipping. The company was placed into liquidation in 1998. To date, this is the biggest award against a director in New Zealand.
Directors of a company that continues to trade while not meeting the solvency test are in danger of having their actions, or inactions, labelled “reckless.” They can be held personally liable for any resulting losses.
In defending themselves from liability, directors will not be able to resort to a commercial judgment argument. It will be the courts who decide, based on the facts in particular situations, whether decisions by directors are “reasonable” or “reckless”.
For instance, in the South Pacific Shipping case, the High Court found that a decision of the board to expand operations while insolvent constituted an illegitimate business risk. It stated the board should instead have decided to cease trading.
Deciding to expand meant the directors knowingly became parties to operating the company in a reckless manner, with the result the principal director was held to be personally liable.
The breadth and generality of the key words in the legislation should be seen by directors as a cause for concern rather than comfort. The $41 million suit brought by the liquidators of Feltex against the directors specifically relies on these concepts of “good faith” and “reckless trading.”
The continuing unfolding of what has been termed “the great recession” is revealing the weakness of the corporate governance arrangements of some companies. This in turn exposes directors to personal liability.
We define corporate governance as those structures, processes and systems that underpin the integrity of a company’s undertakings. CEOs who withhold information from a board, over-dominant CEO’s, ill-prepared and unskilled directors, and directors who don’t ask relevant questions of management are examples of poor corporate governance.
The Court of Appeal has established that there is no such thing as a sleeping director. It has held that directors have a positive duty to be involved in the affairs of the company, and to actively know what the company is doing.
Good corporate governance is not just a fashionable term. It is at the heart of a director’s responsibilities, and potential liability. In a report presented last month to Parliament’s Commerce Committee, Registrar of Companies Neville Harris stated that the quality of corporate governance was a key factor in the failure of the finance company industry.
Directors should take an active interest in the company. One is simply to attend board meetings. A recent dispute at the New York Stock Exchange revealed many directors had low attendance rates.
Lack of attendance is unlikely to meet the “duty of care” test of the Companies Act. Nor does absence absolve a director from decisions taken at meetings they don’t attend. This was established in the South Pacific Shipping case.
Probably the best course of action is to seek appropriate professional advice. This conveys two benefits. First, if done early enough, it can help avoid actions that might carry a company into the area where personal liability might occur. Second, seeking and acting on appropriate professional advice is an absolute defence against a personal liability action.
We may well be entering “uncharted waters”. But in the event of storms, prudent preparation means no director need go down with the ship.