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Risk vs. liability: What you need to know

With the ever increasing fast pace of society, a successful business, particularly an entrepreneurial one, often needs to take business risks to stand out. However, risks often bring with them the potential for liability. 

For many business owners, company law is an unsexy, dry topic with little that can be done to dress it up to be attractive or enticing. However, the fact is that directors cannot afford to be ignorant on what they are required to know or take a blasé approach to their legal duties. Knowledge and compliance of directors duties is a must, as failure to comply with these duties may result in directors being personally responsible for any loss caused by the breach of these duties, or even criminal prosecution by ASIC.

Directors’ (and officers’) duties

While the corporate vehicle provides investors and business owners access to different taxation rules and provides protection of personal assets of its shareholders, there is no doubt that, especially in recent times, directors have been increasingly exposed to the risk of regulatory action or claims.

Directors’ (and officers’) duties are primarily imposed by the Corporations Act 2011 (Cth), but also stem from other various laws and the common law. Some of the more significant duties are:

  • To act in ‘good faith’

A director must perform their duties in good faith and for a proper purpose. A breach of this duty would be resultant from the director acting dishonestly or fraudulently.

  • To act in the best interests of the Company

This duty requires the director to act for the good of the total organisation rather than for personal gain or benefit of a third party. This can become confusing especially in the situation where directors and shareholders are one in the same, as with most small businesses. It is important to remember that the company is considered a separate legal entity, has its own interests and these interests may not be the same as the director’s interests.

While the law does not prohibit such conflicts of interests occurring, it does require that interest to be declared. Many boards include a ‘declaration of interest’ section at the commencement of each board meeting so that these might be signalled and a decision made as to whether or not the director concerned should remain present during discussion of that issue.

  • To act with care and diligence

This duty is one of personal judgment. It focuses on the amount of skill, experience, expertise and integrity brought by the director to his or her role. The statutory duty of care and diligence requires that a director must exercise their duty and responsibilities in the same manner as would any reasonable person who was a director of an organisation in similar circumstances.

This duty requires directors to pay due attention to the affairs of the company while at the same time recognising the need to delegate some duties (to management for example). An example is that while there is an expectation that directors attend every board meeting, it may not be possible. Despite this, when a decision is made at a board meeting which results in an action being brought against the company, non-attendance at the relevant board meeting, wont excuse joint liability or responsibility along with other directors.

A well-known example is the case of Commonwealth Bank of Australia v Friedrich and Ors (1991) where the chairman signed an annual financial statement that the company was solvent when in fact it was not. Although he was given misleading account information from the CEO at the time, the chairman was deemed to not have examined the accounts sufficiently carefully  in a manner as would be expected of someone in his position.

  • Improper use of information

A director would commonly come into information as a result of his or her position, but they must not use this information to act in their own interests or the interests of someone else. Insider trading is an example of the misuse of such information or the passing of sensitive information to a competitor to disadvantage the primary organisation.

  • Duty not to trade while insolvent

While the majority of a directors’ duties are primarily for the protection of shareholders, if your company is insolvent, or there is a real risk of insolvency, your duties expand to include creditors (including employees with outstanding entitlements).

The essence of this duty is not to allow the company to trade while the organisation cannot meet its debts as and when they fall due. The duty requires directors to know the financial position of the organisation and to be sure that it is financially viable. Given the common lack of financial expertise of many directors in Australia, the knowledge required to meet this duty is often supplemented by outside expertise or delegated to a board committee.

What is the court’s attitude to breaches?

A major factor the courts consider in whether it exonerates a director for a breach of the law is whether the director acted honestly and in good faith and that, given the circumstances of the case, it is fair and reasonable for them to be forgiven. The director would need to demonstrate that they have made a genuine attempt to meet the standard of care required of him or her while acting as a director.

The importance of the topic was signified in May this year, when the High Court of Australia reaffirmed the finding that seven non-executive directors of James Hardie (including high profile former chairwoman Meredith Hellicar) breached their duties as directors in approving a misleading ASX announcement.

The ASX statement said that the company had established a fully funded compensation plan, called the Medical Research and Compensation Foundation, to address claims from people suffering asbestos related diseases. However, the foundation was underfunded by more than $1.5 billion and faced potential bankruptcy.

Importantly, the Court also held that the general counsel and company secretary, Peter James Shafron, failed to discharge his duties with care and diligence, in relation to the actuarial work that underpinned the statement released and that he failed to provide proper advice to the board and the CEO.

This decision sends a clear warning to all company directors, when making potential misleading statements to investors. To avoid the potential risks, there should be continued disclosure and boards must place careful consideration on statements in their company’s releases, to ensure they are true and accurate.

While the emphasis was on company directors, the case further shows that the buck does not stop there as such duties also apply to company secretaries and company officers (key executives), and those involved in corporate governance and policies (e.g. those preparing board materials).

When a board considers making a public statement:

  1. Care must be taken in preparing and approving minutes of meetings.
  2. Careful consideration should be given to the drafting of ASX announcements using convenient terms.
  3. Constant reviews should be conducted on the current corporate record keeping practices.
  4. The company should determine and be clear on who in the organisation is likely to be an officer and what their role should be in any given matter.

Directors’ and officers’ insurance

The potential personal exposure for directors and officers means that it is rare to find a board that does not have directors’ and officers indemnity insurance. This insurance is designed to indemnify for loss in the event the company or the individual is sued in conjunction with the performance of directors’ duties as they relate to the company. The indemnity does not, however, extend to protect directors when they have found to have wilfully breached company law or the standards required as established in common law.

No matter the size of your company, there is no escaping the fact that all directors are required to meet certain legal obligations that are owed both to the company and the public. Recent high profile cases have signified that courts are prepare to pierce the corporate veil that directors have used to protect themselves from personal liability, in instances where they fail to meet their obligations.

Today, being a director is much more complex and, at times, onerous than say a decade ago. Board members and other key management must know and be conscious of the laws that describe their duties. This article only scratches the surface of these matters, but every board should spend the time discussing these matters with their advisors.

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Stephanie Borg

Stephanie Borg

Stephanie Borg is a solicitor with Neville & Hourn Legal.

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