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Those
Inescapable Directors' Duties
There is no
escaping the fact that all directors are required to meet certain
legal duties and responsibilities. While organisations have access
to a range of categories for incorporation (these include companies
limited by shares e.g. limited liability or proprietary companies,
incorporated associations, a company limited by guarantee or a trust)
there is essentially no difference in the duties and responsibilities
of directors in each category. This is so on both sides of the Tasman.
The rules or
duties for directorship are derived from two sources: statutes passed
by parliaments at both State and nation-wide levels; and case law
as determined by the courts from time-to-time. The main sources
of statute are the Companies Act and the Incorporated Societies
Act in New Zealand and the Corporations Law and the various state
specific Associations Incorporations Acts in Australia.
For many directors
company law is a dry and very unsexy topic and really there is no
way that we can dress it up to look enticing or engaging. The fact
is, however, that directors cannot afford to ignore the requirement
that they must know about their legal duties, however dull that
may feel. So we will be brief and to the point and make clear, at
least, the basic things that all directors should know.
A
director's duty of care
Basically speaking
all directors, whether of a not-for-profit or a for-profit organisation
owe a 'duty of care'. This includes:
- A duty to
act in good faith;
- A duty not
to gain advantage by improper use of the position of director;
- A duty not
to misuse information;
- A duty to
act with diligence and care; and
- A duty not
to trade while insolvent.
With the term
'duty of care' on the table, there needs to be added another that
should also be at the forefront of a director's governing vocabulary;
'fiduciary responsibility'. The word 'fiduciary' means trusteeship.
Directors have a trusteeship responsibility on behalf of the organisation's
owners and other key stakeholders. In other words they are not there
for themselves but for others on whose behalf they hold a position
of 'trust'. In the corporate world this applies primarily to the
relationship to shareholders, in not-for-profit organisations to
members or whatever other category of 'legal owner' exists, e.g.
in some cases the Government, State or National/Commonwealth. (For
further information on ownership see Good Governance # 10, "Who
Owns Your Organisation?") Increasingly a director's fiduciary responsibility
is seen as also including a responsibility for certain other categories
of stakeholders such as, in certain instances, creditors. While
the board does not owe a legal duty to employees, nonetheless there
is a growing acceptance that it owes a moral duty to this group
of special stakeholders.
Acting
in good faith
A director's
duty is to the organisation as a whole. In other words the expression
of the role must be seen to be in the best interests of the total
organisation, not of groups of owners/stakeholders or individuals,
no matter how persuasive, influential or powerful these may be.
Secondly there is a requirement that a director must discharge their
duty for proper purpose; in other words for the good of the total
organisation rather than for personal gain or for the benefit of
a third party.
Improper
use of the position of director to gain advantage
As tempting
as it may be at times, a director may not use his or her position
as a director to make personal gain for themselves or a third party
e.g. a relative, friend or another organisation. This tenet forms
the basis of the commonly used term 'conflict of interest' where
a director has, or is seen to have, personal interests that compete
with the interests of the organisation of which they are a director.
A director's first loyalty must be to the organisation of which
he or she is a board member. An example of improper use of position
would be where a director has an interest in a company that provides
services to the organisation that they govern. Using the knowledge
gained from being a director of the service-receiving company, the
director could ensure that the service providing company had an
advantage in the bidding process and thus gain the contract to provide
the service. Conflicts of interest among corporate directors typically
involve pecuniary or financial interests. In not-for-profit boards,
the interest is more likely to be of a non-financial nature. A subtle
example of such competing interests might be when a parent of a
child with a disability is a board member of the organisation providing
services to their child. In this case, the parent as board member
could influence the board's decision-making process in the setting
of direction and priorities so that certain services were provided
relevant to their child's or their own needs, perhaps at the expense
of the greater needs of the full range of children with disabilities.
While the law
does not, indeed could not, prohibit such conflicts of interest
occurring, it does require that the interest be declared. Many boards
include a 'declaration of interests' 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 in
the room during the discussion of that issue.
Improper
use of information
This provision
is similar to the previous one in that a director must not use information
gained in the course of their directorship to gain a personal advantage
or to create advantage for a third party. Information gained while
a director must not be used to the detriment of the organisation.
Insider trading is an example of the misuse of such information.
Another example would be passing on sensitive information to a competitor
to the disadvantage of the primary organisation. The standard applied
in assessing the extent of any such misuse can be broadly stated
as when there is a breach of a standard of conduct that would be
expected of a person in the position of the alleged offender with
knowledge of the duties, powers and authority of a director; in
other words, when it is reasonable to assume that the alleged offender
knew that they were doing the wrong thing in law.This
general criterion can be applied in most circumstances connected
to breaches of company law.
Acting
with due care and diligence
Whereas it would
be clear when a director had breached any of the previous duties,
whether or not a director acted with due care and diligence is a
matter of judgement. In essence this duty 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 of care and diligence in the same
manner as would any reasonable person who was a director of an organisation
in similar circumstances or who held an office holder position similar
to that held by the alleged offender. The test then would be whether
or not the person acted in a reasonable manner given their knowledge
and the expectations held of any person in the same position.
This element
of the law requires directors to pay due attention to the affairs
of the organisation/company while at the same time recognising that
directors need to delegate some of their duties to management. It
also recognises that directors may not be able to attend every board
meeting, although there is a very clear expectation that full attendance
should be the norm. Non attendance at a board meeting where certain
decisions were made leading to an action against the organisation
is unlikely to be upheld as a reason for a director being excused
his or her joint responsibility along with all other directors.
Perhaps the
most well known case in respect of this element of organisational
law is the Commonwealth Bank of Australia v. Friedrich and Ors (1991)
in which the Chairman of the National Safety Council (Victoria)
was found liable for in excess of $97M as the result of a breach
of his duty of care to the (not-for-profit) company. The Chairman,
Max Eise, signed the annual financial statement stating that the
company was solvent when in fact it was not. Although Mr Eise, and
indeed all of the directors, had been fooled by the CEO, John Friedrich
who, by all accounts, was found to be a consummate liar, nonetheless
Mr Eise was deemed to not have examined the accounts sufficiently
carefully in the manner as would be expected of someone in his position.
The message
that this sends to all directors, including directors of community
based not-for-profit organisations, is that there is an expectation
that they will learn what their duties are, will take these duties
seriously and will act in a manner that is befitting of a person
acting on behalf of the good or welfare of others. In practice this
means understanding the role, knowing the law in respect of directorship,
attending board meetings and reading papers and reports relevant
to the board. Directors should not be merely passive recipients
of information presented to the board by management but should actively
question the veracity and integrity of this to their satisfaction.
In order to understand and interpret information presented, directors
must understand the organisation that they govern and be aware of
the issues facing the organisation and the industry within which
it operates. It is also not unreasonable to expect that directors
will undertake training in directorship and will keep up with developments
in the law relating to their role on the board. In this respect
governance as a discipline is beginning to catch up with management
in that there are models, changing understandings about how to best
carry it out given certain circumstances, examples of best practice
and commonly held standards that support laws about what can and
cannot be done in the exercise of the role.
A
duty not to trade while insolvent
The final common
duty is the duty not to trade while the organisation is insolvent,
in other words not to continue to trade when the organisation cannot
meet its debts as and when these fall due. Insolvency is probably
the most common cause of the demise of organisations in the not-for-profit
and commercial sectors. They simply run out of money. Directors
have a duty 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 the average not-for-profit director the
knowledge required to meet this duty is often supplemented by outside
expertise or delegated to a board committee. We feel that it is
not unreasonable that every director should be able to read a balance
sheet and be able to interpret a profit and loss report. To this
end directors who are not financially literate should seek help
to increase their skills in order to carry out this aspect of their
governance duties. When an organisation is insolvent and an action
is brought against it by creditors, because there is no money in
the organisation's coffers, the directors' personal assets are at
risk.
There are quite
heavy penalties for failing this duty, the prime example being the
aforementioned Max Eise and his $97M fine.
There
can be forgiveness
Most court jurisdictions
have the ability to provide forgiveness for certain breaches of
the law provided that it can be demonstrated that the directors
acted honestly and in good faith and that, given the circumstances
of the case, it is fair and reasonable for them to be forgiven.
To gain such forgiveness, however, a director should expect that
he or she will need to be able to demonstrate that a genuine attempt
to meet the standard of care required of him or her while acting
as a director was made.
Being an unpaid,
volunteer director of a not-for-profit organisation, however, does
not provide protection from liability for breach of any of the duties
of directorship.
While fines
are typically applied in respect of a breach of most of these directorship
duties, it is not uncommon for courts to seek damages from individual
directors when an organisation has traded while insolvent. In this
way the court attempts to recover some of the losses suffered by
those bringing the action against the organisation and its directors.
Business
judgement and risk
The law recognises
that in order to run a successful business, particularly an entrepreneurial
one - and many not-for-profit organisations are very entrepreneurial,
it is essential that certain business risks be taken. The concept
of the Business Judgement Rule has recently been introduced, recognising
the need for certain levels of risk-taking. The rule (as it applies
in Australia) requires a director to reasonably demonstrate that:
- he or she
made a judgement in good faith and for proper purpose;
- did not have
a material interest in the subject matter of the judgement;
- informed
himself or herself about the subject matter to a reasonable extent;
and
- reasonably
believed the judgement to be in the best interests of the organisation.
The judgement
must rationally be believed to be in the best interests of the organisation
unless the belief is one that no reasonable person in the same position
could hold. This rule, however, does not diminish a director's responsibility
to ensure that the organisation is solvent, nor does it cover for
dishonest actions or non-disclosure of conflicts of interest.
To
whom is this duty of care owed?
Quite simply
the duty is owed to the organisation or company. The assumption
is that by acting in the best interests of the company or organisation
directors are, by definition, acting in the best interest of the
members or shareholders. Having stated this, however, it must be
acknowledged that there may be times when a board of directors,
whether of a not-for-profit or for-profit organisation, finds itself
determining that the expressed wishes of the members or shareholders
are not in the best interest of the company. In such circumstances,
the board and therefore its directors must put the organisation's/company's
best interests first, before constituent or personal interest, even
if this means incurring the wrath or disapproval of members or shareholders.
When
do these legal requirements not apply?
It should be
noted that there are instances when many of these provisions do
not apply to directors. For example directors of hospitals and community
health care organisations in Victoria (and most likely in the other
States in Australia as well) are protected by legislation against
personal liability. Some subsidiary boards of large community service
providing organisations are also protected, the parent organisation
accepting all legal liability. Such protection against personal
liability should not, however, tempt directors to think that they
can act carelessly or outside of the standards by which all directors
are required to work. It might be argued that, because of the protection
enjoyed, such boards have an additional moral responsibility to
meet required standards as an expression of their leadership role.
A
duty to meet other legislative requirements
While the duties
discussed thus far focus specifically on the role of organisation
directors, there is yet a wide range of other legislation that impacts
on organisational life. While not speaking directly to directors,
nonetheless directors need be cognisant of the impact on their organisation
of legislation such as that applying to employment, the workplace,
trading, the environment, their particular client group, e.g. people
with disabilities, their industry, e.g. trade or profession specific
law and the raft of statutes relating to human rights, and so on.
In most jurisdictions failure to observe legal requirements may
result in heavy financial penalties for both directors and officers.
What
about director's indemnity insurance?
It is rare
these days to find a board that does not have directors' indemnity
insurance. This insurance is designed to provide indemnity for loss,
including legal expenses, for individual directors and officers
of organisations when they have committed wrongful acts, or are
alleged to have committed wrongful acts while in the course of exercising
their duties. Directors should not, however, expect to be protected
when they have been found to have wilfully breached company law
or the standards required as established in common law. In other
words directors can expect to be protected when they 'do wrong'
while genuinely trying to 'do right' but not when they 'do wrong'
and know it.
In
summary
Being a director
these days is much more complex that it was, say, a decade ago and
these complexities are as relevant to part-time, volunteer, not-for-profit
organisation directors as to highly paid professional corporate
directors. Board members are required to know and respect the laws
that describe their duties and responsibilities and to also be conscious
of the raft of other legislation that impacts on the organisation
that they govern. While there is protection against personal loss
in the form of indemnity insurance and the ability of the court
to 'forgive', both of these depend on the director having acted
'in good faith' with the genuine belief that they were acting in
the best interests of the organisation. Recent high profile court
cases in New Zealand, Australia and the USA should serve as guidance
as the standard of behaviour sought from directors. Every time such
cases are prosecuted through the courts and brought to the notice
of the public via the various public media sources, the bar is raised.
As directors we cannot expect that we will ever return to the days
when forgiveness was almost always automatic, when directorship
was a 'behind closed doors' secret activity and when merely warming
a boardroom seat constituted adequate governance. Those of us who
are directors of organisations owe to our stakeholders the promise
that we will do our duty to the highest standards. Once the role
is understood, next on the list for directors is to know and understand
the law.
This article
merely scratches the surface of these matters but it is intended
as a beginning from which greater understanding might develop. We
recommend that every board should spend time discussing these matters,
preferably with the assistance of a trained specialist, perhaps
your organisation's legal advisor.
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