Directors must rethink liability implications of Companies Bill
March 18, 2009
By Etienne Swanepoel
Directors have two broad duties. At common law, directors are subject to fiduciary duties requiring them to exercise their powers in good faith and for the benefit of the company. They also have the duty to display reasonable care, skill and diligence in carrying out their duties.
Up to now directors' duties have been dealt with by common law. The Companies Bill 2008 codifies these duties. There are two issues: the codification of duties and retention of common law and the provision of a judgment business rule that provides a gold standard against which to judge the exercise of these duties.
The King committee on corporate governance recently released a draft of its revised report, known as King 3. One issue that arises relates to the connection between King 3 and the legal duties of directors.
The preface to King 3 states that corporate governance involves the establishment of structures and processes, with appropriate checks and balances, which enable directors to discharge their legal responsibilities. This, then, in short, is the link between governance principles and the law.
King 3 fortifies the doctrine of separation of powers between the directors and the shareholders, as is evident by the very subject matter of the codes, which is to provide the conceptual framework within which directors can wisely govern a company.
Arguably, the functionality of the duties imposed on directors is to act as a constraint on their unfettered powers to manage a company, which arises by virtue of the separation of powers doctrine.
Codification of the common law chiefly takes place in section 76(3) of the bill. It provides that a director must exercise his powers in good faith and for a proper purpose. That exercise must be in the company's best interests, with both the degree of care, skill and diligence that may reasonably be expected of a person carrying out the same functions as those of the director, who has the general knowledge, skill and experience of that director.
Section 76(4) introduces the business judgment rule. It provides that, in taking a decision, a director will satisfy these statutory (but not common law) duties if the director has taken reasonably diligent steps to become informed about the matter.
The director either must have no material personal financial interests in the matter or must have disclosed these and the director must believe, and have a rational basis for believing, that the decision was in the best interests of the company.
Further innovations include section 77, which deals with the liability of directors. Under section 77(2), directors may be held liable for losses or damages suffered by the company (but unlike under the common law, not for a disgorging of any profit gained) in accordance with the common law principles relating to a breach of statutory fiduciary duty.
Section 77(3) provides for specific liabilities. For example, a director will be liable if a distribution is approved despite knowing that the company will not comply with the solvency and liquidity test contained in the bill. Section 77(9) provides an escape from section 77(3) under certain limited instances.
The discussion is not complete without reference to sections 75 and 78. The former places certain disclosure obligations on directors; the latter deals with liability insurance and indemnities.
In short, the liability of directors in the bill is broadly determined by sections 75, 76 and 77. For this analysis we are only concerned with the liabilities of persons when acting as directors. However, they may well also be liable more generally.
Once liability has been established, recovering any resultant loss or damages from directors is complex. Section 20(6) provides that each shareholder has a claim for damages against any person who fraudulently or, due to gross negligence, causes the company to do anything inconsistent with the bill or any of the limitations contemplated in section 20.
On the other hand, section 218(2) provides that any person who contravenes a provision of the bill is liable to any other person for any loss or damage suffered as a result of that contravention.
On the face of it, it appears that due to the liability arbitrage between section 20(6) and section 218(2), it may be more expedient to proceed via the latter, which is the easier. It also seems as if sections 20(6) and 218(2) would include directors.
The next piece of the liability puzzle is section 157, which provides for class actions against errant directors. These are unknown under our common law. It would seem that this right is in addition, in a company law context, to the general class rights set out in section 38(c) of the Bill of Rights.
Then there is the much-commented-on section 165, which replaces the common law derivative action. Section 165 provides that a person - including shareholders, directors and trade unions - may demand that a company protect its own legal interests.
In the case of a breach of a director's duties, any of the persons listed in section 165 could demand that the company institute proceedings against the director to recover any losses or damages suffered by the company as a result of the breach.
There are differing views as to whether the bill sharply increases the exposure of directors to liability. If the guiding principle is the business judgment rule, which would not apply in respect of the specific liabilities contained in section 77(3), it would seem this is not the case. This view may, however, be too narrow, as the business judgment rule applies only to statutory duties and not to common law duties.
Undoubtedly, the number of pipelines through which losses and damages may be recovered from directors is much more complex and numerous.
It would therefore seem at first glance that substantively the bill does not radically alter the position of directors. Procedurally, however, it seems as if the pendulum has swung in favour of plaintiffs.
The costs of responding to each and every allegation, which will no doubt increase due to section 165, will be substantial. It must follow that the increased procedural complexity in itself is likely to inhibit directors' conduct.
There are also common sense issues in regard to governance that obviously affect liability. For example, what is the reporting structure in the company? Here, it is essential that directors have a direct line of sight to those who manage substantial parts of the resources of the company. Placing intermediaries between these managers and directors when it comes to reporting is frankly just short-sighted and ill advised.
In summary, certain positive duties are imposed on directors. The law expects each director to apply his or her mind to the company's issues that require attention.
Directors cannot abrogate these duties. In the words of a colleague: "It is not a free ride to be part of a board."
As there is joint and several liability only between those directors who are in breach of their individual duties, a director who is not individually liable cannot be jointly and severally liable. Dissenting directors could conceivably use section 165 to demand of a company that it protect its interests. In doing so, they may seek to sterilise themselves of collective responsibility.
The framework applicable to directors' liability once the bill comes into force will be different from what it is today. It will take careful thought to absorb the new regime.
Etienne Swanepoel is a partner at Webber Wentzel. The opinions expressed are his own.
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