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"Literally insane"? Maybe not. Ill-advised? Definitely

03 September 2012

This article first appeared in the September issue of Boardroom Magazine. 

The intention to criminalise breaches of directors’ duties in the Companies and Limited Partnerships Amendment Bill is “literally insane”, according to Professor Stephen Bainbridge, a US governance expert.

Google ‘Professor Bainbridge, criminalising agency costs’ and read it for yourself.  The Professor has a full-blooded, talkback radio blogging style.  But he is also the William D. Warren Distinguished Professor of Law at UCLA, has a long list of academic articles and books to his credit and in 2008 made Directorship Magazine’s top 100 most influential people in the field of corporate governance.

So when he suggests the proposed new section 138A should be thrown back, we should at least give him a hearing – especially as his concerns are widely shared in New Zealand.

Section 138A, which the Bill would insert into the Companies Act, provides that it is a criminal offence punishable by up to five years’ jail or a fine of up to $200,000 to knowingly act or omit to act in a way that is seriously detrimental to the interests of the company, or will result in serious loss to the company’s creditors.  

So what’s wrong with that?  As the collapse of the finance companies has reminded us, the damage created by corporate failure can be devastating and far-reaching.  Surely, then, the penalties for poor or reckless governance should be severe.  True, but a number of other factors must also be considered.

Professor Bainbridge identifies one of them:  “The problem is that business decisions rarely involve black-and-white issues; instead, they typically involve prudential judgements among a number of plausible alternatives.  Given the vagaries of business, moreover, even carefully made choices among alternatives may turn out badly”.

A lot has already been written in the New Zealand context about how making directors criminally liable for decisions taken in good faith will deter good people from taking up directorships.  For us, the key question is not so much about getting directors in the door, but what they do when they’re there. 

This needs some focus, because the environment for corporate decision-making is a critical part of the wider issue of stimulating enterprise, innovation and ultimately growth – all of which are currently in short supply. 

So will these new crimes succeed in deterring the errant while being a matter of pure indifference to the diligent?  There are several reasons to doubt it.

Consider the reckless trading provision, which has been described by Professor Peter Watt, perhaps New Zealand’s leading authority on governance issues, as “problematic” even in its purely civil form.  Directors can be deemed to have traded recklessly if they take on debt that the company was unlikely to be able to perform but this determination can only be made once it has become apparent that the debts cannot be honoured.  

Even under existing laws, the safest thing for directors to do in terms of their own position when a company is in financial difficulty is to “hand over the keys to the bank” and have the company go into receivership.  It may be the safest, but is it the best?  The answer depends on the circumstances, but the INSOL international workout principles are firmly against such risk aversion, which can unnecessarily destroy economic value and harm stakeholders – including the most vulnerable, the company’s employees.

Looking at this provision with a wider lens, if we’re going to jail directors for incurring debts they can’t perform, why stop there?  Why not criminalise anyone who over-extends themselves causing serious loss to their creditors?  The short answer is that we used to, but we abandoned the Dickensian debtors’ prison as part of the same civilising impulse that saw an end to witch trials, bear-baiting and the stocks. 

Neither is the offence required because creditors, or liquidators on their behalf, can already recover from directors personally where they have been shown to have breached the reckless or insolvent trading provisions of the Companies Act.  Adding a crime into this framework tilts the dial strongly against managed workouts and reduces the incentives on creditors to monitor and manage their own position. 

Similarly with the failure to act in the company’s “best interests”.  Let’s begin with what it’s not.  It’s not deceit, false accounting, misstatement when offering securities, theft in a special relationship or fraudulent trading – all of which (and much more besides) are crimes for which directors are already personally liable, represent legitimate matters of public interest, and are not so abstract as to be literally “in the eye of the beholder”.

The elements of the “best interests” offence are much more slippery and imprecise, encompassing everything from various levels of negligence, to disloyalty and other forms of “mismotivation” (what the economists simply call “agency costs”).  From a prosecutor’s perspective, then, it is something of a one-size-fits-all, which can be wheeled out whenever there is a damaging corporate failure. 

The ready retort to these concerns is that these crimes all require “knowledge”.  In the context of corporate decision-making, however, a knowledge element by itself is an inadequate marker of the sort of “egregiousness” that is supposed to make us comfortable with attaching criminal sanctions to otherwise legitimate business activities. 

Little that a company does is accidental and it is all under the ultimate management of the directors.  If a company fails, the situation is very often serious, or even “egregious”, for those impacted by it.  The real issue then becomes the assessment of prosecutors and the courts about the business judgements of the directors, influenced heavily by their eventual outcomes.

Which brings us back to Professor Bainbridge’s point.  Risk and return are positively correlated.  Shareholders, and the economy, benefit from directors taking legitimate risks.  Where there is no theft, deceit or misstatement, how are prosecutors and judges to distinguish between competent risk-taking and criminal mismanagement?   The efficiency costs of risk aversion and standing still are no less real for being invisible.

For every Enron there is an Apple.  Companies come to grief, causing harm, but they are also a vital part of the engine for economic growth, innovation and human aspiration.  The company form was originally born out of the risky venture of sending goods around the world in sailing ships.  That’s the function companies are going to have to continue to fulfil if we’re going to get anywhere. 

Ross Pennington is a Partner at Chapman Tripp specialising in finance, derivatives and securities.

 

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