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NZ to impose 20:20 hindsight test on directors

29 August 2012

This article was first published by ALB Online.

​Hindsight is a wonderful perspective - perfectly informed, clear and untroubled by doubt.  But these are not the conditions in which business decisions are made, which is why it is just plain wrong to apply a retrospective “success test” to the exercise by directors of their fiduciary duty.

Yet this will be the effect if section 138A, which the Companies and Limited Partnerships Amendment Bill would insert into the New Zealand Companies Act, goes ahead.

The relevant provisions read:

  1. Every director of a company who does an act, or omits to do an act, in breach of the duty in section 131 (duty of directors to act in good faith and in best interests of company) commits an offence if he or she knows that the act or omission is seriously detrimental to the interests of the company.
  2. Every director of a company who does an act, or omits to do an act, in breach of the duty in section 135 (reckless trading) commits an offence if he or she knows that the act or omission will result in serious loss to the company’s creditors.  [Emphasis added.]

Proposed penalties are up to five years in jail and up to $200,000 in fines.

The difficulties that the Bill mires itself in are best illustrated by comparison with the Australian Corporations Act which criminalises breaches only where the director or other officer is reckless or “intentionally dishonest” and which is silent on the seriousness of the detriment or losses caused by the offending.

These two seemingly small differences create a very large difference in the exposure of directors to having their actions judged after the event.

The focus in the Bill on the size of the detriment or losses implies a retrospectivity into the New Zealand framework which is absent from the Australian legislation.  This fails to recognise that the potential for loss is inherent in business risk-taking, which is precisely what the corporate form exists to enable.  Quite apart from that, switching the yardstick for moral culpability from honesty to scale is wrong in principle and leaves scope for real injustice. 

Intentional dishonesty casts a relatively narrow net compared to the focus on simple knowledge plus scale of harm.  The New Zealand test also insufficiently recognises that criminal law should be employed only when engagement in the prohibited conduct involves a harm-related moral failing, not just a breach of a rule or departure from a standard.1

Although the Australian provision conforms better to normal criminal law principles, any offence based on the “best interests” duty is vulnerable to the criticism that the underlying elements are too uncertain to form the basis for a crime. 

The duty was originally fiduciary in nature and is inherently imprecise in scope, 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 point of view, then, it is a handy tool to employ where no specific wrongdoing among the existing laws can be found but there is pressure to hold someone to account for corporate failure.  But where the crime encompasses a series of elements that are fundamentally matters of opinion and degree, there is a danger of justice that is not just overbroad but arbitrary.2  

The Bill was presented in Parliament as part of an Economic Development Action Plan yet at least some commentators view this sort of measure - which Professor Stephen Bainbridge has described as “literally insane” on his blog, ProfessorBainbridge.com - as detracting from an enterprise economy.  The Professor lectures in law at UCLA and in 2008 made Directorship Magazine’s top 100 most influential people in the field of corporate governance.

His point is that business decision-making typically involves choosing among a number of plausible alternatives and that, given the vagaries of the market, even carefully made choices may turn out badly.  So, even with the clarity of hindsight, the courts may be unable to distinguish between competent risk-taking and criminal mismanagement with the result that, all the threat of criminal conviction will achieve is to discourage directors from taking risks.

Another, more subtle but more corrosive effect of loading criminal liability on to directors is that it can set up a conflict between the director’s interests and the company’s interests. 

Already it is common practice for boards to employ separate counsel to consider the implications for directors of big transactions.  Clearly this is to be encouraged to the extent that it tests management’s thinking and the business case behind the proposition.  But if the board feels exposed and is simply looking for a reason to turn down a proposal which, although not guaranteed, has a reasonable chance of success, the company and the shareholders will be the poorer.

Much was made in the Bill’s First Reading of the need to address conduct arising in the finance company collapses, including inadequate disclosure and the misappropriation of funds for the personal benefit of directors.  These are not elements in the new crimes, however, and it seems to have escaped the legislators’ attention that convictions are being successfully secured against finance company directors under the Securities Act and the theft and fraud provisions in the Crimes Act. 

Proponents of criminalisation seem to believe that the existence of criminal sanctions will not inhibit honest directors in their decision-making but overseas experience provides little to justify such faith.  A justice of the US Supreme Court, for example, recently described a similarly open-ended corporate crime in the US as law in a state of chaos, being made up by judges and prosecutors as they go along. 

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

Footnotes

  1. Refer the UK Law Commission Consultation Paper No. 195 Criminal Liability in Regulatory Contexts (November 2010).
  2. Dick Thornburgh “Over-criminalisation and the need for legislative reform” (Testimony before the Committee on the Judiciary of the US House of Representatives, 2009).

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