Directors’ duties – how much stick is too much stick?

This article was first published in the August issue of Boardroom magazine.

If recent securities law reform proposals are adopted, the new Financial Markets Authority (FMA) will have the power to enforce core directors’ duties and to initiate civil actions on behalf of investors.

The current chairperson of the Securities Commission has long argued for such powers, and has chafed against the limitations on the Commission’s role, especially in the fall-out from the finance company collapses. The Commission can hold directors to account only in relation to disclosures made in a prospectus or securities advertisement, or for breach of specific obligations in the Securities Act 1978, Securities Markets Act 1988 or related  securities legislation.

Until then, enforcement is primarily the responsibility of the company as the core director duties are owed to the company, although following insolvency a receiver or liquidator may pursue breaches and in limited circumstances shareholders may seek leave from the Court to take a derivative action against directors on behalf of their company. As is well known, the core duties, laid out in the Companies Act 1993, include:

  • to act in good faith and in the company’s best interests, and to exercise powers for a proper purpose

  • to comply with the Act and with the company’s constitution

  • to exercise due care, diligence and skill

  • to avoid carrying on the business of the company in a manner likely to create a substantial risk of serious loss to the company’s creditors, and

  • to avoid incurring obligations unless satisfied that the company will be able to honour them when required to do so.

The definition of the core director duties is not subject to review, nor is an extension of director duties to company officers as applies in Australia. The Ministry of Economic Development (MED) says it is not aware of any problems with the status quo for those matters.

It is also worth noting MED’s statement that it “has not drawn any conclusions to date” on whether or not there should be public enforcement of directors’ duties to reinforce the current reliance on private enforcement. But it is probably safe to assume that some momentum will build for reform.

The influential Capital Markets Development Taskforce has provided some support to the Commission Chair’s recent public advocacy, by recommending that the regulator (in effect, this will be the FMA which is timetabled to come into existence early next year) should be given the ability to initiate and co-ordinate class actions.

Also, and likely to be an important factor for the Government, is that change would bring New Zealand into closer alignment with Australia where ASIC has the power to enforce statutory directors’ duties, including to obtain pecuniary penalties for breach of the obligations.Some examples MED has identified of potential director misconduct are where a director:

  • sells an asset to, or buys an asset from, the company at above or below economic value

  • uses information obtained as a director to buy or sell shares in the company

  • fails to exercise due effort or skill in making decisions on behalf of the company, andtakes excessive risks with the remaining assets of an insolvent company.

The argument MED offers for reform is that the regulator would be incentivised to take action in all cases of serious breach, whereas this is not true of either the company or of an insolvency practitioner. Companies will generally only pursue directors if the expected compensation exceeds the costs of the litigation and, if the company is closely-held, the incentives are even weaker as legal action would set directors against each other.

But MED is also mindful that if the regime is made too punitive, good candidates will be discouraged from taking up directorships and boards will become too risk-averse in their decision-making – both of which would be damaging to economic growth.

There may be some merit in giving the FMA the ability to enforce directors’ duties for companies that are public issuers where:

  • the shareholders either lack the resources to take action or choose not to, or

  • where the directors have used their position or knowledge acquired through it to transfer value from the company to themselves – either through self-dealing or through related party transactions.

But the design of the policy will be critical

Key to this is the question of whether there should be criminal sanctions, as in Australia where the maximum penalties for a criminal conviction are A$200,000, five years’ imprisonment, or both, for individuals and A$1.1 million against a body corporate.

Clearly there will come a point at which the march toward criminalisation in the boardroom will deter people from becoming directors and will deter boards from making rational business decisions or will mean that they become so focussed on looking behind their backs and seeking expert independent input that they miss out on opportunities.

Criminal offences would, however, require a high standard of proof and are proposed by MED only for serious misconduct and only where there is a “guilty mind element”.

Again, the Australian model has been proposed for possible adoption. Under section 184 of the Australian Corporations Act 2001, it is a criminal offence:

  • if a person is reckless or intentionally dishonest and fails to exercise his or her powers or discharge his or her duties in good faith in the best interests of the corporation or for a proper purpose, and

  • to use a position dishonestly, or the information obtained from holding the position dishonestly, to gain advantage for one’s self or another person or cause detriment to the company.

If criminal offence provisions are to be introduced in New Zealand, it will be even more important to get the balance right between deterring bad behaviour and deterring the intelligent and nimble risk-taking which sits at the heart of entrepreneurialism.

Two criteria are essential

First, as the Institute of Directors research and policy manager, Dr William Whittaker, has said, public enforcement cannot be allowed to become an opportunity for the regulator “to second-guess a rational action or business decision with the benefit of hindsight with a view to holding directors personally liable for company and shareholder losses”.

Second, personal liability should attach only where it can be established beyond reasonable doubt that the relevant directors were intentional participants in the misconduct and either knew the essential facts or were wilfully blind to them.

Submissions on the MED’s discussion paper close on 20 August 2010, and amendment legislation is intended to be introduced to Parliament next year for commencement in 2011.

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Related topics: Financial Markets Authority; Directors; Financial services regulation

Corporate & commercial; Financial services regulation; Litigation & dispute resolution; Corporate governance

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