Directors’ duty of care

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This topic is within Business Associations.

Contents

Required Reading

Redmond, Paul Corporations and Financial Markets Law 6th ed, 2013, LBC, pp. [7.70]-[7.130].

Introduction

[1] Directors (and other officers) owe several duties towards their companies. One of the main duties is the duty to exercise due care and diligence in discharging their duties (ie, not to be negligent). This duty exists both under the general law and under s 180 of the Corporations Act.

The general law duty of care

[2] Directors must take reasonable care in performing the functions of office. This cause of action is just the normal negligence in tort law, and follows those same rules (ie, breach of duty, proof of damages, causation, remoteness etc). The standard of care is measured by:

  • The care an ordinary man might be expected to take in the circumstances upon him own behalf: Re Brazilian Rubber Plantations (1911)
  • What is reasonably to be expected of each director, having regard to his knowledge and experience not by considering what the court itself would think reasonable: Re Brazilian Rubber Plantations.
  • Whether a director has exercised a reasonable degree of care and diligence “can only be answered by balancing the foreseeable risk of harm against the potential benefits that could reasonably have been expected to accrue to company from conduct in question”: ASIC v Doyle (2001); ASIC v Vines (2007).
  • Executive directors may be held to higher standards of care under their contract of employment - usually service contracts will contain covenants on the director’s part to meet performance standards appropriate to professional managers. Even where there is no such express provision, it may well be implied term of contract that directors will perform his/her duties to professional standards of care and diligence, if not skill: Lister v Romford Ice and Cold Storage Co Ltd [1957].

The duty does not impose upon directors a general obligation to ensure that the company doesn’t contravene Act/other legislation, rather whether they breach their duty in respect of such contravention is again determined by same general balance as outlined above.

There has been relatively little enforcement activity with respect to this duty of care due to standing rules prior to 2000 which stated that only other directors could bring action, and due to the difficulty in characterising director conduct as negligent. Thus, liquidators bringing claims are usually the cases in which these duties are tested.

Which members of the company have a duty of care?

  • Exec directors and other officers:
    • Degree of skill required measures objectively in relation to board matters and others that fall within director’s special calling
    • Under implied term in contract, an exec director would be taken to have promised co that he/she had skills of a reasonably competent person in his/her category of appointment and that he/she would act with reasonable care, diligence and skill: Wheeler
  • Non-exec directors and exec directors acting outside their calling
    • Case law has applied no objective standard of reasonably competent company director analogous to reasonably competent member of a particular profession against whom conduct can be measured
    • This is partly due to absence of any shared body of expert knowledge of what is involved in directing of comapnies.
  • Company chairman and audit committee chairman
    • Question of whether a non-exec director who occupies position of chairman of company and chairman of audit committee is subject to special standard of care, skill and diligence explored in ASIC v Rich

The statutory duty of care

[3] The general law duty is complimented by a statutory duty of care and diligence contained in s 180 (1):

  • A director or officer must exercise the degree of care and diligence that a reasonable person would exercise if they were a director or officer of a company in the company’s circumstances and occupied the office held by, and had the same responsibilities within the company as the director or officer: s 180 (1).
    • Doesn’t require proof of loss - just failure to exercise the standard of care (note: the general law duty of negligence does require proof of damages).
    • The standard of care under this duty is not higher than that under the general law duty: ASIC v Adler.

Section 180 is a civil penalty provision whose contravention attracts penalty and compensation provision of Pt 9.4B in addition to general law and other statutory remedies and obligations such as those arising out of contracts of employment: s 185.

  • The criminal sanctions were removed in 2000 upon the basis that the concept of negligence is inconsistent with dishonesty since the latter suggested an active awareness of wrongdoing rather than failure to exercise sufficient care and diligence.

Statutory defences

The Act provides for certain defences to a breach of the duty of care:

  • The business judgment rule.
  • The reliance defence.
  • The delegation defence.

The business judgment rule

The business judgment rule is a defence which protects directors in situation where they legitimately and in good faith believed they were making the right decision. It reflects the courts' reluctance to interfere with business decisions (ie, it is not the courts place to decide whether a business decision was correct or not - judges are not business experts).

The business judgment rule protects against both the general law and the statutory duty of care. It is provided for in s 180 (2):

  • A director or other officer of a corporation who makes a (positive) business judgment won't be in contravention of the duty of care (both general law and statutory) if director:
    1. Made the judgment in good faith and for a proper purpose; and
    2. Has no personal interest in the subject matter of the business judgement; and
    3. Has informed themselves about the subject of judgement to extent that they reasonably believe to be appropriate; and
    4. Has a rational belief that the decision is for the benefit of the company.

A 'business judgment' is defined in subsection (3) as "any decision to take or not take action in respect of a matter relevant to the business operations of the corporation".

Positive business judgment

The rule applies only to business judgements consciously made and involving exercising of judgement according to definition.

  • Failure to act is not protected unless it is a decision taken by exercise of judgement - accordingly rule does not protect omissions to act such as failure in oversight/monitoring
  • Eg, where director has failed to exercise any financial oversight functions and the lack of any such system has enabled fraud by a subordinate official to occur, rule’s protection would not be available and their conduct would be judged by reference to duty of care standard.

The requirements of good faith and disinterestedness

Automatically inapplicable where the director has an interest in the subject matter or outcome of the business judgement. The court’s general unwillingness to assess the merits of business decisions of necessity ends when a transaction is one involving a predominantly interested board with a financial interest in the transaction adverse to the corporation.

The requirement of an informed decision

The rule only applies where the director informs themselves about the subject of judgement to extent that they reasonably believe to be appropriate. This requirement mixes subjective and objective characteristics.

  • Focus is upon the preparedness of the director in reaching a particular decision as opposed to quality of decision itself.
  • American Law Institute lists the following as matters that may be relevant to an assessment of the “appropriateness” of into before a board:
    • Importance of business judgement to be made;
    • Time available for obtaining info;
    • Costs related to obtaining info;
    • Director’s confidence in those exploring a matter and making presentations;
    • State of the company’s business at time, and nature of competing demands for board’s attention;

Different backgrounds of individual directors, distinct role each plays in company, and general value of maintaining board cohesiveness, may all be relevant when determining whether a director acted reasonably in believing that info was appropriate under circumstances.

  • There is US authority supporting determination of informational adequacy by reference to a “gross negligence” test in sense of “reckless indifference to or deliberate disregard of the whole body of shareholders” or conduct “without the bounds of reason”: Smith v Van Gorkom)
  • The amount of info required for decision to ensure protection of business judgement rule is itself a business judgement which attracts protection of the rule if it itself satisfies the informed decision .
  • Despite this apparent self-referential nature of this element, strength of its extractions is revealed in 2 well-known decisions in the US in the 1980s: Smith v Van Gorkom and Hanson Trust PLC v ML SCM Acquisition Inc see p 382 – 3.

The requirement of rational belief as to company benefit

This requirement has 2 elements:

  1. Subjective test of belief: it requires that director to have actually believed that the decision was rational.
  2. Objective test of rationality: very low standard, belief deemed rational if unless it is so unreasonable that no reasonable person in their position would hold it.

Reliance defence

Directors may have a defence when they have relied on someone else's information in acting in a certain way. The defence is provided for in s 189 which specifies that a director will not be in breach if:

  1. A director relies on information, or professional or expert advice, given or prepared by:
    • an employee of the corporation whom the director believes on reasonable grounds to be reliable and competent in relation to the matters concerned; or
    • a professional adviser or expert in relation to matters that the director believes on reasonable grounds to be within the person's professional or expert competence; or
    • another director or officer in relation to matters within the director's or officer's authority; or
    • a committee of directors on which the director did not serve in relation to matters within the committee's authority; and
  2. the reliance was made:
    • in good faith; and
    • after making an independent assessment of the information, having regard to the director's knowledge of the corporation and the complexity of the structure and operations of the corporation.

Delegation defence

s 198D allows directors (unless otherwise prohibited by the company's constitution) to delegate their powers. Directors are usually liable for the actions of their delegates: s 190 (1). However, subsection (2) they may be protected from this liability if:

  1. the director believed on reasonable grounds that the delegate would exercise the power in conformity with the duties imposed on directors of the company by this Act and the company's constitution (if any); and
  2. the director believed:
    1. on reasonable grounds; and
    2. in good faith; and
    3. after making proper inquiry if the circumstances indicated the need for inquiry;
    • that the delegate was reliable and competent in relation to the power delegated.

Case law

Daniels v Anderson:[4]

  • Facts: AWA adopted a “managed hedging” strategy to hedge against FX (foreign currency) exposure. AWA suffered substantial losses, however, early profitable figures were found to be based on speculative trades, failure to disclose losses and by paying losses with funds borrowed from other banks. The oversight was left to general manager and finance manager, neither of whom had experience with FX transactions.
    • Negligence on their part was assumed, and trial judge considered that chairman and CEO, Hooke, misplaced unquestioning reliance these parties. AWA sued auditors (DHS) alleging negligence in audits on the basis that DHS had a duty to discover and report to Hooke regarding the FX exposure.
    • Auditors cross-claimed against directors claiming AWA was guilty of contributory negligence, or that they caused any loss suffered by AWA.
  • Held (Clarke and Sheller JJA): “The responsibilities of directors require that they take reasonable steps to place themselves in a position to guide and monitor the management of the company”. However, “it would be unreasonable to expect every director to have equal knowledge and experience of every aspect of the company’s activities”.
    • A director cannot proceed on the basis that ignorance and a failure to inquire are a protection against liability for negligence
    • “As a general rule, a director should acquire at least a rudimentary understanding of the business of the corporation… A director cannot set up as a defence lack of the knowledge needed to exercise the requisite degree of care…Directors may not shut their eyes to corporate misconduct and then claim because they didn’t see it they did not have a duty to look… A director is an essential component of corporate governance. Consequently, a director cannot protect himself behind paper shield bearing the motto ‘dummy director’”: Francis v United Jersey Bank
    • “A person who accepts the office of director of a particular company undertakes the responsibility of ensuring that he or she understands the nature of the duty a director is called upon to perform. That duty will vary according to the size and business of the particular company and the experience or skills that the director held himself out the have in support of appointment to the office”
    • In short, directors can't rely on the fact that they are non-executive directors and that they have no knowledge in this area - an integral part of accepting the position of a director is to acquire at least a rudimentary understanding of the business of their company. They also must maintain this familiarity.
    • Not unreasonable for NEDs to have accepted the assurance they received from DHS - DHS was negligent, with AWA one third contributorily negligent.

Permanent Building Society (in liq) v Wheeler:[5]

  • Facts: PBS sued former directors for failing the duty of care in connection with purchase from Tower of a parcel of land. PBS had no expertise in property development. At same time that PBS was negotiating purchase, Tower was also negotiating to acquire capital of JCDL from CHL - CHL held capital in PBS, and PBS’s chairman (W) had a controlling interest in CHL.
    • Hamilton was MD of both PBS and JCDL, holding no shares. He attended PBS board meetings, declaring his interest as MD of JCDL and did not vote or take part in decision.
    • Alleged that Hamilton breached duty by failing to express opposition to and vote against adoption of resolutions, to purchase land from Tower
  • Held (Ipp J): the duty is not a fiduciary duty, but is actionable in equity. The test to apply is an objective one in the sense that the question is what an ordinary person, with the knowledge and experience of the defendant might be expected to have done in the circumstances. Inherent in this test is a balancing exercise between the risk of harm on one hand and the potential benefits on the other.
    • These matters may be influenced by considerations such as whether the director is an executive director or a NED, but are always dependent on the particular circumstances.
    • H breached his duty. It must still be proved that the breach of duty caused the loss to PBS though.
    • There will be causation if, the negligent act as a matter of ordinary common sense and experience, could be regarded as a cause of the loss. PBS failed to establish that the loss was caused by a breach by H at common law.
    • In equity, PBS failed to prove that but for the breach by H of his equitable duty the loss to PBS would not have occurred.

ASIC v Adler:[6]

  • Outlines the principles applicable to the duty of care and diligence, now enacted in s 180:
  1. Directors owe duty at common law and equity
  2. But, equitable duty is not properly classified as fiduciary
  3. Statutory duty is essentially the same as the duty under common law
  4. In determining whether D has exercised reasonable care and diligence, one must ask what ordinary person with knowledge and experience of D might be expected to have done in circumstances if he was acting on own behalf
  5. But, under implied term in contract of employment, ED taken to exercise care and skill of person in his category of appointment
  6. Although standard of reasonable care is generally said to be that of an ordinary prudent person, there is some suggestion Ds of professional trustee co owe higher duty
  7. In determining whether D has breached statutory standard, the court will have regard to co’s circumstances, Ds position and responsibilities within co
  8. In accordance with these responsibilities, Ds are required to take reasonable steps to place themselves in position to guide and monitor management of company - see p 376 and Daniels.
  9. D appointed to a co because of special expertise in area of co’s business is not relieved of duty to pay attention to co’s affairs which might reasonably be expected to attract inquiry, even outside area of expertise
  10. At general law D entitled to rely on judgement, info and advice of mgt and other officers appropriately so entrusted BUT such reliance would be unreasonable where Ds know/should have known any facts which would deny reliance on others
  11. Although reasonableness of reliance/delegation must be determined in each case some things may be important in determination of reasonableness - see p 376
  12. General law explains what CA now requires when referring (s 190(2)) to “reasonable grounds” in codifying Ds responsibilities for actions to delegate
    • Section 198D, Ds may delegate powers - delegation must be recorded: s 251A
    • D will be responsible for Ds exercise of power if he did not believe on reasonable grounds and in good faith, after making proper inquiries if circums indicate need for it, that delegate was reliable and competent in relation to power delegated and would exercise power in conformity with duties imposed on D of co by CA: s 190(2)
  13. For purposes of s 180(1) failing to ensure co makes loans only in accordance with its authorised practises and failing to ensure co has proper system of audit in business to avoid defalcation by officers may amount to breach
  14. Where there is transaction involving potential conflict between interest and duty, like here, duty falls to be exercised in context requiring special vigilance, calling for scrupulous concern on part of those officers who became aware of that transaction to ensure any necessary corporate approvals are obtained and safeguards put in place. While primary responsibility will fall on D/officer proposing to enter into transaction, this does NOT excused other Ds/Os who become aware of transaction

ASIC v Rich:[7]

  • Says that wording of phrase in s 180(1)(b) “occupied the office held by, and had the same responsibilities within the corp” appears to be partly intended to make it clear, especially since Daniels v Anderson that no-exec directors are NOT subject to same standard as exec directors, and partly to affirm that standard is an objective one
  • Reference to the “same responsibilities within the corporation” is NOT limited to specific tasks delegated to particular director by formal means such as through the co’s constitution or a resolution
  • Reasonable degree of care and diligence: CANNOT be defined without reference to the nature of and extent of the foreseeable risk of harm to the co that would otherwise arise. No act/omission is capable of constituting failure to exercise care and diligence under the section UNLESS at relevant time it was reasonably foreseeable that harm to interest of the co might be caused by that act/omission
  • Corporations circumstances: consideration must be given to type of co involved; size and nature of its business, provisions of its constitution; composition of the board and distribution of work between board and other officers; status of the co as listed/unlisted entity; and, in case of parent co, size and nature of business of its subsidiaries if they are under the general supervision of the parent
  • Content of requirement of diligence: discusses this content as it applies to both exec and non-exec directors. Here Austin J importantly and interestingly relied on expert opinion evidence as to roles and responsibilities of a MD and finance director. He said that this recourse may be had to such evidence because the objective standard that applies to the duty of care and diligence has regard to the knowledge and expertise of persons in the same recognised calling as person charged with contravention
  • Degree of negligence: NO HIGHER than that which would support claim of negligence at CL
  • Looks at special category of degree of negligence of chairman of board.
  • Here breach of duty resulted from neglecting to observe management, find out actual financial position of corporation and failing to inform board of relevant developments that could adversely affect the corporation

ASIC v McDonald:[8]

  • Facts: ASIC sued EDs and NEDs and non-directors of Hardies. Board said to have approved a press release for ASX - approved draft which said co is “fully funded” (they weren't). ASIC sued them for approving something carelessly - there was no loss, but loss is not needed under the statute. Directors alleged some of them were not there.
  • Held: some duties cannot be delegated. Looks at level of diligence required on part of non-exec director and limits of that director’s ability to rely on expertise of co-directors/management. Non-exec directors cannot abdicate responsibility for a key statement to the ASX concerning a highly significant restructure of the group.
    • Looks at special category of chairman and CEO in degree of negligence.
    • Requirement that judgement be rational was explained as constituting “a requirement going beyond mere grounds for belief and could require identification of the facts and matters upon which any such belief was based”
    • Breach of duty found where voting to approve an announcement to the ASX concerning the corporate groups ability to meet all legitimate present and future asbestos claims, in circumstances where: (in one case) the director ought to have known that it was misleading; (in 2 other cases) the directors had not obtained and familiarised themselves with the terms of the announcement; and (in the case of a director/CEO and of a secretary/general counsel), they failed to advise the board that the announcement was in too emphatic terms.
    • Section 180 not a criminal proceeding - just about one draft press release – handed out huge pecuniary penalty orders and disqualification orders, even NEDS go down.

End

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References

Textbook refers to Redmond, Paul Corporations and Financial Markets Law 6th ed, 2013, LBC.

  1. Textbook, [7.70].
  2. Textbook, [7.75].
  3. Textbook, [7.80].
  4. (1995) 37 NSWLR 438.
  5. (1994) 11 WAR 187.
  6. [2002] NSWSC 171.
  7. [2003] NSWSC 287.
  8. [2009] NSWSC 287.
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