Dialogue: Directors' duties still allow leeway to take risks

By ROSS DILLON*

Directors have been described as the mind and will of the company.

A director must lead the company and control how it is to operate.

This involves employees and resources - the company itself firstly, with other rights vested in financiers, creditors and a residue of rights with the shareholders.

So directors are dealing with other people's money and other people's lives.

There is always a problem when one person is dealing with the property or interests of another, namely an all-too-human tendency to take less care of someone else's interests.

The courts have developed duties to address this problem. The main ones carried forward into the Companies Act 1993 are:

* The duty to act in good faith for the benefit of the company as a whole ( ie, not for the director's own benefit, or the benefit of a big shareholder, or shareholders as against employees or creditors).

* The duty not to steal company property.

* The duty to be careful in decision-making.

* The duty not to act where there is a conflict of interest, without the consent of the board of directors.

This is an interesting duty, given the qualification. Someone on the board of a company that borrows money can be on the board of the lender and vote on sensitive issues between those two, provided the company is aware of the conflict.

New Zealand is one of a few countries that allow this, presumably due to the limited pool of people who are able and likely to be directors. Conflicts of interest are much more likely in a small country.

Where these rules are breached, the transaction involved can be impeached only to the extent that the company did not receive fair value from the arrangement.

* The duty not to profit from personal dealing with the company (again, unless consent is obtained). This duty is qualified in the same way as the conflict-of-interest duty. It is a similar issue.

* The duty to exercise powers only for proper purposes. This has been the subject of a variety of judicial decisions, but in general terms it means in the interests of the company. A new issue of shares made to defeat a takeover offer has been held by the courts to breach this duty.

* The duty to act in accordance with the company constitution. The constitution spells out in detail how the company is to operate.

* Finally, there is an inter-related set of statutory duties, which often become the focus of attention when things go wrong. These are:

* The duty to exercise the care, diligence and skill of a reasonable director, given his or her responsibilities. For instance, the director responsible for financial control must keep the books up to date.

* The duty not to trade recklessly. This has associated with it the duty not to incur a liability when the director believes it cannot be paid.

This is not a test of insolvency.

Insolvency is often the focus of comments when a company ceases trading, but it is not directly related to directors' duties under law.

Directors can continue to trade a company while it is insolvent, even for some time.

They do not have to put the company into liquidation once it is insolvent, but they must have a reasonable basis for believing that it will trade its way out of problems.

Finally, there is a duty under the Financial Reporting Act 1993 to prepare proper financial records.

It is obvious that in order to direct the company, directors must check its financial health to see what it has been, and may be, capable of.

In performing all these duties, directors are entitled to rely on reports they have commissioned, enabling them to form decisions. Thus the director responsible for finance can rely on information provided by the accountant.

However, the director must be satisfied that the accountant is up to the task.

These duties often involve little more than to be informed and act reasonably in relation to that information. If directors are not informed and make a wrong decision, they might face personal liability.

The Companies Act 1993 provides that directors will be personally liable for the debts of the company if proper accounting records have not been kept and this failure contributed to the company collapse.

If the directors did not know that a product line was not making money because they did not have sufficient records, they might be personally liable for the loss should the company collapse.

But it must be proven that the directors' failure caused the collapse.

The regulation of directors' actions is designed to give them wide discretions, to allow them to direct the company to take on commercial risk.

A wide mix of types of liability are imposed to balance the exercise of those discretions against other interests (consumers, employees, shareholders, financiers, creditors and the general public) while preserving the benefits that arise from the operation of the limited liability company structure.

How well have directors in New Zealand exploited their opportunities?

One answer is to consider the number of times directors are successfully sued for breach of their duties. My own view is that there are few successful cases against directors of public listed companies.

But a survey on that basis measures a negative indicator (litigation risks) rather than the positive sign of commercial success.

The best answer to the question is to consider the judgment of the sharemarket itself. A generally good performance will be reflected in buoyant share prices, evidencing confidence in the future performance of companies and their directors.

Over the past four years, the average results have been poor. But the Herald graph of the market over the past 12 months, making due allowance for the tragic events of September 11, indicates the markets' opinion that the downward trend has been arrested, if not yet reversed.

While individual companies may have performed well (and full credit to them), the average performance looks to have bottomed out.

Better times ahead? We all hope so.

* Ross Dillon is a partner in legal firm Gaze Burt and advocacy director of the NZ Shareholders' Association.