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How concerned should directors and officers be about their potential liabilities?

It is a reality of the late 20th century that directors and officers of companies face numerous potential liabilities. The Companies Act has served to emphasize this reality. Directors and officers therefore need to be very concerned about potential liabilities. Prior to the Companies Act, directors already owed fiduciary duties and duties of skill and care to their companies. The Companies Act codifies these duties. It also reinforces and extends these duties in various ways. It is also very significant that the Companies Act increases the range of persons to whom directors are made accountable for breaches of their duties.

What are the directors' duties?

The Companies Act describes the overriding fiduciary duty of directors as being to act honestly and in good faith and in the best interests of the company. A breach of this duty usually involves the director doing something that he should not have done at all. The Companies Act also requires a director to exercise the degree of prudence and skill that a normally prudent person would exercise in comparable circumstances. A breach of this duty usually involves the director doing badly something that he may legitimately do.

The Companies Act enforces and supports these general duties owed by directors by a variety of more specific statutory provisions.

For example, directors may be made jointly and severally liable for:

·       authorising the issue of shares for a consideration other than money if the consideration received is less than fair;

·       permitting certain transactions (such as financial assistance, share redemptions, dividends or indemnities) when there are grounds for believing that the company is insolvent;

·       "oppressive conduct" by a company, its affiliates or directors.

To whom are the directors' duties owed?

The Companies Act substantially increases the range of persons to whom directors are made accountable. While most directors' duties are owed to the company itself, the Companies Act provides for a "derivative action" that allows shareholders and others to sue directors on behalf of the company. In some situations, directors are made directly liable to persons other than the company. For example, in relation to insider trading, a director may be liable both to persons who suffer a direct loss and to the company for any benefit received by him. The liability faced by directors where they are found to have been engaged in "oppressive conduct" probably includes liability to shareholders, creditors and others.

What are the directors' duties and liabilities in situations of possible company insolvency?

Directors always operate under their overriding fiduciary duty to act honestly and in good faith and their duty to exercise skill, diligence and care. However, specific duties and potential liabilities arise in the context of any possible insolvency. In particular, whenever questions arise about the solvency of a company, it is necessary to ensure that the company does not:

·           Unfairly incur new debts and obligations which it will not be able to meet; or

·           Engage in transactions which further prejudice its ability to meet its obligations.

As under the former Companies Ordinance, the court can impose personal liability on directors, officers and others for continuing to trade fraudulently or in reckless disregard of whether the company is able to meet its liabilities. The Companies Act also prohibits specified transactions where a company does not satisfy various prescribed solvency tests. Directors who authorise any such transaction are exposed to personal liability.

Directors need to be able to:

·           Recognise those transactions which are prohibited unless the relevant solvency test is met;

·           Ensure that the appropriate solvency test is properly applied; and

·           Take all available steps to minimise their own exposure to personal liability.

Which transactions are prohibited unless a solvency test is pursued?

Unless the company can pass the relevant solvency test, the Companies Act prohibits certain transactions. These are:

·       Making a payment to purchase, redeem or otherwise acquire the company's own shares;

·       Reducing the stated capital, except for the purpose of declaring its stated capital to be reduced by an amount that is not represented by realizable assets;

·       Paying a dividend;

·       Providing financial assistance (including loans and guarantees):

§      to a shareholder, director, officer or employee of the company or any associated company or to any associate of such person, or

§      to anyone for the purpose of, or in connection with, the purchase of shares of the company or an affiliated company; and

·       Paying to a shareholder any sum ordered in an action commenced to remedy "oppression".

How do the solvency tests work?

Each of the solvency tests is in two parts. For example to pass the solvency test prescribed for the payment of a dividend, the company must be able, after the payment of the dividend, to meet its liabilities when they become due; and the realizable value of its assets must exceed the aggregate of its liabilities and stated capital. The first limb of each of the solvency tests is the same. However, the second varies depending upon which of the transactions is being considered.

What are some of the things a director can do to avoid liability in situations of questionable solvency?

Directors need information to avoid trading while insolvent and to apply the entire range of solvency tests imposed by the Companies Act. They should:

·       See that the company's books are kept in accordance with modern accounting standards;

·       Ensure that they are kept informed of the company's financial situation by an officer of the company on whom they can reasonably rely;

·       Identify the key factors which could lead to insolvency; and

·       Ensure that they are informed as soon as possible about changes which have occurred, or may occur, in relation to those key factors.

 

If a director believes that the company may be, or may become, insolvent he should also:

·       Check that all steps have been taken to protect the directors by obtaining appropriate indemnities and insurance cover;

·       Take immediate steps to get the information and professional advice necessary to decide whether to continue trading;

·       Ensure that no specified transaction is approved unless the company passes the appropriate solvency test;

·       Consider whether or not to resign, weighing the risks associated with resignation against the benefits;

·       Bear in mind that he can protect himself from liability by relying in good faith on the company's financial statements represented to him by a company officer and on a report of a professional (including an attorney, accountant and appraiser); and

·       Consider whether a unanimous shareholder agreement (a USA) can be used to protect the directors from liability.

What defences are available to protect directors?

Even if a director is prima facie liable for breach of one of the duties imposed, there are a number of conditions and limitations imposed on liability which may provide protection in appropriate cases. For example, a director will not be liable for permitting any of the specified transactions (such as financial assistance, share redemptions, dividends or indemnities) when there are grounds for believing that the company is insolvent, if he relied in good faith upon:

·       financial statements of the company represented to him by an officer of the company; or

·       a report of an attorney-at-law, accountant, engineer, appraiser or other person whose profession lends credibility to a statement made by him.

The Companies Act has also retained a section from the former Companies Ordinance (which does not exist in the Canadian legislation and was not in the Companies Act 1995 until the recent amendments) which provides important protection to directors, officers and auditors. This allows the Court to relieve such persons from liability (wholly or partly) if they have acted honestly and reasonably and, having regard to all the circumstances, ought fairly to be excused.

Can a company indemnify or insure a director against personal liability?

Provision is made for a company to indemnify directors, and to obtain insurance for them, but only in circumstances where they have acted honestly and in good faith and in the best interests of the company. In specified situations there are additional requirements for a director or officer to be indemnified, i.e.

·       where his liability arises out of criminal proceedings or administrative actions that are enforced by a monetary penalty, he must also have had reasonable grounds for believing that his conduct was lawful; and

·       where his liability arises out of a "derivative action", court approval for the payment of an indemnity must also be obtained.

What steps should directors take to secure an indemnity?

Generally speaking, the Companies Act merely allows a company to indemnify a director or officer against personal liabilities but does not require the company to do so. For a director or officer to require an indemnity to be given to him, there must be some positive obligation imposed on the company to provide it.

 

In Canada it is normal for a company's by-laws to provide that it must indemnify directors and officers if the requirements of the by-laws are met. This practice should usually be followed when continuing an existing company under the Companies Act and when incorporating a new company.

 

A director or officer should never assume the existence of the appropriate By-law, but should look into it and ensure that it is as broad as possible. This should be done as part of accepting an appointment and when any important change occurs, such as continuation under the Companies Act. If a director or officer is not satisfied, he should consider resigning. Directors and officers should also take the extra step of getting an express contractual right to an indemnity. This eliminates technical hurdles about enforcing the non-contractual By-laws. It also ensures that the company cannot unilaterally change the right to the indemnity.

 

There are provisions in the Companies Act which require a company to indemnify directors and officers in specified circumstances, even where there is no By-law or contract to that effect. This right arises under the Companies Act where the director or officer is substantially successful on the merits of the claim and the same "good faith" requirements are met. This provision reflects the fact that if substantial success is achieved, the director or officer should be indemnified.

 

If a person is nominated by a shareholder to be a director of a company then before accepting such an appointment it would be wise to seek an indemnity from such shareholder who could offer an indemnity in wider terms than that which the company could give and hopefully the nominating shareholder would have a deeper pocket.   

What are the advantages of obtaining insurance?

Although insurance cover is only available subject to the same "good faith" requirements as apply to indemnities, it is advisable that it be obtained. The reason for this is that an indemnity is of little value if the company that is to provide it has become insolvent. Insurance cover is particularly useful because many instances of director's liability arise in circumstances where a company is insolvent. It is also important to note that the coverage and exclusions under a policy of insurance must be carefully reviewed, as there may be restrictions in the policy beyond the "good faith" requirements imposed by the Companies Act.

 

 

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