What are the risks of being a company director

The starting point with limited companies is that the company is a separate legal entity from those that own it (the shareholders) and those that manage it (the directors). In most situations it is difficult for a 3rd party to “pierce the corporate veil” and successfully make a claim against directors but this does not tell the whole story. In an increasing number of scenarios, because the directors have day to day control of a company, they are subject to potential statutory (criminal as well as civil), or common law liabilities for directors.

All company directors should ensure they are aware of potential personal liability, act accordingly, and consider ways in which to protect themselves legally.

The following are some of the most important risks for directors:

Health and Safety

Responsibility for health and safety is primarily the responsibility of the company and not individual directors but where a company commits a Health and Safety offence and directors have consented or connived with the commission of that offence of a director or been demonstrably negligent causing the offence, the director may be liable to be prosecution under section 37 of the Health and Safety at Work etc Act 1974 which carries a maximum sentence of 2 years  in prison and an unlimited  fine. He or she may also be disqualified from being a director for a period of time (section 2(1) of the Company Directors Disqualification Act 1986).

Bribery Act

The Bribery Act 2010 contain some very harsh provisions against directors. In essence, directors can face criminal liability, including very sizeable fines, even where they have done nothing to encourage or countenance bribery or corruption and weren’t even aware of it. The Act places positive obligations on directors to take all reasonable steps proactively to prevent bribery and corruption. The starting point for any company will be based on having appropriate policies and training for staff but ongoing risk analysis, compliance monitoring and other initiatives are also necessary. The larger the company the more the directors will be expected to do to comply and businesses which trade internationally or in sectors which are more prone to corruption are expected to be especially vigilant.

Insolvency

The Insolvency Act 1986 contains various provisions for director wrongdoing. Although they only apply when a company has gone into liquidation (so therefore do not apply to administration and this is a reason why in some situations creditors will ensure as a matter of principle that a company is liquidated so that directors they suspect of wrongdoing will be investigated)  they relate to the conduct of the directors before the liquidation.

Section 214 – Wrongful trading

A liquidator may apply to court for an Order that a director be found personally liable to replace company’s assets where the director knew or ought to have concluded  there was no reasonable prospect the company would avoid insolvent liquidation and he or she has failed to take appropriate steps to minimise potential losses for  creditors.

Section 213 – Fraudulent trading

Intent to defraud may be inferred if a person obtains credit knowing or suspecting that there will be no funds to pay the debt. If proven the director will, in addition to being liable to contribute to the company’s assets, be guilty of a criminal offence.

Section 212 – Recovery for misfeasance

The liquidator, a creditor or a shareholder can sue for damages where directors have misapplied or retained or become liable or accountable for any money or property of the company. This would include, for example, improper payments of dividends, using money for personal gain such as loans or excessive salary.

Sections 238 – Transactions at an undervalue

A transaction at an undervalue occurs where, in the 2 years prior to the company going into liquidation, assets are disposed of for significantly less than they are worth.

Section 239 – Voidable Preferences

A preference, which is liable to be set aside, occurs where one or more creditors receive preferential treatment to other creditors in the 6 months prior to liquidation (the period is 2 years if transactions under suspicion are with related entities such as shareholders or connected companies). The liquidator can apply to have transactions set aside but must prove that the directors acted with a desire to prefer creditors over others.

Disqualification

Directors who are found to have been involved in wrongdoing associated with insolvency, such as described above, may face disqualification, which in severe cases, can be for as long as 15 years.

Personal guarantees

In many small companies, especially those without a successful track record and history, it is very difficult to obtain finance without the directors giving personal guarantees.

In addition to the obvious risks of personal liability based on a default, many bank guarantees contain aspects which are not immediately obvious and which create additional risks. These include :-

• Most guarantees are drafted as providing continuing security, meaning the guarantee is not automatically cancelled even if it was taken out to guarantee a particular loan which has been paid off., The guarantee  will continue, unless cancelled,  and will apply automatically to other borrowings the company has with the lender.
• The amount owed potentially rising, including interest and possibly costs – if possible, it is always worth seeking to cap liability to a fixed amount.
• Personal Guarantees can be cumulative. If you have signed a guarantee and are then asked to sign a new guarantee for a higher amount, you may well be liable for both amounts.
• You should not assume, if other directors have also signed personal guarantees, that the bank will only expect you to pay back an equal proportion to others who have given guarantees. The lender may pick and choose who it goes against and has no obligation to be fair. When several directors give guarantees, indemnities should be considered between them so that if not all are proceeded against by the lender, those that aren’t are liable to repay the guarantors who have been pursued and have paid out.

What can directors do to protect themselves from all these risks?

• Remain aware, vigilant and professional at  all times – keep up with the law
• Obtain legal and other advice when unsure of the implications of a situation in the company
• Document decisions and decision making processes to show a proactive and reasonable approach to issues
• Act with honesty, integrity and reasonableness at all times – this of itself can constitute a defence to most potential liabilities for directors.
• Seek an indemnity from the company against any financial liability or costs of defending criminal or regulatory proceedings.
• Obtain Directors & Officers Insurance although be aware that, as with any insurance policy, there may be exclusions for some matters and the policy may be voided by dishonesty, criminal activity and so on.

You have probably seen lots of articles and webinars hammering on about directors’ duties.

You are left feeling slightly depressed about the idea of becoming a director. Or maybe you are one already and wondering if it’s really worth it.

There are recurring topics when it comes to risks of being a Director.  You will have heard about the Mainzeal case [1]  and perhaps also Debut Homes [2].  In both cases, directors were held to be in breach of their duties under the Companies Act 1993. They were, as you probably know, pinged heavily for their failures.

Like much media reporting, the headlines can be scarier than the detail. So perhaps it’s time for some good news.

Make no mistake, recent law tells us that we need to be fully alert when carrying out our duties as directors.  There is no excuse for not being well aware of the law (and if you haven’t read these cases, then at least find a good summary and get on with it.)

However the good news is that the Companies Act itself provides some relief from what some of the doom merchants are saying.

The good news starts by having a closer look at the long title of the Companies Act which says:

An Act to reform the law relating to companies, and, in particular,—

• to reaffirm the value of the company as a means of achieving economic and social benefits through the aggregation of capital for productive purposes, the spreading of economic risk, and the taking of business risks; and

• to provide basic and adaptable requirements for the incorporation, organisation, and operation of companies; and 
• to define the relationships between companies and their directors, shareholders, and creditors; and 
• to encourage efficient and responsible management of companies by allowing directors a wide discretion in matters of business judgment while at the same time providing protection for shareholders and creditors against the abuse of management power; and
• to provide straightforward and fair procedures for realising and distributing the assets of insolvent companies.

If you look at the underlined bits, you will see that Parliament itself has affirmed the value of the company as an essential engine to carry out “economic and social” policy in our country. It accepts the taking of “business risks”.  If you are a director you are allowed “a wide discretion in matters of business judgement”.

But it’s a balancing act: This policy and the latitude allowed must be held in clear tension and balance with the “protection for shareholders and creditors against the abuse of management power”.

Why is this good news?  Fundamentally, it gives a strong direction to Courts to allow for sensible business risk.  But at the same time it strongly indicates what is not sensible. It prescribes boundaries, beyond which you as a director ought not to go.  If you are in danger of heading over a boundary line, then you will have some clear choices to make.

The comfort this gives is that it will ensure that Courts are not quick to find small discrepancies and whack the directors too readily – otherwise the fundamental purpose of the Act is undermined and a major policy for the successful operation of business and social enterprise is undermined.  There is and must be scope for risk taking.

What are the reasonable limits to the scope of risk?

Now this is where it might get a bit dull, but it is important.

Solvency is the issue – the touchstone.

Section 4 of the Act sets out two types of solvency:

• Trading solvency – the requirement that the company is able to pay its debts as they become due in the normal course of business;
• Balance sheet solvency – the requirement that the value of the company’s assets must be greater than the value of its liabilities, including contingent liabilities.

You as a director must have a “sober assessment” on an ongoing basis as to the company’s likely future income and prospects.  Not all directors are financially minded or trained (some are there for other skills).  Such directors need to make sure they are getting reliable and current summaries from those who are financially literate.

The three key duties that you have as a director are:

• You must act in good faith in what you believe to be the best interest of the company (section 131);
• You must not agree to cause or allow the company’s business to be carried on in a manner that is likely to create a substantial risk of serious loss to the company’s creditors (section 135);
• You must not agree to the company incurring an obligation unless you believe at that time, on reasonable grounds that the company will perform the obligation when it is required to do so (section 136).

In a nutshell here is what the Act is trying to put the brakes on:

1. Directors making decisions (or avoiding decisions) that are likely to result in people beyond the shareholders suffering loss e.g. creditors. Its one thing for the company to put its own funds at risk (including shareholders contributions), but it’s quite another for the company to begin to put third parties at risk.  The law may accept the former as a reasonable “business risk”. But it may view the latter as an “abuse of management power”.
2. Directors making decisions to avoid their own personal guarantees being called on. As a director you may have entered into a personal guarantee to support the company borrowings or other commitments e.g., a lease. Again the law takes a dim view of any action you take as a director which is more about you protecting your guarantee and less about protecting third party creditors or even shareholders.

If you are facing a doubtful situation what should you do?

• Resign? That may be your only option.  Merely voting against a dodgy proposition may not be enough in the longer term.  Raising issues at a board level and giving the board a reasonable time to change its stance may be a reasonable position. However if the company continues to sail on into troubled waters, contrary to your views, then you must act.
• Trigger insolvency regimes? That may well be the alternative to the above but is fairly rarely done by directors in New Zealand.  It is more common to hear the view that a director continued on the board in the hope of “rescuing” its direction.  Again, this is a doubtful strategy.

Directors’ and Officers’ liability insurance.

This sort of insurance is highly advisable for most trading companies.  (You can’t have any such insurance if you don’t have a constitution – this is discussed more here).

As a director you may be well aware that you have a policy and may even know what the total cover is. But are you aware of other essential details such as:

• The notice provisions and how soon the insurer must be notified for the policy to be effective?
• Whether the defence costs under that policy are adequate in today’s climate? In particular make sure the defence costs, of any action that you are relying on, are separate from the liability costs – something that some directors have in the past found out wasn’t applicable – to their considerable cost.
• What is covered and what is not? This seems obvious, but finding out after an insurable event arises, is not the best time to become more acquainted with your policy.

Conclusions

• Company law accepts that business risk is a reality. The Company structure permits a certain degree of freedom;
• Balanced with that, the same law guards against over extending the use of that freedom to trade with other people’s money and not just your own company’s, or to be trading in a way that is more with an eye to protecting your own personal interests (e.g. personal guarantee protection) than that of the company and its creditors;
• So you should take all reasonable steps to be alert and knowledgeable about your company’s financial position and prognosis, put in place appropriate insurance and have the courage to take appropriate steps when you think the company is getting into difficulty.
• Being a director can be a valuable contribution to our country’s economic and social well- being. Don’t be put off by the headlines only. Make your decision to ‘sign up’ based on a bit of solid research-and if you do become a director, maintain that approach throughout.

We have a lot of experience helping Directors, Boards and Companies – if there is something you would like to discuss then let us know.

[1] Yan v Mainzeal Property and Construction Limited (in liquidation) [2021] NZCA 99.

[2] Debut Homes Limited (in liquidation) v Cooper [2020] NZSC 100.