Skip to Content »

Do we need a ‘balance’, or a rule, on director liability?

  • November 13th, 2014

This afternoon I will present to a group of lawyers who’ve been sold a seminar session that knocks off their full 10 points worth of annual Continuing Professional Development in one day.

I hope some will be interested in policy because I’m struggling to see how I can make a bare legislation update interesting, to people there under compulsion, not intellectual or professional curiousity.

With luck I’ll be drawn into argument over what the courts are telling us on directors.

We’re all now floundering without a compass in the fog of company law. Confused legislation, and conflicting judicial approaches mean lawyers can’t confidently tell directors what is left of the ‘business judgment’ rule. It was not complicated in the recent past. It said that judges should not second guess business decisions in the absence of evidence of bad faith or gross negligence.

That was then. Now directors plow shareholders’ millions into buying legal ‘sign-offs’. Subjecting business decisions to lawyer reassurance brings lawyers into the heart of hundreds of businesses that would rarely have talked to a lawyer 3 decades ago. Yet the Lombard case showed that clean sign offs may not be enough.

Despite the high profile cases, not many directors have been held liable. Even fewer have had to pay material sums. But being sued is immensely costly and outcomes are unpredictable. Directors have heard that D & O policies may be invalidated, or not cover legal costs.

So director liability cases sow disproportionate fear. They justify universal investment in rituals of overt diligence to placate the unpredictable judges.  Sign-offs are bought at the cost of shareholders, not the directors. So director liability law is profitable for lawyers and insurers.  Yet the apparent ‘failure’ of prosecutions, and the absence of any New Zealand equivalent to the multiple century ‘die in jail’ sentencing we read about in other jurisdictions lead to deep disappointment from lay people. Court cases which may be a crippling waste of money and initiative can still  fail to build investor confidence. The rarity of useful recovery of investor money in court cases makes them seem farcical to investors who’ve been lead to expect more than law can deliver.

Chapman Tripp and Russell McVeagh have recently turned their fog lights into that fog. Chapman Tripp congratulates Parliament for passing something that was not as stupid as first introduced. Russell McVeagh draws atttention to an Australian court decision that highlights how much (probably unintentional) risk our directors face from recent poorly written reform, which Australian directors are now better protected from.

Jim Farmer QC reflects on his experience defending the Lombard directors. He penetrates further than most commentary, though without showing much more than silhouttes. He draws on the respectable scholarship that our courts ought to discuss, but have not..

Farmer sets the scene referring to the constant and ludicrous cry of the regulators for

…” shorter and simpler offer documents”.

He goes on:

“Having defended the directors of Lombard in their unsuccessful appeals in the Court of Appeal and Supreme Court (except as to sentence in the latter), I find that objective and, generally, the cry for less time on compliance one that has a major disconnect with the views of the Judges, which can be broadly summarised as a need for more, not less, detail.  

This may be the inevitable outcome of the statutory provision in the Securities Act that empowers the Court to find a statement misleading and untrue by omission but it is also a reflection of the way in which Judges, who seldom have practical commercial or board experience themselves, interpret that provision.  While there is invariably judicial denial that hindsight is being applied, the fact of a corporate collapse and the sense that someone within the company must be to blame – rather than external events beyond the company’s control – puts directors at risk when the offer documents are later subjected to close judicial scrutiny.”

The paper helpfully traverses the origins of company law, and the unique features that made it a key to the Anglo-sphere leaving competing economies behind. But curiously it does not highlight the key protection created by the classical era judges which modern legislators and judges have discarded. Perhaps even the best of the current judges and commentators do not remember what we’ve dumped, if  Farmer’s paper is a guide.  He does not highlight the importance of losing the distinction between dishonesty on the one hand, and foolishness or carelessness on the other. The law once assured ‘stakeholders’ it would not forgive directors who were dishonest, or who feathered their own nests at the expense of the company, but on the other hand (with some anomalous exceptions) it broadly told stakeholders not to come crying over spilt milk for losses from poor choice of directors, including if they were incompetent or negligent.

Farmer refers to

..”the famous case of Re City Equitable Fire Insurance Company in the English Court of Appeal in 1925 where it was allowed that directors’ duties had to be viewed, first, in the context of the particular business carried on by the company and, secondly, the manner in which the work of the company was distributed between the directors and management.  The Court also said that regard should be had to the fact that directors’ duties were of an intermittent or part-time nature to be performed at periodical board and board sub-committee meetings.”

He calls on judges to revive that kind of balancing assessment.

I think another approach is more likely to bear fruit. Judges already think they are balancing risks, where the legislation allows.Some show pride in decisions that require directors to continually ‘up their game’. They think they are doing God’s work in making it risky for people to take on directorships who can’t penetrate the mysteries of modern compliance accounting. They feel particular virtue in discouraging sleeping directors, and house-hold name appointments.

I’ve seen no evidence that any modern judge or legislator has taken into account the highly respectable scholarship that suggests that directors should be sleeping stewards,  lest they have a dog, and bark as well. That view of proper directorship is particularly important to justify the near universal pattern in small companies, where it would be absurd for directors to try continually to follow the activity of their general manager. Directors are often appointed solely as a probity backstop. They do their job well if they  come awake only when an agency risk is likely to materialise (the risk of management diverting company resources to their own benefit) or when it is time to change management.

Instead some judges, too many journalists and most regulators (many of them of the lawyer/cleric persuasion) may take at face value much of the voluminous ‘governance’ dogma. It seems designed to make out of directing a full time, licenced craft and mystery. It requires directors to set strategy, to oversee accounting and other compliance activity, to second guess and engage with management in myriad ways.  For many companies and investors that may now be their reasonable expectation. But that  hands on governor model has not been shown to be value adding.  It has no more empirical research foundation than ‘angels on the head of a pin’ theology.

When invited to consider whether  extra liability and diligence is efficient our judges/regulators have no tools for considering the question. Several I’ve discussed this with are puzzled by the argument that directors will demand part or, or much of the return that should be going to shareholders, if they face the asymmetric risk (having to reimburse for losses, but not receiving the gains of efficiently risky decision-making).  They understand that having to compensate shareholders (or creditors) for risk decisions necessarily made under the uncertainties of time pressure, inadequate information, and competing priorities, could be problematic, but they miss completely the significance of not sharing in the upside of such decisions that prove profitable. The director’s incentives when faced with asymmetric risk are to over-invest in precautions, especially when the cost can all fall to the account of the company (shareholders).

So a  key need is to re-establish for the clerical lawyer class the moral/economic  underpinning of classically efficient rules, such as caveat emptor, and the ‘business judgment’ rule.

Farmer’s piece heads in the right direction. But it should have a simple concluding paragraph.  There is no point in  calling for ‘balance’ from judges un-equipped to work through the factors. So we’d be better to revert to the bright-line rules of more simple days (simple rules for a complex world).

In brief:

  1. Limited liability is not a privilege – it is efficient standard form contracting for allocation of the inevitable risks of loss in a business world where we know, and want, to allow for an infinite range of decision modes, ranging from simple intuition, to the most highly systematic and researched decision – making.
  2. director liability should be swift and ruthless for dishonesty. Current law is disgracefully slow, and expensive in maintaining the right levels of risk for dishonesty;
  3. There may be a category of negligence so wanton that it would be efficient to characterise it as deemed breach of the duty of good faith (call it recklessness as to the outcome for others).
  4. But otherwise shareholders accept the consequences of mistakes in the selection of directors, and directors honest mistakes or derelictions, as just one species of the risks of investment, among all the much bigger ones they accept when gambling on the unknown future;
  5. More specific ex ante allocations of risk can be matters of contract (including the Articles or constitution of the company) which can vary for the circumstances of each company.

Leave your comments:

* Required fields. Your e-mail address will not be published on this site

You can use the following HTML tags:
<a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>