DIRECTORS' DUTIES OF CARE

• Published date: 01 December 2011
• Date: 01 December 2011
• Author: John H FARRAR LLB (Hons) (University of London), LLM (University of London), LLD (University of London), PhD (University of Bristol); Emeritus Professor of Law, Bond University; Professor of Corporate Governance, University of Auckland.

Issues of Classification, Solvency and Business Judgment and the Dangers of Legal Transplants

In the Anglo-American world and Singapore, the duties of care of directors developed in equity, statute and common law. This leads to complications. Some jurisdictions now have a business judgment rule which gives directors immunity from suit by the company if certain conditions are fulfilled. The question is whether the rule can be transplanted, what are the consequences and in particular what should be the relationship with insolvent trading.

I. Introduction

1 The duties of care of directors in the common law world are

complicated by reference to history and the untidy way in which the law has developed.1 The original duty of care arose in equity and pre-dated

common law negligence. In Australia, Malaysia and Singapore, the next stage of development was the adoption of a statutory duty of care. Unlike other jurisdictions like Canada, New Zealand and the UK, this was not a restatement or codification of the law. Originally, breach was the subject of a criminal penalty and this is still the case in Singapore and Malaysia. In Australia, the criminal penalty has been dropped but a breach is still a subject of a civil penalty. More recently, Australian courts have recognised a common law duty of care and the assumption has been that this effectively supersedes the equitable duty of care. This, however, is not necessarily so and there are some differences. In Australia and now Malaysia, all three duties of care are subject to a statutory business judgment rule. This provides that in the case of a business judgment as defined, provided that four conditions are fulfilled, directors are immune from liability to the company for negligence. However, this does not apply to a failure to prevent insolvent trading. South Africa and Germany have also adopted their own versions of a business judgement rule.2 The problem is that none of these jurisdictions seems to have adequately considered the complex and significantly different context of the business judgement rule in the US, a country which has Chapter XI in its Bankruptcy Act and a culture which is much more tolerant of lack of liquidity and strongly focuses on business rehabilitation. It also has an active Bankruptcy Bar from whom the federal bankruptcy judiciary is chosen. Chapter XI, which was originally designed for small firms, enables a company with liquidity problems to trade its way back to solvency under court supervision.3 Insolvent trading as such does not lead to draconian penalties. The business judgement rule, which pre-dates the pro-debtor bankruptcy provisions, is basically a pro-business rule which is an abstention doctrine on the part of the courts.4 The common theme between them is recognition of the legitimacy of entrepreneurial risk taking, absent fraud and self-dealing. Another matter which further complicates the situation in Australia is the adoption of prudential regulation for deposit taking institutions and insurance companies by the Australian Prudential Regulation Authority, which deals with appointment of directors, risk taking and liquidity and adds more rigorous standards for directors in those sectors.5 These prudential regulatory standards have not been adequately promulgated and bear a complicated relationship with the law. This article will consider first the three duties of care and their consequences; secondly, the relationship between the duties of care and insolvent trading, and the relationship of these to the prudential regulatory standards; and thirdly, the impact of the business judgment doctrine and business judgment rule.

II. The duty of care in equity

2 The original development was in equity and the locus classicus on the duty and standard of care has long been the judgment of Justice Romer at first instance in the English case of Re City Equitable Fire Insurance Co Ltd6 (“Re City Equitable”) in 1925. This pre-dates Donoghue v Stevenson.7Re City Equitable was a long judgment involving a case of investigation of fraud in the winding up of an insurance company. The company had been defrauded by its managing director, Bevan, who was convicted and sentenced. A misfeasance summons was brought by the liquidator to make the other directors liable for negligence in respect of losses occasioned by investments, loans and the payment of dividends out of capital. Justice Romer found that the directors were guilty of negligence in certain respects but were exonerated by a provision in the articles in the absence of “wilful neglect or default”. Such clauses have since been outlawed. Justice Romer laid down a number of propositions of law which were accepted by the Court of Appeal and later followed but which have increasingly been called into question.

A. Proposition 1

In discharging the duties of his position … a director must, of course, act honestly; but he must also exercise some degree of both skill and diligence.[8]

3 In Re Brazilian Rubber Plantations and Estates Ltd,9 Justice Neville said of a director of a rubber company:

He is not, I think, bound to take any definite part in the conduct of the company's business, but so far as he does undertake it he must use reasonable care in its dispatch. Such reasonable care must, I think, be measured by the care an ordinary man might be expected to take in the same circumstances on his own behalf.

4 This seems to lay down an objective test for the standard of care but there is no reference to risk. It is clear from the other three propositions laid down by Justice Romer that some characteristics of the particular director could be taken into account. Note also the equivocation between care, skill and diligence in the judicial usage.

B. Proposition 2

A director need not exhibit in the performance of his duties a greater degree of skill than may reasonably be expected from a person of his knowledge and experience. A director of a life insurance company, for instance, does not guarantee that he has the skill of an actuary or a physician … [D]irectors are not liable for mere errors of judgment.[10]

5 It is difficult, if not impossible, to formulate a single objective duty of skill for company directors as there is no common body of knowledge shared by company directors. It is difficult to regard company directorship as a separate calling.

6 One final point is on the question of skill. A director acts as a member of a group, the board. What is required is not so much a skilful director as a skilful board. Different members may be chosen for different skills and, in some cases, their personal qualities of integrity, common sense and judgment, which are not skills as such.11

C. Proposition 3

A director is not bound to give continuous attention to the affairs of his company. His duties are of an intermittent nature to be performed at periodical board meetings, and at

meetings of any committee of the board upon which he happens to be placed. He is not, however, bound to attend all such meetings, though he ought to attend whenever, in the circumstances, he is reasonably able to do so.[12]

7 Although this proposition indicated a lax standard, it did in fact tighten up existing law. Nevertheless, Justice Romer's dicta represent a more lenient approach than would be tolerated today. Directors are now regarded as being subject to a positive obligation to keep informed about the affairs of a company.13

D. Proposition 4

In respect of all duties that, having regard to the exigencies of business, and the articles of association, may properly be left to some other official, a director is in the absence of grounds for suspicion, justified in trusting that official to perform such duties honestly.[14]

8 This is a maxim of common sense but the extent of delegation depended on the type of company and the nature of the business.15 The extent of delegation had to be reasonable and there seem to be some duties which a director cannot delegate.16 In Australia and New Zealand, delegation is expressly dealt with by statute.17

9 An interesting question is whether the equitable duty of care is fiduciary. Clearly it attaches to an office which is fiduciary but this does not necessarily make every duty of a director fiduciary. In Permanent Building Society v Wheeler,18 Ipp J thought that it was equitable but not fiduciary. In an interesting extra-judicial paper, Justice J D Heydon19 considers the contrary, that is that it is an equitable and fiduciary duty

of care and that this has consequences for causation, remoteness, limitation and proprietary remedies.20 However, the weight of authority seems to be against this view.21

III. The statutory duty of care

10 Until recently it was not the practice of UK legislation to

include the general duties of directors. The first jurisdiction to include a provision was the Victorian Companies Act 1958 which provided the model for the Uniform Companies Acts 1961–1962. These in turn were followed in the Singapore and Malaysian legislation. This survives in s 157 of the Singapore Companies Act22 which provides as follows:

(1) A director shall at all times act honestly and use reasonable diligence in the discharge of the duties of his office.

…

(3) An officer or agent who commits a breach of any of the provisions of this section shall be –

(a) liable to the company for any profit made by him or for any damage suffered by the company as a result of the breach of any of those provisions; and

(b) guilty of an offence and shall be liable on conviction to a fine not exceeding $5,000 or to imprisonment for a term not exceeding 12 months.

(4) This section is in addition to and not in derogation of any other written law or rule of law relating to the duty or liability of directors or officers of a company.

11 This was based on s 124 of the Australian Uniform Companies Act 1961. The Australian wording was changed in s 232(4) of...