In an age of increasing liability risk, directors and officers are often reminded that it is important to do their “due diligence”. In this third installment of our series on D&O liability in Canada, Samantha Horn and Genna Wood of the Toronto office of Stikeman Elliott LLP consider the concept of due diligence both in a general sense and as it specifically applies to the fulfillment of duties under business corporations law, employment law, environmental law and tax law.
What is a Due Diligence Defence?
Due diligence can be raised as a defence against allegations that a director or officer bears personal liability with respect to the corporation’s non-compliance with a statutory or regulatory requirement. While statutory due diligence defences are formulated in a wide variety of ways, and consequently vary in the scope of their application, they generally apply where a director or officer made adequate efforts to ensure that the corporation would comply with the law, even if, for some reason for which the director or officer cannot fairly be blamed, those efforts may ultimately have failed to prevent such non-compliance. If this sounds vague, it is perhaps unavoidably so: as discussed below, the scope of the due diligence defence varies somewhat from statute to statute and situation to situation.
Can this defence exist even where a statute doesn’t expressly provide for it?
Many statutes expressly qualify some or all of their D&O liability provisions with a “due diligence” defence (even if the term “due diligence” is not always used). However, even where there is no due diligence clause, it may be open to a director or officer to argue that, in virtue of having been “duly diligent”, he or she ought not to be regarded as having contravened a statutory duty. For example, under a well-established principle of Canadian law, due diligence defences may generally be asserted where a defendant has been charged with a “strict liability” criminal offence.
How is the defence typically worded?
The wording of due diligence defences varies quite widely amongst statutes, often with significant consequences for the scope of the protection provided. An example of a broad and general due diligence clause is found in the Canada Consumer Product Safety Act (CCPSA):
…due diligence is a defence in a prosecution for an offence under subsection (1).
The precise meaning of “due diligence” in a broadly worded clause such as this would be determined over time, primarily as a result of judicial consideration of the statute. Because there are many similar clauses in a range of statutes that establish various types of public safety and environmental standards, the interpretation of the CCPSA due diligence clause could also be informed by judicial consideration of the corresponding clauses in other statutes (as well as by jurisprudence on due diligence generally, particularly insofar as it emanates from appellate courts).
In contrast with the CCPSA clause, the due diligence provision in Ontario’s Toxics Reduction Act, 2009 is more narrowly focused:
If a corporation commits an offence under this section, a director, officer, employee or agent of the corporation who directed, authorized, assented to, acquiesced in or failed to take all reasonable care to prevent the commission of the offence, or who participated in the commission of the offence, is also guilty of the offence, whether the corporation has been prosecuted for the offence or not. [emphasis added]
As with the CCPSA definition, this version of the due diligence defence may gradually be refined as case law relating to the statute develops. However, the wording of the Toxics Reduction Act clause is somewhat more specific and might (arguably) be interpreted as ruling out the assertion of a due diligence defence where any form of approval, assent or acquiescence existed. Where no such approval, assent or acquiescence existed, this due diligence clause would appear to allow defendants (including directors and officers) to advance the defence that (for example) they had established and/or followed certain policies or protocols that could reasonably have been expected to prevent the type of non-compliance that allegedly occurred.
Due Diligence in Key Types of Legislation
In the remainder of this post, we look at four commonly encountered types of statutory due diligence defences, namely those imposed by business corporations law, employment law, environmental law and the law of taxation.
Business corporations legislation
Under federal and provincial business corporations statutes, directors may be liable for issuing shares for inadequate non-cash consideration, for the payment of improper dividends, or for payments to shareholders when the corporation is insolvent (or which render the corporation insolvent). The Canada Business Corporations Act (CBCA) and its provincial and territorial counterparts (e.g. Ontario’s Business Corporations Act (OBCA)) provide a statutory due diligence defence in favour of directors for these liabilities. Often referred to as the “reasonable diligence” defence, these provisions offer directors and officers a defence where they can demonstrate that they acted with the care, diligence and skill that a reasonably prudent person would have exercised in comparable circumstances. Generally speaking, the CBCA and its provincial and territorial equivalents provide that a director will have met this standard where he or she relies in good faith on the financial statements of the corporation or an auditor’s report and the reports of professionals such as lawyers, accountants, engineers, or appraisers. This defence may apply to enable directors to, for example, rely in good faith on independent legal and financial advisors in defending against a hostile take-over bid, a related-party transaction or a director conflict of interest situation. When relying on the advice of a professional, directors should ensure that the professional has appropriate qualifications and ensure that the advice is provided in writing. Directors should actively engage with the professional giving the advice, rather than passively accepting it.
The CBCA and its provincial and territorial equivalents also provide defences that may be applicable against claims of breach of fiduciary duty, duty of care or of the general duty to act in accordance with the legislation and constating documents. Depending on which statute is applicable and which duty is alleged to have been breached, the applicable statutory defence will generally be either a “good faith reliance” defence, a “reasonable diligence” defence, or a combination of the two.
In addition to being diligently engaged with the management of the corporation by attending meetings, reviewing reports from experts and employees, and dissenting on decisions with which they disagree, directors should also ensure that the record of their participation is adequate to support a due diligence argument should the need to mount such a defence ever arise.
Indemnification under business corporations statutes
Under the CBCA (and generally under similar provincial and territorial statutes), a director or officer may be indemnified by the corporation against all costs, charges and expenses he or she reasonably incurs in respect of any civil, criminal or administrative actions or proceedings in which he or she is implicated in the capacity of director or officer. It should be noted that the minimum standard for such indemnification to be permissible is that the director or officer have acted honestly and in good faith, with a view to the corporation’s best interests. Strictly speaking, this is not a diligence standard, but it is nevertheless the case that exercising “due diligence” before taking actions or decisions will generally help a director or officer to satisfy the “honesty and in good faith” test and thereby to qualify for indemnification.
Legislation governing recovery of unpaid wages, etc.
Directors may also face statutory liability for unpaid employee wages, vacation pay and reimbursable expense claims, depending on the statute of incorporation and the province in which the corporation operates. Under the CBCA, OBCA and many of the other provincial business corporations statutes, directors may be liable to employees for up to six months’ wages. In addition, the OBCA also covers vacation pay accrued for up to twelve months under Ontario’s Employment Standards Act, 2000 (Ontario ESA). Amounts recoverable from a director personally are usually restricted to amounts that fell due during the director’s time in office and there are mechanisms designed to ensure that, where possible, directors will share such liabilities.
In addition to the CBCA, OBCA, etc., it is also important to bear in mind that provincial employment legislation (such as the Ontario ESA) can also come into play in cases of unpaid wages. Unlike the business corporations act provisions, which apply to businesses incorporated under those acts (no matter where they operate), the ESA provisions apply generally to most workplaces within a province’s borders, including the great majority of commercial enterprises. The Ontario ESA (like similar statutes elsewhere) provides an alternate means of securing payment of unpaid wages and vacation pay, with one chief difference being that it creates a complaint-driven investigative and regulatory process rather than relying on employees to initiate civil proceedings on their own. Like the business corporations statutes discussed above, it specifically provides for recovery against directors personally.
To return specifically to due diligence, the CBCA provides for a due diligence defence with respect to claims for unpaid amounts, allowing directors to argue that they acted with “the care, diligence and skill of a reasonably prudent person” to avoid non-payment. This “due diligence” standard sets the bar relatively high because it is objective and requires the exercise of skill. In other words, directors who were very unsophisticated with respect to business matters (or, more colloquially, “in over their heads”) might not meet this due diligence standard even if they had sincerely tried to do what was right. The CBCA provision explicitly incorporates the defence of good faith reliance on financial statements and professionals, although one commentator has stated that this defence would likely have narrow application to employment law situations.
In order to make out the defence, directors ought to ensure that appropriate controls are in place regarding the payment of employee wages, such that any problems that could arise will be brought promptly to the attention of the board. Once the board becomes aware that there may be issues regarding payment, it ought to take steps to rectify the problem, and document the steps taken, e.g. with detailed board minutes that show the directors engaging with the issue. Directors should also require management and other employees who report to them to provide frequent status updates until the matter is resolved. Finally, a director who disagrees with the board’s decision about a course of action should ensure that his or her dissent is properly recorded.
One difference between the CBCA and OBCA is that the latter’s statutory reasonable diligence defence does not apply to the directors’ personal liability for unpaid wages and accrued vacation pay. Because the OBCA does not create a statutory due diligence defence with respect to this particular liability, the responsibility of directors for unpaid wages and accrued vacation pay could be more difficult to avoid, but in general, the advice above would still apply.
Directors and officers may be personally liable for the violation of environmental statutes. For example, the Canadian Environmental Protection Act (CEPA) provides that if a corporation commits an offence under the Act, any director, officer, agent or mandatary of the corporation who directed, authorized, assented to or acquiesced in the decision is a party to and guilty of the offence. Subject to certain exceptions,CEPA also provides a due diligence defence if the accused establishes that he or she exercised “all due diligence” to prevent the commission of an offence. While the precise meaning of “all due diligence” does not appear to have been determined through litigation, the broader and more general phrasing of the requirement in CEPA (as opposed to the CBCA, for example) likely reflects the relatively severe consequences of a conviction under that act (that is, by making the defence easier to establish).
In addition, in Ontario the Environmental Protection Act (EPA) places a positive statutory duty on directors and officers to take all reasonable care to prevent the corporation from, among other things: illegally discharging or causing or permitting an illegal discharge of a contaminant; failing to notify the governmental authority of such a discharge; or contravening an order made under the EPA.
The leading environmental case in Ontario regarding the defence of due diligence and directors is that of R v. Bata Industries Ltd., where the court enumerated a list of factors that it will take into consideration when determining whether a director has satisfied the statutory duty:
- Whether the board of directors established a pollution prevention “system” and whether there was supervision or inspection or improvement in business methods;
- Whether each director ensured that the corporate officers were instructed to set up a system sufficient within the terms and practices of its industry of ensuring compliance with environmental laws;
- Whether each director ensured that the officers reported back periodically to the board on the operation of the system, and were officers instructed to report any substantial non-compliance to the board in a timely manner;
- Whether the directors relied on environmental compliance reports provided by the officers of the corporation, or other reports provided to them by corporate officers, consultants, counsel or other informed parties; Whether the directors could substantiate that the officers were promptly addressing environmental concerns brought to their attention by government agencies or other concerned parties including shareholders; Whether the directors were aware of the standards of their industry and other industries which deal with similar environmental pollutants or risks; and Whether the directors immediately and personally reacted when provided notice the system has failed.
Administrative orders (such as preventative clean up orders) are also being issued more regularly in Ontario to directors and officers, especially in insolvency situations. Certain of these EPA orders can be made against a person who has or had the management or control of an undertaking or property, including an officer or director (as a person in management or control of the undertaking and/or property), and it is these orders that are being used against officers and directors in Ontario. On the face of the EPA one does not need to have been in control of the property when it is suspected that contamination may have occurred. Unlike the statutory duty discussed above, there is no due diligence defence (or limitation period) for such orders, and they can impose significant liability on certain persons to either clean-up or prevent unlawful discharges from occurring. Furthermore, the orders are not predicated on an offence having been committed or anything unlawful having been done. In effect, those provisions of the EPA could see directors or officers ordered to clean up contamination caused by, among others, previous owners and/or neighbours.
Directors may be personally liable if their corporation fails to deduct, withhold, pay or remit amounts for employee payroll deductions, non-resident withholding tax, share purchase credits as required, employee Canada Pension Plan contributions or employment insurance. Directors may assert a due diligence defence if they can demonstrate that they exercised the degree of care, diligence and skill to prevent the failure that a reasonably prudent person would have exercised in comparable circumstances.
In Buckingham v. R., the Federal Court of Appeal held that a director will not face personal liability for his or her corporation’s failure to remit taxes if he or she can show that he or she was specifically concerned with the tax remittances and exercised due diligence with a view to ensuring that they were made. However, where a director condones the continued operation of the corporation by diverting employee source deductions to other purposes, the due diligence defence will be unavailable. This is to ensure that directors of a corporation in financial difficulty are not tempted to divert remittances due to the Crown to other creditors in hopes of keeping the corporation afloat.
The most extensive discussion of the interpretation of the defence is contained in Soper v. R. In that 1997 case, Robertson J.A. indicated that Revenue Canada was not correct in suggesting, in what was then the current version of its Information Circular 89-2, that a director, in order to satisfy the due diligence requirement, must take positive action by setting up controls to account for remittances, by asking for regular reports from the company’s financial officers on the ongoing use of such controls, and by obtaining confirmation at regular intervals that withholdings and remittances had taken place. (It is nonetheless prudent for directors take steps such as requesting confirmation of tax remittances.)
The views of the Canada Revenue Agency on the interpretation of s. 227.1, including the due diligence defence, are now found in Information Circular 89-2R2 (March 24, 2006). Paragraphs 11-18 of the Circular provide guidance on steps directors ought to take to ensure that they have a due diligence defence available to them:
- Directors should make sure that the corporation is properly withholding deductions. Also, a corporation and its directors must act responsibly. Directors must make every reasonable effort to ensure that source deductions, GST/HST, excise duty, and amounts charged under the ATSCA [Air Travellers Security Charge Act] and the SLPECA [Softwood Lumber Products Export Charge Act, 2006] are withheld, collected, remitted, and paid.
- Directors are not liable if they exercise due diligence, that is, the care that a reasonably prudent person would take in similar circumstances to make sure that the corporation deducts, withholds, collects, remits, or pays the amounts due. To do this, directors should use methods such as:
- establishing a separate account for withholdings from employees and remittances of source deductions and for remittances of GST/HST, excise duty, and amounts charged under the ATSCA and the SLPECA;
- calling on financial officers of the corporation to report regularly on the status of the account; and
- obtaining regular confirmation that withholdings, remittances, or payments have in fact been made during all relevant periods.
- If the corporation is in receivership or bankrupt, one of the responsibilities of directors may include advising the receiver and manager or trustee in writing of the banking arrangements in place for paying the source deductions withheld, the GST/HST, excise duty, and charges under the ATSCA and the SLPECA.
- To demonstrate that they exercised due diligence, directors must show that they took reasonable steps to prevent the failure to deduct, withhold, remit, or pay. In other words, the steps must be taken before the failure has occurred.
- Directors are obliged to be aware of what is happening in the corporation that they are a director of. They must maintain effective lines of communication between them and the corporation’s responsible employees.
- Directors cannot claim that they were unaware of their obligations or the corporation’s obligations under the statutes. A reasonably prudent person who knows that he or she is a director but is uncertain about his or her responsibilities must at least try to find out what is expected of him or her and to carry out that duty.
- While directors may delegate their statutory responsibilities to other people, they remain responsible for ensuring that payroll deductions, GST/HST, excise duty, and charges under the ATSCA and the SLPECA are remitted.
- An objective standard is applied when considering a due diligence defence. This does not mean that the director’s particular circumstances are to be ignored. The circumstances must be considered against an objective standard of a “reasonably prudent person.”
The liability risk of directors and officers of Canadian companies can be mitigated by careful consideration of the due diligence defence and the specific types of actions that it requires in areas such as employment, environmental, taxation and corporate governance. As always, obtaining and following the advice of qualified counsel who are fully apprised of the details of a company’s specific situation will be a key step in ensuring compliance.