Directors play a central role in the management of a company and are therefore pivotal to its growth and success. In addition to the day-to-day duties associated with operating and managing the business of a company, it is important that directors also understand the legal duties and obligations associated with their appointment.
Directors’ duties and obligations at law fall broadly into two categories: the duty to act with loyalty and in good faith, and the duty to act with care and diligence. We set out below a further breakdown of these legal duties and obligations, who they apply to and the consequences of a breach.
Where are directors’ duties and obligations found?
There are three primary sources of directors’ duties and obligations:
- Legislation – the primary piece of legislation governing companies is the Corporations Act 2001 (Cth) (Corps Act), however various other legislation also sets out duties and obligations on directors in specific circumstances or sectors;
- Common law (i.e. judge made law that is derived from custom and past matters before the Courts) – these duties have now largely been codified in the Corps Act but provide helpful guidance on how directors’ duties are interpreted; and
- Constitutional documents – the constitution of the company contains certain restrictions, procedures and obligations that directors must comply with when performing their duties.
Who the duties apply to?
The duties contained in the Corps Act apply not just to directors, but also to certain other senior management in a company. These include persons making or participating in making decisions affecting the whole or a substantial part of the business of the company and persons that can significantly affect the company’s financial standing. Where directors are accustomed to acting on the instructions or wishes of another person, then that person will likely also be caught. For the purposes of this note however, we have focused solely on duties and obligations as they would apply to directors.
Importantly, a person can be deemed a director even if they are not listed as so in the company register. Section 9 of the Corps Act ensures the following individuals are captured:
- a person properly appointed as a director;
- a person appointed as an alternative director who is acting in that position;
- a person, even though not appointed as a director, who acts as if he is a director; and
- a person whose instructions or wishes the directors typically comply with.
Who do directors owe their duties and obligations to?
Whilst solvent, the directors must act in the best interests of the company. When considering what the best interests of the company are, a director should look at the interests of the shareholders as a whole group and not focus on individual shareholders’ needs and desires, particularly where a decision would clearly have a different effect on different shareholders.
This is particularly relevant for companies with a small number of shareholders where directors are appointed as a direct nominee of their appointing shareholder. In these cases, directors should be very careful to ensure their decisions are in the interests of the company as a whole, and not simply made for the benefit of their appointing shareholder. For wholly owned subsidiaries, a director may consider the best interests of its holding company, provided the subsidiary’s constitution expressly provides for this and the subsidiary is not insolvent at the time the decision is made.
At the point where a company ceases to be solvent or is at material risk of becoming solvent, then directors must from that point forward act only in the best interests of its creditors.
Finally, a director that is also the sole shareholder of a company must still comply with the obligations described in this note.
What are the primary director duties?
The Corps Act imposes four primary duties on directors of companies:
- to act with care and diligence;
- to act in good faith in the best interests of the company and for a proper purpose;
- not to improperly use their position or information obtained due to their position; and
- to prevent insolvent trading.
We explore these further below.
Duty to act with care and diligence
A director must exercise his or her powers and discharge his or her duties with the same degree of care and diligence that a reasonable person would exercise if that person:
- were a director of a company in the company’s circumstances; and
- occupied the office held by, and had the same responsibilities within the company as, the relevant director.
In determining whether a breach has occurred of this duty, the courts will consider what an ordinary person in the position of the director would have done in the circumstances.
To satisfy these obligations, a director must take steps to ensure access to and understand relevant information that is necessary to properly monitor the financial affairs of the company and to competently guide the company’s management. The responsibility cannot easily be delegated to other directors (see further on this below), staff or advisors and a director cannot hide behind his or her own ignorance. It is not necessary for directors to personally review every step of data collection and analysis leading up to a report or recommendation put to directors but the director must question and probe the validity of such information and be confident in its robustness before using it to underpin a decision.
The Corps Act gives some helpful guidance on when a director has complied with the duty to act with care and diligence. A director will have complied with the duty where:
- the director has acted in good faith for a proper purpose;
- the director does not have a material personal interest in the relevant matter;
- the director is properly informed about the relevant matter to the extent the director reasonably believes appropriate; and
- the director rationally believes he or she has acted in the best interests of the Company.
Importantly, a director is not prevented from taking actions that have an element of risk to the company, but must be satisfied that the perceived benefits to the company are sufficient to justify any potential harm, both financial and reputational, that the company may suffer.
Duty to act in good faith and for a proper purpose
A director must exercise his or her powers and discharge his or her duties:
- in good faith in the best interests of the company; and
- for a proper purpose.
The duty to act in good faith requires that a director honestly and diligently considers the interests of the company when performing his or her duties and must ensure any final decision is ultimately in the company’s best interests (i.e. the interests of shareholders as a whole, or where the company is insolvent, the interests of its creditors).
The duty to act for a proper purpose requires directors not use their position to gain an advantage for themselves or a third party or to cause detriment to the company. Where the decision would not have been made, but for the improper purpose, the decision may be considered invalid and the director will be in breach of his or her obligations.
A breach of this duty typically arises where a director assumes the company’s interests align with his or her own and makes a decision on that basis. To avoid any breach, directors must never misuse or abuse their powers or take advantage of the company’s assets, opportunities or confidential information for their own advantage.
Duty not to improperly use position or information
Director must not improperly use their position, or information obtained because of their position, to:
- gain an advantage for themselves or someone else; or
- cause detriment to the company.
When assessing a breach, the courts will look at the director’s intent and not what actually transpired. Therefore, if the advantage was incidental and the director made the decision or used the information in good faith and for a proper purpose without regard to such advantage or the director made the decision or used the information in the belief that it would not result in detriment to the company, then no breach is likely to have occurred.
Importantly, information need not be considered confidential to be caught by this obligation, and needs only be information that the director has received in his capacity as director of the company.
Duty to prevent insolvent trading
Directors have a positive duty to prevent a company trading if the company is insolvent. A company is insolvent if it is unable to pay its debts as and when they fall due and directors should consider, before incurring any new debt, whether there are reasonable grounds to suspect that the company is insolvent or will become insolvent after incurring the debt.
Where a director has failed to prevent a company from becoming insolvent, he or she may however be able to rely on one of the following defences:
- at the time the debt was incurred, the director had reasonable grounds to believe the company was solvent and would remain solvent;
- the director believed that a competent and reliable employee or advisor was monitoring the company’s solvency position and such person has not informed the director of any impending solvency issue;
- at the time the debt was incurred, the director was not participating in the management of the company due to illness or other extenuating circumstances; or
- the director otherwise took every reasonable step available to prevent the company incurring the debt.
As explained above, ignorance or a lack of understanding of the financial position of the company is not a defence. It is a criminal offence if the director is aware but ignores the fact that the company is insolvent.
Other obligations directors should be aware of
Duty to avoid conflicts of interest
Directors have a fiduciary duty to the company, which means that directors must at all times put the interests of the company above their own. Directors should therefore always ensure that at no time a personal interest in a matter conflicts with the interests of the company. Conflicts of interest can arise in various circumstances but are often seen where either the director has a personal interest (either directly or indirectly) with a party that wishes to contract with the company, or where the director becomes aware of an opportunity that he or she may wish to pursue personally to the company’s detriment.
The company’s constitution can include express provisions about how directors should deal with a conflict of interest. Where such provisions exist, they may require the director to make full disclosure of the conflict and may or may not permit the director to vote on the relevant matter. Where voting is permitted, the director must however still vote in the best interests of the company and cannot have regard to his or her personal interests. If the constitution of a company accommodates conflicts of interest, the provisions should be strictly complied with to avoid any potential liability.
Another means to resolve a director conflict issue, is to make full disclosure of the relevant matter and have any decision ratified by ordinary resolution at a meeting of shareholders.
Duty to disclose material personal interests
In addition to the constitution, the Corps Act also provides certain disclosure requirements where a conflict of interest arises. Where a director has a personal interest in a matter relating to a company’s affairs the director must give the other directors notice of that matter as soon as possible after becoming aware of the conflict. Not all interests need to be disclosed however and the Corps Act expressly provides the following exceptions:
- the relevant interest arises by virtue of the director being a shareholder of the company and the interest is common to all shareholders;
- the directors are already aware of the nature and extent of the interest and how it relates to the company; and
- the director has previously given notice of the nature and extent of the interest and such notice remains effective.
Once the matter has been disclosed the director is then permitted to vote on the matter, except where voting is prohibited under the company’s constitution.
Duty to keep books and records
Directors must ensure that the company keeps adequate and accurate records that correctly record and evidence transactions the company has entered and reflects the company’s financial position and performance. A key secondary benefit to keeping proper records is that it often provides useful evidence that a director has complied with his or her duties and obligations. This is particularly important where the company is nearing insolvency, as a company will generally be presumed insolvent throughout a period where it has failed to keep appropriate financial records.
Other legislation that may contain directors’ duties
There are various other laws that impose obligations and duties on directors and their application will depend on the business being undertaken by the company and the sectors in which it operates. Common areas where liability could arise include competition and fair trading, workplace health and safety, environment, employment, taxation, compliance with stock exchange listing rules, and compliance with accounting standards. Directors should seek appropriate advice when concerned about their obligations in these areas.
Duties and obligations under the company’s constitution
A director should always ensure that he or she is familiar with the rules, obligations and procedures set out in the constitution of the company as this often gives guidance on how certain matters should be dealt with and may, in some circumstances, alter the obligations directors have under the Corps Act.
Relying on the advice of others
Whilst ignorance is not a defence, a director is permitted to rely on the advice of others in performing his or duties provided certain conditions are met:
- where the advice was from an employee, the director reasonably believed the employee is reliable and competent;
- where the advice was from a professional adviser or expert, the director reasonably believed the advice was within the person’s professional or expert competence;
- where the advice was from a fellow director or officer, the matter was within that person’s authority; and
- where the advice was from a committee of directors on which that director did not serve, the advice was within the committee’s authority, and
in each case the director relied in good faith on the advice after diligently assessing it, having regard to his or her knowledge of the company and the complexity of the structure and operations of the company.
Penalties for failure to comply
Penalties for a breach of directors’ duties and obligations can be serious and include fines of up to $200,000 and claims for damages and account of profits. Serious breaches can result in imprisonment for up to 5 years or disqualification from managing companies in the future.
Intent is important when determining the quantum of any penalty, and directors are more likely to be guilty of a criminal offence where they are reckless or intentionally dishonest in performing their duties.
Directors’ duties and obligations can be a complicated area and a failure to comply can lead to significant consequences for both the company and the director personally. Directors should immediately seek advice where they are uncertain of their obligations or duties or how any conflict should be dealt with.