Should directors be held more liable for company performance?

James Burt

New Zealand is a highly entrepreneurial society. Even during the sluggish economic growth of the past three years we have maintained an average company registration rate in excess of 45,000 a year. 

Not all of those companies will succeed. Risk is fundamental to the "nothing ventured nothing gained" ethos which drives a capitalist economy. 

What makes that risk-taking acceptable to the investor is the concept of limited liability, which states that an investor is liable for the company’s obligations only to the limit of his or her investment.

Limited liability means that a person who pays $100 for shares risks that $100 but no more. Similarly, a person who buys a bond for $100, or sells goods to the company for $100 on credit, risks $100 but no more. No one risks more than he or she invests. 

When a business fails, the shareholders are the ones to have their investment wiped out first, but each investor has a guaranteed maximum on the loss he or she must bear.

Were that protection not in place, it is doubtful that anyone would be prepared to buy shares, never mind start a business. Which is why limited liability was central to the development and global domination of Western capitalism, and why it has been characterised as one of the greatest inventions of modern times.

It is the reason markets exist and can diversify. It is the reason that firms can raise capital at a low cost, because investors do not need to worry that, if one of their investments goes belly up, they will lose their entire wealth. This is particularly important when investors have no role in the management of the company.

No need for kneejerks

Yet there is a tendency to forget all of this when there is a large-scale company collapse, as evidenced recently when a commentator called for amending the limited liability provisions in the Companies Act to increase directors’ personal liability for the performance of the company.

There are a number of problems with this proposition.

First, limited liability does not operate to protect directors; it operates to protect shareholders. This distinction can become blurred in the small "mum and dad" companies so common in New Zealand, where the shareholders and the directors are one and the same. 

But in law and, in larger corporates, in practice, directors and shareholders have very distinct roles and powers which should not be conflated. Directors are the managers, not the muscle, behind the company.  Power ultimately rests with the shareholders. 

The shareholders own the business. They appoint directors to manage the company, and generally choose people with experience and expertise. Just as quickly, shareholders can remove the directors, modify or revoke the company’s constitution, or place the company into liquidation.

Second, directors are already personally accountable for their actions when managing the affairs of the company. It is the directors who are in the firing line after a company fails if they have in any way acted in bad faith, had a conflict of interest, acted recklessly, misled investors, or traded while insolvent. 

Where a company is insolvent, or is close to becoming insolvent, the directors have duties not just to the shareholders of the company, but to take into account the interests of the creditors as a whole. 



Directors will be personally liable if a court decides that they have allowed the business to be run in a manner likely to create a substantial risk of serious loss to company creditors (including employees or contractors). 

Directors in the dock

The string of successful prosecutions arising out of the finance company collapses – Lombard, Capital + Merchant, Nathans Finance and Bridgecorp, to name a few – is evidence that directors will be held accountable for their actions and that there is a range of penalties available under the Companies Act, the Crimes Act and the Financial Advisers Act.

Indeed, there is widespread concern among corporate governance experts, including the Institute of Directors, all the major corporate law firms, BusinessNZ and INFINZ, that the Companies and Limited Partnerships Amendment Bill as currently drafted over-exposes directors to liability.

It does this by seeking to criminalise behaviour which is not motivated by any criminal intent, thereby failing to strike an appropriate balance between achieving regulatory compliance and allowing directors to engage in legitimate risk-taking.

Fortunately, the select committee has acknowledged this issue and has asked officials to redraft the relevant section in the Bill for presentation to the House via a Supplementary Order Paper. 

We await the SOP with interest.

James Burt is a senior associate at Chapman Tripp, specialising in restructuring and insolvency

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11 Comments & Questions

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You'll be doing well James to provide any sort of definition of "legitimate risk-taking"

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All very noble stuff Mr Burt but as anyone in the real world will tell you the big issue is with directors who are reckless, incompetent, and/or negligent.

I would say that in many failures of large, well capitalised companies it is very likely the directors have been one or all of these things. Too early to say much about Manizeal but who knows what will come out if the company's affairs receive more than a cursory examination.

The companies you mention in your "string of successful prosecutions" are a very small minority of those cases where directors' conduct could and should have been much more closely examined.

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This all B.S . regarding directors of failed companies. Unfortunately companies sometimes fail. That is not always the fault of the directors.To suggest that the directors should bear the responsibility for that failure is nonsense .

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The directors know, or should know, the legal requirements of being a director.
No one is forced to be a director.
If their behaviour is found to be illegal, of course they should be held to account.
Now we have the laws of being a director reviewed by MPs who one day hope to retire onto a company board that will keep them in the style they have become accustomed to. That is a position of no responsibility, no work and plenty of income.
I think we can all correctly guess the content of the upcoming "SOP".

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Very little will come from this review given the obvious self interest of the politician reviewers.
The benefits and protections afforded by limited liability companies are well understood and valuable; they should be maintained.
Perhaps a middle course would be to make directors of a failed company liable to repay (shock! horror!) fees and benefits received over the preceeding three years.
liberte

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"The shareholders own the business. They appoint directors to manage the company, and generally choose people with experience and expertise. Just as quickly, shareholders can remove the directors, modify or revoke the company’s constitution, or place the company into liquidation".

This comment is fine in theory but in practice doesn't stand up to scrutiny. In NZ most shares are held by disparate institutions like fund managers and insurance companies on behalf of their passive individual NZ shareholders. Only a handful of these institutions work together to try to get better results for the owners of these shares by, for example, lobbying to get rid of poorly performing managements or demanding CEO pay not be more that 10 X the lowest-paid employee, as they collect most of their income from fees and dividends. In truth, the shareholders have no real power despite being the owners. Listed company directorships resemble somewhat a cosy club and many directors are recommended and appointed by one another, which is why certain names keep cropping up again and again on various boards.
Shareholders may be able to vote but have little say in their hiring and firing as the institutions who control the shares vote in accordance with director/management wishes.The hired help has long since taken over the mansion and the real owners must simply put up or sell up.

The NZ sharemarket is so tiny and insignificant in global terms that its closure would be felt only by those who work in the finance industry in this country. Shareholder rights here are very weak and highly underdeveloped (class action lawsuits are virtually unheard of), NZ shareholders lack the time or inclination needed to become knowledgable about their investments and investing, few listed companies meet the criteria to be called investment grade and given that most goods and services for sale in NZ are produced by foreign companies it begs the question why anyone would want to buy a miniscule fractional ownership in any company listed on the NZX when there are better and safer opportunities to be found elsewhere.

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Directors carry on the activities of a company and Companies can break the law. If the law they break is criminal the Directors should get charged as they are the only ones able to contract the company to the criminal activities, ergo Bridgecorp. If it is a 'civil' matter, the Directors should be held to account also, I guess as the fma is doing with strategic. Companies can take risks and fail, if they do the assets, limited to those of the company should be disposed of by the liquidator the same as if the company was an individual and went bankrupt.

If the Directors did no break any laws, only their reputation should hold them to account.

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In regards to Solid Energy, here we have a CEO who was paid in excess of $1.1m, plus management and staff receiving $23.5m in "performance related bonuses" over the past couple of years while the company slips into insolvency. Yet the law allows for "risk-taking" as an excuse for what looks to me like reckless profiteering at the expense of the company. When does risk-taking stop and incompetence and greed starts? It beggars belief that this kind of nonsense goes on. I think company directors and CEO's need to have their hands held to the flame a little more so that they don't feel they can walk away from their disasters with massive salaries and golden handshakes intact.

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All fine in theory. To call it a string of prosecutions is merely spin, every year there are many small to medium company liquidations that simply go under the radar where creditors lose millions. The Companies Office is only interested in pursuing directors where it is "in the public interest" read as "where we get publicity". The Liquidators don't pursue the directors because there is little left to fund what are legal costs of up to and exceeding $50,000. The government is reluctant to release funds from the Liqudiation Surplus Account held by the Public Trust to fund these actions unless there is an almost certainty of outcome (yeah right), oh and yes, its in the public interest. Business owners, keep an eye on who you deal with and tighten up your credit policies.

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Yes , absolutely Directors should be held to account. If the company is run properly there would be full financial reporting to the board on a monthly basis, and the discussion on the accounts should be a standard agenda item.
If these directors are unable to understand financials then someone should talk them through it. This applies to all companies big and small. If the news is bad then they have the opportunity and the repsonsibility to act on, and take into account the financial state of the company on all other decisions they make.
Frin

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If current laws cannot protect the misery and cost to workers, subcontractors, and creditors from the calculated mismanagement that has been happening, then the law needs to change. A robust enforcement of laws already in place would substantially change the directorships within companies. Is that what those that govern us are afraid of?

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