Should directors be held more liable for company performance?
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