James Farmer


Corporate Governance and Directors' Liability

Tuesday, August 19, 2014

I was recently invited to attend the annual Corporate Governance Seminar that Minter Ellison Rudd Watts put on, this year held on 5 August at the Langham Hotel in Auckland.  Minters and its Chair Cathy Quinn (a former member of the Securities Commission) are to be congratulated for promoting these occasions on such an important topic.

The evening was a stimulating one with an experienced and expert panel.  The theme was that there needs to be a shift in focus from the traditional role of a board of directors as supervising and ensuring regulatory and legal compliance and proper performance of management within those parameters to a more innovative, value-added, role.  The point was summed up in a Minters’ publication (Mettle Issue 2) handed out at the seminar which, among other things, contained a quote from Michael Stiassny (senior partner of KordaMentha and chairman of Vector) which read:

“The level of regulatory intrusion into businesses occupies a considerable amount of time around the board table.  Many people would acknowledge the fact that the time spent could be better focused on building a business and driving innovation – as opposed to compliance”.

Former CEO of the New Zealand Stock Exchange, Mark Weldon, on the panel claimed authorship for this as the theme for the night and even the obligatory regulator (from the Financial Markets Authority) on the panel said that the FMA wished to encourage shorter and simpler offer documents.  Having defended the directors of Lombard in their unsuccessful appeals in the Court of Appeal and Supreme Court (except as to sentence in the latter), I find that objective and, generally, the cry for less time on compliance one that has a major disconnect with the views of the Judges, which can be broadly summarised as a need for more, not less, detail.  

This may be the inevitable outcome of the statutory provision in the Securities Act that empowers the Court to find a statement misleading and untrue by omission but it is also a reflection of the way in which Judges, who seldom have practical commercial or board experience themselves, interpret that provision.  While there is invariably judicial denial that hindsight is being applied, the fact of a corporate collapse and the sense that someone within the company must be to blame – rather than external events beyond the company’s control – puts directors at risk when the offer documents are later subjected to close judicial scrutiny.

After being at the Minters’ seminar and having a vague recollection that I had written papers in this area ten or more years ago, I searched back through my records and, sure enough found four such papers (copies of which are available on request by email) that I had presented as follows:

24 June 2002 – “Governance Lessons to be learned from Air New Zealand” (address to Institute of Directors, Wellington)

18 September 2002 – “Corporate Collapse: the Role of the Board Performance in Success and Failure”

16 April 2003 – Paper (untitled) presented at Corporate Governance Conference

18 February 2005 – “Corporate Governance – the Role of Independent Directors” (address to Legal Research Foundation, Auckland)

The stimulus for these papers was my involvement as an independent director on the Air New Zealand board (for 13 years) brought to a spectacular climax with the demise of Ansett, Air New Zealand’s wholly owned Australian subsidiary, in September 2011 (just after the terrorist attack in the United States).  At the time, I was acting chairman, the chairman having stepped aside on conflict of interest grounds in relation to the events at the time.

Key points that appeared from my re-reading of the papers are the underlying platforms on which company law was based when it went through its key developmental legal phase in 19th century England.

The first of these was the introduction of limited liability and the separation of the corporate form from the shareholders.  Every student of company law will have been told of the landmark House of Lords decision in Salomon v. Salomon & Co, in which it was held that it was not contrary to the true intent and meaning of the Companies Act 1862 for a trader (who was a boot and shoe manufacturer), in order to limit his liability and to obtain the preference of himself as debenture-holder over other creditors, to sell his business to a limited liability company consisting of himself and six members of his own family (the company being solvent at the time).  After incorporation, the company, as Lord Macnaghten described it, “fell upon evil days”, there having been “a period of great depression in the boot and shoe trade”, strikes of workman leading to existing contracts being withdrawn and spread around various firms (all external events having little if anything to do with the company’s competence).

Limited liability of corporations has been credited as being the most efficient form of industrial organisation and one that has promoted trade, innovation and investment.  Easterbrook and Fischel (Harvard, 1991), The Economic Structure of Corporate Law, list 6 benefits and attributes of limited liability:

  1. It decreases the need to monitor agents, thus reducing investors’ costs and making diversification and passivity a more rational investment strategy.
  2.  It reduces the costs of monitoring co-investors or shareholders and indeed makes the identity and personal wealth of other shareholders irrelevant.
  3. Through the free transferability of shares, it enables poor managerial and corporate performance to be subjected to new investors who can assemble controlling blocks and new management teams to improve corporate efficiency and returns.  A feature of this is that shares are fungible and trade at one price in liquid markets in that the value of shares is set by the present value of the income stream generated by a firm’s assets.
  4. It avoids the need for investors to search for additional information about a company because the shares will have a market price based on what is known about the company.
  5. It allows more efficient diversification.
  6. It facilitates optimal investment decisions by enabling investors to hold diversified portfolios so that each investor can hedge against the failure of one project by holding stock in other firms.

 Put shortly, limited liability has proved to be a means of managing risk, on the one hand, and increasing efficiency and firm performance on the other.  As Professor Len Sealy from Cambridge University said in his work, Company law and Commercial Reality (1984): the role that limited liability performs in modern commercial life is unique and vital in that it has facilitated “expansion and achievement on a scale that … in the considered view of leading economists, could not have been achieved without [it]”.

Those benefits however require an acceptance that if a limited liability company fails, then the investment will be lost – but only up to the level of each shareholder’s investment and holding.  There can be no recourse to other assets held by the shareholder.  Contrast this position with the Lloyds’ Names in the insurance world.

The law has however properly recognised that those who control the company, namely the board of directors, must perform their duties with a requisite degree of competence and in particular must act honestly and not negligently.  There is, though, a tension between the entrepreneurial and value-enhancing objectives of the limited liability company, on the one hand, and the standards imposed by the Courts on directors’ decisions and conduct.

In this respect, a key development in judicial attitudes to directors was that in nineteenth century England after the enactment of the first Companies Act, it was the Chancery Judges who seized jurisdiction over company matters.  They were the Judges who then applied to directors the concept of fiduciary obligations and who likened directors to trustees.   

The problem with that was that Chancery Judges would not allow trustees to take risks with property, particularly because, typically, beneficiaries under private trusts lack the capacity to look after the property for themselves – for example, infant beneficiaries under a trust or will.  That inevitably means, in the eyes of the law, that trustees must invest only in safe investments (Government bonds and the like).  By contrast, venture and risk are what business is all about.  It follows that directors must be able to sanction management hazarding the company’s funds and assets in much the same way that a sole trader would his or her capital.

That was tempered by the famous case of Re City Equitable Fire Insurance Company in the English Court of Appeal in 1925 where it was allowed that directors’ duties had to be viewed, first, in the context of the particular business carried on by the company and, secondly, the manner in which the work of the company was distributed between the directors and management.  The Court also said that regard should be had to the fact that directors’ duties were of an intermittent or part-time nature to be performed at periodical board and board sub-committee meetings.

In this last respect, a recurring theme of the panel speakers at the Minters’ seminar was that there is a need for non-executive directors to assume a closer relationship with management, to undertake greater due diligence about the company and the industry in which it operates and to be better remunerated in recognition of the fact that simply turning up to periodic board meetings from time to time was unlikely to enable them to perform their directors’ duties adequately.  This of itself will lead to the creation of further tensions, those between the directors and the professional managers.  The greater involvement of directors in the company’s affairs may provide them with greater protection from legal liability and indeed the New South Wales Court of Appeal in Daniels v. Anderson (1995) said that ignorance was no defence and directors must inform themselves about the affairs of the company.  Following that dictate may however mean that directors will more readily have attributed management failings to them.


In my view, the debate on corporate governance and directors’ liabilities does need to find the correct balance between the protective role of directors and their facilitative role in the adding of value to shareholders’ investments.  Writing in 1984 (above), Len Sealy said all the emphasis in the discussion on corporate governance is on the issue of constraints.  The same point was also made by an American writer who said, more colourfully, that the centre of public debate is on “restricting, constraining, watchdogging [rather than on] enabling, encouraging, liberating, inspiring our people and our institutions to creative achievement”.

Indeed.  But with every major corporate collapse, with every economic depression, with a Global Financial Crisis, the pendulum swings back to the imposition by the courts of liability of directors for the losses that have been suffered.  A change in judicial awareness of the true nature of company law needs a wider recognition, notwithstanding the occasional recognition by a commercial aware Judge of the dimensions of the situation.  In this last respect, the Judgment of the Court in a Western Australian case – Vrisakis v. Australian Securities Commission (1991) 11 ASCR 162 – should be compulsory reading.  As was said in that case:

“The management and direction of companies involve taking decision and embarking upon actions which may promise much, on the one hand, but which are, at the same time, fraught with risk on the other.  That is inherent in the life of industry and commerce.  The legislature undoubtedly did not intend … to dampen business enterprise and penalise legitimate but unsuccessful entrepreneurial activity.  Accordingly, the question whether a director has exercised a reasonable degree of care and diligence can only be answered by balancing the foreseeable risk of harm against the potential benefits that could reasonably have been expected to accrue to the company from the conduct in question.

Even then, foreseeability may not be a reliable touchstone to judge director and managerial performance.  In considering particular corporate collapses, the business environment in which a company operates and its vulnerability to unexpected external events must be taken into account.  The point was made by Professor Harold Demsetz, a leading US economist, who distinguished between firms that operate in a stable market and those that do not (Ownership, Control and the Firm (1988, Blackwell).  Firms, he said, that transact in markets characterised by stable prices, stable technology and stable market shares are firms in which managerial performance can be measured with relative ease and at relatively low cost.  By contrast, in the case of firms that operate in less predictable environments, with frequent changes in relative prices, technology and market shares that are subject to unexpected external shocks, managerial behaviour simultaneously figures more prominently in the firm’s fortunes and is more difficult to monitor.

As Demsetz put it, “a firm’s control potential is directly associated with the noisiness of the environment in which it operates”.  In assessing managerial accountability, he thought it important to distinguish between sources of instability that comprise firm-specific risks and those that are external or economy-related events which are “beyond a firm’s control and, at best, can [only] be reacted to intelligently”. Example: finance company (Lombard) and Global Financial Crisis and cessation of bank refinancing to developer clients and funding of their purchasers.  Demsetz was cited to the Court of Appeal in the prosecutions of the Lombard directors without judicial reaction. Indeed, that Court was unwilling to examine the causes of Lombard’s collapse.

Concerns have been expressed publicly many times that a legal environment that is too tough on directors will dissuade good people from going on to company boards.  The part-time nature of the job exacerbates vulnerability of directors.  So too does the combination of public clamour and media coverage of corporate collapses and Judges who have little commercial knowledge or experience.  And yes, value enhancement is a worthy objective for a board to focus on but directors downplay their custodial role at their peril.

Jim Farmer QC
19 August 2014

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