Sleeping directors awake to escape clause Law Reporter

Can a ‘sleeping director’ escape liability? - yes, in certain socially recognised circumstances

Ever since the late 1980s it has been made clear that the notion of the sleeping director is one that should be taken out of the vocabulary of those who aspire to company board positions in Australia. Although there are "defences" to the insolvent trading provisions of the Corporations Act (see section 588H in particular) these are rarely successfully utilised in cases where directors may be sued for insolvent trading. Now, a decision of Palmer J of the New South Wales Supreme Court, suggests that in a special case directors may escape liability if the circumstances are socially unique. In Southern Cross Interiors Pty Ltd (in liquidation) & Anor v Deputy Commissioner of Taxation & Ors ((2001) 19 ACLC 1495), Palmer J did excuse the wife in a husband and wife team of directors from liability under the insolvent trading provisions in these circumstances (as taken from the CCH Report). The sole directors of Southern Cross Interiors Pty Ltd (the company) were a husband and wife. Their business which involved contracting and installing partitioning in commercial premises was initially successful before experiencing some financial difficulty. The company eventually went into liquidation and the liquidator commenced proceedings against the Deputy Commissioner of Taxation (the Commissioner) for recovery of a debt of an unfair preference for payments of tax made in 1997. The Commissioner argued that the liquidator had failed to prove that the company was insolvent at the time that the payments were made. He based his argument on the fact that the amounts owed were due but were in fact not payable. There was no evidence before the court that the company had any arrangements with creditors extending the time for the repayment of debts. The Commissioner also sought a declaration that the directors of the company were liable to indemnify the Commissioner for any payment that the court ordered the Commissioner to make to the liquidator on the basis that they had effectively allowed the company to engage in insolvent trading.

The company was successful in the case with the court holding that there was an unfair preference. However, the Commissioner failed in his action against the relevant directors. Importantly, the Commissioner's claim against the wife failed because she was able to rely on a defence under what is now section 588H(4) of the Corporations Act (it was the Corporations Law at the time). Palmer J in a lengthy judgment examined the role of the insolvent trading provisions and the earlier cases in which the "sleeping director" defence had been said to be no longer available. He noted that the defences contained in section 588H were aimed at allowing directors to be excused where they could establish the relevant information. The following extract from his judgment is a useful summary of the way in which these defences operate (at para 110). "The defences afforded by [sections 588H(2) and (3)] will, in many cases, overlap. Reasonable reliance on information provided by apparently competent executives or auditors may justify an expectation of solvency for the purposes of both [provisions]. But the defence afforded by [section 588H(4)] is, clearly, quite different in character and scope from the [other defences]. A person who has not taken part in the management of a company at the relevant time cannot claim to have actually expected solvency, or to have had reasonable grounds for expecting solvency, for the purposes of the [other defences]. Ordinarily, such a person would have had no grounds at all for expecting anything as to the company's financial position during the time of non-participation. Yet, [section 588H(4)] affords such a person a defence if his or her non-participation is for 'some good reason'."

The judge then went on to consider a number of cases in which the defences had been considered and suggested that in this case the wife was able to establish the defence because of "special circumstances". However, he noted that before directors could put forward such a defence they had to overcome certain presumptions arising from the law's expectations of the performance of directors in companies. Again, a quote from the case affords some useful guidelines for directors in a significant number of smaller companies. "123. In my opinion, in evaluating a defence under [section 588H(4)] it is proper to start with the assumption that a person who accepts appointment as a company director has a sufficient understanding of the responsibilities which that office carries with it to know what is required of him or her in order to discharge those responsibilities as the law requires. That assumption is justified in a society which is generally literate, educated to secondary school standard, exposed to commercial transactions at varying levels ranging from the purchase of a car or home to running small businesses, and in which the professional assistance of accountants and solicitors is readily available. But that assumption is by no means an irrebuttable presumption. Many examples can readily be given in which the assumption would not be valid: recent immigrants from non-English speaking countries who are themselves not English speaking; those with limited education and little, if any, exposure to a commercial environment, such as indigenous people in remote areas; those with intellectual disabilities, to name but a few.

124. It may be said that people in these categories are inherently unlikely to find themselves appointed as company directors. As a general observation, that is undoubtedly so. But it is the difficult and unusual cases, as well as the commonplace, with which the law, as embodied in [section 588H(4)], must deal. Assume, for example, that a non-English speaking immigrant with no commercial experience is persuaded by a rogue to sign a consent to be a company director on the assurance that the document is something quite different or that appointment as a company director is merely a formal bureaucratic requirement which does not entail a responsibility for the company's management. Assume, for example, that a criminal threatens a highly experienced and competent company director with death or injury unless the director remains on the board of a company but turns a blind eye to the company's activities. Can it be said that the policy of the Corporations Act or the expectations of the community require that persons such as these be held accountable for insolvent trading and be denied a defence under section 588H(4)? So to hold would make the office of a director one of strict liability."

In these circumstances, the judge went on to hold that there were good reasons why someone who was in a position of pressure, or disadvantage in some way, might well be able to escape liability. He relied, in support of his reasoning, on a recent decision of the High Court of Australia in Garcia v National Australia Bank Ltd ((1998) 194 CLR 395). In that case a woman (a wife) who had guaranteed bank loans and who had not been forced to do so was nevertheless not obliged to pay the bank under those guarantees because the court recognised that women played a rather special position in society notwithstanding the fact that equal opportunity and other developments have significantly the position of women. Palmer J noted that the law recognised the relationship of trust and confidence between the husband and wife which in some cases would lead the wife to provide certain assurances or assistance to the husband and in these circumstances the relevant defence might well apply. He concluded that in his view the law should (at para 134):

"recognise that a wife's failure to appreciate the reality of her responsibilities as a director due to deferral to her husband in the circumstances referred to in [the Garcia case] ... may be a 'good reason' for failing to participate in management for the purposes of the defence under section 588H(4) [and other special provisions]. Such recognition will not undermine the policy of the law that those who accept office as a director are expected to act with competence and diligence in discharging the duties of their office. Whether the wife has truly failed to appreciate her responsibilities and whether such failure has anything to do with trust and confidence in the marital relationship are questions of fact in each case." So, in his view, in a situation where a woman who is not very experienced in business, and who may be quite unaware of the responsibilities of a directorship is told by her husband whom she trusts and believes to be honest, and who she thinks is knowledgeable in the affairs of the company, that some formality is required of her to allow the company to be established etc, and who allows him to continue to manage the company, has a good reason for not participating in the management of the company and can escape liability under the insolvent trading provisions. Such cases would be rare. But in this case the circumstances were such as to allow the wife to escape liability under the relevant section.

The decision is an important one for it shows that the law does not always adopt a strict black and white approach to these types of issues. It also shows that there are members of the judiciary who will reflect on the circumstances arising in a particular situation, assess the social as well as the legal issues, and by using any available discretion in an appropriately constructive fashion, reached what many would regard as a more acceptable result in such cases. This should not provide those who wish to aspire to directorships with any kind of assurance that the law will be lax in dealing with appropriate situations, but it does offer at least some opportunity for discretion to play an important role.

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