Lessons for directors from the Courts

Three recent Federal Court cases shed light on when directors may be found to have breached their duty of care, a timely reminder of “stepping stone” liability risk.

Under the “stepping stone” approach, directors may find themselves facing personal penalties when their company breaches the law, such as disclosure requirements. Directors may not be able to rely on the “business judgment rule” defence in these cases, and could find themselves facing penalties higher than those that might be imposed on the company itself.

In separate cases, the Federal Court found that directors of Storm Financial Limited (Storm), Padbury Mining Limited (Padbury) and Sino Australia Oil and Gas Limited (in liq) (Sino) had breached their duty of care by causing or permitting the companies to contravene provisions of the Corporations Act. While the penalties for the Storm and Sino directors are yet to be determined, disqualification orders of three years and pecuniary penalties of $25,000 were imposed on two Padbury directors, along with cost orders of $200,000.

Under s 180(1) of the Corporations Act, directors (and other officers) must exercise their powers and discharge their duties with the degree of care and diligence that a reasonable person in their position would exercise. A director may breach this duty in a myriad of ways, including by failing to prevent the company from contravening the Corporations Act. Liability arising in this manner is ”stepping stone” liability because the corporate contravention is a “stepping stone” to a finding by a court that a director breached the s 180(1) duty of care.

The recent cases discuss important principles about the stepping stone approach to liability and the duty of care. All directors should familiarise themselves with these principles, including the following:

1. Directors who authorise or permit a company’s contravention do not automatically breach their duty of care – each case rests on its own facts.

In Sino’s case, the Court endorsed comments made by Justice Brereton in 2006 in ASIC v Maxwell: “it is a mistake to think that ss 180, 181 and 182 are concerned with any general obligation owed by directors at large to conduct the affairs of the company in accordance with law generally or the Corporations Act in particular; they are not”.

Similarly, in the Storm case, Justice Edelman did not accept ASIC's submission that an actual breach by the company was sufficient to establish director liability under s 180(1). His Honour said that s 180(1) is not a duty of strict liability, “[n]or is it a duty which requires the director to take every possible step to avoid a foreseeable risk of contravention of legislation”. He added that the steps that a reasonable director must take will always depend on all of the company’s circumstances and each case should be assessed on its own facts.

2. For a director to be found liable the company need not have committed an actual breach of the law – the risk of a breach by the company may be sufficient.

In Storm’s case, Justice Edelman doubted whether an actual breach by a company is a necessary requirement for breach of s 180(1) by a director. He said: “suppose a director unreasonably (within the terms of s 180(1)) and intentionally commits acts which are extremely likely to involve a serious breach of the Corporations Act perhaps even threatening the very existence of the company. … [I]t might be seriously doubted whether the director could escape liability simply because, by some good fortune, no actual breach eventuates. Loss is not a required element of an action for contravention of s 180(1) of the Corporations Act.”

In Padbury’s case, Justice Siopis reflected that “ultimately, each case must be considered on its own facts”. Here the managing director and executive chairman of Padbury admitted (and the Court agreed) that when they authorised or approved the release of an ASX announcement about a project that was misleading or deceptive or likely to mislead and deceive, it would be harmful or potentially harmful to Padbury.

3. In determining whether a director's duty of care has been breached, a Court will consider all of the circumstances including the foreseeable risk of harm to any of the interests of the company, as well as the potential benefits to the company.

In Storm’s case, Justice Edelman emphasised that all of a company’s interests are relevant when considering the foreseeable risk of harm and potential benefits that could reasonably have been expected to accrue to the company from the conduct in question. These interests include the company’s reputation, which may be adversely affected by legal noncompliance. His Honour also noted that the possible harm to the company is not confined to financial harm. Unlawful conduct may cause non-financial detriment to a company.

Provided the potential or actual contravention by the company is reasonably foreseeable, the likelihood of the breach is only one matter to be considered. Edelman J added that even if Storm’s contraventions of the Corporations Act were reasonably foreseeable but unlikely (rather than likely, as he in fact concluded), the consequences were so significant and the burden of alleviating action so minimal that it was still possible that a s 180(1) breach by the directors might have occurred.

4. Directors must inform themselves fully about the contents of a prospectus and make sure that the information is accurate, and cannot rely blindly on others to do so.

In Sino’s case, the non-English speaking executive chairman signed prospectus documents issued by Sino. The prospectus documents were deficient with the result that Sino as a company breached its disclosure obligations under the Corporations Act. The chairman was found to have breached his s 180(1) duty of care in a number of respects, including for exposing Sino to the imposition of civil penalties for its contraventions of the Corporations Act and to the cost and trouble of legal proceedings and ASIC’s investigation (which ultimately led to the company’s liquidation).

Justice Davies said the “failure by [the chairman] to ensure that he could understand, even in the most basic sense, the content of the documents he was signing was a breach of his director's duties” and the duty of care required that the chairman “inform himself fully and comprehensively about the content of the prospectus documents to ensure that the information contained in them was accurate”.

Justice Davies noted that the fact that the chairman was not an English speaker or writer and did not understand Australian legal requirements “did not mean that hecould just leave it all to others and did not excuse him from performing his own duties with reasonable care and diligence.”

5. Directors can breach their duty of care even if the directors are the only shareholders and the company is solvent.

The Storm directors claimed that they could not have breached their duty of care to the company because, as a solvent company, the only interest of Storm was the interest of its shareholders, and as the only shareholders were the directors, the company was being managed in accordance with the shareholders’ informed wishes.

In rejecting this argument, Justice Edelman noted that the interests of a company include the interests of shareholders. He added that while the “interests of shareholders ‘may’ be correlative to the interests of the company because those interests ‘intersect’,” they are “not necessarily identical”.

His Honour “accepted that the pursuit of ventures which involve risk is one key purpose of the limited liability corporation” and that this is “an important context in the assessment of whether s 180(1) has been contravened”. However, he stressed that this “does not give a director carte blanche to engage in any venture even if the venture is highly likely to (and does) contravene the law”.

These cases can be accessed here: ASIC v Cassimatis (No 8) [2016] FCA 1023 (Storm case), ASIC, in the matter of Padbury Mining Limited v Padbury Mining Limited [2016] FCA 990 (Padbury case) and ASIC, in the matter of Sino Australia Oil and Gas Limited (in liq) v Sino Australia Oil and Gas Limited (in liq) [2016] FCA 934 (Sino case).

In August 2016, the Queensland District Court found a former director of whitegoods distributor Kleenmaid guilty of fraud and multiple counts of insolvent trading. The director has been sentenced to 9 years imprisonment. Another former Kleenmaid director received a 7-year prison sentence last year and a third director is awaiting trial.