Many entrepreneurial businesses are organized as corporations. As a result, the owner of a business is often also a director of a corporation. The obvious reason for becoming an owner and a director is to retain control of your business, in terms of long range planning and the day-to-day operation of the business. However, along with the control that comes with being a director, is exposure to legal liability from various sources. A lawsuit against the former directors of the Canadian Commercial Bank involving many millions of dollars was recently settled. Directors' liability is a very real concern. In this edition of The Entrepreneur, we will examine a few of the potential sources of legal liability to which directors are exposed, and some practical ways to protect yourself from such liability.
The Standard of Care for Directors
Both federal and provincial business corporations legislation provide for the standard of behaviour which directors must meet when exercising their duties as directors. A director who fails to meet this standard will be liable to the corporation for any damages suffered by the corporation as a result. For example, the Business Corporations Act (Alberta) provides that "every director ... in exercising his powers and discharging his duties shall act honestly and in good faith with a view to the best interests of the corporation, and shall exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances". This contains two requirements: a "good faith" requirement and a "standard of care" requirement. This standard of care can only be met by regular attendance at directors' meetings and by paying careful attention to the corporation's affairs. A director or officer of a corporation must comply with the applicable legislation and also with the articles, by-laws and any unanimous shareholder agreement of the corporation. No provision in a contract or in the corporation's articles, by-laws or resolutions relieves a director or officer from the duty to act in accordance with the required standard of care. Although it may appear unlikely that your closely held corporation would sue you because you are a director and perhaps the controlling force behind the corpora-tion, in situations where bankruptcy trustees or receivers or other interested parties (such as banks or other creditors) become involved in a corporation, legal actions can be brought by those parties on behalf of the corporation, thus exposing you as a director to liability. Therefore, it is critical that the director conducts himself prudently in all matters relating to the corporation, even if he or she is the sole director and shareholder of the corporation.
The standard of care required of directors is probably becoming even more stringent. In a number of recent cases the courts appeared to examine the business merits of decisions taken by boards of directors in respect of takeover bids for their corporations. In some cases, the courts made the directors personally liable to the shareholders because the directors did not make sufficient enquiries as to the value of the corporations' shares. Since such cases, the cost of directors' liability insurance has risen dramatically. These cases illustrate the willingness of courts to impose personal liability on directors.
Directors may also be liable for a breach of the good faith requirement. Such liability may exist not only in relation to the corporation or its shareholders, but also to parties with whom the corporation deals. For example, if a director decides that the corporation should not perform a particular contract and this decision is made by the director on the basis of his own interest, instead of on the basis of the best interests of the corporation, then not only can the corporation be liable to the other party for a breach of contract, but the director may be personally liable to that other party for causing the corporation to breach the contract. Directors must base their decisions on the corporation's interests, not on their own interests.
Director's Liability Under Business Corporations Legislation
Business corporations legislation also makes directors personally liable in various ways. For example, the Business Corporations Act (Alberta) makes the directors of a corporation jointly and severally liable to the corporation's employees for all debts owing by the corporation to those employees, to a maximum of six months wages for each employee. Thus as a director you will want to ensure that employees' wages are always paid promptly out of the corporation's funds. The Alberta Act makes directors personally liable to restore to the corporation amounts paid by the corporation for share repurchases or redemptions, or amounts paid by the corporation as dividends, in circumstances where the corporation could not meet the financial tests prescribed by the Act. As a director authorizing such corporate proceedings you should ensure that those corporate financial tests can be met.
Other Areas of Director's Liability
There are a number of specific federal and provincial laws which make directors liable for things which the corporation should have done. For example, the Income Tax Act (Canada) makes the directors of a corporation personally liable for the failure of the corporation to withhold certain taxes from employees' paycheques and remit the deductions to Revenue Canada. If a corporation fails to deduct unemployment insurance premiums from its employees' wages, then the Unemployment Insurance Act (Canada) makes the directors of the corporation personally liable for those amounts which the corporation should have deducted and remitted to the federal government for unemployment insurance premiums. The Canada Pension Plan Act has a similar provision with respect to the deduction and remittance of Canada Pension Plan contributions. Because of this personal exposure of directors to Revenue Canada for income tax, UIC and CPP deductions, it is worth-while for directors to ensure that the corporation is making the proper deductions when paying salaries, wages and commissions to employees. The Excise Tax Act makes directors liable to Revenue Canada for Goods and Services Tax which the corporation ought to have collected and remitted to Revenue Canada. As you are aware, this GST arises on a daily basis for most corporations. These are just examples. There are all kinds of other specific laws imposing liability on directors, but they are too numerous to mention here.
Disclosure of Interests in Contracts
Business corporations legislation requires disclosure by a director of any interest in a material contract. A director is liable to restore to the corporation any profits that the director makes as a result of contracts entered into between the corporation and any party in which the director has a personal interest. This liability can be avoided if the director has disclosed this personal interest and abstained from voting as a director of the corporation in respect of that particular transaction. If you as a director are in such a position make sure you disclose your personal interest and abstain from the vote. This is related to the good faith requirement mentioned above.
Director's Liability Insurance
To protect yourself as a director against potential liability you may wish to consider obtaining director's liability insurance. However, you may decide that the cost of such insurance is too high to justify obtaining it. The insurance industry is concerned not only with the increased likelihood of liability for directors' conduct and the large damage awards involved, but also with the legal costs that may be involved in defending a suit. Your insurance agent or broker can give you advice in this area.
Avoidance of Liability
The Alberta Business Corporations Act states that a director who is present at a meeting of directors is deemed to have consented to resolutions passed or actions taken unless (a) he requests that his dissent be entered in the minutes, (b) he sends his written dissent to the secretary of the meeting before the meeting is adjourned, (c) he sends his dissent by registered mail or delivers it to the registered office of the corporation immediately after the meeting is adjourned, or (d) he otherwise proves that he did not consent to the resolution or action. A director who votes for or consents to a resolution or action is not entitled to dissent. If you think a particular corporate action should not be taken, then express your dissent at the directors' meeting and have that dissent recorded.
A director is not liable (except for liability for wages) if he relies on (a) financial statements of the corporation presented to him by an officer of the corporation or in a written report of the auditor of the corporation which fairly reflect the financial condition of the corporation, or (b) an opinion or report of a lawyer, accountant, engineer, appraiser or other person whose profession lends credibility to a statement made by him. It is no defence to say that you were uninformed or did not have the time to keep up with the corporation's affairs. As a director, you are obligated to make yourself informed, even if you require expert reports or opinions.
The foregoing is provided to you for the purpose of highlighting a few of the relevant legal issues relating to directors' liability. There are a number of other ways in which a director can become personally liable to the corporation or third parties, including its shareholders. These legal issues may have serious practical consequences for you as a director. By consulting your legal advisors you may find ways in which you can minimize your exposure to such personal liability.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.