Canada: Peoples v. Wise: A Turning Point for Directors’ Duties

The Supreme Court of Canada recently released its decision in Peoples Department Stores Inc. v. Wise, a decision that is now Canada’s leading case on directors duties. Many see the decision as welcome relief for directors because, on the facts of the case, the Court relieved directors of a duty to creditors. A closer look reveals a very different picture.

The case is significant for four reasons: (1) It holds that directors owe duties to more than just the corporation; (2) It establishes an objective standard of care for directors and rejects the subjective standard; (3) It appears to adopt a Delaware style business judgment rule; and (4) It provides a first comment on the relationship between corporate governance standards and director liability.

The immediate issue in Peoples was whether directors owed duties to creditors. The Supreme Court of Canada clearly said they do. Peoples was argued solely on the basis of s. 122 (1) of the Canada Business Corporations Act ("CBCA"), a parallel of which is found in most provincial corporate statutes, and which imposes a duty on directors and officers to:

(a) Act honestly and in good faith with a view to the best interest of the corporation; and

(b) Exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances.

The court held that directors owe no duty of care to creditors under s. 122(1) (a) because it stipulates that the duty it creates is owed to the corporation. However, under s. 122(1)(b) the identity of beneficiaries was "much more open ended" and "obviously" included creditors. That change is significant. Until Peoples, it had been black letter law that directors owed their duties to the corporation. ¹

Extending the duty of care beyond the corporation is significant enough for the director-creditor relationship. Of even greater significance is the likely impact on shareholders. In the United States, directors have long owed duties to shareholders. The direct duty to shareholders has been used by American courts to justify aggressive review of board decisions, especially in take-over bid litigation. Canadian courts have tended to distinguish American cases on the basis that American law imposed a duty to shareholders while Canadian law imposed a duty to the corporation. The extension of s. 122(1)(b) to beneficiaries beyond the corporation wipes out that distinction. If the Supreme Court is prepared to extend the duty under s. 122(1) (b) to creditors, it is a much smaller step to extend it to shareholders.

At common law, a director’s standard of care was subjective. That is to say, the standard of care turned on the director’s individual capabilities. This often turned directors’ liability cases into an unseemly effort by directors to establish their own incompetence, thereby justifying a lower standard of care. The statutory duty of care in section 122 of the CBCA requires directors to "exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances." What this provision meant has been debated since its introduction in 1975. The debate turned on whether "comparable circumstances" referred to the individual skill set of the director or the factual circumstances surrounding the case. Until recently, the leading authority had been the decision of the Federal Court of Appeal in Soper v. Canada, [1998] 1 F.C. 124 which described the standard as being "objective subjective" which could take into account the lower personal skill set of certain directors. In Peoples v. Wise the Supreme Court of Canada rejects this approach and calls expressly for an objective test. It is likely that the objective test will be used to toughen the standards of care that apply to directors. While directors with lesser skills will be held to the higher, objective standard, directors with superior skills will not be able to take advantage of a lower objective standard of care. Where directors possess superior skills, they will be required to apply them to the issues at hand.

Most interesting is the Supreme Court’s extensive obiter about the business judgment rule.

Historically, Canadian corporate decisions had been protected by the business judgment rule which holds that courts should not interfere with honestly made business decisions. Until recently, Canadian courts focussed on the result of the decision. If the result was reasonable, courts did not interfere. The difficulty with this approach is that board decisions rarely involve questions to which there are "right" answers. They involve judgment calls about risk taking. Focussing on results makes it easy to rationalise decisions. Almost any "judgment call" can be justified on some basis, particularly in the hands of sophisticated parties and skilled counsel.

Recent decisions by courts and securities commissions demonstrate a radical shift in approach from result to process. The shift to process leads to a more aggressive review of directors’ decisions. A focus on process recognises that it is almost impossible to assess whether a result is reasonable when the process influences the result. In a realm where there are no right answers, only a reasonable process ensures a reasonable result.

When addressing the business judgment rule, the Supreme Court first referred to and adopted the results oriented business judgment rule but also went on to adopt the more recent process oriented approach. In doing so, the Court appears to be adopting the business judgment rule as it is applied by American, and particularly by Delaware, courts. While Canadian courts had historically applied only the reasonable result test, Delaware courts have long applied a two-pronged test that requires directors first to establish that they followed a reasonable decision making process and second, that the result of the decision was reasonable.

The Supreme Court’s apparent adoption of the Delaware business judgment rule may make Delaware case law on the issue more readily acceptable to Canadian courts than it has been in the past. Delaware courts have adopted a substantially more aggressive approach to directors’ decisions than Canadian courts have. Their focus on process has involved determining, among other things, whether directors spent an adequate amount of time on the decision, whether directors understood the issue, whether they tested the information they were given or simply accepted the conclusions of others, and whether they debated the issues openly and candidly among themselves.

The Supreme Court also referred to the plethora of rules, regulations and guidelines that have been the focus of most corporate governance analysis in recent years. The court stated:

"The establishment of good corporate governance rules should be a shield that protects directors from allegations that they have breached their duty of care. However, even with good corporate governance rules, directors’ decisions can still be open to criticism from outsiders."

While worded a little cautiously, what the court appears to be signalling is that the absence of proper corporate governance structures will be held against a corporation but the presence of governance structures does not end the analysis. Put another way, corporate governance structures are a means to an end. The desired end being an effective, independent-minded board. A state of the art governance structure may encourage board independence but does not ensure it. As a result, the extensive corporate governance regulation and practice that has emerged in recent years is likely to play only secondary importance when board conduct is challenged. The focus before the courts will be the adequacy of the board’s decision making process, not their governance structure.

© Copyright 2004 McMillan Binch LLP