When considering regulatory compliance and enforcement in the financial services industry, it is common to focus on the entity that holds the Australian Financial Services Licence (AFSL) and the large number of specific obligations that apply to it.
However, directors of AFSL holders are also concerned to know what their own liability is if the company fails to comply with its legal obligations or the financial services business ceases to be financially viable. This article looks at
- what the implications of these events happening are for the directors; and
- what steps they can take to put them in the best position to defend any legal claims against them that might arise.
Who is subject to these laws?
A “director” includes anyone who is formally appointed as a director (whether executive or non-executive) and also any “shadow” directors – being a person who is not formally a director, but who acts in that position or on whose instructions or in accordance with whose wishes the formally appointed directors or the company are accustomed to act.
The directors of an AFSL holder have, like the directors of any other company, the powers and duties as set out in the Corporations Act 2001 and under general corporate law concepts. These include the power to exercise all the powers of the company other than those exercisable in a general meeting of shareholders.
Given the wide management powers given to directors, it is not unexpected that they are also subject to a range of duties imposed by law and obligations owed to the company, the shareholders and third parties (such as clients or creditors).
Directors' duties include (but are not limited to):
- not to use information gained because of their position to benefit themselves or others or cause damage to the company;
- not to act recklessly or in an intentionally dishonest manner; and
- to act in good faith and in the best interests of the company.
These duties are fiduciary. That is, they are duties to act in the best interests of the company, rather than the best interests of the director personally.
Directors must also act with care and diligence in the discharge of their duties. The standard that is applied is that which a reasonable person holding the position would apply. There is a defence to the charge that a director failed to act with due care and skill if the director shows that the board were making a business decision in the discharge of their duties.
It is not necessary in order to prove a breach of duty for it to be shown that a director, in failing to perform with due care and skill, acted dishonestly, or engaged in deliberate wrongdoing or acts of what the law refers to as “moral turpitude”.
The consequences of breaches of director's duties (against the directors personally) range from pecuniary penalties to disqualification.
For example, a director who fails to exercise due care and diligence in the discharge of their duties can attract significant monetary penalties. If the company suffers damage as a result of the contravention, a Court may also make a compensation order against the director.
Therefore, directors may find themselves in a position where they have caused detriment to the company by placing the company in a position where it is at risk of adverse regulatory outcomes or claims from clients, creditors or other affected persons. Having done so, they may then be the subject of action in their personal capacities (either from ASIC, liquidators, shareholders, clients or other affected persons) on the basis that they have breached their duties.
Financial services law issues
The obligations under an AFSL are personal to the licensed entity and are not directly binding on the directors. Despite the above, a breach of the financial services laws by the licensed entity could result in liability for the directors under the principles set out above.
Note also that for AFSL holders that operate registered managed investment schemes and superannuation funds there are specific duties that are imposed on the directors personally.
ASIC also has the power under the financial services laws to make banning orders against any person (with the directors of a non-compliant AFSL holder being an obvious starting point for ASIC) in a wide range of circumstances. Such orders prevent the person from providing financial services.
Note: the operation of the insolvent trading laws have been partially suspended during the period of the COVID-19 pandemic. The summary below is of the laws as they normally operate.
A company is insolvent if it is unable to pay all its debts when they fall due – determined on a cash flow basis.
A director has a positive duty to prevent insolvent trading by the company and they face significant personal monetary and potential criminal consequences (not to mention adverse professional consequences) if they allow the company to trade whilst insolvent.
The legislation requires a director of a company to prevent the company from incurring a debt if:
- the company is already insolvent at the time the debt is incurred; or
- by incurring that debt, or by incurring a range of debts including that debt, the company becomes insolvent, and, at the time of incurring the debt, there are reasonable grounds for suspecting that the company is already insolvent, or would become insolvent by incurring the debt.
A director has a defence if it is proved that, at the time the debt was incurred, the director:
- had reasonable grounds to expect that the company was solvent and would remain solvent even if it incurred the debt;
- had reasonable grounds to believe that a competent and reliable person who was responsible for providing adequate information about the company's solvency was fulfilling that responsibility, and the director expected that, based on the information that person provided to the director, the company was, and would remain, solvent even if it incurred the debt;
- because of illness or other good reason did not take part in the management of the company at that time;
- took all reasonable steps (such as appointing an administrator) to prevent the company incurring the debt.
A director must ensure that proper financial records are kept by the company and take reasonable steps (ASIC's Regulatory Guide RG217: Duty to prevent insolvent trading: Guide for directors contains some useful practical guidance in this regard) to remain properly and fully informed about the financial affairs of the company at all times so that they can reasonably form a view about:
- the company's present financial viability; and
- the impact of incurring any further debts.
In a liquidation of the company, directors can be held personally liable for the unpaid debts incurred by the company whilst it was insolvent. Such amounts can be recovered as a debt due to the company (or to the relevant creditor if that creditor has brought the proceedings with the liquidator's consent).
If a director contravenes this duty then the director may also be subject to:
- civil and criminal penalties;
- disqualification from managing a corporation.
Director penalties under taxation laws
The directors of a company are responsible for making sure the company meets its PAYG withholding and superannuation guarantee (“SG”) obligations under taxation legislation. If the company fails to meet a PAYG withholding or SG liability in full by the due date then the directors will become personally liable for director penalties equal to the unpaid amounts.
Directors in this situation will receive a directors penalty notice from the ATO which essentially gives them 3 options:
- paying the debt;
- appointing an administrator to the company; or
- wind up the company.
A director will have a defence and not be liable for a director penalty if they:
- did not take part (and it would have been unreasonable to expect them to take part) in the management of the company during the relevant period because of illness or for some other good reason;
- took all reasonable steps, unless there were no reasonable steps they could have taken, to ensure that one of the three actions described above happened.
Strategies to manage liability
As can be seen, it is inherent in the role of a director that they may attract personal liability for the legal contraventions and insolvency of the company. The risk is a real one and there have been many high profile cases over the years where boards of directors have been subject to successful legal action from regulators and shareholders (typically backed by class action litigation funders) – and a significant proportion of these cases have involved the financial services industry.
The major risks for a director are that the company contravenes the law, is allowed to trade while insolvent or fails to discharge its taxation obligations. In each of those situations the director can be personally liable for losses incurred by other persons and can face civil and criminal penalties.
In order to manage and mitigate these risks directors can take a number of actions:
- obtain directors and officers indemnity insurance cover;
- obtain indemnities from the shareholders or some other related entity of substance;
- carefully manage the company cash flow and ensure that they receive regular, up to date and reliable cash flow forecasts;
- adopt and maintain effective legal and regulatory compliance arrangements;
- appoint an administrator to the company if it appears that it is, or soon will be, insolvent.
How we can help
Holley Nethercote is able to assist directors to manage their liability risk in a number of ways including:
- providing training on a director's duties;
- providing advice in relation to particular concerns that arise;
- preparing deeds of indemnity;
- advising on regulatory requirements for insurance cover;
- conducting a regulatory review of an AFSL holder's business.
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.