Directors duties

There are many benefits to operating a business through an incorporated entity. However, it is important to understand that the great benefits of operating behind the corporate veil come at a very important price. Directors of a company (usually the same people as some or all of the owners) have a number of duties that they must follow. There are several sources from where directors duties arise. The best-known of these is the Corporations Act; but, there is also law created by the courts.

1. Corporations Act

Under the Corporations Act 2001 (Cth), several duties are specifically set out as follows:

· care and diligence (section 180)

· good faith (section 181)

· use of position (section 182)

· use of information (section 183)

· keeping financial records (section 286)

· insolvent trading (section 588G)

It is important for directors (also usually the owners) of a small business to understand that the protection they get from personal liability and of their personal assets in a company, is because the company and the directors are separate legal entities. This means that the directors must act and make decisions in the best interests of the company, as opposed to what might be in the directors’ best interests. These duties also apply to “officers” of the company, which includes the secretary.

The directors are responsible for the management and control of the company. Accordingly, the directors must act appropriately in governing the company’s affairs. The duties in these sections essentially mirror the duties of directors in the court-made law, over hundreds of years. Each of these is briefly described below.

It should be noted that the duties are in addition to the limit on authority established by the company’s constitution or at a shareholders general meeting or at a board meeting.

2. Care and diligence

There is an obligation that all directors take all necessary steps to have a basic understanding of the key details of the company, including its activities, size, distribution of functions and its financial position. That they must carry out their duties in the same way that a “reasonable person” in the same situation might act.

There can also be a breach of this duty by causing a company to enter into risky transactions without any prospect of producing a benefit. The director will meet this duty if the decision is made using the “business judgment rule”.

All directors are required to know what is going on with the company. If one director makes a decision that breaches the duty of care and diligence, it will be no defence for the other directors to say that another director made all the decisions and they played no part in the management of the company.

3. Good faith

Directors must act in good faith in the best interests of the company and for a proper purpose. This includes avoiding a conflict of interest, and to reveal and manage conflicts if they arise. This is a duty of honesty and trust.

This happens in small businesses where the directors are also the shareholders. What action might be in the best interests of the shareholders may not be in the best interests of the company. For example, where a company may be facing financial difficulty and potentially insolvency, the directors must weigh up the risking the company’s money to do a certain thing, with a duty to the company’s creditors not to unduly risk the money that could otherwise pay them. This is a balance that directors need to be aware of and act accordingly.

4. Use of position

A director must not use their position to gain advantage for them self or anyone else or to cause harm or damage to the company. This arises from the concept that there cannot be a conflict of interest between the company and the private interests of the director, so that the stakeholders of the company including the creditors have confidence that the market place is being operated properly.

Even though in small business, the shareholders and the owners are usually the same people, there is no defence for a director getting the consent of the shareholders to take any particular action.

5. Use of information

A person must not use information known only because they were a director of the company to gain advantage for them self or anyone else or to cause harm or damage to the company. This duty is essentially one of confidentiality and it continues after a person stops acting as a director.

6. Keep financial records

A company must keep written financial records that:

· accurately record and explain the company’s transactions, financial position and performance; and

· enable true and fair financial statements to be prepared and audited.

In addition, the company must prepare a number of reports each year, including a financial report and directors’ report. These records must be kept by directors for a period of 7 years.

Failure to comply with these requirements is a strict liability offence and can result in criminal penalties applying for the directors and officers.

7. Insolvent trading

A director of a company is not to trade while the company is insolvent. If the company is insolvent at a time when a new debt is incurred, the directors of the company may be personally liable for that debt. The directors will be spared personal liability for insolvent trading if they put the company into “voluntary administration”. Go to www.krodok.com.au to learn more about how owners of small business protecting their personal investment in their companies can act as a protection in an action for insolvent trading.

The operation of the liability for insolvent trading was altered during the Covid-19 period, so that in certain circumstances there is a moratorium on insolvent trading until 31 December 2020. Whilst it is expected that it will be fixed by the Government before the end of the year, there is a question about whether the protections for insolvent trading will apply in circumstances that the directors do not put the company into external administration by 31 December.

8. Shadow directors

The duties referred to above apply to “directors” as that term is defined in the Corporations Act. The definition includes a person validly appointed to that position but can also include a person who acts as if they were the director.

Whether or not a person is a “shadow director” depends on how they act towards the company but also how the business acts towards them. If the company routinely follows what the person says, it is more likely that the person will be found to be a director with the liabilities set out above. The same applies to the interpretation of “officer”.

9. Penalty

If a director (or shadow director) is found to have breached these duties, they may be personally liable to pay an amount to the company that is equal to the loss that is suffered by the company. A director can also be banned from acting as a director if they are found to be in breach of their duties. However, in more serious cases where the director may have acted recklessly or deliberately, the directors may be criminally liable for those actions.

If a person is served with legal proceedings alleging a breach of directors duties, they should seek legal advice. Early legal advice will give directors the best chance to protect their personal possessions from attack.