NZSA Best Practice

By Ross Dillon, Partner, Gaze Burt and Advocacy Director, New Zealand Shareholders Association Incorporated
A limited liability company is a "legal fiction" - an unnatural entity that only has any existence because the law chooses to recognize it. It has no body, takes up no physical space, can take no actions of itself. Yet it owns property, pays taxes, employs people, manufacturers goods, provides services, flies people around the world, and often is internationally recognized.
How can something that does not have a natural existence do this? The answer is simply that real people carry out real activities in the name and in the guise of "the company".
Shareholders put up money that is used by the company to buy property - which the company, not the shareholders, then owns. Employees carry out work for and in the name of the company. The company pays them wages, but the excess value (the "profit"), is owned by the company.
If we pretend that the company had a body, then shareholders and other sources of funding provide the heart, blood, lungs (as money is fundamental to the operation) and nervous system (these entities tend to convey pain when things aren’t going well). Employees provide the "muscle" - the hands, arms, legs and feet to get things done. What is missing from the analogy is the head.
The management team of any company is the head. Directors of a company have been described in the Courts as "the directing mind and will" of the company.
A Director must lead the company and control how it is to operate - "direct" its actions.
The actions are the actions of others - the employees. The resources are the resources of others - the company itself in the first instance, with other rights vested in financiers, other creditors, and a residue of rights with the shareholders. Directors are thus dealing with other people’s money, and other people’s lives.
There is always a problem when someone is dealing with the property or interests of another. There is an all too human tendency to take less interest in or care of that other person’s interests.
The law has always intervened to protect those other interests. In ancient times the concept was called a "trust". On person had to trust another to protect his or her interests. This situation was formalized into a series of very strict rules, with very strict parameters, finally evolving into what we know now as the law of trusts.
In trust law, the obligations are very strict. If the trustee (the person looking after the rights of another) acts in a way that was less careful than someone should act when looking after their own interests, and a loss occurs, then the trustee must personally pay back every cent lost. A trustee is required to act prudently (not take risks). This type of duty is often referred to as a fiduciary duty
Where someone is merely doing a limited form of work for another, the law uses another test, set at a much lower level. The person doing the job should use the usual level of skill applicable for that type of job. Anything less than that, is negligent. As long as the person is not negligent, they are not liable for any loss.
In other cases, usually involving problems between people who do not normally have anything to do with each other, the law merely requires that people are not careless. Careless use of a motor vehicle is the type of thing we are talking about in this case.
In New Zealand, we even have a unique category that involves no fault of any kind - accepting that there is some wider public benefit in acknowledging that accidents simply happen (and sharing the burden for such accidents among every taxpayer). This is found within the statutory regime of our Accident Compensation legislation.
Given that directors are using other people’s money, where is their liability set? Is it at the level of a trustee given that directors, like trustees, play with other people’s money? Or do we accept that "accidents happen" in business much the same as in other spheres of life, so avoiding any issues of personal liability?
The answer is not one thing, or the other. In fact, each form of liability is used by the law to govern the actions of directors, depending on the particular matter at issue.
The first point to keep in mind is the purpose of allowing companies to exist at all. Why does the law chose to recognize them? The answer is that they have proved to be a useful structure for business, as they do allow an "accidents will happen" approach. If a company does collapse, the liability of the company is limited to what the company owns. Recourse can not normally be made to the assets of the shareholders, directors, or employees. In other words, companies exist to limit business risk.
This in turn allows companies to take on commercial risks. It allows a business to be set up, and structured in a way that the shareholders personal wealth is not at risk. Someone who wishes to open a shop can use a company structure to own and operate the shop. If it is not successful, the shareholders house or farm will not have to be sold (barring the requirements of a financier). Only the assets owned by the company are at risk.
Given that business involves risk, it would be inconsistent with that model and purpose to fix directors with the same strict duties as trustees. This would stop them from taking the very business risks that the company structure is designed to encourage. But how much risk can the directors take with someone else’s money?
The courts have developed a number of duties over many years, to address this problem. Many of those duties have now been carried forward into the Companies Act 1993.
Some of these could be seen as a "watered down" version of trustees duties. The main ones (and this is not designed to be comprehensive) are as follows:

The duty to act in good faith for the benefit of the company as a whole ( i.e. not for the directors own benefit, or the benefit of one shareholder, or shareholders as against employees or creditors). The concept of "good faith" is an essential part of fiduciary duties.
The duty to give adequate consideration to matters for decision (i.e. not to be careless). This is a duty far less than that of a trustee.
The duty not to act where there is a conflict of interest, without the consent of the Board of directors. This is an interesting duty, given the qualification. This means someone on the Board of a company that borrows money, can be on the Board of a company from whom money is borrowed, and vote on sensitive matters at issue between those two companies, provided the company is aware of the conflict. New Zealand is one of the few countries that allow this, presumably due to the limited pool of people who are able and likely to be directors. Conflicts of interest are much more likely in a small country than in a large one. Where these rules are breached, the transaction involved can only be impeached to the extent that the company did not receive fair value from the arrangement. Again, this is far short of the duties imposed on trustees, who generally can not act at all when a conflict of interest arises.
The duty not to obtain a profit from personal dealing with the company (again, unless consent is obtained). This duty is qualified in the same way as the conflict of interest duty. It is a very similar issue.
The duty not to appropriate company property (i.e. not to steal). Enough said.
The duty to exercise their powers only for proper purposes. "Proper purposes" have received a variety of judicial decisions, but in general terms it means the purposes for which the power was given, in the interests of the company. If that definition appears a little circular, you can imagine how difficult it has been for directors, or anyone else advising in this area, to obtain a clear view of what is required of them. The concept of "proper purpose" is in fact very similar to the concept of "good faith" - it is hard to define, but you tend to know it when you see it.
The duty to act in accordance with the company constitution. The company constitution is the document that spells out in some detail how the company is to operate. Think of it rather like the constitution of a state. If the government operates outside the constitution, it can be bought before the Courts, and some form of redress can be provided. Exactly the same applies to directors operating outside the constitution of the company.

Finally there are a small set of inter-related statutory duties, that are often the prime target for inquiries when things go wrong. These are:

Section 137 - the duty to exercise the care, diligence and skill of a reasonable director, given the responsibilities he or she undertakes in relation to the company. The director responsible for financial control must keep the books up to date. The one responsible for marketing must make sure goods are being properly developed, tested and sold. This is a duty consistent with the concept of negligence, discussed in the opening paragraphs. It is less than a fiduciary duty, but requires a higher standard of action than mere carelessness.
Section 135 - the duty not to trade recklessly. This has associated with it section 136 - the duty not to incur a liability when the director believes it can not be paid. A director can quite legally continue to operate an insolvent company, provided he has a reasonable basis for believing that the company will trade out of temporary difficulties. However, the threshold is one of carelessness (the concept of recklessness and carelessness being equivalent), and is a lower standard than negligence.
It should be noted that this is not a test of insolvency. Insolvency is often the focus of comments when a company ceases trading. It is obviously an important commercial issue, but it is not directly related to director’s duties under New Zealand law. Directors can continue to trade a company while it is insolvent, even for extended periods of time. They do not have to take steps to put the company into liquidation once it is insolvent. However, they must have a reasonable basis for believing that it will trade its way out of problems, if they chose to continue.
Finally is the duty under the Financial Reporting Act 1993, to prepare proper financial records. It is reasonably obvious that in order to direct the company, it is necessary to check it’s financial health in order to see what is has been, and may be, capable of. If the body is starving through lack of funds, it may not be a good idea to embark on a major new project. Starving bodies are not very successful at running marathons.

In the performance of all these duties, directors are entitled to rely on reports they have commissioned, enabling them to form their decisions. Thus the director responsible for finance can rely on financial information provided by the company accountant. The director does not have to prepare the accounts him or her self. The director must, however, be satisfied that the company accountant is capable of performing that task.
Thus, it is fair to say that these particular duties often in practice involve little more than "to be informed", and to act reasonably in relation to that information. This is something less than negligence, but more than carelessness. If the directors are informed, and reasonably decide to do something that does not achieve success, then they face no liability. If they are not informed and make the same decision, which is not successful, they may be.
Section 300 of the Companies Act 1993 provides that directors will be personally liable for the debts of the company, in circumstances where proper accounting records have not been kept, and this failure to keep proper records has contributed to the company collapse.
For instance, if the directors did not know that a particular product line was not making money because they did not have sufficient records, they may be personally liable for the loss should the company consequently then collapse. It should be noted there must be what is called a "causative link" between the director’s failure, and the collapse. One should have caused the other. If that link can not be proven then the directors can not be held personally liable.
In summary, it can be seen that the purpose of the regulation of director’s actions in New Zealand is designed to provide wide discretions in their use of the company resources, for the purpose of allowing the company to take on commercial risk. A mix of types of liability are imposed in order to provide some protection to the company, its employees, financiers, and shareholders in order to achieve that purpose, while preserving the benefits that arise from the operation of the limited liability company structure. In essence, the directors must ensure that any conflicts of interest are disclosed, that their actions are reasonable, their decisions are informed, and that they are made for a proper purpose in the best interests of the company. Provided these criteria are met, then generally directors will not be liable for the outcome.