Question

LAW OF BUSINESS- Canada

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1)Identify the source of and briefly discuss the present standard of care with respect to the duty of competence owed to a corporation.

explain how the Director of a company are able to meet their statutory standard of care, and identify the various methods that directors should employ to achieve this goal.

2)Identify two situations where a director may face personal liability in contract for a corporation’s contracts.  

Identify five situations that might give rise to statutory liability for a director of a corporation.

Answer 1

2.

Nature of the Problem

Not so long ago, boards of directors of large companies were quiescent bodies, virtual rubber stamps for their friends among management who put them there. By the late 1970s, with the general increase in the climate of litigiousness, one out of every nine companies on the Fortune 500 list saw its directors or officers hit with claims for violation of their legal responsibilities.“D & O Claims Incidence Rises,” Business Insurance, November 12, 1979, 18. In a seminal case, the Delaware Supreme Court found that the directors of TransUnion were grossly negligent in accepting a buyout price of $55 per share without sufficient inquiry or advice on the adequacy of the price, a breach of their duty of care owed to the shareholders. The directors were held liable for $23.5 million for this breach.Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985). Thus serving as a director or an officer was never free of business risks. Today, the task is fraught with legal risk as well.

Two main fiduciary duties apply to both directors and officers: one is a duty of loyalty, the other the duty of care. These duties arise from responsibilities placed upon directors and officers because of their positions within the corporation. The requirements under these duties have been refined over time. Courts and legislatures have both narrowed the duties by defining what is or is not a breach of each duty and have also expanded their scope. Courts have further refined the duties, such as laying out tests such as in the Caremark case, outlined in Section 27.4.3 "Duty of Care". Additionally, other duties have been developed, such as the duties of good faith and candor.

Duty of Loyalty

As a fiduciary of the corporation, the director owes his primary loyalty to the corporation and its stockholders, as do the officers and majority shareholders. This responsibility is called the duty of loyalty. When there is a conflict between a director’s personal interest and the interest of the corporation, he is legally bound to put the corporation’s interest above his own. This duty was mentioned in Exercise 3 of Section 27.2 "Rights of Shareholders" when Ted usurped a corporate opportunity and will be discussed later in this section.

Figure 27.3 Common Conflict Situations

Two situations commonly give rise to the director or officer’s duty of loyalty: (1) contracts with the corporation and (2) corporate opportunity (see Figure 27.3 "Common Conflict Situations").

Contracts with the Corporation

The law does not bar a director from contracting with the corporation he serves. However, unless the contract or transaction is “fair to the corporation,” Sections 8.61, 8.62, and 8.63 of the Revised Model Business Corporation Act (RMBCA) impose on him a stringent duty of disclosure. In the absence of a fair transaction, a contract between the corporation and one of its directors is voidable. If the transaction is unfair to the corporation, it may still be permitted if the director has made full disclosure of his personal relationship or interest in the contract and if disinterested board members or shareholders approve the transaction.

Corporate Opportunity

Whenever a director or officer learns of an opportunity to engage in a variety of activities or transactions that might be beneficial to the corporation, his first obligation is to present the opportunity to the corporation. The rule encompasses the chance of acquiring another corporation, purchasing property, and licensing or marketing patents or products. This duty of disclosure was placed into legal lexicon by Judge Cardozo in 1928 when he stated that business partners owe more than a general sense of honor among one another; rather, they owe “the punctilio of honor most sensitive.”Meinhard v. Salmon, 164 N.W. 545 (N.Y. 1928). Thus when a corporate opportunity arises, business partners must disclose the opportunity, and a failure to disclose is dishonest—a breach of the duty of loyalty.

Whether a particular opportunity is a corporate opportunity can be a delicate question. For example, BCT owns a golf course and a country club. A parcel of land adjacent to their course comes on the market for sale, but BCT takes no action. Two BCT officers purchase the land personally, later informing the BCT board about the purchase and receiving board ratification of their purchase. Then BCT decides to liquidate and enters into an agreement with the two officers to sell both parcels of land. A BCT shareholder brings a derivative suit against the officers, alleging that purchasing the adjacent land stole a corporate opportunity. The shareholder would be successful in his suit. In considering Farber v. Servan Land Co., Inc.,Farber v. Servan Land Co., Inc., 662 F.2d 371 (5th Cir. 1981). a case just like the one described, the Farber court laid out four factors in considering whether a corporate opportunity has been usurped:

1. Whether there is an actual corporate opportunity that the firm is considering
2. Whether the corporation’s shareholders declined to follow through on the opportunity
3. Whether the board or its shareholders ratified the purchase and, specifically, whether there were a sufficient number of disinterested voters
4. What benefit was missed by the corporation

In considering these factors, the Farber court held that the officers had breached a duty of loyalty to the corporation by individually purchasing an asset that would have been deemed a corporate opportunity.

When a director serves on more than one board, the problem of corporate opportunity becomes even more complex, because he may be caught in a situation of conflicting loyalties. Moreover, multiple board memberships pose another serious problem. A direct interlock occurs when one person sits on the boards of two different companies; an indirect interlock happens when directors of two different companies serve jointly on the board of a third company. The Clayton Act prohibits interlocking directorates between direct competitors. Despite this prohibition, as well as public displeasure, corporate board member overlap is commonplace. According to an analysis by USA Today and The Corporate Library, eleven of the fifteen largest companies have at least two board members who also sit together on the board of another corporation. Furthermore, CEOs of one corporation often sit on the boards of other corporations. Bank board members may sit on the boards of other corporations, including the bank’s own clients. This web of connections has both pros and cons.For a further discussion of board member connectedness, see Matt Krant, “Web of Board Members Ties Together Corporation America,” at http://www.usatoday.com/money/companies/management/2002-11-24-interlock_x.htm.

Duty of Care

The second major aspect of the director’s responsibility is that of duty of care. Section 8.30 of RMBCA calls on the director to perform his duties “with the care an ordinarily prudent person in a like position would exercise under similar circumstances.” An “ordinarily prudent person” means one who directs his intelligence in a thoughtful way to the task at hand. Put another way, a director must make a reasonable effort to inform himself before making a decision, as discussed in the next paragraph. The director is not held to a higher standard required of a specialist (finance, marketing) unless he is one. A director of a small, closely held corporation will not necessarily be held to the same standard as a director who is given a staff by a large, complex, diversified company. The standard of care is that which an ordinarily prudent person would use who is in “a like position” to the director in question. Moreover, the standard is not a timeless one for all people in the same position. The standard can depend on the circumstances: a fast-moving situation calling for a snap decision will be treated differently later, if there are recriminations because it was the wrong decision, than a situation in which time was not of the essence.

What of the care itself? What kind of care would an ordinarily prudent person in any situation be required to give? Unlike the standard of care, which can differ, the care itself has certain requirements. At a minimum, the director must pay attention. He must attend meetings, receive and digest information adequate to inform him about matters requiring board action, and monitor the performance of those to whom he has delegated the task of operating the corporation. Of course, documents can be misleading, reports can be slanted, and information coming from self-interested management can be distorted. To what heights must suspicion be raised? Section 8.30 of the RMBCA forgives directors the necessity of playing detective whenever information, including financial data, is received in an apparently reliable manner from corporate officers or employees or from experts such as attorneys and public accountants. Thus the director does not need to check with another attorney once he has received financial data from one competent attorney.

A New Jersey Supreme Court decision considered the requirements of fiduciary duties, particularly the duty of care. Pritchard & Baird was a reissuance corporation owned by Pritchard and having four directors: Pritchard, his wife, and his two sons. Pritchard and his sons routinely took loans from the accounts of the firm’s clients. After Pritchard died, his sons increased their borrowing, eventually sending the business into bankruptcy. During this time, Mrs. Pritchard developed a fondness for alcohol, drinking heavily and paying little attention to her directorship responsibilities. Creditors sued Mrs. Pritchard for breaches of her fiduciary duties, essentially arguing that the bankruptcy would not have occurred had she been acting properly. After both the trial court and appellate court found for the creditors, the New Jersey Supreme Court took up the case. The court held that a director must have a basic understanding of the business of the corporation upon whose board he or she sits. This can be accomplished by attending meetings, reviewing and understanding financial documents, investigating irregularities, and generally being involved in the corporation. The court found that Mrs. Pritchard’s being on the board because she was the spouse was insufficient to excuse her behavior, and that had she been performing her duties, she could have prevented the bankruptcy.Francis v. United Jersey Bank, 87 N.J. 15, 432 A.2d 814 (N.J. 1981).

Despite the fiduciary requirements, in reality a director does not spend all his time on corporate affairs, is not omnipotent, and must be permitted to rely on the word of others. Nor can directors be infallible in making decisions. Managers work in a business environment, in which risk is a substantial factor. No decision, no matter how rigorously debated, is guaranteed. Accordingly, courts will not second-guess decisions made on the basis of good-faith judgment and due care. This is the business judgment rule, mentioned in previous chapters. The business judgment rule was coming into prominence as early as 1919 in Dodge v. Ford, discussed in Chapter 26 "Legal Aspects of Corporate Finance". It has been a pillar of corporate law ever since. As described by the Delaware Supreme Court: “The business judgment rule is an acknowledgment of the managerial prerogatives of Delaware directors.…It is a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.”Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984).

Under the business judgment rule, the actions of directors who fulfill their fiduciary duties will not be second-guessed by a court. The general test is whether a director’s decision or transaction was so one sided that no businessperson of ordinary judgment would reach the same decision. The business judgment rule has been refined over time. While the business judgment rule may seem to provide blanket protection for directors (the rule was quite broad as outlined by the court in Dodge v. Ford), this is not the case. The rule does not protect every decision made by directors, and they may face lawsuits, a topic to which we now turn. For further discussions of the business judgment rule, see Cede & Co. v. Technicolor, Inc.,Cede & Co. v. Technicolor, Inc., 634 A.2d 345 (Del. 1993). In re The Walt Disney Co. Derivative Litigation,In re The Walt Disney Co. Derivative Litigation, 906 A.2d 27 (Del. 2006). and Smith v. Van Gorkom.Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).

If a shareholder is not pleased by a director’s decision, that shareholder may file a derivative suit. The derivative suit may be filed by a shareholder on behalf of the corporation against directors or officers of the corporation, alleging breach of their fiduciary obligations. However, a shareholder, as a prerequisite to filing a derivative action, must first demand that the board of directors take action, as the actual party in interest is the corporation, not the shareholder (meaning that if the shareholder is victorious in the lawsuit, it is actually the corporation that “wins”). If the board refuses, is its decision protected by the business judgment rule? The general rule is that the board may refuse to file a derivative suit and will be protected by the business judgment rule. And even when a derivative suit is filed, directors can be protected by the business judgment rule for decisions even the judge considers to have been poorly made. See In re The Walt Disney Co. Derivative Litigation, (see Section 27.5.2 "Business Judgment Rule").

In a battle for control of a corporation, directors (especially “inside” directors, who are employees of the corporation, such as officers) often have an inherent self-interest in preserving their positions, which can lead them to block mergers that the shareholders desire and that may be in the firm’s best interest. As a result, Delaware courts have modified the usual business judgment presumption in this situation. In Unocal Corp. v. Mesa Petroleum,Unocal Corp. v. Mesa Petroleum, 493 A.2d 946 (Del. 1985). for instance, the court held that directors who adopt a defensive mechanism “must show that they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed.…[T]hey satisfy that burden ‘by showing good faith and reasonable investigation.’” The business judgment rule clearly does not protect every decision of the board. The Unocal court developed a test for the board: the directors may only work to prevent a takeover when they can demonstrate a threat to the policies of the corporation and that any defensive measures taken to prevent the takeover were reasonable and proportional given the depth of the threat. The Unocal test was modified further by requiring a finding, before a court steps in, that the actions of a board were coercive, a step back toward the business judgment rule.Unitrin v. American General Corp., 651 A.2d 1361 (Del. 1995).

In a widely publicized case, the Delaware Supreme Court held that the board of Time, Inc. met the Unocal test—that the board reasonably concluded that a tender offer by Paramount constituted a threat and acted reasonably in rejecting Paramount’s offer and in merging with Warner Communications.Paramount Communications, Inc. v. Time, Inc., 571 A.2d 1140 (Del. 1989).

The specific elements of the fiduciary duties are not spelled out in stone. For example, the Delaware courts have laid out three factors to examine when determining whether a duty of care has been breached:In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996).

1. The directors knew, or should have known, that legal breaches were occurring.
2. The directors took no steps to prevent or resolve the situation.
3. This failure caused the losses about which the shareholder is complaining in a derivative suit.

Thus the court expanded the duty of oversight (which is included under the umbrella of the duty of care; these duties are often referred to as the Caremark duties). Furthermore, courts have recognized a duty of good faith—a duty to act honestly and avoid violations of corporate norms and business practices.For more information, see Melvin Eisenberg, “The Duty of Good Faith in Corporate Law,” 31 Delaware Journal of Corporate Law, 1 (2005). Therefore, the split in ownership and decision making within the corporate structure causes rifts, and courts are working toward balancing the responsibilities of the directors to their shareholders with their ability to run the corporation.

Personal Liability of Directors and Officers for Corporate Contracts

Most businesspeople are aware that incorporation shields a company’s directors, officers and shareholders from personal liability. However, the circumstances in which directors and officers may lose this protection are less commonly known. This article explains what directors and officers who execute contracts for a corporation should do to avoid personal liability for their corporation’s contractual obligations.

In law, a corporation’s identity is separate from the people controlling the business. As a result of this distinction, using a corporation to carry on a business affords the people who direct the company recognized protections, the most important of which is immunity from personal liability for the acts of the corporation. This characteristic is often referred to as a corporation’s “limited liability status” and has led many directors and officers to assume that they can never be found personally liable for the conduct of a corporation they control. In reality, directors and officers may not always be shielded from personal liability.

In a 2013 British Columbia Court of Appeal case, Pageant Media Ltd. v. Piche, the president and chairman of a corporation was found personally liable for the corporation’s breach of a contract that he executed on its behalf. The Court concluded that the president could not rely on the limited liability status of the corporation because he did not clearly identify that he was acting as an agent for the company. The contract and all correspondence, invoices and business cards did not refer to the legal name of the corporation and its limited corporation designation was not displayed. Further, the president signed order forms in his own name, without stating his relationship to the corporation, and paid invoices with his personal credit card.

The Court found that, when someone signs a contract on a corporation’s behalf, that person has a duty to give clear notice to the other contracting party that he or she is acting solely as an agent for the corporation and is not entering into the contract personally.

Generally, this obligation to give clear notice is met if the contract has been executed “per” an authorized signatory of a corporation. Notice can also be inferred from the circumstances where, for instance, invoices show the corporation’s legal name with its limited corporation designation of “Ltd.” or “Inc.”, or where payments are made by cheques drawn on a corporation’s account.

However, if it has not been made clear that a corporation is the contracting party, the person who signs the contract on its behalf runs the risk of being held personally liable for any breach or default of the contract by the corporation.

In addition to the duty to give clear notice discussed in the Pageant Media decision, there are statutory requirements that must be satisfied if the people controlling a corporation wish to rely on its limited liability status. Section 27 of B.C.’s Business Corporations Act (Act) requires a company to conspicuously display its name at its place of business, on documents like contracts, business letters and invoices, and on monetary instruments such as promissory notes and cheques.

If a company fails to meet these requirements, Section 158 of the Act provides that any directors or officers who knowingly permit the contravention may be personally liable to those people who suffer loss or damage as a result of being misled. Directors and officers may also be personally liable for the amount of any cheque that is issued by a company—but not paid—if the company’s name is not displayed on the cheque.

The limited liability status of a corporation is one of its most important advantages, especially when the corporation becomes party to a contract. When a corporation enters into a contract, its directors and officers will not generally be held personally liable for any breach or default of the contract—assuming they have not engaged in fraud, illegality, or other improper conduct. According to Pageant Media, however, they could find themselves personally liable even absent such conduct.

Consequently, any time you execute a contract as agent of a corporation, it is critical that you clearly indicate that the corporation is the contracting party. If you fail to take sufficient steps to communicate to the other contracting party that you are signing a contract in your capacity as an authorized signatory of a corporation, you may be held personally liable for the corporation’s obligations under the contract, including any loss or damage that results from a breach or default by the corporation.

Statutory liabilities that pose risks for directors

The word “statutory” comes from the word “statute”, which means an act of a legislature, whether federal or provincial. Statutory liability thus derives from a specific piece of legislation, as opposed to liability under the Civil Code of Québec, Article 1457 of which refers to “rules of conduct” without specifically defining them, thus leaving it to the courts to determine if an instance of conduct runs afoul of that provision.

The scope of the statutory regime5 applicable to an organization and its members varies with the nature of the organization and its activities. While some statutory liabilities concern the majority of corporations, others will affect only a small number of them. By way of example, virtually all legal persons are subject to tax legislation6, whereas the Cultural Heritage Act7 affects only a limited number of them.

These statutory norms have a protective function and are aimed at preventing reprehensible conduct that may harm society as a whole or certain of its members8. Identifying such statutory norms can allow to mark the risk areas specific to an organization and, consequently, its directors. It is therefore very important to be aware of these norms, not only to avoid being punished for contravening them, but also in order to educate oneself on the standards of conduct to be adopted within the organization, thus encouraging the embedment of a culture of compliance that will result in better day-to-day management of the organization9.

To make it easier to understand statutory liabilities, here are a few concrete examples in various areas of the law:

i) Legislation to recover money owed to the government

• Compelling directors to personally pay amounts due and unpaid by the corporation on account of withholdings and deductions at source;10
• Compelling directors to personally pay amounts due by the corporation on account of excise taxes;11

ii) Legislation to protect workers

• Compelling directors to personally pay unpaid wages;12
• Sanctioning directors personally for offences under the Occupational Health and Safety Act committed by or on behalf of the corporation;13

iii) Legislation to protect investors

• Sanctioning directors personally for an offence committed by or on behalf of the corporation under the Securities Act;14
• Facilitating civil actions by investors against directors, pursuant to the Securities Act;15

iv) Legislation to protect the environment

• Sanctioning directors personally for an offence committed by or on behalf of the corporation under the Canadian Environmental Protection Act;16
• Creating a presumption of a director having committed an offence under the Environment Quality Act;17
• Making directors solidarily liable for unpaid amounts pursuant to the Environment Quality Act;18

v) Legislation to protect personal information and to prevent the sending of unsolicited electronic messages (often associated with the term “spam”)

• Sanctioning directors personally for an offence committed by or on behalf of the corporation involving a breach of personal information;19
• Sanctioning directors personally for an offence committed by or on behalf of the corporation involving a breach of anti-spam rules20.

vi) Legislation to protect consumers

• Making directors solidarily liable for unpaid amounts pursuant to the Consumer Protection Act21.
• Sanctioning directors personally for an offence committed by or on behalf of the corporation involving a contravention of consumer protection legislation22.

vii) Legislation to counter anticompetitive practices

• Sanctioning directors by imprisonment or fines for offences committed by or on behalf of the corporation involving a contravention of certain provisions of the Competition Act23.
• Facilitating civil actions against directors of corporations that have taken part in a fraud or fraudulent tactics in connection with the tendering, awarding or management of a public contract – for example by rigging a bid pursuant to a call for tenders24.

2. Means of dissuading delinquent behaviours

Provincial and federal legislatures have enacted statutory provisions making directors personally liable for offences committed by the organization (i.e. by its employees or representatives) or for damages the organization caused to third parties. Statutory liability provisions may lead to purely civil consequences (monetary compensation to the injured party), or instead penal sanctions (fines, restrictions on activities), or even criminal ones (imprisonment).

Thus, in order to protect society at large and dissuade delinquent behaviours, the State sometimes directly sanctions the persons at the heart of the decision-making process of corporate entities. Legislative and regulatory policy, based on the premise of the separate legal personality of legal persons, long tended to refrain from holding directors personally liable for acts of the corporation. However, with the emergence of major corporate scandals25, many began to consider it inadequate to sanction only the corporation, and to allow the individuals who participated in the decision-making process to be free from liability. In cases involving allegations of offences or fault against corporations, the evidence is often complex, particularly when trying to prove the intention of someone in a position of authority to commit an act that potentially could result in breaking the law. Thus, since the 1990s there has been a progressive shift in legislative approach towards directly targeting the individuals through whom corporate decisions are made, namely the corporation’s directors and officers26. This realignment affected not only the criminal liability of corporate entities27 (aiming at a host of sectors involved in economic activity, such as occupational health and safety, competition or the environment) but also led to the statutory liability of directors as briefly described above.

In certain cases, a director’s liability will be presumed. Thus, even if a director did not commit a fault or an offence in the performance of his/her duties, he/she can nevertheless be found liable for damages. It will then usually be possible to rebut that presumption with a defence of reasonable diligence. For example, Quebec’s Environment Quality Act28 creates a presumption of liability on the part of the directors of a corporation when the statute is contravened, but that presumption is rebuttable:

115.40. If a legal person or an agent, mandatary or employee of a legal person, partnership or association without legal personality commits an offence under this Act or the regulations, its director or officer is presumed to have committed the offence unless it is established that the director or officer exercised due diligence and took all necessary precautions to prevent the offence.

(emphasis added)

We should point out that compliance with statutory norms will not necessarily defeat a civil lawsuit, and that non-compliance does not automatically constitute a civil fault29.

Conclusion

To summarize, it is incumbent on directors to fully understand the legal context in which they serve and be familiar with the internal rules specific to the corporation they manage. Directors must also be cognizant of the public statutes and regulations that may have an impact on their liability. And because there are a variety of situations where a decision made by directors may render them statutorily liable, individual directors in such situations would be well advised to insist on a legal opinion from a lawyer who specializes in this area.

Moreover, in order to be fully protected, directors should ensure they are covered by adequate D&O insurance, and even an indemnification agreement with the corporation, in the event they are sued or prosecuted. For more information on such insurance and indemnification protection, we encourage you to read our next article in that regard.30