Its not the puppet but the puppeteers

More wisdom on directors' liability - can they be liable when a company breaches a contract?

As readers of this journal know, companies are artificial persons. They can only act through the agency of human beings - usually directors or other officers of the company. While it is common for companies to be charged with breaching the various provisions of the statutes, it is now becoming more common for individuals (especially directors) to be joined in litigation for either direct involvement in alleged breaches or as aiders or abettors.

In the case of company directors, of course, there is a different range of potential liability. They are liable under specific provisions of the Corporations Law and related legislation. But, even apart from trade practices, environment protection, occupational health and safety and other areas, directors may find themselves joined as defendants in specific situations, as occurred recently in Tsaprazis & Ors v Goldcrest Properties Pty Ltd & Ors ((2000) 18 ACLC 285).

The decision of Justice Hodgson, Chief Justice in Equity in the New South Wales Supreme Court, although only an interlocutory issue, throws up the kind of questions that will arise more and more as the law changes to make directors liable in a wider variety of areas. The recent proposed amendments to make directors liable for the wages of employees in the Employee Entitlements amendments is testament to this growth in situations where directors may be held personally liable in specific circumstances.

The facts of the Tsaprazis case are taken from the CCH company law notes.

Three persons leased premises from Dernu Pty Ltd. The lease contained covenants by Dernu to maintain the premises in good condition. It was claimed by the lessees that water had entered the property due to structural defects. The premises were sold by Dernu to another company, Goldcrest Properties Pty Ltd, which purported to terminate the lease on the grounds that it was impracticable or undesirable to repair the damage.

A number of claims for damages were brought by the lessees. One claim involved an allegation against the principal director (and shareholder) of Dernu, on the basis that a duty of care was owed by the director to the lessees not to breach the lease so as to cause economic loss to them, and that the director negligently breached this duty of care by failing to ensure that Dernu complied with its obligation.

Although the director had not guaranteed the company's obligations under the lease, the lessees submitted that a duty of care could be found to exist where there was sufficient indication of possible damage, proximity and vulnerability. It was alleged that the director knew of the lease, knew of circumstances which meant that the lessees would be severely damaged by a breach of contract, contributed to the creation of those circumstances, and then, having the power to ensure that the company did not breach the contract, failed to do so.

The director argued that there were good reasons of "principle and policy" that there was no duty of care in this situation. It was submitted that the law of negligence should not be used in substance to give rise to a director's guarantee of a corporate lessor's obligations.

As indicated earlier, the matter was a matter on the preliminary issue - whether the statement of claim could remain in its current form. It was argued that the particulars were not capable of establishing the necessary relationship between the relevant director and the plaintiffs. The defendant director argued that the law should not be extended too far despite the recent High Court decision in Perre v Apand Pty Ltd ((1999) 73 ALJR 1190).

Justice Hodgson agreed with the argument that the case of Perre v Apand should not extend the law too far. Quoting from Chief Justice Gleeson in that case he suggested it was important that despite the expansion given to the obligations of persons to avoid causing damage to others, there needed to be some intelligible limits placed on the law of negligence to keep it within the bounds of commonsense and practicality.

But, Hodgson CJ went on to consider the position of the company director in the context of general principles involving contracts made by companies. While he recognised that only the company is liable under such a contract, not its shareholders or directors, directors may "become indirectly liable to other contracting parties through breach of their directors' duties to the company, or through breach of the Corporations Law relating to such matters as insolvent trading." (at para 11) In his view directors were not generally liable for inducing breaches of contract (for example, if they allowed the company to break a contract) unless of course the directors knew that this was occurring and encouraged the company to break the contract. Having reached this general view he then put up the following proposition which suggested in specific cases liability may well arise.

"It is pertinent to note that there would generally be a problem with a director contracting with a third party that he or she would cause the company to perform the obligations of the company under a contract with that third party. Certainly, if a director received consideration in return for such a promise, this would be a secret commission, unless the consideration was received with the informed consent of the company, and in situations of insolvency, possibly the informed consent of creditors. Even if there were such informed consent, it seems to me that a direct promise to act as a director in a particular way, where the director's obligation is to act bona fide in the interests of the company in all situations, may itself be a breach of fiduciary duty. It would be a breach of fiduciary duty to perform that promise if that performance was not itself in accordance with the fiduciary duty of the director. (see para 15 of the case)

He then went on to suggest that what was alleged was that the director knew of a contract and the circumstances of the contract, including the fact that the other parties to the contract would be damaged in the case of a breach of the contract, and had the power to ensure that the company did not breach that contract, then it is plainly sufficient to give rise to a duty to exercise reasonable care that the company fulfil its contract. However, if the director took some positive action knowing that meant the contract would be broken (and the other party suffered loss) then the director might be liable for a breach of his duty to act with reasonable care. The facts of the case would clearly be important in this context.

As the law expands the obligations of directors, making it important for them to take into account the interests of creditors where a company may be close to insolvency, or now the interests of employees in the context of the proposed new legislation, the potential for personal liability is increasing. The next step, of course, would be for the courts to say that the director owed a direct duty to persons such as employees. That would be an extraordinary step _ one it is hoped will not occur. But, in the light of the way in which the law has been developing, specific situations may well give rise to such remarkable assertions and perhaps a conclusion on the part of the court in appropriate circumstances.

The clear message from this case is that, while in normal circumstances directors will not be liable where companies do not fulfil contracts resulting in damage to other parties, depending on the circumstances of how the directors were expected to behave in relation to the events surrounding the breach of the contract, the directors may well find themselves liable or at least being sued. In this case the director was sued but the pleadings were struck out. The next case may well end up differently.

Disclaimer

The purpose of this database is to provide a full-text record of all articles that have appeared in the CDJ since February 1997. It is aimed to assist in the research and reference process. The database has a full-text index and will enable articles to be easily retrieved.It should be noted that information contained in this database is in pre-publication format only - IT IS NOT THE FINAL PRINTED VERSION OF THE CDJ - therefore there might be slight discrepancies between the contents of this database and the printed CDJ.