Are there still some sleeping directors left Law Reporter

Recent spectacular business failures are no excuse to further amend the law.

The events surrounding the collapse of One.Tel and HIH raise again the question of the role of non-executive directors, their duties of care and liabilities in the event of insolvent trading. So much has been written in the newspapers about what should have happened and did not happen in those two companies – and there are others – that the Prime Minister, regrettably, has again decided to amend the law even before it has even been tested.

The suggestion that we need to amend our Corporations Law at this time, before the most recent amendments to the insolvent trading provisions of the Law, and some of the other changes introduced in the last two years, are tested in the courts is disappointing and worrying. Such changes will simply add considerable cost to doing business. But, regrettably these events are not merely flashes in the pan. The recent decision of Mullighan J of the South Australian Supreme Court in Sheahan (as liquidator of South Australian Service Stations) v Verco and Hodge [2001] SASC 91 is testament to this. The facts of the case are these. South Australian Service Stations, owned and operated a number of service stations in South Australia. The purchase and operation of two of the businesses of the company had been mostly financed by loans from the Bank of Singapore and the ANZ Bank. The loan had been secured by a charge over the assets of the company and the personal assets of the managing director, a Mr Linke. Further finance had apparently been sought and obtained in return for a shareholding being provided by Messrs Verco and Hodge in 1990 and 1991. They were pastoralists/farmers. Both became non-executive directors of the company. They were, however, not active participants in the management of the company. The company had been incorporated in 1977 and until 1990 had been under the control of Mr Linke and his family.

Some time later, the company went into liquidation (July 1992) when creditors sought to enforce their mortgages. The question was whether Verco and Hodge were liable for the failure of the company either as directors pursuant to their common law or the statutory duties of care and diligence (then section 232(4) of the Corporations Law see now section 180(I)) and what their liability might be pursuant to section 588G of the Corporations Law which deals with insolvent trading. The company apparently became insolvent on 4 June 1991. Questions had been raised as to whether insolvency arose earlier – and whether Verco and Hodge (among other directors) allowed the company to incur debts while insolvent. In the case against Verco and Hodge, Linke did not give evidence. Apparently, proceedings against him had been discontinued (he had become a bankrupt). Mullighan J held that Linke had embarked on a course of conduct that apparently might have misled the creditors and his co-directors. At all times, he had represented that the company was in a sound financial position with a considerable potential to increase its profits. As a result, substantial liabilities (including various interest payments and depreciation) were not brought to account so it appeared the company was making a profit which in fact was not the case. On 12 March 1992, receivers and managers were appointed and it was wound up in July 1992.

Mullighan J held that (unfortunately) there had been a failure on the part of the directors to exercise appropriate care and diligence. While both defendants were non-executive directors they had previous business experience but had relied on Linke to provide management expertise. The company had only held one board meeting in nearly two years. There had been no general meetings of the company either during that period of time so that the 1990 and 1991 accounts had neither been considered nor adopted. The court held that there were a number of other breaches of statutory duties relating to the maintenance of accounting records. The absence of any formal enquiries by the non-executive directors concerning the financial position of the company was also noted by the Judge. While they had relied upon the reports (of an informal nature) provided by Linke, this in the judges' view was inadequate. The non-executive directors were also held to have failed to examine the company records to verify information provided by Linke and to make specific enquiries concerning certain purchases, provisions of finance etc. It was the overall failure on the part of these directors to investigate the company's financial position and to monitor it properly that contributed to his finding that there was a breach of duty.

As the non-executive directors had been held to be liable for insolvent trading it was argued that this was imposing a double barrelled obligation and imposition on them. However, Mullighan J noted that the liquidator could pursue directors for losses sustained by the company. The action for negligence was a separate action brought on behalf of the company. Having found that the directors were in breach of their duties, the judge then turned to the question of whether their negligence was the cause of the losses sustained by the company. In his view although the actions on the part of the non-executive directors, were unfortunate, they were not the cause of the losses. Accordingly, they were not liable to compensate the company. In the judge's view the company's financial difficulties only arose in fact when the major financiers, the Bank of Singapore and the ANZ Bank called in their loans. The judgment of Mullighan J is important because it contains some interesting statements of what one can expect of a non-executive director, especially in a smaller company and in relation to the consideration of financial records, statements etc. While the statutory provision under consideration at the time was different, in some respects, to section 180 of the Law, the comments of Mullighan J set out below are in my view relevant in today's corporate law scenario.

In reaching the finding that the directors were in breach of their duties to act with appropriate care and diligence, both at common law and under the statute, Mullighan J had regard to the fact that they were non-executive directors and to their reliance on Mr Linke. What caused him to reach his conclusions were described in these words (para 121): "They took no steps to inform themselves about the affairs of the company or to become familiar with the service station business and how they were run in the general sense. The extent to which they, as non-executive directors, were justified entrusting and relying upon Linke as the chief executive officer or managing director and [the senior administrator] depends upon the nature and circumstances of the company as they existed, not as Verco and Hodge thought them to exist. This is so because of their failure to inform themselves about the affairs of the company. Had they done so and found it to be financially healthy and well managed with appropriate procedures for reporting through the chief executive officer to the board of directors, it may be expected that they could have left many matters to Linke and staff of the company without being in breach of their duty as directors. ...

"While it may be accepted that as non-executive directors they were not under an obligation to carry out a detailed inspection of the day to day activities of the company, they were obliged to be aware of the true financial position and capability of the company and to act appropriately if there are reasonable grounds to expect that the company will not be able to pay its debts (relying on the Friederich case)." The judge also noted that while the company was not a public company and the only shareholders were investors or entities which they controlled, it had large debt. Lenders in that circumstance were entitled to expect that the company would be managed properly and the directors were obliged to do so whether they were executive or non-executive directors. Mullighan J also noted that while Verco and Hodge were graziers/farmers without great experience, and that this was known to Linke who had substantial assets and was a successful businessman, they were not relieved of their obligation as directors. They were not men ignorant of financial matters and they had some commercial expertise. They were also apparently members of certain racing clubs and owned considerable sums of money which they had managed.

This decision is an extremely interesting one. It will be fascinating to see whether there are any appeals brought against the findings made by the judge. It may be seen by some as imposing too harsh a standard on non-executive directors. To what extent, the statutory business judgment rule which is now in existence, would have relieved either Verco or Hodge of liability had the case been brought under the current law, is not clear.

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.