Directors walk fine line when companies fail

Whether one accepts corporate failure as the necessary “creative destruction” of a capitalist economy, or the systemic by-product of competition in a free market, the end result is always painful for those who have invested in a failed business.

The demise of Feltex is the latest New Zealand example of a large corporate collapse followed by calls to flog the guilty parties. The recent string of finance company failures has also seen calls for action. This is an understandable human reaction and efforts to ascertain liability on the part of various actors in the drama, including directors, are only right and proper. Where loss has been suffered as the result of a failure to meet legal duties and obligations, the law needs to take its course.

However, it is important to keep in mind that business failure, by itself, is not a legal wrong. If failure in business was automatically actionable in the courts no rational person would ever contemplate being a director. Who among us is invulnerable to failure? The law recognises this. It imposes duties and standards of behaviour against which directors’ actions are to be judged, it does not judge the quantum of an annual result. As a matter of general legal duty (as opposed to specific legal obligation, for example filing tax returns), a director will suffer sanction if he or she is careless, disloyal, reckless or fraudulent in the prosecution of his or her duties. The law will not punish a director (in the absence of any of the above) for being wrong or mistaken in the direction of their company. Poorly performing but blameless directors should see their directorships dwindle in line with their reputation.

Central to the issue of director performance is the ability of a director to rely on the opinions of experts. A non-executive director simply cannot do the actual work of management or of the auditors, internal or external. In many situations directors are forced to rely on the opinions of others. The law recognises this and provides specific defences. The Companies Act provides that directors may rely on information prepared or supplied, and on professional or expert advice given by a professional adviser or expert in relation to matters which the director believes on reasonable grounds to be within the person’s professional or expert competence. This applies only when the director is acting in good faith, makes proper inquiry when demanded by circumstance and has no knowledge that such reliance is unwarranted. The Financial Reporting Act provides a defence for directors if they have taken all reasonable and practical steps. This is as it should be. To hold directors liable where they have relied on experts for information that the directors are not able substantively to form themselves would make the directorial role problematic to the point of impossibility.

In the light of all the above it is interesting then to read the recent report of the Securities Commission on its inquiry into Feltex, in particular the company’s compliance with certain financial reporting obligations. Feltex had breached certain banking covenants with ANZ and the issue was whether this breach required disclosure as a material matter in the 31 December 2005 half year accounts under NZ equivalents of international financial reporting standards (NZ IFRS). The directors were aware of the breach but considered it had been waived as the bank had expressly told them no action would be taken and had advanced further funds. Nevertheless, the breach had not been formally waived. The board requested Ernst & Young to conduct a review of the December accounts to ensure compliance with NZ IFRS. Feltex required its employees to provide all information requested to Ernst & Young and the board audit committee followed this up by asking Ernst & Young if they had any reservations about information supplied to them and if they could confirm that the financial statements were compliant with NZ IFRS. Ernst & Young did so confirm.
The Commission noted all the board actions but nevertheless was of the view that the board had failed to adequately appreciate the significance of the breach and the financial reporting obligation for material disclosure under NZ IFRS. It referred the matter to the Registrar of Companies. It is interesting to note that the Feltex collapse itself was unrelated to this, a matter of pure compliance. Had the board asked for and received a formal waiver, there would have been no issue.
The moral for future and present directors then is that despite your best and honest efforts and despite the advice of experts you can still be viewed as failing in specific duties. Being a director is not for the faint hearted.