Liability of Company Directors: Everything You Need to Know
The liability of company directors is typically non-existent when it comes to corporations which have protections in place for high-ranking members and owners.3 min read
The liability of company directors is typically non-existent when it comes to corporations which have protections in place for high-ranking members and owners. Even if a high-ranking member makes a bad decision, the law will not make that person liable unless there's a violation of a specific duty.
The law that handles corporations has expanded liability terms. Even though there's a shield from liability, there are occasions where the law does hold officers and directors accountable for their business decisions.
Officer and Director Liability
The occasions when officer and director liability happens is called piercing the corporate veil. The director is responsible for acting in good faith and using care in a situation the way a normal person would in a similar situation. The business judgment rule protects directors as long as the decision is made with the best intentions for the company and in good faith. This is why a corporation is advantageous as a legal structure because it protects people from liability for the actions and debts in the business.
Yet, there are circumstances where liability is limited and the court will hold officers, directors, and shareholders liable. A court does this if it believes the business was not formed for legitimate purposes. If a business is not distinguishable from its owners, courts won't allow owners to benefit from limited liability.
As an example, Joe's Bakery Inc. and its owner Joe have the same bank account and Joe signs contracts under his name. Joe may be liable for breaching a contract because he and his company are not legally distinguishable. If businesses are formed for illegal purposes, courts will not allow compensation to owners. If there are little to no corporate formalities, like a record keeping, a court may place liability on the people controlling the business.
How Does a Court Determine if Directors Acted in Good Faith?
First, the court looks at the responsibilities and duties of the director and asks what a reasonable person with general skills and knowledge would conclude. It's a test to figure out if the director has the minimum threshold of competence to perform the role. Secondly, the court looks at their skill, experience, and knowledge as a subjective test.
Director oversight liability is based on the good faith concept.
Director personal liability for debt during insolvency happens when a company is insolvent, and an insolvency practitioner wants to see if the director is acting in wrongful trading that doesn't maximize the return of the company.
It's important for directors to make sure they:
- Act in the best interests of the creditors first, once they understand the corporation's financial position.
- Communicate clearly with creditors and shareholders.
- Act on professional advice.
- Do everything possible to find new business and manage debts.
Director Liability and Good Faith
A director's obligation includes acting in good faith with corporate information and reporting which the board deems correct. Failure to do this will mean the director is liable for losses due to non-compliance. Directors are at risk if they fail to oversee the compliance program or act passively. The board has to be trained to identify warning signs and oversee compliance.
A corporate director is subject to liability when he fails to implement an information system or if while implementing this control, the director fails to oversee its operations. Directors should implement compliance and monitoring programs within the business, and oversee the programs for possible law violations. In the event of a possible violation, directors should, in good faith, stop the wrongdoing from continuing.
A director in good faith should assure:
- There is a corporate information and reporting system.
- The system is is enough to ensure that the board has the information to comply with laws so that actions can be done in a timely manner for ordinary operations.
Even if these steps seem simple, it can be easy for the director to slip and face liability. By using an outside company to become an independent counsel and investigate potential fraud claims, as well as help in damage control, the board of directors can limit oversight liability for them and for the company. Using an outside counsel can help directors to investigate claims of fraud or other wrongdoing.
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