In brief - Taking steps to mitigate personal liability risk is key
Directors have a myriad of strict duties at law. When these duties are breached — whether innocently, negligently, or deliberately — a director is at risk of being held personally liable. However, there are essentially three ways a director can mitigate that risk.
- fully understand and comply with duties
- maximise the protection that can be afforded to them by the company of which they are a director
- have and understand the cover provided to them under a directors' and officers' insurance policy
Fully understanding and complying with duties under the Corporations Act
Many director's duties have been codified by the Corporations Act 2001 (Cth)
(the Act) which sets out that:
- a director's power must be exercised and discharged with the degree of care and diligence that a reasonable person would exercise in the position of that director
- a director must exercise his or her powers and discharge their duties in good faith in the best interests of the company and for a proper purpose
- a director's position must not be improperly used to gain personal advantage or to cause detriment to the company
- a director must not misuse information gained in his or her position as a director for personal advantage or to cause detriment to the company
- a director must act honestly and in good faith
- a director must disclose all material personal interests to the company
- a director must keep proper books and records that explain transactions and the financial position of the company
- a director must not permit a company to incur a debt at a time when the company is insolvent or the director should reasonably suspect the company is insolvent*
*Please note that this article does not deal with directors' duties for a company trading while insolvent.
Business judgment rule under the Corporations Act may provide defence
When determining whether a director's duty has been breached, courts are often reluctant to substitute their judgment for the business judgment of the director. This is reflected in the business judgment rule contained in section 180(2)
of the Act, which provides a defence to the requirement that a director exercise its powers and duties with a degree of care and diligence.
Under the business judgment rule, a director is taken to have met the duty, and its equivalent duties at common law and equity, where they:
- made the judgment in good faith for a proper purpose
- did not have a material personal interest in the subject matter of the judgment
- informed themselves about the subject matter of the judgment to the extent they reasonably believe to be appropriate
- rationally believed that the judgment was in the best interests of the company
Despite the apparent limited statutory reach of the business judgment rule, a form of this rule has been developed by the courts and will be applied to varying extents to the other director's duties.
Other liabilities include failing to comply with Competition and Consumer Act, OHS, environmental protection, and tax and superannuation laws
In addition to liability for breaching a director's duty, there are other liabilities for which a director can become personally liable. These additional liabilities include where the company fails to comply with:
- the Competition and Consumer Act 2010 (Cth) which regulates areas such as product liability, consumer protection and competition policy
- occupational health and safety laws which provide for the health, safety and welfare of employees at work
- environmental protection laws which prohibit things like the disposal of waste without lawful authority, causing leakage or spillage of harmful substances, and emissions of ozone depleting substances
- tax and superannuation laws
While a claim against a director will most commonly be brought by the company itself, its shareholders or a liquidator, various regulators, including the Australian Securities and Investment Commission
(ASIC) and the Australian Prudential Regulatory Authority
(APRA) also have the ability to bring a proceeding against a director.
Maximising protection afforded to directors by indemnities
A company is prohibited under section 199A(2)
of the Act from indemnifying its directors against any of the following liabilities:
- a liability owed to the company itself or to a related body corporate of the company
- a liability for a pecuniary penalty order or a compensation order, or
- a liability owed to a third party that did not arise out of conduct in good faith
A company is also prohibited under section 199A(3) from indemnifying its directors against legal costs incurred in defending or resisting proceedings in certain situations where liability or guilt has been established.
However, a company is able to indemnity its directors for all liabilities that fall outside the scope of this provision. Such an indemnity is typically contained in the company's constitution whereby the company agrees to:
- indemnify its directors against liability incurred by them, other than liability which is prohibited, and
- indemnify its directors against legal costs and expenses incurred by them in defending legal proceedings where it is alleged they have done or omitted to do some act in their capacity as director
While an indemnity in the company's constitution is an important line of defence, it has its limitations. Namely, only current directors are able to enforce the clause as a result of section 140(1)(b)
of the Act which states that a company's constitution has effect as a contract between the company and each director. Therefore, once a person ceases to be a director of the company, they are unable to enforce the constitution as a contract.
Due to this limitation, it is usually preferable that a director enter into a deed of indemnity. A deed of indemnity is a contractual agreement between the company and its director(s). The deed sets out the basis on which the company will indemnify the director for personal liabilities and associated legal costs that arise as a result of their role as a director.
It is important to be aware that the prohibitions contained in section 199A apply to deeds of indemnity as well.
That is why companies commonly take out directors' and officers' insurance as it provides important additional protection where:
- the company makes a decision not to indemnify a director, or
- the company is unable to indemnify a director
Understanding directors' and officers' liability insurance (D&O)
D&O is a specialist form of liability insurance. A corporate D&O policy generally has three insuring agreements or "sides":
- Side A, which seeks to indemnify directors and officers for their legal liability as directors and officers when their corporations do not indemnify them
- Side B, which seeks to indemnify corporations for the indemnity they grant to directors and officers for their liability as directors and officers. For this side to respond to claims, the director or officer must be named in proceedings. In other words, this insuring agreement will not respond in the event that only the corporation is the subject of the proceedings
- Side C, which seeks to indemnify the insured corporation for claims arising from the purchase or sale of securities of the corporation
It is important to be aware that D&O policies differ. Therefore, the starting point is always the policy itself and identifying what the policy says. In particular:
Is it a claims-made policy?
D&O policies are generally claims-made policies, meaning that the policy only covers claims made during the policy period. This is irrespective of when the events giving rise to the claim occurred. The implication being that a policy needs to exist at the time a claim is made.
Has proper disclosure been made?
An insured is under an obligation to disclose information to the insurer. This includes notifying the insurer of any pending claims or events that may give rise to a claim as soon as they arise. Failure to comply with this obligation may result in the insurer seeking to avoid or reduce its liability under the policy.
What are the policy terms?
It is important that the precise terms of the policy are understood as different policies may have different definitions, terms, conditions and exclusions. For example, the definition of director and/or officer may not necessarily be the same as the definition contained in the Act. Moreover, if a company does business outside of Australia, does the policy provide worldwide cover? Or if there is an ASIC investigation, liquidator's examination or Royal Commission, will legal costs incurred be covered under the policy?
What are the policy limits?
D&O policies generally have an overall limit and sub-limits for specific aspects of cover. The adequacy of those various limits should be considered in light of the size of the company and its appetite for risk mitigation.
What are the policy exclusions?
Policy exclusions will vary depending on the insurer but generally exclude claims for bodily injury (save for any employment practice liability claims if they are specifically included), dishonesty, fraud and intentional breach. Furthermore, certain liabilities are incapable of being covered. These liabilities include wilful breaches of a director's duty or contraventions of section 182
and section 183
of the Act.
Of course, there are numerous other considerations that should be taken into account when seeking to understand a D&O policy. If a director or company is unsure about the adequacy of the cover they have in place, they should consult their insurance broker.
Risk management for directors
A director is subject to numerous risks which can result in the director becoming personally liable. The best way directors can protect themselves from that risk is to fully understand and comply with their duties, maximise the protection afforded to them by the company, and have and understand the cover provided to them under a D&O policy.
This is commentary published by Colin Biggers & Paisley for general information purposes only. This should not be relied on as specific advice. You should seek your own legal and other advice for any question, or for any specific situation or proposal, before making any final decision. The content also is subject to change. A person listed may not be admitted as a lawyer in all States and Territories. © Colin Biggers & Paisley, Australia 2023.