Critique on Board directors’ role and liabilities

Wednesday, 22 February 2012 01:19 -     - {{hitsCtrl.values.hits}}

By Cassandra Mascarenhas

The role and responsibilities of a director on the board of a company is a topic that has risen to the forefront of the business community, both in Sri Lanka and globally, in recent times and tackling the billion rupee question of ‘Sweat or Blood,’ a CEO Breakfast Debate on accountability and protection was held last week.

Organised by the collaborative efforts of Janashakthi Insurance PLC, ACCA, ICCS and the Daily FT, the debate was a well-rounded one with representatives from differing professions undertaking the responsibility of shedding some light on this topical issue.

From left: Brandix Lanka CEO Ashroff Omar, Sampath Bank Independent Non-Executive Director Sanjiva Senanayake, Architect of the Companies Act 2007 Harsha Cabral PC, Daily FT Editor Nisthar Cassim (moderator), former Attorney General Mohan Peiris, Janashakthi Insurance Managing Director Prakash Schaffter and Nithya Partners Precedent Partner Arittha WikramanayakeThe responsibilities of a director

The debate fittingly commenced with an address by the Architect of the Companies Act 2007 Harsha Cabraal who defined the responsibilities of a director as set out in the Act.

Citing from a section just below Section 118 in the Act, he noted that it clearly states the actions a board of directors can do personally and what are the actions they can delegate. There is another list given in Schedule Six of that which sets out very clearly that there are certain functions the board is responsible for and that there are certain functions that they can’t delegate.

“So that’s very clearly set out. You can have a hired CEO or a hired CFO but the board’s responsibility might remain within these certain transactions. Then you find a very important section in 187 which simply says in black and white that the directors ought to have the best interests of the company and act in good faith,” he said.

However, situations arise when sometimes you are the director of a subsidiary company appointed by the main company. Now which company’s rights would you look after? The best interests of the subsidiary or the man who appointed you there, he questioned. The articles have to spell out very clearly what that role is about.

Acting in good faith and in the best interests of the company is simplified in Section 187 and is something all directors should know, Cabraal added. The next section 188 very simply says that all directors should always follow the provisions of the Companies Act and the articles of the particular company.

A company has its own articles, internal management document and provisions of the Companies Act which ought to be followed. The next section, 189, says you must not act in a negligent manner and outlines the standard of care that is expected of you when you are on the board.

Cabraal explained that these are three simple sections which speak volumes on the role as a director; it is now clear-cut and everyone should know that when you are a director, you are bound by at least these three sections which give a clear guideline.

“There are so many other sections, say from Sections 191 to 200, it tells you what is conflict of interests in shares, what is conflict of interests in contracts, what are the things you should do and not do, what should be entered in the interest register – these are expanded in your securities legislation as well when it comes to insider trading and so on and so forth,” he detailed.

There are other very important sections in this Act – especially 219 and 229 – in regard to what a director should do in an insolvency situation and what a director should do when there is a serious loss of capital. These sections should be kept in mind because the shareholders may not know how the company is managed or run. The directors are privy to this.

The shareholders may get to know when they look at the quarterly accounts or maybe the annual accounts, then it will be too late whereas 219 and 220 specifically put the entire responsibility on the directors to ensure that if there is a serious situation that has arisen in the company, to arrest that situation then and there, call the shareholders and inform them that the company is in trouble and ask them what line of action should be taken. The serious loss of capital situation is very important.

These are all provisions which hand a lot of responsibility to the director, in addition to the other financial management mechanisms of solvency and a whole lot of features in regard to the financial management of the company, these are clear-cut provisions set out in the Act across the board for all companies and these are things that directors should know.

“Now why do we need this? Because becoming a director is so simple. Any fool can become a director. There is no major qualification that is sought to become a director. If you are above 18, if you’re not a convict, if you’re not mad, you can become a director. Reading or writing is not necessary. So if you don’t know to read or write and if you make them directors, if you put fools on boards, you know exactly what the outcome would be,” he stated strongly.

Although these are basic features give the clear-cut role of the responsibilities of a director, again, these responsibilities are balanced by certain other provisions of the Act. A lot of people used to say that these are draconian provisions that have been introduced to the Companies Act, which is not so because there are a couple of provisions in the Companies Act, especially 190, which tells you that you can rely on third party expertise, your fellow directors, your committees, he explained.

“Say for example, if I’m on the board and there is a financial issue that comes up, I might rely on my colleague who is a director of finance of the board, who is a chartered accountant so that you guard yourself, you’re not acting in a reckless manner as you may find situations on certain boards where there are plans, parties to influence your thinking. As long as you guard yourself with all these actions, no one can say that you are acting in a reckless manner. The standard of care of a particular director, if the standard of care is of a lesser category then the standard will be very much lower,” he said.

He then emphasised on the importance of dissent. If a director does not personally think a decision made is not good for the company, the dissent should be recorded. It may not be unanimous but a director can always dissent. However that is something that you always don’t see on boards, Cabraal observed.

Very rarely do you find dissent because most of the directors are under obligation to the chairman; they are under obligation because they get favours from the company, the privileges of the company which is why there is always a balance of independent, non-executive directors because their credibility matters. He added that if you are a non-executive director and your voice is not heard, there is no point on being on such boards.

Section 190 gives a director on boards a lot of protection. There is another feature in the Companies Act – Section 218 where it provides insurance for directors, so let the company pay the insurance, Cabraal advised.

“There are specific instances when liability can be avoided if you have the insurance cover. In addition to that, the regulatory element will come in when additional provisions that may make your life difficult. Insider trading is one jurisdiction we have seen that happening. Not anymore, as the stock market is not that vibrant these days. Otherwise most of the people in the business regime would know how this happens,” he said.

The other element of executive, non-executive and independent directors comes from the corporate governance mechanisms. These are new features that have been fostered upon the business community. Corporate governance was not heard of before 1992, when the Cadbury Commission started talking about corporate governance.

The concept previously was that companies have to look after their shareholders. If the shareholders are happy, if dividends are declared, then it’s a good company, but this is not the case anymore. Corporate governance has opened the doors and you have to now look after the shareholders, the company, the employees, the creditors, other stakeholders and the world at large.

“It is sometimes better to be on a board which is regulated because you would know it long before a company crashes as there would be internal controls, risk management and so many committees which might pick up what is going wrong. The most important thing you have to realise is that in the Companies Act alone, the civil liability that is attracted to directors could be seen in 29 places but the criminal liability that is attracted is a new feature because it’s much wider than it was. There are 105 provisions in the Companies Act which attract criminal liability, not only fines but one could even end up in jail. These provisions should be known by all directors who are on boards, whether listed or otherwise,” he concluded.

A legal perspective

Former Attorney General Mohan Peiris addressed the gathering next, adding a legal perspective to the proceedings.

“Although the billion rupee question is sweat or blood, I believe it need not be either. I don’t think that the law is that draconian. I do believe that if one takes an objective view of what the law is, there shouldn’t be too much of a difficulty adhering to it but if you get to the bottom line of it, it is about good faith in the best interests of the company. It is easier said than done but that is the bottom line,” he noted at the outset.

Act No. 7 of 2007 provides an extension from the provision of creditors. Creditors according to Peiris can be defined as those who have extended credit to the company such as banks, suppliers who supply good and services on credit, stakeholders to whom directors owe a duty.

Taking Section 187, it simply says a person exercising powers of performing duties of a director of a company shall act in good faith, and subject to sub-section two, in what that person believes to be in the best interest of the company. There is an inbuilt good faith mechanism and a duty to act in what you believe to be in the interests of the company. Although this duty has yet to be tested in Sri Lanka, this formulation of the duty has been interpreted all over the Commonwealth.

Identifying the parameters of this duty, he stated that as long as you act honestly, in other words if you believe in a particular course of action is in the interests of the company, then the courts have gone to the extent of saying that they will not supervise the course of the action, or what the Americans call the business management rule.

Defining these interests in a company, Peiris explained that they have to take precedence over personal interests of individuals and Section 187 declares that. In one case, the court had said that the interests of the company would generally mean the interests of the shareholders and that’s the bottom line. However, an interesting development is that the interests of the company should be equated with the interests of the creditors.

 In 1988, it was declared that the directors must act in the interest of creditors too. It was followed earlier by a New Zealand case reported in 1985, that this duty towards the creditors intrudes only when the company is nearing insolvency. The rationale to that is that it is the creditors’ money that is at risk when insolvency sets in.

Now while interpreting this case in the interests of the company, Sri Lankan courts are certainly likely to follow this precedence and hold that the phrase would include the interests of the creditors. As if to strengthen this duty towards creditors, there is another provision in Section 219 of the Companies Act which states the duty of a director, a breach of which is likely to result in dire consequences.

Section 219 simply states that if a director believes that a company is unable to pay its debts as they fall due, he must immediately call a board meeting to consider that the board must apply to the courts to wind up the company or the company should constitute its business.

When you find the fortunes of your company sliding downhill, a director has two options. “At a board meeting you have to take either of the two decisions: mainly whether to wind up the company or continue trading. Now Section 214 of the Insolvency Act is quite striking. If you know or ought to have known before the commencement of the real winding up that there was no prospect of the company picking up, then you have to stop trading – and directors who continue to trade face the risk of contributing towards the payments of the debts of the company. In other words, the statute lifts the corporate veil through Section 219,” he detailed.

He submitted that Section 219 can be successfully evoked to debrief directors and this section has been successfully engaged in the commercial courts recently in a winding-up application.

“My advice to you is to get your views recorded at the board meetings because if you are one of them who advised against trading, against the danger signals and the majority decides to trade, your dissent may provide in your defense if you were in that unlikely event of being prosecuted, you can defend yourself against the liabilities imposed on directors in terms of Section 219,” he stated.

Majority shareholders and independent directors

Speaking from the perspective of an executive director, Brandix Lanka Ltd. CEO Ashroff Omar outlined that the role has both pros and cons. As an executive director, decision making is very fast and you can be motivated and incentivised to take pretty significant leaps into opportunities you spot.

“Being a majority shareholder allows a director to convince the rest of the board to side with you and hopefully the business gains tremendously from those decisions. If you are a minority shareholder on the same board you may not have the same appetite for risk-taking and there the problems begin. They prefer to go along at a steady pace so that he does not risk his share of holdings. In order to manage that conflict, I believe the best thing is proper communication and good independent directors,” he said.

While an independent director could be obligated to the majority shareholder because of the big role that he plays, he added, the role of the independent director is crucial.

As an independent non-executive director of Sampath Bank PLC, Sanjiva Senanayake stated that unfortunately independent directors only seem to have disadvantages. The role of the independent director, he explained, is not to really run the company but to manage it especially in companies which are critical for the economy, taking for instance a bank, as if a bank is not managed properly it could result in wider ramifications for society.

“As an independent director, I take a very practical point of view as I know that I cannot know that everything an executive director knows so you need to find ways around that and have a practical way of looking at what an independent director can do. It’s important to have no other connections with the company. You look at yourself as the eyes and ears of the minority shareholders and those not represented on the board. If you do your job honestly other things fall into place,” Senanayake said.

However, there is an issue with the definition of an independent director. Although the shareholders are supposed to appoint directors, the process works differently as there is a nominations committee influenced by people on and off the board and it is this committee that makes the final decision. Therefore, a director who seems independent from the outside actually may not be.

From the viewpoint of an independent director, it is important that they understand the dynamics of the board and where the other directors fit in.

“I realise there are limitations but you need to understand the business, whatever board you are on, and the key drivers and factors in accessing that business. Widen your network of contacts. I think it’s very good for directors to be exposed to management staff to see how the business is run as you get a much better feel of what the business is about and you react to situations in a practical sense when you understand what the company is trying to do,” he advised.

He added that building up contacts outside the company is also vital as one cannot know everything that is going on everywhere but at the same time, you need to keep abreast of happenings. Widening that network and finding out which parts of the economy are relevant to your business is very important.

Furthermore, independent directors should make sure that minutes are carefully written especially in critical issues. That’s not only protection but also gives a message to the board that you are serious about what goes into the minutes.

“I also feel that you need to get independent views from outside from professional organisations and in many cases they are much more independent. Management is driven by certain concerns – it is very important for the board that the right incentives are made and given to the management. Majority shareholders may want to be aggressive or not want to put in money when the need comes up but it needs to be rationally discussed and a decision taken for the best of the company – which is the role of the independent director.”

The problem of enforcing the law

Nithya Partners Precedent Partner Arittha Wikramanayake observed that there has been a huge paradigm shift in company law with the introduction of the new Companies Act in 2007. It has eliminated all possibilities of directors finding excuses for not meeting the responsibilities of liabilities and responsibilities when they are elevated to these positions.

“Apart from the law itself, you find that there have been several other initiatives by institutions and I’m primarily referring to things pertaining to corporate governance and one of the biggest problems of meeting responsibilities of directors is that most people didn’t know how those responsibilities should be lived up to,” he said.

Other problems undergone include the fact that most directors clearly did not know what their status was when they got on boards. Even now, it is very common for people to come and say that they are just a non-executive director and don’t have the same responsibilities as an executive director which is completely remedied now. If you are on a board of directors, you share the same responsibilities as everybody else around the table with you, he stated. Even people who are not designated as directors can be held responsible for directors’ liability in terms of the new Companies Act.

The law has also been made meaningful by bringing in proper sanctions. Until the enactment of Act No. 7 of 2007, the highest penalty in terms of the Companies Act was a fine of Rs. 250 and that was a joke.

“In my opinion, it actually encouraged people to violate the law. People used to think that they could pay that fine and break the law but now that has been taken away and the sanctions have been made more meaningful, with one of the fines been brought up to a million rupees and there are also personal liability brought in through several sections,” Wikramanayake noted.

“The point I would like to make is that although the Companies Act is excellent, there are many new sanctions, the law has been codified and can be understood in simple terms, the problem is enforcement. If you take a look at how the Registrar of Companies enforces or monitors the compliance of the Act, I think it requires a lot more and is a bit of a joke at the moment.”

The next responsibility is the shareholders. If you look at the way that the Companies Act is formulated, the primary responsibility of enforcing those liabilities is with the shareholders and you still find that shareholders are either ignorant or too hesitant to enforce their rights. Most shareholders are generally too reluctant to come forward and have them enforced for several reasons, ignorance and cost. There has to be a mechanism by which those rights are enforced and until that is done, he didn’t think that there would be a change in the way directors live up to their responsibilities.

“The next problem is the point of directors. In my opinion, I think 90 per cent of the independent directors are not independent. Once they get on boards, they are basically the puppets of the people who appointed them. The Companies Act can only lay down the law and until you find people with spines, you are not going to be able to make this law meaningful,” he said strongly.

The final point he made came back to enforcement and that is the role of the judiciary. There is no predictability on how the law can be applied. Looking at the decisions you get from the judiciary, Wikramanayake didn’t think they can be defended on any terms and he felt that the legal profession has to take responsibility for this.

Managing a director’s liability

Janashakthi Insurance PLC Managing Director Prakash Schaffter delved into the aspect of directors’ liability insurance. He pointed out that directors’ liability insurance is still in its infancy in Sri Lanka and while Sri Lanka should not go down the route of the US, it will traverse at least some of that path.

It is obvious that directors have a wide variety of duties and responsibilities and there is a potential for lawsuits from a variety of segments – employees, customers, shareholders and regulators. In the West, most of the lawsuits are from shareholders who feel the directors have not looked after their interests. In our part of the world, a great majority of the lawsuits come from regulators. In the business world, managing risk is important. And as far as the potential liability that directors face, there are many ways to manage this.

“Insurance is only one of the mechanisms but it is a mechanism that many look to. The Companies Act of 2007 specifically mentions insurance. What we insurers do is that we transfer a significant portion of your risk to us. It does not mean that you can transfer the entirety of your risk and that once you have an insurance policy, the director can do exactly what he wants and not take care of what he actually has to do. We only take a certain portion of your risk,” Schaffter cautioned.

He explained that the Directors and Officers Liability Cover is today increasingly becoming the expected norm.

“With the advent of the global village and increased trade relationships, foreign partners especially from the West expect you to have the standard or the seal of directors and officers liability cover. We are also looking for foreign direct investments in Sri Lanka. Foreign companies are taking stakes in local companies and you have foreign directors being appointed. It is sometimes a prerequisite that the local company has adequate insurance cover before they serve on these local boards,” he noted.

Covers provided by insurance companies are more or less similar. There are slight variances from one to another but by and large, there are many similarities. It must be borne in mind, that as per our law, the companies’ articles of association have to specifically permit companies to take out Directors and Officers Liability Cover. It also requires formal board approval. Many companies which have gone down the route of insuring their directors and officers have had to amend their articles and make sure that they are permitted to take on this cover.

The insurance policy covers claims made by courts and out of court settlement itself does not suffice for the insurance company to settle it. There is however an exception to this. If the express concurrence of the insurance company is obtained for an out of court settlement, and most insurance companies would prefer an out of courts settlement, then the insurance company would step in and pay that component.

Legal fees are usually covered – most policies would cover legal fees, the reason being that the insurance company has a vested interest in protecting the directors’ concerns, not protecting themselves from liability or wrongdoing but certainly ensuring that they have the best legal advice when defending themselves. Legal fees are usually incurred with the mutual consent of the insurer concerned.

Punitive fines or penalties of a civil nature are insurable. Take for example, health and safety at work. If an employee is unfortunately killed due to a boiler explosion and the directors are charged because the investigations reveal poor working practices, if there is a civil fine which results, the insurance policy would step in and pay that fine.

“Criminal fines and penalties are specifically excluded. This is because it is primarily against public policy. The legal costs however are paid by the insurance company. If the directors are found guilty of criminal negligence then the directors would have to repay the legal costs incurred to the insurance company. If they are acquitted, the insurance company would pay the legal costs,” Schaffter explained.

Finally, he stated that the insurance policy also specifically excludes liability arising from any act intentionally done or knowing that it breached contract or statute.

Putting the provisions to the test

Architect of Companies Act 2007 Harsha Cabraal commented on some of the points raised by some of the panellists towards the end of the debate, noting that many collapses have been witnessed since the 2007 Act came into operation.

“This came in after the horses bolted but if you look at the listed finance companies, listed leasing companies and the banks – banks are now highly regulated – you will no longer see another Seylan scenario because long before it happens, the regulator will see this happening,” he stated.

Looking at the topics that were discussed, especially concerns about cases, he observed that the provisions have been tested in other parts of the world, especially Canada and Australia but not so much in Sri Lanka. These provisions need to be tested by the courts unfortunately it has not happened.

Taking for example the Golden Key scenario, he noted that it could have been a case where all these provisions discussed could have been tested.

“There are cases filed in the commercial high court to wind up the company for fraudulent trading, solvency issues unfortunately all those cases are stabled because of the Supreme High Court fundamental rights application. Now the depositors should have moved to liquidate the company. It is a right royal mess today in the Supreme Court. The good cases where we have tested these sections are all held up because of fundamental right issue and so most of the novel sections in this act have not been tested so far,” Cabraal explained.

Commenting on this issue, former Attorney General Mohan Peiris stated that there are two indictments in the Supreme Court in Colombo in the Golden Key Group of Companies but added that what is surprising are the number of sympathisers from the business world who think that this was a commercial collapse. “I would take some of the blame for the system but let me tell you that the system doesn’t work unless the private sector cooperates with us,” he said.

“I think there must be some soul searching in the corporate world if we are to put this right. The legal system means nothing, it is a dead system if the public do not cooperate with that legal system and give it life and I think that is what we need. Our community is dying because we do not have the discipline or conscience to identify what is right and wrong and we compromise – we are willing to sleep with the devil himself in the name of corporate advancement. It is time we come up with prudential measures to be put in place and support them so that we don’t have a repetition in the future.”

Pix by Daminda Harsha Perera