As a small business owner, it is likely that at some point along your company’s growth you will think about or decide to incorporate your business. The corporate structure can be very beneficial; however, incorporation does impose requirements in terms of the make-up and operation of your business. One of these requirements is that the company elect one or more directors. The directors of a company are in charge of running the business at the highest level. The role brings with it several duties and obligations, and with those duties and obligations comes liability. Unlike shareholders, who are protected from personal liability in corporations, directors are not so lucky. Missteps in the role can result in the director or corporation paying damages to shareholders. It is important, therefore, for business owners and directors to understand the legal considerations the role of director imposes on both parties.
The Role of the Director
Directors, and the board of directors, manage and supervise the management of the business and the affairs of the corporation. What does this mean in practice? Directors have the power to make company by-laws, authorize the issuance of securities, appoint officers of the corporation (like the CFO and CEO), and make other business arrangements. The Canadian Business Corporations Act (CBCA) requires that incorporated companies elect at least one director. Distributing corporations (corporations that issue shares, which are held by more than one person and any of which remain outstanding) are required to have at least three directors, but at least two of them cannot be officers or employees of the corporation or its affiliates. There are also other requirements that the CBCA imposes, including a residency requirement, such that at least 25 per cent of the board of directors must be made up of Canadian residents.
The role of the director is not to be confused with that of a shareholder or an officer of the corporation, although in smaller corporations these roles may sometimes overlap. Shareholders own equity in the company; they are part owners of the business. They have the power to elect and remove directors, approve, amend or appeal bylaws, or make other fundamental changes to the corporation in certain circumstances. However, they do not manage or supervise the management of the corporation as the directors do, unless shareholders pass a unanimous shareholder agreement and adopt all the roles, responsibilities, and liabilities of the directors. The directors appoint officers of the corporation, which include positions such as Chief Operating Officer, Chief Executive Officer, President, etc. They oversee the day-to-day operations of the company, and the power to do so is delegated to them by the directors.
Both the directors and officers of a corporation act on behalf of the corporation, and therefore shareholders can hold directors accountable for actions that breach their obligations to the corporation. The two primary ways that directors may be held legally liable for breaching their obligations is by violating their duty of care and duty of loyalty. Each of these duties will be explained in turn, as well as an overview of what directors need to avoid to prevent legal actions by shareholders.
Duty of Loyalty/Fiduciary Duties
Directors must be loyal to the corporation. As a director, you are afforded access to important and confidential business information. Further, the role of the director is to ensure that the corporation thrives in the market and turns a good profit for the shareholders. Therefore, it is important for individuals in the role to devote their time, energy, and the information they receive as a director for the sole benefit of the company. This is the duty of loyalty, or commonly referred to in law as a fiduciary duty. Fiduciary duties are not unique to the context of business law. They typically arise in situations where an individual is acting on behalf of another in a relationship that requires loyalty, honesty, and consideration of the best interests of the individual they are working for. In the context of business law, this loyalty and honesty is owed to the company.
The duty of loyalty is outlined by s.122(1)(a) of the CBCA, which reads that “Every director and officer of a corporation in exercising their powers and discharging their duties shall… act honestly and in good faith with a view to the best interests of the corporation(.)” The best interests of the corporation has historically been difficult to narrow down in Canadian courts because of the changing perception of what exactly is a “corporation” and who is to be considered when making decisions. Often, the corporation is defined as those who own it, i.e., the shareholders. However, the idea of shareholders as the “who” of the company and the maximization of profits as the “best interests” of the company has changed in recent years. A decision of the Supreme Court of Canada in 2008, BCE Inc. v. 1976 Debentureholders, found that directors may take into consideration other entities when acting in the best interests of the corporation. This decision was recently codified by the Canadian government in the CBCA, which now states that directors and officers acting with a view to the best interests of the corporation may consider the interests of the shareholders, employees, retirees and pensioners, creditors, consumers, governments, the environment, and the long-term interests of the corporation.
So, what exactly does the fiduciary duty or duty of loyalty entail for you as a director? Directors must avoid corporate opportunities, self-dealing transactions, and competition with the corporation. This means that directors must avoid using their position to derive personal benefit from the corporation by way of contracting with the corporation unless it is beneficial to the corporation (self-dealing). Directors likewise cannot personally pursue opportunities that were presented to them by the nature of their position as directors and that the corporation may have an interest in. Finally, directors cannot work in competition with the corporation. Directors also have particular obligations in the context of hostile takeovers, in which any defensive measures must only be implemented by directors when they have a genuine belief that they are in the best interests of the corporation, they have reasonable grounds for this belief, and they have prior shareholder approval or ratification after adoption.
Duty of Care
The second duty that directors must uphold is the duty of care, which is outlined in the CBCA under s.122(1)(b). “Every director and officer of a corporation in exercising their powers and discharging their duties shall…exercise the care, diligence, and skill that a reasonably prudent person would exercise in comparable circumstances.” The duty of care is another widely used concept in law. It simply means that directors must meet a certain standard of care when they are acting in their role. As business decision-makers, directors must ensure that the decisions they make on a daily-basis are made reasonably, prudently, and honestly. There are many ways that directors can satisfy this duty, and it will vary depending on the circumstance at hand. However, directors can help ensure that they are acting reasonably in their roles by, for example, exercising their due diligence, remaining well-informed and present, and acting in good faith (not superstitiously or with ill-intent). In fact, two main defences directors can employ, when their decisions are reviewed by courts for lacking duty of care, is that of due diligence and good faith. These defences are outlined under s.123 of the CBCA and are successful when the director can prove that, in exercising their role, they relied in good faith on either financial statements of the corporation represented to the director by an officer of the corporation or in a written report of the auditor of the corporation fairly to reflect the financial condition of the corporation; or a report of a person whose profession lends credibility to a statement made by the professional person. This means that if the director reasonably relied on professional reports or representations of particular facts while making their decision, they cannot be held personally liable as a result.
Generally, courts grant directors some leeway in their roles through what is known as the business judgment rule. This rule entails that courts will not substitute their own decision-making for that of the directors. The court of law instead assumes that directors have a certain level of business acumen and rely on this knowledge in their role. The business judgment rule therefore protects decisions made by directors if the decision was within the reasonable range of options that the director had available to them at the time. If not, the court will then look to what the standard of care should have been in that particular circumstance and assess whether the director met this standard. The standard of care is based on the understanding that the directors hold a minimum level of competence in their role in comparison to a layperson.
Other Director Liabilities and Requirements
Outside of the two duties, directors may be held liable to different parties in other ways. For example, directors are each held personally liable for the debt of up to six months of wages for employees. When issuing shares for consideration rather than money and the value is therefore less than what the share would have been worth that day, directors are liable to pay the difference. Directors also must act according to the CBCA when looking into purchasing, redeeming, or acquiring shares, paying commissions, paying dividends, paying indemnities, and paying shareholders.
Protection from Liability
According to s.122(3) of the CBCA, no provision in a contract, the articles, the by-laws or a resolution relieves a director or officer from the duty to act in accordance with this Act or the regulations or relieves them from liability for a breach. Meaning, directors in breaching their duty of care or duty of loyalty are held liable for the damages incurred because of their actions. However, there are certain ways that directors may be able to avoid personally paying for the damages incurred in litigation. We have already alluded to defences that directors may employ during litigation, including the good faith defence and due diligence defence. The two other ways are through corporate indemnification and insurance.
Section s.124(1) outlines that a corporation may indemnify or pay back the expenses that the director incurred when acting at the corporation’s request and if the individual acted honestly and with a view to the best interests of the corporation. In criminal or administrative actions, the director must have had reasonable grounds for believing that their conduct was lawful to receive indemnification. Further, the director has a right to indemnification from the corporation if they are held by the court to have not committed any fault or omitted to do anything they ought to have done, and likewise acted honestly and with a view to the best interests of the corporation.
Further, directors may be protected from liability through insurance, as outlined by s.124(6) of the CBCA, which writes that corporations may purchase and maintain insurance for the benefit of individuals for any liabilities incurred by them as director or officer of the corporation.
Although the corporate structure affords deference to directors and officers of the company through the business judgement rule, there are still circumstances where courts can find directors personally liable for breaching the duties they owe to the corporation. To ensure that your business is well protected from any unexpected expenses, it is important to both understand the obligations directors have towards the company and how the company may likewise be held liable through indemnification.
The content of this article is written for general information purposes only and does not constitute specific legal advice. This article should not be used as a substitute for competent legal advice from a licensed lawyer. Please contact us if you’d like to speak to an Emerge Law lawyer.