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Corporate Governance: Directors and Officers’ Liability

You are a corporate director or officer – do you know your duties, obligations, and potential liabilities?

The content of this post is for information purposes only. It does not constitute legal advice and any reliance on it does not establish a lawyer client relationship with the author or with Yocto Law.

Overview

Starting a business is a particularly exhilarating endeavor. Founders are understandably preoccupied by the grueling tasks of setting up and financing their new business ventures. Unfortunately, corporate governance is a matter often left unattended at this busy time. Positions as directors or officers of both public and private corporations carry specific duties, responsibilities, and liabilities. Liability is based on conduct as well as on breach of specific legislative requirements and directors and officers can even be held personally liable in certain instances. It is therefore imperative that heads of corporations become familiar with these duties, responsibilities, and obligations as soon as possible to establish good corporate governance practices and to minimize associated liability risks. This post is intended to provide you with a high level overview of the duties, obligations, and associated sources of liability for directors and officers and is not intended as legal advice.

Duties and Obligations of Directors and Offices

A corporation acts through its directors and its director-appointed officers. Directors and officers have a primary duty to comply with the applicable governing statutes (the Canada [1] or Ontario [2] Business Corporations Acts for federally or provincially incorporated entities, respectively) and their regulations as well as the corporate articles, by-laws and the terms of any unanimous shareholder agreement. [3] However, except as specifically noted in the applicable legislation, directors and officers have a duty to act in accordance with the governing legislation and cannot “contact out” of their statutory duties and associated liabilities through provisions in any contract, including in the corporate articles or by-laws, or in any corporate resolutions. [4]

Directors and officers have an obligation to exercise due diligence and care in their governance and management of a corporation’s affairs and to act in good faith and in the best interest of the corporation. These obligations are captured by the duty of loyalty (also referred to as fiduciary duty) and the duty of care (also referred to the duty of diligence). [5]

i. Duty of loyalty / Fiduciary duty [6]

Representing the business interest of others imposes on directors and officers of corporations an affirmative duty to protect those interests and not exploit their positions for personal benefit. Directors and officers have fiduciary obligations both under statute and at common law (judge made law based on legal precedent) to act honestly and in good faith with a view to the best interests of the corporation. The Supreme Court of Canada clarified that acting in “the best interest of the corporation” means that directors must act to maximize the value of a corporation and not simply to act in the best interest of its shareholders. [7] This duty is owed to the corporation and is underpinned by the subjective motivation of directors and officers to respect the trust and confidence entrusted to them to manage the corporation’s assets and affairs, and to serve the corporation selflessly, honestly, and loyally. Notably, directors and officers cannot renounce their fiduciary duty at will upon termination of employment or upon resignation. [8] This can be thought of in the same context as non-competition agreements in which a person agrees not to compete with an employer for a fixed period after resignation or termination of employment.

 ii. Duty of Care [9]

Directors and officers must also exercise care and diligence in supervising and managing a corporation’s affairs while acting reasonably and in good faith. This duty is owed to the corporation as well as to individual stakeholders. Although directors and officers are general advisers to a business and are not specialists, they do have an active individual duty to keep themselves informed of the affairs of the corporation and to ask questions where necessary. Their decisions are not expected to be perfect, especially with the benefit of hindsight, but they are expected to be reasonable. Unlike the subjective nature of fiduciary duty, the duty of care is measured on an objective standard. The degree of care and diligence required of a director or officer is that which “a reasonably prudent person would exercise in comparable circumstances.” [10]

            iii. Other obligations

In addition to the duty of loyalty and the duty of care, directors and officers also have an obligation to act in a manner that is not oppressive, unfairly prejudicial to, or which unfairly disregards the interests of shareholders and other stakeholders. If any of these duties or obligations are breached, shareholders have access to legislative remedies. Once such remedy is the so-called oppression remedy. The oppression remedy protects the reasonable expectations of individual stakeholders, including corporate creditors, by evaluating the effects of the manner in which the corporation is managed on the interest of a stakeholder. Stakeholders are allowed to make a claim for personal compensation for harm to their interests in light of a corporation’s oppressive or prejudicial treatment. Another available remedy is a derivative action, which allows a complainant who has an interest in the corporation to initiate litigation on behalf of the corporation for wrongs done to it if the directors do not act to right the wrongs.

Directors and officers’ liability

The nature of a corporation as a separate legal entity (“SLE”) shields or veils the personalities of its shareholders, directors, and officers from personal liability for the actions and debts of the business. Piercing the corporate veil refers to instances where the protective “veil” is lifted to expose shareholders, directors, or officers to personal liability for the debts and acts of the corporation.

In a recent case, the Ontario Court of Appeal [11] upheld a previous decision that outlined the instances in which courts will pierce the corporate veil:

Typically, the corporate veil is pierced when the company is incorporated for an illegal, fraudulent or improper purpose. But it can also be pierced if, when incorporated, ‘those in control expressly direct a wrongful thing to be done’…and …’the courts will disregard the separate legal personality of a corporate entity where it is completely dominated and controlled and being used as a shield for fraudulent or improper conduct.’ “[12]

Therefore, to pierce the corporate veil, a corporation need not have been incorporated for an illegal, fraudulent or improper purpose. In fact, it is sufficient for a director or officer who acts as “the directing mind” behind an improper act to be held personally liable. This liability exists even where the corporation only has one officer, director, and shareholder.

Examples of potential triggers for piercing the corporate veil and exposing individual corporate actors to personal liability include instances where: the corporation is not treated as a separate entity by its shareholders (likely more common in closely held corporations), where shareholders draw money directly from the corporation, or where there is a lack of formality and documentation in the directors’ consideration of a purchase or sale of corporate assets. Corporations that operate in a parent-subsidiary relationship may be at higher risk of having the veil pierced if the subsidiary has no semblance of control over its daily operations, or where the subsidiary is undercapitalized to finance its investments and relies on the parent for funding its operations, such that the subsidiary appears as a mere instrument of the parent corporation.

Despite the governing principle that a corporation’s status as a separate legal entity shields its directors, officers, and shareholders from personal liability, in addition to liability arising from fraud or misrepresentation claims as described above, direct liability can arise from provisions in a number of federal and provincial statutes. Directors can be held liable for breaching their duties as mandated by the applicable legislation including the duty of care, fiduciary duty and the duty to disclose conflicts of interest and capitalize on corporate opportunities, and for specifically enumerated acts, such as unpaid employee wages, improper or deficient financial reporting, improper issuance of shares, and improper authorization of certain acts, to name a few.

i. Specific statutory liability

Statutory liability for corporate directors is onerous because directors are jointly and severally liable, (which means a director could be liable for all damage resulting from a claim regardless of the degree of fault, if the other defendants are not available or are not able to satisfy the damage award) for a number of specific matters including:

Debts to employees for wagesThis represents one of the largest potential liability areas for directors. Directors are jointly and severally liable to employees of a corporation for up to six months’ wages and up to 12 months of vacation pay (Ontario) owed to each employee (the “debt”) while acting as directors. [13] How this liability applies differs between federally and provincially incorporated entities.

For federal corporations (incorporated under the CBCA), an action for the debt may be initiated against the corporation. Directors are jointly and severally liable for the debt while acting as directors and for 2 years after a person ceases to be a director if: 1) the corporations was sued for the debt within the past 6 months and part or all of the debt has not been paid by the corporation; 2) a claim for the debt was proved within 6 months of the date the corporation began liquidation proceedings or the date it was dissolved, whichever occurred earlier, or 3) a claim for the debt was proved within 6 months after the date a bankruptcy assignment or a bankruptcy order was issued.

For Ontario corporations, the OBCA allows claims for the debt to be brought simultaneously against a corporation and against an active director. Directors are liable for the debt if the debt is not satisfied by the corporation or if a corporations goes into liquidation, is wound up, or makes an assignment into bankruptcy either before or after an action for the debt is commenced and the claim is proved. Unlike for federally incorporated entities, where a 6 month timeframe exists within which a claim must be proved before directors become liable for the debt, and an explicit 2 year liability period exists after a person ceases to be a director within which a claim may be brought, no specific liability limitations are provided under the OBCA. However, liability of a person who ceases to be a director of an Ontario corporation is subject to the 2 year general limitations period under the Ontario Limitations Act. [14] The 2 year limitation period is triggered on the effective date of a director’s resignation. Furthermore, directors of both federal and Ontario corporations who have satisfied a claim for debts to employees are entitled to compensation from the other directors who were liable for the claim. [15]

Directors’ liability for wages and other employee-related issues including source deductions, filing of tax returns, maintenance of proper records, pensions, and employee safety matters can be further expanded under the Employment Standards Act, [16] the Canada [17] or Ontario [18] Income Tax Acts and the Excise Tax Act, [19] as well as under the Ontario Pensions Benefits Act, [20] the Canada Pensions Plan Act, [21] the Employment Insurance Act, [22] and any applicable workplace health and safety legislation. The area of directors’ liability is complex and those affected should seek prompt advice from a well-qualified legal professional.

Issuing shares for consideration other than money [23] Directors who vote for, or consent to, issuing shares in exchange for property, past services, or other non-monetary consideration from which the corporation did or may stand to draw a benefit, are jointly and severally liable to the corporation for the difference in value if the value of the consideration received by the corporation is less than the fair equivalent amount that the corporation would have received had the shares been issued for money on the date of the vote or resolution. Directors remain exposed to this liability for a period of 2 years from the date of the vote or resolution that authorized the action.

If a director is found liable and has reimbursed the corporation for the difference in value, a director is entitled to contribution from the other directors who voted for or consented to the unlawful issuance of shares. [24] Therefore, in order to insulate oneself from liability in this regard, it is imperative that directors promptly exercise their right to dissent. By statute, a director is deemed to have consented to any resolution passed or action taken at a meeting of directors, regardless of whether he/she was present, unless a director actively exercises his/her right to dissent. Because directors lose the right to dissent once they vote for or consent to a resolution, it is critical that directors exercise their right to dissent immediately. The dissent must be noted in the minutes of the meeting or submitted to the corporate secretary before or immediately after the meeting is adjourned. In the event that a decision made by directors triggers a claim, a director who dissented and whose reason for the dissent is noted in the corporate record has evidence to demonstrate his/her objection and may be able to exculpate him/herself from liability.[25]

Voting or consenting to authorizations contrary to statute [26] – Directors who vote for or consent to a resolution that authorizes: 1) a purchase, redemption or other acquisition of shares, 2) a payment of a commission, dividend, indemnity, or 3) a payment to a shareholder contrary to the applicable statute, are jointly and severally liable to reimburse the corporation for any money distributed which the corporation has not already recovered. Directors are exposed to liability for 2 years from the date of the resolution authorizing the action that gave rise to the complaint. Similarly to the issuance of shares for non-monetary consideration, if a director is found liable and has reimbursed the corporation for any balance owing, the director is entitled to contribution from the other directors who voted for or consented to the contested action. [27] Therefore, in order to insulate oneself from liability in this regard, it is imperative that directors properly exercise their right to dissent, as discussed above.

ii. Disclosure of interest obligations [28]

Another possible liability landmine for directors and officers is neglecting the statutory requirement that officers and directors disclose direct or potential conflicts of interest. A director or officer of a corporation is precluded from dealing on behalf of the company with him/herself and from pursuing engagements in which he/she has personal interest conflicting with the interest of those whom he/she is bound by fiduciary duty to protect. Therefore where personal interests compete with corporate interests, such conflicts must be disclosed in writing.

For example, if a director or officer of a corporation is a party to, or has a material interest in a party, or is a director or officer of a party involved in a contract or a transaction that the corporation is considering, the nature and extent of any interest that he or she has in an actual or proposed contract or transaction with the corporation must be disclosed. If this concerns a director, this disclosure must be made as soon as the proposed contract or transaction is considered by the corporation, and for both a director and an officer, as soon as the director or officer becomes aware of, or becomes interested in that transaction. With limited exceptions, [29] a director who is required to make a disclosure cannot vote on any resolution to approve the contract or transaction. Where a corporation determines not to pursue an opportunity offered to it, the director or officer is free to pursue it on his/her own.

If a director or an officer fails to comply with this requirement the corporation or any of its shareholders may apply to a court to set aside the contract or transaction and/or require the director or officer to repay the corporation any profit or gain the director or officer realized on it.

Defences to liability

Ignorance, resignation, and corporate indemnification are not defences for liability.

i. Reasonable diligence and good faith [30] 

A director can immunize him/herself from liability for breach of fiduciary duty and breach of the duty of loyalty under the applicable legislation if the director exercised the care, diligence, and skill that a reasonably prudent person would have exercised in comparable circumstances. This includes relying in good faith on reports or statements made by persons whose profession lends credibility to those statements (e.g. lawyers, accountants, auditors, engineer, etc.) or on a report by, or the advice of, an officer or employee of the corporation, where it is reasonable in the circumstances to rely on such reports and advice.

Acting reasonably and in good faith is also a prerequisite to a director or officer’s right to indemnification [31] by the corporation. Such indemnification is available to an actively serving or a former director or officer of the corporation for all reasonable costs, charges, and expenses that he/she incurred while defending him/herself in a civil, criminal, administrative, investigative, or other proceeding in which the individual is involved because of his/her association with the corporation. However, indemnification is only available if a director or officer acted honestly, in good faith, and in the best interests of the corporation. If the case involved a criminal or administrative action, the individual must have demonstrated that he/she had reasonable grounds to believe that his/her conduct was lawful, and the court determined that the individual did not commit any fault and did not omit to do anything that the individual should have done. [32]

ii. The business judgment rule

Courts are generally reluctant to intervene in corporate management matters. The business judgment rule (BJR) recognizes the autonomy and authority of a corporation to manage its affairs through its directors and officers because they are in a better position than courts to understand and evaluate the needs of the corporation. In instances where complaints are made regarding alleged failure of the directors to meet their common law and statutory duties, courts will defer to the business judgment of directors if the directors’ decisions were informed and made diligently. The Supreme Court of Canada summarized this defence succinctly by saying:

            … directors are only protected (by the business judgment rule) to the extent that their actions actually evidence their business judgment. The principle of the defence presupposes that directors are scrupulous in their deliberations and demonstrate diligence in arriving at decisions. Courts are entitled to consider the content of their decisions and the extent of the information on which it was based and to measure this against the facts as they existed at the time the impugned decision was made. Although Board decisions are not subject to microscopic examination with perfect vision or hindsight, they are subject to examination [33] 

Therefore, to avail themselves of this defence, directors must consider all material information reasonably available to them prior to making decisions on behalf of the corporation. Notably, the BJR is not available as a defence to a breach of either the duty of loyalty or a breach of conflict of interest obligations. However, it may be relied upon as defence in a breach of the duty of care if the processes or procedures followed by directors to arrive at a decision were demonstrably sound and informed, the directors acted reasonably and diligently, and they did not engage in unlawful/fraudulent behavior, bad faith, pure rubber stamping, blind faith reliance, or dishonest or careless actions.

Summary

Positions as directors and officers of corporations carry prestige as well as duties and obligations that, when breached, can result in significant liability that must be borne by the corporation (through indemnity) or, in some cases, personally by the directors and officers. To ensure that a corporation minimizes its liability risk by engaging in positive corporate governance practices, it is imperative that directors and officers become familiar with the statutory and common law duties and obligations associated with their positions.

To effectively manage the liability risk to which directors and officers are exposed, corporations should seek the advice of a legal professional to develop awareness training and devise practice protocols and policies that instruct directors and officers on their common law and statutory duties, responsibilities, obligations, and corresponding liabilities which they may face through their acts or omissions, including:

●  implementing a director’s indemnification policy that clearly states the rights and obligations of directors and the extent of protection provided by the corporation;

●  implementing policies against outside employment/business that may interfere with or influence the organization’s duties

●  advising against accepting gifts, favours, or services related to company duties

●  establishing an atmosphere of candour that encourages directors and officers to question anything that is unclear regarding the activities of the organization and to communicate their decisions clearly and

●  establishing a formal procedure for documenting how decisions are made and seek counsel from legal representatives in advance of making potentially controversial decisions

It is likewise advisable that corporations carry officers and directors’ liability insurance to buttress against claims and damages incurred by such individuals in their capacities as directors and officers of a corporation as well as for individuals acting in the same capacity for another entity at the corporation’s request.

Citations:

[1] Canada Business Corporations Act, R.S., 1985, c. C-44, s. 1; 1994, c. 24, s. 1(F) [CBCA].

[2]Business Corporations Act, RSO 1990, c B.16 [OBCA”].

[3] CBCA at subsection 122(2) and OBCA at subsections 115(1) and 134(2).

[4] CBCA at subsection 122(3) and OBCA at subsections 134 (2) and 134(3).

[5] CBCA at subsection 122(1) and OBCA at subsection 134(1).

[6] CBCA at subsection 122(1)(a) and OBCA at subsection 134(1)(a).

[7] Peoples Department Stores Inc. (Trustee of) v. Wise, [2004] 3 S.C.R. 461, 2004 SCC 68 [Peoples].

[8]Can. Aero v. O’Malley [1974] S.C.R. 592.

[9] CBCA at subsection 122(1)(b) and OBCA at subsection 134(1)(b).

[10] CBCA at subsection 122(1)(b).

[11] Shoppers Drug Mart Inc. v. 6470360 Canada Inc. (Energyshop Consulting Inc./Powerhouse Energy Management Inc.), 2014 ONCA 85.

[12]642947 Ontario Ltd. v. Fleischer (2001), 56 O.R. (3d) 417 (C.A.).

[13] CBCA at subsection 119 and OBCA at subsections 131(1) and 131(2).

[14] S.O. 2002, c. 24, Sched. B.

[15] CBCA at subsection 119(6) and OBCA at subsection 131(5).

[16] S.O. 2000, c. 41 at subsections 38 and 81(1).

[17] RSC 1985, c 1 at section 227.1.

[18]R.S.O. 1990, c. I.2.

[19] R.S.C. 1985, c. E-15 at section 323.

[20] R.S.O 1990, Chapter P.8 at section109 and 110(2).

[21] R.S.C. 1985, c. C-8 at section 21.1(1).

[22] S.C. 1996, c. 23 at section 83(1).

[23] CBCA at subsections 25(3) and 118(1) and OBCA at subsection 130(1).

[24]CBCA at subsection 118(3) and OBCA at subsection 130(3).

[25] CBCA at subsection 123 (1) and OBCA at section 135.

[26] CBCA at subsection 118(2) and OBCA at subsection 130(2).

[27] CBCA at subsection 118(3) and OBCA at subsection 130(3).

[28] CBCA at section 120 and OBCA at section 132.

[29] unless the contract or transaction relates primarily to his or her remuneration as a director, officer, employee, agent of the corporation or an affiliate; is for indemnity or insurance; or is with an affiliate.

[30]CBCA at subsections 123(4) and 123 (5) and OBCA at subsection 135(4).

[31] CBCA at section 124 and OBCA at section 136.

[32] CBCA at subsections 124(2) and 124(5) and OBCA at subsections 136(1) and 136 (4.2).

[33] Supra note 7 at para 153.

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