Do directors breach their duty of care by allowing the company to breach the law?

What you need to know

• The Full Federal Court has provided guidance on the scope of the duty of care and diligence owed by company directors and officers under s 180(1) of the Corporations Act. The duty is owed to the company but it is a public duty, requiring consideration of the interests of the company itself apart from the wishes of the shareholders. Those interests include avoiding exposure of the company to civil penalties or other liability, and in the present case not jeopardising the company's Australian Financial Services Licence by failing to take steps to comply with the law. 
• Contrary to the common misconception that the interests of the company are the same as the interests of shareholders, shareholder ratification of directors' conduct (especially where the shareholders are the directors) does not prevent breach of s 180 (a civil penalty provision).  
• The Court commented on the so called "stepping stones" approach to liability, by which directors and officers become liable for breaching their statutory duty of care because their company breaches the law. Instead, on the majority approach, while a company's breaches do not of themselves lead to directors' liability, they may be relevant on that question, and a director (and other officers) can be liable for failing to take reasonable steps to prevent detrimental breaches of the law.  
• Section 180(1) is not to be used as an improper means for visiting accessorial liability on directors. For a breach to be established it must be shown that at the time of the relevant conduct it was reasonably foreseeable that harm would be caused to the interests of the company. The court will then consider how a reasonable person in the position of the director or officer would have balanced that risk against the potential benefits that could be expected to accrue to the company.

What you need to do

• When considering a company's regulatory compliance obligations, be mindful that directors and officers must exercise their powers and discharge their duties with care and diligence so as not to expose the company to a reasonably foreseeable risk of harm.

By majority, the Full Federal Court recently dismissed an appeal by Emmanuel and Julia Cassimatis, the former directors of Storm Financial, against findings by Edelman J (before he was appointed to the High Court) that they breached their statutory directors' duty of care. 

First instance shipwreck: Storm directors breached the duty of care

The collapse of Storm Financial in 2009 left thousands of investors with significant losses, and served as a catalyst for law reform to better protect the interests of retail investors.

ASIC commenced civil penalty proceedings against the former directors (and sole shareholders) of Storm, Mr and Mrs Cassimatis in late 2010. 

In 2016, the Court found that the directors had each committed one contravention of s 180(1) of the Corporations Act. Edelman J held they allowed Storm to provide a one size fits all "Storm model" of financial advice to 11 investors who were vulnerable.

The "Storm model" of advice involved the use of ''double-gearing'' whereby investors were generally required to take out a home loan and a margin loan to fund substantial investments in index funds. In allowing Storm to provide such advice, the Court held the Cassimatises caused or permitted Storm to contravene provisions such as s 945A(1)(b) and (c) (now repealed) and 912A(1)(a) (the efficiently, honestly and fairly obligation) of the Act and exposed Storm Financial to the risk of losing its AFSL. 

We discussed the 2016 judgment in our previous update. 

The Cassimatises were subject to a civil penalty of $70,000 and banned from managing corporations for a period of 7 years.

What is the scope of the statutory duty of care?

The Cassimatises' appeal had two bases:

• That  Edelman J misapplied s 180 of the Act by applying the section in "an abstract manner, divorced from the wishes of its shareholders”. The Cassimatises submitted that, as a solvent company, Storm’s interests were effectively those of its shareholders, i.e. the Cassimatises themselves; and
• That Edelman J erred in his approach to s 945A (which, very broadly, required retail investors be given appropriate advice).  As these provisions have now been replaced by the Future of Financial Advice best interest duties provisions, we do not discuss this aspect of the judgment here.  

Justices Greenwood and Thawley upheld the decision of Edelman J.  Justice Rares disagreed in relation to s 180 and would have allowed the appeal.

Approach to s 180

Justice Greenwood, with Thawley J taking a similar approach, held that s 180(1) is a duty owed to the company, which is not expressed to be “subject to the will of the shareholders unanimously expressed”. Instead, s 180(1) adopts a normative, objective and irreducible standard of care and diligence, which goes beyond simply the interests of the shareholders. It is a question of what a reasonable person would do as a director or officer, in the corporation's circumstances, occupying the relevant office and having the responsibilities they held. 

Although it may be a duty owed to the company, it is not merely a private duty, but also a public concern. 

Importantly, for this reason, Justice Greenwood said, "the shareholders cannot sanction, ratify or approve, qua themselves as directors, their own conduct in contravention of s 180.  Nor can they release themselves from such a contravention."

Justice Greenwood went on to say, “the circumstance that, at all material times during the period of the impugned conduct, Storm was solvent and that the appellants acted, at all times, with their own approval in their capacity as the holders of 100% of the issued shares in Storm, of their own conduct, as directors, is not an answer to the question of whether, in their capacity as directors, they failed to discharge the irreducible minimum standard required of them by s 180(1).” 

Greenwood J noted:

• The objective standard required by s 180(1) is likely equivalent to the duties at common law and in equity.
• There seems to be little practical utility in the safe harbour business judgment rule in s 180(2).

Stepping stones liability

The Court considered the often controversial "stepping stones" approach to attributing liability. Greenwood J thought phrases such as "stepping stones" liability unhelpful, because the question is not whether the directors breached their duty of care because they breached other provisions of the Act – rather, it is the failure to exercise care and diligence to avoid foreseeable harm that gives rise to the breach of the Act. (Although on the way ASIC put its case the breaches of the other provisions of the Act had to be determined, it is clear ASIC did not need to set such a high bar.) 

Justice Thawley (in agreement with Greenwood J) said, "Section 180(1) applies according to its terms. It imposes a duty to meet the specified standard of care in exercising powers and discharging duties… A company’s contravention might be a material fact relevant to the question whether a director failed to meet the standard mandated by s 180(1) by exposing a company to risk; but it is not an essential ingredient of liability in the way it is in a case of accessorial liability."

The Storm model involved significant risks of breach of the law, which could be highly detrimental to the company, to the extent of putting its AFSL at risk.  The Cassimatises were closely involved in all aspects of the company.  As such, it was foreseeable that there would be real risks to the company. 

Justice Rares disagreed, saying that this approach rendered directors liable for breaches of the law by the company, without the parameters provided for liability as an accessory being observed. 

It remains to be seen whether the Cassimatises will seek special leave to appeal to the High Court, to resolve the different approaches taken in the Full Federal Court. 

Authors: Andrew Carter, Partner and Stephen Meechan, Lawyer.