Business Lawyers

Canadian directors are running scared - mass resignations are hitting the press - directors are consulting lawyers and protecting personal assets. Given the state of Canadian law, only the imprudent, reckless, asset-poor or well-insured among us can permit himself to act as a corporate director and that's a problem in the boardrooms of corporate Canada.

Canadians, and in particular Montrealers, have traditionally viewed appointment to any board of directors as an honour, accompanied by recognition, photos in the commercial press, and a round of congratulatory letters and calls, not to mention another entry in one's CV. Practically, it offers an inside look at a business and an opportunity to discuss policy and planning with successful people. The board is the master of the corporation, subject slightly to the rarely expressed views of shareholders.

In the past, the only real duty of the directors, as expressed by law, was to "act honestly and in good faith with a view to the best interest of the corporation and exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances."

But in the last 20 years, and increasingly in the last five, there has been an important extension to the list of responsibilities.

Legislatures have conscripted directors to help enforce compliance with corporate obligations by making them personally liable for failure to comply. This theory holds that the most effective way to achieve compliance is to hold others responsible and force them to use their legal power to compel respect for the state's objectives.

The second trend is our courts' great extension of what "due diligence" really means, from its original "man in the street" notion of common sense to the high standard of a professional manager. One is tempted to call this view, "undue vigilance."

The heart of the problem is, of course, that directors often have no real knowledge, or control, of the types of situations that give rise to liability.

Moreover, in some cases the corporation is unable to honour the legal obligation through no fault of its own, or of the directors. The end result of personal liability is, at best, unfair. Examples number in the hundreds, but practically they can be summed up in the top 10.

1) Salaries: Both federal and Quebec corporate law makes directors liable for up to six months of "back pay.'' As most bankruptcies or closings occur before the last pay cheques are cashed, this usually involves at least 4 percent of the annual payroll. There is some argument, even in Quebec, that this may include severance allowance as well. [Note: severence pay is now largely excluded following the Supreme Court's Crabtree decision]

2) Vacation pay: Vacation pay is assimilated to back pay. Depending on vacation entitlements, this can mean another 4 to 8 percent or more of the annual payroll.

3) Benefits are also assimilated to pay. Potentially this might include claims that would have been covered by employer-sponsored insurance plans.

4) Deductions at source: Both federal and Quebec tax laws impose personal liability for deductions at source not remitted. As most employers remit on a monthly basis, this could mean as much as six weeks worth of such payments (or about 35 percent of one-twelfth percent of the annual payroll).

5) GST/QST etc. Generally speaking, any taxes that the corporation collects (or should have collected) from others will involve personal liability. GST/QST involve 14 percent of sales (less credits).

6) Environment: Both Quebec and federal statutes make directors personally liable for some environmental contaminations and for failure to carry out clean-ups.

7) Reports: Very often directors must file tax returns, statistical reports, etc., for insolvent corporations.

8) Shareholders: Shareholders can and do sue if they feel the directors are not responding to their interests.

9) Dividends: Tough solvency tests must be met for dividends and directors are liable even though they don't benefit personally.

10) Securities: In public issues, investors can sue directors personally for statements or material omissions in the offering documentation.

Most of the above examples allow a director to successfully avoid personal liability by showing that he has exercised due diligence, though this is not true in other cases, while others involve personal no-fault liability.

But courts are applying ever higher standards of such diligence on directors. Indeed, in one case involving Bata Industries, the court codified its notion of due diligence in environmental matters. Such due diligence is not restricted to asking the responsible officer of the corporation for a verbal report that nothing is amiss.

It now must be more strict and structured and could involve the following:

A great many companies are turning to directors' and officers' liability insurance, with premium rates depending on the corporation's real risks and business policies. In extreme cases, a trust fund may even be required to supplement insurance or cover excluded items. Many corporate directors are turning to Asset Protection Trusts or other devices to isolate their major assets from attack should all else fail (MBM August, 1992). This is especially intelligent if the directors have no real choice to be on the board through family or some other connection.

All of us know intellectually that sometimes good situations become bad ones. However, when we sit on a board for some time, our emotional sense of the long-term relationship can keep us from reading pretty clear signals, such as: a) financial restructuring or troubles like cash flow crises or even requests from lenders for more security; b) increased premiums on directors' liability insurance or changes in coverage; c) infrequent board meetings: d) evasive answers to liability questions by management; e) inadequate back up; and f) resignations or difficulty in recruitment of new directors.

The "outside director" is often required by corporate law, especially if the company is publicly traded. The courts have traditionally applied a lower test of "due diligence" for such persons and that trend continues, as such persons can generally rely on the confirmation of others. However, even here, the standards are rising and all the above comments apply.

Some potential outside directors would be well-advised to try to seek membership on a mere "advisory board" if that will satisfy the perceived requirement to assist a customer, supplier, friend or relative.

From a legal point of view, a prospective directorship is not worth it unless the risk is small and well insured. On the other hand, if the business or personal gains involved are substantial, the answer might be yes, if the risks and exposure can be reduced.

Until legislatures and courts recognize that the profound danger of depriving corporations of competent directors outweighs the perceived benefits of compliance from insolvent or unwilling corporations, we shall be forced to resort to looking after our own interests - whether or not the long-term interest of the corporation (or the economy) is served.