Understanding and Complying with the Director’s Duties

Directors’ duties are prescribed behaviours and rules that a person must follow when they are acting as a director. They come from both common law (i.e. judges’ decisions in court cases) and statute (principally the Corporations Act). All directors of Australian companies are required to comply with the directors duties.

So what are the directors’ duties?

The key duties of directors are to:

• act in good faith in the best interests of the company;
• exercise their powers for the purposes for which they were conferred (i.e. duty to act for a proper purpose);
• act with reasonable care and diligence;
• avoid conflicts of interest; and
• prevent insolvent trading.

Duty to act in good faith

Directors must act for the benefit of the company and its shareholders. A breach of this duty is usually a civil offence, meaning a breaching director will have to pay a fine and may be disqualified from acting as a director. However, if the director was reckless or intentionally dishonest when failing to act in the company’s best interests, they may have committed a criminal offence.

Duty to act for a proper purpose

Directors must exercise their powers and discharge their duties for a proper purpose. The company's constitution may specify what is meant by a proper purpose. For example, one proper purpose regarding the power to issue shares is to raise capital. By contrast, issuing shares for the substantial purpose of diluting an existing shareholder's voting power is likely to be an improper exercise of the power.

Duty to exercise care and diligence

A director is in charge of the business’ day-to-day operations and makes decisions on behalf of the shareholders who own the company. A director must perform their role with a degree of care, diligence and skill that you would expect of an ordinary person in their position.

Business Judgment Rule

The business judgment rule recognises that directors often make decisions with imperfect information, which will sometimes result in a financial loss. So if you make a business decision that turns out to be wrong, you usually will not breach your directors’ duties if you’ve exercised “business judgment”. This is true even if another director would have made a different decision.

 To be covered by this rule, a director must be able to demonstrate that they:

• researched and asked questions about the decision’s impact beforehand;
• believed that the decision was in the company’s best interests; and
• were not influenced by a personal benefit that you would have received from the decision.

Duty to avoid conflicts of interest

Directors must not place themselves in a position where there is an actual conflict, or a real possibility of conflict, between their duties to the company and a personal interest or duty owed elsewhere (for example, to another company). It is not necessary for the company to suffer any detriment or the director to obtain any advantage in order for this duty to be breached.

A director who has a material personal interest in a matter that relates to the affairs of the company must give the other directors notice of the interest, unless an exception applies (for example, the interest relates to a proposed contract that is subject to approval by members).

In addition, a director of a public company who is required to disclose such an interest may not be present at a directors' meeting while the relevant matter is being considered and may not vote on the matter, unless the disinterested directors resolve that the interest should not disqualify the director. The same restriction usually does not apply to directors of a proprietary company, depending on its constitution and the particular circumstances. However, even where a director is permitted to vote on a matter in which they are interested, they must do so with regard to the best interests of the company.

Under the replaceable rules in the Corporations Act, if the director of a proprietary company complies with the requirement to disclose any personal interest before a transaction is entered into, the director may retain benefits under the transaction and the company cannot avoid the transaction merely because of the director's interest.

Nevertheless, an interested director is not entitled to deal freely with the company merely because they disclose their personal interest. The director must continue to satisfy all of their duties, particularly the duties to act in the company's best interests and with care and diligence. In some circumstances, those other duties may oblige an interested director to take additional action to protect the company's interests, such as disclosing further information about the transaction or actively attempting to prevent a transaction that is not in the company's interests.

Duty to prevent insolvent trading

Directors must prevent their company from doing business when it is insolvent. A company is insolvent when it cannot pay its debts on time. If your company trades while it is insolvent, you will breach your duty if:

• you were a director at the time that the company incurred the debt;
• the company was insolvent or became insolvent because of that debt; and
• there were reasonable grounds for suspecting that the company was insolvent, or would become insolvent (i.e. you knew, or should have known, that the company had debts which were due and that it could not pay them on time).

 A director in breach of their duty to prevent insolvent trading faces serious consequences and may:

• have to compensate creditors, including suppliers, lenders and employees;
• have to personally compensate the company for debts incurred after it became insolvent; and
• be disqualified from managing a company. Criminal penalties, such as further fines or imprisonment, may also apply where a director has acted dishonestly.

Safe Harbour Exemption

The safe harbour exception allows a director to develop a course of action that is reasonably likely to put creditors and shareholders in a better position than if the company was immediately wound up. When assessing whether their course of action will succeed, a director should carefully consider the company’s financial situation and seek professional advice. This exception might be suitable where a company is facing a short period of financial trouble and where the path to solvency is clear and likely.

Directors will not be able to rely on the safe harbour if the company is not meeting its obligations in relation to employee entitlements or its taxation reporting obligations.

Know Your Duties

If you are, or are considering becoming, a director of an Australian company, it is critical that you understand and are across the directors duties.

Our team of commercial law experts at Allied Legal can help, as we have a wealth of experience assisting directors navigate their duties. You can connect with one of our commercial law experts by giving us a call on (03) 8691 3111 or sending us an email at hello@alliedlegal.com.au.