Third Dimension – Is Ignorance Bliss? An Examination Of The Duty Of Care And Diligence

March, 2016

By James Thomson, Lawyer, and Lily Zhang, Paralegal

It is a long standing principle under both the common law and legislation in Australia that directors and officers of a company must exercise a reasonable degree of care and diligence in carrying out their duties and exercising their powers.

Given the nature of not-for-profit and charitable organisations, many directors and officers will be engaged as volunteers on a part-time basis, often having little to do with the day to day running of the organisation. These non-executive directors might assume that because of their limited involvement, their duty of care and diligence is reduced proportionately.

This article examines whether this is the case at law, and what steps a director or officer can take to reduce the risk of a breach of the duty of care and diligence.

1. What is the duty?

Section 180(1) of the Corporations Act 2001 (Cth) (Corporations Act) places an obligation on directors and officers of corporations to exercise their powers and discharge their duties with the degree of care and diligence that a reasonable person would exercise if they:

(a) were a director or officer of the corporation in the corporation’s circumstances; and

(b) occupied the office held by, and had the same responsibilities within the corporation as, the director or officer.

Whilst section 180(1) of the Corporations Act does not apply to charities registered with the Australian Charities and Not-for-profits Commission, a similar obligation is placed on those charitable organisations as part of Governance Standard 5, created by section 45.25(2) of the Australian Charities and Not-for-profits Commission Regulation 2013 (Cth) (ACNC Regulation).

Further, section 39A(4) of the Associations Incorporation Act 1985 (SA) applies to certain “prescribed” associations only and section 84 of the Associations Incorporation Reform Act 2012 (Vic), contain similar duties.

Interestingly, section 180(1) of the Corporations Act applies to directors and officers of a corporation personally, whereas section 45.25(2) of the ACNC Regulation does not. Rather, that section requires a charitable organisation to ensure that its “responsible entities” exercise a degree of care and diligence. The term “responsible entities” essentially refers to those persons who are responsible for governing a charity. In the case of a company, this will be the company’s directors, or in the case of an association, its committee members.

Often, charitable organisations will include provisions in their constitutions requiring directors or committee members to comply with Governance Standard 5. The constitution, being a contract between the organisation and its directors / committee members, is enforceable against those directors and committee members.

2. What does the duty require?

In essence, a director, officer or committee member (collectively referred to in this article as Responsible Person) should place themselves in a position so that they can properly guide and monitor management of the organisation, and make decisions using sound business judgment based on an appropriate degree of knowledge of the business of the organisation.

Determining whether a Responsible Person has breached their duty of care and diligence requires an examination of the Responsible Person’s conduct in the context of the organisation’s particular circumstances (as required by section 180(1)(a) of the Corporations Act).

Although the Court will view the circumstances of an organisation on a case by case basis, these circumstances might include, for example:

(a) the size and nature of the organisation’s business or operations;

(b) the composition of the board of the organisation and the individual board members’ experience and expertise;

(c) the limitations of the organisation’s financial and management reporting systems; and

(d) the manner in which the responsibility for the business of the organisation is distributed between the Responsible Persons and employees.

Section 180(1)(b) also requires the examination of the particular responsibilities that the Responsible Person is performing. The responsibilities placed on a Responsible Person will include those specifically created by statute, the organisation’s constitution or a resolution of the organisation or otherwise (such as under a contract of employment of a non-executive director). Furthermore, responsibilities may be extended to include those flowing from a particular Responsible Person’s experience and skills that they have brought to their office, even in the absence of a specific delegation of responsibility. For example, when examining the standard to be applied to an officer of an organisation, the Courts have previously held that a secretary who is also general counsel for an organisation is responsible for providing advice on compliance with all of the legal requirements relevant to the organisation.

Whilst not an exhaustive list, and noting that each case needs to be examined on its own particular facts, case law suggests that a Responsible Person may be seen to have breached their duty of care and diligence by:

(a) failing to take reasonable steps to assess their organisation’s financial position and performance;

(b) failure to familiarise themselves with the fundamentals of the organisation’s business and its operations;

(c) failing to maintain cash reserves adequate to ensure that the organisation does not trade insolvently;

(d) failing to ensure that sufficient meetings of Responsible Persons are held in order to facilitate proper management of the organisation;

(e) failing to ensure proper financial statements and records are maintained;

(f) entering into transactions that a Responsible Person acting with reasonable care and diligence would not have entered into; or

(g) making misleading statements to members of the organisation or the public.

3. The Business Judgment Rule

Section 180(2) of the Corporations Act provides a business judgment rule, which acts as protection from liability under s 180(1) of the Corporations Act. It essentially exists to ensure that directors and officers are not discouraged from taking advantage of opportunities that involve responsible risk-taking. A similar protection is offered under regulation 45.110 of the ACNC Regulation, for Responsible Persons of registered charities.

The protection offered only applies to business judgements, meaning any decision to take, or not to take, action in respect of a matter relevant to the business operations of the organisation. Importantly, liability that arises from a failure to make a decision or lack of supervision does not fall within the scope of this rule.

Responsible Persons will have been taken to have met their duty of care and diligence, if the Responsible Person:

(a) makes the relevant judgment in good faith for a proper purpose;

(b) does not have a material personal interest in the subject matter of the judgement;

(c) has informed themselves about the subject matter of the judgement to the extent they reasonably believe to be appropriate; and

(d) rationally believes that the judgement is in the best interest of the organisation.

The burden of proof lies with the Responsible Person seeking to rely on the protection provided by the business judgment rule.

4. Practical steps to comply with the Business Judgment Rule

Whether or not the business judgment rule will be satisfied often turns upon the state of mind and conduct of the Responsible Persons at the time that the decision was made. This means that documentary evidence can play a key role in raising a defence under the Business Judgment Rule.

4.1. Board Papers

Board papers are essentially information packages that assist the Responsible Persons of an organisation to make an informed decision on matters which are put before them. They are formal records of the information and advice on which the board relied in making its decision and, as such, are crucial pieces of evidence that can be used to demonstrate if a business judgment was reasonably informed.

Some useful tips for the preparation and use of board papers are as follows:

(a) board papers should not be unnecessarily detailed, but should provide all the necessary information to ensure that the Responsible Persons are reasonably informed of the matters upon which they are to make a decision;

(b) board papers should state their purpose clearly, for example, is a resolution proposed in respect of the subject matter of the paper, or is it presented for discussion purposes only;

(c) if a resolution is proposed, then the board paper should clearly state the resolution and the risks of the alternative decisions open to the Responsible Persons. Where relevant, the recommendations of senior management should also be included;

(d) board papers should be written in plain English, and should ideally follow a common form and structure;

(e) board papers should be distributed among the Responsible Persons prior to the meeting, in order to allow them enough time to properly review and consider the paper; and

(f) the organisation should keep copies of all board papers along with its minutes book for future reference.

Whilst creating board papers may be an administrative burden for smaller organisations with limited administrative resources, their importance cannot be understated when it comes to the decision making of an organisation’s governing body. Not only do board papers assist Responsible Persons to make the decision that is in the best interests of the organisation, they can also help to protect the Responsible Persons from personal liability.

4.2 Minutes of Meeting

Along with board papers, board minutes are also extremely important records of the decision making process of Responsible Persons. In conjunction with board papers, they provide a relatively complete picture of what information a Responsible Person has based their decision on, as well as the reasons for which a particular decision was made.

Generally speaking, two forms of minutes are utilised, as follows:

(a) Minutes of Resolution – normally these minutes will principally contain the wording of the resolutions considered by the meeting, rather than also including a narrative on the background of the resolution, or the reasons upon which the decision was made; or

(b) Minutes of Narration – these minutes are often much more comprehensive than minutes of resolution, and will usually contain details on discussions and reasoning surrounding a decision which is made.

Some useful tips for the preparation of minutes are as follows:

(a) minutes should strike a balance between the minutes of resolution and the minutes of narration styles. They should not be a transcript of the meeting, but they should provide sufficient detail as to how and why a decision was reached, as well as why any alternative decisions were rejected;

(b) if the reasons for a decision are clear from a board paper, then you may choose not to record the reasons in the minutes. However, if they differ from those stated in the board paper, then they should be included in the minutes;

(c) any personal interests of Responsible Persons declared should be recorded in the minutes. If that person has excused themselves from the meeting, their absence should be recorded, as well as their return to the meeting (and the timing of each);

(d) any significant issues or concerns raised by Responsible Persons, and the way in which they were resolved, should be recorded in the minutes; and

(e) where action is needed as a result of a decision made at the meeting, the minutes should record who is responsible for that action, what is to be done and by when.

Minutes should be signed by the chairman of the meeting or of the next meeting, and entered into the organisation’s minute books within one (1) month of the meeting. By virtue of section 251A(6) of the Corporations Act, such minutes properly entered will be prima facie evidence of what occurred at the meeting of a company. In respect of other organisations not covered by the Corporations Act, following the procedure set out in section 251A(6) of that Act is considered to be good governance regardless.

In any event, minutes should be prepared as soon as reasonably practicable after close of the meeting.

5. Conclusion

Responsible Persons are obligated to place themselves in a position that allows them to properly guide and monitor management of their organisation. They should ensure that decisions are made using sound business judgment and are based on an appropriate degree of knowledge of the business of the organisation.

It is acknowledged that the preparation of documents, such as board papers and minutes of meeting, can seem to be an administrative burden, especially for smaller organisations. However, they are imperative in demonstrating that decisions made by the Responsible Persons of an organisation were made properly, and with due care and diligence.

This article originally appeared in Third Dimension – Summer 2016

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vera-visevic

Vera Visevic | Partner
T: +61 2 8289 5812
E: vvisevic@millsoakley.com.au

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