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Legal trends: Directors in the litigation firing line

by Eric Levenstein

There was a time a company directorship was valued for its prestige and easy income, with little thought given to the duties, responsibilities and liabilities the appointment carried.

Today, a company directorship is fraught with hazards, not to mention a much higher threat of litigation. Far greater accountability is demanded of company directors from shareholders, law makers, employees, consumers, environmentalists, creditors and the courts than was the case in the past.

The Second King Report on Corporate Governance (King 2) provides shareholders who believe they have been poorly treated by directors with further grounds to hold errant directors liable for mismanagement of companies in South Africa.

King 2 outlines the responsibilities and accountability of directors towards shareholders and stakeholders. It applies to all JSE-listed companies in South African banks, financial institutions, insurers, public sector enterprises and local government.

King 2 applies to all companies preparing their financial statements after 1 March 2002. It places the board of directors at the heart of the corporate governance system, and places the responsibility for the performance and affairs of the company at board level.

Delegating authority to board members or management does not absolve directors of their duties and responsibilities. The consequences for lapses of good corporate governance can be serious, including suspension from the JSE for listed companies and the shame of having one’s name appear on a proposed register of delinquent directors to be kept by the Registrar of Companies.

Directors’ liabilities are addressed in both common law and statute, notably Section 424 of the Companies Act.

The courts have been divided on whether directors who allowed companies to trade in insolvent circumstances should be held personally responsible for the debts of the company.

Limited liability can discourage directors from continuing to trade in technically insolvent situations, as the major risk passes from the shareholders (whom the directors represent) to creditors.

Traditionally, a company is regarded as technically insolvent when its assets exceed its liabilities, but this is a limiting definition as a company in such circumstances may still be able to pay its debts.

In the 1997 case Philotex (Pty) Ltd & Others vs JR Snyman & others, the court stated that when a company traded recklessly or with intent to defraud, any person who was knowingly a party to such conduct could be held personally liable for the debts of the company. The court found that the directors had acted recklessly in incurring debts of R1,6 million, knowing the company was incapable of paying its creditors. Directors also secured a claim over the company’s assets prior to liquidation, thereby prejudicing creditors.

Far more worrying for directors is the recent case of Kalinko vs Nisbert, where the judge stated that directors who drive companies into liquidation through reckless or fraudulent trading may soon be forced to reimburse shareholders for losses. This is in line with English and US legislation. Kalinko was given leave to sue the directors for damages. Assuming a final judgment is granted, this would prevent directors hiding behind the corporate veil to avoid fiduciary accountability and liability to shareholders.

Increasingly, society recognises that companies are guided by ordinary people who, acting as a team, should behave according to the same standards expected of individual members of society. King 2 provides clear guidelines on risk management techniques that can be employed to protect directors.

The following are some key issues requiring proactive attention from directors to limit the threat of litigation:

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the company’s ability to meet financial obligations;
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withheld and misleading information;
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compliance with legislative and regulatory requirements;
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insider trading;
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public announcements;
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multiple directorships;
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takeovers and mergers.

Generally, any director who fails to exercise care, skill and diligence in the discharge of his fiduciary responsibilities will be personally liable to the company for any loss arising from the breach.

The bottom line is this: directors, as a result of King 2 and recent court decisions, will be expected to demonstrate far higher standards of corporate governance than was previously the case, under penalty of potential litigation. Some may balk at the additional liabilities they now face and chose not to accept board positions. But with proper care, diligence and attention to compliance issues, it will and should remain a rewarding and fulfilling endeavour for the benefit of shareholders, creditors, and the corporate community in South Africa.

Eric Levenstein is a partner in the Corporate recoveries, liquidations and insolvency department at Werksmans Attorneys. He can be contacted on tel. (011) 535 8000 or by e-mail on mailto:elevenstein@werksmans.co.za

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The Big Change is a business strategy blog and newsletter published by Arthur Goldstuck, managing director of World Wide Worx, a leading technology research organisation based in Johannesburg, South Africa.

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