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Directors’ Duties in Effective Governance - NZ Business Magazine – March 2009

Sat April 12th 2014


An old proverb says "Opening a shop is easy, but keeping it is an art". I'm not sure who wrote this, or when, but he (or she) got it right. Well, mostly right. It's actually more than an art. It's also about risk, commitment, and elbow grease. Today, running a business is also about vision, strategic goal-setting, quality management, and effective governance.

In the commercial arena, directors of companies have significant responsibilities to ensure that the business and affairs of their companies are well managed and successfully governed. For corporate governance to be effective, it must be thoughtfully directed through policy and objective, and rigorously maintained.

A Broad Definition

When we talk about corporate governance in a broad sense, we are really talking about the systems and structures that a corporate entity should ordinarily have in place to watch over its affairs and operations. A more specific definition would usually be applied in context. Hence, corporate governance in the financial sector would obviously involve overseeing implementation of good audit and financial reporting systems and the capacity to identify and control business risks such as credit control, exchange rates, exposure concentration, and so on.

The Implications for Directors

Directors must have a clear understanding of the company's strategic plan and objectives. They must also have correct structures in place which will enable the implementation of the strategic plan and attainment of objectives, and have appropriate systems in place to identify business risks.

We have seen, through the recent wave of corporate catastrophes, that proper compliance with the legal obligations is critical to the success of the company, and failure to do so will ultimately lead to its premature demise, and probably legal action by affected parties.

It follows that directors must not only understand what is required of them, legally speaking, but must also actively perform their legal duties. The Companies Act 1993 ("the Act") imposes a number of duties on directors. Some of the more interesting ones are discussed briefly below:

a) A duty in relation to Obligations

A director cannot agree to the company incurring an obligation unless he believes at that time (on reasonable grounds) the company will be able to perform it when it is required to do so. An example would be if a major national food retailer entered into licensing deals (say, for pre-packaged meals), but did not even have a requisite infrastructure in place to complete obligations to licensees to ensure that delivery was on time, with quality and production levels maintained at a high standard. Another example is when directors enter into lease arrangements when the company can neither pay the rental, nor has any strategic plan to even operate in the premises.

b) Good Faith

A director must, when performing duties and exercising powers, always act in good faith in what he or she believes to be the best interests of the company. Ultimately this means that the director should act in an honest and transparent manner in the discharge of his or her duties as a director, and should not act in such a way as to cause some harm or disrepute to the company.

A director cannot argue that he or she has acted in the "best interests of the company" if they were motivated by personal gain in making certain decisions on behalf of the company.

A point of interest is that the duty of good faith can be extended to include the interests of the shareholders as well. In other words, if the Constitution allows, a director can only act in the interests of one group of shareholders in the company, (say, in joint ventures) even though that may not be in the best interests of the company.

c) Duty of Care

A director must exercise the care, diligence, and skill of a reasonable director when exercising powers or performing duties. The important test in this case is what a reasonable director would do in those exact circumstances.

To ascertain whether a reasonable duty of care was exercised, it is essential to consider: the nature of the company, the nature of the decision, and the position of the director and the responsibility being undertaken.

Even though the test of reasonableness is an objective one, there are some subjective considerations. For example, the duty of care expected from the director of a public listed company would not be exactly the same as a director of a small closely-held company in those circumstances.

d) Proper Purpose

A director is required to exercise his powers at all times for a proper purpose, which means that he/she cannot exercise powers for a purpose which was not intended by the Constitution or approved by the Board. For example, directors cannot issue shares for the primary purpose of avoiding a takeover of the Company (rather than for the legitimate reason of simply increasing the capital of the Company).

The legal test applied to ascertain whether an action was for a proper purpose or not is an objective one. This means that it is not so much the director's own opinion that counts. Rather the question would be what a "reasonable" director would do in that situation.

e) Legislation and the Constitution

A director should not agree to the company acting, or act himself, in a manner which is inconsistent with the Constitution of the company or is contrary to the Act. This duty is all-encompassing and requires directors to act within the constraints of the Act and the rules of the company.

Some Key Principles

Quite apart from ensuring that they individually observe and practice their legal duties properly (as required within their organisation), a Board of Directors must adopt certain key principles in operating their organisations. Below are some common principles in corporate governance which all boards should promote and practise :

1. Establishing a clear vision, identifying opportunities for growth and development and setting objectives;

2. Having a sound understanding of the business of the organisation, the marketplace it operates in, the other players in that marketplace (the competition), identifying what is distinctive about its own business, communicating its vision clearly, and understanding the nature of its risks;

3. Acknowledging that the ultimate responsibility for ensuring that the organisation's risks are properly identified, monitored, and controlled lies with the board;

4. Acknowledging that a fundamental requirement is to be scrupulous in recognising and avoiding potential conflicts of interest. All potential conflicts must be disclosed as early as possible (collectively or individually). If they do arise, then it is best to manage conflicts in ways which do not harm the company or organisation; and

5. Having rigorous internal and external audit arrangements in order to ensure transparency and independence at all times.

Conclusion

With increasing legislative changes, and in an economy scarred by corporate collapses and recession, the significance of good governance comes to the forefront as an integral part of any organisation. In looking at governance, we are reminded that the legal requirements placed upon directors of companies are critical to the proper running of a company. As many directors and organisations have recently discovered, keeping the shop open is not easy. It is bound to get harder in a recessive economy. Implementing good governance into a business will certainly help to keep it.

NZ BUSINESS Magazine – March 2009