Capping non-executive directors' liability

Although there is no official definition provided for a director. However, in view of the established case law, directors include any person occupying the position of a director by whatever named called.
The director extends beyond a person who is validly appointed a director. The concept includes those who knowingly assume the office of director even if there is any defect that may afterwards be discovered in his appointment.
The directors are expected to act with appropriate skill and care while performing their official duties.
With the recent corporate failures in the developed economies, the duties and legal responsibilities of non-executive directors have been under discussion that may have an important impact on the concept of non-executive director that is understood commonly in Pakistan, where the term director has been sometimes used carelessly without realising the duties and liabilities attached to this position.
DIRECTORS' RESPONSIBILITIES: The Companies Ordinance 1984 of Pakistan and the British Companies Act 1985 do not make any distinction between executive and non-executive directors or their legal duties and liabilities arising out of these appointments.
These two categories of directors are treated alike and therefore, no distinction is made regarding negligence in their fiduciary duty of skill and care.
In that case, the code of Corporate Governance (the Higgs Review) recommends the appointment of at least 50% directors as non-executive directors in the listed companies that result in sharing the same legal responsibilities that is expected from the executive directors.
These equal responsibility and liability are without any comparable benefit or remuneration paid to non-executive directors.
The question being debated these days is if it is reasonable to expect from non-executive directors to share the same extent of legal liability that is expected from executive directors who are responsible for day-to-day managing the affairs of the company.
The executive directors have enough time, human resources and information to make and implement decisions compared with a group of non-executive directors who lack all these resources and are still exposed to equal liability with executive directors in carrying out their fiduciary duty of skill and care. Is there any need that the law be amended to cap the legal liabilities of non-executive directors that may arise in the light of the Code of Corporate Governance contained in Regulations 36, 37 and 43, of the listing regulations of Karachi, Lahore and Islamabad stock exchanges for the purpose of establishing a framework of good governance for listed companies.
CASE LAW: The case law in this case was established in the famous case of City Equitable Fire Insurance Co Ltd ([1925] Ch 407, Chancery Division). In this case the facts were that a company suffered a great financial loss as a result of fraud by its chairman.
The liquidator brought this action against other directors for negligently failing to detect the fraud. Two of the directors were in the end found negligent, but were saved by a clause in the articles of association that exempted directors from liability for negligence except losses caused by their own willful neglect or default.
It was also observed that a director was not required to exhibit in the performance of his duties a greater degree of skill than may reasonably be expected from a person of his knowledge and experience. If directors acted within their powers, if they acted with such care as was reasonably expected from them, having regard to their knowledge and experience, and if they acted honestly for the benefit of the company they represented, they discharged both their equitable as well as their legal duty to the company.
This observation was based upon the case law established on the famous case of Lagunas Nitrate Co v Laguna's Syndicate ([1899] 2 Ch 392 at p. 435). This meant that directors were not liable for mere errors of judgements.
The traditional interpretation of the old case law was that the directors were only liable for gross errors of judgement amounting to negligence.
Furthermore, there was no general professional standard of expertise required of directors. Thus comments on the leading case of Re City Equitable Fire Insurance Co Ltd [1925] Ch 407 stated that the degree of skill required is a subjective test with no minimum reasonable amount of skill being required.
Under such a test the less knowledge and experience a director had, the less skill was expected of him, and the less likely he was to be liable when something went wrong.
It is arguable in these days if such a case law is representative or held valid in today's environment when more emphasis is being laid on the appointment of independent and non-executive directors due to stringent corporate governance rules being implemented throughout the world.
CURRENT DEVELOPMENTS: With the latest developments emerging from regulatory and legislative measures and the requirements of the business communities, where recent collapses of well reputed corporations were the result of huge losses to shareholders and investors, it was generally felt that directors acted carelessly and did not protect the interest of shareholders in preventing these losses.
In some cases, they in fact were the cause of these losses. This perception changed the entire thinking relating to the issue of directors' liabilities.
In a recent British case, City Equitable Life Assurance v Bowley [2003] BCC, former non-executive directors sought a summary judgement for excusing them from all liability for negligence and breach of fiduciary duty under section 727 of the Companies Act 1985 on the basis that they acted honestly and reasonably and considering all the circumstances ought fairly to be excused. Langley J turned down the petition on the ground that there were sufficient prospects of a success and the case should go to trial. If the claim for negligence proceeded, so too should the claim for breach of fiduciary duty.
This interim decision was possibly based upon the support provided by an Australian case, Daniels v Anderson (1953) 13 ACLC 614, the New South Wales Court of Appeal where it was held that the directors must take reasonable steps to place themselves in a position to guide and monitor the management of the company.
This decision firmed up the perception that directors should be held responsible for any negligent act they may commit in carrying out their duties of skill and care.
These decisions raised uncertainty as to the circumstances in which a director can delegate his responsibilities to others and still rely on them without accepting any legal liability that may cause substantial damage to his personal reputation or wealth or he may become criminally liable for any negligent actions.
This also makes sufficiently clear those directors who are wholly inactive or passive run high risk of being found negligent.
AVAILABILITY OF NON-EXECUTIVE DIRECTORS: As per above discussion, there has been a general perception that experienced persons are reluctant to accept the positions of non-executive directors.
It was evident from a list of available candidates for senior positions at Independent Television Company in the UK due to arduous liabilities that can confront directors where non-executive directors legal responsibilities and liabilities remain the same as those of executive directors.
In a survey conducted recently by Korn/ Ferry International of United States, the survey was based on directors from fortune 1000 companies and organisation from 15 different countries, the increased liability of corporate board membership prompted 23 percent of Fortune 1000 directors to turn down additional board seats in 2002 compared with only 13 percent in 2001.
This demonstrates the importance given to excessive exposure of liability by these non-executives directors.
Thus the British Secretary of State for Trade and Industry was asked to put a cap on the potential liabilities that a director might face if sued so that the availability of experienced people is not disrupted due to shortage of these candidates. (The Times, February 25, 2004 p. 27 " Would a liability cap fit directors"). Sir Derek Higgs, author of the Higgs Review, also mentioned that some of the directors interviewed argued that consideration should be given to capping liability by way of contract between a company and its directors or by agreeing that any damages should be proportionate to liability rather than an absolute limit to their potential liability for non-executive directors.
There is another school of thought that strongly argues that if liability is reduced, non-executive directors would not take their responsibilities seriously and that situation could undermine the efficiency of boards.
This argument also carries special weight that needs to be evaluated especially in countries like Pakistan, where the process of selection and appointment of non-executive directors is quiet different than the developed economies.
APPOINTMENT OF NON-EXECUTIVE DIRECTORS
PRIVATE SECTOR: In Pakistan, it is common to appoint family members and friends as non-executive directors in private sector listed companies.
These non-executive directors are normally uneducated, inexperienced and mostly uninterested to act as whistle-blowers. They are unable to evaluate alternative business proposals effectively.
They are normally appointed due to their share holdings or to fill a vacancy in the board.
STATE-CONTROLLED CORPORATIONS: In State-owned corporations, personal contacts and nepotism play a greater role in their appointments and non-executive directors are appointed by the ministries on personal acquaintances and private contacts to obtain inside information to protect their own personal interests. No attention is ever paid about the ability or suitability of the candidates for these positions. If we look at the list of non-executive directors of important state owned corporations, we should be ashamed of our self as a nation to know how they companies are being governed by the boards that is composed of either government civil servants or owners of defunct and ill managed companies.
Most of them are blacklisted by the financial institutions for non-payment of their dues or are declared as defaulters.
This exemplifies the type of guidance these non-executive directors provide to the boards. Under these circumstances, we are not sure how better results could be expected from these institutions to protect shareholders and government interest.
AWARENESS OF LEGAL RESPONSIBILITIES: In Britain, it is widely realised that due to complex nature of directors' responsibilities and their legal liabilities, the directors were not properly aware of their duties, their responsibilities and to whom they are responsible.
Therefore, it was felt that there was a need to codify directors' duties so that there is minimum confusion for directors to work effectively. This question has been debated extensively but no consensus has emerged so far.
This is confirmed by a survey conducted by the Institute of Director in Britain which concluded that about 75 percent of directors were not aware about the exact nature of their duties and were not clear as to whom they are accountable.
Under these circumstances it seems unfair to expect effective performance from non-executive directors.
On this point the Law Commission in Britain concluded that there should be a statutory statement of directors main fiduciary duties and a directors duty of care and skill should be prepared and signed by the director at his appointment so that there is no confusion that the non-executive directors were unaware regarding their responsibilities.
POSITION IN PAKISTAN: The comparison between British and Pakistani directors is important to argue if there should be a cap on the liabilities of non-executive directors.
In Britain, the non-executive directors have a professional position inducted into the companies for constructive, impartial and independent advisory role.
These non-executive directors on average get around approximately 40,000 pounds per annum in Britain and other developed economies according to a survey published in Sunday Telegraph May 30, 2004 by "Income Data Service".
It was further stated in the same survey that this compensation has jumped almost 36% over the last twelve months.
The increase in this compensation for non-executive directors may be attributed towards a busy schedule that is demanded from this group of directors compared with the past performance and a substantial exposure to higher legal liabilities that are associated with these appointments.
The importance of capping their liabilities may be justified as their time, effort and dedication to perform their function desires this treatment.
However, there seems to be no consensus on this issue. It is being generally argued that the government would have to be ensured that there is reluctance from prospective candidates to accept these positions before any decision is taken.
Although France has taken steps to cap the liabilities of non-executive directors to ensure that trained and professional people are available for these positions and these people are not reluctant to accept these positions.
Whereas in Pakistan, the purpose of these appointments are somewhat different as described above.
The lenient attitude towards these appointees may harm the effective functioning of the board on the basis that these non-executive directors perform no function at all, they do not act as whistleblowers, they have the least knowledge of the business they look after.
They are non-executive directors of several companies within the same group of companies where there active participation is almost negligible.
These non-executive directors are paid no remuneration's at all. They are not compensated even for the time spent by them to perform the company's business. They are neither properly trained regarding their official duties nor they have any idea the type of exposure relating to their legal liabilities they are accepting by being non-executive directors.
It is also surprising to note that they are not covered under any insurance policy to cap their legal liabilities.
It is arguable if any individual under these circumstances may spare this amount of time where he has not been reimbursed for the time spent as a non-executive director.
This leads us to believe that non-executive directors may just attend the meetings without being well prepared to contribute effectively into the operational matters of these companies.
In that case, the appointment of non-executive directors as part of the Best Corporate Governance may itself become meaningless and without any benefit to the company.
HOW TO MAKE THEM EFFECTIVE: Under these circumstances, they should be given a statement of their statutory duties to make them aware what is expected of them and in case, they fail, they may be exposed to legal penalties.
The directors should sign this statement of duties at the time of accepting these positions. This should serve as a warning to those candidates who wish to remain passive directors.
This mandatory statement of duties would deter a lot of amateur persons seeking to become passive directors in different corporations in furtherance of their personal interests or they would become active player to safeguard there own responsibilities.
This should make the boards more effective and thus may result in improved corporate governance.
Having considered the above developments, it seems reasonable that there should be a debate in Pakistan, if the liabilities of non- executive directors need to be reviewed and capped in the current changing environment taking into accounts Pakistan's peculiar situation.