Director Duties and The Business Judgment Rule

When you are asked to take on a director role for a corporation, it may be an honor, but keep in mind this comes with a lot of responsibility. Your role is to protect the shareholders, and therefore the decisions you are signing off on or voting for, should not be made frivolously, and, as history has demonstrated to us, through a variety of lawsuits, shareholders have questioned controversial decisions made by directors. This article examines the care that a director must take when making decisions, and what the review process and potential implications might be, should that care not be taken.

Business Judgment Rule

The business judgment rule provides deference to the decisions of directors, and under this rule, courts have determined that directors are in the best position to take into account the diverse interests of the corporation and its stakeholders (including what weight to give the stakeholder interests), so long as an appropriate degree of prudence and diligence are demonstrated by the directors in the making of the business decision in question.

Directors Two General Duties: Fiduciary Duty and Duty of Care

There are two general types of duties imposed upon directors in connection with their management of the corporation’s business and affairs Canada Business Corporations Act (CBCA s. 122(1) and the Ontario Business Corporations Act ( OBCA, s.134(1).

The first duty is a fiduciary duty to act honestly, in good faith, and with a view of the best interest of the corporation s. 122(1), CBCA; s.134(1), OBCA. A directors duty might come into question if they are personally transacting with or for the corporation, taking corporate opportunities for themselves ( see Canadian Air Service Ltd. v. O’Malley et al for an example of what this looks like), or competing with the corporation while having a fiduciary duty to the corporation (self-dealing).

The second duty is a duty of care which is satisfied by exercising a level of care, diligence, and skill that a reasonably prudent person would exercise in a comparable circumstance s.122(1)(b), CBCA;s.134(1)(b), OBCA. Directors at the very least should have a basic level of competence to perform the job. If they do not, they should acquire the necessary skills or resign before incurring liability for breaching their duty to the corporation. When a director possesses a particular skill or qualification, the duty becomes more stringent. For example, a director who is a qualified accountant would be in breach of their duty of care if they did nothing to address a failure to withhold income tax from employee wages.

In Ambs v The Queen, 2020 TCC, the directors breached their duties owed to the corporation. Two brothers were the only two directors of a corporation. During the applicable taxation years, the corporation failed to remit employee source deductions under the Income Tax Act, the Canada Pension Plan, and the Employment Insurance Act. The Corporation also failed to remit net tax under the Excise Tax Act (ETA).

The issues, in this case, were whether the two directors exercised the degree of care, diligence, and skill to prevent the remittance failures that a reasonably prudent person would have exercised in comparable circumstances and whether the directors could rely on the due diligence defence under the CBCA to protect them from any liability. It was held that, for the directors to avail themselves of the due diligence defense (s.123(4) of CBCA), they must establish that they took the appropriate actions promptly to limit the risk of non-payment of these remittances.

There was little, if any, evidence to show that the corporation and its directors had taken steps to ensure that remittances would be made promptly. Rather, the evidence showed that the actions of both directors were largely curative, rather than preventive. Therefore, If directors fail to act diligently and apply the necessary skill required to prevent particular harm from occurring their behavior may be considered as a breach of their duty of care. One key takeaway from this decision is that directors have a responsibility to prevent failures from occurring, rather than attempting to rectify or remedy the harm they created after it has occurred.

Director’s fiduciary duties restrain self-dealing, fraudulent behavior, and preferential treatment by directors. The duty of care can be interpreted as requiring a director to consider the best interests of the shareholders by exercising due diligence and applying the necessary skill needed in order to achieve the best results for the shareholders. Depending on the jurisdiction and how it interprets the rule, “the best interest of the corporation” may not simply mean what is best in terms of profit or share value (check with your local counsel to consider what the answer is in your jurisdiction). Rather, consideration may also be given to long-term interests that could ultimately impact the corporation.

The business judgment rule is an extension of these enabling corporate statutes, and is described in further detail below.

Deferential Shield

The business judgment rule can act as a shield to protect the board of directors from frivolous legal allegations regarding their conduct related to the decisions they make on behalf of the corporation. Under the business judgment rule, case law (in many jurisdictions) indicates that, unless it is clear that directors have violated the law or acted against the interests of the shareholders and the corporation, the courts should defer from interfering with the directors’ decisions.

The business judgment rule is not a substantive rule of law, but instead, it is a rebuttable presumption that in making a business decision the directors of a corporation acted on an informed basis, and with the honest belief that the action taken was in the best interests of the corporation and its shareholders. This presumption applies when there is no evidence of fraud, bad faith, or self-dealing on the part of the directors. In the absence of the latter evidence, the courts may defer to the business judgment rule, however, if there is evidence of the above the court may interfere with the directors’ decision and hold the director liable for the negative consequences of their decisions.

Case Law: Deference and Good Faith

Peoples Department Store Inc. (Trustee of) v. Wise is a Supreme Court of Canada decision on the scope of the fiduciary duty upon directors and officers of a corporation. In this case, the court concluded that, when examining the duty of directors under section 122(1) of the CBCA, that there is a distinction between the interests of the corporation and those of the stakeholders and creditors. The Peoples case involved an action by the trustee in bankruptcy of Peoples Department Stores Inc. (the “Peoples Stores”) against the corporation’s directors. Before the corporation’s bankruptcy, the directors had agreed to implement a joint inventory procurement policy with Wise Stores Inc. (“Wise Stores”), the corporation’s parent company. The trustee claimed that by undertaking this action, the directors had favored Wise Stores over the Peoples Stores to the detriment of the creditors of Peoples Stores. Reader, recall, that each corporation is a “separate legal person”, each, with its own board of directors, and therefore, if the board of directors of business#1 acts to benefit business #2, the decisions could be called into question - and were in this case.

The main issues, in this case, were: (1) whether the directors breached their duties owed to the corporation, and (2) if this duty was owed to their creditors as well under s.122(1) of the CBCA. Here, the trial judge found that there was no fraud or dishonesty in the Wise brothers’ attempts to solve the mounting inventory problems of Peoples and Wise. The Wise brothers discovered the serious inventory management problem and implemented a joint inventory procurement policy they hoped would solve it. In the absence of evidence of personal interest or improper purpose in the new policy, and in light of the evidence of a desire to make both Wise and Peoples “better” corporations, the court concluded that the directors did not breach their fiduciary duty under s. 122(1)(a).

Therefore, an honest and good faith attempt to redress a corporation’s business/financial problems (that were not caused by the directors) does not, if unsuccessful, qualify as such a breach. At all times, directors owe their fiduciary obligations to the corporation, and the corporations’ interests are not to be confused with the interests of the creditors or those of any other stakeholder.

Case law indicates that directors and officers will not be held to be in breach of the duty of care under s. 122(1)(b) of the CBCA if they act prudently and on a reasonably informed basis. The standard of care is an objective one. The decisions of directors and officers must be reasonable business decisions in light of all the circumstances, including the prevailing socio-economic conditions, about which they knew or ought to have known. While courts are ill-suited and should be reluctant to second-guess the application of business expertise to the considerations that are often involved in corporate decision-making, they are capable, on the facts of any case, of determining whether an appropriate degree of prudence and diligence was brought to bear in reaching what is claimed to be a reasonable business decision.

Self-dealing

Director decisions that are non-arms length transactions could be scrutinized, and if found to be “self-dealing” - could also end up in court, with an unfavorable decision for the directors. For example, a director could sell a company asset to a family member for an unjustifiably low price. This would be an example of self dealing that the business judgement rule would not insulate from.

When challenging the decisions of directors, the onus is on the plaintiffs to show evidence that the directors have acted in bad faith,engaged in fraud, committed a breach of trust, created a conflict of interest, abdicated corporate responsibility, or failed to apply due diligence as discussed above.

Obviously this is a complicated topic - make sure you consult with counsel if you are worried about the decisions you are making as a director, or the decisions your directors are making on behalf of your company.

Review Process:

Questions to ask when determining if you as director have satisfied your fiduciary duty and duty of care.

  1. Have you applied an appropriate degree of prudence and diligence in reaching your decisions?
  2. Have you exercised reasonable care and skill during the decision-making process?
  3. Have you exercised your business judgment appropriately and reasonably?
  4. Have you acted honestly and in good faith with a view of the best interests of the corporation?
  5. Have you attempted to avoid conflicts between the interests of the corporation and any opposing interests, including your own?

If the answers are affirmative to the questions above, this will enable the business judgment rule to act as a shield for your decisions made as a director of the business.

Take-Aways

  • act in good faith;
  • act in the best interests of the corporation (not in self-interest - the concept of a “duty of loyalty” plays a role here);
  • act on an informed basis;

For more information on directors duties and the business judgment rule, check out these blog posts (as discovered on our partner organization, Mondaq.com), or search our articles on board liability, fiduciary duty, business and judgement

Written by: Mark Kiggundu

Edited by: Rajah Legal


Written by Rajah. Rajah Lehal is Founder and CEO of Clausehound.com. Rajah is a legal technologist and technology lawyer who is, together with the Clausehound team, capturing and sharing lawyer expertise, building deal negotiation libraries, teaching negotiation in classrooms, and automating negotiation with software.