John Shaw: Do your homework before joining a board

Many company directors sit on the boards of small, closely held companies set up to run family-owned businesses.

Usually they hold this position because they own shares in the company and thus have an interest in its success.

However, such an interest by itself is not a sufficient qualification to be a board member. These directors may have a good understanding of the business issues but not of their legal obligations.

Sometimes these directors are just family friends or employees in the business. There is a natural tendency to defer to the more experienced members of the board and those with the greater influence that comes with having money invested in the business.

This can put less powerful directors in a difficult position, and at considerable risk, given their legal obligations and potential financial exposure.

Company law abounds with rules that must be complied with, and potentially stiff penalties if they are not. Company directors are held responsible for making sure these rules are followed. It is assumed they know what the rules are and how to observe them. Ignorance of the law is no defence.

The Companies Act 1993 sets out a specific list of the duties of directors. These include duties:

* To act in good faith and in the best interests of the company.

* To use the care, diligence and skills that a reasonable director would exercise in the same circumstances.

* Not to agree to the business being carried on in way likely to cause a substantial risk of serious loss to the company's creditors.

* Not to agree to the company incurring an obligation unless the director believes at that time on reasonable grounds that the company will be able to perform the obligation when it is required to do so.

Each of these duties, especially the last, must be the ongoing concern of any responsible and prudent company director. Failure to perform these duties can lay the director open to legal action.

Directors also take responsibility for the actions of their co-directors. When a decision is made to take action against the directors of a company, such as proceedings against the boards of failed finance companies, all directors can be included in the action. This can be the case even where some directors may have lesser responsibility for the mistakes that caused the company to fail or breach its legal obligations.

This shared responsibility was illustrated recently in a case where the Court of Appeal accepted a newly appointed director could become responsible, on appointment, for the earlier actions of a co-director who accepted funds from investors without meeting the requirements of the Securities Act 1978.

The Court held the new director shared liability with the other director to return the investment monies to the investors, unless it could be shown the new director was not aware of the illegality.

It is most unwise to join or remain on a board that has a cavalier or negative view about the need for legal compliance, including the keeping of company records and the maintenance of statutory registers.

Some boards, especially of smaller companies, treat legal compliance as an unnecessary and bureaucratic distraction from the principal goal of making money. They have fallen into the trap of behaving as if it does not matter to anyone outside the company how it is run, whether it keeps proper records, or how the board conducts its affairs, provided the business objectives are being met, the shareholders get their dividends and the bank is kept happy.

However business objectives are not always met and companies often fail, leaving creditors unpaid and investors out of pocket. When this happens the mess has to be sorted out, and liability for the financial consequences is allocated. In many cases the mess is the result of the failure of the directors to apply proper standards of due diligence and corporate governance.

These failures can prove costly for the shareholders, who can see the value of their investments shrink or even disappear, and for directors, who can be held personally liable for the debts of the company.

A recent case in the High Court shows the perils of directors who ignore their statutory obligations for proper corporate record-keeping. A husband and wife were directors of a company. The company failed, owing a significant amount to creditors.

The liquidator took action directly against the directors, claiming the board had breached its obligation under the Companies Act to keep proper accounting records.

The directors said they had left all these matters to another director and blamed him for the compliance failures. The High Court said the husband and wife could not ignore their legal obligations and held that they had personal liability for the company's debts.

Anyone intending to become a company director is therefore strongly advised to do their homework in advance and to get satisfactory answers to some key questions, such as:

* What are the major risks facing the company? Are these being identified and managed properly and are they being honestly reported to the board on an ongoing basis?

* What are the company's legal obligations? Is there a robust legal compliance programme in place that can highlight and correct any failures?

* Is there a realistic business plan? Is the financial performance of the company being properly tracked and reported to the board?

* Are board decisions taken with sufficient formality and documentation? Are they supported, if necessary, by independent specialist advice?

Aspiring and existing directors should also consider taking some formal training, such as the courses offered by the Institute of Directors.

John Shaw is a consultant with the Auckland law firm Lowndes Associates. He specialises in commercial law with particular reference to company and business acquisitions, securities, legal compliance and corporate governance. He has extensive experience in private practice and as general counsel of public companies.