We often get asked what it means to be a “reasonable” director under section 137 of the Companies Act 1993 (the “Act”). That section imposes a duty of care on all directors, requiring them to exercise “the care, diligence, and skill that a reasonable director would in the same circumstances”.
Section 137 of the Act sets a clear expectation for directors to act with care, diligence, and skill. By following the standard of a “reasonable director” and carefully considering the context of each decision, directors can help protect their companies, creditors, and themselves from potential liability.
Duty of Care under Section 137
The duty of care holds directors to an objective standard. This means that the courts will assess their conduct against that of a competent and diligent director, regardless of their personal experience or knowledge. This is a contrast to section 131 which has a subjective standard (based on what that director believed). A director must make decisions using the same level of care and attention that a reasonably competent director would in the same context. This standard ensures that all directors—whether newly appointed or experienced—are held accountable to the same expectations of responsibility.
However, this duty isn’t applied uniformly across all cases. The courts will also consider several factors specific to the director’s role and the company’s situation. These factors influence the level of care that is deemed reasonable, making the standard context-dependent. The factors include:
- Nature of the Company: A large, publicly listed company will have different governance expectations compared to a small, family-owned business.
- Nature of the Decision: Critical financial or strategic decisions will require more diligence than routine administrative matters. For example, entering a high-risk financial arrangement demands more scrutiny than minor operational decisions.
- Director’s Position: Executive directors, involved in daily management, will be held to a higher standard compared to non-executive directors who may have more of an oversight role. Executive directors are expected to have a more detailed understanding of the company’s operations and finances.
The courts apply the “reasonable director” test by evaluating whether the director acted in a manner that a reasonably competent director would have in the same position and under similar circumstances. For example, an executive director should be more aware of day-to-day business risks and financial health, especially when making decisions about continuing to trade in the face of potential insolvency.
Breaches of the Reasonable Director Standard
Directors who fail to meet the standard set out in section 137 risk being found in breach of their duties. Common scenarios where directors fall short of this standard include:
- Trading While Insolvent: One of the most frequent breaches involves continuing to trade when the company is unable to meet its debts as they fall due. Directors are expected to halt trading when insolvency is evident or imminent. Failing to do so can result in significant financial harm to creditors.
- Case Example: In the Mainzeal case, directors were found liable for allowing the company to continue trading while insolvent, even though they relied on assurances of financial support from external sources. The court held that the directors failed to protect the interests of creditors, and their reliance on vague promises of support was unreasonable.[1]
- Improper Transactions: Directors can be held responsible for engaging in or allowing improper transactions that harm the company or its stakeholders. This includes entering contracts or financial arrangements without proper due diligence, exposing the company to undue risk.
- Failure to Manage Financial Risks: Directors must monitor the company’s financial health and take action to address risks such as insolvency or declining revenues. Ignoring warnings can result in breaches of the duty of care.
Directors who breach section 137 may face personal liability for any losses incurred by the company or its creditors. Depending on the severity of the breach, directors could also be disqualified from serving on boards in the future. In extreme cases, where fraud or reckless conduct is involved, criminal charges may be brought against the director.
Guidance for Directors
To ensure compliance with section 137 and avoid personal liability, directors should consider the following guidelines:
- Understand Your Role: Be clear on your specific duties within the company. Are you responsible for daily operations (executive director), or do you have an oversight role (non-executive director)?
- Exercise Due Diligence: Make sure you have all the relevant information before making decisions. This includes understanding the company’s financial health and assessing the risks associated with major decisions.
- Consider the Context: The actions required of a director may vary depending on the size of the company and the nature of the decisions being made. Larger companies with complex operations may require greater scrutiny and involvement from directors.
- Seek Expert Advice: If you are unsure about a decision—especially one involving high financial risk—seek professional advice from lawyers, accountants, or other specialists. A reasonable director knows when to consult experts.
- Document Decisions: Keeping records of your decision-making process, including the information you relied on, can be helpful if your actions are later questioned in court.
We have also written a guide on Mainzeal and its implications here.
This article is for general informational purposes only and does not constitute legal advice. For advice specific to your situation, please contact a qualified legal professional. Reproduction is permitted with prior approval and credit to the source.
[1] Richard Ciliang Yan v Mainzeal Property and Construction Limited (in liq) [2023] 1 NZLR 296; [2023] NZSC 113.
