If you're invited to become a director or an officer of a corporation, there are many things to consider but often overlooked is the issue of what you should do to protect your personal assets from your potential personal liabilities as a director or officer.
I'm sure you are all aware that a corporation is a separate legal entity with its own assets and liabilities. It is still a basic principle in our corporate law that employees, officers and directors are not personally responsible for the debts of a corporation. All business corporation statutes, however, impose a standard of conduct upon directors and officers and if directors or officers fall below that standard they will be exposed to personal liability. In discharging duties to the corporation, every director and officer shall:
(a) act honestly and in good faith with a view to the best interests of the corporation; and
(b) exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances.
Notwithstanding that a director or an officer meets these standards, there are approximately 200 statutes that impose liability on directors in various situations and more that 100 statues that impose liability on officers. Some of the most well known are the Ontario Business Corporations Act, the Canada Business Corporations Act, the federal Income Tax Act and the Ontario Income Tax Act, the Employment Standards Act, the Retail Sales Tax Act, the Employment Insurance Act, the Canada Pension Plan Act, the Excise Tax Act, the Occupational Health and Safety Act of Ontario, the Ontario Water Resources Act and the federal Wage Earner Protection Act. There are many more but these are ones that are frequently encountered.
No one becomes a director or officer of a corporation expecting that their personal assets will be put at risk while they are carrying out work on behalf of the corporation. This paper lists eight suggestions that will help to protect your personal assets. Even if you are already a director or officer, you will benefit from considering the suggestions that follow.
Have The Corporation's By-Laws Reviewed
All corporate law statutes, under which corporations are incorporated, permit corporations to indemnify their directors and officers from claims brought against them in their capacity as directors. A corporation can only indemnify its directors to the extent it is permitted to do so by its governing statute. The statutes provide that indemnification in certain circumstances is mandatory but in other circumstances the corporation may indemnify but is not required to do so.
The practice has grown up that the indemnifications provisions contained in the applicable corporate law statute are replicated in a corporation's by-laws except that the provisions that are permissive in the statute are made mandatory in the by-laws. This is obviously a good thing if you are a director or officer or soon to be a director or officer.
The permissive provisions are among the most important because they permit indemnification for directors and officers against all costs, charges and expenses, including an amount paid to settle an action or satisfy a judgment, reasonably incurred by the individual in respect of any civil, criminal, administrative, investigative, or other proceeding in which the individual is involved.
Another important permissive provision is that a corporation may advance money to a director or officer for the costs, charges and expenses of a proceeding, subject to the possibility of having to repay the money in certain circumstances.
One of the problems with by-laws is that they're boring and don't get a lot of attention. If the corporation has been around for a number of years, its by-laws may not have been updated to adopt the broad language and forms of indemnification which are now permitted. Even the by-laws of more recently incorporated entities should be checked because not all by-laws are the same and depending on who did the incorporation, the indemnification provisions may not have received as much attention as they should.
A by-law amendment requires director approval in the first instance but must be submitted to the shareholders at the next meeting of shareholders where it can be confirmed, rejected or amended. The broadest permitted indemnification provisions in a corporation's by-laws are important as your first line of defence.
Get An Indemnification Agreement
This is a formal contract that should be entered into between each director and officer and the corporation. It should obligate the corporation to indemnify its directors and officers from any claims brought against them while acting on behalf of the corporation. The indemnity should be as broad as permitted by the corporate law statute. It cannot provide an indemnity beyond what is permitted but in practice it can go into more detail about the terms of the indemnification and it can clarify some ambiguities, and uncertainties in the legislative language. To a limited extent it can deal with some things not covered in the statutes.
In many aspects, it will cover the same ground as an updated set of by-laws containing a broad indemnification. It provides additional protection however in two important respects. Firstly, as a contract between two parties, it is not open for one party to alter the contract without the consent of the other party. By-laws, on the other hand, may be changed by a corporation at any time provided the appropriate procedures requiring board and shareholder approval are followed.
This was illustrated by a case in 2008 in the United States in which members of a board who opposed a contested takeover were removed following completion of the takeover. The corporation then took steps to amend its by-laws so that the corporation had no obligation to indemnify former directors. The amended by-law survived a court challenge brought by the former directors.
Secondly, most well drafted indemnification agreements will contain an obligation on the corporation to obtain and maintain in place at all times a director and officer liability insurance policy, commonly referred to as “D&O Insurance”.
An indemnification agreement is your second line of defence.
Get D&O Insurance
The most comprehensive indemnification provisions in a by-law and a well-drafted indemnification agreement will be of no assistance if the corporation is insolvent. Unfortunately director and officer liability often becomes an issue when a corporation is in financial difficulty and approaching the area of insolvency. In those situations, it will be the insurance company or companies under the D&O Insurance who step in and pay the indemnification. In the absence of such a policy a director or officer with a claim for indemnity would rank as an unsecured creditor in a bankruptcy.
It may be safe to say that any D&O Insurance is better than none at all, but they are not all the same, they have become quite complicated and there are significant variations among insurance companies. The policies also change frequently. Before choosing a policy a good deal of time and attention should go into understanding how they work and some of the options available. The assistance of a professional adviser who has experience with D&O Insurance can be invaluable. In many cases, it will not be the same person who is advising on the other types of insurance that corporations commonly carry.
Without intending to be an exhaustive list, here are some things to look for:
(a) Are the coverage limits approprite for your business?
(b) Is the definition of directors and officers broad enough? It should include former directors and officers and anyone elected or appointed after the policy is in place.
(c) If a director or officer also acts in that capacity for a subsidiary, he or she should be covered; and similarly if they act as a director or officer of another corporation at the request of their employer.
(d) Examine the exclusions carefully; all D&O policies have them for such things as dishonesty, fraud or criminal conduct. There should, however, be an obligation to defend up until the time a matter has been adjudicated upon. An insurer should not be relieved of an obligation to defend based on allegations of a third party.
(e) Consider whether entity coverage is appropriate. The issue is whether the corporation itself should have coverage. All policies will have a coverage limit. If the corporation and the officers and directors share the same limit then coverage under the policy may be exhausted by claims against the corporation before the directors and officers are fully indemnified.
(f) There should be no right for the insurer to terminate the policy except for non-payment of premiums.
(g) There should be some form of severability. If coverage is denied to one person due to their dishonest conduct, the innocent parties should still receive coverage.
These are all claims made policies and usually have a one-year term. This means that it is the policy in place at the time you become aware of a claim or potential claim that must respond, and not the policy in place when the events occurred that lead to the claim. With this type of policy timely reporting of claims is critical. If you become aware of a claim or potential claim, there will be no coverage for that claim unless it is reported before the end of the term of the policy then in place.
D & O Insurance is your third line of defence.
Be Able To Claim A Due Diligence Defence
Not all, but a significant number of the statutes which impose liability on directors permit the director to avoid liability if they can establish a defence of due diligence. The Income Tax Act, the Excise Tax Act and the Retail Sales Tax Act all permit a director to assert a due diligence defence. For example, if there was a failure to remit employee withholding tax, then the director must demonstrate that he used the care, diligence and skill to prevent the failure to remit that any reasonably prudent person would have exercised in comparable circumstances.
In order to assert such a defence, a director must act responsibly at all times. Make sure adequate controls are in place. Take steps to correct any problems that arise. Document actions taken and get regular reports and statements from management. If you disagree with a course of action, make sure your dissent is properly recorded.
There are a lot of reported cases on directors claiming a due diligence defence but for the most part they are dependent on the facts of each case.
For failure to remit claims processed by the Canada Revenue Agency under the Income Tax Act and the Excise Tax Act, or by the Ontario Ministry of Finance under the Retail Sales Tax Act, each director will receive a letter indicating that the agency is considering an assessment against the individual for the corporation's unpaid remittances. The letter will stipulate a time period usually 30 days, within which to provide documentation to establish a due diligence defence. The opportunity to do so should not be ignored. Seek the help of a professional adviser because if you succeed at this stage and prevent the assessment being issued against the director it will be much less costly than fighting the assessment after it's issued.
Make Sure Any Dissents Are Recorded Properly
Some of the statutory provisions that impose liability on directors require that a director have voted for a matter. If you attend a meeting of directors, then you are considered to have consented to any resolutions passed or action taken at the meeting unless:
(a) you request that your dissent be entered in the minutes of the meeting;
(b) send a written dissent to the secretary of the meeting before the meeting is over, or
(c) send a dissent by registered mail or deliver it to the registered office of the corporation immediately after the meeting is terminated.
If you are not present at a meeting at which a resolution is passed or an action taken you are deemed to have consented unless within seven days of becoming aware of the resolution you:
(a) cause your dissent to be placed in the minutes of the meeting, or
(b) send your dissent by registered mail or deliver it to the registered office of the corporation.
If you abstain from a vote or do not dissent properly, you are considered to have consented. If you do not like what is going on, you should dissent and make sure that you do so properly so that it is a legally effective dissent.
Rely On Experts
As a director, you are entitled to rely in good faith on the work of experts including:
(a) financial statements represented to you by an officer of the corporation or in a written report by an auditor;
(b) interim or other financial reports represented by an officer of the corporation;
(c) a report or advice of an officer or employee where it is reasonable in the circumstances to rely on the report or advice; or
(d) a report of a lawyer, accountant, engineer, appraiser or other person whose profession lends credibility to a statement made by such person.
If a board is considering a difficult issue and none of the directors and none of the senior officers have expertise in that area, consider commissioning the report of an expert. It should help you make a more informed decision and it may also help protect your personal assets.
Unanimous Shareholder Agreements
Modern corporate statutes permit unanimous shareholder agreements. They are a written agreement among all the shareholders of a corporation and are often referred to as a “USA”. It may restrict in whole or in part the powers of the directors to manage or supervise the management of the business and affairs of the corporation.
They are an important means for shielding directors from liability in the appropriate circumstances. If the USA restricts the directors or the powers of directors to manage or supervise the management of the business and affairs of the corporation, the directors are relieved of their duties and liabilities and the shareholders take over all the rights, powers, duties and, most importantly for this discussion, the liabilities of the directors.
In many small private corporations where there are directors but the board does not really function as a board, then the liabilities of the directors can be transferred to the shareholders with the use of a properly drawn USA. If the shareholders are all corporate shareholders, then the individual director's liability becomes a corporate liability of the shareholders and the personal assets of the directors are protected. If some of the shareholders are individuals then care should be taken that they are not inheriting a liability which was not intended.
A USA can be used even in the context of a corporation with only one shareholder. In such a case the shareholder, or perhaps the parent company in the case of a corporate shareholder, signs a unanimous shareholder declaration which has the same effect as a USA.
If all else fails, resign. Resigning will only be helpful to prevent incurring further liabilities. It will not protect you from any liabilities arising from events which occurred while you were a director.
If you decide to resign, just like dissenting, you must make sure that you do so properly. You must resign in writing because a resignation becomes legally effective at the time a resignation in writing is received by the corporation unless the resignation specifies a later date. Generally, if you are resigning, you want it to be effective as soon as possible. I always recommend that a resignation be hand delivered, sent by courier, or sent by fax or e-mail to a senior officer at the corporation.
Do not stop there however. It is also important to see that your resignation is reported in Ontario under the Corporations Information Act by filing an appropriate Notice of Change. This puts the fact of your resignation in the public record and allows you to report the date when you believe your resignation became effective. Sometimes that date may be disputed.
Being on the public record with your resignation and its effective date is important. When government officials are considering an assessment against a director, the first place they check is the public record. You do not want to be in the position where you receive a letter proposing to assess you personally when you resigned years before but your resignation was never properly noted on the public record.
The date of resignation can also be critical because many of the statutes that impose liability on a director have a two-year limitation period. For example, a claim for unpaid wages against a director under the Employment Standards Act, a claim for which there is no due diligence defence, cannot be made more than two years after a director resigns.