By Julien Morissette, Lawyer and Partner, Osler, Hoskin & Harcourt

Introduction

When a business is on the “verge of insolvency”, the ground is often fertile for liability claims against the directors of the company. In 2004, the Supreme Court identified the source of this phenomenon:

• The interests of shareholders, those of the creditors and those of the corporation may and will be consistent with each other if the corporation is profitable and well capitalized and has strong prospects. However, this can change if the corporation starts to struggle financially.¹

This article is a brief summary of the law applicable to directors’ liability, particularly when a company is insolvent or approaching insolvency. The various obligations of directors, their sources, and the means used to sanction non-performance will all be discussed.

Who is a director?

First of all, there are two types of directors: the de jure director and the de facto director. The Canada Business Corporations Act² defines the term “director” as follows:

• director means a person occupying the position of director by whatever name called;³

De jure directors are those who are chosen in accordance with corporate laws and whose names appear in the appropriate registries.

The concept of de facto director arises mainly from case law. The de facto director is a person who acts as a director would, but without the official title. This characterization will depend on the acts carried out by the person in the company’s administration⁴. A de facto director generally incurs the same liability as a de jure director.

Subsection 109(4) of the CBCA provides for the concept of de facto director, upon a situation where all the directors have resigned or been removed. Paragraph 109(5)(c), however, creates a particular exception for trustees in bankruptcy, receivers, and receivers-managers who manage a company or control its property for the sole purpose of realizing security or administering the property of a bankrupt. In general, although the wording of the provisions may vary, provincial corporate statutes lead to the same result.

In some cases, shareholders will have duties that are normally those of directors when a unanimous shareholders’ agreement removes the powers of directors⁵. However, this mechanism should not be used as a simple means of circumventing the law for de jure directors. When confronted with a stratagem, the courts can ascribe personal liability upon “those who exercise ultimate decision-making control over the operation of the company” by recognizing their status as de facto directors⁶.

Liability sources

Directors have fiduciary duties, primarily loyalty, diligence, and skill⁷. Directors must act in the best interests of the company while exhibiting care and skill. In addition, exemption from these duties is strictly prohibited, except in the event of a unanimous shareholders’ agreement⁸. This fiduciary duty may extend in certain cases to creditors. In the Wise decision, the Supreme Court of Canada wrote that it may be legitimate to take into account the interests of creditors, amongst others⁹.

In addition to their fiduciary duties, directors must act in good faith. Although it is possible to find a director liable on this basis alone, the threshold is high¹⁰. In matters of tort or extra-contractual liability, it is generally difficult to establish a duty of care, in addition to the need to prove fault, damage, and causation.

In certain cases, directors can be sanctioned when they do not warn trade creditors of the increased risks of the company’s insolvency; this is the principle of insolvent trading. This concept is only partially accepted in Canadian law, but non-disclosure of financial problems may be wrongful when the director has knowledge of hopeless insolvency and knows that the creditor will not be paid¹¹.

Many specific provincial and federal statutes – too many to list in this article – also ascribe liability to directors, particularly in relation to unpaid salaries and vacations as well as tax, environmental, and pension plan obligations. In a handful of cases, directors may also face criminal liability, although criminal prosecutions are very rare. With rare exceptions, these statutes provide for the possibility of a due diligence defense.

Protection of directors

To minimize the risks associated with their role, directors can use several means of protection. Due diligence in decision making is a key element. This concept, although vague, is incorporated into many statutes and requires that directors’ decisions be made after sufficient deliberation and be well documented. This particularly includes regular contact with company management, seeking independent advice, and priority payment of sensitive claims such as salaries and source deductions.

Indemnities provided by the company are another essential protection method for directors. These indemnities, permitted by section 124 of the CBCA and mandatory for certain provincial corporations, may be provided for in the corporation’s by‑laws or be granted by contract. However, they depend on the solvency of the company, making their effectiveness variable. Considering a contractual indemnity provided by a third party, such as an affiliate company, may provide additional protection.

Liability insurance is often preferred to an indemnity, because its effectiveness has been confirmed by case law¹² and does not depend on the company’s solvency. However, this insurance is not without its drawbacks: it can be difficult to obtain, often has many exclusions (such as environmental or tax liability) and the cost can be prohibitive. Additionally, it generally only covers claims received during the coverage period. It is paramount to consult the policy to understand the exact terms.

The exercise of dissent is another method of protection available to directors. This approach, provided for by corporate statutes¹³, allows directors to formally object to certain decisions of the board of directors, such as the payment of dividends, by following strict formalities. However, abstaining from a vote, refusing to take a position, or even resigning is not considered forms of dissent¹⁴.

Finally, resignation can be a means of last resort to limit a director’s liability. It is essential that the name of the director be removed from the relevant registry to avoid any dispute and to comply with all legal formalities for the resignation to be valid¹⁵. There is always a risk following resignation of continuing to be considered a de facto director when the resigning director is not replaced. Also, and importantly, the bankruptcy of a company does not cause the presumed resignation of its directors, who must still follow the same formalities¹⁶.

Recourses

Directors can be held liable in several ways. Here are the different possible remedies:

1. Direct action;
2. Oppression remedy;
3. Derivative action;
4. Penal prosecution.

A direct action is the classic remedy that a creditor can bring to hold a director liable. Its basis is in common law or in a particular statute. Some of these remedies can or must be sought by a trustee¹⁷ or by other parties¹⁸.

The oppression remedy is based on section 241 of the CBCA. This section gives broad powers to the courts to remedy unjust or oppressive behaviour, to the extent that creditors can demonstrate a sufficient standing.

Derivative actions comprise a category of remedies which can be sought by a third party on behalf of the company when it remains passive in the pursuit of its interests. Although the action is brought by a third party, the company remains the holder of these remedies. Sections 239 and 240 of the CBCA allow, among other things, creditors to bring an action on behalf of the company.

Penal prosecutions cannot be brought by creditors. These are either brought by the Crown or by a trustee who has obtained authorization or a court order¹⁹. These proceedings will be brought before a criminal court and not before a court which has jurisdiction over insolvency matters.

Conclusion

When it comes to directors’ liability, prevention should always be the priority. In the most dramatic cases, it is always possible for a director to resign, to limit his or her liability to the past. In any event, and even in the most difficult situations, a well-advised director will be able to considerably limit his or her liability.

[The author would like to thank Michée Kisembo and Étienne Dussault, law students at Osler, Hoskin & Harcourt, for their collaboration in writing this article.]

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