Johannesburg — Companies Bill may trigger flight from boardrooms, writes Eric Levenstein

LIFE for errant directors is about to get a whole lot hotter once the draft Companies Bill, intended to overhaul the Companies Act of 1973, is finally enacted in 2010.

Internationally, legislators and corporate law reformers have become alarmed at the degree of leniency that was being shown to company directors who had acted negligently or recklessly -- as shown by the astonishingly long jail sentences handed down to former Enron executives for their part in the collapse of the energy group. The message was clear: directors engaging in reckless or fraudulent behaviour face the same kind of sentences typically handed down to murderers and rapists.

The ramifications of reckless behaviour in the boardroom can have catastrophic and far-reaching impacts, as shown by the collapse of Enron, Tyco, Worldcom and other corporate titans. The failure of these businesses destroyed billions of dollars in shareholder value, not to mention the misery visited on employees, suppliers and shareholders.

Sections 91 and 93 of SA's new Companies Bill set out the standards for directors' conduct. Though the details still have to be finalised, directors will be expected to exercise a degree of care, skill and diligence, such as would be expected of a reasonable individual placed in a similar position. A financial director signing off on a false or untrue financial statement can no longer point the finger of blame at the auditors. Similarly, a CEO placing his signature to any untrue statement may be held personally responsible.

This is a sharpening of section 424 of the existing Companies Act, which imposes penalties on directors trading recklessly or with intent to defraud. The seminal case which put Section 424 to the test was Philotex (Pty) Limited & Others vs JR Snyman & Others. The court stated that when the business of the company has been carried on recklessly, or with intent to defraud creditors or for any fraudulent purpose, any person who was knowingly a party to such conduct may be held personally liable for the company's debts.

The court record reflects a history of unsuccessful recapitalisation attempts, poor cash flow, overvalued stock and a board that ignored the reports of auditors. The court found that the directors had acted recklessly in incurring debts of R1,6m, knowing that the company was incapable of paying its creditors and in securing a claim over the company's assets prior to liquidation -- thereby prejudicing creditors. The court found that the directors had not acted in accordance with accepted business practice, and ordered them to pay R1,76m to the creditors, plus the latter's legal costs.

The facts, briefly, were that Wolnit, a company in the Rentmeester group, was, despite making substantial losses, kept alive as a going concern by financing provided by its holding companies (Rentbel and Rentmeester). The financial transactions aimed at keeping Wolnit going were not fully disclosed in the financial statements. The purpose of not doing so appeared to be an attempt to avoid tarnishing the reputation of the group by the liquidation of one of its subsidiaries, rather than a true belief that it was a viable concern.

Wolnit was eventually voluntarily liquidated in 1989. The appellants, former creditors of Wolnit, brought an action against the respondents in terms of section 424 of the Companies Act. The court had to decide whether the directors should be declared personally liable for the debt of Wolnit on the basis that they had conducted the business recklessly in terms of this section.

The Supreme Court of Appeal overturned an earlier decision that the directors should not be held personally liable. This was an important case in outlining the boundaries of reckless behaviour by directors.

The new Companies Bill extends the concept of stakeholders to embrace not just shareholders, but employees, creditors, suppliers and society at large. This also gives effect to the recommendations of the King II Code on Corporate Governance relating to triple bottom line reporting covering financial, environmental and social impacts of business.

Under the existing law, directors are required to discharge their responsibilities for the benefit company as a whole and to act in the long-term interests of the company. Under this standard, directors could find decisions which are deemed to be for the short-term benefit of the company -- such as acquisitions intended to flatter near-term financial results -- open to challenge by shareholders. Such decisions can be difficult to contest in court, given the onerous burden of proof on the plaintiffs. But this much is clear: directors are likely to tread more carefully once the new Companies Bill introduces personal liability for reckless or negligent behaviour.

The new bill borrows heavily from law revisions elsewhere in the world, notably the UK, which published a White Paper in 2004 on Modernising Company Law. It introduced the concept of "enlightened shareholder value" which forces directors to develop productive relationships with all stakeholders, and not just shareholders.

Already, we have witnessed a spate of high-profile resignations of corporate executives in SA, often for unspecified reasons. But it is safe to assume that the onus of personal liability must have weighed on their decisions to seek the quiet life. This could be the start of a more widespread flight of talent from the boardroom, which is certain to become a major issue for the economy going forward.

But it is not all bad news for directors. The new Companies Bill should provide greater legal clarity for directors. If you are a responsible director, attend all the board meetings, stay informed of affairs within the company and exercise sound judgment, then you are well within the bounds of the new law and there should not be a problem.

The Business Judgment Rule, which was first floated in the King II report and is likely to take a more substantive form in the upcoming King III report, will provide a measure of protection for directors who make business judgments in good faith and for a proper purpose, have acted on an informed basis without material personal interest and who have a rational belief that the decision is in the best interests of the corporation. If one of these requirements is not met, the rule will not provide any assistance.

Directors' decisions, however unwise, that meet this standard will therefore be protected in terms of the Business Judgment Rule.

The new bill will hold directors to a higher standard, and is therefore to be welcomed. There are cases of individuals in SA who are on 10 or 15 boards. They cannot possibly give the proper amount of attention to so many companies. We are likely to see directors being far more selective about the board positions they assume and, I suspect, many will simply decline board positions in light of the onerous responsibilities now imposed on them.

Eric Levenstein is a director in the commercial litigation department at Werksmans Attorneys.