The Liability of Directors in Canada

Laws on director liability and foreign corruption are converging toward a common standard as business operations become more globalized, but there are still key differences in the law between Canada and the US

Most corporate directors
wouldn’t dream of making late-night forays down back alleys in the seamier districts of third-world capitals. But they often do the corporate equivalent — signing on as directors of emerging-market companies whose operations and inner financial workings are less than perfectly transparent.

Directors are also exposed to elevated risks when the biggest and best-known domestic corporations venture into emerging markets, where entrenched business practices demand off-book payments to everyone from customs agents to government ministers.

In an increasingly global economy, laws on director liability and foreign corruption are converging toward a common standard. But lawyers say we aren’t there yet and a director’s treatment before a court of law may be very different depending on whether that court is in Canada or the United States.

Hair-raising headlines in both countries are highlighting the differences and similarities in the ways emerging-market imbroglios are treated by the two legal systems and the kinds of risks US citizens face if they find themselves subject to Canadian laws relating to director liability.

 

Emerging markets

Directors’ exposure to emerging-market risks has been sharply highlighted in the Sino-Forest affair, which involves a Toronto Stock Exchange (TSX) listing and forestry assets in China.

Sino-Forest Corporation, with a market capitalization that reached C$5.78 billion, is under investigation by the RCMP and has been suspended from trading by the Ontario Securities Commission (OSC). Its troubles began after US short-seller Carson Block of Muddy Waters, LLC pointed to irregularities and called the company “a multi-billion-dollar Ponzi scheme.” Sino-Forest has denied allegations of fraud and sought protection under the Companies’ Creditors Arrangement Act (CCAA).

A preliminary Sino-Forest ruling demonstrates that directors can’t count on company-provided indemnity protection in cases of corporate insolvency, says Julie-Martine Loranger, with the Montréal office of Gowling Lafleur Henderson LLP.

In Sino-Forest, the court disallowed the payment of indemnities to auditors and underwriters who were being sued by investors. The court ruled that indemnity claims were, at bottom, driven by claims of unsecured investors on the assets of the company and therefore subordinate to the secured claims of creditors. The same principle extends to directors’ indemnities and applies in both Canada and the US, Loranger says.

“If the company goes belly up, you’re sitting on a nice piece of paper that’s not worth anything,” she says. She advises directors to insist companies provide third-party D&O (directors and officers) liability insurance and to make sure it’s as comprehensive as possible.

More or less simultaneously, the Delaware Court of Chancery has refused to dismiss a suit against US-based independent directors of Puda Coal Inc. for breach of fiduciary duty in In re Puda Coal, Inc. Stockholders Litigation, Del. Ch. C.A. 6476-CS. The suit was filed after an audit found that two China-based directors had misappropriated all of the company’s assets, including its only producing property. Chancellor Strine said those who oversee Delaware-incorporated companies with operations in foreign countries can’t be “dummy directors.”

“If the assets are in [China], you’re not going to be able to sit in your home in the US and do a conference call four times a year….That won’t cut it,” Strine said. To meet the Delaware good-faith test he said a director must 1) “have your physical body in China an awful lot”; 2) “have in place a system of controls to make sure you actually own the assets”; 3) “have retained accountants and lawyers who are fit to the task of maintaining a system of controls over a public company”; and 4) possess “the language skills to navigate the environment in which the company is operating.”

Barry Bresner, with Borden Ladner Gervais LLP in Toronto, says that while Delaware decisions tend to be influential in Canada, the Puda pronouncements are a preliminary ruling and likely an example of “a judge using loose language” that shouldn’t be taken as the final word. He notes that where there are no “red flag” indicators of trouble, directors “are entitled to rely, by and large, on financial statements and professional advisors” under US law.

Alex Cobb, of Osler, Hoskin & Harcourt LLP in Toronto, says “everybody took note” of the Puda ruling but he thinks its influence in Canada will be limited. Canada, he says, would likely not go so far as to require a regular physical presence of directors in a foreign country or that they speak the language there.

On the other hand, Cobb says, “the fact that operations are taking place where everybody speaks a language you don’t speak is just not an excuse. If you’re a director, you have to know what’s going on, who’s doing it, pursuant to what rules, how much money is being spent and what it’s being spent on. If you need to work a little harder to find those things out, so be it,” he says. “And don’t sign anything that’s written in Cyrillic.”

He notes that the OSC was already in the midst of an Emerging Markets Issuer Review when the Sino-Forest scandal broke and that they’ve since released a Guide for Issuers Operating in Emerging Markets. It calls on directors to “exercise additional diligence” to ensure that companies meet OSC requirements. The guide recommends securing independent translators; being wary of over-dependence on local management; exercising skepticism whenever corporate structures appear unusually complex; giving special attention to related-party transactions; identifying and disclosing all risks and particularly those unique to the operating jurisdiction; ensuring timely disclosure and remediation of risks and weaknesses in the business; careful evaluation of credentials of professional experts; and paying special attention to the capabilities of the underwriter and outside auditor, relative to the foreign jurisdiction.

Increasing the ante in emerging markets are June 19 amendments to Canada’s Corruption of Foreign Public Officials Act (CFPOA), making it comparable to the US Foreign Corrupt Practices Act (FCPA) and the UK Bribery Act. A new books-and-records provision will make it an offense to attempt to disguise bribes paid to foreign officials. Milos Barutciski, with Bennett Jones LLP in Toronto, says an individual director who knows about corruption issues and does nothing about them “could easily engage his or her liability” and the same is true for an entire board.

More broadly, Barutciski says that under the CFPOA, Canadian boards “will have to deal squarely with systems and policies,” putting in place means to prevent bribery and falsification of records, as US counterparts generally have done. Under the new amendments, maximum terms of imprisonment have been increased from five years to 14.

“Companies carrying on business in high-risk areas have to address those risks,” Barutciski says. “The majority of even large public companies in Canada don’t have an anti-corruption policy in place.” And lest anyone suspect hyperbole, he adds, “I’m not saying this casually.” It’s an exposure he says Canadian directors need to address in the very short term.

While it’s still relatively uncommon for Canadian courts to find company directors personally liable for corporate misdeeds, it’s a decidedly less rare thing for directors to have to defend legal actions in Canada stemming from their board responsibilities.

Emerging-market fiascos, laws that now allow class actions in all provinces and securities regulations making it easier to launch proxy fights, are only three of many reasons the director class in Canada finds itself more frequently on the defensive.

“Plaintiffs are being more and more creative in their theories of the causes [of legal actions],” says Loranger. “If you sit as a director, you really, really need to know what you are doing,” she tells both Canadian and American clients who contemplate accepting appointments to boards of Canadian companies.

Bresner says criminal liability is generally “harsher” for directors under United States laws than it is in Canada.

“As Conrad Black found out, if you’re going to be prosecuted criminally, you probably don’t want that to happen in the US,” Bresner observes. “But in civil law, it seems to switch the other way,” with Canada showing wider scope for director liability.

“The key difference is the ‘oppression remedy’ here,” he says. “It comes as a huge surprise to US directors who come to Canada to sit on boards.” Under s. 241 of the Canada Business Corporations Act (CBCA), courts are given power to impose any remedy they deem fit in order to rectify oppressive conduct by a corporation or its representatives.

Cobb says most developed nations seek to make their corporate law “fairly homogenous [because] nobody wants to be the jurisdiction everybody wants to avoid,” and this is particularly true between Canada and the US. Still, he says, there are important differences and Canada’s more conservative legal tradition may actually work to make it more likely that directors will be named in civil actions.

“In the US, discovery [of witnesses] is essentially unlimited,” Cobb says. “In Canada, you get to examine one person. You don’t get these marathon depositions of 25 people.” This, he says, may work as an incentive for plaintiffs to sue individual directors in order to force them into discovery.

Differences in director liability between the two countries are sometimes subtle — and sometimes not, Cobb says. Making this point with an investigator from the US Securities and Exchange Commission (SEC), he put it this way: “We’re a real country — with a flag and everything.”

 

Reach

American citizens can find themselves facing director’s liabilities in several ways under Canadian laws, Cobb says. First, and most obviously, if a company is incorporated under the CBCA or provincial statute, directors can be liable under Canadian law regardless of nationality. Directors of any company acting as an employer in Ontario can be liable for unpaid wages or payroll deductions under the Ontario Employment Standards Act, no matter where the company is incorporated. Any company listed on the TSX is subject to the Securities Act (Ontario) and other “real and substantial connections” to Ontario may also make directors liable in provincial courts. This includes liability for the accuracy of disclosures by issuers of any securities traded within the province, regardless of where the issuer is listed.

“If there is a ‘real and substantial connection’ to Ontario, then an Ontario court may consider that it has jurisdiction,” he says.

Bresner says roughly 100 Canadian statutes impose liability on directors if they “authorize, permit or acquiesce” in a corporate action that violates one of these statutes, making it vital to ensure dissenting opinions are both expressed and recorded in minutes of board meetings. This is a wider view of liability than US case law that generally requires “participation” or “control” by an individual director.

 

No Contest

Where criminal proceedings are concerned, Cobb notes that there’s a very important difference between the OSC and the SEC. While the SEC has been very successful using no-contest agreements to impose fines and settle cases against companies and individuals for various misdeeds, the OSC is not currently permitted to accept no-contest settlements.

“In order for the OSC to accept a settlement, they need to find fact,” Cobb says. “Any facts you agree to … will find their way into other proceedings [such as civil litigation, and] as a practical matter that means you want to settle with them last.” To change this dynamic, the OSC has proposed allowing no-contest settlements, except where a person has engaged in “egregious, fraudulent or criminal conduct.” But a June 17 hearing on the matter encountered heated opposition from investor advocates and the plaintiffs’ class action bar.

 

The Key

In both countries, the key to hauling directors before the courts in a civil action lies in “piercing the corporate veil”; convincing the court to set aside the limited liability protections of the company in order to hold directors liable. On both sides of the border, courts show considerable reluctance to set aside the separate-entity status of corporations, but American legal scholars count “veil piercing” as the most heavily litigated issue in US corporate law.

US common law has established five causes of director liability: 1) a company acting as the “alter ego” of an individual; 2) corporate undercapitalization; 3) fraud; 4) failure to uphold corporate governance requirements; and 5) co-mingling of personal and corporate assets. But experts say US courts have shown reluctance to find directors liable in the absence of direct participation and intent.

Canadian common law has established four similar causes for piercing the corporate veil, and one that has been called “uniquely Canadian.” The Canadian outlier occurs when failure to attach personal liability would be “flagrantly opposed to justice.”

While the Supreme Court of Canada has given some credence to the dictum of “flagrantly opposed to justice,” other courts have expressed doubts about this high-sounding but seldom-used principle. Bresner says the wording may be more unique than any liability arising from it, and that, in most cases, it’s likely made redundant by the “alter ego” principle. Still, it persists as an apparently open-ended potential cause of action.

 

Governance

Both countries have moved to tighten corporate governance since the Enron, Tyco and WorldCom accounting scandals in 2001 and 2002. Put simply, statutes, securities regulations and case law have dashed the once-popular notion that board positions are sinecures for which the only essential qualification is being the friend of a well-connected friend.

In the US, the Sarbanes-Oxley Act of 2002 made officers of publicly traded companies personally responsible for the accuracy of financial statements and imposed greater responsibilities on corporate directors, board committee members and auditors. But Bresner says it also preserved the directors’ defense of “reasonable reliance” on financial statements and professional opinions — absent willful blindness.

In Canada, the Securities Act (Ontario) was also amended, Bresner says. It imposed “personal liability on directors and officers of public companies for false or misleading statements in public documents, such as prospectuses, offering memoranda and financial statements, as well as oral statements and for failure to make timely disclosure of material changes. Part of those changes included extension of the potential [directors’] liability to purchasers of securities in the secondary market.”

Most importantly, and in contrast with the US, Canadian law upholds the oversight responsibility of the full board, even over its own committees.

“In Canada, yes, you can delegate — but that doesn’t get you off the hook.” Bresner cites the 2002 Repap case, in which board chairman and US citizen Steven Berg proposed to the Repap Enterprises Inc. board that he be named “senior executive officer,” above the existing president and CEO, with a salary, signing bonus, option grant, eight-year pension credit and $27-million termination provision, all of which the court found out of proportion with the company balance sheet.

 

Oppression

All but two members of the Repap board resigned and a newly named board approved the Berg contract on the recommendation of its new compensation committee. Shareholders, led by TD Asset Management, then filed an oppression action. They alleged Berg violated fiduciary duties as a board member and that the board breached its duty under s. 122 of the CBCA “to exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances.”

The Ontario Superior Court of Justice set aside Berg’s entire compensation package and ruled that directors failed in their duty of care. Repap confirmed that directors in Canada have an obligation to make an informed decision — regardless of any delegation of responsibilities, Bresner says.

Another oppression finding of compelling interest to American directors of Canadian companies is Ford Motor Co. of Canada, Ltd. v. OMERS (Ontario Municipal Employees Retirement System). In that case, the Ontario Court for Appeal ruled in 2006 that the internal pricing policy of parent Ford Motor Company (Ford) was unfairly oppressive to Ford Canada's minority shareholders. Ford planned to take the Canadian subsidiary private and valued its shares at C$185 per share. But the court found that transfer pricing of products had depressed Ford Canada profits by $2.6 to $3 billion between 1985 and 1995, unfairly reducing share value. The court also ruled that Ford Canada’s financial statements had incorrectly led shareholders to believe transfer payments between parent and subsidiary were negotiated at arm’s length.

 

Business Judgment

Ford Canada relied on the business judgment rule, widely recognized in both Canada and the US, which says that courts should not second-guess good-faith business decisions in order to impose liability on officers and directors. But in Ford v. OMERS the court found that Ford Canada had simply accepted transfer prices of its parent, without applying business judgment of any kind.

Ford v. OMERS says that parent-company nominee directors of a Canadian subsidiary “can’t just do what the mother ship tells them to do,” Cobb says. “You really have to remember there’s a duty to all stakeholders.”

The leading expression of this duty of care to all stakeholders is found in BCE Inc. v. 1976 Debentureholders, where the Supreme Court of Canada ruled in 2008 that the BCE (Bell Canada Enterprises) board was required to take account of debentureholders’ interests in arranging a leveraged buyout of the corporation. After reviewing the buyout process, the court found that due consideration had been given and that no oppressive conduct occurred.

BCE clarified a wider Canadian fiduciary duty than the “Revlon duty” in US law, Cobb says. In Revlon, the Delaware Supreme Court said that whenever the sale of a company becomes inevitable, directors become “auctioneers” whose sole duty is to maximize shareholder value by selling to the highest bidder. Revlon holds US shareholder interests paramount, while BCE upholds the fiduciary duty of directors in Canada to act in the best interests of the corporation itself, including all stakeholders (shareholders, creditors and others).

 

Process

Loranger says there’s increasing court focus on board process in both the US and Canada. Reluctant to impose their own judgment over that of boards of directors, courts in both countries have increasingly relied on reviewing board process to adjudicate claims. In both countries, she notes, courts have added up the minutes spent on making decisions in order to assess the exercise of due care. They look at whether “red flags” – signs of mismanagement or wrongful acts – have been closely scrutinized by the board, whether the right questions have been asked and the credentials of outside consultants have been adequate.

She stresses that every director should carefully review board minutes and ensure that his or her own dissenting votes and reasons for them are fully captured. As a director herself, she says, she keeps her own notes to compare with the official minutes before signing off.