FAQs About the Director’s Duty of Care and Diligence

The law imposes certain responsibilities on directors known as directors’ duties. One such duty is the obligation to act with care and diligence. Directors can face consequences if they do not carry out this duty. This article will explain:

• what the duty of care and diligence is;
• where it comes from;
• the implications for directors; and
• the possible consequences of breach.

What is the Duty of Care and Diligence?

This responsibility requires all directors and other officers (such as secretaries and others involved in managing company property) to exercise their powers and discharge their duties with care and diligence. The duty exists to protect shareholders, creditors and investors and provide a means by which directors can be held accountable for their actions and decisions.

The duty of care and diligence exists both at common law (case law) and under the Corporations Act 2001 (the Act). Historically, the courts applied a subjective test to determine whether a director had acted with:

• care;
• skill; and 
• diligence.

Here, they looked at what they were thinking at the time of taking action or making a decision. This set a low bar and directors were often found to have acted with care. This evolved into an objective test, taking into account what a reasonable person with the same skills and knowledge of that director, would have done in a similar position and situation.

Under the Act

This objective test has been codified in the Act. The Act requires all directors and officers of a company to exercise their powers and discharge their duties with care and diligence. The Act provides that this duty will be discharged if a director has exercised ‘business judgment’ in making the decision. A director will be held to have exercised business judgment if they:

• make the decision in good faith for a proper purpose;
• do not have a material personal interest in the subject matter of the judgment; 
• inform themselves about the subject matter of the judgment to the extent they reasonably believe to be appropriate; and
• rationally believe that their decision is in the best interests of the company (and a belief will be rational unless it is one that no reasonable person in the director’s position would hold). 

As such, the statutory test is objective as it takes into account what a reasonable person would do. However, the test has subjective elements. This is because the ‘reasonable person’ is a person who:

• is a director of that particular company;
• with the same responsibilities; and
• faces similar circumstances.

Purpose of the Duty

The purpose of this duty is, therefore, to distinguish between legitimate, commercial decisions on the one hand and reckless or ill-informed decisions on the other. The intention is not to stifle commerce, and the law recognises that carrying on a business necessarily involves taking risks and exercising commercial judgment. If directors take action while performing their duties which ultimately fails or results in financial loss, this does not automatically imply a lack of care and diligence. 

Nonetheless, companies receive capital from investors (who may be members of the public) and can significantly influence the economy. As such, there are valid public policy reasons to insist that directors act carefully and responsibly in the exercise of their functions.

What Does This Mean for Directors?

The requirement to act with care and diligence does not mean that directors must have extraordinary skills and abilities. Rather, it requires that they undertake real and sustained efforts to understand the company and their obligations.

Directors must inform themselves about the operations and affairs of the company to the extent they feel appropriate. This means that they cannot remain passive or ill-informed. They must be able to read and understand financial statements and attend company board meetings.

If a director or officer has extensive experience and qualifications, this is taken into account when deciding whether the director has acted with care. This is because the comparison will be against what a reasonable person with the same knowledge and experience would do in the circumstances. Conversely, a director who doesn’t have particular qualifications will not be held against the same decision-making standards as a director who does. 

What Happens if Directors’ Breach This Duty?

The requirements of the duty of care and diligence at common law and under the Act are substantially similar. However, the common law prescribes different consequences for breach of the duty than statute.

At common law, if a person proves that a director has not complied with this obligation, they might be entitled to compensation. This is only if they can demonstrate that the breach of duty caused that person damage and loss. Of course, these are two separate questions. Someone can conceivably prove breach but receive no remedy if they cannot show that the breach caused their loss.

Under the Act, a director who has breached this duty may be given a Civil Penalty Order. These orders require the director to pay a sum to ASIC on behalf of the Commonwealth. These orders can reach a maximum of $200,000. A court can also disqualify a director from acting as a director for a certain period or require them to pay compensation to the company or others for any loss or damaged suffered.

Key Takeaways

Directors have a number of duties which they must meet. One of these duties is the duty of care and diligence. The Act looks at what a reasonable person would do in the circumstances. If you have any questions about whether you have properly exercised care and diligence, contact LegalVision’s business lawyers on 1300 544 755 or fill out the form on this page.