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Reasons for Proposed Corporate Law Change to Allow for ‘Charter Option’

This is the third in a series of posts on this subject. The full version of the article was published by the Institute of Corporate Directors in its Journal and as a web resource.

Encouraging Risk-Taking

The main purpose of the proposed “Charter Option” – empowering corporations to limit director liability –  is to make it easier for corporations to attract directors who would otherwise be deterred by the prospect of personal liability.   As noted earlier, the Charter Option would only exculpate directors who have acted in good faith, loyally and without self-interest.

The encouragement of corporate risk-taking has traditionally been supported by English law. In one famous case, Re City Equitable Fire Insurance, the court pointed to three reasons for exculpating directors:

(i) a director need not exhibit a greater deal of skill than may reasonably be expected from a person of his knowledge and experience;

(ii) a director is not liable for errors in business judgment, as his primary function is to use his own particular talents in advocating corporate risk-taking; and

(iii) a director is not bound to give continuous attention to the affairs of the corporation.  In the absence of grounds for suspicion, eh is fully justified in trusting corporate officials to be honest.

As noted by former Delaware Chief Justice Veasey, the effect of the Delaware provision is that derivative due care claims seeking personal liability of directors can normally be dismissed at an early stage without the need for a trial.  He notes that the law is “designed … to protect directors and to encourage qualified personals to act as directors” … and that it is “very much in the stockholders’ interest that the law not encourage directors to be risk averse.  Some opportunities offer the prospect of great profit at the risk of very substantial loss, while the alternatives offer less risk of loss but also less potential profit.”

In one takeover case, J.P. Stevens & Co. Stockholders Litigation, the Delaware Court of Chancery noted that “there is great social utility in encouraging the allocation of assets and the evaluation and assumption of economic risk by those with … skill and information.”  Accordingly, “courts have long been reluctant to second-guess such decisions when they appear to have been made in good faith.”

Fostering Economic Activity by Attracting Directors

It is in the interest of Canada’s continued prosperity to attract the best people possible to oversee adn direct management of our corporations.

In her book entitled Corporate Governance, Professor Christine A. Mallin noted that “in general, small and medium-sized firms will have simpler corporate governance structures than large firms…; a small number of non-executive directors (NEDs); a combined chair/CEO; longer contractual terms for directors due to the more difficult labour market for director appointments into small and medium-sized companies.”

The role and importance of NEDs was emphasised in the Cadbury Report (1992) and in the Code of Best Practice in the U.K. that NEDs “should bring an independent judgment to bear on issues of strategy, performance, resources, including key appointments, and standards of conduct” (para. 2.1).  Similarly, the Hampel Report (1998), also from the U.K. stated: “Some smaller companies have claimed that they cannot find a sufficient number of independent non-executive directors of suitable calibre.  This is a real difficulty, but the need for a robust independent voice on the board is as strong in smaller comapnies as in large ones” (para. 3.10).

It is human nature for a prospective director to be averse to serving if he or she will face personal liability for honest decisions made while serving on a board.  On the other hand, directors will understand that they owe a duty to act loyally and without self-interest; they will understand that the law cannot, and will not, protect them should they act otherwise.

In particular, small business, which accounted, as of 2004, for half of all private sector employment in Canada, may consider the Charter Option to be especially helpful both in attracting quality directorial candidates and in reducing or eliminating the need for director and officer insurance which is often disproportionately expensive and difficult to obtain, if available to them at all.

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