Directors’ Duties and Obligations Under Australian Corporate Law - The Duty of Care and Diligence

Reading Guide

I. Foreword - Why understanding directors’ duties matters

II. Legal sources and classification of directors’ duties

III. Defining the duty of care and diligence

IV. Case study on the duty of care and diligence

V. Two defences: the business judgment rule, and reasonable reliance and delegation

I. Foreword - Why Understanding Directors’ Duties Matters

Company directors wield considerable power - so considerable, in fact, that Australian corporate law takes the unusual approach of defining their powers residually: other than those powers expressly conferred on the general meeting by the Act and the company's constitution, all remaining powers vest in the directors. In other words, directors have control over virtually every aspect of a company’s external operations and internal management.

With that power, however, comes the risk that directors and officers may disregard the company’s interests, mismanage its affairs, or pursue personal gain. Keeping directors’ powers in check has therefore always been at the heart of corporate law and is a topic I have long wanted to write about in a series of articles. For investors, particularly minority shareholders who have co-invested alongside others, understanding directors’ duties enables better oversight of how directors exercise their powers, and better protection of the company’s interests as well as their own. For those in management, whether a major shareholder serving as director or a company officer, a clear understanding of one’s duties is the surest way to avoid legal pitfalls, protect one’s reputation and assets, and serve the company, its shareholders, and other stakeholders more effectively.

II. Legal Sources and Classification of Directors’ Duties

Under Australian corporate law, directors are subject to stringent fiduciary duties, statutory duties, and other contractual obligations. This reflects the fact that directors’ duties derive from multiple legal sources, including statute, common law, equity, and contract (the latter encompassing both the company’s constitution and the director’s employment agreement). All of these bodies of law operate concurrently. For convenience, this article refers to the relevant law collectively as “Australian corporate law”, and where necessary distinguishes between “statute”, primarily the Corporations Act 2001 (Cth) (Corporations Act) enacted by Parliament, and “general law”, the common law and equitable principles developed through centuries of case law.

Directors’ duties under Australian corporate law fall broadly into three categories:

• Duties of care and diligence;

• Duties of loyalty and good faith;

• Other statutory duties.

  
  

As the first instalment in this series on directors’ duties, we begin with the duty of care and diligence.

III. Defining the duty of care and diligence

The “duty of care and diligence” may sound like abstract legal jargon, so let’s start with a simple analogy. Imagine you have agreed to take your friend’s seven-year-old child, Tom, to the beach on your own for the day. The moment you accept that responsibility, you instinctively know that you need to keep a constant eye on him to make sure he is safe, and that he doesn’t get sunburnt, hungry, thirsty, or overtired. That instinctive sense of responsibility captures the essence of the duty of care and diligence. In the same way, when shareholders invest their hard-earned money into a company, the directors who run and manage that company should exercise their powers and make every important decision with the utmost caution and attentiveness.

Now let’s look at how Australian law actually defines this duty. Section 180(1) of the Corporations Act provides:

A director or other officer of a corporation must exercise their powers and discharge their duties with the degree of care and diligence that a reasonable person would exercise if they: (a)  were a director or officer of a corporation in the corporation's circumstances; and (b)  occupied the office held by, and had the same responsibilities within the corporation as, the director or officer.

The general law imposes a substantially similar standard, so there is no need to set out its formulation separately here.

Let’s now look at how Australian courts break down and apply this provision:

First, the courts have held that the test for whether a director or officer has breached the duty of care and diligence is an objective one. The court measures the director’s conduct against what an ordinary reasonable person would have done in the same circumstances. As for what constitutes an “ordinary reasonable person”, the classic judicial formulation in Australia is “the man on the Bondi tram”. That expression is obviously outdated, the reasonable person includes both men and women, and the Bondi tram was replaced by the 380 bus over 60 years ago. But the point it conveys remains: the reasonable person is someone of ordinary intelligence and life experience who acts sensibly and fairly.

Second, the court places that reasonable person in the specific circumstances of the company in question, taking into account: the provisions of the company’s constitution, the size and nature of the company’s business, the composition of the board of directors, the particular functions assigned to the relevant director, that director’s experience and skills, and the division of responsibilities among the directors.

Third, the court places that reasonable person in the actual position of the director or officer and assigns them the same responsibilities — not only those conferred by legislation, the company’s constitution, and board resolutions, but also those that arise from the particular circumstances of the company. For example, if a company has three directors with backgrounds in management, technology, and finance respectively, the very composition of the board implies that each director’s responsibilities will differ.

Finally, the court compares the level of care and diligence actually exercised by the director or officer against the level that an ordinary reasonable person in those specific circumstances would exercise if they were acting on their own behalf. From this comparison, the court reaches its conclusion on whether the duty has been breached.

It is also worth noting that the courts have recognised that where a transaction involves a potential conflict of interest, directors and officers should be especially vigilant. They should not only involve other directors and officers in the decision-making process, but should also follow proper procedures to obtain the necessary authorisation from the company.

IV. A Case Study on Breach of the Duty of Care and Diligence

In the leading cases on the duty of care and diligence, the defendants have typically been executive and non-executive directors of listed companies. The usual scenario involves a listed company suffering a breach of the Corporations Act due to the negligence of its directors or officers, leading to proceedings against those directors personally. However, this does not mean that directors and officers of small proprietary companies are exempt from the duty. The following case involving a small proprietary company helps illustrate how the duty operates in practice:

Strategic Management Australia AFL Pty Ltd v Precision Sports & Entertainment Group Pty Ltd [2016] VSC 303

Facts:

A and B were licensed sports agents and both directors of Company A. Company A’s core business was representing AFL players in negotiations with AFL clubs and sponsors, and earning annual commissions based on the players’ remuneration. A and B secured management agreements with a number of AFL players on behalf of the company and successfully negotiated employment contracts between those players and their clubs. However, A and B failed to notice that many of the management agreements between Company A and the players were shorter in duration than the employment contracts between those players and their clubs. Naturally, they also failed to take any steps to renew the management agreements. As a result, once those agreements expired, Company A had no legally enforceable basis on which to secure its ongoing income.

The court’s reasoning:

The court applied the reasonable person test by placing an ordinary reasonable person in a comparable company (a sports management agency) and considering A’s and B’s roles within the company. The court concluded that both had breached their duty of care and diligence, reasoning as follows. First, the company’s core business was to represent players in negotiations with clubs and earn commissions or service fees from those players. Second, all of that income depended on valid, legally enforceable management agreements being in place. Third, A and B were both experienced, licensed agents whose core responsibility was to ensure that this revenue stream was continuous and properly safeguarded. Accordingly, a reasonable person in their position would have ensured that the original agreements were of sufficient duration, or would have regularly reviewed the expiry dates and proactively sought renewals to protect the company’s income. A and B failed to do so, and were therefore found to have breached their duty of care and diligence as directors.

V. Defences Available to Directors and Officers

At this point, some readers may have realised that the duty of care and diligence could potentially impose an unduly heavy burden on directors. In practice, the courts are also reluctant to second-guess directors’ commercial decisions, for two reasons. First, the courts do not consider themselves better placed to make business decisions than directors who possess the relevant industry experience and expertise. Second, the commercial world is inherently risky, and directors are often required to make bold decisions. If well-intentioned directors were held personally liable for honest business judgments, they would become overly cautious and risk-averse, ultimately stifling economic vitality and organic growth.

For these reasons, the Corporations Act provides the following two defences for directors.

5.1 The Business Judgment Rule

The first defence is the business judgment rule, set out in section 180(2) of the Corporations Act. A business judgment made by a director or officer will not breach the statutory duty of care and diligence if all of the following conditions are satisfied:

a. The judgment was made in good faith and for a proper purpose;

b. The director did not have a material personal interest in the subject matter of the judgment;

c. The director or officer reasonably believed that they were appropriately informed in relation to the subject matter of the judgment; and

d. The director or officer rationally believed that the judgment was in the best interests of the company. (A belief that a judgment is in the best interests of the company is generally presumed to be rational unless no reasonable person in the director’s position would have held that belief.)

It is also worth noting that section 180(3) defines a “business judgment” as any decision to take or not to take action in respect of a matter relevant to the business of the company. In other words, if a director or officer breaches the duty of care and diligence through sheer inaction - by failing to turn their mind to a decision at all — the business judgment rule offers no protection.

5.2 Reasonable Delegation and Reliance on Others

In the course of business, directors and officers inevitably need to delegate tasks to, or rely on advice from, others — whether employees, auditors, lawyers, or other professionals. Sections 189 and 190 of the Corporations Act provide further protection for directors. At the same time, however, the legislation also reflects the legislature’s expectation that directors will exercise care in choosing whom to delegate to and whom to rely upon.

Section 189 provides that, in assessing whether a director has fulfilled their duties, a director’s reliance on information or advice provided by an employee of the company, a professional or expert adviser, or a committee of directors, is presumed to be reasonable, unless it is shown to be unreasonable after consideration of the following factors:

1. Whether the information or advice was provided by:

1) An employee whom the director could reasonably believe to be competent and trustworthy;

2) A professional or expert whom the director could reasonably believe to be giving advice within their area of professional competence; or

3) A committee of directors on which the director did not serve.

2. Whether the reliance was in good faith; and

3. Whether the director made an independent and proper assessment of the information or advice relied upon.

Under section 198D of the Corporations Act, unless the company’s constitution provides otherwise, directors may delegate their powers to others in certain circumstances. Section 190 provides that where a director delegates their powers in accordance with section 198D, the director remains responsible for the acts of the delegate, unless:

1. The director reasonably believed that the delegate would exercise the power in conformity with the Corporations Act and the company’s constitution; and

2. The director’s belief was held reasonably, in good faith, and after making proper inquiry.

As we can see, while reliance on others and delegation can in certain circumstances serve as a valid defence, this does not mean that directors can use them as a convenient way to shirk responsibility. Any reliance or delegation must be reasonable, made in good faith, and supported by independent judgment or proper inquiry.

Conclusion

The duty of care and diligence is one of the most fundamental and important duties owed by directors. If I were to offer one piece of advice to readers who serve as directors or officers, it would be this: think of the company as Tom, the friend’s child we mentioned at the beginning. Then, from the perspective of an ordinary reasonable person, regularly ask yourself whether the care you are providing meets the standard of reasonable care and diligence, whether you have reasonably anticipated risks, reasonably avoided inappropriate risks, and whether your reliance on and delegation to others has been reasonable.

In the next article in this series, I will discuss directors’ duties of loyalty and good faith, with a particular focus on the concept of “fiduciary duty”, a concept that may be unfamiliar to most readers but plays a critically important role in Australian law. Fiduciary duties are not confined to the director–company relationship; they also arise between employees and employers, trustees and beneficiaries, agents and principals, lawyers and clients, and partners in a partnership. An understanding of fiduciary duties is therefore valuable for anyone working and living in Australia.

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Ausjuris Legal team has extensive experience in corporate law as well as insolvency and liquidation matters. Please contact us to obtain professional legal services.

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The information provided in this article is for general informational purposes only and does not constitute formal legal advice. Receipt of this information does not create a lawyer–client relationship. Ausjuris Legal and Yang Wenjun accept no liability for any loss arising from the use of, or reliance on, the information contained in this article.