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Guide Legal: When businessmen become directors

When a business transitions from a sole proprietorship or partnership to a corporation, the move requires a shift in how decisions are made. In particular, making decisions solely as a businessman (or woman, of course) is different from making decisions as a corporate director, so it is important to know how directors’ decisions will be judged. In addition, it is helpful to understand the legal standard for assessing a conflict of interest, and to know about one tool — the oppression remedy — that a court may use to rectify director misconduct.

The guiding principle

The guiding principle for all directors is to act “honestly, in good faith, and with a view to the best interests of the organization.” This itself can require a shift in thinking: the sole proprietor of a business can make decisions that best serve his own interests, but a director’s duty is to put the corporation above himself. So, for example, deferring taxes may benefit the owner but increase taxes payable by the corporation; approving such an action could be a breach of the director’s duty.

Where a court is asked to assess a director’s decision, the judge will defer to the business judgment of the directors, as long as the decision “lies within a range of reasonable alternatives.” That is, a court will not criticize a decision — even one that led to a bad outcome — simply because another reasonable person would have made a different decision. Any decision that was on the spectrum of appropriate choices in the circumstances is acceptable.

A director’s decision is more likely to be on that spectrum of reasonable choices where the director can demonstrate due diligence in making that decision. Directors have a duty to inform themselves about the issues being decided, actively ask questions for more information, and consult outside professionals where independent advice is needed. Directors must also be aware of potential problems that may flow from their decisions, and be proactive in preventing or mitigating those harms.

In determining the best interests of the corporation, directors must also consider the impact of their decisions on a range of the organization’s stakeholders — including investors, employees, suppliers, creditors, customers and members — but ultimately the organization’s interests reign supreme.

Recent political events have brought conflict of interest concerns into public discourse. For a corporate director, a conflict of interest exists where a director has a “material interest” in a proposed transaction or decision. Any non-trivial benefit could be a material interest. That interest need not belong to the director himself — it could extend to family members or even friends.

Where a director believes he has a conflict of interest, he should disclose the nature of that conflict as soon as possible, and refrain from participating in deliberations on that topic. To avoid the perception of pressuring other directors, it is also prudent to leave the room during the discussion.

When a director is an owner or employee in addition to being a director, he will by definition have an interest in many decisions. Those decisions should be made with advice from outside professionals, whose recommendation, review or blessing can often shield a decision from attack. Thus, for example, an accountant should give an opinion about the fairness of proposed salary increases.

Where a director fails to identify and disclose a conflict of interest, that director might be liable to the organization for any profits made from the transaction. Similarly, the decision at issue might be overturned, although before doing so a court would assess whether the transaction was fair and reasonable to the organization.

The oppression remedy

In some cases, people who are unhappy with a director’s decision can challenge that decision in court. Statutes in most provinces provide a tool for directors or shareholders to attack decisions that were “unfairly prejudicial” or taken in “unfair disregard” of one person’s interests. This “oppression remedy” is most often invoked for closely held corporations (especially family companies), but is available for the decisions of any corporation.

Decisions that are vulnerable to a court challenge under the oppression remedy usually involve conduct that is abusive, harsh, self-interested or coercive. It may relate both to the substance of the decision, and to the procedure followed in reaching the decision.

To succeed, a shareholder or director who brings an oppression action must show that he had a reasonable expectation that a corporation or its directors would behave in a particular way, based on the relationship between the parties, past practices, promises made, or other factors.

Where a complainant can demonstrate that corporation failed to meet his reasonable expectations, which caused him harm, the court has a wide range of options to help the injured party. For example, the court can set aside or amend agreements the corporation has made, compel directors to take certain steps, or order that a party’s shares be purchased at fair value by the corporation or another shareholder. The court will take a broad approach and find the best way to undo the harm caused by the oppression.

While the oppression remedy can be both extreme and expensive to pursue, directors should keep all these principles in mind when making decisions and trying to act in a corporation’s best interests.

Naomi Loewith is a litigator at Lenczner Slaght in Toronto. She regularly advises boards of directors, and has brought and defended legal actions about corporate decision-making.

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