Misrepresentations by Other Directors Can Be Costly

Directors who sit on the board of a company may not realize it, but they can be liable for statements made by fellow directors who are found to have misrepresented the company’s state of affairs to an investor.

The so-called “indoor management rule” allows outsiders, including investors, to rely on statements made by qualified persons, including directors, even if they are acting outside their authority. A director speaks for the company, so the company will be liable for any misrepresentation made by a careless director. But what about the other directors—are they also liable for misrepre­sentations made by their fellow directors?

The general rule is that a director will not be found personally liable for the wrongful acts of the company or fellow directors. As Lord Reid put it in Tesco Supermarkets Ltd. v. Nattrass, a director’s mind “is the mind of the company. If it is a guilty mind, then that guilt is the guilt of the company.” As a matter of policy, courts have recognized that businesses cannot function effectively when directors are driven away by potential exposure to ill-founded litigation.

Generally speaking, corporate directors are usually shielded from personal liability when aggrieved shareholders or customers bring lawsuits. But there are, of course, exceptions. Fraud, deceit, or negligence on the part of the director can implicate them personally.

In Peracomo Inc. v. TELUS Communications Co., for example, a fisherman who was the sole shareholder and “directing mind” of his company intentionally cut a fibre-optic cable that was entangled with his anchor because he mistakenly believed the cable to have been abandoned. The result was almost $1 million in damage. The Supreme Court of Canada considered the fisherman to be “a good man who did a very stupid thing,” but still held that he was personally liable for negligently cutting the cable. The company was also liable for his negligence. This was the case even though he was incorporated and had been acting in the course of his corporate duties, much like a director.

Other exceptions are found in legislation. The most common ones occur where a pro­spectus or similar document is issued which contains a misrepresentation.

British Columbia’s Securities Act imposes liability on all directors for misrepresenta­tions in a prospectus or circular, or in prescribed disclosure documents such as financial statements. In addition, the Securities Act says the purchaser is auto­matically deemed to have relied on any such misrepresentation (without requiring the plaintiff to prove reliance as would normally be the case).

In relation to this issue, a leading case in Ontario, which has a similar provision in its legislation, is Kerr v. Danier Leather Inc.. Warm weather created a low demand for leather clothing, and Danier missed its sales forecast. Shareholders alleged a misrepresentation and brought a class action against Danier along with the com­pany’s CEO and CFO. The trial judge found that the CEO and CFO had acted in good faith in issuing the forecast, but still held them personally liable for the company’s misrepresentation because their belief that the year-end forecast would be met was objectively unreasonable.

Fortunately for Danier’s directors, on appeal, both the Court of Appeal and the Supreme Court of Canada held that the original estimate had been reasonable and, consequently, there had been no misrepresentation.

B.C.’s Securities Act also offers directors some protection by setting out a number of defences for misrepresentations made in a prospectus or similar document. For example, a director is not liable if, among other things, the prospectus was filed with­out the director’s consent or if, upon learn­ing of the misrepresentation, the director withdrew consent and gave public notice of the reason for withdrawing.

As well, in cases of secondary market dis­closure, where shares are purchased other than directly from the company, the court’s permission is required before a party can start a lawsuit on the basis of misrepre­sentations. To weed out frivolous claims or “strike suits”—lawsuits that likely cannot succeed on their merits but may end up being settled to avoid costly litigation—the court must be satisfied that the action is being brought in good faith and has a rea­sonable chance of success.

Bottom line: the watchword for corporate directors is “vigilance.” Know that a director may be exposed to liability if other directors in the company misrepresent a material fact to investors. What follows are only some of the steps all directors should take as a matter of routine:

• Reviewing the company’s investment disclosure documents;
• Ensuring that all pertinent information is available before approving financial statements; and
• Confirming that any forecasts or disclosure documents are based on up-to-date information and include appropriate cautionary statements.

For more information on directors and officers liability, please contact Steve.

Peter Mennie, Articled Student, assisted with the research and writing of this article.

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