To what extent can a company indemnify a director?

To put this question in context, the starting point is that a director of a company is not personally liable for the liabilities, debts and other obligations of a company, (i.e. the director benefits from limited liability).

However, over time Governments have made many exceptions to this general principle. In Australia, there are now more than 700 laws that can make a director personally liable for an act, omission or obligation of the company. (i.e. personal liability). The policy rationale behind personal liability is to ensure that directors act responsibly, i.e. that they do not take unnecessary risks or expose the company, its employees and the public, to unnecessary risks.

Examples of Commonwealth legislation that can impose personal liability on directors include:

  • The Australian Consumer Law, (e.g. offences relating to unfair practices and product safety and product information);
  • Work health and safety legislation;
  • Environmental laws;
  • Employment Law; and
  • Taxation laws.

In almost all cases where directors can become personally liable there must be some level of culpability, i.e. the director must deliberately or recklessly fail to do what is expected of them.

Can a company provide a director with an ‘indemnity’?

Because directors can be subject to personal liability, many directors will not take on this role unless the company first agrees to indemnify them against the personal liability. This is usually done either by the company agreeing to indemnify the director against the personal liability from its own assets (i.e. by giving an Indemnity), or by the company obtaining a policy of insurance that covers the potential personal liability (i.e. a policy of Insurance).

Are there any restrictions on the extent of the Indemnity a company can give?

The Government was not entirely happy that directors could get around personal liability by obtaining an Indemnity from the company, so it introduced laws to prohibit (or void) an Indemnity given by a company to a director (i.e. the Prohibition). The idea behind the Prohibition was to once again make directors personally liable from their own assets.

However, over time, to encourage people to take on the important role of directorships, and to strike a balance between protecting honest and diligent directors while guarding against irresponsible behaviour, the Government watered-down the Prohibition.

The law now states that a company can provide a director with an Indemnity for the potential personal liabilities, EXCEPT CERTAIN personal liabilities that:

  • The director owes the company itself, (i.e. as between the company and the director); or
  • Arise from particularly naughty acts or omissions on the part of the director.

The extent of the current Prohibition is found in Division 1 of Part 2D.2 of the Corporations Act 2001 (Cth) (the Act).

The important thing to note about the Prohibition is that a company can indemnify a director in all respects, other than what is covered by the Prohibition.

No indemnity for a liability to the company itself

As noted above, a company cannot exempt or indemnify a director from a liability the director owes to the company itself (s.199A(1) of the Act).

When you think about this, it makes sense. To do otherwise would mean that the director can do whatever they want without the company having any recourse against them. There is a clear relationship of responsibility here that should not be able to be circumvented by a ‘get out of jail free card’ in the form of the Indemnity.

No indemnity for a civil penalty or compensation order

The Act contains several provisions that impose civil penalties or require a director to compensate the company for wrongful conduct. A company cannot indemnify a director against penalties and orders that:

  • Arise under a civil penalty provision (of which there are currently 46, and which include such things as the director’s duties to the company) (s.199A(2)(b) of the Act); and
  • Where the contravention:
    • materially prejudices the interests of the company or its members; or
    • materially prejudices the company’s ability to pay its creditors; or
    • is serious.

An example includes using confidential information obtained during a directorship for an improper purpose that causes material prejudice to the company. It is worth noting that an Indemnity can be given against civil penalties for conduct that does not cause material prejudice and is not serious.

No indemnity for liability to a third party from conduct not in ‘good faith’

A company is also prevented from indemnifying a director from a liability to a third party (i.e. not the company) that arises from conduct that is ‘not in good faith’ (s.199A(2)(c) of the Act).

First, it is important to note that a personal liability must first arise between the director and the third party. As noted above, this is only likely to occur in limited circumstances.

Secondly, the liability must arise in circumstances where the director has not acted in good faith. The concept of ‘good faith’ is an abstract term that is not defined in the Act. However, it is generally synonymous with acting honestly and sincerely, and having regard to the interests of the other party, rather than acting dishonestly, fraudulently or ‘wrongfully’. The concept is derived from the Latin term bona fide, and the courts use the two terms interchangeably.

A possible example of this could be liability for the deliberate disclosure of a third party’s confidential information while knowing you had an obligation of confidentiality.

Can the company provide an indemnity for legal costs?

Taking on a directorship can expose a person to the potential of becoming involved in expensive legal actions. These actions can involve the director but be brought against the company, or they may be brought directly against the director themselves.

As a rule, a company can indemnify a director for legal costs that arise from acting as a director.

However, once again an indemnity is prohibited if the legal costs relate to:

  • Proceedings that result in the director having a liability covered by section 199A(2), as discussed above, (i.e. liability to the company, for a civil penalty, for a compensation order or to a third party arising from conduct not in good faith); or
  • Defending or resisting criminal proceedings in which the director is found guilty;
  • Defending or resisting proceedings brought by ASIC or a liquidator for a court order, if the grounds for making the order are established, (this includes actions by ASIC to disqualify the director, for oppression, civil penalties and injunctions); or
  • Proceedings brought by the director for relief under the Act, which the court denies.

The notable thing here is that the company can indemnify the director for these legal costs if the director is ultimately successful in defending the proceedings, i.e. if the director is innocent. However, this is of little help if the director cannot afford to properly defend these issues in the first place. To help here, the company can provide the director with a loan to meet legal costs (under section 212(2) of the Act). If the director is successful, then the company can indemnify the director for the costs. However, if the director is found responsible (or guilty), then the director must repay the loan to the company.

Can a company take out insurance on behalf of the director?

A Company may also pay premiums for a policy of insurance against a director’s liability.

However, this is prohibited if the policy relates to:

  • Conduct involving a wilful breach of duty in relation to the company;
  • A contravention of the director’s obligation not to use their position as a director to gain an advantage for themselves (or someone else), or to cause detriment to the company (s.182 of the Act); or
  • A contravention of the director’s obligation not to improperly use information obtained in the role of director to gain an advantage for themselves (or someone else), or to cause detriment to the company (s.183 of the Act).

This prohibition does not apply to a policy of insurance to cover legal costs – so the company can pay for a policy to cover legal costs for these matters, as well as legal costs for matters otherwise subject to the prohibition against the Indemnity – irrespective of the outcome of the legal action.

A director should, therefore, ensure that directors and officers insurance (or D&O insurance) is taken out on their behalf, and should carefully consider the scope of the cover to ensure that potential liabilities and legal costs are covered, to the extent possible.

How does a company provide the Indemnity to a director?

It is common practice for directors to enter a Deed of Indemnity with the company, particularly if there is no indemnity contained in the company’s constitution. If this Deed is properly drafted and consistent with the Act, it will then create a personal contractual right of indemnity from the company and in favour of the director.

The Deed may also cover the issue of legal costs, including provision for the company to make a loan to the director to cover such costs and a mechanism to offset the loan against an indemnity if the director is successful in defending the action.

Another thing these Deeds often include is a legal right on the part of a former director to continue to have access to the company’s books and records (and sometimes other resources) if they are needed by the director to defend themselves from an action brought after they have resigned.

For assistance in understanding the potential liability of directors, and putting in place a compliant Deed of Access and Indemnity, call us on 1300 654 590.

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