Directors owe duties to the company, not to shareholders – Clyde & Co

Daniel Le Roux, Christopher MacRoberts and Gregg Hammond, 13/07/2020

The Supreme Court of Appeal (“SCA”) delivered a significant judgment on the interpretation of the Companies Act relating to the liability of directors and auditors for claims by shareholders.

The judgment offers a clear, thorough analysis of the law in relation to the liability of directors for claims by shareholders, as well as the limitations to the liability of auditors against such claims.

On 3 July 2020 the Supreme Court of Appeal (“SCA”) delivered a significant judgment on the interpretation of the Companies Act relating to the liability of directors and auditors for claims by shareholders.

The SCA unanimously dismissed an appeal by Hlumisa Investment Holdings (RF) Limited and Eyomhlaba Investment Holdings (RF) Limited (“the plaintiffs”) in their action against certain former directors of African Bank Investment Limited (“ABIL”) and the former auditors of ABIL, Deloitte.  

The judgment offers a clear, thorough analysis of the law in relation to the liability of directors for claims by shareholders, as well as the limitations to the liability of auditors against such claims. 

It offers valuable guidance as to the ‘proper plaintiff’ rule for losses suffered as a result of the alleged misconduct by directors, and the appropriate method for shareholders to exercise recourse through a derivative action.

The High Court decision

The plaintiffs in the High Court (Gauteng Division, Pretoria) were two shareholders of ABIL. The first to tenth defendants were former directors of ABIL and African Bank Limited (“the Bank”). The eleventh defendant, Deloitte, had been the auditor of ABIL and the Bank.   

The plaintiffs alleged that from 2012 to 2014, the directors conducted the business of the Bank recklessly and in contravention of s 22(1) of the Companies Act, 2008 (“Companies Act”) (a company must not carry on its business recklessly, with gross negligence, with the intent to defraud any person or for any fraudulent purpose) and s 76(3) (when a director exercises his/her power, he/she must do so in good faith, in the best interests of the company and with the degree of care, skill and diligence that may be reasonably expected of a person carrying out the same functions in relation to the company as carried out by that director, and having the general knowledge, skill and experience of that director).  

The plaintiffs alleged that these breaches resulted in significant losses on the part of the Bank which in turn caused the share price of ABIL to fall from R28.15 per share to R0.31 per share. 

The plaintiffs’ claims, which were jointly in excess of R2 billion, were based on the total diminution in the value of their ABIL shares.

The plaintiffs’ relied on a statutory cause of action rooted in s 218(2) of the Act, which states:“Any person who contravenes any provision of this Act is liable to any other person for any loss or damage suffered by that person as a result of that contravention.”

In the High Court the directors took exception successfully to the plaintiffs’ particulars of claim on three grounds:

• first, that the particulars of claim lacked averments necessary to sustain a cause of action because a claim for reflective loss is not sustainable in South African law;
• second, the particulars of claim did not contain allegations entitling the plaintiffs to rely on s 218(2) of the Act in that the applicants did not claim that they suffered loss as a result of the directors’ alleged contraventions, but rather as a result in the diminution in the value of their ABIL shares, which in turn resulted from losses sustained by the Bank and ABIL; and
• third, the particulars of claim did not contain sufficient averments to sustain a cause of action based on the representations allegedly made by the directors in a prospectus in that they did not allege that they relied on the representations, that they acted on the strength of it or suffered damages as a result of the directors’ representations.

The SCA decision

The shareholders’ claims against the directors were quintessentially reflective loss claims. The wrong done to the company (ABIL) was the basis of the appellants’ claim and the diminution in share value directly correlated to the losses suffered by ABIL.

At the heart of the SCA’s decision is the concept of separate legal personality which is fundamental to company law. A company is an entity separate and distinct from its members. 

Loss sustained by a shareholder in the value of his/her shares is reflective of the loss suffered by the company. The shareholder does not suffer any personal loss, but rather a loss in the value of the company.

The directors and Deloitte adopted the position that the claims by the shareholder plaintiffs – which, if proven, enured only to the company – were unsustainable at common law, at the instance of shareholders in their capacity as such, and could also not be brought in terms of s 218(2) of the Companies Act.

Deloitte’s stance was that it owed a legal duty to the company but not to the appellants in their capacities as individual shareholders in the company.

The SCA affirmed that it is not merely the company’s existence as a separate legal person that deprives the shareholder of an action against the wrongdoer; what deprives the shareholder of a right of action is the fact that the company has a right to recover damages for its loss.

The SCA agreed with the High Court’s finding that, “where a wrong is done to a company, only the company alone may sue for damage caused to it” and that “shareholders … do not have a direct cause of action against the wrongdoer“. 

The fiduciary duties owed by directors which are codified in terms of s 76(3) are owed to the company, not to individual shareholders. The company, in the event of a wrong done to it in terms of any of the provisions s76(3), can sue to recover damages under s 77(2)(b) & s 77(3)(b), meaning the company would be the proper plaintiff. 

The applicable provisions of the Companies Act make it clear that the legislature decided where liability should lie for conduct by directors in contravention of certain sections of the Companies Act and who could recover the resultant loss.

Common law principles have been preserved and complimented by the Companies Act in what the SCA described as a “harmonious blend”.

For purposes of s 218(2), the person who can sue to recover loss is the one to whom harm was caused. There must be a link between the contravention and the loss allegedly suffered.

In this case, the alleged loss was occasioned to the company and the company is the entity with the right of action.

The SCA upheld the decision of the High Court and the directors’ exceptions.

In relation to Deloitte, the shareholders’ claim against them was for pure economic loss in delict. To overcome the general rule against the recovery of pure economic loss, wrongfulness on the part of Deloitte would need to be established.

The question for purposes of the wrongfulness enquiry was whether public and legal policy considerations dictate that the auditors of African Bank be held liable to the shareholders of ABIL for the reflective losses they sustained as a result of the underlying losses suffered by the Bank. In this regard, the SCA affirmed that:

• the claims against the auditors were barred by the rule against claims for reflective loss;
• The duty of auditors is owed primarily to the company. Auditors have no duty to third parties with whom there is no relationship; and
• individual shareholders do not have claims against the auditors, because financial statements are not prepared for the benefit of shareholders’ individual investment decisions.  The purpose of audit reports is neither to protect the interests of investors nor individual shareholders, but to report on the stewardship of the directors to the shareholders as a body.

The SCA recognised that imposing a legal duty on auditors in a case such as this raises the spectre of indeterminate liability.

If the shareholders’ claims were to be recognised despite the fact that their loss is merely a reflection of the underlying loss suffered by the Bank and ABIL, there is no reason to prevent all others who suffered reflective losses from pursuing similar claims. 

For this reason amongst others, the SCA found no basis to establish wrongfulness on the part of Deloitte and its exceptions were also upheld.

Effect

This judgment is ground-breaking in affirming that under the Companies Act:

• directors do not owe fiduciary duties to shareholders, but to the company itself;
• shareholders cannot claim from directors for their reflective loss suffered, save in very limited circumstances;
• section 218 of the Companies Act was not intended to alter the common law position that a shareholder cannot claim against a director for reflective loss;
• an appropriate remedy for claimants in the position of the plaintiffs may be to pursue a derivative action under section 165 of the Companies Act.

Clyde & Co (Daniel Le Roux, Christopher MacRoberts and Gregg Hammond) successfully represented the directors together with Chris Loxton SC, Ian Green SC and Ndumiso Nxumalo. 

Deloitte was represented by Kathryn Gawith of Webber Wentzel, with Wim Trengove SC, Michael van der Nest SC, Danie Smit and Lerato Zikalala.