Duties of a company officer: care, loyalty and personal liability

Service page: Commercial contracts lawyer: drafting, review and enforcement.

The chapter on duties in the Companies Law does not speak of the “board of directors” as a body, but of the officer (office holder) as a person, and it places on the officer two completely separate duties, with a different liability regime for each.

This distinction is the heart of the matter. Most mistakes in this area come from treating the two duties as one thing, and then discovering, too late, that the policy or the exemption clause in the articles of association does not cover what happened.

The duty of care: what exactly is measured

Section 252 of the Companies Law does not create a new tort. It points outward, to the tort of negligence in the Torts Ordinance:

Companies Law, section 252(a) (unofficial translation)

An officer owes the company a duty of care as stated in sections 35 and 36 of the Torts Ordinance [New Version].

What the reference means: the analysis is an ordinary negligence analysis: duty, breach, damage and causation. Section 252(b) adds a point that is easy to miss: this provision does not prevent an officer from having a duty of care toward another person. In other words, the duty toward the company does not replace a possible duty toward a creditor, an investor or a third party.

Section 253 is the section that sets the actual bar, and it is worded as a requirement of process, not a requirement of result:

Companies Law, section 253 (unofficial translation)

An officer shall act with the level of skill with which a reasonable officer would act in the same position and in the same circumstances, including taking, in view of the circumstances of the matter, reasonable measures to obtain information relating to the business advisability of an action brought for their approval or of an action done by them by virtue of their office, and to obtain any other information that is of importance for such actions.

Note the wording: the Law does not require the decision to turn out to be right. It requires reasonable measures to obtain information before the decision. This is why minutes that record what data was presented, who presented it and what was asked are a director’s most important practical protection, well ahead of the insurance policy. The second most important protection is the wording of the exemption and indemnity clauses in the articles of association and in the coverage agreement, and that is where reviewing an agreement before signing comes in.

Section 253A adds a clarification that is especially important for someone appointed to the board because of their professional background: the appointment of a director who has accounting and financial expertise, or professional qualifications under section 219(d) or 240(a1), does not change the liability placed on them and on the other directors of the company under any law. The professional qualification does not increase the liability of the person who has it, and does not reduce the liability of the others around the table.

The duty of loyalty: three things to refrain from, and a duty of disclosure

The duty of loyalty is built differently. It is not measured by reasonableness but by a closed list of prohibited conduct:

Companies Law, section 254(a) (unofficial translation)

An officer owes a duty of loyalty to the company, shall act in good faith and for its benefit, and this includes – (1) refraining from any action that involves a conflict of interest between the performance of their role in the company and the performance of another role of theirs or their personal affairs; (2) refraining from any action that involves competition with the company’s business; (3) refraining from exploiting a business opportunity of the company in order to obtain a benefit for themselves or for another; (4) disclosing to the company any information, and delivering to it any document, relating to its affairs, that came into their hands by virtue of their position in the company.

In practice, the four paragraphs cover most of the disputes that reach the court in private companies: a director who is also a supplier of the company, a founder who opens a parallel business, a manager who takes for themselves a customer who came to the company, and an active shareholder who knows something and does not tell. As with the duty of care, here too section 254(b) makes clear that the duty toward the company does not exclude a duty of loyalty toward another person.

A conflict of interest is not necessarily prohibited, but the conditions are strict

Section 255 allows the company to approve an action of those that section 254(a) prohibits, on two cumulative conditions: that the officer acts in good faith and the action or its approval does not harm the company’s interests, and that the officer disclosed to the company, a reasonable time before the date of the discussion of the approval, the nature of their personal interest in the action, including any material fact or document.

A few words in the section make all the difference: “a reasonable time before”. Disclosure made at the meeting itself, after the material has already been circulated and the people involved have already formed a position, does not meet the condition. Section 255(b) adds that the approval itself is given under Chapter Five: as the approval of an ordinary transaction for actions that are not material, and as the approval of an extraordinary transaction for material actions.

What happens in case of a breach

Section 256(a) says that the laws that apply to breach of contract apply, with the necessary changes, to a breach of the duty of loyalty toward the company, and section 256(b) adds that the person in breach is regarded as having breached their engagement with the company. The practical result: the full range of contract remedies is available to the company: enforcement, rescission and damages.

The subsection that surprises third parties is 256(c): the company may cancel an action that an officer did in its name toward another person, or claim damages from that person even without canceling, if that person knew of the breach of the duty of loyalty and knew or should have known that the action had not been approved. Section 256(d) creates the protective mechanism: it is presumed that a person should not have known that approval was lacking if they received the board’s confirmation that all the required approvals had been given.

This is why, in a transaction with a company, it is worth demanding a board confirmation in this wording. Not as a formality, but to come within the presumption.

Exemption, indemnity and insurance: the line that cannot be crossed

This is where the distinction between the two duties turns into money. Section 258 sets the three basic points: a company may not exempt an officer from liability for breach of the duty of loyalty toward it; it may exempt the officer from liability for breach of the duty of care, and may insure or indemnify, all only in accordance with what is set in that chapter.

Section 259 adds the formal condition and the exception: an exemption in advance from breach of the duty of care is possible only if a provision for it was set in the articles of association, and even then the company may not exempt a director in advance from liability for breach of the duty of care in a distribution. A dividend distribution is exactly the place where a director’s personal liability is exposed, and it is exactly the place from which the Law does not allow an exemption in advance.

Indemnity (section 260) also depends on a provision in the articles of association, and covers, among other things, a financial liability imposed in favor of another person under a judgment, including a judgment given in a settlement or an arbitral award approved by a court, and also reasonable litigation expenses, including attorneys’ fees, in an investigation or a proceeding that ended without an indictment being filed and without financial liability as an alternative to criminal proceedings.

Insurance (section 261) also depends on a provision in the articles of association, and covers three situations: breach of the duty of care toward the company or toward another person; a financial liability imposed in favor of another person; and breach of the duty of loyalty, but only if the officer acted in good faith and had reasonable grounds to assume that the action would not harm the company’s interests. This is the only exception in the Law that allows any cover at all for a breach of loyalty.

What has no effect, even if it is written in the articles of association

Section 263 voids in advance provisions of the articles of association or board resolutions that permit insurance, indemnity or exemption for: breach of the duty of loyalty (except for that exception in section 261(2)); breach of the duty of care committed intentionally or recklessly, unless it was committed only negligently; an action intended to make an unlawful personal profit; and a fine, a civil fine, a monetary sanction or a composition payment (kofer) imposed on the officer.

Section 264 closes the loophole: a provision in the articles of association, in a contract or given in any other way that contracts out of this Article, directly or indirectly, will have no effect. What is more, accepting an undertaking to indemnify or insure for a breach of loyalty that does not fall within the exception is itself a breach of the duty of loyalty.

The forgotten duty: calling a meeting

Section 257 places an active duty that is easy to ignore: if a director learns of a company matter in which a prima facie breach of the law or harm to proper business practice has been discovered, they must act without delay to call a meeting of the board of directors. Not report to the CEO, not raise it at the next meeting. Call a meeting.

Looking back, this is the section that decides whether a director was part of the problem or part of the solution. A record of a demand to call a meeting, in writing and dated, is often the only document that separates the two.

What to do in practice

• Before accepting an appointment, ask to see the articles of association and check whether they contain provisions on exemption, indemnity and insurance. Without a provision in the articles, sections 259–261 do not allow the company to grant any of the three.
• Ask for the officers’ policy itself, not the terms sheet. The difference between cover for negligence and cover that includes the section 261(2) exception is the difference that will come to light exactly on the day you need it.
• Put any personal interest in writing, before the meeting, not during it. “A reasonable time before the date of the discussion” is a condition in section 255, not a custom.
• Demand that the minutes record what data was presented before the decision. Section 253 measures the means of gathering information, and minutes that record only the vote prove nothing.
• In a transaction with a company, demand a board confirmation that all the required approvals have been given. Section 256(d) turns it into a presumption in your favor.

Frequently asked questions

What is the duty of care of an officer in a company?

Section 252 of the Companies Law refers to the tort of negligence in sections 35 and 36 of the Torts Ordinance. Section 253 sets the bar: acting with the level of skill of a reasonable officer in the same position and in the same circumstances, including taking reasonable measures to obtain information on the advisability of the action before the decision. The requirement is one of process, not of result.

What is an officer prohibited from doing under the duty of loyalty?

Section 254(a) lists three things to refrain from and one duty of disclosure: to refrain from an action that involves a conflict of interest; to refrain from an action that involves competition with the company’s business; to refrain from exploiting a business opportunity of the company to obtain a benefit for themselves or for another; and to disclose to the company any information, and deliver any document, relating to its affairs that came into their hands by virtue of their position.

Can a company exempt a director from liability in advance?

Only from breach of the duty of care, and only if a provision for it was set in the articles of association (sections 258(b) and 259(a)). It is not possible to exempt anyone at all from breach of the duty of loyalty (section 258(a)). In addition, section 259(b) prohibits exempting a director in advance from liability for breach of the duty of care in a distribution.

Can an officer be insured against breach of the duty of loyalty?

Only on one condition. Section 261(2) allows insurance for breach of the duty of loyalty toward the company, provided that the officer acted in good faith and had reasonable grounds to assume that the action would not harm the company’s interests. Outside this exception, section 263 voids any provision of the articles of association or resolution that permits insurance, indemnity or exemption for a breach of loyalty.

What is D&O insurance, and what must it not cover?

D&O (Directors and Officers) insurance is insurance of the liability of directors and officers. Under section 261 of the Companies Law, 5759-1999, a company may enter into such an insurance contract only if a provision for it was set in the articles of association, and for a liability imposed on the officer because of an action they did by virtue of being an officer of the company: breach of the duty of care toward the company or toward another person, financial liability in favor of another person, and breach of the duty of loyalty under the conditions in section 261(2). Section 263 voids a provision that permits insurance for breach of the duty of care committed intentionally or recklessly, an action intended to make an unlawful personal profit, and a fine, a civil fine, a monetary sanction or a composition payment imposed on the officer.

What must a director do on learning of a breach of the law in the company?

Section 257 requires the director to act without delay to call a meeting of the board of directors when they learn of a company matter in which a prima facie breach of the law or harm to proper business practice has been discovered. This is an active and independent duty, not just an internal report.