SLEEPING DIRECTORS AND SEXUALLY TRANSMITTED DEBT

Publish Date: January 11, 2004

Many small companies have husband and wife directorships where only one of them is actively involved with the management and affairs of the business.

Directors who have little or no involvement in the management and affairs of the company are referred to as silent or sleeping directors.

Prior to 1995 it was a legal requirement that all companies have a minimum of two directors.  This requirement was abolished by the First Corporate Law Simplification Act 1995 (Cth), however, many companies continue to have a silent director.  Sometimes this may arise from a misunderstanding of the current law and perhaps in circumstances where the constitution of a company (drafted prior to 1995) states that two or more directors at any one time are required. However, not all cases will arise from a misunderstanding of the law.  In the context of family companies there may remain possible advantages in the form of income splitting for tax purposes.

Silent directors are more often than not spouses, relatives or friends of the active director.  While this scenario is very common it is can be a risky proposition for the silent director since they are still subject to the same liabilities and responsibilities as an active director. 

As silent directors are often the spouse or partner of the active director, debt that silent directors become liable for upon a company’s failure is often referred to as ‘sexually transmitted debt’.  Liability for debts upon a company’s failure cannot necessarily be avoided by pleading ignorance to the affairs of the company.

A recent NSW Court of Appeal case (Deputy Commissioner of Taxation v Clark [2003]) has confirmed that the notion of the silent director does not form part of Australian company law, at least in the context of insolvent trading provisions.  That case involved a company which had as its only directors a husband and wife, Mr and Mrs Clark.  The active director was Mr Clark and Mrs Clark was effectively a ‘silent’ director.  While she would sign documents from time to time for the company Mrs Clark did not have an understanding of or involvement in the management or affairs of the company.  She had not been a director of any other company and did not have any business experience.  In her own words:

                “I would usually have a frying pan in one hand and be signing with the other.”

Mrs Clark sought to rely upon her ignorance of the company’s affairs as a defence to a claim brought against the directors by the Commissioner of Taxation under the Corporations Act.  This claim arose in circumstances where the company was wound up, the liquidator of the company sought recover ‘preference payments’ made to the tax office and the tax office in turn claimed an indemnity from the directors.

Under the Corporations Act, a defence is available (in respect of such a claim as the Clark case) in circumstances where the director did not take part in the management of the company “because of illness or for some other good reason”.  The relevant issue to be decided was whether being a silent director in the circumstances of being married to the active director constituted ‘some other good reason’.

The Court of Appeal held that Mrs Clark did not have ‘some other good reason’ and was accordingly liable to indemnify the tax office.  In arriving at this conclusion the Court stated:

“ … every director is expected to participate in the management of the company.  The test is well expressed in terms of a duty to put himself or herself into a position to guide and monitor the management of the company … That is why the defence is only available with respect to non-participation at a specific point in time.”

Whether or not a director is aware, he or she has a duty to exercise reasonable care and diligence in the discharge of his or her duties.  A director’s non-participation in the management of the company will usually involve a breach of this duty. 

If you require a review of your company's structure and constitution in order to remove the risk to silent directors, or would like to discuss other risk minimisation strategies, or need help in understanding your potential liability as a director, please contact Matthew Smith on 49076319

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