Directors Beware: Indemnity in a Company’s Constitution is not Foolproof

The constitution (formerly known as articles of association) of companies in Malaysia generally contains an indemnity provision in favour of directors, indemnifying them against liabilities (for example, associated legal fees and financial costs) incurred by the directors in defending legal suits by third parties where judgement has been given in their favour in respect of any negligence, default, breach of duty or breach of trust. However, to what extent can the directors solely rely on an indemnity provision in a company’s constitution to bring an indemnity claim against the company? This question was considered by the Malaysian Court of Appeal in the case of Perdana Petroleum Bhd (formerly known as Petra Perdana Bhd) v Tengku Dato’ Ibrahim Petra bin Tengku Indra Petra & Ors [2021] 6 MLJ 663.

Facts of the Case

In this case, four former directors of Perdana Petroleum Berhad (Company) filed an action at the High Court to seek an indemnity against the Company to claim for their legal fees and expenses incurred in defending two previous lawsuits commenced by the Company (or on the Company’s behalf) against the directors for, among other things, breaches of statutory and fiduciary duties.

The directors successfully sought an order from the High Court, requiring the Company to indemnify the directors in respect of their legal expenses (approximately RM2.6 million) in connection with the previous lawsuits. The directors had largely relied on Article 170 of the Company’s constitution (which followed Article 113 of the Table A model articles under the now repealed Malaysian Companies Act 1965) in their indemnity claim, which provided as follows:

Indemnity

Every director, managing director, agent, auditor, secretary, and other officer for the time being of the company shall be indemnified out of the assets of the company against any liability incurred by him in defending any proceedings, whether civil or criminal, in which judgment is given in his favour or in which he is acquitted or in connection with any application under the Act in which relief is granted to him by the Court in respect of any negligence, default, breach of duty or breach of trust.

Dissatisfied with the outcome, an appeal was brought by the Company to the Court of Appeal. One of the principal issues before the Court of Appeal, which forms the focus of this article, was whether the former directors were entitled to avail themselves of the above indemnity provision found in the Company’s constitution. To the directors’ dismay, the Court of Appeal answered the question in the negative and ruled that the former directors could not rely on Article 170 alone to claim for indemnity.

The Court of Appeal’s Decision

In coming to this decision, the Court of Appeal reasoned that the Company’s constitution constituted a binding contract only between the Company and its shareholders, and not between the Company and other third parties such as its directors or officers. As a result, even though the Company’s constitution contained Article 170 which provided an indemnity in favour of the directors, this alone, without more, could not give the directors a contractual right to enforce the relevant article against the Company. The Court of Appeal justified its reasoning based not only on local and other common law cases, but also the wording of Section 33(1) of the Malaysian Companies Act 2016 which, in essence, states that a constitution shall, “when adopted, bind the company and the members”.

The Court of Appeal also highlighted that for the directors to avail themselves of the protection offered by the Company’s constitution, Article 170 had to be incorporated into a separate binding contract between the directors and the Company. This can be done by way of an agreement, whether expressly or impliedly, like any other terms of a contract. In this regard, the court observed that “comparatively little is required for the incorporation of a term in the article that provides indemnity to an auditor or director who is appointed.” Without such incorporation, the provision in the Company’s constitution will not automatically become terms of a contract between the Company and the directors.

In the present case, since the directors were unable to point to any binding contract (whether in oral or written form) with the Company containing or incorporating Article 170, there was no contractual basis for the directors to seek an indemnity against the Company.

Comments and Takeaways

The Perdana Petroleum Berhad decision is not entirely surprising, and, in fact, it is consistent with the position in the United Kingdom. In Globalink Telecommunications Ltd v Wilmbury Ltd [2003] 1 BCLC 145, for example, Stanley Burnton J held that the articles of association of a company were not automatically binding between a company and its directors, unless they were expressly or impliedly incorporated into an agreement between them.

It goes without saying that directors are exposed to the risks of being held personally liable for wrongdoing arising in the course of managing a company. This is understandably so given that a host of different obligations and fiduciary duties are imposed on directors by either common law or statutory provisions. Given the Perdana Petroleum Berhad decision, there is now more reason for directors in Malaysia to look for other means to protect themselves from potential liabilities since merely having indemnity provisions in a company’s constitution is not sufficient.

At the very least, as guided by the Court of Appeal, one of the protections which directors could look to is to ensure that the relevant indemnity provisions are expressly incorporated in their contract of appointment or employment (which governs the overall contractual relationship between the directors and the company), or a separate deed of indemnity. It is worth noting that it takes very little effort to incorporate such indemnity provision as a term in the directors’ contract, but such incorporation is absolutely necessary if reliance is to be placed upon it.

One thing to bear in mind is that mere appointment of the director is not a valid argument for the directors to rely on the relevant indemnity provision in a company’s constitution. Appointing a director in accordance with the constitution of a company merely attests to the fact that the appointment was validly made. Provisions in the constitution are mainly mandates and authority given to directors of a company, and appointment does not per se, automatically constitute a binding contract between a director and a company. The company’s obligations in other contracts entered into with third parties would ultimately depend on the terms of these separate contracts.

Alternatively, directors may also consider taking up a directors’ and officers’ insurance to obtain additional protection against potential liabilities arising in the course of their duties. Taking the relevant steps as mentioned above is critical to give directors the peace of mind they need while discharging their onerous and demanding directors’ duties.

For further information, please contact Glynn Cooper, Wan Jian Loh, Jarry Tay or your usual Herbert Smith Freehills contact.

Disclaimer
Herbert Smith Freehills LLP is licensed to operate as a Qualified Foreign Law Firm in Malaysia. Where advice on Malaysian law is required, we will refer the matter to and work with licensed Malaysian law practices where necessary.

Glynn Cooper
Glynn Cooper
Partner, Kuala Lumpur
+60 3-2777 5102
Wan Jian Loh
Wan Jian Loh
Associate, Kuala Lumpur
+60 3-2777 5143
Jarry Tay
Jarry Tay
Associate, Kuala Lumpur
+60 3-2777 5128

The rise of ESG – implications on the duty to act in the best interest of the company

Under the laws of most jurisdictions, directors of a company are duty-bound to act in the best interest of the company. Traditionally, fulfilling this duty meant that directors would need to have regard to the benefit of shareholders as a whole, shareholders being the ultimate owners of the company. However, recently, there has been a shift away from this short-term shareholder-focused view towards a more long-term sustainable value creation-focused view.

Globally, there has been an increasing recognition that the conduct of a company affects various stakeholders around it, and that companies should have regard to environmental, social, human, and economic considerations. These considerations – commonly referred to as ESG considerations – once seen as a voluntary part of companies’ corporate governance framework, are now rapidly being enacted into hard law across different jurisdictions.

How are these recent shifts affecting the legal position on directors’ duty to act in the best interest of the company? In this article, we will explore the current legal positions in the UK, Europe and Malaysia on directors’ duty to act in the best interest of the company vis-à-vis ESG considerations.

Position in the UK

Presently, UK law incorporates ESG considerations as part of a director’s duty to act in the best interest of the company.

The Company Law Review Steering Group (CLR) was formed by the UK government in 1998 to review UK’s company law with a view of creating a more competitive economy. One of the key recommendations of the CLR was for there to be a shift in focus away from the individual interests of members to a focus on the “managing of the complex of relationships and resources which comprise the company’s undertaking”.

These recommendations were reflected in the law when the Companies Act 2006 was enacted. Under Section 172(1) of the Companies Act 2006, a director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole. In doing so, directors are obliged to have regard to (amongst others):

  • the likely consequences of any decision in the long term;
  • the interests of the company’s employees;
  • the need to foster the company’s business relationships with suppliers, customers and others;
  • the impact of the company’s operations on the community and the environment; and
  • the desirability of the company maintaining a reputation for high standards of business conduct.

Since Section 172(1) of the Companies Act 2006 came into force in 2007, directors of UK-incorporated companies have been legally obliged to take into consideration various ESG matters as part of their decision-making processes. These include matters such as climate change, maintaining biodiversity, human rights, health and safety, bribery, corruption, competition and so on. A failure to comply with these obligations may result in directors being liable for losses suffered by the company as a result of such a breach.

Position in Europe

Recently, in February 2022, the European Commission published a proposal for a directive on corporate sustainability due diligence which includes an article providing that member states shall ensure that, when fulfilling their duty to act in the best interest of the company, directors must take into account the consequences of their decisions on sustainability matters, including matters such as human rights, climate change and environmental consequences. This obligation would not apply to companies meeting certain thresholds calculated based on the number of employees and worldwide turnover and would not apply to small and medium enterprises.

This proposal is currently being presented to the European Parliament and the Council for approval. Once adopted, member states will have two years to transpose the directive into national law.

Current position in Malaysia

As the position currently stands, there is no strict legal obligation on directors of Malaysian companies to specifically take ESG matters into consideration as part of their decision-making process.

Similar to the CLR, the Corporate Law Reform Committee (CLRC) in Malaysia was formed by the Companies Commission of Malaysia in 2003 to conduct a review of Malaysian companies law. While the CLRC acknowledged the importance of a company having regard to long-term, sustainability concerns, the CLRC was of the view that social obligations of the company should not be expressly incorporated into the scope of directors’ duties under the Companies Act.

Under Section 213(1) of the Companies Act 2016, a director of a company is required to exercise his powers in good faith in the best interest of the company. A breach of this duty is a criminal offence and may additionally result in directors being liable for losses suffered by the company.

Reflecting the CLRC’s position and in contrast to the UK Companies Act 2006, there is no express obligation under this section on directors to have regard to ESG considerations. We are also not aware of any Malaysian caselaw which has extended the scope of obligations of directors under Section 213(1) to specifically cover ESG matters.

That is not to say directors of Malaysian companies do not have any legal obligations vis-à-vis ESG considerations at all. Local regulators and governing bodies have also come up with their own standards in adopting ESG matters. Since 2016, Bursa Malaysia has required Malaysian public-listed companies to include sustainability reporting in their annual reports. Directors of large, listed companies are also required to apply the corporate governance and sustainability practices in the Malaysian Code on Corporate Governance.

Possible future direction for Malaysia

In terms of the impact on the ESG movement on director’s duty to act in the best interest of a company in Malaysia, we see two possible directions of travel:

  • Following the trends in other jurisdictions, Section 213(1) of the Companies Act 2016 may at some point in time be amended to expressly oblige directors to have regard to ESG considerations. That said, given the wide-ranging scope of ESG considerations, the liability (currently, a criminal liability) for a breach of this duty may need to be reconsidered. Following the approach taken in Europe, de-minimis exceptions may also be applied such that only directors of larger companies with sufficient resources are subject to this duty.
  • Even if legislative change does not occur, Malaysian courts may read into Section 213(1) of the Companies Act 2016 an obligation for directors to have regard to ESG considerations. A failure to manage ESG issues may result in legal, reputational, operational and financial implications on a company, and it can be argued that managing these risks are intrinsic to a director’s obligation to act in the best interest of the company.

Given the global focus on ESG, it would be prudent for directors of Malaysian companies to start incorporating ESG practices into a company’s business model where possible.

For further information, please contact Peter Godwin, John Ling or your usual Herbert Smith Freehills contact.

Peter Godwin
Peter Godwin
Managing Partner, Kuala Lumpur
+60 3-2777 5104
John Ling
John Ling
Senior Associate, Kuala Lumpur
+60 3-2777 5107

 

 

 

 

 

 

 

 

Disclaimer
Herbert Smith Freehills LLP is licensed to operate as a Qualified Foreign Law Firm in Malaysia. Where advice on Malaysian law is required, we will refer the matter to and work with licensed Malaysian law practices where necessary.