THE DIRECT LIABILITY OF EMPLOYEES OF AN INSOLVENT COMPANY
Abstract:
Recent decisions of high authority have held that in certain circumstances, corporate employees may be directly liable to third parties in the tort of negligence for causing pure economic loss. Furthermore, such a direct remedy becomes all the more appealing in the wake of the corporate employer’s insolvency. Despite a divergence of judicial opinion as to how and when such liability may arise, it is submitted that it is the nature of the skill, or service, being relied upon that is ultimately determinative of which test the court will employ in deciding whether liability will be incurred by the employee. Therefore, whilst the nature of a professional employee’s work renders them vulnerable to tortious claims under this heading, the interposition of the company’s separate legal identity leaves corporate clients bereft of an effective remedy and provides unwarranted protection for negligent directors.
1.1 Introduction
When a company is insolvent, it is axiomatic that its liabilities will outweigh its assets, thus the general body of a company’s unsecured creditors are almost certainly never repaid in full, if at all. Therefore, where a client of the company has suffered loss as a result of the negligence of an employee, he (the client) may pursue either a claim in contract or tort against the company, or sue the employee directly in respect of his loss. There is a clear incentive to adopt the latter approach where the company is insolvent since a valid claim against the company will be entered as a proof for a dividend in the company’s liquidation. Therefore, since the assets of the company are distributed pari passu amongst creditors of the same rank, the claimant would only be entitled to the pro rata value of his claim out of the available assets. Comparatively, a direct claim is far more effective as it will be satisfied out of the personal assets of the tortfeasor and would therefore reap far greater financial value.
Accordingly, Part 1 of the following analysis broadly outlines the situations in which employees may be held personally liable for their tortious acts whilst Part 2 and Part 3 will respectively address the direct liability of directors and professional employees where their negligence causes pure economic loss. Finally, Part 4 will draw together several conclusions and observations to demonstrate that whilst the law of tort lacks uniformity in its treatment of professionals as opposed to directors, uniformity can and should be achieved in order to provide the corporate client with an effective form of redress and ensure that the act of incorporation is not used as a vehicle to render negligent employees immune from liability for causing pure economic loss.
1.2 The Parameters Of Discussion
Whilst the company is the only proper plaintiff in an action for a director’s breach of his fiduciary duties, a tortious duty of care can exist between a director and a third party. Accordingly, there are three distinct scenarios in which a director may be held personally liable for the losses of a third party namely, (i) when a director commits, or causes the company to commit, the tort of deceit; or (ii) when a director procures, or causes the company to procure, a breach of intellectual copyright; or (iii) when a director is deemed to have assumed personal responsibility for financial losses suffered by a third party resulting from the director’s negligence. It is this final category upon which the following discussion will be focused as the doctrinal basis underpinning when a third party may recover pure economic loss attracts the greatest degree of judicial disagreement and misconception.
1.3 The “Extended” Hedley Byrne-type Doctrine
The unprecedented decision of the House of Lords in Hedley Byrne v Heller, laid down the principle that a party could recover for pure economic loss sustained as a result of that party’s reliance on the negligent misstatement of the tortfeasor, where a special relationship, ‘equivalent to contract’, existed between the parties. This principle was subsequently applied and expanded upon by Lord Goff in Henderson v Merrett, wherein his Lordship concluded that ‘…a duty of care may exist in respect of words as well as deeds’ where there is an assumption of responsibility by one party to the other, such as to create a special relationship. Furthermore, unlike its parent decision, this “extended” Hedley Byrne-type liability could be applied in tripartite scenarios where the claimant sues upon ‘loss as a result of inaccuracy in the advice or information furnished initially to an intermediary.’ Thus, it became possible to hold a third party liable for negligent acts or advice causing purely financial loss, despite the fact that a contract existed only between the plaintiff and the intermediary.
2.1 The Direct Liability Of Directors
The application of such “extended” Hedley Byrne-type liability in relation to a director of a company limited by shares was subsequently approved in Williams, the facts of which are briefly set out below:
Mr. Mistlin was the managing director and majority shareholder of a private company limited by shares that was in the health foods business. In reliance upon business projections, in the production of which Mr. Mistlin played a ‘prominent part’, the claimants entered into a franchise agreement with the company. In reliance upon the projections, which had been negligently prepared, the claimants suffered financial losses and commenced an action against the defendant company and Mr. Mistlin, alleging that the defendants had assumed responsibility towards the claimants in respect of such losses. As the company was soon wound up, proceedings continued solely against Mr. Mistlin.
The House of Lords, unanimously reversed the decision of the Court of Appeal, holding that the respective elements of the tort had not been made out. Nonetheless, Lord Steyn, who delivered the only reasoned judgment, agreed that in principle a director could be fixed with tortious liability in respect of negligent advice, statements or the ‘provision of services’ where the ‘existence of a special relationship between plaintiff and tortfeasor,’ could be proved. Thus, the party seeking to make out the elements of the tort must prove:
(i) that based on things said or done by the defendant, the tortfeasor had conveyed, directly, or indirectly, that he had assumed personal responsibility for the claimant’s loss; and
(ii) that it was reasonable for the claimant to have relied upon the assumption of responsibility by the tortfeasor, such as to create a special relationship between the parties.
Thus, as Mr. Mistlin had neither dealt with the plaintiffs personally, nor given any undertaking that he was personally responsible for the plaintiff’s reliance on the projections, he could not be said to have assumed personal responsibility for the claimaint’s. The effect of this decision, however subtle, cannot be understated as it renders directors nearly invulnerable from tort claims by company clients where those clients have suffered pure economic loss directly as a result of the director’s negligence.
Firstly, Lord Steyn identified the company’s separate legal identity as the shroud from which a director must have emerged before he could be said to have personally assumed responsibility. It is only where a director ‘has positively abandoned the shield of the company’s separate personality’ that personal liability may accrue (Grantham and Rickett, 1999: 138). Secondly, Lord Steyn demonstrated that he favoured the “assumption of responsibility” test over the “threefold” test as being determinative in deciding whether a director could be held liable under the “extended” Hedley Byrne principle. Quoting from the judgment of Lord Goff in Henderson, his Lordship held that once the requisite elements of the tort had been made out, there was then ‘no need to embark on any further inquiry whether it is “fair, just and reasonable” to impose liability for economic loss,’ dismissing both judicial and academic hostility to the assumption of responsibility test.
The rejection of the threefold test suggests that ‘traditional issues of “proximity” and “neighbourhood”’ are irrelevant as to whether a director will be directly liable in tort since he carries out his functions on behalf of the company. Therefore, in the absence of ‘things said or done’, there can be no special relationship between the director and the claimant and thus no assumption of personal responsibility by the former to the latter. Indeed, it is the author’s view that where a client deals with the company, there is a presumption against the assumption of responsibility by the individual director unless the plaintiff is able to prove, on the evidence, that the director has said or done something that the law ought to deem as being an effective assumption of responsibility.
Consequently, it becomes clear that the ‘assumption of responsibility’ doctrine, as applied in Williams, is not only restrictive and narrow in its scope of application, but is also difficult to pin down as a coherent principle of law.
Accordingly, there is clearly a cause for concern where a third party enters into a business transaction with a small “one-man” company purely on the basis of the director’s experience and business acumen. Where the company is under-capitalised and the director has not ‘said or done’ anything such as to assume personal responsibility, the effect of Williams is that the company client is left bereft of an effective remedy in respect of the director’s negligence for which he has sustained pure economic loss.
3. The Direct Liability Of Professional Employees
In stark contrast, the subsequent Court of Appeal decision in Merrett v Babb has proven difficult to reconcile with the decision in Williams. The former decision concerned a prospective mortgagor who had approached a building society with a view to obtaining a loan. The building society then engaged a firm of surveyors to carry out a valuation of the property. This was was negligently performed by Mr. Babb, a salaried employee of the firm whose surveyor’s report failed to notice several structural defects. The mortgagor then commenced proceedings against Mr. Babb in his personal capacity as the firm had since ceased business following the bankruptcy of its principal partner. The Court of Appeal (Aldous LJ dissenting) applied Smith v Eric S. Bush; Harris v Wyre Forest District Council, holding that the individual surveyor did owe a duty of care to the plaintiff in his personal capacity and was therefore personally liable for financial losses incurred as a result of his negligence, notwithstanding that the defendant was uninsured in respect of the claim.
May LJ, with whom Wilson J expressed agreement, was of the view that the facts before him were ‘barely distinguishable from those in Harris v Wyre Forest District Council’ and thus, he was bound to find in favour of the plaintiff. Having canvassed a great deal of the authority concerning when a duty of care would arise in respect of pure economic loss, May LJ concluded that in addition to the ‘necessary ingredient’ of reliance, ‘[t]he question in each case is whether the law recognises that there is a duty of care.’ In answering this question in the affirmative, May LJ relied upon the judgment of Lord Griffiths in Smith v Eric S. Bush wherein his Lordship stated:
‘The valuer is discharging the duties of a professional man whether he is…acting on his own account or is employed by a firm of independent surveyors. The essence of the case against him is that he as a professional man realised that the purchaser was relying upon him to exercise proper skill and judgment in his profession and that it was reasonable and fair that the purchaser should do so.’
In reaching his decision, Lord Griffiths unequivocally employed the threefold test of forseeability, proximity and whether it would be fair, just and reasonable to impose liability in deciding whether a duty of care existed. Thus, what becomes clear is that the reconciliation of Williams and Merrett v Babb lies in the fact that whilst a director carries out his duties on behalf of the company, the professional employee attracts a higher standard of care as he is in a position to know the importance placed on the quality of his work and the risk borne by the plaintiff should he (the professional employee) be negligent.
This distinction can be most clearly observed from the fact that establishing reliance under Williams involves determining whether the claimant, in relying upon the tortfeasor’s assumption of responsibility, was reasonable in doing so. Comparatively, the element of reliance as viewed by Lord Griffiths and May LJ, asks whether the tortfeasor knew, or ought to have known, that he was being relied upon. Once it can be proven that that the defendant knows ‘that specific interests of the plaintiff are at issue,’(Dugdale and Stanton, 1998: 119) there is no further inquiry as to whether the claimant was reasonable in relying upon the quality of the defendant’s work. Whilst the knee-jerk reaction may be that this unfairly places employees in a vulnerable position, it is submitted that where one deals with a professional, there is an expectation of the level of service rendered.
4.1 Is The Direct Liability Of Professionals Justifiable?
At the outset, it is observed that the vulnerability of the professional employee’s position may be justified on the basis that professionals occupy a unique position in society. Jackson and Powell (2002: 1) point out that not only is professional work ‘skilled and specialised’ with substantial training a prerequisite, but that professionals are often bound by ethical codes of conduct. Furthermore, independent bodies made up of esteemed members of that profession often regulate and promote standards of excellence whilst ensuring that ethical and professional conduct is adhered to. Finally, being a professional clearly attracts prestige and status in the community, (Jackson and Powell, 2002: 2) which often makes the occupation an attractive one.
As Witting points out (2004: 68), the decision of Merrett v Babb serves as a ‘corrective for failures by professional bodies to regulate effectively’ and as a reminder that the court may adopt a ‘standards-setting “function”’. The standard referred to here is clearly the requirement to exercise reasonable care and skill in the course of one’s work. However, the distinguishing characteristic is the nature of the work contracted for, which will be of a specialised nature. Therefore, it can be said that the expectations placed on professionals are represented in law by the imposition of a more onerous duty of care that takes into account the subjectively higher level of their skills.
4.2 Should Incorporation Protect Professional Employees From Direct Liability?
As highlighted by Whittaker and Machell (2008: 804), a growing number of professionals are converting their traditional partnerships into Limited Liability Partnerships as ‘part of their broader risk management strategy.’ However, simply because professionals ‘…are allowed to provide their services by way of limited liability companies,’ does not detract from the fact that ‘…the actual work [is] done by natural persons, either directors or other employees…themselves often professionally qualified.’ Furthermore, judicial antipathy towards employing the restrictive ‘assumption of responsibility’ test in relation to professionals is indicative of the underlying policy reasoning that professionals ought to be subject to a higher standard of care than the reasonable man. As a consequence, the corporate identity of a professional employee’s firm is of no relevance in determining the direct liability of the professional employee for negligence occasioning pure economic loss.
The recent decision of Yazhou Travel Investment Co Ltd v Bateson Starr (A Firm), by the High Court in Hong Kong, demonstrates the devastating effectiveness of tortious liability in “circumventing” the separate legal identity of the corporate employer. In considering the direct liability of two consultant solicitors who were employees of the defendant firm for negligence causing pure economic loss, Judge GP Muttrie considered both Williams and Merrett v Babb and concluded that the plaintiffs had reasonably relied on a valid assumption of responsibility by the solicitors towards the claimant, so as to create a special relationship between the parties. The learned judge then proceeded to comment obiter dictum:
‘I venture to suggest that in most cases, simply because of the personal nature of the solicitor-client relationship, there will be such a special relationship…The client sees the solicitor as “my solicitor” and relies [reasonably] on him as such…The solicitor…knows that the client will suffer injury if he makes a mistake in his professional work.’
With respect, this analysis lends itself to the application of the threefold test in Caparo v Dickman and Merrett v Babb rather than a valid application of the assumption of responsibility doctrine laid down in Williams. Nonetheless, the point made by the learned judge is explicitly clear. A solicitor, or any professional for that matter, is in a unique position as regards his client, even where the contractual agreement (retainer) exists between that professional’s employer and the client. Indeed, direct liability may be warranted not just because higher expectations are placed on professionals, but because a central aspect of their job involves direct dealings with clients of their corporate employers.
4.3 A Call for Uniformity
Unlike professionals who gain their status based on accreditation and the other factors mentioned above, anyone may be a director provided that there are no restrictions in the articles prohibiting their appointment and that the procedural requirements of the Companies Act 2006 are complied with. Nonetheless, it is the author’s view that the distinction between a plaintiff who relies upon a professional and a plaintiff who chooses to deal with a small, private company based on the skill and experience of the director of that company is unjustifiable. Whilst it is not contended that directorship should be considered a profession, there is clearly a need to take into account more than just ‘things said or done’ in determining a director’s tortious liability for causing pure economic loss.
Indeed, in 2007 – 2008, out of the 2,686,500 companies registered at Companies House, 2,228,800 were private companies limited by shares with an issued share capital of £100 or less, pointing to the systemic trend of under-capitalisation of private companies. In the case of a one-man company (where the individual is both director and majority/sole shareholder), the effect of such under-capitalisation is to limit a director’s liability qua shareholder. The fact that the separate legal identity of the company was considered sacrosanct in Williams, has the further effect of protecting a director’s position qua employee. Short of personally indemnifying a company client’s losses such as to be deemed as having assumed responsibility towards that client, the interposition of the company’s separate legal identity renders a director’s tortious liability for causing pure economic loss almost purely a matter of academic debate rather than practical concern.
However, it is submitted that based on the origins of the “assumption of responsibility” doctrine, it is the author’s view that the position may not be as settled as it seems. Whilst the original expression used in Hedley Byrne was that of a ‘voluntary assumption of responsibility’, subsequent decisions have since done away with the requirement of “voluntariness”. Lord Griffiths, in Smith v Eric S. Bush, stated that:
‘The phrase “assumption of responsibility” can only have any real meaning if it is understood as referring to the circumstances in which the law will deem the maker of the statement to have assumed responsibility.’
Subsequently, in Phelps v Hillingdon London Borough Council (decided after Williams), Lord Slynn suggested that the assumption of responsibility:
‘…means simply that the law recognises that there is a duty of care. It is not so much that responsibility is assumed as that it is recognised or imposed by the law.’
Accordingly, the assumption of responsibility test may be interpreted as a willingness of the courts to impose a duty of care on a tortfeasor as it would be illogical for an employee to expressly indemnify a client against his losses. Though the ‘primary focus’ must be on ‘things said or done’, the fact that the assumption of responsibility is objectively determined allows the court to consider secondary factors such as whether, on the facts before it, liability ought to be imposed. As Stanton (2006: 147) insightfully notes, there is a growing willingness of the judiciary not to champion any one test and that an amalgamated approach has since grown in popularity. Furthermore, in her analysis of Lord Steyn’s speech in Williams, Lady Justice Arden stated:
‘…where…it is common ground that the person providing the information has special knowledge, the critical question is whether, when the circumstances are viewed objectively, the defendant must be taken to have assumed responsibility for the provision of that information to the claimant.’
Therefore, an objective appraisal of whether an assumption of responsibility has occurred will likely mean that questions of proximity and forseeability may filter into the decision making process. Whilst such an “ad hoc” approach may justify academic criticism that ‘…the tests being posited are in reality shrouds for discretionary decisions driven by the policies underlying the circumstances,’ a degree of certainty must be sacrificed in order to ensure the availability of an adequate remedy.
4.4 Conclusion
It has been argued that where a company is insolvent, the direct liability of professional employees is not only attractive and plausible, but desirable as the professional employee occupies a unique position qua professional. Whilst established company law principles firmly safeguard the position of directors against claims for negligence causing pure economic loss, it is contended that Williams may not be the last say in the direct liability of directors, especially with regards to “one-man” companies. The purpose of limited liability has always been the protection of the equity investors of the company whilst the separate legal identity of a company facilitates its ability to trade as a commercial entity. To date, opportunistic directors have unfortunately used the latter characteristic of the corporate entity as an effective disclaimer of personal responsibility. Therefore it is the author’s view that where a company is insolvent, the availability of direct liability of corporate employees under the tort of assumption of responsibility will have the twin effects of deterring such undesirable behaviour and providing corporate clients with an effective form of compensation.
Bibliography
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Bank of Credit and Commerce International (Overseas) Ltd v Price Waterhouse [1998] PNLR 564
Bolam v Friern Hospital Management Committee [1957] 1 WLR 582
C Evans & Sons Ltd v Spritebrand Ltd [1985] 1 WLR 317
Caparo Industries Plc v Dickman [1990] 2 AC 605
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Smith v Eric S. Bush; Harris v Wyre Forest District Council [1990] 1 AC 831
Spartan Steel & Alloys Ltd v Martin & Co (Contractors) Ltd [1973] QB 27
Spring v Guardian Assurance plc [1995] 2 AC 296
Standard Chartered Bank v Pakistan National Shipping Corporation (No. 2 and 4) [2003] 1 AC 959
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White v Jones [1995] 2 AC 207
Williams v Natural Life Health Foods Ltd [1997] 1 BCLC 131
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Statutes
Companies Act 2006 (c.46) (London: HMSO)
Insolvency Act 1986 (c.39) (London: HMSO)
Insolvency Rules 1986 (SI 1986/925) (London: HMSO)
Limited Liability Partnership Act 2000 (c.12) (London: HMSO)
Websites
Companies Register Activities, Companies House Official Website, available online at <http://www.companieshouse.gov.uk/about/companiesRegActivities.shtml> (Last Visited 17 March 2009)
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