What is the Boards Exposure to Identified Business Fraud

What is the board’s liability /exposure to identified business fraud?

Corporate criminal laws are being revised and strengthened across the globe to respond to the development of sophisticated fraud schemes, advancements in technology facilitating these schemes, and in the wake of corporate collapses arising from business fraud. Fraud schemes range from the simple to the complex in terms of how these are perpetrated and can take many forms. Whether this be internal or external fraud, ranging from asset misappropriation and embezzlement, through to cyber attacks and supplier or customer fraud, the cost on your business can be significant.

You can read about internal and external fraud here.

Core Principles owed to Corporate Entities

To understand the board’s potential liability to identify business fraud, we must give consideration to fundamental principles relating to directors and their obligations to a company. This includes understanding the concept of the “corporate veil” – that is, the legal distinction between a corporation and its shareholders, directors, and officers.

 

This principle establishes that a company is a separate legal entity from its owners, thus protecting them from personal liability for the company’s debts and obligations. Conceptually, the “corporate shield” protects directors’ personal assets from business-related risks and liabilities.

For companies incorporated and operating in Australia, directors and officeholders owe strict duties and obligations to the company. These obligations, often referred to as fiduciary duties, are derived from common law, equity and statute. 

 

The four main legal duties based on general law and statute are to:

  1. Act in good faith and for a proper purpose
  2. Act with reasonable care, skill and diligence
  3. Not to improperly use information or position
  4. Disclose and manage conflicts of interest

What about Charities and NFPs?

Importantly, for charities and not-for-profits, including those incorporated associations and those registered with the Australian Charities and Not-for-Profit Commission (ACNC), the directors or committee members are obliged under the governance standards and held to the same level of responsibility and accountability.
These duties, summarised below, are extracted from ACNC Governance Standards 5: Duties of Responsible Persons:

  • To act with reasonable care and diligence;
  • To act honestly and fairly in the best interests of the charity and for its charitable purposes;
  • Not to misuse their position or information they gain as a responsible person;
  • To disclose conflicts of interest;
  • To ensure that the financial affairs of the charity are managed responsibly; and
  • Not to allow the charity to operate while it is insolvent.

When the “Horrible” Happens

When a business fraud occurs, the spotlight is inevitably turned to the directors and officers of the company. The questions asked include:

  • What did the directors and other officers do to minimise the risk of organisational fraud occurring?
  • Can the directors and other officers be held personally liable for what has occurred?
  • Can those directors and other officers demonstrate that they have adequately discharged their duties when the organisation falls victim to fraud?

Strategies to Reduce Personal Liability from Business Fraud

As they say, prevention is better than cure. From the onset, an organisation is best placed to mitigate fraud occurring through measures including:

  • Promoting a strong ethical corporate culture and “tone at the top”;
  • Implementing a carefully designed and effectively operating internal control environment;
  • Ensuring there are documented policies, procedures and protocols bolstered with ongoing training and awareness;

Establishing a Framework for Managing Fraud Risks

It is crucial for organisations to have checks and balances in place to identify and prevent fraud. You can read about ‘recognising the red flags’ and obtain practical suggestions to combat business fraud here. Other advisable measures for directors and office holders includes deeds of indemnity and insurance.

Understanding Deeds of Indemnity

A deed of indemnity is a contractual agreement between a company and a company director. A deed of indemnity can help to indemnify a director against liabilities or legal costs incurred in his or her professional capacity as a director of the company.

It also commonly deals with matters such as access to documents and insurance. Importantly, the indemnity and insurance clauses detail specifically:

  1. The company’s indemnity in favour of the director (including the rights and obligations of the parties in the event that a party seeks to rely on the indemnity), and
  2. Each parties’ rights and obligations in relation to directors’ and officers’ (D&O) liability insurance which can include the type and term of insurance cover to be maintained, respectively.

It is preferable for a dirctor to enter into a separate deed with the company to provide protection for a director, particularly for that period of time after they cease serving as a director of the company. The scope of each deed of indemnity will depend on the position agreed by the company and the director.

It is prudent for the director to obtain independent legal advice before entering the deed of indemnity.

Exploring D&O Insurance

Directors and officers (D&O) insurance indemnifies a director for liabilities incurred in the role of director. It is similar to a deed of indemnity but provides important additional protection where the company:

  • is legally prohibited from indemnifying a director;
  • decides not to indemnify a director; and/or
  • is unable to indemnify a director because, for example, it is insolvent.

D&O insurance offers additional benefits such as continuity of cover (after a director ceases holding office) and clarity regarding the ongoing rights and obligations of the directors and the company.

There are new and emerging risks that can lead to legal actions and claims, including allegations and instances of business fraud, breach of privacy, environmental liability, employment practice liability, and other disclosure and regulatory issues.

Directors and officers should consider their personal risk appetite to ensure any material business risks are captured in the relevant deed of indemnity and insurance policy.

A Word of Caution

As noted earlier, the concept of the “corporate veil” can potentially be “lifted” (or figuratively “pierced”) ultimately reducing or eliminating the protections afforded by the corporate shield to directors’ personal assets being exposed to business-related risks and liabilities.

Directors can be personally exposed in circumstances including:

  1. Breaches in fiduciary duties: This includes not acting in the best interests of the company, not managing material conflicts of interest, failing to exercise their powers and discharge their duties in good faith, or intentional dishonesty.
  2. Fraud: If a director uses the company for fraudulent purposes, they can be personally liable for the company’s liabilities.
  3. Insolvent Trading: Directors can be personally liable if they allow the business to incur debt while insolvent.
  4. Avoiding Legal Obligations: If a director uses the corporate structure to avoid legal responsibilities, courts may lift the veil to hold them personally accountable. This includes illegal phoenix activity.
  5. Statutory Regimes: Various laws, including the Corporations Act 2001, Australian Consumer Law, and Tax Administration Act 1953, can impose personal liability on directors for specific violations.
  6. Personal Guarantees: Directors or shareholders may voluntarily accept personal liability for business debts.

Safeguard Against Personal Liability Due to Business Fraud

A strong ethical culture, carefully designed and effectively operating internal control environment and ongoing internal and external audit activity offers the greatest preventative protection for your business against fraud. Obtaining relevant indemnities and insurance policies offers directors additional defensive protection in the event of an allegation or instance of business fraud. 

For an obligation-free chat, get in touch with the Bishop Collins Audit team. We can assist you with audit and assurance services, during which our experts will provide advice and guidance on how to protect your business against fraud, or how to deal with any fraudulent activity you suspect.

If you’re interested in learning more about internal and external audit, fraud risk management, and awareness training, get in touch with us for an obligation-free chat or simply call us on (02) 4314 8020