Our article addresses the liability of board members in joint stock companies under Turkish law, explaining the fault-based regime, delegation of authority, differentiated joint liability, the scope of discharge, the liability action, limitation periods and protection strategies.
Taking a seat on the board of directors of a joint stock company is as much the assumption of a serious legal risk as it is a position of standing. A loss suffered by the company, an erroneous decision taken, a neglected obligation or an irregularity that went unnoticed may, years later, turn into a claim for damages directed at the personal assets of the board members. In practice, many directors do not sufficiently assess the extent to which a minute they have signed, or a meeting they did not attend but to which they also entered no dissent, will bind them in the future. Yet the Turkish Commercial Code has bound the liability of board members to a detailed regime, has founded this regime on fault, and has provided that each member be assessed according to its own role and its own degree of fault. This article comprehensively examines the liability of board members in joint stock companies, the conditions of liability, the effect of the delegation of authority, the principle of differentiated joint liability, the scope and limits of discharge, the liability action, the limitation periods and the means by which directors may protect themselves.
1. The Legal Framework of Liability
The liability of board members in joint stock companies is regulated in the chapter of the Turkish Commercial Code headed legal liability. Under the provision at the centre of this regulation, founders, board members, managers and liquidators are, where they breach through their fault the obligations arising from the law and from the articles of association, liable for the loss they cause to the company, to the shareholders and to the company's creditors. The scope of this provision is strikingly broad; liability is not limited to board members alone, but also covers the company's founders at the incorporation stage, the managers exercising management authority and the liquidators in the liquidation process. The circle of persons towards whom liability is owed is likewise threefold; a member may be held liable towards the company itself, towards the shareholders and towards the company's creditors. This broad framework reveals the magnitude of the risk carried by board membership. However, this broad scope does not mean that liability is automatic or absolute; the law has bound liability to specific and strict conditions.
2. The Principle of Fault-Based Liability
Under Turkish law, the liability of board members is a liability based on fault; it is not strict liability. This distinction is exceedingly important. A board member cannot be held liable automatically merely because it serves on the board or because the company has made a loss. For liability to arise, a faulty conduct on the part of the member must exist. As regards the degree of fault, the law has drawn no distinction; a member may be held liable on account of its intent, its gross negligence and even its slight negligence. However, the degree of fault carries great importance at the stage of apportioning liability and becomes decisive in the application of the principle of differentiated joint liability. Fault is assessed according to the standard of care the member must show; what is expected of a board member is to show the care of a prudent manager and to observe the interests of the company in conformity with the rules of good faith. That a member conducted a reasonable inquiry when taking the decision, gathered the necessary information and decided having regard to the company's interest may leave it without fault even where the outcome subsequently turns out badly. The reality that commercial decisions carry risk by their very nature cannot be disregarded in the assessment of liability.
3. The Four Conditions of Liability
For the legal liability of a board member to arise, four conditions must exist together. The first condition is that an obligation arising from the law or from the articles of association has been breached. Among these obligations are a broad range, such as the duty of care and loyalty, refraining from transactions that will cause the company loss, keeping the books and records required by law in due form, convening the general assembly in time, and taking the necessary measures in cases of loss of capital and over-indebtedness. The second condition is fault; the breach must arise from the member's fault. The third condition is loss; it is required that the company, the shareholder or the creditor has suffered a concrete and provable loss. Proving the existence and the amount of the loss falls to the claimant and is, in practice, the most critical element determining the fate of such actions. The fourth condition is causation; there must be an adequate causal link between the member's faulty conduct and the loss arising. Where any one of these four conditions is not fulfilled, no liability arises. In judicial practice there are a considerable number of liability actions dismissed on account of the failure to prove, in particular, fault and the causal link.
4. The Duties of Care and Loyalty
At the centre of the liability of board members lie the duties of care and loyalty. The duty of care requires the member to perform its functions with the attention and care that a prudent manager would show. This standard is objective; the member's personal level of knowledge and experience does not lower what is expected of it. A board member, even where it is not an expert in the field, is obliged to evaluate the information presented to it, to ask questions on matters it does not understand, to obtain expert opinion where necessary and to conduct a reasonable examination. The duty of loyalty, on the other hand, requires the member to place the company's interest ahead of its own personal interest. This duty covers refraining from transactions creating a conflict of interest, not using company information for personal benefit and not competing with the company. The breach of these two duties constitutes the most widespread basis of liability actions. In practice, situations such as related party transactions, the irregular use of company resources and the non-disclosure of a conflict of interest are in particular assessed as breaches of the duty of loyalty and give rise to grave consequences in terms of liability.
5. Delegation of Authority and the Liability of the Delegating Member
In modern company management it is not possible for the board to conduct all business itself; for this reason the law permits the delegation of functions and authority. The effect of the delegation of authority on liability is a matter of great importance in practice. Under the law, board members or organs that delegate to another, on the basis of the law, the functions and authority arising from the law cannot be held liable for the acts and decisions of these persons unless it is proved that they failed to show reasonable care in the selection of the persons to whom the delegation was made. This regulation turns the delegation of authority into a genuine shield against liability; however, for this shield to be effective there are two conditions. The first condition is that the delegation has been made in conformity with the law, that is, by means of a duly adopted internal directive and within the framework provided for by the law; an irregular delegation does not produce the result of release from liability. The second condition is that reasonable care has been shown in the selection of the person to whom the delegation is made; a member who delegates authority to an incompetent or untrustworthy person remains liable for its carelessness in that selection. Moreover, the delegation of authority does not wholly eliminate the delegating member's duty of oversight; the member is expected to apply a reasonable supervision in the field it has delegated.
6. Breaches Beyond a Member's Control
The law has adopted a further important principle drawing the limits of liability; no one may be held liable on account of breaches of the law or of the articles of association that remain beyond its control. This principle is a clear reflection of the approach of individualising liability. In practice this principle provides great protection particularly as regards non-executive members and independent board members. It would not be fair for a member who does not take part in the day-to-day functioning of the company and who merely attends board meetings to be held liable for an irregularity never presented to it and impossible to notice through reasonable supervision. For this principle to operate, the member must establish that the breach in question remained outside its own sphere of control and that it was not possible to notice it through reasonable oversight. However, this protection is not unlimited; where a member has disregarded signs giving rise to suspicion, has failed to evaluate warnings that reached it or has deliberately avoided information, it cannot benefit from the defence of lack of control. In practice the courts make their assessment by examining in detail each member's job description, its actual role and its access to information.
7. Differentiated Joint Liability
One of the most important innovations introduced by the Turkish Commercial Code is the abandonment of the classic understanding of joint and several liability and the adoption of the model of differentiated joint liability. Under this model, where several persons are obliged to compensate the same loss, each of them is jointly and severally liable for that loss together with the others to the extent that the loss can personally be attributed to it, according to its fault and the requirements of the circumstances. This regulation expresses a radical break from the old understanding. Whereas in the old system the degree of fault mattered only in the internal relationship, that is, at the stage of recourse, in the new system the degree of fault has become decisive in the external relationship too. The practical result is this; a member at slight fault cannot be held liable for the entirety of the loss caused by a member at grave fault, but is liable only for the portion corresponding to its own fault. This model provides serious protection particularly as regards members to whom authority has been delegated, non-executive members and independent members. Moreover, differentiated joint liability operates only as regards a loss caused jointly; for a loss caused by a member alone, only that member is held liable.
8. The Legal Effect of Discharge
The discharge decision given by the general assembly is an exceedingly important institution as regards the liability of board members. Discharge is a declaration of will meaning that the general assembly approves the transactions of the board members relating to the relevant financial period and will not claim liability on account of these transactions. With the giving of a discharge decision, the company's right to bring an action against the board members as regards the transactions within the scope of the discharge ends as a rule. Shareholders who voted in favour of the discharge likewise cannot benefit from this right. As regards shareholders who voted against the discharge or who did not attend the general assembly, there is a special regulation; the right of these shareholders to bring an action lapses upon the passing of six months from the date of the discharge. This short period may lead to serious losses of rights in practice; a shareholder objecting to the discharge decision must act within the six-month period. It is clear that the discharge decision is one of the most effective instruments available to board members for managing liability risk; for this reason care must be taken to obtain a discharge at the end of each financial period.
9. The Limits of Discharge
Although discharge provides strong protection, it is not an absolute and unlimited shield. The most important limit of discharge relates to its scope. Discharge produces effect only as regards transactions submitted to the knowledge of the general assembly and known to it. Transactions concealed or withheld from the general assembly or remaining outside its knowledge, and the losses arising from them, fall outside the scope of the discharge. This rule is a fundamental safeguard preventing the abuse of discharge; otherwise, board members could escape liability by obtaining a discharge while concealing their irregular transactions. Accordingly, as regards a loss that emerges subsequently and was unknown at the time of the general assembly, a discharge decision that has been given does not protect the members. A further limit of discharge relates to persons; the discharge decision ends the right of action of the company and of the shareholders who voted in favour, but does not affect the right of action of the company's creditors. Particularly in the event of the company's bankruptcy, a discharge decision does not constitute a defence as regards the claims directed by creditors against board members. These limits show the danger of neglecting risk management in reliance on a discharge.
10. The Liability Action and the Parties
The liability action to be brought against board members carries a structure of its own as regards the capacity to sue. The company may bring an action directly on account of the loss it has suffered; this action is conducted by a decision of the general assembly or, in the event of bankruptcy, by the bankruptcy administration. Shareholders too may bring an action; however, there is an important distinction here. In an action brought by a shareholder on account of the loss suffered by the company, it is requested that the compensation be paid to the company; the shareholder acts not in its own name but indirectly, for the making good of the company's loss. By contrast, where a loss has arisen directly in the shareholder's own assets, it may request that this loss be paid to it. As regards the company's creditors, the right of action arises as a rule in the event of the company's bankruptcy; in this case the creditors may request compensation for the company's loss. The court before which the action is to be brought is the commercial court of first instance at the place of the company's head office. For the action to succeed, the four conditions of liability must be proved by the claimant; the amount of the loss and the causal link are, in practice, the elements most difficult to prove.
11. Limitation Periods
The period within which the liability action may be brought is expressly regulated in the law. The liability action is subject to a limitation period of two years from the date on which the claimant learned of the loss and of the person liable, and in any event five years from the date on which the act giving rise to the loss occurred. These two periods run together; the short period of two years begins from the moment of learning, while the long period of five years begins to run from the date of the act and expires even where learning has not occurred. As regards the limitation periods, the matter most debated in practice is when the moment of learning occurred; this determination directly affects whether the action has been brought within time. It is accepted that learning requires not merely being aware of the existence of the loss, but also knowledge of who the person liable is and of the extent of the loss. Moreover, where the act at the same time constitutes an offence and a longer limitation period is provided for in the criminal laws, that longer period applies. The shortness of the limitation periods requires rights holders to act swiftly the moment they notice the loss; delay may lead to the dismissal of the action without an examination of the merits.
12. The Importance of Recording Dissent
One of the most effective and most practical instruments as regards protecting board members from liability is the recording of dissent. Where a board member does not have its dissent from a decision it did not support entered in the minutes of the meeting, it is deemed to have participated in that decision and may be held liable for the loss arising from it. By contrast, a member who has its dissent duly entered in the minutes is as a rule released from liability arising from that decision. In practice this matter is unfortunately neglected frequently; members fail to record their dissent owing to a concern for harmony in the meeting environment or an insufficient grasp of the importance of the matter, and years later face a serious risk of damages. For the recording of dissent to be effective, it is useful that not only the fact of opposition to the decision but also the grounds of the dissent be clearly entered in the minutes. Likewise, it is important that a member who did not attend the meeting clarify its position upon learning of the decision and, if necessary, have its objection recorded. The regular keeping of meeting minutes, the reasoning of decisions and the filing of the information and documents on which the decision was based constitute decisive evidence in a liability action to be brought in the future.
13. Criminal Liability and Administrative Sanctions
The liability of board members is not only of a civil nature; in certain cases criminal liability and administrative sanctions may also come onto the agenda. Commercial law legislation provides for criminal sanctions as regards various acts such as the breach of the obligation to keep books, the irregular preparation of documents and irregularities relating to capital undertakings. Alongside this, legislation in fields such as tax, social security, competition, data protection and the environment may further impose administrative fines and cases of liability as regards company directors. As regards criminal liability, the basic principle to be observed is the personal nature of penalties; under this principle a person may be punished only for its own act. For this reason, sanctions applied merely by reliance on the capacity of being a board member constitute a breach of the principle of the personal nature of penalties and may be annulled on judicial review. Board members must follow closely their obligations in these fields as much as their civil liability, must ensure that the company's compliance systems are functioning and must have a command of the legislation in their own fields of responsibility.
14. Strategies for Protection from Liability
There are various strategies to which board members may have recourse in order to manage liability risk. The first strategy is the documentation of the decision-making process; before each important decision, sufficient information must be gathered, expert opinion must be obtained where necessary and this process must be recorded in writing. Documenting that a decision rested on a reasonable inquiry is the strongest evidence of the absence of fault. The second strategy is the meticulous use of recorded dissent. The third strategy is making the delegation of authority in due form; clear job descriptions must be established by means of an internal directive and it must be documented that care was shown in the selection of those to whom delegation was made. The fourth strategy is taking care to obtain a discharge at the end of each financial period and ensuring that the information submitted to the general assembly is complete; a discharge resting on incomplete information provides no protection. The fifth strategy is taking out directors' liability insurance; this insurance constitutes an important safeguard against claims for damages arising from members' liability and is becoming increasingly widespread in corporate companies. The sixth strategy is the establishment of an effective compliance and internal control system within the company; a functioning compliance system both prevents breaches and constitutes evidence establishing the member's care.
15. Conclusion and Practical Recommendations
Board membership in a joint stock company brings, alongside important powers, a serious legal liability. The basic considerations in this field may be summarised as follows. Liability rests on fault; a member is liable only where it causes loss by breaching through its fault an obligation arising from the law or from the articles of association, and the proof of these four conditions falls to the claimant. Thanks to the principle of differentiated joint liability, each member is held liable only to the extent of its own fault; the understanding of collective and undifferentiated liability has been abandoned. A delegation of authority made in due form protects the delegating member, provided care was shown in the selection of the person to whom the delegation was made. No one may be held liable for breaches remaining beyond its control; this principle is an important safeguard particularly for non-executive and independent members. Discharge provides strong protection, but covers only transactions within the knowledge of the general assembly and does not affect the rights of creditors. The liability action is subject to limitation periods of two years and five years; rights holders must act without delay. Finally, recorded dissent, the documentation of decision processes, the correct structuring of the delegation of authority and directors' liability insurance are the most effective instruments in managing the risk.
The liability of board members is closely connected with the other fields of company law and commercial contract law. Our article on choice of law and jurisdiction agreements in international commercial contracts, which addresses the determination of the law applicable to companies' commercial relationships, and our analysis of force majeure and hardship in international commercial contracts, which examines extraordinary circumstances in the performance of contractual obligations, address the matters connected with the liability of board members.
For advisory services on the liability of board members, liability actions, discharge processes, the structuring of delegations of authority and the establishment of corporate compliance systems, you may contact us at info@guzeloglu.legal.