Sunk cost is money or resources that have already been spent and cannot be recovered.
In simple terms, imagine you bought a non-refundable concert ticket for RM 600, but on the day of the movie, you can’t make it. The RM 600 you spent on the ticket is sunk cost because you can’t get that money back, unless you’re able to sell it to someone else.
In the legal world, understanding sunk costs can help with making decisions about ongoing or future investments. For example, if a company has spent a lot of money on a project that isn’t working out as planned, the company needs to determine whether to continue funding the project. If they consider the sunk costs in their decision, they might be tempted to keep spending more to justify the initial expense. After all, you’re already in this deep, you might as well make a commercial decision to go all the way.
We’ve advised several companies on recovery of sunk costs and directors’ liability, which usually occurs when there is a boardroom tussle, change in directors or shareholders. Here are several key legal ramifications to consider:
1. Fiduciary Duty:
Directors have a fiduciary duty to act in the best interests of the company and its shareholders. This includes making prudent financial decisions. If directors continue to invest in a failing project solely to recover sunk costs, they may be breaching their duty by not acting in the company’s best interests.
2. Business Judgment Rule:
The business judgment rule protects directors from personal liability if they make informed, good faith decisions in the best interest of the company.
However, if it can be shown that directors ignored economic realities (such as continuing to fund a losing project to recover sunk costs), they might not be protected by this rule.
3. Duty of Care:
Directors must exercise due care, diligence, and skill in their decision-making processes. Persisting with a project because of sunk costs without a reasonable expectation of future return may be seen as a lack of due diligence.
4. Insolvency and Creditor Interests:
If a company is nearing insolvency, directors’ duties shift to consider the interests of creditors.
Mismanagement in the form of ignoring sunk costs and making poor financial decisions can lead to personal liability for directors if it exacerbates the company’s financial problems.
5. Shareholder Lawsuits:
Shareholders may sue directors for mismanagement if decisions appear to be influenced by an irrational focus on sunk costs.
Directors can be held liable for losses caused by such mismanagement, especially if these decisions result in a significant decline in the company’s value. So it is incumbent on the directors to ensure that necessary steps are taken to justify/ mitigate and substantiate any decisions made on behalf of the company.