corporate law

http://www.thecorporation.com

http://www.apra.gov.au

[page 19]

Australian Securities and Investments Commission:

Role and Powers

CHAPTER 2 Establishment, status and organisation Transparency and accountability Role Principal functions

Register and regulate companies Receive and process information Register company auditors and liquidators Regulate financial markets and providers of financial services Regulate the creation of and trading in futures contracts Investigate contraventions of the corporations legislation Investigate contraventions of the provisions of the consumer protection laws

Powers

Exemption power Investigations and information gathering

[page 20]

Enforcement action after investigation Protection of private interests

Obligations as to fairness Self-incrimination Legal professional privilege Duty of confidentiality

Parliamentary inquiry into ASIC’s performance

[page 21]

Australian Securities and Investments Commission: Role and Powers

Learning Objectives After completing this chapter you should be able to:

Understand the law governing the establishment and organisation of the Australian Securities and Investments Commission (ASIC).

Explain the role and functions of ASIC.

Describe the general powers of ASIC.

Comprehend the investigative powers of ASIC.

Explain what action ASIC can take during the course of, or after completing, an investigation.

Outline the safeguards afforded to individuals when an ASIC investigation is being conducted and explain the problems which exist in these safeguards.

Key Cases

ASIC v DB Management Pty Ltd (2000) 199 CLR 321; [2000] HCA 7

ASIC v Hellicar (2012) 286 ALR 501; [2012] HCA 17

ASIC v Plymin (No 2) (2002) 20 ACLC 1756; [2002] VSC 356

ASIC v Vizard (2005) 23 ACLC 1309; [2005] FCA 1037

Australian Securities Commission v Zarro (1991) 6 ACSR 385; 10 ACLC 11

Laycock v Forbes (1997) 25 ACSR 659

National Companies and Securities Commission v News Corporation Ltd (1984) 2 ACLC 301

Otter Gold Mine Ltd v ASC (1997) 15 ACLC 1732; [1997] FCA 1199

R v Norton Smith (1998) 16 ACLC 1152; [1998] TASSC 48

Re Guardian Investments Pty Ltd; Wade v Guardian Investments Pty Ltd (1984) 2 ACLC 165

Sorby v Commonwealth (1983) 152 CLR 281

Key Sections

Corporations Act 2001 (Cth) ss 464, 596A, 596B, 657, 1323, 1324

Australian Securities and Investments Commission Act 2001 (Cth) ss 1, 11, 12, 13, 19, 29, 49, 50, 68, 69, 93AA, 127, 244

• •

2.1

[page 22]

Introduction

The effectiveness of the law governing corporations, like any other law, depends on the mechanisms available for its enforcement. Recognising this, the Commonwealth Parliament has established an independent, public regulatory authority, the Australian Securities and Investments Commission (ASIC), to administer all aspects of Australia’s corporate law. ASIC is led by five Commissioners, accountable to the Commonwealth Government Minister and the Parliament, and is also held accountable through administrative and judicial review.

Under its charter, ASIC is required to take whatever action it can take, and is necessary, in order to enforce and give effect to the laws of the Commonwealth that confer functions and powers on it: Australian Securities and Investments Commission Act 2001 (Cth) s 1(2)(g) (ASIC Act). The laws that confer functions and powers on ASIC include:

Corporations Act 2001 (Cth); and Australian Securities and Investments Commission Act 2001 (Cth).

These two pieces of legislation are commonly referred to as the corporations legislation: ASIC Act s 5. ASIC also has other regulatory functions under many other areas of the law, including superannuation, insurance, consumer credit, finance broking and banking. Thus, ASIC is also Australia’s corporate, markets and financial services regulator. However, for purposes of this chapter, ASIC’s primary responsibility is to administer the national scheme laws governing corporations in Australia. Accordingly, the focus in this chapter is on the work done by ASIC under the Corporations Act and the ASIC Act.

Establishment, status and organisation

ASIC was established in 1980 as the national corporate watchdog and was originally known as the National Corporations and Securities

Commission (NCSC). However, in 1991, the NCSC and the Corporate Affairs Offices of the states and territories were replaced by the Australian Securities Commission (ASC) which, in turn, was renamed as the Australian Securities and Investments Commission (ASIC) in 1998 to reflect its expanded brief when additional functions were vested in ASIC.

Since 1998 ASIC has been entrusted with the added responsibility of administering the laws designed to promote the integrity of the Australian payments system and the insurance and superannuation industries, with a view to enhancing the protection of the interests of consumers of financial products and services. Consequently, ASIC enforces and regulates company and financial services laws to protect investors, creditors and consumers.1In 2010 ASIC took on additional responsibilities for regulating trustee companies, consumer credit and finance broking (such as home loans, personal loans, credit card and consumer leases). On 1 August 2010, ASIC also assumed responsibility from the Australian Securities Exchange (ASX) for the supervision of trading on Australian licensed equity, derivatives and futures markets.

[page 23]

From 28 May 2012, ASIC became responsible for the national Business Names Register by taking over this responsibility from the states and territories. More than 1.4 million active business names were transferred to the new register. ASIC has published Regulatory Guide 235 Regulating your business name to assist people who wish to run a business in Australia using a distinctive business name (a name other than their own name). See further Chapters 3 and 4.

The law establishing ASIC requires that it be composed of not less than three and not more than eight members: ASIC Act s 9. At least three members must be full- time members. Members are formally appointed by the Governor-General, on the recommendation of the responsible Commonwealth Minister. Only people qualified by knowledge or experience in business, administration of companies, financial markets, financial products, financial services, law, economics or accounting may be nominated as members: ASIC Act s 9. The responsible Minister is the

2.2

Commonwealth Treasurer. ASIC must have a chairperson and a deputy chairperson, both of whom are appointed by the Governor-General: ASIC Act s 10.

ASIC is required to, and has, established a regional office in every state and territory to serve the interests of business communities around Australia. In 2015–16, the operating expenditure of ASIC was $371 million. A user-pays funding model has been introduced under the ASIC Supervisory Cost Recovery Levy Act 2017, effective 1 July 2017. This new law changes the way ASIC is funded. Under the new arrangements, regulated entities will receive an invoice for ASIC’s regulatory services delivered in the prior year.2

Transparency and accountability

ASIC is statutorily independent of the Commonwealth Government. However, in order to ensure its accountability to parliament, and ultimately to the public, ASIC is accountable to a Commonwealth Minister. The Parliamentary Joint Committee on Corporations and Financial Services provides parliamentary oversight of ASIC.

Under s 12(1) of the ASIC Act, the Minister has authority to give written directions of a general nature to ASIC about the policies it should pursue or the priorities it should adopt in the performance of its duties. In practice, the directions power has been rarely exercised.3 It was last used in 1992 when the Commonwealth Government gave direction to ASIC regarding its relationship with the Commonwealth Director of Public Prosecution in the investigation and prosecution of serious corporate

[page 24]

wrongdoing. To ensure the independent operation of ASIC and its objectivity, the Minister has no power to give ASIC directions about a particular matter.

2.3

•

ASIC is also subject to external accountability by the Commonwealth Parliament. An additional level of transparency and accountability is provided by the review of decisions made by ASIC. The majority of ASIC’s powers and discretion are subject to judicial or administrative review (or both) by the Federal Court and the Administrative Appeals Tribunal respectively. Actions by members of ASIC are also subject to judicial review. As a consequence of the members being appointed by the Commonwealth, members of ASIC are officers of the Commonwealth for the purposes of s 75 of the Commonwealth Constitution.

Role

ASIC regulates Australian companies, financial markets, financial services organisations and professionals who deal and advise in investments, superannuation, insurance, deposit taking and credit. For the purposes of this chapter, discussion is confined to the traditional corporate watchdog function that ASIC performs over the 2.3 million Australian companies in existence. Following the referral by the states of their powers over corporations to the Commonwealth in 2001,4 Australia now has a national scheme for the regulation of companies. ASIC is responsible for administering this scheme of law.

In discharging this responsibility, ASIC is required to strive to promote a fair, efficient and competitive capital market environment. More particularly, s 1(2) of the ASIC Act requires ASIC to strive to:

maintain, facilitate and improve the performance of the financial system and the entities within that system in the interests of commercial certainty, reducing business costs, and the efficiency and development of the economy; promote confident and informed participation of investors and consumers in the financial system;5 administer the law effectively and with a minimum of procedural requirements; receive, process and store, efficiently and quickly, the information given to ASIC; ensure that information is available as soon as practicable for access

•

2.4

2.5

by the public; and take whatever action it can take, and is necessary, in order to enforce and give effect to the law.6

In addition, ASIC is responsible for overseeing certain aspects of the Australian financial system and in promoting market integrity and consumer protection in relation to the Australian financial system: ASIC Act s 12A(3).

[page 25]

Importantly, ASIC also has some responsibility for law reform. ASIC is required to constantly examine the operation of the laws it administers, advise the Minister of any perceived deficiencies in the law and make recommendations to the Minister as to how these problems can be overcome: ASIC Act s 12A(5).

Although ASIC is dependent on its funding from the Commonwealth Government, why is it essential to ensure that ASIC performs its functions independently of the Commonwealth Government?

Principal functions

In the discharge of its responsibilities to administer the Corporations Act and regulate companies, ASIC performs a number of important functions. These include the following.

Register and regulate companies A very important function of ASIC is to register companies. The ‘company’ as a legal structure through which business is carried on has, over time, become increasingly popular. As of July 2016, there were 2.37

•

2.6

million registered companies in Australia. In 2015–16, ASIC registered 246,051 new companies. ASIC is responsible for regulating the activities of all companies operating in Australia. In 2015–16, ASIC raised $876 million for the Commonwealth in fees and charges, an increase of 6.4% from 2014–15. The increase in revenue is driven by continued net company growth coupled with fee indexation.

It needs to be appreciated that ASIC is not the sole regulator of companies operating in Australia. Given the growing interdependence of markets, ASIC does not operate in isolation but rather as one link in a chain of economic and financial regulators promoting market integrity and consumer protection. Several other organisations also play a significant role in this respect. These include:

The Australia Securities Exchange (ASX) Compliance – responsible for monitoring and enforcing compliance with ASX operating rules and for promoting standards of corporate governance among Australia’s listed companies. In August 2010 ASIC took over the regulation of stockbrokers and other market participants and this left the ASX largely supervising the Listing Rules.7 The Financial Reporting Council, the Australian Accounting Standards Board and the Auditing and Assurance Standards Board – these bodies play a crucial role in setting accounting standards.

[page 26]

Professional bodies like CPA Australia and the Institute of Chartered Accountants in Australia and New Zealand – also significantly influence the setting of accounting standards. The Australian Prudential Regulation Authority (APRA) – establishes and enforces prudential standards and practices for deposit-taking institutions, insurance companies and larger superannuation funds to ensure they meet their financial promises.

Receive and process information ASIC receives and processes information about companies and makes this information available to interested parties.

2.7

2.8

2.9

ASIC maintains a number of registers of companies, financial service providers and registered auditors and liquidators. These registers contain a lot of information in relation to the affairs of companies. Any document required to be lodged under the Corporations Act must be lodged with ASIC.

ASIC keeps all of this information, in digital form, in a central database called ASCOT. The function of receiving and processing information is very beneficial to society as a whole. Information held by ASIC is generally available to the public. Interested members of the public can obtain relevant information about any registered company (for example, investors in it, its management or its financial condition) by searching the ASCOT database. During 2015–16, 90.7 million searches of ASIC’s database were undertaken by members of the public, other government agencies and information brokers. The two registers most searched were the companies register and the Business Names Register.

Register company auditors and liquidators Under Pt 9.2 of the Corporations Act, ASIC is responsible for the registration of persons wishing to practise as auditors and liquidators in Australia. As of June 2016, there were 4483 registered company auditors and 707 registered liquidators.

Regulate financial markets and providers of financial services The Corporations Act requires any person who wishes to carry on the business of providing financial services (buying and selling financial products) to hold an Australian Financial Services (AFS) licence, unless exempted by the Minister. ASIC has the responsibility of licensing and supervising all financial service professionals. This includes operators of financial markets, clearing and settlement facilities as well as market participants. As of June 2016, ASIC has issued 5726 credit licences.

Regulate the creation of and trading in futures contracts ASIC is responsible for the regulation of trading in futures contracts over commodities. The regulation of trading in futures is covered by the

2.10

2.11

2.12

• • •

provisions of Ch 7 of the Corporations Act.

[page 27]

Investigate contraventions of the corporations legislation ASIC is responsible for the overall administration of the corporations legislation, including investigating suspected contraventions. During 2015–16, ASIC (in collaboration with the Commonwealth Director of Public Prosecutions) completed 175 major investigations, and secured 22 criminal convictions and 13 imprisonments. ASIC also completed 36 civil proceedings. During 2015–16, ASIC obtained $210.5 million in compensation or remediation for investors and financial consumers.

Investigate contraventions of the provisions of the consumer protection laws

ASIC is responsible for administering certain provisions of other laws designed to protect the interests of consumers. As part of this responsibility, ASIC undertakes investigations where it is suspected that a contravention of the relevant law may have occurred.

Powers

As noted earlier, ASIC is entrusted with the responsibility of administering the corporations legislation which protects investors in companies. To discharge this great responsibility effectively, ASIC has been vested with very wide powers. Under s 11(4) of the ASIC Act, ASIC has power to do whatever is necessary for or in connection with, or reasonably incidental to, the performance of its functions. ASIC’s extensive powers include:

the power to exempt compliance with the Corporations Act; the power to investigate and gather information; and the power to commence civil proceedings and criminal action as part of its enforcement strategy.

2.13

• • • • •

Exemption power Wide discretion has also been conferred on ASIC to exempt any person from the operation of some provisions of the Corporations Act. The matters in respect of which ASIC may exercise the powers of exemption are:

financial reporting (ss 340–341); managed investment schemes (s 601QA); takeovers (s 655A); fundraising (s 741); and product disclosure statements (s 1020F).

Generally, ASIC uses its powers to modify the law or to exempt a person or persons from complying with certain aspects of the Corporations Act where it is satisfied that the cost of complying with the law is likely to significantly outweigh its overall benefit. ASIC exercises these powers through the issue of class orders or specific instruments. The power to make these instruments is conferred under the provisions listed above.

[page 28]

In ASIC v DB Management Pty Ltd (2000) 199 CLR 321; [2000] HCA 7, the High Court of Australia acknowledged that class orders (known as legislative instruments since 2015) and other regulatory instruments issued by ASIC under its statutory exemption and modification powers can create, take away or modify the legal rights of individuals. As such, they have (in effect) the force of law. ASIC’s power to make and issue regulatory instruments is derived from the provisions of the Corporations Act.8

In order to provide guidance as to how it will exercise its discretionary and other powers, ASIC issues Regulatory Guides (formerly known as policy statements and practice notes). Unlike class orders (which are made under express statutory powers), Regulatory Guides do not have the force of law. They do, however, serve a very important function. Through them, ASIC informs the community of its interpretation of the Corporations Act. This assists the general community to better

2.14

2.15

understand the operation of the Act. Members of the business community and other interested parties can then proceed to organise their affairs with reasonable certainty. For example, ASIC Regulatory Guide 217, Duty to Prevent Insolvent Trading: Guide for Directors (July 2010) sets out key principles to help directors understand and comply with their duty to prevent insolvent trading. It should be noted, however, that the issue of a regulatory guide or other guidance document on any matter does not mean that ASIC is bound to exercise its powers only in the manner set out in the published policy or guide. This was confirmed in Otter Gold Mine Ltd v ASC (1997) 15 ACLC 1732; [1997] FCA 1199.

Investigations and information gathering To ensure compliance with the law, ASIC is vested with special powers of investigation and information gathering under Pt 3 of the ASIC Act. Where ASIC decides to undertake an investigation, it can require any person to render to it all necessary assistance in connection with the investigation.

Investigations

subpoena: an order to produce documents; an order to attend before a court or public authority.

An essential element of the investigation process is information gathering. To facilitate this, ASIC is given very broad powers. It can examine any person of interest by subpoena and any relevant document. Through the exercise of these powers, ASIC may be able to gain access to all relevant information, documents and records. ASIC devotes substantial resources to the task of investigating suspected breaches of the law. In 2015–16, ASIC dealt with 9,751 reports of alleged misconduct, 1% more than in 2014–15. In 2015–16, ASIC received more misconduct reports in the corporate governance area and slightly fewer reports about market integrity and registry integrity.

Under s 13 of the ASIC Act, ASIC is authorised to initiate an investigation if it suspects, on reasonable grounds, that:9

•

a contravention of the corporations legislation (other than the excluded provisions)10 may have been committed (s 13(1)(a));

[page 29]

a contravention of a law concerning the management of the affairs of a body corporate or managed investment scheme may have been committed (s 13(1)(b)(i)); a contravention of a law which contravention involves fraud or dishonesty in relation to a body corporate, managed investment scheme or financial products may have been committed (s 13(1)(b) (ii)); a contravention involving unacceptable circumstances within the meaning of the provisions of the Corporations Act dealing with takeovers may have occurred (s 13(2)); or a contravention of the consumer protection provisions (Pt 2 Div 2) of the ASIC Act may have been committed (s 13(6)).

ASIC cannot invoke its power of investigation on the basis of mere speculation. To be able to commence an investigation, it must be satisfied that any of the circumstances outlined above may have happened.

In ASIC v Plymin (No 2) (2002) 20 ACLC 1756; [2002] VSC 356, the Supreme Court of Victoria held that the power of investigation conferred on ASIC under s 13(1) may be exercised both for the purpose of determining whether to commence a criminal prosecution or to launch civil penalty proceedings under Pt 9.4B of the Corporations Act. ASIC’s power to commence an investigation may also be triggered by the receipt of a report from an insolvency practitioner who is administering the company: ASIC Act s 15. Insolvency practitioners (such as receivers and liquidators) are obliged to report on suspected breaches of the law. The role and powers of insolvency practitioners is discussed in Chapter 22.

These circumstances aside, ASIC must carry out an investigation if it is directed to do so by the Minister. Under s 14 of the ASIC Act, the Minister has power to direct ASIC to investigate a particular matter if it is in the

• • • • • •

2.16

public interest to do so. There is a wide range of matters which may form the subject of an investigation at the direction of the Minister. Examples of these are set out in s 14(2) and include:

a contravention of the corporations legislation; the conduct of the affairs of a particular corporation; dealings in financial products; the establishment or conducting of financial markets; the provision of clearing and settlement facilities; or the giving of advice about financial products.

Apart from investigations that may be conducted as described above, the Corporations Act also enables ASIC to investigate the affairs of a company in certain other circumstances.

summons: a document, issued by a court official, compelling a person to appear before a court.

Under s 596A, ASIC can apply to the court to issue a summons to a person who is or was an officer or provisional liquidator of a corporation to be examined about the corporation’s affairs. In a similar vein, s 596B permits ASIC to apply to the court to require any person who has taken part or been concerned in the examinable affairs11 of a company and has been, or may have been, guilty of misconduct in relation to the corporation to appear before the court for examination. Again, under this provision, any person who may be able to give information about the examinable affairs of a

[page 30]

company can similarly be summoned, on the application of ASIC, to appear before the court to be examined about the affairs of the company.

Power to examine persons Part 3 Div 1 of the ASIC Act deals with the examination of persons. Under s 19(2) of the ASIC Act, ASIC can, when carrying out an investigation, serve written notice on any person requiring that person to appear before

2.17

it for examination on oath.12

At common law every person enjoys the right against self-incrimination. This protection is not available to any person required to appear before ASIC for examination – s 68(1) of the ASIC Act has removed this right. According to this section, it is not a reasonable excuse for any person required to do so to refuse to give information, sign a record or produce a book on the ground that to do so might tend to incriminate him or her or expose him or her to a penalty. The protections available to examinees under these circumstances are outlined below: see also Corporations Act s 1349.

Power to inspect books In order to obtain information required to establish whether or not a contravention of the law may have been committed, ASIC may need to gain access to certain books and documents. ASIC has been granted wide, but not unlimited, powers to achieve this under Pt 3 Div 3 of the ASIC Act. It can subpoena for inspection any document required to be kept by the corporations legislation. ASIC can also require any person having possession of a book required to be kept by the corporations legislation to deliver up that book for inspection: ASIC Act s 29(2). ASIC can give notice to produce books dealing with the affairs of the company (ASIC Act s 30)13 and books dealing with financial products and financial services: ASIC Act ss 31 and 32A. The notice to produce books extends to the books in the possession of the company’s auditor and liquidator: ASIC Act ss 30A and 30B. ASIC Act s 33 authorises ASIC to give a notice to produce documents in a person’s possession.14 Any notice requiring the production of specified books and documents must be in writing.

[page 31]

Australian Securities Commission v Zarro (1991) 6 ACSR 385

•

2.18

2.19

Federal Court of Australia

Facts: The ASC (now ASIC) required Westpac Bank to produce certain specified documents relating to the affairs of a company being investigated for breach of the corporations legislation. The common law has long established under principles of banking law that, as a general rule, a bank owes a duty of confidentiality to its customer. Westpac Bank refused to hand over the documents of its corporate customer to ASC, citing bank-customer confidentiality.

Decision: The court held that the exercise of the ASC’s statutory obligations must override Westpac’s common law duty of confidentiality to its customer. Thus, Westpac Bank was bound to release the requested documents and make disclosure to ASC.

In order to protect the interests of private parties, certain limitations are placed on the power of ASIC to require the production of books. Under s 28 of the ASIC Act, this power may be exercised only in a limited set of circumstances. It may be used if the inspection of books and documents are necessary to enable ASIC to:

perform or exercise any of its functions and powers under the corporations legislation; determine whether any requirement of the corporations legislation has been complied with; determine whether there has been a contravention of the corporations legislation, or a contravention concerning the management or affairs of a body corporate, or a contravention of that involves fraud or dishonesty in relation to the affairs of a body corporate or financial products; or effectively conduct any investigation commenced by it (under Pt 3 Div 1 of the ASIC Act).

Power to hold hearings ASIC has power to hold hearings for the purposes of performing or exercising any of its functions and powers under the corporations legislation (other than the excluded provisions): ASIC Act s 51. A hearing may be held in public or in private: ASIC Act s 52(1).

Enforcement action after investigation Through the exercise of its powers of investigation, ASIC may gain

2.20

2.21

relevant information about the affairs of a company. Where this information reveals a contravention of the law, ASIC can utilise the information gained to commence criminal, civil or administrative proceedings against errant individuals or organisations. ASIC’s enforcement role is emphasised under s 1(2)(g) of the ASIC Act, which directs ASIC to take whatever action it can and is necessary in order to enforce and give effect to the corporations legislation.

[page 32]

Power to initiate criminal proceedings If, after conducting an investigation or examining any person, ASIC is of the view that a breach of the corporations legislation may have been committed and that any person involved ought to be prosecuted, it can initiate a criminal prosecution or cause one to be commenced against that person: ASIC Act s 49 and Corporations Act s 1315.

Under current practice, applying the guidelines established by ASIC and the Commonwealth Director of Public Prosecutions (DPP), ASIC prosecutes only minor regulatory offences.15 Where an investigation conducted by ASIC reveals a commission of serious breach or breaches of the corporations legislation, the matter is referred to the Commonwealth DPP for further action. In 2015–16, ASIC secured 30 convictions, of which 14 people were jailed.

Power to seek civil remedies Following an investigation or examination conducted (as described above), ASIC may, if it is in the public interest to do so, commence proceedings seeking civil remedies from the courts: ASIC Act s 50.16 In these proceedings, based on public interest considerations, ASIC can take legal action in the name of a company without the need for the company’s consent. In such circumstances, ASIC may seek damages for fraud, negligence, default, breach of duty or other misconduct committed in connection with a matter to which the investigation or examination related. For example, since 2007, ASIC has launched over 19 legal actions

for the benefit of investors in Westpoint, a property development company which collapsed in 2006.17 ASIC has thus far returned to investors about $160 million of the $388 million in losses caused to nearly 4000 investors. ASIC mounted legal actions against the former directors of Westpoint, its auditors and financial advisers – around $93 million of the $160 million represents compensation as a result of ASIC actions.

Additionally, ASIC may seek orders excluding certain individuals from participation in the management of companies or from participating in the provision of financial services. For example, in 2013–14, ASIC had 62 people disqualified or removed from directing companies.

Further, once ASIC commences an investigation or criminal or civil proceedings, it is empowered by s 1323 of the Corporations Act to seek protective orders for the preservation of corporate property. Relief commonly granted under this provision consists of orders freezing assets. ASIC is also empowered, under s 1324 of the Corporations Act, to seek an injunction to restrain conduct which is or would be a breach of the Corporations Act. Section 1324(10) confers judicial discretion on the court to also make an award of damages. The commencement of an investigation into the affairs of a company also enables ASIC to apply to the court for the company to be wound up: Corporations Act s 464. Details of some outcomes achieved in the recent past as a result of civil action taken by ASIC are set out in Table 2.1.

[page 33]

Table 2.1 ASIC Remedies18

Full details as to enforcement actions taken by ASIC can be obtained

•

• •

2.22

from its annual reports, which are available at <http://www.asic.gov.au>.

For further discussion on legal aspects relating to directors’ duties, see Chapters 15–18.

ASIC v Vizard (2005) 23 ACLC 1309; [2005] FCA 1037 Federal Court of Australia

Facts: Mr Vizard was a director of Telstra. ASIC commenced investigations into certain share purchases undertaken by Mr Vizard while he was a director of this publicly listed company. ASIC suspected that in 2000 Mr Vizard used confidential Telstra information, which he obtained in his capacity as a director of Telstra, to trade in the shares of three listed public companies namely, Sausage Software Ltd, Computershare Ltd and Keycorp Ltd. At the conclusion of its investigations, ASIC was satisfied that this was the case. Quite significantly, Mr Vizard agreed with the allegations made by ASIC. ASIC commenced civil penalty proceedings in the Federal Court against Mr Vizard seeking the following orders:

declarations that Mr Vizard contravened the corporations legislation when he improperly used Telstra information to gain an advantage for himself or other parties (resulting in a conflict of interest); pecuniary penalties in such amount as the Federal Court considers appropriate for the contraventions; and a disqualification order prohibiting Mr Vizard from being involved in the management of companies.

Decision: The court found that Mr Vizard had breached his duties as a director of Telstra when he used confidential Telstra information to trade in the shares of three listed public companies as alleged by ASIC. The court made orders:

banning Mr Vizard from managing any corporation for 10 years; and requiring him to pay pecuniary penalties (civil fine) of $390,000 to the Commonwealth Government.

[page 34]

Power to accept enforceable undertakings As an alternative to civil or administrative enforcement action, ASIC may accept a written undertaking from any person in connection with any matter over which it has control: ASIC Act ss 93AA and 93A. Once given, an enforceable undertaking may only be withdrawn or varied with the consent of ASIC. ASIC can apply to the court for appropriate relief if

an undertaking given to it by a person is breached. Enforceable undertakings are not used as alternatives to criminal enforcement action.

Enforceable undertakings are advantageous in a number of ways. In the first place, the giving of such an undertaking enables ASIC to achieve an outcome desired by it. For example, ASIC may seek an enforceable undertaking to secure compensation for aggrieved parties or to require a person to do or refrain from doing something. Quite significantly, this result may be achieved much more quickly than if the matter had proceeded to litigation. Once given, the undertaking is enforceable by court order.

Enforceable undertakings can thus be used to promote compliance with the law on a timely basis. As they are flexible and can be implemented swiftly, enforceable undertakings are commonly used by ASIC as a regulatory tool. The number of enforceable undertakings accepted by ASIC in the recent past are set out in Table 2.2.

ASIC has issued a regulatory guide which explains when it considers it appropriate to accept enforceable undertakings, the terms acceptable to it and what action it is likely to take if an enforceable undertaking given to it is breached: RG 100 Enforceable Undertakings (updated February 2015). A list of enforceable undertakings that ASIC has accepted from people and companies to date is available on the ASIC Enforceable Undertaking Register.19

Table 2.2 ASIC Enforceable Undertakings20

Year Number of Enforceable Undertakings

2015 22 (13 accepted)

2014 26

2013 20

2012 16

2011 20

2010 7

2009 10

•

2.23

2.24

Do you think that ASIC is an effective regulator or a toothless watchdog?

[page 35]

Protection of private interests

Substantial coercive powers are conferred on ASIC. While it is generally accepted that this is essential in order to enable ASIC to perform its duties effectively, it is also recognised that there is potential for abuse of these powers. It is therefore important that the legal system provides some mechanisms to protect individuals against such a prospect. Some of the safeguards currently available are examined below.

Obligations as to fairness As part of the protections provided by the law, ASIC is required to act with fairness in the conduct of its investigations, examinations or hearings. In particular, any requirement by ASIC to a person to appear before it for examination must be in writing, in the prescribed form and must state the general nature of the matter to be inquired into: ASIC Act s 19(2). In addition, any person being examined by ASIC is entitled to have a lawyer of his or her choice at the examination. The lawyer is allowed to address the person conducting the examination. The lawyer can also examine the person being examined about matters in relation to which he or she has been examined by the examiner: ASIC Act s 23(1).

ASIC’s litigation strategy, arising from failure to call a material witness, was criticised by the Court of Appeal in Morley v ASIC (2010) 81 ACSR 285; [2010] NSWCA 331 and addressed authoritatively by the High Court of Australia in ASIC v Hellicar (2012) 286 ALR 501; [2012] HCA 17, discussed below, during the litigation against the board of directors of James Hardie Ltd. For a fuller discussion of the facts, legal issues and ultimate decision in the James Hardie litigation (during the period 2009– 12), and its implications for directors, officers and corporate governance, see Chapter 17.

The discussion below centres on whether ASIC breached its duty of fairness during the conduct of the James Hardie litigation and whether, as regulator, it has more stringent requirements to discharge the burden of proof.

ASIC v Hellicar (2012) 286 ALR 501; [2012] HCA 17 High Court of Australia

Facts: ASIC sought a court declaration that the directors and officers of James Hardie had breached their statutory duty of care and diligence, under s 180(1) of the Corporations Act, by allowing the company to release a key document to the public which was found to be misleading. ASIC alleged, and the respondents denied, that the misleading document was approved at a board meeting prior to its release. All of the eight respondents had no actual recollection of events at that crucial board meeting, which occurred some seven years before they gave evidence at trial. The minutes of the board meeting recorded the approval of the document by the board. Due to defects in the recording of the minutes, the primary judge, however, did not rely on the minutes as evidence to find a breach of the law.

In rejecting the evidence of the defendants at the trial, the primary judge inferred that the board did approve the misleading document and therefore held that all of them had breached their legal duties as directors and officers. The court applied the civil penalty provisions, arising from a breach of s 180(1), and imposed pecuniary penalty orders and banning orders: see Chapter 17 for discussion on the operation of s 180 and the consequences of breach.

[page 36]

All of the defendants successfully appealed and the New South Wales Court of Appeal overturned the liability decision. It did so, among other reasons, on the basis that ASIC had failed to act as a model litigant. The Court of Appeal concluded that it was unfair for ASIC not to have called the company’s lawyer, who had also attended the board meeting, to give evidence as to whether the board approved the misleading document or not. As a result, the appellate court held that this omission affected ASIC’s proof of the facts.

Issue: Was the Court of Appeal right to overturn the primary judge’s finding (that the board had approved the draft ASX announcement) for the reason given? Did ASIC breach its duty to conduct a fair trial in such circumstances?

Decision: The High Court readily accepted that ASIC has a duty to act fairly when conducting proceedings but did not accept that this duty required ASIC to call the company’s lawyer as its witness in this case for four key reasons.

First, each side in a trial is free to decide the evidence to be called and what questions are to be asked subject to the rules of evidence and fairness. Second, deciding the facts of a case is a court’s task, not a task for the regulatory agency. Third, incorrect assumptions were made by the Court of Appeal that ASIC’s conduct denied the defendants some advantages or subjected them to some disadvantage. It was open to the defendants to call the company’s lawyer as witness. Fourth, the source and content of

2.25

the duty of fairness which says that particular evidence must be called, to avoid breach of this duty, was not identified by the Court of Appeal or in argument before the High Court.

Significance: Having affirmed the liability of the eight respondents (seven non-executive directors and one officer)21 by placing emphasis on the minutes which showed absence of care and diligence in board approval of a misleading document of significance, the High Court remitted this case back to the Court of Appeal of the New South Wales Supreme Court to decide the appeal on the civil penalties. Chapter 17 discusses the liability decision, reported as Gillfillan v ASIC (2012) 92 ACSR 460; [2012] NSWCA 370, which imposed banning orders of varying lengths and pecuniary penalties of various amounts on each of the respondents.

natural justice: a requirement for the decision-maker to act fairly, in good faith and without bias, and must give a person an opportunity to be heard.

ASIC is obliged to accord natural justice (or procedural fairness) to any person likely to be adversely affected by a finding arising from a hearing conducted by it: ASIC Act s 59(2). However, while it is bound to accord natural justice, it does not necessarily follow that ASIC must observe the rules of evidence when conducting its hearings. This is expressly confirmed by s 59(2)(c) of ASIC Act. As the High Court acknowledged in National Companies and Securities Commission v News Corporation Ltd (1984) 2 ACLC 301, rules of natural justice are flexible depending on the power exercised and the legislation relevant to the exercise of that power. Essentially, as noted by the Federal Court in Laycock v Forbes (1997) 25 ACSR 659; 15 ACLC 1814, the obligation to observe the rules of natural justice requires that ASIC provide to any person who may be adversely affected by its decision all the material available to it and upon which it will base its decision. Also, ASIC must ensure that it gives such a person an opportunity to put before it any evidence that that person considers relevant. Further, the affected person must be given an opportunity to make any representations he or she may consider advisable.

Self-incrimination At common law, every person under investigation enjoys the right to remain silent. This is commonly known as the right against self- incrimination.

[page 37]

2.26

In Sorby v Commonwealth (1983) 152 CLR 281, the High Court of Australia noted that under the protection provided by this long-established rule:

… a person may refuse to answer any question or to produce any document or thing, if to do so ‘may tend to bring him into the peril and possibility of being convicted as a criminal’.

There can be no doubt at all that the refusal by a person under examination to answer questions can seriously hamper ASIC in its investigations. To overcome this difficulty and to assist ASIC to investigate suspected contraventions of the corporations legislation effectively, the right against self-incrimination has been removed: ASIC Act s 68.22 According to this provision, it is not a reasonable excuse for a person to refuse or fail to give information, sign a record or produce a book when required to do so by ASIC on the ground that giving the information, signing the record or producing the book might tend to incriminate the person or make the person liable to a penalty. Thus under this provision, any person under examination, who does not answer all questions relevantly put to him or her, risks prosecution. This makes it easier for ASIC to obtain relevant evidence.

perjury: the making of a false statement under oath.

Section 68 is subject to an important qualification aimed at protecting members of the community. If a person under examination by ASIC states before the examination that any statement made might incriminate him or her, the incriminating statement is not admissible in criminal proceedings except for perjury. That statement is also not admissible in civil proceedings for the imposition of a pecuniary penalty order against that person: ASIC Act s 68(3). The recent addition of s 1349 makes it clear that the operation of s 68(3) (and penalty privilege more broadly) does not apply to disqualification orders under the Corporations Act.

Legal professional privilege Confidential communications passing between a lawyer and client or between a third party and a lawyer, at the request of a client, for the dominant purpose of providing legal advice are protected by the doctrine of legal professional privilege. When applied, this doctrine allows a person to maintain confidentiality over, and thus avoid disclosure of,

2.27

communications (whether written or oral) between that person and a lawyer for legal advice, unless the right is waived. In the context of ASIC investigations, this principle is reinforced by s 69(2) of ASIC Act. Under that provision, a lawyer who is required to give information or to produce a document is entitled to refuse to do so where the relevant communication was made in the course of a professional relationship of lawyer and client.

The doctrine of legal professional privilege is an important common law right. It enables citizens to obtain proper and effective legal advice under conditions of confidentiality. The difficulty, however, is that a claim of legal professional privilege can be used to frustrate ASIC in its investigations and prevent it from discovering the full truth of any matter it may be looking into. Indeed, there are perceptions that this doctrine is used at times to insulate questionable conduct from scrutiny and thus stymie the public interest in discovering the truth. To avoid this situation, s 69(3) of the ASIC Act requires a lawyer refusing to disclose a communication on

[page 38]

the ground of legal professional privilege to provide full particulars identifying the source of the communication. ASIC can then use its powers to secure the requisite information from that source. The terms of ASIC Act s 68(2) make it clear that a claim of privilege cannot be made by a body corporate: Schlaepfer v Australian Securities and Investments Commission [2017] FCA 1122.

Duty of confidentiality In the performance of its duties, ASIC collects vast amounts of information. The indiscriminate disclosure of such information has the potential in some circumstances to seriously adversely affect the interests of subjects. To avoid this, s 127 of the ASIC Act imposes a duty of confidentiality on ASIC. Under this provision, ASIC is required to take all reasonable measures to protect from unauthorised use or disclosure information given to it in confidence in connection with the performance

2.28

of its functions or the exercise of its powers under the corporations legislation: ASIC Act s 127(1).

However, under some limited circumstances, ASIC may properly disclose information obtained by it in the course of its work to certain persons and organisations, for example, the Minister or a Royal Commission to enable them to discharge their functions. The persons or organisations to whom this information may be disclosed are specified in s 127(2A)-(4B) of the ASIC Act.

ASIC recognises that the release of information in its possession, even when authorised, can have serious and undesirable implications for affected parties. Accordingly, it has determined that confidentiality is one of the prime considerations it will take into account before disclosing information to third parties. This position is set out in Regulatory Guide 92: Procedural Fairness to Third Parties. It has also made clear that before taking any decision to release information, it will grant an opportunity to any person likely to be adversely affected by such a decision to make representations to it: see Regulatory Guide 103: Confidentiality and Release of Information.

Parliamentary inquiry into ASIC’s performance

ASIC’s performance as a corporate regulator has come under intense scrutiny by the Senate Economics Reference Committee which released a scathing report (in June 2014) identifying a large number of improvements required for ASIC to become a more effective watchdog.23 The inquiry was sparked by perceived shortcomings in ASIC’s slow response to the serious scandals and misconduct which plagued the financial planning industry. The committee found ASIC to be ‘a timid, hesitant regulator, too ready and willing to accept uncritically the assurances of a large institution that there were no grounds for ASIC’s concerns or intervention’.24

[page 39]

Significantly, the inquiry found that ASIC conceded that its trust in some institutions was misplaced. The committee made the following robust observations:25

In the committee’s opinion, ASIC has been in the spotlight far too frequently for the wrong reasons. It is acknowledged that not all of the criticisms levelled at ASIC are justified; ASIC is required to perform much of its work confidentially and in a way that ensures natural justice. It is also constrained by the legislation it administers and the resources given to it for this purpose. Nevertheless, the credibility of the regulator is important for encouraging a culture of compliance. That ASIC is consistently described as being slow to act or as a watchdog with no teeth is troubling. The committee knows, however, that ASIC has dedicated and talented employees that want to rectify the agency’s reputation.

This inquiry has been a wake-up call for ASIC. The committee looks forward to seeing how ASIC changes as a result.

ASIC has made repeated calls for increases in its enforcement power. In October 2016, the Minister for Revenue and Financial Services announced a taskforce to review the enforcement regime of ASIC, with a report anticipated in 2017.26 The taskforce will assess the suitability of the existing regulatory tools available to ASIC to perform its functions adequately.

1. 2.

6. 7. 8.

10.

[page 40]

Revision Questions

What is the role of ASIC? Explain the accountability mechanisms that exist as a check on the responsible use of ASIC’s extensive powers. Under what circumstances may ASIC bring a legal action in the name of a company in the exercise of its investigatory powers? As part of its enforcement strategy, ASIC may also accept an enforceable undertaking. Explain the concept of ‘enforceable undertakings’. Identify at least two circumstances when ASIC can exercise its exemption powers. Explain the concept of ‘class orders’ and their legal status. Under what circumstances may ASIC hold a hearing? Outline the manner in which private interests are protected during the exercise of ASIC’s extensive coercive powers. Under current practice, who is responsible for prosecuting serious breaches of the corporations legislation? After investigating the affairs of a company, what action can ASIC take instead of commencing civil litigation?

Problem Question ASIC was investigating the affairs of Pinesett Ltd. In particular, it wished to ascertain whether certain prominent personalities owned an undisclosed substantial interest in the company. To this end, ASIC commenced an investigation in relation to the affairs of Pinesett Ltd. As part of this investigation, ASIC required Kentrev to appear before a member of ASIC for examination on oath and to answer questions.

Kentrev is most perturbed about his appearance before ASIC. He is particularly concerned

(a) (b) (c)

1. 2.

because, sometime after this appearance, one of his colleagues, Renev, gave evidence in other related proceedings which established that Kentrev’s evidence before ASIC was false. Also, in execution of a search warrant, ASIC seized documents which included letters written by Kentrev to his overseas lawyer in relation to the matter which is the subject of ASIC’s investigation.

In relation to the above, advise Kentrev on the following: Did ASIC have the power to hold the investigation and the hearing? What action may ASIC take against Kentrev in the circumstances? What action may Kentrev take to protect his interests?

Guidelines for Answering Problem Questions

When answering a problem question concerning ASIC, we suggest that the following method may be helpful:

Identify the powers of ASIC in circumstances such as these. Identify the legal protections available to persons likely to be affected by the activities of ASIC in the performance of its duties.

[page 41]

Further Reading

Academic Journals J Austin, ‘Does the Westpoint Litigation Signal a Revival of the ASIC s

50 Class Action?’ (2008) 22 Australian Journal of Corporate Law 8.

H Bird, D Chow, J Lenne and I Ramsay, ‘Strategic Regulation and ASIC Enforcement Patterns: Results of an Empirical Study’ (2005) 5 Journal of Corporate Law Studies 191.

H Bird, G Gilligan and I Ramsay, ‘The Who, Why and What of Enforceable Undertakings Accepted by the Australian Securities and

Investments Commission’ (2016) 34 Company and Securities Law Journal 493.

J Bird, ‘Regulating the Regulators: Accountability of Australian Regulators’ (2011) 35(3) Melbourne University Law Review 739.

V Comino, ‘Effective Regulation by the Australian Securities and Investments Commission: The Civil Penalty Problem’ (2009) 33 Melbourne University Law Review 802.

J du Plessis, ‘Reverberations After the HIH and Other Recent Australian Corporate Collapses: The Role of ASIC’ (2003) 15 Australian Journal of Corporate Law 225.

J Hedges, H Bird, H Louise, G George, G Andrew and I Ramsay, ‘The Policy and Practice of Enforcement of Directors’ Duties by Statutory Agencies in Australia: An Empirical Analysis’ (2017) 40 Melbourne University Law Review 905.

M Hyland, ‘Is ASIC Sufficiently Accountable for its Administrative Decisions? A Question of Review’ (2010) 28 Company and Securities Law Journal 32.

B Mees and I Ramsay, ‘Corporate Regulators in Australia (1961–2000): From Companies Registrars to ASIC’ (2008) 22 Australian Journal of Corporate Law 212.

T Middleton, ‘The Role of Lawyers in the Context of ASIC’s Investigative and Enforcement Powers’ (2010) 28 Company and Securities Law Journal 107.

M Nehme, ‘Enforceable Undertakings: Are They Procedurally Fair?’ (2010) 32 Sydney Law Review 471. M Nehme, ‘Monitoring Compliance with Enforceable Undertakings’ (2009) 24 Australian Journal of Corporate Law 76.

M Nehme, M Hyland and M Adams, ‘Enforcement of Continuous Disclosure: The Use of Infringement Notice and Alternative Sanctions’ (2007) 21 Australian Journal of Corporate Law 112.

M Welsh, ‘Civil Penalties and Responsive Regulation: The Gap Between Theory and Practice (2009) 33 Melbourne University Law Review 908.

M Welsh, ‘Eleven Years On – An Examination of ASIC’s Use of An Expanding Civil Penalty Regime’ (2004) 17 Australian Journal of Corporate Law 175.

Practitioner Journals M Adams and M Nehme, ‘The Active Use of Enforceable Undertakings

by ASIC – Part 1’ (2007) 59 Keeping Good Companies 260.

M Adams and M Nehme, ‘The Active Use of Enforceable Undertakings by ASIC – Part 2’ (2007) 59 Keeping Good Companies 326.

R Dennings, S Carroll and WL Chen, ‘The Six Phases of an ASIC Investigation – and What You Can Do Now to be Prepared’ (2015) 67 Governance Directions 158.

[page 42]

Practitioner Works R Austin and I Ramsay, Ford’s Principles of Corporations Law, 15th ed,

LexisNexis Butterworths, Australia, 2012, Ch 3.

T Middleton, ASIC Corporate Investigations and Hearings, Lawbook Co, Australia, looseleaf and online.

You will find useful study resources, including quizzes for each chapter, when you go to <http://learning.lexisnexis.com.au>. The quiz is a great tool to help you self-test your knowledge.

http://asic.gov.au/regulatory-resources/find-a-document/reports/rep-535-asic-cost-recovery-arrangements-2017-18/

10.

11. 12.

13.

14.

15.

16.

17.

18. 19. 20. 21.

22.

See s 12A(1) of the ASIC Act for the additional responsibilities conferred upon ASIC under a variety of other legislation other than the Corporations Act. See further Report 535 ASIC cost recovery arrangements: 2017–18 available at <http://asic.gov.au/regulatory-resources/find-a-document/reports/rep-535-asic-cost- recovery-arrangements-2017-18/>. Mainly for these reasons, as expressed by the Federal Treasurer in a letter to former ASIC Chairman (Jeffrey Lucy) dated 20 February 2007:

The government recognises and will continue to respect the statutory independence of ASIC. It is important for confidence in the regulatory framework that ASIC is, and is seen to be, exercising independent judgement about the application of the regulatory framework to individual circumstances … given the importance the Government attaches to protecting ASIC’s independence, both real and perceived, the use of the directions power would only be considered in rare and exceptional circumstances.

This was achieved by each state enacting a Corporations (Commonwealth Powers) Act: see, for example, Corporations (Commonwealth Powers) Act 2001 (NSW). See, for example, the role and aim of the regulator in ASIC v Storm Financial Ltd (2009) 71 ACSR 81; [2009] FCA 269. Other regulators, such as the Australian Prudential Regulation Authority (APRA), are also responsible for administering some of these Acts. Information regarding the role and powers of ASX Compliance can be found at <http://www.asx.com.au/regulation/asx-compliance.htm>. A list of class orders issued by ASIC and in effect to date can be viewed at <http://asic.gov.au/regulatory-resources/find-a-document/legislative-instruments/>. For examples, see ASIC v Diploma Group Limited [2017] FCA 549; ASIC v AGKM Green Pty Ltd [2017] FCA 846. The excluded provisions are s 12A of the ASIC Act, which deals with ASIC’s other functions and powers and Pt 2 Div 2 of the ASIC Act which deals with unconscionable conduct and consumer protection in relation to financial products: ASIC Act s 5. The term ‘examinable affairs’ is defined in s 9 of the Corporations Act. For example, see Schlaepfer v Australian Securities and Investments Commission [2017] FCA 1122; ASIC v Sino Australia Oil and Gas Ltd (in liq) (2016) 115 ACSR 437; [2016] FCA 934. This case is discussed in Chapters 9, 14, 17 and 20. For example, see FAL Healthy Beverages Pty Limited v Manly Warringah Sea Eagles Ltd [2016] NSWSC 1058. For example, see Masu Financial Management Pty Ltd and Australian Securities and Investments Commission [2017] AATA 97; ASIC v Uglii Corporation Ltd (2016) 116 ACSR 389; [2016] FCA 1099. A research report by the Centre for Corporate Law and Securities Regulation, The University of Melbourne, gives some interesting insights into the type of cases prosecuted by ASIC. See Bird et al, ASIC Enforcement Patterns, <http://cclsr.law.unimelb.edu.au/research-papers/ASIC%20Enforcement.pdf> at 81–2. For analysis on the scope of s 50, see ASIC v Bank of Queensland Ltd (2011) 86 ACSR 258; [2011] FCA 1361. See, for example, Goodman, In the matter of Glenhurst Corp Pty Ltd (in liq) (ACN 006 277 087) [2010] FCA 667; Markov v Dukes [2010] FCA 1419. ASIC, Annual Reports, 2012–16. See <www.asic.gov.au/euregister> ASIC, Annual Reports, 2009–15. The liability of the company officer of James Hardie, Peter Shafron, was established in this judgment and in the accompanying High Court judgment in Shafron v ASIC (2012) 286 ALR 612; [2012] HCA 18 which is discussed in Chapter 17. For analysis on the scope and operation of s 68, see Schlaepfer v Australian Securities

http://www.asx.com.au/regulation/asx-compliance.htm

http://asic.gov.au/regulatory-resources/find-a-document/legislative-instruments/

http://cclsr.law.unimelb.edu.au/research-papers/ASIC%20Enforcement.pdf

http://www.asic.gov.au/euregister

23.

24. 25. 26.

and Investments Commission [2017] FCA 1122. See Senate, Economics References Committee, Performance of the Australian Securities and Investments Commission, June 2014 at <http://www.aph.gov.au/Parliamentary_Business/Committees/Senate/Economics/ASIC/Final_Report/index See n 23 at xviii. See n 23 at xxii. See <www.treasury.gov.au/ConsultationsandReviews/Reviews/2016/ASIC- Enforcement-Review>.

http://www.aph.gov.au/Parliamentary_Business/Committees/Senate/Economics/ASIC/Final_Report/index

http://www.treasury.gov.au

[page 43]

Business Structures

CHAPTER 3 Different types of business structures Sole traders

Introduction Establishment Governing law Control Liability Fundraising Continuity of existence Privacy Taxation Advantages and disadvantages

Partnerships Introduction Governing law Establishment Essential elements of a partnership Rules relating to establishment of a partnership

Liability — partners and outsiders

[page 44]

Control Partners’ relationship, rights and duties Fundraising Continuity of existence and termination of a partnership Privacy Taxation Advantages and disadvantages Limited partnerships

Joint ventures Introduction Establishment Governing law Control Liability of joint venturers Fundraising Relationship between joint venturers Difference between a joint venture and a partnership Continuity and termination of the joint venture Privacy Taxation Advantages and disadvantages

Trusts Introduction Types of trusts Implied trusts, resulting trusts and constructive trusts Establishment and essential elements of a trust Governing law Control Liability

Rights and obligations of trustees Right of indemnity Rights and obligations of beneficiaries Fundraising Continuity of existence and termination Privacy

[page 45]

Taxation Advantages and disadvantages

Companies Introduction Establishment Alternative registration process Post-registration requirements Governing law Control Liability Types of companies Distinction between proprietary and public companies Distinction between small and large proprietary companies Parent and subsidiary companies Company conversions Fundraising Winding up and deregistration Privacy Taxation Advantages and disadvantages

Associations Introduction Establishment

Governing law Control Liability Fundraising Continuity of existence Privacy Taxation Advantages and disadvantages

Overview comparison of business structures

[page 46]

Business Structures

Learning Objectives After completing this chapter you should be able to:

Discuss the different types of business structures that exist (sole traders, partnerships, joint ventures, trusts, associations and companies) and their distinguishing characteristics.

Explain the procedures involved in choosing the appropriate structure to be used.

Explain the manner of establishment and costs of running each business structure.

Explain the control characteristics of each business structure.

Discuss the projected life cycle of the business structure and the transferability of the interests in the structure.

Identify the capacity to expand the business and raise funds under each structure.

Explain the exposure to personal liabilities for debts under each structure.

Appreciate the taxation advantages of each business structure.

Define a partnership and distinguish partnerships from joint ventures.

Distinguish a company from other legal structures, with particular reference to the concept of limited liability and the separate legal entity rule.

Distinguish between the different types of companies that can be registered under the Corporations Act and explain their purposes (company limited shares, company limited by guarantee, no liability companies and unlimited companies).

Explain the distinction between proprietary and public companies and between small and large proprietary companies with reference to the Corporations Act.

Distinguish between parent and subsidiary companies in a corporate group.

Key Cases

Brian Pty Ltd v United Dominions Corporations Ltd [1983] 1 NSWLR 490

[page 47]

Canny Gabriel Castle Jackson Advertising Pty Ltd v Volume Sales (Finance) Pty Ltd (1974) 131 CLR 321

Chan v Zacharia (1984) 154 CLR 178

Salomon v Salomon & Co Ltd [1897] AC 22

Key Legislation

Corporations Act 2001 (Cth)

Relevant state and territory:

Associations Incorporation Act

Partnership Act

Trustee Act

[page 48]

Introduction

The decision as to what legal structure is most appropriate for a particular business enterprise is of vital importance, and is also one of the most common tasks of accountants as professional business advisers. Advice relating to the most appropriate business structure is critical to the ultimate success or failure of any new business. This is because the legal structure may be accompanied by a range of regulatory requirements that may impose large and burdensome compliance costs on the business. A particular business structure may be inappropriate for a new business because its nature is overly complex and therefore too expensive for the purposes of the client who wishes to establish the business. Similarly, a particular business structure may be inappropriate because, although simple, its scope is too limited to facilitate the continued growth and prosperity of the business.

The task of a professional business adviser is to recommend a business structure that meets the needs of the client’s current and (hopefully) future business plans. In order to achieve this aim, the adviser cannot simply rely on a stock-standard recommendation (such as a small proprietary company) but must examine the client’s personal circumstances and attempt to provide a structure that meets most, if not all, of their needs and wants. This will require a broad knowledge base, including tax, finance, employment law, occupational health and safety laws, and possibly corporate law (depending on the structure chosen).

This chapter examines the type, features and characteristics of the different business structures that are available. All of the structures should be considered before any final decision is made. Additionally, the choice of structure must be seen in a longitudinal sense — therefore, the structure that may be suitable for a business today might not be suitable for future years.

Different types of business structures

3.1

• • • •

• • •

• • • • •

There is a wide variety of legal structures by which individuals may pursue business objectives. This chapter is designed to introduce a range of alternative structures for running a business: sole trader, partnership, joint venture, trust, companies and associations. Each structure has its own characteristics and the decision to use one or other of the structures will be influenced by many relevant factors such as:

the size of the business and the ability to expand the business; establishment and operating costs involved; exposure to individual liability if the business fails; the ability to participate in management and the scope for managerial control; the treatment of profits; the concerns for taxation liabilities; and the need for, and scope of, financial privacy.

The risk, and consequences, of business failure are usually one of the paramount considerations in determining a business structure.

[page 49]

It should be remembered that the choice of one or other of the structures does not preclude the business restructuring in the future. An example of this type of restructuring could be the transition from a partnership business structure to a company structure. This could be necessitated by the need to introduce additional capital, or, alternatively, to take steps to limit the liability of the partners. Care must be taken during any proposed restructure to ensure that taxation implications, such as capital gains tax and goods and services tax issues, have been considered beforehand.

This chapter examines in detail the type, features, characteristics and the advantages and disadvantages of the different business structures available. The range of business structures considered here are:

sole traders; partnerships; joint ventures; trusts; companies (proprietary and public); and

•

3.2

3.3

associations.

Note that the law relating to partnerships and associations is outlined in this chapter and covered in greater detail in Chapter 4, together with case illustrations.

Sole traders

Introduction A sole trader is the person carrying on business as an independent individual. The business is the individual and they are indistinguishable. The business is owned and controlled by the sole trader who also enjoys all of the profits and is directly liable for tax on income earned. It is the simplest form of business structure and is common in the business world.

[page 50]

Establishment There is no need for any formal establishment process to set up a business as a sole trader. It is the simplest, cheapest and an easier form of business to create with minimal legal formalities. Assuming the sole trader is intending to trade under his or her own name, that name does

• •

•

• •

not need to be registered.

If, however, the sole trader intends to trade under a name other than their own name, then the Business Names Registration Act 2011 (Cth) makes it compulsory to register the business name. The following types of entities may apply to hold a business name:

an individual (for example, a sole trader); an incorporated entity, including an Australian registered company (has an ACN), an Australian registered body (has an ARBN) or other incorporated entity (no ACN or ARBN); an unincorporated entity, including a trust, superannuation fund or unincorporated body or association; a partnership or joint venture partnership; or a joint venture.

To register a business name, the individual or entity will need to have an Australian Business Number (ABN) or ABN application reference number (unless an exemption applies).

The details required for registration of the business name include details of the nature of the business, the date of commencement of the business, the principal place of business and the full name and address of the applicant. The purpose of the national Business Names Register is to provide a way to identify the individual (or entity such as a partnership or company) that is carrying on a business under a business name. Note, however, that registering a particular name does not give the individual or entity exclusive trading rights over the name. The duty to register a business name is separate to any steps that business owners may take to protect any intellectual property rights in a name or brand, such as registering a trademark.

The other purpose of the Business Names Register is to allow business owners to check business name availability, register or renew a business name all on one national online service, at any time. A fee is payable to register a business name. For further guidance on the regulation of business names, visit ASIC’s website at <http://www.asic.gov.au>. see also RG 235: Registering Your Business Name.

Governing law

3.4

3.5

3.6

Governing law There is no specific governing law applicable to the structure of being a sole trader. That does not mean that there is no law otherwise applicable. For various professionals, this law can be in the form of the need to be registered and comply with the rules of professional bodies in order to practise. Examples include solicitors and accountants in private practice, migration agents and real estate agents.

The myriad of general commercial laws applicable to all businesses also apply to a sole trader. For example, formalities include the need to register for an Australian

[page 51]

Business Number (ABN) and for goods and services tax (GST) with the Australian Taxation Office (ATO). Similarly, the need to be in possession of appropriate regulatory approvals, such as liquor and gambling licences, is also relevant to sole traders. Compliance obligations with laws dealing with such matters as fair trading, insurance (public liability and workers’ compensation), occupational health and safety, and general industrial/employment laws are also relevant to sole traders.

Control The sole trader has the advantages of simplicity and control. A sole trader may employ other people but these people work within the sole trader structure and are accountable only to the sole trader.

Liability The sole trader is personally liable for debts incurred and that liability is unlimited. This means that if the sole trader cannot pay their debts, then they may well have to provide funds from their personal assets, and if there is a shortfall, they may be placed into bankruptcy. Unlike the use of companies which offer the benefit of limited liability, discussed below, personal assets are at risk. The sole trader may, however, seek to

3.7

3.8

3.9

3.10

minimise the risk of personal liability through various insurance policies (such as public liability insurance and professional indemnity insurance).

The business, even though it may be trading under a business name, is not separately liable for any debts — the reason being that the granting of a business name does not bring into creation a business structure.

Fundraising The sole trader has access to limited resources to fund their business and growth. The sole trader relies on savings or loans, or on business profits to finance growth.

Continuity of existence The benefits of perpetual succession, described earlier in Chapter 1, are not applicable to sole traders. The business of the sole trader normally ends on the death or bankruptcy of the individual. In the case of death, there may be provisions in the testamentary document (will) stating who is to inherit and continue the business on the death of the sole trader. This gift may or may not be accepted and its terms may or may not be binding on the recipient.

Privacy Apart from disclosure to the Commissioner of Taxation, profits do not need to be disclosed and financial affairs can be kept private.

Taxation The sole trader is liable, according to the tax rate applicable to individual taxpayers, for the payment of taxes on income earned.

[page 52]

CGT: this stands for Capital Gains Tax which is levied on profits made from the sale or

3.11

3.12

transfer of capital assets.

Table 3.1 Overview of Taxation

Structure: Sole Traders Control rating High

Set-up costs Low

Liability for debts Unlimited

Loss utilisation Taken up in personal income tax return

CGT on sale of assets Payable by the individual

Record keeping requirements Ordinary tax record keeping

Is there CGT small business rollover relief? Yes

Advantages and disadvantages The sole trader has the advantages of simplicity, flexibility and control. There are, however, significant disadvantages, mainly that the sole trader is personally liable for debts incurred by the business. Furthermore, the financing options available for a sole trader business are limited. Taxation of sole traders offers both advantages and disadvantages. A tax advantage is the ability to use business losses to offset other taxable income. A disadvantage is that a person may be liable to pay income tax up to the top marginal tax rate (currently 50.5% inclusive of budget repair levy on wealthy taxpayers), whereas companies pay no more than 30% on profits earned.

Partnerships

Introduction A partnership is a business structure that involves more than one person carrying on the business in common with a view to profit. This definition appears in the Partnership Acts in each state and territory and is used to distinguish partnerships from other structures, such as joint ventures and trusts. Each of these business structures (considered below) will give rise to different legal consequences such as liability and compliance costs. It is therefore important to be able to identify whether a business with

3.13

3.14

multiple persons is operating as a partnership or not. A detailed consideration on the law of partnerships, together with case studies, can be found in Chapter 4.

Partnerships are commonly used for family businesses, usually for reasons of sharing control or (more often) for taxation reasons. Professional groups such as doctors, dentists, accountants and engineers are also ideally suited for this type of structure.

Governing law The laws regulating a partnership are the respective states and territories responsibility. The states and territories laws are: Australian Capital Territory Partnership Act 1963

New South Wales Partnership Act 1892

[page 53]

Northern Territory Partnership Act 1997

Queensland Partnership Act 1891

South Australia Partnership Act 1891

Tasmania Partnership Act 1891

Victoria Partnership Act 1958

Western Australia Partnership Act 1895

Establishment The creation of a partnership is based on an understanding between the partners (whether express or implied) to work together in the same business enterprise in order to attempt to make a profit that will be shared between them.

3.15

•

It is common for a partnership to be established under a contract (called a partnership agreement or sometimes, a partnership deed), which sets out the rights and obligations of the partners. However, a partnership can be established even without any express oral or written statement (that is, by the conduct of the parties satisfying the definition of a partnership).

Essential elements of a partnership As noted above, the Partnership Acts provide a definition of a partnership, which is:

… partnership is the relation which exists between persons carrying on a business in common with a view of profit. [emphasis added]

Arising from this definition, each of the following elements is required for a partnership to exist:

There must be a valid agreement between the parties as required by the word ‘relation’. The agreement does not have to take the form of a written contract, as discussed earlier, and can be implied from all of the circumstances. There must be a ‘business being carried on’. Business is defined under the Partnership Act to include every trade, occupation and profession. It is generally accepted by the courts that the word ‘business’, as used in the Partnership Act, excludes domestic transactions and the conduct of hobbies. An example of a domestic arrangement could include the sale of a jointly owned family home or car. The carrying on of a business may involve a continuing activity over a period of time, or it may involve a single event: see Canny Gabriel Castle Jackson Advertising Pty Ltd v Volume Sales (Finance) Pty Ltd (1974) 131 CLR 321 (involving a rock concert) discussed below at 3.33. There must be two or more persons working in the business together (‘in common’), although there may be silent partners who are not actively involved in the management. The fulfilment of this statutory criterion can be determined by seeing if there is an agency relationship which can bind the parties and, importantly, whether there are mutual rights and obligations between the parties on whose behalf the business is being carried on. See Chapter 4 at 4.11 for case studies illustrating the operation of this concept.

•

3.16

3.17

•

There must be a motivation to run the business so as to generate a profit, even if the business is ultimately unsuccessful in making a profit (‘view of profit’).

[page 54]

Rules relating to establishment of a partnership In order to assist with the task of identifying a partnership, the Partnership Acts provide a number of rules that provide guidelines on the existence or non-existence of a partnership in certain situations involve the sharing of profits. These rules are identified and considered in detail in Chapter 4 at 4.13–4.21 with reference to case illustrations.

Liability — partners and outsiders The determination of whether a partnership exists is important. The relationship in partnership imposes special liabilities on the partners. The basic rule is that each partner is both a principal and agent of the business as a result of the statutory agency relationship provided for by the Partnership Act. This means that each partner may incur liabilities on behalf of the business, and each partner will be liable for debts and obligations properly incurred on behalf of the business by other partners. Under the Partnership Act, each partner is jointly liable for contracts entered into on behalf of the partnership.

As a consequence of these legal ramifications, the golden rule is that one must choose one’s partners very carefully! See Chapter 4 at 4.22–4.30 for a wider discussion, and case illustrations, on the liability of partners for contract, tort and crime.

Why should a partner be liable for the debts and obligations incurred by other partners without their express approval?

Control

3.18

3.19

Control Each partner has the ability to partake in management, unless there is an agreement to the contrary. Each partner, as noted earlier, is agent and principal of the other. Partners, therefore, have the ability to manage the business and bind each other and be bound by the actions of their partners.

Partners’ relationship, rights and duties Mutual trust and confidence are the essence of a partnership, thus a partnership relationship is also regulated by the law of fiduciary obligations. This is an equitable relationship (arising under equity) where one person assumes responsibility for protecting and promoting the interests of another person who is vulnerable to abuse. Partners are therefore fiduciaries for each other partner in the business. This means that partners must act with honesty, loyalty and put the interests of the partnership ahead of personal interests.

This fiduciary relationship flows from the fact that partnerships are presumed to have arisen out of the trust, confidence and reliance that exist between the partners. The fiduciary obligations continue until the partnership is fully wound up (that is, even after the business has ceased trading activities): Chan v Zacharia (1984) 154 CLR 178 (discussed in Chapter 4 at 4.33).

The consequence of being fiduciaries is that partners are bound to give full disclosure of material information to the partners, and to act in good faith in the best interests of the partnership rather than in their own interests. Where a partner breaches their

[page 55]

fiduciary obligations, there are a range of remedies that may be sought by the other partners, including an injunction (for example, to stop the partner working for a competing business) or an account of profits (to claim back profits made by the partner in breach of their fiduciary obligations).

3.20

3.21

3.22

3.23

Fundraising Unlike companies, partnerships cannot raise funds from the general public. Partnerships rely on the partners’ savings or loans, or on business profits to finance growth. However, unlike the sole trader, a partnership formed for gain can have a maximum of 20 partners, thus increasing the pool of funds available. Section 115 of the Corporations Act 2001 (Cth) limits most partnerships (there are some exceptions listed in the Corporations Regulations 2001 (Cth) which relate to professional partnerships) to a maximum of 20 partners.

Continuity of existence and termination of a partnership Traditionally, any changes in the membership of the partnership terminated the business. This was based on the notion that partnership is a fiduciary relationship that requires the mutual trust and confidence between the partners. The Partnership Act, for example, states that the death, retirement or bankruptcy of a partner results in the termination of the partnership unless there is an agreement to the contrary. However, this provision may be (and is frequently) altered by the partnership agreement. Thus, it may be seen that large professional partnerships (such as lawyers and accountants) continue to operate even as dozens of partners change each year. The partnership agreement may of course provide that the business will terminate at a particular time and will usually provide for the distribution of the business’ assets. The partnership can also be terminated by the court on certain grounds: discussed in Chapter 4 at 4.40–4.44.

Privacy Aside from basic taxation requirements, there is no obligation to make public disclosure of financial information. Limited partnerships (see below) have slightly more onerous disclosure obligations.

Taxation Each partner is responsible for their own tax affairs and payment. A partnership tax return is filed with the ATO for administrative purposes.

3.24

3.25

Table 3.2 Overview of Taxation

Structure: Partnerships

Control rating Medium

Set-up costs Low

Liability for debts There is joint and several partner liability

Loss utilisation Can be used to reduce the partner’s other assessable income

[page 56]

Structure: Partnerships

CGT on sale of assets All partners are liable

Record keeping requirements Taxation records need to be maintained

Is there CGT small business rollover relief? Yes

Advantages and disadvantages The advantages of a partnership structure are the lack of formality and low costs in establishment. It is easily changed and provides privacy for commercial dealings with little disclosure needed to outside bodies. The pooling of capital and resources is a plus, compared to a sole trader, as is the simplicity and tax arrangements.

The disadvantages include unlimited liability, limitation of numbers who can participate in the partnership, difficulty in disposing of the share in the partnership (lack of liquid trading market and limitations imposed by partnership agreement) and some sacrifice of control due to group decision-making.

Limited partnerships One of the biggest disadvantages of a partnership is the unlimited liability of the partners. To overcome this problem, the limited partnership was developed in England and adopted in Australia. In all jurisdictions in which limited partnerships operate, their formation is dependent on registration. The legislation in the different states enables the formation of a partnership with at least one general partner with

3.26

unlimited liability and one or more limited partners whose liability is capped at the amount of capital they have paid in (or promised to pay in). However, the partners with the limited liability are not permitted to take part in the management of the business of the partnership and cannot bind the firm, although they can inspect the partnership books. The partnership liabilities are required to be disclosed in a public register of limited partnerships.

Importantly, the creation of a limited partnership will change the taxation treatment of the business from a partnership (which involves flow- through of both profits and losses) to that of a company (which does not allow flow-through).

Limited partnerships are discussed further in Chapter 4 at 4.51–4.54.

Joint ventures

Introduction A joint venture is another type of business structure that is commonly used today, particularly in high risk capital, or high risk enterprise, activities. The joint venturers are able to bring in different skills or assets, or a combination of these, into the enterprise. Typical examples of where a joint venture might be employed are in mine explorations, property development, construction, manufacturing, publishing, entertaining, hospitality management and share farming ventures.

[page 57]

A joint venture has been judicially defined in Brian Pty Ltd v United Dominions Corporations Ltd [1983] 1 NSWLR 490 at 506 as:

… an association of persons, natural or corporate, who agree by contract to engage in some common, usually ad hoc undertaking for joint profit by combining their respective resources, without, however, forming a partnership in the legal sense (of creating that status) or corporation; their agreement also provides for a community of interest among joint venturers each of whom is both principal and agent as to the others within the scope of the venture over which each venturer exercises some degree of control.

3.27

3.28

3.29

Joint ventures, while different from partnerships, may overlap and can sometimes blur the boundaries between these two structures. Unlike the continuity in business activities in partnerships, joint ventures are usually formed to undertake commercial activities that have a finite life. The sharing by the joint venturers of the product or result of the joint venture, rather than profit, is another distinguishing factor. Other differences are discussed below.

Establishment There are no formal legal requirements for establishing a joint venture. For example, unlike the specific regulation of companies, there is no Joint Ventures Act or a register of joint ventures. However, as with all contracts, the absence of a written agreement stating the rights and liabilities of the parties may add to confusion, debate and ultimately cost in resolving differences. It is not uncommon for lawyers to prepare a written contract to govern the terms and conditions of the business relationship and the manner in which it can be terminated.

Governing law There is no specific state or federal legislation that deals with formation or operation of a joint venture. The formalities for the registration of a business name, discussed earlier, will apply. In the absence of any relevant legislation impacting on the activities of the joint venture (such as mining or intellectual property statutes), the principles of general law will apply in relation to the joint venture.

It is important to remember that anyone intending to enter into a joint venture agreement must make themselves aware of any legislation, or other controls, that may regulate the business activity of the joint venture. For example, in a joint venture involving mining exploration, other legislation in this case will include licensing provisions, pollution provisions and occupational health and safety laws.

Control The joint venturers will usually bring different benefits (such as skills and

3.30

3.31

working capital) to the project. Therefore, the control to be exercised by each party will usually be limited to each party’s area of expertise. Usually a joint venture agreement will provide for a management vehicle, such as a management committee made up of representatives of the co-venturers. In the case of a joint venture company, the joint venture participants will each have shares in the company and will appoint directors to the board.

[page 58]

Liability of joint venturers A joint venture is not a separate legal entity and therefore the liability will flow through to the joint venturers. It is important that each joint venture participant maintain appropriate legal compliance systems to isolate their own liability for personal injuries and other breaches of the law.

The joint venturers may also agree between themselves to share liabilities in specified proportions (contribution agreements or in some cases contracts of indemnity), but this agreement does not bind third parties. Joint venturers may both participate in an activity that breaches the law (for example, by causing personal injury) and may thus become jointly and severally liable. The concept of joint and several liability, which also applies to certain liabilities in a partnership, is explained in Chapter 4 at 4.22.

If the joint venture is in reality a partnership, then an agency relationship will exist between the partners resulting in joint (collective) liability for debts.

Fundraising A joint venture offers the advantage of pooling physical, financial and human capital between the joint venture participants. Unincorporated joint venturers will be reliant on loans and trading profits to finance growth. Incorporated joint ventures utilising a public company as a business structure have the flexibility to access funds from the general public.

3.32

3.33

Relationship between joint venturers The joint venturers, ordinarily, are not in a fiduciary relationship. However, the courts have recognised that particular situations may give rise to a fiduciary relationship even between joint venturers. There is no rule that joint venturers can never owe fiduciary duties, but in the ordinary situation they will not owe each other fiduciary duties unless they deal with each other so as to create a fiduciary relationship: United Dominions Corporation Ltd v Brian Pty Ltd (1985) 157 CLR 1. The property rights flowing from the joint venture project will be determined by the terms of the joint venture agreement.

Difference between a joint venture and a partnership As noted above (see 3.15) a partnership is defined as the relation that exists between persons carrying on a business with a view to profit. A joint venture agreement will usually be structured so as to keep the participants as separate as possible, which may take the project outside of the definition of a partnership. This will usually involve the distinction between sharing the final product and sharing the profits from selling the product.

On some occasions, depending on the facts of each case, a joint venture may be deemed to be a partnership. This can occur because the activities of the joint venture overlap with the activities that define a partnership. The mere fact the parties state in their agreement that the undertaking is a joint venture, and is not a partnership, is in

[page 59]

itself meaningless. The courts are not bound by the stated words in the agreement, rather they are required to analyse the activities and actions of the parties to determine what form of relationship actually does exist.

The case of Canny Gabriel Castle Jackson Advertising Pty Ltd v Volume Sales (Finance) Pty Ltd (1974) 131 CLR 321 demonstrates that the courts are not bound by the labels the parties place on their business relationship.

•

• •

Canny Gabriel Castle Jackson Advertising Pty Ltd v Volume Sales (Finance) Pty Ltd (1974) 131 CLR 321 High Court of Australia

Facts: Fourth Media Management was a promoter that was in the business of managing the tours of Australia by both Cilla Black and Elton John (entertainers). Volume Sales (Finance) Pty Ltd agreed to finance the tours. Accordingly, a written agreement was entered into in which Fourth Media Management agreed to assign (transfer) to Volume Sales a half interest in the contracts and this half interest was described by all parties involved as being on the basis of a joint venture. At the same time the finance advanced by Volume Sales was described as a loan to the joint venture. The net profits of the joint venture were to be divided at the end of the contract. All matters were to be agreed by the parties and any losses were not to be shared on the same basis as the profits. Subsequent to the agreement with Volume Sales, an equitable charge (type of security) was granted to Canny Gabriel (a third party) on the basis of additional finance being advanced by that party.

Decision: On the facts of this case, it was held that the arrangement between Fourth Media and Volume Sales was a partnership regardless of the joint venture label provided by the parties. The court held that it was a partnership on the basis that profits were being shared equally between the parties and the management and the conduct of the arrangement was dictated by their joint agreement. The High Court held (at 327):

… it seems to us that the contract exhibited all the indicia of a partnership except that it did not describe the parties as partners and did not provide expressly for the sharing of losses, although we venture to think that it did so impliedly.

The key differences between joint ventures and a partnership are that in the case of a joint venture:

The activities are of a specific duration or for a limited purpose, whereas the activities of a partnership are often continuing and indefinite. The liability is individual rather than joint and several as in a partnership. Joint venturers can, subject to agreement, freely dispose of their interest (property or share) in the joint venture, whereas partners need to assign their interest and do not enjoy this general freedom. The parties are not necessarily in a fiduciary relationship, whereas partners owe each other fiduciary duties. The joint venture is a separate venture for each party. The joint venturers receive a share of the product, whereas partners share profits — as demonstrated by the following key statement.

3.34

3.35

[page 60]

United Dominions Corporation Ltd v Brian Pty Ltd (1985) 157 CLR 1 High Court of Australia

Perhaps in this country, the important distinction between a partnership and a joint venture is, for practical purposes, the distinction between an association of persons who engage in a common undertaking for profit and an association of those who do so in order to generate a product to be shared among the participants.

Accordingly, the best way to ensure that a joint venture is not considered as a partnership by the court is to give the venturers a share of the product and allow each participant to decide how it will dispose of his or her share. Product sharing may not always be possible. In such instances, the parties should carefully consider alternative business structures if they wish to avoid a partnership relationship and the consequences of this.

Continuity and termination of the joint venture A joint venture is not a separate legal entity. Therefore, the joint enterprise will last as long as the parties continue to act under the joint venture agreement, which will usually provide for a range of termination events. The joint venture agreement will also provide for the distribution of rights to products and intellectual property generated by the joint venture.

Privacy Unincorporated joint ventures enjoy financial privacy. They can keep their business affairs confidential from the other joint venturers. Incorporated joint ventures, utilising a large proprietary company or a public company as the business vehicle, will have to publicly disclose financial statements (such as profit and loss statement and balance sheet). The financial disclosure obligations of such companies are considered below under the topic of companies.

3.36

Taxation An unincorporated joint venture is not a separate legal entity. As a result, each of the parties enjoys financial privacy and is responsible for their own accounting procedures and taxes. From a taxation perspective, this translates into a structure that is similar to that of a sole trader. However, if the joint venture is using a company as the management vehicle, then the taxation characteristics of a company (discussed below) will apply.

Table 3.3 Overview of Taxation

Structure: Individual Joint Venture Participants

Control rating Medium

Set-up costs Low

Liability for debts Depends on structure used by participant (trust partnership or company)

[page 61]

Structure: Individual Joint Venture Participants

Loss utilisation Depends on structure used by participant (trust partnership or company)

CGT on sale of assets Depends upon structure used by participant (trust partnership or company)

Record keeping requirements Ordinary record keeping requirements

Is there CGT small business rollover relief?

Depends on nature of business

Structure: Company Structure Used as a Management Company

Control rating Low/medium

Set-up costs Medium/high

Liability for debts Limited to the company

Loss utilisation Losses offset against future company income — do not flow through to shareholders

CGT on sale of assets Gains taxed in company’s hands at the company rate

Record keeping requirements Yes need to be maintained but substantiation rules do not apply

Is there CGT small business rollover relief?

Depends on nature of business rollover relief

3.37

3.38

Advantages and disadvantages The advantages of a joint venture are that it can be used for any purpose and normally is used for the achievement of tasks related to a specific project or a specific period. Each party to the joint venture is treated separately and assets are held as individual entitlements. Liability remains individual, related to the task or role undertaken, and interests can be disposed of or assigned.

Some of the disadvantages include the occasional need to employ a manager for the joint venture which may result in additional cost. There is also the need to avoid co-mingling of assets in order to avoid issues of partnership arising. The separateness of interests may detract from the overall effectiveness of the joint venture.

Trusts

Introduction The trust is a creation of the law of equity and has existed for many hundreds of years. The original purpose of trusts was to create a more flexible method of dealing with, and preserving, real property as part of family estate planning purposes. In more modern times, trusts have developed into a popular, although complicated, commercial business structure. The complexity of the trust structure arises from the

[page 62]

fact that they are based on flexible rules of equity, which are not prescriptive. This means that trusts can take a number of forms, discussed below. In addition, trusts are usually constructed to fit within the boundaries of statutory regimes that are themselves often complex (particularly tax law, family law and social security law).

Trusts can be formed for public or private purposes, either intentionally or not (as explained below). In practice, a trust is usually created,

• • •

3.39

3.40

3.41

deliberately, as a commercial structure to exploit the benefits they provide, such as:

tax minimisation; asset protection; and reducing asset levels for income thresholds.

Types of trusts There are various ways to categorise trusts. One way is to distinguish between the method of creating the trust.

Express trusts An express trust occurs where the parties intend to establish a trust relationship over particular property. This usually involves the creation of a trust deed to establish and regulate the trust. Common examples of express trusts include superannuation trusts, cash management trusts and trading trusts. In the context of establishing a business, the express trust will be the method chosen to create the trust.

Fixed trusts and unit trusts Another method of categorising trusts is on the basis of the method of distributing the benefits of the trust. This involves distinguishing between fixed trusts and unit trusts.

3.42

In a fixed trust, the entitlements of the beneficiaries are pre-determined. The trust deed will also provide what level or percentage of return the beneficiaries are to receive from the profits of the trust. Unlike a discretionary trust, discussed below, the trustee lacks discretion in these matters. This feature makes a fixed trust attractive

[page 63]

for use in the case of unit trusts. In a unit trust, the fund is divided into a number of equal units held by the unit holders (the beneficiaries). The trustee manages the trust property on behalf of the unit holders and distributes capital and income according to the entitlement of the unit holder. In this way, unit trusts are often used when funds are pooled for either public or private investment purposes.

Discretionary trusts In a discretionary trust, the trustee has discretion as to how the profits and capital of the trust are to be distributed among the beneficiaries. Unlike the unit trust, the identity or the amount to be distributed to the beneficiary is not pre-determined at the time when the trust is created. This is deliberate and the beneficiaries may include unborn children. The trustee’s discretion may be with respect to which beneficiaries receive a distribution, or it may be the size of the distribution — and often it extends to both. The discretionary trust is particularly useful, in this manner, as a method of minimising tax as distributions may be tailored to particular (low income or high deduction) beneficiaries. This flexibility in the distribution of trust income makes discretionary trusts popular for income splitting purposes.

This type of tax minimisation strategy is legal. However, the use of trusts to evade the payment of tax is illegal. Therefore, there are numerous tax rules regulating the use of discretionary trusts. For example, subject to few exceptions, drastic tax penalties apply when trust income above a threshold amount is channelled to children under the age of 18. An exception arises, for example, when the minor is in full-time employment or has inherited income from a deceased estate.

3.43

3.44

It is important to bear in mind that the categories of trusts set out above are descriptive rather than prescriptive. They help to explain how particular trusts work, but the law of equity is flexible and each individual trust must be examined in order to determine the rights, powers and obligations of each of the parties (that is, the trustee and beneficiaries).

Implied trusts, resulting trusts and constructive trusts This type of trust is not expressly determined by the parties. Indeed, both trustee and beneficiary may not believe they are involved in a trust relationship. However, the circumstances of the case require that a trust be recognised by law. The two common examples of implied trusts are resulting trusts (for example, where a loan for a particular purpose fails, there may be a resulting trust recognised to return the loan funds to the lender) and a constructive trust (where a person holds property in breach of fiduciary obligations, that person may be said to hold some or all of the property as ‘constructive trustee’). A common example of a constructive trust arises when a partner (in a partnership) or a director (of a company) makes a personal profit by breaching their fiduciary duties. In such circumstances, the partner or director will have to hold onto the property as a constructive trustee (and will have disposed of rights of ownership) for the benefit of the partnership or company.

Establishment and essential elements of a trust A trust involves a separation between the legal and equitable (otherwise known as ‘beneficial’) rights in property. Ordinarily, the owner of property will hold both the

[page 64]

legal title (for example, for land their name is recorded on the register of land titles) and equitable title (meaning they have the right to benefit from owning the property). However, a trust will separate these two interests and give them to different people.1 The Butterworths Encyclopaedic Australian Legal Dictionary defines a trust as: ‘A device by which one person holds property for the benefit of another person.’ This

definition recognises that there are several elements to the creation of a trust:

Settlor — this is the person who creates the trust by donating or transferring property to the trust. It is not uncommon for the creator to establish a trust with a nominal amount of money (for example, $50) as trust property. On the happening of this event, the settlor no longer has control over the trust property which thereafter legally belongs to the trustee. As noted above, a trust can be created in a variety of ways. When trusts are created unintentionally (such as constructive, implied or resulting trusts explained above), the need for a settlor does not arise.

Trust property — any type of property may be received by the trust, such as money, land, shares or intellectual property (for example, a patent).

Trustee — this is the person who is the legal owner and controller of the trust property. The trustee, who is usually appointed in the trust deed, manages the trust on behalf of the beneficiaries and is held accountable by being subject to fiduciary duties. However, depending on the type of trust, a person may become a trustee through the operation of the law. This arises in cases of constructive or implied trust (explained below) and the appointment will be valid even where there is no deed of appointment.

Beneficiary — this is the person who benefits from the fiduciary relationship between the trustee and themselves. The beneficiary holds an equitable interest in the trust property as they have the right to compel the trustee to manage the trust property in accordance with the purposes of the trust and the directions and powers contained in the trust deed.

In family trusts, such as discretionary trusts, it is not uncommon for the settlor to be a trustee and a beneficiary so long as there are other beneficiaries to create a valid trust.

As noted above, the trust is a flexible instrument regulated by the law of

•

equity. There are, however, a number of formalities that may apply with respect to the creation of a valid and enforceable trust.

First, each trust must satisfy the ‘three certainties rule’. This rule requires that the creation of a valid trust will only occur where there is:

Certainty of intention — this requires that the person who owned the property before (the ’settlor’) intended that the property should be held on trust, rather than, say, giving the property to another person as a simple gift. This may be proved by clear words of intention, such as ‘I declare that I now hold this property as trustee for my children’. Certainty of subject matter — this requires that the trust property be clearly identified.

[page 65]

Certainty of objects — this requires that the beneficiaries of the trust be capable of identification. A non-charitable trust in favour of no person is invalid, while charitable trusts are governed by special rules to uphold their validity.

Second, if the trust is a non-charitable trust it must not infringe the rule against perpetuities. This means that, in most cases, the trust must be terminated within 80 years of its creation. This rule is regulated by the perpetuities statute in each state and territory and is designed to ensure that the legal and equitable titles are held by the same person(s) within a reasonable amount of time. The rule against perpetuities arose out of concerns that property could be divided through a trust for several generations.

Third, certain types of trust property (particularly land and equitable interests) will require that the trust be established in writing, usually by a written declaration or trust deed. However, this rule does not apply to the remedial trust where the court orders that property be held on trust for someone else (for example, a constructive trust as explained below).

Governing law

3.45

3.46

3.47

The law of trusts is mainly derived from equitable principles imposing fiduciary obligations on the trustee. In addition, trusts are subject to the Trustee Acts of each state2 and territory.3 A further layer of regulation will usually apply to trusts. For example, trustees of superannuation trusts are regulated by the law of equity, the Trustee Acts, taxation laws and superannuation laws.

Control The management of trusts is undertaken by the trustee, who may also be the settlor (that is, the person setting up the trust), or one of the beneficiaries (but not the only beneficiary). The trustee’s role and powers are defined by the trust instrument, which may direct and guide the trustee in many ways. For example, the trustee may be answerable to external advisers relating to the investment of large sums of trust money. External persons may also be conferred with a power to replace the trustee under the trust instrument.

As a general rule, the beneficiaries cannot interfere in management (unless, for example, there is a breach of the trust agreement). Trustees are accountable to the beneficiaries and can be liable for breach of fiduciary duty and acts of negligence.

Liability A trust is not a separate legal entity. The trustee is the legal owner of the trust property and therefore carries liabilities accruing from the use of the trust assets. However, the trustee has a general right of indemnity for debts and liabilities incurred in the proper administration of the trust. This means that the trustee may claim reimbursement out of the trust assets. In some situations, identified below, the trustee may also seek indemnification by the beneficiaries.

[page 66]

Given that a trust is not a separate legal entity, it is mainly for this reason that a trading trust will form a company — which is a separate legal

3.48

3.49

person and offers limited liability, to act as a corporate trustee. A proprietary company with a paid-up capital of $1 or $2 dollars (the latter commonly called a $2 company) is usually formed for this purpose. In this way, the trustee will enjoy the benefit of limited liability. However, should the trustee abuse their powers and act in breach of the trust deed, s 197 of the Corporations Act removes the protection of limited liability. In such circumstances the directors will be personally liable for the loss.

Rights and obligations of trustees The trustee, as legal owner of the trust property, has all of the rights of an ordinary legal owner of property. However, the exercise of these rights will usually be subject to particular limitations imposed by the trust deed. For example, the trust deed may limit the trustee’s ability to use the trust property as security for a loan, or may prohibit the trustee from investing trust funds in certain types of investment products (for example, non- investment grade or unregulated products). The trustee also has various statutory rights under the Trustee Act of the particular state or territory in which they are managing the trust. These powers provide certainty where a trust deed does not clearly provide or prohibit the power.

Right of indemnity An important right given to a trustee is the right to be indemnified for debts properly incurred in the due administration of the trust. This right of indemnity means that a trustee may use trust property (including money) to pay debts that arise in the ordinary course of managing the trust. For example, a trustee should insure the trust property against fire, theft or other damage, and the trustee could use trust funds to pay for the insurance premium each year. Similarly, if a trustee pays trust debts out of their own funds they may seek reimbursement from the trust property.

What happens if the trust property is insufficient to satisfy the debts incurred by the trustee? The general rule of equity is that the beneficiaries must indemnify the trustee pro rata. This means that in a simple express fixed trust with two beneficiaries, each with an equal entitlement to the trust distributions, they would be obliged to contribute 50% of the amount needed to satisfy the trust debt over the value of the

• •

•

• • •

trust assets. However, this rule is complicated in its operation and may be varied by the provisions of the trust deed itself (that is, by restricting the trustee’s right of indemnity). Furthermore, this right to seek indemnification from the beneficiaries will not ordinarily apply to a discretionary trust, as the class of beneficiaries (or ‘objects of the trust’) might not have an ascertainable interest in the trust (because they might not receive any distribution when the trustee exercises his or her discretion). The beneficiaries, even in a fixed trust, may avoid the operation of the duty of indemnity by disclaiming (that is, giving up) their interest in the trust.

The trustee’s right of indemnity only applies to trust debts that were ‘properly incurred’. Thus, if a trustee incurs the debt by acting in breach of trust (for example, by obtaining a secured loan when the trust deed prohibits the use of trust property as

[page 67]

security), then they will lose their right of indemnity. The trustee will not be able to use the trust assets or make a claim against the beneficiaries to repay an improperly incurred debt.

In addition to fiduciary duties, the trustee will have various obligations expressed in the trust deed and under the relevant Trustee Act (found in each state and territory). The law of fiduciary obligations imposes a range of duties on the trustee, including the duty to:

keep proper financial records; give full and frank disclosure to the beneficiaries of important matters relating to the administration of the trust; act only within the terms of the trust deed, or on instructions from the beneficiaries; exercise due care and diligence in the administration of the trust; act fairly between the beneficiaries; and act only in the interests of the beneficiaries within the terms of the trust (and therefore to avoid conflicts of interest).

Where a trustee fails to comply with the obligations imposed by the trust

• • • • •

•

3.50

deed, they are said to be in ‘breach of trust’. In addition, a trustee may fail to comply with their fiduciary obligations and thus breach their fiduciary duty. If a trustee acts in breach of their obligations, a beneficiary may seek relief from the court including:

replacing the trustee; winding up the trust; an injunction against further breaches; the rescission of a contract entered into by the trustee; the imposition of a constructive trust over property improperly obtained by the trustee; and an account of profits improperly made by the trustee.

The general rule is that a defaulting trustee must restore property to the trust that has been improperly dissipated.

Rights and obligations of beneficiaries Similar to a trustee, the rights and obligations of the beneficiaries are determined by the terms of the trust deed and the rules of equity (particularly the rules of fiduciary relationships).

The beneficiaries’ rights also include the right to apply for court orders under the Trustee Acts of each state and territory (for example, to apply to have the trustee removed for improper conduct). At general law, beneficiaries have the right to enforce the proper administration of the trust, which includes the right to inspect trust documents and to receive information from the trustee. Where there is doubt, the beneficiaries may seek directions from the court to assist in enforcing the proper administration of the trust. Importantly, unless the trust deed provides otherwise, there is no right to receive a distribution from the trust. If the trustee has a power to distribute in their discretion, then a beneficiary cannot force the trustee to distribute trust property to them.

[page 68]

absolutely entitled: where there are no subsisting legal or equitable rights on the trust property,

3.51

3.52

including the trustee’s right of indemnity that may prevent the distribution of trust property to the beneficiaries.

One of the most significant rights given to beneficiaries comes from the rule in Saunders v Vautier (1841) 4 Beav 115, which provides that the beneficiaries may terminate the trust by asking the trustee to transfer the trust property to them according to the terms of the trust deed. However, this right only applies if all beneficiaries agree, are over 18 and are ‘absolutely entitled’ to the property. Thus, the rule has no operation where the trustee has paid out properly incurred debts and may claim an indemnity against the trust property.

In respect of obligations owed by the beneficiaries, the primary obligation is to indemnify the trustee for debts properly incurred (noted above). The rationale for this obligation is explained in the famous Hardoon case.

Hardoon v Belilios [1901] AC 118 House of Lords (UK)

The plainest principles of justice require that the [beneficiary] who gets all the benefit of the property should bear its burden unless he can [show] some good reason why his trustee should bear them himself.

That is, because the trustee is managing the trust property for the benefit of the beneficiaries, they should carry the financial burden for that management where the trust property is insufficient. It should be noted that where the trustee is a company, the trust creditors may have an action against the directors of the trustee company if the directors acted in breach of trust — for example, when the director acts beyond the scope of his or her powers under the trust deed. The prospect of personal liability for the director arises from s 197 of the Corporations Act.

Fundraising Trusts are able to accumulate significant amounts of money by attracting contributions from an unlimited number of investors. However, if the

3.53

•

3.54

public are invited to contribute, then the trust is usually regulated as a managed investment scheme under the Corporations Act: see 19.13–19.22. Trusts may also obtain debt finance, but the lender will want to ensure that the trust instrument allows the lender to access the trust funds through the trustee’s right of indemnity.

Continuity of existence and termination Generally, a non-charitable trust must not last for longer than 80 years under the rule against perpetuities, although there are some states where this rule allows for longer periods (sometimes over 100 years). This means that the legal and beneficial interest must be held by one or more persons within the perpetuity period (which is generally 80 years but can be different in some states and territories).

A trust may be terminated in one of the following ways:

Revocation — if a trust deed has a clause stating that the settlor or the trustee can revoke the trust, they will be able to terminate the trust. Beneficiaries’ consent — if the beneficiaries are all of full age and legal capacity and they all agree to the termination of the trust, they can terminate the trust.

[page 69]

Court order — the court has the power to terminate a trust if it believes, for instance, that the trust that has been created is a sham. Distribution of trust property — when all the trust property has been distributed to the beneficiaries, the trust will cease to exist.

Privacy Depending on the type of trust (that is, whether the trust is regulated as a managed investment scheme or not), there is generally no obligation to disclose information to the public (aside from general tax compliance).

Taxation

3.55

3.56

•

Trust income is assessed in the hands of the trustee or, if fully distributed, in the hands of the beneficiary — but not both.

Table 3.4 Overview of Taxation

Structure: Trusts

Control rating Medium/low

Set-up costs Medium to high

Liability for debts Trustee is liable

Loss utilisation Losses offset against future trust income

CGT on sale of assets Beneficiaries are liable

Record keeping requirements Yes but the substantiation rules do not apply

Is there CGT small business rollover relief? Yes

Advantages and disadvantages The advantages of trusts lie in the fact that they are a very flexible business structure that can involve an almost limitless variety of rights and obligations. Trusts are particularly useful for tax planning as they allow income splitting and family estate planning. The disadvantage of trusts is that there are very complex tax laws that seek to minimise the incidence of tax avoidance and to regulate tax evasion and this raises the compliance costs of using this structure. The potential complexity of individual trusts may also mean that clients may not fully understand the nature of their business structure, unlike better understood structures such as partnerships and companies.

What would you say to a client to explain how they might use a trust for their business?

Companies

Introduction

3.57

• • •

Companies registered under the Corporations Act 2001 (Cth) are either proprietary companies or public companies. The main difference between them is that proprietary companies are essentially smaller and private. Section 113 of the Act

[page 70]

states that proprietary companies cannot have more than 50 shareholders and are not permitted to raise funds that require the issue of a disclosure document to investors under Ch 6D of the Act (such as a prospectus.). The regulation of corporate fundraising is discussed in detail in Chapter 9. Other key differences are considered below.

There are over 2.5 million companies in Australia, with approximately 2242 public companies (as of July 2017) listed on the Australian Securities Exchange (ASX) with a market capitalisation in excess of $1.5 trillion. These figures demonstrate that the majority of Australian companies are proprietary in nature, for reasons discussed below at 3.82–3.83.

The popularity of companies, as a form of business structure, arises from the fact that they are an artificial creation by law. The main characteristic of a company is its recognition as a separate legal entity. A company is a legal person and is considered to be distinct from its owners, directors, members, employees and agents. As a consequence of this unique feature, a company has the powers of an individual and is able to do the following under its own name:

own and dispose of property and other assets; enter into contracts; and sue and be sued.

Companies also enjoy the unique advantage of perpetual succession (that is, it continues even if its members die, retire or resign).

Limited liability is another unique feature of companies that makes it attractive as a vehicle to conduct business. Shareholders are not liable, in their capacity as shareholders, for the company’s debts. This advantage

3.58

arises from the decision in Salomon v Salomon & Co Ltd [1897] AC 22, a landmark case in company law which held that the debts of a company are not the personal debts of the person who controls the company. Accordingly, at common law, a distinction is drawn between personal debt and company debt.4 This affords limited liability to the controller of the company, even if the company is a ‘one-person’ business with no other shareholders or directors — as recently reinforced in the following judicial passage:5

… a company, even a ‘one-man company’, is a distinct entity from its owner. The courts have upheld this ’separate entity doctrine’ since the decision in Salomon v Salomon & Co Ltd. This remains the case in the absence of a statutory basis to the contrary, and in the absence of some factor which would merit a departure at common law — for example, where a company structure has been used either to commit fraud or for the sole or dominant purpose of circumventing an existing personal legal obligation.

Salomon’s case, and the important legal implications arising from separate entity rule, is discussed further in Chapter 5 at 5.1–5.6.

[page 71]

Establishment A company is created through the process of registration under the Corporations Act. As a consequence of reforms under the Corporate Law Reform Act 1998 (Cth), and under the Corporations Legislation Amendment (Simpler Regulatory System) Act 2007 (Cth), this process is now streamlined and quicker than before. An application for company registration with ASIC requires the following.

Figure 3.3 Incorporation Checklist

Incorporation proceeds by registration with ASIC. Registration procedures are governed by Corporations Act s 117 and broadly require these steps:

Determine the type of company you wish to incorporate: eg, limited by shares or limited by guarantee; public or private. Choice will affect what is included in application for incorporation: see ss 112, 117(2)(a); Decide whether or not the company requires a constitution and if so, draft it; see s 117(3); Obtain written consent from each proposed director and secretary for the new company: see ss 117(2)(d), 117(2)(e); Reserve a name for the company: see s 117(2)(b);

8. 9. 10.

3.59

3.60

Locate a registered office where documentation can be sent or served: see s 117(2)(g); Locate a principal place of business (which may be the same as your registered office): see s 117(2)(j); Determine the company’s share structure and members (be aware of special requirements where shares issued for consideration other than cash: see s 117(1)(l); Complete a Form 201, ensure it is signed and lodged with ASIC: see s 117(1); Pay registration fee; Receive from ASIC the certificate of registration — Company has full legal capacity and powers of an individual: s 124. The company remains in existence until it is deregistered: s 119.

The completion of a prescribed application form (s 117) Form 201 (application for registration as an Australian company) requires details, as applicable, about the class and type of company, share structure details, director and secretary details, members’ share details, registered office details.

A company name If a company conducts a business under a name that is different from the company’s name, it must register the name under the Business Names Registration Act 2011 (Cth). A person may choose, to propose, and reserve for a fee, a company name with

[page 72]

ASIC so long as the name is not already registered or offensive or suggestive of illegal activity.6 Through ASIC Connect (online registry portal), a business name can be registered and paid for online. It is not necessary, however, to give a company a distinctive name. Instead, ASIC is authorised by law to give every company registered under the Corporations Act a name through allocation of a unique nine-digit number known as the Australian Company Number (ACN). For example, the company’s name might be ‘ACN 123 456 789 Pty Ltd’. The ACN must appear on every public document and negotiation instrument (for

3.61

3.62

example, a cheque) issued by the company and on all documents required to be lodged with ASIC: ss 123 and 153.

Constitution or replaceable rules or both A person may choose to draw up the company’s own constitution to provide for internal management rules, such as the procedure for meetings, share transfers and the manner in which directors can be appointed or removed. It is not necessary, however, for a company to prepare its own constitution. Instead, the company may choose to take advantage of the basic replaceable rules in the Corporations Act dealing with internal governance or adopt a combination of both: s 135. See Chapter 6 at 6.4 for a fuller discussion on the role and significance of a company’s constitution and the replaceable rules.

The table under s 141 of the Corporations Act, dealing with rules of internal management, sets out the provisions of the Act that apply as replaceable rules. Single director/shareholder proprietary companies, however, have no need for a formal set of rules governing its internal relationships. Accordingly, s 135(1) of the Act provides that the replaceable rules do not apply to such companies. Instead, the Act has special provisions applicable to single director/shareholders that are incapable of modification. For example, s 198E sets out the powers of directors of single director/shareholder companies.

The modern practice can be contrasted with the position before law reform in July 1998 where it was compulsory for many, not all, companies to prepare a memorandum of association and articles of association. The reasons for the abolition of these documents are discussed in Chapter 6 at 6.4.

Written consents and appointments A company needs to have at least one member: s 114. A proprietary company must have at least one director who must ordinarily reside in Australia: s 201A(1). A public company must have at least three directors of whom at least two must ordinarily reside in Australia: s 201A(2).

3.63

3.64

Written approval is required from people who agree to be a company’s director (must be at least 18 years old), secretary (required for public companies only) and shareholder.

The same person may be both a director of a company and the company secretary. Although consents are required before registration, it is not required to be lodged

[page 73]

with ASIC. Instead, it must be given to the company after registration so that the details can be recorded in the register of members.

Payment of prescribed registration fees A registration fee must accompany the application form. Following law reform designed to offer an incentive to use a company for business, the fee for registering companies with a share capital is $479 (a sizeable reduction from the previous amount of $800).

The company is then registered by ASIC and this registration will be recognised by the issue of a certificate of registration: ss 118 and 1274. The company comes into existence and attains maturity immediately, beginning on the day of registration, and remains in existence until it is deregistered: s 119. Once registered, the company can conduct business throughout Australia without the need to register in individual state and territory jurisdictions.

Alternative registration process There are alternative processes available to register a company. Instead of lodging Form 201, a company can be registered in minutes by instructing a business service provider who specialises in the registration of company structures. On the provision of the company name and the names of the company officers and the proposed shareholding, the business service provider will register the company for a fee. Business service providers can save the purchaser time and can also offer the

3.65

3.66

3.67

convenience of full company secretarial services. Alternatively, a pre- registered company (commonly known as a ’shelf company’) can be purchased from a business service provider. Thereafter, the shares are transferred to the new owner. Other changes, such as alterations to the company’s constitution and the company’s name, are at the discretion of the new owner. For complex corporate structures, a company can also be registered by a solicitor acting on the client’s instructions.

Post-registration requirements Registered office

A company must have a registered office in Australia and must inform ASIC of the location of the office: s 142. The purpose of the registered office is to have a place where all communications and notices to the company may be sent. It is common for directors of proprietary companies to nominate their accountant’s office for this purpose. Unlike proprietary companies, the registered office of public companies must be open to the public: s 145. A post office box cannot be the registered office of a company.

Appointment of a company secretary It is no longer compulsory for a proprietary company to appoint a company secretary. A public company, however, must have at least one secretary: s 204A(2).

[page 74]

Appointment of an auditor All public companies must appoint an auditor within one month of incorporation: s 327A. The directors of a proprietary company may appoint an auditor if the company has not done so at the general meeting: s 325.

Appointment of a public officer

3.68

3.69

3.70

• • •

3.71

The Income Tax Assessment Act 1997 (Cth) requires every company to appoint a public officer within three months after the commencement of business, otherwise the company will be subject to a daily fine after that time. The public officer is answerable for the company’s requirements and tax obligations under the Act and, in the case of default, is liable for the same penalties applicable to the company.

Maintenance of a minute book A company must keep a minute book in which it records, within one month, proceedings and resolutions of meetings of the company’s members and directors: s 251A. A minute that is recorded and signed is evidence of the proceeding or resolution to which it relates, unless there is evidence to the contrary.

Maintenance of registers Section 168 requires a company to set up and maintain the following registers:

a register of members; a register of option holders; and a register of debenture holders if the company has issued debentures (this topic is discussed further in Chapter 10).

Section 173 allows anyone the right to inspect the register and obtain copies. In exercising this right, members, registered option holders and registered debenture holders cannot be charged. The Act regulates the manner in which the information acquired can be used: s 177. For example, the information gained from the register cannot be used to create a mailing list for advertising material. A register may be kept either in a bound book or on a computer. If stored in the latter, its contents must be capable of being printed out in hard copy.

Keep ASIC informed Companies are obliged to notify ASIC of a variety of relevant matters, including changes in company officers (ss 201L and 205B), changes in

3.72

3.73

location of a register (ss 172 and 1302) or changes to the registered office or principal place of business: ss 142 and 146.

Annual statement and fee Prior to law reform in 2003, all companies were obliged to lodge an annual return with ASIC together with the payment of a fee. The annual return required companies to verify the basic information held by ASIC on their database which included details

[page 75]

about the officeholders, share structure, principal place of business and registered office. The annual return, together with a signed declaration stating the company was solvent, had to be returned to ASIC with a fee.

Since the abolition of annual returns in 2003, aimed at the reduction of regulatory burdens on business, ASIC now issues an Annual Statement with the same details (described above) which the company is still required to review for accuracy. However, if no changes are required, the company no longer has to lodge anything but must still pay the annual review fee (currently $254 for proprietary companies and $1201 for public companies).7 Changes, if any, are required to be lodged with ASIC within 28 days. Companies are now required to pass a solvency resolution within two months after each review date, unless the company has lodged a financial report with ASIC under Ch 2M of the Corporations Act within the previous 12 months.

Other practical tasks Other practical tasks associated with the establishment and maintenance of the company include obtaining insurance, opening of a bank account and the creation of a common seal to serve as the company’s signature. The common seal is a company stamp used on formal documents, such as loan documents. However, following law reform in 1998, a common seal is no longer compulsory: s 123. If the company does have a common seal, it must bear the company’s name and either the ACN or Australian

3.74

Business Number (ABN) if the same as the ACN. The manner in which a company may make contracts and execute documents without using a seal is discussed further in Chapter 7.

Compared to the alternative business structures, discussed earlier in this chapter, the costs of establishing and maintaining a company is relatively expensive — despite recent reforms and incentives aimed at reducing transaction costs and making it simpler and cheaper to conduct business via a corporate structure.

Governing law The Corporations Act governs the formation, operation and dissolution of companies. The Corporations Act is administered by the Australian Securities and Investments Commission (ASIC), a national corporate watchdog which derives its powers from the Australian Securities and Investments Commission Act 2001 (Cth). There are two sources of law governing companies. Apart from the statutes identified above, general law (consisting of common law and equity) also has an important role. Many of the foundational legal principles in company law, such as the treatment of companies as a separate legal person and the imposition of a fiduciary relationship between directors and companies, originated from judicial decisions.

ASIC works closely with other governmental regulatory agencies, such as the Australian Competition and Consumer Commission (ACCC) and the Australian Prudential Regulation Authority (APRA), to achieve enforcement and compliance. ASIC also has a close working relationship with the Australian Securities Exchange (ASX) to achieve effective law enforcement. The regulation of companies was

[page 76]

discussed earlier in Chapter 1 at 1.5. ASIC’s objectives and role are discussed further in Chapter 2.

There are other bodies associated with corporate law regulation. The

3.75

Takeovers Panel reviews decisions by ASIC in its exercise of statutory powers under the takeover provisions in Ch 6 of the Corporations Act and also considers whether takeover activities are compliant or unacceptable under the Act.

The Companies Auditors Disciplinary Board reviews the performance standards of auditors and is empowered to take disciplinary action against these members of the profession who have failed to carry out their duties properly. Sanctions include the ability to suspend registration and to impose monetary fines.

The Financial Reporting Council has the main function of setting Australian accounting and auditing standards and to monitor the compliance with auditor independence.

Until its recent abolition, the Corporations and Markets Advisory Committee (CAMAC) had an advisory role to the Commonwealth Government and considered the need for law reform.

Control There is separation of management from ownership in a company. All companies have a board of directors. The board is charged with the management of the company and the running of its day-to-day activities, although it should be remembered that the board’s powers may be either limited or expanded by the company’s constitution.

The main duties of directors, while carrying out their management role, are to ensure that they are exercising their duties in good faith and for a proper purpose. As they owe a fiduciary duty to the company, they have to exercise their duties with care, skill and due diligence. The duties owed by directors have been recognised in the general law and the Corporations Act has in turn confirmed, re-stated, partly codified and partly extended the recognised common law duties of directors. These duties are discussed in detail in Chapters 15–17.

The owners of the company are generally referred to as members. They generally hold ordinary shares in the company which entitles them to voting rights. These voting rights enable the members to provide

3.76

influence on the actions undertaken by the board of directors. These voting rights, however, do not include any right to have a say in the management of the company as a consequence of the delegation of management powers to the board of directors.

Although the members have no direct say in the management of the company, they are entitled to exercise certain rights under the Corporations Act. These rights enable them to seek relief from the court where oppression of a minority interest is occurring or where the actions of directors have been detrimental to members of the company and an action can be sustained against the directors. The various statutory and common law rights and remedies available to shareholders are discussed further in Chapter 19.

[page 77]

Liability One of the great benefits of forming a company is that such entities offer limited liability. The promotion of commercial activity and investment in early Victoria, afforded by limited liability, is captured in the following judicial passage:8

This innovation [limited liability] was designed principally as a device for attracting investment, and represented a real boon for enterprises looking to raise capital in the Victorian colony — in particular, mining companies. The source of the success of the limited liability company form was in enabling the issue of large numbers of shares in the event of a company becoming successful, without the disincentive of unlimited liability for shareholders … an important purpose of company law has always been to promote innovation in commerce

The effect of limited liability is that members are not generally liable for the company’s debts. The doctrine of limited liability, in effect, limits the liability of members of a company, and it makes members only liable to pay the issue price of the share. In the absence of any proven wrongdoing, neither the directors nor the members will become liable for the company’s debts. Ordinarily, directors’ personal assets and wealth are not at risk.

Limited liability achieves various economic goals:9

•

Facilitates investment — limited liability facilitates investment and encourages economic activity by shielding investors from any corporate loss in excess of their share capital. This protection reduces the cost of raising capital. Promotes market efficiency — limited liability promotes the liquidity and efficient operation of securities markets, as the wealth of each shareholder of a public company is irrelevant to the trading price of its shares. This allows shares to be freely traded, which may, in turn, promote efficient management for fear of a takeover arising from mismanagement and its negative impact on the trading price of shares. The threat of management being replaced, in such circumstances, offers incentives for proper and diligent management. Reduces monitoring — limited liability decreases the need for shareholders to monitor the managers of companies in which they invest. The risk to those shareholders of a company’s failure is limited to the loss of the equity invested. Encourages equity diversity — limited liability allows investors to acquire shares in a number of companies and also to diversify their risks.

Limited liability can also offer some disadvantages, particularly to creditors and outsiders — for example, it may result in excessive risk- taking activities. The Corporations Act, however, recognises this risk by making directors personally liable for company debts incurred during insolvent trading: s 588G. This protective statutory provision, designed to safeguard the interests of creditors, is discussed further in Chapter 18. The risk of ‘moral hazard’, or displacement of business risk to outsiders, is problematic in corporate groups. The risks arising from allowing limited liability in the corporate group context, together with case studies, is discussed

[page 78]

further in Chapter 5. The practical ’self-help’ measures that creditors can take to negate the effects of limited liability are discussed below.

Not all companies under the Corporations Act are limited liability

3.77

3.78

companies. The various types of companies that can be registered and their purposes for which they are best suited are discussed next.

Types of companies The Corporations Act recognises a number of different types of companies, some of which may be conducted for profit and offer limited liability. The Act, however, also allows for a company with unlimited liability or for the creation of a not-for-profit company. The manner in which the Act provides for business structures achieving commercial, welfare and social ends (such as charities and recreational clubs and societies) are discussed next. Section 112 of the Corporations Act classifies, as follows, various types of companies according to the liabilities of members.

Company limited by shares Companies limited by shares can be registered as either proprietary companies or public companies. This type of company is a popular choice for conducting business as it offers limited liability.

Section 9 of the Corporations Act defines a company limited by shares as: ‘a company formed on the principle of having the liability of its members limited to the amount (if any) unpaid on the shares respectively held by them.’

This means that if the shares are fully paid shares, members have no

further liability. Members’ personal assets are not at risk in order to satisfy payment of the company’s debts. The benefits of limited liability have been noted above.

However, in practice, it is sometimes said that limited liability is a myth. This may be true, depending on whether the creditor has taken active steps to protect their interests by negating the advantages of limited liability. For example, as a matter of commercial practice, it is usual for lending institutions (banks) and trade creditors to seek a personal guarantee for the company’s liabilities from the director as a pre- condition to a corporate loan or the supply of goods on credit. In such instances,

[page 79]

should the debtor company default in its payment, the lender will seek payment from the director on the basis of a personal contractual guarantee. In this way, directors can become personally liable for the company’s debts in their capacity as guarantors.

Spigelman CJ in CIT Credit Pty Ltd v Keable (2006) Aust Contract R 90- 243; [2006] NSWCA 130 remarked on the common practice of taking personal security when creditors are dealing with a company ([at 42]):

The obtaining of guarantees from directors is a common transaction in Australian commercial practice. It is a product of the combined effect of limited liability and of tax incentives to incorporate small businesses or to operate through family trusts with corporate trustees. The general nature of what a guarantee entails is part of the usual knowledge of the overwhelming majority of persons who become company directors, particularly since the removal of the requirement that all companies must have two directors.

Other forms of security may also be sought. For example, a creditor may seek a mortgage over the director’s house or personal assets to secure the performance by the company of its obligations under a loan. If the company fails to make repayment on the loan as agreed with the creditor, the director may lose the house. The court in Brighten Pty Ltd v Bank of Western Australia Ltd [2010] NSWSC 13310 endorsed the following submission made by the creditor (at [34]):

… it would be extraordinary that a bank or financial institution lending over $32,000,000 to any

3.79

private company, let alone a foreign private company, would not obtain as security a mortgage over the relevant real property together with a fixed and floating charge over all the assets of a relevant borrower(s) and a personal guarantee from the individual(s) standing behind the corporate borrower(s).

Whether limited liability is sometimes a myth or not is, ultimately, dependent on the respective bargaining positions of the debtor and the creditor. A company name must indicate the company’s legal status: s 148. A proprietary company must include the word ‘proprietary’ or the abbreviation ‘Pty’ in its name. This signals to the outsider that they are, essentially, dealing with a small company that is privately owned with limited membership and fundraising abilities.

Section 148(2) of the Act obliges companies which limit the liability of members to have the word ‘limited’ or the abbreviation ‘Ltd’ as part of and at the end of its name. This provision exists to serve as a warning to prospective creditors that care should be taken to protect their own interests, due to their limited recourse, when transacting with a limited liability company.

Company limited by guarantee Companies limited by guarantee must be registered as public companies: s 112(1). In a company limited by guarantee, the liability of members is limited to the amount of money owed under that guarantee. The members’ guarantee will be for a fixed amount generally specified in the company’s constitution (for example, $20) irrespective of whether the company is wound up with debts that exceed the amount

[page 80]

of the members’ guarantees. The members’ obligation to pay only arises when the company is wound up.

The inability to have the power to issue shares is a distinctive feature of a company limited by guarantee: s 124. The absence of share capital, and the subsequent lack of equity funding, makes such companies unsuitable for purposes of commercial trade. This is the primary reason why

companies limited by guarantee are often used for ‘not-for-profit’ activities and large non-trading organisations such as charities, recreational and sporting clubs and associations (religious, educational and community-based groups). The capital needs of companies limited by guarantee are generally modest and can be obtained through membership fees, grants, fundraising activities and the like. The inability of a company limited by guarantee to distribute profits as a dividend to members also makes this type of company unsuitable for trading purposes: s 254SA.

Current examples of public companies structured in this way include the Governance Institute (formerly Chartered Secretaries Australia Ltd), Choice (also known as Australian Consumers Association) and Standards Australia (originally incorporated by Royal Charter).

Based on efficiency considerations and cost, it may be more appropriate for smaller ‘not-for-profit’ clubs and associations that have local membership or state-based (as opposed to Australia-wide membership) to incorporate under the Associations Incorporation Act discussed below at 3.91. This is likely to be a cheaper structure to operate and maintain than having to comply with the regulatory and administrative burdens imposed on public companies under the Corporations Act, such as disclosure obligations and financial reporting requirements, even though law reform in 2010 has aimed to reduce the financial reporting requirements for companies limited by guarantee by introducing a three- tier reporting framework. A small company limited by guarantee, as defined under s 45B, is exempt from preparing an annual financial report and director’s report: ss 285A and 292(3). These exemptions, however, do not apply if a member with at least 5% of the votes makes a written request for such documents or when the company is directed by ASIC to produce such documents: s 294A.

Companies limited by guarantee formed for non-commercial objectives and using its income in promoting those purposes, such as a charity, can be exempt by ASIC from the requirement for using ‘limited’ in its name: s 150.

No liability company

3.80

• •

•

No liability companies must be registered as public companies: s 112(1). Section 112(2) of the Corporations Act states that a company may be registered as a no liability company only if that company:

has share capital; has a constitution which must state that its sole objects are mining purposes; and has no contractual right under its constitution to recover calls made on its shares from a shareholder who fails to pay them.

No liability companies are used exclusively for mining purposes and that stated purpose must appear in the objects clause (a clause stating the intended business)

[page 81]

in its constitution. The requirement for a constitution is an exception to the general rule. As discussed earlier, constitutions are no longer compulsory for all other types of companies.

The company’s inability to sue a shareholder to recover calls made on its shares, while the company is trading or during winding up, is another distinctive feature of no liability companies.

Ordinarily, if a company issues partly paid shares in another type of company (such as a company limited by shares) and later makes a call for the balance owing on the shares to be paid (hence the expression ‘calls made on its shares’), the shareholder is obliged to pay the amount owing. Failure to pay will result in a breach of contract which will entitle the company to sue the shareholder for damages. This result, however, is not the case in no liability companies, which allow the shareholder to choose whether to pay a call. This deliberate choice afforded to shareholders under the Act arises from the recognition that mining exploration activities can be highly speculative and risky. Thus, it is not unusual for no liability companies to offer shares on a partly paid basis, as it begins exploration activities, and then later to make calls on the shares should it require further finance to maximise mining opportunities.

3.81

If a shareholder in a no liability company does not pay calls made on the shares, the company cannot sue the shareholder for breach of contractual obligation as noted earlier. Instead, if the call on the shares remains unpaid within 14 days after payment is due, the shares are immediately forfeited to the company: s 254Q(1). The forfeited shares are then offered for sale by public auction within six weeks after the call became payable: s 254Q(2). The proceeds of the sale are first used to meet the expenses incurred as a result of the forfeiture and then to satisfy the calls on the shares that are due and unpaid. Then, the balance (if any) is paid to the member whose shares are sold: s 254Q(11). In the event of the shares being withdrawn from sale, as a result of no bids, the shares are then disposed of in the manner determined by the company in accordance with its constitution or by resolution: s 254Q(9).

Should mining companies wish to avoid the statutory restrictions imposed on no liability companies, discussed above, they may elect to register as a company limited by shares (either as a proprietary or public company). For the purposes of public awareness and the protection of creditor interests, s 148 requires that a no liability company must have the words ‘No Liability’ or the abbreviation ‘NL’ at the end of its name.

Unlimited company Unlimited companies can be registered as proprietary or public companies: s 112(1). Historically, prior to the introduction of limited liability in 1855 in England, this is the oldest type of company in existence. Unlimited company means a company that must have a share capital but whose members have no limit placed on their liability: see the definition of unlimited companies in s 9. During winding up, the company’s assets are used to satisfy any outstanding liabilities. Should the assets be inadequate for this purpose, members will have to make an equal financial contribution to meet the shortfall. This feature makes it unattractive for use for trading purposes, which naturally involves risk and the potential threat to personal assets being dissipated to meet debts. The benefits of limited liability and the incentive for structuring a trading venture as a company limited by shares were discussed earlier.

[page 82]

3.82

•

Unlimited companies are sometimes used by certain professions, such as accounting and legal, where the rules of the professional society prohibit limited liability. In such instances, all the other benefits of a company (discussed earlier) are available except for limitation of liability.

Distinction between proprietary and public companies Companies operate in both private and public sectors of the economy and come in all sizes, large and small. On the one hand, you can have public companies which may be listed on the ASX to meet capital needs through the issue of shares (equity finance) or debentures (debt finance) to investors and also to provide an important market for investors to trade their securities. Equity and debt financing is discussed further in Chapters 9 and 10 respectively. Some of these public companies have many subsidiary companies resulting in complex group structures.

On the other hand, as a proprietary company, you can have a small family business with a paid-up capital of $1 being managed and controlled by a single person. Prior to law reforms allowing for sole person proprietary companies in 1995, many proprietary companies were formed (and remain in existence) with a paid-up capital of $2 reflecting the then statutory requirement of a minimum of two persons to form a company. It was typical for the husband and the wife to be each issued with a share with a paid-up capital of $1 and to conduct the business as directors.

Companies registered under the Corporations Act are either proprietary companies or public companies. A company limited by shares or an unlimited company may be formed as a proprietary company, as discussed earlier.

A proprietary company is most suitable for use by a small business as such a company generally enjoys financial secrecy, less regulatory burdens than public companies (discussed below) and is less expensive to maintain. It forms the majority of Australian companies. Section 113 contains the defining characteristics of a proprietary company with reference to its maximum size and restricted fundraising ability. It states that a proprietary company:

must have no more than 50 non-employee shareholders; and

•

• • •

•

except if it is raising funds from its own employees or shareholders, a proprietary company is prohibited from engaging in any fundraising activity that would require disclosure to investors under the fundraising rules in Ch 6D of the Act (for example, advertising in a newspaper inviting people to invest in the company).

If the above limitations are breached, ASIC has the power to require the company to convert into a public company: s 165.

In contrast, s 9 defines a public company as a company other than a proprietary company. Essentially, this means that a public company has unlimited membership and greater access to raise funds from the public. Given that public companies are generally reliant on the public for its funding and that the investing public is at risk, parliament has considered it necessary to subject such companies to financial disclosure and more regulation (such as auditing and reporting requirements) than proprietary companies.

Apart from the differences in the company name and the minimum number of directors required (discussed earlier), the following are some of the other key

[page 83]

differences between proprietary and public companies. Unlike public companies, proprietary companies are privileged and are exempt from:

holding annual general meetings; appointing a company secretary; appointing an auditor (unless it is a large proprietary company, explained below); the regulations in Ch 2E of the Act concerned with financial benefits to directors (discussed further in Chapter 16); and the disclosure obligations in s 195 concerned with declarations of material personal interest by directors (discussed further in Chapter 16).

The Corporations Act makes a further distinction between ’small’ and

3.83

•

‘large’ proprietary companies: s 45A. This distinction (discussed at 3.83) has important consequences for compliance with accounting requirements and for the disclosure of key financial data. Large proprietary companies, given their size and potential to affect the community, are economically significant and attract public accountability for reasons discussed next.

Distinction between small and large proprietary companies Proprietary companies form the majority of Australian companies and can have a significant economic influence. The ability to access public financial information and to act on it is important, especially for suppliers of credit and labour. If all proprietary companies were to enjoy financial secrecy, small trade creditors, employees and other stakeholders would not be in a position to demand financial information. In this context, parliament has thought it desirable and in the public interest to impose financial reporting obligations (such as the preparation of a balance sheet and profit and loss statement) on large proprietary companies. Small proprietary companies are exempt from these requirements. It is thought that the costs of imposing similar obligations on them would outweigh the benefits given their operations are generally not regarded as being economically significant.

The Corporations Act provides a size test to distinguish between small and large proprietary companies. A proprietary company is classified as small if it satisfies at least two of the following tests (s 45A):

gross operating revenue of less than $25 million (formerly $10 million) for the financial year; gross assets of less than $12.5 million (formerly $5 million) at the end of the financial year; or fewer than 50 employees at the end of the financial year.

A company that does not satisfy at least two of these tests is classified as a large proprietary company.

A large proprietary company is required to prepare and lodge an annual report (made up of an audited financial report and a directors’ report) with ASIC. These reports are then made available to members of the

3.84

public for a prescribed fee. As noted earlier, small proprietary companies are exempt from these auditing and reporting requirements. This offers small proprietary companies the twin advantages of a reduced compliance cost burden and financial privacy. However, shareholders in small proprietary companies are able to direct the company to prepare a financial report if they have 5% of the voting capital: s 293. This provision ensures that

[page 84]

shareholders in small proprietary companies have adequate access to financial information without imposing an unreasonable burden on small companies. In addition, ASIC is able to direct a company to prepare and lodge a financial report with ASIC and to have that report audited: s 294.

As part of the federal government’s Simpler Regulatory System reforms in 2007, the thresholds at which audited financial reports are required to be prepared have been increased by 150% in the manner indicated above. The current threshold represents the first adjustment made since 1995 to keep pace with national economic growth and inflation. These measures were also introduced to reduce the compliance and reporting costs for about 1000 fewer proprietary companies that will be required to lodge annual reports. It is estimated that, on average, it costs $60,000 for a company to produce an annual report. Based on these figures, it is estimated that this reform will represent a saving to companies of $60 million per year.

Parent and subsidiary companies Under modern company law, the commercial reality is that many businesses are conducted through a network of companies which share common directors. A parent company (also known as holding company) may have as many subsidiary companies as it wishes in its group, ranging from a few companies to a few hundred. The legal significance of corporate groups and their impact on society cannot be underestimated. The treatment of each company within the group as a separate legal entity, together with the benefits of limited liability and the ability to

•

3.85

quarantine assets, provides powerful incentives to structure in this way. The legal treatment of corporate groups and its significance is discussed further in Chapter 5 at 5.24–5.46.

In ascertaining whether companies are related to each other as parent and subsidiary companies, s 46 of the Corporations Act sets out the following test which requires the parent company to:

control the composition of the subsidiary’s board of directors (for example, by appointing or removing all or a majority of the directors); be in a position to cast or control more than half of the maximum votes at the subsidiary’s general meeting; or hold more that half of the issued share capital of the subsidiary company.

If any of these tests are met, s 50 of the Act will treat the companies as ‘related’ companies. This test is relevant to consider when, for example, determining whether a parent company is liable for the debts caused by a related company trading while insolvent under s 588V.

Company conversions The Corporations Act recognises that some people may no longer regard their type of company as appropriate and may wish to change the type of company. The need for change may arise for a variety of reasons, including a shift in size of the business activities of the company. For example, a large proprietary company may have experienced massive growth and wish to access greater fundraising options to finance expansion in trade. In such circumstances, it is possible for a proprietary company limited by shares to convert into a public company limited by shares in order to raise equity or debt finance by offering securities to the investing public.

[page 85]

However, only some kinds of company conversions are allowed. Section 162 of the Act regulates the types of conversion that are permissible, with the steps to follow set out in ss 163 and 164. The need to pass a special

3.86

3.87

3.88

3.89

resolution and to notify ASIC of the change in status is a basic requirement.

Fundraising A significant advantage of using companies as a business structure is the flexibility in the forms of available finance. Companies may use both equity (shares) and debt (debentures) finance to fund their business needs. Furthermore, companies have access to flexible forms of finance not available to business structures based on individuals, such as convertible securities: see Chapters 10 and 11.

Winding up and deregistration As a company has perpetual succession, it does not die on the death, retirement or bankruptcy of the founder or the shareholders. It will come to an end when the company is deregistered by ASIC and there are a number of winding up processes that can be used to achieve deregistration. This topic is discussed further in Chapter 22.

Privacy Only small proprietary companies enjoy financial privacy. Large proprietary companies and public companies must file their financial statements (profit and loss account and balance sheet) with ASIC and they are publicly accessible.

Taxation Since companies are separate legal entities, they are taxed separately from their members. The company will need to calculate its profit for the year and apply the gazetted company taxation rate to the profit. For the financial year 2015–16 the tax rate applicable is 30% and this rate is applied to every dollar of profit earned — there being no tax free threshold as there is with Australian resident taxpayers.

Table 3.5 Overview of Taxation

3.90

3.91

Structure: Companies

Control rating Medium/low

Set-up costs Medium/high

Liability for debts Company is liable

Loss utilisation Losses offset against future company income

CGT on sale of assets Gains taxed in the company’s hands at the company rate

Record keeping requirements Yes but the substantiation rules apply

Is there CGT small business rollover relief? Yes

[page 86]

Advantages and disadvantages There are many advantages to running a business through a company structure. There are relatively low compliance costs (for the majority of companies which are small proprietary companies). The legal distinction between small and large proprietary companies was discussed above. Running a publicly listed company will incur substantial compliance costs to satisfy reporting obligations under the Corporations Act and under the ASX Listing Rules. There is also the significant advantage of limited liability for members and managers, and the range of flexible fundraising options available. Lastly, companies pay a flat rate of 30% tax, but do not have the advantage of any tax-free threshold (as individual taxpayers do). In addition, a disadvantage for members is that tax losses are not passed through to the members (as in partnerships) because the company is a separate legal entity.

Associations

Introduction Most people have been, or will be, involved in some form of a sporting or common interest club or association during their lifetime. These associations may take many forms ranging from the amateur car enthusiasts’ club to the semi-professional sporting club. The law not only provides structures for profit-making activities, such as companies, but

3.92

also accommodates structures that have some social or welfare ends as their objectives. It is common for a group of people to get together to form an association for purposes unconnected with profit making — for example, groups of people wishing to pursue charitable, religious, educational or sporting interests with like-minded people.

A common feature of all such organisations is that they are not set up for profit. In setting up the association, the committee members may choose for the association to remain unincorporated or may choose to form an incorporated association under the relevant Associations Incorporations Act of the states and territories.

Larger clubs and associations will usually be registered as a company limited by guarantee under the Corporations Act as this offers limited liability for members and, importantly, national recognition. However, for smaller clubs and associations there are two other options that are cheaper and common; either to remain unincorporated or to incorporate. The factors which influence choice, concerning personal liability issues, are outlined below and discussed in detail in Chapter 4 with reference to case illustrations.

A small scale club or association, generally, will be established as an unincorporated association, while larger bodies (particularly those which need to sign contracts and own property) will be registered under the Associations Incorporation Act of their respective state or territory.

Establishment There are few formalities required in forming an unincorporated association. There is no fixed set of rules that need to be followed, although the association will usually

[page 87]

have some form of internal rules (which may have contractual force). The association does not even need to have a name to exist. The reason behind this is that the unincorporated association is not a separate legal

3.93

3.94

entity. Accordingly, the parties will not be able to use the name of the unincorporated association to enter into a contract or to sue other people. In effect, this means that the individual members of the association are each contracting and are liable for any debts incurred.

An incorporated association is established by registration under the Associations Incorporation Act of a particular state or territory. A standard form is required to be completed and a (relatively) small fee is payable to the state or territory fair trading department. An incorporated association must generally have a set of internal rules (known as a constitution) that comply with the requirements of the Act. These rules will have the legal effect of a contract between the members of the association with respect to compliance with the rules.

Governing law There is no specific legislation that deals with unincorporated associations as it is a structure known, but not accepted, as being a separate entity by the common law. In some circumstances, associations soliciting monies from the public by requesting donations may need to be registered under various state Acts applicable to charitable fundraising.

Incorporated associations are governed by the Associations Incorporation Act of the respective state or territory. Unlike the Corporations Act, these Acts do not apply nationally, which means that registration applies only to a particular state or territory.

Control Both unincorporated and incorporated associations will have a management committee that is responsible for administering the rules and the general running of the association. There will usually be particular office holders, such as president and treasurer. For incorporated associations, legislation requires that a public officer or secretary be appointed whose role is to manage legal compliance.

Liability

3.95

3.96

Liability As an unincorporated association is not a separate legal entity, it has no capacity to enter into a legally binding contract or to incur tort or criminal liability in its own name. However, that does not mean that persons working within the association have no liability. It may be possible that liability will accrue to the members of the management committee as a group, or liability may accrue to the members as a whole (only for small clubs where the members have appointed the committee to act as their agents), or liability may accrue to individual members (whether members of the committee or not). Where the obligations have been incurred on behalf of the unincorporated association only, it is possible that no one is liable! This is because where a person has entered into a contract on behalf of a non-existent person (and an unincorporated association does not exist as a separate entity in law), it does not generally create a binding contract.

The liability problems that arise with unincorporated associations are largely avoided by incorporation. An incorporated association is recognised in law as being

[page 88]

a separate legal entity and may sign contracts, own property and be involved in litigation in its own name.

Fundraising The formation of an association allows for the pooling of resources among the members. As associations are usually not run for profit, they are dependent on the membership fees and external sources, such as fundraising activities or grants, for their funding. The size limitation on commercial partnerships (limited to a maximum of 20 under s 115 of the Corporations Act) does not extend to associations as they are not formed for purposes of gain. Profit making is not the main purpose of incorporated associations (though it can be an ancillary purpose).

Continuity of existence

3.97

3.98

3.99

3.100

Continuity of existence Unincorporated associations are not recognised by law as being separate entities so their existence continues as long as members are participating in the activities of the association. Incorporated associations are separate legal entities and therefore have perpetual existence. They may be wound up by the members or by the court on a range of grounds similar to those that apply to companies: see Chapter 22.

Privacy There is no requirement to disclose information for unincorporated associations. Incorporated associations do have various disclosure and reporting requirements under the Associations Incorporation Acts. For example, accounts may have to be audited.

Taxation As associations are run not-for-profit, and frequently take the form of registered charities under state, territory and federal law, they are normally exempt from tax. The tax-exempt status, however, may be lost by the conduct of the association (for example, if it conducts significant trading activities for profit).

Advantages and disadvantages The advantage of both types of associations is that they are relatively easy to set up and use. The compliance costs, even for incorporated associations, are very small (especially when compared to companies formed under the Corporations Act). Incorporated associations provide the advantage of separate legal existence and limited liability, while unincorporated associations do not enjoy these benefits.

Overview comparison of business structures

3.101 The following table provides a summary of the advantages and disadvantages of the range of business structures discussed in this chapter.

[page 89]

Table 3.6 Advantages and Disadvantages

Structure: Sole Traders Ease of establishment Advantage

Management and control Advantage

Liability Disadvantage

Fundraising Disadvantage

Continuity Disadvantage

Privacy Advantage

Tax Both (flow through losses and profits)

Structure: Partnerships Ease of establishment Advantage

Management and control Advantage

Liability Disadvantage

Fundraising Advantage (over sole trader) Disadvantage (compared with Co)

Continuity Both (need to manage changes through partnership deed)

Privacy Advantage

Tax Both (flow through losses and profits)

Structure: Joint Ventures Ease of establishment Disadvantage (usually complex agreement)

Management and control Advantage

Liability Advantage (provided not a partnership)

Fundraising Advantage

Continuity Neutral

Privacy Advantage

Tax Neutral

Structure: Trusts Ease of establishment Disadvantage

Management and control Both (trustee maintains control, beneficiaries are generally passive)

Liability Both (depending upon nature of trust)

Fundraising Advantage

Continuity Neutral (80 years is sufficiently long for most businesses)

Privacy Advantage

Tax Both (income splitting, no loss sharing, and complex rules)

[page 90]

Structure: Companies Ease of establishment Advantage (although publicly listed companies expensive and hard to establish)

Management and control Advantage (shareholders may also be directors and maintain control)

Liability Advantage

Fundraising Advantage

Continuity Advantage

Privacy Neutral, except for public Co where it is a disadvantage

Tax Advantage

Structure: Associations Ease of establishment Advantage

Management and control Advantage for incorporated associations Disadvantage for unincorporated associations

Liability Advantage for incorporated associations Disadvantage for unincorporated associations

Fundraising Advantage

Continuity Advantage for incorporated associations Disadvantage for unincorporated associations

Privacy Advantage

Tax Neutral

10.

[page 91]

Revision Questions

How are partnerships created? How are they defined under the Partnership Act and what is the maximum size of a commercial partnership?

Identify at least three differences between partnerships and joint ventures.

Explain the concept of limited liability.

Compare and contrast the characteristics of a company limited by shares with a company limited by guarantee.

Identify at least four differences between proprietary and public companies.

Under what circumstances will a proprietary company be classified as small and what advantages are conferred on them under the Corporations Act?

How are trusts created, and what are the main purposes of discretionary trusts?

Compare the manner in which a partnership, a proprietary company and a public company can raise funds.

Compare the manner in which partnerships, joint ventures, trusts and companies are managed.

What are the disadvantages of running a club or society as an unincorporated association? What are the essential criteria for an

• • • •

association to qualify to incorporate under the Associations Incorporation Act?

Problem Question You have the task of advising clients as an accountant. Among your clients is a family — with a mother and father both aged 50 (and with considerable wealth), and four children, aged 21, 18, 17 and 10. The parents wish to involve their children in their next business venture. The parents anticipate contributing $2 million of their own capital and having the venture borrow a further $2 million. The parents seek your advice as to how the venture should be structured.

The investments under consideration are:

a retail business; a farm; a speculative mining venture; and a long-term investment portfolio.

Advise the parents, with reference to the relevant facts, as to how the various business ventures under consideration should be structured. Examine the relative advantages and disadvantages of the structures available in law for acquiring and conducting these proposed investments. Issues to examine will include the relative complexity, flexibility, aspects of liability and suitability for financing purposes for each particular structure contemplated.

[page 92]

Guidelines for Answering Problem Questions

When answering a problem question concerning legal issues relating to business structures, we suggest that the following method may be helpful:

Ascertain the needs of the client. If the business is not for profit, consider the advantages and disadvantages of unincorporated associations compared with incorporated associations. If the business is for profit, consider both corporate and non- corporate forms of business structures.

Consider what are the most important concerns of the client (cost of establishing and maintaining business structure, risk of personal liability, ability to control, ability to raise funds, taxation considerations, financial privacy or a combination of these). Discuss the comparative advantages and disadvantages of the chosen business structure so as to facilitate an informed decision by the client. Particular attention must be paid to the given facts so that an appropriate answer can be given relevant to the client’s needs. It is always important to structure an answer in response to the given facts.

Wang and Erin have been close friends for a long time and decide that they want to start a business together. Wang has a great deal of experience in running businesses but due to a recent business failure, he has little money to put into the new venture. Erin has little business experience but considerable personal assets (over $50 million) due to the death of her beloved husband, a wealthy businessman. Erin is concerned about exposing her assets to a new business venture but does want to have an opportunity to invest in Wang’s new venture. The business would involve a substantial capital outlay (approximately $1 million). Erin’s assets are held through the Erin Trust No 1 (which has ABC Pty Ltd as trustee), with Erin being one of two beneficiaries (the other is her son, Luke). Erin’s accountant David is the sole director of ABC Pty Ltd (acting as trustee of Erin Trust No 1). The trust assets include investment securities and a building in Chinatown (worth $20 million) that has a tenant whose lease is due to expire in four months. It is possible that the new business could use this location.

Wang and Erin come to you as their business adviser for advice as to how they might structure their new business.

Draw up a list of at least five questions that you would want to ask Wang and Erin before giving your opinion. Advise Wang and Erin as to the legal differences between running their business through a partnership, trust and company.

[page 93]

Further Reading

Academic Journals

M Chetwin, ‘Joint Ventures — A Branch of Partnership Law?’ (1990) 16 University of Queensland Law Journal 256.

F Easterbrook and D Fischel, ‘Limited Liability and the Corporation’ (1985) 52 University of Chicago Law Review 89.

J Farrar, ‘Frankenstein Incorporated or Fool’s Parliament? Revisiting the Concept of the Corporations in Corporate Governance’ (1998) 10 Bond Law Review 142.

J Farrar, ‘Legal Issues Involving Corporate Groups’ (1998) 16 Company and Securities Law Journal 184.

H Ford, ‘Trading Trusts and Creditors’ Rights’ (1981) 13 Melbourne University Law Review 1.

K Fletcher, ‘Continuing Liability of a Retired Partner’ (1996) 70 Australian Law Journal 294.

A Goldfinch, ‘Trustee’s Duty to Exercise Reasonable Care: Fiduciary Duty?’ (2004) 78 Australian Law Journal 678.

P Halpern, M Trebilcock and S Turnbull, ‘An Economic Analysis of Limited Liability in Corporations Law’ (1980) 30 University of Toronto Law Journal 117.

R McQueen, ‘Life without Salomon’ (1999) 27 Federal Law Review 181.

E Peden and J Carter, ‘The Bonds of Partnership’ (2000) 16 Journal of Contract Law 275.

S Sievers, ‘Incorporation of Non-profit Associations: The Way Ahead?’ (2000) 18 Company and Securities Law Journal 311.

M Twomey, ‘Protection for Partners from Unlimited Liability in Certain Circumstances?’ (2003) 24 The Company Lawyer 86.

Practitioner Journals N Oakes, ‘The New Face of Salaried Partnership’ (2003) 41(3) Law Society Journal 49.

3. 4.

5. 6.

J Silveri, ‘Restructuring Partnership’ (2001) 75(11) Law Institute Journal 16.

A Veljanovski, ‘Limiting Liability: The Third Way’ (2005) 79(1-2) Law Institute Journal 46.

Practitioner Works N D'Angelo, Commercial Trusts, LexisNexis Australia, 2014.

K Fletcher, The Law of Partnership in Australia, 9th ed, Lawbook Co, Australia, 2007.

S Sievers, Associations and Clubs Law in Australia and New Zealand, 3rd ed, Federation Press, Australia, 2010.

You will find useful study resources, including quizzes for each chapter, when you go to <http://learning.lexisnexis.com.au>. The quiz is a great tool to help you self-test your knowledge.

Where both the legal and equitable titles are held by the same person, there is said to be a ‘merger’ of the trust, and the trust is terminated with the person holding full ownership: see Wood v Douglas (1884) 28 Ch D 327. Trustee Act 1925 (NSW); Trustee Act 1973 (Qld); Trustee Act 1936 (SA); Trustee Act 1898 (Tas); Trustee Act 1958 (Vic); Trustee Act 1962 (WA). Trustee Act 1925 (ACT); Trustee Act 1893 (NT) and Trustee Act 1907 (NT). This distinction can be removed under statute law during insolvent trading, thus conferring personal liability on the director for the company’s debts: see, for example, s 588G of the Corporations Act which is discussed in Chapter 18. Schiavello Group Pty Ltd v Exquisite Australia Pty Ltd [2015] VCC 4. A search of company and business names can be carried out at any ASIC Service Centre or be done via The Organisation and Business Names Check facility available at <www.asic.gov.au>. Since 2007, companies have the option to pay their annual review fees in advance for a period of 10 years by a single payment at a discounted rate (but without the prospect of a refund). Clarke (as trustee of the Clarke Family Trust) v Great Southern Finance Pty Ltd (recs and mgrs apptd) (in liq) [2014] VSC 516. The reasons for the existence of limited liability are drawn from a report prepared by the Companies and Securities Advisory Committee, Corporate Groups Final Report, May

10. 2000. See, further, A Hargovan, ‘A Lender May Wear Both Belts and Braces: Brighten Case Illuminates Law on Equitable Considerations Challenging Appointment of Receiver’ (2010) 9 Insolvency Law Bulletin 150.

[page 95]

Partnerships and Associations

CHAPTER 4 Partnerships

Governing law Establishment Formally Other ways of creating a partnership Essential elements of a partnership Rules relating to establishment of a partnership Liability – partners and outsiders Partners’ relationship, rights and duties Partnership property Continuity of existence and termination of a partnership Limited partnerships Venture capital limited partnership

[page 96]

Associations Introduction Unincorporated associations Incorporated associations Law reform (New South Wales and Victoria) Victoria

[page 97]

Partnerships and Associations

Learning Objectives After completing this chapter you should be able to:

Explain the different ways to create a partnership and the formalities necessary for certain partnerships.

Define a partnership and identify the sources of partnership law.

Discuss and apply the essential elements in the statutory definition of a partnership.

Discuss and apply the supplementary statutory rules for determining the existence of a partnership.

Explain the partner’s liability in contract, tort and crime.

Explain the fiduciary duties of partners.

Explain the liabilities of new and retired partners.

Discuss the circumstances in which a partnership can be dissolved (with or without a court order).

Discuss the legal consequences of dissolution of a partnership.

Discuss the advantages and disadvantages of unincorporated associations.

Discuss the essential criteria for incorporation under the Associations Incorporation Act and the benefits of incorporation.

Key Cases

Beckingham v Port Jackson and Manly Steamship Co Ltd [1957] SR (NSW) 403

Birtchnell v Equity Trustee, Executors and Agency Co Ltd (1929) 42 CLR 384

Cameron v Hogan (1934) 51 CLR 358

Canny Gabriel Castle Jackson Advertising Pty Ltd v Volume Sales (Finance) Pty Ltd (1974) 131 CLR 321

Chan v Zacharia (1984) 154 CLR 178

[page 98]

Checker Taxicab Co Ltd v Stone [1930] NZLR 169

Cox v Hickman (1860) 8 HL Cas 268

Cribb v Korn (1911) 12 CLR 205

Davis v Davis [1894] 1 Ch 393

Dubai Aluminium Co Ltd v Salaam [2002] 3 WLR 1913

Duke Group Ltd v Pilmer (1999) 73 SASR 64

Everett v Federal Commissioner of Taxation (1980) 143 CLR 440

Goldberg v Jenkins (1889) 15 VLR 36

Keith Murphy Pty Ltd v Custom Credit Corporation Ltd (1992) 6 WAR 332

Law v Law [1905] 1 Ch 140

Manley v Sartori [1927] Ch 157

Mann v Hulme (1961) 106 CLR 136

Mercantile Credit Co Ltd v Garrod [1962] 3 All ER 1103

Pioneer Concrete Services Ltd v Galli [1985] VR 675

Polkinghorne v Holland & Whitington (1934) 51 CLR 143

Re Buchanan & Co (1876) 4 QSCR 202

Re Megevand; Ex parte Delhasse (1878) 7 Ch D 511

Smith v Anderson (1880) 15 Ch D 247

Trimble v Goldberg [1906] AC 494

United Dominions Corporation Ltd v Brian Pty Ltd (1985) 157 CLR 1

Key Legislation

Corporations Act 2001 (Cth)

Relevant state and territory:

Associations Incorporation Act

Partnership Act

[page 99]

Introduction

A partnership, simply defined, is a structure where persons in a business relationship are acting in common with a view to profit. Partnerships, as a form of business structure, have existed for many centuries and predate the development of companies. Its popularity today as a vehicle to conduct a trade or profession has not, however, been radically diminished for a variety of reasons. The contemporary use of partnerships, and its attractions, can still be attributed to the ease with which it can be formed and the cheap cost of maintaining such a business organisation. Based on contractual agreement, a partnership is easy to create without many formalities or, generally, the need for registration (unless it is a specific type of partnership, such as a limited partnership which is discussed below) and is a cheaper structure to maintain due to lighter regulation compared to companies. Although undesirable, for reasons discussed below, a partnership relationship can be verbal in nature or be implied from conduct.

Such distinctive features make partnerships a popular and common choice to conduct businesses, overshadowing some of the disadvantages (such as statutory agency and unlimited liability) discussed below. Furthermore, some professions are precluded from conducting their professional activities via a corporate structure with limited liability and, therefore, a partnership is the preferred choice. Income splitting between spouses conducting a business as a partnership, a legitimate tax minimisation device, adds to the attraction of conducting business through a partnership.

This chapter is also concerned with the formation of associations that have a non-profit motive. Associations typically fall into the categories of charities, sport, recreation, education or community service clubs. The chapter explores the options available to such social organisations that wish to be formed but without exposure to personal liability in the conduct of such non-profit associations. The chapter discusses the advantages and disadvantages of unincorporated associations as non-legal entities, in contrast with taking the voluntary step of incorporating a non-profit association under the Association Incorporation Act available in each Australian state and territory. The chapter

4.1

4.2

proceeds with a consideration of partnership law first and builds on the outline of partnership law discussed in Chapter 3.

Partnerships

Governing law Partnership is governed by the largely uniform, state1 and territory2 based Partnership Acts and the rules of common law and equity. Other relevant statutes, however, such as the Corporations Act 2001 (Cth), described above, and the Taxation Act3 also regulate some aspects of partnerships.

Section 115 of the Corporations Act limits the size of partnerships formed to gain a profit. These are restricted to a maximum of 20 partners, except for professional

[page 100]

partnerships. For example, as a result of government exemptions, accountants can have up to 1000 partners, lawyers up to 400 partners and doctors up to 50 partners.

It is important to remember that none of the Partnership Acts is a complete code and it is essential to consider case law decisions (dealing with, for example, the fiduciary duties of partners) as well as judicial interpretations of the Partnership Act. This approach to the governing law on partnerships is reinforced under the various Partnership Acts which state that the rules of equity and of common law applicable to partnership shall continue in force except so far as they are inconsistent with the express provisions of the Act’.4

Establishment The Partnership Acts do not prescribe the manner in which a partnership can be created. This can be contrasted to the formation of companies which requires approval of, and registration with, the Australian

4.3

Securities and Investments Commission (ASIC) and the payment of registration fees.

The creation of a partnership is contractual in nature. The rules applicable to the formation of a contract must be followed for the partnership to have validity. As with most contracts, there is an absence of special formalities. As a general rule, partnerships can be formed either formally or informally. The following discussion offers examples of the different ways in which a partnership can be formed.

Formally Written agreement

The partnership agreement (contract) may be evidenced in writing, for example, in the form of a partnership deed under seal, or a memorandum, or it may even be the record of the minutes of a meeting. The written agreement sets out the rights and obligations of the partners and facilitates the resolution of disputes within a partnership. In the event of disputes arising from an oral agreement, there can be difficulties in proving what was said and to whom it was addressed, as evidenced in AM Marketing Pty Ltd v Howard Media Pty Ltd [2010] NSWSC 803 discussed below.

A written agreement has an advantage in that it can be presented as evidence concerning what was agreed between the parties at a particular point in time. This may result in certainty being obtained about the legal nature of the business relationship between the parties in the event of a dispute arising.5

An additional reason for having a written partnership agreement arises from the fact that the Partnership Act does not always impose specific obligations on partners. Written partnership agreements, therefore, are very important to determine how the partners are going to deal with each other, the manner in which the affairs of the firm are to be conducted and the manner in which profits and losses and capital contributions are to be distributed on dissolution.

[page 101]

• • • • • • • • • • • •

4.4

Written agreements should expressly include, at the least, the following:

the names, addresses and occupation of the partners; the nature, purpose and duration of the business; the amount of capital to be contributed by each partner; whether any interest is to be paid on capital contributions; the proportion in which profits and losses are to be shared; the amount of salaries payable; the manner in which the business is to be managed; whether any limitation is to be placed on the authority of a partner; the legal effect of death, retirement or bankruptcy of a partner; the method of calculating goodwill of the business; the manner in which the partnership will dissolve (terminate); and the manner in which disputes will be resolved (for example, through mediation).

Some jurisdictions insist on a written agreement. In Tasmania, there is a statutory requirement, under the Mercantile Law Act 1935 (Tas), that a partnership agreement that lasts more than one year must be in writing in order for it to be enforceable.

The partners can vary their respective rights, obligation and duties during the course of the partnership by varying their agreement. The Partnership Act6 offers such flexibility:

The mutual rights and duties of partners, whether ascertained by agreement or defined by this Act, may be varied by the consent of all the partners, and such consent may be either expressed or inferred from a course of dealing.

Registration of a business name The partnership, like a sole trader, may elect to use a business name for trading purposes. If the partners choose to trade under a name different from the actual names of the partners, the name must be registered under the Business Names Registration Act 2011 (Cth). For example, if a husband and wife with the initials and surname of ‘I M Rich’ and ‘U R Rich’ chose to conduct a florist business under the name of ‘Busy Bee Florists’, the business name Busy Bee Florists would have to be registered. The registering of the business name as Busy Bee Florists enables the public, or other interested parties, to have access to the information that is

4.5

•

4.6

required to be disclosed at the time of registration.

This information is held in a public registry, and, among other things, it details the identities of persons conducting the business and the business location. This information is particularly useful for creditors. By accessing this information, creditors can ascertain who is operating the business. It may also be a basis for creditors to establish the trading terms that are to be applied to the business entity. For further guidance on the regulation of business names, visit ASIC’s website at <http://www.asic.gov.au>; see also RG 235, Registering Your Business Name.

[page 102]

Oral agreement A simple oral agreement is sufficient to create a partnership. This method of establishment is common but is inadvisable, simply because there may be a lack of certainty regarding the partners’ rights and liabilities towards each other.7

Why do you think it might not be advisable to form a partnership on the basis of an oral agreement only?

Other ways of creating a partnership Partnerships may also be created in the following ways:

Conduct The existence of a partnership can be simply implied by the conduct of the parties without the awareness of the parties that they are in fact partners. It is possible for parties to be in a partnership relationship without any express reference to the nature of their business being a partnership relationship. There have been cases where parties have

4.7

2. 3.

4.8

expressly stated that they are not in a partnership relationship but the courts have found that their relationship is one of partnership. For example, if two friends regularly operate a hot dog stand on a street corner, they may well be partners under the Partnership Act if the statutory definition of a partnership is satisfied. Aspects of the statutory definition, dealing with a business being conducted in common with a view to profit, are discussed further below.

By estoppel (holding out) The Partnership Acts8 provide that, in certain circumstances, a non- partner can become liable as a partner on the basis of ‘holding out’ if:

by words (spoken or written) or by conduct the non-partner knowingly allows themselves to be represented as a partner; credit was given to the firm on the faith of the representation; and the outsider relied on the representation.

In such circumstances, the non-partner who has been held out to the world to be a partner can be exposed to partnership liability and can be sued for the debts owing by the partnership. The nonpartner is estopped (legally prevented) from denying the truth of the representation in this event.

Essential elements of a partnership The Partnership Act in each jurisdiction provides a definition of a partnership and states that:9

[page 103]

… partnership is the relation which exists between persons carrying on a business in common with a view of profit.

Arising from this definition, there are three essential elements which are required for a partnership to exist.10 The following must be proved in order to conclude that a partnership relationship exists among the parties:

• • •

4.9

carrying on a business; in common; and with a view of profit.

As observed by the Victorian Court of Appeal11 quoting the famous authors Higgins and Fletcher on partnership law, the statutory definition is framed in ‘deceptively simple language that has given rise to many problems with interpretation’.

The following discussion analyses each component of the statutory definition separately to determine its ambit and operation. It is important to remember, however, that one has to look at the overall facts and circumstances to determine the intention of the parties. That must be determined by applying an objective test, and not by reference to what the parties thought, or said they thought, about the nature of their arrangements. As recognised by the High Court in Toll (FGCT) Pty Ltd v Alphapharm Pty Ltd (2004) 219 CLR 165 at [40]:

It is not the subjective beliefs or understandings of the parties about their rights and liabilities that govern their contractual relations. What matters is what each party by words and conduct would have led a reasonable person in the position of the other party to believe.

It also pays to remember the following judicial observation made in AM Marketing Pty Ltd v Howard Media Pty Ltd [2010] NSWSC 803 at [134]:

… there are many ways in which people will combine in some human endeavour in the hope and expectation of making or enhancing a profit by so combining … Simply because they do so and because they may enter that arrangement for that purpose, does not mean that they are in partnership.

With these cautionary remarks in mind, attention is turned to the statutory definition of a partnership.

‘Business being carried on’ It is relevant to establish compliance with the following concepts when looking at this particular essential element, namely — the meaning of ‘business’ and ‘carrying on’.

The Partnership Acts provide that business includes every trade, occupation or profession.12 Although this definition is not

comprehensive, it is generally accepted by the courts that the word ‘business’, as used in the Partnership Acts, excludes domestic transactions and the conduct of hobbies.

[page 104]

An example of a domestic arrangement could include the sale of a jointly owned family home or car. An example of a hobby could include the maintenance of horses on a farm which is used purely for recreational and private purposes by a family (as opposed to horse-breeding for commercial racing purposes which may qualify as a business).

The question of whether a particular activity constitutes a business involves questions of fact and degree, as recognised in the following passage in Evans v Federal Commission of Taxation (1989) 89 ATC 4540 at 4555:

… There is no one factor that is decisive of whether a particular activity constitutes a business … Profit motive, scale of activity, … repetition and a permanent character, continuity and system are all indicia to be considered as a whole, although the absence of any one will not necessarily result in the conclusion that no business is being carried on.

The Partnerships Acts do not define ‘carrying on’. Judicial guidance, however, can be obtained from the earlier case of Smith v Anderson with its emphasis on a degree of continuity and later cases, discussed below, which accepts single venture businesses within the definition of ‘carrying on’.

An isolated act, however, can still satisfy the statutory requirement so long as it is accompanied with an intention of repetition. This would be a question to be determined by the facts of each case.

From the precedents discussed, based on traditional case law, it is clear that continuity and system are important as well as the question of intention to continue to provide for repetitious acts. The traditional cases, such as Smith v Anderson, predate modern case law which recognises that a partnership may exist in respect of a single venture. The High Court of Australia has accepted that a single adventure or undertaking may still satisfy the statutory requirement, as signalled in the following with

reference to two leading Australian decisions on partnership and joint venture law.

Ultimately, the intention of the parties in the circumstances of each case will play a crucial role in determining whether there is the ‘carrying on of a business’.

Smith v Anderson (1880) 15 Ch D 247 Court of Appeal (UK)

Facts: A ‘trust’ was created for investment purposes to purchase shares and debentures in a number of companies. Smith, an investor, and more than 20 other people were holders of trust certificates. Each of the trust holders had the right to choose the trustees who had restricted rights of management. Smith applied to wind up the ‘trust’ on the basis that it was not a trust but was, in reality, an illegal partnership which exceeded the maximum number of 20 people.

Issue: The court had to decide whether it was a trust or a partnership. Decision: It was held that the structure was not a partnership because the act being undertaken was isolated and there was no intention to repeat the venture. The court focused on the expression ‘carrying on’ and held that:

… [it] implies a repetition of acts and excludes the case of an association formed for doing one particular act which is never to be repeated. That series of acts is to be a series of acts which constitute a business … The association, then, must be formed in order to carry on a series of acts having the acquisition of gain for their object.

[page 105]

Re Griffin; Ex parte Board of Trade (1890) 60 LJQB 235 Court of Appeal (UK)

If an isolated transaction, which if repeated would be a transaction in a business, is proved to have been undertaken with the intention that it should be the first of several transactions, that is with the intent of carrying on a business, then it is a first transaction in an existing business.

4.10

United Dominions Corporation Ltd v Brian Pty Ltd (1985) 157 CLR 1 High Court of Australia

A single adventure under our law may or may not, depending upon its scope, amount to the carrying on of a business … Whilst the phrase ‘carrying on a business’ contains an element of continuity or repetition in contrast with an isolated transaction which is not to be repeated the decision of this Court in Canny Gabriel Castle Jackson Advertising Pty Ltd v Volume Sales (Finance) Pty Ltd [discussed below] suggests that the emphasis which will be placed upon continuity may not be heavy. [emphasis added]

Distinguishing between actual and contemplated partnerships It is not uncommon for parties to prepare a business plan, an essential strategy to promote commercial success, before the execution and translation of the business plan into a trading business. Within this context, a thorny question arises when the parties have taken a few steps towards achieving their business goals but, for whatever reason, fail to accomplish that purpose and have incurred expenses in that process. Who bears the liability? Is it the individual who contracted or is it the partnership on the basis of joint liability of partners for partnership debts? The latter conclusion can only be reached if the statutory definition of a partnership is satisfied. This then raises the practical question as to whether preliminary activities undertaken by parties, towards a contemplated partnership, constitute a partnership at that stage or not.

Courts draw a distinction between activities which constitute the carrying on of a business and activities which are preparatory to the commencement or setting up of a business.13 The latter, ordinarily, does not constitute the carrying on of a business — unless the facts show that it was part of the ‘business activity’ the parties agreed on, as illustrated below by the House of Lord’s decision in Miah v Khan.

Pioneer Concrete Services Ltd v Galli [1985] VR 675 Victoria Court of Appeal

… [B]efore the business gets underway, those preparatory acts cannot be characterised as constituting or forming part of a business; nor can the participants be described at that stage as carrying on … a business.

[page 106]

A distinction must be drawn, as shown in Galli above, between contemplated and actual partnerships. Whether the element of a business being ‘carried on’ is satisfied or not is a question of fact and depends on the circumstances of each case. The following decision in Miah v Khan demonstrates that is possible to find the existence of a partnership if the parties go beyond steps of an exploratory or preparatory nature but stop short of the business actually conducting trade.

Miah v Khan [2000] UKHL 55; [2001] 1 All ER 20 House of Lords (UK)

Facts: A head waiter and chef employed by a restaurant wished to open their own Indian restaurant but did not have the required capital. In May 1993, the parties approached the chef of another restaurant who had some capital with a view to inviting him to become business partners in a new restaurant. A fourth person was invited not to be a partner but an employee of the partnership. A fifth person, who was the owner of a restaurant, was invited to provide business experience and to be a passive (or ‘sleeping’) partner. All parties agreed to this arrangement with 50% of the profits to be shared among three of the four partners and the remaining partner to have a 50% share in the business.

By 1 December 1993, the parties had found suitable premises for the new restaurant, obtained planning permission, taken a lease on the premises, opened a partnership bank account in the names of some of the partners, arranged a bank loan, commissioned a design, entered into a contract with a firm of builders for the conversion and fitting out of the premises and contracted for the purchase of the equipment and table linen. The money in the partnership bank account was funded by one of the parties and was used solely for business purposes.

Although the restaurant opened for trade in February 1994 (behind schedule), the relationship between the parties had broken down by then (on 26 January 1994) leading to an end of their commercial relationship. The litigation arose in this context when the parties had to decide on whether the acquired assets and trading profits were partnership property (and therefore capable of being shared) or not. In resolving this issue, the court had to address the statutory definition of partnership, in particular the contentious issue of whether a ‘business had been carried on’ by the parties prior to the breakdown in the relationship on 26 January 1994.

Issue: Did the parties ever carry on business in partnership together? If so, it follows that partnership accounts have to be settled following termination of the partnership.

Decision: The parties had actually embarked on the venture on which they agreed, therefore a business was ‘carried on’. This conclusion was supported by the fact that assets had been acquired, liabilities incurred and expenditures had been undertaken with the authority of all the parties. Given that the parties were also acting in common with a view to profit, the statutory definition of partnership was satisfied.

In rejecting the Court of Appeal’s finding (in a 2:1 majority decision) that a partnership did not exist at the time of the breakdown in relationships, Lord Millet (in a unanimous decision of the House of Lords which supported the trial judge’s finding) held:

… they [the Court of Appeal] described the business which the parties agreed to carry on together as the business of a restaurant, meaning the preparation and serving of meals to customers, and asked themselves whether the restaurant had commenced trading by the relevant date [26 January 1994]. But this was an impossibly narrow view of the [business] on which the parties agreed to embark. They did not intend to become partners in an existing business. They did not agree merely to take over and run a restaurant. They agreed to find suitable premises, fit them out as a restaurant and run the restaurant once they had set it up. The acquisition, conversion and fitting out of the premises and the purchase of the furniture and equipment were all … undertaken with a view of ultimate profit, and formed part of the business which the parties agreed to carry on in partnership

[page 107]

together. There is no rule of law that the parties to a joint venture do not become partners until actual trading commences. [emphasis added]

Buxton LJ, the dissenting judge in the Court of Appeal [1997] EWCA 2890 (finding in favour of a partnership) held:

… [the alternate explanation that views] the relationships between the parties in respect of all the various undertakings as springing from a series of separate and ad hoc arrangements, which did not and could not ripen into partnership until the restaurant opened for trade … challenges commonsense … [the parties actions] were not engaged in on a random or ad hoc basis, nor was it merely coincidental that the same persons were engaged in them.

Significance: It is the carrying on of a business, not a mere agreement to carry it on, which is the test of partnership, hence the importance of distinguishing between actual and contemplative partnerships. Furthermore, the facts of this case demonstrate that a business can be ‘carried on’ before it actually opens its doors for trade.

The question whether activities preparatory to the commencement or setting up of a business satisfied the ‘carrying on a business’ aspect of the definition of partnership was examined in the following case where the facts are distinguishable from Miah v Khan.

Goudberg v Herniman Associates Pty Ltd [2007] VSCA 12 Victoria Court of Appeal

Facts: Williams conceived of a business project which involved the conversion of the dining areas of

4.11

selected hotels in Sydney into franchised restaurants. Based on his experience as a hotelier, he formed the view that the dining areas of some hotels made very little income and saw a business opportunity to increase revenue by introducing a chain of franchised restaurants. To further the project, Williams involved Goudberg and they made several trips to America to undertake market research (a feasibility study). They visited a variety of restaurants and tasted food, looked at kitchens, services and prices. After their second trip to America, they confirmed that Applebee’s was the franchised chain of restaurants they wanted to introduce into Sydney hotels. Shortly thereafter, Williams started to make enquiries of architects and contracted with Herniman Associates which provided architectural services and, thereafter, sued both Williams and Goudberg as partners for amounts totalling more than $186,000 for unpaid fees. The evidence showed that no agreement was ever reached with Applebee’s and no venture capital was ever obtained.

Issue: Were Goudberg and Williams ‘carrying on a business’ in a partnership? If so, it follows that Goudberg will be jointly liable with Williams, as a partner, for unpaid fees due to Herniman under the contract to provide architectural services.

Decision: Goudberg and Williams were acting in common and were acting with a view to profit with the business concept devised but, crucially, were not carrying on a business. The absence of this essential element in the statutory definition of a partnership meant that Goudberg and Williams were not partners and, therefore, were not jointly liable for the debts. In overturning the decision of the Victorian Civil and Administrative Tribunal which held that a partnership existed, Maxwell P (in a unanimous decision) held:

… nothing done by Williams and Goudberg … could be regarded as constituting the carrying on of a business. Quite simply, there was no business in existence. Plainly, there was a plan in existence for the establishment of a business … all that Williams and Goudberg had done was to undertake preliminary investigations, in the nature of feasibility studies and demographic surveys, and exploratory trips to the United States … in furtherance of the project … and taken an important decision in furtherance of the project [by selecting the franchise model] … on no reasonable view could [these] matters constitute the carrying on of a business.

[page 108]

After recognising that there is clear judicial authority that a partnership can be established for the purposes of a single transaction, President Maxwell held:

The present case would have been entirely different if, for example … commercial arrangements had been entered into with a particular hotel, such that the business was either up and running or about to be. There would then have been a quite different question for determination.

Significance: The case demonstrates that preliminary steps taken to establish a business, which either has no prospect of coming into existence or has not got underway, does not satisfy the legal test for the existence of a partnership.

Business must be carried on ‘in common’ The fulfilment of this statutory criterion can be determined by seeing if there is an agency relationship which can bind the parties. Thus, this

agency criterion requires that the persons concerned be principals in the business. As a result, if two or more persons are principals, each will be bound by transactions into which one of them enters in the name of the business. It is not sufficient that one person be the employee of the other, or that the business be carried on by one (for example, as trustee) for the benefit of the other: Momentum Productions Pty Ltd v Lewarne (2009) 254 ALR 471; [2009] FCAFC 30.14

The ‘carrying on a business in common’ requirement does not mean, however, that all the partners must take an active role in the affairs of the business. In fact, it is not uncommon to find only one person takes an active management role in the business. It simply means that the business must be carried on by or on behalf of the partners. The court will seek the answer to the following question in testing for the agency relationship — does the person who, in fact, carries on the business do so as agent for the persons alleged to be partners?: Lang v James Morrison & Co Ltd (1911) 13 CLR 1. Thus, judicial interpretation of the phrase ‘carrying on’ accommodates inactive contributors of capital, commonly referred to as ‘sleeping partners’ who still bear all the risks of a partnership (such as unlimited liability).

More than agency, however, is required to satisfy the statutory definition of a partnership. Importantly, there must be mutuality of rights and obligations between the parties on whose behalf the business is being carried on, as illustrated in the case examples below. Whether this element is satisfied or not is a question of fact and depends on the circumstances of each case. The requirements of agency and mutuality are reflected in the Partnership Acts15 as being the consequences of entering into a partnership.

Duke Group Ltd v Pilmer (1999) 73 SASR 64 South Australia (Full Court)

In order to meet this criterion (acting in common), it is not necessary that each of the alleged partners should take an active part in the direction and management of the firm. The business may well be carried on by or on behalf of the partners by someone else. The person carrying on the business must be doing so as agent for all the other persons who are said to be partners.

[page 109]

In Smith v Anderson, discussed earlier, the absence of mutual rights and obligations between the investors in the trust was an additional reason for the court rejecting a partnership relationship on the facts of that case. Although the investors in the trust had a common interest, it could not be said that they were carrying on business ‘in common’.

Smith v Anderson (1880) 15 Ch D 247 Court of Appeal (UK)

Persons who have no mutual rights and obligations do not, accordingly … constitute an association because they happen to have a common interest or several interests in something which is to be divided between them.

The following case illustrates that a common interest in property or business in itself is insufficient to satisfy the acting ‘in common’ requirement. It also demonstrates the additional need for mutuality of rights and obligations which are essential to a partnership.

Keith Murphy Pty Ltd v Custom Credit Corporation Ltd (1992) 6 WAR 332 Western Australia Supreme Court

Facts: A builder and property owner agreed to share profits after developing and selling land. The builder agreed to build on land owned by the property owner and to be liable for the building costs. No meetings were held, nor was there a common bank account or a fiduciary relationship between the parties.

Decision: The court held that the common interest in the business was not enough to demonstrate a partnership between the co-owners. There was no evidence to indicate any intention to form a partnership.

The following case illustrates that two persons carrying on complementary but separate businesses do not satisfy that aspect of the

statutory definition of a partnership concerned with the need of carrying on a business ‘in common’.

Checker Taxicab Co Ltd v Stone [1930] NZLR 169 Supreme Court (NZ)

Facts: A driver hired a taxi car from the owner of a garage. The written contract provided for the taxi to be returned to the owner’s garage in good condition after each use. The driver met the expense of running the car and paid, by way of rental, an agreed percentage of his earnings derived from this activity. In a dispute between the parties, the court had to determine the relationship between the owner and the driver of the taxi.

Decision: The court held that the relationship was not a partnership because it was not a business being carried on by persons in common. The arrangement comprised two distinct and separate businesses. The owner exercised no control over the driver. There was no evidence of mutual rights and obligations between the owner and the driver. The absence of acting ‘in common’ meant that the relationship was not a partnership.

[page 110]

The following case illustrates that two persons, in a de facto relationship, carrying on two businesses as a restaurant were not in a partnership due to the lack of mutual obligations in their business relationship.

Kang-Kem v Paine [2004] NSWSC 3 New South Wales Supreme Court

Facts: A de facto couple was involved in the conduct of two restaurants. The plaintiff, who had a background in the hospitality industry, initiated the idea of running restaurants and relied on the defendant for financial contributions. The defendant knew nothing about running a restaurant business. The plaintiff played the principal role in the operation of both restaurants, although the defendant attended each restaurant regularly to support and assist the plaintiff. On a breakdown in the de facto relationship, the plaintiff sought to wind up the alleged partnership and sought a contribution of profits following the sale of one of the restaurants.

Issue: Did the de facto couple conduct a business in common? If so, it follows that the plaintiff would be entitled to exercise the rights of a partner and seek an account of profits.

•

Decision: Although both parties were conducting businesses and with a view to profit, there was no evidence of mutual rights and obligations in the parties’ relationship. Thus, no partnership existence for the following reasons given by Barrett J:

There was no evidence of mutuality. Neither party acted, in the affairs of the business, as the agent of the others and of both together. The rights and obligations arising from the business … were not mutual [in nature]. They were separate or several rights and obligations, even though each party played a part in the totality of activities. [Both parties] had an interest in seeing the restaurants successfully operated. But the interest was not an interest in common. The defendant … had an investment to protect. That was the source of her interest. It was the interest of an investor rather than a proprietor or business operator.

The following case illustrates that two parties, in a commercial relationship, were not in a partnership due to the failure to satisfy the acting ‘in common’ aspect of the legal definition of a partnership. The case is also significant because it:

highlights indicators which are contrary to the existence of a partnership;16 and demonstrates the risks in trying to establish a partnership by relying on conduct and oral agreement.

AM Marketing Pty Ltd v Howard Media Pty Ltd [2010] NSWSC 803 New South Wales Supreme Court

Facts: The plaintiff (AM Marketing Pty Ltd) was a marketing consultant. The defendant (Howard Media Pty Ltd) was a publisher. The defendant approached the plaintiff to market some print products. Both parties agreed orally that the plaintiff will receive a 50% share of the profits resulting from marketing and advertising contract sales. Both parties established a joint bank account which initially was operated jointly but later only one signature (that of the defendant) was required to operate the account. Unlike the defendant, the plaintiff did not have internet banking access codes to operate the account. The plaintiff sued the defendant for overdue invoices that were issued for marketing services rendered. The defendant denied that there was a debt owing to the plaintiff because it was alleged that the parties were in a partnership.

[page 111]

Issue: The central issue was whether the business relationship between the parties was that of a partnership.

Decision: Although both parties were conducting a business with a view to profit, the absence of mutuality in their relationship meant that the acting ‘in common’ test was not satisfied. The court

• • • •

• •

4.12

•

4.13

rejected the defendant’s argument that the operation and control of the joint bank account showed evidence of relevant ‘mutuality’. The court also found that the following factors undermined the conclusion that the parties were in partnership:

No partnership accounts or tax returns were ever prepared or lodged. Both parties maintained separate and distinct accounts. The plaintiff issued itemised tax invoices to the defendant seeking payment for services rendered. The use of the invoice system and the preparation of accounts by each party demonstrated the separateness of the parties in relation to activities undertaken jointly. Each party operated from different premises with separate ownership of plant and equipment. The defendant’s practice of deducting the payment for editorial services to the plaintiff before the distribution of profits was held to be inconsistent with the partnership.

Based on such factors, the court held that the intention to operate the business ‘in common’ was lacking. Furthermore, the court held that the fact that parties may have called themselves partners and used the language of partnership in email communication is not a basis for concluding that a partnership exists. The court affirmed that a partnership cannot be created by mere representation that one exists.

‘With a view to profit’ In order to satisfy this statutory element of the definition of partnership, the object of the business must be the acquisition of financial gain. It does not matter whether the venture is successful or not and makes losses, so long as the requisite intention to seek profit is present. This requirement generally excludes clubs and societies that are formed for non-profit making activities, such as the promotion of sport or other cultural activities, from the ambit of partnership law.

The intention to make a profit is said to lie ‘at the very heart’ of the partnership relationship: Bova v Avati [2009] NSWSC 921.

Contrast the decision in Miah v Khan with the decision in Goudberg v Herniman Associates Pty Ltd, discussed above, where an opposite conclusion was reached. Can you discern a valid distinction?

Rules relating to establishment of a partnership Determining whether a partnership exists is not always easy. Whether a partnership exists is a mixed question of fact and law: Momentum

4.14

Productions Pty Ltd v Lewarne (2009) 254 ALR 471; [2009] FCAFC 30.

The Partnership Acts17 set out a number of rules, as guidelines, to assist in determining if a partnership exists or not. The rules, considered below, state that certain facts by themselves involving the sharing of profits does not create a partnership — unless accompanied by the essential definitional criteria for a partnership considered above.

[page 112]

Rule 1: Co-ownership of property Joint tenancy, tenancy in common, joint property or part ownership does not of itself create a partnership as to anything so held or owned, whether the tenants or owners do or do not share any profits made by the use thereof.18

This section shows that co-owners of property who share profits are not necessarily partners unless the partnership elements (carrying on a business in common with view to profit) are fulfilled. Ordinarily, co- owners are not agents for each other and do not usually share profits or losses or carry on business in common, unless the facts demonstrate otherwise.

Davis v Davis [1894] 1 Ch 393 Chancery Division (UK)

Facts: Two brothers inherited from their father equal shares as tenants in common in a business and in three houses. The sons continued to manage the business, but did not enter into a formal partnership agreement. Each withdrew money from the business on a weekly basis. They offered the homes as security to the bank pursuant to a loan agreement. They later defaulted on the loan repayment.

Issue: Was the business relationship a partnership and were the houses partnership property? Decision: The court held that this co-ownership appeared to be a partnership, unless there was evidence to the contrary to rebut this finding. The court, however, found no evidence to rebut the presumption of partnership and held the business relationship to be a partnership. In doing so, the court was influenced by the fact that the two brothers withdrew the same amount of money each week and inferred that there was a partnership.

4.15

Rule 2: Sharing of gross returns The sharing of gross returns does not of itself create a partnership, whether the persons sharing such returns have or have not a joint or common right or interest in any property from which or from the use of which the returns are derived.19

‘Gross return’ means the revenue gained from a business before any expenses are deducted. Sharing profits in this way, by itself, does not mean that there is a partnership. For example, co-owners of property sharing rent cannot be said to be partners merely because they receive and share the profits. For there to be a partnership, the essential definitional elements of a partnership (discussed at 4.8-4.12 above) are needed.

Cribb v Korn (1911) 12 CLR 205 High Court of Australia

Facts: Mr Cribb agreed to allow Mr Rano to farm two paddocks on his property. The agreement noted that Cribb was going to supply the land and equipment and Rano was to supply the labour and the two were to share the gross proceeds equally. Rano, in turn, hired Mr Korn to

[page 113]

help him take care of the fields. Korn was injured and he sued both Cribb and Rano alleging that they were partners and as a consequence they were both his employers.

Issue: Was the agreement between Cribb and Rano a partnership or a tenancy agreement? Decision: The court held that Cribb and Rano were not partners. While they may have been sharing gross returns, it was clear that they had never intended to conduct the enterprise in the form of a partnership. The arrangement took the form of either a lease or a licence of property from Cribb to Rano in exchange for which Rano would make a payment to Cribb as a percentage based on the gross return of product produced and sold by Rano. At no time was Rano working the land on behalf of Cribb and himself. He was working on his own behalf, and was paying Cribb rent for the opportunity. Furthermore, the parties could not be said to be acting ‘in common’ due to the lack of mutual rights and obligations between them.

According to Barton J:

To be partners, they must be shown to have agreed to carry on some business — in this case

4.16

4.17

the business of farming — in common, with a view of making profits and afterwards of dividing, or of applying them, to some agreed object. There is nothing to show that the appellant intended to engage in farming at all, or to be concerned in the transaction beyond his right to compensation.

Rule 3: Sharing of profit and losses One of the common features of running a business in common is sharing profits and losses. This is addressed by the Partnership Acts in the following rule:

The receipt by a person of a share of the profits of a business is prima facie evidence that the person is a partner in the business, but the receipt of such a share, or of a payment contingent on, or varying with the profits of a business, does not of itself make the person a partner in the business.20 [emphasis added]

Thus, it is possible to share profits without being a partner. The sharing of the profit and loss of a business is a stronger indicator of a partnership relationship21 unless the surrounding circumstances rebut this intention. Someone receiving a share of profits does not automatically have to disprove the existence of a partnership at least as long as there are other circumstances, which indicate that no partnership was ever intended. There are five specific exceptions where this presumption of partnership does not apply.

Debt paid out of profits The mere fact that a creditor receives payment out of a company’s profits does not make the creditor a partner in the business:

The receipt by a person of a debt or other liquidated demand by instalments or otherwise out of the accruing profits of a business does not of itself make the person a partner in the business or liable as such.22

The mere sharing of profit in a business by a creditor does not necessarily mean that the creditor is a partner. The right of the recipient to receive the profit does not arise from participation of partnership. It arises because of the existence of a relationship

[page 114]

4.18

of creditor/debtor. However, if it can be proved that the essential elements of partnership exist, then the creditor will be considered as being a partner.

Cox v Hickman (1860) 8 HL Cas 268 House of Lords

Facts: A partnership business was in financial difficulties. The partners assigned (transferred) the business of the firm to trustees, who were also the creditors of the firm, who took on the task of managing the firm until all the debts were paid. This arrangement was entered into as an attempt to avoid insolvency. The trustees, as creditors, were also entitled to a share in the firm’s profits. When the firm dishonoured a financial document (a bill of exchange), the trustees were sued in their capacity as partners of the firm.

Issue: Did the trustees, who shared in the profits of the business, become partners in the firm? Decision: The sharing of the profits by the trustees, without more, did not make them partners, and therefore the action failed. Furthermore, the trustees were not conducting a business ‘in common’. The trustees had retained their true relationship, with the firm, that of debtor and creditor.

Payment to agents or employees It is common in some industries to reward employees and agents with a share of the profits; however, this does not necessarily make them a partner as the following role demonstrates:

A contract for the remuneration of a servant [employee] or agent of a person engaged in a business by a share of the profits of the business does not of itself make the servant [employee] or agent a partner in the business or liable as such.23

Such an arrangement can be used as an incentive to induce employees to work harder or more efficiently but they do not, by themselves, make those employees partners in the business. The same rule applies for agents sharing or receiving part of the profit of the business. It should be noted that the words refer to an actual share of the profits and not remuneration by reference to a share in the profits.

The following case illustrates the operation of the rule that profit sharing under a business arrangement, without more, does not make the agent a business partner.

Re Buchanan & Co (1876) 4 QSCR 202 Queensland Supreme Court

Facts: After relocating to Brisbane, Buchanan entered into an agreement with a partnership of T and M located in Sydney. It was agreed that T and M would consign certain of their products to Buchanan who would sell them and would retain half of the profit from the sale. Buchanan held himself out to others in Brisbane as being in partnership with T and M. When Buchanan became a bankrupt, he tried unsuccessfully to join T and M in his bankruptcy as partners.

Decision: The court held that at all material times Buchanan was merely an agent and was not a partner. The mere sharing of profits was inadequate to constitute a partnership. There was no evidence of a business being carried on in common.

[page 115]

The following case illustrates the need to distinguish between the sharing of profits paid for the supply of services and the sharing of partnership profits in determining a partnership relationship.

Beckingham v Port Jackson and Manly Steamship Co Ltd [1957] SR (NSW) 403 New South Wales Supreme Court

Facts: A syndicate purchased a submarine with the purpose of having it open to the public who could enter and tour by paying an entry fee. The syndicate contracted with the Steamship Company to pay rent for wharf space and to share the profits of this business venture with the Steamship Company in its capacity as manager of the exhibition which was to run for several years. The agreement also stipulated that the syndicate was to remain at all times in the ‘ownership and possession’ of the syndicate. During a storm, the Steamship Company arranged for the submarine to be towed into more open waters for the protection of the submarine and the surrounding property. During the towing operations the submarine broke loose and was wrecked. The syndicate sued the Steamship Company for damages caused by their negligence. The Steamship Company, in turn, argued that they were in partnership with the syndicate in a submarine exhibition business and could not be sued because they were acting in the interests of the partnership.

Issue: What was the true status of the parties relationship — that of partners or agents? Decision: The court reviewed the terms of the agreement between the parties and concluded that an agency relationship, and not partnership, existed. The court held:

4.19

4.20

… [it] is clear … that the parties sought to avoid the creation of a partnership, and, in particular, to prevent any authority from arising in the syndicate … to pledge the credit of the Steamship Company or the creation of any liability in the Steamship Company to third parties … the Steamship Company is expressed to act … as agents for the syndicate … to manage the syndicate’s [business] of exhibiting the submarine – all this for reward to the Steamship Company in the form of a fixed annual rental and a percentage of the net proceeds of the admission charges …

Significance: The case illustrates that the sharing of profits, without more, is insufficient to constitute a partnership. On the facts of this case, the sharing of profits was simply a means of making payment to an agent, the Steamship Company, for services rendered to the syndicate.

Payment to deceased partner’s widow, widower or child A person being the widow, widower or child of a deceased partner, and receiving by way of annuity a portion of the profits made in the business in which the deceased person was a partner, is not by reason only of such receipt a partner in the business or liable as such.24

Such payments do not convert the widow, widower or child into partners in the deceased partner’s firm. The payment will not make the recipient a partner, unless the essential elements of partnership are there. Unless the elements of being a partner are satisfied, the spouse or child will not be liable to creditors of the firm.

[page 116]

Payment of interest Lenders who receive either interest that varies with the profit or a percentage of the firm’s profit instead of interest are not partners in the borrowing firm except if the essential elements of a partnership are met:

The advance of money by way of loan to a person engaged or about to engage in any business on a contract with that person, that the lender shall receive a rate of interest varying with the profits, or shall receive a share of the profits arising from carrying on the business, does not of itself make the lender a partner with the person or persons carrying on the business or liable as such: Provided that the contract is in writing and signed by or on behalf of all the parties thereto.25

Such a provision offers protection to lenders, as genuine creditors, who advance money in return for a share of the profit.

4.21

Re Megevand; Ex parte Delhasse (1878) 7 Ch D 511 Court of Appeal (UK)

Facts: Delhasse lent £10,000 to Megevand and Schoeppi for use in their business that Megevand and Schoeppi intended to carry on in partnership. In return, Delhasse was entitled to share in profits and losses to the extent of 25%. It was an express part of the agreement that the advance was a loan and that Delhasse was not to be considered to be a partner of Megevand and Schoeppi. Delhasse could also examine the partnership books when he chose, receive a quarterly statement, make further loans on equivalent terms and terminate the arrangement by notice in certain cases. The £10,000 was the only capital of the business.

When Megevand and Schoeppi were committed to bankruptcy, Delhasse lodged a claim as a creditor to recover the debt of £10,000 owed to him. The court rejected Delhasse’s claim on the basis that he was a partner.

Issue: Was the real status of Delhasse, creditor or partner? Decision: The court found that the loan agreement gave Delhasse all the rights which a dormant business partner would be expected to have. Consequently, Delhasse’s claim was rejected as the court considered him to be a partner. James LJ held:

If ever there was a case of partnership this is it. There is every element of partnership in it. There is the right to control the property, the right to receive profits, and the liability to share in losses … the loan is a mere pretence, the object being to enable the so-called lender to be, not only a dormant partner, but the real and substantial owner of the business, for whom and on whose behalf it is to be carried on, and yet to provide that he shall not be liable for the loss, in case loss shall be incurred.

Significance: Apart from illustrating that it is possible for a creditor to overstep the boundaries of a genuine debtor-creditor relationship and be held as a partner, this case also demonstrates the courts’ readiness to ignore the labels attached by the parties and to ascertain the true relationship between the parties. The Canny Gabriel case, discussed in Chapter 3, further illustrates the latter point.

Payment for goodwill An ex-owner of a business who continues to receive part of the future profits of the business as payment for the sale of the business to the partnership is not by this reason alone a partner:

[page 117]

A person receiving by way of annuity or otherwise a portion of the profits of a business in consideration of the sale by the person of the goodwill of the business is not by reason only of such receipt a partner in the business or liable as such.26

•

4.22

However, he or she may be deemed to be a partner if the essential elements of a partnership (the statutory definition) are satisfied.

In determining the existence of a partnership, the courts focus on all of the facts of a given case to ascertain contractual intention to establish such a business relationship. The courts are not blinded by the labels given to the relationship by the parties, as seen in Re Megevand; Ex parte Delhasse above and reinforced in the following passage in Stekel v Ellice [1973] 1 WLR 191:

He may or may not be a partner, depending on the facts. What must be done … is to look at the substance of the relationship between the parties; and there is ample authority for saying that the question whether or not there is a partnership depends on what the true relationship is, and not on any mere label attached to that relationship. A relationship that is plainly not a partnership is no more made into a partnership by calling it one than a relationship which is plainly a partnership is prevented from being one by a clause negativing [rejecting] partnership.

The Court of Appeal in M Young Legal Associates Ltd v Zahid [2006] 1 WLR 2562 in England noted, in a similar context, ‘you look at the reality, you do not look at the form or the window-dressing’ in determining a partnership relationship.

Profit sharing is the best sign of a partnership but it is not, by itself, conclusive to establish a partnership. Why do you think, other than profit sharing, there must be evidence to prove the existence of a partnership? What concerns do you think the law has in requiring further evidence?

Liability — partners and outsiders One of the key reasons to determine if a partnership exists or not is because of the nature of liability of the partners to outsiders. It is important to remember that a partnership is not a separate legal entity; it is the partners as a whole.27 Partners are jointly liable for contracts made by or on behalf of the firm. Partners are jointly and severally liable for any tort (for example, negligence) committed by the firm. The liability of partners in contract, tort and crime is discussed below.

A partnership is not a separate legal entity. As a consequence, third

4.23

parties (or outsiders) must contract with the individual partners. This raises an important issue of whether the contract entered into by the individual partner is binding on the firm. The partnership addresses this issue by providing an agency provision, discussed below.

An agent may have actual authority (express or implied) or apparent authority. In the case of the former, a partner will have the power to bind the rest of the partners. The actual authority is the real authority given by the firm to a particular partner. Accordingly if a partner, acting within his real authority, buys goods on behalf of the firm, then of course the firm is bound. A partner usually has implied powers to bind

[page 118]

the firm in all transactions that are necessary to carry on the business in the usual way such as selling assets of partnership, buying goods of the kind usually employed in the firm’s business account of the partnership, hire employees for the carrying out of the firm’s business, borrow money, contract debt, give securities for those debts and pay debts and receive payment of debts.

In cases of apparent authority (where the parent has no actual authority but has the appearance of authority), a problem will arise where a partner may exceed their actual authority and the question will be: ‘Will the rest of the partners be liable?’ The partners will be liable only if the following statutory provision is satisfied.

Power of partner to bind the firm The section below establishes the agency relationship between partners and sets out the circumstances in which a partner has the power to bind the other partners:

Every partner... is an agent of the firm and of the other partners for the purpose of the business of the partnership; and the acts of every partner who does any act for carrying on in the usual way business of the kind carried on by the firm of which the partner is a member, binds the firm and the other partners, unless the partner so acting has in fact no authority to act for the firm in the particular matter, and the person with whom the partner is dealing either knows that the

partner has no authority, or does not know or believe the partner to be a partner.28 [emphasis added]

Essentially, any act of a partner done within the scope of the partnership business and in the ordinary course of business is binding on all other partners. An exception, however, arises if the third party outsider (for example, a supplier or creditor) actually knows that the partner lacks authority or is not a partner.

For the firm to be bound by the act of the partner, the section requires the following four requirements to be met:

There must be a transaction of the kind carrying on by the firm. This means that the transaction must be within the scope of the firm’s normal business. Partners will be liable for the acts of any of the partners if those acts are a kind of business the firm usually carries on. Whether or not a transaction is within the scope of a particular kind of business is a question of fact.

Mercantile Credit Co Ltd v Garrod [1962] 3 All ER 1103 Queens Bench (UK)

Facts: Garrod and Perkin conducted a garage business in partnership, with Garrod playing a less active role in the daily management. The partnership agreement prohibited the buying and selling of cars as part of the partnership business. Unknown to Garrod at the time, Perkin acted in breach of this agreement and fraudulently sold a car (which did not belong to him) to a third party (Mercantile Credit). The purchaser sued both partners for the refund of the purchase price which had been paid to the firm.

Issue: Could the purchaser sue Garrod, the innocent partner, to recover the purchaser price even though Perkin acted in breach of the partnership agreement?

[page 119]

Decision: The court held that Garrod was liable to refund the purchase price, despite the fact that the partnership agreement prohibited this activity. The sale of the car fell within the scope of a garage’s normal business. Accordingly, Perkin had apparent authority to transact.

The transaction must be done in the usual way. In order for the transaction to be binding on the firm, it must be

transacted in the usual way. Essentially, this means that the transaction must not put the outsider on enquiry and arouse suspicion. For example, if a partner enters into a transaction within the scope of the firm’s business, an outsider should not have reason to be suspicious if the transaction is being done ‘in the usual way’. Failure to act on suspicion, by making enquiries to see that the firm has authorised the transaction, could result in the firm not being bound by the transaction. The meaning of ‘the usual way’ will ultimately depend on the facts of each case. The following case illustrates a partnership transaction not done in ‘the usual way’.

The Partnership Acts29 address the firm’s liability arising from unusual activity involving credit by offering the firm protection by excluding all partners from liability (unless they authorised the transaction) — but retains individual partner liability:

Where one partner pledges the credit of the firm … for a purpose apparently not connected with the firm’s ordinary course of business, the firm is not bound unless the partner is in fact specially authorised by the other partners; but this section does not affect any personal liability incurred by an individual partner.

As can be seen by this statutory provision, a partner using credit of the firm for private purposes (that is, a purpose unrelated to the firm’s ordinary business) will incur personal liability and, ordinarily, the firm will not be liable unless it approved of the loan transaction.

Goldberg v Jenkins (1889) 15 VLR 36 Victoria Supreme Court

Facts: A partner borrowed money from a moneylender in the name of the partnership, at an exorbitant interest rate of 60%, and defaulted on repayment. The moneylender sued the partnership for repayment of the loan.

Issue: Did the loan agreement bind the firm or should the moneylender be aware that this loan transaction was not conducted in the usual way and therefore not binding on the firm?

Decision: The court held that a partner borrowing funds on behalf of the firm at an unrealistic rate of 60% interest was acting beyond the ‘usual way’ and the rest of the partners were not bound because of the excessive interest rate which was radically out of step compared to normal commercial interest rate at that time. Hodges J held:

… a partner can only bind his co-partners by conducting the business in a way in which the

4.24

4.25

businesses are ordinarily conducted, and consequently has no … authority to go outside the ordinary mode of … transacting business, and to pledge his co-partners or the credit of the partnership for transactions which are not business transactions at all …

A person conducting his transactions in the ordinary way ., would have been able to obtain all the advances which he could reasonably require at rates varying from six to

[page 120]

10 per cent, but in this case, the interest was something over 60 per cent, and that … is not conducting business at all; and the person lending money on those terms knows that the person borrowing is not conducting an ordinary business transaction, and that, therefore, the partner borrowing would have no power to bind his partners.

The outsider must not know or suspect that the partner was exceeding his authority.

The outsider must have known or at least must believe that the person with whom he/she was dealing was a partner.

Requirements 3. and 4. reinforce the concept of apparent authority by recognising that the firm can still be bound despite the absence of actual authority by the partner. Even if a particular transaction falls outside the scope of actual or apparent authority, the partnership will be bound if it ratifies the action of the partner in breach of authority.

Liability of partners in contract, tort and crime A partnership is not a separate legal entity, and therefore a partner’s liability to outsiders is generally unlimited. Accordingly, a partner is liable for partnership debts and obligations to the full extent of their personal resources which includes assets held in their name. As a consequence of personal and unlimited liability for all the debt of the partnership, a partner faces the real risk of bankruptcy.

Liability of partner for debts and contracts Each partner is jointly liable for any contract incurred by or on behalf of the partnership. The Partnership Acts30 state:

Every partner in a firm... is liable jointly with the other partners for all debts and obligations of the firm incurred while the partner is a partner, and (if the partner is an individual) after the

4.26

partner’s death [his or her] estate is also severally liable in a due course of administration for such debts and obligations so far as they remain unsatisfied but subject to the prior payment of the partner’s separate debt. [emphasis added]

Joint liability means that there is only one right of action available against the partners. This implies that the plaintiff will be stopped from bringing further proceedings against the other partners if he or she did not include them in his or her first action. This can be a problem in the case of sleeping partners. The plaintiff might not know of their existence and accordingly will not include them in his or her law suit. Since the liability is joint, the plaintiff will not be able to take further action against the sleeping partners. To remedy this problem, it is wise to sue the partners under the name of the ‘firm’. In this way, all partners (even if the plaintiff does not know of their existence) will be included in the action.

There is only one exception where the liability will be joint and several. It arises in the case of deceased partners. Therefore, if a partner who was a member of the firm when the debt was incurred dies before the firm is sued, his or her estate will become severally liable for that debt. The creditor will sue the surviving partners jointly and if their combined assets are not enough to discharge the debt, the creditor will be able to bring a further action against the deceased partner’s estate.

[page 121]

Liability of partner for wrongs Partners are liable for the wrongful act or omission of any partner acting in the ordinary course of business of the firm, or with the authority of his or her co-partners. The Partnership Acts,31 which provide for collective liability as well as individual liability, state:

… any wrongful act or omission of any partner … acting in the ordinary course of business of the firm, or with the authority of his or her co-partners, loss or injury is caused to any person not being a partner in the firm, or any penalty is incurred, the firm is liable thereof to the same extent as the partner so acting or omitting to act. [emphasis added]

For a plaintiff to succeed with legal action against partners under the Partnership Acts, that person must be able to prove that the wrongful act or omission was committed:

• •

by a partner; that the partner was acting in the ordinary course of the firm’s business; or with the authority (actual or apparent) of his or her co- partners; that the plaintiff suffered loss or injury; and that the plaintiff’s loss or injury was caused by the wrongful act or omission.

Each partner is jointly and severally liable for any wrong (a civil wrong, such as negligence or deceit) committed by the firm.32 Joint and several liability means that the partners can be sued as a group ( jointly) or individually (severally) by the plaintiff. If the plaintiff elects to sue some of the partners (and not all), the partners that are personally liable can seek a contribution from the other partners for the damages paid.

The following case, Dubai Aluminium Co Ltd v Salaam, illustrates the firm’s liability for an elaborate fraud by a partner (even though all of the other partners were personally innocent of any dishonesty).

Dubai Aluminium Co Ltd v Salaam [2002] 3 WLR 1913; [2002] UKHL 48 House of Lords (UK)

Facts: Dubai Aluminium Ltd (the plaintiff) was induced, through fraudulent means, to pay US$50 million in a series of sham (fake) consultancy agreements (over a six-year period) drafted by a firm’s solicitor who was a partner. The solicitor had no authority from his partners to conduct himself in this manner. The plaintiff sought to make the firm vicariously liable for the actions of the dishonest partner under the Partnership Act.

Issues: Did the partner’s wrongful conduct, while advising on and drafting legal agreements, occur in the ordinary course of the firm’s business? Was the entire firm (the innocent co-partners) vicariously liable for a partner’s dishonest assistance in breach of trust or fiduciary duty?

Decision: The drafting of the agreements was regarded as an act done within the ordinary course of the firm’s business (even though they were drafted for a dishonest purpose), and therefore the firm was held to be liable. The court found that these acts were so closely connected with the acts the errant solicitor was authorised to do that they may properly

[page 122]

be regarded as done by him while acting in the ordinary course of the firm’s business. Accordingly, the

4.27

firm was held to be vicariously liable for the errant solicitor’s dishonest wrongdoing and stood in his shoes for purposes of liability.

Lord Nicholls of Birkenhead offered this view on the rationale for vicarious liability and the broad interpretation of the phrase ‘ordinary course of employment’:

Whether an act or omission is done in the ordinary course of a firm’s business cannot be decided simply by considering whether the partner was authorised by his co-partners to do the very act he did. The reason for this lies in the legal policy underlying vicarious liability … [which] is based on the recognition that carrying on a business enterprise necessarily involves risk to others. It involves the risk that others will be harmed by wrongful acts committed by the agents through whom the business is carried on. When those risks ripen into loss, it is just that the business should be responsible for compensating the person who has been wronged. This policy reason dictates that liability for agents should not be strictly confined to acts done with the employer’s authority … It is fair to allocate risk of losses [arising from agent’s actions even when they defy instructions] to the business that leave the wronged with the sole remedy, of doubtful value, against the individual employee who committed the wrong. To this end, the law has given the concept of ‘ordinary course of employment’ an extended scope.

Significance: The decision illustrates that this section of the Partnership Act, providing for the vicarious liability of partners, has very broad application and is not limited to torts or other common law wrongs — it extends to equitable wrongdoings (such as breach of fiduciary duty arising under equity) as demonstrated by the facts and decision in this case.

Liability in tort The Partnership Act33 makes partners jointly and severally liable for torts which occurred within the normal course of the partnership business (as opposed to when a partner acts personally outside the scope of the partnership business). Vicarious liability, however, does not extend to situations where partners are ‘acting on a frolic’ of their own (that is, outside the normal course of business).

Polkinghorne v Holland & Whitington (1934) 51 CLR 143 High Court of Australia

Facts: One partner, in a firm of three solicitors, advised their long-established client (Polkinghorne) to sell government securities (a safer form of investment) and to instead invest in shares in a company which he had registered for an associate and knew to be a mere shell. This company had no shares, no bank account and did no business. The client followed the partner’s advice, invested and suffered loss. The client sued all the partners to recover compensation for loss suffered.

Issue: Were the two innocent partners liable for the loss suffered by a client caused by the fraudulent

•

4.28

activities of the errant partner?

Decision: Although the errant partner disappeared with the client’s money, the legal action against the innocent partners was successful. The giving of investment advice was held to be within the scope of the errant partner’s authority as a solicitor of the firm. Accordingly, the firm was liable for the errant partner’s negligent omission

Similarly, the decision in Lloyd v Grace, Smith & Co Ltd [1912] AC 716 also demonstrates that a partnership can be liable for fraud carried out for the benefit of an individual

[page 123]

partner. See Chapter 7 at 7.6 for detailed discussion of this case where the wronged person acted in reliance on the ostensible (or apparent) authority of the employee.

Is it fair that tort liability is imposed on all of the partners both joint and severally even where only one of the partners may have committed the tort?

Criminal wrong The partnership’s liability for wrongs committed by any of its partners extends, not only to civil wrongs, but also to certain criminal wrongs which incurs a penalty.34 The criminal liability will only arise in cases where there has been a breach of some regulatory statute that imposes strict liability offences (that is, without the need to prove criminal intention or a guilty mind, otherwise known as mens rea) — for example, offences under the occupational health and safety laws and consumer protection laws.

The partnership is not a separate legal entity and therefore it is important to note that the firm itself cannot be liable for crime — as opposed to companies which can be liable in this way. It is the individual partners who will bear the criminal liability in their personal capacity.

4.29

(a)

(b)

Liability for misapplication of money or property The Partnership Acts provide for the liability of the firm where money or property of a third person has been received and misapplied by a member of a partnership. The relevant section provides:35

Where one partner acting within the scope of the partner’s apparent authority receives the money or property of a third person and misapplies it; or When a firm in the course of its business receives money or property of a third person, and the money or property so received is misapplied by one or more of the partners while it is in the custody of the firm, the firm is liable to make good the loss. [emphasis added]

Either of the scenarios (a) or (b) may lead to the liability of the firm. Similar to liability in tort, liability for misapplication of money or property is joint and several. This section, however, does not apply when the partner receives money or property in a private capacity unrelated to partnership business.

Mann v Hulme (1961) 106 CLR 136 High Court of Australia

Facts: Mann and Richardson were partners in a law firm. Richardson received investment money from the firm’s client, Mr and Mrs Hulme, to be offered as mortgage finance to clients of the firm in the building trade. The couple was persuaded to do so by Richardson’s recommendations and assurances that the investment was safe. The money was misappropriated by Richardson who was subsequently jailed for his fraudulent actions. The couple sued the partnership to recover the money invested.

[page 124]

Issue: Was the firm (Mann, the innocent partner) liable for the money received in the name of Richardson on the basis that Richardson (the errant partner) was acting within the scope of a partner’s apparent authority?

Decision: The court held that the firm was liable (on the basis of joint and several liability) because Richardson’s actions, in accepting investment funds, were within the scope of his apparent authority as a partner in a firm of lawyers. The acceptance of the money was held to be within the ordinary course of a solicitor’s business.

4.30

(1)

(2)

4.31

• • • •

Liability for misapplication of trust property The Partnership Acts36 make the firm liable for the improper use of trust property for partnership purposes:

If a partner... being a trustee improperly employs trust property in the business or on account of the partnership, no other partner is liable for the trust property to the persons beneficially interested therein: Provided as follows:

This section shall not affect any liability incurred by any partner by reason of the partner’s having notice of a breach of trust, and

Nothing in this section shall prevent trust money from being followed and recovered from the firm if still in its possession or under its control. [emphasis added]

It is important to note that this statutory provision has limited effect in that it only operates when a partner, who is also a trustee, improperly brings the trust property to the firm to be applied for partnership purposes — for example, to be used as the partner’s capital contribution.

In such circumstances, the beneficiaries of the trust cannot, ordinarily, sue the innocent partners for the errant partner’s breach of trust — unless the statutory exception identified above is applicable: namely, when the innocent partners participate in the misapplication of the trust property through their knowledge of the breach of trust.

Note, however, that the beneficiaries are entitled to sue the firm to recover the trust property if it still is in the control of the firm.

Partners’ relationship, rights and duties The relationship that exists between partners is a fiduciary relationship. The important concept of ‘fiduciary duty’ extends to trustees, company promoters and directors. This concept is further explained and illustrated, with case law discussion, in Chapter 8 at 8.2-8.5 and in Chapter 16 at 16.1- 16.7.

As part of the fiduciary duties owed to each other, partners must:

avoid conflicts of interest; not make secret profits; not compete with the firm; and not disclose confidential information.

4.32

(1)

(2)

[page 125]

Helmore v Smith (1886) 35 Ch D 436 Court of Appeal (UK)

Their [the partners] mutual confidence is the life-blood of the concern. It is because they trust one another that they are partners in the first instance; it is because they continue to trust one another that the business goes on.

Duty to act in good faith and with loyalty As fiduciaries, a partner’s personal interest should not conflict with the interest of the partnership. Partners are not allowed to use their positions in the firm or the knowledge they gain through the firm to make personal profit. Accordingly, they cannot compete with the firm. If the partners breach any of these duties, without first obtaining the consent of the rest of the partners, then they will be liable to account for any benefit that they receive as a consequence. The partners also have to render true accounts and provide full information of all things affecting the partnership to any partner or the partner’s legal representatives.37

The restriction on partners competing against the firm is recognised in the Partnership Acts under the following provision:38

Accountability of partners for private profits Every partner must account to the firm for any benefit derived by the partner without the consent of the other partners from any transaction concerning the partnership, or for any use by the partner of the partnership property, name, or business connexion.

This section applies also to transactions undertaken after a partnership has been dissolved by the death of a partner, and before the affairs thereof have been completely wound up, either by any surviving partner or by the representatives of the deceased partner. [emphasis added]

Birtchnell v Equity Trustee, Executors and Agency Co Ltd (1929) 42 CLR 384 illustrates the prohibition on partners from making private profits without the knowledge and consent of the firm, and the consequence of breach — namely, the need to hand over the private profits to the partnership for the

benefit of the partners jointly. Similarly, the decision in Pathirana v Pathirana [1967] 1 AC 233 (discussed below at 4.48) also illustrates the accountability of partners for private profits.

Birtchnell v Equity Trustee, Executors and Agency Co Ltd (1929) 42 CLR 384 High Court of Australia

Facts: A partner in a real estate firm shared profits with the firm’s client arising from land speculation activities, without disclosing this information to the other partners in the firm. This conflict of interest was discovered after the partner died. The rest of the firm’s partners sued the executor of the deceased partner’s estate for an account of those profits, flowing from the breach of fiduciary duty.

[page 126]

Decision: The High Court ordered the partner’s executor to account to the firm for all profits arising from the resulting conflict of interest. The court held:

… the partnership was entitled to avail itself of any opportunity to embark upon such a transaction [land speculation activities] which came to the knowledge of the partners or any one of them and knowledge and information acquired by a partner as to the readiness of a client to share such profits … were all matters which no partner could lawfully withhold from the firm and turn to his own account … Porter [the deceased partner] took advantage for himself of an opportunity which arose in the transaction of the firm’s business in connection with one of its clients and of a nature which the firm was entitled to consider, and use for itself.

However, the fact that a business carried on by a partner is similar in nature to that of the partnership does not mean the partner is accountable to the partnership for its profits unless the business is in fact, or reality, competing with the partnership.

Trimble v Goldberg [1906] AC 494 Privy Council (UK)

Facts: In this case, partners entered into the purchase of several plots of land being the property of H.

•

4.33

After the plots were purchased by the partnership, one of the partners purchased other plots belonging to H on his own account. This partner then resold the plots of land at a profit.

Decision: It was held that because the transactions were not within the scope of the original agreement, and the actions had not been injurious to, or had any connection with, the partnership business. Accountability was therefore not necessary. The transaction was held to be a separate activity, not falling within the scope of the partnership.

Law v Law [1905] 1 Ch 140 illustrates the need for partners to make full disclosure to each other of all things affecting the partnership business and the prohibition against using knowledge to benefit themselves to the detriment of other partners.

Law v Law [1905] 1 Ch 140 Court of Appeal (UK)

Facts: Two brothers, William and James, were partners in business. William played a minor role in the business and agreed to let James buy his partnership interest. James paid the agreed purchase price and the partnership relationship was dissolved. William later discovered that James had failed to disclose all of the partnership assets, causing him to sell at undervalue, and sued James for misrepresentation.

Decision: William succeeded in recovering an increased payment to compensate for selling at a lower price. The court held that, as a fiduciary, James had a duty to make full disclosure of all partnership assets.

Although partners are able to negotiate the content of the fiduciary duties that exist at equity (as opposed to the mandatory duties under the Partnership Act) and modify them by reducing their scope, why do you think it is generally not in their interests to adopt this approach?

[page 127]

Duration of the fiduciary duty It is important to remember that the fiduciary duty of partners may arise

in certain circumstances before the partnership formally commences, and will continue even after the dissolution, at least until all the debts of the partnership have been paid and all the assets have been divided.

United Dominions Corporation Ltd v Brian Pty Ltd (1985) 157 CLR 1 High Court of Australia

Facts: United Dominions Corporation Ltd (UDC) and Brian were members of a joint venture with another company SPL. Prior to forming the joint venture, UDC and SPL entered into a contract involving the proceeds of the future joint venture if SPL failed to repay money lent to it by UDC. Brian was unaware of this contract. During the course of the joint venture UDC took all of the profits and relied on the previous contract (as SPL had indeed failed to repay the money). Brian alleged that this was a breach of the fiduciary relationship between the joint venturers. The joint venture agreement specifically stated that the participants were joint venturers not partners.

Issue: Did a fiduciary relationship exist between UDC and Brian even though they were involved in a joint venture?

Decision: The court found that there was a fiduciary relationship between UDC and Brian and ordered UDC to pay Brian its share of the joint venture profits. The court also found that, despite the wording of the joint venture agreement, there was a partnership between the joint venturers. As Mason, Brennan and Deane JJ said (at 12):

A fiduciary relationship with attendant fiduciary obligations [duty of good faith, loyalty and honesty] may, and ordinarily will, exist between prospective partners who have embarked upon the conduct of the partnership business or venture before the precise terms of any partnership agreement have been settled.

The decision in Law v Law, discussed above, also demonstrates that the fiduciary duty owed to partners extends to the process of dissolution. The duration of fiduciary duties also extends to any opportunities that arise after dissolution of the partnership but before the affairs of the partnership are wound up — as illustrated by the High Court’s decision in Chan v Zacharia.

Chan v Zacharia (1984) 154 CLR 178 High Court of Australia

•

4.34

Facts: Chan and Zacharia, who were partners in a medical practice, dissolved their partnership. The lease on the premises in which they conducted their surgery was a valuable asset of the firm. The option to renew the lease had to be undertaken by both the partners. After dissolution, but before the winding up of the partnership affairs, Chan sought to exclude Zacharia from practising there by taking up a new lease in his own name alone. In this way, Chan sought to continue the medical practice on his own.

Decision: The High Court held that Chan had breached his fiduciary duty by failing to act with perfect fairness and good faith and was therefore accountable for that private profit. Dean J held that Dr Chan abused his fiduciary position as a trustee and former partner to seek an advantage for himself and in which he subjected the performance of his fiduciary obligations to the pursuit of his personal interest. He holds and will hold any fruits of that abuse of fiduciary position and pursuit of personal interest on constructive trust for those entitled to the property of the dissolved partnership.

[page 128]

If the partnership business had already ceased trading, why was it improper for Dr Chan to obtain the new lease in his own name?

Right of partners to manage The Partnership Acts39 state that ‘every partner may take in the management of the partnership business’.

Indeed, the right to participate in management is one of the key attractions of a partnership. Based on notions of mutual trust and confidence, each partner has a say in the business. Each partner, as noted earlier, is agent and principal of the other. Partners, therefore, have the ability to manage the business and bind each other and be bound by the actions of their partners.

It is important to note, however, that partners can agree to the contrary and exclude certain persons from management. This step, to modify the right to manage, may be taken if the partners have particular concerns about their exposure to unlimited liability for the debts and obligations of the firm. It is also appropriate to consider taking this step against passive

4.35

4.36

(or sleeping) directors who are not inclined to show any interest in partaking in management.

Right of partners to remuneration The Partnership Acts40 state that ‘no partner shall be entitled to remuneration for acting in the partnership business’.

As fiduciaries, partners are expected to put the partnership’s interests ahead of personal interests and therefore should not expect to be paid for conducting their management duties. That is the policy consideration underpinning this section. In practice, however, partners exclude the operation of this section by entering into an agreement to the contrary which permits the payment of salaries.

Right of partners to share profit and losses The partners are entitled to share equally the profit and losses of the partnership:

All the partners are entitled to share equally in the capital and profits of the business, and must contribute equally towards the losses whether of capital or otherwise sustained by the firm.41

Where the partnership agreement states otherwise, this rule of equality will not apply and the partnership agreement will have effect. Accordingly, the partnership agreement can have a profit allocation clause and state, for example, that one of the partners will receive 70% of the profit while another partner will receive 30% of the profit. If so, then it is inferred that the losses in such circumstances will be shared in the same proportion if the partnership agreement is silent on the sharing of the losses: Re Albion Life Assurance Society (1880) 16 Ch D 83.

[page 129]

As regards capital contributions, the practice is for partners to receive their own capital contributions according to the amount contributed. This result is likely to occur when the parties have addressed the manner in which profits are to be shared, but the agreement is silent on the manner

4.37

(a) (b)

4.38

4.39

in which capital is to be shared. In such circumstances, the courts generally apply this section by displacing the presumption of equality and finding in favour of an agreement to the contrary: Kelly v Tucker (1907) 5 CLR 1.

Right of partner to indemnity As an agent of the firm, the partner is entitled to be indemnified by the firm for all liabilities he or she incurs when acting in the ordinary course of the firm’s business. The Partnership Acts provide:42

The firm must indemnify every partner in respect of payment made and personal liabilities incurred by the partner.

In the ordinary and proper conduct of the business of the firm, or In or about anything necessarily done for the preservation of the business or property of the firm.

Right of partner’s access to books Partnership books should be kept in the place of business and the partners can access them and have copies of them at any time except if the partnership agreement stipulates otherwise.43 A partner may appoint an agent, such as an accountant, to look at the books on their behalf. All inspections are subject to the need to keep the information confidential.

Partners cannot use the information acquired for private purposes in conflict with the fiduciary duties owed to the partnership.

Partnership property The Partnership Acts44 provide:

All property, and rights and interests in property, originally brought into the partnership stock or acquired, whether by purchase or otherwise, on account of the firm, or for the purposes and in the course of the partnership business, are called in this Act partnership property, and must be held and applied by the partners exclusively for the purposes of the partnership, and in accordance with the partnership agreement.

Whether a particular asset will be considered as partnership property depends heavily on the intention of the partners and on the partnership agreement. If they wish, they can agree that their separate asset will

become partnership property or, alternatively, they can agree to keep all the assets as their own separate property.

Generally all property brought into the partnership or acquired afterwards will generally be the property of the firm. Each partner has an undivided interest in the whole of the assets of the partnership. The interest of a partner in partnership

[page 130]

assets is not a fixed proportion of each item nor is it an immediately ascertainable quantity of the item; it is an indefinite and fluctuating interest. Accordingly, the assets that become partnership property will belong to the partners collectively rather than each contributing partner individually. Each partner is said to have a ‘beneficial interest’ in every asset of the partnership: Canny Gabriel Castle Jackson Advertising Pty Ltd v Volume Sales (Finance) Pty Ltd (1974) 131 CLR 321. In the eyes of equity, therefore, a partner has an undivided interest in the whole of the partnership property. This interest is nonspecific and of a unique kind: Sze Tu v Lowe [2014] NSWCA 462.

The High Court of Australia, below, examined the nature of an individual partner’s interest in the partnership property.

Everett v Federal Commissioner of Taxation (1980) 143 CLR 440 High Court of Australia

Although a partner has no title to specific property owned by the partnership, he has a beneficial interest in the partnership assets, indeed in each and every asset of the partnership … His share in the partnership consists of a right to a proportion of the surplus after the realisation of the assets and payment of the debts and liabilities of a partnership … Historically the interest of a partner in a partnership has been considered to be an equitable interest because it is a right or interest enforceable in equity and not a law … A partner’s interest in the partnership is a chose in action assignable (transferable) in whole or in part …

The nature of a partner’s interest in partnership property was examined by the High Court in Commissioner of State Taxation v Cyril Henschke Pty Ltd [2010] HCA 43; 242 CLR 508 which reaffirmed these legal principles.

4.40

4.41

4.42

Continuity of existence and termination of a partnership Because the partnership is a contractual agreement between the partners, and conducted on the basis of mutual trust and understanding, any changes in the composition of the partnership will technically terminate it and a new firm would arise. Such changes include the following.

Death or bankruptcy of a partner In the absence of an agreement to the contrary, the death or bankruptcy of any partner will automatically bring the partnership to an end:

Subject to any agreement between the partners, every partnership is dissolved as regards all the partners by the death or bankruptcy of any partner.45

The firm’s business may be formally wound up, the debts of the firm paid and the assets sold and the proceeds divided between the partners.

[page 131]

The members of a two person partnership cannot agree that, on the death of one, the partnership survives. That is because, once one member of a two person partnership dies, there can no longer be any relationship which exists between ‘persons’ carrying on a business in common with a view of profit: Lawrence v Gunner; Gunner v Lawrence [2015] NSWSC 944. The position is different in multi-person partnerships where the parties may agree that if anyone of them dies, the partnership remains in existence among the survivors.

Retirement of a partner or introduction of a new partner Departure under these circumstances will lead to the termination of the partnership. This will happen even if the partnership’s business ‘appears’ to be continuing with the remaining partners. The same rules will apply if a new partner is introduced into the partnership. When a new partner is introduced, the previous partnership will automatically be dissolved and a

4.43

4.44

new partnership will emerge in its place.46

Expulsion or introduction of a new partner For a partner to be expelled from the partnership, the partnership agreement needs to clearly state that this is a possibility:

No majority of the partners can expel any partner unless a power to do so has been conferred by express agreement between the partners47

It is not enough, as demonstrated in the statutory provision above, that all the partners decide to expel one partner if the partnership agreement does not allow it.

In addition to the need for an express agreement allowing expulsion, the following relevant considerations need to be taken into account:

The expulsion must be in good faith and not motivated by improper purposes. Any power given by the agreement to expel a partner needs to be strictly interpreted in accordance with the terms of the partnership agreement. The partner expelled must be given the opportunity to be heard and to defend him or herself against the charges on which expulsion is based.

Means of dissolution Dissolution, which has the effect of bringing the partnership relationship to an end, can occur in many ways such as:

In accordance with the terms of the partnership agreement For instance, the partnership agreement might point out under which situation a partner might be expelled (see above), for example, through professional conduct,

[page 132]

or deemed to be retired. Agreements for dissolution of partnerships are common (a necessary part of commercial activity) and courts have generally been prepared to give effect to them.

Through illegality The Partnership Acts provide that ‘a partnership is in every case dissolved by the happening of any event which makes it unlawful for the business of the firm to be carried on, or for the members of the firm to carry it on in partnership’.48

By expiry of the agreed term or termination of venture or notice A partnership can be entered into with the understanding that its business will be terminated at a certain date. It can also state that the partnership has been entered into for specific venture and once the venture is completed the partnership will be wound up.

In certain cases, the partnership agreement will not specify a date or event for the termination of the partnership

In those instances the partnership will continue for as long as the partners are willing to work with each other.49 This is known as a partnership at will, as opposed to a partnership with a fixed term. A fixed- term partnership may be expected to terminate automatically once the agreed period has expired or once the venture has been completed. On the other hand, a partnership for an indefinite term will generally require the partners to terminate it. This will happen when a partner serves a notice to the partners to end the partnership. Although the principles regarding dissolution by notice have not received much detailed judicial consideration in Australia, it is clear that notice of termination may be inferred by conduct: Ryder v Frohlich [2004] NSWCA 72.

By court order The Partnership Acts provide for the following circumstances under which a partner can apply to court to dissolve a partnership:

• • • • • •

4.45

4.46

permanent insanity; permanent incapacity to perform partnership duties; prejudicial conduct of the partners which affects the firm’s business; wilful or persistent breach of partnership agreement; the business can only be carried on at a loss; and when it is just and equitable to dissolve the partnership.

The ‘just and equitable’ ground confers broad judicial discretion in deciding when to dissolve the partnership.50 It has been applied, for example, where there has been

[page 133]

complete deadlock in management due to breakdown in personal relationships between the two persons in charge of the business, as illustrated in Re Yenidjie Tobacco Company Ltd [1916] 2 Ch D 426. That case concerned two persons who were the only directors and shareholders in the business. There was such a state of antagonism between the parties that they refused to communicate with each other. Although the business was profitable, the order was made by the court to wind up the company due to the deadlock in management. It was said, in that case, that if the two directors had been partners in a partnership, the winding up would have been just and equitable.

Consequences of dissolution Dissolution is the catalyst for winding up the affairs of the partnership or the creation of a new partnership to continue from the old one where, for example, a partner has become bankrupt, retired or died.

Notice It is important for partners to give public notice, in the Government Gazette (and newspapers as well in some jurisdictions), when the partnership is dissolved. Failure to publicise can result in the retiring or departing partner still being held liable for the firm’s debts, even though he or she is no longer an actual partner. The Partnership Acts51 provide

4.47

that outsiders are entitled to treat all apparent partners of the firm as still being partners until they have notice of the change. Liability, in such circumstances, arises from partnership by estoppel (that is, the person can be legally prevented from denying that he or she is a partner).

Ongoing fiduciary duties It is important to remember that, as part of the partners’ fiduciary duty, there is continuing accountability during the period of dissolution and events leading to the eventual winding up of the partnership where assets are sold and proceeds distributed.

Chan v Zacharia (1984) 154 CLR 178 High Court of Australia

The relationship between the partners was curtailed and altered by the dissolution of the partnership. It did not however cease. In particular … each doctor [partner], by reason of his position as a former partner, remained under fiduciary obligations in respect of the partnership property which was to be realised and applied in paying or discharging partnership debts and liabilities and the expenses of … the winding up …

Notwithstanding the dissolution of the partnership, ‘the good faith and honourable conduct due’ from each partner to the other persisted during for the purposes of winding up the affairs of the partnership and each partner remained under a fiduciary obligation to cooperate in and act consistently with the agreed procedure for the realisation, application and distribution of partnership property.

[page 134]

This means that partners are still accountable to each other for any benefit or opportunity obtained while the affairs of the firm are being wound up, as demonstrated earlier with reference to the decision in Chan v Zacharia at 4.33. Thus, the partner’s ordinary obligations not to mislead each other and to make full disclosure of relevant matters are applicable during the period of dissolution leading to winding up and the finalisation of the firm’s business: Trinkler v Beale (2009) 72 NSWLR 365; [2009] NSWCA 30.51

4.48

Profits made after dissolution? The Partnership Acts address delays in payment to a partner who has exited the partnership but the firm continues to trade using its capital or assets without, in the meantime, settling the financial accounts with the outgoing partner. In such circumstances, the outgoing partner may be entitled to a share of the resulting profits from the continuing trade or to a rate of interest fixed by the Act52 unless there is an agreement to the contrary:

… the outgoing partner … is entitled, at the option of the partner … to such share of the profits made since the dissolution as the Court may find to be attributable to the use of the partner’s share of the partnership assets, or to invest at the rate of six per centum per annum [in New South Wales, Tasmania and Western Australia with varying rates in other states] on the amount of the partner’s share of the partnership assets.

This provision recognises that winding up and discontinuance of a business may not immediately follow dissolution of a partnership. A continuing partner who carries on the business after dissolution on his or her own account, without the consent or authority of the outgoing partner, may be held liable to account to the outgoing partner. If so, the outgoing partners may elect to a share of the profits or, instead, claim interest. The latter option is likely to arise when the profits made are either negligible or non-existent (as in the situation where losses are incurred).

Manley v Sartor [1927] Ch 157 Chancery Division (UK)53

Facts: The death of a partner dissolved a partnership, but the surviving partners continued the partnership business on their own account for nearly two years thereafter. The question arose as to the entitlement of the personal representatives of the deceased partner to a share of the profits earned between the death of the partner and the winding up.

Decision: In holding that the partner’s estate was prima facie (eligible) to a share of the profits, Romer J held:

… where … the surviving partners, instead of realising the assets and distributing the proceeds amongst the partners … choose to carry on the business and make profits by virtue of the employment of any of the partnership assets, then, … such profits belong to all the persons interested in the partnership assets by means of which the profits have been earned in accordance with their rights and interests in those assets; that is to say, proportionately to their interests in those assets.

4.49

•

[page 135]

Romer J, however, drew a distinction between the profits earned from the use of the partnership assets and the profits earned purely and solely by reason of the exercise of skill and diligence by the surviving partner. In the case of the latter, those profits are earned by sources outside the partnership assets and, therefore, are not profits in which the outgoing partner could be entitled to share.

The decision in Pathirana v Pathirana [1967] 1 AC 233 illustrates the operation of this statutory provision under the Partnership Act. Two partners (X and Y) operated a petrol service station and had agreed to end their partnership. Before the date of termination, partner X negotiated a new agreement with the petrol supplier and continued to conduct the business as a sole trader. On the discovery of these events, partner Y successfully claimed a share of the profits on the basis that partner X utilised the capital contribution (asset) of partner Y and was, therefore, entitled to a share of the profits made since the dissolution. This case also illustrates the consequences of a partner being held to be accountable to the firm for private profits made without the consent of the co-partner, discussed above starting at 4.31.

Partners’ rights to partnership property? Where dissolution proceeds to a winding up, the Partnership Act54 addresses the partner’s rights regarding application of the partnership property by providing that:

… every partner is entitled, as against the other partners in the firm, and all persons claiming through them in respect of their interests as partners, to have the property of the partnership applied in payment of the debts and liabilities of the firm, and to have the surplus assets after such payment applied in payment of what may be due to the partners respectively after deducting what may be due from them as partners to the firm; and for that purpose any partner … may, on the termination of the partnership, apply to the court to wind up the business and affairs of the firm.

This statutory provision has the following practical effects:

It entitles the partner to apply to court to appoint a receiver (in practice, often an experienced accountant, to take control of the partnership and ensure fair treatment of, and distribution to, creditors) on the partnership’s non-compliance with this provision under the Act.

•

4.50

•

• •

It confers a lien (type of security) over the partnership property which can be exercised by a former partner through sale of that property in an attempt to ensure that partnership debts are met from partnership property. The aim of this section is to guarantee the proper administration of partnership property and to ensure that debts of the firm are paid first before the debts of the individual partners.

Final settlement of accounts? The final act, in dissolving a partnership which no longer trades, is to wind up the partnership and settle all of the accounts. The rules for distributing assets (otherwise known as the settling of accounts) among partners are determined according to the provisions of the partnership agreement. If there is no such agreement relating to the

[page 136]

final settlement of accounts, the Partnership Act55 provides for repayment according to the following priority:

creditors’ debts (this priority payment cannot be altered by agreement); partners’ advances (such as loans, which must be distinguished from capital contribution); partners’ capital; and remaining assets (considered to be profits and known as the ultimate residue, which is to be divided in the same proportion in which the profits are distributed).

The rules of distribution provided by the Act ensure that creditors who are owed money by the partnership will receive their payment first. As indicated above, this priority payment cannot be altered by the partnership agreement. If there is a shortfall in partnership funds available for making such payment, the partners will have to access funds from personal assets to meet this liability.

After the creditors have been paid, the partners then distribute whatever is left over — the distribution is done in proportion to which profits are to

4.51

4.52

be received (as opposed to distribution in the proportion of capital contributed). This distribution formula underscores the desirability of having a written partnership agreement which addresses such important matters and eliminates disputes on who is to get how much following the distribution of assets on a dissolution of the partnership.

Limited partnerships One of the biggest disadvantages of a partnership is the unlimited liability of the partners. To overcome this problem, the limited partnership was developed in England to provide for limited liability and has been adopted in most jurisdictions in Australia.56 Limited partnerships are used by professionals (for example, doctors, accountants, engineers, architects) or other commercial partnerships (for example, real estate agents or mining projects) or other small to medium businesses needing to raise funds in a relatively straightforward way.

Formalities Limited partnerships are formed on registration;57 for example, a limited partnership in New South Wales must register with the Registrar (Commissioner of Fair Trading) or in Victoria with Consumer Affairs — and they come into existence on the issue of a certificate of registration.58 Compliance obligations include the supply of the full names of each partner, their status (as general or limited partner), their capital contribution as a limited partner and the address of its registered office. To protect outsiders from risk, the legislation requires the words ‘limited partnership’59 or the abbreviation LP, in some states, to be included on all business documents of the firm and penalties are imposed for non- compliance. Limited partnerships must

[page 137]

maintain a registered office in New South Wales, which also displays the certificate of registration of the partnership.

The legislation in the different states enables the formation of a

4.53

4.54

• •

•

partnership with at least one general partner with unlimited liability60 (up to 20 general partners is permissible in New South Wales) and one or more limited partners whose liability is limited to the amount of capital they have paid (or promised to pay) to the partnership.

General partner and limited partner As seen above, a limited partnership consists of a general partner and one or more limited partners. The partner with the limited liability, however, is not permitted to take part in the management of the business of the partnership and has no power to contractually bind the firm.61 A limited partner, however, can inspect the partnership books.

In contrast with the restrictions on the limited partner, a general partner undertakes the management and conduct of the partnership operations but has unlimited liability for the debts of the partnership.

Advantages and disadvantages Limited liability partnerships offer the following advantages:

simple to form (when compared to companies); absence of a limit on the maximum number of limited partners in New South Wales, Queensland and Victoria; confers the benefit of limited liability on the limited partners without having to incorporate; limited partnerships can be used in most businesses needing to raise capital and where the additional formalities and complexities of a company registered under the Corporations Act 2001 (Cth) are not required; and limited partnerships are taxed in the same way as companies and at the same company rate of tax for income tax purposes. Partners therefore are not subject to tax unless distributions are made by the limited partnership to the partners.

Limited liability partnerships suffer from the following disadvantages:

limited liability partners cannot be involved in the general management of the partnership. If such partners become actively

•

4.55

involved in the affairs of the partnership (subject to narrow exceptions concerning the protection of the value of their investment), they lose their limited liability status and will become liable for all the debt of the partnership; and limited liability will be lost if there are defects in the registration process resulting in improper registration. The partners will be treated as general partners in such circumstances.

[page 138]

The Department of Commerce in Western Australia notes that only a handful of limited partnerships are registered each year, and there are perhaps 1100 or so that have been registered since the commencement of the legislation in Western Australia.

Venture capital limited partnership Venture capital limited partnerships (VCLP) are venture capital funds structured as partnerships that make equity investments in relatively high risk start-up and expanding Australian companies. Venture capital is an important source of funds for expanding businesses and restructuring businesses as well. Venture capital investments are therefore high risk as they are providing funding to entrepreneurial businesses at difficult stages of their development. For the purposes of risk minimisation and taxation benefits, many jurisdictions (such as New South Wales, South Australia and Victoria) have amended their Partnership Acts by creating the incorporated limited partnership as a structure for venture capital investment funds. In introducing this structure in 2004, the New South Wales Government anticipated that more than $1 billion will be invested in Australian growth companies.

An incorporated limited partnership must have at least one general partner but no more than 20, and at least one limited partner. The general partners are responsible for the management of the partnership, while limited partners are investors.

The Commonwealth is responsible for the registration and reporting

4.56

process of venture capital limited partnerships. The Venture Capital Act 2002 (Cth) and the Income Tax Assessment Act 1997 (Cth) have facilitated the creation of this type of tax-exempt venture capital investment vehicle.62 Registration of this type of investment vehicle entitles it to flow- through taxation treatment. This means that partners in these types of limited partnerships are taxed on their share of the income, profits, gains and losses of the partnership, according to the partner’s tax status. Further, eligible foreign investors have no tax liability (such as capital gains tax) on their investment gains.

As part of the eligibility requirements for these concessional tax benefits, the VCLP must have capital of at least $10 million for investment in Australian businesses with total assets of not more than $250 million and be registered as a limited partnership. Furthermore, registration by Innovation Australia (the Board) is required under the Venture Capital Act 2002 (Cth) to be recognised as a VCLP.

Associations Introduction

The law not only provides structures for profit-making activities, such as companies, but also accommodates structures that have some social or welfare ends as their objectives. Non-profit associations are an important and integral part of our

[page 139]

community fabric. It is common for a group of people to get together to form an association for purposes unconnected with profit making. For example, the group may wish to pursue charitable, religious, educational or sporting interests with like-minded people. In setting up the association, the committee members may choose for the association to remain unincorporated or may choose to form an incorporated association. This chapter discusses the advantages and disadvantage of both options.

4.57

4.58

1. 2.

Unincorporated associations

Establishment There are little formalities required in forming an unincorporated association. Generally, there is no fixed set of rules that need to be followed.

Governing law Neither is there specific legislation that deals with unincorporated associations. The general law will apply to the parties managing the association. However, depending on the social objectives of the association, specific compliance obligations can arise. For example, associations raising funds from the public by seeking donations may need to be registered under various state Acts applicable to charities.63

An unincorporated association will usually have written rules (or a constitution) to deal with membership, management, objects and purposes of the association, and there will be stated procedures to be followed for the alteration of the written rules or constitution.

Management powers and duties are exercised by a committee.

Usually the court will not consider that the rules of the association have any legal effect and will not be willing to interfere in the management of an association unless one of these two situations arises:

The rules are dealing with proprietary rights of members. There is a clear indication that the rules are legally binding.

The High Court has stated that there are no legal obligations arising from these rules, unless the rules make it clear that they are to have contractual effect.

Cameron v Hogan (1934) 51 CLR 358 High Court of Australia

Facts: Hogan (a former Premier of Victoria) was expelled from the Australian Labor Party (ALP), in circumstances that he asserted were in breach of party rules. Hogan sought a court order invalidating his expulsion from the Party, which at the time was an unincorporated association. Hogan also sought compensation for his expulsion.

Issue: The key issue concerned whether members of an unincorporated association could seek court orders to enforce compliance with the internal management rules.

[page 140]

Decision: The court decided that the membership rules of an unincorporated association could only be enforced if the nature and purpose of those rules had been to form a legally enforceable contract between the members. In this case, the ALP rules did not have contractual force and therefore Hogan could not seek court assistance in enforcing them because he had no proprietary interest that the court could protect. The court did, however, state that where the rules conferred rights or benefits on the members, such as the right to use the association’s facilities, and a member had been denied those benefits in breach of the rules, a member could seek a court remedy to regain access to those benefits. It must be remembered that Hogan was seeking compensation for breach of the rules. As the majority of the High Court said (at 374):

… [as] such associations are established upon a consensual basis but, unless there were some clear positive indication that the members contemplated the creation of legal relations inter se, the rules adopted for their governance would not be treated as amounting to an enforceable contract.

Other cases have criticised the Cameron decision and have attempted to distinguish that case.

McKinnon v Grogan [1974] 1 NSWLR 295 New South Wales Supreme Court

Facts: North Sydney Rugby League Football Club (the club), an unincorporated association, was formed for the purpose of promoting and managing rugby league football within the North Sydney District. A dispute arose in relation to the validity to the Annual General Meeting (AGM) of the association.

Decision: The court stressed that the Cameron case was 40 years old and was frequently distinguished or ignored as it was ‘out of tune with the needs of the time’. The court noted that the public expects it to solve disputes concerning sporting, social and political associations in the same way it deals with commercial enterprises. It concluded that the members of the club, when they joined the association, intended to be bound by its rules. Since the proceedings before the court involved an issue that went to the heart of the affairs of the club (the AGM was dealing with election of members of the committee), the court decided that it was an issue of public importance because it was dealing with a ‘civil rights of a proprietary nature’. Accordingly the court intervened in the management.

4.59

Liability Liability under contract?

An unincorporated association is not a separate legal entity, and therefore it has no capacity to enter into a legally binding contract. The consequence is that the committee members run the risk of unlimited personal liability for any contracts entered into in the name of the association.

Bradley Egg Farm Ltd v Clifford [1943] 2 All ER 378 Court of Appeal (UK)

Facts: Bradley Egg Farm Ltd had its poultry tested by an employee of an unincorporated association, Lancashire Utility Poultry Society, to check if the birds were infected by any disease. This association was formed for the purpose of providing various technical

[page 141]

services to its members. The test conducted by the employee was negligent and, as a result, the birds either died or had to be killed. Bradley Egg Farm Ltd attempted to sue the members of the committee for breach of contract. The committee members argued that they were not liable.

Decision: The committee members were found to be personally liable in damages for breach of contract. The Court of Appeal also noted the committee may be indemnified from the association’s funds (also called common fund).

However, the situation will become more complicated where there are medium-and long-term contracts. The question that might arise is if there is a change in committee members of the association, which of the committee members (past or present) will be liable on the contract?

Freeman v McManus [1958] VR 15 Victorian Supreme Court

The fact that the members of a society have entrusted its affairs and management to a committee does not give the committee authority to make contracts binding on the members especially in a case where the members have no interest in the society funds.

This decision was confirmed in Carlton Cricket and Football Social Club v Joseph.

Carlton Cricket and Football Social Club v Joseph [1970] VR 487 Victorian Supreme Court

Facts: A 21-year lease was entered into on 21 February 1967 between Carlton Cricket and Football Social Club (Carlton), a company limited by guarantee, and Fitzroy Football Club (Fitzroy), an unincorporated association. Carlton alleged that Fitzroy was in breach of the contract. The following question arose: Was there a contract between Carlton and Fitzroy?

Decision: The court decided that Fitzroy, being an unincorporated association, could not enter into the long-term lease. Accordingly, there was no contract in this instance.

It is important to note that members of an unincorporated association are not liable for any contracts entered into on their behalf. They do not have to compensate the committee for any payment made by the committee.

Freeman v McManus [1958] VR 15 Victorian Supreme Court

The members of the committee could not be regarded in the circumstances [long-term contracts] … as authorizing the undertaking of obligations of the kind dealt with in the document in such a way as to make themselves personally liable for the performance of those obligations over the years.

[page 142]

Bradley Egg Farm Ltd v Clifford [1943] 2 All ER 378 Court of Appeal (UK) … that does not mean that they [the members of the association] thereby give the Committee authority

4.60

4.61

to make contracts binding on them. Otherwise a person who pays a subscription … to his society might find himself involved in liabilities of an unknown amount.

Liability under tort The approach taken in relation to tortious liability of unincorporated associations is similar to the approach taken with contracts. The members of the committee will be personally liable in respect to tortious claims.

Smith v Yarnold [1969] 2 NSWR 410 New South Wales Court of Appeal

Facts: Smith, a spectator at a greyhound race, was injured when the grandstand collapsed. The race was organised by the Taree Greyhound Racing Club, an unincorporated association. Smith sued Yarnold, a committee member. The legal action was under both tort (occupiers’ liability) and contract (purchase of ticket).

Issue: Were Yarnold and the other committee members liable? Decision: The court held that the committee was liable as occupiers of the premises.

Note that the members of the association are not liable for the tort liability of the association. The committee cannot ask them for any reimbursement.

Smith v Yarnold [1969] 2 NSWR 410 New South Wales Court of Appeal As regards liability to a stranger, … members of a committee will be liable personally, to the exclusion of the other members …

Member liability As noted earlier, members of an unincorporated association are not liable

4.62

4.63

for contract or tort liability of the association. As far as the members are concerned, their liability is usually limited to the amount of their subscription or entrance fee (unless the association’s rules say otherwise).

Wise v Perpetual Trustee Co Ltd [1903] AC 13 Privy Council (UK)

Associations [are clubs] of a peculiar nature. They are societies, the members of which are perpetually changing. They are not partnerships; they are not associations for gain; and the feature which distinguishes them from other societies is that no member as such becomes liable to pay to the funds of the society, or to anyone else, any money beyond the subscriptions required by the rules of the club to be paid so long as he remains a member. It is upon this fundamental condition, not usually expressed but understood by everyone, that clubs are formed; and this distinguishing feature has been often judicially recognised.

[page 143]

Gift to unincorporated associations Gifts to an association cannot be made to the name of the unincorporated association because the unincorporated association does not legally exist. As it is not a separate legal entity, for the gift or donation to be valid, a trust must be created, whereby the beneficiaries are the present and future members of the unincorporated association.

Rights of members on dissolution The members of an unincorporated association are entitled to share the surplus on dissolution of the unincorporated association.

Re Sick and Funeral Society of St John’s Sunday School; Golcar Dyson v Davies [1972] 2 All ER 439 Chancery Division (UK)

4.64

•

4.65

Facts: An unincorporated association was created in 1866 to provide sickness and death benefits to the teachers and students at a Sunday school. In 1966, the members decided on the dissolution of the association because it did not serve any useful purpose anymore. No members’ contributions were accepted after 31 December 1966. The assets of the association were around £4000 at the time of the dissolution. Four members of the association who stopped paying contributions since 1963 tried to pay arrears in the hope that they will be able to participate in the distribution of the surplus assets.

Issue: Could the members in arrears claim entitlement to share in the surplus assets of the association?

Decision: The court held that the members who had paid contributions up to the time of dissolution were entitled to the distribution of the surplus of the assets of the association. However, the four members who had discontinued paying contributions did not have an entitlement.

Summary It is true that unincorporated associations are very easy to establish but it has several key disadvantages such as:

The unincorporated association is not an entity recognised by the law (therefore it lacks perpetual succession and the ability to sue or contract in its own name). There are problems and uncertainties with entering into long-term contracts. The validity of such contracts is questionable. The committee members are liable for the debts of the association.

Incorporated associations To solve the problems that might arise from unincorporated associations, in particular the risk of personal liability, states and territories introduced the

[page 144]

Associations Incorporation Act64 allowing associations to incorporate and to enjoy all the benefits arising from being recognised as a separate legal entity. Once incorporated, an association has all the powers of an individual and is legally able to do things in its own name, such as own land, sign a lease, sue or be sued and to continue to exist regardless of changes in membership.

4.66

Compared to the option of incorporating as a company limited by guarantee under the Corporations Act, the Associations Incorporations Act provides a simple and inexpensive means for a charitable or a not- for-profit club or society to become a legal entity. The Associations Incorporations Act imposes less onerous regulatory conditions compared with obligations on public companies under the Corporations Act. Associations incorporated under state laws are not administered by ASIC, but by the various state authorities (for example, by the New South Wales Office of Fair Trading in New South Wales and Consumer Affairs in Victoria).

However, unlike the limited jurisdiction of the state-based Associations Incorporation Acts which are confined in their application to state boundaries, the Corporations Act offers the advantage of applying throughout Australia. As a result, companies incorporated under the Corporations Act need only incorporate once (compared to six times under the legislation of each state if the nonprofit organisation were to operate nationally). Such factors are relevant to consider when advising under which legislation (state or Commonwealth) incorporation would be most appropriate for small, community-based groups. There are more than 36,000 registered incorporated associations in New South Wales as of 30 June 2015.

Associations typically fall into the categories of charities, sport, recreation, education or community service clubs.

Establishment Incorporation under the Associations Incorporation Act is voluntary. An incorporated association must apply to the relevant statutory body to be registered and a registration fee is levied.65 This is preceded by an application to reserve a name, together with a prescribed fee. The registration application is accompanied with a copy of the association’s rules (sometimes referred to as the constitution) dealing with its internal governance. These documents are generally available to members of the public on request and on payment of a prescribed fee. On the issue of a certification of incorporation, the association becomes a beneficiary of the separate entity rule. The assets of an unincorporated association will

• •

• • • • •

•

4.67

usually be transferred to the incorporated association on registration. Since the incorporated association is a separate legal entity, it has all the powers of an individual that were identified above.

Despite the differences in legislation in each state or territory, basically an incorporated association may need to do the following:

[page 145]

form a management committee; appoint a public officer (responsible for lodging documents and who is the primary contact); have a registered office; act in accordance with its objects and rules or constitution (model rules or a model constitution can be adopted); hold an annual general meeting; keep minutes of all committee and general meetings; keep a register of members; lodge an annual statement; keep proper accounting records and, in some states, lodge audited financial statements; have a common seal (no longer compulsory in New South Wales due to reforms in 2009 which come into effect on 1 July 2010); and have public liability insurance (no longer compulsory in New South Wales).

Governing law Incorporated associations are governed by the statute laws of the states and territories: Associations Incorporation Acts.66 The legislation lacks uniformity in content. For example, in the Australian Capital Territory, New South Wales and Victoria an association that applies for incorporation is required to have a minimum of five members. In Western Australia, it must have six members and in Queensland, a minimum of seven members. Some jurisdictions require annual accounts to be audited, whereas others (for example, Western Australia) do not impose this obligation.

4.68

4.69

4.70

Associations formed with the purpose of trading or securing pecuniary profit to the members from the transactions of the association are not eligible for incorporation. This does not mean that associations cannot profit from its operations; but it does mean that any profits are to be used to further the objects of the association. Basically, associations are prevented from providing personal gain to the members.

Similarity and differences with companies Both companies and incorporated associations are separate legal entities. However, an incorporated association cannot generate profits for its members and distribute them. This restriction does not apply to companies which may choose to distribute their profits as dividends. The legal treatment of dividends is discussed further in Chapter 20. Other differences between incorporation under state-based legislation (Associations Incorporations Act) and Commonwealth legislation (Corporations Act) were discussed above.

[page 146]

Control A management committee, whose powers and duties are specified in the association’s rules, generally manages an incorporated association. The committee members are accountable. They owe a fiduciary duty to the association and have a duty to act in the best interests of the members.

Liability An incorporated association is a separate legal entity, separate from the individual members. The committee and the members of an incorporated association are not liable to contribute towards the payment of the debts and liabilities of the incorporated association, or the costs, charges and expenses of the winding up of the association in excess of their agreed association membership cost. However, members or officers are not protected from liability for their own negligence or other illegal acts committed by them.

4.71

4.72

4.73

• • • •

• •

Termination An incorporated association has perpetual succession. However, there are a number of ways in which an incorporated association can be brought to an end. These include a decision by members to voluntarily wind up the association so long as it is solvent, or members can apply to court to have the association wound up in certain circumstances.

Taxation As long as the association’s objects are not focused on profit for members, and any residue on winding up of the association is prohibited from being returned to the members of the association (therefore the residue is to be passed to a like-minded association or charity), then the association will normally be considered to be a non-profit association that will be tax exempt and will not be required to pay income tax on its earnings. However, note the case of Re Sick and Funeral Society of St John’s Sunday School; Golcar Dyson v Davies, referred to above, where a distribution of residual assets was being considered.

Advantages and disadvantages of incorporation The major advantages to be gained from incorporation of an association are:

can sue and be sued in its own name; can enter into contracts and acquire, hold and dispose of property; can operate a bank account in its own name and can borrow money; members or officers are protected and are not generally liable to contribute towards the payment of the association’s debts or liabilities; can accept gifts or bequests; and has perpetual succession.

[page 147]

Some of the key disadvantages of incorporation an association are:

•

• •

4.74

•

expenses associated with incorporation and meeting ongoing statutory obligations (such as maintaining proper financial and membership records and registers and reporting obligations); restrictions on the ability to carry on business or trade; and less flexibility in the conduct of the association compared with unincorporated associations.

Law reform (New South Wales and Victoria) The Associations Incorporation Act 2009 (NSW) came into effect on 1 July 2010 (replacing the earlier legislation passed in 1984) and was amended in 2016. Most of the changes are designed to modernise the law, reduce red tape, allow more flexibility for associations, provide for corporate governance and offer stronger protection of association finances. The following is an overview of the changes introduced under the current Act in New South Wales:

the inclusion of an objects section in the Act to reinforce the idea that the legislation provides for the registration of associations formed for the purpose of engaging in small-scale, non-profit and non- commercial activities; an association’s ‘rules’ have been replaced with a ‘constitution’ and a model constitution (which is not compulsory to adopt) is set out in the Regulation; there is more flexibility for the conduct of meetings (for example, through the use of postal ballot and technology); common seal is no longer be required to execute documents (this brings execution of documents in line with the Corporations Act 2001 (Cth) which is discussed further in Chapter 7 at 7.17) — instead, documents can be signed by two authorised signatories; no need to hold an annual general meeting (AGM) every calendar year (although the association must still hold an AGM within six months of the end of the financial year); there is a two-tiered financial reporting system according to income and assets (only larger ‘tier 1’ associations are required to have their annual accounts audited and lodged with New South Wales Fair Trading, unless exempted); there are new provisions dealing with statutory duties of committee members and obligations of office bearers (such as the need to

•

4.75

•

• • • • •

disclose conflicts of interest and to refrain from voting on any matters relating to a conflict of interest); at least three committee members must reside in Australia and the public officer must be a resident of New South Wales; and introduction of a penalty notice system whereby certain offences are dealt with by a ‘penalty notice’ which is a type of fine, instead of having the matter dealt with in court.

The Associations Incorporation Act 2009 (NSW) was amended in April 2016 and September 2016 following a statutory review of the Act undertaken in 2015. Based on community feedback, the amendments targeted provisions that were unclear or impractical. The amendments are located in the Associations Incorporation Regulation 2016 (commenced 1 September 2016) and introduced changes to improve the policy objectives of the Act, for example, to allow for electronic voting when association members are voting remotely, provided this is permitted by the association’s constitution.

[page 148]

Victoria The Victorian Government overhauled and amended the Associations Incorporation Act 1981 (Vic) in two stages during 2009 and 2010, and has passed the Associations Incorporation Reform Act 2012 (Vic) (and its associated regulations) which came into effect on 26 November 2012. The following are the main features of the law reform:

the removal of the prohibition on trading provided that it relates to the association’s purpose. However, the prohibition against distribution of any surplus income or assets to its members remains; enhanced governance arrangements; revised annual reporting requirements and audit thresholds; improved grievance and dispute resolution procedures; facilitated use of technology at committee meetings; replacing all references to ‘Public Officer’ in the Act with ‘Secretary’ who is required to submit all documents and notifications to Consumer Affairs Victoria;

• •

•

defining the term ‘Office Holder’ and clarifying his or her duties; and including, as modified, a range of insolvency provisions of the Corporations Act 2001 (Cth).

The Associations Incorporation Reform Act 2012 (Vic) has codified the duties of office holders of incorporated associations who must:

exercise powers and duties in good faith and for a proper purpose;67 exercise powers and discharge duties with reasonable care and diligence (and can rely on the business judgment rule as a defence to claims that he or she has failed to meet the required standard of care and diligence);68 not make improper use of information or position;69 and not allow the organisation to trade while it is insolvent.70

Significantly, the Victorian reforms rely heavily on the directors’ duties and civil penalty provisions of the Corporations Act 2001 (Cth), discussed in Chapters 15-19, which are applicable to office holders (defined as a member, secretary or employee who makes or participates in decision- making that affect the operations of the incorporated association) who have breached legal duties owed to the incorporated association. Such officer holders may be liable to a pecuniary penalty of up to $20,000.

Western Australia has also taken steps to modify its laws, largely along the lines of New South Wales and Victoria, and passed the Associations Incorporation Act 2015 (commencing on 1 July 2016).

Clubs and associations do not have to be incorporated, but there are some benefits to choosing this option. Why might a sporting club or association want to be incorporated?

2. 3. 4.

9. 10.

11.

[page 149]

Revision Questions

How are partnerships created? How are they defined under the Partnership Act and what is the maximum size of a commercial partnership? What is the legal definition of a partnership? Explain the concept of conducting a business ‘in common’. Explain the relevance of profit sharing in determining the existence of a partnership. Explain the concept of joint and several liability and identify instances when such liability arises under partnership law. When will a firm be bound in contract by the actions of the partners? Explain the concept of fiduciary duty, and its scope or duration, as applied to partnership law. What effect does the death, bankruptcy or retirement of a partner have on the partnership? Identify the various grounds for dissolving a partnership. Offer at least four reasons for incorporating a non-profit association. What are the essential pre-requisites for incorporation under the Associations Incorporation Act?

Problem Question Rose, Mary, Violet and Sonny are the best of mates. Rose and Mary run the Busy Bee Florist Shop in partnership with each other. Due to a long drought and unseasonal weather, the business bank account is overdrawn and the Friendly Bank is refusing to honour any more

• • • •

cheques. Rose approaches Violet for a loan in return for a share in the business. Violet agrees to lend the partnership $20,000 in exchange for the drawing up of a loan agreement which was to document, among other things, the following terms:

The lender will receive a share of the profits and losses to the extent of 20%. The lender has a right to examine the partnership books at will. The lender has a right to receive a quarterly business statement. The money advanced is a loan and the lender is not to be regarded as a partner of the business.

Rose executes the loan document, as requested, prior to Violet advancing the money. Both parties signed the loan document. Meanwhile Mary approaches Sonny, who is also their employee, for a loan.

Sonny agrees to lend $10,000 to Mary but he requires some interest on the loan. A deal is struck which results in Sonny receiving his salary plus a one-eighth share of the net profit (or a oneeighth share of the firm’s losses) in consideration for making a loan to the firm.

Rose and Mary inform the Friendly Bank that Violet and Sonny are now partners in the Busy Bee Florist Shop. Business continues to decline and Rose and Mary secretly decide to take an extended holiday in the Congo Basin.

Both Violet and Sonny were unaware of the large debt owing to Friendly Bank and believed the purpose of their loans was to expand the business of the Busy Bee Florist Shop. Friendly Bank seeks to recover debts owing by the Busy Bee Florist Shop from Rose and Mary.

Advise Violet and Sonny of their potential liability to the Friendly Bank in relation to the Busy Bee Florist Shop.

[page 150]

Guidelines for Answering Problem Questions

When answering a problem question concerning legal issues relating to partnerships, we suggest that the following method may be helpful:

Consider and apply the statutory definition of a partnership to ascertain the status of the parties. This exercise, of necessity, also involves working with the rules in the Partnership Act offering guidance on this issue. As part of the exercise in the point above, consider and apply each of the definitional elements of a partnership: ‘business’; acting ‘in common’ and ‘profit’ motive. The focal point, generally, will be on establishing the requirement of acting ‘in common’.

It is important to remember that the fact that the parties may share profits is not conclusive of a partnership. Consider the rules and precedents on profit sharing. Read the facts carefully to see if it raises issues concerning the creation of a partnership through informal means, such as implied conduct or the concept of partnership by estoppel. On the establishment of a partnership, consider the liability rules for partnerships (contract, tort and crime as appropriate to the question) and the nature of each partner’s liability ( joint and several or otherwise). Read the facts carefully to ascertain if the partners have breached duties owed to each other, such as fiduciary duties, and the consequences of these. Examine the facts to see if the grounds for dissolution are relevant and, if so, the consequences of dissolution with particular attention to the settlement of accounts. Particular attention must be paid to the given facts to aid your conclusion. It is always important to structure an answer in response to the given facts.

Wang and Erin decide to investigate the business idea further. Erin suggests that Wang undertake preliminary investigations to determine what equipment will be needed and that he start to work on a draft business plan.

Wang likes the location of the building owned by Erin’s trustee and without talking to Erin (who is overseas on holiday in Africa and can’t be reached for two weeks) Wang signs up for a three-year lease in his own name. Wang said nothing to the landlord about any other business partners and does not mention Erin. Wang also enters into leasing arrangements for plant and equipment and furniture for the café as well as ordering 200 kilos of premium coffee beans imported directly from Venezuela under the name of ‘The Sydney Café’, which is what he has discussed calling the business with Erin. Wang also enrolls in a ‘master barista’ course that costs $3,000. Wang has not told Erin about any of this.

When Erin returns, she and Wang agree that they will be partners in this new business with Wang running the café, including managing staff, ordering stock and seeing to the day-to- day business affairs. Erin would like to remain a silent partner at the moment but will contribute 60% of the initial capital needed with Wang contributing the other 40%.

Erin is shocked when Wang sends her an invoice for 60% of the costs he has incurred in establishing their new business. Erin is outraged, and complains that she never asked Wang to spend any money or enter into any contracts on her behalf.

What are Erin’s legal rights in this situation?

[page 151]

Further Reading

Academic Journals K Fletcher, ‘Continuing Liability of a Retired Partner’ (1996) 70 Australian

Law Journal 294. K Fletcher, ‘Partnership: Breach of Fiduciary Duties and Remedies’

(2007) 81 Australian Law Journal 3. R McQueen, ‘Life without Salomon’ (1999) 27 Federal Law Review 181. E Peden and J Carter, ‘The Bonds of Partnership’ (2000) 16 Journal of

Contract Law 275. M Twomey, ‘Protection for Partners from Unlimited Liability in Certain

Circumstances?’ (2003) 24 The Company Lawyer 86.

Practitioner Journals N Oakes, ‘The New Face of Salaried Partnership’ (2003) 41(3) Law

Society Journal 49. J Silveri, ‘Restructuring Partnership’ (2001) 75(11) Law Institute Journal

16. A Veljanovski, ‘Limiting Liability: The Third Way’ (2005) 79(1-2) Law

Institute Journal 46.

Practitioner Works K Fletcher, The Law of Partnership in Australia, 9th ed, Lawbook Co,

Australia, 2007.

2. 3. 4. 5.

6. 7.

8. 9. 10.

11. 12.

13.

14. 15. 16.

17. 18.

19.

20.

21. 22.

23.

24.

25.

You will find useful study resources, including quizzes for each chapter, when you go to <http://learning.lexisnexis.com.au>. The quiz is a great tool to help you self-test your knowledge.

Partnership Act 1892 (NSW); Partnership Act 1891 (Qld); Partnership Act 1891 (SA); Partnership Act 1891 (Tas); Partnership Act 1958 (Vic); Partnership Act 1895 (WA). These Acts are largely based on English legislation, the Partnership Act 1890 (UK), and have been amended over the years. Partnership Act 1963 (ACT); Partnership Act 1997 (NT). Income Tax Assessment Act 1936 (Cth); Income Tax Assessment Act 1997 (Cth). ACT s 5; NSW s 46; NT s 4; Qld s 48; SA s 1C(1); Tas s 5; Vic s 4; WA s 6. For illustration of the difficulties arising from establishing the terms of an alleged partnership agreement, see Hocking v Lambiris aka Wilkie [2009] NSWSC 382; AM Marketing Pty Ltd v Howard Media Pty Ltd [2010] NSWSC 803. ACT s 23; NSW s 19; NT s 23; Qld s 22; SA s 19; Tas s 24; Vic s 23; WA s 29. For illustration of the difficulties arising from an allegation that an oral partnership agreement existed, see Howard Media v AM Marketing [2010] NSWSC 803; Lawrence v Gunner; Gunner v Lawrence [2015] NSWSC 944. ACT s 18; NSW s 14; NT s 18; Qld s 17; SA s 14; Tas s 19; Vic s 18; WA s 21. ACT s 6; NSW s 1; NT s 5; Qld s 5; SA s 1; Tas s 6; Vic s 5; WA s 7. A valid agreement between the parties is required by the word ‘relation’. The agreement does not have to take the form of a written contract, as discussed earlier, and can be implied from all of the circumstances. Goudberg v Herniman Associates Pty Ltd [2007] VSCA 12. ACT (Dictionary); NSW s 1B(1); NT s 3; Qld s 3 (Dictionary); SA s 1B(1); Tas s 4; Vic s 3(1); WA s 3. For example, see Keith Spicer Ltd v Mansell [1970] 1 All ER 462; Pioneer Concrete Services Ltd v Galli [1985] VR 675. For application of these authorities, see Allison v Tuna Tasmania Pty Ltd [2015] TASSC 31. See this case for a fuller discussion on the ‘acting in common’ requirement. ACT ss 9-10; NSW ss 5-6; NT ss 9-10; Qld s 9; SA ss 5-6; Tas s 10-11; Vic ss 9-10; WA s 13. For discussion on the indicia of partnership, see Walters v Scarborough [2011] NSWSC 1380; Marzec v Lysiak [2015] NSWSC 647. ACT s 7; NSW s 2; NT s 6; Qld s 6; SA s 2; Tas s 7; Vic s 6; WA s 8. ACT s 7(2); NSW s 2(1); NT s 6(1)(a); Qld s 6(1)(a); SA s 2(1)(a); Tas s 7(a); Vic s 6(1); WA s 8(1). ACT s 7(3); NSW s 2 (1)(2); NT s 6(1)(b); Qld s 6(1)(b); SA s 2(1)(b); Tas s 7(b); Vic s 6(2); WA s 8(2). ACT s 7(4); NSW s 2(1)(3); NT s 6(1)(c); Qld s 6(1)(c); SA s 2(1)(c); Tas s 7(c); Vic s 6(3); WA s 8(3); Walker v Hirsch (1884) 27 Ch D 460. ACT s 7(4)(a); NSW s 2(1)(3)(a); NT s 6(1)(c)(i); Qld s 6(1)(c)(i); SA s 2(1)(c)(i); Tas s 7(c)(i); Vic s 6(3)(a); WA s 8(3)(a). ACT s 7(4)(b); NSW s 2(1)(3)(b); NT s 6(1)(c)(ii); Qld s 6(1)(c)(ii); SA s 2(1)(c)(ii); Tas s 7(c)(ii); Vic s 6(3)(b); WA s 8(3)(b). ACT s 7(4)(c); NSW s 2(1)(3)(c); NT s 6(1)(c)(iii); Qld s 6(1)(c)(iii); SA s 2(1)(c)(iii); Tas s 7(c)(iii); Vic s 6(3)(c); WA s 8(3)(c). ACT s 7(4)(d); NSW s 2(1)(3)(d); NT s 6(1)(c)(iv); Qld s 6(1)(c)(iv); SA s 2(1)(c)(iv);

http://www.ausindustry.gov.au

26.

27. 28. 29. 30.

31.

32. 33.

34. 35. 36. 37.

38. 39.

40.

41.

42.

43. 44.

45.

46.

47. 48. 49. 50.

51. 52.

53.

54. 55. 56.

57. 58. 59. 60.

Tas s 7(c)(iv); Vic s 6(3)(d); WA s 8(3)(d). ACT s 7(4)(e); NSW s 2(1)(3)(e); NT s 6(1)(c)(v); Qld 6(1)(c)(v); SA s 2(1)(c)(v); Tas s 7(c)(v); Vic s 6(3)(e); WA s 8(3)(e). Belgravia Nominees Pty Ltd v Lowe Pty Ltd [2015] WASCA 143. ACT s 9(1); NSW s 5(1); NT s 9; Qld s 8(1); SA s 5(1); Tas s 10; Vic s 9; WA s 26. ACT s 11(1); NSW s 7(1); NT s 11(1); Qld s 10(1); SA s 7(1); Tas s 12; WA s 14; Vic s 11. ACT s 13(1), (2); NSW s 9(1); NT s 13(1), (3); Qld s 12(1); SA s 9(1); Tas s 14; Vic s 13; WA s 16. ACT s 14(1), (2); NSW s 10(1); NT s 14(1); Qld s 13(1); SA s 10(1); Tas s 15; Vic s 14(1); WA s 17. ACT s 16(1); NSW s 12(1); NT s 16(1); Qld s 15(1); SA s 12(1); Tas s 17; Vic s 16; WA s 19. ACT s 14(1), (2); NSW s 10(1); NT s 14(1); Qld s 13(1); SA s 10(1); Tas s 15; Vic s 14(1); WA s 17. ACT s 16(1); NSW s 12(1); NT s 16(1); Qld s 15(1); SA s 12(1); Tas s 17; Vic s 16; WA s 19. ACT s 15(1); NSW s 11(1); NT s 15(1); Qld s 14(1); SA s 11(1); Tas s 16; Vic s 15; WA s 18. ACT s 17; NSW s 13; NT s 17; Qld s 16; SA s 13; Tas s 18; Vic s 17; WA s 20. ACT ss 33-35; NSW ss 28-30; NT ss 32-34; Qld ss 31-33; SA ss 28-30; Tas ss 33-35; Vic ss 32-34; WA ss 39-41. ACT s 34; NSW s 29; NT s 33; Qld s 32; SA s 29; Tas s 34; Vic s 33; WA s 40. ACT s 29(5); NSW s 24(1); NT s 28(1); Qld s 27(1)(e); SA s 24(1)(e); Tas s 29(e); Vic s 28(5); WA s 34(5). ACT s 29(6); NSW s 24(1)(6); NT s 28(1)(f); Qld s 27(1)(f); SA s 24(1)(f); Tas s 29(f); Vic s 28(6); WA s 34(5). ACT s 29(1); NSW s 24(1)(1); NT s 28(1)(a); Qld s 27(1)(a); SA s 24(1)(a); Tas s 29(a); Vic s 28(1); WA s 34(1). ACT s 29(2); NSW s 24(1)(2); NT s 28(1)(b); Qld s 27(1)(b); SA s 24(1)(b); Tas s 29(b); Vic s 28(2); WA s 34(2). ACT s 29; NSW s 24; NT s 28; Qld s 27; SA s 24; Tas s 29; Vic s 28; WA s 34. ACT s 24(1); NSW s 20(1); NT s 24(1); Qld s 23(1); SA s 20(1); Tas s 25(1); Vic s 24(1); WA s 30(1). ACT s 38(1); NSW s 33(1); NT s 37(1); Qld s 36(1); SA s 33(1); Tas s 38(1); Vic s 37(1); WA s 44(1). The general principles with respect to retirement of partners were explained in Hadlee v Commissioner of Inland Revenue [1989] 2 NZLR 477 and applied by the High Court in Commissioner of State Taxation v Cyril Henschke Pty Ltd [2010] HCA 43. ACT s 30; NSW s 25; NT s 29; Qld s 28; SA s 25; Tas s 30; Vic s 29; WA s 35(1). ACT s 39; NSW s 34; NT s 38; Qld s 37; SA s 34; Tas s 39; Vic s 38; WA s 45. ACT s 31; NSW s 27; NT s 31; Qld s 30; SA s 27; Tas s 32; Vic s 31; WA s 38. The ‘just and equitable’ ground for dissolution is also found under s 461(1)(k) of the Corporations Act and discussed further at Chapter 19. ACT s 41; NSW s 36; NT s 36; Qld s 39; SA s 36; Tas s 41; Vic s 40; WA s 47. ACT s 48(1); NSW s 42(1); NT s 46(1); Qld s 45(1); SA s 42(1); Tas s 47(1); Vic s 46; WA s 55(1). This key case was followed in Popat v Shonchatra [1997] 1 WLR 1367; Pathirana v Pathirana [1967] 1 AC 233; Gill v Sandhu [2006] Ch 456. ACT s 45; NSW s 39; NT s 43; Qld s 42; SA s 39; Tas s 44; Vic s 43; WA s 50. ACT s 50; NSW s 44; NT s 44; Qld s 47; SA s 44; Tas s 49; Vic s 48; WA s 57. Partnership Act 1892 (NSW) (amended in 1991); Partnership (Limited Liability) Act 1988 (Qld); Partnership Act 1891 (SA); Limited Partnership Act 1908 (Tas); Partnership Act 1958 (Vic) (amended in 1992); Limited Partnership Act 1909 (WA). NSW s 50A; Qld s 7; SA s 51; Tas s 5; Vic s 52; WA s 5. NSW s 58; Qld s 51(3); SA s 56; Tas s 13; Vic s 58; WA s 13. NSW s 75(2); Qld s 56(1); SA s 75(2); Vic s 75(2). NSW ss 51-52; Qld s 4(1); SA s 47; Tas s 4(2); Vic s 50; WA s 4(2).

61. 62.

63. 64.

65.

66.

67.

68.

69.

70.

NSW ss 67, 65; Qld ss 10, 11; SA ss 58, 59, 63; Tas s 4; Vic ss 67, 61, 65; WA s 6. Apart from VCLP, the Venture Capital Act 2002 (Cth) now establishes three other types of limited partnerships to be used as a structure for venture capital investment namely: Early Stage Venture Capital Limited Partnerships (ESVCLP); Australian Venture Capital Fund of Funds (AFOF); and the Venture Capital Management Partnership (VCMP). Discussion of each type of incorporated limited partnership is beyond the scope of this book. For further information, see Innovation Australia (the board) <http://www.ausindustry.gov.au/innovationaustralia>. An example is the Charitable Fundraising Act 1991 (NSW). Associations Incorporation Act 1991 (ACT); Associations Incorporation Act 2009 (NSW); Associations Act 2003 (NT); Associations Incorporation Act 1981 (Qld); Associations Incorporation Act 1985 (SA); Associations Incorporation Act 1964 (Tas); Associations Incorporation Reform Act 2012 (Vic); Associations Incorporation Act 2015 (WA). For example, the Commissioner of Fair Trading in New South Wales and in Western Australia has the responsibility to administer the Associations Incorporation Act 2009 (NSW) and Associations Incorporation Act 2015 (WA) respectively. Associations Incorporation Act 1991 (ACT); Associations Incorporation Act 2009 (NSW); Associations Act 2003 (NT); Associations Incorporation Act 1981 (Qld); Associations Incorporation Act 1985 (SA); Associations Incorporation Act 1964 (Tas); Associations Incorporation Reform Act 2012 (Vic); Associations Incorporation Act 2015 (WA). See Chapter 15 for discussion of these concepts in the context of directors’ and officers’ duties to companies. See Chapter 17 for discussion of these concepts in the context of directors’ and officers’ duties to companies. See Chapter 16 for discussion of these concepts in the context of directors’ and officers’ duties to companies. See Chapter 18 for discussion on the law relating to insolvent trading.

[page 153]

Incorporation and its Effects

CHAPTER 5 Company as a separate legal entity Legal consequences of the separate legal entity concept

Distinction between private and company debts Distinction between private and company assets Company contracting with its member (as employee and director) Company liable in tort to a member

Ignoring the corporate veil Common law

Sham Avoidance of legal obligation Fraud Assistance in breach of fiduciary duties

Corporate groups

[page 154]

Corporate groups and the veil Veil-piercing on agency grounds Problems posed by corporate groups Need for law reform Law reform for insolvent corporate groups

Statute law Statutory veil-piercing Section 588G (director’s personal liability for insolvent trading) Section 260A (financial assistance) Section 588FP (security interests in favour of company officer) Section 197 (directors’ liability as trustee) Corporate groups as single entities Section 588V (group liability for insolvent trading) Section 296 (consolidated group accounts)

[page 155]

Incorporation and its Effects

Learning Objectives After completing this chapter you should be able to:

Understand the nature of a company with reference to the basic rule of company law that a company is a separate legal entity.

Explain the legal consequences flowing from the separate legal entity rule.

Understand the concept of the corporate veil and the need to lift or pierce the corporate veil in certain circumstances.

Outline the circumstances when the law is prepared to lift or pierce the corporate veil through departure from the separate legal entity rule.

Identify veil-piercing circumstances, both at common law and under statute law, with particular reference to the Corporations Act 2001 (Cth).

Explain the legal treatment of companies within the same group (corporate groups) and circumstances when the law is prepared to pierce the veil, both at common law and under the Corporations Act.

Key Cases

Adams v Cape Industries Plc [1990] Ch 433

Andar Transport Pty Ltd v Brambles Ltd (2004) 206 ALR 387; [2004] HCA 28

Gilford Motor Co Ltd v Horne [1933] 1 Ch 935

Green & Clara Pty Ltd v Bestobell Industries Pty Ltd [1982] WAR 1

Industrial Equity Ltd v Blackburn (1977) 137 CLR 567

Jones v Lipman [1962] 1 All ER 442

Lee v Lee’s Air Farming Ltd [1961] AC 12

Macaura v Northern Assurance Co Ltd [1925] AC 619

Re Darby; Ex parte Brougham [1911] 1KB 95

Salomon v Salomon & Co Ltd [1897] AC 22

Smith, Stone & Knight Ltd v Birmingham Corp [1939] 4 All ER 116

Walker v Wimborne (1976) 137 CLR 1

Key Sections

Corporations Act 2001 (Cth) ss 124, 197, 260A, 267, 588G, 588V

5.1

[page 156]

Introduction

corporate veil: a concept which describes the artificial screen that separates the company from its members. It is founded on the separate legal personality which the law gives to companies.

This chapter focuses on the legal characteristics of a company. On the incorporation of a company, it becomes a separate legal entity from its members and controllers. The separate legal entity rule is a longstanding principle of corporate law and was most famously recognised by the case of Salomon v Salomon & Co Ltd [1897] AC 22. This chapter will explain the fundamental concept of a company as a separate legal entity. In addition, the consequences of the separate legal entity doctrine, which creates a screen known as the ‘corporate veil’, will be illustrated. It should be noted that a strict application of this legal rule can lead to unsatisfactory results. Potential problems caused by a rigid application of the separate legal entity rule will be highlighted, and techniques devised by legislatures and the courts to overcome such problems will be explained. This chapter discusses the limited circumstances in which the law departs from the separate entity rule by looking into the company, and disregarding the corporate veil, to examine the purpose of its creation and the manner of its control. Other significant legal characteristics of a company are also examined.

Company as a separate legal entity

Modern company law in Australia, and in other countries such as China, India, Singapore, Malaysia, England, New Zealand, Canada and South Africa rests on the legacy of the foundational legal principle recognised in the leading case of Salomon v Salomon & Co Ltd [1897] AC 22. This case is authority for the legal principle that an incorporated company is a separate legal entity from its founder, shareholders and directors. It is a legal person with its own legal personality separate from that of its

shareholders or directors. Salomon’s case is as relevant today in Australia, and in many parts of the common law world, as it was in 1897, and thus deserves closer attention.

The following extracts examine the case and explain the various decisions culminating in the important and final decision of the House of Lords which enshrined the recognition of a company as a distinct legal person.

Salomon v Salomon & Co Ltd [1897] AC 22 Houses of Lords (UK)

debentures: these are documents that create or acknowledge debts owed by the company. See Chapter 10 for fuller discussion.

Facts: Mr Salomon was a sole trader who operated a boot manufacturing business for over 30 years. He had gradually built up a thriving business. He later sold the business, for nearly £39,000, to a limited company he formed, Salomon & Co Ltd. All the requirements of the Companies Act 1862 (UK) were observed. Mr Salomon held 20,001 shares, while his wife and five of his children each took up a single share in the company (total shares issued: 20,007). No shares were issued to the public as this was intended to be a private company.1 Mr Salomon was the managing director, with two of his sons

[page 157]

also appointed as directors. The purchase price paid by the company was more than the market value of the business (but this was insignificant to the case as the shareholders consented to the overvaluation). The purchase price was paid in this way: Mr Salomon received some cash, £10,000 in debentures (secured over the assets of the company)2 and the balance in fully paid shares. Mr Salomon therefore became a large secured creditor of the company, as well as a controlling major shareholder and managing director. debentures:

Shortly after, as a result of a downturn and strikes in the boot industry, the company went into liquidation. The company’s assets were insufficient to pay both the debenture holder (secured creditor with priority claim) and the ordinary unsecured creditors in full. In meeting the priority claims of the debenture holder, the unsecured creditors were left out in the cold.

indemnify: this refers to money payable to compensate another person for liability or loss incurred by the latter.

The liquidator, on behalf of the unsecured creditors, objected to the payment of the secured debt on

•

the basis the company was acting either as agent or trustee for Mr Salomon. Consequently, the liquidator argued that Mr Salomon should indemnify the company for its debts. Earlier decisions: At trial, Vaughan William J held for the liquidator (acting on behalf of the unsecured creditors) for the following reasons:

The company was held to have conducted the business not in its own right but as agent for Mr Salomon. It was held that the business was Mr Salomon’s business. This finding was influenced by the high degree of control which Mr Salomon exercised over the company’s affairs. Consequently Mr Salomon, as the principal, had a legal duty under the law of agency to indemnify his agent, Salomon & Co Ltd, against business liabilities.

The Court of Appeal also held for the liquidator but rejected the agency relationship grounds as the reason. In their view, the sale and transfer of the business precluded an agency relationship. However, the Court of Appeal also focused on the high degree of control which Mr Salomon exercised over the company’s affairs and the fact that all the shareholders were related to each other. These factors lead the Court of Appeal to hold:

The company was instead acting as a trustee and was holding the business on trust for Mr Salomon. Under the law of trusts, a trustee (such as Salomon & Co Ltd) was entitled to an indemnity from the beneficiary (such as Mr Salomon) for debts incurred as trustee. Consequently, Mr Salomon incurred liability to the liquidator to pay the amount owing to the company’s trade creditors.

Lopes LJ, of the Court of Appeal, observed that:

It never was intended that the company to be constituted should consist of one substantial person and six mere dummies, the nominees of that person, without any real interest in the company. The Act contemplated the incorporation of seven independent bona fide members, who had a mind and a will of their own, and were not the mere puppets of an individual who, adopting the machinery of the Act, carried on his old business in the same way as before, when he was a sole trader. To legalise such a transaction would be a scandal.

House of Lords: On appeal, the House of Lords reversed the decision and rejected the legal reasoning in the earlier decisions by holding that the company was neither agent nor trustee for Mr Salomon. This was despite the high level of control exercised

[page 158]

by Mr Salomon in the company’s affairs. It held that, provided there is no fraud, the company is a separate legal entity. The debenture given by the company was valid and therefore Mr Salomon, the founder and controller of the company, succeeded in his claim against the company in his capacity as secured creditor. Furthermore, the House of Lords was satisfied that Mr Salomon had fully complied with the requirements of the Companies Act 1862 (UK), which required a minimum of seven people to form a company without the need for them to be unrelated or unconnected. The fact that the seven shareholders in Salomon’s case all belonged to the same family was held to be of no legal consequence.

The following extracts from the judgments demonstrate:

Separate legal nature of a company Lord Halsbury LC: Either the limited company was a legal entity or it was not. If it was, the business belonged to it and

5.2

not to Mr Salomon. If it was not, there was no person and no thing to be an agent at all; and it is impossible to say at the same time that there is a company and there is not.

… But short of such proof [fraud] it seems to me impossible to dispute that once the company is legally incorporated it must be treated like any other independent person with its rights and liabilities appropriate to itself, and the motives of those who took part in the promotion of the company are absolutely irrelevant in discussing what those rights and liabilities are. Company attains maturity at birth and that members need not be independent Lord Macnaghten: There is nothing in the Act requiring that the subscribers to the memorandum should be independent or unconnected or that they or any of them should take a substantial interest in the undertaking, or that they should have a mind or will of their own … When the memorandum is duly signed and registered, though there be only seven shares taken, the subscribers are a body corporate ‘capable forthwith’, to use the words of the enactment, ‘of exercising all the functions of an incorporated company’. Those are strong words. The company attains maturity at birth. There is no period of minority — on interval of incapacity. I cannot understand how a body corporate thus made ‘capable’ by statute can lose its individuality by issuing the bulk of its capital to one person, whether he be a subscriber to the memorandum or not. The company is at law a different person altogether from the subscribers to the memorandum; and, though it may be that after incorporation the business is precisely the same as it was before, and the same persons are managers, and the same hands receive the profits, the company is not in law the agent of the subscribers or trustees for them. Impact on unsecured creditors Lord Macnaghten: If … the declaration of the Court of Appeal means that Mr Salomon acted fraudulently or dishonestly, I must say that I can find nothing in the evidence to support such an imputation. The purpose for which Mr Salomon and the other subscribers to the memorandum were associated was ‘lawful’ … the unsecured creditors of A Salomon and Company, Limited, may be entitled to sympathy, but they have only themselves to blame for their misfortunes. They trusted the company … but they had full notice that they were no longer dealing with an individual …

Salomon’s case demonstrates, as early as 1897, the legal recognition of what was practically a ‘one person company’ (because Salomon controlled 20,001 shares and dominated the business). In order to form a company, and to thereby obtain the benefits of incorporation, Salomon needed six more persons to hold shares. This can

[page 159]

be contrasted with legislative reform in 1995 (passage of the First Corporate Law Simplification Act 1995 (Cth)) that now permits the formation of genuine ‘one person companies’: s 114.

Salomon’s case also demonstrates that a ‘one person company’ is not

•

ordinarily treated as an agent of that controller. The company exists quite separately from its members. This long-standing legal principle was emphasised by the High Court in Andar Transport Pty Ltd v Brambles Ltd (2004) 206 ALR 387 at 403-4; [2004] HCA 28 at [50] which relied on earlier judicial observations and held that:

… it matters not that the plaintiff had control or the capacity to control the defendant’s activities, for the principle that a corporation is a legal entity distinct from the corporators applies with equal force to a company which is ‘a one person’ company.

This legal position, however, is not always easily understood by all, as recognised in this judicial passage:3

In common parlance, at least among non-lawyers, it is not unusual to regard corporations as comprising and being interchangeable with, in aggregate, the people who direct and work for them. That is true particularly of corporations that exist to provide the professional or other services of their personnel.

The importance of separate legal entity is illustrated by the reorganisation of James Hardie Industries from an Australian company to a Dutch (Netherlands) based corporate entity in 2001. Unfortunately, the lack of funding for the asbestos victims of James Hardie products led to a number of complex decisions. In ASIC v Macdonald (No 11) (2009) 256 ALR 199; [2009] NSWSC 287 the court held the company (both the original Australian company and the new entity) liable for misleading and deceptive conduct, as well as the directors and officers of the company for breaching their duties. This decision, together with the accompanying High Court decisions in ASIC v Hellicar (2012) 286 ALR 501; [2012] HCA 17 and Shafron v ASIC (2012) 286 ALR 612; [2012] HCA 18 affirming liability, are discussed further in Chapter 17.

As a consequence of the decision in Salomon’s case, what practical steps should creditors take to protect their interests?

5.3

• • •

•

5.4

5.5

Legal consequences of the separate legal entity concept

The decision in Salomon’s case has many legal ramifications. Some of the main consequences flowing from the application of the separate identity principle, as discussed below in the case studies, are that once a company is incorporated:

There is a distinction between private and company debts. There is a distinction between private and company assets. A company can contract with its members (making it possible for a person to act in multiple capacities, for example as director, shareholder and employee). A company can be liable in tort to a member.

[page 160]

Distinction between private and company debts The House of Lord’s decision in Salomon’s case affirms that debts entered into using the company’s name belong to the company and not to the founder or controller or the director or anyone else who authorised the debt. The company, being a separate legal person, bears the liability for the debt as demonstrated in Salomon’s case, regardless of whether the creditor is also a shareholder.4 This position at common law can, however, be modified by statute law resulting in exceptions in certain circumstances. For example, through statutory intervention in s 588G of the Corporations Act 2001 (Cth) (discussed below and in detail in Chapter 18) on grounds of public policy and creditor protection, directors can be personally liable for corporate debts incurred during trading while insolvent. Similarly, under s 197, directors of a trustee company may, in limited circumstances, be personally liable for the debts incurred by the trustee company for reasons discussed earlier in Chapter 3.

Distinction between private and company assets Assets purchased by the company or otherwise held in the company’s

5.6

name belong to the company. They are not owned by the directors, shareholders or other participants in the company. Even a shareholder who owns 100% of the shares and is the sole director does not own the assets of the company. A company is a separate legal entity and can own property in its own right: s 124. In these circumstances, the company is the legal owner with ownership rights to the property. This is a consequence of the separate legal entity concept in Salomon’s case, as illustrated in Macaura v Northern Assurance Co Ltd [1925] AC 619. This case demonstrates that a company holds its property separately from the property of its members.

Macaura v Northern Assurance Co Ltd [1925] AC 619 House of Lords (UK)

Facts: Mr Macaura, owner of a timber plantation, sold his business to a company he formed in which he was the main controlling shareholder. Prior to the sale, he had insured the timber in his own name in his capacity as sole trader. He did not transfer the insurance policy to the company. Later, the timber was destroyed by fire. The insurance company refused to pay under the insurance policy held by Mr Macaura because he had no ‘insurable interest’ in the timber, as it was a company asset and therefore belonged to the company.

Decision: The House of Lords upheld the argument of the insurance company. The company as a separate legal entity, which now owned the timber, did not have an insurance policy.

Lord Sumner:

It is clear that the appellant [Mr Macaura] had no insurable interest in the timber described. It was not his. It belonged to the [company]. He owned almost all the shares in the company, and the company owed him a good deal of money, but, neither as creditor nor as shareholder, could he insure the company’s assets. 5

[page 161]

Company contracting with its member (as employee and director) As a separate legal entity, a company can enter into contractual relations with its members. The fact that the member is a controlling shareholder or a director does not prohibit them from contracting with the company,6 as illustrated in Lee v Lee’s Air Farming Ltd [1961] AC 12.7

5.7

Lee v Lee’s Air Farming Ltd [1961] AC 12 Privy Council (UK)

Facts: Mr Lee was a major shareholder of a company he formed for the purposes of conducting a crop dusting business. He was also the governing director. Mr Lee contracted with the company to work as chief pilot. The company had taken out a workers’ compensation insurance policy for its employees. During employment, while flying the plane, Mr Lee was killed in an air crash. Mrs Lee, his widow, claimed compensation under that policy. The insurance company denied the claim, arguing that Mr Lee was not a worker.

Decision: The Privy Council upheld the widow’s claim on the basis that the company, as a separate legal entity, could enter into an employment contract with Mr Lee. Lord Morrison:

… the active aerial operations were performed because the deceased was in some contractual relationship with the company. That relationship came about because the deceased as one legal person was willing to work for and to make a contract with the company which was another legal entity … nor were any contractual obligations invalidated by the circumstances that the deceased was the sole governing director in whom was vested the full management and control of the company. Always assuming that the company was not a sham then the capacity of the company to make a contract with the deceased could not be prejudiced merely because the deceased was the agent of the company in its negotiation.

… it is a logical consequence of the decision in Salomon’s case that one person may function in dual capacities. There is no reason, therefore, to deny the possibility of a contractual relationship being created as between the deceased and the company.

Company liable in tort to a member The intersection between long-established corporate law principle (separate entity rule) and employment law principle (all employers owe a duty of care to provide a safe system of work for their employees)8 makes it permissible for an injured employee (who is also the founder and director of the company) to sue that company for negligence.

The High Court in Nicol v Allyacht Spars Pty Ltd (1987) 163 CLR 611 allowed an injured employee to recover damages in negligence against the corporate employer for failure to provide a safe system of work, despite the fact that the injured employee was also a director/controller of the business. The court was satisfied that the injured employee, one of three directors of the corporate employer, was not solely responsible for implementing the system of work. However, the damages awarded were

5.8

reduced because of contributory negligence on the part of the injured employee.

[page 162]

Nicol v Allyacht Spars Pty Ltd (1987) 163 CLR 611 High Court of Australia

… it does not seem to me that the duty of an employer and an employee in such regard [to provide a safe system of work] can ever be co-extensive or co-terminous. The duty is that of the employer and even if the employee is entrusted with its performance it remains an independent obligation of the employer of a more comprehensive kind to ensure that reasonable care is taken.

The failure to take reasonable steps to provide adequate equipment and a safe system of work was the failure of the company and it matters not that the plaintiff was instrumental in the making of the decision which led to the failure, for the company was a legal entity distinct from its directors and employees.

Of course, there can be no recovery by an employee who has failed to take reasonable care for his own safety where the employer has discharged the obligation to provide proper equipment and a safe system of work and has taken reasonable steps to ensure that they are used … That, however, is a different situation.

The following High Court decision in the Andar Transport case illustrates the consequences arising from the intersection between legal principles in corporate law and the employer’s duty of care to provide a safe system of work arising under employment law. The case also demonstrates that the non-delegable duty of care rests on the employer whether or not the employer takes any share in the conduct of the operations and however the business is formed or structured.

Andar Transport Pty Ltd v Brambles (2004) 217 CLR 424 High Court of Australia

Facts: Andar Transport Pty Ltd (Andar) was a company that provided a laundry delivery service under

a contract with another company, Brambles, using its own truck and driver. The contract made it clear that the worker used by Andar to perform its duties was not an employee of Brambles.

Mr Wail (the founder, controlling shareholder and managing director of Andar) was also the main employee of Andar who performed Andar’s duties under the contract with Brambles. Mr Wail, who had previously worked for Brambles as an employee performing similar laundry delivery work, had incorporated Andar when Brambles ceased employing workers and switched to private companies, such as Andar, to perform these tasks.

Mr Wail sued Brambles for negligence when he injured his back while unloading laundry, as part of his duties for Andar, under a system of work originally designed by Brambles and then continued by Andar. Andar took no steps to assess or modify the system of work. Brambles then joined Andar to the litigation, claiming Andar was negligent in failing to provide a safe system of work and also liable in respect of Wail’s injuries and sought a contribution towards damages.

Issue: The case addressed the significance of Andar’s separate legal entity status in the context of the law imposing a non-delegable duty of care on employers (to safeguard the health and safety of employees) in a situation where the injured employee (Mr Wail) was also a shareholder and director of the employer company (Andar). In such circumstances, is the corporate employer’s (Andar’s) duty of care co-extensive with the employee (Mr Wail), or personal to the corporate employer (Andar)?

[page 163]

Decision: The majority of the High Court judges (6:1) held that the employer’s duty to provide a safe system of work cannot be imposed co-extensively on both the employer and employee. In other words, the duty remains personal to the employer. In the context of this case where the employer is a company (Andar), it meant that Andar owed its employee (Mr Wail) a duty to provide a safe system of work.

The majority held that Andar had breached its duty of care, as employer, by failing to ensure that the system of loading and unloading the laundry trolley was safe for its employees (even though the system was originally devised by Brambles).

Consequently, Brambles was entitled to seek a contribution from Andar in respect of its liability for negligence to Mr Wail.

Kirby J noted the significance of the separate legal entity concept for modern company law in the following passage:

No party to this appeal argued a challenge so fundamental as to the doctrine in Salomon’s case. It is too late in the day, and inappropriate in this case, to suggest that, in law, Mr Wail and Andar [Transport Pty Ltd] were the same legal entity. In law, they had different duties and responsibilities. Legal liability, and, dare I say it, insurance arrangements and premiums, are dependent upon the dichotomy that the law draws in such cases.

Significance: The majority decision is a reminder from the High Court, in an employment and corporate law context, that the fact that a company may ultimately be owned or controlled by one person will not affect its status as a separate legal entity, nor its obligation to provide a safe system of work for its employees. The case demonstrates that the consequences of Salomon’s case, despite its existence for over a century, are commonly misunderstood by those at the coalface owning, managing and working for corporate commercial entities.

•

5.9

One of the key consequences flowing from Salomon’s case is the distinction between private debt and company debt. Do you think this distinction is fair?

Ignoring the corporate veil

Earlier, this chapter emphasised the separate legal entity principle as being the foundational rule of company law. However, the courts have also recognised that in certain circumstances, for example arising from corporate misconduct, the separate legal entity principle is not sacrosanct and has been prepared to depart from the normal rule by ignoring the corporate veil for certain purposes.

The concept of a ‘corporate veil’ can be best understood as a theoretical screen which descends on the company when it is incorporated and, ordinarily, prevents outsiders from peeping in to see who is in charge or control of the company. Lord Denning recognised in Littlewoods Mail Order Stores Ltd v McGregor [1969] 3 All ER 855 at 860 that incorporation does not fully ‘cast a veil over the personality of a limited company through which the courts cannot see’. In certain circumstances, discussed below, courts may wish to look behind the corporate veil to determine why the company was formed, or to see who is in charge or actually controlling the company. They look to see what really lies behind. The judicial technique used by the courts to ignore the corporate veil is often referred to as ‘lifting’ or ‘piercing’ the corporate veil.

[page 164]

Although the ultimate effect of piercing is to look beyond the corporate veil, there is a difference in the two approaches as noted by Staughton LJ in Atlas Maritime Co SA v Avalon Maritime Ltd (No 1) [1991] 4 All ER 769 at 779 (also cited in Idoport Pty Ltd v National Australia Bank Ltd [2004] NSWSC 695):

To pierce the corporate veil is an expression that I would reserve for treating the rights and liabilities or activities of a company as the rights or liabilities or activities of its shareholders. To

5.10

5.11

lift the corporate veil or look behind it, on the other hand, should mean to have regard to the shareholding in a company for some legal purpose.

However, in common with other academic texts and the majority of case law on this topic, these concepts are used interchangeably in this chapter.9

It is a vexed issue, however, as to precisely when the corporate veil will be ignored at common law.10 It has been accurately observed that lifting or piercing the corporate veil ‘is a vivid but imprecise metaphor’: Re Polly Peck International Plc [1996] 2 All ER 433 at 447 per Walker J. Although empirical evidence in the United States has documented veil-piercing as the most litigated issue in company law,11 this legal issue has been described as among the most confusing areas in company law.12

[page 165]

The Supreme Court in the United Kingdom acknowledged that the basis

5.12

5.13

for the ability to pierce the veil is ‘somewhat obscure’13 and queried if veil piercing is a ‘doctrine, metaphor or label.14

This description is true for the Australian position and can be attributed to the fact that there is ‘no common, unifying principle, which underlies the occasional decision of courts to pierce the corporate veil’: Idoport Pty Ltd v National Australia Bank Ltd [2004] NSWSC 695. This outcome is not surprising as veil-lifting cases are inherently fact-specific and subject to interpretation, often resulting in the absence of clarity.15 In spite of these difficulties, the courts have long recognised that the corporate form can be abused and the tendency of many business people to perform a kind of ‘dance of the corporate veil’ and to ‘duck and dive behind the corporate veil’.16

Lifting the corporate veil is designed to penetrate the shield of limited liability in special circumstances and reach the assets of the company. Although not exhaustive, the following grounds for lifting the veil have been identified in Dennis Willcox Pty Ltd v FCT (1988) 79 ALR 267 at 272 (applying Pioneer Concrete Services Ltd v Yelnah Pty Ltd (1986) 5 NSWLR 254):

[T]he separate legal personality of a company is to be disregarded only if the court can see that there is, in fact or in law, a partnership between companies in a group, or that there is a mere sham or façade in which that company is playing a role, or that the creation or use of the company was designed to enable a legal or fiduciary obligation to be evaded or a fraud to be perpetuated.

Despite the uncertainties inherent in this area of the law, the result in Salomon’s case makes it clear that the entity doctrine cannot be ignored merely because a court considers it just or fair to do so. Courts have traditionally justified lifting the corporate veil in cases involving an element of impropriety and dishonesty, of which the most significant is known as the ‘sham’ or ‘façade’ ground. This will arise in cases where a company is used as nothing more than an artificial device for the purpose of ‘shielding themselves from their pre-existing liabilities under contract, tort or statute’: Adams v Cape Industries plc [1990] Ch 433 at 539 per Slade LJ.

In contrast to the uncertainty that exists at common law, there are many provisions in the Corporations Act that specifically authorise the court to ignore the corporate veil.17

5.14

• • • • • • • •

5.15

Examples of such statutory provisions are discussed below at 5-47-5-55.

[page 166]

Common law

Despite the absence of any discernible broad principle at common law on disregarding the corporate veil, a review of the case law illustrates that the courts are prepared to disregard the corporate veil in special and limited circumstances when, for example, a company is used:

as a sham to hide the real purpose of the controller;18 to avoid an existing legal obligation (contractual or fiduciary);19 as a vehicle for fraud;20 to assist in a director’s breach of fiduciary duties;21 to trade with the enemy (grounds of public interest); 22 to evade tax; 23 as a mere puppet of its controller;24 and to act as an agent or partner in a corporate group.25

In the United Kingdom, the Supreme Court in Prest v Petrodel Resources Ltd [2013] UKSC 34 reviewed the history of veil piercing, noted the difficulties in this area and grappled with the issue as to whether there is need to retain or reject the concept of veil piercing. Lord Sumption recognised that courts in the past purported to pierce either on the basis of concealment or evasion — the latter demonstrated below in 5.18 with reference to the Gilford Motor case. Other judges doubted that there are only these two categories for veil piercing. All the judges agreed, however, that there is a limited power to pierce which will only arise in carefully defined circumstances.

For a (non-exhaustive) summary of circumstances in which the courts in Australia will be prepared to ignore the corporate veil, see the judgment of Young J in Pioneer Concrete Services Ltd v Yelnah Pty Ltd (1986) 5 NSWLR 254. It is important to note that the particular facts of a case heavily influence judicial approaches in disregarding the corporate veil. The following section offers examples of the special circumstances in

5.16

5.17

which judicial initiatives were used to ignore the consequences of the separate legal entity rule following from the incorporation of a company.

[page 167]

Sham A review of the case law illustrates that the courts are prepared to disregard the corporate veil in special circumstances when, for example, a company is used as a sham to hide the real purpose of the controller. ‘Sham’, however, is a word to be used with caution. Lockhart J, in Richard Walter Pty Ltd v Commissioner of Taxation (1996) 67 FCR 243; 96 ATC 4,550 at 4,552 warned of the ambiguity and uncertainty that surrounds its meaning and application. The reason is that, although a company may be involved as a façade in sham transactions, the company itself will not be a sham unless it appears that it was not properly registered. This is to say, once a company is properly registered and observes all the compliance obligations imposed by statute, it continues to exist as a legal entity and in this sense it is a reality and not a sham. The High Court in Andar Transport Pty Ltd v Brambles Ltd (2004) 206 ALR 387 at 402; [2004] HCA 28 at [45] relied on the judgment of Windeyer J in Peate v Federal Commissioner of Taxation (1964) 111 CLR 443 and held:

If a company is duly incorporated and registered under the [Corporations] Act and the proper records are kept in due form and the prescribed returns are made, it continues to exist as a legal entity [and is not a sham].

However, a secondary and wider meaning is also attached to the sham exception and is often used when the court does not accept a legitimately incorporated entity at face value on the basis that it acts as a ‘front’ to ‘mask’ the real operations.26 Similarly, commercial transactions entered into by parties with the common intention not to give effect to the ostensible transactions and to create legal rights and obligations can also be classed as a sham, as recognised in the following classic definition given by Lord Diplock in Snook v London and West Riding Investments Ltd [1967] 2 QB 786 at 802 (CA):

[Sham means] acts done or documents executed by the parties to the ‘sham’ which are intended by them to give to third parties or to the court the appearance of creating between the parties

5.18

5.19

legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intended to create.

A characteristic feature of sham transactions is the intention to create a smokescreen and to disguise fact from fiction. The sham exception to Salomon’s case was applied by the High Court in England in Kensington International Limited v Republic of Congo [2006] 2 BCLC 296.27 That case demonstrates that the court is willing to mitigate the rigour of the separate entity doctrine if there is an improper or dishonest attempt to avoid existing debts by contracting and trading through a network of sham companies. Further illustrations of such arrangements are provided below.

Avoidance of legal obligation The following cases illustrate various attempts by the incorporator to deliberately use the company to avoid contractual obligations undertaken by them. In such circumstances, the courts have held the company to be a mask used to conceal identity and have been prepared to ignore the corporate veil to enforce legal and contractual obligations.

[page 168]

Gilford Motor Co Ltd v Horne [1933] 1 Ch 935 Court of Appeal (UK)

Facts: Horne was the managing director of Gilford Motor Co Ltd, the plaintiff company. As part of his employment contract with the plaintiff company, Horne agreed that he would not solicit any of the customers of the company during the term of the contractual agreement or after he had left the company for a period of five years. Shortly after Horne resigned from his employment, and within the five-year non-compete period, he incorporated a company with his wife and friend as the shareholders. Horne caused the newly formed company, which engaged in similar services to Gilford Motor Co Ltd, to target the customers of his former employer. Horne sent advertising material to persons who had been customers of Gilford Motor Co Ltd while he was employed as its managing director. The plaintiff company sought an injunction to restrain Horne from breaching his contractual agreement.

Issue: Could Gilford Motor Co Ltd succeed in obtaining an injunction to restrain Horne when the infringing conduct was conducted by another person, namely, the newly formed company which is a beneficiary of the separate legal entity rule?

5.20

Decision: After reviewing the particular facts of this case, reproduced below, and Horne’s close involvement in the business activities of the newly formed company, the court was satisfied that the new company was a ‘mere cloak or sham’ used by Horne to commit breaches of his contractual obligations. The court granted an injunction, against both Horne and, significantly, the new company he incorporated to carry out his business. Although the new company was not subject to the contractual agreement between Horne and Gilford Motor Co Ltd, an injunction was granted against that company for reasons reproduced below.

Lord Hanworth MR endorsed the following part of the judgment given by Fawell J, the trial judge:

The defendant company is a company which, on the evidence before me, is obviously carried on wholly by the defendant Horne. Mrs Horne, one of the directors, is not, so far as any evidence I have had before me, taking any part in the business or the management of the business. The son … is engaged in a subordinate position in that company, and the other director, Howard, is an employee of the company. As one of the witnesses said in the witness box, in all dealings which he had had with the defendant company the ‘boss’ … was the defendant Horne, and I have not any doubt on the evidence I have had before me that the defendant company was the channel through which the defendant Horne was carrying on his business. Of course, in law the defendant company is a separate entity from the defendant Horne, but I cannot help feeling quite convinced that … one of the reasons for the creation of the company was the fear of Mr Horne that he might commit breaches of the covenant in carrying on the business as, for instance, in sending our circulars as he was doing, and that he might possibly avoid that liability if he did it through the defendant company. There is no doubt that the defendant company has sent our circulars to persons who were at the crucial time customers of the plaintiff company.

After adopting this passage from the earlier judgment of Farwell J, Lord Hanworth MR concluded:

I am quite satisfied that this company was formed as a device, a stratagem, in order to mask the effective carrying on of a business of Mr EB Horne. The purpose of it was to try to enable him, under what is a cloak or a sham, to engage in business which … he had a fear that the plaintiffs might intervene and object.

[page 169]

Similarly, following from the precedent in the Gilford Motor case, the following case also illustrates the avoidance of contractual obligations and a departure from the separate legal entity rule.

Jones v Lipman [1962] 1 All ER 442 Chancery Division (UK)

Facts: Lipman had contractually agreed to sell certain property to Jones. Shortly before the date of settlement, Lipman changed his mind and requested Jones to cancel the purchase contract.

5.21

Subsequent to Jones’ refusal to release Lipman from the contract, Lipman formed a company, Alamed Ltd, in which he and one other were the directors and only shareholders. Lipman then sold the property to Alamed Ltd at a much lower price. Jones then sued Lipman and Alamed Ltd for breach of contract and claimed the contractual remedy of specific performance.

Issue: Could Jones succeed in obtaining Lipman to perform on a contract in which the subject matter of the contract, the property, was no longer owned by Lipman (the new owner being the company, a separate legal person)?

Decision: The court ignored the corporate veil, looked into the company and found that it was wholly owned and controlled by Lipman who could compel the company to transfer the property. The court therefore granted the equitable remedy of specific performance. Russell J, in reliance on the judgment in the Gilford Motor case, reproduced above, held:

[The] comments on the relationship between the individual [Horne] and the [newly formed] company apply even more forcibly to the present case. The defendant company [Alamed Ltd] is the creature of the first defendant [Lipman], a devise and a sham, a mask which he holds before his face in an attempt to avoid recognition by the eye of equity.

Similarly, the corporate veil was ignored in the following case example on the basis of avoidance of legal obligations, namely, employee entitlements arising from wrongful dismissal.

Creasey v Breachwood Motors Ltd [1993] BCLC 480; [1992] BCC 638 Queen’s Bench Division (UK)

Facts: Creasey was employed by Breachwood Welwyn Ltd. Following his dismissal, Creasey brought legal action for wrongful dismissal against this corporate employer. Before the hearing of the court case, the controllers of Breachwood Welwyn Ltd caused the company to stop trading and transferred all of its assets to Breachwood Motors Ltd, another company which they also controlled. Through their restructuring efforts and scheme, the controllers reduced Breachwood Welwyn Ltd to a shell. Breachwood Motors Ltd paid all of the Breachwood Welwyn Ltd’s creditors, but did not make provision for funds to pay Creasey, as creditor, should his claim succeed.

Creasey did succeed in his wrongful dismissal claim, with the court awarding substantial damages against Breachwood Welwyn Ltd, by now defunct and dissolved.

Issue: Could Creasey, the employee, have the judgment enforced against Breachwood Motors Ltd, a separate legal person who was not the employer?

[page 170]

Decision: The court held it was reasonable to infer that avoidance of legal obligations to pay its employee legal entitlements was one of the key reasons for shutting down Breachwood Welwyn Ltd. In these circumstances, the court held it was appropriate to lift the corporate veil and hold Breachwood Motors Ltd liable for the debt payable to Creasey.

5.22

5.23

Fraud The courts are prepared to ignore the corporate veil if a company is used as a vehicle to conduct fraud.

Re Ballantyne Suites Pty Ltd v Ballantyne Chambers Pty Ltd (in liq) [2014] VSCA 223 at [34] Supreme Court of Victoria, Court of Appeal

At common law, a court will piece the corporate veil where a corporate structures used to perpetrate fraud.

This is demonstrated in the following case where the company was a mere façade to conceal fraudulent activities.

Re Darby; Ex parte Brougham [1911] 1 KB 95 King’s Bench Division (UK)

Facts: Darby and Gyde, both undischarged bankrupts, formed a company called City of London Investment Corporation (CLIC) in which they were the shareholders and sole directors. Subsequent to their purchase of a licence to work a quarry, CLIC then promoted another company called Welsh Slate Quarries Ltd, to which the public subscribed to shares via a prospectus. CLIC then sold the licence to Welsh Slate Quarries Ltd at a grossly inflated price. Although the purchase price was paid to CLIC, Darby and Gyde ultimately received the money and shared the large profits from the sale.

Welsh Slate Quarries Ltd collapsed and Darby and Gyde were convicted of making fraudulent statements in the prospectus. The liquidator of the collapsed company sought to recover the profits from Darby and Gyde, arguing that they were the real promoters and not CLIC which was viewed as a ‘dummy’ company. Darby argued that it was the company (CLIC) which made the profits, not him. (The liquidator, Brougham, only proceeded against Darby to recover the profits as he had considerable assets and Gyde had none.)

Issue: Could Darby, under the name of the ‘dummy’ company (CLIC), retain any of the secret profits which he made on the sale to the company?

Decision: The court ignored the corporate veil by looking into the company to see who was in charge and control. The court was satisfied that CLIC was a ‘dummy’ company used by Darby and Gyde to conduct fraudulent activities and that they were the real vendors and promoters and had acted in

5.24

5.25

breach of their duties of disclosure as promoters.28 The court ordered Darby to disgorge (surrender) the undisclosed secret profits made to the liquidator.

[page 171]

Assistance in breach of fiduciary duties The courts have shown readiness to lift the corporate veil when a company has knowingly assisted in a director’s breach of fiduciary duty, as demonstrated in the following case.29

Green & Clara Pty Ltd v Bestobell Industries Pty Ltd [1982] WAR 1 Western Australian Supreme Court

Facts: Mr Green, while the managing director of Bestobell Industries, acquired a shelf company called Clara Pty Ltd. While Green was the manager of Bestobell Industries, a fiduciary relationship existed between him and Bestobell Industries with the result that he was under an obligation not to place himself in a situation where his duty to the Bestobell Industries and his own interest might possibly conflict. Unknown to Bestobell Industries, Green secretly caused his own company, Clara, to submit a tender for a commercial project in competition with Bestobell Industries. Clara was the successful tenderer and was awarded the contract which it performed.

Issue: Could Bestobell Industries seek to recover the profits made by Clara from Green on the basis that Green had breached his fiduciary duty owed to Bestobell Industries? It must be remembered, based on Salomon’s case, that Clara and Green were separate persons in law. Therefore, ordinarily, it means that Bestobell Industries cannot succeed in its claim unless the corporate veil is lifted.

Decision: The court held that the evidence showed that Clara had knowingly assisted and was involved in the director’s breach of fiduciary duty. The corporate veil was lifted and Green and Clara were treated as one and the same person. As a consequence, Green was liable to account to Bestobell Industries for the profits received in performing the contract.

This case is also instructive in illustrating the fiduciary duty that a director owes the company and the consequences flowing from a breach. These aspects of the case are discussed further in Chapter 16 at 16.4.

•

5.26

•

Some commentators have argued that the concept of veil-piercing is troublesome and should be abolished. Do you agree?

Corporate groups

The High Court has characterised a corporate group as ‘a number of companies which are associated by common or interlocking shareholdings, allied to unified control or capacity to control’: Walker v Wimborne (1976) 137 CLR 1 at 6 per Mason J. The relatively modern concept of utilising corporate group structures to transact business and partition assets is a universal phenomenon. Many medium to large companies in Australia are structured as corporate groups. Research on group

[page 172]

structures in Australia’s Top 500 listed companies in 1997 showed that 89% of the listed companies surveyed controlled other entities. The study found that the greater the market capitalisation of a listed company, the more companies it was likely to control. Significantly, the study showed that the average number of controlled entities in a group was 28.30

A more recent empirical study on corporate groups in Australia as at June 2007 found that nearly 88% of the sample companies studied (1526 companies) were structured as a corporate group.31

There are many economic and commercial benefits in conducting a business through a corporate group. These include:32

reducing commercial risk, or maximising potential financial return, by diversifying an enterprise’s activities into various types of businesses, each operated by a separate group company; attracting capital without losing overall corporate control by creating a separate subsidiary to conduct the business and allowing minority shareholders to invest in it;

•

5.27

lowering the risk of legal liability by confining high liability risks, including environmental and consumer liability, to particular group companies, with a view to isolating the remaining group assets from this potential liability; and reduction in the administrative burden through tax consolidation. Tax law reform, with effect from 2002, allows for groups to elect to consolidate for tax purposes and thereby lodge a single tax return. The ability to increase tax deductions and improve the utilisation of tax losses are also seen as key benefits flowing from consolidation of wholly-owned entities in a corporate group.33

The doctrines of separate corporate personality and limited personal liability are not set at nought by the mere existence of a relationship of subsidiary and holding company: Ace Property Holdings Pty Ltd v Australian Postal Corp [2011] 1 Qd R 504; [2010] QCA 55. The close links and benefits between the separate entity doctrine and the doctrine of limited liability provide powerful incentives to structure as a corporate group. The separate entity doctrine, which emphasises that an incorporated company is a legal entity separate from its founders or controllers, lies at the heart of corporate law. Unsurprisingly, many commercial structures and arrangements are shaped by this important legal fiction afforded by this basic legal doctrine.

Together with another important feature of corporate law, the conferral of limited liability is another useful tool relied on to insulate shareholders from personal liability for the company’s actions. The maximisation of limited liability afforded by the dual level of limited liability available to parent and subsidiary companies are an attractive

[page 173]

legal feature for corporate groups.34 Limited liability, together with the separate personality rule, favours the externalisation of the social costs of corporate behaviour and shifting the risk of business operations away from shareholders.

5.28

5.29

Corporate groups and the veil

The separation of each company within a particular group of companies is, ordinarily, steadfastly respected by the courts in Australia and England, in spite of the proliferation of conglomerates, holding companies and subsidiaries. In The Albazero [1977] AC 774 at 807, Roskill LJ observed:

… each company in a group of companies … is a separate legal entity possessed of separate legal rights and liabilities so that the rights of one company in a group cannot be exercised by another company in that group even though the ultimate benefit of the exercise of those rights would enure beneficially to those person or body corporate irrespective of the person or body in whom those rights were vested in law. It is perhaps permissible under modern commercial conditions to regret the existence of those principles. But it is impossible to deny, ignore or disobey them.

For similar conclusions, see Adams v Cape Industries plc [1990] Ch 433.

Judicial authorities consistently state that without contractual obligations or statutory obligations35 or veil-piercing, creditors of each group are entitled to look only to the resources of that company for payment of debts. In Walker v Wimborne (1976) 137 CLR 1, it was held that assets of the corporate group cannot be pooled to pay for the debts incurred by each company within the group. The debts incurred by each company belonged to that company, not to the corporate group collectively.

Industrial Equity Ltd v Blackburn (1977) 137 CLR 567 High Court of Australia

[Mason J (as he then was) held (in reliance on his earlier judgment in Walker v Wimborne)]: it can scarcely be contended that the [consolidated] provisions of the [Companies] Act operate to deny the separate legal personality of each company in the group. Thus, in the absence of a contract creating some additional right, the creditors of company A, a subsidiary within a group, can only look to that company for payment of their debts. They cannot look to company B, the holding company, for payment.

[page 174]

5.30

5.31

5.32

The courts have consistently emphasised that each company within a corporate group is a separate legal entity.36 Directors are therefore bound to consider the interests of the company on whose board they are sitting. As Owen J said in Bell Group Ltd (in liq) v Westpac Banking Corp [2008] WASC 239 at [4621]:

The law does not require directors of a group of companies to ignore the interests of the wider group. But it does demand that where one or more companies in a group enter into a transaction or transactions, consideration must be given to the interests of that company or those companies. Most commercial transactions involve both benefits and detriments and, in considering the interests of the participants and those affected by the transaction, it will usually be a case of balancing the two.

This builds on the earlier High Court decision in Industrial Equity Ltd v Blackburn (below). The courts have also repeatedly cautioned not to confuse a ‘legal entity’ with an ‘economic entity’.37

Industrial Equity Ltd v Blackburn (1977) 137 CLR 567 High Court of Australia

Facts: The Corporations Act requires dividends to be paid from profits. A parent company sought to treat the profits earned by one of its subsidiaries as its own profits prior to them being passed to the holding company by way of dividend. The parent company argued that the court should treat the group as a single entity and therefore this course of action was permissible. The subsidiary company argued that:

… the parent company could not treat the subsidiary’s profits as its own profits before the subsidiary formally distributed those profits to the parent company by way of dividend.

Issue: Could the parent company treat the other companies within the group as a single enterprise? Decision: The High Court rejected the argument of the parent company through reliance on Salomon and Walker v Wimborne, holding that each company in the group remained a separate legal entity. The court reached this conclusion despite the fact that the Corporations Act requires the preparation of group accounts

Consistent with the legal treatment of corporate groups at common law in Australia, the court in Adams v Cape Industries [1990] Ch 433 at 536 in England recognised that for better38 or worse39 the law respects the separate entity rule when applied to companies within the same corporate group.

5.33

5.34

[page 175]

Bank of Tokyo Ltd v Karoon [1987] AC 45 Court of Appeal (UK)

[Counsel] suggested … that it would be technical for us to distinguish between parent and subsidiary company in this context; economically, he said, they were one. But we are concerned not with economics but with law. The distinction between the two is, in law, fundamental and cannot here be bridged.40

Adams v Cape Industries Plc [1990] Ch 433 Court of Appeal (UK) … our law … recognises the creation of subsidiary companies which though in one sense the creatures of their parent companies, will nevertheless under the general law fall to be treated as separate legal entities with all the rights and liabilities which would normally attach to separate legal entities.

As a general rule, the corporate veil shields the company from outsiders looking into the affairs of the company. However, as explained above, the entity doctrine is not absolute, nor are its limits clear. The following discussion with reference to veil-piercing on agency grounds is testament to the uncertainty that exists in the law.

Veil-piercing on agency grounds Australian empirical research on lifting the corporate veil has revealed that existence of an agency relationship between a company and its controller is the ground most frequently argued before the courts.41 The most frequently-cited decision concerning the identification of an implied agency relationship between members of a corporate group is the decision of Atkinson J in Smith Stone & Knight Ltd v Birmingham Corp [1939] 4 All ER 116.

1. 2. 3. 4.

5. 6.

5.35

Smith, Stone & Knight Ltd v Birmingham Corp [1939] 4 All ER 116 Kings Bench Division (UK)

Facts: Smith, Stone & Knight Ltd was the parent company of a subsidiary company, Birmingham Waste Co Ltd. The local council compulsorily acquired the land, owned by the parent, on which the subsidiary company conducted business. For technical reasons, the subsidiary company could not sue the local council for compensation for disturbance caused to their business. Instead, the parent company sought compensation from the local council. The local council argued that the parent and subsidiary companies were separate legal entities and therefore the parent company was not entitled to compensation.

Issue: Was the subsidiary company carrying on business as agent for its parent company? Could the two companies be treated as a single legal entity? If so, on what legal basis?

Decision: Atkinson J famously identified an agency relationship between the parent company and the subsidiary on the basis of answering the following six questions:

[page 176]

Were the profits treated as the profits of the parent? Were the persons conducting the business appointed by the parent? Was the parent the head and the brain of the trading venture? Did the parent govern the adventure, decide what should be done and what capital should be embarked on the venture? Did the parent make the profits by its skill and direction? Was the parent in effectual and constant control?

On the facts before him, his Honour decided that all six questions could be answered in the affirmative stating:

If ever one company can be said to be the agent or employee, or tool or simulacrum of another, I think the Waste company [the subsidiary] was in this case a legal entity, because that is all it was. There was nothing to prevent the claimants [the parent] at any moment saying: ‘We will carry on this business in our own name.’ They had but to paint out the Waste company’s name on the premises, change their business paper and form, and the thing would have been done.

Significance: This case has received a mixed and limited reception in Australian company law, with some courts following this precedent and other courts declining to do so for reasons discussed below.

An examination of the Australian law concerning lifting the corporate veil on the basis of an implied agency reveals that control, even overwhelming control, of a company is not sufficient to create an implied agency between the company and the controller.42

5.36

Briggs v James Hardie & Co Pty Ltd (1989) 16 NSWLR 549 New South Wales Supreme Court

As the law presently stands, in my view the proposition advanced by the plaintiff that the corporate veil may be pierced where one company exercises complete dominance and control over another is entirely too simplistic. The law pays scant regard to the commercial reality that every holding company has the potential and, more often than not, in fact, does exercise complete control over a subsidiary.

This issue was raised more recently in Shagang Shipping Co Ltd v Ship ‘Bulk Peace’ [2014] FCAFC 48, which considered whether a parent company could be considered to be the owner of a ship that was technically owned by its subsidiary company on the basis that the parent exercised extensive control over the affairs of the subsidiary. It was found that control was not enough to ignore the separate legal status of the subsidiary and attribute the ownership of the ship to the parent company.

[page 177]

Shagang Shipping Co Ltd v Ship ‘Bulk Peace’ [2014] FCAFC 48 Federal Court of Australia

Control can be exercised by a parent company exercising its rights as shareholder, nominating directors and seeing its commercial wishes put into execution through the lawful separateness of corporate entities carrying out those underlying commercial wishes of those who own the shares. It may be, in certain circumstances, that intervening companies between assets and parent companies are mere distractions, or shams, or have no part to play whatsoever in the legal activity of ownership and deployment. If that be the case, that must be proven. One of the difficulties that arises with the Admiralty Act, and regimes of its character, not only in Australia, but in many other countries, is the need to confront the commercial reality of one-ship companies, often with common directors and often with shareholding that goes back to ultimate parent companies.

As indicated by the quote above, the mere fact that one company completely controls another is insufficient to constitute an agency relationship, and the basis for veil-piercing, between the parent company and subsidiary company. This is also demonstrated by the leading

5.37

• • • •

5.38

decision in Tate v Freecorns Pty Ltd [1972] WAR 204, which concerned a tort claimant’s action to recover from a parent company for injuries suffered in the wholly-owned subsidiary’s premises. Burt J at trial considered the argument that the wholly-owned subsidiary was ‘occupying’ the premises as agent of its parent and stated (at 208):

No doubt the fact that [the subsidiary] is a company controlled and wholly owned by [the parent company] may throw some light on [the question as to whether the subsidiary was carrying on the business as agent of the parent] but it cannot be decisive. One is still required to look at all the facts to see what the true relationship was and unless the facts show that relationship to be one of principal and agent one cannot, apart from estoppel and consistently with the authorities ignore the separate legal entities of various companies within a group and look instead at the economic entity of the whole group … so as to make the parent company either vicariously or directly liable for the tortious acts of its wholly owned subsidiary or for the tortious acts of the servant of the wholly owned subsidiary.

His Honour found that the subsidiary company was not the agent of the parent on the basis that:

The subsidiary owned the premises from which it traded. The subsidiary engaged its own employees. The subsidiary purchased its own stock. The profits made by the subsidiary were beneficially owned by it, and only part of the profits were distributed to the parent by way of dividends.

Tate v Freecorns was followed in a decision of the South Australian Supreme Court in ACN 007 528 207 Pty Ltd (in liq) v Bird Cameron (Reg) (2005) 91 SASR 570, which provides a typical example of how Australian courts have dealt with applications to lift the corporate veil on the basis of an implied agency.43

[page 178]

ACN 007 528 207 Pty Ltd (in liq) v Bird Cameron (Reg) (2005) 91 SASR 570 South Australian Supreme Court

5.39

Facts: This case involved a professional negligence claim made against two firms of accountants (Bird Cameron (Reg) and Bird Cameron Partners) by one of their former clients (ACN 007 528 207 Pty Ltd (in liq)). The claim arose because advice, provided by the firm through a limited liability company controlled by the partners (BPM), was incorrect and resulted in the client suffering substantial financial losses. One of the key issues involved in the case concerned whether BPM was conducting much of the firm’s accounting practice as the implied agent of the firm’s partners. The client sought to establish an agency between BPM and the partnerships because BPM had only minimal assets.

Decision: Besanko J refused to find an agency between the partners and the company primarily on the basis that the company operated its own independent business despite the control exercised by the partners. One of the most important factors relied on by his Honour was the fact that the profits made by the company were not owned by the partners in the firm, but rather were owned by the company and distributed as franked dividends (whereas in Smith, Stone & Knight the profits were transferred directly to the parent). His Honour said (at [112]):

The first matter identified by Atkinson J in Smith, Stone & Knight v Birmingham Corporation [1939] 4 All ER 116 [that is where the profits of the business are treated as the profits of the parent company] is an important, sometimes very important indicator of whether or not there is an agency relationship. In this case, the profits generated by the general practice were received by BPM and that is an indicator that it was not an agent.

Significance: The Bird Cameron decision reaffirms the importance of the beneficial ownership of profits for identifying an agency relationship between members of a corporate group. The case is also significant for the judicial approach adopted to determine an implied agency relationship. Besanko J was critical of the six-point test formulated in Smith, Stone & Knight to establish an agency relationship for the following reasons:

… the first [criteria relating to profits] identifies an issue which is important to the question whether there is an agency. However, too much emphasis on the other five [criteria] relates to control and control of itself cannot be a decisive indicator of agency. If it were otherwise there would often be an agency between a parent company and its subsidiary or a sole shareholder and his company. Such a result is not only inconsistent with Salomon v Salomon & Co Ltd but also with High Court authority which recognises the separate legal existence of companies in a group (Industrial Equity Ltd v Blackburn …; Walker v Wimborne …).

Although Smith, Stone & Knight has been followed in Australia … the weight of authority in England and in this country [Australia] is that it does not provide a definitive test of agency.

It has long been established that a commonality of business interests between a holding company and its subsidiary does not, of itself, make the subsidiary, or the subsidiary’s director, the agent of the holding company: Consolo Ltd v Bennett [2012] FCAFC 120. The sharing of profits between a parent and a subsidiary is not itself evidence of an agency relationship where the subsidiary company has real existence and a valid reason for incorporation: Hobart Bridge Co Ltd v Commissioner of Taxation (1951) 82 CLR 372.44

[page 179]

5.40

5.41

5.42

As demonstrated in this chapter, factors that constitute an agency relationship for purposes of veil-piercing are currently unsettled. The passage above from the Bird Cameron case demonstrates that the authoritative status of Smith, Stone & Knight in Australian company law awaits resolution either through litigation in the High Court of Australia or through statutory reform.

Problems posed by corporate groups As discussed earlier, the enduring features of modern corporate law (separate entity rule and limited liability) combine to provide a powerful incentive for a company to do business through subsidiary companies. This result has been aided by a generally strict application of the entity doctrine in Australia by the High Court (as shown in Walker v Wimborne; Industrial Equity Ltd v Blackburn) with scant attention paid to the commercial realities within a corporate group which may suggest otherwise. See critical judicial remarks by Dodds-Streeton J in Varangian Pty Ltd v OFM Capital Ltd [2003] VSC 444 at [142]:

The underlying unity of economic purpose, common personnel, common membership and control have not been held to justify lifting the corporate veil. As recognised by Rogers J in Briggs, even the complete domination or control exercised by a parent over the subsidiary is not a sufficient basis for lifting the corporate veil. This is an area in which the law pays scant regard to the commercial reality.

The following cases demonstrate the tension arising between the legal treatment of corporate groups and the commercial realities.

Briggs Qintex Australia Finance Ltd v Schroders Australia Ltd (1990) 3 ACSR 267 New South Wales Supreme Court

As I see it, there is a tension today between the realities of commercial life and the applicable law in circumstances such as those in this case. In the everyday rush and bustle of commercial life in the last decade it was seldom that participants to transactions involving conglomerates [complex group structures] with a large number of subsidiaries paused to consider which of the subsidiaries should become the contracting party …

Regularly, liquidators of subsidiaries, or of the holding company, come to court to argue as to which of their charges bears the liability … As well creditors of failed companies encounter difficulty when they

5.43

have to select from amongst the moving targets the company with which they consider they concluded a contract. The result has been unproductive expenditure on legal costs, a reduction in the amount available to creditors, a windfall for some, and an unfair loss to others. Fairness or equity seems to have little role to play.

The Full Court of the Federal Court decision in Commissioner of Taxation v BHP Billiton Finance Ltd (2010) 182 FCR 526; [2010] FCAFC 2545 highlights the confusion

[page 180]

that corporate groups continue to generate, more than 110 years after the House of Lords in the Salomon case declared that dominance and control by a shareholder did not affect the separate legal status of the company.

Commissioner of Taxation v BHP Billiton Finance Ltd (2010) 182 FCR 526; [2010] FCAFC 25 Full Federal Court

Facts: BHP Billiton Ltd, one of the largest mining and resources companies in the world with a market capitalisation value in excess of US$165 billion, has operations that span the globe. The significant scale and capital intensive nature of BHP Billiton’s operations required a continuous stream of debt finance. In order to facilitate this, BHP Billiton established a finance subsidiary BHP Billiton Finance Ltd (hereinafter Finance Ltd) in 1975 to borrow all funds used for debt finance of the members of the corporate group. Finance Ltd borrowed significant funds from a range of external creditors (from around the world) using a mix of short-, medium- and long-term borrowings. In a period that spanned many financial years, Finance Ltd earned billions in interest through this commercial activity and paid tax accordingly.

Finance Ltd was a wholly-owned subsidiary within the BHP Billiton group. It had no individual employees, with its workers drawn from other companies within the BHP group. Finance Ltd paid for these services from its own funds. Its directors were appointed by the parent company, which also provided final sign-off on strategy matters, such as overall borrowing and lending arrangements within the group through Finance Ltd. Decisions as to the appropriate capital structure maintained by group companies were determined by the parent company and its board.

The dispute at the centre of the case concerned the tax deductibility of two failed projects undertaken by the BHP Billiton corporate group during the 1990s. Finance Ltd wrote off large portions of its debts owed by BHP Billiton as being bad. It claimed these as deductions under the Income Tax Assessment Act 1997 (Cth), which requires that the debt be lent during the course of a business lending money. The Commissioner of Taxation issued a notice disallowing the deductions on the basis that Finance

(1)

(2)

(3)

(4)

5.44

Ltd was not operating a business of lending money but rather as a mere conduit for BHP Billiton’s investment activities.

It is significant to note that the Commissioner conceded from the outset that the evidence in this case established that:

Finance Ltd was incorporated in 1975 for a legitimate business purpose, namely, to carry on the business of financier; Finance Ltd entered into borrowing transactions, totalling billions of dollars, with a variety of third parties; Finance Ltd borrowed substantial sums of money from those third parties at commercial rates of interest; and Finance Ltd loaned those borrowed funds to related entities to fund both operational activity and new projects at a higher rate of interest which earned substantial profits and generated income tax liabilities.

Notwithstanding these concessions, however, the Commissioner contended that Finance Ltd had not established that its activities (acting at its own right) amounted to the carrying on of a business of lending money.

Issue: Was the in-house finance company (Finance Ltd), a subsidiary of BHP Billiton, conducting its activities in its independent right or as a mere conduit for its parent company? If the latter, then the tax deductions claimed by Finance Ltd will be disallowed.

[page 181]

Decision: The Full Court, in a unanimous judgment, held that the facts did not support the Commissioner’s argument that Finance Ltd was in a business that was merely an appendage to the business of the corporate group as a whole. The Commissioner’s submissions denying the separate legal existence of Finance Ltd, in light of the undisputed facts and concessions made above which showed a legitimate and independent in-house finance business being conducted, were held to be ‘perverse’. The court affirmed that the debts written off by Finance Ltd as bad were losses incurred by Finance Ltd and, indeed, were allowable deductions under the Income Tax Assessment Act.

Significance: The decision underscores the point that the courts will not lightly infer an agency relationship between a parent and subsidiary company and ignore their individual corporate existence. While a wholly-owned subsidiary usually takes its management and strategic direction from its parent or holding company, the decision shows that in no way diminishes the separate and independent status that each company has within the corporate group.

Judicial observations in Stanborough v Woolworths Ltd [2005] NSWADT 203 at [44], in the context of disparities in redundancy payments for employees working for separate companies within the same corporate group, also illustrates the tension between commercial realities and the sanctity of the separate entity doctrine:

… the [employee] argued that because of the intermingling of some of the activities of Woolworths and AIW [both companies which belonged to the same corporate group], Woolworths should be regarded as the employer of AIW’s employees … because for all practical purposes the two companies were one and the same entity. That may well be a

reasonable response from the average person who is not interested in the niceties of company law, but it is not the answer compelled by law.

Whilst it is understandable that the applicant may feel aggrieved by the fact some people within the same group of companies received more generous redundancy payments than others we cannot change the realities of company law. [emphasis added]

The separate legal entity doctrine and its limits have gained renewed prominence recently in a spate of scandals involving corporate groups engaged in restructuring for questionable purposes related to employment conditions and entitlements,46 and health and safety liabilities.

The following case study on employer liability for asbestos injuries, arising from the restructure of the James Hardie Group of companies, has been described by the secretary of the Australian Council of Trade Unions as ‘one of the most morally and legally repugnant acts in Australian corporate history’47 for reasons discussed below. As noted by one media commentator, James Hardie:

… has been forced to repay liabilities, shamed by unions, governments and victims, publicly flogged by the media, been the subject of a special commission and ultimately brow-beaten into appropriately compensating its victims.48

The actions of the James Hardie group in seeking to shelter group assets from tort victims and the Patricks group of companies in seeking to minimise employee

[page 182]

entitlements through the use of corporate groups49 raises an important question about the use of corporate groups in Australia. Specifically, these developments raise a public concern as to what extent should company law ignore the separate entity status of individual members of a corporate group?

James Hardie

The James Hardie group of companies manufactured asbestos products, including insulation and cement, for over half a century in Australia. In 2001, the restructure of James Hardie Industries Ltd (JHIL) raised issues concerning the separate entity doctrine in the context of the company’s exposure to asbestos-related compensation claims. In an effort to quarantine itself from such claims, as it has been widely suggested, JHIL established the Medical Research and Compensation Foundation (MRCF) to compensate people injured by asbestos products that were manufactured in the past by two former subsidiaries. It was publicly said that the MRCF would have sufficient resources to meet compensation claims. However, it was significantly underfunded. MRCF received $293 million from JHIL to fund asbestos injury claims. It was estimated that the total claim against the James Hardie group was in excess of $2.2 billion. Shortly after, JHIL relocated itself from Australia to the Netherlands and transferred its assets to a Netherlands based company (James Hardie Industries NV), ostensibly for taxation considerations.

Following considerable public and government anger and union backlash against the restructure, the New South Wales Government appointed David Jackson QC in 2004 to examine the relationship between the funding shortfall and the restructuring efforts of the James Hardie Group. The Jackson Inquiry found that JHIL had acted within the law but, more relevantly, the Commissioner also commented that the circumstances considered by this Inquiry suggest there are ‘significant deficiencies in Australian corporate law’.50 The Attorneys-General of New South Wales and Victoria have voiced concern over the potential for other companies to attempt to divest themselves of liability by hiding behind the corporate veil. 51

The Commissioner also raised serious questions about corporate governance and breaches of the Corporations Act arising from misleading statements made by company officers of JHIL. A press release by the company stating that MRCF was ‘fully funded’ and would meet its liabilities was of particular concern to the Commissioner and the regulator.

ASIC commenced civil penalty proceedings in 2007, seeking banning orders and fines, against a number of former and current directors and former executives, alleging that they failed to act with requisite care and diligence and therefore in breach of their statutory duty under s 180(1) of the Corporations Act — which is discussed further in Chapter 17. The results of the James Hardie litigation in ASIC v McDonald (No 11) [2009] NSWSC 287, affirmed by the High Court in ASIC v Hellicar (2012) 286 ALR 501; [2012] HCA 17 and Shafron v ASIC (2012) 286 ALR 612; [2012] HCA 18 in which the CEO and director Peter Macdonald and several other executive officers were found to have breached their duties set out in the Corporations Act by failing to properly advise the board regarding an important press release related to the restructure that was misleading and deceptive, are fully discussed in Chapter 17. The non-executive directors and the company officer were found on appeal to the High Court to have contravened their duties based on the evidentiary value of the board minutes which showed that the board actually approved the press release: ASIC v Hellicar (2012) 286 ALR 501; [2012] HCA 17 discussed further in Chapter 17.

[page 183]

The James Hardie litigation also deals in a unique way with the balance (under civil law rather than criminal law) between the corporate liability for misleading statements and the personal liability of the individual directors and officers contraventions of the Corporations Act. The penalties ranged from $350,000 and a 15-year ban for the CEO to a ban of one year and 11 months and a $20,000 financial penalty for some of the other directors for breaches of the Corporations Act. The recent civil penalty decision, cited as Gillfillan v ASIC [2012] NSWCA 370 which deals with the liability of all the directors and officers (except for the CEO and CFO who did not appeal), is discussed further in Chapter 17.

5.45

The following case study on the waterfront dispute between employers and employees, arising from the restructure of the Patrick Stevedore Group of companies, was triggered by the decision to dismiss all employees and shift assets to other entities for reasons discussed below.

The Waterfront Dispute In the waterfront dispute of 1998 (Patrick Stevedores Operation No 2 Pty Ltd v Maritime Union of Australia (1998) 77 FCR 478; 27 ACSR 521), a corporate restructure in the Patrick Stevedore Group of companies occurred in the context of an industrial dispute with the Maritime Union of Australia (MUA). Prior to the dispute, various companies within the group performed the stevedoring business and employed staff. Later, the employer companies sold their stevedoring business which included the property, plant and equipment to another member of the corporate group (Patrick Operations No 2 Pty Ltd). As a result of corporate manoeuvres designed to separate companies within the group from its assets, only one stevedoring company within the group held all the assets. The other companies held no assets except a contractual right to supply labour which could be terminated in the event of an industrial dispute. Following such a dispute by the MUA, the contract was terminated causing the employer companies to be placed in voluntary administration and the dismissal of the employees. The stevedoring company then entered into employment contracts with a new staff. Significantly, based on the entity doctrine, any claims by the employees lay only against the employer companies which had no assets to satisfy their claims. Unfortunately, such a fact scenario involving corporate groups and dealing with the loss of employee entitlements was not uncommon prior to the introduction of s 596AB of the Corporations Act which now prescribes penalties for transactions entered into with the intention of defeating employee’s rights to their entitlements. Apart from concerns dealing with directors’ duties, the rigour of the entity doctrine and the grounds, if any, for mitigating its rigour is also raised by these facts.

A negotiated settlement between the parties denied the High Court an opportunity to consider the limits of the entity doctrine in Patrick Stevedores Operations No 2 Pty Ltd v MUA (1998) 195 CLR 1.52

In DHN Food Distributors Ltd v London Borough of Tower Hamlets [1976] 1 All ER 462, Lord Denning suggested that a parent and subsidiary company should be treated as a single economic unit, based on a common enterprise approach, and applied that reasoning in that case. This judicial approach has been extensively criticised in both England53 and Australia54 on the basis that the decision to lift the corporate veil and

[page 184]

to treat the group as a single entity in DHN was reached on the basis of

•

5.46

•

justice, rather than on legal authority. This case, together with the mixed acceptance of the Smith, Stone & Knight case, discussed earlier, demonstrates that the law in Australia has not yet fully worked out answers to lifting the corporate veil in corporate groups.

Commercial activities, such as those undertaken in the James Hardie Group and the Patrick Group (discussed above in the case studies), prima facie, for legitimate purposes raise a central issue posed by the legal treatment of corporate groups. To what extent should company law ignore the separate entity status of individual members of a corporate group?

Need for law reform In a review of Australian corporate law as it applies to corporate groups, the Companies and Securities Advisory Committee (CASAC) issued the Corporate Groups Final Report (May 2000) and found that fundamental changes to corporate law principles were not required. In particular, CASAC recommended that the existing principles of tort liability should not be changed for corporate groups and preferred, instead, for tort liability to be left to specific statutes and general common law principles. The introduction of a general tort liability for parent companies in corporate groups was seen as undesirable for the fear that it would undermine the separate entity principles and could have negative consequences for the economy: see further, [4.20]–[4.22] of the Corporate Groups Final Report, May 2000.

However, CASAC did recommend law reform that would allow a wholly- owned corporate group to have the choice to be a consolidated group for all or some of the group companies and be governed by single enterprise principles.55 Consequently, under this recommendation for a new regime, it would be permissible for:

the law to treat the consolidated corporate group as one legal structure; directors of group companies to act in the overall consolidated corporate group interest without reference to the interests of their particular group companies;

•

5.47

5.48

5.49

the parent company and each group company to be collectively liable for the contractual debts of all group companies; and group companies to merge at the discretion of the directors of the holding company.

Law reform for insolvent corporate groups The Corporations Amendment (Insolvency) Act 2007 (Cth) introduced a new statutory basis for ignoring the corporate veil: statutory pooling provisions. These provisions (contained in a new Div 8 of Pt 5.6) provide either a liquidator or a court to consolidate members of a corporate group that are in liquidation. Ordinarily, each company with a corporate group would be subject to a separate liquidation procedure. The pooling provisions allow these liquidations to be consolidated to provide for a more efficient distribution of assets to creditors.56

[page 185]

Statute law

Parliament has for a variety of reasons, ranging from the need to ensure accountability to the need to protect public interest, deliberately chosen in specific instances to cast aside the basic principle of company law, namely, the separate personality of the company. The legislative erosion of the separate legal entity rule can be found in numerous statutes, including the Income Tax Assessment Act 1997 (Cth),57 the Customs Act 1901 (Cth)58 and the Proceeds of Crime Act 1987 (Cth).59 This chapter, however, will confine discussion to relevant examples under the Corporations Act.

Statutory veil-piercing The Corporations Act seeks to ensure that the corporate form is not abused or subject to improper activities. This is achieved by imposing liability in specific instances on company officers, such as directors, for harm caused by the company.

5.50

5.51

5.52

Section 588G (director’s personal liability for insolvent trading) Section 588G imposes personal liability on directors who allow a company to incur debts while insolvent. The liquidator, or creditor with prior consent, can sue the company director for payment of the company’s debts incurred when the company is unable to pay its debts as and when they become due and payable. Section 588G imposes a positive duty, in such circumstances, for directors to stop trading and to protect creditor interests by ceasing to incur further debts. The duty to prevent insolvent trading is one of the core statutory duties imposed on company directors. The law relating to the operation of s 588G and the statutory defences available to directors under s 588H to avoid personal liability are discussed in Chapter 18.

Section 260A (financial assistance) Subject to compliance with the provisions of s 260A of the Corporations Act, a company is generally prohibited from giving finance assistance for the acquisition of its own shares. The reasons for this general prohibition, underpinned by the maintenance of capital rule, are discussed in Chapter 17. If the financial assistance prohibition is breached, the company is not guilty of an offence: s 260D. Instead, the Corporations Act ignores the corporate veil by making the company officers liable, either under the civil penalty provision or criminal offence provision for dishonest conduct, for their company’s breach of the statute. Under the civil penalty provisions, the company officer can be subject to disqualification orders, compensatory orders and pecuniary penalties. These sanctions and remedies are discussed further in the chapters on directors’ duties: see Chapters 15-17.

[page 186]

Section 588FP (security interests in favour of company officer) The introduction of the Personal Property Securities Act 2009 (Cth) (PPSA), with effect from 30 January 2012, has repealed Ch 2K of the Corporations Act because the PPSA now governs registration and priority of security interests in personal property. Thus, s 267 of the Corporations Act which

5.53

5.54

5.55

dealt with charges in favour of company officers has been replaced by a similar new provision under s 588FP which reflects the changes in terminology introduced by the PPSA:60 for further discussion, see Chapter 12.

Section 588FP is designed to prevent an insolvent company from granting a security interest (referred to as a charge under the old law) in favour of an officer of the company, or any associated person, in order to avoid prejudice to the company’s creditors. It lifts the corporate veil by treating such officers, who have been granted a security interest over the company’s property and seek to enforce it within six months of its creation, differently from loans secured by other independent external creditors. Company officers, in such circumstances, cannot enforce the security interests without first obtaining the court’s permission.

Section 197 (directors’ liability as trustee) Section 197 lifts the corporate veil between trustee companies and their directors by imposing personal liability on the directors for certain debts incurred by the corporate trustee which manages the trust. If a trustee enters into a transaction in breach of the terms of the trust, the trustee will generally lose their right of indemnity out of trust assets.

Corporate groups as single entities Further to the discussion earlier on the treatment of companies within a group, the Corporations Act does depart from Salomon’s case in certain circumstances and is prepared to treat a group of companies as a single entity as shown in the following statutory examples.

Section 588V (group liability for insolvent trading) Ordinarily, as discussed earlier with reference to the position at common law, each company within the company is responsible for its own debts: Walker v Wimborne (1976) 137 CLR 1.

Section 588V lifts the corporate veil by making the holding company liable for the debts of its subsidiary where there are reasonable grounds

5.56

for suspecting that the subsidiary is insolvent at the time of incurring that debt.

Section 296 (consolidated group accounts) Chapter 2M of the Corporations Act, in particular s 296, obliges companies to comply with accounting standards and regulations. The Corporations Act, through Australian

[page 187]

Accounting Standard 1024, requires a company that is a main entity to prepare consolidated financial statements for the financial year for the main entity and all the entities it controls.

The preparation of consolidated financial statements recognises the economic reality that the corporate group is performing as one organisation.

2. 3. 4.

10.

[page 188]

Revision Questions

Explain the significance of the decision in Salomon v Salomon & Co Ltd [1897] AC 22 for modern company law. What are the arguments for and against the separate entity rule? Why was the company in Salomon’s case not regarded as a sham? Discuss at least three legal consequences flowing from the legal principle established in Salomon’s case. Explain the concept of ‘corporate veil’ and judicial approaches to that concept. Why do corporate groups pose special problems for corporate law? Why is the test for agency, as advanced by Atkinson J in Smith, Stone & Knight Ltd v Birmingham Corp [1939] 4 All ER 116, regarded as controversial? Identify at least two instances when companies in corporate groups will be treated as a single legal entity under the Corporations Act? Identify at least three instances when the corporate veil will be disregarded under the Corporations Act. Explain the impact of s 588G of the Corporations Act on the legal principle established in Salomon’s case.

Problem Question For the past five years Chu has been the New South Wales Operations Manager of Computers Pty Ltd, a company which retails computer software and hardware. Due to his senior position, Chu knows the identity and requirements of the company’s major clients.

In March 2017 Chu, aged 50, decides to retire. As part of his employment contract with Computers Pty Ltd, Chu had agreed that he will not compete against the company in New South Wales for two years.

In April 2017 Systems Pty Ltd was incorporated for the purposes of engaging in the retail business of selling computer software and hardware. Chu’s wife holds all the issued capital in Systems Pty Ltd and is the only director. This new company actively solicits business from the customers of Computers Pty Ltd in New South Wales.

After Chu left Computers Pty Ltd in March, the company reorganised its business so that its software business was, from 1 July 2017, carried on by its wholly-owned subsidiary called Software Pty Ltd. Software Pty Ltd and Computers Pty Ltd have the same directors and management. Software Pty Ltd now operates the retail software and hardware division previously operated by Computers Pty Ltd.

Advise Computers Pty Ltd as to whether the company can seek a court injunction to prevent Systems Pty Ltd from soliciting its customers. Refer to relevant cases to support your answer.

Guidelines for Answering Problem Questions

When answering a problem question concerning legal personality of a company, we suggest that the following method may be helpful:

Identify the legal characteristics of a company, with particular reference to the separate legal entity rule. The important point is to acknowledge this basic rule of company law

[page 189]

as established in Salomon’s case. It is important to remember that veil piercing is the exception, and not the general norm in company law. Work out whether there has been some impropriety or valid reason to explore the possibility of ignoring the corporate veil, either under common law or the Corporations Act. Review the circumstances when the courts are likely to ignore the corporate veil (fraud, sham, avoidance of legal obligations) and

•

then, with reference to the given facts, identify the relevant ground with reference to relevant precedents. If the problem involves improper or unlawful activities involving companies within a corporate group, first consider the general legal principles governing corporate groups: Walker v Wimborne (1976) 137 CLR 1; Industrial Equity v Blackburn (1977) 137 CLR 567. Work out whether there are valid grounds for ignoring the corporate veil (as discussed above), including the ground of agency. If agency as a ground for veil piercing is relevant to the given facts, then:

Discuss the relevance of control in establishing agency (Briggs v James Hardie & Co Pty Ltd (1989) 16 NSWLR 549). Apply the test for agency established in Smith, Stone & Knight v Birmingham Corp [1939] 4 AII ER 116. Discuss the controversial precedent and legal status of Smith, Stone & Knight in Australian company law where it has been relied on or referred to without disapproval. Consider the legal critique of the Smith, Stone & Knight case offered by Besanko J in the Bird Cameron case (2005) 91 SASR 570.

Consider relevant statutory provisions that pierce the corporate veil (such as ss 588G and 588V dealing with insolvent trading) if the given facts suggest corporate financial difficulties.

Wang and Erin have decided to set up their café as a company (Sydney Café Pty Ltd, ‘SCPL’). Wang and Erin will be the sole directors of SCPL. SCPL will have 2,000 shares on issue. Wang is entitled to 800 shares and will hold these in his own name. Erin is entitled to 1,200 shares and will hold these through her family trust (Erin Trust No 1) in the name of her trustee (ABC Pty Ltd). Erin is the sole shareholder of ABC.

Erin has also lent $200,000 to SCPL in her own name by taking debentures issued by SCPL to assist with the establishment of the business. Wang has borrowed $100,000 from EastBank under his own name which he also spends buying debentures issued by SCPL.

Complete ASIC Form 201 for SCPL. Wang wants to save costs by having his apartment in Bondi, NSW as the company’s

registered office because he is unsure whether the café can also be the registered office and he does not want to rent new office space just to maintain the SCPL registered office.

Advise Wang as to what the Corporations Act requirements are for the SCPL registered office

Further Reading

Academic Journals R Baxt, ‘Tensions Between Commercial Reality and Legal Principle —

Should the Concept of the Corporate Entity be Re-examined?’ (1991) 65 Australian Law Journal 352.

[page 190]

P Blumberg, ‘Limited Liability and Corporate Groups’ [1986] Journal of Corporation Law 573.

P Blumberg, ‘The Transformation of Modern Corporation Law: The Law of Corporate Groups’ (2005) 37 Connecticut Law Review 605.

F Easterbrook and D Fischel, ‘Limited Liability and the Corporation’ (1985) 52 University of Chicago Law Review 89.

J Farrar, ‘Doctrinal Incoherence and Complex Variables in Piercing the Corporate Veil Cases’ (2014) 29 Australian Journal of Corporate Law 23.

J Farrar, ‘Frankenstein Incorporated or Fool’s Parliament? Revisiting the Concept of the Corporation in Corporate Governance’ (1998) Bond Law Review 142.

J Farrar, ‘Legal Issues Involving Corporate Groups’ (1998) 16 Company and Securities Law Journal 184.

J Farrar, ‘Piercing the Corporate Veil in Favour of Creditors and Pooling of Groups — A Comparative Study’ (2013) 25 Bond Law Review 31.

M Gronow, ‘Insolvent Corporate Groups and their Employees: The Case for Further Reform’ (2003) 21 Company and Securities Law Journal 188.

A Hargovan, ‘Breach of Directors’ Duties and the Piercing of the

Corporate Veil’ (2006) 34 Australian Business Law Review 302. A Hargovan, ‘Piercing the Corporate Veil on Sham Transactions and

Companies’ (2006) 24 Company and Securities Law Journal 436. A Hargovan and J Harris, ‘Piercing the Corporate Veil in Canada: A

Comparative Analysis’ (2007) 28 The Company Lawyer (UK) 58. A Hargovan and J Harris, ‘The Relevance of Control in Establishing an

Implied Agency Relationship Between a Company and its Owners’ (2005) 23 Company and Securities Law Journal 461.

A Hargovan and J Harris, ‘Together Alone: Corporate Group Structures and Their Legal Status Revisited’ (2011) 39 Australian Business Law Review 85.

J Harris, ‘Lifting the Corporate Veil in Industrial Disputes’ (2004) 22 Company and Securities Law Journal 69.

J Harris, ‘Lifting the Corporate Veil on the Basis of an Implied Agency: A Re-evaluation of Smith, Stone and Knight’ (2005) 23 Company and Securities Law Journal 7.

J Harris and A Hargovan, ‘Corporate Groups: The Intersection Between Corporate and Tax Law’ (2010) 32 Sydney Law Review 719.

J Harris and A Hargovan, ‘The Nature of the Corporate Employer’s Duty of Care to Employees: Is it Co-extensive?’ (2004) 32 Australian Business Law Review 367.

M Moore, ‘A Temple Built on Faulty Foundations: Piercing the Corporate Veil and the Legacy of Salomon v Salomon’ [2006] Journal of Business Law 180.

D Noakes, ‘Corporate Groups and the Duties of Directors: Protecting the Employees or the Employer?’ (2001) 29 Australian Business Law Review 124.

S Ottolenghi, ‘From Peeping Behind the Corporate Veil to Ignoring it Completely’ (1990) 52 Modern Law Review 338.

P Prince, J Davidson and S Dudley, ‘In the Shadow of the Corporate Veil: James Hardie and Asbestos Compensation’ (2004) <http://www.aph.gov.au/library>.

V Priskich, ‘CASAC’s Proposals for Reform of the Law Relating to Corporate Groups’ (2001) 19 Company and Securities Law Journal 360.

I Ramsay and D Noakes, ‘Piercing the Corporate Veil in Australia’

http://www.aph.gov.au/library

(2001) 19 Company and Securities Law Journal 250. I Ramsay and G Stapledon, ‘Corporate Groups in Australia’ (2001) 29

Australian Business Law Review 7.

[page 191]

L Sealy, ‘Modern Insolvency Laws and Mr Salomon’ (1998) 16 Company and Securities Law Journal 176.

M Warren, ‘Corporate Structures, the Veil and the Role of the Courts’ (2017) 40 Melbourne University Law Review 371.

S Watson, ‘Who Hides behind the Corporate Veil? Finding a Way Out of the Legal Quagmire’ (2002) 20 Company and Securities Law Journal 198.

Practitioner Journals J Farrar, ‘Bypassing the Corporate Veil’ (1999) 19(2) Proctor 22. M Welland, ‘Lifting the Corporate Veil: Personal Liability of Receivers,

Administrators and Liquidators’ (2000) 12 Australian Insolvency Journal 4.

Practitioner Works H A J Ford, R P Austin and I Ramsay, Ford’s Principles of Corporations

Law, LexisNexis, Australia looseleaf and online, Ch 4. S Presser, Piercing the Corporate Veil, West, Australia, looseleaf and

online (US law).

You will find useful study resources, including quizzes for each chapter, when you go to <http://learning.lexisnexis.com.au>. The quiz is a great tool to help you self-test your knowledge.

http://business.srnh.com.au

3. 4. 5.

10.

11.

12.

13. 14. 15.

16.

17. 18. 19.

20. 21. 22.

It should be noted that the case reflects the company statute law at that time, in 1897, where proprietary companies could incorporate with the abbreviation ‘Ltd’ as part of their name. Today, modern company law requires proprietary companies to have the word or abbreviation ‘Pty’ as part of its name. See, further, Chapter 3 for the distinction between proprietary and public companies. Mr Salomon effectively transferred half of these debentures to a financier, Mr Broderip, as security for a loan of £5000 which Mr Salomon used to support the business. Ballard v Multiplex [2012] NSWSC 426 at [320]. For application of Salomon’s case, see Consolo Ltd v Bennett [2012] FCAFC 120. It should be noted that s 17 of the Insurance Contracts Act 1984 (Cth) overcomes the problem faced by Mr Macaura in Australia by allowing a claim even where the person making the insurance claim does not have an insurable interest at the time of the claim. During legal argument in the case of Andar Transport Pty Ltd v Brambles Ltd (2004) 206 ALR 387; [2004] HCA 28, the legal submissions by the lawyers of Andar Transport Pty Ltd demonstrated a reluctance to accept that an individual may act both as director and employee without unduly affecting the company’s legal capacity. This submission was rejected by the High Court for reasons discussed later in the chapter. For application of this case, see ACN 079 638 501 Pty Ltd (in liq) v Pattison [2012] VSC 445. Kondis v State Transport Authority (1984) 154 CLR 672; [1984] HCA 61; New South Wales v Lepore; Samin v Queensland; Rich v Queensland (2003) 212 CLR 511; [2003] HCA 4. For example, see the similar approach by the Supreme Court in the United Kingdom in VTB Capital Plc v Nutritek International Corp [2013] UKSC 5. P Oh, ‘Veil-Piercing’ [2010] 89 Texas Law Review 81, ‘From its inception veil-piercing has been a scourge on corporate law … [and] has befuddled courts, litigants and scholars alike’. R Thomson, ‘Piercing the Corporate Veil: An Empirical Study’ (1991) 76 Cornell Law Review 1036. For recent empirical studies in the United States, see n 6 above. H Easterbrook and D Fischel, ‘Limited Liability and the Corporation’ (1995) 52 U Chi L Rev 89. VTB Capital Plc v Nutritek International Corp [2013] UKSC 5. Prest v Petrodel Resources Ltd [2013] UKSC 34. Some United States commentators have advocated abolishing veil-piercing due to the dysfunctional nature of the doctrine. See, for example, S Bainbridge, ‘Abolishing Veil Piercing’ (2001) 26 Journal of Corporation Law 479 at 506-14. For a strong counter- view, see R Thompson, ‘Piercing the Veil: Is the Common Law the Problem?’ (2005) 37 Connecticut Law Review 619. Caesar’s Empire Karoake (a firm) v Lam Chuen Ip [2004] HCA 004594/2003 (High Court of Hong Kong Special Administrative Region). See, for example, ss 197, 267, 558G and 588V See, for example, the case cited in n 19. For examples where the court lifted the corporate veil on the basis that the company acted as a ‘front’ to ‘mask’ the real operations, see Gilford Motor Co Ltd v Horne [1933] Ch 935; Jones v Lipman [1962] 1 WLR 832; Kensington International Ltd v Republic of Congo [2006] 2 BCLC 296; [2005] EWHC 2648; and Artedomus v Del Casale [2006] NSWSC 146; Commissioner of Fair Trading v TLC Consulting Services Pty Ltd [2011] QSC 233. See, further, A Hargovan, ‘Breach of Directors’ Duties and the Piercing of the Corporate Veil’ (2006) 34 Australian Business Law Review 302. See, for example, Re Darby [1911] 1KB 95. See, for example, Green v Bestobell Industries Ltd [1982] WAR 1. See, for example, Daimler Co Ltd v Continental Tyre and Rubber Co (Great Britain) Ltd [1916] 2 AC 307.

23.

24.

25.

26. 27.

28.

29.

30.

31.

32.

33.

34.

35.

36.

37.

38.

39.

See, for example, Federal Commissioner of Taxation v Whitford’s Beach Pty Ltd (1982) 150 CLR 355. See, for example, the suggestion in Ascot Investments Pty Ltd v Harper (1981) 148 CLR 337 where the majority judgment articulated this ground but held it did not apply to the given facts. See the dissenting judgment for judicial application of this ground in the context of divorce proceedings and allegations of avoidance of payment of spousal maintenance. See, for example, Smith Stone & Knight Ltd v Birmingham Corp [1939] 4 All ER 116; Re FG (Films) Ltd [1953] 1 WLR 483; Hotel Terrigal Pty Ltd v Latec Investments Ltd (1965) 113 CLR 265; Spreag v Paeson (1990) 94 ALR 679; Australian Liquor, Hospitality and Miscellaneous Workers’ Union, Western Australia Branch v Burswood Catering and Entertainment Pty Ltd (2002) 82 WAIG 544. See case cited in n 19. For commentary on this case, see A Hargovan, ‘Piercing the Corporate Veil on Sham Transactions and Companies’ (2006) 24 Company and Securities Law Journal 436. The decision may have been different if Darby and Gyde satisfied the law relating to promoters’ duties by making full and proper disclosure of the profits and obtaining genuine consent of the shareholders. The law on promoters’ duties is further discussed in Chapter 8. For a critical review of arguments to lift the corporate veil in order to attribute liability to directors for the receipt of property of the company in breach of fiduciary duty, see Cornerstone Property & Development Pty Ltd v Suellen Properties Pty Ltd [2015] 1 Qd R 75; [2014] QSC 265. I Ramsay and G Stapledon, Corporate Groups in Australia, Research Report, Centre for Corporate Law and Securities Regulation, University of Melbourne, Melbourne, 1998. S van der Laan and G Dean, ‘Corporate Groups in Australia: State of Play’ (2010) 52 Australian Accounting Review 121. The reasons for the existence of corporate groups are drawn from a report prepared by the Companies and Securities Advisory Committee, Corporate Groups Final Report, May 2000. S van der Laan and G Dean, ‘Corporate Groups in Australia: State of Play’ (2010) 52 Australian Accounting Review 121. Blumberg contends that allowing corporate groups to nest limited liability within limited liability results in too great a shift of risk away from the corporate group and, further, that the principal justification for limited liability is absent in the case of corporate groups. See P Blumberg, ‘Limited Liability and Corporate Groups’ (1986) 11 Journal of Corporation Law 573. See, for example, s 558V of the Corporations Act which makes a holding company liable for insolvent trading by its subsidiary. For application of the leading authorities, see Australian Competition and Consumer Commission v Prysmian Cavi E Sistemi Energia SRL (No 8) [2014] FCA 376. In Australia, see for example, Premier Building and Consulting Pty Ltd v Spotless Group Ltd [2007] VSC 377 at [346] per Byrne J; Varangian Pty Ltd v OFM Capital Ltd [2003] VSC 444 at [142] per Dodds-Streeton J. Professor Thompson argues that there remains an economic justification for the use of separate corporations despite the recognition of unfair externalisation of risk to outsiders: R Thompson, ‘Piercing the Veil: Is the Common Law the Problem?’ (2005) 37 Conn L Rev 619 at 622. P Blumberg, ‘Accountability of Multinational Corporations: The Barriers Presented by Concepts of the Corporate Juridical Entity’ (2001) 24 Hastings Int’l & Comp L Rev 297 at 303 argues that the entity doctrine ‘is a legal conception that is manifestly anachronistic and bears no relationship to the economic reality’. See, further, P Blumberg, ‘The Transformation of Modern Corporation Law: The Law of Corporate Groups’ (2005) 37 Conn L Rev 605.

40. 41.

42.

43.

44. 45.

46.

47. 48.

49.

50.

51.

52.

53. 54.

55.

56.

57. 58.

For application, see Hawes v Dean [2014] NSWCA 380. I Ramsay and D Noakes, ‘Piercing the Corporate Veil in Australia’ (2001) 19 Company and Securities Law Journal 250. For a collection of legal principles dealing with the issue of control and its relevance for veil-piercing on agency grounds, see McConnell Dowell Constructors (Aust) Pty Ltd v Gas Transmission Services WA (Operations) Pty Ltd [2007] VSC 301; Premier Building and Consulting Pty Ltd v Spotless Group Ltd [2007] VSC 377. See also Al-Shennag v Statewide Roads Ltd [2008] NSWCA 300. For a discussion of the Bird Cameron decision, see A Hargovan and J Harris, ‘The Relevance of Control in Establishing an Implied Agency Relationship Between a Company and its Owners’ (2005) 23 Company and Securities Law Journal 459. For application, see CT Money Pty Ltd v GJ & SG Thompson (No 3) [2012] NSWSC 528. The case affirmed the decision at first instance in BHP Billiton Finance Ltd v Commissioner of Taxation (2009) 72 ATR 746; [2009] FCA 276. The High Court refused leave to appeal on the issue concerning the legal treatment of corporate groups, but granted leave to appeal on other grounds based on taxation issues. Commissioner of Taxation v BHP Billiton Finance Ltd [2010] HCA Trans 229 (appeal against Commissioner of Taxation v BHP Billiton Finance Ltd (2010) 182 FCR 526). See further, A Hargovan and J Harris, ‘Together Alone: Corporate Group Structures and Their Legal Status Revisited’ (2011) 39 Australian Business Law Review 85. For a recent application of this case, see Federal Commissioner of Taxation v Visy Industries USA Pty Ltd (2012) 205 FCR 317; [2012] FCAFC 106; Visy Packaging Holdings Pty Ltd v Commissioner of Taxation [2012] FCA 1195. See, for example, Australian Liquor, Hospitality and Miscellaneous Workers’ Union, Western Australia Branch v Burswood Catering and Entertainment Pty Ltd (2002) 82 WAIG 544. Transcript, ‘ABC 7.30 Report’, 28 July 2004. E Knight, ‘Victory for ASIC over Hardie, but How Big and for How Long?’ 24 April 2009: <business.srnh.com.au>. For a detailed account of the exploitation of the entity doctrine in the James Hardie group, see A Hargovan ‘Corporate Governance Lessons from James Hardie’ (2009) 33 Melbourne University Law Review 984. See further, D Jackson QC, Report of the Special Commission of Inquiry into the Medical and Research Compensation Fund (2004), available at <http://www.cabinet.nsw.gov.au/publications.html>. See further, E Dunn, ‘James Hardie: No Soul to be Damned and No Body to be Kicked’ [2005] Syd L Rev 15 <http://www.austlii.edu.au/au/journals/SydLRev/2005/15.html>. See, further, D Noakes, ‘Dogs on the Wharves: Corporate Groups and the Waterfront Dispute’ (1999) 11 AJCL 27; D Noakes, ‘Corporate Groups and the Duties of Directors: Protecting the Employee or the Insolvent Employer?’ (2001) 29 ABLR 124. For example, see Woolfson v Strathclyde Regional Council (1978) SLT 159. For example, see Pioneer Concrete Services Ltd v Yelnah Pty Ltd (1986) 5 NSWLR 254; 24 Hour Fitness Pty Ltd v W & B Investment Group Pty Ltd [2015] VSCA 216 at [31] (noted criticism and doubted whether DHN was authority in Australia). For a more detailed discussion of the pooling provisions, see J Harris, ‘Corporate Group Insolvencies: Charting the Past, Present and Future of Pooling Arrangements’ (2007) 15 Insolvency Law Journal 78 and J Harris, ‘The Revised Statutory Pooling Provisions’ (2007) 19 Australian Insolvency Journal 28. For a more detailed discussion of the pooling provisions, see J Harris, ‘Corporate Group Insolvencies: Charting the Past, Present and Future of Pooling Arrangements’ (2007) 15 Insolvency Law Journal 78 and J Harris, ‘The Revised Statutory Pooling Provisions’ (2007) 19 Australian Insolvency Journal 28. See Pt 3-90 (consolidation regime). See s 243CA which provides for judicial discretion to lift the corporate veil: ‘Where the

http://www.cabinet.nsw.gov.au/publications.html

http://www.austlii.edu.au/au/journals/SydLRev/2005/15.html

59.

60.

Court is assessing the value of benefits derived by a person (defendant) because of engaging in a particular prescribed narcotics dealing … the Court may treat as property of the defendant any property that … is subject to the effective control of the defendant.’ See s 28 which provides for judicial discretion to lift the corporate veil: ‘In assessing the value of benefits derived by a person from the commission of an offence the court may treat as property of the person any property that … is subject to the effective control of the person.’ A similar statutory provision, for purposes of law enforcement, can also be found under s 53A of the Australian Federal Police Act 1979 (Cth). See Personal Property Securities (Corporations and Other Amendments) Act 2010 (Cth), which commenced from 30 January 2012.

[page 193]

Internal Governance: Constitution and

Replaceable Rules

CHAPTER 6 Creating the corporate constitution

Objects clause Replaceable rules

Section 140 statutory contract Company v Members Company v Members (in another capacity)

Interpretation of the constitution Amending the corporate constitution

[page 194]

Internal Governance: Constitution and Replaceable Rules

Learning Objectives After completing this chapter you should be able to:

Understand the role of the corporate constitution.

Understand the traditional distinction between the memorandum of association and articles of association and its relevance in modern company law.

Discuss the concept and role of replaceable rules.

Outline the source and content of a company’s internal management rules.

Explain the contractual nature of the constitution and replaceable rules, the parties to, and operation of, the statutory contract.

Explain the limitations on altering the corporate constitution.

Key Cases

Ashbury Railway Carriage & Iron Co v Riche (1875) LR 7 HL 653

Bailey v NSW Medical Defence Union Ltd (1995) 184 CLR 399

Eley v Positive Government Security Life Assurance Co (1875) 1 Ex D 20

Gambotto v WCP Ltd (1995) 182 CLR 432

Hickman v Kent or Romney Marsh Sheep-Breeders’ Association [1915] 1 Ch 881

Peters’ American Delicacy Co v Heath (1939) 61 CLR 457

Key Sections

Corporations Act 2001 (Cth) ss 124, 125, 128, 129, 134-136, 140,141,180, 181

[page 195]

Introduction

All organisations are bound both by Australian laws and their own constitutions (effectively, the company’s ‘set of internal rules’). Before July 1998, every company was required to have a memorandum of association and articles of association. These documents were developed in the United Kingdom from 1844 and explained to the outside world the company’s purpose and objectives. The memorandum of association was the external document that covered the name of the company, who was responsible for its incorporation, the amount of capital that could be raised and the limit of liability of its members. Some memoranda even included a list of business activities that the company would or might engage in and this was called the ‘objects clause’.

The articles of association, in contrast to the memorandum, was an internal document, made publicly available by the requirement for all public companies to lodge their articles with the regulator, Australian Securities and Investments Commission (ASIC). The articles were the internal rules regulating the operation of the business, such as the shareholders’ rights, the regulation of meetings, the appointment of directors and other such internal management issues. The articles, concerned with governance rules, are commonly referred to as the ‘by-laws’ of the company.

The previous corporate legislation, prior to the CLERP reforms of July 1998, did have a standard memorandum and articles, which were known as ‘Table A’. However, in practice, very few companies would ever adopt these standard articles, which then caused confusion between investors, creditors and regulators. A common problem would arise within groups of companies, which had different memoranda and articles for each entity within the group.

replaceable rules: refers to statutory provisions, dealing with internal management located in the Corporations Act, which a company is free to adopt or reject in preference for drafting its own set of internal rules.

As part of the Corporations Law Simplification Task Force on corporate law reform, it was proposed that memoranda and articles be abolished. The Company

6.1

Law Review Act 1998 (Cth), as part of the effort to simplify and modernise company law, amended the legislation to convert automatically all existing memoranda and articles into a ‘corporate constitution’. By virtue of the then s 1415 (subsequently repealed) all companies’ documents were converted on 1 July 1998. Many of the important rules that were included in articles of association now exist in the Corporations Act, but with an option to ‘opt-out’ of the law. These rules are called replaceable rules and are listed in the table found in s 141, discussed below. The rationale for such significant changes to the Corporations Act 2001 (Cth) is also discussed below.

Creating the corporate constitution

In July 1998 the need for companies to have separate constitutional documents — memorandum of association and articles of association — was dispensed with by amending the law. All companies have replaced two documents with an optional single document called the corporate constitution. So companies formed before 1 July 1998 (approximately one million) would probably have a memorandum and articles of association, which is now known as the corporate constitution, unless they decided to repeal them. Alternatively, a company could completely rely on the replaceable rules that have been included in the Corporations Act.

Only public companies are required to lodge their corporate constitutions. ASIC can request a copy of the corporate constitution from a proprietary company to be lodged

[page 196]

with ASIC under s 138 or a member of the company may request a copy: s 139. Of course, a company may choose to have a hybrid document which is a mixture of their own corporate constitution and some of the replaceable rules in the Corporations Act.

The Company Law Review Act 1998 has impacted in the following way.

For companies that existed (known as incorporated) prior to 1 July 1998, there were three choices:

do nothing — so that the existing memorandum and articles are consolidated and become the corporate constitution; choose to repeal their corporate constitution and accept the replaceable rules of the Corporations Act; or adopt a corporate constitution by passing a special resolution. The constitution adopted may include replaceable rules and/or their own draft individual provisions.

For companies registered after 1 July 1998, there are just two choices:

do not register a corporate constitution and allow the replaceable rules to automatically apply; or create a specific corporate constitution which will automatically displace the replaceable rules in their entirety or in part (if so stated expressly).

There are three types of companies to whom the general rules above automatically apply differently:

No liability companies — these must have a corporate constitution as there is still a requirement for a mining purposes objects clause: s 112(2). Sole member/director proprietary companies — if the same person is both a director and member of the company, then the replaceable rules do not apply: s 135(1). Such companies with only one member and director have their own specific provisions in the Corporations Act, such as ss 198E, 201F and 202C. Listed companies — as the ASX Listing Rules (LR 15.11) require certain provisions to be contained within a corporate constitution, these companies cannot rely solely on the replaceable rules.

The only remnant from the previous memorandum of association that may continue today is the objects clause. The Corporations Act makes an objects clause mandatory for no liability (NL) companies, but any company is able to place such a clause into its corporate constitution: s 125. This may arise if the company holds a political view, such as only dealing with ethical entities or environmental companies. A practical example is The Body Shop Plc (United Kingdom company). This

6.2

company states in its corporate constitution that the company will not purchase from suppliers that engage in animal testing for cosmetic products.

Objects clause Historical position

The objects clause (also known as a scope of business clause) was part of the memorandum, which described a long list of business activities in which the company might engage. The objects clause had two purposes: first to protect

[page 197]

investors who would know how their money would be invested and, second, to protect creditors so that the company’s capital was not spent in unauthorised activities: Financial Industry Complaints Service Ltd v Deakin Financial Services Pty Ltd [2006] FCA 1805.

ultra vires: a Latin expression which literally means ‘beyond power’. Historically, if a company acted beyond the legal power conferred on it in its constitution, the resultant act was invalid at common law. This is no longer the case due to ss 124-125 of the Corporations Act.

The objects clause unfortunately suffered a number of problems because of the common law concept of ultra vires. The legal meaning of ultra vires is exceeding the powers of the entity. As a consequence, if a company exceeded its contractual powers, as spelt out in its objects clause, the resultant contract was void. In the context of company law, this meant that a company could only carry on the business activities that were stated in the objects clause in the memorandum. In Ashbury Railway Carriage & Iron Co v Riche (1875) LR 7 HL 653, the House of Lords declared that the company did not have the capacity to enter into a contract because it was outside (or ultra vires) its objects clause.

6.3

Ashbury Railway Carriage & Iron Co v Riche (1875) LR 7 HL 653 House of Lords

Facts: The comprehensive objects clause of the company provided that it was formed to make, sell or hire railway carriages and wagons. The company entered into a contract for the financing of the construction of a railway in Belgium. The company later sought to repudiate the contract. When an action for damages was brought against the company, it pleaded the defence that the contract was outside the scope of its objects clause.

Decision: Although the company in general meeting had passed a unanimous resolution to ratify the contract, as it was ultra vires, the contract was not binding on the company.

Apart from causing unfairness to innocent contracting parties, as illustrated above, the objects clause could become very restrictive if a new business opportunity arose. Many companies had objects clauses that continued for many pages, so as to cover virtually every conceivable business activity. There were legal arguments in respect of what was the company’s main purpose of business and attempts by the courts to restrict the expansion of a company’s potential business activities. Parliament deemed it important enough to intervene with a statutory solution to the problem. With the abolition in Australia of the ultra vires doctrine, the objects clause is no longer mandatory: s 125.

Current position Through statutory amendments in 1984, an object clause is now optional. Under s 124 of the Corporations Act, the company has the full capacity of an individual, which allows the corporation to engage in any lawful business activity. This effectively removes the whole concept of ultra vires for corporations,1 and gives the company full contractual capacity.

A company is allowed to place a restriction in its corporate constitution by s 125. For example, this restriction could be used to prevent a cosmetics company from contracting with a business that uses animals for testing products. Despite s 125, the

[page 198]

•

6.4

company, as a separate entity, retains its capacity to contract even though this activity may be in breach of the restriction. Although the company would be bound in the contract, the officers would be most likely to be in breach of their duties for failing to comply with the corporate constitution.

The corporation’s freedom to contract is further supported by ss 128-129, which provide extensive rights of assumptions to those third parties who transact with a company. These include the right to assume (s 129(1)) that a company’s constitution and replaceable rules have been complied with. The right of assumption may be lost if the contracting third party knew or suspected that their assumption was incorrect. The company’s contractual capacity and liability for contracts are discussed further in Chapter 7.

What is the relevance, if any, of the doctrine of ultra vires in modern company law?

Replaceable rules The Explanatory Memorandum to the 1998 reforms offered the following advantages for the introduction of replaceable rules:

reduction or elimination of expenses in keeping corporate constitutions up-to-date; and

the relevant replaceable rules are now located in the relevant place in the Act, rather than in a table. For example, the replaceable rules on meetings are located with the statutory provisions on meetings.

If a company decides not to draft their own constitution, the replaceable rules under s 135 provide the basic standards required for a company to function. For example, the minimum number of members required to be present at a shareholders’ meeting (called the ‘quorum’) would be uncertain without a constitution. Section 249T states the minimum

• • • • • • •

number is two members, but it is a replaceable rule and therefore a corporation could have its own constitution to set the quorum, for example, at a minimum of five members.

Within s 141, there is a table that conveniently lists 39 different replaceable rules covering, for example:

appointment and removal of directors (ss 201G and 203C); powers of directors (s 198A); inspection of books (s 247D); directors’ meetings (ss 248A-G); members’ meetings (ss 249C and 250J); transfer of shares (ss 1072A, 1072B, 1072D, 1072F, 1072G); and procedure for payment of dividends (s 254U).

It should be noted that s 141 merely offers a convenient summary of the replaceable rules, which are, in fact, located throughout the Corporations Act, depending on their topic. For example, the replaceable rules relating to directors’ and members’ meetings are found scattered throughout Ch 2G. These rules can apply to either proprietary

[page 199]

or public companies and can be identified as replaceable by its heading in the Corporations Act.

The advantage of relying on the replaceable rules is that they will always be abreast of statutory change and this will save many companies the difficulty and expense associated with constitutional amendment. However, the replaceable rules have a bias towards proprietary companies, rather than public companies. It is doubtful whether many public companies would wish to rely on such rules, as they are capable of funding the cost of ‘custom-made’ rules, rather than adopting those found under s 141.

Importantly, there is one replaceable rule that is specified as mandatory for public companies but not for proprietary companies. The rule relates to the member’s right to appoint a proxy (an authorised agent) and is

•

found in s 249X. Therefore, s 249X may be adapted or repealed by a proprietary company, but is compulsory for all public companies.

Finally, it is worth noting that the internal management of a company is regulated by s 134, which states that a company must comply with the replaceable rules, the corporate constitution, or a combination of both. The combination of the corporate constitution and replaceable rules has the effect of creating a contract between members and the company: s 140(1). The legal significance of this contractual relationship is discussed below.

The Company Law Review Act 1998 (Cth), in effect from 1 July 1998, introduced significant changes to the source of internal governance rules by abolishing the need for traditional company documents in existence since the nineteenth century, such as the memorandum of association and the articles of association Why do you think such a reform was desirable?

6.5

• • •

Section 140 statutory contract

According to s 140(1), the terms of the corporate constitution bind the company and all its members with the terms of a deemed special statutory contract.2 This contract can be enforced by the company against its members, the officers against the company, and between the members themselves.

Section 140 has the effect of a contract between:

the company and its members; the company and its directors and secretaries; and between the members themselves.

However, any of these parties can orally or implicitly vary the operation (rather than the terms of the contract) of this corporate constitutional contract: Re Aero Marine Consulting Pty Ltd [2003] FCA 1016. For example, where a company’s constitution requires a director’s resignation to be in writing in order for it to be effective, these formalities can be dispensed with by the company by agreement with the director: Latchford Premier Cinema Ltd v Ennion [1931] 2 Ch 409.

[page 200]

The effect of the corporate constitution as a binding contractual document is significant because the constitution sets out the distribution of powers between the members, the directors and the company. It is common for corporate constitutions to adopt replaceable rule s 198A (replaceable rules are discussed further below), which confers the managerial authority of the corporation onto the board of directors. Once the company is formed with such a provision in its constitution, the members are not permitted to tell the directors how to manage the company. This is because the members have already given up this power by purchasing shares in a company with a constitution that provides for directors to exercise managerial power. Therefore, the only way for

6.6

members to direct the board of directors is to alter the constitution to change the distribution of authority. This may involve an amendment to the constitution to require member approval for certain transactions (for example, contracts in excess of $50,000). The inability of members to force the directors to comply with their wishes was determined in Automatic Self-Cleansing Filter Syndicate Co Ltd v Cuninghame [1906] 2 Ch 34, where the majority shareholder passed a resolution directing the company to sell an asset to another company that he controlled. When the directors refused to transfer the asset, the majority shareholder sought court orders to complete the transaction. The court held that to make the orders would be in effect to take away the management power of the board of directors, which under the constitution had been given only to the board. If the shareholder wanted to change the allocation of power, he could only do so by altering the constitution, which required a special resolution, and he did not have 75% of the votes.3

Company v Members These various parties can also enforce any of the rights contained in the corporate constitution. This will often relate to issues such as voting rights, pre-emption rights (a right to be offered any company shares first in the event of them being offered for sale) or, as in the leading United Kingdom case of Hickman v Kent or Romney Marsh Sheepbreeders’ Association [1915] 1 Ch 881, reliance on a dispute resolution clause rather than litigation.

Hickman v Kent or Romney Marsh Sheepbreeders’ Association [1915] 1 Ch 881 Chancery Division (UK)

Facts: The Sheepbreeders’ Association was concerned with the quality control of breeding thoroughbred sheep in the United Kingdom. One of the articles of association of the company included a provision that stated that if a dispute arose between a member and the company, it should be referred to arbitration before going to court. A dispute arose by the expulsion of Mr H from the company (the Association) and he tried to sue in court. The company wished to rely on the statutory

contract in the corporate constitution for the matter to be settled by dispute resolution rather than litigation.

Decision: The court held that the statutory constitutional contract was enforceable by the company against the member, so that a ‘stay’ (a legal halt of the proceedings) to the case should be granted until Mr H had completed the arbitration of the dispute outside the forum of a court of law.

[page 201]

The company in question was able to stay legal proceedings against it until the parties had completed arbitration, as stated in the company’s constitution. This decision was followed by the Supreme Court of Western Australia: see Carew-Reid v Public Trustee (1996) 20 ACSR 443.

The fact that the constitution is a contract means that all parties to the contract (that is, the members, company and the officers) have an additional range of rights and remedies based on contractual law principles. This will typically involve the grant of an injunction to prevent a breach of the statutory contract from continuing, as illustrated in Andrews v Queensland Racing Ltd (2009) 74 ACSR 538; [2009] QSC 338 discussed below.

There is some doubt about whether members are able to claim damages for a breach of the constitution. Clearly, if the member’s loss is merely reflective of a loss of share value (where the breach lowers the value of the shares), then that claim would be prevented by the ‘reflective loss’ principles from Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch 204 (applied in Australia by the Queensland Court of Appeal in Thomas v D’Arcy [2005] 1 Qd R 666). However, if a member could prove that the breach caused them to suffer a loss in their capacity as a member, which is not merely reflective of a lessening of the company’s value, then it appears there is no reason the member could not obtain damages: see McLaughlin v Dungowan Manly Pty Ltd [2010] NSWSC 187. Although the conclusion of the primary judge on this issue was not challenged on appeal in Dungowan Manly Pty Ltd v McLaughlin (2012) 90 ACSR 62; [2012] NSWCA 180, Bathurst CJ reviewed judicial authorities (and without deciding the issue) arrived at a contrary view.

• • •

6.7

Andrews v Queensland Racing Ltd (2009) 74 ACSR 538; [2009] QSC 338 Supreme Court of Queensland

Facts: Andrews was one of five founding directors of Queensland Racing Ltd (QRL). According to its constitution, two directors must retire at the Annual General Meeting (AGM). Accordingly, Andrew (together with another director) was due to retire but Andrew wished to be reappointed. The relevant clause in the QRL’s constitution provided, among other things, that a shortlist of candidates:

be prepared by an Independent Recruitment Consultant (as defined under the constitution); be prepared by reference to the extensive selection criteria appended to the constitution; and contain a minimum of four names.

Following the selection of a maximum of four names by an Independent Consultant acting upon the instruction of the company’s solicitor, Andrews sought an injunction to restrain QRL from acting upon the shortlist on the basis of QRL’s non-compliance with its constitution in the process of selecting directors.

Issue: Was the independence of the consultant compromised by the consultant acting on external instructions and did the consultant make an error in selecting a maximum (rather than a minimum) of four persons on the shortlist when a total of 26 applications were received?

Decision: The court answered both these questions in the affirmative and granted an injunction which prevented QRL from acting on the shortlist.4 It was held that as a director and member of the company, Andrews was entitled to the election or appointment of directors decided lawfully in accordance with the statutory contract. As a member of the company, it was held that Andrews had a personal right to have the selection of directors conducted in the manner prescribed by the company’s constitution.

[page 202]

The court refused the company’s attempt to seek judicial relief from compliance (under the statutory forgiveness provisions in s 1322) on the basis of the substantial injustice it would cause to the member’s personal right to have the shortlist prepared in accordance with the constitution.

Company v Members (in another capacity) However, the constitution does not create a legal relationship between the company and outsiders, and therefore cannot be enforced by an outsider against the company: Eley v Positive Government Security Life Assurance Co (1875) 1 Ex D 20.

Eley v Positive Government Security Life Assurance Co (1875) 1 Ex D 20 Chancery Division (UK)

Facts: A company’s constitution stated that E was to be the company’s solicitor and could only be removed for misconduct. No directors’ or shareholders’ resolution specifically approved of E’s position as company solicitor. E worked as the company’s solicitor for some time and was given shares in the company for completing legal work for the company. The company stopped employing E to do legal work and he sued the company for breach of contract for his position that was protected in theconstitution.

Decision: The corporate constitution could only be enforced by a member in so far as it affected their membership status. As the constitutional provisions for E’s status as company solicitor did not affect him as a member of the company, he could not take action to enforce the constitution to allow him to continue as the company’s solicitor.

This principle has been supported and followed in Morris v Hanley (2003) 173 FLR 83; [2003] NSWSC 42 where the court affirmed that there is no authority to date which could justify the enforcement of the statutory contract by an outsider.4

Hickman v Kent or Romney Marsh Sheepbreeders’ Association [1915] 1 Ch 881 Chancery Division (UK)

… this much is clear — first, that no article can constitute a contract between the company and a third person; secondly, no right merely purporting to be given by an article to a person, whether a member or not, in a capacity other than that of a member, as, for instance, as solicitor, promoter, … can be enforced against the company; and thirdly, that articles regulating the rights and obligations of the members generally as such do create rights and obligations between them and the company …

[page 203]

Interpretation of the constitution

6.8 As illustrated above, the terms of the constitution take effect as a deemed statutory contract between the company and the members. The treatment of the constitution as a contract has an influence on the interpretation of its terms. The corporate constitution will be interpreted as a commercial document so as to give effect (wherever possible) to business efficacy. The meaning of the constitution is to be objectively assessed. In Lion Nathan Australia Pty Ltd v Coopers Brewery Ltd (2006) 236 ALR 561; [2006] FCAFC 144 the court determined that constitutions as ‘commercial documents, must be read as a whole and, where appropriate, having regard to the purpose that, from an objective perspective, they were intended to serve’. The surrounding circumstances that led to the formulation of the constitution may be relevant to assist with interpreting ambiguous clauses in the constitution. However, unlike ordinary commercial documents, it is difficult to imply terms into the corporate constitution. In Australasian Centre for Corporate Responsibility v Commonwealth Bank of Australia (2016) 248 FCR 280; [2016] FCAFC 80, it was held that there was no basis to imply a term into the constitution of the Commonwealth Bank of Australia allowing members to make an advisory resolution to the board about how management reported on carbon emissions generated by projects funded by the CBA.

The range of surrounding circumstances to aid interpretation of the statutory contract in companies is, however, perhaps more limited than in other cases involving commercial contracts: HNA Irish Nominee Ltd v Kinghorn (2010) 78 ACSR 553; [2010] FCAFC 57. This is because, as recognised by the court in that case, constitutions, and replaceable rules, can be amended at different times and in different circumstances. In addition, the members involved in the creation of the constitution at particular times may change. According to the court, such factors suggest that ordinarily primacy must be given to the objective intention gathered from the language in which the constitution is expressed rather than to other features of the surrounding facts in which its provisions may have been made. Such an approach was favoured by the court in Sumiseki Materials Co Ltd v Wambo Coal Pty Ltd [2013] NSWSC 235 which emphasised that unless the words under consideration are ambiguous, regard may not be had to surrounding circumstances.5

6.9

•

Amending the corporate constitution

The corporate constitution can be legally altered by passing a special resolution, which requires 75% majority vote by the members and following a basic procedure. Alterations are allowed subject to a number of statutory and common law safeguards, so as to protect minority shareholders from the majority shareholders who may abuse their position of power: see Chapter 19. The primary restrictions on the alteration of the constitution are contained in the Corporations Act:

[page 204]

Section 140(2) — prohibition of any imposition of further liability on members by requiring additional shares to be taken up or increasing a member’s liability to contribute capital; members will only be bound by the alteration if they agree inwriting:6 Ding v Sylvania Waterways Ltd (1999) 46 NSWLR 424. Sections 232-234 — protection of minority members against oppression or the majority acting in an unfairly prejudicially manner: see 19.22-19.27.

Ding v Sylvania Waterways Ltd (1999) 46 NSWLR 424 New South Wales Supreme Court

Facts: SW owned submerged land in an adjoining residential development. The shareholders of SW consisted of owners of blocks of land adjoining the waterway. SW’s constitution originally provided that SW could charge a once only membership fee. SW’s constitution was amended in 1995 to provide that SW could charge the membership fee as an annual levy to pay for the maintenance of the waterway. Ding had been a member prior to 1995 and objected to paying the new annual levy.

Decision: A shareholder is not bound to contribute more money than the initial price of their membership (for example, share price or membership fee). The court found that the effect of s 140(2) was to overturn any special contract with regard to increased liabilities through a constitutional amendment without written consent.

special resolution:

a resolution passed by at least 75% of the votes cast by the members at a meeting. Compared to an ordinary resolution, this is a higher threshold. An ordinary resolution requires a majority of members present and voting to be passed.

The statutory right to alter the corporate constitution stems from s 136.7 A special resolution has to be passed by the members entitled to vote at a general meeting. The company will put forward the motion in a notice of the meeting, which must be provided at least 21 days in advance. The exact words of the change to the constitution must also be provided in the notice of the meeting. At the meeting, at least 75% of the votes cast (not of the total number of members) is required. Votes cast include all the votes of members present and the proxy votes that are available to the proxy holders (usually the chair of the company or other member- nominated person): see 12.24-12.25. A public company must also file the amended constitution with ASIC.

A sole member and director company wishing to amend its constitution need only sign a record of the amendment, which will become the minutes of the deemed meeting: s 249B.

There are no specific statutory protection provisions for minority shareholders to prevent alteration to the constitution. However, there is a general minority protection provision in ss 232-234, which may be used. Sections 232-234 afford a variety of remedies to a member in the event that the affairs of the company or an act or omission are oppressive, unfairly prejudicial or are unfairly discriminatory, or operate against the interests of the company as a whole. The company may also be wound up for a similar reason: s 461. Alternatively, a member can imply a separate ‘special contract’ based on the terms of the constitution. This argument was successful in the High Court case of Bailey v NSW Medical Defence Union Ltd.

[page 205]

Bailey v New South Wales Medical Defence Union Ltd (1995) 184 CLR

399 High Court of Australia

Facts: Dr B was a member of the New South Wales Medical Defence Union Ltd (NSWMDU), an organisation that provided professional negligence insurance to its members. The NSWMDU was a company limited by guarantee and its corporate constitution had an objects clause that provided the purpose of the company was to indemnify its members against claims. In the early 1970s, Dr B treated a patient who would sue him years later for negligence. In 1982 the corporate constitution of the NSWMDU was amended to give the company the discretion to refuse to provide assistance to its members at any time. In the mid-1980s Dr B was sued by a patient for treatment in the early 1970s and he received assistance from the NSWMDU. However, before the case had finished Dr B died and the NSWMDU’s assistance ceased. The estate of Dr B was ordered to pay the patient over $500,000 and the executor, Mrs Bailey, sought to enforce the NSWMDU’s constitution so as to pay these costs.

Decision: The NSWMDU and Dr B were parties to a contract of insurance (a special contract) that required the company to indemnify Dr B’s estate. The majority of the High Court explained the basis of a special contract as follows:

… ‘whilst the [constitution] of a company regulates the relations of the members amongst themselves as members and with the company, [the existence of a constitution does not] preclude a member from contracting individually with the company upon terms which may or may not be defined by reference to the [constitution]’. The company can always alter its constitution, but in doing so cannot escape an action for breach of contract. As the majority stated: ‘a company cannot unilaterally vary its contracts by altering its [constitution] unless that is the basis upon which the contract was made’. In this case the parties could not have intended that the obligation to indemnify could be unilaterally withdrawn years after the injury that gave rise to the claim actually arose.

The need to protect minority shareholders from detrimental changes to the constitution was identified in Allen v Gold Reefs of West Africa [1900] 1 Ch 656. The United Kingdom court held that for an amendment to the company’s constitution to be valid, it must be ‘bona fide for the benefit of the company as a whole’. This principle was followed (although criticised) in the Australian High Court case of Peters’ American Delicacy Co v Heath (1939) 61 CLR 457. However, this concept was uncertain and imprecise, and could cause ambiguities in the law by way of interpreting what the artificial company collectively thought about an issue.

Peters’ American Delicacy Co v Heath (1939) 61 CLR 457 High Court of Australia

Facts: A number of special resolutions were passed at a members’ meeting of Peters’ altering the

constitution, so as to provide that the dividend distributions could be paid to members with shares rather than cash. The value of each member’s dividend distribution was calculated in proportion to the amount paid up on each member’s shares, rather than according to the value of shares held by the member. Several members (including H) challenged the validity of the resolutions altering the constitution on the basis that the amendments were not bona fide for the benefit of the company as a whole. This was the test that had been used in Allen v Gold Reefs of West Africa.

Decision: The chief reason for denying an unlimited effect to widely expressed powers such as that of altering a company’s [constitution] is the fear or knowledge that an apparently regular exercise of the power may in truth be but a means of securing some personal or

[page 206]

particular gain, whether pecuniary or otherwise, which does not fairly arise out of the subjects dealt with by the power and is outside and even inconsistent with the contemplated objects of the power …

However, in 1995, the High Court revisited this principle and stated that the appropriate standard for any amendment to a corporate constitution should be ‘the proper purpose’ test.

Gambotto v WCP Ltd (1995) 182 CLR 432 High Court of Australia

Facts: Mr Gambotto, a minority shareholder with a 0.1% interest in WCP Ltd (15,898 shares out of 16,980,031), brought an action to prevent an amendment to WCP’s constitution. The amendment would permit Industrial Equity Ltd, which owned 99.7% of WCP Ltd, to compulsorily purchase (expropriate) Mr Gambotto’s shares.

Decision: The High Court rejected the ‘bona fide for the benefit of the company as a whole’ test presented by Allen v Gold Reefs of West Africa. Rather, the High Court held that the amendment of WCP’s constitution was invalid as it was not for a proper purpose, even though WCP Ltd could show a substantial saving in administrative costs. Further, the High Court held that an alteration to a company’s constitution to facilitate the expropriation of the shares of the minority would not be valid simply because it was made for a proper purpose; it must also be fair in the circumstances. According to the court, it would be proper to expropriate shares if it would save the company from significant detriment or harm. This would occur, for example, where the shareholder to be bought out was competing with the company or where the shareholder’s membership of the company would result in the loss of its business.

The court held that it is for the majority shareholders to prove that the amendment to the constitution is valid.

Thus, any repeal or modification of a corporate constitution that permits

•

the compulsory acquisition of minority shareholders’ shares will only be valid if exercised for a proper purpose and be fair in the circumstances. However, the High Court in Gambotto held that an alteration to the constitution that does not involve the expropriation of shares or rights will only be invalid if the alterations are ultra vires, by going beyond any purpose contemplated by the constitution, or if deemed oppressive.8 The effective date of the constitutional amendment will be the date of the resolution or that date specified by the resolution: s 137.

It should be noted that, subsequently, the Corporations Act was amended to provide a general method of compulsory acquisition of shares (under Ch 6A) provided that minimum conditions (including at least 90% ownership of the shares in that class) are met.

In Gambotto’s case, the High Court stated that a share in a company ‘is more than a capitalised dividend stream’ in that it confers property rights. What is the significance of holding shares in a company? What type of ownership role do shareholders play (if any)?

1. 2.

4. 5. 6. 7.

9. 10.

[page 207]

Revision Questions

What were the articles of association? Why were the articles of association replaced? What were they replaced with? How does ultra vires work? Why was it a problem for the objects clauses of some companies? What are replaceable rules and where can they be found? What benefits are associated with using the replaceable rules? How can a company alter its corporate constitution? How are shareholders’ rights protected from oppressive changes in the corporate constitution? What is the ‘proper purpose’ test in amending the corporate constitution? Between which parties is the corporate constitution enforceable? What are the benefits of the corporate constitution being a contract between the members and the company?

Problem Question Eliza is a major shareholder in Dunkirk Ltd. Eliza is concerned that the company wishes to maintain the old fashioned ‘memorandum of association’ which has been prepared for Dunkirk Ltd, because the objects clause as drafted limits the objects of the company to the development, manufacture and sale of instantaneous transport devices. Eliza believes that the experimental and developmental work that Alison is doing (and the further technology which may be developed as the full implications of Alison’s work are realised) may have spin-offs into a number of related areas. For example, Alison’s work may lead to breakthroughs in optical fibre technology, clothing fibres, cardiovascular research, metallurgy and a number of related areas.

Eliza is concerned that the narrowness of the memorandum may hamper not only the

2. 3.

company’s ability to move into related commercial areas, such as leasing of those transport devices, but also the development and commercial exploitation of similar forms of transport which the company’s ongoing research may uncover. She has read that there is no legal reason to have a memorandum or articles, even if they are now called a corporate constitution. The company’s research may also expose potentially exploitable products or secret processes in other area,s such as clothing fibres and metallurgy. When Eliza raised these concerns with the company’s lawyers, they advised her that this was the standard form for their companies, and that there was no cause for concern.

Advise Eliza of the company’s position and also explain how the replaceable rules idea may help the company in the future.

Guidelines for Answering Problem Questions

When answering a problem question concerning legal issues relating to the corporate constitution, we suggest that the following method may be helpful:

It is important to determine whether the company has stated objects or are there any limitations on the powers of the company in the constitution.

[page 208]

If so, check to see if ultra vires is a relevant issue. If so, and the contract is ultra vires, determine whether the company can avoid enforcement of the contract. Consider the relevant statutory provisions (ss 125 and 126) of the Corporations Act. Once an ultra vires act has been determined, what are the consequences of such an act? If the question is concerned with the enforcement of the corporate constitution, determine whether the parties fall under the statutory contract in s 140. If so, discuss the legal effect of the corporate constitution with

reference to the common law and the Corporations Act. Check to see if the corporate constitution has been lawfully altered. If not, identify the common law or statutory limitation on the freedom to alter and the remedies available (for example, the test in Gambotto’s case or s 232 dealing with oppressive conduct).

Wang and Erin want to ensure that the SCPL internal rules are appropriate and flexible enough as the business grows. They also want to make sure that they are protected in the event of a dispute arising between them.

Wang attempts to draft a constitution, but a friend tells him that he can just rely on the Replaceable Rules in the Corporations Act and if he finds these aren’t suitable, he can just vote to change them.

Erin agrees that there will be little profit during the first two years and so there will be no dividend rights until the third year; however Erin wants to ensure that if the business is very profitable in the first two years, that equivalent dividends can be made up in the third year.

Erin trusts Wang (who has been her close friend for many years) but she also wants to protect herself if they have a falling out at some point. Wang is concerned about Erin potentially selling her stake in the business at some future point and him losing control of the business that he is putting all of his energy into.

Review the list of replaceable rules and formulate a list of RR that you believe should be included in the SCPL constitution. What else should be included in the SCPL constitution? Is it possible for Wang to simply change the constitution by voting his shares?

Further Reading

Academic Journals E Boros, ‘How Does the Division of Power Between the Board and the

General Meeting Operate?’ (2010) 31 Adelaide Law Review 169. R Grantham, ‘Company Directors and Compliance with the Company’s

Constitution’ (2003) 20(4) New Zealand Universities Law Review 450. S Kevans, ‘Oppression of Majority Shareholders by a Minority?’ (1996)

18 Sydney Law Review 10.

V Mitchell, ‘The High Court and Minority Shareholders’ (1995) 7 Bond Law Review 58.

P Omar, ‘Powers, Purposes and Objects: The Protracted Demise of the Ultra Vires Rule’ (2004) 16 Bond Law Review 93.

J Paterson, ‘AFL Club Membership: A Glorified Stadium Entry Ticket, or a Genuine Ownership Stake in the Club?’ (2010) 28 Company and Securities Law Journal 507.

[page 209]

I Ramsay and B Saunders, ‘What Do You Do with a High Court Decision You Don’t Like? Legislative, Judicial and Academic Responses to Gambotto v WCP Ltd’ (2011) 25 Australian Journal of Corporate Law 112.

R Walton, ‘Gambotto v WCP Ltd: A Justified Reassertion of Minority Shareholders’ Rights or Unwelcome Step Back in Time?’ (2000) 12 Australian Journal of Corporate Law 20.

Practitioner Journals R Chesterman, ‘Oppression by the Majority — Or of it?’ (2004) 25(2)

Australian Bar Review 103. S Fridman, ‘Gambotto v WMC Ltd: An Analysis of the High Court

Decision’ (1995) 6 Butterworths Corporations Law Bulletin 119. S Hempel, ‘Is Your Company’s Constitution Up to Date?’ (2003) 54

Keeping Good Companies 612. J Hill and W J Koeck, ‘In the Firing Line — Directors and Statutory

Derivative Action’ (2000) 52 Australian Company Secretaries 21. D Pereira and P Cleary, ‘Amending Your Constitution — Important

Developments for Responsible Entities’ (2009) 61 Keeping Good Companies 329.

S Rusiti, ‘Shareholder Agreements — Setting the Terms of a Business Relationship’ (2008) 46(9) Law Society Journal (NSW) 49.

Practitioner Works

P Brown (ed), Australian Corporation Practice, LexisNexis, Australia, looseleaf and online, Chs 7-8.

H A J Ford, R P Austin and I Ramsay, Ford’s Principles of Corporations Law, LexisNexis, Australia, looseleaf and online, Chs 4-5.

You will find useful study resources, including quizzes for each chapter, when you go to <http://learning.lexisnexis.com.au>. The quiz is a great tool to help you self-test your knowledge.

Some judges still use the phrase ultra vires in respect of the capacity of the directors: Darvall v North Sydney Brick & Tile Co Ltd (1988) 14 ACLR 474. See also S Woodwood, ‘Ultra Vires Over Simplified — Changes to Company Powers’ (1997) 15 Company and Securities Law Journal 162. This can be contrasted with the position of internal rules used by unincorporated associations, which do not generally form a specific contract between the members. For discussion on legislative history of s 140(1), see Wambo Coal Pty Ltd v Sumiseki Materials Co Ltd [2014] NSWCA 326. See further Capricornia Credit Union Ltd v ASIC (2007) 159 FCR 69; [2007] FCAFC 79; Australasian Centre for Corporate Responsibility v Commonwealth Bank of Australia [2015] FCA 785. In a further action in Andrews v Qld Racing Ltd (No 2) [2009] QSC 364, the director successfully sought a court order for a new shortlist of candidates to be prepared by a newly appointed independent consultant. This approach was upheld on appeal in Wambo Coal Pty Ltd v Sumiseki Materials Co Ltd [2014] NSWCA 326. For application, see John Melick Investments Pty Ltd v Harbour View Mansions Pty Ltd [2016] NSWSC 1318. For discussion on the operation of s 136, see Wambo Coal Pty Ltd v Sumiseki Materials Co Ltd [2014] NSWCA 326. The impact of the Gambotto case has caused much academic debate: see I Ramsay and B Saunders, ‘What Do You Do with a High Court Decision You Don’t Like? Legislative, Judicial and Academic Responses to Gambotto v WCP Ltd’ (2011) 25 Australian Journal of Corporate Law 112; R Walton, ‘Gambotto v WCP Ltd: A Justified Reassertion of Minority Shareholders’ Rights or Unwelcome Step Back in Time?’ (2000) 12 Australian Journal of Corporate Law 20; S Fridman, ‘Gambotto v WMC Ltd: An Analysis of the High Court Decision’ (1995) (6) Butterworths Corporations Law Bulletin 119.

[page 211]

Corporate Liability: Tort, Crime and Contract

CHAPTER 7 Primary and secondary liability

Primary liability Secondary liability

Corporate liability in tort Primary liability in tort Vicarious or secondary liability in tort

Corporate criminal liability Primary or direct criminal liability at common law Secondary or statutory vicarious criminal liability Corporate criminal liability under the Criminal Code

Remedies for corporate misconduct Civil remedies under the Corporations Act Criminal remedies under the Corporations Act Civil penalties under the Corporations Act

[page 212]

Corporate liability in contract Common seal Need for authority Usual authority of company officers Indoor management rule Are there any statutory protection rules for third parties?

[page 213]

Corporate Liability: Tort, Crime and Contract

Learning Objectives After completing this chapter you should be able to:

Understand how a company may be liable for tort, crime and contract.

Appreciate the role of agency in determining corporate liability.

Distinguish between primary and secondary liability for corporate tort and crime.

Explain how a company can be liable in tort and crime under the concept of vicarious liability.

Explain how a company can commit a crime either directly or indirectly by aiding and abetting an individual.

Appreciate the difference between civil and criminal penalties and the hybrid form, civil penalties, under the Corporations Act 2001 (Cth) and the remedies for corporate misconduct.

Understand how a company is contractually bound under principles of agency law.

Distinguish between the concepts of actual authority and apparent authority.

Explain the operation of, and rationale for, the indoor management rule (also known as the rule in Turquand’s case) and its limitations.

Explain the statutory assumptions under the Corporations Act (s 129)

that assist the outsider when contracting with the company and limitations (s 128).

Key Cases

ABC Developmental Learning Centres Pty Ltd v Wallace [2006] VSC 171

ASIC v Adler (2002) 41 ACSR 72

Bugge v Brown (1919) 26 CLR 110

Freeman & Lockyer v Buckhurst Park Properties (Mangal) Ltd [1964] 2 QB 480

Hamilton v Whitehead (1988) 166 CLR 121

H L Bolton Engineering Co Ltd v T J Graham & Sons Ltd [1957] 1 QB 159

[page 214]

Hollis v Vabu Pty Ltd (2001) 207 CLR 21; [2001] HCA 44

Lennard’s Carrying Co Ltd v Asiatic Petroleum Co Ltd [1915] AC 705

Lloyd v Grace Smith & Co [1912] AC 716

Meridian Global Funds Management Asia Ltd v Securities Commission [1995] 2 AC 500

Moore Stephens (a firm) v Stone Rolls Ltd (in liq) [2009] UKHL 39

Northside Developments Pty Ltd v Registrar-General (1990) 170 CLR 146

Royal British Bank v Turquand (1856) 6 El & Bl 327; (1856) 119 ER 886

Tesco Supermarkets Ltd v Nattrass [1972] AC 153

Key Sections

Corporations Act 2001 (Cth) ss 79, 124, 126, 127, 128, 129, 198A, 198D, 1308, 1308A, 1312, Pts 9.4B, 9.5

Criminal Code Act 1995 (Cth) Pt 2.5

[page 215]

Introduction

Section 124 of the Corporations Act 2001 (Cth) reinforces the common law position established in Salomon v Salomon & Co Ltd [1897] AC 22 that the corporation is a separate legal entity. As a result, as discussed earlier in Chapter 5, the law in many ways treats corporations as though they are individuals, with their own legal rights and responsibilities. Personal characteristics can be attributed to corporations for the purposes of civil and criminal liability, including knowledge and state of mind: Tesco Supermarkets Ltd v Nattrass [1972] AC 153.

As such, a corporation may enter into a contract in its own name and, if it fails to adhere to the contract, the corporation may be sued (and found liable) for breaching that contract: Ferguson v Wilson (1866) LR 2 Ch App 77. It is a necessary corollary that, if the other party to the contract does not fulfil its contractual obligations, the corporation may sue for that breach. Similarly, if a corporation conducts its business negligently, it may be sued in tort. The corporation that contravenes the criminal law is equally liable for those crimes. A corporation is liable for all of its actions under the civil and criminal law.

However, the corporate world is not that simple. Corporations are inanimate legal persons, which require individual human beings (for example, directors and employees) to operate them on a day-to-day basis. Indeed, s 198A states that the business of a company is to be managed by or under the direction of the directors. The company’s power to enter into contracts, for example, may be exercised by an individual acting on the company’s behalf: s 126. In the same way, individuals on whom the company has bestowed its powers (directors) may delegate these powers to other individuals (employees): s 198D. It can be seen how quickly the waters of corporate liability can become muddied as authority and responsibility are shifted from the company to its individual directors and, in turn, down the line to management and lower-level employees.

In seeking to determine where liability rests for the acts of a corporation, it is important to distinguish between the liability of the company itself, the liability of its employees and agents themselves, and those situations where the

7.1

• •

7.2

company is taken to be responsible for the illegal actions of its employees and agents. There are a wide range of laws (legislation and case law) involved beyond the Corporations Act which can have a significant impact on corporate and individual liability, such as the Crimes Acts (State and Federal) and the Occupational Health and Safety Acts and the Fair Work Act 2009 (Cth).

Primary and secondary liability

Attribution of knowledge to a principal from an agent and to a company from an employee has its conceptual and theoretical difficulties at times: Bunnings Group Ltd v CHEP Australia Ltd [2011] NSWCA 342. When we accept that corporations are simply a legal fiction — a mere entry on a piece of paper — it becomes difficult to believe that a company can actually commit a wrong itself, whether civil or criminal. This confusion is not eased by the basic principle of corporate law, which makes corporations legal persons in their own right. Thus, in one sense, a company is very much capable of committing civil and criminal wrongs, while in another, it is incapable of doing anything without the intervention of individual human beings. Since the act or omission of a corporation that constitutes a wrong, in fact, will be

[page 216]

the act or omission of a natural person, the liability of a corporation will always be derivative, rather than original. Despite this, the corporate law establishes two forms of liability:

primary; and secondary.

Primary liability A corporation’s liability is primary (or personal) when the corporation is deemed to have committed a wrong itself. A registered company is a legal ( juristic) person by virtue of s 124 and the House of Lords decision

in Salomon v Salomon & Co Ltd [1897] AC 22. This means that a corporation is capable of legally engaging in conduct even where someone else (such as the board of directors) is physically performing the action. A common approach to fix corporate liability is to equate the legal personality given to a company with the personality of an individual with all human attributes: HL Bolton (Engineering) Co Ltd v T J Graham & Sons Ltd [1957] 1 QB 159.

H L Bolton Engineering Co Ltd v T J Graham & Sons Ltd [1957] 1 QB 159 Court of Appeal (UK) Denning LJ

A company may in many ways be likened to a human body. It has a brain and a nerve centre which controls what it does. It also has hands which hold the tools and act in accordance with directions from the centre. Some of the people in the company are mere servants and agents who are nothing more than hands to do the work and cannot be said to represent the directing mind or will. Others are directors and managers who represent the directing mind and will of the company, and control what it does.

The state of mind of these managers is the state of mind of the company and is treated by the law as such. So you will find that in cases where the law requires personal fault as a condition of liability in tort, the fault of the manager will be the personal fault of the company. … So also in the criminal law, in cases where the law requires a guilty mind as a condition of criminal offence, the guilty mind of the directors or the managers will render the company itself guilty.

In determining primary liability for a company, the House of Lords in Lennard’s Carrying Co Ltd v Asiatic Petroleum Co Ltd [1915] AC 705 adopted the organic approach to attribution which necessitates locating those people in the company whose mental state can constitute the directing mind and will of the company. This case, in which the organic theory originated, is discussed further below.

Generally, the organic theory of attribution states that those people entrusted with a high degree of responsibility for the management of the company can be said to represent the company’s directing mind and will. The organic theory, underpinned by agency law principles,1 allows the company to be identified with the individuals who are in charge and control. Consequently, people such as directors and other executive officers of the company can be said to be acting as the company rather

7.3

than for the company. In this way, their state of mind is attributed to the company

[page 217]

and is determinative of the company’s liability for a civil wrong or crime. In Tesco Supermarkets Ltd v Nattrass [1972] AC 153 at 170, Lord Reid illustrated the operation and potential consequences of the organic approach when describing who represents the ‘directing mind and will’:

He is not a servant, representative, agent or delegate. He is an embodiment of the company or, one could say, he hears and speaks through the persona of the company, within his appropriate sphere, and his mind is the mind of the company. If it is a guilty mind then that guilt is the guilt of the company.

The common law has grappled with the issue of the liability of a director for his or her company’s conduct at different times on various bases: Australian Executor Trustees Limited v Propell National Valuers (WA) Pty Ltd [2011] FCA 522. In practice it is often difficult to establish that the company’s actions are the same as those of the humans involved unless it is a small corporation, with only one shareholder and director. But it is possible for the corporation to be in breach of the law, especially if the statute specifies that it is a ‘strict liability offence’ and thus no intention is required to be proved by the prosecution. Also, the directors or senior managers maybe involved in a contravention of the law, which is similar to conspiracy to commit a crime.

Secondary liability

vicarious liability: liability imposed on one person for the wrongful act of another on the basis of the legal relationship between them, for example, that of employer and employee.

A corporation’s liability is secondary when the corporation is made liable for the acts or omissions of a natural person (usually, an employee or agent). This is more commonly known in civil law matters as vicarious liability. Thus, secondary liability is not a question of whether or not the corporation itself committed an act or omission; rather, it is a matter of whether the corporation is responsible for an act or omission committed

by a person with whom the corporation has a special relationship.

tort: a civil obligation (such as the duty not to be negligent) that can generate a right to damages where it is breached. A duty owed under tort law is called a ‘tortious obligation’.

At first glance, this distinction appears relatively straightforward. However, it has a different operation depending on whether the wrong committed is a tort, or a breach of contractual rights or is criminal in nature. In some instances, the corporation’s primary and secondary liability appear inextricably entwined and the determination of one may need consideration of the other.

For instance, in relation to those tortious and criminal actions that require proof of fault or a guilty mind on behalf of the company, in determining whether the company managers, who may be deemed to represent the ‘directing mind and will’ of the company: H L Bolton Engineering Co Ltd v T J Graham & Sons Ltd [1957] 1 QB 159.

Once the facts have been uncovered, it becomes a question of law for the court to determine whether the natural person carrying out the act in question is acting as an employee or agent of the company (in which case, the corporation may face vicarious (secondary) liability) or whether the person is acting as the directing mind and will of the company (in which case, the person’s acts become the acts of the company and primary liability attaches to the company).

Thus, in determining the personal or primary liability of a corporation, it will remain important to consider the actions of the natural persons who give the corporation its direction and life. Conversely, when the natural person is an agent or representative of the company, the question only then arises whether the corporation is vicariously liable for the misdeeds of these persons. A corporation

[page 218]

can be ordered to pay damages in a civil case (which can also be covered by an insurance policy) or in a criminal case, the statute may specify that

7.4

the fine is equal to five times that which an individual person is required to pay as a maximum.

In the interests of clarity, it is important to consider the operation of corporate liability in each of the distinct spheres of tort, criminal law and contract.

Corporate liability in tort

The law of torts operates to rectify the financial loss suffered by a victim by transferring the loss to the person found to have caused it. Companies may be liable in tort in much the same way as individuals. There are many types of civil actions, such as torts, but the most common is the tort of negligence. To that end, for example, a person who suffers loss as a result of the company’s negligence may sue a company.

As stated earlier, a corporation may be found to be personally (or primarily) liable in tort; and this is determined by the relationship between the corporation and the natural person responsible for the tortious act. Thus, where the negligent individual is found to be the directing mind and will of the company (usually where the individual is a senior manager or director), the individual’s acts are deemed to be the acts of the company and the company will be held to be negligent.

Alternatively, a corporation may face secondary or vicarious liability for the acts of its employees or agents. In such cases, there is no suggestion or pretence that the tortuous conduct is that of the company; rather, the act remains that of the individual and the company is deemed to be responsible for the acts of that individual by virtue of the relationship between the company and the individual.

Quite often in modern commercial law, statutes deem employers to be (vicariously) liable for the acts of their agents and employees, which occur while the employee is acting within the scope of his or her employment. For example, in relation to financial services and markets, s 769B of the Corporations Act states that:

… conduct engaged in on behalf of a body corporate by a director, employee or agent of the

7.5

body, within the scope of the person’s actual or apparent authority … is taken … to have been engaged in also by the body corporate.

This statutory limitation requiring the conduct to have been within the scope of the employee’s employment largely reflects the common law position.

Thus, it can be seen that whether a company is primarily liable or vicariously liable depends on the nature of the relationship between the company and the individual who engages in the tortious conduct. It is worthwhile considering primary and secondary tortious liability in light of specific case examples, so as to properly illuminate the difference between the two.

[page 219]

Primary liability in tort In most cases where a tort has been committed in the course of a company’s business activities, liability will be imposed vicariously on the

company. Thus, whether or not the company is directly or primarily liable is a relatively uncommon consideration. However, where a company is accused of being knowingly involved in or assisting a contravention of the law by others, for example, it becomes important to consider the actions of the company itself. In order to do so, the courts have developed a process of looking at the actions of those natural persons who occupy a sufficiently senior position within the company so as to allow the courts to deem that person’s acts be the acts of the company itself. Alternatively, many statutory provisions relate directly to the actions of the company and proof of a breach (or innocence) will require reference to the conduct of the company itself.

One of the developments in tort law has been the concept of proportionate liability. This means that previously the plaintiff (person who brings the civil action) could sue a variety of defending parties (the company, directors, managers and employees) and all could be held liable. In reality, the company tended to have insurance, thus they paid the whole claim to the plaintiff. However, a series of tort cases resulted in major compensation claims for each state and territory, as well as the federal government introducing legislation that has significantly changed the previous law. This limits what each defendant can be required to pay in compensation. In New South Wales, the Civil Liability Act 2002 (NSW) was passed which states the process the court can follow to apply a percentage to determine how much each defendant will be required to pay of the final compensation. Speaking generally, where the proportionate liability legislation applies, in order for a claimant to recover 100% of the claimant’s

[page 220]

loss, the claimant must sue each and every wrongdoer who contributed to that loss. No wrongdoer is liable to the claimant for more than that wrongdoer’s share of responsibility for the loss.

Lennard’s Carrying Co Ltd v Asiatic Petroleum Co Ltd [1915] AC 705 House of Lords

Facts: The appellant company, Lennard’s, owned a ship, which had a history of problems with its boiler engines. Another company, John M Lennard & Sons Ltd, the managing director of which was Mr Lennard, managed the appellant company. Mr Lennard was also a director of the appellant company. The ship was to deliver a load of petroleum to the respondent company, Asiatic; however, the ship’s engines failed, causing the ship to run aground. On doing so, the ship sustained damage such that vapour from the petroleum on board escaped and was ignited by the ship’s combustion engines. The resultant explosion caused the loss of the ship and the cargo. Asiatic sought damages for the loss of the cargo of the ship, which was due to be delivered to them. While the appellant company (Lennard’s) acknowledged that the ship was unseaworthy, they sought to rely on a statutory defence to the claim of damages, which allowed the ship’s owners to avoid liability for damage arising without their fault or privity (knowledge). The appellant company argued further that, even if the loss occurred with the knowledge or as a result of the fault of Mr Lennard, this was not the fault or knowledge of the appellant company, and therefore the defence should apply.

Decision: The House of Lords determined that Mr Lennard was the directing mind and will of the appellant company and, therefore, Mr Lennard’s knowledge of the cause of the accident was the knowledge of the company. The House of Lords held that the defence did not apply and Asiatic was entitled to claim damages from the appellant company.

Viscount Haldane LC explained the court’s reasoning as follows:

Did what happened take place without the actual fault or privity of the owners of the ship who were the appellants? My Lords, a corporation is an abstraction. It has no mind of its own any more that it has a body of its own; its active and directing will must consequently be sought in the person of somebody who for some purposes may be called an agent, but who is really the directing mind and will of the corporation, the very ego and centre of the personality of the corporation. … whatever is not known about Mr Lennard’s position, this is known for certain, Mr Lennard took the active part in the management of the ship on behalf of the owners, and Mr Lennard, as I have said, was registered as the person designated for this purpose in the ship’s register. Mr Lennard therefore was the natural person to come on behalf of the owners and given full evidence not only about the events of which I have spoken, and which related to the seaworthiness of the ship, but about his own position and as to whether or not he was the life and soul of the company. For if Mr Lennard was the directing mind of the company, then his action must, unless a corporation is not to be liable at all, have been an action of the company itself.

It can be seen, therefore, that where the court determines that a natural person is the directing mind and will of a corporation, the conduct and mind of the natural person is the conduct and mind of the corporation. The attribution of corporate liability, based on the organic theory of liability, was closely examined by the United Kingdom House of Lords in Moore Stephens (a firm) v Stone Rolls Ltd (in liq) [2009] 1 AC 1391; [2009] UKHL 39. In this case, Mr Stojevic operated and owned a company, Stone & Rolls Ltd (S&R) as a one person company. The five Law Lords were

7.6

actually split three to two as to whether the auditors (MS) should be held liable for negligence for the fraud committed by Mr Stojevic and his company (S&R), in respect of a major bank loan of millions of pounds. It was held

[page 221]

that S&R could not sue successfully as the person that committed the fraud (Mr Stojevic) was actually the company’s ‘sole actor’. In this way, the majority decision attributed the dishonesty of Mr Stojevic (his ‘mind and will’) to his company (S&R) and held that the company could not take advantage of its own fraud. The judgment examined many of the leading judicial authorities discussed above and also matters of policy. Lord Brown made a clear statement as to one man companies (at [197]):

Here, not merely was Mr Stojevic ‘the directing mind and will of the corporation, the very ego and centre of the personality of the corporation’, but Stone & Rolls Ltd (S&R) was, even on the most exacting definition of the term, a one-man company. As Mr Sumption QC put it, uncontentiously, at the beginning of his printed case: ‘[Mr Stojevic] was as completely identified with the company as it is possible for a human agent to be. He had sole control over the company’s every act. He was the company’s sole beneficial owner. There were no independent or innocent directors whom Mr Stojevic had to deceive to make the fraud happen. There were no innocent shareholders relying upon the auditors to monitor the management. There were no employees’.

Vicarious or secondary liability in tort Apart from primary liability, a company can also be liable for the actions of its human representatives through secondary liability.

Where the actions of its human agents do not personify the company, but are sufficiently connected to the company, this would be adequate to make the company liable through reliance on the concept of vicarious liability. The Supreme Court of Canada in John Doe v Bennett [2004] 1 SCR 436 (per McLachlin CJ) stated the rationale of vicarious liability as follows (at [20]):

Vicarious liability is based on the rationale that the person who puts a risky enterprise into the community may fairly be held responsible when those risks emerge and cause loss or injury to members of the public. Effective compensation is a goal. Deterrence is also a consideration.

The hope is that holding the employer or principal liable will encourage such persons to take steps to reduce the risk of harm in the future.

In Scott v Davis (2000) 204 CLR 333; [2000] HCA 52, the High Court discussed the origins of vicarious liability. There, the court noted that vicarious liability grew from the mediaeval times, during which the master of the house was deemed responsible (legally liable) for the acts of his children, servants and wife. Times have certainly changed, however, as five Justices of the High Court observed in Sweeney v Boylan Nominees Pty Ltd (2006) 226 CLR 161; [2006] HCA 19, whatever the logical and doctrinal imperfections and difficulties in the origins of the law relating to vicarious liability, the concept is deeply rooted.2

It is essential to distinguish in one’s mind the concept of direct liability, dealt with above, from the concept of vicarious liability.3 Direct liability operates so as to deem the actions of certain senior people to be the actions of the corporation itself — in so doing, the corporation is held to have committed the tortious action in its own right. By contrast, vicarious liability does not seek to perform some kind of metaphysical transfer of physical actions; rather, the liability of the corporation stems from the law regarding the

[page 222]

corporation to be responsible for the action of certain people within the control of the corporation. That is, the doctrine of vicarious liability does not require the corporation to be at fault for liability to attach; it is sufficient that a person for whom the corporation is responsible has committed the wrong. By definition, therefore, direct liability and vicarious liability are mutually exclusive — as recognised by the Appellate Court in Christian Youth Camps Ltd v Cobaw Community Health Services Ltd [2014] VSCA 75.

The common law has developed these principles so that today, essentially, an employer is liable for all actions of its employees that are committed within the scope of the employee’s employment. However, there must be a sufficient connection with the duties and responsibilities of the employee as employee, for the employer to be vicariously liable.

An employer will not be vicariously liable for a wrongful act if it is committed by the employee in what is often described as being ‘upon a frolic of his own’: Morris v C W Martin & Sons Ltd [1966] 1 QB 716; State of New South Wales v Lepore; Samin v Queensland; Rich v Queensland (2003) 212 CLR 511; [2003] HCA 4.

The early English case of Lloyd v Grace Smith & Co [1912] AC 716 illustrates how the doctrine of vicarious liability operates.

Lloyd v Grace Smith & Co [1912] AC 716 House of Lords

Facts: The respondent firm of solicitors (Grace, Smith & Co) employed a man named Mr Sandles who was their manager of conveying and their managing clerk. He had authority to arrange and negotiate real estate (land and property) sales and to carry them out, and also to receive deeds for safe custody. The appellant, Mrs Lloyd, approached the firm of solicitors with a view to getting advice in relation to two cottages she owned. Mrs Lloyd received advice from Mr Sandles to sell the two cottages and to return at a later date with the deeds to the properties. On her return, Mrs Lloyd was given two documents to sign, which were neither read over nor explained to her. Mrs Lloyd signed the forms assuming that the documents were necessary to allow the sale of the cottages to be arranged. In fact, the documents were a conveyance transferring the ownership of the two properties to Mr Sandles. Some months later, this fraud was uncovered by the firm of solicitors and Mrs Lloyd sued to recover the title deeds to one of her properties and the value of the other property, which Mr Sandles had sold in the meantime. The firm of solicitors denied that Mrs Lloyd had ever instructed the firm, arguing that she had merely conveyed title to her properties to Mr Sandles. Mrs Lloyd denied having conveyed the properties to Mr Sandles and alleged that she was induced to execute the conveyance by the fraud of Mr Sandles, who was acting in the course of his employment and within the scope of his authority as managing clerk of the firm.

Decision: The firm of solicitors was responsible for the fraud committed by their representative in the course of his employment.

As Lord MacNaughton said:

The general rule is, that the master is answerable for every such wrong of the servant or agent as is committed in the course of the service and for the master’s benefit, though no express command or privity of the master be proved. To that statement of the law no objection of any sort can be taken. But it is a very different proposition to say that the master is not answerable for the wrong of the servant or agent, committed in the course of the service, if it be not committed for the master’s benefit.

The High Court discussed Lloyd v Grace Smith & Co in Bugge v Brown

(1919) 26 CLR 110 and expanded on the operation of the doctrine of vicarious liability in

[page 223]

Australia. The High Court emphasised that it does not matter if the employer did not authorise, permit, sanction or know of the actual unlawful acts or omissions of the employee. The relevant question is whether the employee was acting within the scope of his or her employment, and the employee may be doing so even when acting without express authorisation from his or her employer. Although these cases seem very old, they are still valid authority for the laws discussed.

Vicarious liability was revisited by the High Court in Hollis v Vabu Pty Ltd (2001) 207 CLR 21; [2001] HCA 44. Among other things, the court reiterated the principle that an employer’s vicarious liability does not extend to the tortious acts of independent contractors. The case also contains an in-depth discussion of how the law determines whether a person is an employee or an independent contractor for the purposes of vicarious liability.

Hollis v Vabu Pty Ltd (2001) 207 CLR 21 High Court of Australia

Facts: Vabu Pty Ltd operated a courier business called Crisis Couriers, which engaged individual couriers to deliver parcels. The appellant (Hollis) was injured by the negligent act of an individual bicycle courier in the course of making a delivery. The courier was unable to be identified personally but was wearing a uniform which indicated that he had been engaged by the company. The appellant sued the company. Mr Hollis argued that Vabu Pty Ltd was vicariously liable for the acts of the bicycle courier as the couriers were employees. Mr Hollis argued in the alternative that even if the couriers were not employees, the couriers were the agents of Vabu Pty Ltd and therefore vicarious liability should be imposed. Vabu Pty Ltd denied liability on the grounds that the bicycle couriers were not employees, but rather independent contractors.

Decision: The majority found for the appellant, finding the bicycle couriers to be employees of Vabu Pty Ltd and therefore the company to be vicariously liable for the damage caused. As the majority said:

It has long been accepted, as a general rule, that an employer is vicariously liable for the tortious acts of an employee but that a principal is not liable for the tortious acts of an

7.7

independent contractor. In general, under contemporary Australian conditions, the conduct by the defendant of an enterprise in which persons are identified as representing that enterprise should carry an obligation to third persons to bear the cost of injury or damage to them which may fairly be said to be characteristic of the conduct of that enterprise.

It can be seen from these cases that companies can be held liable for the civil actions of their employees and agents. This could be for the simple fact that companies tend to have insurance policies, which provide them with much ‘deeper pockets’ to pay claims than individuals may have. The courts are keen to hold someone legally responsible when there has been a clear breach of duty, especially if it is to an innocent third party, as evidenced in the following judicial passage:4

… we are of the view that an innocent victim of an employee’s tort should, under ordinary circumstances, be compensated. In this regard, the employer is usually the

[page 224]

person best placed and most able to provide effective compensation to the victim. In our view, making the employer vicariously liable is not only a practical solution, but also fair and just. After all, a person who employs another to advance his own interests and thereby creates a risk of his employee committing a tort should bear responsibility for any adverse consequences resulting therefrom. This view is buttressed by the consideration that the employer may redistribute the cost of providing compensation for his employee’s torts through mechanisms such as insurance.

It should be noted that the distinction that the common law draws between independent contractors and employees for purposes of establishing vicarious liability has, however, been the subject of judicial criticism as observed by five justices of the High Court in Leighton Contractors Pty Ltd v Fox (2009) 240 CLR1; [2009] HCA 35.

Corporate criminal liability

Before discussing the manner in which a company can attract criminal liability, it is important to understand one of the fundamental concepts underlying criminal law. Whether or not a person is guilty of a criminal offence rests in large part on the Latin maxim actus non facit reum, nisi mens sit rea. That is, the act itself does not constitute guilt unless done

with a guilty intent.

From the above maxim, it can be seen that, as a general rule, there are two key elements to all criminal offences:

the guilty act (actus reus) representing the physical element of the offence; and the guilty mind (mens rea) representing the mental element of the offence.

Simply put, for a criminal offence to be proven, a person’s criminal conduct must be accompanied by the intention to carry out that act. Logical, simple examples are not difficult to find: a person carrying a gun, which accidentally discharges, killing another person cannot be guilty of murder unless it can be proven that the person carrying the gun intended to cause the death of the second person. If this intention is absent, then there can be no offence of murder committed, although another criminal offence such as manslaughter may be found.

When the law seeks to impose criminal liability on corporations, the situation is not, however, quite so logical or simple. Corporations, by their very nature, appear to function outside the sphere of the criminal justice system. When one considers both corporations and the operation of the criminal justice system, a multitude of questions immediately arises. How can an inanimate being like a corporation ever possess the necessary guilty mind? How can society punish or deter a corporation? Can society ever really need to be protected from a corporation? How can a corporation be sent to jail?

These kinds of questions have taxed judges, lawyers and academics since the inception of the corporation. In an effort to answer these questions, corporate criminal liability has developed in a similar way to the civil law. That is, in many ways,

[page 225]

corporate criminal liability is largely analogous to the liability of

• •

companies in tort. Most particularly, as in the civil law discussed earlier, a corporation can be held either:

primarily (directly) liable for criminal offences; or liable under a statute for the criminal actions of its employees (secondary or vicarious liability).

Absent a statutory provision to the contrary, vicarious liability has been rejected as a means of establishing mens rea in crimes requiring proof of that element (as otherwise criminal guilt could be found without the offender possessing the necessary intent): Presidential Security Services of Australia Pty Ltd v Brilley (2008) 73 NSWLR 241; [2008] NSWCA 204.

Generally speaking, there are three categories of corporate criminality.

First, a company may be convicted of a crime that is committed by the directors or employees of the company, who occupy a sufficiently senior position within the company so as to be deemed to be acting as the company.5 It can be seen that, based on the organic theory, this is similar to the ‘directing mind and will’ concept under the law of tort.

non-delegable statutory duty: a legal obligation that cannot be satisfied by delegating responsibility to someone else.

Second, a company may be convicted of a crime by virtue of its failure to perform a non-delegable statutory duty. These two categories are forms of direct liability.

The third category of crime for which a company may be convicted is the acts of their employees within the scope of their employment. This third category can be seen as reminiscent of secondary or civil vicarious liability; however, it is only possible under statutory criminal law.

Once again, much rests on the position held by the natural person vis-à- vis the company. In determining whether a person is acting as the company or for the company, the principles discussed by Denning LJ in H L Bolton Engineering Co Ltd v T J Graham & Sons Ltd [1957] 1 QB 159 are directly applicable: see Tesco Supermarkets Ltd v Nattrass [1972] AC 153.

Under the Corporations Act, criminal proceedings may be commenced by either ASIC or the Commonwealth Director of Public Prosecutions: s

7.8

1315. Such proceedings must be commenced within five years of the commission of the offence, unless the leave for a later commencement is obtained from the Minister. The Commonwealth Treasurer, as a Federal Minister, has overall responsibility for corporations and securities law.

Primary or direct criminal liability at common law Criminal liability may attach to a corporation directly, in the sense that the corporation is taken to have committed a crime itself.6 At common law, the traditional viewpoint has been that, in determining direct corporate criminal liability, the court will turn to the individuals in charge of the company. Where that person is in a position to be acting as the corporation itself, then that person’s conduct and mental state is taken to be that of the corporation.

[page 226]

Tesco Supermarkets Ltd v Nattrass [1972] AC 153

House of Lords

I must start by considering the nature of the personality which by a fiction the law attributes to a corporation. A living person has a mind which can have knowledge or intention or be negligent and he has hands to carry out his intentions. A corporation has none of these: it must act through living persons, though not always one or the same person. Then the person who acts is not speaking or acting for the company. He is acting as the company and his mind which directs his acts is the mind of the company. There is no question of the company being vicariously liable. He is not acting as a servant, representative, agent or delegate. He is an embodiment of the company or, one could say, he hears and speaks through the persona of the company, within his appropriate sphere, and his mind is the mind of the company. If it is a guilty mind then that guilt is the guilt of the company.

Thus, in general, corporate criminal law adopts the mental state of the person who is an embodiment of the company as the mental state of the company itself. In this way, the court held in S & Y Investments (No 2) Pty Ltd v Commercial Union Assurance Co of Australia Ltd (1986) 82 FLR 130 that a company can be guilty of manslaughter (death caused by accident) where its directing mind (director or senior manager with guilty intent) kills a person during the course of their employment.

However, a strict application of the organic theory would mean that the conduct of junior employees and managers below the top tier of control would be unlikely to be held to constitute conduct of the company itself. In other words, a company may escape criminal liability if the wrongful conduct was caused by the actions of low-level employees.

[page 227]

This undesirable limitation, under the organic theory of liability, has been recognised by the courts. In Meridian Global Funds Management Asia Ltd v Securities Commission [1995] 2 AC 500, the Privy Council held that the acts and knowledge of persons who could not be identified with a company’s directing mind and will could still be attributed to the company. In addition to the organic approach, the Privy Council recognised the need for the courts, in exceptional cases, to develop ‘special rules’ of attribution in criminal cases where failure to do so would frustrate the policy of the statute under consideration.

Meridian Global Funds Management Asia Ltd v Securities Commission [1995] 2 AC 500 Privy Council (UK)

The company’s primary rules of attribution … are usually sufficient … In exceptional cases, however, they will not provide an answer … the court must fashion a special rule of attribution for the particular substantive rule. This is always a matter of interpretation …

. [if] intended to apply to a company, how was it intended to apply? Whose act (or knowledge, or state of mind) was for this purpose intended to count as the act of the company? One finds the answer … by applying the usual canons of interpretation, taking into account the language of the rule (if it is a statute) and its content and policy.

The decision in ABC Developmental Learning Centres Pty Ltd v Wallace [2006] VSC 171 relied on and applied the key statement, reproduced above, in Meridian Global Funds Management Asia Ltd v Securities Commission to dispel the idea that for all offences the person with whom a corporation is identified must be its directing mind and will.7 The Supreme Court of Victoria responded to the need to fashion a special rule of attribution to achieve corporate liability for the criminal conduct of its junior employees.8

ABC Developmental Learning Centres Pty Ltd v Wallace (2006) 161 A Crim R 250; [2006] VSC 171 Victorian Supreme Court

Facts: ABC Developmental Learning Centres Pty Ltd (ABC), part of the ABC group of companies which are one of the largest providers of child care in the world, was successfully prosecuted in the Magistrates Court at Sunshine by the Department of Human Services, through its officer Joanne Wallace, for breach of two relevant provisions of the Children’s Services Act 1996 (Vic).

The prosecution arose in the following circumstances. In 2003, a child just under the age of three escaped from the child care centre owned by ABC and wandered into the surrounding streets while staff were inattentive. The child was returned unharmed to the child care centre by a neighbour. The Acting Magistrate held that these events contravened the Children’s

[page 228]

Services Act. Section 26 required ABC, as proprietor of the centre, and its staff, to ensure that every reasonable precaution was taken to protect the child from any hazard likely to cause injury. Section 27

required ABC and its staff to ensure that children were adequately supervised. The Acting Magistrate found that the child was able to escape because ABC staff failed to observe and prevent him from scaling a playground fence with a 90 cm square foam cube that he pushed 12 metres for this purpose. The two child care workers, caring for a group of 12 children during the temporary absence of a third worker, had failed to take reasonable precautions to protect the child from hazards and to adequately supervise him. The Acting Magistrate attributed liability and held that the failures of the two staff were ultimately the failures of the company. Consequently, ABC was fined $200 without conviction on the inadequate supervision charge under s 27 of the Act.

On appeal to a single judge of the Victoria Supreme Court, ABC contended that the finding of the Acting Magistrate was wrong in law. The fundamental legal question for determination by the appellate court in ABC was whether crimes arising out of the conduct of low-level employees can be attributed to the company, resulting in the criminal liability of the company?

Decision: Bell J in the Victoria Supreme Court dismissed the appeal and held that ABC was guilty of the offences by reason of the failures of its staff. Central to the decision was his Honour’s reliance on the legal approach adopted in Meridian to determine corporate liability for the actions of employees in the context of the criminal law. Adopting Meridian as a framework for analysis, Bell J held that in the case of junior employees (as in this appeal) the company can still be identified with their actions if this is required by the terms of the offence and the achievement of the policy objectives of the enabling statute. Thus, to determine if attribution of liability to ABC was possible, it was imperative to turn the judicial spotlight on the terms of the offence and to identify the policy considerations underpinning the regulatory offences.

After careful consideration of the nature of the charges brought against ABC and the policy of the Act with reference to the Second Reading Speech in Parliament by the Minister, Bell J found that the protection, supervision and care of young children by child care service providers were paramount considerations in the legislation. His Honour noted that such young children under the age of six, left within the care of service providers for potentially long periods, are an extremely vulnerable group in our community. Based on these relevant factors, his Honour concluded that the policy considerations underpinning the offences ABC were charged with:

… are designed to protect children and are an important component of the scheme by which the policy of the Children’s Services Act is implemented. A children’s service proprietor that is a company can only protect children from hazards and supervise them through employees … the terms of the offence and the policy of the legislation are such that the actions of such persons [the employees,] done within the scope of their work can be attributed to the company. If their actions do not comply with standards expressed [above], it can count as non-compliance by the company for the purposes of a prosecution.

The judicial approach adopted by the Victorian Supreme Court in ABC Developmental Learning Centres represents a variant of the organic theory (‘directing mind and will’ legal approach) and is an express endorsement of the ‘special rules’ of attribution as characterised by the Privy Council in Meridian Global Funds Management Asia Ltd. Both cases are a reminder that there is judicial readiness to find that parliament can make employees liable even if they are not the directing mind and will of the company.

•

7.9

[page 229]

What are the limitations or weaknesses of the organic theory?

Accessorial liability The general rule that the acts and intentions of those who are the directing mind and will of the company are to be attributed to the company, does not apply where those who are the directing minds and will have themselves committed a crime against the company: R v Gomez [1993] AC 442.

For instance, the High Court of Australia has reaffirmed the principle that a company may not have consented to the criminal actions of its sole director and shareholder, even though the director/shareholder was the embodiment of the company itself: Macleod v R (2003) 197 ALR 333; [2003] HCA 24.

Therefore, to summarise and simplify, the general rule is that where a company is accused of a crime, the acts and intentions of those who are the directing minds and will of the company are to be attributed to the company. This rule does not apply where the crime committed by the directing minds and will of the company is a crime against the company itself.

accessorial liability: within the context of this section, refers to a director being liable for dishonestly assisting the company to commit a breach of the law.

The Australian courts have taken the general rule and its separate legal entity foundation to the next logical conclusion. Where a corporation is found to have committed a crime, the natural person who performed the prohibited physical conduct may also be charged as an accessory to the company’s crime. This concept of accessorial liability in the corporate sphere was expounded in R v Goodall (1975) 11 SASR 94. of the law.

R v Goodall (1975) 11 SASR 94 South Australian Supreme Court

[M]y view is that the logical consequence of Salomon’s Case … is that the company, being a legal entity apart from its members, is also a legal person apart from the legal personality of the individual controller of the company, and that he in his personal capacity can aid and abet what the company speaking through his mouth or acting through his mind may have done.

Thus, the law of corporate criminal liability acknowledges that the company and those who control it are strictly separate persons. At the same time, the law accommodates this fiction on the proviso that, in examining the company’s criminal conduct and will, one must turn to the acts and will of those natural persons in control of the company. It follows, therefore, that the company is directly liable for criminal offences where a natural person sufficiently senior so as to be acting as the company performs the prohibited physical act. This is not vicarious liability; the natural person is neither charged with, nor is taken to have committed, the crime. The crime is solely the company’s.

This idea that it is the company that has committed the crime permits the natural person whose actions are those of the company to be found guilty of aiding or abetting the company’s crime.

The High Court has considered the distinction between a company’s criminal acts and the accessorial liability of corporate officers in Hamilton v Whitehead (below).

[page 230]

Hamilton v Whitehead (1988) 166 CLR 121 High Court of Australia

Facts: Mr Whitehead was the managing director of a company charged with a criminal offence under

the Companies (Western Australia) Code (the predecessor to the Corporations Act). He was charged with being knowingly concerned in (that is, an accessory to) the company’s commission of these offences. The respondent argued that, as Mr Whitehead had committed the criminal acts complained of on behalf of the company, he could not also be an accessory to his own acts. The applicant argued that the criminal acts were, in fact, committed by the company and, therefore, Mr Whitehead could be an accessory to the company’s crime.

Decision: The court found for the applicant and ordered that the matter be remitted to the Supreme Court of Western Australia.

The company’s direct liability was explicitly stated by the court in the following terms:

[The Companies Code] speaks directly to the company. It is not a case of a company being made liable for an act performed by a servant of the company on its behalf. The liability imposed is direct, not vicarious.

...

[T]here can be no doubt, on the facts of the present case, that the respondent, in placing the advertisement and in dealing with those who replied to it, was the company. He was its managing director and his mind was the mind of the company. The company therefore was liable as a principal for the breaches … of the Code. The liability was direct, not vicarious.

One can only fully comprehend the concept of direct criminal liability by accepting the legal fiction that treats companies as separate legal entities. A strict application of the doctrine espoused in Salomon’s case [1897] AC 22 is necessary for the criminal law to co-operate with corporate law.

Finally, direct liability may be imposed on a company by statute. Laws made by parliament may prohibit a company from acting in certain ways (for example, dumping chemicals in Sydney Harbour) and impose penalties on the company (usually fines) if such action is taken. These are usually determined as ‘strict liability offences’.

It is also common for federal and state statute laws, such as those governing occupational health and safety issues, to impose direct criminal liability onto directors and officers for corporate fault. For example, the Work Health and Safety Act 2011 (NSW) imposes a direct duty on directors and officers to exercise due diligence to ensure, as far as reasonably practicable, that a company’s activities are undertaken safely. This duty, and potential criminal liability, exists irrespective of whether the company itself commits an offence. Although this statute still imposes criminal liability on directors directly, it is an improvement from the predecessor statute where directors were deemed to be guilty of corporate offences with a reverse onus of proof on the director to show that they were not in a position to influence the conduct of the company

7.10

or that they acted with due diligence. This was a more severe type of direct liability regime which was the subject of much criticism and law reform efforts.

As a result, the New South Wales Government passed the Miscellaneous Acts Amendment (Directors’Liability) Act 2012 (NSW), which commenced on 11 January 2013, in order to introduce a nationally consistent reform of legislation regulating the criminal responsibility of directors and officers for corporate offences. The Act amends

[page 231]

over 40 statutes so that directors and officers are no longer automatically liable for offences committed by companies unless they acted as an accessory and facilitated that particular offence. Instead of a director having to prove their innocence, the prosecution must establish the guilt of the director. These changes reduce the number of New South Wales legislative provisions which impose criminal liability on directors for corporate offences from over 1000 to less than 150. A key exception, however, applies to certain environmental offences where, on public policy grounds and based on a serious risk of significant damage to the environment, the New South Wales government has chosen to retain the reverse onus of proof approach.

Secondary or statutory vicarious criminal liability The common law traditionally has not recognised vicarious liability for criminal offences. The reasoning for this stance was discussed in Tesco Supermarkets Ltd v Nattrass (below).

Tesco Supermarkets Ltd v Nattrass [1972] AC 153 House of Lords

[T]he concept [of vicarious liability] has no general application in the field of criminal law. To constitute a criminal offence, a physical act done by any person must generally be done

by him in some reprehensible state of mind. Save in cases of strict liability where a criminal statute, exceptionally, makes the doing of an act a crime irrespective of the state of mind in which it is done, criminal law regards a person as responsible for his own crimes only. It does not recognise the liability of a principal for the criminal acts of his agent: because it does not ascribe to him his agent’s state of mind.

[Lord Morris held that ‘in general, criminal liability only results from personal fault. We do not punish people in criminal courts for the misdeeds of others’.]

While this is the longstanding common law position, parliament has long since changed this in statute law. The situation is different where mens rea does not form part of the offence. Corporate vicarious criminal liability is governed by statute law in Australia. Parliament may create offences of strict or absolute liability, and it has long been accepted that, in such a case, the application of vicarious liability principles is not inhibited: Presidential Security Services of Australia Pty Ltd v Brilley (2008) 73 NSWLR 241; [2008] NSWCA 204. This is illustrated in the judicial quote in the key statement in the Mousell Bros case below.

Mousell Bros Ltd v London and North Western Railway Co [1917] 2 KB 836 Kings Bench Division

To ascertain whether a particular Act of Parliament has that effect [by imposing vicarious corporate liability] or not, regard must be had to the object of the statute, the words used, the nature of the duty laid down, the person upon whom it is imposed, the person by whom it would in ordinary circumstances be performed, and the person upon whom the

[page 232]

penalty is imposed … Once it is decided that this is one of those cases where a principal may be liable criminally for the act of his servant [employee], there is no difficulty in holding that a corporation may be a principal. No mens rea [guilty mind] being necessary to make the principle liable, a corporation is in exactly the same position as a principal who is not a corporation.

Many statutes simply provide that employers are liable for the conduct of their employees, which includes criminal conduct. To return to the example given earlier, s 769B provides for both civil and criminal

•

vicarious liability in relation to offences against those found in Ch 7 of the Corporations Act:

[C]onduct engaged in on behalf of a body corporate by a director, employee or agent of the body, within the scope of the person’s actual or apparent authority … is taken … to have been engaged in also by the body corporate.

...

If … it is necessary to establish the state of mind of the body, it is sufficient to show that a director, employee or agent of the body … had that state of mind.

Similarly, other examples of modern legislation which impose corporate criminal liability without looking to the directing mind of the company include such provisions as:

Section 84 of the Competition and Consumer Act 2010 (Cth) expressly imputes to the company the conduct and the state of mind of every director, servant or agent of the company acting within the scope of the person’s actual or apparent authority. Section 85 of the Proceeds of Crime Act 1987 (Cth) provides that where a director, servant or agent of the company commits the offence of money laundering, the company is deemed to be liable. Section 8ZD of the Taxation Administration Act 1953 (Cth) allows for a company to be liable for a taxation offence by expressly imputing the intention of the servant or agent who committed the act to the company.

In R v Australasian Films Ltd (1921) 29 CLR 195, a company was charged with offences under the Customs Act 1901 (Cth) because it was responsible for acts done by its agents during the course of employment. The company’s agents had acted with intent to defraud the revenue.

Due to this dual liability of the natural person representative of a company and the company itself, the Corporations Act provides for penalties appropriate to each offender. Naturally, a corporation, being a fictional entity, cannot be jailed. Section 1312 provides that where a corporation is convicted of an offence against the Corporations Act, the maximum fine that the court can impose is equal to five times the maximum amount that could be imposed on a natural person convicted of the same offence.

• There is no one answer to the question whether the criminal actions of employees (or directors or contractors) of a company can be counted as the actions of the company. Do you agree? Discuss.

[page 233]

Strict or absolute corporate criminal liability forms another bases of liability. Strict liability arises where the proof of mens rea (guilty mind) is not an essential element of the statutory offence. Wrongful conduct (actus reus), or the omission to perform to certain prescribed standards, is sufficient to give rise to corporate liability. Under this approach, the law is not fixated on the corporate hierarchy of the employees. Statutory offences under children welfare and safety laws, for failure to provide adequate supervision of children, are good examples of this approach.

In the ABC case discussed earlier, the Victorian Court of Appeal9 did not rely primarily on attribution to determine corporate liability. Instead, in the alternative, the Appeal Court held that the statute imposed absolute corporate criminal liability on the child care proprietor. Liability was determined on the basis that the Children’s Services Act 1996 (Vic) imposed a duty of care on the child care operator (ABC Ltd) which could not be delegated to another person. In this way, by failing to meet the required standards of care, ABC’s liability for breach was absolute. The reasoning of the Court of Appeal is captured in the following extract:

Under the [Children’s Services Act], the proprietor has a duty to ensure — that is, make certain — that a certain state of affairs exists viz adequate supervision of all children … [The] section is framed to achieve a result. Unless there is adequate supervision, a company is in breach. Liability under the section does not depend on any failure by the company itself, meaning by those persons who ‘embody the company’. If it is proved that there was not adequate supervision, it is immaterial where in the organisation the failure occurred.

Corporate criminal liability under the Criminal Code

7.11 The Criminal Code Act 1995 (Cth) (the Criminal Code) was enacted to clarify the principles of criminal liability under Commonwealth statutes. It does not apply to state laws.

The Criminal Code talks in terms of ‘physical’ and ‘mental’ elements that constitute an offence. Physical elements are the criminal conduct (the actus reus as explained at 7.7), while the mental elements relate to the concept of the guilty mind (mens rea). Chapter 2 of the Criminal Code is titled ‘General Principles of Criminal Responsibility’. Section 1308A of the Corporations Act makes this chapter directly relevant and applicable to corporate law. That is, Ch 2 of the Criminal Code applies to all offences against the Corporations Act.

Of particular importance is Pt 2.5 of the Criminal Code, titled ‘Corporate Criminal Responsibility’.10 Part 2.5 of the Criminal Code contains s 12.2 which imposes liability on corporations in the following way:

If a physical element of an offence is committed by an employee, agent or officer of a body corporate acting within the actual or apparent scope of his or her employment, or within his or her actual or apparent authority, the physical element must also be attributed to the body corporate.

While appearing familiar, this attribution to the company of the criminal acts of its employees, agents and officers is a marked change from the common law position

[page 234]

espoused in Tesco Supermarkets Ltd v Nattrass [1972] AC 153. Lord Reid’s judgment in Tesco (extracted above at 7.10) specifically excluded direct corporate liability where the natural person was acting as a servant, representative, agent or delegate. Rather, the test for direct liability in Tesco was whether the natural person was ‘an embodiment of the company’.

That is, at common law, a corporation could be held directly liable for the criminal acts of its officers or staff who were in a sufficiently senior position to effectively be an embodiment of the company. Contrast that with the position under the Criminal Code, which imposes direct liability

•

on corporations for the criminal acts of all its employees, provided the employee is acting within the scope of his or her employment.

Therefore, the Criminal Code combines elements of the civil law with the criminal law to produce a very broad test for direct criminal liability.

Additionally, when determining whether a corporation had the requisite mental state, the Criminal Code offers some new benchmarks. A corporation will be found to have the required guilty mind if it ‘expressly, tacitly or impliedly authorised or permitted the commission of the offence’. In line with the common law, the Criminal Code determines that such an authorisation or permission will have been given by the corporation if the board of directors or other upper level manager either granted the authorisation or permission or carried out the relevant criminal conduct themselves. That is, a senior person (effectively, the directing mind and will of the company) will be deemed to represent the mind and will of the company under the Criminal Code.

However, the Criminal Code expands on the common law in relation to establishing the guilty mind of the corporation. Beyond merely looking to the mind of its board and senior management, the Criminal Code permits examining whether the corporation had a corporate culture that directed, encouraged, tolerated or led to the commission of the offence. Alternatively, a corporation will be deemed to have authorised or permitted the commission of an offence (and thereby be guilty of it itself) if it failed to create and maintain a corporate culture that required compliance with the relevant provision. The Criminal Code also imposes penalty units (as does the Corporations Act) for contraventions of specific offences. A penalty unit is $210 for all offences committed after 1 July 2017: s 4AA of the Crimes Act 1914 (Cth). The penalty regime is discussed further in 7.14.

How does the Criminal Code Act 1995 (Cth) widen corporate liability? Discuss.

7.12

1. 2. 3.

Remedies for corporate misconduct

Under the Corporations Act, remedies come in three forms:11

civil; criminal; and a hybrid of these two, civil penalties.

[page 235]

A full range of civil, criminal and hybrid remedies are available to remedy corporate wrongs.12 An in-depth discourse into remedies is beyond the scope of this text; however, what follows is an explanation of those remedies that are either peculiar to corporate law or of particular importance (or both).

It is important to note that there is some overlap between the three varieties of remedy. They do not operate at the exclusion of each other, nor do they derogate from common law or equitable remedies. That is, a person may find himself or herself in breach of the Corporations Act and be liable in more than one of civil, criminal and civil penalty proceedings. Indeed, some provisions of the Corporations Act carry dual liability themselves. For example, a person who breaches the insider trading provisions may commit a criminal offence (s 1043A(1)) and be in breach of a civil penalty provision: s 1043A(2).

Additionally, a person’s conduct may result in contraventions of, and proceedings being brought against them for, both a civil penalty provision and an entirely separate criminal provision. For example, Rodney Adler, a former director of HIH Insurance Ltd, was found to have breached, among other things, his duties as a director under ss 180, 181 and 182 of the Corporations Act: see ASIC v Adler [2002] NSWSC 171 and [2002] NSWSC 483. In relation to the same conduct, Adler was also subsequently charged criminally with breaching the market manipulation and misleading or deceptive conduct provisions of the Corporations Act. Such a dual prosecution does not involve double jeopardy or abuse of process; while it does involve more than one set of proceedings relating

7.13

7.14

to the same set of factual circumstances, the civil penalty and criminal provisions have substantially different elements and are directed towards achieving different ends: see R v Adler [2004] NSWSC 108.

Civil remedies under the Corporations Act Part 9.5 (ss 1318-1327) of the Corporations Act contains the statutory powers of courts in relation to proceedings involving a contravention or anticipated contravention of the Act. For example, s 1318 gives the courts a broad power to grant a person relief from liability for a contravention of the Corporations Act where the person has acted honestly and, in the circumstances, the court deems it appropriate to excuse the person. Additionally, s 1322 gives the courts power to forgive procedural irregularities, which are technically contraventions of the Corporations Act, but which will result in no substantial injustice to any person. For example, a failure by a company to lodge a form with the Australia Securities Exchange within the required period would amount to a contravention of the Act; however, the courts have been willing to grant the company additional time to lodge the form without incurring a penalty: Re Wave Capital Ltd (2003) 47 ACSR 418; [2003] FCA 969.

Section 1324 of the Corporations Act permits the courts to grant injunctions restraining a person from engaging in conduct that would amount to a contravention under the Act or requiring a person to engage in conduct in compliance with the Act.

[page 236]

Finally, the courts may award damages or compensation in a variety of circumstances, including where breaches of Ch 5C (managed investment schemes), Ch 6CA (continuous disclosure), Ch 6D (fundraising) or Pt 7.10 (market misconduct) have occurred: Corporations Act s 1325.

Criminal remedies under the Corporations Act Section 1311 of the Corporations Act is often overlooked. It states that all provisions of the Act are criminal unless the provision in question states

7.15

otherwise. Section 1311 also provides that the standard penalty for a criminal contravention is five penalty units, unless either the particular provision contains an alternative penalty or an alternative penalty is listed in Sch 3 of the Act. In Sch 3, the maximum penalty faced by an individual is 200 penalty units and/or five years’ imprisonment.

Penalty units are defined in s 4AA of the Crimes Act 1914 (Cth). All offences are treated at $210 per penalty unit as of 1 July 2017, subject to increases in line with the consumer price index.13 Quite naturally, it is impossible to send a corporation to prison, which explains the significantly greater pecuniary penalties faced by such bodies. This does not mean, however, that a corporation cannot be found to have contravened a provision that only provides for imprisonment as a penalty: Criminal Code s 12.1(2). In such a situation, s 4B of the Crimes Act 1914 (Cth) permits a pecuniary penalty to be imposed in lieu of the term of imprisonment.

In addition to the above penalties, in certain circumstances, ASIC has the option of issuing a penalty notice to a person who ASIC believes has committed an offence against the Corporations Act: s 1313. On receipt of a penalty notice, the recipient may pay the penalty contained within the notice, in return for which no further action will be taken by ASIC. Penalty notices are designed to be issued only in relation to breaches of minor (generally administrative) criminal provisions. If a criminal provision carries a penalty listed in Sch 3, then a penalty notice may not be issued in the event of a contravention.

Finally, one can readily observe that gaining an understanding of the corporate criminal law requires knowledge of not merely the directly relevant statute prohibiting the conduct in question, the Corporations Act, but also those statutes that provide general principles of criminal law applicable to Commonwealth offences (that is, the Crimes Act 1914 (Cth) and the Criminal Code). This adds an unwelcome level of complexity, particularly when the patchwork of statutes rarely makes direct reference to one another.

Civil penalties under the Corporations Act The civil penalty regime is located in Pt 9.4B of the Corporations Act and,

• •

•

• •

inexplicably, is divided into:

‘corporation scheme’ civil penalties; and ‘financial services’ civil penalties.

[page 237]

Civil penalties are a hybrid of civil and criminal remedies and, consequently, are generally misunderstood. In theory, a civil penalty is something of a misnomer, given that the aims of the civil law generally do not include pecuniary penalties. Pecuniary penalties (that is, fines) are most often a creature of the criminal sphere. The other often confusing element of the civil penalty regime is that, in proving a contravention, ASIC needs only satisfy the civil standard of proof — on the balance of probabilities — not the more difficult, criminal standard. Thus, the civil penalty is effectively a punitive remedy available on proof of a breach on the balance of probabilities.

Where ASIC satisfies the court that a breach of a civil penalty provision has occurred (for example, directors duties), ASIC may seek orders:

imposing a pecuniary penalty (fine) of up to $200,000 (s 1317G); and/or compensation orders; and/or disqualification orders may also follow under s 206C.

Once aware of the outcomes of a civil penalty breach, one can clearly see the interlocking of the criminal and civil laws; the fine is a criminal remedy, the compensation order (damages) is a civil remedy. The High Court has stated that the civil penalties can be akin to a criminal procedure: Rich v ASIC (2004) 220 CLR 129; [2004] HCA 42.

The following case is a good illustration of proceedings which deal with the civil penalty provisions, penalties and compensation orders, and applications for disqualification from managing companies in litigation relating to the collapse of HIH Insurance Ltd.

ASIC v Adler (2002) 41 ACSR 72; [2002] NSWSC 171 New South Wales Supreme Court

Facts: Rodney Adler, Ray Williams and Dominic Fodera were former directors of HIH Insurance Ltd (HIH) and HIH Casualty and General Insurance Co Ltd (HIHC), which was a wholly-owned subsidiary of HIH. Adler also was the sole director and joint shareholder (with his wife) of Adler Corp Pty Ltd, which was the fourth defendant in this case. Adler was also the sole director of another company, Pacific Eagle Equity Pty Ltd (PEE), the sole shareholder of which was Adler Corp. PEE was the trustee of Australian Equities Unit Trust (AEUT). In June 2000, HIHC paid $10 million to PEE as an investment in AEUT. AEUT used that $10 million to buy shares in HIH, purchase three businesses from Adler Corp, and make loans to Adler Corp and entities associated with Adler Corp. The $10 million payment was made in such a way that it would not come to the attention of HIH directors other than Adler, Williams and Fodera. There was no documentation in place in relation to the payment. There was no disclosure of the transaction made to the board, nor was the transaction approved or ratified by the HIH Investment Committee. The outcome was that AEUT’s investment in HIH’s shares made a $2.1 million loss and its purchases of the three businesses from Adler Corp resulted in losses to AEUT of $3.9 million. HIH was placed in liquidation in August 2001. ASIC claimed (among other things) that Adler’s conduct as a director of HIH, HIHC and PEE in relation to the $10 million payment was in breach of his duties as prescribed by ss 180(1), 181(1), 182(1) and 183(1) of the Corporations Act. ASIC also claimed Williams and Fodera had breached their duties as directors as prescribed by ss 180(1), 181(1) and 182(1) of the Corporations Act. ASIC brought proceedings for breach of

[page 238]

these civil penalty provisions, seeking fines, compensation orders and orders disqualifying the defendants from managing corporations.

Decision: The court found in favour of ASIC, holding that the three directors had amassed 182 breaches of their duties as directors. The civil penalty contravention orders were successfully obtained by ASIC, with Adler being disqualified from managing corporations for 20 years, fined $450,000 and Adler was made jointly and severally liable for $7.9 million in compensation payable to HIHC. Williams was disqualified from managing corporations for 10 years, fined $250,000 and was made jointly and severally liable for $7.9 million in compensation payable to HIHC. Fodera was fined $5000. Adler Corp Pty Ltd was fined $450,000 and was made jointly and severally liable for $7.9 million in compensation payable to HIHC.

The area of corporate liability is clearly a complex journey of civil law and criminal law. It is made more complex by the fact that a company needs humans to operate as either employees or agents, which naturally makes the company (as an employer or as the principal) liable for the actions of its humans. However, in the area of criminal law, it is complex to show the guilty mind of a company. The development of civil penalties in corporate law has added a further level of complexity for what should be civil actions are now deemed to be closer to a criminal procedure.

7.16

7.17

7.18

Corporate liability in contract

Once a company is registered, it is granted the legal capacity and powers of an individual, which includes, quite naturally, the ability to enter into contracts in its own name: Corporations Act s 124.

Common seal A company may execute documents and contract with, or without, reliance on its common seal. A common seal is a legal stamp, which contains the company’s name and Australian Company Number (ACN) or Australian Business Number (ABN). The company may choose to have a common seal (s 123), which is used as if the company was signing the contract itself. The common seal is the equivalent to the signature of an individual person. Traditionally, prior to law reform in 1998 making it optional for a company to have a common seal, this was a common method for a company to transact directly. Section 127(2) requires the affixation of the common seal to be witnessed by two directors or one director and one company secretary. For a proprietary company that has a sole director who is also the sole company secretary, that director is required to witness the fixing of the seal.

Alternatively, a company may execute a document without the use of a common seal. The company may contract directly with third parties by executing a contract. In such situations, s 127(1) requires two directors or one director and the company secretary to sign as if they were the company. For a proprietary company that has a sole director who is also the sole company secretary, that director is required to sign.

[page 239]

Need for authority However, as discussed earlier, a company, being a legal fiction, relies on individuals to engage in the day-to-day activities of running its business, including entering into contracts on its behalf. Whereas in determining corporate liability in tort, the question is whether the natural person was

•

the directing mind and will of the company or whether they were a mere employee or agent. However, the question in relation to contractual liability is whether the individual had the authority to enter into the particular contract on the company’s behalf.

Thus, in contract, the law focuses on the existence and, if in existence, the nature, of the person’s authority to act for the company and not the person’s position within the company per se.

More specifically, the law of corporate contractual liability draws heavily on the law of agency, which is reflected in the language used in many of the judgments extracted below.

The rules concerning actual and apparent authority apply where the principal is a company. They are supplemented by provisions of the Act where companies are concerned. The usual starting point in any consideration of a director’s actual authority is the constitution of the company, which invariably provides for directors’ powers. Express actual authority of a director usually derives from the constitution of the company or from some antecedent act such as a resolution of the board of directors: Northside Developments Pty Ltd v Registrar-General (1990) 170 CLR 146. See also the decision in Junker v Hepburn [2010] NSWSC 88.

As a result, as seen above, corporations (and sometimes its board of directors) are generally referred to as the ‘principal’; the individual in question who enters into the contract on behalf of the principal is known as the ‘agent’; and the third party with whom the agent contracts is known as the ‘contractor’.

There are different types of authority recognised by the law. An agent may have:

actual authority which can be express or implied. For example, the replaceable rule in s 198A(2) authorises the board of directors to exercise the powers of the company. Alternatively, actual authority can be implied from statements or from the principal’s conduct; apparent (or ‘ostensible’) authority which arises by law in certain circumstances where consent from the principal is absent and the person has the appearance of authority; and

• no authority to act at the time of entering into the contract, but may have authority ‘back-dated’ or granted in retrospect by the company’s subsequent ratification of the contract. The difference between actual and apparent/ostensible authority was explained in the seminal judgment of Diplock LJ in Freeman & Lockyer v Buckhurst Park Properties (Mangal) Ltd.

[page 240]

Freeman & Lockyer v Buckhurst Park Properties (Mangal) Ltd [1964] 2

QB 480 Court of Appeal (UK)

Facts: Messrs Kapoor and Hoon formed, at Kapoor’s suggestion, the respondent company, Buckhurst, to purchase and re-sell a large block of land. Kapoor and Hoon (and two others) were appointed directors of the company. The company’s constitution permitted the appointment of a managing director, but none was appointed. Kapoor entered into a contract with the appellant firm of architects, Freeman & Lockyer, for the provision of architectural and survey services in relation to the property owned by Buckhurst. The other directors of Buckhurst were not consulted in relation to this contract. Freeman & Lockyer completed the work under the contract, but were not paid. They sued Buckhurst and Kapoor and, at trial, Buckhurst was held to be bound by the contract. Buckhurst then appealed, claiming that the contract was only binding on Kapoor as Buckhurst had not authorised Kapoor to enter into such contracts. Buckhurst argued that Kapoor lacked the authority to enter into contracts on Buckhurst’s behalf and therefore the contract was not binding on the company.

Decision: The appeal was dismissed and the contract was binding on Buckhurst. This was because the board of directors had been aware of, and had acquiesced in, Kapoor acting as

[page 241]

managing director in relation to the development and sale of the company’s property. By such conduct, the board represented that Kapoor had authority to enter into contracts of a kind which a managing director would in the normal course be authorised to enter into on behalf of the company.

Diplock LJ explained the court’s reasoning as follows:

An actual authority is a legal relationship between principal and agent created by a consensual agreement to which they alone are parties. … To this agreement the contractor is a stranger; he may be totally ignorant of the existence of any authority on the part of the agent. Nevertheless, if the agent does enter into a contract pursuant to the actual authority, it does create contractual rights and liabilities between the principal and the contractor.

...

An apparent or ostensible authority, on the other hand, is a legal relationship between the principal and the contractor created by a representation, made by the principal to the contractor, intended to be and in fact acted on by the contractor, that the agent has authority to enter on behalf of the principal into a contract of a kind within the scope of the apparent authority, so as to render the principal liable to perform any obligations imposed on him by such contract … The representation, when acted on by the contractor by entering into a contract with the agent, operates as an estoppel, preventing the principal from asserting that he is not bound by the contract. It is irrelevant whether the agent had actual authority to enter into the contract.

To support a claim of apparent authority, Lord Diplock held that it must be shown that:

a representation that the agent had authority to enter on behalf of the company into a contract of a kind sought to be enforced was made; such representation was made by a person or persons who had ‘actual’

7.19

authority to manage the business of the company either generally or in respect of those matters to which the contract relates; the contractor was induced by such representation to enter into the contract, that is, he or she in fact relied on it; and under its constitution the company was not deprived of the capacity either to enter into a contract of the kind sought to be enforced or to delegate authority to enter into a contract of that kind to the agent.

Diplock LJ’s discussion of the principles underpinning actual and ostensible authority is regarded as pre-eminent in Australia and is frequently applied. The High Court of Australia has accepted these principles: see Crabtree-Vickers Pty Ltd v Australian Direct Mail Advertising & Addressing Co Pty Ltd (1975) 133 CLR 72.14

Usual authority of company officers A director is not, merely by holding that office, an agent of the company. An ordinary individual director of a company does not have ostensible authority to bind it. Directors can act only collectively as a board and the function of an individual director is to participate in decisions of the board. In the absence of some

[page 242]

representation made by the company, a director has no ostensible authority to bind it: Northside Developments Pty Ltd v Registrar-General (1990) 170 CLR 146.

Thus, the word ‘Director’ under the name of a director (without more) does not confer authority to bind the company: J Wright Enterprises Pty Ltd (in liq) v Port Ballidu Pty Ltd [2010] QSC 213. Whether in any particular case the company has acted in other ways to make or hold out a director as its agent is a matter of fact and degree depending on the circumstances: Elkington v Farsands Solutions Pty Ltd [2012] NSWCA 334. A company secretary does not have implied authority to manage the company. However, under principles of modern company law, a secretary has implied authority to manage the administrative affairs of the

•

7.20

company: Panorama Developments (Guilford) Ltd v Fidelis Furnishing Fabrics Ltd [1971] 2 QB 711. All public companies must have at least one secretary: s 204A(2). The appointment of a secretary is now optional for proprietary companies.

What justification, if any, is there for the legal concept of apparent authority? Discuss.

Indoor management rule15

A company, as a separate legal entity, may always contract directly with third parties rather than relying on an agency relationship. The normal method for the company to contract directly is by executing a contract under s 127. This requires two directors or one director and the company secretary to sign as if they were the company. Alternatively, as discussed earlier, the company may have a common seal (s 123), which is used as if the company were signing the contract itself. Although common seals are now optional, many companies retain them, even if they do not use them for each transaction. In reality, most companies, through their board of directors, will delegate the capacity to contract to agents and employees under s 198D.

One area that caused problems was agents or employees of the company either committing a forgery on the company or failing to follow the internal procedures a company might expect to be followed. In such circumstances, what protection is there for persons dealing with a company in good faith? The modern law tries to protect the innocent third party from suffering losses which are caused by the company. At common law, where a forgery arose, it was stated that the company should not be liable under Ruben v Great Fingall Consolidated Ltd [1906] AC 439. This has been refined by parliamentary intervention, found in ss 128 and 129.

Where a company has set procedures, for example, in its internal documents, for entering into contractual relations, it would be hard for an outsider (the third party) to be expected to know what the company

7.21

required for internal approvals. This difficulty is highlighted in a leading case called the Royal British Bank v Turquand (1856) 119 ER 886, which developed a special rule of company law which is known as the rule in Turquand’s case or ‘the indoor management rule’, designed to overcome the outsider’s difficulties of proving that a company authorised the transaction.

[page 243]

What is the indoor management rule? In the old English case of Royal British Bank v Turquand, still of relevance in modern company law, the court held that an outsider acting in good faith can assume that all internal procedures had been followed by a company unless they know otherwise. The following case discussion illustrates the manner in which innocent outsiders are assisted by the operation of the indoor management rule.

Royal British Bank v Turquand (1856) 119 ER 886 Court of Appeal (UK)

Facts: Turquand, a mining company, had a clause in its deeds of settlement (similar to a corporate constitution) that allowed the company to borrow money once it had been approved and passed by resolution of the shareholders at a general meeting. Turquand entered into a loan with the Royal British Bank and two of the company directors signed and attached the company seal to the loan agreement. The loan had not been approved by the shareholders. The company defaulted on the repayments and the bank sought restitution. The company refused to repay claiming that the directors had no right to enter into such an agreement. Turquand claimed that the bank had constructive notice of the shareholder approval clause in their deeds of settlement.

Decision: Turquand was required to repay the loan to the bank and was permitted to assume that the loan document was legitimate. Parties dealing with companies have the right to presume that the internal processes of the companies have been properly carried out. Parties need only be aware of the companies public documents to be assured that the agreements between themselves and the companies are authorised.

The indoor management rule provides some degree of protection for innocent third parties dealing with companies to make sure their

• • •

7.22

•

contracts are valid and binding. When acting in good faith, persons dealing with a company may assume that internal acts of management have been properly performed and are not bound to inquire whether such acts have been regular. Acts of internal management include:

following proper procedure for appointment of directors; following proper procedure for meetings; and following proper procedure for the passing of resolutions.

The High Court’s decision in Northside Developments Pty Ltd v Registrar- General (1990) 170 CLR 146 represents the most authoritative Australian judicial analysis of the common law formulation of the indoor management rule. The basis of the indoor management rule, and the balancing exercise required, was explained by Chief Justice Mason of the High Court in the Northside case (at 164):16

What is important is that principle … in Turquand’s case … give sufficient protection to innocent lenders and other persons dealing with companies, thereby promoting business convenience and leading to just outcomes. The precise formulation and application of that rule calls for a fine balance between competing interests. On the one hand, the rule has been developed to protect and promote business convenience which would be a hazard if persons dealing with companies were under the necessity of

[page 244]

investigating their internal proceedings in order to satisfy themselves about the actual authority of officers and the validity of instruments. On the other hand, an over-extensive application of the rule may facilitate the commission of fraud and unjustly favour those who deal with companies at the expense of innocent creditors and shareholders who are the victims of unscrupulous persons acting or purporting to act on behalf of companies.

Limitations to the indoor management rule The indoor management rule does not apply when the outsider:

either knows of internal irregularities within the company (actual knowledge or awareness of irregularities defeats the operation of the indoor management rule); or is put on enquiry from surrounding circumstances.

The second exception, commonly referred to as the ‘put on enquiry’ exception, warrants further attention. What does this expression mean and how does it operate?

Morris v Kanssen [1946] AC 459 House of Lords (UK)

[The indoor management rule] is a rule designed for the protection of those who are entitled to assume, just because they cannot know, that the person with whom they deal has the authority which he claims. This is clearly shown by the act that the rule cannot be invoked if the condition is no longer satisfied, that is, if he who would invoke it is put upon his enquiry. He cannot presume in his own favour that things are rightly done if enquiry that he ought to make would tell him that they were wrongly done.

[This judicial passage was adopted by the High Court of Australia in the Northside Developments case, discussed below.]

A person is denied the benefit of the indoor management rule if the facts or evidence show that the person ought to have known of any discoverable defects where a reasonable person would have been prompted to make inquiries. A person, even one who has no special relationship with the company concerned, may be put on enquiry by the very nature of the transaction. The following High Court decision in Northside Developments Pty Ltd v Registrar-General illustrates the operation of the ‘put on enquiry’ exception to the indoor management rule.

Northside Developments Pty Ltd v Registrar-General (1990) 170 CLR 146 High Court of Australia

Facts: The common seal of the company, Northside Developments, was affixed to a mortgage document. The mortgage was over a piece of land owned by Northside, its only major asset, and was an instrument to guarantee a loan from Barclays Bank to one of the directors of Northside. Northside would gain no advantage from entering into the mortgage. The loan was unrelated to the purpose of its business. The director of the company and the director’s son, acting as the company’s secretary, signed the document. The son had not been appointed as secretary. The company’s articles required authorisation of the use of the seal and attestation

[page 245]

by a director together with another director or with the secretary. The other directors of the company

•

7.23

•

did not know of or authorise the signing of the document. In addition, they were unaware that the director’s son was purporting to act as the company’s secretary.

Decision: This case is the exception to Turquand’s rule. When the loan was defaulted on, it was found that Northside was not bound by the document. The common seal was invalid. The circumstances surrounding the document should have put Barclays Bank on enquiry. That is, when there was no commercial advantage for Northside to enter into the agreement, Barclays Bank should have been suspicious about the validity of the document and should have made enquiries.

Significance: An outsider can presume that the internal processes of a business have been conducted legally unless there are significant circumstances where they should be put on enquiry. If this occurs, further enquiries must take place before a document will be presumed to be valid.

The indoor management rule, designed to promote business convenience, is a rogue’s character. Do you agree?

Are there any statutory protection rules for third parties? Over time, exceptions started to develop and questions as to the third parties’ knowledge and when an officer or member of the company entered a contract with the company they could not claim to be a third party and rely on the Turquand rule. Parliament determined it was time to provide some added statutory protections to third parties dealing with companies.

The indoor management rule and the concept of apparent authority are reinforced under the statutory assumptions in s 129 of the Corporations Act.

Sections 128-129 17 of the Corporations Act state that an outsider dealing with a company can make a series of assumptions, even when there is no constructive notice given, or where the dealings involve fraud or forged documents. Constructive notice was the ability to know all public documents about the company anywhere in the world, which is quite unrealistic when entering into a contract with a company by a third party. These assumptions are found in s 129 and are listed below:

The corporate constitution (and the previous memorandum and articles of association), and replaceable rules if adopted, have been

•

complied with by the corporation (this provision in s 129(1) aims to restate the indoor management rule). Persons named in the company’s extract of particulars, made available to the public by ASIC, are properly appointed as a director or secretary of the company and have authority to exercise the powers and duties customarily exercised by that kind of officer of a similar company: s 129(2).18 If ASIC’s register does not record the appointment of a director, an outsider is precluded from relying on the indoor management rule to assume that a director was duly appointed.19

[page 246]

Officers or agents held out by the company are properly appointed and have authority to exercise the powers and duties customarily exercised or performed by that kind of officer or agent: s 129(3). Officers and agents of the company properly perform their duties to the company: s 129(4).20 A document has been duly executed by the company if the document appears to have been signed in accordance with s 127(1) (that is, executed without a common seal): s 129(5).21 Documents are duly executed with seal if the seal appears to have been fixed in accordance with s 127(2): s 129(6).22 Warranties given by officers and agents that a document is genuine or a true copy means that the company cannot deny and avoid liability for a false document issued by the officer or agent: s 129(7).

There are some limitations to the use of the s 129 statutory assumptions for third parties, which are found in s 128(4):

where there is actual knowledge of the true position, which is based on a question of proof; or there is imputed knowledge, where the person merely suspects the assumption is incorrect. There has to be sufficient information for the person to be suspicious that the assumption should not be relied on and further investigation of the facts is warranted.

For purposes of the limitations to the statutory assumptions contained in

s 128, the knowledge or suspicion must exist at the time of the dealings with the company. The onus of proof lies on the party seeking to disentitle the reliance on the assumption: Soyfer v Earlmaze Pty Ltd [2000] NSWSC 1068; see also Sunburst Properties Pty Ltd v Agwater Pty Ltd [2005] SASC 335.

Sunburst Properties Pty Ltd v Agwater Pty Ltd [2005] SASC 335 Supreme Court of South Australia

Section 128(4) appears to place the burden on the company to establish the person’s subjective knowledge or suspicion that the s 129 assumptions relied on were incorrect. That is to say, a person does not lose the benefit of the assumptions in s 129 merely because the person’s suspicions, in the circumstances, should have been aroused.

In this respect, the operation of s 128(4) can be contrasted with the ‘put on enquiry’ test that applies when a person seeks to enforce a defective contract at common law,23 as discussed earlier in the Northside Developments case. It would appear that the common law uses a stricter test by adopting an objective standard: Sunburst Properties Pty Ltd v Agwater Pty Ltd [2005] SASC 335. Consequently, a person does not lose the benefit of the assumptions in s 129 merely because their suspicions ought

[page 247]

to have been aroused: Sunburst Properties Pty Ltd v Agwater Pty Ltd [2005] SASC 335. The approach of the majority judgment in Bank of New Zealand v Fiberi Pty Ltd (1993) 14 ACSR 736, discussed below, appears to reinforce the view that the statutory exception in s 128(4) does not incorporate the ‘put on enquiry’ test.24

In Bank of New Zealand v Fiberi Pty Ltd, the Court of Appeal considered the operation of the statutory defences under s 68A of the Companies Code — the predecessor provisions of ss 128-129.

•

Bank of New Zealand v Fiberi Pty Ltd (1993) 14 ACSR 736 New South Wales Court of Appeal

Facts: Fiberi Pty Ltd had two directors, both of whom were equal shareholders in the company. The company did not have significant assets, save for a property it owned in which the two directors lived as a married couple. The one director, Doyle, had many other business interests. Together with his son, Doyle controlled many other companies in which the other director of Fiberi Pty Ltd held no financial or managerial interest. Doyle, and his son, used the common seal of Fiberi to guarantee loans made by the Bank of New Zealand (BNZ) to their group of companies. The common seal was witnessed by Doyle, as director, and by his son in his capacity as secretary of Fiberi. The son had not been appointed as secretary. The other director of Fiberi only became aware of the financial obligations undertaken by Fiberi when the companies owned by the Doyles collapsed.

The innocent director of Fiberi challenged the authenticity of the loan documents and BNZ, in turn, sought to rely on the statutory protections contained in ss 128-129 (the almost equivalent provisions, in broad terms, to those actually considered in the case).

Issue: Was Fiberi, the owner of a single asset, bound to this loan transaction which guaranteed the obligations of other unrelated companies in which a director had a self-interest?

Decision: This case is an exception to the statutory assumptions that an outsider can make when dealing with the company. Fiberi was not bound to the guarantee transactions because BNZ should have known through its relationship with Fiberi that the Doyles did not have the authority to execute these guarantees on behalf of Feberi. Priestley and Clarke JJA held:

… a reasonably competent and reasonably prudent bank official in [similar circumstances] would, as a matter of routine, have seen to it that the bank was in possession of information, on which the bank could rely, showing the identity of the duly appointed directors and agents of the various companies in Mr Doyle’s group, independently of Mr Doyle’s oral assurances. The obtaining of such information should have been a matter of no difficulty. Should there have been any difficulty, then the need for obtaining the information would become only more obvious.

Significance: The majority judgment adopted the view that the statutory defence does not incorporate the stricter ‘put on enquiry’ test at common law. The dissenting judge in this case, however, thought otherwise. Until there is a judicial decision by a high ranking court on the operation of s 128(4), the uncertainty remains as to whether the standard required to discharge this statutory defence is the same as the standard required at common law.

The twin benefits of the indoor management rule and the statutory assumptions (ss 128-129) mean that an outsider need not bother making inquiries when transacting with a company as the company will always be legally bound to the transaction. Do you agree?

1. 2.

3. 4.

6. 7.

10.

[page 248]

Revision Questions

What is the significance of s 124 of the Corporations Act? Explain the organic theory of attribution in determining corporate liability. What is the difference between primary and secondary liability? What is vicarious liability? How does the directing mind and will affect liability in tort and crime? What is the principle in Tesco Supermarkets v Nattrass? How do ostensible authority and actual authority differ? What affect does this have on a corporation’s liability? What is the aim of the indoor management rule and how does it operate? Explain with reference to a relevant precedent. What are the limitations to the operation of the indoor management rule? Explain with reference to a relevant precedent. What statutory protection exists, under the Corporations Act, for the protection of innocent third parties contracting with the company? What limitations, if any, are there to these assumptions?

Problem Question Vanessa is a director of Smash Ltd, and is in charge of the company’s production line and related activities. One day when the factory is operating at full capacity to fill an urgent and lucrative order, the production line jams. Clot, a company employee, crawls into the middle of the machinery and is eventually able to sort out the problem. He calls out that he has rectified the problem and is coming out, whereupon Vanessa orders the production line be immediately restarted (there is usually a short delay while the machinery warms up). The supervisor, Simon, refuses to start the machinery until Clot actually gets out, but Vanessa reaches past him and presses the restart button, commenting that there’s plenty of time. Unfortunately, Clot has stopped to admire the internal workings of the machinery, the

2. 3.

machinery starts up quicker than usual because it is still warm, and Clot is trapped inside. Pieces of Clot continue to be found in and around the machinery for weeks after.

Advise all parties on the implications of these facts, so far as relevant to company law.

Guidelines for Answering Problem Questions

When answering a problem question concerning legal issues relating to contractual liability, we suggest that the following method may be helpful:

It is important to determine the existence of authority to contract (either actual or apparent authority). If so, check to see if the formalities (s 172) have been satisfied. If not, determine whether assumptions at common law (the indoor management rule) or under the Corporations Act (ss 128-129) can assist the outsider in enforcing the corporate contract. Check to see if the limitations on these assumptions are applicable, either at common law or under the Corporations Act.

[page 249]

When dealing with a problem question concerning legal issues relating to corporate liability in tort or crime, we suggest that the following method may be helpful:

It is important to determine whether the company attracts primary or secondary liability for the tort or crime. Check to see if the organic theory (directing mind and will approach) is applicable to the facts. Alternatively, check to see if the concept of vicarious liability is applicable. For criminal liability issues, check to see if there is need to depart from the Tesco approach and fashion a special rule of attribution

4. for criminal liability. Check to see if the Criminal Code Act 1995 (Cth), or any other statutory provision, such as liability provisions under the Competition and Consumer Act 2010 (Cth) are relevant.

Wang decides to expand the SCPL business by acquiring a mobile café van worth $70,000. Wang signs a contract with Axion Finance Ltd to pay for the vehicle. Axion buys the vehicle and then leases it to SCPL under a five-year lease. It is anticipated that SCPL will buy the van at the end of the lease (or enter into a new lease with Axion). Wang signs the contract in the following manner:

‘Signed Wang, Director Sydney Café Pty Ltd’

WAng does not ask Erin to also sign and he does not ask her permission to enter into this contract, although he has previously discussed the possibility of providing mobile café services with her. Wang plans to drive this van to local football matches on Saturday to earn extra income for the business. Wang uses his young son, Victor, to help him operate the mobile café van on weekends. Unfortunately, Victor is very clumsy and he spills boiling hot coffee on a customer, whose hand is badly burnt. The victim (Sally) wants to sue SCPL and Wang and Victor for $100,000 for her injuries.

The Axion lease contract contains a requirement that SCPL indemnify Axion for any loss or damage however caused through the use of the vehicle. Erin claims that Wang was not authorised by SCPL to sign the lease with Axion and so SCPL is not liable for the indemntity to Axion.

Who may be liable for the harm suffered by Sally?

Further Reading

Academic Journals N Andrews, ‘If the Dog Catches the Mice: The Civil Settlement of

Criminal Conduct under the Corporations Act 2001 and the Australian and Securities Investment Act’ (2003) 15 Australian Journal of Corporate Law 137.

A Capuano, ‘Catching the Leprechaun: Company Liability and the Case for a Benefit Test in Organic Attribution’ (2009) 24 Australian Journal of Corporate Law 177.

R Edmunds, ‘Corporate Killers’ (2001) 13 Australian Journal of Corporate

Law 231. R Edmunds and J Lowry, ‘The Continuing Value of Relief for Directors’

Breach of Duty’ (2003) 66 Modern Law Review 195. E Ferran, ‘Corporate Attribution and the Directing Mind and Will’ (2011)

127 Law Quarterly Review 239. N Foster, ‘Personal Civil Liability of Company Officers for Company

Workplace Torts’ (2008) 16 Torts Law Journal 20.

[page 250]

G Gilligan, H Bird and I Ramsay, ‘Civil Penalties and the Enforcement of Directors’ Duties’ (1999) 22 University of New South Wales Law Journal 417.

R Grantham, ‘Attributing Responsibility to Corporate Entities: A Doctrinal Approach’ (2001) 19 Company and Securities Law Journal 168.

S Hardingham, ‘Sections 128-129 of the Corporations Act: Allocating Risk of Loss for Unauthorised Corporate Contracts’ (2004) 22 Company and Securities Law Journal 559.

A Hargovan, ‘Fashioning the Rules of Attribution for Corporate Liability’ (2006) 24 Company and Securities Law Journal 388.

J Hill, ‘Corporate Criminal Liability in Australia: An Evolving Corporate Governance Technique?’ [2003] Journal of Business Law 1.

Practitioner Journals J Daniels, ‘Changes to Civil Liability of Corporations’ (2004) 7(9) IHC

105. C Hanson, ‘Directors Forced to Confront Risks of Responsibility’ (2002)

54 Keeping Good Companies 134.

Practitioner Works P Brown (ed), Australian Corporation Practice, LexisNexis, Australia

(looseleaf and online), Chs 1 and 13.

10.

L Chapple and P Lipton, Corporate Authority and Dealings with Officers and Agents, Centre for Corporate Law and Securities Regulation, 2002.

J Clough and C Mulhern, The Prosecution of Corporations, Oxford University Press, Melbourne, 2002.

H A J Ford, R P Austin and I Ramsay, Ford’s Principles of Corporations Law, LexisNexis, Australia (looseleaf and online), Pt 4, Chs 12-16.

A Pinto and M Evans, Corporate Criminal Liability, Sweet & Maxwell, London, 3rd ed, 2013.

You will find useful study resources, including quizzes for each chapter, when you go to <http://learning.lexisnexis.com.au>. The quiz is a great tool to help you self-test your knowledge.

For further discussion on the relationship between the principles of agency and the ‘organic theory’, see Christian Youth Camps Ltd v Cobaw Community Health Services Ltd [2014] VSCA 75. For a review of the judicial authorities on the concept of vicarious liability, see ACE Insurance Limited v Trifunovski (2013) 295 ALR 407; [2013] FCAFC 3. For practical illustration of the complexities in this area of the law, see Christian Youth Camps Ltd v Cobaw Community Health Services Ltd [2014] VSCA 75. Court of Appeal in Singapore: Skandinaviska Enskilda Banken AB (Publ), Singapore Branch v Asia Pacific Breweries (Singapore) Pte Ltd [2011] SGCA 22 at [77]. See, for example, Australian Communications and Media Authority v Radio 2UE Sydney Pty Ltd (No 2) (2009) 178 FCR 199; 258 ALR 254; [2009] FCA 754. For historical review of development of the law on corporate criminal liability, see Presidential Security Services of Australia Pty Ltd v Brilley (2008) 73 NSWLR 241; [2008] NSWCA 204. For fuller consideration of the Meridian approach to ‘rules of attribution’ in a statutory context, see Public Prosecutor, Director of (Vic) (Reference No 1 of 1996) [1998] 3 VR 352. Although the Victorian Supreme Court of Appeal in ABC Development Centres Pty Ltd v Wallace (2007) 16 VR 409; [2007] VSCA 138 confirmed the result in the ABC case based on entirely different reasoning, significantly, the three judges added that should their reasoning be incorrect, they supported the reasoning of Bell J in the Victoria Supreme Court on the question of attribution. The High Court subsequently refused ABC’s application to appeal. ABC Development Learning Centres Pty Ltd v Wallace (2007) 16 VR 409; [2007] VSCA 138. It applies generally to the Corporations Act, as mentioned above. However, it does not apply to Ch 7 (see s 769A), which has replaced the operation of Pt 2.5 with s 769B.

11.

12.

13.

14.

15.

16.

17.

18.

19. 20.

21.

22.

23.

24.

Other statutes, such as the Competition and Consumer Act 2010 (Cth), offer a similar range of remedies. Examples of actions being brought under the three different arms of liability include Hadid v Lenfest Communications Inc [1999] FCA 1798 (civil action); ASIC v Adler (2002) 41 ACSR 72 (civil penalty provisions); and R v Rivkin (2003) 198 ALR 400; [2003] NSWSC 447 (criminal provisions). When the penalty unit was introduced in 1992, its value was set at $100. This value was adjusted to $110 in 1997, $170 in 2012, and to $180 in 2015. These increases were made broadly in line with changes in the CPI. In 2015, the Crimes Act was amended to introduce an indexation mechanism to automatically increase the value of the penalty unit every three years in line with CPI. Pursuant to amendments under the Crimes Amendment (Penalty Unit) Act 2017, the first adjustment to CPI will occur on 1 July 2020, with indexation to take place on 1 July every three years thereafter. For judicial application of these principles, see, for example, Australian Workers’ Union v Leighton Contractors Pty Ltd (2013) 295 ALR 449; [2013] FCAFC 4; Quikfund (Australia) Pty Ltd v Prosperity Group International Pty Ltd (in liq) (2013) 92 ACSR 343; [2013] FCAFC 5. For judicial discussion on the origins of the indoor management rule, see Northside Developments Pty Ltd v Registrar-General (1990) 170 CLR 146; Caratti v Mammoth Investments Pty Ltd (2016) 50 WAR 84; [2016] WASCA 84. The High Court judgments in Northside Developments reveal different views as to the juridical basis of the indoor management rule. For exploration of this issue, see the mammoth judgment in Caratti v Mammoth Investments Pty Ltd (2016) 50 WAR 84; [2016] WASCA 84. For a review of the legislative history of these provisions, see Esperance Cattle Company Pty Ltd v Granite Hill Pty Ltd [2014] WASC 279; Caratti v Mammoth Investments Pty Ltd [2016] WACA 84. For application, see In the matter of Sydney Project Group Pty Ltd (Administrators Appointed) (Receivers and Managers Appointed) and SET Services Pty Ltd (Administrators Appointed) (Receivers and Managers Appointed) [2017] NSWSC 881. Ashrafinia v Ashrafinia; Fakhrabadi v Ashrafinia [2012] NSWSC 500. For analysis on the operation of s 129, and in particular s 129(4), see Great Investments Ltd v Warner (2016) 335 ALR 542; [2016] FCAFC 85. For analysis on the operation of s 129, and in particular s 129(5), see Caratti v Mammoth Investments Pty Ltd [2016] WASA 84; Zhang v BM Sydney Building Materials Pty Ltd [2016] NSWCA 166. For application, see Otta International Pty Ltd v Asia Pacific Carbon Pty Ltd [2017] NSWSC 1267. For a useful discussion of the legal principles relevant to s 128(4), see Eden Energy Ltd v Drivetrain USA Inc (2012) 90 ACSR 191; [2012] WASC 192. For a similar conclusion, see Correa v Whittingham (No 3) (2012) 267 FLR 120; [2012] NSWSC 526.

[page 251]

Promoters: Duties and Liabilities

CHAPTER 8 Who is a promoter? Duties of a promoter

Duty to make disclosure Remedies for breach of duties

Rescission of contract Rescission of contract and damages Constructive trust order

Pre-registration contracts Difficulties at common law Statutory approach: liability for pre-registration contracts Company’s liability on ratification Consequence of failure to register company or ratify contract Promoter’s liability

[page 252]

Promoters: Duties and Liabilities

Learning Objectives After completing this chapter you should be able to:

Discuss the definition and role of promoters.

Explain the fiduciary duties of promoters.

Outline the remedies for breach of the promoter’s duties.

Discuss the liability of promoters for pre-registration contracts.

Key Cases

Emma Silver Mining Co Ltd v Lewis & Son (1879) 4 CPD 396

Erlanger v New Sombrero Phosphate Co (1878) 3 App Cas 1218

Gluckstein v Barnes [1900] AC 240

Tracy v Mandalay Pty Ltd (1953) 88 CLR 215

Twycross v Grant (1877) 2 CPD 469

Key Sections

Corporations Act 2001 (Cth) ss 131-133, 711, 728, 729

8.1

[page 253]

Introduction

Generally, promoters are persons who are involved with organising and supervising the formation of a company. Promoters are placed in a powerful position of control in respect of the fledgling company. Promoters may also contract on behalf of the company before it is actually formed. Their position and activities raise issues of accountability and liability. The poor image that promoters generally had at the turn of the last century is captured in the following extract:

If … we were asked to say what picture formed in our minds at the mention of the expression ‘company promoter’, most of us would probably confess that we envisaged a character of dubious repute … and who, after rising to affluence by the preying on the susceptibilities of a gullible public, finally retires from the scene in the blaze of a sensational suicide or Old Bailey [a famous court in England] trial. In other words, we … envisage someone whose profession it was to form bogus companies and foist them off on the public to the latter’s detriment and [the promoter’s] own profit. Such figures have existed and it is probably too much to hope that they will ever be entirely eradicated …1

The chapter explains the manner in which the law seeks to ensure that the promoter’s power is not abused, such as to harm the company and its investors.

It is worth observing, however, that the modern practice of incorporating private companies is largely reliant on the services provided by professionals who sell ‘shelf companies’ to meet the instant needs of their clients. Consequently, the growth of the professional promoter has seen a decline in the nineteenth-century practice of the old-time promoter who typically was a sole trader or partner who converted their business into a corporate structure. All promoters, large or small, nonetheless are prohibited from taking advantage of their position and owe a duty to act in good faith towards the company.

Who is a promoter?

The term ‘promoter’ does not have a fixed definition. It is not defined in the Corporations Act 2001 (Cth), nor is its meaning defined with precision at common law. The court has long recognised that the term ‘promoter’ is not a term of law, but rather one of business: Whaley Bridge Calico Printing

• • •

•

• • •

Co v Green (1880) 5 QBD 109. This is deliberate and ensures flexibility so as to capture a wide range of persons within the scope of the law on promoters.

Any person who is actively involved, either playing a minor or central role, in organising the formation of a company falls within the definition of promoter: Twycross v Grant (1877) 2 CPD 469; Emma Silver Mining Co Ltd v Lewis & Son (1879) 4 CPD 396. Typical activities associated with promoters include:

negotiation of preliminary agreements; preparation of the company’s constitution; identifying prospective directors and shareholders;

[page 254]

preparation of the company’s fundraising documents (for example, an offer information statement or profile statement or a prospectus); raising capital, either before or after incorporation; payment of registration fees; and registration of the company with ASIC.

Emma Silver Mining Co Ltd v Lewis & Son (1879) 4 CPD 396 Common Pleas Division, High Court of Justice (UK)

With respect to the word ‘promoters’, we are of opinion that it has no definite meaning: see Twycross v Grant (1877) 2 CPD 469 where Cockburn CJ described a promoter as ‘one who undertakes to form a company with reference to a given project and to set it going, and who undertakes the necessary steps to accomplish that purpose’. As used in connection with companies, the term ‘promoter’ involves the idea of exertion for the purpose of getting up and starting a company and also the idea of some duty towards the company.

Professional people, such as lawyers, accountants and bankers, are often involved in carrying out professional services during the incorporation of a company. They are not regarded as promoters if they act purely in their

professional capacity in the ordinary course of their profession: Jubilee Cotton Mills Ltd v Lewis [1924] AC 958.

The concept of a ‘promoter’ also extends to people who are not directly responsible for incorporation. It includes inactive persons who play a passive role in forming the company if they agree to share in the profits arising from the established company, as found in Tracy v Mandalay Pty Ltd (below).

Tracy v Mandalay Pty Ltd (1953) 88 CLR 215 High Court of Australia

Facts: A family company (RSC) was used to purchase land to develop a block of residential units. The land was then sold to a newly formed development company, Mandalay Pty Ltd, for this purpose. The purchase was funded by selling units off the plan. A change in the planning laws prevented the proposed construction. In a legal action against the promoters (consisting of various shareholders of RSC that originally bought the land), the new controllers of Mandalay Pty Ltd sought to recover the moneys paid by its shareholders. Some of the shareholders of RSC took no active part in this project but stood to profit. The High Court had to determine the status of these inactive participants in the project.

Decision: The High Court approved the following passage in Emma Silver Mining Co Ltd v Lewis & Son (1879) 4 CPD 396 at 407-8 per Lindley J:

… it is in our opinion an entire mistake to suppose that after a company is registered its directors are the only persons who are in such a position towards it as to be under fiduciary relations to it. A person not a director may be a promoter of a company which is already incorporated, but the capital of which has not been taken up, and which is not yet in a position to perform the obligation imposed upon it by its creditors.

Accordingly, the High Court held:

But it is not only the persons who take an active part in the formation of a company and the raising of the necessary share capital to enable it to carry on business who

[page 255]

are promoters. It is apparent from the passage cited [above] those persons who leave it to others to get up the company upon the understanding that they also will profit from the operation may become promoters.

Who constitutes a promoter in any particular case is therefore a question of fact.

•

8.2

8.3

Why do you think it is appropriate that the law does not provide a fixed definition for the word ‘promoter’?

Duties of a promoter2

Once identified as a promoter, such persons automatically owe fiduciary duties to the company: Aequitas v AEFC (2001) 19 ACLC 1006; [2001] NSWSC 14; Americana Leadership College v Coll [2003] NSWSC 295. This means that promoters must act honestly, in the best interests of the company and avoid conflicts of interest. These concepts, which also apply to directors, are discussed further in Chapters 15-16 dealing with directors’ duties. The reason for the imposition of a stringent fiduciary duty can be found in the following case.

Erlanger v New Sombrero Phosphate Co (1878) 3 App Cas 1218 House of Lords

They stand, in my opinion, undoubtedly in a fiduciary position. They have in their hands the creation and moulding of the company; they have the power of defining how, and when, and in what shape, and under what supervision, it shall start into existence and begin to act as a trading corporation.

Duty to make disclosure It is not uncommon for promoters to enter into contractual relations with the company being formed. The promoter is accountable to the company once it is formed. A promoter is allowed to make a profit out of a promotion but with the genuine informed consent of the company. As fiduciaries, promoters have a duty to make full and complete disclosure to an independent board of directors to enable them to make an impartial decision on the promoter’s conduct.

Erlanger v New Sombrero Phosphate Co (1878) 3 App Cas 1218 House of Lords

… it is, in my opinion, incumbent upon the promoters to take care that in forming the company they provide it with an executive, that is to say, with a board of directors, who shall both be aware that the property which they are asked to buy is the property of the promoters, and who shall be competent and impartial judges as to whether the purchase ought or ought not to be made.

[This passage was quoted by the High Court in Tracy v Mandalay Pty Ltd (1953) 88 CLR 215 and in Aequitas v AEFC (2001) 19 ACLC 1006.]

[page 256]

Erlanger v New Sombrero Phosphate Co (1878) 3 App Cas 1218 House of Lords

Facts: A syndicate, headed by Erlanger, acquired an island thought to be rich in minerals for £55,000. The syndicate then formed a company, and its directors included puppets of Erlanger. The island was then sold for £110,000 to the company through a nominee. The directors approved of the purchase without enquiry into facts or figures. Erlanger profited in this way to the harm of the newly formed company and its shareholders. New directors were appointed. They took legal action to recover the purchase price and to rescind the contract.

Decision: The House of Lords held that Erlanger, as a promoter, had breached this fiduciary duty to the newly formed company. The court allowed the company to recover the purchase price and, as a consequence of rescission, for the property to be transferred back to Erlanger. Further to the passages quoted above, the court noted that: It was the vendors, in their character of promoters, who had the power and the opportunity of creating and forming the company in such a manner that with adequate disclosures of fact, an independent judgment on the company’s behalf might have been formed. But instead of so doing they used that power and opportunity for the advancement of their own interests. Placed in this position of unfair advantage over the company which they were about to create, they were, it seems to me, bound according to the principles constantly acted upon in the courts of equity, if they wished to make a valid contract of sale to the company, to nominate independent directors and fully disclose the material facts. This passage was quoted by the High Court in Tracy v Mandalay Pty Ltd (1953) 88 CLR 215.

Similarly, Gluckstein v Barnes reaffirms that disclosure to the initial shareholders, the ‘cronies’ of the promoters, is inadequate.

8.4

Gluckstein v Barnes [1900] AC 240 House of Lords

It is too absurd to suggest that a disclosure to the parties in this transaction is a disclosure to the company of which these directors were the proper guardians and trustees. They were there by the terms of the agreement to do the work of the syndicate, that is to say, to cheat the shareholders; and this, forsooth, is to be treated as a disclosure to the company, when they were really here to hoodwink the shareholders, and so far from protecting them, were to obtain from them the money, the produce of their nefarious plans. …

[This passage was referred to in Aequitas v AEFC (2001) 19 ACLC 1006; [2001] NSWSC 14.]

A partial or incomplete disclosure is inadequate; the disclosure must be explicit.

Gluckstein v Barnes [1900] AC 240 House of Lords

Facts: Gluckstein and three others bought a property for £140,000 and then promoted a company to which they sold the property for £180,000. The four persons in this syndicate were made the first directors of the newly formed company. The prospectus by which money was obtained from the public disclosed the profit of £40,000. In reality, the syndicate really

[page 257]

paid only £120,000. A £20,000 profit made by buying a discounted mortgage on the property was not disclosed. The company sought to recover the undisclosed profit of £20,000.

Decision: The House of Lords held that the syndicate, as promoters, had breached their fiduciary duty and were liable to account to the company for their secret profit. The disclosure made to the company was inadequate. The company lacked independent directors:

These gentlemen set about forming a company to pay them a handsome sum for taking off their hands a property which they contracted to buy with that end in view. They bring the company into existence by means of the usual machinery. They appoint themselves sole guardians and protectors of this creature of theirs, half-fledged and just struggling into life, bound hand and foot while yet unborn by contracts tending to their private advantage, and so fashioned by its makers that it could only act by their hands and only see through their eyes. They issue a prospectus representing that they had agreed to purchase the property for a sum largely in excess of the amount which they had, in fact, to pay. On the faith of this prospectus they collect subscriptions from a confiding and credulous public. And then

8.5

•

8.6

8.7

•

comes the last act. Secretly, and therefore dishonestly, they put into their own pockets the difference between the real and the pretended price …

Mr Gluckstein defends his conduct … he says … he did in fact make a proper disclosure. With all deference to the learned counsel for the appellant, that seems to me to be absurd. … To talk of disclosure to the thing called the company, when, as yet there were no shareholders, is a mere farce. To the intended shareholders there was no disclosure at all. On them was practised an elaborate system of deception …

Some companies, such as small proprietary companies, may not have an independent board of directors. In these instances, full disclosure to the existing or potential shareholders as a whole is equally effective: Aequitas v AEFC (2001) 19 ACLC 1006; [2001] NSWSC 14. Disclosure may occur through the company’s constitution or, in the case of public companies, a fundraising disclosure document, such as a prospectus, issued to potential investors in a public company.

Why do you think it is appropriate for the law to impose stringent duties on a company promoter?

Remedies for breach of duties

Fiduciary duties are owed to the company. Thus, it is the company which must sue for breach of fiduciary duties. The common law allows for a range of remedies. Depending on the facts of each case, remedies include the following.

Rescission of contract This remedy typically arises when, for example, the promoter has a personal interest in a contract with the company and fails to make disclosure. Rescission has the effect of restoring the parties to their pre- contractual position, as evidenced in Erlanger v New Sombrero Phosphate Co (1878) 3 App Cas 1218. However, the right to rescind may be lost when:

it is impossible to restore the parties to their original positions;

•

• •

8.8

there has been undue delay;

[page 258]

the contract has been affirmed; or innocent third parties have acquired an interest in the property.

joint and several: liability of two or more persons, so that all are liable jointly (by being sued jointly) or each is liable separately (by being sued in an individual capacity). In the case of the latter the defendant may seek a contribution from the other defendants.

If the company chooses not to rescind the contract, it is precluded from recovering the promoter’s secret profit. An exception arises when the secret profit can be treated as separate from the contract price, as evidenced in Gluckstein v Barnes [1900] AC 240. In that case, the company did not rescind the contract. The company was still allowed to recover the £20,000 secret profit as it was separate from the disclosed profit. The liability of promoters is joint and several. A practical illustration of this concept can be found in Gluckstein v Barnes [1900] AC 240 at 248-9, where the House of Lords noted:

Mr Gluckstein … complains that he may have a difficulty in recovering from his co-directors their share of the spoil, and he asks that the official liquidator may proceed against his associates before calling upon him to make good the whole amount with which he has been charged. My Lords … I cannot think that this is a case in which any indulgence ought to be shewn to Mr Gluckstein. He may or may not be able to recover a contribution from those who joined with him in defrauding the company. He can bring an action at law if he likes. If he hesitates to take that course or takes it and fails, then his only remedy lies in an appeal to that sense of honour which is popularly supposed to exist among robbers of a humbler type.

Mr Gluckstein’s share of the repayment of secret profits in Gluckstein v Barnes was £6341.

Rescission of contract and damages This remedy arises when the promoter’s misrepresentation to the company is fraudulent. The company may rescind the contract and claim damages as well: Re Leeds and Hanley Theatres of Varieties Ltd [1902] 2 Ch 809.

8.9

•

8.10

•

Constructive trust order This remedy arises when a promoter has acquired property for the company but has retained it for personal gain. The company may acquire a constructive trust order from the court to require the promoter to hand over the property at the original purchase price.

There are many statutory provisions dealing with promoters’ liability, in particular during corporate fundraising. For example:

s 711: imposes disclosure requirements for the nature and extent of the promoter’s interest in the formation or promotion of the company. Non-compliance results in a breach of s 728(1); s 728: imposes civil and criminal liability for a false statement or misleading statement or omission in fundraising disclosure documents; and s 729: allows for investors who suffer loss or damages through reliance upon the defective disclosure document to seek compensation.

These provisions are examined in detail in Chapter 9.

[page 259]

Pre-registration contracts Pre-registration contracts (also formerly known as pre-incorporation contracts) are contracts entered into on behalf of the company before the company has been formally registered with ASIC. The company’s promoter may wish to transact in this way for a variety of reasons. For example, the promoter might wish to take advantage of market conditions and:

purchase property immediately to secure premises in which to trade before an anticipated increase in mortgage interest rates; import raw materials that may have become cheaper due to the sudden rise in local currency; or purchase or lease company vehicles before an anticipated price increase.

To exploit any favourable commercial environment that may temporarily

8.11

exist in the lead up to registration and to overcome the prospect of delay, the promoter therefore might negotiate a purchase of premises, or order raw materials, and immediately sign the contract in the name of the unregistered company. Prior to statutory developments, discussed below, the enforcement of pre-registration contracts presented many difficulties at common law.

Difficulties at common law

ratification: the subsequent approval and adoption of a contract capable of resulting in binding legal relations.

An unregistered company has no legal existence. This fact means that an unregistered company cannot sign a contract itself, or appoint an agent to do so on its behalf. Furthermore, the legal principles on (under the law of agency) require the existence of a principal with power to enter into the contract itself when the purported agent is contracted. These factors combined to present difficulties at adoption of common law in the enforcement of pre-registration contracts.

The problem of enforcement is best illustrated in Black v Smallwood (1966) 117 CLR 52. In this case a contract was signed by two promoters as directors of a company that they believed to be incorporated, but which, in fact, was not. An action was brought against them when they refused to proceed with the contract and they argued that they were acting as agents on behalf of the proposed company. After close scrutiny of the facts, the High Court held that neither the company, nor the promoter who purported to sign a contract on the company’s behalf, were liable on the contract. However, if the evidence shows that a promoter contracted as a principal, and in this way can be distinguished from Black v Smallwood, then the promoter will be personally bound to the pre-registration contract: Kelner v Baxter (1866) LR 2 CP 174. In reality, often the outsider was left without a contract and remedy, except perhaps a claim against the promoter for breach of warranty of authority.3

These difficulties at common law have been overcome through statutory intervention in Pt 2B.3 of the Corporations Act.4 The modern practice of purchasing a ‘shelf’

8.12

8.13

[page 260]

company (ready-made company) also has a similar effect. This arises from the fact that the ‘shelf’ company is already registered and, having legal capacity, contracts in its own name as a separate entity.

Statutory approach: liability for pre-registration contracts Sections 131–133 are intended to be a complete5 code of rights and liabilities in the area of pre-registration contracts. Within this context, it is intended to replace the common law: s 133. The liability provisions reflect policy considerations of fairness and certainty. Unlike the position at common law, it aims to ensure that outsiders dealing with non-existent companies are not prejudiced.

Company’s liability on ratification A company becomes bound by and is entitled to the benefit of a pre- registration contract entered into on its behalf or for its benefit if the company is registered and ratifies the contract within an agreed time or within a reasonable time after the contract is entered into: s 131(1). Under that section, the common law rule that prohibits ratification of a pre- incorporation contract is overcome. Ratification has the effect of creating a binding contract. The Act is silent on the procedure for ratification. In practice, the company may ratify the contract in several ways. For example, through the company’s board of directors passing a resolution, or an authorised individual using the company’s optional common seal to approve the contract. These methods are known as express ratification. The partial performance of the contract by the company may also result in ratification, known as implied ratification.

The concept of ‘reasonable time’ required for ratification is undefined in the Act and, accordingly, will be determined by exercise of judicial discretion in each case. A post-registration ratification period of one month, to ratify a commercial property lease, was held to be ‘reasonable’ for purposes of s 131 of the Act: Classic International Pty Ltd v Lagos (2002) 60 NSWLR 241.6

8.14

8.15

• •

•

Consequence of failure to register company or ratify contract The person who enters into the pre-registration contract is liable to pay damages to the other contracting party if the company is not registered or the contract is not ratified within either an agreed time or a reasonable time after the contract is entered into: s 131(2). Under that provision, the amount recoverable is the same as that which would have been awarded as damages if the contract had been ratified, but was then breached by the company. If the company has been registered it may have to repay some or all of this amount to the person who entered into the contract on its behalf: s 131(3)(c). However, despite any rule of law or equity, the person has no right of indemnity against the company: s 131(2).

[page 261]

Promoter’s liability

novation: arises when a new agreement is entered into in substitution for the old agreement. This has the effect of discharging the original contract.

The Act provides several ways for a promoter to avoid liability for pre- registration contracts, namely, when:

obtaining a signed release from the other contracting party (s 132(1)); the company and the other party enter into a new contract in substitution of the pre-registration contract, known as novation (s 131(2)–(3)); or the company is registered and ratifies the contract within requisite periods (s 131(1)).

The ratifying company has primary liability for breach of the pre- registration contract. For purposes of outsider protection, the Act also allows for the promoter to be under a potential secondary liability. The company’s subsequent failure to perform its contractual obligation, after ratification, may result in a court order for the promoter to pay the whole or any part of the damages which the ratifying company is ordered to pay: s 131(4). This section aims to ensure that the promoter does not abuse the corporate form and thus avoid liability. For example, abuse may occur

when the promoter is the major shareholder of a company which, because it is deliberately undercapitalised or without assets, is unable to meet its contractual obligations. The section is designed to ensure that an outsider is not left without a remedy.

1. 2. 3. 4. 5.

6. 7.

8. 9.

10.

[page 262]

Revision Questions

Who, in law, is a promoter? What are the typical functions of a promoter? What duties does a promoter owe to the company at common law? To whom must a promoter make disclosure? What potential remedies are available to the company at common law for a promoter’s breach of duty? Explain the meaning of a pre-registration contract. What is the impact of ss 131-133 of the Corporations Act on the common law? When is a company bound to a pre-registration contract? How can a promoter avoid personal liability for a pre-registration contract? When will a promoter be personally liable for a pre-registration contract?

Problem Question Alicia, an astute property developer, employed Adam and Robin to form a company to be called Batco Ltd and to make all the necessary arrangements regarding contracts to be entered into by Batco Ltd. Alicia herself had no active role in the incorporation of Batco Ltd. However, she became one of Batco Ltd’s three directors with Adam and Robin. Immediately after incorporation, Batco Ltd bought a commercial development site planned for a petrol station in Pitt Street from Alicia for $900,000. The site had been purchased earlier by Alicia for $700,000 less a discount of $20,000 for allowing the vendor to remove some fixtures on the site. The actual price paid by Alicia was therefore $680,000.

Alicia, on the sale of the petrol station site to Batco Ltd, disclosed the profit of $220,000 to the board of directors. In the prospectus issued by Batco Ltd to the public, it was disclosed

that the price Alicia had paid for the development site had been $700,000. No further reference was made to the property transaction.

In the month prior to the sale of the property by Alicia to Batco Ltd, she was informed by the Sydney town clerk that Pitt Street was to be converted into a pedestrian mall and permanently closed to motor vehicle traffic. She was advised to immediately apply to the Sydney City Council for consent to have the property rezoned for other commercial purposes. Alicia did not do so or disclose this information to Batco Ltd.

Advise, with reasons: (a) Is Alicia a promoter? (b) If she is a promoter, what legal duties does she owe to Batco Ltd? (c) Is Alicia entitled to retain her profit? (d) What remedies, if any, do Batco Ltd and its shareholders have against her?

[page 263]

Guidelines for Answering Problem Questions

When answering a problem question concerning legal issues relating to promoters and their duties, we suggest that the following method may be helpful:

First, it is important to determine, with reference to relevant case law whether the person is in fact a promoter. If so, explain the nature of the fiduciary duties that the promoter owes to the company. Demonstrate, with reference to the given facts, the manner in which the promoter may have breached either their common law duty or statutory duty under the Corporations Act. Once a breach of duty has been established, discuss the relevant remedies available either at common law or under the Corporations Act. If the question is concerned with a pre-registration contract, determine whether the company has been registered and has ratified such a contract within the agreed time or, if no time is

specified, within a reasonable time. If so, discuss the effect of ratification on the company and the promoter with reference to the Corporations Act. Consider the alternative methods in which a promoter can avoid personal liability for breach of the pre-registration contract (for example, check to see if a signed release has been given by the other contracting party or a new contract has been entered into by the company). Check the given facts to see if the circumstances make it likely for the court to exercise its judicial discretion and make the promoter liable if the company fails to perform the ratified pre-registration contract: s 131(4).

Prior to Wang and Erin setting up SCPL, Wang had entered into a commission arrangement with Axion Finance which paid Wang $2,000 commission for entering into the contract to acquire the van. Of course, this is not disclosed to Erin who is furious. Erin is also unhappy with Wang’s long-term coffee bean supply agreement which she believes is too expensive. Wang signed this agreement before SCPL was registered.

Assess who may be liable for the lease contract with Axion and the coffee bean supply agreement. What action (if any) could SCPL take against Wang for the secret commission?

Further Reading

Academic Journals W Courtney, ‘Failed Pre-registration Contracts and the Statutory

Remedy’ (2007) 25 Company and Securities Law Journal 226. M J Whincop, ‘Of Dragons and Horses: Filling Gaps in Pre-

incorporation Contracts’ (1998) 12 Journal of Contract Law 217.

[page 264]

Practitioner Journals D Bugden, ‘Management Rights: Are Developers Promoters?’ (1996) 26

Queensland Law Society Journal 281.

Practitioner Works H A J Ford, R P Austin and I Ramsay, Ford’s Principles of Corporations

Law, LexisNexis, Australia, looseleaf and online.

You will find useful study resources, including quizzes for each chapter, when you go to <http://learning.lexisnexis.com.au>. The quiz is a great tool to help you self-test your knowledge.

L C B Gower, Principles of Modern Company Law, 5th ed, Sweet & Maxwell, London, 1992, p 296. For review of the leading authorities, see Meriton Apartments Pty Ltd v The Owners Strata Plan No 72381 [2015] NSWSC 202; Links Golf Tasmania Pty Ltd v Sattler (2012) 292 ALR 382; 90 ACSR 288; [2012] FCA 634. This remedy is suggested in dicta per Windeyer J in Black v Smallwood (1966) 117 CLR 52 at 64; cf Newborne v Sensolid (Great Britain) Ltd [1954] 1 QB 45. For an overview of the development of the law in this area, see B J McAdam Pty Limited v Jax Tyres Pty Ltd (No 3) [2012] FCA 1438. Grove J in Bay v Illawarra Stationery Supplies Pty Ltd (1986) 4 ACLC 429 suggests that there are gaps in this code. For an example of where incorporation and ratification of a pre-registration contract did not incur within a ‘reasonable’ time, see L-TAG Technologies Co Ltd v SA Cement Supply Pty Ltd [2014] SADC 120.6.

[page 265]

Corporate Fundraising

CHAPTER 9 Nature of debt and equity capital

Payment Repayment of principal and priority Taxation Membership and corporate control

Key definitions General regulation of capital raising Purpose and role of disclosure documents

Disclosure obligations Types of disclosure documents

Prospectus Short form prospectus Offer information statements Profile statements

When are disclosure documents required? Definition of securities Offers exempt from disclosure

Rights issues exemption Lodgement of disclosure documents

[page 266]

Contents of disclosure documents Prospectus Disclosure requirements for prospectuses

Presentation of disclosure documents Regulatory guidance

Application money Minimum subscriptions Prospectus offerings and ASX listing Role of ASIC in fundraising

Review of disclosure documents Power to issue stop order Power to issue exemptions and modifications

Prohibitions, liabilities and defences Misleading and deceptive conduct Supplementary and replacement disclosure documents Civil liability Criminal liability Statutory defences

Regulated conduct during fundraising Restrictions on advertising Prohibitions against securities hawking Fundraising in the digital age

Crowd-sourced funding: Eligible unlisted public companies Gatekeeper role of CSF intermediary Defective CSF offer document and liabilities Defences Other investor protection measures

Crowd-sourced funding: Proprietary companies

[page 267]

Corporate Fundraising

Learning Objectives After completing this chapter you should be able to:

Identify the legal and commercial issues that are relevant for companies deciding between raising debt or equity capital.

Explain the general purpose and role of disclosure obligations during corporate fundraising.

Define key terms in capital raising such as securities and debentures.

Understand the compliance obligations under Ch 6D of the Corporations Act 2001 (Cth) during corporate fundraising.

Discuss the types of disclosure documents and the circumstances where they are used.

Discuss the required content for disclosure documents.

Explain the role and powers of ASIC during corporate fundraising.

Explain the liability provisions for defective disclosure documents and defences.

Key Cases

ASIC v Axis International Management Pty Ltd (No 5) (2011) 81 ACSR 631; [2011] FCA 60

Cadence Asset Management Pty Ltd v Concept Sports Ltd (2005) 56 ACSR 309; [2005]

FCAFC 265

Fraser v NRMA Holdings Ltd (1995) 127 ALR 543

Key Sections

Corporations Act 2001 (Cth) ss 113, 700, 704-706, 708-719, 723, 727-729, 731-734, 736, 739, 761A

[page 268]

Introduction

securities: defined in the Corporations Act (s 761A), for purposes of Ch 6D, to include shares, debentures and options.

Companies have many choices when deciding how to fund their commercial activities. For example, a company can raise finance through retained profits, or by seeking further contributions from its shareholders, or through loans from several sources: its officers or their relatives, banks or other financial institutions. An alternative is for the company to offer securities, such as shares or debentures, to the public for purposes of investing funds in the company. The balance between the amount of debt and the amount of equity that a company has is called the ‘gearing ratio’. The company’s gearing ratio may change over time depending on the current economic trends and changes in interest rates. This chapter focuses on the legal issues rather than the financial issues (including tax policies) which often influence a company’s decision to raise debt or equity capital at any point in time.

The raising of equity capital refers to the process when the company issues shares to meet its capital needs. Persons holding ordinary shares become company shareholders. They are generally entitled to a dividend for their investment, the amount being dependent on the company’s profitability and dividend policy. Capital raising by initial public offerings of shares (IPO), often referred to as floats, are popular.

The raising of debt or loan capital includes the process where the company issues debentures to the public to meet its capital needs. Debentures are essentially acknowledgments of debt which can be issued to individuals or groups of investors. Holders of debentures are entitled to a fixed rate of interest for their investment and a return of the principal amount loaned on maturity of the debt.

Debentures and shares both fall within the statutory definition of securities which means that companies issuing them could be subject to a range of regulatory obligations under Ch 6D of the Corporations Act 2001 (Cth) which deals with fundraising. Debenture issues also come within the scope of

9.1

obligations imposed on the borrowing company under Ch 2L of the Corporations Act which regulates debentures. Debentures that involve a security interest generate further statutory obligations which arise under a different piece of legislation: the Personal Property Securities Act 2009 (Cth) which is commonly referred to as the PPSA.

This chapter examines the nature and purpose of the regulatory obligations that arise during corporate fundraising, particularly the application of Ch 6D of the Act. Chapter 10 examines debentures and secured debt fundraising (including the operation of the PPSA).

Nature of debt and equity capital

institutional investor: a large investor usually a corporation or an investment trust (such as a superannuation fund).

Companies have choices when raising capital. There are many sources of debt capital available to companies, including private loans from shareholders or officers, bank loans and the practice of offering debentures to the public. Companies limited by shares also have the option of raising share capital by issuing more shares, including different classes of shares such as ordinary and preference shares. The reasons for, and differences between, different classes of shares are discussed in Chapter 11. Public companies are able to engage in large-scale fundraising by issuing debt and equity securities to the public at large. Large public companies commonly issue securities to institutional investors: although small

[page 269]

investors (known as retail investors) may also be permitted to purchase securities in major capital raisings. Proprietary companies are not permitted to make general offerings of securities to the public: s 113.

This raises the question as to how companies choose appropriate levels

9.2

9.3

9.4

9.5

of debt and equity capital. The relative levels of debt and equity capital that a company maintains are known as the company’s ‘gearing ratio or level’, with the greater amount of debt being referred to as the company being ‘highly geared’.

Some factors that may influence the choice whether to raise capital through the issue of shares or debentures include the following.

Payment The company is contractually bound to pay a fixed rate of interest to debenture holders regardless of the company’s performance and profitability, while the amount of dividend payable for ordinary shares (if any) depends on the company’s profitability and dividend policy and is generally determined by the directors.

Repayment of principal and priority Debenture holders have a right of repayment in full on maturity of the loan, while shareholders have no right to the return of their capital, although returns of capital are possible during the life of the company and on a winding up if the company is solvent.

The claims of debenture holders as creditors take priority over shareholders for return of their investment during liquidation. Shareholders are only repaid from surplus funds, if any, left after the payment of creditor’s claims.

Taxation The cost incurred in raising debt capital together with the interest payments for debentures will generally be tax deductible for the company, while these advantages do not extend to dividends.

Membership and corporate control Debenture holders and other lenders are creditors and external to the company, while other investors who purchase shares in the company

9.6

•

– – – –

•

become shareholders and are generally entitled to exercise membership rights such as the right to attend and vote at members’ meetings. The right to vote gives members a voice in the company. Members are able to remove directors, while creditors have no such power under the Corporations Act: ss 203C, 203D.

Key definitions

In order to understand how corporate fundraising is regulated, it is important to know several key definitions that underpin the application of the relevant parts of the Corporations Act:

[page 270]

Securities: securities are essentially investment instruments, such as shares and debentures. Securities are defined in s 92, although the scope of this definition differs depending on what part of the Act uses the term ‘securities’. Thus, for purposes of fundraising, securities have a slightly different meaning for corporate fundraising rules under Ch 6D of the Act compared with, for example, the meaning of securities under the takeover laws in Ch 6 of the Act. For purposes of Ch 6D of the Act, with which this chapter of the book is concerned, securities are defined under s 700 (with cross-reference to s 761A) as:1

shares; debentures; a legal or equitable interest in shares or debentures; or options to acquire shares or debentures.

Security: this term can refer to two different things. First, a security can simply be an individual investment instrument (a share or debenture is a security — to issue shares or debentures is to issue securities). Second, security may refer to a right against the debtor’s property given to a lender to secure the repayment of a loan. A company charge or mortgage is a type of security. Recent law reforms under the Personal Property Securities Act impacts on security interests and is discussed in Chapter 10.

•

– – –

–

– – –

Debentures: debentures are essentially debt securities and are discussed further in Chapter 10. Derivatives: a derivative is a type of financial instrument that involves a payment in the future with the calculation of the payment based on a reference benchmark such as an asset, an interest or exchange rate, a commodity price or the value of an index (such as the ASX 200): see s 761D. Derivatives are based on types of contractual arrangements such as forwards, options and swaps (or a combination of these). The regulation of derivatives falls outside the scope of this book. Financial products: this is a broad classification of particular arrangements and instruments which is covered by the detailed laws in Ch 7 of the Corporations Act which is concerned with financial services and markets. Section 763A offers a general definition of a financial product as a facility through which a person does one or more of the following:

makes a financial investment; manages financial risk; or makes non-cash payments.

It is important to note that each of these examples above in relation to financial products have their own statutory definitions which are discussed further in Chapter 21.

It is also important to note that, for the purposes of this book, the Corporations Act offers a specific definition of financial products under s 764A which includes:

a security (such as a share or debenture — see the definition of security in s 761A above); an interest in a managed investment scheme; a derivative; and a margin lending facility.

[page 271]

The disclosure obligations that apply to financial products under Ch 7 of the Act (dealing with financial services and markets) are discussed in Chapter 21. It should be noted that Pt 7.9 of the Act (which deals with

9.7

•

financial product disclosure obligations, such as product disclosure statements or PDSs) does not generally apply to securities: s 1010A. This means, therefore, that disclosure obligations relating to the issue of shares and debentures is regulated under Ch 6D rather than under Ch 7 (Pt 7.9) of the Corporations Act.

General regulation of capital raising

The regulatory structure for corporate capital raising relies largely on the importance of disclosure to investors. Disclosure obligations, the purpose for which is discussed below, arise largely from the issue of disclosure documents by the company under Ch 6D of the Act.

Capital raising may also be regulated by the terms of the company’s constitution (if one is used by the company) which may set out the company’s capital structure requirements. Chapter 2H of the Act (dealing with classes of shares) may also be relevant where the company engages in equity capital raising. This is discussed in Chapter 11 in more detail.

Debt capital raisings can also give rise to obligations under Ch 6D of the Act where the debt instruments are classified as debentures. Debentures issued to the public may also require compliance with the obligations imposed under Ch 2L of the Act which is discussed in Chapter 10.

Apart from the legal framework under the Corporations Act, public companies which are listed on the Australian Securities Exchange (ASX) will be subject to the requirements of the ASX Listing Rules which impose a range of rules relating to changes in capital structure of listed companies. The ASX Listing Rules are contractually enforceable by the ASX.

For issuers offering securities under a disclosure document, ASIC has issued regulatory guides to help them and their advisers understand ASIC’s interpretation of the fundraising rules in Ch 6D of the Act. These include:2

Regulatory Guide 254: Offering securities under a disclosure document (RG 254);

• •

•

9.8

9.9

Regulatory Guide 228: Effective disclosure for retail investors (RG 228); Regulatory Guide 107: Fundraising: Facilitating electronic offers of securities (RG 107); and Regulatory Guide 261: Crowd-sourced funding: Guide for public companies (RG 261).

[page 272]

Purpose and role of disclosure documents

Disclosure documents are often required when companies invite investors to provide capital in the form of investor equity, such as shares, or in the form of corporate debt, such as debentures. The policy reason underlying the Ch 6D disclosure regime is that it would be difficult for retail investors to obtain the information they need without mandatory disclosure.

The general purpose of disclosure documents is to promote disclosure of information that investors reasonably require in order to make informed investment decisions, and to protect investors from exploitation.

Hurst v Vestcorp Ltd (1988) 12 NSWLR 394 New South Wales Court of Appeal

In the case of public companies two requirements were common, namely the disclosure to members of the investing public, by a statement called a prospectus, of the information deemed necessary for informed investment decisions to be made and the compliance with certain minimum standards by those raising funds from the investing public. These dual requirements of information and minimum standards have long been considered the minimal protections necessary for informed investment decisions to be made and investments effected with proper protection.

Disclosure obligations The primary function underlying Ch 6D of the Act is to address the

9.10

9.11

9.12

9.13

imbalance of information between issuers of securities and potential investors: ASIC v Axis International Management Pty Ltd (No 5) (2011) 81 ACSR 631; [2011] FCA 60.

Disclosure obligation provisions exist in Ch 6D of the Act principally because, in broad terms, they aim to do the following.

Achieve a fair and well-informed market A prospectus provides all the information that an investor might reasonably need to know in order to make a reasoned decision about the merits of the investment proposal. To ensure fairness, the same information is available to all investors at the same time. The availability of reliable information is at the heart of an efficient capital market. 3

Assist investors in identifying risks Disclosure documents must contain all the known and reasonably anticipated risks associated with the industry in which the company operates. This requirement allows investors to make an informed investment decision.

[page 273]

Promote cost-effective access to information Disclosure of material information in an effective way enables investors to make more confident assessments about securities without undertaking their own costly inquiries. It is generally more practicable and cost-effective for the fundraiser, rather than the numerous investors, to undertake inquiries and disclose details about its own business.4

Deter unscrupulous practices If no fundraising or disclosure laws existed, investors could easily be defrauded by the use of false information. Capital markets would easily lose credibility and decline. Disclosure documents are more than

•

9.14

marketing tools. They also create legal rights and obligations between the investors and the persons offering the securities. Disclosure documents are a source of potential liability for the persons involved in the offering of securities, for example, in the event of misleading statements or omission of material matters: ss 728 and 729. Similarly, the disclosure document also provides a potential method of protecting the interests of the company, for example, by clearly identifying the risks involved in the investment opportunity offered.

Why should corporate fundraising be subject to regulatory controls? Is a ‘caveat emptor’ (let the buyer be aware) approach desirable, instead, as a regulatory response to corporate fundraising? Consider the following advertisement and identify the concerns, if any, from an investor’s and regulator’s point of view:5

Watch your MONEY GROW 30% per annum and NO FEES

It’s secured and guaranteed For FREE details phone DON on 02 1234 5678

NOW

Types of disclosure documents

Prior to the Corporate Law Economic Reform Program Act 1999 (Cth) (effective March 2000), public companies undertaking fundraising issued a standard full-disclosure document known as a prospectus. In response to the complexity and often prohibitive cost of producing a standard full- disclosure document, the Corporate Law Economic Reform Program Act aimed to reduce the cost of fundraising, particularly for small- to medium- sized public companies which often paid a higher relative cost to raise capital than large companies which had economies of scale for producing the necessary information, higher credit ratings and institutional investor interest.

[page 274]

• • •

9.15

Following from these concerns, Ch 6D the Corporations Act now makes provision for the following types of disclosure documents that may be used for offering securities to prospective investors: ss 709, 713 and 713A. These are:

a prospectus (standard full disclosure document); a short form prospectus; a transaction specific prospectus (adopting special content for continuously quoted securities); a two-part simple corporate bonds prospectus; an offer information statement; and a profile statement.

Each is used in different circumstances and each is subject to different levels of disclosure.

Prospectus A prospectus is the most common form of disclosure document and must generally be prepared for an offer of securities under Ch 6D of the Act: s 709(1). However, a prospectus need not be prepared if the capital raising fits within one or more of the exceptions in s 708 or if the amount of money to be raised is $10 million or less: s 709(4).

Compared with other types of disclosure documents, the prospectus is a detailed, and often lengthy, full-disclosure document.

Section 713 permits the use of transaction-specific prospectuses by disclosing entities offering continuously quoted securities.6 This type of prospectus includes specified limited content, because the issuers that use them are subject to the continuous disclosure regime (under the Corporations Act and ASX Listing Rules)7 and the market will generally already have the information available to it to make an informed assessment of the offer. The continuous disclosure regime, and the meaning of ‘disclosed entities’, are discussed further in Chapter 20. The specific disclosures required are set out in ss 711 and 713.

Following amendments in 2014, a specific disclosure regime applies to offers of ‘simple corporate bonds’ which must be offered under a two-part

• •

(a)

(b)

9.16

simple corporate bonds prospectus. One of the key reasons for the reform was to address what retail investors perceived to be a regulatory bias under the old law. t was felt that companies structured their fundraising for offers of corporate bonds either solely to wholesale investors, or only to certain retail investors in the form of a rights issue or share purchase plan in order to avoid compliance with the fundraising regulatory regime. To this end, the reform aims to simplify disclosure obligations for companies issuing corporate bonds in order to:8

[page 275]

… facilitate increased trading of retail corporate bonds … improve the attractiveness for corporations issuing corporate bonds to retail investors while ensuring effective consumer protections are maintained … [to] aid the establishment of a strong and liquid retail debt market in Australia … through a streamlined disclosure regime … [and to] addresses this perceived regulatory bias [against all retail investors].

A simple corporate bond is a debenture (discussed in Chapter 10) with terms of that issue that meet certain criteria set out in s 713A. These include:

quotation of the securities on a prescribed financial market; and the issuer is a body with continuously quoted securities.

A two-part simple corporate bonds prospectus consists of:

a base prospectus with a life of three years, which must include general information about the issuer that is unlikely to change over the three-year life of the document; and an offer-specific prospectus which must include details of the offer.

This combined document is a prospectus, and therefore a disclosure document, for purposes of the Corporations Act: s 713B.

Short form prospectus Section 712 permits the use of a short form prospectus in an effort to reduce the length and complexity of prospectuses that are distributed to potential investors. The short form prospectus simply refers to material already lodged with ASIC, for example, the company’s financial reports,

9.17

• • • •

instead of including it or summarising it in the prospectus. This is intended to facilitate the presentation of prospectuses to retail investors in a manner best suited to their needs, while still making available a more technical analysis to investors, professional analysts and advisers who wish to seek further information. Investors are entitled to a copy of the lodged documentation from the company, at no cost, upon request: s 712(5).

The value of the short form prospectus provisions is that the material incorporated by reference is deemed to be disclosed, whether or not investors choose to access it: s 712(3).

Offer information statements As noted above, s 709 allows for an offer information statement to be used, instead of a prospectus, for an offer of securities if the amount to be raised from the issue of securities (and combined with all previous equity capital raisings that have used an offer information statement) is $10 million or less: s 709(4). By enabling capital raising up to the $10 million limit without a prospectus, the Corporations Act is intended to facilitate more efficient capital raising, particularly for start-up companies and small and medium-sized enterprises (SMEs). The disclosure requirements for an offer information statement are simplified, less demanding and lower than for a prospectus. However, concerns about giving less information than that required by a prospectus have led to their infrequent use. The required contents of an offer information statement are stated in s 715.

[page 276]

Section 715 states that an offer information statement must:

identify the company and the nature of securities on offer; describe the company’s business; describe the purpose for the funds raised; state the nature of risks involved in investing in securities;

•

• •

•

9.18

give details of all amounts payable (including fees, commissions or charges) in respect of the securities; state a copy has been lodged with ASIC who takes no responsibility for its contents; state that it is not a prospectus and that it has a lower level of disclosure; state that investors should obtain professional advice; include audited financial statements prepared within the previous six months; and disclose any other information required by regulations.

The inclusion of warnings are particularly important in ensuring that inexperienced investors are made aware of the risks involved in an offer information statement.

It should be noted that the ASX requires a prospectus from companies wishing to be listed and have their securities quoted on the ASX.

Profile statements Section 709(2) allows for a brief summary statement, known as a profile statement, to be prepared in addition to a prospectus. As with offer information statements, this reform is part of the policy objective of simplifying and reducing the volume of disclosure material. The company is still obliged to prepare and lodge a prospectus with ASIC. However, s 721 allows for a profile statement, rather than the prospectus, to be sent out with offers with ASIC approval. Investors are entitled to a copy of the prospectus, at no cost, upon request: s 721(3). The required content of a profile statement is set out in s 714. There are currently no approved uses for profile statements.

The background to the introduction of profile statements has been explained by ASIC as follows:9

The profile statement provisions have been developed against a background of concern about the usefulness of the prospectuses to investors. In particular, there are perceptions that the current prospectus provisions can result in some long and complicated documents that are drafted more with a view to avoiding possible liability than to communicating to investors the information they need in a readily comprehensible manner.

•

9.19

Do you think it is desirable to have different types of disclosure documents? Do you believe that investor interests are adequately protected by disclosure documents other than a prospectus?

When are disclosure documents required?

Under s 706 of the Corporations Act, an offer of securities for issue needs disclosure to investors unless s 708 or s 708AA says otherwise. The specific exemptions from

[page 277]

disclosure (contained in ss 708 and 708AA) are considered below. To understand when disclosure documents are required during fundraising, it is essential to examine the meaning of the concepts ‘offer’ and ‘securities’ as used in s 706.

Chapter 6D of the Act unlocks the meaning of these concepts by providing statutory definitions. ‘Offer’ is widely defined and includes inviting applications for the issue of securities: s 700(2). Thus, any written or oral invitation designed to induce investors to buy securities falls within the concept of offer which extends beyond its normal meaning in contract law, as demonstrated in the following judicial statement in ASIC v Australian Investment Forum Pty Ltd (No 2) (2005) 53 ACSR 305:10

Section 700(2) makes it clear that the distinction between ‘offer’ and ‘invitation to treat’ which is drawn in the classical theory of contract formation is not to be slavishly applied in determining whether an offer requiring disclosure under Ch 6D has been made … Many investors would have made up their minds about whether to take up securities well before they are confronted either with the application form or with some document containing all of the terms of a contract.

Thus, for purposes of Ch 6D of the Act, an offer will still be regarded as being made by the company even if funds were not solicited: ASIC v Great Northern Developments Pty Ltd (2010) 79 ACSR 684; [2010] NSWSC 1087.

9.20

• • • •

• •

9.21

Section 700(4) provides that Ch 6D of the Act also applies to securities that are received in Australia, regardless of where any resulting issue, sale or transfer occurs.11

Definition of securities As noted in 9.6, securities are defined in s 92. Section 92(4) states that, for purposes of Ch 6D, the term ‘securities’ has the same meaning as it has in Ch 7 of the Corporations Act: s 700(1). In Ch 7, a security is defined in s 761A as:

a share in a body; a debenture in a body; a legal or equitable interest in shares or debentures; or an option to acquire shares or debentures.

The application of Ch 6D is not confined to public companies only. ‘Body’ is widely defined in s 9 to include corporate or unincorporated bodies and also includes a society or association. There are limitations on capital raisings by proprietary companies, unless a proprietary company converts to a public company: ss 162-164. Section 113(3) prohibits a proprietary company from engaging in any activity that would require disclosure to investors under Ch 6D, except for share offers to:

existing shareholders; or employees of the company or of a subsidiary of the company.

[page 278]

Offers exempt from disclosure Section 708 of the Corporations Act provides a number of specific exemptions from the requirement to use a disclosure document when issuing securities. Reference should also be made to s 708AA which exempts certain rights issues from the need to prepare a disclosure document.

In general, the exemptions are intended to ensure that the operation of

9.22

• •

– – –

the securities markets is not unreasonably hampered by the costly requirement to prepare and use a disclosure document.

To reduce the cost of fundraising and ensure an efficient fundraising process with a degree of flexibility, s 708 exempts the need for disclosure documents when an offer of securities is made in any of the circumstances discussed below. The defendant (usually the company) bears the onus of proving facts which would bring them within the statutory exemption: ASIC v Cycclone Magnetic Engines Inc (2009) 71 ASCR 1; [2009] QSC 58; ASIC v Axis International Management Pty Ltd (No 5) (2011) 81 ACSR 631; [2011] FCA 60; ASIC v Astra Resources plc [2015] FCA 759.

Small-scale, personal offers Disclosure is not required when personal offers are made to a maximum of 20 investors in any 12-month period and with no more that $2 million being raised: s 708(1). To prevent abuse by a person making offers to retail investors at large, a personal offer is defined in s 708(2) as one that:

may only be accepted by the person to whom it is made; and is made to a person who is likely to be interested in the offer because:

of some previous contact with the offeror; of some professional or other connection between those parties; or of statements or actions by that person that indicate they are interested in offers of that kind.

This exception is designed to facilitate small-scale capital raisings without the costs of preparing a disclosure document which can sometimes be prohibitive.

Breach occurs if it results in securities being issued to more than 20 people, or in the company raising more than $2 million by issuing securities, in any 12-month period. Issues of securities that are exempted by other provisions in s 708 are not counted in calculating these amounts and issues of securities: s 708(5).

Sophisticated investors

9.23

•

The Corporations Act permits offers to be made to ‘sophisticated investors’ without a disclosure document: s 708(8). This exception applies to investors in any of the following categories:

the minimum amount payable for the securities on acceptance of an offer by the person to whom the offer is made is at least $500,000; a person whom a qualified accountant certifies to have net assets of at least $2.5 million or a gross income for each of the previous two financial years of at least $250,000 a year (see Corporations Regulations 2001 (Cth) reg 6D.2.03), or the offer

[page 279]

is made to a company or trust controlled12 by the person and the company or trust satisfies these financial requirements; or a person who receives an offer through a licensed dealer who believes on reasonable grounds that they have previous experience in investing in securities which allows them to assess the merits of the investment. The licensee must provide a written statement of their reasons for being satisfied. For further information regarding the licensing of securities dealers, see Chapter 21.

Section 708(10) imposes stringent requirements and obligations on the financial services licensee certifying the exemption, as explained by Barrett J in ASIC v Elm Financial Services (2005) 55 ACSR 544; [2005] NSWSC 1065 and endorsed by Brereton J in ASIC v Maxwell (2006) 59 ACSR 373; [2006] NSWSC 1052:

The requirement that the licensee be ‘satisfied on reasonable grounds’ … is one that must be approached with diligence and care. The licensee has a statutory duty to make inquiry about all matters relevant to the opinion it must form and then … to consider whether, in the factual circumstances, there exist the reasonable grounds … woolly thinking about some general concept of ‘sophisticated investor’ is entirely misplaced.

ASIC v Maxwell (2006) 59 ACSR 373; [2006] NSWSC 1052 New South Wales Supreme Court

9.24

•

9.25

Facts: ASIC instituted proceedings against an accountant, Mr Coakley, who was retained by a group of companies involved in fundraising to act as a Financial Services Licensee for the purposes of claiming the s 708(10) sophisticated investor exemption. The evidence showed that Mr Coakley had not met most of the investors, nor investigated their financial circumstances and had no reasonable basis for being satisfied that those investors had previous experience sufficient to allow them to assess the merits of the offer and the risks involved. Despite these failures, Mr Coakley issued a written statement of reasons in an attempt to satisfy the legal requirements for fundraising.

Decision: The statutory conditions for the operation of s 708(10) exemption were not satisfied. Mr Coakley’s conduct contravened the misleading and deceptive conduct provisions (both under the Australian Securities and Investments Commission Act 2001 (Cth) (ASIC Act) s 12DA(1) and the Corporations Act s 1041H(1)). The court granted, among other things, an injunction, under s 1324, permanently restraining Mr Coakley from publishing statements referring to offers of securities.

The rationale for the exclusion from the disclosure requirements for sophisticated investors is that they are thought likely to have sufficient resources to obtain independent professional advice or, because of the size of their potential investment, they can obtain pertinent information from the issuer because of their bargaining power.

Professional investors The Corporations Act permits offers to be made to ‘professional investors’ without a disclosure document: s 708(11). ‘Professional investors’ are widely defined in s 9 to include:

financial services licensees acting on their own behalf;

[page 280]

trustees of superannuation funds which has assets of at least $10 million; listed entities (companies and trusts) or related bodies corporate of listed entities; and persons who control gross assets of at least $10 million for purposes of investment in securities.

Offers to persons associated with the company The Corporations Act permits offers of securities to be made to people closely connected to the company or its officers without a disclosure

• • •

9.26

• • •

9.27

9.28

document: s 708(12). Disclosure is not required if the offer is made to:

senior managers of the company; senior managers of a related company; or the spouse, parent, child, brother or sister of the senior manager or a company controlled by any of these closely related persons.

A ‘senior manager’ is a person (other than a director or a secretary of the corporation) who either participates in making decisions that affect a substantial part of the business or who has the capacity to affect significantly the corporation’s financial standing: s 9.

Offers made to existing security holders The Corporations Act permits offers of securities to be made to present holders of securities without a disclosure document: s 708(13). Disclosure is not required for offers:

under a dividend reinvestment plan; for fully paid shares pursuant to a bonus share plan; or to existing debenture holders: s 708(14).

Note that a company which fails to comply with the requirements of s 283AA when making an offer of debentures (which requires a trust deed and trustee) cannot rely on the exemption in s 708(14): ASIC v Great Northern Developments Pty Ltd (2010) 79 ACSR 684; [2010] NSWSC 1087. The obligations of a borrowing company under s 283AA are discussed in Chapter 10.

Offers for no consideration The Corporations Act permits offers of securities (other than options) that do not require consideration to be made without a disclosure document: s 708(15). This means that offers for the free issue or transfer of securities do not need disclosure.

Offers under schemes, takeovers or deeds of company arrangement The Corporations Act permits offers of securities made in connection

9.29

•

9.30

9.31

(a)

(b)

(c)

with a scheme of arrangement, takeover or deed of company arrangement to be made without a disclosure document: s 708(17), (17A) and (18).

[page 281]

Debentures of certain companies The Corporations Act permits an offer of debentures made by specified companies without a disclosure document when made by:

an Australian-authorised deposit-taking institution as defined in s 9; or a body registered under the Life Insurance Act 1995 (Cth): s 708(19).

Offers by exempt bodies and public authorities The Corporations Act permits an offer of securities made by exempt bodies or exempt public authorities without a disclosure document: s 708(20) and (21). Exempt bodies are defined in s 66A as being essentially co-operative societies, friendly societies and incorporated associations. An exempt public authority is defined in s 9 as a body corporate that is a public authority or instrumentality, or agency of the Crown.

Rights issues exemption Rights issues are a method of fundraising in which existing members in a company are given the opportunity to purchase securities in proportion to their holdings on specified terms. The main definitional elements of a rights issue under s 9A are:

the offer is made to all existing holders in the offer class (apart from certain non-residents); the offer is pro rata (that is, in proportion to the offeree’s holding at the time of the offer); and the terms of the offer are the same.

According to the Explanatory Memorandum that was issued when this

•

9.32

provision was introduced,13 investor interests will be protected through reliance on the original prospectus disclosure on listing and the continuous disclosure rules to make an informed decision in relation to a rights issue. Accordingly, the disclosure exemption is intended to facilitate retail investors’ access to a discounted form of fundraising, while ensuring they have adequate information about the securities being offered.

If any offers of securities fail to comply with any one of these exemptions, then disclosure is compulsory under s 706 and the need for a disclosure document arises.

Do you believe that the current statutory exemptions applicable to small-scale offers and sophisticated investors are appropriate?14 If not, what types of potential abuse can you envisage?

[page 282]

Lodgement of disclosure documents

A disclosure document to be used for an offer of securities must be lodged with ASIC prior to distribution: s 718. A person must not distribute an application form for an offer of securities that needs disclosure unless the application form is included in, or accompanied by, the disclosure document: s 727.15 This requirement reflects the legislative policy of encouraging investment decisions to be made through reliance on the contents of a disclosure document.

Consent is required of any person, such as directors, professionals and experts, whose statements are included in the disclosure document: s 716(2).16 This requirement is significant for potential defendants due to the liability provisions for a defective disclosure document that are considered below.

9.33

As a result of the Corporate Law Economic Reform Program Act, disclosure documents no longer require registration with ASIC due to the concern that registration may create a false impression of ASIC approval of its contents. This means that when the disclosure document is lodged with ASIC, the company can immediately distribute it. An exception arises in the case of an offer of unlisted securities where the Corporations Act requires a waiting period, also known as exposure period, of 7-14 days after lodgement: s 727(3).

The purpose of the exposure period is to allow ASIC an opportunity to selectively check disclosure documents for compliance with Ch 6D. The Explanatory Memorandum to the Corporate Law Economic Reform Program Act explained the role of the exposure period as follows:

The 7 to 14 day period gives ASIC and the market an opportunity to consider the disclosure document before the commencement of subscriptions for the securities on offer. Where the disclosure document was defective, the market could draw it to the attention of ASIC or aggrieved parties could, if appropriate, seek injunctions preventing the fundraising.

Disclosure documents found to be defective during the exposure period can become subject to a stop order issued by ASIC: s 739. This means that the company is restrained from continuing with the fundraising process until remedial action is taken to rectify the defects. The role of ASIC in fundraising and the effect of a stop order are considered below.

Contents of disclosure documents

Prospectus The overall aim of the disclosure provisions is to ensure that prospective investors are given sufficient relevant and accurate information to make an informed investment

[page 283]

decision. The important role served by disclosure, and its historical

9.34

• • • •

9.35

origins, was explained by Finkelstein J in Cadence Asset Management Pty Ltd v Concept Sports Ltd (2005) 55 ACSR 145; [2005] FCA 1280 at [1]:

Vast sums of money are invested in shares. Shares, however, have no intrinsic value themselves. Their value depends upon the prospects of the corporation that has issued the shares. Their price depends upon how much people are willing to pay based on their evaluation of these prospects. When shares are created and offered to the public, those invited to subscribe must have some idea what the shares will be worth. They have no practical opportunity of making any independent inquiry. The prospectus serves this function. It is the means by which the promoters (and others) are required to disclose to the public everything which could influence the mind of the investor. The Joint Stock Companies Act 1844 … introduced the principle of compulsory disclosure through the medium of a prospectus and this has been a feature of English and Australian company law ever since.

It should be noted that this case was overturned on appeal, though not affecting this point.

The level of disclosure required varies according to the type of disclosure document issued. The disclosure requirements for offer information statements and profile statements were discussed earlier.

Disclosure requirements for prospectuses There are several standards of disclosure for prospectuses imposed by the Corporations Act:

general disclosure test (s 710); specific disclosure (s 711); alternative disclosure test for an offer of listed securities (s 713); and disclosure provisions for two-part simple bonds prospectus (ss 713C, 713D and 713E).

General disclosure test The Corporations Act reflects a changed emphasis on matters that are required to be disclosed in a prospectus. The current general disclosure test, based on a ‘reasonable investor’ standard, can be contrasted with the prescriptive approach adopted by the legislation prior to 1991. Before then, the prospectus disclosure test was based on a checklist which required detailed disclosure about a number of specified items. The current approach has abandoned the legislative practice of setting out a long and detailed list of particular matters (the checklist approach) to be

• •

• • •

• •

•

included in a prospectus.

Section 710 of the Act now places the responsibility on the offeror to decide what information is material to the decision of prospective investors and therefore needs to be disclosed.

Section 710(1) requires the prospectus to provide all the information that investors and their professional advisers would reasonably require to make an informed assessment of:

the rights and liabilities attaching to the securities offered; the assets and liabilities of the body;

[page 284]

the financial position and performance of the body; the profits and losses of the body; and the prospects of the body.

Section 710(2) sets out the matters to have regard to in deciding what information should be included in a prospectus. These are:

the nature of the securities and of the body; if the securities are investments in a managed investment scheme — the nature of the scheme; the matters that likely investors may reasonably be expected to know; and the fact that certain matters may reasonably be expected to be known to professional advisers of investors.

The modern approach to disclosure requirements in a prospectus leaves it to the directors and their advisers to decide what is necessary to enable investors to make an informed decision.

The level of disclosure required is qualified by the requirement of ‘reasonableness’. In deciding what information is reasonable for investors and their professional advisers to expect to find in the prospectus, directors and their advisers must ensure that reasonable inquiries are made to discover relevant information for inclusion. This investigative

9.36

9.37

exercise cast upon issuing companies, directors and their advisers is known as due diligence.

The performance of due diligence activities requires reasonable inquiries to be made of the business, legal and financial affairs of the company for purposes of verifying the accuracy of its records and representations made in the prospectus. It is common practice for issuing companies to form a due diligence committee comprising of its directors and advisers to review and ensure that the prospectus is complete and accurate. Due diligence is an important defence against investor legal action for a claim in damages: s 731.

Specific disclosure In addition to these general disclosure requirements, the Corporations Act imposes an obligation on an issuer to include in a prospectus certain specific information. In particular, s 711 requires disclosure of:

… interests and fees of certain people (promoters, directors, proposed directors, professional advisors and underwriters) involved in forming the company or preparing the float.

In the event of failure to disclose personal interest, the court will not allow for the judicial process to be used to enforce an undisclosed side deal: Kent v Aspermont Ltd [2003] WASC 107.

Alternative disclosure test Special prospectus content rules apply for continuously quoted securities17 on the securities exchange: s 713. Reduced disclosure requirements apply to companies

[page 285]

known as disclosing entities due to their enhanced continuous and periodic disclosure obligations under the Corporations Act and the listing rules of the ASX : see 9.15 and Chapter 20 for further discussion on disclosure requirements. Disclosure rules are relaxed for offers of continuously quoted securities as information that is material to a

9.38

9.39

•

• •

prospective investor’s decision whether or not to invest in the securities would be publicly available. The prospectus must state that, as a disclosing entity, the company is subject to regular reporting and disclosure obligations and that copies of documents lodged with ASIC may be obtained from, or inspected at, an ASIC office: s 713(3).

Presentation of disclosure documents

The Corporations Act requires the information in a disclosure document to be worded and presented in a clear, concise and effective manner: s 715A. This statutory provision is intended to make issuers explain the practical implications of what is being offered, rather than presenting a mass of legal and financial details. The policy objective is to ensure that the disclosure document presents a balanced picture of risk and return, rather than ‘over-disclosure’ of every conceivable risk as a tool to limit liability.18 Contravention of this standard is not an offence, but ASIC has the power to issue a stop order under s 739.

Regulatory guidance Due to the general dissatisfaction with the quality of prospectuses issued, in 2011 ASIC released Regulatory Guide 228: Prospectuses: Effective disclosure for retail investors (RG 228) aimed at providing practical tools to assist issuers and their advisers to produce clear, concise and effective disclosure. The key goal is to make it much easier for retail investors to use and to understand a prospectus.

Prior to the release of RG 228, ASIC identified the following shortcomings in some prospectuses:

front sections of a prospectus are often ineffective, include repetitive summaries, over-emphasise the benefits of the offer, and have a high ratio of marketing statements and photographs which distract investors from important substantive information; they are too long and complex; risk disclosure is too general and may resemble a ‘shopping list’ which does not explain to investors how the risk is relevant; and

•

9.40

there is an absence of complete disclosure on directors and key managers who are leading or managing the company, and relevant benefits or interests they have.

ASIC’s key solutions for more user-friendly prospectuses contained in RG 228 include the following:

provision of one balanced investment overview that tells retail investors key information on which to focus and which helps them navigate the prospectus;

[page 286]

photographs are permissible only after this investment overview is provided and the issuer must ensure that the photographs are relevant; key risks must be highlighted and explanation given as to what these risks mean and some indication must be given of what is likely to happen if the risk occurs; inclusion of a clear explanation of the company’s business model (how the company plans to make money and/or generate income or capital growth); explanation of whether directors and key managers have appropriate expertise and background and any related party transactions, and especially how the latter may conflict with the interests of investors; and disclosure of any legal or disciplinary action against directors and key managers that are less than 10 years old and are relevant to the person’s role.

Application money

The application money received from people applying for securities under the disclosure document must be held in trust until the securities are issued or transferred or the money is returned to the applicants: s 722. If the application money needs to be returned to an applicant, the person

9.41

• •

must return the money as soon as practicable.

Failure to hold subscription funds in trust and to refund investors following failure of an IPO, together with misappropriation of such funds for personal use, will result in a breach of directors’ duties. In ASIC v Warrenmang Ltd (2007) 63 ACSR 623; [2007] FCA 973, Gordon J held that the contraventions of ss 722 and 733 were serious and that the legislative safeguards were breached by the director who authorised or permitted the company to commit these contraventions. Furthermore, by misappropriating a portion of the subscription moneys for himself, the director had breached his statutory duties to exercise a proper degree of care and diligence (s 180); to act in good faith in the best interests of the company and for a proper purpose (s 181); and to refrain from improperly using his position to gain an advantage for himself or someone else, or to cause detriment to the company (s 182). The law on directors’ duties is discussed in Chapters 15-17.

Minimum subscriptions19

It is important that the risk of an unsuccessful securities offering, and particularly a company’s first offering, should not be borne by subscribers: Anemtech Ltd v Eyres Reed McIntosh Ltd (1986) 10 ACLR 780. This principle dealing with investor protection is reflected in ss 723 and 724.

If a disclosure document for an offer of securities states that the securities will not be issued or transferred unless:

[page 287]

applications for a minimum number of the securities are received; or a minimum amount raised.

The person making the offer is prohibited from issuing or transferring any of the securities until that condition is satisfied: s 723(2). An issue of

1. 2.

9.42

shares in breach of a minimum subscription clause is not an invalid allotment, but rather a voidable transaction: Spangaro v Corporate Investment Australia Funds Management Ltd (2003) 47 ACSR 285; [2003] FCA 1025. All application monies must be held in trust until the issue or transfer of the securities: s 722(1).

The Corporations Act sets out choices open to the offeror if the disclosure document’s conditions are not met or are defective. If a minimum subscription condition is stated in the disclosure document and is not satisfied within four months after the date of the disclosure document, the person offering the securities must do one of the following:

repay the money received by the person from applicants; give the applicants specified supplementary or replacement documents and give them one month to withdraw their application and be repaid; or issue or transfer the securities to the applicants and give them the required supplementary or replacement documents and one month to withdraw their application and be repaid: s 724(2).

An unresolved issue, until recently, has centred on the issue determining who makes the choice among the three courses of action in s 724(2). Barrett J in Roadships Logistics Ltd v Tree (2007) 64 ACSR 671; [2007] NSWSC 1084 held that the Act puts the choice in the hands of the person carrying out the obligation, that is, the person making the offer under a disclosure document.

Prospectus offerings and ASX listing

The ASX provides a ready marketplace for the trading of securities of listed companies. Securities can be bought and sold through the securities exchange with a minimum of delay. These advantages make it attractive for newly floated companies to seek quotation of its securities on the securities exchange. It is also a material consideration for an investor to know whether the offeror intends to seek quotation of the securities being offered on a securities exchange. Accordingly, if a company intends to seek admission to the official list of a securities

•

1. 2.

exchange and to apply for quotation of the securities being offered, the prospectus should include a statement to that effect.

Section 723(3) renders void any securities issued or transferred in response to an application made under a disclosure document which states or implies that the securities are to be quoted on a securities market of a securities exchange where:

an application for the admission of the securities to quotation is not made within seven days after the date of the disclosure document; or the securities are not admitted to quotation within three months after the date of the disclosure document. In these circumstances, the person offering the securities must return the money they received from the applicants as soon as practicable: s 723(3).

[page 288]

Section 724 deals with the same circumstances but where applications for the securities being offered have not yet resulted in the issue or transfer of securities. Section 724 provides that if application for admission is not made within seven days, or the securities are not admitted to quotation within three months after the date of the disclosure document, the person offering the securities must do one of the following:

Decisions in Re Insurance Australia Group Ltd (2003) 45 ACSR 702; [2003] FCA 581 and Re Wave Capital Ltd (2003) 47 ACSR 418; [2003] FCA 969 suggest that an honest and unintended failure to observe procedural fundraising requirements in ss 723 and 724 may not mean that the offer of securities is automatically void. Both Federal Court decisions affirm that judicial discretion in s 1322(4)(d)20 of the Act is available to authorise an

9.43

extension of time specified in the Act for lodging an application for quotation of securities. The additional costs and administrative inefficiencies, which would result from a refund of subscription moneys and subsequent redepositing of those moneys by subscribers, influenced the exercise of the court’s discretion in favour of the applicants in both cases.

French J in Re Wave Capital Ltd warned blatant disregard of the Act may lead to refusal of relief. In this instance, the oversight by the company’s secretary and the fact that members of the board had no mechanism for checking compliance with statutory requirements resulted in an order that the costs of the court application not be paid out of company funds. The imposition of personal liability on the company secretary for court costs orders in Re Wave Capital Ltd sends a strong message to company officers to take seriously, and to properly perform, due diligence activities during corporate fundraising.

As a general proposition, a company seeking admission to the official list of the ASX must comply with the admission criteria set out in Ch 1 of the ASX Listing Rules. ASX, however, retains absolute discretion about whether to admit a company to the official list of ASX: ASX Listing Rule 1.19.10. A listed company is contractually bound to the listing rules.

Role of ASIC in fundraising

Review of disclosure documents The Corporations Act mandates that all disclosure documents must be lodged with ASIC prior to public distribution. You may also recall that the system of registration

[page 289]

was abolished due to the possibility of investor misconception that ASIC has endorsed the disclosure document.

•

9.44

ASIC’s Regulatory Guide 152 details its approach to lodged disclosure documents. The following is an overview. ASIC has stated that:

It will conduct selective compliance reviews of some, but not all, disclosure documents following their lodgement. If it has concerns about a disclosure document which cannot be resolved in the seven-day waiting period for unlisted securities, it will extend the period to 14 days: s 727(3). Following the 14-day period, if ASIC’s concerns have not yet been satisfactorily resolved, and it believes that delay may be prejudicial to the public interest, it may impose an interim stop order, pending a hearing. ASIC will expect a supplementary or replacement document to be issued to ensure that no securities are issued on the basis of the defective disclosure document. ASIC will not take responsibility for the content of the prospectus: s 711(7)(b).

Power to issue stop order If ASIC is satisfied that an offer of securities under a disclosure document lodged with ASIC would contravene s 728 (see below for more detail), s 715A (discussed above) or s 734 (see below), ASIC may issue an interim stop order.21 The interim stop order prevents the offer, sale, issue or transfer of securities under the disclosure document while the order is in force: s 739. In effect, the stop order freezes the fundraising process. Following the lodgement of a supplementary or replacement disclosure document, ASIC may revoke the stop order if its concerns are met, otherwise a meeting will be held to determine whether a final stop order should be made.

Pending a hearing, ASIC can issue an interim stop order if it believes that any delay in making an order would be prejudicial to the public interest: s 739(3). ASIC’s power to issue a stop order does not come to an end upon the closing of the offer under the disclosure document: Thompson v ASIC (2002) 41 ACSR 456; [2002] FCA 512.

Statutory amendments in 2007 extended ASIC’s stop order powers to allow it to intervene in cases of misleading and deceptive advertising of securities, similar to current practice in the case of other financial

• •

•

9.45

•

products under Ch 7 of the Corporations Act. For purposes of s 739(6), an advertisement or publication of securities is defective if:

there is a misleading or deceptive statement; or there is an omission of material required by the relevant subsection in s 734(5) or (6); or the advertisement or publication relates to an offer of securities in a class that is not already quoted, and is published before a disclosure document in relation to the offer is lodged.

‘Defective’ is defined further in s 739(7) to include a misleading statement about a future matter if the person does not have reasonable grounds for making the statement. Section 739(8) is a reminder that the statutory definitions of ‘defective’ are non-exhaustive.

[page 290]

Power to issue exemptions and modifications ASIC may exempt a person from a provision of the fundraising provisions or it may modify the application of Ch 6D: s 741. For example, ASIC has provided relief for offers of securities made on the internet that are not directed towards people in Australia: ASIC Corporations (Offers Over the Internet) Instrument 2017/181. This discretionary power is important to achieve a more efficient and cost-effective access to equity.22

Do you think that ASIC’s policy of selective and random checks on disclosure documents for compliance obligations is an appropriate regulatory strategy? Should investors be expected (and are they able) to check the accuracy of information provided in disclosure documents?

Prohibitions, liabilities and defences

9.46

• •

•

A key policy objective of the Corporations Act is to bring about an investment environment in which investors are properly informed about the risks associated with investment opportunities. Chapter 6D aims to ensure that disclosure documents provide reliable, useful and accurate information for investors. Accordingly, sanctions are imposed for wrongful conduct or claims.

It is an offence to offer securities that require a disclosure document (that is, that are not exempt under ss 708 or 708AA) without the lodgement of a disclosure document with ASIC: s 727 (for illustration of the consequences, see ASIC v Axis International Management Pty Ltd (No 5) (2011) 81 ACSR 631; [2011] FCA 60, discussed in the case study below at 9.49). Under the Corporations Act, there are criminal penalties for, and civil remedies in respect of, defective disclosure documents. The key prohibition against defective disclosure documents lies in s 728 which forbids misstatements in, or omissions from, disclosure documents. A disclosure document would contravene s 728 if there is:

a misleading or deceptive statement in the disclosure document; an omission from the disclosure document of material required by the disclosure requirements set out in ss 710-715 (as outlined at 9.33-9.37); or a new circumstance that has arisen since the disclosure document was lodged and, if it had arisen before the disclosure document was lodged, the circumstance would have been required to have been included in the disclosure document.

Both criminal and civil consequences may arise from a breach of these requirements.

[page 291]

ASIC v Sino Australia Oil and Gas Ltd (in liq) (2016) 115 ACSR 437; [2016] FCA 934 Federal Court of Australia

Facts: Sino Australia Oil and Gas Limited (in liq) (Sino) was the Australian holding company of a Chinese operating company providing specialised drilling services to the oil and gas industry. Sino’s

•

9.47

• •

board compromised of three directors — two non-executive directors resident in Australia and Mr Shao, the executive director and chairman. Sino was listed on the ASX on 12 December 2013 after raising approximately $13.6 million under an initial public offering (IPO).

The original prospectus, followed by a replacement prospectus and a further supplementary prospectus (discussed in 9.48 below), were all signed by Mr Shao. The director admitted that he did not understand the English language, whether in oral or written form and did not obtain a full Chinese translation of each prospectus document before signing it or authorising its release.

ASIC alleged that Sino breached its continuous disclosure obligations23 and made misleading and deceptive statements in its prospectus documentation during 2013. ASIC also alleged that Mr Shao failed to act with the proper degree of care and diligence24 as a Sino director and that he breached continuous disclosure laws.

Decision: The court held that Sino had contravened ss 674(2), 728(1)(a), 728(1)(b), 728(1)(c), 1041H25 of the Corporations Act, finding that it:

made false representations in its prospectus documentation in relation to patents that it claimed it and its Chinese-based subsidiary held; failed to disclose that its profit forecast for the 2013 calendar year would be significantly less than forecast in its replacement prospectus; failed to disclose in its prospectus documents the existence of a loan agreement with the sole director of Sino’s Chinese-based subsidiary; made misleading and deceptive statements in its prospectus documentation in relation to the existence of service contracts it claimed to hold in China; made misleading or deceptive statements in relation to a claim that it had received a sum of $3.1 million from the proceeds of convertible notes; and provided false information to its auditors in relation a Chinese-based subsidiary.

The court also held that Mr Shao’s failure to obtain a full translation of the prospectus documents before signing or authorising them was a failure to discharge his duties with reasonable care. The fact that Mr Shao was not an English speaker or writer and did not understand Australian legal requirements did not mean that he could just leave it all to others and did not excuse him from performing his own duties with reasonable care and diligence (at [70]). The court found (at [87]) that Mr Shao ‘failed to educate himself about disclosure requirements under Australian law’.

In the subsequent civil penalty decision, Mr Shao was disqualified from managing a company for 20 years and ordered to pay compensation in the sum of $5,539,758. That sum represented the loss and damage the company will suffer to compensate the shareholders that were misled and deceived by the content of the prospectus during the capital raising. A pecuniary penalty of $800,000 was imposed on Sino: ASIC v Sino Australia Oil and Gas Ltd (in liq) (2016) 118 ACSR 43; [2016] FCA 1488.26

[page 292]

Misleading and deceptive conduct Examples of misleading or deceptive statements include:

circulation of false reports of increased sales; circulation of false reports of mineral strikes;

• •

circulation of inflated profit forecasts without reasonable grounds; or circulation of a prospectus with incomplete material information that can be described as ‘tricky’.

The last example in the list above was illustrated in the case of Fraser v NRMA Holdings Ltd (1995) 127 ALR 543 discussed below. Although this case was decided under the identical statutory provision in s 52 of the Trade Practices Act 1974 (Cth) (now s 18 of the Australian Consumer Law), as it was permissible at that time, litigation based on a defective disclosure document can no longer be brought under that Act due to later law reform in 1998. This means that, under current law, litigation based on a defective disclosure document must be brought under the relevant statutory provisions in the Corporations Act, such as ss 728 and 1041H. The relevance of the NRMA case, however, lies in its application of the ‘misleading and deceptive’ provision which corresponds to the statutory language used in s 728 of the Corporations Act.

Fraser v NRMA Holdings Ltd (1995) 127 ALR 543 Federal Court of Australia Full Court

Facts: The directors of the NRMA, a motoring group, converted this mutual organisation into a company by incorporating it as a company limited by guarantee. This conversion process into an ordinary company, a type of reorganisation, is known as demutualisation. Prior to this conversion, the directors prepared a prospectus which set out the benefits of demutualisation and mailed it together with a notice of a meeting to all of the members of this motoring group so that they could vote in favour of demutualisation. The prospectus stated, repeatedly, that the members would be ‘better off’ under this proposal to reorganise and strongly recommended a ‘yes’ vote in favour of the proposal. The prospectus also stated, on numerous occasions, that the members would benefit from this proposal by acquiring ‘free shares’ in the new company.

Some of the directors of the NRMA, who opposed demutualisation on the basis that it was not in the members’ best interests, sought a court injunction to prevent the meeting on the grounds that the prospectus was misleading and deceptive and, therefore, in breach of the Trade Practices Act. They succeeded in the original decision and then NRMA Ltd appealed.

Issue: Was the information in the prospectus, strongly worded to encourage a favourable response from the membership, misleading or deceptive or likely to mislead or deceive?

Decision: The court dismissed the appeal on the basis that the prospectus failed to make full and fair disclosure of all facts which were material to enable the members to make a properly informed decision. The prospectus had failed to adequately explain why the members would be ‘better off’, failed to state the main disadvantages about the proposed restructure which the board had recommended and failed to include the statements of the dissenting directors’ reasons.

• •

It was held that the persistent use of the phrase ‘free shares’ promised to the members were, on the contrary, not in fact free. The prospectus had failed to explain clearly that the members who accepted the ‘free shares’ would be giving up their current membership rights (and all entitlements attached to those rights) in the NRMA in exchange for those shares.

[page 293]

In these circumstances, the Full Court held:

… the failure to identify and inform members about the disadvantages of which the directors making the recommendations were aware was to leave the members in a half light …

Significance: The case demonstrates that information contained in a disclosure document must be balanced (fairly presented) and not exclude material information that is relevant to enable an informed decision to be made — otherwise liability can be attracted under s 728 for misleading and deceptive statements.

It is not necessary in every case for a profit forecast to be provided: GIO Australia Holdings Ltd v AMP Insurance Investment Holdings Pty Ltd (1998) 30 ACSR 102. However, when a profit forecast is provided, ASIC has cautioned against its incorrect use. ASIC’s policy on the inclusion of profit forecasts is detailed in ASIC Regulatory Guide 170, Prospective Financial Information. The following is an overview. ASIC states that the general test of whether prospective financial information must be disclosed is whether it is:

relevant to its audience; and reliable (that is, there must be a reasonable basis for it: GIO Australia Holdings Ltd v AMP Insurance Investment Holdings Pty Ltd (1998) 29 ACSR 584).

Information is not material to investors if it is ‘speculative or based on mere matters of opinion or judgment’: AAPT v Cable & Wireless Optus Ltd (1999) 32 ACSR 63; [1999] NSWSC 509. Although case law in this area relates to takeovers, ASIC considers that they state principles that apply equally to disclosures made in a disclosure document.

Additional information must be provided with prospective financial information to enable investors and their advisers to make an informed assessment. Information can be misleading if it is presented in isolation from the assumptions and a description of the methodologies used to

9.48

9.49

develop the information: see, for example, Westfi Ltd v Blend Investments Pty Ltd (1999) 31 ACSR 69.

Supplementary and replacement disclosure documents Where the person making the offer becomes aware that the disclosure document contains misleading or deceptive statements, has omitted key information, or new circumstances have arisen since lodgement that are materially adverse from the point of view of an investor, they may lodge a supplementary or replacement document with ASIC: s 719(1). Additionally, if the person making the offer becomes aware that information in a disclosure document is not worded and presented in a clear, concise and effective manner, the person may lodge a supplementary or replacement document with ASIC: s 719(1A). These provisions exist to ensure that disclosure documents remain current and reliable, do not breach s 728 and present an opportunity to cure defects.

A replacement disclosure document, as the name suggests, replaces the original document and is appropriate when there are major or drastic changes since the lodgement of the original document. For purposes of investor protection, an offer made after lodgement of the replacement document must be accompanied by a copy of the replacement document. A supplementary document, as the name suggests, supplements the information in the original document and is appropriate when, for example, the assumptions on which the profit forecast is made are unclear. Offers

[page 294]

made after lodgement of the supplementary document must be accompanied by copies of both the original disclosure document and the supplementary document.

Civil liability A breach of s 728 gives rise to civil liability for defective disclosure. Section 729 states that any person who has suffered loss or damage

• • • • •

•

because of defective disclosure can claim a civil remedy from persons identified in s 729. This means that an investor may bring a recovery claim for a misleading statement or material omission or failure to include a new matter in the disclosure documents against:

the company; the directors; any proposed director named with their consent; an underwriter named with their consent; a person named with their consent as having made a statement that is included or on which a statement made in the disclosure document is based, for example, any person whose profession or reputation gives authority to their statement, such as an expert geologist or an auditor. Such persons will only be liable for the loss or damage caused by the inclusion of that statement; and a person who contravenes, or is involved in the contravention, of s 728(1).

Section 729(1) makes clear those persons who may be liable for a defective disclosure document. Where only some of the persons named above are named as defendants in a civil liability action under s 729(1), it is presumed that those defendants may cross-claim and seek a contribution from others to whom liability might reasonably attach.

Cadence Asset Management Pty Ltd v Concept Sports Ltd (2005) 56 ACSR 309; [2005] FCAFC 265 Full Federal Court

Facts: Concept Sports Ltd (the defendant) wished to raise $12 million. It issued a prospectus offering 24 million ordinary shares at an issue price of $0.50 each. The prospectus contained financial information about the company, including forecast sales revenue and forecast earnings before interest and tax. The prospectus also contained statements about the company’s activities, the strength of its business and the future prospects for that business.

The plaintiff, Cadence Asset Management Pty Ltd, subscribed for 100,000 shares in Concept Sports Ltd on the strength of the prospectus in June 2004. In September 2004, the plaintiff sold the shares to a third party at an average price of 11.5 cents per share.

Issue: The plaintiff sued the defendant under s 729 to recover damages and alleged that the prospectus was defective due to:

1. 2.

non-compliance with the disclosure provisions in s 710; and the forecast for sales revenues and earnings and the statements about the company’s outlook being misleading and deceptive in breach of s 728.

[page 295]

Concept Sports Ltd objected to the plaintiff’s claim on the basis that they were barred from bringing their claim because of the operation of the rule in Houldsworth’s case.27 This rule stated that a shareholder could only claim a remedy by first rescinding their share purchase. However, Cadence had already sold their shares so they could not rescind the purchase and therefore the rule prevented them from claiming against the company. The trial judge, Finkelstein J, held that this judicial precedent (decided in 1880) limited the operation of the statutory remedies in ss 728 and 729 and upheld the objection.

Decision: The Full Federal Court disagreed and upheld the entitlement of the subscribing shareholder (Cadence Asset Management Pty Ltd) to recover from the company issuing the prospectus (Concept Sports Ltd) the loss suffered as a result of the subscription without the need to rescind the contract to acquire the shares.

Chapter 6D of the Corporations Act was held by the Full Federal Court in the Cadence Asset Management case to be a complete code designed to protect investors from misleading and deceptive statements and omissions from mandatory disclosure documents. That code was held to provide a powerful remedy to achieve that purpose, which should not be read down as being limited by the judicial precedent in the Houldsworth case. It should be noted that in late 2010 the Corporations Act was amended to remove the rule in Houldsworth’s case by inserting s 247E, which states that a member is not prevented from bringing a claim merely because they continued to hold shares or had previously sold shares.

The value of a shareholder’s right to a civil remedy for damages or a refund arising from a breach of the fundraising laws under Ch 6D is underscored by the publicity order ASIC obtained, under s 1324B of the Act, in ASIC v Axis International Management Pty Ltd (No 5) (2011) 81 ACSR 631; [2011] FCA 60 where the court held:

The orders sought in this case [to bring] by both letter and advertisement to the attention of those shareholders [who] may well have a cause of action, of which they may be unaware … will also have the effect of bringing to the attention of the general public, including those who may be considering fundraising, the relevant provisions of the Corporations Act and the consequences of non-compliance as well as the fact that the corporate regulator will pursue such matters.

The publicity order granted by the court, following the company’s breach of s 727 in failing to make disclosure when offering securities, is reproduced in the key statement below.

[page 296]

ASIC v Axis International Management Pty Ltd (No 5) (2011) 81 ACSR 631; [2011] FCA 60 Federal Court of Australia

declaratory orders: court orders that clarify the existing legal rights of parties involved. For example, a declaration may be made by a court that a particular section of the Corporations Act has been contravened.

Notice to shareholders in Firepower Holdings Group Limited [hereinafter Firepower]

The Federal Court of Australia has ruled that certain offers to sell shares in Firepower were in breach of the Corporations Act 2001 (Cth).

That Act prohibits offers for the sale of shares within one year of the original issue of the shares unless a prospectus is lodged with ASIC or unless certain exemptions apply. For example, an exemption applies if offers are to ‘sophisticated investors’ who (it appears from an accountant’s certificate) have net assets of at least $2,500,000 or gross income for each of the last two financial years of at least $250,000.

The court has found that on several occasions, [the defendants] offered shares for sale where no prospectus had been lodged with ASIC [as required under s 727] and none of the exemptions applied.

Persons who bought shares in Firepower before [the relevant date] may wish to take legal advice on whether any exemptions applied in their case, and if not whether they have a right to seek damages or a refund of the money paid for the shares.

[It should be noted that, in addition to the publicity order above, the court in the Firepower case also made declaratory orders against the company28 and the directors for the following reasons:

Declaratory orders: … are sought by [ASIC] as the national corporate regulator for the important purpose of recording … contraventions of the Corporations Act … by [the directors], as well as the Court’s disapproval of their contravening conduct … [Such] orders will serve an important law enforcement purpose by communication to those defendants and the public … that the [directors] conduct contravened s 727.

As a consequence of the declaration orders, ASIC successfully sought disqualification orders (under s 206E) against the directors in ASIC v Axis International Management Pty Ltd (No 6) [2011] FCA 811. Mr Johnson, as the controlling mind of the company, was banned from managing a company for 20 years and Mr Ward was banned for six years. Declaration orders and directors’ disqualification orders from management are discussed in Chapter 14.]

9.50

9.51

9.52

•

Criminal liability A breach of s 728 is an offence and can also give rise to criminal liability if the defect is materially adverse from the point of view of an investor: s 728(3). Sections 731-733, discussed below, provide defences to criminal proceedings for breach of s 728(3).

Statutory defences Defendants identified in s 729 as liable for defective disclosure documents may avoid their civil and criminal liability if they can satisfy one of the following defences set out in ss 731-733.

Due diligence defence for prospectuses Section 731 provides a due diligence defence for prospectuses only. Liability can be avoided if the defendant can prove they:

[page 297]

made all inquiries (if any) that were reasonable in the circumstances; and after doing so, believed on reasonable grounds that the statement was not misleading or deceptive; or after doing so, believed on reasonable grounds that there was no omission from the prospectus.

To succeed under this defence, the defendant needs to show that they undertook reasonable inquiries to verify their information and had reasonable grounds to believe in the accuracy of the disclosure statements. It is considered best practice for an issuing company to establish a due diligence committee to co-ordinate and supervise the verification process. The creation of a paper trail that records all the checklists, meetings and decisions helps to demonstrate evidence of best practice in the preparation of the prospectus.

9.53

9.54

•

9.55

Lack of knowledge defence for offer information statements and profile statements

Section 732 provides a lack of knowledge defence for offer information statements and profile statements only. This defence reflects the reduced disclosure requirements for offer information statements and profile statements and legislative policy that dispenses with the need for a stringent due diligence process in the preparation of these documents. As a result, the defendant only need prove that they did not know that the statement was misleading or deceptive or that there was material omission. In practice, this may be a problem since, as noted by commentators,29 by the time of the trial the defect and its consequences will be manifest.

Reasonable reliance defence The reasonable reliance defence applies to all types of disclosure documents: s 733. The defence in s 733 will be made out if a defendant proves that they placed reasonable reliance on information given to them by:

someone other than a director, employee or agent of the company (if the defendant is a company); or someone other than an employee or agent of the individual (if the defendant is an individual).

It is common practice for the issuing company to engage a variety of external experts and professional advisers when preparing a disclosure document. For purposes of this defence, a person who provides professional or advisory functions (such as an auditor or solicitor) is not regarded as an agent of the company or individual: s 733(2). This means that a defendant can use this defence if they relied on someone unconnected who performed a specific advisory or professional function.

Withdrawal of consent defence The withdrawal of consent defence applies to all types of disclosure documents (s 733(3)):

(a) (b) (c)

9.56

•

9.57

[page 298]

A person who is named in a disclosure document as:

being a proposed director or underwriter; or making a statement included in the document; or making a statement on the basis of which a statement is included in the document;

… is not liable [in a criminal or civil action] … if the defendant proves that they publicly withdrew their consent to being named in the document ….

Unawareness of new matter defence The unawareness of new matter defence applies to all types of disclosure documents and a defendant is not liable in a criminal or civil action if they can prove that they were unaware ‘of a new circumstance [arising] since the disclosure document was lodged’: s 733(4). If the defendant is aware of the new circumstance, the Act obliges them to ‘lodge a supplementary or replacement disclosure document with ASIC’: s 719.

Do you think that the expansion of the liability provisions for defective disclosure documents beyond the company and its directors is appropriate? What are the pitfalls, if any, of such an expansive or blanket approach to liability?

Regulated conduct during fundraising

The general need for an issuer to prepare and lodge a disclosure document with ASIC was discussed earlier. Chapter 6D generally aims to ensure that investment decisions are made with reference to the contents of a disclosure document. To achieve this purpose, and ensure that protective provisions for investor interests are not undermined, the marketing and distribution of securities are regulated under the

9.58

•

9.59

Corporations Act. In particular, Pt 6D.3 imposes restrictions on advertising and prohibits the practice of share hawking.

Restrictions on advertising The general restrictions on advertising and publicity in s 734 reflect the general policy of ensuring that disclosure documents remain the main source of investment information rather than information supplied by advertisements or other forms of promotion.

However, limited direct advertising campaigns and publicity is allowed before the disclosure document is lodged but the extent permissible is dependent on whether the offers of securities are to be quoted on the ASX or not: see s 734(5).

After the lodgement period advertising is allowed provided it identifies the securities, refers to the disclosure document and states that anyone wishing to acquire securities will need to complete an application form: s 734(6).

Other general exceptions relate to:

A news report or genuine comment in a newspaper or periodical or on radio or television about a disclosure document or information contained in a disclosure document: s 734(7).

[page 299]

Independent reports (for example, by someone other the company or its directors and that person must not have an interest in the success of the issue or sale and not act at the instigation of, or by arrangement with, the company and must not receive payment or other benefits): s 734(7).

Prohibitions against securities hawking A person must not offer securities for issue or sale in the course of, or because of, an unsolicited meeting with another person or an unsolicited

• • • •

•

9.60

9.61

phone call to another person, unless the offer is exempt: s 736. This practice, which often involves unsolicited badgering of investors and pressure selling, is known as ‘securities hawking’.30

The exemptions in s 736(2) relax the general prohibition and allow share hawking for offers made:

to sophisticated investors (as defined in s 708(8)); to professional investors (as defined in s 708(11)); of listed securities made by telephone by a licensed securities dealer; to a client by a licensed securities dealer through whom the client has bought or sold securities in the last 12 months; or under an eligible employee shares scheme (see the definition in s 9).

If securities are issued to an investor in breach of s 736, the investor may return the securities within one month and are entitled to be repaid the amount they paid for the securities: s 738. Section 736 creates a strict liability offence, so there is no mental element required for a breach of this section.

Fundraising in the digital age It is now common to observe the routine use of email and the internet (web-based platforms) to make offers of securities under Ch 6D of the Act. Companies are increasing relying on electronic disclosure documents and electronic application forms, including the distribution of these documents by a variety of electronic devices (computers, tablets and smartphones). In response to such developments, ASIC has issued RG 107 Fundraising: Facilitating electronic offers of securities (March 2014) to guide the market and explain the manner in which the provisions in Ch 6D are still applicable to the regulation of corporate fundraising. This document offers good practice guidance with the aim to ensure that companies still comply with the policies underpinning Ch 6D, discussed earlier at 9.8-9.13 (purpose and role of disclosure documents) and under 9.58-9.59 (restrictions on advertising and securities hawking).

The impact of modern technology has also resulted in new ways of raising funds from savvy investors and consumers eager to help start-ups (innovative businesses). Crowd funding, in particular, is growing in

9.62

popularity with a wide range of platforms (websites like Kickstarter, Pledgie and IndieGoGo) available to connect investors with business ideas. Crowd funding, as recognised by ASIC, involves the use of the internet and social media to raise funds in support of specific project or business idea. People who pledge their money to support such business initiatives typically expect

[page 300]

to receive some reward (which could be in the form of equity) in return for their funds. It is currently over a billion dollar worldwide phenomenon.

Promoters of crowd funding, however, need to be aware of the legal environment in which they operate. The Corporations Amendment (Crowd- sourced Funding) Act 2017 amends the Corporations Act 2001, and makes minor amendments to the Australian Securities and Investments Commission Act 2001, to provide a legislative framework for crowd- sourced funding. The Act received Royal Assent in March 2017 and came into effect from 29 September 2017. The Federal Government, at the time of writing, proposed an extension of the law reforms to proprietary companies, discussed below at 9.67.

Crowd-sourced funding: Eligible unlisted public companies

Part 6D.3A of the Corporations Act provides the legal framework for equity-based crowd-sourced funding by eligible unlisted public companies to make offers of ordinary shares to retail investors. Section 738A makes clear that the object of the new Part 6D.3A is to provide a disclosure regime that can be used for certain offers of securities for issue in small unlisted companies, instead of complying with the requirements of Part 6D.2.

Generally, this new regime reduces the regulatory requirements for public fundraising while maintaining appropriate investor protection

• • •

•

• •

9.63

measures.31 To qualify as an eligible company, the following requirements in s 738H(1) need to be satisfied. The company must:

be a public company limited by shares; have its principal place of business in Australia; have the majority of its directors (excluding alternate directors) living in Australia; not exceed the assets and annual revenue cap of $25 million (including the assets and revenue of its related parties);32 not be a listed company (including its related parties); and not have a substantial purpose of investing in other companies, entities or schemes (including its related parties), for example, a managed fund.

Eligible unlisted companies can raise up to $5 million in any 12-month period. Funds raised under offers made to sophisticated or professional investors under the exceptions in s 708(8) and (11) of the Corporations Act do not count towards the issuer cap.

Retail investors have an investment cap of $10,000 per company in any 12-month period (the ‘investor cap’) and a cooling-off period allowing them to withdraw from a crowd-sourced funding offer up to five days after making an application: s 738ZD. The legislated cooling-off period is a vast improvement from the Bill which had originally proposed a 48-hour cooling-off period.

[page 301]

Gatekeeper role of CSF intermediary The crowd-sourced funding (CSF) intermediary occupies a central role in the new regime. The CSF intermediary is required to host the crowd- funding offer and to publish it on its online platform. The CSF intermediary must hold an Australian financial services (AFS) licence authorising it to provide crowd-funding services. The offers are to be made through a licensed CSF intermediary’s platform, using an offer document which is to remain open for a maximum of three months.

•

9.64

(a)

The offer document must include the minimum information required by law, such as a prominent general risk warning about crowd-sourced funding, information about the company (financial, operational and management), the offer (rights and risks)33 and investor rights (cooling- off period): s 738J(2). The offer document must be worded and presented in a ‘clear, concise and effective’ manner: s 738K. Misleading or deceptive content is prohibited: s 738U.

The licenced CSF intermediary has an important gate-keeping role to perform; for example, they must perform checks on the operating company, its directors and the offer document issued: s 738Q. he prescribed checks undertaken by the licenced CSF intermediary are spelt out in the regulations and are to be conducted to a ‘reasonable standard’: s 738Q. Failure to conduct checks or to the required standard is a strict liability offence.

The gatekeeper obligations are intended to ensure that an intermediary does not publish, or continue to publish, the offer document in four specific circumstances as follows (s 738Q):

not satisfied as to the identity of the company or its directors or other officer; has reason to believe that any of the officers are not of good fame or character; has reason to believe that the company or its officers have, in relation to the CSF offer, knowingly engaged in conduct that is misleading or deceptive or likely to mislead or deceive; or has reason to believe that the offer is not eligible to be made as a CSF offer.

Defective CSF offer document and liabilities The new regime provides for civil and criminal liabilities for a defective CSF offer document. The definition of ‘defective’, and the consequences of breach, are aligned with the existing provisions in Chapter 6D applying to prospectuses and other offer documents. ‘Defective’, for these purposes, means:

the CSF offer document contains a misleading or deceptive statement; or

(b)

(c)

(a)

(b)

there is an omission from the CSF offer document of information required by s 738J; or since the document was first published on a platform of a CSF intermediary, a new circumstance has arisen that would have been required by s 738J to be included in the document if it had arisen before the document was so published: s 738U.

[page 302]

A person who suffers loss or damage because an offer of securities under a CSF offer document may recover the amount of the loss or damage from a person identified in s 738Y(5), namely:

People liable on disclosure document

Item These people … are liable for loss or damage caused by …

1 the company making the CSF offer

any contravention of subsection (1) in relation to the CSF offer document

2 each director of the company making the CSF offer

any contravention of subsection (1) in relation to the CSF offer document

3 a person named in the CSF offer document with their consent as a proposed director of the company

any contravention of subsection (1) in relation to the CSF offer document

4 an underwriter (but not a subunderwriter) to the issue named in the CSF offer document with their consent

any contravention of subsection (1) in relation to the CSF offer document

5 a person named in the CSF offer document with their consent as having made a statement: that is included in the CSF offer document; or on which a statement made in the CSF offer document is based

the inclusion of the statement in the CSF offer document

6 a person who contravenes, or is involved in the contravention of, subsection (1)

that contravention

7 a CSF intermediary that publishes the CSF offer document on a platform of the intermediary

a contravention of subsection (1) in relation to the CSF offer document, but only if paragraph (3)(b) is satisfied

9.65

•

9.66

intermediary

Note: For exceptions to liability, see section 738Z.

Criminal liability arises when the statement, omission or new circumstance which led to the document being defective is materially adverse from the point of view of an investor: s 738Y(4).

ASIC may make a stop order under s 739 in relation to a defective CSF offer document. To ensure accuracy and reliability of the information in the offer, a company is obliged to provide a replacement or supplementary CSF document in certain circumstances: s 738W.

Defences Partially aligned with the existing provisions in Ch 6D applying to prospectuses and other offer documents, s 738Z provides that a person may rely on the following defences when sued for a cause of legal action under s 738Y:

[page 303]

Lack of knowledge. This defence is currently available in respect of offer information statements (but not in respect of prospectuses, which have a higher due diligence threshold). Reasonable reliance on information given by someone else — statements and omissions. Consistent with the position in relation to existing disclosure documents, a person that performs a particular professional or advisory function will not be taken to be an agent of the body or individual. Withdrawal of consent — statements and omissions. Person making use of this defence has the evidentiary burden of demonstrating that they did in fact withdrew their consent publicly as they would be best placed to be able to do this.

Other investor protection measures Broadly aligned with the existing provisions in Chapter 6D applying to prospectuses and other offer documents, Part 6D.3A also has a general

9.67

•

prohibition against advertising and share hawking with limited exceptions.

The purpose of the advertising rules is to protect investors by ensuring they make informed decisions regarding the merits of a CSF offer based on the information contained in the CSF offer document rather than advertisements. Exceptions to the advertising restrictions that are consistent with the exemptions available in relation to advertising other types of offer documents under Chapter 6D of the Act are available: s 738ZG.

Crowd-sourced funding: Proprietary companies

The new laws under Part 6D.3A only apply to eligible unlisted public companies. The new laws did not address the regulatory barriers which prevent proprietary companies from accessing the crowd-sourced equity- funding.

In September 2017, the Corporations Amendment (Crowd-sourced Funding for Proprietary Companies) Bill 2017 was introduced into the Federal Parliament to address this gap and to remove current regulatory obstacles. Key features of the Bill includes proposals to:

remove the 50 shareholder cap that currently applies to proprietary companies — investors who acquire shares through crowd-funding offers will not be counted towards the cap. Subsequent transfers by crowd-funding investors who on-sell their shares will also be exempt if the company is not listed on a financial market. The aim is to ensure that proprietary companies with crowd-funding investors will not be forced to convert into a public company, and comply with its more onerous obligations, upon breach of the 50 shareholder cap; ensure that proprietary companies with shareholders that acquire shares through a crowd-funding offer will not be subject to the takeover rules; ensure that proprietary companies with crowd-funding shareholders prepare financial reports in accordance with accounting standards,

•

with financial statements to be audited once the company raises at least $3 million from crowd-funding offers.

[page 304]

The aim is to provide financial transparency and to allow investors to monitor progress and make informed decisions about their investment; ensure that crowd-funding proprietary companies have a minimum of two directors, rather than the usual one director. The aim is to provide greater transparency and certainty around succession planning; and ensure that crowd-funding proprietary companies comply with the existing related party transaction provisions34 that apply to public companies.

[page 305]

Revision Questions

What are securities for purposes of the fundraising disclosure provisions? What is the difference between a prospectus and a profile statement? Under what circumstances are companies exempt from preparing a disclosure document? How does the Corporations Act define a ‘small-scale offer’ and a ‘sophisticated investor’? When will a debenture issue require a disclosure document to be issued? How do you determine what ‘material’ information must be included in a disclosure document? What purpose do supplementary and replacement disclosure documents serve? Who may be potentially liable for defective disclosure during a capital raising? How could due diligence be proved if the directors are sued for a defective prospectus document?

Problem Question Flywell Ltd is the owner of an Australian domestic airline. The Australian travel market is very competitive. The management of Flywell Ltd is concerned about the plans of a rival airline company that intends to expand its Australian domestic operations. The board of directors of Flywell Ltd decides to revamp its fleet of aircraft and to purchase extra planes, but the company does not have the capital. Flywell Ltd wishes to induce each investor to invest $10,000 with the company in exchange for shares in the company. The company aims

(a).

(b).

(i) (ii) (iii)

to raise between $9 million and $11 million in new funds. The company has approached you for advice.

Advise Flywell Ltd of its fundraising obligations under the Corporations Act, paying particular attention to the specified facts. Refer to the facts above. Assume Flywell Ltd has issued shares and has lodged a prospectus with ASIC. The prospectus contains a totally unrealistic profit forecast made by the directors and supported by a quote from an independent industry expert. Flywell Ltd’s expansion was a disaster because market demand for domestic travel slumped unexpectedly soon after the prospectus timeframes closed.

The investors have commenced legal action on the basis that the profit forecast statements in the prospectus were misleading or deceptive. Assuming this to be the case, advise the following parties on their respective rights and liabilities:

the investors of Flywell Ltd; Flywell Ltd; and Flywell Ltd’s directors.

Guidelines for Answering Problem Questions

When answering a problem question concerning legal issues relating to corporate capital raising, we suggest that the following method may be helpful:

It is important to determine, first, whether the statutory definition of securities is satisfied to see if Ch 6D is applicable. Determine what type of security is involved (usually shares or debentures).

[page 306]

If so, the next enquiry should consider whether any of the statutory exemptions from the need to issue a disclosure document are applicable to the facts. Is a disclosure document required? Is the question dealing with a primary issue or secondary issue of securities? Consider the operation of s 1041H for disclosure that is not under a formal disclosure document like a prospectus. If none of the statutory exemptions are applicable, the next enquiry should determine which type of disclosure document is

4. 5.

10.

appropriate and reasons should be offered for the choice. If the securities are debentures, see Chapter 10. The content provisions of the relevant disclosure document should be considered to check for statutory compliance. What type of information must a disclosure document contain? Should the disclosure document be defective, the need to issue a supplementary or replacement disclosure document should be considered. In this context, ASIC’s enforcement role and ability to issue a stop order must also be considered. Check to establish that the minimum subscriptions, if any, are satisfied. If not, discuss the legal consequences. The consequences of failure to correct a defective disclosure document must be considered with reference to the statutory liability provisions in s 728. Is the investor entitled to remedies for loss or damage suffered? The potential defendants, listed in s 729, should be identified and their potential defences under Ch 6D should be considered. Ascertain whether any of the statutory restrictions on advertising or share hawking provisions have been breached.

Wang and Erin have resolved their differences and the SCPL business is now doing very well. Wang decides that now is a good time to expand the business by opening up new stores. The café was recently featured in the Good Café Guide and business is booming. Wang estimates that they will need another $3 million to open up two more stores. Erin may be interested in investing another $200,000. The head barista, Sean, is also interested in investing $100,000. Wang decides to put an advertisement in the local Chinese language newspaper:

‘New investors needed: greater than 20% returns on investment guaranteed … Call Wang 0412345678’.

There is no reasonable basis for this claim, but Wang is optimistic of the business’ future prospects.

Wang decides to register a new company, SC Future Pty Ltd (with Wang taking on the sole director role and SCPL owning all the shares in SC Future), and this new company will issue securities to the public to raise money for the expansion of the SCPL business.

Advise Wang as to his position, and the position of SC Future and SCPL in relation to the fundraising activities. What action (if any) could ASIC take?

[page 307]

Further Reading

Academic Journals M Adams and A Hargovan, ‘Taking Corporate Governance Seriously

During Fundraising: Exposure to Personal Liability for Cost Orders’ (2004) 22 Company and Securities Law Journal 335.

T Ancev, ‘Equity Crowdfunding in Australia: A Regulatory Balancing Act’ (2015) 33 Company and Securities Law Journal 352.

E Boros, ‘Corporations Online’ (2001) 19 Company and Securities Law Journal 492.

E Ip, ‘The Share Capital Puzzle: The Corporate Decision to Issue Ordinary or Preference Shares’ (2002) 20 Company and Securities Law Journal 289.

K Kazakoff and L Chapple, ‘Market Response to Offer Information Statements’ (2003) 21 Company and Securities Law Journal 231.

C Moore, ‘Equity crowdfunding in Australia: how far have we come and where to next? (2017) 35 Company and Securities Law Journal 102.

T Wong, ‘Crowd Funding: Regulating the New Phenomenon’ (2013) 31 Company and Securities Law Journal 89.

Practitioner Journals M Adams and A Hargovan, ‘Costs Orders: A New Wave of Liability for

the Company Secretary?’ (2003) 55(11) Keeping Good Companies 644. T Stumm, ‘Prospectus Alternatives under the Simpler Regulatory

System Act’ (2007) 59(11) Keeping Good Companies 663.

Practitioner Works

6. 7.

9. 10.

11. 12.

13.

14.

15.

LexisNexis, Australian Corporations Law: Principles and Practice (looseleaf and online) [7.10.0005]-[7.10.0465].

You will find useful study resources, including quizzes for each chapter, when you go to <http://learning.lexisnexis.com.au>. The quiz is a great tool to help you self-test your knowledge.

Simple corporate bonds (discussed below at 9.15) issued under a two-part simple corporate bond prospectus are excluded from this definition of ‘securities’. A listing of other relevant regulatory guidance (up to 2016) can be found in Appendix 2 of RG 254. ASX Listing Rule 3.1 also imposes a continuous disclosure obligation on companies listed on the securities exchange. Fundraising: Corporate Law Economic Reform Program Proposals for Reform: Paper No 2 (1997) 9. This example is taken from ASIC v Maxwell (2006) 59 ACSR 373, although the telephone number has been changed for privacy reasons. See section 9 for definition of ‘continuously quoted securities’. For example, s 674(2) of the Corporations Act imposes an obligation on listed companies to comply with the listing rules. ASX Listing Rule 3.1 requires that ‘once an entity is or becomes aware of any information concerning it that a reasonable person would expect to have a material effect on the price or value of the entity’s securities, the entity must immediately tell ASX that information’. Explanatory Memorandum, Corporations Amendment (Simple Corporate Bonds and Other Measures) Bill 2014 at pp 5-7. ASIC Policy Proposal, ‘Fundraising: Profile Statements’ Paper No 1, July 1999. For discussion, and illustration, on the concept of offer as applied under Ch 6D, see ASIC v Great Northern Developments Pty Ltd (2010) 79 ACSR 684; [2010] NSWSC 1087; ASIC v Axis International Management Pty Ltd (No 5) (2011) 81 ACSR 631; [2011] FCA 60. For application of s 700(4), see ASIC v Astra Resources plc [2015] FCA 759. ‘Control’ is defined in s 50AA to include the capacity to determine the outcome of decisions about the entity’s financial and operating policies. Corporations Legislation Amendment (Simpler Regulatory System) Bill 2007, Explanatory Memorandum at [5.7]. See, for example, C Peter, ‘Revisiting the Regulation of SME Fundraising’ (2006) 24 Company and Securities Law Journal 319; The Treasury, Corporate and Financial Services — Regulation Review, 2006. For contraventions of s 727, see ASIC v Pegasus Leveraged Options Group Pty Ltd (2002) 41 ACSR 561; ASIC v Australian Investors Forum (No 2) (2005) 53 ACSR 305; ASIC v Australian Investors Forum Pty Ltd (No 3) (2005) 56 ACSR 204; ASIC v Elm Financial Services Pty Ltd (2005) 55 ACSR 411; ASIC v Axis International Management Pty Ltd (No 5) (2011) 81 ACSR 631; [2011] FCA 60; ASIC v Astra Resources plc [2015] FCA 759.

16.

17. 18.

19.

20.

21.

22. 23.

24.

25.

26.

27.

28.

29.

30. 31.

32.

33.

34.

See further, ASIC Regulatory Guide 55: Statements in disclosure documents andPDSs: Consent to quote (RG 55). See s 9 for definition of ‘continuously quoted securities’. ASIC Media and Information Release, ‘ASIC Releases Draft Guidance on Shorter, Better Prospectuses’, 8 February 2006. For the historical and modern meaning of this concept, see Spangaro v Corporate Investment Australia Funds Management Ltd (2003) 47 ACSR 285; [2003] FCA 1025. Section 1322 of the Act provides that company proceedings are not necessarily invalidated by procedural defects, unless the defect causes substantial injustice. See, for example, stop order issued by ASIC on pre-prospectus publications by Bitcoin Group Ltd (ASIC Media Release, 13 February 2015). See further, ASIC Regulatory Guide 51: Applications for relief (RG 51). The company was a listed disclosing entity. The company and Mr Shao admitted that from 12 December 2013, the company was required to disclose market sensitive information to the ASX immediately by operation of ASX Listing Rule 3.1 and s 674 of the Act. See Chapter 20 for discussion on continuous disclosure law. See Chapter 17 for discussion on this aspect of the case concerning breach of director’s duties by Mr Shao. See Chapter 21 for discussion on s 1041H dealing with misleading or deceptive conduct in relation to a financial product or financial service. See further A Hargovan, ‘Foreign Directors of Australian Companies Put on Notice: No Leniency for Ignorance of Duties’ (2017) Governance Directors 37. A rule, known as the rule in Houldsworth’s case (Houldsworth v City of Glasgow Bank (1880) 5 App Cas 317) states that a shareholder cannot sue for damages for a fraud or misrepresentation inducing subscription for shares unless he or she first renounces the share purchase contract. If applicable to Ch 6D of the Corporations Act, it would mean that Cadence Asset Management Pty Ltd would be barred from bringing its damages claim because the shares were already sold to a third party and, thus, incapable of rescission. However, as discussed above, the Full Federal Court held that the rule in Houldsworth’s case does not apply to claims made by shareholders under Ch 6D. In 2010, s 247E was inserted into the Act to confirm that the mere fact that a shareholder had continued to hold shares or had sold their shares would not prevent the person from claiming damages. For a similar result, see ASIC v Great Northern Developments Pty Ltd (2010) 79 ACSR 684; [2010] NSWSC 1087. H A J Ford, R P Austin and I Ramsay, An Introduction to the CLERP Act 1999 — Australia’s New Company Law, Butterworths, 2000, p 63. See further, ASIC Regulatory Guide 38: The hawking provisions (RG 38). See further, ASIC Regulatory Guide 261 Crowd-sourced funding: Guide for public companies (RG 261). See the Appendix for template offer document. See the definitions of ‘related body corporate’ in s 50 and ‘subsidiary’ in s 46 of the Corporations Act. See the definition of ‘control’ in s 50AA and the meaning of ‘associate’ in ss 10, 11, 15 and 16 of the Corporations Act. Common risks for an early stage or start-up business includes financing risk, competition risk, technological and operational risks, and legal or regulatory risks. The law on related party transactions in Chapter 2E of the Corporations Act is discussed in Chapter 16 at 16.12.

[page 309]

Debt Finance

CHAPTER 10 Debentures

Statutory definition Exceptions

Obligations of the borrower How debentures may be described Trustee for debenture holders Contents of the trust deed Duties and liabilities of a trustee Duties of borrower and guarantor

Secured finance Types of security devices Overview of Personal Property Securities Act 2009 (Cth) Demise of the fixed and floating charge distinction Attachment and perfection of a security interest Registration of a financing statement

[page 310]

Priority of security interests Taking free (extinguishment) rules Enforcement rules Invalidation of security interests

[page 311]

Debt Finance

Learning Objectives

After completing this chapter you should be able to:

Apply the statutory definition of debentures and outline the main exclusions from that definition.

Understand the manner of regulating debentures under the Corporations Act 2001 (Cth).

Outline the legal obligations of a borrowing company when offering debentures to the public.

Explain how major law reform under Personal Property Securities Act 2009 (Cth) (PPSA) applies to corporate secured debts.

Outline the types of charges a borrowing company may give the debenture holder as security for a loan.

Describe the difference between fixed and floating charges and discuss how the PPSA treats this traditional distinction.

Discuss the procedure for the attachment and perfection of security interests under the PPSA.

Outline the system of priorities under the PPSA.

Key Sections

Corporations Act 2001 (Cth) ss 9, 283AA, 283AC, 283BA, 283BB, 283BH, 283DA, 283GA, 588FL, 588FM, 761A, 764A

Personal Property Securities Act 2009 (Cth) ss 8, 10, 12, 13, 14, 19, 20, 21, 55, 62, 153, 267

10.1

[page 312]

Introduction

Chapter 9 identified some of the key considerations that companies face when raising new capital. That chapter, in particular, examined the range of statutory obligations that are imposed on companies raising capital using a formal disclosure document (such as a prospectus) under Ch 6D of the Corporations Act. It should be remembered that Ch 6D of the Act applies to securities, which include both shares and debentures. As noted in Chapter 9, debentures are a form of debt security that can be issued to individuals or to groups of investors.

In addition to the legal framework under Ch 6D, debentures that are issued to the public must generally comply with the requirements of Ch 2L of the Corporations Act — the latter imposes obligations such as the preparation of a debenture trust deed and the appointment of a trustee to represent the debenture holders’ interests.

Debentures come in both secured and unsecured forms. Secured debentures have previously had to comply with Ch 2K of the Corporations Act which regulated the registration and priority of company charges. Chapter 2K was repealed by the introduction of the Personal Property Securities Act 2009 (Cth) (PPSA), which commenced on 30 January 2012. The PPSA made fundamental changes in the law about security interests and introduced a new regime for registering and enforcing both personal and corporate secured debt arrangements.

This chapter provides an overview of the legal issues concerned with companies raising debt capital, both on a secured and on an unsecured basis.

Debentures

A company may issue debentures to raise debt capital. The term ‘debenture’ is defined at common law and under the Corporations Act. At common law, the courts have acknowledged that the term ‘debenture’ is difficult to define but that it has identifiable characteristics, namely, it is a

10.2

document issued by a company that evidences debt, which may be secured or unsecured.

Handevel Pty Ltd v Comptroller of Stamps (1985) 157 CLR 177 High Court of Australia

Any discussion of the nature of a debenture must begin with the statement that English judges of great authority have confessed that the term defies accurate definition … However, it has been generally agreed that two characteristics of a debenture are, first, that it is issued by a corporation and, secondly, that it acknowledges or creates a debt … The debt may be secured on the assets of the company but, security in this sense is not an essential characteristic of a debenture … not every document creating or acknowledging a debt of a company is a debenture. It has been said that commercial men and lawyers would not use the term when referring to negotiable instruments.

[page 313]

Statutory definition

chose in action: an intangible personal property right protected by law.

Prior to the commencement of the Corporate Law Economic Reform Program Act 1999 (Cth) (referred to as the CLERP Act) in March 2000, a debenture was defined as a document issued by the company under which it acknowledged or created a debt. Similar to the common law definition, the old statutory definition was narrow in that it was only concerned with paper or documents that evidenced debt. To accommodate technological advances and the practice of electronic commerce in debentures, the CLERP Act expanded the definition of debentures in s 9 to mean a chose in action that includes an undertaking by the body to repay, as a debt, money deposited with or lent with the body. The statutory definition may not always apply because s 9 states ‘unless a contrary intention appears’. This was applied in Re Amerind Pty Ltd (Rec and Man Apptd) (in liq) (2017) 121 ACSR 206; [2017] VSC 127, where the common law definition was found to apply to s 433 because otherwise that provision (which provides employees with priority over

10.3

•

circulating security interests) would not apply to corporate bank loans.

In the recent case involving ABN Amro and Standard and Poor’s (ABN Amro Bank NV v Bathurst Regional Council (2014) 224 FCR 1; [2014] FCAFC 65) the court considered whether a form of debt-based derivative instrument called a collateralised debt obligation (or CDO) was a debenture. The court considered the common law and statutory definitions of debentures and held that the CDO did not involve the repayment of a debt. The instrument provided ‘a return of the amount deposited, at a time and in an amount, not linked to the conduct of the business of the company which issued it but instead measured by the performance of a separate index’ and held that this was not a debenture: at [673]. The court held (at [676]):

Here, the nature of the loan and the obligation to repay it are quite different from that which is contemplated by the usual fundraising activities traditionally associated with the issue of debentures.

Similar to the common law definition, s 9 includes a debt that is secured or unsecured within the statutory definition.

Exceptions However, not every corporate undertaking to repay money deposited or lent is to be treated as a debenture for purposes of the Corporations Act. Section 9 contains a number of exceptions and excludes, for example, undertakings:

to repay money as part of a trade finance arrangement (for example, where goods are supplied under an invoice on 30-day repayment terms); by an Australian ADI (authorised deposit-taking institution, such as a bank) to repay money deposited with it, or lent to it, in the ordinary course of its banking business; and to pay money under a cheque or bill of exchange.

It appears, following the collapse of Banksia Securities Ltd, that investors do not fully understand the distinction between debentures and ADI deposits. Debenture investments are higher risk than a deposit with a bank, building society or credit union that is prudentially supervised by

10.4

•

• • •

the Australian Prudential Regulatory Authority (APRA). As part of the effort to ensure that debenture issuers are more financially resilient, ASIC has released a number of regulatory guides which are discussed further below.

[page 314]

Obligations of the borrower

How debentures may be described To ensure that investors are not misled about the nature of their investment and the level of security attached to it, the Corporations Act regulates and limits how the borrower may describe debentures. Section 283BH(1) states that debentures can only be described in a prospectus or any other document inviting loans as either a:

mortgage debenture (when secured by a first registered mortgage over real property); debenture (any other type of security arrangement); an unsecured note; or an unsecured deposit note.

Each description of these terms has a distinctive feature that signals to the investor whether the loan is secured or unsecured. However, this obligation only applies to debentures that would require a disclosure document to be issued under Ch 6D of the Act. The disclosure regime, and types of disclosure documents required under Ch 6D of the Act, was discussed in Chapter 9 and is applicable here.

In 2011 ASIC issued a Consultation Paper 151 Debt Securities: Modifying the Naming Provisions and Advertising Requirements (March 2011) which proposed modifications to the debenture naming provisions under s 283BH of the Act. The proposed changes involve the introduction of a new term that sits between debentures and unsecured notes, simply called ‘notes’. This term would be available for notes that currently fall within the statutory term ‘unsecured notes’ but which are secured over

10.5

intangible property. ASIC subsequently released Class Order CO 12/1482, which implemented this reform. ASIC has the power to modify the operation of Ch 2L under s 283GA.

ASIC has been very active in trying to better educate the public about the risks associated with investing in debenture products which has involved increasing the regulation of advertising of debenture products and requiring standard benchmarking of several key risk factors for unlisted notes.1

Trustee for debenture holders

trust deed: a document which spells out the rights and duties of the borrowing company and debenture holders and is monitored for compliance by the trustee on behalf of the latter.

Before a company raises capital by issuing debentures, a trustee must be appointed to protect the interests of the debenture holders. Trustees are viewed as important gatekeepers, responsible for monitoring the financial position of the debenture issuer. The trustee and the borrowing company enter into a trust deed, the terms of which set out the respective rights, powers and duties of the trustee, the company and the debenture holders. Debenture trustee companies are required to be registered by ASIC under the new Ch 5D of the Corporations Act. The reforms regulate the reporting of financial information and the setting of fees by trustee companies, as well as imposing duties on directors and employees of trustee companies.

[page 315]

These reforms aim to bring debenture trustee services within the scope of broader financial services regulation under Ch 7 of the Act, including the requirement to hold an Australian Financial Services Licence and the application of the consumer protection provisions in Ch 7. Financial services under Ch 7 of the Act are discussed in Chapter 21.

The appointment of a trustee is necessary to protect the interests of the

• • • • •

10.6

debenture holders against the risk of breach of the borrowing conditions. It is difficult for the individual debenture holders, who tend to be scattered throughout the country or hold (relatively) small investments, to supervise and enforce the loan themselves.

The trustee monitors the activities of the borrowing company and checks that the lending conditions set out in the trust deed are either not breached or, if breached, remedial action is taken to rectify any breach: s 283DA. The trustee undertakes these functions on behalf of the debenture holders.

For the purposes of investor protection, there are restrictions on who can be a trustee. The Corporations Act prescribes rules for the appointment of a trustee which, often in practice, are banks, life insurance companies and other qualified companies.

Section 283AC requires the trustee to be any one of the following types of bodies, free of any conflict of interest or duty with the borrowing company:

a state or territory public trustee; a licensed trustee company (see Ch 5D); a body corporate registered under the Life Insurance Act 1995 (Cth); an Australian ADI (such as a bank); or a body corporate approved by ASIC.

If the borrower becomes aware that the trustee cannot be a trustee, the trustee must be replaced: s 283BD. To ensure the continuous protection of debenture holders, an existing trustee continues to act as trustee until a new trustee is appointed and has taken office: s 283AD.

Contents of the trust deed The trust deed is an important document that sets out the rules for the operation of the debentures, the rights and duties of the trustee and borrower, and it often imposes controls on the future borrowing activities of the company as an additional safeguard for the interests of debenture holders.

• • •

10.7

•

• •

10.8

The Corporations Act prescribes the minimum content of the trust deed. Section 283AB requires the trust deed to provide that the following are held in trust by the trustee for the benefit of the debenture holders:

the right to enforce the borrower’s duty to repay; any charge or security for repayment; and the right to enforce any other duties that the borrower and any guarantor have under the terms of the debentures, or the trust deed or under Ch 2L of the Corporations Act.

[page 316]

Duties and liabilities of a trustee The duties of a trustee extend beyond administering the payment of interest and principal as they fall due. Section 283DA sets out the trustee’s duties. The trustee must ensure the following:

exercise reasonable diligence to ascertain whether the borrower and guarantor (if any) are complying with their obligations; notify ASIC of any breaches by the borrower; and act in the best interests of the debenture holders.

Section 283HB allows either the trustee or ASIC (but not the borrower) to apply to the court to make a range of orders to protect the debenture holders: see further Re Banksia Securities Ltd (in liq) (rec and man apptd) [2016] NSWSC 357.

Acting to protect the debenture holders’ interests The trustee must give the debenture holders a statement explaining the effect of any proposal that the borrower submits to them before any meeting that either the court calls in relation to a scheme of arrangement or any meeting that the trustee calls.

The trustee has a duty to comply with directions given to it at a debenture holders’ meeting, unless the trustee thinks it is objectionable and obtains a court order confirming the objection: s 283DA.

• •

10.9

• •

•

10.10

•

Trustees may call a meeting of debenture holders to inform, and submit proposals for their protection, if the borrower or guarantor fails to remedy any breach of Ch 2L, the terms of the debenture or provisions of the trust deed when required by the trustee: s 283EB(1).

Trustees are liable for breach of trust when they fail to exercise the degree of care and diligence required under the Corporations Act. This duty is breached when, for example, the trustee:

allows the charged property to diminish in value; or allows the borrower to undertake other loans which increases the risk to the original debenture holders.

Attempts to exempt or indemnify the trustee against such breaches are generally void: s 283DB(1).

Duties of borrower and guarantor General duties

Section 283BB states that the borrower must:

carry on and conduct its business in a proper and efficient manner; provide a copy of the trust deed to a debenture holder or trustee upon request; and make all financial and other records available for inspection by the trustee, their authorised representative or by a registered auditor.

[page 317]

Specific duties The borrower has the obligation to:

notify ASIC of the trustee’s name within 14 days of appointment (s 283BC); find a replacement trustee as soon as practicable if the trustee has ceased to exist, has not been validly appointed, cannot act as trustee, or has failed or refused to act as trustee (s 283BD); give the trustee written details of any charges created within 21 days

•

10.11

after its creation (s 283BE); give the trustee and ASIC quarterly reports which must include, for example, any matter that may materially prejudice any security or the interests of the debenture holder (s 283BF); call a meeting of debenture holders where the holders of 10% or more of the nominal value of the issued debentures direct the borrower to do so and the purpose of the meeting is to consider financial statements laid before the AGM or give the trustee directions in relation to the exercise of any of its powers (s 283EA); and maintain a register of debenture holders (ss 168 and 171).

A guarantor is defined in s 9 with reference to a body that has guaranteed the repayment of any money deposited or lent to the borrower under the debenture. The duties of the guarantor set out in ss 283CA-283CE substantially reflect the general duties of the borrower considered above.

Following a string of high-profile collapses in the debenture sector, including Banksia Securities Ltd, ASIC has put forward proposals to strengthen the regulation of the debenture sector which is worth about $4 billion. ASIC launched several enforcement actions against multiple parties involved with collapsed debenture issuers, such as Gippsland Secured Investments, Wickham Securities and Banksia Securities.

Why do you think it is essential to appoint a trustee for debenture holders and to subject the trustee to onerous statutory obligations?

Secured finance

A lender will often require assurance that they will be paid. This assurance is usually satisfied when the company that borrows (debtor company) grants security over its property to the lender. This allows the lender to have both a contractual right to receive repayment of the debt (derived from the loan document) as well as a right against the secured assets. The advantage of security is that the rights against the debtor’s

10.12

•

property may persist even if the borrower becomes insolvent (as seen, for example, in Salomon’s case discussed in Chapter 5), while the contractual right to payment will typically be compromised or even extinguished in insolvency. See the earlier discussion in Chapter 3 on the reasons why creditors will often seek security when dealing with a limited liability corporate entity.

Security will generally give the creditor priority because it can seize the secured property and sell it to repay the debt. This, of course, is subject to competing security

[page 318]

claims against the same property (that is, where the debtor has granted multiple securities over the same assets).

Corporate law, therefore, makes a distinction between creditors who have rights against the property of the debtor (secured creditors) and creditors who only have bare contractual rights against the company — but not its individual assets (unsecured creditors).

Types of security devices The law recognises several types of security devices:

the mortgage (which at common law transfers the legal title to the secured assets to the creditor); the equitable charge (which allows the appointment of an independent person (known as a receiver) to seize the secured assets and sell them to discharge the debt); the pledge (where the creditor holds property of the debtor to ensure payment; the property may be sold provided certain conditions are satisfied); and the lien (where the creditor retains the debtor’s property until payment is made; generally, sale of the property is not allowed).

The Corporations Act blurs the distinction between an equitable charge and a mortgage by defining a charge as including a mortgage: s 9. Thus,

10.13

• •

•

• •

a legal charge issued by a company can be either a mortgage or an equitable charge. Legal charges have traditionally been further differentiated between fixed and floating charges (discussed below), although this distinction is mostly irrelevant now because of the Personal Property Securities Act 2009 (Cth) (‘PPSA’) which provides its own system for prioritising security interests.

This system of security devices is complex, having both legal and equitable rules governing these security devices — as well as a diverse range of federal and state statutory regimes which require registration of some, but not all, security devices. In an effort to reduce such complexities and confusion, the PPSA was introduced on 30 January 2012.

Overview of Personal Property Securities Act 2009 (Cth) The PPSA is a fundamental piece of reform which does the following:

rewrites the law on traditional securities; replaces the conceptual framework on security interests and introduce new terminology; provides a single national law governing security interests; fundamentally changes the system for recognising and enforcing security devices; and introduces a single Personal Property Securities (PPS) Register which acts as an ‘electronic noticeboard’ of security interests.

The PPSA covers both individuals and companies taking or giving security over virtually all kinds of property, except for land, fixtures and water rights (among other

[page 319]

exceptions). Personal property, for the purposes of the PPSA, encompasses a range of classes of property, including:

goods; inventory;

• •

• • • •

•

motor vehicles, aircraft and watercraft; financial property (including cash, bank accounts, financial instruments); agricultural property (including crops and livestock); intangible property (including intellectual property, licences); certain personal and/or contractual rights; and proceeds of personal property (for example, proceeds from the sale of secured collateral).

The review of the PPSA conducted for the Federal Government by Mr Bruce Whittaker recommended simplifying these collateral classes.2

It can be seen from the expansive definition above that personal property under the PPSA is anything that can be owned, traded or otherwise treated as property — except for a significant exception, land (which includes buildings and fixture that is attached to the land and forms parts of the land, such as in-built refrigerators, lifts and air-conditioning systems). Further exclusions are identified at 10.17. For a discussion of fixtures and the PPSA, see Power Rental Op Co Australia LLC v Forge Group Power Pty Ltd (in liq) (rec and man apptd) [2017] NSWCA 8 (where mobile gas turbines placed onto large trailers were held not be fixtures and were therefore subject to the PPSA).

The impact of the PPSA on security interests will be discussed further below. It is useful, however, to note several key terms that are used in the following discussion:

secured party — this is the person who has been given security in personal property to ensure that a debt is repaid or an obligation is performed; debtor — this is the person who owes money to the secured party or is obliged to perform an obligation; grantor — this is the person who has rights in personal property (including, but not limited to, full ownership rights) over which they grant a security interest to the secured party. The grantor will usually be the debtor, but may not be in the case of a guarantee, for example: collateral — this is the personal property that is subject to the security interest. It may include tangible property such as goods or intangible property such as book debts;

•

10.14

security agreement — this is the agreement that confers the security interest in the grantor’s personal property; and security interest — this is the security device that allows the secured party to exercise rights against the collateral on default. Traditional security devices, such as a mortgage or charge will constitute a security interest under the PPSA, provided that they satisfy the definition in s 12 of the PPSA.

[page 320]

Demise of the fixed and floating charge distinction The distinction between fixed and floating charges has existed in Australian and English law for well over a century. It will, however, become largely irrelevant over time as the PPSA takes hold over commercial transactions: see generally Hamersley Iron Pty Ltd v Forge Group Power Pty Ltd (in liq) (rec and man apptd) (2017) 320 FLR 259; [2017] WASC 152 (which notes that the principles of the law relating to floating charges are redundant under the PPSA).

The traditional distinction between fixed and floating charges was to consider whether the debtor company was free to deal with the secured assets in the ordinary course of business without the prior permission of the secured creditor: Re Spectrum Plus Ltd (in liq) [2005] 2 AC 680; [2005] UKHL 41.

Before the PPSA reforms, a fixed charge was said to attach to particular assets (such as plant and equipment) which prevented the company from dealing with the property without the consent of the secured party (the lender). In contrast, a floating charge could float or hover above the charged assets (often a whole asset class such as, cash, book debts, trading stock or even all of the debtor company’s current and future property). This made it possible for the debtor company to deal with charged property without first needing to ask the permission of the secured party. A floating charge, however, would become fixed once the debtor company defaulted on the loan. This was known as ‘crystallisation’ of the charge. The law recognised that the loan contract may provide for automatic crystallisation, even before notice of default had been served

• •

•

on the debtor: Fire Nymph Products Ltd v The Heating Centre Pty Ltd (1992) 7 ACSR 356. The concept of crystallisation is now irrelevant under the PPSA: Hamersley Iron Pty Ltd v Forge Group Power Pty Ltd (in liq) (rec and man apptd) (2017) 320 FLR 259; [2017] WASC 152.

Under the new PPSA:

a floating charge becomes a security interest in ‘a circulating asset’; a fixed charge becomes a security interest in a ‘non-circulating asset’; and the concept of crystallisation is abolished. All PPSA security interests attach to collateral automatically. Security documents may still provide for enforcement to depend on events of default.

The new terminology closely resembles the traditional distinction between floating and fixed charges.

Before the PPSA reforms, the distinction drawn between fixed and floating charges over the company’s assets also had significant implications for priority claims on the company’s assets in the event of insolvency and winding up. One feature of floating charges is that they were (generally speaking) subordinate in priority to fixed charges, and in particular were subordinate to employee’s statutory priority entitlements (such as unpaid wages and leave pay).

It is important to note that, despite the change in terminology in the manner indicated above, the PPSA will preserve this legal distinction through the use of the circulating and non-circulating asset concept: see PPSA s 339. Sections 433 and 561 of the Corporations Act (both of which confer priority on employee entitlements) have been amended to cover circulating security interests. See further Re Langdon; Forge Group Ltd (Rec and Man Apptd) (in liq) (2017) 118 ACSR 434; [2017] FCA 170.

[page 321]

The impact of the PPSA reforms on priority rules and on charges created in favour of company officers is discussed below in 10.20 and 10.23.

[page 322]

10.15

•

10.16

PPSA reforms

collateral: the debtor’s property that is used as security for a loan or to ensure the performance of an obligation.

The PPSA reforms are made up of several key statutes, some of which impact directly on the Corporations Act as shown below:

Personal Property Securities Act 2009 (Cth) (PPSA) — which introduces a new system for dealing with priority disputes between secured parties and includes new statutory enforcement mechanisms; Personal Property Securities Regulations 2010 (Cth) — which sets out what information is required on a financing statement, including the important element of how to describe collateral; Personal Property Securities (Corporations and Other Amendments) Act 2010 (Cth) and the Personal Property Securities (Corporations and Other Amendments) Act 2011 (Cth) — each of which makes significant changes to the Corporations Act to facilitate the move to the PPS regime and away from ASIC’s Register of Company Charges and the contents of Ch 2K of the Corporations Act (which is repealed by the PPSA reforms).

Section 343 of the PPSA required the government to conduct a review of the PPSA within three years of commencement. This review was conducted by leading PPSA lawyer Bruce Whittaker in 2014 and completed in March 2015. The review considered a broad variety of aspects of the PPSA and the operation of the PPS Register and made 394 recommendations, most of which related to simplifying and streamlining the operation of the legislation. At the time of writing, the government had not given its response to the report.3

reservation of title: a supply agreement where the supplier retains the title to goods but transfers possession to the buyer. Title only passes when payment is made. If the buyer becomes insolvent prior to payment, the supplier may seek to recover the goods.

Included transactions The PPSA scheme is based on the concept of a ‘security interest’. A security interest is defined in s 12(1) of the PPSA as:

… an interest in personal property provided for by a transaction that, in substance, secures payment or performance of an obligation (without regard to the form of the transaction or the identity of the person who has title to the property).

This definition will cover traditional security devices, such as mortgages and charges over personal property. Importantly, this definition takes a substance over form approach. The previous system of security devices focused on the form of the transaction (that is, was it a mortgage or a charge) and, as a result, did not include quasi-security devices such as reservation of title arrangements. This approach has now changed.

The ‘in-substance’ approach in s 12(1) means that arrangements which would previously have not been included as security devices will now be treated as security interests under the PPSA.4 Finance leases are a good example of pre-PPSA arrangements that were not charges and hence were not registrable, but will now be PPSA security interests (because the arrangement in substance secures the payment of the lease fees) and will be registered on the PPS Register (PPSR).

[page 323]

The in-substance approach requires that the transaction giving rise to the security interest be consensual in nature: Dura (Aust) Constructions Pty Ltd ((in liq) (recs and mgrs apptd)) v Hue Boutique Living Pty Ltd [2014] VSCA 326 (equitable charge in funds deposited in a court supervised account to allow an appeal to proceed was not consensual as it arose by court order not by consent).

If a transaction does not fit within s 12(1), it may be deemed to be a security interest under s 12(3) of the PPSA, regardless of whether the transactions in substance secure the payment or performance of an obligation. There are three categories of deemed security interests:

the interest of a transferee under a transfer of an account or chattel paper; the interest of a consignor who delivers goods to a consignee under a commercial consignment; and the interest of a lessor or bailor of goods under a PPS lease.

10.17

• •

• • •

10.18

A detailed discussion of these arrangements is outside the scope of this book.5 However, the most important category will be 3.

bailment: the temporary transfer of exclusive possession from the bailor to the bailee who is responsible for dealing with the bailed goods and either returning them to the bailor or transferring them on behalf of the bailor (for example, a drycleaner is a bailee of clothes they hold for cleaning).

Paragraph 3 refers to a PPS lease which is defined in s 13 as a bailment or lease of goods for more than two years. This section was amended in 2015 to remove a 90-day period for serial numbered property and again in 2017 to change the original one-year time frame to a two-year time frame and to remove the general category of indefinite terms. Following these changes, only leases or bailments for a term of two years or more will be deemed to be PPS leases. These changes were due to extensive complaints from the short-term hiring industry about the costs involved in administering registrations for hiring goods and also because many commercial contracts involving goods fail to provide a termination date which under the prior provision would have been caught by the PPSA. A PPS lease must involve a bailor or lessor who is ordinarily in the business of bailing or leasing goods.6

Excluded transactions There are a number of types of transactions that are specifically excluded from the PPSA under s 8. The most important exclusions from the PPS are:

security interests over land or fixtures; security interests that arise automatically under law (such as liens that arise otherwise than under a specific contractual provision); security interests that arise under statute; rights of set-off or netting; and banking rights to combine accounts.

Attachment and perfection of a security interest In order to obtain priority, a secured party must ‘perfect’ their security interest. This is a similar requirement to the prior requirement (under the repealed Ch 2K) to notify

• •

•

[page 324]

grantor: the person who has rights over personal property and confers a security interest in the personal property that will be used as collateral for a loan or other contractual obligation. The grantor will usually be the debtor, but may be a third party (such as a grantor).

the creation of a charge and register the charge with ASIC. Perfection refers to a number of steps, including the ‘attachment’ of the security interest to the secured assets (known as collateral). The steps to perfection are (s 21):

the attachment of the security interest to the collateral; the secured party obtains enforceable rights against third parties (that is, someone other than the debtor) over the collateral; and the secured party either retains possession of the collateral or registers a financing statement.

Each of these will be discussed in brief.

Attachment refers to the secured party’s security interests becoming applicable to the personal property that are being (or will be) used as collateral. Essentially, the issue here is when will the secured party have legal rights against the collateral (that is, when does their security interest attach to the collateral)?

The PPSA provides that a security interest attaches to collateral when the grantor of the security interest has rights in the collateral or the power to transfer such rights: s 19.

Clearly, where the grantor owns the property they will have rights in the collateral, but other interests such as the right to use and possess property under a lease are sufficient to allow a security interest to attach to the collateral. For example, in Re Maiden Civil (P&E) Pty Ltd; Albarran v Queensland Excavation Services Pty Ltd (2013) 277 FLR 337; [2013] NSWSC 852 a long-term lease of excavation equipment under an oral hire purchase agreement involved the lessor (hiring company) taking a security interest in the equipment, which attached to the equipment when the hirer took possession: see s 19(5).

10.19

Furthermore, attachment requires that value be given for the security interest or that the grantor ‘does an act by which the security interest arises’. In most cases a signed loan agreement that provides for a security interest (such as a charge) will be sufficient to constitute attachment.

A secured party will have enforceable rights against a third party where the security interest has attached to the collateral and the secured party either has possession of the collateral or has a written security agreement that covers the collateral: s 20 of the PPSA. The written agreement must be signed or adopted by the grantor: see generally Primaplas Pty Ltd v Gelpack Enterprises Pty Ltd (in liq) [2015] NSWSC 1558 (which discusses who can be authorised to sign security agreements and how the grantor’s conduct can demonstrate acceptance of the agreement).

The third step required for perfection is for the secured party either to retain possession of the collateral or to register a financing statement. This is discussed below in 10.19.7

[page 325]

Registration of a financing statement A financing statement is simply a notice registered on the PPS Register,8 which gives notice that a security interest covers particular collateral of the grantor: see s 153.

A financing statement may be registered at any time (including before the transaction that creates the security interest is finalised), although mere registration will not achieve perfection-attachment and rights against third parties are all required before registration of a financing statement will provide perfection.9

One acceptable description of the collateral is for ‘all present and after– acquired propert’, which is equivalent to a floating charge over all of the debtor’s property, another is simply ‘other goods’. A misdescription of the collateral that is seriously misleading will lead to the financing statement being ineffective which could jeopardise the secured party’s priority: s 164. The most common forms of errors discussed in the PPSA cases have

10.20

• • •

•

been the failure to properly record a company’s ACN (which is required to be registered rather than the business’ ABN). Somewhat confusingly, where the registration involves a company acting as a trustee the registration must include the ABN of the trust and not the ACN of the company. The Whittaker Review of the PPSA recommended in its final report that the trustee company’s ACN be used for consistency and clarity. See generally, Re OneSteel Manufacturing Pty Ltd (admin apptd) (2017) 93 NSWLR 611; [2017] NSWSC 21.

commercial property: any personal property that is not consumer property

consumer property: personal property held by an individual, other than personal property used (to any degree) in a business that has an ABN.

Registration may last no longer than 25 years for commercial property or seven years for consumer property.

Financing statements may be amended from time to time. Furthermore, a single financing statement can be used to cover a number of transactions between the secured party and the grantor.

Priority of security interests The previous priority rules under Ch 2K of the Corporations Act were complex. The main rules under Ch 2K (ss 279–282 now repealed) were that:

a registered charge would take priority over an unregistered charge; a fixed charge would take priority over a floating charge; and where the charges were the same the first to be registered would prevail.

However, the former rules above were subject to several exceptions. The PPSA aims to simplify the priority rules for security interests. The main (or default) priority rules are set out in s 55 of the PPSA. These are:

a perfected security interest will take priority over an unperfected security interest (s 55(3)); where two unperfected security interests compete the first to attach

•

(a)

(b)

will prevail (s 55(2)); and

[page 326]

where two perfected security interests compete, the first security interest that was perfected by registration of a financing statement or by possession of the collateral will prevail (s 55(4)–(5)).

PMSI: a security interest over new assets provided to the debtor and takes a super priority over existing perfected security interests.

However, there are several key exceptions to the main priority rule. The most important is the use of a purchase money security interest, otherwise known as PMSI. PMSIs are defined in s 14(1) of the PPSA:

a security interest taken in collateral, to the extent that it secures all or part of its purchase price; a security interest taken in collateral by a person who gives value for the purpose of enabling the grantor to acquire rights in the collateral, to the extent that the value is applied to acquire those rights; the interest of a lessor or bailor of goods under a PPS lease; the interest of a consignor who delivers goods to a consignee under a commercial consignment.

There are several exceptions to the definition of a PMSI in s 14(2), including over goods that are intended to be used predominantly for personal, household or domestic purposes.

Where a supplier (for example, an equipment lessor) registers a PMSI over the collateral by registering a financing statement that specifically notes that the security interest is a PMSI, then it will take priority over almost all other security interests (including a bank with a prior floating charge over all the debtor company’s assets). There are certain time constraints which the PMSI holder must comply with in registering their financing statement: PPSA s 62.

Another important exception to the main priority rule concerns financial

10.21

10.22

institutions who take security interests over funds in accounts that they hold for customers: PPSA s 75.

Taking free (extinguishment) rules Part 2.5 of the PPSA provides a number of rules that allow a person to take collateral free from existing security interests that have attached to the collateral. These rules are based, in part, on general law concepts of the bona fide purchaser for value. One particularly important extinguishment rule relates to sales or leases in the ordinary course of business: PPSA s 46. See further Warehouse Sales Pty Ltd (in liq) v LG Electronics Australia Pty Ltd [2014] VSC 644.

It should also be noted that the failure of a secured party to perfect a security interest will lead to the security interest vesting in the grantor upon the grantor’s insolvency, which extinguishes the security interest: PPSA ss 267, 267A. See further Power Rental Op Co Australia LLC v Forge Group Power Pty Ltd (in liq) (rec and man apptd) [2017] NSWCA 8; Re OneSteel Manufacturing Pty Ltd (admin apptd) (2017) 93 NSWLR 611; [2017] NSWSC 2.

Enforcement rules Chapter 4 of the PPSA sets out detailed rules that allow any secured party to take enforcement action against the collateral. Any secured party may seize and sell

[page 327]

the asset, subject to the requirement to hand over the collateral to a higher ranking secured creditor after notice of an intention to seize and sell is given. The rights and powers provided by Ch 4 of the PPSA do not take away from existing rights and remedies that the parties would otherwise have: PPSA s 114. Where the security interest covers commercial property, most of the enforcement provisions may be contracted out of by the parties: PPSA s 115.

10.23

10.24

The rules also allow a secured party to foreclose on the debtor by retaining possession of the asset, again subject to the rights of a higher- ranking secured creditor objecting to the foreclosure. Section 111 imposes an overarching obligation on secured parties who exercise enforcement powers under Ch 4 to do so in an ‘honest and commercially reasonable manner’.

Significantly for corporate law, the enforcement rules in Ch 4 of the PPSA will not apply to security interests granted by companies where the secured party appoints a receiver over the collateral: PPSA s 116. In that case the principles of receivership under general law and Pt 5.2 of the Corporations Act will apply. The law on receivership is discussed in Chapter 22.

Invalidation of security interests Aside from the taking free rules in the PPSA, the Corporations Act may also render security interests void in the following circumstances for the purposes of protecting the interests of unsecured creditors.

Unregistered security interests Former s 266 of the Corporations Act invalidated a charge against the liquidator or the administrator if the company went into liquidation or voluntary administration within six months and the company has failed to lodge notice of the registrable charge with ASIC within 45 days of its creation. This encouraged companies to ensure that their charges were registered on time.

Under the PPSA reforms, the prior Corporations Act s 266 (which appeared in Ch 2K) is replaced with new s 588FL of the Corporations Act which operates on largely the same grounds, although the 45-day period has been replaced by 20 business days. Thus, a secured party must ensure that they perfect their security interest within 20 business days after entering into the security agreement and at least six months prior to the commencement of a winding up or voluntary administration. It is possible for the court to grant an extension of time within which to register on the PPSR: see s 588FM of the Corporations Act and Re

10.25

10.26

Appleyard Capital Pty Ltd (2014) 101 ACSR 629; [2014] NSWSC 782; Re OneSteel Manufacturing Pty Ltd (admin apptd) (2017) 93 NSWLR 611; [2017] NSWSC 2; Re KJ Renfrey Nominees Pty Ltd (Trustee); OneSteel Manufacturing Pty Ltd v OneSteel Manufacturing Pty Ltd (2017) 120 ACSR 117; [2017] FCA 325.

Sections 267 and 267A of the PPSA provide further than an unperfected security interest is void upon liquidation or voluntary administration.10 It should be noted that s 588FL will not apply where the secured party perfects their security interest by possession.

[page 328]

Security interests in favour of company officers Former s 267 of the Corporations Act prohibited a charge created in favour of a ‘relevant person’ (defined as company officers or their associates) from being enforced within six months of its creation without court approval. For example, this provision seeks to avoid an insolvent company from granting a charge in favour of its director or secretary, shortly before its collapse, and thus securing a preference to its officers to the prejudice of unsecured creditors.

Under the PPSA, a similar rule has been inserted into s 588FP of the Corporations Act.

Circulating security interests created shortly before liquidation Section 588FJ of the Corporations Act invalidates a circulating security interest created during six months ending on the relation-back day11 for a company being wound up in insolvency. This limits the ability of secured parties to take security over all or substantially all of a distressed company’s assets in the time leading up to the company’s insolvency.

A circulating security interest is a security interest that is taken over circulating assets. Any reference to a floating charge is to be read as a reference to a security interest over circulating assets: s 339(5). While the concept of a circulating security interest approximates the former use of

a floating charge, the two concepts are not exactly the same. Circulating assets are defined as either the list of assets in s 340(5) of the PPSA or any assets that the secured party has given the grantor express or implied authority to transfer, in the ordinary course of the grantor’s business, free of the security interest: PPSA ss 340(1), 341. There are numerous exceptions to the circulating asset concept: PPSA ss 340(2)–(4), 341.12

2. 3. 4.

[page 329]

Revision Questions

When will a debenture issue require a disclosure document to be issued? What obligations are imposed on debenture trustees? Is a bank loan a debenture? What can a debenture trustee do if the borrower fails to comply with their obligations under the debenture instrument? What types of arrangements are covered by the PPSA? How is this different from the previous Ch 2K of the Corporations Act? Are written security agreements required for perfection under the PPSA? What is a PMSI and what priority status does it provide to a secured party? How can a perfected security interest lose its priority?

Problem Question Aztec Mining Ltd is a company that needs funds to expand its business. The company plans to engage in a large-scale equity capital raising in the next 12 months but wishes to raise as much debt as possible before that time while cheap debt is readily available.

Aztec has been involved in fundraising discussions with a venture capital firm Empire Capital LLP (based in New York). Empire Capital has agreed to lend Aztec $30 million in a single loan facility. Empire will also assist Aztec to establish a further $30 million unsecured note issue for domestic investors that will carry 12% interest and may be convertible to ordinary shares in Aztec at the option of the noteholder in five years’ time. Aztec makes a presentation to wealthy investors at a private function conducted by Empire Capital in Sydney.

Empire Capital’s loan document is based on an old precedent and contains a floating charge clause covering all of the company’s property. Aztec also has a long-term lease with LeaseCo covering mining equipment for the next eight years.

What legal issues under the Corporations Act and the PPSA are raised by this situation?

Guidelines for Answering Problem Questions

When answering a problem question concerning legal issues relating to corporate debt capital raising, we suggest that the following method may be helpful:

It is important to determine, first, whether the statutory definition of debenture is satisfied to see if Chs 6D and 2L may be applicable. If so, the next enquiry should consider whether any of the statutory exemptions from the need to issue a disclosure document are applicable to the facts (see ss 708, 708AA). Is a disclosure document required? Consider the operation of s 1041H for disclosure that is not under a formal disclosure document like a prospectus. If none of the statutory exemptions is applicable, comply with the requirements for disclosure documents (see Chapter 9).

[page 330]

If the debentures require a disclosure document, determine whether Ch 2L must be complied with. Also assess whether there is any security interest included in the terms of the debenture (note the description obligations under s 283BH and the requirements of the PPSA). If a security interest is included in the debentures, check whether the secured party has perfected their security interest. Then apply the priority rules under the PPSA.

After obtaining legal advice about their fundraising objective, Wang and Erin decide to issue debentures to investors to raise the $3 million. Approximately 1,000 debentures will be issued to investors. The debentures will be secured over all of the assets of SCPL and will pay 10% interest. The debentures will also carry warrants over SCPL shares that will allow debenture holders to swap their debentures for a fixed number of shares in SCPL in the future. Wang also wants to ensure that SCPL can buy back the debentures at some point.

After reading about debentures on the internet, Wang is concerned that the company’s trading relationships with suppliers might also be debentures because they involve the provision of credit.

Advise Wang as to what rights and obligations SCPL will have in relation to the debenture fundraising. Will the debentures need to be registered on the PPSR? What potential consequences may arise if the registration is incorrect?

Further Reading

Academic Journals E Brown, ‘From “If Not, Why Not?” to “If Not, NOT!” — Regulatory

Reform of the Debenture Sector’ (2014) 32 Company and Securities Law Journal 159.

C Clarke, ‘The Threshold Requirements of the PPSA: Does a s 12 Require and Interest In Rem in order to Create a Security Interest?’ (2016) 27 Journal of Banking and Finance Law and Practice 6.

I Davidson, ‘Overview of the New Personal Property Securities Law’ (2011) 35 Australian Bar Review 93.

J Harris, ‘Assessing the Effect of the PPSA on the Corporations Act and Corporate Law Teaching’ (2012) 27 Australian Journal of Corporate Law 72.

D Loxton, ‘New Bottle for Old Wine? The Characterisation of PPSA Security Interests’ (2011) 23 Journal of Banking and Finance Law and Practice 163.

N Mirzai, ‘The Personal Property Securities Act and Commercial Lease Arrangements: A Practitioner’s Guide’ (2011) 22 Journal of Banking and Finance Law and Practice 3.

C Pearce, ‘A Broken Record: Amending and Removing Registrations on the PPSA’ (2016) 25 Australian Property Law Journal 173.

A Tranter-Wilson, ‘The Circulating Security Interest in Review: Architectures of Certainty, Flexibility and Control’ (2017) 28 Journal of Banking and Finance Law and Practice 3.

L Widdup, ‘Registration Errors, Priority Rules and the Policy behind the PPSA: In Pursuit of Certainty or Fairness?’ (2016) 44 Australian Business Law Review 175.

B Whittaker, ‘Retention of Title Clauses under the Personal Property Securities Act 2009 (Cth)’ (2010) 21 Journal of Banking and Finance Law and Practice 273.

T Wong, ‘Unlisted and Unrated Debentures: The End, or a New Beginning?’ (2014) 32 Company and Securities Law Journal 159.

[page 331]

Practitioner Journals J de Szell, ‘PPSA update: court orders later time for registration’ (2016)

17 Insolvency Law Bulletin 153. L Meehan, ‘Seriously! When Will Registrations (Financing Statements)

Be Seriously Misleading?’ (2015) 15 Insolvency Law Bulletin 161.

Practitioner Works P Brown (ed), Australian Corporate Practice, LexisNexis Butterworths,

looseleaf and online, Ch 19. N Mirzai and J Harris, Annotated Personal Property Securities Act,

WoltersKluwer CCH, 3rd ed, 2018. C Wappett, S Edwards and B Whittaker (Eds), Personal Property

Securities in Australia, LexisNexis Butterworths, looseleaf and online.

You will find useful study resources, including quizzes for each chapter, when you go to <http://learning.lexisnexis.com.au>. The quiz is a great tool to help you self-test your knowledge.

http://www.ag.gov.au/consultations/pages/StatutoryreviewofthePersonalPropertySecuritiesAct2009.aspx

6. 7.

8. 9.

10.

11.

12.

See ASIC Regulatory Guide 69: Debentures and unsecured notes: Improving disclosure for retail investors (RG 69)(June 2010). Whittaker, Review of the Personal Property Securities Act 2009, Final Report, 2015, Recommendation 93. A copy of the report and consultation papers can be found at <http://www.ag.gov.au/consultations/pages/StatutoryreviewofthePersonalPropertySecuritiesAct2009.aspx (viewed 30 September 2017). Section 12(2) of the PPSA includes a list of examples of transactions that may fit within s 12(1) which includes hire-purchase arrangements, leasing transactions, flawed asset arrangements and consignment arrangements. See A Duggan and D Brown, Australian Personal Property Securities Law, 2nd ed, LexisNexis Butterworths, Sydney, 2015; J Harris and N Mirzai, The Annotated Personal Property Securities Act, 3rd ed, WoltersKluwer CCH, Sydney, 2017. See, further, Re Arcabi Pty Ltd (rec and man apt) (in liq) [2014] WASC 310. It should be noted that the PPSA provides for temporary perfection of certain security interests. This may occur where a security interest over collateral is perfected and the collateral generates proceeds (for example, by selling some or all of the collateral to generate cash as proceeds of the sale). Where the security agreement does not expressly cover proceeds, the PPSA will deem the security interest to extend to the proceeds but only for a temporary period of five business days: s 33 of the PPSA. See <http://www.ppsr.gov.au>. The financing statement must describe the collateral according to whether it is commercial property or consumer property. In addition, the financing statement must describe the class of collateral that the property belongs to which is set out in Personal Property Securities Regulations 2010 (Cth) Sch 1 item 2.3. For a discussion of the vesting on insolvency rules, see M Broderick and D Morrison, ‘Vesting of Personal Property in Insolvency under the PPSA’ (2014) 22 Insolvency Law Journal 20. Section 9 of the Corporations Act defines the relation-back day as either the day on which the application for a winding up order was filed or the day on which the winding up is deemed to have commenced. See further, Hamersley Iron Pty Ltd v Forge Group Power Pty Ltd (in liq) (rec and man apptd) (2017) 320 FLR 259; [2017] WASC 152; Re Langdon; Forge Group Ltd (Rec and Man Apptd) (in liq) (2017) 118 ACSR 434; [2017] FCA 170; A Tranter-Wilson, ‘The Circulating Security Interest in Review: Architectures of Certainty, Flexibility and Control’ (2017) 28 JBFLP 3.

http://www.ppsr.gov.au

[page 333]

Share Capital and Transactions Affecting Share

Capital

CHAPTER 11 Shares

Legal nature of shares Classes of shares Common classes of shares Flexible nature of preference shares Non-share securities Protection of class rights

Maintenance of capital Reform of the maintenance of capital rule Authorised share capital reductions Financial assistance a company to acquire its shares Share buy-backs

[page 334]

Share Capital and Transactions Affecting Share Capital

Learning Objectives After completing this chapter you should be able to:

Describe the legal nature of a share.

Distinguish between different classes of shares.

Explain the manner in which class rights of shareholders are protected.

Explain the maintenance of capital rule and its contemporary relevance.

Identify the various types of share capital transactions available.

Explain the statutory provisions governing share capital transactions and the protection of creditors and shareholders.

Discuss the consequences of breach of the statutory provisions affecting share capital transactions.

Key Cases

ASIC v Adler (2002) 41 ACSR 72; [2002] NSWSC 171

Trevor v Whitworth (1887) 12 App Cas 409

Key Sections

Corporations Act 2001 (Cth) ss 232, 246B–246G, 254A(2), 256A–256E, 257A–257J, 258A–258F, 259A, 260A, 260C, 1324

[page 335]

Introduction

Shares are an important part of any diversified investment portfolio, and seem to dominate the business news on television and in newspapers. Indeed, news sources constantly bombard us with detailed information about share prices and the movements in the All Ordinaries, ASX 200 (Australian Securities Exchange) and other foreign share market indices such as the Dow Jones (US) or FTSE (UK). Why are shares so important that they command our constant attention? Why do large falls in stock prices generate panic and concern about the stability of the economy? The reason lies in the fact that Australia has one of the highest proportions of share ownership in the world. According to the 2017 ASX Australian Investor, 37% of the Australian population (6.9 million people) own shares either directly or indirectly (usually through superannuation funds). This means that a large portion of the nation’s wealth, including retirement savings, is invested in shares.

The size of investments in shares is very significant, with the total market capitalisation at about $1.5 trillion. It is clear that investment in shares, even if only indirectly through superannuation, is an important issue for many (if not most) Australians.

Shares are also important for matters of corporate governance and corporate control. In particular, the voting powers conferred on ordinary shares may be used in a number of ways, such as removing directors from the board and disapproving of major transactions including takeovers and capital transactions. The power of shareholders to vote on matters at general meetings is dealt with partially in this chapter but also in Chapter 12. This chapter examines the legal nature of shares and the regulation of share capital transactions.

Legal nature of shares

11.1

• • •

• •

•

chose in action: a property right that is exercised by legal enforcement (that is, court action). Shares are a chose in action because they cannot be physically possessed and the rights attached to shares are enforceable by law.

Shares are personal property: s 1070A. They are intangible in nature, which the law calls a ‘chose in action’. Consequently, as property, shares have the following significant features. Shares are:

transferable (can be bought and sold); capable of use as security; and capable of devolution by will.

Shares have been judicially defined as comprising of a collection of rights and obligations relating to an interest in a company of an economic and proprietary character.1

These features confer rights on the company and on the holder of shares. Generally, the shareholder enjoys the right to:

vote at the company’s general meeting; participate sharing in the company’s profits by way of receiving a dividend; and participate in the distribution of any surplus assets of the company when it is wound up: see Chapter 22.

[page 336]

In return, the company has the right to expect payment of the shares and for the shareholder to be bound to the company’s constitution or rules. Ultimately, the rights and liabilities of the company and the shareholder are determined by several factors, such as the terms of the share issue, the company’s internal rules (the corporate constitution) and the provisions of the Corporations Act 2001 (Cth). In particular, s 140 is significant in this regard as it creates a contractual relationship between the parties.

Although shares are intangible in nature, shareholders (as members of the company) do have either physical or electronic certificates to prove that they hold a particular number, and type, of shares in the company.

11.2

•

11.3

Classes of shares It should be noted that shares may come with different rights and obligations attached to them. Not all shares necessarily have the same characteristics. Some companies may wish to have different classes of shares each with different rights. A company may wish to issue different classes of shares for several reasons, for example:

to confine corporate control in the hands of particular persons as is often the case in closely-held proprietary companies (often family companies); to raise finance by conferring extra dividend rights upon preferential shareholders, which are similar to external creditors. Such shareholders usually have more limited voting rights; or to minimise tax which may require different classes of shares, particularly where there are foreign shareholders involved who may not benefit from Australia’s dividend imputation credit system.

Common classes of shares There are different ways to classify shares, one method being to distinguish between shares that have ordinary rights, and those that have additional rights. The common rights of shareholders were noted above to be voting at a members’ meeting, receiving dividend payments and receiving a distribution of surplus capital upon the winding up of the company. Therefore, we may distinguish between shares that have an ordinary level of these rights (that is, the same rights as other shareholders), and shares that carry additional rights. Shares that provide additional rights are known as ‘preference shares’.2

Section 254A provides the company with the express power to issue preference shares (as well as other types of shares such as bonus shares and partly paid shares (see below)). The most common type of preference is in relation to dividends entitlements. For example, an investor may not want to vote at members’ meetings either because they are uninterested in the control of the company or because their shareholding (and hence the number of votes they have) will usually be very small (particularly in publicly listed companies). This investor is mainly interested in economic returns on their investment in shares and may therefore find it

attractive to purchase preference shares which carry higher dividend entitlements but less voting rights.

[page 337]

In the above method of distinguishing share classes, we can see a difference between ordinary shares and preference shares. It is important to note that preference shares are designated as such by the terms of their issue and the terms of the company’s constitution, not simply by their differing rights to other shares issued by the company: Beck v Weinstock (2013) 251 CLR 425; [2013] HCA 15 (where preference shares were issued but no ordinary shares were ever issued).

We may also distinguish between different classes of shares according to whether the shares carry any additional liability to pay money to the company. As was noted in Chapter 3, it is a common feature of Australian companies that the shareholders have liability that is limited to the payment of the full price of their shares. Thus, another method of classifying shares is to distinguish between fully paid and partly paid shares. The main difference between these two classes of shares is that shareholders holding partly paid shares are liable to pay the unpaid amount of the share price at a future time when requested by the company in accordance with the terms of the share issue. For fully paid shares, the shareholders have no financial liability to the company beyond the money they have already paid to purchase their shares. Both ordinary and preference shares may be fully or partly paid.

Brisconnections Group

The issue of partly paid securities (including shares) received considerable media attention in 2009 due to problems faced by the large Brisbane toll road company, Brisconnections. This company had won a tender process to build Australia’s largest public–private partnership infrastructure project consisting of a long toll road from Brisbane city to Brisbane airport. As with many toll road projects in recent years, the business model of using debt to pay distributions even before the road was completed proved unsustainable during the global financial crisis when debt (particularly traditional bank debt) proved increasingly difficult to secure on an ongoing basis. Doubts about the business model caused

the company’s units (the company’s securities were made up of stapled securities in a unit trust attached to the management company overseeing construction) to sink to the lowest possible price on the ASX to $0.001. At this seemingly cheap price, many retail investors bought thousands of units. The subsequent financial problems caused for these investors arose from the fact that each of these units was partly paid instalment securities. This meant that these largely unsophisticated investors were buying units that were issued at a total price of $3 with only $1 being paid on issue, and two $1 instalments to be made in the future. In Brisconnections, investors who bought their securities at the low price were, however, buying a debt of $2 per unit as there were still two remaining instalments due to be paid. Unwittingly, many unsophisticated retail investors were buying into a debt of several hundred thousand dollars and faced bankruptcy if they could not pay the instalments when due.

After much drama and several court cases, including an unsuccessful attempt to wind up the company and to replace its management, Macquarie Capital Advisors Ltd (as a joint underwriter) offered to buy the units held by small retail investors who held 50,000 units or less. The resulting investor confusion and anger from this debacle led the ASX to introduce a rule, from 1 July 2009, aimed at greater investor protection and at preventing a recurrence of such ‘unexpected’ liabilities. Brokers now have to obtain an agreement from their clients, prior to purchasing partly paid securities, that their clients have read and understood the disclosure documents relating to the securities and are aware of their legal obligations in purchasing the securities.

The Brisconnections case study demonstrates that while partly paid shares and other securities can have some benefits in attracting retail investors, those benefits can also turn into large financial problems if investors do not understand that they are really only paying

[page 338]

the first of multiple payments. (It is worth observing that Telstra had also used this method of instalment payments to attract small retail investors to buy shares.)

In February 2013, following the appointment of administrators, receivers and managers were appointed to the Brisconnections Group. See Chapter 22 for the significance and operation of these forms of external administration.

closely held company: the company does not have many shareholders, and is usually a small proprietary family company.

Another method of classifying shares is by creating different classes in the corporate constitution, each of which may carry different rights, such as rights to dividends, rights to vote and rights to share in any surplus if the company is wound up. For example, in many closely held companies, which are often family companies, there will be alphabetical classes of shares (Class A, Class B, Class C etc).

In the family company involved in Beck v Weinstock (2013) 251 CLR 425; [2013] HCA 15, there were 14 classes of alphabetical shares, although only some of the share classes were actually issued.

11.4

•

A common right in companies with differential class shares is the right of pre–emption. A family company may establish Class A shares which are held by the parents who created the business, Class B shares held by their children and Class C shares by employees. The company’s constitution may provide that before shares can be transferred they must be offered to another higher ranking class of shareholders. Thus, if employees wanted to sell their shares they would have to offer them to the Class B shareholders for purchase first. Even in some very large commercial businesses this type of share capital structure exists.3

Flexible nature of preference shares The Corporations Act does not define a ‘preference share’, but the concept is well entrenched in company law.4 As noted above, a preference share is basically a share with an enhanced right — typically the right to receive a higher dividend payment than other shares.5 Where the preference shares have limited voting rights and enhanced economic rights, they are similar in nature to debt finance.

However, preference shares may come with a wide variety of rights, including the right to convert the preference share into an ordinary share (usually to secure full voting rights). The range of preference shares includes:

Convertible preference shares — allow the holder to convert the shares into ordinary shares at the end of a fixed period: permitted under s 254G. Participating preference shares — allow the holder the right to receive ordinary dividends as well as preferred dividends. Cumulative or non-cumulative preference shares — the former allows the holder to carry over any unpaid dividend entitlements where the company does not generate sufficient profit to pay the full interest rate. Non-cumulative preference shares do not carry over to subsequent years.

[page 339]

•

11.5

Redeemable preference shares — allows, on the happening of a particular event or at a fixed time, for the shares to be bought back either at the company’s option or the holder’s option: s 254A(3). Preference shares may only be redeemed if the shares are fully paid up and if there are sufficient profits or proceeds from a new share issue designed to pay for the redemption: s 254K.

Non-share securities It is important to note that the analysis above has focused on the traditional concepts of ordinary and preference shares. These are both types of ‘securities’ which are regulated under the Corporations Act. Generally speaking, except in particular instances where the Act is only concerned with shares (such as voting at a members’ meeting, with only shares conferring ‘votes’), the Act regulates the creation, distribution and transfer of ‘securities’ rather than simply shares. Securities have different definitions within the Corporations Act, with the general definition contained in s 92, which specifically includes shares, debentures and options. Another definition of securities is provided in the context of regulating financial services business, which is quite complex and need not be dealt with here. For a discussion of financial services, see Chapter 21.

The options referred to in s 92 consist of a contractual right to either sell shares to another person (known as a put option) or to buy shares from another person (known as a call option). The holder of an option is not considered to be a shareholder (and hence a member) of a company, but is rather a contingent creditor of the party writing the option: Re Compania de Electricidad de la Provincia de Buenos Aires Ltd [1980] Ch 146. The relevant legal relationship exists between the writer of the call option (who is, or will soon become, a current shareholder) and the holder of the call option (that is, the person who wishes to purchase the shares at a future time). The value of trading in options and other types of equity- linked financial instruments such as warrants, ETFs, CFDs, futures and other types of derivatives is far in excess of the trading value of actual share trades each day.6 The use and regulation of complex financial instruments is, however, outside the scope of this book.

Protection of class rights

11.6

• •

•

Protection of class rights The Corporations Act offers protection to shareholders against improper variation or cancellation of rights attached to a class of shares. Part 2F.2 is designed to ensure that shareholder interests are safeguarded by regulating the way in which class rights, such as voting rights or dividend rights or rights to participate in surplus assets on a winding up, can be varied or cancelled.

Section 246B(1) states the company must follow the procedure spelt out in its constitution. If the company lacks a constitution or if it is silent, then the procedure set out in s 246B(2) for variation or cancellation must be followed which requires:

a special resolution passed by the company; and a special resolution passed at a meeting of the holders of the affected class; or the written consent of members with at least 75% of the votes of the affected class.

[page 340]

The company must give written notice of the variation or cancellation to the members of the affected class within seven days after the event: s 246B(3). ASIC must also be notified of any division or conversion of shares within 14 days: s 246F.

Where the class rights provisions are not complied with, there are several remedies available to shareholders including:

Affected members can apply for a statutory injunction under s 1324 to enforce compliance with s 246B. If some members of the class disagree with a variation or cancellation of their rights, or the modification of the company constitution for such purposes, they may apply to court for such acts to be set aside. The court application must be made by members with at least 10% of the votes of the relevant class: s 246D. The court may set aside the variation, cancellation or modification if it is satisfied that it would unfairly prejudice the applicants: s 246D(5).

•

• • • • •

•

11.7

A single member of the affected class can rely on the oppression remedy under s 232 if the variation or cancellation is oppressive, unfairly prejudicial, unfairly discriminatory or contrary to the interests of the members as a whole. This important remedy for shareholders, under s 232, is discussed further in Chapter 19.

It should be noted that companies listed on the official list of the ASX are generally required to have only one class of ordinary shares, unless the ASX grants an exemption: ASX LR 6.2. In addition, preference shareholders for ASX listed companies must be permitted to vote in the following circumstances (ASX LR 6.3):

during a period during which a dividend (or part of a dividend) in respect of the share is in arrears; on a proposal to reduce the entity’s share capital; on a resolution to approve the terms of a buy-back agreement; on a proposal that affects rights attached to the share; on a proposal to wind up the entity; on a proposal for the disposal of the whole of the entity’s property, business and undertaking; and during the winding up of the entity.

Listing Rule 6.3 also provides that preference shareholders cannot be permitted to vote on any matter other than those listed above.

Maintenance of capital

Company law subscribes to the need for a company limited by shares to maintain its share capital as a fund for the purposes of creditor assurance and protection. This is known as the maintenance of capital rule. The rationale for this rule is based on the principle of limited liability and the general inability of creditors to have recourse

[page 341]

to directors or shareholders to meet their claims.7 If a company could

freely reduce its share capital, it may result in the company having insufficient funds left to meet creditors’ claims.

Re Exchange Banking Company (1882) 21 Ch D 519 Court of Appeal

The creditor has no debtor but that impalpable thing the corporation, which has no property except the assets of the business. The creditor gives the credit to that capital and he has therefore a right to say the corporation shall keep its capital and not return it to the shareholders.

The rationale for the maintenance of the capital rule is provided in the following passage by Lord Watson in the classic case of Trevor v Whitworth.

Trevor v Whitworth (1887) 12 App Cas 409 House of Lords

Paid-up capital may be diminished or lost in the course of the company’s trading; that is, a result which no legislation can prevent; but persons who deal with and give credit to a limited company, naturally rely on the fact that the company is trading with a certain amount of capital already paid, as well as the responsibility of its members for the capital remaining at call; and they are entitled to assume that no part of the capital which has been paid into the coffers of the company has been subsequently paid out, except in the legitimate course of its business.

Tied in with the concern about maintaining a minimum capital reserve to satisfy creditors’ claims was the desire that external creditors should have some knowledge about the financial structure of the corporation. As noted in Chapter 5, a corporation is treated as a separate legal entity and may own property and sign contracts in its own right. However, the liability of the corporation may be effectively limited by the value of its assets (see, for example, the phenomenon of the $2 company, which has only $2 of assets). Therefore, corporate law has, until 1998 in Australia, required that companies state what the value of their share capital was. Each share in a company would have a proportion of that value, known as ‘par value’. For example, if a company had share capital worth $100,000 and issued 100,000 shares on registration, each share would have a par

11.8

• • •

value of $1. This was required to be stated in the company’s constitution, and would thus allow external creditors to assess the risk of default (which contributes to the pricing of credit). As part of the maintenance of capital rules, companies were generally not permitted to issue shares at a ‘discount’ to par value.

However, over time it became clear that the value of share capital is largely irrelevant to most creditors who are more concerned with cash flow and asset valuations than share capital. In 1998, the Company Law Review Act 1998 (Cth) abolished par values: see now s 254C. The abolition of par values means that the

[page 342]

maximum liability of shareholders with partly paid shares is the issue price at which they purchased the shares.8

Reform of the maintenance of capital rule In the last century, the maintenance of capital rule had become deeply entrenched in company law. Until the recent shift in legislative policy in 1998, the maintenance of capital rule was heavily emphasised in legislative provisions which imposed onerous procedures for companies undertaking share capital transactions, such as:

share capital reductions; share buy-backs; and financial assistance for the acquisition of shares.

Overall, the 1998 reforms represent a departure from a strict legislative application of the maintenance of capital rule to share capital transactions when compared with the traditional approach. For example, the current approach to a capital reduction is no longer dependent on court approval. The modern approach makes it easier for companies to undertake share capital transactions while simultaneously protecting creditor and shareholder interests by emphasising the need for the company to remain solvent afterwards. As shown below, the modern

•

11.9

(a)

(b) (c)

legislative approach has struck a balance between the need for easier and streamlined procedures for share capital transactions and the need for creditor and shareholder protection.

However, despite the reforms of 1998, the maintenance of capital rule remains an important principle of company law. For example, a strict expression of the maintenance of capital rule can be found in the regulation of the source for payment of redeemable preference shares: s 254K.

Why does the maintenance of capital rule still exist today? Are there other more effective ways for creditors to determine the capacity of a business to repay its debts?

Authorised share capital reductions The statutory provisions regulating share capital transactions under Ch 2J of the Corporations Act are underpinned by considerations which relate to the maintenance of the capital rule. The company’s general freedom to enter into share capital transactions is affected by the need to consider shareholders and creditor interests. Section 256A states that the rules to be followed by a company for reductions in share capital and for share buy-backs are designed for this purpose by:

addressing the risk of these transactions leading to the company’s insolvency; seeking to ensure fairness between the company’s shareholders; and requiring the company to disclose all material information.

[page 343]

The following discussion centres on the types of share capital transactions a company can enter into, the manner in which such transactions are regulated under Ch 2J of the Corporations Act and the consequences of breach of these statutory provisions.

•

• •

•

There are many legitimate commercial reasons for a company to elect to reduce its share capital. The company may wish to benefit its shareholders without in any way harming creditor interests. For example, the company may wish to:

return surplus capital in excess of its commercial needs to shareholders; bolster earnings per share; and eliminate small shareholdings by buying out the shareholders.

The 1998 reforms have facilitated the procedure for reduction of capital by removing the need for court approval but without sacrificing creditor and shareholder protection. Section 256B(1) permits an authorisation for reduction of capital if the reduction satisfies the following three criteria:9

It is fair and reasonable to the company’s shareholders as a whole (consideration of price is relevant) The overriding consideration here is that the reduction must be fair and reasonable to the shareholders collectively, rather that every individual shareholder. The court is concerned with overall fairness and recognises that in some cases there will be some who dissent and some who may be less favourably served than others. Ordinarily, the court is slow to dissent from the decision of an informed shareholders’ meeting: Re Allas Energy Pty Ltd (1998) 27 ACSR 729.

It does not materially prejudice the company’s ability to pay its creditors This involves the creation of a ‘material’, as opposed to theoretical, increase in the likelihood that the reduction in capital will result in a reduced ability to pay creditors: Re CSR Ltd (2010) 265 ALR 703; [2010] FCAFC 34.

It is approved by shareholders The type of shareholder approval required depends on whether the reduction is an equal reduction or a selective reduction. Section 256B(2) states that the reduction is an equal reduction if:

it relates only to ordinary shares; it applies to each holder of ordinary shares in proportion to the number of ordinary shares they hold; and the terms of the reduction are the same for each holder of ordinary

11.10

• • •

•

11.11

shares.

In such circumstances, the reduction must be approved by a resolution passed at a general meeting of the company: s 256C(1).

In all other circumstances where shareholders are not treated equally and proportionally, known as a selective reduction, the reduction must be approved by either a special resolution or a resolution passed by all ordinary shareholders at a general meeting: ss 256B(2) and 256C(2).

[page 344]

It has been held that the function of the shareholders in a general meeting under s 256B(1) is to consider approval of a proposed resolution — they cannot effectuate it: In the matter of Molopo Energy Ltd; Molopo Energy Ltd v Keybridge Capital Ltd [2014] NSWSC 1864.

Statutory exemptions from shareholder approval Certain capital reductions are permitted without shareholder approval when there is no risk of material prejudice to the interests of creditors. For example, ss 258A–258F recognise the need to exempt compliance with s 256B procedure in the following circumstances:

capital reductions undertaken by unlimited companies; capital reductions resulting from the cancellation of forfeited shares; capital reductions arising from the cancellation of shares bought back by the company under the buyback provisions of ss 257A–257J; capital reductions arising from the redemption of redeemable preference shares out of the proceeds of a new issue of shares made for the purposes of redemption; and capital reductions arising from lost capital — for example, where assets are stolen or destroyed by fire.

Disclosure and notice requirements Section 256C(4) ensures that material information is conveyed to

11.12

11.13

11.14

shareholders by imposing a disclosure obligation on the company. All material information, known to the company that is material to the shareholders’ decision on how to vote on the resolution, must be disclosed by the company.

Before the notice of the meeting is sent to shareholders, the company must lodge with ASIC a copy of the notice and any document relating to the reduction sent to shareholders: s 256C(5). For a selective reduction, the company must lodge with ASIC notice of the resolution within 14 days after it is passed: s 256C(3). This notice requirement enables ASIC to enter the information into its Alert system, to which creditors may subscribe. In turn, this provides either ASIC or creditors with an opportunity to oppose the reduction.

Consequences of breach Several consequences may arise from non-compliance with the three criteria in s 256B(1), identified above.

Civil penalty Failure to comply with the criteria in s 256B results in the company’s contravention of the Corporations Act: s 256D. However, the contravention does not affect the validity of the capital reduction, nor is the company guilty of an offence: s 256D(2). Any person who is involved in the company’s contravention is in breach of s 256D(3) which, significantly, is a civil penalty provision. In effect, ASIC will be able to apply to the court under Pt. 9.4B to seek disqualification orders, compensation orders and pecuniary penalties against the company’s directors or officers involved in the breach.

[page 345]

Insolvent trading liability for directors As a consequence of the linkage of the share capital transaction provisions in Ch 2J with the insolvent trading provisions under s 588G, it

11.15

11.16

11.17

is possible for directors to be at risk of liability to personally compensate the company under s 588G. Such a risk arises if the company becomes insolvent as a result of the reduction of capital. For purposes of s 588G(1A), a reduction of capital is the equivalent of incurring a debt. See further Chapter 18 for discussion on the operation of the insolvent trading provisions under s 588G.

Offence A breach of s 256B, accompanied by dishonesty, risks a fine or imprisonment for five years or both: s 256D(4).

Statutory injunction ASIC or any person whose interests are affected, such as a shareholder, may seek a statutory injunction and damages under s 1324 to restrain the company from entering into an unlawful reduction of capital.

Financial assistance a company to acquire its shares

financial assistance: this will often involve some form of monetary amount such as a loan but financial assistance may extend to other types of financial transactions or benefits.

For the purposes of shareholder and creditor protection under the maintenance of capital rule, the Corporations Act generally seeks to prevent a company from misuse of its resources by giving financial assistance for the purchase of its shares. The legislative intent is to ensure that persons who acquire shares in the company do so from their own funds and do not diminish the company’s resources. The legislative concern also extends to the prospect of company directors using the company’s funds in this manner to benefit themselves, perhaps to gain control, at the expense of the company and other stakeholders. For these reasons, s 260A of the Corporations Act regulates the conditions under which a company is allowed to offer financial assistance for the self- purchase of its shares.

Section 260A states that a company may financially assist a person to acquire shares in the company or a holding company only if:

(a) (i) (ii)

(b) (c)

• •

•

giving the assistance does not materially prejudice: the interests of the company or its shareholders; or the company’s ability to pay its creditors; or

the assistance is approved by shareholders under s 260B; or the assistance is exempted under s 260C.

The concept of financial assistance is undefined in the Corporations Act. However, s 260A(2) acknowledges that financial assistance may take the form of paying a dividend. Further guidance on its meaning can be found at common law. The courts have interpreted financial assistance broadly to include direct and indirect forms of assistance. For example, it includes the company:

making a loan (ASIC v Adler (2002) 41 ACSR 72; [2002] NSWSC 171); making a gift (Re VGM Holdings Ltd [1942] Ch 235);

[page 346]

giving security over the company’s assets (Firmin v Gray & Co Pty Ltd (1984) 8 ACLR 865); and releasing a debt owed to the company (E H Dey Pty Ltd (in liq) v Dey [1966] VR 464).

The courts focus on the commercial realities of the transaction when deciding if financial assistance has been given: Connective Services Pty Ltd v Slea Pty Ltd [2017] VSC 182. The prohibition is focused on whether the transaction results in the impoverishment of the company’s assets: ASIC v Adler (below).

ASIC v Adler (2002) 41 ACSR 72; [2002] NSWSC 171 New South Wales Supreme Court

Facts: See Chapter 17 for a fuller discussion of the facts of this case. Adler received an unsecured loan of $10 million from a subsidiary of HIH (of which he was a director) without any documentation. Part of the loan funds were used to purchase shares in HIH.

Decision: The court found that the result of the loan was to diminish the financial resources of HIH

11.18

•

11.19

•

because it acquired no enforceable rights to secure repayment of the loan, and therefore the loan constituted unlawful financial assistance. Santow J held:

The company suffered material prejudice as a result of the financial assistance, so contravening s 260A of the Corporations Act. It did so by exchanging cash for either unsecured indebtedness owed to it, or alternatively [for] equitable rights [by way of a resulting trust] in respect of the company’s shares. Such rights … were from the start of materially lesser value than the cash handed over. This is because such equitable rights would be likely to be contentious and to require expensive litigation to enforce in court. Thereafter material prejudice also resulted from the other elements of the transaction, that is, the lack of safeguards in, and disadvantageous terms of, the [loan] …

Significance: The law will apply to a transaction which involves a net transfer of value that causes material prejudice to the interests of the company or its shareholders or the company’s ability to pay its creditors. This case is also an important decision on directors’ duties: see Chapters 15–17.

Shareholder approval Approval by the shareholders for financial assistance must either be:

a resolution agreed to by all ordinary shareholders at a general meeting; or a special resolution passed at a general meeting of the company (with no votes being cast in favour of the resolution by the person acquiring the shares or by their associates): s 260B(1).

Statutory exemptions Section 260C excludes certain transactions from the prohibition on financial assistance. For example, the following transactions are excluded:

finance assistance given on ordinary commercial terms where the company’s ordinary business includes providing finance and the assistance is in the ordinary course of that business (s 260C(2)); finance assistance given to enable company employees to acquire fully paid shares under an employee share scheme approved by the company in a general meeting (s 260C(4));

[page 347]

financial assistance in a reduction of capital in accordance with Pt

•

11.20

11.21

2J.1 (s 260C(5)(a)); and financial assistance in a share buy-back in accordance with Pt 2J.1 (s 260C(5)(b)).

Consequences of breach Several consequences may arise from non-compliance with the criteria in s 260A, identified above.

Civil penalty Failure to comply with s 260A results in the company’s contravention of the Corporations Act. However, the contravention does not affect the validity of the capital reduction, nor is the company guilty of an offence: s 260D(1). Any person who is involved in the company’s contravention is in breach of s 260D(2) which, significantly, is a civil penalty provision. In effect, ASIC will be able to apply to court under Pt. 9.4B to seek disqualification orders, compensation orders and pecuniary penalties against the company’s directors or officers involved in the breach.

ASIC v Adler (2002) 41 ACSR 72; [2002] NSWSC 171 New South Wales Supreme Court

Facts: The facts of this case are discussed in Chapter 7. The legal issues surrounding the financial assistance for the acquisition of a company’s shares were discussed above. The discussion here concerns whether three of the key directors in HIH (Adler, Williams and Fodera) were involved in the company’s contravention of s 260A so as to be liable under s 260D(2).

Decision: In finding in the affirmative, Santow J held both Adler and Williams had knowledge of the essential facts and had co-operated to ensure that the in-house HIH expertise was not brought to bear in assessing the wisdom of purchasing shares in HIH itself, through the fact that the transaction was entered into with no input from the investment committee or the board. His Honour held that Fodera’s position as the company’s financial officer would cause him to know of the company’s poor financial condition, declining share price and the urgent need of the $10 million by Adler to pay for the purchase of HIH shares. It was concluded that he too would be a person who ‘is involved in a company’s contravention of s 260A’, albeit to a lesser extent than the other two directors. The sanctions awarded by the court were under the civil penalty provisions and these remedies were discussed earlier in Chapter 7. The chapters on directors’ duties also contain a further discussion on the civil penalty provisions.

11.22

11.23

11.24

11.25

Significance: The case demonstrates that if a company gives financial assistance in breach of s 260A, the company is not guilty of any offence but the person who is involved in the breach is liable under the civil penalty provisions.

Insolvent trading liability for directors As a consequence of linking the share capital transaction provisions in Ch 2J with the insolvent trading provisions under s 588G, it is possible for directors to be at risk of liability to personally compensate the company under s 588G. Such a risk arises if the company becomes insolvent as a result of the reduction of capital. For purposes of s 588G(1A), the company’s giving of financial assistance is the equivalent of incurring a debt.

[page 348]

Offence A breach of s 260A accompanied by dishonesty, risks a fine or imprisonment for five years or both: s 260D(3).

Share buy-backs Permitted share buy-back schemes are an exception to the maintenance of capital rule and the general rule in s 257A which prohibits a company from acquiring its own shares. As a result of statutory reforms in 1995 which removed legislative complexity and simplified the law in this area, share buy-back activity by listed companies have become increasingly popular.10

11.26

•

• • •

•

11.27

11.28

11.29

Reasons for share buy-backs There are many reasons as to why a company may undertake to buy back its own shares, for example:

to return surplus funds, due to lack of suitable investment opportunities, to shareholders who can make more efficient use of these funds than the company; to signal to the market that the company is undervalued; to increase earnings per share; to reduce administrative overheads in listed companies by buying back shares from holders of parcels of odd-lot shares; to reduce the threat of a takeover by reducing the number of shares available to a hostile bidder; or to facilitate the sale of employee shares by departing company employees.

Types of share buy-backs Chapter 2J of the Corporations Act regulates five types of share buy-back activity.

Minimum holding buy-backs It is defined in s 9 as a buy-back of all of a holder’s shares in a listed company, if the shares are less than a marketable parcel of shares within the meaning of the rules of the relevant financial market. This is also known as an odd-lot buy-back. A company may wish to engage in this type of buy-back to reduce its administrative expenses and burden in servicing the needs of shareholders with very small amounts of shares.

[page 349]

Employee share scheme buy-backs It is defined in s 9 as a scheme which has as its purpose the acquisition of shares in a company by or on behalf of employees of the company and the scheme must have been approved by the company in a general

11.30

11.31

(2) (a) (b)

(e)

11.32

11.33

meeting. A company may wish to engage in this type of buy-back when employees terminate employment with the company.

On-market buy-backs It is defined in s 257B(6) as an on-market buy-back if it results from a buy-back offer made by a listed company on the securities exchange in the ordinary course of trading.

Equal access buy-back scheme This type of buy-back must satisfy the following requirements in s 257B(2) to qualify as an equal access scheme:

An equal access scheme is a scheme that satisfies all the following conditions: the offers under the scheme relate only to ordinary shares; the offers are to be made to every person who holds ordinary shares to buy back the same percentage of their ordinary shares; all of those persons have a reasonable opportunity to accept the offers made to them; buy-back agreements are not entered into until a specified time for acceptances of offers has closed; the terms of all the offers are the same.

Selective buy-back schemes It is defined in s 9 as a buy-back other than the four other types discussed above. This type of buy-back occurs when the company buys back shares from particular shareholders or from holders of other than ordinary shares, such as preference shares. The statutory requirement for approval of a selective buy-back is stricter because of the unequal nature of the offer. It requires approval by special resolution of the shareholders or the unanimous approval by all ordinary shareholders at a general meeting: s 257D. This requirement is also designed to alert other shareholders whose interests may be at risk by this type of buy-back which may facilitate increased shareholding and corporate control by particular shareholders.

Regulation and consequences of buy-backs A company must give advance notice to ASIC of its intention to enter

into a buy-back scheme, except when undertaking a minimum holding buy-back: s 257F. As a general rule, subject to statutory exceptions, a company cannot buy back more than 10% of its shares within 12 months: s 257B(4). This is commonly known as the ‘10/12 limit’.

A company that has bought back shares cannot re-issue them. All shares bought back under any type of buy-back scheme must be cancelled: s 257H. This means that all rights attaching to those shares, such as the right to vote or receive dividends, are cancelled.

ASIC must be notified of the cancellation of the shares bought: s 254Y.

[page 350]

Share Buy-Backs: Village Roadshow

The attempts by Village Roadshow (a large Australian film and media production company which also operates cinemas around the world) to buy back all of its ‘A Class non-voting preference shares’ in recent years have given rise to suspense, drama, intrigue and numerous court applications and regulatory investigations. Prior to 2002, Village Roadshow had more than 250 million non-cumulative preference shares, with roughly the same number of ordinary voting shares. As Village’s business model changed from being primarily a cinema operator and media company to being a film and television production and distribution company (with much of the media assets sold off and major movies such as the Matrix trilogy being produced by Village) its capital needs also changed. The film production business is very capital intensive, therefore Village changed its dividend policy and stopped paying dividends to its ordinary shareholders so that it could reinvest profits into the business.

This caused a huge controversy on the market as the company’s preference shareholders were concerned that their dividends would also be reduced or cut entirely. Village eventually did cut dividends for preference shareholders. This resulted in a large drop in the price of the company’s ordinary and preference shares. Village then proposed a scheme of arrangement to buy back its preference shares for $1.25 (with only 25c being in cash and the remainder paid in unsecured notes with a 10% interest rate). This compares with commercial valuations of the preference shares between $2.27 and $2.75 per share. However, the scheme of arrangement was overturned by the Victorian Supreme Court because of defects in the voting procedures to approve the scheme proposal. Village then failed to win approval with a revised scheme of arrangement as it battled a mystery foreign investor who blocked the revised scheme. Village appealed to the Takeovers Panel and ASIC, and eventually had the foreigner’s shares sold off after the foreign investor failed to properly disclose the true owners of the shares (which were held through a Swiss bank). In 2004, Village changed its approach and undertook a series of on-market buy-backs rather than a scheme of arrangement, which resulted in more than 50% of the preference shares being cancelled, costing more than $170 million. Village also undertook a buy-back of its ordinary shares (costing more than $40 million), which

11.34

11.35

11.36

resulted in the company having approximately 230 million shares (both preference and ordinary) on issue. By the end of 2005, Village had resumed paying dividends to its ordinary and preference shareholders, and had continued to buy back its ordinary shares, and the dividends payments continued in 2006 with the share price of both ordinary and preference shares continuing to rise.

The case of Village Roadshow demonstrates that buy-backs may be undertaken in different ways (under the procedures in Ch 2J or alternatively under a scheme of arrangement) but that either way involves several potential complications. While share capital reductions may improve earnings per share and share price, they are themselves very costly to undertake.11

Consequences of breach Several consequences may arise from non-compliance with the criteria in s 257A, identified above.

Civil penalty Failure to safeguard creditors’ interests or comply with the procedures for authorised share buy-backs will result in the company’s contravention of the Corporations Act. However, the contravention does not affect the validity of the share acquisition,

[page 351]

nor is the company guilty of an offence: s 259F(1). Any person who is involved in the company’s contravention is in breach of s 259F(2) which, significantly, is a civil penalty provision. In effect, ASIC will be able to apply to court under Pt 9.4B to seek disqualification orders, compensation orders and pecuniary penalties against the company’s directors or officers involved in the breach.

11.37

11.38

588G(1A), the company’s buy-back agreement is the equivalent of incurring a debt.

Offence A breach of s 259A, accompanied by dishonesty, risks a fine or imprisonment for five years or both: s 259F(3).

1. 2.

4. 5. 6.

7. 8.

10.

[page 352]

Revision Questions

Explain the differences between ordinary and preference shares. Explain the manner in which shareholders are protected from variation or cancellation of share rights. Explain the maintenance of capital rule and its relevance in modern company law. What are the reasons for undertaking a capital reduction? What are the minimum requirements for a capital reduction? Identify the types of share buy-backs permissible under the Corporations Act. What are the reasons for undertaking share buy-backs? How are creditor interests protected during share capital transactions? When is the giving of financial assistance permissible under the Corporations Act? What are the consequences for failure to comply with Ch 2J of the Corporations Act?

Problem Question Acme Mining Ltd (AML) is a small capitalised professional services company providing staff and consulting services to the booming Western Australian mining industry. The directors of AML are Max, Alexandra and Henry, each of whom owns 20% of the shares in AML, with the remainder traded over the Australian Securities Exchange (ASX).

The directors of AML are concerned that their company’s shares seem to be trading at a discount compared to other companies in the mining services industry. They undertake a strategic review of the company’s capital structure called ‘Project Valiant’ whose goal is to increase the share price of AML. Project Valiant involves several key transactions:

The company will restructure its share capital by splitting its current shares into two classes: Class A voting shares and Class B non-voting convertible preference shares. Class A shares will have no dividend rights, with only Class B shares carrying a dividend entitlement (but no voting rights). The company will engage in a selective share buy-back to acquire 30% of the company’s listed share capital. This selective buy-back will offer $2 per share for all shares purchased from the company between 2005–2010. The only shareholders with shares that qualify for this buy-back are Max, Alexandra and Henry and a few minor shareholders who hold no more than 10% collectively. This buy-back effectively results in Max, Alexandra and Henry (and the minority shareholders) selling back one-third of their shares to the company for $2 per share. AML shares have never traded on the ASX above $1.80 (their current price). Max, Alexandra and Henry are interested in using their buy-back payments to acquire Class B shares. The proposed buy-back has been severely criticised by the company’s institutional shareholders and by the media, as unfairly favouring Max, Alexandra and Henry. However, as they currently hold 60% of the company’s voting shares they have said that they have the power to make this change regardless of what the other shareholders think.

You are the company secretary for AML and have been asked to prepare a report for the board of directors on the legal issues involved in the implementation of Project Valiant. Your advice should note relevant provisions of the Corporations Act and what the potential consequences may be for the company and its directors if these provisions are breached.

[page 353]

Guidelines for Answering Problem Questions

When answering a problem question concerning share capital, we suggest that the following method may be helpful:

Determine who the shareholders are and their rights, including what class of shares they hold. You may need to make assumptions regarding the content of the corporate constitution and the application (or non-application) of the replaceable rules listed in s 141. If the rights of shareholders, or classes of shareholders, are being adversely affected consider discussing the protections given to

class rights, and the range of members’ rights (Chapter 12) and members’ remedies (Chapter 19). If the question seems to be dealing with dividends and questions of solvency, then consider discussing when dividends can and cannot be paid (Chapter 20), in addition to potential liability for insolvent trading. If the question relates to a reduction of capital in some way (such as a buy-back or financial assistance to purchase shares), then you will need to identify what procedure is being used and discuss whether the legal requirements of Ch 2J for that procedure have been complied with. Common issues include the potential prejudice to creditors, insolvent trading and problems with holding members’ meetings and voting at those meetings.

There is likely to be an overlap with members’ rights and meetings: see Chapter 12.

Wang and Erin’s company SCPL has a constitution that provides for multiple classes of shares. The only shares that have been issued have been 800 shares to Wang (in his own name) and 1,200 shares to ABC Trustee Pty Ltd (as trustee of Erin Trust No 1) for Erin. Erin wanted to ensure that she had majority voting power in a members’ meeting and could remove Wang from the board of directors if needed. Both parcels of shares carry the same right to dividends and 1 vote per share.

Wang has proposed that an employee share scheme be introduced to help motivate and keep high performing staff. Wang’s proposal involves issuing new shares that carry priority dividend rights, but don’t have any voting rights.

Advise whether this is permitted under the Corporations Act and if so, what procedure (if any) must be followed.

Further Reading

Academic Journals G Bateman, ‘Voting on Selective Buy-Back Approvals’ (2006) 20(1)

Commercial Law Quarterly 3. Y Cho and V Kishore, ‘The “Material Prejudice” Test and the Financial

Assistance Prohibition’ (2004) 78 Australian Law Journal 194.

P Cornwell, ‘Material Prejudice and Financial Assistance: The Financier’s Viewpoint’ (2004) 78 Australian Law Journal 746.

N D’Angelo, ‘Private Equity Investing by Financial Institutions: Navigating Hidden Reefs in Treacherous Waters’ (2003) 31 Australian Business Law Review 311.

G Fleming, ‘Event Studies in Law and Finance: Australian Research’ (2003) 21 Company and Securities Law Journal 151.

K Fletcher, ‘Re-baiting the Financial Assistance Trap’ (2000) 11 Australian Journal of Corporate Law 119.

[page 354]

M Holub and J Mitchell, ‘Unlimited Buy-backs: What Are They Good for?’ (2011) 25 Australian Journal of Corporate Law 176.

E Ip, ‘The Share Capital Puzzle: The Corporate Decision to Issue Ordinary or Preference Shares’ (2002) 20 Company and Securities Law Journal 289.

A Lamba and I Ramsay I, ‘Comparing Share Buybacks in Highly Regulated and Less Regulated Market Environments’ (2005) 17 Australian Journal of Corporate Law 261.

J Mannolini, ‘The Brave New World of No Par Value Shares’ (1999) 17 Company and Securities Law Journal 30.

J McConville, ‘Schemes of Arrangement, Selective Buy-Backs and Village Roadshow’s Preference Share Tussle: Entering the Matrix’ (2005) 2 Macquarie Journal of Business Law 203.

M Welsh, ‘The Corporations Act Financial Assistance Provisions Offer Limited Assistance to Creditors’ (2003) 17(1) Commercial Law Quarterly 3.

Practitioner Journals A Blomfield, ‘Ensuring Your Company’s Selective Share Buy-Back

Complies with the Corporations Act’ (2006) 3(6) Corporate Practice 63. V Dwyer and N Alston, ‘Legal Tools of Capital Management’ (2003)

3. 4. 5.

10.

11.

55(7) Keeping Good Companies 39.

Practitioner Works H A J Ford, R P Austin and I Ramsay, Ford’s Principles of Corporations

Law, LexisNexis, Australia (looseleaf and online), Chs 17 and 24. I Renard and G Santamaria, Takeovers and Reconstructions in Australia,

LexisNexis, Australia (looseleaf and online), Chs 13 and 14.

You will find useful study resources, including quizzes for each chapter, when you go to <http://learning.lexisnexis.com.au>. The quiz is a great tool to help you self-test your knowledge.

Archibald Howie Pty Ltd v Commissioner of Stamp Duties (NSW) (1948) 77 CLR 143 at 156. For a discussion of the history of preference shares, see Beck v Weinstock (2013) 251 CLR 425; [2013] HCA 15. See, for example, Coopers Brewery Ltd (a large, South Australian beer company). See Beck v Weinstock (2013) 251 CLR 425; [2013] HCA 15. The ASX Listing Rules provide that preference shares for ASX listed companies must confer a dividend in preference to ordinary shares: LR 6.5. The Bank for International Settlements estimates that the use of equity linked derivatives up to mid-2015 was notionally valued at over US$7.9 trillion. This is much smaller than the credit default swap market (over US$16.3 trillion) and interest rate derivatives market (over US$505 trillion): see <http://www.bis.org>. For a fuller discussion on the maintenance capital rule, see the High Court judgment in Beck v Weinstock (2013) 251 CLR 425; [2013] HCA 15. For a fuller discussion on the historical significance of par values and the consequences of its abolition, see the High Court judgment in Commissioner of Taxation v Consolidated Media Holdings Ltd (2012) 293 ALR 257; [2012] HCA 55. For judicial observations on policy considerations concerning reductions of capital, see St George Bank Ltd v Commissioner of Taxation (2009) 256 ALR 391; [2009] FCAFC 62; Alcan (NT) Alumina Pty Ltd v Commissioner of Territory Revenue (2009) 239 CLR 27; In the matter of Molopo Energy Ltd; Molopo Energy Ltd v Keybridge Capital Ltd [2014] NSWSC 1864. For discussion on accounting treatment of share buy-back, see Commissioner of Taxation v Consolidated Media Holdings Ltd (2012) 293 ALR 257; [2012] HCA 55. For a discussion of the Village Roadshow buy-back saga, see J McConville, ‘Schemes of Arrangement, Selective Buy-Backs and Village Roadshow’s Preference Share Tussle: Entering the Matrix’ (2005) 2 Macquarie Journal of Business Law 203.

http://www.data61.csiro.au/en/Our-Work/Safety-and-security/Secure-Systems-and-Platforms/Blockchain

http://www.bis.org

[page 355]

Membership Rights and Meetings

CHAPTER 12 Becoming a member

Methods of acquiring membership status Register of members Share transfers

Termination of membership Membership rights

Right to inspect registers and obtain copies Members of listed companies Limits of membership rights Different types of shares create different rights

Membership liabilities Partly paid shares Contribution during insolvency

Company meetings How are meetings initiated? Board meetings

Members’ meetings

[page 356]

Role of chair during meeting Voting at members’ meetings Adjournment and closure of meetings Challenging the result of meetings

[page 357]

Membership Rights and Meetings

Learning Objectives After completing this chapter you should be able to:

Outline what rights and obligations company members have as a result of their shareholding.

Explain how a person can become a member of a company and how they may stop being a member.

Explain the role and use of the Register of Members.

Discuss the manner in which rights attaching to shares are protected from improper alterations.

Discuss what rights company members have in relation to calling, and voting at, company meetings.

Explain the different types of members’ meetings that may be held (Annual General Meeting, Extraordinary General Meeting).

Explain the difference between an ordinary resolution and a special resolution.

Explain how companies make decisions through the use of meetings. Explain how defects in the conduct of meetings may be cured.

Key Cases

Australasian Centre for Corporate Responsibility v Commonwealth Bank of Australia (2016) 113 ACSR 600; [2016] FCAFC 80

Automatic Self-Cleansing Filter Syndicate Co Ltd v Cuninghame [1906] 2 Ch 34

IMF (Australia) v Sons of Gwalia Ltd (2005) 143 FCR 274; [2005] FCAFC 75

Whitlam v ASIC (2003) 57 NSWLR 559; [2003] NSWCA 183

Key Sections

Corporations Act 2001 (Cth) ss 177, 231, 249D, 249H, 250A, 250J, 516

[page 358]

Introduction

As noted in Chapter 5, it is a fundamental principle of corporate law that corporations are artificial entities, which are given legal recognition as separate legal persons that are capable of making legally-binding decisions. It is therefore important to understand how it is that corporations as artificial entities are able to make these decisions.

The basic principle is that the rights and responsibilities of managing the corporation are usually conferred on the board of directors or upon others to whom they delegate these powers: s 198A. Extensive corporate governance rules are imposed on directors to ensure that powers are used appropriately and that responsibilities are fulfilled: see Chapters 14–18.

However, it would be incorrect to assume that only directors have the power to make decisions for the company. Many important decisions (such as the appointment of directors, approval of related party transactions and the decision to wind up the company voluntarily) are left for approval by the members’ meeting. When considering the decision-making processes that occur within companies, an analogy can be drawn with parliament, in so much as there are certain organs of government that can make decisions based upon a delegation of authority from a majority of the people (voters). So too, a corporation — where the directors are agents of the company and are given authority to manage the company on behalf of the members, with the members given regular opportunities to vote out directors whom they believe are underperforming ( just as voters can vote out governments of which they do not approve).

Membership of a corporate body is a special and complex relationship. It is essential to understand what rights and obligations company members have, and how the exercise of those rights and the enforcement of those obligations may influence the operation of the company. It is also important to understand and appreciate that the rights and obligations of individual members are determined by the type of ownership interest that the member has (normally the ownership of some type of share in the company) and by the way that the

company’s internal rules (the ‘constitution’) distribute the decision-making power between the different corporate organs.

A member owns an interest in a corporation. However, membership does not of itself entitle a member to participate in management of a corporation. There is an important legal distinction between ownership and management. Management of a corporation is normally carried out by the corporation’s officers and directors, who may or may not be members. This makes ownership of shares in a company quite different from many other business relationships, such as partnerships: see Chapter 4.

A member is generally not in a fiduciary relationship, either with the company or the other members. Although, as we discussed earlier in Chapter 6, the members are in a contractual relationship with the company and a contractual relationship with each other, in so far as those relationships concern the enforcement of the corporate constitution.

While the company’s members have the power through a members’ meeting to influence corporate decision-making, the interests and voting patterns of individual members are not identical, with each member voting in their own best interests. There is, however, a power within the majority of the company’s voting members to bind the minority members who dissent.

The power of the majority is best expressed in their ability to appoint directors to the board and thus influence the executive decision-making of the company. Minority members are, however, given extensive powers to ensure that the voting process is carried out fairly and

[page 359]

appropriately. This is dealt with in Chapter 19. Aside from the important rights to attend and vote at company meetings, members also have significant rights to access and obtain information from the company. Most of the information that is available to the public is contained in the statutory registers maintained by the company and ASIC. However, members also have rights to receive copies of company annual reports, and rights to inspect company registers without charge.

12.1

• • • • •

12.2

This chapter will first discuss what rights and obligations arise from membership of a company, then outline member liability, and finally discuss how company meetings are held.

Becoming a member

Methods of acquiring membership status Any person with legal capacity to own property (whether an individual or a corporation) may become a member of a company. Membership may be obtained in a number of different ways. The most frequent methods are by:

agreement in the application for registration of the company; transfer from another member; transmission (that is, on death or bankruptcy); the conversion of debentures or exercise of options into shares; and having a subscription for shares on an application form attached to a prospectus accepted by the company.

As noted in Chapter 3, companies in Australia come in two basic forms: companies limited by shares and companies limited by guarantee. The former is used for commercial activities and the latter, more commonly, for charitable and sporting activities. If a company’s capital is limited by shares, the member is usually called a shareholder. The member of a company limited by guarantee is simply referred to as a member (for example, a member of the local tennis club).

Register of members The details of each company member (that is, name, address, number of shares held, date of share acquisition etc) are recorded on the Register of Members maintained by the company under s 169.

Inclusion of a person’s name onto the Register of Members is legally significant because once a company’s initial capital is established, any subsequent shareholders only derive their legal status as members from

12.3

inclusion on the Register of Members: Maddocks v DJE Constructions Pty Ltd (1982) 148 CLR 104. In Maddocks, the High Court said:

A person who subsequently to incorporation applies for shares to be allotted to him, or purchases shares from an existing shareholder, does not become a member of the company until his name is entered in the share register.

However, if a lawful purchaser of shares is denied registration of their share transfer they may have rights against the seller (for misleading and deceptive conduct,

[page 360]

for example) or rights against the company directors in respect of their failure to properly register the transfer. The issue of refusal by the directors to record share transfers is dealt with below.

rectification: the remedy of rectification involves correcting an error in a document, in this case the Register of Members.

Any person whose interests are affected by the information contained on a company register may apply to the court for an order under s 175 that the register be corrected to properly reflect the names and details of the members of the company (this is called rectification).

Share transfers In order to have a person’s name recorded on the Register of Members, that person must have had their ownership stake in the company (that is, their shares in the company if the company is limited by shares) transferred to them by another person, either by the company itself (for example, through a share capital raising using a prospectus) or by a pre- existing member of the company who is transferring some or all of their shares in the company to the person. A transfer of shares refers to the passing of title in the shares from the company or from an existing member to another person. The transferee only becomes a member when their name is included on the register.

The transfer of shares between persons may be undertaken either through

a licensed financial market such as the Australian Securities Exchange1 or through a simple share purchase contract if the company’s shares are not listed on a licensed financial market. It is common for large companies to manage their members’ register through a share registry company, such as Computershare. Smaller companies may maintain physical share certificates that are numbered and tracked through the company’s share register, but this becomes difficult as the number of shares and the number of members increase.

securities: see the definition in s 92.

Part 7.11 of the Corporations Act 2001 (Cth) provides the rules for processing and approving of the transfer of securities, which includes shares and other financial instruments such as options. Part 7.11 provides different mechanisms for transferring securities depending on whether the company has those securities listed on a licensed financial market (such as the ASX or the Sydney Futures Exchange). These markets use licensed clearing and settlement facilities to process securities transfers. A clearing and settlement facility involves completing the payment and transfer of ownership of securities through an electronic system. This is different from the trading of securities (that is, the process of buying and selling), which also occurs over an electronic computer system accessed by licensed traders (or ‘brokers’). It is common for both debt and equity securities in public companies to be settled using electronic clearing and settlement facilities. One of the major debt clearing facilities in Australia is Austraclear,2 which is run by the ASX.

The ASX process for completing share trades on the market is called ‘CHESS’ (which stands for Clearing House Electronic Sub-register System), which manages the on-market share trades electronically and is connected to the computer system of each stockbroker (known as a market participant) who trades on the market on behalf of their investor clients.

[page 361]

The Corporations Act provides different sets of rules to carry out the

transfer of securities. If the securities are listed, then the transfer process is governed by the transfer rules of the particular market: see Pt 7.11 Div 4. The ASX, for example, has an extensive number of rules and requirements relating to the conduct and completion of share trades on the market.

However, if a company’s securities are not traded over a licensed financial market, then the rules for transferring those securities are found in the Corporations Regulations 2001 (Cth) Pt 7.11 Div 3, which essentially require that the approved forms contained in the Regulations be used to carry out the transfer.

The transfer of shares over licensed financial markets is protected against fraud through the provision of compensation regimes maintained by each licensed financial market and also by the National Guarantee Fund which provides limited compensation in the event that a market participant (such as a stockbroker) defrauds a client through a securities transfer transaction. Part 7.5 of the Corporations Act establishes the requirements on licensed financial markets and their participants to maintain adequate financial compensation measures to protect investors against fraud.

Blockchain and share transfers

The ASX CHESS system was introduced in 1994 and since that time has undergone a number of upgrades and improvements, the most recent being the move to a T+2 settlement process for cash equities in March 2016. The ASX has been reviewing distributed ledger technology (DLT), with one prominent example being blockchain technology as a potential replacement for the existing CHESS system. The ASX has been trialling a DLT with a New York firm for the past two years. This is part of broader efforts to increase the speed and efficiency for processing securities trading in order to make the ASX more attractive to market participants as the market competes for capital with other regional securities exchanges in the Asian region.

Blockchain and other DLT systems allow for distributed networks to store and transfer information in a manner that is said to be robust and secure and allows for decentralised verification of transactions by the network itself, rather than through a central authority. DLT systems have also been used in trials overseas involving the NASDAQ exchange in the United States and by exchanges in Germany, Japan, Korea and Russia. Aside from settlement of securities transfers, blockchain and other DLT systems may open up shareholder voting and meetings as well as dividends payments. Blockchain and other DLT systems offer a range of advantages for processing transactions, including speed, relatively low transaction costs and varying degrees of anonymity. The CSIRO’s Data61 team released two detailed

12.4

12.5

papers in 2017 setting out opportunities and challenges for DLT and blockchain technology, which can be found on their website: <http://www.data61.csiro.au/en/Our-Work/Safety-and-security/Secure- Systems-and-Platforms/Blockchain>.

Share certificates Recognition of membership of a company usually comes with a share certificate signed by the company (ordinarily by attaching the company’s seal), which acts as proof of ownership of those particular shares. In order to transfer ownership in those shares, the share certificate must be accompanied with the signed contract to transfer the shares (known as an instrument of transfer) and sent to the company with a request to register the transfer into the new member’s name. Once the company registers the transfer, the new member is recorded as the owner of those shares on the Register of Members.

[page 362]

However, as noted above, some companies list their shares and other securities (such as options and debentures) on licensed financial markets (such as the ASX) and the transfer of these securities occurs electronically using the clearing and settlement rules of the financial market. For shares traded over the ASX, the CHESS system does not incorporate physical share certificates as share transfers are all made electronically. Thus, ‘share certificates’ are electronically recorded within the CHESS system with no need to send a formal written request for the company to transfer the ownership. The CHESS system manages the transfers automatically. A similar system operates for debentures.

Directors’ right to refuse registration As noted above, the rights that accrue to members are ordinarily established upon the member being included in the company’s Register of Members. A transferee member (that is, someone who has purchased shares from an existing member) may have their name included on the company’s Register of Members by lodging a registration form with the company: s 1071D. However, it should be noted that the company is not

•

• •

12.6

bound, strictly speaking, to register the transfer of its shares simply because the new owner requests it. For example, a company may have particular requirements in its constitution relating to how share transfers may be made and who may be allowed to become a member in the company. If these requirements are not met, then the company need not register the transfer.

Furthermore, s 1072F(2) (a replaceable rule) provides company directors with the discretion to refuse to register a transfer if:

the instrument of transfer and share certificate are not lodged with the company; the registration fee (if any) is not paid; and the directors have not been provided with reasonable information to demonstrate the person’s entitlement to transfer the shares.

Section 1071F allows a transferee to apply to the court for an order that the share transfer be registered if the company has refused to register the transfer ‘without just cause’. In determining what a just cause may be, the court will consider whether the refusal to register the share transfer was made for a proper purpose and in the best interests of the company: Roberts v Coussens (1991) 25 NSWLR 171. The meaning of the terms ‘proper purpose’ and ‘the best interests of the company’ are discussed in Chapter 15.

Disputes concerning the registration of share transfers commonly occur in small proprietary companies that may wish to control the membership base of the company (for example, by refusing to register share transfers to persons who are not members of a particular family). This is recognised in s 1072G (a replaceable rule), which provides directors of proprietary companies with the general discretion to refuse registration of transfers for any reason.

Termination of membership

Just as the creation of membership status comes with the inclusion of a member’s name on the company’s Register of Members, the termination

•

• •

•

12.7

of membership occurs

[page 363]

when the company removes a member’s name from the register. The termination of membership may arise because:

the member’s death has transferred their shares to another person (including a beneficiary under a will or the person’s executor or administrator); the member has sold their shares to another person (including to the company through a share buy-back); the member has had their shares forfeited by the company; the member has become bankrupt and their trustee in bankruptcy now owns the shares for the benefit of their creditors; or the company in which the member owns shares has been deregistered by ASIC.

As noted above, s 175 allows the court to rectify (that is, amend or correct) the company’s Register of Members if a member’s name is removed by error.

Membership rights

Members may be granted rights either by specific provisions of the Corporations Act or because of the contractual operation of the company’s internal management rules (known as the corporate constitution). The general operation and enforcement of the corporate constitution was discussed in Chapter 6. The present focus is therefore on the most common rights exercised by company members, which are discussed below.

Being a member of company means that the member is a part-owner of the company. Each share held by the member represents a small ownership stake in the company. The more shares owned by a member, the more the member owns of the company. However, it should not be

thought that owning a particular proportion of shares confers on a member a similar proportional ownership of the company’s assets. The company is a separate legal entity that owns the assets in its own name. For example, owning 50% of the company’s shares does not mean that the member owns 50% of the company’s assets. While the company’s directors manage those assets for the benefit of the shareholders, the individual assets of the company are not owned by the shareholders. This result was demonstrated in Macaura v Northern Assurance Co [1925] AC 619 (considered at 5.5), where Macaura was unable to claim on an insurance policy held over the company’s assets (trees on a tree farm) because as a shareholder he did not own those assets — the company did.

However, merely being a member does give rise to a number of basic legal rights. A member, once on the Register of Members (or legally entitled to be on the register), has a number of legal rights under the Corporations Act and also under the company’s constitution. The company’s constitution will usually provide for the rules relating to the issue of shares by the company and what rights each class of shareholders has within the company (such as voting and dividend rights). These key membership rights are often expressed as terms of the statutory contract established by s 140, and may be enforced by the members if the company (or another member) breaches them: see Chapter 6. For a public company, any document that provides rights to shares must also be lodged with ASIC: s 246F.

[page 364]

Therefore, it may be said that the most important common law rights that are given to members under the corporate constitution are:

Table 12.1 Common Law Rights of Members

Common Law Membership Right For Discussion

The right to enforce the statutory contract See Chapter 6

The right to appoint directors See Chapter 14

The right to a dividend See Chapter 20

• • • • • •

• •

•

12.8

The right to attend members’ meetings See 12.16– 12.28

The right to vote at a members’ meeting See 12.25

The right to receive information from the company (including information relating to proposed members’ meetings)

See 12.8, 12.17

These basic common law rights are further supplemented by various statutory rights contained in the Corporations Act such as:

the right to wind up the company (s 461); the right to enforce compliance with the Corporations Act (s 1324); the right to call a members’ meeting (s 249D); the right to put resolutions to a members’ meeting (s 249N); the right to distribute a statement to members in a meeting (s 249P); the right to receive a copy of the company’s annual financial report (s 314); the right to inspect the company’s registers free of charge (s 173(2)); the right to approve certain executive remuneration (s 200B) or related party benefits (Ch 2E); the right to remove directors of public companies from their office (s 203D); and most importantly, the right to bring an oppression action (s 232) or a statutory derivative action (ss 236–237) — these actions are discussed in Chapter 19.

Right to inspect registers and obtain copies This right deserves particular consideration because it has become prominent in recent years, in part because of the growth of shareholder class actions. The last five years have seen a dramatic rise in the number of class actions being brought against large Australian public companies for allegedly providing misleading information to the stock market. Companies that have been subjected to these actions include Multiplex (a large construction company), Aristocrat Leisure (one of the world’s largest poker machine manufacturers), National Australia Bank (one of the country’s big four banks), Leighton (an international construction company) and Centro (one of the world’s largest shopping centre owners).

A class action is essentially a court proceeding where the applicants (referred to as ‘plaintiffs’) join together and sue the defendant company together using a representative plaintiff. This enables the plaintiffs to share the costs of litigation and, importantly, allows plaintiffs with relatively small claims (for example, less than $30,000) to pursue legal action because they are sharing the costs with hundreds (or perhaps even thousands) of other plaintiffs. Thus, the individual cost to each plaintiff

[page 365]

is small. Some class action funding arrangements may even allow the plaintiffs to avoid all of the costs of litigation.

In order for a proposed shareholder class action to include the largest number of plaintiffs (and thus maximise the potential compensation award), the persons running the class action (typically a law firm or litigation funder such as Bentham IMF)3 need to be able to identify and then contact as many of the shareholders as possible. Therefore, access to, and use of the information contained in, the Register of Members is of enormous significance. Although the right to inspect the register is provided in s 173, only members are able to inspect the register without paying a fee.

More important, for a class action, is the right to use information found upon inspecting the register. The class action organisers must be able to use the contact details for each member listed in the register, so as to identify if that member is interested in joining the class action. However, s 177(1)(a) provides that a ‘person must not use information about a person obtained from a register … to contact or send material to the person’. There would be little point in inspecting the Register of Members to determine the postal address of each member if one could not then contact those members in relation to the proposed class action. However, s 177(1A) provides that this prohibition ‘does not apply if the use or disclosure of the information is for a purpose relevant to the holding of the interests recorded in the register or the exercise of the rights attaching to them … or is approved by the company’. Given that the class action is normally taken against the company, it is unlikely that its

12.9

approval will be given. It is therefore necessary for the class action organisers to establish that the information obtained from the Register of Members will be used for a purpose relevant to the holding (or exercising) of the interests recorded in the register. The leading decision on this issue is IMF (Australia) v Sons of Gwalia Ltd (2005) 143 FCR 274; [2005] FCAFC 75, which held that a class action funder could not use the information on the Register of Members to contact members to inform them about a class action relating to their purchase of shares because the right to sue based on circumstances that existed prior to purchasing shares was not a right directly ‘relevant to the holding of the interests recorded in the register’.

One problem that the IMF decision does not address is the issue of members being contacted by prospective purchasers of their shares, who obtain the member’s contact details by searching the Register of Members. There are numerous firms that engage in predatory share offers by obtaining copies of the Register of Members of large public companies in order to offer to purchase the shares of small shareholders. One example involved offers made to OneSteel shareholders which offered a price slightly above the current trading price of the shares — except that the price was to be paid in instalments over 15 years. Given the time value of money, this meant that the price actually received by the shareholders was below the trading price. This was held by the court to be misleading conduct: National Exchange Pty Ltd v ASIC (2004) 49 ACSR 369; [2004] FCAFC 90.

In 2010, several amendments were made to the Corporations Act to address issues relating to unsolicited share offers and more general concerns about the privacy of information contained on company registers. First, s 173 was amended to require persons wishing to obtain a copy of the Register of Members to disclose what purpose

[page 366]

they intend to use the information for: s 173(3A). Certain purposes are expressly prohibited under Corporations Regulations 2001 (Cth) reg 2C.1.03:

(a) (b)

(c)

(d)

12.10

• •

•

soliciting a donation from a member of a company; soliciting a member of a company by a person who is authorised to assume or use the word stockbroker or sharebroker in accordance with section 923B of the Act; gathering information about the personal wealth of a member of a company; making an offer or invitation to which Division 5A of Part 7.9 of the Act applies.

Note: Division 5A of Part 7.9 of the Act applies to unsolicited offers to purchase financial products off-market.

Second, s 177(1AA) of the Corporations Act was amended to limit the ability of a person to use information obtained from a register (including the Register of Members) for one of these ‘prescribed purpose’.

A person is also prohibited from disclosing information contained on a register if it is likely to be used for one of these prohibited purposes: s 177(1AA). Any person who makes a profit by contravening s 177 owes a debt to the company made up of the amount of the profit: s 177(3).

For more information concerning misleading and deceptive conduct in securities transactions, see Chapter 21.

Members of listed companies If the company is a public company and has its securities listed on the ASX, then the ASX Listing Rules require that certain management decisions receive membership approval (through an ordinary, or in some cases a special, resolution passed at a members’ meeting). For example, the ASX Listing Rules4 require membership approval for the following actions:

where the company proposes to sell its main business (ASX LR 11.2); where the company proposes to issue more than 15% new share capital in a 12-month period — unless the issue is pro rata among existing members (ASX LR 7.1); where the company proposes to make a significant change to its trading activities (ASX LR 11.1); and where the company proposes to engage in a related party transaction

12.11

worth more than 5% of the share capital (ASX LR 10.1).

Limits of membership rights Despite having a number of legal rights, the actual power to manage the company’s business is left to the board of directors: s 198A. While the members are given rights and powers under the Act and the company’s constitution, the members may not attempt to take away the management responsibilities and powers from the board of directors: Automatic Self- Cleansing Filter Syndicate Co Ltd v Cuninghame [1906] 2 Ch 34. In that case, the court held that once the directors were given the power of management, a simple resolution passed at a members’ meeting could not take away that authority. The authority could only be taken away by amending

[page 367]

the corporate constitution (that is, by changing the document which conferred the managerial authority on the directors in the first place). As Davies J said recently in Australasian Centre for Corporate Responsibility v Commonwealth Bank of Australia [2015] FCA 785 at [16]:

… if the company’s constitution gives to the board the power to manage the company’s business, the directors are exclusively responsible for the management of the company and shareholders cannot control the directors in the exercise of that power or direct the board by resolution to exercise that power in a particular way (save for any matters that are within the power of the company in general meeting)

This decision was upheld on appeal.

Australasian Centre for Corporate Responsibility v Commonwealth Bank of Australia (2016) 113 ACSR 600; [2016] FCAFC 80 Full Federal Court

Facts: The Australasian Centre for Corporate Responsibility (ACCR) represented more than 100 members entitled to vote at the general meeting of the CBA (Australia’s largest listed company) and

proposed a choice of three resolutions to be put to the CBA members at the 2014 AGM. The resolutions were expressed to be in a particular order so that if resolution 1 was not distributed to members, then resolution 2 and so on. Resolution 1 stated that it was ‘the opinion of the shareholders’ that it was in the best interests of the company that the directors provide to shareholders a report explaining the greenhouse gas emissions from borrowers funded by the bank and how the bank was managing the risks associated with these emissions. The second resolution requested that directors include the same information in their directors’ report to the members. The third resolution included the same request for a report to members but did so by seeking to amend the CBA constitution to require the report to be provided each year. The bank distributed the third resolution to members but refused to distribute resolutions 1 or 2. The Bank’s directors distributed the third resolution with a statement recommending that the members vote against the resolution. The ACCR unsuccessfully sought court orders directing the bank to distribute all three resolutions to its members at the next AGM.

Issue: Were the resolutions matters that members could validly consider and vote on at the company’s AGM?

Decision: The court agreed with the statements in NRMA v Parker (1986) 6 NSWLR 517 that it was not a proper role for the general meeting to express an opinion about how the directors exercise their management power. While members may have personal views on management’s behaviour, it is not the role of the members’ meeting to give an opinion on this. The court held (at [37]):

… shareholders in general meeting have no authority to speak or act on behalf of the company except to the extent and in the manner authorised by the company’s constitution or any relevant statute, and to an extent and in a manner consistent with the constitution or statute.

In this case, there was no statutory provision or power in the constitution to allow the members to express an opinion to the board by passing a resolution. The court held that the ACCR failed to provide any basis for a power to provide an opinion to the board (including any notion that the members’ meeting had some form of residual plenary power).

The court also held that the statement issued to members recommending they vote against it was within the power of the board. Although ACCR lost its court battle with CBA, in 2015 the Bank did commit to increasing its reporting on carbon emissions related to its lending arrangements.

[page 368]

The members may be said to have control over the actions of directors only indirectly by removing the directors from office. As the House of Lords said in Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821:

… directors, within their management powers, may take decisions against the wishes of the majority of shareholders, and indeed that the majority of shareholders cannot control them in the exercise of these powers while they remain in office.

These principles were applied by the Full Federal Court in Capricornia Credit Union Ltd v ASIC (2007) 159 FCR 69; [2007] FCAFC 79, where the

court considered an application by a credit union to have access to the membership register of another credit union so as to contact those members for the purpose of informing them of a takeover proposal and to ‘assist or facilitate convening a meeting of members to consider, and if thought proper, pass resolutions giving directions to [the board of directors] in relation to the proposal’. In this case the credit union had a provision in its constitution similar to s 198A which gave the managerial power of the corporation to the directors, unless specific powers were given to the members (and none had been). The court found that the board of directors was responsible for dealing with the takeover proposal and it was not within the power of the members to convene a meeting to pass resolutions directing the board as to the management of the company. The court stated (at [59]):

Although directors may now be removed by ordinary resolution (s 204D), the proposition that members generally may not instruct directors as to the performance of their duties remains valid. In the present case, it is supported by the constitutional vesting of management in the board. That may only be amended by special resolution: s 136(2). To allow members to direct the board would detract from that provision. For this reason we agree that [the proposed resolution be rejected].

The court also rejected a further proposed resolution that the board be replaced with directors who would be prepared to give effect to the directions of members. The court noted that such a requirement on the conduct of directors could put them in conflict with their general law and statutory duties to act not in the interests of particular members (even an overwhelming majority of members) but in the interests of the company as a whole. See further Chapter 15 for a discussion of these duties.

It is important that shareholders appreciate what legal rights they have and where those rights fit into the delicate balance between the powers of management (that is, the board of directors) and the powers vested in the members’ meeting. The importance of having at least this basic appreciation is particularly high given the continuing rise in Australia of ‘mum and dad’ shareholders, resulting from the spate of privatisations, floats and demutualisations, such as Commonwealth Bank, GIO, Qantas, Telstra, TAB, Woolworths, NRMA and AMP.5 Most of these companies have large numbers of shareholders (sometimes more than a million shareholders). It is also becoming increasingly common for investors to use derivatives, such as contracts for difference (CFDs) and exchange

traded funds (ETFs), to invest in the stock market rather than purchasing individual shares. It is also important to note that the majority of shares owned in individual public companies listed on the ASX are held not by individual shareholders, but rather, by large institutional investors such as superannuation funds and financial services companies such as the National Australia Bank. The power and influence that these large institutional

[page 369]

shareholders have is considerable. An industry has developed to advise institutional shareholders how to vote at members’ meetings and to promote good corporate governance practices.

Shareholder activism

Shareholder activism seems to be rising in Australia. Shareholder activism refers to efforts by institutional investors (such as superannuation funds) or sophisticated investors (such as hedge funds or active fund managers) to seek to influence the management strategy of a public company. Shareholder activism has been prominent for many years in the United States, with activist investors such as Carl Icahn, Daniel Loeb and Bill Ackerman achieving celebrity status both for their strident activist campaigns as well as for their immense wealth. Institutional activists also include large pension funds such as CalPers in the United States. These activist investors try to change management strategy, usually with some recommended goal in mind that (argues the activist) will increase value for shareholders. This may include selling assets, closing loss-making divisions, restructuring operations and/or alternate cash management (such as paying higher dividends). Activists use a mix of private and public criticism of existing management which can extend to media interviews, investor briefing notes and social media postings. This may escalate towards efforts to remove members from the board, vote against remuneration plans and to appoint new members recommended by the activist. Some of the world’s largest companies have been targeted by activist investors, including Apple, Nestle, Sony, Yahoo and recently in Australia BHP Billiton (where US-based Elliott Capital Management has run a prolonged campaign to refocus strategy and divest large assets to return further capital to investors).

In Australia, activists can utilise members’ rights such as requesting meetings be held and that resolutions and statements be distributed to members. Activists can also seek support to oppose remuneration reports at AGMs of publicly listed companies which can lead to directors being put up for mandatory re-election if two strikes are obtained. The two strikes rule is discussed further below.

Different types of shares create different rights

12.12

Different types of shares create different rights Although this chapter is concerned with the broad notion of membership of all companies, as the vast majority of companies are limited by shares, it is important to focus on the membership rights that are created by different types of shares. As noted in Chapter 11, there are many different types of shares that may be issued by a company, with the most basic distinction being drawn between ordinary shares and preference shares.

Where a company has only ordinary shares, all members have the same rights. However, companies may have different types of shares and/or different classes (subsets) of a particular type of share. The ability to issue different classes of shares allows companies the flexibility to offer appropriate securities to different types of investors. For example, some investors are primarily interested in dividend payments and not the ability to vote at members’ meetings. Thus, companies may issue preference shares that give a higher dividend yield and do not typically carry full voting rights. Other investors may not be as interested in dividend yields as capital growth of the share value, and hence may be more interested in superior voting rights, which gives them a higher degree of control over the composition of the board of directors.

[page 370]

Where a company has different classes of shares (such as ordinary shares and preference shares), it is important to recognise that the alteration of the rights attaching to these shares may be regulated by the company’s constitution or by the Corporations Act. Section 246B provides that where a company’s constitution sets up a procedure for the variation or cancellation of class rights (for example, reducing the dividend yield payable on a class of preference shares), then class rights may only be varied or cancelled by following that procedure.

Where the company’s constitution does not provide a special procedure for varying or cancelling class rights, the alteration of class rights can only occur by special resolution (that is, 75% majority) of the company and of a meeting of the holders of the particular class affected. Breach of these statutory provisions entitles a member to rely on a range of

12.13

12.14

statutory remedies under the Corporations Act, including the application for an injunction under s 1324 or an order under s 233 (for breach of the oppression remedy in s 232). Members’ remedies are discussed further in Chapter 19. A failure to comply with s 246B may be remedied by an order under s 1322: see Biodiesel Producers Ltd v Stewart [2007] FCA 722 (issue of new class of shares without shareholder consent).

Membership liabilities

Having considered the various rights and powers that membership confers, it is now appropriate to outline the obligations that arise because of membership in a company. The liabilities and responsibilities imposed on company members vary according to the circumstances of the company. Indeed, usually membership liabilities and responsibilities only arise when the company becomes insolvent and the liquidator attempts to maximise the pool of available funds for the company’s creditors.

It should be recognised that the primary obligations of company members are generally economic in nature (that is, the liability to contribute funds to the company). This does not mean, however, that additional liabilities may not be imposed on company members of particular companies. Further liabilities, if any, must be imposed under the corporate constitution and are subject to strict voting and enforcement requirements both under statute (see s 140(2)) and common law (see Gambotto’s case) and were discussed in Chapter 6.

Partly paid shares One of the basic principles of corporate law is that shareholders have limited liability up to the unpaid value of their shares. Thus, the first liability that members of a company have is the liability to pay to the company any unpaid value on their shares. Section 254M of the Corporations Act requires a member to contribute any unpaid value on their shares if the company requests that it be paid (referred to as a ‘call’). Calls are most frequently made by liquidators when the company becomes insolvent because the liquidator is responsible for obtaining the

12.15

best return for the company’s creditors. The failure of a member to pay on a call is essentially a breach of contract by that member because they have agreed to purchase the shares on the understanding that their liability was up to the full purchase price of the shares. By refusing to comply with the call, the member is refusing to fully pay for his or her shares.

[page 371]

If the company is a no-liability company (which is only allowed for mining ventures), then the refusal to pay a call allows the company to forfeit the member’s shares under s 254Q. However, the member may redeem their shares in certain circumstances under s 254R if they pay the call to the company after forfeiture but before the shares are sold by the company.

Contribution during insolvency The general rule of corporate law is that past and present members of a company are responsible for paying the company’s debts: s 515. A person who is liable to contribute to the payment of the company’s liabilities is known as a ‘contributory’. However, the principle of limited liability has rendered this rule of little operation in many situations, and this is recognised in the words of s 515 which provide that it operates ‘subject to this division’ (that is, subject to the rules in Pt 5.6 Div 2 — Contributories). The rules in Pt 5.6 Div 2 include the rules that a member of a company limited by shares is not liable to contribute any more than the unpaid value of their shares (s 516), and a member of a company limited by guarantee is not liable to contribute more than the guaranteed amount: s 517. Furthermore, a former member is not liable for debts incurred after their membership is terminated: s 520.

However, the liability of a contributory, although somewhat remote in most companies because of limited liability, is long lasting and extends to the estate of a deceased contributory (s 528) and also to the trustee in bankruptcy of a bankrupt contributory: s 529.

12.16

12.17

Company meetings

Company meetings are a vitally important feature of the corporate decision-making process. Company meetings include both meetings of the board of directors and meetings of the company’s members (including, for public companies, the Annual General Meeting or AGM). The meetings of the company’s board of directors are held to review the performance of the company’s executive management team and to make decisions about the future progress of the company. The most commonly recognised form of members’ meeting is the AGM, which is held to inform members about a public company’s annual performance and to vote on the election or re-election of company directors, or any other business that requires membership approval (such as a capital reduction or approval of related party transactions). Occasionally, an urgent matter will arise that requires membership approval and an extraordinary members’ meeting will be called to consider the proposal. It should be noted that only public companies are required to hold AGMs: see s 250N.

How are meetings initiated? All meetings require prior notice to be given and to allow the opportunity for participants at the meeting who are eligible to vote to be able to put forward a motion. Directors’ meetings are initiated by a simple notice of meeting given to each director. Usually, there will be a standing notice for monthly board meetings (such as the first Monday of each month).

[page 372]

Members’ meetings have different types of notice requirements, depending on what type of decision will be made at the meeting. This is referred to as putting forward a motion, which may be passed by a resolution (that is, by a vote of the members). Most motions only require a simple majority of votes (known as an ordinary resolution). However, some proposals (such as selective capital reductions) require a 75% majority and are called ‘special resolutions’. The significance of including a proposal requiring a special resolution in the members’ meeting is that

12.18

• • •

•

extra notice is required, because the motion for special resolution must be included in the notice itself: s 249L(1)(c).

The notice period is set at 21 days for a members’ meeting (s 249H), which is extended to 28 days for ASX listed companies: s 249HA. The time limit for giving notice may be shortened if all of the members entitled to attend and vote at the meeting consent to the meeting being convened on shorter notice: s 249H(2). It should be noted that short notice of meetings cannot be given for publicly listed companies.

The notice of meeting will generally state what business is to be considered, including the provision of any proposed resolutions that are formulated at that time. The directors must provide sufficient information for the members to know what is proposed to be decided at the meeting. This requirement allows members to determine how they may wish to vote at the proposed meeting, particularly in public companies, when many of the members will choose not to attend the meeting but rather vote by proxy.

quorum: a valid meeting must have a minimum number of members present. This minimum number is known as the quorum. A meeting that is held without the minimum number of members present is called an ‘inquorate’ meeting

If the company is deadlocked so that it is difficult to call a members’ meeting, the Corporations Act allows the court power to direct that a meeting be held: s 249G. A deadlock may arise when, for example, the members are in dispute and certain members refuse to attend a meeting so as to prevent a quorum from being reached.

Contents of the notice of meeting Section 249L requires that the following information be provided in the notice of meeting:

the place, date and time of the meeting; the general nature of the business to be conducted at the meeting; copies of any motions requiring special resolutions to be put to the meeting; and details of proxy entitlements (that is, explaining how a member may appoint a proxy to vote on their behalf).

12.19

The notice of an AGM for a publicly listed company requires further details to be provided: s 249L(2). The requirement that the notice explain the general nature of business to be conducted at the meeting was explained by Young J of the New South Wales Supreme Court in the following case.

Jenashare Pty Ltd v Lemrib Pty Ltd (1993) 11 ACSR 345 New South Wales Supreme Court

A notice of meeting must contain in clear language a full summary of the business with which the meeting has been convened to deal. The people receiving the notice must be able to decide whether it is worthwhile them attending or whether they are quite content for the business at the meeting to be dealt with in their absence.

[page 373]

Thus, there is a clear obligation imposed on directors to ensure that the members are properly informed about the nature and purpose of the proposed meeting: ENT Pty Ltd v Sunraysia Television Ltd (2007) 61 ACSR 626. Where the directors fail to properly notify the members with regard to the proposed meeting by giving misleading information in the notice of meeting, the members may seek a court injunction to stop the meeting being held: see Chequepoint Securities Ltd v Claremont Petroleum NL (1986) 11 ACLR 94 (where the information sent to members was misleading as it did not properly explain the value of the proposed transaction).

If there is a defect in the notice of meeting, the court has the power to cure the defect under s 1322. Late notices or notices that contain misleading information are examples of defective notices. The problems posed by defective meetings are dealt with below.

Board meetings Each of the directors on the board owes an obligation to the company to

12.20

convene and attend regular board meetings: see 17.7. Most public company boards in Australia comprise between four and nine directors, and would meet at least once a month. Board meetings may generally be called by any director who gives notice to all of the directors on the board: s 248C (a replaceable rule). What is reasonable notice will depend on the circumstances: see further McMaster v Eznut Pty Ltd (Admin Apptd) (2006) 58 ACSR 199; [2006] WASC 109. It must be made clear to the directors when they are having a board meeting (as a decision-making organ), as opposed to merely meeting as officers of the company. However, as with most procedural matters the corporate constitution may make specific rules regarding the calling and the conduct of board meetings. It is common for directors to meet at regular intervals, such as the first Tuesday of every month.

At the meeting of the board, there is one vote per director and only a simple majority of votes is required to pass the motion as a resolution. Any resolutions decided must be recorded in the board’s minute book. Alternatively, directors may pass a resolution without a meeting, provided the motion is circulated to all the directors to sign: s 248A. This alternative method is a replaceable rule: s 135.

The quorum for a board meeting is normally two directors but, again, this is a replaceable rule: s 248F. As noted earlier, a proprietary company may have only one director.

If there is a defect in holding a board meeting (such as insufficient notice being given), the court may grant an order curing the defect under s 1322.

Members’ meetings There are two types of members’ meetings, the Annual General Meeting (or AGM) and the Extraordinary General Meeting (or EGM). The AGM is held each year to consider the company’s annual report and annual financial accounts, and also to elect directors. The EGM is only held when a particular issue arises that requires the urgent consideration and approval of the members.

Annual General Meeting

12.21

•

• • •

Only public companies are required under the Corporations Act to hold Annual General Meetings. Section 250N(2) requires all public companies to hold an AGM

[page 374]

within five months after the end of that company’s financial reporting year. A public company may, however, apply to ASIC for an extension of time to hold its AGM: s 250P.

Under s 250R, the AGM is held to consider:

the company’s annual financial report, directors’ report and auditor’s report; the election of directors; the appointment of company auditors; and the auditor’s remuneration.

Where the public company is also listed on the ASX, then the AGM must also consider and vote on the remuneration report, although the members’ vote does not bind the directors: s 250R(2), (3). Section 250R does not provide members with the right to put advisory resolutions to the board of directors concerning the management of the company: Australasian Centre for Corporate Responsibility v Commonwealth Bank of Australia (2016) 113 ACSR 600; [2016] FCAFC 80.

Given public concern about the size of executive and director remuneration, there have been calls from some sectors to make the members’ vote binding. The federal government’s response to these calls for reform has been to amend the Corporations Act to provide for the board to be required to stand for re-election where the company’s remuneration report has received at least 25% votes against in two consecutive years: ss 250U-–250Y. In the past two years, several large ASX listed companies have received a first strike (that is, >25% votes against the remuneration report), including CBA, AGL, Seven Group, Bluescope Steel, Fairfax Media and Lend Lease. It should be noted that in counting the 25% required for a strike, the votes of ‘key management personnel’ are not counted: s 250R(4)–(5).

•

[page 375]

How effective is a non-binding vote on remuneration for influencing corporate boards?

Aside from considering the company’s annual reports and election of directors, the purpose of the AGM is to provide an opportunity for members to put questions to the company’s board regarding the company’s performance. The chair of the AGM must provide a reasonable opportunity for members to ask questions: ss 250S, 250SA. The company’s auditor may attend a public company’s AGM (in which case members may ask them questions (s 250T)) but is required to attend the AGM of a public company listed on the ASX and must also be available to answer members’ questions: s 250RA.

•

The future of the AGM

The role of the Annual General Meeting (AGM) has long been controversial. Attendance at the AGMs of public companies has been low for a long time and seems to be declining. The effectiveness of the AGM as a decision-making body is open to question given the low attendance (less than 1% of members attend the AGM) and overall low participation rate (including members voting by proxy). Furthermore, most resolutions of large public companies are determined by proxy votes that are known several days before the meeting even takes place. It is legitimate to question whether the AGM is just for show? Does it merely give small shareholders the appearance of meaningful participation by allowing them (regardless of how small their shareholdings are) to ask questions of the senior executives? Shareholder activists such as Stephen Mayne have used the questions and answer sessions at AGMs to hold boards accountable in a very public way.

However, in recent years the increasing influence of proxy advisers (research institutions that advise institutional shareholders on voting at members’ meetings) and the role of activist institutional investors have meant that there are a range of other influences on company decision-making outside of the AGM. On the other hand, the recent introduction of the ‘two strikes rule’ for publicly listed AGMs has made the voting on remuneration reports an important accountability mechanism, at least with regard to executive remuneration.

In December 2011, the Parliamentary Secretary to the Treasurer referred the role of the AGM to the Corporations and Markets Advisory Committee (CAMAC). CAMAC was asked to inform the federal government on:

the future of the annual general meeting in Australia, including how documents and meeting forms should change to meet the needs of shareholders in the future; the risks and opportunities presented by advancements in technology, in the context of maintaining the ongoing relevance and efficacy of the AGM; and the challenges posed to the structure of the AGM by globalisation, including potential increases in international share ownership and dual-listing.

At the time of writing, CAMAC had released a discussion paper on the AGM which is available on its website. The discussion paper gives a detailed overview of the role of the AGM and its potential future use. Unfortunately, CAMAC was stripped of its role by the federal government in 2015, with a Bill before parliament to abolish CAMAC. All current reviews undertaken by CAMAC (including the future of the AGM) were transferred to the Commonwealth Treasury. No further announcement has been made by Treasury.

What role do you think members’ meetings should have?

[page 376]

12.22

Extraordinary General Meeting An EGM may be called by the company’s directors or by the members themselves holding at least 5% of the votes in the meeting. However, where the members call the meeting themselves, the members must pay the costs of holding the meeting, with the result that almost all EGMs are called by the directors.

The members may require the directors to call an EGM under s 249D if members holding at least 5% of the votes in the meeting make a written request to the board of directors. This method offers the advantage that the meeting is conducted by the company rather than by the members and therefore the company is responsible for the organisation and costs associated with holding the meeting. Section 249D was amended in 2015 to remove the ability of 100 members to requisition a company meeting. This was done because of concerns about the cost of the procedure for company and the potential for the procedure to be misused, particularly as 100 members is not a large number when some publicly listed companies have hundreds of thousands of members.

The request for a meeting under s 249D must also contain the proposed resolutions that are to be put to the meeting. Directors are not required to hold the s 249D meeting if the resolutions contained in the written request are invalid or if the meeting is to be held for an improper purpose: NRMA v Parker (1986) 6 NSWLR 517 (approved in Australasian Centre for Corporate Responsibility v Commonwealth Bank of Australia (2016) 113 ACSR 600; [2016] FCAFC 80). A s 249D meeting will be held for an improper purpose where the members seeking to hold the meeting are doing so for a purpose otherwise than to have the members consider and vote on the resolutions notified to the directors: NRMA Ltd v Scandrett (2002) 43 ACSR 401; [2002] NSWSC 1123. If it is proven that the members are calling the meeting for an improper purpose (that is, a purpose other than for the members to consider and vote on the resolutions), then the court may grant an order preventing the meeting from taking place: Humes Ltd v Unity APA Ltd (in liq) [1987] VR 467.

The requirement to hold the meeting can be very costly for large companies. In the recent case of Woolworths Ltd v GetUp Ltd (2012) 90 ACSR 670; [2012] FCA 726, the court allowed Woolworths to delay

•

12.23

holding the requisitioned meeting until the time of the AGM to minimise the expenditure of resources. Woolworths estimated holding the extraordinary general meeting would cost it $550,000. The proposed meeting was aimed at changing the constitution to prohibit Woolworths from owning or operating electronic gaming machines. Woolworths is a major supermarket chain but it also owns a large number of licensed premises that have gaming machines. The resolution was not passed by the AGM in 2012, with only 2.47% of the votes passed in favour of the proposal.

Should members with only 5% of the votes in a meeting be able to require the company to call a members’ meeting even though they could not pass a resolution themselves?

However, it could be argued that company meetings, particularly for public companies with large numbers of small shareholders, do not make directors and executives accountable because no individual shareholder typically has any more than 5% or 10% of the company. The Commonwealth Parliament’s Joint Committee on Corporations and Financial Services produced a report on shareholder engagement

[page 377]

in 2008 which reaffirmed the importance of members’ meetings and recommended a range of ways to improve voting rules to ensure that members are able to express their collective will through the company meeting.

Who can attend a meeting? A members’ meeting may be attended by:

proxy: if a member cannot attend the meeting that member may still submit their vote by lodging a proxy vote with the company. This is usually done by mail, but it may also be done by nominating another person to vote on the member’s behalf.

•

• •

• • •

12.24

any member whose membership rights include the right to attend a company meeting; a proxy; validly appointed by a member who has the right to attend and vote at the company meeting; a director of the company; the auditor of the company; or any other person permitted by the chair of the meeting.

Of course, as with most matters of internal company procedure, the right to attend a company meeting may be modified by the corporate constitution.

Role of chair during meeting The person who is responsible for controlling the progress of the meeting is known as the ‘chair’ of the meeting (also sometimes referred to as chairman or chairperson).

The chair of a board meeting is referred to as the chairman of the board of directors, although another person may be elected to chair a particular meeting if the chairman of the board is not present.

The directors may elect a chair for a members’ meeting and, if that person is not available or does not attend the meeting, then the members may elect a chair: s 249U — a replaceable rule.

The chair’s role in a members’ meeting is to control the progress of the meeting, including the flow of questions from the members and the counting of the votes on motions put to vote by the members (including proxies). As Young J noted in Kelly v Wolstenholme (1991) 4 ACSR 709, the chair:

… exercises procedural control over the meeting by … nominating who is to speak, dealing with the order of business (unless that is already set out by a written notice of meeting), putting questions to the meeting, declaring resolutions carried or not carried, in due course asking for any general business, and declaring the meeting closed.

The chair’s power to decide on the validity of votes submitted by proxy confers a broad discretion but may be open to challenge in court on the

12.25

basis that the chair acted under an error or law or acted in bad faith: Re Portman Iron Ore Ltd; Golden West Resources Ltd (2008) 170 FCR 409; [2008] FCA 1362 (where the chair dismissed a large number of proxy votes and unsuccessfully claimed that such a decision could not be challenged in court, although ultimately the challenge made no difference as the proxy votes were insufficient to change the result of the meeting). If the chair improperly counts votes, it is not regarded as a procedural irregularity that can be cured under s 1322: Carpathian Resources Ltd v Hendriks (2011) 81 ACSR 542; [2011] FCA 41. The chair’s role in administering votes on directors’ remuneration packages

[page 378]

Was also considered in the important decision in Whitlam v ASIC (2003) 57 NSWLR 559; [2003] NSWCA 183 considered below. See also Re Ryde Ex-Services Memorial & Community Club Ltd (admin apptd) [2015] NSWSC 226 at [104]–[108].

The role of the chair is discussed in more detail at Chapters 14 and 17.

Voting at members’ meetings At the members’ meeting, each member may vote depending on the number of shares they own and the voting rights that are attached to those shares. As noted above, ordinary shares generally have one vote per share, and, in companies where there are different classes of shares, there may be shares that carry more votes or no votes at all.

Although members will typically have the right to attend and vote at a members’ meeting, historically the rate of membership participation in voting is very low. Where a member is unable to attend a meeting, they may appoint another person to have the right to vote their shares. These votes are known as proxies.

The right to appoint a proxy is a replaceable rule for proprietary companies, but is mandatory for public companies: s 249X. Proxies may be voted in advance, specifying whether they are for or against the

motion (similar to a postal vote in a political election). Alternatively, the proxy holder (who is often the chair of the meeting) may be given discretion over when to vote and in which direction to cast the votes. In 2011 the Corporations Act was amended to require that proxies (including those who are acting as chair of the meeting) vote as directed in the proxy document: s 250BB. There are also special rules dealing with key management personnel who are appointed as proxies when voting on remuneration reports for publicly listed companies: s 250BD.

Whitlam v ASIC (2003) 57 NSWLR 559; [2003] NSWCA 183 New South Wales Court of Appeal

Facts: This case concerned the legality of actions taken by Mr Whitlam as chair of a members’ meeting of the NRMA. The meeting was held during a tumultuous period for the company, with a long-running dispute between various membership factions (including the factions supporting Mr Whitlam’s position as president of the company). The members’ discontent also related to the company’s relatively poor performance. One of the resolutions proposed at the meeting was to grant the directors a pay increase, which was vigorously opposed by a significant portion of the membership. It appeared that the vote on the pay increase would fail on the basis of proxy votes. Mr Whitlam as chair of the meeting had the responsibility of receiving and voting the proxy votes. However, he breached a company procedural requirement by failing to sign a large number of proxy votes that were against the resolution to increase the directors’ remuneration.

The result of failing to sign the proxies was that, although they were submitted for consideration, they were not counted and the resolution passed. ASIC took action against Mr Whitlam for breach of directors’ duties on the basis that he deliberately failed to sign the proxies. Mr Whitlam argued that this failure was a simple inadvertent error. At trial, Mr Whitlam was found to have breached his directors’ duties and was banned from being a director. Mr Whitlam appealed to the New South Wales Court of Appeal.

Decision: The Court of Appeal overturned the trial decision for a number of reasons. Relevantly for present purposes, the Court of Appeal held that Mr Whitlam’s duties as proxy

[page 379]

holder were not directors’ duties owed to the company, but rather were merely duties owed to the individual members who directed their proxies to him. Thus, by failing to properly vote the proxies Mr Whitlam was not in breach of directors’ duties under Pt 2D.1 and could not therefore by banned from being a company director. An application by ASIC for special leave to appeal to the High Court was refused.

Significance: This case affirms that in dealing with proxies, a director is not acting as a director of the company, but rather as an agent of the member granting the proxy, which means that a director will not be in breach of their duties under Pt 2D.1 if they fail to vote the proxies appropriately. They may,

however, be in breach of s 250A (which requires proxy holders to vote according to the directions of the member), but that is not a civil penalty provision, nor may it lead to a banning order against the director.

The votes used to calculate whether a motion has been passed are always the votes actually cast — that is, the actual people present at the meeting and voting plus the proxies that have been lodged prior to the meeting. Thus, the total number of members eligible to vote is irrelevant.

In theory, a company with 1000 shareholders and 1,000,000 votes could make a decision with 10 members attending with a total of 500 votes (provided that 10 members satisfied the quorum requirements in the company’s constitution). In such a situation, a motion would be passed if 251 votes are cast in favour of the motion, rather than 500,001 eligible votes.

An ordinary resolution requires a simple majority, which means more than 50% of the votes cast. As noted above, a special resolution would require a majority of at least 75% of the votes cast. The Corporations Act requires special resolutions in the following situations:

Table 12.2 When is a Special Resolution Required?

Nature of Proposal Section Number

Changing company name, or company type ss 157, 162

Changing corporate constitutions s 136

Variation of class rights s 246B

Selective capital reductions s 256C

Approving financial assistance to buy the company’s shares s 260B

Approving a capital reorganisation s 411

Resolution to wind up the company ss 461, 491

The actual process of voting is decided on a show of hands together with any proxy votes sent to the company. However, even where the motion has been passed on a show of hands, the members have the right in certain situations to require the company to conduct a formal poll, which is an actual count of all votes cast: s 250J.

A poll may be requested on any resolution, unless the company’s

12.26

12.27

constitution prohibits the taking of a poll with respect to the election of the chair or with respect to adjournments of the meeting. The poll is conducted in accordance with the instructions of the chair. The poll is becoming more popular for public companies, due

[page 380]

to the inaccuracy of a show of hands and the ASX requirement to record the number of proxy votes. The failure of a chair to conduct a poll when necessary will invalidate a resolution passed on a show of hands: Re Print Mail Logistics Ltd [2012] NSWSC 792.

Adjournment and closure of meetings A meeting may be adjourned by the members to give further time to consider unfinished business at the meeting. A meeting may also be adjourned where the meeting has become too rowdy and order needs to be restored, as demonstrated in the members’ meeting in the Whitlam case considered above.

The company’s constitution will ordinarily provide a specific procedure for adjourning the members’ meeting. If the chair fails to adjourn the meeting after a request by the majority of members, the members may elect a new chair. The adjournment of a meeting means that no further business can be conducted until the meeting is formally reconvened. The meeting is closed once the business proposed in the notice of meeting is completed and the chair declares the meeting closed.

Signed resolutions Proprietary companies have the ability to pass resolutions without holding a formal meeting by circulating the proposed resolutions to each member. The resolution is passed if all of the members eligible to vote sign the resolution: s 249A. Similarly, a company with only one member may pass a resolution by signing a written copy of the resolution: s 249B.

12.28

12.29

Minutes All meetings must have minutes as a record and public companies must file special resolutions with ASIC within 14 days of the meeting. The minutes of a general meeting must be entered into the minute book within one month, and can be signed by the chair at the next meeting: s 251A. The minutes perform the function of verifying what business was discussed and resolved at the meeting. The importance of minutes was underscored in the James Hardie litigation (discussed in Chapter 17) with particular reference to the decision in ASIC v Hellicar (2012) 286 ALR 501 where the High Court found that the minutes documented the board approval of a misleading ASX media release which the board denied had happened. See Chapter 17 for a fuller discussion on the legal issues in the James Hardie litigation and the significance of this High Court decision.

Challenging the result of meetings The result of a meeting will only be valid and enforceable if the meeting itself was validly held. There are several defects that may arise when a meeting is held:

There may be a defect in the notice of meeting either because the notice was sent too late (that is, less than 21 or 28 days), or because the details of the notice are incorrect, incomplete or misleading. A meeting may be defective because the minimum number of persons required to attend the meeting (known as a ‘quorum’) has not been met. The corporate

[page 381]

constitution will usually set out the quorum required for members’ and directors’ meetings. If this minimum number is not present, then the meeting is said to be ‘inquorate’. Section 249T provides that the required quorum for members’ meetings is two members who must be present for the duration of the meeting. Being a replaceable rule, s 249T may be replaced by a different provision in the company’s constitution.

The meeting may have been invalidly conducted because it failed to comply with the required procedure set down in the Corporations Act or in the company’s constitution for conducting a meeting (including putting forward motions and counting votes). A meeting may also be invalidated because the matters considered by the meeting are impermissible, for example, the meeting may represent minority oppression because certain shareholders are illegally excluded from attending or voting at the meeting or the meeting may be convened for an improper purpose (such as occurred in the Capricornia Credit Union case discussed above).

Situations 1–3 may be described as procedural defects, while situation 4 may be said to represent substantive invalidity.

Section 1322 provides a remedy to prevent procedural defects from displacing the results of otherwise valid meetings. Section 1322(2) provides that a proceeding under the Corporations Act is not invalidated merely because of a procedural irregularity, unless the court is of the view that the irregularity may cause substantial injustice, which cannot be remedied in any other way by the court. This means that there is a general rule that procedural irregularities should not invalidate ‘proceedings’ under the Act. A members’ meeting may be a proceeding under the Act, because the Act requires the company to hold a members’ meeting in certain circumstances: Re Broadway Motors Holdings Pty Ltd (in liq) (1986) 6 NSWLR 45. The courts have interpreted the phrase ‘procedural irregularity’ broadly.

Section 1322(1) specifically states that it includes (which means it is a non-exclusive definition so it may include other examples as well) the quorum requirements of a meeting and defective notices of meeting. Where a meeting suffers from a defective notice, s 1322(3) specifically provides that the meeting or any action taken in that meeting is not void merely because of a defect in the notice of meeting (such as the failure to give notice to a particular member). Thus, a defective meeting may be cured by the general power under s 1322(2), but substantial injustice must not be caused by doing so, or by the specific provision in s 1322(3) if the defect relates to the notice of meeting.

In addition, s 1322(4) provides the court with the broad power to cure procedural defects (including defective meetings), which may be used

• • •

where the meeting is inquorate, or where there has been a mistake in the voting procedures used in the meetings.

However, the power of the court to cure procedural defects is limited by the requirements of s 1322(6) which provides that the court may only make an order curing a defect under s 1322(4) where:

the defect was procedural in nature; the person who contravened the requirements acted honestly; or it is just and equitable that the order curing the defect be made.

[page 382]

Weinstock v Beck (2013) 251 CLR 396; [2013] HCA 14 High Court of Australia

Section 1322(4) and related provisions reflect a long-standing legislative recognition that mistakes will happen in corporate governance and that it is not in the public interest that the validity of decisions made in relation to corporations be unduly vulnerable to innocent errors which may be corrected without substantial injustice to third parties. In accordance with its evident purpose, [s 1322] is to be construed broadly and applied pragmatically, principally by reference to considerations of substance rather than those of form.

The Weinstock case concerned an ineffective appointment of directors, with one of the issues being whether the appointment could be validated by s 1322, which the lower court held it could not as the invalidity concerned non-compliance with the constitution and was not a breach of the Corporations Act. The High Court allowed the appeal and held that s 1322 can apply to breaches of the constitution. However, the court did note that s 1322 does have limits, as French CJ noted (at [40]):

The dispensing power conferred on the Court by [s 1322(4)] is not in the nature of a general absolution for all past errors. It does not authorise the making of an order declaring that an impugned act, matter or thing is valid. It allows a determination by the Court that the act, matter or thing done ‘is not invalid’ by reason of a provision of the Corporations Act or a provision of the constitution of a corporation. The remedy may be sought by a party fearing or suspecting invalidity on such a ground or, as in the present case, to meet a contention of invalidity advanced by another party in adversarial proceedings. The effect of a declaration under the

provision is limited to overcoming invalidity flowing from a particular contravention or contraventions.

No order curing the defect may be made where to do so would cause substantial injustice to any person: s 1322(6)(c). The courts determine whether substantial injustice is caused by considering the effect of the meeting on the parties involved and balancing the competing interests of those parties: Elderslie Finance Corp Ltd v Australian Securities Commission (1993) 11 ACSR 157. See also Re Keneally [2015] NSWSC 937 (which discusses the role of s 1322 for meetings called on invalid notice); Re Jervois Mining Ltd (2016) 117 ACSR 205; [2016] NSWSC 1650 (which discusses the role of s 1322 when the two-month period for removing directors under s 203D is not complied with).

A discussion on the range of remedies members have, in respect of illegal or unfair actions by the directors or majority shareholders, is considered in Chapter 19.

3. 4.

6. 7. 8. 9.

10.

[page 383]

Revision Questions

What is the distinction between management and membership of a company? How are their roles and powers different? Why should members have rights in respect of inspection of documents? What limitations are imposed on information gained from inspecting the Register of Members? How does a person become a member of a corporation? What is the difference between a membership right and a members’ remedy? Can you give two examples of each? What limitations are imposed on the members’ power to call an extraordinary meeting? What is a proxy and how does it work? What are the requirements for a valid meeting? How are votes conducted at a members’ meeting? Can the holder of a proxy vote choose not to vote the share in accordance with the direction given by the shareholder? Can company members convene a meeting for the purpose of advising directors as to the management of the company?

Problem Question Alex is a member of Acme Ltd, a public company listed on the ASX. Acme Ltd’s constitution provides that each ordinary shareholder is to be given a copy of all proposed resolutions (both ordinary and special) at an upcoming members’ meeting in the notice of meeting. Alex and many other shareholders have been dissatisfied with Acme Ltd’s management for some time due to the company’s consistently poor performance and declining share price. Alex decides to actively campaign against the current board of directors, by contacting all of the company’s members and asking them to direct their

(a)

(b)

proxies to him at the next AGM so that he can vote out the current chairman of the board who appointed the company’s senior management team. Alex hopes that this will send a message to the remaining board and the senior management team that they need to improve their performance.

How could Alex contact all of the members of Acme Ltd? How might Acme Ltd be able to prevent Alex from contacting all of the company’s members?

Assume that Alex was unsuccessful in his attempt to obtain sufficient proxy votes to vote out the current chairman. However, Alex’s campaign has raised greater awareness within the company’s membership about the failings of the current chairman and a large number of proxies are assigned to the chairman to vote against a motion to increase the directors’ remuneration at the next AGM. Acme Ltd’s chairman is also the chair of the AGM and ‘inadvertently’ misplaces the proxy votes voting against the directors’ remuneration increase.

What possible consequences may result from the failure to properly vote the proxies?

[page 384]

Guidelines for Answering Problem Questions

When answering a problem question concerning membership rights, we suggest that the following method may be helpful:

Determine whether the person involved in the question is, in law, a member of the corporation. Do they meet the s 231 requirement? If not, then the question may be concerned with the rights of persons who have purchased shares but have not had their ownership recorded in the Register of Members. If the person is a member (and often the question will state this explicitly), then determine what the member wants to do. Do they want information? Do they want to contact other members? Do they want to vote? The answer to these questions should guide you to the relevant part of this chapter (that is, registers or meetings). Alternatively, perhaps something is happening to the entitlement of the member (that is, their rights to information, to attend

meetings, or to vote at meetings) may be adversely affected. In this case, you should consider the application of members’ remedies such as s 232 (oppression — dealt with in Chapter 19), or s 1324 injunctions. Often the issue of membership rights will be raised in relation to defective meetings. If there appears to be a defect in a meeting (either through invalid notice or by improper conduct at the meeting), then you should consider using s 1322 to cure any procedural defect. It is important to remember that membership rights are often raised in questions about other areas of corporate law, such as directors’ duties or members’ remedies.

Wang and Erin decide that they will take on another director to run a new pop-up store business that will operate pop-up cafes in major shopping malls. Wang wants help in managing the expansion plans. It is decided that a new director (John) who is an expert in beverage businesses will be appointed to the board. John is also issued with 50,000 options that will vest if certain performance targets are met within two years of his appointment as joint-CEO of the new SC Pop Up Pty Ltd (Pop Up). Both Wang and Erin are also directors of Pop Up. The company’s constitution provides that the minimum quorum for a directors’ meeting is two.

Late one evening, Wang and John have a discussion over dinner at a restaurant in Chinatown, and after a few drinks they decide that Pop Up should set up a franchise business model given the growing reputation of the Sydney Café brand. Wang had sent Erin a text message just before the meeting to advise that they were going to discuss a major potential opportunity and asked whether she wanted to join them, but she said no because it was late at night.

The next morning John instructs the company’s solicitors to draw up a franchise agreement. No further discussion with Erin takes place as John believes that he and Wang have made a valid decision as the company over dinner. When Erin finds out she is angry and gives the opposite instructions to the company’s solicitors. The solicitors say they can’t act unless they receive a board resolution. John then circulates an email to Erin and Wang with a resolution to press ahead with the franchise proposal and asks them to sign and return to him.

How would you characterise the conduct of Wang, John and Erin according to the requirements of the Corporations Act? Could s 1322 be used to address any issues?

[page 385]

Further Reading

Academic Journals E Boros, ‘Virtual Shareholder Meetings: Who Decides How Companies

Make Decisions?’ (2004) 28 Melbourne University Law Review 265.

E Chapple and T Hubner, ‘The “Two Strikes” Rule on the Remuneration Report: Threats and Opportunities for Boards’ (2013) 28 Australian Journal of Corporate Law 166.

H Chia and I Ramsay, ‘An Analysis of Shareholder Resolutions Involving Australian Listed Companies from 2004 to 2013’ (2016) 34 Company and Securities Law journal 618.

P Darvas, ‘Section 249D and the “Activist” Shareholder: Court Jester or Conscience of the Corporation’ (2002) 21 Company and Securities Law Journal 248.

D DeMott, ‘Shareholder Nominations of Directors’ (2004) 78 Australian Law Journal 311.

J Harris, ‘Barbarians at the Gate? Activist Investors and s 249N of the Corporations Act 2001 (Cth)’ (2016) 34 Company and Securities Law journal 151.

B Jacobsen and H Pender, ‘The Controversy Continues: The Case for Regulatory Reform on Members’ Resolutions in Australia’ (2016) 34 Company and Securities Law journal 292.

R Levy, ‘Aspects of the Law Relating to Contested Elections of Directors’ (2015) 33 Company and Securities Law journal 404.

I Omotayo, ‘A Critique of the Theories Underpinning Proxy Solicitation by the Board of Directors’ [2001] Journal of Business Law 377.

N Pathak and H Lauritsen, ‘A Shareholder’s Right to Call General Meetings: A Sharp Sword for the Disgruntled Shareholder or Just a Blunt Instrument?’ (2005) 23 Company and Securities Law Journal 283.

1. 2. 3. 4. 5.

R Simmons, ‘Why Must We Meet? Thinking about Why Shareholder Meetings Are Required’ (2001) 19 Company and Securities Law Journal 506.

G Stapleton, ‘Reconceptualising the Nature of Modern Shareholding (and Making Voting Easier)’ (2000) 18 Company and Securities Law Journal 395.

R Zakrewski, ‘The Law Relating to the Single Director and Single Shareholder Companies’ (1999) 17 Company and Securities Law Journal 156.

Practitioner Journals M Camilleri and C Dunne, ‘Raising “General Business” at General

Meetings — What Can You Discuss?’ (2006) 3 Corporate Practice 57.

Practitioner Works H A J Ford, R P Austin and I Ramsay, Ford’s Principles of Corporations

Law, LexisNexis, Australia (looseleaf and online), Pt 4, Chs 12–16.

A Lang, Horsley’s Meetings, 7th ed, LexisNexis Butterworths, Australia, 2015.

You will find useful study resources, including quizzes for each chapter, when you go to <http://learning.lexisnexis.com.au>. The quiz is a great tool to help you self-test your knowledge.

See <http://www.asx.com.au>. See <http://www.asx.com.au/services/settlement/austraclear.htm>. See <http://www.imf.com.au>. For more information concerning the ASX Listing Rules, see <http://www.asx.com.au>. The most recent ASX Share Ownership Survey (2014) states that over approximately 36% of the Australian adult population own shares.

http://www.asx.com.au/services/settlement/austraclear.htm

http://www.imf.com.au

http://www.ethics.org.au/on-ethics/blog/june-2016/corporate-culture-duties-directors

[page 387]

Corporate Governance

CHAPTER 13 Defining corporate governance Legal regulation of corporate governance

Directors’ and officers’ duties Members’ rights Members’ remedies Internal corporate organs Internal management rules Market disclosure rules Safeguarding the integrity of financial information Summary Compliance and due diligence issues

Non-legal regulation: ASX Listing Rules ASX Corporate Governance Principles and Recommendations

Board structure Scope of the debate Legal and non-legal regulation of board size Board composition

Summary

[page 388]

Corporate Governance

Learning Objectives After completing this chapter you should be able to:

Discuss the meaning of corporate governance and the role of law in the corporate governance debate.

Explain the monitoring role that directors perform within corporations.

Discuss the importance of independent non-executive directors within the framework of corporate governance.

Outline the gatekeeper functions of auditors and professional advisers.

Key Sections

Corporations Act 2001 (Cth) ss 180, 181, 182, 183, 184, 191, 198A, 588G; Ch 2E (related party transactions); Pt 2M.4 Div 3 (auditor independence)

Key References

ASX Corporate Governance Principles, 2014, 3rd edition

[page 389]

Introduction

Corporate governance has been a widely discussed issue, especially over the past decade. In particular, the public and the government’s attention have been focused on the failure to implement sound corporate governance practices. Although corporate governance is an old concept, it became widely discussed after the financial collapses in the late 1980s and then again in the late 1990s and the more recent global financial crisis (GFC). A fundamental question is: Why do large public companies fail? How does a central pillar of the business community like an insurance company, in whom the public policy holders trust to protect them in times of serious financial need, collapse. In 2001, Australia’s second biggest insurance company, HIH Insurance Ltd, entered insolvent administration. This collapse caused over $5 billion of damage to both individuals and businesses that relied upon their insurance policies with HIH for protection against financial ruin. The HIH collapse raised questions about the ‘quality’ of the company’s corporate governance systems, and this debate caused a critical eye to be reflected upon our corporate laws in general. Although the questions were asked of publicly listed companies, they also apply to the not-for-profit sector and the public sector — governance is a key concept of management.

After HIH collapsed, numerous stories about the extravagant lifestyle of the company’s directors were discussed in the media. For example, Raymond Williams, the company’s managing director, reportedly used company funds to give his secretaries lavish gifts that included expensive gold watches. There was public outrage that the management of such a large company could have squandered millions of dollars of shareholder funds. The Commonwealth Government established a royal commission to investigate the causes of the company’s collapse. HIH is an interesting case study not only because it involved so many breaches of the law (directors’ duties, related party transactions and misleading financial markets) but also because it demonstrates the possibility of systemic failures in corporate governance. HIH did not collapse because of one self-interested transaction. Its failure represents a consistent deficiency in internal management controls and procedures and, to a

large extent, the inadequacies of external controls such as auditors, regulators and professional advisers.

Furthermore, it should not be thought that HIH was unusual or extraordinary. Certainly, the size of the collapse, was the largest that Australia had seen, although the collapse of Enron and Worldcom in the United States were much larger in terms of the scale of insolvency. The GFC has seen many large financial institutions collapse or require government assistance to continue trading. Fortunately, Australian companies have fared relatively well during the GFC, with no major banks requiring a government bailout or declaring bankruptcy as has occurred in the United States, United Kingdom and Europe. The fallout has caused a review of corporate governance standards and practices around the world to be re-examined

However, a number of highly leveraged businesses that depended on excessive amounts of debt have collapsed, including Babcock & Brown, Allco Finance Group and ABC Learning. These collapses have raised important corporate governance issues of adequate transparency and disclosure and managing conflicts of interest. Corporate corruption and bribery, particularly for companies involved in overseas dealings, has also been a hot political and business topic with major public companies such as Leighton Holdings (now known as CIMIC), Rolls Royce,1

[page 390]

the Australian Wheat Board (AWB Ltd)2 as well as a former subsidiary of the Reserve Bank of Australia,3 which have all been involved in bribery scandals involving foreign officials. The reputational damage caused by the behaviour of senior executives and their companies has also had huge impacts on the resilience of the economy and investor confidence in the securities markets.

In any age, some corporations, even very large corporations, will fail. The law cannot completely eradicate greed, foolishness or bad management. The VW emissions scandal resulted in a pay-out estimated to be in excess of $25 billion in damages, fines and compensation, with class actions launched in Australia. The Wells Fargo bank scandal in the United States, where bank employees were encouraged to open fake bank accounts and engage in fraudulent practices,

13.1

resulted in a $185 million dollar fine. The Commonwealth Bank of Australia (CBA), currently the largest entity on the ASX, is under investigation for facilitating money-laundering and other criminal activities, over its failure to adequately monitor cash deposits into its automated teller machines (ATMs). This has hurt CBA’s share price and its executives’ bonuses have been removed, even before the case has been heard in court. A class action by investors has been launched due to the bank’s failure to disclose this bad news on time to the market.

This raises a key question. What role does ‘good’ or ‘bad’ corporate governance play in ‘protecting’ the public from corporate collapses and scandals? Furthermore, what role can the law play in ensuring sound corporate governance? This chapter provides an overview of the regulatory and policy perspectives of corporate governance. There is strong evidence that good corporate governance does provide sustainability for corporations.

Defining corporate governance

It has been observed that a decade ago, the term ‘corporate governance’ was barely heard but today, like climate change and electric cars, corporate governance is a staple of everyday business language. What then does corporate governance mean?

Corporate governance is an amorphous concept that is impossible to define in a universal manner. One of the most commonly cited definitions is that given in the Cadbury Report (1992), which described corporate governance as ‘the system by which companies are directed and controlled … boards of directors are responsible for the governance of their companies’.4 The Cadbury Report arose from the financial collapses in the late 1990s in the UK and the impact on the reputation of investors in global markets. Many common law jurisdictions established similar reviews of

[page 391]

13.2

corporate governance — in Australia, it was known as the Bosch Report and in South Africa, the King Report.

In his final report on the collapse of HIH (referred to above), Royal Commissioner, Owen J, stated:5

Corporate governance — as properly understood — describes the framework of rules, relationships, systems and processes within and by which authority is exercised and controlled in corporations. Understood in this way, the expression ‘corporate governance’ embraces not only the models or systems themselves but also the practices by which that exercise and control of authority is in fact effected.

This description has been adopted by the ASX Corporate Governance Council, which then expanded on this to say ‘corporate governance influences how the objectives of the company are set and achieved, how risk is monitored and assessed, and how performance is optimised’.6

These broad notions of corporate stewardship may be contrasted with the narrower concept discussed in the financial economics literature. In a well-known article, Shleifer and Vishny stated, ‘corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment’.7

It is important, therefore, to understand that any definition of corporate governance, and hence any discussion about the structure and purpose of corporate governance rules and practices, takes place according to a particular discipline-based perspective concerning what corporate governance means. Corporate governance, as an area of practice and research, reaches across finance, accounting, management and strategy. For some disciplines, corporate governance is defined broadly, while others define it narrowly. This chapter focuses on the legal regulation of corporate governance.

Legal regulation of corporate governance

A range of legal rules exists that make up the broad framework of corporate governance. All of these rules are the subject of substantive examination in other chapters of this book. The purpose of this discussion is simply to draw them together to mark out the scope of

•

13.3

• • •

corporate governance laws.

It should be noted at the outset that corporate governance is regulated by a combination of:

hard law (for example, found in the content of the Corporations Act 2001 (Cth) impacting on directors’ duties and liabilities identified below and discussed further in Chapter 14–18); soft law (for example, found in sources of corporate governance standards that companies may voluntary chose to adopt, such as Codes of Conduct); and

[page 392]

hybrid law (arises when there is ‘enforced self-regulation’, for example, the disciplinary action taken by the ASX in the removal of a listed company due to that company’s non-compliance with the ASX Listing Rules, including the ASX Corporate Governance Principles).

Directors’ and officers’ duties The most obvious examples of corporate governance laws are the duties and obligations imposed on company directors and officers by the Corporations Act (ss 180–184, 588G) and by the general law. These duties include the duty to:

act with care and diligence; act in good faith in the best interest of the corporation; and not allow the company to continue incurring debts when it is insolvent.

In addition, the Act imposes limitations on directors and officers receiving collateral benefits from the company, or conferring such benefits on ‘related parties’: see Ch 2E.

The Corporations Act does not prescribe how companies (public or private) construct their boards of directors aside from minimum numbers (noted earlier in Chapter 3). Despite the lack of detailed provisions in the

13.4

13.5

Act, the courts have seen fit to require directors to independently monitor management as part of their duties of care and diligence. One of the key cases on this issue is the AWA litigation, which is discussed at length in Chapter 17. The New South Wales Court of Appeal in AWA (Daniels v Anderson (1995) 37 NSWLR 438) stated that directors must become familiar with the business of the company and how it is run and must ensure that the board is able to effectively audit the management of the company so that it can satisfy itself that the company is being properly run. In addition, independent non-executive directors have been actively pursued by ASIC for insolvent trading under s 588G: see Chapter 18. These developments in case law (that is, at general law) demonstrate that the law imposes strict requirements on all directors (executive and non- executive) to continuously monitor the running of the company. The role of directors and officers and the different types of directors is discussed in detail in Chapter 14.

These various directors’ and officers’ duties are enforceable by the company and/ or ASIC and are the subject of extensive discussion in Chapters 15-18. Enforcement action may result in extensive penalties and remedies, such as pecuniary penalties and disqualification orders against directors and officers — as illustrated in ASIC v Vizard (2005) 23 ACLC 309; [2005] FCA 1037 (discussed in Chapters 2 and 16) and in Gillfillan v ASIC (2012) 92 ACSR 460; [2012] NSWCA 370 (James Hardie case, discussed in Chapter 17).

Members’ rights Members of the company have the right to attend and vote at members’ meetings (such as the annual general meeting held by a public company). Members also have the right to receive information about the company, such as copies of the company’s annual report and notifications of upcoming members’ meetings: see Chapter 12.

Members’ remedies It is important to note that shareholders (as members of the company) do not generally control the management of the company’s affairs: s 198A. Shareholders do, however, have

13.6

13.7

[page 393]

extensive remedies under the Act, including the right to enforce compliance with the Act where directors are acting against the interests of the shareholders: see Chapter 19. For example, members may bring an action against the company where it has managed in a manner that is oppressive, unfairly prejudicial or unfairly discriminatory against their interests: s 232.

In addition, members may seek court approval to bring a statutory derivative action in the company’s name: ss 236 and 237. This may be used to enforce the company’s rights against the directors for breach of their duties. See Chapter 19 for a detailed legal treatment on the remedies of members. In recent years investor class actions have had an important role in addressing perceived corporate governance failings, particularly relating to failures to disclose accurate information in a timely manner.8

Internal corporate organs Another legal corporate governance mechanism is the requirement that certain decisions, such as the decision to wind up the company voluntarily, or the approval of a capital restructure, is to be made by the members in a general meeting (usually by a special resolution). As noted in previous chapters, there are various organs of decision-making authority within corporations. This system of dividing authority (albeit for a small number of matters) between the members and the directors is another method of regulating the conflicts between stakeholders (in this case members and the company’s management). Thus, the shareholders (in their formal capacity as members of the company) can convene a meeting to remove a director or the whole board with a simple majority (more than 50%). In reality, most shareholders would prefer to sell their shares or agree to being bought out, rather than going through the costs and public disclosure involved in litigation.

Internal management rules In addition to individual rights conferred on members (such as voting

13.8

rights and information rights) to provide a monitoring mechanism against corporate management, s 140 of the Corporations Act provides that the company’s internal rules (whether made up of a constitution, the replaceable rules or a combination of the two) operate a statutory contract between the company and the members (among others). This statutory contract forms part of the corporate governance legal framework that constrains the exercise of corporate managerial power. Section 198A (which is a replaceable rule, but most companies have a clause that is similar) delegates the management of the company to the board of directors.

Market disclosure rules Apart from rules that are enforceable by members of the company (or ASIC), there are also a diverse range of legal rules that centre on the timely disclosure of accurate information about the company (particularly public companies) to the market. For example, listed companies are bound by continuous disclosure laws: s 674. There has been a growing number of cases where directors and officers have been disciplined by the courts for failure to take their obligations seriously to ensure that the market is not misled by the failure to provide material information in a timely

[page 394]

manner: for example, see discussion in Chapter 20 on ASIC v Sino Australia Oil and Gas Ltd (in liq) (2016) 118 ACSR 43; [2016] FCA 1488; ASIC v Hellicar (2012) 88 ACSR 246; [2012] HCA 17; Shafron v ASIC (2012) 88 ACSR 126; [2012] HCA 18; and ASIC v Citrofresh International Ltd (No 2) (2010) 77 ACSR 69; [2010] FCA 27.

Public companies (even if unlisted) are bound by public fundraising rules to provide minimum levels of disclosure when raising new equity capital: Ch 6D of the Act (see further Chapter 9). Directors are also bound by law to disclose potential conflicts of interest under s 191.

Safeguarding the integrity of financial information

13.9

13.10

13.11

Safeguarding the integrity of financial information The Corporations Act provides extensive requirements relating to the auditing and disclosure of company financial information: see Ch 2M. One corporate governance issue that has been raised after the collapse of companies, such as HIH Ltd and Enron, has been the extent to which auditors operate under a conflict of interest by providing other non-audit services to companies and having employees of auditing firms take up senior positions with audited companies. Since 2004, Pt 2M.4 of the Act has imposed strict independence requirements on external auditors, including requirements to make a declaration of independence, requiring auditor rotation and putting limitations on ex-auditors working for audit clients. These issues are discussed in Chapter 20.

Summary The discussion above provides a brief overview of the range of legal rules of corporate governance that arise under general law and also under the Corporations Act. Some of these rules set fixed prohibitions (such as the duty not to improperly use a position as a director in s 182), while others set broad standards (such as the requirement to disclose material information to the market under s 674).

However, law is only one disciplinary method of analysing corporate governance issues. It should not be thought that only the law covers the field of corporate governance regulation. Indeed, there are various non- legal forms of regulating corporate governance, to which attention is now turned.

Compliance and due diligence issues One issue that is often misunderstood by business people is the appropriate role of legal compliance and due diligence. As noted above, the law establishes a range of rules in the form of legislation and case law. Directors and company officers are judged by regulators and ultimately the courts according to whether they have ‘complied’ with the rules. In order to demonstrate this, companies should have compliance systems in place as part of their risk management procedures to minimise the chance that the company (and its directors and officers) will fail to meet

the standard required by the law. Companies should ensure that their due diligence program is adequately maintained by regular reviews to ensure that it remains effective.

However, establishing a due diligence process does not, of itself, demonstrate compliance with the law. Moreover, having in place a compliance system will not, of itself, prevent a breach of the law from occurring. Using due diligence and compliance systems may, however, be relevant when a court has to determine what level of civil

[page 395]

penalty should be imposed.9 Compliance and due diligence systems are important parts, though not sufficient in themselves, in meeting the legal requirements of corporate governance rules. The corporate regulators have been discussing the role of ‘corporate culture’ for the last few years, but this is a difficult area to actually identify such culture and pass laws in its regard. In determining penalties, the court often takes into account evidence of a culture of compliance.

As discussed earlier, a company is a separate legal entity in the eyes of the law, due to the decision in Salomon v Salomon & Co Ltd and s 124. As such, companies can be perceived as being ‘corporate citizens’ with responsibilities to be good corporate citizens, based upon their reputations. The power of social media (instantaneous communication through websites and applications like Twitter, Facebook, LinkedIn, Instagram, Snapchat and so on) enables a corporation’s reputation to be hurt very quickly and for decisions to be changed by large corporations. For example, the musician Taylor Swift refused to have her music available for download on the Apple Music platform because the world’s largest company did not want to pay artists for three months (the free trial period of the Apple Music service). Within a weekend, Apple corporation, under pressure from millions of fans, changed its mind and agreed to pay the relevant artists for their music.

13.12

Seven Network (Operations) Ltd v Harrison [2017] NSWSC 952 Supreme Court of New South Wales

How can a simple contract case, in respect of confidentiality of a settlement agreement, generate so much media attention? Seven Network (Operations) Ltd v Harrison has many different aspects, but illustrates the power of social media in modern litigation, handling of internal complaints and investigations and the impact on a company’s reputation and share price. The facts of the case relate to an executive assistant (EA) who used her corporate credit card without proper authorisation (she made personal purchases for goods and services etc), as well as authorised purchases. Once discovered, the EA was transferred to a different area of the company, while external auditors commenced a review of all corporate credit card holders’ accounts. The alleged breaches were shown to be much bigger than first thought, but the EA then disclosed that she had engaged in a personal relationship with the company’s CEO (although she did not work directly for the CEO). A confidential settlement was agreed, including payments for finishing employment and non-reimbursement of the credit card funds, in return for company equipment (mobile phone and other records), as well as confidentiality over all facts. In December 2016, Ms Harrison decided to disclose the personal affair and other issues via Twitter and contacted a number of journalists to publish her accusations. Channel Seven applied in February 2017 for an interim injunction (referred to by the general media as a ‘gagging order’) to stop a breach of the confidentiality agreement. A number of claims and counter- claims were made and three serious attempts at mediation were commenced.

Although Channel 7 brought the case in the NSW Supreme Court, a counter-action by the former employee, under Fair Work Australia legislation, was commenced in the Federal Court of Australia in Melbourne. Ms Harrison then removed her lawyers and acted as a self-representing defendant. Justice Sackar of the Supreme Court of NSW, handed down a judgment which focused on the equitable relief of an injunction, and supported the original covenant (confidentiality agreement) between the parties. Significantly, he noted that all parties had been injured by the claims in the case and ordered that the plaintiff’s costs

[page 396]

(which are estimated to be between $250,000 to $500,000) should be paid by Ms Harrison, who has said she may become bankrupt. The case, from the media perspective, sounds like a David and Goliath battle. In reality, the case deals with reputational damage, and questions about how companies manage internal disputes and how the lines between public and private affairs can become blurred. This raises the questions of what Seven could have done better to minimise this dispute entering the public domain, and what responsibility should be put onto senior management and the board for allowing the dispute to be.

Non-legal regulation: ASX Listing Rules

This section is referred to as ‘non-legal regulation’ in order to highlight the difference between legal rules contained in the Corporations Act and

general law principles with rules and standards that are not enforceable by legal processes (for example, court action).10

There are a broad range of non-legal rules and standards that influence and regulate (to varying degrees) the practice of corporate governance. In this section, the focus is on the securities exchange, which is regulated under the financial services provisions in Ch 7 of the Corporations Act: see Chapter 21. However, our focus is not on the regulation of the market as such, but rather on its substantial impact on corporate governance as an example of a non-legal rule. In this regard it may be said that capital market rules act as a quasi-legal method of regulation. It should also be noted that the focus is on the management of public companies (rather than Pty Ltd companies), and particularly public companies that are listed on a licensed financial market (such as the Australian Securities Exchange). In pure numbers, these companies represent only a small proportion of all companies: 2216 listed entities compared with over 2.2 million registered companies.11 However, these companies represent a much greater proportion of the value of all registered companies. Furthermore, the investment of the public’s funds, rather than merely the funds of the entrepreneur operating the business, makes corporate governance standards in public companies an important issue. If a public company fails because of poor corporate governance, its impact may be felt far and wide.

Securities exchanges have been part of Australia’s corporate landscape since the 1840s. The Australian Stock Exchange Ltd (now known as the Australian Securities Exchange or ASX Ltd) was formed in 1987 after an amalgamation of the separate stock based stock exchanges.12 The ASX provides an important mechanism for the non-legal regulation of publicly listed companies.13 For entities that are traded on the ASX official list (which includes indices such as the ASX 200 and the All Ordinaries) there are obligations in contract law to comply with the market’s internal rules (called the ASX Listing Rules (LR)). The ASX LR may be enforced by court order under s 793C of the Corporations Act.

[page 397]

•

13.13

The ASX LR provide a range of corporate governance mechanisms for companies listed on the exchange. These mechanisms include:

periodic and continuous disclosure requirements (ASX LR 3 and LR 4); limitations imposed on making structural changes to the company (ASX LR 7 and LR 11); and minimum capital liquidity requirements (ASX LR 12).

In recent times the ASX have taken action to further reassure market confidence by creating the Corporate Governance Council. Members of the council include industry associations (such as the Australian Institute of Company Directors and Governance Institute of Australia), as well as investor and funds management representatives (such as the Australian Shareholders’ Association).

A key feature of the ASX Corporate Governance Principles and Recommendations (discussed below) is the ‘if not, why not’ approach to enforcement. This means that listed companies are not required to comply with the principles but, if they do not comply, there is an obligation to explain their actions in their annual reports to the ASX under LR 4.10. This approach demonstrates the quasi-legal nature of regulation-listed companies cannot be sanctioned for failing to comply the ASX recommendations and principles (discussed below) that are not mandatory, but are legally required to meet the reporting requirements of the ASX LR.

According to the ASX, effective ‘if not, why not’ reporting practices involve:14

identifying and explaining the Recommendations the company has not followed; and explaining how its practices accord with the ‘spirit’ of the relevant Principle.

ASX Corporate Governance Principles and Recommendations The discussion below briefly charts the development of the current ASX corporate governance principles and, more significantly, provides an overview of each principle which, as noted by the ASX, is of equal

•

• •

•

importance.

The ASX Corporate Governance Council was formed in 2002 to develop a principles-based corporate governance framework in order to serve as a practical guide for listed companies. The Council had a broad stakeholder group, across many professional bodies, to represent the interests of all relevant players. In 2003, the council released the ASX Principles of Good Corporate Governance and Best Practice Recommendations which contained 10 principles designed to promote high quality corporate governance practices. However, in recognition of the evolving nature of corporate governance and the need to respond to the changing circumstances of a company, the ASX undertook a review of the first edition and substantially restructured its contents. The second edition was released in 2007 and the guidelines were renamed as the ASX Corporate Governance Principles and Recommendations to reflect the reality that there is no single model of good corporate governance. The 2007 document was amended further in June 2010 to reflect the need for board diversity and the third edition was released in 2014.

The eight principles and accompanying recommendations are as follows:

[page 398]

Table 13.1 ASX Corporate Governance Principles and Recommendations (2014, 3rd ed)

Principle 1 Lay solid foundation for management and oversight

Recommendation 1.1 Respect the roles and responsibilities of the board and management

Recommendation 1.2 Undertake checks before appointing a person

Recommendation 1.3 Written agreement with each director and senior executive

Recommendation 1.4 Company secretary accountable to board via chair

Recommendation 1.5 Diversity policy for the board and committees, with measures

Recommendation 1.6 Disclose a process of board evaluation

Recommendation 1.7 Disclose a process of evaluating the senior executives Principle 2 Structure the board to add value

Recommendation 2.1 A structured nomination committee

Recommendation 2.2 Disclose a skills matrix for the board currently and future

•

• •

•

• •

•

Recommendation 2.3 Name the independent directors on the board

Recommendation 2.4 Majority of the board should be independent

Recommendation 2.5 The chair should be independent

Recommendation 2.6 Inducting new directors and professional development Principle 3 Act ethically and responsibly

Recommendation 3.1 A code of conduct for all directors, executives and employees Principle 4 Safeguard integrity in corporate reporting

Recommendation 4.1 An audit committee with a charter and independent chair

Recommendation 4.2 CEO/CFO provide declaration before financial statements approved

Recommendation 4.3 At AGM the external auditors must be present to answer questions Principle 5 Make timely and balanced disclosure

Recommendation 5.1 Clear written policy on continuous disclosure under listing rules Principle 6 Respect the rights of security holders

Recommendation 6.1 Provide information about itself and governance to investors

Recommendation 6.2 Design and implement investor relations program for communications

Recommendation 6.3 Full disclosure of policies and processes for meetings of investors

Recommendation 6.4 Investors should have options to receive electronic communications

[page 399]

Principle 7 Recognise and manage risk

Recommendation 7.1 Risk committee should be established

Recommendation 7.2 Review and report risk management framework annually

Recommendation 7.3 Clear internal audit function and how it works

Recommendation 7.4 Disclose material exposure to economics, environmental and social sustainability risks and how they are managed

Principle 8 Remunerate fairly and responsibly

Recommendation 8.1 A remuneration committee established with independent directors

Recommendation 8.2 Full disclosure of remuneration policies and practices

Recommendation 8.3 If equity based remuneration, fully disclose policy for transactions to be permitted that limit economic risks.

As can be seen above, each of these eight core principles of corporate governance is explained by reference to recommendations regarding how to implement the principles. There is a stronger emphasis on disclosure, such as the provisions relating to gender and other board diversity requirements of ASX listed companies. This balances companies from

•

13.14

13.15

being forced into having a higher level of female directors by way of quotas or targets, but fully disclosing the information to the market, so that investors and organisations like BlackRock, can analyse the corporations status.15

Should corporate governance rules be contained in prescriptive laws? Are market codes of conduct more effective and efficient than detailed legal rules in promoting good corporate governance?

Board structure

Having provided an overview of the range of legal and non-legal regulatory tools of corporate governance, we will now examine a ‘key issue’ in corporate governance, which continues to generate extensive debate and calls for regulatory reform (both legal and non-legal). The purpose of this discussion is not to engage in a detailed examination of all aspects of board structuring but rather to highlight important practical issues that give rise to legal and non-legal problems within the broad spectrum of the corporate governance debate. An additional consideration is that each country is influenced by its legal system and history. Thus European companies have a two-tiered board system, whereas common law countries tend to have a unitary board.

Scope of the debate The debate concerning the make-up of the board of directors involves two elements:

How many directors should a board have? How many directors are too many or too few to govern the corporation effectively?

[page 400]

13.16

Who should be appointed to the board of directors, in particular how many independent non-executive directors should be appointed and how diverse in gender should the board composition be?

The ASX has addressed the issue of board diversity by placing an additional requirement on boards to address changes in the structure of boards: ASX Corporate Governance Principles and Recommendations 3.2 (reproduced above) require boards to establish and disclose a policy concerning gender diversity with measurable objectives for achieving gender diversity.

The first issue is largely an empirical question about how companies, and how types of companies, work effectively. There has been considerable debate in non-legal disciplines about how large a board of directors should be.16 It is clear that there is no simple, one-size fits all model.

Between 2005–07, the UTS Centre for Corporate Governance, with the law firm Dibbs Abbott Stillman, conducted an Australian Research Council funded project to examine the impact of corporate governance principles in practice.17 This empirical legal research examined 67 companies across the ASX listings and provided valuable data by questionnaire and interviews with senior corporate officers. The findings18 showed that there is no optimum size, but in a larger entity a maximum of 12 directors was common. There had been a substantial growth in the use of subcommittees of the board, including the Risk Committee, Audit Committee (now mandatory) and Remuneration and/or Appointments Committee.

Legal and non-legal regulation of board size Neither the Corporations Act nor the ASX Listing Rules impose limits on the size of corporate boards. The Act does provide that public companies must have at least three directors, with at least two directors ordinarily living in Australia: s 201A(2). In their 2010 Board Study (the latest available), the Korn Ferry Institute observed the trend towards a movement away from large boards to a more manageable size of between six and nine directors.19 In the ASX top 50 companies, 48% of such companies now have been eight and nine directors, up from 36% in 2009.20 A more recent study by the Australian Institute of Company

13.17

Directors (AICD) based on information up to 2011 found that ASX top 50 had an average board size of nine, while the ASX top 20 had an average board size of 9.84 directors.21

[page 401]

Board composition A more difficult question than the size of the board of directors is the issue of how that board should be structured. Particularly, there is much debate about whether the board of directors should be made up of a majority of independent non-executive directors (NEDs).22 The UK Corporate Governance Code (June 2010) identified the following principles with regards to the role of non-executive directors:

… [they] should scrutinise the performance of management in meeting agreed goals and objectives and monitor the reporting of performance. They should satisfy themselves on the integrity of financial reporting and that financial controls and systems of risk management are robust and defensible. They are responsible for determining appropriate levels of remuneration of executive directors and have a prime role in appointing and, where necessary, removing executive directors, and in succession planning.23

A study by the Australian Council of Superannuation Investors (ACSI) in 2015 showed that the proportion of non-executive to executive directors in the ASX101–200 companies hit a record 83.4% in 2015. This percentage was up from 82.2% in 2014, and 80.8% in 2013. In the ASX100, the proportion of NEDs averaged 85% in 2015. These figures show the continued prevalence of non–executive directors serving on the boards of Australia’s ASX top 200 companies. Almost 79% of the NEDs in the ASX101–200 companies are independent.24

The theory behind the push for more independent directors on corporate boards is that they will provide an effective monitoring device on executive management.25 However, there have also been concerns raised that independent non-executive directors are only working part-time on that board, and will have other commitments that may limit their capacity to monitor management. Furthermore, the flow of information within the corporation will come via executive management. Therefore, independent directors are at a substantial informational and capacity disadvantage compared with executive managers.

Studies have found that boards with a majority of independent non- executive directors on average do not necessarily lead to improvements in financial performance compared with companies that have differently structured boards.26 Other studies have found that boards with large proportions of independent non-executive directors provide greater voluntary disclosure,27 and promote lower levels of earnings management and accounting fraud.28

[page 402]

There are often many factors which can impact on the profitability or value of a corporation independent of good corporate governance practices, but there is a strong evidence that good practices will provide benefits in the long-term via sustainability. The impressive data produced by Claessens and Yurtoglu in 2012 demonstrated the value on a global scale.29

The research conducted by the UTS Centre for Corporate Governance (discussed above) illustrated that the issue of implementing the right board structure was very dependent on the size of the company, its historical background and its shareholder base. There was a strong need to comply with the ASX Corporate Governance Principles and Recommendations, and risk management was critical. Many of the respondents that had detailed knowledge of the ASX principles wanted to demonstrate their compliance.

In the area of corporate social responsibility and gender diversity on the board, most respondents only wanted the best directors selected on merit and not imposed by government or regulation. The complexity of gender diversity alone has been articulated by numerous researchers and the issue of ‘glacial pace of change’ regularly occurs.30 Although the percentage of female directors across the ASX 200 has risen since 2009 when it stood at just 8.3%, however, the AICD’s Gender diversity report shows that at the end of August there were 25.4% female directors across the ASX 200 — only marginally above the 25.3% achieved by the end of 2016.31 As at August 2017, a total of 11 boards in the ASX 200 still do not have any women.

13.18

•

Summary The purpose of this chapter was to highlight an area where the legal and non-legal regulation of corporate governance overlap, and to demonstrate that ‘problems’ of ‘bad’ corporate governance are not resolved simply by increasing or decreasing legal regulation.32 These are complex issues that are best approached from a multi-disciplinary perspective. The law may be a blunt instrument in corporate governance regulation, but is a useful one.

Should corporate governance laws become more or less prescriptive? Is it useful to have a Corporations Act that is thousands of pages long? Does the size and complexity of corporate governance regulation limit compliance?

3. 4. 5.

9. 10.

•

[page 403]

Revision Questions

What are the difficulties in defining the term corporate governance? Identify three legal mechanisms that regulate corporate governance. What role do independent directors play in corporate governance? Why is executive remuneration a corporate governance issue? Identify three corporate governance gatekeepers and briefly outline their role in corporate governance regulation. What role does the ASX have in corporate governance in Australia? What are two types of legal sanctions used to regulate corporate governance practices? How are the perspectives on corporate governance from financial economics and the law different? What is ASIC’s role in corporate governance in Australia? Provide two examples of hard and soft corporate governance laws.

Sample Essay Question Students are unlikely to be given a problem-based question for corporate governance in a standard corporate law course. The detailed topics of directors’ duties and directors and officers (see Chapter 14–18.) contain sample problems that may also be relevant to corporate governance topics. Students are more likely to be given an essay or discussion question as assessment for a corporate governance topic.

The discussion points raised in this chapter are all examples of possible essay topics that could be set as an assignment. Common topics include:

corporate social responsibility;

• •

•

the role and value of independent directors; problems with executive remuneration (particularly disclosure and approval of remuneration plans); or board accountability and conflicts of interest.

Guidelines for Answering Essay Questions

When answering essay questions concerning corporate governance, we suggest the following method may be helpful:

Try to determine the scope of the question. Look for the instructional words, for example, discuss, compare and contrast, critically analyse. Each of these instructions will require a different approach. Students should check with their university or faculty learning centre to seek out resources about academic writing (if possible in business law). Once the scope of the question has been determined, plan out the structure of the essay. For a 2000-word essay that asks for your critical opinion, try to have at least three main points that you wish to raise in your essay. Which point should come first, second and third? One approach is to start at the most important (or persuasive) point and then work through less important points.

[page 404]

Identify the scope of research required — check the assessment criteria or marking guide. Do you need to look up articles, cases, books or government reports? Check the final chapter of this book for guidance on researching corporate law. Do a literature review to determine if anyone else has written on the same topic. You should not simply copy their approach! Academic articles (including web-based materials such as law firm newsletters) can be useful as a point of comparison with your

paper. Your course co-ordinator has designed a specific question and will usually penalise you if you simply copy material from other sources. Once you have identified the relevant points, start writing. Continually ask yourself whether there is another viewpoint you could take. Anticipate questions/doubts that the marker might have, and address those questions in your response. Do not shy away from negative points in your argument — respond to them. Give yourself at least two days away from the paper before you proofread it. Ideally, have someone else read it (such as a relative or flatmate) to make sure your argument is clear and persuasive.

It is important to remember that each course is different and has different requirements and expectations in their assessment. This is a general guide only.

Further Reading

Academic Journals The following references represent a small sample of the vast literature

published on the wide discipline of corporate governance, both locally and internationally:

M Adams, ‘Board Diversity: More Than a Gender Issue?’ (2015) 20(1) Deakin Law Review 279.

F de Zwart, ‘Enron and Hastie: What Can We Learn?’ (2014) 29 Australian Journal of Corporate Law 169.

J du Plessis, ‘The German Two-tier Board and the German Corporate Governance Code’ (2004) 15 European Business Law Review 1139.

J du Plessis, J O’Sullivan and R Renschler, ‘Multiple Layers of Gender Diversity on Corporate Boards: To Force or Not to Force?’ (2014) 19(5) Deakin Law Review 1.

N Dunbar, ‘The Role and Value of Independent Directors in Modern Australian Corporate Governance’ (2012) 30 Company and Securities Law Journal 312.

J Fallon and B Cooper, ‘Corporate Culture and Greed — The Case of the Australian Wheat Board’ (2015) 25 Australian Accounting Review 71.

G Gilligan, ‘Sarbanes Oxley and Convergence in Corporate Governance — Views from Australia’ (2011) 25 Australian Journal of Corporate Law 150.

A Hargovan, ‘Corporate Governance Lessons from James Hardie’ (2009) 33 Melbourne University Law Review 984.

A Keay, ‘Exploting the Rationale for Board Accountability in Corporate Governance’ (2014) 29 Australian Journal of Corporate Law 115.

A Klettner, T Clarke and M Adams, ‘Corporate Governance Reform: An Empirical Study of the Changing Roles and Responsibilities of Australian Boards and Directors’ (2010) 24 Australian Journal of Corporate Law 148.

V Nagarajan, ‘Regulating for Women on Corporate Boards: Polycentric Governance in Australia’ (2011) 39 Federal Law Review 255.

[page 405]

A Veljnovski, A Brooks and J Oliver, ‘Independent Directors and Australia’s Corporate Governance Model: A Survey of Independent Directors’ Views’ (2009) 24 Australian Journal of Corporate Law 33.

Practitioner Works R P Austin, H A J Ford and I Ramsay, Company Directors: Principles of

Law and Corporate Governance, LexisNexis Butterworths, Australia, 2005.

R Baxt, Duties and Responsibilities of Directors and Officers, 20th ed,

Australian Institute of Company Directors, 2012.

S Bloomfield, Theory and Practice of Corporate Governance: An Integrated Approach, Cambridge University Press, 2013.

H Brown and R Worthington, ‘Corporate Culture — Reflections from 2016 and Lessons Learnt’ (2017) 69 Governance Directions 100.

J du Plessis, A Hargovan, M Bagaric and J Harris, Principles of Contemporary Corporate Governance, 3rd ed, Cambridge University Press, 2014.

J Farrar and P Hanrahan, Corporate Governance, LexisNexis, 2016.

A Hargovan, ‘Failure to Make Adequate Enquiries: Civil Penalties for Former Chair of AWB Ltd’ (2017) 69 Governance Directions 307.

S Longstaff, Corporate Culture and the Duties of Directors, (2016) The Ethics Centre, <www.ethics.org.au/on-ethics/blog/june-2016/corporate- culture-duties-directors>.

R Nicolson, ‘The Rolls-Royce Bribery Case and Its Implications in Australia’ (2017) 69 Governance Directions 117.

R Sainty, ‘Engaging Boards of Directors at the Interface of Corporate Sustainability and Corporate Governance’ (2016) 68 Governance Directions 85.

E Sheedy, ‘Risk Governance and culture’ (2016) 68 Governance Directions 19.

B Tricker, Corporate Governance: Principles, Policies and Practices, Oxford University Press, 3rd ed, 2015.

Selected Reports

Australia

ASX Corporate Governance Council 2014, Corporate Governance Principles and Recommendations, 3rd ed.

ASX 2009, Analysis of Corporate Governance Disclosures in Annual Reports for Year Ended 31 December 2008, <http://www.asx.com.au>.

Australian Government Attorney-General’s Department, Proposed Amendments to the Foreign Bribery Offence in the Criminal Code Act 1995, Public Consultation Paper, April 2017.

Corporations and Markets Advisory Committee (CAMAC) (2011), Executive Remuneration Report, <http://www.camac.gov.au>.

Corporations and Markets Advisory Committee (CAMAC) (2010), Guidance for Directors Report, <http://www.camac.gov.au>.

F Hilmer, ‘Strictly Boardroom: Improving Governance to Enhance Company Performance’ (Hilmer Report), Melbourne, Business Library, 1993.

The Centre for Corporate Governance (UTS and the Australian Council of Superannuation Investors) 2010, Board Effectiveness & Performance — The State of Play on Board Evaluation in Corporate Australia and Abroad, Research Paper, October, pp 10–18, 22–32, <http://www.acsi.org.au/recent-news/call-for-companies-to-consider- effective-disclosure-beyond-process-on-board-evaluation.html>.

[page 406]

The HIH Royal Commission, The Failure of HIH Insurance, Commonwealth of Australia, 2003, <http://www.hihroyalcom.gov.au>.

Productivity Commission, Executive Remuneration in Australia, Report No 49, Final Inquiry Report, Melbourne, Commonwealth of Australia, December 2009, <http://www.pc.gov.au>.

United Kingdom

http://www.acsi.org.au/recent-news/call-for-companies-to-consider-effective-disclosure-beyond-process-on-board-evaluation.html

http://www.hihroyalcom.gov.au

http://www.pc.gov.au

Cadbury Committee, Committee on the Financial Aspects of Corporate Governance Report, 1992.

Committee on Corporate Governance, Final Report (Hampel Report), 1998.

Committee on Corporate Governance, Review of the Role and Effectiveness of Non-Executive Directors (Higgs Report), January 2003.

Financial Reporting Council, The UK Stewardship Code, September 2012 <https://www.frc.org.uk/Our-Work/Publications/Corporate- Governance/UK-Stewardship-Code-September-2012.pdf>.

Financial Reporting Council, The UK Corporate Governance Code (2016).

Financial Reporting Council, Corporate culture and the Role of the Boards — Report of Observations (2016).

The Parker Review Report, A Report on the Ethic Diversity of UK Boards: ‘Beyond One by 21’, (2016).

OECD OECD, Board Practices: Incentives and Governing Risks, 2011,

<http://www.oecd.org>.

OECD, Corporate Governance and the Financial Crisis, 2010, <http://www.oecd.org>.

OECD, Fighting the Crime of Foreign Bribery: The Anti-Bribery Convention and the OECD Working Group on Bribery, 2017.

OECD, OECD Foreign Bribery Report: An Analysis of the Crime of Bribery of Foreign Public Officials, OECD Publishing, 2014, Paris, <http://dx.doi.org/10.1787/9789264226616-en>.

OECD, Principles of Corporate Governance, September 2015, <http://www.oecd.org>. <http://www.oecd.org/daf/ca/principles- corporate-governance.htm>.

https://www.frc.org.uk/Our-Work/Publications/Corporate-Governance/UK-Stewardship-Code-September-2012.pdf

http://www.oecd.org

http://dx.doi.org/10.1787/9789264226616-en

http://www.oecd.org

http://www.oecd.org/daf/ca/principles-corporate-governance.htm

10.

11.

12.

13.

14.

You will find useful study resources, including quizzes for each chapter, when you go to <http://learning.lexisnexis.com.au>. The quiz is a great tool to help you self-test your knowledge.

See R Nicolson, ‘The Rolls-Royce Bribery Case and its Implications in Australia’ (2017) 69 Governance Directions 117. See ASIC v Flugge (2016) 119 ACSR 1; [2016] VSC 779; ASIC v Flugge (No 2) (2017) 119 ACSR 551; [2017] VSC 117; A Hargovan, ‘Failure to Make Adequate Enquiries: Civil Penalties for Former Chair of AWB Ltd’ (2017) 69 Governance Directions 307; J Fallon and B Cooper, ‘Corporate Culture and Greed — The Case of the Australian Wheat Board’ (2015) 25 Australian Accounting Review 71. See Chapter 2 ‘Note Printing Australia and Securency — a Case Study on Risk Management and Integrity Practices’ in the report of the Parliamentary Joint Committee on the Australian Commission for Law Enforcement Integrity, Integrity of Overseas Commonwealth Law Enforcement Operations, Commonwealth of Australia, June 2013 at <https://www.aph.gov.au/Parliamentary_Business/Committees/Joint/Australian_Commission_for_Law_Enforcement_Integrity/Completed_inquiries/2010- 13/integrity_inter_op/report/c02>. Committee on the Financial Aspects of Corporate Governance (Sir Adrian Cadbury, Chair), Report of the Committee on the Financial Aspects of Corporate Governance, Gee Publishing, 1992 (hereafter referred to as the ‘Cadbury Report’) at [2.5]. HIH Royal Commission, ‘The Failure of HIH Insurance, Commonwealth of Australia’, Canberra, 2003, Vol 1, p 101. ASX Corporate Governance Council, Corporate Governance Principles and Recommendations, 3rd ed, 2014, p 3. A Shleifer and R Vishny, ‘A Survey of Corporate Governance’ (1997) 52 Journal of Finance 737 at 737. See L Chapple, V Clout and D Tan, ‘Corporate Governance and Securities Class Actions’ (2014) 39 Australian Journal of Management 525. See ASIC v Chemeq Ltd (2006) 58 ACSR 169; [2006] FCA 936 at [96] per French J; C Parker and O Conolly, ‘Is There a Duty to Implement a Corporate Compliance System in Australian Law?’ (2002) 30 Australian Business Law Review 273. In this regard, perhaps the title could have been ‘quasi-legal regulation’ because the mechanisms we have selected for analysis are themselves heavily regulated by ‘legal’ rules. See <http://www.asx.com.au/about/asx/index.htm>and ASIC Company Registration Statistics <http://www.asic.gov.au>. The first official stock exchange in Australia was the Melbourne Stock Exchange established in 1861: see ‘History of the ASX’ at <http://www.asx.com.au/research/market_info/history/history_ASX.htm>. It should be noted that the ASX is not the only stock market (or ‘licensed financial market’ using the words of the Corporations Act). There are also derivatives markets, and other competing stock exchanges such as the Bendigo Stock Exchange. However, the ASX remains the largest and most influential financial market in Australia and therefore we are limiting our discussion to it. ASX Corporate Governance Principles and Recommendations, 3rd ed, 2014, p 3.

https://www.aph.gov.au/Parliamentary_Business/Committees/Joint/Australian_Commission_for_Law_Enforcement_Integrity/Completed_inquiries/2010-13/integrity_inter_op/report/c02

http://www.asx.com.au/research/market_info/history/history_ASX.htm

15.

16.

17.

18.

19.

20. 21.

22.

23. 24.

25.

26.

27.

28.

29.

30.

31. 32.

M Adams, ‘Board Diversity: More Than a Gender Issue?’ (2015) 20(1) Deakin Law Review 279 at 292. For example, see A Boone, L Field, J Karpoff and C Raheja, ‘The Determinants of Corporate Board Size and Composition: An Empirical Analysis’ (2007) 85 Journal of Financial Economics 66; C Raheja, ‘Determinants of Board Size and Composition: A Theory of Corporate Boards’ (2005) 40 Journal of Financial and Quantitative Analysis 283. For Australian analysis see H Nguyen and R Faff, ‘Impact of Board Size and Board Diversity on Firm Value: Australian Evidence’ (2006) 4 Ownership & Control 24. LP 0454243 ‘The Changing Roles of Company Boards and Directors’, A Klettner, T Clarke and M Adams, ‘Corporate Governance Reform: An Empirical Study of the Changing Roles and Responsibilities of Australian Boards and Directors’ (2010) 24 Australian Journal of Corporate Law 148. For details of the report’s finding see A Klettner, T Clarke and M Adams, ‘Corporate Governance Reform: An Empirical Study of the Changing Roles and Responsibilities of Australian Boards and Directors’ (2010) 24 Australian Journal of Corporate Law 148 at 169–75. See <http://www.kornferryinstitute.com/files/pdf1/2010_Board_Of_Directors_Study_In_Australia_And_NZ.pdf The study is available at <http://www.eganassociates.com.au/research/research.asp>. Australian Institute of Company Directors, ASX 200 Snapshot Report (2012), available at <http://www.aicd.com.au>. See A Boone et al, ‘The Determinants of Corporate Board Size and Composition: An Empirical Analysis’ at fn 13. Financial Reporting Council, The UK Corporate Governance Code, June 2010, p 9. ACSI Annual Survey of S&P/ASX200 Board Composition and Non-executive Director Remuneration, November 2016, <http://www.acsi.org.au>. See the Cadbury Report at [4.10]ff. See also G Proctor and L Miles, Corporate Governance, Cavendish Publishing, 2003, Pt II. See a review of the literature in G Stapledon and J Lawrence, ‘Board Composition, Structure and Independence in Australia’s Largest Listed Companies’ (1997) 21 Melbourne University Law Review 150. For more contemporary research, see L Nottage and F Aoun, ‘The Rise of Independent Directors in Australia: Adoption, Reform and Uncertainty’ (19 March 2015). Sydney Law School Research Paper No 15/09. Available at SSRN: <http://ssrn.com/abstract=2567504>. See E Cheng and S Courtenay, ‘Board Composition, Regulatory Regime and Voluntary Disclosure’ (2006) 41 The International Journal of Accounting 262. M Benkel, P Mather and A Ramsay, ‘The Association Between Corporate Governance and Earnings Management: The Role of Independent Directors’ (2006) 3 Corporate Ownership & Control 65. S Claessens and B Yurtoglu, Corporate Governance and Development — An Update (Global Corporate Governance Forum, 2012). J du Plessis, J O’Sullivan and R Renschler, ‘Multiple Layers of Gender Diversity on Corporate Boards: To Force or Not to Force?’ (2014) 19(5) Deakin Law Review 1 at 3; V Nagarajan, ‘Regulating for Women on Corporate Boards: Polycentric Governance in Australia’ (2011) 39 Federal Law Review 255. <http://aicd.companydirectors.com.au/advocacy/board-diversity/statistics>. There are obviously many topical issues in corporate governance that have not been raised, for example, executive remuneration, the role of hedge funds, sovereign funds and private equity, the utility of continuous disclosure laws etc.

http://www.kornferryinstitute.com/files/pdf1/2010_Board_Of_Directors_Study_In_Australia_And_NZ.pdf

http://www.eganassociates.com.au/research/research.asp

http://www.aicd.com.au

http://www.acsi.org.au

http://ssrn.com/abstract=2567504

http://aicd.companydirectors.com.au/advocacy/board-diversity/statistics

[page 407]

Directors and Officers

CHAPTER 14 What or who is an officer?

Statutory definition Employees, executives and secretaries

What or who is a director? How are directors officially appointed? What is a de facto director? What is a shadow director? Summary of definitions

Qualifications for company directors How can a director be removed from office?

Removal procedure in corporate constitution Statutory removal Resignation Disqualification

[page 408]

Directors and Officers

Learning Objectives

After completing this chapter you should be able to:

Apply the definitions of officer and director to a set of facts.

Appreciate the differences between the definitions of officer and director.

Describe the different types of directors and officers.

Discuss how directors and officers may be appointed and removed.

Explain the various ways in which directors can be disqualified from office.

Key Cases

ASIC v Adler (2002) 42 ACSR 80; [2002] NSWSC 483

Buzzle Operations Pty Ltd (in liq) v Apple Computer Australia Pty Ltd (2010) 77 ACSR 410; [2010] NSWSC 233

Buzzle Operations Pty Ltd (in liq) v Apple Computer Australia Pty Ltd (2011) 81 NSWLR 47; [2011] NSWCA 109

Corporate Affairs Commission v Drysdale (1978) 141 CLR 236

Grimaldi v Chameleon Mining NL (No 2) (2012) 200 FCR 296; [2012] FCAFC 6

Shafron v ASIC (2012) 88 ACSR 126; [2012] HCA 18

Key Sections

Corporations Act 2001 (Cth) ss 9, 188, 198A, 201A, 203C–203D, 206A–206F and 240A

14.1

[page 409]

Introduction

A typical Australian corporation has key corporate officers such as the directors, the chief executive officer (CEO), the company secretary and senior managers (often called ‘executives’ within corporations).

An artificial entity like a corporation must be able to make legal decisions through the actions of real people (referred to as the ‘organs of the company’). In law, the company is seen as a separate legal entity and is therefore the real ‘person’ who is employing managers, employees and transacting with third party suppliers or customers.

This chapter deals with the role and functions of directors and other corporate officers. The subject of corporate officers is one of the most important areas of corporate law and involves many complex and inter–linked issues. It is essential that managers have a sound understanding of the inter-relationship between the common law duties, the equitable fiduciary duties and the statutory duties. There are also some laws that are applied to all corporate officers and some laws only to directors; thus, the definitions hold the key to the application of the law. This book will discuss the rules regulating directors and officers over the next four chapters.

What or who is an officer?

The concept of an officer of a corporate body has been around since 1844, when the first joint stock companies were allowed to be registered with the government: see Chapter 1. The meaning of ‘officer’ was simple in that it referred to the directors and the company secretary of a registered company. However, over time, different concepts of officers have emerged. For example, taxation laws adopt the concept of ‘public officer’, and more recently the superannuation industry has adopted the concept of a ‘responsible officer’.

14.2

(a) (b)

(i)

(ii)

(iii)

With the introduction of financial services reform in 2001 we now have a confusing situation whereby a company engaged in financial services will have a public officer, other officers as defined under the Corporations Act, nominated responsible officers with the Australian Securities and Investments Commission (ASIC), and then registered responsible officers under the Australian Prudential Regulatory Authority (APRA). This chapter, however, is primarily concerned with officers under the Corporations Act as defined in s 9 (discussed below) to include directors, the company secretary and other senior executives.

Statutory definition For the purposes of the Corporations Act, the law states in the s 9 dictionary that an ‘officer’ of a corporation means:

a director or secretary of the corporation; or a person:

who makes, or participates in making, decisions that affect the whole, or a substantial part, of the business of the corporation; or

[page 410]

who has the capacity to affect significantly the corporation’s financial standing; or in accordance with whose instructions or wishes the directors of the corporation are accustomed to act (excluding advice given by the person in the proper performance of functions attaching to the person’s professional capacity or their business relationship with the directors or the corporation) …

The definition of an officer is wider than that of a director and, as such, captures a broader group who have control within a corporation. The definition of director is explained in detail below.

What are the practical implications of the legal distinction between an officer and a director? Part 2D.1 of the Corporations Act imposes specific legal duties on all officers, such as the duty of care and diligence: see

•

14.3

14.4

Chapter 17. Some duties, however, are solely applied to directors — such as the duty not to trade while insolvent under s 588G. Thus, it is important to be aware of the statutory definition of ‘officer’ because of the instances where different statutory duties are applicable to officers and directors. Before examining the question as to who is a director, it is necessary to discuss the other types of officers, including the senior employees, the executives who are not appointed as directors and the company secretary.

Should legal obligations only be owed by the board of directors? Why is it necessary to impose statutory duties on directors and officers?

Employees, executives and secretaries As a matter of policy, the senior managers of a corporation will have legal responsibilities attached to their position. This idea is derived from the organic theory that was discussed in Chapter 7. Although the company is a separate legal entity, it is important to hold individuals to account. Thus, the senior officials of the company, including the directors, the executive employees and the company secretary are all included in the definition of officers and have the same primary duties found in ss 180– 184. In practical terms, there are some differences that should be noted under the definition of each position.

Employees The term ‘employee’ does not refer to each and every employee of a company, rather only to senior managers of the corporation. It relates to managers under a contract of employment, which always carries with it a traditional common law duty of fidelity (faithfulness) owed by all employees to the company. It would be a breach of this duty to set up a competing business by using customer lists and other confidential information gained from an employer: see, for example, Holyoake Industries (Vic) Pty Ltd v V–Flow Pty Ltd (2011) 86 ACSR 393; [2011] FCA 1154 (where senior employees, and several executives and directors,

•

purchased a competing business by using confidential information gained from their employment).1

[page 411]

Similar facts occurred in Hodgson v Amcor (2012) 264 FLR 1; [2012] VSC 94,2 where Hodgson was the group general manager for the large packaging company, Amcor. Hodgson’s employment was terminated and he claimed compensation but Amcor resisted paying compensation based on a breach of fiduciary duty by Hodgson. Hodgson with other senior employees had purchased several businesses from Amcor without the knowledge or consent of the company. The court held that Hodgson was an officer of the company because he headed the largest division which gave him responsibility for a large portion of the company’s business. Although he did not report to the board, he did report to the managing director. In short, he was one of the most senior executives within the company. The court held (at [1329]) that:

Hodgson’s participation in the management of Amcor was real and direct, even though he was not in a role in which ultimate control within the company was exercised. His role was considerably greater than merely performing an administrative function carrying out the orders of others responsible for a company’s management.

However, the other senior employees (who were senior divisional managers of particular Amcor subsidiaries) were not found to be officers because they were mid–level managers who all reported to Hodgson.

The CLERP 9 reforms implemented in 2004 introduced the new definition of a ‘senior manager’. A senior manager is defined as:

a person (other than a director or company secretary of the corporation) who:

makes, or participates in making decisions that affect the whole, or a substantial part of the business or the corporation; or has the capacity to affect significantly the corporation’s financial standing.

The reason this reform was made was to correct any anomalies in relation to the title of officer that already existed within the Act and as

14.5

such clarify the distinction between the personnel within a corporation and their duties and responsibilities.3 In the context of the Corporations Act, this distinction makes interpretation of each individual’s responsibility much more clearly defined and eradicates the confusion in interpreting what responsibilities each individual owes to the company. This reform arose out of the recommendations made by the Royal Commission into the collapse of HIH Insurance, conducted by Neville Owen J. In 2006 the Corporations and Markets Advisory Committee (CAMAC) released its report on the issues of corporate duties below board level, which recommended minor amendments to clarify who is caught within the statutory duties.4 At the time of writing, no legislative amendments had been made to implement these recommendations.

Executive officers An executive officer is one of the most senior employees in the corporate organisation, and will usually have a specific title, such as CEO or managing director. Large organisations usually have a small team of senior executives, such as the chief financial officer, chief information officer and general counsel.

[page 412]

The term ‘executive officer’ relates to those persons who take part in the management of the corporation. Thus, it is necessary to look at the meaning of management and the degree of participation that is necessary to fit within the definition. There has been competing case law on this topic.5 The judgment of Ormiston J in Commissioner for Corporate Affairs v Bracht [1989] VR 821 took a wide view of the meaning of both management and participation so that it included participation in the corporation’s decision–making processes, and was not confined to the ultimate decision-maker, but it still had to be more than merely having some responsibility. The concept of management should therefore be confined to ‘central management’. Mere administrative work performed by a company secretary or accountant would not constitute management, nor would the execution of instructions by an agent obeying orders or following set policies. In the James Hardie litigation, the general counsel

and the chief financial officer were both found to be officers of the company: Morley v ASIC (2010) 81 ACSR 285; [2010] NSWCA 331. The general counsel appealed this decision but was unsuccessful in the High Court of Australia: Shafron v ASIC (2012) 247 CLR 465; [2012] HCA 18.6

Shafron v ASIC (2012) 247 CLR 465; [2012] HCA 18 High Court of Australia

Facts: This case was one part of the James Hardie litigation which ASIC brought against several non– executive directors and executive officers concerning their role in the restructure of the James Hardie group of companies (see Chapters 5 and 17 for a fuller discussion of the facts). This particular case involved Peter Shafron who performed in a dual role as the co-company secretary and group general counsel. Shafron was clearly an officer of the company because of his role as company secretary (see s 9); however, he claimed that his conduct related to his role as general counsel and he did not act as an officer of the company in that role because he was not the ultimate decision maker. The lower courts had found that Shafron was acting as an officer when he engaged in the defaulting conduct. Shafron appealed to the High Court.

Issues: Was Shafron an officer of James Hardie Industries? Did he act in two different and separate capacities (one as co–company secretary, and officer, and the other as general counsel, potentially not an officer)?

Decision: The High Court found that Shafron was appointed to act in both capacities and he could not neatly divide his two roles so that he would sometimes be acting as an officer and sometimes not as an officer. The High Court confirmed the lower courts’ rulings that Shafron was the second or third most senior executive in the James Hardie group and occupying such a role meant that he participated in making significant decisions that made him an officer of the company, not only with respect to the restructuring proposal but on other matters also.

Significance: This case confirms that persons with multiple roles in a company will be assessed according to their whole position and their time cannot be divided up to meet different roles. Thus, Shafron’s dual role in the company as company secretary and general counsel meant that he did not occupy two separate and distinct roles, each in some part-time capacity.

[page 413]

The High Court’s decision in the Shafron case also helped to explain the meaning of the phrase to ‘participate in making decisions’.

Shafron v ASIC (2012) 88 ACSR 126; [2012] HCA 18 at [26] High Court of Australia

… the idea of ‘participation’ directs attention to the role that a person has in the ultimate act of making a decision, even if that final act is undertaken by some other person or persons. The notion of participation in making decisions presents a question of fact and degree in which the significance to be given to the role played by the person in question must be assessed.

As Austin J stated in ASIC v Vines (2005) 55 ACSR 617; [2005] NSWSC 738 at [1049]:7

… the definition of executive officer is to identify, amongst those who work for the corporation, that group whose responsibilities are significant enough to justify the imposition of special statutory duties.

This point is also supported by the decision in Buzzle Operations Pty Ltd (in liq) v Apple Computer Australia Pty Ltd (2010) 77 ACSR 410; [2010] NSWSC 233, where the court considered whether Apple (the company) or its Australian finance director were officers of the corporation. This case is important because it considered the meaning of both s 9(b)(i) (participate in making decisions) and s 9(b)(ii) (‘capacity to affect significantly the corporation’s financial standing’) in the definition of officer.

Buzzle Operations Pty Ltd (in liq) v Apple Computer Australia Pty Ltd (2010) 77 ACSR 410; [2010] NSWSC 233 New South Wales Supreme Court

Facts: This case concerned the collapse of Buzzle and the liquidator’s attempt to hold Apple liable as an officer of Buzzle. The formation of Buzzle depended on Apple’s consent to transfer contractual rights from other companies to the newly formed Buzzle. As part of this proposal, Apple had various representatives who participated in key management meetings of Buzzle. Apple also made a range of requests for Buzzle to make before Apple would give its consent. One of Apple’s Australian executives had an office in Buzzle’s headquarters and regularly met with Buzzle executives.

Issue: Did Apple participate in making decisions for Buzzle? Was Apple an officer because of its potential power to significantly affect Buzzle’s financial standing?

Decision: Apple was not an officer of Buzzle. When it had discussions with Buzzle’s management and made requests for Buzzle to change its internal operations, Apple was only acting to protect its own independent commercial interest and was not ‘participating’ in making decisions for Buzzle.

Furthermore, although Apple clearly had the capacity to affect significantly Buzzle’s financial standing (as its refusal could cause the business to close) it did not have that capacity as part of Buzzle’s internal governance structure. Apple was only acting to protect its own independent commercial interest and was not acting as an officer of Buzzle. The court stated (at [124]):

Any bank or financial institution of significant worth, or any wealthy person or company, had the same capacity … They have the capacity to affect the financial

[page 414]

standing of every company. It would be absurd to say that on that account, the Commonwealth and State Governments, every bank, wealthy company and wealthy individual, is an ‘officer’ of every other company owing duties to that company.

Significance: The Buzzle case narrows the scope of the meaning of officers to persons who are acting as part of the company’s internal governance structure. It is possible, however, that external persons who have significant influence over the company may be shadow directors, which is discussed further below.

The decision in Buzzle was confirmed on appeal in Buzzle Operations Pty Ltd (in liq) v Apple Computer Australia Pty Ltd (2011) 81 NSWLR 47; [2011] NSWCA 109, although that case was mainly concerned with arguments regarding the definition of shadow directorships and did not discuss the issue of who is an officer.

The law imposes a vast array of duties on such executives, which are discussed in the following three chapters, because of their position of power and their ability to influence and potentially cause harm to employees, shareholders, creditors and the community.

An executive officer will usually assume three different capacities, and is therefore subject to the duties owed by all three positions within the company. An executive can be, simultaneously:

an employee of the company, and therefore owes a duty of fidelity in relation to their contract of employment; a director of the company (due almost always to occupying a position on the board), and therefore is subject to all directors’ duties; and an agent of the company, with the ability to legally bind the company.

This can be contrasted with the role of the non–executive director, who is a member of the board, but not an employee, nor an agent of the company. A non-executive director does not take part in the day–to-day

14.6

management of the business. A comparison of the duties imposed on executive and non–executive directors is undertaken in Chapter 17.

Company secretaries

company secretary: the chief administrative officer in the company and usually responsible for much of the company’s legal compliance obligations.

Under s 204A, every public company is required to have a company secretary. Previously, all companies were required to have a company secretary. However, proprietary companies after July 1998 are exempt from this requirement. In practice, many proprietary companies still retain the company secretary, who also has a financial/accounting or legal compliance role. It is common for the company secretary to hold more than one role within the company.

Approximately 100 years ago, the position of company secretary was seen as merely a ‘servant of the board’ or as a mere clerk. However, that position changed after Lord Denning’s judgment in Panorama Developments (Guildford) Ltd v Fidelis Furnishing Fabrics Ltd [1971] 2 QB 711. His Lordship recognised that the secretary, who had rented motor vehicles for his personal use and paid for them on his corporate credit card, could bind the company as he held the ‘key administrative position’.

It is important to note that the authority only applies to administrative contracts rather than commercial contracts. Thus, if a corporate secretary purchases a

[page 415]

photocopier, it would be administrative, but to arrange the bank overdraft would be deemed commercial. The board or CEO could always give the secretary the express authority to enter a commercial contract, but it is not implied.

• • •

• •

Panorama Developments (Guildford) Ltd v Fidelis Furnishing Fabrics Ltd [1971] 2 QB 711 Court of Appeal

[A company secretary in modern times is] an officer of the company with extensive duties and responsibilities … [he or she] regularly makes representations on behalf of the company and enters into contracts on its behalf which come within the day–to–day running of the company’s business … [he or she] is certainly entitled to sign contracts connected with the administrative side of a company’s affairs, such as employing staff, and ordering cars … [he or she] has no apparent authority to enter into commercial transactions upon [their] own decision, save for transactions of an administrative kind required for the day to day running of the company’s affairs.

The company secretary’s duties and responsibilities, as conferred by s 188(1), are summarised below:

the requirement for a company to have a registered office: s 142; the requirement that the registered office be open to the public: s 145; the lodgement of various specific notices with ASIC: ss 146, 178A, 178C, 205B, 254X and 349A; the lodgement of financial reports with ASIC: ss 319 and 320; and the requirement to respond to an extract of particulars or a return of particulars: ss 346C and 346D.

The company secretary is bound by the same statutory duties as directors, contained in ss 180–183, and is appointed by the board of directors: s 204D. Although the only statutory qualification is that the secretary must be over 18 years old (s 204B), the duty of care and the standards of performance expected of a company secretary are the same as a director. The terms and conditions of the appointment of the secretary, including remuneration, are determined by the board of directors under s 204F. The name and address of the company secretary is kept on the public record by ASIC: s 205B. If there is a change of details, including the appointment of a new secretary, ASIC must be informed within seven days: s 205C.

The actual role of the company secretary will depend on the size and type of the corporate entity. It is also common for a company secretary to have another executive role within the company, such as chief financial officer or general counsel. Indeed, the increasing importance of legal compliance in areas such as competition law, consumer law,

•

environmental law and workplace safety in addition to corporate law, has meant that it is now common for company secretaries to have a legal background and also serve as the company’s general counsel: see, for example, Shafron v ASIC (2012) 247 CLR 465; [2012] HCA 18 (discussed above).

It is common for the company secretary of an ASX listed company to be the contact person who deals with the ASX on behalf of the company. In Morley v ASIC (2010) 81 ACSR 285; [2010] NSWCA 331 (the decision that Shafron appealed from)

[page 416]

the New South Wales Court of Appeal found that this meant that Shafron (as co–company secretary) had the primary responsibility for ensuring that the company’s ASX releases were not misleading. On appeal, the High Court preferred to view the matter as involving Shafron as a senior executive who was expected to use his legal expertise across all his roles, rather than as one where Shafron was liable because of his company secretarial role: Shafron v ASIC (2012) 247 CLR 465; [2012] HCA 18. In other cases, it has been held that a company secretary who merely lodges an ASX release when requested to by the CEO (who drafted the release) is acting in a purely administrative role and should not have responsibility for any resultant defects in the ASX release: ASIC v Narain (2008) 169 FCR 211; [2008] FCAFC 120.

Who should have responsibility for a defective ASX release? Should the company secretary who lodged the release be responsible for checking its accuracy? Should the chief financial officer (CFO) be responsible if the information released is financial in nature?

What or who is a director?

14.7

(a)

(i)

(ii)

(b)

(i)

The definition of a ‘director’ is found in s 9 of the Corporations Act and has been subject to a great deal of judicial debate over time.

By law, public companies must appoint a minimum of three directors, while proprietary companies need only appoint one, under s 201A. The directors must ordinarily reside in Australia, but overseas directors may also be appointed to the board.

It is important to note that the law does not distinguish between performance expectations of local and foreign directors as evidenced in ASIC v Sino Australia Oil and Gas Limited (in liq) (2016) 115 ACSR 437; [2016] FCA 934. See Chapters 9 and 17 for detailed discussion of this case which shows that ignorance of Australian corporations law is not a valid excuse for any director, whether resident in Australia or overseas.8 In disqualifying the foreign–based director in Sino (the company), Mr Shao, from managing a company for a period of 20 years, the Federal Court in the civil penalty decision in ASIC v Sino Australia Oil and Gas Ltd (in liq) (2016) 118 ACSR 43; [2016] FCA 1488 held [at 11]:

Mr Shao’s explanation was that he did not understand Australia’s legal requirements. If he did not understand Australia’s legal requirements, his lack of knowledge demonstrated a lack of diligence and care by him in informing himself properly and fully about the company’s legal obligations and a serious lack of appreciation of the importance of continuous disclosure.

Section 9 defines a director as:

a person who:

is appointed to the position of a director; or

is appointed to the position of an alternate director and is acting in that capacity; regardless of the name that is given to their position; and

[page 417]

unless the contrary intention appears, a person who is not validly appointed as a director if:

they act in the position of a director; or

(ii)

1. 2.

14.8

the directors of the company or body are accustomed to act in accordance with the person’s instructions or wishes. Subparagraph (b)(ii) does not apply merely because the directors act on advice given by the person in the proper performance of functions attaching to the person’s professional capacity, or the person’s business relationship with the directors or the company or body.

This is not a very helpful definition, but does indicate that the courts will look at the function of the person rather than at their job title. Therefore, a person referred to as a governor, manager or trustee of a company could be a director for corporate law purposes. Conversely, a marketing director may not be a member of the board and may not fall within the statutory definition.

The definition does, however, highlight that there are three possible categories of ‘directors’ for the purposes of the Act:

officially appointed directors; directors who are acting under a defective appointment (‘de facto directors’); or persons who exercise directorial control but are not officially appointed (‘shadow directors’).

The courts have stressed that it is important not to focus too heavily on the labels given to particular categories, but rather to assess whether the person comes within the statutory definition: Grimaldi v Chameleon Mining NL (No 2); Chameleon Mining NL v Murchison Metals Ltd (2012) 200 FCR 296; [2012] FCAFC 6.

How are directors officially appointed? When a company is established there are certain processes that the founders of the company must complete before the company is registered: see Chapter 3, of which one of the most important is the selection and registration of directors with ASIC by naming the proposed directors in the company’s application for registration.

14.9

When a director has been selected, and has given their consent to the appointment, ASIC must be informed. The names, addresses, dates and places of birth of all directors must be registered with ASIC within 28 days of being appointed: s 205B(1). Any changes to these details or if a director ceases holding that position, then these changes too must be registered with ASIC, also within 28 days: s 205B(4) and (5).

There are many different types of company directors or labels given to directors that may be officially appointed to the board of directors, including the following.

Chairperson Every board of directors must appoint a person to chair the meetings of the board. This person may be known as the chair, a chairperson, a chairwoman or most commonly referred to as the chairman. The role of the chairperson is to manage the company meeting and in Australia is usually a different person to the chief executive officer or managing director. In the United States, it is very common for the chair and the CEO to be one and the same person. In Australia, the chairperson is typically seen

[page 418]

as being the chief intermediary between the executive management (particularly the CEO) and the board of directors.

The chairperson will work closely with the chief executive officer and the company secretary in the preparation for all members’ meetings and in determining the agenda of board meetings. It is normal that the chair will have a casting vote if there is a split in the voting at a meeting. The precise role of the chair may well depend on the individual’s style and the size and history of the corporation. Directors’ meetings are discussed further in Chapter 12 at 12.19.

•

14.10

14.11

14.12

What potential benefits are there in separating the roles of the chair and the CEO?

Managing director (MD) The directors of a company may appoint any of their number as the managing director (MD) in control of running the day–to–day business of the company. The replaceable rule in s 198C allows the managing director to be appointed with any of the powers of any director in order to fulfil these day–to–day requirements of the company.

The general role of the managing director involves being accountable to the board for everyday decisions and being responsible for the executive employees of the company. It is now more common to call an MD by the American title, chief executive officer or its acronym, CEO.

Executive directors Executive directors are required to manage a significant part or aspect of the business of the company. Thus, it is the executive director’s responsibility to account for the everyday management, actions and decision–making of the senior management of the company in respect of that element of the business. For example, some companies have the chief financial officer (CFO) as a member of the board of directors.

Non–executive directors Non–executive directors of a company are usually appointed to the board with the intent that they will bring an external, independent view to the management of a company. Usually a large percentage of the board is comprised of non-executive directors, particularly for public companies listed on the ASX. It is believed having an external perspective brings a balance to the composition and priorities of a board. Non–executive directors are required to consider the interests of the company as a whole and the perspectives of shareholders rather than the immediate and constant needs of independent units of the company. The growth in non– executives has followed recommendations contained in the ASX Corporate Governance Council’s Corporate Governance Principles and

14.13

•

Recommendations: see Chapter 13.

Nominee directors Nominee directors are directors appointed to represent the needs and interests of a particular stakeholder group. Stakeholders who usually have a nominee director

[page 419]

considering their interests include a major shareholder, a large creditor or joint venture representatives. The shareholders are of course, subject to the company’s constitution, entitled to elect the board of directors. However, candidates for board vacancies are usually nominated by the chairman, with the shareholders’ vote being either to accept or reject the nomination.

The demarcation of the responsibilities of nominee directors can be problematic, especially when the boundaries of responsibilities are questioned. This occurs when a choice must be made between the interests of the external stakeholder (such as a shareholder) and the company. In this context, the question often arises: whose interests should the nominee director represent? The High Court of Australia in Walker v Wimborne (1976) 137 CLR 1 required that the paramount interest must be to the company as a whole rather than any other stakeholder. Section 187 provides some relief in the situation of a director of a wholly– owned subsidiary, but this would not extend to a joint venture company. As to the legal regulation of corporate groups, see Chapter 5. Further discussion of nominee directors is provided in Chapter 15.

In view of the fact that modern corporations often involve large numbers of related companies making up a corporate group, is it still appropriate to require nominee directors to give preference to the interests of their company over the interests of the broader group?

14.14

14.15

Alternate directors Under the replaceable rule in s 201K(1), a director is able to, with the approval of other directors, appoint an alternate director to utilise any or all of the director’s powers. This alternate director will be able to utilise the powers of the director when the director is unable to be present at a meeting. However, when the director is present, the alternate director will hold none of their powers.

When an alternate director exercises the director’s powers, this exercise is as legitimate as if the director had made the exercise: s 201K(3). The alternate director is only liable for actions that are made while in the role of alternate director.

What is a de facto director? Where a person acts in the position of a director without proper authority, that person may nonetheless still be treated by the law as being a director of the company. The significance of being treated as a director is that the fiduciary duties at general law and the statutory duties imposed on directors by Pt 2D.1 and s 588G will apply, despite the defect in appointment. The key case concerning the identification of de facto directors is the decision in Corporate Affairs Commission v Drysdale (below).

Corporate Affairs Commission v Drysdale (1978) 141 CLR 236 High Court of Australia

Facts: Drysdale was appointed as a director of Command Minerals to fill a casual vacancy until the next Annual General Meeting, at which Drysdale was not re–elected by the members. Command Minerals’ corporate constitution provided that as Drysdale had not been re-elected at the AGM, he ceased to be a director of the company. However, he

[page 420]

continued to act as a director for a further two years by attending board meetings, voting on resolutions with the other directors and participating generally in the management of the company.

Drysdale was then prosecuted for breach of directors’ duties for his conduct after the AGM (that is, when he was no longer officially appointed as a director).

Issue: Could Drysdale be prosecuted for breach of directors’ duties even when he was not officially appointed as a director? Was Drysdale a de facto director?

Decision: Drysdale was a de facto director, which therefore meant that he was bound by the statutory duties of company directors. Mason J described a de facto director as one ‘who acts in the position [of director], with or without lawful authority’.

Significance: This case provides an explanation of the term ‘de facto director’.

A person can be found to be a de facto director even where they do not actively consent to act as a director, provided that their actions demonstrate that they are ‘acting in the position’ of a director. This consideration is broadly interpreted by the courts, so that a person does not need to be said to have engaged in activities that only a director could lawfully have done (such as signing documents as a director of the company), provided that the person can be said to have occupied the position of a director. This is demonstrated by the recent Grimaldi case.

Grimaldi v Chameleon Mining NL (No 2); Chameleon Mining NL v Murchison Metals Ltd (2012) 200 FCR 296; [2012] FCAFC 6 Full Federal Court of Australia

Facts: This case concerned an action by Chameleon Mining against Grimaldi, who was a person that had performed work as a consultant for Chameleon Mining and in that capacity had received extensive private benefits. Grimaldi had also assisted with decisions made by the Chameleon board which caused the company to give up substantial funds for use by Grimaldi and his associates for little or no benefit to Chameleon Mining. Grimaldi had acted as a consultant in several important transactions for Chameleon. The case is complex with a range of claims against Grimaldi and his associates. For present purposes it is useful to note that Chameleon claimed that Grimaldi was a de facto director of Chameleon and in that capacity had breached his directors’ duties to the company (see further Chapters 15 and 16). Issue: Was Grimaldi a de facto director of Chameleon Mining? Decision: Although Grimaldi acted as a consultant for Chameleon Mining, this did not prevent a finding that he was a de facto director. This was based on a number of important decisions that Grimaldi made for Chameleon and the level of autonomy he was given for those transactions. The transactions included negotiating the purchase of major assets for Chameleon, and managing a major fundraising initiative for the company (including determining the content of key documents).

The court set out a summary of the principles applicable to determine if a person is a de facto director (at [62]–[76]), which is a useful source of reference.

(a) (b) (c) (d)

(e) (f)

Significance: This case confirms that the question of whether a person is a de facto director depends on what they do for the company. That is, are they acting as if they are a director of the company?

A person may be a de facto director if he or she is engaged generally in the affairs of a company, in contrast to a person who performs specific functions as an external consultant: Re Swan Services Pty Ltd (in liq) [2016] NSWSC 1724 at [27]. A person can be a de facto director even where there are other officially appointed directors: Grimaldi

[page 421]

v Chameleon Mining NL (No 2) (2012) 200 FCR 296; [2012] FCAFC 6: at [74]. See also Re Swan Services Pty Ltd (in liq) [2016] NSWSC 1724 (general manager (administration) and acting CEO was not enough to make a person a de facto director).9

In Holland v Revenue and Customs Commissioners [2011] 1 All ER 430, the United Kingdom Supreme Court held that a de facto director is someone who is ‘part of the corporate governing structure’. This was applied by the court in the Buzzle case: Buzzle Operations Pty Ltd (in liq) v Apple Computer Australia Pty Ltd (2010) 77 ACSR 410; [2010] NSWSC 233. The appeal from this decision was mostly concerned with shadow directors and is discussed below.

Re ACN 092 745 330 [2017] NSWSC 241 Supreme Court of New South Wales

In Re ACN 092 745 330 [2017] NSWSC 241 at [112], Barrett AJA (citing Smithton Ltd v Naggar [2015] 1 WLR 1893) noted the following questions as useful factors in determining whether a person is a de facto director:

whether the person has assumed responsibility to act as a director; the nature of the corporate governance structure and the position the person occupies within it; what the person actually did, as distinct from any job title; the cumulative effect of the activities relied on, with the whole of the circumstances being looked at ‘in the round’; whether the company regarded the person as a director and held him or her out as such; whether third parties considered that the person was a director; and

(g)

14.16

whether the person was consulted about or participated in directorial decisions.

What is a shadow director? A shadow director is a person who, although not formerly appointed as a director, is able to exert significant influence over the decisions made by the board of directors. The key issue is whether the officially appointed board of directors is ‘accustomed to act in accordance with the person’s instructions or wishes’.

Re Akron Roads Pty Ltd (in liq) (2016) 117 ACSR 513; [2016] VSC 657 Supreme Court of Victoria

Clearly a shadow director need not be someone who attends board meetings. The statutory definition contemplates someone as a source of influence over the board members. A de facto director, on the other hand, is somebody who acts in the position of a director. Thus, such a person would usually be somebody who participates in board decisions as a director but who was not formally appointed a director. A person who acts in a managerial position or carries out a managerial function would not normally be said to be acting in the position of a director.

[page 422]

In Australian Securities Commission v AS Nominees Ltd (1995) 133 ALR 1, it was stated that to be a shadow director does not require the person to actually give directions or instructions that cover all matters involving the board.10 All that is required is that whenever the shadow director gives directions or instructions to the board, the board are accustomed to act in accordance with those directions or instructions. Similarly, in the United Kingdom in Secretary of State for Trade and Industry v Deverell [2001] Ch 340, it was found that it is not necessary to prove that the alleged shadow director intended to exert control over the board; all that needs to be proved is that the board is accustomed to act in accordance with those instructions. Influence over a majority of the board is all that is needed: Buzzle Operations Pty Ltd (in liq) v Apple Computer Australia Pty Ltd (2011) 277 ALR 189; [2011] NSWCA 109.11 In Buzzle the court also noted that

14.17

influence over executive officers who were not directors was insufficient to constitute a person a shadow director, unless a direct link could be established to show that the influence over executives had created an influence over the majority of the board of directors.

The court held that a rigid distinction between a shadow director and a de facto director might not always be appropriate and a person may fit within both categories: Grimaldi v Chameleon Mining NL (No 2); Chameleon Mining NL v Murchison Metals Ltd. (2012) 200 FCR 296; [2012] FCAFC 6 at [69].12

For a summary of factors relevant for determining whether a person is a shadow director, see Re Akron Roads Pty Ltd (in liq) (No 3) (2016) 117 ACSR 513; [2016] VSC 657 at [271].

Is it possible for a creditor to be shadow director of its debtor company? There has long been some doubt as to whether the level of control and influence exercised by large secured creditors (such as banks) may render them shadow directors. However, as noted by Chesterman J in Emanuel Management Pty Ltd v Foster’s Brewing Group Ltd (2003) 178 FLR 1; [2003] QSC 205 at [264]:

… it is, I think, significant that there is no reported case in which a secured creditor has been held a de facto or shadow director of the borrowing company despite there being innumerable examples over the decades of creditors who have taken a keen interest in, and exercised a marked degree of supervision over, the affairs of their debtors.

In Emanuel, Chesterman J noted that one of the reasons that secured creditors are not held to be shadow directors is that when secured creditors exercise power and influence over the board of the debtor company, they are acting merely to protect their own interests in ensuring the repayment of the debt. This point was applied in the recent Buzzle case (discussed below). The courts are also, no doubt, highly reluctant to find that a secured creditor is a shadow director due to the dramatic negative impact that such a finding would have on the availability of corporate finance.

[page 423]

Buzzle Operations Pty Ltd (in liq) v Apple Computer Australia Pty Ltd (2010) 77 ACSR 410; [2010] NSWSC 233 New South Wales Supreme Court

Facts: In this case the liquidator of Buzzle sued Apple Computer Australia and its finance director for a range of alleged contraventions including insolvent trading (s 588G) and void charges (s 267). Buzzle was a company formed by the merger of several Apple resellers who accounted for almost half of the Apple products sold in Australia at the time. As the major supplier and also the major secured creditor, Apple’s consent was needed in order to merge the businesses and eventually list on the ASX. If Apple failed to consent, neither the merger nor the ASX listing could occur and the business would fail. Several Apple executives, particularly its finance director, had extensive discussions with the owners of the previous businesses both before and after the merger created Buzzle. Apple imposed various conditions on its continued support of the business. The negotiations between Apple and Buzzle were so detailed that Apple’s finance director kept an office inside Buzzle’s headquarters and regularly attended meetings with the directors and senior managers.

Issue: Was Apple and/or its finance director liable for insolvent trading as shadow directors of Buzzle? Decision: Neither Apple nor its finance director were shadow directors. Although the Buzzle directors felt they had no choice but to act in accordance with Apple’s wishes and instructions, in reality they always had a choice about whether or not to accept Apple’s conditions. The court held (at [247]) that while it is not necessary to prove that the directors had absolutely no discretion, ‘there must be a causal connection between the instruction or wish of the shadow director and the act taken by the directors’.

The court noted the statutory language that the board must be ‘accustomed to act in accordance’ with the shadow director’s wishes or instruments requires that there be a pattern of compliance by the board: at [248].

Importantly, the court held that when Apple imposed conditions on its continued support for the business, it was doing so in order to protect its own interests rather than doing so in order to take part in decisions of the company: at [243].

There was no proof by the liquidator that Apple or its finance director had exercised influence over a majority of directors so that they could be held to be shadow directors. Only two members of the board were in regular contact with Apple and its finance director and the relevant decisions were made by the entire board acting to promote the interests of the company. Merely because the board felt it needed to agree to Apple’s conditions did not mean that the board was ‘accustomed to act in accordance with its wishes or instructions’.

Significance: This case demonstrates that an external person will not be held to be a shadow director where they impose conditions for their continued support of the company on a commercial arm’s length basis. This should provide greater certainty for secured creditors that they are unlikely to be held to be shadow directors by imposing conditions on their continued financial support for companies in distress.

The New South Wales Court of Appeal subsequently dismissed an appeal of the trial decision in Buzzle. In Buzzle Operations Pty Ltd (in liq) v Apple Computer Australia Pty Ltd (2011) 277 ALR 189; [2011] NSWCA 109 the

14.18

leading judgment was given by Young JA, who approved of the reasoning in the trial decision regarding the analysis of the shadow director argument. His Honour then gave a summary of the relevant principles: at [227]–[232].

[page 424]

Buzzle Operations Pty Ltd (in liq) v Apple Computer Australia Pty Ltd (2011) 277 ALR 189; [2011] NSWCA 109 New South Wales Court of Appeal

… it seems to me that various principles emerge from the leading authorities.

First, not every person whose advice is in fact heeded as a general rule by the board is to be classed as a de facto or shadow director.

Second, if a person has a genuine interest of his or her or its own in giving advice to the board, such as a bank or mortgagee, the mere fact that the board will tend to take that advice to preserve it from the mortgagee’s wrath will not make the mortgagee, etc a shadow director.

Third, the vital factor is that the shadow director has the potentiality to control. The fact that he or she does not seek to control every facet of the company or the fact that from time to time the board disregards advice is of little moment.

Fourth, [the] proposition that the evidence must show ‘something more’ than just being in a position of control must be shown. The whole of the facts of the case must be shown to see whether that power to control was put into practice. The emphasis that one must judge on the whole of facts and circumstances is made many times over in the leading cases.

Fifth, although there are problems with cases where the board of the company splits into a majority and minority faction, so long as the influence controls the real decision–makers, the person providing the influence may be a shadow director.

Summary of definitions The following diagram shows the overlapping nature of the definitions of director and officer in s 9 of the Corporations Act.

14.19

1. 2. 3. 4.

[page 425]

Qualifications for company directors

In order for a person to hold the position of director, they must satisfy the four conditions set in the Corporations Act which dictate whom may be a director. These are:

The person must not be disqualified from being a director: s 201B(2). The person must be at least 18 years of age: s 201B(1). The person must be an individual (rather than a company): s 201B(1). The person must agree to the appointment: s 201D.

There are other varied conditions which dictate who can be the director of a company. Specifically, under the CLERP 9 reforms, two years must have passed before an ex-auditor can become the director of a company they previously audited. Additionally, an auditor cannot be a company director of a company they are responsible for auditing: see Chapter 19.

How can a director be removed from office?

14.20

•

• •

14.21

14.22

A director can be removed from office in a number of ways:

by the company complying with a removal procedure in the corporate constitution; by the company complying with the statutory conditions (ss 203C and 203D); by resignation (s 203A); or by the director becoming disqualified from managing a corporation (s 206A).

Removal procedure in corporate constitution Directors can be removed from their position through a variety of means, both voluntarily and involuntarily. The term of a director’s office is usually specified in the company’s constitution. However, the members of a company will usually decide when the director’s period in office should finish and be voted on again.

Statutory removal There are set procedures for the statutory removal of a director from a company. There is a distinction between the procedure applied for the removal of a public company director and that which is applied to a director of a proprietary company.

Under s 203C, which is a replaceable rule (thus can be varied by the corporate constitution), the removal of a director by members of a proprietary company only requires an ordinary resolution to be passed by the members at a general meeting. An ordinary resolution is based on a simple majority of votes (that means over 50% of the votes cast at a members’ meeting including any proxies) being passed. In practice, this would require the board of directors to convene a general meeting of members with 21 days’ notice or at least 5% of the members’ votes to requisition the company to call the meeting.

[page 426]

14.23

For the removal of a director in a public company, s 203D is applied (which is not a replaceable rule). Section 203D states that members of a public company can remove a director by passing an ordinary resolution at a general meeting. However, the public company director that is being removed has statutory entitlement to defend themselves against such an action. The director must receive at least two months’ prior notice of the removal before the general meeting. The director also has the statutory right to put their case before the members by sending a written statement to all members. The power to remove directors using the process referred to in s 203D applies regardless of any provision in the company’s constitution or any agreement that the company may have with the director: s 203D(1). There are divergent views as to the effect of s 203D. In Scottish & Colonial Ltd v Australian Power & Gas Co Ltd (2007) 65 ACSR 313; [2007] NSWSC 1266, the court held that failing to follow the s 203D procedure (by failing to give two months’ notice) rendered the removal of a director invalid because s 203D was mandatory, while in State Street Australia Ltd (Trustee) v Retirement Villages Group Management Pty Ltd (2016) 113 ACSR 483; [2016] FCA 675, the court held that while s 203D would apply where inconsistent with the provisions in a company constitution, s 203D was not an exhaustive code for removing directors.

In practice, it is very difficult to remove a public company director, mainly because of the damage it causes to the company’s public image (with recent examples including large companies such as Telstra, the National Australia Bank and Echo Entertainment). However, the fact that shareholdings in public corporations are often widely dispersed between hundreds of thousands of shareholders also makes it difficult to garnish sufficient support to remove a director, unless the chairperson supports the resolution (and votes undirected proxies to support the resolution). The more usual outcome is that pressure will be put on the director to resign.

Resignation Under s 203A a company director can give their notice at any time in order to resign. The Corporations Act requires that the company director give proper notice to the members of a company if they are to retire. Section 203A requires that a company director give their notice in

14.24

1. 2.

writing at the registered address of the company.

Disqualification There are a variety of methods by which a director can be disqualified from acting as a director or managing a company. The first, automatic disqualification, will occur through two methods:13

disqualification of a convicted person; or disqualification of undischarged bankrupts.

If a person is convicted of any offence that is a contravention of the Corporations Act that is punishable by imprisonment for more than 12 months, or it is an offence that involves dishonesty that is punishable by imprisonment for more than three months, then they may be disqualified from managing companies automatically: s 206B(1).

[page 427]

Additionally, if a director is convicted of an offence which has the capacity to significantly affect the corporation’s financial standing, then disqualification will occur: s 206B(1).

The period of disqualification will depend on several factors. If the disqualified individual is not given a prison sentence, then the person will be disqualified for five years from the date of conviction. Conversely, if the person is imprisoned, then the date of disqualification is five years from the release from prison. This period can be extended by ASIC under s 206B(2). This provision allows ASIC to extend the period of disqualification for up to an additional 15 years with approval from the court if they find reason to do so.

Undischarged bankrupts are also automatically disqualified from directing companies under s 206B(3). People who have undertaken deeds of arrangements under the Bankruptcy Act 1966 (Cth) and have not fully satisfied their terms under s 206B(4) of the Corporations Act will also be automatically disqualified. ASIC intermittently publishes lists of people

who are disqualified from directing companies. These details are widely available on their website.

civil penalty: the Corporations Act provides a range of non–criminal penalties for breach of specified provisions (including directors’ duties) which are listed in s 1317E. These provisions are called ‘civil penalty provisions’.

Directors may also be disqualified by a court order. The courts through s 206C have the power to disqualify an individual from directing and managing corporations. The individual in question must have contravened a civil penalty provision under the Corporations Act in s 1317E.

The court has a high degree of discretion in determining whether they will disqualify someone under s 206C. Section 206C(2) dictates that the court must consider the person’s conduct in relation to any management, business or property of any corporation when determining whether a person will be disqualified through this method. However, the court may also take into account any other issues that it deems to be appropriate in the circumstances. The court is not bound by any minimum or maximum length of disqualification in this instance. Discretion is used to examine the relevant contravention and the period of disqualification which is appropriate in the circumstances.

Directors who have managed failed companies within the last seven years may also attract the scrutiny of the courts and accordingly be disqualified from managing companies. Any person who is found within the last seven years to have been an officer in two or more companies that have failed, and the court determines that the failure was due, in part at least, to how the company was managed can be disqualified for up to 20 years: s 206D(1). As in the situation where a person has breached a civil penalty provision, the court will take into account when determining whether or not and for how long to disqualify the person, the person’s conduct in regards of the management, business and property of the any corporation they have been involved in, and any other matters the court sees as appropriate.

ASIC also has the power to apply to the court to disqualify a person who has been disqualified under the law of a foreign country: s 206EAA.

• •

• • • •

Repeated contraventions of the law may also attract a period of disqualification for a director. This disqualification is enforced by the courts and the power to do so is given under s 206E(1).

[page 428]

In order to attract this type of disqualification, the person must have been found to have at least been a member of a body corporate that has contravened the Corporations Act, and that each time a contravention occurred reasonable steps to prevent the contravention were not taken. ASIC is the only body who may apply for such a disqualification.

ASIC v Adler (2002) 42 ACSR 80; [2002] NSWSC 483 New South Wales Supreme Court

Facts: Mr Adler obtained an unsecured loan from HIH (a company that he was a director and shareholder of) to purchase shares in a company that he was involved in, which the court held was in breach of his statutory duties (ss 180(1)–182 which are listed as civil penalty provisions under s 1317E) and issued a declaration of contravention of civil penalty provisions. The declaration allowed the court to impose a period of disqualification of Mr Adler under s 206C.

Issue: How should the court determine what is the appropriate disqualification period? Decision: The court disqualified Mr Adler from management for 20 years. In reaching that decision, the court stated that the determination of disqualification periods is governed by the following relevant factors:

specific deterrence (that is, will the defendant commit another breach in the future?); general deterrence (that is, the penalty must be harsh enough to discourage other people from engaging in similar conduct); dishonest conduct should attract a longer disqualification period; the amount of loss suffered by the company; whether the defendant abused a position of trust; and whether the company or the defendant has a history of similar breaches.

Significance: This case provides guidance on how to determine the length of a court–ordered disqualification. Although this case was decided by a single judge, it has been subsequently adopted by the Victorian Court of Appeal (consisting of three judges) in Elliott v ASIC (2004) 205 ALR 594; [2004] VSCA 54.

ASIC v Vizard (2005) 145 FCR 57; [2005] FCA 1037 Federal Court of Australia

Facts: Steve Vizard is a well–known businessman and celebrity who was a company director on a number of boards including Telstra. After an ASIC investigation, Mr Vizard admitted liability for misusing his position as a director of Telstra to attempt to gain a personal advantage by buying and selling shares in three companies that were dealing with Telstra before the market was informed about Telstra’s plans. In order to conceal his activities, Mr Vizard set up a company to conduct the illegal share trading and procured his accountant to own and manage the company following Mr Vizard’s instructions. Mr Vizard then funded the share trades through a family trust. This illegal trading was, however, largely unsuccessful due to the stock market tech crash. Overall, Mr Vizard suffered a net loss on the three series of trades made using confidential Telstra information. After Mr Vizard admitted wrongdoing and co–operated with ASIC, both ASIC and Mr Vizard agreed that the appropriate penalty should be $390,000 ($130,000 per illegal share trade) and a disqualification from acting as a director for five years.

[page 429]

Issue: What was the appropriate penalty for Mr Vizard? Decision: Mr Vizard was fined $390,000 for the three illegal share transactions and banned from being a director for 10 years. Finkelstein J took into account the deliberate breaches of duty by Mr Vizard and the covert means by which he attempted to conceal his illegality (that is, by conducting the trades through a company and trust to hide his identity). Finkelstein J felt that while there were a number of elements in mitigation of Mr Vizard’s conduct (such as his good character, co–operation with authorities and no chance of re–offending), the seriousness of the breach (it was a deliberate breach of duty and could have earned Mr Vizard a substantial profit) warranted a severe penalty to discourage others from engaging in such illegal activities (known as general deterrence).

ASIC also have their own powers under s 206F of the Corporations Act to disqualify people from directing a corporation where the person has been involved in several failed companies. When ASIC considers that a person is inappropriate for managing corporations, they will prepare a case against the person showing the reasons why they are not appropriate directors. The director in question will receive this material and will then be given an opportunity to address any of the issues showcased and any other issues they believe prove they should not be disqualified: s 206F(1) (b).14

If ASIC elects to disqualify someone using this power, they will serve the person with a notice informing them of their subsequent disqualification. The disqualification is valid from the date of service.

This form of disqualification is preferred by ASIC as, in the court proceedings as mentioned above, ASIC carries the burden to prove to the court that the person in question is inappropriate to be a company director and as such should be disqualified. In proceedings under ASIC’s rule, the onus is on the director in question to prove that they are an appropriate person to hold a directorship and avoid disqualification. The High Court in Visnic v ASIC (2007) 231 CLR 381; [2007] HCA 24 ruled that ASIC’s power to disqualify was constitutionally valid on the basis that it did not represent the exercise of judicial power.

Under s 206G(1), a person who is disqualified from directing companies may apply for court granted leave to manage a particular company or companies. ASIC must be informed 21 days before the court is to examine the application: s 206G(2). The order, if it is granted by the court, may allow full unrestricted access to direct a particular company or companies or can impose limiting conditions on the grant. The principles that the court applies in hearing an application for leave to manage a corporation while disqualified were considered in Adams v ASIC (2003) 46 ACSR 68; [2003] FCA 557 at [8] per Lindgren J.

4. 5. 6.

9. 10.

[page 430]

Revision Questions

How would you prove that a particular person was a director of a company? How has the role of company secretary changed over the years? What are the key roles of the company secretary today? What is the difference between an officer and a director? What is the significance of this difference? What is the role of the chair of the board of directors? How can a person be a shadow director? What is the perceived value of having non–executive directors on a company board? Explain the different roles played by executive and non–executive directors. Explain the nature of the legal relationship between a director and his or her nominee on the board. How may directors be removed from the board? What factors does the court take into account when deciding whether to disqualify a director?

Problem Question Alex, Mary and Jacob establish a company in which they each take shares. Alex has another job as an accountant and so he contributes most of the money to the new company and receives 60% of the shares in the company. Alex is quite busy with his accountancy practice and so he chooses not to become a director of the company.

Mary and Jacob plan to run the business themselves; each takes a 20% shareholding and they also act as officially appointed directors. However, Jacob forgets to submit a written acceptance of his role as a director. During the first year the company runs very well with

4. 5. 6.

Mary acting as CEO and Jacob as company secretary. However, given that Alex owns a majority of the shares in the company, he is consulted about any significant decisions by Mary and Jacob. If Alex disagrees with the course of action proposed by Mary and Jacob, then normally they will compromise to suit Alex. One day while Alex is inspecting the company’s accounts (which he regularly does) he notices some accounting anomalies which suggest that Mary has been misappropriating funds from the company. Furthermore, Alex believes that the company has been insolvent for some time.

(a) Does Alex fit within the definition of an officer under the Corporations Act? (b) Can Jacob avoid liability as a director by arguing that he was not officially appointed (due to the fact that he did not accept his position in writing)?

Guidelines for Answering Problem Questions

When answering a problem question concerning directors and officers, we suggest that the following method may be helpful:

Ascertain the role of the person within the company. What is their title? What role do they play in the company’s business? What authority do they have? Apply the definitions of officer and/or director in s 9 (bearing in mind that the definition of officer includes director).

[page 431]

If they are a director/officer, then work out what type of director/officer they are (that is, executive/non–executive, nominee, chairman etc). This is a particularly important step if the question also includes directors’ duties. Verify that the director/officer has been officially appointed. Can the director/officer be removed from office? Is the director/officer liable to be disqualified by the court or by ASIC?

Erin is concerned about the strong friendship that has developed between Wang and John. While she has usually been consulted by Wang on major decisions in the past, Wang now seems to talk mostly with John. Erin is curious as to how John was appointed and whether he is validly acting as managing director of Pop Up. She believes that John’s appointment (which was four months ago) is now at an end.

Erin is also concerned about the bizarre behaviour that Wang has been demonstrating lately. Wang has been concerned about the profitability of the business so he engages the advice of a psychic (Athena). Wang sees Athena once a week and she tells him what the future holds (or so he believes). Wang begins to ask increasingly specific questions about potential financial outcomes in the future and Athena gives Wang specific answers. Initially Wang was just doing this out of interest but he began to see a correlation between Athena’s predictions and the next week’s sales figures. Increasingly Wang relies on Athena to set the sales forecasts for the JC Expansion stores. He does not tell Erin or anyone else about this. Wang relies on Athena’s financial projections to construct sales projections in the company’s accounts. Wang puts Athena on a retainer as a ‘management consultant’ which Athena runs through her company ‘Starwoman Enterprises Pty Ltd’. Athena takes up an office next to Wang in the head office of SCPL.

Advise Erin as to John’s status as a director. Could Athena be considered a director or officer of SCPL?

Further Reading

Academic Journals J Anderson, ‘On the Brink: Creditors as Shadow Directors When

Dealing with Debtors Approaching Insolvency’ (2014) 22 Insolvency Law Journal 169.

D Armstrong, ‘Guidance for General and Corporate Counsel: Reflections on James Hardie’ (2012) 26 Commercial Law Quarterly 19.

T Bednall and V Ngomba, ‘The High Court and the C–suite: Implications of Shafron for Company Executives Below Board Level’ (2013) 31 Company and Securities Law Journal 6.

M Evers and J Harris, ‘The Duties of In–house Counsel: The Bold, the Bright and the Blurred?’ (2009) 37 Australian Business Law Review 267.

B Fitzgerald, ‘Out of the Shadows? Clarifying the Liability of Secured Creditors in Workouts’ (2012) 20 Insolvency Law Journal 179.

A Hargovan, ‘Dual Role of General Counsel and Company Secretary:

Walking the Legal Tightrope in Shafron v Australian Securities and Investments Commission’ (2012) 27 Australian Journal of Corporate Law 112.

A Watterson, ‘Minimising the Risk of Shadow Directorship: Advice for Distressed Debt Investors’ (2016) 27 Journal of Banking and Finance Law and Practice 310.

[page 432]

Practitioner Journals D Atkin and D Cheilyk, ‘Jumping at Shadows: Shadow and De Facto

Directors’ (2015) 19 In House Counsel 41. A Hargovan, ‘Judicial Guidance on De Facto Director Liability for

Insolvent Trading’ (2017) 69 Governance Directions 108. A Hargovan, ‘Foreign directors of Australian companies put on notice:

No leniency for ignorance of duties’ (2017) 69 Governance Directors 37. A Hargovan, ‘Identifying Company Officers — Judicial Signposts by the

High Court in the James Hardie Decisions’ [2012] Butterworths Corporation Law Bulletin [472].

A Hargovan, ‘Raising the Bar for General Counsel and Company Secretaries — High Court Decision in James Hardie’ (2012) 64 Keeping Good Companies 260.

A Hargovan, ‘Throwing Light on Shadow Directors — Court of Appeal in Buzzle v Apple’ (2011) 10 Insolvency Law Bulletin 173.

A Hargovan, ‘Directors’ and Employees’ Duty of Fidelity — Holyoake’ (2011) 63 Keeping Good Companies 668.

Practitioner Works R P Austin, H A J Ford and I Ramsay, Company Directors: Principles of

Law and Corporate Governance, LexisNexis Butterworths, Australia, 2005.

H A J Ford, R P Austin and I Ramsay, Ford’s Principles of Corporations Law, LexisNexis, Australia (looseleaf and online) Ch 7.

7. 8.

10.

11.

12.

13.

14.

You will find useful study resources, including quizzes for each chapter, when you go to <http://learning.lexisnexis.com.au>. The quiz is a great tool to help you self–test your knowledge.

For fuller discussion, see A Hargovan, ‘Directors’ and Employees’ Duty of Fidelity – Holyoake’ (2011) 63 Keeping Good Companies 668. The damages award was varied on appeal: V–Flow Pty Ltd v Holyoake Industries (Vic) Pty Ltd (2011) 86 ACSR 393; [2011] FCA 1154. See further A Hargovan, ‘Company Officers in the Judicial Spotlight’ (2012) 64 Keeping Good Companies 365. As such, the definition of ‘executive officer’ was removed and replaced with ‘senior manager’ in order to correct confusion between an ‘executive officer’ and an ‘officer’. CAMAC papers may be accessed from the CAMAC website, <http://www.camac.gov.au>. A narrower view of management was put forward in Holpitt Pty Ltd v Swaab (1992) 33 FCR 474 by Burchett J, which was an insolvent trading case rather than a director’s duty case. See further A Hargovan, ‘Dual Role of General Counsel and Company Secretary: Walking the Legal Tightrope in Shafron v Australian Securities and Investments Commission’ (2012) 27 Australian Journal of Corporate Law 112. This aspect was not challenged on appeal: Vines v ASIC (2007) 62 ACSR 1. See further A Hargovan, ‘Foreign Directors of Australian Companies Put on Notice: No Leniency for Ignorance of Duties’ (2017) 69 Governance Directors 37. See further A Hargovan, ‘Judicial Guidance on De Facto Director Liability for Insolvent Trading’ (2017) 69 Governance Directions 108. For a case where actual directions were given to a company’s board by a person held to be a shadow director, see Ho v Akai Pty Ltd (in liq) (2006) 24 ACLC 1,526; [2006] FCAFC 159. See further, A Hargovan, ‘Throwing Light on Shadow Directors — Court of Appeal in Buzzle v Apple’ (2011) 10 Insolvency Law Bulletin 173. For a case where a person who purported to be an employee but where the evidence showed that such a person was both a de facto director and a shadow director, and consequently liable for insolvent trading, see Featherstone v D J Hambleton as Liquidator of Ashala Pty Ltd (in liq) (2015) 107 ACSR 131; [2015] QCA 43. There is also provision that persons disqualified under other statutes, namely the Competition and Consumer Act 2010 (Cth) and the Australian Securities and Investments Commission Act 2001 (Cth) are automatically disqualified under the Corporations Act: see ss 206EA, 206EB. For a discussion of the administrative law issues concerning ASIC’s power under s 206F, see Culley v ASIC (2010) 183 FCR 279; [2010] FCAFC 43; Quinlivan v ASIC (2010) 81 ACSR 522; [2010] FCAFC 161.

[page 433]

Directors’ and Officers’ Duties: Good Faith and

Proper Purposes

CHAPTER 15 Overview of duties Directors’ duties

To whom are directors’ duties owed? Corporate social responsibility

Fiduciary duties Overview

Duty to act in good faith and in the company’s best interests Proper purpose rule Statutory duties under the Corporations Act Defences: disclosure Relief from liability

Criminal actions against directors Double jeopardy rule

[page 434]

Directors’ and Officers’ Duties: Good Faith and Proper Purposes

Learning Objectives After completing this chapter you should be able to:

Discuss the scope of the fiduciary duties of loyalty and good faith at general law and under the Corporations Act 2001 (Cth).

Appreciate the difference between equitable fiduciary duties and statutory duties and be able to apply appropriate duties to particular factual problems.

Explain the role of ASIC in ensuring compliance with directors’ and officers’ statutory duties.

Discuss the manner in which directors and officers may obtain relief from breaches of duty at general law and under the Corporations Act.

Discuss the remedies available for breach of directors’ and officers’ general law and statutory duties.

Key Cases

ASIC v Adler (2002) 41 ACSR 72; [2002] NSWSC 171

Bell Group Ltd (in liq) v Westpac Banking Corp (No 9) (2008) 70 ACSR 1; [2008] WASC 239

Brunninghausen v Glavanics (1999) 46 NSWLR 538

Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821

Kinsela v Russell Kinsela Pty Ltd (in liq) (1986) 4 NSWLR 722

Mills v Mills (1938) 60 CLR 150

Ngurli v McCann (1953) 90 CLR 425

Permanent Building Society (in liq) v Wheeler (1994) 14 ACSR 109

R v Byrnes and Hopwood (1995) 183 CLR 501; 130 ALR 529

Spies v R (2000) 201 CLR 603; [2000] HCA 43

Westpac Banking Corp v Bell Group Ltd (in liq) (No 3) (2012) 89 ACSR 1; [2012] WASCA 157

Whitehouse v Carlton Hotel Pty Ltd (1987) 70 ALR 251

Key Sections

Corporations Act 2001 (Cth) ss 181, 184, 1317E, 1317G, 1317H, 1317S, 1318

1. 2.

[page 435]

Introduction

Previous chapters have examined the fundamental nature of companies. They are juristic persons (artificial but recognised in the eyes of the law) and are dependent upon human beings to make decisions on their behalf. In the previous chapter, we looked at the different types of officers and directors, including the chair, the non-executive directors, the executives and the company secretary, as well as senior employees/managers who act on behalf of the company. Upon being deemed by the law to be an officer, a number of legal duties will flow from holding that position within the company.

Directors, who control and manage the company, are in a powerful position and it is easy for their extensive powers to be abused, for example, through fraud or mismanagement. The law recognises the company’s vulnerability to abuse by directors and officers. For purposes of accountability and to minimise risk of wrongful or illegal behaviour, the law imposes stringent duties on officers and directors. Essentially, the legal duties imposed on officers and directors are to ensure that they act not for their own benefit but for the benefit of the company. These legal duties are derived from three distinct sources of law:

traditional common law (including the law of negligence); the principles of equity (particularly the law of fiduciary obligations); and the statutory duties, under the Corporations Act 2001 (Cth), imposed by parliament.

fiduciary: a person upon whom the law of equity imposes obligations because of the power, influence and responsibility that the fiduciary has over another vulnerable person (known as the principal). A company director occupies a fiduciary position over the company as principal.

The first two sources are commonly called ‘general law’ and overlap with the third source ‘statutory law’. This chapter examines one part of the equitable fiduciary obligations imposed on company directors and officers, the duty to act in good faith in the best interests of the company and the duty to act for a proper

15.1

1. 2. 3. 4.

purpose. Both the general law and statutory versions of these duties are discussed in this chapter. Chapter 16 discusses the fiduciary and statutory obligation known as the ‘no-conflict’ rule. Chapter 17 examines the general law and statutory duty to act with care and diligence. Chapter 18 discusses the directors’ duties that arise when a company gets into financial difficulty, with reference to both general law and statute law.

Overview of duties

All directors and officers of a corporation are bound by a number of general law and statutory duties. The Corporations Act clarifies and codifies the existing judge-made legal duties that are imposed upon directors and officers. As a result, there are similarities between the judge-made rules (that is, the rules from common law and equity) and the statutory rules. All directors owe the company equitable duties of loyalty and good faith. As part of that duty, directors must:

act in good faith in the interests of the company; act for a proper purpose; avoid conflicts of interest; and retain discretion.1

[page 436]

For the sake of convenience these duties are considered separately in this chapter and the next chapter.

In addition, directors must exercise care, skill and diligence in the performance of their duties. This is similar to the common law duty to avoid negligence resulting in reasonably foreseeable harm: Donoghue v Stevenson [1932] AC 562 (the ‘Snail in the Bottle’ case). This duty is discussed in Chapter 17.

objective standard: an objective standard is determined by what a reasonable person would do or

would have believed, not what the director actually did or actually believed, which is a subjective standard.

These general law duties are reinforced under the Corporations Act. For example, the duties to act in good faith and for a proper purpose are reinforced in s 181 of the Corporations Act. Sections 182 and 183 reinforce the duty to avoid conflicts of interest by prohibiting directors from making improper use of their office and information. Section 180(1) reinforces the duty of care by imposing the same objective standard that arises under common law.

A key difference, however, lies in the enforcement of these duties and the remedies that flow from the different sources of law. The company, as plaintiff (the applicant for a court order), enforces the duties owed at general law. This is a consequence of the duties being owed to the company, which at law is a separate person. In practice, it is the board of directors, as part of their management power who decide to litigate in the company’s name. This can be problematic in instances where it is alleged that the directors themselves have breached a duty owed to the company. The Corporations Act addresses such difficulties by empowering shareholders to litigate on the company’s behalf in certain circumstances via a statutory derivative action under Pt 2F.1A. The rights of shareholders, in particular, to enforce duties imposed on directors and other officers, is discussed further in Chapter 19.

[page 437]

Generally, ASIC enforces the statutory duties arising under the Corporations Act. The company, however, may also seek a civil penalty remedy (discussed below) if the court has issued a declaration of contravention of directors’ duties under the Corporations Act. The different remedies and consequences are identified and discussed below.

The fundamental duties that are imposed on all officers, which naturally overlap with one another, can be best illustrated in a Venn diagram.

Figure 15.2 is an overview of officers’ duties and shows the interrelationship between the Corporations Act, the common law and equitable duties.

The overlapping areas represent how the Corporations Act in Pt 2D.1 (duties of company officers) reflects parts of the general law principles. For example, the prohibition against a director having a conflict of

interest can be found under the Corporations Act (s 182) and at general law expressed as a fiduciary duty. In other instances, duties are specifically laid out in statute. For example, the prohibition on insider trading is found in s 1043A. Some duties are applied exclusively to directors. For instance, a specific example that is applied to directors (and not all officers) is the positive duty not to trade while the company is insolvent as required by s 588G. This provision is an enhancement of the common law duty to consider creditors in times of financial trouble, as affirmed by the High Court in Spies v R (2000) 201 CLR 603; [2000] HCA 43.

[page 438]

The bottom two circles of the diagram represent the civil actions that could be brought under either the common law (such as a breach of contract or the tort of negligence) or under the equitable fiduciary duty (such as a conflict of interest).

The top circle represents the imposition of statutory duties by parliament through the Corporations Act which may give rise to a criminal offence (as found in ss 184 and 1043A). Where the circles overlap, there may be a choice of legal actions under the common law and equity or with the statutory duties, which are stated to be a civil penalty (for example, ss 180–183) by virtue of s 1317E.

Section 185, found where the three circles intersect in Figure 15.2, provides that the duties imposed by the Corporations Act are additional to the duties imposed at common law and in equity, rather than exclusive of them. Thus, a director could be sued for all three types of actions rather than just the Corporations Act or the common law/equitable principles that have been breached.

An example of a director being held liable for all three types of actions occurred in South Australia State Bank v Clark (1996) 19 ACSR 606. In that case, the CEO was held liable for breach of the duty of care (a common law duty), breach of equity through a conflict of interest and also for

15.2

contravening statutory duties as a director. All of these concepts will be discussed further below.

Directors’ duties

To whom are directors’ duties owed? The question of to whom the duties of directors are owed is normally answered by the phrase ‘to the company as a whole’. This was interpreted by the United Kingdom Court of Appeal as meaning not the company as an entity outside and apart from its shareholders, but rather the general body of shareholders: Greenhalgh v Arderne Cinemas Ltd [1951] Ch 286.

[page 439]

Owen J considered this principle in the mammoth decision in Bell Group Ltd (in liq) v Westpac Banking Corp (No 9) (2008) 39 WAR 1; [2008] WASC 239 (the written reasons for this decision run to more than 2500 pages).

15.3

Bell Group Ltd (in liq) v Westpac Banking Corp (No 9) (2008) 39 WAR 1; [2008] WASC 239 at [4393] Western Australia Supreme Court

… [the principle stated in Greenhalgh] does not mean that the general body of shareholders is always and for all purposes the embodiment of ‘the company as a whole’. It will depend on the context, including the type of company and the nature of the impugned activity or decision. And it may also depend on whether the company is a thriving ongoing entity or whether its continued existence is problematic. In my view the interests of shareholders and the interests of the company may be seen as correlative not because the shareholders are the company but, rather, because the interests of the company and the interests of the shareholders intersect. [emphasis added]

This statement was not discussed on appeal, where the majority of the Western Australian Court of Appeal confirmed the decision that the directors had failed to act in the best interests of their companies: Westpac Banking Corp v The Bell Group Ltd (No 3) (2012) 89 ACSR 1; [2012] WASCA 157.

Individual shareholders The principle that directors and other officers owe duties to the company as a whole ordinarily means that while duties are owed to the collective body of shareholders, duties are not owed to particular shareholders individually. This was held in Percival v Wright [1902] 2 Ch 421 which was a case where directors who purchased shares from an individual shareholder without informing him of a major pending transaction affecting the value of his shares were held not to be in breach of their duty as this was owed to the company as a whole and not to individual shareholders. This decision has prevented individual shareholders from taking action against the board of directors for breach of their duties, because the duties were owed not to particular shareholders, but to the company as a whole. This meant that only the company could take action against the directors. This became known as the ‘rule in Foss v Harbottle’ or ‘the proper plaintiff rule’: see Chapter 19.

The principle that only the company could enforce a breach of the directors’ duties leads to the obvious practical problem that the company only acts on the initiative of the directors, which led to numerous common law exceptions to the rule in Foss v Harbottle (1843) 2 Hare 461;

67 ER 189. These exceptions have now largely become irrelevant as Pt 2F.1A allows actions to be taken in the name of the company using a statutory derivative action if leave is granted by the court under s 237: see Chapter 19.

There are, however, several cases that recognise an exception to the general rule that fiduciary duties are owed to the company and not to individual shareholders.

These exceptions have arisen where the nature of the relationship between particular directors and particular shareholders have been said to be fiduciary in nature so that

[page 440]

fiduciary obligations are owed by those directors to those shareholders. Coleman v Myers [1977] 2 NZLR 225 is an example of such a situation. In that case, the purchase of shares by a director in a closely-held family company (that is, a company with few shareholders) was found to give rise to a fiduciary relationship between the purchaser (director) and the seller (shareholder) because of the trust and reliance elements in their relationship. This decision in New Zealand was followed in Australia in Brunninghausen.

Brunninghausen v Glavanics (1999) 46 NSWLR 538 New South Wales Court of Appeal

Facts: B and G were the shareholders and directors in a family company. However, after a disagreement between them G took no active part in the management of the company until their mother-in-law intervened to make peace. Shortly thereafter, G agreed to sell his shares to B. However, G was not aware that B was negotiating to sell the company to another person for a higher price per share than B was offering G. Thereafter, B sold the business and profited from the higher price to the detriment of G.

Decision: The relationship between B and G was fiduciary in nature because G had been effectively locked out of the company and had no way of verifying the true value of his shares in the company. These elements of vulnerability and control in a small family company give rise to fiduciary obligations on B to provide full disclosure to G regarding the potential sale of the business.

• •

•

15.4

The decisions in Coleman and Brunninghausen may be distinguished with the earlier decision in Percival v Wright [1902] 2 Ch 421 on the basis the purchaser in Percival (the company chair) was not related to the shareholder selling their shares. The special factual relationship between directors and shareholders, a key ingredient giving rise to the exception in Brunninghausen, was absent in that case. In Crawley v Short (2009) 76 ACSR 286; [2009] NSWCA 410 at [122] the court recognised that the special fiduciary relationship between a shareholder and a director can arise in the following circumstances:

one shareholder undertakes to act on behalf of another shareholder; one shareholder is in a position to have special knowledge and knows that another shareholder is relying on her to use that knowledge for the advantage of another shareholder as well as herself; and where the company is in reality a partnership in corporate guise (called a quasi-partnership).

Employees The courts have consistently held that officers do not owe a duty to consider the company’s employees ahead of shareholder interests. In the famous case of Parke v Daily News Ltd [1962] Ch 927, the court found that bonus payments to employees as compensation for their dismissal following a sale of the company’s business was not a proper use of the company’s funds.

[page 441]

Parke v Daily News Ltd [1962] Ch 927 Chancery Division (UK)

The view that directors … are entitled to take into account the interests of its employees, irrespective of any consequential benefit to the company, is one which may be widely held … but no authority to support that [view] as a proposition of law was cited … such is not the law …

15.5

The law does not say there is to be no cakes and ale, but there are to be no cakes and ale except such as are required for the benefit of the company.

[The company may provide extra benefits to employees but only if that delivers a benefit to the company.]

However, in more recent times, the protection of employee entitlements (such as wages) has become a hot topic. The Patrick’s waterfront dispute in the late 1990s (where a company that employed hundreds of workers was stripped of its assets to prevent the workers being paid their full entitlements) and the collapse of Ansett Airlines (where thousands of aviation workers were compensated by the federal government after the Ansett group of companies became insolvent) sparked widespread debate about the protection of employee entitlements such as wages and superannuation. Part 5.8A of the Corporations Act now provides for director liability where they have allowed the company to enter into a transaction designed to defeat worker entitlements.

Nominee directors In the last chapter, we considered the range of different directors and officers, including nominee directors. A nominee director is an example of a director who is appointed by a particular shareholder to represent their interest. Occasionally, a company’s constitution may also provide for the appointment of a director to represent employees. Nominee directors are obliged to act in the best interest of the company that they are serving as directors. This, of course, allows the nominee director to act in the best interest of his or her appointing shareholder, providing that the interests of that shareholder do not conflict with the best interests of the company.

Re Broadcasting Station 2GB Pty Ltd [1964–1965] NSWR 1648 New South Wales Supreme Court

Facts: This case concerned the legality of the actions of several nominee directors who had been appointed by the company’s majority shareholder. The claim was based on minority oppression (see

15.6

Chapter 19) and alleged that the directors had failed to act in the best interests of the company because they acted only in consideration of the majority shareholder’s interests.

Issue: Did the directors breach their duty to act in the best interests of the company? Decision: The directors had not breached their duty because their actions were not done against the interest of the company. The court said that the directors’ conduct would have been in breach of duty had it been proven that the directors would have acted for the nominee even if that would have harmed the company’s interest. In subsequent cases the courts have stressed that directors need to consider the interests of the company separately to any other interests. Clearly, the interests of the company must remain paramount.

[page 442]

Corporate groups

subsidiary: this is defined in s 46 of the Corporations Act

Modern corporations often use subsidiaries (particularly subsidiaries which are ‘wholly owned’ by a corporate shareholder) to promote the interests of the overall group, rather than to promote the interests of the subsidiary.2 Directors of companies that are part of larger corporate groups are placed in a particularly difficult position. The High Court’s decision in Walker v Wimborne (1976) 137 CLR 1 at 6, discussed earlier in Chapter 5, requires directors of subsidiary companies to act in the best interests of those companies, and not merely for the benefit of the larger corporate group. However, it will often be the case that actions done to benefit the corporate group will also provide a benefit for the subsidiary (albeit often an indirect benefit).

It is common for directors of subsidiary companies to consider the interests of the parent company when making decisions for the subsidiary. In the leading decision of Charterbridge Corp Ltd v Lloyds Bank Ltd [1970] Ch 62 at 74, the court held that where there is no evidence of actual consideration of the subsidiary’s interests, the directors may be found to have acted properly provided that:

… an intelligent and honest man in the position of a director of the company concerned, could, in the whole of the existing circumstances, have reasonably believed that the transaction was for the benefit of the company.

•

• •

•

15.7

The Charterbridge test has been applied on numerous occasions: see recently, Mernda Developments Pty Ltd (in liq) v Alamanda Property Investments No 2 Pty Ltd (2011) 86 ACSR 277; [2011] VSCA 392; Linton v Telnet Pty Ltd (1999) 30 ACSR 465; [1999] NSWSCA 33. However, there are some authorities that cast doubt on its use: Equiticorp Finance Ltd (in liq) v Bank of New Zealand (1993) 11 ACSR 642 (NSWCA); Westpac Banking Corp v The Bell Group Ltd (No 3) (2012) 89 ACSR 1; [2012] WASCA 157 at [1012] per Lee AJA.

Section 187 provides that directors of ‘wholly-owned’ subsidiaries may act in the best interests of the holding company (that is, the company that owns all of the shares in the subsidiary) provided that:

the subsidiary’s constitution expressly authorises the directors to act in the interests of the holding company; the director acts in good faith; the director in fact acts in the best interests of the holding company; and the subsidiary remains solvent.

Creditors Ordinarily, a company’s creditors may not seek payment from the directors of the debtor company for reasons discussed earlier in Chapter 5 with reference to Salomon’s case. A company, after all, is a separate legal entity with the rights and powers of a real person: s 124. Therefore, this includes the right to borrow money and be sued for its repayment by a creditor.

[page 443]

However, the notion of benefiting ‘the company as a whole’ has at various times been found to include an obligation upon the directors to take into account the interests of creditors in specific circumstances, namely, insolvency: see Kinsela below. The view that directors could owe duties to consider the creditors’ interest, gained momentum when Mason J said in the High Court decision in Walker v Wimborne (1976) 137 CLR 1 at 6–7 that:

… it should be emphasised that the directors of a company in discharging their duty to the company must take account of the interest of its shareholders and its creditors. Any failure by the directors to take into account the interests of creditors will have adverse consequences for the company as well as for them.

However, 24 years later the High Court decision in Spies v R (2000) 201 CLR 603; [2000] HCA 43 made it clear that this statement did not provide creditors with an independently enforceable duty against directors.3 To demonstrate this, the court quoted the following passage from Re New World Alliance Pty Ltd (1994) 122 ALR 531 at 550:

Where a company is insolvent or nearing insolvency, the creditors are to be seen as having a direct interest in the company and that interest cannot be overridden by the shareholders. This restriction does not, in the absence of any conferral of such a right by statute, confer upon creditors any general law right against former directors of the company to recover losses suffered by those creditors … the result is that there is a duty of imperfect obligation owed to creditors, one which the creditors cannot enforce save to the extent that the company acts on its own motion or through a liquidator.

Thus, outside of situations involving insolvent trading (where creditors are given the statutory power to pursue the directors for repayment of debts) directors’ duties are owed to the company and not to the creditors. One result of directors’ duties not being owed directly to creditors is that, at general law, creditors cannot enforce a breach of those duties (because the duties are owed to the company not the creditors).

However, (as Mason J also said in Walker v Wimborne) the directors should take into account the creditors’ interests as the creditors often provide the financial support vital for the company’s success. Thus, the duty on directors to consider creditor interests arises when the company is insolvent or approaching insolvency, as demonstrated in the decision in Kinsela v Russell Kinsela Pty Ltd (in liq) (1986) 4 NSWLR 722. In that case, the New South Wales Court of Appeal stated that ‘the directors’ duty to a company as a whole extends in an insolvency context to not prejudicing the interests of creditors’.4 The only time when it can be said that directors owe duties directly to creditors is when the company is insolvent, in which case the creditors may recover their debts directly, in certain circumstances, from the directors for insolvent trading on the basis of the statutory provision in s 588G: see Chapter 18. This is not because the directors have contravened the general law obligation to act in the company’s interests (with the creditors making up the company’s interests during times of insolvency) but rather because a statutory

regime (Pt 5.7B Div 3) makes directors personally liable to creditors for insolvent trading.

[page 444]

In Bell Group Ltd (in liq) v Westpac Banking Corp (2008) 70 ACSR 1 at [4422] Owen J explained the law in this way:

… the creditors are entitled to have their interests considered within (and not in addition to) the confines of the duty of the directors to act in the interests of the company.

Thus, upon insolvency the value of the shareholder’s equity falls to zero, and the concept of the directors coming under a duty to act in the ‘interests of the company as a whole’ changes from a focus on the shareholders’ interest in the residuary to the interests of the creditors.

The Bell Group case involved a successful claim that the directors knew that corporate restructuring transactions (mainly concerned with repaying bank debts) would cause detriment to the company’s other unsecured creditors at a time when the company was insolvent (and therefore the ‘interests of the company’ focused attention on creditors’ interests).

The decision of Owen J in the Bell Group case was subject to a partially successful appeal: Westpac Banking Corp v Bell Group Ltd (No 3) (2012) 89 ACSR 1; [2012] WASCA 157. Unfortunately, the issue of whether, and to what extent, directors owed a duty to consider creditor interests was not dealt with uniformly on appeal. There were statements, however, by some members of the Court of Appeal that suggested that directors owed a duty to ‘protect’ creditor interests upon insolvency. Acting Justice Drummond stated (at [2031]): ‘Directors in discharging their fiduciary duties to their company must, if the company is sufficiently financially distressed, have regard and give proper effect to the interests of creditors.’ His Honour further stated (at [2042]) that directors will breach their duty to the company by acting in circumstances where they know that creditors will be prejudiced, even if they have subjectively considered what is in the best interests of the company (including the various stakeholders such as creditors and members).5

This would seem to be an expansion of the nature of the duty, at least as was understood prior to the appeal decision. At the time of writing the appeal decision was subject to a High Court appeal. We await the decision of the High Court, which hopefully will clarify the issue more than 35 years since Mason J’s comments in Walker v Wimborne (above) started the controversy.

Another illustration of this duty is provided in ASIC v Sydney Investment House Equities Pty Ltd (2008) 69 ACSR 1; [2008] NSWSC 1224 where a company director was found to be in breach of his duties under s 181 (as well as s 180) for allowing the company to loan money to another company in the group when he should have known that both companies were insolvent and the interests of the company’s creditors would be prejudiced by the loans. See also ASIC v Somerville (2009) 74 ACSR 89; [2009] NSWSC 934 where directors engaged in phoenix company activity by stripping assets out of insolvent companies and transferring them into new companies set up with similar names. The directors were found to have contravened s 181 of the Corporations Act by failing to consider the interests of creditors of the previous companies when they transferred the assets.

[page 445]

Kinsela v Russell Kinsela Pty Ltd (in liq) (1986) 4 NSWLR 722 New South Wales Court of Appeal

Facts: The Kinsela family operated a funeral business through a company. The company held insurance to cover the cost of funeral services. When a new statute regulating such insurance was introduced, the Kinsela family became concerned about their business being adversely affected due to its precarious financial position. The family company, thereafter, signed a lease with the husband and wife (who were also directors and shareholders in the family company) to rent business premises at a price substantially lower than market value. This occurred at a time when the company was clearly insolvent. A shareholders’ meeting, consisting of the family members, ratified the transaction.

After the company was put into liquidation, the liquidator challenged the transfer of the lease on the basis that the directors had breached their fiduciary duties in failing to consider creditor interests when transferring the lease to themselves at undervalue.

•

15.8

Issue: Did the directors breach their duties to the company by engaging in an uncommercial transaction that disadvantaged the company’s creditors? Could there be a breach of duty here even though the company’s shareholders approved of the transaction?

Decision: The directors acted in breach of their duties and could not as shareholders approve of their own conduct due to the detriment it caused to creditors. Therefore the shareholders could not approve of the directors’ conduct that caused detriment to the creditors. As the company approaches liquidation, the company’s assets are ‘in a practical sense [the creditors’] assets and not the shareholders’ assets that, through the medium of the company, are under the management of the directors’: at NSWLR 730 per Street CJ. His Honour then stated (at NSWLR 733): ‘the directors’ duty to a company as a whole extends in an insolvency context to not prejudicing the interests of creditors’.

Significance: This decision is significant for two reasons. First, it recognises that as the company enters insolvency, the primary beneficiaries of directors’ duties change from the shareholders as a whole, to that of the creditors as a whole. As subsequently made clear from the Spies case, this duty is a limited duty which applies only in insolvency situations. Second, it shows that the fiduciary duty to consider creditor interests during insolvency cannot be relaxed or removed by the shareholders. This limitation illustrates the ‘fraud on the minority’ concept which is discussed further in Chapter 19 in the context of the limits to shareholder ratification.

Should directors and other officers owe a duty to protect creditor interests? How would such a duty relate with the statutory duty to prevent insolvent trading?

Corporate social responsibility The critical issue as to whom the duties are owed raises several questions regarding the company’s relationship with other key stakeholders such as employees, creditors and individual shareholders. Should duties be owed to such a wider class of corporate stakeholders? The following case study raises these wider issues.

James Hardie Ltd

Few companies in Australia have generated as much adverse corporate law publicity as James Hardie Ltd (which has changed its name to James Hardie Industries NV after registering in the Netherlands and then to James Hardie Industries SE when it subsequently moved to Ireland). James Hardie is a company that produced and distributed asbestos

[page 446]

products (primarily building products) for most of the twentieth century. Exposure to asbestos fibres has been linked to lung cancer and other various respiratory illnesses, which has resulted in thousands of negligence and product liability cases against James Hardie and other former asbestos producers (such as CSR). It is widely accepted that claims arising out of exposure to asbestos products will continue to increase in the coming decades, with some estimates expecting in excess of 200,000 new cases of asbestos-related illness to develop over the next 20 years. James Hardie therefore has a known exposure to asbestos litigation that will only increase in the future.

In the late 1990s, the board of directors of James Hardie decided to reorganise the corporate group. This resulted in the asset-rich companies in the group being relocated to the Netherlands (which offers favourable tax advantages but also does not recognise Australian court decisions, which would prevent any liability imposed in Australia being enforced in the Netherlands) and the companies with asbestos-related liability remained in Australia. The remaining Australian companies were given several hundred million dollars to establish a medical research and compensation foundation to pay compensation claims arising from asbestos-related liabilities of James Hardie companies. The foundation’s funds were inadequate to meet the claims of asbestos sufferers who used or worked with James Hardie products.

After much public debate about the propriety of James Hardie’s restructure, the New South Wales Government established a Special Commission of Inquiry to investigate the matter. The Commission’s report was critical of the accuracy of various statements made by senior officers of James Hardie and of media releases made by the company, but did not find any breach of directors’ duties. ASIC subsequently commenced action against 10 former directors and officers of James Hardie companies in respect of alleged breaches of statutory directors’ duties.

The James Hardie restructure has generated considerable public outrage relating to the actions of Hardie’s company directors adopting a policy to deliberately minimise the company’s exposure to asbestos liabilities, and thereby deny compensation to potentially hundreds of thousands of asbestos victims. James Hardie’s board of directors have consistently justified their conduct on the basis that the restructure maximises the interests of shareholders. Community activists (such as victim support groups and the union movement) have argued that the restructure is morally reprehensible because it denies victims their legal entitlements to compensation. This demonstrates the tension between promoting the interests of shareholders in maximising profits and the interests of other stakeholders such as tort victims and creditors.

Since the completion of the Special Commission of Inquiry, James Hardie has agreed to pay additional funds to the research and compensation fund to ensure that victims are compensated. James Hardie has also since moved its corporate headquarters from the Netherlands to Ireland.

In April 2009, the New South Wales Supreme Court found that 10 former directors and officers of James Hardie were in breach of their duty of care and diligence under s 180(1) for allowing the company to issue an ASX release that was misleading or deceptive because it suggested that the medical research and compensation foundation was ‘fully funded’ and could meet all future claims. Pecuniary penalties and banning orders were imposed (although these were subsequently reduced by the New South Wales Court of Appeal when the litigation finally ended in late 2012: Gillfillan v ASIC (2012) 92 ACSR 460; [2012] NSWCA 370). The case has been up to the High Court of Australia and was finally resolved in 2012, more than 10 years after the company’s restructure. The James Hardie litigation is discussed in detail in Chapter 17. The James Hardie restructure demonstrates the obvious tension between the legal obligations of company directors (which are owed to the company and its shareholders) and the community expectations of corporations to provide compensation to victims harmed by corporate malfeasance.

•

15.9

[page 447]

Should directors be permitted to disregard community interests in favour of promoting shareholder wealth?

Fiduciary duties

Overview The relationship between directors and their company is classified by the law as a ‘fiduciary relationship’: Hospital Products Ltd v United States Surgical Corporation (1984) 156 CLR 41. The law of fiduciary relationships is derived from equitable principles and is based upon imposing restrictions on those people in a position of power over others who may be vulnerable to harm through the exercise of that power. Directors and other officers owe a fiduciary duty to the company because they control the company and make decisions for the company. The company is therefore vulnerable to their actions and relies on the directors and officers to act properly. It is mainly for such reasons that fiduciaries are subject to higher standards of behaviour than other parties acting at arm’s length.

Howard v Commissioner of Taxation (2014) 253 CLR 83; [2014] HCA 21 at [31], [34] High Court of Australia

The relationship of director and company is one of a class of accepted relationships which attract proscriptive fiduciary duties, including a duty ‘not to obtain any unauthorised benefit from the relationship and not to be in a position of conflict’. Those proscriptive duties attach to the powers and discretions exercised by company directors. As fiduciary agents, directors must exercise their powers

1. 2. 3. 4.

‘honestly in furtherance of the purposes for which they are given’ and not for their personal benefit or gain or for that of a third party.

Despite their broad judicial formulations fiduciary duties are not infinitely extensible. That point was made in Chan v Zacharia, which concerned the content of the fiduciary duties of members of a partnership inter se. The limits of those duties were to be determined by the character of the venture for which the partnership existed, the express agreement of the parties and the course of dealings actually pursued by the firm … [the scope of the fiduciary relationship] is to be ‘moulded according to the nature of the relationship and the facts of the case’.

As a fiduciary, there are four central obligations governing corporate behaviour:

to act in good faith, in the best interests of the company; to act for a proper purpose; to avoid conflicts of interest; and not to make a secret profit.

The first two of these duties are considered in this chapter. The remaining duties, dealing with the ‘conflict’ rule and the ‘profit rule’ are considered in the next chapter. These duties are split up in this way in the book for the sake of convenience. It is important to note that particular conduct may, depending on the facts of each case, involve a breach of all four aspects of directors’ fiduciary duties.

[page 448]

A director of Company A, who causes the company to enter into a transaction with his family company (Company B) at an inflated price without giving full disclosure of that fact to the company, may be said to be acting not in the best interests of Company A, but rather to benefit his family company (Company B). The director may also be said to be exercising his powers for an improper purpose (that is, the purpose of benefiting his family company). That improper purpose also gives rise to a conflict of interest by placing his personal interest ahead of the interests of Company A. The secret profit his family company (Company B) is making at the expense of Company A forms the basis of the conflict and breach of fiduciary duty.

These facts resemble the case of Groeneveld Australia Pty Ltd v Wouter Nolten (No 3) (2010) 80 ACSR 562; [2010] VSC 533 (a managing director leased office space to the company without disclosure or consent).

constructive trustee: a legal remedy imposed by a court which makes a defaulting fiduciary hold property obtained through a breach of duty on trust for the benefit of the principal (in this case the company).

All officers must avoid breaches of these equitable fiduciary duties, and a breach may result in the officer holding property obtained through a breach of duty as a trustee under a constructive trustee (on behalf of the company). Alternatively, the officer may be liable to pay equitable damages or the company may rescind any contract that was improperly made by the officer. In addition to these equitable remedies, officers may also be liable for civil or criminal penalties under the Corporations Act because these equitable duties are largely reproduced in ss 181–183. The remedies for breach of duty are further considered below.

Each of the above categories of fiduciary duty will be considered by examining the fiduciary duties first at general law and then the statutory equivalent duties. It should be noted that, generally speaking, the legal principles that have arisen at general law (dealing with fiduciary duties) apply to the interpretation of the equivalent statutory duties. Thus, in seeking understand what the Corporations Act means when it refers to ‘acting for a proper purpose’ in s 181(b), it is necessary to examine fiduciary duty cases at general law on the proper purpose rule.

ASIC v Adler (2002) 41 ACSR 72; [2002] NSWSC 171 is the leading modern decision concerning breach of fiduciary duties and will be used as a key case for discussing these duties.

ASIC v Adler (2002) 41 ACSR 72; [2002] NSWC 171 New South Wales Supreme Court

Facts: Adler obtained an unsecured loan from HIH (a company of which he was both a director and shareholder) to purchase shares in a company in which he was involved, which the court held was in breach of his statutory duties. Adler also used some of the funds to buy more shares in HIH in the hope of increasing the share price. ASIC alleged that Adler and Williams (the founder and CEO of HIH) had breached the statutory equivalent of their fiduciary duties owed to HIH (that is, ss 181–182). The facts comprising the allegations of breach of fiduciary duty included:

Adler: Acted for an improper purpose by attempting to gain an advantage for himself by obtaining the unsecured loan from HIH to purchase shares in a company that he was

involved in. Furthermore, Adler acted improperly by seeking to obtain a benefit from the loan by using part of the loan funds to purchase HIH shares on the stock market.

[page 449]

Williams: Sought to use his senior position in HIH in order to benefit Adler and himself through the increased share price of HIH that would be achieved when Adler used part of the loan funds to purchase HIH shares on the stock market.

ASIC also claimed that the HIH Finance Director (Fodera) breached his fiduciary duties by facilitating the transaction.

Significance: This case considers the range of fiduciary breaches including conflicts of interests (the conflict between the interests of HIH and the personal benefits sought by Adler and Williams), making a secret profit (Adler and Williams deliberately sought to avoid proper HIH internal processes to avoid detection of their activities) and acting for an improper purpose (Adler was only motivated by trying to advantage himself at the detriment of HIH).

The Adler case will be referred to in greater detail under each of the categories of fiduciary duty, discussed below.

15.10

Duty to act in good faith and in the company’s best interests

All fiduciaries (including company directors) have an obligation to act in good faith and in the best interests of their principal (for directors and officers, the principal is the company). The meaning of the term ‘in the best interests’ of the company

[page 450]

involves a consideration of ‘who’ the company is for the purposes of the law. At the start of this chapter, it was noted that directors owe their duties to the company as a whole, and that this phrase generally refers to the body of shareholders, rather than specific shareholders, and not creditors6 or employees. Thus, it may be said that the fiduciary duty to act in the company’s best interests is a general obligation to act in the interests of its members, at least when the company is solvent. This is also known as the shareholder primacy rule. In acting in the interests of the company, ordinarily, shareholders will also benefit through increased profitability, dividends and capital gains.

The requirement to act in ‘good faith’ is a common element of corporate regulation7 and is generally taken to refer to an obligation to act honestly. To put it another way, directors have an obligation to use their powers honestly to benefit the company and not for some other ulterior purpose (such as obtaining a private benefit). There is clearly an overlap between this duty and the proper purpose rule (discussed below), so that acting for an improper purpose (that is, to gain a private benefit) may also constitute a failure to act in good faith in the interests of the company as a whole. For example, a director who acts solely to benefit themselves will not be acting for a proper purpose nor will they be acting in good faith in the best interests of the company. Both of these elements are found in s 181(1), which was considered by Black J in Colorado Products Pty Ltd (in prov liq) (2014) 101 ACSR 233; [2014] NSWSC 789 at [420]:

[Section 181] may be contravened if a director promotes his or her personal interest in a

•

situation where there is a conflict or real or substantial possibility of a conflict between those interests and the company’s interests …

It has been held that one difference between the duty to act in good faith and the duty to act for a proper purpose is that the former is based on a subjective analysis (and is concerned with whether the director actually acted honestly) while the latter is concerned with an objective analysis (that is, was the conduct carried out for proper purpose?): see the discussion in Westpac Banking Corp v Bell Group Ltd (No 3) (2012) 89 ACSR 1; [2012] WASCA 157 at [1979]–[1988] per Drummond AJA.8

However, it should not be assumed that the honest director will necessarily be able to avoid liability simply by believing that what they were doing was for the benefit of the company. Far from it, both the law of fiduciary obligations and its statutory equivalents in ss 181–183 of the Corporations Act contain rules that may be breached even by honest and well-intentioned directors. As stated by Bowen LJ in Hutton v West Cork Railway Co (1883) 23 Ch D 654 at 671:

bona fides: a Latin term which means to act in good faith.

Bona fides cannot be the sole test, otherwise you might have a lunatic conducting the affairs of the company, and paying away its money with both hands in a manner perfectly bona fide yet perfectly irrational.

[page 451]

Should directors have a simple defence of acting honestly in the best interests of the corporation? Discuss the advantages and disadvantages of such a defence.

The test seems to have both subjective and objective elements. Where the directors actually believe that they are harming the interests of the company, clearly they would breach their duty to act in good faith. Where they subjectively believe that they are acting in the best interests of the company, the court will not substitute its view of the commercial value of

15.11

the transaction to the company for that of the directors. Rather, the courts look for objective evidence that the directors actually held the belief that they were trying to benefit the company. For example, a director may subjectively believe that transferring the company’s assets to themselves during a hostile takeover will benefit the company by defeating the takeover. Such views would not prevent a court from seeking objective evidence that the directors acted in such a manner so as to benefit the company. It may also be easier to simply bypass the subjective element by suggesting that such conduct is in fact a failure to act for a proper purpose (discussed below).

Proper purpose rule Despite the extensive powers given to directors, for example, under the replaceable rule in s 198A dealing with management, they do not have unlimited power.

As part of their fiduciary duty, directors must exercise their powers for a proper purpose. The proper purpose rule can be traced to the historical principle of fraud on a power as stated in the High Court case of Mills v Mills (1938) 60 CLR 150: see further 20.21. The general rule is that directors, as fiduciary agents of the company, are required to exercise their powers only for the benefit of the company. Any use of power by directors that is not undertaken for the benefit of the company is an improper use of that power and therefore a breach of fiduciary duty.

An exercise of power that is designed to secure some private advantage for the director is considered to be an improper purpose because it is outside of the purpose of benefiting the company: Mills v Mills (1938) 60 CLR 150 at 185 per Dixon J.

Mills v Mills (1938) 60 CLR 150 High Court of Australia

Facts: The directors of Charles Mills (Uardry) Ltd passed a resolution which increased the voting power of the managing director by providing the company’s dividend distribution to be by way of

bonus shares to ordinary shareholders (which included primarily the managing director). The minority director (who held only preference shares with triple voting rights) challenged the validity of the resolution on various grounds including on the basis that the majority directors did not act bona fide in the best interests of the company.

Issue: Could the resolution be changed on the basis that the majority directors breached their duty to act bona fide in the best interests of the company?

Decision: The court found that the resolution was made bona fide in the best interests of the company despite the fact that the directors received a benefit under the transaction. Latham CJ considered the issue of when directors may act in a manner that benefits themselves (at 163):

[page 452]

… it is generally desired by shareholders that directors should have a substantial interest in the company so that their interests may be identified with those of the shareholders of the company. Ordinarily, therefore, in promoting the interests of the company, a director will also promote his own interests. [Directors are not] prohibited from acting in any matter where their own interests are affected by what they do in their capacity as directors. Very many actions of directors who are shareholders, perhaps all of them, have a direct or indirect relation to their own interests. It would be ignoring realities and creating impossibilities in the administration of companies to require that directors should not advert to or consider in any way the effect of a particular decision upon their own interests as shareholders. A rule which laid down such a principle would paralyse the management of companies in many directions.

Therefore, Latham CJ found that directors will not necessarily breach their duties if they act in a manner that benefits a class of shareholders in which they themselves are shareholders.

Significance: This case makes it clear that engaging in conduct that will benefit the directors (who happen to be shareholders) does not mean, on its own, that the directors acted for an improper purpose.

The court will undertake a two-step process to decide whether a director has used a power for an improper purpose:

Determining what the purpose of the power is (that is, why does the power exist?).

This process will also disclose, by implication, what purposes the power may not be used for. This step is essentially a question of identifying the legal scope of the power.

Deciding (as a matter of fact) what purpose the director had for exercising the power and whether that purpose is within the range of permissible purposes.

This two-step analysis was proposed in Howard Smith Ltd v Ampol

15.12

Petroleum Ltd [1974] AC 821 (a case concerning the power to issue shares to facilitate a friendly takeover bidder). Assistance in applying this two- step test can be gained from Ipp J’s comments in Permanent Building Society (in liq) v Wheeler (1994) 14 ACSR 109 at 137, where his Honour summarised the law in this area:

Fiduciary powers granted to directors are to be exercised for the purpose for which they were given, not collateral purposes. It must be shown that the substantial purpose of directors was improper or collateral to their duties as a director. The issue is not whether business decisions were good or bad; it is whether directors have acted in breach of their fiduciary duties. Honest or altruistic behaviour does not prevent a finding of improper conduct. Whether acts were performed for the benefit of the company is to be objectively determined (that is, a proper purpose being a purpose to benefit the company).9 However, evidence as to the subjective intentions or beliefs is nevertheless relevant. The court must determine whether, but for the improper or collateral purpose, the directors would have performed the act in dispute.

[page 453]

Mixed purposes In many cases of alleged improper actions by the board, it may be said that there are a range of possible purposes that could have motivated the board to act in that manner. The decision in Mills v Mills clearly stated that the board may only exercise their powers for the purpose for which those powers exist. However, Mills also made it clear that the mere possibility of an improper purpose (that is, a purpose that the power was not created for such as to secure a personal benefit for the directors) does not render the exercise of power improper.

The real question is what actually motivated the exercise of power. Dixon J in Mills v Mills used an approach known as the ‘but for’ test. This approach asks whether the power would still have been exercised if the improper purpose did not exist.

15.13

To put it another way, if the directors were not going to receive a benefit, would they still have acted the same way? If the answer is yes, then the motivation is not improper (because the directors still would have acted in the same way even if they had not received a benefit). If the answer is no, then the directors are really motivated by the improper purpose resulting in a breach of duty.

The court will use evidence of the surrounding circumstances, such as minutes of board meetings and internal corporate communications, to assist in objectively determining the actual purpose of the directors. The ‘but for’ test was described as follows in the leading case in Whitehouse v Carlton Hotel Pty Ltd.

Whitehouse v Carlton Hotel Pty Ltd (1987) 162 CLR 285 High Court of Australia

… regardless of whether the impermissible purpose was the dominant one or but one of a number of significantly contributing causes, the [share] allotment will be invalidated if the impermissible purpose was causative in the sense that, but for its presence, ‘the power would not have been exercised’.

In ASIC v Drake (No 2) (2016) 118 ACSR 189; [2016] FCA 1552 at [498], Edelman J (who has since been appointed to the High Court) questioned whether the ‘but for’ test was relevant for assessing breach of s 181, but in that case these comments were mere obiter as the parties accepted that it was.

Share issues The area where legal disputes relating to alleged improper purposes arise most often concerns the exercise of the power of directors to issue shares. Companies are given the specific power to issue shares under s 124, with directors given the power to manage the company’s affairs under s 198A. Therefore, directors have the right to issue the company’s shares. Given the power of voting attached to most shares, there is the potential for the power to issue shares to be used by directors to

• •

•

manipulate control of the company.

[page 454]

Ngurli Ltd v McCann (1953) 90 CLR 425 High Court of Australia

The power must be used bona fide for the purpose for which it was conferred, that is to say, to raise sufficient capital for the benefit of the company as a whole. It must not be used under the cloak of such a purpose for the real purpose of benefiting some shareholders or their friends at the expense of other shareholders or so that some shareholders or their friends will wrest control of the company from the other shareholders.

The directors of a company cannot ordinarily exercise a fiduciary power to allot shares for the purpose of defeating the voting power of existing shareholders by creating a new majority.

The power to issue shares has often created problems where the directors attempt to use that power to manipulate the voting power by issuing more shares to retain control over voting at a members’ meeting. The Whitehouse case is a classic example of this occurrence.

Whitehouse v Carlton Hotel Pty Ltd (1987) 70 ALR 251 High Court of Australia

Facts: The Carlton Hotel company was owned by the Whitehouse family. Mr Whitehouse was the ‘governing director’, which meant that he had control over the management of the company. Control over the voting in the company was achieved by maintaining three classes of shares:

Class A shares — held by Mr Whitehouse and had unrestricted voting powers. Class B shares — held by Mrs Whitehouse, and only permitted voting after the death of Mr Whitehouse. Class C shares — held by the children of Mr and Mrs Whitehouse, which provided profit sharing but no voting rights.

After Mr and Mrs Whitehouse divorced, Mr Whitehouse issued Class B shares to his two sons (who sided with him, while his daughters sided with Mrs Whitehouse). This was done to attempt to ensure that his sons maintained control over the company after he died. Mr Whitehouse subsequently fell out

• – –

– –

• – – –

–

with his sons and directed the company to challenge the share issue as being for an improper purpose (that is, Whitehouse used the company to challenge the share issue that he himself made).

Issue: Was the share issue invalid as being for an improper purpose? Decision: The share issue was invalid because Mr Whitehouse’s purpose in issuing the shares was to dilute the control of the company away from his wife and daughters after his death. It was not a proper purpose to issue shares for the purpose of manipulating control.

As Mason, Deane and Dawson JJ said (at 254):

The reason why … it is impermissible for the directors of a company to exercise a fiduciary power to allot shares for the purpose of destroying or creating a majority of voting power … [lies in the fact that] it is simply no part of the function of the directors as such to favour one shareholder or group of shareholders by exercising a fiduciary power to allot shares for the purpose of diluting the voting power attaching to the issued shares held by some other shareholder or group of shareholders.

Significance: This case demonstrates that the power to issue shares may not be used to manipulate control of the company’s voting rights.

[page 455]

There are a number of significant cases concerning share allotments. Those cases demonstrate the following:

Proper uses of the power of allotment include: to raise capital (Ngurli v McCann (1953) 90 CLR 425); to foster business connections (Harlowe’s Nominees Pty Ltd v Woodside (Lake Entrance) Oil Co (1968) 121 CLR 483); for an employee share scheme; and as consideration for the purchase of an asset (Winthrop Investments Ltd v Winns Ltd (No 2) (1979) 4 ACLR 1).

Improper purposes may include: to entrench the existing board of directors (Whitehouse v Carlton); to fight off a hostile takeover bidder (Howard Smith); to discriminate against particular shareholders or classes of shareholders (Mills v Mills); to reconfigure the majority shareholdings in the company (Howard Smith); and to issue shares as part of a remuneration scheme which the director knows he or she is not entitled to (Groeneveld Australia Pty Ltd v Wouter Nolten (No 3) (2010) 80 ACSR 562; [2010] VSC 533).

Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821 is a key case concerning the issue of shares for an improper purpose.

Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821 Privy Council (UK)

Facts: This case involved the takeover contest for a company called Miller. Howard Smith and Ampol were competing to take complete control of Miller. Ampol and its associate owned approximately 55% of the shares in Miller. The directors of Miller wished to attract a higher bidder and so they issued shares to Howard Smith on the basis that Howard Smith would offer more for the company than Ampol. The effect of the share issue was to dilute Miller’s share capital so as to turn Ampol’s majority shareholding in Miller into a minority interest and thus make Howard Smith’s bid more likely to succeed. Ampol sought a declaration from the court that the share issue was undertaken for an improper purpose.

Issue: Were Miller’s directors acting for a proper purpose when they issued shares to assist with Howard Smith’s takeover?

Decision: The shares were issued for an improper purpose because it was primarily engaged in to dilute the majority shareholdings.

Significance: This case provides a further demonstration that the power to issue shares must not be used to manipulate control of the company’s voting rights. The case is significant as it provides the two step-test for assessing whether a particular exercise of power is proper or improper.

The result in Howard Smith may be contrasted with an earlier case in Harlowe’s Nominees.

[page 456]

Harlowe’s Nominees Pty Ltd v Woodside (Lake Entrance) Oil Co (1968) 121 CLR 483 High Court of Australia

Facts: Woodside entered into a lucrative joint venture with another company and sought to further consolidate that business relationship by issuing shares to that other company. Harlowe’s (a

15.14

15.15

substantial shareholder in Woodside) sought a declaration from the court that the share issue was not for a proper purpose on the basis that Woodside did not require further capital.

Decision: The shares were issued for a proper purpose. The court stated that:

… although primarily the power is given to enable capital to be raised when required for the purposes of the company, there may be occasions when the directors may fairly and properly issue shares for other reasons, so long as those reasons relate to a purpose of benefiting the company as a whole, as distinguished from a purpose, for example, of maintaining control of the company in the hands of the directors themselves or their friends

The share issue provided Woodside with greater financial flexibility to enable better planning for future undertakings. Such financial stability made a continuing commercial with its joint venture partner more likely.

It should be noted that cases such as Howard Smith and Harlowe’s Nominees would be dealt with differently today in Australia as takeover contests are regulated by the Takeovers Panel rather than through the courts: see Corporations Act Ch 6.

Managing conflicting interests between classes of securities In Mills v Mills (1938) 60 CLR 150, Latham CJ pointed out that in situations where a company has different classes of securities (such as both ordinary and preference shares), actions by directors have the real potential to cause conflict between the different classes, so that any action by the board will necessarily cause detriment to one of the classes. In that scenario, the High Court found that the duty of company directors is to act in a manner that does not unreasonably discriminate against one particular class of securities. As Latham CJ stated (at 164): ‘the question which arises is sometimes not a question of the interests of the company at all, but a question of what is fair as between different classes of shareholders.’

Statutory duties under the Corporations Act The general law duty of good faith and the duty to use powers for a proper use are reinforced under s 181, as demonstrated in the diagram below.

[page 457]

15.16

Statutory duty of good faith and proper purposes (s 181) The duty under s 181 requires all directors to exercise their duties and powers in good faith for the best interests of the company and for a proper purpose. Although these duties are expressed as two separate tests, there may be overlap in certain cases (for example, the exercise of a power to benefit the directors rather than the company will breach both limbs as it is not in good faith and not for a proper purpose). Section 181 may be enforced either by the company or by ASIC.

The principles that apply under this section are the same as those that apply under fiduciary duties in equity, discussed earlier. Thus, the requirements of good faith, in the best interests of the company and to act for a proper

purpose are defined by reference to the fiduciary duty cases discussed above.

However, a significant difference between the statutory duty and its fiduciary equivalents lies in the consequences for breach. A breach of this section is a civil penalty provision. The severity of the penalty will depend upon whether there was any intention to deceive or defraud the company, members or creditors. If there is an attempt to be reckless or intentionally dishonest, a separate criminal offence may be committed under s 184(1).

[page 458]

It should be noted that the duty under s 181 is not breached merely because a director is acting in their position at a time when the company contravenes the law. As Brereton J stated in ASIC v Maxwell (2006) 59 ACSR 373; [2006] NSWSC 1052 at [106]:

This duty is imposed not to secure compliance with the various requirements of the Corporations Act, but, as it was at general law, to prevent abuses of directors’ powers for their own or collateral purposes.

His Honour went on (at [109]) to narrow the scope of s 181 to deliberate breaches of law: ‘In my opinion, s 181 is contravened only where a director engages deliberately in conduct, knowing that it is not in the interests of the company.’

More recently, the knowledge requirement has been qualified in a manner consistent with the general law position discussed above (see the comments of Ipp J in Wheeler noted above). Hamilton J in ASIC v Sydney Investment House Equities Pty Ltd (2008) 69 ACSR 1; [2008] NSWSC 1224 at [43] said:

… consciousness in this sense means knowledge of the facts that make the conduct not in the best interests of the company; it is not necessary to establish knowledge that the conduct constituted a breach of the law or was improper.

Clearly, merely acting in a negligent manner by failing to protect the company’s interest is not (as shown by Maxwell and Sydney Investment House Equities) proof of acting in bad faith or acting improperly. Some

15.17

positive knowledge by the defendant director, objectively assessed, is required that will amount to an awareness that their conduct is not in the best interests of the company. In ASIC v Flugge [2016] VSC 779 at [1965]– [1991] the court applied both an objective and subjective test to the conduct.

Civil remedies at general law A breach of the fiduciary duties will allow the company (not ASIC), at general law, to sue the directors for equitable compensation, rescission of contract, an account of profits, a constructive trust or an injunction. These remedies are discussed below.

ASIC v Adler (2002) 41 ACSR 72; [2002] NSWSC 171 New South Wales Supreme Court

Facts: The facts of the Adler case were outlined above at 15.9. Issue: Did Adler, Williams and Fodera’s conduct in facilitating the $10 million loan contravene s 181? Decision: Adler’s conduct was in breach of his duties under s 181. The purpose of the loan was to allow Adler and entities associated with him to purchase shares in HIH so as to prop up the share price. The purpose of this transaction was not to benefit HIH (on the contrary, the company suffered a loss of $10 million) but rather to confer a private benefit on himself, which was an improper purpose and a failure to act in good faith in the best interests of HIH. Adler, through his family company Adler Corporation, made a profit by selling its shares in HIH during this time.

Williams and Fodera were not, however, liable for breach of s 181. Although he was aware of the purpose of the transaction, Williams played a passive role in the share trading and

[page 459]

despite the opportunity for substantial profits did not sell his shares in HIH while the share price was artificially high. Santow J said (at [454]):

I do not consider it would be right to attribute lack of good faith or improper purpose in relation to what appears a less than adequate supervisory role of the kind rather invoking, justifiably, a conclusion of lack of due diligence.

ASIC did not prove that Fodera knew about the improper purpose of the loan (although his conduct was negligent under s 180).

15.18

Statutory remedies

[page 460]

Breach of s 181 is a civil penalty provision. The practical significance of this is that a breach of s 181 need only be proved on a balance of probabilities — this is a lower standard of proof compared to the criminal

15.19

standard which requires a breach to be proved beyond a reasonable doubt.

The civil penalty concept entails a hybrid of civil penalties (compensation, pecuniary penalty and banning orders) and was introduced into Australian corporate law in 1993. The change in enforcement strategy for breaches of the Corporations Act, from criminal to civil standard of proof, was brought about in an effort to secure greater success at corporate law enforcement. It is important to note, however, that criminal sanctions for breach of s 181 are reserved for conduct that is reckless or intentionally dishonest: s 184.

It is also relevant to note that s 185 recognises that an officer may be sued for breaches of the common law, equity or the statutory duties.

The pecuniary penalties stated in the above figure are set out in s 1317G itself, rather than using the more general ‘penalty unit’ which is used for general criminal fines under Sch 3: see further Crimes Act 1914 (Cth) s 4AA (each penalty unit is $210).

Defences: disclosure The general rule is that a fiduciary (such as a company director) may avoid liability at general law for acting improperly, such as acting for an improper purpose, if the fiduciary has given full disclosure to their principal (in the case of a director, the principal is the company) and the principal consents to the fiduciary acting under the conflict. The ability of a fiduciary to cure defects in the observance of standards expected of a fiduciary is more commonly seen in cases involving conflicts of interest and, therefore, is discussed in detail in the next chapter.

Groeneveld Australia Pty Ltd v Wouter Nolten (No 3) (2010) 80 ACSR 562; [2010] VSC 533 is a recent example where disclosure was an issue in a good faith case. In that case, the court found that a managing director who proposed a resolution to the board of directors to issue options over shares to himself as part of his executive remuneration plan was acting in bad faith. This was because he failed to disclose that he had acted in

15.20

• •

breach of his fiduciary duties by leasing property to the company at above market rates and had diverted a business opportunity from the business to his private family company. These breaches of fiduciary duty would have triggered a clause in the options contract that would have prevented them being issued. While the lease and diversion of opportunities were in breach of the conflict and profit rules (see Chapter 16 ), the managing director’s conduct in simply proposing that his options over shares be issued when he knew that he was not entitled to the options (given his other breaches of fiduciary duty) was found to be acting in bad faith. His generic disclosure to the board that ‘I have an interest’ in the proposed options issue was found by the court to not be sufficient disclosure to excuse the bad faith.

In Duncan v Independent Commission Against Corruption [2016] NSWCA 143, the court found that several directors who failed to disclose that a disgraced politician was involved in a company whose shares they were seeking to sell to the company on whose board they sat did not obtain the fully informed consent of the company simply by declaring that they had an interest in the transaction. Their conduct in the circumstances was intentionally dishonest.

[page 461]

Relief from liability It is possible for an officer to apply to the court for relief from a contravention of the Corporations Act under ss 1317S and 1318. This provision only applies to civil matters (that is, not criminal prosecutions) and requires that:

the person has acted honestly; and having regard to all the circumstances of the case, including those connected to the person’s appointment, the person ought to be excused from liability.

The court may relieve the person either wholly or partly from liability on such terms as the court thinks fit. It is unlikely however that a person who

15.21

(a)

(b)

(c)

(d)

has been found to have acted in bad faith or to have improperly used this position as a director or officer would qualify for relief.

Indemnification and insurance Section 199A(1) of the Corporations Act prohibits a company from granting a blanket indemnification to officers (which includes directors under s 9) for breaches of duty. Therefore, a company cannot have a provision in its constitution that automatically excuses directors from any future breach of duty.

While a company will usually indemnify an officer for liability incurred in the proper performance of their role, s 199A(2) prohibits an indemnity (other than for legal costs) for liability owed to the company (that is, where the company may sue the officer for acting improperly), liabilities owed in respect of civil penalties (under ss 1317G–1317HA), or for liabilities owed to third parties (that is, not the company) in respect of acts not done in good faith. Indemnification for legal costs are, however, prohibited under s 199A(3) for:

defending or resisting proceedings in which the person is found to have a liability for which they could not be indemnified under subs (2); defending or resisting criminal proceedings in which the person is found guilty; defending or resisting proceedings brought by ASIC or a liquidator for a court order if the grounds for making the order are found by the court to have been established; or proceedings for relief to the person under this Act (for example, under s 1317S or s 1318) in which the court denies the relief.

In addition to restrictions on indemnification by the company, s 199B prohibits the company paying for an officer’s insurance coverage in respect of liability for wilful breach of duty or a contravention of ss 182 and 183.

Directors’ and officers’ insurance policies will typically have specific exclusions to cover these types of situations. However, the precise wording of these exclusions will need to be examined as occurred in

15.22

Wilkie v Gordian Runoff Ltd (2005) 221 CLR 522; [2005] HCA 17, where the court found that the insurance company was obliged to fund Mr Wilkie’s defence to criminal charges, despite an exclusion in the policy relating to criminal liability. The court found that the exclusion only applied to a finding of criminal liability and the insurance company was therefore liable to fund Mr Wilkie’s defence of the charges as liability had not yet been determined.

[page 462]

Criminal actions against directors

Directors can be criminally prosecuted under s 184(1) if they breach their duties, under s 181, in a manner that is intentionally dishonest or reckless. There is no requirement that the prosecution prove that the defendant derived any benefit from their breach of duty: R v Wilkie (2008) 220 FLR 2230; [2008] NSWSC 1064. See further Duncan v Independent Commission Against Corruption [2016] NSWCA 143 (where failing to disclose important information was found, in the circumstances, to involve intentional dishonesty).

ASIC, with the aid of the Australian Federal Police, will conduct the criminal investigation, following strict procedures as to how evidence is collected and making determinations as to whether a prosecution should be completed. If it is a minor contravention of the law, ASIC will conduct the actual prosecution in the lower criminal courts. If the matter is more serious, with the potential for an officer being sent to jail, then the case is usually passed to the Commonwealth Director of Public Prosecutions for their attention.

All the provisions of the Corporations Act contain criminal sanctions for breach, unless the specific provision in question states otherwise: s 1311. A list of criminal penalties is provided in Sch 3 of the Act.

There are some overriding criminal principles that should be noted in

•

• •

•

15.23

understanding the operation of the criminal provisions of the Corporations Act. These points include:

Subject to Sch 3, the standard criminal penalty is five penalty units ($1,050): s 1311(5); and s 4AA of the Crimes Act 1914 (Cth) defines a penalty unit as $210 (as of 1 July 2017). Maximum criminal penalties for individual offenders found in Sch 3 are set at 2000 penalty units ($420,000) and/or five years’ imprisonment. Corporate offenders face fines of five times the amount specified for an individual, in lieu of a term of imprisonment: s 1312. Thus, currently the maximum penalty faced by corporate criminal offenders is $2.1 million. Penalty notices may be issued by ASIC: s 1313. Criminal prosecutions may be commenced by ASIC or the DPP: s 1315. Prosecutions must be commenced within five years of the contravention: s 1316.

Chapter 2 of the Criminal Code Act 1995 (Cth), which contains general principles of criminal responsibility and defences, applies generally to the Corporations Act under s 1308A.

Double jeopardy rule It is quite possible to imagine that Mr Adler and Mr Williams thought the legal proceedings against them were over when they were ordered to pay compensation to HIH and pay pecuniary penalties, and were disqualified from managing corporations. However, ASIC, with the DPP, also laid criminal charges against them. Mr Adler raised the defence of double jeopardy.

[page 463]

Double jeopardy is defined as the ‘placing of an accused person in peril of being convicted of the same crime in respect of the same conduct on more than one occasion’.10 Australian courts have taken a strict line against these arguments and have distinguished the officers’ civil duties

to the company from those of the criminal law. In this case a criminal prosecution was allowed to proceed based on similar events to the civil penalties.

Adler v Director of Public Prosecutions (2004) 51 ACSR 1; [2004] NSWCCA 352 New South Wales Court of Criminal Appeal

Facts: Adler was disqualified from being a director and ordered to pay substantial compensation for various breaches of civil penalty provisions. The Commonwealth DPP then commenced criminal proceedings against Adler for breaches of the criminal law arising out of the same conduct. Adler argued that the criminal proceedings should be terminated because they were an abuse of process as they constituted double jeopardy since criminal sanctions would effectively punish Adler twice for the same conduct.

Issue: Should the criminal proceedings be terminated in circumstances where the conduct providing the basis of the criminal charges has already given rise to civil penalty orders?

Decision: The court found that the criminal charges were not an abuse of process because, despite the punitive nature of civil penalties, obtaining civil penalty orders was not a ‘prosecution’ of Adler. The court based its decision on the ‘civil nature’ of civil penalties (that is, the fact that civil evidence rules and not criminal evidence rules applied) and the fact that the elements required to be proved under the criminal charges were not the same as those relevant to proving a breach of the civil penalty provisions.

Note: The High Court refused Adler’s application for special leave to appeal against the New South Wales Criminal Court of Appeal’s decision and Adler then changed his plea to guilty.

Despite the ruling in the Adler case above, the court retains a discretion to grant a stay against a civil case where a criminal investigation is pending: ASIC v Flugge (2008) 21 VR 252; [2008] VSC 473.

In 2004 Mr Williams (director of HIH Ltd) pleaded guilty to three criminal charges for being reckless and failing to use his powers for a proper purpose in signing a letter, knowing it to be misleading on 19 October 2000. He also authorised the issue of a prospectus that contained a material omission on 26 October 1998 and authorisation statements in the 1998-99 HIH Insurance annual report, which he knew were misleading by overstating the operating profit by $92.4 million.

Mr Adler (director of HIH Ltd) waited until the beginning of his criminal

trial on 16 February 2005 to plead guilty to four criminal charges. These charges related to two counts of disseminating false information on 19 and 20 June 2000 that were likely to induce a person into buying HIH shares. He also pleaded guilty to one count of obtaining money by false statements under the Crimes Act 1900 (NSW) and one count of being intentionally dishonest by not acting in the best interests as a director of HIH under s 184 of the Corporations Act.

[page 464]

In 2005 Mr Adler was sentenced to four and a half years imprisonment, with a non-parole period of two and a half years for the charges in R v Adler (2005) 53 ACSR 471; [2005] NSWSC 274. A day later, Mr Williams was sentenced to four and a half years, with a non-parole period of two years and nine months in R v Williams (2005) 53 ACSR 534; [2005] NSWSC 315.

Under the sentencing guidelines, the judges had to take into account the different sentencing regimes under the Commonwealth law and under the New South Wales state laws, as well as a discount in jail term for the guilty plea. Mr Williams in fact received a 25% discount for his early plea, whereas Mr Adler only received a 10% discount for his guilty plea on the first day of the criminal trial.

These high profile sanctions may be contrasted with those imposed on other HIH officers, such as the managing director of HIH Insurance being sentenced to only 15 months’ jail and chief financial officer Dominic Fodera being sentenced to two years’ jail (for offences relating to other contraventions of the Act).

2. 3.

4. 5.

6. 7.

8. 9.

10.

[page 465]

Revision Questions

What are the sources of directors’ duties? Why is it important to know from which source the duty arises? Who are the parties that can enforce a breach of directors’ duties? Explain the concept of fiduciary duty. To whom are such duties owed in corporate law? What remedies are available for breach of fiduciary duty? Can honest conduct by a director still result in a contravention of s 181? How is honesty applied in a case involving s 181 and the equivalent duty under general law? How can the propriety of an officer’s purpose be established? For what purposes can directors cause the company to issue shares? When will directors be criminally liable for breach of their duties? Can criminal and civil proceedings be maintained against a defendant director in respect of the same conduct at the same time? Will a director’s disclosure of breach of duty to the company prevent a breach of s 181 arising?

Problem Question AccountCo Ltd is a successful computer software company in Sydney which specialises in accounting and business management software and maintains roughly 20% of the market. Managemart Ltd is a large competitor of AccountCo Ltd with 50% of the market in Sydney for business management software applications. Managemart Ltd is interested in acquiring AccountCo Ltd’s market share to create the dominant player in the Sydney market.

Managemart Ltd announces on 1 January 2017 that it has acquired 19% of the shares in

(a) (b)

(c)

AccountCo Ltd and is making a full takeover offer for AccountCo Ltd because ‘in its opinion the current management of AccountCo Ltd are not providing value for shareholders’. In the takeover offer Managemart Ltd proposes to:

remove the entire management team of AccountCo Ltd; fully integrate AccountCo Ltd’s management software business into Managemart Ltd’s business structure which will involve significant redundancies in AccountCo Ltd; and allow AccountCo Ltd’s accounting software business to remain in its current state with a view to a possible sell off in the future.

The directors of AccountCo Ltd, who are also shareholders in AccountCo Ltd, are extremely worried by the proposed takeover as they fear for their positions and the future direction of the company.

On 5 January 2017 AccountCo Ltd announces a new share issue proposal that will only apply to shareholders that were registered on 31 December 2015 or before (which specifically excludes Managemart Ltd). The proposal is in the form of a bonus issue that will provide three free shares for each existing share that a member holds. The effect of the issue is that Managemart Ltd’s shareholding will be substantially diluted and will make it very difficult to mount a successful takeover. All eligible shareholders will receive a substantial benefit by accepting the free shares. The proposed share issue will cost the company $500 million to implement and is likely to eliminate the company’s profit for the financial year 2016-17.

Advise whether the directors of AccountCo Ltd have breached their common law and statutory duties under the Corporations Act.

[page 466]

Guidelines for Answering Problem Questions

When answering a problem question concerning directors’ duties, we suggest that the following method may be helpful:

Determine whether the person involved in the question is a director or officer for the purposes of the s 9 definitions. Determine what type of company is involved (that is, public or proprietary, large or small, complex or simple). Establish whether the question concerns fiduciary principles (such as misusing power or acting in bad faith) or the duty of care. Determine exactly what contravening act the person has done —

5. 6.

8. 9.

have they acted to give themselves a benefit? If so, then ss 181-183 may be relevant. If they have failed to act, then s 180(1) or s 588G may be relevant: see Chapters 17 and 18. Then discuss the statutory provisions and relevant cases (at least one leading case per issue) for that issue (that is, negligence, fiduciary duties or insolvent trading). Work through the legal test for that particular duty. Determine if any defences may apply. For example, have they obtained fully informed consent of the company? Comment on what consequences (that is, remedies and penalties) may apply. Can they be granted relief from liability under s 1317S? Most directors’ duties problems tend to involve multiple breaches of duties (such as negligence and acting for an improper purpose). The key step is working out what duties may have been breached, which you can usually determine in steps 3 and 4 above.

The SCPL business is doing really well and is expanding at a rapid rate. Some of the customers of the business have been complaining that the company does not use sustainable coffee supplies that help the farmers who supply the coffee beans. Some of these customers have been leaving complaint messages on the company’s Facebook and Instagram pages. Erin has read some of these messages and raises the issue with Wang as CEO/MD. Erin asks Wang to set aside a portion of the profits of the business to donate to projects in the regions where their coffee beans are sourced from and to increase the unit price that they pay to farmers. Lastly, Erin asks Wang to donate 5% of profits each year to charitable causes which can then be posted up on the Sydney Café’s social media portals. Wang responds that to donate profits to charity would be a breach of directors’ duties to act in the best interests of the company.

Is Wang correct? Would donating profits to charity breach directors’ duties? Why/ why not? Would your answer be any different if the Sydney Café was a publicly listed company on the ASX with thousands of shareholders?

Further Reading

Academic Journals

H Anderson, ‘Director’s Personal Liability to Creditors: Theory vs Tradition’ (2003) Deakin Law Review 209.

V Baumfield, ‘Stakeholder Theory from a Management Perspective: Bridging the Shareholder/ Stakeholder Divide’ (2016) 31 Australian Journal of Corporate Law 187.

[page 467]

N D’Angelo, ‘Directors of Insolvent Trustees and Trusts: Duties and Liabilities in Respect of Beneficiaries and Trust Creditors’ (2017) 35 Company and Securities Law Journal 75.

A Hargovan, ‘Directors’ Duties to Creditors in Australia After Spies v R: Is the Development of an Independent Fiduciary Duty Dead or Alive?’ (2003) 21 Company and Securities Law Journal 390.

A Hargovan, ‘Geneva Finance and the “Duty” of Directors to Creditors: Imperfect Obligation and Critique’ (2004) 12 Insolvency Law Journal 134.

A Hargovan and J Harris, ‘For Whom the Bell Tolls: Directors: Duties to Creditors after Bell’ (2013) 35 Sydney Law Review 433.

J Harris, A Hargovan and J Austin, ‘Shareholder Primacy Revisited: Does the Public Interest Have Any Role in Statutory Duties?’ (2008) 26 Company and Securities Law Journal 355.

K Hayne, ‘Directors’ Duties and a Company’s Creditors’ (2014) 38 Melbourne University Law Review 795.

L Ho, ‘Good Faith and Fiduciary Duty in English Law’ (2010) 4 Journal of Equity 29.

A Keay, ‘Director’s Duty to Take into Account the Interests of Company Creditors: When is it Triggered?’ (2001) 25 Melbourne University Law Review 315.

E Klein and J du Plessis, ‘Corporate Donations, the Best Interest of the Company and the Proper Purpose Doctrine’ (2005) 28 University of New South Wales Law Journal 69.

R Langford, ‘The Fiduciary Nature of the Bona Fide and Proper Purposes Duties of Company Directors’ (2009) 31 Australian Bar Review 326.

K Loxley, ‘ “Unashamedly More Interventionist” Courts and the Fading Significance of a Director’s State of Mind’ (2014) 32 Company and Securities Law Journal 486.

J Mayanja, ‘Clarifying the Object of Directors’ Endeavours: What Australia can Learn from the United Kingdom’ (2014) 37 University of New South Wales Law Journal 874.

L Sealy, ‘Directors’ Wider Responsibilities’ (1987) Modern Law Review 164.

M Welsh and H Anderson, ‘Directors’ Personal Liability for Corporate Fault: An Alternative Model’ (2006) 26 Adelaide Law Review 299.

N Young, ‘Has Directors’ Liability Gone Too Far or Not Far Enough? A Review of the Standard of Conduct Required of Directors Under Sections 180-184 of the Corporations Act?’ (2008) 26 Company and Securities Law Journal 216.

Practitioner Journals M Adams and M Nehme, ‘Australian Overregulation? — Effect on

Directors’ Liability’ (2009) 61(2) Keeping Good Companies 104.

Practitioner Works R P Austin, H A J Ford and I Ramsay, Company Directors: Principles of

Law and Corporate Governance, LexisNexis Butterworths, Australia, 2005.

6. 7.

10.

You will find useful study resources, including quizzes for each chapter, when you go to <http://learning.lexisnexis.com.au>. The quiz is a great tool to help you self-test your knowledge.

The duty to retain their discretion to make decisions in the best interests of the company requires the directors not to bind themselves to vote in a particular manner as such an agreement may be against the interests of the company at the time of the meeting. This duty is rarely an issue in litigation (though see recently ASIC v Macro Realty Developments Pty Ltd [2016] FCA 292) and will not be considered further. A study by Ramsay and Stapledon in 2001 revealed that the majority of the top 500 ASX listed companies had at least one controlled entity (for example, a subsidiary company) with an average of 28 controlled entities per corporation: I Ramsay and G Stapledon, ‘Corporate Groups in Australia’ (2001) 29 Australian Business Law Review 7. See further A Hargovan, ‘Directors’ Duties to Creditors in Australia after Spies v R: Is the Development of an Independent Fiduciary Duty Dead or Alive?’ (2003) 21 Company and Securities Law Journal 390; R Maslen-Stannage, ‘Directors’ Duties to Creditors: Walker v Wimborne Revisited’ (2013) 31 Company and Securities Law Journal 76. See also the detailed discussion given to this issue in Bell Group Ltd (in liq) v Westpac Banking Corp (2008) 70 ACSR 1; [2008] WASC 239 per Owen J at 20.3. See further A Hargovan and J Harris, ‘For Whom the Bell Tolls: Directors’ Duties to Creditors after ‘Bell’ (2013) 35 Sydney Law Review 433. Except if the company is insolvent or approaching insolvency as noted above. See, for example, the ‘business judgment rule’ defence in s 180(2) and the statutory derivative action discussed in s 237(2): see Chapter 19. See further K Loxley, ‘“Unashamedly More Interventionist” Courts and the Fading Significance of a Director’s State of Mind’ (2014) 32 Company and Securities Law Journal 486. See similar comments in ASIC v Sydney Investment House Equities Pty Ltd (2008) 69 ACSR 1; [2008] NSWSC 1224 at [34] per Hamilton J. See similar comments in ASIC v Sydney Investment House Equities Pty Ltd (2008) 69 ACSR 1; [2008] NSWSC 1224 at [34] per Hamilton J.

[page 469]

Directors and Officers: Conflicts of Interest

CHAPTER 16 Scope of fiduciary duties Duty to avoid conflicts of interest

Test for establishing a conflict of interest Directors working for competing companies Common examples of conflicts Obligation to actively avoid conflicts Secret profits

Statutory duty to avoid conflicts of interest (ss 182–183) Statutory duty to disclose material personal interests (s 191) Related party transactions Consequences of breaching fiduciary duties Defences to liability

Members’ consent

[page 470]

Directors and Officers: Conflicts of Interest

Learning Objectives After completing this chapter you should be able to:

Explain how a conflict of interest may arise.

Discuss what measures directors and officers may take to address actual and potential conflicts of interest.

Outline the available remedies for transactions entered into under conflicts of interest.

Discuss how compliance with the ‘no conflict rule’ may be enforced.

Key Cases

ASIC v Adler (2002) 42 ACSR 80; [2002] NSWSC 483

Cook v Deeks [1916] 1 AC 554

Furs Ltd v Tomkies (1936) 54 CLR 583

Regal (Hastings) Ltd v Gulliver [1967] 2 AC 134

Streeter v Western Areas Exploration Pty Ltd (No 2) (2011) 82 ACSR 1; [2011] WASCA 17

Transvaal Lands Co v New Belgium (Transvaal) Lands & Development Co [1914] 2 Ch 488

Key Sections

Corporations Act 2001 (Cth) ss 9, 182, 183, 191, 195, 1317E, 1317G, 1317H, 1317S, 1318

16.1

[page 471]

Introduction

As noted in the previous chapter, directors and other officers occupy positions of power and control within the corporation. The corporation and its various stakeholders are vulnerable to exploitation by the directors and other officers. The corporation’s stakeholders, particularly the members, suffer from information asymmetries as corporate insiders have access to information about the business that external stakeholders do not. Members and other capital providers enter into contracts with the company to use their capital for particular purposes. Creditors have a contractual expectation that their credit will be repaid according to the terms of the credit arrangement. For members, they have an expectation that their capital contributions will be used by the company’s management to increase enterprise value and (hopefully) provide an economic return on their investment. None of the company’s stakeholders bargains with the company on the expectation that directors and officers will use their positions of power for private purposes. As demonstrated in Chapter 15, such purposes would be ‘improper’ and can give rise to a range of civil and criminal sanctions.

This chapter considers the directors’ interests in transactions with their company, specifically acting under a conflict between their duty to the company and personal interests. The obligation to avoid conflicts of interest stems from the directors’ and officers’ roles as fiduciaries occupying a position of power and influence. They are, therefore, required to act in the best interests of the company.

Scope of fiduciary duties

Directors are clearly fiduciaries to the company as principal. This is one of the universally accepted categories of fiduciary relationships: Hospital Products Ltd v United States Surgical Corporation (1984) 156 CLR 41. However, to refer to a relationship as fiduciary tells us little about the scope of the obligations that exist between the fiduciary (director) and its

principal (the company). The relationship between the parties, including any contracts and the actual functions performed by the fiduciary, must be assessed to determine the actual requirements of the fiduciary duty. This assessment is also not determined merely by attaching the labels of non-executive or executive director. Each person’s role and conduct (within the company) must be assessed in total.

Canberra Residential Developments Pty Ltd v Brendas (2010) 188 FCR 140; [2010] FCAFC 125 Full Federal Court

… the mere existence of a fiduciary relationship does not define the nature of the duties that arise for three reasons. First, it is wrong to assume that the duty owed by a fiduciary attaches to every aspect of the fiduciary’s conduct, however, irrelevant that conduct is to the relationship that is the source of the duty. Second, the scope of the duty is very much dependent upon the facts of the particular case. In most cases the duty will be determined in large part by reference to the nature of the activities of the principal. Third, defining the scope of the duty must be approached with commonsense and with an appreciation of the sort of circumstances in which it has been applied in the past. It should only be applied to a state of affairs which discloses a real conflict of duty and interest and not just some theoretical or rhetorical conflict.

[page 472]

It is common to refer to fiduciary duties as involving a ‘no conflict rule’ and a ‘no profit rule’. This distinction is, strictly speaking, really only for analytical convenience. Both rules derive from the overarching duty of loyalty and good faith that all fiduciaries (including directors) owe. This was explained in the Grand Enterprises case (at [26]-[29]) as follows.

Grand Enterprises Pty Ltd v Aurium Resources Ltd (2009) 72 ACSR 75; [2009] FCA 513 Federal Court of Australia

As a fiduciary the interest of a director in relation to a corporation may in some cases be measured in

16.2

terms of a financial profit that a director might stand to earn. In other cases the question of profit may not be in issue, but a director may have a conflict of duties owed to different entities. It is for that reason that the authorities and texts usually draw a distinction between a ‘profit rule’ and a ‘conflict of interest rule’ … Nonetheless, there is a tendency to conflate the two rules and for a complainant simply to assert that a fiduciary has a ‘conflict of interest’ without specifying more. …

The profit rule is perhaps clear enough. [This is called] the ‘conflict of duty and interest’. A director as a fiduciary has an obligation not to allow a conflict between his or her duty to the company and his or her personal interests. Accordingly, a director should not use his or her position as director to derive an unauthorised benefit.

The conflict of interest rule [is referred to as] a ‘conflict of duty and duty’, [and] obliges a director to avoid a conflict of the duty owed to the company with a duty owed to some other person. This conflict rule has particular application in circumstances where a person is a director of two companies which have common dealings.

Duty to avoid conflicts of interest

A key responsibility of being a director, which arises from the fiduciary position that directors occupy, is the need to avoid conflicts of interest. This was expressed in Aberdeen Railway Company v Blaikie Bros (1854) 1 Macq 461 at 471-2 (a case involving a contract entered into between a company and a partnership where the chairperson of the company was also a partner in the firm), by Lord Cranworth LC, who said:

… that no one, having fiduciary duty to discharge, shall be allowed to enter into engagements in which he has, or can have, a personal interest conflicting, or which possibly may conflict, with the interests of those whom he is bound to protect.

This principle and duty are very well established across all persons that hold a fiduciary position and many cases have discussed the underlying nature of this duty.

[page 473]

Bray v Ford [1896] AC 44 House of Lords

16.3

It is an inflexible rule of a Court of Equity that a person in a fiduciary position, such as the director of a charitable company, is not, unless otherwise expressly provided, entitled to make a profit. The director is not allowed to put himself or herself in a position where his or her interest and duty conflict.

[Similar comments were made by Lord Upjohn in Phipps v Boardman [1967] 2 AC 46 at 123.]

The rule that directors (as fiduciaries) cannot act under a conflict of interest (for example, by making a secret profit out of the company’s dealings) extends to situations even where the director only makes an indirect profit, as demonstrated by the Transvaal case.

Transvaal Lands Co v New Belgium (Transvaal) Lands & Development Co [1914] 2 Ch 488 Court of Appeal (UK)

Facts: Two directors of Transvaal were also involved in another company called New Belgium. One of the directors (Samuel) was a shareholder and director of New Belgium, while the other (Harvey) was only a shareholder (holding the shares as trustee for other persons). The two directors of Transvaal persuaded the other directors to agree to have Transvaal purchase property from New Belgium without disclosing their interest in that company or the benefit that they would obtain from the purchase (as shareholders in New Belgium).

Issue: Did the two directors breach their duties to avoid conflicts of interest? Decision: The directors had acted under a conflict between their duty to promote the interest of Transvaal and their personal benefit in selling property to Transvaal through their other company, New Belgium. This was despite the fact that Harvey only held the shares as trustee for other persons. The directors should have disclosed their interest in New Belgium before Transvaal purchased the property. The purchase transaction was rescinded by Transvaal.

Astbury J, whose judgment was upheld by the Court of Appeal, relied on the established authorities1 and held:

… a director of a company is precluded from dealing, on behalf of the company with himself, and from entering into engagements in which he has a personal interest conflicting, or which possibly may conflict, with the interests of those whom he is bound by fiduciary duty to protect …

Significance: This case demonstrates that the fiduciary obligation not to act under a conflict of interest is wide and extends to both direct and indirect conflicts.

Test for establishing a conflict of interest The famous decision in Phipps v Boardman [1967] 2 AC 46 (a case concerning a trustee and solicitor’s fiduciary obligations in respect of purchasing shares in a company partially owned by the trust) is authority

•

for the following statement of principles regarding how company officers should manage their conflicts of interest:

[page 474]

Company officers should assess the question of whether there is a real possibility of conflict between their private interests and the interests of the company. In other words, officers should assess whether the interests are compatible. Can the officer follow one interest without harming the other? Company officers must make full disclosure of all potential conflicts, and abstain from influencing deliberations. If an independent board of directors and/or the company’s members approve of the conduct, the officer can be said to have obtained the company’s informed consent.

The NSWCA recently in Coope v LCM Litigation Fund Pty Ltd (2016) 333 ALR 524; [2016] NSWCA 37 at [109]) explained the test derived from Boardman v Phipps as follows: ‘The test for the existence of a conflict or a real and substantial possibility of a conflict is objective. It is to be determined from the standpoint of the objective observer with knowledge of all relevant facts and circumstances’.

The application of the conflict requires that the scope of the fiduciary’s duties be identified first and then an assessment made as to whether the conduct does (or would) be in conflict with their duty to the company. This is demonstrated by the following statement by Hayne and Crennan JJ (at [61]) in the High Court decision in Howard.

Howard v Commissioner of Taxation (2014) 253 CLR 83; [2014] HCA 21 High Court of Australia

… the working out of the application of the rule to company directors is not achieved by the bare repetition of its terms. Much closer attention must be given to the duties, interests and alleged manner of conflict than is given by simply observing that directors owe fiduciary duties. It is necessary to identify the duties or interests which are said to conflict or present a real possibility of conflict.

•

• •

•

Similarly, the NSWCA in Coope v LCM Litigation Fund Pty Ltd (2016) 333 ALR 524; [2016] NSWCA 37 at [106] recently explained: ‘Not all personal interests come within the conflict rule. The interest must give rise to a conflict or a real or substantial possibility of conflict’. It is important to identify the boundaries of fiduciary responsibility that the fiduciary has in respect of the company, and this will be determined by reference to:

the constitution of the company and the internal rules it imposes on directors and officers; the contract that exists between the director or officer and the company; the role and responsibilities undertaken by the director or officer; and any express authorisation or limitation of authority given by the board of directors (or under its delegation) to the director or officer.

The decision in Bell Group Ltd (in liq) v Westpac Banking Corp (2008) 39 WAR 1; [2008] WASC 232 provides a useful summary of the principles used to assess conflicts

[page 475]

of interest. That case concerned an alleged breach of fiduciary duty by company directors in renegotiating financing arrangements in a manner that provided little benefit to the company but substantial benefit to the company’s major financiers. The following statements are taken from the lengthy judgment (it is over 2500 pages long):

Generally speaking, liability arises not from the mere existence of a conflict of interest but from the pursuit of personal interest by, for example, actually entering into a transaction in which the relevant conflict exists, or the actual receipt of personal benefit in circumstances of such conflict (at [4504]). [T]he test for ascertaining a possible conflict is objective. It is not necessary to establish fraud, dishonesty or bad faith (at [4508]). [C]onflicts of interest may relate to monetary and non-monetary interests (at [4509]). [T]he conflict may relate to a direct or indirect interest (for example, a direct shareholding or an indirect shareholding through someone

•

16.4

• •

16.5

else) (at [4509]). [T]he nature of the conflict must be sufficiently significant as to provide some measure of motivation for the director’s conduct (at [4510]-[4512]).

Directors working for competing companies A director who serves on the boards of two competing companies is not necessarily in breach of the ‘no conflict of interest rule’: London and Mashonaland Exploration Co Ltd v New Mashonaland Exploration Co Ltd [1981] WN 165. In that case the court held that a director could serve on the board of competing companies provided that the company’s constitution did not prohibit such conduct. Of course, such a director must be careful not to disclose confidential information of one company to the competitor. Mashonaland was applied recently in Streeter v Western Areas Exploration Pty Ltd (No 2) (2011) 82 ACSR 1; [2011] WASCA 17, which is discussed further below.3

In Australian Careers Institute Pty Ltd v Australian Institute of Fitness Pty Ltd (2016) 116 ACSR 566; [2016] NSWCA 347 the NSWCA noted (at [4]) that, ‘it is not inevitably the case that a director who occupies board positions in competing companies is in breach of his or her fiduciary obligations to one or the other of them merely by reason of that fact’. The court explained that this was because the fiduciary duty must be shaped by the nature of the legal relationship between the individual director or officer and the company, so that what may be a conflict for one person might not be a conflict for another.

Should a director be permitted to serve on the boards of two competing companies? How might a company prevent one of its directors from working for a competitor?

Common examples of conflicts Three common situations involving the rule against conflict of interests are:

2. 3.

16.6

diversion of business opportunities;

[page 476]

misappropriation of company property; and secret profits (undisclosed commissions).

Diversion of business opportunities It is a fundamental rule of equity that fiduciaries may only act for the benefit of their principal. Therefore, directors and other company officers may not use their position as directors to take away business opportunities that properly belong to the company.

Green v Bestobell Industries Pty Ltd (1982) 1 ACLC 1 Western Australian Full Supreme Court

Facts: Green was a senior manager of Bestobell, a company which was involved in construction projects. Through his work for Bestobell, Green became aware that the construction project that Bestobell was involved in was calling for a new round of tenders for construction work. Without first obtaining the approval of Bestobell, Green submitted a tender for the new construction work through a company he set up called Clara Pty Ltd. Green knew that Bestobell would also submit a tender and he knew what Bestobell’s construction costs would be, so he ensured that Clara’s tender was for a lower price than Bestobell’s. After Green left his position at Bestobell, the construction contract was awarded to Clara Pty Ltd. Bestobell sued Green for breaching his fiduciary duty and sought to claim the secret profit he made (an ‘account of profits’).

Decision: The court found that Green had breached his fiduciary duty by acting under a conflict of interest through the misappropriation of Bestobell’s business opportunity.

The key point is that the opportunity must have been made available to the director because of their position in the company, as illustrated in Industrial Development Consultant Ltd v Cooley [1972] 1 WLR 443. In this case, the managing director received information from a government department about a potential project that fell within the scope of his company’s business. His company’s previous bid for similar work had been rejected. Nonetheless the managing director did not disclose the

information to his company but sought to exploit it personally. The court held (at 451):

The defendant had one capacity and one capacity only in which he was carrying on business at that time. That capacity was as managing director of [IDC]. Information which came to him while he was managing director and which was of concern to [IDC] and was relevant for [IDC] to know, was information which it was his duty to pass on to [IDC] because between himself and [IDC] a fiduciary relationship existed …

This position may be contrasted with cases where the opportunity does not arise because of the person’s position as a company director or officer. This occurred in Peso Silver Mines Ltd (NPL) v Cropper (1966) 58 DLR (2d) 1 where the Supreme Court of Canada ruled that a director (Cropper) who was approached in his personal capacity as a business person to invest in a speculative mining venture, which had previously been presented and rejected in good faith for sound business reasons by Peso (a company on whose board he was a director) was not a breach of fiduciary duty because the opportunity did not arise because of his position on the board of Peso. There was no evidence in the case that Cropper had used any confidential information owned by Peso to exploit the commercial opportunity.

[page 477]

The need to carefully consider the capacity of the parties when receiving the commercial opportunity is demonstrated in the recent important case of Streeter v Western Areas Exploration Pty Ltd (No 2) (2011) 90 ACSR 1; [2011] WASCA 17.

Streeter v Western Areas Exploration Pty Ltd (No 2) (2011) 90 ACSR 1; [2011] WASCA 17 Western Australian Court of Appeal

Facts: Streeter and his accountant (Cooper) took shares in Western Areas Exploration Pty Ltd (WAE — a gold prospecting company) after a request from the board to invest capital. The company had no money and no ability to develop its only asset (a 70% interest in exploration rights over a potential gold site). Streeter and Cooper accepted board positions and Cooper also acted as company secretary.

Streeter provided financial support to the company and paid all of its bills. He was the company’s largest shareholder and its largest creditor.

The chairman, Brailey, had another job as a stockbroker as the company was largely dormant. Brailey was presented with an opportunity to develop a start-up nickel prospecting company and arranged for a meeting with Streeter. Streeter proposed to use WAE as the listing vehicle but the proponents rejected that plan and required a new company to be established. The proponents built upon Streeter’s prior offer and suggested the new company take up WAE’s gold prospecting rights. Streeter agreed and set up a new company. He also arranged for WAE to sell its prospecting rights into the new entity Western Areas NL (WANL). WAE received shares in the IPO of WANL as consideration for the asset sale. Streeter had also purchased the minority (30%) holding in the gold prospecting rights and had sold that to WANL without informing WAE.

Several years later WANL discovered a large nickel deposit (using funds subsequently provided by Streeter) and its shares increased dramatically. Nothing valuable came of the gold prospecting rights previously owned by WAE. After WANL became successful (some six years later), Brailey caused WAE to take action against Streeter and Cooper for breaching their directors’ duties.

Issue: Did Streeter and Cooper receive the opportunity to invest in WANL in their capacity as directors of WAE? Were they acting in breach of a fiduciary duty owed to WAE? Did they need to give an account of profits for the benefit they received from their investments in WANL?

Decision: The Western Australia Court of Appeal unanimously found that WAE was not entitled to recover from Streeter and Cooper, except for the failure to disclose the purchase of the minority holding in the gold prospecting rights. The court, however, was split in its reasoning. The majority found there was no breach of fiduciary duty as the rejection of the initial offer to use WAE by the nickel proponents meant that the subsequent offer was made to Streeter and Cooper in their private capacity as venture capital investors.

The minority judge found that the opportunity was only presented to them because of their role at WAE (the offer originally came through the WAE chairman). However, his Honour found that WAE had waited too long to bring its action as it had waited several years until WANL was successful after it had found and developed a new project unrelated to the WAE gold prospecting rights (which had also cost Streeter significant further monies).

All three judges emphasised that it would not be a breach of fiduciary duty for Streeter and Cooper to be on the boards of two companies in the same industry.

Significance: This case is a good example of illustrating the need to assess the capacity in which the director or officer receives the commercial opportunity to determine if there is a breach of fiduciary duty.

[page 478]

It is important to note that the breach of fiduciary duty does not arise merely because the officer obtained a profit from diverting business opportunities from the company (although this will often be the case). It arises because the officer has allowed their personal interest to conflict with the company’s interests. The result of that conflict does not determine liability, although it is relevant for determining the appropriate remedy.

Therefore, company officers can breach their fiduciary duty through conflicts of interest even where they make no profit, or where the company suffers no loss, or even in cases where the company makes a profit. This issue is discussed further below when the key statement in Furs Ltd v Tomkies (1936) 54 CLR 583 and the important decision in Regal Hastings Ltd v Gulliver [1967] 2 AC 134 is considered.

The obligation to avoid a conflict of interests extends even beyond the contract of employment — if a director or officer takes advantage of a business opportunity that was presented to them because of their position, they will not be able to exploit it merely by resigning from their position in the company: Canadian Aero Service Ltd v O’Malley (1973) 40 DLR (3d) 371 (where two senior executives developed a business proposal to use as a tender on behalf of the company for a major government contract and then resigned to set up a competing business to exploit this information, which constituted a breach of their fiduciary duties). A similar result occurred in Holyoake Industries (Vic) Pty Ltd v V- Flow Pty Ltd (2011) 86 ACSR 393; [2011] FCA 1154.4

Holyoake Industries (Vic) Pty Ltd v V-Flow Pty Ltd (2011) 86 ACSR 393; [2011] FCA 1154 Federal Court of Australia

Facts: Holyoake was the Victorian subsidiary company of an international group that was involved in the manufacture, distribution and installation of commercial air-conditioning equipment. A number of executives of Holyoake’s Victorian subsidiary (including the managing director) received information about the company’s major competitor looking to sell his business. This information was obtained while Holyoake’s managing director was visiting the competing business (V-Flow) to discuss a purchase order of parts from Holyoake. The executives also referred to internal information on the business held by Holyoake (based on an earlier merger discussion) and decided to purchase the business in their own name, without telling Holyoake. The executives obtained bank finance for the purpose by explaining that the business would benefit from their experience and customer links (information that belonged to Holyoake). The executives also told the bank that they had already contacted Holyoake’s customers to suggest they shift their business to the competing business. Once the finance was obtained, the executives all resigned from Holyoake without giving a reason.

Decision: The court held that the conduct was a breach of fiduciary duties as the executives had received information about the business purchase while acting as fiduciaries for Holyoake. The executives claimed that they only worked on the purchase transaction after work hours; however, the

16.7

court held that fiduciary duties do not stop at the end of the work day for opportunities that were obtained while acting as a fiduciary.

[page 479]

A similar finding was made in the High Court’s decision in Chan v Zacharia (1984) 154 CLR 178 (a partnership case, discussed earlier in Chapter 4), where a doctor in a medical partnership tried to exploit a lease option after the partnership business ceased but before the partnership accounts had been finalised. Even where the business has closed down, the directors may be prevented from exploiting an opportunity that belongs to the company: Vadori v AAV Plumbing (2010) 77 ACSR 616; [2010] NSWSC 274 (where the directors/members closed down a business so that they could exploit the business through a competing company — the conduct was found to be a breach of fiduciary duties and the minority members obtained relief under the oppression remedy — the topic on shareholders rights and remedies in Chapter 19 discusses the oppression remedy).

Misappropriation of company property Directors and other company officers (as fiduciaries) may only use the company’s property for the purpose of benefiting the company, not for a private benefit. Where a company officer uses company property for a private purpose without the company’s permission, the officer breaches their fiduciary duty.5

It is important to note that although knowledge is not always considered property, the company’s property for the purposes of the conflict rule may include intellectual property and trade secrets. For example, as noted above in Green v Bestobell, Green (a senior manager of Bestobell) misappropriated details of Bestobell’s construction costs so as to formulate a lower tender offer for his competing company Clara Pty Ltd. Similarly, in Canadian Aero, the officers used inside information to formulate a successful tender for their competing business.

Cook v Deeks is a famous example of misappropriation of company

16.8

property by directors.

Cook v Deeks [1916] 1 AC 554 Privy Council (UK)

Facts: In this case, several directors (including two Deeks brothers and another director) of the Toronto Construction Company had a disagreement with one of the other directors (Cook). The directors then negotiated a major construction project on behalf of the company, but diverted that project to a new company that they had established in an attempt to exclude Cook from the project. (Cook was neither a shareholder nor director of the new company.) The directors then used their shareholdings to pass a resolution at a members’ meeting declaring that the company (that is, Toronto Construction) had no interest in the project, effectively freezing out Cook from the project.

Issue: Did the directors breach their fiduciary duty by giving the business opportunity to the new company rather than Toronto Construction?

Decision: The directors acted in breach of their fiduciary duty and the shareholders’ resolution was invalid because the directors/shareholders were acting under a conflict of interest. As the court said (at 563):

[page 480]

… [directors] who assume the complete control of a company’s business must remember that they are not at liberty to sacrifice the interests which they are bound to protect, and, while [apparently] acting for the company, divert in their own favour business which should properly belong to the company they represent.

Significance: This case shows that there are special limitations on the ability of the majority of members to exploit corporate opportunities.

See also Groeneveld Australia Pty Ltd v Nolten (No 3) (2010) 80 ACSR 562; [2010] VSC 533, where the managing director of the company, Groeneveld, set up an IT consulting business to offer Groeneveld’s customers IT support instead of using Groeneveld’s internal IT services. The customer contact lists were the property of Groeneveld and could only be used for the purposes of pursuing Groeneveld’s business.6

Obligation to actively avoid conflicts Part of the fiduciary’s duty to the principal (in this case, the director’s duty to the company) involves the requirement to actively avoid acting on a

conflict. In the recent decision in Australian Careers Institute Pty Ltd v Australian Institute of Fitness Pty Ltd (2016) 116 ACSR 566; [2016] NSWCA 347, the NSWCA court held that a director of a national fitness institute acted under a conflict of interest when he established his own training company in Victoria that itself established a national fitness business. The national fitness institute on whose board the director sat had operations in Victoria through a subsidiary company. This arrangement where the director was involved in two fitness companies set up a conflict between his ongoing role with the national training fitness institute and his private business. The director had entered into a shareholders’ agreement when the national fitness institute was established which obliged him to work cooperatively with the other shareholders to further the interests of the national institute. There was thus a breach of duty even where the director did not misuse confidential information or misuse any business opportunity the property of the national institute. The breach arose from acting under a conflict between the duty owed to the institute and the director’s personal interest.

Conflict of interest issues often arise where the conflict leads to personal benefit accruing to the director acting in breach of duty, and they seek to retain the benefit by establishing they had informed consent of the company.

North-West Transportation Co Ltd v Beatty (1887) 12 App Cas 589 Privy Council

[A] director … is precluded … from entering into arrangements in which he has a personal interest conflicting … with the interests of those whom he is bound by fiduciary duty to protect … Any such dealing [upon full and proper disclosure] … may, however, be affirmed or adopted by the company, provided such affirmance or adoption is not brought about by unfair or improper means, and is not illegal or fraudulent or oppressive towards those shareholders who oppose it.

[page 481]

It should be noted that this is not a duty to disclose that a breach of duty

has occurred. Rather, if the fiduciary director or officer receives a benefit as a result of a breach of duty, they cannot retain the benefit unless they establish that the company (as principal) has given fully informed consent to the conduct: Regal Hastings Ltd v Gulliver [1967] 2 AC 134. There is also a statutory duty to disclose material personal interests under s 191, which is discussed further below.

The Full Federal Court explained this issue in the context of fiduciary obligations owed by employees: Blackmagic Design Pty Ltd v Overliese (2011) 191 FCR 1; [2011] FCAFC 24. In that case, the court stated (at [108]) that:

… there is undoubtedly a breach when the fiduciary places himself or herself in a position of conflict. The breach is excused or perhaps does not arise if the principal consents. In other words, it is not enough that there be disclosure, there must be consent. Disclosure is part of a defence.

To whom, however, must this disclosure be made? If the directors manage the affairs of the company (see s 198A), then is it right for a director (or multiple directors) to make disclosure of conflicts to the other directors only? Should directors be able to approve of their own conflicts? Certainly, following from cases such as Cook v Deeks (above), the answer must be no. Disclosure must be made to the shareholders at the general meeting to ensure an unbiased and independent consent. This principle, together with the stringent nature of the fiduciary duty, is reinforced with reference to the classic case of Furs Ltd v Tomkies.

Furs Ltd v Tomkies (1936) 54 CLR 583 High Court

… no director shall obtain for himself a profit by means of a transaction in which he is concerned on behalf of the company unless all the material facts are disclosed to the shareholders and by resolution a general meeting approves of his doing so, or all the shareholders acquiesce.

An undisclosed profit, which a director so derives from the execution of his fiduciary duty, belongs in equity to the company. It is no answer … that the profit is of a kind which the company could not of itself have obtained, or that no loss is caused to the company by the gain of the director.

However, as also demonstrated in Cook v Deeks (where the majority of the

16.9

shareholders were also directors and voted in a general members’ meeting to disclaim the company’s interest in a contract secured by their competing business in breach of their fiduciary duty), even disclosure to the general body of shareholders may be insufficient if the majority of shareholders are involved in the conduct. In such a situation, the actions of the majority shareholders in approving of director conflicts may itself constitute minority oppression: see Chapter 19.

It should be noted that there is some authority for the view that directors may give proper disclosure to the board only: see Queensland Mines Ltd v Hudson (1978) 18 ALR 1. However, the facts of this case are distinguishable from the other key cases in

[page 482]

this area — in this case the two shareholders were represented on the board.7 Outside of such a situation involving representation of shareholders on the board who are aware of the disclosure issues, the law demands disclosure to the shareholders as a whole rather than merely the board of directors: see, for example, Furs Ltd v Tomkies (1936) 54 CLR 583. Ultimately, whether disclosure of conflicts of interest and consent will be sufficient to protect the director from breach of fiduciary duty will depend on the material facts of each case.

If the company enters into a transaction that involves a conflict of interest by a director or other officer, the failure to disclose the conflict and seek the company’s fully informed consent will render the contract voidable at the option of the company. If the director has misused the company’s property in order to pursue their conflict of interest, then they will be accountable to the company for the improper gain.

Secret profits The restriction on directors and officers from making secret profits is another aspect of the broad fiduciary duty imposed on company directors under equity. It is permissible for a director to make a profit, but the issue of breach of fiduciary duty often relates to disclosure and this will vary

depending on the circumstances of each case. Importantly, the director will be in breach of their fiduciary duty regardless of the impact on the company. It is irrelevant whether or not the company also makes a profit arising from the directors’ conduct. As noted at the start of this chapter, the breach arises because the fiduciary allows him- or herself to be put in a position where they are motivated by personal interest rather than purely seeking to benefit the company’s interests. There is no need to establish intentional wrongdoing; indeed the director may believe that they are acting to benefit the company, but their conduct will be assessed objectively by standards of the conduct of reasonable persons in the circumstances: Hart Security Australia Pty Ltd v Boucousis (2016) 117 ACSR 408; [2016] NSWCA 307.

A good example of the realisation of a profit that was deemed to be ‘secret’ occurred in Regal (Hastings) Ltd v Gulliver.

Regal (Hastings) Ltd v Gulliver [1967] 2 AC 134 House of Lords

Facts: Regal owned a cinema in Hastings in England and the directors of Regal were keen to purchase the two competing cinemas in Hastings. The directors of Regal established a subsidiary company to purchase the competing cinemas. The subsidiary had only a small amount of paid up capital, because it was intended that Regal (that is, the parent company) would own all of the shares in the subsidiary. However, the landlord who owned the land where the other two competing cinemas were situated asked for the subsidiary company to have its capital fully paid up to a value of £5000, or alternatively for the directors to provide personal guarantees to ensure the payment of the rent. Unfortunately, Regal could only contribute £2000 to the subsidiary and so the directors of Regal (and their solicitor) decided to give the remaining £3000 to the subsidiary to make up the £5000 required by the landlord. Therefore, the directors of Regal and Regal’s solicitor became the owners of shares

[page 483]

in the subsidiary which were intended to have been the property of Regal (the parent). The shares in the subsidiary were later sold at a profit. When new directors were appointed to Regal, the former directors and solicitor were sued for breach of fiduciary duty. Regal sought an account of profits from the directors and solicitor.

Issue: Did the directors of Regal breach their fiduciary duty by making a private profit in the transaction even in a situation where the company could not have made any such profit without the directors’ actions?

16.10

Decision: The House of Lords found that the directors of Regal were in a fiduciary relationship with Regal and therefore were liable to account for the profit made by selling the subsidiary’s shares. The House of Lords found that the solicitor was not acting in a fiduciary capacity with respect to financing the subsidiary and therefore was not liable to account for the profit he made. The House of Lords rejected an argument put by the directors that they should not be liable to account, because Regal was incapable of making the profit since it could not contribute the full £5000 required by the landlord. Lord Russell said (at 144-5):

The rule of equity which insists on those, who by use of a fiduciary position make a profit, being liable to account for that profit, in no way depends on fraud, or absence of bona fides, or upon such questions or considerations as whether the profit would or should otherwise have gone to the plaintiff, or whether the profiteer was under a duty to obtain the source of the profit for the plaintiff, or whether he took a risk or acted as he did for the benefit of the plaintiff, or whether the plaintiff has in fact been damaged or benefited by his action. The liability arises from the mere fact of a profit having, in the stated circumstances, been made. The profiteer, however honest and well intentioned, cannot escape the risk of being called to account.

Lord Russell also noted that the directors could have sought approval of their transactions from the company (at 150):

They could, had they wished, have protected themselves by a resolution (either antecedent or subsequent) of the Regal shareholders in general meeting. In default of such approval, the liability to account must remain.

Significance: This case demonstrates the inflexibility of the fiduciary rules against making personal profits. The case is also significant because it recognised that the directors could have saved themselves by obtaining the fully informed consent of the company prior to the transaction.

Another case involving secret profits was Furs Ltd v Tomkies (1936) 54 CLR 583 where the managing director was directed to negotiate the sale of the company’s business and in doing so negotiated a commission from the purchaser without the consent of the company, which was a breach of fiduciary duty for which he was liable to account to the company.

Statutory duty to avoid conflicts of interest (ss 182-183)

The directors’ and officers’ fiduciary duty to avoid conflicts of interest, at general law, is reinforced under the Corporations Act. Sections 182 and 183 provide that an officer or employee must not improperly use their position (s 182) or information (s 183) obtained because of their position:

• •

[page 484]

in order to gain a benefit either for themselves or someone else; or to cause detriment to the company.

These duties reflect the fiduciary duties discussed above relating to the no conflict and no profit rules. These rules prevent directors, officers and employees from keeping advantages that properly belong to the company. Employees can be in breach of ss 182-183 either in their own capacity, or also if they are involved in a director’s breach of these sections, as shown in Hydrocool Pty Ltd v Hepburn (No 4) (2011) 83 ACSR 652; [2011] FCA 495.8

These provisions are widely drafted and interpreted broadly by the courts. In Chew v R (1992) 173 CLR 626, the High Court found that the sections do not require proof that the officer actually achieved his or her purpose in attaining a benefit for themselves or another person (this was applied by the subsequent decision in R v Byrnes and Hopwood (1995) 183 CLR 501). Rather, the sections require proof that the officer believed that the intended result would be an advantage for himself or herself or for some other person or a detriment to the corporation. However, where the officer knew they were being dishonest that would generally prove impropriety: Kwok v R (2007) 64 ACSR 307; [2007] NSWCCA 281 at [80] per Santow JA, where it was stated that ‘dishonest use of a director’s position would necessarily mean that the use was also improper, but not every improper use of position is necessarily dishonest’.

R v Byrnes and Hopwood (1995) 183 CLR 501 High Court of Australia

Impropriety consists in a breach of the standards of conduct that would be expected of a person in the position of the alleged offender by reasonable persons with knowledge of the duties, powers and authority of the position and the circumstances of the case.

The High Court noted in Doyle v ASIC (2005) 56 ACSR 159; [2005] HCA

78 at [35] that impropriety will be found where the director or officer breaches:8

… the standards of conduct that would be expected of a person in his [or her] position by reasonable persons with knowledge of the duties, powers and authority of the person’s position as a director or officer.

Such an approach was adopted in Downer EDI Ltd v Gillies (2012) 92 ACSR 373; [2012] NSWCA 333 where the court held that the director had made improper use of the company’s funds in breach of s 182.9 While the court accepted that the CEO personally believed that his actions were honest and appropriate when he used the company’s funds, the court rejected the view that such factors are determinative in establishing whether there is breach of directors’ and officers’ duties.

ASIC v Vizard, below, is a good illustration of the enforcement of the statutory no conflict rule in s 183, the application of the civil penalty provisions arising from

[page 485]

a breach of s 183 and the application of the precedent in the Regal Hastings case (discussed above) which demonstrates that a director can still be liable for breach of fiduciary duty, despite no loss or harm being caused to the company.

ASIC v Vizard (2005) 145 FCR 57; [2005] FCA 1037 Federal Court of Australia

Facts: Vizard was a non-executive director of Telstra. During his time as director, Vizard obtained information from board meetings and internal briefing documents that outlined a strategy of acquisitions in other IT firms. Vizard then established a family trust, managed by his accountant, to purchase shares in firms that Telstra had intended to takeover or acquire large stakes in. Most of these share trades were losses, and no Telstra funds were used for the acquisitions (that is, Telstra did not suffer any losses from the share trades). ASIC sued Vizard for breach of s 183 (and its predecessor provision).

Decision: Vizard admitted liability and was ordered by the court to pay close to $400,000 in pecuniary

•

penalties and was disqualified from being a company director for 10 years.

The court, relying on the precedent in Regal Hastings, said (at [28]):

… a director is denied the ability to use such information for his or her own purposes. It does not matter that the director’s action causes no harm to the company or does not rob it of an opportunity which it might have exercised for its own advantage.

Given that directors’ duties are owed to the company, why should directors be liable for breach of fiduciary duty even where the company suffers no loss? Do directors’ duties have a public interest value that extends beyond mere protection of the company and its investors?

The statutory duties found in ss 182 and 183 (avoidance of conflicts of interest) are wider than those equivalent duties under the common law or equity. The common law and equity only impose duties on directors, whereas the words used in the Corporations Act extend the duty to cover directors, officers and even employees.

It has been held that a breach of the equitable obligation of confidentiality may provide evidence that a person has ‘improperly’ used information in relation to a case under s 183: Del Casale v Artedomus (Aust) Pty Ltd (2007) 73 IPR 326; [2007] NSWCA 172. In that case, two directors set up a competing business but were found not to have contravened their duty of confidentiality as they did not disclose the information to anyone else, but rather used it themselves in circumstances where it formed part of their general know-how and would not be restrained by equity. They were therefore found not to have used the information ‘improperly’. This may be compared with Zomojo Pty Ltd v Hurd (No 2) [2012] FCA 1458 where the court found that a former director of a high frequency trading (HFT) firm breached confidentiality by mimicking elements of the HFT software to set up his own trading firm. This conduct was found to be an improper use of information gained while he was acting in a fiduciary capacity. Similarly, in Ezystay Systems Pty Ltd v Link 2 Pty Ltd [2015] NSWSC 1105, it was held that a director who uses company documents and information to set up a business in competition with the company

16.11

• •

•

will be in breach of statutory duties (ss 182 and 183) and fiduciary duties. In both Zomojo and Ezystay appeals were dismissed.

[page 486]

Statutory duty to disclose material personal interests (s 191)

The equitable obligation to disclose conflicts of interest is reflected in s 191(1) of the Corporations Act. It should be noted that s 191 does not override equitable duties but stands alongside them: s 193. Section 191(1) states that:

a director of a company; who has a material personal interest in a matter that relates to the affairs of the company; must give the other directors notice of the interest unless subs (2) says otherwise.

The first element requires consideration of the broad definition of a director in s 9 of the Act, which was discussed in Chapter 14. Note that this section does not apply to the broader category of ‘officers’.

The second element requires identification of what is meant by a ‘material personal interest’. Furthermore, this interest must relate to the affairs of the company. ‘Material’ was explained in the McGellin case.

McGellin v Mount King Mining NL (1998) 144 FLR 288 Western Australian Supreme Court

‘Material’ in this context, I think, means that the interest involves a relationship of some real substance to the matter under consideration or the contract or arrangement which is proposed. In that way the nature of the interest should be seen to have a capacity to influence the vote of the particular director upon the decision to be made … It is the substance of the interest, its nature and capacity to have an impact upon the ability of the director to discharge his or her fiduciary duty which will be important.

An interest that is of a small value only is not material for this purpose: Grand Enterprises Pty Ltd v Aurium Resources Ltd (2009) 72 ACSR 75; [2009] FCA 513.

Recently, a situation where several directors of a company sought to delay a meeting where there were proposed resolutions to vote them off the board was found to constitute a ‘material personal interest’ because the directors were no doubt concerned about losing their jobs: see Drillsearch Energy Ltd v McKerlie [2009] NSWSC 517.

The requirement that the interest be not only material, but also a personal interest, means that where the interest is held by someone other than the director it will not fit within s 191: Grand Enterprises Pty Ltd v Aurium Resources Ltd (2009) 72 ACSR 75; [2009] FCA 513 at [69]. In Grand Enterprises shares held by a director (and his wife) in a contractual counterparty represented less than 1% of the issued shares in the company and were not material, while 7% of the shares held in another contractual counterparty were held through a company in which the director held a 25% interest but the court found these were too remote an interest to be a material personal interest.

[page 487]

Importantly, s 191(2) provides a range of situations where disclosure by the director is not required. For example, notice is not required if the director’s interest arises because the director is a member of the company and the interest is held in common with the other members of the company. It is also common for the company’s constitution (if any) to make provision for dealing with conflicts of interest by directors. Clearly, the extent of fiduciary obligations is shaped by the nature of the contractual dealing between the fiduciary and his or her principal (in this case between the director and the company).

Section 191(3) requires that the director give notice of the details of the ‘nature and extent of the interest’ and ‘the relation of the interest to the affairs of the company’. This generally reflects the position under general

law principles. For example, in Imperial Mercantile Credit Association v Coleman (1873) LR 6 HL 189, a declaration by a director that he was ‘interested in the transaction’ without further clarification was held to be insufficient disclosure. The transaction involved the sale of securities issued by the company through a stockbroking firm in which he was a partner.

Section 192 allows a director to give standing notice of their conflicts to the board, without the need to raise the issue at every board meeting.

For public companies, s 195 prohibits a director with a material personal interest that requires disclosure from voting on a resolution concerning the transaction or being present during the vote — unless specifically exempted under s 195(2). Contravention gives rise to a criminal offence and the offence is one of strict liability: s 195(1B).

There may be situations where mere disclosure of a conflict is insufficient to protect the director from breach of duty. Particular situations may require the director to actively protect the company’s interest. This may arise because the director has intimate knowledge of the transaction which may protect the company from harm. It is also arguable that senior board members, such as the managing director or CEO, may be required to do more than merely abstain from voting. In ASIC v Adler (2002) 41 ACSR 72; [2002] NSWSC 171 at [735], Santow J stated that where a director under a conflict has significant power and influence over the board of directors (in this case Williams had control over the board of directors) then ‘mere disclosure of a conflict between interest and duty and abstaining from voting is insufficient to satisfy a director’s fiduciary duty’.

The director may also be under a positive duty to take steps to protect the company’s interest such as by using such power and influence as he or she had to prevent the transaction going ahead, or at least warn the other directors of the known risks involved in the transaction: see, for example, Permanent Building Society v Wheeler (1994) 11 WAR 187, where the managing director was found liable for breaching his duties by failing to warn the board over a transaction from which he had absented himself due to a conflict of interest. This issue is typically raised as part of an

16.12

argument that the director has failed to act with care and diligence — this duty is discussed further in Chapter 17.

[page 488]

Related party transactions

The Corporations Act 2001 (Cth) provides a specific procedure for conflicts that involve a public company providing a financial benefit to directors and other related entities. A public company must comply with Ch 2E, which is entitled ‘Financial benefits to related parties’. Chapter 2E was introduced in 1992 and requires a public company and its controlled entities which seek to give a financial benefit to directors or other related

•

• •

• • •

parties to obtain prior approval of shareholders.

The effect of these provisions is that full disclosure must be made to shareholders and the transaction is only permitted if the statutory procedure in Ch 2E is followed. These statutory provisions arose out of some inappropriate transactions conducted between Christopher Skase and his company Qintex, which caused the shareholders and creditors to lose millions of dollars in assets. The leading decision in ASIC v Adler (2002) 41 ACSR 72; [2002] NSWSC 171 also involved contraventions of the related party transaction provisions.

Financial benefit is defined in s 229 as a broad interpretation and it can include the following situations:

giving a financial benefit indirectly;

[page 489]

giving a financial benefit by making an informal agreement; or giving a financial benefit that does not involve payment of money.

The term financial benefit is to be given the broadest interpretation, ‘the economic and commercial substance of the transaction or associated conduct trumps legal forms and other niceties. The consideration given or to be given for the benefit is irrelevant for definitional purposes’: ASIC v Avestra Asset Management Ltd (in liq) [2017] FCA 497 at [149].

Only certain people will be classified as related parties for the purposes of s 208 and Ch 2E. These are defined in s 228 as:

a controlling entity of the public company; directors of the public company or its controlling entity and their spouses and de facto spouses, parents and children; an entity controlled by a related party; an entity that was a related party during the previous six months; or an entity that acts in concert with a related party on the understanding that the related party will receive a financial benefit if the public company gives the entity a financial benefit.

• • •

ASIC v Adler (2002) 41 ACSR 72; [2002] NSWSC 171 New South Wales Supreme Court

Facts: HIH paid $10 million for a unit in a trust controlled by Adler (a director of HIH). Adler controlled the trust through two companies (Adler Corp and PEE) both of which he controlled. The unit trust was managed by PEE, whose sole shareholder was Adler Corp, which was ultimately controlled by Adler. The assets in the trust that PEE managed were technology stocks worth substantially less than $10 million. PEE used part of the $10 million to purchase HIH shares. Adler Corp had substantial shareholdings in HIH. At no time was shareholder approval sought for the loan.

Issue: Was the $10 million loan by HIH a financial benefit given to a ‘related party’? If so, was the transaction ‘at arm’s length’ so as to provide a defence against a breach of the related party transactions provisions?

Decision: The court found that the $10 million payment was a financial benefit provided to PEE, Adler Corp and Adler in breach of s 208, because no member approval was obtained prior to the payment. The payment could not be characterised as being an ‘arm’s length transaction’ so as to take advantage of the defence in s 210, because the payment was unsecured, inadequately documented and allowed for the self-acquisition of securities by HIH.

Significance: The Adler case is one of the few judicial decisions on the related party transaction provisions.

However, the related parties are still allowed to gain a financial benefit if they follow the procedures laid down in Ch 2E or if the transaction fits within the statutory exceptions. Under s 208, it is necessary for a public company or an entity it controls to give a financial benefit to a director or other party, the company must obtain the approval of its members and give the financial benefit within 15 months of the approval. The approval process involves convening a members’ meeting and a simple majority passing the resolution. The related party that is receiving the benefit must not vote on the resolution.

[page 490]

The exceptions to the rule in s 208 include:

transactions at arm’s length on ordinary commercial terms (s 210);10 remuneration or reimbursement for officers and employees (s 211); indemnities, exemptions, insurance premiums and legal costs (s 212);

• • • •

16.13

• •

•

small scale benefits, under $5000 (s 213); benefits provided to or by closely-held subsidiaries (s 214); ‘fair’ benefits to related parties as members (s 215); and court ordered financial benefits (s 216).

The burden of establishing that an exception applies is on the party seeking to rely on it: Waters v Mercedes Holdings Pty Ltd (2012) 203 FCR 218; [2012] FCAFC 80.

If a related party of a public company is found to be in contravention of s 208, it does not mean that the validity of any contract or transaction connected with the giving of the benefit is actually affected: s 209. However, the person who is involved in a contravention of s 208 contravenes a civil penalty provision: s 1317E.

Consequences of breaching fiduciary duties

voidable: This means that the contract can be terminated by the innocent party (that is, the company)

Under general law, a failure to disclose a conflict of interest rendered the transaction voidable at the option of the company. Aside from rescinding the contract, the company can seek to obtain a range of remedies:

an injunction to stop the breach of duty continuing; a constructive trust over assets acquired arising from the breach of duty (as illustrated in Chapter 4 with reference to the outcome in Chan v Zacharia (1984) 154 CLR 178, which dealt with the consequences of a partner being in breach of fiduciary duty); an account of profits to strip away gains made by the breach of the duty (as illustrated above in Regal (Hastings) Ltd v Gulliver [1967] 2 AC 134; Green v Bestobell Industries Pty Ltd (1982) 1 ACLC 1); or equitable compensation.11

For contraventions of the statutory duties, both ss 182 and 183 are civil

penalty provisions under s 1317E. Therefore, breach of these provisions may result in a declaration of contravention being made by the court and thereafter ASIC may apply for a pecuniary penalty order (s 1317G) and/or a disqualification order (s 206C) and/or compensation for the company (s 1317H).

[page 491]

It should be noted that the concept of damages under s 1317H includes any profit made by the defendant director which therefore corresponds to the equitable remedy of an account of profits.12 The court may also order an injunction under s 1324, appoint a receiver or make an asset preservation order under s 1323.

A serious contravention of ss 182 or 183 which is dishonest or reckless may result in a criminal liability under s 184(2). This action may be taken by ASIC and/or the Commonwealth Director of Public Prosecutions.

Sections 191 and 195 (disclosure provisions) are not civil penalty provisions but may give rise to criminal sanctions under s 1311 and Sch 3.

16.14

[page 492]

Defences to liability Members’ consent

ratification: the shareholders may agree to approve of the directors’ conduct provided they have been given full information. Such an approval is known as ratification

As fiduciary duties are owed to the principal, it is logical that the

16.15

• •

•

principal can give permission to the fiduciary to act in a manner that would otherwise be a breach of duty. This is known as ratification. If all the members of the company agree to ratify a breach by the officers, it may be possible to correct the previous, or future, contravention of the law. The weight of judicial authors favours the view that ratification be obtained from the members and not merely from the board of directors: Furs Ltd v Tomkies (1936) 54 CLR 583; Cook v Deeks [1916] 1 AC 554. Where the directors are the only members, then ratification by them will be sufficient: Queensland Mines Ltd v Hudson (1978) 18 ALR 1 (applied recently in Cornerstone Property & Development Pty Ltd v Suellen Properties Pty Ltd [2015] 1 Qd R 75; [2014] QSC 265).

However, ratification by the members will not be effective to forgive a breach of duty where:

the members have not given fully informed consent; the ratification constitutes minority oppression, as illustrated above with reference to the decision in Cook v Deeks [1916] 1 AC 554; the company becomes insolvent (because, in insolvency, the duties of directors change from being owed to the shareholders to being owed to creditors as discussed later in Chapter 18 with reference to the decision in Kinsela v Russell Kinsela Pty Ltd (1986) 4 NSWLR 722); the acts are illegal (that is, criminal acts) or are beyond the power of the company (for example, issuing shares for an improper purpose); or the acts represent a misappropriation by the directors of the company’s property (as this would allow the shareholders to misappropriate the company’s property which is also not permitted).

Ratification may occur through a formal members’ meeting (such as the AGM) or through the ‘the doctrine of unanimous consent’. This doctrine is also referred to as the Duomatic principle because it was recognised in the decision Re Duomatic Ltd. [1969] 2 Ch 365. Duomatic decided that the consent of the members may be presumed where all of the members know about a breach of duty but act in a manner consistent with their approval (or ratification) of that breach.

The High Court has stated that ‘the shareholders of a company cannot release directors from the statutory duties imposed under statute law (the

former equivalent provisions to ss 180(1) and 182)’: Angas Law Services Pty Ltd (in liq) v Carabelas (2005) 53 ACSR 208; [2005] HCA 23 at [32] per Gleeson CJ and Heydon J. However, it is clear that where the directors have obtained the prior permission of the shareholders to engage in certain conduct (provided that the shareholders freely consented and were fully informed), this will be an important factor in determining if a penalty (such as a disqualification order or pecuniary penalty) should be imposed. It may even restrict the scope of duty so that any act done with permission could not be ‘improper’ for the purposes of ss 181-183.

2. 3.

7. 8.

10.

[page 493]

Revision Questions

What are the sources of directors’ and officers’ duties to avoid conflicts of interest? What is the test for establishing that there is a conflict of interest? What remedies are available for breach of the ‘no conflict rule’? Answer with reference to remedies at general law and under the Corporations Act. What relevance does the fact that the director did not derive any benefit from their conduct have for assessments of acting improperly under ss 182 and 183? How do the courts determine whether a director has acted improperly? If a corporate business opportunity is offered to a director personally, will there be a breach of fiduciary duty? What is a material personal interest? How is criminal liability assessed in cases involving conflicts of interest? Why was there a breach of duty in the Regal (Hastings) case when the company could not have obtained the profits without the assistance of its directors? How relevant is the fact that directors have received ratification from the members for their actions when assessing impropriety?

Problem Question Barry Badler is the CEO of HealthCo Pty Ltd, a major supplier of medical equipment in Queensland. Barry also has a broad range of personal investments in a number of

4. 5.

companies. These investments are managed by his superannuation trustee (his wife) and he has no direct control over the trust. Lately, his wife has been investing the trust funds into a number of medical supply companies including MediCall Ltd, in which she has built up a 10% stake. She has not told Barry about her investment strategy.

In early August, HealthCo considers a tendering process for one of its major supply contracts. MediCall lodges a tender bid and Barry is on the tender committee. As a result of Barry’s recommendation, MediCall wins the tender contract.

In October Barry takes over control of his superannuation trust and builds up a further stake in MediCall so that his trust controls 19% of the company. Barry then pressures the company to appoint his wife onto the board of directors.

Advise Barry of his obligations under the Corporations Act arising from his dealings with MediCall. Were his actions in August and October in breach of the no-conflict rule?

Guidelines for Answering Problem Questions

When answering a problem question concerning directors’ duties, we suggest that the following method may be helpful:

[page 494]

Determine exactly what contravening act the person has done — have they acted to give themselves a benefit? If so, then ss 181-183 may be relevant. If they have failed to act, then s 180(1) or s 588G may be relevant (see Chapters 18 and 19). Then discuss the statutory provisions and relevant cases (at least one leading case per issue) for that issue (that is, negligence, fiduciary duties or insolvent trading). Work through the legal test for that particular duty. Determine if any defences may apply: for example, have they

7. 8.

obtained fully informed consent of the company? Comment on what consequences (that is, remedies and penalties) may apply. Can they be granted relief from liability under s 1317S? Most directors’ duties problems tend to involve multiple breaches of duties (such as negligence and acting for an improper purpose). The key step is working out what duties may have been breached, which you can usually determine in steps 3 and 4 above.

Wang is still looking at opportunities to enhance the business. He undertakes a review of the contracts involved in the business and decides that new arrangements need to be made for cleaning the company’s premises. Wang proposes for SCPL to enter a cleaning contract worth $50,000 with a cleaning business (CleanCo Pty Ltd). CleanCo is a company run by Wang’s daughter Elise (who lives with her mother). Wang has also considered entering into a new coffee supply contract worth $100,000 with a company controlled by his sister, Mei Ling. Lastly, Wang proposes to buy a catering business from his former wife, Rui, at a price agreed between Wang and Rui over coffee last week and calculated on a paper napkin. Wang and Rui split up four months ago. The price is slightly expensive, but Wang believes that combining the catering business with his coffee expertise will produce high profits.

Are there any breaches of directors’ duty here? What obligations does Wang have if he wants to complete these transactions? Would your answer be any different if SCPL was a public company?

Further Reading

Academic Journals R Baxt, ‘Escaping the Dilemma of Conflict — Is Resignation the Only

Course?’ (1997) 15 Company and Securities Law Journal 326. I Devendra, ‘Statutory Directors’ Duties, the Civil Penalty Regime and

Shareholder Ratification: What Role Does the Public Interest Play?’ (2014) 32 Company and Securities Law Journal 399.

P Finn, ‘Fiduciary Reflections’ (2014) 88 Australian Law Journal 127. J Glister, ‘Diverting Fiduciary Gains to Companies’ (2017) 40 University

of New South Wales Law Journal 4.

J Harris, A Hargovan and J Austin, ‘Shareholder Primacy Revisited: Does the Public Interest Have Any Role in Statutory Duties?’ (2008) 26 Company and Securities Law Journal 355.

J Kirby, ‘The History and Development of the Conflict and Profit Rules in Corporate Law — A Review’ (2004) 22 Company and Securities Law Journal 259.

R Langford, ‘The Fiduciary Nature of the Bona Fide and Proper Purposes Duties of Company Directors’ (2009) 31 Australian Bar Review 326.

[page 495]

M Pearce, ‘Company Directors as Super-Fiduciaries’ (2013) 87 Australian Law Journal 464.

S Scott, ‘The Corporate Opportunity Doctrine and Impossibility Arguments’ (2003) 66 Modern Law Review 852.

R Teele-Langford, ‘The Relationship between Conflicts, Profits and Bona Fides’ (2013) 31 Company and Securities Law Journal 423.

Practitioner Journals M Adams and M Nehme, ‘Australian Overregulation? — Effect on

Directors’ Liability’ (2009) 61 Keeping Good Companies 104. A Hargovan, ‘Director’s Breach of Fiduciary and Statutory Duties — the

Decision in Hydrocool’ (2011) 63 Keeping Good Companies 414. A Hargovan, ‘Directors’ and Employees’ Duty of Fidelity — Holyoake’

(2011) 63 Keeping Good Companies 668. A Hargovan, ‘Downer for CEO — Serious Misconduct Ruling by

Appellate Court in Downer Case’ (2012) Keeping Good Companies 668. A Hargovan, ‘Golden Handshakes and Breach of Directors’ Duties’

(2014) 66 Governance Directions 216. K Sanders and M Tan Kiang, ‘Managing Conflicts of Interest and Duties

on Boards’ (2005) 53 Keeping Good Companies 674.

Practitioner Works

6. 7.

10. 11.

Practitioner Works R P Austin, H A J Ford and I Ramsay, Company Directors: Principles of

Law and Corporate Governance, LexisNexis Butterworths, Australia, 2005, Chs 8 and 9.

H A J Ford, R P Austin and I Ramsay, Ford’s Principles of Corporations Law, LexisNexis, Australia, looseleaf and online, Ch 9.

You will find useful study resources, including quizzes for each chapter, when you go to <http://learning.lexisnexis.com.au>. The quiz is a great tool to help you self-test your knowledge.

Aberdeen Railway Co v Blaikie Bros (1854) 1 Macq 461; North-West Transportation Co v Beatty (1887) 12 App Cas 589; Imperial Mercantile Credit Association v Coleman (1871) LR 6 Ch App 558. The appeal from this decision was allowed in part, but not on matters affecting this discussion: Westpac Banking Corp v The Bell Group Ltd (in liq) (No 3) (2012) 89 ACSR 1; [2012] WASCA 157. See also the detailed review of authorities in Links Golf Tasmania Pty Ltd v Sattler (2012) 90 ACSR 288; [2012] FCA 634 at [545]ff. See, however, the strong criticism of the Mashonaland case in Poon Ka Man Jason v Chen Wai Tao [2016] HKEC 759, FACV 17/2015. See further, A Hargovan, ‘Directors’ and Employees’ Duty of Fidelity — Holyoake’ (2011) 63 Keeping Good Companies 668. It should be noted that the remedies ordered by the court were overturned on appeal, but the appeal did not challenge the findings of breach of fiduciary duty: V-Flow Pty Ltd v Holyoake Industries (Vic) Pty Ltd [2013] FCAFC 16. Similar facts occurred in Holyoake Industries (Vic) Pty Ltd v V-Flow Pty Ltd (2011) 86 ACSR 393; [2011] FCA 1154 (using customer lists to benefit a competing business). For a more recent example with similar facts, see Cornerstone Property & Development Pty Ltd v Suellen Properties Pty Ltd [2015] 1 Qd R 75; [2014] QSC 265. See, further, A Hargovan, ‘Director’s Breach of Fiduciary and Statutory Duties — the Decision in Hydrocool’ (2011) 63 Keeping Good Companies 414. This case also deals with the director’s breach of the duty of care and diligence, which is discussed in Chapter 17. See, further, A Hargovan, ‘Downer for CEO — Serious Misconduct Ruling by Appellate Court in Downer Case’ (2012) Keeping Good Companies 668. See further, Re Boart Longyear Ltd (No 2) [2017] NSWSC 1105, It should be noted that this is not the difference between the price paid by the company and the estimated value of the property. That would involve the court fixing a new price for the goods which is not permitted, The company must have suffered loss

12.

on the whole of the transaction to claim compensation. For a discussion of the difference between equitable compensation and an account of profits, see DTM Constructions Pty Ltd trading as QA Developments v Poole [2017] QSC 210. For a critique of this provision, see V-Flow Pty Ltd v Holyoake Industries (Vic) Pty Ltd [2013] FCAFC 16.

[page 497]

Directors and Officers: The Duty of Care and Diligence

CHAPTER 17 Duty of care, skill and diligence

Traditional standard Trend towards higher standards Modern duty of care and diligence Proving damage Statutory codification of the duty of care, skill and diligence Statutory defences Business judgment rule

Law reform proposals

[page 498]

Directors and Officers: The Duty of Care and Diligence

Learning Objectives After completing this chapter you should be able to:

Discuss the general law and statutory duty of care imposed on directors and officers.

Discuss the manner in which the standard of care is measured and applied to directors and officers under the modern law.

Explain how the standard of care is shaped by the individual director’s or officer’s circumstances, including their role and responsibilities within the company.

Assess the standard of care expected of persons occupying an executive or non-executive board position.

Discuss the right of directors to delegate their functions and the limitations that the law imposes on the delegation and ‘reliance on others’ defence.

Discuss the significance and operation of the business judgment rule.

Discuss the remedies for breach of the general law duty of care and the statutory duty of care.

Key Cases ASIC v Adler (2002) 42 ACSR 80; [2002] NSWSC 483

ASIC v Cassimatis (No 8) (2016) 336 ALR 209; [2016] FCA 1023 ASIC v Healey (2011) 196 FCR 291; [2011] FCA 717 (Centro case) ASIC v Hellicar (2012) 88 ACSR 246; [2012] HCA 17 (High Court appeal for James

Hardie directors) ASIC v Macdonald (No 11) (2009) 71 ACSR 368; [2009] NSWSC 287 (James Hardie

trial) ASIC v Rich (2003) 44 ACSR 341; [2003] NSWSC 85 (Greaves’ case) ASIC v Rich (2009) 75 ACSR 1; [2009] NSWSC 1229 (One.Tel trial) ASIC v Vines (2005) 55 ACSR 617; [2005] NSWSC 738 (trial) AWA v Daniels (1992) 9 ACSR 383 (AWA trial)

[page 499]

Daniels v Anderson (1995) 37 NSWLR 438 (AWA appeal) Permanent Building Society (in liq) v Wheeler (1994) 14 ACSR 109 Rich v ASIC (2004) 50 ACSR 242; [2004] HCA 42 Shafron v ASIC (2012) 88 ACSR 126; [2012] HCA 18 (High Court appeal for James

Hardie company secretary/general counsel) Vines v ASIC (2007) 73 NSWLR 451; [2007] NSWCA 75 (appeal) Vrisakis v ASC (1993) 11 ACSR 162

Key Sections Corporations Act 2001 (Cth) ss 9, 180, 189, 1317E, 1317G, 1317H, 1317S, 1318

[page 500]

Introduction

Investors in a business provide funds to the business on the basis of certain assumptions. One of those assumptions is that the directors and managers will use those funds for the purposes of running a successful business. Shareholders hope that by purchasing shares in a company, their investment will allow them to share in the potential future profitability of the company by way of increasing share values and dividend payments. Thus, shareholders do not expect directors to under-perform or to shirk from their responsibilities. Creditors expect that directors and managers will run the business successfully so that the company can repay its debts including interest.1

These expectations on the performance level of directors raise an important question. How does the law keep directors and other officers accountable for the level of effort they put in to running the business? This question is particularly significant for large public companies, which may have corporate governance problems arising from their large number of dispersed shareholders with small numbers of shares. Given this typical make-up of large public companies, there are often limitations on the shareholders’ ability to effectively monitor management and to ensure that directors and officers act in accordance with the expectations of their stakeholders. Noting that numerous Australians are economically exposed to the success or failure of major corporations through a government policy of compulsory superannuation, there are legitimate community expectations that corporations will be managed with an appropriate level of due care and diligence by those responsible for decisions and commercial risk-taking.

The law provides a protective and accountability mechanism by imposing a legal duty on directors and officers to act with reasonable care and diligence. Just as ordinary citizens are expected by the law of tort (negligence law) to act as a reasonable person would in response to foreseeable risks of harm, company directors and other officers are bound by common law and statutory duties (s 180(1)) to exercise their powers in the same manner as a reasonable person would if they occupied a similar position in a similar type of company.

The standard of liability set by the law, based on an objective standard, is designed to draw a line between responsible and irresponsible decisions and business judgments involving commercial risk-taking. The law does not impose liability for mere mistakes or for decisions that simply turn out poorly.

The key question for directors and officers, in discharging the duty of care and diligence at general law and under statute law, is whether they have acted as a ‘reasonable person’ would have in similar circumstances. The answer to this question is dependent on the facts of each case, as illustrated in the following passage:2

No rule of universal application can be formulated as to a director’s obligation in all circumstances. The extent of his duty must depend on the particular function he is performing, the circumstances of the specific case and the terms on which he has undertaken to act as director.

One of the basic problems with a concept such as ‘a reasonable person’ is that there is a subjective element (‘What do I think?’) and there is an objective element (‘What do people generally think?’). This can be challenging for courts, as they do not wish to second guess what the board of directors and the senior managers of a company were thinking on a specific item of business. The court does need to believe that a group of business people would make a similar decision based on the available facts.

[page 501]

In order to prevent the stifling of innovative commercial decisions and legitimate commercial risk-taking, the law offers protection in certain circumstances to directors and officers for decisions that later turn out to be unwise and cause harm to the company. As a general rule, the courts will not interfere with the merits of a business judgment, through hindsight, that is rational and made in good faith. This judicial attitude is reinforced under the Corporations Act 2001 (Cth) which provides for statutory protection against liability for breach of the duty of care in s 180(2), known as the business judgment rule. The requirements for a successful discharge of the business judgment rule, as a defence specifically aimed against a claim of breach of duty of care, is discussed below.

17.1

Duty of care, skill and diligence

Traditional standard The common law duty of care, skill and diligence that is expected by the courts has traditionally been set at a very low standard. This test was originally deemed to be a very subjective test, that is, what the directors actually thought rather than what a court would think in the particular circumstances. The basic test, which can be contrasted with the higher modern test in the AWA cases discussed below, was laid down in Re City Equitable Fire Insurance Co Ltd [1925] Ch 407. In that case, Romer J (whose judgment was approved by the English Court of Appeal) considered claims made against the directors of an insolvent company who had signed fraudulent cheques produced by the managing director. The issue, therefore, was whether the directors had breached their duties by failing to detect the fraud before signing the cheques. The company’s constitution prohibited the directors from being personally liable unless they were shown to have acted with gross negligence. Such an indemnity against liability is now prohibited under s 199A. The significance of the case lies in the principles that Romer J provided for assessing the duty of care and diligence.

Re City Equitable Fire Insurance Co Ltd [1925] Ch 407 Chancery Court (UK)

Directors must exercise such degree of skill and diligence as would amount to the reasonable care, which an ordinary man might be expected to take, in similar circumstances, if the business were their own. However, directors need not exhibit in the performance of their duties a greater degree of skill than may reasonably be expected from a person of their particular knowledge and experience. Directors are not bound to give continuous attention to the affairs of the company because the duties of directors are of an intermittent nature to be performed at periodical board meetings, and at meetings of any committee to which the directors may be appointed, and though not bound to attend all such meetings the directors should attend them when reasonably able to do so. Directors may properly rely on the actions of company officials, unless there are reasonable grounds for suspecting that the officials are not adequately performing their roles.

17.2

[page 502]

objective test: the standard is assessed by what a reasonable person would have known, done or believed. It is different from a subjective test which merely relies on what the director says they knew, did or believed.

This was a subjective test that relied on the individual officer’s skill, knowledge and experience. This former approach can now be compared with the objective test, or objective statutory standard of care that was introduced into the corporations legislation in 1993: see now s 180(1). Until this time, prior to common law developments and statutory reform in the 1990s, the common law duty for directors was the lowest standard for any professional person. The idea that the shareholders were ultimately responsible for the unwise appointments of directors led to the duty of care, skill and diligence being set at a remarkably low level.3 Historically, directors were viewed as country gentlemen and were not expected to realise the significance of certain information in the financial accountants4 or to be aware of the company’s affairs.5

Trend towards higher standards It should be noted that the nature of corporate governance, and indeed public perceptions and expectations concerning corporate governance standards, have now changed dramatically since 1925 when Romer J made the famous statements that are summarised above. This can be seen from the following influential comments by Kirby P in Metal Manufacturers Pty Ltd v Lewis (1988) 13 NSWLR 315 at 318-19:

The time has passed when directors and other officers can simply surrender their duties to the public and those with whom the corporation deals by washing their hands, with impunity, leaving it to one director or a cadre of directors or to a general manager to discharge their responsibilities for them.

These comments strike at the third principle stated by Romer J in Re City Equitable Fire Insurance Co, that is, directors may protect themselves by delegating their responsibilities to other company officers (as long as they do not have a suspicion of wrongdoing). Similar comments, in elevating the standards of performance expected of the modern director, have been made in numerous cases involving the pursuit of directors for

17.3

breaching the prohibition on insolvent trading. In Commonwealth Bank of Australia v Friedrich (1991) 5 ACSR 115 at 126, Tadgell J said that:

As the complexity of commerce has gradually intensified (for better or for worse) the community has of necessity come to expect more than formerly from directors whose task it is to govern the affairs of companies to which large sums of money are committed by way of equity capital or loan. In response, the parliaments and the courts have found it necessary in legislation and litigation to refer to the demands made on directors in more exacting terms than formerly; and the standard of capability required of them has correspondingly increased.

The 1992 Cadbury Report into corporate governance in the United Kingdom was followed in Australia by the Bosch Report into corporate governance which coincided with a higher expectation of directors’ performance standards being demanded from the courts. Corporate governance is discussed further in Chapter 13.

[page 503]

As Middleton J recently noted in the Centro case (ASIC v Healey (2011) 196 FCR 291; [2011] FCA 717 at [14]):

A director is an essential component of corporate governance. Each director is placed at the apex of the structure of direction and management of a company. The higher the office that is held by a person, the greater the responsibility that falls upon him or her. The role of a director is significant as their actions may have a profound effect on the community, and not just shareholders, employees and creditors.

Modern duty of care and diligence The imposition of statutory corporate governance duties on directors was initiated in the 1960s, and has progressively increased (especially since the corporate collapses of the 1980s) over the years with changing community expectations of corporate responsibility.6 A central element of this trend of higher expectations of directors’ performance has been the link between corporate scandals and corporate law reform. The corporate greed and excesses of the 1980s resulted in spectacular corporate collapses which put the retirement savings of millions of Australians at risk. Tapping into community sentiment, the judiciary and parliament subsequently refashioned and elevated the standards of care and diligence expected of directors and other officers.

It became unacceptable to simply claim that one did not have the experience or skills needed to manage a company. Many of the cases discussed below arose out of the major corporate collapses in 2001, such as HIH Insurance, One.Tel and the takeover of GIO by AMP. There is clear evidence that, under the modern approach, the courts are taking into account community expectations and demanding a higher standard of care than was thought necessary in the past.

Any doubts that may have existed with regard to the continued relevance of the somewhat lax principles expressed in Re City Equitable Fire Insurance Co to modern corporate governance (see, for example, the quotes from the Friedrich decision above) were brought to attention in the AWA litigation which generated two important decisions:

the original trial decision of Rogers CJ (NSWSC, Common Law Division) in the AWA case: AWA v Daniels (1992) 9 ACSR 383; and the subsequent appeal decision of Sheller and Clarke JJA in Daniels v Anderson (1995) 37 NSWLR 438 — this is the landmark case on the director’s duty of care, skill and diligence at general law and is also significant for purposes of interpreting the statutory duty of care under s 180(1).

It is fair to state that the AWA litigation, as referred to collectively, created a fundamental shift in the assessment of common law directors’ duties of care, skill and diligence in Australia — the appellate court decision in Daniels v Anderson is of particular importance for this reason. This decision can be seen as a movement from the older subjective test to the more modern contemporary objective test that is now applied to directors and officers of a company.

[page 504]

AWA v Daniels (1992) 9 ACSR 383 New South Wales Supreme Court (Trial Decision)

Facts: The AWA case concerned the assessment of responsibility for large losses incurred by AWA Ltd, a publicly listed company, on the foreign currency market. AWA derived nearly 25% of its profit from foreign exchange currency trading. The company officer in charge of the foreign exchange currency trading (Koval) was allowed to operate within the company without any effective supervision. Koval then concealed losses made in these transactions by making unauthorised loans to cover the losses, which eventually amounted to nearly $50 million. At all times AWA had engaged Daniels, an accountant (who worked for the firm that is now Deloittes) to audit the company’s accounts and internal processes. The audit conducted by Daniels revealed deficiencies in internal control and, in particular, over Koval’s activities. This information was conveyed by the auditor to Hooke, the managing director of AWA. Both Hooke and the auditor, however, failed to convey this information to the board of directors. AWA sued Daniels and his firm for negligence in failing to report the deficient internal controls over the foreign exchange trading activities to the board.

Daniels then countersued the directors of AWA (including both executive and non-executive directors) for contributory negligence, alleging that they failed to exercise a reasonable degree of care and diligence in the discharge of their duties.

Issue: Had the directors of AWA acted in breach of their duty of care, skill and diligence? Decision: Rogers CJ found the auditors and executive directors liable in negligence. His Honour found that the directors of AWA had failed to put in place an effective internal system to enable them to monitor the proper conduct of the audit, which had contributed to the failure to report the irregularities. His Honour recognised that the exact nature of this obligation would change according to the size and complexity of the company involved. In other words, the larger and more complex the company is, the broader the level of monitoring will be required. His Honour, however, found that the non-executive directors were not negligent.

Significance: Rogers CJ’s decision moved away from the traditional formulation of directors’ duties expressed above by Romer J in 1925 in the Fire Insurance case. Particularly, Rogers CJ noted that the duty of executive directors to act with proper care, skill and diligence was to be objectively assessed (whereas Romer J allowed a subjective assessment). Rogers CJ thus drew a distinction between executive and non-executive directors and imposed a lesser standard on non-executive directors ( just as Romer J had done). His Honour also agreed with Romer J that directors may properly rely on the advice given by the company’s internal auditors without breaching their duty. This was particularly important in his assessment that the non-executive directors were not negligent (that is, because they had relied on the advice of the executive directors).

While the AWA case was being determined, the Commonwealth Parliament was investigating and reviewing a change to the statutory duties of reasonable care and diligence. The introduction of the Corporate Law Reform Act 1992 (Cth) rewrote the previous statutory provision and introduced s 232 (which has been refined and replaced by the present s 180(1)). The statutory duty also provides for an objective standard of care.

[page 505]

Daniels v Anderson (1995) 37 NSWLR 438 New South Wales Court of Appeal (Appeal Decision)

Decision: On appeal, Sheller and Clarke JJ delivered the majority judgment largely affirming what Rogers CJ’s found during the trial decision in the AWA case. Indeed, the Court of Appeal agreed that the executive director acted in breach of his duties and that the non-executive directors had not acted in breach of their duties.

In confirming that the director’s duty of care is not merely subjective, limited by the director’s knowledge and experience or ignorance, the Court of Appeal laid down the following principles governing the performance expectation of the modern director (with reference to Friedrich and also to United States case law):

Directors should acquire at least a rudimentary (basic) understanding of the business of the corporation and should become familiar with the fundamentals of the business. Directors are under a continuing obligation to keep informed about the activities of the corporation. Directors may not shut their eyes to corporate misconduct and then claim that because they did not see the misconduct, they did not have a duty to look. The sentinel (guard) asleep at his post contributes nothing to the enterprise he is charged to protect. Directorial management does not require a detailed inspection of day-to-day activities, but rather a general monitoring of corporate affairs and policies. Accordingly, a director is well-advised to attend board meetings regularly. While directors are not required to audit corporate books, they should maintain familiarity with the financial status of the corporation by a regular review of financial statements which may give rise to a duty to inquire further into matters revealed by those statements. A director is not an ornament, but an essential component of corporate governance. Consequently, a director cannot seek protection behind a paper shield bearing the motto ‘dummy directors’. The concept of a sleeping or passive director has not survived and is inconsistent with the requirements of current company law. If a director feels that he or she has not had sufficient business experience to qualify them to perform the duties of a director, they should either acquire the knowledge by inquiry, or refuse to act.

A clear and common theme emerges from the above principles — namely, the days of the sleeping director are well and truly over. A director can no longer safely proceed on the basis that ignorance and a failure to inquire are a protection against liability for negligence.

Significantly, the Court of Appeal rejected the view that directors can simply represent a particular field of experience. Sheller and Clarke JJA stated that:

There is no doubt reason for establishing a board which enjoys the varied wisdom of persons drawn from different commercial backgrounds. Even so a director, whatever his or her background, has a duty greater than that of simply representing a particular field of experience. That duty involves becoming familiar with the business of the company and how it is run and ensuring that the board has available means to audit the management of the company so that it can satisfy itself that the company is being properly run. [emphasis added]

Their Honours also dismissed the notion that the duty of directors was intermittent (that is, it need only be assessed according to how many board meetings the particular directors attended). Their Honours said:

… the board should meet as often as it deems necessary to carry out its functions properly.

The question is what in the particular case are the duties and responsibilities of the directors and then what time is required of them as a board to

[page 506]

carry out these duties and responsibilities. It is not a matter of tailoring the extent of the duty or function to pre-fixed intervals between board meetings.

Finally, their Honours stated that:

As the law of negligence has developed no satisfactory policy ground survives for excluding directors from the general requirement that they exercise reasonable care in the performance of their office …

… a person who accepts the office of director of a particular company undertakes the responsibility of ensuring that he or she understands the nature of the duty a director is called upon to perform. That duty will vary according to the size and business of the particular company and the experience or skills that the director held himself or herself out to have in support of appointment to the office.

There are some differences, however, in the approach of the trial and appeal decisions. Principally, the Court of Appeal disagreed with Rogers CJ’s unequal treatment of the performance expectation of executive and non-executive directors. Instead, the Court of Appeal saw no need to differentiate in this manner and held that the same standards of care apply to the duty of directors, whether executive or non-executive.

Significance: The importance of Daniels v Anderson cannot be underestimated. The most significant consequence of the decision is the clear principle that directors’ duties are assessed objectively, and ignorance by directors (either through inexperience or unreasonable delegation of responsibility) of internal problems will not be a defence against liability for negligence.

This case is also authority for the rule that the same standards of care are imposed on the executive and non-executive directors in modern company law.

Consequently, the modern director is expected to inform himself or herself about the affairs of the company and can no longer remain ignorant about such affairs or take a passive interest in decisions made by the board. Nor can he or she remain financially illiterate — directors are expected, at the least, to be able to read and understand key financial statements such as the profit and loss account and balance sheet.

Commonwealth Bank of Australia v Friedrich (1991) 5 ACSR 115 Victorian Supreme Court

A director is obliged to obtain at least a general understanding of the business of the company and the

17.4

effect that a changing economy may have on that business. Directors should bring an informed and independent judgment to bear on the various matters that come to the board for decision:

… the stage has been reached when a director is expected to be capable of understanding his company’s affairs to the extent of actually reaching a reasonably informed opinion of its financial capacity …

The importance of directors monitoring the company’s financial performance is recognised by their statutory obligation to sign off on the financial reports (for disclosing entities that are required to produce annual financial reports: see Chapter 20). This was emphasised in the recent Centro case (ASIC v Healey (2011) 196 FCR 291; [2011] FCA 717). In that case the board of directors of various Centro entities (Centro is a large corporate group involved in building and managing shopping centres) was found to have failed to act with care and diligence under s 180(1) by failing to carefully supervise the production of accurate financial information (the company had mischaracterised its debt by over $1 billion).

[page 507]

ASIC v Healey (2011) 196 FCR 291; [2011] FCA 717 Federal Court of Australia

What each director is expected to do is to take a diligent and intelligent interest in the information available to him or her, to understand that information, and apply an enquiring mind to the responsibilities placed upon him or her. Such a responsibility arises in this proceeding in adopting and approving the financial statements. Because of their nature and importance, the directors must understand and focus upon the content of financial statements, and if necessary, make further enquiries if matters revealed in these financial statements call for such enquiries.

Assessing whether a breach has occurred One difficulty with the application of the objective nature of the standard of care, skill and diligence is that each person, each company and each managerial position is different and no universally consistent benchmark can be set to measure and assess the conduct of company directors. However, the courts have recognised that while the standard is objectively assessed (that is, what would a reasonable person have done, not what the individual company director was in fact capable of doing), the actual requirements of that standard will depend on what sort of role that person was performing in the company: Vrisakis v Australian

1. 2. 3.

Securities Commission (1993) 11 ACSR 162 at 213 per Ipp J.

In ASIC v Vines (2005) 55 ACSR 617; [2005] NSWSC 738, Austin J worked with extensive evidence from professional accounting firms in order to determine what the common activities of a chief financial officer (CFO) of a large corporate group of insurance companies would be. In his judgment, Austin J noted that the modern s 180(1) was similar to the common law tort of negligence. In the actual case, the purpose of this analysis was to determine what a ‘reasonable’ CFO would have done in the position of Mr Vines who occupied a similar position in the company. Extensive evidence was also given in that case of Mr Vines’ actual roles in the corporate group. Austin J’s finding of a breach of s 180(1) by the CFO was upheld on appeal: Vines v ASIC (2007) 73 NSWLR 451; [2007] NSWCA 75.

It should be noted that the Court of Appeal in Daniels v Anderson (discussed above) recognised that the standard of care will be influenced by the size and nature of the company, and the director’s position and responsibilities within that type of company. Therefore, it is important to determine:

the size and complexity of the company; what the defendant director did within the company; and whether a ‘reasonable director’ would have done the same thing in that situation (this may be based on evidence of what other directors within similar companies typically do).

As explained in DTM Constructions Pty Ltd v Poole [2017] QSC 210 at [37]:

There is therefore an objective and a subjective test involved in determining whether an officer or director has acted with appropriate care and diligence, given the Court is required to not only consider the care and skill a reasonable person would exercise but to take into account the actual position of the officer in the corporation and the type of corporation in question.

[page 508]

In the Centro case (ASIC v Healey (2011) 196 FCR 291; [2011] FCA 717) the fact that non-executive directors had extensive experience in corporate finance and accounting was relevant in determining what a reasonable

17.5

non-executive director would do in the circumstances (which involved approving the company’s financial reporting).

The minimum standard of care expected of directors and officers is captured in the following key statement in Deputy Commissioner of Taxation v Clark — this case is discussed further in Chapter 18 dealing with the directors’ personal liability for insolvent trading under s 588G.

Deputy Commissioner of Taxation v Clark (2003) 57 NSWLR 113; [2003] NSWCA 91 New South Wales Court of Appeal

What constitutes breach of the standards of care and diligence, in a particular case, will depend on a wide variety of circumstances including the precise nature of the business conducted by the company and the composition of the board. However, the case law [such as Friedrich; Daniels v Anderson] indicates that there is a core, irreducible requirement of involvement in the management of the company.

Although the standard of skill may vary in accordance with the particular skills of the directors, the core, irreducible requirement of skill involves an objective test, such as ‘ordinary competence’ … or ‘reasonable ability’ … An equivalent objective test applies to the core, irreducible requirement of diligence, such as ‘reasonable steps to place themselves in a position to guide and monitor the management of the company’ …

Thus, all directors (no matter how experienced or how skilled or knowledgeable) have a fundamental obligation to monitor the performance of the company: see also the AWA case.

Do non-executive directors owe a lesser standard of care? There is judicial tension on the key issue whether non-executive directors owe a lesser standard of care, as discussed earlier with reference to the AWA litigation. The weight of judicial authority appears to favour the approach adopted by the New South Wales Court of Appeal in Daniels v Anderson and expects the same performance standards of all directors. The decision in ASIC v Rich (2003) 44 ACSR 341; [2003] NSWSC 85 (see below for a summary) reaffirms this approach by holding that non-executive directors cannot avoid liability by claiming that their non-executive status allows them to perform their functions to a lesser

standard than executive directors. It reiterates that the standard of care is always objective, regardless of whether the director is executive or non- executive.

The significance of non-executive status lies in the fact that the nature of the obligations imposed on company directors (that is, the legal requirements that are actually demanded of them) are to be determined in accordance with the director’s actual role within the company, which is determined by whether the director is executive or non-executive. It is clear that an executive director will have greater responsibility within a company than a non-executive director, and therefore the legal obligations imposed on that director will be more onerous.

[page 509]

This does not mean, however, that non-executive company directors can avoid liability by taking no actual role within the company. The legal principle established in cases, such as Friedrich, AWA and Daniels, is that all company directors owe the basic duty of sufficiently monitoring the company’s affairs by maintaining an awareness of the company’s activities and financial status. Such knowledge is a necessary component of the director’s appraisal of an agreement to the company’s annual reporting requirements. How each individual director and officer discharges this monitoring role will, of course, depend on their position and responsibilities within the company as described earlier.

ASIC v Rich (2003) 44 ACSR 341; [2003] NSWSC 857 New South Wales Supreme Court

Facts: ASIC sued several directors of One.Tel Ltd, the insolvent telephone company, for breach of statutory duties. The directors sued by ASIC included Rich (an executive director) and also Greaves, who was a non-executive director and chairman of the company. Greaves defended ASIC’s case against him by arguing that his conduct as an officer was not in breach of any legal duty. Greaves’ defence was based on the notion that the conduct of non-executive chairmen did not come under similar legal duties as executive officers. Greaves, however, was a very experienced company officer and was also the chairman of the company’s finance and audit committee. It is important to note that

this was not a trial of whether Greaves (or any of the other officers) were actually negligent, but rather whether ASIC could sue Greaves by alleging negligence in similar terms to the alleged negligent conduct of the executive directors.

Decision: The court found that Greaves’ position as a non-executive chairman did not prevent him from owing duties to the company to act with due care. Greaves’ conduct in failing to remain informed of the company’s financial position was capable of giving rise to a claim that he had breached his duty of care and diligence. Greaves’ background and experience, in addition to his important role within the company (as finance and audit committee chairman), both contributed to the formulation of the requirements of his duties owed to the company. He could not rely on his non-executive status to justify failing to satisfy the basic requirement to remain properly informed regarding the company’s financial position.

Significance: Merely holding the title of a non-executive director will not result in a lower standard of duty. Directors will be expected to use their knowledge and skills to a reasonable standard.

In 2009, the trial decision against Mr Rich ( joint CEO) and Mr Silbermann (Finance Director) held that ASIC had failed to prove that One.Tel was insolvent at the relevant times, and therefore its case against Rich and Silbermann could not establish that they had breached their duties under s 180(1) by failing to advise the board of directors that the company was insolvent and should cease trading. The case (ASIC v Rich (2009) 75 ACSR 1; [2009] NSWSC 1229) contains a substantial discussion on the business judgment rule defence in s 180(2) which is discussed further below.

One of the most important cases on the duty of care for both directors and senior executives is the litigation involving the former directors and executives of the James

[page 510]

Hardie building materials company. This case will be used as a case study for this topic and is referred to throughout the chapter.

James Hardie

In Chapter 15 we discussed the James Hardie restructuring as a case study on corporate social responsibility and the scope of the obligation to act in the best interests of the company. The facts in the James Hardie restructuring, discussed earlier in Chapter 5 and summarised below, also present a good case study on the exercise of the duty of care and diligence. ASIC sued the directors and various officers in the New South Wales Supreme Court alleging that they had breached their statutory duty of care and diligence (among other duties) by allowing the companies to contravene disclosure obligations arising under the Corporations Act 2001 (Cth), and to engage in misleading or deceptive conduct.

In 2001, the management and the board of directors of James Hardie had decided to reorganise themselves to be a Netherlands-based company named JHI NV. The legal method adopted to create the new structure was a scheme of arrangement. A variety of reasons were given for this re- organisation including taxation and business costs (savings), and that the appropriate level of funding for future asbestos victim claims would be met through a trust (the Medical Research and Compensation Foundation — MRCF). The true motive behind the re-organisation has never been publicly stated and was agreed by the board of directors that it was based on a ‘business case’.

In 2001 JHI transferred assets worth $293 million to establish the MRCF and stated the trust was ‘fully funded’. By the end of 2003 the liability estimates were $1.573 billion, as stated in the Jackson Report.

The civil action commenced in February 2007 by ASIC against the original listed entity (JHI) and its former directors. The major focus of the case was on the ASX media release. ASIC brought the civil action against 12 defendants, being the original company, James Hardie Industries (now with a change of name called ABN 60 Pty Ltd) and the current company (James Hardie Industries NV) with the three executive officers (Peter Macdonald, Peter Shafron and Phillip Morley) and seven non- executive directors including Michael Brown, Michael Gillfillan, Meredith Hellicar (chair), Martin Koffel, Geoffrey O’Brien, Gregory Terry and Peter Willcox.

[page 511]

In ASIC v Macdonald (No 11) (2009) 71 ACSR 368; [2009] NSWSC 287 there were 52 allegations of contraventions of the Corporations Act brought against the 12 defendants. Both companies, JHI (ABN 60 Pty Ltd) (JHIL) and the current entity, JHI NV, as well as the seven non-executive directors and three executives (CEO, general counsel and CFO) were all named. ASIC was successful in proving 33 of the contraventions covering officers’ duties, misleading and deceptive conduct, false statements in relation to securities and breaches of continuous disclosure rules.

The trial court found that each of the directors, the CEO, CFO and general counsel/company secretary had breached their duty of care and diligence under s 180(1).8 Their negligence centred on their failure to prevent the company from issuing a misleading press release that claimed that a newly established medical research foundation would be fully funded to meet all legitimate, future, asbestos-related claims against the company, in both the present and the future. This was despite evidence from the company’s expert financial advisers that such funding would be insufficient unless a detailed set of assumptions came into effect (such as minimal increases in claims, and consistent investment returns of establishment funds at over 11% per year for 51 years!).

The trial court found that the directors and officers should have known that such unrealistic assumptions meant that it was misleading to claim that the foundation was fully funded. Indeed, several non-executive directors gave evidence that they had not considered the press release and would have voted against it because it was obviously misleading.

The trial court found that the CEO (Macdonald), company secretary/general counsel (Shafron) and the CFO (Morley) failed to properly advise the board about the nature and limitations of the restructuring plan and the misleading nature of the ASX release. In a separate civil penalty case, the trial court ordered remedies for the breaches of the Corporations Act. The company, James Hardie Industries NV, was only ordered to pay a pecuniary penalty (civil fine) of $80,000.9

The CEO, for his 10 contraventions of the law, received a pecuniary penalty (fine) of $350,000 and a banning disqualification order of 15 years from taking part in the management of a company. The civil penalty decision against the CEO, who did not participate in further appeals, remained undisturbed: ASIC v Macdonald (No 12) (2009) 73 ACSR 638; [2009] NSWSC 714The company secretary and general counsel (Shafron) received a seven-year ban from management and a pecuniary penalty of $75,000 which was later affirmed on appeal: Gillfillan v ASIC (2012) 92 ACSR 460; [2012] NSWCA 370.

Except for the CEO, all of the defendants appealed the trial decision: Morley v ASIC (2010) 81 ACSR 285; [2010] NSWCA 331. All of the defendants, except for Shafron (company secretary and in house lawyer) and Morely (CFO,) succeeded in the New South Wales Court of Appeal. This court overturned a key finding of fact made by the trial court. The Court of Appeal was not satisfied on the facts that the ASX release had actually been approved at the relevant meeting of the board of directors. This finding was based on a number of factors, such as the company’s failure to enter the board minutes within the one-month period required by s 251A and, more significantly, the failure of ASIC to call a key witness who participated in the relevant board meeting.

The New South Wales Court of Appeal in 2010, however, upheld the trial court’s finding of contraventions of s 180(1) by Morley and Shafron regarding their briefing of the board and the company of key risks and limitations on the actuarial modelling that underpinned the compensation fund.

[page 512]

The New South Wales Court of Appeal in 2010, however, reduced the period of Morley’s

disqualification from a period of five years to two years and the pecuniary penalty from $35,000 to $20,000 in an effort to strike a balance between personal deterrence (found to be low) and general deterrence (found to be important) arising from the facts of this case. Interestingly, although Shafron’s appeal succeeded in part and failed in part and dishonesty was not found, the Court of Appeal upheld the seven-year period of disqualification imposed by the trial court because of the high need for personal deterrence which arose in the following circumstances:

… [the general counsel] was the more seriously delinquent in his failure to exercise due care and diligence when the failure was moulded by a desire that an important item of market information should not be disclosed … it is … a matter which … justifies … characterisation of Mr Shafron’s failure … as flagrant [and] serious in the important area of ensuring an informed market.

ASIC successfully appealed the decision of the New South Wales Court of Appeal. In2012, the High Court of Australia handed down two appeal decisions in the James Hardie litigation.

The first appeal, ASIC v Hellicar (2012) 88 ACSR 246; [2012] HCA 17, concerned a point of evidence, specifically whether the court could be satisfied that the directors had approved the ASX release. Hellicar was also concerned about whether ASIC owed a duty of prosecutorial fairness and if so, whether this was breached by ASIC failing to call a key witness to give evidence as to whether the board approved the misleading ASX document at the board meeting. The court held that it was satisfied that the board had approved the ASX release based on the evidence. The minutes of the meeting, which noted the approval had been given, were approved without objection at the next month’s board meeting which supported the finding by the High Court. The High Court also held that it was doubtful that ASIC owed a duty of prosecutorial fairness.

The High Court’s finding of fact regarding the board’s approval of the misleading ASX announcement means that the actual determination that the non-executive directors had breached their duties is contained in the 2009 trial decision: ASIC v MacDonald (No 11).10 The second High Court appeal, Shafron v ASIC (2012) 88 ACSR 126; [2012] HCA 18, concerned the duty of care owed by Shafron as company secretary and general counsel.11 Only Shafron was party to this appeal. The High Court held that there was no reason to disturb the findings of the New South Wales Court of Appeal, which held that Shafron had breached his duty of care owed to the company by failing to give relevant information to the company concerning the scope of the economic modelling that underpinned the establishment of the foundation and whether the company needed to disclose its deed of covenant and indemnity entered into after the restructuring which limited the asset holding company’s liability to the Australian-based entities. In upholding the liability of the seven non-executive directors and the liability of the company secretary and general counsel (Shafron) for breach of s 180(1), the High Court remitted the case to the New South Wales Court of Appeal to determine appeals against penalties.

The James Hardie litigation concluded in November 2012, more than 11 years after the initial ASX announcement, in the New South Wales Court of Appeal in Gillfillan v ASIC (2012) 92 ACSR 460; [2012] NSWCA 370 with mixed results on the issue of civil penalties.

The New South Wales Court of Appeal in Gillfillan v ASIC (2012) reduced the penalties imposed on the seven non-executive directors by the trial judge, but affirmed the original

[page 513]

penalty imposed on Shafron discussed above.12 The disqualification period for five of the non- executive directors, based in Australia, was reduced to two years and three months and the pecuniary penalty was reduced to $25,000. For the two US-based non-executive directors, the disqualification was reduced to one year and eleven months and the pecuniary penalty was reduced to $20,000.

•

17.6

The period of disqualification was reduced for the US-based directors as their contravention (in approving a document that they had not seen) was not the same as the Australian-based directors (who had a copy of the misleading document at the board meeting).

Significantly, the New South Wales Court of Appeal in Gilfillan v ASIC (2012) 92 ACSR 460; [2012] NSWCA 370 expressed its disapproval of the poor standard of performance by the defendants and refused to grant judicial relief under s 1317S for reasons discussed below in 17.19.

The James Hardie litigation raises interesting issues about the extent of scrutiny required of non-executive directors and the extent to which managing a company that contravenes the law will demonstrate a breach of the duty of care.12 It must be remembered that the liability of the directors was concerned with their approval of a document to the ASX that was misleading. It seems sensible that a director will not be held personally responsible for any breach of the law by the company. This issue was discussed in the case of ASIC v Maxwell (2006) 59 ACSR 373; [2006] NSWSC 1052,13 where Brereton J found that merely being a director of a company that contravened certain corporate fundraising laws did not mean that the director had been negligent. Negligence is demonstrated by a failure to balance the potential benefits to the company compared with the potential risks to the company. Something more is required than simply being on the board when the company breaks the law.14 In the James Hardie case, the appellate court agreed with the trial judge and found that the officers (Morley and Shafron) failed to protect the company from the adverse consequences of engaging in misleading or deceptive conduct.

Does the James Hardie litigation mean that all company disclosures must be approved by the board? Why/why not?

Directors’ liability for misleading and deceptive market announcements Continuous disclosure, and the prohibition against misleading or deceptive conduct in relation to financial products or financial services (under s 1041H), are fundamental to the integrity of the Australian securities market and are some of the main ingredients for investor protection. Directors and officers, in particular, need to be aware that

misleading and deceptive announcements made to the market can give rise to direct liability for breach of the duty of care and diligence under s 180(1), as illustrated above in the James Hardie litigation and in further case examples below.

[page 514]

Apart from officers, managing directors have also been found liable for breaching s 180(1) for allowing the company to release misleading information to the market in ASIC v Citrofresh International Ltd (No 2) (2010) 77 ACSR 69; [2010] FCA 27.15

In Citrofresh, the managing director of a chemical company drafted a misleading ASX release which stated that the company had found a way to stop the spread of the AIDS virus and was found liable for breaching s 180(1).16 The court agreed with ASIC’s submissions that no reasonable managing director and chief executive officer of a publicly listed company would have authorised the release of these statements to the ASX and the public which lacked justification. The court held that the director’s conduct placed the company in jeopardy by exposing it to legal action and harming its financial interests and reputation. In breaching the duty of care and diligence, the director was ordered to pay a pecuniary penalty of $20,000 and was disqualified from managing corporations for a period of seven years.

In determining the disqualification period, the court rejected the submission that a lesser penalty was warranted because the director was not a professional director or an experienced director with public company experience. Goldberg J in Citrofresh was motivated by the following public interest considerations:

… it is in the public interest that in such circumstances a significant period of disqualification be imposed so as to bring to the attention of directors of corporations that they must take their duties and responsibilities as directors very seriously. It is also in the public interest that such a period of disqualification be imposed to protect the public.

The Centro case (ASIC v Healey (2011) 196 FCR 291; [2011] FCA 717) is also relevant here. Although that case did not involve misleading or deceptive conduct, it did involve directors failing to comply with their

•

17.7

duty of care and diligence under s 180(1) by allowing the company to release its financial reports with over $1 billion in debt mischaracterised as non-current liabilities when in fact the debt was a current liability.

In ASIC v Mariner Corporations Ltd [2015] FCA 589 the directors were found not to have contravened s 180(1) merely because the company made an announcement that could have been misleading. The court ultimately found that the announcement (which concerned the pricing of a takeover bid) was not misleading, but even if it was, it was based on a mere mistake which was not negligent.

Should directors be liable for breaching s 180(1) where the company releases misleading statements to the public? To what extent should the board of directors be involved in approving information released by companies to the public? Where a CEO or other officer (such as a company secretary) approves of a misleading press release but the release has been drafted by other employees who should be liable?

[page 515]

Attendance at board meetings As mentioned above, Romer J in Re City Equitable Fire Insurance Co Ltd [1925] Ch 407 believed that directors owed only intermittent duties to the company. One of the consequences of this intermittent duty was that directors were not bound to attend every board meeting. Romer J stated (at 429) that directors were not bound to attend all board meetings ‘although [directors] ought to attend whenever in the circumstances [they are] reasonably able to do so’. The majority decision of the Western Australia Court of Appeal in Vrisakis v Australian Securities Commission (1993) 11 ACSR 162 at 170 rejected this traditional belief by stating that ‘a director is expected to attend all meetings unless exceptional circumstances, such as illness or absence from the State prevent him or her from doing so’. In Sheahan v Verco (2001) 37 ACSR 117; [2001] SASC 91 the court found several non-executive directors to be in breach of the duty of care and diligence by failing to convene or attend any board

17.8

17.9

meetings over several years.

Special board positions There has been much debate as to whether all officers are equal or whether there are some distinctions based on the precise position held, such as chief executive or chair of the board. The general consensus is that all officers are equal in their duties but the level of skill and care expected may change depending on the position held. As noted in Chapter 14, there are various types of company officers, including the chair of the board, managing director and non-executive directors.

In a particular case, the officers (such as the chair of the board) may have certain powers and responsibilities, such as participating on special committees (for example, the audit committee). The possession of particular powers and responsibilities will be taken into account when determining whether the officer has complied with the duty of care, skill and diligence (and its statutory equivalent in s 180(1)). In ASIC v Rich (see below) the chairman, Mr Greaves, was held to hold a special position that must reflect his skills and diligence. This has also been applied to a chief financial officer in the Vines case (see below).

Chair of the board The chair of the board of directors has a special responsibility to oversee the operations of the board as a decision-making organ of the company, to provide strategic leadership and to act as a central conduit between the board and executive management. The chair also has a key role in selecting the CEO. See Chapter 14 for a further discussion of the role of the chair.

ASIC v Rich (2003) 44 ACSR 341; [2003] NSWSC 85 New South Wales Supreme Court

Facts: The basic facts in Rich were discussed above. In addition to those facts, Greaves also argued

that the role of chairman was largely ceremonial. Greaves argued that in light of this it was perfectly reasonable to rely on the executive officers to properly monitor the company.

[page 516]

Decision: Austin J found that the position of chairman that Greaves occupied was not, in contradiction to Greaves’ arguments, a purely ceremonial position. Austin J said: ‘if the duty to keep informed exists for all company directors, it must be a duty imposed on the company chairman.’ His Honour also stated that just as community expectations of corporate governance standards for directors had become more onerous in modern times, ‘the court’s role, in determining the liability of a defendant for his conduct as company chairman, is to articulate and apply a standard of care that reflects contemporary community expectations’.

In Agricultural Land Management Ltd v Jackson (No 2) [2014] WASC 102, the chair of the board of directors of Agricultural Land Management Ltd presided over a board meeting where documents explaining that a transaction was a related party transaction were presented to the board. The chair was also a director of the related company. When he subsequently signed the contract on behalf of the company, this was held to be a breach of the duty of care and a contravention of related party transaction provisions.

In ASIC v Flugge (2016) 119 ACSR 1; [2016] VSC 779, the former chair of AWB Ltd was present at an important meeting when information was passed that the United Nations (UN) was inquiring about AWB Ltd making inappropriate payments to Iraq, in breach of UN sanctions. The failure by the former chair of AWB Ltd to make any enquiries into the proprietary of the payments was held to be a breach of duty of care and diligence under s 180(1). The court held that a reasonable director, in the circumstances of the chair, would have made such enquiries. The court was satisfied that had adequate enquiries been made, it would have confirmed that unusual payments in breach of UN sanctions were being made by AWB Ltd and that the conduct would have ceased. Based on the civil penalty provisions, the former chair was disqualified from managing a company for a period of five years and a pecuniary penalty of $50,000 was imposed by the court: ASIC v Flugge (No 2) (2017) 119 ACSR 551; [2017] VSC 117.17

In ASIC v Sino Australia Oil and Gas Ltd (in liq) (2016) 115 ACSR 437; [2016] FCA 934 (hereinafter Sino), the chair of Sino was held to be in breach of

17.10

his s 180(1) duty of care and diligence due to his failure to understand documents and his failure to understand disclosure requirements for a publicly listed company on the ASX. The failure by Mr Shao, the chair of Sino, to ensure that he could understand the content of the documents he was signing (prospectuses) was a breach of his director’s duties. Based on the civil penalty provisions, Mr Shao was disqualified from managing a company for 20 years and ordered to pay compensation to the company in the sum of $5, 539,758 for the loss and damage the company will suffer and to compensate shareholders that were misled and deceived in the prospectus during capital raising: ASIC v Sino Australia Oil and Gas Ltd (in liq) (2016) 118 ACSR 43; [2016] FCA 1488. 18

[page 517]

Managing director The position of the managing director (MD) or CEO is particularly important as the chief executive of the company. More than any other director or other officer, the MD or CEO should be in a position to effectively monitor and control key decisions and information flows within the organisation. The importance of this position has been recognised in the case law where it has been held that the MD or CEO may have an extra obligation to seek to protect the company’s interests and to fail to do so may be negligence.

Permanent Building Society (in liq) v Wheeler (1994) 14 ACSR 109 Western Australia Full Supreme Court

Facts: In this case, several directors of Permanent Building Society (PBS) had knowledge that PBS was purchasing property from another company in which the directors had an interest. The case was therefore primarily based on the no-conflict rule (discussed in Chapter 16). However, one of the issues that also arose was what standard of care the managing director owed to the company.

Decision: The managing director had failed to exercise due care and diligence as the company’s general manager. The court found that the managing director’s disclosure of his conflict of interest was not sufficient to discharge his duty of care, skill and diligence as he should have taken steps to ensure that the rest of the directors were properly informed of the possible harm that may have been

caused to the company by the acquisition and to point out possible methods of reducing the risk of the transaction.

Similar comments were made about the position of HIH CEO (Ray Williams) in ASIC v Adler (2002) 42 ACSR 80; [2002] NSWSC 483. More recently, the case of ASIC v Macdonald (No 11) (2009) 71 ACSR 368; [2009] NSWSC 287 demonstrates the importance of the role actually performed by the individual director or officer. In that case Peter Macdonald was director and CEO of James Hardie. In the role of CEO, Macdonald was primarily responsible for managing the company’s restructuring and personally gave briefings on the restructure to the board and to important investment analysts. This individual responsibility meant that the law imposed a particularly high standard of care and diligence on him to ensure that the information released to the public was not misleading or deceptive.

It is certainly not the case that all CEOs will be found negligent if the company releases misleading statements to the market. In the James Hardie case, however, the information related to the sufficiency of funding for all future asbestos-related litigation which was a very significant issue for the company. Macdonald, in taking charge of the restructuring, was found to have failed to act with care and diligence by failing to prevent the company from releasing misleading information, particularly in circumstances where he was aware of evidence that suggested that the restructure would not be sufficient for all future claims against the company.

In Re Lawrence Waterhouse Pty Ltd (in liq); Shaw v Minsden Pty Ltd [2011] NSWSC 964, the court held that a managing director was in breach of s 180(1) for failing to ensure that the company maintained adequate books and records.

[page 518]

In Downer EDI Ltd v Gillies (2012) 92 ACSR 373; [2012] NSWCA 333, the New South Wales Court of Appeal held that the CEO was in breach of s 180(1) for exposing the company to financial and reputational risk arising

17.11

from unfunded tax liabilities incurred during his participation in the company’s bonus scheme.19

Chief financial officer The position of chief financial officer (or CFO) is one of the most senior executive positions within a company. The CFO is responsible for ensuring that the flow of financial information within the company and to the public is accurate and sufficient to ensure that the company complies with its legal obligations to disclose financial information. The CFO may also hold other positions within the company such as company secretary or company director.

In the James Hardie case (ASIC v Macdonald (No 11) (2009) 71 ACSR 368; [2009] NSWSC 287), the company’s CFO, Phillip Morley, was responsible for all of the finance, audit, tax and treasury aspects of the James Hardie group of companies. As noted in the case study above, the James Hardie case concerned the liability of the company’s directors and officers for breaching their duty of care and diligence by allowing the company to issue a press release stating that a new medical research foundation would be ‘fully funded’ to satisfy all legitimate future asbestos claims against the company. A major component in the company’s decision- making process that led to the press release being issued was the sufficiency of the financial information to support the claim that the new medical research foundation would be ‘fully funded’. As CFO, Morley had been responsible for verifying the sufficiency of the financial information. The verification process involved consulting experts including actuaries (Trowbridge), accountants (PWC) and economists (Access Economics). Each of these experts verified the information, although their verification was based on certain limited assumptions, such as no major increases in the rate of claims and investment returns of more 11% for the next 51 years. Even on these assumptions the best estimate was no more than 51% likely to eventuate.

Morley was found by the court to have contravened his statutory duty of care and diligence as CFO because he did not clearly communicate these limitations and their consequences to the board of directors. A reasonable CFO would have known that the range of limited assumptions

•

meant that the press release could not state with certainty that the foundation was fully funded. Morley’s appeal against this decision was unsuccessful: Morley v ASIC (2010) 81 ACSR 285; [2010] NSWCA 331. Morley did not seek special leave from the High Court to appeal this decision.

The decision in ASIC v Vines (2003) 48 ACSR 322; [2003] NSWSC 1116 allowed expert evidence from accountants as to what a reasonable person appointed as a group CFO of an insurance group of companies would do in the particular circumstances involved in that case (large losses from a reinsurance subsidiary in the context of a hostile takeover battle).

The 2003 Vines decision was a preliminary trial regarding the acceptability of the expert evidence concerning the role of chief financial officers. In 2005, Austin J handed down the final decision in this case (ASIC v Vines (2005) 55 ACSR 617; [2005]

[page 519]

NSWSC 738), which held that Vines had failed to act with care and diligence in relation to the accuracy of profit forecasts given during the takeover battle for GIO (of which Vines was the Group CFO). That decision was largely confirmed on appeal in Vines v ASIC (2007) 73 NSWLR 451; [2007] NSWCA 75, although the court overturned some of the contraventions found by Austin J, based on a different view of the significance of some evidence provided to the court.

In the Centro case (ASIC v Healey (2011) 196 FCR 291; [2011] FCA 717) the CFO accepted that he had breached his duty of care and diligence under s 180(1) by allowing the company to release incorrect information in its annual financial report.

What factors should the court take into account when determining the appropriate standard of care imposed on directors and officers?

17.12

General counsel and company secretary The role of general counsel extends across all of the company’s legal affairs — from being involved with drafting key contracts, negotiating contracts, developing internal policies to ensure legal compliance and securing external legal advice where necessary. The role of the company secretary was discussed in Chapter 14, and involves key administrative and legal compliance functions. The person occupying the general counsel position often also holds the position of company secretary. There have not been many cases where general counsel and company secretaries have been sued for negligence. In the James Hardie case (ASIC v Macdonald (No 11) (2009) 71 ACSR 368; [2009] NSWSC 287 (trial); Morley v ASIC (2010) 81 ACSR 285; [2010] NSWCA 331 (appeal); Shafron v ASIC (2012) 88 ACSR 126; [2012] HCA 18 (HCA appeal)), the court found that the general counsel and company secretary for James Hardie, Mr Peter Shafron, breached his duty of care and diligence under s 180(1) by failing to do more to prevent the company from releasing a misleading press release which asserted that the funds used to establish a medical research foundation to handle the company’s asbestos injury claims was sufficient to meet all legitimate future claims. The press release said that it was certain that the foundation was fully funded. This was misleading because the company had information that the funds provided to the foundation may not be sufficient to meet all future claims if certain limited assumptions used by the company’s expert financial advisers to determine the size of the funding required did not materialise.20

As noted above, in relation to the company’s CFO Morley, the board was not properly advised of the precise nature of these limitations. Mr Shafron argued that, as CFO, this was Morley’s role. The court, however, rejected that argument and stated (at [411]) that ‘[i]n the absence of explanation by Mr Morley, it was Mr Shafron’s duty in protecting JHIL from legal risk to have advised the board of the limitations’. This puts the responsibility for managing the company’s legal risk onto the general counsel and company secretary. Mr Shafron failed to mitigate this risk appropriately by not properly briefing the board of directors and thus allowed the defective media release to be released.

[page 520]

17.13

On appeal in Morley v ASIC (2010) 81 ACSR 285; [2010] NSWCA 331, the New South Wales Court of Appeal held that the media release was not in fact presented to the board for approval and so contraventions based on the board approving the release were overturned. However, the appeal court found that Shafron had failed to act reasonably by failing to fully inform the company concerning the risks of breaching continuous disclosure laws (concerning the delayed disclosure of a deed of covenant and indemnity which limited the rights of the compensation fund to pursue the asset holding company based in the Netherlands) and by failing to inform the board of key limitations in the actuarial modelling. As noted above, Shafron’s appeal to the High Court was unsuccessful with the High Court finding no reason to overturn the contraventions found by the New South Wales Court of Appeal. In the case of a person holding joint titles as company secretary and general counsel (like Shafron), the High Court held that it is not possible to sever duties and responsibilities into watertight compartments, one marked ‘company secretary’ and the other marked ‘general counsel’: Shafron v ASIC (2012) 88 ACSR 126; [2012] HCA 18

Proving damage It must also be remembered that merely proving that a director has failed to act according to the required standard of care and diligence does not, automatically, entitle the company to damages. As with ordinary negligence cases (such as Donoghue v Stevenson [1932] AC 562 — the famous ‘Snail in the Bottle’ case), the company must prove that the director’s breach of duty caused the company to suffer loss or damage. The question, then, will be whether (on the balance of probabilities — that it is more probable than not) the company still would have suffered the loss had the director acted according to the required standard: Permanent Building Society (in liq) v Wheeler (1994) 14 ACSR 109 at 162 per Ipp J. In Wheeler, a breach of duty was found against the managing director (Hamilton) but the company failed to prove that this breach of duty caused the loss as the remaining directors would still have voted to approve the transaction. Hamilton had abstained from voting after he declared his interest in the transaction, but even had he not breached his duty the result would have been the same as the other directors would still have acted the same way. The issue of remedies for breach of directors’

17.14

(a) (b)

duties is dealt with further below. In ASIC v Flugge (2016) 119 ACSR 1; [2016] VSC 779 at [1864] it was accepted that a breach of the statutory duty of care under s 180(1) can be found even where there is no proof of loss being suffered by the company.

Statutory codification of the duty of care, skill and diligence The common law principles (see 17.1-17.13) are incorporated into the legislation under s 180(1):

A director or other officer of a corporation must exercise their powers and discharge their duties with the degree of care and diligence that a reasonable person would exercise if they:

were a director or officer of a corporation in the corporation’s circumstances; and occupied the office held by, and had the same responsibilities within the corporation as, the director or officer.

The cases discussed above, therefore, are equally applicable to the interpretation of the statutory duty.

[page 521]

It will be seen that s 180(1) uses the words ‘care and diligence’ but not ‘skill’. This statutory formulation may be contrasted with the traditional common law rule which refers to the duty of ‘care, skill and diligence’. This may perhaps imply that there is still no objective statutory standard of skill. However, the Explanatory Memorandum to the Corporate Law Reform Act 1992 (Cth) (which reworded the statutory provision) seemed to assume that an objective standard of skill had been achieved by the statutory provision.

There is judicial authority to support the view that the statutory words of

s 180(1) (and its predecessors) incorporate an objective standard of skill for executive directors: see ASIC v Adler (2002) 41 ACSR 72; [2002] NSWSC 171.

Skill was defined by Clarke and Sheller JJA in Daniels v Anderson (1995) 37 NSWLR 438 at 667 to mean ‘that special competence which is not part of the ordinary equipment of the reasonable man but the result of aptitude developed by special training and experience’. The standard applied by Austin J in ASIC v Vines (2005) 55 ACSR 617; [2005] NSWSC 738 at [1058] was stated as:

The statutory formulation adopts an objective standard of care, measured by reference to what a reasonable person of ordinary prudence would do, enhanced where an appointment to the board of directors is based on the appointee having some special skill, by an objective standard of skill referable to the circumstances.

The New South Wales Court of Appeal confirmed this view: Vines v ASIC (2007) 73 NSWLR 451; [2007] NSWCA 75.

As noted above, expert evidence can be used by the court to help the judge determine what a reasonably competent chief financial officer or other special position of an officer would do in certain assumed circumstances. Each officer will owe a duty of care and diligence at an objective level based on their purported skills and expertise in the context of the corporation’s circumstances.

The duty requires that the judge looks at a ‘like’ position, so as to compare a particular officer with a person holding a similar position. This enables the court to look at both any special expertise held by an individual director and the distribution of functions within the corporation.21 The words the ‘corporation’s circumstances’ in s 180(1) relate to ‘the type of company, the size and nature of the company’s business, the composition of the board and the distribution of its work between the board and other officers’ as stated in the case of Commonwealth Bank of Australia v Friedrich (1991) 5 ACSR 115.

[page 522]

Common law vs statutory negligence

17.15

1. 2. 3.

As noted previously, there are three sources of directors’ duties:

statutory duties; common law duties, such as care, skill and diligence; and equitable fiduciary duties.

The statutory duty imposed on company directors to act with care and diligence under s 180(1) of the Corporations Act is similar, but not identical, to the common law duty not to act negligently. ASIC v Vines makes a clear link between the statutory duty of care under the Corporations Act and the developments within the common law tort of negligence. Austin J relied on the famous High Court negligence case of Wyong Shire Council v Shirt (1980) 146 CLR 40 to help determine what a reasonable person would do. Consideration of the magnitude of the risk and the degree of probability of its occurrence, along with the expense, difficulty and inconvenience of taking alleviating action and any other conflicting responsibilities the defendant may have, are important in determining what a reasonable director would do. This view was confirmed on appeal in Vines v ASIC (2007) 73 NSWLR 451; [2007] NSWCA 75, where Spigelman CJ noted that a breach of the statutory standard generally involves no greater threshold than that which applies to common law negligence.22 This was explained in Vrisakis v Australian Securities Commission (1993) 11 ACSR 162 at 212, where Ipp J said:

… the question whether a director has exercised a reasonable degree of care and diligence can only be answered by balancing the foreseeable risk of harm against the potential benefits that could reasonably have been expected to accrue to the company from the conduct in question.

This passage has been applied in several subsequent cases including ASIC v Maxwell (2006) 59 ACSR 373; [2006] NSWSC 1052; Vines v ASIC (2007) 73 NSWLR 451; [2007] NSWCA 75; and ASIC v Mariner Corporations Ltd [2015] FCA 589.

In Vrisakis v Australian Securities Commission (1993) 11 ACSR 162, Ipp J compared the tests for assessing breach of the common law standard and the statutory provision and found that the two are not the same. This is because common law negligence is centred on the duty to avoid causing harm by engaging in conduct that unreasonably creates a risk of harm. However, Ipp J stated that the statutory duty of care and diligence involves an assessment of whether the company director acted in a

manner that no reasonable director would have acted, in light of the extent of the risk of harm to the company that the conduct created. This risk must be balanced against the potential benefit that the company could have received through the conduct. Ipp J said (at 212):

The mere fact that a director participates in conduct that carries with it a foreseeable risk of harm to the interests of the company will not necessarily mean that he has failed to exercise a reasonable degree of care and diligence in the discharge of his duties. The management and direction of companies involve taking decisions and embarking upon actions which may promise much, on the one hand, but which are, at the same time, fraught with risk on the other. That is inherent in the life of industry and commerce.

[page 523]

The legislature undoubtedly did not intend by [the 1993 equivalent of s 180(1)] to dampen business enterprise and penalise legitimate but unsuccessful entrepreneurial activity.

The reference to balancing risk of harm to the company should not be interpreted narrowly and refers to harm to any of the interests of the company. This means that it is not only the potential for monetary loss that must be weighed. Matters such as the potential effect on the reputation of the company and potential regulatory action must also be included in the balancing exercise: see ASIC v Cassimatis (No 8) (2016) 336 ALR 209; [2016] FCA 1023 at [480]-[484] per Edelman J. Justice Edelman also stated that the ‘balancing’ exercise should not be taken literally, so that all directors need to do is engage in a simple cost/benefit analysis to comply with their duty. For example, directors who cause the company to break the law and potentially incur a penalty may still be in breach of the duty of care even where the gain to the company (or minimisation of loss to the company) is greater than any regulatory fine: at [485]. This is because his Honour held that the harm to the company included more than mere monetary amounts.

ASIC v Cassimatis (No 8) (2016) 336 ALR 209; [2016] FCA 1023 at [497] Federal Court of Australia

It can be immediately accepted that the pursuit of ventures which involve risk is one key purpose of

•

17.16

17.17

the limited liability corporation. That purpose, and its basis as a reason why some shareholders invest, is an important context in the assessment of whether s 180(1) has been contravened by a director. The business judgment rule (which is not relevant in this case) adds further weight to this matter. However, this does not give a director carte blanche to engage in any venture even if the venture is highly likely to (and does) contravene the law.

Does the duty of care and diligence dampen entrepreneurial risk-taking?

What then are the differences between common law and statutory negligence?

As has been discussed above, the content of the duty to exercise care and diligence (s 180(1)) is substantially similar to the common law standard of care, skill and diligence. The primary differences between the common law and statutory requirements relate to the consequences of breaching the duties rather than the content of the duties.

A breach of the statutory provision may result in the imposition of a civil penalty order provision under s 1317E and may result in the director being disqualified from office under s 206C or being forced to pay compensation under s 1317H. The common law duty, however, provides the remedy of damages for loss caused to the company. Although s 180(1) is a civil penalty provision, it does not give rise to criminal liability (unlike other directors’ duties: see ss 184, 588G(3)). A breach of s 180(1) does not provide its own course of action for damages, that only arises because of s 1317H: Day v Woolworths Ltd [2016] QCA 337 at [75].

[page 524]

Should directors’ duties extend below the board of directors? As demonstrated above, recent decisions have focused attention on the accountability of non-director employees. The report of Owen J on the HIH Royal Commission examined these developments and, while

17.18

1. 2. 3.

17.19

reiterating the principles concerning the statutory requirements discussed above, did not recommend any extension of these principles. In its April 2006 report, the Corporations and Markets Advisory Committee (CAMAC) recommended that the Corporations Act be amended to extend the duties in ss 180 and 181 beyond directors and officers to persons who take part in the management of the corporation. At the time of writing, no proposal had been announced to amend the Act in line with this recommendation.

Statutory defences There are three main defences that a director may invoke in respect of an alleged breach of duty under s 180(1) or the common law equivalent. These are:

delegation of responsibility to others; reliance on others; and the business judgment rule.

Aside from these defences, the Corporations Act also provides the court with the power to grant relief from liability under s 1317S (for civil penalty contraventions) and s 1318 (for certain general law contraventions). Both of these provisions require the director or officer to establish that they acted honestly and in all of the circumstances ‘ought reasonably to be excused from liability’, as illustrated in the case of Re McLellan; Stake Man Pty Ltd v Carroll (2009) 76 ACSR 67; [2009] FCA 1415 discussed in Chapter 18.

In the final James Hardie penalty case in 2012, the New South Wales Court of Appeal held that the court could be satisfied that the US-based directors had not acted honestly (or at least the directors had not satisfied the court that they had acted honestly) where the directors had acted recklessly in failing to request a copy of the draft ASX release when deciding on its release at a board meeting: Gillfillan v ASIC (2012) 92 ACSR 460; [2012] NSWCA 370. The court identified the seriousness of their breach of duty of care and diligence (at [301]-[302]) as follows:

… [it] … lay in their failure to concern themselves with the terms of a critically important document to be released, with board approval, to the ASX, the media and the public at large … [they] abdicated their responsibility at the meeting by not asking for a copy of a critical

•

17.20

document … or at least abstaining from voting on the resolution … they provided no information on what led them to acquiesce in the vote on such an important matter …

The court held that in such circumstances there was no ground to conclude that the US directors ‘ought reasonably to be excused’ from their liability.

In accepting that the conduct of the five Australian directors in approving the document did not involve dishonesty, the New South Wales Court of Appeal in Gillfillan v ASIC (2012) 92 ACSR 460; [2012] NSWCA 370 nonetheless held that this was not a case where the conduct of management excused or significantly mitigated the seriousness of the contraventions found against the directors for the following reasons:

the actions of the Australian directors were ‘a glaring failure to discharge their responsibilities on a matter of very great significance to the company and the wider

[page 525]

community’ and was ‘a serious departure from the required standard of care and diligence’ (at [233], [249]); the Australian directors were ‘not entitled simply to rely on management when voting to approve the release of a crucial document present to the board for its endorsement and imprimatur’ (at [299]); as the primary judge found, ‘all that was required to follow what was conveyed to the ASX by the announcement was a capacity to read English’ (at [219]); and ‘the market operated on a false basis and by reason of the misleading ASX announcement, the price of JHIL shares was artificially maintained’ (at [234]).

Delegating responsibility to others The ability to delegate responsibilities and rely on subordinates to carry out tasks is an essential part of effective management under s 198D. Company directors are given the responsibility for either managing the

•

company’s business or, in larger companies, monitoring the performance of management. In either case, the directors will need to rely on others, including in some cases other directors, to implement management decisions. Given that directors will not necessarily have expertise in all areas of the company business, it is a legitimate question to ask whether directors may be able to act with due care and diligence by relying on others who are more qualified.

Romer J in Re City Equitable Fire Insurance Co found that directors were not negligent if they relied on a delegate (that is, someone to whom a function has been delegated) to perform sufficiently, provided that the directors had no grounds to suspect that delegate was acting improperly. This position was applied by Rogers CJ in the AWA case. However, the AWA appeal (Daniels v Anderson) found that directors could only rely on delegates if they were sufficiently monitoring the company’s affairs so as to be aware if there were irregularities.

It is clear from decisions such as AWA that directors have a positive obligation to monitor the company’s performance and to ensure that management are held accountable. There is a difference between delegating tasks to subordinates (particularly in large, complex corporations), and abdicating the role of director by totally relying on management without independent supervision.

Under statute, s 198D provides that directors may delegate powers and functions to a subcommittee of the board of directors. However, directors are responsible for the actions of the persons to whom they delegate their powers and functions: s 190.

Section 190(2) states that a director is not responsible for the decisions which have been delegated under s 190 if:

the director believed on reasonable grounds that at all times the delegate would exercise the power in conformity with the duties imposed on directors of the company by both the Corporations Act and the corporate constitution; and the director believed on reasonable grounds and in good faith and after making proper inquiries (if the circumstances indicated the need for an inquiry) that the delegate was competent and reliable.

17.21

• •

[page 526]

Section 189 states that directors can reasonably rely on information or advice provided by others only if:

the reliance is made in good faith; and the director relied on the information or advice after making an independent assessment of the information or advice in the context of the director’s position and the company’s operational complexity.

Directors who act in breach of their duty of care will be unable to comply with s 189 if they fail to make any independent assessment of how the executive management are running the company.

In ASIC v Mariner Corporation Ltd (2015) 106 ACSR 343; [2015] FCA 589, the court found that the executive chairman was able to rely on information provided by the CEO who was responsible for dealing with financiers in circumstances where information was discussed at board

•

meetings, which demonstrated an independent assessment. In that case ASIC unsuccessfully argued that the directors had breached s 180(1) by announcing a takeover in circumstances where the funding for the takeover bid was not completed.

A similar conclusion was reached in the James Hardie case (ASIC v Macdonald (No 11) (2009) 71 ACSR 368; [2009] NSWSC 287), where the court held that the non-executive directors could not blindly rely on management with respect to the board approving an important press release about the company’s future. In that case, one of the non-executive

[page 527]

directors said he would often tune out or take a break whenever disclosure issues were discussed. He did this because he believed he could rely on management to decide what information had to be disclosed. The trial judge found that all of the non-executive directors were in breach of s 180(1) by failing to oppose the company’s press release which was misleading in a material respect on the sufficiency of funds provided to a new medical research foundation set up to manage claims in respect of asbestos-related illness resulting from conduct by various companies in the James Hardie group.

On the issue of delegation and reliance, Gzell J held (at [260]-[261]):

This was not a matter in which a director was entitled to rely upon those of his co-directors … this was a key statement in relation to a highly significant restructure of the James Hardie Group. Management having brought the matter to the board, none of them [the non-executive directors] was entitled to abdicate responsibility by delegating his or her duty to a fellow director. Nor was this a case of reliance upon management, a co-director or expert adviser. Management had sought the boards’ approval and the task of approving the Draft ASX Announcement involved no more than an understanding of the English language used in the document.

This has been confirmed by the High Court: ASIC v Hellicar (2012) 88 ACSR 246; [2012] HCA 17.23

The people that a director can rely on for information, professional or expert advice under s 189 are expressly stated in the Corporations Act as:

an employee, whom the director believes on reasonable grounds to be

•

reliable and competent in relation to the matter; a professional adviser or expert in relation to matters that the director believes on reasonable grounds to be within the person’s professional or expert competence; another director or officer in relation to matters within their director’s or officer’s authority; or a committee of directors on which the director did not serve in relation to matters within the committee’s authority.

A director cannot rely on advice where the circumstances are such as to give rise to a duty to inquire into a matter. This was explained in the AWB case (ASIC v Flugge).

ASIC v Flugge (2016) 119 ACSR 1; [2016] VSC 779 at [1874] Victorian Supreme Court

… if facts have come to the attention of a director’s [sic] that has awoken his suspicion that something is amiss or the suspicion of a prudent has been awakened or would have awaken the suspicion of a prudent director, then the director has a duty to inquire into the matter. Further, the director is not excused from making his own inquiries by relying on the judgment of others.

[page 528]

A director cannot rely on legal advice unless the director actually makes an independent assessment of the effect of that advice: Re Idylic Solutions Pty Ltd; ASIC v Hobbs [2012] NSWSC 1276 (legal advice was given on the requirement to register managed investment schemes, but the director gave mere ‘lip service’ to the advice and acted as he intended anyway, even where warnings of illegality were clearly present).

A director cannot rely exclusively on other directors and professional advisers to discharge their legal duties and the disclosure obligations imposed on publicly listed companies under the ASX. In the Sino case (discussed at 17.9), concerning the director’s failure to understand disclosure requirements, Mr Shao alleged he relied on the advice given to

(1) (2)

(3)

(4) (5)

(6)

him by the two other directors on the board and professional advisers. Mr Shao told the court (at [69]):

… I was completely dependent on the two Australian directors and I depended on their profession to manage this [continuous disclosure obligations] and I don’t really know the Australian policies about disclosure and I was totally dependent on the two directors. If our company didn’t do a perfect job please understand I was not a master of the Australian legal system, the language or the culture …

The court held this did not excuse Mr Shao from the need to pay attention to disclosure requirements and to perform his own duties with reasonable care and diligence: ASIC v Sino Australia Oil and Gas Ltd (in liq) (2016) 115 ACSR 437; [2016] FCA 934.

Useful judicial guidance on reliance and the limits of reliance and delegation, and a collection of the judicial authorities on this issue, can be found in the judgment of Santow J in ASIC v Adler — this case is considered further below in the context of the operation of the business judgment rule.

ASIC v Adler (2002) 41 ACSR 72; [2002] NSWC 171 New South Wales Supreme Court

Although reasonableness of the reliance or delegation must be determined in each case, the following may be important in determining reasonableness:

the function that has been delegated such that ‘it may properly be left to such officers’; the extent to which the director is put on inquiry, or given the facts of a case, should have been put on inquiry; the relationship between the director and delegate, must be such that the director honestly holds the belief that the delegate is trustworthy, competent and someone on whom reliance can be placed. Knowledge that the delegate is dishonest and incompetent will make reliance unreasonable; the risk involved in the transaction and the nature of the transaction; the extent of steps taken by the director, for example, inquiries made or other circumstances engendering ‘trust’; whether the position of the director is executive or non-executive: Permanent Building Society v Wheeler per Ipp J, though in Daniels v Anderson the majority judges have moved away from this distinction.

[page 529]

Centro

Centro is a group of companies involved in developing and managing shopping centres both in Australia and overseas. At its business peak, Centro controlled over $20 billion in shopping centre assets around the world and was one of the largest shopping centre managers both in Australia and in the United States. Centro’s structure was very complicated and involved placing key assets in subsidiary trusts many of which were unlisted. Interests in the trusts were sold to outside investors, although Centro companies would retain an interest in the trusts.

Centro more than doubled its size in a period of a few years because it was able to borrow billions of dollars in cheap debt through the short- and medium-term debt capital markets. In summary, Centro depended on its ability to renew debt contracts every few months.

During 2007 Centro purchased a large United States shopping centre company (which managed hundreds of shopping centres in the United States) for over $6 billion. This was funded by a form of short-term finance known as a bridging loan. Bridging loans are common for both domestic and commercial finance and are based on the assumption that the borrower will be able to refinance the loan by obtaining a longer-term loan. In Centro’s case it assumed that it could use the debt capital markets to raise the funds needed to refinance.

However, during mid-2007 the seeds of the global financial crisis (GFC) were beginning to emerge as the securitisation markets (which allow financial institutions to spin-off loans in the capital markets) tightened up and then abruptly shut down at the end of 2007. Consequently, Centro was unable to raise cheap debt to refinance its bridging loan.

In its 2007 financial accounts Centro mistakenly characterised more than $1 billion in bridging finance as non-current liabilities (that is, debts which do not need to be repaid within 12 months). It took Centro several months to correct this error. When its financial accounts were restated, the GFC had begun and Centro’s share price tumbled to less than net tangible asset backing. Centro has spent the next several years trying to restructure its operational and financial arrangements with a restructuring deal finally implemented using a scheme of arrangement in 2011.

In 2009, ASIC took action against the CFO and the directors of Centro who sat on the board during 2007 (including the former CEO and managing director Andrew Scott). ASIC argued that the directors and officers breached s 180(1) by failing to detect the mischaracterisation of non-current debt in the 2007 accounts. The defendants argued that they were entitled to rely upon the auditors (PWC) and the knowledge and expertise of the company’s audit committee. In June 2011, ASIC succeeded in its action: ASIC v Healey [2011] FCA 717. At the time of writing no penalties had been imposed and the court had not yet considered whether the defendant’s conduct justified relief from liability under ss 1317S and 1318.

Although this case was not directly argued on the grounds of s 189, it is an important case regarding the ability of non-executive directors to rely on executive management and external advisers. During the trial, the directors (including the managing director) stated that they had not fully read and understood the characterisation of the company’s debt profile. Several directors stated in court that they had more important matters to focus on. It should be noted that the board papers were more than 1200 pages long (with an executive summary of more than 80 pages). The court flatly rejected these arguments noting that the requirement for directors to approve the accounts and verify their accuracy required all directors to apply an enquiring mind to their role. While the directors did not need to be aware of every detail, nor did they need to turn themselves into expert auditors in order to approve the

•

accounts, failing to appreciate that more than $1 billion in bridging (that is, short-term) finance was a current liability was a fundamental failure to act with care and diligence. The court said (at [142]):

It is not envisaged by the Act that directors can simply put the discharge of those functions [that is, approving the accounts as required by the statute] in the hands

[page 530]

of apparently competent and reliable persons, for directors are a part of the process themselves by undertaking the task of approving and adopting the financial statements and reports.

The court went on to say (at [174]): ‘This task demands critical and detailed attention, and not just “going through the motions” or sole reliance on others, no matter how competent or trustworthy they may appear to be.’

The Centro case provides an important reminder that while directors are entitled to rely on management (indeed they are wholly reliant upon management) for necessary information, the board has a range of explicit statutory functions and cannot delegate these to others, even professional and experienced experts. Both the Centro and James Hardie cases demonstrate that if the board is required to make a decision, it must fulfil that responsibility with care and diligence.

Should directors have to double-check the financial details appearing in the accounts before they sign off on the annual reports? Is it sufficient for directors (particularly non-executive directors) to simply appoint a professional auditor and expect them to detect inaccuracies?

Business judgment rule

17.22 At general law, there is reluctance by the courts to second-guess the decisions of management when there is the benefit of hindsight rather than the commercial imperatives that a board must face at each meeting. As the Privy Council said in Howard. Smith Ltd v Ampol Petroleum Ltd [1974] AC 821 at 832:

There is no appeal on merits from management decisions to courts of law: nor will courts of law assume to act as a kind of supervisory board over decisions within the powers of management honestly arrived at.

[page 531]

Section 180(2) of the Corporations Act adopts a similar approach to business decisions made by directors. In March 2000, when parliament introduced the refined statutory duty of care and diligence in s 180(1), they also introduced a statutory business judgment rule as a director’s defence against decisions resulting in commercial failure and causing harm or loss to the company: s 180(2). The business judgment rule defence was introduced as a result of successful lobbying by the business community who were concerned with the development of higher performance standards under the duty of care fashioned by the courts and reinforced in s 180(1) of the Corporations Act:

• • • •

The statutory business judgment rule in s 180(2) is narrow in its application. It can only be relied on as a defence relating to the reasonable care and diligence under s 180(1) or the equivalent duty under the common law. It does not apply to other directors’ duties, such as insolvent trading.

The business judgment rule is a defence for all officers who are to be taken as complying with the duties in s 180(1) and the common law equivalent, if all the following conditions in s 180(2) are satisfied:

the business judgment was made in good faith for a proper purpose; the officer does not have a material personal interest in the events; they inform themselves about the subject matter; and they rationally believe that the judgment is in the best interests of the corporation.

It is important to note that the need for a business judgment is also an essential pre-requisite for the s 180(2) defence to operate successfully. A business judgment means any decision to take or not to take action in respect of a matter relevant to the business operations of the corporations: s 180(3). The onus is on the defendant director to establish evidence to support each element of the business judgment rule defence: ASIC v Rich (2009) 75 ACSR 1; [2009] NSWSC 1229; DTM Constructions Pty Ltd v Poole [2017] QSC 210 at [34].

ASIC v Adler (2002) 41 ACSR 72; [2002] NSWSC 171 New South Wales Supreme Court

Facts: Adler obtained an unsecured loan from HIH Ltd (a company of which he was a director and shareholder) to purchase shares in a company that he was involved in, which the court held was in breach of his statutory duties: ss 180(1)-182. Adler raised the defence of the statutory business judgment rule to avoid liability for breaching s 180(1). Adler also used some of the funds to buy more shares in HIH in the hope of increasing the share price. See Chapter 16 for the topic of related party transactions and a fuller discussion of the facts.

Williams, the founder and executive director of HIH, allowed the company to make such a highly speculative and risky loan to Adler without at least making sure proper safeguards were put in place — such as receiving an independent appraisal of the loan by way of proper due diligence and by ensuring that the loan was approved by the company’s investment committee, if not the board. In acting this way, in favour of his fellow director and to the detriment of HIH, the court held that Williams had breached the s 180 duty of care and diligence.

•

[page 532]

Issue: Did the business judgment rule protect Adler and Williams from what would otherwise have been breaches of their directors’ duties?

Decision: The court decided that Adler could not rely on the business judgment rule defence in s 180(2), because he clearly had a material personal interest in the transaction that gave rise to the breach of duty due to of his connection with the company that the loan funds were used to purchase. Adler also had a material personal interest in increasing HIH’s share price which gave him a material personal interest in the transaction, preventing the application of s 180(2).

Similarly, the court held that the business judgment rule defence in s 180(2) could not apply to Williams who neglected to deal with proper safeguards. His Honour held:

Given that the purpose of Mr Adler was to make, maintain or stabilise the HIH share price and of HIH to make a quick profit, Mr Williams, as a major shareholder in HIH, had ‘a material personal interest’ [and therefore was in breach of s 180(2)(b)] … in encouraging share purchasing in HIH shares by [Adler’s investment company] via Mr Adler … [Furthermore], there is no basis for an inference that Mr Williams properly informed himself about the subject matter of any judgment he made [as required under s 180(2)(c)], as for example by having proper independent advice obtained on behalf of HIH.

For other examples where the business judgment rule defence has failed see:

Gold Ribbon (Accountants) Pty Ltd (in liq) v Sheers [2006] QCA 335 (deliberate failure by a director to participate in board decisions was not a ‘business judgment’); and ASIC v Citrofresh International Ltd (No 2) (2010) 77 ACSR 69; [2010] FCA 27 (CEO failed to establish that engaging investor relations advisers allowed him to be properly informed as to the accuracy of an ASX release regarding scientific tests when the advisers were not scientists. The CEO had personally drafted the release).

The business judgment rule was given detailed consideration in the Rich case which is the leading case on the operation of this defence.24

ASIC v Rich (2009) 75 ACSR 1; [2009] NSWSC 1229 New South Wales Supreme Court

Facts: The facts involved in Rich were discussed above in 17.5. Essentially, ASIC sought to argue that Rich ( joint CEO) and Silbermann (Finance Director) of One.Tel Ltd had breached s 180(1) by failing to

• • • • •

•

17.23

advise the board of the company’s insolvency. The judge (Austin J) discussed the operation of the business judgment rule in detail.

Issue: Even if the officers were in breach of s 180(1), could they rely upon the business judgment rule defence?

Decision: The officers could rely upon the defence. Austin J defined a ‘business judgment’ as involving a decision to take or not to take action in respect of matters relevant to the business operations of the corporation (including matters of planning, budgeting and forecasting): at [7274].

[page 533]

His Honour held that a failure by a director to undertake proper oversight of the company’s affairs cannot be a business judgment: at [7278].

Austin J determined that the following factors are relevant for a consideration of whether a director’s belief that they are properly informed is reasonable (at [7283]):

the importance of the business judgment to be made; the time available for obtaining information; the costs related to obtaining information; the director’s or officer’s confidence in those exploring the matter; the state of the company’s business at that time and the nature of competing demands on the board’s attention; and whether or not material information is reasonably available to the director.

Austin J said:

The qualifying words, ‘to the extent they reasonably believe to be appropriate’, convey the idea that protection may be available even if the director was not aware of available information material to the decision, if he reasonably believed he had taken appropriate steps on the decision-making occasion to inform himself about the subject matter.

Lastly, his Honour held (at [7289]) that the meaning of the term ‘rational belief’ could be satisfied where:

… the director’s or officer’s belief would be a rational one if it was based on reason or reasoning (whether or not the reasoning was convincing to the judge and therefore ‘reasonable’ in an objective sense) but it would not be a rational belief if there was no arguable reasoning process to support it.

Significance: This decision helps explain the scope of the elements of the business judgment rule.

Law reform proposals

The statutory business judgment rule has been the topic of intense public debate in recent times. Insolvency practitioners have been advocating a form of business judgment rule safe harbour for insolvent trading (see ss 588G and 588H), while directors are pursuing good faith restructuring attempts, which has recently been supported by the Productivity

Commission and the Financial System Inquiry: see Chapter 18. Aside from concerns about defences during restructuring, there has been a broader debate concerning the range of personal liabilities that directors may be subjected to,25 which has led to calls to broaden the existing statutory business judgment rule or to otherwise add more comprehensive protections for directors against liability for good faith business decisions.

The Australian Institute of Company Directors (AICD) released a detailed discussion paper in August 2014, which recommended the ‘honest and reasonable director defence’ be inserted into the Corporations Act:

Honest and reasonable director defence

Notwithstanding any other provision of this Act or the ASIC Act, if a director acts (or does not act) and does so honestly, for a proper purpose and with the degree of care and

[page 534]

diligence that the director rationally believes to be reasonable in all the circumstances, then the director will not be liable under or in connection with any provision (including any strict liability offence) of the Corporations Act or the ASIC Act (or any equivalent grounds of liability in common law or in equity) applying to the director in his or her capacity as a director.

If accepted, this would represent a major change from the current law as it changes the existing duty of care (which is objectively assessed) into a subjective assessment ‘degree of care and diligence that the director rationally believes to be reasonable in all the circumstances’.

The former Justice Robert Austin has proposed a different change by including a new presumption against liability for directors be inserted in state, territory and federal interpretation laws. This would apply to both criminal and civil liability. The presumption could be overcome by establishing that the director did not make a business judgment or if there was a business judgment the director was dishonest, had a material personal interest in the subject matter of the decision that was not disclosed to the board or the decision was such that no reasonable person could have made the decision if they were in the director’s position.26

6. 7.

10.

[page 535]

Revision Questions

What are the sources of directors’ and officers’ duties to act with care and diligence? What is the significance of these different sources? How do you prove what a reasonable person would have done in particular circumstances? Is the duty of care more lenient for non-executive directors? Why/why not? How do you establish that a director was properly informed for the purposes of asserting the protection of the business judgment rule? If a director acts in breach of s 181, can they rely on the business judgment rule for protection? Why/why not? Who can enforce the duty of care and diligence under s 180(1)? What remedies are available for contravention of the duty of care and diligence? Does a CEO or chair of the board of directors owe a special duty of care that is more onerous than for other directors? Is the standard of a ‘reasonable person’ just an example of the courts substituting their views on corporate governance in place of the directors’ views? Discuss. Is a director required to be aware of all of the major decisions that a corporation makes? Why/why not?

Problem Question Barry Badler is the managing director and majority shareholder of Dodgy Insurance Ltd

(DIL) which is a large insurance company listed on the Australian Securities Exchange (ASX). DIL has approximately 20% of the professional indemnity insurance market in Australia. Lately, DIL has been experiencing serious cash flow problems with the result that many legitimate insurance claims made by DIL policy holders have been denied without good reason. These problems have not prevented DIL continuing to offer insurance contracts to new clients. The internal auditors of DIL estimate that the company is incurring losses of $1 million per week. They compile this information in an internal memo to Barry Badler, but he does not read the memo as he has not been into his office for the last two weeks.

Barry has been very busy lately so he has not been attending any of the board meetings of DIL and has no idea about the current financial status of the company. Barry is busy because he is a director of many different Australian companies, including Here to Help Ltd (HTHL), a large insurance company listed on the ASX with approximately 30% of the general insurance market.

HTHL is keen to expand its Australian insurance business and is actively looking to acquire other insurance companies. The possibility of HTHL acquiring another insurance company in Australia is raised at a HTHL board meeting in December 2016 which is attended by Barry, who never misses HTHL board meetings. At the board meeting Barry suggests that HTHL takeover DIL and thus acquire a larger share of the professional indemnity insurance market in Australia. The members of the board know that Barry is a director and major shareholder in DIL and assume that he is fully aware of the company’s financial position. When they ask Barry if DIL is good value, Barry responds by saying ‘Absolutely it is’. If the takeover is successful, Barry is likely to make a large profit on the shares he owns in DIL.

[page 536]

Ray Milligans is the managing director of HTHL and is also a close personal friend of Barry Badler. Ray is very excited about the prospect of taking over his friend’s insurance company because he knows that DIL has not been performing well and believes that his excellent management can make DIL profitable again. Ray directs HTHL’s company lawyer to draw up a takeover agreement to allow HTHL to buy DIL, without performing the usual due diligence checks to verify the financial status of DIL. Ray is relying solely on Barry’s advice that DIL is good value. Ray does not allow any further audits or investigations to be undertaken by HTHL, even though it is common knowledge that the professional indemnity insurance market in Australia is not very profitable.

As part of the purchase agreement, Barry agrees to resign his position as managing director of DIL and take up a consultancy for six months to HTHL for a $20 million fee. The fee was negotiated personally between Barry and Ray Milligans, with no other directors of HTHL aware of the large consulting fee being paid to Barry. Ray has agreed to such a large consulting fee for Barry because Barry has undertaken to use half of the fee to buy shares in HTHL in order to boost HTHL’s share price.

By March 2017 HTHL completes its successful takeover of DIL. In June 2017, reports emerge in the financial press that DIL may have been insolvent at the time of the takeover by HTHL. Barry Badler and Ray Milligans are now concerned about possible ASIC investigations into the takeover.

Advise both Barry and Ray as to their potential liability under s 180(1) of the Corporations Act 2001 (Cth).

4. 5.

7. 8.

Guidelines for Answering Problem Questions

When answering a problem question concerning directors’ duties, we suggest that the following method may be helpful:

Determine whether the person involved in the question is a director or officer for the purposes of the s 9 definitions. Establish whether the question concerns fiduciary principles (such as misusing power or acting in bad faith) or the duty of care. In particular, look out for facts such as directors not having business experience or remaining ignorant about the company’s affairs, excessive reliance on others, not attending board meetings or asking any questions at such meetings. These are facts which often suggest the duty of care is a relevant legal issue for consideration. Determine exactly what contravening act the person has done — have they acted to give themselves a benefit? If so, then ss 181-183 may be relevant: see Chapters 15 and 16. If they have failed to act, then s 180(1) or s 588G may be relevant: see also Chapter 18. Then proceed to discuss the statutory provisions and relevant cases (at least one leading case per issue) for that issue (that is, negligence, fiduciary duties or insolvent trading). Work through the legal test for that particular duty. Determine if any defences may apply: for example, would the business judgment rule apply? (duty of care only); has the person reasonably relied on another person under s 189? Comment on what consequences (that is, remedies and penalties) may apply. Can they be granted relief from liability under s 1317S? Most directors’ duties problems tend to involve multiple breaches of duties (such as negligence and acting for an improper purpose). The key step is working out what duties may have been breached,

which you can usually determine in steps 3 and 4 above.

[page 537]

Wang is proposing a radical move for the SCPL business as he would like the business to move into themed restaurants (the ‘Sydney Bar and Grill’). Wang has been working on this as a project for several months and has produced a 200 page report with detailed financial and market analysis. He sends a copy of this to Erin and John and proposes a discussion of the report at the next board meeting (in two days’ time).

At the meeting Wang, John and Erin have a 30 minute discussion about this proposal and Erin believes that Wang has done his homework and has produced a compelling business case. Erin asks lots of questions and is happy with Wang’s responses. Erin signs off on the proposal. John seems pre-occupied on his laptop and he says, ‘I trust you Wang, whatever you think is best.’

What Erin doesn’t know is that Wang has made up some of the financial figures to make his proposal more attractive. Wang proposes to cause SCPL to guarantee a new $10 million bank loan for Pop Up. If the financial forecasts for the new venture are not accurate and lower profits are generated, the bank will be able to seize all of the assets of both companies.

Assume that the new venture is a disaster and the JC group of companies falls into liquidation.

Could the liquidator take action against Wang, John and Erin for breaching their duty of care? What would Wang, John and Erin (separately) need to establish the statutory business judgment rule?

Further Reading

Academic Journals W Bainbridge and T Connor, ‘Another Way Forward? The Scope for an

Appellate Court to Reinterpret the Statutory Business Judgment Rule’ (2016) 34 Company and Securities Law Journal 415.

T Bednall and V Ngomba, ‘The High Court and the C-suite: Implications of Shafron for Company Executives Below Board Level’ (2013) 31 Company and Securities Law Journal 6.

M Buckingham, ‘A Company Director’s Duty of Care and Diligence:

Fiduciary or Non-fiduciary?’ (2016) 31 Australian Journal of Corporate Law 370.

M Byrne, ‘Do Directors Need Better Statutory Protection When Acting on the Advice of Others?’ (2008) 21 Australian Journal of Corporate Law 238.

P Crutchfield and C Button, ‘Men Over Board: The Burden of Directors’ Duties in the Wake of the Centro case’ (2012) 30 Company and Securities Law Journal 83.

A Hargovan, ‘Corporate Governance Lessons from James Hardie’ (2009) 33 Melbourne University Law Review 984.

A Hargovan, ‘Directors’ and Officers’ Dereliction of Duties and Disqualifications: An Analysis of James Hardie’ (2010) 21 The Company Lawyer 265.

A Hargovan, ‘Dual Role of General Counsel and Company Secretary: Walking the Legal Tightrope in Shafron v ASIC’ (2012) 27 Australian Journal of Corporate Law 112.

J Harris, ‘Relief from Liability for Company Directors’ (2009) 12 UWSLR 152.

J Harris and A Hargovan, ‘Still a Sleepy Hollow? Directors’ Liability and the Business Judgment Rule’ (2017) 31 Australian Journal of Corporate Law 319.

J Harris, A Hargovan and J Austin, ‘Shareholder Primacy Revisited: Does the Public Interest Have Any Role in Statutory Duties?’ (2008) 26 Company and Securities Law Journal 355.

[page 538]

J Harris and M Nehme, ‘An Analysis of the Vines Appeal’ (2007) 25 Company and Securities Law Journal 554.

W Heath, ‘The Director’s “Fiduciary” Duty of Care and Skill: A Misnomer’ (2007) 25 Company and Securities Law Journal 370.

A Huggins, R Simnett and A Hargovan, ‘Integrated Reporting and Directors’ Concerns about Personal Liability Exposure: Law Reform Options’ (2015) 33 Company and Securities Law Journal 176.

D Jordan and M Legg, ‘The Australian Business Judgment Rule after ASIC v Rich’ (2013) 34 Adelaide Law Review 403.

R Langford, ‘The Distinction Between the Duty of Care and the Duties to Act Bona Fide in the Interests of the Company and for Proper Purposes’ (2013) 41 Australian Business Law Review 337.

K Loxley, ‘Unashamedly More Interventionist Courts and the Fading Significance of a Director’s State of Mind (2014) 32 Company and Securities Law Journal 486.

A Lumsden, ‘The Business Judgment Defence’ (2010) 28 Company and Securities Law Journal 164.

S Sievers, ‘Directors’ Duty of Care: What is the New Standard’ (1997) 15 Company and Securities Law Journal 392.

T Voogt, ‘Articulating Care, Skill and Diligence Standards for Non- executive Directors’ (2017) 35 Company and Securities Law Journal 128.

N Young, ‘Has Directors’ Liability Gone Too Far or Not Far Enough? A Review of the Standard of Conduct Required of Directors under Sections 180-184 of the Corporations Act?’ (2008) 26 Company and Securities Law Journal 216.

Practitioner Journals M Adams, ‘Officers’ Duties — Are We Keeping Up with Changes?

(2008) 60(6) Keeping Good Companies 344. A Hargovan, ‘Caution against Board Groupthink — Civil Penalties in

James Hardie’ (2013) 65 Keeping Good Companies 36. A Hargovan, ‘Directors’ and Officers’ Statutory Duty of Care Following

James Hardie’ (2009) 61 Keeping Good Companies 586. A Hargovan, ‘Directors’ Liability for Misleading and Deceptive Market

Announcements — The Citrofresh Decision’ (2010) 62 Keeping Good Companies 454.

A Hargovan, ‘Downer for CEO — Serious Misconduct Ruling by Appellate Court in Downer Case’ (2012) 64 Keeping Good Companies 668.

A Hargovan, ‘Failure to Make Adequate Enquiries: Civil Penalties for Former Chair of AWB Ltd’ (2017) Governance Directions 306.

A Hargovan, ‘Honesty is No Excuse for Liability of James Hardie Officers’ (2011) 63 Keeping Good Companies 354.

A Hargovan, ‘Foreign Directors of Australian Companies Put On Notice: No Leniency for Ignorance of Duties’ (2017) Governance Directions 37.

A Hargovan, ‘Raising the Bar for General Counsel and Company Secretaries — High Court decision in James Hardie’ (2012) 64 Keeping Good Companies 260.

J Harris and A Hargovan, ‘Revisiting the Business Judgment Rule’ (2014) 66 Governance Directions 634.

Practitioner Works R P Austin, H A J Ford and I Ramsay, Company Directors: Principles of

Law and Corporate Governance, LexisNexis Butterworths, Australia, 2005, Chs 8 and 9.

H A J Ford, R P Austin and I Ramsay, Ford’s Principles of Corporations Law, LexisNexis (looseleaf and online), Ch 9.

[page 539]

J D Heydon, ‘Are the Duties of Company Directors to Exercise Care and Skill Fiduciary?’ in S Degeling and J Edelman, Equity in Commercial Law, Lawbook Co, Australia, 2005.

P Redmond, ‘Safe Harbours or Sleepy Hollows: Does Australia Need a Statutory Business Judgment Rule?’ in I Ramsay (ed), Corporate Governance and the Duties of Company Directors, Melbourne University Centre for Corporate Law and Securities Regulation, 1997

You will find useful study resources, including quizzes for each chapter, when you go to <http://learning.lexisnexis.com.au>. The quiz is a great tool to help you self-test your knowledge.

2. 3. 4. 5.

10.

11.

12.

13.

14.

15.

16.

17.

18.

19.

20.

21. 22.

23.

For a discussion of whether the duty of care is a public wrong or a private wrong, see ASIC v Cassimatis (No 8) (2016) 336 ALR 209; [2016] FCA 1023. See Gould v Mount Oxide Mines Ltd (1916) 22 CLR 490 at 531. For example, see Turquand v Marshall (1869) LR 4 Ch App 376. For example, see Re Denham and Co (1883) 25 Ch D 752. In Re Cardiff Savings Bank (Marquis of Bute’s case) [1892] 2 Ch 100, in dismissing a claim of negligence against the Marquis, who had become the president of the board of the bank at the age of six months and held that position for over 40 years (during which time he attended only one board meeting), the court said that the Marquis was entitled to rely on the bank’s managers to perform their duties properly and could not be liable for their neglect. For a discussion of the history of the duty of care, see ASIC v Cassimatis (No 8) (2016) 336 ALR 209; [2016] FCA 1023. It should be noted that the 2003 decision in the Rich litigation related to an application by the chairman to strike out ASIC’s s 180(1) action against him. This should not be confused with the 2004 Rich decision which concerned the nature of civil penalties, or the 2009 decision which concerned Mr Rich’s alleged negligence. See further, A Hargovan, ‘Directors’ and Officers’ Dereliction of Duties and Disqualifications: An Analysis of James Hardie’ (2010) 21 The Company Lawyer 265. The original company was exempted under a special Act of Parliament, James Hardie (Civil Liability) Act 2005 (NSW). For detailed analysis of the original decision, see A Hargovan, ‘Corporate Governance Lessons from James Hardie’ (2009) 33 Melbourne University Law Review 984. See further, A Hargovan, ‘Dual Role of General Counsel and Company Secretary: Walking the Legal Tightrope in Shafron v ASIC’ (2012) 27 Australian Journal of Corporate Law 112. See further, A Hargovan, ‘Caution against Board Groupthink — Civil Penalties in James Hardie’ (2013) 65 Keeping Good Companies 36. The Maxwell case was examined in detail in ASIC v Cassimatis (No 8) (2016) 336 ALR 209; [2016] FCA 1023. See also ASIC v Mariner Corporations Ltd [2015] FCA 589 and the quote from Ipp J in Vrisakis in 17.4. See also further discussion of this issue: J Harris, A Hargovan and J Austin, ‘Shareholder Primacy Revisited: Does the Public Interest Have Any Role in Statutory Duties?’ (2008) 26 Company and Securities Law Journal 355. See further J Harris and S Webbey, ‘Personal Liability for Corporate Disclosure Problems’ (2011) 29 Company and Securities Law Journal 463; T Bednall and P Hanrahan, ‘Officers’ Liability for Mandatory Corporate Disclosure: Two Paths, Two Destinations?’ (2013) 31 Company and Securities Law Journal 474. See further, A Hargovan, ‘Directors’ Liability for Misleading and Deceptive Market Announcements — The Citrofresh Decision’ (2010) 62 Keeping Good Companies 454. See further A Hargovan, ‘Failure to Make Adequate Enquiries: Civil Penalties for Former Chair of AWB Ltd’ (2017) Governance Directions 306. See further A Hargovan, ‘Foreign Directors of Australian Companies Put on Notice: No Leniency for Ignorance of Duties’ (2017) Governance Directions 37. See further, A Hargovan, ‘Downer for CEO — Serious Misconduct Ruling by Appellate Court in Downer Case’ (2012) 64 Keeping Good Companies 668. See further, A Hargovan, ‘Raising the Bar for General Counsel and Company Secretaries — High Court Decision in James Hardie’ (2012) Keeping Good Companies 260. This was discussed in detail in ASIC v Rich (2003) 44 ACSR 341; [2003] NSWSC 85. His Honour did however note that the punitive consequences of breaching the statutory duties (that is, disqualification orders and pecuniary penalties) would involve a consideration of ‘a higher level of seriousness’: at [146]. For further illustration of the operation of the reliance defence, see ASIC v Citrofresh

24.

25.

26.

International (No 2) (2010) 77 ACSR 69; [2010] FCA 27. See also ASIC v Mariner Corporation Ltd (2015) 106 ACSR 343; [2015] FCA 589, where the court would have applied s 180(2) but it was already decided that s 180(1) was not contravened. See further A Huggins, R Simnett and A Hargovan, ‘Integrated Reporting and Directors’ Concerns about Personal Liability Exposure: Law Reform Options’ (2015) 33 Company and Securities Law Journal 176. See further J Harris and A Hargovan, ‘Revisiting the Business Judgment Rule’ (2014) 66 Governance Directions 634.

[page 541]

Directors and Officers: Corporate Governance

During Times of Financial Distress

CHAPTER 18 Range of potential legal issues during financial distress

Assessing options for distressed companies Giving the company time

Duty to consider creditors’ interests Voidable transactions

Types of voidable transactions Relevance of insolvency Timeframe Defences to voidable transactions Is the transaction voidable?

Duty to avoid insolvent trading Background to the insolvent trading prohibition

Elements of the prohibition A person is a director of the company When is a debt incurred? When is a company insolvent? Reasonable ground to suspect insolvency

[page 542]

Preventing insolvent trading Safe harbour reform Defences to insolvent trading Reasonable grounds to expect solvency (s 588H(2)) Reasonable reliance on others (s 588H(3)) Absence from management (s 588H(4)) Reasonable steps to prevent company incurring the debt (s 588H(5)) Recovering repayment for debts incurred during insolvency Relief from liability

[page 543]

Directors and Officers: Corporate Governance During Times of Financial Distress

Learning Objectives After completing this chapter you should be able to:

Discuss how directors may be liable for insolvent trading under the Corporations Act 2001 (Cth).

Explain the statutory defences to, and consequences of, insolvent trading under the Corporations Act.

Identify the potential liabilities faced by directors and officers during times of financial distress.

Discuss what measures directors and officers may take to minimise the risk of liability when the company suffers financial distress.

Explain how transactions entered into prior to insolvency may be undone by a liquidator after the company enters formal insolvency proceedings under Pt 5.4 of the Corporations Act.

Explain how creditors’ interests are protected during times of corporate financial distress.

Key Cases

ASIC v Elliott (2004) 48 ACSR 621; [2004] VSCA 54

ASIC v Plymin (2003) 46 ACSR 126; [2003] VSC 123

Deputy Commissioner of Taxation v Clark (2003) 57 NSWLR 113; [2003] NSWCA 91

Hall v Poolman (2007) 65 ACSR 123; [2007] NSWSC 1330

Morley v Statewide Tobacco Services Ltd [1993] 1 VR 423

Metropolitan Fire Systems v Miller (1997) 23 ACSR 699

Re McLellan; Stake Man Pty Ltd v Carroll (2009) 76 ACSR 67; [2009] FCA 1415

Southern Cross Interiors Pty Ltd (in liq) v Deputy Commissioner of Taxation (2001) 53 NSWLR 213; [2001] NSWSC 621

Westpac Banking Corp v The Bell Group Ltd (in liq) (2012) 89 ACSR 1; [2012] WASCA 157

Key Sections

Corporations Act 2001 (Cth) ss 9, 95A, 180, 181, 182, 588E, 588G, 588GA, 588H, 588M, 1317E, 1317G, 1317H, 1317S, 1318

18.1

[page 544]

Introduction

The global financial crisis (GFC) and its prolonged fallout drew attention to the regulation of companies in financial distress and how the law might better support such companies and their managers when trying to save their businesses from formal insolvency. In particular, the role and liabilities of directors and officers is a significant aspect of the law’s role for companies approaching insolvency. Low levels of regulation might encourage directors and officers to recklessly trade on businesses that are hopelessly insolvent which will cause harm to the company’s creditors, including suppliers and employees. However, over-regulation might discourage directors and managers from attempting to save viable business, opting instead for formal insolvency with consequential losses in asset values, jobs and debt repayments. This can have a domino effect as suppliers and customers of collapsed businesses may also suffer financial distress as a result of the collapse. Australian corporate law seeks to strike a balance between these two extremes. The recovery from the GFC has not lessened the importance of these issues and they remain a hot topic. The Federal Government responded to recommendations by the Productivity Commission to introduce a safe harbour for directors against insolvent trading to facilitate corporate rescue attempts, with the safe harbour operational from 19 September 2017.

This chapter discusses a range of legal issues relevant for assessing the role and duties of directors and officers of companies suffering financial distress.

Range of potential legal issues during financial distress

Assessing options for distressed companies When a company enters a period of financial distress there are a number of stakeholders who will be concerned to protect their interests. These

•

stakeholders include large creditors such as banks, small creditors such as suppliers and, of course, the employees. It is important to note that negotiations at this time will focus on determining if the business can be saved. The question that stakeholders must ask themselves is whether the business is worth saving. This will involve consideration of a range of issues including:

Does the company have a sufficient business plan to trade out of its difficulties? Can the company’s debts be restructured to give it time to trade out of its difficulties? Are the company’s major creditors prepared to give sufficient support to keep the business going? Does the company have the necessary managerial expertise to turn the business around? Are the company’s key executives prepared to work to turn the business around rather than resigning to avoid potential liability and damage to their reputation?

Companies generally seek to avoid some types of external administration under Ch 5 of the Corporations Act (such as receiverships and liquidation) because of the adverse impact on the business’ goodwill. See Chapter 22 for discussion on the different types of external administration (schemes of arrangement with creditors, voluntary

[page 545]

administration, receivership and liquidation). Putting a business into receivership, for example, may drive customers and suppliers away if they become concerned about delivery of goods and services and payment thus minimising any chance to save the business. Putting a company into liquidation will end the company’s business as the aim of liquidation is to terminate the business and sell all of the company’s assets to pay creditors. Therefore, it is necessary to negotiate a restructuring with a view to what adverse consequences may arise if the restructuring fails and the company enters formal insolvency. Formal insolvency usually involves substantial losses as asset sales during external administration,

18.2

such as receivership and liquidation, tend to generate prices well below book value and are generally insufficient to pay all the creditors.

Recent reforms have sought to partially address the adverse effects of formal insolvency appointments that seek to restructure a company in financial distress by rendering ipso facto clauses ineffective in creditors’ schemes that seek to restructure the company (s 415D), receivership over all or substantially all of the company’s property (s 434J) and in voluntary administration (s 451E). These provisions are due to commence in early 2018.

However, if the economic foundations of the business model are unsound, it will serve everyone’s interests to put the business into external administration (such as schemes of arrangements with creditors, receivership, voluntary administration or even liquidation if the company is hopelessly insolvent) because this allows for capital to be more productively used in the economy. Business failure and insolvency are essential elements to a capitalist economy. The law does not stop businesses from failing or closing down. The issue is how can the law help businesses that are viable to deal with their financial troubles while also allowing hopeless businesses to close down efficiently. External administration, including both compulsory and voluntary liquidation, is discussed in Chapter 22. Negotiations during times of financial distress will be focused on avoiding formal insolvency proceedings in liquidation and its drastic consequences.

Giving the company time One advantage of formal insolvency proceedings is that they generally provide a stay prohibiting claims against the company being enforced in court (although there are some exceptions to this prohibition: see Chapter 22). Outside of insolvency, there is an urgent need to secure the support of major stakeholders in order to succeed in turning the business around.

loan covenants: performance requirements provided in a loan documents designed to protect the lender from the risk of non-payment, such as a requirement for the debtor to maintain minimum asset levels. Breaching a covenant may allow the bank to demand full repayment of the loan either immediately or in a short timeframe.

18.3

This will typically include obtaining waivers from the company’s banks where the company has breached loan covenants and securing a ‘standstill agreement’ from the major creditors. A standstill agreement is a contract whereby the major creditors agree not to enforce repayment of their debts by suing the company during the period of the restructuring. This may also extend, either formally or informally, to agreeing not to fund an action against the directors for insolvent trading (which is discussed further below).

Finally, it is also important that companies attempting a restructure maintain open communications with their major stakeholders. This may extend to keeping the market up-to-date with restructuring efforts by complying with continuous disclosure obligations: see Chapter 20. A failure to keep the market properly informed may lead to a shareholder action against the company based on defective disclosure (under either s 674, s 675 or s 1041H).

[page 546]

Duty to consider creditors’ interests

As noted earlier in Chapters 15–17, the duties of company directors and officers are owed to the company. The interests of the company are normally measured against the broad interests of shareholders (the so- called doctrine of ‘shareholder primacy’). Directors do not owe duties to the company’s creditors while the company is solvent: see the Spies case discussed in Chapter 15. This is largely because the company’s creditors have contractual relations with the company, which is a separate legal entity, and not the directors.

However, it has long been recognised that as a company approaches insolvency the objects of the corporation’s focus changes from providing wealth to shareholders to seeking to prevent further losses to creditors.

This is because under s 563A shareholders are generally the last ranking claimants in insolvency and will receive no return from the company

when its creditors are not paid in full (that is, because it is insolvent and there are insufficient funds to pay all debts). Thus, as the company approaches insolvency, it becomes less likely that the shareholders will receive any return and the creditors’ right to repayment is put further at risk. This was recognised in Kinsela v Russell Kinsela Pty Ltd (in liq) (1986) 4 NSWLR 722 and was discussed in Chapter 15.

What are the potential consequences of a director breaching their duty to consider the interests of creditors during insolvency?

Creditors are unable to sue the directors personally ( just as shareholders are unable to sue the directors personally because the duties are owed to the company) for the reasons discussed in the Spies case in Chapter 15. There is little point in suing an insolvent company for repayment, as often there is nothing to gain.

A possible remedy may, in limited circumstances, involve suing those that have benefited from the company directors breaching their duty to consider the interests of creditors.

The law of equity provides that a person who dishonestly receives a benefit as a result of conduct in breach of the directors’ fiduciary duties may, subject to certain requirements, be obliged to repay that benefit. This is based on a rule of the law of equity known as the ‘rule in Barnes v Addy’, which is named after the decision in Barnes v Addy (1874) 9 Ch App 244. That case found that a person who receives property (including money) as a result of a breach of trust or breach of fiduciary duty (such as the duty to consider the interests of creditors) may be liable to account by returning the property or repaying the money. There are two situations where this can arise (known as the two ‘limbs in Barnes v Addy’), where the person:

was acting as an agent of a trustee or fiduciary and knew that they were receiving property in breach of trust or fiduciary duty (referred to as ‘knowing receipt’); or knew that they were assisting a trustee or fiduciary to breach their duty (referred to as ‘knowing participation’).

The issue of Barnes v Addy liability arose in an important case concerning the liability of particular creditors who knowingly assisted directors to

breach their duty to consider the interests of creditors generally by engaging in transactions that

[page 547]

improved the position of the particular creditors to the detriment of other creditors. These issues arose in Westpac Banking Corp v The Bell Group Ltd (in liq) (2012) 89 ACSR 1; [2012] WASCA 157.

Westpac Banking Corp v The Bell Group Ltd (in liq) (2012) 89 ACSR 1; [2012] WASCA 157 Western Australian Court of Appeal

Facts: This case was one of the largest cases ever decided in Australian courts, which lasted over 17 years and resulted in a decision that was explained in over 2600 pages by the trial court. The facts were very complex and largely related to laws that operated during the 1980s (which is when the events took place). Therefore, we will summarise the facts only briefly.1

This case concerned the restructuring of companies associated with Alan Bond (a well-known Australian corporate entrepreneur from the 1980s whose companies collapsed into insolvency, with Bond also going to jail and being declared bankrupt). Bond’s companies (The Bell Group) included both Australian and overseas enterprises. Many of these companies had unsecured bank loans that they could not repay from their assets, nor from funds from other companies in the group. The only significant funds available to the group were generated by newspaper and publishing assets. The overall group of companies was hopelessly insolvent with many hundreds of millions of dollars in outstanding debts. The directors, in this context of financial distress, negotiated a restructure with the group’s various banks.

The restructure involved the banks taking security over the group’s assets, including over companies that previously had not provided security to the banks or been party to the loans. Furthermore, the companies in the group agreed that all future funds generated from asset sales would be used to pay down the bank loans. In exchange for this security, the banks agreed to extend the period of the loans. This restructure therefore allowed the banks to elevate their rights, over the companies’ assets, above those of other unsecured creditors. The companies collapsed into liquidation just over one year later. The liquidators then sued the banks and various other parties for a range of claims, including both limbs in Barnes v Addy.

Issues: Did the directors of companies in the group breach their duty owed to their particular company by agreeing to the restructure (and thus causing a detriment to the creditors of those companies) without considering the benefit that would accrue to each particular company (as opposed to the whole group)?

If the directors were in breach of their duty, did the banks knowingly participate in this breach of

fiduciary duty or receive a benefit as a result of a breach of fiduciary duty and thus become liable for their benefit under the rule in Barnes v Addy?

Decision: The court found (by a 2:1 majority) that the directors had breached their duties by acting to benefit particular companies in the group (and their bankers) without considering the benefit to each individual company at a time when the insolvency of the companies was doubtful. The banks knew or should have known of the breaches of duty and were liable to repay their benefits received under the restructure, that is, the value of the secured amounts recovered during the liquidation (several hundred million dollars).

A key fact was that the restructuring agreement put all of the group’s cash and assets under the control of the banks at a time when the bank loans far exceeded the practical ability of the group companies to repay. The restructure did not save the business but merely delayed the inevitable liquidation, and did so solely for the benefit of the banks. The banks were ordered to pay over $1 billion to the liquidators. At the time of writing the appeal to this

[page 548]

decision had not been determined. One of the appeal judges in the majority (Lee AJA) saw this as an example of equitable fraud by the banks, who acted to give themselves a better position in insolvency. Another majority appeal judge (Drummond AJA) held that the directors had breached their duties by failing to protect the creditors’ interests when they knew that the companies were insolvent. This was because the interests of the company included the interests of creditors and the directors had simply failed to consider the interests of creditors other than the banks. The minority judge on appeal (Carr AJA) held that the directors had considered the interests of creditors because they were working to save the companies by engaging in the negotiations with the banks.

Significance: This case is very significant for companies seeking to restructure their operations during times of financial distress, as it demonstrates that obtaining security for reworking loan arrangements might not protect the major creditors if they knew that the company was insolvent and the directors were breaching their duties to the company (including the interests of all of the creditors).

The appeal from this decision to the High Court was settled which makes this ruling binding law.

The Bell case was applied recently in Gordon v Leon Plant Hire Pty Ltd [2015] NSWSC 397 at [80], where Black J decided that a director had breached his duties to the company by failing to consider creditor interest when he made payments to himself at a time when the company was insolvent and shortly before tax payments were due. His Honour stated that this involved a conflict of interest (that is, a conflict between the interests of the company’s creditors and the personal interests of the director).

Voidable transactions

18.4

18.5

•

The discussion above has illustrated the risks to creditors associated with corporate financial distress. One legal measure that attempts to protect the interests of creditors of insolvent companies is the ability of liquidators to recover voidable transactions for the benefit of all creditors. The monies recovered from undoing certain transactions, identified below, increases the pool of funds available for purposes of creditor distribution.

Types of voidable transactions The Corporations Act Pt 5.7B Div 1 confers on liquidators (who are appointed over insolvent companies by the court) the power to reclaim property, including money, that has previously been disposed of by the company in the lead up to liquidation (these are called voidable transactions). The purpose of the voidable transaction provisions is to prevent a depletion of the assets of a company as it approaches insolvency transactions and is entered into within a specified limited time prior to the commencement of the winding up.

The power to reclaim voidable transactions may significantly increase the pool of assets available to creditors and thus offer an advantage over other types of external administration, such as voluntary administration where the administrator lacks such powers. The different types of external administration are discussed in Chapter 22.

Voidable transactions may fall within several different categories:

[page 549]

Unfair preferences: which involves a creditor receiving a higher rate repayment than they would receive if the company were in liquidation: s 588FA. To have the effect of giving the creditor a preference, priority or advantage over other creditors, the payment must ultimately result in a decrease in the net value of the assets that are available to meet the competing demands of the other creditors: Airservices Australia v Ferrier (1996) 185 CLR 483. Uncommercial transaction: which is where a reasonable person in the

•

18.6

•

company’s circumstances would not have entered into the transaction having regard to the benefits and detriments involved: s 588FB. A common example of an uncommercial transaction involves a situation where the company releases a debt for no consideration. The Full Federal Court observed in Demondrille Nominees Pty Limited v Shirlaw (1997) 25 ACSR 535, ‘s 588FB is concerned with avoiding bargains of such magnitude that they cannot be explained by normal commercial practice’. Unfair loans: which is where the interest or charges on a loan are extortionate (that is, grossly unfair). Unreasonable director-related transactions: which is where the company enters into a transaction (including a payment or transfer or property) with a director or a close associate of a director and a reasonable person in the company’s circumstances would not have entered into the transaction having regard to the benefits and detriments involved: s 588FDA2. Voidable security interests: which involve a circulating security interest created within six months prior to the commencement of the liquidation, although there are numerous exceptions: s 588FJ.3

Relevance of insolvency Both unfair preferences and uncommercial transactions are only voidable if the transactions occur at a time when the company was insolvent or would become insolvent because of the transactions: s 588FC. A company is insolvent if it is unable to pay all the debts as and when they become due and payable: s 95A. Unfair loans, unreasonable director- related transactions and voidable charges do not require insolvency to be proved in order for the liquidator to recover the property involved (including money transferred by the company).

In order to assist a liquidator to prove that the company was insolvent at a particular time, the Act provides various presumptions of insolvency that may be used for recovery proceedings (such as voidable transactions):

a company fails to keep the financial records required under the Act (s 588E(4));4 and insolvency has been proved in another set of recovery proceedings

18.7

18.8

(including both voidable transactions and insolvent trading).

Timeframe Each of the voidable transactions (except unfair loans) must have taken place within a certain time prior to the ‘relation-back day’, which is generally the date when a

[page 550]

creditor made the application to wind up the company (see s 91 definition of ‘relation-back day’). The timeframes are set out in Figure 18.1.

Unfair loans may be reclaimed by the liquidator regardless of the time they were entered into before the relation-back day: s 588FE(6).

Defences to voidable transactions The ability of a liquidator to reclaim property that has been previously disposed of by the company has the potential to result in unfair outcomes for persons who were genuinely unaware of the company’s dire financial situation when they entered into the transaction to acquire the property. In light of this, s 588FG provides defences against the liquidator’s power

1. 2.

18.9

to reclaim voidable transactions and unfair loans in certain circumstances.

The power of a court to make orders under s 588FF to reclaim a voidable transaction is subject to the defences contained in s 588FG(1). A person who was not a party to the transaction that would otherwise be voidable may rely on the defence in s 588FG(1)(a) where they did not receive any benefit from the impugned transaction. Where that person has received a benefit they may still rely on the good faith defence contained in s 588FG(1)(b). The good faith defence requires that the party seeking to retain the property subject to the voidable transaction claim (the defendant) must prove to the court that:

they received the benefit in good faith;5 they had no reasonable grounds for suspecting the company’s insolvency when the transaction occurred;6 and no reasonable person in similar circumstances would have grounds to suspect the company’s insolvency.

[page 551]

A person who was a party to the transaction may rely on the defence provided in s 588FG(2) which has similar requirements to the defence in s 588FG(1), except that it also requires the party to prove that they gave valuable consideration for the transaction or have changed their position in reliance on the transaction: s 588FG(2)(c). This defence does not apply to unfair loans or unreasonable director-related transactions.

Is the transaction voidable? The steps to be followed to identify whether a transaction is voidable are set out in Figure 18.2 below.

[page 552]

Duty to avoid insolvent trading

Background to the insolvent trading prohibition

18.10

Background to the insolvent trading prohibition As noted above, when a company becomes insolvent the duties of directors change from being owed to the company (that is, the shareholders) to being owed to creditors. However, the general law obligation to creditors in insolvency is supplemented by a statutory duty to avoid insolvent trading (that is, to prevent the company from incurring debts during insolvency). This statutory duty was first introduced into Australia in the 1960s and was modelled on United Kingdom legislation dealing with debts incurred without a reasonable belief that the debts could be repaid.

Companies, through the directors, are prohibited from trading while insolvent as this unfairly places creditors at risk. Ordinarily, the company as a separate legal entity (with the power to enter into legally binding contracts) is liable for the debts it incurs and not its directors. This is a consequence of the decision in Salomon’s case, discussed earlier in Chapter 5. However, as noted earlier in 5.21, the Act allows for the ‘corporate veil’ to be lifted where insolvent trading occurs. For the purposes of director accountability and creditor protection, parliament has imposed a duty that if the company is unable to pay its debts, then the directors should be personally liable for debts incurred after the date of insolvency: s 588M. The insolvent trading provisions allow an individual creditor, with liquidator or court consent, to sue the directors of an insolvent company to recover the repayment of their debt. This can result in potentially large amounts of money being recovered on the basis of personal liability, as occurred in Commonwealth Bank Ltd v Friedrich (1991) 5 ACSR 115, where a voluntary non-executive director was found liable for insolvent trading for over $97 million. The director in that case, of course, was subsequently declared bankrupt.

A breach of s 588G is a civil penalty provision under Pt 9.4B. However, where the insolvent trading occurs due to dishonesty, there is a separate criminal offence under Sch 3, which may incur up to a $420,000 fine and/or five years’ imprisonment. There have been a small number of cases of directors going to prison for insolvent trading, including one of the directors of the former whitegoods manufacturer Kleenmaid, who was sentenced to nine years in prison.

18.11

• •

•

18.12

The insolvent trading provision has also been extended to holding and subsidiary companies under s 588V. However, there has been very little litigation to date using the insolvent trading provisions against holding companies.

Elements of the prohibition The requirements for the statutory offence of insolvent trading are stated in s 588G(1), which can be summarised as follows:

a person is a director at a time when the company incurs a debt; at that time, the company is insolvent or becomes insolvent by incurring that debt; at that time, a reasonable person would have grounds to suspect that the company was insolvent or would become insolvent by incurring that debt; and the director is aware at the time the debt is incurred that there are reasonable grounds for suspecting the company is insolvent, or a reasonable person in a similar position would be so aware.

[page 553]

The following discussion analyses the key statutory elements under s 588G with reference to judicial interpretation.

A person is a director of the company Section 588G applies to directors only. While this may appear to be a narrow application of this section, it is important to remember that s 9 provides a broad definition of director which includes both shadow and de facto directors. These concepts were discussed earlier in Chapter 14 and reference should be made to the statutory definition of director which is based on the actions and level of influence the person has on the board or the running of the company.7

When is a debt incurred?

18.13 A debt is incurred when a binding obligation to pay money arises.

Hawkins v Bank of China (1992) 26 NSWLR 562 New South Wales Court of Appeal

A debt is incurred when a company enters into a contract by which it subjects itself to an unavoidable obligation to pay a sum of money at a future time, even if that obligation is conditional.

It should also be noted that the word ‘debt’ has several meanings for purposes of the insolvent trading provisions. Section 588G(1A) provides for a range of ‘deemed debts’ such as the declaration of a dividend, the reduction of share capital, engaging in share buy-back activity and other share capital transactions.

contingent debts: a debt that is subject to a pre-existing legal obligation (for example, a binding contract) but the actual payment of the debt depends on the happening of a future event, even if the future event may or may not happen. The classic example is a guarantee where the guarantor has an existing legal obligation, but may not need to make payment if the principal debtor complies with the loan.

If the alleged debt is not a deemed debt, then the court must examine the nature of the (usually contractual) liability to pay. The Hawkins case is significant because it recognises that contingent debts are debts for the purposes of insolvent trading. A debt for the purposes of insolvent trading should be a certain sum which is due rather than merely a claim for compensation which requires calculation by the court: Box Valley Pty Ltd v Kidd (2006) 24 ACLC 471; [2006] NSWCA 26 (a case where liability to pay damages for a likely future breach of contract was not a debt for the purposes of insolvent trading).

One problematic issue concerns the relevance of creditor delays in enforcement of the payment of the debt. On one view, it could be argued that a debt is not due until a creditor seeks to actively enforce the debt. However, that view is not reflected in the case law. One of the leading recent decisions to consider this issue was Southern Cross Interiors Pty Ltd (in liq) v Deputy Commissioner of Taxation.

18.14

[page 554]

Southern Cross Interiors Pty Ltd (in liq) v Deputy Commissioner of Taxation (2001) 53 NSWLR 213; [2001] NSWSC 621 New South Wales Supreme Court

Facts: Mr and Mrs Clark were the sole directors of Southern Cross Interiors, although Mrs Clark took no part in the management of the company. The company suffered financial difficulties, despite the fact that many of the company’s creditors were not enforcing payment within the standard 30-day payment terms. A liquidator was eventually appointed and he took action against the Deputy Commissioner of Taxation (DCT) for recovery of tax payments as voidable preferences. The DCT then brought an action against the Clarks to seek recovery of any tax payments that might need to be repaid to the liquidator.8

Issue: As part of the overall question as to when the company became insolvent, an issue was raised as to whether debts had been incurred in light of the lack of enforcement by the creditors.

Decision: Palmer J found that debts had been incurred despite the fact that creditors might not have actively enforced the repayment of those debts.

Significance: This case demonstrates that delays by creditors in enforcing repayment do not prevent the amount owed from being counted as a debt.

Although the Southern Cross Interiors case was overturned on appeal (see Deputy Commissioner of Taxation v Clark below), the appeal did not relate to Palmer J’s discussion of when a debt is incurred. If a creditor has entered into a payment plan to spread the repayment of the amount owing over a period of time, then this may be taken into account when assessing whether the debt is due and payable at that time: see further Smith v Offermans [2015] QCA 55 at [50]–[54]. See also Treloar Constructions Pty Limited v McMillan [2017] NSWCA 72.

When is a company insolvent? The test for insolvency is contained in s 95A which provides that a company is insolvent where it is unable to pay its debts as and when they become due and payable.

The traditional view was that solvency had to be assessed on the basis of the company’s own funds, which relied on a cash flow test rather than a

balance sheet test: see Bank of Australasia v Hall (1907) 4 CLR 1514. Over time, however, the courts have come to accept that a company is not insolvent merely because it does not have sufficient cash to pay its debts: see Rees v Bank of New South Wales (1964) 111 CLR 210. The courts recognise that the real question is whether the company is practically able to pay its debts, whether the funds are derived from cash reserves, assets sales or borrowed funds9. For example, in International Cat Manufacturing Pty Ltd v Rodrick (2013) 97 ACSR 200; [2013] QCA 372, the fact that a major client of the boat manufacturer was supporting the business financially over a period of time meant that the company was not insolvent even though it could not have paid its debts without that continued support.

[page 555]

The assessment of solvency, for the purposes of the insolvent trading provision, was summarised by the Supreme Court of South Australia (Full Court) in Powell v Fryer.10

Powell v Fryer (2001) 37 ACSR 589; [2001] SASC 59 South Australian Supreme Court (FC)

The assessment of a company’s solvency must be undertaken by considering the commercial reality of the company’s financial position. The court should not simply use a temporary lack of liquidity. Regard should be had not only to the company’s cash resources immediately available, but also to moneys which it can procure by realisation by sale, or borrowing against the security of its assets, or otherwise reasonably raise from those associated with, or supportive of, it. It is the inability, utilising such resources as are available through the use of assets or which may otherwise realistically be raised to meet debts as they fall due, which indicates insolvency.

It is legitimate to take into account any indulgences extended to a company by its creditors as to trading terms. However, absent a firm arrangement with all of its creditors for an extension of terms of trade, the court will usually apply the normal terms of trading when assessing solvency. It is not normally proper to base an assessment on a mere failure of creditors (or of some creditors) strictly to enforce payment obligations at a given point in time.

It is not appropriate to base an assessment on the prospect that the company might be able to trade profitably in the future, thereby restoring its financial position. The question is whether it, at the relevant time, is able to pay its debts as they become due — not whether it might be able to do so in the future, if given time to trade profitably.

•

One problematic issue concerns the extent to which directors may be able to rely on non-enforcement of repayment by creditors. This issue was mentioned in the above summary from Powell v Fryer, but it received detailed consideration in Southern Cross Interiors Pty Ltd (in liq) v Deputy Commissioner of Taxation.11

Southern Cross Interiors Pty Ltd (in liq) v Deputy Commissioner of Taxation (2001) 53 NSWLR 213; [2001] NSWSC 621 New South Wales Supreme Court

In assessing solvency, the court acts upon the basis that a contract debt is payable at the time stipulated for payment in the contract unless there is evidence, proving to the court’s satisfaction, that:

estoppel: a legal rule where a person is prevented (estopped) from denying an assumption made by another person because it would be unfair to allow the person to deny the assumption.

there has been an express or implied agreement between the company and the creditor for an extension of the time stipulated for payment; or there is a course of conduct between the company and the creditor sufficient to give rise to an estoppel preventing the creditor from relying upon the stipulated time for payment; or there has been a well-established and recognised course of conduct in the industry in which the company operates, or as between the company and its creditors as a body, whereby debts are payable at a time other than that stipulated in the creditors’ terms of trade or are payable only on demand.

[page 556]

As an alternative to satisfying the legal test of insolvency under s 95A, in limited circumstances, the Corporations Act allows for a presumption of insolvency. For example, s 588E(4) provides for presumptions of insolvency to be made a company has failed to keep or retain financial records for a period of seven years as required by s 286. In such situations, s 588E can be a powerful evidentiary tool to assist ASIC, the

18.15

1. 2. 3. 4. 5. 6.

liquidator or creditor (with prior consent of the liquidator or the court) seeking to enforce the insolvent trading law.12

Reasonable ground to suspect insolvency For the court to determine under s 588G whether there is a reasonable ground for suspecting that the company is insolvent, there will be an application of an objective test rather than the directors’ actual subjective knowledge of the insolvency.

Smith v Bone (2015) 104 ACSR 528; [2015] FCA 319 at [367] Federal Court of Australia

‘Reasonable’ in this context imports the standard of reasonableness appropriate to a director of reasonable competence and diligence, seeking properly to perform his or her duties as imposed by law (when viewed as a whole) and capable of reaching a reasonably informed opinion as to [the company’s] financial capacity.

In Re Swan Services Pty Ltd (in liq) [2016] NSWSC 1724 at [180] Black J explained:

Reasonable grounds for a suspicion of insolvency could be established, for example, where a director of ordinary competence, viewing the whole of a company’s circumstances objectively, would have had no real idea where to find the necessary money to pay debts at the time they were incurred:

In ASIC v Plymin (2003) 46 ACSR 126; [2003] VSC 123 at [386],13 Mandie J considered a list of relevant factors that may be used to assist in determining whether there are reasonable grounds for suspecting insolvency. Of course, no single factor is necessarily determinative on its own. The list is:

continuing losses; liquidity ratios below 1; overdue taxes; poor relationship with the bank; no access to alternative finance; inability to raise further equity capital;

8. 9. 10. 11.

12. 13.

14.

suppliers placing company on cash on delivery (COD), or otherwise demanding special payments before resuming supply; creditors unpaid outside trading terms; issuing of post-dated cheques; dishonoured cheques; special arrangements with selected creditors;

[page 557]

solicitors’ letters, judgments or warrants issued against the company; payments to creditors of rounded sums that are not reconcilable to specific invoices; or inability to produce timely and accurate financial information to display the company’s trading performance and financial position, and make reliable forecasts.

Metropolitan Fire Systems v Miller (1997) 23 ACSR 699 New South Wales Supreme Court

Facts: The Millers were directors of a company called Raydar, which specialised in commercial electrical work. Raydar accepted a contract from Reed to install the electric systems in a large lecture theatre at the University of New South Wales. When Raydar accepted this contract it had a number of unpaid creditors. Raydar was unable to complete the entire job and contracted with Metropolitan Fire Systems (MFS) to perform some of the work on the lecture theatre. MFS completed its work but Raydar could not pay for the work that MFS had done as Raydar had not yet been paid by Reed for the work. Mr Miller (the primary director of Raydar) was assured by Reed that payments would soon be made to Raydar in respect of the electrical work on the lecture theatre. However, the payment from Reed failed to arrive before one of Raydar’s creditors issued a statutory demand demanding payment for previous supplies. MFS then sought a court declaration that Raydar was insolvent and that the Millers breached s 588G by allowing Raydar to incur debts to MFS.

Issue: Were the directors liable for insolvent trading? Was the company insolvent? Decision: Raydar was insolvent as it had large amounts of unpaid debts when it incurred liability to MFS. It had $200,000 in assets and $400,000 in liabilities. The directors should have suspected that the company was insolvent because of the lack of incoming payments and the continued accumulation of business debts that were not paid. Therefore, the directors breached their duty under s 588G.

18.16

ASIC v Plymin (2003) 46 ACSR 126; [2003] VSC 123 Victorian Supreme Court

‘Reasonable’ in this context imports the standard of reasonableness appropriate to a director of reasonable competence and diligence, seeking properly to perform his duties as imposed by law (when viewed as a whole) and capable of reaching a reasonably informed opinion as to a company’s financial capacity.

Preventing insolvent trading One of the key issues that have arisen in numerous cases concerns the power imbalance between executive and non-executive directors. That is, non-executive directors do not play a significant role in the day-to-day management of the company and therefore are heavily reliant on the advice and information given by the executive management team. What then does this mean for the obligation imposed on all directors under s 588G(2), including non-executive directors, to stop the company from trading while it is insolvent?

The Water Wheel case considered this issue.

[page 558]

ASIC v Plymin (2003) 46 ACSR 126; [2003] VSC 123 Victorian Supreme Court (Trial Decision)

Facts: ASIC brought an action against three directors of the Water Wheel group of companies, which were involved in the milling of rice and wheat. The three directors were: Elliott (a non-executive director), Plymin (the managing director) and Harrison (the chairman). Harrison admitted liability, while Elliott and Plymin defended their actions. Water Wheel went into voluntary administration in February 2000, with ASIC alleging that the company traded while it was insolvent in late 1999. During 1999, Water Wheel incurred various substantial commercial debts for stock purchases, transport costs and to obtain additional storage capacity.

In late 1998, Water Wheel was unable to pay all of its debts and one of its suppliers stopped trading

with the company.

Issue: Did Elliott and Plymin breach their statutory duty to prevent insolvent trading? Arguments: Elliott argued in defence against the allegations of insolvent trading that he was unable to prevent the insolvent trading because he was a non-executive director and therefore owed lesser duties to the company.

Decision: Mandie J rejected Elliott’s argument on the basis that the obligation under s 588G requires individual directors to take reasonable action necessary to prevent insolvent trading. As Mandie J said: ‘the essence of a failure by a director to prevent a company from incurring a debt is a failure by that director to take all reasonable steps within his power to prevent the company from incurring such debt’. His Honour found that neither Elliott nor Plymin had taken any steps to prevent Water Wheel’s insolvent trading and therefore both of them had breached their duties under s 588G. As a result of breaching s 588G, Plymin was banned from being a director for 10 years and fined $25,000 and Elliott was banned for four years and fined $15,000.

Significance: The significance of this decision is the recognition that s 588G imposes a positive obligation on all directors to stop the company’s insolvent trading, including non-executive directors. Where the directors cannot prevent insolvent trading they have an obligation to resign immediately.

ASIC v Elliott (2004) 48 ACSR 621; [2004] VSCA 54 Victorian Court of Appeal (Appeal Decision)

Facts: Elliott and Plymin appealed against Mandie J’s decision which held them personally liable for the company’s debts under s 588G and also appealed against the severity of the ban from acting as directors and the fines imposed. Elliott and Plymin challenged the basis of Mandie J’s decision by arguing that a breach of s 588G could only be established where the particular directors sued under that section were aware that the company had incurred a specific debt, and had a duty to prevent the incurring of that particular debt while the company was insolvent. Mandie J had found a breach of s 588G on the basis that all of the directors of Water Wheel had allowed the company to continue incurring debts when there were reasonable grounds for suspecting the company’s insolvency due to the large number of unpaid bills that the company had.

Decision: The Victorian Court of Appeal largely dismissed the appeal. The court found that s 588G did not require proof that individual directors owed a particular duty in respect of each and every debt incurred by the company, nor was it necessary to prove that the individual directors actually knew of the existence of each particular debt. The court therefore agreed with Mandie J’s approach to assessing breaches of s 588G.

[page 559]

The court did, however, reduce Plymin’s ban on acting as a director from 10 to seven years due to the fact that he had a substantial prospect to rehabilitate himself due to his comparatively young age. The Court of Appeal said:

… it is in our view clear that the effect of s 588G(2) is that a director contravenes the section

18.17

(1) (a)

(b)

(i)

(ii)

(iii)

(iv)

‘by not preventing’ or ‘by failing to prevent’ a company from incurring a debt, and that a director will be taken to have so failed if debts are incurred by a company at a time when there are reasonable grounds for suspecting that the company is insolvent.

Following this decision, John Elliott was declared a bankrupt and had to sell off much of his personal property to satisfy corporate debts.

Safe harbour reform In 2017, the Federal Parliament passed reforms to the Corporations Act to introduce a safe harbour for directors against insolvent trading. This reform came after several years of discussions and consultations as to whether insolvent trading should be reformed to better facilitate corporate restructuring and rescue attempts.14

The safe harbour is provided under a new s 588GA(1) which provides:

Subsection 588G(2) does not apply in relation to a person and a debt if: at a particular time after the person starts to suspect the company may become or be insolvent, the person starts developing one or more courses of action that are reasonably likely to lead to a better outcome for the company; and the debt is incurred directly or indirectly in connection with any such course of action during the period starting at that time, and ending at the earliest of any of the following times:

if the person fails to take any such course of action within a reasonable period after that time — the end of that reasonable period;

when the person ceases to take any such course of action;

when any such course of action ceases to be reasonably likely to lead to a better outcome for the company;

the appointment of an administrator, or liquidator, of the company.

If directors are sued for insolvent trading, they bear the evidential burden of identifying the steps they took that made up the course of action that was reasonably likely to lead to a better outcome for the company: s 588GA(3). Once they have identified those steps the liquidator (or creditor) will then bear the onus of proving that s 588GA(1) does not apply. The safe harbour provided by s 588GA(1) will end when the events in s 588GA(1)(b) occur.

The court may take into account a range of factors in determining

(2)

(a)

(b)

(c)

(d)

(e)

whether the director’s course of action satisfies the safe harbour, including (as stated in s 588GA(2)):

[page 560]

For the purposes of (but without limiting) subsection (1), in working out whether a course of action is reasonably likely to lead to a better outcome for the company, regard may be had to whether the person:

is properly informing himself or herself of the company’s financial position; or is taking appropriate steps to prevent any misconduct by officers or employees of the company that could adversely affect the company’s ability to pay all its debts; or is taking appropriate steps to ensure that the company is keeping appropriate financial records consistent with the size and nature of the company; or is obtaining advice from an appropriately qualified entity who was given sufficient information to give appropriate advice; or is developing or implementing a plan for restructuring the company to improve its financial position.

This is likely to mean that directors will seek advice as to the prospects for a successful restructuring of the company that will lead to a better outcome for the company, that is being able to return to financial health. It is important to note that the course of action need not be successful in order to satisfy the safe harbour, it is simply aimed at providing directors with confidence that if they act to come within the safe harbour, they will not then be sued for insolvent trading for the period that the safe harbour operates.

The safe harbour will not apply if certain circumstances occur, such as the company failing to make its tax lodgements, failing to pay employee entitlements or directors failing to provide books and records to the liquidator if the restructuring efforts fail and the company subsequently enters liquidation: ss 588GA(4), 588GB.

•

18.18

• •

•

18.19

The safe harbour will be subject to a mandatory review by the Parliament two years after its commencement: s 588HA. The safe harbour applies to conduct from its commencement on 19 September 2017.

Should directors be obligated to appoint external advisers in order to take advantage of the safe harbour? What advantages and disadvantages can you see from such a requirement?

Defences to insolvent trading Section 588H contains a number of defences to insolvent trading and a director is entitled to rely on any one or more of the statutory defences. The defences in s 588H, which are examined below in turn, are:

reasonable expectation of solvency (s 588H(2)); reliance on others providing the information on the solvency of the company (s 588H(3)); illness or some other good reason resulting in absence from management (s 588H(4)); and reasonable steps to prevent the company from incurring any debts (s 588H(5)).

[page 561]

Reasonable grounds to expect solvency (s 588H(2)) The defence of reasonable grounds to expect solvency means more than a mere hope or possibility that the company will be solvent. It requires that the directors have reasonable grounds for being confident that the company is solvent. This issue arose in Metropolitan Fire Systems v Miller.

Metropolitan Fire Systems v Miller (1997) 23 ACSR 699 New South Wales Supreme Court

Facts: See 18.15. Issue: Were there reasonable grounds for expecting that Raydar was solvent when the debt to Metropolitan Fire Systems for its assistance on the University of New South Wales project was incurred?

Decision: The court found that there were no reasonable grounds for the Millers to expect that Raydar was solvent when the debt to Metropolitan Fire Systems was incurred. Both Mr and Mrs Miller should have been aware that Raydar was unable to pay its debts due to the lack of money being paid to Raydar and the increasing number of unpaid invoices being sent to Raydar.

Significance: The court found that an expectation requires something more than mere hope, and implies a measure of confidence in the company’s solvency.

ASIC v Tourprint International Pty Ltd v Bott (1999) 32 ACSR 201; [1999] NSWSC 581 New South Wales Supreme Court

Expectation, as required by s 588H(2), means a higher degree of certainty than mere hope or possibility of suspecting:

… The defence requires an actual expectation that the company was and would continue to be solvent, and that the grounds for so expecting are reasonable. A director cannot rely on complete ignorance of or neglect of duty … and cannot hide behind ignorance of the company’s affairs which is of their own making or, if not … has been contributed to by their own failure to make further necessary inquiries.

The recent case of Hall v Poolman makes it clear that directors must take a pro-active stance in maintaining their expectation of solvency.

Hall v Poolman (2007) 65 ACSR 123; [2007] NSWSC 1330 New South Wales Supreme Court

There comes a point where the reasonable director must inform himself or herself as fully as possible of all relevant facts and then ask himself or herself and the other directors:

How sure are we that this asset can be turned into cash to pay all our debts, present and to be incurred, within three months? Is that outcome certain, probable, more likely than not, possible, possible with a bit of luck, possible with a lot of luck, remote, or is there is no real way of knowing?

If the honest and reasonable answer is ‘certain’ or ‘probable’, the director can have a reasonable expectation of solvency.

If the honest and reasonable answer is anywhere from ‘possible’ to ‘no way of knowing’, the director can have no reasonable expectation of solvency.

[page 562]

The ‘reasonable grounds to expect solvency’ defence failed in Re McLellan; Stake Man Pty Ltd v Carroll (2009) 76 ACSR 67; [2009] FCA 1415. In that case, discussed in detail below, the court held that the extent of the outstanding and unpaid company debt and the extent to which future debts would be incurred were such that it was unreasonable for the director to expect that the company’s stock could be sold within an adequate timeframe to discharge the debt as and when they fell due. The court was of the view that the director’s belief that a quick sale of the company’s asset (its stock of timber) was an unreasonable expectation which did not go beyond a mere hope or possibility based on the facts of the case.

Directors who are passive and remain ignorant of their company’s financial affairs without asking for figures or information on a regular basis will not succeed under this defence: Statewide Tobacco Services Ltd v Morley (1990) 2 ACSR 405 (discussed below). The Victorian Court of Appeal dismissed an appeal against this decision which imposed personal liability on a spousal director for corporate debt and confirmed that the days of the sleeping directors are over: Morley v Statewide Tobacco Services Ltd [1993] 1 VR 423. These decisions were also influential in raising the standards of care, skill and diligence expected of the modern director, and was relied on in the AWA case and, on appeal, in Daniels v Anderson discussed in Chapter 17.

In 2009, ASIC announced that it would look favourably on directors of small-to medium-sized companies who were pro-active and sought professional advice about the solvency of their business and would be unlikely to sue the directors in such circumstances for insolvent trading.15 As noted above, the proposed new business judgment rule defence (if introduced into law) would also assist here.

•

18.20

• •

•

Should the insolvent trading prohibition work differently between small and large companies?

Reasonable reliance on others (s 588H(3)) This defence is similar to the defence given to directors, in respect of breaches of s 180(1), who reasonably rely on information provided by others: see s 189. This defence recognises the common issues arising between insolvent trading and general statutory directors’ and officers’ duties. Under the defence in s 588H(3), the following elements must be proved:

the director relied on information provided by another person; the director had reasonable grounds to believe that the other person had the responsibility of providing the director with information about the company’s solvency and was competent and reliable in performing this role; and the information provided allowed the director to expect that the company was solvent and would remain solvent even if it incurred the debt.

[page 563]

In Williams v Scholz [2007] QSC 266 (appeal dismissed [2008] QCA 94), both directors submitted that they reasonably relied on an experienced sales manager and company director for providing them with adequate information about the company’s solvency. Chesterman J nevertheless held that the directors failed to establish the essential elements of this defence under s 588H(3) due to their distrust of their sales manager. Furthermore, there was no evidence to establish responsibility on the part of the sales manager to provide directors with financial information. Consequently, his Honour held (at [68]):

The [directors’] evidence destroys their case of reasonable reliance on the sales manager to provide reliable information. Apart from their failure to say what information he gave them, their own testimony shows they did not trust him and could not reasonably rely on him by

reason of that distrust. On their own evidence … they had reason for deep suspicion about how the sales manager … [was] running the company … Yet they did nothing.

Directors must ensure that they rely on someone who is both competent and reliable to provide financial information addressing the company’s state of solvency. Distrust of the person relied on is fatal to the successful discharge of the defence under s 588H(3), as illustrated in Scholz. Directors are expected to be proactive in taking remedial steps to ensure reasonable reliance on others to provide reliable information. For example, as suggested by Chesterman J in Scholz, a company meeting should be convened to have the errant director removed or to ask questions about the company’s affairs. Depending on the circumstances of each case, it is also useful for innocent directors to remember that they have the option to promptly resign or to appoint an external administrator in order to avoid exposure to personal liability for the company’s debts.

Scholz also underscores the basic point that the director must be in a position to prove that a reliable person was responsible for providing the director adequate information about whether the company was solvent. The directors inability to verify the specific tasks entrusted to the delegate was also fatal to their claim of ‘reasonable reliance’ under s 588H(3).

The reasonable reliance defence failed in Re McLellan; Stake Man Pty Ltd v Carroll (2009) 76 ACSR 67; [2009] FCA 1415. In that case, the sole director of a timber mill company engaged an independent accountant to assist with preparing an information memorandum to support a new equity issue or a strategic joint venture. As part of that role the accountant provided advice on the solvency of the business. However, the court found that as the accountant was not specifically engaged for the purpose of providing advice as to solvency, the defence was not satisfied. Similarly, this defence also failed in Re Swan Services Pty Ltd (in liq) [2016] NSWSC 1724. In this case, although the court was satisfied the professional advisers relied upon by the director were competent and reliable, the defence was rejected because the director failed to show that such people were responsible for providing the director with adequate information on solvency.

However, in the Stake Man case, the director’s pro-active stance in

18.21

seeking and acting on professional advise at the earliest sign of financial distress led the court to grant relief from liability under s 1317S. This key aspect of the case is discussed further below.

[page 564]

Given that most of the insolvent trading cases involve hopelessly insolvent companies that have traded while insolvent for extended periods (such as the Water Wheel case), establishing this defence has been difficult. Where there are numerous indicators of insolvency (such as creditor demands, withdrawal of credit, changes to cash on demand payment terms or rejected credit applications) it will be difficult for directors to rely on either s 588H(2) or (3) to escape liability.

Absence from management (s 588H(4)) This defence demonstrates the need for directors to engage with management, unless they can offer valid reasons for absence from management based on the statutory criteria of either ‘illness’ or ‘some other good reason’.

A director’s total reliance on their spousal director for management due to their love, faith and confidence would not entitle reliance on the ‘some other good reason’ aspect of the defence in s 588H(4). The court has not been sympathetic to this line of argument for being absent from management, as it is in conflict with the basic expectation of all directors to ordinarily participate in management: see Deputy Commissioner of Taxation v Clark (2003) 57 NSWLR 113; [2003] NSWCA 91.

Deputy Commissioner of Taxation v Clark (2003) 57 NSWLR 113; [2003] NSWCA 91 New South Wales Court of Appeal

Facts: This was a family company in which the husband and wife were the directors. The wife accepted

the appointment of director, after being requested by her husband, in order to satisfy the requirements for the formation of a proprietary company under the law which required a minimum of two directors at that time. The wife did not take part in the management of the carpentry business conducted by the company. The company incurred a debt while insolvent and Mr Clark, the husband, was found liable for insolvent trading. The trial decision, however, held that Mrs Clark, the wife, was absolved from liability as she was excused from management due to her reliance on her husband.

Issue: Could Mrs Clark rely on s 588H(4) to avoid liability for insolvent trading on the basis that she left the company’s affairs to her husband? Could the delegation by a director of the entire management of the company constitute ‘some other good reason’ for the purposes of s 588H(4)?

Decision: Mrs Clark could not avoid liability for insolvent trading on the basis that leaving the business to her husband was ‘some other good reason’. The words ‘some other good reason’ must be read down so that they did not conflict with the obligation of directors generally to participate in the management of the company. They must be read down in accordance with the scope and purpose of the legislation in which they appeared. Reasons which caused a director never to participate in management were not capable of constituting ‘some other good reason’ for not participating at a particular point in time. Spigelman CJ held:

… Sections 588G and 588H was based on the assumption that a director would participate in the management of the company. This assumption strongly suggests that a total failure to participate, for whatever reason, should not be regarded as a ‘good reason’ for failing to participate at a particular time … it is a basal structure feature of corporations legislation in Australia that directors are expected to participate in the management of the corporation.

[page 565]

In addressing the consequences of the trial court’s decision, which interpreted the law widely in favour of spousal directors by relying on the law dealing with special tenderness shown to married women in other areas of commercial law, Spigelman CJ held:

The recognition of complete abdication of responsibilities as a director as a ‘good reason’, for purposes of the statutory defences, carries with it the risk of reinforcing gender stereotypes and undermining the confidence with which potential creditors will deal with small companies in which women participate with their husbands. Maintaining a firm position on the duties of directors will encourage the use of single director corporate structures for small business.

Significance: The effect of Clark and the earlier decisions such as Morley and Daniels (discussed in Chapter 17) are that a director who fails to actively monitor the management of the company will not be able to escape liability for insolvent trading on the basis that they did not possess the required skills necessary to monitor the management.

Statewide Tobacco Services Ltd v Morley (1990) 2 ACSR 405, decided earlier under the predecessor to ss 588G and 588H, is also a useful case which demonstrates the necessary commitment expected of directors when managing the company. It illustrates that being absent from management, without valid cause, is inconsistent with the positive duty to take an active part in the affairs of the company.

Statewide Tobacco Services v Morley (1990) 2 ACSR 405 Victorian Supreme Court

Facts: Mrs Morley was a director of a small family company run primarily by her husband until shortly before his death. After her husband died, the company was run by Mrs Morley’s son and another director with Mrs Morley and her daughter remaining as directors and shareholders but taking no part in the management of the company. Mrs Morley did receive income from the business and did sign documents in her capacity as a director but she made no effort to monitor how the company was managed by her son. During 1988, the son caused the company to incur debts to Statewide Tobacco Services (the creditor) at a time when the Morley family company was insolvent. The creditor sued Mrs Morley for breaching her statutory obligation not to allow the company to trade while it was insolvent.

Issue: Could Mrs Morley use her reliance on her son to properly manage the company as a defence to insolvent trading?

Decision: The court decided that Mrs Morley could not rely on her lack of participation in the management of the family company to excuse her from the statutory obligation. Ormiston J stated:

It is thus apparent … that a director is obliged to inform himself or herself as to the financial affairs of the company to the extent necessary to form each year the opinion required for the director’s statements. Although that is only an annual obligation, it presupposes sufficient knowledge and understanding of the company’s affairs and its financial records to permit the opinion of solvency to be formed.

Turning attention to the directors’ positive duty to take an active part in the affairs of the company to the extent that they should be aware of what is going on in the company, Ormiston J stated:

A director should not … be entitled to hide behind ignorance of the company’s affairs which is of his own making or … has been contributed to by his own failure to make further necessary inquiries … What each director is expected to do is to take a diligent and intelligent interest in the information either available to him or which he might with fairness demand from the executives or other employees and agents of the company.

[page 566]

Significance: This case confirmed that directors (even non-executive directors) who do not monitor the financial performance of the company will not have a valid defence against insolvent trading. The Victorian Court of Appeal dismissed an appeal against this decision and confirmed that the days of the sleeping directors are over: Morley v Statewide Tobacco Services Ltd [1993] 1 VR 423.

Although not pleaded explicitly, the director in the case of Williams v Scholz [2007] QSC 266 (appeal dismissed [2008] QCA 94) offered some evidence to support a claim that he was ill throughout the time the company traded and did not take part in its management.

18.22

18.23

In Scholz, Chesterman J rejected the director’s reliance on his ‘absence from management due to illness’ defence under s 588H(4) because, on the contrary, the evidence showed that he went to the company’s premises every day, regularly attended directors meetings and travelled interstate on company business on a few occasions. If he was too ill to attend to the company’s affairs, according to his Honour, one would have expected him to remain in the comfort of his home or resign his directorship because he could not discharge his duties.

The decision in Scholz underscores the basic point that failure to lead evidence on the director’s condition of health will make it difficult to sustain this defence. This case demonstrates that it is inadequate for the director to simply allege that he or she has a medical condition and is receiving treatment and therefore ought to be exempt from management due to the ‘illness’ defence in s 588H(4). Substantiating details, such as particulars of the treatment and the effect of the treatment or drugs on the director’s health, together with the date of commencement of treatment is necessary for a reliable assessment to be made under this defence.

Reasonable steps to prevent company incurring the debt (s 588H(5))

This defence provides that a director may avoid insolvent trading if they took all reasonable steps to prevent the company incurring the debt. In most cases, this defence may be established if the directors have acted swiftly in their decision to appoint a voluntary administrator to take over the management of the company. As noted above, the Water Wheel case demonstrates that a director will not be able to escape liability merely because he or she is unable to prevent the debt from being incurred. In such circumstances, the director’s obligation is to resign.

Recovering repayment for debts incurred during insolvency Section 588M gives the liquidator a statutory action for recovery against the director who has contravened the insolvent trading provision in s 588G. This can occur even if the director has not been subject to a civil penalty order (under ss 1317E, 1317G or a disqualification order under s 206C) or conviction brought by ASIC or the DPP. A certificate under s

18.24

588Q can assist proof of the contravention to the unsecured creditor after liquidation has commenced.

The amount recoverable is the amount of the creditors’ loss or damage: see Treloar Constructions Pty Ltd v McMillan [2017] NSWCA 72.16 The amount recovered is a debt

[page 567]

due to the company. The timeframe for bringing the action is limited to six years from the beginning of the winding up: s 588M(4).

In Aris v Express Interiors Pty Ltd (in liq) [1996] 2 VR 507 the question arose as to whether the proceedings should be brought by the liquidator or the creditor. The court stated that the proper plaintiff is the company and thus it should be the liquidator. For the creditor to bring the case against the director under s 588M, their liquidator must consent in writing (s 588R) or the creditor must obtain leave of the court.

Relief from liability Where directors are found to have contravened the insolvent trading prohibition under s 588G, they may apply to the court for relief from liability under s 1317S. This provision applies to civil penalties, with s 588G included in the list of civil penalty provisions provided in s 1317E.

The conditions for relief are quite strict. The director must prove that they acted ‘honestly’ and that in all of the circumstances they ‘ought reasonably to be granted relief’ from liability. Clearly, where the directors have neglected their duties (for example, in the case of the sleeping director) this will be inappropriate. However, where the director has genuinely and reasonably attempted to rescue the business from financial ruin, it may be possible to obtain relief from liability as demonstrated below in the key cases of Hall v Poolman and Re McLellan; Stake Man Pty Ltd v Carroll.

Hall v Poolman (2007) 65 ACSR 123; [2007] NSWSC 1330 New South Wales Supreme Court

Facts: Poolman and Irving were directors of the Reynolds group of wine companies. Both were sued for insolvent trading liability after the companies continued to trade while they were severely insolvent. The companies had increasing debts over several years, a lack of readily saleable assets that could generate cash to pay off debts, a long period of managing creditors through delayed and non- payment of creditors (which grew to almost $5 million) and crucially a tax debt of over $17 million dollars. This was at a time when the company had only $27,000 in cash. The companies attempted to resolve the tax debt with the Australian Taxation Office (ATO) over a period of 10 months. The companies were eventually placed into liquidation and the liquidator sued Poolman, who became bankrupt and did not take any part in the case, and Irving (a well-known and highly successful company director). Irving sought relief from the court under s 1317S.

Issue: Did Irving engage in insolvent trading, and if so, should he be given relief from liability? Decision: Irving had contravened the insolvent trading prohibition because he was aware of the reasonable grounds to suspect insolvency (see the facts above) and yet he allowed the company to continue trading even when it was hopelessly insolvent. However, in seeking to save the company from liquidation by negotiating with the ATO in a genuine and reasonable attempt to resolve the tax issue, Irving acted reasonably and was excused from liability. However, once it became clear that the ATO was unlikely to resolve the dispute within a reasonable time (three months), Irving should have stopped the company from trading and incurring further debts and he was found liable for insolvent trading past that point. In justifying this conclusion, Palmer J noted:

Experienced company directors such as Mr Irving would appreciate that, in some cases, it is not commercially sensible to summon the administrators or to abandon

[page 568]

a substantial trading enterprise to the liquidators as soon as any liquidity shortage occurs. In some cases a reasonable time must be allowed to a director to assess whether the company’s difficulty is temporary and remediable or endemic and fatal.

The commercial reality is that creditors will usually allow some time for payment beyond normal trading terms, if there are worthwhile prospects of an improvement in the company’s position.

What if the administrators were summoned and the Reynolds Group collapsed, only to be told days later that the ATO agreed to settle the dispute on favourable terms? It is not hard to envisage the Directors’ sense of frustration in such circumstances. Mr Irving’s commercial judgment proved erroneous, in my view, but I cannot say that it was made recklessly.

Significance: This case is one of the rare examples where partial relief from liability has been granted to directors. It demonstrates that directors should be given the flexibility, at least for a reasonable period of time, to attempt to save the business and to preserve jobs and enterprise value.

In the subsequent case of Re McLellan; Stake Man Pty Ltd v Carroll (2009)

76 ACSR 67; [2009] FCA 1415,17 the court held that the director should be given complete relief from insolvent trading liability on the basis that the director had acted reasonably in allowing the business to continue trading for a limited time while he tried to turn it around to restore profitability.18

Re McLellan; Stake Man Pty Ltd v Carroll (2009) 76 ACSR 67; [2009] FCA 1415 Federal Court of Australia

Facts: The company, Stake Man Pty Ltd, operated a business of processing and wholesaling raw timber and traded profitably for many years until the company embarked on an expansion plan which proved to be costly, troublesome and ultimately affected the viability of the business. When it became apparent that the expansion plan started to affect the company’s cash flow, the director (Mr Carroll) appointed a specialist accountant in the timber industry to provide advice and to analyse the business model and its profits and losses. The director acted on the professional advice and also, later, sought the advice of an insolvency practitioner and that of a business restructure specialist (Mr McLellan) and placed in the company into external administration. Mr McLellan, as liquidator of the company, pursued the director for insolvent trading and claimed outstanding debts totalling nearly $357,000.

Issue: Did the director engage in insolvent trading and, if so, were the statutory defences under s 588H(2) and (3) applicable? Alternatively, could the director rely on the statutory forgiveness provision under s 1317S?

Decision: Although the court found that the company traded while insolvent (and therefore in breach of s 588G) and that the director’s defences failed (for reasons discussed earlier), the court excused the director from personal liability for the company’s debts based on considerations involving diligence, honesty and fairness.

[page 569]

The court was satisfied that the director did not profit personally, nor did he disregard professional advice during the period of insolvent trading.

The court made the following noteworthy observation:

During the relevant period the position was not one where [the director] Mr Carroll stood still and did nothing while the cash burned. He was taking active steps to expand sales and he kept on trying to [fix the problems in the business].

Significance: This is the first case to fully excuse a director from liability for insolvent trading through the exercise of judicial discretion under s 1317S of the Act. The court addressed the difficult question ‘to trade or not to trade’ when a company is in financial difficulty and navigated a path which afforded the director a safe harbour from personal liability. Note, though, the director was held liable for the liquidator’s costs of litigation because of the liquidator’s success in proving a breach of s 588G.

The quick and positive steps taken by the director in the Stake Man case may be contrasted with the inaction of the directors in Williams v Scholz [2007] QSC 266. In that case, the Queensland Supreme Court declined to exercise judicial discretion under s 1318 (which is in similar terms to s 1317S) and excuse the directors from liability on the basis of their knowledge of deteriorating financial conditions, suspicions of mismanagement and their failure to take remedial steps. As affirmed by the Court of Appeal in Williams v Scholz [2008] QCA 94, this was not a case of inadvertence:19

The [directors] … had a clear intimation that the company was in financial difficulties [but] notwithstanding [this] … the [directors] allowed the company to continue trading, incurring debts and allowing [tradesmen] to provide services and deliver goods … It is not fair to excuse them, especially when the Act specifically imposes a liability on directors in that situation. The function of s 1318 is not to subvert the operation of [the insolvent trading laws].

It is clear that directors who fail to monitor the business and take appropriate action promptly will not be granted relief from insolvent trading liability.

ASIC Regulatory Guide 217, Duty to prevent insolvent trading: Guide for directors (July 2010) sets out key principles to help directors understand and comply with their duty to prevent insolvent trading. As seen above in this chapter, and noted by ASIC in the Regulatory Guide, the law in relation to insolvent trading involves complex legal and accounting issues.

[page 570]

3. 4.

6. 7.

10.

Revision Questions

What potential liabilities arise for directors when the company gets into financial difficulties? How could the duty to prevent insolvent trading be applied to a person not officially appointed as a director? What evidence may support a reasonable suspicion of insolvency? To what extent may a person rely on information provided by others to provide a defence to insolvent trading? Can honest conduct by a director still contravene s 588G? How might honest and reasonable behaviour by a director be used by the court in an insolvent trading case? Who can enforce the duty to avoid insolvent trading? What consequences can arise for directors who contravene s 588G? What presumptions of insolvency may be used in recovery proceedings by liquidators? In what circumstances may a transaction involving a related party be set aside if entered into prior to liquidation? What potential liability may a bank or other major creditor face if they attempt to renegotiate their lending arrangements with a debtor company shortly prior to insolvency?

Problem Question Oracle Manufacturing is a medium-sized ASX listed entity with approximately 100,000 shareholders. The board of Oracle consists of Alex (CEO), Mark (Chairman), Amy (CFO) and two non-executive independent directors, Mei Ling and Anwar. The company secretary and general counsel is Steven who is in charge of legal compliance.

Oracle has several major clients including Acme (a large international industrial firm) which accounts for approximately 30% of its revenues and has been a long-time client. The

(a) (b)

credit crunch from the past 18 months has caused problems for many of Oracle’s clients including Acme, which results in reduced or cancelled orders. This puts significant pressure on the company’s cash flows and management is looking for alternative sources of working capital. Unfortunately, all of the company’s assets are already secured by a floating charge to the bank, and the bank has refused a request to extend the company’s overdraft.

By early September 2017 the company’s financial position has deteriorated due to the collapse of its major client Acme into liquidation. The collapse of Acme puts further pressure on the company’s cash flows and the company has to manage its creditors (including suppliers and lessors) by delaying repayment for as long as possible, in most cases until the creditors threaten legal action. As a result many of its suppliers change their payment terms from 30 days credit to cash on delivery (COD).

The company continues trading until 1 December 2017, when the ATO lodges a director penalty notice on the company’s board of directors for failure to pay the company’s taxes (which means the directors may be personally liable for the company’s tax obligations).

Is the company insolvent at any particular time? What liability could the directors face if the company were insolvent? Would the company secretary also face this potential liability?

[page 571]

Guidelines for Answering Problem Questions

When answering a problem question concerning directors’ duties, we suggest that the following method may be helpful:

Determine whether the person involved in the question is a director or officer for the purposes of the s 9 definitions. Determine at what point the company becomes insolvent or is likely to become insolvent. Establish what the directors knew, or should have known, at that point in time. Did the company continue to trade after this time? If so, discuss s 588G liability. Did the company dispose of assets at an undervalue or enter into other voidable transactions? Work through the legal test for the relevant recovery proceeding.

Determine if any defences may apply: for example, did they act in good faith and without notice of the insolvency (s 588FG(1)) or did they have a reasonable expectation of solvency (s 588H(1))? Comment on what consequences (that is, remedies and penalties) may apply. Can they be granted relief from liability under s 1317S or s 1318?

The business is struggling with the flagship store suffering a severe downturn in business due to the loud and dusty construction work being undertaken nearby. This work is likely to last for another 6-8 months and it looks as though the store will need substantial financial support to see it through this period. The Pop Up stores are also struggling as Pop Up is involved in a rental dispute with a major shopping centre landlord. Wang is hopeful that the dispute will be resolved and following the completion of construction near the flagship store, hopes that thousands of new residents will bring lots of new regular customers.

Wang asks all of the directors to cause both SCPL and Pop Up to agree to take on new finance (from FastCoFinance Ltd). This new loan is very expensive (over 20% interest) and needs to be repaid within 12 months. Wang believes that the new loan will help the business expand and improve its product offerings which will generate new profits and this will allow the loan to be refinanced before it is due.

Erin is concerned about the financial burden this will impose on the business, particularly as a new bank loan was just obtained recently. In her view, Pop Up generates sufficient revenues to fund all of its current and near term operations so why take the risk in taking on even more debt? Erin tells Wang that she will vote against the proposal. Wang tells Erin that he is the managing director and if she doesn’t sign up to the loan facility he will replace her on the board.

Just in case Erin decides to wind up the company, Wang transfers the rights to the company’s trade marks and intellectual property to his family company, WangCo Pty Ltd (a company with only $2 in assets) for $1 million (but this is never in fact paid). At this time, SCPL is late in paying employees, and owes the ATO more than $100,000 in overdue tax payments and Pop Up is more than two months behind on its rent.

Should Erin be concerned about insolvent trading liability? What action could a liquidator take?

[page 572]

Further Reading

Academic Journals

Academic Journals C Anderson and D Morrison, ‘Should Directors Be Pursued for Insolvent

Trading Where a Company Has Entered into a Deed of Company Arrangement?’ (2005) 13 Insolvency Law Journal 163.

A Hanak, ‘The Interaction of the Company Director’s Duty of Care and the Director’s Obligations Relating to Insolvent Trading and Financial Reporting’ (2007) 25 Company and Securities Law Journal 180.

A Hargovan, ‘Directors’ Duties to Creditors in Australia after Spies v R: Is the Development of an Independent Fiduciary Duty Dead or Alive?’ (2003) 21 Company and Securities Law Journal 390.

A Hargovan, ‘Geneva Finance and the “Duty” of Directors to Creditors: Imperfect Obligation and Critique’ (2004) 12 Insolvency Law Journal 134.

A Hargovan, ‘Relevance of Directors’ Unsecured Borrowings, Guarantees and Honesty in Determining Liability for Insolvent Trading’ (2009) Insolvency Law Journal 36.

A Hargovan, ‘Directors’ Liability for Insolvent Trading, Statutory Forgiveness and Law Reform’ (2010) 18 Insolvency Law Journal 96.

A Hargovan, ‘Governance in Financially Troubled Companies: Australian Law Reform Proposals’ (2016) 34 Company and Securities Law Journal 483.

J Harris, ‘Director Liability for Insolvent Trading: Is the Cure Worse Than the Disease?’ (2009) 23 Australian Journal of Corporate Law 266.

J Harris, ‘Relief from Liability for Company Directors’ (2008) 12 UWS Law Review 152.

J Harris, ‘Reforming Insolvent Trading to Encourage Restructuring: Safe harbour or Sleepy Hollows?’ (2016) 27 Journal of Banking and Finance Law and Practice 294.

A Herzberg, ‘Why Are There So Few Insolvent Trading Cases?’ (1998) 6 Insolvency Law Journal 77.

T Howes, ‘Must the Captain Go Down with the Ship? The Avenues Available to Directors to Protect Themselves from Liability for Insolvent Trading’ (2012) 30 Company and Securities Law Journal 7.

P James, I Ramsay and P Siva, ‘Insolvent Trading — An Empirical Study’ (2004) 12 Insolvency Law Journal 210.

P Lewis, ‘Insolvent Trading Defences after Hall v Poolman’ (2010) 28 Company and Securities Law Journal 396.

A MacFarlane, ‘Safe Harbour Reforms — Should Insolvent Trading Provisions be Reformed?’ (2010) 18 Insolvency Law Journal 138.

A Marshall, ‘Is “Due and Payable” a Magic Phrase?’ (2007) 15 Insolvency Law Journal 115.

R Maslen-Stannage, ‘Directors’ Duties to Creditors: Walker v Wimborne’ (2013) 31 Company and Securities Law Journal 76.

K Petch, ‘Insolvent Trading in Australia: The Case for Advance Relief’ (2011) 29 Company and Securities Law Journal 197.

J Purcell, ‘The Contrasting Approach of Law and Accounting to the Defining of Solvency and Associated Directors’ Declarations’ (2002) 10 Insolvency Law Journal 192.

G Sahathevan, ‘The Statement of Cash Flow as a Tool to Determine Solvency’ (2005) 16 Journal of Banking and Finance Law and Practice 93.

L Whitechurch, ‘Should the Law on Insolvent Trading be Reformed by Introducing a Defence Akin to the Business Judgment Rule?’ (2009) 17 Insolvency Law Journal 25.

R Williams, ‘What Can We Expect to Gain from Reforming the Insolvent Trading Remedy?’ (2015) 78 Modern Law Review 55.

[page 573]

Practitioner Journals A Hargovan, ‘Judicial Guidance on De Facto Director Liability for

Insolvent Trading’ (2017) 69 Governance Directions 108. A Hargovan, ‘Insolvent Trading Claim by Creditor: Appellate Court

Guidance in Treloar Constructions Pty Ltd v McMillan’ (2017) 18 Insolvency Law Bulletin 127.

A Hargovan, ‘Tax Debts and Directors Liability for Insolvent Trading’ (2015) 67 Governance Directions 302.

A Hargovan, ‘Assessing Insolvency for Purposes of Directors Personal Liability for Insolvent Trading’ (2014) 66 Governance Directions 428.

2. 3.

M Murray, ‘The Criminal Offence of Insolvent Trading’ (2002) 2 Insolvency Law Bulletin 169.

M Murray, ‘The Eye: The Empty Threat of Insolvent Trading’ (2009) 9 Insolvency Law Bulletin 126.

Practitioner Works R P Austin, H A J Ford and I Ramsay, Company Directors: Principles of

Law and Corporate Governance, LexisNexis Butterworths, Australia, 2005.

You will find useful study resources, including quizzes for each chapter, when you go to <http://learning.lexisnexis.com.au>. The quiz is a great tool to help you self-test your knowledge.

For a more detailed discussion of the facts in the case and its implications, see A Hargovan and J Harris, ‘For Whom the Bell Tolls: Directors: Duties to Creditors after Bell’ (2013) 35 Sydney Law Review 433. See further Weaver v Harburn (2014) 103 ACSR 416; [2014] WASCA 227. See also ss 588FL and 588FP. See further Pozzebon v Australian Gaming and Entertainment Ltd (in liq) (2014) 225 FCR 305; [2014] FCA 1034 (discussing s 588FL); International Cat Manufacturing Pty Ltd (in liq) v Rodrick (2013) 97 ACSR 200; [2013] QAC 372 (this case concerned the predecessor to s 588FP). This presumption does not apply to unfair preferences under s 588FA, unless the creditor who received the preference was a related party to the company in liquidation: s 588E(7). A person acts in good faith when he or she acts with propriety or honesty: Olifent v Australian Wine Industries Pty Ltd (1996) 130 FLR 195. ‘Suspicion’ has been judicially defined as ‘more than idle wondering. It is a positive feeling of actual apprehension or mistrust without sufficient evidence’: Queensland Bacon Pty Ltd v Rees (1966) 115 CLR 266; Dean-Willcocks v Commissioner of Taxation [2008] NSWSC 1113. See further A Hargovan, ‘Judicial Guidance on De Facto Director Liability for Insolvent Trading’ (2017) 69 Governance Directions 108. Section 588FGA provides that a director must indemnify the Commissioner of Taxation where the Commissioner is forced to repay tax payments under the voidable transaction provisions in Pt 5.7B Div 2. See further, A Hargovan, ‘Directors’ Indemnities in Insolvency and Cost Orders’ (2008) 16 Insolvency Law Journal 240. See further Re Cube Footwear Pty Ltd (2012) 92 ACSR 218; [2012] QSC 398 for a review of the authorities.

10.

11. 12.

13.

14.

15.

16.

17.

18.

19.

For a recent summary of the law: see Smith v Bone (2015) 104 ACSR 528; [2015] FCA 319. For discussion of this case, see A Hargovan, ‘Tax Debts and Directors Liability for Insolvent Trading’ (2015) 67 Governance Directions 302. See also Treloar Constructions Pty Limited v McMillan [2017] NSWCA 72. For example, see Sheahan v Ren [2017] FCA 1163; Re Swan Services Pty Ltd (in liq) [2016] NSWSC 1724. See similar factors discussed in Lewis v Doran (2004) 50 ACSR 175; [2004] NSWSC 608 at [75] per Palmer J. For the history of this debate see Harris, ‘Reforming Insolvent Trading to Encourage Restructuring: Safe Harbour or Sleepy Hollows?’ (2016) 27 Journal of Banking and Finance Law and Practice 294. A Hargovan, ‘Governance in Financially Troubled Companies: Australian Law Reform Proposals’ (2016) 34 Company and Securities Law Journal 483. See further ASIC Regulatory Guide 217, Duty to Prevent Insolvent Trading: Guide for Directors (July 2010). See further A Hargovan, ‘Insolvent Trading Claim by Creditor: Appellate Court Guidance in Treloar Constructions Pty Ltd v McMillan’ (2017) 18 Insolvency Law Bulletin 127. See further, A Liability for Insolvent Hargovan, ‘Director’s Trading, Statutory Forgiveness and Law Reform’ (2010) 18 Insolvency Law Journal 96. Contrast Smith v Bone [2015] FCA 319, where the director was trying to address a dispute with the Tax Office but was not seeking to remain informed about the company’s solvency and therefore McLellan and Hall v Poolman were distinguished and relief was not given. See further, A Hargovan, ‘Relevance of Directors’ Unsecured Borrowings, Guarantees and Honesty in Determining Liability for Insolvent Trading’ (2009) 17 Insolvency Law Journal 36.

[page 575]

Members’ Remedies

CHAPTER 19 General law remedies

Fraud on the minority Altering the constitution to take away property rights

Statutory enforcement of the constitution Statutory remedies

Statutory derivative action Operation of Pt 2F.1A Statutory injunction Just and equitable winding up Minority oppression remedy Elements of liability Unfair prejudice and unfair discrimination

Strategic actions Obtaining information Alternative actions

[page 576]

Members’ Remedies

Learning Objectives After completing this chapter you should be able to:

Outline what actions may be taken by a member in respect of conduct by the company that adversely affects their interests.

Demonstrate how to establish that a breach of s 232 has occurred.

Explain what remedies may be sought in respect of minority oppression.

Discuss how alterations to the corporate constitution may be invalidated.

Explain how to establish that it is appropriate for the court to grant leave to bring a statutory derivative action to enforce the company’s rights.

Identify what circumstances may establish that it is just and equitable to wind up a solvent company.

Key Cases

Ebrahimi v Westbourne Galleries Ltd [1973] AC 360

Gambotto v WPC Ltd (1995) 182 CLR 432; [1995] HCA 12

Jenkins v Enterprise Gold Mines NL (1992) 6 ACSR 539

John J Starr (Real Estate) Pty Ltd v Robert R Andrew (A’asia) Pty Ltd (1991) 6 ACSR 63

Morgan v 45 Flers Avenue Pty Ltd (1986) 10 ACLR 692

Ngurli Ltd v McCann (1953) 90 CLR 425

Peters’ American Delicacy Co v Heath (1939) 61 CLR 457

Re Spargos Mining NL (1990) 3 ACSR 1 Swansson v RA Pratt Properties Pty Ltd (2002) 42 ACSR 313; [2002] NSWSC 583

Wambo Coal Pty Ltd v Sumiseki Materials Co Ltd (2014) 101 ACSR 643; [2014] NSWCA 326

Wayde v NSW Rugby League Ltd (1985) 180 CLR 459

Re Yenidje Tobacco [1916] 2 Ch 426

Key Sections

Corporations Act 2001 (Cth) ss 231, 232, 233, 234, 236, 237, 461(1)(k), 1324

[page 577]

Introduction

Throughout this book we have continually examined issues on the role of members in Australian corporate law. We have discussed directors’ duties and the ‘shareholder primacy norm’. We have also looked at the internal rules of corporations and their contractual impact on members. In addition, our discussion of other corporate law issues, including fundraising, share capital, meetings and financial reporting have all had a large focus on the role of members and the importance of protecting members as investors in the company. However, when discussing these issues we have also made it clear that members, while important in corporate law, do not manage the company — the board of directors and senior executive officers manage the corporation. Furthermore, we have largely ignored the fact that the ‘interests’ of members are often in conflict with one another. The members are not necessarily (many would even say ordinarily) a happy homogenous group that all share the same view. Different investors want different things from their shares.

These points are important for this chapter because they highlight the fact that the rights attaching to membership of a company do have limits. A member of a company (even large numbers of members of a company) does not have the power generally to force the company to comply with their wishes. The power structure within corporations is heavily favoured towards majority shareholders and directors and other officers. This can lead to individual members feeling frustrated or unhappy with the way the company is being managed. If it is a publicly listed company, then there may be a ready market in which the aggrieved member may simply sell their shares and thus be relieved of the frustration. However, even in such a company the same circumstances that are making the member unhappy may have caused the share price to drop — what can the member do then?

In recent years the phenomenon of investor activism involving many publicly traded companies has seen vocal shareholder activists undertaking public disputes with boards of public companies by criticising their management decisions and seeking to pressure them to change their strategy. Often these shareholder activists may own only a small amount of shares and not have enough to take over a company or replace the board, but they seek to embarrass

•

the board through public scrutiny and criticism and thereby pressure them into giving in to the activist’s demands. Shareholder activists can come from a broad range of backgrounds, but are usually professional investors including activist hedge fund managers and pension fund managers.

Selling shares when a member is unhappy is often called the ‘Wall Street walk’, but is only available for a small number of companies, that is, those that are publicly traded on stock markets. If an unhappy member owns shares in a proprietary company or an unlisted public company, there is no ready market for the unhappy member’s shares. They may be stuck in the company. Furthermore, many proprietary companies have constitutional limitations on the ability of members to freely transfer their shares. Often members are required to sell their shares to existing shareholders. Company insiders (majority shareholders, directors and managers) may make it difficult for dissenting shareholders wishing to sell their shares by denying them access to company accounts and may (lawfully) withhold commercially sensitive information. Thus, there is no ready market for such shares and this can make it difficult to ascertain an appropriate value for the shares.

[page 578]

In this chapter, we look at the range of remedies that a member may have in relation to actions taken by the company (either by the directors or by a majority resolution in a members’ meeting) against their interests. The central issue examined by this chapter is the means by which an unhappy member of a company may attempt to obtain relief, although it should be noted that in many cases the unhappy member will not be entitled to legal relief. In the course of considering this question we also learn about the ‘price’ of membership of a company — that is, what the individual member signs up to and cannot change regardless of their dissatisfaction. Mere disadvantage or lack of control over company decisions does not entitle a minority shareholder to any legal right; there must be something more — a breach of personal legal rights or breach of the Act, or oppressive conduct, all of which are discussed further below.

An individual member has access to different avenues towards obtaining relief in respect of the situation they find themselves in. The member may be able to call on rights and remedies arising out of:

general law (for example, contract law or equitable principles);

•

statutory enforcement of private rights (for example, enforcing the corporate constitution); or general statutory remedies of members (particularly, the statutory derivative action, the minority oppression remedy or a just and equitable winding up order).

We consider each of these below. It is important to understand the distinction between rights and remedies that are available to a member (personal rights), and those which are available only to the company (corporate rights). A good example of this distinction is improper conduct by directors which may be a breach of directors’ duties (which the company can enforce) but which may also constitute minority oppression under s 232 (which a member can enforce). The statutory derivative action (or SDA) may allow a member to enforce a right of the company to sue, which is discussed below.

In addition, it may be desirable for members to access what we might call ‘strategic’ possibilities. These are possibilities whereby the member might be able to avoid commencing legal proceedings or at least be better informed and perhaps supported if legal proceedings cannot be avoided. These are dealt with at the end of the chapter.

[page 579]

General law remedies

19.1 The primary focus of this chapter is on the range of statutory remedies that company members have under the Corporations Act 2001 (Cth). Certainly, by reference to cases decided before the courts the statutory remedies are more commonly used than general law remedies. It is most likely that the reason for this is that the statutory remedies are easier to obtain than the general law remedies. For example, the statutory minority oppression remedy is a relatively flexible and straightforward action when compared with the equitable doctrine of fraud on a minority.

In this section, we provide an overview of the main general law remedies, including the statutory enforcement of general law rights (that is, enforcement of the company’s internal management rules) before moving on to discuss the statutory members’ remedies.

Fraud on the minority

19.2 As noted in Chapter 12 a member of a company is entitled to exercise the voting rights attached to their shares as they see fit. Shares, and the rights attached to those shares, are the personal property of the member: s 1070A. However, it is a longstanding rule of law that the members exercising a majority vote in a general meeting cannot exercise their block of votes in a manner that is for an improper

[page 580]

collateral purpose. When the members form a majority of votes, their role changes from being a collection of individual members each exercising their personal property (that is, a vote) into forming a decision-making organ of the corporation. The other decision-making organ of the corporation is typically the board of directors, and members exercising majority voting rights bear similar equitable responsibilities to exercise that power for a proper purpose. To allow the majority to exercise their voting powers for their own private benefit would perpetuate a fraud on the minority. The rationale for the fraud on the minority rule is explained by the High Court in Ngurli’s case.1

Ngurli Ltd v McCann (1953) 90 CLR 425 High Court of Australia

Shareholders even where they are also directors are not trustees of their votes and as individuals in general meetings can usually exercise their votes for their own benefit. But there is a limit even in general meetings to the extent to which the majority may exercise their votes for their own benefit … It must be exercised, not only in the manner required by law, but also bona fide for the benefit of the company as a whole, and [these limitations] must not be exceeded.

Even where the majority has seemingly complied with the requirements of law, their vote can be held to be invalid where it is taken for an ulterior purpose: Ngurli Ltd v McCann. For a discussion of the proper purpose rule, see Chapter 15. One area where there is potential for the majority shareholders to abuse their power over the minority is by exercising a vote to change the constitution and thereby change the power structure

19.3

and rights of the stakeholders within the corporation. The last sentence in the quote from Ngurli above (‘bona fide for the benefit of the company as a whole’) was taken from the well-known case of Allen v Gold Reefs of West Africa [1900] 1 Ch 656, in which Master of the Rolls Lindley (of the United Kingdom Court of Appeal) considered the power of the 75% majority of members to alter the company’s constitution. It was in that context that Master of the Rolls Lindley required that the voting be done bona fide and in the best interests of the company as a whole. For further discussion of the limitations imposed on the alteration of the company’s constitution, see Chapter 6 at 6.9.

The notion that the majority power was limited only by the bona fide (that is, good faith) purposes of the majority to act for the ‘benefit of the company as a whole’ was criticised by Dixon J in the High Court of Australia decision in Peters’ American Delicacy Co v Heath (1939) 61 CLR 457 (while the rest of the court applied the test, they also recognised that it would not always work well if there were disputes among the members). Dixon J’s criticism was approved by the subsequent High Court decision in Gambotto (discussed below) which finally removed the Allen’s test from consideration in cases where the constitution was altered.1

Altering the constitution to take away property rights One particular problem at general law concerned the exercise of majority voting power to change the constitution to take away members’ property rights, such as

[page 581]

dividend rights, voting rights or even to force the minority shareholders to sell their shares altogether. As noted in Chapter 6, the Gambotto case imposed a special test for assessing the legality of attempts to change the corporate constitution to provide the majority with the power to compulsorily acquire the minority’s property (in that case, the shares). It is useful to look back at that decision to determine its importance for the range of general law members’ remedies.

1. 2.

Gambotto v WCP Ltd (1995) 182 CLR 432; [1995] HCA 12 High Court of Australia

Facts: WCP was 99.7% owned by wholly-owned subsidiaries of Industrial Equity Ltd (IEL). It was proposed to alter the articles (see now the constitution) to enable any holder of 90% or more of the company’s issued shares to compulsorily acquire all the issued shares. This would allow IEL (through its subsidiaries) to achieve 100% ownership. This would save money in taxation and financial arrangements. Gambotto, who held 0.1% of the company’s shares, sought to have the constitutional amendment set aside as invalid. The price offered for the minority shares was accepted as being fair.

Issue: Could the constitution be altered to provide the majority members with the power to force the minority members to sell their shares?

Decision: The constitutional amendment was invalid. The court rejected the Allen’s test of ‘bona fide and in the interests of the company as a whole’ as an appropriate test for assessing alterations of the constitution. The court determined that constitutional amendments should be assessed according to whether they take away property rights or not. Where a proposed amendment does not seek to confer a power to take away property rights, then the court found that it is assessed according to whether the alteration is within the power of the members (that is, were the appropriate procedures in s 136 followed?). However, where the alteration seeks to confer a power to take away property rights, a different test should apply.

The High Court imposed a new two-stage test for assessing the validity of constitutional amendments to expropriate members’ property rights:

Was the amendment for a proper purpose? Was the amendment fair in all of the circumstances?

The fairness test involves procedural fairness (Was the process fair, including all relevant information being disclosed?) and substantive fairness (Was the price fair?). In this case, while the price was fair the purpose of taking away Gambotto’s shares to obtain tax and other financial benefits for the majority through 100% ownership was not a ‘proper purpose’ …

Significance: This case confirms that members have valuable property rights in their shares which cannot (aside from specific statutory provisions allowing alteration or removal such as in Ch 2J) be taken away by majority power. As the court stated:

To allow expropriation where it would advance the interests of the company as a legal and commercial entity or those of the general body of corporators would, in our view, be tantamount to permitting expropriation by the majority for the purpose of some personal gain and thus be made for an improper purpose.

The Gambotto case was applied in Bundaberg Sugar Ltd v Isis Central Sugar Mill Co Ltd [2007] 2 Qd R 214; [2006] QSC 358 and more recently in a situation involving the material variation (rather than expropriation) of class rights: Dungowan Manly Pty Ltd v McLaughlin (2012) 90 ACSR 62; [2012] NSWCA 180.

[page 582]

•

The Gambotto decision has been considered to be highly controversial.2 Indeed, in the more than 10 years since the High Court’s decision, Gambotto has not often been followed by the courts. In most cases, the courts have found ways to distinguish the case and limit its operation to situations involving essentially the same facts. One of the most common ways of distinguishing Gambotto is where the conduct relies on a specific statutory provision such as an authorised share capital reduction under Ch 2J or a scheme of arrangement under Pt 5.1 of the Corporations Act.

It should also be noted that the Corporations Act provides a power to compulsorily acquire minority shares under Pt 6A.

Despite the criticism of Gambotto, it remains an important case that protects minority members from their property rights being taken away against their will through a constitutional amendment. The case confirms that members have property rights in their shares which simply cannot be taken away for the purposes of increasing business. As noted by the majority in Gambotto (at (1995) 182 CLR 447):

A share is liable to modification or destruction in appropriate circumstances, but is more than a ‘capitalised dividend stream’: it is a form of investment that confers proprietary rights on the investor.

Was the High Court in Gambotto right to characterise a share as ‘more than merely a capitalised dividend stream’? Why do you think investors buy shares?

onus of proof: the obligation imposed on one of the parties to litigation to establish that the legal elements of their case are satisfied.

Aside from providing a new test for assessing the legality of amending the constitution to take away property rights, the High Court’s decision in Gambotto also reversed the onus of proof. Under the previous test in Allen v Gold Reefs (considered above) the plaintiff who sought to have a constitutional amendment set aside would have to prove that the amendment was not undertaken ‘bona fide and in the interests of the company as a whole’. Following Gambotto, once it is established that the

19.4

• • •

amendment is to confer a power on the majority to take away property rights, the onus of proof is reversed so that the majority must prove that they undertook the amendment for a proper purpose and that the amendment was fair in all the circumstances.

Statutory enforcement of the constitution

In Chapter 6 we discussed the company’s internal management rules, called the corporate constitution. This consists of either a formal written document called a constitution, or a reliance on the rules stated in the Corporations Act as ‘replaceable rules’, or a combination of a written document and some of the replaceable rules.

Significantly, we noted in Chapter 6 that the corporate constitution is given (because of s 140) the effect of a statutory contract between:

[page 583]

the company and each member; the company and each director and company secretary; or a member and each other member.

In light of our previous discussion of the statutory contract, it is not necessary to cover in detail the rights of members to enforce the provisions of the corporate constitution. It should be emphasised, however, that those enforcement rights only operate to protect a member against conduct that impacts on their rights as a member of the company, and not in some other capacity: see 6.6 for a discussion on Hickman v Kent or Romney Marsh Sheepbreeders’ Association [1915] 1 Ch 881. This should be contrasted with the minority oppression remedy discussed below, which is not so limited.

Statutory remedies

19.5

•

• • •

19.6

Statutory derivative action Overview: before 2000

One aspect of the longstanding ‘rule in Foss v Harbottle’ provided that if a wrong was done to the company (for example, by a breach of directors’ duties), then the company was the proper person to bring an action to seek a remedy (known as the ‘proper plaintiff rule’). There were, however, a number of exceptions to this rule. These exceptions included:

where the actions of the company were ultra vires (or beyond the power of the company);3 where the requirements of the company’s constitution were not satisfied; where the matter infringed on the personal rights of the member;4 where the conduct constituted a fraud on the minority; and where the interests of justice required that an exception be made.

These exceptions allowed the company’s rights to be enforced by individual members. The ability of an individual member to bring a case in the name of the company to enforce the company’s rights is known as a ‘derivative action’. This is because the plaintiff (that is, the person applying for a court order) is seeking to protect someone else’s rights (in this case the company’s rights).

After 2000 The common law derivative action exceptions to the rule in Foss v Harbottle are now largely irrelevant because Pt 2F.1A provides a statutory derivative action (or SDA), which abolishes the common law action from 13 March 2000: s 236(3).5 In broad

[page 584]

terms, Pt 2F.1A entitles a member to apply to the court for permission (known as ‘leave’ by the court) to enforce the company’s legal rights.

The rights sought to be enforced by an SDA may be rights that the company has against its directors (for breach of duty) or against a third

19.7

party which the company is unwilling to enforce. For example, the company may have rights to seek damages for breach of a supply contract but may refuse to take action because of a conflict of interest between the directors and the supplier (that is, the directors may have an interest in the supplier and may not allow the company to sue it).

The difficulty that the SDA addresses is that it is for the directors in the exercise of their management power to make decisions about whether to involve the company in litigation, and they are therefore highly unlikely to allow the company to sue themselves. As noted in Chapter 16, this problem is also the reason why ASIC (and not just the company) is given the power to enforce statutory directors’ duties.

Operation of Pt 2F.1A Part 2F.1A begins in s 236 with a statement of the scope for a person to

•

• •

19.8

enforce the company’s rights. It provides that a person who is:

[page 585]

a member, a former member or a person entitled to be registered as a member, whether of the company or a related body corporate; or an officer or former officer of the company;

member: this is defined in s 231 to be a person included on the company’s register of members.

may bring proceedings on behalf of the company or intervene in any proceedings in which the company is a party for the purposes of taking responsibility on behalf of the company for the proceedings or a step in them (for example, compromising or settling them). However, the person can only do so if leave is granted under s 237.

Thus, s 236 lists the persons who may seek court permission to effectively take control of the company’s legal proceedings to enforce its rights. While the leave application is brought in the person’s name, if leave is granted and proceedings are commenced on behalf of the company those proceedings must be brought in the company’s name: s 236(2). This reflects the fact that leave is to stand in the company’s shoes and enforce its legal rights, so naturally the company is the party in that action. Importantly, this also means that any benefit that results from the case will flow to the company, not to the person bringing the action in the company’s name. Furthermore, the person who obtains leave to bring the SDA is also liable for the costs of the litigation, although the court has the power under s 242 to make any order it considers appropriate as to costs.6Requirements for leave

Requirements for leave In order to obtain leave of the court to bring an SDA, the applicant (that is, person applying for leave) must satisfy the court that the requirements of s 237(2) are satisfied. These requirements are as follows:

(a)

(b) (c)

(d)

(e) (i)

(ii)

19.9

it is probable that the company will not itself bring the proceedings, or properly take responsibility for them, or for the steps in them; and the applicant is acting in good faith; and it is in the best interests of the company that the applicant be granted leave; and if the applicant is applying for leave to bring proceedings — there is a serious question to be tried; and either:

at least 14 days before making the application, the applicant gave written notice to the company of the intention to apply for leave and of the reasons for applying; or it is appropriate to grant leave even though subparagraph (i) is not satisfied.

Each of these elements will be explained in further detail.

Section 237(2)(a) Under this requirement, the applicant for leave must have evidence that the company will not bring the proceedings or properly take responsibility for them. This may be proved where the company opposes the granting of leave to bring the SDA. It may also be satisfied where the SDA is to be brought against the directors and they deny wrongdoing (Vadori v AAV Plumbing (2010) 77 ACSR 616; [2010] NSWSC 274 at [257]) or where the company has only two directors and the application is brought by one

[page 586]

director to take action against the other director: Huang v Wang [2015] NSWSC 510 at [22] (appeal dismissed: [2016] NSWCA 164). For an example where this element could not be satisfied, see Cody v Live Board Holdings Ltd [2014] NSWSC 820 where the directors offered to resign and allow the dissenting member to nominate replacement directors. The court held that it was not probable that if this occurred the company would not bring an action against the (former) directors.

19.10

•

Section 237(2)(b) The requirement of good faith was explained in Swansson v RA Pratt Properties Pty Ltd.

Swansson v RA Pratt Properties Pty Ltd (2002) 42 ACSR 313; [2002] NSWSC 583 New South Wales Supreme Court

Facts: Swansson (S) was a shareholder and director of RA Pratt Properties, who sought leave under s 237 to bring proceedings in the name of the company against a former director (who was also the ex- husband of S) for alleged breach of duties. H was alleged to have entered into transactions on behalf of the company while earning a secret commission and acting to benefit other companies, including companies in which S also had an interest.

Decision: The court refused to grant leave because S could not provide sufficient evidence to establish that she was acting in good faith or that the action was in the best interests of the company.

In establishing good faith there are two interrelated factors:

whether the applicant honestly believes that a good cause of action exists and has a reasonable prospect of success; and whether the applicant is seeking to bring the derivative action for such a collateral purpose as would amount to an abuse of process.

In addition, Palmer J stated that the court will not lightly grant leave to bring an SDA.

Significance: This case explains the meaning of good faith for the purposes of the SDA.

In the New South Wales Court of Appeal decision in Chahwan v Euphoric Pty Ltd t/as Clay & Michel (2008) 65 ACSR 661; [2008] NSWCA 52 at [74], Tobias JA summarised the good faith test from Swansson:

… as a current or former shareholder or director of the company, [the applicant] would suffer a real and substantive injury if a derivative action were not permitted provided that that injury was dependant upon or connected with the applicant’s status as such shareholder or director.

Would it be easier for a current shareholder to establish that they are acting in good faith (that is, because the benefit will flow to the company of which they are a member) than it would be for a former shareholder who will receive no part of the benefit if the SDA succeeds?

19.11

•

Section 237(2)(c) In order to prove that leave is in the best interests of the company, the applicant should give evidence of:

[page 587]

the character of the company, that is, the nature of the company’s operations; the business of the company so that the effects of the proposed litigation on the conduct of the business may be appreciated; whether there are other means of obtaining the same redress so that the company does not have to be brought into litigation against its will; and the ability of the defendant to meet at least a substantial part of any judgment in favour of the company so that the court may ascertain whether the action would be of practical benefit to the company.

This list is a summary used by the Full Court of the South Australian Supreme Court in Ragless v IPA Holdings Pty Ltd (in liq) (2008) 65 ACSR 700; [2008] SASC 90 at [35] per Debelle J. The list summarises points originally made by Palmer J in Swansson v RA Pratt Properties Pty Ltd (2002) 42 ACSR 313; [2002] NSWSC 583 at [55]-[60].7

The court may consider what benefit will be gained by the applicant for leave in determining whether the SDA will be in the best interests of the company: Transmetro Corp Ltd v Kol Tov Pty Ltd (2009) 71 ACSR 582; [2009] NSWSC 350 (where granting leave to the applicant to bring an SDA would have put the applicant in a position of breaching his director’s duties for another company — an appeal against this decision was dismissed in McEvoy v Caplan (2010) 78 ACSR 167; [2010] NSWCA 115).

Where the company is solvent, its interests are likely to resemble the interests of members. In such a case, the fact that the shareholders may derive a collateral personal benefit from leave being granted is irrelevant: Huang v Wang (2016) 114 ACSR 586; [2016] NSWCA 164 at [59].

Section 237(2)(d)

19.12

(i) (ii)

Section 237(2)(d) The reference to a serious question to be tried is concerned with demonstrating that there is evidence to support a legal claim. As Debelle J said in Ragless v IPA Holdings Pty Ltd (in liq) (2008) 65 ACSR 700; [2008] SASC 90 at [40]:

The court must determine whether the applicant has demonstrated that there is a real question to be tried, that is to say, whether the applicant is able to identify the legal or equitable rights to be determined at trial in respect of which the final relief is sought.

This does not mean that the applicant must be able to show that it has sufficient evidence to win its case if given leave by the court to bring the SDA. The court is attempting to balance the interests of the company and the applicant by requiring the applicant to show a sufficient likelihood of success to justify in the circumstances the preservation of the status quo pending the trial: South Johnstone Mill Ltd v Dennis (2007) 163 FCR 343; [2007] FCA 1448. In MG Corrosion Consultants Pty Ltd v Vinciguerra (2011) 82 ACSR 367; [2011] FCAFC 31 at [67] the Full Federal Court said:

… there would be little point [to] … the introduction of s 237 CA if there were to be a complete trial of the issues before granting leave. This is obvious as there would be no point in conducting the derivative action if all the facts needed to be established in the derivative action had already been proven in the leave application. It would turn the leave application into a trial. There is no basis for thinking that this was the legislative intention when the amendments were introduced in 2000.

[page 588]

Section 237(3) also provides a rebuttable presumption that the action is not in the best interest of the company. This presumption will apply, and the applicant will not be granted leave where the proceedings involve the company and a third party company (for example, a contract dispute between the company and a supplier) and the company has decided not to take action, or to settle an existing case. The presumption that the application is against the company’s interests will only operate where all of the directors who participated in that decision not to take action or to settle the case (s 237(3)(c)):

acted in good faith for a proper purpose; and did not have a material personal interest in the decision; and

(iii) (iv)

19.13

19.14

informed themselves about the subject matter of the decision to the extent they reasonably believed to be appropriate; and rationally believed that the decision was in the best interests of the company.

Thus, there is the possibility of leave being granted in relation to contractual, tort or even criminal proceedings against the company but the onus on the applicant in such a case will be a heavy one: MG Corrosion Consultants Pty Ltd v Vinciguerra (2011) 82 ACSR 367; [2011] FCAFC 31. This is because they must overturn the presumption noted above.

It has been held that where the company is insolvent or approaching insolvency, the best interest of the company will include consideration of the impact of the SDA on the company’s creditors: Maher v Honeysett & Maher Electrical Contractors Pty Ltd [2005] NSWSC 859 (applied in Chahwan v Euphoric Pty Ltd t/as Clay & Michel (2008) 65 ACSR 661; [2008] NSWCA 52 at [87] per Tobias JA). Where the company is in liquidation, the court cannot grant leave to bring an SDA because the company will be under the control of a liquidator: Chahwan v Euphoric Pty Ltd t/as Clay & Michel (2008) 65 ACSR 661; [2008] NSWCA 52. However, the court may give permission for another person to bring court proceedings on behalf of a company: Ragless v IPA Holdings Pty Ltd (in liq) (2008) 65 ACSR 700; [2008] SASC 90.

Section 237(2)(e) This is a procedural matter and should be easily established in most cases because the applicant will have notified the company in accordance with the statutory requirement.

Relevance of ratification One of the problems with the common law derivative action under the exceptions to the rule in Foss v Harbottle was that the member could not bring the derivative action if the case involved a matter that was ratified by the majority of the members. Thus, if the directors had breached their general law duties but the majority of the members had ratified (that is,

•

19.15

approved of) the conduct by passing a resolution in a members’ meeting, then a derivative action could not be brought.

One of the advantages of the SDA over the common law derivative action is that s 239 provides that the prior ratification of conduct does not prevent an applicant from applying for leave to bring an SDA. Therefore, the SDA is broader in its scope than the common law derivative action. However, as noted below, this has not resulted in more cases being run than under the common law rule.

[page 589]

How Often Is the SDA Used? In 2006, the University of Melbourne Centre for Corporate Law and Securities Regulation conducted an empirical analysis of all of the decisions on the SDA provisions (which commenced in 2000): see I Ramsay and B Saunders, ‘Litigation by Shareholders and Directors: An Empirical Study of the Statutory Derivative Action’, Centre for Corporate Law and Securities Regulation, The University of Melbourne, 2006. The study found that the number of SDAs undertaken between 2000-06 (31 in total) was comparable with the number of common law derivative actions taken in the preceding five years (30 in total). Therefore, the SDA has not ‘opened the floodgates’ to shareholder litigation. The study also found that more than half of the allegations argued in the SDA related to breach of directors’ duties, and that the applicants succeeded in only 61% of cases. Of these 61% of cases where leave was granted, in none of the cases was the company ordered to pay the litigation costs of the applicant in pursuing the SDA (as opposed to merely the leave application, where costs were ordered in 21% of successful cases).

Is it too expensive to bring an SDA? Should the Corporations Act force the company to pay for the subsequent litigation if the applicant obtains the leave of the court to bring an SDA?

Statutory injunction Section 1324 provides the court with the power to order an injunction to stop a person from engaging in conduct that is in breach or would breach

the Corporations Act (including failing to comply with a requirement of the Act). The court may also issue a mandatory injunction under s 1324 ordering a person to do a particular thing. In addition, s 1324(10) allows the court to order that compensation (‘damages’) be paid either in addition to, or instead of, granting an injunction. In order to obtain damages, there must be sufficient grounds to award an injunction; damages are not an independent remedy on their own under s 1324(10): McCracken v Phoenix Constructions (Qld) Pty Ltd (2012) 289 ALR 710; [2012] QCA 129.

An application for an injunction under s 1324 may be made by ASIC, or by any person whose interests are affected.8

Despite its wide language there has not been extensive use of the provision. The applicant must satisfy the court they qualify as a ‘person whose interests are affected’. This is referred to as the ‘standing’ issue in applications under the section. In Broken Hill Proprietary Co Ltd v Bell Resources Ltd (1984) 2 ACLC 157 at 162 Hampel J said ‘in my view the interests referred to are interests of any person (which includes a corporation) which go beyond the mere interest of a member of the public’. This wide view of standing under s 1324 has been endorsed on many subsequent occasions. However, this raises the question as to whether a member may seek to enforce obligations under the Corporations Act by applying for a statutory injunction and/or compensation under s 1324 and thus bypass existing enforcement mechanisms within the Corporations Act.

There are differing views in the case law regarding whether s 1324 may be used by members to take action in respect of directors’ duties, and thus bypass the statutory

[page 590]

derivative action and civil penalty provisions. In Mesenberg v Cord Industrial Recruiters Pty Ltd (1996) 39 NSWLR 128, Young J decided that the court should not allow members to use the s 1324 injunction to take action against directors when the civil penalty regime provided a

•

19.16

complete code. Significantly, as noted in Chapter 15, directors’ duties are owed to the corporation and therefore only ASIC or the corporation can enforce them. Mesenberg maintains this state of affairs; however, it has been criticised.9

A different line of authorities, including Allen v Atalay (1994) 11 ACSR 753 and Airpeak Pty Ltd v Jetstream Aircraft Ltd (1997) 73 FCR 161; 23 ACSR 715,10 have decided that s 1324 is drafted broadly and should be applied on its ordinary meaning. This means that provided a member (or creditor) can establish that the conduct affects their interests (whether it be undertaken by the directors or otherwise), then they may obtain an injunction and/or damages under s 1324.

Most recently, the Queensland Court of Appeal has held that a creditor cannot obtain an award of damages under s 1324(10) against a director for breach of directors’ duties: McCracken v Phoenix Constructions (Qld) Pty Ltd (2012) 289 ALR 710; [2012] QCA 129. The court held that an award of damages could only be given where an injunction could be sought, and the award of damages was therefore ancillary to the power to grant an injunction. The power to award damages under s 1324(10) is not an independent right; it exists to support other substantive rights. Importantly, the court held that to allow a breach of directors’ duties to be enforced by s 1324(10) would circumvent the purpose of the civil penalty regime in Pt 9.4B. Unfortunately, there was no discussion of the Mesenberg case, but this result supports the reasoning in Mesenberg.11

Is it appropriate for the statutory injunction provision, including the ability to seek damages, to be used where an action against directors would not otherwise be available to members? Should the Corporations Act be enforceable by anyone?

Just and equitable winding up Section 461 provides the main method for the compulsory winding up of solvent companies by a court order. This provision confers judicial discretion to wind up a company under a broad range of grounds. A common reason for compulsory winding up under this section is the just

•

• • •

•

and equitable ground in s 461(1)(k) (although there are other grounds under s 461 for winding up companies that have engaged in oppressive conduct).

The just and equitable ground has its origins with the very first corporate law statute in 1844. However, for much of the time since then it has been given a very narrow interpretation. One of the reasons for this is that liquidation is an extreme remedy and the courts were understandably reluctant to liquidate a solvent business.

[page 591]

In contrast, a similar provision in the Partnership Acts allowing partnerships to be wound up where the partners could no longer work together has been interpreted broadly by the courts. This is based on the fact that partnerships have traditionally been considered to be a relationship of mutual trust and confidence between the partners. Where this relationship breaks down and cannot be repaired, it may be fair to wind up the partnership business.

The change in attitude towards the just and equitable ground for winding up came in 1916 with the decision in Re Yenidje Tobacco [1916] 2 Ch 426. In that case the court found that the business was in effect a partnership and that the two owners and directors were involved in an irreconcilable dispute and were no longer speaking with each other. In such a situation, it was just and equitable to wind up the company.

The range of situations that may come within the scope of the just and equitable ground are generally categorised as follows:

justifiable lack of confidence in the management of the company’s affairs; breach of equitable considerations; fraudulent or oppressive conduct; company unable to make or implement decisions caused by deadlock in management; and failure of substratum (or the company’s purpose).

19.17

Justifiable lack of confidence in the management of the company’s affairs12

Where the management of the company has conducted the company’s affairs in breach of the law, a member of the company may seek a just and equitable winding up order on the basis that he or she has a ‘justifiable lack of confidence’ in the management: see Loch v John Blackwood Ltd [1924] AC 783 (where the directors refused to hold general meetings or to pay dividends so as to force the shareholders into selling their shares). In Re New South Wales Leagues Club Ltd [2014] NSWSC 1610 at [54], Brereton J stated:

A failure by those in control of a company to comply with their constitutional and statutory obligations can, in some circumstances, provide grounds for winding up the company … But more than an isolated breach is required; [the cases on this issue] are characterised by a persistent or sustained disregard of constitutional or statutory obligations, which renders it impossible for the complainants to exercise their rights under the corporate constitution.

In more recent times, a ‘justifiable lack of confidence’ has been used by ASIC to wind up solvent companies that were running illegal investment schemes (ASIC v AS Nominees Ltd (1995) 62 FCR 504); and where companies have consistently failed to comply with the Corporations Act (ASIC v West (2008) 100 SASR 496; [2008] SASC 111, dealing with a failure to keep proper accounts). This ground has also been used by the Australian Taxation Office to wind up a company managed by persons who had consistently failed to comply with taxation laws over a 40-year period: DCT v Casualife Furniture International Pty Ltd (2004) 9 VR 549; [2004] VSC 157. In ASIC v ActiveSuper Pty Ltd (No 2) (2013) 93 ACSR 189; [2013] FCA 234 at [20] Gordon J (who has since been appointed to the High Court of Australia)

[page 592]

stated that the ground of a ‘justifiable lack of confidence’ covers a ‘risk to the public interest that warrants protection’. This must be assessed on the whole of the circumstances.

19.18

Re Wondoflex Textiles Pty Ltd [1951] VLR 458 Victorian Supreme Court

Facts: Milne (the plaintiff) was approached by Jacobson to become the managing director of the company (Wondoflex Textiles) which he accepted. Milne was then given a loan by the company to purchase a minority shareholding in the company. Jacobson acted as governing director (as one of the founders of the business) and appointed his son as another director (with Milne already being a director). Jacobson then set about trying to force Milne out of the business by selling his shares at an undervalue. In order to achieve this, Jacobson took several unfair actions including dismissing Milne from his job in the company and making false accusations against him. Milne refused to sell his shares at an undervalue and sought a winding up order on the just and equitable ground.

Decision: The court found that Jacobson’s conduct was unfair and demonstrated that Milne had a ‘justifiable lack of confidence in the management of the company’ sufficient to support a just and equitable winding up order. Furthermore, the court found that the structure of the company’s capital (small number of shareholders, with residual discretion in directors to refuse entry of new shareholders) allowed a partnership analogy (following Re Yenidje Tobacco) to be applied. This also supported a just and equitable winding up order on the basis that Jacobson could not be trusted to run the company fairly in the future.

In the end, the judge did not order a winding up but allowed the parties to agree to a better solution, which was for Jacobson to buy out Milne for a fair price.

Equitable considerations The law of equity was originally developed to provide relief against the harshness of the common law in England. Today all courts in Australia possess both common law and equitable jurisdiction. The equitable considerations relevant to a winding up under s 461(1)(k) focus on the mutual trust and confidence that exists within closely held and managed corporations, and is not necessarily founded in illegality. Ebrahimi v Westbourne Galleries illustrates this point and is a classic example of the disastrous effect that a breakdown in mutual trust and confidence can have on a small company.

Ebrahimi v Westbourne Galleries Ltd [1973] AC 360 House of Lords (UK)

Facts: E and N were partners in a carpet business. Later, they incorporated their business and were the only shareholders and directors of a company involved in the management of the same business. Soon

(i)

(ii)

(iii)

19.19

after the company’s incorporation, N’s son G was also appointed a director with both E and N transferring shares to G. All of the company’s profits were paid as directors’ fees rather than distributed to the shareholders as dividends. After a dispute between E and N, N and G combined and used their majority voting power to pass a resolution to remove E as a director. In this way, E no longer shared in the company’s profits as a director. Despite the company’s constitution allowing for such a resolution to remove a director, E applied for relief under the just and equitable provision in the relevant British Act.

Decision: The House of Lords granted E relief on the basis that the just and equitable provision enabled the court to impose equitable considerations onto the management of the company particularly where the company involved a close personal relationship between

[page 593]

the persons involved. In this case, E’s exclusion from the company’s management breached equitable principles of good faith resulting in the need to dissolve the company.

Significance: This case is significant because it confirms that equitable considerations can empower the court to look behind the separate legal entity and look at the relationship between the company’s controllers for the purpose of determining whether the company should be wound up despite the resistance of some of the members.

In deciding that the company should be wound up, the House of Lords also commented on where it may be appropriate to superimpose equitable considerations on the management of the company. Lord Wilberforce said (at 378):

The superimposition of equitable considerations typically may include one, or probably more, of the following elements:

an association formed or continued on the basis of a personal relationship, involving mutual confidence — this element will often be found where a pre-existing partnership has been converted into a limited company; an agreement, or understanding, that all, or some (for there may be ‘sleeping’ members), of the shareholders shall participate in the conduct of the business; and restriction on the transfer of the members’ interest in the company — so that if confidence is lost, or one member is removed from management, he cannot take out his stake and go elsewhere.

The decision in Ebrahimi has been applied in Australia on several occasions: see, for example, Re Amazon Pest Control Pty Ltd [2012] NSWSC 1568 where the court provided a detailed review of the authorities.

Fraudulent or oppressive conduct This ground is the same as the minority oppression remedy which is discussed below at 19.22 and following.

19.20

19.21

Company unable to make or implement decisions This ground involves more than the simple failure of directors to act for the company. It requires that there is little prospect of the company being able to continue trading: CIC Insurance Ltd v Hannan & Co Pty Ltd (2001) 38 ACSR 245; [2001] NSWSC 437. In CIC Insurance, there were no directors acting for the company and no candidates willing to fill the board positions. A similar situation arose in the well-known decision Re Yenidje Tobacco Co [1916] 2 Ch 426, where the court wound up a very profitable company owned and managed by two individuals who refused to communicate with each other (all correspondence was done through the company secretary). Similarly, in Campbell v Backoffice Investments Pty Ltd (2009) 238 CLR 304; [2009] HCA 25, the High Court of Australia noted that the complete failure of the company’s two directors and shareholders to work together justified winding-up on s 461(1)(k) grounds. As Dodds- Streeton JA said recently in Accurate Financial Consultants Pty Ltd v Koko Black Pty Ltd (2008) 66 ACSR 325; [2008] VSCA 86 at [119]:

Winding up is the characteristic remedy in circumstances where a working relationship predicated on mutual co-operation, trust and confidence has broken down, whether resulting in deadlock or otherwise. Equity would not ordinarily order the continuation

[page 594]

of such an association where it would be a futility, would require continuing supervision or would be tantamount to specific enforcement of a contract of personal services.

Failure of substratum The failure of a company’s substratum refers to a fundamental change in the operations of the company, which results in the company’s inability to carry out the functions for which it was originally incorporated. The best example of a failure of substratum occurred in the decision in Re Tivoli Freeholds [1972] VR 445 where a company that traditionally owned theatres was liquidated after it ceased trading in the theatre business and became an equity investment vehicle. In Re Tivoli, Menhennitt J of the Victorian Supreme Court stated (at 468):

It may be just and equitable to wind a company up if the company engages in acts which are entirely outside what can fairly be regarded as having been within the general intention and common understanding of the members when they became members.

•

19.22

For example, in a recent case involving the collapse of a forestry- managed investment scheme, the court held that it was just and equitable to wind up the scheme as its insolvent situation and lack of restructuring proposals made it impossible to achieve the purposes of the scheme: Capelli v Shepard (2010) 77 ACSR 35; [2010] VSCA 2 at [104] (the application was made under a similar provision to s 461(1)(k) in relation to managed investment schemes).

Is it necessary to wind up a solvent company merely because the purpose of the company has changed? Why might a shareholder not simply sell their shares?

Although the just and equitable winding up provision (s 461(1)(k)) is an important remedy for company members, the power to wind up the company is an extreme order that will only be made where it is absolutely necessary. In situations where the conduct is merely unfairly impacting on the minority members (rather than being examples of clear impropriety where winding up is necessary), then it may be more appropriate to apply for relief under the minority oppression remedy which will now be discussed.

Minority oppression remedy The minority oppression remedy is arguably the most important members’ remedy, and is contained in Pt 2F.1 of the Corporations Act. The key provision is s 232, which is broadly defined by the courts. Where s 232 is breached, the court may grant orders under s 233, including orders to buy out the minority’s shares in the company. Part 2F.1 provides a wide-ranging basis for a member of a company to seek relief from the courts.

The action under s 232 (commonly known as the ‘minority oppression remedy’) was originally introduced into corporate legislation because it was felt that the just and equitable winding up remedy (discussed above) was too severe a remedy for solvent corporations.13

[page 595]

The oppression remedy therefore provides a more flexible range of solutions to address problems of minority exploitation.

Originally, the minority oppression remedy was restricted to conduct that adversely affected members in their capacity as members (similar to the actions that may be taken to enforce the statutory contract in the constitution under s 140). However, over time there have been several amendments to the provision so that it now applies to persons whether in their capacity as members or in any other capacity. The provision is not, however, unlimited as only members or former members are allowed to apply for the court’s orders: s 234.14

The broad wording of s 232 means that it is now the starting point for exploring the possibilities for an unhappy member, no matter what the particular circumstances causing them to be aggrieved may be.

19.23

• •

•

Elements of liability In order to seek a remedy under s 233, the member applying for an order must prove that one of the elements of s 232, which are:

[page 596]

company’s affairs: this is broadly defined in s 53 and includes the business management and internal affairs of the company.

the conduct of a company’s affairs; an actual or proposed act or omission by or on behalf of a company; or a resolution, or a proposed resolution, of members or a class of

• •

19.24

members of a company (as to members meetings, see Chapter 12),

are either:

contrary to the interests of the members as a whole; or oppressive to, unfairly prejudicial to, or unfairly discriminatory against, a member or members whether in that capacity or in any other capacity.

It should be noted that there is no requirement to prove that the company or its officers intended to cause harm to the members. As the majority of the High Court of Australia said in Campbell v Backoffice Investments Pty Ltd (2009) 238 CLR 304; [2009] HCA 25 at [176], it should not be ‘supposed that there cannot be oppression on the part of one who thinks that he or she is acting rightly’. There is no requirement that the member making the application has actually suffered harm because of the conduct: Re Spargos Mining NL (1990) 3 ACSR 1.

Key terms in s 232(e)15

Section 232(e) contains three key terms: oppressive, unfairly prejudicial and unfairly discriminatory. While some decisions have considered the operation of s 232 as if these terms were separate, the better view is that these terms work as a composite whole. Each of these terms are elements of the same issue, commercial unfairness: see Morgan v 45 Flers Avenue Pty Ltd (1986) 10 ACLR 692 (in that case, low dividends and high levels of remuneration paid to the director were held not to be oppressive as the director had earned financial rewards). There is no need to establish that all of the terms are present in a particular dispute.

Importantly, whether the conduct fits within the scope of s 232(e) is assessed objectively, which means that the court will consider how a reasonable person would view the conduct within the context in which it occurs. This is demonstrated by the important case in Wayde v NSW Rugby League Ltd (1985) 180 CLR 459, which is discussed in more detail below. Section 232(e) is not engaged merely by poor management decisions, nor is it likely to be contravened by some minor misconduct: Donaldson v Natural Springs Australia Ltd [2015] FCA 498.

19.25

Before considering the meaning of the key terms within s 232, it is useful to remember the following general principles as stated by the court in Shelton v National Roads and Motorists’ Assn Ltd (2004) 51 ACSR 278; [2004] FCA 1393 at [23]:

It is not practicable to delineate the numerous ways in which oppressive conduct may by established. The court will generally look at the overall course of conduct and consider whether it is so unfair that reasonable directors will not consider it fair. If directors exercise a power so as to impose a disability or burden on a member that is unfair according to ordinary standards of reasonableness and fair dealing, then such conduct may be described as oppressive. The question is one of fact and degree for the court to determine … the test of unfairness is objective.

[page 597]

Oppressive This term has been defined as meaning ‘burdensome, harsh and wrongful’: Scottish Co-operative Wholesale Society Ltd v Meyer [1959] AC 324. In that particular case, the parent company deliberately withheld supplies from its subsidiary (of which it was the majority owner) in an attempt to bankrupt the company so that it could operate the business in its place. The parent company had unsuccessfully attempted to buy out the minority shareholder and was therefore attempting to drive the company out of business. The minority shareholder was successful in establishing that the parent company’s conduct was ‘oppressive’.

However, it should be noted that the Meyer case was decided under an earlier version of s 232, which was more limited than the present s 232 as it did not include the terms ‘unfairly prejudicial’ or ‘unfairly discriminatory’. Therefore, it is clear that the operation of s 232 is broader than merely conduct that is burdensome, harsh and wrongful: see Wayde v NSW Rugby League Ltd.

In the decision in John J Starr (Real Estate) Pty Ltd v Robert R Andrew (A’asia) Pty Ltd, Young J summarised the various decisions on the meaning of oppression in the following way.

•

• •

•

3. 4.

John J Starr (Real Estate) Pty Ltd v Robert R Andrew (A’asia) Pty Ltd (1991) 6 ACSR 63 New South Wales Supreme Court

The simple subordination of the wishes of the minority by the exercise of the voting power of the majority is not, of itself, oppressive. Oppression is something done against a person’s will and in his or her despite. The acts of oppression must result from some overbearing act or attitude on the part of the oppressor. Oppression may occur even though all members of a company are treated equally.

It can be seen that the meaning of oppressive conduct has been interpreted by the court to be something that involves the majority unfairly imposing their will on the minority. The element of unfairness is expressly stated in the other key terms in s 232(e). This unfair imposition of the majority’s will on the minority is demonstrated by the John J Starr case.

John J Starr (Real Estate) Pty Ltd v Robert R Andrew (A’asia) Pty Ltd (1991) 6 ACSR 63 New South Wales Supreme Court

Facts: John J Starr (Real Estate) Pty Ltd (JJS) was a minority shareholder in, and a franchisor of, Robert R Andrew (A’Asia) Pty Ltd (RRA) (both companies were involved in real estate). John Starr (principal of JJS) was also a director of RRA. Robert Andrew and his wife controlled 63% of the shares and dominated the board meetings of RRA. JJS alleged that Andrew ran RRA in an overbearing manner, consistently claimed that it was ‘his company’ and behaved as though he could do what he wanted.

[page 598]

Decision: The actions of RRA constituted oppression of JJS as minority shareholder of RRA. The majority shareholders were ordered to purchase the minority’s shares at fair value.

The facts that supported the finding of oppression were:

Robert Andrew brought forward important matters for the members without giving sufficient notice to the members. Robert Andrew refused to provide the board with a budget on the ground that planning and budgets were a matter for management. Robert Andrew unreasonably restricted the speaking time available to directors at board meetings. Robert Andrew tried to exclude JJS from certain board meetings.

19.26

Robert Andrew terminated JJS’s real estate franchise.

Significance: This decision is a good example of how the majority cannot exploit their voting power (both at board and members’ meetings) to limit or exclude the minority from participation within the corporation

Unfair prejudice and unfair discrimination Prejudice and discrimination both involve the notion of conduct that adversely affects the interests of the member applying for a court order under s 232. However, the Act recognises that mere prejudice or discrimination is insufficient. As noted in High Court decisions such as Ngurli and Mills (see 15.11,-15.14), the members will not necessarily have shared common interests. It is therefore important that the conduct complained of consists of more than merely preferring one group of members over another group. The prejudice or discrimination must be unfair. As noted by Young J in Morgan v 45 Flers Avenue Pty Ltd (see 19.24), the court makes an objective assessment of what a reasonable businessperson would think of the conduct (that is, was the conduct commercially fair and reasonable?).

The most important case on the minority oppression remedy in Australia is the High Court’s decision in Wayde.

Wayde v New South Wales Rugby League Ltd (1985) 180 CLR 459 High Court of Australia

Facts: The constitution of the New South Wales Rugby League (then known as the articles of association) contained a provision that allowed the league to determine which teams would be permitted to play in the competition. The constitution also provided that the directors of the league were to exercise their powers in the best interests of the game of rugby league. The directors determined that the number of teams in the competition was uneconomical (with several clubs in poor financial condition) and detrimental to the players (because there were too many games). The league conducted an independent review of the competition and called for applications for the new competition the following year that were to be made according to a set of objective guidelines. Western Suburbs (Wests) put in an application for the next year, which was rejected. Wayde, on behalf of Wests, applied for an order that the league’s action was a breach of the predecessor of s 232(e).

Issue: Was the league’s action oppressive, unfairly prejudicial or unfairly discriminatory?

• •

•

Decision: The league’s decision to exclude Wests was made in good faith and did not constitute oppression. The decision was within the power of the directors under the

[page 599]

company’s constitution and was done for the benefit of the competition. The directors had reasonably balanced the interests of the company against the detriment caused to Wests in being excluded from the competition.

The leading decision was given by Brennan J, who made several important comments about the operation of s 232:

There is no need to establish any irregularity or breach of legal rights. Mere prejudice or discrimination is not sufficient to establish a breach of s 232, particularly where the constitution expressly allows directors to prejudice or discriminate against members for the benefit of the company. The court will assess the conduct according to ‘ordinary standards of reasonableness and fair dealing’. This is an objective assessment and requires the court to determine whether a reasonable director would think the conduct unfair.

In this case, the directors had properly weighed up the interests of the company and of Wests and their decision was not one that no reasonable director would have made and did not therefore breach the predecessor of s 232(e).

Significance: This case, particularly the leading decision of Brennan J, demonstrates that the conduct will be assessed objectively and that no breach will occur where the directors reasonably balance up the competing interests and act in good faith within the scope of their power and in the interests of the company.

It should be noted here that the league was exercising an existing power in the constitution. They were not trying to amend the constitution to provide a power to exclude Wests, so the case may be distinguished from Gambotto.

A useful comparison may be made between the outcome in Wayde and the decision in Jenkins v Enterprise Gold Mines NL (1992) 6 ACSR 539, where it was held that directors who entered into transactions for the sole benefit of the parent company without any apparent benefit to the subsidiary were engaging in conduct in breach of the predecessor of s 232(e). Reasonable directors would not agree to sacrifice the company’s assets for nothing. The court in Jenkins went further and noted that where the directors of the subsidiary were engaging in transactions under which they had a conflict of interest (due to their board positions on the parent company and other companies within their corporate group), oppression would be assumed unless the directors could demonstrate that there were good commercial reasons to enter into the transactions.

In a related case, Re Spargos Mining NL (1990) 3 ACSR 1, Jenkins was able to obtain orders under a predecessor provision to s 232 against

(i)

(ii)

(iii)

(iv)

(v)

(vi)

another company associated with Enterprise Gold (Spargos Mines) in which he was also a shareholder and similar conduct had occurred. The orders included replacing the board of directors and changing the company’s constitution to ensure that the company had:

… energetic, competent, independent management with full and complete powers to investigate and provide such remedies to the company as are available in relation to past misconduct, as well as to secure for the company, at least in the immediate future, effective management skills.

In a subsequent South Australian decision, the principles underpinning the oppression remedy were summarised as follows.16

[page 600]

PT Krakatau Steel v Felix Resources [2010] SASC 170 at 240 South Australian Supreme Court

The principles upon which claims of oppressive conduct under ss 232 and 233 of the Corporations Act are to be determined are well established. The principles relevant to the determination of the claim … include:

section 232 requires more than proof of mere prejudice or discrimination. An applicant must establish oppression or prejudice or discrimination which is unfair. It is the unfairness of the conduct in question which is at the heart of an oppression claim;

whether the conduct in question is oppressive or unfair in the relevant sense is to be determined by an objective assessment, ie, by considering whether in the eyes of a reasonable commercial bystander there has been conduct which is so unfair that reasonable directors who consider the matter would not have thought the conduct fair;

unfairness may take many forms and may ‘lie in the harm suffered as a result of the conduct of management, the prejudice caused, the lack of reasonable commercial justification for the course taken, or simply in the decision-making processes within the company’;

the determination of the fairness or otherwise of the conduct in question requires a conclusion of fact. The determination is to be made by reference to the commercial context in which the conduct occurred;

the consideration of context may also require an examination of the conduct of an applicant. The applicant’s behaviour may mean that the impugned conduct was not unfair, even though it may have been prejudicial;

oppression is not normally established by showing merely that there are persons in the control of the company and that they have outvoted the applicant. The mere disadvantages of being in a minority, no matter how ‘galling and even if financially damaging these may be … do not in themselves constitute oppression’;

(vii)

(viii)

(ix)

19.27

conduct which is lawful, for example, because it is authorised by the law or by the company’s [constitution], may nevertheless be oppressive. In this respect the legitimate expectations of the company’s shareholders may be relevant;

probity: refers to acting honestly and in good faith.

the conduct of the affairs of a company may be oppressive even though it does not involve a lack of probity. An applicant does not have to establish a dishonest motive, purpose or intention by those engaged in the conduct, as it is the effect of the conduct which is material. However, proof of a lack of probity may make it easier to establish that the conduct in question was oppressive;

the fact that all members of the company have been treated uniformly does not necessarily mean that there has been no oppression.

Common examples In order to demonstrate the scope of the minority oppression remedy, it is useful to consider the range of situations where the court has found conduct in breach of s 232.

[page 601]

Table 19.1 Conduct in Breach of s 232

Circumstances Case Name Remedy

Excessive remuneration for directors where previous profits had been paid as dividends, not remuneration.

Roberts v Walter Developments Pty Ltd (1992) 10 ACLC 804

Not appropriate to buy out minority. Majority ordered to pay dividend to minority shareholder.

Failure to revise dividend policy. Company was increasing profits, and common understanding between the shareholders that dividends would continue to grow with the company.

Shamsallah Holdings Pty Ltd v CBD Refrigeration & Airconditioning Services Pty Ltd (2001) 19 ACLC 517; [2001] WASC 8

Majority ordered to buy out minority shares.

Majority members (who were also directors) issued new shares to themselves to dilute voting rights of minority.

Re Dalkeith Investments Pty Ltd (1984) 9 ACLR 247

Majority ordered to buy out minority shares.

Misappropriation of business opportunity belonging to the company by the directors setting up a competing business.

Vadori v AAV Plumbing (2010) 77 ACSR 616; [2010] NSWSC 274

Majority ordered to buy out minority shares.

Paying a dividend to some but not all members. William Buck (WA) Pty Ltd v Faulkner (No 6) [2013] WASC 342

Winding up order granted under s 233.

•

Breaches of directors’ duties by acting in the best interests of a particular shareholder rather than acting in the interests of the company as a whole.

HNA Irish Nominees Ltd v Kinghorn (No 2) (2012) 88 ACSR 427; [2012] FCA 228

Winding up order granted under s 233.

Major shareholder appointing a voluntary administrator where there was no clear breach of a secured loan in order to pressure minority shareholder and seize control of the company.

Ubertini v Saeco International Group SpA (2014) 98 ACSR 138; [2014] VSC 47

Major shareholder ordered to buy out shares.

It is clear that in many situations in cases where the minority oppression remedy is applied, the case may also be argued on the basis of a breach of directors’ duties. In oppression cases, it is often the case that it is the conduct of directors that creates the oppression, but the cases are not alleged breach of directors’ duties because, as noted in Chapter 16, directors’ duties are owed to the company, not to individual members. Usually oppression cases will involve a series of actions or a course of behaviour over a period of time, but oppression may be found in a single action, such as issuing shares for an improper purpose. This could also involve a breach of directors’ duties, as discussed in Chapter 15.

[page 602]

In s 232 cases, the member is applying for orders to remedy the contravention of a personal right (which may be caused by the company’s conduct, or by the conduct of the directors or majority shareholders) not to be oppressed.

What are the differences between a member bringing an SDA in respect of breach of directors’ duties, and a member seeking relief under the minority oppression remedy?

In order to further demonstrate the scope of the minority oppression remedy, the following cases provide examples of where members have failed to establish a breach of s 232.

Table 19.2 Members Have Failed to Establish Breach of s 232

Circumstances Case Name Reason for Failure to Prove Breach of s 232

Low dividend payments combined with high directors’ fees.

Morgan v 45 Flers Avenue Pty Ltd (1986) 10 ACLR 692

The directors’ fees were justified given the profitability of the company. The low dividends were only a temporary measure (and the dividends were not $0 as in other cases).

Inability to dispose of minority shareholding.

McWilliam v LJR McWilliam Estates Pty Ltd (1990) 20 NSWLR 703

Minority members unhappy with company policy were not entitled to have their shares bought out by the company. Changes in the dividend policy were motivated by tax law rather than unfairness towards minority (even if the changes disadvantaged the minority members).

Loans to directors at commercial rates. Agreement not to sue directors for breach of duty.

French v Smith [2004] VSCA 207

Loans at commercial rates, and properly recorded in company books did not harm the company or reduce its assets. There was insufficient evidence to establish that company would have succeeded in action against directors.

It can be seen from the table above that the minority oppression remedy is not designed to provide minority members with a remedy against conduct that is an ordinary feature of minority ownership. As a minority member, it should not be assumed that your wishes will always be observed. Thus, as noted above, merely being outvoted in a meeting — even if you believe that the majority vote will harm the company’s interests — is not sufficient to establish a breach of s 232. The conduct of the majority members or the company (driven by the directors and executive officers who manage the company) must have an element of commercial unfairness, so that it may be said that in all the circumstances it is ‘oppressive, unfairly prejudicial or unfairly discriminatory’ against the minority.

[page 603]

Dividend Policies as a Tool of Oppression A good example of the scope of the oppression remedy is illustrated with reference to the non- payment of dividends.

As a member, there is no right to receive a dividend as the decision to declare dividends is dependent upon the director’s discretion. Certain classes of shares (such as cumulative preference shares) may carry a right to receive higher dividend payments than other members but the company has no legal obligation to pay a dividend each year to members. Indeed, s 254T prohibits the payment of dividends

unless the assets test is satisfied and the payment is fair and reasonable to all members and would not materially prejudice the company’s ability to pay its creditors. Members may wish the company to pay a particular dividend; however, this is typically a matter for management: see ss 198A and 254U. Following decisions such as Automatic Self-Cleansing Filter Syndicate Company Ltd v Cuninghame [1906] 2 Ch 34 the majority of members cannot exercise management decisions unless they are given that power in the company’s constitution. Thus, the decision by a board to defer a dividend or refuse to increase a dividend payment in a particular year will rarely fit within the minority oppression provision. However, if management uses dividend policy as a tool of oppression then s 232 may be triggered, but this will require more evidence of oppression than simply the refusal to pay a dividend.

Wambo Coal Pty Ltd v Sumiseki Materials Co Ltd (2014) 101 ACSR 643; [2014] NSWCA 326 New South Wales Court of Appeal

Facts: Sumiseki Materials Co Ltd (SM) held shares in Wambo Coal Pty Ltd (WC). The shares in WC were split into two classes, ordinary shares (held by PAM) and B class shares held by SM. PAM was a subsidiary of Peabody Energy Corp, which was the ultimate holding company of WC. SM obtained the shares following a sale by it of all of the shares in WC to another company (Hunter), which was then restructured (in a transaction involving SM, WC and Hunter) to provide SM with a right to a regular payment based on the profits obtained by WC in running a coal mine in New South Wales. SM and WC then agreed that WC’s constitution would be amended to create the B class shares and this involved changing the right to payment to a dividend right under the constitution. The constitutional provision entitled B class shareholders to receive a dividend every six months based on 25% of the profit interest, which was defined to mean ‘an amount equal to the profit of the Company available for dividend purposes for the relevant period’ based on either the interim or final accounts (depending on the period). The constitution also provided directors with the power to declare ‘such dividends as in their judgment the financial position of the company justifies’ and the power to carry forward profits without declaring a dividend. SM received dividends for the following nine years, but then the board of WC passed a resolution stating that no dividend would be paid to B class shareholders for the 2009 financial year, and similar resolutions were passed in the next year. The WC board stated that their reason for doing this was not to pay a dividend which may put the company in breach of loan covenants for a loan agreement the company had just entered into with its holding company. Prior to entering the loan agreement the company had unsuccessfully tried to convince SM to restrict its dividend rights.

Issue: Was a dividend required to be paid? Could the directors rely upon the loan agreement as justification for there being no profit available for dividends? Was the failure to pay a dividend oppressive under s 232?

[page 604]

Decision: The wording of WC’s constitution meant that B class shareholders had a right to receive a dividend every six months. Although the directors had a discretion to carry forward profits to future years, this discretion had to be read in a manner consistent with the right of B class shareholders to be

19.28

• • •

paid a dividend every six months. Profits available for dividends referred to profits earned by the company, not profits after the directors had determined what funds should be kept aside to comply with its loan covenants with the holding company loan. That is, the directors could artificially decide that funds had to be set aside to avoid those funds being ‘available for dividends’ by entering into a loan agreement with its holding company that required a certain level of funds to be maintained. The court held that on an objective assessment the loan agreement was entered into not for commercial reasons but rather to frustrate the right of SM to receive dividend payments, which made the conduct oppressive and a breach of s 232.

Significance: This case is significant as it explains the relationship between law and accounting relating to the ascertainment of profit and the payment of dividends. It also demonstrates the important role that the constitution has in creating members’ rights.

What orders may be made? Where a breach of s 232 has been established, the court has the power to make a range of orders under s 233, including:

to wind up the company; to amend the company’s constitution; and to order the company to purchase the member’s shares.

Generally speaking, the court will be reluctant to wind up a solvent company unless there is a compelling reason for doing so (such as directors engaging in fraud). Where the oppressive conduct consists of passing a resolution at a members’ meeting, the court may simply invalidate the resolution and order another meeting to be held in accordance with law.

Where the company has gone into an insolvent liquidation, the court will not order a compulsory purchase of the minority’s shares as the control of the company passes onto the liquidator and the oppression has ceased and will not continue as the liquidator is in control. Furthermore, in an insolvent liquidation the member’s shares are likely to be worthless: Campbell v BackOffice Investments Pty Ltd (2009) 238 CLR 304; [2009] HCA 25 (buy-out order should not have been made where member’s shares were worthless following sale of assets during liquidation.

Re Spargos Mining NL (1990) 3 ACSR 1

19.29

Western Australia Supreme Court

Facts: A shareholder (Mr Jenkins) sought orders under the former minority oppression provision in s 320 of the Companies Code (WA) (predecessor to s 232 of Corporations Act 2001 (Cth)). The company (Spargos) was part of a larger group of companies (the IRL group) and shareholders representing this group controlled members’ meetings and the composition of the board of directors. The board caused the company to enter into several risky transactions that were for the benefit of the group (which included giving loans and issuing new shares), and the shareholder argued that this involved oppression as it disregarded the interests of Spargos’ shareholders.

Issues: Was the conduct oppressive? If so, what orders should be made?

[page 605]

Decision: The conduct of the company’s affairs was oppressive. The court ordered that the board of directors be replaced with independent management chosen by the court to enable a full investigation of the prior conduct of the directors. The court also ordered that the constitution be changed for a 12- month period to allow the independent managing director to carry out their role without being replaced by the members. In this case it was not appropriate to appoint a receiver and manager as such an appointment would have resulted in termination of several key contracts.

Significance: This case demonstrates that the role of remedies available for minority oppression is much broader than simply causing the company or the majority of the members to buy out the minority shareholders.

Valuing shares17

One of the more common orders sought from the court under the minority oppression remedy is that the majority members purchase the shares of the minority members. In this situation, the key issue is what value should be put on the shares. The market price of the shares may be artificially low due to the oppressive conduct. Therefore, the courts have said that the value of shares should be assessed by establishing what their value would have been if the oppressive conduct had not occurred: Rankine v Rankine (1995) 18 ACSR 725. The same point was made by the Full Federal Court in Smith Martis Cork & Rajan Pty Ltd v Benjamin Corp Pty Ltd (see below).

Dynasty Pty Ltd v Coombs (1995) 59 FCR 122 Full Federal Court

19.30

Where the company was making losses and had a balance sheet dominated by two significant assets, the net tangible assets method of valuing the minority shares was appropriate. In other cases it may be more appropriate to consider dividend history or past earnings and potential future earnings.

The court said ‘it is not just a question of value; it is a matter of fixing a price that should be paid to [the minority member]’.

The decision in Dynasty Pty Ltd v Coombs was applied in the subsequent decision in Smith Martis.

Smith Martis Cork & Rajan Pty Ltd v Benjamin Corp Pty Ltd (2004) 207 ALR 136; [2004] FCAFC 153 Full Federal Court

Facts: The parties worked in a financial planning business, which was established as a company with each of the founders taking ordinary voting shares through separate family trusts. In addition, the founders and their employees had shares with a higher dividend rate, which paid 80% of the fees earned by the founders and employees in the business. The industry standard was only 40% in fees as remuneration. One of the original founders was removed as a director and terminated from the business in circumstances where the court found a breach of s 232. The trial judge ordered the majority to buy out the minority’s shares (held by Benjamin Corp on behalf of the founder) at a price that reflected the

[page 606]

industry standard of 40% remuneration, resulting in higher price per share valuation. The defendants appealed that decision.

Issue: How should the shares be valued? Decision: It was appropriate to determine the price in accordance with the industry standard fee structure. If the higher fee structure was accepted, the majority would benefit and the minority’s shares would be valued less. If the court considers it is appropriate to make an order that the other members purchase the shares of the oppressed shareholder, its task is to fix a price that represents a fair value in all the circumstances.

Strategic actions Many of the rights to seek court assistance discussed in this chapter have involved the application of specific remedial provisions of the Corporations Act, such as the oppression remedy. However, taking litigation to enforce a statutory or general law right involves a great deal more than merely asserting the power of the statutory provision. In order

19.31

to obtain court orders, a member must have sufficient evidence to prove that their legal rights (whether arising under general law or under statute) have been infringed in some way. How is this evidence obtainable? Furthermore, what if the member does not have sufficient funds to commence litigation in their own right? What else can a member do? It should be noted that there are a range of approaches that a member may take, aside from commencing litigation directly against the company and/or its directors.

Obtaining information As noted in Chapter 12, members of a company have a right to receive information from the company, including copies of the annual report (provided they request a copy) and notification of upcoming members’ meetings. Members may also seek access to the company’s books by court order under s 247A. There is also scope for the company to voluntarily allow members to inspect the books under s 247D (a replaceable rule).

In addition to inspecting books, members may obtain information by asking questions at the members’ meeting; however, such a move (particularly in large companies with hundreds of thousands of shareholders) is subject to the chair of the meeting allowing a ‘reasonable’ time for members to ask questions. This, of course, does not mean that each individual member will be given time to ask questions, or will be able to ask multiple questions.

Lastly, members (or indeed any person) may obtain access to the company’s register of members under s 173. Members may do so without charge, while ordinary members of the public may be asked to pay a fee to inspect and copy the register. Of course, as noted in Chapter 12, information obtained from the share register may only be used for limited purposes under s 177, which may mean that the member seeking to start a class action against the company will have trouble using the share register information for the purposes of contacting members about the class action: see 12.8.

[page 607]

19.32

Alternative actions In addition to sourcing information that may be relevant for commencing litigation, members may be able to take indirect action by complaining to ASIC. As noted in Chapter 2, ASIC has extensive investigation powers and may be able to remedy the breach of the Act without the member taking legal action. Similarly, the member of an ASX listed company may complain to the ASX; however, as noted above the member of a listed company may prefer to simply sell their shares. An alternative to complaining to regulators may be to contact shareholder bodies such as the Australian Shareholders’ Association or Institutional Shareholder Services, who take an active role in monitoring and reviewing the corporate governance practices of major publicly listed companies.

6. 7.

10.

[page 608]

Revision Questions

How do you determine whether someone is a member of a company? Does it matter for obtaining member’s remedies if the person was previously a member but is now no longer a member? How can a member enforce a breach of directors’ duties? Who may be paid compensation if the action is successful? What remedies may a member seek in respect of a breach of the company’s constitution? Explain the difference between a member’s personal rights and company rights. How does the court satisfy itself that it is ‘just and equitable’ to wind up a solvent company? What is the meaning of good faith in s 237(2) (SDA)? How does the court establish unfair prejudice or unfair discrimination? When can a statutory injunction be used to provide a member with a remedy? Explain the principle of fraud on the minority. How is it different from minority oppression? When is it not permissible to alter the corporate constitution?

Problem Question Acme Ltd is an ASX listed agricultural company that supplies major supermarkets with fresh produce daily. Acme’s main competitor is Beta Ltd, which is controlled by the feisty New Zealand corporate tycoon Mick Doonan. Mick has been keen to takeover Acme since he moved into the Australian domestic market six years ago. He formulates a plan to obtain a strategic stake in the company to contain his competitor and ultimately secure control via

a hostile takeover. Mick convinces a number of institutional shareholders to sell their stakes to him slightly above market price, which gives him a 16% share of the company. This makes Mick the only foreign national shareholder in Acme.

Over the next two years Mick secures a position on the board and begins to cause trouble by secretly leaking information to the press in order to embarrass the company and keep the share price low. Mick also votes against every proposal put forward by the board at the members’ meetings. Acme’s board is keen to remove Mick from the board and the share register so they devise a plan (codename ‘Project Rainbow’) to alter the company’s constitution to totally remove Mick from the company. The company proposes to hold an extraordinary members’ meeting on 1 February 2017 to vote on the following resolution:

Proposition 1 — that the company’s constitution be amended so as to provide that any shareholder who is not, as of 1 January 2017, an Australian citizen or (if a corporation) whose main residence is not in Australia must divest themselves of all shares in Acme Ltd by selling their shares to the company at $2 per share.

Proposition 2 — if proposition 1 is not carried, then the company’s constitution be amended by providing that any persons, other than Australian citizens on 1 January 2015, holding shares will be stripped of their voting rights immediately.

Advise what remedies Mick may have in this situation. Include in your response an assessment of how Mick’s own conduct is relevant in determining whether he should have a remedy.

[page 609]

Guidelines for Answering Problem Questions

When answering a problem question concerning members’ remedies we suggest that the following method may be helpful:

Identify the relevant persons in the question, and establish their capacities (that is, are they directors, members, creditors or have more than one capacity?). Determine what role they have in relation to the corporation. For example, if they are a director what are their responsibilities? If they are a member, how many votes do they have in the general meeting? If the provisions in the constitution are not provided in the facts of the question, make an assumption about what the constitution

might contain (that is, the replaceable rules). What is the question asking you to do? If the question is asking you to advise a member, then determine what remedy (that is, damages, injunction, SDA, buy out, winding up) the member would want most. Then select the appropriate action that will provide for that remedy (note that the remedies are usually listed in a separate court orders provision such as s 233). If the question is asking you to advise directors (or the majority members) about their conduct, assess the potential actions that may be taken against them and what consequences would flow from that. If the question is asking you to advise directors, note that their improper conduct (for example, trying to manipulate control) may also be in breach of their directors’ duties. Consider what other issues are raised by the question, particularly issues such as constitutional amendments, removing directors and the validity of general meetings.

The expansion of the café business has not gone well and Wang decides to raise even more funding by issuing new shares to an associate of his (a wealthy hedge fund manager name Ben) against Erin’s wishes. Wang is concerned about Erin’s controlling position in the company and so he simply exercises his power as managing director and CEO of SCPL and Pop Up to issue the shares. This makes Ben a part owner with 25.1% of the votes in each company. This dilutes Erin’s shareholding to below 50%.

Erin and Wang are no longer speaking, but the business continues on under Wang’s control. Over time, the relationship between Wang and Erin deteriorates further and she now wants to take a more active role in management. She proposes that she take on the role of Executive Chair of the board and also a management position in both companies. Wang rejects this and says she is not qualified to undertake these roles. Erin states that she and Wang set up the business as partners and now he is denying her the right to participate in management.

Wang responds by passing a resolution at an ‘emergency’ board meeting called on 24 hours’ notice. Erin does not attend the meeting but Wang and John pass a resolution removing Erin from the board. Wang then invites Ben to attend the meeting and they pass a shareholders’ resolution ratifying Erin’s removal and the issue of new shares to Ben. Wang tells Erin over the phone that she will never get another cent out of the business because he will not declare any further dividends.

Erin is furious and seeks your advice as to her legal options here.

[page 610]

Further Reading

Academic Journals V Baumfield, ‘Injunctions and Damages under s 1324 of the

Corporations Act: Will McCracken v Phoenix Constructions Revive the Narrow Approach?’ (2014) 32 Company and Securities Law Journal 453.

R Brockett, ‘The Valuation of Minority Shareholdings in an Oppression Context: a Contemporary Review’ (2012) 24 Bond Law Review 101.

R Chesterman, ‘Oppression by the Majority: Or of It?’ (2004) 25 Australian Bar Review 103.

N Kulkani, ‘In Defence of McCracken: A Response to “Why Do Courts Cut Back on Statutory Remedies Provided by Parliament under Corporate Law”’ (2015) 89 Australian Law Journal 175.

M Legg and L Travers, ‘Oppression and Winding Up Remedies after the GFC’ (2011) 29 Company and Securities Law Journal 101.

S Lo, ‘The Continuing Role of Equity in Restraining Majority Shareholder Power’ (2004) 16 Australian Journal of Corporate Law 96.

M May, ‘Oppression in the Context of Corporate Trustees’ (2013) 87 Australian Law Journal 271.

J McConvill, ‘Ensuring Balance in Corporate Governance: Parts 2F.1 and 2F.1A of Corporations Law’ (2001) 12 Australian Journal of Corporate Law 293.

S McNee, ‘The Just and Equitable Ground: A Remedy of Last Resort’ (2001) 9 Insolvency Law Journal 147.

I Ramsay, ‘An Empirical Study of the Use of the Oppression Remedy’ (1999) 27 Australian Business Law Review 23.

R Turner, ‘Directors’ Fiduciary Duties and Oppression in Closely-held Corporations’ (2013) 31 Company and Securities Law Journal 278.

3. 4. 5.

10.

Practitioner Works F Callaway, Winding Up on the Just and Equitable Ground, The Law Book

Company Limited, Australia, 1978. H A J Ford, R P Austin and I Ramsay, Ford’s Principles of Corporations

Law, LexisNexis, Australia (looseleaf and online), Ch 11. I Ramsay and B Saunders, ‘Litigation by Shareholders and Directors: An

Empirical Study of the Statutory Derivative Action’, Centre for Corporate Law and Securities Regulation, University of Melbourne, 2005.

You will find useful study resources, including quizzes for each chapter, when you go to <http://learning.lexisnexis.com.au>. The quiz is a great tool to help you self-test your knowledge.

For a recent summary of the law, see Hancock v Rinehart [2015] NSWSC 646 at [57]- [61], See I Ramsay (ed), ‘Gambotto v WCP Limited: Its Implications for Corporate Regulation’, University of Melbourne Centre for Corporate Law and Securities Regulation, 1996, at <http://cclsr.law.unimelb.edu.au>; I Ramsay and B Saunders, ‘What Do You Do With a High Court Decision You Don’t Like? Legislative, Judicial and Academic Responses to Gambotto v WCP Ltd (2010) 25 Australian Journal of Corporate Law 112. It should be noted that the ultra vires rule no longer applies in Australia due to s 125. See Chapter 12. For a comparison of the general law derivative action with the statutory derivative action, see Oates v Consolidated Capital Services Ltd (2009) 76 NSWLR 69; [2009] NSWCA 183. See also M Bini, Foss v Harbottle: Alive and Well in the Public Sector?’ (2014) 88 Australian Law Journal 406. See further A Monichino, ‘Costs in Statutory Derivative Actions: The Lingering Ghost of Wallersteiner’ (2015) 33 Company and Securities Law Journal 104. For a detailed summary of the law see Blakeney v Blakeney (2016) 113 ACSR 398; [2016] WASCA 76. For a discussion of the differences between a statutory derivative action and a statutory injunction, see Sutherland v Pascoe (No 2) (2012) 92 ACSR 174; [2012] FCA 1361. See H Bird, ‘A Spanner in the Works: The Impact of Mesenberg v Cord Industrial Recruiters on Enforcement Rights under the Corporations Law’ (1997) 25 Australian Business Law Review 179. The conflicting authorities were considered recently in Re Idylic Solutions Pty Ltd

http://cclsr.law.unimelb.edu.au

11.

12.

13.

14.

15.

16. 17.

(2013) 93 ACSR 421; [2013] NSWSC 106 where the expansive approach (contrary to Mesenberg) was adopted. For a critical assessment, see the detailed analysis in V Baumfield, ‘Injunctions and Damages under s 1324 of the Corporations Act: Will McCracken v Phoenix Constructions revive the Narrow Approach?’ (2014) 32 Company and Securities Law Journal 453. For collection of authorities on winding up due to well-founded and justified lack of confidence in the management and conduct of the affairs of the companies under s 461(k), see ASIC v Gognos Holdings Ltd [2017] QSC 20. For a discussion of the history of the minority oppression remedy, see E Boros, Minority Shareholders’ Remedies, Clarendon Press, Oxford, 1995. For judicial analysis of the standing requirement under s 234, see Treadtel International Pty Ltd v Cocco (2016) 117 ACSR 176; [2016] NSWCA 360. For a summary of the legal principles on ss 232 and 233, considered to be settled by the Full Court of the Federal Court, see Mackay Sugar Limited v Wilmar Sugar Australia Limited (2016) 116 ACSR 426; [2016] FCAFC 133. See also William Buck (WA) Pty Ltd v Faulkner (No 6) [2013] WASC 342 at [108]. For principles governing the valuation of company shares, see the judgment of Bathurst CJ in Tomanovic v One Australia Pty Ltd (2015) 104 ACSR 596; [2015] NSWCA 11.

[page 611]

Accounts, Auditors and Dividends

CHAPTER 20 Auditors

Role of auditors Law reform Qualifications for appointment Termination and removal of company auditors Which companies must appoint auditors?

Performing the audit Auditor independence Duties and obligations of auditors Australian Consumer Law Proportionate liability

Supervision of auditors Reporting requirements

Continuous disclosure Class actions Directors’ liability

Periodic disclosure Annual reporting Half-yearly reporting

[page 612]

Publicly listed companies Introduction to dividends How are dividends paid?

Reforming s 254T Prior law Future reforms Dividend rights Incurring a debt Declaration of dividends Interim dividends Final dividends Payment Dividend reinvestment plans

Invalid dividend payments

[page 613]

Accounts, Auditors and Dividends

Learning Objectives After completing this chapter you should be able to:

Provide an overview of how auditors are regulated in Australia.

Explain the duties and obligations company auditors owe to their clients.

Explain the continuous disclosure obligations that arise under both the Corporations Act 2001 (Cth) and the ASX Listing Rules.

Outline the consequences that may arise if disclosure requirements are breached.

Understand the role that dividends play in corporate financial management.

Explain when and how a company may pay a dividend.

Key Cases

Daniels v Anderson (1995) 37 NSWLR 438

Esanda Finance Corp Ltd v Peat Marwick Hungerfords (Reg) (1997) 188 CLR 241

James Hardie Industries NV v ASIC (2010) 81 ACSR 1; [2010] NSWCA 332

Jubilee Mines NL v Riley (2009) 69 ACSR 659; [2009] WASCA 62

Key Sections

Corporations Act 2001 (Cth) ss 254S, 254T, 254U, 254V, 254W, 292, 296, 307, 308, 674, 677, 1292, Pt 2M.4 Div 3

20.1

[page 614]

Introduction

The regulation of companies attempts to balance the competing public interests in encouraging commercial investment and the efficient allocation of capital with the interests of investor protection and market transparency. The efficient market hypothesis suggests that capital markets will price securities based on publicly available information. Corporate law therefore places an emphasis on the disclosure of accurate and timely information. Investors will have greater confidence investing in capital markets that provide reliable and timely information. Disclosure laws therefore help to maintain deeper capital markets.

This chapter discusses corporate disclosure requirements, including continuous and periodic reporting under the Corporations Act 2001 (Cth). Reporting, however, has little value if the quality and accuracy of the information contained in the report cannot be independently verified. This chapter also deals with the regulation of the auditing profession, which plays a central role in maintaining the quality of information required by statute. Finally, this chapter includes an overview of the laws relating to dividend payments.

Auditors

Role of auditors Company auditors play an important role in maintaining compliance with the law. The primary role of an auditor under the Corporations Act is to verify that financial information disclosed by the company under the requirements of the Act correctly reflects the state of the company’s accounts.

In recent years, auditing firms have also developed highly profitable corporate advisory businesses, which, in some cases, have been more profitable than their traditional auditing work. This has led to extensive public debate concerning the level of audit independence and the quality

•

• •

20.2

•

of audit information, particularly after large corporate collapses such as HIH, One.Tel and Enron where independent audit reports showed that the companies were making a profit, when in fact they were heavily in debt. In some cases, questions were raised about whether the independence of the audit firms in those cases had been compromised because of the large fees for non-audit services obtained by those firms from their audit clients. As a result of the audit independence controversy, the federal government commissioned Professor Ian Ramsay1 to conduct a review of audit independence in Australia (the Ramsay Report). The Ramsay Report recommended that auditor independence be improved by:

clarifying the requirements for auditor independence in the Corporations Act itself (including providing extensive definitions to clarify what conduct reduced independence); developing stricter guidelines on the provision of non-audit services by audit firms; strengthening the role of company audit committees; and imposing greater regulatory supervision of auditor independence.

[page 615]

Professor Ramsay’s law reform recommendations have been largely adopted by the Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 (Cth) (known as CLERP 9).

Law reform CLERP 9 significantly changed the way that audit work is carried out in Australia. The most significant changes were:

proportionate liability: the person sued for negligence only has to pay for the proportion of the damage that their negligence caused. Previously if an audit (or other professional) acted negligently they would be sued for 100% of the damage caused, even where other persons were also responsible.

improving the standards of auditor regulation through changes to the powers of the Financial Reporting Council and the reconstitution of

•

the Auditing and Assurance Standards Board; imposing statutory requirements for auditor independence and audit partner rotation; and providing proportionate liability in respect of claims made against auditors.

In subsequent years there have been several changes made to the regime introduced by the CLERP 9 reforms. In 2010 the Corporations Amendment (Corporate Reporting Reform) Act 2010 (Cth) introduced amendments to address reporting and audit requirements for companies limited by guarantee.

Major reforms to audit regulation were introduced in 2012 in the Corporations Legislation Amendment (Audit Enhancement) Act 2012 (Cth). These amendments are discussed further below, but in brief provide for:

audit firms to publish annual transparency reports if they audit a certain number of significant entities; five-year time periods for mandatory auditor rotations to be extended in certain cases; and clarification of the role of the Financial Reporting Council as an advisory body.

The reforms also give ASIC further powers to take action against auditors in respect of deficiencies in audit reports and to communicate with audited bodies where there are suspected deficiencies (thus overriding confidentiality restrictions). This follows several significant auditing scandals involving major companies such as Centro (a large operator of shopping centres whose auditor admitted in court that they did not understand the law regarding dividend payments) and ABC Learning (a large operator of child care facilities whose auditor authorised development fees to be recorded as revenue).

Audit Reports

In June 2017, ASIC released a report of its investigations into the quality of audit reports, Report 534: Audit Inspection Program Report for 2015–16. This report examined 93 audit files from audit firms of different sizes. The report found that across the more than 390 topics in 25% of key audit areas, auditors

• • •

•

20.3

20.4

did not obtain reasonable assurance that the financial report as a whole was free of material misstatement. Some of the notable reporting topics included:

adequacy of asset valuations; auditing of revenue calculations; and maintaining a strong culture of audit within companies.

[page 616]

What is the role of company auditors? Should auditors be responsible for defective information produced by companies?

Qualifications for appointment The Corporations Act requires company auditors to be registered by ASIC. It is an offence to perform work as a company auditor without being registered under the Act: ss 324BA–324BC. The Act provides for the registration of individual auditors, auditing partnerships and auditing companies: s 324AA. In order to be qualified for registration as a company auditor, the applicant must hold a degree from an accepted university and during the course of that study the applicant must have completed courses in auditing and company law: s 1280(2A). Alternatively, an applicant may satisfy ASIC that he or she has relevant experience that is equivalent to the requirements of s 1280(2A): s 1280(2B). ASIC may also require an applicant for registration to comply with an auditing competency standard that ASIC has approved, such as the standard under s 1280A: s 1280(2). ASIC may register a company auditor subject to such terms and conditions as it thinks fit.

Termination and removal of company auditors A company auditor may be removed from office by the members passing an ordinary resolution at a members’ meeting: s 329. However, the company’s auditor must be given at least two months’ prior notice of the intention to propose his or her removal at a members’ meeting. This

20.5

20.6

allows the auditor time to produce written submissions in defence of his or her position within the company, which may be distributed to the members at least two weeks prior to the members’ meeting. An auditor may resign with ASIC’s consent: s 329(5).

Which companies must appoint auditors? All companies, unless exempted by ASIC, are required to keep financial records: s 286. However, not all companies are required to produce independently audited annual financial statements. Only public companies, large proprietary companies and companies limited by guarantee that are not classified as ‘small companies limited by guarantee’ under s 45B are generally required to produce annual audited financial statements: ss 292 and 301(1).

In addition, small proprietary companies and small companies limited by guarantee may also be requested by ASIC or a shareholder to prepare a financial report and a directors’ report: ss 293–294B. In that case, the company is only required to have the financial statement audited if s 301 requires it.

Performing the audit

Where the audit is conducted by an audit partnership or audit company, the Corporations Act draws a distinction between lead auditors and review auditors. The lead auditor is the registered company auditor working for the audit partnership

[page 617]

or audit company who is primarily responsible for conducting the audit, while the review auditor’s role is to review the overall conduct of the audit: s 324AF.

Sections 307, 307A and 308 provide that in performing an audit and

•

20.7

completing the audit report, a company auditor must form an opinion about whether:

the company’s annual financial report complies with the accounting standards; the company’s annual financial report represents a true and fair view of the company’s financial position; he or she has been given all assistance necessary for the conduct of the audit; the company has maintained financial records that are sufficient to enable a financial report to be prepared and audited; and the company has kept all records and registers as required under the Act.

In order to properly perform the audit, the auditor is given a statutory right to access the company’s books and may also require company officers to provide information that may assist with the audit: ss 310 and 312.

Auditor independence The CLERP 9 reforms introduced the statutory requirement that all company auditors satisfy the test of independence: see Pt 2M.4 Div 3. Auditors are required to give their audit clients a declaration of independence under s 307C. The statutory test of independence imposes an obligation on company auditors to take action to remove the existence of a ‘conflict of interest situation’: ss 324CA–324CC. Section 324CD provides guidance as to what is meant by a ‘conflict of interest situation’ by providing a general test of the auditor being able to ‘exercise objective and impartial judgment in relation to the conduct of the audit’. The relationships (if any) between members of the audit team and officers of the audit client are relevant in determining whether an auditor is capable of exercising objective and impartial judgment: s 324CD(2). Certain relationships between company auditors and audit clients are prohibited under ss 324CE–324CH.

Audit rotation

20.8

20.9

20.10

•

• • •

20.11

In addition to managing conflicts of interest, the CLERP 9 reforms also imposed a requirement on companies to engage in audit partner rotation: ss 324DA–324DD. This involves replacing the registered auditor of a listed company at least after every five successive financial years. Thus, a listed company cannot use the same registered auditor for more than five financial years in a row. This measure is aimed at enhancing auditor independence. The reforms introduced in 2012 allow for this five-year period to be extended by a further two years in certain cases, provided no conflict of interest exists: ss 324DAA–324DAD.

Auditors obtaining employment with former audit clients As stated in the practical example above, one of the independence measures introduced by CLERP 9 concerns the movement of key personnel between auditing firms/companies and their audit clients. This is done by imposing a general obligation of independence on company auditors, and also by restricting the types of commercial relationships that may exist between members of the audit firm/company and the audit client: see the categories of relationships in s 324CH.

[page 618]

Duties and obligations of auditors The obligations imposed on company auditors arise from the statute and also from the common law. The statutory duties of company auditors include the duty to:

audit the client company’s financial reports in accordance with the relevant accounting and auditing standards; attend the Annual General Meeting for publicly listed companies; report on possible breaches of the Corporations Act to ASIC;2 and sign an auditor’s independence declaration and maintain their independence from the audit client.

Liability of auditors to the audit client and third parties Auditors, like other professionals, may be liable to compensate their

20.12

20.13

client if they provide audit services in breach of an existing legal obligation. The most common sources of legal obligations that are imposed on auditors (indeed all professionals) are the following.

Contract law

privity of contract: only the parties to a contract are bound by it and can enforce it.

The scope of obligations that are imposed on auditors is determined to a large extent by reference to the specific tasks that the auditor has been engaged under contract by the client to undertake. If the auditor fails to comply with the terms of its contract, the client may sue for compensation for breach of contract. However, liability under contract will only arise between the auditor and the audit client (that is, not to third parties). Owing to the doctrine of privity of contract, an auditor will not be liable in contract law to a third party (that is a non-client).

Law of negligence Holding auditors liable for negligent auditing work involves suing the auditor for lost profits (which is referred to as ‘pure economic loss’). Traditionally, the law has been reluctant to award compensation for negligent acts resulting in pure economic loss (as opposed to negligence resulting in physical injury) because of a fear that the boundaries of liability will extend far beyond the professional and client. Indeed, in a famous United States case concerning auditor liability (Ultramares Corp v Touche (1931) 255 NY 170) it was said that:

… if liability for negligence exists, a thoughtless slip or blunder, or the failure to detect a theft or forgery beneath the cover of deceptive entries, may expose accountants to a liability in an indeterminate amount for an indeterminate time to an indeterminate class.

This fear of opening the courts to boundless claims of lost profit, particularly in claims by non-clients against auditors, has led the courts to impose very stringent requirements for a plaintiff to prove in order to establish that a company auditor owed them a duty of care.

[page 619]

•

Esanda Finance Corp Ltd v Peat Marwick Hungerfords (Reg) (1997) 188 CLR 241 High Court of Australia

Facts: Esanda was a finance company that lent money to various companies based on a publicly available audit report prepared by Peat Marwick Hungerfords (PMH). The debtor companies turned out to be insolvent and Esanda sued PMH for negligently preparing the audit report, which it said caused it to suffer pure economic loss.

Decision: The court found that Esanda had failed to adequately argue that the auditors owed it (as a non-client third party) a duty to avoid negligent advice resulting in pure economic loss. Brennan CJ provided the test that is required to be satisfied before such a claim can be successfully made:

… it is necessary for the plaintiff [that is the party that suffers loss because of the negligent audit report] to prove that the [auditor] knew or ought reasonably to have known that:

the information or advice [contained in the audit report] would be communicated to the plaintiff, either individually or as a member of an identified class; the information or advice would be communicated for a purpose that would be very likely to lead the plaintiff to enter into a transaction of the kind that the plaintiff does enter into; and it would be very likely that the plaintiff would enter into such a transaction in reliance on the information or advice and thereby risk the incurring of economic loss if the statement should be untrue or the advice should be unsound.

If any of these elements be wanting, the plaintiff fails to establish that the defendant owed the plaintiff a duty to use reasonable care in making the statement or giving the advice.

Significance: The Esanda decision provides guidance regarding when auditors may be liable for losses suffered by individuals other than their audit clients.

The leading decision on directors’ duties of care and diligence is also a leading case concerning the liability of auditors in negligence to their clients.

Daniels v Anderson (1995) 37 NSWLR 438 New South Wales Court of Appeal

Facts: AWA lost substantial sums of money through the trading activities of one particular employee. The auditors (Daniels) knew that there were insufficient internal controls on the trading activities of this particular employee but failed to immediately report on the deficient control mechanisms. The

20.14

20.15

company sued the auditors for negligence in failing to report on the deficient internal controls within the company before the losses were incurred.

Decision: The auditors were negligent in failing to immediately report on the internal deficiencies that left the company at risk of substantial losses. The Court of Appeal found that:

… in accordance with their own audit manual, the standard practices and procedures of the auditing profession and common prudence, [the auditors] were under a duty to report the acknowledged absence of proper records and the weakness in internal controls to management and then, in the absence of appropriate and timely action by management, to the board.

The auditors’ liability in negligence was, however, reduced by the contributory negligence of AWA’s board of directors.

Significance: The Daniels decision provides guidance regarding when auditors may be liable for losses suffered by their audit clients.

[page 620]

Australian Consumer Law Outside of common law obligations arising from contract or tort, there is also the possibility that auditors may face actions for incorrect audit reports under the misleading and deceptive conduct provisions of the Australian Consumer Law: Sch 1 of the Competition and Consumer Act 2010 (Cth).3

Proportionate liability The collapse of HIH, which, prior to its financial collapse, was Australia’s largest professional indemnity insurer, has led to dramatic increases in insurance premiums for professionals such as auditors. In response to the rise in professional insurance premiums, federal and state governments have introduced legislative changes limiting the amount of liability that is incurred by one negligent party. This is known as ‘proportionate liability’ because each wrongdoer is only responsible for the proportion of the plaintiff’s loss that was caused by their actions. Traditionally, liability in negligence has been ‘joint and several’, which means that even if the audit firm was not the only party responsible for the plaintiff’s losses, it may be sued for all of the loss and would then have to seek contribution from other parties also responsible for the plaintiff’s losses. The parliamentary intention of introducing proportionate liability

is that it will reduce the temptation for victims to sue professionals such as auditors because their liability will be limited to the actual damage or loss that their conduct caused. Proportionate liability provisions relating to misleading or deceptive conduct are found in the Corporations Act in Pt 7.10 Div 2A and in the Australian Securities and Investments Commission Act 2001 (Cth) Pt 2 Div 2 Subdiv GA. These provisions are based on similar provisions in the Competition and Consumer Act 2010 Pt VIA and equivalent state legislation.4

This reform has occurred at the same time as the ‘professional standards’ reforms which allow professions (such as auditing, engineering etc) to sign up for uniform liability schemes that impose maximum caps on liability provided that certain statutory requirements are met. All states have now enacted professional standards legislation to allow professionals to take advantage of these protections. This has had the effect of stemming the dramatic increases in professional liability insurance that occurred after the collapse of HIH.

Auditor Liability The global financial crisis has seen several large businesses getting into financial trouble with debt levels (or ‘gearing’) that are too high. Many businesses have had difficulties in negotiating loan extensions and have been driven to the brink of bankruptcy by bank reluctance to roll over corporate loans. Given the credit rationing that has occurred in corporate finance (where banks and other financiers become reluctant to expand their lending due to financial uncertainty), the market has treated debt levels and debt maturities (that is, the due dates on corporate loans) as being highly important in valuing the prices of corporate securities (both debt and equity securities).

[page 621]

Auditors play an important role in verifying the company’s financial position, including the characterisation of profit and the distinction between current and non-current liabilities. The auditors of ABC Learning have faced a class action lawsuit for their characterisation of development fees as profits, which ultimately made up a significant proportion of ABC’s reported profits, even though these amounts were not revenues made from trading activities.

The distinction between current and non-current liabilities is also important for market assessments of the company’s value going forward. The distinction is recognised in AASB 101 as liabilities that will

20.16

• •

•

fall due for payment within 12 months or longer than 12 months. Obviously, if a company has a large loan due for repayment within the next 12 months that will place pressure on the company’s cash flow and ultimately profits. Therefore, if a company misrepresents current liabilities as non-current liabilities this has the potential to significantly mislead the market as to the company’s near term financial prospects. This occurred with Centro Properties Group, a large owner and manager of shopping centres in Australia and the United States, where more than $1 billion of corporate loans were mistakenly characterised in the company’s annual financial statement as being non-current when they were in fact current liabilities. This error has resulted in several class actions being commenced against Centro seeking more than $1 billion in compensation after the company’s share price collapsed by more than 95% in 12 months. Centro has joined its auditors in the action alleging the auditors acted negligently. The settlement of the Centro actions was approved in mid-2012 for $250 million, with auditors PWC contributing one third of that amount.

Aside from private investors and companies suing auditors, the corporate regulator ASIC has also become involved in litigation against auditors. ASIC recently settled a representative action against KPMG alleging negligence in auditing the accounts of collapsed property development group Westpoint for just under $70 million. ASIC also accepted an enforceable undertaking with the former lead auditor of Centro which imposes a three-year ban from working as an auditor, and an enforceable undertaking with the former auditor of ABC Learning for a five-year ban.

Supervision of auditors

Auditors come under the formal supervision of the Companies Auditors Disciplinary Board. The board has the power to suspend or cancel the registration of an auditor on an application by ASIC: s 1292. The grounds for suspending or cancelling an auditor’s registration include:

where the auditor has failed to comply with his or her duties; where the auditor has not performed any significant audit work for more than five years; where the auditor has breached a condition of his or her registration by ASIC; where the auditor has failed to comply with his or her independence obligations; and where the auditor is not a fit and proper person to remain registered as an auditor.

The board may discipline an auditor under s 1292 for failing to provide sufficient information in the audit report even in excess of information ordinarily required under the Act. In Re Vouris (2003) 47 ACSR 155; [2003] NSWSC 702, it was found that proper practice might call for information or advice to be given even in the absence of a specific legislative

20.17

•

20.18

requirement. ASIC can also take enforcement action by accepting an enforceable undertaking from an auditor, who may agree as part of the undertaking not to work as an auditor: see ASIC Act s 93AA.

[page 622]

Reporting requirements

Companies come under a range of legislative reporting and disclosure requirements. These obligations may be categorised by the timing of the disclosure requirement. The range of disclosure requirements may be categorised as either:

continuous disclosure (that is, the information must be disclosed whenever it occurs); or periodic disclosure (that is, the information must be disclosed at specific time periods during the year).

Continuous disclosure Chapter 6CA of the Act imposes disclosure obligations on ‘disclosing entities’. Disclosing entities are identified under Pt 1.2A of the Corporations Act, with the most common category being companies whose securities are listed on the ASX: s 111AE. Public companies which do not have their securities listed on the ASX may also be classified as disclosing entities where they have issued securities under a disclosure document (such as a prospectus) with more than 100 people holding those securities: s 111AF.

The rationale for continuous disclosure has been discussed in several cases including in the recent James Hardie appeal. The appeals to the High Court in relation to the James Hardie litigation do not cover the company’s liability for breaches of continuous disclosure laws, which was determined by the New South Wales Court of Appeal. The High Court cases refer only to the individual liability of the directors and officers

involved: ASIC v Hellicar (2012) 88 ACSR 246; [2012] HCA 17; Shafron v ASIC (2012) 88 ACSR 126; [2012] HCA 18.

James Hardie Industries NV v ASIC (2010) 81 ACSR 1; [2010] NSWCA 332 New South Wales Court of Appeal

The continuous disclosure regime, contained in s 674 and the Listing Rules, is designed to enhance the integrity and efficiency of Australian capital markets by ensuring that the market is fully informed. The timely disclosure of market sensitive information is essential to maintaining and increasing the confidence of investors in Australian markets, and to improving the accountability of company management. It is also integral to minimising incidences of insider trading and other market distortions.

It is also to be noted that s 674 is remedial legislation to enhance the public interest and to protect individual investors. It should be construed beneficially ‘so as to give the fullest relief which the fair meaning of its language will allow’.

[page 623]

Continuous disclosure rules exist in both the ASX Listing Rules (LR 3.1) and Ch 6CA (ss 674–675) of the Corporations Act. Section 675 applies disclosure obligations on non-listed disclosing entities, with the

(1)

(2) (a) (b)

(c)

(i)

obligation to disclose the information to ASIC. Section 674 imposes the disclosure obligation on listed disclosing entities,

[page 624]

with the obligation to disclose the information to the licensed financial market (such as the ASX). However, the disclosure obligation under s 674 is only triggered where the listing rules of the licensed financial market require the entity to disclose the information to the market. Thus, s 674 does not apply unless there is breach of ASX LR 3.1.

ASX LR 3.1 provides:

Once an entity is or becomes aware of any information concerning it that a reasonable person would expect to have a material effect on the price or value of the entity’s securities, the entity must immediately tell ASX that information.

The dictionary to the ASX Listing Rules (ASX LR 19.12) provides that:

… an entity becomes aware of information if a director or executive officer … has, or ought reasonably to have, come into possession of the information in the course of the performance of their duties as a director or executive officer of that entity.

It is important to note that ASX LR 3.1 still applies even if the information is generally available. This is broader than s 674 of the Corporations Act which only applies where the information is not generally available. The test imposed under s 674 is an objective one which is ‘assessed ex ante the relevant event which requires disclosure’ (James Hardie Industries NV v ASIC (2010) 81 ACSR 1; [2010] NSWCA 332 at [546]):

Section 674 Obligation to disclose in accordance with listing rules

Subsection (2) applies to a listed disclosing entity if provisions of the listing rules of a listing market in relation to that entity require the entity to notify the market operator of information about specified events or matters as they arise for the purpose of the operator making that information available to participants in the market. If:

this subsection applies to a listed disclosing entity; and the entity has information that those provisions require the entity to notify to the market operator; and that information:

is not generally available; and

(ii) is information that a reasonable person would expect, if it were generally available, to have a material effect on the price or value of ED securities of the entity;

the entity must notify the market operator of that information in accordance with those provisions.

Information is generally available if it consists of a matter that is readily observable or where it has been made known in a manner that would bring it attention to persons who commonly invest in securities which may be affected by the information and a reasonable time for disseminating the information has passed: s 676. See further Grant-Taylor v Babcock & Brown Ltd (in liq) (2016) 245 FCR 402; [2016] FCAFC 60;

The term ‘a readily observable matter’ was interpreted in the insider trading case of R v Firns (2001) 51 NSWLR 548 as being information which could be observed even if no person actually observed it. Thus, publication of information on the ASX Company Announcements platform will make the information readily observable

[page 625]

even if no person actually reads the announcement.5 The concept of information being ‘readily observable’ refers to the information that can be accessed easily or without difficulty: Grant-Taylor v Babcock & Brown Ltd (in liq) (2016) 245 FCR 402; [2016] FCAFC 60.

Information will be ‘material’ for the purposes of continuous disclosure laws if it would be likely to influence persons who commonly invest in securities in deciding whether to acquire or dispose of the securities: s 677. However, the requirement to disclose information must be viewed in light of other disclosure laws, such as the prohibition on misleading or deceptive conduct, as demonstrated by the Jubilee Mines case. The concept of materiality in the phrase ‘material effect’ in s 674(2)(c)(ii) of the Act refers to information that is non-trivial, which may involve a balancing of both the probability that the event will occur and the anticipated magnitude of the event on the company’s affairs: Grant-Taylor v Babcock & Brown Ltd (in liq) (2016) 245 FCR 402; [2016] FCAFC 60.

The ASX Listing Rules (LR 3.1A) allow a limited number of exceptions

20.19

from the obligation to disclose information under LR 3.1. ASX LR 3.1A provides an exception to rule 3.1:

Listing rule 3.1 does not apply to particular information while all of the following are satisfied.

3.1A.1

One or more of the following applies.

It would be a breach of a law to disclose the information;

The information concerns an incomplete proposal or negotiation;

The information comprises matters of supposition or is insufficiently definite to warrant disclosure;

The information is generated for the internal management purposes of the entity; or

The information is a trade secret; and

3.1A.2

The information is confidential and ASX has not formed the view that the information has ceased to be confidential; and

3.1A.3

A reasonable person would not expect the information to be disclosed.

The exception to disclosure only applies if ASX LR 3.1A.1, 3.1A.2 and 3.1A.3 can all be satisfied.

Class actions In recent times, the use of the continuous disclosure regime has been increasing with both ASIC and private investors taking actions against companies for breach of the

[page 626]

provisions. As noted in Chapter 12, shareholder class actions are becoming more popular in Australia. The continuous disclosure regime has provided fertile ground for shareholder class actions where companies fail to release information to the market in a timely manner. Many large, publicly-listed companies such as Multiplex, Aristocrat

Leisure, Telstra, Centro and Newcrest Mining Ltd have been subject to shareholder class actions based on alleged breaches of continuous disclosure obligations. For example, securities class actions brought against the Centro Group alleging it had breached its continuous disclosure obligations and engaged in misleading and deceptive conduct concerning the disclosure of its borrowings in 2007–08 were settled for $200 million in 2012. See Chapter 17 for discussion on the Centro case. In addition to a penalty of $1.2 million imposed by the court in ASIC v Newcrest Mining Ltd [2014] FCA 698, Newcrest Mines paid $36 million in an agreed settlement with shareholders in a class action for breach of continuous disclosure rules when it had failed to make timely disclosure to the market certain material information in relation to expected total gold production and expected capital expenditure.6

Reform of Continuous Disclosure Laws The continuous disclosure regime has been a key feature of Australia’s disclosure framework since the early days of the Australian Stock Exchange (now the Australian Securities Exchange). Continuous disclosure has been formalised in the corporate law statute books since 1994 and is currently found in Ch 6CA of the Corporations Act.

The continuous disclosure regime operates by requiring material information to be disclosed to the market, either through a licensed financial market operator or by disclosure to ASIC (for those disclosing entities that are not listed). The primary provisions are found in ASX Listing Rules 3.1–3.1B. ASX Listing Rule 3.1 requires material information to be released ‘immediately’ unless the carve-out provisions (in ASX LR 3.1A) apply. ASIC has taken action against companies who fail to disclose material information after only a few hours. The term ‘immediately’ has caused some concern about whether companies may be forced to disclose information before it is verified. There is a danger that such conduct could itself contravene the prohibition on misleading or deceptive conduct under s 1041H: Jubilee Mines NL v Riley (2009) 69 ACSR 659; [2009] WASCA 62. It is also possible that the need for immediate disclosure could be used by market manipulators, particularly in the case of unsolicited and informal takeover discussions. In 2012, David Jones was the subject of an informal and incomplete takeover approach by a private equity firm based in England, which turned out to be nothing more than a shell company with a letter box address. When David Jones announced the approach to the market, its share price increased dramatically.

In 2012, the ASX undertook a consultation process to reform the continuous disclosure provisions in the Listing Rules. The consultation process has resulted in changes both to the Listing Rules and to Guidance Note 8. The changes commenced on 1 May 2013. There is no change to the wording of LR 3.1, but the examples given in the notes have been replaced with a new set of examples. The carve-out provisions in LR 3.1A have been reordered so that the five situations (previously LR 3.1A.3) are now listed first (in new LR 3.1A.1) and the reasonable person test (previously LR 3.1.1) is now listed third (new LR 3.1.3). This was done to better reflect the process of assessment that companies actually undertake:

(1) (2) (3)

Does the situation fall within one of the categories? If yes, then is the information confidential? If yes, then in those circumstances would a reasonable person expect the information to be disclosed?

[page 627]

The content of ASX GN 8 (2013) has been completely rewritten, including the production of a new abridged version for the use of company directors and officers. The revised GN 8 has a broad range of practical examples to help guide companies as to what should be disclosed and when the information should be disclosed. Significantly, the new GN 8 provides that ‘immediately’ does not mean instantaneously and companies should have a reasonable opportunity to verify information before releasing it to the market. Of course, how long companies should take depends on the type of information and the circumstances. New GN 8 makes it clear that companies should be prepared for disclosure of key information (such as major transactions) by having draft releases ready. The new GN 8 also recommends an increased use of trading halts to limit trading in an uninformed market.

Further amendment to ASX GN 8 was made, with effect from 1 July 2015, which expanded the existing guidance on earnings surprises, publication of analyst forecasts and consensus estimates, and investor briefings. The need for further guidance arose from the circumstances surrounding the improper disclosure activities of Australia’s biggest gold miner, Newcrest, which agreed to pay $1.2 million in fines for selective disclosure made to analysts and for concealing sensitive financial information from shareholders. See, further, ASIC v Newcrest Mining Ltd [2014] FCA 698 where the court observed that selective disclosure to analysts can generate confusion and a loss of faith in market integrity.

It is a criminal offence to fail to comply with the continuous disclosure requirements: see the penalties listed in Sch 3. There is, however, an available defence where the person took all reasonable steps to ensure that the company complied with its continuous disclosure obligations and reasonably believed that the company was in fact complying with those requirements.

The continuous disclosure provisions are civil penalty provisions under s 1317E. Therefore, failing to comply with continuous disclosure requirements may result in the declaration of a civil penalty breach which can involve the imposition of a pecuniary penalty (that is, a fine) or a compensation order under s 1317H. Section 674(2A) also imposes liability on individuals involved in the company’s contravention of the continuous disclosure rules, although there is a due diligence defence available under s 674(2B).

Furthermore, where the company is listed on the ASX, the failure to comply with the continuous disclosure requirements will also breach the ASX Listing Rules (LR 3.1) which may result in the company’s suspension

20.20

• •

or removal from listing. This effectively limits the ability to trade in the company’s securities.

Directors’ liability Directors may also contravene their duty of care and diligence under s 180(1), and be liable under the civil penalty provisions for breach of directors’ duties, by not complying with continuous disclosure obligations.

In ASIC v Sino7 (discussed in Chapters 2, 9, 14 and 17) the Federal Court held that the company had contravened s 674(2) of the Act by failing, between 13 December 2013 and 1 April 2014, to notify the ASX that circumstances had arisen as a consequence of which its profit forecast of $13.66 million for the financial year January to December 2013 would not be achieved. The court held that the director (Mr Shao) was involved in the company’s contravention of s 674(2) and thereby contravened

[page 628]

s 674(2A). In relation to Mr Shao, the court declared that he contravened ss 180(1) and 674(2A), finding that he:

was involved in the contraventions committed by Sino; failed to inform himself about Sino’s disclosure requirements and failed to acquaint himself with the disclosure requirements for publicly listed companies under Australian law.

By failing to inform himself about the disclosure requirements, it was held that Mr Shao did not discharge the degree of care and diligence that a reasonable person would exercise as director and Chairman of the company. The court recognised that Mr Shao’s conduct as a director of Sino had exposed the company to the imposition of civil penalties for its contraventions of the Act, to the cost and trouble of legal action and ASIC’s investigation into the affairs of the company.

In the civil penalty decision, the court imposed a pecuniary penalty of $800,000 on Sino and disqualified Mr Shao from managing a company

•

20.21

for a period of 20 years: ASIC v Sino Australia Oil and Gas Ltd (in liq) (2016) 118 ACSR 43; [2016] FCA 1488.8 The court in Sino accepted ASIC’s submission that heavy penalties will send a strong message that it is vital that people contemplating entry into the Australian market (foreign- based directors) must familiarise themselves with and understand the rules of the market, and adhere to those rules. The decisions in the Sino case emphasise that a director’s disregard of the law (in this case disclosure laws) through ignorance or lack of proper understanding is not an excuse and will not be tolerated.

Despite the broad range of civil and criminal remedies under the Corporations Act, ASIC has complained that each of these remedies requires court applications, which are expensive and time consuming. ASIC therefore argued for administrative remedies which may be levied without court approval. CLERP 9 introduced Pt 9.4AA in the Corporations Act, which provides ASIC with the power to issue infringement notices where a company fails to comply with its continuous disclosure requirements. This allows ASIC to fine a company for allegedly breaching disclosure requirements, even though the breach has not been proven in court. While most of the infringement notices issued are against small and medium sized companies, ASIC has obtained payments from infringement notices paid by several large listed companies for allegedly failing to comply with continuous disclosure obligations including Commonwealth Bank of Australia, Rio Tinto and Leighton Holdings.9

Do you believe that it is appropriate for ASIC to have powers to impose on-the-spot fines without proving a breach of the Act? Is it proper for ASIC to be the judge/jury and executioner?

[page 629]

Periodic disclosure There is also a range of periodic disclosure reporting requirements under

20.22

•

the Act including an obligation to lodge annual reports (which include the annual financial statement) and for some companies the obligation to lodge half-yearly reports. Section 285 provides a summary of the reporting requirements imposed on companies under the Corporations Act. The requirement to provide periodic reports to the company’s members is in addition to the more basic requirement that the company maintain proper financial records: s 286. If a company fails to maintain proper financial records, it may be presumed to be insolvent under s 588E, which can lead to an insolvent trading action against the directors under s 588G. For more information regarding insolvent trading, see Chapter 18.

Annual reporting Disclosing entities are required to produce annual reports, which are lodged with ASIC: s 319.

Annual reports include the annual financial report, the directors’ report and the auditor’s report:

Annual financial report: The contents of the annual financial report are prescribed by ss 295-297. One key element of the annual financial report is the solvency declaration by the directors. Directors’ report: The contents of the directors’ report are prescribed by ss 298-300B. Auditor’s report: The auditor’s report concerns whether the annual financial report complies with the accounting standards and whether it represents a true and fair view of the company’s financial position. Furthermore, the auditor’s report must contain details of any defects, irregularities or deficiencies in the company’s internal procedures.

The importance of directors satisfying themselves that the information contained in the annual reports is accurate and not misleading was emphasised in the recent case of ASIC v Healey (2011) 196 FCR 291; [2011] FCA 717, where the court found that the directors who had signed off on the annual reports without appreciating that the reports misclassified debts as non-current liabilities (of close to $2 billion) had acted in breach of their duty of care and diligence under s 180(1). The directors and executives who were sued by ASIC claimed that they could simply rely

20.23

20.24

• •

on the auditors to advise them of any problems, but the court found that this was not complying with their duty of care and diligence. This duty is discussed further in Chapter 17.

Half-yearly reporting Entities that are listed on the ASX, are involved in public fundraising or are involved in off-market takeovers are also obliged to produce half- yearly reports for ASIC: ss 111AC-111AJ (definition of disclosing entities) and 320.

The information that is required to be disclosed on a half-yearly basis is similar to the information that is required to be disclosed in the annual reports outlined above: see ss 302-306.

[page 630]

Publicly listed companies In addition to the obligation to comply with the reporting requirements under the Act, companies that are listed on the Australian Securities Exchange (ASX) are also required to comply with the continuous and periodic disclosure obligations that exist under the ASX Listing Rules:10

continuous disclosure (noted above); and periodic disclosure: Chapter 4 of the ASX Listing Rules contains periodic reporting requirements for listed companies (including annual reports, half-yearly reports and quarterly reports).

As noted above, a breach of the ASX Listing Rules can lead to suspension or removal of the company from the ASX list, which would damage the company’s reputation and severely limit the company’s public fundraising opportunities.

Introduction to dividends

20.25

20.26

dividend: A monetary payment to a member as a reward for investing in the company and thus contributing to the company’s success.

Where a company trades successfully and achieves a profit, there are several ways for the company to deal with that profit. Companies often use profits to finance growth through investments or acquisitions. Alternatively, a company may choose to give all or, more likely, part of the profits to the members. There are various ways to give profits to members including an authorised capital reduction (for example, a share buy-back), or by way of a dividend payment. Dividend payments are important for both public and proprietary (that is, private) companies. For public companies, the payment of high dividends attracts investors to purchase shares in the company, which assists in maintaining (and hopefully increasing) the company’s share price. During the global financial crisis, dividend payments were cut by many public companies seeking to retain surplus funds to repay debt during times when credit markets remained tight.

For proprietary companies, the illiquid market for the company’s shares (because of the restrictions on public capital raising for proprietary companies) means that dividend payments are usually the only way for members to obtain financial returns from the business (because there is no ready market for their shares).

Companies limited by guarantee are not permitted to pay a dividend to members: s 254SA.

How are dividends paid?

The payment of dividends is regulated by the company’s constitution and/or replaceable rules (see Chapter 6), and by the Corporations Act (particularly Pt 2H.5). The corporate constitution will normally set out the process for, and any limitations on, the payment of dividends. It is not permissible for dividends to be paid

[page 631]

• • •

20.27

inconsistently with the requirements of the company’s constitution: BTR Nylex Ltd v Churchill International Inc (1992) 9 ACSR 361. The improper payment of a dividend can give rise to an action for insolvent trading (if the company is insolvent at the time of the payment), a breach of directors’ duties (such as the duty to act with care and diligence) or perhaps a breach of the capital reduction rules in Ch 2J.

Section 254U is a replaceable rule that provides the board of directors with the power to determine:

that a dividend is payable; when the dividend amount is due to be paid; and how the dividend will be paid (for example, in cash, shares or options).

The section also provides that interest does not accrue on dividend payments.

As a replaceable rule, it is important to remember that s 254U may be replaced by a different provision in the company’s constitution. In closely-held proprietary companies (for example, family companies) the constitution may provide that the consent of a particular party is required before a dividend can be determined.

Reforming s 254T Prior to 2010, s 254T and its predecessors had traditionally imposed a profits test for the payment of dividends. That is, a company could not pay a dividend otherwise than out of profits. During the global financial crisis many companies suffered asset write downs (such as property investment companies) which adversely affected their ‘profits’. Calls were made to the federal government to reform dividend laws to introduce an insolvency-based test (that is, a company could pay a dividend as long as the payment did not make the company insolvent). However, the federal government introduced laws with little consultation in mid-2010 which replaced the profits test previously in s 254T with an assets over liabilities test:11

Section 254T Circumstances in which a dividend may be paid

(1) (a)

(b)

(c)

(2)

A company must not pay a dividend unless: the company’s assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient for the payment of the dividend; and the payment of the dividend is fair and reasonable to the company’s shareholders as a whole; and the payment of the dividend does not materially prejudice the company’s ability to pay its creditors.

Note 1: As an example, the payment of a dividend would materially prejudice the company’s ability to pay its creditors if the company would become insolvent as a result of the payment.

Note 2: For a director’s duty to prevent insolvent trading on payment of dividends, see section 588G.

Assets and liabilities are to be calculated for the purposes of this section in accordance with accounting standards in force at the relevant time (even if the standard does not otherwise apply to the financial year of some or all of the companies concerned).

[page 632]

This new section seems innocuous; however, the determination of a surplus of assets over liabilities is to be made using accounting standards ‘at the relevant time’. This requires all companies to calculate asset and liability levels using accounting standards; however, the majority of companies are small proprietary companies that are not required to have audited accounts or to prepare financial statements so this obligation is particularly onerous on a large number of companies.

The requirement that the accounting standards be imposed at the relevant time for paying a dividend is problematic as dividends are typically determined in advance of payment. For large companies, there is usually a time gap between the finalisation of financial statements and the payment of dividends. The new wording seems to require the application of accounting standards at the time of payment in addition to the time when financial results are signed off. Which accounts could be used at the time of payment? Would the use of management accounts be sufficient? Would these need to be audited? There are many unanswered questions posed by these changes. Moreover, what will constitute material prejudice to members and fairness to the company’s members? If a company decides to refuse to pay a dividend in order to preserve cash this will benefit creditors, but may be unfair to members. In KGD Investments Pty Ltd v Placard Holdings Pty Ltd (2015) 110 ACSR 379; [2015]

20.28

VSC 712 it was held that borrowing money to pay a dividend and thereby increasing the leverage of the company was not of itself evidence of unfairness to creditors.

Furthermore, the new s 254T refers to the time ‘immediately before the dividend is declared’: s 254T(1)(a). This terminology will pose problems for many companies who do not have provisions in their constitutions that allow for dividends to be formally declared. Typically, dividends are simply determined by the company rather than declared. This is because a declaration of a dividend creates a debt under s 254V(2). The wording of the new s 254T means that all companies will need to insert the power to declare dividends in their constitution in order to pay dividends.

Prior law As noted above, prior to 2010 s 254T of the Corporations Act imposed a profits test for the payment of dividends. The former test was stated as a prohibition on companies paying dividends ‘otherwise than out of profits’. The concept of profits proved to be somewhat difficult to determine, and differences between law and accounting developed over time. The classic definition of profit was provided in Re Spanish Prospecting Co Ltd.

Re Spanish Prospecting Co Ltd [1911] 1 Ch 92 Court of Appeal (UK)

‘Profits’ implies a comparison between the state of a business at two specific dates usually separated by an interval of a year. The fundamental meaning is the amount of gain made by the business during the year. This can only be ascertained by a comparison of the assets of the business at the two dates.

Another notable description of the legal concept of profit for the purposes of paying dividends was given in Lee v Neuchatel Asphalte Co (1889) 41 Ch D 1 where it was said:

[page 633]

•

20.29

A dividend may be paid out of current annual profits, out of profits arising from the excess of ordinary receipts over expenses properly chargeable to the revenue account, provided there is nothing in the constitution prohibiting such an application.

Over time cases developed detailed rules concerning profit calculations and the availability of dividends:

the company’s profit and loss account must show a profit on the date that a dividend is declared (QBE Insurance Group Ltd v ASC (1992) 38 FCR 270); a company could justify a profit from gains in circulating capital (Ammonia Soda Company Ltd v Chamberlain [1918] 1 Ch 266); a company could justify a profit based on unrealised capital gains (Dimbula Valley (Ceylon) Tea Co Ltd v Laurie [1961] Ch 353); and a company could borrow money to pay dividends (QBE Insurance Group Ltd v ASC (1992) 38 FCR 270).

The amendments to s 254T remove from consideration these old principles of the profit rule and dividend payments and replace them with an asset-based test and requirements to be fair to members and not prejudice the company’s ability to pay creditors. As noted above, however, that does not mean that the new dividend laws are any clearer than the previous law.

Future reforms The reform of s 254T has caused considerable concern from corporate managers, accountants and lawyers. This led the federal government to announce a further consultation period for reviewing the operation of s 254T. The Treasury Department has released a draft Bill for consultation which proposes to replace the current s 254T with a rewritten (and longer) provision. The Corporations Legislation Amendment (Remuneration Disclosures and Other Measures) Bill 2012 proposed by the Labor Government to address the issue was ultimately not introduced into parliament. A change of government in 2013 led to an alternative reform proposal in Corporations Legislation Amendment (Deregulatory and Other Measures) Bill 2014 (Cth). This bill proposed to replace the current s 254T with:

254T Circumstances in which a dividend may be declared or paid

20.30

Declaration of dividends

(1) A company must not declare a dividend unless, immediately before the dividend is declared, the directors of the company reasonably believe that the company will, immediately after the dividend is declared, be solvent.

Note: For a director’s duty to prevent insolvent trading on payment of dividends, see section 588G.

Payment of dividends without declaration

(2) A company must not pay a dividend unless, immediately before the dividend is paid, the directors of the company reasonably believe that the company will, immediately after the dividend is paid, be solvent.

Note: For a director’s duty to prevent insolvent trading on payment of dividends, see section 588G.

(3) Subsection (2) does not apply to a dividend that is declared.

[page 634]

The proposed amendments would also clarify that payment of a dividend under the proposed s 254T can constitute a reduction of capital but only if it is an equal reduction: see proposed new s 254TA.

The Corporations Legislation Amendment (Deregulatory and Other Measures) Bill 2014 (Cth) was passed by the parliament on 19 March 2015, but the amendments to the dividend rule in s 254T and the new s 254TA were not included in the Bill that was introduced into parliament. At the time of writing it was unclear if or when the changes to the dividend rule would be introduced into parliament.

Dividend rights It is important to note that members have no general right to the payment of dividends. The directors are not bound to use the company’s profits to pay a dividend: QBE Insurance Group Ltd v ASC (1992) 38 FCR 270. The mere failure to pay a dividend will not ordinarily amount to oppression of the members: see Chapters 12 and 19. It is possible that the company may bind itself contractually to pay a dividend: Wambo Coal Pty Ltd v Sumiseki Materials Co Ltd (2014) 101 ACSR 643; [2014] NSWCA 326 (constitution

•

20.31

and shareholders’ agreement required company to pay a dividend to its preference share holder).

Why might a company decide not to pay a dividend if sufficient funds are available? What else could a company use those funds for?

Where dividends are payable, s 254W provides rules relating to equal treatment concerning members of the same class of shares in a company with respect to dividend rights. Section 254W(2) provides directors of proprietary companies with more flexibility by stating that ‘the directors may pay dividends as they see fit’. It should be noted, as stated above, that the payment of dividends may also be prescribed by the company’s constitution. In addition, Pt 2F.2 provides protection for the class rights of classes of shareholders. Thus, if the company wanted to alter the dividend rights of a particular class of shares, such as preference shares, it could only do so by complying with the requirements in Pt 2F.2:12 see 11.6.

call: a request by the company for the members to pay some or all of the unpaid price of their shares.

Members of a class of shares in a no-liability company are generally not entitled to a dividend distribution where a call has been made on their class of shares and the call remains unpaid.

Incurring a debt In Chapter 18 the duty of company directors to prevent the company from incurring a debt that leads to, or is incurred during, the company’s insolvency, was considered. Given the serious consequences of insolvent trading, it is therefore important to be able to determine when a company ‘incurs a debt’ in relation to a proposed dividend. Under s 254V, the time when a debt is incurred in relation to a proposed dividend payment depends on whether the company’s constitution has express provisions providing for the declaration of dividends. If the company’s constitution does contain

20.32

[page 635]

such a provision, then s 254V(2) provides that a debt will be incurred by the company when the dividend is declared.13

If the company does not have such a constitutional provision, then the debt is only incurred when the time for payment (as specified in the declaration) arises: s 254V(1). It is interesting to note that s 588G(1A) provides for a slightly different outcome with respect to insolvent trading. For the purposes of the insolvent trading prohibition, where the company does not have an express constitutional provision for the declaration of dividends, then the debt is only incurred when the dividend is actually paid.

interim dividend: in some situations a company may wish to pay a dividend before the end of the financial year which is called an interim dividend.

The declaration of an interim dividend does not, however, create a debt owing by the company to the members: Industrial Equity Ltd v Blackburn (1977) 137 CLR 567. Interim dividends are discussed further below.

Declaration of dividends As noted above, the rules relating to a declaration of a dividend are usually provided for in a company’s constitution. The constitution will ordinarily provide that a company must declare (that is, announce to the members) that a dividend is payable to the members before the dividend is due to be paid.

If the company does not have such a constitutional provision, then s 254U (a replaceable rule) provides directors with the power to pay a dividend without a prior declaration. Before the enactment of s 254U, it was common for companies to refer dividend payments to the general meeting of the members for approval. It is now far more common for directors to declare what dividend is payable without requesting approval from the members. As noted above, whether or not a company declares a dividend will be significant in determining when the company incurs a debt with respect to the payment of that dividend.

(a)

(b)

2. (a)

(b)

20.33

20.34

Example of a resolution declaring final dividend:14

Resolved that the following final dividends are declared out of the profits of the company for the year ended 30 June 2017:

a dividend of 10% per share amounting to $2 in respect of preference shares (franked as to 100%); a dividend of 5% per share amounting to $1 in respect of the ordinary shares (franked as to 100%).

Resolved further that: the declared dividends be paid to members on the Register of Members as at 30 June 2017 in proportion to their respective entitlements; and the dividend be paid by 1 July 2017.

Interim dividends An interim dividend is a dividend payment based on the anticipated profit that will be disclosed in the annual accounts which have not been finalised at the time of the interim dividend: Marra Developments Ltd v BW Rofe Pty Ltd [1977] 2 NSWLR 616. The

[page 636]

directors may withdraw an interim dividend at any time before payment is due: s 254V; Brookton Co-operative Society Limited v FCT (1981) 147 CLR 441. As a result, members are unable to enforce the payment of an interim dividend before the payment is actually due.

Final dividends A final dividend is a dividend that is payable on the basis of profits disclosed in the company’s finalised annual accounts as presented to the members in the annual general meeting.

Prior to the introduction of s 254U (which provides directors with the power to pay dividends without requiring a declaration), the main difference between an interim and a final dividend was that a debt was

20.35

20.36

20.37

ordinarily incurred when a final dividend was declared by the board: Industrial Equity Ltd v Blackburn (1977) 137 CLR 567. As noted above, reforms to s 254T suggest that all dividends will need to be declared.

Where the directors declare a final dividend without specifying a date for payment, subject to the constitution and s 254U, the declaration creates an immediate debt due to the members: Potel v IRC [1971] 2 All ER 504.

Payment Once a dividend has become due and payable, the actual method of payment may be determined by the board of directors under s 254U, which is a replaceable rule, or in accordance with the company’s constitution. Section 254U provides examples of different payment methods including the payment of cash, the issue of shares, the grant of options or the transfer of assets.

Dividend reinvestment plans A dividend reinvestment plan (or DRP) refers to the situation where a member accrues the right to a dividend payment, but rather than taking the amount as a cash payment, the amount owing to the member is credited to the member’s name in a company account which is then used by the member at a later date to purchase more shares in the company: see BTR Nylex Ltd v Churchill International Inc (1992) 9 ACSR 361. Dividend reinvestment plans offer tax and brokerage savings to the member as well as normally offering the shares at a discount to the member. They are commonly used by public companies listed on the ASX.

Invalid dividend payments

Where the board of directors proposes to pay dividends without conforming to the Corporations Act or the company’s constitution, a number of possible consequences may arise:

the directors will most likely be in breach of their statutory and

3. 4.

common law duties of care owed to the company;

[page 637]

the company will be in breach of the authorised capital reduction provisions in Pt 2J.1; the directors may be forced to pay the invalid dividend themselves; or a party whose interests are affected by the improper dividend payment may seek to have the payment prevented by seeking a statutory injunction under s 1324.

A member who receives a dividend when they knew or ought to have known that the directors were not lawfully able to distribute the payment will be liable to return the money to the company, as the decision in Moxham v Grant demonstrates.

Moxham v Grant [1900] 1 QB 88 Court of Appeal (UK)

Facts: Directors of a company engaged in an unauthorised capital reduction by distributing a dividend using capital rather than profit. The directors obtained the shareholders prior agreement to the dividend distribution. The company was later wound up, and the liquidator obtained an order from the court that the directors repay the money to the company.

Decision: The directors were entitled to be indemnified by the members in respect of the repaid money.

9. 10.

[page 638]

Revision Questions

In what circumstances may a company not lodge an annual report with ASIC? Explain the reporting requirements under the Corporations Act that public companies have with respect to their members. What role do the disclosure obligations imposed under the ASX Listing Rules play in monitoring the financial performance of publicly listed companies? In what circumstances may a partner in an audit firm take on a position as a company officer in an audit client? In what circumstances may a company auditor owe a duty of care to non-audit clients? Outline the continuous disclosure obligations under both the Corporations Act and the ASX Listing Rules, including the range of sanctions available for contravention of those obligations. What role does ASIC play in enforcing the reporting obligations under the Corporations Act? How is the materiality of information determined for continuous disclosure laws? How are dividends declared? What are the potential consequences for directors who pay a dividend other than by complying with s 254T?

Problem Question Azure Ltd is a public company listed on the ASX and is involved in manufacturing and distributing drugs for medical treatment. The company has recently raised $25 million from

a prospectus share offering through the ASX, with a stated purpose of the capital raising to provide sufficient funds to expand the company’s manufacturing operations. However, the expansion project suffers from construction delays which substantially increase the costs of construction to $50 million. The company obtains a bridging loan from its main bank but does not disclose this information to the market on the basis that the information regarding construction costs are commercial in confidence.

The company is also mindful of the expectations of its investors and decides to pay a dividend based on the level of its current assets even through it has had significant asset write downs in the current financial year.

Advise the company as to its potential liabilities under the Corporations Act 2001 (Cth) and the ASX Listing Rules.

Guidelines for Answering Problem Questions

When answering a problem question concerning legal issues relating to auditing and/or disclosure requirements, we suggest that the following method may be helpful:

It is important to determine what legal issues the question involves: are there auditing issues, disclosure issues and/or dividend payment issues? If the question relates to auditing requirements, then the issue may concern the validity of the auditor’s appointment, the independence of the auditor or the sufficiency of the

[page 639]

auditor’s actions. The first two categories are largely statute-based, while the last (that is, performing the audit) may be concerned with either the auditor’s duties to the client (in contract, tort or under the Australian Consumer Law) or to third parties. It will usually be difficult to establish auditor liability to third parties. If the question is concerned with the auditor’s independence, then you should consider the range of activities carried on by the

auditor and his or her firm and how these may give rise to a conflict. If the question concerns the disclosure obligations, then you should determine whether the company is listed on the ASX. If it is, then the ASX Listing Rules will also be relevant. You should also determine whether the company is a disclosing entity for the purposes of Pt 1.2A. After deciding these issues, you should then work through the continuous disclosure obligations in either s 674 or s 675 (depending on the entity involved). Assess whether the information is material, whether it has already been disclosed to the ASX or ASIC and whether the carve outs in ASX LR 3.1A apply. Finally, work through what the possible consequences may be (for example, compensation orders). If the question concerns dividend payments, determine whether the company can pay a dividend by working through the elements in s 254T. Assess the potential effect of the dividend payment on members and creditors. Consider whether the company has sufficient powers in its constitution to pay a dividend and then discuss how the dividend can be paid (or explain why it cannot be paid).

Wang and John declare a ‘special dividend’ that is only payable to shareholders who are also executive managers in the company. However, Erin argues that no dividend should be able to be paid because SCPL is insolvent and paying the dividend will prejudice the interests of creditors and other members. Wang produces an auditor’s report from DodgyBros Accountants, who certify in an unqualified auditor’s report that the company can continue as a going concern for the next 12 months. This is based on revaluing the business’ goodwill and intellectual property to more than $20 million. DodgyBros has no basis for this revaluation, they simply relied on the information provided by Wang.

What are the potential consequences under the Corporations Act of paying the dividend? Can Erin stop the dividend being paid?

What action (if any) could be taken against DodgyBros Accountants for their audit of SCPL and Pop Up?

Further Reading

Academic Journals S Alevras and J du Plessis, ‘The Payment of Dividends: Legal

Confusion, Complexities and the Need for Comprehensive Reform in Australia’ (2014) 32 Companies and Securities Law Journal 312.

H Anderson, ‘Reliance and Assumption of Responsibility Establishing Auditor’s Duty of Care’ (1996) 14 Company and Securities Law Journal 374.

T Bednall and P Hanrahan, ‘Officers’ Liability for Mandatory Corporate Disclosure: Two Paths, Two Destinations?’ (2013) 31 Company and Securities Law Journal 474.

J Cheyne, ‘Babcock and Brown’s Last Hurrah: The Latest on Dividends and Continuous Disclosure’ (2016) 34 Company and Securities Law Journal 543.

[page 640]

A Desai and M Ramsay, ‘The Use of Infringement Notices by ASIC for Alleged Continuous Disclosure Contraventions: Trends and Analysis’ (2011) 39 Australian Business Law Review 260.

C Di Lernia, ‘Odyssey Through a Forest? Continuous Disclosure and the Need for Practical Guidance’ (2012) 40 Australian Business Law Review 424.

G George, ‘Auditor Independence — Who Guards the Guardians? — A Critique of the Ramsay Report into the Independence of Auditors’ (2001) 13 Australian Journal of Corporate Law 327.

G Golding and N Kalfus, ‘The Continuous Evolution of Australia’s Continuous Disclosure Laws’ (2004) 22 Company and Securities Law Journal 385.

S Lombard and J Viven, ‘Continuous Disclosure and Good Faith’ (2014) 32 Company and Securities Law Journal 419.

D McFarlane, ‘Materiality in Corporate Continuous Disclosure:

Historical Uncertainty, Current Challenges and Future Opportunities’ (2015) 33 Company and Securities Law Journal 7.

M Nehme, M Hyland and M Adams, ‘Enforcement of Continuous Disclosure: The Use of Infringement Notice and Alternative Sanctions’ (2007) 21 Australian Journal of Corporate Law 112.

G North, ‘A Call for a Bold and Effective Corporate Disclosure Regulatory Framework’ (2010) 28 Company and Securities Law Journal 331.

G North, ‘Public Company Communication, Engagement and Accountability: Where Are We and Where Should We Be Heading?’ (2013) 31 Company and Securities Law Journal 167.

J Overland, ‘Insider Trading, Materiality and the Reasonable Person: Who Must Be Influenced for Information to Have a Material Effect?’ (2017) 45 Australian Business Law Review 213.

I Ramsay, ‘Enforcement of Continuous Disclosure Laws by the Australian Securities and Investments Commission’ (2015) 33 Company and Securities Law Journal 196.

E Raykovski, ‘Continuous Disclosure: Has Regulation Enhanced the Australian Securities Market?’ (2004) 30 Monash Law Review 269.

D Reichel, ‘Continuous Disclosure in Volatile Times’ (2010) 28 Company and Securities Law Journal 84.

A Zandstra, J Harris and A Hargovan, ‘Widening the Net: Accessorial Liability for Continuous Disclosure Contraventions’ (2008) 22 Australian Journal of Corporate Law 51.

Professional Journals R Austin and B Smith, ‘Analyst Briefings: the Newcrest Case’ (2014) 66

Governance Directions 425.

Practitioner Works H A J Ford, R P Austin and I Ramsay, Ford’s Principles of Corporations

Law, LexisNexis, Australia, looseleaf and online, Chs 10, 18.

6. 7. 8.

10.

11.

12. 13. 14.

You will find useful study resources, including quizzes for each chapter, when you go to <http://learning.lexisnexis.com.au>. The quiz is a great tool to help you self-test your knowledge.

Professor Ramsay is the Director of the Centre for Corporations and Securities Regulation at the University of Melbourne and a co-author of Ford’s Principles of Corporations Law. Registered company auditors are also required to lodge annual reports of their activities with ASIC: s 1287A. See further H Anderson, ‘Auditors’ Liability: Is Misleading or Deceptive Conduct an Alternative to Negligence?’ (1999) 17 Company and Securities Law Journal 350. As to the operation of these provisions see generally: Hunt & Hunt Lawyers v Mitchell Morgan Nominees Pty Ltd (2013) 247 CLR 613; [2013] HCA 10; Selig v Wealthsure Pty Ltd (2015) 255 CLR 661; [2015] HCA 18. Compare ASIC v Macdonald (No 11) (2009) 71 ACSR 368; [2009] NSWSC 287, where the court noted that information disclosed in ASIC filings was not readily observable as ordinary investors would have had difficulty locating the information as the relevant company changed its name several times. This point was not dealt with expressly in the appeal: James Hardie Industries NV v ASIC (2010) 81 ACSR 1; [2010] NSWCA 332. Earglow Pty Ltd v Newcrest Mining Ltd [2016] FCA 1433. ASIC v Sino Australia Oil and Gas Ltd (in liq) (2016) 115 ACSR 437; [2016] FCA 934. See further A Hargovan, ‘Foreign Directors of Australian Companies Put on Notice: No Leniency for Ignorance of Duties’ (2017) 69 Governance Directors 37. See A Desai and I Ramsay, ‘The Use of Infringement Notices by ASIC for Alleged Continuous Disclosure Contraventions: Trends and Analysis’ (2011) 39 Australian Business Law Review 260; M Nehme, M Hyland and M Adams, ‘Enforcement of Continuous Disclosure: The Use of Infringement Notice and Alternative Sanctions’ (2007) 21 Australian Journal of Corporate Law 112. See also ASIC RG 73: Continuous Disclosure Obligations: Infringement Notices, June 2012. The ASX Listing Rules may be accessed through the ASX website: <http://www.asx.com.au>. See S Alevras and J du Plessis, ‘The Payment of Dividends: Legal Confusion, Complexities and the Need for Comprehensive Reform in Australia’ (2014) 32 Companies and Securities Law Journal 312. Protection for public company shareholders is also given in ASX Listing Rule 6.10. Section 588G(1A) reinforces this position. This sample precedent was adapted from Australian Encyclopaedia of Forms and Precedents, LexisNexis Butterworths, Australia, 2007, Corporations: Dividends, Pr 35.180 (written by J Hambrook).

[page 641]

Financial Services, Managed Investment Schemes and

Financial Markets

CHAPTER 21 Financial services regulation

Licensing of financial service providers AFS licence Compliance with AFS licence

Disclosure obligations Important disclosure documents What are the consequences for failing to disclose? Licensed financial markets

Managed investment schemes Registration requirements Responsible entity Scheme constitution Compliance plan Compliance committee

Winding up schemes ASIC’s regulatory powers

Market misconduct Criminal breaches Civil misconduct

[page 642]

Financial Services, Managed Investment Schemes and Financial Markets

Learning Objectives After completing this chapter you should be able to:

Provide a broad outline of the system for regulating the financial services industry.

Explain the rationale for financial services reform.

Define financial products and financial services.

Outline the licensing regime for financial services providers and financial markets under Ch 7 of the Corporations Act 2001 (Cth).

Summarise the main regulatory requirements for operating a managed investment scheme.

Explain the scope of provisions relating to market misconduct, including insider trading, misleading or deceptive conduct and unconscionable conduct.

Outline the possible consequences for breaching the market misconduct provisions in Ch 7 of the Corporations Act.

Key Cases

ASIC v Chase Capital Management Pty Ltd (2001) 36 ACSR 778; [2001] WASC 27

ASIC v National Exchange Pty Ltd (2005) 56 ACSR 131; [2005] FCAFC 226

National Exchange Pty Ltd v ASIC (2004) 49 ACSR 369; [2004] FCAFC 90

21.1

Key Sections

Corporations Act 2001 (Cth) ss 601ED, 601EE, 761A, 763A, 766A, 991A, 1041H, 1043A

[page 643]

Introduction

This chapter provides an introduction to the laws regulating the financial services industry, which includes the concepts of managed investment schemes and the various licensed financial markets that operate in Australia. In addition, this chapter will discuss the regulation of managed investment schemes and offences dealing with market misconduct.

These are areas that have involved considerable scrutiny in recent years. In financial services, the Financial System Inquiry (FSI) was released in late 2014, with the Government responding in October 2015. The FSI final report made 44 recommendations, covering a broad range of areas including banking, superannuation, corporate fundraising and regulatory mandates. The regulation of financial services providers remains a hot topic with regular reforms proposed to improve disclosure to investors and improve the independence of advisers and standards of advice.

In the area of managed investment schemes regulation, CAMAC suggested fundamental reforms in 2014, but CAMAC was then disbanded and Treasury has not responded to the suggested reforms, although Treasury has released proposals for a new corporate collective investment vehicle regime.1

Financial services regulation

The regulation of the financial services industry has become a complex area of law that has many provisions contained in the Corporations Act, as well as detailed provisions in Ch 7 of the Corporations Regulations 2001 (Cth). In addition to statutory provisions, there are numerous policy

• • •

21.2

21.3

statements and guidelines produced by the regulator, the Australian Securities and Investments Commission (ASIC). For many businesses operating in the financial services industry, there will also be further regulation from other federal agencies such as the Australian Prudential Regulation Authority, the Australian Taxation Office and the Reserve Bank of Australia.

The regulatory framework in Ch 7 centres around a detailed licensing regime for:

financial service providers; issuers of financial products; and financial markets.

In addition, Pts 7.7 and 7.9 of the Act impose uniform disclosure rules relating to the provision of financial services, and the supply of financial products.

Licensing of financial service providers The Corporations Act imposes a mandatory requirement that all providers of financial services must have an Australian Financial Services licence (AFS licence) which is regulated under Pt 7.6 of the Act. There is, however, a small list of exceptions from this requirement found in s 911A(2). In addition, ASIC may grant specific exemptions by

[page 644]

class order: this provides relief from certain requirements under the Act for specific activities or transactions.

passing what is called a class order. It is a criminal offence under s 911A to carry on a financial services business in Australia without the AFS licence.

Providing a financial service This is defined in s 766A and includes various activities including

21.4

providing financial product advice; dealing in a financial product; or making a market for a financial product. Each of these concepts is then given an expanded definition in ss 766B, 766C and 766D. Given the introductory nature of this chapter, attention is simply drawn to the relevant definitions, and we will not go into the very complex and detailed nature of these definitions.2

financial product: see generally ss 762A-765A. A facility through which a person makes a financial investment, manages financial risk or makes non-cash payments.

AFS licence The AFS licence is issued by ASIC and contains specific authorisations that relate to the activities of the financial services business, with the result that the licensee (that is, the holder of the AFS licence) is permitted to carry on business in the areas covered by the authorisations. The AFS licence will also specify whether the financial services business is providing services for retail or wholesale clients (these terms are explained below).

A financial services business that provides advice on financial products is known as a ‘providing entity’. There are two types of providing entities:

AFS licensee — the licensee is a provider of financial services licensed under the Corporations Act by ASIC to operate a financial services business. Employees, directors and agents that are connected with the AFS licensee are representatives, but are limited to the authority that is stated in the AFS licence. Authorised representative — under s 916A, an AFS licensee can authorise a representative, by written order, that they may provide financial services or advice under their licence, on behalf of the licensee. The financial services specified may be for some, or all of the financial services, covered by the licence. The licensee must then notify ASIC, which maintains a register of licensees and their authorised representatives. It should be noted that an authorised representative may only be authorised to give advice about a limited range of financial products, including products issued by a particular company. This became an issue in relation to the marketing of agricultural managed investment schemes (MIS) for tax purposes by

21.5

•

• • • •

• •

•

accountants. Many accountants were authorised representatives of large MIS operators. such as Great Southern and Timbercorp, but were only authorised to sell their particular products. Investors rely on their accountants to give them tax advice and may have believed that the ‘authorised representative’ status meant that the accountants were qualified financial advisers. At the time, there was virtually no regulation of the terms ‘financial adviser’ and ‘financial planner’, although this has now been rectified with the introduction of legislation restricting the use of these terms.3

All AFS licensees and their authorised representatives must be licensed before they start operating or operating within an organisation that deals in financial services.

[page 645]

How do you apply for an AFS licence? The AFS licence can be applied for online or in written form through ASIC, under s 913A. ASIC must grant the AFS licence if the conditions of the application have been met, including the satisfaction of the s 912A obligations and any conditions imposed by ASIC. The s 912A general obligations for all AFS licensees include the need to:

do all things necessary to ensure that the financial services covered by the licence are provided efficiently, honestly and fairly; avoid conflicts of interest; comply with all the restrictions of the licence; comply with all the financial services laws; have adequate financial, technological and human resource capabilities to provide the financial services; maintain the competence to provide those financial services; ensure that its representatives are adequately trained, and are competent to provide those financial services; have a dispute resolution system (if the services are provided to retail clients); and have adequate risk management systems.

21.6

Any breach or potential breach of a licensee’s obligations laid down under s 912A or s 912B must be reported to ASIC as soon as practicable, but no more than 10 business days following the licensee gaining knowledge of the breach or potential breach under s 912D. Should a licensee fail to make such a report, they may face a penalty of 50 penalty units ($10,500) or imprisonment for one year, or both.

ASIC may also impose specific conditions under s 914A on a particular licence depending on the individual circumstances of the business entity facts and the type of financial services that the licensee is licensed to carry out.

Compliance with AFS licence All holders of an AFS licence must comply with the relevant provisions contained in Ch 7 of the Corporations Act, as well as any conditions attached to the specific AFS licence that has been issued by ASIC. AFS licence holders are also responsible for the actions of their authorised representatives: ss 917B and 917C.

The consequences for not complying with the Corporations Act, or the AFS licence requirements, could be severe and can include ASIC suspending or cancelling the AFS licence. Once an AFS licence has been suspended or cancelled, ASIC may make a banning order against a person or a company prohibiting that person or company from providing financial services and from holding another AFS licence: s 920A. This effectively prevents the person or company from carrying on a financial services business.

Here are some interesting statistics on licensing under Ch 7 of the Corporations Act.

[page 646]

Table 21.1 AFSL Numbers

Year Number of Licences

2002 35

21.7

2003 626

2004 3853 (this was the final year of the transitional arrangements) 2005 4135 2006 4415 2008 4768 2010 4874 2012 3343 2014 3391 2015 3690

Disclosure obligations

All businesses providing financial services, whether an AFS licensee or as an authorised representative of an AFS licensee, must be aware of their legal obligations in providing advice. Legal obligations in relation to the provision of advice may arise either under the common law or under Ch 7.

The two most important common law duties are:

to take reasonable care, diligence and competence in preparing the advice so as to avoid being sued for the tort of negligence or for breach of contract; and to avoid any conflicts of interest that may affect the advice being provided and this is best satisfied by full and frank disclosure.

In addition, all AFS licensees have a broad statutory obligation under s 912A to act ‘efficiently, honestly and fairly’. Each individual AFS licence has specific conditions that must be complied with, as well as various consumer protection requirements under the Australian Securities and Investments Commission Act 2001 (Cth). One of the most important obligations is avoiding engaging in misleading or deceptive conduct in terms of the advice or the production of a misleading, defective disclosure document (such as a financial services guide or a statement of advice). The civil consequences of misleading of deceptive conduct are discussed below.

21.8

All AFS licensees are required, as a condition of their licence, to have appropriate dispute resolution arrangements in place to deal with potential client disputes. In addition, AFS licensees that deal with retail clients are required to have adequate compensation arrangements in place.

[page 647]

The Limits of Disclosure A large proportion of the rules in Ch 7 are based on the primacy of disclosure. Chapter 7 requires product issuers and providers of financial services to give investors large amounts of information. It is common for Product Disclosure Statements (PDS) to reach more than 150 pages. It must be queried whether this information is actually useful. Sophisticated investors probably do not need the information as they already have it through monitoring existing market disclosure, while unsophisticated investors may not be able to fully understand the information that is provided. The recent collapses of several large debenture issuers (including Banksia in rural Victoria) have highlighted that simply disclosing the nature of investment products may not be sufficient for many investors. In the case of Banksia, the company borrowed from investors by issuing debentures. Banksia then lent the investors’ money to various projects, including property developments. Banksia kept only a very small proportion of these funds as a capital reserve (less than 5%) and when several property developments failed it collapsed. The risks involved in Banksia’s business were plainly stated to investors, but the query is whether they understood the full scope of those risks and the risks that they were taking by purchasing the financial products.

The Financial System Inquiry Final Report recommended that ASIC be given a product intervention power that would allow it to ban certain financial products from being sold to types of investors. The report also recommended that disclosure documents given to investors could be improved.

Important disclosure documents One of the key recommendations of the Wallis Inquiry was for a more consistent system of disclosure about financial products and financial services so as to allow investors to make more informed choices about investments. The obligation to provide a detailed document to potential investors and clients of financial services businesses is generally only applied to ‘retail clients’ (commonly referred to as ‘mum and dad investors’) rather than the professional and more sophisticated ‘wholesale clients’ which includes institutional investors (such as banks and

superannuation funds). The underlying philosophy is that wholesale clients are seen as being able to protect themselves and therefore do not require extensive disclosure (they will usually have their own in-house analysis). Retail and wholesale clients are defined in ss 761G and 761GA.

The range of mandatory disclosure documents for retail clients fall into three categories:

Financial services guide — if a retail client makes an enquiry as to a providing entity’s financial services, then the client must be provided with a financial services guide or more commonly referred to as an ‘FSG’. There are various exceptions noted in s 941C. The major disclosure obligations relating to FSGs are set out in ss 942B and 942C, the Corporations Regulations and ASIC regulatory documents. Statement of advice — if the retail client has sought personal financial advice (rather than general advice), then the providing entity is required to give a statement of advice, or more commonly referred to as an ‘SoA’. The major disclosure requirements relating to SoAs are set out in ss 947B and 947C, the Corporations Regulations and ASIC regulatory documents. Product disclosure statements — all issuers of financial products, including authorised representatives, must provide retail clients with a product disclosure statement (more often known as a PDS) before the sale of the product is

[page 648]

completed. The major disclosure requirements relating to PDS are set out in s 1013D, the Corporations Regulations and ASIC regulatory documents.

Parts 7.7 and 7.9 of the Corporations Act provide detailed requirements as to what information must be included. These documents frequently run for more than 100 pages! The rationale for such extensive disclosure obligations is that the information will explain the nature and scope of the product or service and will allow investors to choose the most appropriate investment for them. Of course, this rests on the assumption that all of the information is:

1. 2. 3.

•

21.9

relevant for all investors; expressed in language that can be understood by all investors; and most importantly, actually read by investors!

Is there a danger of too much information being disclosed to investors? Do you think that retail investors read all of the information that is required to be disclosed under Ch 7 of the Corporations Act? Where do you think retail investors get their investment information from?

Disclosure and the FSI Report The Financial System Inquiry Final Report recommended that the government ‘Remove regulatory impediments to innovative product disclosure and communication with consumers, and improve the way risk and fees are communicated to consumers’ (recommendation 23). This recommendation is based on product issuers taking advantage of a broader range of disclosure measures (including the use of social media tools) to inform potential investors about their financial products.

At present Ch 7 of the Corporations Act prescribes detailed disclosure documents which may provide too much information and/or information in a form that is not suitable for all potential investors. Page 214 of the Final Report states:

Mandated product disclosure requirements, which set form and content requirements, are impeding issuers from developing innovative approaches to communicating disclosure information. With technological developments, such as those enabling online financial services, consumer expectations have changed, but the current regime inhibits the ability of firms to meet these expectations.

The Inquiry supports the need for mandated product disclosure, which is necessary to inform the market and to support issuers and consumers in setting out the terms of their contract. However, the Inquiry sees scope to provide issuers with more flexibility to communicate mandated disclosure to better engage and inform consumers.

Moves to improve and simplify disclosure have already been made with Simple Corporate Bonds introduced in 2014 (see ss 713A-713E, discussed in Chapter 10).

What are the consequences for failing to disclose? There are a number of legal consequences for the producers of the disclosure documents discussed above, including the FSG, SoA and PDS. The AFS licensee or the authorised representative can be held liable both under the civil law and the criminal law for failing to provide a disclosing

document as well as including false or misleading information.

[page 649]

There are specific criminal offences, such as failing to provide a disclosure document by a providing entity in s 952C. There are further offences of giving a disclosing document while knowing it to be defective (s 952D) or giving the defective document without knowing it to be defective: s 952E. If the FSG does not comply with the legal requirements it is an offence (s 952I) and if it relates to an SoA it is a separate offence: s 952J. In respect of a PDS there are similar criminal offences found in s 1021C.

Where a retail client suffers a loss or damages, they may claim under s 953B in respect of an FSG/SoA. The court has additional powers to make orders, such as the return of money or payment of interest under s 953C. In respect of a PDS, there are remedies for persons acquiring the financial product under the defective PDS in s 1016C. Civil liability may arise for misleading and defective statements under s 1022B. ASIC has powers to make stop orders in respect of a PDS (s 1020E) and, on application, may make exemptions or modifications to the document: s 1020F.

The Future of Financial Advice The federal government has sought to overhaul the way that financial advice is regulated in Australia through its reforms ‘The Future of Financial Advice’ or FOFA as they are commonly known. These reforms primarily target certain types of remuneration practices by prohibiting certain arrangements. The reforms also include a new overriding obligation to act in the ‘best interests of the client’: s 961B. The provisions in s 961B set out a number of steps that must be complied with in order to satisfy the new best interests test. The new rules cannot be contracted out of by the parties: s 960A.

Licensed financial markets

financial market:

21.10

this is defined under s 767A as a facility through which offers to acquire or dispose of financial products are regularly made or accepted.

For many years, the Australian Securities Exchange (ASX) and its associated bodies provided the dominant markets for financial products (particularly shares, options, debt securities and derivatives). Indeed, so entrenched was the ASX that the previous version of Ch 7 of the Act contained specific rules relating to the ASX. Therefore, one key initiative of the FSR amendments in 2001 was to expand the regulatory scope to include the possibility that other financial markets would develop in competition to the ASX.

Part 7.2 of the Corporations Act now provides for a uniform system of licensing of financial markets, with the ASX being merely one of the financial markets licensed to operate in Australia (although remaining the biggest and most well-known financial market).4 Similarly, Pt 7.3 of the Act provides for uniform licensing of clearing and settlement facilities, which are the bodies that process the transfer of ownership (and payment for) financial products traded on licensed financial markets.

All Australian market operators must hold a financial markets operating licence under s 791A, unless exempt from this requirement. A body corporate may apply for an Australian market licence by lodging an application with ASIC: s 795A.

In similar fashion to holders of an AFS licence, holders of a market licence have a variety of obligations to abide by under their licences (set out in s 792A). In general, licensees are required to do all things necessary to ensure that a market is fair, orderly

[page 650]

and transparent. They must comply with the conditions of their licence, have a self-imposed regulation system or employ someone to regulate their market activities, and have sufficient resources to operate the market sufficiently and with the correct supervisory structure. In addition, there are requirements relating to compensation for investors (Pt 7.5), and

21.11

21.12

the licensed market’s internal operating rules must comply with the statutory standards set out in the Act and the Regulations.

ASIC is responsible for the monitoring and enforcement of financial markets and market participants.5

Managed investment schemes

Managed investment schemes (MIS) are collective investment vehicles that allow investors to pool their funds under the direction of an investment manager. Managed investment schemes mainly relate to financial assets, but may also include primary production schemes, time- sharing arrangements and property and mortgage schemes. Since the FSR amendments in 2001, investments in managed investment schemes have been classified as ‘financial products’ and therefore fit within the disclosure and licensing requirements of Ch 7, outlined above.

Section 9 of the Act defines a managed investment scheme as either a time-share scheme or a scheme where the investors pool their money collectively in return for benefits (or potential benefits) produced by the scheme and do not retain the day-to-day control over its use.

The definition of a ‘managed investment scheme’ in s 9 also provides a number of exceptions that are not classified as MIS, including partnerships, franchises and superannuation funds.

Registration requirements Where a collective investment fits within the definition of a managed investment scheme under s 9, the main consequence is that it will need to be registered with ASIC. Section 601ED requires that a MIS that has more than 20 members, or was promoted by a person in the business of promoting MIS, must be registered.

When applying for registration of an MIS, the promoter must provide the following documents to ASIC (s 601EA(4)):

• • •

the scheme’s constitution; the scheme’s compliance plan; and statements by the responsible entities’ directors that the compliance plan and constitution comply with various requirements under Ch 5C.

Clearly then, the impact of registering an MIS is that the operator of the scheme must comply with the numerous requirements of Ch 5C, which imposes substantial

[page 651]

compliance costs. This, however, is deemed necessary in the interests of protecting investors in MIS.

On registration of the entity, ASIC will supply the scheme with an Australian Registered Scheme Number (ARSN). This number is similar to the registration number that is given to newly formed companies — the Australian Company Number (ACN). The ARSN is required to be placed on any document that will be submitted with ASIC in relation to the scheme: s 601EC.

It has been a problem in recent years that promoters of managed investment schemes have attempted to resist registering their schemes by keeping their member numbers below 20. However, the practice of members holding issues on trust for other members has been prohibited by s 601ED, which ensures that any members that are members through trust holdings are counted within the membership quorum. Once a managed investment scheme is registered, it will be considered a financial product and thus regulated under the disclosure and licensing provisions in Ch 7.

Where a managed investment scheme fails to register its schemes, ASIC, a member of the scheme or the person operating the scheme may apply to the court to have the scheme wound up: s 601EE.

In addition, operators of unregistered schemes may be fined a maximum of 200 penalty units under s 601ED(5) or jailed for up to five years (or

21.13

both). Corporations conducting unregistered schemes may attract five times this with up to 1000 penalty unit fines.

ASIC v Chase Capital Management Pty Ltd (2001) 36 ACSR 778; [2001] WASC 27 Western Australian Supreme Court

Facts: Four companies operated several ‘investment syndicates’ through which investors contributed money to purchase shares in one of two investment clubs. Members of the clubs were given the ‘opportunity’ to invest in various ventures proposed by each club.

The clubs acted as the conduit for the investments, and arranged the investments for the members of each club. None of the clubs was registered as a managed investment scheme with ASIC.

Issue: Should the syndicates be wound up for being illegal unregistered managed investment schemes?

Decision: The investment schemes were operating in contravention of s 601ED(5) because they were not registered. The schemes fit within the definition of a ‘managed investment scheme’ as they involved the pooling of money paid by investors to receive the rights to benefit from the scheme profits in the context of the investors not maintaining day-to-day control over how their money was used.

It was held that the exercise of the court’s discretion to wind up the scheme involved similar considerations as in a winding up of a company on the just and equitable ground under s 461(1)(k). The court considered that it was in the public interest to wind up the scheme as there had been regular breaches of investor protection provisions, in particular, the offering of securities without a prospectus.

[page 652]

Responsible entity All managed investment schemes must be controlled by a responsible entity (RE). The RE is liable to scheme members for any loss or damage resulting from contravention of Ch 5C (s 601MA) and it holds the scheme property in trust for the benefit of the scheme members: s 601FC(2).

The RE must be a public company that holds an ABN and an Australian Financial Services licence which allows them to act as an RE: s 601FA. Generally, ASIC will only issue the AFS licence for a particular type of

21.14

• • • •

•

investment which means the RE will be restricted to operating the MIS within that particular category.

The RE, in order to maintain their status, must fulfil a set of minimum standards including the maintenance of financial standards — a minimum $50,000 of tangible assets, or if the schemes’ assets exceed $10 million, the scheme must maintain a minimum quota of 0.5% of the schemes’ assets in a tangible form.

In order to perform its functions, the RE may appoint an agent to carry on its functions: s 601FB. This person may carry on ‘anything that it is authorised to do in relation to the scheme’: s 601FB(2). The RE is liable for any action of its agents in ensuring that it has properly performed its duties under s 601GA(2). Even if the agent acts fraudulently, or outside their scope of authority, the RE will be found negligent for the behaviour of the agent: s 601FB.

At the time of writing, the Corporations and Markets Advisory Committee had recommended that the role of the RE as trustee be replaced by converting the management investment scheme from the current trust structure into a separate legal entity structure where the RE was simply the manager of the MIS. This would avoid having the RE as the owner of the MIS assets as it currently does as trustee.6 At the time of writing, the government had not proposed any legislative change.

Duties and functions of the responsible entity Responsible entities hold a variety of responsibilities in order to maintain their licences.

Section 601FC provides that the RE must:7

act honestly and fairly; exercise a normal person’s degree of care and diligence; act in the best interests of its members; avoid taking advantage of information gained in the role of responsible officer in their own interests; ensure that the scheme’s compliance plan meets with the requirements of s 601HA and that the constitution meets the

•

21.15

requirements of ss 601GB and 601GA; ensure that the scheme property is clearly identifiable as the scheme’s property and that it is held separately from any other property of any other scheme; ensure that all payments made out of the scheme’s money is paid in accordance with the scheme’s constitution;

[page 653]

report to ASIC any breach of the Corporations Act that is likely to have a material adverse effect on members; and carry out or comply with any other duty not inconsistent with the Corporations Act that is conferred on the RE of the scheme’s constitution.

Employees and officers of the managed investment scheme have similar responsibilities to those of the RE: ss 601FD and 601FE.

Removal of the responsible entity The RE of a managed investment scheme cannot be changed without certain procedures being followed. Often, the RE of a managed investment scheme will, at some stage, want to retire. This is not a simple process. In order to retire from a registered scheme, a members’ meeting must be held and members must be informed as to the reasons for the RE’s desire to retire. For an unlisted or unregistered scheme an ‘extraordinary resolution’ must be passed by the members in order for the retirement of the RE to be accepted by the members.

An extraordinary resolution may be a difficult path for the RE to take, as 50% of the possible votes that are allowed (including members who choose not to vote) must be positive votes for the acceptance of the new RE: s 601FL. If no acceptable RE is accepted by the members, then the current RE can either apply to ASIC to appoint a ‘temporary responsible entity’ or to continue on in the position themselves. If the member is approved via the extraordinary resolution, then a notice informing ASIC must be lodged with ASIC within two days of the appointment: s 601FM.8

•

21.16

•

• •

The removal/replacement of the RE must be instituted by at least 100 members or, in a smaller scheme, by at least 5% of the scheme’s members. These members must make a request of the RE to call a members’ meeting to hear and consider the extraordinary resolution to remove/replace the RE. The meeting is required to be held within two months of the request being made to the RE: s 252B. All members may vote and a 50% majority of votes must be received for the resolution to pass.

ASIC or the scheme member may apply to the court for the appointment of a temporary RE of the scheme under s 601FP if the scheme does not have a RE who meets the requirements of s 601FA.

In your view, what is the difference between an MIS and a company? Do MIS investors have the same rights and protections as members of a company? Should they?

Scheme constitution All registered managed investment schemes must have a constitution. The scheme constitution is important because it determines the relationship between the RE and the member/investor. The Corporations Act does not set out detailed

[page 654]

contents requirements for the constitution. Under s 601GA, it only specifies that the constitution must make adequate provisions for the following matters:

the consideration that is to be paid to acquire an interest in the scheme; the investment power of the RE; the method by which complaints made by the members in relation to the scheme are dealt with; and

•

21.17

21.18

the winding up of the scheme.

The constitution of a registered scheme might be changed by special resolution of the members of the scheme or by the RE if the RE reasonably considers that the change will not adversely affect members’ rights: s 601GC(1). See further 360 Capital Re Ltd v Watts (2012) 36 VR 507; [2012] VSCA 234.

Compliance plan The development of a compliance plan is an integral process for a managed investment scheme. Managed investment schemes must have a compliance plan before ASIC will issue the licensee with a licence to operate a MIS or be registered. Additionally, having an up-to-date and active compliance plan and schedule will enable a managed investment scheme to fulfil its regulatory activities and thus satisfy its statutory obligations under the Corporations Act. An RE should also put in place a compliance monitoring system.

The RE must ensure at all times a registered company auditor is engaged to audit compliance with the scheme’s compliance plan: s 601HG(1).

The auditor must notify ASIC as soon as possible if he or she has reasonable grounds to suspect that a contravention of the Corporations Act has occurred and if he or she believes that the contravention has not been or will not be adequately dealt with by commenting on the auditor’s report given to the RE or by bringing it to the attention of the RE.

Compliance committee The RE of a registered scheme should establish a compliance committee if less than half of the directors of the RE are external directors of the RE: s 601JA. The committee must have at least three members and a majority of them must be external members independent of the RE: s 601JB(1). The role of the compliance committee is outlined in s 601JC, and includes monitoring the extent to which the RE complies with the scheme’s compliance plan and to report on any possible breaches of the Act or of the scheme’s constitution.

21.19

21.20

Winding up schemes For a variety of reasons, a managed investment scheme may be wound up. Generally, a managed investment scheme will specify in its constitution the period for which it will continue to exist. The period of operation will vary according to the purposes of the members and the type of scheme that it is; however, it may vary from a few days to 80 years (the most common period for a trust to exist). Mainly. however, the constitution of a scheme will provide for the scheme to be wound up ‘in specified circumstances or upon the happening of a specified event’: s 601NA.

[page 655]

Other circumstances which may result in a winding up of the scheme would be if the members elected to call a meeting and vote through resolution to wind up the scheme or if the responsible officer of a scheme feels that a winding up would be in the best interests of the members. In this situation, the RE would conduct a general meeting and a 50% vote of members would be required in order to enable the winding up of the scheme.

Under s 601NE, the RE has the duty to perform the winding up procedures. The RE should complete the winding up following the guidelines set by the scheme’s constitution. Alternatively, on some occasions, the scheme will receive a court order to be wound up: s 601ND. On these occasions, often the court will issue a procedure timetable and tasks to be completed during the winding up. These tasks are still conducted by the RE or agent unless contrary orders are issued by the court.

ASIC’s regulatory powers Under the Corporations Act, ASIC is granted power over all provisions and entities defined within Ch 5C. In regards to managed investment schemes, this gives ASIC extensive powers of regulation, modification and participation. Under s 601QA, ASIC is given the power to exempt or

21.21

modify a licensee’s actions through either self-investigation or through application by an external body. Modification refers to modification of any condition for any particular body or licensee.

Market misconduct

The financial services laws have a number of prohibited conduct provisions that apply across all financial services. These regulations were developed over the last 50 years mainly to deal with regulating the share trading markets. However, after the implementation of the FSR regime, the market misconduct provisions are applied to all financial services and products in order to regulate the industry.

The market misconduct provisions in the Corporations Act may be divided into two categories:

Criminal breaches: this includes the major criminal offences, such as false statements, market rigging, market manipulation and insider trading. Civil breaches: this includes the provisions which do not have a criminal consequence but can give rise to a civil action. The two most common examples are misleading or deceptive conduct and unconscionable conduct.

The market misconduct provisions are incorporated into the Corporations Act to ensure the integrity of the financial markets in Australia. Market misconduct activities result in individuals deriving an unfair benefit, and thus producing a detriment to other market participants. As such, in order to maintain consumer and financial product providers’ confidence in the markets (such as companies listed on the securities exchange), Australian corporate and financial services laws have been implemented to deter certain illegal practices, discussed below.

[page 656]

Criminal breaches

21.22

1. 2. 3.

21.23

Criminal breaches There are three main criminal offences that relate to market misconduct in financial services law:

hawking; market manipulation; and insider trading.

Hawking Securities hawking refers to the unsolicited selling of financial products by means such as cold calling by telephone or unscheduled meetings. The hawking provisions are applied to both AFS licensees and their authorised representatives.

The hawking of financial products occurs when financial products or services are offered for sale in the course of or because of an unsolicited meeting or telephone call. Section 992A bans the unsolicited hawking of securities such as shares and debentures, as well as financial products such as superannuation and insurance. The prohibition is against offerors or their authorised representatives in order to prevent pressurised selling of such products to retail clients. The reason for the prohibition is to prevent retail clients from making uninformed decisions and purchases relating to financial products and services.

A breach of the hawking conditions is a criminal offence. Retail consumers may also have the right to return the financial product within one month under s 992A or to take civil proceedings against the offeror under s 1324. The hawking conditions do not apply to unsolicited communications such as emails, letters, facsimiles, brochures and media advertisements. However, if an offeror uses these methods to advertise their products, they need to ensure that they still comply with any other relevant consumer protection laws.

There may be some exemptions or modifications to these provisions by ASIC.

Market manipulation

21.24

•

• •

•

21.25

Often the offences of market manipulation and insider trading are confused. Market manipulation can be defined in two ways. It can mean a general term for all prohibited conduct relating to financial products and services. In Pt 7.10 of the Corporations Act, there are two divisions dealing with prohibited conduct. Insider trading, although a type of market manipulation, is treated as a separate division of the Corporations Act. The major difference between insider trading and market manipulation is the distinction between artificial information (market manipulation) over the true facts (insider trading).

Market manipulation is defined in s 1041A as carrying out a transaction to create an artificial price for the trading of financial products on a financial market operated in Australia.

As well as the broad market manipulation prohibition, there are other specific offences in Pt 7.10 Div 2:

[page 657]

false trading and market rigging (creating a false market by buying and selling without changing the real ownership — for example, by transacting with a related party); false or misleading statements; inducing persons to deal in financial products on the basis of misleading information; and dishonest conduct (a general catch-all provision).

Insider trading Insider trading occurs when a person trades in shares or other financial products based on sensitive information that is not readily available to the public through the market in order to make a personal profit. A person may be an individual or a corporate entity. Insider trading is one of the major categories of market misconduct that is prohibited by the Corporations Act and attracts serious criminal charges for the perpetrators of such actions. The crime of insider trading is prohibited under Pt 7.10 Div 3 of the Corporations Act.

•

Insider trading, which undermines the integrity of the stock market, is treated by the courts as a serious criminal offence. In December 2010, the maximum penalty for insider trading was effectively doubled to imprisonment for 10 years (and/or a fine of the greater of $765,000 or three times the total value of the benefits attributable to the offence). As observed by the court in Director of Public Prosecutions (Cth) v Hill [2015] VSC 86, it is the highest penalty provided for in the Corporations Act, and reflects the seriousness with which the legislature regards this offence.

In sentencing offenders for insider trading offences, courts have repeatedly made the following observation, as illustrated in R v Zhu [2013] NSWSC 127:

… those who involve themselves in insider dealing are criminals: no more or less. The principles of confidentiality and trust, which are essential to the operations of the commercial world, are betrayed by insider dealing and public confidence in the integrity of the system which is essential to its proper function is undermined by market abuse

… The message must be clear: when done deliberately, insider trading is a species of fraud; it is cheating.

The crime of insider trading, while usually associated with the trading of shares, is not exclusively restricted to this type of financial product. Insider trading can occur with any financial product that is traded on a market including derivatives, superannuation products etc.

A 1989 report by the House of Representatives Committee on Legal and Constitutional Affairs (the Griffiths Committee) published a paper which sets out various theories that are considered reasons to make insider trading illegal. The paper, ‘Fair Shares for All: Insider Trading in Australia’ explains the following as reasons for Australian legislative provisions to prohibit the practice of insider trading in Australia:9

[page 658]

Economic efficiency: insider trading is damaging to the integrity of the financial market and the expectations and confidence of the participants in any market. Corporate injury: insider trading can injure the corporate health of the company for which the financial products were released.

•

21.26

Fairness: market participants should have equal access to information from the company or body that has issued the financial product onto the market. Confidence in the market and its functions would waiver if insider trading was prevalent. Fiduciary duty: a person holding this duty (such as company director or senior officer) should not profit from their position.

In R v Glynatsis [2012] NSWSC 1551 at [139]-[143], Johnson J summarised the rationale for punishment in insider trading cases:10

Insider trading offences are regarded as a serious form of criminal activity. They serve to undermine the integrity of the stock market: R v Doff [2005] NSWSC 50; 23 ACLC 317 at [40]. The offences are difficult to detect: R v Rivkin [2003] NSWSC 447; 198 ALR 400 at 409-410 [44].

General deterrence is important in the sentencing process to provide a firm disincentive to insider trading, and with a need to sound “a clarion call” to discourage illegal and unethical behaviour by persons who are in a position to offend in this way: R v Rivkin at 409-410 [44]; cf R v Doff [2005] NSWCCA 119; 54 ACSR 200 at 212 [56].

Insider trading not only has the capacity to undermine the integrity of the market, it also has the potential to undermine aspects of confidence in the commercial world generally arising from breaches of trust: Hartman v R [2011] NSWCCA 261 at [94].

The cases have emphasised the particular gravity of offences by a “true insider”, who abuses the office or employment occupied by the offender to take advantage of information acquired in the course of that employment in order to avoid potential losses by an early sale or to buy with a view to profit: R v Doff at 212 [57] (NSWCCA).

Insider trading is not a form of victimless crime, and it is a form of cheating: R v Hartman [2010] NSWSC 1422 at [45], [94]; Hartman v R at [94]; R v Bateson [2011] NSWSC 643 at [15]- [21].

Basic insider trading prohibition Section 1043A states that there are three distinct crimes of insider trading:

The insider must not trade in the financial products while they are in possession of inside information relating to the products, and they know the information is not available to the market. The provision makes it a crime to acquire or dispose of the financial products either directly or through an agent. The insider must not procure another person to acquire or dispose of a financial product. This means the insider must not actively encourage another person to buy or sell financial products while in

possession of the inside information. Note that the conduct of a contravenor can be found to have procured the acquisition of shares by another person even if no shares were in fact acquired by that person. That is because the conduct of the contravenor might have incited or encouraged the other person to acquire shares, but the person might ultimately

[page 659]

have ignored that encouragement, or been unable to act on it: ASIC v Hochtief Aktiengesellschaft (2016) 117 ACSR 589; [2016] FCA 1489. The communication of the information to a third party of the inside information where that person is likely to acquire or dispose or procure another person to deal in the financial products.11 This crime is narrowly defined to relate to financial products that are traded on an Australian financial market.

Under insider trading laws, an ‘insider’ is considered to be a person who possesses ‘inside information’. Inside information is defined in s 1042A to mean information that is not generally available and, if made available, a reasonable person would expect it to have a material effect on the price or value of the particular financial product.

A company can commit the offence of insider trading and face civil and criminal penalty, as shown below in ASIC v Hochtief Aktiengesellschaft (2016) 117 ACSR 589; [2016] FCA 1489. This is the first case where the court has been asked to fix a pecuniary penalty on a corporation in respect of a civil contravention of s 1043A of the Corporations Act.

ASIC v Hochtief Aktiengesellschaft (2016) 117 ACSR 589; [2016] FCA 1489 Federal Court of Australia

Facts: Hochtief AG, a large top 50 ranked company based in Germany, is registered as a foreign company in Australia. It controls a worldwide group of companies that operate in the construction

industry. The corporate group it controls employs 44,000 employees. At the end of 2013, it had a market capitalisation of almost €5 billion.

One of its subsidiaries is Hochtief Australia Holdings Limited (Hochtief Australia). Hotchief Australia was a substantial shareholder in a well-known Australian construction company, Leighton Holdings Limited, holding more than 50% of its issued shares and more than 50% of its voting shares. Leighton is a top 100 ranked ASX-listed company.

In 2014, Hochtief AG procured Hochtief Australia to acquire further shares in Leighton. It did so in circumstances where it was in possession of ‘inside information’ concerning Leighton (that is, its senior officers possessed information that was both not generally available and material to the price of Leighton shares). It also admitted that it ought reasonably to have known that the information possessed the qualities that made it inside information. Hochtief AG’s notional and unrealised profit from its acquisitions was $206,740. ASIC sought, and Hochtief AG consented to the making of, a declaration that Hochtief AG had contravened s 1043(1)((d) of the Corporations Act.

Decision: Hochtief AG was ordered to pay a pecuniary penalty of $400,000 to the Commonwealth Government and to pay the legal costs of ASIC which amounted to $50,000. The court was surprised that a company the size and status of Hochtief AG had no comprehensive compliance system, procedures or training in place to ensure that its officers who were involved in its operations in Australia were aware of, properly understood, and did not contravene Australia’s insider trading prohibition.

The court held [at 167] that the pecuniary penalty:

… adequately reflects the serious nature of Hochtief AG’s contravention, but also takes into account that the contravention was the result of a single act on one day,

[page 660]

resulted in a single day of trading and was not deliberate or intentional, but was the result of a serious failure by a senior officer to exercise appropriate care and diligence in all the circumstances. The contravention was towards the middle or slightly lower side of the scale of seriousness of civil contraventions of the insider trading prohibition. It was by no means a minor or trivial contravention. By the same token, it was nowhere near the worst possible case.

The court rejected the submission made by Hochtief AG for a pecuniary penalty in the sum of $100,000 for the following reasons [at 169]:

While the contravention did involve carelessness and inadvertence, rather than actual knowledge and deliberateness, the careless was such as to amount to a serious failure to exercise appropriate care and diligence in the circumstances. It also involved a serious failure on the part of Hochtief AG to put in place appropriate systems and procedures relating to insider trading. It resulted in significant trading in a major Australian public company which, because it involved insider trading, had the capacity to significantly undermine the integrity and efficiency of the relevant securities markets. It was by no means a victimless crime: the victim was the market.

Note: A corporation convicted of the criminal offence of insider trading is liable to pay the greater of 45,000 penalty units (at the time of Hochtief AG’s contravention, that would have amounted to $7.65 million), or, if able to be calculated, three times the benefits obtained from the offence, or otherwise 10% of the corporation’s annual turnover in the preceding 12-month period.

•

It is interesting to note that an insider for the purposes of insider trading provisions does not need to have any connection to a company at all. An insider needs only to have ‘inside information’. As such, while insiders are usually officers of the company, employees, professional advisers, public servants and secondary insiders, an insider could also be an individual who has overheard a confidential conversation on the street or who has stumbled on the information unintentionally.

R v Farris (2015) 107 ACSR 26; [2015] WASC 251 Western Australia Supreme Court

An offence against s 1043A does not require that it be shown that there was any causal connection between possession of the information and the decision to sell the shares. It may be that a person who commits the offence has some legitimate reason for wanting to sell his shares and the fact that he is in possession of information which gives him an advantage over other participants in the market is not material to his decision. Motive or use are not elements of the offence, though they may be relevant to sentence.

The High Court in Mansfield v R; Kizon v R (2012) 247 CLR 86 [2012] HCA 49 addressed the broad scope of the insider trading provisions and held that it catches conduct by those trading based on information whether it is true or false.

Given that one of the rationales for insider trading regulation is the limitation of misconduct by fiduciaries, should the insider trading provisions be limited to persons working for the company whose products are being traded?

[page 661]

An illustration of the difficulties of determining whether a matter is inside information or not (by applying the definition of that term in s 1042C, which includes a ‘readily observable matter’) is the case of R v Firns (below).

R v Firns (2001) 51 NSWLR 548; [2001] NSWCCA 191 New South Wales Court of Criminal Appeal

Facts: This matter involved a company whose central business involved holding exploration licences in Papua New Guinea through a wholly-owned subsidiary. A subsidiary was granted a licence over an area thought to contain gold prospects. At 9.30 am on 28 July 1995, the subsidiary won an appeal over the Papua New Guinea Government abolishing a regulation that would have affected the licence. At 10.08 am the father of Firns, who was in the Papua New Guinea courtroom, telephoned his son in Australia and informed him of the favourable news. Firns promptly rang his stockbroker at 10.27 am to purchase 400,000 shares in his wife’s name and a further 300,000 shares at a later date. Firns was charged with insider trading which was successfully appealed. The New South Wales Supreme Court considered whether the information used was ‘generally available’ in the sense of being a ‘readily observable matter’ under the Corporations Act.

Decision: The appeal was successful and it was held that the information was generally available. Firns’ actions were not considered to be insider trading under s 1043A. The court found that information may be readily observable if it is publicly available even when no one has observed it.

Under s 1042C(1)(b), information becomes generally available if it has been made known in a manner that would or would be likely to bring it to the attention of people who commonly invest in financial products of a kind whose price might be affected by the information. There is also a requirement that a period of time has elapsed since it became known. The time period must be reasonable enough to have allowed the information to have disseminated.

The continuous disclosure provisions found under Ch 6CA of the Corporations Act complement the insider trading provisions. These provisions require disclosing entities, such as listed companies, to reveal any price-sensitive information available which may influence the market price for the financial product.

ASIC has had mixed results in taking enforcement action in respect of insider trading. While it won the high profile case involving Rene Rivkin, it had a significant failure in its case against Citigroup: ASIC v Citigroup Global Markets Australia Pty Ltd (No 4) (2007) 62 ACSR 427; [2007] FCA 963. In recent times, however, ASIC has undertaken a number of successful prosecutions of individual insider traders where a large number of them have pleaded guilty.

21.27

• •

•

21.28

Civil Claims of Insider Trading Against Citigroup In ASIC v Citigroup Global Markets Australia Pty Ltd (No 4), information communicated to a trader at the bank was alleged to constitute insider trading by the bank. The communication came from the trader’s manager. A senior manager of the advisory arm of the bank informed the trader’s manager that as a result of the trader’s purchases in Patrick Corporation ‘we may have a problem’.

[page 662]

The trader’s manager then told him to stop buying shares in Patrick Corporation. What the trader did not know was that the bank was advising Toll Holdings about a possible takeover strategy against Patrick Corporation. The trader thought that he was being reprimanded for an inappropriate investment portfolio selection and sold the Patrick Corporation shares. The insider trading claims failed because the trader was not an officer of Citigroup and therefore his knowledge of the information when he made the trades could not be attributed to the company: see s 1042G. Second, the claim failed because the company had a valid Chinese wall defence under s 1043F.

What defences are available for insider trading? If charged with the crime of insider trading, there are various defences that an accused can attempt to utilise to avoid prosecution in relation to contraventions of s 1043A. These defences are provided in ss 1043B- 1043M. For example, there are defences available for:

underwriters (s 1043C); communicating information under a legal requirement, such as a court order (s 1043E); and Chinese walls (ss 1043F and 1043G).

In addition there is the ability of the court to grant relief from civil liability under s 1043N.

Civil misconduct In addition to breaches of the Corporations Act that give rise to criminal liability, there are a number of important provisions in the Act that impose minimum civil standards of conduct on providers of financial services. The most important of these provisions are those dealing with:

• •

21.29

• •

misleading or deceptive conduct; and unconscionable conduct.

Misleading or deceptive conduct The term ‘misleading or deceptive’ is not defined in the Corporations Act. However, that term is used in s 18 of the Australian Consumer Law (former s 52 of the Trade Practices Act 1974 (Cth)), which is one of the most commonly litigated provisions in Australian law with literally thousands of cases considering its meaning. In the Full Federal Court’s decision in National Exchange Pty Ltd v ASIC (2004) 49 ACSR 369; [2004] FCAFC 90 it was determined that the decisions on the former s 52 of the TPA were relevant for determining the scope of s 1041H of the Corporations Act. National Exchange accepted that the term usually involves people being ‘led into error’. This may involve intentional or unintentional conduct, and may also involve circumstances where a true fact generates an error of assumption. It is therefore important that all of the circumstances are considered to determine whether the conduct is misleading or deceptive within s 1041H.

The introduction of s 1041H is a part of a broader regime to provide specific rights and remedies for misleading or deceptive conduct within different areas of corporate law.

[page 663]

Thus, in addition to misleading or deceptive conduct in relation to financial services (s 1041H), there are also similar provisions dealing with misleading or deceptive conduct in:

takeovers (s 670A); and corporate fundraising under Ch 6D (s 728).

The misleading or deceptive conduct provisions have been frequently tested by the controversial figure David Tweed and his various companies, including National Exchange Pty Ltd. Tweed’s method involves obtaining copies of the share registry of large public companies. The companies Tweed selects generally have large numbers of small

retail shareholders, such as recently privatised companies like the Commonwealth Bank or recently demutualised entities such as AMP. Tweed’s company then makes offers to these small retail shareholders, with the consideration for the sale to be paid over a long period of time (sometimes 15 years or longer). These offers, of course, do not explain the time value of money, so a price of $1.50 per share over 15 years will be worth considerably less than paying that price at the time of purchase.

ASIC v National Exchange Pty Ltd (2003) 47 ACSR 128; [2003] FCA 955 Federal Court of Australia

Facts: National Exchange made an offer to purchase shares from shareholders in a company known as ‘OneSteel’. Ninety-five per cent of the company’s shareholders owned less than 5000 shares each in the company. The offer was for $2 per share, which compared favourably with the then current market price for the shares of $1.93. These terms were highlighted in bold. Also on the offer document was the term that the payments of the $2 were to be made over 15 years. This equated to 13.3c per year, but this was not clearly explained in the offer. ASIC claimed that this was a misleading and deceptive practice as no discerning shareholder would accept an offer of this type and that few would realise that the offer was to be paid over 15 years. ASIC claimed that by reading the document, the average person would believe that the offer was to be paid in full on acceptance.

Decision: The offer involved misleading or deceptive conduct. Finkelstein J said:

In the end I am left with the clear impression that a number of shareholders will have wrongly formed the view that they had received a cash offer for their shares. I accept that they may be shareholders who did not stop to analyse the offer in detail and were only influenced by the general impression of the offer document. It is that impression which is misleading, though the offer contains no specific false statement. That is enough to establish a contravention of s 1041H. The section is not there for experts; it is there to protect the general shareholding public, many of whom do not analyse offer documents in any great detail, but act on appearances and impressions. This cannot be characterised as unreasonable conduct on their part. It is just the natural order of things.

The company was given 28 days in which to issue any shareholders who had accepted the offer with a letter outlining their right to terminate their contract for the purchase of their shares within a 28-day period. Additionally, OneSteel was issued with an injunction preventing them from acting on the transfer of any shares within the 28-day period. It is interesting to note that OneSteel shares eventually traded near $7 each, so National Exchange would have made an extraordinary profit if it had succeeded. OneSteel is now called Arrium and its shares have since fallen to less than $1.

National Exchange made an unsuccessful appeal to the Full Federal Court: National Exchange Pty Ltd v ASIC (2004) 49 ACSR 369; [2004] FCAFC 90.

•

21.30

[page 664]

Other recent examples where ASIC has been successful in arguing that companies engaged in misleading or deceptive conduct under s 1041H include:

Citrofresh (a chemical company) claiming scientific tests proved that its cleaning products prevented the spread of the AIDS virus when in reality they merely sanitised surfaces to the same degree of usual cleaning products. While the company consented to orders sought by ASIC, the CEO involved in drafting the ASX release contested the matter and lost (ASIC v Citrofresh International Ltd (No 2) (2010) 77 ACSR 69; [2010] FCA 27); Cycclone Magnetic Engines claiming that its vehicle engines operated purely on magnetic power without the need for fuel (ASIC v Cycclone Magnetic Engines Inc (2009) 71 ACSR 1; [2009] QSC 058); and James Hardie claiming that its asbestos compensation fund was fully funded to compensate victims for 50 years when in reality the money could run out in only a couple of years (James Hardie Industries NV v ASIC (2010) 81 ACSR 1; [2010] NSWCA 332).

Unconscionable conduct Unconscionable conduct is a difficult concept to understand. Historically, the principles of equity enabled innocent parties, where unfair advantage had been taken, to bring a legal action to avoid their legal obligations. The courts would only apply the unconscionable conduct principles in a limited set of circumstances. With the development of the consumer protection legislation now contained in the Australian Consumer Law, parliament determined that unconscionability should be included as a statutory right in addition to the law of equity.

Currently, the Australian Securities and Investments Commission Act 2001 contains two provisions that provide a remedy where unconscionable conduct, carried out in trade or commerce, is involved in connection with the provision of financial services: ss 12CB and 12CC.12 In addition, s 991A imposes an obligation on financial services licensees not to engage in unconscionable conduct.

In the leading decision on the financial services unconscionability provisions, the Full Federal Court defined unconscionable conduct.

ASIC v National Exchange Pty Ltd (2005) 56 ACSR 131; [2005] FCAFC 226 Full Federal Court of Australia

‘Unconscionable conduct’, on its ordinary and natural interpretation, means doing what should not be done in good conscience. In a case where the discrepancy in price and value is great, as in the present case, and the conduct is systematically and directly focused on vulnerable but unnamed members, some of whom can be expected to accept the offers, such conduct can reasonably be described as being against good conscience. The targeted offerees in this case could reasonably be expected to include persons who are unacquainted with share values, inexperienced in trading their interests, lacking in commercial experience and some of whom act inadvertently and are elderly. The evidence shows that Tweed believed from his past experience that such persons were more likely to accept the offer.

[page 665]

It should be noted that the National Exchange case failed, however, because ASIC could not prove that Mr Tweed’s offer to purchase shares was ‘conduct in trade or commerce’. A banning order imposed by ASIC on Mr Tweed was subsequently overturned by the Administrative Appeals Tribunal on the basis that Mr Tweed and National Exchange were not engaged in providing financial services: Re David Tweed and Australian Securities and Investments Commission [2008] AATA 514.

A contravention of the unconscionability provisions does not give rise to any criminal liability but does allow for civil actions for compensation. Any person who suffers loss or damage because of unconscionable conduct by a financial services licensee or in relation to the provision of financial services may recover the amount of the loss or damage from the person who acted unconscionably. The court will determine the exact amount based on the parties’ submissions depending on the circumstances of the unconscionable conduct.

8. 9.

10.

[page 666]

Revision Questions

What is a financial product, and what is its relationship with providing a financial service? What potential liabilities may the holder of an Australian Financial Services licence have for the actions of their employees, agents and representatives? What is the difference between a wholesale client and a retail client? Describe three obligations that are imposed on holders of an Australian Financial Services licence. What offences are provided under Ch 7 in relation to insider trading? What are the potential consequences for breaching the insider trading prohibition? How do you establish misleading or deceptive conduct in relation to financial services? What is the purpose of financial services reform? Outline ASIC’s enforcement role in relation to the financial services industry. Describe three basic regulatory requirements imposed on operators of managed investment schemes.

Problem Question Mary has recently received a letter in the post from a company called FastCash Promotions.

The letter contains the following information:

Do you want to be a millionaire???? Who wouldn’t! Come along to a free seminar at the

town hall this Saturday night to hear from world famous professional investor Warren Buffer. Warren will share his secrets about investing in shares and derivatives to make you rich! Warren’s system (InvestaClub) has guaranteed returns of 25% per year.

Mary attends the free seminar that weekend and hears from Warren Buffer and a range of other people described as ‘professional investment managers’ who are all ‘accredited by ASIC and government-approved’. The seminar involves the speakers promoting a range of investment strategies involving property, shares and other securities. All of the strategies are run through the InvestaClub system where investors put in $100 per week, with the pooled amounts being managed by the InvestaClub’s ‘professional managers’. The investments are described as being ‘no risk’ because they are ‘guaranteed’ by Warren’s company, InvestmentPro International, ‘a multi-billion dollar corporation’. In order to take part in the InvestaClub scheme, investors need to borrow the money from InvestaBank. This is described as being to ‘minimise tax through negative gearing’.

Mary reads the one page Information Memorandum and signs up to InvestaClub and borrows $10,000 from InvestaBank which is deposited with InvestaClub each week in $100 amounts. For the first three months Mary receives monthly ‘investment reports’ that detail how much money she has made and invite her to sign on as a ‘premium member’ that will allow her to double her returns if she agrees to direct debit her bank account for another $50 per week. Mary signs the bank authority form to set up the direct debit.

Six months later Mary reads in the newspaper that the ‘crook’ Warren Buffer has fled Australia to return to the United States, leaving investors chasing millions in unpaid investments. Mary calls the investor relations number in her Information Memorandum only to find that it has been disconnected. It appears that the InvestaClub was a scam and Mary may have lost her money. Worse still, the company is still withdrawing money from her account under the direct debit facility.

[page 667]

(a) What issues under the Corporations Act arise in this question? (b) Do there appear to have been any breaches of Ch 7 (financial services) of the Act? (c) What powers does ASIC have in relation to the InvestaClub scheme?

Guidelines for Answering Problem Questions

When answering a problem question concerning financial services we suggest that the following method may be helpful:

Determine what type of financial services question you are working on. Is this a question about licensing, disclosure, misconduct or managed investment schemes? It is important to

recognise that financial services is a broad area of corporate law, so you should be guided by the precise wording of your problem question as to what aspect of financial services regulation you are dealing with. After determining the scope of your question, identify the relevant part of Ch 7 (financial services) or Ch 5C (managed investment schemes). Outline whether the transaction falls within the relevant licensing or disclosure regime prescribed by those provisions. For example, if the question involves a managed investment scheme, discuss whether the scheme comes within the definition of a managed investment scheme in s 9, then discuss whether the registration requirement in s 601ED is satisfied. Then if unregistered discuss ASIC’s power to ask the court to wind up the scheme: s 601EE. If the question concerns disclosure, focus on what type of product is involved (does it meet the relevant definitions in Pt 7.1?), and what type of disclosure document will be required for that type of product. You should bear in mind that the product may be exempted from disclosure under Ch 7 or may be regulated under another part of the Act (such as Ch 6D or Ch 2L). Identify whether any person has suffered loss from the non- compliance with the Act. If so, look for rights to compensation under the Act (particularly in Pt 7.10). If provisions of the Act have been breached, assess whether there are any civil or criminal penalties that may apply to the company and any person involved in the contravention (see Sch 3 for the list of criminal penalties). Last, determine whether the persons involved in the contravention may be granted relief by the court under s 1318.

Wang has one last plan to try and save the business. Wang believes that the company’s coffee can be marketed through supermarkets and online sales channels. However, to do this, the business will need to increase production on a significant scale and this will require even more funding.

Wang comes up with an idea to sell ‘coffee entitlement coupons’. These coupons will involve investors paying $1,000 each, in exchange for a five-year supply of café quality

coffee beans. The $1,000 from each investor will be pooled and then used to invest in new equipment. Investors will also receive 5% of the sales of the new products for the first five years, and then an entitlement to redeem their coupons by a repayment of $1,000 plus another $1,000 in coffee beans. Wang says that investors are guaranteed to make a minimum of $10,000 over five years as the sales of the company’s coffee beans grows.

Would this proposed fundraising require SCPL to obtain an AFSL? Could this be classified as operating a managed investment scheme?

[page 668]

Further Reading

Academic Journals M Adams, ‘Does Increasing Criminality Make for Better Reform of the

Financial Services Industry?’ (2002) 14 Australian Journal of Corporate Law 202.

M Adams, A Young and M Nehme, ‘Preliminary Review of Over- regulation in Australian Financial Services’ (2006) 20 Australian Journal of Corporate Law 1.

H Bird and G Gilligan, ‘Deterring Corporate Wrongdoing: Penalties, Financial Services Misconduct and the Corporations Act 2001 (Cth)’ (2016) 34 Company and Securities Law Journal 332.

V Comino, ‘The Adequacy of ASIC’s Tool Kit to Meet its Obligations under Corporations and Financial Services Legislation’ (2016) 34 Company and Securities Law Journal 360.

S Corones and K Irving, ‘Raising Levels of Awareness of Rights and Obligations in the Provision of Financial Product Advice to Retail Clients’ (2014) 32 Company and Securities Law Journal 192.

S Corones and T Galloway, ‘The Effectiveness of the Best Interests Duty — Enhancing Consumer Protection?’ (2013) 41 Australian Business Law Review 5.

S Degeling and J Hudson, ‘Fiduciary Obligations, Financial Advisers and FOFA’ (2014) 32 Company and Securities Law Journal 527.

M Duffy, ‘Insider Trading: Addressing the Continuing Problems of

Proof’ (2009) 23 Australian Journal of Corporate Law 149. G North, ‘Companies Take Heed: The Misleading or Deceptive Conduct

Provisions are Gaining Prominence’ (2012) 30 Company and Securities Law Journal 342.

J Overland, ‘Corporate Liability for Insider Trading: How Does a Company Have the Necessary “Mens Rea”?’ (2010) 24 Australian Journal of Corporate Law 266.

J Overland, ‘The Possession and Materiality of Information in Insider Trading Cases’ (2014) 32 Company and Securities Law Journal 353.

J Overland, ‘What Is Inside “Information”? Clarifying the Ambit of Insider Trading Laws’ (2013) 31 Company and Securities Law Journal 189.

J Overland, ‘Re-evaluating the Elements of the Insider Trading Offence: Should there be a Requirement for the Possession of Inside Information?’ (2016) 44 Australian Business Law Review 256.

J Overland, ‘Insider Trading, Materiality and the Reasonable Person: Who Must Be Influenced for Information to Have a Material Effect?’ (2017) 45 Australian Business Law Review 213.

G Pearson, ‘Risk and the Consumer in Australian Financial Services Reform’ (2006) 28 Sydney Law Review 99.

S Riley and G Li, ‘Disclosure Requirements and Investor Protection: The Compatibility of Commonwealth, State and Territory Laws in Serviced Strata Schemes’ (2009) 16 Australian Property Law Journal 262.

B Saunders, ‘Has the Financial Services Reform Act Fixed the Problems with the Regulation of Securities and Derivatives?’ (2010) 21 Journal of Banking and Finance Law and Practice 33.

Practitioner Works L Butler, G Dal Pont, R Stewart and R Batten, Financial Services,

LexisNexis, looseleaf and online.

You will find useful study resources, including quizzes for each chapter, when you go to <http://learning.lexisnexis.com.au>. The quiz is a great tool to help you self-test your knowledge.

https://consult.treasury.gov.au/financial-system-division/asia-region-funds-passport/

3. 4.

7. 8.

10.

11.

12.

See further <https://consult.treasury.gov.au/financial-system-division/asia-region- funds-passport/>. See further L Butler, G Dal Pont, R Stewart and R Batten, Financial Services, LexisNexis, Australia (looseleaf and online). Corporations Amendment (Simple Corporate Bonds and Other Measures) Bill 2013. A list of licensed financial markets operating in Australia is available on the ASIC website at <http://www.asic.gov.au>. See Corporations Act 2001 (Cth) Pt 7.2A. See further <http://www.asic.gov.au/asic/ASIC.NSF/byHeadline/Markets%20homepage>. CAMAC, Managed Investment Schemes Report, July 2012, available at <http://www.camac.gov.au>. See further Wellington Capital Ltd v ASIC (2014) 106 ACSR 12; [2014] HCA 43. See further LM Investment Management Ltd (in liq) (recs and mgrs apptd) v Bruce (2014) 102 ACSR 481; [2014] QCA 136; Re City Pacific Ltd; City Pacific Limited ACN 079 453 955 v Bacon (No 2) (2009) 73 ACSR 59; [2009] FCA 772 (concerning the interpretation of s 601FM). For a more detailed discussion of insider trading, see G Lyon and J du Plessis, The Law of Insider Trading in Australia, Federation Press, Australia, 2005; CAMAC, Insider Trading, November 2003 at <http://www.camac.gov.au>. The sentence imposed by Johnson J was increased on appeal but the court quoted his Honour’s summary of the law: R v Glynatsis [2013] NSWCCA 131. In Khoo v R [2013] NSWCCA 323 at [11], Leeming JA said there is no rule ‘that mandates that tipping is less criminal than insider trading’. For a detailed examination of the law of statutory unconscionability, see Paciocco v Australia and New Zealand Banking Group Ltd [2015] FCAFC 50 (the 'bank fees case’).

http://www.asic.gov.au/asic/ASIC.NSF/byHeadline/Markets%20homepage

[page 669]

External Administration and Insolvency

CHAPTER 22 Overview

Different types of external administration Why is external administration important? Purposes of external administration

Winding up How is winding up commenced? Commencement of a winding up Common characteristics of compulsory and voluntary liquidations Who may work as a liquidator? Duration of liquidation Liquidator’s role Impact on creditors Advantages and disadvantages

Receivership How is receivership commenced?

Who may work as a receiver?

[page 670]

Duration Receiver’s role and powers Impact on directors Impact on the company Impact on creditors Overlap between receivership and other types of external administration Advantages and disadvantages

Voluntary administration Need for voluntary administration How is voluntary administration commenced? Who may work as a voluntary administrator? Duration Administrator’s role Role of administrator during creditor meetings Administrator’s powers Administrator’s duties and liabilities Impact of the administration on the company and its directors Impact of the administration on creditors Impact of the administration on employees Deed of company arrangement Contents of a deed Variation and termination of a deed Role of the court during a voluntary administration Specific powers Advantages and disadvantages of voluntary administration

Scheme of arrangement

How is a scheme of arrangement commenced? Creditors’ meeting Final court approval Who may work as a scheme administrator? Duration Scheme administrator’s role and powers Impact on creditors Advantages and disadvantages

[page 671]

External Administration and Insolvency

Learning Objectives After completing this chapter you should be able to:

Explain the advantages and disadvantages of each type of external administration for insolvent companies (winding up also called liquidation, receivership, voluntary administration and scheme of arrangement).

Outline the main procedures involved in each type of external administration, including the timelines and outcomes.

State who may appoint each type of external administrator.

Discuss how each type of external administration impacts on the company’s stakeholders including creditors and employees.

Outline the role and powers of the court in external administration.

Key Cases

Australasian Memory Pty Ltd v Brien (2000) 200 CLR 270; [2000] HCA 30

David Grant & Co Pty Ltd v Westpac (1995) 184 CLR 265

Lehman Brothers Holdings Inc v City of Swan (2010) 240 CLR 509; [2010] HCA 11

Key Sections

Corporations Act 2001 (Cth) ss 411, 420A, 435A, 436A, 439A, 440B, 440D, 440J, 441A, 447A, 459A, 459E, 459G, 459H, 459J, 477, 553, 556, 563A, 601AH

• •

[page 672]

Introduction As noted throughout this book, a company is ordinarily managed by the board of directors and senior executive officers for the benefit of the company as a whole. The courts have typically interpreted the ‘company as a whole’ to mean that directors are responsible for maximising shareholder wealth. However, when a company gets into financial trouble and is unable to pay its creditors, it may be in the best interests of the company to have an external person appointed to manage the company rather than the directors and officers. External administration, therefore, simply refers to a situation where an external person is appointed (in one of several ways either by the company, or its creditors, or the court) to manage the company and, in particular, its financial affairs with a view to either:

rescuing the company; or providing a fair and orderly process for dealing with its property during insolvency.

Various types of external administration (scheme of arrangement, receivership, voluntary administration and liquidation) with different outcomes are provided for in Ch 5 of the Corporations Act 2001 (Cth).

There are sound reasons for appointing an external person to manage a company that is in financial difficulty or insolvent. One of the principal reasons is to provide a disincentive for shareholders to encourage management to take unnecessary risks as the company approaches the point of insolvency. As noted in Chapter 12, the concept of shareholder primacy dominates modern corporate law. As a result, shareholders are treated as the corporation’s residual claimants and directors are expected to manage the corporation to increase the size of the company’s residual assets (that is, the surplus of assets over the company’s fixed contract claims). However, when a company is in financial distress the importance of shareholders is reduced as an insolvent company will have insufficient funds to pay creditors in full and shareholders will therefore receive no return.

Therefore, the company should be managed for the benefit of creditors once it becomes insolvent, or once it approaches insolvency (see the discussion of

22.1

voluntary administration below). This view has support in the cases, with Kinsela v Russell Kinsela Pty Ltd (in liq) (1986) 4 NSWLR 722 holding that as the company approaches insolvency the best interests of the company changes from the shareholders to the creditors. In that case, discussed earlier in Chapter 15, the New South Wales Court of Appeal held that in such financially precarious situations the shareholders do not have the power to absolve directors for acting to the detriment of creditors by leasing company property at below market rates.

phoenix companies: this refers to the practice of shifting assets from one company to another and then putting the former company into liquidation with no assets in order to avoid paying debts.

The case demonstrates that as the company approaches insolvency, the interests protected by the law are not the shareholders, but the creditors. More recently, the duty to consider creditor interests has been confirmed in the Bell litigation which was discussed in Chapters 16 and 18. The past two years have seen major reforms for Australia’s insolvency laws, with the commencement of the Insolvency Law Reform Act 2016 (Cth) in two stages on 1 March 2017 and 1 September 2017, the introduction of the safe harbour against insolvent trading for directors (which commenced on 19 September 2017) and a new prohibition against contract clauses that automatically trigger on insolvency (known as ipso facto clauses) which is due to start in early 2018. The government has proposed further reforms to address companies that avoid employee entitlement payments and to deal with improper phoenix companies.

[page 673]

external administration: an external manager (liquidator administrator or receiver) takes over the management of the insolvent company.

Overview

Different types of external administration There are four main types of external administration:

1. 2. 3. 4.

22.2

• •

winding up (also called liquidation); receivership; voluntary administration; and scheme of arrangement.

There is a fundamental difference between winding up and other forms of external administration. The purpose of winding up is to terminate the company’s business, distribute all of the company’s assets and, ultimately, to deregister the company so that it no longer exists. Other types of external administration have the purpose of either preserving assets (for example, receivership) or of restructuring the company and its debt repayment obligations to save it from liquidation (voluntary administration and scheme of arrangement). Below is a brief summary of the four types of external administration, with the remainder of the chapter providing further explanation of these points.

Winding up A winding up or liquidation involves the appointment of an independent external person, the liquidator, whose task is to sell all of the company’s assets and distribute the proceeds to the company’s creditors. The surplus, if any, is distributed to the shareholders in accordance with the company’s constitution, although in corporate insolvency there is rarely any surplus. Once the assets have been distributed, the liquidator will submit reports to ASIC and take steps to deregister the company. Deregistration effectively terminates the company’s legal existence as a separate entity. One distinguishing feature of liquidation is that liquidators have special powers to undo previous corporate transactions (called ‘voidable transactions’) and to sue directors, on behalf of creditors, for insolvent trading: see Chapter 18.

Liquidation is a form of ‘external administration’ for the purposes of the Insolvency Practice Schedule (Corporations), which sits in Schedule 2 of the Corporations Act. The significance of this is that rules in Part 3 of the IPS (Corporations) apply to liquidation. These rules include provisions relating to:

remuneration approval; reporting obligations;

• •

22.3

•

creditor meetings; and court powers.

Receivership A receivership typically involves a secured creditor (normally a bank or finance company or trustee acting on behalf of debenture holders (see Chapter 10) appointing an independent person, the receiver, to take possession of the secured property and either:

sell it to repay the secured debt; or

[page 674]

manage the business until the risk posed to the security can be removed (for example, by restructuring the business).

The appointment of a receiver is a drastic step that is normally taken by a secured creditor when the company has defaulted on its loan contract (usually by failing to repay or by breaching a condition of the loan, such as minimum capital requirements). The receiver is usually conferred with management powers and takes over the running of the company’s business. The receiver’s power includes the ability to sell the company’s assets to repay the loan. The receiver owes the company a duty of care when selling secured assets.

It should be noted that the court also has the power to appoint a receiver if it can be proved that the company’s assets are in danger (for example, when the directors threaten to remove assets from Australia to prevent creditors being repaid). In practice, the private appointment of a receiver by a secured creditor is more common than a court appointed receiver (public appointment).

Receivership is not a form of ‘external administration’ under the IPS (Corporations) and so Part 3 of the IPS does not apply to receivers. Receivers are still required to be ‘registered liquidators’ and so Parts 1 and 2 of the IPS (Corporations) apply.

22.4

22.5

Voluntary administration (VA) Voluntary administration provides for the rehabilitation of insolvent companies by allowing time for the company to restructure. The VA procedure involves appointing an independent external person, the voluntary administrator, who takes control of the company from the directors and formulates a report for the company’s creditors on the future direction of the company. The creditors may decide to vote that the company be put into liquidation, to end the administration (which rarely happens due to the financial difficulties of companies in voluntary administration) or to enter into a ‘deed of company arrangement’ or DOCA as it is commonly referred to.

The DOCA allows the company to enter into a deed with its creditors to restructure its affairs (both debt and equity capital may be restructured) so as to preserve the business or at least to provide for a better return than would be obtained through an immediate liquidation. Voluntary administration is a form of ‘external administration’ under the IPS (Corporations) and so Part 3 of the IPS applies.

Scheme of arrangement A scheme of arrangement may be entered into between a company and its creditors under s 411 of the Act. Since the introduction of voluntary administration in 1993, creditors’ schemes of arrangement are rarely used except for very complex corporate insolvencies such as insurance companies, large corporate groups or companies that have many layers of secured debt, with recent examples including Nine Entertainment, Atlas Iron and Boart Longyear. This is because schemes are more complex and expensive to undertake than voluntary administrations that result in a DOCA. A DOCA has similar features to a scheme of arrangement but is easier and cheaper to achieve because of the absence of mandatory court involvement in VA. A scheme of arrangement is not a form of ‘external administration’ under the IPS (Corporations).

[page 675]

Why is external administration important?

22.6

22.7

Why is external administration important?

moratorium: a prohibition upon creditors taking enforcement action (such as litigation) against the insolvent company for the period of the external administration.

It is important for businesspeople and accountants, as insolvency practitioners, to be aware of the different types of external administration because of the manner in which it impacts on the different stakeholders (creditors, shareholders, employees and directors). For example, ordinarily the rights of creditors of the company are limited or restricted during the course of voluntary administration, called a moratorium. Businesspeople and professional advisers need to be able to understand what each of the different forms of external administration can offer and the advantages and disadvantages of each form of external administration. The following treatment adopts this approach.

Purposes of external administration Aside from the purpose of appointing an external person to manage the affairs and deal with the assets of the insolvent company in the interests of the company’s creditors (noted above), the law provides for external administration in order to ensure that the company’s assets are used in a manner that is fair to all creditors.

The Australian Law Reform Commission General Insolvency Inquiry (commonly known as the Harmer Report) undertook a detailed review of insolvency law in the mid-late 1980s. It provided a list of purposes that should guide Australian insolvency law, which are:

Insolvency law should provide mechanisms that enable both debtors and creditors to participate with the least possible delay and expense. An insolvency administration should be impartial, efficient and expeditious. The law should provide a convenient means of collecting or recovering property that should properly be applied toward payment of the debts and liabilities of the insolvent company. The principle of equal sharing between creditors (pari passu) should be retained. Insolvency law should support the commercial and economic

•

22.8

22.9

processes of the community. Insolvency law should harmonise with the general law.

In recent years, the goal of saving companies in financial distress has become more prominent. The ability to save a company through restructuring its operations and financial affairs can help to preserve economic value and jobs. The introduction of the safe harbour for directors against insolvent trading has the goal of supporting directors who want to try to save their company by providing protection for their restructuring efforts provided that certain standards are met.

Should insolvency law have a goal of trying to save businesses in financial distress? Or should the goal of insolvency law simply be to distribute the debtor company’s assets to creditors?

Pari passu distribution In the absence of an external administration regime, there is a danger that individual creditors could take enforcement proceedings against the company and therefore drain the company’s scarce resources to the detriment of the remaining creditors. The primary purpose of the law is to recognise that once a company becomes insolvent it is more efficient to centrally control the repayment of debts. This is done under the

[page 676]

pari passu principle which provides that if there are insufficient assets to fully repay all of the creditors, each class of the creditors should be paid in the same proportion. Thus, if there are insufficient assets to repay all of a company’s trade creditors, each of them may be repaid, for example, 20% of their outstanding debt (stated as 20c in the dollar).

Investigations Another purpose of external administration is to investigate and report on

the causes of corporate insolvency. All forms of external administration have public reporting obligations (usually by way of periodic reporting to ASIC and/or public meetings to creditors), which allow for the external administration to report on why the company failed and whether any breaches of the Act may have occurred.

The Cost of Insolvency Corporate insolvency by definition involves a company whose assets are insufficient to satisfy the claims of all of its creditors. The appointment of an external administrator (such as a liquidator or administrator) to take over the company and provide for the orderly payment of creditors imposes a further cost on the company’s assets. Insolvency practitioners are professionals who should not be expected to work for free. However, several recent cases have put insolvency practitioner remuneration into the public spotlight.

The cost of the Burrup Fertilizers receivership, conducted by national firm PPB, involved sending teams of accountants from Melbourne to remote regions in Western Australia for weeks at a time at a cost of tens of millions of dollars and resulted in a judicial inquiry into the conduct of the receivers under s 423, which at the time of writing was still ongoing: see Re Oswal; Burrup Fertilisers Pty Ltd (rec and man apptd) v Carson, McEvoy and Theobald (recs and mgrs) (No 4) [2013] FCA 398. A series of decisions in New South Wales have raised questions about the proportionality of insolvency practitioner fees when the cost of the work carried out by insolvency practitioners consumes most or all of the fund available for creditors: see Re AAA Financial Intelligence Ltd (in liq) (No 2) [2014] NSWSC 1270; Re Hellion Protection Pty Ltd (in liq) [2014] NSWSC 1299. In these cases the remuneration of the liquidator was reduced to a proportion of the fund available for creditors, which meant that the liquidator had undertaken significant work at their own expense.

Internationally insolvency practitioner fees have also been highly topical, with the Lehman Brothers collapse costing more than US$1 billion in legal and accounting expenses, and the United Kingdom undertaking a review of insolvency practitioner remuneration (the Kempson review in 2013).

In Australia, the Insolvency Law Reform Act 2016 (Cth) inserted a new harmonised set of insolvency rules, the Insolvency Practice Schedule, into the Corporations Act and the Bankruptcy Act 1966 (Cth), which provides for the approval of ‘remuneration determinations’ by creditors as well as giving creditors rights to remove insolvency practitioners and to require information, documents and reports by liquidators and administrators.

Furthermore, the Financial System Inquiry final report in December 2014 recommended that corporate disclosure obligations be more technology-neutral and recognise different electronic means of gathering and publishing information. This is consistent with ASIC’s continuing move to electronic lodgements by insolvency practitioners. However, insolvency processes are still heavily based on physical notice to creditors and hard copy reports. Insolvency practitioners are required by legislation to undertake significant reporting and investigations which do not always result in returns to creditors. Meanwhile, many liquidations involve companies with little or no assets which means that any work undertaken by liquidators will be unfunded, which itself results in minimal reporting.

•

22.10

22.11

1. 2.

[page 677]

Is it preferable that the Australian corporate insolvency process be funded to a larger extent by public money? Should there be a government liquidator to undertake matters where there are little or no assets?

Winding up

How is winding up commenced? A winding up may be commenced in a number of ways depending on the type of winding up that is to be used. Broadly speaking there are two types of winding up which are discussed below.

Compulsory winding up This type of winding up is commenced by a court order under Pt 5.4 of the Act, which may be granted either on the basis of:

insolvency (under s 459A); or some other ground (under s 461, including the ‘just and equitable ground’ discussed in Chapter 19).

In either category, a person has to have permission (referred to as ‘standing’) to apply to the court. The range of persons who may apply for a compulsory winding up order are set out in ss 459P (for insolvency) and 462 (for other grounds), and include creditors, ASIC and a limited number of other eligible applicants.

The most common ground for commencing liquidation is insolvency under s 459A. The key element of this ground is the ability to prove that the company is insolvent. Insolvency is defined in s 95A as being the inability to pay debts as and when they become due and payable. However, the mere fact that the debtor company has not in fact paid a

debt does not, of itself, prove that the company is unable to pay that debt. The debtor company may dispute the existence or the quantum of the debt.

[page 678]

It may be difficult for an external creditor (or other eligible applicant) to prove that the company is unable to pay its debts. Therefore, s 459C provides for a list of events that allow the court to presume that the

company is insolvent. The most common event is the company’s failure to comply with a statutory demand: s 459C(2)(a).

serving: this means giving a copy of a court application to the other party in the case.

This ground involves the creditor (who must have a debt that is due and payable for more than $2000: s 459E) serving a notice on the debtor company demanding that the debt be repaid within 21 days. If the debtor company does not repay the debt within the 21 days, the court will presume that it is insolvent and is unable to pay the debt. The 21-day time limit is strictly enforced and cannot be extended once it has expired. The statutory timeline is important because it means that debtor companies that receive a statutory demand must take action within 21 days or they will be presumed to be insolvent. This was decided by the High Court decision in David Grant & Co Pty Ltd v Westpac (1995) 184 CLR 265.

[page 679]

David Grant & Co Pty Ltd v Westpac Banking Corp (1995) 184 CLR 265 High Court of Australia

Facts: Westpac served a statutory demand on David Grant & Co (DGC) that DGC applied to the court to have set aside. The application by DGC was outside the 21-day time limit imposed under s 459G. DGC sought to extend the time limit for opposing the statutory demand under s 1322(4).

Issue: Could the demand be set aside outside the 21-day period? Decision: The time for applying to set aside a statutory demand could not be extended by s 1322 as s 459G provided that demands could only be opposed within the 21-day time period. An extension of time could be sought under s 459R; however, that section still required the application for an extension to be made within 21 days of the service of the demand.

Significance: This decision means that any application to extend the period of time to challenge a statutory demand must be brought within 21 days of the demand being served. Failure to apply to set aside the demand within that time will result in the presumption of insolvency arising.

Given the strict time limits for complying with a statutory demand or for seeking to have it set aside, it is important for company accountants to raise the receipt of statutory demands with senior management as a matter of urgency.

A debtor company may apply to set aside the statutory demand on the basis of:

offsetting amount: a monetary claim that the debtor company has against the creditor which may be used to reduce the total debt owed to the creditor

a defect in the demand which causes substantial injustice (s 459J(1) (a)); an offsetting amount owed by the creditor that would reduce the total outstanding undisputed amount below the $2000 threshold (s 459H); or some other reason (s 459J(1)(b)).1

A statutory demand may also be set aside if there is a genuine dispute between the parties about the existence or extent of the debt: s 459H. This ground may also be used where there is an offsetting amount that may be set up by the debtor against the creditor.

The court requires much more from a debtor company than simply a claim in court disputing the debt: John Holland Construction & Engineering Pty Ltd v Kilpatrick Green Pty Ltd (1994) 14 ACSR 250. The debtor company must be able to demonstrate in court that the debt is actually disputed or that there are real grounds to argue for the existence of an offsetting amount. Therefore, it is important for companies involved in disputed debts to retain all physical evidence of the existence of the dispute (for example, letters, emails, invoices etc) which may be used in court as proof of the disputed nature of the debt.

When the court hears an application to set aside a statutory demand based on a genuinely disputed debt, it is not the role of the court to determine the exact amount of the debt or indeed whether the debt exists at all, rather the court needs only to determine whether there is a genuine dispute about the debt: Eyota Pty Ltd v Hanave

[page 680]

Pty Ltd (1994) 12 ACSR 785. The actual dispute can be resolved in debt

1. 2.

22.12

recovery proceedings.

It should be noted that the statutory demand procedure merely gives rise to a presumption of insolvency, which the debtor company may overcome at the final court hearing to determine whether to appoint a liquidator. However, it will be difficult for the debtor company to rely on problems with the statutory demand or disputes about the debt at that late stage due to s 459S (court permission will be required). Therefore, in a compulsory winding up in insolvency there are likely to be at least two court hearings, including:

a hearing to determine whether to set aside the statutory demand; and a hearing to determine whether to appoint a liquidator.

Section 459S effectively means that disputes about the debt owed by the debtor company must be raised at the first court hearing, and, if unsuccessful, will not be permitted at the final hearing.

Once the insolvency of the company has been established, the court may appoint a liquidator or may dismiss or adjourn (that is, delay) the hearing: s 467. An adjournment may be given if the company has been placed into another type of insolvency regime, such as voluntary administration.

The company may oppose the winding up application, primarily by establishing its solvency. Any of the company’s creditors may also oppose the making of a winding up order. This may occur where the creditors are seeking to undertake an informal reorganisation of the company, which may provide a better return than a formal insolvency appointment.

Voluntary winding up A winding up is voluntary because it does not require a court order to appoint the liquidator. This is carried out under Pt 5.5 of the Act, which provides for both members’ and creditors’ voluntary winding up. ASIC also has the power to put a company into a creditors’ voluntary winding up under Pt 5.4C.

Members’ voluntary winding up

22.13

•

22.14

A members’ voluntary winding up may only be undertaken if the company is solvent. The process involves:

the directors making a declaration that the company is solvent and will remain solvent for at least 12 months after the commencement of the winding up (s 494); the members passing a special resolution (requiring a 75% majority vote) to wind up the company voluntarily; the liquidator being appointed (provided they consent to the appointment) and taking control of the company from the directors. At that point, the company must generally stop trading and members are prohibited from trading their shares without the liquidator’s permission: s 493.

[page 681]

If the directors fail to make a declaration of solvency, or if a liquidator appointed by the members determines that the company is insolvent, then the voluntary winding up may only be undertaken with the permission of the creditors. The process converts, in this manner, into a creditors’ voluntary winding up.

Why would members want to wind up a solvent company?

Creditors’ voluntary winding up Following either event described above, a creditors’ meeting will be called and the creditors must pass an ordinary resolution to wind up the company. It is important to note that creditors cannot generally initiate a voluntary winding up, because s 490 provides that a company may only be wound up voluntarily by a special resolution of the members. This means that a members’ special resolution is required even for a creditors’ voluntary winding up, which is achieved by holding a members’ meeting first: s 497. If the creditors do not approve of the liquidator appointed by

•

• •

•

22.15

the members, then they can replace them by requiring a creditors’ meeting to be held and passing a resolution: IPS (Corporations) s 90-35.

A company may also enter a creditors’ voluntary liquidation by a creditors’ vote at the end of a period of voluntary administration: s 446A.

ASIC also has the power to order a company to be wound up under Pt 5.4C. Section 489EA sets out a number of reasons that may allow ASIC to wind a company up, including:

the response to a return of particulars given to the company is at least six months late and the company has not lodged any other documents in the last 18 months; the company is more than 12 months late in paying its review fee; ASIC believes the company is not carrying on business (provided ASIC gives notice to the directors beforehand); or ASIC believes it is in the public interest to wind up a formerly deregistered company after it had been reinstated.

ASIC cannot order a winding up if there is already an application before the court to have the company wound up: s 489EA(7). An ASIC ordered winding up proceeds as a creditors’ voluntary winding up: s 489EB.

Aside from the method of appointment, the voluntary winding up process is similar for both a members’ and creditors’ voluntary winding up, with the liquidator being appointed by the meeting and then taking control of the company.

Commencement of a winding up The day that the winding up commences is significant because it is at that time when voidable transactions are assessed by the liquidator for potential recovery. Voidable transactions were discussed in Chapter 19.

A court ordered winding up will generally begin on the date of the court order: s 513A(e).

[page 682]

22.16

•

• •

•

22.17

A voluntary winding up generally commences when the special resolution is passed by the company’s meeting in a members’ voluntary winding up or the creditors’ meeting in a creditors’ voluntary winding up: s 513B(e).

The commencement date may be earlier than the date of the special resolution where the company was already in some other form of external administration. For example, if a company goes from voluntary administration to liquidation, then the commencement date of the liquidation is generally the date the administrator was appointed.

Common characteristics of compulsory and voluntary liquidations Although the grounds and procedure for appointing a liquidator differ between compulsory and voluntary liquidations, the process of effecting the liquidation of the company under both forms is basically similar. In both cases:

the liquidator takes control of the company and analyses the company’s financial position; the liquidator must keep the creditors and members of the company informed of the progress of the liquidation (see IPS (Corporations) Divs 70, 75); the liquidator must attempt to satisfy all of the company’s liabilities and then distribute any remaining assets of the company to the members in accordance with the statutory priorities and corporate constitution; the liquidator may engage in litigation on behalf of the company; the liquidator comes under the supervisory power of the court (see IPS (Corporations) Div 90); and the final result is ordinarily the deregistration of the company.

Who may work as a liquidator? IPS (Corporations) Div 20 provides for a registration system for company liquidators. A person must not work as a liquidator unless they are registered with ASIC: s 532(1).2 In order to be registered by ASIC a person must:

• • • •

•

22.18

have certain educational qualifications (essentially an approved undergraduate degree in accounting); be a fit and proper person; maintain adequate professional indemnity insurance; and demonstrate sufficient experience in insolvency work.3

The Corporations Act also prohibits certain categories of persons from acting as a liquidator of particular companies, which are directed towards situations of bias or conflicts of interest. A registered liquidator is prohibited from acting if:

they are a creditor of the company (or of a related company) for more than $5000; or own a substantial shareholding in a company (or related company) that is owed more than $5000 by the company in liquidation: s 532(2) (a) and (b).

[page 683]

Furthermore, officers, employees and auditors of the company in liquidation are prohibited from working as the company’s liquidator: s 532(2)(c).

A registered liquidator may choose to be registered to work only as a receiver, in which case they cannot work as a liquidator or administrator.

Duration of liquidation There is no pre-set time limit on liquidations. A liquidation will typically end when the liquidator has the company deregistered by ASIC, which results in the company’s name being removed from the official register of companies, and its separate legal entity status is extinguished. A liquidator generally can only apply for deregistration after all of the company’s assets have been sold and the proceeds have been distributed among creditors to repay as much of the company’s debts as possible. The realisation of the company’s assets will often take some time as liquidators may wish to take court action on behalf of the company and investigate the actions of the company’s officers in the lead up to

22.19

liquidation.

Liquidation is therefore a time-consuming process that may literally take years. In one famous case, the liquidators of failed companies associated with businessman Alan Bond, the Bell Group, took court action against a number of banks which has resulted in the liquidation lasting for more than 20 years. The liquidations of the former large public companies, Ansett Airlines and HIH Insurance, are still ongoing more than 17 years after they collapsed. It may be said then that a disadvantage of liquidation for creditors is that it may take a long time to complete and obtain payment.

In addition, the court has the power to grant a temporary or permanent stay of the liquidation under s 482, although the court will not generally exercise this power where the company remains insolvent.4

Liquidator’s role The liquidator’s main responsibility is to ascertain the extent of the company’s assets and liabilities. Once this is achieved the liquidator must determine the most efficient method for realising the cash value of the company’s assets. This may be obtained by selling individual business assets or by selling the whole or part of the business as a going concern. Any proceeds are then distributed to the company’s creditors under the priority payment provisions in Pt 5.6 (particularly s 556). Employees have a special priority ranking under s 556. Where there are insufficient funds to pay employees’ priority entitlements, the employees may make a claim against the Fair Entitlements Guarantee (FEG) scheme operated by the Commonwealth Government which will pay these priority amounts and then stand in the place of the employees if there are any returns from the liquidation.5

The High Court of Australia’s decision in Sons of Gwalia Ltd v Margaretic (2007) 231 CLR 160; [2007] HCA 1 which held that shareholders with claims for damages for statutory misleading or deceptive conduct (s 1041H) or defective disclosure (under s 674) may be classed as ‘creditors’ of the company and thus seek to attend and vote

•

22.20

• •

•

[page 684]

at creditors’ meetings, and receive a distribution from the liquidator. This has been recently overturned in legislation with s 563A now requiring that such claims (defined as ‘subordinate claims’) be postponed until all other debts and claims are paid in full. This means that shareholders will rarely receive a return in corporate insolvencies.6

Should shareholders be allowed to claim statutory compensation as creditors in corporate insolvencies? Do shareholders accept the risk of corporate failure when they purchase shares?

Once all of the company’s assets have been realised and the proceeds distributed to creditors, the liquidator will send copies of their final report to creditors and to ASIC which will then deregister the company, ending the company’s separate legal existence.

Powers of the liquidator Liquidators have various powers under the Corporations Act, which are set out in Pt 5.4 (for court appointed liquidators) and Pt 5.5 (for voluntary liquidators). However, the main powers are listed in s 477, which includes the power to:

manage the company’s affairs; take and defend legal action on behalf of the company, including the ability to sue directors for insolvent trading and to recover voidable transactions (see Chapter 19); and make compromises with creditors.

Liquidators have the power to sue directors for breach of duties owed to the company under Pt 2D.1 and for insolvent trading: s 588G (discussed in Chapter 19). Liquidators may also reclaim property disposed of by the company prior to its liquidation under the voidable transaction provisions in Pt 5.7B Div 2. Liquidators can also sell their right to sue under the Corporations Act: IPS (Corporations) s 100-5. These powers

22.21

allow the liquidator to enlarge the assets available for distribution to creditors.

In order to assist with recovery proceedings, liquidators may need to examine persons involved with the company to determine exactly what assets the company has and what claims may be brought by the company in respect of possible breaches of directors’ duties and voidable transactions: see ss 596A, 596B. Liquidators may conduct compulsory public examinations before the court of officers and former officers of the company: s 596A. Liquidators may also apply to the court to examine a person who has information concerning the affairs of the insolvent company: s 596B. Section 596B applications form the majority of court- based examinations as they are broader in scope than s 596A examinations.

Disclaimer A liquidator is given a statutory power under the Corporations Act to disclaim onerous property or contracts: s 568. This power is consistent with the underlying policy of liquidation because it promotes the efficient winding up of the company by

[page 685]

allowing liquidators to preserve and protect the insolvent company’s assets without wasting resources on maintaining unprofitable or burdensome property or contracts.

Section 568 allows the liquidator to disclaim in writing property that is burdensome on the company because it is unprofitable and would be, or has been, difficult to dispose of. The most common situation involves the disclaimer of unprofitable leases which will relieve the company from the obligation to pay ongoing rent and maintenance. Of course, the lessor still has a claim for rent for breach of contract but this is simply a provable debt in the liquidation and will not typically be paid in full as the company is insolvent.

22.22

The liquidator’s power to disclaim contracts was recently considered by the High Court of Australia in Willmott Growers Group Inc v Willmott Forests Ltd (rec and man apptd) (in liq) (2013) 251 CLR 592; [2013] HCA 51. In that case the manager of a forestry investment scheme went into receivership and liquidation. The manager had previously leased land to investors to grow trees over 25 years. The receivers of the manager sought to sell the land, but the sale would produce a higher price if the land was not subject to long-term leases so the liquidator sought to disclaim the leases under s 568. The High Court held that as a lease is a contract it may be subject to disclaimer under s 568. The liquidator also has power under s 568 to dispose of any shares or contracts (even where they are not unprofitable). The liquidator must gain the court’s approval to disclaim a contract that is not unprofitable: s 568(1A).

Re Real Investments Pty Ltd [2000] 2 Qd R 555; [1999] QSC 89 Queensland Supreme Court

A contract is unprofitable for the purpose of s 568 if it imposes on the company continuing financial obligations that may be regarded as detrimental to the creditors, without producing sufficient reciprocal benefit to the company. Contracts which will delay the winding up of the company’s affairs because they are to be performed over a substantial period of time and will involve expenditure that may not be recovered are unprofitable. However, a contract is not unprofitable merely because the company could have obtained a better bargain.

Before a liquidator may effectively dispose of the onerous property or contract, a notice of the proposed disclaimer must be given under s 568A. The publication of the proposed disclaimer allows a person interested in the property that is to be disclaimed to apply to the court to attempt to prevent the liquidator from disclaiming the property: s 568B. Even after the liquidator has disclaimed the property or contract, a person aggrieved by the disclaimer may apply to the court to set it aside: s 568E.

Applying for directions Liquidators may also apply to the courts for directions about the legality of their conduct or proposed transactions: IPS (Corporations) ss 90-15

22.23

• • •

(orders to determine any question in relation to an external administration), 90-20 (who may apply for court orders). The court will not give directions over matters of commercial judgment (such as the appropriate value of a proposed sale transaction by the liquidator) but will give assistance to liquidators that are unsure about possible legal liability arising

[page 686]

from their conduct. For example, a liquidator may wish to seek court directions that it is appropriate to sell company property to a related party, as such an action may give rise to possible breach of fiduciary duty. The effect of the court’s directions is to give the liquidator limited protection from prosecution, provided that the liquidator acts within the court’s directions.

Statutory responsibilities Liquidators have various statutory responsibilities including the duty to:

collect the debtor company’s property (s 478); keep various books and accounts (IPS (Corporations) Div 70); and report to ASIC on possible breaches of the law (s 533).

In addition, it should be noted that liquidators are themselves included within the definition of ‘company officer’ under s 9 of the Act. This means that liquidators are bound by the statutory duties of company directors and officers in Pt 2D.1 (particularly ss 180-184) discussed earlier in Chapters 16-18.

If a liquidator has not performed their role appropriately, for example by being biased towards one particular creditor, then the court may replace them under IPS (Corporations) Div 90. Liquidators may also be removed by the creditors at any time and without any particular reason: IPS (Corporations) s 90-35. The court and ASIC also have the power to conduct an investigation into the liquidator’s conduct: IPS (Corporations) ss 90-5, 90-10. The Insolvency Law Reform Act 2016 (Cth) also introduced a

22.24

power for the court, ASIC or the creditors to appoint a liquidator to review the conduct of the liquidation: IPS (Corporations) ss 90-23, 90-24.7

Impact on creditors The appointment of a liquidator will not generally terminate contracts entered into by the company prior to liquidation. Therefore, a creditor will still have a legal right to the repayment of their debt even after a liquidator is appointed. However, given the policy of insolvency law to provide for equal treatment of creditors (the pari passu rule), it would be unfair on the creditors to allow individual creditors to enforce repayment and thus deplete company resources to the detriment of the remaining creditors. Therefore, the appointment of a liquidator imposes a moratorium on the enforcement of claims by creditors against the company during the liquidation: s 471B. The commencement of liquidation provides the creditors with a right to lodge a claim with the liquidator (called a proof of debt), to attend and vote at creditors’ meetings and to receive a share of the distributions made by the liquidator.

Following amendments made by the Insolvency Law Reform Act 2016 (Cth), creditors are also given rights to require the liquidator to provide information, documents or reports in relation to the external administration, and rights to require the liquidator to convene creditor meetings: see IPS (Corporations) Div 70.

Secured creditors are generally not impacted by liquidation because they retain a right against the debtor company’s assets. In the event that a liquidator is appointed

[page 687]

(or typically, when an application for the court to appoint a liquidator is made), the security instrument will usually provide for the secured creditor to seize control of the secured assets. The assets that are available in liquidation therefore will only include unsecured assets and any further funds that the liquidator may recover from directors (through

22.25

breach of duties or insolvent trading) or from voidable transactions (for example, granting security over a pre-existing obligation may be an unfair preference and therefore voidable by the liquidator). It is also possible that a secured creditor’s security interest will be lost to the company if they have failed to properly perfect it prior to liquidation: s 588FL.8 This will have the effect of increasing the pool of assets available for unsecured creditors as the property held under the (unperfected) security may be sold by the liquidator.

Employees, in particular, bear the brunt of liquidation. The appointment of a court ordered liquidator acts as an automatic notice of termination of their employment: McEvoy v Incat Tasmania Pty Ltd (2003) 130 FCR 503; [2003] FCA 810 at [6]. The liquidator does, however, have the power to allow the employees to continue working for the purposes of winding up the company.

The appointment of a voluntary liquidator does not automatically terminate employment contracts, but the liquidator has the power to terminate the contracts after their appointment.

Advantages and disadvantages There are few benefits to undertaking a process of liquidation. Liquidation effectively kills the company’s separate existence and terminates its workforce causing a substantial adverse impact on workers, customers and the broader community. The devastating effect of liquidation may be attributed to the fact that company management typically does not take action to rehabilitate the business before it is too late, with the result that most companies entering liquidation are hopelessly insolvent.

However, one of the advantages is that liquidators have extensive powers of investigation and they have the time to determine why the company failed and whether any action should be taken against the directors and officers. In particular, liquidators may sue the directors for insolvent trading, and claim back property transferred by the company prior to liquidation under the voidable transaction provisions.

22.26

22.27

Receivership

How is receivership commenced? Receivership may be commenced in one of two ways. The first (and most common) method for commencing receivership is for a secured creditor (typically a bank or finance company) to appoint a receiver where the debtor company (the borrower)

secured creditor: a creditor who has rights in the debtor’s property as collateral for a loan.

[page 688]

defaults on a requirement of the loan contract (usually failing to make periodic repayments). In practice, such private appointments of receivers are common.

The second method for commencing a receivership is for the court to appoint a receiver to safeguard the company’s assets. The power of courts to appoint receivers is found in several statutes including the rules of court and also, for example, in ss 232(1)(h) (oppression) and 1323(1)(h) (general powers of the court) of the Corporations Act. Very few court appointed receivers are used each year with the vast majority of receivership appointments occurring under private appointments. One of the reasons for this is the strict view that the courts have traditionally taken in applications for a court appointment of a receiver.

Who may work as a receiver? In order to accept appointments as a receiver, a person must be a registered company liquidator: s 418. The requirements for registration as a company liquidator were discussed above. There are also specific limitations on particular persons working as receivers in respect of certain companies: s 418. These exclusions are based on the requirement for insolvency practitioners to remain independent of the company. It should be noted that the independence requirements expected of

22.28

22.29

privately appointed receivers are different from those expected of liquidators and voluntary administrators. This is because privately appointed receivers owe their duties to the appointing creditor, and not to the creditors as a whole.

Duration There are no specific time limits on the receivership procedure, and some companies stay in receivership for years. The open-ended nature of receivership is derived from the fact that receivers are appointed to safeguard the assets or, where that is not possible, to sell the assets for the benefit of the appointing creditor.

A court appointed receiver is usually appointed to protect the assets as an emergency measure until a final court order (such as appointing a liquidator) can be obtained. Therefore, a court appointed receiver is unlikely to sell the company’s assets unless there is a clear need to sell (for example, the goods may be perishable and need to be sold quickly). A privately appointed receiver, on the other hand, is appointed to protect the appointing creditor’s interest and so may be more likely to sell property if it would satisfy the creditor’s debt.

Receiver’s role and powers A receiver’s role is primarily to protect the company’s assets. The receiver, therefore, has the power to manage the corporation’s affairs for this purpose. Generally speaking, this means that receivers take over the management of the corporation from the directors. The appointment of a receiver does not, however, remove the directors from their positions. The directors merely lose their power to manage the corporation (as conferred by s 198A) to the extent of the management powers conferred on the receiver. Section 420 confers extensive management powers on the receiver, subject to the powers conferred through the appointing document. Section 420 provides for a range of specific powers given to receivers, including the power to control the

[page 689]

1. 2.

property of the company in accordance with the appointing instrument, the power to carry on the business of the company and the power to engage or discharge employees of the company.

However, unlike liquidators and voluntary administrators, the receivership provisions in Pt 5.2 of the Corporations Act do not provide a complete code. The provisions in Pt 5.2 are designed to act as a supplement to the powers and responsibilities imposed on receivers by their appointing instrument. Therefore, a court appointed receiver has the duties and powers as stated in the court order that appointed them. Similarly, a privately appointed receiver will have the duties and powers that are provided in the security instrument.

Given the extensive powers conferred on receivers, it is not surprising that they are subject to extensive duties and obligations. Receivers are subjected to two types of legal duties:

duties under general law (specifically contract, tort and equity); and duties under statute.

The duties under general law are based primarily on the expectation that receivers will perform their function at a level of reasonable skill and diligence. Thus, a receiver who sells property of the debtor company at a gross undervalue will cause harm to the appointing creditor, who may not receive full repayment from the secured loan. Such action will also cause harm to the company’s other creditors who will be unable to retrieve payment (as the company’s assets have been unable to repay the secured debt and therefore there are no assets left to pay unsecured creditors). Last, such action will cause harm to the debtor company because its assets are insufficient to repay its debts, which will usually cause the company to go into liquidation. Therefore, under general law (that is, non- statutory law) receivers owe duties to the appointing creditor, the general creditors and the debtor company. Nonetheless, the duty owed to the appointing creditor is treated as paramount.

Receivers also have a number of statutory duties under the Corporations Act. These duties arise primarily through the inclusion of a receiver as an officer of the company under s 9. Thus, the duties of company directors and officers under Pt 2D.1 (ss 180-184) also apply to receivers. In the example above, a receiver who negligently managed the debtor

22.30 (1)

(a) (b)

company’s assets could be sued for breach of the statutory duty of care and diligence under s 180(1). Furthermore, receivers are also bound by duties under Pt 5.2 of the Act, the most important of these being the duties with respect to the power of sale.

It should not be thought that the only function of the receiver is to sell the secured assets to repay the appointing secured creditor. Undoubtedly, the power to sell the company’s assets is a very significant power. Receivers owe common law duties not to recklessly disregard the interests of the debtor company and must account for any surplus once the appointing creditor’s debt has been repaid: Expo International Pty Ltd v Chant (No 2) [1979] 2 NSWLR 820. This duty is enhanced by s 420A of the Corporations Act. Of course, receivers may also continue trading the business if they reasonably believe that such conduct will be effective in preserving the company’s assets, providing the appointing instrument gives them management powers (which is common).

[page 690]

The power of sale Section 420A(1) provides that:

In exercising a power of sale in respect of property of a corporation, a controller must take all reasonable care to sell the property for:

if, when it is sold, it has a market value — not less than that market value; or otherwise — the best price that is reasonably obtainable, having regard to the circumstances existing when the property is sold.

Thus, a receiver who sells the debtor company’s property without reasonably attempting to obtain the best price in the circumstances may be liable to pay compensation. This is calculated at the difference between the price that would have been obtained if a proper sale process were followed and the price that actually was obtained. A typical example may involve a receiver who sells debtor company property without obtaining an expert valuation of the property, with the result that the sale price is well below market value.

When exercising the power of sale, receivers will generally have a choice

22.31

of selling by auction, tender or private treaty. If using the tender process, it is important that the receiver adopt a fair and open tender process.

The practical considerations relevant for compliance with s 420A were explained in Florgale Uniforms Pty Ltd v Orders.9

Florgale Uniforms Pty Ltd v Orders (2004) 11 VR 54; [2004] VSC 65 Victorian Supreme Court

The expert evidence establishes that the exercise of all reasonable care by a receiver would entail a process of selecting the method of realising the highest net return, by considering the different available means of sale and weighing the prices likely to be achieved against the likely costs and expenses entailed and the relative risks of the various methods in all the circumstances. The process is informed by the objective of securing the best possible return for the secured creditor, subject to the obligations imposed by general law doctrines and s 420A. It necessarily involves the exercise of judgment, taking into account all the relevant variables and circumstances of the particular case. It does not depend on matters of price or revenue alone, or any single factor in isolation.

In my opinion, the process of evaluating and balancing the competing costs and benefits and the associated risks of various methods of sale will not, in every case, require a formal comparative analysis or documented calculations. All will depend on the circumstances of the individual case, including the scale of the receivership, the value and nature of the property involved, the receiver’s expertise in relation to the type of property, relevant expert advice, the advice or input of proprietors and staff, the trading history and marketing of the company, including during the receivership, and other relevant variables in a realistic commercial context.

Liability of receivers Receivers act as the agent of the debtor company and are not managing the company in their personal capacity. This means that a receiver who continues to employ workers, or continues to incur rental of property used by the company, will not be

[page 691]

personally liable for those debts. The debtor company is liable because the receiver is acting as its agent. This is consistent with the legal liability of directors when they enter into contracts on behalf of the company.

22.32

However, where the receiver enters into new contracts they will be personally liable under s 419, although the receiver will generally be able to use the company’s assets to satisfy that liability. A receiver will also usually seek a right of indemnity from the appointing secured creditor before he or she accepts the appointment.

Impact on directors The effect of receivership on the role and powers of the directors of the company placed into receivership depends on the type of appointment and the terms of the appointment instrument.

In a court appointment, the receiver is ordinarily appointed to control and manage the company’s entire assets, resulting in the directors having little role to play in the management of the company and no powers unless granted by the receiver.

In a private appointment, the scope of the receiver’s power is determined by the terms of the security instrument, which may cover all of the company’s property or only particular assets. The receiver is usually given management powers over the company’s assets, although if the security covers only certain assets the scope of this management power will be limited.

Hawkesbury Development Co Ltd v Landmark Finance Pty Ltd [1969] 2 NSWR 782 New South Wales Supreme Court

Receivership and management may well dominate exclusively a company’s affairs and dealings and relations with the outside world. However, it does not permeate the company’s internal domestic structure. That structure continues to exist even though the directors no longer have authority to exercise their ordinary business management functions. A valid receivership and management will ordinarily supersede, but not destroy, the company’s own organs through which it conducts its affairs. The capacity of those organs to function bears an inverse relationship to the validity and scope of the receivership and management.

[This principle has been applied on several subsequent occasions including by the Full Federal Court in Ernst & Young (Reg) v Tynski Pty Ltd (2003) 47 ACSR 433; [2003] FCAFC 233.]

22.33

The appointment of a receiver does not prevent the board of directors from challenging, on behalf of the debtor company, the validity of the receiver’s appointment, or any of his or her acts during the receivership: ss 418A and 434A. The directors of the debtor company also have an obligation during receivership, similar to other forms of external administration, to report to the receiver regarding the company’s affairs: s 429.

Furthermore, the appointment of a receiver does not mean that the common law and statutory duties owed by directors cease. Directors continue to be bound by their

[page 692]

duties while the company is in receivership, although the stringency of those duties is substantially lessened by the receivership, particularly if the company has stopped trading: Rosetex Co Pty Ltd v Licata (1994) 12 ACLC 269 (where a director was permitted to compete against the company while the company in receivership had stopped trading, provided that no confidential information owned by the company in receivership was used).

Impact on the company The appointment of a receiver or other controller will significantly impact on the company’s business and commercial reputation. Section 428 requires companies in receivership or under the control of a controller to notify the public of such control by placing the words (‘receiver appointed’)10 after the name of the company in all its public documents.

Aside from public notification requirements, receivership may also have more dramatic consequences for the debtor company as the appointment of a receiver is likely to be a triggering event in any other security agreements entered into between the debtor company and other secured creditors, meaning that even if not all of the company’s property is subject to the receivership, the remaining portion of the company may be placed into another form of external administration (most likely voluntary

22.34

administration or further receivership). It is here that the conflict between secured creditors (the contest of priority) arises. As to the priority rules relating to secured debts, see Chapter 10. It should be noted that the enforcement provisions of Ch 4 of the Personal Property Securities Act 2009 (Cth) do not apply while the company is in receivership: PPSA s 116.

Impact on creditors The appointment of a receiver does not terminate the contracts entered into by the company. Furthermore, the private appointment of a receiver does not (unlike in liquidation and in VA) impose a moratorium on the enforcement of claims by creditors against the company. This might seem, then, that creditors are free to seek repayment of their debts against companies in receivership. Although there is no statutory moratorium on claims during a privately appointed receivership, there are effectively minimal claims made against the debtor company because the assets are not owned by the company, but rather by the secured creditor who has title, and therefore it is likely that the company would be unable to pay any judgment debt.

The Corporations Act was amended in 2017 to provide that ipso facto clauses in contracts could not be exercised due to the appointment of a receiver as managing controller (where they are appointed over the whole or substantially the whole of the company’s property): s 434J. Ipso facto clauses are provision in contracts that operate automatically on the appointment of an external administrator (such as a liquidator, administrator or receiver) or on the company’s insolvency. The ipso facto amendments are due to commence in early 2018.

Receivership presents a particular problem for employees. This is because the receiver takes over the management of the business and therefore has the power to

[page 693]

hire and fire employees. Employee entitlements, including any damages payable for breach of the employment contract or unfair dismissal, are

22.35

22.36

not incurred by the receiver but rather by the company because the receiver acts as the agent of the debtor corporation. While employees receive some protection under liquidation (through their priority ranking in s 556 and the FEG arrangements) and voluntary administration (employee entitlements cannot be varied without their consent in a DOCA), there is no similar protection in receivership because (in theory) a receivership does not terminate the business of the debtor company.11

Overlap between receivership and other types of external administration Liquidation

Secured creditors, whose security has become enforceable generally, have a direct property right in the secured assets. This enables them to take possession of those assets without any further approval or court application necessary. Therefore, the private appointment of a receiver is not prevented by the fact that the debtor company is already in liquidation. Similarly, a company that is currently in receivership may still be placed into liquidation.

The appointment of a liquidator may, however, invalidate certain securities: see ss 588FJ, 588FL and 588FP.

At common law, one consequence of liquidation on a pre-existing receivership was often to terminate the receiver’s position as an agent of the debtor company. The significance of this termination was potentially to render the receiver personally liable for debts and liabilities incurred during the receivership.

Section 420C now protects the agency status of a receiver after the appointment of a liquidator provided that the receiver obtains the permission of the court or the liquidator when taking action on behalf of the company.

Voluntary administration A large secured creditor (that is, a creditor with an enforceable security over the whole or substantially the whole of the company’s property) is

22.37

allowed to enforce its security within the decision period of a voluntary administration: s 441A. Where a receiver is already in control of secured assets of a company, the appointment of a voluntary administrator will not prevent the receiver from acting. This is because all secured creditors are permitted to continue enforcing their security prior to the commencement of administration.

Advantages and disadvantages There are several advantages to receivership. First, the receiver replaces the debtor company’s management and thus safeguards the company’s assets from further depletion. Second, a privately appointed receiver works for the benefit of the appointing

[page 694]

secured creditor and provides an efficient way to maximise their interests. However, this is also a disadvantage for other creditors. Unlike a liquidation or voluntary administration, the privately appointed receiver does not act for the benefit of creditors generally and aside from duties owed in equity and under statute (of which breaches are generally hard to prove), the receiver is not directly liable to the general creditors.

A further disadvantage of receivership is the lack of a moratorium, particularly with regard to property that is leased by the debtor company. In a voluntary administration, the moratorium applies also to leased and hired property, which allows the company to continue in business even if the owner of the property would like to terminate the contract. In receivership, a landlord (for example) may terminate the lease if a receiver is appointed. This is one reason why voluntary administration was introduced, because receivership was often seen as signalling the ‘death knell’ of the debtor company. Furthermore, the almost exclusive focus of private receivership on protecting the rights of secured creditors to the exclusion of other stakeholders has led some to doubt the continuing utility of the procedure. Indeed, the United Kingdom recently abolished private receivership in insolvency in favour of promoting corporate rescue through administration.

•

22.38

(a)

(b)

Should private receivership be limited to better protect companies in financial distress and the interests of all creditors?

Voluntary administration

Need for voluntary administration Part 5.3A of the Corporations Act introduced the voluntary administration procedure in Australian corporate law in 1993. Voluntary administration was introduced following the recommendations of the Australian Law Reform Commission’s General Insolvency Inquiry (the Harmer Report) in the late 1980s.

corporate rescue: a procedure that is designed to save the insolvent company rather than simply selling its assets.

The Harmer Report recommended the introduction of a corporate rescue regime, to perform a similar role to the United States Ch 11 bankruptcy procedure. Given the corporate rescue imperative, the purpose of voluntary administration is therefore to assist insolvent companies to trade out of their difficulties: s 435A(a). The object of Pt.5.3A is stated in s 435A as being to provide for the business, property and affairs of an insolvent company to be administered in a way that:

maximises the chances of the company, or as much as possible of the business, continuing in existence; or if it is not possible for the company or its business to continue in existence — results in a better return for the company’s creditors and members than would result from an immediate winding up of the company.

This purpose may, however, be unachievable, with some companies facing a hopelessly insolvent future (often because of changing economic conditions beyond the company’s control).

In situations where the company in financial distress is unable to be rescued, the purpose of voluntary administration is to provide a more efficient insolvency process than other alternatives.

[page 695]

The Harmer Report expressed the hope that entering into a voluntary administration would allow a hopelessly insolvent company more time to arrange its affairs (for example, by attempting to sell the company’s business as a going concern) so as to attempt to provide creditors with a

22.39

higher possible return on their debts than they would receive by going straight into liquidation. This intention, as seen above, is expressed as a statutory purpose of voluntary administration: s 435A(b).

[page 696]

Lehman Brothers Holdings Inc v City of Swan (2010) 240 CLR 509 High Court of Australia

The Part [5.3A] is drafted in a way that emphasises the need for prompt action in implementing its provisions, and prompt decisions by creditors about the fate of a company to which administrators are appointed. As the statement of the object of Pt 5.3A in s 435A makes plain, the central concern of the Part is regulation of the administration of an insolvent company.

The speed with which it is expected that an administrator and the creditors will act may suggest that Pt 5.3A was expected to find common application to small and medium enterprises. It would not be right, however, to draw from that observation a conclusion that [voluntary administration] can have no application to larger or more complex enterprises.

How is voluntary administration commenced? There are three ways to commence voluntary administration:

Section 436A by the company (except where the company is in liquidation): the directors must make a board resolution that an administrator should be appointed because the company is or may become insolvent. Section 436B by the liquidator who may appoint an administrator in writing. The appointment of a voluntary administrator by a liquidator does not terminate the liquidation. Section 436C by a secured creditor (except where the company is in liquidation): a secured creditor with an enforceable security interest over the whole or substantially the whole of the company’s property12 may appoint an administrator. Most bank-secured financing documents are expressed to take a security interest over all of the company’s assets so this requirement will be satisfied in most cases.

•

22.40

Despite there being three ways to appoint an administrator, the vast majority of appointments are made by the company’s directors (under s 436A). Secured creditors may be reluctant to appoint a voluntary administrator because an administrator has a duty to act in the best interests of all creditors. Thus, they may prefer to appoint a receiver who will act in their interests.

Why do you think that company directors would want to appoint an administrator? What advantages does administration have for the directors?

Who may work as a voluntary administrator? Similar to other external administrators, discussed above, only registered company liquidators can work as voluntary administrators: s 448B. In recent times concerns have been raised about the independence of voluntary administrators. This is of

[page 697]

a particular concern because the majority of appointments are made by company directors. Fears have been raised that directors may be appointing ‘friendly administrators whom they hope will not undertake an extensive investigation (particularly with regard to possible breach of directors’ duties and insolvent trading). Concerns may be raised regarding the fact that many insolvency practitioners work within large accounting and professional advisory firms who may be under a conflict of interest if they are appointed by the directors of an insolvent company. These concerns led to amendments to the Corporations Act that require administrators (and voluntary liquidators — see s 506A) to declare all previous relationships with the company and its directors at the time of appointment: s 436DA. This gives the creditors an opportunity to remove the voluntary administrator at the first creditors’ meeting held within eight business days after the appointment. Creditors may also form a committee of creditors to assist and advise the administrator during the

22.41

1. 2.

22.42

administration.13 Creditors can also replace administrators at any time under IPS (Corporations) s 90-35.

Duration The voluntary administration of a company begins when the administrator is appointed and ends after the final creditors’ meeting: s 435C(1). The final creditors’ meeting must generally be held within five business days before or after the 20-business-day ‘convening period’ (for a maximum total of 25 business days assuming the VA does not commence in December or prior to Easter in which case the convening period is 25 business days) after the administrator’s appointment: s 439A.

For complex corporate insolvencies, this time frame will be difficult, if not impossible. Thus, the law allows extension of the time limit either by adjourning the creditors’ meeting (for a maximum of 45 business days) or by seeking a court ordered extension under s 447A. In recent years the courts have granted lengthy extensions of time to enable the administrator to develop a workable solution directed to achieving the purposes of voluntary administration as expressed in s 435A.

There are three possible outcomes to the final creditors’ meeting held under s 439A:

terminate the administration and continue trading; enter into a deed of company arrangement between the company and its creditors; or liquidate the company.

The majority of voluntary administrations proceed to a liquidation, with the remaining proportion of administrations entering into a deed of company arrangement as part of a process to recapitalise the business or sell it to a solvent buyer.

Administrator’s role The role of the voluntary administrator is to investigate the company’s affairs so that a recommendation can be made to the creditors at the final creditors’ meeting as to the future of the company in relation to one of the

22.43

1. 2.

three possible outcomes identified above.

[page 698]

Once appointed over a company, the voluntary administrator takes control of the business and the directors are effectively frozen out of the management. Section 437D states that any transaction dealing with the company’s property without the prior written consent of the administrator or court approval is void. Therefore, only the administrator has the power to deal with the company’s assets or manage the business. Typically, an administrator would allow the management to continue in the day-to-day operations of the business, under the supervision of the administrator.

Role of administrator during creditor meetings As noted above, the administrator must call a final creditors’ meeting within five business days after the end of the 20-business-day convening period. The convening period commences on the next business day after the administrator is appointed: s 439A(5). The sole purpose of the second creditors’ meeting is to decide the future of the company in voluntary administration: s 439C. At the meeting, which is chaired by the administrator, the creditors receive a report from the administrator that must recommend one of three possible outcomes of the administration:

terminate the administration and return the company to the directors; terminate the administration and place the company into a voluntary creditors’ winding up; or the creditors sign a deed of company arrangement with the company that terminates the administration and outlines a scheme to repay at least part of the debts owed by the company.

In order to vote at either meeting, a creditor must have its claim to be owed a debt by the company (called a ‘proof of debt’) accepted by the administrator: see Corporations Regulations 2001 (Cth) reg 5.6.23.

Voting in creditors’ meetings is ordinarily done by a simple majority show of hands, although a formal poll may be required to determine a more precise majority. The rules for creditor meetings are found in IPS

22.44

• • •

•

22.45

(Corporations) Div 75 and Insolvency Practice Rules (Corporations) Div 75.

Administrator’s powers Section 437A provides administrators with the power to:

control the company’s business, property and affairs; carry on that business and manage that property and those affairs; terminate or dispose of all or part of that business, and may dispose of any of that property; and perform any function, and exercise any power, that the company or any of its officers could perform or exercise if the company were not under administration.

As noted above, the powers of company officers are suspended during the period of voluntary administration: s 198G. Furthermore, only the administrator is permitted to deal with the company’s property during the course of administration. The administrator may, however, grant permission to another person to deal with company property.

[page 699]

The administrator’s powers during the administration extend to all property held by the company, even property that the company does not own (such as goods leased or under hire-purchase arrangements). Section 440B imposes restrictions on the rights of third parties to take action against the property used by the company, while ss 442B and 442C allow the administrator to continue to deal with such property in limited circumstances in order to achieve the goals of voluntary administration.14 If the third party has a security interest in the whole or substantially the whole of the company’s assets, then it may take enforcement action within 13 business days after appointment: s 441B.

Administrator’s duties and liabilities A voluntary administrator is an ‘officer’ as defined in s 9 of the Act. This

•

22.46

•

means that the duties of company officers in ss 180-184 apply to voluntary administrators. The administrator also has the statutory responsibility to report any potential breaches of the Act by company officers to ASIC: s 438D.

Similar to receivers and liquidators, a voluntary administrator works as the agent of the company (s 437B), and does not usually incur personal liability for their actions. There are some limited exceptions (s 443A):

a voluntary administrator will incur personal liability for rent payable by the company from five business days after their appointment, although the administrator may disclaim liability under the lease by serving a notice on the lessor (in which case the administrator is bound to return the property to the lessor); and a voluntary administrator will also incur personal liability for contracts entered into by the administrator during their appointment.

Administrators can claim an indemnity over the company’s assets in order to satisfy their personal liability: s 443D.

Impact of the administration on the company and its directors The appointment of a voluntary administrator does not discharge any contracts or other obligations owed by the company. Individual suppliers may of course decide that they no longer wish to supply the company and certain contracts (leases for example) may specify termination on the appointment of a voluntary administrator or other external administrator.

As noted above, VA suspends the powers and functions of the company’s board of directors for the period of the administration. The administrator assumes control of the company: s 437A.

Section 438B also imposes statutory duties on the directors of the company under administration to assist the administrator by:

providing the administrator with a report regarding the company’s affairs; giving the administrator any company books that the directors have in their possession;

• •

22.47

[page 700]

attending on (that is, assisting) the administrator; and providing any information concerning the company’s affairs that is required by the administrator.

Only the administrator has the power to deal with the company’s property during the administration. Any attempt to deal with the company’s property without the administrator’s prior written consent or the court’s approval will have no legal effect: s 437D. If a director, or indeed any other person, attempts to deal with the company’s property without consent, that person may be liable to pay compensation to any party that suffers damage as a result of the invalidity of the transaction: s 437E.

On the positive side, as noted above, the appointment of a voluntary administrator will suspend the enforcement rights against director guarantees of the company’s debt for the period of the administration: s 440J. As many small- to medium-sized businesses involve personal guarantees from company officers to secure corporate loans, this provides an incentive for directors to be pro-active and appoint an administrator if the company gets into financial difficult by giving protection against enforcement of those guarantees (at least for the period of the VA).

Impact of the administration on creditors The impact that voluntary administration will have differs depending on the type of creditor. Generally speaking, one of the distinct advantages of voluntary administration is the extensive moratorium on claims against the company in administration. This is designed to provide the company with time to restructure its affairs so that it may achieve the statutory purposes of voluntary administration under s 435A.

Reforms to the Corporations Act in 2017 provide protection for companies in administration against ipso facto clauses in contracts that are triggered if a company entered administration: s 451E. This protection helps the company during administration because in the absence of this protection parties to contracts with the company may be able to

22.48

terminate or vary their contract simply because the company has entered administration. The contractual counterparty may attempt to use the ability to terminate or vary contracts to try and extract further benefits from the company in order to refrain from exercising their ipso facto rights. The ipso facto protection does not continue if the company goes from administration into a deed of company arrangement, unless the court orders otherwise. These reforms are due to commence in early 2018.

Secured creditors For secured creditors that have commenced enforcement proceedings prior to the appointment of the voluntary administrator (for example, by appointing a receiver), the administration will not prevent them from continuing to enforce their rights: s 441B.15 For secured creditors with a security interest over the whole or substantially the whole of the company’s property (including property supplied to the company under a PPSA lease or retention of title arrangement), they will be permitted to enforce their rights for up to 13 business days after the administrator’s appointment: s 441A. However, after

[page 701]

vesting: the security interest in collateral being transferred to the debtor so that a secured creditor becomes unsecured.

the 13-business-day ‘decision period’ they will be bound by the moratorium and must wait until the end of the administration. The moratorium is further enhanced by s 440B, which renders security interests unenforceable against the company under voluntary administration without approval from the court or the administrator. The appointment of the administrator may also mean that the security interest is vested in the company: PPSA ss 267, 267A; see also Corporations Act s 588FL.

The ability of the administrator to deal with assets subject to security is limited unless the court or the secured creditor gives permission. However, these large secured creditors (typically banks) have

22.49

•

22.50

considerable bargaining power and will usually negotiate with the administrator to obtain maximum protection rights for the duration of the administration (such as by obtaining written permission to appoint a receiver even after the 13-business-day decision period).

Unsecured creditors There is a statutory moratorium (or stay) of pre-existing claims against the company when an administrator is appointed under s 440D. During the moratorium period:

judgment creditors may not seek to enforce the payment of debts ordered by the court; and court officers (sheriffs etc) may not execute repayment for judgments debts.

The moratorium under s 440D may be broken if permission to enforce action against the company and its property is given in writing by the court of by the administrator. However, this is generally difficult to obtain as the administrator seeks to keep the business together and preserve the pool of assets leading up to the final creditors’ meeting. The moratorium is a necessary component of voluntary administration as a corporate rescue mechanism (which is one of the goals of Pt 5.3A stated in s 435A) because it gives the debtor company time to determine the appropriate future direction of the company without the need to defend claims against the company’s property.

Impact of the administration on employees Unlike in a liquidation, the appointment of an administrator does not automatically terminate the employment contracts of employees. The administrator does, however, have the power to manage the company under s 437A. Consequently, the administrator may therefore choose to terminate the employment of particular workers, or indeed all workers. The power to manage the company under s 437A does not, however, provide statutory basis to terminate employment contracts in breach of industrial instruments such as awards or certified agreements: Patrick Stevedores Operations No 2 Pty Ltd v Maritime Union of Australia (No 3) (1998) 195 CLR 1 at [138] per Gaudron J. If employees wish to pursue the

22.51

• • •

administrator in respect of payment of their entitlements in the event that they are terminated by the administrator, their legal actions will be caught by the moratorium under s 440D.16 Employees do receive protection against variation of the priority of their statement workplace entitlements if the company enters a deed of company arrangement (discussed below).

[page 702]

Deed of company arrangement A deed of company arrangement may be entered into after voluntary administration has ended. This outcome may result if the company’s creditors agreed to the deed at the final creditors’ meeting held under s 439A. At the final meeting of creditors, the company’s creditors will decide whether the company should continue to trade independently, whether the company should be put into liquidation or whether a deed of company arrangement will be entered into. If the creditors fail to make a decision (that is, fail to pass a resolution at the final meeting), then the company will automatically go into a creditors’ voluntary liquidation: s 446A.

A deed of company arrangement is an arrangement between the company and its creditors whereby the creditors agree not to pursue their otherwise legally enforceable rights against the company in order to give the company a better opportunity to meet its liabilities. Importantly, a deed only requires a simple majority of creditors to pass a resolution to approve a deed proposed by the administrator at the final creditors’ meeting.

The deed may include any number of possible changes to the company’s business including:

sale of company assets; altering company management; or specific changes to company business leading up to an eventual liquidation.

The deed is carried into operation by a deed administrator whose powers

22.52

•

and responsibilities are determined by the terms of the deed. The deed must be executed within 15 business days of the creditors’ resolution: s 444B. If the company fails to execute the deed (that is, sign the deed) within the required time, the process will automatically transfer into a creditors’ voluntary liquidation. The administrator will normally be the deed administrator unless the creditors decide to change the administrator. The deed may be varied or terminated by the creditors or the court, which ordinarily plays a supervisory role but can be engaged by creditors to protect the company: see in particular s 445D.

Effect of deed of company arrangement on creditors When a deed of company arrangement has been executed by the company’s creditors, it binds all of the company’s unsecured creditors, as well as the company’s officers: s 444D. Creditors cannot be forced to give up rights they may have against parties other than the debtor company (such as directors or related companies): Lehman Brothers Holdings Inc v City of Swan (2010) 240 CLR 509.17

Secured creditors are only bound by a deed if they voted in favour of the deed. In practice, this means that secured creditors rarely vote in favour of proposed deeds. If an unsecured creditor is concerned about the impact of the deed on their rights, they may apply to the court to have the deed set aside: see s 445D.

[page 703]

Creditors are bound by a deed of company arrangement to the extent that their claims arose prior to the time specified for that purpose in the deed. Until the deed terminates, they may not:

make or prosecute an application for the winding up of the company; or take any action against the company or its property without the court’s leave.

It is also important to bear in mind that the court has the power to limit the rights of secured parties under a deed where the exercise of those

•

22.53

• • • •

rights would adversely affect the purposes of the deed. However, the court can only make such an order where it would not prejudice the creditor’s rights (s 444F). For example, a deed may propose to sell the business as a going concern in order to fully repay the company’s debts. If a secured party (who would not usually be bound by a DOCA proposal unless they voted for it) opposed such a sale, the administrator could seek a court order preventing them from enforcing their security so as to allow the sale to proceed. In such a situation, the court would require the administrator to pay a proportion of the sale proceeds into a separate account to meet the secured party’s debt.

The court may also make an order limiting the ability of owners and lessors to recover their property if such recovery action would frustrate the purpose of the deed.18

The advantages of a deed of company arrangement for creditors are that there is a chance that they may obtain a greater proportion of their debts and will obtain their money more quickly than if the company had been put into liquidation. However, these returns are still relatively low: between 5-14%.19 While this seems very low, in many liquidations there is nil return to unsecured creditors.

Why are the returns in voluntary administration so low? Do you think directors may leave appointing an administrator until the company is hopelessly insolvent? Are there any risks in appointing an administrator too early?

Contents of a deed The contents of a deed of company arrangement (a deed) are prescribed under s 444A(4), reg 5.3A.06 and Sch 8A. The following is a summary of matters that must be disclosed in a deed:

the property covered by the deed; the impact of the deed on the pre-existing debts of the company; who shall administer the deed; whether the deed is subject to any conditions;

• •

•

22.54

1. 2.

the duration of the deed; and how the deed may be terminated.

[page 704]

The contents provided in Sch 8A are merely default provisions that may be varied in the deed voted on by creditors. Employees must be given priority for their statutory entitlements (similar position under liquidation: see s 556), otherwise they must approve of the DOCA under a resolution at a separate meeting: s 444DA.

Why is it necessary to give special protection to employees under a DOCA?

Variation and termination of a deed A deed of company arrangement may be altered by an ordinary resolution passed at a creditors’ meeting: s 445A. A creditor who is dissatisfied with the variation of the deed may apply to the court for an order setting aside the variation: s 445B.

A deed of company arrangement may be terminated in three ways:

by the terms of the deed itself; by a creditors’ resolution passed at a meeting held under s 445F (subject to s 445CA); or by an order of the court under s 445D or s 447A.

The court also has the power under s 445G to make an order concerning the validity of a deed.

The importance of the court’s powers to terminate a deed cannot be overstated. This is because the creation and implementation of a deed do not require court permission, which opens up the possibility of abuse or oppression of smaller creditors. There is also the potential for an

22.55

impartial administrator to put forward a deed that favours particular creditors. In these situations, the court may set aside the deed.

The leading decision on s 445D is Bovis Lend Lease Pty Ltd v Wily (2003) 45 ACSR 612; [2003] NSWSC 467, where Austin J considered that issues of administrator independence (a consultant of the administrator’s firm had previously given advice to the sole director of the company under administration) and the fact that this was not made known to the creditors’ meeting when voting on the proposed deed were sufficient to justify terminating the deed of company arrangement.

Role of the court during a voluntary administration General powers: s 447A

Voluntary administration was designed to minimise the amount of court involvement in order to keep costs and delays to a minimum. The court does, however, have a general supervisory power with respect to voluntary administrations under s 447A(1), which provides: ‘The Court may make such order as it thinks appropriate about how this Part is to operate in relation to a particular company.’ The power of the court to make orders regarding the operation of voluntary administration has been interpreted very broadly. 20 The width of the power under s 447A was considered by the High Court in Australasian Memory Pty Ltd v Brien.

[page 705]

Australasian Memory Pty Ltd v Brien (2000) 200 CLR 270; [2000] HCA 30 High Court of Australia

Facts: Joint voluntary administrators held the final creditors’ meeting eight days earlier than required under s 438A. The creditors resolved at the meeting to place the company into liquidation, with the voluntary administrators becoming joint liquidators. As part of the liquidation a statutory demand was served on debtors of the insolvent company. Two of the debtors challenged the capacity of the

• • • • • •

22.56

•

liquidators to issue demands for payment on behalf of the company where the liquidation had not been validly commenced because the final creditors’ meeting had been held too early.

Issue: Could s 447A be used to correct the defective appointment of the liquidator, which resulted from the final creditors’ meeting being held too early?

Decision: The court decided that the defective final creditors’ meeting purportedly held early under s 439A could be validated by an order under s 447A. This was based on a broad view of the role of s 447A, which the court found should not be limited to correcting defects and irregularities, but rather should have a more substantive operation that allowed the court to shape the operation of voluntary administration. In this case, the court used the power under s 447A to validate the company’s transfer between voluntary administration and liquidation. It should be noted that ss 438A and 439A were amended in 2007 to provide more flexible time limits.

Significance: The effect of the High Court’s decision is that s 447A may be used to alter how a particular voluntary administration proceeds, by changing the requirements of Pt 5.3A as they apply to that particular company. The power may be used even where there is no defect or problem (such as the failure to hold a creditors’ meeting on time) regarding the ordinary requirements of Pt 5.3A.

The broad interpretation given by the High Court has been enthusiastically embraced in subsequent decisions. Examples of where s 447A has been used include:

removing an administrator; amending or terminating a deed of company arrangement; extending time periods under Pt 5.3A; approving a proposed deed of company arrangement; curing procedural defects in meetings held under Pt 5.3A; and invalidating the resolutions of a creditors’ meeting under Pt 5.3A.

Despite the breadth of the scope of s 447A, it is not however without limits. The courts have noted on several subsequent occasions that the court may only exercise power under s 447A in a manner that is consistent with the objects of Pt 5.3A: see Re Ansett Australia Ltd and Mentha (2001) 115 FCR 376; [2001] FCA 1806.

Specific powers In addition to broad general powers under s 447A, the court also has a number of specific powers with respect to the conduct of voluntary administration and the execution and implementation of deeds of company arrangement. The court has the following specific powers:

making orders to protect creditors (IPS (Corporations) s 90-15);

•

22.57

declare the validity of an administrator’s appointment (s 447C); and

[page 706]

give directions to the administrator about the conduct of the administration (IPS (Corporations) s 90-15).

The power to give directions is particularly important because, as noted above, the administrator incurs personal liability for many debts that accrue during a VA. It is important for administrators to be as certain as possible that their conduct will not be open to challenge in court by a disgruntled stakeholder. If an administrator seeks some degree of certainty about the legality of a proposed course of conduct, the administrator may apply for directions from the court. An application for directions cannot be made concerning the commercial merits of a particular decision: Re Ansett Ltd (No 3) (2002) 40 ACSR 433. The court will only give directions regarding questions of law.

Advantages and disadvantages of voluntary administration Voluntary administration has several significant advantages over other forms of external administration. First, voluntary administration provides a very extensive moratorium over claims against the company, which gives the company time to formulate a restructuring process. Where the company enters into a deed of company arrangement, there is a considerable amount of flexibility in the deed procedure that allows the company and its creditors (with the administrator facilitating the process) to come to a mutually beneficial restructuring proposal that will hopefully return the company to solvency or at least provide a better return to the creditor than would result from the company’s winding up.

Second, the coverage of the moratorium over secured creditors as well as owners and lessors of property used (but not owned) by the debtor company provides considerable leverage for the administrator to continue trading the business or to sell the business as a going concern. Other types of external administration do not cover these situations and therefore the owner can demand return of the property (depending on the

22.58

provisions in the lease or supply contract). As an example, a lessor of an office building leased by the debtor company could terminate the lease on liquidation, but could not recover the property after the appointment of a voluntary administrator.

Third, voluntary administrations are quicker and cheaper to implement than a scheme of arrangement (discussed below). Unlike a scheme of arrangement, there is no need for mandatory court involvement in voluntary administration, saving time and expense. There are also some disadvantages of voluntary administration. First, the time limits imposed on administrators are, in complex cases, highly unrealistic. There is not enough time for the administrator to fully investigate the company’s affairs to make a proper recommendation to the creditors at the final meeting.

Furthermore, in some cases it may be that directors appoint a voluntary administrator to delay the winding up of the company or to frustrate (because of the moratorium) litigation against the company. Lastly, it may well be that the directors appoint the administrator in the vain hope of saving the company, when in fact the business is hopelessly insolvent and should be wound up without further delay.

[page 707]

Scheme of arrangement

How is a scheme of arrangement commenced? A scheme of arrangement is commenced by the debtor company formulating a debt reorganisation with its creditors. Prior to putting the reorganisation plan to the creditors for a vote, the company must prepare an explanatory statement (s 412) which details the nature of the scheme. The content of the explanatory statement is prescribed under s 412 of the Corporations Act and Sch 8 of the Corporations Regulations.

Once the company has prepared the scheme proposal and explanatory statement, it must seek the court’s permission to hold a creditors’

• •

•

22.59

•

meeting to vote on the scheme proposal. In deciding whether to grant permission to hold the creditors’ meeting, the court will examine:

whether the explanatory statement complies with the law; whether the court would approve of the scheme if creditors did vote for the proposal; and whether the scheme proposal is commercially fair and reasonable. In other words, would a reasonable business person approve of the scheme?

Once court approval to hold the meeting has been obtained, the company must hold a creditors’ meeting.

Creditors’ meeting Section 411(4) provides that the creditors’ meeting may approve of the scheme proposal by passing a resolution of creditors with a majority constituting 75% of the value of debts owed by the company. However, that 75% majority must comprise at least 50% of the creditors of the company who are eligible to vote at the meeting.

One difficulty with schemes of arrangement is that the creditors’ meeting must be divided up into different classes of creditors, where the interests of creditors are different. In practice, this has led to much confusion with unhappy creditors challenging meetings on the basis that classes were improperly constituted. However, the courts have interpreted the need for different classes as referring to differences in rights held by creditors (for example, secured creditors and unsecured creditors have fundamentally different rights), and not merely that the creditors have different interests (such as some creditors supporting the scheme while others not supporting it): see First Pacific Advisors LLC v Boart Longyear Ltd (2017) 121 ACSR 136; [2017] NSWCA 116.

Can you think of three different classes of creditors who may be involved in a Discussion scheme of an insolvent company and would need to be placed into separate voting classes?

22.60

22.61

22.62

Final court approval One disadvantage with a scheme of arrangement is that it requires the approval of the court on two occasions. The first court approval is obtained in relation to holding the creditors’ meeting to consider the scheme and accompanying explanatory statement.

[page 708]

The second court approval is required after the creditors have approved the scheme: s 411(4). Thus, the court has the discretion to refuse to allow the scheme to proceed even where a majority (or indeed, all) of the creditors have approved the scheme. This is designed to protect the ‘commercial morality’ of the scheme provisions, with the court ensuring that the scheme is commercially appropriate. This involves the protection against possible oppression of the minority creditors, and the need to prevent insolvent companies from continuing to trade. The court is unlikely to approve of a scheme that does not return the company to solvency.

Who may work as a scheme administrator? Scheme administrators are required to be independent of the company and must be registered company liquidators. While acting as a scheme administrator, the person will be considered an ‘officer’ of the corporation under s 9 of the Corporations Act and therefore will come within the duties and obligations of company officers under the Act.

Duration There are no legislative prescriptions as to the duration of a scheme of arrangement, which is entirely appropriate given that the scheme essentially involves a contractual relationship whereby the company’s creditors agree to restructure their debt contracts in exchange for the results proposed by the scheme (usually the rehabilitation of the debtor company and the continuation of a trading relationship).

22.63

22.64

Scheme administrator’s role and powers These are provided under the terms of the scheme proposal, further demonstrating the flexibility of a scheme of arrangement.

Impact on creditors The impact of the scheme on creditors’ rights will be determined by the proposals documented in the scheme. It should, however, be noted that a scheme will impact on the rights of dissenting creditors (that is, creditors who do not vote for the scheme proposal at the creditors’ meeting). Dissenting creditors are bound by the terms of the scheme if the required majority approves the scheme at the creditors’ meeting and the court grants final approval to the scheme. Of course, a dissenting creditor may seek to oppose the scheme by giving evidence in court when it considers whether to grant final approval. A dissenting creditor may also complain to ASIC, as ASIC must be consulted regarding proposed schemes and will make submissions to the court (usually in writing) regarding its views on the proposed scheme.

A scheme may be used to require creditors to give up their rights against third parties (such as directors or related companies) where the scheme is being funded by the third party and there is a sufficient connection between the purposes of the scheme and the claims of creditors. This was recognised in the Opes Prime scheme which involved a complex financial services business that was funded by several banks. The clients of the firm had claims against Opes Prime and also brought claims against the funding banks for participation in misleading or deceptive conduct. The banks contributed more than $200 million to support a scheme provided they received a release from claims by creditors of Opes Prime. The Full Federal Court approved the

[page 709]

scheme after an overwhelming majority of creditors voted in favour of it: Fowler v Lindholm (2009) 178 FCR 563; [2009] FCAFC 125.

Advantages and disadvantages

22.65

Advantages and disadvantages There are several advantages and disadvantages to schemes of arrangement. First, the flexibility of the scheme proposal is a big advantage as the company and its creditors can design an appropriate restructuring proposal. However, this advantage also applies to a deed of company arrangement. Second, a scheme of arrangement is able to bind dissenting creditors, but this too is a feature of the DOCA procedure.

Against this, there are significant disadvantages to using schemes in corporate insolvency. First, a scheme is a time-consuming process that requires both court and creditor approval. Second, the requirement to seek court approval twice (first to hold the creditors’ meeting and second to implement the scheme) is overly expensive compared with voluntary administration. The process to implement a scheme is cumbersome compared with the process of voluntary administration.

It is therefore understandable that since the introduction of voluntary administration in 1993 there have been only a small number of schemes of arrangement used in corporate insolvencies.

Lehman Brothers Holdings Inc v City of Swan (2010) 240 CLR 509 High Court of Australia

The structure and detailed terms of Pt 5.1 [schemes of arrangements] are quite different from those of Pt 5.3A [voluntary administration]. In particular, court approval in advance is always required under Pt 5.1; in Pt 5.3A the role of the court is only belated and occasional — after the deed of company arrangement has been entered, and even then only if the creditor complains. The much more ample oversight of the court under Pt 5.1 contrasts with the significant things which can be done under Pt 5.3A [such as the entering into of a deed of arrangement] without court sanction.

Table 22.1 Advantages and Disadvantages

[page 710]

[page 711]

4. 5.

6. 7. 8.

9. 10.

Revision Questions

What rights does an unsecured creditor have in external administration? Can a liquidator attempt to rescue an insolvent corporation by trading the business out of its troubles? Why/why not? What qualifications does a liquidator need to work as a court appointed liquidator? In whose interests does a receiver serve? Why is corporate rescue a legitimate aim of corporate insolvency law? What is a statutory demand and how is it significant? What is the role of the court in voluntary administration? Why is voluntary administration more popular than a scheme of arrangement? How are employees treated under receivership? Why does an external administrator need to be independent?

Problem Question Eric, Mary and Mei Ling are the only shareholders and directors of Acme Pty Ltd, a trading company that supplies food products to cafes around Brisbane. In recent times, Acme’s cash flows have been pressured because several large customers including CafeNow (a large franchise coffee shop with hundreds of outlets) have been late in paying their invoices. This has meant that on several occasions Acme has not had sufficient funds to pay its bills, particularly rent. The owner of its warehouse (Leaseco Ltd) has written several letters warning that if Acme is late in paying its rent, it will be evicted from the premises.

At the same time as the company’s cash flow troubles, the employees take industrial action in an attempt to receive a pay increase. This strike stops deliveries from the warehouse for two days, with several customers cancelling their supply contracts with Acme. The cash flow problems are increased when the company’s bank, Eastbank Ltd, threatens to appoint a receiver over the company if it does not pay its monthly interest within two weeks.

Eric, Mary and Mei Ling convene a board meeting to consider their options. Eric and Mei

(a)

(b)

Ling would like to negotiate with their creditors to restructure the company’s debts. Mary, however, would like to sell out and change industries.

Advise Eric, Mary and Mei Ling as to their options under the external administration procedures under the Corporations Act, including the advantages and disadvantages of such procedures. What impact would the procedures have on Acme’s creditors?

Guidelines for Answering Problem Questions

When answering a problem question concerning an overview of corporate insolvency, we suggest that the following method may be helpful:

First consider what outcomes the stakeholders (directors, secured and unsecured creditors) want.

[page 712]

Discuss what rights and powers the stakeholders may have under the different types of external administration. Explain what advantages and disadvantages the different types of external administration pose for the stakeholders. Depending on the wording of the question, choose the type of external administration that has the biggest advantages and least disadvantages for the stakeholder you are advising. Explain the process involved in initiating and completing the chosen form of external administration. References should be made to relevant statutory provisions in Ch 5 of the Corporations Act. Avoid quoting the content of those sections directly. Instead, try to summarise the rules underpinning the statutory provisions.

Erin and John realise that there is no hope for Wang and the business must be placed into external administration. Erin, John and Ben all convene a members’ meeting to remove Wang from the board. They come to you for advice about the company’s options for external administration. In particular, they are interested to hear about how different types of external administration could affect them, and what powers of investigation a liquidator, administrator or receiver may have to review their conduct in the company.

Further Reading

Academic Journals L Aiken, ‘Controlling the “Controller”: The Receiver’s Obligations under

Section 420A and in Equity’ (2005) 19 Commercial Law Quarterly 16. C Anderson and D Morrison, ‘Part 5.3A: The Impact of Changes to the

Australian Corporate Rescue Regime’ (2007) 15 Insolvency Law Journal 243.

J Armour and S Frisby, ‘Rethinking Receivership’ (2001) 21 Oxford Journal of Legal Studies 73.

J Ballo, ‘The Willmott Forests Decision: Changes to the Corporate Insolvency Regime?’ (2015) 23 Insolvency Law Journal 31.

M Broderick and D Morrison, ‘Vesting of Personal Property in Insolvency under the PPSA’ (2014) 22 Insolvency Law Journal 20.

N D’Angelo, ‘What Directors Need to Consider before Calling in an Administrator — And It’s Not Just Solvency’ (2006) 24 Company and Securities Law Journal 7.

A Hargovan and J Harris, ‘The Shifting Balance of Shareholders’ Interests in Insolvency: Evolution or Revolution?’ (2007) 31 Melbourne University Law Review 591.

J Harris, ‘Adjusting Creditor Rights Against Third Parties During Debt Restructuring’ (2011) 19 Insolvency Law Journal 22.

J Harris, ‘Corporate Group Insolvencies: Charting the Past, Present and Future of Pooling Arrangements’ (2007) Insolvency Law Journal 78.

J Harris, ‘The Constitutional Basis of s 447A: Is It a Power Without Limit?’ (2006) 14 Insolvency Law Journal 135.

J Harris and B Gordon, ‘Lost in Transition: Section 447A and the Question of Members’ Rights When a Company Transitions from Voluntary Administration to a Creditors’ Voluntary Liquidation’ (2005) 13 Insolvency Law Journal 96.

[page 713]

J Harris and A Hargovan, ‘Sons of Gwalia: Navigating the Line between Membership and Creditor Rights in Corporate Insolvencies’ (2007) 25 Company and Securities Law Journal 7.

S Maiden, ‘What Can a Voluntary Administrator Do About a Concurrently Appointed Receiver?’ (2006) 24 Company and Securities Law Journal 410.

D Morrison, ‘When is a Company Insolvent?’ (2002) 10 Insolvency Law Journal 4.

Practitioner Works H A J Ford, R P Austin and I M Ramsay, Ford’s Principles of Corporations

Law, LexisNexis, Australia (looseleaf and online), Chs 25-28. A Hargovan, ‘A Lender May Wear Both Belt and Braces: Brighten Case

Illuminates Law on Equitable Considerations Challenging Appointment of Receiver’ (2010) 10 Insolvency Law Bulletin 150.

A Hargovan, ‘Limitations to Deed of Company Arrangements: The Lehman Brothers Case’ (2009) 10 Insolvency Law Bulletin 39.

A Hargovan and J Harris, ‘Administrator Liability When Selling Encumbered Assets’ (2014) 15 Insolvency Law Bulletin 158.

J Harris, ‘Restructuring Nirvana? Chapter 11 Bankruptcy and Australian Insolvency Reform’ (2015) 16 Insolvency Law Bulletin 42.

M Murray and J Harris, Keay’s Insolvency, 10th ed, Thomson Reuters, Australia, 2018.

You will find useful study resources, including quizzes for each chapter, when you go to

5. 6.

10. 11.

12.

13.

14.

15.

16.

17.

18.

<http://learning.lexisnexis.com.au>. The quiz is a great tool to help you self-test your knowledge.

For illustration, see A Hargovan, ‘Lawyers’ Affidavits, Statutory Demands and Indemnity Costs: Lessons for Advisors’ (2010) 10 Insolvency Law Bulletin 110. It should be noted that there is an exception made for the members’ voluntary winding up of a proprietary company, where the liquidator is not required to be registered with ASIC: s 532(4). There are a number of other requirements; see further ASIC’s Regulatory Guide 258: Registered liquidators <http://www.asic.gov.au>. See K van Zwieten and R Austin, ‘Termination and Setting Aside of Winding Up Orders’ (2007) 81 Australian Law Journal 932. See further <https://www.employment.gov.au/fair-entitlements-guarantee-feg>. For a discussion of the scope of the amended s 563A, see Re TEN Network Holdings Ltd (Admins Apptd) (Recs and Mgrs Apptd) [2017] NSWSC 1247. If creditors appoint the reviewing liquidator then the review can only relate to the remuneration and expenses of the liquidation. See also Personal Property Securities Act 2009 (Cth) s 267 (PPSA). See, for example, Pozzebon (Trustee) v Australian Gaming and Entertainment Ltd (in liq) (2014) 225 FCR 305; [2014] FCA 1034 (registration lodged too close to liquidation and security interest vested in the debtor company when it entered liquidation). See further Chapter 10 on the operation of the PPSA. For useful collation of legal principles on the receiver’s duty of care under s 420A, see Boz One Pty Ltd v McLellan [2015] VSCA 68. Substitute ‘receiver and manager’ or ‘controller’ where applicable. See further McEvoy v Incat Tasmania Pty Ltd (2003) 46 ACSR 392; [2003] FCA 810 (applied recently in Vickers v Challenge Australian Dairy Pty Ltd [2011] FCA 10). These words are not specifically defined in the Corporations Act. In National Australia Bank Ltd v Horne (2011) 85 ACSR 639; [2011] VSCA 280 the court held that security over 68% of the company’s assets was not ‘substantially the whole of the company’s assets’. See further Senate Economics Committee, ‘The Regulation, Registration and Remuneration of Insolvency Practitioners in Australia: The Case for a New Framework’, September 2010. THC Holding Pty Ltd v CMA Recycling Pty Ltd [2014] NSWSC 1136 reinforces the need for all administrators to take care when disposing of property not owned by the company. For discussion, see A Hargovan and J Harris, ‘Administrator Liability When Selling Encumbered Assets’ (2014) 15 Insolvency Law Bulletin 158. There is also an exception for creditors who need to enforce security over perishable property: s 441C. See further P Darvas, ‘From the Outside Looking In: Employees and Voluntary Administration’ (2001) 19 Australian Business Law Review 409; C Hammond, ‘Relationship of Administrators to Company Employees’ (1999) 7 Insolvency Law Journal 74. See J Harris, ‘Adjusting Creditor Rights Against Third Parties During Debt Restructuring’ (2011) 18 Insolvency Law Journal 22. See Re Strazdins; DNPW Pty Ltd v Birch Carroll & Coyle Ltd (2009) 178 FCR 300; [2009] FCA 731 (where the court made an order preventing the lessor from recovering