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LAW205 Commercial & Corporate Law for Accountants

Corporate Governance and Directors’ Duties (Part II)

Week 5

CHAPTER 12

DUTIES OF DIRECTORS AND OTHER OFFICERS PART 2 Good faith and proper purpose

At the end of this topic you should know:

the conduct expected of directors under their duties of good faith and loyalty;

the overlap between the general law and statutory formulations of the duties of good faith and loyalty;

the requirements under the general law and the Corporations Act for the duty of good faith and proper purpose; and

the statutory formulation of the duty to retain discretions.

Outline of Duties of Loyalty and Good Faith

Directors owe duties of loyalty and good faith because they are in a fiduciary relationship with the companies on whose behalf they act. These duties can be divided into various categories:

to act in good faith in the interests of the company;

to use powers for their proper purpose;

to retain discretionary powers; and

to avoid actual and potential conflicts of interest and duty.

To Whom are the Duties Owed?

The duties are owed to the company (Percival v Wright [1902]), but has been extended to:

individual members;

creditors;

beneficiaries of trust; and

employees.

Duty to Act in Good Faith – Description and Source

The duty to act in good faith in the interests of the company requires directors to act “bona fide [good faith] in what they consider – not what the court may consider – is in the interests of the company”: Re Smith & Fawcett Ltd [1942].

The duty arises under:

the general law – in particular, from principles of equity collectively known as “fiduciary law”; and

ss181 (statutory duty) and 184 (can be criminal) of the Corporations Act.

Examples of Breach of Duty

Controlling members and controlling company assets.

Providing personal benefits.

Favourable directors’ transactions.

Forgiving debts owed to the company.

Transferring company assets to others.

Scope of Duty

Directors are required to act in good faith in what they consider to be the interests of the company as a whole — Re Smith & Fawcett.

Directors should consider the interests of the company as a commercial entity and the members of the company: Darvall v North Sydney Brick & Tile Co Ltd (1988).

In companies with two or more classes of shares, the courts have focussed on whether the decision was fair as between the different classes of members: Mills v Mills (1936).

Scope of Duty

If the company is insolvent or nearing insolvency then “interests of the company” includes the interests of creditors: Spies v R (2000).

In relation to dealings between companies in a corporate group, directors of wholly owned subsidiaries may make decisions which are in the best interests of the holding company, but not necessarily the best interests of the subsidiaries: s 187.

In relation to directors of partly owned subsidiaries, there are two lines of authority: one that favours directors having regard to the interests of the group (Charterbridge Corp Ltd v Lloyds Bank Ltd [1970]), and the other that favours the interest of the company in which they are a director (Walker v Wimborne (1976).

Scope of Duty

In relation to nominee directors, directors of wholly owned subsidiary companies, who were nominated by the holding companies, may have dual loyalties: s 187.

In relation to current employees and the community, directors may consider their interests, if they can affect the interests of the company (eg in industrial matters, or sponsorship that provides good public relations): Parke v Daily News Ltd [1962].

The company’s constitution may also permit directors to take account of a particular stakeholder’s interest ahead of others: Berlei-Hesta (NZ) Ltd v Fernyhough [1980].

Duty to Exercise Power for Proper Purposes

The duty concerns how directors, in managing a company, exercise the powers given to them by their employment contract, the company’s internal rules and the Corporations Act: ss 198A-198C.

The duty arises under fiduciary law (General law), and ss 181 and 184 of the Corporations Act.

The onus of establishing that the directors have acted improperly rests on the person(s) making allegations: Australian Metropolitan Life Assurance Co Ltd v Ure (1923).

Determining Whether Breach of Duty

To determine whether there has been a breach, courts apply a two-step test:

ascertain the nature and purposes for which power is conferred — the legal purpose by reviewing the internal rules, or the type of company, its structure and activities; and then

compare with the actual purpose or reason for which power was exercised by determining what the directors subjectively believed at the time they exercised the power.

Determining Whether Breach of Duty

In relation to multiple purposes, look at the substantive or dominant purposes (Whitehorse v Carlton Hotel Pty Ltd).

If the actual purpose for the exercise of the power is within the range of legal purpose(s), the directors have acted properly and discharged their duty.

If the actual purpose is outside the legal purpose(s), a breach of duty will have taken place.

Examples of Improper Purposes

Allotment of shares to defeat takeover: Howard Smith v Ampol Petroleum [1974].

Allotment of shares to transfer control of a major company asset: Bailey v Mandala Private Hospital (1988).

Dominant purpose of allotment of shares to preserve the position of majority members: Whitehorse v Carlton Hotel Pty Ltd (1987).

Allotment of shares used to dilute/devalue existing members: Kotokovich Constructions Pty Ltd v Wallington (1995).

Section 181 – Good Faith and Proper Purpose

The statutory duty in good faith has been interpreted as being broadly equivalent to the general law duties to act in good faith, in the interests of the company and for proper purposes.

The standard is to be determined objectively: ASIC v Adler (2002).

Section 184 imposes criminal penalties for breach of the duty to act in good faith and for proper purpose when a director is “reckless” or “intentionally dishonest.”

Duty to Retain Discretions

The general law imposes two duties on members of a board in respect of their discretions:

duty to exercise an active discretion; and

duty to retain directors’ discretion.

Directors can fetter their discretion but this can breach their duty to retain discretion (MIA Group Ltd).

Duty to Retain Discretions

The scope of the duty may be limited by:

a company’s internal rules (see for example delegation to others ss 189-190);

delegation to a managing director (s 198C replaceable rule);

delegation to a committee (s 198D replaceable rule); and

their right to act in the interests of the person or company who nominated or appointed them.

CHAPTER 13

DUTIES OF DIRECTORS AND OTHER OFFICERS PART 3 Conflict of interest and disclosure

At the end of this topic you should know:

the requirements under the general law and the Corporations Act for conflicts of interests;

the requirements under the general law and the Corporations Act for disclosure of interests;

how directors may be excused from breaches of their duties; and

to what extent directors can be insured against personal liability.

Duty to Avoid Conflict of Interests

All fiduciaries are under a duty to avoid actual or potential conflict of interest situations. The duty is a strict one.

A director can be in breach even though the director acts honestly and does not stand to make a profit.

A director can also be liable even if the company cannot proceed with the transaction in question.

Source of Duty

The duty arises out of the:

General law (Fiduciary Duties); and

Statutory duties (ss 182-184)

Source of Duty

The duty gives rise to a number of disclosure obligations, including:

the requirements in ss 191-194, 205G (listed companies) and 200A-200J (retirement payments);

Ch 2E (related party transactions); and

Pt 7.10, Div 3 (insider trading provisions).

Listed public companies must also comply with disclosure obligations in the ASX Corporate Governance Principles and recommendations.

Companies are also encouraged to self-regulate by industry associations e.g. the Investment and Financial Services Association (IFSA)

Examples of Conflict of Interest

Contracts with the company: Transvaal Lands Co v new Belgium (Transvaal) Land & Development Co [1914]; South Australia v Clark (1996).

Personal Profits: Regal Hastings v Gulliver [1942].

Bribes & Undisclosed Benefits: Furs Ltd v Tomkies (1936).

Misuse of Company Funds: Paul A Davies (in liq) Pty Ltd v PA Davies [1983].

Taking up a corporate opportunity: Cook v Deeks [1916].

Using confidential information: ASIC v Vizard (2005).

Competing with the company: Bell v Lever Bros [1932].

Statutory Duties – Improper Use of Position (s181) or Information (s182)

Section 182 reinforces the general law principle that a person in a fiduciary (that is, a position of trust) should not improperly use their position to make any gain, or cause detriment to the corporation.

Section 183 supplements the general law fiduciary duty to avoid conflicts by improperly using company information for any gain, or cause detriment to the corporation.

“Improperly use” refers to an abuse of power or the doing of an act which the officer or employee in question knows (or ought to know) that he or she has no authority to do: R v Byrnes (1995).

Remedies and Consequences for Breach of Directors’ Dutiesa

The common law and equity developed a number of remedies to compensate successful plaintiff companies pursuing directors or company officers for breach of fiduciary duties including:

common law damages; equitable compensation; account of profits; rescission of contract; and constructive trust and injunctions.

Remedies and Consequences for Breach of Directors’ Duties

Sections 180-183 are civil penalty provisions. The maximum penalty for a civil penalty order that a court can impose under s 1317G is $200,000 for each contravention.

Where directors or company officers breach their duty recklessly or with intentional dishonestly the director or company officer may be liable for criminal prosecution: s 184. See also Kwok v the Queen (2007).

Disclosure of Interest – General law

There is a requirement that directors involved directly or indirectly in a contract with the company disclose that interest to the general meeting, not just to the chair or the board of directors: Furs Ltd v Tomkies (1936).

If this requirement is breached, the contract is voidable at the option of the company: Kinsela v Russell Kinsela Pty Ltd (in liq) (1996).

The general law permits a director who is a member to vote in a general meeting on a matter in which the director has a conflict of interest (North West Transportation Co Ltd v Beatty (1887)) unless the director controls the voting power or there is a connection with a “related party transaction”.

Disclosure of Interest – Statute

The duty to disclose in s 191 (1) applies to all public and proprietary companies except for single proprietary companies: s 191(5).

A director must disclose any material interest except those interests listed in s 191(2).

If a director of a proprietary company discloses a material personal interest as required by s 191, the company’s internal rules may allow that director to vote and retain any personal benefits from the transaction in question: s 194. McGellin v Mount King Mining NL (1998) 144 FLR 288 “material” means “a relationship of some real substance”.

Disclosure of Interest – Statute

A director of a proprietary need not disclose an interest if the other directors are aware of the nature and extent of the interest and its relation to the affairs of the company: s 191(2)(b).

A director may give fellow directors standing notice of the nature and extent of an interest: s 192.

Disclosure is to fellow directors at a board meeting, not to the general meeting as required by the general law.

Sections 191 and 192 take effect in addition to any general law rules about conflicts of interests and any relevant provisions in a company’s constitution: s 193.

Relevant Issues – Conflicts of Interest

Disclosure

obligations

Board meeting

General meeting

All companies s 191

All companies

under general

law

Reinforced for public company by Chapter 2E

Restrictions on voting where the director has a ‘material personal interest’

Entitlement

to vote

Board meeting

General meeting

Private company

s 194

replaceable

rule: can vote

Public company

s 195

can’t vote

unless exempted

General law permits

voting by directors

who are members; but

there are restrictions

Chapter 2E prohibits

voting by directors

on related party transaction

Disclosure of Interest – Consequences of Contravention

A breach of s 191(1) is a criminal offence.

The contract may be voidable at the option of the company if the company’s constitution required the director to make disclosure and the director failed to comply with that requirement, in addition to breaching s 191(1): Camelot Resources Ltd v MacDonald (1994).

Directors of public companies with private interests in company transactions have additional disclosure and voting obligations under ss 195, 205G, Pt 2D.2 and Ch 2E.

Related Party Transactions

Subject to a number of exceptions, the rules in Ch 2E provide:

A public company or entity controlled by a public company must not “give a financial benefit” to a “related party”: s 208.

“Related parties” is defined in s 228.

“Giving a financial benefit” is defined in s 229.

There are a number of exceptions to the prohibition.

Contravention of s 208 does not invalidate a transaction and is not an offence by the public company or entity, but is a civil penalty, and if involves dishonesty, is a criminal offence: s 209.

case on point: ASIC v Adler (2002)

Exoneration and Relief for Breach

A director may be excused from civil liability arising from a breach of the director’s general law duties by:

the members in general meeting – ratification;

the company’s internal rules; or

the court.

See figure at 13.310.

Exoneration and Relief for Breach

Ratification is not available where:

there is a fraud on the minority;

the company is near insolvency, or would prejudice creditors;

it would defeat a members’ personal right;

it would be oppressive; or

there are breaches of statutory duties.

Exoneration and Relief for Breach

A constitution that purports to exempt, indemnify or insure a contravention of ss 199A or 199B is void: s 199C.

Under s 1318, officers may be relieved of liability if they have acted honestly and, according to the court, “ought reasonably to be excused”: Edwards v A-G (NSW) (2004).