'Be careful what you wish for!'
Make no mistake! The duties imposed upon the directors of companies are onerous. And to make it worse, 'ignorance of the law' is no excuse! You can still be held legally liable for a breach of duty, even if you were unaware that the duty even existed.
But how can a director perform his or her duties to a company without knowing what their duties are?
This blog is the 1st in our 'Company' series. The blogs are aimed at introducing to you the bewildering range of directors' duties ' without tears.'
Other blogs in the series will expand on the unique duties imposed on a director. Notably, the duties are imposed from the moment a director accepts office.
They include the duties to:
- act honestly in the performance of your office as a director;
- act in good faith and in the best interests of your company;
- exercise the company's powers for proper purposes;
- act with due care, skill and diligence;
- refrain from any improper use of information or opportunity obtained from the company; and
- prevent the company from incurring debt once it has become insolvent.
The growth of companies in modern Commerce
Company vehicles proliferate all fields of Commerce. There are building companies, trading companies, mining companies, trustee companies, superannuation funds, insurance and (of course) family companies.
You name the form of business, and the chances are that they are 'run' by a company. Even our churches are operated by companies. Although we are not suggesting that churches are solely businesses, they are nevertheless operated by a series of related companies in order to administer the different areas of their work. And that work may range in spectrum from maternity nursing through to funeral services. Indeed, the Catholic Church is well-known as being the world's largest corporate institution. In Australia alone, it has a whopping wealth presently estimated at $30 billion.
So, it doesn't really matter whether they are profitable or charitable in nature, or if they are privately or publicly listed. Companies are the 'vehicles' used by business and enterprise to drive Commerce. The tax advantages and limited legal liability of companies are two major reasons why they are preferred to such alternative business associations as personal traders, partnerships or trusts.
Companies are here to stay! And those companies are controlled and managed by their directors.
Preparing for the role of a company director
The 'driver' of the company vehicle is the director (or directors) of the company. Yet the drivers of these important vehicles of business are often unqualified for the task at hand. Even a 17 year old school student needs a driver's licence before they can drive a motor vehicle. But not so, for a company director! A 40-year-old businessperson can direct a private company without a licence, or any training or prior experience whatsoever. The usual requirement is simply the completion of details necessary for a shelf company to be registered.
No 'L' plate is required for a company director. Once registered, you can start driving your company vehicle in any direction you want (regardless of the consequences).
Although the position is somewhat different with publicly listed companies, the fact is that a vast majority of registered companies are privately operated. They may range in size from a 'mum and dad' family company through to Gina Rinehart's company, Hancock Prospecting Pty Ltd. Last year, the company reported a total of over $21 million in assets.
Training courses are available to the directors of private companies to develop the skills and knowledge needed to run a business. But these courses are desirable, not compulsory. The law as to companies is largely self-regulated.
Admittedly, ASIC will penalize companies and directors for the late lodgement of returns, or for non-compliance with changes to directorship (or other administrative governance matters). But the regulation and control of the duties and powers of companies is imposed on the Directors themselves.
Without proper steering, the company vehicle is apt to lose control of its direction. If so, this will inevitably lead to a major 'crash'. The result for the shareholders will be a 'write-off' of the company's business and its assets.
In those circumstances, ASIC may well decide to take legal action against the company's directors. If so, the financial penalties are severe. For instance, the directors of publicly listed companies can be fined hundreds of thousands of dollars. The penalties can also include long-term disqualification from office. High-profile prosecutions of the directors of publicly listed companies, include that of Mr Rich (a director of One-Tel) and Mr Vizard (a director of Telstra). In the case of Mr Vizard, he was disqualified for a period of 10 years and fined almost $400, 000.
Therefore, it is up to the Directors collectively to safely run the company business. Their aim should be to keep the company 'on the road' of good commerce and governance.
Of course, the Courts and ASIC are always available to provide assistance, if asked. But their roles of intervention are somewhat limited. It is not untoward to regard them as a 'referee' and a 'safety inspector' respectively.
The arduous tasks of navigating the rules and regulations of company law are imposed upon the Directors themselves. It is really up to them to ensure 'safe driving' on their corporate journey.
The company series in our blogs are intended to provide a 'road map' to assist company directors. The blogs canvas a range of topical and practically relevant matters which arise in this area of law.
Statements of principle
Below are a number of principles which have been applied to the different duties of directors (introduced earlier). Reference is also made to several case-examples, both actual and hypothetical. Each demonstrate the scope and variety of the relevant legal principles.
Duty of honesty
- The duty requires the director to make decisions based on what he or she honestly believes to be in the company’s ‘best interests.’ Doubtless, there is a significant overlap between this duty and the related duty of good faith (referred to under the next heading).
- The general test is whether an ‘intelligent and honest’ person in the position of a company director would reasonably believe the transaction to have been made for the benefit of the company.
- The test (sometimes known as the ‘reasonable director’s test) has both subjective and objective components. Not only must the director have honestly believed he or she was acting in the company’s best interests. That belief must have been objectively reasonable.
Acting in good faith and in the best interests of the company
- The Courts apply a primarily objective test when determining if a director has acted in 'good faith'. It has sometimes been called the 'reasonable director' test.
- The relevant question is whether a comparable person with the same level of knowledge and skills (as the director) would reasonably have made the same decision in the circumstances - see Bell Group v Westpac Banking Corporation ( 9 ).
- When determining what is in the 'best interests' of the company, the interests are generally equated to the body of shareholders in the company.
- However, there are number of exceptions to that rule. The exceptions widen the scope of duty towards such diverse 'interests' as creditors, or companies within a related group of companies.
- Ordinarily, the company's best interests are represented by its shareholders as a whole. But that does not mean the directors are permitted to discriminate between different classes of shareholders when promoting their respective interests.
- If a company has become insolvent or is nearing that point, then the 'best interests' of a company may extend to the creditors' interests in the circumstances- see Kinsella v Russell Kinsella Pty Ltd.
- If one company in a group provides a benefit to one of the other companies, that is not a breach of the duty per se. But there does need to be a relative 'balance' of the benefits and detriments which pass between the two companies.
Exercising company power for a proper purpose
- A company director must exercise his or her powers (generally under the company constitution) for their intended purposes, not for a collateral purpose: see Ngurli v McCann
- For example, diluting the number of company shares solely to prevent a company takeover would not be a proper purpose. The power to allot shares was not originally intended for that type of purpose.
- The Court determines the substantial or primary purpose for which a power was exercised, rather than any secondary or incidental purposes. It then decides whether that primary purpose was proper or not- see Howard Smith Ltd v Ampol Petroleum
Acting with due care, skill and diligence
The following examples are likely to constitute breaches of duty, depending on the circumstances:
- Permitting the company to enter a contract which holds no financial benefit
- Failing to take the necessary steps to ensure the company is paying wages to its employees
- Passing on confidential information to a competitor (including customer lists and instruction manuals)
- Failing to participate in supervising the company's management (particularly an executive director): see Daniels v Anderson
- Failing to ensure that the company is meeting its business and record-keeping obligations- see ASIC v PFS Business Development
Refraining from improper use of a company's information or opportunities
- A director has equitable and statutory duties which limit their use of information or opportunities obtained because of their position in the company.
- For instance, if a director acts improperly by using company information, he or she will be held to account to the company for any profits gained.
- Another example is where a director sets up a company in competition with the original company - see Courtenay Polymers Pty Ltd v Deang
- There are a number of different applications as to how this duty has been breached. Further examples are contained in the case summaries at the end of this blog.
Insolvent trading
- The directors are duty bound to prevent their company from incurring debts when it is effectively ‘insolvent.’
- A company’s business is considered to be insolvent if it is unable to pay its debts ‘as and when’ they become due. The classical signs of insolvency include payments being made well after the dates due, ‘selective’ payments of invoices because of cash-flow difficulties and demands by creditors for payment.
- The test of a director’s liability is again determined objectively. The question is whether the director had ‘reasonable grounds’ to suspect the company was insolvent (or would become insolvent if further debt was incurred).
- If a ‘reasonable director’ placed in the same circumstances would have been aware of those grounds of suspicion, then a defendant director will likely be held liable.
Case Summaries
Permanent Building Society (in liq) v Wheeler (1994) 11 WAR 187
Facts:
Mr. Wheeler served as director of both Permanent Building Society (PBS) and a separate company, Capital Hill (CH). PBS granted a loan of $1.5M to CH. Wheeler, as director of both entities, knew CH was in a very dire financial situation and probably could not repay the loan. Wheeler disclosed his interests in CH and abstained from voting in the Board of Directors meeting at the time the loan was granted.
Issue:
Did Wheeler’s actions constitute a breach of his equitable duties to PBS?
Conclusion:
Disclosing his interests and abstaining from the vote was insufficient to discharge Wheeler’s equitable duty to exercise reasonable care and skill. Wheeler had a duty to take positive steps to protect PBS, which involved making appropriate disclosures of CH’s financial problems at the time the loan was granted.
Wheeler was jointly liable for the repayment of some $1.8M in favour of PBS.
Green v Bestobell Industries Pty Ltd [1982] WAR 1
Facts:
Green was a Senior Manager of Bestobell (head of their VIC division). The WA division of Bestobell had obtained a contract for phase 1 of the QEII medical centre and were tendering for phase 2. Green had learned of this opportunity, and knew how the WA division went about tendering because he had worked for that division before. Green decided to set up his own company, made a lower tender for the same contract and resigned from his position as Senior Manager. Green’s new company was awarded the contract and made a profit.
Issue:
Did Green’s actions constitute a breach of his fiduciary duties to Bestobell?
Conclusion:
Green made use of the knowledge gained as a fiduciary to make an unauthorised profit for himself. Green knew Bestobell was tendering for this particular contract and set out to compete directly with his employer, and there was a real sensible possibility of conflict. It was not a defence that Bestobell would not have won the contract even if Green had not set up a new company. It was not a defence that Green had resigned by the time he had started making the profit – he had engaged in the conflict that ultimately produced the profit when he was still employed by the company.
Green and his company were liable to account for profits.
Hydrocool Pty Ltd v Hepburn (No 4) [2001] FCA 495
Facts:
The Managing Director of Hydrocool (Hepburn) was responsible for negotiating a licensing agreement with another company. He had used information about the deliberations of the Board of Directors to advantage himself and other employees by trying to negotiate a term in the agreement that gave him job security. The company was in a difficult financial position, and he believed this posed a threat to his continued employment. Hydrocool did not agree to the terms and the agreement was not executed. The company sued for the loss of opportunity to earn fees from the licence and royalties.
Issue:
Did Hepburn breach his fiduciary duty to avoid a conflict between his interest and his duty?
Conclusion:
The Court held that Hepburn had breached sections 182 and 183 of the Corporations Act – as he was using information from the Board of Directors deliberations as well as his position as Managing Director to conduct the negotiations to advance his personal interests.
Hydrocool was entitled to equitable compensation for the breach.
Asic v Healey [2011] FCA 717 (‘the Centro decision’)
Facts:
The board of directors for Centro approved financial reports and statements that did not disclose significant amounts of short-term debt owed by the company. This debt was classified incorrectly as non-current liabilities which had the effect of distorting the true financial position of Centro. ASIC brought an action against the CEO, CFO and 5 non-executive directors of Centro.
Issue:
Does a mischaracterisation of debt in financial statements constitute a breach of a director’s duty to exercise care and diligence, as well as a breach of an officer’s duties?
Conclusion:
ASIC successfully established breaches of sections 180(1), 344(1) and 601FD of the Corporations Act against Centro and the board. The non-executive directors could not argue that they relied on others as they still had a duty to be across the financial status of the company.
ASIC v Adler (2002) 41 ASCR 72
Facts:
In June 2000, HIH Insurance (HIH) paid $10 million for a unit in a trust which was controlled by Mr Adler. Mr Adler was, at the time, a non-executive director of HIH. Adler controlled the trust through Adler Corp and Pacific Eagle Equity Pty (PEE). Adler Corp was PEE's sole shareholder.
The assets in the trust which PEE managed were technology stocks. These stocks were worth substantially less than $10 million. PEE used part of the $10 million to purchase HIH shares. Alder Corp also had substantial shareholdings in HIH. No shareholder approval was sought for the loan.
ASIC commenced proceedings against Adler and two other directors for contravening the related party transaction, financial assistance and directors’ duty provisions of the Corporations Law 1998 (Cth).
Issue:
Was the $10 million loan by HIH to PEE a financial benefit given to a "related party"?
If this was the case, was the transaction actually conducted "at arm's length", which would provide a defence to Adler against a breach of related party transactions provisions?
Conclusion:
Adler had contravened several directors’ duties in this case, one being his duty to act in good faith in the interest of HIH and HIHC. Section 181(1)(a) of the Corporation Act states that a director should perform their power and duties in good faith in the interests of the company as a whole.
The NSW Supreme Court held that the $10 million payment was a financial benefit provided to PEE, Adler Corp and Adler because no shareholder approval was obtained prior to the payment. It was held that Adler acted for an improper purpose by attempting to gain an advantage for himself by obtaining the loan from HIH to purchase shares in a company he was involved in. Further, the payment was unsecured, inadequately documented and allowed for the self-acquisition of securities by HIH. Therefore, the transaction was not conducted "at arm's length".