Director’s Duties: The Duty to Act Honest and in Good Faith

Director's Duties The Duty to Act Honest and in Good Faith Kean Legal Barristers and Solicitors

Corporate Wedding Vows?

Your appointment as the director of a company is an important commitment. Once the directorship is recorded in the company’s books, you are expected to perform the duties commensurate with your position.

Your later registration as a director with ASIC is merely a formality. In a sense, it’s a public recognition of your special relationship with the company! You are now expected to make decisions on its behalf, whether as part of a board or as the sole director.

 Depending upon the type of constitution that governs the company’s conduct, there are a variety of different powers that the directors may decide to exercise (for given purposes). Those purposes may range from purchasing stationery for the office through to the acceptance of a takeover bid. 

 Not unlike wedding vows, your appointment entails the making or acceptance of a series of commitments. And as with any marriage, those commitments are expected to be honoured; and they are expected to last!

Perhaps the most important commitment in any relationship is that of honesty or candour. By the same token, the core duty of a director to his or her company is that of honesty. In the affairs of life, honesty is the ‘best policy’. In company affairs, it is enshrined as a legal duty. Any breach of that core duty carries sanctions for non-compliance.

Content of the Duty

A duty of honesty ‘begs’ the question. Honesty about what? Honesty about what you really think of your fellow directors? Honesty about what you did last night?  Are these matters intended to be the ‘currency’ for your next board meeting? Surely not!

From the legal perspective, the duty requires a director to make decisions for the company which he or she honestly believes to be in the ‘best interests’ of the company. 

The reference to ‘best’ interests is not intended to set an ultimate standard. A director is not expected to attain the ‘very best’ outcome (ie one which provides the greatest possible benefit for the company’s varied interests).  Rather, the duty places an onus on directors to make decisions:
–  for the benefit of the company as a whole; or
–  that do not unduly prejudice the interests of the company.

Whether (or not) a director actually believes their decision was made for the company’s benefit is a subjective question. It can only truly be determined by ‘reading the mind’ of the director concerned. Unfortunately, Courts are not mind-readers! Therefore, the legal test of the relevant duty includes an objective component. 

 In a particular case, a Court may conclude that a director’s decision was (apparently) made honestly. But the Court will then ask a further question. Was the decision one that would have been made by a ‘reasonable’ director in the same circumstances? 

This added component provides an objective standard for the Court’s analysis of whether a breach of duty has occurred. Indeed, it’s an application of a well-known judicial idiom. A company director must not only have acted honestly. He or she must ‘be seen’ to have acted honestly.

It is apparent that the Court’s approach to the duty has been ‘borrowed’ from the law of negligence. The ‘reasonable’ person test is usually applied to determine a breach of a duty of care in tort law. It is also now applied to the particular standard of honesty expected of company directors.

To determine whether a director’s actions were objectively honest, the Courts must ask itself :
(a) would an intelligent and honest person (exercising the same knowledge and skill)
(b) standing in the position of the company director
(c ) have reasonably believed the transaction was made in the interests of the company
(d) having regard to all of the circumstances?

What are the company’s interests?

The object of the duty is to ensure that a director acts honestly for the company’s best interests. But how can it be determined what those interests are? After all, the company itself is made up of directors, shareholders, employees and other stakeholders (even creditors). Each have potentially competing interests. Which of them truly represents the company’s ‘best interests’?

Generally, the Courts have considered that the interests of the shareholders are paramount to the company’s interests as a whole: Spies v R (2000) (HC) The following principles, however, clarify that broad statement

  • The interests of a majority of the shareholders do not necessarily constitute the company’s ‘interests’;
  • Nor is the company bound to represent the interests of any particular shareholder, or any group of shareholders ;
  • Even future shareholders need to be taken into account when determining the company’s interests as a whole.
  • The over-riding duty of the directors is to the company as a whole: Bell Group Ltd ( in liquidation ) v Westpac ( No. 9).

In relation to its employees, the company has no particular duty to act in their best interests. Nevertheless, a decision by the Directors that substantially benefits its employees (rather than its shareholders) is not a breach of duty per se. For instance, a decision to award bonus payments to a company’s employees may have been made to encourage them to be more productive. If so, such a decision is likely to benefit the company as a whole. But, bonus payments to the company’s ex-employees would not provide such a benefit: see Parke v the Daily News Pty Ltd.

Generally, the directors (or other persons who influence a company’s activities) are not presumed to constitute the interests of the company as a whole. Therefore, their own interests are not ordinarily relevant in determining what is truly in the best interests of the company.

In exceptional cases, however, the company’s ‘best interests’ will extend to stakeholders other than merely its body of shareholders. Examples include:

  • When a company is insolvent or nearly insolvent (see Kinsela v Russell Kinsela Pty Ltd); or
  •  where a company acts for the mutual benefit of itself and another related company (ie within a group of companies)

In the case of Kinsela v Russell Kinsela Pty Ltd (in liquidation)), the particular company was insolvent, and substantial moneys were owed to its creditors. The Court held that, in the circumstances, the directors’ duties extended to actions being taken in the best interests of the creditors.

The reasoning for the extension of the scope of liability was that insolvent companies were trading with the creditors’ money during the winding-up period. Therefore, the creditors’ money was directly at risk if a breach of duty occurred.

Determining the question of honesty

In determining the requirement of ‘honesty’ in legal terms, a number of points are worth noting:

  • The common law duty of honesty has now been supplemented by the statutory duty of ‘good faith’ under section 181 (1)(a) of the Corporations Act.
  • The tests of liability for breach of the common law duty and the statutory duty appear to be substantially identical in many respects
  • Therefore, there is a considerable (if not complete) overlap between the scope of the pre-existing duty of honesty and the statutory duty of good faith imposed on directors.
  • Apart from the common law and statutory duties mentioned, there is also an equitable (i.e. fiduciary) duty owed by directors to act for the benefit of their company
  • The equitable duty has also been likened to the duty of fidelity owed by an employee to his or her employer- see Hodgson v Amcor Ltd (2012) (VSC).

However, the specific duty has been distinguished from the related statutory duty to act for a ‘proper purpose’. The duty to act for a proper purpose is referred to in section 181(1)(b) of the Corporations Act; also see Bell Group Ltd (in liq) v Westpac Banking Corporation (no.9). (The latter duty is  the subject of a later blog in our Company series).

The type of factors a Court takes into account when determining the question of honesty include:

  • The statements made by the directors themselves about their intention or belief (although this factor is by no means conclusive);
  • The real or genuine considerations that were actually taken into account by the directors when determining the company’s interests;
  • A ‘cross-check’ of the directors’ stated intentions or beliefs by examining all the surrounding facts and circumstances; and
  • Whether a reasonable or rational director (or board) would believe the decision had been made in the best interests of the company.

As noted, the fact that a director honestly believed his or her decision was in the best interests of the company is not enough to escape liability. That decision must also be regarded as rational or reasonable in its nature. (This factor introduces the objective component of the directors’ decision-making, discussed earlier).

Defences

In relation to a breach of the statutory duty of good faith, the Court has power to excuse a director from liability in limited circumstances: see section 1318(1) of the Corporations Act.

To succeed on the basis of the defence, a director must establish that he or she has:

  • acted honestly; and
  • ought fairly to be excused from the breach of duty (having regard to all the circumstances).

A major difficulty in utilising this ground of defence is that lack of honesty is an element of the breach of duty itself. However, it is arguable that the defence is intended to apply to cases where a defendant director was found to have personally acted honestly, but was still found objectively liable (i.e. according to the stringent ‘reasonable director’ test).

The defence might also be specifically applicable to cases where a defendant director had acted honestly, but not in ‘good faith’ for the company’s interests. (This view assumes that its scope of meaning is wider than the legal meaning of ‘honesty’ at common law).

Even in relation to the civil penalty remedies for breach of duty, a similar ground of defence is available to a defendant director: see section 1317S(2) of the Corporations Act.

By contrast, the general law doctrine of ratification of a breach of duty by the company’s shareholders is not available to a breach of this type. There is authority to the effect that the defence cannot excuse a breach of the statutory duty to act in good faith: see Forge v ASIC.

Remedies

Because of the interplay of common law, equitable and statutory remedies, there are a wide variety of options available.  

In relation to the impugned decision, it is possible to obtain a declaration from the Court to set aside or ‘reverse’ the resulting transaction: see Kinsela v Russel Kinsela (1986) 4 NSWLR 722.

Preventative remedies are also available to injunct any breach of a perceived breach of duty. If any loss has been suffered as the result of the breach, equitable compensation can be ordered in favour of the company.

For example, in the case of Brunninghausen v Glavanics (1999) 32 ACSR 294, two brothers-in-law were  directors of a company owned by their family. One of the men bought the other’s shares without disclosing that he was planning to sell the company at a much higher price. Therefore, the shares were sold from one director to the other at a significantly lesser value as the seller:

  • had no knowledge of the activities of the company;
  •  was unable to gain access to the relevant information; and
  • was unable to thereby establish the true value of the shares he was selling.

The Court found that the purchaser of the shares at the lesser value had acted in breach of his duty to the company in the circumstances. To remedy the loss by the under-value sale, the defendant director was ordered to pay $300, 000 in compensation.

As the statutory duty of good faith is a civil penalty provision, the defendant director may also be fined for more serious breaches: see section 1317E and G of the Corporations Act. Although such actions require ASIC to seek a declaration of contravention from the Court, the company can intervene in the action to seek compensation for any loss it has suffered as a result of the director’s actions: see sections 1317H and J of the Corporations Act.

As a deterrent remedy, ASIC can also seek orders to disqualify a director from managing any company for a period of years: see s206C of the Corporations Act. In a well-publicised case, Mr Adler of HIH Insurance was disqualified from acting as a director for a period of 20 years.

The prohibition was imposed because of a number of serious breaches of his duties, including that of honesty.

In some circumstances, even criminal proceedings may be brought against a defendant director for breaches of his or her duties. If the breaches are found to have been committed in a reckless or intentionally dishonest manner, a fine or even imprisonment can be imposed: see sections 184(1) and 1317P of the Corporations Act.

Case-summaries:

Cassimatis v Australian Securities and Investments Commission [2020] FCAFC 52

Facts:

The appellants in this case, Mr and Ms Cassimatis, were the sole shareholders and executive directors of Storm Financial Pty Ltd (Storm). Storm held an Australian Financial Services Licence.  

ASIC brought proceedings against Mr and Ms Cassimatis centred around the cases of 11 vulnerable customers.

ASIC alleged that: 1) by giving ‘inappropriate’ financial advice to these vulnerable clients, Storm had contravened various sections of the Act, including s9451A(b) and s9451A(c); and

2) that by permitting (or failing to prevent) these contraventions, Storm’s directors had contravened their duties under s180(1).   

Held:

In separate judgements, Justice Thawley and Justice Greenwood confirmed the primary judge’s assessment that the directors’ conduct was in breach of s180(1).  

Justice Greenwood stated that the contraventions arose out of a primary failure to act in accordance with the objective standard of being honest and to act in good faith towards the 11 vulnerable customers.

 Percival v Wright

Facts:

  • In this case, a director of a company bought shares from a member at a price less than that for which the director knew a third party had expressed interest.
  • The third party was willing to buy all of the shares in the company.
    • The director did not disclose to the  shareholder that the third party was offering to buy the shares at a higher price.
    • A takeover did not happen. But after the facts  became known, the shareholder sought to rescind the sale. It was claimed that the director had breached his fiduciary duty by not acting honestly and in good faith

Held: 

The director owed the duty to all shareholders as a group, but not to the individual shareholder (ie to act honestly and in good faith).

Parke v Daily News Ltd

Facts:

  • The case concerned a company that owned 2 unprofitable newspapers and sold them both.
  • The company directors decided to disburse surplus proceeds to the employees as compensation for losing their jobs. However, the minority shareholders instituted legal action to prevent this.

Held:

  • The payment of surplus proceeds to its employees was not in the best interests of the company as they were:
    • Gratuitous;
    • Detrimental to the shareholders and the company as a whole by removing capital; and
    • In essence, the directors were trying to avoid paying entitlements to minority shareholders through the provision of surplus proceeds.
  • The directors were in breach of their duty to act honestly and in good faith. The company directors owed a fiduciary duty to the minority shareholders to act in good faith and honestly.
  • The Court held that trying to avoid paying entitlements to minority shareholders (through the payment of surplus proceeds to its employees) was not acting in good faith.

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