Directors’ Duties: Legal Liability for Improper Purposes

Directors' Duties Legal Liability for Improper Purposes Kean Legal Barristers and Solicitors

The ‘right’ decision made for the wrong reasons!

Directors are given important powers to advance and control the direction of their company. Most of these powers are to be found in the Company’s memorandum and articles of association, or in its replaceable rules (if adopted by the company). Some powers are also implied by general law to enable the directors to manage the company’s business.

The available powers vary widely in their content and importance. For instance, the directors usually have wide powers to regulate the company’s employees e.g.- 

  • to increase or decrease the remuneration of the company’s employees;
    • to give bonuses to the employees generally (or to a particular employee); or
    • to increase or decrease the number of employees working for the company.

The various powers ordinarily extend to both the company’s assets and to the conduct of the directors themselves, including:

  • The power to acquire premises for the company’s use;
    • The power to borrow monies on behalf of the company;
    • The appointment of new directors;
    • The removal (or dismissal) of an existing director; or 
    • The payment of salaries or bonuses to directors (whether present or retiring).  

The powers exercisable by directors even extend to rights over the shareholders of the company. For example, the directors can resolve to issue new shares in the company, to make calls on shares, or to award share bonuses to existing shareholders.

However, there is an important fetter on the use of powers exercisable by directors. They cannot be used for ulterior motives or for extraneous purposes. To do so would constitute an abuse of the power. If so, the Courts are able to set aside such abuses.

By way of example, the following exercises of power by directors have been set aside by the Courts:

  • Refusing to register a transfer of the company’s shares to a competitor;
  • The issuing of new shares in a company (in order to dilute the shareholding held by a competitor);
  • Entering into a service agreement for a director or employee (even though there was no real benefit to the company resulting from that agreement);
  • Using a company’s funds to promote the re-election of its directors (see ABA v FAI Insurance); and
  • Exercising a particular power for the benefit of a third party, such as a bank or holding company (Bell Group Ltd v Westpac Banking Corp No 9).

A number of the above-mentioned examples are referred to in the case summaries at the end of this blog. Anecdotally, many of the major cases in this area of law appear to involve either:

  • the issuing of new shares in the company; or 
    • the refusal to register the transfer of existing shares. 

Both forms of power can also have an ulterior motive (or an improper purpose) of either taking or of maintaining control over the company itself. As an example, existing directors of a company can prevent a takeover if they refuse to transfer shares to competing interests. On the other hand, some directors could authorise a fresh issue of shares for the purpose of allowing a takeover of the company by the new shareholders.

Remedies 

Where the Courts have ruled that a power was wrongfully exercised, the company is entitled to an order effectively cancelling the directors’ decision. However, until such a decision by the directors has been cancelled (or ‘set aside’), it must be carried out by the company’s servants or agents. 

In particular, if the decision involves the making of a contract with a third party, then any delay in applying to the Court could prevent an order being made to overturn the decision. For instance, if the company exercises its power to buy a large parcel of land, then the Court is unlikely to set aside that contract if it was made with an innocent vendor. (Such a person would be unaware that any wrongful power had been exercised).

Therefore, it is important to act quickly in applying to a Court of law if you believe a company decision was made for an improper purpose, or has exceeded the limits of the power relied on.

The remedy of an injunction may be sought from the Court to stop the power being exercised. The Court can even grant the order where a wrongful exercise of power has only been notified, but has not yet actually occurred. 

If a power has been wrongfully exercised, the company can also claim compensation from the director (or directors) responsible.  

The amount of compensation payable will be based on the resulting financial loss caused to the company. If more than one director was responsible, then they will each be jointly and separately liable for the amount of the loss.

The duty to act for a proper purpose is required by common law, and is also now imposed by statute (see s181 of the Corporations Act). The statutory duty imposes further remedies and sanctions. 

A civil penalty may be imposed upon the directors for a breach of that duty. Criminal sanctions (including a fine or imprisonment) can also apply if a director has contravened the provision in a reckless manner, or with a dishonest intent (see s184 of the Corporations Act).

Defences

If a director is found to have acted for an improper purpose, they may nevertheless have a defence against liability. The most important issue is the company’s informed consent to the breach of duty that has occurred.

If the directors inform a general meeting of the company’s shareholders about the wrongful exercise of power, the wrongful decision can be ratified (i.e. validly authorised). It is arguable that such a decision can be prospectively or retrospectively validated by the company’s shareholders in that way.

However, great care needs to be taken in the conduct of a meeting of this type. Amongst other matters, the directors need to fully disclose the nature and extent of the wrong. They must also ensure the shareholders receive enough information to make a fully informed decision whether (or not) to consent to the ratification.

Other general and specific defences are also available in relation to a wrongful exercise of power.

Statements of legal principle

The following statements of legal principle provide some guidance as to the way the Courts have dealt with the issues.

  • The Courts accept that directors of a company have vested rights and duties to decide how a company’s interests are best served. Therefore, a Court will be loath to review an exercise of discretion by the directors which has been made in good faith, as long as it was not made for an irrelevant purpose: Harlowe’s Nominees v Woodside
  • Directors of companies are considered to be fiduciary agents. Therefore, a power conferred upon them cannot be exercised in order to obtain some private advantage, or for a purpose which is alien or foreign to the power: Mills v Mills (HC).
  • The directors must exercise their powers in a bona fide manner i.e. the power must be used for the purpose for which it was actually conferred. (The onus of proving that a discretion has been misused is imposed on the claimant): Australian Metropolitan Life Assurance Co. v Ure.
  • The line drawn between proper purposes and improper purposes for a directors’ exercise of power can be difficult to discern. In some cases, the directors might exercise a power for several different purposes – some of which may be considered proper; while others would be improper. Yet, the presence of an improper purpose does not, of itself, render the decision invalid.
  • The Courts generally favour the ‘substantial object’ test in such cases. It is only if an improper purpose was either:
  • The substantial or predominant object of the exercise; or 
  • A necessary purpose (without which the power wouldn’t have been exercised)

that the exercise of power will be invalidated: Ngurli v McCann.

  • The Courts will construe the ‘substantial’ purpose for which a company power is exercised in each case. A secondary purpose that is improper will not (of itself) render a director liable for breach of the relevant duty: see Howard Smith Ltd v Ampol Petroleum. The Courts will examine the factors relating to the purpose and effect of an exercise of power. Their aim is to objectively determine the primary or substantial purpose for which the power was exercised.
  • A company decision to take advantage of a favourable commercial opportunity may be considered the substantial purpose of an exercise of power. Other purposes of a secondary nature (such as staving off the possibility of a take-over) will not give rise to legal liability per se: see Pine Vale Investments Ltd v McDonnell.  
  • In determining the question of objectivity, the Courts must weigh a number of competing factors which relate to the particular exercise of power. Even if the directors believe they are acting honestly or in the best interests of the company, they may still be considered (objectively) liable. The question is not whether the directors honestly believed their decision was in the best interests of the company. Rather, the question is whether their decision was the most favourable to the company (as gauged by its shareholders as a whole): Darvall v North Brick and Tile Co Ltd.
  • Lastly, it should be noted that the particular duty to act for a ‘proper purpose’ is different in nature from related duties to act in ‘good faith’ or in the ‘best interests’ of the company. In many cases, these duties overlap in relation to the same set of circumstances. However, different principles apply to each of them. (Issues related to those other directors’ duties are detailed in another blog in this Company series).

Case-summaries

In the case of Piercy v Mills & Co, the directors had issued new shares solely for the purpose of maintaining control of their company. The shares were intended to dilute the interest of a shareholder who had acquired the majority of the previously issued shares). However, the new allotment was held to be invalid.

Re Roith Ltd presents as another interesting example of the relevant principles. Shortly before he died, the controlling director of two related companies entered into a formal service agreement with one of the companies. The real aim of entering the agreement was to provide a pension for his wife after his death. However, the service agreement provided no genuine benefits to the company. In fact, the agreement incurred ongoing expenses (including the payment of the pension). 

Upon analysis of the arrangement, the Court was satisfied that the directors had not acted bona fide in the interests of the company at the time they entered into the service agreement with the controlling director. As a result, the agreement was held to be effectively invalid and unenforceable.

In the case of Rossfield Group Operations v Austral Group, the Court considered a mix of proper and improper purposes relating to decisions made by the company’s directors.

Various steps were taken to order the company’s finances, and to better realise the potential profits from its assets. One of the motivations for the directors’ activities was the recognition of a possible takeover offer being made upon the company.

Yet, it was concluded that the latter purpose was only incidental to the primary or substantial purposes for the exercise of power. Therefore, the decisions were held to be valid.

In the case of Harlowe’s Nominees v Woodside (noted earlier), the directors of the company admitted they knew of a potential takeover by a buyer of their company’s shares. But they claimed that the primary reason for their allotment of a substantial parcel of shares at the time was to ensure the financial stability of the company. The finance was needed for its gas and oil exploration programme (made in collaboration with other companies). The Court accepted that the power had been exercised properly in the circumstances.

In Mills v Mills, the relevance of the interests of stakeholders in a company was emphasised. The Court ruled that, not only must the powers available to company directors be exercised for their intended purpose, they must be exercised in the company’s interests. Those interests are generally represented by the company’s shareholders as a whole.

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