Directors’ duty to act in good faith and for proper purposes

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This topic is within Business Associations.

Contents

Required Reading

Redmond, Paul Corporations and Financial Markets Law 6th ed, 2013, LBC, pp. [7.215]-[7.305].

Introduction

Another key directors' duty is the equitable duty to act in good faith and for a proper purpose. This means that directors must exercise their powers bona fide for the benefit of the company: Richard Brady Franks v Price (1937). Duty of good faith is different from other duties as it:

  • Permits a challenge to be made to a particular decision taken or transaction entered into by directors
  • This means that the company has the right to set aside a transaction by reason of the breach of the duty of good faith on the part of the directors who made the decision, depending on proof that the other party to the transaction had notice of the breach of the duty: Harlowe’s Nominees.
  • Note that the 'assumptions' rule in s 129 (4) is meant to protect an outsider from having its transaction with the company revoked for a directors' failings. This means that the transaction can only be invalidated if the assumption in s 129 (4) is displaced by knowledge or suspicion (on behalf of the outsider) that it is incorrect: s 128 (4).

Judicial reluctance to intervene in directors’ decisions

Courts have been reluctant to get involved in disputes relating to the merits of particular corporate decisions. The principle of limited judicial intervention is expressed in the narrowly cast grounds of judicial review for breach of directors’ duties of good faith, and in procedural rules which limit shareholder standing to sue for breach of duty or irregularities in corporate procedure and governance.

The elements of the duty to act in good faith

The traditional formulation requires directors to act bona fide for benefit of company as a whole:

  • In its application to directors, inquiry is directed to the intention, motive and beliefs of the directors and whether they have made interests of the company as their principal consideration.
  • Thus directors will abuse their discretionary powers if they use them in order to achieve advantage for themselves, to confer benefit upon a third party, shareholder or class of shareholders, or stranger to company, or to damage the company itself.

The modern duty comprises three distinct, independent but interrelated duties applicable to directors when acting as such and exercising corporate powers. Each duty sustains an independent ground for judicial review and intervention in directors’ decisions (ie, only need one).

  1. Subjective good faith
  2. Proper purpose
  3. Consult and act in reference to company interests

Duty of subjective good faith

Directors have a duty to act honestly in the company’s interests as the director’s perceive those interests. The process of judicial review is confined to inquiry as to each director’s subjective intent.

  • Honest belief that the action is in the company’s interest is necessary, but this doesn’t validate the action - the decision may be vitiated by breach of either of the other two elements of the duty, each of which have an objective content.

The duty to exercise powers for a proper purpose

Directors must exercise their corporate powers for the purposes for which they were granted the position of director. This permits the court to invalidate decisions taken by directors where the motivating purpose is one which a court permits as beyond those for which the particular power may legitimately be exercised or if not to benefit the company generally.

  • Some applications of the duty of good faith do not distinguish between the good faith and purpose elements as independent heads of duty but invoke each as a synonymous expression of a single underlying equitable obligation.
  • Power must be exercised “bona fide – that is for the purpose for which it was conferred, not arbitrarily or at the absolute will of the directors, but honestly in the interest of the shareholders as a whole”: Australian Metro Life Assurance v Ure, Ngurli v McCann.
  • The need to distinguish between the good faith and proper purposes requirement becomes important where the power in question is capable of more objective characterisation.

The strict fiduciary standard does not sit comfortably with the realities of directors’ office, especially in proprietary companies where directors will often have a shareholding interest in the company

  • Accordingly, a 'mixed purpose' doctrine has been developed by courts to lessen the strictness of this requirement - thus in Mills v Mills, Latham CJ said that to invalidate their action merely for fact of such interest would be to set “an impossible standard” and require directors to “live in an unreal region of detached altruism”. He proposed the test of validity in terms of “what was “the moving cause” of the action of the directors?”
  • Dixon J expressed this adequately: “But if, except for some ulterior and illegitimate object, the power would not have been exercise, that which has been attempted as an ostensible exercise of the power will be void, notwithstanding that the Ds may incidentally bring about result which is within purpose of power and which they consider desirable”: Mills v Mills.
    • Ie, but for test: if not for the ulterior motive, would the director still have acted as he did?

The duty to consult and act by reference to company interests

The last head of the duty is to consult, and act by reference to, those interests which the law identifies as the interests of the company, and to have regard to outside interests only derivatively, if at all (ie, the interests of the company are determined objectively). The duty to consult the companies interests represents longstanding ground of judicial review that is not tied to individual directors' subjective good faith and denies directors the role of derivative interpreters of common interests.

  • This legal issue, in the specific aspect of permitted scope of recognition of non-shareholder stakeholder interests, is directly related to questions of corporate purpose and corporate social responsibility.
  • Where directors act by reference to interests extraneous to those recognised by law as interests of the company, their action will not be saved by their honest belief that they are acting for companies benefit.

Individual subjects of the duty

The duty primarily attaches to the exercise of powers vested in directors acting collectively, however is also owed by directors individually. The validity of the directors’ decision is determined by reference to the motives and purposes animating a majority of the board - where the relevant corporate power is vested in an individual, the relevant purpose and intention is simply that of the individual director.

Statutory duty of good faith

The equitable duty is given statutory backing in the Corporations Act. Some of the relevant sections include:

  • s 181 civil liability: contravention of the duty to act in good faith is a civil penalty provision.
  • s 184 criminal liability: a director who contravenes the duty to act in good faith and is either reckless or intentionally dishonest in doing so incurs criminal liability.
    • s 1311 and Sch 3, if a director is found liable under s 184, he or she may receive 5 years imprisonment or pay 2000 penalty points.

Cases

Re Smith and Fawcett Ltd:[1]

  • Facts: company was formed to takeover business carried on by Smith and Fawcett. The company issued share capital with shares divided between them as its only directors. Article 10 stated that “directors may at any time in their absolute and uncontrolled discretion refuse to register any transfer of shares”
    • Fawcett died and his executors applied to Smith to be registered as members and to have plaintiff (Fawcett's son and beneficiary) appointed as a director. Smith refused to the registration and appointment but offered to register shares and buy remaining at price fixed by himself.
    • Fawcett rejected offer - Smith appointed his solicitor as director and Fawcett again applied to be registered as member. Application rejected and he sought companies share register rectified by inserting his name as holder of shares.
  • Held: “Directors must exercise their discretion bona fide in what they consider – not what a court may consider – is in the interests of the company, and not for any collateral purpose”. In constructing the relevant provisions of the articles, it must be borne in mind that one of the rights of a shareholder is the right to deal freely with his property and to transfer it to whomsoever he pleases.
    • The articles of a company obviously specify the limits of the directors' power (and their discretions) - however, the directors' powers are also always limited by their obligation to exercise their power in good faith and for a proper purpose.
    • Here, art 10 gives directors an uncontrolled and absolute discretion and the director’s refusal to issue the shares was a bona fide consideration of the interests of the company - appeal dismissed.

Australian Metropolitan Life Assurance Company Ltd v Ure:[2]

  • Facts: Contest for control of insurance company developed between two groups of shareholders, the majority of board supporting one group. Mrs Ure, leading member of other group, purchased parcel of shares sufficient to enable her faction to command ordinary resolution in GM and thus procure election of her husband to board. Purchaser submitted share transfers to board for resolution.
    • Article 21 conferred on board power to refuse to register share without assigning reason for decision. Accordingly, the directors refused and gave no reason although reference made independently to Mr Ure being disbarred solicitor. Directors also convened extraordinary GM of the company to consider resolution authorising board to issue substantial block of shares, 1/2 to existing members, 1/2 to staff and such other persons as directors should think fit.
    • Mrs U commenced proceedings to have the company register transfers and to restrain holding of meeting and share issue
  • Held: whilst the company’s constitution may give directors the power to make a certain decision, it must be exercised bona fide, not arbitrarily or at the absolute will of the directors, but honestly in the interests of the shareholders as a whole.
    • It cannot be said that because the transfer would enable a majority to effect its will, the directors are bound to register. If the directors honestly acted upon the business consideration mentioned, it was within their power, even though a transient majority though differently or desired differently, to refuse to register.
    • However, if directors acted upon some extraneous reason when coming to this conclusion, then their power is gone
    • It is for the applicant to place circumstances before the court as will reasonably lead to the conclusion that in some way an improper use has been made of the power.
    • Here, the directors were acting in their power, appeal dismissed.

Harlowe’s Nominees Pty Ltd v Woodside (Lake Entrance) Oil Company NL:[3]

  • Facts: Woodside was engaged in oil and gas exploration and collaborated in its exploration with other companies including B. It had issued share capital. Woodside’s directors were concerned about “mystery buyer” acquiring substantial shareholding in the company through purchasing shares and made allotment to B
    • Mystery buyer challenged allotment on grounds it was against proper purpose and not in consideration of best interests of company. Contended that as corollary to general fiduciary principle, it could not be suggested that power to issue shares had been exercised bona fide in interests of company unless company had at time an immediate need for capital secured by new issue.
  • Held: “The principle is 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 the purpose of benefitting the company as a whole, as distinguished from a purpose eg, maintaining control of the company in the hands of the directors themselves of their friends”
    • If the directors have an actual purpose of thereby creating an advantage for themselves otherwise than as members of the general body of shareholders, the allotment would be voidable as an abuse of the fiduciary power (purpose of ensuring the particular board's continued power of the company is improper).
    • Here, the allotment was not for improper purpose but to give Woodside greater freedom to plan for future joint operations with B and so ensure its long-term stability rather than defeating mystery buyer.

Ngurli Ltd v McCann:[4]

  • The powers conferred on shareholders in GMs and on directors by articles of association of companies can be exceeded although there is a literal compliance with their terms - powers must not be used for an ulterior purpose.
  • “Fraud” merely means that the power has been exercised for a purpose beyond the scope of or not justified by the instrument creating that power
  • “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 shareholder or their friends at the expense of other shareholders or so that some shareholders or their friends will wrest control of the company from other shareholders”
  • If the defendants truly and reasonably believed at the time that what they did was for the interest of the company, they are not chargeable with a breach of trust merely because in promoting the interest of the company they were also promoting their own: Hirsche v Sims (1894)
  • When will the courts interfere to prevent the abuse of powers contained in the articles?
    • Where it is necessary to prevent an abuse by the majority of the powers conferred upon a company in general meeting
    • Where it is necessary to prevent an abuse by the directors of the powers conferred on them by the articles
      • The court is more ready to interfere in the second than it is in the first instance
  • The powers entrusted to the directors by the articles to be exercised on behalf of the company are fiduciary powers. Where the validity of acts of directors exercising a fiduciary power is questioned, a higher standard is required than in the case of shareholders who do not, when voting at meetings, exercise any power of a fiduciary nature (but are allowed to act in their own interest so long as not prejudicing minority)

Hogg v Cramphorn Ltd:[5]

  • Facts: The primary purpose of a scheme by a board of directors was to ensure control of the company by the directors and their supporters. Is this manipulation of the voting power a legitimate act on the part of the directors?
  • Held: accepted that the board acted in good faith and that they believed that the establishment of a trust would benefit the company - however, the essential element of the scheme was to ensure control of the company by the directors and those whom they could confidently regard as their supporters.
    • “Directors are not entitled to use their powers of issuing shares merely for the purpose of maintaining their control of the company, or merely for the purpose of defeating the wishes of the existing majority of shareholders”: Piercy v S Mills.
  • Unless a majority in a company is acting oppressively towards the minority, this court would not interfere with the exercise of the majority’s constitutional rights or inquire into the merits of the views held or policies favoured - but the power to issue shares as a fiduciary power was exercised for an improper purpose and should be set aside.

Teck Corp Ltd v Millar:[6]

  • Facts: A was formed to take over certain mining claims but lacked resources so sought a contract with major company to develop property. Such contracts usually provide for major company to develop exploratory program which if successful they could develop the mine providing necessary services.
    • T, P and C proved to be suitable company’s expressing interest - A’s directors were impressed with P’s reputation and excellent record (T was relatively inexperienced). T steadily buying shares in A and A and P realised that they were close to securing control. Reaction was to accelerate negotiations and signed agreement with C (?) who would assume responsibility for exploration and development and if successful put into production and allotted shares
    • T sued A, its directors and C alleging the directors were actuated by an improper and extraneous purpose, not in best interests but to frustrate Ts attempt to obtain control.
  • Held: claim that Hogg stands for the principle that an allotment of shares made for the purpose of defeating an attempt to secure a majority is improper, even if the directors genuinely consider that it would be beneficial to the company to gain that control.
    • However, if this is correct, directors are not able to allot shares to frustrate an attempt to obtain control of a company, even if they believe that this is in the best interests of the company to do so - if directors cannot issue shares to defeat an attempt to maintain control, then presumably they cannot exercise any of their powers to defeat the claims of the majority or to deprive the majority of the advantages of control.
    • The impropriety lies in the directors’ purpose. If the purpose is not to serve the company’s interest, then it is an improper purpose. Impropriety depends on upon the proof that the directors were actuated by a collateral purpose, it does not depend on the nature of any shareholders’ rights that may be affected by the exercise of the directors’ powers
    • Directors ought to be allowed to consider who is seeking control and why. If they believe that there will be substantial damage to the company’s interest if the company is taken over, then the exercise of their powers to defeat those seeking a majority will not necessarily be categorized as improper.
    • Should apply the general rule in this way: (1) Directors must act in good faith; and (2) there must be reasonable grounds for their belief.
    • In this case, the directors wanted to prevent T from acquiring control because T sought to obtain a better deal for himself (and worse for A) through gaining control of A. Done for a proper purpose and in good faith.

Howard Smith Ltd v Ampol Petroleum Ltd:[7]

  • Facts: Millers (Company) had a mob of shareholders with majority shareholdings, and another bunch trying to buy shares in Millers. Millers board don’t want them to have majority (because then they might be replaced), so the board sells more shares out.
    • As a result, the voting power of the two biggest shareholders became diluted. The company itself doesn’t lose anything as they are selling out more shares and getting more capital, and the directors didn't personally gain anything from it.
    • There were two motives: (1) to dilute the power of majority and (2) make money for company.
  • Held: if self-interest is involved, directors cannot assert that their action was bona fide in the interest of the company. However, self-interest is only one instance of improper motive. Held a two-stage test:
    1. Start with a consideration of the power exercised by the directors, including the nature of this power and any limits within which it may be exercised [legal question]
    2. Then examine the substantial/primary purpose for which that action was taken and to reach a conclusion whether that purpose was proper or not [factual question]. In doing so, give credit to the bona fide position of the directors and respect their judgement in matters of management (business judgement rule)
    • To use their fiduciary power solely for the purpose of shifting the power to decide to whom and at what price shares are to be sold cannot be related to any purpose for which the power over the share capital was conferred upon them. Directors contravened the duty.

Cayne v Global Natural Resources Plc:

  • Note: this is merely obiter.
  • Hogg held that honest belief did not prevent motive for issuing shares from being improper - must not be carried too far.
  • Harlowe’s Nominees and Teck Corp went some way toward supporting restriction on scope of decision in Hogg and adds that Mills v Mills shows that where main purpose of directors resolution is to benefit company it doesn’t matter that incidentally benefits a director.

Whitehouse v Carlton Hotel Pty Ltd:[8]

  • Facts: Mr Whitehouse had all the shares and all the power. Decides to set up ‘what happens when I die’ procedure. He has class A shares, wife has class B shares, and kids have class C shares. They divorced, and having class B shares, could not get them back. She has class B, can’t get them back
    • He cooks up scheme so that boys get shares so they can swamp everybody. Wife dies, boys fall out with dad. Mr Whitehouse in trouble now - goes to court and says when he issued shares to boys he did it for improper purpose.
  • Held: a decision made without good faith and for an improper purpose is voidable, but not against a third party who has no notice of the circumstances constituting the breach of duty - they are protected by the indoor management rule. If the third party can show they were a bona fide purchaser without notice, transaction will stand.
    • Mere existence of the impermissible purpose is not sufficient to render the exercise of the fiduciary power to a lot shares voidable.
    • Test in Mills v Mills was invalidation and will follow only if impermissible purpose/combination of impermissible purposes can be seen to have been dominant (“the substantial object,” “the moving cause”).
    • This case says that the preferable view is whether the impermissible purpose was causative “but for” its presence, in which case the power would not have been exercised but not concluded view as this case doesn’t deal with competing permissible and impermissible purposes .

Parke v Daily News Ltd:[9]

  • Facts: company published two newspapers which were running at loss over number of years. Board enters contract to sell newspapers disposing of substantially all company’s assets. Result would be redundancy of overwhelming majority of employees. Directors proposed to use balance of sale $ to give redundancy payments. Minority shareholders challenged saying payment is ultra vires the company.
  • Held: “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. The test must be what is reasonably incidental to, and within the reasonable scope of carrying on, the business of the company”
    • Looks at stakeholder interests in context of employees and says directors are entitled to look at their interests in deciding/considering best interests of the company but there is no authority to support this proposition as a proposition of law.
    • Held that no matter how laudable and enlightened their motives in light of industrial relations today, such motives are not recognised as sufficient justification.
    • “Stripped of all its side issues, the essence of the matter is this, that the directors of the defendant company are proposing that a very large part of its funds should be given to its former employees in order to benefit those employees rather than the company, and that is an application of the company funds which the law… will not allow… the proposal to pay compensation is one which a majority of shareholder is not entitled to ratify”

Equiticorp Finance Ltd (in liq) v Bank of New Zealand:[10]

  • Facts: Bank lent money to Uruz, wholly owned subsid of ETL, member of Equiticorp. Loan made to finance takeover bid for Monier and loan secured by lodgment of Monier shares and by guarantee from ETL. Following difficulties with takeover, Bank reviewed its exposure to Equiticorp.
    • Bank insisted that funds of members of the Equiticorp group be applied in reduction of the Uruz debt - Hawkins reluctantly took this step on behalf of those companies. Subsequently those companies went into liquidation and their liquidators sought orders that this application of their funds was in breach of the fiduciary duties of the directors of those companies
    • At trial Judge said intelligent and honest man in the position of a director of those companies could believe that the application of the liquidity reserves towards the repayment of the debt was for the benefit of the companies The issue was whether the directors exercised their powers for the benefit of the company.
  • Held: there are difficulties with applying an objective test - the preferable view is that where directors have failed to consider the interests of the relevant company, they should be found to have committed a breach of duty. If the transaction was objectively viewed, in the interests of the company, then no consequences would flow from the breach.
    • Having regard to liquidity, and holding company’s guarantee of debt, those responsible thought that the steps taken would protect the group as a whole, and thus of benefit to the companies
    • It can be seen that actions carried out for the benefit of the group as a whole may, in certain circumstances, be regarded as benefiting one or more companies in the group
    • Exception: where the interests of the company, which is part of a group, is so inextricably bound up with the welfare of the group, that what is in the interests of the group is in the interests of the company

Remedies

The remedies include:

  • Equitable damage
  • Equitable injunction
  • Rescission and Restitution.
    • If a third party can show that he has made bona fide purchase for value without notice, the transaction will stand (Whitehouse v Carlton)
  • Civil Penalty Provision
  • Injunction
  • Oppression Remedy

Also criminal liability if reckless or intentionally dishonest.

End

This is the end of this topic. Click here to go back to the main subject page for Business Associations.

References

Textbook refers to Redmond, Paul Corporations and Financial Markets Law 6th ed, 2013, LBC.

  1. [1942] Ch 304.
  2. (1923) 33 CLR 199.
  3. (1968) 121 CLR 483.
  4. (1953) 90 CLR 425.
  5. [19677] Ch 254.
  6. (1973) 33 DLR (3d) 288.
  7. [1974] AC 821.
  8. (1987) 162 CLR 285.
  9. [1962] Ch 927.
  10. (193) 32 NSWLR 50.
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