Ch 17 Directors’ Duties part 2 – Good faith, best interests

proper purpose, conflicts

Exercise 17.2: Directors’ fiduciary duty to act in the best interests of the
company.
Whose best interests are directors assessing?? Who is the company??

This is an important, imprecise, and sometimes shifting test.

The general starting position is that the best interests of the company means the best
interests of the shareholders as a whole. The whole of the shareholders, not just a
majority, not the major shareholders, but the whole group of shareholders as a whole.

The test is objective – how would an ‘intelligent, honest and reasonable’ director
assess the best interests of the shareholders as a whole?

BUT if the circumstances of the company change and it moves towards insolvency
then the interests of the shareholders as a whole move aside to allow consideration of
the creditors as a whole. The closer to insolvency, the more thought should be given
to creditors’ interests.

If directors do not act in creditors’ interests and the co goes into insolvency then
likely various transactions (that might benefit shareholders e.g. dividends, return of
capital) will be debts that a liquidator might pursue against directors. See Voidable
transactions and s 588G.

If directors do not consider creditors as a whole, but pay ‘special’ creditors first then
that would likely be preferential payments, also something the liquidator could pursue
as a voidable transaction.

Exercise 17.2: Directors’ duty to act for a proper purpose.

A proper purpose is generally a corporate reason – to advance SH wealth via the co

business.

Ask:

 Why were the Ds given this power? (e.g. power to issue shares is so Ds can
raise capital for the co business) (also called the legal purpose)
 Why did these D really use their power? (e.g. issue shares to dilute voting
power of a SH they don’t like) (also called the factual purpose)
  Was the factual purpose within the legal purpose? Or outside the legal
purpose? (e.g. using share issue power to dilute is not within the legal purpose
of raising capital).

Exercise 17.7 – Kestrel Pty Ltd – the issue of new shares

Keenan is unhappy about the new share issue. Keenan will allege Chelsea and Campbell
issued the shares for the purposes of controlling the voting power in the company.
Keenan asks whether the directors have breached directors’ duties when then set up the
company BirdFert Pty ltd which will make profit that Kestrel Pty Ltd should pursue. The
directors are using their position as directors to gain for themselves, misuse of position.

The new shares - The board of directors has the power to issue new shares in the
company, but the power must be exercised for a proper purpose: Mills v Mills (1938).

Section 181(1)(b) of the Corporations Act also covers this duty of proper purpose,
page 500. Note the two ‘limbs’ of s 181 (1) – (a) good faith in co’s best interests, and,
(b) proper purpose. A director is in breach if both limbs are not satisfied.

A proper purpose for issuing shares is:

• raising capital,
• employee incentive schemes, or
• for acquisitions.
An improper purpose for issuing shares would be for the purpose of:
• retaining control, or
• depriving shareholders of rights.

It is legitimate for Chelsea and Campbell to issue the shares to themselves, if it is to

raise capital. If the purpose of the share issue is to deprive another shareholder of their
rights is not a proper purpose.

The resolution says the purpose is to raise capital, however Keenan should check the
evidence. Relevant evidence would be things such as the financial position of the
company and plans for the business – does this indicate the need for more capital? Do
the shareholders pay the money when they receive the shares? Or are the shares issued
at call (no money paid now)?

What about if the directors want to raise capital AND get rid of Keenan (mixed
purposes)? Where officers may be motivated by a number of purposes — some of
which are proper and some of which are improper —the court will ask whether the act
would have been performed if it were not for the reasons behind the improper
purpose: Whitehouse v Carlton Hotels Pty Ltd (1987). Ask the question – if not for
getting rid of Keenan, would the directors have gone ahead with this share issue? If
no, then getting rid of Keenan (the improper purpose), is the motivating purpose (the
real purpose) and the directors are in breach.
Setting up BirdFert Pty Ltd - arguably directors have diverted the company’s property
or opportunity for their personal gain. They certainly have this opportunity by virtue
of their role as directors of Kestral P/L. S 182 is relevant, page 513.

Note s 182 applies very broadly – directors, officers and employees.

Note that s 182(1) has two limbs – Ds must not improperly use their position to – (a)
gain an advantage for themselves or someone else, or, (b) cause detriment to the
company. Doing either (a) or (b) is a breach. So it is no defence for a D to argue
something like “yes, I got an advantage but so did the co”. Note a D could get an
advantage if it was fully disclosed and approved by the company.

S 182(1)(a) - Directors must not take for their own benefit property, information or
corporate opportunities that belong to the company.
A corporate opportunity exists where:
• the company is considering an actual business opportunity, or
• there is a business opportunity that the company might reasonably be expected
to be interested in, given its current business: Cook v Deeks (1916).

Conflict – the directors Chelsea and Campbell have put themselves in a position of
conflict where there duties to Kestrel and BirdFert conflict by causing BirdFert to take
a business opportunity that belongs to Kestrel. The conflict will be ongoing. Kestrel’s
interests are to sell the bird droppings at the highest price, whereas BirdFert’s interests
are to buy the droppings at the lowest price. Directors should not put themselves in a
position where their duties to one company may conflict with their duties to another
company.

Exercise 17.8 – Petra, director of Quagmire Pty Ltd – is she just a rubber
stamp?

All directors, including nominee directors such as Peta, must act honestly and
reasonably believe there is no conflict between the interest of the party they represent
and the interests of the company, as the interests of the company should prevail. Peta
is not just a “rubber stamp” and custodian for Pewterschmidt Ltd’s interests and must
act in the best interests of Quagmire Pty Ltd.

Exercise 17.9 – Sand and Snow Ltd makes a donation of $5m and buys shares
in Abominable Pty Ltd.

The $5m donation – The reason for the donation may be a socially worthy reason –
but is it in line with the directors’ duties to the co??

Directors must use their powers in good faith powers in the best interests of the
company as a whole. This duty exists at the general law and is reflected in section
181(1)(a) of the Corporations Act and under general law.
This means that the director must genuinely and reasonably believe that they are
acting in the best interests of the company: Charterbridge v Lloyds (1970).
Although the donation may have general moral merit, for the donation to be a proper
exercise of the power the directors must honestly believe that the donation is for the
benefit of the company as whole. There is no obvious business purpose (as there
would be if spending money a the co factory). Can the directors argue there is a co
purpose to the donation? Possibly. E.g. enhanced goodwill or reputation or maintain
the surfing industry after the Tsunami. The directors need to be able to explain why it
is in the co’s best interests to make the donation. The size and use of the donation will
be relevant. Some shareholders, Barry, will disagree.

Purchasing the significant inventory from Abominable Pty Ltd – Note that S & S Ltd
is a public company (‘Ltd’ in the name indicates this).

Public companies are subject to the related party transactions rules (RPT). These rules
protect the co from directors giving benefits to related parties without SH knowledge
and approval.

Any major transactions S & S Ltd enters into ought to be checked against the related
party transactions regime, to ensure the sale of the inventory is not a transaction that is
“tainted” by directors’ conflicts.

On the facts, it is not clear what Maia’s role is, but the RPT rules apply to all public
companies and any person involved in the transaction is in breach, s 209. Is Maia are
related party to S & S Ltd?? See s 228 list, page 515. Is Maia involved in a RPT that S
& S Ltd engages in?, s 209 E.g. as the accountant who sets up and ‘helps’ the
transaction?

The regime requires disclosure to the general meeting of any transaction where a
related party to the company receives a financial benefit.

If the transaction is not exempt from the Corporations Act Chapter 2E, it will need to
be approved by the company at a general meeting (SH meeting) after full disclosure, s
208.

The main exception under the Corporations Act Chapter 2E is an “arm’s length”
transaction as provided by section 210. Can this transaction be justified as arm’s
length (the terms you would expect this deal to be done on in the market)?

Note, proprietary companies that have crowd source funding share capital are also
subject to the related party transactions rules. This is to protect SHs as they will not
have the awareness that SHs in a pty ltd co often have because they are so far
removed from the co business.

Exercise 17.10 – Sweetie Pty Ltd – issuing shares

Issuing the new shares – as discussed above, the board of directors has the power to
issue new shares in the company, but the power must be exercised for a proper
purpose: Mills v Mills (1938). This is mirrored in section 181(1)(b) of the
Corporations Act. A proper purpose for issuing shares is:
• raising capital,
• employee incentive schemes, or
• for acquisitions.
An improper purpose for issuing shares would be for the purpose of:
• retaining control, or
• depriving shareholders of rights.

It is legitimate for the board to issue new shares, if it is to raise capital. If the purpose
of the share issue is to deprive another shareholder of their rights is not a proper
purpose. The resolution says the purpose is capital raising, but as per the questions
above, check whether this seems to be true on the facts.

Where officers may be motivated by a number of purposes — some of which are

proper and some of which are improper —the court will ask whether the act would
have been performed if it were not for the reasons behind the improper purpose:
Whitehouse v Carlton Hotels Pty Ltd (1987).

Here it is relevant that the directors seem to have issued just enough shares that it
changes the voting power between shareholders and gives them control of the
board……. Hmmmmmm. Would they have made this share issue if not for the
improper purpose of control??

Exercise 17.11 – President watches and the vote to exonerate the directors

The directors Stella, Marcus and Magda have breached their fiduciary duty not to
place themselves in a position of conflict of interest by taking a business opportunity
that belonged to President Watches Pty Ltd.

Note that conflicts of interest can be approved by the ‘principal’. In a D/co scenario,
Ds can seek approval from their ‘principal’, the co, by a SH vote. So generally
directors who have breached their fiduciary duty not to place themselves in a position
of conflict can seek the company’s approval for their actions.

Here the SHs vote to approve the conflict. But we should consider the equitable limits
on the majority voting power. SHs do not have unlimited voting power to do whatever
they want, regardless of the effect on the minority of SHs. The approval obtained by
Stella, Marcus and Magda is not effective as it constitutes a fraud on the minority and
is a breach of the limits on majority voting power. In the circumstances the company
has the basis of a cause of action. The SH approval will not prevent this.

Exercise 17.12 – Footy Pty Ltd – the fight between the directors

As discussed above, the board of directors has the power to issue new shares in the
company, but the power must be exercised for a proper purpose: Mills v Mills (1938).
This is mirrored in section 181(1)(b) of the Corporations Act. A proper purpose for
issuing shares is:
• raising capital,
• employee incentive schemes, or
• for acquisitions.
An improper purpose for issuing shares would be for the purpose of:
• retaining control, or
• depriving shareholders of rights.
It is legitimate for the board to issue new shares, if it is to raise capital (as per the
resolution). If the purpose of the share issue is to deprive another shareholder of their
rights is not a proper purpose.

Exercise 17.13 – Pr

17.13 Carla Ltd, a New South Wales company, buys shares in Leesa Ltd, a
Queensland company, and soon accumulates 19 per cent of the issued shares.
Both Carla Ltd and Leesa Ltd are listed companies that trade on the ASX.
The Australian Financial Review reports that a takeover bid is imminent. The
board of Leesa Ltd resolves to issue 2 million shares in Leesa Ltd to Banjo Ltd, a
Gold Coast company.
‘We want to defend Queensland companies from these predatory attacks from
down south’, the managing director of Leesa Ltd tells the media, ‘and we need
capital for the purchase of a new building for our headquarters!’
Advise Carla Ltd. Might Leesa Ltd’s board have breached their directors’
duties? Explain your answer.

Answer:

As above, the board of directors has the power to issue new shares in the company,
but the power must be exercised for a proper purpose: Mills v Mills (1938). This is
mirrored in section 181(1)(b) of the Corporations Act. A proper purpose for issuing
shares is:
• raising capital,
• employee incentive schemes, or
• for acquisitions.
An improper purpose for issuing shares would be for the purpose of:
• retaining control, or
• depriving shareholders of rights.

Who is the proper decision maker for the decision about whether to sell the co? Ds or
SHs? Shareholders. They should be able to decide whether they want to sell their
shares in a takeover situation. That is why it is improper for Ds to thwart this by
issuing new shares to dilute SH voting power and block the takeover.

Exercise 17.14 – GV Mild Pty Ltd and GV Cheese Pty Ltd

In establishing GV Cheese Pty Ltd, arguably directors have diverted the company’s
property or opportunity for personal gain.
Directors must not take for their own benefit property, information or corporate
opportunities that belong to the company. A corporate opportunity exists where:
• the company is considering an actual business opportunity, or
• there is a business opportunity that the company might reasonably be expected
to be interested in, given its current business: Cook v Deeks (1916).
This is reflected in the Corporations Act, as section 182 provides that officers and
employees of a company must not improperly use their position to gain an advantage
for themselves or someone else, or cause detriment to the company.
Jill, Lizette and Allan have breached their duties to the company in connection with
their dealings with GV Cheese as they have put themselves in a position where there
duties to GV Milk and GV Cheese conflict by causing GV Cheese to take a business
opportunity that belongs to GV Milk.

In relation to Kerry, the conflict rule also applies where there is a conflict between the
director’s duty to the company and the director’s duty to another company. Kerry’s
position on the executive of another company may be incompatible, in any event he
must ensure not divulge information obtained as a director of one company to the
other company.

Exercise 17.15 – Banana Pty Ltd and the opportunity to distribute potatoes

(a) Mitchell and Kylie think this would be a very profitable endeavour and want
to set up a new company called Potato Sellers Pty Ltd to sell Potato Ltd’s
potatoes. Can they do this?

No they cannot, Mitchell and Kylie will breach their duty to the Banana Ltd if they do
as they will have put themselves in a position where their duties to Banana Ltd and
Potato Sellers Pty Ltd conflict by causing Potato Sellers Pty Ltd to take a business
opportunity that belongs to Banana Ltd. See Cook v Deeks [1916] AC 1 554.

(b) Mitchell and Kylie present the Potato Ltd proposal at the board meeting of
Banana Ltd. After a lot of discussion, Mitchell, Kylie and Tao reject the idea on
the basis that selling potatoes is inconsistent with Banana Ltd's primary business
of selling bananas. Can Mitchell and Kylie now enter into a transaction with
Potato Ltd? How should they proceed if they want to act upon Potato Ltd’s
proposal?

Even if the company is not in a position to take up the corporate opportunity, there is
still a breach if the director takes the benefit. The courts interpret the conflicts rule
strictly. Canadian Aero Services v O’Malley (1973). Mitchell and Kylie can proceed
to act on Potato Ltd’s proposal provided they give notice to the other directors in
accordance with the Corporations Act section 191.

(c) Mitchell and Kylie start Potatoes Sellers Pty Ltd using Banana Ltd’s
confidential list of distributors to sell potatoes. Advise Banana Ltd.

Mitchell and Kylie will have breached their duty to Banana Ltd by using confidential
information belonging to Banana Ltd, see section 182 of the Corporations Act.

(d) Tao has a banana farm that has been owned by her family for several
generations. She wants to sell the farm to Banana Ltd for $1 million. Can she do
this? Advise Tao.
Banana Ltd is a public company so the sale of the banana farm by Tao to Banana Ltd
would be prohibited by the Corporations Act Chapter 2E unless transaction is at
“arm’s length”: (Corporations Act section 210) or the company members approve the
transaction after full disclosure (Corporations Act section 208). Tao, as a director of
Banana Ltd, is a “related party” under section 228 and selling a property in which she
has an interest in would amount to a financial benefit under section 229.

(e) Assume instead that Kylie and Tao form Potato Sellers Pty Ltd. Potato
Sellers Pty Ltd has 10 shareholders who are mostly friends and family of Kylie
and Tao. The board comprises Kylie, Tao and Sergei. Potato Sellers Pty Ltd
owns a large potato-sorting machine that it no longer needs. Tao wants to enter
into a contract with Potato Sellers Pty Ltd to buy the machine. Advise Tao what
she should do before entering into the contract.

As Potato Sellers Pty Ltd is a proprietary company, before entering the contract Tao
should make disclosure to the board of Potato Sellers Pty Ltd in accordance with
Corporations Act section 194 (assuming Potato Sellers has adopted the Replaceable
Rules). Section 194 requires a director who has a material personal interest in a matter
that is being considered by the board to disclose the nature and extent of the interest
and its relation to the affairs of the company to the other directors. Once disclosed to
the other directors, then the director may vote on the matter and retain any benefits
from the transaction, and the company cannot set aside the transaction.

Exercise 17.16 – Varsity Grub Pty Ltd uses Tory’s company to do its
marketing

Emily owes duties to Varsity P/L as a director. Because she has an interest in Tory’s
co, Emily has a conflict between her duties as D of Varsity and her personal interests.

Ds have a duty to avoid conflicts. Ds can cure this by fully disclosing and seeking the
co approval.

It is irrelevant that the co does not suffer a loss, or even that it gains a benefit. The
duty is to avoid conflicts. Or fully disclose the conflict and ask for approval.

Emily has breached her duty to avoid conflict of interest by benefiting personally by
the appointment of Tory’s company via Emily’s shareholding in that company.

Emily should have made disclosure before the contract to the other directors pursuant
to s 194 (assuming Varsity Grub has adopted the Replaceable rules).

Varsity Grub is a pty ltd co. Section 194 requires a director who has a material
personal interest in a matter that is being considered by the board to disclose the
nature and extent of the interest and its relation to the affairs of the company to the
other directors (explain the benefit they get). Once disclosed to the other directors,
then the director may vote on the matter and retain any benefits from the transaction,
and the company cannot set aside the transaction.