Answer guides Ch 16 Directors’ Duties – C are and Diligence,

Insolvency
Exercise 16.7 – Little Gold Pty Ltd and the decision to buy the gold
tenements

We are asked whether any of the directors have breached their duty of care un der the
statute, s 180, or the general law. We need to bear in mind that the directors have
different roles and responsibilities so what is reasonable for one director might not be
reasonable for another director even in respect of the same board decision. Please
review the wording of s 180 (1) p 476. Sometimes the decision is so careless that you
can conclude that none of the directors have reached the minimum standard of care. See
the checklist based on the AWA v Daniels case. Sometimes you might conclude that a
particular director with a particular role and expertise had a higher duty of care.
Consider Vines, the CFO, in ASIC v Vines in respect of the preparation of a profit forecast.

Did each of the three directors here, J, B and L, exercise the degree of care and diligence
that a reasonable person would exercise if they were a director of a similar company
and had the same responsibilities as the director. Note that the general law test is
based on a ‘reasonable’ director and the s 180 duty is based on a ‘reasonable’ director,
so the duty under general law and statute are the same. You can use cases decided
under either source of law to understand whether the director’s conduct was
reasonable in the circumstances or not.

It can be easiest to look at what is referred to as the minimum standard, the test from
the Daniels case. You may see that on the facts the director failed to do something on
the list, and so the director is in breach without you needing to do any further analysis.
See the lists on pages 474 and 479. These directors did not use much diligence in
making this decisions.

Two directors, J and L, do not read the reports on which the business decision is
made. The third director, B, only reads the executive summary. They have all failed to
meet the requirements to be informed and ask questions so they have appropriate
understanding.

The failure to appropriately inform themselves would mean that they cannot use the
Business Judgement Rule in s 180(2) to say they were reasonable. Review the rule on
p 476 and see p 486.

The directors might try and argue that they relied on the experts who provided the
report, Big Geo, under s 189. This reliance defence will protect directors who
reasonably rely on experts (after all, directors are human and cannot be expert on
everything). See page 484-485. Is the directors’ reliance on Big Geo reasonable given
Big Geo is inexperienced in this field?? To use the s 189 reliance defence, directors
need to check the expert has the expertise and skills as a first step. These directors did
not do that and so will not be protected by the defence. S 189 also requires directors to
make an independent assessment of the expert advice, another thing our directors did
not do.

Exercise 16.8 – Noble Stationery Pty Ltd and mistakes in its financial reports
Does this fact scenario remind you of any cases?? ASIC v Healey where the directors
approved financial reports that incorrectly classified short term liabilities as long term.
These sorts of mistakes can have a serious impact on the financial position and solvency
of a company (and flow on to employees, creditors including the public via debts to the
ATO, and shareholders). For these reasons, understanding and monitoring the company
financial information is regarded by courts as a key responsibility of directors.

The error here seems even more blatant than in Healey as the $50m loan is not included
in the financial reports at all. Would a reasonable director have made this same mistake?

All directors should understand and ask questions about the financial information and
test whether it matches their understanding of the company’s financial position. See the
minimum standard discussed above. None of the directors seem to have done this, so all
are in breach of their DOC to the co.

Note that if the error was not so significant, and if some of the directors had made an
attempt to monitor the finances, we might conclude that some directors had met their
duty. Note that directors with financial expertise (Sula, the accountant) are expected to
use that expertise and so may be held to owe a higher DOC. Non-executive directors may
not be held to as high a standard as executive directors, but they must at least meet the
minimum standard in Daniels.

Note all of the directors (Rick) have attended meeting either, another fundamental
requirement of the minimum standard for directors.

Can any of the directors raise a defence? The BJR in s 180(2) or the reliance defence
in s 189? As above, the directors need to inform themselves to claims the BJR. And
the directors need to make an independent assessment under s 189. None of this has
been done by these directors so no defences available.

Exercise 16.9 – Papadopolis Ltd, a slow sales period, and debts taken on by
the company

(a) It transpires that Shoddey & Dadgy’s report was incorrect, and
Papadapolis Ltd is placed into liquidation. Does Luis have any liability
under s 588G of the Corporations Act?

A director is liable under s 588G if:

1. They were a director when the debt was incurred

Yes, Luis is a director when he approves the co entering into the contract
involving $10m payment.
2. At the time the debt was incurred the company was insolvent or would
become insolvent by incurring the debt or there were reasonable grounds to
suspect the company was insolvent or would become insolvent by incurring the
 debt.
Here the risk is that the co will not be able to pay the $10m debt and that this debt
will cause the co to become insolvent. Even if the co is not technically insolvent
already,
3. The director was aware there were grounds for suspecting or a reasonable
person in the director’s position would be aware.
At its lowest, the question is whether a reasonable person would have suspected
the co might become insolvent. What Luis actually knew is irrelevant. Suspicion is
feeling of apprehension about insolvency. It does not require a belief that the co
will become insolvent. It is not a hard test to satisfy.

Luis was aware of the financial position and business trends for the co, and the
negative indicators would cause a reasonable person to be suspicious that such a
substantial debt of $10m might cause insolvency.

Does Luis have a defence under s 588H, see p 491? Did he have evidence to expect
the co would remain solvent? Do the accounting reports show the co will remain
solvent after the $10m debt? I don’t think so. So no defence here. None of the other
sub sections seem relevant.

(b) How would your answer be different if Luis was ill when the contract was
entered into, and instead his fellow directors made the decision to move
forward with the contract?

Luis would claim s 588H(4) and absence from management for a good reason.

(c) How would your answer be different if Luis did not seek a solvency
report, but entered into the contract because he thought that the company
was performing well?

Luis would need to show what a reasonable person would have expected the co to
remain solvent under s 588H. There needs to be evidence and reasonable grounds
supporting the expectation – not just hope or irrational belief.

(d) What if his fellow directors were eager to enter into the contract but Luis was
against it, even after reading the solvency report? How would you have
advised Luis?

Luis would need to show that he took all reasonable steps to prevent the co incurring
the debt. This is more than simply disagreeing or voting against the transaction. S
588H(5) requires calling in administrators or resigning.

Exercise 16.10 – Regal Cinematic

The liquidator now wishes to commence an action against the directors (a)
alleging the directors breached their duty of care, skill and diligence; and (b) for
insolvent trading. What would you advise Patra, Yu Yan and Rebecca about
their respective situations?

Directors’ conduct comes under review when liquidators come into a company. There
will be losses, and the people who lose out when the co is insolvent will be seeking
answers, and will hope that someone will be held liable and required to contribute
funds.

Patra
The issue is Patra’s liability:

1. Breach of fiduciary duty

2. Breach of duty of care and diligence
3. For insolvent trading. 

Fiduciary duty: by keeping her knowledge of the company to herself, and indeed
concealing the truth by post-dating cheques Patra has breached the fiduciary duty to
act in the best interests of the company.

Duty of care and diligence: Patra as Managing director has a standard of care as
appropriate to her responsibility for day to day management (refer ASIC v Vines). At
the least Patra seems to have lacked diligence by engaging Farid as building inspector.
Patra should have informed herself and been satisfied that Farid was competent and
reliable, Daniels v Anderson (1995) 13 ACLC 614. As managing director, it is
arguable that Patra should have sufficient industry knowledge to know that the fire
exits and sprinklers were a problem.

Insolvent trading: Liability for Insolvent trading for Patra under Corporations Act
section 588G will be established if:

 Patra was a director when the debt was incurred.

 At the time the debt was incurred the company was insolvent or would
become insolvent by incurring the debt or the were reasonable grounds to
suspect the company was insolvent or would become insolvent by incurring
the debt.
 Patra was aware there were grounds for suspecting or a reasonable person in
Patra’s position would be aware.

Patra has been post-dating cheques so it is hard to avoid the conclusion she was aware
of insolvency when debts were incurred. This is one of the red flags for insolvency as
referenced in the Waterwheel case (ASIC v Plymin) discussed in chapter 14.

Yu Yan and Rebecca

Fiduciary Duty: It does seem there is any evidence that Yu Yan and Rebecca have
breached their fiduciary duty.
Duty of care and diligence: As non-executive directors Yu Yan and Rebecca do not
have the standard of care as executive directors, who are responsible for day-to-day
management. Yu Yan and Rebecca are entitled to allow Patra to be responsible for
day to day management but this does not relieve them of the responsibility to be
familiar with the company’s business and financial position and monitor management,
Daniels v Anderson (1995) 13 ACLC 614.It appears that Yu Yan and Rebecca have
not paid sufficient attention to the financial statements likely breaching their duty.
The facts are not as strong as in Patra’s circumstances however it may be that Yu Yan
and Rebecca lack monitoring and diligence and have breached their duty of care and
diligence.

Insolvent trading: Liability for Insolvent trading for Yu Yan and Rebecca under
Corporations Act section 588G will be established if:

 Yu Yan and Rebecca were directors when the debt was incurred.
 At the time the debt was incurred the company was insolvent or would
become insolvent by incurring the debt or the were reasonable grounds to
suspect the company was insolvent or would become insolvent by incurring
the debt.
 Yu Yan and Rebecca were aware there were grounds for suspecting or a
reasonable person in Yu Yan’s and Rebecca’s position would be aware.

Although Yu Yan and Rebecca do not seem to have actual knowledge, the law asks 
“what ought they have known”. A reasonable person may well have paid more
attention to the financial statements and been aware of grounds for suspecting. In the
circumstances Yu Yan and Rebecca are liable. 

Yu Yan and Rebecca as non-executive directors cannot be passive directors and

simply wait or expect their managing director to point out any discrepancies or
financial difficulty.
16.11 Elena, Dieter and Adira are friends who work together at a costume hire shop.
While Elena and Dieter work in the store serving customers, Adira is a highly
skilled costume designer and is responsible for purchasing new costumes.
Together, the three decide to start a costume hire business specialising in
vampire costumes. They form a company called Volturi Pty Ltd to own the
business. Elena, Dieter and Adira are each issued 10 shares in Volturi and Dieter
and Adira are appointed directors. Elena does not wish to be a director, because
she is busy with the care of her baby daughter, Stephanie. Dieter is appointed
Volturi’s managing director.
At a board meeting, Adira proposes that Volturi purchase all of its costumes
from a manufacturer in India. Adira says she has received Binaples of the
costumes and they look fantastic – although she fails to tell Dieter that she hasn’t
tried on any of the costumes. Relying on Adira’s expertise in the field, Dieter
agrees, and they pass a resolution that all of Volturi’s costumes will be
purchased from the manufacturer in India. In accordance with the resolution,
Adira proceeds to purchase a large number of vampire costumes from the
Indian manufacturer.
Unfortunately, the costumes that Adira purchases for Volturi are made from a
coarse, chemical-treated fabric that gives many wearers a severe rash. Several
customers initiate lawsuits against Volturi, claiming damages due to the rashes
they have developed. As a result of the lawsuits and the inability of Volturi to
hire out the costumes, Volturi sustains large losses and is on the verge of
liquidation.
(a) Does Volturi Pty Ltd have any claims against Adira and/or Dieter? If so,
what remedy would Volturi Pty Ltd seek?
(b) Would your answer change if Dieter was originally unsure whether Volturi
Pty Ltd should purchase the costumes, and he had engaged an external
costume expert who then supported Adira’s conclusions?

Answer: 

Volturi Pty Ltd may have claims at common law for breach of duty of care and
diligence against Dieter and Adira. Dieter and Adira are subject to a standard of care
that requires them to understand the company’s business and be aware of the
fundamentals of the business including knowing the industry the company is in. As
directors, are Dieter and Adira responsible for the company’s operations? If this is
Adira’s special skill, then her failure may well have breached this duty.

As managing director Dieter’s standard of care will require him to have the skill for
day-to-day management of the company on the other hand Adira’s standard of care
will be tested against people of same skill and expertise i.e. with experience with
costumes.

If Dieter retained an external expert after informing himself about the expert and
being satisfied that they were competent and reliable, they may have satisfied the
standard of care as set out in s 189 of the Corporations Act.

[LOs  16.2,16.3,16.4 and 16.5]