Forgive perhaps Forget unlikely Law Reporter

Can shareholders forgive directors for breaches of duty - the South Australian Full Supreme Court suggests that they can, even if the breach ‘might’ amount to a statutory breach.  Forgive, perhaps. Forget, unlikely.

Can shareholders forgive directors for breaches of duty - the South Australian Full Supreme Court suggests that they can, even if the breach 'might' amount to a statutory breach

As readers of Law Reporter will know, one of the most important initiatives pursued by the AICD is to ensure there are adequate safeguards in the Corporations Act and in the common law to "protect" directors where, in relevant circumstances, they are caught up in an accidental breach of the Act or of a common law duty.

Sometimes, they may be caught up in actions taken by other directors and by the company in respect of which they do not concur. So, it was regarded as a major victory by the AICD when Federal Treasurer Peter Costello agreed to introduce the due diligence defence with respect to the new continuous disclosure regime introduced by CLERP 9.

For many years the courts have exercised a power to forgive directors for breaches of duty. These powers contained in section 1318, and more recently in section 1317S of the Act (with respect to breaches of statutory duties) operate in essence after the event. If directors breach either a common law duty or a statutory duty they can ask the court to excuse that breach on the basis that they have acted honestly, reasonably, and in all the circumstances the breach should be excused.

This is an important safeguard and one that the courts should be exercising more generously than they have in the past. In that context in a separate note in this month's Law Reporter we shall be commenting on a very recent New South Wales decision "Edwards & Ors v Attorney General & Anor. (2004) NSWCA 272 (judgment delivered 6 August 2004) in which a more generous approach has been foreshadowed.

In addition to the ability of the courts to forgive directors, the shareholders themselves can ratify or forgive directors for breaches of common law duties - or to put it another way, duties under the general law. This can even apply to forgiving breaches that might occur in the future - in other words telling the directors that even if they do something in the future, and this may amount to a breach of a duty, this can be forgiven if the shareholders approve of the conduct and all appropriate safeguards are followed. This was enunciated by the New South Wales Full Supreme Court in 1975 in the case of Winthrop Investments Ltd v Winns Ltd ([1975] 2 NSWLR 666). That court suggested that shareholders could in anticipation of a potential takeover instruct directors to adopt a course of conduct that might otherwise amount to a breach of duty by issuing shares which might, in effect, frustrate a takeover.

But, the more critical question is whether shareholders can in fact forgive directors of a breach of duty where that breach amounts to a statutory breach of the law. Often the common law duty coincides with a statutory duty. For example, there is a common law (general law) duty imposed on directors to act with appropriate care and diligence. A similar statutory duty exists - see section 180 of the Act. There are also other examples in both the common law and the legislation.

This particular question - ie whether shareholders could forgive directors of a breach of a common law duty that might also amount to a statutory duty - has been the subject of some disagreement between our courts in the past. A brief summary of that disagreement is discussed later. The question has now been considered again recently by the South Australian Full Supreme Court in Carabelas & Anor v Scott ((2004) 22 ACLC 881).

The facts of the Carabelas case are taken from the CCH report of the case with some additional editorial comments.

Mr and Mrs Carabelas were the directors and only shareholders of Angas Law Services Pty Ltd (ALS). ALS had granted a mortgage over property it owned to the Commonwealth Bank of Australia (CBA) as security for certain moneys advanced or to be advanced to Mr Carabelas. That property was also mortgaged to Hindmarsh Building Society (HBS). Certain funds were advanced to Mr Carabelas by CBA. A proportion of these were advanced to ALS, allowing it to discharge the HBS mortgage. ALS then sold the property, and the proceeds of the sale were taken by CBA under its mortgage.

Various journal entries were made recording the transactions in the accounts of ALS. The entries expressed the transactions as debts owed by ALS to Mr Carabelas.

In prior proceedings, ALS and its liquidator Mr Scott had successfully claimed (in the Supreme Court of South Australia) compensation from Mr and Mrs Carabelas under section 229(7) of the Companies (South Australia) Code (the Code). ALS had alleged that the grant of the mortgage to CBA breached section 229 of the Code. ALS and Scott had also claimed compensation for a breach of duty of care at common law or breach of fiduciary duty in the alternative.

The trial judge, having allowed the application under section 229(7), did not deal with the alternative grounds namely that these amounted to preferences.

Scott had also claimed that three transactions recorded in ALS's books were unfair preferences given by ALS to Mr and Mrs Carabelas. Scott claimed that each transaction was an insolvent transaction and was voidable (pursuant to sections 588FA, 588FC and 588FE of the Corporations Law) [similar provisions exist in the Act] - these matters were not considered by the trial judge.

Mr and Mrs Carabelas appealed and disputed that the court had been correct in finding breaches of sections 229(2) and (4) of the Code. These provisions are replicated in sections 180 and 182 of the Act. (They deal with the duty to exercise reasonable care and diligence and the duty to not improperly use the directors' position to the detriment of the company or the advantage of the director.)

They also argued that the claim was being pursued out of time and questioned whether the journal entries on which the preference claims were based did, in fact, effect a transaction. They submitted that the entries did not represent transactions and that, therefore, no unfair preferences were given. Alternatively, if transactions had resulted, they only occurred subsequent to the start of the winding up.

Before the Full South Australian Supreme Court the main question was whether the shareholders of ALS, who were of course also the directors, by agreeing to the granting of the mortgage by the company meant that they had in effect foreshadowed that the company could not claim that the grant of the mortgage amounted to a breach of duty on the part of the directors pursuant to the relevant sections of the Code.

As noted the trial judge had held in favour of the liquidator but the Full Court unanimously allowed the appeal.

The appeal court ruled that the agreement, even though it had been an informal one, of the shareholders of ALS to the granting of the mortgage to the CBA was enough to prevent ALS then claiming, either in its own name or through a liquidator, that the relevant directors had breached their duty in allowing the company to grant the mortgage. At the time that the mortgage has been granted by the company it has not been insolvent. As there were no other shareholders or persons who could make a valid claim in relation to the property of the relevant company, no one was prejudiced by the decision of the directors to agree to the mortgage. On behalf of the court Doyle CJ rules that a string of cases, permitted the directors to obtain relief from liability.

This was so despite the fact that the mortgage involved the use of the company's assets to discharge a liability that was owed by one of the directors.

Justice Debelle, in Pascoe Limited v Lucas (1998) 16 ACLC 1247 at 1278 had suggested that because the "statutory duties reflect the duties of a director at common law and in equity, I do not think there is an impediment to the shareholders excusing a breach of the statutory duty". This statement was made in 1998 but unfortunately did not take into account the earlier views expressed by Justice McPherson in the Queensland Supreme Court in Marson Pty Ltd v Pressbank Pty Ltd ((1988) 12 ACLR 465) where he noted:

"I should not be understood to mean that disclosure to a ratification by shareholders is effective to relieve a director of the liability imposed by [the statute] although the fact of such disclosure may well be relevant to the question of whether the director had acted honestly in terms of [what is now section 181 of the Act]."

Santow J had in Miller v Miller ((1995) 16 ACSR 73) relied on the views of McPherson J where he noted (at page 89) the following:

"Ratification is not available when it would constitute a fraud on the minority ... or misappropriation of company resources ... or was entered into by an insolvent company to the prejudice of creditors ..., or defeated a member's personal right ... or was oppressive or where the majority in general meeting acted for the same improper purpose as directors.

It is also clear enough that ratification cannot cure a breach of statutory duty, more especially one imposing criminal liability."

When the High Court of Australia in Macleod's case (Macleod v R (2003) 197 ALR 333) held that directors could not escape criminal liability by "manipulating" a vote within the company to approve certain transactions between the company and themselves (to their financial benefit) on the basis that the company was a different person from the directors, this seemed to put at rest the argument that shareholders could forgive their own breaches of duty where this amounted to a crime or a breach of the statutory duty. [Company Director, September, 2003]. However, as a result of the South Australian Full Supreme Court decision in Carabelas a related question has been raised.

Before dealing with that related question, it is interesting to note in passing that the court did not think it was necessary to consider some of the other issues raised by the case - whether the claim against the directors had been made too late, for example.

The court felt that even though it was unnecessary to consider these issues this argument would have failed. The court also did not consider the other claims relating to the argument that the transactions were voidable because they were insolvent. In the court's view as the company was not insolvent those arguments could not be established. It will be interesting again to see what happens in the High Court in that particular regard.

In the author's view the decision of the court in Carabelas, while it reflects a finding by the court that there was no breach of the relevant statutory provision (because in effect the shareholders had forgiven what the directors were about to do as being a potential breach) seemed to be at odds with some of the earlier cases discussed above, including Macleod v R. Such a conclusion may also amount to a disenfranchisement of persons whose interests could well be argued to be affected by such action. Section 1324 of the Act provides that on application by either the Australian Securities and Investments Commission or any person "whose interests are affected", the court may grant an injunction or even damages against directors or other officers of a company where they are about to or have committed a breach of a statutory duty. The expression "any person whose interests are affected" has been interpreted in a very wide fashion by the courts over the years. This has led the courts to suggest that section 1324 may be an appropriate avenue for shareholders to seek remedies against directors where impediments may lie under procedural or other rules.

While ASIC has used the section on more than one occasion, with some success in obtaining injunctions etc, the section has not yet been used, to my knowledge, successfully by civil litigants against directors. Included in section 1324(10) of the Act is a power in the court to grant damages in a case where there is a basis for granting an injunction, in addition to or instead of the injunction, making it clear that the Parliament intended the section to be given wide use.

The implications of the decision in Carabelas seems to be that the shareholders (who were also the only shareholders and the directors of the company) by agreeing in advance that what the company was about to do could remove any impediment facing the company and its directors in going forward with a particular course of action.

However, the finding by the court that the company was solvent is an important factor.

If creditors could have been affected by the decision then any suggestion that those creditors would be unable to seek a remedy under section 1324 by virtue of a vote of the shareholders would be quite extraordinary in my view.

Directors will be watching this area of law very closely as it evolves.

This is particularly so as a special leave application has been successfully made by the liquidator to the High Court of Australia.

The High Court will now be able to deal with this matter for the first time.

The right of courts

to forgive

Entrepreneurial activity, risk taking, and the right of courts to forgive elevated by the New South Wales Court of Appeal

In the previous note we have considered the implications of the decision in the South Australian Full Supreme Court in the Carabelas case where the court held that the shareholders could forgive directors of breaches of duty in such a way that might well neutralise possible actions by third parties.

If that view is incorrect, there is still hope for directors in adopting an optimistic approach in pursuing vigorously their activities as directors. This optimism may also be further enhanced by the decision of the New South Wales Court of Appeal in the case of Edwards & Ors v Attorney General & Anor [2004] NSWCA 272. This particular case arises out of the facts that are the subject of the ongoing enquiry by David Jackson QC in New South Wales into certain matters arising out of the court approved reconstruction of the James Hardie Industries Limited Group of Companies a few years ago.

In 2001 two companies Amaca Pty Ltd and Amaba Pty Ltd, which were subsidiaries of James Hardie Industries Limited, had become the subsidiaries of a new company, the Medical Research and Compensation Foundation (MRCF), a company limited by guarantee.

MRCF was the trustee of a trust under which Amaca and Amaba were to continue in operation paying debts including claims for asbestos-related injuries with funds being paid into certain medical research funds.

The plaintiffs in this case included MRCF and the current directors of MRCF. They sought an order from the New South Wales Supreme Court that is described briefly below.

The two sets of plaintiffs sought advice from their barrister as to what they should do about meeting certain claims based on asbestos issues bearing in mind that David Jackson QC had been appointed to inquire into the various matters relating to the establishment of MRCF etc. The plaintiffs received advice that they should continue to pay claims during the relevant period. But they felt that doing so would expose them to potential liability. Accordingly the plaintiffs issued a process in the NSW Supreme Court under the relevant legislation seeking orders under section 1318(2) of the Corporations Act (the Act) (as well as other orders or advice from the court). The order sought under the Act was to this effect:

"An order that each of the first plaintiffs be relieved, in whole, from liability for any negligence, default, breach of trust, or breach of duty in his capacity as a director of the second plaintiff Amaca Pty Ltd ... and/or Amaba Pty Ltd ... arising out of the payment by those companies of their debts on or after 24 June 2004 and before [a date in December 2004] as and when they fall due including debts arising in respect of claims made for asbestos-related liabilities."

The issue was referred to the NSW Court of Appeal.

Young CJ on behalf of the Court of Appeal traced the background to the arrangements whereby Amaca and Amaba became subsidiaries of MRCF rather than subsidiaries of James Hardie Industries. The essential problem, quoting from this judgment, was this:

"If MRCF, Amaca and Amaba continue to authorise or pay current claims [in relation to asbestos injuries] this will make the pool of funds available to meet future claims rather diminished. However, if claims including judgments are not paid, then a person who has obtained a judgment could force Amaca and Amaba into liquidation. Alternatively, this can be anticipated and MRCF or Amaba and Amaca can moves themselves into liquidation and appoint a provisional liquidator."

It is not my intention to discuss in detail the relevant background to the claim and the limited orders that were eventually made by the court. The main question was could the court provide the directors with the kind of "relief" or, one could describe this as some kind of immunity, in the context of future actions. In a learned judgment by Young CJ (with which the rest of the court - Spigelman CJ and Mason P - agreed) Young CJ discussed a number of issues that are very dear to the heart of directors.

In relation to section 1318 of the Act, counsel for the directors advised that the relevant directors had been unable to obtain any relevant insurance and that there was a personal risk that they would be liable for breaches of duty when they were merely acting pursuant to the operations of the trust. Young CJ, one guesses with some reluctance, noted that previous decisions on this particular and related issues suggested that while one can "apply" for relief under section 1318, that application can only occur:

"... where, at the time of the application, a person has reason to apprehend that a claim might be made against him or her in respect of default etc. ... There can be no jurisdiction unless there has been a past or continuing breach.

It would follow that if there had been no breach at all but merely an anticipated breach, then no application can be entertained [by the court under this section]."

The court recognised that every time a new payment had been made to a claimant there might be a fresh course of action on the part of the directors which might be described as an act of default. But these would be future acts "which the court cannot prospectively sanction".

Young CJ also had some interesting things to say about the impact of section 1318 on the liability of a corporate trustee and directors of a corporate trustee. He agreed that in this particular context section 197 of the Act was the relevant provision rather than section 1318. Having turned to that particular problem he made some useful comments on the interpretation of that section by the Full Court of the South Australian Supreme Court in Hanel v O'Neill ((2003) 48 ACSR 378), which have been commented on in these pages [May 2004].

As readers may know, that decision has caused an enormous amount of concern across a wide section of the community. There are thousands of discretionary trusts that have been established under the corporate form in Australia.

The majority of the South Australian Full Supreme Court had insinuated that, if there were no assets in the trust fund, there could be no entitlement to an indemnity by the trustee corporation and therefore the directors would become liable.

Such an interpretation, although made in additional comments by the majority and not central to the decision in the case, have been interpreted as creating an enormous problem for directors of trust companies. Indeed, Justice McDougall in a recent New South Wales decision of Intagro v ANZ Banking Group ([2004] NSWSC 618), even though he had great difficult in accepting the reasoning of the majority in Hanel v O'Neill, felt that he had no option but to follow that decision because it was the decision of a Full Court. Young CJ noted that his court did not have to deal with the particular issue but added these observations which will give great heart to many.

"If [this court had to deal with the case of Hanel v O'Neill] I may well have yielded to the temptation so valiantly resisted by McDougall J in the Intagro case [and chosen not to follow the reasoning in Hanel v O'Neill]."

One final observation by Chief Justice Young will be seen by many as a clear signal that much of our regulatory reform is going down the wrong track at this time. In discussing the basis for creating limited liability companies and including in the legislation a provision such as section 1318, Young CJ noted as follows (at paras 76 and 77):

"The purpose of the Corporations Act and its predecessor was for permitting the economy to be advantaged by such entrepreneurial ventures with limited liability and to regulate the rights of members inter se [sic] the rights between members and creditors of corporations.

As time went on, it was realised that fraudsters could manipulate the system so as to perpetrate fraud and exceptions were placed against limited liability to such as liability for trading while insolvent. Nonetheless the essential purpose of the [Corporations Act] remains and whenever one is construing any particular provision one must be careful not to take one's gaze off the essential purpose and pay overmuch attention to technical details or wording of individual provisions. One must not so concentrate on the wording of single sections of the Corporations Act that one misses where they fit into the jigsaw showing the whole picture. To put the matter another way, just like in life, those who concentrate on a single issue are likely to miss the riches of the big picture ..."

That interpretation parallels approaches by Young CJ in earlier cases in which he has considered similar issues. It indicates the kind of approach he will take in these type of cases and wherever possible he will try to give the Act a sensible commercial interpretation so as not to put too much of a dampener on appropriate and innovative business activities.

The decision will be seen as a major breakthrough which will provide great assistance to those who want to see sensible changes made to the law to overcome the difficulties enunciated in the earlier decision in Hanel v O'Neill.

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