Section 1324 finally shown to work

Saturday, 01 October 2005


    A major victory for shareholders and other persons whose interests are affected

    Section 1324 of the Corporations Act, which was introduced many years ago (it previously was section 574 of the Corporations Law), gave standing to not only the regulator (now the Australian Securities and Investments Commission), but to any person “whose interests are affected”, to seek an injunction or a declaration from the court against directors and others who breach statutory duties set down in the Act.

    In addition the section allows the court (see now section 1324(10)), in an appropriate case to make an order awarding damages, not only to the person who brings the action, but to others who may be associated with the relevant plaintiff. This award of damages may be made as an alternative to an injunction or declaration, or in addition to the relevant injunction or declaration.

    While ASIC has sometimes used the section to obtain a quick remedy by way of injunction against directors and others who have breached a provision of the Act, there have been very few decided cases, to my knowledge, in which a private plaintiff (someone who is not the regulator) had obtained a final order from the court based on the section.

    On the other hand, many cases have tested the language of the section which provides that the remedy is available to any person “whose interests are affected”.

    Ever since the rather spectacular but unsuccessful attempt by the late Robert Holmes A’Court to take over BHP through Bell Resources in the 1980s, there have been a series of cases in which courts have been asked to interpret the expression “any person whose interests are affected”.

    The judge in Bell Resources v BHP, Hampel J of the Victorian Supreme Court, gave the expression “any person whose interests are affected” a wide reading. His interpretation has been followed by a number of different judges including a current member of the High Court of Australia, Justice Hayne while a member of the Supreme Court of Victoria.
    In one decision – the Mesenberg case decided by Justice Peter Young in the late 1990s – the judge suggested that the section could not be used by a private plaintiff in the manner suggested; but his view has been rejected by a number of further decisions.

    Now, in the West Australian Supreme Court Justice Hasluck in the case of Liwszyc & Anor v Smolarek & Ors ([2005] WASC199) has rejected allegations made by the defendant directors that the section could not be used where a breach of the statute occurs.

    The facts of the case are probably not unlike those which may arise in the context of a number of smaller companies. The plaintiffs sought to be reinstated as directors of the defendant company Eznut Pty Ltd. They also wanted to preserve the status quo in the company pending the trial of the matter.

    The defendants (who included the effective managing director) opposed the orders on the basis that they were the proper directors of the company, that they should be at liberty to proceed with the management of the company (which basically was to commercially exploit a new type of fastener) – and suggested that any statutory breach that had been committed amounted to a minor breach which could be forgiven by the court pursuant to section 1322 of the Act.

    Eznut was a closely held company with elements of a joint venture type arrangement involved with the two sets of parties disagreeing as to how the company should be run. One of the plaintiffs wanted to raise additional capital but this was rejected by the managing director. As a result of this disagreement a general meeting was held which purported to remove the plaintiffs as directors of the company, appointing one of the daughters of the defendant, S, as a director. This led to shares being transferred to her and proxy forms being used to elect the defendant S to the chairmanship of the board. There were other issues that arose out of the dispute but it is not necessary to deal with them.

    Against this background the plaintiffs sought an injunction relying on section 1324 of the Act, alleging that the defendants had acted in breach of their duty and, as such, the court should make an appropriate order under section 1324.

    A court will only grant an injunction if it is necessary to do so. It is usual for issues such as those raised in this case to be tried pursuant to conventional proceedings. However, counsel for the plaintiffs argued that it was necessary for the injunction to be granted to preserve the status quo pending the trial. It was further necessary to ensure that funds invested by third parties were not dissipated as a consequence of any precipitate action that might be taken by the defendants while in control of the company.

    The plaintiffs’ major arguments were that they had been improperly removed as directors, and that votes had been improperly used pursuant to proxies in order to achieve that result.

    The defendants argued that the court lacked the power to grant an injunction pursuant to section 1324. They said no breach of the Act had been established.

    Justice Hasluck briefly examined section 1324. He noted that the court did have the power to grant an interim injunction pending a full trial. In order to obtain an injunction the plaintiff must satisfy the court that the claim is not frivolous, that there is a serious question to be tried, and that on the balance of convenience it is appropriate for an injunction to be granted. If the award of damages is an adequate remedy then an injunction would not normally be granted. But, if events are evenly balanced it is clearly appropriate for the court to try to preserve the status quo. The plaintiffs, however, were seeking more – they wanted an injunction to be framed in such a way that it would lead to them being reinstated as directors.

    In assessing whether the court should grant an injunction of this kind, Hasluck J noted that the court must feel “a high degree of assurance that the plaintiff will ultimately succeed and that the injunction will, after a full trial, be shown to have been rightly granted.” [at par 42]

    The judge then went on to examine the various duties of directors which it had been alleged had been breached and which were now reflected in specific provisions of the Act – namely sections 180 and 181. He noted that, while the court did have the power to forgive procedural irregularities in the running of the meeting (which had been suggested had occurred here), the court would not do so if the irregularities caused substantial injustice that could not be remedied by an order of the court. Only minor errors would normally be excused.

    Justice Hasluck recognised that his role in deciding whether an injunction should be granted in these circumstances had to be exercised with a great deal of care.

    After considering the facts in some detail he noted that there was:

    “a serious issue to be tried as to whether the first defendant was acting in an adversarial manner and in breach of fiduciary and contractual duties owed to other members of the company in purporting, by unilateral action to [make an appointment].

    “That being so, the failure to comply with the requirement that the directors are required to act pursuant to decisions taken at a properly constituted meeting may amount to a contravention of the Act within the meaning of section 1324. Arguably, such a contravention is not excused ... When the circumstances are considered as a whole there is an arguable case that the facts and matters taken together amount to a significant contravention which lies outside the protection afforded [the power of the court to forgive irregularities].” (at paras 103-105)”
    There was evidence before the court that what had happened amounted to a failure on the part of the defendants to properly consult other directors and let them participate in the decision making.

    In taking into account each of the provisions, he held that there was “a serious issue to be tried ... which [amounted to] a contravention which may warrant the grant of injunctive relief pursuant to section 1324(4) of the Act” (para 110). He held that it was appropriate for the injunction to be granted. In his view, on the basis of the facts before him, the court was likely to make a declaration of invalidity at the trial thus confirming the need for an injunction.

    What made the decision more important as far as the judge was concerned was the fact that there were “other investors involved and investors are entitled to presume that the rules of corporate governance will be observed, for they underpin the contract between the parties.” (at para 121)

    The plaintiffs were also reinstated as directors of the company. The actions taken by the defendants in terms of their running of the board of directors was to keep “on hold”, and the matter was set for trial.
    The facts of the case are of minor significance, but the willingness of the court to grant an injunction shows that section 1324 does have some real teeth.

    If the section can be used in this way, it will be a very powerful weapon which may be used by any person “whose interests are affected” in scenarios where directors are required to act in the interests of society – a change in the law that is being suggested in the context of inquiries before the Joint Parliamentary Committee and pursuant to an inquiry by CAMAC.

    The decision is a high water mark in this quite controversial area of the law.


    Realigning shareholder interests

    When issues and allotment of shares will be held invalid – the first of two cases of interest to directors of closely-held companies

    Despite the fact that the law in relation to the duties of directors to use their power for proper purposes is well settled, especially in the context of closely-held companies, or joint venture companies, where there may be a clash of interests and control is a problem, directors can fall into the trap of placing or issuing shares for inappropriate purposes to facilitate what they believe to be the objectives of the company.

    The recently-appointed judge of the Supreme Court of WA, Justice Simmonds, had to rule on such an issue in Netbush Pty Ltd v Fascine Developments Pty Ltd ((2005) 23 ACLC 1123).

    The action arose out of disputes within a group of companies in which the Roberts family controlled substantial interests. The end of the third marriage of a member of the family, resulted in an apparent need to settle certain loans and other obligations that had been generated during the earlier part of the company’s existence.
    The particular director of the company had been the sole shareholder and director and company secretary of a company in the “group”. Over a period of time certain allotments of shares were made by him to various persons. These allotments were later challenged by Netbush, a shareholder, when it brought proceedings to wind up the company and to have the allotments set aside and the share registers rectified. Netbush alleged that the allotments were made in such a way as to trigger an action based on the oppressive remedy which it established allowed the court to wind up the relevant company.

     The critical issue concerned whether the shares had been issued for a proper purpose. The overriding principle, as enunciated by Justice Simmonds in this case, is that where shares are to be allotted the directors “cannot exercise [their power] to allot shares for the purpose of defeating the voting power of existing shareholders by creating a new majority”. [at para 46]
    In other words directors cannot favour one shareholder or group of shareholders over another, and allot shares for the purpose of diluting the voting power of the other shareholders. Where there is provision in the corporate constitution which permitted the directors to act in a different fashion, (e.g. to favour one group) there may be an argument of a breach of duty.
    Even though the director believed he was acting for altruistic purposes, this was not an excuse where the shares were inappropriately issued. In such circumstances, it will be possibly appropriate for the shareholders to argue that there is oppression or a breach of duty on the part of the directors and have the share issue set aside.
    On the facts of this case Simmonds J ruled that the share issue was invalid and it was set aside.
    The case confirms what should be a pretty basic and well understood rule in the context of corporate governance. Even in a scenario where the constitution may allow some flexibility in utilising powers, there is a statutory duty which requires directors to act in good faith and for proper purposes (s181).
    Merely because a company has granted power to directors to deal in a specific fashion which may appear to be selfish and concerned only with the interests of certain shareholders will not prevent such an action being challenged under the statutory provision if not under the common law.


    When company money may be spent to properly defend a case

    Should a court wind up a company which has no chance of successfully defending a case? The second item of interest to directors of closely-held companies

    Directors must act in what they believe to be the bests interests of their company. Generally speaking courts will not second guess their decisions.

    When a company faces both financial and other difficulties and it may be inappropriate for the company to be run so as to trade out of its difficulties.

    It may be better for the company to be wound up and the cost of running an unsuccessful business financially contained.

    An interesting recent decision of White J in the New South Wales Supreme Court is concerned with when a director, who was a major shareholder in a company, could oppose a winding up order and expend corporate funds in defending such a case.

    In Cassegrain & Anor v CTK Engineering Pty Ltd ((2005) 54 ACSR 249) the judge held that directors were acting inappropriately in opposing the winding up proceeding. The facts are briefly these (as taken from the Butterworths report).

    The plaintiffs were class B shareholders in CTK Engineering. These shares did not give them voting rights.
    Claude Cassegrain was the sole director of CTK and was vested with the principal role of managing the company.
    It was alleged by the plaintiffs that Cassegrain had caused the company to enter into transactions with parties that he was associated with – in other words that there was a conflict between his duty to the company and his own interests – and that certain of these transactions had been concealed from the other shareholders. The plaintiffs sought an order to wind the company up. They argued that it was being run in an oppressive manner to the other shareholders, and that therefore it was just and equitable that the company be wound up. The plaintiffs also sought orders that Cassegrain pay both the costs of the plaintiffs and indemnify the company in relation to any costs that were awarded against it in defending the case.

    In response to the application brought in the Supreme Court of New South Wales a provisional liquidator had been appointed. As a consequence of advice the director received and apparently agreed with, it seemed that the liquidation of the company was inevitable.

    But he resisted the claim that costs should be awarded against him as a result of his attempts to defend the action.

    After examining all of the relevant facts in this particular case Justice White concluded that it was appropriate for costs to be awarded against the relevant director.

    He argued that it was not unreasonable for him to spend the company’s money in defending the proceedings if he genuinely believed that this was the right course.

    The director believed that the venture which the company had embarked on would be profitable and that a winding up order would be highly detrimental. White J agreed that it was a business decision.
    Generally the court would not second-guess such a decision. But in this case the director had been advised that it was inevitable that “the court would determine that the company would be wound up”. Indeed there was a suggestion that he had initially accepted that advice.

    While the court accepted that the defendant director could properly expend company funds in obtaining and assembling evidence in support of his understanding that the winding up action could be defended, this was not the course which he took.

    In the opinion of the court this course of action was not in the best interests of the company. The expenditure of these company funds was oppressive and unfairly prejudicial to the plaintiff shareholders. In the circumstances the appropriate remedy was that the costs of the company should be paid by the defendant.

    It is always sensible for directors when facing difficult decisions to take appropriate advice and to evaluate that advice to spend large (or small) amounts on the basis of their own assessment of the facts. Such a scenario may be quite detrimental to the company, with potential personal consequences to other shareholders whose interests might be financially affected.

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