Professor Bob Baxt reviews a recent case which shows that honesty alone may not be enough to prevent a director from breaching the Corporations Act .

    When directors’ honest belief may not be enough

    With the ongoing debate as to whether the statutory business judgment rule (SBJR) in section 180(2) of theCorporations Act might be extended to other provisions in the Act 2001 (Cth), especially those relating to insolvent trading, it is useful to remind ourselves that one of the elements for that rule to operate is that the director has acted honestly. But honesty, and an honest belief in the context of a director’s actions, may not be enough to save the director from committing breaches of provisions of the Act including section180(1) – the duty to act with reasonable care and diligence.

    Indeed, the decision of Justice Jagot in Diakyne Pty Ltd v Ralph [2009] FCA 721 highlighted the fact that despite Justice Jagot’s finding that the relevant director had behaved honestly, that director was not “excused” from a ruling that he was acting in breach of a number of provisions of the Act.

    Briefly the facts were these. Ralph was the sole director of Colorado Investments and held 99 per cent of it shares. He was also a director of Diakyne and its managing director. A contract had been entered into between Colorado and Diakyne whereby Colorado would provide management services to Diakyne (in this case, to be provided primarily by Ralph). The remuneration was set at a fee of $240,000 a year, plus bonuses. Ralph’s appointment was primarily to enable him to secure further investment in Diakyne, which was developing certain medical care products.

    One of Ralph’s tasks was to negotiate a deal on behalf of Diakyne with MediVac, a company that specialised in health and medical products, where MediVac would acquire all Diakyne shares. In return, MediVac would issue shares to Diakyne shareholders and Diakyne would become the wholly owned subsidiary of MediVac.

    The shareholders of Diakyne became majority shareholders in MediVac. Ralph also became a director of MediVac. Accountants were engaged to assess the transaction, its appropriate value to the company and related aspects. The accountants concluded the arrangements were fair and reasonable even though the shareholding in MediVac was restructured.

    Under the management services contract referred to earlier, there was a clause allowing for a performance bonus to be paid to Colorado by Diakyne if certain events occurred. In essence, this bonus was to be available if Colorado – that is, Ralph – could ensure either:

    1. Diakyne shares were listed on the national stock exchange via a public offering or a reverse trade takeover; or
    2. He and the company would arrange a trade sale of the Diakyne business above a certain amount.

    By the end of 2007, shortly before MediVac’s annual general meeting (AGM), it became clear that Ralph would not be re-elected to the MediVac board of directors. Shortly before the AGM, Ralph resigned. But on the relevant afternoon, he prepared and signed a tax invoice on a Colorado letterhead addressed to the Diakyne board seeking payment of the performance bonus referred to above.

    The amount was fixed according to a formula in the consultancy agreement at $100,000 plus GST ($110,000 in total). Ralph also prepared for approval a board resolution of Diakyne in support of the payment. He then organised for another director to act as co-signatory of the resolution by Diakyne. The resolution was passed by the board of Diakyne. The bonus payment was made to Colorado.

    As soon as the bonus payment was made known to MediVac, an extraordinary general meeting of Diakyne’s shareholders was called (they were, of course, the directors of MediVac as MediVac owned all the shares in Diakyne). This meeting resolved to remove Ralph and others as directors of Diakyne. Then a joint meeting of the boards of MediVac and Diakyne took place and resolved in joint minutes that the bonus payment should be challenged.

    Ralph was then asked to resign from his position as Diakyne’s CEO and was advised that the contract would be challenged. He was also told that the question of a bonus payment to him, and the validity of the contract with Colorado, would be discussed by the board. As a result, repayment of the bonus was demanded.

    The allegations brought by Diakyne against Ralph raised a number of issues. The main ones were that the bonus payments should be set aside on the basis that Ralph had breached his duties as a director of the relevant companies in the following ways:

    1. He had not acted with the appropriate care and diligence that was expected of a director pursuant to section 180(1) of the Corporations Act;
    2. He had breached his duties to act in good faith pursuant to section 181(1) of the Act; and
    3. That in authorising or directing the making of the payment of the bonus to Colorado, Ralph exercised his powers as a director of Diakyne improperly to gain an advantage either for Colorado or for himself in contravention of section 182(1) of the Corporations Act.

    I will not discuss the detailed evidence considered by Justice Jagot in evaluating how Ralph attempted to justify the contract for the payment of the bonuses and the calculation of the bonus payment. The conflicts of interest and the apparent difficulties that Ralph and his co-directors in Diakyne put themselves in a scenario where potential conflicts loomed are more important.

    It is useful, nevertheless, to highlight some of the facts that had affected the findings of breaches of duty. The following factors were regarded as important:

    1. Diakyne’s financial position was parlous at all relevant times and Ralph knew this;
    2. The payment of $110,000 was a substantial sum and although it would not make Diakyne insolvent, it was a payment that “would be of significance to Diakyne’s finances” (at [95]); and
    3. There was evidence that the relevant payment was not agreed to by all the parties as being “deserved”. Indeed, there was evidence that Ralph had been “miffed” that the parties were prepared to renege on the relevant deal and this led to his resignation from the board of MediVac. This was inconsistent with his suggestion that no one ever doubted that the payment was “payable” and therefore that the contract was enforceable.

    Justice Jagot noted that Ralph’s “acknowledgement that he was ‘miffed’ about the events leading up to [the relevant offence] needs to be recognised as an understatement”.

    She stated: “I am satisfied that from [at least September 2007], Ralph was aware that the other directors of MediVac … were concerned about ... not only the validity and enforceability of the [relevant contract], but also [remuneration due to the company] having regard to the bonus payments.” (at [102] and [104])

    She was also satisfied that Ralph knew that there was a risk that the payment would be challenged.

    While Justice Jagot noted that Ralph denied he had been aware of these difficulties, she added that in all the circumstances “Ralph also must have known that if his position on MediVac’s board was undermined, his continued role as a director of Diakyne ... would be under direct threat” (at [105]).

    Justice Jagot also appeared surprised that neither Ralph, nor his fellow directors, had sought to obtain independent advice as to the entitlement of Colorado to the relevant payment. This, coupled with the difficulties surrounding the interpretation of the contract, and the fact that “Ralph had a personal interest in the payment of the Colorado invoice”, was a significant factor (at [117]).

    In these circumstances, when Ralph took the relevant steps, the effect of which was to ensure the full payment of the Colorado invoice while he was still on the board of Diakyne and its managing director, was a matter of some concern (at [117]).

    In all the circumstances, taking into account “the ambiguities [that] were apparent on the face of the contract, [and that Ralph] had disputed the bills from others involved in the same transaction … Diakyne’s financial situation [being unsound] and $110,000 [being] a substantial sum … it is … so plain, so manifest and so simple … that any ordinary person of ordinary prudence would not have made an immediate payment to Colorado of the full amount claimed and thereby removing Diakyne’s opportunity to negotiate a commercial resolution more favourable to its interests, even if they honestly believed the claim was authorised by the contract” (at [122]).

    In conclusion, Justice Jagot ruled that Ralph had contravened a duty imposed on him by section 180(1) of the Corporations Act to exercise his powers with appropriate care and diligence that any reasonable person, if they were a director of Diakyne in the relevant circumstances, would observe. In the relevant circumstances, “any reasonable person would have known that the consequence of authorising and directing the payment … would be to ensure Colorado received the money without Diakyne having any opportunity to debate or dispute the making of the payment. Knowledge of this consequence alone would [also] establish a breach of section 181 in the circumstances described” (at [126]).

    I should note in passing that Justice Jagot observed that because Ralph could not be shown to have acted in good faith and in the best interests of the company in pursuing the payment, that the SBJR in section 180(2) of the Corporations Act could not be relied on by him.

    The judge stated that the relevant findings led her to conclude that sections 181(1) and 182(1) of the Act had been breached.

    “In exercising his power as a director of Diakyne to sign a resolution of Diakyne’s board which resolved to pay the prescribed bonus of $110,000 to [Colorado] … and an instruction to [the merchant bank] authorising [the relevant payment], Ralph did not act in good faith for the best interests of Diakyne and for a proper purpose and did improperly use his position to gain an advantage for Colorado (and, thereby, for himself). Ralph intended to and in fact gained an advantage for Colorado by ensuring Colorado received the money without Diakyne having any opportunity to debate or dispute the making of the payment. The actions of [Ralph], assessed against the objective standard of impropriety, warrant that description” (at [127]).

    In all the circumstances, the judge held that the payments were made in breach of the relevant duties and this allowed Diakyne to terminate the contract and to seek repayment of the $110,000.

    The decision clearly depended on the relevant facts, including the uncertainty surrounding the validity of the contract. Further, the fact that the company that was to make the payment really had no real chance to properly assess whether the payment was due and payable was critical. Even though Ralph honestly believed the payment was one that had been earned by virtue of the work that had been done by him, in all of the circumstances, bearing in mind the doubts and uncertainties, he was not acting with appropriate care or diligence. Furthermore, there was a clear conflict in these circumstances and when that was added to the uncertainties surrounding the validity of the amounts due, breaches of the relevant legislation had been clearly established.

    The result of the case is not surprising in my view. It illustrates the importance of showing not only that honesty exists, but that the actions of the directors are always in good faith and in the best interests of the relevant company. Without that additional element, breaches of duty will be more likely to be established.


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