Company Law: Case Study on Legality of Issuing “B” Class Shares

Introduction

This case scenario raises a number of pertinent legal issues, which will be addressed in this paper. The first issue is whether the proposed issue of “B” class shares is legal, and if not, whether and how Kevin could prevent the issue of such shares by James and Vicky. Secondly, whether the formation of PayPerWork Pty Ltd (PPW), a wholly owned subsidiary is valid, and if so whether Rosta’s share sale PPW to Keywest is valid.

Thirdly, whether the equipment lease agreement entered between James and Leasetech Ltd (LT) binds Rosta and if so, whether LT is entitled to indemnity against the injury of Sally. Fourthly, what are the potential actions and remedies that Rosta and ASIC may pursue against PayPerWork Pty Ltd (PPW), James and Vicky, and what their prospects of success would be? Lastly, what steps could Kevin have taken to stop the registration of PPW and the subsequent transfer of Rosta’s assets to PPW?

Whether the proposed issue of “B” class shares is legal, and if not, whether and how Kevin could prevent the issue of such shares by James and Vicky?

S246C of the Corporation Act (CA) permits the variation of rights attached to existing stock, upon compliance with certain conditions specified thereunder. Where a company has only one class of shares, an issue of new shares is deemed to vary the rights in the existing shares if the new shares carry with them rights which are different from those attached to the existing shares and those new rights are neither entrenched in the company’s constitution or any other document lodged with the ASIC. To effect a variation, s246B(2)CA compulsorily requires Companies that do not have a constitution to guide the procedure to pass a special resolution at a meeting, which must be supported by members holding at least 75% of the shares in the class affected by the variation. In addition to the special resolution, all members holding the shares in the affected classes ought to be given a written notice of at least seven (7) days, failure to which the company commits a strict liability offence S246B(4)CA.

According to s246DCA, if a member of a company is aggrieved by the variation, cancellation or modification of their class rights, they may challenge the same before a Court of law, if they have a minimum of 10% shares. However, such a challenge can only be done by way of Application filed in Court within one month after the impugned variation, cancellation or modification, and failure to file the Application within the said period of one month affirms the variation, cancellation or modification s246D(3)CA.

Turning to the facts of this case, there is no gainsaying the fact that issuing new shares (Class “B”) to employees of Rosta would affect the rights attached to the already existing Class “A” shares. This is because while the new shares do not allow voting rights, they carry priority dividend rights as compared to Class “A”.

            However, to properly assess the effect of the issue of Class “B” shares, a preliminary issue would arise as to whether Kevin is a member of Rosta. From the facts, Kevin initially invested $50,000 in Rosta by way of convertible note, with the investment able to convert to a 10% shareholding in Rosta, the equivalent of 100 fully paid “A” class shares. Although it could be argued that at the time James and Vicky decided to issue “B” class of shares, Kevin had not yet converted his investment into “A” class shares, under the convertible note, both James and Vicky knew that Kevin was a member of the company by virtue of his investment and that the failure to convert the investment into shares at an earlier stage was an agreed strategy. As such, the delay in conversion would not affect the rights Kevin had in 10% of the existing class “A” shares. 

            Having established that Kevin was a member of Rosta before September 2017 when James and Vicky issued “B” class shares to IT employees and that the rights in his class of rights were varied, it would emerge that James and Vicky had an obligation to comply with the mandatory statutory requirements for a special resolution as required by S246B(2)CA. It is also not clear whether Kevin received a written notice as required by the provision.

It, therefore, follows that Kevin had the right to challenge the decision made by James and Vicky, within a month after it was made. He would do so by filing an Application in Court in accordance with s246DCA. In determining the merits of Kevin’s Application, the Court would consider both the procedure followed in arriving at the decision to issue “B” shares and the substantive fairness of the decision to do so. In the leading case of Clemens v. Clemens Bros Ltd [1976]2 All E.R. 268, the Court considered the validity of a resolution allowing issuance of new shares to certain employees and directors in that case, which had the effect of lowering the Plaintiff’s controlling stake. The Court, while quashing the resolution, expressed the position that the powers of directors are fettered by the rights of minority shareholders of a company and must be exercised in a fair and equitable manner.

From the rules stated above, Kevin’s challenge of the issue of “B” shares could succeed if he demonstrates to the court that there was procedural impropriety on the part James and Vicky and that the issue was unfair to him. On the other hand, James and Vicky would need to show that the decision was made in the best interests of Rosta and that they followed the statutory procedures already elaborated elsewhere above.

Whether the formation of PayPerWork Pty Ltd (PPW), a wholly owned subsidiary is valid, and if so whether Rosta’s share sale PPW to Keywest is valid?

Under s46CA, a company is considered to be a wholly-owned subsidiary if its ownership vests only in members of one body corporate. S50AACA stipulates that an entity controls a second entity if it has the capacity to make decisions that affect the latter’s financial and operational policies.

            From the above statutory definitions, there is no doubt that PPW, as incorporated, is Rosta’s subsidiary. The first issue that would need to be determined is whether PPW was validly incorporated and whether Vicky had the power to exercise a casting vote in passing a resolution for the formation of PPW.

            Decisions as to the formation of a subsidiary are a preserve of the directors of a company. As such, a resolution must be passed by the Board of directors before such a formation. It is settled under common law that a director may have the power to exercise a casting vote if the same is specifically agreed by the company’s constitution. Although Rosta lacks a written constitution, James and Vicky agreed that the latter would have a casting vote in case of a deadlock in decision making. Vicky, therefore, acted within her powers when she ruled for the establishment of PPW and transfer of assets.

            But what is of more contention is the fact that PPW was formed with the sole aim of buying Rosta’s assets, while leaving the burden to offset liabilities on Rosta. The jurisprudence laid in Gilford Motor Co Ltd v Horne [1933] Ch 935 is instructive as to the validity of companies whose formation offends existing rights. In that case, an employee bound by a post-employment contract that barred him from taking part in a competing business formed a company under which he’d compete with his former employer. The Court’s finding was that the Company was that the formation of a company would not help the defendant in evading contractual obligations to non-competition as the veil of incorporation could be lifted.

            In this case, there is no doubt that PPW was formed with the sole aim of evading the Rosta’s contractual obligations and liabilities. On that basis, PPW and its directors could be held liable for Roska’s liabilities.

Whether the equipment lease agreement entered between James and Leasetech Ltd (LT) binds Rosta and if so, whether LT is entitled to indemnity against the injury of Sally?

Under the common law principle established by the English House of Lords in Royal British Bank v. Turquand(1856)6 El. & Bl. 327, those dealing with officials of a company are not obligated to make inquiries as to any limitations as to the officials’ limitation of power to bind the company for which they claim to act for. This position is further buttressed by s130CA which states that a person is not taken to have constructive notice of company information by the merefact that such information about the company is available at the ASAIC.

Therefore, there exists a presumption that a company’s officials have the power to enter into binding contracts with third parties. As the facts disclose, James had not sought the permission of Vicky and Kevin before proceeding to enter into the lease agreement with LT. However, he executed the contract in his capacity as director of Rosta. As such, the contract would bind Rosta, since LT had no obligation to find out internal Company information as to the authority of James to execute the lease contract.

The fact that Rosta does not have a written constitution further proves the fact that LT had no other way, other than reliance on the representations made by James, of ascertaining whether James, in fact, had authority to bind Rosta. As such, Rosta is liable to pay LT the amounts owed in the lease and to indemnify it for the injuries suffered by Sally in accordance with the signed lease agreement. At the same time, Rosta has the right to either pursue James for acting as its unauthorized agent resulting in loss or to ratify James’ actions, in which case James will not be personally liable for the loss.

What are the potential actions and remedies that Rosta and ASIC may pursue against PayPerWork Pty Ltd (PPW), James and Vicky, and what their prospects of success would be

It is a long-established principle that a company is separate from its shareholders and directors. In the landmark case of Salomon v Salomon & Co Ltd, the Court determined that a company is a separate entity, having a separate personality from those who own it. It is on this basis that s236CA provides that a member of a company may bring proceedings in the name and on behalf of the company seeking remedies against other parties. Such a suit is known as a derivative action and its application was affirmed in the English case of Foss v Harbottle [1843] 67 ER 189 where the Court established that the procedure where a wrong is committed against a company, it is the company itself that becomes a claimant in the resultant judicial proceedings. Similarly, the ASIC is empowered to bring protective proceedings on behalf of shareholders under s50 of the Australian Securities and Investments Commission Act.

 In this case, it is clear from the facts that as a result of the decisions made by James and Vicky, Rosta suffered loss. In addition, the company could not pay the debts lawfully owed to LT, hence resulting in insolvency. In this regard, an action may be brought against PPW, James, and Vicky for unlawfully converting the assets of Rosta to be PPW’s and seeking a reversal of the transfer. In addition, the ASIC may bring an action on behalf of creditors such as LT, seeking remedies against PPW, James, and Vicky.

 The two actions enumerated above may succeed on the basis that PPW is wholly owned by Rosta and its formation was for the sole aim of transferring Rosta’s assets, with a view to defeating future lawful claims such as the one by LT. It was, therefore, geared toward perpetuating illegalities committed by James and Vicky. Therefore, the Court would, most likely, lift PPW’s veil of incorporation, thereby holding James and Vicky personally liable, and requiring them to bear Rosta’s liabilities.

What steps could Kevin have taken to stop the registration of PPW and the subsequent transfer of Rosta’s assets to PPW?

As already stated, under s236CA, an individual member of a company may bring proceedings on behalf of a company. To do so, one requires leave of the Court, which can only be granted once the Court is satisfied that, among other factors, it is probable that the company may not bring the proceedings for the impugned actions, or take responsibility for them and that the applicant has brought the proceedings in good faith s237CA. Before seeking leave of the Court to commence such proceedings, it is generally required that the aggrieved person to issue a notice to the company at least fourteen (14) days prior, although it is not mandatory s236 (2) (e)CA.

Once the case proceeds to a full hearing of the issues raised, a Court has the power and discretion to issue a wide range of orders that it considers appropriate s241CA. Those orders may include a direction compelling officers of the company to do or desist from doing a specified act.

A closer look at the peculiar circumstances of this case would reveal that Kevin’s rights were violated as the transfer of Rosta’s shares to PPW failed to consider, among other entitlements, Kevin’s shareholding in Rosta.  That forms the basis for Kevin’s claim challenging the formation of PPW and the subsequent transfer of Rosta’s shares to PPW. To challenge the two actions, Kevin would need to notify Rosta, James, and Vicky of his intention to sue them in Court. If notwithstanding the notice given, James and Vicky proceeded with the formation of PPW and sale of Rosta’s assets to Keywest, Kevin would then be entitled to apply for leave from the court to bring an action against James and Vicky seeking orders of injunction so as to prevent the actions complained of from taking place.

Conclusion

From the foregoing analysis, it emerges that the issue of “B” class shares to employees of Rosta is impermissible as James and Vicky did not follow the procedure required under the Corporation Act. Furthermore, Kevin had the right to file an Application in Court challenging the issue of “B” class shares, within a month of the issue.

A further corollary is that the formation of PPW and sale of Rosta’s assets to keywest was invalid and flies against established principles, hence there existed a ground for Kevin to bring derivative action against James and Vicky, preventing them from the establishment of PPW and transfer of Rosta’s shares. Moreover, the lease agreement between James and LT binds Rosta, which makes Rosta liable for the injury of Sally and payment of the amounts agreed under the lease. Therefore, ASIC may bring proceedings on behalf of LT and other creditors, as against PPW, James and Vicky, seeking for an order of settlement.

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