Directors Legal Duties; Case Study

PART A

1. Is prevention of insolvent trading a fiduciary duty?

The aggressive development of the jurisprudence towards director duties to creditors as being classified as fiduciary has only occurred in Australian jurisprudence in the last decade in “Westpac Banking Corporation v Bell Group Ltd. (No. 3) (2012) 89 ACSR 1” (hereinafter mentioned as the “Bell Appeal Case”). The Court held that the acts of the director will not be held as bonafide if proper consideration is not given to the interests of the creditor in times of insolvency. The facts in brief is that creditors brought action against the Company when the Company restricted its financial arrangement which decreased the pool of assets out which the creditors could be compensated for in liquidation. Authorities earlier to the Bell Appeal case mainly considered on the duties for avoiding “conflict of interest” to reveal such as fiduciary duties (see “Breen v Williams (1996) 186 CLR 71; Pilmer v Duke Group Ltd (in liq) (2001) 207 CLR”). However, the Bell Appeal case expressly classified the directors’ duties under “Section 181 of the Corporations Act, 2001” to act for a proper purpose and in the best interests of the Company also as fiduciary duties.

However, the Bell Appeal case also expressly distinguished between the two duties – “to act in the best interest of the Company”, and that “to act for a proper purpose” as separate and distinct duties. The case held that resolving creditors interest during times of insolvency would also be said to be in the favorable interest of the Company and the directors would fail their duty towards the company if creditors’ interests were prejudiced.

That, creditors interests during insolvency would be paramount is also evidenced by the decision of the court, that the subjective state mind of the directors to ensure adequate protection of creditor interests, which also overrides director beliefs and business judgments according to Drummond AJA. The “business judgment rule” was first introduced in the “Corporate Law Economic Reform Program (CLERP) Act 1999”, to ensure that a director would exercise due care and diligence, on the same standard as a reasonable person would in his position- Section 180(1). Section 180 (2), mitigates liability if the director acted in good faith and taken precautions to that reasonable judgment was exercised.

The above Bell Appeal case has dismissed both defenses – business judgment under Section 180 (1), as well has subjective mind of the director under Section 180 (2) – to ensure that creditors interest are given paramount importance. Practices like insolvent trading which diverts resources away from creditors’ due leaving shortage in time of insolvency. There is thus no doubt that the duty to prevent such practices fall under fiduciary duties of directors but perhaps extend to even beyond that courtesy of the Bell Appeal case.

2. How does the safe harbour defense under s588GA operate?

“Section 588G of the Corporations Act 2001 (Cth)” (the Act) prohibits insolvent trading by imposing a “positive duty” on the company directors not to indulge in the practice. The section imposes penalty on the directors if they fail to prevent the company from accruing debt while it is solvent; or if it becomes insolvent due to the debt when there were reasonable grounds to foresee that accruing such debt would make the company insolvent.

The safe harbor defense in Section 558GA(1) acted as a defense for directors to prevent them from becoming personally liable under Section 588G (as above). The section absolves the director of liability if it can be ascertained that further debt was accrued in insolvent trading because there was a reasonable and bonafide belief that by reason of such transaction the company may become solvent again. This encourages the director to take positive action to restructure the debts of the company and actively try to bring the company out of liquidation. In the absence of the safe harbour defense, the trend would be that as soon as the company becomes on the verge of insolvency, the directors would just abandon any plans of revival and let the company go to avoid personal liability – this would lead to huge losses of shareholder value. Indeed, insolvent trading is a gamble, but if done right, can lead to positive increases in creditor values as well – because creditors rarely get repaid the full amount owed in insolvency cases even when they are preferential creditors.

3. Who does it (s588GA) protect, and is this different to the business judgment rule s180

(2)?

The safe harbour defense under section 588GA aims to protect directors from personal liability when they can establish that they acted  reasonably after being informed on the circumstances with the presumption that taking a risk (such as insolvent trading) would be beneficial for the company in long run to bring it out of insolvency.

The business judgment rule under Section 180 (2) requires directors to “act in good faith” with a reasonable degree of skill and care that another reasonable person in their position might exercise, so as to bind them in a fiduciary relationship to work to achieve the best interests of the shareholders and the company in all their dealings.

The main difference between these two is that the safe harbour defense can be claim only in times of insolvency or on the verge of it, and the business judgment rule operates at all other solvent times. Another difference is that during insolvency, the directors have to keep in mind the interest of the creditors also, to avail the safe harbour defense. However, in solvent times when exercising the business judgment rule, the concerns of the shareholders is paramount.

4. Restrictions on the operation of the s588GA defense

It should be remembered that, to avail the safe harbour defense, the entire burden of proving that there was a genuine belief in the directors that such trading would lead to positive outcomes for the company would entirely be on the directors. On this note, Section 588GA(4) and 588GA(5) specifies certain exceptions when safe harbour defense would not operable. Broadly these are when the company is unable to meet the pay requirements of its employees and unable to meet the requirement to file tax returns and notice even after 12 months from which the debt was incurred, where the statutory and regulatory authority has already issued a formal order for winding up and where the shareholders have voted to appoint a liquidator.

5. Changes to Division 3 and its effect on number of voluntary insolvencies in Australia in the future

As per “Section 491 of the Corporations Act 2001” (Cth) (the Act), a voluntary windup by the members of a company can be initiated by the a special resolution whereby the Directors are obligated to give a statement as to the solvency of the company to the “Australian Securities and Investments Commission (ASIC)”. Thereafter a liquidator is appointed, who if of the opinion that the company is indeed insolvent, may proceed to make an application to the Court to start winding up proceedings, make an appointment of an administrator to manage the affairs of the company or call a meeting of creditors who may then decide by majority to initiate wind up proceedings, which shall then be called as creditor’s voluntary windup.

Changes to Division 3 including the safe harbour defense brought about by the 2018 amendments to the Act has brought about the cultural shift in the board by providing an incentive to directors to hold on to the control of the Company for a longer period of time in case of impending insolvency in the hopes of revival of the Company. Before the introduction of these changes, especially the safe harbour defense, directors would tread especially cautiously and declare voluntary winding up if they sense that a company might have a chance to become insolvent, even if the directors wanted to personally venture a revival of the company. This made sense given that “Section 588G of the Corporations Act 2001 (Cth)” attributed strict personal liability to directors for insolvent trading of the outcomes were less than favorable. As Vantage Performance Executive Director Michael Fingland points out, measures like the safe harbour defense may cause a 5-10 percent reduction of the rate of failure of companies and may inject a value of about extra 13 million AUD into the economy (“https://www.vantageperformance.com.au/safe-harbour-law-will-save-aussie-businesses”). According to Mr. Fingland, it has been a long running practice in Australia that company directors in crisis times akin to impending insolvency would just give up and declare insolvency by calling for a shareholders meeting and pushing for a special resolution to that effect, simply to avoid personal liability; this leads to a lot of unnecessary job cuts and loss of livelihood for employees in the corporate sector. As Mr. Fingland calls it, measures such as the safe harbour defense has the effect of establishing a ‘protective bubble’ around the liabilities of the directors.

It would thus be very prudent to presume that given their new-found freedom to venture into risks, Director would not become more incentivized to make an effort for revival of a sick company and would not be in a hurry to declare voluntary insolvency at the drop of a hat, thus decreasing the number of voluntary insolvency cases in Australia.

PART B

The talented Mr Daly

1. Did Mr. Daly breach any directors’ duties?

Mr. Daly, as executive director of Linchpin Capital has violated several of his director duties under Australian law. They are as follow:

  • Duty to act with due care and diligence – “Section 180 of the Corporations Act 2001 (cth)” (the Act) imposes the common-law duty upon directors to act with reasonable care and diligence that a reasonable person might exercise in a similar position of responsibility. One of the cases when this duty would be breached is entering into grossly risky transactions without a clear benefit for the company and its investors. Mr. Daly, had borrowed money from the Company for personal ‘cash flow shortages’ which was actually utilised to fund his daughter’s wedding and give himself a raise, which he himself approved as a director. This clearly violates the duty to action with reasonable care and diligence under Section 180 of the Act as it is highly unethical and unjustifiable that a financial company would utilise money raised from investors fund personal expenses of the management staff. The same obligation was also violated when Mr. Daly approved a similar request for a personal loan made by another director.
  • Good Faith Duty – Section 181 of the Act imposes a fiduciary obligation on directors to utilise the money “in the best interests of the company and for proper purpose”. As this is a duty of fidelity and trust, it is termed as a fiduciary duty imposing strict liability on violators. As mentioned above, Mr. took out personal loan from company assets to fund his daughter’s wedding and approved a similar loan to another director to fund his divorce and purchase of a car. This is against the legitimate interests of the business and his shareholders and would definitely not hold up as a “proper purpose” under Section 180. Mr. Daly has thus breached his fiduciary duty.
  • Improper use of position – Section 182 of the Act imposes a duty on directors to not misuse their position of power and authority in a company to secure an advantage for themselves or another person leading to detriment of the Company. Mr. Daly used company money for his own personal borrowings and allowed another director to do the same. Thus, he is clearly guilty of taking advantage of his position as a director, in violation of Section 182.
  • Improper use of Information – Section 183 of the Act imposes an obligation on directors not to use their position to gain information to help themselves or another person to the detriment of the Company and the stakeholders. A Product Disclosure Statement (PDS), is a central brochure that is given to prospective clients which gives detailed information about the financial product. One of the sections of a PDS contains what is called an “Investment Universe”, which sets limits on where the investor’s moneys would be invested. This section was kept deliberately vague with no limits and having a provision that money may occasionally be loaned to management, so that directors like Mr. Daly can abuse it to grant themselves personal loans out of company money. This is thus a clear violation of Section 183.

2. Did any of the other directors breach their duties?

When the directors of Mr. Daly’s company were interviewed by the “Australian Securities and Investments Commission (ASIC)”, one of them clearly mentions that one of the main reasons that Mr. Daly wanted a personal loan was to fund his daughter’s then upcoming expensive wedding. Another director wrote a one page letter to the Board asking for a financial loan (which was approved by the Board with Mr. Daly in it) of 30,000 dollars for a divorce with his wife and to fund his treatment for his ageing mother’s illness. He admitted that he did not himself the capacity and capital to pay it back, but expected his mother’s estate to pass on to him as the only son in three years’ time – that was his mother’s life expectancy according to the doctors. This is outrageous dodgy and risky – for e.g. what if his mother decides to write a will cutting out her son entirely from his supposed inheritance. As Paul Green, a forensic accountant interviewed by Mario Christodoulou of ABC news points out, this sort of behaviour is highly unethical and completely unauthorized. It is very clear that the entire business was being run akin to a private club for siphoning off money from investors to enrich the management themselves and thus all the other directors are also guilty of violating the same directors duties as Mr. Daly – i.e. duty to act with due diligence under Section 180 of the Act, fiduciary duty to put interests of the company and its investors over personal interests of management under Section 181, improper use of official position under Section 182 and improper use of information under 182 of the Act.

3. Was the Company guilty of insolvent trading?

Insolvent trading is defined as acquiring debts when the company is insolvent or becomes insolvent because of such debt. Section 588G of the Corporations Act, 2001 (the Act), imposes personal liability on directors for insolvent trading if the person was aware of the financial state of the Company or where a reasonable person in a similar position would be aware of such position in the same place.

Mr. Daly is the executive director for a financial company called Linchpin Capital. Linchpin owns two other companies – one is a financial advice business called the Beacon Group and the second is an investment fund called the Investment Income Opportunity Fund (IIOF) where the funds are channeled to from the Beacon Group. IIOF is again divided into a registered fund where not much money is kept and which is only the public face, and an unregistered fund – where the bulk of the money is kept. The registered fund has been facing shortages for a long time and in 2015 an email was sent to Mr. Daly by another director about money shortages in the fund. In 2017 again, another email was sent saying that a tax bill was being unable to be paid due to cash shortages.

It was thus very clear that the directors were aware that the fund was insolvent but were still accruing debts by giving out personal loans to directors which did not in any way lead the company to a better position. Thus, the company is guilty of insolvent trading.

4. Defenses available for insolvent trading.

The statutory defense available to insolvent trading is if the director was unaware of the financial condition of the company, and where a reasonable man would also not be aware of the same in a similar position – as per Section 588G (2) of the Act. However, this defense cannot be claimed by Mr. Daly and the other directors as they were aware of the liquidity concerns of the firm by virtue of the above stated email of 2015 and so much so that the company was not being able to pay a tax bill – as according to a 2017 email (both quoted above).

The second defense available is the safe harbour defense under Section 588GA, which absolves directors from liability if the act undertaken was for better the position of the Company for its revival. However, the acts concerned here is giving out personal loans to directors without a definite pay back schedule. This is no way can be reasonably said to be for the better of the Company and thus the safe harbour defense also cannot be claimed here.

5. Would the new safe harbour defense assist the directors?

The safe harbour defense under Section 588GA of the Act provides that a director would be absolved of personal liability for insolvent trading, if he can prove that the decision was undertaken for securing a better outcome for the revival of the company. However, the impugned act here, is accruing liabilities by granting personal loans from the funds of investors without a definite schedule of payback. Indeed, as Mr. Daly confesses to Mario Christodoulou of ABC, only the interest payments were deducted from his salary, and the principal remains outstanding. Loans were given despite a 2017 email that the fund does not have money to pay a tax bill. The fund was practically insolvent, which was unethically being suppressed by management. Thus, the impugned personal lending can in no way be said to be for the betterment of the business by a reasonable person, and thus the safe harbour defense will not be available to the directors.

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