The Principles and Rules in the Present Companies Act 2006: Common Law and Law - Case Study Example

1 Introduction Corporations and companies, by reason of their being mere fiction of law, depend upon their agents to act, negotiate, and otherwise transact on their behalf for the end purpose of benefiting them. Directors of companies and corporations carry out important functions within the corporate structure, many of which are fiduciary in nature. Thus, the law, both common and statutory, imposes upon them stricter obligations and duties to ensure that they strictly act on behalf and for the benefit only of the company and not for themselves or for other entities. The law has adopted, through the years, a number of principles and rules to ensure that directors put company interests first before other interests. Many of these principles are already codified and integrated into the present Companies Act 2006, like for example, the “proper purpose” principle that imposes upon directors not only to exercise powers conferred upon them but to exercise these powers for the purpose for which they were conferred. These principles effectively constraint directors from veering away from company interest and reneging on their fiduciary duties owed to the company. 2 Principles Preventing a Company Director to Act Other than for Company Interests 2.1 The ‘proper purpose’ principle One of the duties imposed by the law on company directors is to act only within the confines of the functions and powers granted them by the company’s Constitution. This doctrine is essayed is s 171(1) of the Companies Act 2006. The same section, in the next subsection, also stresses that such powers legally conferred must only be exercise for the purpose for which they were granted and needless to say, that purpose is for the benefit of the company. This, in a nutshell, is the ‘proper purpose’ doctrine. It has been acknowledged, however, that a director’s act may still be valid even if the same is not granted by the company’s Constitution so long as it abides by the agency rules. Absent both conferment of power by the company’s constitution and by agency rules, express or implied, a director’s act is a breach of duty under the Company Act 2006 (Morse 2007 165). In the case of Hely-Hutchinson v. Brayhead Ltd [1968] 1 QB 549, for example, its CEO, who also acted as Board Chairman and de facto Managing Director, guaranteed the company’s debt to a creditor on behalf of the company, which is into the electronic business. The money loaned was used to infused into a company, formerly owned by the creditor, and which is about to be taken over by Brayhead. The creditor himself was guaranteed a seat in Brayhead’s board, which he eventually gave up when the company he formerly owned got into liquidation. The money the creditor lent to Brayhead turned out to be inadequate to institute a company turnaround. The creditor sued Brayhead for the amount loaned, which the latter declined to pay on the ground that it was not legally incurred by it because the CEO had no express authority to enter into a contract of loan. The Court did not agree with Brayhead’s defence on the ground that the Board Chairman’s act in incurring and guaranteeing the loan was within the powers conferred to him in accordance with the agency rules, implicit though it may be. The conferment of the power on the CEO to contract loans for Brayhead was implied because not only had he been acting as de facto Managing Director of the Brayhead with the knowledge and consent of the Board, he had also, by practice, contracted loans for the company before without prior knowledge of the company but reported them afterwards, all of which were subsequently ratified by the Board. He therefore has, ostensible or apparent authority to enter into the contract, making the company liable for the loan to the creditor. In determining the existence of ‘proper purpose’ in every act of the director, resort must be had to the context of that act. In the case of Howard Smith Ltd. v. Ampol Petroleum Ltd. and Others [1974] 2 WLR 689, the Court looked into the substantial purpose for which an assailed act of the directors was done in order to determine whether or not the act was intra vires or not. The case involved the sale of a bloc of shares of R.W. Millers Holdings after the death of its founder. The bloc, a substantial percentage of the total shares were bought by Ampol, but when the latter offered to buy the remaining shares the Board decided the offer was too low. Another company, Howard Smith Ltd. offered a higher bid and Ampol, reacted by combining with another shareholder for a majority share and moved to reject Smith’s offer. The Millers’ directors issued shares to Smith at a premium price that would reduce the 55% shares Ampol and its associate held and at the same time raise much needed revenues to raise its capital. Ampol went to court to invalidate the issuance of shares by the Millers’ directors. The court granted the Ampol petition and nullified the shares issuance on the ground that by virtue of the ‘proper purpose’ principle the act of the directors was obviously primarily to dilute the holdings of Ampol and its associate to prevent their taking over the company. Although the act of issuing shares was intra vires because it was within the ambit of their powers to do so, it was exercise for an improper purpose. 2.2 The “good faith” principle One of the principles in English company law pertaining to directors is the “good faith” principle which must accompany all their acts when performing on behalf of the company with the end goal of ensuring that the company succeeds in all its endeavours. There are two elements to this principle: acting with honesty, and; motivated by the best interest of the company. The first element is subjective, that is, it can only be determined within the context of a director’s perspective whilst the other is a quasi-objective test as it takes into account the perspective of an intelligent person in a director’s position. The Court held in the case Charterbridge Corp. Ltd. v. Lloyds Bank Ltd. [1970] 1 Ch 62 at 74 that “[The test] is whether an intelligent and honest man in the position of the director of the company concerned, could, in the whole of the existing circumstances, have reasonably believed that the transactions were for the benefit of the company” (cited in Cassidy 2006 217). In Item Software (UK) Ltd v Fassihi [2004] EWCA Civ 1244 [2005] 2 BCLC 91 (Court of Appeal), the Court declared that acting in good faith for the benefit of the interest of the company includes the obligation to report a director’s misconduct to the company. This case involves a defendant who had a dual position in his company: as a director and employee. The defendant approached a company, Isograph, whose products his own company, IS, is a distributor for. During the renegotiation for a new distribution agreement, the defendant broached the idea of putting up a new company of his own to handle the company’s distribution in lieu of the company he was presently working. Whilst making this offer, he also encouraged the company he was working for to take a tough stance against Isograph. Unsurprisingly, the negotiations between the two companies broke down and Isograph terminated the distribution agreement and contracted with the defendant’s newly set up company. Upon knowing this, IS fired the defendant and instituted an action against him on the ground that breached the duty to act in the best interest of the company and on his failure to report his own misconduct to IS. The lower Court ruled in favor of IS on both counts ratiocinating that the defendant’s setting up of a new company that would take over the distribution contract with his own company’s client was an not “an act of legitimate entrepreneurial activity” and therefore, an act of bad faith. The part imposing upon the director the duty to inform the company of his own misdeed was appealed on the ground that it was impossible to expect a person to report his own misdeed. The appeals court sustained the lower court’s judgment on the basis of the reasoning that if he fails to do so, it would make the company be susceptible to erroneous business decisions because of the lack of knowledge of certain data. In imposing the “good faith” principle on directors, an important underpinning is the company’s interest and how to define it exactly. According to the case of Greenhalgh v. Arderne Cinemas [1951] Ch 286, the company’s interest is that of the corporators in their entirety since the company, which actually holds the company interest, is a mere legal fiction and protecting its interest is not exactly something realizable in concrete terms without equating the phrase, however, to shareholders because the director owes a duty to all shareholders, not only in the present but also in the future, according to the case of Henry v Great Northern Railway [1857] 44 ER 858 (Cassidy 2006 217). 2.3 The “unfettered discretion” principle One of the duties imposed by law on directors is to exercise independent judgment to the extent that their discretion should be left unfettered. This does not mean, however, that the director could freely delegate his power unless so provided by the company’s constitution. This principle is subject to certain exceptions: one, when a director enters into a contract with an entity and the contract calls for him/her to act in a particular manner in the future, and; when the company constitution so authorises him/her. An example of this dictum is the case of Fulham Football Club Ltd. v Cabra Estates plc [1994] 1 BCLC 363. This case involves an agreement, contained in a ‘Letter of Undertaking’ by Fulham directors, in their individual capacity, in favor of Vicenza Developments and the Cabra Estates where they promised to use their powers as directors to support all future planning applications of the latter relative to the lands Fulham was holding for them and to prevent themselves from frustrating or thwarting, in any manner, such planning applications. When Vicenza and Cabra eventually filed for a planning application involving the land held by Fulham for them, the directors demurred on the ground that the previous agreement was not in harmony with the law and that they, as directors, are prevented by law to fetter their judgments. The Court disagreed. It held that the Fulham directors cannot use the law to frustrate an agreement which they had previously entered into willfully nor can it be used to rob other companies from beneficial contracts. The directors should have questioned the validity of the agreement at the time they entered into it and not when they are called upon to implement it. 2.4 The reasonable care, skill, and diligence principle Section 174 of the Company Act 2006 imposes upon directors the obligation to exercise their obligations with reasonable care, skill and duty at all times with these terms pegged on the “general knowledge, skill and experience” reasonably expected from one who is exercising a director’s functions vis-à-vis the company and the “general knowledge, skill and experience” that the director possesses. There are two tests often employed in the past to determine if a director has indeed abided by this duty: the subjective test and the objective test. These tests paralleled that of the Insolvency Act 1986 but the present company law has rejected the old purely subjective test in favour of the new approach – subjective/objective test - reflected in recent case law (Morse 2007 170). The old subjective test was employed in the case of Re City Equitable Fire Insurance Co Ltd [1925] Ch 407. The case involves the loss of a company because of the machinations of its Chairman and to a small degree, to investment failings. The liquidators included in his suit the other directors of the company who, albeit were not guilty of any wrongdoings, were nevertheless, to him guilty for failure to arrest the losses and were, therefore, negligent of their duties. The Court absolved the directors because of a provision in the company’s constitution that frees directors from any culpability to acts that are not willful and intentional. In this case, the court took into consideration not the duties of the directors per se but the circumstances under which those duties are to be observed, like the nature of the company, the manner of work distribution among directors and company officials, and generally, the extent of duties as director and the skills needed to dispose his duties. In the more recent case of Re D’Jan of London Ltd [1994] 1 BCLC 561 (Chancery Division), the Court’s decision, which ended the purely subjective test, became the basis for s 174 of the present company law. The case involves a mistakenly filled up insurance policy, done by an insurance broker for a company director. The error was fatal because it was made into a case of misrepresentation by an insurance company and made the basis of its rejection for an insurance claim when the building the insurance was supposed to cover was gutted down by fire. The question in the insurance form asks whether the applicant had, at any time, been a director of a company that had gone into liquidation which was answered by a ‘No’ by the broker. The director’s error was that he signed without reading the form at all. The liquidators, after the company had gone into insolvency, sued the director to recoup the company’s losses on the ground of negligence and misfeasance. The Court sustained the liquidators holding that the director breached his duty to exercise his duties and functions with care when he signed the insurance form without checking the contents. Clearly, this holding was a departure from the earlier case of City Equitable because it gave a verdict on the basis of a director’s duties without taking into consideration subjective matters. 2.5 “Conflict of duty and interest” principle The case of Aberdeen Railway Co v Blaikie Bothers [1854] 1 Macq 461 illustrates the rule on conflict of interest brought about by self-dealing. A company entered into a contract with another for the production of iron chairs. When the latter was not able to abide by the terms of the contract, one of the parties sued the other. The defendant argued that they cannot be held liable under the contract because it was void considering that at the time the contract was entered into the Chairman of the complainant was also the Managing Director of the defendant, resulting into a conflict of interest. The Court sustained the argument of the defence ruling that there was indeed a conflict of interest stressing that the rule against conflict of interest is an intractable one and cannot be made subject to any other consideration even one where the contract turned out to be more beneficial to both parties. “Such agents have duties to discharge of a fiduciary nature towards their principal. And it is a rule of universal application, that no one, having such duties to discharge, shall be allowed to enter into engagements in which he has, or can have, a personal interest conflicting, or which may possibly conflict, with the interests of those whom he is bound to protect” (Aberdeen Railway Co v Blaikie Bothers [1854] 1 Macq 461). The only exception to this rule is when there was prior express approval by the other directors for a director to engage in a venture that may conflict with the interest of the company. There is also the controversial Canadian case Peso Silver Mines Ltd v Cropper [1966] SCR 673, where a Canadian court ruled that the rule is not breached if a company has informed the directors that it will not pursue a potential venture and the directors or any of them decide to pursue it themselves. Moreover, a contract entered into by a director attended by conflict of interest may be ratified by the Board (Sealy & Worthington 2009 309). 2.6 No profit rule A director is also prohibited from accepting gifts from third parties by reason of his being a director for that company or by doing (or omitting) to do something as a director for that company. This rule is not breached, however, if acceptance of the gift or consideration has no possibility of resulting into a conflict of interest (s 176, Companies Act 2006). In GVDC Co Ltd v Koshy [1998] BCLC 613, a UK company entered into a joint venture with other entities to cultivate a cotton and wheat farm in Zambia. It was the biggest investor. The venture created the GDVC as its corporate vehicle, with investors being represented to its board in accordance with the size and amount of their investments. Mr. Koshy, director and managing director of the UK company called Lasco also served as a director of the GDVC and in 1987 the former loaned a huge amount of money to the latter at estimated profit of millions of dollars. The venture did not flourish and was eventually placed under receivership. The receiver instituted an action against Mr. Koshy and Lasco for, among others, breaches of fiduciary duties. Koshy was found guilty as charged on the ground that he did not disclose the extent of his interest in the UK company to the other directors of GDVC prior to entering into a contract of loan and he was therefore liable to the extent of the profit made by him from the loan transaction between GDVC and Lasco. Under the no profit rule a director is banned from making a profit out of transaction entered secretly by him on the basis of his fiduciary position with the company. 3 Conclusion The present Companies Act 2006 already contains many of the principles and rules that effectively constraints directors from doing what is expected of them as such, although many of these principles were originally spawned by common law and case law. These principles and rules are necessary adjunct to persons who are conferred with powers to act for and behalf of the companies to guarantee that these persons always act for the benefit of the company. Many of these principles keep directors from exercising their powers for self-interest and self-profit like the ‘no profit rule’ that clearly prohibits them from personally profiting from transactions entered into by their companies or the ‘no conflict’ that compels them to divulge the extent of their interests, if any, in these transactions. Additionally, these principles and rules also compel directors to use their powers carefully and diligently so as not to injure their companies and its shareholders as a whole and protect their interest at all times as illustrated by the ‘unfettered decision’ rule. These principles and rules, however, are useless and are without teeth if there are no remedies for their breaches. These remedies, available to the company and shareholders are what keep these principles and rules working in the first place. References: Aberdeen Railway Co v Blaikie Bothers [1854] 1 Macq 461 Cassidy, J, 2006 Concise Corporations Law Federation Press. Charterbridge Corp. Ltd. v. Lloyds Bank Ltd. [1970] 1 Ch 62 at 74. Fulham Football Club Ltd. v Cabra Estates plc [1994] 1 BCLC 363. GVDC Co Ltd v Koshy [1998] BCLC 613. Greenhalgh v. Arderne Cinemas [1951] Ch 286. Hely-Hutchinson v. Brayhead Ltd [1968] 1 QB 549. Henry v Great Northern Railway [1857] 44 ER 858. Hicks, A. & Goo, S.H. 2008 Cases and Materials on Company Law Oxford University Press. Howard Smith Ltd. v. Ampol Petroleum Ltd. and Others [1974] 2 WLR 689. Item Software (UK) Ltd v Fassihi [2004] EWCA Civ 1244 [2005] 2 BCLC 91 (Court of Appeal). Morse, G. 2007 Palmer's Company Law: Annotated Guide to the Companies Act 2006, Volume 2006 Sweet & Maxwell. Peso Silver Mines Ltd v Cropper [1966] SCR 673. Re City Equitable Fire Insurance Co Ltd [1925] Ch 407. Re D’Jan of London Ltd [1994] 1 BCLC 561 (Chancery Division). Sealy, L. & Worthington, S. 2007 Cases and Materials in Company Law Oxford University Press. Read More