Recent Decisions of the Zadok Board - Essay Example

Legal Advice Clarke Bros Legal Counsel In the matter of: Recent decisions of the Zadok Board Sir: In view of the recent developments and decisions taken by the Zadok Board, we propose to present for your review an examination of the issues that arise in these respects and possible remedial recourse that may be available through an application of the law. The Zadok Company has been incorporated in accordance with Articles in the Table A form. Incorporation therefore involves separation of ownership and control, it is the members who own the company and allot shares, which constitutes a delegation of the shares as spelt out under s.80 to s.96. Amber and Boris are the executive Directors of the Company, but from the perspective of ownership of shares, it may be noted that Clarke Bros has a greater ownership stake, since they own 5% of the shares while Boris and Amber own 2% each. Berle and Means point out that with the growing size of corporations, ownership and management have been separated1 however companies are now so dominated by directors that their shareholders may be denied an effective say in the decisions of the Company. Justice Plowman in the case of Parke v Daily News Ltd2 held that the primary duty of the directors of a corporation is to their shareholders, superseding their duty to their employees. In the execution of his duties, it is inevitable that a Director will face a conflict of interests, but he is required to be self regulated by a strong code of ethics in his dealings. The Executive Director is the principal agent of the Company but under the law, has been held to be subject to the same standards of loyalty and good faith in his duties as that expected from trustees3 and therefore has a fiduciary duty to the shareholders4. However, the functions of directors originated as a flexible concept in the courts in the nineteenth and twentieth centuries. For example in the case of directors in Turquand v Marshall, the Court held that it “could not interfere with the discretion exercised by them”.5 In the case of Re Dunham and Co, the Court found that the director has been guilty of “considerable negligence” yet held that he had not breached his duty of diligence and care.6 However the duty of skill of a Director was best laid out by Romer J in the Re City Equitable Fire Insurance Co Ltd7 where he stated that while a Director was expected to exercise a certain level of skill and diligence that an ordinary reasonable man would apply under the circumstances, this did not mean that he was required to demonstrate a level of skill that was not commensurate with his experience. Moreover, a Director is not obliged to give continuous attention to the affairs of his company or take responsibility for the decisions that are made in his or her absence7a. The case of Re Brazilian Rubber Plantations and Estates Ltd8 had also established the fact that a Director is not required to bring any special knowledge or experience to the task of functioning as the Director of a corporation. However, the standard of care a Director is expected to exhibit will be commensurate with the level of his experience and qualifications, for example in the case Dorchester Finance Co, a higher standard of care was expected from the Directors because they were accountants.9 Similarly in the case of Re D’Jan of London, Hoffman J clarified the duty of care required from Directors by applying an objective test with a subjective element9a, which was that of standard diligence in a person possessing a level of skills and experience that could reasonably be expected from another person in the same position, to which the director’s own special skills and experience could be added.9b A director’s most important duties are his fiduciary duties to the Company, however the duty of skill has been deemed to be of less importance as established through the cases mentioned above. But in view of changing community standards, the Courts have also moved to require more of directors, such as for example in the case of Re Australian Venezolana Pty Ltd10 where it was held that directors were expected to make reasonable efforts to acquaint themselves with Company affairs. In the case of complicated situations where technical or expert knowledge is required, directors are now expected to seek and procure such expert advice in the interest of the shareholders of the Company, failing which they can be held guilty of a breach of duty of care and skill under the law11. The changing expectations from the directors of corporations are best exemplified through the words of Justice Kirby of Australia, in the case of Metal manufacturers Pty Ltd v Lewis, where he stated: “The time has passed when directors…. can simply surrender their duties ….by washing their hands, with impunity, leaving it to one director or a cadre of directors or to a general manager to discharge their responsibilities for them.”12 A person like a Director who is in a fiduciary position of trust has certain legal obligations that stem from his or position of trust.13 A person in such a position is endowed with the power to influence the interests of a person/s who is in a beneficiary position and can rightfully expect that such fiduciary power will be exercised for the benefit of the beneficiary. The fiduciary duties of directors direct that they work for the benefit of the Company and the nature of these fiduciary duties has been elucidated by Farrar who lays out three principal duties owed by the directors to the Company: (a) Directors have a bona fide duty to act in the company’s interest and must not exercise their powers for a collateral purpose. (b) A director who profits as a result of his position as Director of a company is liable to account for such profits (c) In a situation where the director’s duty to the company conflicts with his personal interests, then any contract that arises in such a situation may be annulled by the Company.14 In the case of Mills v Mills, Latham CJ stated that a director must act “bonafide for the benefit of the company.”15 In the recent case of Chan v Zacharia, it was further held, as per Deanne J, that a fiduciary must not allow a situation to develop where there will be a conflict of his fiduciary duties with his personal interests and he/she must not make use of the fiduciary position to gain a personal advantage16. The duties of the director to the company are set out under in the Companies Act, which imposes a duty upon the directors to look out for the interests of the company and its employees as well as its shareholders17. Sections 151 and 152 of the Companies Act also deal with unauthorized financial assistance rendered that could be detrimental to the company’s best interests. Applying the standards that have been set out above, it may be stated that an executive Director like Amber or Boris has a higher standard of care and diligence that he owes to the Company and its shareholders since he is responsible for the day to day management of the affairs of the Company. The first issue that arises is Amber’s purchase of the office building in central London in July 2004. A person in Amber’s position could be argued to possess the knowledge and skill for a real estate purchase, however in the case of a large scale commercial transaction, Amber could reasonably have been expected to consult an expert, since he is not equipped with specialized real estate skills. It may be noted that since the business of the Company has to do with telecommunications, Amber cannot be expected to be fully conversant with the field of real estate in estimating the value and true worth of real estate property. However, as a Director, he is obligated to seek expert opinion especially in such situations where technical expertise may be required and there are large amounts of money involved. His failure to consult an expert could even be construed to be a breach of trust, by applying the principles laid out in the case of Re Duomatic Ltd18. Moreover, the Companies Act of 1985 provides an extensive definition of those who may be classified as directors and “connected persons’19 and these person/s are required to disclose information to shareholders and acquire their authorization in the form of expression of approval through a resolution passed in a general body meeting of the Company, as far as “substantial property transactions” are concerned., which includes all transactions for a value greater than 2000 pounds.20 This is even more so when non cash assets of a value that is either more than 100,000 pounds or equivalent to 10% of the company’s net assets are concerned. The real estate purchase that has been carried out by Amber has been done without the knowledge and approval of the shareholders and the decision to reorient the company priorities and accordingly purchase such an expensive piece of real estate has been made without the knowledge of Zadok’s shareholders, of which Clarke Brothers is the largest shareholder. While the ordinary activities of the Company could possibly have been carried out and some policy decisions made without consulting the shareholders, the issue in this case is the purchase of a piece of real estate that involves a significant part of the Company’s assets. Therefore action may be brought against him for this loss in a court of law, where Amber will be liable for (a) having entered into such a purchase without expert assistance in a situation which called for it, which could render him guilty of a breach of trust of his position as executive director of the firm and (b) entering into a large scale purchase involving a significant part of the company’s assets and incurring a loss for the Company – all without prior consultation and approval from the shareholders. The loss of J6 million clearly establishes the fact that Amber has not acted in a manner that is for the benefit of the Company. Since this decision to purchase the property and then to re-sell it after realizing it was a bad investment, it can all give rise to action by the shareholders to render the purchase annulled by the Company.21 Section 322 of the Act establishes the basis for a declaration annulling such substantial property transactions unless they cannot be reversed. Since the acquisition of the property is in itself questionable, having been entered into without the express sanction of the shareholders, the validity of the sale may also be questioned and reparation made to the Company for the losses it has sustained through the negligence and breach of duty of its director Amber. This would be in line with the decision that was handed down in the case of Daniels v Anderson, where it has been held that directors are required to exercise care in the performance of their duties22. In reference to the purchase of electrical equipment for the amount of 250,000 pounds from a company where Boris’ wife has significant ownership rights, there is a clear case of conflict of interests involved. Boris’ personal interests are to bring profit to his wife while his duties to the Company deem that he act in the best interests of the Company. Therefore in this instance, Clarke Brothers may consider bringing suit against Boris under Section 459 of the Companies Act of 1985, requesting the Court to pass an order decreeing that the affairs of the Company “are being conducted or have been conducted in a manner which is unfairly prejudicial to its members generally or of some part of its members.”23 The recent case of Bhullar v Bhullar re-established the court’s strict enforcement of the fiduciary duties of directors in the case of conflicts that arise when there is a clash of fiduciary duties and personal interests.24 Therefore, awarding the contract for purchase of electrical equipment in the large amount of J250,000 to a company where half the shares are owned by Boris’ wife, making her the owner of 50% of the company, is a clear breach of the fiduciary duty of Boris to watch out for his company’s interests rather than accrue gains for his wife. The case of Cook v Deeks would also be relevant in this instance, and may be applied to the conduct of Boris. In the Cook case, it was held that there directors had breached their duty to their company by diverting a contract from their company to another one they had formed themselves25. In such instance, secret gains accrue to others through the special favors of the directors at the expense of the Company, which is also the case with the purchase of equipment from Boris’ wife’s company. In this instance, Boris is diverting the contract from a legitimate party to his own wife, which is also equivalent to transferring those interests to himself. It is also the same issue of conflict between fiduciary duties and personal interests that arises under the issue of Amber diverting a substantial contract away from Zadok and towards a Company in which he owns 75% of the shares and is therefore practically a full scale owner. The business of J10 million that was brought by Southern Lights was intended to be for Zador, since previous business transactions had already been carried out with this Company. However, Amber has in effect, deprived Zador of this benefit and has therefore deliberately worked against the interests of his own company. When combined with the losses he has caused to Zador on the real estate deal, his breach of fiduciary duty is even more glaring. In the case of Regal (Hastings) Ltd v Gulliver, the Directors were deemed to be acting in good faith, yet the court established a strict standard of director liability and illustrated the principle that directors cannot make a personal profit through their actions as directors26. It may be clearly seen that Amber was able to gain access to the contract from Southern Lights purely in his capacity as the Director of Zador and he made direct use of the advantage accruing to him by virtue of his position at the Company in order to divert the contract to a company where he has a substantial interest in order to add to his own personal profit, thereby he is clearly in breach of his duties. In the case of Regal (Hastings) Lord Macmillan set out a two fold test as follows: “(i) that what the directors did was so related to the affairs of the company that it can properly be said to have been done in the course of their management and in utilization of their opportunities and special knowledge as directors; (ii) that what they did resulted in a profit to themselves.”27. Further more Lord Russell emphasized the liability that would exist to a director in such a case; “The profiteer, however honest and well informed, cannot escape the risk of being called upon to account.”28 Therefore, Amber will undoubtedly be held strictly liable by the Court for his action to deliberately accrue a profit to himself, by making use of the advantage he had as director of Zador, in a direct abuse of his fiduciary position. Lord Cranworth highlighted the unethical issue of being involved in transactions where there is a conflict of interest, such as that which exists in this case; “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 possibly may conflict, with the interests of those whom he is bound to protect.”29 Thus Amber is in clear breach of his fiduciary duties. He definitely has a personal interest in the transaction with Southern Lights and has acted in a manner that directly contravenes the interests of Zador and its shareholders, that he is bound to protect, all the more so because he is a shareholder himself. Conclusion: On the basis of the above, it is recommended that Clarke brothers initiate legal action against both Boris and Amber, since they have both been guilty of a breach of fiduciary duties and have allowed their personal interests to predominate in the transactions listed above. While Boris is guilty of action to acquire secret profits to himself by awarding a contract in this capacity as director to his wife, the courts can deem the entire transaction to be null and void since there has been a breach of trust and may require Boris to reinstate the amount to Zador. The case against Amber is even stronger, since he has willfully and deliberately caused losses to Zador through irresponsible purchase of land and subsequent sale at a loss and can be held liable for such losses in the event the purchase cannot be nullified. He could have achieved some respite from the Courts but for the fact that his action to divert the contract from Southern Lights to his own company clearly indicates the motive to make personal profits at the expense of the Company, at which his position has brought him the gains through contact with Southern Lights. If it were not for his position as Executive Director of Zador, he would not have had access to the people from Southern Lights nor would he have had the authority to make a contract with them on Zador’s behalf which he willfully misappropriated by diverting the contract for his personal gain. As Executive Director of the Company, the duty of care and diligence that is due from him is even greater than that which can be expected from an ordinary employee of the company or a stock holder, therefore he will be all the more liable. Not only will he have to compensate for the loss of the contract to Southern Lights, he will also have to compensate Zador for the losses from the real estate purchase and sale. Bibliography * Berle, Adolf A and Means, Gardiner C, 1968. The Modern Corporation and Private Property Harvest, USA, 1968 (Revised edn) * The Companies Act of 1985 * Farrar, J.H, Hannigan, B.M, 1998. Farrars Company Law, London Edinburgh and Dublin: Butterworths, pp 378 * Jowitts Dictionary of English Law (2nd ed), 1977. London: Sweet & Maxwell, London, vol 1, p 788. * Lowry, John; Edmunds, Rod, The No Conflict-No Profit Rules and the Corporate Fiduciary: Challenging the Orthodoxy of Absolutism, J.B.L. 2000, Mar., 122-142. * Sealy, 1967, The Director as Trustee CLJ 83 * Sealy, LS, 2001. Cases and Materials in Company Law, Butterworths, Seventh Edition Cases: * Aberdeen Railway Co v Blaikie Bros (1854) 1 Macq 461 (HL) * Bhullar v Bhullar (2003) EWCA Civ 424; (2003) WL 1202661 * Cook v Deeks (1916) a AC 554. * Chan v Zacharia (1984) 154 CLR 178 at 198-9 * Daniels v Anderson (1995) 13 ACLC 614 * Dorchester Finance Co Ltd v. Stebbing [1989] BCLC 498 * Great Eastern Railway Co. v. Turner (1872) 8 Ch App 149 at 152 * In Re Duomatic Ltd [1969] 2 Ch 365 * Mills v Mills (1938) 60 CLR 150 at 158 * Metal manufacturers Pty Ltd v Lewis (1988) 12 NSWLR 315 at 317 * Parke v Daily News Ltd (1962) 1 Ch 927 at 962-3 * Regal (Hastings) Ltd v Gulliver (1967) 2 AC 134 * Re Australian Venezolana Pty Ltd (1962) 4 FLR 60 at 66. * Re DJan of London Ltd [1994] 1 BCLC 561 * Re Lands Allotment Co [1894] 1 Ch 616 at 631 * Re Dunham and Co (1883) 25 Ch D 752 at 766 * Re City Equitable Fire Insurance Co Ltd (1925) 1 Ch 407 * Re City Equitable, Ibid n.7 at 429 * Re Brazilian Rubber Plantations and Estates Ltd (1911) 1 Ch 425 at 437 * Turquand v Marshall (1869) 4 Ch App 376 at 386 Read More