Duty of Good Faith and of Avoiding Conflict of Interest - Essay Example

Running head: Business Law Duties of Director Business Law Introduction There are different legal obligations imposed on corporate directors in their corporate activities. The duties to avoid conflict of interest as a director, the duties of good faith, and the duty of care and diligence are three of these duties imposed on directors. Failing to observe such duties would make them civilly and criminally liable. This paper shall reflect on the above statement, evaluating it and discussing the nature and the extent of the statutory duties imposed on directors by the Corporations Act. This discussion shall include a critical analysis of the nature, application and effectiveness of the three duties of directors under the Corporations Act. This paper shall consider different authorities on the subject matter in order to arrive at a scholarly appraisal of the subject matter. Discussion Duty of good faith and of avoiding conflict of interest According to section 181 of the Corporations Act, “a director or other officer of a corporation must exercise their power and discharge their duties in good faith in the best interest of the corporation and for a proper use”. Violations of this provision make a director civilly and criminally liable. For directors who act dishonestly and recklessly, criminal liability may be forthcoming (Organisation for Economic Co-operation and Development, 1997). The directors’ duty is to avoid conflicts of duty and interest and therefore, he must not allow conflicts of interest to compromise his position in the company. Sections 191-195 of the Corporations Act set forth obligations for directors to not allow conflicts of interest to arise from his actions. Based on these provisions, directors are therefore called on to notify the board of directors when there are instances of personal interest which have a bearing on the company activities and affairs (Panoramic Resources, 2008). Section 195 of the Corporations Law specifies that a director of a public company cannot be present during a voting or board meeting where the members are deliberating an issue where he is an essential person of interest. He may however be present if the other directors pass a resolution allowing him to be present and to vote; and if the ASIC orders a specific order on the issue (Corporations Law, 2001). The responsibilities in the section cover board meetings, and meetings of committees of the board. This is to be applied even if the committee would not have any bearing on the affairs of the company. Committees under advisory capacities are therefore part of the prohibition (Tomasic, et.al., 2002). In evaluating the terms under which “material” interest exists, this refers to something real, not theoretical or remote (Panoramic Resources, 2008). Being material implies an evaluation of the relationship between the advantage which the director expects and the actual contract being assessed. In instances when the director’s concerns in the matter would be significantly impacted by the result of the board’s discussion, it therefore must be disclosed (Panoramic Resources, 2008). In considering the “interests,” these must be personal (Tomasic, et.al., 2002). This implies that a director who is merely a party to a transaction and who does not stand to profit from the transaction may be allowed to participate in the board’s evaluation of the transaction. Section 195 does not specify that an interest needs to be financial or that such interest be direct or indirect (Corporations Law, 2002). The section connotes that in instances when the relative of a director of a company to which he and his family members are interested in would benefit from the contract being considered, it is important to evaluate whether or not the material and personal interest of the director is at stake. This case is apparently also applicable in instances when an indirect advantage to the director is significant or substantial (Tomasic, et.al., 2002). Other exceptions to the imposed absence of the director, is seen in section 191(2) (Corporations law, 2002) when a director is also a shareholder having interests common with other shareholders, in cases where the shareholders have agreed to a contract, or when a problem manifests merely because the director is considered a guarantor of a loan to be sought by the company. Part of the director’s role in avoiding any conflict of interest is on the prohibition on the inappropriate use of his position to gain personal advantage or some form of advantage for someone else and which in turn would likely cause negative consequences for the corporation (Walton and Henderson, 2005). Violations of this section carry civil penalties and where fraud is present, criminal sanctions may also apply. These same liabilities also apply to the improper use of information which comes to a director. In the R v. Bynes (1995 13 ACLC 1488) case, the High Court clarified the definition of impropriety. “Impropriety does not depend on an alleged offender’s consciousness of impropriety. Impropriety consists of a breach of the standards of conduct that would be expected of a person in the position by reasonable persons with knowledge of the duties, powers, and authority of the position and the circumstances of the case”. This definition in effect negates the ‘ignorance excuse’ and assumes a person’s consciousness of his actions. It is therefore incumbent upon the director to be aware of his actions at all times and to be vigilant in his duties as director. In evaluating the possibility of imposing criminal sanctions on a director, section 184(2) sets forth two ways whereby criminal liability may be imposed on a director. First is when the director deliberately used his position as director to gain advantage for themselves or for someone else to the detriment of the corporation (Corporations Law, 2002). In other words, the dishonesty is deliberately used to profit himself or someone else. Another way of incurring criminal liability for a director is on the misuse of his position to recklessly to gain an advantage for himself or for someone else to the detriment of the company (Corporations Law, 2002). The concept of recklessness has been discussed in various cases and evidence for recklessness has been deemed either subjective or objective (Tomasic, et.al., 2002). In the Story v. NCSC (1988 6 ACLC 560 at 571) case, the court pointed out that the legal conceptualization of recklessness usually involves some form of fraud. This is not to say that recklessness as a concept has already been clarified. In actual practice, there is still some confusion about its application. In the Pollard v. DPP (Cth) (1992 8 ACSR 813 at 827) case, the court set forth that there are various interpretations used by the court for the word “reckless.” Such diverse and varying definitions are based on the fact that the word can be applied in different contexts and under different statutes. The evaluation of “recklessness” is therefore on a case to case and contextual basis. It is also the director’s duty not to misappropriate property or information. He must therefore not use company property to further his personal goals or to benefit another person without the authority of the corporation (Walton and Henderson, 2005). This law is supported by the Corporations Law provision which does not allow a public corporation or an entity it wholly owns from attributing financial benefit to a related party of the public company. In effect, these provisions prohibit directors from making personal profits to the disadvantage of the corporation while using their position as director (Corporations Law, 2002). This practice puts the company at a disadvantage because the director possesses an unfair advantage over the corporation based on his knowledge and relationship with the corporation. Such unfair advantage therefore needs to be appropriately sanctioned through criminal and civil mandates. Even with the proper precautions, there are still many ways by which the personal interests of directors and the interests of the corporations may clash. Conflicts may be seen in the holding of competing directorship; in making loans or payments to directors; representation of nominating shareholders; misuse of inside information; and the appropriation of corporate opportunity for himself or for another person (Tomasic, et.al., 2002). Principles governing these conflicts have been set forth in various cases, one of them being Aberdeen Railway Company v. Blaikie (1854 1 Macq 461 at 471-472) where the court pointed out that a corporation is acting through its agents, and these agents must act in the best interests of the corporation they are representing. These agents have fiduciary duties to perform “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 conflict, with the interests of those whom he is bound to protect” (Aberdeen v. Blaikie, 1854). This point was further supported in the case of AM Spicer & Son Pty Ltd. V. Spicer (1931 47 CLR 151 at 175), where the court pointed out that a director having fiduciary duties to perform for a corporation would not be allowed to carry out acts which conflict with interests that he is bound to protect. Where directors are involved in this conflict of interest, they have a duty to inform the corporate authorities (Marshall and Ramsay, 2009). In cases where private benefits are seen in the violation of the above rule, liability must also be imposed for the profit attributed to the person to whom the duty is owed. As mentioned in the case of Parker v. McKenna (1874 LR 10 Ch App 96 at 118), no agent in his function and duration as agent can be allowed to profit off of his activities without the knowledge and consent of his principal. This decision and ruling was echoed and supported in other cases. They further define the importance of keeping the personal and corporate interests of the director separate from each (Ong, 2007). Good faith In relation to the above duty, the duty of good faith is also an essential part of a director’s responsibility to his company (Thompson, 2009). The director’s duty to function and to carry out his duties in good faith and in the best interests of the corporation stems from common law and from Section 181(1) (a) of the Corporations Law. The substance of both duties is similar to each other and both provisions contain objective standards, simply stated in the case of Hutton v. West Cork Railway (1883 23 Ch D 654), “would a reasonable person, in the director or officer’s position, acting in good faith, believe his/her conduct to be in the best interest of the company”. This test triggers the questions: what are the company’s best interests; and did the director act in a way similar to that of a reasonable person in his position who perceived in good faith that he was acting to support those interests (Thompson, 2009)? This standard is based on an objective qualification therefore there can still be a ruling of breaching of good faith in instances where the director honestly perceived his actions being in the best interests of the corporation (Hutton v. West Cork Railway, 1883). In the case of ASIC v. Adler (2002 NSWSC 171) where the HIH Casualty and General Insurance Ltd (HIHC) illegally gave financial help to Pacific Eagle to buy shares in the holding company of HIHC, the court decided that Adler violated his duty to act in good faith and in the best interests of HIH Insurance Limited (HIH) and HIHC. It ruled that the payment of $10 million by HIHC to PE prejudiced the interests of HIHC; and that Adler was just protecting his personal interests as a shareholder of HIH by rendering support for the HIH share price. The fact that Adler did not reveal his personal interests in the purchase gives the situation a stronger basis for liability. In considering the “best interests” of the corporation, the different groups related to corporate activities must be considered by the director: shareholders, employees, creditors, other members of the corporation including wholly owned subsidiaries (Corporations Law, 2002). A shareholder’s interests will be based on their collective interests, specifically in shareholder profit. In the case of ASIC v. Adler, the director acted illegally in violation of sections 208 and 260A which pertains to financial assistance. The fact that Mr. Ray Williams acted indifferent to the fate of the company also reflected a violation of the shareholder’s best interests (Lipton, 2003. In relation to employee interests, it is not essential for directors to have regard for the interests of employees as ruled in the case of Parke v. Daily News (1962 Ch 927). The interests of the employees, community, and the public are relevant only if they affect the interests of the company and the shareholders (Cassidy, 2005). In the case of Parke v. Daily News, the Board of Daily News Ltd. sought to abandon the company’s newspaper publication business and sell its assets. The shareholders were set to benefit, but the employees were considered redundant. The board then decided to make a payment to the employees and this was objected by minority shareholders. The court ruled that even as the payments made were admirable, they could not be considered beneficial for the company. These payments are therefore not valid. For corporate groups in interests of the holding company, even as companies have their own interests, courts believe that decisions would be made in relation to group interests (Walker v. Wimborne 1976, 3 ACLR 529). If the individual is a director of a wholly owned subsidiary, section 87 sets forth that the director of a wholly-owned subsidiary will act in the interests of the holding company and not be liable for breach of duty to the subsidiary in instances where the constitution of the subsidiary allows the director to act in the interests of the holding company; where the director acts in good faith for the best interests of the holding company; and where the subsidiary is not insolvent at the time of acting (Corporations Law, 2002). In cases when the directors did not consider the interests of their subsidiary company, there would be an apparent evidence of breach of duty. In the case of Equiticorp Finance Ltd. V. Bank of New Zealand (1993 11 ACLC 952), Equiticorp Holding Corp. (EHL) was the owner of Finance Group and Industrial Group and each of these groups also wholly and partially owned other subsidiaries. As a whole, they all made up Equiticorp Finance Ltd (EFL). Hawkins was the chairman of EHL and owned 41% of the shares. EFL and EFSA (Equiticorp Financial Services Ltd) invested 50 million dollars each in BNZ, and Uruz owed the bank $200 million. The bank threatened to withdraw support from the group if the money owed was not paid. Hawkins then directed EFSA and EFL to utilize the money in the banks under their names to pay for Uruz’s debt. This was not approved by either group. When the group collapsed, liquidators were assigned to the different companies wanting to recover about $50 million for the bank. Arguments were made about the payments being unauthorised and done in breach of the directors’ responsibilities to act in the best interests of the corporation. The court applied the general test for determining best interests. The court explained that losing the support of BNZ for the Equiticorp Group would have been against the interests of EFL and EFSA. The steps taken by the directors of EFL and EFSA were meant to protect the entire group and the Holding company. In the end, this was the favourable move for the EFL directors (Chapple and Lipton, 2002). In considering creditors interests, the courts have ruled that the interests of creditors are superior to the interests of shareholders in instances when the company is insolvent or near insolvency. This was exemplified in the Kinsella v. Russell Kinsela Pty Ltd. (1986 4 ACLC 215 at 223) case where a company with a funeral parlour as its only asset became insolvent. As the directors discovered this, they immediately leased the parlour to two of the directors at a considerably low rate. This was their idea of keeping the asset away from creditors. The court ruled that this action was not legal because the directors should not have released the asset because they had creditors to think of (Thompson, 2009). In this case, the interests of the creditors were put at risk. Duty of care and diligence A corporate director also has a duty to act with care and diligence. This legal responsibility was set forth in section 180(1) of the Corporations Law which emphasizes that a director of a corporation must exercise his powers and carry out his duties with the same degree of care and diligence that a reasonable person would exercise if they were a director of a company. Traditionally, there have been no clear definitions in the treatment of duties, functions, and responsibilities for different types of directors. Decisions on cases brought before the courts have traditionally acknowledged the fact that directors are not responsible for all aspects of a company and that their liability has therefore been held to be limited. With the rest of the society being more aware about the performance of companies, courts have now set forth higher standards in the evaluation of director’s actions (Panoramic Resources, 2008). Provisions were then introduced in the Corporations Law which was set to recognize the difference between executive directors (with management roles) and non-executive directors (independent directors). In the case of AWA Ltd. v. Deloittes (1992 10 ACLC 933), the court ruled that it was not always possible for directors to have full involvement with the affairs of the corporation. The court instead specified that the board’s function included the following functions: setting up goals of the company; appointing company chief executive; overseeing plans for managers in the acquisition of financial and human resources; and evaluating at intervals the company’s progress in achieving its goals (AWA Ltd. v. Deloittes, 1992). The court also held that the non-executive directors cannot be expected to supervise the daily affairs of the company and therefore may be excused from liability. The chairman/chief executive officer must be the one who is required to act with due care and diligence in all things impacting on the company. The executive directors are employees of the company and are involved in the daily activities of the company (Walker, 2005). They are therefore more likely to be held liable for not acting with due diligence. A non-executive director on the other hand is more likely to gain second-hand information about the company’s activities and cannot therefore be held liable for not acting with due diligence towards the company. He may however still be assessed based on the appropriateness of his action according to systems in place in the collection of relevant data (Thompson, 2009). Directors can also be held liable for common law negligence. Negligence can be fashioned to a case where different acts of a director are considered negligent (Panoramic Resources, 2008). The fiduciary responsibility of a director does not prevent the application of the common law duty of care. Section 180(2) of the Corporations Law includes a statutory business judgment rule. However, various analysts have the belief that lawmakers chose a provision which was limited in application because it only covers the duty to act with care and diligence under the Corporations Law or under common law, ignoring the other duties, specifically the duty relating to insolvency (Panoramic Resources, 2008). This section calls for different steps before application. It operates in the sense that the company director making the business judgment would fulfil the obligations of the duty to act with care if he performs the following actions as well: make a judgment of good faith for a proper purpose; not have material personal interest in the subject matter of the judgment; inform themselves of the subject matter of judgment to the extent appropriate; and rationally believe that judgment is in the best interest of the company (Panoramic Resources, 2008). The law also points out that a director’s belief that the judgment made is meant for the best interests of the company will be considered the rational judgment, unless such belief is one which a reasonable person would not hold (Walker, 2005). The qualification of a business judgment is also very narrow in application as it seems to refer to a decision to take or not to perform an action in relation to a matter applicable to the business of a company. In order to further clarify the duty of the director to act with care and diligence, Section 198D points out that directors will be able to delegate some of their responsibilities in specific activities (Tomasic, et.al., 2002). When delegation is applied, there are different duties for directors in relation to the actions of the delegate. Moreover, the Corporations Law specifies that directors and officers will be able to consider the information given by others in some situations. The law specifies that a director cannot be held liable for the actions of a delegate if the director believed in the following grounds: that the delegate at all times would carry out the power delegated in accordance with the duties set forth by the director and in accordance with the provisions of the Corporations Law; and in good faith, after proper investigation, the delegate was reliable and competent in terms of power delegated (Tomasic, et.al., 2002). In the Vrisakis v. ASC case (1993 9 WAR 395 at 451), the court examined the impact of the statutory care and diligence rule. The court ruled that the decisions in previous cases which set forth an appropriate test of a director’s care and diligence must be followed. The test considers the balancing exercise between the risk of harm and potential benefit. The Overend & Gurnery Co. v. Gibb case (1872 LR 5 HL 480) points out that the directors were knowledgeable of the circumstances “of such a character so plain, so manifest, and so simple of appreciation, that no men with any ordinary degree of prudence, acting on their own behalf, would have entered into such a character as they entered”. The court held them liable for violating their duty of care and diligence. The test of care and diligence was echoed in the case of ASC v Gallagher (1993 11 ACLC 286 at 194) where the court ruled that the test is an objective test in the sense that the “question is what an ordinary person, with knowledge and experience of the defendant, might be expected to have done in the circumstances, if he was acting on his own behalf”. The courts have also made rulings on the actions of directors who act with care and diligence, exempting them from any liability. But the primary duty of care and diligence is still demanded of directors and failing to do so opens them up to the possibility of civil and criminal liability. Conclusion This paper presents a complete picture of the different duties of directors – the duties of avoiding conflict of interest, the duty to act with good faith, and the duty to act with care and diligence. The duty to avoid conflict of interest is based on the premise that a director must not use his position to profit himself or others to the detriment of the company he is seeking to serve. The duty to act with good faith is based on the concept that a director must act based on what a reasonable person is expected to do under the circumstances if he were in his place. The duty to act with care and diligence is based also on the reasonable person test – that a director must act with the care and diligence expected of a reasonable person, under similar circumstances. These duties are important considerations in the director’s life because failing to perform these makes him civilly and, instances of fraud and deceit, criminally liable as well. Works Cited Cassidy, J. (2006). Concise corporations law. New South Wales: Federation Press Chapple, L., & Lipton, P. (2002). Corporate authority and dealings with officers and agents. University of Queensland. Retrieved 04 May 2011 from http://cclsr.law.unimelb.edu.au/files/1010-Law_Mono21.pdf Lipton, P. (2003). The demise of HIH: corporate governance lessons. Australian Corporate Governance. Retrieved 04 May 2011 from http://www.australian-corporate-governance.com.au/hih_royal_commission.pdf Marshall, S. & Ramsay, I. (2009). Stakeholders and Directors’ Duties: Law, Theory and Evidence. Melbourne University. Retrieved 04 May 2011 from http://cclsr.law.unimelb.edu.au/files/Stakeholders_and_directors__duties_paper_%2810_05_09%291.pdf Ong, D. (2007). Trusts law in Australia. New South Wales: Federation Press Organisation for Economic Cooperation and Development. (1997). OECD economic surveys: Australia. Sydney: OECD Publishing Panoramic Resources Ltd. (2008). A guide on the duties and responsibilities of directors. Retrieved 04 May 2011 from www.panoramicresources.com/download.cfm?DownloadFile... Thompson, E. (2009). Corporations Law 730 – 456. Melbourne University. Retrieved 04 May 2011 from www.mulss.com/sts.../Corporations%20Law%20-%20Tute%205.doc Tomasic, R., Bottomley, S., & McQueen, R. (2002). Corporations law in Australia. New South Wales: Federation Press Walker, G. (2005). Commercial applications of company law in New Zealand. New Zealand: CCH New Zealand Limited Walton, J. & Henderson, K. (2005). How to Identify and Manage Conflicts of Interest. New South Wales: AICD List of Cases Aberdeen Railway Company v. Blaikie (1854) 1 Macq 461 at 471-472 AM Spicer & Son Pty Ltd. V. Spicer (1931) 47 CLR 151 at 175 ASIC v. Adler (2002) NSWSC 171 Equiticorp Finance Ltd. V. BNZ (1993) 11 ACLC 952 Hutton v. West Cork Railway (1883) 23 Ch D 654 Kinsella v. Russell Kinsela Pty Ltd. (1986 4 ACLC 215 at 223) Overend & Gurnery Co. v. Gibb case (1871–72) LR 5 HL 480 Parke v. Daily News (1962) Ch 927 Parker v. McKenna (1874) LR 10 Ch App 96 at 118 Pollard v. DPP (Cth) (1992) 8 ACSR 813 at 827 R v. Bynes (1995) 13 ACLC 1488 Story v. NCSC (1988) 6 ACLC 560 at 571 Vrisakis v. ASC case (1993) 9 WAR 395 at 451 Walker v. Wimborne 1976, 3 ACLR 529 Read More