Duties of Directors
Introduction
Pursuant to principles that developed under the common law, directors of a corporation are deemed to have a fiduciary duty to the company and its shareholders. In the exercise of this duty, they are expected to act in good faith, prudent business people and with the utmost care.
Whereas the Directors’ authority to bind the company depends on their acting collectively as a Board, their duties to the company are owed by each Director individually. These duties are owed to the company and the company alone and not to individual shareholders as was held in Percival v. Wright where certain shareholders wrote to the Company’s Secretary asking if he knew anyone willing to buy their shares. Negotiations took place and eventually the company chairman and two other directors bought the shares. The Plaintiff subsequently discovered that prior to and during their own negotiations for sale, the Chairman and the Board of Directors had been approached by 3rd Party with a view to the purchase of the entire company’s assets at a higher price per share. When the Plaintiff brought an action to set aside the share sales it was held that the directors were not agents for the individual shareholders and did not owe them any duty to disclose.
The duties of directors fall into two broad categories:
Duties of care and skill in the conduct of the company’s affairs
Fiduciary duties of loyalty and good faith.
Duties of Care and Skill
The duties of care and skill were well summed up by Romer J., in the case of Re: City Equitable Fire Insurance Co. Here the directors of an insurance company left the management of the company’s affairs almost entirely to the Managing Director. Owing to the Managing Director’s fraud, a large amount of the company’s funds disappeared. Certain items appeared in the balance sheet under the heading “loans at call or short notice and “Cash in Bank or in Hand”. The directors did not inquire how these items were made up.
If they had inquired they would have found that the loans were chiefly to the Managing Director himself and to the Company’s General Manager and the cash at Bank or in hand included some £13,000 in the hands of a firm of stockbrokers at which the managing director was a partner.
On the company’s winding up, an investigation of its affairs disclosed a shortage in its funds of more than £1.2 million incurred mainly due to the delinquent fraud of the Managing Director for which he was convicted and sentenced. The other directors had all along acted in good faith and honestly but the liquidator sought to make them liable for the damages.
It was held that the directors were negligent. Justice Romer reduced the directors duties of care and skill as follows; “A director need not exhibit in the performance of his duties a greater degree of skill than may reasonably be expected from a person of his knowledge and experience.”
This proposition prescribes the standard of skill to be exhibited in actions undertaken by directors. The test is partly objective and also partly subjective because a reasonable man would be expected to have the knowledge of a director with his experience.
Given that the board of Retailer is considering tenders by these Australian companies for a lucrative contract to supply Retailer with the clothing. The best the board should do is come up with the best choice in the tenders. At the Retailer board meeting, if Jones’, statement had been made prudently and unbiased, then he would have fully discharged his legal duties to Retailer.
However this is not the case. He makes this statement fully aware of the fact that Myco has had financial difficulties in recent times and needs to secure this contract with Retailer, and it was therefore misleading.
In Re Brazilian Rubber & Plantations Estates Ltd. , Neville J. had the following to say: “It has been laid down that so long as they act honestly, Directors cannot be made responsible in damages unless they are guilty of gross negligence. A Director’s duty requires him to act with such care as is reasonably expected from his having regard to his knowledge and experience. He is not bound to bring any special qualifications to his office… He is not bound to take any definite part in the conduct of the company’s business but insofar as he undertakes it he must use reasonable care. Such reasonable care must be measured by the care an ordinary man might be expected to take in the same circumstances on his own behalf.”
The remaining directors on the board agreed with Jones on the basis of the fact that they know Smith to be a successful and well-respected businessman and reason that Myco is most likely to supply the clothing without disruption and at reasonable prices and in awarding the tender to Myco to supply Retailer, they acted in a manner that a reasonable director would have.
Fiduciary Duties
In the absence of any provision in the certificate of incorporation, it is the duty of the directors to manage the company and not the shareholders. In acting with such managerial authority therefore, the directors are expected to carry out these unyielding fiduciary duties to the corporation and its stockholders.
The directors must always act bona fide in what they consider and not what the courts may consider to be in the best interest of the company. In this context, the term company means the present and future members of the company on the basis that the company will be continued as a going concern thereby balancing long-term view against short term interests of existing members.
The directors must always exercise their powers for the particular purpose for which they were conferred and not for extraneous purposes even if the latter are considered to be in the best interests of the company. For example the directors are invariably empowered to issue capital and this power should be exercised for only raising more funds when the company requires it. Hence it will be a breach of the directors’ duties to issue the company shares for the purpose of entrenching themselves in the control of the company’s affairs.
Referring to the case of Punt v. Symons in this case the directors issued shares with the object of creating a sufficient majority to enable them to pass a special resolution depriving the other shareholders of some special rights conferred upon them by the company’s articles.
It was held that a power of a kind exercised by the directors in this case was a power which must be exercised for the benefit of the company. Therefore a limited issue of shares to persons who are obviously meant and intended to secure the necessary statutory majority in a particular interest was not a fair and bona fide exercise of the power.
They must not fetter their displeasure to act for the company for example, the directors cannot contract either among themselves or with third parties as to how they will vote at future Board meetings. However, where they have entered into a contract on behalf of the company they may validly agree to take such further action at Board meetings as maybe necessary to carry out such a contract.
As fiduciaries the directors must not place themselves without consent of the company in a position in which there is a conflict between their duties to the company and their personal interests. Good faith must not only be done but it must also manifestly be seen to be done. The law will not allow the fiduciary to place himself in a position where he will have his judgments to be biased and then argue that he was not biased.
This principle applies particularly when a director enters into a contract with his company or where he makes any secret profit by being a director. As far as contracts are concerned a contract entered into by the Board on behalf of the company and another director is governed by the equitable principle which ordains that a fiduciary relationship between the director and his company vitiates such contracts. Such contract is therefore voidable at the instance of the company. Reference may be made to the case of Aberdeen Railway v. Blaikie
In this case, the Defendant Company entered into a contract to purchase a quantity of chairs from the Plaintiff partnership. At the time that the contract was entered into a director of the company was also one of the partners. The issue was whether the company was entitled to avoid the contract. The court held that the company was entitled to avoid the contract.
The Judge said that as a body corporate can only act by agents and it is the duty of those agents so to act as best to promote the interests of the corporation whose affairs they are conducting. Such an agent has a duty of a fiduciary nature to discharge towards his principal. It is a rule of universal application that no one having such duties to discharge shall be allowed to enter into or can have a personal interest conflicting or which may possibly conflict with the interests of those whom he is bound to protect.
This principle is strictly applied no question is entertained as to the fairness or unfairness of the contract so entered into. However, it is possible for such contract to be given effect by the articles of association. At their narrowest the Articles might provide that a director who is interested in a Company contract should disclose his interests and he will not be counted to decide that a quorum is raised and his votes will also not be counted on the issue. At their widest the articles might allow the director to be counted at Board meeting.
Smith is the Chairman of the board and Managing Director of Retailer, and holds 30% of the issued share capital at Myco Pty Ltd. In addition, the directors of Myco are Smith’s wife and his brother in law. Given that the same Board he chairs, is considering tenders by these Australian companies for a lucrative contract to supply Retailer with the clothing, the degree to which the conflict of interest cannot be overemphasized. This notwithstanding, when the tenders are considered by the Retailer board, Smith remains present to hear board discussion on the different tenders, although he does not vote.
In order to create a balance between these two extremes and ensure that a minimum standard prevails the Corporation Act provides that it is the duty of a director who is interested in any contract or proposed contract to disclose the nature and extent of his interest to the Board of Directors when the contract comes up for discussion. Failure to do so renders the defaulting director liable to a fine. In addition the failure also brings in the equitable doctrine whereby the contract becomes voidable at the option of the company and any profit made by the director is recoverable by the company.
The shortcoming of this provision is that the director has to disclose to the Board of Directors and not to the general meeting. It is not sufficient for a director to say that he is interested. He must specify the nature and extent of his interests and is also required to abstain from voting at the Board meeting and his vote will not be taken in determining whether or not there is a quorum on the Board. This therefore means that if Smith had complied with this provision, then he can escape liability.
In respect of all other profits which a director may make are out of his position as a director the equitable principle which requires the directors to account for any such profits is vigorously enforced. This is because the Courts have equated directors to trustees and their duties have also been equated to those of Trustees. In those circumstances where the directors have breached their duty to exercise their powers for the proper purpose, the shareholders may forgive them by ratifying their action
This does not necessarily make directors trustees. There are two basic differences between directors as Trustees and Ordinary Trustees. That is:
The function of ordinary trustee is to preserve the Trust Property but the role of a director is to explore possible channels of investment for the benefit of the company and these necessitates some elements of having to take a risk even at the expense of the company’s property.
Whereas trust property is vested in the Trustees, a company’s property is held by the company itself and is not vested in the trust.
Nevertheless if the directors make any secret profits out of their positions then the effect is identical to that of ordinary trustees. They must account for all such profits and refund the company.
In the case of Regal Hastings v. Gulliver, Lord Macmillan had the following to say; “The directors will be liable to account if it can be shown that what they did is 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 utilisation of the opportunities and special knowledge and what they did resulted in a profit to themselves.”
As the company is a distinct entity from the members and since directors owed their duties to the company and not to individual shareholders, in the event of breach of those duties any action for remedies should be brought by the company itself and not by any individual shareholder. The company and the company alone is the proper Plaintiff. This is generally referred to as the rule in Foss V. Harbottle. Therefore, the most appropriate remedy for a shareholder who later discovers that entering the contract with Myco, rather than a competing company, has in fact cost Retailer $10 million over the term of the three year contract he would have to commence a Derivative Action, that must show that the wrong complained of was such as to involve a fraud on the minority which is not ratifiable by the company in general meeting; that the wrong doers hold the controlling interests; he must join the company as a nominal defendant and it must be brought in a representative capacity on behalf of the plaintiff and all other shareholders except the Defendant. Thus the court may grant an order of rescission.
Conclusion
The best summation for this problem would be what was stated by Roskill J., in Industrial Development Consultants v. Cooley that, “It is an overriding principle of equity that a man must not be allowed to put himself in a position where his fiduciary duty and interest conflict”
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