Directors’ duties to shareholders – do they even exist?

Articles, Procedure + Litigation

It is a well-established principle of law that a director owes a fiduciary duty to a company. This means amongst other things that a director must exercise his or her powers in such a manner which promotes the best interests of the company.

Sometimes a director also owes fiduciary duties directly to shareholders as well.

Directors’ duties to a company

Sections 180-183 of the Corporations Act 2001 (Cth) (Act) set out duties owed under the Act by directors to the company of which they are the controlling mind. They are similar to the common law duties and require directors to:

  • act with care and diligence (section 180);
  • act in good faith in the best interests of the company and for a proper purpose (section 181);
  • not improperly use their position in the company to gain an advantage for themselves or someone else or to cause detriment to the company (section 182); and
  • not improperly use information to gain an advantage for themselves or someone else or to cause detriment to the company (section 183).

Repeat after me – I must guide, monitor and oversee

In Re HIH Insurance Ltd (in prov liq) and HIH Casualty and General Insurance Ltd (in prov liq); Australian Securities and Investments Commission v Adler and Others [2002] NSWSC 171 (HIH), Santow J set out some fundamental principles with respect to directors’ responsibilities:

  • Directors must be in a position to guide and monitor the company;
  • Directors are under a constant obligation to keep up to date about the activities of the company;
  • Directors, as part of their management responsibilities must monitor the company’s policies and affairs; and
  • Directors must keep up to date with the financial position of the company by regularly reviewing the company’s financial statements.

These principles dictate that directors should be “on top” of all of a company’s operations, policies and financials. Only then, armed with this information, can directors be in a position to act in the bests interests of the company and properly discharge their fiduciary and statutory duties (in particular the duty contained in section 180 of the Act).

It is important to note that whilst it is permissible for directors to rely on other members of management or external advisers, such as accountants, whether a director’s reliance is reasonable will be determined on a case by case basis.

Do Directors have to read and understand financial statements?

For those directors who think they are not required to read or understand financial statements – guess again.  In Australian Securities and Investments Commission v Healey  [2011] FCA  717, Middleton J made it crystal clear that directors are required to have the “ability to read and understand the financial statements, including the understanding that financial statements classify assets and liabilities as current and non-current, and what those concepts mean.”  (our emphasis)

The above statement is especially pertinent in relation to directors signing off financial statements pursuant to section 295(4) of the Act, which states:

The directors’ declaration is a declaration by the directors:

(c)  whether, in the directors’ opinion, there are reasonable grounds to believe that the company, registered scheme or disclosing entity will be able to pay its debts as and when they become due and payable; and

(ca)  if the company, registered scheme or disclosing entity has included in the notes to the financial statements, in compliance with the accounting standards, an explicit and unreserved statement of compliance with international financial reporting standards—that this statement has been included in the notes to the financial statements; and

(d)  whether, in the directors’ opinion, the financial statement and notes are in accordance with this Act, including:

(i)  section 296 (compliance with accounting standards); and

(ii)  section 297 (true and fair view); and

(e)  if the company, disclosing entity or registered scheme is listed—that the directors have been given the declarations required by section 295A.

Section 295 of the Act is explicit and makes clear the declaration in section 295(4) is a director’s declaration which “…imposes ultimate responsibility for those matters upon the directors in a way that they cannot delegate.” (our emphasis). Accordingly, whilst the financial statements may be prepared by Bob and Linda in accounts or external accountants, this does not diminish a director’s responsibility to read and understand the financial statements, nor does it change the fact that it is a director’s responsibility and theirs alone, to sign off on the financial statements, pursuant to section 295(4) of the Act.

Sometimes directors owe fiduciary duties to shareholders

In addition to the duties owed to the company, the law has held that sometimes directors owe duties directly to shareholders. The extent of these duties was usefully summarised in Brunninghausen v Glavanics [1999] NSWCA 1999.

Background

Mr Brunninghausen (B) was a majority shareholder and the controlling director of a company which imported ski gear. Mr Glavanics (G) was also a director and a minority shareholder of the same company; G did not take an active part in the running of the company. G and B were brothers in-law. The relationship between B and G declined, despite an intervention from the mother-in-law to attempt a reconciliation.

As a result of this breakdown B and G engaged in discussions for G to sell his shares to B and retire as director. G made an offer to B for the sale of his shares and a solicitor was instructed to draft an agreement based on G and B’s negotiations.

Unknown to G, B, a number of days before offering to buy G’s share, had been approached with an offer to purchase the business by a third party. B agreed to sell the business to the third party. Subsequent to this agreement, G and B signed a transfer deed transferring G’s shares to B and G resigned as director of the company. Two months later B sold the business.

G claimed that there had been a breach of fiduciary duty and/or a breach of a duty of care, as well as misleading and deceptive conduct in breach of the Fair Trading Act 1987 (NSW), on the basis that B had failed to tell G about the offer to purchase the business made by the third party.

The Court found that B owed a fiduciary duty to G to disclose the offer. The duty was one owed by B as a director, to G, as a shareholder. B appealed to the Court of Appeal and lost.

Principles to be extrapolated from Brunninghausen

The Court of Appeal held that:

  • there was a good reason why, generally, directors do not owe fiduciary duties to shareholders and only owe fiduciary duties to the company. The court opined that if directors owed fiduciary duties to shareholders, directors could potentially be “liable to harassing actions, brought by minority shareholders. Notwithstanding this concern, the court held the duty existed in this case”; and
  • The fiduciary duty owed by the director to the company overrides any duty owed to shareholders, if these fiduciary duties ever were to conflict.

When assessing when a fiduciary duty could arise between directors and shareholders the Court considered, amongst other things, the following:

The “bare facts of the relationship.” 

Applying this to G and B:

  • B was the sole controlling director;
  • B and G had a familial association;
  • the mother-in-law intervened in an attempt to reconcile B and G; and
  • B had exclusive knowledge of the proposed sale

What knowledge does the shareholder have? Is the shareholder at a disadvantage because of information which he or she does not know?

In cases where the shareholder is ignorant of material facts of which the director is aware and which might impact his or her judgment, a fiduciary duty may arise.  In Brunnighausen, b was at a distinct advantage given that he was aware of the pending negotiations with third parties for the sale of the company and G knew nothing.  B had the capacity to effect the interests of G to his detriment.

Is the vulnerable party aka the shareholder “entitled to expect” a particular standard of conduct from the director?

In Brunninghausen the Court found that the family relationship between the parties and the intervention of the mother–in–law, created a position pursuant to which the court found that G was entitled to expect that “he would not be cheated by non-disclosure of negotiations.”

The lesson for directors is tread carefully. As stated by Handley JA:

“a fiduciary duty owed by directors to the shareholders where there are negotiations for a take-over or an acquisition of the company’s undertaking would require the directors to loyally promote the joint interests of all shareholders. A conflict could only arise if they sought to prefer their personal interests to the joint interest. That is the very conduct which would be proscribed by the duty.”  (our emphasis)

Further guidance

The case of Crawley v Short [2009] NSWCA 410 provides further guidance as to what situations may lead to a fiduciary duty arising as between a director and a shareholder:

  1. where one shareholder undertakes to act on behalf of another shareholder;
  2. where one shareholder is in a position to have special knowledge and knows that another shareholder is relying on her or him to use that knowledge for the advantage of another shareholder, as well as herself or himself; (analogous to the position in Brunninghausen); and
  3. where the company is in reality a partnership in corporate guise, often termed a quasi-partnership.

Conclusion

The fiduciary duty owed by a director to a company is absolute. It is a director’s job to guide, monitor and oversee all aspects of the company so as to ensure he or she acts in the best interest of the company.

The fiduciary duty owed by a director to a shareholder is qualified and subject to the duty owed to the company, if there is a conflict. Directors should however be aware, that directors can owe fiduciary duties to shareholders in certain circumstances and how those circumstances may arise.

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