Is the derivative action alive and well Law Reporter

  • Date:01 Dec 2003
  • Type:CompanyDirectorMagazine
A few years ago when the Corporations Act was amended to introduce a Statutory Business Judgment Rule, the Federal Treasurer said that as a quid pro quo, the Government needed to ensure that shareholders had a greater ability to seek remedies in the courts against directors who had breached their duties.

Is the derivative action alive and well?

A classic example of applying such action in the case of a closely held or private company

A few years ago when the Corporations Act was amended to introduce a Statutory Business Judgment Rule, the Federal Treasurer said that as a quid pro quo, the Government needed to ensure that shareholders had a greater ability to seek remedies in the courts against directors who had breached their duties.

The rule in Foss v Harbottle (1843) 2 Hare 461 has made it very difficult for shareholders to bring an action against directors for breaches of duty if the company refused to sue. In addition, individual shareholders, especially in a "closely held" company often found it difficult to act against their colleagues who are directors.

There have been very few cases in which the new statutory derivative action contained in sections 236 and 237 of the Corporations Act have been successfully utilised. One such case arising out of a Queensland dispute (Law Reporter, November 2002) was a decision of MacPherson J in the Queensland Supreme Court on the statutory derivative action (Metyor Inc & Ors v Queensland Electronics Switching Pty Ltd & Ors [2002] 20 ACLC 1517.

Now, in the New South Wales Supreme Court, Barrett J has considered the statutory derivative action in the context of a shareholder who claimed that directors owed a duty to the shareholder as opposed to the company in carrying out certain actions. This case, Charlton v Baber (2003) 21 ACLC 1671 is a classic example of when the statutory derivative action might well be used in a closely held (or private) company. However, the shareholder did not get everything he wanted.

The facts of the case are taken from the CCH Law Report of the case.

Charlton, a shareholder and former director of Newcastle Auto Air Pty Limited, alleged that the other director, Baber, breached the fiduciary duties owed by that director to the company. To that end, the shareholder sought to bring a statutory derivative action under Pt 2F.1A of the Corporations Act in the name of the company. A court may grant leave to an applicant to commence a statutory derivative action where the pre-requisites in sec 237 were met. The company was in liquidation. The external administration commenced as a voluntary administration before passing into a creditors' voluntary winding up. The administrators became the liquidators.

Charlton also alleged that the other director of the company owed a fiduciary duty to him, which was also breached by the director.

The separate allegations – (a) breach of fiduciary duty owed to the company and (b) breach of fiduciary duty owed to the shareholder – were pleaded in identical terms except for the persons to whom the duties were owed.

The alleged breach of fiduciary duty owed to the shareholder was based on alleged misrepresentations by Baber which led to Charlton transferring some of his shares in the company to other persons, and allegations of improper issue of shares by Baber to a related party. The alleged breach of fiduciary duty owed to the company was based on excessive remuneration, improper payment of dividends, questionable lease arrangements and other uncommercial loans.

Barrett J granted the application but only in part. One of the major problems was whether in fact a director owed any duty to a shareholder. The Judge held, in this case, that the relevant director did not owe a fiduciary duty to the shareholder as pleaded. But his ruling on the issue is very interesting because it indicates when in fact such a claim may well succeed.

Recognising that the New South Wales Court of Appeal in Brunninghausen v Glavnics (1999) 17 ACLC 1247 had held that in certain circumstances, a director could be said to owe a duty to a shareholder, Barrett J indicated that in order for a shareholder to successfully plead that a duty was owed by the directors to the shareholder, the relevant shareholder would have to satisfy the court that this duty was not one that competed with any duty owed by the director to the company. He added the following:

In short, the company remains the beneficiary of the comprehensive fiduciary duties to which directors are subject by virtue of their office; and parallel duties in corresponding form are not owed to any shareholder, although particular circumstances may give rise to a particular duty owed by a particular director to a particular shareholder or particular shareholders (at para 17).

The judge, having dismissed the claim on that particular score, nevertheless did recognise that the statutory derivative action procedure contained in sections 236 and 237 of the Corporations Act could be applied even though a company was in liquidation. Although the relevant section (in this case section 237(3) referred to decision making by company directors – which tended to indicate that the section should only operate where a company was successfully trading) this was only a rebuttable presumption.

The court has to be satisfied that all of the criteria in section 237 are established before it could grant leave for a statutory derivative action – ie on behalf of the company – to be brought.

The court must grant the application, however, if it is satisfied that:

(a) it is probable that the company will not itself bring the proceedings, or properly take responsibility for them, or for the steps in them; and

(b) the applicant is acting in good faith; and

(c) it is in the best interests of the company that the applicant be granted leave; and

(d) if the applicant is applying for leave to bring proceedings – there is a serious question to be tried; and

(e) either:

(i) at least 14 days before making the application, the applicant gave written notice to the company of the intention to apply for leave and of the reasons for applying; or

(ii) it is appropriate to grant leave even though subparagraph (I) is not satisfied.

If all these factors are established, there was no discretion left to the court.

In this case, Barrett J was satisfied that the liquidator was not likely to bring action on the company's behalf. The evidence suggested that although the issues concerning excessive remuneration and the uncommercial loans, among others, had been mentioned in the report of the administrator to creditors, there was no adverse comment on it in the report. In other words, the first ground was satisfied – the company was unlikely to bring the action.

The second ground requires that the court must be satisfied that the shareholder was acting in good faith. The shareholder here felt a responsibility that the creditors had suffered loss and was not acting for a collateral purpose that could be described as an abusive process.

Turning to the third ground, Barrett J felt that it was in the company's interest that such a statutory derivative action was brought. In his view, the best interests of the company in this context reflected the interests not only of the company but in particular, the body of creditors. A statutory derivative action which was successful would increase the pool of assets available for distribution to creditors.

He then turned to the next ground – was there a serious question to be tried. In his view, while the issues concerning the uncommercial loans and successive remuneration were not serious questions because the evidence was so poor, there was a serious question in relation to the dividend payments and the lease arrangements. The notice provision (ie (e)) had been satisfied so in all the circumstances, leave was granted but on limited terms.

This is one of the clearest examples of the statutory derivative action at work. While it may be hard going, in the sense that a number of steps have to be established, the fact that shareholders can succeed in appropriate circumstances is a vindication for the introduction of the statutory derivative action.

Making them pay

Duties of directors to pay the Commissioner of Taxation

The law is constantly being amended to make directors liable for the debts of insolvent companies, especially if the debts are due to the Commissioner of Taxation in appropriate circumstances where the relevant company is unable to meet monies due to the Commissioner (for example, monies set aside for paying group tax of employees). Recently, in Crosbie v Commissioner of Taxation (2003) 21 ACLC 1659 decided in the Federal Court of Australia, an important right was given to former directors of a company who might have been left with the responsibility of having to pay the funds due to the Commissioner.

In this case the actual payment that had been made was being challenged as a preference. The payment had been made by the company to the Commissioner in relation to withholding tax with respect to the Goods and Services Tax regime. It was argued that the Commissioner had received the payment in preference to others who might otherwise have received the relevant monies as creditors of the company. In the event of a voidable transaction occurring, and the company not having the funds to meet the relevant payment, the Commissioner of Taxation could sue the directors on the basis that they should be personally liable in this particular case.

The Commissioner of Taxation did not wish to contest the claim brought by the liquidator of the company against the Commissioner of Taxation. In the circumstances, the former directors would have been left potentially liable. They sought leave, in effect, to represent the Commissioner of Taxation in defending the claim that the payment was a voidable preference.

Finkelstein J held that even if the proceedings had not been taken against the directors in this particular case "the interests of justice would demand that they be given permission to intervene in the proceeding between the plaintiffs and the defendant or especially where, as in this case, the defendants will not take steps to protect its possible liability to the plaintiffs".

The eventual success or otherwise of the director's arguments is not known.

Disqualification criteria

When will the court allow a director otherwise disqualified to be reappointed?

Under section 206G of the Corpor-ations Act, the court has a discretion in granting leave to a person who, having been convicted of an offence, seeks leave to be appointed a director.

In Adams v Australian Securities and Investments Commission (2003) 46 ACSR 68, the applicant, still serving a disqualification order, made an application to the court to be given leave to manage five companies. He had been disqualified from managing a corporation following a conviction in 1998 of a charge of having conspired to defraud the Commonwealth of sales tax revenue. His disqualification for five years was due to expire within seven months of the application date. Adams argued that as the offence occurred many years ago and as the five companies were about to enter a joint venture with a Chinese organisation which wanted him to manage the companies, the disqualification order should be lifted. ASIC (which had apparently been joined in the action as a party) argued that in its view Adams needed to show that it was necessary for him to manage the companies.

Lindgren J, in dismissing Adams' application, listed a number of criteria the court would consistently consider as relevant in dealing with an application of this kind. The major ones are:

1. The applicant bears the onus of establishing that the court should make an exception to the policy which would normally lead to the disqualification remaining on foot.

2. The legislative policy is one of protecting the public, not of punishing the offender.

3. A disqualification order was made to deter others from engaging in conduct of a particular kind.

4. A further objective is the more general one of deterring others from abusing the corporate structure to the disadvantage of shareholders, investors and others who deal with the company.

5. The prohibition itself contemplates that there will be hardship to the offender; therefore hardship by itself is not a persuasive ground for granting leave.

6. The court, in exercising its discretion, will have regard to the nature of the offence of which the applicant has been convicted, the nature of his involvement and the general character of the applicant, including his conduct in the intervening period since he was removed from the board of directors and from management. Where, as in a case such as this, the applicant seeks leave to become a director and to take part in the management of particular companies, the court will consider the structure of those companies, the nature of their businesses and the interests of their shareholders, creditors and employees. One matter to be considered will be the assessment of any risks to those persons or to the public which may appear to be involved in the applicant's assuming positions on the board or its management. (Para 8 of the case.)

Lindgren J then evaluated why the Chinese companies wanted Adams to become involved. He found it difficult, on the basis of the information before him, to accept that proposition.

The Chinese interests have, out of the blue, stated that they will not enter into any transactions with the companies with which Mr Adams is associated unless he is made a director of them. There is evidence that Mr and Mrs Adams have travelled to China and, ... there is evidence that Mr Adams has been productively negotiating on behalf of the Australian companies. The evidence is that the Chinese interests do not know that Mr Adams is disqualified from being a director. In the circumstances, one would not expect that they would unilaterally impose a requirement that he be made [a director]. (at para 29).

The judge recognised that only seven months remained until the disqualification was completed. The Chinese investment of millions of dollars would not come to fruition during that period if Mr Adams was not made a director. He concluded that while the brevity of the unexpired period remaining was "a double-edged sword, no significant harm would be done to the members of the companies or to the public if prohibition continued to operate for a period as short as seven months" (see para 31).

On this basis, the application was dismissed, with Adams invited to make a further application in due course.


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