Neither forgive nor forget Law Reporter

  • Date:01 Jun 2005
  • Type:CompanyDirectorMagazine
In last month’s Law Reporter we commented on the New South Wales Court of Appeal decision in Forge v Australian Securities and Investments Commission which, among other things, suggested - indeed decided - that shareholders could not forgive directors of a company of a breach of statutory duty imposed under the Corporations Act.

Neither forgive nor forget

The High Court rules that shareholders should not be able to forgive breaches of statutory duty

In last month's Law Reporter we commented on the New South Wales Court of Appeal decision in Forge v Australian Securities and Investments Commission which, among other things, suggested - indeed decided - that shareholders could not forgive directors of a company of a breach of statutory duty imposed under the Corporations Act.

Now, two members of the High Court of Australia, in the long-awaited decision involving the Carabelas family has signalled, in observations unnecessary for the actual decision, that the ability of shareholders to forgive directors of a breach of duty is quite unlikely to be recognised.

Unfortunately, from the point of view of this particular issue being resolved once and for all, the decision in the High Court appeal in the Carabelas case, i.e. Angas Law Services Pty Ltd (in liquidation) v Carabelas ([2005] HCA 23) could not finally resolve this question because, on the critical issue of whether a breach of statutory duty had in fact occurred, the High Court unanimously ruled that the information presented to the lower courts in South Australia was insufficient.

The facts of this case are fairly complex. It is a pity that the High Court of Australia could not have determined the case on the basis of established facts.

The critical question was whether there had been in fact a novation (i.e. a renewal) of arrangements between Carabelas, the principal shareholder of the relevant companies, and the companies which he and his wife controlled, in relation to certain moneys that were advanced to Carabelas and which were owed to the relevant company.

Carabelas, a lawyer, approached the Commonwealth Bank of Australia (CBA) in June 1988 to obtain an advance of $2.5 million. He had been active in the property market and his family company Angas Legal Services (ALS) owned certain premises together with other companies of which he and his wife were the sole directors and shareholders (his wife in effect was a nominal shareholder). The total value of the properties owned by Mr and Mrs Carabelas and/or by their companies was estimated to be $3.6 million. The relevant property had been subject to a mortgage to the Hindmarsh Building Society (HBS) for a debt of $435,040 owned by ALS to HBA.

In July 1988 the CBA advanced $1,750,000 to Mr and Mrs Carabelas. Securities were taken by the bank over property owned by Carabelas and/or by his companies including ALS. Carabelas applied $435,040 of this amount to repay the debt owned by HBS and to discharge the mortgage. The mortgage was then in effect given to the CBA. It was common ground that at that time ALS, Carabelas and the family companies were solvent.

Accounts for ALS and other companies were kept by the accountant, a Mr Vlassis. Although there was no detailed examination of this issue in the trial it appears that during the second half of 1989 the fortunes of Carabelas and the family companies declined. On 11 October 1989 the property was sold for $910,000 and all the proceeds paid to the CBA to reduce the indebtedness of Carabelas to the bank. Certain journal entries were made by Vlassis. An amount of $446,710.31 was debited to Carabelas' loan account with ALS. There was some dispute as to what amount was actually owed by Carabelas to ALS at the time of this adjustment.

Financial statements of ALS for the year ended 30 June 1990 were later prepared by Vlassis showing a debt owed by Mr Carabelas to ALS of the amount stated above. A later journal entry showed that this amount together with a further smaller amount was owed to ALS by three companies which Mr and Mrs Carabelas controlled. Carabelas had argued that this transaction reflected the fact that he was acting as an agent for these companies in relation to the transaction. That argument had been rejected both at the trial court and on appeal.

The liquidator sought to prove that the journal entries had recorded a "real and effective, but unlawful, transaction, which was described in the pleadings as a 'novation'" (at para 10 of the High Court decision).

The debts said to have been owed by these companies to ALS were later written off by ALS. The liquidators argued that this particular action was either a second contravention of the relevant statute or part of a single course of conduct which amounted to a contravention of the relevant statute.

In effect it

was argued that Carabelas had arranged for ALS to enter into a contract of novation by which the debt owed by him to ALS was discharged, and in its place a series of debts said to be owed by ALS to a number of insolvent Carabelas companies were substituted.

In their High Court judgment Chief Justice Gleeson and Justice Heydon stated (at para 10) that this allegation depended "upon the shaky premise that in truth there had been such a transaction, rather than a series of incorrect accounting entries by [the accountant]. Apart from the journal entries, and the financial statements in which they were reflected, there was no evidence of any contract of novation [that is renewal of the contract]. The signatures of Mr and Mrs Carabelas to the financial statements were not admissions that there had been a novation. Rather, they reflected the contention (ultimately found to be without foundation) that Carabelas had not been a principal borrower but had acted merely as agent for various companies."

The critical issue was what actually took place at the relevant time. As Justices Gleeson and Heydon, who were the only judges who considered the question of ratification in any detail in the decision, noted (at para 10):

"If there had been a transaction of novation, by which a debt owed by Mr Carabelas to ALS was discharged and there were substituted for it a series of debts owed by insolvent companies, it would be clear that the transaction contravened [the relevant statute] and resulted in loss to ALS. The problem for the appellant was to establish that there had been such a transaction."

Gleeson CJ and Heydon J, at this point considered in some detail the decisions of both Williams J and the Full Court of the South Australian Supreme Court. It is unnecessary to go into the detailed consideration because the High Court ruled that in effect the court had not properly considered the evidence and the issues therefore had to be reconsidered by the South Australian Full Court. It is also unnecessary to consider the further question of whether this actions created preferences in breach of certain other provisions of the Act.

However, Gleeson CJ and Heydon J did go on to consider the question of whether in fact, assuming that the issue had been considered on the question of ratification, such an approach to the issues was appropriate.

In doing so the court reviewed the decisions in Pascoe Ltd (in liquidation) v Lucas ([1990 S ASC 519]) and certain other cases including Miller v Miller ([1995] 16 ACSR 73) which had been canvassed by Doyle CJ in the Full Court of the South Australian Supreme Court. The High Court referred to the remarks of Doyle CJ in Carabelas appeal court and noted that in referring to these cases Doyle CJ had made certain interesting comments:

"Informal assent by the shareholders of ALS to the grant of the mortgage to [the Commonwealth Bank] is sufficient to prevent ALS [through its liquidators] complaining that in granting the mortgage the directors acted in breach of their duty to the company. The company was not insolvent at the time. 1 There were no other shareholders. There was no other person with a claim to the property in question. There is no allegation that this was a dishonest or fraudulent transaction, although it is to be noted that it was alleged that there was no commercial advantage to ALS in the grant of the mortgage, beyond securing the money required to repay HBS. It is true that the grant of the mortgage, the use of company assets to discharge a liability of Mr Carabelas, and in that sense contemplated the misappropriation of ALS' assets. But this was not a misappropriation, contrary to the interests of any other person." (quoted by the High Court of Australia at para 25)

Readers may recall that Doyle CJ concluded that the mortgage transaction did not involve a breach of the statute. However, Doyle CJ did not reject the thrust of the decision of Debelle J in Pascoe indicating it was difficult to reconcile the relevant authorities (see 22ACLC at para 59).

There was an inference, influenced by the reference to the decision in Pascoe, that if the informed consent was obtained in relation to matters that traversed both a common law and a statutory breach that such a ratification could be effective to cure both (see 22ACLC at para 59). It was this rather inconclusive reflection on the law that has been a catalyst for the interest in the High Court judgement in Carabelas.

Regrettably, because the High Court (in three separate judgments) felt that the initial question - whether there had in fact been a novation of the loan at a time when the companies were in fact insolvent (thus triggering the possibility of a breach of the provisions) had not been properly considered- this was perhaps not necessary to deal with the more interesting question (from our perspective) - could ratification in effect relieve directors of a breach of statutory duty?

Despite this qualification, Chief Justice Gleeson and Justice Heydon went on to consider this question .

In their view had the appellants been able to establish the relevant facts then a contravention of the relevant statute may well have been established. In the view of the High Court, such actions on the part of the shareholders, Mr and Mrs Carabelas, would have involved "an abuse of power that could not have been ratified by the self interested consent of Mr Carabelas and the acquiescence of Mrs Carabelas" (at para 32).

In reaching this conclusion the two judges reflected on some of the earlier authorities and made these further comments:

'Where ratification operates to protect a director from civil liability to a company it does so upon the principle that 'those to whom [fiduciary] duty is owed may release those who owe the duties from their legal obligations and may do so either prospectively or retrospectively, provided that full disclosure of the relevant facts are made to them in advance of the decision'." See para 32 of the High Court decision quoting from Gower, Principles of Modern Company Law (Seventh Edition) at para 437.

The two judges then noted that the shareholders of a company cannot release the directors from the statutory duties imposed by the provisions of the Act. In such a case, their acquiescence in a context of the particular set of circumstances "might affect the practical content of those [statutory duties]. It might, for example, be relevant to a question of impropriety. A company's right to recover depends upon the existence of a contravention. If such a contravention has occurred, the question whether the company has lost its right of action under [the relevant statutory provision] because of some binding decision on the part of its shareholders to release the potential defendants is another matter, and one that did not arise in this case." ([2005] HCA 23 at para 437).

`The two members of the High Court felt Doyle CJ, notwithstanding the rather inconclusive remarks referred to above, could not have ruled that the shareholders could relieve the directors of their statutory duty.

Regrettably, the language of the South Australian full court decision does not lead to such a clear conclusion.

Other members of the High Court agreed with the reasoning of the Chief Justice and Justice Heydon in dealing with the factual scenario.

However, because of the factual scenario being as unclear as it was they did not need to consider the question of ratification.

Although in many ways the decision of the High Court in this case is not a complete answer to the question of whether shareholders can forgive company directors of a breach in the context of specific facts, the general comments made by Chief Justice Gleeson and Justice Heydon provide a sufficient answer to deal with this question once and for all.

It would be a brave judge, in my view, who would suggest that a different result should be reached in this context in light not only of the comments made by the members of the High Court, but by virtue of a series of decisions including the decision in Forge discussed in last month's Law Reporter.

Protecting your investment

Can shareholders recover separately for losses sustained by companies

as a result of a breach of duty owed to the company?

When shareholders invest in a company they hope that their investment will increase in value and that this will be reflected in the ability of the company to benefit from its overall successes and performance.

If a company suffers losses as a result of events either within its control or as a result of negligence or breaches of duty on the part of directors, can the shareholders who have suffered a loss in the value of their shares recover for that loss?

This issue was answered in the positive by the New Zealand Court of Appeal in the case of Christensen v Scott ([1996] 1 NZLR 273).

This question had not been considered recently in a major Aust-ralian case covered in our law reports until the decision of the Queensland Court of Appeal in Thomas v D'Arcy and Ors ((2005) 23 ACLC 39.

The facts, as taken from the CCH Company Law Reports, were briefly these: Thomas had been a shareholder in three companies, Novado Pty Ltd, Meadowbury Pty Ltd and Carphone Company of Great Britain Pty Ltd.

At all relevant times Thomas was the owner of half of the issued shares in Novado and half of the issued shares in Meadowbury.

Novado owned all of the issued shares in Carphone.

The defendants were a firm of lawyers who were instructed to provide legal advice in relation to Thomas' business and personal interests. The three companies sought to establish a business.

A bank had provided the companies with significant loans. These loans had been secured by charges taken over the assets of the company and registered mortgages over the properties including certain property owned by Thomas.

Following default under the securities which had been given to the bank, it appointed an agent to sell the company's assets as well as the mortgaged properties (including those owned by Thomas).

Obviously concerned with their developments, Thomas initiated proceedings against D'Arcy and his legal firm, alleging that they had been negligent and also in breach of their alleged retainer to advise him of the steps he could have taken to have restrained the bank, and/or its agents from selling the assets.

Thomas claimed, among other things, that, but for the failure on the part of the solicitors to act properly, he could have retained all or part of the value of his shareholdings in Novado and Meadowbury. The claims brought by Thomas were challenged and were struck out by the trial judge, Douglas J, in the Supreme Court of Queensland.

He ruled that a shareholder was not entitled to claim or recover damages for loss which amounted to a diminution in the value of the shares flowing from loss or an injury caused to the assets of the company.

An appeal was brought against the decision of Douglas J - Thomas wished his claim to be adjudicated upon. The Queensland Court of Appeal comprising McPherson JA, Williams JA and White J upheld the trial judges' ruling.

McPherson CJ, who delivered the main judgment, noted that where a company suffers loss as a result of wrongs done to it, the traditional view in company law is that the company and not any of its shareholders will be the relevant plaintiff. As the court noted in its judgment, there were exceptions to this rule - especially where there is a fraud on shareholders or the shareholder can claim to have a derivative right. It is in relation to the existence of a derivative right that Thomas brought his particular claim relying in particular on the New Zealand decision of Christensen v Scott ([referred to earlier). McPherson CJ also held, that the measure of loss that Thomas could recover from the allegedly negligent persons, should only be a reflection of the loss sustained by company in which he held shares. In reaching this conclusion McPherson JA (together with other members of the Court of Appeal) declined to follow the New Zealand case. He relied instead on the House of Lords decision, Johnson v Goorwood & Co [2002] 2AC222. In doing so he endorsed the principle emphasised in that decision that if a shareholder was able to sue for the loss that he or she had sustained in the value of his or her shares, there would be either a double recovery at the expense of the defendant or at the expense of the company and other shareholders.

It was the company or companies which suffered the loss that should seek to recover those damages which when added to the profits of the company would be reflected in the return to the shareholder.

The Court of Appeal held that the claim by the shareholder could not be sustained and the relevant cause of action was correctly struck out by the trial judge.

A cause for reflection

CAMAC provides some 'guiding lights' for company directors and officers

Obligations imposed on company directors by both the common law and the Corporations Act are not slight. Furthermore, legislation under the broad rubric of business regulation has grown in its coverage, with the creation of new regulators to ensure that the legislation is enforced, and in particular to pursue penalties and the associated enforcement regime.

Once upon a time, one could always work on the presumption that you were innocent unless proven guilty by the Crown, a regulator or, in civil litigation, by the plaintiff.

That is no longer necessarily the case in many sectors of our legislation, including areas of the Corporations Act and other business regulations such as the Trade Practices Act, environment protection legislation and occupational health and safety legislation.

In the AWA case (Daniels v Anderson (1995) 37 NSWLR 438), the NSW Court of Appeal decision led to a call by directors for a statutory business judgment rule. This was introduced into our statute in 2000, but it has yet to be properly tested. In addition, directors do have the ability to seek forgiveness from the court and shareholders in the circumstances under s 1318 of the Corporations Act.

The recent decision in Edwards v Attorney-General (2004) 60 NSWLR 667 (a case involving the James Hardie company) saw just how restrictive that provision of the Corporations Act is.

The CLERP 9 legislation introduced in 2004 made certain persons directly responsible for the failure of companies to properly disclose information to the stock market.

Due to intense lobbying by various organisations, including the AICD, Treasurer Costello agreed to the introduction of a specific defence (based on due diligence) to avoid liability in such cases. This defence is important.

But, there is no similar defence in such areas as insolvent trading where there has been a significant shift in the mid-1990s from enabling both directors and officers to be made responsible for insolvent trading to simply imposing such a liability on directors.

Justice Neville Owen, in the HIH Report, suggested that many aspects of our corporate legislative regime, which places significant burdens on directors, may need revision to take account of the fact that it was not necessarily directors, but officers, who may in fact be the primary "culprits" in causing the company to collapse or cause it to be the relevant subject of litigation.

Two separate reports published by the Corporations and Market Advisory Committee (CAMAC) have provided a number of alternatives, some of which will be welcome by directors, which all impose possible higher responsibilities on officers.

The two reports, entitled "Personal Liability for Corporate Fault" (dated 6 May) and "Corporate Duties Below Board Level" (12 May) call for a number of changes both under specific business regulatory regimes (eg occupational health and safety legislation) as well as the Act.

It is important that the recommendations of CAMAC are carefully considered. A business judgment rule or a due diligence defence should be available in many scenarios currently not the subject of such a regime.

Section 1318 of the Act, which could not be utilised by the directors of the Research and Compensation Fund in Edwards, may need to be amended to permit courts greater flexibility in dealing with issues of forgiveness of directors for potential breaches of duty. However, at the same time, the law should not allow shareholders to forgive directors for breaches of duty where other interests are potentially involved. The legislation clearly recognises those other interests, and they need to be protected as well.

A better balance, however, needs to be struck in dealing with these issues. The reliance on strict liability legislation in areas such as occupational health and safety etc, is going too far in the wrong direction. Similarly, the presumption of guilt with the defendant having to establish innocence, is clearly a message that we must fight against.

CAMAC in its first paper, "Personal Liability for Corporate Fault" suggests a number of templates that might deal with the regime of strict liability. It suggests (at para 8.1) that the regime of legislation which imposes liability on individuals involved in corporations is to "ensure, as best [as the legislation can] that ... corporations comply with regulatory standards and other requirements". CAMAC then suggests that this may be promoted by a legislative template. Three different types of templates are put forward for consideration. We have set out in summary the relevant templates here. The three templates are:

One which had been recommended by the Australian Law Reform Commission in its paper Principled Regulation(2002). This is a template based on State and Territory legislation and it provides that:

"Where a corporation contravenes relevant legislation:

any director or other person who is concerned, or takes part, in the management of the corporation is also liable unless the person proves that he or she:

- was not in a position to influence the relevant conduct; or

- if the person cannot prove this defence, that he or she:

- exercised all due diligence to prevent the relevant conduct, or

- took all reasonable steps to prevent the relevant conduct."

A second alternative suggested by CAMAC is a State template based on the Occupational Health and Safety Act (Vic) 2004 which provides:

"Where an offence committed by a body corporate is attributable to an officer of the body corporate failing to take reasonable care, that officer is also guilty of an offence.

In determining whether an officer of a body corporate is guilty of an offence, regard must be had to:

- what the officer knew about the matter concerned;

the extent of the officer's ability to make, or participate in the making of, decisions that affect the body corporate in relation to the matter concerned;

- whether the contravention by the body corporate is also attributable to an act or omission of any other person; and

- any other relevant matter.

'Officer' has the same meaning as in s 9 of the Corporations Act."

CAMAC also suggests a third alternative - that a responsible officer of a corporation should be appointed to oversee compliance with particular legislation who would be primarily responsible in the circumstances of breach.

That template provides as follows:

"A corporation must appoint an individual [or individuals] within the corporation to be a responsible officer [for particular designated purposes]. If the corporation fails to appoint a responsible officer, each director of the corporation is taken to be a responsible officer.

"A responsible officer must take reasonable steps to ensure compliance by the corporation with its obligations under the Act [in relation to those designated purposes]. A responsible officer is liable for non-compliance unless that person proves that he or she took all reasonable steps."

As I noted earlier, there is no specific discussion on the possibility of a business judgment rule defence as an alternative to the template. However, this alternative should be more fully considered and is one that the AICD has been pursuing for some time in relation to insolvent trading. It is recommended as one that should be discussed in considering this report.

In its second paper, "Corporate Duties Below Board Level" CAMAC has put forward a number of preliminary proposals; this in affect would:

  • extend the duties in ss 180 (of the Act) (care and diligence) and 181 (good faith and proper purpose) beyond directors and some corporate officers to 'any other person who takes part, or is concerned, in the management of that corporation;
  • extend the prohibitions in ss 182 and 183 (dealing with improper use of corporate position or information) beyond directors, other officers and employees of a corporation to 'any other person who performs functions, or otherwise acts, for or on behalf of that corporation; and
  • extend the prohibitions in ss 1309(1) and 1307 (providing false information) beyond officers and employees of a corporation to "any other person who performs functions, or otherwise acts, for or on behalf of that corporation".
These proposed changes, which are put forward as a direct result of recommendation of Justice Neville Owen, will impose stronger responsibilities on company officers below the position of director. This is a critical issue for many officers in companies and will obviously be the subject of dispute and discussion. Nevertheless, it is important to recognise the framework against which the recommendations are being made - where officers in positions of great responsibility etc are allegedly guilty of significant breaches.

The AICD will be concerned that there is no discussion of a possible business judgment rule defence to the duty of insolvent trading. This matter was not raised directly by Justice Owen in the HIH Report, but it should be considered at this time.

Both CAMAC papers merit close consideration by the AICD and its members.

Disclaimer

The purpose of this database is to provide a full-text record of all articles that have appeared in the CDJ since February 1997. It is aimed to assist in the research and reference process. The database has a full-text index and will enable articles to be easily retrieved.It should be noted that information contained in this database is in pre-publication format only - IT IS NOT THE FINAL PRINTED VERSION OF THE CDJ - therefore there might be slight discrepancies between the contents of this database and the printed CDJ.