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TUTORIAL NO 12: Duty to Account for Secret Profits; Indemnification of directors/officers

Exercise 12.1 Long Problem Question Ted Egan opened a hardware shop at Waverley in 1965. A couple of years later he employed young Laurie Adams, fresh from school, to work in the store. Laurie proved to be a smart boy and they got on very well. In 1970 when Ted decided to open a second store, in Randwick, he asked Laurie to come into the business in partnership with him. They formed Egans Hardware Pty Ltd with Ted holding 55% and Laurie 45% of the 50,000 ordinary shares that were then issued. They appointed themselves joint managing directors of the company; Ted ran the Waverley store and Laurie the Randwick store. Both stores prospered over the following decades. There were no other directors.

Ted retired from active involvement in the business in 1996 although he has remained as a nonexecutive director of the company. Ted also then sold some of his equity to Laurie so that Laurie now holds 60% and Ted 40% of the equity in the company. Upon Teds retirement, Lauries daughter, Lizzie, was employed to take over the management of the Waverley store. Laurie thinks that she has done an excellent job and brought in a new clientele of independent women interested in home renovation.

During the 1980s Laurie persuaded Ted to let the company expand into importing and distributing building products for the plumbing trade. (Egans Hardware has a good reputation in the plumbing trade and plumbing supply represents a major part of its trade business.) Laurie then established reliable overseas sources of supply and distributed these products through a range of outlets including their two shops. The supply business proved profitable for a while but Ted was never comfortable with it and they abandoned it a few years later. Laurie now proposes to Lizzie that a new company be formed to resume the supply business, using some of the overseas supply contacts that he had developed earlier and distributing products through the old supply outlets he had developed. He wants to encourage his daughter so he contributes $20,000 of his personal savings to assist with start up costs. No documentation is provided in relation to the funds. Laurie suggests to Lizzie that she form and run a company to import and distribute plumbing products through any hardware outlets in NSW that will take them, including the Waverley and Randwick stores where he claims they will not receive any favoured treatment. Lizzie will continue to work half time as manager of the Waverley store and the rest of her time will be devoted to developing her own business. Lizzie agrees and Lizzies Plumbing Supplies Pty Ltd is soon incorporated. Lizzie relies upon the old supply and distribution contacts in developing her business. Laurie tells Ted that Lizzie will now work half time only for the company but does not tell him anything more about Lizzies new venture. Laurie tells the third director, the solicitor Vaughan, what is to happen and Vaughan thinks that it is a clever solution to the problem of keeping Lizzie involved in the companys business while also developing her own skills and financial base. (a) Advise Laurie, Lizzie and Vaughan whether there are any legal problems raised by this proposal. The constitution of Egans Hardware Pty Ltd provides: The quorum for a meeting of directors shall be two directors. No director shall be disqualified from being a director or being counted in a quorum, or shall otherwise be accountable to the company, because of their dealings or transactions with the company if they disclose those dealings or transactions to the company.

(b) Assuming that there may be breaches of directors/officers duties here, can the relevant directors/officers be indemnified by the company for any costs incurred in defending themselves against legal action, including fines or damages/compensation payable? Can they insure themselves against such costs?

Pty company different rules will apply.

a) Lauries liabilities and obligations Laurie is a director of Egans and hes put money into the plumbing supplies business. He hasnt revealed to Ted that theyre using the contacts/information that Laurie had when they were involved in the plumbing business. He also hasnt informed Ted about Lizzies personal business interests. Is there a real possibility of conflict? (Phipps v Boardman) Queensland Mines v Hudson the company ratified the director doing something and then later asked for some of the profits court held no Peso Silver Mines - opposite result, director had rejected the opportunity for a mining lease and
Cropper who was a director of peso silver mines decided to take the opportunity in his own personal capacity. Court said: nothing wrong since company rejected the opportunity.

Cook v Deeks 2 Deeks brothers and Hines and Cook. The company Toronto Constructions was going to get benefit of a contract and the 2 Deeks brothers created another company (dominion) which got contract instead. Court said that they took the opportunity and they should really have bought Cook out. The companys constitution says that the quorum must be with 2 directors and Ted and Laurie havent spoken therefore Laurie could be in breach. In the companys constitution rules in relation to disclosure did not follow therefore may be a breach. Consequences and Remedies Aberdeen Account of profits. Regal Hastings v Gulliver Green v Bestobel Industries R v Chew Canadian Judge came up with a series of factors to consider when assessing whether someone has breached good faith and taken advantage of their position: 1. The position of office held 2. Nature of opportunity and how recent it is in this case, the plumbing was 20 years ago. So much time has lapsed between 3. The specifics of the opportunity and whether it was because they were a director that they knoew about it 4. Amount of knowledge possessed Laurie set up all the contacts 5. Special or private circumstances in which the opportunity was obtained Common knowledge or a secret deal that was proposed? Not relevant here. 6. Time in the continuation of fiduciary duty where the alleged breach occurred In this case Laurie is a director of Egans and Lizzie still works there. 7. When has the relationship been terminated? Lizzie Lizzie is acting as a senior manager s9 so she has a responsibility to Egans but she also has responsibility as an employer and she cant use the information gained from her position s182/s183.

Vaughan We dont know who Vaughan is whether he is a director of Lizzies or Egans company. From the wording it is difficult to differentiate. This raises the following issues: Quorum As a solicitor, he should know that what is being proposed Should have advised Lizzie to disclose breach of fiduciary duty

b) A company cant indemnify the directors/officers (s9) for certain breaches S199A (1) (3) S199B (1) premiums for certain liabilities cant ensure for breaches of s182/183 or general duties. Can indemnify for legal costs not for any penalties that may arise subsequent to trial. Can indemnify them for costs of investigation leading up to action. For private company, procedural defects can be ratified by the board. Criminal/ASIC/Court order/or if court says you cannot indemnify them. EXTRA NOTES Cooke v deeks constructive trustees Gained knowledge from working in the firm, property of the company Nature in which the fiduciary uses the information, benefit of t he company. eg breach of confidence. Information is not property Must satisfy the Statutory requirement for disclosure s191 to the board of directors And Case law regal hastings fiduciary has to act within their powers, when they are ultra vires there is ratification by the shareholders. GM had to be called to ratify. Vaughn solicitor third director o o o S182 Phipps v boardman Solicitor is a fiduciary Phipps v boardman profit rule, fiduciary must be accountable. And if get access to information by way of office hpold it on trust.

Misappropriation rule director cannot apply the property of the company for the benefit of him or another Conflict and profit rule prohibition , not to be in a position of conflict. Or need to manage it CL duty is in addition to s185

Whether lizzie is an officer . S181,182,183 (latter 2 apply to employees as well Whether laurie acting under an undisclosed conflict Inherent conflict of laurie being an investor in lizzies business which also supplies Phipps case real possibility of conflict as opposed to complete and utter prohibition (demonstrates courts practicality) Conflict arising by way of lauries position could result in a case for account of profits based on use of egans confidential information to start the new business Also possible breach of DoC by Vaughn 7.545-7.560 indemnification and insurance issues.

General approach to corporations questions 1. Case law 2. Statute s182, 183 etc steps 1. Misappropriation, profit, conflict and profit rule. 2. Failure to disclose 3. Ratification 4. Remedy damages or compensation, accout nfor profits.

Director of fiduciary obtains a profit a. In circumstances where the is a significant possibility of conflict (Phipps v boardman) i. peso no conflict b. By reason or by use of office (cook v deeks opportunity belongs to the company) i. Regal hastings v gulliver when board said dont want to invest, the directors took opportunity because of knowledge.

Secret profits S182,183 include employees Conflict - Cant be buyer and seller - Aberdeen railway.

Misappropriation rule Profit rule Conflict and profit rule 12.2 ben keller 2001australian business judgment rule the law institute journal

Exercise 12.2 Discussion Question

What is the purpose of the statutory business judgement rule (s.180(2))

Statutory s180(2) defence to breach of duty of care Rationale guardians of the shareholder interests, must be accountable Enshrining accountability in statute Operates as a defence eg good faith etc 4 limbs required to be addressed. Definition Suppose to only use the coproate funds in the way they are authorised to

Contractarian wouldnt need BJR cos contracts protect each party. Comes from Common law Turquon v marshall Pinevale investments case Mcdonalds case Awa cases

defence in s180(2) S180(2) o Doesnt explain whats a breach but what need to do to comply with s180(1) o ASIC v Rich [2009] Austin J described as a defence director bears onus of proof. Genral oversight not protected Cant just look over documents, have to do something with them Difference between monitoring and making a decision o 2a good faith o 2b material interest (same deintion for conflict of interests) (personal) o 2c informed decisions informed themselves about the subject matter of the judgement to the e they reasonably believed to appropriate.

o 2d rational judgement in best interests of company. Like wednesbury unreasonableness, so unreasonable no reasonable person would ahve? S180(3) business judgement rule o business judgement means any decision to take or not take action in respect of a matter relevant to ..? o Inaction isnt a business judgement must be conscious o Directors have to establish made a particular decision consciously o And equivalent duties in common law and equity. o Good faith and proper purpose

Shareholder Primacy Theory: What theory of the corporation best justifies the need for such a statutory rule? BJR provides defence for directors if theyve done something shareholders dont like they can say they did it in the best interests of the company. Making them accountable markets demand that directors must make the best decisions in interests of the company. Shareholder primacy theory not really about protecting directors, but protecting shareholders from bad directors. Proscribing what they have to do for the benfit of the company, shareholders. Business judgement rule furore because no need for legislation because the markets will regulate themselves eg you will be removed by shareholders, reputation ruined. Stakeholder theory - Defence to stakeholders. Encouraging entrepenueiralism, commercial growth. Institution governing the relationships between all parties that contribute to firm specific assets Must explain both models and but evaluate the best

Is it in public interest for widely held company to be run exclusively for shareholders? Berle v means debate similar to constitutional law they proposed that it was in the interests of the company for there to be a separation of powers. Shareholders having their interests being looked after by professional managers (manegerialist theory) directors are management all mamangement is by virtue of delegation of the board. Creates other issues, agency costs in the market environment. Does the current rule fulfil its purpose?