Good Case Study Companies Act

RMIT University Company Law LAW2450 CASE STUDY FACTS SEMESTER 2 2016 The Cast You: Graduate accountant Sarah: Partner in the accounting practice to whom you report Laurence Douglas: The owner of a car parts business Betty Tan: Wife of Laurence Douglas Matthew: Son of Laurence and Betty Racing Parts: The business name of Laurence’s current business Mark: Laurence’s father, a retired accountant Andy: Warehouse manager Tom: Office manager Michelle: Part-time receptionist in the business Jonathan: Bank manager Sam: Voluntary Administrator and Liquidator (fellow partner in the firm with Sarah) Authorship: Alex Wong (edited by Aaron Lane July 2016) Notes: The following case study is to be read in conjunction with the Tutorial Program. Note that the case study is fictional and does not depict any actual person, company or event. Copies of copyright material in this compilation have been made in accordance with the provisions of section VB of the Copyright Act for the teaching purposes of the University. LAW2450 Company Law RMIT University 2 TOPIC 1: INCORPORATION OF A COMPANY Congratulations you have secured a position as a graduate accountant in your co-op year/ after graduation with an accounting practice. Sarah the partner in the accounting practice asks you to attend the 6 am meeting on Monday 20 January 2016 with herself and Laurence Douglas a long standing client of the firm. You are required to take notes and prepare answers for Laurence to his queries. Laurence Douglas is aged 49 and married to Betty Tan and they have one child Matthew who is aged 17. Laurence is very entrepreneurial and has been running a car parts business in Dandenong Victoria by himself as a SOLE TRADER for the last 5 years under the business name of Racing Parts (Racing). Turnover was $659,000 per annum in the first year and has now grown to over $3m per annum. A lot of his customers are local and overseas businesses. There are 8 staff in the office/warehouse. The business operates from rented premises and Laurence would like to buy a building. Laurence feels that the business will expand further and has growth plans for the business as well as other activities he is interested in. He also wants to expand into running a café/restaurant later on. He has been told by his father Mark (a retired accountant) that he should now run his business as a company. He is unsure about this and makes an appointment to see Sarah his accountant. Prior to the meeting, you review his file and note that he and Betty have the following assets: A family Home in Hawthorn with a market value of $1.55m. There is a mortgage on the property of $561,000. The house is owned by Betty. The house was previously owned by Laurence and Betty but when he started up his business it was decided to transfer the house solely to Betty for asset protection reasons. They also own jointly 1,000 Telstra shares which cost $3.30 each in the initial float and 500 CBA shares bought in 1990 which cost them $10.90 each. The current value is $5.61 for the Telstra shares and $88 for the CBA shares. These were bought for Matthew and are intended to be given to him when he turns 21. They also jointly own a portfolio of blue chip Australian shares currently valued at $254,637. ($127,318 each) There are two motor vehicles, a BMW series 7 worth $135,000 which is owned by Betty and a VW Transporter Van used for the business owned by Laurence worth $18,000. Laurence also over the year bought computers, desks, office furniture, shelving for the business which cost him approximately $23,000. The current value in the financial accounts is $8,650. Laurence has $190,568 in superannuation and Betty has $136,000 in superannuation. LAW2450 Company Law RMIT University 3 Betty works as a sales and marketing manager in the city for a financial services company. She is on a total salary package of $155,000. At the meeting Laurence hands over the business results to date (June2015) and his draft budget of sales and expenses for the 2016 financial year, for review. The 2016 budget shows expected sales of $4,764,000 and a net profit of $637,979. During the meeting he had the following questions: – Should I stay as a sole trader? – What other options are there besides a company? – Is my father correct in setting up a company to run the business? – What are the benefits and disadvantages of each structure? – How is a company different from me as I still WANT TO BE IN CONTROL and run the business? – What sort of company should I form? – How and who forms the company? • What is the cost? • What information do you need from me if I decide to form a company? – Can I call the company Racing Parts Pty Ltd? – How long does it take to set up? – Do I have to set up separate bank accounts and financial records for the company or can I use the existing Racing Parts bank accounts? – Should I transfer the VW van and other assets to the company? – Can the company pay for the running expenses of the BMW? – Can I have more than one company when I start up my other activities in the future? – If I buy the building to run the business from should I, Betty or the company or something else own it? – How does the company operate? – Who runs the company and who owns the company? • What are my responsibilities LAW2450 Company Law RMIT University 4 • What are my liabilities • What are my benefits? • What are the liabilities of the company? • What happens to the staff, and the current lease etc? – How do I control the company? – When should the company commence business now or at the start of the new financial year or some other time? If the company is appropriate Laurence is keen to retain control of the company both from a managerial and ownership basis but recognises that he will need other people such as senior staff and his father to help. His wife Betty at this stage has no interest in the business but is prepared later on to be involved if required. Laurence tells you that last week he bought some additional shelving and other office equipment for the business worth $12,000 plus an iPad and a new Samsung Galaxy phone worth $1,200 with his personal credit card. They were on special and he decided to buy now. However if it is appropriate to have the company run the business he wants these items to be owned by the company and paid for by the company. After the meeting Sarah asks you to prepare a report that answers all of Laurence’s questions, plus answers to questions that he may not have asked. He wants to be the only director and shareholder of the company at this stage. Sarah also asks you to in your report to Laurence to: • Explain the accounting treatment in the company for the $12,000 of equipment and electronic equipment of $1,200 that he bought. • How do you recognise the transfer of ownership of the VW van and existing business equipment to the company? • What happens to the staff, the rent of the shop and the relationship with the suppliers and the customers? • How will Laurence get paid for it? • Explain to him the consequences of being a shareholder and director • Make sure Laurence understands the legal implications for himself and the company. LAW2450 Company Law RMIT University 5 • Laurence is now happy with the need to have a company to run his business. On your advice He agrees that the best choice is a proprietary company. As you complete the application form to incorporate the company, (Form 201) He advises you that although He wishes to have complete control of the company He also wants to have his father (Mark) involved as a fellow director later on. Mark is a retired accountant with over 30 years’ experience and would greatly assist Laurence with the duties as a director and with the financial and administrative aspects of the business. His wife may also own some shares in the company and also his son later on (but no more than 10% in total) • He has read in the paper recently that a shop owner in the city was recently fined for having an unsafe shop as a customer slipped and broke his leg on a wet floor another customer suffered burns to his body when a waiter split some hot soup over them. Laurence wants to know: • On the drive way to the warehouse trucks park to deliver and pick up. Sometimes trucks drip oil or grease on the drive way. What if a customer or staff member slips on the oil or grease? Am I liable or the company? • If Racing Parts Pty Ltd was found guilty of a similar offences what would be the consequences for the company and the directors. LAW2450 Company Law RMIT University 6 TOPIC 2: RULES OF A COMPANY You advise Laurence that it is normal for the company to have a rule book (see Form 201) which will set out the rules and procedures relating to running the company and set out the rules for members and operators. Laurence has the following questions for you: • Why does the company need a rule book? • What is the purpose of the rule book? • It’s my company and I can do anything I want. • Do I have to state what the company is going to do? • Who creates the rule book? • Who is bound by the rule book? • What if I want to change the rule book? • How do I change the rule book? • What do I need to consider when I want change the rule book? You have incorporated for Laurence his new company Racing Parts Pty Ltd ACN 402 351 892. It was incorporated on 25 January 2016. You agree that the best time to start the business of the company is 1 March 2016. (Explain why to Laurence and not now) You have also applied for the ABN and TFN for the company. As Laurence is busy with the management, administration and planning of the company, it is up to certain staff to order goods and supplies and the hiring of staff i.e. to ensure that the business runs smoothly. This happened in the past when he was a sole trader. Tom the office manager looked after the office and Andy looked after the warehouse. LAW2450 Company Law RMIT University 7 TOPIC 3: DEALING WITH THIRD PARTIES Laurence recognises that for the business to grow he cannot do everything himself and therefore he needs to delegate. He asks Andy his warehouse manager and Tom his office manager both of whom have been with him for 5 years to carry out those activities generally involved in running the business. Andy deals with the suppliers and freight companies to ship the goods out. Anything to do with the warehouse is his domain. Tom deals with the logistics staff issues office procedures and administration issues. He also asks his father Mark to keep an eye on the finances of the company. He also asks you to prepare the paperwork to appoint Mark as a director of the company effective from 1 April 2016. Mark notes that the company needs additional funds if it is to grow and achieve Laurence’s goals. He suggests an overdraft facility from the Bank. Laurence asks him to go to the bank on behalf of the company to get additional funding of no more than $90,000. Laurence knows about motor parts but very little about finance. Michelle who is a part time mother helps out in the office. Tom has given her authority to order stationery from Officeworks where the company had a credit account. Mark goes to the Dandenong Branch of the Westpac Bank and sees Jonathan the business banking manager on 31 March 2016. Laurence has banked with Westpac for the last 25 years. Mark tells Jonathan that he has been asked by his son Laurence to organise additional finance for his company. Laurence is the managing director and knows the basics of finance but is too busy to deal with the Bank. He has always regarded Mark as the finance expert even though he has not yet been appointed as a director. Jonathan has dealt with Mark before and assumes he has the authority to negotiate funding for the company especially when Mark says he has been asked by his son to arrange finance. Mark therefore agrees on a term loan of $160,000 and an overdraft of $15,000 up to a maximum of $45,000. The bank requires security for the funds. Mark offers as security the new company plant and equipment valued at $13,200 plus goodwill plus the assets transferred from Laurence to the new company. Mark and Laurence are also required to provide a personal guarantee to the bank for the overdraft before the loan can be approved. The constitution that you drafted for the company states that any loans over $100,000 must be approved by the Board of directors and the shareholders i.e. Laurence at this stage. There has been no formal meeting of the “board of directors” approving the loan Laurence who has been busy marketing the business comes to see you at the quarterly review of the company accounts and asks you the following questions: LAW2450 Company Law RMIT University 8 • Although I asked my father and senior staff to enter into contracts on behalf of the company, is the company liable to pay for the goods ordered or are the individuals liable? • I am not happy with the borrowings of $160,000 but based on Dad’s advice that the company needs it I will go with it. • You reminded me that in the constitution any borrowings over $100,000 must be approved by the Board of Directors. This was not done. • How can I guarantee the loan if I don’t have security to offer as the house is owned by Betty? • What if the company does not pay back the loan? • Am I liable under the personal guarantee or Betty? • Will we lose our house? • Explain to me what is a personal guarantee? • What assets could the company provide as security to the Bank? • It is now 31 December 2016. The business is going well and according to Mark the draft financial accounts he has prepared show a profit of $385,000. • However Laurence can only see $238,000 in the bank. • Sarah asks you to explain to Laurence why there is a difference between cash at bank and profit. LAW2450 Company Law RMIT University 9 TOPIC 4: MANAGING THE COMPANY As Laurence has been so busy servicing existing clients and getting new clients he feels the need to sit and talk to all staff about the business. Laurence is a believer that if staff know what is going on they are happier. Sarah asks you to call Laurence and arrange a meeting with him to discuss why he should call a meeting of staff. In the meeting Laurence advises you of the following matters: • His father is planning to take 6 months off and do a cruise around the world with his wife Bev • Tom is a key member of the business and Laurence would like to make him a director as he sees him as someone who can take over the business later on. • Andy who runs the warehouse is also a key member and he feels that he should also be a director. However Mark found out that Andy was a director of a company that was insolvent four years ago and he was fined $12,000 for breaching the Corporations Act. Eight years ago he also ran a company which became insolvent and he was declared a bankrupt. He is no longer a bankrupt. • Matthew his son is studying accounting and legal studies at school and wants to study business and marketing at university. Laurence thinks it would be a good idea to make him a director • Laurence wants to make sure he always has the final say on all management matters. • Who would you appoint as a director and how would you ensure that Laurence retains control? • At the meeting with Laurence, Mark, Sarah and you it was agreed to appoint Tom as a director on 3 June 2016. • Andy won’t be appointed at this stage but he is regarded as a senior person in the company. Andy is not happy about this snub. • Matthew on reflection is too young and immature to be a director but Laurence may appoint him as a director later on (possibly after finishing his degree at university) • Laurence asks Sarah to consider being a director of the company to replace Mark whilst he is away on holidays. • Laurence has heard from his best friend Mary that there is a lot of work and procedures involved in running meetings and looks to you to help his simplify the process but also make sure the company and the directors comply with the law. LAW2450 Company Law RMIT University 10 You advise his in the meeting that the following issues need to be addressed: • Standard of behaviour of directors • Who meets and why • Who are directors • The different types of directors • What can they decide and what can the members decide • Separation of powers • Who calls the meetings • Who controls the meetings • Laurence wants to keep control • The purpose of the meetings • What issues are decided • Management v ownership • How are matters decided? • • • Vote by majority • What if not happy? Delegation of powers How do I appoint directors? • Andy • Tom • Matthew • What conditions do they have to meet? • How do I remove directors? • Can they object? LAW2450 Company Law RMIT University 11 TOPIC 5 & 6: DIRECTORS DUTIES Laurence, Tom and Mark have now all been appointed as directors of the company. Sarah will be appointed as an alternate director to the company to replace Mark whilst he is on his holiday for 6 months. Sarah has a strong background in tax and finance law but knows little about the motor parts industry. At the quarterly meetings with Laurence and Mark to discuss the management accounts, budgets and planning issues for the company (Tom never attends as he is too busy running the office and sorting out issues with customers and suppliers. His knowledge of finance is limited, as he never did finance and left school at 17 and has worked ever since. However he can read a bank statement and knows you should not spend more than you earn.) In your discussions with Laurence you find out the following about the other directors: • Mark is smart in relation to the financials but knows nothing about motor parts. He is also not up to date with current tax and accounting laws and still uses paper and pen to prepare the draft financial accounts. He is not familiar with MYOB or QuickBooks and has not heard about the Cloud. • Tom knows all about motor parts and dealing with suppliers, has an interest in speed boats but knows nothing about finance and relies on Laurence and Mark to deal with the financial aspects of the company. • Laurence is the brains and like Tom has a basic understanding of finance but left everything to his dad Mark. His strength is marketing and talking to people. Remember he does not understand the difference between the profit of the business and cash in the bank. During you discussions with all of them in addition to the above you find out the following: • Laurence has told his dad Mark that he and Tom are reliant on him for the financial stuff. • Tom also delegates to Michelle the responsibility of keeping the office tidy. Andy is responsible for keeping the warehouse safe. • Tom and Laurence order all the motor parts. Tom received from one major parts distributor free tickets to the 2016 football grand final plus a trip to Cairns for his family. The price of the parts ordered by Tom are on average about $2-$5 per item more expensive but Tom does not disclose any of this to the other directors in the board meetings as they are still making large profits on the sale of these items. LAW2450 Company Law RMIT University 12 • Tom and Andy also share things. They both one day would like to run their own business. Tom has been talking to the customers and downloading confidential data about them and the prices of items on to his home computer. • Andy also allows Tom to take parts home to do up his speedboat. He tells Laurence that the items that Andy takes have been scrapped. The estimated value is about $8,000. • Remember Tom does not understand finance and so does not know of the tight cash flow conditions of the company. Whilst there are reasonable margins it is a high volume business. Competition is tough as more parts are being imported from overseas. This causes cash flow problems, particularly from 4 major customers who are slow paying. You have reviewed the monthly cash flow statements prepared by Mark and note that these are some months there is insufficient cash to pay the creditors and staff. In those months Laurence has had to tip in some of his own funds. You know from discussions with Laurence that Laurence’s company has been threatened with insolvency on 2 occasions for failure to pay its suppliers. On each occasion Laurence with Sarah’s help has negotiated payment terms on behalf of the company. • The monthly cash flow schedules indicate that it is becoming difficult for the company to maintain the repayment schedules on the overdraft, pay suppliers and staff. • One major supplier of motor parts is now demanding the immediate repayment of their outstanding debt of $68,000. • Another supplier will only deliver if it is cash on delivery. • You note that there is only $45,000 in the bank today and debtors owing are $119,000 but the cash will not come in for another 20 days. • You advise Laurence and Mark that the company is under capitalised and needs more funds. • You suggest that to avoid this problem in the future the company should either issue more shares or get a further loan from the Bank • Laurence is interested in issuing more shares because his wife’s family in Singapore has money and might be prepared to invest. • He is concerned with Tom and Mark possibly trying to take control of the company but he needs them in the company • Laurence wants to retain control so he is only prepared to issue the shares if he keeps control of the company LAW2450 Company Law RMIT University 13 • Andy is disappointed that he was not made a director and is thinking of setting up his own business with or without Tom in a couple of years’ time and has a good relationship with some of the key clients of the company. • Laurence may therefore make him a director to prevent him leaving At the meeting you and Laurence feel it is important that all the directors understand their duties and responsibilities. Laurence asks you to prepare a paper detailing the following issues for all the directors: – What are their duties and obligations? – Who do they owe the duties to? – Are they liable for the actions of the other directors? – If they breach their duties who can take action against them? Laurence rings you on Monday afternoon at 4.30 pm wanting to see you and Sarah urgently. Mark is on his 6 months holiday. Laurence tells you the following relating to Tom and Andy: • Andy was not happy about not being appointed as a director. His past failings were not his fault. It was the accountants. • Laurence knew something was wrong when customers that he expected would continue buying from Racing Parts Pty Ltd had cancelled their existing contracts or did not want to renew their contracts. • In his discussions with the customers they said they had found a cheaper company for their motor parts. • Laurence asked the ex-customers for the name of the company (Power Parts Pty Ltd) they were going to. • Laurence wants you to do a company search. On behalf of Laurence you search the ASIC site and find out that the company is operated and owned by Andy and his boyfriend, who happens to be Tom’s cousin. Sarah advises Laurence. Laurence now understands why Andy has been staying late at night in the warehouse. The computer system was easily accessible from the warehouse as well as the office. He was probably accessing financial and customer details from the company files. Mark remember dislikes computers and used paper to record everything. LAW2450 Company Law RMIT University 14 Laurence estimates that the company has lost 4 major clients and the profit on these 4 clients is about $225,000. Laurence wants to fire Andy and possibly Tom but not before the company Racing Parts Pty Ltd gets back the lost profits and customers if possible. \Tom is also causing you problems. His attention to detail is slipping and he seems to be making more mistakes which has also led to some customers going elsewhere. Laurence finds out from Michelle that Tom is getting free trips and gifts from a particular parts supplier. Mark has done an analysis for Laurence of the parts ordered by Tom, their costs and it shows that the prices the company is paying to the suppliers is about $2-$5 higher than the next supplier. The quality of the goods is the same from each supplier. Remember Tom has never told Laurence or the other directors about this or of the benefits that he and his family received. Laurence also finds out that Tom is spending a lot of money on his speedboat and wonders if he is using parts from the warehouse for free. If Laurence proves this can he get Tom to pay it back? Laurence is really upset by all this and with Mark being away he is reliant on you for assistance and advice. He wants to know what he and the company can do to take action against Tom and Andy. Also should he report them to ASIC? He comes to see you on Friday afternoon at 4.30 pm. Sarah wants you to prepare a report to Laurence answering the above before you go home for the evening. LAW2450 Company Law RMIT University 15 TOPIC 7: FINANCING OF COMPANIES – SHARE CAPITAL It is now July 2018. The company has been operating for 2 years. The issues relating to Andy and Tom have been resolved. Laurence has retained Tom as office administrator but removed him as a director and also sacked Andy. Andy is now facing further action from the regulator ASIC. Laurence has 95% of the shares and his dad owns the other 5% Faced with the loss of customers and the need to rebuild his business in a tightening economy Laurence feels in discussions with Mark and yourself that it is better to grow the business by looking at other business opportunities rather than contract the business. Two opportunities have arisen: • A new business venture (Laurence is getting sick of selling motor parts). An opportunity has arisen to purchase a café in Glenferrie Road Hawthorn for $450,000. • In addition the landlord of the warehouse in Dandenong is planning to sell the warehouse and has given notice to Laurence to vacate. An opportunity to purchase a bigger warehouse has arisen in Tullamarine for $859,000. Laurence would feel more secure if he owned the warehouse. • What entity should the café business be run in and what entity should own the warehouse? • After reviewing his business plan and financial projections you estimate that the company will need $1,286,000 in funds to achieve this aim. Neither Laurence nor Betty has the cash. • You advise him that given the uncertainty of the financial markets it is highly unlikely that the company can raise all of the funds by getting other investors. As well Laurence does not want to go to the expense of issuing a prospectus and being a public company, or losing control. • How will it raise funds without soliciting the public for money? • Should the existing company own the warehouse or some other entity? • Given Laurence’s need for control he wants the warehouse to be owned by the company. What is your view? • Betty’s family from Singapore are interested in investing in the company. They are prepared to put in $900,000 by way of equity but want a guaranteed return per annum of 5.5%. They will also contribute the funds in three stages of $300,000 each provided certain milestones are met. • Would you recommend fully paid shares being issued each time or partly paid shares and making a call each time? LAW2450 Company Law RMIT University 16 • The balance of the money needed $386,000 will need to be borrowed. • The interest rate charged by the bank is 7.5%. • Will the company need to borrow more initially as Betty’s family will not be investing the full amount? • Betty’s family also want her to be a director of the company to look after their investment in the company. They also want her to be an ordinary shareholder of the company. This is part of the condition of the $900,000 being invested in the company • Should Laurence transfer to her 5% of his shares or should more shares be issued by the company? LAW2450 Company Law RMIT University 17 TOPIC 7: FINANCING OF COMPANIES – DEBT CAPITAL Mark has to approach the bank for an additional loan of $986,000 on behalf of the company as Betty’s family will only invest initially $300,000. What information will the bank need? Laurence asks you the following questions: • Arrange for the paper work to appoint Betty as a director and arrange for the transfer of the 5% of shares from Laurence to Betty if appropriate. What is the consequence for Laurence by transferring shares to Betty? • What are the best options for the company to acquire the funds? • What are the benefits and disadvantages of each option? • What if the company issues shares to raise funds, what does Laurence need to consider to retain control of the company? • If the company makes a profit from trading does it have to pay the amount out as a dividend to all the shareholders? • What is a debenture? • Why does the bank want a security for any loan? • What is a personal guarantee? You prepare draft financial accounts for Racing Parts Pty Ltd showing the above acquisitions. The consolidated financial accounts show the following: • Stock of motor parts and accessories of $387,000 • Trade debtors of $495,000 (all due within 60 days at the latest) • Shop fixtures and fittings $75,000 (at written down value) • Café business $450,000 (at current valuation) • Warehouse $859,000 (at current valuation) (consider a separate entity owning the building (explain why) • Total assets are worth $2,266,000 • There is a current mortgage to ANZ Bank secured over the house of $160,000 for the existing overdraft • A debenture of $986,000 secured over the shop, equipment, stock and trade debtors. LAW2450 Company Law RMIT University 18 • Trade creditors are $375,000 • Bank overdraft $125,000 (increased because of cash flow issues from $45,000) • Unpaid superannuation for staff is $5,890 • Total liabilities is $1,651,890 • This leaves net assets of $614,110 being: • Share capital $1,000 • Preference shares issued $300,000 • Accumulated profits of $313,110 Laurence, Mark and Betty are now the ordinary shareholders of the company. Laurence owns 90% of the company, Mark 5% and Betty 5%. This was the result of Laurence transferring 5% to Betty. What are the consequences for Laurence and Betty? Betty has also been appointed as a director to represent the interest of her family who will hold $900,000 worth of preference shares in the company. Her family hold their shares through a company (called Tiger Lily Investments Pty Ltd) as trustee for the Tiger Lily Family Trust. You have completed the paper work to transfer the shares from Laurence to Betty, appoint Betty as a director and resign Sarah as the alternate director now that Mark is back. You have also issued the preference shares to Tiger Lily Investments Pty Ltd Under the terms of the issue the preference shareholders get 5.5% dividends every year noncumulative. The shares are to be repaid in 5 years’ time. The acquisition of the café in Hawthorn and the new warehouse are going fine and profits seem to be improving. Given this Mark suggests at a board meeting of the directors that he and Laurence should be paid a bonus of $150,000 each. LAW2450 Company Law RMIT University 19 TOPIC 8: MEMBERS REMEDIES Betty is concerned about this as she believes that it will reduce the profits and reduce the dividends to her family. Betty is aware that the shares were preference shares but she did not note that the dividends were non-cumulative. She trusted Mark her father in law. Laurence and Mark come and see you and ask if they can pay themselves the large bonuses of $150,000 each. You note that Laurence has not drawn a commercially realistic salary for the last 2 years. Mark has not been paid director’s fees for the last two years nor for the accounting work. They don’t believe Betty deserves such a large bonus as she has not contributed to the profitability of the business and she has a full time job. They are not comfortable with Betty being in meetings as she has nothing to add. Can they exclude her? They think she should not get a bonus at all. Based on this no dividends will be payable to the ordinary shareholders. Based on the current economy and the down turn in manufacturing in Victoria and the future closure of Ford and Holden and other businesses this has an impact on the café. Customers are not spending much as anticipated and Laurence is not that keen now on running a café. You have prepared the management accounts for the company and it shows that the 6 months profits will be down and the ability to pay the fixed rate of dividends to the preference shareholders may not be possible nor in the best interest of the company. Laurence wants to know if they can reduce the rate of dividends to the preference shareholders from 5.5% to 2%. Betty’s family don’t want to see their return from their investment affected and want to make sure that the dividends are maintained. Betty’s family wants to stop Laurence and Mark altering the constitution to reduce the dividend rate Betty is also aware that Mark and Laurence have been misusing company property for their own benefit and causing the company lose value and put the assets of the company at risk. She believes that the company should take legal action against them. She has mentioned this in the board meetings but Laurence and Mark have always outvoted her and refused to take legal action. As a consequence of this Betty’s family now refuses to contribute any more of the balance of $600,000 to the company. LAW2450 Company Law RMIT University 20 Laurence comes to see you and asks your opinion as to: • Can he and Mark take the $150,000 bonus? • Can they alter the constitution to reduce the dividend rate to 3% for the preference shareholders? • What can the preference shareholders do about it? • As an ordinary shareholder, Laurence and Mark also want dividends • Can they pay themselves and not Betty a dividend? • Can Betty take action against Laurence and Mark or does the decision of the majority directors win? Racing Parts Pty Ltd has been trading for a number of years now. However given the recent issues with her wife’s family and his soon to be ex-wife, Laurence has not been devoting a lot of time to running the business as the managing director. The café is not trading to the level expected. He is also concerned that the collection of debtors for the motor parts business is too slow and the creditors are continually pressing for payment. Two major creditors are a supplier of cardboard boxed (RH) and a paper supplier (Lombards). The cardboard supplier has threatened to wind up the company unless it’s debt of $9,379 is paid immediately. This debt has been outstanding for 68 days. Lombards has a Rompala clause in its contract but the contract has not been registered. They are owed $24,783 which has been outstanding for 59 days. In addition the motor parts business is struggling to increase sales as the market has become more competitive. Power Parts Pty Ltd is still taking clients from Racing Parts Pty Ltd and is advertising strongly in Melbourne. Racing Parts Pty Ltd is finding it increasingly difficult to pay the wages for the staff as well as their superannuation. On reflection the purchase of the warehouse and the café has put additional pressure on the cash flow of the business. The interest rate on the debenture is obviously higher than current interest rates and this is impacting on the cash flow of the business. Even Sarah is concerned whether Racing Parts Pty Ltd can pay their accounting bill for services provided. Currently there are outstanding accounting fees of $14,973 Laurence and Mark come to see you and you present you with an updated cash flow statement, draft financial accounts to date as well as a list of his outstanding creditors and a list of his debtors that shows the company will run out of funds within the next 2 months and will not be able to repay the interest on LAW2450 Company Law RMIT University 21 the debenture as well as the dividend to the Tiger Lily Investments Pty Ltd as well as the company’s general operating costs. TOPIC 9: RECEIVERSHIP AND VOLUNTARY ADMINISTRATION • The bank has indicated to Mark that it is not prepared to advance the company any more funds and has indicated that it wants its debenture of $986,000 and mortgage loan of $160,000 repaid. • The debenture trust deed for the loan has a clause that allows the Bank to demand early repayment if certain conditions are not met. One of these conditions is that trading stock as a percentage of total current assets must not fall below 50% • In the financial accounts you prepared it showed that the amount of trading stock to total current assets is 44%. • The bank has advised Laurence that unless things improve in the next two months they will appoint a receiver. • Laurence has no further funds to contribute to the company. His ex-wife and his family are not talking to him. • Mark is prepared to lend $10,000 to the company but wants security for the loan against the trading stock. • Laurence and Mark make an appointment to come and see you and Laurence on Friday afternoon. LAW2450 Company Law RMIT University 22 TOPIC 10: INSOLVENCY • He was just advised by the Bank that they appointed a receiver to his company. • At the meeting you present the following draft financial statements for the company: – Current assets • Cash $0 • Trade debtors $265,814 • Trading stock $222,400 – Total current assets – Noncurrent assets $488,214 • Warehouse plant • and equipment $35,000 • Café at cost $320,000 • Warehouse $859,000 • Goodwill of cafe $130,000 – Total non-current assets $1,344,000 – Total assets $1,832,214 – Current liabilities – • Bank overdraft $46,000 • Trade creditors $483,652 • Interest owing on debenture $11,503 • PAYGW payable $48,975 • GST payable $86,247 • Loan from Mark $10,000 • Superannuation payable $36,394 Total current liabilities LAW2450 Company Law $722,771 RMIT University 23 – Non-current liabilities • Debenture payable • Mortgage $986,000 $160,000 _ Total non-current liabilities $1,146,000 – Total liabilities $1,868,771 – Net liabilities ($36,557) – Shareholders’ funds – Share capital ordinary $1,000 – Preference shares $300,000 Retained losses ($337,557) Net Capital ($36,557) Advise Laurence • Can the bank recover its money and how does it do so? • Can any of the creditors wind up the company? • If the company directors feel the company can survive what should they do? • If there is no prospect of the company surviving what should the directors do? • Can Mark get his $10,000 back if the company becomes insolvent? After the meeting between you, Laurence, Mark and Sarah it is agreed that the safest course of action is to appoint a voluntary administrator. Sam another partner in the firm is an official liquidator and agrees to be the voluntary administrator. Mark provides you with a list of the known creditors of the company Your task is to draft a notice to the creditors advising them that Racing Parts Pty Ltd is in administration. Formal appointment of Sam as the administrator is given by the Board of directors of Racing Parts Pty Ltd (Laurence and Mark, Betty is absent from the meeting) Notices are sent out to the creditors and also ASIC is notified. LAW2450 Company Law RMIT University 24 During his investigations and discussions with Laurence and Mark, Sam is made aware of the following issues: • The payment of the $150,000 bonus to Mark and Laurence • Betty advised him of the actions of Laurence and Mark that caused the company to lose value and the misappropriation of company property • Suppliers are now demanding cash on delivery • Customers are refusing to pay as the quality of the motor parts has declined and is not what they were lead to believe • Creditors are threatening to wind up the company • Laurence also advises you that because of the various threats by the creditors he authorised the payment to RH the cardboard of $9,379 in preference to the other outstanding creditors. • He has not drawn a wage of $25,000 owed for the last 4 months • He also authorised the transfer of warehouse fixtures worth $4,000 to settle another creditor worth $2,087 • Mark has told Laurence that he would like his loan of $10,000 back and that he is owed outstanding directors fees of $4,692 • Because of the financial position of the company, Laurence approached Cash Suppliers Ltd on behalf of the company for a short term loan. The loan was unsecured and the interest rate was 8% per month. The amount borrowed was $15,000 • On reviewing all the matters Laurence advises the creditors in the second meeting that the best option for the company, the creditors and the shareholders is to liquidate the company. The Bank agrees and by poll the creditors agreed to appoint Laurence to be the liquidator. LAW2450 Company Law RMIT University 25

Help

In accordance with Section 131 of the Companies Act 1993 ("Act"), directors have a duty to act in good faith and in what they genuinely believe to be the best interests of the company.  While it may be expected that directors should always behave in such a manner, and not place their personal interests ahead of the company's, various judgments have explored the extent of this duty and provided more information about the considerations director should take account of when exercising their powers.

The Duty
As noted in the decision of Sojourner v Robb1, the duty is one of loyalty and arises out of the fiduciary relationship that directors owe to the company from their position as its agents.  Additionally, although a director must act in good faith and in the best interests of the company on most occasions, Section 131 of the Act outlines that there are a few exceptions to this duty which allow a director to act otherwise, as follows:

  1. A director of a company that is a wholly-owned subsidiary may, when exercising powers or performing duties as a director, if expressly permitted to do so by the constitution of the company, act in a manner which s/he believes is in the best interests of that company’s holding company even though it may not be in the best interests of the company;
  2. A director of a company that is a subsidiary (but not a wholly-owned subsidiary) may, when exercising powers or performing duties as a director, if expressly permitted to do so by the constitution of the company and with the prior agreement of the shareholders (other than its holding company), act in a manner which s/he believes is in the best interests of that company’s holding company even though it may not be in the best interests of the company; and
  3. A director of a company that is carrying out a joint venture between the shareholders may, when exercising powers or performing duties as a director in connection with the carrying out of the joint venture, if expressly permitted to do so by the constitution of the company, act in a manner which s/he believes is in the best interests of a shareholder or shareholders, even though it may not be in the best interests of the company.

Duty of Good Faith in Practice
The decision of Sojourner v Robb outlined that the duty to act in good faith and in the best interests of the company has two limbs as follows:

  1. The objective criteria of how a reasonable director in their position may be expected to act, and
  2. The subjective criteria of whether that director believed what they honestly were doing was right.

Therefore, it is not simply enough for a director act in a way that is, in their view in the best interests of the company, if that view is founded on a "wholly inappropriate appreciation" as to a company's best interests.  By the same token, that decision indicated that a director will not simply be in breach of this duty if they acted incorrectly, but in good faith, and genuinely believed that what they were doing was correct.

If they act genuinely (but incorrectly), while they may not breach their duty to act in good faith, they may still be liable for company losses  under the (stricter) reckless trading provisions listed in Section 135, which we discuss in our article which particularly relates to 'non-executive' directors.
See Reckless Trading Article 


Case Studies
On review of how recent Courts have interpreted the duty, we review two different cases where the motivations of the directors in question were found to be quite divergent, resulting in quite contrasting decisions in terms of breach of the director's duty under Section 131 of the Act.  A key fact to note is that the interests of creditors as well as shareholders need to be taken into account by the directors when acting in the best interests of the company.

Sojourner v Robb
In this decision, the Robbs were directors of a company (Aeromarine) whose business was to make luxury yachts. Aeromarine proved to be unprofitable and so they sold the stock and plant of the company to a new company, which the Robbs were also directors of, for no consideration. This new company continued to trade with other clients. Sojourner (and at least one other client) had commissioned Aeromarine to build a boat for him, and so once Aeromarine was liquidated Sojourner, as an unsecured creditor of Aeromarine, received nothing. Sojourner sued.

The High Court discussed the duty in detail and outlined that the duty does not just include acting in the best interests of shareholders, as the company's best interests do not necessarily always align with those of shareholders. The Court found that:

"If a director believes that the duty to act in the best interests of the company is a duty always to act in the best interests of the shareholders, and never in the interests of the creditors, in a situation of doubt as to the solvency of the company, the director cannot be said to be acting in good faith. Creditors are persons to whom the company has ongoing obligations.  The best interests of the company include the obligation to discharge those obligations before rewarding the shareholders."

The Court found that while the Robbs thought they were acting in the best interests of the company when they sold its assets to the new company, they were not acting in good faith, nor in the best interests of the company.  The Court found that the Robbs made three errors of law, as follows:

  1. Firstly, when the directors considered the solvency of Aeromarine, they did not bring into account the company's ability to earn a good income from its skilled staff and long-standing relationships with customers; that is, they did not value its goodwill;
  2. Secondly, they appear to have disregarded the interests of the plaintiffs because the plaintiffs were not current creditors or creditors of Aeromarine; and
  3. Thirdly and therefore, as a direct consequence of these other errors, they did not recognise that their duty to Aeromarine included doing their best to ensure the company met all its obligations, current and contingent.
The Court found that although the directors here were, in its view, decent people with no intention to act otherwise than in the best interests of the company, they had breached their obligations under Section 131.  In doing so, the Court stressed the importance of gaining professional advice before selling a business to a new company, especially where the sale was not at arm's length.  The Court used its discretion under Section 301 to order that the directors pay the liquidator an amount sufficient to enable the purchaser's proof of debt to be satisfied; the debt of unsecured creditors with interest and the liquidator's costs, which altogether was later determined to be approximately $500,000.00.

FXHT Fund Managers Limited (in liq) v Oberholster 2
This decision was one which the liquidators levelled accusations of breaches of several different duties under the Act – including reckless trading, which were found to be substantiated.  Dr Oberholster (a doctor by trade) became a director of a company whose business was the management of private clients' investments in foreign exchange markets, after being introduced to the business by an acquaintance, the other director of the company.  The company went into liquidation and his acquaintance was subsequently charged with fraud. It was alleged Dr Oberholster also breached his duty under Section 131 for several reasons including:
  1. Because he sought to ensure that trade creditors were paid, as this in turn would benefit Dr Oberholster as a guarantor;
  2. For taking steps to ensure that the company was operating at a profit, as this would benefit him in his capacity as a shareholder; and
  3. For encouraging a potential investor to invest in the business which would benefit Dr Oberholster as a shareholder.
The Court found that while a director is not permitted to put his/her interests ahead of the company's, Dr Oberholster's actions to ensure creditors were paid and that the company was making a profit could hardly be said to be a breach of his duty under Section 131. Furthermore, the Court found that Dr Oberholster's comments to the investor were made in good faith (and therefore not in breach of Section 131 of the Act), and the investor was an accountant who, in the Court's opinion, would have no doubt carefully considered the contract – which spelt out the risks – in detail, before investing $350,000.00.  The Court was satisfied that Dr Oberholster acted in good faith and found that he "incorrectly, but genuinely, believed there were limited risks with the business. It is also relevant that once he discovered the problem, Dr Oberholster acted swiftly and decisively in an attempt to protect the investors' money".

The High Court found that he was not in breach of his duty under Section 131 to act in good faith and in what he believed to be in the best interests of the company. The decision was upheld on appeal, although we reiterate that Dr Oberholster was still held liable for reckless trading under Section 135 of the Act.

Please kindly direct any enquiries to:

Andrew Knight on (09) 306 6730 (aknight@mcveaghfleming.co.nz) or
Harry Forsythe on (09) 306 6727 (hforsythe@mcveaghfleming.co.nz)

© McVeagh Fleming 2017

This article is published for general information purposes only.  Legal content in this article is necessarily of a general nature and should not be relied upon as legal advice.  If you require specific legal advice in respect of any legal issue, you should always engage a lawyer to provide that advice. 

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1    [2006] 3 NZLR 80817
2
   
(2009) 10 NZCLC 264, 562

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