Director Duties: Altering Company Constitution and Insolvent Trading

This article discusses the process of altering the company constitution and expropriation of minority shares. It also explains the duty of directors to avoid insolvent trading and indicators of insolvency. The article provides commentary and case laws to support the discussion.

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Question 1
Part A
Process of Altering the Company Constitution
According to section 136 of the Corporations Act the constitution of the company can be
amended through special resolution passed by the shareholders1. However, for the special
resolution to pass, at leat75% of the votes must be in favor the amendment. It goes without
saying that if 75% of the votes are in favor the amendment of the constitution; this decision will
bind the minority even if they voted against the amendment. It is instructive to note that the
special resolution to amend constitution will be binding if there are other additional requirements
spelled out in the constitution that should be met before the constitution is amended.
Expropriation of Minority Shares
There are certain amendments to the constitution that will not be binding even if passed by the
special resolution according to section 136 of the Corporations Act. These include; amendments
that provides for the variation or cancellation of class rights, amendments that are targeted at
expropriating the shares of violating the rights of the minority. The power of the majority
shareholders to amend the company constitution with a focus on expropriating the rights of
minority shareholders has been limited according to the High Court in Gambotto v WCP Ltd.
(1995)2. The court held that the power of the majority shareholders to amend the company
constitution wit a view of expropriating the rights of minority shareholders will be lawful if
a. It is exercised for a proper purpose
b. It is not oppressive with respect to the rights of the minority shareholders and;
c. It is considered to be fair and just
Further the court decided that the decision of the majority shareholder to expropriate the rights of
the shareholders through amending the constitution should only be exercised if there is
1 Corporations Act 2001
2 Gambotto & Anor v WCP Ltd (1995) 10 ACLC

disclosure of all the fundamental information to all the shareholder, an independent valuation of
the shares to be expropriated should be done by an expert. The reasoning inherent in Gambottoh
is that an amendment of the company constitution targeted at expropriation of the rights and
shares of the minority shareholder is only valid if the continued existent of the minority as a
shareholder is detrimental to the company.
Commentary
It is submitted to Amaya that although the resolution has ben passed by a majority o the
shareholder according to section136 of the Corporation Act it will not be binding. This stems
from the fact that the decision is oppressive and is a violation of her right as a minority
shareholder. Suffice say the power of Sammy and Huw to expropriate her shares as a minority
shareholder has been limited pursuant to the decision Gambotto v WCP Ltd. (1995). Sammy and
Huw’s decision to expropriate her shares was not made for a proper purpose since it was based
on the fact that she had become member of another rival company. It can also be argued that the
expropriation of Amaya’s expropriation of shares was not done in good faith and not for the best
interest of the company. Sammy and Huw made the amendment for their own benefit.
Conclusion
It is a plausible conclusion that Sammy and Huw will be bared from including the clause that is
focused on expropriating Amaya’s shares. It is apparent that the Sammy and Huw id not follow
the process of altering the constitution of the company set by law.
Part B
Promoters and Pre-Incorporation Contracts
Pre-incorporation contracts refer to a contract that has been entered to by a company that has not
yet ben registered. A business that has not been incorporated is not a separate legal entity and
lacks the legal capacity and powers that have been envisaged under Section 124(1) of the
Corporations Act 2001. On the other hand, a person who undertakes to form a company through

making various business plans and preparing the business for registration as company is referred
to a promoter. It is a well settled principle in common law in the landmark case of Kelner v
Baxter (1866) that any person purport to be agent of the company, transacting business on behalf
of company that has not been incorporated lacks legal capacity3.
Liability of Promoters to Pre-Incorporation Contracts
The reasoning in Kelner v Baxter (1866) is an affirmation of the common law precept that an
incorporated company cannot ratify or adopt a contract that was entered into by an individual
who represented himself as its agent when it was not incorporated. In Phonogram Ltd v Lane
(1982) the court took to the view that if an individual cannot be held as a party to a contract if he
does not exist in the legal sense4.
The court in Kelner pronounced that a promoter is personally liable for a contract that he entered
into before the company was incorporated because they it the promoter who personally gave
onset to the transaction. .
According to Newborne v Sensolid (Great Britain) Ltd (1954) a pre-incorporation contract will
be binding on the promoter if he entered not behalf of the non-incorporated company but in his
own capacity5.
Liability of Company to Pre- Incorporation Contracts
The approach taken by statute is a significant departure from the common approach. According
to section 131(1) Corporation Act a company will be bound by a contract that was entered into
by a promoter before the company was incorporated if the company ratifies or adopts the
contract within a reasonable time after it has been brought to life through incorporation. It bars
noting that section 131(1) is applicable even in circumstances the name of the proposed company
is still available. It applies as long as the company can be identified reasonably through the name
that has been proposed. According to Hely-Hutchinson v Brayhead Ltd (1967) third party is
3 Kelner v Baxter (1866) LR 2 CP 174
4 Phonogram Limited v Lane [1982] 1 QB 938
5 Newborne v Sensolid (Great Britain) Ltd [1954] 1 QB 45

allowed to make the assumption that the person purporting to act for the company has power to
bind the company to the contract6.
Commentary
The contract entered into between Huw and Gracey fits into the definition of pre-incorporation
contract because it as formed before Oh My Pty Ltd was incorporated. Huw was purporting to
act on behalf of Oh My Pty Ltd before it was incorporated fits into the definition of a promoter.
According to the strict common law position Huw the promoter and not the company Oh My Pty
Ltd will be personally liable for the contract because the company did not legally exist when he
made the agreement with Grace. The precepts of common law suggest that Oh My Pty Ltd did
not have legal capacity. However the common law position has been rendered bad law by statute
(section 131(1) Corporation Act). Oh My Pty Ltd will be liable for the contract because
immediately after was incorporated Gracey was continued to supply the podcasts as agreed in the
pre-incorporation contract.
Conclusion
It can be concluded that Oh My Pty Ltd is contractually bound to pay Gracey her monthly fee for
next year. In the strict legal sense Gracey can sue Oh My Pty Ltd or breach of contract and sek
for damages.
Question 2.
Part A
Director Duty Section 181 Corporation act 2001
According to the Parliament Australia, 1989) a director is the mind and the soul of the company.
Section 181 obligates directors to demonstrate good faith in all their undertakings for the
company and further dictates that the director should perform his responsibilities in the bet
interest of the company and for a proper purpose. An individual is deemed to be in breach of this
duty if his actions done on behalf of the company were not in good faith, not for a proper
6 Hely-Hutchinson v Brayhead Ltd [1967] 1 QB 549

purpose an not for the benefit of the company as a whole. Owen J in Bell Group Ltd (in liq) v
Westpac Banking Corp (No 9) (2008) held that the test to be applied in determining breach of
section 181 is an objective test where the question is whether a reasonable person with similar
skills and knowledge as the director would have reasonably done in a similar situation7.
Duty to act in Good Faith
In Re S & D International Pty Ltd (No4) (2010), Robson J held that the directors statutory duty
to act bona fide (in good faith) for the benefit of a company whole under section 181 is replica of
the common law duty8. According to Whitehouse v Carlton Hotel Pty Ltd (1987) a director has
an obligation to be honest about his dealing. This includes disclosing any information that may
be detrimental to the stakeholder of the company9.
Act / Use Power for a Proper Purpose
In Howard Smith Ltd v Ampol Petroleum Ltd (1974) Wilberforce LJ brought to force a two-stage
test for establishing if a director used his power for proper purpose or not10. He noted that It is
prudent to take into account;
a. The power that was exercised by the director in question,
b. The nature of the power
c. The limits placed on the exercise of the power
d. The primary purpose for which the power is exercised
In Australian Securities & Investments Commission v Adler (2002) in determining whether there
was a breach of section 181 Santow J held that the decision of the director to cause the company
to buy high-end assets during period when the company was focused on mitigating its exposure
to risks amounted to using power for an improper purpose contrary to section 18111.
7 Bell Group Ltd (in liq) v Westpac Banking Corp (No 9) (2008) 225 FLR 1
8 Re S & D International Pty Ltd (No 4) [2010] VSC 388, Robson J
9 Whitehouse v Carlton Hotel Pty Ltd - [1987] HCA 11
10 Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821
11 Australian Securities & Investments Commission v Adler (2002) 168 FLR 253

The Best Interest of the Company
The general position is that the best interest of the company includes the interest of all
stakeholders of the company including shareholders, employees, and creditors. According to
Parke v Daily News Ltd (1962) directors and company should factor in the interest of all
stakeholder of a company when making a decision that is likely to affect them12. In Mills v Mills
(1938) the court decided that when acting in the best interest of the company directors should put
a primary focus on the interest of all shareholders although they may have disparate views13.
Commentary
The three directors of Drink It Up Pty Ltd Krstopher, Aiden and Jaden have obviously acted in
breach of section 181. This stems from the fact that by concealing information about the
resolution the directors passed to incorporate a new company, H2O Pty Ltd, and transferring
assets of the profitable spring water business to it from Drink It Up Pty Ltd from the other five
shareholders the company amounted to not acting in good faith. The three directors were not
honest about their dealings. On the hand, the decision of the three directors to incorporate a new
company and transfer all assets of the spring water business from Drink It Up Pty Ltd to the new
company amounted to not using power for a proper purpose.
Conclusion
It can be concluded that the three directors of Drink It Up Pty Ltd will be personally liable under
the Corporation Act for breach of section 181. According to the Corporation Act the three
director will be penalized by a 5 years jail term or pay $200,000 as fine or bot for breach of
section181.
Part B
Duty of Director Not to Trade When Company is Insolvent
Test for Insolvency
12 Parke v Daily News Ltd (1962) CH 927
13 Mills v Mills (1938)

The test for whether an individual or entity insolent has been provided under section 95A of the
Corporations Act 2001. It provides that a person or entity is held to be solvent if he able to pay
all debts incurred by the company if they are due or when they become due. Further it provides a
person is not solvent then he is deemed to be insolvent.
Director Duty to avoid Insolvent Trading
The duty of a director to avoid any trading activity knowing that the company is insolvent has
been provided in Section 588G of the Corporations Act 2001. It provides that a director of a
company will be in breach of the aforementioned section if he failed to cause the company not to
trade while insolvent and;
a. On the face of it, there is credible evidence and sufficient ground to hold to hold the
belief that the company is insolvent
b. A reasonable person who could have ben the director of the company ought to know that
the company is insolvent.
According to section 588G (1a) the duty not to cause the company to trade when it is insolvent is
only applicable to a person who was by definition of the Act a director at the time the company
incurred the debt14. In addition, section 588G(3) a director will be liable for breach of the duty to
avoid trading while insolvent if his omission to do so was accentuated by a dishonest reason.
Indicators of Insolvency
Any reasonable director should be able to know all the financial activities of a company and
determine when the company will not be able to pay any debts that are due or when they become
due. According to the section C of RG 217 ASIC Regulatory Guide 217 – Duty to Prevent
Insolvent Trading – A guide for Directors (RG 2a17) director of a company should take the
following factor into consideration in determining is a company is insolvent;
a. The company has been incurring losses continuously
b. The company is not able to provide an accurate and comprehensible financial record of
its business
14 Corporations Act 2001

c. The company ha been defaulting or is about to default in meeting any financial
obligation.
d. The company is facing a legal threat from a creditor.
Director Liability for Breach of Duty to Prevent Insolvent Trading
Section 588M provides if there if there is evidence that a director breached the duty to prevent
insolvent trading and the company is going through the process of liquidation any person who
traded with the company during that time and is about to incur a loss has power to initiate a legal
action against he director a creditor. According to Powell v Fryer (2001) a complaint (creditor)
seeking remedy for los suffered as a result of the director breach of this duty is entitled to
compensatory damages15. The compensation must put the complainant in the position he was
before the trade occurred.
Commentary
It can be argued that before Kristopher engages in any trade or transaction for Drink It Up Pty
Ltd he must be sure that the company is able to settle any debt. This duty that Kristopher ought
to adhere to arises from the fact that Drink It Up Pty was already undergoing financial hardship.
It was reasonably foreseeable to the Kristopher that Drink It Up Pty was not able to pay any debt
a it had no profitable business. By applying the objective test it can be argued that a reasonable
director who was in a similar capacity as Kristopher would have foreseen that the company
would not be able to pay its debts.
Conclusion
It can be conceded that Dhruv has powers to take legal action as a ‘creditor’ against Kristopher
as the director. This stems from the fact that Kristopher is liable for breach of section 588G
which imposed on him a duty to prevent insolvent trading.
References
Australian Securities & Investments Commission v Adler (2002) 168 FLR 253
15 Powell v Fryer [2001] SASC 59

Bell Group Ltd (in liq) v Westpac Banking Corp (No 9) (2008) 225 FLR 1
Corporations Act 2001
Corporations Act 2001 (cth)
Gambotto & Anor v WCP Ltd (1995) 10 ACLC
Hely-Hutchinson v Brayhead Ltd [1967] 1 QB 549
Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821
Kelner v Baxter (1866) LR 2 CP 174
Newborne v Sensolid (Great Britain) Ltd [1954] 1 QB 45
Parke v Daily News Ltd (1962) CH 927
Phonogram Limited v Lane [1982] 1 QB 938
Powell v Fryer [2001] SASC 59
Re S & D International Pty Ltd (No 4) [2010] VSC 388, Robson J
Senate Standing Committee on Legal and Constitutional Affairs, Parliament of Australia,
“Company Directors’ Duties: Report on the Social and Fiduciary Duties and
Obligations of Company Directors” (1989),
Whitehouse v Carlton Hotel Pty Ltd - [1987] HCA 11