Liability of Directors and Auditors: A Critical Analysis

The assignment content discusses the role of directors in a company and their responsibilities under the Corporations Act 2001 (Cth) and the Trade Practices Act 1974. It also explores the doctrine of fiduciary relationship and its implications on auditors' duties towards third parties who rely on audit reports. The summary highlights that directors are expected to discharge their duties with due care and caution, and can be held liable for breach of duty. Auditors, on the other hand, have a duty to exercise reasonable care and skill in executing their statutory duties and can be made liable for negligence or fraud. The content also touches upon the concept of 'special relationship' between auditors and third parties, which is essential in proving the existence of a duty of care in tort.

QUESTION 1
The Ankita Winery is currently a general partnership firm run by two partners, Aysha and
Dilara who are involved in the business on day to day basis. They have equal rights, duties
and liabilities in their discharge of duties, including the right to make decisions, sharing of
profits, and administrative matters. Their business model fulfils all the essential elements of
a partnership firm explained under Section 5 of the Partnership Act, 1958, and includes the
following features as mentioned herein below:
 Both Dilara and Aysha are involved in the business and have equal interest and
participation in the business.
 Both have an intention to run a profitable business
 Both have equal share of profits
 Both having contributed time, talent and money and sharing of management
responsibility
 Both are keen to build a profitable entity.
After the decision was made to sell a part of the business to Polat in lieu of the services
provided by him, it is wise to convert the existing partnership firm into a Proprietary Limited
“Pty Ltd” company, with Dilara Aysha and Polat being the shareholders. The company will
continue to be managed by the three directors, all of whom have set responsibilities in their
area of expertise. The need to form a company in this case arises for the following reasons:
Ease of raising finance: Raising finances through private investors or placement or equity
infusion is easier in case of companies. Since Ankita has long been facing cash crunch,
raising capital will help clear the past dues, as well as help deployment of cash effectively. A
proprietary company can raise investment from prospective investors, bankers etc.
Better access to talent, and resources: With the capital available, Ankita can have access to
better talent and resources. Since Ankita is inclined to stabilize the existing business and
improve business prospects, company formation is a preferred model.
Easy transfer of share: Since, Polat is a prospective shareholder of the company, x amount
of shares can be transferred to him while the others can be retained by Aysha and Dilara. In
case of any prospective investor, some more shares can easily be transferred without any
legal or administrative hassles
Why should Ankit choose company over a partnership?

Ease of Taxation: While the partnership requires the partners to show their effective control
over the assets, liabilities and profits emerging out of business, proprietary companies enjoy
tax advantages in addition to limited liability.
Better credibility: as compared to a partnership. This will create a better image for the
company in the eyes of the potential customers, bankers, investors and suppliers.
Limited Liability: While in a partnership, each of the partners are equally responsible for the
debts, in a Pty, the liability of the shareholders is limited to the share capital they have
subscribed and the debts to which they have personally subscribed. The personal assets of the
shareholders are not under threat if the company incurs financial losses and debts.
Proprietary company is governed under the provisions of Section 45A of the Corporations
Act, which includes proprietary companies as well as the entities which convert themselves
into proprietary company under the Act. Process of registration of proprietary company is
relatively simpler and can be made under Section 118 or 601 BD. Ankita Winery can convert
into a proprietary company under Part 2 B7 of the Corporation Act, 2001
QUESTION 2
Issue-Whether Amanda and Ruby are engaged in commercial unfairness and engaged in the
acts of unjust enrichment and oppressive conduct against minority share holder? Whether Leo
in this status as a minority shareholder, entitled to relief under Section 233 of the
Corporations Act? Whether the due process has been followed for Leo’s removal from office
under s 249 and s 203(C) has been complied with? What are the remedies available to Leo?
Principle:
Section 232 of the Corporation Act is relevant to the point of unfairly, discriminatory act
against a shareholder caused by the abuse of power and control over the company in bad
faith. Leo should therefore rely on this provision of the Act by stating that the Company
directors have acted in the manner which is oppressive against him as a minority shareholder.
In order to prove his point, Leo has to take the following grounds
1. Refusal to consider payment of dividends despite the company making substantial
profits.
2. Application of company funds to benefit the directors such as opting to lease two
expensive cars for their exclusive use.
3. Use of funds to the benefit of the majority by enriching themselves through excessive
raises and bonuses.
4. Removal of Leo from the board arbitrarily

In re Roberts v Walter Developments & Ors(1997) 15 ACLC 882, the conduct of the majority
shareholder included failure to pay dividends, failure to consider the legitimate requests of
the minority shareholder and refusal to give him access to the company records. Although, it
must be noted here that the, the lone act of not paying dividend does not amount to
oppression, the relevant facts such as the directors paying huge raises and bonuses and
extravagance to themselves have to be considered. The case of Shamshallah v CBD
Refrigeration and Air conditioning Services Pty Ltd., is relevant to this point, to the extent
that though there has been significant jump in revenues, the dividend track record has not
been good. There is no oppression meted out only because the executive directors have
decided to reward themselves with substantial increase in salaries. But when the same is done
in bad faith, it results in commercial unfairness and oppression.
Leo’s dismissal from office under s 203C(a) of the act had to be made after the directors are
satisfied that they have complied with all the formalities. A director cannot be compelled to
resign where he has been appointed by ordinary resolution under s201(G). Although in the
present case, we are not clear as to the constitution of the company allows them to do so, but
the statutory norms prescribe that fair procedures have been followed after taking into
account the unfair dismissal laws and natural justice requirements. In the present case
however, it is evident that Leo has not been accorded a chance to defend himself or giving
him a chance to speak. Such removal is arbitrary, unjust and against the principles of natural
justice and equity.
Remedies
Leo can approach the court for remedy under Section 233 of the Act, for action against
Amanda and Ruby and contrary to the interests of the shareholder. The breach of duties by
the performing directors have given rise to the Leo’s rights Although the best remedy here is
to seek an order from the court for the buying of his shares at a price determined by the court,
there are a number of other legislative remedies to which Leo is entitled to, that include:
 He can seek for the winding up of the company
 He can bring about legal proceedings and seek an order of injunction restraining the
directors from removing him as a shareholder.
 Bringing an action against the existing directors and exercise his right as a director of
the company, having access to the books, dividend as well as other legitimate
entitlements.

 He can seek alternative and equitable relief by appointing an arbitrator to arrive at a
solution acceptable to both the parties. This includes a relief whereby Amanda and
Ruby could buy his shares at a fair price, as per the current valuation.
Other reliefs available to Leo include:
-Filing a suit for breach of duties on the directors under the Corporations Act. The act
prescribes four basic duties for directors under Section 180-183. The directors are
expected to carry out their job with due care, diligence and restricted from improper use
of position and improper use of information. The breach of duties attract penalty to a tune
of $ 200,000 under the Act.
- Leo, in his capacity as a director has a statutory right to access the financial records of
the company under s 290. He has a right to access other books of the company under s
198 of the Act.
- Amanda and Ruby have breached the terms of contract and have failed in their
statutory duties as directors and indulging in commercial unfairness. Absence of proper
disclosure and misuse of power is actionable under Part 2D.1.
-Leave from the court. In the given circumstances where Amanda and Ruby have acted in
an arbitrary manner and in a way which is detrimental to the interests of the minority
shareholder, it is unlikely that they would agree to sort the matter amicably with Leo.
Hence, he can seek leave from the court under the s 237 of the Act. In order to do so, he
must prove to the court that he is acting in good faith and in the best interests of the
company. The company on the other hand is unlikely to take responsibility for their
actions and inactions.
Conclusion: Amanda and Ruby are engaged in employee oppression under s 232 of the
Act, as well as for the breach of duty in their capacity as directors of the company and
therefore can be held liable for their acts.
QUESTION 3
Issue:
Whether Erol breached his duties as the director of the company? Whether all the directors
are liable for the inadvertence caused by Erol? What is the role of individual directors in the
present case?

Principle
The duties of the directors prescribes that the directors exercise care skill and diligence in
exercising their duties under s 180 of the Corporations Act. Similarly there is an obligation
under s 232(4) of the Act to exercise reasonable care and diligence to prevent commission of
fraud by the company. Besides, the director has a duty to prevent insolvent trading by
company under s 588G. Since the directors of the company are expected to discharge their
duties with due care and caution, they can be held liable for breach of duties. Besides, they
can also be held liable under the Trade Practices Act, 1974, and have to compensate a person
who suffers loss through reliance of defective reporting.
However, in this case since Erol acted in good faith and due to sheer inadvertence, he can
claim protection under s 1318 of the Act, which provides protection for company officers
against the consequences of a breach for having acted honestly and ought fairly to be excused
for negligence or breach.
Position of individual directors
In her role as the Managing Director, Vanessa is expected to discharge her duties with due
care and caution. When TACH incurred losses upon investing in other enterprises, she should
have exercised caution in dealings. By entering into uncommercial transaction under s 588F,
and failing to take steps to effectively prevent the company from incurring debt, makes her
liable for her acts. The standard of care has been explained in the court in the case of AWA
Ltd v Daniel, where it was held that the directors of any company are required to take all
reasonable steps to monitor the management and functioning of the company. Additionally,
they also have a duty to seek professional advice, if need be.
In her capacity as the MD, Vanessa ought to have taken due care to assess whether the report
is correct or not. Secondly, she since she had reasonable grounds to believe that the company
is already going through financial stress, she ought to have taken help of external auditor and
assessed the figures in detail. This makes her liable for the breach of duty.
Erol- As a director of the company Erol ought to have exercised his duty with care by
revealing the losses of the company. Being the CFO of the company, it is expected that he
exercises high level of skill and caution in preparing the financial statements. It is highly
unlikely that he did not find an opportunity to communicate to the other directors of the
losses. Although it is due to his inadvertence that led to others to believe that the company

was making profit, such negligence is not excusable under the act as it is neither reasonable
nor is it expected of a Financial officer to make such inadvertence. He is liable for the breach
of duty and is liable to pay damages, if the company decides to initiate legal proceedings
against him. Besides, he can also be held liable for damages for misleading conduct, in the
event where any third party relies on the statements made in the report.
Kurt- in his role as the director, he ought to take care of the events that take place in the
company. Although he is a shadow director, that does not absolve him from his duties.
Passive neglect and non participation can be no ground of defence, as has been held in a
number of cases. In the case of State wide Tobacco Services Ltd v Morley(1990)8 ACLC
827, the court was held that the director is expected to take intelligent interest in the
information with fairness from the executives of the company. In the absence of the
reasonable diligence on the part of Kurt, he is equally responsible as the others for the breach
of conduct.
Remedies:
Although in the above case, all the directors can be held liable for their acts; there are certain
ways where they could avoid consequences. Here, the directors can take defence by stating
that they had acted in bona fide, and without any intention to make enrich them in any way.
 S 1318 of the Act protects those officers of the company who have acted in good
faith and honestly.
 The directors can also take defence under the business judgement rule under s 180(2)
where in, he can state that the judgement was made in good faith and without any
material personal interest in the subject matter. This rule therefore gives grounds for
directors to avoid liability for breach of duty.
 The company can seek indemnification or insurance if they have to pay liability with
respect of breach of duty.
PART B
QUESTION 4

The Doctrine of Fiduciary relationship binds the auditor to the company who appointed him
to carry out the statutory duties. The non-statutory duties are what bind him to the company
where he has a duty to exercise reasonable care and skill in executing his auditory duties.
Test for Reasonable care and skill
The test for reasonable care and skill though, is a subjective matter, the same has been
explained in the case of Re-London and General Bank, where it is held that he must not
certify what he does not believe to be true and therefore must exert reasonable care before he
certifies anything to be true. Undoubtedly, the duty of the auditor is an onerous one, where a
higher degree of skill, expertise and care has to be exercised in carrying out one’s duties
towards the company. Lopes L.J. in re Kingston Cotton Mill Co (No 2), stated “It is the duty
of an auditor to bring to bear on the work he has to perform that skill, care and caution which
a reasonably competent, careful and cautious auditor would use. This aspect also highlights
the reason why the auditor has duty towards the third parties relying on the audit reports as
well.
Duties towards the third party
The general; albeit, a narrower principle binding the auditor to the third party is that the
auditor owes duty of care to the audit client only, and does not extend to the third party. The
rationale behind this principle is that there is no contractual privity between the third party
and the auditor. In the absence of the privity to contract, there is no corresponding duty and
obligation between the parties.
In reality, investors make decisions of the creditworthiness of the company and decide to
invest or not invest based on the audit report of the company. The case of Caparo Industries
Plc v Dickman, highlights the need to bind the auditors with the third parties by imposition of
duty of care. The House of Lords reiterated that the company is not the only entity which
relies on the auditor’s report, but there are a number of potential creditors and investors who
rely on the statements of the auditor’s. Ernst& Ernst v Hochfelder is a landmark case in this
regard where the Ernst & Young served as auditors to FP investments Inc., tax shelter
partnership firm, who entered into partnerships with prospective customers to cultivate
tropical plants in Hawaii. While the prospectus provided for project details etc., it failed to
mention that the company was cash trapped. The investors on the other hand, relying on the
statements made by E&Y, lost their money. E&Y was ordered to pay $18.9 million as
damages.

In order to prove that there has been negligence between the auditor, the burden of proof lies
on the third party who after relying on the statements made by the auditor, suffered huge
losses.
Test of privity-existence of special relationship
Under contractual law the absence of privity of contract between the third party and the
auditor, cannot make the auditor liable. Hence, the auditor owes a duty of care in tort if there
is privity between the parties. In order to prove this, the third party is required to prove to the
court the existence of ‘special relationship’ and sufficient degree of proximity between the
auditor and himself, and the auditor knew that the statements would be communicated to the
third party. In Re Esanda Finance v Peat Marwik Hungerfords, the court held that the
existence of special relationship in addition to reasonable forseeability of loss is vital in
proving the economic loss.
Reasonable forseeability of the loss
The third party has to prove it was reasonably foreseeable not just the audit client but also the
third parties would rely on the statement made by the auditor. The decision given by Lord
Denning in the case of Candler v Cranes Christmas and co is relevant wherein it was held that
the auditors prepare reports for client knowing very well that those reports are going to be
used to persuade the third party to adopt a certain cause of action. The onus is on the third
party to prove that upon reliance on such reports suffered economic loss.
I agree with the fact that the auditors have a duty towards the parties who rely on the
statements made by the auditor. The investors often rely on the statements made by auditor to
understand the creditworthiness and financial health of the company before making
investments. There is a corresponding duty on the part of the auditor to take adequate care
and caution while making such reports. Hence, they are accountable to the third parties for
their statements reports. Hence, the auditors owe a duty towards the third party, and can be
made liable for their inaction, negligence and fraud.