In our previous case note, we discussed the recent decision of the NSW Court of Appeal, Mualim v Dzelme.[1]  In that case, the Court reversed the transfer of control of a family company from parents to their son (the sole director).  The decision hinged on whether an issue of shares many years earlier by the son to himself was valid.  The result of the share issue was to transfer control of the company to the son.  Before that, the parents had been the sole shareholders and had controlled the company.  On appeal the share issue was invalidated.

The Court had to decide:

Is an issue of shares (for the purpose of transferring control to a director) valid without the prior informed consent from the shareholders?

Mualim confirms that shareholders can approve a transfer of control to a director by giving informed consent prior to the share issue.   Under these circumstances, there is no breach of the directors’ fiduciary duty.

Although not considered in Mualim, we also discuss whether such an issue can be validated by the shareholders after the event (i.e., ratified).  In some circumstances, ratification has the effect of waiving the company’s rights against the directors in respect of that breach of fiduciary duty.

To be effective, both in relation to shareholders giving prior approval and retrospective ratification, it is essential that the consent is fully informed.

Finally, in some limited circumstances, the share issue may still be valid, even without member consent.  There is no breach of fiduciary duty in the following circumstances.

  1. The company constitution expressly permits the issue of shares for the transfer of control.
  2. The directors honestly believed the purpose of the issue was in the interests of the company. However, these cases are rare.  Whether the purpose of issuing shares is proper in a particular case depends on the state of mind of the director and all the circumstances.  The courts will assess those factors to decide whether the issue was made in the best interests of the company or for another reason.

The law: background

Directors’ fiduciary duties and share allotments

Directors have both statutory (legislated) duties and fiduciary (general law) duties, and there is considerable overlap between these.  Statutory duties are set out in the Corporations Act and include (among others) a fundamental duty to act with care and diligence.[2]

Directors’ fiduciary obligations are based on the broad principles of fairness and trust.  Some fiduciary duties include the ‘no-conflict rule’, the ‘no-profit rule’ and the ‘no-misappropriation rule’.  Fiduciary duties exist between the company and the directors (including shadow directors).

The power to issue shares is a fiduciary power.

All acts by a director, including causing the company to issue shares, must be for a proper purpose.  Directors may not issue shares for an improper, extraneous or ulterior purpose.  The purpose of diluting voting power of existing members is ordinarily an improper purpose.  However, there are some limited circumstances in which diluting voting power may be a proper purpose, if it is in the company’s interests.

Proper purpose

The law does not exactly define the purposes for which a share issue is permitted.  Although the most common purpose is to raise capital, this is not the only permitted purpose.  The fundamental question is whether the issue was made honestly and in the interests of the company.

In fiduciary matters, courts are likely to accept the directors’ judgement about the company’s best interests unless there is evidence of oppression or deceit.[3]  The courts acknowledge that complex practical considerations influence how directors exercise their right and duty to make decisions.  The underlying premise is that the directors are aware of what the company’s interests are, and how those interests are achieved.  Therefore the courts will rarely interfere with an exercise of fudiciary power that is authorized by the company constitution, and exercised in good faith and not for irrelevant purposes.

In a separate case, the High Court noted that ‘it is arguable that special circumstances may arise in which the dilution of the voting power of an existing shareholder or group of shareholders or the creation of new voting power may constitute a legitimate purpose to be pursued by directors in the exercise of a fiduciary power to allot shares. Circumstances in which statutory provisions make a particular spread of voting power compulsory or commercially essential are a possible example of the kind of case where that may be so.’[4]

The law applied in Mualim v Dezleme

Is a discretionary issue of shares with informed consent by shareholders valid?

The Court stated in Mualim that, even if the director decision was not made in the best interests of the company, there can be no breach of the fiduciary duty if the principal (in this case, the shareholders) gives informed consent to the issue.  Additionally:

  1. The company constitution must permit or authorize the issue of shares; and
  2. The shareholders’ consent must be informed. Interestingly, many disputes have arisen over the years regarding the adequacy of the consent purportedly given.

In Mualim, the parents alleged that the son’s fiduciary power was exercised fraudulently, the share issue being for an improper purpose, and without their informed consent.  The Court had to determine if, on the facts, the parents had given informed consent.

Informed Consent

Generally, informed consent requires the principal (ie the shareholder) to know all the material facts and circumstances, and to be fully informed of her or his rights.  The disclosure required for consent must reveal the extent and nature of any conflicting interest, or duty, or profitable opportunity.  The information must be delivered in a fashion that is comprehensible to the average commercial person.  Too much information may undermine the efficacy of informed consent.

In this case:

  1. The issue of new shares would dilute the parents’ interest in the capital of the company from 100% to 10%; and
  2. This would result in a change in control of the company, that is, the parents would no longer control a general meeting of the company.

… and consent must be documented

Because the share issue occurred in 2004, questions of proof and evidence were important in Mualim.  The lower Court had decided that the burden of proof lay with the party alleging fraud (ie the parents).  However, the parents had very little documentation of transactions between them and the company.

In contrast, the Court of Appeal noted that the company had a responsibility to maintain records documenting consent to such an important transaction.  Particularly given the son’s usually diligent record-keeping in his role as company director, the lack of company documentation to prove the parent’s informed consent was considered significant.

As we discussed in our earlier case note, companies should keep timely and accurate minutes of meetings and resolutions, in a minute book, to ensure that the minutes are valid.  In Mualim, the minutes did not comply with the Corporations Act provisions.  Therefore, the minutes, although accepted as a type of evidence, were not presumed to be accurate.

As a result, the Court found that there was insufficient evidence to support a finding that the parents had given informed consent to the discretionary issue.

Is a discretionary issue valid without informed consent at the time?

When an issue of shares takes place without members’ prior consent, the issue may be valid if:

  1. the constitution permits the issue. If the constitution expressly authorises a share issue for the relevant purpose, this authorisation by the constitution will be sufficient; or
  2. If the constitution only generally confers the fiduciary power of issue on the directors, another element is required. Namely, in addition to the constitution not prohibiting the issue, there must also be one of the following:

a)the directors honestly believe the issue is in the best interests of the company (ie there is no breach of fiduciary duty; the issue is for a proper purpose); or

b)(in limited circumstances) the members ratify the issue (ie ratification of a breach of duty).

The company constitution

The company’s constitution may expressly permit a director to exercise a power (e.g. to issue shares) for personal gain, or for altruistic reasons that do not benefit the company.  However, the constitutional permission must be express.  A director cannot ordinarily allot shares to dilute the voting power of existing shareholders, or to maintain company control by the directors or associates.

The 1986 High Court decision referred to earlier noted that a constitutional provision conferring ‘all power of directors’ did not indicate that the director was intended to be ‘free of the restraints of the exercise of a fiduciary power’ to allot shares.  However, the Court stated that it ‘may be assumed that the [Constitution] of a company could be so framed that [it] conferred upon a governing director authority to exercise a power to allot shares for the purpose of diluting the voting power or other rights of existing shareholders’.[5]  As above, this would be rare.

Improper purpose:  Member ratification of a share issue that is a breach of fiduciary duty

Ratification ideally is obtained at a general meeting of the company’s members.  For ratification to be effective, companies should scrupulously follow procedural requirements (eg, issue of Notice of Meeting, 21 days notice, agenda distributed).

The Notice of Meeting must set out:

  1. the nature of the share issue;
  2. how that issue is a breach of fiduciary duty;
  3. that the directors seek to be absolved from that breach;
  4. that at the meeting shareholders will be asked to authorize the breach and waive the consequences;
  5. the rights of the company against the directors based on that breach of duty; and
  6. that the effect of ratification is to waive those rights.

Take away messages

Members can, in some cases, approve an issue of shares for an improper purpose, or ratify a previous share issue that has breached a director’s fiduciary duty, including, in some cases, an issue of shares to effect a transfer of company control.

Members cannot approve or ratify a decision that breaches a statutory duty, or a decision that is contrary to the company’s constitution.  However, a company’s constitution may expressly permit an issue of shares to transfer company control.

In cases where member approval or ratification is required, a key issue is that the members must give informed consent.  To ensure consent is informed we recommend:

  1. Independent valuations. We recommend that compensation offered to members is based on independent valuations, and members are given full access to all valuations.
  2. Full disclosure of the surrounding circumstances. Disputes have arisen when, following a valuation agreement by shareholders, a major contract has been announced.
  3. Timely, accurate minutes, kept in a minute book, that document all meetings, declarations, resolutions and proceedings.
  4. General meetings to geive the necessary approval conducted strictly in accordance with provisions in the Corporations Act.
  5. Records kept of the information (content and mode of delivery) made available to members; including question raised by members, and responses to those questions.
  6. Documentation of members’ consent.

[1] [2020] NSWSC 1240.

[2] Corporations Act 2001 (Cth) s 180(1).  For example, in relation to the share issue in Mualim, there was no breach claimed of the director’s statutory duty of care and diligence.  The son executed the share issue with care and diligence, documenting the share issue, notifying ASIC and updating the share registry.

[3] In contrast, when the courts are assessing a potential breach of a statutory duty, there is relatively greater scrutiny of directors’ reasoning, and a requirement of evidence to support decisions made by directors.  For this reason, meticulous records keeping is always advised.

[4] In Whitehouse v Carlton Hotel Pty Ltd (1987) 162 CLR 285.

[5] Whitehouse v Carlton Hotel Pty Ltd (1987) 162 CLR 285,295.

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This article is for general information purposes only and does not constitute legal or professional advice.  It should not be used as a substitute for legal advice relating to your particular circumstances.  Please also note that the law may have changed since the date of this article.