Timely reminder of directors’ duties

Business

In the recent case of Morgenstern v Jeffreys, the Court of Appeal dismissed an appeal against a High Court ruling that Morgenstern had breached his duties as a director by selling all of the shares in Morning Star Limited to Morning Star Enterprises Limited (in liquidation) for $3.5 million.

In the recent case of Morgenstern v Jeffreys [2014] NZCA 449, the Court of Appeal dismissed an appeal against a High Court ruling that Morgenstern had breached his duties as a director under sections 131, 135 and 137 of the Companies Act 1993, by selling all of the shares in Morning Star (St Lukes Garden Apartments) Limited (MS St Lukes) to Morning Star Enterprises Limited (in liquidation) (MSE) for $3.5 million. 

Background

The purpose of the sale was to enable Morgenstern, who was the sole shareholder and director of MSE, to repay his overdrawn current account with MSE.  It was held that the consideration for the shares in MS St Lukes was excessive.  MSE, which was already in serious financial difficulties at the time of the transaction, failed within a year of the transaction, owing several million dollars to creditors.

Summary of Law

The Court of Appeal summarised the law relating to directors’ duties, saying:

“There is no dispute that the duties imposed on directors by ss 131, 135 and 137 are owed to the company and require directors to act in the best interests of the company.  A director must not put his or her personal interests ahead of those of the company.  The duties arise regardless of the size of a director’s shareholding and role in the company.  They apply even if the shareholding is 100 per cent.  It is also well established that, at least when a company is in financial difficulties, the duties extend to a requirement to take into account the interests of the company’s creditors.”

The Court went on to say:

“The existence of these duties means that where there is a transaction between a director and the company there is likely to be a conflict of interest between the director’s personal interests and the separate interests of the company.  Unless the transaction is for “fair value”, the company may avoid it within three months.  If a director seeks to uphold the transaction, the onus of establishing fair value is on the director.  Similarly, a director involved in such a transaction who wishes to avoid breaching the director’s duties to the company will need to be able to satisfy a court that the transaction was for fair value.”

Morgenstern had an obligation to ensure that MSE paid a fair value for his shares in MS St Lukes.  Morgenstern had not obtained an independent valuation for the shares and, as a result, he was held to have failed to discharge his onus of proving that the shares were purchased for fair value.

Section 131: Duty to act in good faith and in the best interests of the company

The Court held that Morgenstern had clearly failed to act in good faith and in what he believed to be the best interests of MSE.  The Court was satisfied that the evidence supported the findings that Morgenstern did not honestly believe the sale of shares to be in the best interests of MSE and that his dominant purpose was to avoid exposure to a claim for recovery of his current account.  The following factors were taken into account by the Court:

  1. The sale of shares was a related-party transaction in which Morgenstern was under a conflict of interest;

  2. The transaction was solely for his own personal benefit;

  3. No consideration had been given to the interests of MSE; and

  4. No independent share valuation had been obtained.

Section 135:  Duty not to allow reckless trading

The Court held that Morgenstern clearly engaged in reckless trading.  In the circumstances that existed at the time of the transaction, the purchase of the shares by MSE was likely to create a substantial risk of serious loss to the company’s creditors.  Further, the transaction amounted to reckless trading because it had the potential to cause the demise of MSE.  The fact that MSE failed within a year of the transaction served to confirm how reckless the transaction was.

Section 137:  Directors’ duty of care

The Court held that Morgenstern had clearly breached the duties of care, diligence and skill that a reasonable director would have observed in the circumstances.  In the Court’s view, no reasonable director would have proceeded with this transaction, which was clearly only in the interests of Morgenstern himself.

Relief

The power of the Court to order relief for a breach of directors’ duties under sections 131, 135 and 137 is contained in section 301(1) of the Companies Act 1993.  Section 301(1) allows the Court wide discretionary powers, including that it may order the person to:

“repay or restore the money or property or any part of it with interest at a rate the court thinks just; or

contribute such sum to the assets of the company by way of compensation as the court thinks just”.

The Court held that the “restitutionary” approach to relief under section 301(1)(b) was suitable.  The appropriate amount of compensation was the company’s actual loss; that is the amount required to put the company back into the position it would have been in but for the transaction.

MSE was balance sheet insolvent at the date of the transaction and it incurred a “but for” loss of $3.5 million due to the share transfer.  The Court found no reason why Morgenstern should not be ordered to repay the full $3,499,999 (being the purchase price of $3.5 million less the sum of $1.00, for which the shares were subsequently sold to another party).

Conclusion

While the decision is not especially surprising or controversial, it serves as a useful reminder to all directors of companies to be mindful of their duties as directors, especially when there is or may be a conflict of interest involved.  In particular, where any director is considering a related-party transaction involving the company, such transaction must be for “fair value” and it would be prudent to obtain an independent and expert valuation of the relevant property, prior to entering into the transaction.

For further information on directors’ duties, please contact a member of our Business Team at Cavell Leitch.  Our Business Team members are experts in all aspects of legal business advice and compliance and are more than happy to discuss any questions you may have.

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