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Section 131: Duty of Directors to Act in Good Faith and in Best Interests of Company

Wednesday, September 20, 2017
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. 

____________________________

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

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