Legal Issues Regarding Company Constitution And Shareholding Restructuring

Case 1: Gosh Pty Ltd and Oh My Pty Ltd

1. Sammy and Huw met whilst studying an IT degree and have just graduated. Together they have come up with an idea for a subscription business providing highly entertaining podcasts and interviews using a new ‘app’ that they have designed for smartphones. Rather than sell the app to Apple, Google or Samsung, they decide to start a company (which they want to register with the name “Gosh Pty Ltd”) to market and sell the app to end-users.

Huw, keen to get started, approaches Gracey who is a well-known Australian radio host. Huw negotiates a contract on behalf of Gosh with Gracey for the exclusive supply of a weekly podcast to their new company. The contract is signed by both parties on the 20th April 2018, and provides that Gracey is to be paid a fee of $4,000 per month for the period of one year for the provision of weekly podcasts.

When Sammy and Huw go to register Gosh Pty Ltd on the 1^st of May 2018, they discover that there is already a competitor company that has registered that name. As such, they register the company Oh My Pty Ltd instead. Oh My Pty Ltd adopts a constitution and Sammy and Huw are listed as the two company directors. Oh My then enters into an employment contract with Amaya to act as the company’s accountant. Sammy and Huw each hold 45% of the company’s shares and Amaya is given a 10% shareholding.

On the 10^th of May 2018, Sammy and Huw convene their first directors’ meeting. Sammy is pleased to hear that Huw has already managed to sign a contract with Gracey for her weekly podcast and they begin paying the $4,000 monthly fee.

On the 1^st of July 2018 Sammy and Huw find out that Amaya has just accepted an accounting position with their competitor Gosh Pty Ltd and is trying to encourage

Gracey to provide her podcasts to Gosh instead. Sammy and Huw immediately call a members’ meeting and pass a resolution that alters Oh My’s constitution to provide that directors may determine that the company can buy back shareholdings of less than 11% at their discretion. Oh My also refuse to continue to pay Gracey her monthly fee.

a. Amaya, what the process for altering a company constitution is, and whether she can prevent the inclusion of the clause allowing the directors to expropriate her shares?

b. Gracey, what recourse, if any, she has for the non-payment of her monthly fee for the remainder of her one year contract?

2. Drink It Up Pty Ltd is a company that is involved in two businesses: the bottling and marketing of spring water, which is very profitable, and the production and marketing of organic fruit juices which has been making a loss. The directors of the company are Kristofer, Aida and Jaden. Kristofer owns 40% of the shares in the company and Aida and Jaden owning 20% of the shares each. The remaining 20% of shares are owned by five outside investors (Dhruv, Rose, Neve, Timur and Jean-Luc).

Drink It Up has been having financial difficulties, with a number of outstanding payments to creditors—particularly those that supply the fruit juice business. At a board meeting on the 1^st of July 2018, Kristofer proposes a resolution to incorporate a separate company, H2O Pty Ltd and to transfer the profitable water business to this company. The resolution is unanimously passed.

On the 7^th of July 2018, H2O Pty Ltd is incorporated, the assets related to the springwater business are transferred to it and all customers and suppliers are updated with the new details.

On the 3^rd of July, Kristofer had been approached by Dhruv who had asked if he could purchase additional shares in Drink It Up Pty Ltd. Kristofer agreed to sell him an additional 5% of the shares himself, and they completed the transaction on the 5^th of July.

Upon application by creditors who had not been paid, the court orders that a liquidator be appointed and Drink It Up Pty Ltd be wound up in insolvency. Lily-Mae is then appointed as liquidator.

a. Lily-Mae whether the directors of Drink It Up Pty Ltd have breached s181 of the Corporations Act 2001 (Cth) or their equivalent equitable duties and what penalties or remedies might be applicable; and

b. Dhruv whether he has an action against Kristofer for breach of directors’ duties for selling him the shares in Drink It Up Pty Ltd just before it was going into

The provisions related to the way in which the constitution of a company can be altered are provided through the Corporation Act 2001 (Cth). The constitution is the main document which sets out the relationship of the members with the company, third parties and between members. There is a specific procedure to be followed for altering the constitution which has been provided under s 136 of the Act.

It has been provided through s 136(2) of the Act that the constitution of a company may be repealed or modified through passing a special resolution. It has been further stated by s 136(3) of the CA that it may be provided through the constitution that there would be no effect of a special resolution unless a requirement which has been specified in the constitution in relation to its modification or repealing has been met. Under s 136(4) it has been further clarified that unless a contradiction is provided by the constitution the organization would be able to repeal and modify the requirement mentioned in s 136(3) if the requirement has been itself satisfied.

However, in the case of Gambotto v WCP Limited, the courts had limited the right of the majority shareholders to alter the constitution in relation to expropriation of shares. It was stated by the court in this case that the alteration of the constitution to expropriate shares of the minority would be valid only if it is done for a proper purpose and it would not be oppressive to minority shareholders. In this case it was further clarified by the court that expropriation of share is allowed when the minority share holding act in a way which is detrimental for the company or the minority is competing with the organization. The alteration would not be allowed if the directors are doing it to take commercial advantage for themselves.

The first requirement for alteration of a constitution under s 136 is that it requires a special resolution. Special resolution means voting by 75% of the shareholders of the company. In this case Sammy and Huw hold 90% of the shares in the company and thus have the capacity of passing a special resolution to alter the constitution under s 136(2). In addition there is no requirement which is provided through the facts which could prevent the alteration of constitution under s 136(3) and 136(4). Thus the alteration is valid under the CA. However the application of Gambotto v WCP Limited is also required to analyze the validity of the alteration done by Sammy and Huw. It has been provided through the facts that the alteration is being done in relation to the expropriation of shares of those who have less than 11% holding and in this case it is Amaya.

The court stated in this case that expropriation would only be valid if it is done for a proper purpose and it would not be oppressive to minority shareholders. In this case it can be stated that it is oppressive to Amaya who is a minority share holder. However, the court further clarified that fact that expropriation of share is allowed when the minority share holding act in a way which is detrimental for the company or the minority is competing with the organization. In the present situation it is provided that Amaya is also acting as the accountant for the competitors of the company. She is also trying to get Gracey to take the podcasts to the other company she is working for. Thus, it is clear that she is competing with the company and the alteration of the constitution would therefore be valid.

Case 2: Drink It Up Pty Ltd

The provisions related to contract before registration are dealt under the rules of s 131 of the Corporation Act 2001 (Cth). It has been stated by s 131(1) that if a person has formed or intends to form a contract for the benefit of or behalf of the company prior to its registration, the company is bound to the terms of such contract and is entitled to the benefits if a company or a company which is identifiable reasonably with it ratifies the contract. The ratification has to be within a time which the parties to the contract have agreed or a reasonable time if there is no agreement.

Further, under s 131(2) it has been clarified by the CA that a person would be liable to compensate to every other party to the pre-registered contract in case the company does not ratify the contract within the specified or reasonable time, or if it does not get registered. The compensation amount would be the amount which the company would have to pay in case the contract was ratified by the company and was not performed.

In case there is a proceeding which has been brought in relation to s 131(2), the court has the power if it is identified that the although the company has been registered it is not ratifying the contract or has gone into a substitution if it, to do anything which it considers to be apt in the situation under s 131(3). This may include paying all or part of damages which the person is liable to pay, return the property received under the contract and pay compensation to the party to the contract.

In addition under the provisions of s 131(4) in case a company has ratified a preregistration contract and is not able to perform it as a whole or in part, the court may order the person to pay the damages which the company is required to pay.

The facts of the case stipulate that Huw has formed a contract with Gracey under which Gracey is to be paid with $4000 every month for a one month period in relation to provisions of weekly podcasts. This has been done on 20th April 2018 and was on behalf of Gosh. Unfortunately the name Gosh was not available and the company had been registered in the name of Oh My Pty Ltd. This means that Oh My Pty Ltd is a company which is reasonably identifiable with Gosh. The contract has been formed before the registration of the company and thus it is a pre registration contract under s 131. If a person has formed or intends to form a contract for the benefit of or behalf of the company prior to its registration, the company is bound to the terms of such contract and is entitled to the benefits if a company or a company which is identifiable reasonably with it ratifies the contract as per s 131(1). However Oh My Pty Ltd have not ratified the contract.

This means that under the provisions of s 131(2) Huw may be asked to compensate Gracey as there is no ratification which has been done on the situation and Gracey decides to make a claim. Further the application of s 131(3) would signify that if Gracey makes a claim the court may ask Oh My Pty Ltd to pay all or part of damages which Huw is liable to pay to Gracey or return the property received under the contract and pay compensation to Gracey. In addition, under s 131(4) the court may also ask Huw to compensate Gracey if it is identified that Oh My Pty Ltd have ratified the contract with Gracey and have breached the contract.

There have been various duties imposed on directors by the operation of common law and Corporation Act 2001 (Cth) these duties can be divided in statutory duties and general duties. Under common law there is a duty that the directors act in good faith and for a proper purpose ensuring the best interest of the company. These duties have been incorporated into the CA through the rules of s 181.

The duty is in relation to good faith of directors and other officers. Under s 181(1) a director or officer of a company has to exercise powers and discharge duties for a proper purpose and in good faith towards the organization’s best interest . The breach of this section results in civil penalty provisions which are provided through s 1317E of the Act .

The provisions of breach of section 181 had been discussed in the case of Kinsela v Russell Kinsela Pty Ltd (in liq) . In this case the court stated that the best interest of the company generally does not include taking into consideration the interest of the shareholders. However, when the company is approaching insolvency or is insolvent the interest of the creditors have to be considered. In addition it was stated in the case of Whitehouse v Carlton Hotel Pty Ltd that the powers which are used by the directors must only be for an intended purpose. In case the action is not considered to be of a proper purpose by a reasonable person then also the court can identify the breach of this section as held in the case of Bell Group Ltd (in liq) v Westpac Banking Corp (No 9).

In the present situation it is provided that the directors of Drink It Up Pty Ltd have decided to form a new company as they are facing losses with respect to the their fruit juice business and making profit in relation to the spring water business. All assets in relation to the spring water as been passed to the new company named H2O Pty Ltd. This has been done to avoid financial difficulties which Drinks was subjected to in relation to paying its creditors in the fruit business. Under s 181 the directors have to act for a proper purpose and in good faith towards the organization’s best interest. In this situation a proper purpose may be identified objectively by the court as per the case of Bell Group Ltd (in liq) v Westpac Banking Corp. Any reasonable person would not feel that the act is for an intended purpose, as asked by the case of Whitehouse v Carlton Hotel Pty Ltd. This is a clear attempt to defraud the creditors on the part of the directors. This action would also not be considered to be in the best interest of the company under the provisions of the case of Kinsela v Russell Kinsela Pty Ltd. The company Drinks have been subsequently wound up and it can be clearly stated that the actions which had been entered upon by its directors to divide the company was for an improper purpose and also not done in good faith for the best interest of Drinks. Thus s181 have been breached by the directors of the company. They would have to pay fine under s 1317E extending up to $200000 or may be banned from managing the company under s 206C

In the case of Percival v Wright it had been stated by the court that the directors of the company only have general duties imposed on them in relation to the company as a whole and not to individual shareholders. In this case the directors purchased shares from the shareholders who wanted to sell the shares at a lower rate before selling the company which would make the price of the shares high. The court held that there was no breach of duty on the part of the director as they do not owe duties to individual shareholders.

However, this decision had not been followed by the court in the case of Coleman v Myers . In this case it has been stated by the court that the directors have a fiduciary obligation to the shareholders under which they are required to disclose all material facts in relation to an offer which can change the mind of the person to get into the transaction. This situation had been further discussed by the courts in the case of Peskin v Anderson . In these case it was stated by the courts that the there is an exception to the general rule provided in the case of Percival v Wright. This would take place when the situation is such that a greater duty is owed to the individual shareholder by the directors in situation where it is visible that the shareholder is putting reliance on the directors for guidance or when he shareholder is a vulnerable person.

Further, it is provided under s 588G that the directors should not indulge into trading when they know that the company is insolvent. In case they have indulged into a conduct which can be considered as insolvent trading they can also be personally liable for the losses incurred by the investor.

Whether Kristofer have breached directors duties or not would depend on the fact that whether he owed any duty individually to Dhruv. The application of the case of Percival v Wright in this situation would clarify the fact that the directors of the company only have general duties imposed on them in relation to the company as a whole and not to individual shareholders. Here also the facts of the case where similar to the facts in hand. In this case the directors purchased shares from the shareholders who wanted to sell the shares at a lower rate before selling the company which would make the price of the shares high. No duty was indentified in this situation. Thus, in case of Dhruv and Kristofer also the court would hold that there is no individual duty owner. However there have been contradictory rulings made in the cases of Coleman v Myers and Peskin v Anderson providing exception to the general rule. The exception applies when it is visible that the shareholder is putting reliance on the directors for guidance or when he shareholder is a vulnerable person. However the facts provided through the case study does not depict any such reliance put by Dhruv on Kristofer. This would signify that the exceptions provided in Coleman v Myers and Peskin v Anderson cannot be applied in the present situation. Therefore, Kristofer was not required to disclose to Dhruv that the company is going to be insolvent.

Thus, it can be stated evidently that Kristofer did not individually owe any duty to Dhruve and no duty has been violated.

Bell Group Ltd (in liq) v Westpac Banking Corp (No 9) (2008) 225 FLR

Coleman v Myers [1977] 2 NZLR 225

Corporation Act 2001 (Cth)

Gambotto v WCP Limited [1995] HCA 12

Kinsela v Russell Kinsela Pty Ltd (in liq) (1986) 4 NSWLR 722

Percival v Wright [1902] 2 Ch 401

Peskin v Anderson [2001] BCLC 372

Whitehouse v Carlton Hotel Pty Ltd (1987) 162 CLR 285