Not so Nice Cream – Directors' duties and "successor" director appointments

A recent NSW Supreme Court decision demonstrates that shareholders should carefully monitor not just the operations of a business, but the corporate governance and shareholding arrangements also, and raise (and hopefully deal with) any issues as soon as possible. The case also highlights the need for successor director appointments to take place while there is a valid power to appoint those successors.

Nice Cream: a family and its company suffer a loss

Gani and Jorida Mualim and their son Dean incorporated Pacific Springs Pty Limited and acquired "Nice Cream", an ice cream manufacturing business. Dean's de facto husband, Ricards Dzelme, was involved in the Pacific Springs business.

Initially, Gani and Jorida each held 100 ordinary shares in Pacific Springs and Dean was appointed the sole director and secretary. In 2004, Dean allotted to himself 1,800 ordinary shares, making him the majority shareholder of the company. Dean died in 2018, following which Ricards was appointed as executor and trustee of Dean's will and a director of Pacific Springs, and inherited Dean's shares in Pacific Springs.

In 2018, Gani and Jorida sued Ricards and Pacific Springs (In the matter of Pacific Springs Pty Limited [2020] NSWSC 1240). While there were a number of issues raised at trial, the arguments on the matters relating to directors' duties, and the appointment of directors, centred around the validity of:

• Key issue #1: Dean, as director of Pacific Springs, issuing 1,800 shares in Pacific Springs to himself; and
• Key issue #2: the appointment of Ricards as a director of Pacific Springs after Dean's death.

Key issue #1: A director issuing shares in the company to him or herself

Gani and Jorida argued that the 1,800 shares were issued for an improper purpose: to gain control of Pacific Springs. As a result, the company's register of members should be corrected under section 175 of the Corporations Act 2001 (Cth).

The Court asked two questions to determine whether Dean exercised his fiduciary duties for an improper, extraneous or ulterior purpose:

1. First, as a matter of law, what is the purpose for the power to issue shares? As part of this, the Court considered:
   
   
   • whether the issue of shares was made honestly, in the interests of the company, and whether there was any evidence of an injustice (for example, deceit or oppression);
     
     
   • whether the purpose to allot the shares was to defeat the voting power of existing shareholders by creating a new majority, or to dilute the voting power held by an existing shareholder or group of shareholders; and
     
     
   • that, while the power to allot new shares is primarily to enable capital to be raised, it is too narrow to say that the only valid purpose to issue shares is to obtain new capital, with various occasions where directors may fairly and properly issue shares for other reasons that benefit the company as a whole.
     
     
2. Second, as a matter of fact, what was the purpose for which the power was exercised? Here the Court is concerned with the state of mind of the director, which is informed by the surrounding circumstances.

Ultimately, the Court determined that Dean had the power under the Constitution to issue the shares, and this was done with the knowledge and consent of Gani and Jorida (as shareholders in Pacific Springs, to whom the fiduciary duties were owed) and so was valid.

Key issue #2: Appointing a new director via, or as a result of, a will

The Constitution of Pacific Springs contained provisions that enabled a director or the shareholders to appoint directors, with all acts done by "by any person acting as a director" [emphasis added] being valid. The Court determined that:

• the office of director is personal to a director, vacated on the director's death and cannot be "handed down" as personal property under a will or exercised by a director's attorney; and
  
  
• Dean appointing Ricards as a director with the appointment taking place after Dean's death, meant that Dean did not have the power under the Constitution to appoint Ricards. That is, once Dean died, he was not a director and could not appoint another person as director.

Therefore, Ricards was not validly appointed as a director of Pacific Springs pursuant to either Dean's will or the Constitution.

The question then became whether the Court should make an order under section 1322 of the Corporations Act to cure this irregularity. This required the Court to be satisfied, amongst other things, that any one of the following conditions were met:

• the matter was essentially of a procedural nature;
  
  
• Ricards acted honestly in being appointed as a director of Pacific Springs (and relevant to this is whether proper and competent expert advice was sought, and whether Ricards acted without deceit or conscious impropriety); or
  
  
• it is just and equitable that the order be made,

and that no substantial injustice has been or is likely to be caused to any person by granting the order.

The Court decided to make the order because:

• the appointment of Ricards was made on the advice of Pacific Springs's accountant when Ricards was the executor named in Dean's will, the beneficiary of Dean's estate and therefore soon to be the majority shareholder – essentially, Ricards acted honestly; and
  
  
• it was just and equitable to make the order, and no substantial injustice would arise from that order – there was no evidence that Ricards acted in any untoward way in his role as director, Ricards was a long-serving operations manager supported and advised by the company's professional accountants, lawyers and staff, the minority shareholders had never taken a role in the business and lived overseas and calling a meeting of shareholders would have inevitably resulted in the appointment of Ricards, with no particular benefit to be gained from the time and cost involved in that process.

What does this mean for you?

This decision puts shareholders on notice that they should monitor not just the operations of a business, but the corporate governance and shareholding arrangements also, and if any issues arise, such issues should be raised (and hopefully dealt with) as soon as possible.

From a director succession perspective, the case also highlights the need for successor director appointments to take place while there is a valid power to appoint those successors – for example, appointments could be put in place at the time that the succession plans are agreed. Otherwise, as demonstrated here, there is a risk that, over the passage of time, irregularities may arise because at the time the succession is intended to occur, there is no valid power to appoint successor directors.