Need to Answer The Questions Based on The Business Laws?

Requirement

Question 1: Dilara and Aysha have inherited a winery from their Great Grandfather Ankit, called “Ankita”.  Dilara and Aysha have continued to run the winery as a going concern.  They share profits equally.  As the years progressed, it had become apparent that Dilara and Aysha did not have enough working capital to keep the winery going.  In addition, given Great Grandfaher Ankit was rather old and liked “old things”, the winery became run down, and large amounts of money need to be spent to restore the winery.
Dilara and Aysha are approached by Polat, a well-known French winemaker, who wishes to buy part of the Ankita Winery and work there as a chief winemaker.  
Dilara and Aysha are excited as both Polat’s money and expertise are desperately needed at Ankita.  Dilara and Aysha visit your office and ask your legal advice as to: 
a)    what type of business organisation are Aysha and Dilara currently operating; and                                                                                               
b)    whether their current business structure is the most suitable vehicle for selling part of the Brothersglen Winery to Polat or whether they should consider another form of business structure, and, if so, which one? 

Answer: The Ankita Winery is currently a general partnership firm run by two partners, Aysha and Dilara who are involved in the business on day to day basis. They have equal rights, duties and liabilities in their discharge of duties, including the right to make decisions, sharing of profits, and administrative matters.  Their business model fulfils all the essential elements of a partnership firm explained under Section 5 of the Partnership Act, 1958, and includes the following features as mentioned herein below:

  1. •    Both Dilara and Aysha are involved in the business and have equal interest and participation in the business.

  2. •    Both have an intention to run a profitable business

  3. •    Both have equal share of profits

  4. •    Both having contributed time, talent and money and sharing of management responsibility

  5. •    Both are keen to build a profitable entity.

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After the decision was made to sell a part of the business to Polat in lieu of the services provided by him, it is wise to convert the existing partnership firm into a Proprietary Limited “Pty Ltd” company, with Dilara Aysha and Polat being the shareholders. The company will continue to be managed by the three directors, all of whom have set responsibilities in their area of expertise. The need to form a company in this case arises for the following reasons:

  1. Ease of raising finance:  Raising finances through private investors or placement or equity infusion is easier in case of companies. Since Ankita has long been facing cash crunch, raising capital will help clear the past dues, as well as help deployment of cash effectively. A proprietary company can raise investment from prospective investors, bankers etc.

  2. Better access to talent, and resources: With the capital available, Ankita can have access to better talent and resources. Since Ankita is inclined to stabilize the existing business and improve business prospects, company formation is a preferred model.  

  3. Easy transfer of share: Since, Polat is a prospective shareholder of the company, x amount of shares can be transferred to him while the others can be retained by Aysha and Dilara. In case of any prospective investor, some more shares can easily be transferred without any legal or administrative hassles

  4. Why should Ankit choose company over a partnership?

  5. Ease of Taxation: While the partnership requires the partners to show their effective control over the assets, liabilities and profits emerging out of business, proprietary companies enjoy tax advantages in addition to limited liability.

  6. Better credibility:  as compared to a partnership. This will create a better image for the company in the eyes of the potential customers, bankers, investors and suppliers.

  7. Limited Liability: While in a partnership, each of the partners are equally responsible for the debts, in a Pty, the liability of the shareholders is limited to the share capital they have subscribed and the debts to which they have personally subscribed. The personal assets of the shareholders are not under threat if the company incurs financial losses and debts.

Proprietary company is governed under the provisions of Section 45A of the Corporations Act, which includes proprietary companies as well as the entities which convert themselves into proprietary company under the Act.  Process of registration of proprietary company is relatively simpler and can be made under Section 118 or 601 BD. Ankita Winery can convert into a proprietary company under Part 2 B7 of the Corporation Act, 2001

Question 2: Leo purchased two shares in Thomas The Tank Engine Pty Ltd for $500,000 in total.  Thomas The Tank Engine Pty Ltd makes and builds trains which they manufacture and sell to retail stores.  Leo, now a non-executive director of Thomas The Tank Engine Pty Ltd, is unhappy with the state of affairs of the company.  The following occurred:Thomas The Tank Engine Pty Ltd revenue has increased 300% Leo has received no dividends to date and Ruby and Amanda, the two executive directors of Thomas The Tank Engine Pty Ltd, have decided to pay no dividends this year.  Ruby and Amanda have voted themselves a large pay rise and bonus.  Ruby and Amanda have arranged for Thomas The Tank Engine Pty Ltd to lease two expensive cars for their exclusive use.  Leo attends his first directors’ meeting and questions the dividend policy and asks that he objection to the lease of the cars be recorded. Amanda and Ruby decide to remove Leo from the board.  They hold a members’ meeting and remove Leo from the board.  
Advise Leo as to his rights as a shareholder/member.    

Answer: Issue-Whether Amanda and Ruby are engaged in commercial unfairness and engaged in the acts of unjust enrichment and oppressive conduct against minority share holder? Whether Leo in this status as a minority shareholder, entitled to relief under Section 233 of the Corporations Act? Whether the due process has been followed for Leo’s removal from office under s 249 and s 203(C) has been complied with? What are the remedies available to Leo?
Principle:
Section 232 of the Corporation Act is relevant to the point of unfairly, discriminatory act against a shareholder caused by the abuse of power and control over the company in bad faith. Leo should therefore rely on this provision of the Act by stating that the Company directors have acted in the manner which is oppressive against him as a minority shareholder. In order to prove his point, Leo has to take the following grounds

  • 1.    Refusal to consider payment of dividends despite the company making substantial profits.

  • 2.    Application of company funds to benefit the directors such as opting to lease two expensive cars for their exclusive use.

  • 3.    Use of funds to the benefit of the majority by enriching themselves through excessive raises and bonuses. 

  • 4.    Removal of  Leo from the board arbitrarily

In re Roberts v Walter Developments & Ors(1997) 15 ACLC 882, the conduct of the majority shareholder included failure to pay dividends, failure to consider the legitimate requests of the minority shareholder and refusal to give him access to the company records. Although, it must be noted here that the, the lone act of not paying dividend does not amount to oppression, the relevant facts such as the directors paying huge raises and bonuses and extravagance to themselves have to be considered.  The case of Shamshallah v CBD Refrigeration and Air conditioning Services Pty Ltd., is relevant to this point, to the extent that though there has been significant jump in revenues, the dividend track record has not been good. There is no oppression meted out only because the executive directors have decided to reward themselves with substantial increase in salaries. But when the same is done in bad faith, it results in commercial unfairness and oppression. 
Leo’s dismissal from office under s 203C(a) of the act had to be made after the directors are satisfied that they have complied with all the formalities. A director cannot be compelled to resign where he has been appointed by ordinary resolution under s201(G). Although in the present case, we are not clear as to the constitution of the company allows them to do so, but the statutory norms prescribe that fair procedures have been followed after taking into account the unfair dismissal laws and natural justice requirements. In the present case however, it is evident that Leo has not been accorded a chance to defend himself or giving him a chance to speak. Such removal is arbitrary, unjust and against the principles of natural justice and equity. 

Remedies

Leo can approach the court for remedy under Section 233 of the Act, for action against Amanda and Ruby and contrary to the interests of the shareholder. The breach of duties by the performing directors have given rise to the Leo’s rights Although the best remedy here is to seek an order from the court for the buying of his shares at a price determined by the court, there are a number of other legislative remedies to which Leo is entitled to, that include:

  1. •    He can seek for the winding up of the company

  2. •    He can bring about legal proceedings and seek an order of injunction restraining the directors from removing him as a shareholder.

  3. •    Bringing an action against the existing directors and exercise his right as a director of the company, having access to the books, dividend as well as other legitimate entitlements. 

  4. •    He can seek alternative and equitable relief by appointing an arbitrator to arrive at a solution acceptable to both the parties. This includes a relief whereby Amanda and Ruby could buy his shares at a fair price, as per the current valuation. 

Other reliefs available to Leo include:

  • -Filing a suit for breach of duties on the directors under the Corporations Act. The act prescribes four basic duties for directors under Section 180-183. The directors are expected to carry out their job with due care, diligence and restricted from improper use of position and improper use of information. The breach of duties attract penalty to a tune of $ 200,000 under the Act. 

  • - Leo, in his capacity as a director has a statutory right to access the financial records of the company under s 290. He has a right to access other books of the company under s 198 of the Act. 

  • -   Amanda and Ruby have breached the terms of contract and have failed in their statutory duties as directors and indulging in commercial unfairness. Absence of proper disclosure and misuse of power is actionable under Part 2D.1. 

  • -Leave from the court. In the given circumstances where Amanda and Ruby have acted in an arbitrary manner and in a way which is detrimental to the interests of the minority shareholder, it is unlikely that they would agree to sort the matter amicably with Leo. Hence, he can seek leave from the court under the s 237 of the Act. In order to do so, he must prove to the court that he is acting in good faith and in the best interests of the company. The company on the other hand is unlikely to take responsibility for their actions and inactions. 

Conclusion: Amanda and Ruby are engaged in employee oppression under s 232 of the Act, as well as for the breach of duty in their capacity as directors of the company and therefore can be held liable for their acts. 

Question 3: The board of Tobacco Alp Coffee House Ltd (TACH Ltd), a large coffee bean company listed on the Australian Stock Exchange, which makes the best possible coffee beans in the world, is comprised of three directors, two of whom are executive directors and one of whom is a non-executive director:

  • Vanessa is the managing director of TACH Ltd.  She has been the managing director for 5 years.

  • Kurt is a non-executive director who barely attends board meetings, and is Vanessa’s partner.

  • Erol is an executive director of the board, who has substantial experience in the coffee bean industry, and is also the Chief Financial Officer of TACH Ltd. The board of TACH Ltd has recently entered into a number of investments, including a new coffee bean factory, and some investments which have been losing large sums of money.  At a board meeting in August 2016, the board considered the company’s financial statements relating to the loss making investments.  The financial statements were negligently prepared and showed a profit instead of a loss.  These financial statements were prepared by Erol.

During the board meeting, Erol failed to tell the directors about the loss and Vanessa failed to ask any questions about the financial statements, and Kurt (as per usual) was absent from the meeting.  Due to time constraints, Vanessa failed to read the financial statements, believing that Erol would discuss the statements with him if there were any important matters that required his attention.  
The board of directors do not identify the mistake and authorise further investment in the loss making business ventures.  By September 2016, TACH Ltd is insolvent.

Discuss any liability of the directors of TACH Ltd in relation to these events. What are the consequences, if any of a breach of the Corporations Act? Refer to relevant legislative provisions and case law in your answer.

Answer: Issue: 
Whether Erol breached his duties as the director of the company? Whether all the directors are liable for the inadvertence caused by Erol? What is the role of individual directors in the present case?
Principle
The duties of the directors prescribes that the directors exercise care skill and diligence in exercising their duties under s 180 of the Corporations Act. Similarly there is an obligation under s 232(4) of the Act to exercise reasonable care and diligence to prevent commission of fraud by the company. Besides, the director has a duty to prevent insolvent trading by company under s 588G. Since the directors of the company are expected to discharge their duties with due care and caution, they can be held liable for breach of duties. Besides, they can also be held liable under the Trade Practices Act, 1974, and have to compensate a person who suffers loss through reliance of defective reporting.
 However, in this case since Erol acted in good faith and due to sheer inadvertence, he can claim protection under s 1318 of the Act, which provides protection for company officers against the consequences of a breach for having acted honestly and ought fairly to be excused for negligence or breach. 

Position of individual directors

In her role as the Managing Director, Vanessa is expected to discharge her duties with due care and caution. When TACH incurred losses upon investing in other enterprises, she should have exercised caution in dealings. By entering into uncommercial transaction under s 588F, and failing to take steps to effectively prevent the company from incurring debt, makes her liable for her acts. The standard of care has been explained in the court in the case of AWA Ltd v Daniel, where it was held that the directors of any company are required to take all reasonable steps to monitor the management and functioning of the company. Additionally, they also have a duty to seek professional advice, if need be. 
In her capacity as the MD, Vanessa ought to have taken due care to assess whether the report is correct or not. Secondly, she since she had reasonable grounds to believe that the company is already going through financial stress, she ought to have taken help of external auditor and assessed the figures in detail. This makes her liable for the breach of duty. 
Erol- As a director of the company Erol ought to have exercised his duty with care by revealing the losses of the company. Being the CFO of the company, it is expected that he exercises high level of skill and caution in preparing the financial statements. It is highly unlikely that he did not find an opportunity to communicate to the other directors of the losses. Although it is due to his inadvertence that led to others to believe that the company was making profit, such negligence is not excusable under the act as it is neither reasonable nor is it expected of a Financial officer to make such inadvertence.  He is liable for the breach of duty and is liable to pay damages, if the company decides to initiate legal proceedings against him. Besides, he can also be held liable for damages for misleading conduct, in the event where any third party relies on the statements made in the report.
Kurt- in his role as the director, he ought to take care of the events that take place in the company. Although he is a shadow director, that does not absolve him from his duties. Passive neglect and non participation can be no ground of defence, as has been held in a number of cases. In the case of State wide Tobacco Services Ltd v Morley(1990)8 ACLC 827, the court was held that the director is expected to take intelligent interest in the information with fairness from the executives of the company. In the absence of the reasonable diligence on the part of Kurt, he is equally responsible as the others for the breach of conduct.

Remedies: 

Although in the above case, all the directors can be held liable for their acts; there are certain ways where they could avoid consequences. Here, the directors can take defence by stating that they had acted in bona fide, and without any intention to make enrich them in any way.

  • S 1318 of the Act protects those officers of the company who have acted in good faith and honestly.

  • The directors can also take defence under the business judgement rule under s 180(2) where in, he can state that the judgement was made in good faith and without any material personal interest in the subject matter. This rule therefore gives grounds for directors to avoid liability for breach of duty. 

  • The company can seek indemnification or insurance if they have to pay liability with respect of breach of duty.

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PART B

Question 4: An auditor owes a duty of care to their clients, and not usually to third parties who rely on the auditor’s report.  What is the policy reasoning behind this concept? What must a third party prove in order to be successful in negligence against an auditor? Do you agree or disagree with this concept? Discuss.

Answer: The Doctrine of Fiduciary relationship binds the auditor to the company who appointed him to carry out the statutory duties. The non-statutory duties are what bind him to the company where he has a duty to exercise reasonable care and skill in executing his auditory duties. 

Test for Reasonable care and skill

The test for reasonable care and skill though, is a subjective matter, the same has been explained in the case of Re-London and General Bank, where it is held that he must not certify what he does not believe to be true and therefore must exert reasonable care before he certifies anything to be true. Undoubtedly, the duty of the auditor is an onerous one, where a higher degree of skill, expertise and care has to be exercised in carrying out one’s duties towards the company. Lopes L.J. in re Kingston Cotton Mill Co (No 2), stated “It is the duty of an auditor to bring to bear on the work he has to perform that skill, care and caution which a reasonably competent, careful and cautious auditor would use.  This aspect also highlights the reason why the auditor has duty towards the third parties relying on the audit reports as well.  

Duties towards the third party

The general; albeit, a narrower principle binding the auditor to the third party is that the auditor owes duty of care to the audit client only, and does not extend to the third party. The rationale behind this principle is that there is no contractual privity between the third party and the auditor. In the absence of the privity to contract, there is no corresponding duty and obligation between the parties. 
In reality, investors make decisions of the creditworthiness of the company and decide to invest or not invest based on the audit report of the company. The case of Caparo Industries Plc v Dickman, highlights the need to bind the auditors with the third parties by imposition of duty of care.  The House of Lords reiterated that the company is not the only entity which relies on the auditor’s report, but there are a number of potential creditors and investors who rely on the statements of the auditor’s. Ernst& Ernst v Hochfelder is a landmark case in this regard where the Ernst & Young served as auditors to FP investments Inc., tax shelter partnership firm, who entered into partnerships with prospective customers to cultivate tropical plants in Hawaii. While the prospectus provided for project details etc., it failed to mention that the company was cash trapped. The investors on the other hand, relying on the statements made by E&Y, lost their money. E&Y was ordered to pay $18.9 million as damages.  
In order to prove that there has been negligence between the auditor, the burden of proof lies on the third party who after relying on the statements made by the auditor, suffered huge losses. 

Test of privity-existence of special relationship

Under contractual law the absence of privity of contract between the third party and the auditor, cannot make the auditor liable.  Hence, the auditor owes a duty of care in tort if there is privity between the parties. In order to prove this, the third party is required to prove to the court the existence of ‘special relationship’ and sufficient degree of proximity between the auditor and himself, and the auditor knew that the statements would be communicated to the third party.  In Re Esanda Finance v Peat Marwik Hungerfords, the court held that the existence of special relationship in addition to reasonable forseeability of loss is vital in proving the economic loss.

Reasonable forseeability of the loss

The third party has to prove it was reasonably foreseeable not just the audit client but also the third parties would rely on the statement made by the auditor.  The decision given by Lord Denning in the case of Candler v Cranes Christmas and co is relevant wherein it was held that the auditors prepare reports for client knowing very well that those reports are going to be used to persuade the third party to adopt a certain cause of action. The onus is on the third party to prove that upon reliance on such reports suffered economic loss. 
I agree with the fact that the auditors have a duty towards the parties who rely on the statements made by the auditor. The investors often rely on the statements made by auditor to understand the creditworthiness and financial health of the company before making investments. There is a corresponding duty on the part of the auditor to take adequate care and caution while making such reports. Hence, they are accountable to the third parties for their statements reports. Hence, the auditors owe a duty towards the third party, and can be made liable for their inaction, negligence and fraud.

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