Directors beware: Federal Court warns against diverting share trading opportunities

Directors often trade in shares in the companies that have appointed them, or carry out business activities in related fields. Many directors are familiar with the restrictions on share trading by key management personnel of ASX listed companies (as discussed in Andrew Lumsden's article on this subject).

However, in a recent decision, the Federal Court (Court) has provided an important reminder that directors of any company—listed or not—are prohibited from taking up opportunities which should properly have been made available to their companies.

THE FACTS

CellOS Software Limited (Company), an Australian unlisted public company, brought proceedings in the Federal Court against its former CEO and director, Mr Jason Huber (Huber).

Huber had been responsible for conducting capital raising to fund the Company’s operations. Instead, however, he secretly bought 48 million of the Company’s shares from early investors at a fraction of the prevailing market price. Huber then sold those shares to new investors for vastly higher prices. He obscured his conduct by holding the shares though a complex web of 47 offshore companies registered in opaque jurisdictions and by concealing his interest in these companies. The profits were used to loan funds back to the Company and for a range of personal matters such as discharging Huber’s prior bankruptcy, Huber’s personal expenses and the purchase of properties in Melbourne and Dubai.

The Court found that:

• Huber ‘promoted the Company shares to investors, ostensibly to raise capital directly for the Company by the issue of new shares, but in fact it was to sell to such investors the same shares, which Huber had purchased from early investors, at a considerable profit margin’;
• Huber’s control and influence meant that he was the person making decisions about the timings of formal share offerings, yet ‘on the side he was also the person running a scheme which was soaking up a class of investors who would otherwise have been likely to have been buying new shares issued by the Company’;
• Huber therefore diverted the opportunity for the Company to issue new shares by misusing his position as a director and, in doing so, improperly gained profits for himself; and
• the loan arrangements between Huber’s entities and the Company were detrimental to and not in the interests of The Company and Huber did not disclose his interest in these transactions.

Accordingly, the Court found that Huber breached his statutory and fiduciary duties to the Company, including:

• not acting in good faith and in the best interests of the Company and for a proper purpose, in contravention of section 181(1) of the Corporations Act;
• breaching a number of common law fiduciary duties (including not acting in the best interests of the Company, improperly using his position to gain advantage for himself, obtaining secret profits, not accounting to the Company for those secret profits, and acting contrary to the interests and to the detriment of the Company); and
• the fact that Huber redirected part of the funds back to the Company through uncommercial debt arrangements only exacerbated the breach of fiduciary duty.

DIRECTORS, DUTIES AND DIVERSION 

Putting aside insider trading issues, a director’s share trading typically has nothing to do with their statutory or fiduciary duties because there is generally no diversion of any business opportunity for the company by such activity. A company is usually not in the business of buying and selling shares in itself.

However, where a director owes a particular fiduciary duty because of the scope and responsibilities of their role (here, Huber’s role in fundraising activities for the Company) their duty is to facilitate that objective rather than to undermine it. In these circumstances, a director will breach their duties if they divert an opportunity from the company to themselves or their associates.

Having regard to previous decisions, the Court considered the following principles to explain which opportunities a director is prohibited from pursuing:

• the corporation is financially able to exploit the opportunity (here the Company was capable of exploiting the opportunity to issue new shares);
• the opportunity is within the corporation’s line of business (here the Court held that a broad interpretation of ‘line of business’ should be taken, but in any case it was within or associated with the Company’s ‘line of business’ to raise capital at the relevant time);
• the corporation has an interest or expectancy in the opportunity (here the Company was clearly interested in new additional capital); and
• by taking the opportunity for his own, the corporate fiduciary will thereby be placed in a position ‘[inimical] to his duties to the corporation’ (here Huber’s opportunity and knowledge came about because he was CEO and charged with responsibility for raising equity funding, and his duty was to create opportunities for direct equity capital raising by the Company rather than diverting them, thereby creating a ‘blatant conflict’).

Previously, Courts had only restricted directors from pursuing opportunities which derived solely from their role.

However, in recent decisions, these restrictions have expanded to include any opportunity obtained because of or using knowledge resulting from the director’s role. This decision continues that new approach and applies it for the first time to a director’s share trading in the Company itself.

SOME PRACTICAL GUIDANCE

Directors should carefully consider whether a proposed personal activity or opportunity:

• conflicts with their companies’ actual, contemplated or possible opportunities; and
• derives from their particular responsibilities, insights and knowledge as a director.

The starker the contrast between the personal interest of a director and their duty to the company, the more likely a court will find pursuing it to be a breach of the director’s duties.

If a director breaches their duties in this way, they will generally be required to account to the company for any profits made, as well as facing serious penalties.

Disclosure: Corrs acted for CellOS in the proceeding.