We acted for one of the parties to a complex shareholder dispute involving multiple companies and alleged director misconduct.
Background
Our client, A, went into business with two other individuals, B and C. The business operated through a number of companies.
As happens all too often with business partners, the three individuals fell out. The parties agreed that A would exit the business and be paid out for his shareholding in the various companies. Additionally, a new individual, D, would join the business and replace A as a director and shareholder. The parties agreed on the purchase price for A’s shares (Share Proceeds). To document the transaction, the parties entered into a Heads of Agreement (HOA).
B and C, in order to fund the acquisition of A’s shares, withdrew cash from the bank accounts of two of the companies in the group, Company A and Company B (Relevant Funds) and applied these towards the Share Proceeds. On learning of this, A also withdrew funds and kept these to safeguard himself financially (A Funds).
Shortly thereafter, B, C and D (Other Parties) engaged lawyers to act on their behalf against A regarding the A Funds. A engaged us to act for him in resolving this dispute. We helped A negotiate a commercial resolution that avoided litigation and reduced their risk of facing personal liability.
Heads of Agreement
The HOA was poorly drafted and contained fundamental issues that went to its validity and enforceability. Some of these are as follows.
First, the HOA was purporting to document the sale of A’s shares in the various companies to the Other Parties. This was not appropriate from a documentation perspective. The appropriate document for this would have been a share sale agreement (SSA). It is not only a matter of labels – indeed, a robust SSA has a range of provisions designed to document the transaction effectively, for example in relation to title, liability, and representations and warranties. Further, a strong SSA should contain clear releases for the benefit of the party leaving the business which, in this case, was our client.
Second, the HOA reflected a lack of due diligence in preparation. Under the HOA, A’s family trust was selling four parcels of shares (A was exiting from a total of four companies). Of these parcels of shares, only two were owned by A’s family trust, and the other two were owned by A personally. However, A was not listed as a seller, only his family trust. Therefore, A’s family trust had no authority to sell all four parcels of shares. This had significant consequences because, among other things, it resulted in an automatic breach of a key representation, namely that the seller had title to, and was the beneficial owner of, the shares (which it clearly was not).
Financial Assistance
Section 260A of the Corporations Act 2001 (Cth) regulates the circumstances in which a company may provide financial assistance to a person to acquire shares in the company or a holding company of that company. Given the Relevant Funds were applied towards the Share Proceeds, this constituted financial assistance. Fatally, in this case, B and C’s withdrawal of the Relevant Funds was not approved under section 260B, nor was it exempted under section 260C. This meant that there was a breach of the financial assistance provisions.
Alleged Loans
The Other Parties asserted that the Relevant Funds were a loan to B and C under Division 7A of the Income Tax Assessment Act 1936 (Cth) (ITAA). The available evidence did not reflect this. For example, when transferring themselves their respective portions of the Relevant Funds, B and C included references that showed the purpose of the transactions was to fund the acquisition of A’s shares. Not very smart, right? Those descriptions clearly indicated that the funds were used to acquire A’s shares, undermining the contention that they were ordinary loans.
Section 109N of the ITAA sets out a number of requirements for complying loans, one of which is for a complying loan agreement to be in place. Hence, our response to this assertion was to ask for copies of the loan agreements evidencing these loans, as well as copies of corporate governance documentation authorising the relevant companies to loan money to B and C. Of course, we knew this documentation did not exist, because that was not the reality of what happened. And we were not surprised that this point was ignored and no documentation was provided.
Of course, you may point out that section 109N requires the loan agreement to be in writing before the lodgement day for the relevant entity’s year of income, meaning they technically could have been prepared later. In reality though, given our client was one of two directors in several of the companies, and one of three directors in others, it was not plausible that the necessary procedures were followed without our client being made aware or signing any documentation to such effect.
Directors’ Duties
As you can probably guess, there were numerous directors’ duties breaches, namely sections 180, 181, and 182.
First, no reasonable director in B and C’s position would use company funds for the purpose of acquiring another shareholder’s shares in the company without complying with the necessary laws, for example the financial assistance rules. Our position was that this was a breach of section 180.
Second, the withdrawals of the Relevant Funds were not made in good faith in the best interests of the relevant companies, nor were they for a proper purpose. If these transactions were genuine loans made in good faith and for a proper purpose, the appropriate procedures would have been followed. Our position was that this was a breach of section 181.
Third, B and C used their positions as directors to gain an advantage for themselves, namely to use company funds for the purchase of another shareholder’s shares. Our position was that this was a breach of section 182.
Key Takeaways
Ensure that the document you are entering into is the most appropriate to reflect the nature of the transaction you wish to undertake.
Ensure that whoever is preparing the relevant transaction documents does the appropriate due diligence, including running the necessary searches, so that the documents reflect reality.
If a company is intending to make a loan to a director, it needs to be appropriately documented. At the least, you should have a Division 7A compliant loan agreement, in addition to corporate governance documentation authorising the company to make the loan in question.
Contact Details
We understand that corporate governance can be difficult. If you are planning a shareholder exit or are concerned about how company funds have been used, contact us before documents are signed or money is moved.
Email: admin@muzariripenny.com.au
Ph: +61 482 724 072