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Introduction to Company Law

Note 3 of 7 Notes

Universiti Kebangsaan MalaysiaFaculty of Law PHD Program in Law

Musbri MohamedDIL; ADIL ( ITM )MBL ( UKM )

Directors duties and liabilities

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I will first address the critical role of graduate and professional education in shaping beliefs about corporate purpose and healthy corporate activity.

But I will discuss law school education; specifically, I contend that what corporate law professors do (and do not) teach may contribute to a faulty outlook on certain baseline issues in the minds of future lawyers who advise corporate directors and officers.

Wrongheaded ideas picked up in law school can critically shape how lawyers discharge their all-important role as legal counselors to business people.

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Evidently something is wrong in the educational culture as well as in the business and professional cultures into which we send our students. Law school is the “gate” through which students must pass if they wish to become lawyers.

Consequently, we who teach them are “gatekeepers” into the profession. Likewise, those of us who teach corporate law are the gatekeepers into a corporate law practice, and we must be mindful of the social role entrusted to us and must endeavor to discharge that role responsibly.

Graduate education, in the business law area as elsewhere, can broaden (or narrow) a student’s intellectual and ethical horizons. Corporate law, like other disciplines, asks certain questions and does not ask others. In other words, it begins with a paradigm and that paradigm frames the ensuing inquiry by including and excluding certain topics.

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About twenty-five years ago—and for a variety of reasons, not the least of which was the dramatic upsurge of wide-scale hostile takeover activity—two related, discipline shaping phenomenon took hold in corporate law scholarship and corporate law teaching.

These paradigm-shifting developments were imported from graduate business schools and economics departments. First, the role of markets in disciplining corporate directors and officers was heavily emphasized.The influence of these markets, of course, included the usual competitive pressures found in relevant product and services markets.

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The capital markets were also said to be severe disciplinarians in at least two ways. First, to successfully access equity markets, a company had to have a compelling, credible story to tell prospective investors. Recent evidence, however, suggests that internal cash flows and debt may be more significant sources of funds than equity, at least for many firms.

Second, once traded on a public market, the share price of a company’s common stock was said to be a shorthand report card on management—a low share price supposedly indicated managerial shortcomings that would make a company vulnerable to an outside bid by an investor (or “raider,” to use the pejorative parlance of the day) who would pay current shareholders a premium to gain a controlling interest and then, in theory, spiff up the company and run it in such a way as to produce wealth for the new owners.

Reality did not always match theory, however, as many companies faltered or outright collapsed under the burdensome debt financing often used to fund an acquisition.

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This broad embracing of market solutions to corporate activity was, at bottom, an argument for a libertarian, deregulatory policy approach to business matters, generally, and to corporate law and securities regulation, specifically.

If markets worked as efficiently as theorized, the oversight role of courts and other corporate regulators could, it was argued, be reduced and the possibility of regulatory error curtailed. Harmonious markets would also supposedly lead to the overall well-being of both shareholders and society at large.

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Corporate law, as a field of study, will not merely be a sub-category of contract law or economics. The second ground-shifting phenomenon that took hold in corporate law over the last quarter century was wide-scale adoption of a shareholder primacy conception of corporate purpose. Within law schools, although there were a few dissenters and some variations on the theme, it was widely assumed (that is, it was not discussed in class or at academic conferences) that the overall purpose of corporate activity was, of course, singularly to maximize shareholder wealth. The corporation was simplistically regarded as a financing vehicle or a “nexus of contracts;” any sense of the corporation as an important social institution wielding vast influence on countless lives was marginalized or lost altogether.

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Educators who are not careful will wrongly convey, in law schools as in business schools, that business activity has one chief and undisputed end: make as much money as possible. Instilling that belief in young law students can lead them, like students in graduate business schools, to think that they too should act so as to maximize their own financial position. In this way, what supposedly is intended as a descriptive account of institutional and individual goals can be wrongly understood as a prescriptive endorsement of self-serving conduct.

Calls for adherence to notions of “professionalism” and the supposed steadying influence of professional rules may prove to be weak counterforces to a rampant wealth-primacy norm in the cultures of business and business-advising to which our students are heading.

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Shareholder primacy as a normative goal was embraced as canonical in corporate law; the scholarly debate was not over ends, it was over means. I could say several things about this but my overall point is this: there are widespread misunderstandings in the business world—as well as in business education and in legal education—with respect to what the law does (and does not) require on the question of corporate purpose. In short, outside unusual circumstances—the so-called “Revlon” mode under Delaware law —no law requires that businesses pursue only the goal of corporate profit or the goal of investor wealth maximization.

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The public’s continuing perception that businesses have wrongly pressed to maximize profits at the expense of other considerations is impeding the restoration of trust in the business sector.

Although various markets certainly constrain managerial discretion to varying degrees in the relevant industry, and although shareholders have voting rights and could oust boards they consider to be too socially or morally responsible, the widespread pursuit of shareholder wealth maximization as a corporate objective largely stems not from law but from social norms and business lore that can powerfully influence managerial belief and conduct. There are, to be sure, normative and policy arguments supporting—and disfavoring—this convention, but there is no legal obligation to follow it.

Certainly, shareholder primacy outside Revlon is not a judicial standard of review for assessing director or officer behavior when challenged in court. In fact, were this not true, the ongoing normative debates about corporate social responsibility and business ethics would be meaningless: in ethical discourse, a moral “ought” necessarily implies “can.” Only if they genuinely possess legal latitude can we meaningfully discuss what managers “should” and should not do in various business settings.

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Probably the most famous assertion as to the proper purpose of business activity came from renowned economist Milton Friedman. He stated as follows:

A corporate executive is an employee of the owners of the business. He has direct responsibility to his employers. That responsibility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while conforming to the basic rules of society, both those embodied in law and those embodied in ethical custom.

Friedman cites no positive law authority for his position. His is strictly a normative position that, as noted earlier, is nowhere mandated. In fact, many positive law authorities permit a contrary view.

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Friedman’s position, moreover, when closely examined proves to be quite tolerant of socially-responsible conduct under certain conditions. He suggests acting in accordance with shareholder desires. Today, different segments of investors appear to have some appetite for responsible conduct, and not simply a desire to make as much money as quickly as possible. This represents a market solution to the issue of corporate purpose, of the kind Friedman, as a free market advocate, would seem to support. Indeed, he qualifies his admonition to maximize profits by using the word “generally,” thereby recognizing that certain investors likely will have different preferences.

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Moreover, Friedman recognizes that executives must also conform not only to law, they must conform to rules “embodied in ethical custom.” As ethical principles evolve in a society—whether they be greater attentiveness to environmental concerns, employee job security and benefits, product safety, or other considerations, such as better risk management—executives, in Friedman’s view, must conform to them. Business practices in a democracy—like law itself—eventually must reflect underlying social norms and, as with other customs, those practices may change. In 2009 we may be entering a period of fundamental rethinking as to society’s expectations of for-profit businesses. We should invite our students to reflect on and discuss these baseline issues in our corporate law classes. Those students will be key participants in shaping business behavior in the private sector, and perhaps in the public sector, in the years ahead.

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Director’ includes any person occupying the position of director of a corporation by whatever name called and includes a person in accordance with whose directions or instructions the directors of a corporation are accustomed to act and an alternate or substitute director.

What are the types and functions of directors? 

Types of Directors 

Managing directors Alternate or substitute directors Nominee directors Executive directors Non-executive directors

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A managing director wears two hats 

That of a director and officer of the company That of an employee with special authority to exercise any or all of the board’s management powers 

Listing Requirements  Power of Managing Director A managing director shall be subject to the control of the Board. 

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Alternate or Substitute Director 

Appointed by a director who is unable  for any time to act as a director and is subjected to the normal duties a director owes to his or her company .Section 138(2) – the appointment does not constitute an assignment of the office of director 

Nominee Director 

Appointed to represent the interest of particular shareholders or creditors on the board of directors 

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Executive Director 

A director to whom the day to-day management of the company has been delegated who is also an employee with special authority to exercise any or all of the board’s management powers . Non – Executive Directors

Who do not take an active role in the daily management of the company but participate in broader policy decisions.  They are frequently appointed because of their experience in business affairs. 

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“Director”

Includes: 

Chief executive officer Chief operating officer Chief financial controller Any other person primarily responsible for the operations of financial management of a company, by whatever name called  Note  also the interpretation of  ‘director’ in Section 4 

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The business and affairs of the company must be managed by or under the direction of the board of directors.

Powers of the board of directors are subject to the M & A or the Companies Act, 1965. The amendments to the Companies Act made significant changes to Directors’ Duties and Liabilities such as:

Duty of care, skill and diligence; andBusiness judgment

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Now 

A director shall exercise his powers:-for a proper purpose, and in good faith in the best interest of the company  Section 132(1A) - added And A director shall exercise reasonable care, skill and diligence with :- Objective standard                       Knowledge, skill and experience reasonably expected of a director having the same responsibilities Subjective standard Any additional knowledge, skill and experience which the director in fact has Thus a director now has a higher standard of duty especially if he/she has more knowledge, skill and experience. 

Duty of Skill If a director possesses special qualifications such as a lawyer or accountant, he is expected to use that skill for the company. A director is therefore required to display a reasonable amount of skill, commensurate with his qualifications and experience 

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How does S 132(1A) affect business judgment?                                                        S 132(1B) states that a director making a business judgment is deemed to meet the requirements of subsection (1A) and the equivalent duties under common law and equity if the director :- makes the business judgment in good faith for a proper purpose does not have a material personal interest in the subject matter of the business judgment is informed about the subject mater of the business judgment to the extent the director reasonably believes to be appropriate under the circumstances reasonably believes that the business judgment is in the best interest of the company 

Section 132(6) - Definition “Business Judgment”Any decision on whether or not to take action in respect of a matter relevant to the business of the company 

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Section 368B 

Introduce statutory protection for whistle-blowers. Where an officer of a company reasonably believes that a matter may breach the CA or its regulations or a serious offence involving fraud or dishonestly is being or has been committed against the company, the officer may report the matter to the Registrar .

The CA protects the whistle-blower from any discrimination, demotion or dismissal.  The whistle-blower is also statutorily immune from any  action in connection with a report made in good faith and in the intended performance of his duties as an officer of the company 

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One of the common law duties imposed upon directors is the duty to avoid conflicts of interest. The underlying philosophy is two-fold, being: (i) to ensure that directors of companies do not abuse their office by making improper personal profits; and (ii) to prevent directors from placing themselves in such a position as to create the appearance that they are acting foremost in their own interests. As has been aptly put by Gower, 'good faith must not only be done but must manifestly be seen to be done'.

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The Companies Act provides directors with full management control over the business of the company and the common law bestows upon them the duty to exercise such powers with unfettered discretion.

Directors are called upon to make decisions which affect not only its members but also its creditors and its employees. They are fiduciaries in whom members of the company place their trust.

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Directors’ Duties

Efficiency arguments call for centralised management – Board of DirectorsRules developed in common law for directors, at first, by analogy with the rules applying to trusteesDirectors’ duties: duties of loyalty and duties of care. The main risks which shareholders run when management of the company is delegated to the board.Duties of loyalty: based on fiduciary principlesDuties of skill and care: based on the principles of the law of negligence.

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To Whom:

Company? “The interests of a company, as an artificial person, cannot be distinguished from the interests of the persons who are interested in it.” Per Nourse LJ in Brady v Brady [1988] BCLC 20 at 40Evershed MR in Greenhalgh v Ardene Cinemas [1951] Ch 286Shareholders (members) have the strongest incentive to monitor the board effectively.The duties are owed to the shareholders collectively as a whole, not individually.CreditorsAs the company nears insolvency, the interests at stake are those of creditors.West Marcia Safetywear Ltd v Dodd [1988] BCLC 250 cf. Re Welfab Engineers Ltd [1990] BCLC 833: when insolvency threatens, the directors may not take a course of action which will leave the creditors in a worse position, but they are not bound to give creditors’ interests absolute priority.Dictum of Street CJ in Kinsela v Russel Kinsela Pty Ltd (in liq) (1986) 4 NSWLR 222.The creditors “become prospectively entitled, through the mechanism of liquidation, to displace the power of the directors and the shareholders to deal with he company’s assets”. But, the directors do not owe any duties to the creditors individually: Re Pantone 485 Ltd [2002] 1 BCLC 266. The creditors are as a group where their interests constituting the company’s interests as insolvency approaches.Employees and other stakeholders? Commercially justifiable…

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Directors’ Fiduciary Duties

Remaining With Their Powers – ultra vires; improper purposes; Good FaithNo Conflict Of Duty & Interest – directors’ remuneration, transactions; donations; competing with the companyUse Of Corporate Property, Opportunity Or InformationBenefits From Third Parties Unfettered Discretion

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Malaysia’s economy depends on the drive and efficiency of the companies.

Therefore, the effectiveness of the board of directors in discharging their duties and responsibilities determines Malaysia’s competitive position.

In other words, Company directors must be free to drive their companies forward, but they have to exercise that freedom within a framework of effective accountability.

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Questions for Discussion during Tutorials

1.State the manner in which a director may be appointed.

2. Can an undischarged bankrupt hold the position of a director? 3. When is a person disqualified from being a director of a company? 4. Explain the various duties of a director.

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The task of clarifying and reformulating directors’ duties so as to promote accountability is not an easy one but it has to be done so as to ensure that our corporate law framework remains effective and can facilitate business.

The confidence of the investors should not be derogated by poor performance of the directors

Musbri Mohamed2011