Doctrine Of Ultra Vires Law Company Business Partnership Essay

Published Date: 02 Nov 2017

INTRODUCTION

In this paper, we will be outlining the corporate capacity profile of a particular company and how this functions in providing somewhat of a cushion especially to a directory when he/she has not acted in accordance to his duties. Next, we will be turning to the doctrine of ultra vires and the business judgment rule individually and what is required of a director to establish certain requirements it to serve as a defence to the breach. Lastly, we will be concluding by looking at the pros and cons of each and whether it still has a place in today’s’ society. For the purpose of this paper, we will not be discussing the remedies for the breach of duty of a director.

The board of directors play a pivotal role in the power to control the management of a company as well as its property and affairs. With this power comes the opportunity for fraud and mismanagement. Anyone who entrusts their property or affairs to another person is at risk of suffering loss by the other person’s wrongdoing. The shareholders of companies are often especially vulnerable, because they are frequently passive investors who do not follow the company’s progress on a day-to-day basis. Their vulnerability is all the more acute if they are numerous and not organised. The law responds to the directors’ position of inducement and the susceptibility of shareholders by making it a point for the directors to abide by strict fiduciary and statutory duties. [1] Due to the fact that the fiduciary owed by directors is the base point for all other duties, we will be outlining its importance in the corporate framework.

A director is said to be in a fiduciary, as opposed to an arm’s length relationship with the company. However, the exact definition of a fiduciary relationship is difficult. [2] Fiduciary relationships may arise because, on the facts, a party has been appointed to act or assumes to act, for the benefit of another whose appointment carries powers that could be exercised to the detriment of another. [3] The existence of a fiduciary relationship does not mean that every duty owed by the fiduciary to the beneficiary is a fiduciary relationship. In Permanent Building

Society v Wheeler [4] , Ipp J considered that if a duty is a fiduciary duty then the director is strictly liable for all losses flowing from the breach. In Re City Equitable Fire Insurance Co [5] , Romer J examined the origins of the duty of care as an incident of the director’s general fiduciary office. The degree of care and diligence was that which a person would apply in his or her own affairs.

DOCTRINE OF ULTRA VIRES

The doctrine of Ultra Vires, well known by company lawyers, states that for registered companies, the business capacity is set out in the objects clause [6] of its constitution, acts done by the company which fall beyond the scope of its objects were void as being beyond its power. As such, a company could only enter into a transaction within or reasonably incidental to its substantive objects: Ashbury Railway Co v Riche. [7] Importantly, in terms of governance, complaints in respect of ultra vires can be made by any member or creditor of the company regardless of the size of their financial stake in the company.

Distinction is drawn between substantive objects (an activity construed as independent of other activities) and mere powers (powers exercised in furtherance of or incidental to objects of the company – eg. The power to borrow or the power to lend). Whether or not these activities are ultra vires depends whether or not they fall within the objects of the company.

If the activities are causally connected to the object they can be classed as being casually connected to the object. It therefore stands that these are not ultra vires and the company is liable to fulfil its contractual obligations. If they are not causally connected to the object then they are clearly not incidental to the objects clause and the common law would deem the activity Ultra Vires and void the contract hence having no effect.

The doctrine of ultra vires played an important role in the development of corporate powers and the corporate framework. For many years, this doctrine has been used by company lawyers in two senses. Firstly, it has been used in the ‘narrow sense’ to describe a transaction which is outside the scope of the objects expressed in the memorandum of association of a company or which can be implied as reasonably incidental to the furtherance of the objects thereby authorised. [8] Secondly, it has also been used in the ‘wide sense’ to describe a transaction which, although it falls within the scope of the objects of a company either expressly or impliedly, is entered into in furtherance of some purpose which is not a purpose authorised by the company memorandum of association. [9] It has been suggested that there is a vital difference between the two since a transaction which is ultra vires in the ‘narrow sense’ is altogether void and cannot confer rights on third parties, whereas ultra vires in the ‘wide sense’ may confer rights on a third party who can show that he dealt with the company in good faith and for valuable consideration. [10] 

It is useful to note at this point that ultra vires in the ‘narrow sense’ proved unworkable and unfair and has since been abolished pursuant to section 125 of the Corporations Act [11] . It permitted a corporation to accept the benefits of a contract and then refuse to perform its obligations based on the grounds that it was an ultra vires. This doctrine had also impaired the security of title to property in fully executed in which the corporations took part in. Therefore, the courts adopted the view that such acts were voidable rather than void and that facts should dictate whether the corporate acts should have effect. [12] 

However ultra vires in the ‘wide sense’ remains fully functional for internal purposes. For example, a member can seek an injunction to prevent an ultra vires act. Similarly, a director who violates an objects clause can be barred for it. [13] 

This doctrine however, has not been very well-received and has been enhanced in the corporate takeover context. The Corporations Act played a pivotal role in eroding ultra vires by promoting contractual freedom, abolition in relation to third parties and clarification of certain issues with regards to directors’ powers.

THE BUSINESS JUDGMENET RULE

Being a director of the company comes with responsibilities and duties that they are required to carry out and are indebted to stick to closely, to comply with the framework on a general level.

The business judgement rule developed by the courts applies to both general law duties and statutory duties of directors and other officers. It is useful to note at this juncture that the definition of Directors and Officers can be found in Section 9 of the Corporations Act. In Australian Securities and Investments Commission v Rich [14] , the court stated that the business judgement rule developed by the courts forms part of the court’s assessment of whether the defendant’s conduct is in breach of a general law duty. However, to the extent the business judgement rule developed by the courts expresses the important principle that provided they act in a certain way, the merits of directors’ commercial decisions will not be reviewed by the courts, the rule can also apply to the statutory duties, such as the duties in section 181 which will be discussed further next.

Directors also owe duties or loyalty and good faith, requiring them to act in the best interest of the company as outlined in section 181 of the Corporations Act. The duties of directors are stated in Part 2D.1 of the Corporations Act where the general duties of ‘care and diligence’ and ‘good faith’ are outlined. The section 180 directors’ duties exist to protect shareholders from directors who may not exactly act in their best interest and could result in harm being caused. In a nutshell, the business judgement rule acts as a defence to breach of the statutory duty of care and diligence in s180.

In Rich, Austin J stated that "since business judgment considerations (referring to the considerations referred to in Harlowe’s Nominees [15] and Howard Smith [16] ) are an integral part of the general law duty, it follows from my earlier reasoning that those considerations are to be taken into account in applying the statutory standard of care and diligence."

This rule will only be useful in providing a defence to those directors who have failed to carry out their duties with due care and diligence if they can establish that they made the business judgements in good faith and for a proper purpose, have acted on an informed basis without material personal interest, appropriately informed themselves of the subject matter and who have a rational belief that the decision is in the best interests of the corporation. If one of these requirements is not met, the business judgement rule will serve no purpose to the directors. We will be considering these requirements in depth as it is vital to know how the business judgement rule needs to be established for it to properly serve its purpose.

The Elements of the Rule

Good Faith and For a Proper Purpose

The director must make the decision in good faith. It would be inconsistent to allow the director to rely on the business judgement rule when judgement was exercised in the absence of good faith. It would be contrary to public policy to allow the director to rely on this rule if the decision was not made in good faith.

The ‘proper purpose’ doctrine has been around for many years now. [17] Its strict application requires all company power to be exercised for the purpose for which it was originally conferred. However, since Howard Smith [18] the doctrine has not been strictly enforced in Australia. It now appears that if the power exercised is one that benefits the company as a whole, then the actions are for a proper purpose. [19] 

Material Personal Interest

The director must not have a material conflict of interest. The word ‘material’ suggests that if a conflict of interest arises it must be one that is immaterial or insignificant. The question of materiality is determined objectively. The ‘significant influence’ issue referred to in respect of the concept of control is relevant to this requirement. If a director exerted significant influence over the other directors, to the extent that they were simply ‘rubber-stamping’ the decision, this requirement would not be satisfied and those directors would not be able to reply on the business judgement rule.

Reasonably Informed

This requirement is fundamental to the duty of care. The question of how much information is required is a very general one and it all depends on the nature of the decision, which includes the subject matter and complexity. There is a subjective orientation to what constitutes being ‘reasonably informed’. It also depends on the circumstances of the particular decision, made by the particular board, in the company’s circumstances. [20] Even though the duty of care establishes an objective standard, a director could seek protection under the rule if the director had the reasonable belief that he or she was sufficiently informed to make the decision.

Rationally Believed that the judgement is in the best interest of the company

If the directors are informed and their decision is one that makes sense, then it is said to have been make on a rational basis. However, if the opposite was true, then this requirement will not be satisfied. For example a decision by the board, after investigation to accept a ridiculously low price for the sale of the company or its assets, may lead to an inference that there is a conflict of interest or lack of good faith in that decision. If that is the case, the rule will be futile.

Pros & Cons of the Business Judgement Rule

Directors, officers, shareholders and Courts will all benefit by having the rule enacted in the Corporations Law. This rule provides an enhancement and clarification of the path to be followed in making decisions. In addition it also outlines the duties that directors are required to abide by and in turn, provides awareness. The benefits to shareholders include the increase in their investments resulting from the ‘go-ahead’ given to directors to engage in responsible risk-taking. When it concerns the Courts, this rule will reduce the involvement of Courts and also free up the courts’ time. In a nutshell, the rule recognises the vast difference between companies and the roles played by executive and non-executive directors. Lastly, it overcomes the uncertainty and ad hoc development in this area of corporate law.

This rule however, has come under much criticism in recent times as well. Some writers suggest that there should no rules at all. What seems to be the most controversial issue is that this rule tends to provide special protections for businesses. [21] The rule seems that it was designed to favour big business as suppose to little guys, the institution over individuals. Also to some, it might be unclear as to what this rule intends to achieve.

CONCLUSION

In conclusion, the Business Judgement Rule and the doctrine of ultra vires has its criticisms however, its pros definitely outweighs its negativities. The criticisms have been addressed by leading commentators and it is clear that the time is right in Australia for a business judgement rule. However, the doctrine of ultra vires still needs to be amended for it to function properly in the twenty-first century.