Inexorable Growth of Companies

The inexorable growth of companies and the increased shareholder sophistication in recent years have led to stronger demand for shareholder rights and remedies that safeguard the interests of investors from errant and manipulative management. Minority shareholders of these companies in particular are therefore vulnerable to corporate fraud by majority shareholders who are often in control of the company.

This essay reviews existing legal avenues for the protection of minority shareholders and presents the functionality and limitations of these legislative and regulatory controls in achieving the intended outcomes.

Majority Rule and its limitations

The great majority of decisions made by a company are made through the Board of Directors and the day to day business of the company is run through the Board of Directors. Hence, the ability to control the Board of Directors is where the real power lies in any company. Generally speaking, any shareholder who (either on his own account or together with other shareholders) holds over 50% of the issued shares in the company will be able to control the Board of Directors (subject to the contrary provision in the Articles of Association or elsewhere). [1] Since the shareholders are entitled to act selfishly when exercising their voting power. If more than 50% of the shareholders’ benefits are the same, then the majority coalition has been built.

In principle, the common rule in the corporate governance of business entities -including corporations, limited liability companies and partnerships – is that absent an agreement or statutory requirement to the contrary, majority rule governs. [2] The majority rule stands for the proposition that the decisions and choices of the majority will always prevail over those of the minorities. [3] In practice, the greater the amount of shareholding of an individual member, the greater rights and powers accrued to that individual member within the company. [4] Thus it appears that a substantial amount of power has been placed in the hands of the majority shareholders and that by virtue of the majority rule, though this approach has the advantage of being able to produce a prompt and clear decision, the minority shareholders are required to accept the decisions made by the majority shareholders. [5] Indeed, majority equity owners often assume that they can do attractive much anything they desire with regard to the business entity.

Unfortunately, majority rule provide only limited incentives for the parties to compromise or to find a way for dealing with issues that serve the interests of all participants. Instead, the incentive is to compromise only enough to build a majority coalition. Once a winning coalition has been achieved, the parties are largely free to ignore the interests of other participants. However, the tendency of majority rule processes is to divide society into two competing. One key to controlling what is sometimes called the “tyranny of the majority” are norms and rules which prevent the majority from disregarding the basic rights of the minority. [6]

Limits Of Majority Rule

At common law a majority vote may be invalid despite literal compliance with the company’s constitution. [7] The majority’s power is limited by an equitable principle. The court will interfere with the majority’s decision where it can be shown that the majority voted for a purpose outside an implied range of purposes for which the power to vote was conferred. The equitable limitation on the majority’s power is usually referred to as the doctrine of fraud on the minority. [8]

“Fraud” does not mean dishonesty but action beyond the implied scope of a conferred power. [9] As Lord Parker put it in Vatcher v Paull [1915] AC 372 at 378:

The term fraud in connection with frauds on a power means that the power has been exercised for a purpose, or with an intention, beyond the scope of or not justified by the instrument creating the power.

An overview of the equitable limitation on majority voting power in Australia is provided in the figure 1 below.

Figure Operation of the equitable limitation on majority voting power in Australia [10]

In abstract, there are two main restrictions on how shareholders are allowed to vote:

Where the shareholders are voting on amending the constitution to give a Co a power to expropriate a shareholder

Where the shareholders are attempting to release the directors from the consequences of the director’s misconduct

These equitable limitations developed gradually from the original limitation that the majority’s power ‘must be exercised, not only in the manner required by law, but also bona fide for the benefit of the company as a whole’. [11] The principle was developed further in Peters’ American Delicacy Co Ltd v Heath where the court said that shareholders should be self-interested since [12] :

“The right to vote is attached to the share itself as an incident of property to be enjoyed and exercised for the owner’s personal advantage”. Contested resolutions involve conflicts of interest “To say that the shareholders forming the majority must consider the advantage of the company as a whole in relation to such a question seems inappropriate, if not meaningless.

LIMITATION ON THE POWER OF MAJORITY SHAREHOLDERS TO ALTER THE CONSTITUTION

An equitable limitation on alterations which perpetrate a fraud on minority interests. [13] In general, the requirements to alter the constitution are that alterations be made by special resolution and in conformity with any other additional requirement in the constitution itself. However in some situations the power of the majority to alter the constitution will be limited by equity and in some situations is limited by statute. There is a limitation on the power of majority shareholders to alter the constitution for the purpose of expropriation of minority shares or valuable rights attaching to minority shares (e.g. voting rights): Gambotto

The High Court decision of Gambotto v WCP Ltd (1995) 182 CLR 432; 127 ALR 417; 16 ACSR 1; 13 ACLC 342 laid down new tests which apply to assessing the validity of amendments to the constitution which give rise to conflicts. [14] The High Court reasserted several times the proprietary nature of a share. This focus led the court to reject the previously applied test, which required amendments to be “bona fide in the interests of the company as a whole”, [15] and to replace it with a dual categorization of amendments to the constitution where conflicts of interest are apparent. A different test for validity is applied in respect of each category. [16]

The three categories of amendment identified by the court are: [17]

Amendments Authorizing Expropriation Of Shares :

Category 1:The expropriation power is exercisable for a proper purpose [18] : Alteration of the constitution to permit a majority to expropriate the shares of a minority may constitute an abuse of the power of alteration. [19] Such a power could not be taken or exercises simply for the purposes of aggrandising the majority. [20] Amendment of constitution to include an expropriation power will be valid if:

Expropriation is a reasonable means to prevent a detriment to the Company: The “continued shareholding of the minority is detrimental” to the Company. E.g. minority shareholder is a competitor of the Company.

Expropriation is necessary to allow Company to continue in its present business. E.g. compliance with foreign ownership restrictions.

If exercising the power will avoid insolvency

However, the majority CANNOT expropriate the minority simply to make money: Not allowed to “expropriate the minority merely in order to secure for themselves. The benefit of a corporate structure that can derive some new commercial advantage by virtue of the expropriation”. [21] Note the dissenting judgment in Gambotto:

“No distinction should be drawn between an expropriation that will enable a company to pursue a beneficial course of action that would otherwise be denied to it and an expropriation that avoids a detriment to the existing interests of the company.”

Generally speaking the majority cannot expropriate the minority merely to secure for themselves a new corporate structure or new commercial advantage. [22] Furthermore, it is not a sufficient purpose for an expropriation, which is otherwise fair, that the expropriation will advance the interests of the company as a legal and commercial entity. Permitting expropriation in such circumstances would be “tantamount to permitting expropriation by the majority for the purpose of some personal gain” [23] and would therefore be undertaken for an improper purpose.

Category 2: The exercise of the power will not operate oppressively in relation to the minority shareholders i.e. it must be “fair in the circumstances” [24] : For the expropriation to be fair in all the circumstances, procedural and substantive fairness need to be present

Procedural fairness: require two matters:

Full disclosure of all material information leading to the alteration [25] , including balanced case for the transaction.

An independent expert’s valuation of the shares to be expropriated [26] , i.e. independent valuation of shares.

Substantive fairness: this involves examination of whether adequate consideration was given for expropriation i.e. “fair price”. Expropriation at less than market price is prima facie unfair.

That market price is not determinative of fairness and a variety of factors must be considered when assessing fairness, including: the assets of the company; market value; dividends; the nature of the company; and its likely future. [27]

The key difference between the category 1 and category 2 is that the first amendments can be undertaken only for a very limited purpose – where the amendment is required to prevent the company suffering significant detriment or harm because of the minority shareholder. The second amendments can be undertaken for a much broader range of purposes. These purposes could include advancing the overall commercial interests of the company.

The expropriation can also include the cancellation of shares rather than the force transfer of those shares, and can also include the extinguishment rather than force transfer, of valuable rights attached to shares. [28]

Amendments Authorizing Expropriation Of Valuable Proprietary Rights Attaching To Shares :

A “valuable proprietary right” would clearly be voting rights. Therefore, if the majority pass a resolution to amend the constitution where the effect of the amendment is to remove the voting right of the minority shareholders, then this amendment would be assessed according to the tests we have just discussed. The amendment must be for a proper purpose and must not operate to oppress the minority shareholders.

The facts of Gambotto concerned an amendment to the constitution to enable the majority to expropriate the minority’s shares. However, the court’s decision was framed in broader terms, applying to amendments to allow expropriation by the majority of valuable proprietary rights attaching to the shares of the minority. [29] The facts of Gambotto were such that the court did not consider what “valuable proprietary rights attaching to shares” actually meant. [30]

In Australian Fixed Trusts Pty Ltd v Clyde Industries Ltd (1959) SR (NSW) 33 McLelland J restrained a company from proceeding to change its constitution in a way which would operate adversely to the interests of custodian trustee shareholders. The proposed amendment would have prevented a custodian trustee from voting in respect of shares held in that capacity unless the majority of the beneficial owners of the shares had directed the trustee as to the manner in which the vote should be cast. The court found the proposed amendment to be objectionable for several reasons: [31]

it focused on custodian trustees in a discriminatory way;

the trustee would need to obtain separate directions in respect of each trust;

the majority direction was to be by number irrespective of the amounts invested by unitholders;

the amendment would deprive the trustee of its discretion under the trust instruments;

it was unreasonable for the amendment to give the directors an unreviewable discretion to determine compliance;

it would be difficult for the trustee to obtain a majority direction within the time prescribed by the proposed amendment.

In those circumstances, the court held that the amendment unfairly discriminated against the minority custodian trustees, and there were no grounds on which a reasonable person could decide that the amendment was for the benefit of the company as a whole. [32]

An older case involving expropriation of valuable rights is Australian Fixed Trusts v Clyde.22. The directors of a company sought to change the constitution to preclude shareholders who held their legal titles for members of public unit trusts from voting without the consent of a majority of the beneficial owners of the units. The Court granted an injunction to restrain the vote. There was no evidence that this was for the benefit of the company as a whole and that the resolution would unfairly discriminate against the trustee shareholders.

Other Amendments To Articles Giving Rise To A Conflict Of Interests:

The high court of Gambotto briefly considers amendment to constitutions which although not involving an expropriation of shares or of valuable proprietary rights attached to shared, give rise to a conflict of interests and advantages between shareholders. In this situation, the court held that the amendment will be valid unless it is “ultra vires, beyond any purpose contemplated by the articles or oppressive as that expression is understood in the law relating to corporations”. [33] The court did not elaborate further on this test. [34]

Finally, according to s 140(2): unless a member of a company agrees in writing to be bound, they are not bound by a modification of the constitution made after the date on which they became a member so far as the modification: [35]

requires the member to take up additional shares; or

increases the member’s liability to contribute to the share capital of, or otherwise to pay money to, the company; or

imposes or increases restrictions on the right to transfer the shares already held by the member, unless the modification is made:

in connection with the company’s change from a public company to a proprietary company under; or

to insert proportional takeover approval provisions into the company’s constitution.

The High Court held that the predecessor to this section did not apply in Gambotto. The joint judgment said that the shares remained transferable without the restriction even after the expropriation notice had been issued.

LIMITATION ON MAJORITY SHAREHOLDERS ATTEMPTING TO RELEASE DIRECTORS FROM A BREACH OF DUTY

Where the constitution allocates general powers of management of the company to the board of directors or the company relies on the replaceable rule contained in s 198A, the directors are primarily responsible for deciding whether the company should begin proceedings in its name to obtain redress for a wrong done to it. [36] The power of the majority to vote on this question is capable of being abused as against a minority of voting members or a group of non-voting members. The most obvious case of abuse is where the board and the majority of members have committed a wrong against the company and they are naturally unwilling to allow the company to proceed against them. [37]

Shareholders can exercise their voting rights meaning that a majority of shareholders can vote in simple (50%) or special (75%) resolutions in a general meeting. [38] Their duty to the Company is NOT fiduciary and may be exercised selfishly. Shareholders of Co can therefore vote to ratify some breaches of duty by the directors. Only some not all breaches of directories duties will be rectifiable:

(a) Duty of care, skill and diligence:

(b) Duty to exercise powers for a proper purpose

This is particularly the case where shares have been issued to a friendly party to frustrate hostile takeover bid

But if majority shareholders are involved in the breach, the then purported ratification amounts to fraud on the minority or oppression and the ratification will be void

(c) Duty to avoid a conflict of interest

This is particularly the case for a business opportunity which the Company is unwilling to exploit [39] or where the director has made a secret profit but has not misappropriated property of the company: where the Company purports to enter into a contract with entity which the director has a personal interest

BUT where a company is financially unable to exploit an opportunity, then this breach cannot be ratified

Ipp J in Biala Pty Ltd v Mallina Holdings Ltd (No 2) (1993) 11 ACSR 785; 11 ACLC 1082 recognised that while the majority which did wrong to the company are in control, and by their voting power prevent the company from instituting proceedings, they are committing a fraud on the minority. [40] However, he also stated that if majority control changes and the new majority decide not to pursue their predecessor’s wrong, and then such refusal does not amount to fraud on the minority. [41]

Here is some types of breaches which shareholders cannot ratify:

(a) Duty of act in good faith and in the best interests of the Company: for example, a transaction by an insolvent (or nearly insolvent company that prejudices the creditors of the Company)

(b) General law duties to creditors: Where company is insolvent or near-insolvent, creditors interests “are paramount” [42]

(c) Duty to exercise powers for a proper purpose: If the Majority shareholders are the directors involved in the breach, then the purported ratification amounts to fraud on the minority [43] and oppression on the minority

(d) Statutory Directors duties: per Miller v Miller

Protect Minority Shareholders Rights

In private companies, the majority shareholders are normally also the directors or founders of the companies who have direct control over the daily management of the firm. The minority shareholders were not given adequate protection. The protection of minority shareholders interests is crucial to encouraging investment. [44]

Oppression remedy: “enables members to apply to the court for a remedy if the majority of votes in favour a resolution alter the constitution/replaceable rules contract to members interest and as a whole, oppressive, unfair prejudicial or unfairly discriminatory to members”. [45]

Minority shareholders are protected by company law in the following ways [46] :

they may take proceedings for injunctive or other relief to prevent the majority from exercising their voting power improperly, by virtue of the doctrine of fraud on the minority;

they may insist that any alteration of class rights or other rights attached to shares be approved by members of the affected class pursuant to statutory protections;

they may enforce their personal rights as members, including their right to enforce the statutory contract created by s 140 and the company’s constitution;

they may take proceedings, if eligible, under the statutory derivative action

they may seek to wind up the company on the just and equitable ground or similar grounds contained in s 461 if the affairs of the company are being conducted unfairly

they may seek any of a wide range of remedies for oppressive or unfair conduct

they may seek relief in respect of corporate misfeasance with the assistance of the court, ASIC, or (if winding up of the company has commenced) the liquidator.

These remedies are considered in the present chapter. Dissatisfied shareholders in a listed company can ordinarily withdraw their investment from the company by selling their shares. If a conflict arises in a company whose shares are not quoted on the stock exchange, a member may have difficulty in departing from the company with the full value of his or her shareholding. Accordingly, most cases of abuse of power or oppression which come before the courts arise out of small unlisted companies.

It shall be seen that where a member shows to the court that the affairs of the company are being conducted in an oppressive or unfair way, the court may order that the company redeem that member’s shares. That may seem a useful remedy where a member wishes to have the company buy back his or her shares but the company is not prepared to use its power to make a selective buy-back at an adequate price. However, the court will not order the company to buy back unless the company is otherwise being conducted oppressively or in an unfairly prejudicial way. On occasion even in a large public company an act of a majority of the members may be such that the minority will seek protection in the courts.

Conclusion

In Ngurli Ltd v McCann [47] the High Court said, quite emphatically:

‘Attempts were made by the … company … to have the issues confirmed in general meeting … As we have said, a shareholder is not a trustee of his vote and can use it to advance his own interests at a general meeting. But even in general meeting a majority of shareholders cannot exercise their votes for the purpose of appropriating to themselves property or advantages which belong to the company for that would be for the majority to oppress the minority. The right to issue new capital is an advantage which belongs to the company. Any attempt by directors or by the company to exercise this right not for the benefit of the company as a whole but so as to benefit the majority … could be restrained in a suit brought … against the company and the majority.’ [48]