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Business Associations Essay UNSW1091

Research Essay

 

1. “Did you ever expect a corporation to have a conscience, when it has no soul to be damned, and no body to be kicked?” – Edward, First Baron Thurlow 1731-1806

With reference to one of the theoretical models of the corporation you have studied discuss whether Australian corporate law’s approach to limited liability is adequate in light of community concerns about issues such as compensation of injured employees.

Former High Court Justice Michael Kirby said once in an address that the need to establish checks on and standards on companies was beyond obvious. [1] He, however, also stated that these checks should not reduce the capacity of a company to perform its main economic function for which it was established. Moreover, he said that each legislative epoch would establish its own standards. As such, the question to be answered here is how the Australian approach to the corporations has upheld ethical standards – particularly, directors liability – but, at the same time, not stifled adventure, risk taking, and entrepreneurship.

Theories of the Corporation

In attempting to harmonise this balance, it is evident that there is no single ‘theory of the corporation’ to guide corporate law in trying to realise this equilibrium. The models themselves are by their very nature simplified and hence limit the ability to provide assistance or substance in determining practical legal questions of corporate law. [2]  It is, for example, customarily accepted that ‘parties have equivalent access to relevant information and the capacity to evaluate the information in light of their respective interests‘.[3] Most interestingly, this is evidently untrue in the case of tort creditors, many of whom are involuntary creditors. Broadly speaking, there seems to have been a failure to recognise that corporations are centrally different in social and economic terms – if not legal terms – from publicly held corporations. Furthermore, the vast majority of companies are proprietary companies.[4] This is a major shortcoming in the effectiveness of economic theory in determining the appropriate way in which the law should treat the numerous problems that arise. To illustrate this, the problem of claims against directors will be used. At the moment, the nexus of contracts model[5] is one of the leading and prominent theories of economic analysis of corporate law.[6]  Bratton describes the nexus of contracts theory by stating, ‘[i]t has not been well understood even though it has been well accepted‘.[7] He argues that, while useful as a metaphor, it resists empirical verification and is itself circular. In addition, the position of, say, for example, an involuntary tort creditor is not considered in this model and therefore its assumptions about the ability of creditors to factor their risk into the returns demanded from the company is irrelevant. While some community concerns brought arise tortiously from contract matters, the majority involve liability for negligence, deceit, and procuring a breach of contract. The nexus of contracts view, therefore, lacks normative value and does not give a clear indication of the way in which the question of directors’ personal liability to creditors ought to be settled. The nexus of contracts approach to law and economic theory is not the only view considered by theoreticians, however.[8] Some theoreticians have held that directors of companies are trustees, however, that said, the beneficiaries of their duties are debatable.[9] There exist numerous reasons as to why the aforementioned view is not a true representation of the corporate model. Kornhauser comments that: ‘Unlike contract, which allows much discrimination in allocating entitlements among parties to the agreement, trust does not seem adequately flexible to explain the complex allocation of obligations and privileges among this web of actors.’[10] First, a trustee has a duty to act cautiously and to preserve the trust property. Directors, on the other hand, are only required to maximise the company’s profit for the benefit of shareholders. Secondly, the trust property is vested in the trustee whereas company property is owned by the company itself and not its directors. Thirdly, trustees cannot make a profit themselves from carrying out their trusteeship, whereas directors can. It can be seen from the above discussion that the recognised economic and social theories of the corporation do not address the position of directors in civil liability matters, which are especially relevant in light of community concerns over the conduct of directors. The theories are thus irrelevant to the courts’ resolution of claims against company directors personally.[11]

Limited Liability and Legal Personality

Generally speaking, in distinction to the nexus of contracts model, the theory of ‘separate legal entity’ describes the company as a legal being in its own individual right and not as an expedient fiction. In line with the principles laid down in Salomon v Salomon & Co Ltd,[12] an act committed in the name of the company is regarded as its own act by virtue of the company’s separate personality as a distinct legal entity.[13] The issue of the nature of a director’s liability under the organic theory, according to Lord Denning, is paired with the fact of a separate corporate personality.[14] Courts, in some cases, have demonstrated an unwillingness to hold a director personally liable, because, quite self-evidently, to do so would undermine the separate legal entity doctrine and the organic theory. The argument is made that while there might be compelling economic or social policy reasons why a director should take responsibility for the debts or loss in profits of a company in some circumstances, the creditors or shareholder’s contract is nonetheless with the company and not the director. Some cases involving a significant degree of personal responsibility by a director appear to totally ignore corporate law’s foundations in the separate legal entity doctrine.

The Australian Positions

There exist four different tests used by courts to determine personal liability of directors conduct committed while acting for the company. Australia has few cases which look at the issue, and these draw heavily on precedents from other Commonwealth jurisdictions. The ‘direct or procure’ test is the most common, and, as such, will be discussed.

The ‘direct or procure’ test attributes liability where the director could be shown to have expressly directed or procured the act or omissions in question. This is the test most likely to lead to liability. It has been applied in a wide variety of torts. The following examination illustrates the diversity of situations where the test has been applied and the sometimes contradictory ways in which it has been expressed. What is interesting is that courts pay no regard to the separate legal entity principle or the organic theory. They are prepared to find the director liable because of the deliberateness of his or her actions in committing the wrongful act. It has been used in cases of negligence for employees injuries and property damage. In Coulton v Holcombe,[15] the plaintiffs sued the defendant, a director of a steel company, for the negligent storage of perishable goods. The contract was between the plaintiff and the company. But Wilson J held that the director was personally liable. The director wrote to the customer, and created an invoice, creating the clear impression that he was personally liable for the services. Wilson J concluded that the defendant assumed a duty of care as a bailee. His Honour also held that if the director had chosen to write on company notepaper, and rendered an invoice on behalf of the company, the necessary factual foundation for holding him personally liable would have been absent. Furthermore, in Microsoft Corporation v Auschina Polaris Pty Ltd,[16] Lindgren J made it plain that lifting the corporate veil to make liable a director of a ‘one-man’ company was no bar to the application of the test.[17] The ‘direct or procure’ test has also been employed in cases concerning nuisance, conversion and deceit. In Sullivan v Desrosiers,[18] Hoyt JA concluded that the rule in Salomon v Salomon & Co Ltd[19] was no barrier to personal liability in a case of nuisance because ‘once it is determined that a person breaches a duty … liability may be imposed on him and he may not escape by saying that as well as being a wrongdoer he is also a company manager or employee’.[20] It is therefore evident that the Australian provisions dealing with limited liability do not themselves entirely undercut any level of personal responsibility.

Implications

It is well acknowledged that directors perform an important role. The law cannot itself stop wrongful conduct by directors altogether. But it can increase the cost to directors – as outlined above – should they engage in such behaviours. For example, if the imposition of personal liability on directors makes it costly for them to increase the risk to, say, for example, creditors, they will not act in such a way as to cause them. This proposed logic of imposing personal liability on directors assumes the law has a significant impact on directors’ decision-making. Thus, it is essential to bear in mind that the principle of limited liability is to make possible risk-taking and directors are expected to make risky decisions for the benefit of shareholders of the company. The question of what the total community costs involved in imposing liability on directors are. Where the extent of the legislative provisions is very wide, even the notion of being subjected to personal liability is all the more prevalent and unpredictable for directors. The threat of potential liability may also not have a significant impact on directors if they can shift their liability effectively. Directors will ask for compensation to bear the risk of being subjected to personal liability.[21] It is likely they will seek higher reimbursement for bearing the risk, as directors are poor risk bearers,[22] Furthermore, they may want the company to insure or cover them. Directors may impose demands on the company which could be translated into more costly corporate governance and loss of social wealth to protect themselves. There also remains the possibility and hence uncertainty that courts may find their risk-shifting ineffective. It has been suggested that because of the perceived availability of risk-shifting through insurance, courts may interpret such statutory defences very strictly, by reasoning that imposition of liabilities on directors would best effect loss-spreading objectives of society.[23]

Conclusion

While theorists moot at models of the corporation, cases do not refer to these writings in deciding claims against companies – not significantly, at least. While these models may assist in discussions of the rights of shareholders or those in contract with the company, they do not reveal the position of employees’ compensation. Courts seem to favor to look at conventional ideas of incorporation, such as separate legal entity, the organic theory and limited liability. Under the rule in Said v Butt,[24] the very fact that the director acts deliberately for the benefit of the company is crucial in excusing the director from personal liability But while these concepts are relevant in establishing contract liability, the state of the company and the liability of shareholders, they are not relevant to employees who have no say in the business. This lack of unanimity appears to be a result of lack of a sound theoretical foundation. There is also a poor understanding of the role of agency within a corporation, and of the rule that agents are primarily liable. Thus, neither the theory of the corporation, nor the familiar concepts of corporate law are of particular use in the judicial resolution of conflicts between directors and community concerns.


[1] ‘The Company Director: Past, Present and Future’.

[2] O Hart, ‘An Economist’s Perspective on the Theory of the Firm’ (1989) 89 Columbia Law Review  1757.

[3] J Gordon, ‘The Mandatory Structure of Corporate Law’ (1989) 89 Columbia Law Review 1549, 1556.

[4] There are approximately 1,432,150 companies in Australia, of which 1,213,400 are proprietary companies.

[5] See, for example, R Coase, ‘The Nature of the Firm’ (1937) 4 Economica 386; A Alchian and H Demsetz, ‘Production, Information Costs and Economic Organisation’ (1972) 62 American Economic Review 777; M Jensen and W Meckling, ‘Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure’ (1976) 3 Journal of Financial Economics 305.

[6] Michael J Whincop, An Economic and Jurisprudential Genealogy of Corporate Law‘ (2002) 14 Australian Journal of Corporations Law 74, 74.

[7] W Bratton, ‘The Nexus of Contracts’ Corporation: A Critical Appraisal’ (1989) 74 Cornell Law Review 407, 410.

[9] E Merrick Dodd, ‘For Whom Are Corporate Managers Trustees?’ (1932) 45 Harvard Law Review 1145; A Berle, ‘For Whom Corporate Managers Are Trustees’ (1932) 45 Harvard Law Review 1365.

[10] L Kornhauser, ‘The Nexus of Contracts Approach to Corporations: A Comment on Easterbrook and Fischel’ (1989) 89 Columbia Law Review.1449, 1450.

[11] [1897] AC 22.

[14] H L Bolton (Engineering) Co Ltd v T J Graham & Sons Ltd [1957] 1 QB 159, 172.

[15] (1986) 162 CLR 1.

[16] (1996) 71 FCR 231.

[17] Ibid, 246-7.

[18] (1986) 76 NBR (2d) 271.

[19] [1897] AC 22.

[20] (1986) 76 NBR (2d) 271, 277.

[21] F Buffini, ‘Calls to Protect Corporate Conscience’, Australian Financial Review, 23 November 2005, p 4.

[22] F Easterbrook and D Fischer, The Economic Structure of Corporate Law, Harvard University Press, Boston, 1991, pp 61-2.

[23] R J Daniels, “Must Boards Go Overboard? An Economic Analysis of the Effects of Burgeoning Statutory Liability on the Role of Directors in Corporate Governance” (1994-5) 24 CBLJ 229, 249.

[24] [1920] 3 KB 497.


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