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WHEN DIRECTORS HAVE DAY TO DAY COMMERCIAL DEALINGS WITH AN ENTITY: DEALING WITH DIRECTOR’S CONFLICT OF INTEREST

This article is for information only and you should seek specialised advice based on your own circumstances

Many agribusiness entities and all irrigation water supply entities in Australia, both government and privately owned, have at least one director who has day to day commercial dealings with the entity,so it is important to consider how these entitiesboth identify and deal with conflicts of interest in their decision-making process.

Why are director’s duties about conflict of interest morerelevant to irrigation supply entities than other entities in different industries?

One of the main difficulties for agribusiness and irrigation water supply entities when making decisions is dealing with the conflicts of interest that arise at board level. As many directors are also purchasers or suppliers,most of decisions they make will affect them personally. In addition, the geographical footprint of supply entities is relatively small and members are extremely conscious of who is affected by board decisions.

  1. What is a conflict of interest?
    Many people refer to sections 191 through 196 of the Corporations Act 2001 (Cth)or the relevant provisions in each state and territory’s co-operative’s legislation. However, you need to look to the common law to find the true scope of the principle and, from that, the extent of the duty.Essentially, a conflict of interest is a set of circumstances that creates a risk that professional judgement or actions regarding a primary interest will be unduly influenced by a secondary interest.
  2. What if all irrigator directors are conflicted?
    A conflict of interest can also arise where a director is asked to consider a decision with a negative impact for members, e.g. adopting or amending the pricing structure for supply to members. The decision to increase prices affects all irrigator directors equally. The directors in this scenario are still conflicted and would need to record the conflict. In most decisions relating to revenue the directors will face similar although perhaps not so obvious conflicts when balancing the financial stability of the entity against the viability of each member’s business.
  3. Duty not to make a secret profit or gain (the so-called profit rule)
    The real issue for directors is to identify a conflict or potential conflict and disclose the issue early so as to not breach the “profit rule”.The general rule is that a director may not use their position to gain a profit or advantage for themselves, nor may they obtain a benefit by entering into a transaction in conflict with their fiduciary duties, without the informed consent of the person to whom they owe the duty. With reference to our earlier example, each of the directors would need to disclose their interest so as to not run foul of the offence provisions in the Corporations Act 2001(Cth).

    The Courts have explained this duty in the following manner:

    1. A director is under an obligation not to promote his personal interests by making or pursuing a gain in circumstances where there is a conflict or a real or substantial possibility of a conflict between his personal interests and those of the company.:
    2. In order tosee whether there is a possibility of conflict you need to adopt an objective test of a reasonable person looking at the relevant facts and circumstances of the particular case.
    3. A director may act with a personal interest even though the director has not freed his or her mind of that personal interest when acting provided that his or her personal interest was not the actuating motive rather than some good faith concern for the benefit of the company as a whole or for fairness as between members.
    4. Mere disclosure of a conflict of interest and abstaining from voting is insufficient to satisfy the director’s fiduciary duty where the director is in a position of power and influence over the board. In such a situation the director is under a positive duty to take steps to protect the company’s interests, for e.g. using such power and influence to stop the transaction from going ahead.
    5. What action beyond mere disclosure depends on how involved the director is in the transaction and the seriousness of possible outcomes for the company.
    6. A director of a company who is also a director of another company must not exercise his powers for the benefit or gain of the second company without clearly disclosing the second company’s interest to the first company and obtaining its consent.
    7. The fact that the profit was made in good faith does not matter.
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    The lesson is:  identify the conflict and disclose the conflict early.

  5. Do we all have a conflict or isthe conflict of one or more directors greater than another?
    It goes without saying that a director on any board has a direct interest in the outcome of decisions made by thatboard. But at what point does the direct interest in a positive or negative outcome become a conflict of interest? And following on from that, does it really matter if a director receives a personal benefit when acting in the best interests of the entity?A common example for irrigation supply entities occurs when the board is asked to consider upgrading an existing item of infrastructure such as a major channel. For the purposes of this example we can assume the upgrade is required because of both the age of the asset and the requirement for further transmission capacity within the scheme. Among the many benefits the upgrade will provide to members, a substantial or significant personal benefit will be derived by one of the directors. We can also assume that the personal benefit derived will exceed that received by other directors and members. That said, all directors and members will receive some benefit from the upgrade.In this scenario all of irrigator directors have a conflict of interest but one director stands to gain more than the other directors or most of the members. The director is more conflicted because the director stands to personally profit or gain from the upgrademore than the others and this could affect their decision. There is no “threshold” or “minimum level” at which a conflict of interest arises; the mere fact a personal benefit is derived is enough.So, for the purposes of the example the director who stands to derive a substantial personal benefit has a greater conflict of interest than the others. All directors with a conflict must declare this and have it recorded in the board minutes and the separate book of conflicts of interest. The director with the greater conflict should refrain from voting, however, the other directors whose conflict is no greater than the members may vote.
  6. The duty to avoid a conflict of interest (the conflict rule)
    Not every conflict of interest can be avoided but each director has a duty to avoid making decisions where a conflict or potential conflict exists. In Hospital Products Case (1984), Mason J stated: “The Fiduciary (in our case a director) is under an obligation not to promote his personal interests by making or pursuing a gain in circumstances in which there is a conflict or a real or substantial possibility of a conflict between his personal interests and those of the person whom he is bound to protect.”A director may not be able to avoid a conflict of interest, but they can act in a manner that will minimise the opportunity for a claim to be brought against them for a breach if they comply with their obligations under the Corporations Act 2001 (Cth), the relevant state and territory’s co-operatives legislation and/or the wider obligation under Justice Santow’s points above.Each director must initially disclose the conflict or potential conflict of interest to the other directors so that the interest can be recorded. Once recorded, a practical measure for avoiding a breach of the duty is to step outside of the boardroom for the discussion and vote. The director can then be invited to rejoin the meeting following the vote.
  7. How can we make decisions if we are all conflicted?
    There is a general principle that says if every director is equally conflicted and the change would similarly affect all shareholder members then all directors can vote. The principle is the same for government owned companies where all directors are equally conflicted.At some point, common sense must prevail, but it is essential that each director record the nature and degree of conflict before voting. The board must satisfy themselves that no one director has a greater conflict than the others. In this respect, the directors must consider the potential gains, or limited losses each director may receive or incur due to their participation in the discussion surrounding the motion, and secondly, in casting their vote.This scenario is very common in water supply entities where all directors are irrigators.
  8. What happens if we make decisions while conflicted?
    In simple terms both civil and criminal actions may be brought against a director where they breach their duty. From a civil point of view, the company would be entitled to seek damages or equitable relief from the director.A director cannot be permitted to retain a profit or benefit that he or she has obtained by reason of a breach of duty. Where it is established to the satisfaction of a Court that a breach has occurred, then that director is liable to account for the profit or benefit obtained.The prevailing view of the courts is that director holds the profit or benefit obtained as a constructive trustee for the entity until it is restored. That said, you cannot punish a director for misconduct under equity by making him or her account for more than he or she actually received as a result of the breach.Where a director has mixed the profit with his own property, the whole will be treated as trust property unless the director can adequately account for the personal component.

    In summary, a director may be required to:

    1. Account to the company for any profits made.
    2. Pay damages and compensate the company.
    3. Comply with terms of any injunction.
    4. Comply with a declaration made by the court.
    5. Restore property to the company; and or
    6. Hold property as constructive trustee for the company.
  9. From a criminal standpoint the penalties range from a term of imprisonment and or fines of up to 2000 penalty units which currently equates to $340,000.00 per offence under the Corporations Act 2001 (Cth) and similar fines under the respective co-operatives legislation.

  10. What to do next?
    The difficulty for agribusiness and irrigation water supply entities directors is identifying real and potential conflicts of interest before making decisions. All directors have a duty in this respect and should approach each decision with caution. It is always best to disclose a conflict or potential conflict in advance, have it recorded in the minutes and abstain from voting.

If you need assistance or want to discuss your obligations simply call

 

Mattila Advisory

02 9252 7177.

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