Legal Insights Issue 1/2018, April 2018 – “DIVISION OF POWERS BETWEEN SHAREHOLDERS AND DIRECTORS”

DIVISION OF POWERS OF MANAGEMENT BETWEEN SHAREHOLDERS AND DIRECTORS

Lee Shih and Joyce Lim discuss the effect of the Federal Court’s decision in the Petra Perdana case

On 14 December 2017, the Federal Court delivered its grounds of judgment in the case of Tengku Dato’ Ibrahim Petra bin Tengku Indra Petra v Petra Perdana Bhd [2018] 2 MLJ 177 (“Petra Perdana”). This case relates to two appeals which emanated from a High Court action relating to questions in company law on governance and management of a company as between its directors and shareholders in general meetings. In particular, it gives guidance on the division of powers between the shareholders and directors on managing the affairs of a company and sets out the test to be adopted in determining whether a director has acted in the best interest of the company.

BRIEF FACTS

The plaintiff, Petra Perdana Berhad (“PPB”), owned 126 million ordinary shares in Petra Energy Berhad (“PEB”), amounting to approximately 64.62% of the issued and paid up capital of PEB. At all material times, the three defendants were directors of PPB.

In April 2007, an ordinary resolution was passed and a general mandate was given to PPB to, among others, divest up to 19.5 million of its shares in PEB (“Shareholders’ Divestment Mandate”). On or about 10 December 2007, PPB divested 9 million of its PEB shares (which represented approximately 4.62% equity stake in PEB), thereby reducing PPB’s holding in PEB from 64.62% to 60%. The Shareholders’ Divestment Mandate was renewed on an annual basis.

Subsequently, pursuant to payment demands by a ship builder in respect of the balance purchase price of a vessel, PPB’s board of directors resolved in August 2009 to sell 10.5 million PEB shares (5.38% equity stake in PEB) (“August Board Mandate”). Pursuant to the August Board Mandate, PPB divested 10.5 million PEB shares on 10 September 2009, reducing its stake in PEB from 60% to 54.62% (“Second Divestment”).

By November 2009, PPB was facing serious financial difficulties and cash flow problems. After considering various fundraising options, PPB’s board of directors resolved to divest PPB’s remaining 54.62% shareholding in PEB (“November Board Mandate”). Pursuant to the November Board Mandate, PPB sold 48.8 million PEB shares (25.03% equity stake in PEB) to Shorefield Resources Sdn Bhd (“Shorefield”), resulting in Shorefield becoming the controlling shareholder of PEB (“Third Divestment”). The proceeds of the disposal obtained from the Third Divestment were utilised to pare down bank borrowings and the gearing ratio of PPB’s group of companies. The Third Divestment also resulted in a gain of approximately RM13.7 million for PPB’s group of companies.

During the board of directors’ meeting on 22 December 2009, the PPB board deliberated on the divestment of the remaining 29.59% shareholding in PEB pursuant to the November Board Mandate (“Intended Fourth Divestment”). The Intended Fourth Divestment did not take place as an injunction was obtained in the High Court by one of PPB’s directors to restrain the sale of the shares.

This led to a corporate power struggle dispute within PPB and resulted in the defendants being removed as directors of PPB at an Extraordinary General Meeting on 4 February 2010.

DECISION OF THE HIGH COURT

With a new management in place, PPB commenced an action in the High Court against the defendants on the basis, among others, that, in causing PPB to undertake the Second Divestment and Third Divestment:

(i) the defendants had acted in breach of their statutory duties under Section 132(1) of the Companies Act 1965 (“CA 1965”);
(ii) the second and third defendants dishonestly assisted the first defendant in the various breaches of duty and were accessories thereto;
(iii) the defendants and the fourth defendant (who was at the material time an executive director of PEB) conspired, whether by lawful or unlawful means, to injure PPB vide the Second Divestment and Third Divestment; and
(iv) the defendants in breach of their fiduciary, statutory or common law duties, failed to act in the best interest of PPB.

The defendants argued that the Second Divestment and Third Divestment were undertaken due to urgent cash flow problems caused by a downturn in PPB’s business. On the other hand, it was PPB’s contention that the cash flow problems were not genuine and that the defendants’ ulterior motive was to dispose of PEB to Shorefield under a conspiracy contrived by the defendants to enable Shorefield to become the controlling shareholder of PEB.

The High Court found in favour of the defendants, holding that, at all times, the decisions by the defendants to undertake the Second Divestment and Third Divestment were business judgments made in good faith after exercising due care and diligence. Further, the High Court found that the defendants did not breach their fiduciary duties to PPB.

DECISION OF THE COURT OF APPEAL

PPB’s appeal to the Court of Appeal was allowed. The Court of Appeal focused on determining whether the defendants had acted in the best interest of PPB and found that the proposition “best interest of the company” was for the majority to decide. In particular, it found that the Shareholders’ Divestment Mandate provided a barometer as to what the shareholders gauged as being the best interest of PPB. In this regard, it was held that in failing to comply with the restrictions of the Shareholders’ Divestment Mandate, the defendants had failed to act in the best interest of PPB. Secondly, the Court of Appeal held that a shareholders’ resolution carried at a general meeting of company amounted to “regulations” pursuant to the articles of association of a company by which the defendants were obligated to comply with. Further, it was held that shareholders by a majority could decide what was in the best interest of a company.

DECISION OF THE FEDERAL COURT

Eighteen questions of law were posed to the Federal Court, seven of which the apex court found unnecessary to answer. This article will focus on the main issues discussed in Petra Perdana.

Division of powers

One of the main issues here was the division of powers between the shareholders in a general meeting and the board of directors. The question posed to the Federal Court was whether the powers of management conferred on directors by CA 1965 and the articles of association could be overridden by an ordinary resolution passed by a simple majority of shareholders at a general meeting. In other words, whether the Shareholders’ Divestment Mandate could override the powers of the directors to divest the PEB shares held by PPB.

The Federal Court answered the question in the negative, holding that shareholders may only override the powers of the directors by altering the articles to take away the powers of the directors, or, by refusing to re-elect the directors of whose actions they disapprove.

Statutory force to this legal position can be found in Section 131B of CA 1965 which provides that “the business and affairs of a company must be managed by, or under the direction of, the board of directors”, subject to “any modification, exception or limitation contained in the Act or in the memorandum or articles of association of the company.”

Furthermore, the articles of association of PPB had set out that the business affairs of PPB shall be managed by the directors with the exception, inter alia, that the directors’ exercise of powers were subject to “these regulations” and CA 1965. The Federal Court (in upholding the High Court’s decision) held that the reference to “regulations” means regulations as envisaged under CA 1965, i.e. the articles of association, and not resolutions passed at a general meeting such as the Shareholders’ Divestment Mandate, and as such, the directors were not bound to comply with the Shareholders’ Divestment Mandate to divest only up to 19.5 million shares in PEB. In other words, the Divestment Mandate did not deprive the defendants of their power to deal with the PEB shares in accordance with CA 1965 and the articles of association.

On this point, while this case was decided in the context of CA 1965, it is interesting to note that the new Section 195 of the Companies Act 2016 (“CA 2016”) provides that shareholders are entitled to pass a resolution in a general meeting to make non-binding recommendations to the directors on management matters, or, pass a special resolution to make a binding recommendation on the directors if the recommendation is in the best interest of the company.

Test for breach of duty to act in the best interest

Another main issue here was the test to be applied in determining whether a director had acted in the “best interest of the company”. The Federal Court held that the test to be applied is a combination of both a subjective element and an objective element.

Subjective element

The breach of a director’s duty is determined based on an assessment of the state of mind of the director, i.e. whether the director (and not the court) considers that the exercise of discretion is in the best interest of the company. The director is under a duty to act in what he believes to be the best interest of the company.

Objective test

However, the director’s assessment of the company’s best interest is subject also to an objective review or examination by the courts. The Federal Court adopted the test laid down by the Court of Appeal in Pioneer Haven Sdn Bhd v Ho Hup Construction Co Bhd & Anor [2012] 3 MLJ 616 which is whether “an intelligent and honest man in the position of the director of the company concerned, could in the whole of the existing circumstances have reasonably believed that the transactions were for the benefit of the company.”

On the facts, the Federal Court decided that the Second Divestment was carried out in view of the urgency of the cash flow problems faced by PPB and as such, it was justifiable to sell the shares at a depressed price. In respect of the Third Divestment, similarly, the Federal Court found that the defendants had carried out the same as they were advised that the cash flow problem faced by PBB for the following 12 months would deteriorate and PPB would face serious liquidity problems.

Applying the tests above, the Federal Court concluded that an honest and intelligent man in the position of the defendants would reasonably have concluded that the Second Divestment and the Third Divestment were necessary in the best interest of PPB. As such, the defendants had acted in good faith and in the best interest of PPB.

Business judgment rule

Briefly, the business judgment rule anticipates that in the absence of fraud, breach of fiduciary duty and conspiracy, a court should not undertake the exercise of assessing the merits of a commercial or business judgment made by the directors of a company, especially with the benefit of hindsight. This is necessary to preserve the directors’ discretion and to protect them from the court’s interference.

This rule was encapsulated in Section 132(1B) of CA 1965 (now Section 214 of CA 2016), which states that a director who makes a business judgment is deemed to meet the requirements of his statutory duty to exercise reasonable care, skill and diligence and the equivalent duties under the common law and in equity if he (i) makes the business judgment in good faith and for a proper purpose; (ii) has no material personal interest in the subject matter of the business judgment; (iii) is informed about the subject matter of the business judgment to the extent that he reasonably believes to be appropriate in the circumstances; and (iv) reasonably believes that the business judgment is in the best interest of the company.

This rule has been applied by the courts consistently (see: Howard Smith v Ampol Petroleum Ltd [1974] AC 821 (PC); Vita Health Laboratories Pte Ltd and others v Pang Seng Meng [2004] 4 SLR (R) 162 (HC); Intraco Ltd v Multi-Pak Singapore Pte Ltd [1995] 1 SLR 313 (CA)).

The Federal Court held that the decisions to undertake the Second Divestment and the Third Divestment were business judgments made for a legitimate purpose by the defendants who had acted in good faith and in the best interest of PPB. As such, there was no basis for the court to substitute its own decision with that of the defendants. Having made the above findings, the Federal Court set aside the orders of the Court of Appeal and reinstated the orders of the High Court.

Distinction in duties owed by Non-Executive Directors and Executive Directors

One of the questions posed to the Federal Court was “whether a distinction should be drawn between executive directors and non-executive directors in circumstance where non-executive directors have limited management functions and played a limited role in executing the impugned decisions made collectively by the board of directors”.

This question followed the High Court’s decision that the two non-executive directors were entitled to rely on the operational forecasts, financial data and information provided to them by PPB’s management as they had less direct knowledge of the day to day operations and finances of PPB than that of the executive director. The Federal Court declined to answer this question given that its answers to the other questions posed were sufficient to dispose of the matter. We will have to wait for another case on this.

CONCLUSION

The Federal Courts decision in Petra Perdana has provided much clarity to the law in respect of the governance and management of a company. In particular, it has affirmed the clear division between the powers of the directors and shareholders in managing the affairs of a company. The case further establishes the appropriate test to be applied in determining whether a director had acted in the best interest of the company, and the application of the business judgment rule in decisions made by directors.


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SUBJECT MATTER: CASE COMMENTARY


WRITERS' NAMES: LEE SHIH (L) & JOYCE LIM (R)


WRITERS' PROFILES:

Lee Shih is a Partner of SKRINE. His main practice areas are corporate litigation, corporate insolvency and international arbitration.

Joyce Lim is an Associate in the Dispute Resolution Division of SKRINE. She graduated from the University of London in 2014.

 

 

 

 
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