Can a company’s constitution bind members?

A case involving dispute resolution procedures

Section 140 of the Corporations Act (Act) is one of the critical and most important provisions which impact on the life of shareholders in companies which are formed to regulate certain associations, businesses or investment programs (amongst other reasons). The section provides:

“A company’s constitution (if any) – in earlier days it was the memorandum and articles of association – that apply to the company have effect as a contract:

(a) between the company and each member;

(b) between the company and each director and company secretary; and

(c) between a member and each other member;

under which each person agrees to observe and perform the constitution [or the memorandum and articles] as far as they apply to that person.”

If the company does not wish to use a constitution, it may rely on the replaceable rules which are an appendix to the Act.

The courts from time to time have had to consider to what extent the constitution of the company governs the direct relationship between the company and the members, or the relationship between the members – ie member to member. The recent decision of the Federal Court of Australia in Financial Industry Complaints Service Ltd v Deakin Financial Services Pty Ltd & Ors ([2006] FCA 1805; 60 ACSR 372) raised some interesting issues. The following facts as set out in the Butterworths Report of this particular case are sufficient to illustrate the critical questions that arose.

The plaintiff (Deakin Financial Services Pty Ltd (Deakin)) was in the business of providing investment advice. In April 2000, it became a member of the defendant, Financial Industry Complaints Service Ltd (FICS). FICS had developed rules, approved by the Australian Securities and Investments Commission (ASIC), which provided procedures for the resolution of complaints against members, including “complaints relating to investment advice provided by a member to a retail investor in relation to a financial service or product”: rule 14. In 2004, FICS amended its constitution, replacing its objects clause with cl 2.3(a), which provided that the objects of FICS included “to act as the complaints resolution body of the financial services industry in Australia”.

Deakin recommended to several of its clients that they invest in a project undertaken by the Westpoint group of companies. Following the collapse of the Westpoint group, a number of the clients filed complaints against Deakin with FICS. When one of those complaints came on for hearing by a panel established by FICS, Deakin argued that the panel lacked jurisdiction to deal with the complaints. The panel ruled it had jurisdiction. Deakin commenced proceedings in the Federal Court of Australia to resolve the dispute. FICS cross-claimed.

The critical issue that faced Justice Finklestein was whether FICS was given the powers to hear the relevant dispute and that they would comply with the arbitration procedures, or whether the strict operation of section 140 of the Act precluded this. Justice Finkelstein ruled that section 140 of the Act by itself would not create a binding contract obliging Deakin to submit to the jurisdiction of FICS. He reviewed many of the earlier decisions in which the application of section 140 of the Act (and its predecessors) had established this rule. In his view these cases made it clear that a company as a general rule of law could not impose on its members an obligation to submit to a particular method of dealing with disputes – ie arbitration – if disputes arose in the affairs of the company.

The question Finkelstein J felt that he had to answer in deciding the issue was whether section 140 of the Act precluded the imposition of the arbitration procedure, or whether a new contract had been entered into between the parties and whether a private contract had in fact been created by Deakin in its decision to be bound by the rules.

The first question Finkelstein J answered in this way:

“… the authorities indicate that although the constitution is a deemed contract it is nevertheless not possible by this contract to do everything that can be done by a private contract. In particular, a company cannot by its constitution enter into what is in effect a commercial arrangement with its members.” (at para 39)

He endorsed the comments made by Salmond J in the New Zealand case of Shalfoon v Cheddar Valley Co-Operative Dairy Co Ltd ([1924] NZLR 561) where that judge noted (at 577):

“A company cannot by its articles whether original or amended, impose upon its members any pecuniary obligations over and above their statutory obligation to pay up the amount of their shares. Any attempt by a company to attach to its shares any accessory or collateral pecuniary liability is ultra vires and void as being contrary to the fundamental principal of limited liability which lies at the root of company law.” (quoted by Finklestein J at para 40)

Finkelstein J felt that there were a number of critical issues that had to be addressed in evaluating this case. The relevant clauses in the agreement between Deakin and FICS were introduced in order to create what he described as a “complete complaint resolution structure that would apply in relation to all complaints” (at paragraph 37). He then made these general comments:

“As the rules are the cornerstone of FICS’ ability to resolve disputes the following question arises: Is Deakin bound by the rules by reason of s 140 [of the Act]? The cases show that members are only bound to observe such of the provisions of the constitution of a company as concern their rights, privileges, powers and obligation as members” (emphasis added) (at para 38).

If the rules concern the internal management of the company and issues surrounding those matters then they are mutually bound. However, in his view if the provisions “purport to have effect on a member in another capacity they will have no operation unless they have been incorporated into a private contract between the company and the member” (at p 383).

Special contract

Finkelstein J noted that a “special contract” cannot be altered except with the consent of the parties. He supported this view by reference to the notion of valuable consideration – new consideration must be provided by the parties in order to create a change to the agreement. The contract between the members of a company is subject to the ability to vary the constitution of the company by procedures set out in the Act.

What was the position in this case? Finkelstein J summarised the position in this way:

“In my view, the external facts establish the existence of a contract between Deakin and FICS to the general effect that Deakin would be bound by FICS’ rules that establish its dispute resolution scheme. The external facts are, on the one hand, Deakin’s application for membership of FICS and its payment of the applicable membership fee (conduct that might be described as an offer to contract) and, on the other hand, the acceptance by FICS of Deakin’s application for membership and the entry of Deakin as a category E member in FICS’ register of members (the acceptance of the offer). The contract came into existence no later than 27 April 2000, the day on which Deakin became a member of FICS. The rules which Deakin agreed to be bound by were the rules in force at the time of the contract, namely the 1999 rules.

This contract has a term that it may from time to time, and under certain circumstances, be amended without the consent of Deakin. Rule 60 of the 1999 rules provides that ‘the Board may amend [the] Rules in accordance with the Constitution after consultation with [various groups]. An amendment will not apply in respect of complaints already accepted by [FICS] unless expressly provided for in the amendment.” (paras 43 and 44)

In the judge’s view the relevant rules of the company needed to be interpreted in the context of specific provisions in the Act which governed the obligations of licence holders operating the type of business they were involved in. Deakin had to be a member of an external dispute resolution scheme approved by the regulator (ASIC), and any attempt to contract out of the operation of those statutory rules would be ineffective. In fact when Deakin applied to become a member of FICS, it authorised FICS “to be its external complaint resolution scheme under the relevant [legislation] and agreed to be bound by the Rules of FICS” (at para 49). Under the circumstances, Finkelstein J felt that the relevant issue arose under the terms of the scheme that had been approved by Deakin and that the obligation to follow the procedures was correctly pursued by FICS.

Finkelstein J also ruled that the relevant arrangements came within the definition of a “managed investment scheme” and therefore was a financial product by virtue of section 764A of the Act.

In all of the circumstances Finkelstein J held that the rules did establish a special contract; these were given further effect by s140 of the Act and Deakin did have to comply with the arbitration procedures. The decision is a clear signal to persons who do not wish the rules of a particular company set up to organise the affairs of a particular association, professional group etc, to ensure that the relevant company’s rules for dealing with the dispute are not binding, but may be used if parties express an option to do so.

Reviving the rights of minority shareholders – the oppression remedy really does work

Two recent decisions, one in the South Australian Supreme Court and one in the New South Wales Supreme Court, show that the oppression remedy contained in s232 of the Corporations Act (Act) does have real teeth and can be utilised in company disputes. This is especially so if the relevant company is what is often known as a ‘closely held’ company, or is established in order to consolidate and make more permanent a partnership or joint venture arrangement. It is therefore interesting to review briefly the two decisions by Duggan J in Harrington v Sensible Funerals P/L and Ors [2007] SASC 66 (Harrington) and by Brereton J in Mopeke Pty Ltd and Ors v Airport Fine Foods Pty Ltd and Ors [2007] NSWSC 153 (Mopeke).

The issues in dispute in Harrington case were briefly these: Harrington and Russell established a funeral business on an equal partnership basis. Russell’s share was then split by him with a colleague, Ms D’Andrea. Harrington’s father had operated a small funeral company and he agreed to assist his son in this new business by providing him with various facilities and equipment he owned. These included mortuary facilities, a vehicle and a body-storing refrigerator. Russell voiced objection to Harrington’s father’s involvement in the business after a year and this led to the father threatening to withdraw the facilities. D’Andrea (who had been appointed a director together with Harrington at the start) and Russell then informed Harrington that they had terminated his position as a director of the company. They argued that because Harrington’s father was in a competing business, this breached the constitution of the company which prevented directors from participating in competing businesses unless they provided a declaration to the company which had been cleared. Harrington argued that this was unnecessary because all of the relevant information was well known to everyone. Russell was appointed as a director in his place, and he advised Harrington that the contract with his father was no longer valid.

In addition to this removal, it was suggested that Russell and D’Andrea had proceeded to issue further shares to themselves by reference to certain loan arrangements that had been put in place to assist the company. Harrington argued that his removal and the issue of the relevant shares and the realignment of the financial affairs of the company amounted to oppressive conduct pursuant to section 232 of the Act.

Duggan J held on the facts that Harrington’s removal was oppressive as there was no basis for Russell and D’Andrea to exclude him from the company’s affairs. He also suggested that the loan arrangements that had been entered into were particularly curious and that the reasons for this action were not easily explained by reference to commercial arrangements. Indeed, he found that various activities that had apparently been entered into by Russell and D’Andrea in order to calculate the relevant loans and how they were to be repaid were unacceptable. “[Russell and D’Andrea] were in a position where they could control the situation and declare that the company had insufficient funds. It was to their advantages to make this assessment at the disadvantage of [Harrington].” (at para 49) Duggan J suggested that the activities were not fair and that oppression was arguable.

Russell and D’Andrea also claimed that Harrington had all of the financial arrangements explained to him previously, had agreed to the loan arrangements, and other matters that were the basis of the disagreement were explained to him. Duggan J felt the mere fact that Harrington had agreed to each of the agreements was probably due to his lack of knowledge and experience. In his view Harrington did not, in fact, agree to the arrangements. He noted:

“I accept that [Harrington] consulted his accountant from time to time, but there is no evidence that the implications of the shareholder loan agreement were explained to him. I find that he was not involved in the all important assessment that the company had defaulted and that the appropriate course to take was to issue shares in the proportions in which they were issued. Although he signed the agreement, I am confident that he did not knowingly take part in what was an artificial arrangement which led to his percentage shareholding in the company being significantly reduced.” (at [51])

In all the circumstances, Duggan J held that the action pursued by Russell and D’Andrea was oppressive, unfair and discriminatory. He felt that, because of the nature of the company being a quasi-partnership, it was appropriate for him to make an order for the purchase of Russell’s business in the remaining shareholders at a fair value.

In Mopeke the facts were briefly these. Two families had decided to form a business for the supply and export of gourmet food (this was done via concession stores in international airport terminals). The Bradfield family held 40 per cent of the shares in the company, while the remaining 60 per cent interest was held by entities held by the Langerlow family. The Bradfield entities (which included Mopeke Pty Ltd) alleged that their nominee, one Petrovski, would remain as executive director of the operations as part of the ‘joint venture’ partnership rationale.

During 2003/04 a number of directors argued that Petrovski was not performing well and at a board meeting on 28 January 2004 he was asked to respond to a performance evaluation which came as a complete surprise to him. Although he later agreed to resign, he then reneged on this decision on the basis that the Langerlow interests were acting unfairly and were trying to pressure him, and through him his company’s interests, out of the arrangement.

The allegations made by Petrovski were that they had changed board meetings to locations and times that he had not been advised of, that they had informed and instructed staff that they were no longer to follow Petrovski’s instructions, that he was locked out of the premises and in other ways precluded from participating in the organisation.

Petrovski and his colleagues brought a case for oppression, alleging a number of grounds. In the first place they said that the company was using its funds to run the defence in this matter, and that this was an unfair use of funds. Brereton J felt that it was appropriate for companies to use their funds if litigation was brought and that it was not unreasonable for this case to be defended as one of the defendants was the company.

Brereton J also rejected Petrovski’s argument that the board minutes and other records were so inaccurate that this amounted to oppressive or unfair behaviour. He felt that whilst such action was regrettable it was not a ground for intervention.

However, he ruled that the removal of Petrovski from management was actionable. In his view, the steps taken by the directors and shareholders to prevent Petrovski from remaining in a position of management were oppressive. In reaching this conclusion he said that it was necessary for someone like Petrovski to show that in a quasi-partnership a party who was excluded in such a fashion needed to establish at least two of the following matters:

1. that an association had been formed or continued on the basis of a personal relationship involving mutual confidence;
2. an understanding had been reached that all or some of the shareholders would participate in the conduct of the business;
3. there were to be restrictions on the transfer of shares so that a particular member in the quasi-partnership could not take out his or her share and go elsewhere.

The judge’s rule was that the majority had used their powers unfairly by removing Petrovski from the business. On the evidence he was satisfied that the Bradfield interests had been incorporated into the quasi-partnership on the basis that it, through Petrovski, would be able to participate in the day-to-day management of the relevant company. He added that there was no need in a case of this kind and that the conduct was also unconscionable.