Fettering of Directors’ Discretions

A private company constitution will generally empower the board to control the management of the company.  As a result, directors have the power to decide future planning matters, develop and manage a business plan and make material business decisions which typically include input into major contracts between the company and third-party suppliers.

There are other matters, usually going to control of the enterprise, that afford a discretion to directors such as the power to determine the level of borrowing by the company, the issue of shares, debentures and options, and whether the company should make a call on shares.  The constitution may also give directors a discretion, by refusal to register a share transfer, as to who may become a member of the company.  Directors may also be able to control the composition of the board by, for example, retaining the power to fill casual vacancies and to appoint directors to fill vacancies (up to the permitted maximum).

Directors have statutory duties in respect of the exercise of their discretions.  A director of a company owes a duty to act in good faith in the company’s best interests and for a proper purpose (Section 181 of the Corporations Act 2001 (Cth) (the Act)).  This statutory duty codifies the expectation that flows from the fiduciary relationship between the company and a director (who is acting for that Company).

Relevantly, as fiduciaries, each director must:

• Give adequate consideration: Directors are required to exercise what commentators call “active discretion”. They cannot be wilfully blind to an issue when exercising a discretion and must give proper consideration when purporting to use a particular discretion.
• Retain discretions: A board cannot delegate without authority and a director cannot fetter the future exercise of discretion in the absence of authority. This is often referred to as a duty to “retain discretions”, whether conferred by the Act or by the company constitution.
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A private company director needs to pay particular attention to the exercise of discretion when considering, and then approving, the execution of a contract with a forward or future obligation.  A director also has a duty to prevent insolvent trading by the company (Section 588G of the Act).  The conduct of a director who actively manages the day-to-day business of the company will be closely examined if an insolvency event occurs.  In exercising their discretion on behalf of the company, if a director ‘gets it wrong’ and an insolvency event occurs, they may be personally liable.

A very practical question arises if a company (as a separate legal entity) seeks to enter a contract that binds it to act in a particular way at a future point in time.  If a company enters a contract with an obligation compelling a future decision or action, which in turn would require further consideration or an assessment of whether the doing of an act or thing is in the best interests of the company at that time, does a director fetter their discretion?

Current global economic uncertainty, future tariff impacts, heightened potential for force majeure events and general geo-political uncertainty have resulted in an increase in more complex future and forward-looking contractual arrangements.  Consequently, directors are seeking advice concerning the process needed to satisfy their directors’ duties when a future matter is unknown, they have little to go on at the time of making the decision and a contractual obligation requires a decision on the date of signing the document.

The relevant law has been settled for some time.  Personal deliberation of an issue must be carried out at the time of determining if a resolution or decision is in the best interests of the company.  However, these judgments and the exercise of discretion when a company enters into a contract or agreement which binds the company to performance of the contract at a future point in time may appear to impede or “fetter”.

In Thorby v Goldberg (1964) 112 CLR 597, a case that is generally quoted to stand for the principle that a contract is void for uncertainty if an essential term is left to be agreed at a future point in time, the court also determined that:

“…the proper time for the exercise of the directors’ discretion is the time of the negotiation of a contract, and not the time at which the contract is to be performed”.

It follows that, when entering the contract, the director must have given adequate consideration to the terms of the agreement and believed in good faith that the performance of the contract (and, by extension, the binding obligation to fulfil a future obligation) was, as a whole, materially beneficial to the company and in its best interests.  If this deliberation process has occurred, the contract will be lawful, and the director will have discharged their duty.

However, a distinction was made in the Thorby case by Menzies J, who cautioned that it is important the exercise of discretion at the time of negotiation did not extend to binding a director to discharge their duties and exercise their powers in a certain way in “any ordinary case”.  A director, as an individual, cannot simply contract out of their duties to the company and, as we often see, this highlights the fact that each decision is subject to the particular facts in each situation.

Circumstances can change.  If the position of a company changes after the contract was entered, the performance of that contract may no longer be in the best interests of the company.  This issue was addressed in Talbot v NRMA Ltd (2000) 50 NSWLR 300 in the context of a rule in the company constitution which fettered the discretion of the director.  It was noted that the Thorby case:

“… leaves open the possibility that in extreme circumstances it could still be a breach of a director’s fiduciary duty to a company if the director carries out such a contract”.

Further, while the principle in Thorby has generally been accepted by the Courts, its application remains nuanced and open to interpretation.  For example, a unique business structure designed to give outside control to an ‘investment vehicle’ company can result in a finding that the director’s duties were fettered upon establishment of the company, and therefore decisions of directors were fettered in an absolute way and in contravention of Section 181 of the Act (see Australian Securities and Investments Commission v Macro Realty Developments Pty Ltd [2016] FCA 292).

There are also instances where the principle in Thorby will not apply.  For example, where a parent company seeks to enter into a contract on behalf of its subsidiaries that binds a subsidiary to a future obligation (see ANZ Executors and Trustees Company Ltd v Qintex Australia Ltd (recs & mgrs apptd) [1991] 2 Qd R 360).

Any assessment of whether it is lawful for a director to bind the company to future performance of an obligation which fetters the exercise of the directors’ discretion will always depend on the circumstances and whether adequate consideration was given to the terms of the contract and discharge of the directors’ duties.

A private company director needs to consider whether they are appropriately exercising their discretion to ensure that they fulfill their fiduciary duties.  A contractual term that pre-determines a matter that would otherwise ordinarily require a director to exercise judgment (particularly at a future point in time) may give rise to a breach of duty.

This area of governance is particularly focused on private companies making business decisions.  When economic landscapes change, those decisions take place in a higher risk environment and, as such, the consequences of decision-making, such as the company becoming insolvent, are far more significant.

This issue is both real and live, as private company directors (particularly SME directors) often personally negotiate and approve material contracts, and the conduct of directors leading up to an insolvency event will be closely examined by regulatory bodies, liquidators and other appointed administrators.

It is important for directors to ensure that, when contracting for a company, they consider provisions that pre-determine the exercise of a future judgment or decision, at the time of signing.  If the future determination is not in the best interest of the company, or is uncommercial or unreasonable, at the time of signing, a decision to accept the provision may amount to a breach of directors’ duties.  Similarly, if that future determination is designed to circumvent a procedural requirement, it is likely the decision to approve the contract will be unlawful.

This article was co-written by Jonathan Gorsevski, Lawyer.

This article is not legal advice.  It is intended to provide commentary and general information only.  Access to this article does not entitle you to rely on it as legal advice.  You should obtain formal legal advice specific to your own situation.  Please contact us if you require advice on matters covered by this article.