It goes without saying that the primary goal of a profit company is to increase the wealth of its shareholders, by paying dividends and causing the price of the company’s shares to increase. The company’s board is entrusted with managing the business and affairs of the company in the interests of the company’s shareholders, as well as its wider stakeholders such as customers, suppliers, creditors, employees and the community. Therefore, to achieve the primary goal, the board must ensure that dividends are paid to the company’s shareholders, but that in paying the dividends, such action will not adversely impact the price of the company’s shares or the wider interests of the company’s other stakeholders.

Every director (and prescribed officer) should be mindful to never turn a blind eye to any decision proposed to be made by the board, especially when it is endeavouring to carry forth the company’s primary goal and, most importantly, even where such director’s voting rights alone cannot change the outcome of the board’s decision.

This article sets out at least one scenario where “turning a blind eye” has very dangerous consequences.

Hypothetical scenario

–       A company’s board of directors consists of three directors.

–       Two of the three directors are the sole shareholders of the company.

–       The two directors who are shareholders wish to declare and pay a distribution (a dividend).

–       The third director, who is not a shareholder, does not believe that the company has sufficient funds to declare a distribution.

Question

What should the third director do?

Applicable Law

Section 46(1) of Companies Act (71 of 2008) (the Act) provides that a company must not make any proposed distribution unless –

(1) (a) the distribution –

(i)    is pursuant to an existing legal obligation of the company, or a court order; or

(ii)   the board of the company, by resolution, has authorised the distribution;

(b) it reasonably appears that the company will satisfy the solvency and liquidity test  immediately after completing the proposed distribution; and

(c) the board of the company, by resolution, has acknowledged that it has applied the solvency and liquidity test as set out in section 4, and reasonably concluded that the company will satisfy the solvency and liquidity test immediately after completing the proposed distribution.

Section 46(6) provides that a director of a company is liable to the extent set out in section 77(3)(e)(vi) if such director was (a) present at the meeting when the board approved such distribution, or participated in making a decision in terms of section 74; and (b) failed to vote against the distribution, despite knowing that the distribution was contrary to section 46.

Section 77(3)(e)(vi) holds a director liable for any loss, damages or costs sustained by the company as a direct or indirect consequence of the director having been present at a meeting, or participated in the making of a decision in terms of section 74, and failing to vote against a resolution approving a distribution, despite knowing that the distribution was contrary to section 46, subject to subsection 77(4).

Section 77(4)(a) limits the liability in terms of section 77(3)(e) and provides that such liability arises only if (i) immediately after making all of the distribution contemplated in a resolution in terms of section 46, the company does not satisfy the solvency and liquidity test; and (ii) it was unreasonable at the time of the decision to conclude that the company would satisfy the solvency and liquidity test after making the relevant distribution.

Section 77(4)(b) furthermore limits the liability of a director to the difference between (i) the amount by which the value of the distribution exceeded the amount that could have been distributed without causing the company to fail to satisfy the solvency and liquidity test and (ii) the amount recovered by the company from persons to whom the distribution was made.

Analysis

On the assumption that the two directors who are also shareholders of the company vote in favour of the resolution to make the distribution and further resolve that the company satisfies the solvency and liquidity test, the third director (who does not verily believe that the company, after making the distribution, would satisfy the solvency and liquidity test) may take the following course of action:

  1. Director fails to vote against decision

If the third director was present at meeting where the board authorised the distribution, or participated in the making of the decision in terms of section 74, by turning a blind eye and not voting against such decision, that director can be held liable in terms of section 77(3)(e)(vi).

If, thereafter, the third director wishes to mitigate his/her position and escape liability, the third director would be able to apply to a court for an order setting aside the decision of the board in terms of section 77(5).

In terms of section 77(5)(b), the court may make (i) an order setting aside the decision in whole or in part, absolutely or conditionally; and (ii) any further order that is just and equitable in the circumstances, including an order (aa) to rectify the decision, reverse any transaction, or restore any consideration paid or benefit received by any person in terms of the decision of the board and (bb) requiring the company to indemnify any director who has been or may be held liable in terms of section 77, including indemnification for the costs of the proceedings under section 77(5).

  1. Director votes against the decision

If the third director votes against the decision, the director will not be held liable in terms of section 77(3)(e)(vi).

It is therefore of paramount importance that directors who find themselves in such situations ensure that, even where they are unable to sway the board against making such decisions, they should expressly vote against such decisions and ensure that their objections are duly recorded in the minutes of the meeting.

Rectifying the unauthorised distribution

If the distribution was authorised by the board and has not yet been paid to the shareholders, a director may in terms of section 20(4), apply to the High Court for an appropriate order restraining the company from doing anything inconsistent with the Act.

Alternatively, once the distribution has been paid, a director may either:

  • in terms of section 165(2), serve a demand upon the company to commence legal proceedings in terms of section 77(5) (see above);
  • in terms of section 165(6) (in exceptional circumstances), apply to a court for leave to bring proceedings in terms of section 77(5) in the name and on behalf of the company without first making a demand as contemplated in section 165(2), or without affording the company time to respond to the demand; or
  • file a complaint in writing with the Companies and Intellectual Property Commission in terms of section 168.

Conclusion

From the above analysis, it is clear that setting rules for and striking a balance between the often opposing interests of the board in its attempt to pay dividends and increase shareholder returns and the wider interests of the company’s other stakeholders, was no doubt one of the hardest tasks of the drafters of the new the Act.

Having regard to the stringent rules in the Act regarding directors’ duties and standards of conduct, a director can never be too careful in taking an active role in every decision of the board and never turning a blind eye to decisions which might not be in compliance with the Act, even where the board is achieving its primary goal.