What Does the Duty to Act in Good Faith Really Mean?

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Table of Contents

• What Are Directors’ Duties?
• Acting in Good Faith
• Insolvency
• Dual company structure
• Acting for a Proper Purpose
• Consequences of Breaching Directors’ Duties
• Key Takeaways
• Frequently Asked Questions

As the director of a company, you have a number of duties to your company. These are known as directors’ duties. One of these duties is the duty to act in utmost good faith in the best interests of the company and for a proper purpose. But what exactly are directors’ duties, and what does it mean to act in good faith and for a proper purpose? This article will discuss this director’s duty to act in good faith so that you can be sure what your legal obligations are as a company’s director.

What Are Directors’ Duties?

Directors are fiduciaries of their company, meaning they owe the company their undivided loyalty. The Corporations Act 2001 (Cth) is the source of different fiduciary duties directors owe to their companies. For example, as a director, you have a duty to:

• exercise reasonable care and diligence in the management of the company;

• act in good faith in the best interests of the company and for a proper purpose;

• not improperly use information or your position to gain an advantage for yourself or someone else or to cause detriment to your company;

• notify other directors of material personal interest when conflict arises;

• avoid any conflicts of interest between yourself and the company; and

• properly manage the company’s finances and ensure that it does not trade while it is unable to pay its debts (insolvent).

However, the broadest and most important of the directors’ duties is the duty to act in good faith in the best interests of the company.

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Acting in Good Faith

To act ‘in good faith’ is to act honestly or sincerely without an intention to deceive. This is also known as acting bona fide. A decision made in good faith is one where you genuinely believe it to be for the benefit of the company as a whole and not merely for your self interest. Additionally, your work is completed in fair dealing. However, this does not mean the decision cannot benefit you too. A decision that benefits both you personally and the company generally is not necessarily one made in bad faith.

Importantly, your decision does not have to have an actual benefit to the company. This is because ‘good faith’ is both subjective and objective. It relates to your state of mind when you make the decision. You, as a director, must genuinely believe that you are acting in the best interests of the company and in a way that an honest and reasonable director would. 

The concept of good faith is closely linked to acting in the best interests of the company.

Acting in the best interests of the corporation means acting for the benefit of the company’s members (i.e. shareholders). Where there are competing interests, you, as the director, need to balance them fairly.

Insolvency

In certain circumstances, directors need to take into account the interests of creditors when acting for a proper purpose, particularly when the company is insolvent or near insolvency.

The general principle is that while a company is solvent, the directors owe their duties to the company itself; which is essentially shareholders. However, as a company approaches insolvency, the interests of creditors become paramount.

If a company does become insolvent, the shareholders’ interests diminish as they are last in line to receive any return after creditors are paid out from the company’s assets. During or close to insolvency, the creditors effectively become the principal stakeholders to whom the directors owe duties.

In this situation, the “proper purposes” for which directors can exercise their powers expand to include protecting creditors’ interests and maximising returns to creditors. Decisions made to prefer shareholders over creditors could potentially breach a director’s duty; specifically, to act for a proper purpose.

Dual company structure

Another common situation is when a company has a wholly-owned subsidiary. In this situation, certain circumstances can align the subsidiary’s interests with the holding company’s interests. The key principle is that directors of a wholly-owned subsidiary can consider the interests of the holding company, provided there is no residual loss or disbenefit to the subsidiary itself.

Essentially, if a subsidiary’s Constitution expressly allows directors to act in the holding company’s best interests, a subsidiary director will have acted in good faith of their interests. If the director acts in good faith in the best interests of the holding company and the subsidiary isn’t insolvent at the time, they will be taken to have acted in the best interests of the subsidiary.

A useful concept the courts have developed to consider the best interests of the corporation is the ‘hypothetical member’. Instead of looking at specific shareholders or groups of shareholders, courts imagine a hypothetical average shareholder. This hypothetical shareholder could be either a current shareholder or a future shareholder. As the director, you need to balance the company’s interests in the short, medium and long term. The court then assesses whether the decision is in the best interests of that hypothetical shareholder.

Acting for a Proper Purpose

This duty requires directors to only exercise the powers they were granted.

The scope of proper purposes is quite broad and broadly covers any legitimate business aim or objective that benefits the company as a whole. To determine what constitutes a ‘proper purpose,’ the motivating purpose behind the exercise of power must align with the objective for which the power was originally granted.

Contrastingly, improper purposes are easier to identify. They typically involve directors acting for their own interests or the interests of a narrow group rather than the company itself.

Some examples where a director may breach this duty include, but are not limited to:

1. issuing new shares to dilute a particular shareholder’s voting power rather than for the legitimate purpose of raising capital for the company;

2. commencing litigation against a party, not to pursue a legitimate claim, but to apply commercial pressure on that party for other purposes; 

3. purchasing shares in other companies owned/controlled by the director substantially for the purpose of raising the share price of those other companies; and

4. exercising powers to provide personal benefits to the director or their associates rather than for the benefit of the company.

Any exercise of power for an ulterior or improper purpose unrelated to the company’s benefit would likely breach this duty.

Consequences of Breaching Directors’ Duties

If you breach your director’s duties, the company can sue you on behalf of the shareholders. An exercise of power by a director in bad faith or for an improper purpose may be invalid. This means that the action may be reversible, where everything will be put back into its original state.

For example, if a director entered into a business contract for an improper purpose, the contract can be cancelled. Consequently, contracting parties, such as yourself, can revert to their original positions before they enter into the contract.

Additionally, a court can order you to stop taking certain actions or order you to pay compensation. This could mean repaying all the profits made from the breach of duty. The court can also order you to restore the company’s position to where it was originally before your breach. Alternatively, courts may order your company to fulfil your contractual obligations regardless. As such, it is in the utmost good faith that you abide by your duties.

Alternatively, the Australian Securities Investments Commission (ASIC) has options to sue you. If ASIC is successful in suing you, you can be:

• ordered to pay up to $200,000 in fines;

• ordered to compensate the company and its shareholders; or

• disqualified from managing a company for a certain period.

Key Takeaways

The director of a company owes a number of important fiduciary duties to the company. One of these duties is the duty to act in good faith in the best interests of the company and for a proper purpose. There are consequences for a company director who breaches these duties, including:

• liability to pay compensation; or

• disqualification from managing a company.

If you have questions about your duties as a company director, our experienced corporate lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 1300 544 755 or visit our membership page.

Frequently Asked Questions