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Dysfunction and danger in the company constitution

By David Oon
February 09 2018
4 minute read
Dysfunction and danger in the company constitution
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Constitutions for a private company, SMSF trustee, discretionary trust trustee, etc can contain many pitfalls for the unwary.

Can a person be sued because of a company constitution?

Because a company is governed by its internal rules in the constitution and by outside laws such as the Corporations Act (2001) (Cth), the constitution can form the basis for a legal challenge. Section 140 of the Act states that a constitution takes legal effect as a contract between the company and shareholders, the company and each director and secretary, and a shareholder and each other shareholder, where each person agrees to observe the rules. Accordingly, advisers may also be at risk if the constitution is unsuitable.


Old company rules

A constitution dated prior to 1995 would typically have been referred to as a ‘memorandum and articles of association’. This terminology is a near-sure sign that a constitution is out of date.

Further, a critical change in law was brought about by the First Corporate Law Simplification Act 1995 (Cth), which reduced the minimum number of directors for a proprietary company from two to one. The reasons for the change included providing greater independence to women seeking to start their own business, and to eliminate so called ‘sexually transmitted debt’. Unfortunately, many older constitutions and memoranda and articles of association will still say the company must have at least two directors. This can be a time bomb for sole director companies or even for multiple director companies as directors inevitably resign, die or lose capacity to make decisions, reducing the number to one. Newer constitutions will usually have addressed this issue.

Who can act when a director loses capacity or dies?

Under company constitutions, a director automatically loses their office when they die or lose mental capacity. Many think that on loss of mental capacity, a director’s attorney under an enduring power of attorney automatically becomes a director, or can at least ‘stand in the same shoes of the director’ and exercise director rights. However, recent case law has shown that this is simply not true.

Under most constitutions, the directors or shareholders have power to appoint new directors. However, in many family and private companies there are only two directors — mum and dad who typically hold shares equally. Upon a loss of capacity or death, the representative of the deceased or incapacitated spouse will usually not have power to appoint a director since they will control only 50 per cent of the shares, not more than 50 per cent.

Accordingly, if either mum or dad loses legal capacity or dies, the remaining director (i.e. the surviving spouse) will often effectively control the ongoing affairs of the company. This may result in the wishes of the director who has lost capacity or died being ignored.

Very few constitutions will ever address this issue, e.g. by providing successor director mechanisms that allow a chosen person to become a director on the loss of capacity or death of one director.

Who can stand in a shareholder’s shoes for succession planning?

Many people assume that an attorney under an enduring power of attorney or executor in the case of death can vote in place of a shareholder after the shareholder has lost capacity or died. However, case law makes it clear that this is not the case unless the company’s constitution empowers the attorney or executor to act. Many constitutions do not deal with the issue. This may mean that shareholders are left in the lurch if they cannot act (e.g. to vote in directors).

Signing, formalities and use of technology

Many older or poorly drafted constitutions will require very technical formalities to be complied with in order to perform simple functions. In particular, they may enshrine the use of older procedures and technologies, and not make space for newer ones. A good constitution will promote flexibility and provisions to prevent decisions and meetings from coming unstuck due to lack of formality.

One example of this is that a circulating resolution (which does not require a meeting) under most constitutions requires every director to sign before it can be passed. However, the majority of directors may wish to pass a resolution without needing the signature of every director. A more flexible constitution will allow a majority of directors to do this. As meetings decline in importance and many resolutions are passed by circulating resolution, this issue is growing in significance.

A further example of this is that section 127 of the Corporations Act states that a sole director who is also the sole secretary can sign documents for the company. It also states that the section does not limit the ways the company may execute a document. A good constitution will add flexibility by stating that a sole director can execute documents, whether or not they are also the sole secretary.

Keeping control in the hands of the intended majority

Under most constitutions, a small number of persons (often two) can form a quorum for a meeting of shareholders or directors. If one or more persons are unable to attend (even due to innocent things such as being caught in traffic), a small number of persons may be able to form a quorum and pass shareholder or director decisions without the input of those not present. This is because decision making is typically structured to allow a majority of those present at the meeting to make decisions, instead of having regard to the overall directors or shareholders. A more considered constitution may address this by requiring an overall majority of all existing director/shareholder votes, ignoring the number present at a given meeting.

SMSF trustee companies

Many SMSF trustee companies currently claim the lower ASIC annual fee reserved for special purpose companies, without having the provisions in their constitution that are required by law to be eligible. A good constitution will have the requisite provisions. An even better constitution will have an automatic switching provision to ensure that the company constitution does not need to be changed again in the future if the company is later used for a different purpose.

David Oon, senior associate, DBA Lawyers