Directors' Duties in Focus - Duty to act bona fide (in good faith)

The duty to act bona fide (in good faith) is one of the most well-known requirements expected of company directors.

If you have been in the driver’s seat of your company for a long time, it can be easy to forget that the company has its own "legal personality".  The reason for this is that without the directors, a company cannot legally act on its own.  Therefore, a director must always remember to comply with duties bestowed on him.

The ‘common law’ requires that a director must at all times, act in good faith in running the business affairs of the company.

This requirement ensures protection for the corporation itself, the shareholders and its creditors.  Director’s decisions must be exercised in good faith, not arbitrarily or at the absolute will of the directors, but honestly in the interests of the shareholders as a whole, (Australian Metropolitan Life Assurance Company Ltd v Ure (1923)).

1. What is acting bona fide or ‘in good faith’?

In Whitehouse v Carlton Hotel Pty Ltd (1987), the Court held that the test as to whether this duty has been complied with is a subjective test of “honesty or good faith”.  The presence or absence of good faith depends on the circumstances that are present in each case (which is why the Courts cannot pin it down precisely).

There is no uniform rule in establishing whether or not under the set of given circumstances, good faith is present.  A transaction entered into by a director on behalf of the company, which is outside of the purpose from which the company is established, may be considered to be entered in bad faith, depending on the circumstances.

If a director knowingly and willingly assents to a contract against the law, this is likely to be considered as not being entered into in good faith.

2. What is ‘In the interests of the company’?

When considering the “interests of the company”, a director should have regard to the shareholders as a collective group.  However, interestingly, when the company is insolvent (or at risk of becoming insolvent), the interests of creditors will prevail, (Kinsela v Russell Kinsela Pty Ltd (in liq) (1986)).

Generally, it is deemed to be in the interests of the company if the act of the director is for the purpose of achieving the objectives of the company.

For example, if a company was established for the purpose of undertaking construction of road projects, the act of a director in entering into contract to undertake a water distribution contract may not qualify as within the purpose for which the company was established.

The personal interests of a director may or may not be the same as the interests of the company.  An act of a director in pursuance to the ordinary course of business of the company binds the company, so long as it is undertaken by the director within the scope of his or her power.

However, observance of good faith in a particular transaction is not always enough.  The intention to benefit the company as a whole needs to also be present.  The act must be in the interests of the company.

3. Business Judgement Rule

Directors must exercise their discretion bonafide in what they consider – and not what a Court may consider – to be in the interests of the company, and not for any collateral purpose (Re Smith and Fawcett Ltd (1942)).

As long as the director acts in good faith and in the interest of the company by entering into a contract or transaction with a third person, he/she cannot be held personally liable if it turns out that the contract or transaction was disadvantageous to the company.  This means that it is the intention of the director which is at the heart of the matter.

It is important that the director acted in good faith according to their honest belief that the contract would be beneficial to the company.  Therefore, a director cannot be said to have breached his duty as a director if he/she observed good faith and for the interest of the company in entering a particular undertaking even if it is determined later on that the deal was not for the best interest of the company after all.

You can read more about director statutory duties and criminal offences from a previous blog here.  

What Should I Do Next?

Contact us if you would like further legal advice on Director's Duties.  Our lawyers at You Legal will be happy to assist you in whatever way we can.

* This blog is for general guidance only. Legal advice should be sought before taking action in relation to any specific issues.