A recent decision of the Federal Court of Australia in MG Corrosion Consultants Pty Ltd v Gilmour [2014] FCA 990 highlights the difficulties that can arise when a privately owned company issues shares to an employee.  Once shares are issued, the employee will no longer be just your employee.  An employee shareholder will have a multitude of other rights, including rights to inspect the books of the company, and may ultimately make claims against the company and/or its directors either in his or her personal right or by a derivative action on behalf, and at the expense, of the company itself.

The facts in MG Corrosion Consultants v Gilmour

Mr Gilmour (Gilmour) owned and managed two businesses:

  • Sola-Kleen Pty Limited (Sola-Kleen), which operated a business manufacturing and supplying solar hot water systems; and
  • MG Corrosion Consultants Pty Ltd (MGCC), which operated a business for supplying chemicals for water treatment in cooling towers and heat exchangers and descaling treatments for the mining and processing industries.

In 2000, Mr Vinciguerra (Vinciguerra) was engaged as an employee of MGCC.  After working for MGCC for a period of time, Vinciguerra was offered 30 fully paid shares in MGCC, the other 70 being held by Sola-Kleen.  Vinciguerra accepted the offer and became a shareholder and director of MGCC in July 2000. Vinciguerra remained a director until 22 April 2004, when he resigned.  He continued as an employee until 29 July 2006, but then terminated his association with MGCC altogether.

Gilmour was a director of MGCC together with Vinciguerra at all times until Vinciguerra’s resignation from that office.

Vinciguerra took proceedings in the Federal Court to inspect MGCC’s books and to obtain leave to pursue a derivative action in the name of MGCC against Gilmour and Sola-Kleen.  Vinciguerra was successful in both proceedings and this case was conducted pursuant to the leave granted to Vinciguerra to pursue the derivative action in the name of MGCC against Gilmour and Sola-Kleen.

The essence of the claim by MGCC (effectively Vinciguerra) was that Gilmour had breached his duty as a director under the Corporations Act 2001 (Cth) (Corporations Act) and as a fiduciary under the general law by authorising payments of money by MGCC to Sola-Kleen that were excessive and/or unnecessary.

Were the claimed expenses excessive and/or unnecessary?

There was a considerable amount of evidence given by experts and other witnesses as to whether the expenses were necessary or excessive and different accounts were given as to whether certain items expensed to MGCC had been concealed from Vinciguerra or agreed by the parties.

Following a lengthy analysis of the evidence, Barker J made the following findings in relation to expenses charged to MGCC by Sola Kleen:

  • Debt Factoring Costs: MGCC entered into a debt factoring agreement in order to deal with a cashflow shortfall that was created by a loan from MGCC to the Gilmour Family Trust.  The debt factoring agreement was entered into for the benefit of Glimour’s interests, at the expense of MGCC as a whole and without the agreement of Vinciguerra.  Therefore, the costs associated with that debt factoring agreement were found to be unnecessary.
  • Wages: There was an overcharge to MGCC in respect of the wages of Ms Stedman.  Ms Stedman worked for both Sola-Kleen and MGCC.  By 2006 and 2007, MGCC was paying the overwhelming majority of her total wages, whereas it was found only 5.97% of her working time was spent doing work for MGCC.
  • Legal Expenses: The legal expenses incurred by MGCC in defending Vinciguerra’s application to inspect MGCC’s books and records were unnecessary on the basis that Gilmour caused MGCC to defend Vinciguerra’s application in order to protect Gilmour’s interests and frustrate Vinciguerra’s attempts to protect his rights as a shareholder of MGCC.
  • Management Fees: Management fees charged for salaries and wages of Sola-Kleen staff who worked in the MGCC business, which were calculated on the basis of a 40% mark-up, were excessive, as a mark-up of 10% was all that was appropriate in the circumstances.
  • Directors Fees:  The fees paid to Gilmour for acting as a director of MGCC exceeded the reasonable amount of such expenses.  The experts agreed that $10,000 a year was a reasonable annual fee in these circumstances and therefore, it was found that there had been an overpayment to Gilmour of $198,546.
  • Rates: The rates incurred by MGCC exceeded the amount by which those expenses related to or were incurred for the purpose of conducting MGCC’s business.

Did Gilmour breach his duties as a director?

Barker J held that Gilmour failed to distinguish between what was in his (and Sola-Kleen’s) interests and what was in the interests of MGCC when he authorised the unnecessary or excessive payments listed above.  Furthermore, Gilmour ran the financial side of MGCC as if MGCC was his own and as if Vinciguerra was effectively an employee, without providing Vinciguerra with any knowledge or say in the financial operations of MGCC. In so acting, Gilmour breached:

  • the good faith obligation created by s. 181 of the Corporations Act;
  • s. 182 of the Corporations Act by gaining an advantage for himself or someone else and caused detriment to MGCC; and
  • his fiduciary duty owed to MGCC not to put his interests and those interests associated with him in conflict with the interests of MGCC.

Given that Gilmour effectively controlled Sola-Kleen, his knowledge and actions were treated as the knowledge and actions of Sola-Kleen and Sola-Kleen was considered to be involved in the contravention of the Corporations Act provisions and complicit in the breach of the fiduciary duty owed by Gilmour to MGCC.

The lesson

The lesson from this case is to think very seriously before giving your employee shares. It is often better to incentivise your employees using what is commonly referred to as “ghost” or “shadow” equity. Such an arrangement does not involve the actual issue of shares to your employee, but allows your employee to receive the same economic benefit of being a shareholder.

If you do issue shares to an employee, you must prepare for, and be ready to respond to, any increase in scrutiny of the company’s decisions, accounts and general governance procedures by that employee and the potential claims that may follow.

Being ready will include ensuring that any arrangements with closely related companies (including in relation to management fees, shared assets, revenues, profits and/or expenses) are reasonable and formally agreed and documented in a manner that is transparent and justifiable to all shareholders.  As was the case in MG Corrosion, the minority employee shareholder may at some future time exercise his or her rights to inspect the books of the company and challenge any fees or expenses that he or she considers have been excessively or unnecessarily charged to the company.

 This case exemplifies the undesirable and costly consequences of remaining in the mind-set of managing a company as a closely held 100% owned company after issuing shares to an employee.  Ultimately, in MG Corrosion, the issue of shares to Vinciguerra achieved the precise opposite of the intended objective of the issue, as it resulted in the breakdown of the relationship and Vinciguerra leaving the business.