- The recent Western Areas decision is a powerful cautionary tale of the dangers of disregarding the rule against wrongful diversion of a corporate opportunities
- The rule is capable of strict application, with significant financial consequences, even for inadvertent breach
- In contemplating any M&A activity, it is essential to consider and discuss with trusted advisers where any possible breach of duty may arise
The rule against wrongful diversion of a corporate opportunities is a fundamental part of directors’ duties. The recent Western Areas1 decision is a powerful cautionary tale of the dangers of disregarding this rule. As it has potential application to all M&A activities, careful consideration of the relevant issues is essential before concluding a transaction.
A stringent rule, strictly applied
On first blush, it is hard to believe that the referral of an opportunity happened upon through a chance meeting on St Georges Terrace, the main street of Perth’s CBD, could lead some 10 years later to a $68 million liability.
The companies at the heart of the dispute have confusingly similar names, Western Areas Exploration Pty Ltd (WAE) and the ASX listed Western Areas NL (WSA). The main actors in the dispute were the directors of WAE at the time, Terry Streeter, David Cooper and Lex Brailey.
In late November 1999, Mr Brailey bumped into an out-of-work geologist, who was looking for seed capital to explore a package of nickel tenements. Although it was disputed, the court held that Mr Brailey became immediately interested in this opportunity and asked Mr Streeter to pursue it on behalf of WAE. Messrs Streeter and Cooper did pursue the opportunity, ultimately not through WAE, but through the newly incorporated WSA.
Mr Streeter received almost 11 million shares in WSA on its IPO and listing on ASX, including by way of options, all of which were exercised. These were issued at various prices, but only 4.5 million of the shares were offered at discount to the IPO price. For the most part then, Mr Streeter’s shares were issued for full value, requiring a substantial investment. Mr Cooper received 400,000 four-year options exercisable at twice the IPO price.
In 2006, Mr Brailey regained control of WAE and caused it to institute proceedings against Messrs Streeter and Cooper, alleging they had acquired their WSA shares in breach of their fiduciary duties. In the result, the court ordered Messrs Streeter and Cooper to hand over the 11 million WSA shares to WAE or, at WAE’s election, to account for their profit from the shares based on market value.
At the time of writing, those shares are worth a staggering $68 million.
A trust broken
The decision becomes more understandable when the relationship of trust between WAE and Messrs Streeter and Cooper is appreciated. The court held that Messrs Streeter and Cooper only became aware of the opportunity to invest in the package of tenements because Mr Brailey asked Mr Streeter to pursue it on behalf of WAE. From WAE’s perspective, it had disclosed the existence of the opportunity in reliance on Mr Streeter putting the company’s interests before his own.
The court found it was clear that, in the initial stages, serious attention was given by Messrs Streeter and Cooper to using WAE as the vehicle to acquire the tenements. However, after a short time, the plan was changed. The court found that Messrs Streeter and Cooper realised that some form of participation in the opportunity by WAE was due and necessary, but they accepted dilution of that participation while negotiating a controlling interest for Mr Streeter. It was held that they deliberately kept the changed proposal from Mr Brailey and the other shareholders of WAE until it was accomplished.
Effectively, they took an opportunity which they knew was of the kind being sought by [WAE] through [WSA] in a manner which secured for themselves major collateral benefits and, thereafter, abandoned any thought of pursuing the same or similar projects by [WAE].2
The rule applies even if company cannot take up the opportunity
The defendants contended that, when the events leading to the litigation occurred, WAE was a failed company, carried on through the life support of loans provided by Mr Streeter. Certainly, at that time it had just $20,000 in cash and had relied on a series of loans totalling $155,000 from Mr Streeter to meet its commitments. Certainly also, it had tried but failed to achieve listing on ASX twice in 1997 and 1998 and was then dormant for the year before the relevant events and thereafter. WAE and its principal shareholders were offered shares in the IPO of WSA, but did not take them up.
How then, could WAE claim Messrs Streeter and Cooper appropriated one of its corporate opportunities?
For one thing, the court did not accept that WAE was incapable of taking up the opportunity. More significantly, however, the decision reinforces the line of authority that the inability or unwillingness of the company does not affect the duties of the director.
That is, even if the company does not wish to or cannot take up the opportunity, the director must still not derive any benefit from the opportunity without the company’s fully informed consent.
And the consent of the company can only be obtained from its shareholders, not from other directors. It goes without saying, fully informed shareholder approval is often a high bar to overcome.
Rule’s harsh application untempered by allowances for effort or other factors
In the 10 years from the opportunity arising to judgment, WSA enjoyed remarkable success, with its shares at the time of writing being worth over 30 times the IPO price.
It appears that WSA’s success had little to do with the tenements acquired through the opportunity in question. Of those seven tenements, three have been surrendered and the remaining four are of very minor significance to WSA’s current operations. Rather, WSA’s success seems in large part due to the acquisition of a suite of tenements near Forrestania, Western Australia, and the numerous capital raisings and effort required for the development of mines on those tenements.
Although canvassing the factors contributing to WSA’s success at length, the court saw no significance in them, pointing out that the entitlements of the original IPO share recipients were not diminished by additional investments, good management or luck.
Neither did the court make any allowance for the efforts of and further investments by Messrs Streeter and Cooper. They were compensated on commercial terms for these, the court said, by the not insignificant remuneration received from WSA and the direct benefits flowing from the investments.
The court was also unsympathetic to complaints of delay—a long six years passed between the opportunity arising and WAE commencing proceedings. For Messrs Streeter and Cooper, this was a period of continued investment, devoted effort and de-risking a junior explorer into an established producer. In the court’s view, none of these amounted to any form of prejudice sufficient to defeat WAE’s claim for disgorgement of profits gained in breach of duty.
The court did reduce the award to WAE by the amount Messrs Streeter and Cooper originally invested to acquire the WSA shares, plus interest (calculated at the relatively high prescribed rates).
The message for directors
The Western Areas decision is unlikely to be seen as changing the law. However, it does provide a recent, local example of the willingness of Australian courts to apply the rule against wrongful diversion of a corporate opportunities strictly. It starkly illustrates the power of the remedies available on breach of duty, with the complainant given the choice between a constructive trust over $68 million worth of shares or an account of profits based on their market value. It shows the determination of the courts to strip ill-gotten gains, without allowances where the causes of the gains are unrelated to the diverted opportunity.
Impact on M&A transactions
Frequently in M&A transactions it is necessary to decide through which corporate entity to pursue an opportunity. Although the Western Areas decision involved a findingof misconduct, the rule against wrongful diversion of a corporate opportunities may apply where there is no deliberate wrongdoing. In addition, while the decision involved a private negotiated acquisition, the principles have equal application in the public arena.
Consider these examples:
- An investment bank pitches an opportunity to the board of one company, which declines to pursue it. One of the directors present believes that another company he is interested in may wish to take up the opportunity.
- An opportunity is identified by a listed company, but before the transaction is concluded, the company’s board decide it would be better housed in an new vehicle to be spun out. The underwriter of the newco’s capital raising is associated with one of the directors.
- A director has interests in a stable of largely independent companies, is well known as a deal maker and often approached with investment proposals. The director raises an opportunity with one of the companies he is interested in before settling on a different match with another of his companies.
Potentially, in each of these examples, the director may take a benefit in connection with the opportunity with the fully informed consent of shareholders of the first company.
There are unlikely to be real issues with diverted opportunities amongst companies in a wholly owned group, but difficulties can arise where there are minority interests or changes in shareholdings. The dangers are particularly acute for the mining moguls of the West, who must regularly balance the competing interests of their controlled entities. However, the same issues can arise for any company.
In contemplating any M&A activity, it is essential to consider and discuss with trusted advisers where any possible breach of duty may occur. Strategies to eliminate or reduce the risk of adverse outcomes can then be explored.