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A director who fails to disclose his personal interest in company contracts risks imprisonment

Failure by a director to disclose a personal interest in company contracts is a criminal offence

The decision in Royal British Bank v Turquand was handed down in the English courts over 150 years ago, but it remains a cornerstone of company law. Essentially, the judgment in this case ruled that, where an outsider deals with a company, he or she is entitled to assume that all aspects of the company's internal governance have been properly carried out.

The rule is based on pragmatism and business convenience.

An outsider ordinarily has no knowledge of the inner workings of the company that he is doing business with.

So, for example, if the outsider has entered into a contract with a company, he usually has no way of knowing whether, at the time that the company's board of directors passed a resolution to enter into the contract, the board meeting was quorate, or whether there had been a flaw in the election of some of the directors who voted on the resolution. It would be inequitable and destructive of business confidence if, in such a situation, the law were to hold that the company is not bound to the contract because of the internal irregularity.

The effect of the Turquand rule

The rule in Royal British Bank v Turquand (for brevity, the Turquand rule) creates an irrebuttable presumption in favour of the outsider that all aspects of the company's internal governance have been properly carried out. The fact that it is an irrebuttable legal presumption means that the presumption holds true even if the company can prove that there was indeed an irregularity in its internal procedures.

A difficulty arises where the Turquand rule clashes with other legal rules.

One such clash occurs where a company enters into a contract whereby it disposes of its entire business (or the greater part of it) or disposes of all its assets (or the greater part of its assets).

In such circumstances, section 228 of the Companies Act of 1973 provides that the disposal must be authorized by a special resolution of the company's shareholders (in essence, by a resolution at a shareholders' meeting which was supported by at least 75% of the total votes cast), except in the case of a disposal between a wholly-owned subsidiary and its holding company or between two wholly-owned subsidiaries of the same holding company.

The logic underlying section 228 is that the company's board of directors has the power to manage the company, but that the disposal of the whole or the greater part of the company's business or assets does not constitute managing the business, but involves putting an end to the business or the greater part of it, and the decision to do so therefore falls outside the powers of the board. The rationale for the requirement of a special resolution in this context is that this is a decision of such a fundamental nature that it ought to require the approval of a substantial body of shareholders' votes.

Assume, however, that the board of directors enters into a contract for such a disposal and (through ignorance or carelessness) the requisite special resolution is not passed at a shareholders' meeting. Is the company nonetheless bound to the contract on the basis of the Turquand rule, in other words, on the basis that the outsider was entitled to assume that the requisite special resolution had indeed been passed, since it was an aspect of the company's internal management?

The Supreme Court of Appeal has now spoken on the issue

Until recently, this was a moot point, and there were conflicting High Court decisions on the issue.

However, the uncertainty has now been resolved by a decision of the Supreme Court of Appeal in Stand 242 Hendrick Potgieter Road Ruimsig (Pty) Ltd v Göbel NO 2011 (5) SA 1 (SCA), in which judgment was handed down in May of this year.

In this case, the Supreme Court of Appeal held that section 228 of the Companies Act of 1973 prevails over the Turquand rule, in other words, that a contract entered into by a company in which it disposes of all or the greater part of its business or assets is not binding on the company unless the shareholders have given their approval by way of a special resolution. The purpose of this section, said the court, is to protect the company's shareholders, and this purpose would be frustrated if the Turquand rule were to apply in these circumstances.

The counterpart in the Companies Act of 2008

Section 112(2) of the new Companies Act of 2008 has a provision substantially identical to section 228 of the Companies Act of 1973, except that the former provides for a further situation where the requirement of a special resolution does not apply, namely, where the disposal in question takes place in accordance with a formal business rescue plan under chapter 6 of the new Companies Act.

As with the 1973 Act the 2008 Act allows shareholder approval by way of a special resolution to be given either in advance or retrospectively, so a slip-up in this regard can be remedied after the event - if sufficient votes can be mustered to pass a special resolution.

Consequently, with the new Companies Act now in force, a special resolution is still required in these circumstances. There seems little doubt that the decision of the Supreme Court of Appeal in the judgment cited above, though technically applicable only to the Companies Act of 1973, resolves the issue for the new Companies Act of 2008 as well - in other words, that this provision of the Act overrides the Turquand rule.

A trap for outsiders
From the point of view of an outsider who is acquiring a company's business or assets, the statutory requirement of approval by way of a special resolution by the shareholders of the target company can present a trap, particularly in circumstances where the outsider is not aware that what he is acquiring is the company's entire business or the major part of its assets.

Even where the outsider enters into such a contract in good faith, and in ignorance of the fact that what he is acquiring is the company's entire business or assets or the greater part, he will be unable to enforce the agreement against the company unless the requisite special resolution has been passed, and no provision of his contract with the company can validly provide otherwise.

Of course, if the shareholders of the disposing company are in favour of the transaction, then they can give approval by way of a special resolution after the event if they had omitted to do so in advance.

But what is the situation where a sufficient number of shareholders are opposed to the transaction to be able to block the passing of a special resolution to approve or ratify the transaction?

In such a situation, the Companies Act of 2008 is clear that the outsider cannot enforce the agreement against the company.

How is the outsider to protect his interests?

If the disposal in question is of the company's entire business or all of its assets, or the greater part, the outsider should therefore insist on having sight of the requisite special resolution before he signs the contract.

If there is any doubt as to whether the contract falls into the category of a disposal of the company's entire business and assets, or the greater part, the safest course of action is to insist that a special resolution be passed before the contract is signed.

If this is not possible because a significant block of shareholders' votes would be opposed o the transaction, then the next best option for the outsider is to ensure that the relevant contract is drawn in such a way that the directors give undertakings in their personal capacity that the company will be bound to the contract, so that the outsider will have a claim for damages against them if the contract turns out not to be binding on the company.

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