A useful warning to directors but no cause for alarm

Media coverage of the Luvit Foods decision in which the Court of Appeal ordered a director to refund investors for shares allotted illegally, even though the woman was not on the board at the time the money was raised, may have alarmed some directors unnecessarily.

Yes, it’s a useful reminder of the importance of carrying out due diligence on a company before accepting a directorship.  But the judgment will probably have a fairly narrow application and does not break new ground.  Instead it merely applies current legal principles to a particular and infrequently occurring set of facts.

Luvit Foods International Limited (Luvit Foods) was incorporated in 1999 with James Chean as sole director.  He held an investor presentation in 2000 where a business proposal for the company was outlined.  No prospectus was registered.  The investors bought parcels of shares on various dates during 2000 and 2001.  On 15 October 2001, after the share offers and allotments had been made, Ai Nee Chean, James Chean’s wife, formally became a director of Luvit Foods.

Luvit in the courts

In the first case in the Luvit Foods saga, the High Court found that Luvit Foods, Tennet International Limited (a related company) and James Chean were liable to repay $1.68 million of investor subscriptions for breaches of the Securities Act 1978 and losses caused under the Fair Trading Act 1986.

The investors then brought a subsequent case for summary judgment against Ms Chean (who was not a party to the previous proceedings) alleging liability under the Securities Act to repay a portion of the subscriptions, and knowing receipt of trust funds and breach of trust.  Associate Judge Faire entered summary judgment for $150,000 claimed in relation to the Securities Act and $573,195 for knowing receipt. 

Ms Chean appealed this decision.

The issue before the Court of Appeal that is relevant for our purposes was whether there was an arguable case that Ms Chean was not liable to repay subscriptions under section 37(6) of the Securities Act:

  • because she was not a director at the time of the share allotments, or

  • via application of the proviso to section 37(6), in that the default in the repayment of the subscription money was not due to any misconduct or negligence on her part.

“Director” is defined broadly in the Securities Act and could include someone who is not in office as a director but carries out the role of one.  Ms Chean played a part in preparing accounts, had signing authority and was otherwise involved in the business.  The investors therefore argued that she had been a director since Luvit Foods was incorporated even though she did not formally take office until she signed the consent in October 2001. 

The Court found that section 37(6) applied to Ms Chean because, whether or not she was a director at the time the allotment was made, she was clearly a director when the obligation to repay subscriptions arose, this being specified as either two months after the subscription receipt date or five months after the date of the prospectus, depending on the nature of the issue. 

The Court left open whether this section applies to directors who were in office when an unlawful allotment was made but not in office when the repayment obligation arose.

Ms Chean’s argument that the default in repayment of the subscription money was not due to any misconduct or negligence on her part (trying to use the proviso) was also unsuccessful as there was no evidence supporting this assertion.

The Court of Appeal upheld the summary judgment entered by Associate Judge Faire in regard to the $150,000 repayment.  However, the $573,195 judgment in relation to knowing receipt was set aside and that matter was directed to proceed to trial. 

Luvit Foods went into liquidation in June 2007, prior to which Mr Chean was adjudicated as a bankrupt on his own petition.

What directors can take from this decision?

There is always value in being reminded of the risks which can befall directors and of the need to ensure that a company’s affairs are conducted at all times in full compliance with all relevant laws. 

In particular, persons taking up directorships during or shortly after the company issues securities need to remember that personal liability to repay subscriptions attaches to directors in office at the time of the repayment obligation set out in section 37(6) and not at the allotment date.

However, the decision is no cause for alarm and turns on its (relatively uncommon) facts – Ms Chean’s close involvement in the business throughout, and knowledge of, the capital raising process.  This case simply demonstrates what can happen when a company acts in breach of the law, and to new directors who do not do their homework before taking office.

Our thanks to Shalindri Silva, Solicitor for her contribution to this article.

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