Chapter 18 Returns to the principals—the law

Introduction

Overview of the chapter. This is the first of three chapters dealing with returns to the principals of closely held companies, a matter of especial practical and legal significance. Many closely held companies represent the sole source of funds for the principal and their family. The combination of ownership and control in closely held companies precipitates on the extraction of funds a far greater degree of legal complexity than in relation to the listed company. This chapter reviews the applicable company and tax law. The subsequent two chapters explore the application of that law to particular distributions, first in one-person companies and then in multi member companies. The chapter presupposes that the reader has read chapter XX on taxation.

Many options. In closely held companies, the principals are generally free, except as constrained by their own financial position and proclivities, to become party to any one or more legal relationships with the firm. The principal will be a shareholder and almost always also a director of the business. In most cases, they are also employees, lenders and borrowers. They may also lease, sell or buy property to or from the firm. Each relationship serves as the vehicle for extracting one or more types of return from the company. Wealth can be returned to the principal in their capacity as a member in the form of dividends, purchase of own shares, return of capital and redemption. As a lender, the principal takes outgoings in the form of interest and loan repayment. As a director, in the form of a director’s fee; as an employee, in the form of salary or wages; as a borrower, in the form of loan proceeds; as a landlord, in the form of rentals; as a tenant, in the form of rental services; and as a seller or buyer, in the form of sale proceeds.

Many rules. Each of the returns is subject to the regulation associated the underlying consensual relationship, eg, that relating to employment contracts, sale of goods, credit contracts and leases. As well, the outgoings are subject to regulation under company law, tax law and matrimonial property law. The ramifications of these statutes vary dramatically with the circumstances of the company and the principals. In some situations, whilst a salary and dividend may attract similar consequences under the tax and matrimonial property statutes, only the one or the other will be permitted under the 1993 Act. In other cases, whilst both are equally feasible under the companies and tax statutes, they will have very different consequences under the matrimonial property legislation. Further, the ramifications will generally vary from one period to the next in the lives of a company and its principals. The number of extraction options and the applicability of three or four significantly different legal regimes, each having its own prerequisites and liability consequences makes planning a particularly intricate exercise. The need for careful planning is obvious. Litigation under the 1955 Act, and now under the 1993 Act, indicates that the extraction of funds exposes the principals to greater liability than most other events in the conduct of the business.¹

The paramount significance of the underlying contract. The regulation of a particular return proceeds from the underlying contractual relationship. An outgoing without a contractual basis constitutes a potential conversion of company assets. In practice, courts try to avoid this result by characterising such outgoings as advances or salary.² The terms of the contract generally fix the nature of the return—eg, as dividend, salary or loan repayment—which in turn determines the applicable statutory regulation. A salary payment is regulated very differently than a dividend under the companies, tax and matrimonial property legislation. The contractual specification of a return also determines its accounting treatment. Whilst all outgoings entail a credit to the cash account, a dividend is debited to retained earnings or profits, salary to expenses, an advance to loan receivables or the principal’s current account, and loan repayments to liabilities. The accounting treatment represents the impact of the outgoing upon the company’s financial statements for the period. These figure significantly in application of the fairness and solvency tests, the principal financial constraints upon returns to principals under the 1993 Act.

Form versus substance. The history of commercial regulation, at least in English-speaking jurisdictions, can be recounted as an ongoing game of cat and mouse between the lawmaker and draftsperson. Most commercial legislation is directed at correcting some perceived abuse associated with a particular contractual relationship. Invariably, the legislation is viewed as objectionable by the parties involved in the supposedly abusive practice as well as by parties who suffer spillover effects from the regulation. In pursuit of their clients’ objectives, which may or may not be legitimate, the adviser will seek to clothe conduct in contractual relationships that fall outside the scope of the legislation. For instance, tax law and company law have traditionally subjected outgoings in the form of dividends to particularly rigorous regulation in view of the consequences of the entity status of the company. In the case of closely held companies, principals have long sought to avoid these constraints by extracting funds in the form of salaries. This forces the courts to decide whether the applicability of the particular regulation will fall to be determined by the terms of the contract or the economic substance of the underlying relationship. In contrast to their counterparts in the USA and Germany, New Zealand courts have traditionally given priority to form over substance except where the contract is found to be a sham. For example, in companies having a very high debt/equity ratio, the USA courts are willing to characterise a payment denominated as interest as a return to risk capital in the nature of dividend. Such judicial activism is, with few notable exceptions, not common in New Zealand.³

Implications for the adviser. The form over substance approach has obvious implications for the adviser. In contrast to their brethren in the USA, New Zealand advisers have more incentive to undertake astute and innovative drafting in that they can rely upon the courts to give effect to the terms of contracts obviously aimed at circumventing a statute. On the other hand, they cannot expect the courts to correct for errors and omissions in accordance with the economic substance of the relationship. As illustrated by the recent decision in Waller v Paul, discussed in chapter XX, errors and omissions in documentation can lead the courts to determinations respecting liability which would be unusual in a system where the judiciary looks to the substance of transactions rather than their form.

Agency problems. When the sole proprietor pays herself or a third person under, eg, an employment contract or lease, the question seldom arises whether the underlying contract is an authorised one. Nor do authority issues emerge as particularly significant where the paying party is a partnership. The partnership regime places no restrictions upon the power of partnerships, imposes very few conditions upon partnership transactions and makes every act by a partner binding upon the partnership.⁴ This reflects the underlying legislative precept that the partnership is not a legal entity but an association of individuals. In contrast, when the paying party is a limited liability company, the payment—whether it be under a lease, loan or employment contract—is fraught with agency problems. In contrast to the partnership, the limited liability company is, as provided by s 15, a juristic entity completely separate from the individuals who manage the company and/or own the shares. As an abstract legal entity, the company has only those powers conferred by the statute and can only transact through the medium of its principals. This gives rise to three distinct levels of agency problems. First, there is the threshold issue whether the payments contract is one that lies within the power of the company. This is seldom a problem in view of s 16(1) which provides that a company has full capacity, rights, powers and privileges, except as restricted by the constitution. In none of the 100 companies contained in the sample of new registrations examined by the author did the constitution impose any such restriction. Further, the statute expressly provides the company the power to enter certain specific disbursement transactions, eg in the form of dividends under s 52, buybacks under s 59 and redemptions under s 68.

Contractual adhesion as an agency problem. The second agency issue concerns the measures necessary to make the company a party to a particular payments transaction. For most payment transactions, this is governed by s 180(1)(c).

An obligation which, if entered into by a natural person, is not, by law, required to be in writing, may be entered into on behalf of the company in writing or orally by a person acting under the company's express or implied authority.

Incurrence of an obligation in accordance with this section entails two conceptually distinct steps. First, the company as entity must decide to enter the particular transaction. Secondly, some person must be given the authority to act on behalf of the company in the transaction. Normally, the power associated with both steps lies within the authority of the board under s 128. The authority required under s 180(1)(c) will be satisfied by a board resolution authorising the company to enter the particular transaction and authorising a particular person to act on behalf of the company in that transaction. For instance, the resolution will authorise the company to enter into a specific lease and authorise the company’s manager to execute the lease on behalf of the company. Whilst the authority issue under s 180(1)(c) comprises two distinct elements, these are frequently conflated in board resolutions. For example, the section would clearly be satisfied where the resolution simply authorised the manager to enter the particular lease on behalf of the company. This resolution, whilst ostensibly limited to a conferral of execution power on the manager, clearly implies that the company, as an entity, has decided to enter the transaction. In other cases, the execution element will be suppressed. For instance, in a closely held company, the employment contract serving as vehicle for wage payments is generally put in place by a board resolution which authorises salary payments of a specified amount to a particular individual. The authority for the actions required to make the payments is vested in the person or persons to whom daily management has been delegated under s 130. It should be noted that, in respect of some payment transactions, the board must seek shareholder approval for the first component of the authority issue, ie, the decision that the company enter the transaction. This is the case, eg, where the payment arises out of a major transaction under s 129, a buyback under s 60(1)(b)(i) or a transaction covered by a s 107 assent.

Statutory restrictions on returns. The third agency issue involves the statutory restrictions upon the exercise of the power to make the particular return. These restrictions fall generally into three categories:

• Financial constraints. Some but not all returns are subject to statutory financial constraints. For example, the double solvency test applies under s 52(1) to returns in the form of distributions. Under ss 141 and 161, the company must receive fair value for outgoings associated with a self-interest transaction or director’s benefit. The liquidity standard in s 136 will apply to any undertaking antecedent to the outgoing.

• Other substantive constraints. Returns to principals must comply with non-financial constraints that vary according to the transaction. For instance, s 53(1) requires that dividends be paid pro rata in respect of all shares in the same class. Under s 60(3), a purchase of own shares must be in the best interests of the company. All company transactions are subject to the general obligations imposed on directors by ss 131 to 137.

• Ministerial obligations. Returns are also subject to a variety of ministerial obligations. For example, the details of a payment in a self-interest transaction must, under ss 140 and 141, be disclosed to the board and to the shareholders and also be entered in the interest register. The payment of salary and dividends must be preceded, under ss 52(1) and 161, by written certifications with specific content.

The failure to comply with these restrictions can result in civil and/or criminal liability for the principal. It also renders the return an unauthorised one. The lack of authorisation has legal consequences which vary according to the outgoing, the nature of the defect in authority, and the identity and role of the persons involved. The following sections review the main statutory constraints and the consequences of non-compliance.

Principal features of the regime. The regime applicable to returns to principals of closely held companies has three main features. Firstly, the basic concern is with the financial effect of the return upon the company in view of its obligation to creditors. This is the thrust of the fairness requirement of s 161, the trading liquidity standard in s 136 and the double solvency test in ss 4 and 52. Secondly; the statute seeks to finesse compliance with these substantive obligation by means of ministerial obligations, ie, the requirement for resolutions and certifications with specific content. Thirdly, different culpability standards apply to the substantive and ministerial obligations. Liability for breach of the substantive obligation is fault based, with the standard being one of reasonableness. This is evident in the wording of ss 56(2)(b), 161(5)(b) and 136. The standard is consistent with the general duty of care in s 137. On the other hand, liability for performance of the ministerial obligations is strict, eg under ss 56(2)(a) and 161(5)(a). These different culpability standards align the nature of the obligation and the capability of the directors. As noted, the substantive obligations involve financial issues that may well be beyond the capability of the typical director. One the other hand, strict liability is appropriate in relation to the ministerial obligations, the performance of which does not require specialised knowledge. Further alignment is achieved by the safe harbour rules in ss 4 and 137 that entitle the director to rely on expert advice.

Self-interest transactions

Self-interest transactions. In XX of the 100 companies in the sample, the shareholders were also the sole directors of the business. In these companies, outgoings to the principal will generally occur on the basis of contracts that qualify for regulation as self-interest transactions as defined in s 139(1)(a):

Subject to subsection (2) of this section, for the purposes of this Act, a director of a company is interested in a transaction to which the company is a party if, and only if, the director—

(a) Is a party to, or will or may derive a material financial benefit from, the transaction.

This definition catches leases, loans, sale and purchase agreements and employment contracts which are employed by the principal as a vehicle for extracting funds from the company. A self-interest transaction must comply with the rules in ss 140 and 141 as well as, in some cases, s 161. Section 140 requires that the director must enter the transaction in the interest register and, where the company has more than one director, disclose their interest and its monetary value to the board. Under s 141, the transaction can be avoided within three months of disclosure to the shareholders unless the company received fair value. This is tantamount to an additional disclosure requirement and a requirement that the company receive fair value in the transaction. As an important corollary rule, s 141(6) provides that a self-interest transaction can only be avoided on the ground of the director's interest in accordance with s 141 or the company's constitution. This provision renders inapplicable the common law governing self-interest contracts by fiduciaries. Under that law, the fiduciary was accountable for profits or the transaction could be set aside without regard to value, disclosure or bona fides.⁵ A criminal offence results from non-compliance with s 140 but not through non-compliance with s 141. Unless the constitution otherwise provides, a director can vote in relation to a transaction in which the director is interested. None of the constitutions examined by the author prohibited the directors voting on self-interest transactions or provided additional or alternative grounds for avoidance of such transactions.

Director benefits. Some self-interest transactions and the associated outgoings will also fall under s 161 that both authorises and regulates certain director benefits. It provides in relevant part:

(1) The board of a company may, subject to any restrictions contained in the constitution of the company, authorise—

(a) The payment of remuneration or the provision of other benefits by the company to a director for services as a director or in any other capacity: …

(c) The making of loans by the company to a director: … —

if the board is satisfied that to do so is fair to the company.

Where, as is usual, the principal is a director, this section applies to outgoings in the form of salary, director’s fee and loan disbursement. It does not, in contrast, catch payments in the form of interest, rental or loan repayment, ie because these are not provided as consideration for services under s 161(1)(a). Director benefits are subject to three requirements. First, s 161(1), as quoted above, requires that the board be satisfied that the benefit is fair to the company. The term fair is not defined. Presumably, like the reference to fair value in s 141, the requirement is concerned with the financial equivalence of the exchange, ie that the company receives consideration of equal value in the form of services under s 161(1)(a). Section 161(4) requires that directors who vote in favour of a benefit sign a certificate certifying their opinion and the grounds for it. Under s 161(2) the board must enter the particulars of the payment or benefit in the interest register. For the event of non-compliance, the statute provides for recovery of the benefit except to the extent that the director proves that it was fair to the company at the time it was given.

Relationship between regulation of self-interest transactions and director benefits. There is obvious overlap between the regulation of self-interest transactions and director benefits. All transactions involving director benefits under s 161 also potentially qualify as self-interest transactions for purposes of ss 140 and 141. However, as noted, the reverse is not true. Whilst leases and contracts for sale and purchase with a director qualify as self-interest transactions, they do not give rise to director benefits. Both regimes employ disclosure and a fairness requirement as the regulatory instruments, albeit in different configurations. A self-interest transaction must be disclosed to the board, in the interest register and to the shareholders. A director’s benefit need only be disclosed in the interest register. The fairness requirement emerges as a defence to avoidance in relation to a self-interest transaction, but represents a precondition in relation to a director benefit. In other words, as a subset of self-interest transactions, director benefits are subject to a reduced disclosure requirement but an increased fairness requirement. This is warranted by differences in the transactions involved. The consideration received by the company for a director benefit, eg under a loan or employment contract, is less palpable than that received under a contract for sale and purchase or a lease with the director. This justifies the somewhat elevated fairness requirement in respect of director benefits. As regards disclosure, as loans and employment contracts with directors can hardly be put in place without board approval, there is no need for a separate requirement for disclosure to the board such as that found in s 140(1). On the other hand, it is harder to justify the absence of a requirement for disclosure to or approval by shareholders in relation to director benefits.⁶ The regimes for self-interest transactions and director benefits are linked by s 143 which provides that ss 140 and 141 do not apply to a benefit given in accordance with s 161. However, this does not mean that compliance with s 161 is voluntary or that a company can choose to forgo compliance with s 161 and instead comply with ss 140 and 141. Instead, non-compliance with s 161 attracts the consequences in that section and, in addition, the transaction no longer qualifies for the exception in s 143. This means that the transaction must also comply with ss 140 and 141 and, should it fail to do so, attracts the civil and criminal liabilities for non-compliance in s 141.

Section 107 assent not a complete panacea. In quite common situations, the provisions on self-interest transactions and director benefits require measures out of proportion to the needs or capabilities of the principals.

Example. Dairy Ltd leases its premises from Premises Ltd. Both companies are owned in equal shares by spouses H and W, who also serve as the sole directors of both companies. H is the managing director and W is a non-executive director.

The lease qualifies as a self-interest transaction in relation to both companies. Accordingly, in both companies, H and W must make disclosures to themselves as the boards and shareholders and must enter details of the transactions in the interest registers. Additionally, the s 180 resolutions used to authorise the lease should reflect board consideration of the fairness of the transaction. Failure to make the disclosures required by s 140 comprises an offence punishable by a fine up to $10,000; failure to make the disclosure required by s 141 tolls the three-month period for avoidance, a fact of potential significance in the event of an intervening liquidation of the company. A s 107(3) assent provides some relief from these requirements and the associated criminal and civil liability consequences. The assent, one executed for each company, would provide that the undersigned, being all the entitled persons of the company, concur in the company entering the lease otherwise than in accordance with ss 140 and 141. Unfortunately, this assent also presumably nullifies s 141(6) and may leave the lease exposed to challenge by the liquidator under the common law. Other problems arise where the s 107 assent is used in relation to s 161 benefits. Whilst the assent provides relief from the disclosure, resolution and certification requirements, it subjects the benefit to the solvency test in s 108. The consequences of non-compliance with S 108 are more serious than those associated with non-compliance under s 161. Further, as discussed in the next chapter, it is not at all clear how the solvency test should apply to loans and remuneration.

The capital maintenance requirement for distributions

Capital maintenance under s 52. Most of the publicity and commentary concerning returns from companies relates to the statute’s capital maintenance rule anchored in s 52(1):

The board of a company that is satisfied on reasonable grounds that the company will, immediately after the distribution, satisfy the solvency test may, subject to section 53 of this Act and the constitution of the company, authorise a distribution by the company at a time, and of an amount, and to any shareholders it thinks fit.

Section 53 imposes a pro rata requirement upon distributions which qualify as dividends. The basic capital maintenance rule in s 52(1) is implemented by a number of other ancillary rules in the section. Subsection (2) requires the board to certify the opinion required under subsection (1) and supply reasons for that opinion. Subsection (3) provides that a distribution becomes unauthorised where, before it is made, the board ceases to be satisfied in relation to compliance with the solvency test. Subsections (4) and (5) elaborate on the concepts of debts and liabilities for the case, not common in closely held companies, where the company has issued preference shares. Subsection (6) makes non-compliance with the certification requirement in subsection (2) an offence punishable by a fine up to $5000.

The nature of the obligation under s 52. It is important to note that s 52 does not require that the company satisfy the solvency test. Instead, the section anticipates a procedure. The board must first satisfy itself as to compliance with the solvency test and then make the certification required by s 52(2). Having done that, the board will authorise the distribution. The final step is the actual distribution of the funds by the company. The embodiment of the capital maintenance regime as a procedure somewhat mitigates the rigours of the solvency test. So long as the board follows the procedure, there will be no contravention of s 52(1) even though the distribution causes the company to contravene the solvency test. In other words, contravention of the solvency test will not, eo ipso, expose the board to liability under s 56 or s 301.

Principal components of the capital maintenance rule. There are four principal components of the capital maintenance rule in s 52. First, the rule applies only to one type of return, ie distributions. Secondly, authority for these outgoings is expressly given to the board, ie, shareholder approval is not required as was the case under the 1955 Act.⁷ Thirdly, outgoings in the form of distributions are subject to a financial constraint, the solvency test defined in s 4(1) and discussed below. Finally, the rule in s 52 is subject to limited variation by the company constitution. The constitution may not negate the solvency test. However, it may impose an additional financial constraint, eg require that dividends be paid only out of current profits or retained earnings. Also, it may require shareholder approval for any distribution.

Section 52 applicable only to distributions. The rule in s 52(1) applies only to an outgoing which qualifies as a distribution under the definition of that term in s 2(1):

"Distribution", in relation to a distribution by a company to a shareholder, means—

(a) The direct or indirect transfer of money or property, other than the company's own shares, to or for the benefit of the shareholder; or

(b) The incurring of a debt to or for the benefit of the shareholder—

in relation to shares held by that shareholder, and whether by means of a purchase of property, the redemption or other acquisition of shares, a distribution of indebtedness, or by some other means:

The scope of the definition is determined, most generally, by the phrase in relation to shares. As applied to closely held companies, the phrase is subject to two possible interpretations.

The ambiguity. On the one hand, in relation to shares can be understood in a contractual sense that would confine the definition to outgoings payable in relation to the rights associated with shares under s 36, other provisions of the Act or the constitution. So construed, the definition catches cash or property distributed by way of dividend, buyback or redemption. It does not, however, apply to payments to members by way of salary, rentals or loan disbursements as these occur not in relation to shares but in relation to some other contractual relationship. As the alternative construction, the phrase in relation to shares can be understood in an accounting sense. Under this approach, the definition catches any outgoing which results in a debit to the shareholder funds segment of the balance sheet irrespective of the nature of the underlying contract. This construction catches the traditional payments to shareholders such as dividends, buybacks and redemptions. However, it also catches payments to shareholders in the form of salary, interest and rentals. These payments are, for accounting purposes, treated as expenses and debited to the profit and loss account, the annual result of which is transferred to the shareholder funds portion of the balance sheet. The accounting approach does not, however, catch outgoings to members in the form of repayment of loan principal or loan disbursements. The first is debited to liabilities and the second to loan receivables.

Ramifications of the ambiguity. The choice between the two interpretations of in relation to shares has far reaching consequences for the operation of a closely held company. The accounting construction brings under the solvency test salary, director fees, rentals and interest paid to members. This would seriously curtail the ability of principals in a closely held company, perceived by some as an abuse of the corporate form, to place outgoings to themselves outside the scope of the capital maintenance regime which under the 1955 Act applied only to dividends, buybacks and redemptions. On the other hand, the construction would deter principals from injecting services or assets into their company at times of financial distress when outside finance is not available. Further, in the case of a healthy concern, compliance with the formality requirements under s 52(1) would complicate performance, and increase the cost, of routine payment transactions.

Ambiguity not resolved by the examples. Unfortunately, little light is shed on the ambiguity by the four specific examples referred to in the definition, ie, purchase of property, redemption, other acquisition of shares and distribution of indebtedness. Redemption and acquisition of shares are consistent with either construction. A purchase of property is consistent with neither. In a purchase of property, the cash outgoing will be offset by a debit to another asset account and will be made in relation to a contractual relationship other than one comprising a share. The reference to distribution of indebtedness casts little light on the problem if for no other reason than the example refers to the very concept sought to be defined. It is interesting to note that the original Law Commission draft used the phrase purchase of shares rather than purchase of property. The ambiguity is revisited below after a consideration of the solvency test.

The solvency test

The solvency test. The solvency test applicable to distributions under s 52(1) appears in s 4(1):

For the purposes of this Act, a company satisfies the solvency test if—

(a) The company is able to pay its debts as they become due in the normal course of business; and

(b) The value of the company's assets is greater than the value of its liabilities, including contingent liabilities.

Subsections (a) and (b) divide the test into two limbs which are known respectively as the trading or liquidity limb and the balance sheet limb. They combine with the definition of distribution in s 2(1) and the obligation imposed by s 52(1) to comprise the statute’s primary capital maintenance regime, one of the chief reforms of the 1993 Act. The regime, borrowed from North American practice,⁸ subjects to a uniform constraint various payments to shareholders which, under the 1955 Act, were the subject of widely differing rules. The regime prevents the company providing benefits to shareholders if this would impair its ability to pay creditors. The trading limb aims to ensure payment of creditors in ordinary course and the balance sheet limb secures payment in the event of winding up. The regime can be viewed as a corollary to the limited liability feature of the company form. Having obtained the benefit of limited liability in relation to the company’s creditors, the members are restrained from extracting from the company the only means for payment of its obligations.

Three modifications of the solvency test. The solvency test is modified for application to three transactions. One modification is found in s 52(4) which anticipates the situation where a company has issued shares which confer a preferential entitlement to current and/or liquidating distributions. The rule in s 52(4) effectively elevates the preferential claimant to the status of a creditor for purposes of the solvency test. In the absence of this provision, it would be possible to charge a dividend or buyback in relation to ordinary shares against the remaining net assets of the company thus subverting the priority conferred by the terms of the preference shares. While the purpose of the rule is self-evident, its statement in s 52(4) and interrelationship with the terms of preference shares are subject to a number of difficulties discussed in a subsequent chapter.

Solvency test modified for financial assistance. A second modification is found in s 77(6) and s 108(5) that address the situation where the company provides financial assistance in connection with the purchase or issue of its shares. Whilst this assistance is not included within the definition of distribution in s 2(1), it is specifically subject to the solvency test by ss 71(1) and 108(1). As applied to such assistance, ss 77(6) and 108(5) provide that, for purposes of the balance sheet test, assets exclude amounts of financial assistance and liabilities include the face value of all outstanding liabilities incurred in connection with the assistance. In the absence of the modification in s 77(6), typical forms of financial assistance, whilst posing a distinct threat to creditors, would not register under the balance sheet test. The application of the solvency test to financial assistance is discussed in detail in chapter XX.

Solvency test applied to s 107(1) transactions. Section 108 subjects to a solvency test six of the eight transactions capable of being implemented by means of a s 107 assent. Section 108 makes two and possibly three modifications to the solvency test. First, the solvency certification need not, unlike the one under s 52(3), identify the grounds for the board’s opinion. Secondly, whilst the solvency test applies under s 52(1) in relation to a distribution, s 108 applies the test to the exercise of the power identified in s 107(1). The ramifications of these two modifications, at least some of which were probably unanticipated by the drafters, are discussed in relation to specific transactions in the following chapter. The third modification concerns the transactions subject to the solvency test under s 108. Of the six transactions identified in s 107(1), five are clearly subject to the solvency test if entered into outside a s 107 assent: dividends, discount schemes, buybacks, redemptions and financial assistance. The sixth transaction in the list is any matter referred to in s 161(1), ie, director benefits in the form of remuneration for services, compensation for loss of office, loans and guarantees. Where the benefit is provided to a non-member director, s 108 applies the solvency test to a transaction which would, under s 161, be subject only to the fairness standard. Where, however, the benefit is provided to a member director otherwise than under a s 107 assent, the solvency test may already apply depending upon one’s construction of the phrase in relation to shares in the definition of distribution.

Delay. As one of its elemental features, the procedure required by s 52(1) cannot be completed instantaneously. More or less time will inevitably elapse between the start of deliberations leading to the resolution and the actual distribution itself. The amount of delay will vary according to the type of distribution. Dividends can be planned so that there is little or no delay. In contrast, considerable delay will be unavoidable in the case of certain buybacks. The shareholders must be given time to consider the buyback offer. Additional delay will result where the company pays the buyback price in instalments. Delay is potentially significant for two reasons. First, any delay complicates the decision required in respect of the solvency test.

Example. On 15 August, the board of XYZ Ltd convenes to receive the annual accounts and authorise a dividend which will be paid on 1 October.

Section 52(1) requires that, on 15 August, the board consider application of the solvency test not to the situation of the company at that date, but rather the situation on 1 October immediately after payment of the dividend. The judgments comprising the opinion required by s 52(1) are difficult enough when the solvency test is applied as of the date when the board reaches the opinion. They become increasingly difficult as the date for application of a solvency test is moved forward from the resolution date. The possibility of delay is anticipated by s 52(3) which provides that the dividend is unauthorised if the board ceases to be satisfied about compliance with the solvency test. Interesting to note in this regard is that s 52 places the board under no positive obligation to review the financial situation of the company between the time of the authorisation and the date set for the distribution.

Nature of the solvency test decision. Application of the solvency test calls for judgments by the board in relation to the financial condition of the company expressed in accounting terminology. In relation to the balance sheet limb, it is necessary that the board identify the assets and liabilities and place a value on them. The trading limb requires that the board project a liquidity profile for an unspecified time-frame. These matters are the subject of rules, procedures and assumptions which comprise the discipline of accountancy. In other words, the solvency test requires from the board decisions which lie outside the expertise of most principals of closely held businesses. As illustrated by the examples in the next chapter, the solvency test, if taken seriously, is fraught with difficulties in even the simplest situations.

The ambiguity in distribution revisited

The problem restated. The policy of creditor protection so evident in the solvency test sheds useful light on the previously identified ambiguity in the definition of distribution. That ambiguity, once again, is whether the phrase in relation to shares in the definition of distribution is to be understood in the accounting sense or contractual sense. The definition undoubtedly catches dividends, buybacks and redemptions. These are all outgoings for which the company receives nothing in return. They enhance the wealth of the members, on a dollar-for-dollar basis, at the expense of the company and, as such, pose a significant threat to the creditors. On the other, just as clearly, payments under contractual relationships with non-members fall outside the definition. When concluded at arms-length and driven by rational self-interest, these transactions are, in theory, mutually beneficial and pose no threat to creditors.

Contractual payments to members as occupying a middle ground. Contractual payments such as salary and interest to members of closely held companies occupy a position between dividends on the one hand and contractual payments to third parties on the other. The member receiving the outgoing will, almost always, comprise or serve on the board which authorises the transaction. Such a member is subject to a clear conflict of interest. As provider of the property, services or capital, the member has an interest in getting the highest possible return. In their capacity as director, the member has an obligation to get the best deal for the company, ie, by negotiating the lowest possible salary, interest or rental. Under the circumstances, there is no a priori reason to believe that the outcome will be mutually beneficial.⁹ On the other hand, unlike a dividend, such a transaction does provide the company with something of value.

Sections 140, 141 and 161 as appropriate. As a matter of principle, it seems appropriate that these transactions be subject to regulation that lies, in terms of severity, between that applicable to dividends on the one hand and the regulation of contractual payments to third parties on the other. Dividends are clearly subject to the rigours of the solvency test. In contrast, contractual outgoings to third parties are subject only to the rules on prudent trading under ss 135 and 136. Where the member is in control of the transaction, it will be regulated by the regime for self-interest transactions and director benefits. In terms of regulatory severity, this regime occupies a middle ground between the regulation of dividends and the regulation of contractual outgoings to unrelated third persons. The core of the regime consists of a disclosure requirement coupled with a fairness requirement. There is no disclosure requirement for contractual outgoings to unrelated third persons. In contrast, the certification requirement applicable to dividends and similar distributions is more severe than the disclosure requirement for director benefits and self-interest transactions. As a financial constraint, the fairness test in the regime for self-interest transactions lies obviously between the solvency test applicable to dividends and the recklessness standard in the prudent trading rules under ss 135 and 136.

Exclusivity of the fairness test. Whilst the regime for self-interest transactions and director benefits is appropriate as a matter of principle for contractual outgoings to members, the question remains whether it applies to the exclusion of the double solvency test. Concurrent application of the solvency test is counter indicated for at least four reasons. First, it would entail an absolutely unprecedented level of formalities for directors’ benefits in closely held companies. As such benefits are generally delivered to persons who also are also shareholders, the board would have to comply with both s 52 and s 161 with their associated resolution and certification requirements. Secondly, application of s 52(1) would make s 161 largely redundant as the solvency test will generally impose a stricter standard than the fairness test. Thirdly, application of the solvency test to contractual outgoings would not be in the interests of creditors. Where a small company finds itself in financial difficulties, the solvency test would prevent payment for inputs acquired from its principals in the form of services, loans or leasing of premises. Very often these are the very inputs that are required for the survival of the business and payment of its creditors. Fourthly, the certification requirement under s 52 is acceptable in the case of one off transactions such as dividends and buybacks but imposes an undue transaction cost if applicable to every recurring payment of salary, interest or rental. The counterpart problem arising under the certification requirement in s 161 is mitigated by the rule in subsection (3) that makes separate authorisations unnecessary. The absence of a comparable provision in s 52 strongly indicates that the capital maintenance regime was not intended to catch such recurring payments.

Consistency with s 107. The proposed solution is also consistent with the treatment of self-interest transactions and director benefits under ss 107 and 108. Section 161 transactions are included the list of transactions subject to the solvency test under s 108(1). The other transactions in the list, eg dividends and buybacks, are clearly subject to the solvency test when delivered otherwise than under a s 107 assent. Inclusion of s 161 transactions in the list is, nonetheless, more consistent with the contractual interpretation of in relation to shares than with the accounting approach. Under the contractual interpretation, extension of the solvency test under s 108(1) to director benefits represents an increase in creditor protection as these transactions are subject only to the fairness test in s 161 when delivered otherwise than pursuant to a s 107 assent. Under the accounting approach, inclusion of director benefits under s 108(1) does not provide any increase in creditor protection as the transactions are subject to the solvency test when delivered otherwise than pursuant to a s 107 assent. Surely the approach which results in an increase in creditor protection is the correct one. The distinguishing feature of a transaction under s 107 is that it enjoys the written assent of all entitled persons including the shareholders. Transactions having such unanimous assent are less likely to be at arms-length than transactions in which such assent is absent. This would warrant an increase in the level of creditor protection from the fairness standard in ss 161 and 141 to the solvency test imposed by s 108.

Particular distributions

Dividends. The archetypal distribution is undoubtedly the dividend. Section 2(1) provides that dividend has the meaning set out in s 53 of the Act. Section 53 defines dividend, if at all, in subsection (1):

A dividend is a distribution other than a distribution to which section 59 or section 76 of this Act applies.

Section 59 refers to a company's purchase of own shares that is expressly permitted by its constitution. Section 76 regulates financial assistance. Under s 53(1), all other distributions qualify as dividends subject to the pro rata requirement in s 52(2).

The board of a company must not authorise a dividend—

(a) In respect of some but not all the shares in a class; or

(b) That is of a greater value per share in respect of some shares of a class than it is in respect of other shares of that class—

unless the amount of the dividend in respect of a share of that class is in proportion to the amount paid to the company in satisfaction of the liability of the shareholder under the constitution of the company, or under the terms of issue of the share.

The exemption in s 52(1) for distributions under ss 59 and 76 recognises that the statute allows financial assistance and purchase of own shares on a non-pro rata basis, ie in relation to some shareholders and not others.

Problems with the definition of dividend. There are two obvious difficulties with the definition of dividend in s 52(1). The first concerns its scope. The statute anticipates other distributions which, whilst they lie outside ss 59 and 76, are surely not meant to be subject to the pro rata rule in s 53(2). The most obvious is a redemption at the option of the company which expressly qualifies as a distribution and may, under s 71, be implemented in relation to some holders and not others. The definition in s 52(1) also catches buybacks, redemptions and financial assistance under s 107, the issue of shares in lieu under s 54 and shareholder discounts under s 55—all of which may be made on a non-pro rata basis. Applied literally, the definition in s 52(1) would, in connection with s 52(2), prevent the company from making non-pro rata payments specifically permitted and regulated elsewhere in the Act. The problem probably reflects a drafting error. The second issue involves a common practice under the proviso to s 52(2). The proviso allows but does not require the board to deviate from the pro rata requirement to the extent that a member’s shares have not been fully paid up. A number of long form constitutions alter s 53(2) to the extent that they make deviation from the pro rata rule mandatory in relation to unpaid shares. In relation to the closely held companies covered by these constitutions, such a limitation upon the board’s authority seems both unnecessary and undesirable.

Buybacks, redemptions and financial assistance under 1993 Act. One of the most important reforms in the 1993 Act relates to the regulation of purchase of own shares, redemptions and financial assistance. Under the 1955 Act, all three transactions were severely restricted. Purchase of own shares was not allowed, financial assistance was prohibited subject to three narrow exemptions, and shares could be redeemed only within the confines of s 66 of the 1955 Act. The 1993 Act provides far greater scope for all three transactions. Their regulation has three essential features. First, they can be implemented only in the particular modes provided by statute. The statute provides six modes for buybacks, four for redemptions and four for financial assistance.¹⁰ Secondly, to a large degree, the statute provides parallel regulation of the various modes. The most obvious example is the special mode available for all three transactions under ss 61, 71 and 78. The rules for special buybacks, special redemptions and special financial assistance follow a similar format and employ identical wording in a number of their features. Thirdly, all three transactions are subject to the double solvency test.

Buybacks. Before the 1993 Act, a company was prohibited from buying its own shares by the rule in Trevor v Whitworth. This 1887 decision by the House of Lords held that the transaction was invalid as a circumvention of the then statutory rules for capital reduction.¹¹ The rule in Trevor was never adopted in the USA and, by the early 1980’s had been abolished by statute in Canada in1970, the UK in l981 and Australia in 1989. The 1993 Act allows but heavily regulates a company’s power to purchase own shares. The transaction must implemented through one of six statutory modes:

• under s 60(1)(a) by a pro rata offer;

• under s 60(1)(b)(i) by an offer to which all members have consented in writing;

• under s 60(1)(b)(ii) by an offer that is expressly permitted by the constitution and made in accordance with the procedure for special offers;

• under s 63 as a stock exchange acquisition with prior notice to shareholders;

• under s 65 as a stock exchange acquisition without prior notice to shareholders; or

• under s 107 with the unanimous assent of all entitled persons.

Each of these modes has its own configuration of ministerial and substantive obligations. For instance, in connection with a buyback under any of the first three modes, s 60 requires that the directors resolve and certify regarding the best interests of the company, the fairness and reasonableness of the terms and their non-awareness of non-disclosed material information. As a buyback qualifies as a distribution, the board must also comply with resolution and certification requirements of s 52. For a buyback by way of special offer, eg, a non-pro rata one under s 60(1)(b)(ii), the board must also resolve and certify regarding fairness for non-participating shareholders as well as distribute to all members a document which discloses the terms of the transaction, the interest of any director and the text of the required resolutions. In closely held companies under the 1993 Act, buybacks will likely be used as a vehicle for a tax efficient return of funds to members as well as an alternative to the traditional cross-purchase arrangement for retiring a member from the business. Such buyout schemes are the subject of chapter XX.

Redemption. The 1955 Act authorised and regulated redeemable preference shares. The regulation was minimalist and concerned primarily capital maintenance. Section 66 of the 1955 Act provided that such securities could be redeemed out of profits, proceeds of a fresh issue or the share premium. Section 66 afforded relief from the rule in Trevor which prohibited a company purchasing its own shares. In closely held companies, redeemable shares appeared to be used principally as an alternative to debt financing for commercial property ventures and as a vehicle for buyout arrangements funded by company assets. The 1993 Act recognises these functional differences and seeks to provide appropriate regulation. The Act distinguishes in s 68 between shares redeemable at the option of the company, at a fixed date or at the option of the holder. Shares redeemable at the option of the holder are regulated by ss 69 to 71 in much the same manner as the purchase of own shares. In contrast, under ss 74 and 75, shares redeemable at a fixed date or at the option of the holder are treated like debt instruments. The board can redeem such shares without any resolutions and certifications respecting, eg, the interest of the company and fairness of the transaction. Nor are such redemptions subject to the full force of the solvency test. In respect of redemptions at the option of the shareholder and redemptions at a fixed date, ss 74(2) and 75(2) provide:

A redemption under this section—

(a) Is not a distribution for the purposes of sections 52 and 53 of this Act; but

(b) Is deemed to be a distribution for the purposes of subsections (1) and (5) of section 56 of this Act.

Subsection 2(a) makes clear that the board can proceed to redeem such shares without making the solvency resolution required by s 52. This removes the risk arising under the 1955 Act that the capital maintenance rules would preclude performance under a redeemable preference share which, by its terms, was intended to operate as a debt security. If the redemption causes the company to fail the solvency test, then subsection (2)(b) preserves s 56(1) that makes the shareholders liable for return of the funds. As sections 56(2) to 56(4) are not applicable, the directors bear no secondary liability. However, the utility of redeemable shares as alternative to debt instruments is impaired by the rule in ss 74(1)(c) and 75(1)(c) that the unpaid shareholder ranks as an unsecured creditor of the company for the sum payable on redemption. Unless this rule can be altered by the company’s constitution or an agreement outside the Act, it will preclude the practice common under the 1955 Act whereby the company provided security for the current and liquidating distributions anticipated by redeemable shares. This issue is explored in chapter XX which considers the use of redeemable shares as a vehicle for buyout schemes.

Threshold anomalies in the redemption regime. The regime for redemptions contains two threshold anomalies. Section 68 requires a constitutional authorisation for the issue of redeemable shares. This requirement is uncalled for in view of the fact that the issue of redeemable shares, depending on the nature of the redemption feature, falls between the issue of ordinary shares subject to a buyback arrangement and the issue of a debt security, both of which lie within the scope of the board’s authority without any constitutional authorisation. The second difficulty arises in connection with the requirement in s 68 that the required constitutional provision be for shares redeemable at the option of the company or at the option of the holder or at a fixed date. The statutory regime in ss 69 to 75 then proceeds on the assumption that redeemable shares will fall into one and only one of these three categories. As discussed in chapter XX, this requirement imposes a significant constraint on the use of redeemable shares in buyout schemes.

Use of redeemable shares by closely held companies. As noted, under the 1955 Act, redeemable preference shares were used by closely held companies principally as a vehicle for buyout agreements and as an alternative to debt financing. However, the drafters of the 1993 Act clearly intended that buyout arrangements be implemented through the provision for purchase of own shares.¹² Recent alterations to the tax legislation have removed the earlier advantages of redeemable preference shares as an alternative to debt financing.¹³ None of the 100 closely held companies in the sample had issued redeemable shares. Nevertheless, as discussed in chapter XX, the rigid regulation of buybacks invites the continued use of redeemable shares as vehicles for buyout agreements. As elaborated in chapter XX, redeemable preference shares will also suit the needs of risk-adverse passive investors in multi-member closely held companies.

Members’ liability for wrongful distributions under s 56. In the event that the company does not satisfy the solvency test immediately after the distribution, the shareholders are liable in accordance with s 56(1). The shareholder must return the monies received unless they establish the defense set forth in s 56(1) that has three elements—

(a) The shareholder received the distribution in good faith and without knowledge of the company's failure to satisfy the solvency test; and

(b) The shareholder has altered the shareholder's position in reliance on the validity of the distribution; and

(c) It would be unfair to require repayment in full or at all.

If the member satisfies the first two elements, it will be an unusual case where the Court denies relief by reason of the third element. In most instances, the only alteration of position will be the member‘s use of the distributed funds. In dealing with the analogous defences under the Judicature Act 1908 and the liquidation provisions of the 1955 Act, the courts have generally held that, as the recipient does not give a second thought to the validity of the payment, the mere expenditure of the funds does not satisfy the reliance requirement in subsection (b).¹⁴ In closely held companies, operation of the good faith requirement in s 56(1)(a) is complicated by the fact that member will in most cases also be involved in the distribution as a director. As perhaps its most remarkable feature, liability under s 56 attaches to shareholders by reason of the company’s distribution of funds in contravention of the solvency test and not by reason of the directors’ non-compliance with s 56(1).

Directors’ liability for wrongful distributions under s 56. Section 56 also imposes liability upon the directors for an unauthorised distribution. That liability is secondary, ie it only applies if and to the extent that the distribution cannot be recovered from the shareholders. There are two possible grounds for liability under s 56(2). If the procedure in ss 52, 70 or 77 [required resolution and certification] is not followed, liability attaches to any director who failed to take reasonable steps to ensure that the procedure was followed. Even where the procedure is followed, if reasonable grounds for the resolution did not exist, liability attaches to any director who signed the certificate.

Strict liability under s 56 in the case of closely held companies. In closely held companies, the various culpability elements in s 56 will generally not protect principals from liability for distributions in contravention of the solvency test. Distributions will generally be unauthorised for one of two reasons. In some cases the distribution will be made without any attempt to comply with s 52, ie, either because the board does not recognise the outgoing as a distribution or is ignorant of the requirement in s 52. In other cases, the board will make the distribution after only pro forma compliance with s 52, eg, without seriously considering the company’s financial situation. Where the distribution causes the company to contravene the solvency test, the principals will be, in the first case, liable in their capacity as shareholders. Their concurrent position on the board will prevent them from establishing the good faith element of the defense under s 56(1)(a). They will also be strictly liable in their capacity as directors for failure to take reasonable steps to ensure the procedure was followed. In the second case, they will be liable as both shareholders and directors by reason of their failure to establish the good faith element and/or the reasonable grounds element in s 56(1)(a) and s 56(2)(b) respectively. The obligation arising under s 56 is probably one that can be enforced by the liquidator by reason of their powers under s 260 and clause (a) of the Sixth Schedule.¹⁵

A director’s obligations under s 4(2)). Section 52 does not exhaustively define the board’s obligations in relation to the solvency test. Section 4(2) provides that

[I]n determining for the purposes of this Act … whether the value of a company's assets is greater than the value of its liabilities, including contingent liabilities, the directors—

(a) Must have regard to—

(i) The most recent financial statements of the company that comply with section 10 of the Financial Reporting Act 1993; and

(ii) All other circumstances that the directors know or ought to know affect, or may affect, the value of the company's assets and the value of the company's liabilities, including its contingent liabilities:

(b) May rely on valuations of assets or estimates of liabilities that are reasonable in the circumstances.

The provision seeks, in subsection (a), to force the directors to take measures which will facilitate performance of their substantive obligation under s 52, ie, to be satisfied on reasonable grounds that the distribution will not cause the company to contravene the solvency test. Compliance is further encouraged by what appears to be a safe harbour in subsection (b). The references to assets and liabilities indicate that the rules apply only in relation to the balance sheet limb of the solvency test. Section 4(2) has a troubled legislative history. There was no counterpart in the Law Commission’s original draft act. ¹⁶ The revised draft act provided for a nonmandatory (may) consideration of financial statements, accounting principles and valuations in connection with application of the solvency test.¹⁷ This was omitted in the first reading of the Companies Bill which followed the original draft act. The present version of s 42, with its mandatory tenor and peculiar limitations, represents the work of the Select Committee.¹⁸

Troublesome uncertainty in s 4(2). Whilst s 4(2) involves a number of compliance issues discussed in the following chapter, there is a threshold uncertainty as to its relationship with s 52. The question is whether the obligation under subsection (2)(a) is an independent one or intended as a corollary to the reasonable grounds element of the obligation under s 52(1) as enforced by s 56(2)(b). The question bears significantly upon the director’s liability for wrongful distribution. If the obligation under s 4(2)(a) is a corollary to s 52(1), then liability for breach will be regulated primarily by s 56(2). On the other hand, if the obligation arising under subsection (2)(a) is an independent one, then liability will arise under the general provisions such as s 301. As a stand alone provision, subsection (2)(a) can be satisfied or breached without regard to compliance with s 52 and vice versa. For instance, a board may completely disregard both of the sources identified in subsection (2)(a) and yet be satisfied under s 52(1), eg, on the basis of their accountant’s advice. Also important in this regard is the fact that subsection (2)(a)(i) contains no culpability element. However, if the obligation is a corollary to s 52(1), then the directors will have the benefit of the culpability elements included in s 56(2). If, on the other hand, the obligation is an independent one, then the directors’ culpability is relevant only as a matter of judicial discretion under s 301 or under s 137 if that provision is construed as applying to performance of all obligations under the Act.

General obligations of directors

Nature and significance for outgoings. Outgoings are subject to the general duties of directors in ss 131 to 137. These include the obligations of loyalty in s 131, proper purpose in s 133, prudent trading in ss 135 and 136 and care in s 137. Relevant to the performance of these general obligations as well as the more specific ones, eg, found in ss 4 and 52, is the rule in s 138 which entitles the directors to rely upon information and advice from experts. The significance of these provisions cannot be over-emphasised. For instance, s 107 allows a wide range of benefits to be delivered without regard to the transaction-specific rules which require, inter alia, that a director benefit under s 161 be in the best interest of the company. A best interest requirement continues to apply to such benefits under the general rule in s 131. The delivery of benefits in the form of salary at a time when the company is in a parlous financial condition might be arguably fair to the company under s 161 but could nonetheless run afoul of the prudent trading rules in ss 135 and 136.

Sections 131, 133 and 134. These sections require directors to act in the best interests of the company, for a proper purpose and in accordance with the Act and constitution. Whereas the rules in s 131 and 134 appeared in the original draft act, s 133 was added by the Parliamentary drafter and emerged in the first reading of the Bill. In the common law of directors' duties under the 1955 Act, the best interests obligation was well established and served, primarily if not exclusively, as a constraint the conduct of the board in corporate reorganisations and restructurings.¹⁹ In contrast, there was little or no common law counterpart, at least in New Zealand, to the best purpose obligation under s 133.²⁰ As regards the rule in s 131, and of particular significance for outgoings, it was also generally recognised that, where a company is insolvent or near insolvent, the interests of the company include those of its creditors. Accordingly, payment of a dividend by a financially distressed company, whilst it may have complied with the then applicable capital maintenance rule, gave rise to a litigatable grievance by the liquidator acting for the creditors.²¹ Where the constitution imposes a constraint on distributions more rigorous than the double solvency test, eg, allowing dividends to be paid only out of current profits, failure to observe that constraint will result in a breach of s 133. If the experience with the general prescription of oppressive conduct under s 10 of the Credit Contracts Act 1983 and s 209 of the Companies Act 1955 is any guide, it is reasonable to expect that the general obligations arising under ss 131, 133 and 134 will be invoked as grounds for challenging board decisions, particularly ones which involve outgoings to directors, not easily litigatable under other parts of the law. For instance, in MacFarlane v Barlow, one of the first derivative actions involving directors' duties under the 1993 Act, a director of a closely held company was held liable under ss 131 and 133 on account of excessive remuneration and low interest loans.²²

Section 137. Perhaps the single most controversial issue in the law reform debate culminating in the 1993 Act involved the rule now found in s 137:

A director of a company, when exercising powers or performing duties as a director, must exercise the care, diligence, and skill that a reasonable director would exercise in the same circumstances taking into account, but without limitation—

(a) The nature of the company; and

(b) The nature of the decision; and

(c) The position of the director and the nature of the responsibilities undertaken by him or her.

Under the common law, a director owed their company a general duty of care similar to that commonly associated with liability for recklessness or gross negligence. That duty constituted an independent liability predicate which was successfully invoked in relatively few but singularly significant cases involving a range of director misconduct.²³ The prevailing view of s 137 is that it carries forward a general duty of care as an independent liability predicate and also prescribes the level of care associated with ordinary negligence.²⁴ Under this view it would be possible, as under the 1955 Act,²⁵ for a director to incur negligence liability for payment of a dividend even though the dividend complied with the capital maintenance requirement in s 52(1). The author favours an interpretation of s 137 which, closely adhering to the words of the statute, differs from the prevailing view in two respects. First, in the author’s view, s 137 is not a separate liability predicate. Instead it imposes a general standard of care in relation to the director's exercise of their powers or duties under the Act. This has important ramifications for a director's responsibility for outgoings. In contrast to pre-Act law, s 137 should not provide an independent ground for holding a director liable for an outgoing. Liability must be predicated on one or more of provisions such as ss 56, 161, and 162 which deal with specific outgoings or benefits. Also, the author’s view leaves no room for strict liability. A director is liable for breach of a specified obligation only if non-compliance resulted from a failure to exercise the care required by s 137. As regards the solvency test, the director can, under this approach, invoke the exercise of reasonable skill and care as a defence for failure to comply with s 4(2)(a) which, as noted, does not contain a culpability element. As the second departure from the prevailing view, the author does not find that s 137 states the level of care required of directors. Instead, the reference to the care, diligence and skill of a reasonable director imports the common law standard which was one associated with gross negligence or recklessness.²⁶ This interpretation has the singular advantage that it provides room for the so-called business judgment rule associated with the gross negligence standard of care.²⁷

Prudent trading under ss 135 and 136. These sections carry forward, with modifications discussed in chapter XX, the rules on reckless trading under s 320(1) of the 1955 Act.

135. RECKLESS TRADING—

A director of a company must not—

(a) Agree to the business of the company being carried on in a manner likely to create a substantial risk of serious loss to the company's creditors; or

(b) Cause or allow the business of the company to be carried on in a manner likely to create a substantial risk of serious loss to the company's creditors.

136. DUTY IN RELATION TO OBLIGATIONS—

A director of a company must not agree to the company incurring an obligation unless the director believes at that time on reasonable grounds that the company will be able to perform the obligation when it is required to do so.

Whilst its predecessor under the 1955 Act was not applied to dividends, s 136 would seem on its terms to apply in some common instances. The declaration of a dividend results in the company incurring an obligation to the shareholders.²⁸ In closely held companies, the payment of a dividend often involves nothing more than a credit to the shareholder's current account. Not infrequently, this puts the current account into credit or increases a credit balance. In this situation, the payment of a dividend has resulted in the company incurring an obligation to a shareholder that is subject to the rule in s 136. Where the dividend takes the form of a cash payment, the company will very often make the payment out of its general checking account. In the event that the account is in overdraft, the payment will cause the debit balance in the account to increase. This represents the company incurring an obligation to the drawee bank that is also subject to s 136. On the other hand, the prescription on reckless trading under s 135 probably does not represent a serious constraint on transactions used as vehicles for outgoings to principals of closely held companies. Taken individually, these transactions do not amount to carrying on a business, as that phrase has been construed in the predecessor to the section under the 1955 Act. The predecessor provision was, as discussed in Chapter XX generally applied to situations where directors traded on or in a company which they knew, or should have known was already insolvent.

Enforcement of the general obligations. The general obligations under ss 131 to 137 are ones owing to the company and, prior to liquidation, can only be litigated by means of a derivative action. For example, in MacFarlane, the director of a two-person company was held accountable under ss 131 and 133 to the company in a derivative action on account of excessive salary payments²⁹. Liability is more likely to attach in the event of liquidation where the breach can, on application of the liquidator or creditor under s 301, result in a court order that the director contribute to payment of the company debts. For instance, in Hilton International Ltd v Hilton, the directors were held liable under the predecessor of s 301 for negligent payment of a dividend.³⁰

Deemed oppressive and prejudicial conduct. Under the 1955 Act, because of the common law restrictions upon the derivative action,³¹ in a closely held company shareholder grievances against directors were usually litigated in an action under s 209 for prejudicial and oppressive conduct. Whilst the action was initially limited to freezeout situations,³² the Court of Appeal in Thomas gave s 209 a more general interpretation which greatly expanded the availability of the remedy.³³ By the time the 1993 Act went into force, the provision had been successfully invoked in several cases where members were aggrieved by particular outgoings to members or directors.³⁴ The 1993 Act carries forward the general provision on oppressive conduct in s 174 and presumably, also, these common law precedents. As an important supplement to this law, s 175 declares as unfairly prejudicial the failure to comply with, inter alia, the transaction-specific requirements for buybacks, redemptions and financial assistance as well as the signing of a certificate without reasonable grounds for the therein stated opinion. Where a director is found to have engaged in prejudicial conduct, the court can order a wide range of relief including the appointment of a liquidator, the payment of compensation or the repurchase of shares.

Sections 292, 297 and 298. A discussion of the legal constraints upon outgoings to principals of closely held companies would be incomplete without mention of these three provisions from Part XVI of the Act which deals with the liquidation of companies. Except for the occasional challenge by another member through a derivative action, outgoings generally give rise to problems only when challenged by the liquidator in the event of a winding up. In that situation, it may be easier for a liquidator to challenge an outgoing under one of these provisions than, eg, to pursue the directors under s 56 for breach of the solvency test. Under s 292 the liquidator is entitled to recover preferential payments, ie, any transfer of property made while the company was insolvent and within a two-year period before commencement of liquidation, and which enabled the recipient to receive more towards satisfaction of a debt than they would have received in liquidation unless the payment took place in ordinary course. Liquidators have successfully invoked this section as a means to recover payments to principals of closely held companies in the form of salary, rentals and loan repayment.³⁵ Where, as often occurs, these payments are made on the eve of liquidation, the recipient will have difficulty establishing the defence under s 292(2) that the payment was made in ordinary course of business.³⁶ Sections 297 and 298 enable the liquidator to recover outgoings for which the company does not receive consideration of equivalent value. Of principal significance is s 298 that deals with transactions between the company and its directors within a three-year period before commencement of liquidation. The liquidator can recover the amount by which the outgoing for the acquisition of property or services exceeded the value of that consideration at the time of the acquisition. The provision can be used where principals are extracting property from the company through excess remuneration or sales at undervalue.³⁷ The value differential may be recovered without regard to the solvency of the company at the time of payment or any bad faith on the part of the recipient.

Taxation

The optimisation exercise. A business is usually established and operated with the objective of generating funds which the principals can use elsewhere, eg for pleasure, family support or investment in other ventures. With this in mind, the adviser will seek to arrange the affairs of the entity and principal in such a manner that a given amount of business income generates a maximum amount of disposable funds or, stated differently, in order to minimise the amount of business income required to produce a given amount of disposable funds. Tax law has an important bearing upon this optimisation exercise.

Example. Sole trader X purchases $10 of petrol for use in their automobile. If X pays tax at the rate of 33% and the vehicle is used for personal purposes, X must earn approximately $15.00 to fund the expense. If the vehicle is used for business purposes, only $10 is required to fund the expense.

The operation of the tax law can make profitable otherwise uneconomic transactions. This is the case where the income from a venture is not taxable but the expenses required to generate that income are tax deductible.

Example. X has the opportunity to invest in a venture which returns 5% pa tax-free. X can fund the investment with money borrowed at the rate of 6% pa.

If the interest expense is non-deductible, the investment proposal is unattractive as it has a negative 1% pa rate of return. If, however, the interest is tax deductible against X’s income from other sources, the otherwise uneconomic investment becomes profitable. Where X is taxed at 33%, the return will be approximately 1% pa, ie $6 spent on interest will generate $5 of tax-free income plus a $2 reduction in X’s tax bill.

Scope of the exercise. Where the business is structured as a one-person company, the optimisation exercise depends upon the tax treatment of incomings and outgoings in relation to both the company and X. Where X controls the incomings and outgoings at both levels, the exercise can be a complex one. The focus of the present chapter is more limited. It assumes that X controls only the internal relationship between herself and the company. Under this assumption, the optimisation exercise involves primarily whether the outgoing is deductible by the company and whether it is assessed to X.

Salary, wages, interest and rentals. These outgoings are deductible by the company as business expenses under BD 2(b) and included in the recipient’s taxable gross income under CD 3. The tax efficiency of these outgoings depends upon the rate at which the company and recipient pay tax. Where both the company and the recipient are taxed at 33%, the funding cost of a $1 after tax return to the recipient is approximately $1.50 of corporate gross income. The same holds true, in the absence of certain elections discussed below, where the company pays no tax and the recipient is taxed at 33%. Where, however, the company pays tax but the recipient does not, the funding cost drops to $1. The principal constraints upon deductibility and assessability—ie the income/capital distinction in relation to assessability and the nexus with income generation in relation to deductibility— generally pose few difficulties in closely held companies. Difficulties do, however, arise in relation to the distinction, discussed below, between these outgoings on the one hand and dividends and fringe benefits on the other. The use of excessive remuneration for services as a device to distribute company profits is constrained by GD 5 in the case of a closely held company (one with five or fewer members) and GD 3 in the case of other companies. Under GD 5, where the remuneration paid to a shareholder, director or a relative exceeds a reasonable amount, the excess is not deductible and shall be deemed to be a dividend.³⁸ The recharacterisation does not apply where the Commissioner is satisfied that the person is an adult employed substantially full-time and participating in the management of the company, and the amount of the salary was not influenced by the fact that the person is a relative of a shareholder or director.

Dividends. Dividends are not deductible by the company but are taxed to the recipient. Without more, this would result in double taxation of corporate income. Where both company and recipient are taxed at 33%, the funding cost of a $1 after tax return to the recipient would be about $2.23 of pre-tax corporate income. This result is mitigated by the regimes for full imputation and qualifying companies.

Imputation. The imputation regime provides the dividend recipient with a tax credit for tax paid by the company on the income used to fund the dividend. Section ME 6(1) requires the company to maintain an imputation credit account. This account is, under s ME 4(1) credited with, inter alia, tax paid by the company. Section ME 6(1) allows the company to attach to a dividend an imputation credit, the amount of which is, under s ME 5(1), debited to the imputation credit account. Where the company pays tax at 33%, the ratio of the credit to the cash component of a dividend may not, under s ME (1) exceed 50%. For purposes of calculating the recipient’s gross income, the amount of the attached income credit is included in the dividend under s CF 6(1). Sections BC 9(1) and LB 2(1) entitle the recipient to offset this credit against tax liability arising from the dividend or income from other sources. Suppose the company earns $1.50 in taxable income. This attracts approximately $0.50 of tax at the 33% corporate rate. If the company distributes the $1 of after-tax profits as a cash dividend, it can attach to that dividend a $0.50 imputation credit that represents the tax paid by the company on the $1.50 of income. The recipient recognises $1.50 of income [$1.00 cash plus the $0.50 tax credit] that, at a tax rate of 33%, attracts approximately $0.50 tax which is offset by the attached credit.

Qualifying company regime. The imputation regime does not provide relief where the company has distributable funds but no taxable income, ie, earns income only in the form of tax-free capital gains or operates at a loss, as there will be no imputation credits available to attach to the dividend. In this case, there is no problem with double taxation as the company has paid no tax. However, taxation of the dividend would deprive the investor of the concessionary treatment otherwise accorded to capital gains. The qualifying company regime provides relief in this situation. Dividends paid by a qualifying company are exempt income under s HG 13(1) to the extent that they are not accompanied by imputation credits. The qualifying company election is available, under s HG 1, to a company with five or fewer shareholders. A written election that the company be a qualifying one must be made by all directors under s HG 3(1) and all shareholders under s HG 4(1). The shareholders must, under s HG 4(1)(b), also elect to be personally liable for their pro rata share of the company’s tax liability. Upon compliance with some additional requirements, the shareholders and directors can also elect under s HG 14 that the company be a loss attributing qualifying company. Having made this election, each shareholder is entitled to deduct against their own taxable income a pro rata portion of the company’s losses.

Tax definition of dividend. The definition of dividend for tax purposes differs from that found in s 53(1). Whereas the company law definition is briefly and generally stated in s 53, the tax definition comprises sub-part CF of the statute containing eight sections and some XX words. The principal components of the sub-part are a list of specifically included items in s CF 2(1) and a list of specifically excluded items in s CF 3(1). Specifically included as dividends are—

• all sums in money distributed in any manner and under any name among all or any of the shareholders;

• credits to a shareholder’s current account;

• discharge of a loan owed by the shareholder to the company;

• the difference between the market value of property distributed to a shareholder and the consideration received by the company;

• the difference between the value of property acquired from the shareholder and consideration provided by the company;

• amounts distributed in respect of any buyback, redemption or return of share capital;

• any expenditure by the company where the benefit is enjoyed by a shareholder; and

• any of the previous benefits made to an associated person of a shareholder.

The list of included items is complemented by an almost equally long list of exclusions in s CF 3(1). The most important exclusions are those for fringe benefits, remuneration and return of capital—all of which would otherwise be caught by one or more of the broadly stated inclusions in s CF 2(1). This complex definition seeks to identify precisely the types of benefit subject to the unique tax treatment afforded dividends. In one sense, it represents an anti-avoidance measure designed to prevent taxpayers from arranging their affairs so as to minimise the impact of tax. For example, the inclusion of current account credits in s CF 2(1)(a) and loan forgiveness in s CF 2(1)(b)(i) prevents companies from returning profits to their principals in the form of non-taxable loan proceeds which are never repaid. The inclusion of transfers of property at under- and over- value in ss CF 2(1)(d) and (e) catches the use of agreements for sale and purchase as devices for extracting company profits.

Fringe benefit in lieu of outgoing. Principals extract funds from their company, at least in part, to fund the subsequent acquisition of goods and services from third parties. Extraction of funds is eliminated to the extent that the principals can use for their private benefit the goods and services owned by the company. The most common example of this practice occurs where the principal has personal use of a company car. Whilst a1959 judgment in the Court of Appeal held that fringe benefits do not constitute an allowance,³⁹ many such benefits would, without more, now constitute a dividend under s CF 2(1)(c) to the extent that market value of the property exceeds the consideration provided by the shareholder. However, since 19XX, the tax consequences of this practice have been regulated by the regime in Subparts CI and ND for fringe benefits. Where a transaction gives rise to a fringe benefit, as defined in s CI 1, it is specifically excluded from treatment as a dividend by s CF 3(1)(g).

Taxation of fringe benefits. The definition of fringe benefit in s CI 1 embraces a list of specifically included and specifically excluded items. Specifically included benefits are the private use or availability of motor vehicles, loans, subsidised transport, specified insurance premiums and contribution to certain superannuation schemes. Exclusions include monetary remuneration, exempt income and on-premises benefits. The value of a fringe benefit is not included in the employee’s gross income. Instead, s ND 1 requires the employer to pay tax at the rate of 49% on the taxable value of fringe benefits and the tax is a deductible item in computing the employer’s taxable income.⁴⁰ This regime tends to equalise funding costs of fringe benefits and monetary remuneration. Where both the company and employee pay tax at 33%, the company can provide a $0.67 after-tax benefit to the employee in the form of either a cash wage or use of a company vehicle at a cost of approximately $1.00 of company gross income. The statute also defines the value of fringe benefits. For example, in the case of motor vehicles, the value of the fringe benefit, computed on a quarterly basis under s CI 3(1), equals 6% of the cost price times a fraction representing the amount of time the vehicle is used for private purposes. In the case of employee loans, the value of the benefit is calculated under s CI 3(2) by reference to the excess of interest computed at the statutory prescribed rate (currently 6.50 % pa⁴¹) over the interest payable under the loan agreement.

Non-cash benefit to shareholder-employees in closely held companies. In most closely held companies, the principal will both hold shares in the business and provide services either as a director or employee. The tax statute provides rules for determining whether non-cash benefits provided such individuals are treated as fringe benefits or dividends. Section CI 2(2) provides that where the employee owns any shares the benefit is deemed received in their capacity as employee, ie as a fringe benefit. However, by way of exception under s CI 2(3), the benefit will be treated as a dividend under s CF 2(1A) where the member’s only service to the company is as a non-executive director.⁴²

Associated persons. The scope of the regimes for fringe benefits and dividends is extended to include benefits provided to associated persons of employees and shareholders. Under the definition in s OB 7, two persons are associated where they are relatives or where they are a company and a person with a voting interest equal to or exceeding 25%. In the context of closely held companies, the associated person extension leads to sometimes unexpected results.

Example. H and W, husband and wife, are the sole shareholders and directors of HW Ltd. H works fulltime as employee and managing director of the company. W is a non-executive director. The company provides cars for the personal use of the spouses as well as their son who neither holds shares in nor participates in the business as a director or employee. ⁴³

Provision of the company car to H, a shareholder-employee, qualifies as a fringe benefit under s CI 2(2). As W is a non-executive director, her company car would qualify as a non-cash dividend under ss CI 2(3), CF 2(1A) and CF 2(1)(e). However, under s OD 7(1), W is also an associated person in relation to H, an employee of the company. Accordingly, the benefit received by W qualifies as a fringe benefit under s GC 15(1). The son is an associated person of both a shareholder and an associated person of an employee. Whilst a cash payment to the son would qualify as a deemed dividend, the provision of a motor vehicle qualifies as a fringe benefit under s CF 2(1)(k).

Loan principal. Funds are frequently extracted from closely held companies in the form of loan principal. There are two possibilities. On the one hand, the outgoing may comprise the proceeds of a loan by the company to the principal. On the other hand, the outgoing may represent repayment by the company of a loan made by the principal to the company. As a general proposition, such loan payments are on capital account and, as such, not deductible by the company and not taxable to the recipient. The non-deductibility of loan principal repayment is anchored in s BD 2(2)(e); incomings in the form of loan proceeds do not fall within any of the components of gross income under s BD 1(1) read in connection with the common law relating to the capital/income distinction.⁴⁴ However, the principal cannot extract in the form of loan repayment more than the amounts which they earlier lent to the company. This generally precludes use of loan repayment as a vehicle to return substantial amounts of funds to the principal. In contrast, the use of loan disbursement as a means of extracting funds is a much more attractive possibility in closely held companies. Whilst the recipient becomes indebted to the company in the amount of the disbursement plus any interest, this is not a problem except in the event of liquidation as the principal controls when and if the company enforces the loan. Further, funds can be extracted in this manner free of some consequences associated with salary [PAYE] or dividends [imputation credits]. Accordingly, principals of closely held companies are tempted to extract funds from the business in the form of drawings or advances. These are debited to a current account, a debit balance in which represents indebtedness from the principal to the company.

Current account practice. This practice is constrained by a number of rules. Section CF 2(1)(a) denominates as a dividend any credit to current account even though unaccompanied by payment of cash. In s CF 2(1)(b) the definition also includes any forgiveness of a company loan to a shareholder. Current account balances are also subject to regulation under the fringe benefit tax regime. A debit balance on a current account will attract fringe benefit tax where the interest charged is less than the prescribed rate, currently 9.94 % pa. Without more, there is an obvious tension between the treatment of current account balances as loans for purposes of the fringe benefit tax and the treatment of such balances as dividends. So long as any debit balance in the current account bears a rate of interest above the prescribed rate, the balance will presumably not comprise a dividend. Where the member is also an employee and the debit balance bears no interest or interest below the prescribed rate, the account will give rise to a fringe benefit tax. This seemingly precludes treatment of the underlying balance as a dividend. Where the debit balance is eliminated or reduced by an allocation of income after the end of the tax year, under ss CI 3(3) to 3(5) the income is deemed to have been credited to the account on the first day of the year. This eliminates any potential fringe benefit tax liability where the intermediate debit balance did not bear interest at least at the prescribed rate.

Return of capital. Return of capital refers to outgoings made in repayment of a member’s investment in a business. This can occur when a company purchases its own shares, redeems shares or charges a dividend against paid up capital. As a general proposition, such outgoings are not deductible to the company and not taxable to the recipient, ie treated in the same manner as loan repayment. However, where a company has retained profits, the question arises whether such an outgoing is returning to the member their original investment and/or the retained profits. Accordingly, in relation to both purchase of own shares and redemptions, the principle is elaborated by relatively complex rules designed to prevent buybacks and redemptions from serving as vehicles for tax avoidance and to integrate them with the regimes for imputation, tax free treatment of capital gains and the qualifying company regime. As applied to the typical closely held company, the rules operate in a fairly straightforward manner. The outgoing is caught as a dividend except where it satisfies either of two specific exclusions provided in s CF 3(1), eg—

• in the case of a pro rata buyback, the transaction results in a capital reduction of at least 15%, or with the written consent of the commissioner, of at least 10%;

• in the case of a non-pro rata buyback, the shareholder has at least a 15% reduction in their interest; and

• and, in either alternative, the amount distributed does not exceed the available subscribed capital per share cancelled, ie the sum of the consideration paid for the shares plus taxable bonus issues less any amounts distributed upon acquisition or redemption of the shares.

Under this approach, a purchase of own shares is, for tax purposes, charged first against the member’s original investment and results in a tax-free distribution. Once the capital account has been exhausted, the outgoing qualifies as a taxable dividend.

Source collection. Collection of tax varies according to the type of outgoing. The tax due in relation to most of the outgoings will be collected through the company’s income tax, PAYE, resident withholding tax and fringe benefit tax. Where not taxed at source, the tax will be collected from the recipient through the provisional tax regime.

Salary, wages and directors’ fees. Where paid on a regular basis, these outgoings qualify as source deduction payments under s OB 2(1) in relation to which, under s NC 2(1), the company is required to deduct the tax from the payment and remit it to the Commissioner, generally by the 20^th of the following month. Where, as often occurs, such outgoings are not paid to the principal on a regular basis, they will be excluded from the source deduction payment category by s OB 2(2) which applies to a shareholder-employee of a closely held company, defined as one with 25 or fewer shareholders. For such a taxpayer, source deduction payments do not include—

• salary or wages which, although regular in amount, are not paid regularly throughout the year; or

• regular payments which do not exceed two-thirds of the total gross income which the taxpayer derives as an employee of the company; or

• income paid or credited to the taxpayer or applied on their account in anticipation of income that may subsequently be allocated to the taxpayer as an employee of the company.

The tax due in relation to such income is collected from the taxpayer through the provisional tax regime. Under s MB 2(1), the taxpayer must make quarterly payments of anticipated tax liability based upon their residual income tax for the immediately preceding income year.

Dividends and interest. The tax due on dividends and interest paid to the principals of closely held companies will be collected from the company through the resident withholding tax regime under s NF 1(2). The deduction rate, as calculated under s NF 2(1), for payments of interest is 21.5% and for dividends 33% with credit allowed for attached imputation credits. In some cases, the company will be exempt from this regime by s NF 2(5). That exemption applies where the company paid less than $5000 in interest in the preceding year and the current year’s interest payment, when aggregated with earlier interest payments, do not exceed $5000.

Fringe benefits. The regime for taxation of fringe benefits is discussed above. Fringe benefits are not taxed to the recipient. Under s CI 1, the company pays tax on a quarterly basis at the rate of 49% on the value of fringe benefits as calculated in accordance with s CI 3. In the case of a closely held company, common fringe benefits will include the use of company owned vehicles and low interest loans. In this regard, it is important to note, as discussed earlier, that non-cash benefits to shareholder-employees are treated as fringe benefits rather than as dividends subject to the resident withholding tax regime. In relation to a residual category of benefits, ie those in s CI 1(h), the company can elect under s CI 2A(1) whether to treat the benefit as a fringe benefit or a dividend.

Conclusion

In relation to the regulation of mundane transactions, it is difficult to find a more complex regime than that which governs returns to the principals of a closely held company. The complexity arises from two main sources. First, the various possible returns are subject to different statutory rules. There are separate regimes for dividends, buybacks, redemptions, financial assistance, director benefits and outgoings channelled through self-interest transactions. In addition to the transaction-specific regulation, general obligations apply across the board to all the transactions. There are inconsistencies within and between both the transaction-specific regimes and the general ones. This level of complexity confronts all companies whether closely held or listed. In the case of closely held companies, an additional level of complexity arises from the fact that the principal will generally stand on both sides of the transaction. This introduces two complications. On the one hand, the principal is free to choose among several transactional vehicles for the return, each subject to its own regulatory and tax regime. On the other hand, the principal faces potential liability as the party that implements the transaction on behalf of the company and in their capacity as the party who receives the benefit. The choice of transaction vehicle involves an optimisation exercise that minimises the principal’s liability exposure and maximises their economic gain under the circumstances. In most cases, the decision cannot be made without consideration of the tax legislation. The tax statute provides an entirely separate regulatory framework that, in its application to closely held companies and their principals, deviates significantly from the terminology used under the l993 Act.

The extent and complexity of the regulatory regime for outgoings is out of all proportion to the significance of the underlying economic reality. That reality is the interposition of a juristic entity between a sole proprietor or a family and their income producing assets. Whilst interposition of the corporate entity primarily serves an insurance function, ie limiting the proprietor's exposure to certain liabilities, the vast bulk of the regulatory regime bears only tangentially on the social and economic problems arising from this stratagem. Even a basic comprehension of the applicable company and tax law lies far beyond the capabilities of those subject to regulation. The advice required for conscientious compliance and transactional optimisation would soon exhaust the profits of many small businesses. In this regard, it is debateable whether the 1993 Act improves on the 1955 Act with its paucity of statutory rules and heavy reliance on the common law. However, complexity and uncertainty is not fatal if there exists identifiable conduct which, lying within the cost constraints and performance capabilities found in closely held companies, will protect the principals from liability on whatever ground predicated. This issue, which turns on the peculiarities of closely held companies, will be addressed in the context of the specific examples considered in the following chapter.