Peter Godwin, Jarry Tay, Arnold Hoong and Tasmine Khaw
Should the directors and shareholders of a company be held personally liable for fraudulent trading if their company is used as a conduit to acquire a partnership interest in an orchestrated scheme which leaves the sellers unpaid?
In the recent Malaysian Federal Court case of Lai Fee & Anor v. Wong Yu Vee & Ors  4 CLJ 1, the Court reiterates the need for parties to have good faith in carrying through with their contracts and has shown that it will not hesitate to find a company’s shareholders or directors liable under Section 540 of the Companies Act 2016 when a company dishonestly conducts the contract in a way to avoid liability for their side of the bargain.
The plaintiffs, who were partners of one Fave Enterprise (Fave), entered into a sale and purchase agreement (SPA) with Centennial Asia Sdn Bhd (Centennial) to sell and transfer their interest in Fave to the defendants (who are individuals) for a consideration of RM 7 million (Purchase Price). In this case, Centennial was, in fact, a dormant company incorporated by the defendants solely as a vehicle to acquire Fave. The parties agreed that the purchase price was to be settled in three instalments. The first two instalments were to be paid by a third-party company known as Westhill Equity Sdn Bhd (Westhill) (a company also controlled by the defendants), with the final instalment to be paid by Centennial.
Upon signing of the SPA, the plaintiffs immediately relinquished their partnership of Fave to the defendants whilst waiting for payment. Subsequently, the first 2 instalments were paid by Westhill, but Centennial failed to pay the final instalment. As a result, the plaintiffs brought an action against Centennial and obtained a judgment for the balance Purchase Price. However, Centennial, being a vehicle with no substantial assets, did not satisfy the judgment debt.
Unhappy with the outcome, the plaintiffs filed an action against the three directors cum shareholders of Centennial for fraudulent trading under Section 540 of the Companies Act 2016, arguing that the defendants intended to defraud the plaintiffs by entering the contract through Centennial, and sought to render the defendants personally liable for the outstanding Purchase Price. The plaintiffs’ claim was dismissed in the High Court and Court of Appeal, and was ultimately brought to the Federal Court.
Federal Court Decision
Two key issues were brought before the Federal Court:
1. Where the plaintiffs have agreed to transfer their interests in Fave to the defendants relying on Centennial’s representation that the balance Purchase Price will be paid, and Centennial failure to honour its obligations, were the defendants personally liable to the plaintiffs due to fraudulent trading under Section 540 of the Companies Act 2016?
2. Is the common law principle that “the law does not expect people to arrange their affairs on the basis that other people may commit fraud” representative of the position of Malaysian law?
On the first issue, the Federal Court decided that the defendants were personally liable to the plaintiffs for the outstanding Purchase Price, as it found that there was an intention on the part of the defendants to defraud the plaintiffs under Section 540 of the Companies Act 2016.
The Federal Court drew references to a number of case laws for legal principles governing the concept of fraudulent trading under Section 540 (or in the past, Section 304 of the Companies Act 1956). The Federal Court also noted a few unusual features of the transaction:
- Centennial was a dormant company, incorporated by the defendants for the sole purpose of acquiring Fave. Despite this, the defendants did not inject any funds or assets of value into Centennial in anticipation of Centennial’s obligation to pay the Purchase Price under the SPA.
- The initial two instalments of the Purchase Price were paid by Westhill even though it was not a party to the SPA, and there was no provision in the SPA referring to this arrangement.
- Fave was transferred to the defendants and not to Centennial, despite the fact that under the SPA, Centennial was the designated buyer and there was no provision on the appointment of nominees to acquire the interest in Fave.
- The SPA provided for the immediate transfer of ownership of Fave upon the execution of the SPA even before the full settlement of the Purchase Price.
In view of the foregoing, the Federal Court found that the defendants had orchestrated a scheme to induce the plaintiffs to agree to transfer their interests in Fave to the defendants, on the representation that Centennial would pay the balance Purchase Price. It was found that Centennial and Westhill were used to create corporate layers, insulating the defendants against personal liabilities when the payment of the balance Purchase Price was not honored. On this basis, the Federal Court concluded that the defendants’ conduct was dishonest according to the ordinary standards of reasonable and honest people. The use of Centennial and Westhill also suggested that the defendants had knowledge that their conduct was dishonest. Consequently, it was held that the defendants had an intention to defraud under Section 540 of the Companies Act 2016, and were, therefore, personally liable to the plaintiffs for the payment of the balance Purchase Price.
On the second issue, the Federal Court concluded that the English position that “the law does not expect people to arrange their affairs on the basis that other people may commit fraud”, as expounded by the English Supreme Court in Takhar v Gracefield Developments Ltd and Others  UKSC 13, is representative of the position of Malaysian law.
In coming to this decision, the Federal Court observed that, as a starting point, the Contracts Act 1950 is the law that governs all contracts in Malaysia. In this regard, the Contracts Act starts on the assumption that all contracts are valid and enforceable because parties who enter into agreements assume the honesty, good faith and fair dealing of the other party. This thus underscores the principle that contractual parties are not expected to arrange their affairs on the basis that other people may commit fraud.
The Federal Court’s decision sees an interesting application of Section 540 (i.e., prohibition of fraudulent trading) to a transaction that involves the sale of interests in a partnership, and it is more than likely that the same concept will apply in any other merger and acquisition transactions involving the sales of shares. This decision should serve as a reminder that parties should conduct their contracts in good faith, and a reminder to directors and shareholders to be mindful of their actions so as not to be seen as having “intent to defraud”, otherwise they may risk finding themselves personally liable for the losses of the counterparty.
This decision also sheds light on the importance of ensuring that the terms and structure of a proposed sale are properly thought-through. As alluded to above, one anomaly of the transaction as called out by the Federal Court was that the SPA provided for an immediate transfer of ownership upon the execution of the agreement even before the full settlement of the Purchase Price. This is often unusual in an acquisition transaction because sellers, if well advised, commonly insist that ownership only changes hand when the entire purchase price (albeit subject to applicable price adjustments) has been settled.
Lastly, this case calls to mind the need for proper due diligence on the counterparty one is dealing with. In this case, from the perspective of the plaintiffs, it was fortunate that the Federal Court had decided the case in their favor, but this was only after a series of lawsuits that were likely to be both time-consuming and costly. Could the plaintiffs have saved themselves from the trouble had they performed adequate diligence on the counterparty? While it is common in an acquisition deal for a purchaser to conduct due diligence on the target and seller, there are equally good reasons for a seller to do the same in relation to its counterparty. At the very least, a seller should be reasonably aware of and comfortable with the financial standing of the buyer to complete a proposed transaction, or otherwise, take necessary steps to mitigate the risk. In circumstances where a buyer lacks the means to meet its commitment, it would not be unreasonable for a seller to ask from the buyer certain financial backing, including, for example, a bank or corporate guarantee.
Herbert Smith Freehills LLP is licensed to operate as a Qualified Foreign Law Firm in Malaysia. Where advice on Malaysian law is required, we will refer the matter to and work with licensed Malaysian law practices where necessary.