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Directors’ conflicts: the impact of the Companies Act 2006

March 2007 - Conflicts of interest. Legal Developments by Lewis Silkin LLP.

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Every director owes a fiduciary duty to avoid conflicts between his own interests and those of the company. In addition, when the company is facing insolvency, its directors must have particular regard to the interests of its creditors, more so than to those of its shareholders.

Such obligations have proved notoriously difficult for directors to comply with, resulting in claims by companies against directors for breach of their duties.

Conflicts of interest are a fundamentally important issue for directors to grapple with and an objective view is valuable. The topic is one on which they should turn to their in-house lawyers for advice.

By the end of 2007, the majority of the provisions of the Companies Act 2006 (the 2006 Act) are likely to have been brought into force. The 2006 Act codifies in statutory form the duties of directors which have to date only been expounded at common law. The Act has sparked much debate about the extent to which it will make a real difference to the manner in which directors must fulfil their obligations.

This month's briefing will examine two decisions on the subject of directors' conflicts of interests, and will consider whether different decisions would have been reached in each case had the Act been in force at the time. The cases focus on conflicts between:

  • a director's personal interests and the interests of the company; and
  • a director's duty to act in the best interests of the company and, where insolvency is looming, his obligation to act in the interests of its creditors.

When a director's personal interests conflict with his duties to the company

Directors are currently under a duty1 to act honestly and in good faith in the best interests of the company. Under the 2006 Act, this duty will change so that directors must promote the success of the company in the interests of the shareholders. It is clear on either basis that the directors must act in the interests of the company. It is not hard to spot where conflicts may easily arise between the company's interests and those of an individual director. A director's salary and bonuses, interests in contracts between the company and a third party, and interests in competing companies are all potential problem areas.

In order not to stifle commercial activity, the Companies Acts have provided for exceptions to what would otherwise amount to breaches of directors' fiduciary duties at common law. For example, s317 of the Companies Act 1985 (the 1985 Act) provides that directors may have conflicting interests in contracts with the company, providing they disclose them to the board.

Simply Loans Direct Ltd v Wood and others

Facts

Simply Loans Direct Ltd was incorporated in 1998 as a joint venture company to operate a mortgage and loan broking business. It was owned by three individuals including the defendant, Mr Wood.

Mr Wood was the ultimate beneficiary of 33 of the company's 100 shares; the other two participants, who put up substantial working capital, received the remainder.

Mr Wood ran the company as sole director and a service agreement was concluded. He remained sole director until late 2005 and until then had been permitted to sign company cheques.

By 2002 it became clear that the company's anticipated level of turnover and profitability was not being achieved, and so an accountant was appointed to carry out an investigation. Simply Loans alleged that the accountant was deliberately obstructed by Mr Wood. After the execution of a search order, it was discovered that Mr Wood had been operating a competing business, engaging in misappropriation of Simply Loans's funds to meet his own personal expenditure and committing various other breaches of his duties as a director. Mr Wood's service agreement was terminated after findings of gross misconduct and serious breaches of his fiduciary duty as a director. Mr Wood admitted many of the allegations about misappropriation and, in April 2006, judgment was given in this respect for £200,000 plus interest.

With regard to separate bonus payments and a salary increase that Mr Wood had granted to himself at the same time as conducting his deception, the company applied for summary judgment.

Arguments

Simply Loans submitted that Mr Wood was in breach of his fiduciary duty requiring him to act in its best interests, and that he had not complied with the disclosure provisions in s317 of the 1985 Act given that there were neither any recorded board minutes approving the salary increase or bonuses, nor any record of a declaration of his conflicting interest.

Mr Wood denied that any salary increase or bonus had been improper. He argued that, as he was the company's sole director, he could duly authorise his own bonus and increase in salary. Mr Wood contended that the shareholders had unanimously agreed, albeit implicitly, that he could do this. He had clearly not considered the issue of a potential conflict of interest with the company.

Decision

It was held that the salary increase and bonuses could not be separated from the other devices that Mr Wood had used to extract money from the company. No fair-minded director in Mr Wood's position could have believed that it was proper to award oneself a salary increase and a large bonus payment, while simultaneously misappropriating hundreds of thousands of pounds from the company. He was certainly not acting in the best interests of the company.

The defence of subsequent approval or waiver by the company was not available to Mr Wood given that he had concealed his conduct throughout, and the Court awarded judgment in favour of Simply Loans on the summary judgment application.

Mr Wood would only have been able to award himself a salary increase and bonuses if:

  • he had satisfied the conditions of s317; and
  • he had complied with his duties as a director.

The absence of board minutes did not make it impossible for the conditions of s317 to be complied with in some other way, provided that Mr Wood as sole director was conscious of his disclosure requirements and first paused for thought about his potential conflicts of interests with the company, effectively acting as he would have done had there been other directors overseeing his actions.

What difference would the 2006 Act have made?

It will remain the duty of a director to place the interests of the company above his own personal interests, and to ensure those interests do not conflict. Section 172 of the 2006 Act provides that a director must act in the way he considers, in good faith, would be most likely to promote the success of the company.2

Directors looking to rely on the exemptions contained in s317 of the 1985 Act should turn to ss182 to 187 of the 2006 Act. The new provisions are lengthier, but at the same time clearly set out what is required of a director who is seeking to rely on them. The relevant provisions of the 2006 Act are broadly the same as those of the 1985 Act, with one exception which is referred to below.

Under the 2006 Act, a director is still required to declare any interest, direct or indirect, that he has in an existing, or proposed, transaction or arrangement entered, or proposed to be entered, into by the company. The declaration should be made as soon as possible during a board meeting or by way of a written notice. Failure to comply continues to leave a director open to the possibility of being fined.

Section 186 of the 2006 Act is a new provision that applies where, as in the Simply Loans case, a company has only one director. A director of such a company can now comply with the declaration of interest provisions by recording his declaration in writing. There is no specific obligation to pause for thought and consider other ‘fictional directors' views'. On the face of it, a written declaration of interest, despite blatantly excessive remuneration, will comply with the obligation. On that front, Mr Wood could potentially have been better off under the 2006 Act.

Nonetheless, had the 2006 Act been in force, the Court would not have reached a different conclusion overall. It would undoubtedly still have found against Mr Wood. In particular:

  • it is now expressly made clear in s175 of the 2006 Act that directors have a duty to avoid conflicts of interest;
  • s176 of the 2006 Act codifies the duty of directors not to accept benefits, including bribes, from third parties;
  • interests of the company are defined as ‘financial success' in the explanatory notes to the 2006 Act; and
  • authorisation by the company of a director's conflicting activities is now more simple, particularly for sole directors, but a declaration of interest is still required.

Directors' conflicting duties when insolvency is looming

Even a company that is established and skilfully run can get into financial difficulties. Its directors will often be well aware of their everyday obligations to act in the best interests of the company. Less well-known are the duties directors are under when insolvency rears its head. Such duties inevitably conflict with the way the company, up until then, has been run in the interests of the shareholders.

At what point does a director's conflict arise between acting in the interests of the company and acting in the interests of creditors?

When a company is unable to pay its debts as they fall due and there is no reasonable prospect that it will avoid going into insolvent liquidation, directors' duties change from having to act in the company's best interests to having to act in its creditors' best interests. The duty requires directors to take all reasonable steps to minimise losses to creditors, who are usually only concerned with ensuring that their bills get paid. Unlike shareholders, whose interests directors are more used to looking out for, creditors are risk-averse and usually have very short-term interests.

Failure to recognise this necessary change in emphasis may result in directors being held personally liable for debts incurred by the company as well as having to face the possibility of being disqualified as a director and receiving a fine.

Re DKG Contractors Ltd

Facts

The defendant directors, Mr and Mrs Gibbons, had incorporated a building business which was supplied with groundwork services by a separate unincorporated business owned by Mr Gibbons. In this way, he became the company's main creditor.

In the ten months before the company went into insolvent liquidation in December 1998, £400,000 of company money found its way into the hands of Mr Gibbons. Cheques drawn in favour of the company were paid into his bank account. Large sums of money were frequently paid to him from the company's account. Company cheques written out to cash were handed to him and no accounts were ever prepared for the company. All of this arose more through the defendants' failure to understand their obligations as directors rather than because of any dishonesty on their part.

From February 1988 the company was unable to pay its debts, thereby satisfying the cash flow test for insolvency from that point onwards. Sixteen judgment debts were entered against the company from May that year, but the payments to Mr Gibbons continued.

Arguments

The liquidator of the company sought to recoup the money that had been paid to Mr Gibbons and to hold him liable for its debts. The liquidator argued that:

  • it was a breach of the directors' duties to creditors to have made the aforementioned payments of company money to Mr Gibbons whether or not for services rendered, when the company was unable to meet its debts as they fell due;
  • the payments were a wrongful preference of Mr Gibbons as defined in the Insolvency Act 1986; and
  • the directors were guilty of wrongful trading, also as defined in the Insolvency Act 1986.

The directors, on the other hand, contended that:

  • the payments had been made lawfully to reimburse Mr Gibbons for services supplied to the company;
  • although Mr Gibbons was not authorised by the articles of the company to contract with it, payments to him had been informally approved by the shareholders, namely Mr and Mrs Gibbons, who were the beneficial owners of the company; and
  • in any event, the directors had acted honestly and reasonably and ought fairly to be excused under s727 of the Companies Act 1985, which permits the court to waive liability for breach of duty in certain circumstances where it would be fair to do so.

Mr Gibbons had numerous conflicts of interest, in that he had to consider:

  • the creditors' interests;
  • the company's interests in continuing to trade; and
  • his own interests.
Decision

The Court held that the directors had indeed acted in breach of their duties by making payments to Mr Gibbons when the company was of doubtful solvency. The payments were also held to be an unlawful preference, and the directors were adjudged liable for wrongful trading.

The company's creditors were not treated equally. Mr Gibbons was paid ahead of the company's general creditors, which in the circumstances amounted to a breach of the requirement on directors to act in the interests of its general creditors as a whole in an insolvency situation.

The directors had unlawfully failed to preserve the company's assets for its general creditors. As soon as the directors knew that a creditor had refused further supplies because of lack of payment, and that other creditors were pressing, they should have obtained the necessary degree of financial information and introduced appropriate financial controls.

The Court ordered the £400,000 be repaid, and required the directors to make a contribution to the company's assets equal to the amount of the trade debts incurred by the company from 1 May 1988. The total liability was limited to what was necessary to pay the creditors and the costs and expenses of the liquidation.

Section 727 of the Companies Act 1985 was drafted so that even if a director is found to have acted in breach of his duties he may be able to escape sanction from the courts. The provision allows the courts to relieve a director from liability providing ‘he has acted honestly and reasonably' and ‘ought fairly to be excused'. However, in this case the Court ruled that although they had acted honestly the directors had not acted reasonably and therefore ought not to be excused. The fact that their own knowledge, skill and experience were ‘hopelessly inadequate' did not protect them. Directors are not entitled to rely upon their own lack of skill and experience in an effort to avoid liability.

What difference would the 2006 Act have made?

The Insolvency Act provisions remain unchanged and s727 of the 1985 Act has been transposed into s1157 of the 2006 Act. The wording of the section is effectively the same.

Section 172 of the 2006 Act for the first time puts on a statutory footing the requirement that directors must have regard to the need to foster the company's business relationships with suppliers and customers.

The Court would still have found against the directors in the DKG Contractors case even if the 2006 Act had been in force when its judgment was handed down.

At the root of the issues in the case was the fact that, when being appointed, the individuals had not been given any information about the duties they were acquiring in their new capacity as directors. Nor did they make any attempt to find out what those duties might be.

Conclusion

The 2006 Act does not substantially change the essential nature of directors' duties. Nonetheless, perhaps the ultimate effect of the introduction of the Act will be that the codification of directors' duties, and the publicity surrounding its coming into force, will mean that directors become more aware of their obligations, and therefore more likely to comply with them.

Simply Loans Direct Ltd v Wood and others [2006] All ER (D) 291 (Jun)

Re DKG Contractors Ltd [1990] BCC 903

By Neville Illingworth-Law, associate, Lewis Silkin LLP.