Directors’ conflicts under the Companies Act 2006

The law on directors’ conflicts of interest has been described as one of the most difficult areas of company law. It is based on complex and inaccessible case law going back to the 1720s. From 1 October 2008 the Companies Act 2006 will restate the common law rules - with some important modifications.

Although the restatement is intended to make the law more accessible to the layman, the old case law will be used by the courts in interpreting the restatement. The case law will also remain the source of the remedies for breach, which reflect the fiduciary character of the duties: in particular, the director may be ordered to account to the company for benefits gained by virtue of the breach, or to pay equitable compensation. The company’s ability to recover does not depend on its being able to prove that it has suffered loss.

Situational conflicts

All directors will be familiar with the process of declaring their interests where they are - or have an interest in a third party that is - contracting with the company. They may be less likely to realise the potential for conflict in other situations: for example, from their duty as a director of another company or their personal interests. It is in this area that the restatement will bring a greater focus and clarity, and will require a more diligent approach than in the past – both in recognising conflicts and in dealing with them.

Section 175 of the Companies Act 2006 codifies the strict duty to avoid situations in which a director has, or can have, an interest that conflicts, or possibly may conflict, with the company’s interests (a situational conflict). The duty applies in particular to the exploitation of any property, information or opportunity, even if the company is not itself in a position to take advantage of it.

Gauging whether a situation gives rise to a section 175 conflict will not always be straightforward, and it is important to understand the scope of the duty:

• This sort of conflict only arises if the company itself is not actively involved: for example, where information is being withheld from the company or opportunities that should come to the company are diverted away or rights that belong to the company are tacitly neglected so that another person can benefit instead. Directors’ conflicts can also arise where the company is actively involved as a party to a transaction or arrangement in which the directors may have interests of their own (transactional conflicts), but these are in a different category and are dealt with in a different way (see below).
• Section 175 bears not just on actual conflict situations, but also situations where a conflict may possibly exist. Its range is therefore very wide. But there is some scope to disregard situations even within that range that cannot reasonably be regarded as likely to give rise to a conflict of interest. This means situations where a reasonable man, looking at the relevant facts and circumstances of the particular case in the context of a commercial relationship, would think that there was no real, sensible possibility of conflict. Any assessment will depend very much on the particular facts, including the director’s circumstances and the company’s constitution, its objectives and its strategy.
• There is no statutory definition of a conflict of interest, but it is safe to say that it includes anything or any connection that could potentially cause the director to put his own, or a third party’s, interests before the company’s. An interest that gives rise to a conflict can be direct (for example, through holding a directorship of a competing company) or indirect (for example, where a director owns an interest in a business which competes with the company). It is also sensible to assume (and articles of association often provide) that an indirect interest includes interests of persons who are connected to the director. These include connected companies, a director’s civil partner and their respective adult children and step-children, the director’s parents, a person who lives with the director as partner in an enduring family relationship, and any children or stepchildren under 18 of such a person who are not also the director’s children or step-children.
• The GC 100 group (made up of general counsel to FTSE 100 companies) has published a questionnaire designed to help directors identify conflicts of interest (available at http://www.practicallaw.com/6-378-7923).

Directors should be reminded that, by disclosing their potential conflicts to the rest of the board, they are reducing the risk of being personally liable for breach of duty. Every director should be mindful at all times of whether there is any situation in which his personal interests could conflict with those of the company. This is particularly important when his interests change, when the company enters a new area of business, or when the board is considering any significant transaction or strategic decision. The director may have concluded, say, that his involvement (as a director or shareholder) with another company, whose business lies in an entirely different sector, simply could not reasonably be seen as being likely to give rise to a conflict – but that could change dramatically with a change of direction by either company, leading to their competing for the same acquisition-target or the same customers; or a conflict could arise quite unexpectedly even where the companies operate in very different areas – as happened when the chief executive of Guardian Media Group had to stand down as a non-executive director of Tesco after it took proceedings against The Guardian.

Authorisation of situational conflicts by directors

There will be no breach if the conflict is duly authorised by the non-conflicted directors.

• For private companies already in existence on 1 October 2008, authorisation by non-conflicted directors will be permitted only if the articles contain nothing to the contrary, and – unless the articles provide expressly for authorisation of conflicts – if the members pass an ordinary resolution before, on or after 1 October 2008 permitting authorisation by the non-conflicted directors. The resolution must be filed at Companies House.
• Private companies incorporated on or after 1 October 2008 will be treated as permitting such authorisation unless their articles specify otherwise.
• For public companies – even those incorporated on or after 1 October 2008 – authorisation by the non-conflicted directors will be possible only if the company’s articles specifically allow it.
• All companies should consider passing resolutions or making provision in their articles for matters that are ancillary to the approval process (see below).

The authorisation process

Where any director considers that he may have a direct or indirect interest that conflicts or possibly may conflict with the interests of the company, he should notify the board in writing of the nature and extent of the interest as soon as possible, explaining, where necessary, how the interest may create a conflict. For example, where a conflict might arise by virtue of another directorship, notification should be made before the director agrees to take up the other appointment.

• Once a notification has been received, the interest should be considered at the next board meeting or, if the nature and timing of an actual or potential conflict requires it, at an earlier meeting of the board convened for that purpose. The director concerned (and any other director with a similar interest) cannot count towards the quorum while the conflict is considered and must not vote on any resolution authorising the conflict. It will normally be appropriate for him to be excluded from discussions about whether to authorise the conflict and the terms of the authorisation.
• The rest of the board should consider carefully whether authorising the conflict would be consistent with their own duties to the company: in particular, the duty to promote the success of the company and the duty to exercise reasonable skill, care and diligence. They may decide that the conflict makes the conflicted director’s position untenable – in which case his options are either to resign or to seek shareholder approval.
• As well as considering whether to authorise the conflicted director to continue in office, the non-conflicted directors should decide if he should be permitted not to do certain things he would otherwise be required to do (for example, disclose to the company information that is of use or value to it, having regard to its business). They may wish to impose restrictions or conditions – for example, that the director should be excluded from those parts of board meetings where the matter is discussed, and should not be provided with board papers or other documents that relate to the matter. The authorisation could be indefinite or for a fixed period of time – but in either case, the board should be able to revoke the authorisation at any time.
• The board will need to be satisfied that it has the power to give authorisation on the terms it wants to: for example, as a constitutional matter, can it dispense with the conflicted director’s normal obligation to disclose information to the rest of the board, and to use his judgement and experience to further the company’s interests? The company’s articles should be checked; it may be necessary to amend them or to seek shareholder approval.

Following authorisation

An up-to-date record should be kept of the interests of each director, and all authorisations sought and given. Both the conflicted director and the rest of the board should review the situation from time to time, and, whenever there is any material change of circumstances, to decide whether the terms of the authorisation should be extended, tightened up or revoked.

The boards of listed and high profile companies should be prepared to explain to their shareholders (for example, in the corporate governance report) how they have dealt with conflicts, and to justify the terms of any authorisations that have been given. Listed companies are recommended to report to shareholders annually on the company’s procedures for ensuring that the board’s powers of authorisation of conflicts are operated effectively and that the procedures have been followed.

Authorisation by shareholders

If all the directors are or may be conflicted, only shareholder approval will do. There may be other reasons for by-passing the board: in a 50:50 joint venture, for example, the shareholders may want the matter to be put to shareholders rather than left with the board.

Where an interest is disclosed to the board some time after it has arisen, and in the meantime the director has been in a position where that interest potentially or actually conflicted with the interests of the company, the breach of duty cannot be cured by the non-conflicted directors (although they could authorise the director to continue in office). Depending on the circumstances, it may be possible to get shareholders to ratify the breach of duty, although ratification will not be effective if the company is insolvent or if the shareholder resolution would not have been passed without the votes of the director concerned and his connected persons.

It is possible for the company’s articles to confer standing authorisation of certain conflicts that would otherwise be in breach of section 175, but it is not clear how far such a provision can go. Automatic authorisation of other directorships or interests within the group – provided that the director has disclosed particulars of any material interest to the other directors - is considered valid, and an article permitting the directors not to disclose to the company confidential information obtained by them in that connection is probably safe, too. It may be feasible, in joint ventures, for the joint venture company’s articles to provide the same in relation to the JV parties’ groups. A blanket dispensation generally authorising the directors to be directors of any other company regardless of the circumstances, and to withhold information thereby obtained (no matter how significant), is unlikely to be lawful.

Transactional conflicts

The section 175 duty does not apply to a director’s conflict of interest arising in relation to a proposed transaction or arrangement involving the company (a transactional conflict). Instead, he has a fiduciary duty under section 177 of the Companies Act 2006 to declare the nature and extent of his interest, and to make further declarations if a declaration turns out to be inaccurate or incomplete. Unless the company’s constitution provides otherwise, the transactional conflict ceases to be an impediment to the director if he duly complies with the section: he will then not have to account to the company for benefits derived from his interest, and the transaction will not be liable to be set aside.

• The director’s conflicting interest in a transaction may arise in any way, and be direct or indirect. For example, he may be the counterparty to the transaction, or the counterparty may be a company in which he, or someone connected to him, is interested; or he may be interested in, say, a subsidiary that is indirectly interested in the transaction with the company – for example, if the company is renewing its head-lease, under which the subsidiary has a sub-lease – and so on.
• Where the company has already entered into a transaction or arrangement in which the director is interested, he is required to disclose to the board the nature and scope of his interest as soon as reasonably practicable (section 182), and to make further declarations if a section 182 declaration turns out to be inaccurate or incomplete. This is not a fiduciary duty, but failure to comply is a criminal offence. Section 182 could come into play where the director has neglected to comply with section 177 (it cannot apply where section 177 has been complied with), or where the director acquires an interest after the transaction (for example, by investing in one of the company’s suppliers).
• Declarations must be made at a board meeting or by means of a written notice that is put before the board. But no declaration need be made if the director’s interest cannot reasonably be regarded as likely to give rise to a conflict of interest; or if the other directors are already aware of it; or if it relates to the director’s interest in the terms of his own service contract.

Benefits from third parties

From 1 October 2008 section 176 of the Companies Act 2006 will impose a duty on a director not to accept a benefit from a third party that is conferred by reason of his being a director or by reason of his doing or not doing something in his capacity as a director. This means benefits of any description, including non-financial benefits. Although the duty is designed principally to prevent directors accepting bribes or other inducements from suppliers and others, it is wide enough to catch all forms of corporate hospitality.

• The duty does not apply to benefits received from the director’s company or another group company (or someone acting on their behalf).
• The duty will not be breached if accepting the benefit cannot reasonably be regarded as likely to give rise to a conflict of interest. In practice this is likely to be an important caveat. But because it is an objective test, the director concerned, and the other directors, should consider whether a reasonable observer, looking at the commercial context, would think that there was a real, sensible possibility that the benefit might create a conflict.
• Unlike section 175, section 176 does not allow the rest of the board to authorise a director to receive a benefit that can reasonably be regarded as likely to give rise to a conflict of interest. That sort of benefit must be refused unless acceptance of it is specifically authorised by the company’s shareholders. The articles could sanction the acceptance of certain benefits, but the degree of specificity required to make this effective would limit the scope and flexibility of the provision.
• As a matter of risk management, or to comply with overseas regulations, a company may well want to have in place internal guidelines on the size and nature of benefits that can be accepted by directors and employees, and a transparent system of logging benefits offered and whether they have been accepted. Although this is not guaranteed to protect a director from being in breach of section 176, it might have some influence on the court’s decision as to whether a particular benefit is caught, and, if it is, whether the court should exercise its discretion (under section 1157 of the Companies Act 2006) to relieve him from liability for breach of duty.