Residual Duties of the Director in the Management - Essay Example

Company Law Question In assessing whether or not Backup’s board of directors have breached any duties, it is necessary to identify the duties they owe to Backup itself. Company law dictates that directors have a fiduciary relationship with the companies they serve.1 As fiduciaries, directors are bound by three residual duties in the management of the company’s affairs. They are: 1- A bona fide duty to act in the best interests of the company at the exclusion of any collateral interest. 2- Should a director uses his position to make a personal profit he is accountable to the company and its members. 3- If a contract is entered into on behalf of the company by a director who has a conflict of interest, the company by its own volition can avoid the contract.2 British courts have taken the position that the directors’ duty of care is calculated to protect the company itself rather than the individual shareholders. Section 309 of the Companies Act 1985 codified this criteria by dictating that directors owe a duty of care to act in the best interests of both the members and the employees of the company.3 In the context of the problem company, Backup was persuaded to advance a loan to EL by Connie and Darshani, two of EL’s directors who also happen to be on the board of directors of the parent company ISL. There is clearly a question of a conflict of interest in that Connie and Darshani have the interests of the parent company and two subsidiaries, which may be competing interests. Moreover, in assessing the duty of care owed by Connie and Darshani and the remaining directors of Backup, the standard of care is relevant. That standard is the measured by reference to the reasonable skill and care that is generally expected of a business man possessing the relevant skills and training.4 The directors of Backup appeared to have reservations about the utility of the loan after hearing of EL’s impending financial problems from Connie and Darshani. Even so, they went against their own business instincts and acted for what appeared to be the best interest of the parent company and each of its subsidiaries. Although Connie and Darshani may have been confronting a conflict of interest, their position as directors of the parent company, a shareholder in EL, a subsidiary provides a means by which they may escape liability. In Re Southard &Co Ltd T where Templeton LJ said that: “A parent company may spawn a number of subsidiary companies, all controlled directly or indirectly by shareholders of the parent company. If one of the subsidiary companies, to change the metaphor, turns out to be the runt of the litter and declines into insolvency to the dismay of its creditors, the parent company and other subsidiary companies prosper to the joy of the shareholders without any liability for the debts of the insolvent subsidiary.”5 Drawing on the reasoning by Templeton, LJ in Re Southard &Co Ltd T Connie and Dashani were at liberty to act as they did in favour of the parent company. Although the loan was advanced to EL, another subsidiary, Connie and Dashani made it clear that the loan was necessary for the benefit of the entire group. So ultimately they were looking after the common interests of ISL to the detriment of its subsidiary Backup, something they were entitled to do according to the ruling in Re Southard &Co Ltd T . The onus were therefore on the remaining directors of Backup to look after the sole interest of Backup, its members and its employees. By going against the evidence of EL’s financial troubles and their business instincts, Backup’s directors were clearly in breach of their fiduciary duties to Backup. Question 2 Like Backup, the board of directors of EL are similarly bound by a fiduciary duty to EL and its employees and members. The duty is to exercise the care and skill of a reasonable business professional. It is entirely doubtful, that Frank’s practice of relying on two specific contracts and concealing important information about EL’s financial situation accords with the reasonable care and skill of a business professional. By virtue of the Companies’ Act 1985, Section 320(2) Frank, as a director of EL is under a duty to disclose and obtain shareholder approval in advance of securing ‘substantial property transactions.’6 Considering that Frank was negotiating a contract with two companies and did not honestly disclose EL’s financial troubles as a means of obtaining approval, is tantamount to not obtaining approval at all. The rationale is that the board of directors were approving a transaction based on false information and would not have approved this transaction had they been privy to all the facts. Personal liability is possible despite a long established principle of company law that the corporate personality is a separate legal entity distinct from its members. There are limited circumstances in which the courts might find it appropriate to dispense with this principle and ignore the principle of separate corporate personality by ‘lifting the corporate veil’ so to speak.7 In order to effectively discuss whether or not Frank or any of the other directors or the parent company as a major shareholder in EL can be held personally liable for EL’s debts, it is first necessary to understand the principle of separate legal personality. This concept was introduced by the case of Salomon v Salomon & Co. Nr. Saloman, the plaintiff was engaged in business as a leather merchant and incorporated the defendant company to carry on his leather business. In order to comply with legislative provisions at the time, Mr. Salomon nominated his his wife and children as shareholders, each of whom held one share each, for him.8 The House of Lords held: 1) There was nothing on-toward about the nature in which the shares were distributed since it was done for the purpose of conforming with statutory formalities for the formation of a company. In other words Mr. Salomon was at liberty to take advantage of the registration requirement even it consequently formed a one-man business. 2) A company formed pursuant to the the Companies Acts is a separate legal person and was not an agent or trustee for the controller. Therefore the company’s debts were its own and were not the debts of its members. The liability of the members would be limited in proportion to the shares that they each held.9 Based on this ruling Frank and Helena are jointly responsible for 20 percent of EL’s liabilities since they own 20 percent of EL’s shares. The parent company owns 80 percent of ELs shares and would be personally liable for that amount. Whether or not liability can be extended beyond the principles of limited liability depends upon the construction of statutory provisions that have modified the separate personality proviso provided for in Salomon. For example Sections 213 and 214 of the Insolvency Act permits the corporate veil to be lifted in cases of fraud and wrongful dealing.10 This is entirely relevant to the EL’s case since Frank admits to fraud to the extent that he deliberately sugar coated EL’s financial situation. In any event, this kind of conduct would amount to wrongful dealing. Whether or not the other directors are complicit will depend upon whether or not the responsibilities delegated to Frank were negligently monitored. According to the facts Connie only met with Frank once every two months, leaving him virtually free to act on his own. It therefore follows that the Members of the board are willing to accept responsibility for Frank’s conduct in managing the company’s affairs. Moreover, under the directors’ fiduciary duties, director’s are required to act diligently and in a manner that corresponds with that of a business man. It is entirely contrary to this tenet of directors’ duties for Helena, Connie and Dashani to accept Frank’s assessment of the company’s financial affairs without inspecting the books themselves. To a great extent, ISL can be personally liable as a parent company. Section 227 of the Companies Act 1985 allows for lifting the veil of the corporation in circumstances where the insolvent company and the parent company are for all intents and purposes, essentially the same. By virtue of Section 227 of the Companies Act 1985, group accounts can be inspected to verify whether or not a subsidiary’s financial activity is essentially that of the holding company.11 Based on this provision it will be necessary for the production of the accounts’ records in respect of ISL and EL in order to prove that they were each operating independently of one another, despite the fact that they share some of the same officers and directors and shareholders. The circumstances in which the court will ignore the corporate veil are ill-defined and the impression is that these circumstances are developed on a case by case basis. Professor Gower said that: “challenges to the doctrines of separate legal personality and limited liability at common law tend to raise more fundamental challenges to these doctrines, because they are formulated on the basis of general reasons for not applying them, such as fraud, the company being a "sham" or "facade", that the company is the agent of the shareholder, that the companies are part of a "single economic unit" or even that the "interests of justice" require this result.’12 Gower and Davies view Adams v Cape Industries Plc as the leading case on the exceptions to the corporate veil. It was held in Adams v Cape Industries Plc it that the court is not “entitled to lift the corporate veil as against a defendant company which is a member of a corporate group” simply because it may be that the company was used to shield a member of that group from the company’s future liabilities. The Court of Appeal explained that: “whether or not this is desirable, the right to use a corporate structure in this manner is inherent in our corporate law.”13 While Adams v Cape Industries Plc was very strict with respect to preserving the principles enshrined in preserving the corporate veil, the House of Lords took a faro more liberal approach in DHN Food Distributors Ltd v Tower Hamlets London Borough Council. In DHN Food Distributors Ltd v Tower Hamlets London Borough Council Lord Denning, referring to the position of a parent company and its subsidiary holdings explained that: “these subsidiaries are bound hand and foot to the parent company and must do just what the parent company says…They should not be treated separately so as to be defeated on a technical point.”14 However, the position taken by Lord Denning did not prevail. For instance in Woolfson v Strathclyde R.C the House of Lords disagreed with Lord Denning’s position on the nature of holding companies and their individual subsidiaries. The House of Lords maintained that the corporate veil would not be pierced unless the evidence demonstrated that the subsidiary company was no more than a façade.15 In Trustor AB v Smallbone (No. 2) the court maintained that the corporate veil would only be lifted in three circumstances. They were: 1) The evidence was such that if the court was satisfied on the evidence that the company was a mere sham or façade 2) The company itself was involved in some impropriety or 3) Where the interest of justice required it.16 In Jones v Lipman the defendant signed an estate contract with the plaintiff. Subsequently, the defendant had a change of heart and formed a company so that the realty was transferred to that company. He claimed that he was no longer the owner of realty and therefore not bound to the terms of the estate contract. The court found that the company was a mere façade for the defendant and he was ordered to sell the realty pursuant to the estate contract.17 Adams has effectively narrowed the circumstances in which the courts will intervene and lift the corporate veil. This is unfortunate since changing times together with the complex development of both the corporate structure and company law, the Salomon v Salomon & Co. rule is in reality perhaps out of place today.18 Although there have been times when the courts have shifted away from this ruling it remains the poster child for the criteria to be met when determining whether or not to lift the veil of the corporation. The prevailing attitude is to safeguard against lifting the corporate veil. In the final analysis, it seems unlikely that the ISL and the individual shareholders will be personally liable for EL’s debts outside of their respective shareholding. Bibliography Davies, P.L. Gower and Davies’ Principles of Modern Company Law. (Sweet and Maxwell, 2003) Farrar, J.H.; Hannigan, B.M., Farrars Company Law. (London, Butterworths, 1998) Gallagher, L. & Zeigler, P. (1990) Lifting the corporate veil in the pursuit of justice. JBL 292 Rickford, J. ‘Fundamentals, Developments and Trends in British Company Law - Some Wider Reflections.’ (2004) 1(4) European Company and Financial Law Review, 391-415. Sealy, L. and Worthington, S. Cases and Materials in Company Law. (Oxford University Press, 2007) . Read More