Directors in Managing the Companys Business - Essay Example

Company Law Question The loan by SPFL to WRFL and SPFL’s guaranteeing of WRFL’s bank loan as well of the management of WRFL are all assessed by reference to directors’ duties as delineated in Sections 170-177 of the Companies Act 2006. Generally, directors’ are responsible for managing the company’s business and affairs and in the discharge of these duties directors owe what is characterized as “strict trustee-like duties to the company”.1 In short, directors are fiduciaries who have a duty to act in good faith and with reasonable skill and care.2 This duty is owed to a number of persons including the company itself, members of the company, employees and creditors.3 The loan by WRFL to SPFL and the guaranteeing of SPFL’s bank loan by WRFL raises the issue of director’s duties to creditors and shareholders. Had SPFL not been experiencing some financial difficulties, there would have been no duties to consider. Creditors typically have no status jointly or severally with respect to companies that are solvent.4 However, when a company is suffering difficulties or is insolvent the position is quite different. Moreover, while creditors will not be able to sue a solvent company for mismanagement, directors do have a duty to safeguard the interests of creditors. As Lord Templeman stated in Winkworth v Edward Baron Development Co. Ltd: A duty is owed by directors to the company and to the creditors of the company to ensure that the affairs of the company are properly administered and that its property is not dissipated or exploited for the benefit of the directors themselves to the prejudice of the creditors.5 In addition to owing a duty to creditors to safeguard against the mismanagement of the company’s property and assets, Section 172 (3) of the Companies Act 2006 carries the duty to creditors a bit further. This further duty is found in the duty to promote the success of the company for its members6 which is subject to the any law that requires directors “in certain circumstances to consider or act in the interests of creditors of the company”.7 Even so, the duty toward creditors is not such that directors are required to act in the best interest of creditors but merely to ensure that action taken would not leave creditors more disadvantaged than they would be upon liquidation.8 The overall duty of directors to act in the best interests of the company and its members generally includes the duty to act in the best interests of its shareholders.9 The duty to shareholders and creditors as described so far will be breached when directors breach the duty to act with due diligence and with the reasonable care and skill of a reasonably skilled and diligent individual with might be expected of a director of a company and the general knowledge, experience and skill that the director possesses.10 It also been held that the directors in exercising their duties to act in the best interests of the company and its members will be judged by the application of an objective test. This test assesses whether or not the director acted the way a reasonable businessman many would have acted in the circumstances.11 Looking at the facts of the case, Miriam at the very least breached her duty to act with due diligence and with the competence required of a director or a reasonable businessman would be expected to act in the circumstances. WRFL was already suffering financial difficulties and the audit used to justify loans contained glaring errors. Moreover it did not contain a fair and accurate reflection of WRFL’s financial position. However, Miriam, Doreen and Hugh had relied on the competence of William the chartered accountant compilation of the company’s financial information. This reliance on William is clearly a contravention of the duty to exercise independent judgment.12 The duty to exercise independent judgment means that the directors are not at liberty to “fetter the exercise of their powers or discretion”.13 This duty is known as the “no fettering rule”.14 The no fettering rule is expressed in Section 173 of the Companies Act 2006 and clearly requires that directors exercise independent judgment although the duty is not breached if there is an agreement “by the company that restricts the future exercise of the discretion by its directors”.15 The director may also be exempt for the duty to exercise independent judgment if the company’s constitution permits it.16 There is no evidence on the facts of the case that any such agreement exists, nor is there any evidence on the facts of the case that the company’s constitution authorizes fettering. The no-fettering rule is about ensuring that directors exercise their respective power on an independent basis to the extent that the discretion is theirs. While they may rely on advice from third parties, the judgment must be theirs. It is directors who must ultimately act in the best interests of the company and they may not blindly following the opinions of others.17 Miriam, Hugh and Doreen, members of the four member board of directors of WRFL, blindly followed William’s compilation of financial information despite the glaring errors and incorrect information. By doing so, the three directors are in breach of their director’s duties in two main ways. First they failed to act with due diligence and with the care and skill expected of directors given their general knowledge and experience. This is particularly significant with respect to Miriam who had experience compiling the company’s financial information before William began doing so five years previously. Secondly, Miriam, Hugh and Doreen failed in their duty to exercise independent judgment by blinding accepting William’s information. The fact that Hugh and Miriam are married and shareholders of both WRFL and SPFL engages an inquiry into whether or not there is a conflict of interests. There is reason to suspect, that Hugh and Miriam supported each other in favour of the best interest of the marital partnership rather than the best interest of the company. After all, the SPFL was suffering financially and had the directors acted with due diligence Hugh and Miriam would have known just how badly the company’s financial problems were. It is therefore reasonable to assume that Miriam and Hugh had not acted diligently in supported the acquisition of loans for an ailing company. The duty to act bona fides and in the best interests of the company, suggests that the company directors are not permitted to act for any collateral purpose.18 The courts have been particularly strict with respect to this particular duty, specifically the duty to avoid a conflict of interests. For example in a one case, a director obtained a contract for himself although it had not be possible for the company he directed to obtain the contract. Regardless the director was held to be in breach of his director’s duty to avoid a conflict of interests.19 In an early case the court ruled that it was not concerned with the fairness or reason behind the transaction itself.20 Additionally, the court is not concerned with whether or not an actual conflict of interest had occurred. The mere fact that one reasonably might have or could have existed is enough to constitute a conflict of interests.21 Moreover, it is a firmly established concept of company law that directors are required to avoid placing themselves in situations where there might be a conflict of interests.22 Section 175(1) of the Companies Act 2006 specifically states that: A director of a company must avoid a situation in which he has, or can have, a direct or indirect interest that conflicts, or possibly may conflict with the interests of the company. Section 175(2) of the Companies Act 2006 is particularly relevant in that it states that the duty to avoid a conflict of interest particularly applies to “the exploitation of any property, information or opportunity”.23 Securing a loan from SPFL when Miriam and Hugh are board members of both SPFL and WRFL, the loan’s benefactors does appear to be a circumstance in which the directors have exploited an opportunity. Section 175(4)(b) however provides an exemption which might excuse Miriam and Hugh. Section 175(4)(b) provides that the duty to avoid a conflict of interests is not breached “if the matter has been authorized by the directors”.24 It is entirely doubtful however, that this exemption would apply in Hugh, Miriam and Doreen’s case since the directors of WRFL were misinformed or more correctly misinformed themselves by blindly following the information compiled by William. The authorization itself is therefore negligent and a breach of the directors’ duties to exercise independent judgment and to act in good faith, with due diligence and with the reasonable care and skill of a director. Similarly, Doreen was negligent at the very least in that she directed all of her attention to the florist aspect of the trade at the Leeds city centre flower shop rather than the financial aspect of the business at that location. By doing so, she failed to detect as she reasonably should have had she acting with the due diligence expected of a director she would have discovered a lot earlier that the Leeds shop manage had been defrauding WRFL. Miriam is also facing the prospect of being found in breach of the duty to avoid a conflict of interest in that the Leeds city centre flower shop manager had been a good friend of hers that she trusted implicitly. While she may have had reason to trust him as a friend, but she obviously did not known him well enough to trust him as a shop manager. It would therefore be reasonable to conclude that Miriam’s reasons for trusting the shop manager were related to her personal relationship, which indicates a conflict of interest in her friend and the company’s best interest. Cumulatively, it is quite possible that Miriam, Hugh and Doreen are facing disqualification on the grounds that they have breached their duties to “acquire and maintain a sufficient knowledge and understanding of the company’s business” so that they were unable to properly “discharge their duties as directors”.25 The court may make a disqualification order in circumstances where the director/directors’ conduct constitutes a breach of contractual, statutory, tortuous or equitable duty.26 Moreover, Miriam, Hugh and Doreen may face personal liability under Section 214 of the Insolvency Act in that they, in acting as they did, did not take all steps to reduce their creditors’ losses when it was obvious that insolvency was unavoidable.27 Miriam and Doreen were particularly negligent with respect to the defrauding of the Leeds flower shop. Doreen had expressed surprise at the shop’s poor performance at board meetings. Yet she failed to look into the matter. In fact, it appears as though the board was negligent as well since it did not conduct an investigation itself. Miriam also demonstrated little or no interest or concern in the store’s performance. In all the circumstances, Miriam, Hugh and Doreen are in breach of their directors’ duties to act in good faith and with due diligence as well as with the special care, skill and the general knowledge expected of directors. Question 2 Directors are under an ongoing duty not to place themselves in a position where there might be a conflict of interests.28 This rule applies to cases where the director is in a position to exploit property, information or an opportunity that arises in the course of his duties as a director.29 There is no infringement if the director obtains the approval of the board to exploit the opportunity, information or property.30 However, Stuart did not seek approval, nor did he disclose the existence of the opportunity for himself or for LOL in his business plan to work with Daily Bread for the purpose of facilitating the latter’s expansion into the UK market. By virtue of Section 177 of the Companies Act 2006, directors are required to disclose both the nature and content of any direct or indirect interest that they may have in a transaction or arrangement or a proposed arrangement or transaction that his company might be linked to.31 The duty is owed to the remaining directors of the company.32 Although Stuart had an opportunity to disclose the proposed arrangement with Daily Bread to the board of directors he omitted that part of the information from his detailed business plan. Stuart therefore deliberately omitted to disclose information to the other directors and therefore deliberately infringed his obligation to disclose that information. The extent of Stuart’s breach can be explained by reference to the nature of the fiduciary relationship between the director and the company which necessitates Section 177 of the Companies Act 2006. The fiduciary relationship imposed upon directors require that they act bona fide in the best interests of the company excluding any and all collateral interests. When a director uses his or her position to make a personal profit, he/she is accountable to the company and its members.33 The duty to disclose contained in Section 177 corresponds with this aspect of the director’s fiduciary duty to act bona fide in the best interest of the company to the exclusion of any and all collateral interests. The duty to disclose in Section 177 is a bit broader than it previously was under Section 320 of the Companies Act 1985. By virtue of Section 320(2) directors were under a duty to disclose and obtain shareholder approval prior to securing a “substantial property transaction”.34 Section 177 of the Companies Act 2006 requires disclosure of a direct or indirect interest in a proposed company transaction or proposed arrangement. In other words the duty to disclose under Section 177 of the Companies Act 2006 is far wider and onerous than the duty to disclose under Section 320 of the 1985 Act. It does however, restate the principles contained in Section 317 of the 1985 Act which requires that directors declare the nature of any interest that he is “in any way, whether directly or indirectly interested” relative to a “contract or proposed contact with the company”.35 In failing to disclose the proposed arrangements made by Daily Bread, Stuart obviously acted dishonestly and for a collateral purpose. Stuart’s conduct was calculated in that he deliberately left out information that would have persuaded the board of directors to approve the business plan therefore leaving the way clear for him to secure the business arrangement for himself. Essentially, what Stuart did was to use his position as director to his own personal profit. Liability exists in such circumstances particularly where the director actively diverts viable opportunities away from his company for himself.36 Stuart obviously acted dishonestly and was certainly actively diverting Daily Bread’s business away from LOL and to himself. He was actively diverting the business away from LOL in making the business proposal and failing to disclose the proposed transaction by Daily Bread, knowing from previous discussions that such a proposal would have very likely gained the approval of the board of directors. It is therefore hardly a coincidence that once the board disapproved of the business plan Stuart resigned his position and started his own company and set up business with Daily Bread. The duty to disclose is founded on the fiduciary principle surrounding the director’s duty of loyalty to the company he serves. The basis of this fiduciary principle was exemplified by Millet LJ in Bristol & West Building Society v Mothew [1998] 1 Ch 1 in which Millet LJ said that: A fiduciary must act in good faith; he must not make a profit out of his trust; he must not place himself in a position where his duty and his interest may conflict; he may not act for his own benefit or the benefit of a third person without the informed consent of his principal.37 The duty to act bona fide in what the director deems the company’s best interest and not for a collateral purpose38 is looked upon as the most important fiduciary duty.39 The bona fide test is a subjective one in that it is not determined by reference to the court’s hindsight. The question for determination is the factors and circumstances operating on the director’s state of mind at the relevant time.40 Looking at the facts of the case for discussion, the facts and circumstances operating at the relevant time strongly imply that Stuart did not act bona fide in the company’s best interest, but rather for his own purpose. SPFL bears the burden of proving that Stuart acted bona fide and in breach of his fiduciary duty as a director. In Extra Travel Insurance Ltd. v Scattergood [2003] 1 BCLC 598 it was held that: It is not sufficient for a company to prove that its directors took action which proved to be damaging to the company, unless it can also show that the directors did not honestly believe that the action was in the best interests of the company.41 Based on the way that Stuart conducted himself it is reasonable to conclude that he did not honestly believe that his action was in the best interest of SPFL. He deliberately diverted business away from SPFL for himself and deliberately failed to disclose the business opportunity to the company. By acting as he did, he obviously knew that it was not in the company’s best interest to divert business away from the company and to secure it for himself. The bona fide principle and the duty to disclose rules tie in with the no conflict rule and is also directly applicable to Stuart’s conduct. The no conflict rule is contained in Section 175 of the Companies Act 2006 and requires that directors avoid a situation or putting themselves in situations where they might have a conflict of interests.42 The no-conflict rule is deeply entrenched in the fiduciary principles and is firmly established in equity’s history.43 The no conflict rule was set forth in Section 459 of the Companies Act 1985 which required that directors not act in a manner that was unfairly prejudicial to the company.44 Acting in a manner unfairly prejudicial to the company would be circumstances where the director subordinated the company’s interest to that of another, including himself.45 These equitable principles arising out of the fiduciary duty emerged in the common law to provide for a no conflict rule46 which is enunciated under the general directors duties under the Companies Act 2006, effectively clarifying and restating the common law principles as provided for under the Companies Act 1985 and expounded upon by the courts in its interpretation of directors duties. The no conflict rule was specifically developed to prevent directors acting in their own personal interests over the interests of their companies.47 Unfortunately, despite the existence of the no conflict rule and its long and enduring historical developments, Stuart was not compelled to remain loyal to the company he directed. Now that Stuart has resigned his position at SPFL he no longer has a duty to act in the best interest of that company. According to the ruling in CMS Dolphinn v Simonet [2001] 2 BCLC 704, the no conflict rule does no continue following the director’s resignation.48 This is entirely unfortunate as it appears to that once the director has already effectively diverted business away from the company and removes himself from the company he mismanages, he is not considered to be in breach of his fiduciary duty.49 However, if he uses an opportunity or information arising out of the fiduciary position as director under the no profit rule for a personal benefit, the director will continue to be liable following his resignation.50 In any event, Stuart is caught by the business opportunity rule. In Cook v Deeks it was said of directors who diverted business away from the company: …while entrusted with the conduct of the affairs of the company they deliberately designed to exclude, and used their influence and position to exclude, the company whose interest it was their first duty to protect.51 There is clearly an overlap between the no conflict and the no profit rule in the business opportunity rule which can both be applied to Stuart. His conduct was deliberate in that he intentionally diverted business away from SPFL for himself and was intentionally dishonest in doing so. It therefore follows that he will not be able to escape liability regardless of his resignation and the fact that the no conflict rule might allow him to escape liability. As it is. the no profit rule does not permit exemption from liability and Stuart clearly obtained a personal profit in the sense that he diverted a business opportunity away from the company for himself. Under the no profit rule he is liable to SPFL for damages. Moreover, it was held in Lindsley vWoodfull [2004] 2 BCLC 131 that a director can be liable under the no conflict rule or the no profit rule if he diverts a business opportunity away from the company and to himself while occupying the seat of director.52 The fact is, following resignation the director is likely to be held liable for diversion under the no profit rule because the business opportunity is deemed to be the company’s property.53 Therefore, the combination of the business opportunity rule and the no profit rule will operate to ensure that Stuart does not escape liability for his breach of fiduciary duties to LOL as a director during the time that he occupied that post. Bibliography Books/Articles/Journals Adenas, M. and Wooldridfe, F. European Comparative Company Law (Cambridge University Press, 2008). Berg, A. ‘Fiduciary Duties: A Director’s Duty to Disclose his Own Misconduct.’ (2005) 121 Law Quarterly Review, 203-220. Collins, N. ‘The No-Conflict Rule: The Acceptance of Traditional Equitable Values?’ (2008)14(4) Trusts and Trustees, 213-224. Hicks, A. and Goo, S. Cases and Materials on Company Law (Oxford University Press, 2007). Rickford, J.‘Fundamentals, Developments and Trends in British Company Law – Some Wider Reflections’ (2004) 1(4) European Company and Financial Law Review, 391-415. Morse, G. Palmer’s Company law: Annotated Guide to the Companies Act 2006 (Sweet and Maxwell 2008). Sealy, L. and Worthington,S. Cases and Materials in Company Law (Oxford University Press, 2007). Sealy,L. ‘Company-Directors’ “Duties” and Exempting Articles,’ (1987) 46 The Cambridge Law Journal, 217-219. Cases Aberdeen Railway Co. v. Blaikie Bros (1854)) 1 Macq 461. Boulting v Association of Cinematography, Television and Allied Technicians [1963] 2 QB 606. Bristol & West Building Society v Mothew [1998] 1 Ch 1. CMS Dolphinn v Simonet [2001] 2 BCLC 704. CMS Dophin Ltd. v Simonet; Quarter Master UK Ltd. v Pyke [2005] BCLC 245. Regentcrest Plc. v Cohen [2001] BCC 494. Cooks v Deeks [1916] 1 AC 554. Extra Travel Insurance Ltd. v Scattergood [2003] 1 BCLC 598. Industrial Development Consultants v. Cooley [1972] 2 All ER 162. Lee Panavision Ltd v. Lee Lighting Ltd [1992] BCLC 22. Lindsley vWoodfull [2004] 2 BCLC 131. London & Mashonaland Exploration Co. v New Mashnonaland Exploration Co. [1891] WN 165. Norman v Theodore Goddard [1991] BCLC 1028. Parke v. Daily News Ltd [1962] Ch 929. Plus Group Ltd. v Pyke [2003 BCC 332. Re D’Jan of London [1993] BCC 646. Re Dominion International Group plc (No 2)[1996] 1 BCLC 572. Re Smith & Fawcett [1942] Ch 304. Regal (Hastings) Ltd v Gulliver [1942] 1 All E.R. 378. Winkworth v Edward Baron Development Co. Ltd [1986]1 WLR 1512 Weldfab Engineers Ltd, Re. [1990] BCLC 833. Yukong Line Ltd of Korea v Rendsburg Investments Corpn of Liberia [1998] 2 BCLC 458. Read More