Conflicted directors on thin ice

Since the beginning of October, UK directors who fall foul of new rules concerning conflicts of interest face being forced to step down or risk being in breach of their duties to the company. The new regime, brought in by the Companies Act 2006, sets out in statute the duty of directors to avoid conflicts of interest. But, as well as formalising the pre-existing duty, many argue the obligation has been significantly extended, as it now applies to situations where a conflict of interest might occur in the future, even if no conflict has yet materialised.

The basic statutory duty is that a director must avoid any situation in which he has, or can have, a direct or indirect interest which conflicts, or possibly may conflict, with the

interests of the company. The duty does not apply if the situation cannot reasonably be regarded as likely to give rise to a conflict. Otherwise, a director must seek authorisation from the company if he wants to continue as a director despite the potential for conflict.

Take, for example, a non-executive director who is on the board of two companies in the same sector, both of which value his industry expertise. Under the old rules, there was no problem unless and until a real issue arose, where the interests of one

company conflicted with those of the other. Since October, the director should not wait for such an issue to arise, but should actively ensure both companies give formal authorisation for him to remain as a director.

Many directors also act as trustees of their company’s pension scheme, or as a director of the trustee company. This is another situation likely to give rise to conflicts and which will therefore require authorisation.

Groups of companies in which directors serve on the boards of both the parent company and one or more subsidiaries may also have an issue with conflicts. It is well established that the interests of group companies do not always coincide, for example where group borrowings are being guaranteed. A director in this situation will now need to ensure he is authorised by both companies.

Other examples are where a director – or a member of his family – has a connection with a professional adviser to the company, or a competitor, or with any entity with whom the company regularly does business.

In short, there is a wide range of situations for which a director should seek prior authorisation under the new rules. If he does not get authorisation and cannot avoid the situation, he will be in breach of duty unless he stands down as a director. This could lead to claims for damages, or an account of profits made, in addition to adverse publicity for both the director and the entire board.

“Directors should be given guidance on the sort of situation which will require authorisation

Possible solutions

Companies, therefore, face the prospect of multiple resignations, unless they have procedures in place to give the necessary authorisation. There are three ways in which a conflict situation can be authorised: by the company’s articles of association, by shareholders, or, under new provisions in the Companies Act, by the board.

The position of group directors is one area that could be dealt with in the articles. Parent companies using the default articles in Table A will already have the necessary authorisations for directors to sit on the board of subsidiaries. However, if the subsidiary company has Table A articles, this would not be sufficient, and the director would need specific authorisation from the subsidiary. Groups may wish to make provision for this the next time they review their subsidiary articles.

If a situation is not sanctioned by the company’s articles, a director could seek approval from the shareholders. This may be relatively straightforward for a wholly owned subsidiary, or for a private company with few shareholders. However, it may be quite impractical for larger, particularly listed, companies.

Since October, it has also been possible for approval to be given by the other directors, where this is allowed by the company’s constitution. Companies need to consider whether this is a matter which should be delegated to the board, or whether it should be reserved to shareholders.

Different rules apply to private and public companies in relation to board approval. Public companies must change their articles of association to include a specific provision giving the board this power. Private companies do not need to change their articles, but any private company incorporated before October 2008 will have to pass an ordinary resolution, allowing directors to authorise conflicts. Conversely, if shareholders in a private company incorporated after October want to reserve this power to themselves, provisions will need to be added to the articles.

Once these constitutional issues have been addressed, practical procedures should be implemented. Directors should be given guidance on the sort of situation which will require authorisation and have clear channels for communicating conflict situations to the company. The company should be ready to consider requests for authorisation at short notice and to obtain the appropriate formal authorisation from the shareholders or, where permitted, from the board.

Fundamentally, each situation needs to be considered on its own merits and a decision taken as to whether it is better to grant authorisation or for the director to step down. Where situations which might lead to conflicts of interest are authorised, ground rules should set out how conflicts should be handled in practice if they arise. Records of all authorised conflict situations will need to be maintained and procedures implemented for the authorisations to be reviewed on a regular basis.