Directors’ conflicts of interests

Introduction

Directors are under a duty to avoid conflicts of interest. Where a director identifies an actual or potential conflict, they must be transparent about the nature and extent of that conflict. The legal impact of a failure to properly declare a conflict will depend on the severity and impact of the conflict on the company and may result in a need for the director to pay compensation or at its most serious, may constitute a criminal offence.

Some conflicts of interest are immediately apparent where others are less obvious. It is essential that directors remain fully informed about a company’s operation so they are able to identify any potential conflicts of interest and take appropriate action. Examples of conflicts of interest can include a director:

• Being a significant shareholder in a competitor
• holding a directorship in a competitor, key supplier or customer
• who is an advisor to the company or a competitor
• wanting to take up (personally or via another company) an opportunity that has been offered to, but declined by, the company
• also being a director of the company’s pension trustee company

This can be particularly challenging for non-executive directors who commonly do not have the same day-to-day knowledge of a company’s operation. The obligation is upon the director to be vigilant to and well informed of issues that may give rise to conflict.

Understanding the requirements

All directors of companies in England and Wales are required to comply with the law as set out in Companies Act 2006 as well as the specific provisions set out in their articles of association. While companies will occasionally adopt the standard form “Model” articles in their entirety, it is more common for companies to amend or replace the standard provisions relating to conflicts of interests with their own bespoke arrangements. There are some reasonably standard formulations used but it is important that a director understands the specifics relevant to each company of which they are an appointed director so they can take appropriate action when required.

Broadly speaking, the Model articles prevent a director from voting on an issue in relation to which they have a conflict of interest. This can be onerous especially for smaller companies where such a restriction could in practice, prevent a company from operating. Where bespoke articles are adopted, these will commonly allow the remainder of the board of directors to approve a conflicted director’s ability to count towards a quorum and/or vote on the basis that a conflict has been declared. However, to allow such approval, a conflict must be declared properly.

Think about the size of your board

A board of only two members may find itself in stalemate if one of its directors is conflicted and (as is the case with the Model articles) a quorum of two directors is required for the board to enact any meaningful business. It is therefore essential to make sure that your board is adequately sized to cope with such scenarios Where quorum isn’t an issue, diversity in the board really matters. By ensuring that you have directors with different interests you can avoid a scenario where your entire board is equally conflicted on a particular matter because they all have similar investments and interests.

Where you are a sole director/shareholder, the obligation to monitor conflicts does not disappear. Board meetings with yourself make little practical sense. However, it is  a good idea to record and monitor decisions properly to evidence that you have observed your duties in the decisions you take as a director. While as a sole director/shareholder you may feel that the interests of yourself and the company are one and the same (and in many scenarios, this may be the practical reality), legally, the company is a separate entity and the interests of the business as a whole will always take precedence over yours as an individual.

What to declare and when

A director is obliged to avoid situational conflicts which are direct (such as where a director sits on the board of two competitor companies) and indirect (such as where a decision a director takes as the board of one company, benefits a 3^rd party to which a director is connected). Most conflicts are capable of being authorised by either the shareholders or the other directors but it is only possible to provide such authorisation if it has been properly declared.

A director must make the other directors aware of both the nature and extent of their interests such that the board can be “fully informed” about a potential conflict of interest. The declaration must take place as soon as reasonably practicable and includes situations that the director ought to be reasonably aware of and not only those of which they are actually aware.

There are circumstances which may negate the need to make a declaration (such as  where the other directors are already aware of it).  However, the court of appeal has recently made it clear that the belief of a director that the other directors are already aware of a conflict must be viewed cautiously and a director should ensure that any declaration of a conflict they believe they have made is recorded in the board minutes.

Shadow directors are not exempt

Shadow directors are the subject of a separate article and as highlighted there, if you are deemed a shadow director then you will be subject to the same duties and responsibilities as a formally appointed director. This includes in relation to conflicts of interests.

It is arguably one of the biggest areas of risks associated with being deemed a shadow director and it is important for individuals and directors to actively consider whether anyone in the business is performing a role which would result in them being designated a shadow director. Equally, it is also important to recognise that just because you haven’t formally been appointed as a director on the board, you can’t assume you are not obliged to comply with the conflicts of interest regime.

Timing

While it is possible for shareholders to ratify a late declaration of a situational conflict of interest, it is a criminal offence for a director not to declare an interest in a transaction being entered into before it is concluded.

There are circumstances where a director may not realise a conflict exists until after a transaction has been entered into. This is not a straight-forward assessment and a director will be held accountable for matters that they should have reasonably known about. That said, it is conceivable that a director may find out after the event that a family member is connected in some way with a transactional counterparty.

Conclusion

Expertise and experience are commonly the reasons why a director is appointed to the board. Those same individuals will be in high demand with competitors and suppliers alike and when coupled with many companies share incentive arrangements, it is easy to see how the potential for conflicts of interests so frequently occur. Understanding how best to handle the specific situations is important to protect both the directors as well as the company’s reputation. If in doubt, get some advice. We’re happy to help.