Directors previously had a common law fiduciary duty to avoid placing themselves in situations where their interests, or the interests of a third party whom they represented, conflicted or potentially conflicted with the interests of their company. However, a director's duty to avoid conflict situations is now on a statutory footing.
In practice, directors finding themselves in a conflict situation would previously satisfy this duty by taking steps to mitigate the conflict eg declaring their interest to the board, absenting themselves from board discussions or - in extreme cases - stepping down from the board. Where a conflict situation arose before 1 October 2008, the common law duty still applies, but new conflict situations are governed by section 175 of the Act.
Section 175 is in some respects more onerous than the common law rules. Directors who allow a conflict situation to arise in the first place will, on the face of it, be in breach of their duty irrespective of any steps they take to mitigate the conflict. However, unlike under the common law rules, directors can avoid breaching their duty by obtaining prior board authorisation of the conflict of interest, if their companies have mechanisms in place to allow this.
What the new rules mean in practice
Boards of private companies incorporated on or after 1 October 2008 can authorise directors' conflicts of interest provided there is nothing in their company's constitution which would invalidate that authorisation. Boards of private companies incorporated before 1 October 2008 can authorise a director's conflict of interest provided there is nothing in their company's constitution that would invalidate authorisation and provided that their shareholders pass an ordinary resolution granting them the power to do so. The articles of association of a public company must specifically permit the directors to authorise the matter being proposed.
Only directors without an interest in the matter may be involved in deciding whether or not to authorise the conflict and, in doing so, must have regard to their own duty to act in the way they consider will most likely promote the success of the company for the benefit of the members as a whole.
It is anticipated that all companies (whether incorporated before or after 1 October 2008) will wish to review their constitution to take account of the new rules.
Why review your company's constitution?
The scope for conflict situations arising is wide. For example, directors who are also shareholders, or who sit on the boards of two or more companies that deal with each other, are very likely to find that their interests conflict.
Unless these conflicts are authorised in advance (and assuming the conflict arose after 30 September 2008), directors will be in breach of their duty and will be potentially liable to their companies (and in certain circumstances individual shareholders) for any losses that occur.
Whilst shareholders may come to the rescue and ratify the breach by ordinary resolution, it would be administratively burdensome, and the fact that they are not obliged to do so provides little comfort for directors. To allow directors to conduct boardroom business effectively, sensibly run companies will look to update their constitution with modern conflict of interest provisions.
Updating your company's constitution
There are two important steps.
Firstly, as set out above, companies must ensure that there is nothing within their memorandum or articles of association that would invalidate board authorisations of directors' conflicts of interests. Provided there is not, boards of private companies incorporated on or after 1 October 2008 will be able to authorise their directors' conflicts of interests. Boards of private companies incorporated before that date will be able to authorise conflicts too, but only once their shareholders have passed an ordinary resolution granting them the power to do so. The articles of association of a public company must specifically permit the directors to authorise the matter being proposed.
In addition, it would be good practice for companies to amend their articles of association to include specific provisions setting out how directors' conflicts should be dealt with. Clearly this will reassure shareholders who will see that the company has sound corporate governance procedures in place to prevent abuse of the power. Putting specific provisions in place also gives an extra safeguard for the board.
There is a statutory safe harbour by which directors who authorise their co-directors' conflicts of interests cannot be accused of infringing their general duties as directors so long as they have followed authorisation procedures set out in their company's articles of association. Directors of companies without authorisation of conflicts provisions in their articles do not have this safeguard. If, in reaching their decision on a conflict, such directors are deemed to have breached any of their statutory or common law duties to their company, they may be held liable to account for losses suffered by the company, or its shareholders, as a consequence of their authorisation in breach of their duty.
To assist with your analysis of how directors' conflicts of interests arising on or after 1 October 2008 will be dealt with, we have prepared a simple flowchart. As well as guiding you through the new rules, this chart will help you determine whether or not your company should consider seeking legal advice.
If you would like a copy of the flowchart, please contact our business services team.