A brief introduction to

PRIVATE COMPANIES LIMITED BY SHARES

Verdant Legal Limited

Registered in England and Wales with number 8061254. Registered office: 1 Lyme Drive, Parklands, Trent Vale ST4 6NW. Authorised and regulated by the Solicitors Regulation Authority (registration number 591677)

CONTENTS
Paragraph Page

Part 1 How private limited companies work ........................................................................................................3

1. 2. 2.1 2.2 2.3 3. 3.1 3.2 3.3 3.4 3.5 4. 4.1 4.2 4.3 4.4 4.5 4.6 5. 6. 7. 7.1 7.2 7.3 7.4 Introduction ................................................................................................................................................................... 3 The constitution of a private limited company ............................................................................................................... 3 Articles of association .......................................................................................................................................................... 3 Memorandum of association ................................................................................................................................................ 3 Shareholders agreement ..................................................................................................................................................... 4 Directors ......................................................................................................................................................................... 4 The role of directors ............................................................................................................................................................ 4 Decisions to be taken collectively by the board ..................................................................................................................... 4 Directors responsibilities and risks ....................................................................................................................................... 5 Company secretaries ........................................................................................................................................................... 5 Transfers of assets to and from directors.............................................................................................................................. 5 Shareholders................................................................................................................................................................... 6 The role of shareholders ...................................................................................................................................................... 6 Share capital ...................................................................................................................................................................... 7 Different classes of share .................................................................................................................................................... 7 Limited liability.................................................................................................................................................................... 8 Ordinary and special resolutions and shareholder powers ...................................................................................................... 8 General meetings and voting rights ...................................................................................................................................... 9 Dividends ...................................................................................................................................................................... 10 Structuring the constitution ......................................................................................................................................... 11 Other company administration matters........................................................................................................................ 11 Accounts .......................................................................................................................................................................... 11 Other records ................................................................................................................................................................... 11 Statutory Books ................................................................................................................................................................ 12 Stationery, websites, emails and other trading disclosures ................................................................................................... 12

Part 2 Tailoring the constitution ............................................................................................................................ 13

1. 1.1 1.2 1.3 1.4 1.5 1.6 2. 3. 3.1 3.2 4. 5. 5.1 5.2 5.3 5.4 5.5 6. Management of the Company ....................................................................................................................................... 13 Composition of the board and management ....................................................................................................................... 13 Conduct of the companys affairs ....................................................................................................................................... 14 Quorum requirements ....................................................................................................................................................... 14 Votes of directors and shareholders ................................................................................................................................... 15 Deadlock provisions .......................................................................................................................................................... 16 Defaulting shareholders ..................................................................................................................................................... 16 Reserved matters ......................................................................................................................................................... 16 Responsibility for funding and liabilities ...................................................................................................................... 17 Capital contributions and funding ....................................................................................................................................... 17 Guarantees ....................................................................................................................................................................... 17 Distribution policies ...................................................................................................................................................... 17 Transfers of shares ....................................................................................................................................................... 18 Pre-emption rights ............................................................................................................................................................ 18 Permitted transfers to family members and other related investors ...................................................................................... 19 Compulsory transfer .......................................................................................................................................................... 19 Expelling defaulting shareholders ....................................................................................................................................... 20 Drag and tag provisions .................................................................................................................................................... 21 Post exit restrictions..................................................................................................................................................... 21

Part 3 Shareholders powers ................................................................................................................................... 22 Part 4 Directors responsibilities and risks .........................................................................................................24
1. 2. 3. Section 1 Strategies for managing risk ......................................................................................................................24 Section 2 General duties of directors under the 2006 Act ......................................................................................... 28 Section 3 Directors duties and risks during a financial crisis .....................................................................................32

PART 1

HOW PRIVATE LIMITED COMPANIES WORK 1. Introduction

A business run through a private limited company will be owned and operated by the company itself. A company has a legal personality which is separate from its directors and shareholders. By offering its shareholders limited liability (discussed at paragraph 4.4 (page 8), below), it is the company that takes the main risk in the success of the business. The legislation which regulates most companies is the Companies Act 2006 (referred to in this note as the 2006 Act). This note provides general information about private companies limited by shares in England and Wales and discusses the operation, corporate structure and typical compliance issues encountered when managing a private limited company. There are other types of company (such as companies limited by guarantee, or public companies) which this note does note discuss. This is not intended to be a definitive guide and should not be used as a substitute for professional advice. We have lawyers equipped to deal with all legal matters which may arise in the establishment or management of a business in the UK and would be happy to help. Many corporate transactions or alterations to share rights can also have taxation implications. We do not advise on taxation matters and recommend that you take taxation advice from a professional tax adviser before taking any steps in a corporate transaction. If you do have any further queries or would like to discuss this any further please do not hesitate to contact Chris King on +44 (0) 845 519 8593 or +44 (0) 7793 916897 or chris.king@verdanlegal.co.uk.

2.
2.1

The constitution of a private limited company

Articles of association
Each private limited company has articles of association. In general terms, articles govern the relationship between the shareholders and the company. The scope of the articles is generally limited to setting out procedural matters governing directors and shareholders, the creation and transfer of shares and the capital structure of the company. Unless a company adopts a bespoke form of articles on its incorporation, any new company incorporated since 1 October 2009 will automatically have as its articles a form prescribed by regulations made under the 2006 Act, named the model articles (replacing its predecessor, Table A from that date). However, the shareholders of a company can adopt articles which are tailored to meet their particular needs. The articles can be changed by special resolution. More details about special resolutions are set out at paragraph 4.5 of this part 1 (page 8), below.

2.2

Memorandum of association
Until the 2006 Act came into force on 1 October 2009, the main purpose of the memorandum of association was to state the intended business of the company. The memorandum would sometimes contain certain restrictions on the type of business or activities the company was able to carry out. However, after that date, the memorandum no longer forms part of the constitution of a company and any restrictions in the memorandum were deemed to be incorporated into the articles. These restrictions can be lifted by special resolution in most circumstances.

PART 1

2.3

Shareholders agreement
As a separate document to the articles, many shareholders typically enter into a shareholders agreement which, as opposed to the articles, focuses to a greater extent on the relationship between each of the shareholders. Whilst some of the subject matter of the shareholders agreement may overlap with the articles (and typically the company will also be a party to this document), a shareholders agreement generally contains rights and obligations of a more commercial nature than those contained in the articles (such as provisions governing the treatment of confidential information and business opportunities). Whilst the articles are required to be registered at Companies House and are available for public inspection, a shareholders agreement is a private document not to be registered. Consequently, the shareholders agreement would be the appropriate document to deal with more confidential matters between shareholders and the company. This note goes into more detail about the kind of provisions which may be contained in articles of association and shareholders agreements (collectively known as equity documents) at paragraph 6 of this part 1 (page 11), and part 2 of this note.

3.
3.1

Directors
The role of directors
Although directors are appointed and removed by the shareholders, the management of a company is vested in its directors as a group and not its shareholders. Unless the articles say otherwise, a director does not need to be a shareholder and a shareholder does not have the automatic right to be a director. In many limited companies, the shareholders are also directors, but these two separate functions should not be confused. There is no limit on the number of directors, but in practice it is normal to have at least two. Once appointed, a director is an officer of the company who is responsible for managing it for the benefit of the shareholders as a whole.

3.2

Decisions to be taken collectively by the board

Each director has extensive powers to manage the business of the Company. For example, each director will normally have the power to sign contracts on the companys behalf but, strictly speaking, all decisions are supposed to be taken by the directors collectively as a board. In order for the board validly to make decisions, the board will be required to follow certain procedures which would normally be set out in the articles. Typically, directors will be expected to attend a meeting to make decisions, but directors can also take decisions by circulating a written version of the resolutions to be decided upon for all directors to sign. Typically, board meetings can only be held if a quorum1 of directors is present and all directors have had notice of the meeting. If the directors cannot reach a consensus, they may vote on the matter. Usually, each director has one vote on any matter at a board meeting and a simple majority of directors is required to decide upon any matter. A company may or may not have one of its directors formally appointed as chairman. If not, any one of the directors may be chosen as chairman of any board or shareholder meeting by those present.

The meaning of quorum is explained at paragraph 1.3 of part 2 of this note, on page 14.

PART 1
The chairman presides over the meeting and may (if the articles say so) have a casting vote at a directors meeting in the case the votes for and against a particular decision are equal. We recommend having minutes of all board meetings signed by the chairman and keeping copies in the companys minute book.

3.3

Directors responsibilities and risks

Directors have extensive legal responsibilities. Many of these are of a technical nature, we recommend keeping us informed about the companys activities so that we may advise to ensure no responsibilities are overlooked. In coming to their decisions, directors have to comply with numerous statutory duties and manage the orderly administration of the company. Part 4 of this note contains a summary of directors responsibilities and risks and our recommendations for managing those risks, generally.

3.4

Company secretaries
Private limited companies may have, but are not required to appoint, a company secretary, who has responsibility for maintaining the companys official books and records, convening shareholders and directors meetings and filing returns and notices at the Companies Registry. We also provide a comprehensive company secretarial service.

3.5

Transfers of assets to and from directors

It is worth noting one particularly important restriction applicable to directors which commonly causes a problem - unless appropriate planning is carried out before any such transaction is entered into. Directors often wish to transfer assets to, or acquire assets from a company. However, if the correct process is not followed, the transaction may be invalidated and the directors involved may be subject to personal liability to the company for any losses the company may suffer.

Transactions caught
The shareholders must first approve by an ordinary resolution,2 the acquisition by: a director of the company or of its holding company, or a person connected (explained below) with such a director from the company a substantial non-cash asset (also explained below); or the company of a substantial non-cash asset from a director or a connected person. There are certain exemptions, and rules which allow contracts to be entered into which are conditional on the necessary ordinary resolution being passed at a later date. However, in any circumstances where the directors plan to carry out such a transaction, we recommend consulting us about the process to be adopted before any further steps are taken. It is worth noting that these restrictions may also catch the grant by the company of security to a director, if the director lends secured funding to the company. This is because security is itself a noncash asset which the director acquires from the company.

See paragraph 4.5 of this part 1, below, on page 8, for an explanation of ordinary resolutions.

PART 1

Substantial non-cash asset

A substantial non-cash asset is one the value of which either exceeds: 10% of the companys asset value and is more than 5,000; or 100,000. It does not matter whether or not the asset is being bought at market value, or whether the company is getting anything else which is valuable to it, in return.

Connected persons
Persons connected with a director include: family members (spouse, civil partner or other person in an enduring family relationship; their children or step children; their spouses or civil partners children or step children who live with the director and are under the age of 18; and their parents); bodies corporate (e.g. company or LLP) in which the director, and any person connected with him or her, together hold more than 20% of the companys shares or voting rights; trustees of any trust of which the director or any person connected to him or her is a beneficiary or where the trustee is entitled confer a benefit on the director and any person connected to him or her; and a business partner of the director or a person connected to the director.

Undervalue transactions
It is also worth noting that an administrator or liquidator may apply to the court for an order avoiding any transactions (such as a transfer of assets) made at an undervalue in the two years before the administration or liquidation if the company was then (or as a result of the transaction became) unable to pay its debts as they fell due. Where the transaction was made with a connected person, there is a presumption that the company was insolvent at the time, unless it can be shown otherwise.3 There is a defence where company can convince the court that it entered into the transaction in good faith and for the purpose of carrying on its business and at the time there were reasonable grounds for believing the transaction would benefit the company. Accordingly, whenever the directors plan to carry out a transaction which may be caught by these provisions, we recommend that they take legal and accountancy advice at the outset, before carrying out any transactions, to avoid any problems later on.

4.
4.1

Shareholders
The role of shareholders
A company owns property in its own right, to which the shareholders have no legal title.

For this purpose, the definition of connected persons is one specifically contained in the Insolvency Act 1985 and different in some respects from the one used, above, for substantial property transactions. It includes (briefly) include directors, shadow directors, associates (within the meaning of section 435 of the Insolvency Act 1986, being certain family members, trusts for the benefit of the directors, shadow directors or their associates, partners in partnership (and their family members) and any associate of the company (including employees and companies under common control)

PART 1
Instead, ownership of the company is determined through the ownership of shares. through the companys share capital the shareholders own the company. Accordingly,

However, although the shareholders own the company, the law perceives shareholders as passive investors, whose role is to provide investment funding to the company and who are only involved to a very limited degree in any management of the company.

4.2

Share capital
Generally speaking, the directors may issue shares if authorised to do so under the 2006 Act, subject to any restriction contained in the articles of association, as follows: the directors of a private company with only one class of shares may allot shares without having to consult the shareholders;4 or where a company has more than one class of shares (more on this below), the directors will need specific authority either in the articles or by way of shareholders resolutions to authorise shares. There are a number of technical requirements which we would be more than happy to assist with. For companies incorporated under any of the companies acts which preceded the 2006 Act, there may be some additional restrictions. Reducing the number of shares allotted can be done in certain circumstances. A company need only have one shareholder. There is no maximum number of shareholders. Ownership of shares determines the right to receive dividends5 and to vote6 at shareholders meetings of the company.

4.3

Different classes of share

A company may issue different classes of shares, each with different rights. Rights to vote and receive dividends may differ between classes. There are a number of different classes of share but the more common classes are ordinary and preference shares.

Ordinary shares
Ordinary shares are the type of shares most commonly encountered in limited companies. These shares are most commonly associated with the right to attend meetings and vote and receive dividends out of the profits of the company. Ordinary shares may sometimes be sub-divided into different classes. Where this is done, it is typical for those shares to be designated by a different letter (for example A shares, B shares and so on). Using this mechanism, the rights of ordinary shareholders in relation to the company can be adapted extensively to suit the commercial arrangements between the shareholders. For example, each class of shares can be given a different number of votes at general meetings, or the right to receive separate dividends for each class of share.

4 5 6

Note that companies incorporated under the Companies Acts 1948 or 1985 cannot do this without passing a further ordinary resolution. For more detail about dividends see section 5 below. For more detail about how shareholders vote on matters, see section 4.6, below

PART 1
Each class of shares would typically only be capable of being varied with the consent of the holders of all or a certain majority of that particular class of shares. Generally, each ordinary share (even different classes of ordinary share) will carry an equal right to a share in the capital (or, more simply put, value) of the company. Because of this, the value of each ordinary share will generally increase or decrease with the fortunes of the company. However, sometimes the shares belonging to institutional investors are paid out in priority to other classes and some classes of share can be linked directly to specific assets within the company ring fencing shareholders rights to the proceeds of a sale of specific assets.

Preference shares
The rights of preference shares can be different from company to company, but typically, preference shares are fixed-income shares. Unlike ordinary shares, they do not normally participate in the success of the company and are therefore seen as a less risky form of investment. Often, preference shares will be entitled to an automatic dividend of a percentage of nominal value of, or the amount paid up on, those shares and will be paid out ahead of the ordinary shareholders. Usually if the there are insufficient profits to pay the dividend, the preference dividend will continue to remain payable and the unpaid amount of dividends will accumulate until eventually paid. Generally, all unpaid amounts of preference dividend must be paid in full before dividends on ordinary shares can be paid. Often preference shares carry no voting rights, or can vote only in very limited circumstances. Often, preference shares will be redeemable, either by the company, or by the shareholder who owns them (or both). Accordingly, the preference shares, in practice, tend to be structured more like debt funding than the equity funding which ordinary shares represent.

4.4

Limited liability
In general terms, the liability of shareholders of a company is limited to the nominal value of the shares allotted to them. Shares may be issued partly paid or nil-paid, which leaves the shareholder with an outstanding commitment to pay the balance due when called upon. Persons to whom shares are allotted pay with cash or other assets of a value no less than the nominal value of the shares. The key benefit of the limited company, therefore, is that it provides a vehicle by which its investors may limit their liability to a fixed financial sum, being the amount they are prepared to invest into, and thus risk in, the business of the company. Of course, there are certain exceptions to the rule of limited liability. Landlords of commercial premises, on leasing property to the company, and banks, on lending money to the company, sometimes require personal guarantees from the shareholders (but even where shareholders have to give such guarantees, limits on the maximum amount of them can often be negotiated) and, if a shareholder is also a director, there are a range of situations when directors can incur specific liabilities for breaches of their duties, or can be liable for their negligence.7

4.5

Ordinary and special resolutions and shareholder powers

A limited range of matters require the specific approval of the shareholders. Shareholders decisions are typically reached either in a general meeting8 or by shareholders who hold the requisite number of

7 8

For more information on the risks which may affect directors, and means of managing those risks, see part 4 of this note. For more details on general meetings, see section 4.6.

PART 1
voting rights signing a written resolution to resolve the matter in question. There are two types of corporate resolutions which the shareholders can pass - ordinary resolutions and special resolutions. Ordinary resolutions can be passed by the shareholders holding at least a majority of voting rights and special resolutions can be passed by the shareholders holding 75% or more of the voting rights. An ordinary resolution is generally required for any item of routine business where the 2006 requires the approval of the matter by the shareholders in a general meeting. Typical examples include: payment of a final dividend; capitalisation of reserves; approval of the acquisition by a director of property belonging to the company (or vice versa; or appointment or removal of a director. The situations when special resolutions are required are set out in the 2006 Act. Typical examples include: alteration of the articles; change of name; reduction of share capital; disapplication of statutory pre-emption rights when issuing shares; approval of certain purchases by a company of its own shares; or approval of the winding-up of the company. It is also worth noting that, generally speaking, by ordinary resolution, the shareholders can require, or authorise, the directors to carry out any act or do any lawful thing in connection with the companys business or assets and it has become common practice for banks, for example, to require shareholders resolutions to approve the entry into financial facilities to ensure that their funding has been given the greatest possible authority by the company that it can give. Accordingly, whilst shareholders are not to be involved in the day to day management of the business, through the mechanism of shareholders resolutions, the shareholders can exercise a substantial influence over the companys affairs. A table listing the most prominent shareholders rights (and what degree of ownership/voting control triggers those rights) is at part 3 of this note.

4.6

General meetings and voting rights

Ordinarily, general meetings are called by the directors, although there are circumstances when shareholders can require the directors to call a general meeting, and call a general meeting themselves if the directors fail to do so.9 Ordinarily, private limited companies (whose shares are not traded on a regulated market) are no longer subject to the requirement to hold an annual general meeting and can call general meetings on 14 days notice,10 except for resolutions to remove the auditors or a director, or appoint an auditor

10

A very brief summary of this right is explained in part 3. It is a power open to shareholders holding 5% in nominal value of shares having the right to vote at general meetings. In calculating notice, the date on which the notice is sent out and the date of the meeting are excluded. This is known as the clear days rule.

PART 1
other than a retiring auditor, which are subject to special rules about notice, which we can assist with if necessary. At a meeting, the matter is proposed to the shareholders, who then vote on the issue. Each share will have a certain voting rights, which are usually set out in the articles. How a matter is decided may differ depending on whether the matter is decided on a show of hands or on a poll. The default position under typical articles is that, if the vote is decided on a show of hands, each shareholder has just one vote. However, if the matter is decided on a poll, the default position is that each shareholder has one vote per share. A poll can normally be demanded by the directors, the chairman, two shareholders with the right to vote at the meeting, or one shareholder with 10% or more of the voting rights at the meeting (but the rights of shareholders to demand a poll can be extended by agreement). If the matter is decided by way of a written resolution under the 2006 Act (which is a common alternative to having a general meeting and simply requires the circulation of a written resolution to the members) each shareholder effectively has the same number of votes as if the matter had been decided on a poll taken at a meeting,11 being one vote per share. The number of votes each share carries can be changed and this is discussed in more detail at paragraph 1.4 of part 2 (page 15) of this note. Note that the rights should only be changed by agreement with shareholders. Changing the rights of minority shareholders, for example, to remove their rights to vote or receive a fair proportion of dividends against their wishes may give them the right to issue legal proceedings against the company and/or its directors.12

5.

Dividends
A company may distribute some or all of its profits to its shareholders as dividends. If a companys articles are silent on the point, directors would be entitled to declare all dividends (final and interim) without the need for shareholder approval. However, most articles set out that directors can pay interim dividends, but that the final dividends for the year must be recommended by directors but declared by shareholders by way of ordinary resolution. If there is any doubt about the application of any procedure, we can assist. The default position is that dividends are normally paid to the ordinary shareholders in an amount proportionate to their shareholding. However, the articles can be drafted so as to allow the directors to pay to each class of shares, or sometimes, to each ordinary shareholder. This is often used as a mechanism for tax planning, or to reflect a profit share arrangement within the company. Certain shares can be put in place with very specific rights to dividends, such as preference shares (mentioned above at paragraph 4.3, page 7). These shares will often automatically be entitled to a fixed dividend each year, paid ahead of the other shareholders. The company can only pay a dividend (whether to the ordinary or preference shareholders) if there are profits available, which are normally determined by reference to the companys statutory accounts. If there are profits left over from the previous year, but no profits in the present financial year, the directors may still be able to pay a dividend.

11

12

In practice, written resolutions are worded in such a way that signing them constitutes a vote in favour of, and not signing them constitutes a vote against, the resolution. The rights shareholders may have are mentioned in more detail in section 2 of part 3 of this note, on page 31 of this note.

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PART 1
If a dividend is declared or paid and there are insufficient profits, the directors are jointly and severally liable to the company for the full amount of the overpayment. Any member who receives an unauthorised dividend and knows or ought to know it is unauthorised, must repay the dividend to the company.

6.

Structuring the constitution

Different issues are raised by different numbers of shareholders, each of whom may have different shareholdings, interests and degrees of influence. For example: a company owned by a single shareholder/director may want maximum possible flexibility to manage the affairs of the company; one of the shareholders (in a company with multiple shareholders) may have seniority, or wish to protect the value of a large investment in the company. Accordingly, that shareholder may require certain enhanced powers and protections; two equal shareholders should decide how they will resolve any deadlock between them; a company which is effectively a partnership (often referred to as a quasi partnership by company lawyers) may want the power to expel members under certain situations; it is usually worth adopting a procedure dealing with the transfer shares; if shares are to be allotted to employees or executive directors it may be important to reserve a power to force them to transfer their shares if they cease to be employed by the company for any reason; or a company in which the main shareholders hope to achieve an exit may want the power to compel minority shareholders to sell their shares if an offer to buy the company is received. Part 2 of this note discusses various options which shareholders might take in order to achieve the most appropriate constitutional structure. Of course, it would be a matter of tailoring the constitutional documents to reflect the shareholders requirements and also to take into account the compliance matters which may need to be provided for, and which are briefly described in part 4.

7.
7.1

Other company administration matters

Accounts
All UK companies (unless dormant) must produce annual accounts containing a profit and loss account and a balance sheet. There are a number of complicated rules about how detailed a companys financial statements must be, and whether or not they need to be audited. Your companys accountant should be able to advise on all these matters. The accounts must be shown to and approved by the shareholders. Typically, accounts are filed online by your accountants, but we can assist with filings where necessary.

7.2

Other records
Each company must file a range of up-to-date information at Companies House, including the accounts and details of any changes to the constitution, share capital, directors or the registered office. In addition, once a year every company must file an annual return showing these details. information filed at Companies House is available for inspection by the public. All

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PART 1
We offer a comprehensive company secretarial service where we can attend to filing. Please let us know if you would like more information about this.

7.3

Statutory Books
Every company is required to keep the following: 7.3.1 Registers of: (a) (b) (c) (d) 7.3.2 7.3.3 7.3.4 members; directors and secretaries; directors interests; and charges.

Copies of any directors service contracts; Minute books containing minutes of all board and general meetings; and Accounting records.

If we incorporate a company for you, we will prepare a set of statutory registers for you. We offer a comprehensive company secretarial service where we maintain the statutory registers for companies on their behalf. Please let us know if you would like more information about this.

7.4

Stationery, websites, emails and other trading disclosures

A company must ensure the following details are on all letterheads, emails and other communications, its website and all official publications: Its full name; Its country of registration and registered number; and Its registered office address. The companys name must also be displayed in a prominent place at the companys places of business or where it keeps its records for inspection. Companies should also have terms of use and a privacy policy complying with data protection rules on their websites, which we can assist with.

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PART 2

TAILORING THE CONSTITUTION

This part of the note outlines some of the most important matters to be considered when tailoring a companys constitution to the needs of the shareholders. We hope that it may assist shareholders or prospective shareholders to consider the range of protections available to them. The discussion is not necessarily exhaustive and we would recommend a further discussion to enable us to draft a constitution which most appropriately reflected your requirements. In order create a constitution with all the provisions discussed below, the company would have to adopt new articles of association and the company and shareholders would have to sign a shareholders agreement. Because of the inevitable overlap and interplay between the shareholders agreement and articles, the below discussion does not differentiate between the two documents. Some forms of protection will require complimentary provisions in both documents and the documents tend to dovetail. A shareholders agreement will offer its parties far greater security and control over the company than can be achieved solely through the articles. However, such protection is not always necessary for every company and we would advise as appropriate on review. In any event, we recommend that the shareholders take accountancy, tax advice and possibly independent financial advice about the best structure to implement, prior to making any major constitutional changes.

1.

Management of the Company

All aspects of equity documents govern the management of the company. However, certain provisions directly prescribe the procedures for taking decisions and allocating responsibility for management functions. These provisions are discussed in this section.

1.1

Composition of the board and management

Representative directors
A shareholder does not have an automatic right to be appointed as a shareholder. However, particularly where the parties expect to be involved in the management of the business, the shareholders may want an entrenched right to appoint themselves or one (or more representatives) to be directors. Often the shareholders want to limit the ability to remove a director from office. This is discussed at more detail in paragraph 1.4 (page 15).

Swamping rights
In certain circumstances, a key investor may want the power to appoint any number of directors to the board and/or exercise an enhanced number of votes, effectively taking control of the company. This is a fairly common right for institutional investors and is typically exercisable when the company breaches the terms of its funding agreements with the bank or is in financial difficulty.

Committees
The agreement can provide for more complicated layers of management, with senior management presiding over a number of committees (for example, it is common to have an audit or remuneration committee). In professional partnerships, there are often several classes of partner (such as full equity, fixed equity (with limited management involvement but a fixed investment in the firm) and salaried (who are simply employees)) with varying degrees of responsibility.
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PART 2
It is becoming popular to convert partnerships and LLPs to limited company status, and it is possible to structure the constitution to reflect the varying powers and responsibilities, with for example, a senior board consisting of the senior partners. We provide bespoke advice to professional partnerships who wish to incorporate or alter their constitution.

1.2

Conduct of the companys affairs

Dealings between shareholders, compliance and oversight

It is worth spelling out key duties of the company, the members and directors, including obligations of good faith and integrity which may not necessarily apply as between the shareholders of a limited company. In addition responsibility for compliance matters can be allocated, such as keeping proper records, maintaining insurance and conducting financial controls. The documentation can enhance the rights of shareholders beyond the general law position, giving e.g.: access to board minutes, financial documents and records which are not normally available to a person in his or her capacity as a shareholder; and rights to (or send professional adviser to) attend and observe directors meetings.1

Financial controls
Perhaps, more importantly, the equity documentation can put in place: procedures for preparation and approval of annual accounts (note that, in the case of private companies, approval by the shareholders is no longer a statutory requirement); provisions for the creation and approval of annual budgets and business plans; and requirements for the preparation of regular management accounts and other financial information.

1.3

Quorum requirements
Quorum means the minimum number of directors (in the case of a board meeting) or shareholders (in the case of a general meeting of shareholders) who must be present at the meeting to make its proceedings valid. The quorum requirements for board and shareholders meetings can be tailored to ensure, for example, that, in order for board decisions to be valid: a sufficient number of board members must be involved in any decision; the representative director of a particular shareholder must be present at board meetings; and/or Similarly, the quorum requirement for shareholders meetings can be set so that certain shareholders or

Institutions sometimes find this useful as a means of gaining representation at board meetings without the formality of appointing a director with the attendant responsibilities and potential liabilities that would otherwise go with that office.

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PART 2
their proxies2 must be present for their proceedings to be valid. We would also suggest including default provisions so that if a member consistently failed to attend meetings, certain quorum restrictions could fall away at adjourned meetings.

1.4

Votes of directors and shareholders

Directors
How directors take decisions at board meetings is discussed in paragraph 3.2 of part 1 (page 4). In most companies, each director will have one vote at each board meeting (regardless of the number of shares anyone has). However it is worth considering whether a director who is (or who represents) a major investor should be given multiple votes on some, or all issues. In private equity investments, enhanced voting rights for directors may also be coupled with swamping rights (discussed under paragraph 1.1, above) and exercisable specifically where the company breaches the terms of its funding agreements with the bank or is in financial difficulty.

Shareholders and weighted voting rights

The general position about shareholders votes is discussed in paragraph 4.6 of part 1 (page 9). Shares can be given unequal voting rights, or their rights can be enhanced only in specific situations, and of course, the company is free to issue shares without any voting rights at all. For example, the shareholders may: create two classes of ordinary share with unequal voting rights, generally (but this is uncommon because the shareholders with more to invest will normally hold more shares and ownership of a greater number of shares is what normally determines the voting rights at shareholder level); or more commonly, provide for enhanced voting rights only in a narrow range of situations. The most common provision of this nature is one which protects a director from being removed, by giving their appointing shareholder the requisite number of votes necessary to defeat any proposal to remove that director from the board. It is worth noting that section 168 of the 2006 Act makes it clear that a company can always remove a director by ordinary resolution, regardless of what the articles or any agreement says. Accordingly, a clause which simply says that a director cannot be removed will not be effective. However, it is possible to give the appointing shareholder enough votes to defeat such a resolution and, generally, to give shares unequal voting rights. Depending on the nature of the investment being made, we may sometimes recommend that this power to effectively prevent the removal of a representative director falls away from a defaulting shareholder (discussed in more detail at paragraph 1.6, below, page 16).

A proxy is a substitute who is appointed to attend a shareholders meeting and vote at it on a shareholders behalf. Proxies can be given authority to vote as they choose, or told to vote in a certain manner. Sometimes, shareholders appoint the chairman of the meeting as their proxy (and would normally be free also to direct how the chairman was to exercise their votes).

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1.5

Deadlock provisions
This is potentially a problem if two members have equal voting power and they cannot agree on a matter. Deadlock provisions can cater for all situations, or be limited to matters of fundamental importance to the company and can provide, by way of example, the following solutions to a deadlock: 1.5.1 providing for a rotating chairman with a casting vote on decisions (note that the chairman of a shareholders meeting is now prohibited from holding the casting vote); or providing (by a number of different procedures) for one of the shareholders to exit from the company.

1.5.2

There are various other possible solutions and we are happy to discuss this in more detail.

1.6

Defaulting shareholders
The equity documents can provide sanctions against a shareholder who commits a serious breach of the agreement or his or her other obligations to the company or commits some other act of serious misconduct. The documentation would normally define such a person as a defaulting shareholder. It is worth considering the situations in which the shareholders and/or company wish to be in a position to take action against a defaulting shareholder. Not all companies provide any special rights for dealing with defaulting shareholders. However, in professional partnerships, for example, these provisions can be very important. These provisions can be used to suspend the rights of (for example, the right to appoint a representative director, to allow the shareholders to consider removal of a defaulting shareholders representative), or expel, defaulting shareholders.3 We would also recommend having a service contract which should cover the circumstances in which a directors employment and directorship with the company may lawfully be ended.

2.

Reserved matters
One of the crucial provisions of the shareholders agreement is a list of matters which the company is restricted from carrying without approval of all, or at least a suitable majority of, shareholders. These provisions protect the shareholders interests in key aspects of the business and are a key tool in protecting the interests of minority shareholders. These may include things like the following (although the list is not exhaustive): 2.1.1 2.1.2 2.1.3 2.1.4 any change to the articles, share capital of the company or the companys business; entering into major contracts; any declaration of dividends or changes to agreed dividend policies; appointment or removal of directors (although these provisions, in particular, should be tailored to suit the requirements of each company4) or senior employees; expelling shareholders (if applicable); buying or selling any business, or major assets, or entering into major capital commitments;

2.1.5 2.1.6

3 4

More about expulsion of defaulting shareholders is discussed at paragraph 5.4, below, page 20. For details about representative directors, see paragraph 1.1, above, page 13.

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2.1.7 entering into financial facilities or negotiating new borrowings with any lender, or entering into major security obligations; or entering into major litigation.

2.1.8

It is very normal to set certain financial levels below which approval is not needed, to allow the board to function at a certain level without needing to refer back to the shareholders.

3.
3.1

Responsibility for funding and liabilities

Capital contributions and funding
It is worth considering how the shareholders propose to fund, e.g. working capital and further funding and when it may be necessary to call on the members to provide further funding, and any limits on the extent of further funding and any conditions on that funding (e.g. all lending to the company to be by way of secured loans or, perhaps, certain shareholders may agree to make a fixed loan contribution).

3.2

Guarantees
Banks, landlords and sometimes other creditors require the directors and/or shareholders to give personal guarantees by which the directors will pledge their own money and personal assets as security for debts of the Company to that creditor. In practice, the liability under guarantees is not always shared equally or fairly (for example, the shareholders may want liability under guarantees to be shared in line with the way shareholders have agreed to fund the company). It is rare for the creditor to accept a sharing arrangement which might weaken the security it is demanding in any way. However, as between the shareholders, the shareholders agreement can provide for whatever sharing agreement they wish. In addition, the equity documentation can put a contractual onus on shareholders to seek a release of the terms of any guarantees given by one of them should he or she exit from the company. We recommend taking legal advice prior to signing any personal guarantee or indemnity.

4.

Distribution policies
There is no obligation on the company to pay dividends. It may be worthwhile setting out a distribution policy to ensure that the parties cooperate to ensure that profits are distributed to the members in a consistent manner. More sophisticated planning can be achieved if the companys constitution provides that each shareholder may receive different levels of dividends (otherwise, dividends are typically paid equally on each share). It is generally the case that dividends are taxed more favourably than salary. Therefore, particularly for owner managed businesses, or where the rewards open to staff are performance based, it may, subject to tax advice, prove beneficial for each of the company and members to receive some of their pay as dividends rather than salary. Provisions in any agreement must be carefully drafted in order to comply with taxation rules so that any intended tax benefits are not disrupted by the drafting we recommend taking tax advice on any dividend policy you may wish to implement.

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5.

Transfers of shares
Perhaps the most important provisions to consider are restrictions on the transfer of shares. Without some sort of restriction on the transfer of shares, they are freely transferrable to anyone. There are many reasons why the shareholders may prefer control of the company to remain with a select group of individuals, or otherwise impose a range of conditions for approval on new members. Many companies which are not advised do not contain any restriction on transfer, or contain out of date restrictions which should be modernised to reflect changes brought about by the 2006 Act. Many companies which do have some sort of restriction contain an article simply permitting directors to refuse to register a transfer of shares, typically without giving reasons. Under section 771(1) of the 2006 Act, if the directors do refuse to register a transfer, whether not the articles of the company say otherwise, they must now give reasons for that refusal. A dissatisfied transferor or transferee can attack the directors decision if he or she can show that they exercised their discretion for an improper purpose, failed to act in good faith in a manner that promotes the success of the company as a whole, or for a reason outside the grounds for rejecting transfers which are specified in the articles. Accordingly, the current law gives a greater the scope was the case in the past for dissatisfied transferors or transferees to mount legal challenges to a refusal to register. Separately to that, private companies may have a limited market for minority shareholdings and preemption provisions (discussed below) are a common way of providing the fairest process for managing the exit of a shareholder from a company. Accordingly, we generally recommend that companies consider the following, all discussed below: pre-emption provisions governing the process by which shares must be offered to other shareholders within the company; permitted transfer provisions governing certain situations when transfers can take place outside of the pre-emption procedure; and compulsory transfer provisions, which are particularly relevant to quasi-partnership companies and private equity investments. It is also worth considering including specific restrictions on: transfers to outsiders - for example, family companies may consider a requirement that any new incoming member must be specifically approved by the shareholders, or some class of them; and a sale of shares during an initial period, in order to incentivise the shareholders to commit, for a limited period, to the company, perhaps tying those restrictions into bad leaver provisions, discussed at paragraph 5.3, below (page 19).

5.1

Pre-emption rights

Offer of shares to be made by shareholder

Generally speaking, pre-emption rights will require any shareholder who wishes to sell shares to offer them to the other shareholders (or sometimes, to specific shareholders, or perhaps even back to the company). There is a wealth of options for pre-emption provisions, and indeed, they can be substantially adapted to suit the requirements of the shareholders. We recommend that companies consider adopting preemption procedures covering such things as:
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to which shareholders, and by whom, shares must be offered; whether the company should be given the opportunity to purchase its own shares (subject to certain technical conditions which must be satisfied); how the price is to be determined (we would normally recommend that if there is a dispute as to price, the question is referred to an independent accountant); the specific valuation procedures which are to apply if shares are to be valued independently (for example, giving the accountant freedom to determine an appropriate market value5; basing the price on the net assets; or opting for more specific valuation policies); whether the shareholder offering to sell his or her shares is to be entitled to withdraw the offer if he or she does not like the results of the valuation (and whether he or she should pay the costs of the valuation in such circumstances); whether a shareholder who wishes to sell shares must offer all (rather than simply a portion) of the shares held by him or her under the procedure (particularly relevant to partnership companies or private equity investments); and similarly, minimum, or total, transfer conditions, making any sale conditional on offers having been received for all, or a specific proportion, of the offerees shares. Note that, if a company chooses to adopt specific tax efficient plans to reward its employees with shares, such as a share incentive plan, there are specific tax rules which apply and which determine precisely how any pre-emption procedures must operate. We would be more than happy to assist with these.

5.2

Permitted transfers to family members and other related investors

Companies often decide to adopt pre-emption procedures (discussed below). However, they may also wish to provide for a number of situations when the pre-emption procedures do not apply. For example, provisions could be included allowing: institutional investors to be able to transfer their shares freely (although, depending on the circumstances, such investors may be limited to being able to transfer their shares only to within their group or to another institutional investor); corporate shareholders to transfer their shares to another company within their group; a certain majority of shareholders to agree, on occasion, to suspend the pre-emption rights to allow shares to be transferred to e.g. an incoming manager or partner; and/or transfers to family members or family trusts without any need to apply any pre-emption provisions. These provisions allow shareholders to structure their shareholdings tax efficiently but can still be drafted in a way that family members to whom shares are transferred may also be required to join in with any sale of the family member who originally transferred shares to them.

5.3

Compulsory transfer
Without specific provisions in the equity documents (usually the articles) the shareholders do not have the right to compel a shareholder to sell his or her shares.

This is the basis we would normally suggest, generally on a pro-rata basis, without a discount on the basis that the shares represent a minority holding, or a premium for any majority holding.

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However, for many companies, it may be important to include provisions which, for example: facilitate the expulsion of shareholders in a quasi-partnership company (particularly defaulting shareholders); or enable the company to require employees and directors shares to be offered for sale on departure; or enable the company to remove a disgruntled shareholder; or enable the company to buy the shares of a shareholder in specific circumstances, such as the bankruptcy or death of a member, or an attempt to transfer the shares in breach of the articles. Typically, the right to force a compulsory sale will be time limited. Often the time limits are in the region of 6 to 12 months from the relevant triggering event. Compulsory transfer provisions can require a sale under a pre-emption procedure similar to that discussed at paragraph 5.1, above (page 18) or, in the right circumstances, sometimes to new, incoming shareholders, approved by the board.

Good leaver/bad leaver

Most commonly, shares will be offered under a pre-emption procedure at a price to be agreed, or in default of agreement, at a market value determined by an accountant. However, in certain circumstances, a shareholder may be required to sell his or her shares for less than market value. These circumstances most commonly arise in companies with an institutional investor. The purpose of these provisions is to incentivise senior management to make the company realise the value of the investors investment, by providing financial consequences if that senior manager leaves the company before that investment has been realised. In order to protect the continuity of the company, it may also be worth considering a substantial discount for the shares of a shareholder who becomes bankrupt, as technically the title to his or her shares may fall into the hands of his or her trustee in bankruptcy, and the company may want to be able efficiently to protect itself against losing control of a portion of its membership in that event. Accordingly, provisions in the articles can be introduced which distinguish between a good leaver and a bad leaver. A good leaver will be offered market value for his or her shares, and a bad leaver will receive a discounted market value. Any discount is usually time limited and will reduce progressively over time, to recognise the value added over time by the senior manager since the investment took place. Good leaver will usually mean leaving employment on grounds of death, disability, unfair or constructive dismissal. Bad leaver will usually mean leaving in circumstances justifying his or her summary dismissal. These definitions can be tailored substantially to suit the requirements of the company. It is worth noting that it the investor is often given the discretion to relax or modify the effect of these provisions under certain circumstances.

5.4

Expelling defaulting shareholders

Compulsory transfer provisions would normally extend to the situations when a defaulting shareholder is removed, and where necessary, can be specifically tailored to the requirements of the company. This may be particularly appropriate in professional partnerships.

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It is worth noting, however, that for various technical reasons, we do not recommend that any bad leaver provisions are included solely to penalise defaulting shareholders or acting as an alternative to seeking damages for any breach by a defaulting shareholder. The limited reasons why a company can justify adopting bad leaver provisions are described at 5.3, above.

5.5

Drag and tag provisions

The intention of many shareholders is to sell their company at some point in the future for a gain. It is often a condition of investments made by institutional investors, that if they find a buyer for the company in the future, the investor can compel a sale of the whole of the company. Similarly, the minority shareholders may wish that, if the majority investor has negotiated a sale with a third party, they should be given the opportunity to take part in that sale, thus giving them the comfort that they too could realise their own investment in the company. Accordingly: drag along provisions can be included in the articles, which provide that, if a certain majority of the shareholders wish to sell their shares to a genuine third party purchaser, they can require the remainder of the shareholders to sell at the same price as per share to that third party purchaser; and tag along provisions set out that if a certain majority of the shareholders are proposing to sell their shares to a genuine third party purchaser, the remainder can require a proposed purchaser to buy all the shares in the company at the same price per share as has been offered to the majority. This has the advantage of making the company more readily marketable and prevents a small minority from obstructing a sale which a requisite majority approves.

6.

Post exit restrictions

It is worth considering including post-exit restrictions protect the companys business by restricting a former shareholder from carrying out activities in competition with the company for a period of time after that shareholder exits from the company. Whilst a director will owe a duty of confidentiality to the company and will have certain obligations which may prevent them from exploiting business opportunities even after leaving the company, a clear contractual obligation will provide far greater clarity to the parties about how they expect to be restricted should they exit, and is generally more straightforward to enforce. Such restrictions are only enforceable if they go no further than is necessary to protect legitimate business interests and protect the trade connection and confidential information of the company. Typical restrictions, widely considered to be enforceable would include the following covenants, always time limited (the rule of thumb is that restrictions of over 12 months are progressively harder to enforce, but we recommend you take specific advice when considering including these provisions in any document before you consider enforcing them) would include restrictions against the former shareholder: setting up in competition with the company and seeking business from its customers (or, potentially more controversial, dealing with customers); interfering with key suppliers; or seeking to entice, or employing, employees, directors or shareholders of the company to a competing business.

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SHAREHOLDERS POWERS
% shareholding or voting rights Section of the 2006 Act (or other statute, if different) Any restrictions

Any shareholding The right to ask a court to call a general meeting Right not to be unfairly prejudiced Right to apply to court to wind up the company, on grounds that it is just and equitable to do so s 306 s 994 s 122(1)(g) of the Insolvency Act 1986 s 769 s 113

The right to a share certificate The right to have the shareholders name entered on the register of members The right to a copy of the annual accounts The right to inspect minutes of general meetings without charge The right to inspect the register of members and index of members names without charge The right to require a copy of the register of shareholders within 10 days of the request (subject to a charge) The right to inspect the register of directors service contracts without charge Right to inspect the registers of directors and company secretaries 5% of voting rights Right to require the company to circulate a statement of not more than 1,000 words about the business to be dealt with at the meeting

s 431 ss. 358

s 116(1)(a)

s 116(2)

s 229(1)

ss. 162(5) & 275(5)

s 314(1)

The request must be received by the company at least one week before the meeting to which it relates

5% in nominal value of shares having the right to vote at general meetings1 Right to require the directors to call a general meeting s 303(2)(a) This can be exercised by sending written notice to the company

Note that this may be different to the more straightforward percentage of voting rights if, for instance, certain shares carry more votes than others.

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Right to call a meeting at the companys expense s 305(1) Can only be exercised if the directors fail to call a general meeting pursuant to section 303 within 21 days from the date they receive a request from the relevant shareholders

10% in nominal value of shares having the right to vote at general meetings The right to refuse consent to short notice of a general meeting ss. 307(4) (6), 2006 Act (Note that the company change its articles to give the right as low as 5%)

Right to demand a poll at a general meeting

s 321(2)(b)

10% in nominal value of the issued share capital (voting or otherwise) The right to require the companys accounts to be audited More than 25% of voting rights The power to block a special resolution More than 50% of the voting rights The power to pass an ordinary resolution 282 A court may have the power to set aside a resolution of the members where the votes have been used to defraud the minority or for a corrupt purpose. s 283 s 476

75% of voting rights The power to pass a special resolution s 283 Again, a court may set aside a resolution where the votes have been used to defraud the minority or for a corrupt purpose

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DIRECTORS RESPONSIBILITIES AND RISKS

As well as the list of general duties set out in the 2006 Act, directors owe other duties under variety of other laws and regulations, such as insolvency and health and safety legislation. This part outlines some of the more important duties and typical strategies for deal with the risks involved. This part is split into three sections: 1. 2. 3. Strategies for managing risk; General duties of directors under the 2006 Act; and Directors duties and risks during a financial crisis.

Whist it is important to understand the duties and risks, we consider that the first step is to adopt strategies to manage risk. Whilst the consequences of a breach of duties can be severe for directors, with adequate protective measures, procedures and processes in place and an understanding of the risks, there is no typical risk which is not capable of being managed. This is why we have placed the strategies for managing risk at section 1. We hope that they are useful and would be happy to discuss them in more detail. Section 1 Strategies for managing risk Consider the insurance options General insurance The basic position is that a director will not be personally liable for a negligent act committed by the company, or more to the point, a companys employee, during the course of the business. Whilst, under these circumstances, the company is also liable, it is also worth noting that a director or employee who has negligently (or intentionally) caused loss to any third party is probably also be personally liable (but the director or employee will rarely be pursued on the basis that the company will normally be expected to have better financial strength and insurance cover). We therefore recommend that each company consults with insurance brokers to ensure that it has in place appropriate types of cover to cover the kinds of risk that the company may face (e.g. product or professional liability). Directors & Officers liability insurance (D&O insurance) D&O insurance also covers directors in respect of the personal financial consequences of any wrongful or unlawful acts whilst acting as directors of the company. A good policy should cover most, if not all of the risks described in section 2. They can sometimes cover some of the costs and certain aspects of personal liability which may arise if the company becomes insolvent (but this will depend on the terms of the policy). D&O insurance is not available against the financial consequences of criminal acts by a director. A companys payment of premiums for D&O insurance is a taxable benefit in kind for
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the director. However, since the insurance normally benefits both the company and the director, the premium is generally apportioned between the company and the director to arrive at the taxable amount. Whilst we cannot advise on specific insurance policies, we can put you in touch with independent brokers who can. Ensure the companys constitution appropriately deals with all relevant compliance issues We recommend reviewing the articles of the company to determine whether: the provisions governing the calling of meetings are appropriate, workable and that meetings are properly convened and quorate when called; provisions to allow directors to authorise conflicts of interest (discussed in more detail in section 2, below); provisions to allow, if necessary, directors to hold multiple directorships on the boards of different companies, without thereby inadvertently breaching duties to the company; provisions to allow the acceptance of corporate hospitality from third parties and other benefits, as appropriate; a formal indemnity to allow a company to pay a directors defence costs in defending proceedings for breach of duty (but this will be on the basis that he or she repays the costs if unsuccessful); and formal permission to the company to obtain and pay for D&O insurance. Allocate responsibility for compliance Except, perhaps, for the smallest size of company, where delegation to specific directors or departments is not necessarily feasible, we recommend delegating responsibility for financial and legal oversight to someone of sufficient seniority within the business. Perhaps the most important aspect is financial management. Responsibility for putting in place and monitoring checks and controls should be delegated to a specific individual who, or department which, is in a position to police issues and who report to the board as a whole on a regular basis. Responsibility for maintaining accounting and corporate records and for statutory notification and filing obligations should be delegated to specific individuals, such as accounting or company secretarial staff (and in that regard, we provide a comprehensive company secretarial service). Responsibility for complying with court orders or undertakings should also be delegated to a particular person or department. It is worthwhile taking into account the particular risks which affect the business and spending time setting up processes to manage and oversee risks to ensure that any persons or departments whose activities carry the greatest risk of breach are consistently monitored. So, for example, the company should be in a position to monitor compliance with key contracts and funding agreements.

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Hold regular board meetings It is important to hold regular board meetings to ensure the directors are kept up to date have appropriate input into decisions. As mentioned below, it is crucial to ensure that the directors are kept as up to date as possible about what is going on. It is also important to establish and audit trail of the companys decisions, particularly to demonstrate compliance with directors duties. Meetings should be minuted to record: matters discussed; instructions given; decisions reached; any professional advice given to the board and any such advice taken into consideration in making decisions; and directors voting for and against proposals. The contents of the minutes should: reflect careful and considered decision making; and be agreed by all directors. Make sure the directors know what is going on Although particular responsibilities are delegated to certain directors, each director has a general responsibility for any breach by the company of its obligations and a responsibility to monitor compliance as a whole. It is therefore important that those with responsibility for each aspect of the companys business or affairs provide regular and structured reports to the board. Directors should ensure that they receive a satisfactory flow of relevant information. In particular, regular management accounts, preferably setting out a profit and loss account, and details of creditors and debtors and, ideally, a balance sheet, are particularly important. Protection against certain liabilities (particularly those which may arise on the brink of, or during, insolvency) can only be based on the data which they provide. Take professional advice where necessary Professional advice will be required on the structure of corporate transactions in order to ensure that they comply with all relevant legal and regulatory provisions. It will almost always be necessary to take advice from both solicitors and accountants in such circumstances. Professional advice which is sought on significant issues should be available: to directors at first hand; in writing; and if necessary at board meetings. Directors should: ask their advisers to clarify anything which is not completely clear; and
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make it clear if whenever they are relying on their advisors advice. Consider appointing non executive directors As a company grows, it may be worthwhile considering appointing a non-executive director who can help to ensure that an objective and independent view is taken of the companys affairs. The non-executive director may be in a better position to take an objective view of the interests affected by a companys actions. Non-executive directors should ideally be wholly independent of the company. Carefully review your companys annual accounts and any management accounts A companys statutory accounts are the primary source of information for shareholders. The directors careful consideration of the draft and of any recommendations or reservations made by any accountants or auditors is therefore crucial

Coping with a financial crisis Involve professional advisers at an early stage. Ensure that you obtain adequate financial information. It is important to keep the companys accountant or auditors closely involved and to seek the advice of lawyers and insolvency practitioners who may provide guidance and range of options to deal with the situation.

Have reliable financial information prepared to determine whether continuation of the business is viable. If appropriate, obtain professional advice to conduct an independent review and to give advice about asset values.

Make sure that all relevant people are aware of the companys problems

The entire board should be alerted to difficulties as they arise. This will be more easily managed if the company has regular board meetings although not all important information can necessarily wait until the next board meeting. We recommend the early supply of full information to the companys bankers and other major creditors to help obtain their support as far as possible. Whilst we recommend taking full minutes of meetings and records of decisions in any event, it becomes more crucial if the company is on the verge of insolvency. If an insolvent liquidation occurs and an action is brought against the directors for wrongful trading, it is vital that they have an adequate record of steps which they took to minimise potential loss to creditors.

Maintain full records of all decisions taken

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Section 2 General duties of directors under the 2006 Act What the duties are about The directors duties set out in the 2006 Act replace a number of common law rules and equitable principles on which they are based. Where more than one duty applies at any time, the directors must comply with each applicable duty. A list of the main statutory duties is set out below: Duty Promote the success of the company Section 172 Explanation A director must, in good faith, promote the success of the company for the benefit of its members as a whole. In doing so, the director must have regard (among other matters) to the: likely consequences of any decision in the long term; interests of the companys employees; need to foster the companys business relationships with suppliers, customers and others; impact of the companys operations on the community and the environment; desirability of the company maintaining a reputation for high standards of business conduct; and need to act fairly as between the members of the company. The duty is subject to any law requiring directors in certain circumstances to consider or act in the interests of the creditors of the company, such as when the company is insolvent, or nearing insolvency. Success is not defined. The government stated that success in this context would usually mean long-term increase in value for commercial companies, and that this is generally a matter for the directors good faith judgment. The obligation to have regard to the listed factors is subordinate to the overarching duty to promote the success of the company for the benefit of its members as a whole but at least some regard must also be had to the listed factors. The list of factors is not exhaustive and all relevant circumstances must be considered in each case. Each director owes the duties only to the company, even where the duty expects him or her to take into account of other things or people. Act within powers Section 171 Each director must act in accordance with the companys constitution (in particular, the articles of association) and must only exercise his or her powers for their proper purpose. Under previous case law covering this area, courts have approached the duty by first ascertaining the purpose for which the power was conferred, and then determining whether that was the directors main purpose when exercising the power. If the directors main purpose was not the purpose for which the power was conferred, it will not matter if he or she exercised the power in good faith or in the
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belief that it would promote the success of the company for the benefit of the members as a whole. Examples of use of powers for a purpose which is not proper include: giving away assets of the company for no consideration to his own private family company of which he was a director; issuing shares clearly made with the object of creating enough voting power to alter the companys articles; and issuing shares to one takeover bidder and not another, to ensure the defeat of one of the takeover bids. Exercise independent judgement Section 173 Directors must not restrict their freedom to make independent decisions. The duty will not be infringed by a director acting in accordance with an agreement entered into by the company that restricts the future exercise of the directors discretion or in a way authorised by the companys articles. At the time that this section was enacted, the then government stated that this duty would not prevent directors relying on advice, as long as the directors exercise their own judgment in deciding whether or not to follow the advice in question. Indeed, bearing in mind the range of other duties, we recommend seeking advice wherever it seems appropriate to do so. Exercise reasonable care, skill and diligence Section 174 A director must exercise the care, skill and diligence which would be exercised by a reasonably diligent person with both: the general knowledge, skill and experience which may reasonably be expected of a person carrying out the functions carried out by a director of the company (the objective test); and the general knowledge, skill and experience that the director actually has (the subjective test). The objective test therefore sets out a minimum standard of care, but if the director in question has specialist knowledge, a higher, subjective standard applies when his or her specialist skill is called upon. Avoid conflicts of interest Section 175 The duty does not relate to any transaction or arrangement with the company but instead relates specifically to the exploitation by the director of any property, information or opportunity which properly belongs to the company. If there is a conflict, the shareholders can authorise it by ordinary resolution. However, we can also amend the articles for companies to allow independent board members to authorise conflicts, in accordance with the 2006 Act, which can simplify matters if a conflict arises. The most obvious situation where an issue may arise is for directors who sit on multiple boards. We can assist with amendments to the articles and other documentation (as necessary) to permit multiple directorships and deal with other issues, such as the appropriate management of confidential information between
29

A director must not, without the companys consent, allow any conflict, or possible conflict, between the duties he or she owes the company and either his or her personal interests or other duties he or she owes to a third party.

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multiple directorships. Do not accept benefits from third parties Section 176 Directors must not accept any benefit (including a bribe) from a third party which he or she receives because of his or her being a director, or doing or not doing anything as a director. The duty will not be infringed if the acceptance of the benefit cannot reasonably be regarded as likely to give rise to a conflict of interest. Benefits conferred by the company, its holding company or subsidiaries, and benefits received from a person who provides the directors services to the company, are also excluded. It is possible to adopt, and we recommend adopting, provisions in the articles which deal with the management of this kind of conflict. These can either be in a standard form, or bespoke to the nature of the company involved. Declare any interest in a proposed transaction or arrangement with the company Section 177/182 Directors must declare to the other directors the nature and extent of any interest, direct or indirect, in a proposed transaction or arrangement with the company. The director need not be a party to the transaction for the duty to apply. An interest of another person in a contract with the company may require the director to make a disclosure under this duty, if the other persons interest amounts to a direct or indirect interest on the part of the director. The declaration must be made before the company enters into the transaction or arrangement. Where a declaration of interest proves to be, or becomes inaccurate or incomplete, a further declaration must be made, if the company has not yet entered into the transaction or arrangement when the director becomes, or should reasonably have been, aware of the inaccuracy or incompleteness. No declaration will be required: where the director is not aware, and could not reasonably be aware, of his or her interest; if the interest cannot reasonably be regarded as likely to give rise to a conflict of interest; if the other directors are already aware of it; or if it concerns the terms of the directors service contract which have been (or are to be) considered at a board meeting or board committee. Directors must also declare interests which come to light in existing transactions and arrangements. Enforcement of the general duties This is a brief summary of the more significant enforcement rights shareholders have and we hope this provides a basic understanding of the issues. However, there are other remedies and this area of law quite complex. We would be more than happy to discuss any aspect of enforcement or compliance issues in more detail. Shareholder rights in respect of unfairly prejudicial conduct A shareholder may apply to court for an order on the grounds that the companys affairs are being or have been conducted in a manner which is unfairly prejudicial to the interests of its members generally, or some part of its membership (including at least the shareholder who is applying to court). Specifically, the shareholder
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must show: some breach of the terms on which the members agreed that the affairs of the company should be conducted; or some use of the rules in a manner which equity would regard as contrary to good faith such as improper allotments being made or misappropriation of company assets. The remedy, in an overwhelming majority of cases is an order that the shares of shareholder who has been wronged are bought by the continuing shareholders, or the company, at a fair value. Cases of this nature are generally expensive for the company, and possibly its directors and shareholders, and can cause substantial disruption to the business. Derivative rights Shareholders may also apply to court to enforce breaches of directors duties directly, on the companys behalf. The right to pursue derivative claims is subject to a number of technical rules which are beyond the scope of this note. The remedies available to shareholders in derivative claims may include, for example, damages or an account of profits (payable to the company) and injunctions, to restrain any conduct which is in breach of the relevant duty. However, it is worth noting that there are some substantial limitations on this right, and substantial protections for directors who have sought to act fairly and in good faith, as follows: Ratification The shareholders have a default right to ratify many cases of negligence, default, breach of duty or breach of trust, after the fact, by passing an ordinary resolution. However: a breach which beyond the legal powers of the company (otherwise known as ultra vires) or which involves a fraud on the minority or corruption by the directors cannot be ratified; and the votes of any director in breach, who is also a shareholder, or anyone connected with that director do not count towards any ratification resolution. Ratification will bar the bringing of a derivative claim. However, even if the conduct has not been ratified, a court must consider whether the conduct could be, and is likely to be, ratified by the company. Because of this limitation on the scope of derivative claims, derivative claims are relatively uncommon. Power of the court to grant relief The court has the power to relieve a director from liability in proceedings for negligence, default, breach of duty or breach of trust if it considers both that: he or she has acted honestly and reasonably; and considering all the circumstances of the case, he or she ought fairly to be excused. A director may also apply to the court for relief where he or she has reason to expect that a claim may be made against him or her.

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Section 3 Directors duties and risks during a financial crisis If a company begins to suffer financial difficulties, in addition to the general duties, outlined above, the director must also have regard to the interests of the companys creditors. Directors who fail to protect the interests of creditors may find themselves liable to account personally for losses suffered. It is therefore important to be able to recognise potential financial problems and have a strategy to cope with a financial crisis. The main provisions about the conduct of directors in an insolvency situation are contained in the Insolvency Act 1986 and the Company Directors Disqualification Act 1986. The provisions also catch shadow directors, who are people in accordance with whose directions or instructions the directors of a company are accustomed to act (but not normally professional advisers) or de facto directors, who are people who act as directors even though not formally appointed. In certain circumstances, a holding company may be a shadow director of its subsidiaries and this may be particularly important when considering whether there are any risks that the holding company may face some liability for the debts of the subsidiary. Wrongful trading Where a company goes into insolvent liquidation, and at some time before the winding up started any director knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation, a liquidator may apply to the court for an order that the director makes a contribution to the assets of the company. Liability for wrongful trading cannot arise until there is, on an objective basis, no reasonable prospect that the company can avoid going into insolvent liquidation. For the purposes of wrongful trading, a company goes into insolvent liquidation if it goes into liquidation at a time when its assets are insufficient for the payment of its liabilities and the expenses of the winding up. The balance sheet basis for insolvency is therefore used for the purposes of wrongful trading. It is a defence that, when the director knew that there was no reasonable prospect that the company would avoid going into insolvent liquidation, he or she took every step that he or she ought to have taken to minimise the potential loss to the companys creditors. For this purpose, a director is judged as a reasonably diligent person, having the general knowledge, skill and experience to be expected of a person carrying out his or her functions, in addition to whatever knowledge, skill and experience he or she in fact had. This is very similar to the duty to exercise reasonable, skill, care and diligence under section 174 of the 2006 Act. The High Court has held that liability only arises for wrongful trading if, on a net basis, it is shown that the company is worse off as a result of the continuation of trading. Accordingly, if a voluntary arrangement or administration order would be of greater benefit to creditors, this may be a better solution for creditors in some circumstances. Resignation is rarely a solution but a carefully planned and documented resignation may be the only option left for a director who has serious concerns and is unable to compel the board or shareholders to act. It can be difficult for liquidators to pursue wrongful trading proceedings and it is often difficult for them to recover their costs of such proceedings. However, on 18 July 2013, the Insolvency Service published a consultation paper on changes to insolvency regulation entitled Transparency & Trust: Enhancing the transparency of UK company ownership and increasing trust in UK business. Amongst other things, it has suggested (1) increasing the powers to administrators to pursue wrongful and fraudulent trading and recover their costs in such proceedings, (2) giving liquidators the power to sell claims for wrongful or fraudulent when
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they lack funds out of the liquidation to pursue those claims themselves, (3) giving courts the power to order disqualified directors to pay compensation to companies in liquidation and (4) extending the time period to pursue disqualification claims from 2 years to 5. The results of the consultation are yet to be published. In truth, due to the numerous practical barriers to claims, there have been fewer claims for wrongful trading than one might expect and many commentators consider that the law as it stands does not bring about sufficient accountability. Accordingly, whilst a strengthening of the law in this area is currently a major focus of government policy, it highlights the need for company boards to adopt proper controls and carefully planned strategy for managing risk. In any event, it is important that the board seeks legal advice and the advice of an insolvency practitioner when faced with a financial crisis, although it may also be prudent in these circumstances for directors to seek their own independent advice. Fraudulent trading If the companys business has been carried on to defraud creditors or for fraudulent purpose, then on an application by the liquidator parties to the business being carried on in this way can be required by the court to contribute to the companys assets. In practice, this provision is raised far less often than wrongful trading because actual dishonesty has to be proved. Misfeasance The Official Receiver, liquidator, any creditor or a contributory (e.g. shareholder or other person who might have to pay into the companys assets in a winding up) can apply to the court for an order that directors who have misapplied company property or who are in breach of their duties should account to the company for the assets concerned to compensate the company. Disqualification The principal purposes of the Company Directors improve accountability of directors. Liquidators, submit reports about directors (including shadow disqualification proceedings against directors. The Disqualification Act are to discourage rogue directors and administrative receivers and administrators are required to directors) to the Secretary of State, who may then initiate consequences of disqualification can be substantial.

The court can prohibit or restrict a person from being a director of any company or from being concerned in any way in the promotion, formation or management of any company, unless it gives consent. The court will make a disqualification order if satisfied that the person concerned: was a director of a company which became insolvent (whether while that person was a director or subsequently); and so acted (as a director of that company alone or that company and another) that he or she is unfit to be concerned in the management of a company. The factors which may lead to this decision include: any misfeasance or breach of any fiduciary duty by the director in relation to the company; any misapplication or retention of any money or other property of the company; failure to comply with duties to keep accounting and statutory records or to file relevant documents with Companies House; and
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the extent of the directors responsibility for the company entering into any transaction liable to be set aside by an insolvency practitioner for being, for example, at an undervalue. The minimum disqualification period is two years and the maximum 15 years. Contravention of a disqualification order can result in imprisonment for up to two years, a fine or both. Anyone who is subject to a disqualification order and who is involved in the management of a company without the courts consent will also be personally liable for all the debts of a company. Phoenix Companies Except with the courts consent, and subject to some exceptions, it is a criminal offence for anyone who has been a director of a company within 12 months of it going into insolvent liquidation to be concerned at any time in the next five years as a director or in the management of any other company bearing the insolvent companys name or any name under which it carried on business or a name which suggests association with it. This provision is aimed at directors who allow a company to go into insolvent liquidation and then re-establish its business under the same or a similar name, leaving creditors unpaid. A person who manages a company in contravention of this provision is personally liable for all the new companys debts.

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