Corporate Governance 2009

Published by Global Legal Group with contributions from:

A practical insight to cross-border corporate governance
www.ICLG.co.uk
The International Comparative Legal Guide to:
Advokatfirmaet Haavind AS
Al Tamimi & Company
ALRUD Law Firm
Anderson Mori & Tomotsune
Arnold Bloch Leibler
Ashurst LLP
Bae, Kim & Lee LLC
Basham, Ringe y Correa S.C.
BCM Hanby Wallace
Bernotas & Dominas Glimstedt
Cechov & Partners
Deneys Reitz Inc
Elvinger Hoss & Prussen
EMD Advocates
Garrigues
Gleiss Lutz
Kunz Schima Wallentin Rechtsanwlte OG
Law firm Miro Senica and attorneys
Lenz & Staehelin
Liepa, Skopina/ BORENIUS
Luiga Mody Hl Borenius
Michael Shine, Tamir & Co.
Osler, Hoskin & Harcourt LLP
Pachiu & Associates
Rnne & Lundgren
Roschier, Attorneys Ltd.
Santa Maria Studio Legale Associato
Schulte Roth & Zabel LLP
Siemiatkowski & Davies
Spasov & Bratanov Lawyers' Partnership
Vasil Kisil & Partners
Vieira de Almeida & Associados
Weinhold Legal, v.o.s.
Zhong Lun Law Firm
v

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Chapter 1
Ashurst LLP
Directors Duties in the
Zone of Insolvency
Introduction
Corporate governance is concerned with supervision of the
management of a company and managing the risk, so that business
is carried out competently and with due care for the interests of all
stakeholders concerned. In the UK this regulation is undertaken
through various statutory provisions and the Financial Reporting
Councils Combined Code on Corporate Governance (Combined
Code) which relates to best practice.
Given the current unstable financial climate, corporate governance
issues will be particularly prominent in directors minds as they
balance the competing interests of their stakeholders. There is a
significant shift in directors duties when a company is faced with
the risk of insolvency. Directors need to be aware of these duties
and the related issues before the company becomes insolvent, as:
their responsibilities are very different from and more
extensive than those which apply to solvent companies;
many of them apply when a company is in financial trouble
but before it is insolvent in the technical sense;
directors who have not been faced with companies in
financial difficulties previously are likely to be unfamiliar
with them; and
failure to comply with them can lead to personal liability
and/or disqualification.
Who Do the Duties Apply to?
The duties apply to all directors. Section 250 of the Companies Act
2006 (2006 Act) defines a director as a person occupying the
position of a director by whatever name called. The common law
has imposed fiduciary duties on all directors, whatever their role,
and a duty of care and skill. Many of those duties have been
codified by the 2006 Act. Other statutes and regulations create
additional offences and many of them impose strict liability.
The common law fiduciary duty of the directors towards the
company was a duty to act honestly and in good faith in the best
interests of the company, and to use the powers granted to them for
the purposes for which they were conferred. Chapter 2 of Part 10
of the 2006 Act has codified certain of these duties.
Further, directors of listed companies must have regard to inter alia
the Listing Rules, Prospectus Rules, Disclosure and Transparency
Rules (DTRs) and the Combined Code. The Listing Rules,
Prospectus Rules, and the DTRs are regulated by the Financial
Services Authority (FSA) and create additional burdens which
are not faced by private companies. Although compliance with the
Combined Code is not mandatory, the Listing Rules prescribe that
officially listed companies must comply or explain how and why
they do not comply in their annual report. The Turnbull Guidance,
Smith Guidance and Higgs Report further supplement the
Combined Code with suggestions for good practice.
Codification of Directors Duties
The seven general duties of directors as codified by and set out in
sections 171 to 177 of the 2006 Act are:
to act within the powers conferred by the companys
constitution;
to promote the success of the company;
to exercise independent judgment;
to exercise reasonable care and skill;
to avoid conflicts of interest;
not to accept benefits from third parties; and
to declare interests in proposed transactions or arrangements.
These duties apply at all times and not just when the company faces
financial difficulty. The new statutory statement of duties does not
cover all duties that directors might owe - other duties, such as the
important duty to consider creditors interests in times of threatened
insolvency, remain uncodified.
The codified duties apply to all directors, including shadow
directors and nominee directors. This in itself can cause difficulties
as obviously the possibility for conflict between a shareholders
requirements and the companys best interests can arise and may be
even more pronounced if the company is facing financial
difficulties.
Directors Duties in the Twilight Zone
In the insolvency world the twilight zone refers to the period
which starts when a solvent company becomes an insolvent one and
ends on the commencement of a formal insolvency process.
In normal circumstances, where the company is in good financial
health, the 2006 Act provides that the primary duty of directors is to
act in a way which would be most likely to promote the success of
the company with reference to the interests of its shareholders as a
whole. However, as previously referred to, this duty is qualified by
section 172(3) of the 2006 Act, which provides that it is subject to
any enactment or rule of law requiring directors, in certain
circumstances, to consider or act in the interests of creditors of the
company. When a company is insolvent the interests of the
shareholders are less important and the directors need to discharge
their duties by reference to the creditors of the company.
There is a significant shift in a directors responsibilities which
occurs when a company is in the zone of insolvency and before it
Rachel Mulligan
Andrew Edge
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is actually technically insolvent. This is a phrase which has not
been defined but that has been used by the courts. It is advisable
that directors regard the shift as occurring when it appears (or
should be apparent to them) that there is a greater than ordinary
business risk of their company failing.
The main problem is that it is not always clear for a director when
this switch or shift occurs. When the company is solvent there is no
reason for directors to consider the interests of creditors. However,
when insolvent, the directors must consider creditors in priority to
shareholders (West Mercia Safetywear Ltd [in Liquidation] v
Dodd [1988] BCLC 250). It is the period in between which causes
most difficulties - the so-called twilight zone.
The reference in section 172(3) is probably reference to the
concepts of wrongful trading and fraudulent trading pursuant to the
provisions of the Insolvency Act 1986 (IA 1986). When
applicable they qualify a directors duty to promote the success of
the company for the benefit of the members as the directors (as a
defence to wrongful trading claims) must show that they have taken
all steps to minimise loss to creditors and failing which may incur
personal liability.
Much is made of the personal liability of directors in the event that
they continue to permit a company in financial difficulties to trade.
However, provided that it can be shown that the director has taken
every reasonable or proper step which he ought to have taken, with
a view to minimising the potential loss to the companys creditors,
that personal liability ought not to be triggered.
Questions arise when a company is in trouble as to whether the
directors, in considering the interests of creditors, should also continue
to have regard to the various factors set out in section 172(1), or
whether they are only relevant when the directors are looking to
promote the success of the company for the benefit of its members.
For example, the directors of a company may decide to continue
trading for a period so as to improve returns for creditors but with
the ultimate aim of filing for insolvency. Although they would be
minimising the potential loss to creditors and possibly reducing the
likelihood of a wrongful trading action, there is always the
possibility that in continuing to trade they have made it harder for
the employees to find alternative work when the company
eventually enters insolvency. There has been no express guidance
on how directors should exercise their duties when approaching
insolvency so it has been assumed that the factors which need to be
considered when a company is trading solvently are not relevant.
However, as mentioned already, it is difficult for directors to know
exactly when creditors interests are to be preferred over the
interests of shareholders as there is no concrete timeline. This in
itself is a further potential conflict area for directors not really
addressed by the courts or legislation - but which more than likely
will be in the not so distant future.
Wrongful Trading (Section 214 IA 1986)
This is probably the most difficult legal problem which a director of
a company in financial difficulties might face. Fear of this liability
may often lead directors to put a company into formal insolvency
proceedings before strictly necessary.
The case law relating to wrongful trading demonstrates that the
courts will typically find directors liable for wrongful trading where
the directors closed their eyes to the reality of the companys
position, and carried on trading long after it should have been
obvious to them that the company was insolvent and that there was
no way out for it (Re Continental Assurance Limited [2001]
BPIR 733).
What is the Standard Required of a Director?
The court will ask the following questions:
(a) during the time that person was a director and before the
commencement of the winding up of the company, did he
know or ought he to have known that there was no
reasonable prospect of the company avoiding an insolvent
liquidation (section 214(2) IA 1986)? If not, then there is no
wrongful trading by that person;
(b) if yes, following the time he did become aware (or ought to
have become aware) that there was no reasonable prospect
that the company would avoid going into an insolvent
liquidation, did he take all reasonable and proper steps with
a view to minimising the potential loss to the companys
creditors? If yes, then the court will not make an order
against that person (section 214(3) IA 1986).
Objective and Subjective Tests
Section 214(4) of the IA 1986 states that the facts which a director
of a company ought to know or ascertain, the conclusions he ought
to reach and the steps which he ought to take are those which would
have been known, ascertained, reached or taken by a reasonably
diligent person having both:
a) the general knowledge, skill and experience that may
reasonably be expected of a person carrying out the same
functions as are carried out by that director in relation to the
company (i.e., an objective test); and
b) the general knowledge, skill and experience that that director
has (i.e., a subjective test).
The court will look at the function carried out by the director in
question when deciding these questions.
What Order Can the Court Make?
The courts discretion in relation to section 214 is very wide. The
main consequence of a finding of wrongful trading is that the
director may be required to make a personal contribution to the
assets of the insolvent company. In addition to personal liability
where a director engages in wrongful trading, he may be
disqualified by a court order for a period between two and fifteen
years (see below).
Fraudulent Trading (Section 213 IA 1986)
Under the IA 1986 a liquidator can apply to court to obtain a
contribution from any person (including, but not limited to a
director) who knowingly continues to carry on the companys
business with the intention of defrauding creditors with the
knowledge that there is no reasonable prospect of the company
being able to pay its creditors (fraudulent trading). Fraudulent
trading is also a criminal offence pursuant to the CA 2006.
Whilst the use of the word fraud suggests a high level of
misconduct, in Re Powdrill & anor v Watson & anor (1995 2
WLR 312) it was suggested that fraudulent trading would
encompass trading either knowing or being reckless as to whether
creditors would be paid.
As fraudulent trading will almost certainly be wrongful trading as
well, it is unlikely that claims will be made for fraudulent trading
when a claim for wrongful trading can be made more easily. The
primary advantage of section 213 is that it can be used against non-
directors.
Recent case law suggests that fraudulent trading claims could become
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increasingly important and of wider application. These indicate that a
participant need only know the elements of a transaction which
transgress the ordinary standards of behaviour (Barlow Clowes
International Ltd [in liquidation] and anor - v - Eurotrust
International Limited and anor [2006] 1 All ER 333).
Preferences (Section 239 IA 1986)
Where a company has at a relevant time given a preference to a
person (being a creditor, surety or guarantor for any of the
companys debts or liabilities), a liquidator (or an administrator)
may apply to the court for an order restoring the position to what it
would have been had the preference not occurred.
A preference takes place if the company does something to put a
surety, creditor or guarantor in a better position than it would have
been in the event of the company entering insolvent liquidation.
The company must be influenced by the desire to achieve this result
(there can be no preference without their desire and, in practice, this
is difficult to show).
The transaction must have taken place within six months (or two
years in the case of connected persons) before the onset of
insolvency and the company must be insolvent at the time or as a
result of the preference. The desire element is presumed if the
preference is given to a connected person.
A director who authorises a preference may be subject to
disqualification under the Company Directors Disqualification Act
1986 (CDDA) and/or may be required to contribute to any shortfall.
Transactions at an Undervalue (Section 238
IA 1986)
A transaction at an undervalue occurs where a company has at a
relevant time (being two years ending with the onset of
insolvency) made a gift to a person or entered into a transaction
where the company receives no consideration or the consideration
received is significantly less in money or moneys worth than the
consideration given by the company.
The company must be insolvent at the time or become insolvent as
a result of the transaction.
The court may order that the company be put in the position that it
would have been in had the transaction not taken place. Often a
director will be joined to the proceedings if he was guilty of
misfeasance in permitting the company to enter into the transaction.
Furthermore, a director who authorises a transaction at an
undervalue may be subject to disqualification under the CDDA in
addition to personal liability.
Disqualification
The CDDA was brought into force with a view to raising standards.
Pursuant to the CDDA, a director may be disqualified from acting
as a director of a company whether directly or indirectly or in any
way being concerned or taking part in the promotion, formation or
management of a company unless he has the leave of the court.
Where a person has been a director of a company which has become
insolvent (either whilst he was a director or subsequently) and the
court finds that his conduct as a director makes him unfit to be
concerned in the management of a company, the court is obliged to
make a disqualification order for between two and 15 years.
A directors conduct will make him or her unfit to be concerned in
the management of a company if the court is satisfied that the
director has been guilty of a serious failure, whether deliberately or
due to incompetence, to perform his or her duties. The court will
have regard to:
any misfeasance or breach of duty by the director;
non-payment of crown debts such as PAYE, National
Insurance contributions and VAT;
the extent of the directors responsibility for the failure by
the company to supply goods or services which have been
paid for;
failure to keep proper books of account and/or to make
statutory returns;
misapplication of the companys funds or property;
trading with a succession of phoenix companies and/or
using a prohibited name;
drawing excessive remuneration; and
the directors responsibility for the company entering into
any preferences or transactions at an undervalue.
It is worth noting that over the years, and possibly as a result of the
growing body of corporate governance guidelines, the number of
disqualification cases before the court has increased dramatically.
On average, for every 10 companies that end up in a formal
insolvency, one director is disqualified.
Announcement Obligations for Directors of
Public Companies
Where a companys shares are listed on the UK Listing Authoritys
Official List, directors additionally have to consider the impact of
the DTRs and the Financial Services and Markets Act 2000
(FSMA) - particularly with reference to those provisions on
misleading the market.
Pursuant to the DTRs, companies which issue securities are under
an obligation to provide to the FSA inter alia any information
which the FSA considers appropriate to protect investors or to
ensure smooth operation of the market.
Directors of such companies are required to notify a Regulatory
Information Service (RIS) as soon as possible where there is a
change in the companys financial condition and when a substantial
movement in the price of its listed securities is likely. This clearly
applies to the situation where directors of listed companies are
aware of a high risk of insolvency.
Directors face difficulties in such circumstances. This obligation
will more than likely cause conflicts with directors first instincts to
protect the companys financial position until a decision has been
reached whether or not to trade on or to implement some form of
rescue. They have information which may cause the share price to
plunge, thus possibly inflicting substantial losses on shareholders.
Making a disclosure may seem inconsistent with a directors duty to
take every step to minimise potential losses to creditors within the
wrongful trading test.
DTR 2 (Disclosure and control of inside information by issuers)
requires an issuer admitted to trading on a regulated market (which
includes the main market of the London Stock Exchange, but not
AIM) to disclose via a RIS any inside information relating to it as
soon as possible (AIM has a separate disclosure regime which is
outside the scope of this paper ). However, DTR 2.5 (Delaying
disclosure of inside information) permits an issuer to delay the
disclosure of inside information in certain limited circumstances.
A recent amendment to DTR 2 recognises that an issuer which
receives liquidity support from the Bank of England or another
central bank may have a legitimate interest in delaying the public
disclosure of this fact.
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If a company does fail to comply with the disclosure requirements
the UKLA may suspend the trading of its shares.
Directors also need to have regard to FSMA provisions relating to
misleading statements and practices which impose criminal
penalties. Under section 397(2) of FSMA any person (not only a
director) who:
(a) makes a statement, promise or forecast which he knows to be
misleading, false or deceptive in a material particular;
(b) dishonestly conceals any material facts whether in
connection with a statement, promise or forecast made by
him or otherwise; or
(c) recklessly makes (dishonestly or otherwise) a statement,
promise or forecast which is misleading, false or deceptive in
a material particular,
is guilty of an offence if he makes the statement, promise or forecast
or conceals the facts for the purpose of inducing, or is reckless as to
whether it may induce another person (whether or not the person to
whom the statement, promise or forecast is made):
(a) to enter or offer to enter into, or to refrain from entering or
offering to enter into a relevant agreement; or
(b) to exercise, or refrain from exercising, any rights conferred
by a relevant investment.
Under section 397, an offence can be committed if a person makes
a false or misleading statement recklessly, even though they do
not realise that it is false or misleading. However, the omission of
a material fact can involve an offence only if the fact was concealed
dishonestly. Under section 397(3) of FSMA, it is also an offence
to act or engage in conduct which creates a false or misleading
impression as to the market in, or price or value of, any relevant
investments if the act or conduct is carried out for the purpose of
creating that impression and thereby inducing another person to
acquire, dispose of, subscribe or underwrite those investments or to
refrain from doing so.
A person guilty of an offence under section 397 is liable to a fine
and/or imprisonment for up to seven years.
It can be seen that directors of listed companies have a more
difficult time in relation to their responsibilities, having to balance
the timing of any necessary announcements against the need to
protect the business of the company, creditors and the share value
of the company.
Serious Loss of Capital
Section 142 of the Companies Act 1985 (to become section 656 CA
2006 with effect from 1 October 2009) provides that directors of
public companies should convene a general meeting where the net
assets of the company are half or less of its called up share
capital, within 28 days of one of them becoming aware of the
position. A failure to convene such a meeting, where necessary, can
leave directors open to a fine of up to 5,000 each.
How Can Directors Protect Themselves?
It is not possible to exempt a director from liability for negligence,
default, breach of duty or breach of trust, but shareholders can ratify
conduct by a director amounting to any of these by ordinary
resolution (unless otherwise stated in the companys articles). The
votes of the director (if he is also a shareholder) and his connected
persons are disregarded in such a resolution.
Acompany can include, and normally does include, an indemnity in
favour of directors within its articles in respect of any liabilities,
costs, charges and expenses incurred in the execution and discharge
of their duties. This includes liability incurred in defending any
civil or criminal proceedings relating to anything done, omitted or
alleged to be done or omitted by a director as an officer or employee
of the company.
Section 232 of the 2006 Act prevents a director from obtaining an
indemnity from the company against wrongful trading liability,
although a third party could give an indemnity. Whether liability is
covered by insurance cover will depend upon the terms of the
policy.
A company can purchase D&O insurance or a qualifying third party
indemnity provision (QTPIP) for its directors against any such
liability. However, the director cannot be covered by an indemnity
or a QTPIP in respect of:
fines imposed in criminal proceedings;
penalties imposed in respect of non-compliance with
regulatory requirements;
the defence costs of criminal proceedings where the director
is convicted;
the defence costs of civil proceedings successfully brought
against the director by the company or an associated
company; and
the costs of any unsuccessful applications brought by the
director for relief.
With ever-increasing standards being required to ensure compliance
with corporate governance guidelines, it seems that professionally
qualified directors may be more regularly in the firing line from
office-holders and the Secretary of State particularly if they have the
requisite deep pockets and/or are backed by D&O insurance
policies.
The decision to indemnify a director may be taken by the companys
board and shareholder approval is not required, although where
there is a potential conflict of interests, it may be prudent for
shareholder approval to be obtained.
No indemnity or insurance is available in respect of fraudulent
trading.
As far as directors of listed companies are concerned, they should
further ensure that they make the appropriate disclosures regarding
going concern status and liquidity risk. The difficult economic
conditions will mean that directors have to consider seriously
whether using the going concern basis of accounting is reasonable.
Conclusion
It is critical that directors still have regard to corporate governance
principles and their duties in times of financial difficulty. Regular
board meetings should be held so that commercial decisions are
recorded in company minutes. It is also important that directors
have up to date financial and legal information available to them at
board meetings to enable them to make informed decisions.
Particular attention should be paid to monitoring compliance with
financial covenants in any arrangements with lenders.
In order to satisfy their legal obligations, directors should keep the
companys position under constant review when in the zone of
insolvency (in most cases on a day-to-day basis) to ensure that there
remains a reasonable prospect of the company avoiding an insolvent
liquidation and that action taken in relation to the company is not
contrary to the best interests of the creditors. Directors should,
therefore, follow the guidelines below:
hold regular board meetings as soon as possible upon them
becoming aware that the company may be in financial
difficulties (and at least every week thereafter). Ideally no
other business would be tabled at the meeting, to permit
complete focus on the issue of whether the business is viable
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and to keep under review the prospect of avoiding insolvent
liquidation. Note that for a group of companies, the directors
should hold separate board meetings for each affected
company and must be careful only to consider the interests of
the relevant company (not its parent or sister companies) at
the relevant meeting;
carefully minute their discussions and conclusions as to why
there is a reasonable prospect of the company avoiding an
insolvent liquidation and, in particular, as to why the
company should continue to trade;
hold early discussions with auditors as regards potential
disclosures;
make sure that they have available all information necessary
to enable them to take an accurate and informed view as to
the financial position (including cashflows) and prospects of
the company. This information should cover not just the
immediate future but also as far into the future as is required
to enable an informed assessment of whether or not the
company will ultimately survive;
in particular the company will need accurate information as
to the make-up of its present (and future) creditors;
the minutes will assist as evidence of whether or not the
directors have taken steps to minimise potential loss to
creditors for the purpose of avoiding wrongful trading
liability;
ensure that there is a proper distribution of responsibility and
delegation within the company;
keep any new commitments to a minimum and consider ways
in which exposure can be reduced;
pay cash wherever possible;
take appropriate professional advice on remedial measures
including taking specialist insolvency advice as soon as
practicable;
consider whether it is possible to inform potential new
creditors of the companys financial difficulties so that they
can make an informed decision whether or not to trade with
the company; and
consider trading through an administration or requesting the
bank to appoint an administrative receiver (if it is able to do
so).
Andrew Edge
Ashurst LLP
Broadwalk House
5 Appold Street
London EC2A 2HA
United Kingdom
Tel: +44 20 7638 1111
Fax: +44 20 7638 1112
Email: Andrew.Edge@ ashurst.com
URL: www.ashurst.com
Andrew Edge is a partner in the corporate department in London,
specialising in mergers and acquisitions and corporate finance. He
has particular expertise in the healthcare sector. Andrew was
seconded to Ashursts Frankfurt office, from January 2002 to May
2005. In the past year he has acted for United Company Rusal, the
worlds largest aluminium company, on its acquisition of a 25 per
cent. state in Norilsk Nickel, and for Protherics plc, on its acquisition
by BTG plc, to form the UKs largest quoted biopharmaceutical
company.
Rachel Mulligan
Ashurst LLP
Broadwalk House
5 Appold Street
London EC2A 2HA
United Kingdom
Tel: +44 20 7638 1111
Fax: +44 20 7638 1112
Email: Rachel.Mulligan@ ashurst.com
URL: www.ashurst.com
Rachel Mulligan is a professional development lawyer in the
corporate department in London, specialising in restructuring and
insolvency. Rachel is a member of the professional development
team and, as such, her role is supporting and developing technical
excellence within the firm. Rachel works on internal and client-
facing documents, is involved in training and also helps generally on
technical legal matters, all across a wide-range of restructuring
related areas. Rachel is also a regular contributor to Corporate
Rescue and Recovery journal.
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