Directors’ conflict of interest: how to comply

Directors operate under a number of duties as prescribed by law. In particular, directors must take positive actions in respect of any potential or actual conflict of interest. This duty is placed on the individual director and not the company. Failure to comply can lead to serious consequences, including criminal proceedings.

Broadly speaking, there are two types of directors conflict of interest: situational and transactional.

Situational conflict refers to where a director is under a duty to avoid a situation in which they have, or possibly may have, a conflict of interest, whereas transactional conflict refers to where conflict arises in relation to a transaction or arrangement between the director and the company.

These two types of conflict can also be classified as actual and potential conflict, and direct and indirect interests. Additionally, a conflict of interest may arise where a director accepts a gift or benefit from a third party.

Common examples of conflict situations typically include where a director has either a professional or personal relationship with persons or entities that are affected by the company’s activities.

This could be where the director, or a connected party such as a family member, holds shares in a different company with which the company of which they are a director of does business, or may do business with in the future.

However, even where a conflict of interest does not arise out of any connection with another individual or organisation, problems can still arise in circumstances where a director is otherwise looking to taking advantage, on a personal basis, of property, information or opportunity that belongs to the company.

This could be, for example, where a director stands to profit from a business opportunity that has arisen in their capacity as a company director but that they have taken advantage of in a personal capacity.

In respect of third party benefits that could give rise to a conflict situation, an example could include a commission paid to a director personally in the course of negotiating a business transaction on the company’s behalf. However, a conflict of interests would not necessarily arise out of something like corporate hospitality, as long as this was moderate and could not reasonably be seen as likely to give rise to a conflict.

Director duties – the rules

The law imposes high standards of conduct on company directors that must be complied with, not least so as to ensure that directors always put the interests of the company before their own.

In particular, by virtue of sections 171 to 177 and section 182 of the Companies Act 2006, there are a number of principal duties associated with being a director. Accordingly, a company director is legally obligated to act in accordance with the following duties, namely:

• A duty to act within their powers (section 171)
• A duty to promote the success of the company (section 172)
• A duty to exercise independent judgment (section 173)
• A duty to exercise reasonable care, skill and diligence (section 174)
• A duty to avoid conflicts of interest (section 175)
• A duty not to accept benefits from third parties (section 176)
• A duty to declare any interest in a proposed or existing transaction or arrangement with the company (sections 177 and 182).

Many of these seven statutory duties are interlinked in some way, with most primarily based on the principles of fidelity, honesty and loyalty. Further, the final three duties relate to the need for directors to avoid or manage conflicts of interest that may affect their objectivity.

The specific duty under section 175 to avoid conflicts of interest also impacts in many ways on the exercise of other duties. By way of example, this underpins the duty to promote the success of the company, not least in having regard to the interests of the company’s employees and the need to act fairly as between members of the company, as well as the desirability of the company in maintaining a reputation for high standards of business conduct.

Directors’ conflict of interest duty

The statutory duty to avoid a conflict of interest under section 175 of the 2006 Act specifically refers to any situation in which a company director has, or can have, a direct or indirect interest or duty that conflicts, or possibly may conflict, with the interests of the company, ie; situational conflict.

This duty applies, in particular, to the exploitation of any property, information or opportunity, whereby it is immaterial whether or not the company could take advantage of the property, information or opportunity in question.

However, the section 175 duty is not infringed if the situation cannot reasonably be regarded as likely to give rise to a conflict of interest or, alternatively, if the matter has been authorised in advance by the other directors who do not have a similar conflict.

That said, authorisation can only be given in the following circumstances:

• Where the company is a private company and there is nothing in the company’s articles that invalidate such authorisation, or
• Where the company is a public company and its articles include provision specifically permitting the directors to authorise the matter.

Duty not to accept benefits from third parties

The duty not to accept benefits from a third party under section 176 of the 2006 Act provides that a director of a company must not accept a benefit from a third party conferred by reason of his or her being a director, or by doing, or not doing, anything as director.

A third party means a person other than the company of which they are a director and any other company within the company’s group.

This provision is designed to avoid conflict situations where a gift or benefit is offered, either because the individual in question acts as a director, or to directly influence him or her to do, or not do, something in their capacity as director.

There is again, however, a statutory exception here. As with the directors conflict of interest duty under section 175, the duty under section 176 will not be breached if acceptance of the benefit could not reasonably be regarded as likely to give rise to a conflict.

That said, in contrast to section 175, the acceptance of a benefit which would breach a director’s duty under section 176 cannot be authorised by the company’s board of directors. This would require a different course of action, for example, prior shareholders’ approval following full disclosure.

Duty to declare any interest in company transactions

The statutory duties under sections 177 and 182 of the Companies Act 2006 provide that a director must declare any potential or existing interest in a transaction or arrangement with the company.

This refers to transactional conflict rather than the situational conflict encapsulated within section 175, and to which different rules apply.

These provisions specifically refer to circumstances where a director, who is in any way interested, directly or otherwise, in a proposed or existing transaction or arrangement with the company, is under a statutory duty to declare the nature and extent of that interest to the other directors.

However, as with the other statutory provisions referred to above, there are again exceptions, namely, there will be no need for a director to declare any interest, whether direct or indirect, in any one the following circumstances:

• It cannot reasonably be regarded as likely to give rise to a conflict of interest
• The other directors are already aware, or ought reasonably to be aware, of any such interest, or
• The director in question is not aware of it him or herself, or rather not aware of the transaction or arrangement in question. For this purpose a director will treated as being aware of such an interest, if they ought reasonably to be aware of it.

Further, a director is not obliged to disclose his or her interest in an existing transaction where they have already disclosed that interest when the transaction was proposed. The director will, however, remain under a duty to make any further disclosure in circumstances where the first disclosure needs correcting.

Complying with director duties

Where a conflict of interest does arise, directors are also under a duty to declare this to their fellow board members and, where at all possible, seek pre-authorisation.

It will then be up to the other non-conflicted board members to decide how to manage or approve the conflict situation using the correct procedures.

Any private companies formed prior to 1 October 2008 must include in their articles of association the power for directors to pre-authorise conflicts of interest. Needless to say, this refers to the power of directors other than the one facing the actual or potential conflict.

For companies incorporated after this date, the power to pre-authorise a directors conflict of interest is automatically implied, although detail can be incorporated into the articles as to the procedures to be followed, namely:

• How, when and where an interest is to be declared by a director
• The procedure by which the independent directors authorise a conflict
• Who can vote and form a quorum in a board meeting
• Which conflicting interests are expressly permitted, for example, other directorships in non-competing companies or an indirect economic interest in possible competitors

However, even where the articles set out in detail how pre-authorisation of a conflict situation is to be dealt with, obtaining authorisation for a directors conflict of interest is not a mere formality.

Both in making any declarations and in making any decisions here, the directors will still need to have regard to their full range of statutory duties, including the duty to promote the success of the company, to act independently of other interests and to act with reasonable care, skill and diligence.

In fact, giving proper consideration to conflict situations makes it all the more important to clearly set out in the company’s articles how these decisions should be sought and reached, not least given that section 180(4) of the 2006 Act provides that where a director complies with any procedure contained within the articles of association, they cannot be in breach of their duties.

Can a conflict of interest be authorised?

In many instances, a directors conflict of interest can be authorised by the directors by way a majority vote. Needless to say, however, only those directors who are not themselves interested in the matter are permitted to vote.

As such, where conflict arises in relation to some or even all of the directors, such as in a private equity or joint venture company, the only practical proposition will be shareholder approval. Further, as set out above, even non-conflicted directors are not permitted to directly authorise a third party benefit and so may instead require shareholders approval.

Typically, conflict situations will be managed in one of two ways, either by the directors or by the shareholders. In the latter case, shareholders can pre-authorise a conflict situation by what’s known as an ordinary resolution, ie; more than 50% support from those shareholders voting. A director who is also a shareholder can participate in the vote, even if he is one of the directors interested in the matter being authorised.

Further, the shareholders can ratify an existing conflict situation. However, in contrast to where shareholders authorise a conflict in advance, the votes of any shareholder who is also an interested director will not be counted, nor will the votes of any shareholder who is connected with an interested director.

Consequences of breaching duties

Liability for breach of the duty to avoid a directors conflict of interest, or any other conflict situation, lies personally with each director, and not with the company itself. Moreover, non-compliance will be treated seriously, in some instances, potentially resulting in criminal sanction.

Although a failure by a director to disclose a situational conflict does not amount to a criminal offence, this may give rise to a civil claim against the director to account to the company for any profit made or benefit received, or for any loss suffered by the company in consequence.

In contrast, any non-disclosure of a transactional conflict will potentially constitute a criminal offence punishable by way of a fine.