Private equity and the new conflicts duty in the UK

(This article is taken from Private Equity Europe, the pan-European publication from the publishers of unquote")

Since 1 October 2008 there has been a duty under section 175 of the Companies Act 2006 on every director to avoid a situation in which he has an interest that directly or indirectly conflicts, or may conflict, with the interests of the company in question. Directors appointed by private equity investors to the boards of portfolio companies can find themselves in an especially sensitive position.

Situational Conflicts

The new duty on so-called situational conflicts is based on a complex body of case-law going back hundreds of years but with some important modifications. Situational conflicts arise only where there is no active involvement of the company and apply, for instance, to the exploitation of any information or opportunity that comes to the attention of the director – even if the company is not itself in a position to exploit it. When a situational conflict arises, the director concerned will be in breach of duty unless his conflict is authorised by the shareholders or by the non-conflicted directors.

Directors have to be able to recognise not only whether a situation is one of conflict but also whether it creates the prospect or the potential for a conflict. This may not always be immediately apparent. They must then decide whether the situation can reasonably be regarded as unlikely to give rise to a conflict. A more meticulous approach is likely to be required than in the past; directors may need legal advice. Examples from the private equity sphere of situational conflicts include an investor director:

• passing information about the company to the private equity house.
  
• obtaining, within the private equity house, confidential information relating to another company that may be of interest or represent a business opportunity to the portfolio company. Not passing the information or opportunity to the portfolio company may be a breach of duty, even though the director holds the information in strict confidence and is legally barred from disclosing it.
  
• acting as a non-executive director of several companies operating in the same industry or with overlapping businesses.

The non-conflicted directors must comply with their duties. To exercise, for example, reasonable skill, care and diligence when considering a request for authorisation. They must also be in a position to assess the impact on the company. Similarly, shareholders cannot effectively authorise a conflict unless they know the relevant facts. Even if a conflict situation has been authorised already, a change in the circumstances – perhaps turning what was a potential conflict into an actual one – will usually need to be disclosed and submitted for authorisation at the time. In extreme circumstances, it may even be necessary for the investor director to resign.

What needs to be done?

Portfolio companies that are private limited companies formed before 1 October 2008 should consider passing an ordinary resolution or amending their articles of association by special resolution:

• so as to enable the independent board to deal with conflicts and to impose appropriate terms on the conflicted director (such as his exclusion from meetings or information where his conflict is relevant)
  
• to permit investor directors to pass information to the private equity house. Specific unusual disclosures of sensitive information may still require authorisation on a case-by-case basis.
  
• to authorise the investor director not to divulge confidential information to the company that he has received in another capacity.

Actual conflict situations should be reviewed across the portfolios and a register should be kept of the interests of each director, and logged on a company-by-company basis.

Transactional Conflicts

Directors have long been familiar with the process of declaring their transactional conflicts arising from interests they might have in a proposed transaction or arrangement with the company - for example, due to holding shares in the counterparty. The new duty relating to transactional conflicts, under section 177 of the 2006 Act, is more prescriptive than its predecessor: it requires disclosure of the nature and extent of the director’s interest and, where necessary, corrective or updating disclosures. But as long as the declaration is made before the company enters into the transaction, the transactional conflict is not an impediment to the director (unless the company’s articles restrict his ability to vote and form part of the quorum).

What’s New?

Whilst the new statutory conflict duties are based on existing case law, as regards situational conflicts in particular, it is likely the restatement will bring greater focus and clarity. Also, directors and private equity houses generally, will need to be more diligent and aware of possible conflicts of interest than in the past.

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• Topics
• Regulation
• UK / Ireland