In the directors’ chair

As part of the process of simplifying UK company law and making it more relevant to smaller businesses, embodied in the Companies Act 2006, the Government has amended the laws governing directors’ duties. Some of the changes are due to come into force in October 2007, others, mainly dealing with conflicts of interest, won’t be in force until October 2008. They do not make a distinction between executive and non-executive directors and so will govern all board members, including those from private equity houses taking non-executive positions in their investee companies.

The rules governing directors’ duties currently come from several sources. Their general duties are set out in common law, which has developed over the years through case law. In essence, the new rules are simply a restatement, in one place, of the current duties with the principles that underpin the current rules still applying. “This is a kind of halfway house in that you have a statutory statement of the law, but the Act says that the principles already established through case law are still relevant when interpreting that statement. So although directors can now see more clearly the primary duties that they owe to the company, case law (past or future) cannot be entirely ignored”, says Victoria Kershaw, professional support lawyer at SJBerwin.

There are, however, a number of changes as the language used is different and as a result, the new rules may be interpreted slightly differently in practice.

The main change coming into force this October is that a director will be expected to “act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole” (section 172). This is a change from the current regime, which says a director has a duty of good faith to act in the company’s best interest.

The wording initially created some confusion as to what “success” meant, but the Government has since clarified that it can be taken to mean a “long-term increase in value”.

The Act then goes on to list six areas that directors are expected to take into consideration when making decisions “amongst other matters”:

• the likely long-term consequences of their decisions

• the interests of the company’s employees

• the need to foster the company’s business relationships with suppliers, customers and others

• the impact of the company’s operations on the community and the environment

• the desirability of maintaining a reputation for high standards of business conduct

• the need to act fairly as between members of the company

The list has caused some concern and it may be hard for directors at times to balance what may sometimes be conflicting interests. The inclusion of the list also now introduces a wider corporate social responsibility element to directors’ decisions. However, in practice, the new provision should not require much change. The Government has clarified that it is not intended to impose bureaucratic burdens on business but that it simply reflects current good practice. It may be that directors are simply able to dismiss one or more of these factors as irrelevant in many cases.

Some lawyers advise documenting the fact that a decision has been reached with consideration to all these factors and any others that the board feels are relevant. Others say that there should be no need for a paper trail. They argue that it should be adequate for the factors to be brought to the attention of directors in briefing papers before the meeting.

Either way, private equity houses need to ensure that directors are up to speed with the new requirements. “Investors should take the opportunity to educate directors of investee companies of what their duties are in this respect,” says Vanessa Knapp, partner at Freshfields Bruckhaus Deringer. “They can include the fact that they have given due consideration to all six factors in the board papers, so whoever prepares these should also be made aware of the requirement.”

There may also be a need for education further down the company structure, so that where directors delegate decisions to management, all those involved understand the duty to consider all relevant factors.

The other main area that private equity houses need to note is that of conflict of interest. The new rules governing this don’t come into effect until October 2008, but firms may wish to consider the actions they need to take rather sooner than next year.

The Act states that a director must avoid situations “in which he has or can have a direct or indirect interest that conflicts with or may conflict with the company’s interests”. This applies particularly to the exploitation of property, information or opportunity, whether or not the company could take advantage of them.

This change is most likely to affect those who hold multiple directorships, i.e. private equity firm board members and non-executive directors who have a portfolio of board positions. It may be hard to work out, for example, whether at some point in the future being on one board might put them in conflict with being on another. The current rules do not require directors to avoid conflicts in this way – they simply have to manage them as and when they arise.

Yet even this area seems unlikely to cause a huge amount of difficulty. “In theory, this shouldn’t change much,” says Oliver Barnes, corporate finance partner at Travers Smith. “There has always been a tension for a private equity director between acting in the best interest of the firm and that of the investee company. Now this is up in lights, firms will have to think more about their decisions and why they have made them. On the whole, though, I think this is more of an issue for public companies than for private ones.”

Bruce Hanton, a partner in the corporate department of Ashurst, agrees. “This looks draconian, but in actual fact it will make little difference to private equity directors.” The Act allows directors who are unconflicted to authorise the conflict or potential for conflict. The general advice is to ensure that a company’s articles of association deals with any conflicts or potential ones – the rules are not infringed as long as the directors act in accordance with the articles. “Private equity houses are more aware of the potential for conflict of interest than other investors and directors and so it’s likely the articles already include all the wording they need to protect themselves under the new regime,” says Freshfields’ Knapp.

In fact, it may well be that some kind of standard wording is developed to deal with the issue of private equity directorships and non-executive directors that hold a board seat for more than one company. “I think we’ll see various lawyers consulting together to work out some kind of wording that works in these situations,” says Hanton. “This will probably end up going into all articles of association.”

There is one other change that may affect private equity houses. In general the consequences of breaching the new rules are much the same as those that apply now. In most instances, only the company can bring an action against a director for breach. However, the Act does allow shareholders to bring an action against a director on behalf of the company. The law says that claims can be brought in “respect of a course of action arising from an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director of the company”. This is wider than the current law and would mean that a director could be sued even if he or she did not benefit from the breach. It also allows claims to be brought against people other than directors, such as auditors.

This is most likely to apply to a public-to-private situation. “If a firm is bidding for a listed company and gets one of the non-executive directors involved, it will be even more important than before to make sure that no-one is in breach of the Act,” says Knapp.

In light of some of the changes, it may also be wise to review your directors’ and officers’ insurance to make sure all professionals in the firm that sit on boards are adequately covered.

Quite how some of the changes to the rules on directors’ duties will play out in practice is impossible to tell at this early stage, but the general consensus is that they are manageable. What is crucial is that private equity houses need to ensure that not only GPs but also the management of the portfolio companies are well versed in how the changes will affect them.