Question
Allan, David and Richard are directors of Springfield Chocolate Ltd which was incorporated in 2008. They hold 60%, 20% and 10% of the company’s shares respectively. John holds the remaining 10%.
Allan has been the company’s managing director for three years.
In May 2011, Springfield Chocolate Ltd was invited to purchase the latest technology in making dark chocolate. The board decided not to buy it because of insufficient funds. In June 2011, Allan purchased it in a private capacity and made a profit of £ 10,000 by selling it to a French company.
In September 2011, Springfield Chocolate Ltd was interested in purchasing a piece of land nearby to build a staff car park. At a board meeting, Allan successfully persuaded the board to buy the land for £ 500,000. It was later discovered that Allan was the previous owner of the farm which was only worth £ 300,000.
At a general meeting, a resolution was proposed to ratify Allan’s misconduct and it was successfully passed with Allan’s support. John is considering bringing a statutory derivative claim against Allan.
Advise John as to Allan’s breach of director’s duties and the merit of the derivative claim.
Answer
The advice sought by John who was a minority shareholder in Springfield Chocolate limited was that Allan’s (a majority shareholder and director in the same company) actions in the discharge of his duties amounted to a breach of his duties as a director and as such, as a shareholder was merited to institute a derivative claim. Under the derivative claim, shareholders are empowered to file an application in the corporations name to pursue a cause of action in which the directors of a corporation have done wrongly, failed or refused to do. A derivative claim is thus a fraud allowed the minority exception to the rule in Foss v Harbottle1. The Companies Act 2006 expressly explains when such an exception may be allowed:
- Constitutes fraud to the minority and that whoever are responsible for committing the said wrong are in control of the company,
- Secondly, the wrongful act committed cannot be ratified by ordinary resolution,
- Thirdly, if the said wrongdoing is outside the company’s objects, it cannot be ratified in any event
Breach of Directors duties
Sections from 171 to 177 of the companies Act 2006 defines the duties of a director as set out in the corporations’ law. These are;
- Duty to act within powers (s.171)
- Duty to promote the success of the company (s.172)1
- Duty to exercise independent judgment (s.173)
- Duty to exercise reasonable care, skill and diligence (s.174)
- Duty to avoid conflicts of interest (s.175)
- Duty not to accept benefits from third parties (s.176)
- Duty to declare interest in proposed transaction or arrangement (s.177)
A breach of director’s duties in this matter refers to the omission or abuse of the duties listed in the Act and specifically under the above listed sections.
Grounds for derivative claims
According to the companies Act 2006, shareholders may pursue a derivative claim for actions arising from an actual or proposed act or omission by a director involving negligence, default, breach of duty or breach of trust on grounds defined in section 260(3).
Advice concerning the merits of Derivative claim suit
It is clearly within the rights conferred to John as a minority shareholder to institute a claim. However we need to look at each of the alleged wrongdoings that John will likely succeed in the suit in order to determine whether it is worthwhile for him to go ahead and file a suit.
Thus, it is wrongful for a director of a company to pursue an opportunity on his own and as such the law should compel him to return the profits made in pursuing that opportunity to the company. On the other hand however, Allan would argue that the company did not have the capacity to pursue the opportunity due to financial inadequacy. Fiduciary duty is argued in the case of Irving truct Co. v. Deustch It disqualifies the argument of financial inadequacy as reason for taking up a corporation’s opportunity. In the ruling, it was stated that directors of solvent companies should refrain from taking up corporate contracts based on the plea of financial inability for if they were “permitted to justify their conduct on such a theory, there will be a temptation to refrain from exerting their strongest efforts on behalf of the corporation”. Since Allan did not make any efforts to seek finances for the company to take up the opportunity, basing on Irving Co. v. Deustch, John would have substantial grounds to argue his case.
The second element of his case arises from the alleged act where Allan persuaded the board to purchase a piece of land he owned adjacent to the company for £500,000 yet its actual value was £300,000. In this alleged act, Allan had not disclosed to the directors that he was the true owner of the said piece of land. This particular omission can be dealt under s.177. Section 190 of the Companies Act 2006 provides that if a transaction between a director and a company is a substantial property transaction, it is voidable unless approved by the shareholders in general meeting. Approval can be informal. A transaction is a substantial property transaction if a director acquires an interest in a non-cash asset, the value of which is over £100,000 or 10% of the asset value of the company. If the substantial property transaction does not receive prior authorisation or ratification within a reasonable period of its conclusion, it is voidable at the instance of the company. The director concerned is liable to make good any profit to the company and to indemnify the company against any loss. Based on these arguments, Allan could be said to have failed to declare his interest concerning the land transaction to the company and therefore gone contrary to s.177. In the case of Airey v Cordell 2006. It is considered that courts should decide whether or not to permit a derivative action. Although John could argue the directors did not make an informed decision simply because some facts were kept from them, the law would argue that they should have made reasonable inquiry before approving the deal otherwise their conduct amounted to gross negligence. The gross negligence by directors would bring in a new twist that probably could add weight to Johns derivative suit but again because the whole deal was later ratified in a general meeting renders the suit a no case.
Bibliography
Airey v Cordell EWHC 2728 Companies Act 2006, Web.
Kelly, D, Hayward, R, Hammer, R, Hendy, J, Hayward, R. Business Law, Taylor & Francis, New York, 2011.
Lane. Representing Corporate Officers, Directors, Managers, and Trustees, Aspen Publishers Online, USA,. 2010.
Niltan Carson Limited v Hawthorne [1988] B.C.L.C. 298.
Ottley, M. Q&A Company law 2009-2010, Taylor and Francis, New York, 2009, p.99.
Routledge, Company law 2010-2011, Routledge, Canada, 2010.
Sealy, L. & Worthington, S. Cases and Materials in Company Law, Oxford University Press, Oxford.