Welcome to MJ Hudson’s monthly On Target, where you’ll find useful tips and insights to ease you through your M&A transactions.
Last month’s On Target summarised upcoming Companies House transparency reforms. This month, we continue on the topic of accountability and transparency, highlighting arrangements and dealings between a company and its directors that would breach English company law, whether undertaken knowingly, or not.
In situations where the directors and majority shareholders approve of the relevant arrangement, it is tempting to consider the breaches as “technical”, and of little consequence. However, in the context of a due diligence exercise (e.g. on a sale), a shareholder complaint or dispute, a credit default or an insolvency process, the consequences for the directors can be severe, and can include personal liability for any resulting losses.
The five arrangements below are common examples rather than an exhaustive list, and each may, in addition, leave the director vulnerable to accusations of breach of duty or may place the director in a position of conflict.
Sometimes it makes business sense to give a loan to a director: for example, to cover relocation costs or to purchase shares, as is common in private equity-owned structures. But companies are generally prohibited from making any substantial loans to directors without shareholder approval. Any time there are director loans contemplated that, taken together, add up to more than £10,000, the board is exposing itself to risk if it neglects to put the deal to the shareholders.
The prohibitions also capture equivalent situations, such as when the company merely gives a guarantee for a loan, advanced to a director; lends money to a family member of the director; or makes a so-called “quasi-loan”. A quasi-loan is a contractual relationship in which a new lender (such as the company) promises to settle an existing debt of the borrower (for example, that of a director to a bank), in return for a promise that the borrower will pay back the company, later.
The consequences for a director of making a prohibited loan can be very severe. The director who received the loan and any director who authorised the transaction can be made to personally compensate the company for any profit any director makes, and all the losses resulting from the loan, which could be the entire value of the loan, if it is unrecoverable. Because of the personal liability involved, companies and directors should consider legal advice whenever loans to directors are discussed.
Before a company buys or sells a non-cash asset from or to a director, it may need shareholder approval. Non cash assets are very broad and include financial items, such as shares or loans, and also physical items, such as vehicles or buildings. In general, the law looks at the total value of all items being traded with the director and requires a shareholder vote where the value is more than the lower of £100,000 or 10% of the company’s asset value. This applies even to deals that are on “arm’s length” terms, so a deal struck at market value still would need to go before the shareholders.
All directors who authorise the transfer are personally liable for any loss the company suffers in the deal. Note that the shareholders can be asked to retroactively ratify a substantial property transaction, which will prevent the transaction from being voided and unwound, but it will not clear the liability of the authorising directors. Directors can only protect themselves by seeking consent before making such a deal.
When it comes to negotiating terms of service contracts with directors, the company (acting through its directors) has wide latitude to set the terms however it likes. The directors must act in the best interests of the company but are not generally required to seek shareholder approval of the final terms.
What a contract cannot do without shareholder approval, however, is guarantee a director employment for more than two years. In practice most director service contracts have a period of less than two years and are freely terminable by the company on notice, and so are not caught by this rule. But a notice period that extends the employment beyond two years, a limited right of the company to terminate, or a director’s option unilaterally to renew a contract beyond two years would constitute such a guarantee.
Compared to some other examples, a breach of this legal requirement has relatively benign consequences. Courts will not uphold any claim by the director to guaranteed employment in excess of two years and will treat the contract as granting the company the right to terminate the contract upon its giving reasonable notice to the director.
The general rule for a private company is that any payment requires shareholder approval if it is made to a director in connection with that director leaving office, a share sale, or an asset sale. Leaving office in this context includes ceasing to be a director, as well as vacating any management or executive role at the company.
On a share or asset sale of the company, directors will sometimes be able to rely on the lawyers handling the resolutions necessary for the transaction. The danger for directors lies in situations that would not otherwise involve outside counsel, such as the retirement of a director. The amount considered to be a payment includes non-cash items such as gifts. The threshold for prohibited gifts is fairly low, at £200. The prohibition extends to people who were formerly, but no longer are, directors.
This does not block payments made in accordance with existing legal obligations such as pension plans, employee termination agreements, or payment of contractual damages.
Problems with director transactions might only show up long after the deal is made. The director might even have left the company, in the meantime. If the company later becomes insolvent, the insolvency practitioner (typically an administrator or liquidator) appointed to oversee the insolvency process has the power to look back at what the company did, leading up to the insolvency. In particular, the insolvency practitioner would look for transactions at an undervalue and preference transactions.
Undervalue transactions are exactly what they sound like: deals in which the company gives a person an asset and in turn receives nothing or significantly less than fair value for that asset. In contrast, a preference transaction does not require the company to have struck a bad deal. A preference transaction occurs when the company owes money to a number of creditors and, intending to help a specific person, treats that person more favourably than that person would have been treated in the event that the company went into liquidation (i.e. ahead of the statutory order of priority for settling a company’s debts).
Directors are subject to a longer period of scrutiny than people unconnected with the company. The insolvency practitioner can look back only six months in most cases but can look back up to two years if there are any undervalue or preference transactions with a person connected to the company, such as a current or former director. Certain key factors which are required to make out the grounds of a preference or undervalue transaction are also presumed where the transaction took place with a director, e.g. that the company was insolvent at the time of an undervalue transaction or that the company was influenced by a desire to prefer the director over other creditors. This reverses the burden of proof and so requires the director to bring evidence to disprove that presumption.
If such an act is found to have taken place, the insolvency practitioner can petition a court to reverse the transaction, restore relevant property to the company, and compel payment of other compensation.
Is this brief too brief? Do you need any help with your next acquisition or sale? Expert legal advice is on hand from MJ Hudson’s M&A team. Just contact any of the On Target team (details below) or your usual MJ Hudson M&A contact, and we’ll gladly help.
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