UK: BLG Directors' and Officers' Liability Review - April 2011

Investors' Claims After Morrison v National Australia Bank – New World Or Old?

By Robert McLauchlan, Simone Hoogeveen and Annemieke Hendrikse

Extra-territorial securities claims in the US courts have been dealt a serious blow by NAB v Morrison. In this article, which we are pleased to co-author with Dutch law firm, Van Doorne, we discuss the claimant lawyers' response and how the Netherlands may present an alternative jurisdiction to the US.

The US Supreme Court's ruling in National Australia Bank v Morrison seriously curtailed claims in US courts by foreign claimant shareholders of a foreign defendant corporation whose shares are traded on a foreign exchange (the so-called "f-cubed" claims). Ten months on, the response of claimant lawyers is now materialising.

In the Morrison case the defendant bank, National Australia Bank (NAB), was incorporated in Australia with American Depositary Receipts (ADRs) traded on the New York Stock Exchange. In 2001, NAB wrote down the value of its US subsidiary HomeSide's assets causing the value of NAB shares and ADRs to drop, allegedly because HomeSide senior executives in the US had manipulated HomeSide's financial models. Class actions were commenced against NAB in the US courts for breach of US securities laws and regulations, including Australian purchasers of NAB shares on the Australian exchange as plaintiffs. The claims were dismissed with respect to these Australian investors for lack of subject matter jurisdiction.

The US Supreme Court ruled that section 10(b) of the Securities Exchange Act and Rule 10b-5 of the SEC Rules do not have extraterritorial application. It declined to endorse long-established case law from lower courts that the application of section 10(b) depends on the "effects" test (whether the wrongful conduct had a substantial effect on the US or upon US citizens) and the "conduct" test (whether the wrongful conduct occurred in the US). Instead it limited the application of section 10(b) to "transactions in securities listed on domestic exchanges, and domestic transactions in other securities".

In Morrison's wake, several decisions from the District Court in the Southern District of New York have extended the USSC finding, precluding claims by US investors who have purchased securities of foreign issuers on foreign exchanges. Attempts by claimants' lawyers to get round the new test by arguing that claimants made their decisions to purchase and initiated or placed their purchase orders for the foreign shares in the US have failed at first instance (Cornwell v Credit Suisse, Re Alstrom Securities Litigation and Plumbers Union Local No 12 Pension Fund v Swiss Re). Most recently, District Judge Batts, hearing an action against the Royal Bank of Scotland arising from write-downs that occurred due to RBS's substantial holdings in subprime assets, rejected the plaintiffs' arguments that section 10(b) applies whenever a security is listed on a US exchange, regardless of whether the security is purchased in the US or through the American exchange ¹. The District Court of Northern California followed a similar line in dismissing claims against Infineon by investors who purchased shares on the Frankfurt Stock Exchange ².

The scope of the Morrison case is expanding. In a ruling in the class action against Société Générale arising from the revelations of the Kerviel trading losses, the Exchange Act was held to be inapplicable to "over the counter" transactions in American Depository Receipts traded in the US on the basis that ADRs are predominantly foreign securities transactions ³. The Morrison decision has also been extended to preclude extraterritorial claims under the Securities Act 1933 (in the RBS case) and the Racketeer Influenced and Corrupt Organization Act (in Norex Petroleum Ltd v Access Industries Inc) ⁴.

What now for non-US securities claimants?

Morrison has certainly cast a chill on claims by or on behalf of non-US investors, at least in the US. As a result, claimant lawyers are looking to alternative jurisdictions with favourable collective regimes in which to bring lawsuits for international investors.

One illustration is the continued growth of securities transactions in Canada, where the Ontario court has recently certified a "global" class of plaintiffs in the Imax litigation ⁵.

In Europe, such alternative venues do not include the UK, which has no equivalent to a US-style class action despite some recent initiatives to the contrary. Provisions to introduce collective redress for investors in relation to claims against any firm authorised by the FSA were amputated from the Financial Services Bill in the "wash up" period before the change of government to allow the rest of the Bill to pass. Nevertheless, it is possible that there will be further attempts to introduce collective actions in this sector, or more generally, in the UK in the future.

The Netherlands

By contrast, the Netherlands, is quickly becoming the leading alternative jurisdiction in Europe for collective securities claims.

The Wet Collectieve Afwikkeling Massaschade (Class Action Financial Settlement Act "the Act") has since 2005 allowed the Amsterdam Court of Appeal to declare a settlement agreement of a large number of similar damages claims binding on the entire group of creditors. The agreement is concluded between an organisation representing the interests of creditors and the parties that make a financial contribution to that settlement. The creditors then become entitled to damages in accordance with the agreement and are precluded from bringing an individual action for damages.

It is therefore no surprise that the Act has already attracted the attention of US lawyers seeking an alternative means for the resolution of mass investor disputes.

Until recently, the leading example of the Act's application in securities claims was the Amsterdam Court of Appeal's ruling on the Royal Dutch Shell settlement of investor class actions in the US arising from its restatement of its oil and gas reserves in early 2004. Before the US courts had issued a final ruling, Shell reached a collective settlement with non-US investors and applied to the Dutch court to have it declared binding on all non-US investors. The Amsterdam court held that it had jurisdiction to hear the case and to issue a decision which also bound non-US claimants not resident in the Netherlands, in order to prevent contradictory rulings. In November 2007, the US court declared itself not competent to hear the claims of non-US shareholders, in part taking into account that an arrangement for the non-US investors was in place under the Act.

The Ahold case is another illustration of the courts in the Netherlands considering the impact of a US class action settlement. In that matter a class action settlement was reached in the US and approved by the US court by which it became binding on all class members worldwide. However, a group of Dutch Ahold shareholders brought a claim before the Dutch court. These Dutch claimants fell within the definitions of the settlement class in the US litigation. However, they were not (actively) involved in the US class action settlement. They did not make timely use of the opt-out facility nor did they apply for the compensation to which they may have been entitled under the settlement agreement, which had been advertised in the Netherlands. In a landmark decision of 23 June 2010, the Amsterdam District Court ruled that the US class action settlement was to be recognised as binding on the Dutch class members. Appeals from the Amsterdam District Court's decision, however, remain possible.

Both Shell and Ahold, however, were decided before Morrison. Both were predicated on the existence of an effective remedy for non-US investors in the US. That situation has now changed, as the Converium case demonstrates.

Converium and its sole shareholder at the relevant time, ZFS, were defendants in a US class action arising from allegations of insufficient reserves and violations of US securities laws on disclosure of the alleged inadequacy of its reserves during its IPO. A US class action settlement was agreed; however following Morrison the US District Court for the Southern District of New York decided it only had jurisdiction to declare the class action settlement binding on shareholders resident in the US and those who bought the securities in the US. Converium, ZFS and two Dutch foundations agreed on a settlement that was to provide for payment to those shareholders who were not part of the US class action settlement. They also agreed to petition the Amsterdam Court of Appeal to declare this settlement binding on this class of non-US shareholders under the Act. The petitioners estimate that the class includes approximately 12,000 shareholders, of whom only a small fraction appear to be residents of the Netherlands ⁶. The other class members are resident in the EU, states that are a party to the Lugano Convention, or in other states.

In a provisional ruling in November 2010, the Amsterdam Court of Appeal considered that the Dutch settlement complemented the US class action settlement and that only the Netherlands offered the possibility of having a settlement agreement declared binding on a whole class within the EU. The Court then concluded that it had jurisdiction to declare the Dutch settlement binding on all other class members excluded from the US class action and not resident in the Netherlands. In doing so, the Court relied on its finding that the characteristic obligation of the settlement agreement is the obligation to pay out the settlement amount. As this is an obligation of the Dutch foundations, who will pay out in/from the Netherlands, jurisdiction was established based on Article 5 of Regulation 44/201 (and the relevant provision of the Lugano Convention).

The Court further considered that by accepting jurisdiction and deciding the claims of all of the shareholders, the risk of conflicting judgments in different states could be averted. The provisional decision to accept jurisdiction in respect of shareholders resident in non-EU and Lugano states is based on the rule of Dutch civil procedure that a Dutch court has jurisdiction to hear cases that start with a petition (as opposed to a case that starts with the issuance of a writ of summons) if one or more petitioners are resident in the Netherlands. Since the Dutch foundations are based in the Netherlands, the Court has jurisdiction to hear the matter. The Court has explicitly qualified its decision as provisional, as the class members have not had a chance yet to put forward their views on the Court's competence to declare the settlement binding to the class pursuant to the Act. It is as yet unclear when a further hearing will take place.

But whether the Amsterdam Court of Appeal can become a venue of first instance for claims by European investors may be questionable. There are crucial differences to US procedure. Although the manner of settlement is similar to that in US class actions, the Act only takes affect if the parties reach an agreement on settlement terms. The Dutch legal system does not provide for a class action in the US style for bringing claims leading to collective monetary relief as it presupposes that actions for damages require individual assessment of claims. This is a significant obstacle to the development of a whole scale collective action practice in the Netherlands. Although the Court can endorse a collective settlement, which is binding on non-represented claimants, the procedure for a collective claim, addressing common issues of breach, causation, and loss, is less developed. The Netherlands also does not possess other important features of the well-oiled US class action machinery contingency fees, jury trials, and punitive damages.

A crucial question is whether other European courts will recognise a decision of the Amsterdam courts declaring a settlement binding on non-Dutch claimants, especially when those jurisdictions do not have class action settlement mechanisms themselves. Although the Brussels Regulation and the Lugano Convention require Member States to give recognition to judgments given in other Member States, it might be argued that such a decision violates principles of public order of the Member State in question.

Another possibility under Dutch law is a request for declaratory relief on the basis of article 3:305a of the Dutch Civil Act. Dutch law allows interested organisations to petition a court for a declaration at law, including a declaratory judgment on liability for certain damages (although as the requesting party is an interested organisation, it is not possible under this article to ask the court to estimate individual damages). Collective action on behalf of investors in Fortis has recently been commenced in respect of alleged fraud and misrepresentation in connection with the €13 billion rights issue in 2007, the value of which was lost in the credit crunch and collapse of Fortis in 2008. Notably, the claimant investor association (or "Stichting") is being advised by well-known US plaintiff law firm Grant & Eisenhofer, who have characterised this claim as representing a "new paradigm" for global securities claims.

In the event that the court declares the defendants liable, the individual claimant has to claim its individual damages separately. It is also possible that after the declaratory judgment the case will be settled between the defendants and the interested/representing organisation and the Amsterdam Court of Appeal will be requested to approve that settlement according to the Act.

Conclusion

The Morrison case has affected the dynamics of investors' claims for international companies with non-US investors. No doubt, their interest groups will bring what influence they can to bear on the SEC and the report that it is preparing for congress as to whether Morrison should be reversed by legislation. In the interim, they will seek to expand the scope for using collective action proceedings such as the Dutch Act not only for enforcing settlements, but also as a vehicle for bringing claims on behalf of investors in the first place. We may also see co-ordinated proceedings in various European jurisdictions develop to the extent that European states are reluctant to recognise decisions of the Amsterdam Court of Appeal under the Act. All in all, there will be much to watch over the coming months.

Footnotes

1 11 January 2011

2 17 March 2011

3 29 September 2010

4 28 September 2010

5 14 February 2011

6 200 of 2,000 shareholders whose contact details are known.

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Law Commission Consults On Alternatives To Criminal Prosecutions In Regulatory Contexts

By James Roberts

The Law Commission has consulted on issues surrounding criminal liability in regulatory contexts, a topic of particular interest in the current environment.

As we reported in the last edition of this publication, there has been a marked increase in frequency and severity of criminal and regulatory investigations into companies. A number of factors are contributing to this, but many can be traced to enforcement attitudes in the wake of problems and publicity ultimately linking back to the financial crisis. It is therefore timely that the Law Commission has consulted on a paper on criminal liability in regulatory contexts.

No doubt these consultation proposals will have a long gestation period and so we present here an initial assessment of the proposals together with some of the recently published responses from interested parties. We will report further on the implications as the debate progresses.

Law Commission proposals

The consultation paper states that the backdrop to its proposals is concern about the increasing number of criminal offences, in particular the fact that a substantial proportion of the 3,000 offences created since 1997 are targeted at business activity, notably in the commerce and financial services sectors. The Companies Act 2006 alone created 20 new offences concerned with the way that companies are established and run, as well as re-enacting 69 offences from previous legislation. The Commission considers that criminal sanctions should only be used to tackle serious wrongdoing, and recommends a reduction in the number of criminal offences used by government departments and agencies. The Commission argues that it is out of proportion for regulators to rely wholly on the criminal law to punish and deter activities that are merely "risky", because they have the potential to lead to harm, unless the risk involved is a serious one.

Of particular note, a number of the proposals in the report relate to establishing fault on behalf of companies and attribution of liability to directors and other individuals (contained in Part 7). The aim of the proposals is to ensure that the law does not target particular businesses (such as small businesses) unfairly, and that businesses and individuals should not be subject to criminal penalties where they have made an effort to comply with the law. In summary, the proposals are as follows:

• Limit the identification doctrine. In the absence of specific statutory provision, the default position for determining whether companies should be liable for statutory criminal offences involving proof of fault should not be the identification doctrine. This doctrine requires a controlling officer of the company him or herself to be proved to have had the fault element of the offence. It is the Commission's view that the doctrine can be more difficult to apply to large as opposed to small businesses, and it may therefore be applied with an unfair emphasis on small businesses. The Commission proposes that the correct approach is for the court to look to the underlying purpose of the statutory scheme for guidance on the right basis on which to hold companies liable for offences committed relating to that scheme.
• Use a due diligence test. Applying a presumption of fault when considering criminal offences under statute that do not involve proof of fault is not the best approach, particularly in regulatory contexts when companies are most likely to be the defendants. A presumption of fault involves the courts reading into the statutory wording a requirement of fault that the prosecution must prove, as a matter of fairness to persons accused of the crime in question. The Commission proposes that the courts should imply a "due diligence" test to such offences (in line with more modern statutes) which permits companies (or individuals) to escape conviction for offences under the statutes if the defendant can show that all due diligence was exercised and all reasonable precautions taken to avoid commission of the offence.
• Limit the attribution test. The statutory attribution of liability to individuals for offences committed by a company where that individual has consented to or connived in the acts constituting the offence is uncontroversial. However, some statutes have gone further, attributing liability where the individual has neglected to prevent the offence. For example, section 400(1) of the Financial Services and Markets Act 2000 (FSMA) provides that if an offence is committed by a body corporate under the Act and it is shown to be attributable to any neglect on the part of an officer then that officer will also be liable for the offence, despite the fact that offences under the Act vary considerably.

• Limit the delegation doctrine. Likewise, the delegation doctrine, which provides that where the running of a business is delegated from X to Y, X still remains liable to be convicted of an offence committed, in relation to the running of the business, by Y may be unfair and disproportionate. The Commission proposes instead, a focus on whether X failed to prevent the offence committed by Y.

• Regulatory authorities to make more use of cost-effective, efficient and fairer civil measures to govern standards of behaviour, such as "stop" notices, enforcement undertakings and fixed penalties.
• A set of common principles to be established to help agencies consider when and how to use the criminal law to tackle serious wrongdoing.
• Where criminal offences are created in regulatory contexts, they should require proof of fault elements such as intention, knowledge, or a failure to take steps to avoid harm being done or pose serious risks. The Law Commission considers that businesses and individuals should generally not be penalised by the criminal law if they have made real efforts to comply with relevant laws in place.

Responses to the consultation

While the Law Commission has not yet published responses to its consultation, a number of the organisations that have submitted responses have made them publicly available, including the Office of Fair Trading (OFT) and the GC100.

The OFT agrees with the rationale that the identification doctrine may be less fair to smaller businesses, and that the courts should look more closely at the underlying principles of the legislation being applied to ensure fairness for both businesses and consumers. However, the GC100 raises the need for clarity and is concerned that the proposal will make it difficult for companies to know in advance what action they must take or avoid so that they are not committing an offence.

Both the OFT and the GC100 share the view that that the courts should be a given a power to apply a due diligence defence to any statutory offence that does not require proof that the defendant was at fault. However, while the OFT would support the application of a stricter due diligence defence that the defendant must take "all reasonable precautions and exercise all due diligence" to avoid commission of the offence, the GC100 prefers a test of due diligence "exercised in all the circumstances" to avoid the commission of the offence. Nevertheless, the GC100 also recognises the need, in certain circumstances, for strict liability offences to exist.

As to the proposals that the attribution test is limited, unsurprisingly the GC100 and the OFT take very different views. While the GC100 argues that one of the difficulties in the test is determining what knowledge of the facts, action or inaction by a director amounts to consent or connivance, the OFT does not believe that directors should be able to escape liability for the actions of their companies when they had no knowledge of the offence in circumstances where that lack of knowledge or the commission of the offence arises from their own negligence.

Other respondents to the consultation take a much more critical view of the Law Commission's proposals. A paper by Professor Steve Tombs and Dr David Whyte of the Institute of Employment Rights argues that the organising assumption of the consultation (ie, that reliance on criminal law may prove to be an expensive, uncertain and ineffective strategy) lacks evidence. The Trading Standards Institute expresses concerns that the removal of a criminal deterrent may undermine the aims of trading standards work. Finally, attention is drawn to the proposal that criminal offences should only be created and amended through primary legislation. The UK Environmental Law Association argues that this proposal is unworkable, given the view that criminal offences can be an appropriate means of implementing European legislation while the Food Standards Agency considers that the proposal is a disproportionate response to concerns that there is insufficient challenge to regulators creating criminal offences.

Conclusions

Anything that can reduce the complexities of the current regulatory and criminal systems is to be welcomed. In addition, the current climate has seen an increase in the regulators targeting individuals for action on the basis that regulators believe it has a greater deterrent effect (such as the FSA's policy of credible deterrence). However, as the Law Commission has flagged in its report, there are instances where this can depart from the principle of fairness if an individual director can be convicted of a serious offence, such as market rigging (section 397(1) FSMA) requiring dishonesty or recklessness, due to mere neglect.

While the responses that are currently publicly available only give an indication of how the Law Commission's proposals have been taken, they suggest there is likely to be significant opposition to any attempt to weaken the criminal regulatory regime.

In any event, the Law Commission does not intend to publish its final report on the proposals until spring 2012. It will then be for Parliament to consider whether to accept the recommendations in the report and make changes to the law. This is something that is by no means certain given the current climate in which the Government and regulators are under public pressure to be seen coming down hard on misbehaviours in certain regulated sectors.

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News digest

FRC Report On Corporate Reporting And Audit

By The Financial Reporting Council (FRC) published a report for consultation on 7 January 2011, entitled "Effective Company Stewardship: Enhancing Corporate Reporting and Audit", which contains seven recommendations aimed at improving the dialogue between company boards and shareholders including:

• Directors should take full responsibility for ensuring that an annual report, viewed as a whole, provides a fair and balanced report on their stewardship of the business.
• Directors should describe in more detail the steps that they take to ensure the reliability of the information on which the management of a company is based and transparency about the activities of the business and any associated risks.
• The growing strength of audit committees in holding management and auditors to account should be reinforced by greater transparency through fuller reports by audit committees and an expanded audit report that includes a separate new section on the completeness and reasonableness of the audit committee report. This should also identify any matters in the annual report that the auditors believe are incorrect or inconsistent with the information contained in the financial statements or obtained in the course of their audit.

The consultation is now closed and details of the response awaited.

The FRC has also recently published "Guidance on Board Effectiveness" to assist companies in applying the principles of the UK Corporate Governance Code.

Representations By Directors In The Twilight Zone

In Lindsay v O'Loughnane (2010) the defendant was a director of two currency conversion companies. The claimant entered into a number of foreign currency exchange transactions with one of the companies but the claimant's money was not used to carry out the exchange and instead used to pay creditors of the company.

The claimant alleged that the defendant had made implied fraudulent misrepresentations by accepting his order, in terms that the defendant's currency exchange business was trading properly and legitimately and that by sending a trade note to the claimant, the defendant had implied that he intended to apply the claimant's monies to pay for the currency and hold them on trust in accordance with the terms and conditions that the claimant had signed.

The defendant submitted that none of these representations could be implied from the mere fact that the defendant, as a director and agent, had entered into a contract on behalf of the company. Otherwise, whenever a company became insolvent, directors and employees would be personally liable. The judge recognised the force of that argument where a director makes a contract in ignorance of the insolvent condition of the company. However, the judge held that in the present case the defendant knew the company was insolvent when it accepted the claimant's order. Therefore, the court held that the defendant had represented that the currency business was trading properly and legitimately, that this was false and therefore fraudulent. The director was held personally liable in deceit.

The case has implications for directors of companies in the "twilight zone" (nearing insolvency, somewhere between the point when the company's financial condition becomes difficult and the commencement of insolvency proceedings) who contract with third parties or continue to deal with them without letting them know of the company's difficulties. In such a case a director must be careful to ensure that there is no risk of misrepresentation, on which personal liability may attach.

In the Lindsay case the court went on to consider whether it would have allowed the corporate veil to be lifted, and the claimant to pursue a claim against the director that ought otherwise to have been pursued against the company. The court agreed that the only case where this has been permitted is where the director controlled the relevant company and used the corporate structure to disguise the wrongdoing, but the wrongdoing was nothing to do with the company. Here, the wrongdoing was at the heart of the actual business of the company (and might in due course give rise to an application for wrongful or fraudulent trading on the part of a liquidator) but it could not be said that the company was being used as a façade to disguise the director's wrongdoing.

Court Considers Whether A "Puppet" Can Be Placed In A "Puppeteer's" Contract

In Antonio Gramsci Shipping Corp & Others v Stepanovs (2011) it was alleged that the corporate defendants were used by their beneficial owners to divert opportunities and profits from the claimant companies. The claimant companies alleged that their senior executive officers had interposed corporate defendants (of which the officers were owners) as charterparties of their vessels, and the true arms-length charterers became sub-charterers at substantially higher rates. Judgment was entered against the corporate defendants. In this action, the claimants sought to pierce the corporate veil and pursue one of the owners. This judgment dealt with the owner's application to set aside service of the claim from out of the jurisdiction, on the basis that the courts of England and Wales did not have jurisdiction, as the owner was not a party to the charterparty contracts which contained the relevant jurisdiction clause.

The Court considered the case law and noted that the trigger for piercing the corporate veil is not fraudulent dealing by a company but the fraudulent use of the company structure. In this case the fraud was plainly not outside the ordinary business of the company because it was set up for the very purpose of fraudulent abuse. The owner accepted that, although the other owners were not a party to the proceedings, if there were a number of wrongdoers with a common purpose, in control of the "creature company", then they could all be said to be in material control so that the veil could be lifted as against one or all of them.

The owner further argued that it was not necessary to pierce the corporate veil where the claimants have an effective remedy against the company following Dadourian v Simms and other case law. The Court held that piercing the veil is exceptional, but it is not a requirement for a claim at the outset to be shown to be necessary. The claimants' case was that as a result of the piercing of the veil the owner was jointly and severally liable under the charterparties. There was no case law in which the "puppeteer" had been placed into the "puppet's" contract, but the Court found that there was no good reason of principle or jurisprudence why the victim cannot enforce the agreement against both.

The Court rejected arguments that the claimants had made an election to pursue the corporate defendants. The Court held that this could only be successful if the claims against the puppeteer and puppet were in the alternative, and if the decisions on election between principal and agent were extended, for which there was no justification. The Court held that it was not a case of a Russian doll with the company being lifted off and disappearing once the alter ego is revealed, but of the curtains being pulled back to reveal the puppeteer and the puppet. The application to set aside service was dismissed.

Conduct Is Still Dishonest Even If Some People Would Disagree

The issue for the Court of Appeal in Starglade Properties v Nash (2010) was whether the defendant director (Nash) had dishonestly assisted in a breach of trust by the company (Larkstore) of which he was sole member and director. It was accepted that there had been a breach of trust that Nash had assisted in, so the question was whether Nash's actions had been dishonest.

Under the terms of an agreement entered into by Nash and Larkstore, Larkstore agreed to pay Starglade half of the net monies received from litigation brought against a third party and to hold all monies on trust for division. The proceedings were settled on 26 January 2007 and Larkstore received approximately £300,000, 50 per cent of which was held on trust for Starglade under the agreement. At this point Larkstore was insolvent. However, instead of accounting to Starglade and taking steps to put Larkstore into administration between 31 January and 27 March 2007, Mr Nash distributed the whole amount amongst creditors including himself. Four of the six payees were, or were connected with, Nash.

The Court of Appeal reviewed the authorities, Royal Brunei Airlines v Tan (1995), Twinsectra v Yardley (2002), Barlow Clowes v Eurotrust Ltd (2006) and Abu Rahman v Abacha (2007) and concluded that the correct test for dishonesty was that laid down in Twinsectra, as interpreted in Barlow Clowes, namely that an enquiry into a defendant's views as regards what the normal standards of honesty are is not part of the test. The court must look at what a defendant knew about the transactions or other matters in question: that is the subjective element of the test. However, it is sufficient for a defendant's conduct to be dishonest judged by the ordinary standards of honest people: the objective element of the test.

At first instance the judge had concluded that the relevant standard was what all normal people would regard as dishonest and that where some people would regard the conduct as dishonest and others would not, the conduct was not dishonest. The judge concluded that, even though he had deliberately preferred other creditors, Nash had not acted dishonestly because the question of whether some directors may prefer some creditors over others is not one most people knew the answer to as a matter of law, nor was it one where there would be a general view as to whether such actions were dishonest. In this case Nash did not consider that his own actions were dishonest. The judge said the question of whether the actions were dishonest might depend on the nature of the advice received.

The Court of Appeal disagreed. It held that the relevant standard is the ordinary standard of honest behaviour and the fact that some might regard the standard as set too high is irrelevant. None of the leading authorities established that the standard was flexible and was to be determined by any one other than by the court on an objective basis. Nash's clear purpose had been to frustrate Starglade. This was achieved by leaving them to pursue an insolvent company without assets. Nash could not be protected on the basis that he had sought limited advice from his solicitor. The Court concluded that the deliberate removal of assets of an insolvent company specifically for the purpose of defeating the just claim of a creditor should not and does not accord with honest standards of commercial behaviour.

Update on Safeway Stores v Twigger

At the end of last year the Court of Appeal gave judgment in Safeway Stores v Twigger (2010) (discussed in the last edition of this publication). The Court of Appeal held in the case that the relevant companies' liability for fines for alleged breaches of competition law were personal to the company. The companies were barred by the principle of ex turpi causa from recovering the fines from the directors and employees that they alleged were responsible for the conduct that led to the fine. The judgment will make it significantly more difficult for companies to bring such claims in the future, although some of the judge's comments left open the possibility that claims might be possible where the company's offence is one of strict liability. The Supreme Court has refused Safeway permission to appeal and accordingly that case stands, which is a considerable relief to directors and their insurers.

Unlawful Distribution – Whether Directors' Intent Is Relevant

The issue in Progress Property Company Ltd v Moorgarth Group Ltd (2010) was whether there had been an unlawful distribution of capital to a shareholder. A company, PPC, sold the whole issued share capital of its subsidiary YMS Properties (No 1) Ltd to another company Moorgarth. PPC and Moorgarth were both subsidiaries of another company Tradegro. The aim of the sale was to remove some properties owned by YMS Properties (No 1) from PPC, before a sale of PPC to Mr Price. Mr Price was a director of PPC and held 25 per cent of its shares (the remaining 75 per cent held by Tradegro). PPC agreed to sell the share capital of YMS Properties (No 1) to Moorgarth for £63,223. This was calculated on the basis of the open market value of the properties said to be £11.8 million less £8 million in liabilities to creditors, less £4 million in respect of a release of an indemnity that PPC was believed to have given in respect of the repairing liabilities of another company in the group YMS, who was the lessee of the properties. However, there was in fact no such indemnity.

PPC, now under control of its new owner, claimed that the sale was at an undervalue, and had been an unlawful distribution of capital to its shareholder. It was accepted that that Mr Moore, a director of PPC and Moorgath genuinely believed that the sale of the shares was at market value, and there was no intention on his part to prefer Moorgarth.

The common law rule is that distribution of a company's assets to a shareholder, except in accordance with statutory procedures, is a return of capital which is unlawful and ultra vires the company. Lord Walker, giving the leading judgment, held that whether a transaction infringes this rule is a matter of substance not form. The essential issue was how the sale was to be characterised. PPC argued that the court should adopt an objective approach, so that there is an unlawful distribution whenever the company enters into a transaction not covered by distributable profits, regardless of its purpose.

Moorgarth submitted that the ultimate test was always one of the directors' subjective intention.

Lord Walker rejected the purely objective approach as oppressive and unworkable. Having reviewed the case law Lord Walker held that an investigation of all relevant facts is required, which will sometimes include the state of mind of the people who are orchestrating the corporate activity. Sometimes states of mind will be irrelevant, and a distribution described as a dividend but paid out of capital will be unlawful however technical the error and well meaning the directors. Where there is a challenge to the propriety of a director's remuneration the test is objective but probably subject to a margin of appreciation. However, the parties' subjective intentions are sometimes relevant, and a distribution disguised as an arm's length commercial transaction is a paradigm example. If a company sells to a shareholder assets at a low value the motives and intentions of the directors will be highly relevant. Questions will be asked such as whether the company was under financial pressure, did it take advice, was the market tested, and how were the terms of the deal negotiated. If it was a genuine arm's length transaction it will stand even if, with hindsight, it was a bad bargain. On an analysis of the facts, it was found in this case that the sale negotiated was not at a gross undervalue and the appeal was dismissed.

Lord Mance agreed with Lord Walker, adding that the question for the court was one of characterisation. The court will not second-guess companies with regard to the appropriateness or wisdom of any transaction, but there may come a point when looking at all of the factors an agreement cannot be characterised as anything other than a return or distribution of capital.

When Is A Director Of A Corporate Director Company A De Facto Director Of Subject Company

In Holland v HMRC (2010) the Supreme Court had to consider the issue of when a director of a corporate director of another company is to be regarded as a de facto director of that other company. Mr Holland was a director of Paycheck (Director Services) Ltd, which was in turn the corporate director of 42 composite companies. If he was held to be a de facto director of those companies, he could be held responsible for the payment of unlawful dividends under section 212 of the Insolvency Act 1986.

Section 212 allows the creditor of a company that has been wound up to request a court to compel an "officer" of the company to pay sums in respect of a misuse of power or breach of fiduciary duty. It was accepted that "officer" includes de facto director. A de facto director is someone who performs the functions of a director and who owes the same duties to the company as a director, but who has not been formally appointed.

The Supreme Court concluded by a majority of 3:2 that Mr Holland was not a de facto director. Their Lordships held that the focus of the court will be on what the individual does and not on what they are called. A critical question will be whether the individual is discharging functions that can only be properly discharged by a director.

The majority agreed that the starting point was to recognise that Mr Holland and Paycheck were separate legal persons. The following principles can be drawn from the majority judgments:

• The mere fact that the individual in question is acting as a director of the corporate director is not enough.
• If everything the individual does was under the umbrella of acting as a director of the corporate director, his acts must be attributed to that role (it was on this basis that Mr Holland was held not to be a de facto director).
• The fact that he might be the guiding mind behind the decisions made by the corporate director was not enough to render him liable.
• To determine otherwise was a matter for the legislature not the courts. (Lord Collins pointed out that Parliament had recently intervened by enacting section 155(1) of the Companies Act 2006 (not in force at the time of the actions at issue in Holland) which provides that at least one director of a company must be a natural person.

The minority dissenting judgments focussed on the fact that Mr Holland had taken all the important decisions in relation to the composite companies. The minority argued that the majority had wrongly adopted a strict focus on capacity.

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