UK: 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.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.