Trustees, Directors Duties and the Companies Act 2006

To many who are already familiar with charitable trusts, whether in the form of companies limited by guarantee or not, the codification of directors duties in the Companies Act 2006 is unsurprising. Charities almost all have provisions for conflicts of interest in their constitutions. Trustees and those who advise them are familiar with the concept of avoiding conflicts of interest. This paper therefore attempts to explore whether or not anything really has changed and what might be the effect on charities immediately or in the future. The conclusions reached are merely observations of my own about the sector, governance within charities, and available case law. I admit to a degree of reliance on the learned writings of others in tackling the subject and in particular the writing of Matthew Conaglen on this subject.

Companies Act 2006

The seven general duties owed by directors appear in sections 171-177 and are the duty

  • To act within their powers
  • To promote the success of the company
  • To exercise independent judgment
  • To exercise reasonable care, skill and diligence
  • To avoid conflicts of interest
  • Not to accept benefits from third parties
  • To declare an interest in a proposed transaction or arrangement

Section 175 the duty to avoid conflicts of interest

Trustees and directors are of course fiduciaries owing duties to their charities. In essence they must act in good faith, must not put themselves in a position where their interest and duty conflict and must not derive any personal benefit from their position. (Mothew)

Taking a very broad approach trustees should avoid situations where they will enjoy direct financial gain, indirect financial gain or where they are placed in a position where there is a conflict of loyalty. Equity has formulated these into the self-dealing rule and the fair dealing rule. Arguably, both are simply examples of the fiduciary duty operating in different factual contexts. Breach of the fiduciary duty may have different remedies and consequences depending on which rule has been violated. The distinction between the rules was drawn in Tito v Wadell (No. 2)

“The self dealing rule is…that if a trustee sells the trust property to himself, the sale is voidable by any beneficiary ex debito justitiae, however fair the transaction. The fair-dealing rule is… that if a trustee purchases the beneficial interest of any of his beneficiaries, the transaction is not voidable ex debito justitiae, but can be set aside by the beneficiary unless the trustee can show that he has taken no advantage of his position and has made full disclosure to the beneficiary, and that the transaction is fair and honest".

Further, although the duty in s.175 of the Companies Act 2006 is expressed in very general terms, the inclusion of the section 177 duty implicitly recognises and codifies the differences between the self dealing and fair dealing rules.

The self dealing rule concentrates on transactions and the direct or indirect financial benefit a trustee may derive from a particular transaction. The consequences of and application of this rule have at times been harsh. It can be traced as far back as Keech v Sandford in [1726] That case and many since have concerned interests in some form of property but the principle, applies equally to knowledge as the most striking case of Boardman v Phipps shows. The fact that a profit, direct or indirect, has been made in circumstances where a fiduciary relationship is found will be enough to question the validity of any transaction. In this context protestations of good faith or an absence of knowledge might not have much force, see for example Regal Ltd v Gulliver [1942].

Finding that there is a fiduciary relationship has historically spread into situations other than the relationship of trustee and beneficiary. Agents, solicitors and even pawnbrokers have been impressed with this duty. Company directors have long been recognised as fiduciaries so the provisions in the Companies Act 2006 are truly a codification of the existing extensive case law.

Any relaxation of the rule on the grounds of “fairness” is limited but does exist. The strictness of the rule can be reduced by the concept of equitable remuneration for technical, honest, and perhaps judicious breaches of trust. In Re Worthington [1954] the inherent jurisdiction of the Court to award remuneration was to be exercised “only sparingly and in exceptional circumstances”. A trustee may also approach the Court for retrospective approval of actions taken. Prospective approval in the form of directions requested by a trustee can also be obtained.

The Fair Dealing Rule

It has been argued that the difference between the two rules is that if the trustee gains the full consent of the beneficiaries based on accurate knowledge and if he can show that he took no advantage of his position and the beneficiary received full value, then the transaction is unlikely to be set aside. The fair dealing rule does therefore truly include an assessment of fairness.

Coles v Trecothick

a trustee may buy from his cestui que trust, provided there is a distinct and clear contract, ascertained to be such after a jealous and scrupulous examination of all the circumstances, proving, that the cestui que trust intended, the trustee should buy; and there is no fraud, no concealment, no advantage taken, by the trustee of information, acquired by him in the character of trustee.

This formulation of the rule and the emphasis on the state of knowledge of the parties relates to the directors duty set out in s. 177 to declare an interest. The judgement of whether or not something is “fair” has developed into a doctrine of transparency based on informed consent in any situation. In the Companies Act 2006 the duty is with regard to proposed transactions but also continues if the transactions change in nature. The duty is expressed in mandatory terms and the director must make the declaration prior to the transaction being entered. The state of the other directors knowledge may be taken into account and the director need not declare an interest if it cannot reasonably be thought that there is a conflict of interest.

Deliberate concealement/transparency

It is clear from the wording of s. 177 that imposing a continuing duty and referring to other people’s state of knowledge is an attempt to codify in the most general terms the case law including the cases on deliberate concealment. The state of each party’s knowledge may be critical in each case. The issue is therefore whether or not disclosure by the benefiting party is adequate to discharge the fiduciary duty.

In Tate v. Williamson, Lord Chelmsford L.C. observed that a transaction between a fiduciary and his principal is liable to be set aside:

“once it is established that there was a concealment of a material fact, which the [fiduciary] was bound to disclose. Nor, after this, is it of any importance to ascertain the real value of the property. Even if the [fiduciary] could have shewn that the price which he gave was a fair one, this would not alter the case against him”.

Conflicts of loyalty

Both the above rules can be seen to be concerned mainly with transactions and direct or indirect financial benefit. The differences between them, despite the dicta in Tito v Waddell appear to be in the differences in on whom the burden of proof lies and thereafter, perhaps a difference in the strictness of the duty. The obvious difference remains the remedy for breach of each of the above rules. The common origin of the rules, the fiduciary relationship, means that the two rules are allied even though apparently distinct. There are many articles written about whether or not there is one rule or two but from a practitioners stance it does not particularly matter which is the operating rule as the reality of the case is that both will be pleaded. Procedure, sufficiency of evidence and the availability of remedies is however not within the scope of this paper and will have to be addressed another time.

A more difficult scenario and perhaps a more common one may be where there is a conflict of loyalty apparent but no tangible benefit can be properly assessed. Again I have to admit to some assistance in the form of articles written by others including an excellent article by Matthew Conaglen in January’s Law Quarterly Review. The article attempts to address the question of what is an “interest” of the trustee or director which gives rise to an actual or potential conflict of interest. He classifies the scenarios in terms of the fiduciary’s level of involvement. The interest concerned could be personal and beneficial to the trustee, could involve some participation by the trustee but lack any beneficial entitlement, or could be any involvement without any personal beneficial interest.

The first two categories could be viewed as the same direct and indirect personal or financial gain mentioned at the beginning of this paper. It really does not matter how the level of actual or potential conflict is assessed- by reference to benefit gained, by reference to the degree of knowledge, or by reference to the degree of involvement or any combination of the above. The cases do not neatly fall into any one category or other and many are unique on their facts.

I do agree though that there is a clear body of case law concerning divided loyalties.

In Bristol and West Building Society v Mothew, which is “widely regarded as masterly survey of the modern law of fiduciary duties”, Millett L. J. stated that:

“A fiduciary who acts for two principals with potentially conflicting interests without the informed consent of both is in breach of the obligation of undivided loyalty [which] automatically constitutes a breach of fiduciary duty”.

In the case where a Trustee wanders into a position of actual conflict he has no option but to immediately cease to act. However, the duties in the Companies Act 2006 do act prospectively and are perfectly capable of concerning situations where there is merely the potential for a conflict of interest. The extent of the existing case law also included both actual and potential situations of conflict.

The point made by Mr Conaglen is that where a trustee has two potentially conflicting duties the test established in Mothew that the trustee should act in good faith, is inadequate. If the duty of loyalty is now classed under s.177 is a fiduciary duty it seems strange to judge liability on the basis of the trustee’s motivation as he alone only truly knows this fact.

Instead of approaching the issue as a practitioner would, by assessing the consequences of a breach, there is growing support for the idea of this duty as an inhibitor to conflicts of interest ever happening. The temptation though is to seek to impose some consequences on a trustee if the duty is breached otherwise there would be no point in having such a duty.

In my view, the issue of a need for increased and better governance by trustees and charities is the manifestation of the growing importance of transparency as a general principle in conflicts of interest. The growing call for greater transparency is not restricted only to charities but to the wider business community.

The extract below is taken from an essay by American professors of business ethics including Warren Bennis,

“When we speak about transparency and creating a culture of candour we are really talking about the free flow of information……. For any institution the flow of information is akin to the central nervous system: the organisations effectiveness depends on it. An organisations capacity to compete, solve problems, innovate, meet challenges, and achieve goals……varies to that degree that information flow is healthy.”

He goes on to say that often it is only lip service that is paid to these principles and that since Sarbanes – Oxley corporate governance in the U.S. has become more transparent. He concludes though,

“That only the character and will of those that run [them]and participate in them can make organisations open and healthy.”

Many of the articles written about the duties in the Companies Act have correctly advised that the adoption of a conflict of interest policy and register of interests will be sufficient to discharge the duty of loyalty in s. 175. In this respect I agree (unusually) with the American Professor in that the policies are only as good as the people applying them.

Conclusion

Apart from the obvious difficulty of trying to prove a negative, i.e. that X did not fail to adequately avoid conflicts or declare interests however remote. Alternatively, in some circumstances liability for an omission either to disclose information or to avoid becoming involved in something might be imposed.

So to those who say the codification of these already established duties will have no effect I would disagree. The change is so subtle that it has largely gone unnoticed and many articles on the subject advise that governance, such as having a conflicts of interest policy, is more important than ever, very few have actually considered how this might play out in reality. Both statutory duties could be viewed as positive duties but just their presence may mean that a Court assesses the facts of a case from a different starting point. It gives the Court a new reason to reassess the differences between self dealing cases and fair dealing cases, to standardise the differenct burdens and sufficiency of proof. An opportunity to reassess the role of good or bad faith is also presented.

The fine distinctions between self dealing cases and fair dealing cases may become distinctions between direct or indirect benefits, or transactional or loyalty based duties.