A Practical Guide to Private Equity Transactions

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Directors’ duties and conﬂicts of interest

This effectively means that there is a minimum standard required by law of

all directors, which is increased should the director have a higher standard of

actual knowledge, skill and experience. A director cannot rely on the fact that

he is generally incompetent to impose an incredibly low standard of skill and

care. However, a director is not expected to have a highly specialised level of

expertise in all areas, only those where he has particular skill and experience.

For example, a director on the audit committee who happens to be a quali-

ed accountant would have a greater duty of care than a director who is not

so qualied. It should also be noted that executive directors might often have

a degree of skill and care imposed by their service contracts which is greater

than the statutory one.

6.7 Duty to avoid conﬂicts of interest (section 175)

The common law on conicts prior to the 2006 Act required that a director did

not put himself in a position where his personal interests conicted with those

of the company, unless the shareholders had consented to such conict. In line

with the general trend towards increased board scrutiny and accountability, the

2006 Act introduces a new statutory duty for directors to avoid any situation

in which he has or can have an interest, direct or indirect, which conicts (or

could conict) with the interests of any company of which he is a director.

The main difference is that, under common law, when a conict of inter-

est arose, directors would be expected to take steps to mitigate the situation,

whilst, under the 2006 Act, the new duty obliges directors not to let the conict

situation arise in the rst place. However, there are three statutory exceptions

where the duty would not be breached:

(a) where the relevant matter cannot reasonably be regarded as likely to give

rise to a conict of interest;

(b) where the relevant matter involves a transaction or arrangement with the

company; this distinguishes the situational conicts that arise generally

(covered by section 175) with transaction-specic conicts (where the mat-

ter would need to be declared to the board under sections 177 or 182 of the

2006 Act);

and

the unconicted directors.

There is no statutory denition of a conict of interest. However, section 175

is very widely drafted in that it catches situations that possibly may result in a

conict. The 2006 Act makes it clear that this includes the exploitation of prop-

erty, information or opportunity, and the fact that the company itself could not

take advantage of that property, information or opportunity is irrelevant. The

sort of conict situations which could be caught include cross-directorships

47 See sections 6.9 and 6.10 below.

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Living with the investment

(whether within or external to the group); being or representing a signicant

shareholder in the company (such as an investor director); being on the board

of the company’s pension trustee company; or owning a piece of land next to

the company’s premises, the value of which could be affected by the com-

pany’s activities. A useful general rule is to regard an ‘interest’ as a very broad

term that includes any thing (or any connection) which could potentially divert

a director’s mind from giving sole consideration to promoting the success of

the relevant group company.

The concept of boards authorising conict situations was introduced by the

2006 Act. Whilst only conict situations that arise after 1 October 2008 need

to be authorised, it is considered best practice also to authorise any conict situ-

ations in existence before 1 October 2008. Directors should go through a process

of identifying their conict situations, and then make arrangements for such situ-

ations to be authorised. This new duty to avoid conict situations is a statutory

one that each director has a personal responsibility to perform. Ideally, directors

should complete a questionnaire to ush out any direct or indirect conict situ-

ations, and such conict situations that do not fall within the exceptions should

be authorised by the shareholders or the unconicted directors.

As for the duty to exercise independent judgment,

it is becoming com-

mon for the articles of association in a private-equity-backed company to pre-

authorise the situational conicts inherent in a buyout. For all directors, this

will include the situational conict that arises as a consequence of a director

being a director of other group companies. In the case of an investor director,

a situational conict also arises as a consequence of the individual being an

employee or representative of the relevant private equity rm, and having a

direct nancial interest in the return achieved by the investor shareholders by

way of carried interest or any relevant co-investment. Investor directors and

other non-executive directors may well sit on the boards of other companies,

that could include customers, suppliers or even direct competitors. The word-

ing that is now generally being included in the articles of association of inves-

tee companies is therefore quite extensive, to ensure that any such conicts are

pre-authorised in so far as that is possible.

The advantage to including such provisions in the articles from the outset is

that all directors (and, in particular, the investor director) can be certain from

the beginning of an investment that these inherent conicts are approved, and

that he will not be in breach of his duties to Newco under the Act, or depend-

ent on managers to pass resolutions at board level to approve the situation. The

same mechanism in the articles can also conrm the ability of the investor dir-

ector to pass condential information to the investors, or protect the investor

director from any claim that could otherwise arise for not passing to Newco

any condential information of which he becomes aware through his involve-

ment in the private equity investors or one of its other investee companies. It

48 See section 6.5 above.

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Directors’ duties and conﬂicts of interest

would not be practicable to manage a private equity portfolio if the duties that

an investor director owed to one company required him to disclose to that com-

pany condential information relating to other companies in the portfolio.

6.8 Duty not to accept beneﬁts from third parties (section 176)

A director must not accept a benet from a third party conferred by reason

of (a) his being a director, or (b) his doing (or not doing) anything as director.

There is an exception that states the duty is not infringed if the acceptance of

the benet cannot reasonably be regarded as likely to give rise to a conict of

interest. Directors will therefore need to consider carefully whether they are

able to accept corporate hospitality, and each benet would need to be consid-

ered in context.

There is no denition of benet in the 2006 Act, and there is no de minimis

threshold. As a result, a common sense approach, with a hint of caution, needs

to be taken. Companies may wish to amend their internal codes of conduct or

policies to enshrine this approach.

In private equity situations, it is not uncommon for investors to agree that

particular directors (for example, its appointed chairman, or a trouble-shooter

appointed on an underperformance) should be remunerated directly by the

investors – typically to motivate an exit by agreeing to pay the director con-

cerned a share of the investors’ exit proceeds. Historically, such arrangements

might even be entered into behind the scenes, without the knowledge of the

other directors or shareholders. Such an agreement could fall foul of this sec-

tion if there is any argument that the conduct which is necessary to trigger the

payment might in any way conict with the interests of the company. To avoid

any doubt, such exit incentives may be better paid by the company itself rather

than the investors, and with the full knowledge and authorisation of the other

directors or shareholders.

6.9 Duty to declare interests in proposed transactions or

arrangements (section 177)

If a director has an interest, whether direct or indirect, in a proposed trans-

action or arrangement with the company, then he must declare the nature and

extent of that interest before the transaction or arrangement is entered into.

This provision deals with so-called ‘transactional’ conicts, i.e. a conict that

arises as a consequence of a particular transaction that is to be entered into, in

contrast to the ‘situational’ conicts covered by section 175.

There are a number of ways a director may declare the interest. It may be

made at the rst board meeting after which his interest arose or he became

aware of it, or it may be made by way of written notice which must be read out

at the next board meeting. Finally, a director can give a general notice to the

board that he is deemed to be interested in all transactions with a particular

organisation. Many articles of association stipulate that a director cannot vote

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at, or be counted in the quorum of, a board meeting at which the proposed

contract is to be considered; this must be checked where any such transaction

or arrangement is to be approved.

Such transactional conicts arise all the time on private equity transac-

tions. All such interests must be considered and declared by management and

investor directors alike. As shareholders in the company (or investor directors

with an interest in the underlying performance of the investor shareholders),

directors will inevitably have a personal interest in matters to be considered by

the board relating to the initial transaction, further renancings or restructur-

ings, and the ultimate exit. It is important to ensure that all of such interests are

declared, and carefully minuted.

6.10 Declaration of interests in existing transactions (section 182)

Whilst not strictly one of the codied directors’ duties, there is also a require-

ment for directors to declare an interest (direct or indirect) in an existing trans-

action or arrangement entered into by the company.

This declaration must be made as soon as reasonably practicable, and may

be made by way of written notice or general notice. The notice must state

the nature and extent of the director’s interest in the body corporate or rm,

or the nature of the connection with the person. The gener al notice must be

given either at a meeting of the directors, or the director has to take reasonable

steps to ensure it is brought up and read at the next directors’ meeting after it

is given. If a director has declared an interest in accordance with section 177

(i.e. at the time the transaction or arrangement was proposed and before it was

entered into by the company), then there is no need for the director to repeat

the declaration under section 182 when the proposed transaction or arrange-

ment becomes an actual one.

6.11 Transactions between companies and directors

In addition to the new statutory duties of directors, the 2006 Act provides that

certain contracts between a company and its directors are prohibited unless

shareholder approval has rst been obtained. For these purposes, shareholder

approval means an ordinary resolution, unless the articles of association pre-

scribe a higher threshold. Most of these rules also apply if the director in question

is a director at the holding company level (i.e. a director of a holding company

must seek approval from the shareholders of that holding company where such

matters are transacted by the relevant subsidiary of that holding company).

(a) Directors’ long-term service contracts (sections 188 and 189)

Directors’ service contracts in excess of two years’ duration (previously ve

years), and incapable of termination by the company before the end of such

term or capable of termination during that term only in specied circum-

stances require shareholder approval.

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Directors’ duties and conﬂicts of interest

(b) Substantial property transactions (sections 190–196)

Substantial property transactions with directors (or shadow directors) or con-

nected persons, where the assets transferred exceed £100,000 or, if lower, 10

per cent of the company’s net assets require shareholder approval. Assets worth

less than £5,000 (previously £2,000) are not included.

Shareholder approval is necessary for a range of payments connected with a

director losing the ofce of director or retiring from that position. Additional

payments requiring approval include:

(a) payments for the loss of any other ofce or employment connected with

managing the company or any subsidiary undertaking;

(b) payments on retirement from any other ofce or employment connected

with managing the company or any subsidiary undertaking;

retires; and

(d) payments by a company to a director of its holding company who loses

ofce/retires.

However, there are a number of exceptions to the need for shareholder approval,

for example in relation to payments to discharge an existing legal obligation

(which captures most circumstances where a bona de payment is made under

a compromise package for the termination of a manager’s employment), and

certain small payments.

(d) Loans to directors (sections 197–214)

The general prohibition on loans to directors that subsisted under the Companies

Act 1985 has been abolished by the 2006 Act. A company can make a loan

to a director of a company, or of its holding company, and provide guarantees

or security to a person who has made a loan to such a director, but only once

shareholder approval has been obtained.

Quasi-loans (e.g. for season tickets) and credit transactions (e.g. arranging

credit card facilities for a director’s use) are still permissible, but in the case of

public companies (and private companies associated with public companies)

these also require shareholder approval.

There are a number of exceptions to the requirement for shareholder

approval, notably a small loan exception which applies to loans of £10,000 or

less (up from £5,000).

49 Section 220 of the Companies Act 2006.

50 Section 221 of the Companies Act 2006.

51 Section 198 of the Companies Act 2006.

52 Section 207 of the Companies Act 2006.

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6.12 Corporate directors and insolvency

The insolvency of companies and the responsibilities of directors of insolv-

ent companies are governed by the Insolvency Act 1986 and the Company

Directors Disqualication Act 1986. These statutes place some of the strictest

standards on directors in carrying out their duties.

A company is insolvent where:

(a) it is unable to pay its debts as they fall due; or

(b) the value of its assets is less than the amount of its liabilities, taking into

account its contingent and prospective liabilities.

The consequences of a company insolvency can be extremely serious for a

director, not least because he can leave himself open to personal liability and

disqualication. In order to minimise his potential liability, a director should

inform the board as soon as he suspects that the company is heading for insolv-

ency. He must also ensure that accurate and up to date nancial information is

available to the board.

If there are cash ow problems, steps should be taken to alleviate the dif-

culties, such as realising assets and chasing debtors, raising additional equity

capital or arranging for a sale to a larger organisation able to assist the com-

pany with its difculties. If the cash situation is so critical that future trading

becomes impossible, the directors must either reach an informal arrangement

with the company’s creditors or follow the formal insolvency procedures.

Professional advice is essential in such circumstances.

(a) Fraudulent trading

If any business of a company has been carried on with intent to defraud cred-

itors of the company, or creditors of any other person, or for any fraudulent

purpose then:

(a) every person (including a director) who was knowingly a party to the car-

rying on of the business in that manner is liable to imprisonment (up to

ten years) or a ne (unlimited) or both (and this applies whether or not the

company has been, or is in the course of being, wound up); and

(b) if it appears in the course of winding up a company that this has been the

case, the court may, on the application of the liquidator, declare that any

persons (including directors) who were knowingly parties to the carrying

on of the business in that manner are to be personally liable to make such

contributions to the company’s assets as the court thinks proper.

The classic example of fraudulent trading is where a company continues to

carry on business and to incur debts at a time when there is, to the knowledge

of the directors, no reasonable prospect of the creditors ever receiving payment

of those debts.

53 Section 213 of the Insolvency Act 1986.

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Directors’ duties and conﬂicts of interest

The fraudulent trading rules have not been particularly successful because

persons have escaped liability due to the absence of actual knowledge, fraudu-

lent intent or bad faith, or because no new liabilities have actually been

incurred. The remedy of wrongful trading, however, imposes liability in cases

where directors have failed to exercise sufcient diligence in monitoring the

company’s affairs, and to take corrective action in the face of insolvency.

(b) Wrongful trading

Wrongful trading is a civil remedy and only applies where a company has gone

into insolvent liquidation.

The courts are empowered, on the application of the liquidator, to order a

past or present director (or shadow director) to contribute to the assets of the

company where, prior to the commencement of the liquidation of the com-

pany (whether voluntary or compulsory), the director knew or ought to have

concluded that there was no reasonable prospect of the company avoiding an

insolvent liquidation.

The function of the courts in dealing with wrongful trading is to com-

pensate the creditors rather than to penalise the directors. Consequently, the

amount that a director will be ordered to contribute will be the amount by

which the company’s assets have been depleted as a result of that director’s

conduct. A lack of fraudulent intent on the part of the director will not neces-

sarily restrict his contribution to a token amount. The director will also be

ordered to pay interest on the amount of his contribution from the date of

commencement of the liquidation, and will have to pay the legal costs of the

person taking the action.

The director will be able to avoid liability if he can show that, once he

knew or ought to have concluded that there was no reasonable prospect of the

company avoiding an insolvent liquidation, he took every step that ought to

have been taken to minimise the loss to the company’s creditors.

The standard to be applied in determining what steps a director ought to

have taken is that of a reasonably diligent person having:

(a) the general knowledge, skill and experience to be expected of a person

carrying out the director’s functions; and

(b) the knowledge, skill and experience that the director actually possesses.

In other words, the standard includes both objective and subjective elements,

similar to those imposed on directors generally under the new duty to exercise

reasonable care, skill and diligence.

The court will have regard to the func-

tions carried out by the director in question, as well as to the particular com-

pany and its business.

54 Section 214(2) of the Insolvency Act 1986.

55 Section 214(3) of the Insolvency Act 1986.

56 Section 214(4) of the Insolvency Act 1986.

57 Section 174 of the Companies Act 2006; see also section 6.6 above.

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What will constitute ‘every step’ will depend on the particular circum-

stances, but could include the sale of assets to meet liabilities, the cessation

of trading, the prompt obtaining of professional advice, or the appointment of

an administrator. It is unlikely that simply resigning will absolve the director

from responsibility, although it may do so if he resigns because his fellow dir-

ectors will not take the appropriate action.

If the court makes an order for contribution against a director, it is also

empowered to make a disqualication order against that director.

Wrongful trading issues must be considered in any situation where an

underperformance arises that is of such signicance that it may call the future

solvency of the investment into question. A wrongful trading action may be

brought against shadow directors as well as actual directors. As a result, the

issue is relevant not only to managers and investor directors, but also poten-

tially to observers or other executives at the private equity rm in the event

that the board is accustomed to acting at the direction of those individuals.

Professional advice is essential in such circumstances – not only when the

issue is rst brought to the attention of the individuals concerned, but also

as any negotiations for a proposed restructuring of the investee company are

continuing.

6.13 Practical guidance on directors’ duties

It should be apparent that the law governing the duties of directors is extensive

and far-reaching. It includes substantial historic case law, the new codied

duties, insolvency legislation and specic obligations. The question a prac-

titioner is often asked, therefore, is whether any practical, easily digestible,

guidance can be offered to enable directors to understand the general nature of

their duties, the pitfalls to look out for, and the steps that can be taken to avoid

potential claims.

At the time that the new general duties were introduced, the Department of

Trade and Industry published a high-level summary of what directors should

and should not do,

which included the following general principles:

Act in the company’s best interests, taking everything you think relevant into •

account.

Obey the company’s constitution and decisions taken under it.•

Be honest, and remember that the company’s property belongs to it and not to •

you or its shareholders.

Be diligent, careful and well informed about the company’s affairs. If you •

have any special skills or experience, use them.

Make sure the company keeps records of your decisions.•

Remember that you remain responsible for the work you give to others.•

58 Companies Act 2006; DTI, Duties of Company Directors: Ministerial Statements (June

2007).

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Avoid situations where your interests conict with those of the company. •

When in doubt disclose potential conicts quickly.

Seek external advice where necessary, particularly if the company is in nan-•

cial difculty.

In addition to this guidance, there are also some practical steps that can be

taken to mitigate against potential claims such as:

Ensure that all new and existing board members are fully briefed on their new •

statutory duties.

When preparing board papers, ensure that any declarations of interest are •

correctly minuted, and that all relevant factors are properly considered.

Review director and ofcer liability insurance policies, to ensure that •

adequate protection is in place for any actions that may arise for breach of the

new codied duties.

7 Conclusion

In this chapter, we have considered some of the issues that can arise during

the lifetime of an investment, and how the documentation and procedures put

in place at the time of the original deal seek to anticipate and regulate these

issues. The importance of good planning (and learning from past mistakes)

when drafting the initial deal documents cannot be understated. When the

time comes to rely on these provisions, the interests of the various participants

can diverge markedly, particularly in an underperformance situation. The

documentation can strengthen the hand of a party, even though the underlying

economics will normally drive the overall outcome.

We have also highlighted the vulnerability of the management equity in an

underperformance situation. It is the instrument that gets the best overall return

per pound invested when all goes well but, by the same token, it is the rst to

lose value and to become worthless. This can create challenges for the inves-

tors and the bank funders, however, given the need to motivate the remaining

and/or replacement managers to turn around the company’s fortunes.

There are numerous inherent conicts of interest in private equity transac-

tions, particularly when considering the interests of the various directors, and

the investor director(s) in particular. Investors and management teams alike

must take all appropriate steps to regulate their behaviour against the back-

ground of the codication of directors’ duties, as well as being mindful of their

duties to creditors should underperformance suggest a risk of insolvency.

Enhancing value during the life of the investment is key to maximising the

interests of all parties to a private-equity-backed deal. For this reason, many

private equity investors will be sensitive to the need to maintain a good work-

ing relationship with their management teams, and do not always press home

the full legal or economic strength of their position either at the time the deal

is negotiated or afterwards. When that trust and condence has evaporated,

the need to move quickly and decisively to protect the investment becomes

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Living with the investment

paramount. If a private equity investor ever has to use (or threaten the use of)

the big stick that the key protections in the investment documents provide, the

chances are that the investment is already signicantly weakened if not fatally

undermined. There may be no choice – but the outcome is rarely satisfactory,

and can also have reputational consequences for both the private equity rm

and the investee business.