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Conflicted

Will Section 175 of the UK Companies Act of 2006 materially change the law on private equity directors' conflicts of interest?

James MacArthur is a partner in the corporate group of Kirkland & Ellis International in London. He can be reached at jmacarthur@ kirkland.com.

It is well established in the UK that company directors have a fiduciary duty not to allow their personal interests to conflict with the interests of the company of which they are a director. As a result, private equity executives appointed to the boards of portfolio companies must take care to identify any conflicts of interest, and to manage conflict of interest situations as they arise appropriately.

This duty to avoid conflicts of interest was originally established by common law and equitable principles, but starting October 1, 2008, the rules will be enshrined in statute by virtue of section 175 of the Companies Act 2006 (?Section 175?). There has been much debate as to whether Section 175 simply codifies the current law, or whether it expands the existing fiduciary duty. The concern arises because Section 175 places a statutory duty on a director to ?avoid a situation in which he has, or can have, a direct or indirect interest that conflicts with or may conflict with the interests of the company.? It has been suggested by some commentators that this new formulation may create difficulties for private equity investment professionals who sit on the boards of portfolio companies, as it may not always be possible within a private equity structure to ensure that conflicts of interests will not arise. Others argue that Section 175 simply restates the existing position.

During parliamentary debate, the Solicitor General took the view that Section 175 simply reflects the current law. However, the GC100 group (of general counsel to FTSE 100 companies) recently expressed the view that the law has in fact changed, suggesting that the conflicts regime is now preventative rather than reactive. At present, if a material conflict of interest arises, the director concerned will generally take steps to mitigate the conflict by, for example, absenting himself from board discussions and, in extreme cases, standing down from the board. Under Section 175, however, directors are required to prevent situations of conflict from ever arising, unless they have the prior consent of the board (or shareholders, if so provided in the company's articles of association).

Section 175 does state that the duty to avoid conflicts of interest is not infringed where a situation ?cannot reasonably be regarded as likely to give rise to a conflict,? but the scope of this safe harbour is clearly open to interpretation, and has yet to be tested.

Authorization of conflicts
It is clear, however, that from October 1, 2008 there will be a change in the procedure for authorising conflicts of interest. Under the current regime, directors might seek to obtain shareholder approval of any conflict of interest that arises to avoid breaching their fiduciary duties. Section 175 instead provides that conflicts may be authorised by the other directors of the company, provided that the company's articles of association do not invalidate such authorisation (although in respect of companies incorporated prior to October 1, 2008 and public companies, these provisions will only apply if the members have resolved to adopt them).

When a board of directors considers whether or not to authorise a conflict of interest, each authorising director (none of whom may be interested in the matter being authorised) will need to have regard to his own duties to the company, including the duty to act in a way he considers, in good faith, will be most likely to promote the success of the company. In most cases, this should provide comfort for shareholders that the board will only sanction conflicts that are in the interests of the company. However, if the shareholders do not feel that this offers adequate protection, it is possible to use the company's articles of association to override the new director approval powers and reserve to the shareholders the right to approve (or disapprove) conflicts of interest.

Impact on private equity firms
Private equity firms typically build portfolios of companies, often in defined industry sectors and it is commonplace for investment professionals working for a private equity firm to sit on the boards of multiple portfolio companies. This practice can give rise to various conflict of interest issues.

In January 2006, while the new Companies Act was being reviewed by Parliament, the chief executive of the British Private Equity and Venture Capital Association (BVCA) wrote to the Department of Trade and Industry (now the Department for Business, Enterprise and Regulatory Reform) expressing concern that the new rules could prove particularly problematic for the private equity industry. Specifically, on each occasion a private equity firm wished to appoint an investment professional to the board of an additional portfolio company, the board of each existing portfolio company of which they were already a director would need to authorise such appointment if there were any risk that the interests of the two companies might conflict. In confidential situations, it may be difficult to obtain the necessary authorisation, such that the only option left to that director would be to resign from the board of one of the companies.

Whether or not the BVCA's concerns prove to be founded remains to be seen (and we will only be able to judge once the new statutory provisions have been tested). During debate, the Solicitor General stated that ?there is no problem with people holding multiple directorships,? but that has not allayed the concerns of many at the impact of Section 175.

The other significant issue for private equity investors is the shift of power from shareholders to the board. In general, a private equity investor is unlikely to be inclined to allow the board of directors of its portfolio companies to determine whether or not its investment professionals may take on other directorships, and so may wish to retain approval of conflicts of interest as a shareholder matter. If this is the case, the articles of association of portfolio companies incorporated after October 1, 2008 will need to contain wording to that effect to avoid scenarios whereby approval of conflicts of interest is given at board level without the explicit authorisation of the major investor.

The way forward
The consequences of a breach of the duty set out in Section 175 are the same as would apply for a breach of the existing fiduciary duty (including potential personal liability for damages), and the onus with regards to conflicts of interest remains, of course, on the individual director. It seems likely, however, that there will be a formalization of the way in which companies and directors approach conflict procedures. Private equity investors, and their investment professionals should, therefore, consider the following:

  • ? A private equity investor should decide whether he wishes to allow the board of directors of a portfolio company to authorize conflicts of interest, either generally or specifically in relation to other directorships to be held by investor directors. If not, appropriate additions to articles of association will need to be made to companies incorporated after October 1, 2008 to negate the effects of Section 175.
  • ? A director should protect himself by seeking the relevant board or, if appropriate, shareholder approval where he is concerned that he may breach the duty to avoid conflicts of interest established by Section 175; this is particularly relevant if the director holds multiple directorships in potentially competing companies (and in portfolio companies within the same industry sector). If there is any doubt as to whether a conflict may exist, approval should be sought with each new directorship – a blanket approval may be insufficient.
  • ? For companies incorporated pre-1 October 2008, a shareholder resolution will be required if the company wishes to take advantage of the board approval provisions in Section 175.
  • ? As ever, if in doubt, legal advice should be sought!
  • Some Practical Examples
    Scenario 1
    Joe is an investment professional at a private equity firm which specializes in the pharmaceutical sector. Joe is appointed to the board of directors of a private UK portfolio company (?Company 1?). What issues should the private equity firm consider?

  • ? Should the board of directors of Company 1 be permitted to authorize conflicts of interest or should this be a shareholder matter?
  • ? When was Company 1 incorporated? This will determine whether a shareholder resolution is required if it is proposed to allow the board of Company 1 to authorize conflicts of interest (if Company 1 was incorporated before 1 October 2008), or to amend the articles of Company 1 if it is proposed that the directors of Company 1 should not have the ability to approve conflicts (if Company 1 was incorporated after October 1, 2008).
  • Scenario 2
    Joe is subsequently appointed to the board of directors of another private UK portfolio company (?Company 2?) in the pharmaceutical sector.

  • ? It is clear that such an appointment may give rise to a conflict of interest with Company 1. Prior to accepting such an appointment, Joe should seek approval of the boards of both companies (if applicable) or otherwise seek shareholder approval.
  • ? Whilst the board of directors of Company 1 would be able to
  • ? approve Joe's acceptance of a directorship of Company 2, it is possible that any subsequent matter giving rise to a specific conflict of interest may also need to be approved. This may cause confidentiality issues. Joe should regularly review the situation, particularly if there is a change of circumstance, and consider whether further approvals are required. In an extreme case, it may be necessary for Joe to resign one of the directorships.
  • Scenario 3
    Joe is appointed to the board of directors of a United States clothes manufacturer. What issues are there to consider in light of Joe's existing directorships?

  • ? The fact of the new company being incorporated in the United States will not affect the considerations regarding potential conflicts that may arise in relation to the interests of the two UK companies of which Joe is already a director. However, as the company is in a different sector and potentially a different geographical market it should mean that conflicts of interest are unlikely, that this could potentially fall within the safe harbor of section 175(4)(a) (the matter cannot reasonably be regarded as likely to give rise to a conflict of interest) and therefore consent would be unnecessary.
  • Clearly, however, the individual must be vigilant with any appointment and consider whether the approval given covers any actual conflict of interest when it arises.