Wearing the right hat in transactions between directors and companies

I never thought I would quote Prince (or Artist formerly known as Prince…or whatever) in an accountancy article but here goes. “Ownership. That’s what you give your kids. That’s your legacy”.  This hits the spot for the dilemma that directors of owner-managed businesses face where it is often difficult to distinguish between their personal affairs and their company’s affairs. However, if the protection of a limited liability company is to be preserved and particularly if the company experiences difficulties, it is important to keep that distinction in mind. You can’t just transfer assets out of the family (or any) business without careful planning.

We are becoming a nation of entrepreneurs and business owners, keen to shake off the shackles of the traditional 9-5. And with that comes exploring opportunities for both personal investment as well as corporate investment. How can directors make sure they’re clear about the differences between personal investment and company investment and what are the pitfalls of directors transacting with their own companies?

Getting started

The starting point is that directors have a duty to declare to the board of their company any interest they might have in a transaction involving the company for which they act. Where that interest relates to an arrangement between the company and the director to buy or sell certain assets, shareholder approval might also be needed. These transactions are referred to as “substantial property transactions” and are governed by Section 190 of the Companies Act 2006.

Shareholder consent is needed when a director – or a person connected to a director – buys a substantial “non-cash asset” from the company or the company acquires a substantial non-cash asset from one of its directors or a person connected to that director.

The definition of connected persons is very wide. Connected persons include a spouse, civil partner, or family member (including step-children) and a connected “person” can also be a company if the director has a 20% interest in that other company. The legislation also captures transactions where the director (or connected person) of a company’s holding company acquires the asset.

A substantial non-cash asset is “any property or interest in property other than cash” where the value is either (a) greater than £5,000 and more than 10% of the value of the company based on its statutory accounts or (if there are no statutory accounts) the amount of its called up share capital; or (b) more than £100,000. This will therefore cover almost all real property transactions.

Shareholder approval

Normally at least 50% of the shareholders must approve the transaction but it is important to check the company’s articles of association as sometimes a higher percentage of approval is needed. Shareholders’ approval can be given at a general meeting of shareholders or if the company’s articles do not prohibit it, by a written resolution. If the shareholders’ approval cannot be obtained before contracts are exchanged for the substantial property transaction, the contract must be conditional on such approval being given.

If there is a holding company involved, shareholder approval is needed from both the shareholders of the company and of the relevant holding company.

Scenarios such as payment of a dividend in specie or the distribution of assets to a member on winding up of a company are not caught by these rules. There can be tax advantages from payment of a dividend in specie but as above, the relevant process needs to be appropriately executed.

Directors should bear in mind their general duties to the company, notably their duties to promote the success of the company, to declare an interest in a proposed or existing transaction of the company, to avoid conflicts of interest and act in its best interests. However, if the company is insolvent, the duty to shareholders is no longer primary as the duty to creditors intrudes.

Where the company is in financial difficulty or where it is either cash flow insolvent (not paying its debts as they fall due) or balance sheet insolvent (which many ostensibly comfortable companies are) take advice before entering a transaction to ensure there is no transaction at an undervalue (selling an asset for less than it is worth) or preference (putting the interests of one creditor – potentially directors or shareholders (or their connected parties) in this case – over the interests of the general body of creditors i.e. they get paid and others don’t).

And if this isn’t done?

If shareholder approval hasn’t been obtained, other shareholders will seek answers (or compensation) and the transaction can be voidable at the company’s request, or its latter appointed liquidator. The relevant director, or the relevant connected person and any other person who authorised the transaction (for example, by signing the contract or the transfer deed) will be jointly and severally liable to pay the company for any gain they made in respect of the transaction or to indemnify them for any loss or damage as a result.

If the transaction is also a transaction at an undervalue or preference, the transactions can be unwound or compensation recovered from the beneficiary of the transaction. The directors can also be found personally liable for the losses suffered by the company, for example, the difference between the sale price to the director and what the asset is actually worth.

Practitioners are usually the first port of call in these scenarios. It is therefore one of those examples where crossing the t’s and dotting the i’s could save the directors cost and hassle of seeking ratification after the event or defending a legal claim from a liquidator if the worst happens in these unstable times. Directors will be very thankful if you can help them avoid the conflicts and pitfalls through your specialist guidance.

The article was written by Wedlake Bell partner Ed Starling, with help from Wedlake Bell solicitor Omar Amin.