Companies Act: go carefully

Next month, 1 October to be precise, will see the introduction of further
provisions of the Companies Act 2006. As is to be expected with such a major
legislative change, many of its provisions have received widespread publicity.
One aspect of the Act, however, which the business community may not fully
appreciate, is the potential for an increase in claims from disgruntled minority
shareholders, relying on changes to shareholder protection brought in by the
Act.

One of the main objectives of the Act was to make directors more accountable
to the shareholders they represent. Central to that objective was the
introduction of a new statutory derivative claim.

A derivative claim is one brought in the name of a company but at the
instigation of a shareholder. The process enables claims to be brought that
might not otherwise be authorised by the board; for example, where a minority
shareholder wishes to bring an action against the wishes of the majority
shareholder who controls the board. This could of course include claims against
the majority shareholder/director himself.

Derivative claims have rarely been seen historically; unhappy shareholders
opting to use the unfair prejudice provisions contained within the former
Companies Act (largely preserved without change by the Act). The new derivative
claim, however, offers an alternative and considerably more attractive route for
bringing claims by minority shareholders.

The new derivative claim means that for the first time a claim can be brought
for a simple breach of a director’s duty. A director who has therefore been
negligent, or not acted for the benefit of the shareholders as a whole (a common
complaint in both the public and owner managed business sector), can be the
subject of a derivative claim.

Of considerable practical significance as well, particularly for the
owner-managed business sector, is that the shareholder/director responsible for
the act or omission will no longer be entitled to vote at a members’ meeting
called to ratify the act or omission. Majority shareholders will therefore no
longer be able to ratify board decisions that may not be in the interests of the
minority shareholders in the way they have been able to in the past.

Whether the new derivative claim will open the proverbial floodgates of
litigation by minority shareholders, or the acquisition of shareholdings by
activist groups with the objective of bringing derivative claims, remains to be
seen. However, it does give rise to new concerns for all directors.

Breach of duty

Any breach of a director’s duty can give rise to a derivative claim. This
includes where a director has failed to act with reasonable skill and care (i.e.
negligence), has failed to exercise independent judgement or has failed to
promote the success of the company for the benefit of its members as a whole.

Finance directors are inevitably at risk in the area of financial management.
This includes not only the financial running of the company but other aspects of
financial management, including advising the board in relation to directors’ pay
and shareholder return (an area which has been the subject of considerable
shareholder litigation in recent years).

While advisers will generally remain unaffected by the new derivative action,
the application of directors’ duties to shadow directors is another new
provision of the Act. Shadow directors are those whose instructions and
directions the board is accustomed to act in accordance with.

In the past, litigation against shadow directors has largely been the
preserve of liquidators (for example, for wrongful trading). However, the Act
now expressly provides that acts or omissions of shadow directors, and former
directors, can be the subject of derivative proceedings. The courts have
recently extended the concept of shadow directors, meaning that consultants,
bankers and funders in particular are at risk, as will advisers whose role in a
company goes beyond giving advice to the board.

Former directors also need to be aware that their exposure to derivative
claims continues, even after they have left a company. By resigning a director
will not be able to avoid liability for acts or omissions during the time he or
she acted as a director.

To protect their position as far as possible against possible future claims,
as part of any termination package, departing directors could negotiate a
continuing obligation on the company to maintain existing D&O cover. Another
potential protection from future claims is the extension, beyond termination of
the directorship, of an existing indemnity from the company contained within a
service agreement. Protection offered through an indemnity in the articles of
association only may prove inadequate as articles can be amended at any time.

Departing directors should be aware though that shareholder approval will
often now be required for any termination package. The new provisions in the Act
which generally require shareholder approval to payments for loss of office also
apply to benefits which a director acquires on termination. An extension of an
existing indemnity could be regarded as such a benefit and therefore shareholder
approval will be needed. Failure to obtain shareholder approval to a termination
package could give rise to a derivative claim in its own right.

Checklist

FDs

• Make sure all your board members understand their duties under the Act

• Set up training on directors’ duties for new appointments to the board

• Do not ignore the interests of minority shareholders – ensure they are
receiving a fair return for their investment

• Ensure the board’s remuneration is objectively justifiable

• Protect yourselves – review your D&O cover and indemnities and keep
that paper trail

Advisers

• Be careful your advice does not extend to instructions

• Make sure the finance directors you advise appreciate their duties and the
possibility of derivative claims

• Ensure business start ups fully understand the new directors’ duties and
adopt suitable protection for board members

Richard King is a partner and Katie Philipson, an
associate at law firm Stevens & Bolton LLP