Shareholders Equity | Free Company Law Essay

Background:

The directors of Springfield Ltd (a company the objects of which are the manufacture and retail of paint) are Homer (the managing director), Marge (the finance director, and a graduate in finance and management), Bart (the marketing director) and Lisa (the research and development director). Each of them holds 25 of the company's 100 shares. Springfield's articles of association state that its shares may not be transferred without the unanimous consent of the directors and that any contract over the value of 50,000 requires the unanimous consent of the board, the quorum for which is three members. Consider the legal position of the following three situations.

a) Springfield's sales have been declining since May 2003. Bart is aware of this, and asks Marge how it is reflected in the company's accounts. Marge replies that profits are a little down, but that she hopes the company will soon "turn the corner". Lisa calls a board meeting and asks Homer to comment on the company's financial situation. Homer replies that he never bothers to look at the accounts and relies on Marge's assessment of them. Lisa suggests that it would be prudent to rationalize the company's product base and to seek the advice of an accountant. Both Marge and Homer disagree. Bart agrees with Lisa's suggestion in principle, but considers that sales will pick up within the next six months and that any decision about Lisa's plan should therefore be postponed. Springfield subsequently enters insolvent liquidation, owing its creditors 500,000. Its accounts reveal that it has been insolvent since February 2004.

b) Homer and Bart decide that Springfield should branch out into the manufacture of furniture. They agree with Apu Associates that Apu shall design a range of dining room furniture for Springfield at a cost of 40,000. Homer and Bart deliberately keep these negotiations secret from Marge and Lisa. The board later meets to discuss whether to purchase machinery from Flanders Ltd with which to manufacture paint. The machinery costs 75,000. Lisa is called away from the meeting and the Homer, Marge and Bart vote in favour of the purchase in Lisa's absence. The board later discovers that Springfield could purchase identical machinery for 35,000 and informs Flanders that Springfield's contract with it is unenforceable because it was entered into in contravention of the company's articles.

c) Krusty Ltd approaches Bart and asks whether Springfield will produce a special metallic paint for its use. Bart puts this to the board of Springfield, who suggest that before entering into such an agreement research should be done into the cost of producing the paint, and whether there might be other customers for it. Bart, aware that Krusty needs the paint urgently, uses 30,000 of his own money to produce the paint. He makes a profit of 20,000 and has since received further orders from Kursty worth 80,000. At the same meeting, Homer proposes that Lisa should receive a bonus of 10,000 in recognition of her hard work. Lisa remains modestly silent, and Homer, Marge and Bart vote in favour of the bonus. Two weeks later Homer and Lisa argue, and Homer tells her that she will not be receiving the bonus.

Legal Background - Insolvency and Creditors:

The key question in respect to insolvency is whether how the creditors under the Insolvency Acts (IA) 1986 & 2000 should be treated and the liability of the company and directors.. If the company was not going in to liquidation and the company was not paying its creditors there would be a simple breach of contract. However in this case there is the added problem of the company going into liquidation, whereby the insolvency laws have indicated there is no preferential treatment between creditors, however in the Re Challoner Case it specifies that this preferential treatment cannot occur amongst creditors of the same class. Therefore in the case of these creditors how does one follow the Insolvency Act 2000 which seems to specifically dealing not with creditors on the whole but the abolition of preferential treatment towards Crown debts? Therefore how does the company deal with the creditors, can they treat customers they owe goods to over normal creditors. In respect to customers were goods are owed one would advise the company to return these funds, especially in respect to his intentions too if the goods were not supplied as equity will remedy injustice in respect to original intentions of the contract as long as not incredible. However, in the case Ian Peter Phillips Case the judgement seems to indicate that an insolvent company must follow the laws, whereby creditors are treated equally; yet under the new SSGR it is most likely that the return of the money, as per the original contract and intentions of the company to supply goods would occur, otherwise equitable principles and the validity of a contractual agreement would be null and void. Also can the creditors sue for the director's mismanagement of the company and lack of action, this is very hard because as long as the company was paying them then the contract is being honored and there is no fraud and there is no specific duty owed to the creditors, as with the fiduciary duty owed to the company and subsequently the shareholders.

Duty held to Shareholders & the Company:

The use of words such as fair-spirited actions of a director in his own personal interest in approved contracts and transactions in the company which he is holding the trust for shareholders embraces different areas of law, which include company law, equitable law and contract law. The first point that has to be noted is that the director owes a fiduciary duty to the shareholders, as he is holding their interests in trust. The actions of a director in company contracts may affect the interest of the shareholders; therefore it may prove that a beneficial contract to the director may be harmful to the shareholders. In order to counter negligent, omission of, or fraudulent actions of directors when considering contracts that are in their favour parliament has introduced legislation, such as the Companies Act 1985 (CA 1985), Companies Act 1989 (CA 1989) and new legislation such as the Companies (Audit, Investigations and Community Enterprises) Act 2004 (CA 2004). However this is not the only law that is applicable to this area, there are also questions of validity of contract and the proper use of one's fiduciary duty under equity law. The following discussion will explore parliamentary legislation under the CA 1985 and CA 1989, it will then consider some of the proposed changes in this area. It will then consider equity, the duties that are imposed on a director and the remedies that are available to the shareholder in a case of misconduct. The conclusion will then consider deeper the changes in company law and consider if this is due to the deficiencies in the law - should the director be fair-spirited in personal transactions, if so should the enforcement be stricter than the present law? Also the duty that the director holds to the company and subsequently to the other shareholders, in this case the other directors is the same as the trustee that is owed to the beneficiary. Therefore the first section will consider the duty of directors to efficiently monitor the actions of other directors rather than relying on their goodwill.

Company Law:

The general duty that the director holds is to the company, which has been established through the law of equity, which will be further discussed in the next section. In relation to contracts that personally benefit the director under contract law the company can make it avoidable as it is in breach of the basic duty that the director holds, which is implied in the present Company Acts. However there is the provision that if the director declares to the board his personal interest, at the soonest possible time, then if the board approves the contract then this contract is valid. This is not the extent to which parliament has legislated director's personal interests in contracts as can be seen in the CA 1985. Section 317 of the CA 1985 has been briefly touched upon in his declaration of personal interest in the contract, yet the legislation goes further to define how and what the director must declare. This includes the nature of the interest; whereby a general notice of interest in a company or with a specific person is sufficient notice; however only the agreement from the board in full knowledge of an interest will save a contract from being avoided, otherwise contract law will allow the contract to be avoided. If the interest is financial, rather than just a connection with a person, then the director must make a declaration to the accounts; hence strictly regulating not only direct contracts but also indirect or casual transactions.There are certain exclusions which include; transactions within the company group; or a service contract between a director and its company; as well as financial transactions which are below the limits set out. Therefore the current law has set out some basic provisions in protecting the company, which impliedly protects the shareholder because the shareholder is whom the director is holding its trust for. Yet after an extensive three year review it has been revealed that the individual shareholder's interests may not be sufficiently protected by protecting the company's interest and declaring any interest in a contract to the board.

The question of fair-spirited arises because is it in the shareholder's interest that agreement comes from the board of directors? Should shareholders be polled? This duty held to the shareholder has been a question of concern in the new CA 2004; whereby the protection of director's liability has been slackened and the powers of investigation into possible wrongdoing, negligence of acts and/or omission of acts will be strengthened. These changes in the law seem to point to ensuring that directors will act in a fair-spirited manner towards the interests of the shareholder. However the main deficiency that the legislation has not dealt with is that the director still owes only a direct fiduciary duty to the company as a whole and not to individual shareholders. This seems to limit the amount of liability the director holds because if the director held a duty to each beneficiary, i.e. shareholder, then they would be liable for legal action from individual shareholders. This would act a deterrent from wrongdoing and treating the individual shareholder's interests in much more fair-spirited manner; however no such duty exists therefore action must be taken if the duty to the company is breached which limits the legal action against a director. The following section will consider this idea of fiduciary duty further and consider if the indirect duty that the director holds, via his duty to the company, is sufficient to protect the shareholder's interests.

Law of Equity:

The present law does not create a fiduciary duty between individual shareholders and a director, rather this is implied because the director owes a fiduciary duty to the company as a whole, which is strictly adhered to in Regal (Hastings) Ltd v Gulliver. This creates a limitation in the extent that the law of equity can protect the individual shareholder's interest, because it means that the company must bring a claim and ordinarily the shareholder cannot bring a claim because no duty is held to the individual shareholder. This can cause problems in the case that all the directors enjoy a personal interest in the transaction and therefore leading to a situation where there is no one in the company prepared to take action against the directors. This has lead the law to make exceptions, but these exceptions are not for the interest of the shareholders but for creditors and employees. Hence creating a situation where there are individual fiduciary duties held but as of yet not held to individual shareholders. Therefore as long as the director believes he is acting in the best interest as the company, not individual shareholders and then he can use and dispose of company property as he wishes.

In addition in personally interested transactions, as long as the company is notified and the board agrees, that are in the best interests of the company and for proper purposes, i.e. not fraudulent, negligent or reckless, are seen as perfectly valid. If the director is to make profit from valid personal dealings this then must be fully disclosed, otherwise he would be in breach of his fiduciary duty to the company; even if the company could not have made profit without this dealing. In short the current law of equity does also provide some indirect provisions in protecting the shareholder; however there is no direct fiduciary duty between the director and individual shareholder; whereas there is a direct duty to an employee or a creditor. This seems to indicate quite a large void in the both the law of equity and legislation as the company would not exist without individual shareholders; therefore as long as it can be shown that an action was in the company's general good interest then the effects on the holdings of an individual shareholder seems to be irrelevant. However in the recent case of Crown Dilmun and Dilmun Investments v Nicholas Sutton and Fulham River Projects the court held that the director, whom held a direct personal interest in the contested deal, required the additional written permission of the deal from individual shareholders in the business deal as there were serious consequences and conflicts in the case and ignorance is no excuse:

The fact that Mr Sutton believes all of this is possible is a good demonstration of his minimal understanding of his duties and responsibilities and possibilities of conflict which he never understood at all.

Therefore the above case indicates that the current legal changes are beginning to understand the importance of fair-spirited actions to individual shareholders.

Application to Marge, Bart, Homer & Lisa - Directors as Trustees?

The conduct of directors have been set up in various Company Acts but at the basic level these duties are similar to the Trustees Act 2000 (TA); which confirmed the common law case of Speight v Gaunt; whereby the trustee must act in the same way that a prudent businessman should act with his own business affairs. There is an exemption to this duty if it has been shown that from the trust instrument that the duty is not meant to apply. Therefore in respect to the duty owed by Homer and after being appointed as a director the question is whether he owes a duty of care in all levels of the company, the financial affairs. If he does is Homer in breach of this duty by leaving all matters to Marge, i.e. if Marge breaches her duty are is Homer liable; whereas Bart and Lisa have made suggestions in the best interests of the company, i.e. reasonably excluding them from liability.

The three trustees have been expressly appointed as directors following the articles of the company, i.e. by Derek, all three accepted the position prior to the trust coming into being. Marge owes this duty of care, which may be construed in a stricter manner than the other three as she is the financial director and because the common law already lays a strict application to solicitors and professionals in their area of trade; therefore it would not be stretching it application to leaving one's trust in the financial director in financial matters as with Homer in this company. Homer as a director by choosing not to get involved the dealings of the company, i.e. leaving it all the financial affairs to Marge. This would be fine as long as he took reasonable steps to monitor and check up on Marge's actions; however there is no evidence of this as a reasonable and prudent business person would, i.e. if he allowed an accountant to deal with her affairs would she not ensure that there was no misappropriation of funds etc by reviewing them regularly, e.g. quarterly. Therefore by not taking such actions he has not fulfilled her statutory duty of care and therefore would be equally liable for loss if Marge mismanaged the trust, as long as the factors were not beyond Marge's control. Bart is also in a dangerous situation as he suggested that Lisa appointing an accountant to look into their financial affairs should be postponed and insolvency has been the result. Lisa, on the other hand, is the only director that has taken prudent actions and as a shareholder can sue the other director's for mismanagement of the company's account.

In the case of Marge, Bart, Homer and Lisa they are the directors and are the only shareholders, therefore making and interesting scenario because the decisions of the directors should naturally benefit the shareholders, the company and the directors. There is no minority shareholder and the situation of Lisa's bonus being rescinded by Homer is very problematic as the other shareholders have supported it. Also there is a problem with the actions of Homer and Bart in making decisions without the approval of Marge and Lisa as per the articles of the company. This causes problems in respect to the fiduciary duty owed as directors to the best interests of the company and subsequently Marge and Lisa, i.e. this could hinder the company and subsequently adversely affect the other two directors. The problem with the rescission of the bonus is that they were not done in a fair manner the greatest impact was on Lisa and the other two director's have had their approval undermined, which seems the be the current actions of Homer. This may also be seen as a breach of Homer's fiduciary duty to the company as this decision can unsettle the company and possibly will directly benefit the power Homer holds over the other shareholders. In respect to the decisions of Bart and Homer in respect to actions Krusty Ltd and the expansion to furniture, which have not followed the articles of the company and may benefit them more than the company. In fact these actions may benefit the company; however this is unimportant because the rules surrounding fiduciary duty and the articles of this company indicate that all decisions need to be passed through the board, because the possibility that the transaction will benefit the director will breach the fiduciary duty he owes to the company and the other shareholders. In short the decision by Homer and Bart to expand into furniture or Bart's decision to contract with Krusty Ltd may be seen as a breach of the director's fiduciary duty under equity.

Bibliography:

  • N. Bridge, 2004, Directors Behaving Badly, NLJ 154(7129)
  • Charlesworth and Morse, 1999, Company Law, Sweet & Maxwell
  • Department of Trade and Industry can be found at: Surrey County Council v Bredaro Homes Ltd [1993] 1 WLR 1361; Burrows [1993] LMCLQ 453; A-G v Blake [1998] Ch 439

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