Private Limited Company

1. Directors have unfettered power in the running of a private limited company and have no responsibility to the shareholders in regard to the decisions that they make. Discuss and form a view on this comment in the context of the overall framework by which companies exist and operate in England and Wales

In 1985, Kenneth Lay, using proceeds from junk bonds, combined his company, Houston Natural Gas, with another natural-gas pipeline to form Enron. From the get-go, the company worked to move beyond just transporting and selling gas. It decided to become a big player in the newly deregulated energy markets by trading in futures contract. In the same way that traders buy and sell soybean and orange juice futures, Enron began to buy and sell electricity and gas futures.

In the early 1990s Lay employed a consultant with a firm called Mckinsey & Co to create a new division of Enron that was to be called Enron Finance Corp. This consultant was Jeffrey Skilling.

With Skilling's foresight, Enron's economic interests grew into different directions creating new markets as it went along. The trading entity of Enron invested several billion US dollars on trading in futures; the downside was that Enron was not earning anything from those billions. The lack of return went largely unreported until December 2001, when the Company announced it was entering into Chapter 11 Bankruptcy.

Commentators have noted that one of the major failings of Enron was within the partnerships that it created for many of its trading operations. Through its chief financial officer Andrew Fastow, Enron created new entities whose debts were kept apart from Enron's own book debts.

However, the bubble burst and in October 2001, the firm's auditors, Arthur Anderson LLP, announced that some of those partnership debts should have been included within Enron's own financial statements.

The Enron saga became more intriguing as the days passed by. Probable criminal activity took place on many levels within the corporation. Within the last chapter of the story, it was reported that massive numbers of accounting documents were destroyed from October 2001 into 2002.

The question is as to how Enron's executives played a shell game with investments and offshore accounts to hide from stockbrokers and holders the financial disaster looming.

Furthermore, how could Enron hide its failings for so long? The question is one of a Corporate Governance matter.

There are many working definitions of Corporate Governance. The main has been triumphed as:

the system by which business corporations are directed and controlled....it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance are met

However, the OECD definition is not the only working definition of Corporate Governance:

can be defined narrowly as the relationship of a company to its shareholders

The Nobel Laureate, Milton Friedman, noted that Corporate Governance is to conduct the business in accordance with owner or shareholder desires, which generally will be to make as much money as possible, while conforming to the basic rules of the society embodied in law and local customs.

It is argued that the main obstacle of corporate governance is in striking a balance between power and accountability. It is important to allow managers and others in the corporation to have the power to carry out their duties to the best of their ability. However, there needs to be enough accountability to ensure that those tasks are performed for the benefit of the owners of the corporation and society in the long term.

However, Corporate Governance is a topic recently conceived, as yet ill defined and consequently blurred at the edges. It has been argued that one of the main obstacles in striking a balance is between power and accountability. It is important to allow managers within the corporation to carry out their duties to the best of their ability without imposing any unreasonable sanctions upon them that dilute their control. Conversely it is important to ensure that managers do not hide or deceive shareholders from the true picture of the company and for managers to have the best interests of the shareholders to heart.

As is often found in many constitutions of companies incorporated in England and Wales, the management of the company are often given unfettered control of the company. It is therefore, often difficult, without an overwhelming majority of the members of the company, to alter the constitution to limit the directors powers. The duties of the directors of a company are quite strict.

The general statement of duty was given by the Master of the Rolls Lord Greene in that the directors of a company must:

act bona fide in what they consider - not what a court may consider - is in the interests of the company, and not for any collateral purpose.

This statement has created a fiduciary obligation on directors to act in the best interests of the company as a whole and not for shareholders; individually or collectively.

There, therefore, exists a slight conflict between the principles of Corporate Governance and that of directors' duties; that Corporate Governance is an attempt to ensure that the shareholders, those that without the Company would not exist, are unduly prejudiced and their investments lost and that of Directors' duties in ensuring that they act within the best interest of the Company as a separate legal entity from the shareholders.

Directors are employed and empowered by the company to act in the interests of the company; it needs to be noted that in an incorporated company, the directors and shareholders are separate legal entities from that of the company itself; the director's duties are not owed to the shareholders but are owed to the Company. As has been already noted, directors owe a fiduciary duty.

It has been shown that 'a fiduciary is someone who has undertaken to act for or on behalf of another in a particular matter in circumstances which give rise to a relationship of trust and confidence.

While ultimately shareholders have the power to expel directors from their offices; directors ought to be, it can be argued, ultimately acting in the best interests of the Company (as a primary concern) and then acting in the interests of the shareholders. However, there is a blurring of the two main principles here; that Corporate Governance and Directors' Duties ultimately attempt to ensure that the survival of the company is seen as paramount and that the Company grow and develop.

2. The 4 shareholders of Clausen Stock Graphic Design Limited, a successful company specialising in the design and maintenance of web sites, are Rupert Clausen, Martin Stock., James Smith and Khurram Hussain. Khurram, Martin and James are directors and they each hold 30% of the shares in the company. Rupert is not a director; he simply holds the balance of the shares (10%). The Company is governed by Table A. The three directors have been in negotiation with Henry's Graphic Design Limited concerning the purchase of new computer software that Henry's have designed and manufactured. The price is 40,000. Clausen Stock Graphic Design Limited do not really need this software as they have something similar already. However the three directors are being privately paid a fee each of 2000 if they sign the contract. Rupert is aware of the possible contract and is against the matter proceeding.

Advise the directors whether they can proceed with the transaction as they feel that they should be able to as they control the company.

Directors of a Company hold powerful positions and are therefore placed under strict guidance; not by the Companies Act or the Companies constitution, but by case law itself.

The general statement of duty, as has already been noted, was given by the Master of the Rolls Lord Greene in that the directors of a company must:

act bona fide in what they consider - not what a court may consider - is in the interests of the company, and not for any collateral purpose.

It has been seen that the duty owed from the director to a company is more of a relationship of trust and a fair duty of loyalty being imposed. Whether a company has the power to enter into a particular transaction is one of good interest; whether it is in the bona fide interest of the company as a whole to enter into such a transaction.

The case of Rolled Steel Products (Holdings) Ltd v British Steel Corporation , moreover Slade LJ, provided us with a test for whether the company ought to enter into particular transactions.

Slade LJ provided that:

  • 1. Is the transaction reasonably incidental to the carrying on of the company's business?
  • 2. Is it a bona fide transaction? And
  • 3. Is it done for the benefit and to promote the prosperity of the company?

If in the circumstances the above answers cannot be answered in the affirmative, then it can be argued that the directors of the company are not acting bona fide in the interest of the company and are in breach of their implied fiduciary duties.

Any breach of this duty can result in Court intervention.

Ultimately a director of a company, or group of directors, must account to the company for any profit that they make by virtue of the position that they hold as directors of the company. This rule is strict and absolute in interpretation and a director will be subject to sanctions without evidence of good faith.

The Courts have made their position clear on the issue of profiting from positions of good faith. In Bray v Ford Lord Herschell noted:

It is an inflexible rule of a court of equity that a person in a fiduciary positionis not, unless otherwise expressly provided, entitled to make a profit; he is not allowed to put himself in a position where his interest and duty conflict. It does not appear to me that this rule is, as has been said, founded upon principles and duty conflict. It does not appear to me that this rule is, as has been said, founded upon principles of morality. I regard it rather as based on the consideration that, human nature being what it is, there is danger, in such circumstances, of the person holding a fiduciary position being swayed by interest rather than by duty, and thus prejudicing those whom he was bound to protect. It has therefore, been deemed expedient to lay down this positive rule.

Lord Upjohn n further enforced the provisions of non-profiting in the case of Boardman v. Phipps:

The rule applicable to the subject has been treated at the bar as if it were sufficiently enunciated by saying, that a trustee shall not be able to make a profit of his trust, but that is not stating it ought to be stated. The rule really is that no one who has a duty to perform shall place himself in a situation to have his interests conflicting with that duty.

In the circumstances, it can be argued that the directors of Clausen Stock Graphic Design Limited are placing themselves in a position where their duty to the Company, which is the overriding duty, is potentially in conflict. Ultimately, the directors of the Company are acting as trustees; if company property is misapplied then the directors of the Company will be answerable to the Company as trustees.

A director of a company ought not to be using his position to, in effect line his own pocket. However, if he does make any profit, he is obliged to notify the board of directors and disclose to the company the full extent of any profit that he has made.

The Company may then ratify the profit that the director has made by ordinary resolution of the members in general meeting. Failing which, the director will have to account for the profit made to the Company.

There is a further duty imposed on the directors of the Company. Statute imposes a duty on directors of any company to declare their interests, whether they are direct or indirect interests, in a contract or a proposed contract with the company.

In any event, the members of the company can only ratify any action taken by a director provided that there is no fraud on a minority shareholder. If a member feels that they are being unfairly prejudiced in that the Company or its officers are infringing on the Company's rights, then it is possible for the minority shareholder to bring a derivative action in the name of the Company where the Company will not sue in its own name.

Even though the directors of the Company have general control with over 70% of the voting rights, the fact that the fraud in effect is being committed by those with majority power of the Company is an indication that a fraud of a minority is occurring.

Fraud on the minority shareholder, being Rupert, would be occurring if the Directors entered into the contract with Henry's Graphic Design Limited. We are informed that the Company does not require the contract or the equipment being provided and it appears that the directors of the Company are willing to use their shareholder voting rights to create a profit for themselves from the contract.

This is potentially a fraudulent act, in that the directors of the Company are exercising their powers for an improper purpose; that being to make a profit from a contract that is unnecessary.

It would not be necessary for Rupert to prove anything more than the existence of the contract and that the directors, being the remaining shareholder, made a profit and attempted to ratify such profit.

The directors would be poorly advised to enter into the contract with Henry's Graphic Design Limited as they may be liable to the Company for the profits that they have made as a consequence of entering into the contract with Henry's Graphic Design Limited.

Ultimately if the Court finds in favour that the minority member, Rupert, has suffered an unfair prejudice, then it may make an order that it feels appropriate in the circumstances. Such sanctions can be either that the company is dissolved and wound up by order of the Court or that the other shareholders or the Company itself should purchase the shares of the petitioner at a fair value.

3. The three directors want advice on what procedures currently exist for their removal as directors either under Table A or by way of current Company Law legislation. They would also like advice on what steps they can take to protect their positions' as company directors.

In accordance with the articles of the Company, in that the Company is using standard Table A articles, the directors can be removed from their offices by simple ordinary resolution (50%) of the members in general or extraordinary meeting.

A general meeting has power to remove directors provided proper notice as to the object of the meeting is given, and may fill vacancies if all the directors are removed or if the directors decline to exercise the power of filling casual vacancies.

A member of the Company may by giving special notice propose a resolution to remove a director. This can be frustrated by the directors of the Company by not calling a general meeting of the members. However, Rupert in this situation could request a general meeting as he is holding over 5% of the voting rights, as could any of the other members. Failing to fulfil such a request will result in the member requesting such a meeting being entitled to call an Extraordinary General Meeting of the members and petition for the removal of a director.

The directors can avoid such situations by entering into shareholder agreements or by changing the articles of the Company to incorporate a Bushel v Faith clause.

The Bushel family owned 100 shares within the family business which had an issued share capital of 300 fully-paid up and issued shares of nominal value 1 each. The Company had adopted Table A as its articles of association but they had also adopted a special article 9. This special articles provided that, the in the event of a resolution being proposed at a general meeting for the removal of a director, any shares held by that director should carry at least 3 votes.

Mr Faith's conduct as a director resulted in the placing on the agenda at general meeting, a provision for Mr Faith's removal as a director. At the general meeting, Mr Faith demanded that a poll vote was taken, invoking his rights under the special article 9 in the companies articles. In invoking the provision of the article, Mr Faith's 100 shares now carried voting rights of 300 votes. The resolution that had been proposed was now defeated by 300 votes to 200.

Mr Faith's sister applied to the Court to have the resolution declared as passed and has an injunction placed against Mr Faith preventing him from continuing as director.

At first instance, Mrs Faith succeeded. However, upon appeal to the Court of Appeal and then to the House of Lords, their Lordships found in favour of Mr Bushel.

The rationale behind such a decision was that it is down to the Company to attach what ever voting rights it sees fit to a particular class of shares. Not withstanding the now section 303 Companies Act 1985, the provisions of the Act, according to their Lordships, did not prevent companies from attaching special voting rights to certain shares for certain occasions.

If the directors of the Company are seeking to ensure their offices or are seeking to prevent themselves from being removed from office, Martin Stock., James Smith and Khurram Hussain ought to seek to alter the articles of association of the Company to incorporate such a provision on the weighting of their shares.

In order to be able to amend the articles of association, being the main constitution of the Company, the members of the company in general meeting or extraordinary general meeting must pass a special resolution (75% of those eligible to vote and count to a quorum) creating such a clause.

With Martin Stock., James Smith and Khurram Hussain having over 75% of the voting rights, the passing of such a resolution should not cause any problems, and the directors can ensure their offices in this manner.

Bibliography

  • Freund Ernst The Legal Nature of Corporations Batoche Books 2000
  • J H Farrar & B M Hannigan Farrar's Company Law 4th Edn Butterworths
  • Gong Byeong-Ho Corporate Governance Yale University Press 1995
  • Gower's principles of Modern Company Law 6th Edn
  • Grant on Corporations (1850) Butterworths
  • Griffin S Company Law Fundamental Principles 2nd Edn Financial Times Pitman Publishing 1996
  • Hall D, Jones R & Raffo C Business Studies Causeway Press 1995
  • Keenan D Company Law for Students 11th Edn Financial Times Pitman Publishing 1999
  • Leipziger et al Corporate Citizenship FT Pitman Publishing 1998

Web-based resources used:

  • The History of Enron; CNN February 2002