Corporate Law Update
- The court finds that the directors of a company undergoing a management buy-out did not owe fiduciary duties to the selling shareholders
- A company was able to justify a demerger distribution by reference to accounts, even though they could only be understood by looking at other documents
The High Court has held that the directors of a company did not owe a fiduciary duty to the company’s shareholders when implementing a management buy-out (MBO).
Vald. Nielsen Holding A/S v Baldorino concerned the MBO of a connectivity business. The company that ran the business was owned by various individuals (the Shareholders), the majority of whom were members of a single family.
The company was managed by three individals (the Managers). Two of the Managers were also Shareholders, and one of those two was the cousin of the company’s founder.
In 2009, following a competitive process, the shares in the company were sold to the Managers and a private equity (PE) investor as part of an MBO. The Shareholders subsequently suspected that the Managers had misled them as to the true value of the business. (Indeed, fewer than five years after the MBO, the business was sold on for around eight times the MBO price.)
The Shareholders argued that, in the specific circumstances of the MBO, the Managers owed them fiduciary duties. These duties, they said, arose out of the fact that the Managers had effectively conducted the competitive sale process, providing information to bidders as part of the process and assisting the PE investor with putting its offer together.
In particular, the Shareholders said the Managers were under a duty not to put themselves in a position in which their interests might conflict with those of the other Shareholders. They said this required the Managers to:
- disclose all material facts relating to the proposed sale to the Shareholders
- ensure they did not prefer their own interests over the Shareholders’
- ensure they did not mislead the Shareholders or any potential buyers
They said the Managers breached this duty by failing to provide them with information relevant to the MBO, including copies of a weighted budget, recent financial information and a data pack produced by the financial advisers on the MBO. They also alleged that the Managers had deliberately misled them.
The key question was whether the Managers did in fact owe the alleged fiduciary duties to the Shareholders.
It so happens that the majority of cases where directors have owed a fiduciary duty to shareholders have involved closely-held family businesses. Although a family connection is not necessary to create a fiduciary duty, it is clearly a situation in which shareholders will often put direct trust in directors.
What did the court say?
The court found that the Managers had committed the tort of deceit (a kind of fraud) by providing false answers to questions raised by the Shareholders. However, it concluded that the Managers had not owed the Shareholders fiduciary duties on the MBO.
The judge confirmed the general rule that directors owe fiduciary duties to their company, not to shareholders. A director’s duty to their company arises out of the legal relationship between them, under which the director directs and controls the company and takes on responsibility for its affairs.
By contrast, a fiduciary duty can arise directly between a director and a shareholder only if there is a “special factual relationship” between them. In reality, this is no different from a duty arising between any two sets of unconnected people.
In the context of a sale of shares in a business, a duty to shareholders might arise if directors represent themselves as agents for shareholders, make material representations, fail to disclose material information, or supply information or advice on which shareholders rely. However, none of these is determinative and, importantly, the director must have assumed a special relationship “over and above the usual relationship” with shareholders.
In this context, the court made the following observations:
- A fiduciary duty is more likely to arise in a family context. In this case, although one of the Managers was the cousin of one of the Shareholders, he and the Shareholder did not have a particularly close relationship. And, although several Shareholders were members of the same family, many shares were held by non-family members.
- The mere fact that a director has more knowledge about a company’s affairs than its shareholders does not automatically give rise to a fiduciary duty. A fiduciary duty is less likely still to arise where, as in this case, Shareholders did have a degree of access to information about the company and have a “regular channel of communication” if they had wanted more.
- Effectively, a director needs to be dealing with a shareholder on a particular transaction for there to be any possibility of a duty arising. However, the mere fact that a director is proposing to buy shares from a shareholder will not create a fiduciary duty.
- Although the Managers had made “false representations”, this too was not enough to create a fiduciary relationship. A duty does not arise whenever a false statement is made.
What does this mean for me?
Managers can find themselves in an awkward position on an MBO. On the one hand, they are officers of the target company and so duty-bound to promote that company’s success for its shareholders. On the other hand, they clearly have a vested interest as potential buyers of the business.
The case gives managers on a typical MBO comfort that they will not be assuming any special duties towards selling shareholders. Nevertheless, managers in this situation should be careful in the way they conduct themselves and ask the following questions:
- Do I have a close connection (such as a family relationship) with any selling shareholders? If so, are they looking to me for guidance on their sale and trusting me to handle their negotiations?
- Have I held myself out as assuming responsibility for any selling shareholder’s interest in the transaction? Have I been acting as a channel for communication or transaction information?
- Is all information I have provided to any selling shareholders correct and accurate? Have I disclosed everything they may consider relevant?
Conversely, the judgment demonstrates the slender legal protections that exist for sellers on an MBO. In this case, the Shareholders were able to make out a case in deceit. However, this can be a difficult claim to establish and is not something selling shareholders should rely on to protect their interests.
It is fair to say the facts of this particular case are unusual. In most cases, the selling shareholders on an MBO will have regular access to detailed financial information – through board observer rights, rights under an investment agreement, or simply by virtue of controlling the board – and so should be in a position to evaluate the value of the shares they are selling.
This case demonstrates the need to use those rights effectively. Absent fraud, it may be difficult for shareholders to pursue managers for brokering a bad deal.
The High Court has said that a company had validly distributed shares in a subsidiary to its shareholders, notwithstanding several alleged defects in declaring the distribution.
In Burnden Holdings (UK) Limited v Fielding and anor, a holding company decided to distribute the shares in one of its subsidiaries to its holding company. The purpose of the proposed distribution was to sell down a proportion of the shares in the subsidiary to a third party, ultimately (although indirectly) generating cash for the company.
The company had been struggling financially for some months when it made the distribution. Within a year, its financial position deteriorated and it was placed into administration. Ultimately, it entered compulsory liquidation.
The liquidator tried to claw the distribution back to satisfy creditors’ claims. In particular, he claimed the distribution was invalid for five reasons:
- The accounts used to justify the dividend should have been set out in a single document, but they were in fact split across multiple documents.
- Those accounts misstated the value of, or omitted completely, certain line items.
- The company’s directors did not hold a board meeting to declare the dividend.
- The directors paid the dividend in breach of duty under the Companies Act 2006.
- The distribution was a transaction defrauding creditors and should be set aside under the Insolvency Act 1986.
Each of these arguments was substantive in itself, which is in no small part why the court’s judgment runs to a hefty 315 paragraphs. We will examine each of the arguments above in turn.
This week, we look at the first argument – were the accounts used to justify the distribution invalid because they were not in a single document?
Why are accounts required?
A company can only make a dividend or other distribution if it has enough distributable profits to cover the amount of the distribution. This is to ensure that, while a company’s profits can be shared among its shareholders, its share capital and reserves remain available to satisfy claims by creditors.
To ensure the distribution only comes out of distributable profits, the company must be able to justify it by reference to “relevant accounts”. These are normally the company’s last annual accounts.
However, if those accounts do not show sufficient distributable profits to make the distribution, the company may be able to draw up “interim accounts” that do show sufficient profits. This may be the case, for example, if the company has made a profit since its last financial year-end.
Interim accounts are generally unaudited and do not need to adopt the same format as annual accounts. They merely need to allow someone to form a reasonable judgment of the company’s assets, liabilities, profits, losses, share capital and reserves and certain provisions.
The First-Tier Tax Tribunal (the FTT) had previously suggested in Vardy Properties (Teeside) Limited v HMRC that interim accounts must be set out in a single document that contains all of the matters required in interim accounts, and not in separate documents.
Were the accounts valid?
In this case, the company justified the distribution using interim accounts. However, those accounts comprised just two pieces of paper. It was not possible to understand them without looking at other documents, such as monthly management accounts and forecasts.
This, the liquidator said, effectively meant that the accounts were split out across multiple documents and so could not constitute valid interim accounts. In particular, he referred to the FTT’s statement that “the degree of detail and formality of [interim accounts] may vary, depending on the context, but a single document is … required in all cases”.
The judge disagreed. He said that the interim accounts had to set out all relevant line items, but it did not matter if the “justification” for those figures was found in other documents. The FTT’s guidance that interim accounts must comprise a single document had to be “seen … in context".
In this case, the interim accounts did in fact record the company’s assets, liabilities, profits, losses and so forth. They were not deficient simply because the underlying basis for those figures was set out elsewhere. It was still possible to form a reasonable judgment of the company’s affairs.
Because the accounts did contain all of the relevant information, the judge did not have to decide whether they had to comprise a single document. However, he said in passing that he did not think this approach applied in all circumstances. There may be circumstances where accounts can be spread out over multiple documents, although the judge did not indicate what those circumstances might be.
What does this mean for me?
It is common for companies to pay dividends and other distributions based on interim accounts. This is particularly handy where a company has made a substantial disposal and wants to return value to shareholders immediately, rather than waiting until financial year-end.
On one level, it is awkward that the Companies Act 2006 does not provide much detail on the form of interim accounts. Annual accounts are subject to very precise content requirements, but there are no such stipulations for interim accounts.
However, as a result, the form and level of detail of interim accounts can vary significantly, from short one-page management accounts for a simple business and small distribution, to a full-blown audited profit-and-loss statement and balance sheet for a substantial return of value.
This decision is helpful in preserving this flexibility. If using interim accounts to justify a dividend or other distribution, directors should ask themselves the following:
- Do the accounts satisfy the statutory requirements? In other words, do they allow a reasonable judgment to be made of the company’s assets, liabilities and provisions, profits and losses, and share capital and reserves?
- If those figures are not explained in the accounts, can they be justified by looking at some other document or documents?
- Critically, do the accounts actually show sufficient distributable profits to pay the dividend?
- If the company is a public limited company (plc), have the interim accounts been filed at Companies House?