UK: A Question of Loyalty - Conflicts of Loyalty

Last Updated: 22 October 2010

By Sarah Chiappini

Sarah Chiappini of Charles Russell LLP looks at conflicts of loyalty, and how trustees need to deal with this.

The final provisions of the Companies Act 2006 (the 2006 Act), which came into force on 1 October 2009, have changed the way in which directors of charitable companies must deal with conflicts of loyalty. A conflict of loyalty will occur, for example, where a person is either both a director of a charity and a director of the charity's trading subsidiary or a director of two charities which have a contractual relationship, i.e. there is a landlord/lessee relationship or one charity makes grants to the other.

Duty to avoid conflicts of interest

Section 175 of the 2006 Act, as modified pursuant to section 181 in relation to charitable companies, provides that a director of a charitable company must avoid a situation in which he/she has, or can have, a direct or indirect interest that conflicts, or possibly may conflict, with the interests of his/her charity.

The reference in the 2006 Act to 'indirect interest' is interpreted as including an interest of those connected to a director, for example members of a director's family and companies controlled by a director. Consequently, any relevant interests of those connected to a director will also need to be addressed.

The duty to avoid conflicts of interest is not, however, infringed in certain situations as set out in section 175. For example, in the case of a conflict of loyalty the conflict is, subject to certain conditions, authorised by the directors.

The practical consequences of the new law

Before the implementation of section 175 of the 2006 Act, when a conflict of loyalty arose it was acceptable practice for directors to vote on a matter on which they had such a conflict but to remember 'which hat they were wearing' when making decisions on behalf of the relevant organisation.

However, pursuant to the 2006 Act, where directors have a conflict of loyalty they must now either:

  • abstain from voting on the relevant matter, provided that there are sufficient directors who are not conflicted to achieve a quorum to enable those unconflicted directors to vote on the matter, or
  • obtain authorisation to vote on the matter from those directors who are not conflicted, subject to prescribed conditions, and only if the charity's memorandum or articles of association permit such conflicts to be so authorised (see below).

In other words, conflicted directors can no longer simply rely on the notion of remembering 'which hat they are wearing' when voting on a matter in which they have a conflict of loyalty.

Prescribed conditions for authorising a conflict of loyalty

The number of unconflicted directors needs to be such that they would constitute a quorum to enable them to authorise the conflicted director to vote. However, many charities will not have a sufficient number of unconflicted directors and/or a sufficiently low quorum (a quorum of two is considered, as a matter of good governance, the minimum number) to enable the conflict to be so authorised.

So, charities that do not have a sufficient number of unconflicted directors to achieve a quorum for the purposes of authorising a conflict of loyalty will need to appoint one or more unconflicted directors. Of course, recruiting charity directors/trustees is often easier said than done. Therefore, in some circumstances, it might be possible/ appropriate simply to reconstitute the boards of a charity and its trading subsidiary or the boards of two charities which have exactly the same directors. Consideration should also be given as to whether it will be necessary or appropriate to reduce the quorum provisions for meetings of directors to, say, two for the purposes of authorising conflicts of loyalty.

One final point on the issue of authorising conflicts of loyalty is that those directors who are not conflicted should be aware of their own duties as directors when giving authorisation for a conflicted director to vote: in particular, their duties pursuant to the 2006 Act to promote the success of the company and to exercise independent judgement.

Memorandum and articles of association: required provisions

To enable a conflict of loyalty to be authorised, the charity's memorandum and articles of association must specifically permit conflicts of loyalty to be authorised in the manner prescribed in section 175 of the 2006 Act. Consequently, many charitable companies will now need to take steps to insert the relevant provisions in the articles of association.

Non-charitable companies

So far as non-charitable private companies are concerned (i.e. a charity's trading subsidiary), section 175 of the 2006 Act provides that unconflicted directors can authorise a director's conflict of loyalty provided that there is nothing in the company's constitution to the contrary. In other words, unlike charitable companies, there is no need to include express provisions in the company's constitution. However, when updating a company's articles of association generally in the light of the 2006 Act we have, for completeness, been inserting the section 175 procedures that need to be followed.

Companies in existence before 1 October 2008

A transitional provision provides that any company, including a charitable company, in existence before 1 October 2008 (when section 175 came into effect) would need to pass a standalone members' resolution before it could authorise conflicts of loyalty pursuant to section 175.

The question then arises whether a company, including a charitable company, which adopts new articles incorporating revised directors' conflicts provisions under the 2006 Act, still needs to pass a separate members' resolution. There appears to be a divergence of opinion on this issue amongst practitioners. Consequently, as a 'belts and braces' measure, we are advising that when companies are revising their articles of association a separate members' (ordinary) resolution is passed conferring authority on the directors to approve conflicts pursuant to section 175.

Steps to take regarding the authorisation of conflicts of loyalty

  • Amend the articles of association to include provisions allowing conflicts of loyalty to be authorised (this is mandatory for charitable companies).
  • For charitable companies and their trading subsidiaries which were in existence before 1 October 2008, arrange for the members to pass an ordinary resolution conferring authority on directors to approve conflicts of loyalty pursuant to section 175.
  • If necessary, appoint new director(s) to ensure that there are at least two unconflicted directors.
  • Consider whether it is necessary or appropriate to reduce the quorum provisions for meetings of directors for the purposes of authorising conflicts of loyalty

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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