UK: New Law Relating To Conflicts Of Loyalty Pursuant To The Companies Act 2006

Last Updated: 30 March 2011
Article by Sarah Chiappini

The Companies Act 2006 ("the 2006 Act"), the final provisions of which came into force on 1 October 2009, has changed the way in which directors of charitable companies and directors of charity trading subsidiaries must deal with a particular type of conflict of interest – generally referred to as a conflict of loyalty.

A conflict of loyalty will occur, for example, where a person is (a) both a director of a charity and a director of the charity's trading subsidiary or (b) a director of two charities which have a contractual relationship – ie there is a landlord/lessee relationship or one charity makes grants to the other.

Duty to avoid conflicts of interest (sections 175 and 181 of the 2006 Act)

Section 175, 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 (eg 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. One of these is that in the case of a conflict of loyalty the conflict is, subject to certain conditions, authorised by the directors.

For the sake of completeness, we should add that the legal position regarding conflicts of interest arising from transactions/arrangements between a director (or a connected person) and his/her charity or the charity's trading subsidiary where a personal benefit will be derived (eg payment of rent for use by the charity of a director's property or payment to a director for services or goods provided to the charity/trading subsidiary) remains the same. Here, all such benefits must be authorised by the charity's governing document or by the Charity Commission (or by virtue of the provisions of section 73A of the Charities Act 1993 regarding payment for services provided to the charity).

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 (a) 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 (b) obtain authorisation to vote on the matter from those directors who are not conflicted, subject to prescribed conditions (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 or their trading subsidiaries 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 and/or their trading subsidiaries which 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, or directors of a charity's trading subsidiary, is often easier said than done, especially in these difficult times. 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.

It may be possible for the member/s of a company to authorise prospectively or to ratify subsequently a breach of section 175 of the 2006 Act where, for example, there are insufficient unconflicted directors. However, we would recommend that at as a matter of good governance these remedies are not relied on by charitable companies and their trading subsidiaries and that the directors of such companies take the steps recommended above in order to ensure that the board is able authorise conflicts of loyalty accordingly.

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.

Inclusion of provisions in the memorandum and articles of association

Pursuant to section 181 of the 2006 Act, the memorandum or articles of association of a charity 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 their articles of association.

Non-charitable companies

So far as non-charitable private companies are concerned (ie 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, for completeness, we have been inserting the section 175 procedures that need to be followed.

On the subject of trading subsidiaries, it is not uncommon for there to be only one trustee of the charity who is not a director of the trading subsidiary and only one director of the trading subsidiary who is not a trustee of the charity (one being the minimum number of unconflicted trustees/directors as recommended in the Charity Commission's guidance CC35 Charities, Trading and Tax - version April 2007). However, this would mean that when, for example, the directors of the trading subsidiary wanted to make a decision as to how much it should pass to its parent charity by way of gift aid payment, there would be an insufficient number of unconflicted directors to constitute a quorum to authorise the conflict pursuant to section 175. We have raised this issue with the Charity Commission and the Commission has confirmed that in the light of the new provisions of the 2006 Act, it will be changing its guidance to recommend that there is a minimum of two (rather than one) directors on the boards of charitable companies and their trading subsidiaries.

Companies in existence before 1 October 2008

Secondary legislation has been introduced which provides that any company (including a charitable company) in existence before 1 October 2008 (ie when section 175 came into effect) would need to pass a stand alone 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 (including charitable companies) are revising their articles of association that a separate members' (ordinary) resolution is passed conferring authority on the directors to approve conflicts pursuant to section 175.

Summary of steps that should be taken regarding the authorisation of conflicts of loyalty

In summary, therefore, the directors of charitable companies and the directors of subsidiary trading companies should take steps to:-

  • amend the articles of association so that they include provisions allowing conflicts of loyalty to be authorised (this is mandatory for charitable companies, pursuant to section 181, and advisable for non-charitable companies so that the procedure for authorising conflicts of loyalty is clearly set out in the articles);
  • 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.

Register of conflicts

As a matter of best practice charities and their trading subsidiaries should maintain (and keep under regular review) a register of conflicts of and benefits to directors and connected persons, which should also include a record authorised conflicts of loyalty. The register might also refer to, for example, the part of the company's memorandum or articles of association which authorises conflicts of loyalty (and transactions or arrangements with directors) and the procedures to be followed in this regard. The establishment and maintenance of an accurate conflicts register is now even more important in the light of the provisions of the 2006 Act.

Consequences of a breach of duties as a director

Finally, it is worth remembering that if a director is in breach of his/her fiduciary duties pursuant to charity law or company law (statutory or otherwise) he/she, together with his/her co-directors who knew, or ought to have known of the breach and failed to do anything about it, may be jointly and severally personally liable to the charity for any loss arising from the default. (There are also specific criminal offences pursuant to the 2006 Act in relation to failure to disclose interests in existing transactions or arrangements).

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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