UK: Directors’ Duties v. Commercial Reality

Madoff Securities International Ltd (In Liquidation)
Last Updated: 26 January 2015
Article by Merley Okine and Lucy Walker

Background

Just six years ago, Bernard Madoff was perceived as a man of integrity, a respected financier on Wall Street and was also CEO and the main shareholder of Madoff Securities International Ltd ("MSIL") in London. Following his arrest on 11 December 2008, Mr Madoff was sentenced to 150 years in prison and ordered to pay US $170 billion in connection with one of the largest scale fraud operations in history involving his New York business which operated as a Ponzi scheme.

Subsequently, MSIL entered into liquidation on 15 December 2009. MSIL's liquidators investigated various payments made from the company to third parties, payments made to Mr Madoff for the purchase of various luxury items (including a £7 million yacht) and also payments in relation to interest on loans taken out by MSIL from Mr Madoff. The liquidators alleged that the payments were made in breach of the former directors' fiduciary and statutory duties to MSIL.

Directors' duties

The liquidators claimed that five former MSIL directors (including Mr Madoff's son) were in breach of the following duties (enshrined in the Companies Act 2006 ("the Act")) in allowing the payments to be made:

  • The duty to act within their powers (section 171)
  • The duty to act in the best interests of the company for the benefit of its shareholders as a whole (section 172)
  • The duty to exercise independent judgement (section 173)
  • The duty to exercise reasonable care, skill and diligence (section 174)

In addition, the liquidators argued that the payments constituted an unlawful distribution of capital to Mr Madoff as shareholder of MSIL.

The Court noted that all of the payments in question were either funded by Mr Madoff or were made at his direction and there was no loss to MSIL. The liquidators' case was therefore made with hindsight, the benefit of which the directors would not have had at the time the payments were made or authorised. In fact, at the time the payments were made the directors had no reason to suspect any foul play and Mr Madoff was highly regarded for his skill and reputation in the financial world.

Breach of duties

Although the judge did not have to determine the issue as to whether all of the above duties had been infringed on the facts, the Court provided useful commentary on the application of the various duties in practise.

Duty to act in the best interests of the company and to exercise independent judgment

The Court confirmed that the duty to act in the best interests of the company was subjective and provided guidance that "it is legitimate, and often necessary, for there to be division and delegation of responsibility" between company directors. However, directors are obliged to keep abreast of the company's affairs in general and should not allow themselves to be "dominated, bamboozled or manipulated" by any fellow directors or use this as an excuse for abrogation of their responsibilities. Directors must exercise independent judgment in accordance with s.171 of the Act. Any director who permits his fellow director to commit a breach of his duties or to misappropriate funds will both be in breach of the duty of reasonable care and skill and will be a party to the breach of their fiduciary duty to act in the best interests of the company.

The Court did, however, find that a director is entitled to rely upon the judgment of a fellow director where their integrity and skill was not open to suspicion. This is particularly so where another director has a greater level of expertise in a particular area. A dissenting director to a majority vote will also not be in breach of his duty by deferring to the views of the majority even if he might have acted differently on his own. Accordingly, as Mr Madoff was (at the time) considered an upstanding financier and businessman with unquestionable integrity, there was no breach in the directors' deference to his decisions regarding the various payments made.

Duty to act within powers and exercise them for the purpose for which they are conferred

This fiduciary duty is enshrined in s.171(b) of the Act. The Court set out a four stage test for breach which requires identification of the following: (1) the power whose exercise is in question (2) the proper purpose for which the power was conferred (3) the substantial purpose for which the power was exercised in the instant case and (4) whether that purpose was proper. The Court did not need to determine the question as to whether the purpose was improper on the facts, but it did provide some useful commentary on when liability will be conferred.

The judge expressed the view that strict liability does not apply to this duty and, rather, liability will be fault based. Therefore, a director's liability for misapplying company property for an improper purpose cannot apply unless the director knew (or ought to have known) that the purpose was improper.

Unlawful distribution of capital

Directors are obliged to maintain the company's capital. Accordingly, a limited liability company not in liquidation may only make payments to shareholders out of distributable profits.

In the circumstances, the Court did not need to determine whether the payments constituted an unlawful distribution of capital, as it was held that there was no distribution of capital from MSIL to Mr Madoff. However, the Court commented that whether a distribution to shareholders infringed this principle would be a question of substance, not form. The question as to whether a transaction is "a disguised distribution of capital" may be heavily influenced by the intention of the parties. The judge considered that "pretence is often a badge of bad conscience", however the Court will not re-categorise a transaction concluded at arm's length if the substance was intended to accord with the form of the transaction.

Duty to exercise reasonable care skill and diligence

The court confirmed that the test for breach of this duty is both an objective and subjective one with reference to the standard of skill expected of a reasonably competent director and also to the particular skill of the individual director.

Decision of the High Court

The Court found that none of the directors were in breach of their duties to act in good faith in the interests of the company. The directors were entitled to rely on the greater knowledge and expertise of Mr Madoff and had no reason to suspect his motives. Consequently, the directors honestly believed at the time that the payments were in the interests of MSIL and were not in breach of their duty to exercise independent skill and judgment. The liquidators' claim against the directors was therefore "unfounded".

Guidance for practise

Although a decision was not required in relation to a number of the arguments raised by the liquidators, the High Court provided useful guidance about directors' duties in a commercial context. The Court confirmed that delegation of responsibilities is a legitimate practice, but that directors owe duties to inform themselves of the company's affairs on the whole. Directors are also entitled to rely upon the greater expertise of other directors in good faith where their motives are not open to suspicion. In addition, directors may defer to a majority decision without breaching their duties even where they might have acted differently on their own.

The decision will be a comfort to directors who are often required to balance their legal duties against the commercial reality of acting alongside fellow directors in areas that may, at times, be beyond their scope of expertise.

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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Lucy Walker
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