The coronavirus outbreak and ensuing lockdown measures are presenting significant and wide-ranging challenges for companies. Faced with unprecedented difficulties, portfolio companies are taking steps which, in many cases, are so material that they require either board or shareholder consideration, such as altering the company's capital structure. For private equity firms navigating the current environment, one question that is particularly relevant, is:
To what extent do they owe duties or responsibilities to portfolio companies, either as controlling shareholders or in their capacity as board members?
Private Equity Funds as Shareholders
Under English law, shareholders do not, by default, owe duties to the company in which they hold shares, or to other shareholders. This means that sponsors generally have discretion to exercise votes, veto rights and other shareholder powers as they see fit (including in their own interests).
Nonetheless, shareholders may be subject to negotiated duties, obligations or responsibilities that are expressly prescribed in a company's constitutional documents, investment or shareholders' agreements or other similar arrangements. For example, to act reasonably or in good faith, or have regard to the interests of minority shareholders in taking a particular decision or exercising a specified right, or not unreasonably withhold consent to a particular matter. Any such contractual requirements will modify the default legal position and mean it is important for sponsors to analyse the relevant documentation agreed with other shareholders (including management).
English law may in certain circumstances also require parties to exercise a contractual discretion in good faith, and not to act arbitrarily or capriciously. The so-called "duty of rationality" is an implied obligation that may arise in commercial contracts (including shareholders' agreements or loan agreements) and take effect even where the parties have sought to retain "sole" or "absolute" discretion. The duty's scope is limited to decisions taken by one party in the exercise of a discretion that affects its counter party in a manner that creates a possible conflict of interest, but the result is that, on rare occasions, a private equity firm could potentially be obliged to act in good faith when taking decisions which affect other shareholders (including management) or employees.
Shadow directorship is a further potential means by which certain duties and responsibilities could be imputed on a shareholder or its representatives. A person (which may be an individual or an entity) may be considered a shadow director of a portfolio company if the portfolio company is accustomed to acting in accordance with that person's individually-and-personally-given directions or instructions. Any shadow director will owe general directors' duties to the portfolio company where, and to the extent that, such duties are capable of applying.
Although designation as a shadow director is not contingent upon a particular percentage shareholding, holding companies will not be regarded as shadow directors provided that due regard has been paid to governance procedures at the portfolio company (for example, by ensuring that all material decisions are duly considered and taken by the portfolio company board, especially where a holding company is seeking to give "directions"). Therefore, the risk for sponsors to be found to be shadow directors should be relatively low.
Private equity firms investing in listed equities may need to have regard to other governance considerations. The Shareholder Rights Amending Directive requires EU-based alternative asset managers to develop and disclose a shareholder engagement policy on how they exercise voting rights and engage as shareholders in EU listed companies, and also provide details of how they have voted in any company general meetings. If not, they must disclose a clear and reasoned explanation for non-compliance. These requirements have been incorporated into the Financial Conduct Authority's Handbook and UK Stewardship Code and so also apply in the UK. Whilst more subtle compared with the various duties and responsibilities discussed above, these considerations may also impact a private equity firm's behaviour and decision making in relation to a listed portfolio investment.
Private Equity Firms' Nominee Directors
Of more material concern to sponsors and their investment professionals is understanding the duties owed by nominee directors on the board of a portfolio company.
All directors of English companies (including non-executive, independent or "nominee" directors) owe fiduciary duties to the portfolio company alone. Whilst nominee directors can represent and take into account their nominating private equity firm's interests when voting or exercising other director powers to the extent that they overlap with those of the company or where shareholders have specifically agreed that shareholder interests may be considered, they are nevertheless subject to overriding statutory duties to promote the success of the portfolio company, to exercise independent judgment and to avoid conflicts of interest.
In instances where a portfolio company experiences financial difficulties, nominee directors continue to owe duties to the company until there is no reasonable prospect of the company avoiding insolvent liquidation or administration. From this point onwards, directors owe duties to the company's creditors as a whole and are obliged to take every step to minimise their potential losses. In such circumstances, a sponsor nominee director is unlikely to be able to consider the interests of the sponsor, given that the interests of the appointing shareholder will likely diverge materially from those of the company's creditors.
Under the wrongful trading regime, directors (including shadow and de facto directors) who do not take steps to minimise a company's losses risk being held personally liable for failing to adhere to this requirement. They may be required to make a personal contribution to the company's assets and be subject to a disqualification order.
These exceptional times have led to an easing of some measures.
In late March, the British government announced that it would temporarily suspend the offence of wrongful trading by directors of UK companies.
This move is designed to enable directors of financially distressed portfolio companies to continue trading during the Covid-19 pandemic and to incur additional debt (including through government funding programmes) without the threat of personal liability should the company ultimately become insolvent. Other insolvency offences however, including fraudulent trading, remain unchanged and sponsors should seek advice at an early stage.
Originally published 5 May, 2020
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.