Corporate update: the latest corporate law developments May 2023

Directors beware: parent company director held to be de facto director of subsidiary

In Aston Risk Management Ltd v Jones [2023] EWHC 603 (Ch) the High Court held that a director of a parent company had been so significantly involved with the day-to-day running of its subsidiary that he became a de facto director of that subsidiary. The case is a useful reminder of the importance of individual group companies each having their own distinct corporate governance structure, with clear and transparent decision-making procedures. 

Types of director

Most companies will formally appoint one or more individuals to act as a director. Where that appointment is valid, the person will be a de jure director (director in law). 

English law also recognises other categories of director, including de facto directors (directors in fact). These are people who have assumed responsibility to act as directors, but who have not been validly appointed as such. Importantly, the general statutory duties of directors (set out in the Companies Act 2006) apply to de facto directors and they can be personally liable for breach of those duties in much the same way as formally appointed directors.

There is no single test for identifying a de facto director, but as seen in the Aston Risk Management case, the court will consider various relevant factors including whether the individual was part of the company’s corporate governance system at the highest level and whether they carried out functions that only a director can perform. 

Facts

The High Court was asked to consider (among other things) whether “LJ”, an individual director of a parent company, was also a de facto director of its subsidiary company.

At all relevant times, the subsidiary had two officially appointed directors, CJ and ML. CJ was also a director of the parent company (along with the first defendant, LJ).

The shareholders of the parent company entered into a shareholders’ agreement setting out how the parent and subsidiary companies would regulate their businesses. The agreement required the subsidiary’s business to be managed overall by its parent company and also prevented the subsidiary’s directors from taking certain decisions without the prior consent of the parent’s board. 

Although never officially appointed as a director of the subsidiary, LJ played a significant part in its day- to-day affairs, holding meetings, making decisions and conducting negotiations on its behalf.

The subsidiary eventually entered administration and claims were brought against LJ for breach of his fiduciary duties as a de facto director of that company. LJ argued that he was not a de facto director and that his actions in relation to the subsidiary were not taken by him individually but were, instead, indicative of him exercising oversight on behalf of the parent company (as envisaged by the shareholders’ agreement).

High Court decision

The Court rejected LJ’s arguments and held that he had acted as a de facto director of the subsidiary. The Court was satisfied that the role that LJ had played in directing the affairs of the subsidiary was consistent with him being part of its corporate governance structure, if not the key and principal element of it. He had also performed functions on behalf of the subsidiary that could only properly be carried out by a director.

Of key importance was the Judge’s finding that LJ had been acting individually, and not as a director of the parent company when he made decisions and acted on behalf of the subsidiary. Reasons as to why the Judge reached this conclusion include that:

• LJ was clearly the dominant personality who drove the required decisions, with CJ (the other director of the parent) simply agreeing with anything LJ wanted. Although LJ may have obtained CJ’s formal agreement to certain actions, these could not readily be categorised as the actions of a properly functioning board.
• The role that LJ played in the subsidiary was fundamental. It was not confined to particular clearly identified decisions but extended to day-to-day decisions that were difficult to categorise as being decisions of the parent company’s board.

Comment

Acting as a de facto director brings with it many uncertainties. The individual “director” may find themselves personally liable for losses suffered by the company and they can also be disqualified from acting as a director in the future. In turn, it is never desirable for a company to have de facto directors as there will inevitably be confusion as to the company’s decision-making structure and who has the authority to effectively bind the company.

Whether a person is acting as a de facto director will always turn on the specific facts of the case. There are, however, some practical steps that can be taken to reduce the risk of this happening. These include:

• ensuring that the relevant company’s corporate governance system is clearly documented and that decisions are made in compliance with that system;
• where decisions are to be made at board level, these should be taken at duly constituted board meetings (or otherwise in accordance with the company’s articles of association) and any meetings should be properly minuted; and
• the involvement of parent company representatives in the day-to-day operational decisions of its subsidiary should be restricted. A representative is less likely to be a de facto director if they have control (e.g. in the form of consent or veto rights) in relation to specified activities only and not in relation to general business operations.

Conversion of shares under articles void for lack of class consent

In DnaNudge Ltd, Re (also known as Ventura Capital GP Ltd v DnaNudge Ltd) [2023] EWHC 437 (Ch) the High Court held that the conversion of preferred shares into ordinary shares in accordance with a provision in the company’s articles of association, which provided for automatic conversion of the shares in certain circumstances, amounted to a variation or abrogation of the rights attached to those preferred shares. As the requisite class consent for that variation or abrogation had not been obtained, the conversion was found to be invalid, void and of no effect.

Facts

The company, DnaNudge Limited, was a medical and health technology company. In January 2022 two investors subscribed £42m for preferred shares in the company. Those preferred shares had various special rights attaching to them, including preferred payment of arrears of dividends and return of capital, plus a priority return in any distribution on liquidation, return of capital or sale of shares amounting to a controlling interest.

The rights attached to the preferred shares were set out in the company’s articles of association which also specified that:

• all the preferred shares would automatically convert into ordinary shares on notice in writing from an ‘Investor Majority’ (the Conversion Provision); and
• the special rights attached to any class of shares may only be varied or abrogated with written consent from the holders of more than 75% in nominal value of the issued shares of that class (the Class Consent Provision).

In May 2022 various ordinary shareholders, together constituting an ‘Investor Majority’, signed a letter purporting to give notice to the company requiring the preferred shares to be converted into ordinary shares in accordance with the Conversion Provision. The company’s solicitors then wrote to the investors informing them that their shares had been converted into ordinary shares and that the company’s register of members had been updated accordingly.

The investors objected to the conversion of their preferred shares. They argued that the conversion amounted to a “variation or abrogation” of the special rights attached to those shares and so could only be done with consent from the holders of those preferred shares under the Class Consent Provision. Since that consent had not been obtained, the investors said the purported conversion of their preferred shares was void.

Decision

The judge agreed with the investors. He said that the conversion of the preferred ordinary shares into ordinary shares amounted to a variation or abrogation of the special rights attached to those shares. After the conversion, those special rights had been extinguished and ceased to exist because the preferred ordinary shares were then ordinary shares.

This gave rise to a “clear tension” between the Conversion Provision, which said the conversion of the preferred shares happened automatically on the required notice being given, and the Class Consent Provision, which required a further consent from the preferred shareholders before the rights attached to those shares could be varied or abrogated by means of that conversion.

The judge viewed this tension as a drafting error and resolved it by implying into the Conversion Provision wording to the effect that the conversion of the preferred shares was “subject always to having first obtained the consent required under the [Class Consent Provision]”. 

So the Class Consent Provision took precedence over the Conversion Provision. And, since the requisite class consent had not been obtained, the conversion of the preferred shares, which amounted to a variation or abrogation of the rights attached to those shares, was invalid, void and of no effect.

Comment

This is a somewhat surprising decision in that the rights attached to the shares, and the way in which those rights could be altered, were set out in the articles of association, negotiated between the parties with the assistance of lawyers. The Companies Act 2006 provides that the rights attached to a class of shares may be varied “in accordance with provision in the company’s articles” and, generally, a shareholder is taken to have agreed to the provisions of the articles in existence when they subscribed for their shares. If they were not happy with those provisions, they could simply choose not to subscribe for the shares. In this case, those provisions included the mechanism for the automatic conversion of the preferred shares on notice from an Investor Majority.

But the issue here was the conflict between the Conversion Provision and the Class Consent Provision. Since that had not been resolved in the drafting of the articles, the court had to step in. To avoid any similar issue, companies and their shareholders should ensure that the interaction between any conversion provision (or any other provision which could amount to a variation or abrogation of class rights) and any class consent provision is expressly dealt with. The articles should specify whether the conversion (or other provision) requires class consent or whether the relevant class is deemed to have consented to the variation or abrogation of their rights in the way provided for in the relevant provision without the need for any further consent.

First published in Accountancy Daily.