Conflicts of interest are topical. There is an obvious unease when a person entrusted to act for one company is influenced by duties or interests owed elsewhere.
With a corporate joint venture, it is common for directors and/or employees of a shareholder to also be directors of, and provide services to, the joint venture company. Director conflicts of interest are inevitable in such a situation, given the separate and independent director duties which will exist to the corporate shareholder and to JVCo.
Often the director conflicts of interest analysis can be reduced to four separate questions: first, have director interests in transactions or arrangements been properly declared; second, has any situational conflict been authorised; third, do the articles of association and/or shareholders’ agreement permit the conflicted director to count in the quorum and vote; and fourth, is the type of transaction being considered by a company one of the limited categories involving directors or connected persons where statute specifically requires shareholder approval, for example substantial property transactions, long-term service contracts and loans/quasi loans/credit transactions?
For corporate joint ventures, the more difficult question can be the third question: whether conflicted shareholder-appointed directors (or the conflicted shareholder) should be allowed to control, influence or block JVCo decisions where the shareholder’s interests diverge from JVCo’s, or whether in such situations control should shift to the non-conflicted director class.
Director conflicts: a case study
MajCo is to own 51% of the share capital of an English joint venture company, JVCo. InvestCo is to own 49%. Each shareholder may appoint two directors. The MajCo-appointed directors will be the A Directors; the InvestCo-appointed directors will be the B Directors. The new Articles of Association of JVCo (referred to here as the Articles) will state that the quorum for directors’ meetings is four directors, including at least one A Director and one B Director. All of the nominated directors are also directors or employees of their appointing shareholder. References to sections are to the Companies Act 2006.
JVCo is to manufacture and distribute specialised paint from a new manufacturing facility to be built by JVCo. MajCo will grant JVCo a technology and IP licence to JVCo (referred to as the licence) and JVCo will enter into a distribution agreement with MajCo. Related party contracts are common in joint ventures. Other examples include manufacturing contracts, leases of real estate, customer contracts, secondment agreements and/or management agreements.
From time to time it is expected that MajCo and JVCo may bid for the same customer contracts, because MajCo offers coating solutions outside JVCo’s technology scope.
Declaration of interests
The A Directors should declare the nature and extent of their interest in the licence and distribution agreement before the transactions are entered into. Section 177 requires this where a director is interested in a proposed transaction or arrangement. There are exceptions where the other directors already know, or ought reasonably to know, of the interest, however the safer approach is to record the declaration clearly in the board minutes.
A more practical joint venture approach is to give a general notice under section 185 that a director is to be treated, for the purposes of section 177, as interested in any transaction or arrangement with a specified company. The A Directors could give a general notice for MajCo and the B Directors could do the same for InvestCo. This reduces the need for repeated declarations for existing or future related party transactions.
But a general notice for contracts between MajCo and JVCo would not cover a competing bid for a third-party customer contract. Although in that scenario there is clearly a conflict between MajCo and JVCo, that scenario does not involve a transaction between MajCo and JVCo and therefore the general section 185 notice does not cover this conflict. A separate section 177 declaration may be necessary.
If a declaration cannot be made before the transaction, for example because a new A Director is appointed or because an A Director was not aware of the conflicted transaction (and this was reasonable – unlikely with a related party contract but perhaps possible in a competing bid situation), section 182 may require a declaration of interest in the existing transaction or arrangement. Unlike section 177, failure to comply with section 182 can be a criminal offence (section 183).
Restrictions on counting in the quorum and voting
The declaration obligations should not be confused with quorum and voting rights. Disclosure under the Companies Act 2006 is mandatory, but the ability of a conflicted director to count in the quorum or vote is primarily a matter for a company and its governance procedures (subject to any specific statutory restrictions) which governance procedures should be incorporated in its articles of association. The confusion can arise because both topics relate to transactions and arrangements in which a director has a potential conflict of interest and some of the language in section 177 (declarations of interest) is the same as that used in Article 14 (restrictions on conflicted directors counting in the quorum) of the Model Articles of Association (Schedule 1 to the Companies (Model Articles) Regulations 2008).
In respect of approving the licence and the distribution agreement, there is therefore no statutory restriction that prevents the A Directors from counting in the quorum or voting on the relevant board resolution. It depends on JVCo’s Articles. Article 14 of the Model Articles would not allow the A Directors to count in the quorum or vote on a board resolution in respect of a transaction or arrangement when they are conflicted (subject to certain exceptions).
Permission to count and vote however is not the same as a release from the directors’ general duties. The directors must still act for proper purposes, exercise independent judgment and promote JVCo’s success.
The drafting choice is therefore essentially between two models. Under Option A, the Articles disapply or modify Model Article 14 so that conflicted shareholder-appointed directors may count in the quorum and vote. Under Option B, the Articles provide that, for related party contracts, only the non-conflicted class of directors is required for quorum and approval (and possibly the conflicted directors are required to withdraw from discussions).
At formation, the parties may be comfortable with all directors attending all board meetings, counting in the quorum and voting to approve and enter into agreed-form documents. The harder question is what happens later if JVCo has a dispute with MajCo under the licence or distribution agreement. InvestCo may be concerned that the A Directors will be reluctant to cause JVCo to pursue MajCo, leaving JVCo unable to act.
With Option B
JVCo’s independence is maintained as MajCo cannot thwart or stifle any attempt by JVCo to act in its best interests, even if that involves bringing proceedings against MajCo; and
it avoids the A Directors being torn between conflicting loyalties and director duties towards JVCo and MajCo, in particular their separate and independent duties to:
- exercise independent judgement (section 173), to exercise their powers for proper purpose (i.e. not their own or someone else’s purposes) (section 171(b)); and
- to promote the success of the company (section 172).
MajCo may see the issues differently. As majority shareholder, it may be uncomfortable if control of a dispute concerning its own commercial arrangements with JVCo passes entirely to the B Directors, particularly if MajCo is indirectly funding JVCo’s claim through its shareholding.
One compromise is to keep Option A but require related party matters to be approved by shareholders as reserved matters and require JVCo to adhere to their directions, with JVCo a party to the joint venture agreement (and/or having these terms in the Articles). This would mitigate against the risk to directors of breaching competing fiduciary duties, as the directors will be obliged to abide by JVCo’s commitments. It does not, however, remove the risk of deadlock; it merely moves it from the board to the shareholders, albeit with the latter having more flexibility as not being subject to duties to act in JVCo’s best interests.
From a neutral best governance perspective, Option B is often the cleaner solution, although it may be commercially difficult for a majority shareholder to accept, who might prefer appropriate escalation and deadlock protections to safeguard its interests.
If Option A is chosen, it should be integrated with the wider deadlock and escalation architecture. The documents should address whether disputes over related party contracts are escalated to shareholders, chairpersons of the shareholders, mediated, referred to an independent expert or business consultant, or ultimately resolved through put, call, third party sale, winding-up or other exit rights. Courts and arbitrators may resolve legal disputes, but they are rarely a substitute for a commercial decision-making mechanism where JVCo needs to decide how best to proceed.
It is noteworthy that conflicts of interest in respect of competing bids may warrant separate treatment. If MajCo and JVCo are bidding for the same contract, both parties may prefer that the A Directors are excluded from JVCo’s bid discussions and related confidential information to guard against one party having an unfair advantage (and also to guard against competition law concerns). The drafting may therefore need to distinguish between related party contract conflicts on the one hand and conflicts arising from competition for third-party opportunities on the other. This assumes that competing third-party opportunities are a possibility with the particular joint venture.
Situational conflicts
A separate matter is that the A Directors may have a situational conflict simply by becoming directors of JVCo while being directors or senior employees of MajCo.
Section 175 requires directors to avoid situational conflicts. The duty cannot be disapplied, but the conflict may be authorised by the directors if the conflicted directors do not count in the quorum or vote and provided that the Articles do not invalidate such authorisation. Alternatively, shareholder authorisation may be available under section 180(4).
The Articles should therefore allow the non-conflicted class of directors to form a quorum and authorise the other class’s situational conflict. Articles often use the concept of “eligible directors” to distinguish those who may count and vote from those who may not.
If authorisation is missed, shareholder ratification under section 239 may be available but it would be cleaner to authorise the conflict at formation and ensure the quorum mechanics work from day one.
General approval of a situational conflict under section 175 in respect of MajCo and JVCo should not be confused with the separate duty to declare interests in related party transactions or arrangements. Section 177 applies when the conflict relates to a transaction or arrangement notwithstanding that the situational conflict may have previously been approved.
Substantial property transactions
Under section 190(1)(b) shareholder approval would be required if the licence or the distribution agreement involves the transfer of a substantial non-cash asset between JVCo and a director of JVCo or a person connected to such a director.
Interestingly MajCo is not deemed connected to the A Directors merely because the A Directors are also directors or employees of MajCo. The relevant connection would usually require the A Director, together with connected persons, to control or hold 20% or more of share capital/voting rights in MajCo.
The broader practical point with the A Directors being also directors of MajCo is the need to consider director conflict provisions from both sides. For example, MajCo may also need shareholder approval as a substantial property transaction when granting the licence or distribution rights under section 190(1)(a).
If the “connection” between an A Director and MajCo exists then the substantial property transaction point needs to be checked because “substantial” under the legislation is not that substantial and “non-cash assets” is very broad as section 1163 extends the definition to the creation of an interest in, or right over, property. The licence could be caught. The distribution agreement perhaps less likely, but it depends on its terms.
Key takeaways
The key point is that JV conflict analysis should not stop at disclosure. Advisers also need to consider situational conflicts and whether the nature of any proposed transaction requires specific shareholder approval. Furthermore, advisers should at the outset have aligned the Articles, joint venture agreement, reserved matters, conflict authorisations, information barriers and deadlock mechanics so that JVCo has a workable route to make decisions when shareholder interests diverge.
In respect of participation, quorum and voting, governance documents may need to deal separately with related party contracts (more obvious) and conflicts over third-party opportunities (possibly more remote but every bit as important assuming such a scenario is a possibility). They should also make clear who decides, who receives information, who counts in the quorum, who votes, and how deadlock is escalated.
These issues are easiest to resolve at formation, when the parties can agree the rules before a dispute arises. If they are left until the conflict has crystallised, the result may be procedural paralysis, exposed directors and a JVCo board that cannot act decisively in the company’s own interests. The real risk is not simply that a conflict exists. It is that, when the conflict matters most, the JV has no agreed mechanism for deciding what to do.
This article is for general information purposes only and does not constitute legal or other professional advice. It should not be relied upon as a substitute for specific advice relevant to your particular transaction or circumstances. The author and Seddons GSC LLP accept no responsibility for any loss arising from reliance on the information contained in this article
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