!Корпоративное право 2023-2024 / 2013-study-analysis_en

Issue: Does the prohibition to exploit corporate opportunities (or the duty not to compete) continue to bind the director after resignation?

See the previous answer.

If the duty continues to apply, how is this dogmatically justified? For example, under English law the prohibition to exploit corporate opportunities derives from the fiduciary position that a director occupies. When a director resigns, fiduciary duties cease to exist. However, the English courts argued that the director violated the duty of loyalty by resigning in order to exploit an opportunity that was, at the time of resignation, already a so-called maturing business opportunity.

It is up to the shareholders to establish such conditions for directors in the founding act (articles of incorporation). In such a case the ban on competition shall continue after the director has lost the position (but not for more than two years). The ban on competition after termination of office can also be contractual (agreed in the contract between the director and the company).

As in scenario 4, but after an initial expression of interest by Bidder in acquiring the assets and before Rival has taken any steps to make a competing offer, the Bidder board determines that an investment of that size is not advisable at the present time in light of Bidder’s weak financial position.

The decision is in the hands of the supervisory board; anyhow, a member of the management board may not pursue an activity for profit in the area of the company’s activity without the consent of the supervisory board. If such consent is given because the company has no interest, the director may pursue such business.

Can the conflicted director participate in the decision of the board?

No.

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382 Directors’ Duties and Liability in the EU

Spain

Hypothetical I: Liability of the parent and directors of the parent for breaches of duty at the level of the subsidiary

A pharmaceutical company is currently developing two new drugs. After assessing the potential liability risks associated with the future products, the directors of the pharmaceutical company decide to incorporate two separate private limited companies, each taking over the development, research and future marketing of one of the two drugs.

The directors of the pharmaceutical company appoint the two project managers as directors of the two subsidiary companies. The two subsidiary companies enter into an agreement allowing them access to the parent company's research facilities. According to the subsidiary's articles of association, all major strategic decisions regarding the research, development and marketing of the drugs are subject to approval by their sole shareholder, the pharmaceutical company. The employees working for the subsidiaries are formally still employed with the parent company, but are posted with the subsidiaries under an agreement entered into by the parent company and the two subsidiaries upon formation of the two companies.

When the directors of the parent company learn about competitors working on similar projects, they try to accelerate the development process of the two drugs. They award substantial bonuses to the subsidiary’s directors, contingent on the drugs receiving regulatory approval within the next 6 months. The original schedule provided for further tests, which would take at least 12 months.

Primarily because of the contingent bonus payment, the directors of the subsidiaries skip some of the planned tests and studies, and cover up this decision in their filings for regulatory approval.

The two drugs gain regulatory approval within the 6 month time span, and are successfully marketed shortly after that.

Two years after the initial marketing, independent studies reveal that one of the drugs causes a rare form of lethal cancer, exposing the relevant subsidiary to enormous product liability claims that far exceed its net assets. The drug developed by the other subsidiary proves to be safe and leads to substantial profits.

1.Is it possible that the parent company would be liable in circumstances comparable to the stylised facts above?

Probably not. The facto/shadow director doctrines are used only in “simple and easy” cases, and not always successfully. Although these doctrines might work for some purposes, they are not a working concept to make the controlling shareholder liable.

2.Under which circumstances would the directors of the parent company face a liability risk in those circumstances?

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In this case, the director could be liable if he speeded up the process and covered it up.

Hypothetical II: Duties in the vicinity of insolvency

After making losses for three consecutive years, an oil trading company’s equity ratio (equity divided by total assets) has fallen below [1% - 5% - 10%]. On average, comparable companies in the same line of business have an equity ratio of about 25%.

The company still has substantial assets, but the thin equity cushion makes it hard for the company to pursue its core business, as trading partners demand higher prices to compensate them for the perceived higher risk of the company's operations.

The company's directors evaluate different possibilities to improve the business prospects of the company. They attribute past trading losses to the substantially higher volatility of oil prices follo fail to convene the mandatory general meeting within two months to adopt a decision on dissolution wing the financial crisis, and maintain the view that the company's business model is sustainable in the long run. After exploring the possibility to raise new equity to recapitalise the business, they conclude that current market conditions would force them to issue new shares at prohibitively low prices, which would lead to a substantial dilution of their current shareholders.

After analysing the market conditions, the directors come to the conclusion that the market price for crude oil is bound to rise significantly over the next year, particularly due to high anticipated demand from emerging market economies. In an attempt to recapitalise the company the directors decide to invest heavily in crude oil futures. They expect that the anticipated increase in oil prices will lead to substantial gains from this transaction, bringing the equity ratio back in line with the industry average, and thus allowing the company to resume their trading operations at more sustainable conditions.

The directors are aware that a sudden substantial fall in oil prices could potentially wipe out the remaining equity of the firm, but they consider the likelihood of this happening to be very low.

Shortly after entering into the forward sale agreement, worries about a sovereign debt crisis lead to a revision of worldwide economic growth forecasts. The price of crude oil falls more than 10% on a single day, the worst one day performance in many years. As the company cannot fulfil the margin calls on its forward sales contracts, the positions are closed by the counterparty. The closed positions have a negative value exceeding the company’s equity, leading to the company’s over-indebtedness. Trading partners refuse to enter into transactions with the company due to its financial position, and banks close all existing credit lines of the company.

Do fiduciary duties prevent directors from entering into particularly risky transactions?

At which point in time does the law provide for additional duties of directors or the change of existing duties in situations of financial distress? (i.e. how is ‘vicinity of insolvency’ be defined?)

What is the legal response to below situation? For example, the law may provide that the directors have to take primarily the creditors’ interests into account, rather than those of the shareholders, or the company must cease to trade and the directors file for the opening of insolvency proceedings.

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Risky transactions are not per se undesirable. But, of course, depending on the circumstances, they may not be recommended: this judgment falls into the standard of the duty of care. The law does not provide additional duties in situations of financial distress, nor a concept or a definition of

‘vicinity of insolvency’. But the two years before the company is declared insolvent by the Court are known as the suspicious period, mainly because claw-back actions cover that period of time, and directors who have been in office during that period, although they may no longer be, can be held liable according to the special liability section of the bankruptcy proceedings.

In the case above the directors may face liability in case they failed to convene the mandatory general meeting within two months to adopt a decision on dissolution. Insolvency is defined as the situation where the debtor cannot regularly discharge its obligations. This provision applies when the dissolution is the consequence of insufficiency of assets. In such a case, directors are liable vis-à-vis company creditors holding unpaid claims arising after the insufficiency of assets.

Hypothetical III: Duty of care

A large banking institution is engaged in retail as well as investment banking. In 2000, a new CEO was appointed, who also sits on the board of directors. The CEO made the decision to invest heavily in collateralised debt obligations (CDOs) backed by residential mortgage-backed securities, including lower-rated securities that pooled subprime mortgages to borrowers with weak credit history. The investments were initially successful, generating high profits for the company. However, beginning in 2005, house prices, particularly in the United States, began to decrease. Defaults and foreclosures increased and the income from residential mortgages fell rapidly.

As early as May 2005, economist Paul Krugman had warned of signs that the US housing market was approaching the final stages of a speculative bubble. Early in 2007, a large US subprime lender filed for bankruptcy protection and a number of investors announced write downs of several billion dollars on their structured finance commitments. In July, 2007, Standard and Poor’s and Moody’s downgraded bonds backed by subprime mortgages. At the end of 2007, two hedge funds that had invested heavily in subprime mortgages declared bankruptcy. In spite of these warning signs, the CEO had continued to invest in CDOs until shortly before the Lehman bankruptcy in September 2008, accumulating a total exposure of more than 20 billion Euro/Pounds/… . The subprime mortgage crisis necessitated massive write downs, leading to an annual loss of eight billion in 2008, which can be attributed in equal measure to the CDO transactions undertaken in 2005-2008.

The CEO resigned in October 2008. As part of the resignation, the CEO entered into an agreement with the company providing that he would receive 50 million Euro/Pounds/… upon his departure, including bonus and stock options, and in addition an office, administrative assistant, car and driver until he would commence full time employment with another employer. In exchange, the CEO signed a non-compete agreement and a release of claims against the company. The agreement with the CEO was approved by all directors (the CEO abstaining from voting), acting on behalf of the company.

After the CEO’s departure and with a new management team in place, it transpires that the old CEO had used a number of ostensibly arms-length transactions with investment firms that were, however, controlled by the CEO’s nominees, to transfer assets at an undervalue to a company owned by the

CEO on the Cayman Islands. When the true nature of these transactions becomes known, the assets are no longer recoverable.

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Questions:

Is the CEO liable for annual loss suffered by the company in 2008?

The business judgment rule should be applied if the director is well informed, the decision is not illegal, and there is not a conflict of interests. I do not think that the CEO could be liable. It is very hard to prove gross negligence, that he made risky decisions at the time (probably, there were other companies acting in the same way, and opinions and predictions at the time were not unanimous).

Have the directors (other than the CEO) breached their fiduciary duties by approving the agreement in conjunction with the resignation of the outgoing CEO?

Issues:

-Who decides on transactions of one of the directors with the company (related party transactions)?

-Is the duty of care used to constrain excessive executive remuneration?

Related party transactions are decided by the board. The way to prevent excessive remuneration in the law’s view is through the approval by the general meeting in case of stock options, and the clarification of the remuneration system in the articles of association.

Have the members of the company’s internal audit committee (of which the CEO was not a member) breached their fiduciary duties by not identifying the true nature of the ostensibly armslength transactions and are they, accordingly, liable for the loss suffered by the company as a consequence of the transactions? Have the other directors (except the CEO) breached their duties?

Issues:

-Does the standard of care depend on the position of the director in the company and his/her expertise? Accordingly, would members of the audit committee be held to a higher standard of care than other directors?

Yes, executive directors could be said to be, in practice, subject to a higher standard, but it does not seem to be the case that the members of the audit committee would be under a higher standard in practice. There is not even a requirement of expertise in order to be a member of the audit committee (it is a requirement that independent directors are on the committee).

-Are directors required to monitor their colleagues on the board? Would they be in breach of the duty of care if they could have identified wrongdoing by another board member but failed to do so? To what extent are they entitled to

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rely on the integrity of and the careful discharge of the duties by the other board members?

Outside directors are not liable for the actions of the executive management unless in cases of fault in eligendo, in vigilando or in instruendo. On the other hand, they are liable to the company if they negligently perform the tasks that are assigned to them as non-executive directors. Monitoring is one of them. If the breach is the result of a decision of the board, all board members are jointly and severally liable for damages caused to the company, except those who voted against the decision and took steps to prevent it or its harmful consequences.

Assuming that the company has a claim against the CEO or another director pursuant to one or more of the above questions, can a minority shareholder enforce the claim?

The directors are the ones who can bring a claim on behalf of the company. However, minority shareholders have standing to bring a derivative action if they own 5% of the share capital. No other special conditions must be satisfied for the derivative action. The costs of the process are borne by the losing party (with some restrictions). Notice that derivative actions are rare.

Hypothetical IV: Duty of loyalty

A mining company (‘Bidder’) considers expanding business operations. The board identifies assets held by another company (‘Target’) as a possible acquisition. The following scenarios ask you to consider the liability of a director (‘A’) on the board of Bidder.

Director A is also majority shareholder in Target, holding 60 percent of the outstanding share capital of the company. As majority shareholder of Target, he is interested in an acquisition that is beneficial to Target. He proposes that Bidder purchase the assets for 10 million

Euro/Pounds/…, knowing that the value ranges between 7 and 8 million. Director A does not disclose his interest in Target to the board of Bidder. A majority of the directors approves the acquisition. A’s vote was not decisive for the positive vote.

Company Law requires directors to disclose conflicts of interests and abstain from voting (art. 229 LSC). The decision could be voidable ex. art. 251 LSC, but the mere violation of the procedural rules applied to conflicted transactions does not make the resolution per se unlawful (doctrine of “resistance”: the resolution should be deemed valid if, even if the rule had been observed, the resolution would have been adopted). Nevertheless, the infringing director may be liable when the decision has caused damage.

As in scenario 1, but Director A discloses his interest in Target to the board of Bidder, and a majority of the uninterested directors approves the acquisition.

If the interested director observes disclosure and abstention duties, the decision should be valid from a procedural perspective. However, besides the procedural dimension, the decision may be challenged on substantive grounds (e.g., if it is not in the company’s best interest).

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As in scenario 1, but when the shareholders of Bidder learn of A’s interest in Target, they ratify the transaction, believing that it is in the company’s interests.

Normally, related party transactions are not ratified by the general meeting. The minority shareholders can protect their interests by challenging the board’s decision (but the minority can only challenge a board resolution if they represent 5% of the company’s share capital) or by suing for damages. If the transaction is also approved by the general meeting – say, a capital increase or decrease – the minority is better protected: Any shareholder can bring a lawsuit and challenge the decision. However, it may typically be very hard to prove that the transaction harms minority shareholders. A high percentage of the successful claims are granted based on the violation of procedural rules. It is hard to win a case on substantive grounds.

Director A is majority shareholder and managing director in a competitor of bidder (‘Rival’), which is also active in the mining business. The assets held by Target that Bidder seeks to acquire consist in claims near Rival’s own mining territories. Director A is of the opinion that the assets are more valuable for Rival than for Bidder. He therefore arranges for Rival to make a competing and higher offer than Bidder, and Target accordingly decides to sell the assets to the former company.

Traditionally, the mechanism to protect the shareholders was the removal of the competing director. In this case, the general meeting is entitled to dismiss the director. After the Law changed in the aftermath of Enron and related scandals, the traditional prohibition to compete has been kept (art. 228 LSC), but the prohibition to exploit corporate opportunities has been added (art. 230 LSC). Both rules can be applicable, but it is not clear how the two rules should be coordinated.

As in scenario 4, but A resigns from his position as director of Bidder before Rival makes the competing offer.

I am not aware of any judicial ruling on the point, but it seems clear that if the corporate opportunity arises while the director is part of the board, he is not allowed to exploit it, even if the action of exploitation takes place later. Resignation makes no difference.

As in scenario 4, but after an initial expression of interest by Bidder in acquiring the assets and before Rival has taken any steps to make a competing offer, the Bidder board determines that an investment of that size is not advisable at the present time in light of Bidder’s weak financial position.

If the company is not interested in the transaction, the corporate opportunities provision does not apply. The conflicted director should abstain from participating in the decision of the board of directors resolving that the company should not pursue the opportunity.

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The United Kingdom

Hypothetical I: Liability of the parent and directors of the parent for breaches of duty at the level of the subsidiary

A pharmaceutical company is currently developing two new drugs. After assessing the potential liability risks associated with the future products, the directors of the pharmaceutical company decide to incorporate two separate private limited companies, each taking over the development, research and future marketing of one of the two drugs.

The directors of the pharmaceutical company appoint the two project managers as directors of the two subsidiary companies. The two subsidiary companies enter into an agreement allowing them access to the parent company's research facilities. According to the subsidiary's articles of association, all major strategic decisions regarding the research, development and marketing of the drugs are subject to approval by their sole shareholder, the pharmaceutical company. The employees working for the subsidiaries are formally still employed with the parent company, but are posted with the subsidiaries under an agreement entered into by the parent company and the two subsidiaries upon formation of the two companies.

When the directors of the parent company learn about competitors working on similar projects, they try to accelerate the development process of the two drugs. They award substantial bonuses to the subsidiary’s directors, contingent on the drugs receiving regulatory approval within the next 6 months.

The original schedule provided for further tests, which would take at least 12 months.

Primarily because of the contingent bonus payment, the directors of the subsidiaries skip some of the planned tests and studies, and cover up this decision in their filings for regulatory approval.

The two drugs gain regulatory approval within the 6 month time span, and are successfully marketed shortly after that.

Two years after the initial marketing, independent studies reveal that one of the drugs causes a rare form of lethal cancer, exposing the relevant subsidiary to enormous product liability claims that far exceed its net assets. The drug developed by the other subsidiary proves to be safe and leads to substantial profits.

Is it possible that the parent company would be liable in circumstances comparable to the stylised facts above?

Under which circumstances would the directors of the parent company face a liability risk in those circumstances?

De-facto director: It is unlikely that a court would find that the parent company is a de facto director. To become a de-facto director a person must assume responsibility as a de facto director, which does not appear to be the case on the basis of the hypothetical. The fact that parent company directors are also subsidiary directors does not make the parent company a de-facto director.

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Shadow director: a person is a shadow director where the directors are accustomed to act in accordance with the instructions of that person. What one needs to identify is a pattern of behaviour in which the directors do not exercise their own judgment, but rather do as the

“shadow director” has instructed. On the facts it seems unlikely that the parent is a shadow director. The parent uses incentives to mould subsidiary director decision-making. Such incentives at this level of the corporate structure would arguably not be required if the parent was used to simply telling the actual directors what to do. Furthermore, under UK law it is unclear what duties in fact apply to shadow directors.

Group liability: it would not be possible to pierce the corporate veil on these facts. There is scope to argue that the parent owes directly a duty of care in tort to the subsidiary customers on these facts – particularly the control the parent assumes in relation to the drug development and approval process. Recent UK tort case law in the context of parent duties owed to subsidiary employees supports this, but it is not clear that this authority can be extended beyond this setting.

Insolvency law would not provide a solution on these facts.

Hypothetical II: Duties in the vicinity of insolvency

After making losses for three consecutive years, an oil trading company’s equity ratio (equity divided by total assets) has fallen below [1% - 5% - 10%]. On average, comparable companies in the same line of business have an equity ratio of about 25%.

The company still has substantial assets, but the thin equity cushion makes it hard for the company to pursue its core business, as trading partners demand higher prices to compensate them for the perceived higher risk of the company's operations.

The company's directors evaluate different possibilities to improve the business prospects of the company. They attribute past trading losses to the substantially higher volatility of oil prices following the financial crisis, and maintain the view that the company's business model is sustainable in the long run. After exploring the possibility to raise new equity to recapitalise the business, they conclude that current market conditions would force them to issue new shares at prohibitively low prices, which would lead to a substantial dilution of their current shareholders.

After analysing the market conditions, the directors come to the conclusion that the market price for crude oil is bound to rise significantly over the next year, particularly due to high anticipated demand from emerging market economies. In an attempt to recapitalise the company the directors decide to invest heavily in crude oil futures. They expect that the anticipated increase in oil prices will lead to substantial gains from this transaction, bringing the equity ratio back in line with the industry average, and thus allowing the company to resume their trading operations at more sustainable conditions.

The directors are aware that a sudden substantial fall in oil prices could potentially wipe out the remaining equity of the firm, but they consider the likelihood of this happening to be very low.

Shortly after entering into the forward sale agreement, worries about a sovereign debt crisis lead to a revision of worldwide economic growth forecasts. The price of crude oil falls more than 10% on a

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