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Scottish Law Commission (Discussion Papers)

You are here: BAILII >> Databases >> Scottish Law Commission >> Scottish Law Commission (Discussion Papers) >> Company Directors: Regulating Conflicts of Interests and Formulating a Statement of Duties [1998] SLC 105(8) (DP) (August 1998)
URL: http://www.bailii.org/scot/other/SLC/DP/1998/105(8).html
Cite as: [1998] SLC 105(8) (DP)
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    Part 8


    Part 8 Substantive Improvements 5: Connected Persons (Section 346) and Remaining Sections of Part X of the Companies Act 1985

    Introduction

    8.1      In this part we review section 346 (meaning of connected person), and then consider the remaining sections of Part X, namely section 345 (power to increase financial limits) and section 347 (transactions under foreign law).[1]

    Section 346: The meaning of connected person

    346.((1) This section has effect with respect to references in this Part to a person being "connected" with a director of a company, and to a director being "associated with" or "controlling" a body corporate.
    (2) A person is connected with a director of a company if, but only if, he (not being himself a director of it) is...
    (a) that director's spouse, child or step-child; or
    (b) except where the context otherwise requires, a body corporate with which the director is associated; or
    (c) a person acting in his capacity as trustee of any trust the beneficiaries of which include...
    (i) the director, his spouse or any children or step-children of his, or
    (ii) a body corporate with which he is associated,

    or of a trust whose terms confer a power on the trustees that may be exercised for the benefit of the director, his spouse, or any children or step-children of his, or any such body corporate; or

    (d) a person acting in his capacity as partner of that director or of any person who, by virtue of paragraph (a), (b) or (c) of this subsection, is connected with that director; or
    (e) a Scottish firm in which...
    (i) that director is a partner,
    (ii) a partner is a person who, by virtue of paragraph (a), (b) or (c) above, is connected with that director, or
    (iii) a partner is a Scottish firm in which that director is a partner or in which there is a partner who, by virtue of paragraph (a), (b) or (c) above, is connected with that director.
    (3) In subsection (2)...
    (a) a reference to the child or step-child of any person includes an illegitimate child of his, but does not include any person who has attained the age of 18; and
    (b) paragraph (c) does not apply to a person acting in his capacity as trustee under an employees' share scheme or a pension scheme.
    (4) A director of a company is associated with a body corporate if, but only if, he and the persons connected with him, together...
    (a) are interested in shares comprised in the equity share capital of that body corporate of a nominal value equal to at least one-fifth of that share capital; or
    (b) are entitled to exercise or control the exercise of more than one-fifth of the voting power at any general meeting of that body.
    (5) A director of a company is deemed to control a body corporate if, but only if...
    (a) he or any person connected with him is interested in any part of the equity share capital of that body or is entitled to exercise or control the exercise of any part of the voting power at any general meeting of that body; and
    (b) that director, the persons connected with him and the other directors of that company, together, are interested in more than one-half of that share capital or are entitled to exercise or control the exercise of more than one-half of that voting power.
    (6) For purposes of subsections (4) and (5)...
    (a) a body corporate with which a director is associated is not to be treated as connected with that director unless it is also connected with him by virtue of subsection (2)(c) or (d); and
    (b) a trustee of a trust the beneficiaries of which include (or may include) a body corporate with which a director is associated is not to be treated as connected with a director by reason only of that fact.
    (7) The rules set out in Part I of Schedule 13 apply for the purposes of subsections (4) and (5).
    (8) References in those subsections to voting power the exercise of which is controlled by a director include voting power whose exercise is controlled by a body corporate controlled by him; but this is without prejudice to other provisions of subsections (4) and (5).

    General

    8.2      Section 346 sets out the definition of "connected person" which is used in many of the sections in Part X.[2] The principal persons who are "connected" for this purpose with a director are:

    (1) his spouse and infant children;[3]
    (2) a body corporate with which the director is associated;[4]
    (3) trustees of a trust under which the director or his family or his associated companies are beneficiaries;[5] and
    (4) partners (and any Scottish firm of which, or with which, the director is a partner).[6]
    8.3      However this is not an exhaustive list and there are complicated provisions for determining whether a body corporate is "associated" with a director. Broadly speaking, he and his connected persons must be interested in 20% of the equity share capital[7] or control (directly or indirectly through another associated body corporate) 20% of the voting power exercisable at any general meeting.[8] The definition of "interest" in Schedule l3, Part I applies for the purpose of section 346[9] so that if the Secretary of State is given power to extend the meaning of interest, it will have effect for the purposes of this section also.

    8.4      Although section 346 is complex we are not aware that there are any particular difficulties in its interpretation or application as it stands.

    8.5          In the main, Part X adopts a principled approach to the legal consequences of the involvement in transactions in breach of Part X of "connected persons". The position of the following may arise:

    (1) counterparties;[10]
    (2) the connected person;
    (3) the director with whom the person is connected; and
    (4) the other director who approved the transaction.
    8.6      Counterparties are affected if as a result of the participation the transaction becomes voidable. This can happen under section 320, section 322A and section 341. Those sections give the company the right to avoid the contract even if the counterparty did not know the facts constituting the breach of the relevant section. Thus Part X prefers the rights of the company to those of the counterparty in this respect. The counterparty is not without a remedy since he can sue the directors who represented that the transaction would be binding for breach of warranty of authority.[11]

    8.7      In some cases Part X imposes liability on the connected person: this happens in section 322(3), 322A(3) and 341(2).[12] Again the connected person may not know the relevant facts. In each case he is given a defence to the statutory claim for an account or an indemnity if he can show that he did not know the relevant circumstances: see section 322(6), 322A(6) and 341(5).

    8.8      The director with whom he is connected is treated more strictly. In two cases, he has a defence to a statutory claim for an account or an indemnity if he can show that he took all reasonable steps to ensure compliance by the company with the relevant provision: sections 322(5) and 341(4). In the case of section 322A, he has no such defence, no doubt because he is expected to know when the board are exceeding their powers (though if he acted reasonably in forming the contrary conclusion he might be entitled to relief under section 727). In the case of section 317 he may find himself in breach of duty even if he did not know about the interest and could not reasonably have done so. We have dealt with this in Part 4 above.[13]

    8.9      There are similar definitions to that in section 346 in related areas. These approach the matter differently and the question arises whether the tests and section 346 should be assimilated. Section 346 is an example of prescriptive legislation, namely legislation which seeks so far as possible to set out a comprehensive list of the matters to be included. It does not for instance seek to set out a principle nor does it contain a sweep up clause at the end to cover other people with whom in a particular case a director may have a sufficient connection to make it right that that person be treated as a connected person of his. This approach may have been deliberately adopted so that a counterparty dealing with a director is able to tell whether the party with whom he is dealing is a connected person of that director.[14] If so, the approach in section 346 would be an application of the certainty principle which we have provisionally identified above.[15]

    8.10      Section 346 may be compared with other similar lists, in particular the definition of "associate" in section 435 of the Insolvency Act 1986 and the definitions of "related party" in the Listing Rules and in FRS 8.[16]

    8.11      It may well be inconvenient and inefficient to have several different definitions, and so we have considered whether section 346 could be more closely aligned to any of them. The definition of associate in the Insolvency Act 1986 is wider than the definition of connected person, especially in relation to close family members. Grandparents, brothers, sisters, adult children, former spouses and reputed spouses are included. This definition applies for the purpose of ascertaining whether a longer period should apply for looking at transactions which might be voidable preferences in England and Wales under section 239 of the Insolvency Act 1986.[17] There is no reason why section 346 should be the same as that in section 435 and indeed as we see it the policy considerations may be very different when the question is whether the fund of assets available for creditors can be increased.

    8.12      The definition in the Listing Rules is relevant to Part X but only where the company is a listed company and it is proposing to enter into a transaction which requires shareholder approval under section 320. Again the definition is in some respects wider: it includes for example persons who have been directors in the last 12 months, and it has a different focus since it also covers shareholders of the company (shareholders having more than 10% of the votes). There is little reason therefore to consider whether section 346 should be adapted to follow this model. The definition of "related party" in FRS 8 applies for the purposes of disclosure in company accounts and it might therefore be more closely connected with Part X. The definition is set out in full in Appendix N. The definition there states that parties such as directors and group companies are "related parties". Another group is presumed to be related unless it can be shown that they do not exercise influence over each other: it must be shown "that neither party has influenced the financial and operating policies of the other in such a way as to inhibit the pursuit of separate interests". Another group are deemed to be related parties because of their personal relationship, for example close family members of directors and any company in which a director had a controlling interest.[18] Control is however defined not by reference to legal rights to control but by reference to "the ability to direct operating and financial policies of the entity with a view to gaining economic benefits from its activities".

    8.13      One of the principles that we provisionally identified in Part 2 was the certainty principle. It is important that company, directors and others should be able, so far as possible, to tell who is a connected person and the tests quoted above involve a high degree of judgment. It must be borne in mind that the contractual rights of a counterparty will be put aside in favour of those of the company if the transaction does not satisfy the procedural rules in Part X and this is another reason why it might be thought preferable not to adopt a judgmental test.

    Consultees are asked:

    (i) whether section 346 gives rise to difficulties in practice;

    (ii) whether they consider that the test of "connected person" should be closer to any of the definitions of "associate" or "related party" considered above.

    Option for reform (1): Make specified additions to the list of connected persons

    8.14          As already pointed out, section 346 does not include cohabitants and it is for consideration whether such persons should be included and if so how they should be defined. Cohabitants are now included as persons who may make claims under the Fatal Accidents Act 1976 and under Law Reform (Succession) Act 1995. In both cases the cohabitant is defined as a person who for the whole of the immediately preceding two years lived in the same household as the deceased as husband or wife of the deceased. This definition would exclude same sex cohabitants and imposes a two-year rule to exclude frivolous claims. In Scotland patrimonial damages (that is damages for pecuniary loss) can be awarded to a person, not being the spouse of the deceased, who immediately before the deceased's death was living with the deceased as man and wife.[19]

    8.15      Again consistently with the certainty principle mentioned above it seems desirable that there should be a qualifying period of cohabitation before a person had to be treated as a connected person so that persons dealing with the company and indeed fellow directors might be better placed to identify the connected person. However, that period should not be too long because then it would deprive the company of important protection under Part X. Bearing in mind those considerations, consultees may feel that a period of one year would be sufficient.

    8.16          It is for consideration whether infant children of the cohabitant who are not children of the director should also be covered if they live with the cohabitant and the director. Children of the director who are born outside marriage would already be included.[20]

    8.17      Finally the question arises whether section 327[21] or section 328[22] should be extended to include cohabitants, and children of the cohabitant who are living with the director and the cohabitant, on the same basis.

    Consultees are asked:

    (i) Should cohabitants, defined as persons who have for a specified period been living with a director of the company in the same household and as man and wife, be connected persons for the purposes of:

    (a) section 346;
    (b) section 327;
    (c) section 328?

    (ii) Should the specified period be a continuous period of one year, or some other period (and if so what), or should there be no period?

    (iii) Should infant children of the cohabitant be treated as connected persons if they live with the director and the cohabitant and the cohabitant has himself or herself become a connected person and if so should that be for the same purposes?

    (iv) Are there any other persons who should be connected persons who are not already covered by section 346?

    Option for reform (2): Give the Secretary of State power to vary the list by regulation

    8.18      Section 346 will always be subject to the defect that another class of person may need to be included or excluded from the list. It is therefore for consideration whether the Secretary of State should have power to add to the list of connected persons by regulation.

    Consultees are asked whether the Secretary of State should be given power to vary the list of connected persons in section 346 by regulation.

    The remaining sections of Part X

    8.19          The sections in Part X which we have not yet considered in this consultation paper are sections 345 and 347.

    345(1) The Secretary of State may by order in a statutory instrument substitute for any sum of money specified in this Part a larger sum specified in the order.
    (2) An order under this section is subject to annulment in pursuance of a resolution of either House of Parliament.
    (3) Such an order does not have effect in relation to anything done or not done before its coming into force; and accordingly, proceedings in respect of any liability (whether civil or criminal) incurred before that time may be continued or instituted as if the order had not been made.
    347 For purposes of sections 319 to 322 and 330 to 343, it is immaterial whether the law which (apart from this Act) governs any arrangement or transaction is the law of the United Kingdom, or of a part of it, or not.
    8.20          Section 345 deals with the power of the Secretary of State to increase financial limits in Part X, and raises no points for review.

    8.21          Section 347 states that for specified purposes, it is immaterial whether the proper law is English or Scottish or some other law. This provision is necessary to prevent parties seeking to avoid the application of sections 319-322 and 330-343 by choosing a foreign law. But for section 347, sections 319-322 would not apply where the proper law of a transaction was not English or Scottish law, and the prohibitions in section 330 would not apply unless again the proper law of the transaction was English or Scottish law or the transaction was to be performed within the jurisdiction.[23]

    8.22      There is a presumption that, in the absence of a contrary intention express or implied, United Kingdom legislation does not apply to the acts of foreign persons or UK persons outside the United Kingdom. The Companies Act 1985 draws a distinction between UK registered companies[24] and other companies. Most of its provisions apply only to UK registered companies, but many of those provisions by their nature apply whether or not the act is done in the jurisdiction.[25] Part X of the Companies Act 1985, other than section 323, applies only to UK registered companies. The provisions are not limited to acts done within the jurisdiction. Section 347 emphasises this point by preventing parties from contracting out of certain sections by choosing a foreign law.

    8.23      There is an issue whether it is necessary for the Companies Act to go that far. A comparison can, for instance, be made with the Employment Rights Act 1996, which covers wage protection and other employment rights. An employee cannot contract out of these rights.[26] The major substantive rights apply, whatever the law governing the employment contract, unless he ordinarily works outside Great Britain.[27] There is no similar restriction in Part X so that its provisions can apply even though the company does not carry on business here, has no assets located here, and has no creditors or members domiciled or resident here. It can be argued that there is no need for the UK to regulate such a case. On the other hand the situation where a company has no business, assets, creditors or members here will be rare, and it would be difficult to draw up a satisfactory statutory exclusion for it.[28] Part X is concerned with the conduct of directors and the safeguarding of its assets. To achieve its purpose it is difficult to see that it can be restricted in its operation except in this very rare case: if there are assets here or persons here who can be prejudiced by corporate self-dealing of the kind restricted by Part X, Part X ought to apply to a transaction even though that transaction is entered into and is to be performed abroad and to the activities of the directors wherever they take place.[29] Moreover, even if at the date of the transaction there is no connection with this jurisdiction a liability may be incurred within the jurisdiction shortly after say a loan to a director has been made and before it is repaid. For these reasons we are provisionally against any territorial restriction being placed on the operation of Part X.

    Consultees are asked if they agree with our provisional view that Part X should apply to acts done outside the jurisdiction. If they disagree with this view, they are asked to state what restrictions should be imposed.

    8.24      There is a minor additional question about the sections to which section 347 itself applies. The section identifies the sections in Part X which are transaction-based, but makes no mention of section 322A or section 322B, which are also transaction based. We provisionally consider that they should do so and provisionally so recommend.

    Consultees are asked whether they agree with our provisional view that section 347 should be amended to include references to sections 322A and 322B.

Note 1   Section 311 is considered in Part 9: see para 9.29 et seq below.    [Back]

Note 2   Ie ss 317, 320-322, 322A, 329, 330, 337, 338, 341, 343 and 344. In addition the options for reform considered above would entail extending the following section to include connected persons: ss 312 and 317.    [Back]

Note 3   Sections 346(2)(a) and 346(3)(a).     [Back]

Note 4   Section 346(2)(b).     [Back]

Note 5   Section 346(2)(c).     [Back]

Note 6   Section 346(2)(d) and (e).     [Back]

Note 7   Defined in s 744 as excluding share capital which carries limited dividend or capital rights.    [Back]

Note 8   Subsection (6) is designed to eliminate circularity.    [Back]

Note 9   Section 346(7).    [Back]

Note 10   By counterparty in this connection we mean another party to the transaction eg a tenant who takes a lease from the company jointly with a connected person of a director and the lease meets the financial threshold in s 320.    [Back]

Note 11   See generally Chitty on Contracts (27th ed, 1994) vol 2, paras 31-093-31-100.    [Back]

Note 12   Criminal liability may also be imposed on, in the case of s 323, a spouse or infant child but they have a defence if they prove that they had no knowledge that the spouse/parent was a director of the company in question. See further para 4.216 above and s 327(1).    [Back]

Note 13   Para 4.105 above.     [Back]

Note 14   The definition in s 346 is to be contrasted with the wider definition of associate in s 435 of the Insolvency Act 1986.    [Back]

Note 15   See para 2.17(7) above.     [Back]

Note 16   See Appendix N.    [Back]

Note 17   This section has no application in Scotland.    [Back]

Note 18   Cf s 346, under which it is sufficient if the director has an interest of 20%. FRS 8 also differs from s 346 with respect to partnerships and trusts.    [Back]

Note 19   See the Damages (Scotland) Act 1976, s 1(1) and Sched 1, para 1(aa).    [Back]

Note 20   Section 346(3)(a). There might also be an argument for including adult children within the definition. It seems somewhat anomalous that a director should be prohibited from, for example, giving a loan to his sixteen year old child, but not his twenty year old child.    [Back]

Note 21   See para 4.216 above.     [Back]

Note 22   See para 5.7 above.     [Back]

Note 23   Dicey and Morris, The Conflict of Laws (12th ed, 1993).     [Back]

Note 24   See the definition of "company" in s 735 of the Companies Act 1985. See also Arab Bank plc v Mercantile Holdings Ltd [1994] Ch 71.    [Back]

Note 25   See, eg, s 121 (alteration of share capital). However, where the company has no real connection with the jurisdiction the court may decline jurisdiction on the grounds of forum non conveniens: see eg Re Harrods (Buenes Aires) Ltd [1991] BCLC 666. There are examples in the Act of provisions expressly applying to acts of UK companies abroad: see, eg, s 398 (verification of charge on property outside the United Kingdom). Some provisions of the Act apply only to foreign companies: see, eg, s 409 of the Companies Act 1985, which requires overseas companies to register charges over property within England and Wales.    [Back]

Note 26   Section 203(1)(a) provides that any contractual provision which seeks to limit or exclude the operation of the Act is void.    [Back]

Note 27   Section 196(1) and (2) and s 204.    [Back]

Note 28   For instance, it may be difficult to define when assets are located here particularly if they are intangible or are moveable, like aircraft.    [Back]

Note 29   Compare the position under the Company Directors Disqualification Act 1996. Proceedings can be taken against the director even though the acts relied upon as constituting unfitness occurred outside the jurisdiction: Re Seagull Manufacturing Co Ltd (No 2) [1994] Ch 91. The Court noted that if the position were otherwise, it could lead to anomalous results since it would mean that disqualification proceedings could not be brought against a foreign director whose activities, conducted exclusively abroad, had shown him unfit to be a director, even though he might seek to expand his activities and to act as a director in England. Ibid, at 104-105.    [Back]

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