The Credit Crunch - How Could it Affect Directors?
21 April 2008 Edward Smerdon
With the credit crunch biting, company directors may also be facing the threat of litigation from shareholders. Edward Smerdon of Reynolds Porter Chamberlain explains how such a situation could occur.
The impact of the credit crunch is creating dangerous ground for company directors as they become open to the threat of litigation. In the US, notorious for its litigious culture, numerous shareholder class actions have been brought against the directors of financial institutions that relied on credit-backed investments linked to the US property market.
Claims against directors of companies directly affected by the sub-prime lending practices are hardly surprising. If shareholders bought shares in reliance upon a successful business model, which later turned out to be flawed, they may have grounds to complain. However, the knock-on effect of the banks’ inability to borrow money from each other is putting pressure on companies not directly affected by the sub-prime crisis.
As property values fell in the US, so did the value of investments linked to them. Many financial institutions have been exposed to significant losses off the back of these falling values. This has affected the banks' ability to lend money to each other, putting some banks at risk. This has resulted in banks reducing their lending or increasing lending charges. The knock-on effect impacts all companies borrowing significant sums.
CLAIMS AGAINST DIRECTORS
For there to be claims against directors, three pre-conditions need to be in place:
1. Financial Need to Sue
The first requirement for there to be any interest in suing a director is there must be a financial need to sue. Over the last five years there has been no economic reason for anyone to sue directors. This may change as we head into more uncertain times.
2. Change in Attitudes to Blame / Funding a Claim
The UK’s relatively benign claims culture is partly due to the fact that traditionally we have not blamed directors at the first sign of trouble. Institutional investors have taken the view that influencing good governance in companies through shareholder pressure is the solution, not the bringing of claims. There are signs of this changing as institutional investors are themselves held to account by their investors for poor investment decisions, and some may already have suffered losses at the hands of the sub-prime crisis.
When such large investors are losing money they can less afford to forgive directors but instead bring claims to recoup some of their lost value. Institutional investors have enough money to bring claims and take the risk of failure in court. Individual shareholders or creditors in insolvent companies can take advantage of the relaxation of rules to permit the funding of claims by a party other than the claimant.
Funding someone else's claim used to be prohibited. This rule has recently been relaxed where a third party ‘funder’ does not seek to influence the claimant's conduct of the claim.
The funder may enter into an agreement with a claimant that it will pay the costs of bringing the claim and the costs of the other party if the claim fails, but if the claim succeeds, that the claimant pays a proportion of the damages and costs recovered to the funder.
This will not lead to a deluge of claims being brought because the funder will only invest in the claims that are reasonably likely to succeed. However, it may make a difference where there is a meritorious claim to bring, but the claimant has insufficient financial means to bring it. This is particularly so with individual shareholders who feel aggrieved at the performance of their directors and creditors of insolvent companies.
There also needs to be assets available to meet claims against directors, if brought. Traditionally, auditors were the targets for liquidators of companies that collapsed because of their unique position in reporting on the state of the companies’ health, and their significant partnership assets backed up by errors and omissions insurance.
However, from 6 April this year auditors will be able to agree 'liability limitation' agreements with audit clients, following a change in the law under the Companies Act 2006. This will allow auditors to cap their liability at a financial sum. Therefore, the ‘deep pocket’ factor driving claims against auditors may diminish.
At the same time, companies have been purchasing ever increasing amounts of D&O insurance. Now cover limits of tens of millions of pounds are not uncommon. There are consequently substantial sums available to meet a settlement or judgment.
3. Changes in the law affecting directors' liability
Companies may, going forward, bring more claims against their directors. The Companies Act 2006 has set out directors’ duties to the company. A director must act in a way which he considers, in good faith, would be most likely to promote the success of the company. In doing so, he must have regard to the following:
- the likely long term consequences of any decision
- the interests of employees
- the need to foster relationships with suppliers, customers and others
- the impact of the company’s operations on the community and environment
- the desirability of the company maintaining a reputation for high standards of business conduct
Decisions on the company’s approach to debt may come under scrutiny particularly if it cannot be shown clearly by the directors that the factors were taken into account.
Directors also owe a duty to exercise reasonable skill, care and diligence. Essentially, this is the duty not to act negligently and will be the duty most commonly relied upon in mismanagement claims. The directors of a company that is struggling to service its debt or suffers a downturn in sales may be vulnerable to allegations of mismanagement.
SHAREHOLDER DERIVATIVE ACTIONS
How can mismanagement claims for alleged breach of these duties be brought?
- By a liquidator pursuant to s.212 of the Insolvency Act
- By the company where sanctioned by a majority of shareholders
- By the company by way of a shareholder derivative action.
This last option has just got considerably easier by virtue of the Companies Act 2006.
Any shareholder may now bring a claim against directors on behalf of the company, for breach of duty.
While it is anticipated the number of shareholder derivative actions will increase, the courts will be strict in deciding whether to allow such claims to proceed and so there will be no flood gate opening. Directors, particularly those who have recently left a struggling company, may find themselves targeted.
While a move to the US model is unlikely to occur any time soon in the UK, the likelihood of claims against directors as a result of the credit crunch seems set to increase. This is because the three pre-conditions for claims against directors may be aligned for the first time.
The shareholder derivative action is a significant development designed to make it easier for companies to bring mismanagement claims. Companies heavily reliant on borrowing to survive may have little option but to bring such claims to off-set their increased costs of borrowing, or simply to inject more cash into the business.