However, when two group companies contract with each other where board members serve on both entities, this potential conflict of interest becomes unavoidable. The increasing frequency of this occurrence has necessitated a closer look at the disclosure and recusal requirement in section 75(5) of the Companies Act 71 of 2008 (Companies Act) and how these procedural aspects are to be dealt with.
Section 75(5) of the Companies Act
In summary, section 75(5) of the Companies Act provides that, if a director of a company has a “personal financial interest” in a matter to be considered at a meeting of the board, or knows that a “related person” has a personal financial interest in the matter, that director must recuse him/herself from a meeting where the matter is to be decided.
Section 1 of the Companies Act defines “personal financial interest”, when used with respect to any person, as “a direct material interest of that person, of a financial, monetary or economic nature, or to which a monetary value may be attributed”. This will often be the case for both parties to commercial contracts.
Importantly, section 75(1)(b) of the Companies Act provides that a “‘related person’, when used in reference to a director, has the meaning set out in section 1, but also includes a second company of which the director or a related person is also a director”.
It is an all too common occurrence that certain members of the board of company A also serve as members on the board for its sister company B (common directors). In this situation, section 75(1)(b) prevents these common directors from voting as regards agreements between company A and company B, as company B would be considered “related” to company A. This section applies notwithstanding that such board members themselves may derive no direct personal financial benefit from the proposed transaction to be approved, and there is no carve-out in section 75 regarding intra-group transactions, even where wholly-owned subsidiaries are concerned. This would be even more problematic where the boards of both company A and company B are constituted entirely by common directors (so-called “mirror boards”), leaving no unconflicted directors to pass a decision once all recusals have been made.
Although practically challenging, the underlying rationale of section 75(1)(b) is that a director of two companies owes a fiduciary duty to both companies and must act in their respective interests. In theory there is a concern around divided loyalties where a director of two companies deliberates on a decision in terms of which both companies have a material financial interest, as the furtherance of one company’s interest may be to the detriment of the other. For instance, in the context of one group company deciding whether to stand as guarantor or surety for another group company’s bank debts, or deciding whether to purchase property from another group company, the concern of the legislature is that the common director is tempted to push through a decision of the first company (guarantor, purchaser) when actually it is the second company’s (borrower, seller) interests he truly has at heart. This goes to the root of the common law position that a director must always avoid a conflict of interest.
Section 75(7) of the Companies Act provides that a decision by a board is valid despite any personal financial interest of a director or related person only if:
(a) “it was approved following disclosure of that interest in the manner contemplated in this section; or
(b) despite having been approved without disclosure of that interest, it:
- has subsequently been ratified by an ordinary resolution of the shareholders following disclosure of that interest; or
- has been declared to be valid by a court in terms of subsection (8).”
Section 75(7) provides three scenarios where a decision may be valid notwithstanding a personal financial interest of a director or related person in three instances.
(a) Firstly, where the conflicted director makes the appropriate disclosure and recuses him/herself in accordance with section 75(5). Practically, this will only be possible where, following the common directors’ recusal, there are sufficient directors remaining who may vote on the matter.
(b) Secondly, where the decision has subsequently been ratified by an ordinary resolution of the shareholders following disclosure of that interest. As regards group entities whose boards consist entirely of common directors, the only option is for all of the directors to disclose their personal financial interests, and thereafter refer the resolution to the company’s shareholder for ratification. It does not seem obvious that this falls within section 75(7)(b)(i), as the latter appears to only deal with situations of non-disclosure (whether inadvertent or mala fide) by the conflicted director, but should pass muster under common law principles.
Thirdly, where the decision has been declared to be valid by an order of court.
In the second scenario, there is no authority to suggest that this remedial provision will not apply where the counterparty to a transaction is also the very shareholder of the company seeking to ratify. Shareholders are not bound by conflict-of-interest rules and can vote their shares in their absolute discretion. In other words, where the counterparty is a holding company, it is acceptable for that holding company to ratify actions “to be taken” or actions “already taken” by the subsidiary seeking approval.
Section 75(5) is problematic for group companies wishing to contract with each other where directors serve on both entities. Common directors must adhere to these provisions or face possible liability for a breach of their fiduciary duties. Although section 75(7) provides remedies for these procedural obstacles, obtaining shareholder approval for each decision taken or to be taken at board level may be slow and administratively cumbersome. Consequently, group companies may consider avoiding this overlap in management by ensuring mirror boards are not pervasive throughout the group, and that there are sufficient “independent” board members on each company board.