The UK has a reputation for possessing robust rules on related party transactions. This perception stems from the view that the common law fiduciary duties of directors in relation to self-dealing were demanding, in particular by requiring shareholder approval of transactions involving a risk of directorial self-dealing. As my recent chapter on the UK system in Luca Enriques and Tobias Tröger (eds), The Law and Finance of Related Party Transactions (CUP 2019) shows, this view, if sustainable at all, rests today on two other things. First, legislative initiatives to save the common law fiduciary duty from the inherent weakness that it could be modified by an ex ante, general waiver contained in the company’s articles. Second, in relation to publicly traded companies, rules made by the financial market regulator and London Stock Exchange, which partly restored the original fiduciary position.
Certainly, in the early days of modern company law the courts announced a tough anti self-dealing doctrine. Lord Cranworth said in The Aberdeen Railway Co v Blaikie Bros (1854) 1 Paterson 394 (HL) 399: ‘no one, having [fiduciary] duties to discharge, shall be allowed to enter into engagements in which he has or even can have a personal interest, conflicting, or which possibly may conflict, with the interests those whom he is bound to protect’. In this case a railway company contracted with the plaintiff for the supply of ‘chairs’—the word referring here to a metal device for securing rails to sleepers. Blaikie was the chairman of the company as well as the managing partner of the supplying partnership, which unsuccessfully sued to enforce the contract. Although much cited, this statement was incomplete, because it failed to make clear that the beneficiaries of the fiduciary duty (ie the company) could modify it, either ad hoc or generally. Since the directors were conflicted this was necessarily a task for the shareholders, but the company’s articles of association, usually drafted under management influence, provided a convenient way of achieving a director-friendly, but shareholder approved modification of the initial rule.
Companies were quick to take advantage of this mechanism. Within a couple of decades of the Aberdeen Railway decision, the articles of most public companies permitted breaches of the ‘no conflict’ rule to be approved by a decision of the independent members of the board (independent in the sense of ‘not involved in the transaction’; not independent in the modern-day corporate governance code sense). It was this version of the duty which Parliament codified in s 177 of the Companies Act 2006. The location may be new, but this concept of how self-dealing transactions should be handled is old.
However, even before 2006 Parliament had identified four situations in which board approval of self-dealing transactions was regarded as inadequate and the initial rule of shareholder approval was restored. Three of these situations concerned directors’ remuneration in one way of another, but the fourth was more general. Substantial property transactions, direct or indirect, between the company and any of its directors require shareholder approval, whether the transaction is a sale or an acquisition of the property by the company. A low bar was set for the definition of ‘substantial’, essentially ruling out only de minimis transactions. So, the general law looks very different, depending on whether the transaction is a property transaction with the director (shareholder approval required) or a non-property one (board approval permitted).
Thus, the general law, applying to all companies, falls some way short of a general requirement for shareholder approval of related party transactions and, in so far as it requires shareholder approval, does not do so through application of common law fiduciary duties. Do the rules applicable to publicly traded companies go further? The rules for companies with a premium listing on the Main Market of the London Stock Exchange, made by The Financial Conduct Authority, certainly extend the general rules in one respect. They apply not only to directors, but also to ‘substantial’ shareholders (10% or more of the voting rights). However, the general law had eventually developed various workarounds to bring significant shareholders within the fiduciary rules for directors, notably through application of those duties to ‘shadow directors’, ie those in accordance with whose directions or instructions the board is accustomed to act. This brings in some influential shareholders who are not directors of the company.
On the central issue of shareholder approval of related party transactions, the FCA’s Listing Rules appear to require it. In fact, however, the requirement is subject to a threshold, which means that the rule will pick up relatively few related party transactions. The transaction must equal or exceed 5% of the company’s assets, turnover, profits or market capitalisation for the shareholder approval requirement to be triggered. Given the size of the Main Market companies, this is a high threshold to cross. A management buy-out of a substantial part of the company’s business might be an example. Below that, but above a 0.25% threshold, the requirement is ex ante disclosure to the market, coupled with a fairness opinion, rather than shareholder approval. This allows shareholders to react adversely to the deal before it is concluded, but does not give them a formal veto. With Main Market companies, even the 0.25% threshold is a substantial hurdle.
In fact, the rules applicable to companies traded on the Alternative Investment Market (AIM) are triggered in practice more often. These rules are made by the Exchange itself, but they track the FCA’s rules, albeit in a less demanding way. Thus, the AIM rules apply only at or above the 5% level and they trigger only an ex ante disclosure requirement, not shareholder approval. Nevertheless, because of the smaller size and more concentrated shareholdings of AIM companies, the rules produce a steady flow of announcements.
Although it is difficult to be sure, the different approaches of the AIM and Main Market rules may be functional. The independent director requirements of the UK Corporate Governance Code, which also applies only to premium listed companies on the Main Market, may mean the managerial self-dealing is effectively checked in that way. The main risk of managerial self-dealing in Main Market companies is thus through remuneration contracts, but these are (i) excluded from the listing rules and (ii) subject to extensive requirements under the Corporate Governance Code and under the general law (‘say-on-pay’) independently of s 177. With AIM companies, the scope for self-dealing with the company’s assets on the part of managers and large shareholders may be greater, because of the lower corporate governance standards. On this basis, the puzzle is why those rules require only disclosure. Perhaps, the general law requirement for shareholder approval of substantial property transactions was thought to catch the core cases requiring shareholder approval. Some limited empirical investigation carried out for the chapter revealed that 88% of AIM disclosures were triggered by shareholders’ or directors’ participation in proposed fund raisings by the company, ie cases falling outside the substantial property transaction rules. This gives some credence to the view that the general law catches property transactions and imposes shareholder approval, probably discouraging related parties from engaging in such transactions.
Returning to the Main Market rules, neither shareholder approval nor supposedly independent directors may operate as expected where there is a controlling shareholder. Controlled companies may be rare on the Main Market, but they are not unknown, especially where the company is incorporated outside the UK and is listed in London for fund-raising purposes. Here, the FCA’s main protection for non-controlling shareholders is the requirement for a contract between the controller and the company, constraining the way in which the controller influences the company, monitored by the independent directors, over whose selection the controller’s influence is constrained. The related party rules now appear as a sanction if the independent directors do not certify annually that the agreement is being observed. Absent this certification, the RPT rules apply to the controlled company with the thresholds removed. Since transactions between the company and its controller are likely to be routine, a comprehensive requirement for shareholder approval is likely to be an effective sanction. However, competition among exchanges on a global basis has led the FCA to remove the most of the controlled company requirements and some of the general RPT rules where the controller is a sovereign entity.
Overall, the headline statement that the UK routinely requires shareholder approval of related party transactions cannot be supported. Indeed, the basic rule is simply disclosure to the board. However, there are sufficient exceptions, both in the Act and in the rules for publicly traded companies, to make it inaccurate to state that the UK joined the international consensus in favour of independent board approval of RPTs. The present patchwork of rules reflects two main things. First, the legislature responded to corporate scandals with the requirement of shareholder approval of substantial property transactions. Second, the institutional shareholders were able to bring their influence to bear on those fashioning the rules for publicly traded companies so as to generate opportunities for the expression of shareholder dissent where the transaction was likely to have a real impact on firm value.
Paul Davies is Allen & Overy Professor of Corporate Law Emeritus at the University of Oxford and a Senior Research Fellow at the Centre for Commercial Law, Harris Manchester College, Oxford.