Conflicts in Directors Making Direct Loans to Companies

Fiduciary Duties are potentially compromised and it just has bad optics

I am a manager of a Fund that loans money to technology companies. Separately, as an individual, I am an active independent director on the Board of several technology companies. Periodically, our Fund does not loan to a company as one or more members of their own board of Directors decides to make the loan directly. I had been thinking this is no big deal as someone on the potential client’s Board stepped up and made a loan to the company, often on terms similar to, or even better terms than the arms length commercial loan my Fund was offering.

In thinking about my personal fiduciary duty as a member of a Board, it struck me that there is an inherent potential conflict if my company took a loan from me directly. This might appear self-serving as the Board member is ‘competing’ with my Fund but the issue goes deeper than that. Having a person that is both a Director as well as a debt stakeholder, puts that person in a position of conflict. Directors have a fiduciary duty to make decisions in the ‘best interests of the company and its shareholders’. There is a potential for significant conflict when Directors are debt holders as debt will take priority over equity shareholders in the case of liquidation or near insolvency.

Breach of Fiduciary Duty
In practical terms, there are two ways a fiduciary can breach its duty (:Chan v Zacharia[1]):

1.       Being in a position of a conflict of interest. A person is in a position of conflict if:·         ‘A reasonable man looking at the relevant facts…would think that there was a real sensible possibility of conflict’: Boardman v Phipps.[2]·         Conflict may arise between duties owed to different principals: Beach Petroleum NL v Kennedy.[4]

2.       Making an improper gain from his position.·         Making any sort of gain is prohibited, regardless of whether it harmed the principal, whether it was even available to the principal or, whether it actually benefited the principal as well: Keech v Sandford; Parker v McKenna; Boardman v Phipps.[5]

The Canada Business Corporation Act spells this out in more detail

In 2004, the Supreme Court of Canada said: In a unanimous decision, the Supreme Court of Canada held in Peoples v. Wise that directors of Canadian corporations owe a fiduciary duty to the corporation and, in particular, do not owe fiduciary duties to creditors of the corporation.

A board member that has made a direct loan to the company, even with the best of intentions, clearly has the potential of breach as they are making a gain of interest charged on the loan. Even if the loan is at nominal or no interest, the loan security ranks ahead of equity shareholders who the Director has a fiduciary duty to have in their best interest. Of course there may be mitigating circumstances where the company is hitting the wall this Friday and they need an emergency midnight loan to stay afloat. Under these less than ideal circumstances, you could make a good case that commercial options were not available in the short time available and therefore the Director who made the loan, did so in the best interests of the company and shareholders. Hopefully, company management would not put the company and Directors in this awkward position and management should be working with commercial debt providers long before this situation arises.

It is governance best practice that directors will take themselves completely out of the consideration of a particular matter where there may be a perception of conflict or a perception that they may not bring objective judgment to the consideration of the matter. In appropriate circumstances, directors will declare their position and absent themselves not only from the vote, but also the discussion. However, directors should be aware that abstaining from voting, except in certain limited circumstances, may not protect them from liability under the corporate statutes.

The upshot is that Directors put themselves at potentially personal risk by making direct loans to companies where they are on the Board of Directors. More importantly there is certainly a very high risk of the perception of potential conflict. Best practices would indicate management should only consider commercial, arms length, debt offerings for the company and not put their Directors at risk of conflict with their fiduciary duties.