Focus
Break-away businesses
PLC January/February 2004
Widening the net of liability
www.practicallaw.com
A number of recent cases have highlighted the courts’ willingness to censure
directors and other senior employees
who defect from their companies and
then take advantage of business opportunities belonging to their previous employers in their new ventures. In the light
of these cases and the revitalised interest
in “start-up” companies, are start-ups,
venture capitalists and other financial
backers of “break-away” businesses also
at increased risk of incurring liability?
to the company, including break-away
schemes in which others are involved.
Their own involvement in the misconduct is no excuse for a failure to report
(British Midland Tool Ltd v Midland International Tooling, www.practicallaw.
com/A29811). In Item Software v Fassihi
the High Court stated that this duty extends to the director owing a duty to confess any serious irregularities with which
he is involved, purely as a result of his directorship ([2003] EWHC 3116).
Directors’ and employees’ duties
Although historically employees were
thought not to owe fiduciary duties, the
courts have increasingly been identifying
circumstances in which they will owe
these duties; for example, where the employee is entrusted with winning business for his employer, or negotiating contracts on his employer’s behalf (Nottingham University v Fishel, www.
practicallaw.com/ A13645). (For further
information on employees’ duties in the
context of business ideas, see feature article “The intellectual property minefield: Rights of employees and consultants”, www.practicallaw.com/A19245.)
It is well established that directors who
consider defecting to start up in competition must sever their connections with
their existing company or gain authorisation before doing so. While they remain
as directors, they are under a fiduciary
duty to promote the best interests of their
company, and must avoid any conflict or
potential conflict between their own and
the company’s interests. The fiduciary
duty ceases once they resign from their directorship, but there is a continuing duty
to refrain from exploiting confidential information or a maturing business opportunity belonging to the company.
Any profit arising from an ex-director’s
exploitation of an opportunity secured
by the company will belong to the
company (even if the company would
never have won the contract itself) (IDC v
Cooley [1972] 1 WLR 443). In CMS
Dolphin v Simonet the High Court held
that in this situation the director “becomes a constructive trustee of the fruits
of his abuse of the company’s property”
(23 May 2001, unreported).
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Directors are obliged to report to the
company information that is important
If an employee owes fiduciary duties he
must report to the company the existence
of a scheme to compete against the company, even when it is the employee himself who is planning to divert an opportunity in breach of his contractual obligations (Item Software).
Directors (or employees) who have
breached their fiduciary duty by diverting
a business opportunity will therefore be
held to be constructive trustees and will
be liable to account for any profits attributable to the breach of fiduciary duty.
Significantly, an account of profits need
not be limited to the profit from exploiting the initial business opportunity; it can
also extend to any other business that has
been won on the back of that opportunity. This may be crucial for start-up
companies that plan to grow the business
from a single major contract that had
originated with the previous employer.
Even if there is no fiduciary duty, the
company may be able to recover lost
profits on a restitutionary basis in certain “exceptional circumstances” (Attorney General v Blake, www.practicallaw.com/A16827). The judiciary has
already indicated its willingness to apply
Blake: in CMS Dolphin the court held
that, even if the claimant had not been
able to recover an account of profits by
reason of the defendant’s breach of fiduciary duty, it would have ordered an account of profits based on the Blake judgment. In Experience Hendrix LLC v PPX
Enterprises, although the circumstances
were not sufficiently exceptional to fall
within Blake, the Court of Appeal ordered the defendant to pay “a reasonable
sum” to compensate the claimant for the
defendant’s knowing and deliberate
breach of contract, when the claimant
would have struggled to establish any financial loss by a conventional assessment of contractual damages ([2002]
EWCH 1353).
The risks for start-ups
The chain of liability will not necessarily
stop at the defecting director or employee. If an account of profits is ordered, the director will remain liable
whether he exploited the opportunity in
person, through a partnership or
through a company controlled by him
(CMS Dolphin).
There is a wide range of action that may
foreseeably be taken against funders who
do not protect their position. In Midas v
Opus the High Court considered the involvement of a third party which, it was
alleged, had procured breaches of a director’s duties and was a knowing participant in those breaches ([1999] ELA
Briefing 2000, Volume 7, issue 9). The
court was prepared to grant relief both
by way of an injunction and damages
against both the director and the third
party. Advisers to a legacy business may,
as a result, increasingly consider taking
action against the funders of break-away
businesses.
Depending on the level of its involvement
and knowledge, the funder could incur
personal liability in one of a number of
ways:
• Conspiracy to interfere with contractual relations. If the funder is party to
an agreement, one purpose of which
is to interfere with a legally recognised contract without sufficient justification, the funder may be a party
to a conspiracy to interfere with contractual relations and could face an
• Accessory to breach of trust/dishonest assistance. Even funders who do
not receive any property in breach of
trust may be liable as accessories if the
court finds that their behaviour has
been dishonest, as judged by the standard in Twinsectra v Yardley, and may
have to pay damages computed on the
basis of the loss suffered by the contracting party (www.practicallaw.
com/A23406).
This leaves funders with the prospect
that by becoming involved with a venture
too early they may be incurring a liability
for inducing a breach of contract (or, say,
conspiracy to interfere with contractual
relations).
Even when an opportunity has moved
across to Newco and is clearly in the sole
possession of the Newco directors, deliberate or unreasonable ignorance of the
proper ownership of the opportunity is
unlikely to protect the funder, which
could still face claims for breach of confidence, knowing receipt or dishonest assistance, for example.
www.practicallaw.com
The risks for funders
• Knowing receipt in breach of trust.
Funders who receive company information from a constructive trustee,
director or employee may be liable if
they receive the information knowing
that they should not have it, or receive
the information without notice of the
trust but subsequently become aware
and then fail to deal with it in a manner which is consistent with the trust.
The possible sanctions are an injunction to restrain use, an order to deliver
up the information and/or damages.
not to make reasonable enquiries as to
whether the material is being communicated in breach of confidence before
making overtures which might encourage the start-up, a court might
conclude that the funder has constructive notice of the breach of confidence and hold the funder liable for
inducing a breach of contract. If the
funder does have concerns, ignoring
those concerns may prove costly.
PLC January/February 2004
Where the wrongdoers establish a new
company (Newco), the court may find
that the company structure is no more
than a sham behind which the wrongdoers were hiding their activities and may
pierce the corporate veil and hold the
company liable, as well as the wrongdoers themselves. This could pose a significant commercial risk for the funders of
Newco if the court concludes that
Newco is no more than a vehicle through
which to exploit opportunities belonging
to another company (see below).
injunction to restrain and/or damages
computed on the basis of the loss suffered by the contracting party.
Focus
If a wrongdoer brings the opportunity to
a partnership of which he is a partner
then the liabilities of the partners will be
joint and several, even if the remaining
partners were entitled to a part of the
profit and were ignorant of the breach
(Imperial Mercantile Credit Association
v Company [1873] LP 6 HL 189).
Proceeding with caution
• Breach of confidence. If the funder
comes into contact or deals with confidential information that the funder
knew or ought to have known belonged to the company, the funder
may be liable to account for any advantage arising from the confidential
information.
• Inducing a breach of contract. Liability for inducing breach of contract
does not require the party inducing
the breach to act maliciously. Where
sufficient intention and knowledge of
the existence of the contract are established, it is enough that the party persuades the employee to breach the
contract (DC Thomson & Co Ltd v
Deaken [1952] Ch 646). Damages recoverable by the employer include
both actual and prospective loss.
For example, if the funder receives
confidential information and chooses
All properly advised funders already seek
to verify the status of prospective breakaway teams but the recent cases and judicial thinking suggest that greater care
ought to be taken particularly in the
framing of conditional offers. If this
trend continues pressure may increase on
funders to undertake some limited due
diligence on prospective teams at an earlier stage. The most significant difficulties are likely to be faced in the context of
the most attractive break-away business
propositions where several funders are in
competition. In these circumstances the
desire to provide comfort to the prospective team sufficient to secure the deal
must be offset against the potential exposure.
Ian Meredith is a partner and Edward
Mackereth is an assistant solicitor in the
Dispute Resolution department at
Nicholson, Graham & Jones.
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