The liability of the dotcom lifestyle
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7 October 2013
10 July 2014
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Marion Simmons QC and Nicolas Shulman report on the abuse of dotcom company corporate funds. Marion Simmons is a QC at 3/4 South Square and Nicolas Shulman is CEO of Adrenaline Media.
The crash in technology stocks has put much pressure on internet companies.
The high-profile collapse of online designer-wear retailer Boo.com has focused media attention on the alleged extravagant "champagne lifestyle" of Boo's young managers, who enjoyed Concorde flights, expensive meals and their rent paid at the company's expense. Although these luxuries may have merely been the pretensions of inexperienced management dabbling in the new economy, when viewed in hindsight through the eyes of investors, the perception is very different.
In the context of a start-up company financed by outside investors, it is irresponsible directors who abuse this investment by indulging in lavish perks. Before committing to such expenses directors should consider whether they are being incurred truly for the company's benefit. If not, they should be aware of the consequences that can follow indulgence at the company's expense, and how this appears in hindsight.
Directors owe duties to the company. They must take care not to do anything in respect of the company which might adversely affect its interest. If they do, they may breach this duty. Admittedly, certain travel, dining and corporate entertaining by its directors may be for the company's benefit. But there is a fine line between the level at which this is an acceptable expense and when it becomes a breach of the directors' duty.
Of course, when the company is doing well, shareholders may not be too concerned about these expenses. A shareholder who is unaware of the company's true financial state may believe that the directors' champagne lifestyles reflect healthy management accounts.
But when a company starts having financial difficulties every directors' previous actions are put under the microscope. Investors will not be happy if the company collapses, less so if they discover that the reason for it was a lack of financial control, with money enhancing the lifestyles of directors acting on company business.
The spotlight is on directors of start-ups. Reaching profitability quickly is the top priority. This involves the wise use and conservation of capital provided to start the company. Justification of opulent expenses is more difficult when the company is in its infancy.
The investors (whether shareholders or debt financiers) may believe that directors should be liable to reimburse the company fully if their money has not been used for the benefit of the company. Being distrustful of a champagne director's wasteful attitude, debt financiers may decide to put the company into liquidation rather than increase investment: shareholders may want the company to continue in business while curbing the directors' spendthrift tendencies.
In the US, it is easier for shareholders to bring actions. Directors of US corporations owe fiduciary duties to their shareholders - in the UK the duty is owed to the company. Although this is a fine distinction (because the shareholders in essence are representative of the company), it does have profound consequences.
In the US, shareholders can maintain an action directly against the directors. The US Plaintiffs' Bar takes cases against careless directors on contingency fees. This provides an efficient corporate governance mechanism to curb management excesses. By contrast, in the UK, the shareholders' remedy is a derivative action on behalf of the company against the directors and the difficulties of bringing a derivative action are notorious.
If the company is in liquidation, the liquidator can bring proceedings against the directors for breach of duty or, under the Insolvency Act 1986, for wrongful and fraudulent trading. Directors' disqualification proceedings may also be instituted against them. In the most serious cases it might even be alleged that the directors' irresponsibility is so great that they acted fraudulently by using the company's finances for personal indulgence. Criminal liability may also be attached.
But liquidation shuts the stable door after the horse has bolted. Creditors may not recover their full losses and shareholders may suffer a cavernous hole in their asset base. Boo's shareholders invested £85m and will recover nothing.
The difficulty in bringing a shareholders' derivative act-ion is a serious failing in the approach of UK law to corporate governance. As internet companies are likely to engage in international operations, their directors may yet find themselves liable on the other side of the Atlantic.
The warning to directors of internet companies, especially those who are young and inexperienced, is clear: they must take their responsibilities extremely seriously. As the new economy develops, it will be interesting to see how many directors heed this warning, whether investors in internet companies keep a more watchful eye over directors' expense accounts, and if UK law can adapt to deal more effectively with these developing corporate governance issues.