When fraud infiltrates your business: investigating misconduct in owner-managed companies

Executive summary

• Why fraud risks are higher in closely held companies
• Common schemes involving directors or controlling shareholders
• Legal claims available including breach of fiduciary duty and unfair prejudice
• The role of forensic accounting in uncovering misconduct
• Practical steps businesses can take to strengthen oversight

Higher fraud risks and common schemes

Fraud in owner-managed companies often persists for years before discovery; there is usually one moment or transaction where the ‘balloon goes up’ which leads others to pull at the thread, and the extent of the fraud begins to unravel.

There are several factors concerning size, structure and governance which contribute to a higher risk of fraud in closely held companies. Firstly, the company’s owners are very often also its directors meaning that there is a lack of independent checks on owner decisions. For example, there is no independent board scrutiny and very often owner-managed companies are exempt from independent audit.

Those owner/directors may have personal financial incentives to manipulate results such as meeting bank covenant requirements or supporting a valuation for a sale or refinancing. The number of related party transactions (for example loans to/from directors, family members on payroll, personal expenses charged to the company and property or services owned by the director) will be higher leading to more frequent examples of undisclosed transactions, misclassification or tax avoidance / evasion issues.

The lack of financial controls / independent checks coupled with a reduced chance of detection both internally and externally means that such fraud can lie undetected for many years. Common schemes often involve misappropriation of company funds by way of running private expenditure through as ‘business expenses’, paying family members who do not actually work for the company and failing to declare overdrawn directors’ loan accounts. Owner/directors may abuse their position by trading with other companies they own at non-market rates, over charging the company for rent of a property they own personally or selling company assets and diverting the proceeds to personal accounts.

Options available when fraud is discovered

1. Unfair Prejudice Petition

If you are a minority shareholder and believe the way in which the company is being managed is unfairly prejudicing your interests as a shareholder, then you have a legal right to issue an unfair prejudice petition which offers a wide range of remedies including:

• A buy-out of the petitioner’s shares (i.e. the person who commences the unfair prejudice petition) at fair value often determined by an independent expert valuer
• A buy-out of the respondent’s shares (i.e. the person who responds to the unfair prejudice petition) (less common but may be appropriate if the petitioner is better placed to run the company going forwards)
• Regulation of the company’s affairs, for example, by way of changes to internal governance (requiring the petitioner to be included in board meetings or imposing approval thresholds for key transactions), restrictions on certain powers and requirements for transparency
• Injunctive relief, for example, to prevent asset stripping or diversion of business
• Where transactions were entered into as part of the unfairly prejudicial conduct they may be set aside or varied
• An order authorising court proceedings in the company’s name (this is particularly useful where the wrongdoers control the company)
• Financial compensation to the petitioner
• Changes in the company’s constitution
• Director related orders, for example, reinstating the petitioner as a director
• Order an independent investigation or valuation
• In certain circumstances, the court can order that the company be wound up

Both prejudice and unfairness must be shown for such relief to be granted. Prejudice will be evident where the economic value of the petitioner’s shares has significantly decreased or been put in jeopardy by the conduct complained of (albeit prejudice is not necessarily confined to economic harm). When assessing the fairness of specific conduct, the court will consider the basis on which the petitioner agreed to become a member of the company (for example, the company’s articles of association, any agreements between the shareholders and any subsequent amendments). However, whilst the prejudice must be unfair, bad faith is not required.

A breach of fiduciary duties (in summary, duties requiring directors to act loyally, honestly, and in good faith in the interests of the company [1]) by directors is normally a good indication of unfair prejudice, but on its own will not suffice; there has to be an associated loss to the company. The misuse or misappropriation of company assets or the procurement of an allotment of shares to dilute a minority’s interests will normally be considered unfairly prejudicial conduct. Serious mismanagement may constitute unfair prejudice, but much will depend on the seriousness and scale of loss arising.

An offer to purchase the petitioner’s shares can stop an unfair prejudice petition in its tracks where the offer is found to be equivalent to the remedy that the court would award if successful in the unfair prejudice proceedings. In O’Neill v Phillips, Lord Hoffmann provided guidance about what must be included within a fair offer i.e. that the offer must provide for a valuation to be conducted by a competent expert to whom both parties have the opportunity to make representations following full disclosure of information relevant to the value of the shares.

2. Derivative claim for breach of fiduciary duties

An alternative route to recover losses arising from fraud within an owner/managed company may be for the company itself to bring a claim against its directors for breach of fiduciary duties. This is appropriate as the loss is the company’s loss and therefore it is the company’s claim to bring. Difficulties arise where the perpetrators of the fraud retain control over the company, such that they can prevent a claim being issued by the company. In those circumstances, shareholders can apply to court for permission to bring a derivative claim i.e. a claim brought by them personally on the company’s behalf.

It is important to note that because the action is brought on behalf of the company, the remedies belong to the company – not the shareholder personally. Remedies available to the company include:

• Damages to compensate the company for any loss caused by the directors’ breach
• Account of profits where a director has made a personal profit from their breach
• Rescission of a contract, for example if the breach involved a self-dealing transaction the court may set it aside
• Return of company property or restoration of its value if the property no longer exists
• Injunctions to prevent an ongoing or future breach i.e. preventing a director from completing an improper transaction or from using confidential information
• Setting aside or preventing share allotments
• Disqualification or removal of the director

Negotiated settlements

Neither of the above legal routes are particularly easy to navigate nor cheap. However, the threat of such action is sometimes enough to bring parties to the negotiating table. This is particularly so if the parties are agreed on the basis of the commercial divorce i.e. they agree which party will buy the other party out of the business. Even in such circumstances, the assistance of a forensic accountant may be required to establish the fraud, and a specialist company valuer may be helpful in valuing shares.

The cost of a forensic accountant can appear high, but should the matter proceed to trial, the support of an expert will be required in any event. Furthermore, the better supported your case is at the outset, the more likely you will be to persuade your opponent of the risk in their position and to achieve a negotiated settlement. Overall, settling the matter without recourse to legal proceedings will be much cheaper than running a case to trial. Tenet has a strong track record of achieving early resolutions for clients, thereby avoiding unnecessary legal spend or having to be embroiled in court proceedings all the way to trial.

Steps you can take to strengthen financial oversight

There are simple, practical steps owner-managed companies can take to mitigate against the risk of fraud including the following:

• Ensure regular formal Board meetings are held with documented minutes
• Ensure directors’ interests in transactions are declared in accordance with the Companies Act 2006
• Split responsibility for financial transactions so that transactions over a certain level require two or more authorising individuals and ensure these provisions are followed through in bank mandates and online banking setup
• Formalise who can commit the company to contracts with third parties and again, consider requiring two or more authorising individuals over a certain level in terms of cost or time period
• Use external bookkeepers / accountants where possible to ensure external oversight
• Consider appointing a non-executive director or external adviser to review key decisions
• Reconcile bank accounts, payroll records and directors’ loan accounts on a regular basis and ensure these are independently reviewed
• Prepare monthly management accounts
• Set annual budgets and compare actual spend against what was estimated
• Ensure directors’ expenses are supported by receipts etc and independently authorised
• Ensure all related-party transactions are declared
• Consider a voluntary audit
• Create a transparent culture where those at the top model ethical behaviour keeping personal and business finances separate
• Ensure internal processes and procedures are followed
• Encourage reporting of concerns without fear of retribution

We have included below recent feedback from clients facing the prospect of issuing an unfair prejudice petition where Tenet managed to negotiate an early settlement through mediation:

“The whole process is what it is, but having you both guiding, navigating and advising us along the journey was the best part of it all. As previously mentioned we tried several other firms but they didn’t fit or align with our ethos. From the first conversation over the phone and then meeting you both we knew we were in the right hands… We know you will say you were just doing your job, but there’s always a manner in which ones conducts themselves that makes them standout from the rest.”

[1] Codified in ss.171-177 of the Companies Act 2006