Managing risk in property management companies – corporate governance and considerations for directors

It has recently been announced that Companies House has launched an awareness campaign and online guide to highlight key considerations for flat management company directors in relation to corporate governance issues. Companies House makes it clear that their guide is not designed to replace a property management company seeking professional advice where appropriate, however, it aims to offer guidance to flat management company directors as to their responsibilities, including to Companies House.

Companies House have reported that each year they receive multiple complaints from residents living in shared buildings or properties such as flats. These range from disputes between residents to disputes between the residents and the property management company itself, but Companies House cannot deal with these complaints. In these circumstances, the appropriate recourse is through The Property Ombudsman, The Property Redress Scheme, Court proceedings or alternative methods of dispute resolution such as mediation.

The role of property management companies

Property management companies are often incorporated by residents to help manage communal areas of a shared residential property, or one or more shared residential properties. The residents themselves are usually the directors and/or shareholders of the company, with representatives (often from each flat) appointed to the board of directors. It may also be the case that the management company owns the freehold of a block of flats (or estate) who in turn leases flats to the residents who are also shareholders.

Unfortunately, issues and disputes can often arise in relation to a director’s failure to comply with corporate governance issues or disputes between the directors and shareholders themselves. This is because by their nature, flat management companies are often not entirely fit for purpose. Such companies are incorporated to hold the freehold of one or more properties to take advantage of being a limited liability company. However, in so doing, residents are bound by strict company law requirements that are in reality, more suitably equipped to regulate companies trading on more traditional commercial terms. In practice, those with day-to-day management of the company are doing so in their spare time and in many cases, the interests of the individual board members are not necessarily aligned.

Disputes that can arise

Issues can arise when one or more directors (who is often, but not always, a majority shareholder) breaches his or her fiduciary duties and does not take into account the views and considerations of the shareholders of the company. Typical disputes include:

• Directors incurring expenses without the appropriate consent being obtained, for example in relation to refurbishments at the building.
• Directors taking decisions in relation to the company without following the proper process, for example in relation to management decisions and filing statutory accounts.
• Directors preferring the interests of themselves over other directors or shareholders. An example of when this can arise is when a member of the board wishes to carry out works to their own property and use their powers to help approve such works which may be contrary to the interests of some or all of the resident shareholders. In those circumstances, a conflict of interest can arise.
• Satellite litigation being created in relation to company law issues rather than being dealt with as a landlord and tenant dispute. This issue arose recently in the case of Houldsworth Village Management Co Ltd v Barton [2019] EWHC 3590 (Ch) in which a leaseholder who was also a shareholder in the property management company, sought to use company law to inspect the register of members so that he could propose a general meeting of members and make resolutions to remove and replace the existing directors and the managing agent. The Court of Appeal held that because the leaseholder had complied with the requirements of the relevant legislation, he was entitled to use company law to further his interests as a leaseholder.
• One of the practical difficulties which can arise is that residents in this scenario wear different “hats”. On the one hand they own a lease of a flat and so are a leaseholder who is obliged to comply with the tenant covenants in the lease and on the other they own a share in the property management company with responsibility for the management of the building. So, they will be a shareholder and may also be a director of the property management company.

It is therefore particularly important that there are appropriate rules and agreements in place between the directors and shareholders and that these are duly followed.

Duties of directors

All company directors must be aware of their legal responsibilities to the company, to their shareholders or members and to other bodies, such as Companies House. This is applicable to all directors, whether they are a shareholder or not.

There are typically two types of company:

1. A company limited by shares – the money invested in this company (known as its capital) is divided into “shares”. The shares are legally and/or beneficially owned by shareholders or members.
2. A company limited by guarantee – these companies do not have shares or shareholders, but instead are owned by “guarantors”. These are more often used for not-for-profit or charitable purposes, including Housing Associations.

The rules that directors should follow are set out primarily in the Companies Act 2006 and will also be enshrined in a company’s Articles of Association and in the case of property management companies, often in a lease as well. Duties include to promote the success of the company, act in the best interests of the company for the benefit of the shareholders as a whole at all times, to keep accurate company records and to file accounts at Companies House on time.

In the event accurate records are not kept up to date and/or filed at Companies House, the director can be left exposed to a claim against them.

This could be a claim by the company, instigated by an aggrieved shareholder and known as a “derivative action”. The shareholder bringing the derivative action 'stands in the shoes' of the company to bring a claim against the director in question. Such a claim could be brought for breach of fiduciary duty or breach of contract (e.g. in relation to a lease).

Alternatively, directors who do not keep on top of the corporate governance aspects of a company (for example, failing to file statutory accounts on time) can be exposed to a criminal prosecution by Companies House, potentially resulting in a criminal record, a fine and possibly disqualification depending on whether the director in question is a first time offender.  This is separate to any automatic fine rendered by Companies House to the company in question for late filing of documents and is a stark reminder that directors can be exposed to both civil and criminal sanctions and so it is important that directors seek regular advice as to their duties to avoid disputes and complaints arising.

Rights of shareholders

In relation to property management companies, individuals typically buy “shares” in the management company when they purchase their residential property and so shares will automatically transfer upon sale or purchase of the property. However, an individual may still remain a director subject to the company’s rules (in relation to which, a summary of a director’s duties is set out above). Under the rules governing some property management companies, an individual can only hold the post of director if they own a flat at the building, so it is important that property management companies understand their obligations and remove directors, where circumstances dictate.

Unless specific rights are enshrined and documented in a Shareholders’ Agreement, shareholders have relatively limited rights of access to company documentation compared to directors (for example, statutory accounts and other publicly available information). Shareholders therefore put their trust in directors to appropriately manage a company on a day-to-day basis.

Smaller businesses (including property management companies) may be run as a 'quasi-partnership' where business relationships and management roles evolve over time and often operate on a more informal basis.  A quasi-partnership can be created when individuals decide to go into business together and agree to jointly manage and share the risk of the business.  This scenario may not so much arise in the case for a resident association, but could arise when a family run trading company sells the assets and goodwill of their business and uses those funds to invest in property, setting up a property management company in the process.

In these situations, it may be possible for a minority shareholder to show that certain equitable understandings in the form of legitimate expectations have been breached (for example that they would be involved in the management of the business), that may give rise to a cause of action under s.994 of the Companies Act 2006 even if this is not documented within a legally binding document. In such cases, a Court may order for the majority shareholders to buy out the minority at fair value. Shareholder disputes can then arise as to how the assets owned by the company are managed going forwards.

How to manage and mitigate risk

Sometimes disputes are unavoidable. However, forward planning and suitable documentation can go a long way to saving valuable management time and company resources.

It is therefore important that a company’s Articles of Association and other documents relevant to the company in question, such as its lease or freehold agreement, are well-drafted and there is a Shareholders’ Agreement in place to document specific rights and obligations. As for directors, it is also important that advice is sought at an early stage (often before a dispute has fully arisen) in order to manage risk and hopefully avoid the escalation of a dispute.

This article was written by Stephen Burns and Katie Bewick. For more information, please contact Stephen, Katie or your usual Charles Russell Speechlys contact. This insight is not a substitute for legal advice on the specific circumstances of the case.