Extending the Fiduciary Duty of Loyalty: Item Software (UK) Ltd v. Fassihi

Reading time: 11-12 minutes.

In Item Software (UK) Ltd v. Fassihi, the Court of Appeal considered two issues. Firstly, it determined whether or not a company director was in breach of his fiduciary duty of loyalty by failing to disclose his own misconduct to the company, and secondly, if an employee was entitled to claim his remuneration to the date of his dismissal notwithstanding the fact that the date for the payment of that remuneration had not been reached. Lady Justice Arden clarified the law by utilizing policy doctrine and extended the fiduciary duty of loyalty to disclosure of a director’s own misconduct. In relation to the second issue, the Court ruled that the director could make a time-apportioned claim for his salary under the Apportionment Act, 1870. This article primarily focuses on the first issue.

What are the facts of the case?

Item Software Ltd (UK) (Claimant) distributed software products and at the relevant time, a major part of the Item’s business was the distribution of software products to Isograph Ltd. The directors of Item included Mr. Fassihi (Defendant) and Mr. Dehghani. The defendant was employed from 1 May 1995 and the contract expressly provided that Mr. Fassihi should not use confidential information belonging to Item for his own purposes.

In November 1998, Item attempted to negotiate more favourable terms with Isograph. Mr. Fassihi encouraged Mr. Dehghani to press Isograph for improved terms. At the same time, Mr. Fassihi secretly approached Isograph with his own proposals which involved establishing his own company, RAMS International Ltd. (RAMS), to take over the contract. On 24 April 1999, Mr. Fassihi had sent a fax to Isograph referring to RAMS and urged Isograph to accept a conditional notice to terminate the existing distribution arrangements which Item had given.

In the end, the negotiations between Item and Isograph failed because Item insisted on terms that Isograph was not prepared to accept. Item then discovered the defendant’s misconduct and Mr. Fassihi was summarily dismissed on 26 June 1999. Item brought proceedings against Mr. Fassihi alleging that he was in breach of his duty as a director and employee in seeking to divert the contract with Isograph to RAMS and for having pressed Mr. Dehghani to take a hard line in the negotiations with Isograph with the intention of improving RAMS’ chances of securing the contract. Both these claims failed before the judge in the trial. However, Item succeeded on a further allegation that Mr. Fassihi was in breach of his duty in failing to disclose to Item his own wrongdoing.

What did the court decide?

During the trial, Item couldn’t not succeed in the diversion or sabotage issues as the judge found that, in the negotiations with Isograph, Item insisted on terms that Isograph was not prepared to accept. This was deemed to be the cause of failure of the negotiations. Furthermore, Mr. Fassihi was the sales and marketing director of Item and it appeared from the facts that he may have had day-to-day responsibility for the trading relationship with Isograph but not the responsibility for strategic business decisions regarding that relationship.

There was nothing to suggest that Mr. Dehghani would have negotiated more cautiously if Mr. Fassihi had not pressed him to seek better terms. In relation to the crucial issue of law, namely: “whether, in addition to Mr. Fassihi’s breach of duty in seeking to divert Item’s main contract to his new company, the failure to disclose that misconduct to  Item was a further breach of duty”, it was held by the trial judge that Mr. Fassihi’s misconduct did give rise to a superadded duty of disclosure as in Syborn Corpn v. Rochem Ltd, there was a separate and independent aspect of his duties which required him to disclose the facts. Furthermore, the judge stated that there was a clear case of fraudulent concealment as Mr. Fassihi had failed to tell Mr. Dehghani of what he had done, while remaining involved in the negotiations with Isograph and was part and parcel of his dishonest scheme to rob his employers of their business.

The judge argued that the director owes fiduciary duties to the company for reasons given in Horcal Ltd v. Gatland and it is difficult to justify how a director who was making profit by appropriating the company’s contract for his own benefit would not be under duty to disclose what he had done. This scenario is distinguishable from the one in Bell v. Lever Bros Ltd due to the fact that Mr. Fassihi was a director of Item as well as an employee. Therefore, the non-disclosure of Mr. Fassihi’s conduct was a breach of duty.

On appeal, L.J. Arden states that in relation to the disclosure issue, she considers the position of Mr. Fassihi as a director because a director is not simply a senior manager of the company and the duties of a director are in general higher than those imposed by law on an employee and disagrees with the trial judge’s superadded duty of disclosure by stating that a fiduciary does not owe a separate and independent duty to disclose his own misconduct to his principal.

However, she observed that this case is based on the fundamental duty a director is subject to, that is the duty to act in what he in good faith considers to be in the best interests of the company. Furthermore, the duty of loyalty is a time-honoured rule that focuses on principle rather than the particular words which have been used previously. This principle is dynamic and it reflects the flexible quality of the doctrines of equity. The fact that the duty of loyalty has never before been applied so as to require a fiduciary to disclose his own misconduct was not a good objection to the application of the fiduciary principle.

Based on this policy doctrine, the Court of Appeal held that there is no basis on which the defendant could reasonably have come to the conclusion that it was not in the best interest of Item to know of his breach of duty and Mr. Fassihi could not fulfil his duty of loyalty except by informing Item about RAMS, and his plan to acquire the Isograph contract for himself.

In relation to the apportionment issue, the court observed that, if section 2 of the 1870 Act applies, Mr. Fassihi is free to claim that part of his June salary (1 to 26 June) as his employment contract contained no provision which expressly excluded the operation of the 1870 Act. Furthermore, the Court distinguishes this case from the case of Boston Deep Sea Fishing And Ice Company v. Ansell, by observing that in the Boston case there was no attempt to rely on the 1870 Act and therefore it is not an authority as to the effect of the 1870 Act. To conclude, L.J. Arden allowed the appeal and held that none of the authorities cited, detracts from the interpretation to sections 2 and 3 of the 1870 Act and based on that interpretation Mr. Fassihi can make a time-apportioned claim for his salary for the period 1 to 26 June.

What can be made out of this judgement?

The fiduciary duty of loyalty has been a source of debate among academics. It is argued by some that the requirement of loyalty is subjective as it requires fiduciaries to exercise their judgement in a manner, which they subjectively believe to be in the best interests of the beneficiary, while others have argued that the duty of loyalty is best understood as the summation of the various doctrines that are applied peculiarly to fiduciaries, rather than as a legal duty that is directly enforceable on its own right.

In the case of Item Software Ltd where full disclosure was seen as an extension of the fiduciary duty of loyalty; the Delaware court, in the case of Malone v. Brincat, where it was established that absolute honesty was required from the fiduciaries; the Canadian Court, which adopted the English approach and the Scottish Court, where the question of full disclosure being a part of the fiduciary duty of loyalty was left open.

The Australian Courts seem to be an outlier as they have rejected this proposition. They view the fundamental duty of loyalty as proscriptive by nature and this stance does not easily accommodate a duty of full disclosure as a primary fiduciary obligation. According to the Australian Courts, the fiduciary obligation of loyalty is exhausted by the proscriptive ‘no conflict’ and ‘no profit’ rules. In contrast to the Australian Courts, academics and legal scholars have observed the importance of this extension of the fiduciary duty of loyalty.

For example: Licht argues that the common law regime of fiduciary loyalty implements a dual-pronged approach that ensures certain outcomes. The first prong i.e. the prohibition of any pursuit of self-interest aims to counteract self-interestedness and the second prong, which requires full disclosure by the fiduciary aims to combat information asymmetries.

Academics like Lee have claimed that there is a directional element in fiduciary obligations that includes a duty to act solely for the benefit of the principal. This directional element was explained in Item Software, when the court described the director’s duty to act in the company’s best interests. Furthermore, Lee explains that this duty consists of a duty to act in the sole interests of the company as the fiduciary obligations are not result-oriented and do not specify a particular standard to be attained by the fiduciary. She further argues that this positive, directional element of fiduciary obligation was seen in the case of Regal (Hastings) Ltd v Gulliver, where the House of Lords found the directors liable to account to the company for their profits due to the fact that the directors has made use of those fiduciary positions to make those profits.

It is argued that it was enough that the fiduciary used its fiduciary position to make a profit for itself and it did not matter that it had not been shown that the interests of the principal had been adversely affected. However, some academics are not convinced by the best interests duty applied in Item Software. Edelman argues that the difficulty with the duty to act in the best interests is that the duty is extremely vague. Furthermore, it is observed that the extreme vagueness has generated much academic criticism such as  being unhistorical, simplistic, true in part only and misleading.

In conclusion…

The approach taken by L.J. Arden in the caseof Item Software started a chain reaction and various jurisdictions around the world adopted this approach. It is crucial to note that even though the court stated that the duty of disclosure was not an independent duty, it functioned in the exact way as it operated as a separate and additional source of liability. Furthermore, I believe that Mr. Fassihi was in clear breach of his fiduciary duty primarily due to the conflict of interest and his duty to not make (potential) secret profits. The court arguably erred by placing too much emphasis on the full disclosure aspect of the fiduciary duty of loyalty and should have adopted the Australian courts’ approach instead.

-This article is brought to you in collaboration with Priyam Raj Kumar from University of Edinburgh, Scotland.

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