UK: Directors’ and Officers’ Liability Review: Spring 2006

In Autumn 2001 we devoted an edition of this Review¹ to a detailed examination of the then recently published final proposals of the Company Law Reform (‘CLR’) steering group. At the time of the CLR proposals, no one imagined that it would then take another four and a half years for a new Companies Bill to be introduced into Parliament. Along the way, much has happened to alter the liability landscape for directors and therefore the precise shape of these further reforms. It is nevertheless instructive to consider the effect of the current Bill under the same thematic headings as before, and in doing so to put these further reforms into the broader context of the current liability framework which directors face.²

The Company Law Reform Bill runs to 509 pages and comprises some 885 separate clauses. According to the Government it is supposed to contain " sweeping changes to simplify and improve company law".

Whether it achieves this objective must be open to doubt particularly in circumstances where the new Act will have to be read alongside other Companies Acts which will continue to remain in force. The reforms continue the trend of the last few years in focusing attention heavily on the director and his role within the company. Should directors feel comforted or unsettled by these latest reforms? This edition of the Review sets out to examine the evidence.

These remain broadly true to the original mandate of the CLR. The Government’s most recent statements say that their proposals are focused on four key objectives:

• enhancing shareholder engagement and a long-term investment culture;

• ensuring better regulation and a "Think Small First" approach;

• making it easier to set up and run a company; and

• providing flexibility for the future.

These aims, although laudable, are not necessarily consistent with the need for clarity and certainty when it comes to questions concerning directors’ duties and liabilities. This tension can perhaps most clearly be seen in relation to the new Statutory Statement of Directors Duties.

One of the most significant aspects of the Company Law Reform Bill for directors is the proposed new ‘Highway Code’ setting out for the first time a statutory statement of their legal duties. The overall intent is that (with a few exceptions) these statutory duties should simply reflect, rather than amend, the current common law position, in an attempt to make them more accessible and easy to understand for those who have to follow them.

It is questionable whether this objective will be achieved in practice. At least in the short term, there is likely to be an unsettling period as the courts get to grips with the precise implications of the new statement. More fundamental concerns have also been expressed by a number of respondents to the consultation process, such as the Law Society. Two in particular seem to us to suggest that this aspect of the reforms may in certain respects prove something of an unhappy compromise:

• The ‘Highway Code’ does not cover all of the duties that a director owes to the company, as some duties remain uncodified (such as the duty to take into account the interests of creditors when insolvency is threatened) and other duties are included elsewhere within the Bill (such as the duties related to the preparation and delivery of accounts). The new statement also does not seek to codify the remedies for breach of these duties, which is likely to lead to a variety of difficult legal issues that will need to be worked out as cases come before the courts.

• Whilst the current version of the statutory code may appear fairly ‘user friendly’, it is likely to become rapidly encrusted with case-law interpreting its various nuances in a way that will quickly prevent it from being a ‘one stop shop’ for directors looking to find out precisely what is expected of them. Also, the status of existing common law in this area will become unclear.

One advantage for directors, however, is that the current version of the Bill expressly provides that their duties are owed to the company (clause 154(1)). Despite concerted efforts from some quarters during the consultation process, this preserves in a strong statutory form the ‘shield’ that directors enjoy against litigation by a wide range of diverse interest groups, although even here questions will remain as to precisely what as a matter of law "the company" is for this purpose (clause 156).

A director of a company must – (a) act in accordance with the company’s constitution, and (b) only exercise powers for the purposes for which they are conferred.

Comment: What is the constitution? As well as the company’s Articles, its ‘constitution’ includes decisions taken in accordance with the Articles and also potentially certain other decisions, for example by the members to the extent they can be regarded as decisions of the company.

A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole.

In fulfilling the duty imposed by this section, a director must (so far as reasonably practicable) have regard to:

1. the likely consequences of any decision in the long term;
2. the interests of the company’s employees;
3. the need to foster the company’s business relationships with suppliers, customers and others;
4. the impact of the company’s operations on the community and the environment;
5. the desirability of the company maintaining a reputation for high standards of business conduct; and
6. the need to act fairly as between members of the company.

This is generally referred to as the principle of "enlightened shareholder value", and there is concern that this does more than merely reflect what the common law requires of directors. What does "success of the company" mean especially in those companies where profits may not be the sole driver? How likely is it that the courts will become involved in second guessing the directors’ judgements? Some of the factors listed here are difficult to reconcile, for example the interests of employees and the long-term consequences of any decision. How will the courts adjudicate on which are the most important? There is a danger of bureaucracy with detailed minutes seeking to justify each significant decision (and in the input of each director) by reference to all of these factors in order to reduce liability risk.

A director of a company must exercise independent judgement.

This duty is not infringed by his acting: (a) in accordance with an agreement duly entered into by the company that restricts the future exercise of discretion by its directors; or (b) in a way authorised by the company’s constitution.

Concerns have been expressed over the fact that the ‘Highway Code’ does not expressly deal with the issue of delegation. The better view, however, is probably that this duty neither permits nor restricts the power to delegate. In practice, it will probably be prudent to ensure that the company’s Articles deal with the issue explicitly.

A director must exercise reasonable care, skill and diligence.

This means the care, skill and diligence that would be exercised by a reasonably diligent person with:

1. the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company; and
2. the general knowledge, skill and experience that the director has.

This test, although not new, is still relatively underdeveloped by the courts. An interesting question is how much weight the court will attach to the subjective limb of the test where the individual concerned is a non-executive who in fact possesses plenty of relevant skill and experience but does not have the time to deploy it.

A director must avoid a situation in which he has, or can have, a direct or indirect interest that conflicts, or possibly may conflict, with the interests of the company.

This applies in particular to the exploitation of any property, information or opportunity (and it is immaterial whether the company could take advantage of [it]).

This duty is not infringed: (a) if the situation cannot reasonably be regarded as likely to give rise to a conflict of interest; or (b) if the matter has been authorised by the directors.

In a change to the current law, the new provisions now permit conflicts to be authorised by independent directors (unless the company’s constitution prevents this), rather than only by the members. One consequence of this, however, is that companies with a sole director cannot avail themselves of this new authorisation mechanism.

It may also be noted that this duty does not apply to those conflicts that arise where a director is interested in a proposed transaction or arrangement with his company – in such cases, there is a specific duty that applies, which we consider below.

A director must not accept a benefit from a third party conferred by reason of: (a) his being a director; or (b) his doing (or not doing) anything as director.

This duty is not infringed if the acceptance of the benefit cannot reasonably be regarded as likely to give rise to a conflict of interest.

This deals with bribes and other personal benefits. There is no provision for board authorisation, although, as under the current law, members will continue to be able to do so (see clause 164(4)).

Some have questioned whether this might give rise to problems over accepting relatively minor corporate entertainment, although it is to be hoped a sensible approach will prevail in practice.

If a director is in any way, directly or indirectly, interested in a proposed transaction or arrangement with the company, he must declare the nature and extent of that interest to the other directors.

Any declaration required must be made before the company enters into the transaction or arrangement.

A director need not declare an interest:

• if it cannot reasonably be regarded as giving rise to a conflict of interest; or

• if, or to the extent that, the other directors are already aware of it (and for this purpose the other directors are treated as aware of anything of which they ought reasonably to be aware).

This is another change to the existing law, as currently shareholder approval is required for transactions between a company and a director. This is now to be replaced by a permissive regime requiring only disclosure to the Board (although, if desired, more onerous requirements may still be included in the company’s Articles).

Note that there is also a separate regime requiring disclosure of directors’ interests in the company’s transactions under clauses 165 to 170, backed by criminal sanctions for noncompliance: this is the replacement for the old section 317 of the Companies Act 1985. Many have expressed the view that it is unhelpful that there will now be two separate regimes covering what is broadly the same territory, as this is bound to give rise to uncertainty in practice. It is not clear what view the Government takes about this, as it has generally not yet responded to the consultation responses at that level of detail.

The Bill may make it easier for shareholders to sue the directors of their company. Under the existing law, it is well established that directors owe their duties to the company and not directly to the shareholders (see Percival v Wright (1902) 2 Ch. 421). In order to prevent abuse, the so-called ‘derivative action’ (also known as the exception to the rule in Foss v Harbottle) currently enables a shareholder to sue the directors in limited circumstances, where there has been a ‘fraud on the minority’ – which for these purposes means the wider equitable notion of abuse or misuse of power – and the wrongdoers in question are in control of the company.

However, clauses 239 to 243 of the Bill contain a statutory restatement of the derivative action, which broadens the circumstances in which – at least in theory – it may be brought. In particular, such a claim may now be brought in respect of any "negligence, default, breach of duty or breach of trust by a director". This is much broader in principle than the current law. In practice, however, it may be doubted whether this will result in any significant extension of the circumstances in which such claims may be expected. Concerns that this will fuel the development of US-style securities litigation are probably quite far off the mark, for a number of reasons:

• The proceeds of the litigation will still accrue to the company, rather than directly to the individual shareholders bringing the action.

• The courts will continue to retain a key discretion over whether a derivative action may proceed, and permission to do so will be refused where, amongst other things, the claimant shareholder is not acting in good faith or where a disinterested director would not consider that continuing such a claim would promote the success of the company.

• Permission to continue a derivative action will in any event be refused in respect of a claim against a director based upon an act or omission that could be authorised or ratified by the company – in practice, this is likely to exclude the possibility of such claims in respect of ordinary negligence by directors.

Nevertheless, although the effect of this statutory form of derivative action has probably been exaggerated, there is little doubt that greater potential will exist for tactical proceedings to be brought by shareholders against an incumbent board, and faith must therefore be placed in the willingness of the courts to exercise restraint in stifling such claims at an early stage.

As discussed in previous editions of this Review, the old section 310 of the Companies Act 1985, which prohibited any indemnification of directors by their company (with some minor exceptions), has already been repealed and replaced by a permissive regime enabling a company to indemnify its directors in a wide range of circumstances. This was implemented by the Companies (Audit, Investigation and Community Enterprises) Act 2004, and brought into force on 6 April 2005. All restrictions on corporate indemnification of officers and company secretaries have been abolished. In relation to directors, the only situations in which corporate indemnification remains unlawful are now:

• damages awarded to the company;

• fines and penalties in criminal and regulatory proceedings; and

• defence costs incurred in unsuccessfully defending either criminal proceedings or civil proceedings brought by the company itself (successful defences of either kind can be indemnified).

This is good news for directors. It is nevertheless worth noting that the Government rejected calls in the latest round of consultations for directors to be able to limit their liability to the company. The introduction of proportionate liability for auditors (see below) therefore leaves the director as the only type of defendant who now faces the prospect of unlimited liability.

This new permissive corporate indemnification regime gives rise to a number of complex implications for directors and their companies, which we propose to consider in detail in a subsequent edition of this Review. The short point is that, in light of the legislative changes, it is very important to consider a company’s articles of association and its standard form service contracts for its directors together with the terms of any D&O liability insurance which it may purchase to ensure that there are no unintended or unexpected gaps.

The CLR proposals contained a number of reforms affecting the important relationship between auditors and directors. Given that questions arise in many cases of relative fault between the directors and the auditors, the precise parameters of this relationship can have a material effect on the exposures to which each is subject.

A number of the CLR’s proposals in this regard have already been implemented through the Companies (Audit, Investigation and Community Enterprises) Act 2004:

• Directors are each now required to make a statement that all information relevant to the preparation of the accounts has been disclosed to the auditors. This can be draconian, as a director can be guilty of a criminal offence even where he was not in fact aware of the relevant information that was not disclosed to the auditors.

• Auditors now have enhanced rights to require information from a wider range of people than previously, including employees. Non-compliance can again be a criminal offence.

The Bill contains provisions enabling auditors to limit their liability to the company under certain circumstances. There is, however, no similar provision applicable to directors, who, as noted above (under ‘corporate indemnification’), retain unlimited liability to the company. This creates an imbalance in the positions in which each stand to the company. What the practical implications of this will be remains to be seen. One effect, at least in principle, is that the company may be left with a recovery shortfall in proceedings against its auditor, which it may look to make good in other ways. One obvious possibility may be claims against former directors, especially where, for example, there has been an acrimonious change of Board in the meantime. This imbalance, even where directors have the benefit of D&O insurance, may lead Boards to think twice when approached by auditors seeking to limit their liability.

A significant feature of the CLR proposals involved introducing an audited "operating and financial review" (OFR) for large companies, covering non-financial and forward-looking information about the development, performance and position of the company including relevant environmental, social and community issues.

The OFR was finally introduced last year by Regulations made under the Companies Act 1985, in respect of financial years commencing on or after 1 April 2005. It was promptly scrapped in November 2005 in a speech given by the Chancellor of the Exchequer to the CBI, supposedly as part of a ‘simplification plan’ to cut red tape costing businesses up to £1 billion per annum. The Government claims that scrapping the OFR will result in savings of up to £33 million per annum.

However, it seems that no-one is happy with this move. Whilst it may be seen by some as ‘business friendly’, the reality is that investor groups increasingly require this type of enhanced reporting, and the OFR had in any event been a voluntary process for many FTSE 100 companies long before it was mandatory, and will presumably continue to be so.

Furthermore, the Government is intending to replace the OFR with a new, supposedly simpler, ‘business review’ to meet the minimum standards required by the EU Accounts Modernisation Directive (rather than supposedly ‘gold-plating’ those standards via the OFR). This, accordingly, means yet further public consultation and deliberation, followed by the development of appropriate business processes to adapt to further new requirements. The Financial Reporting Council has, perhaps helpfully in light of this, announced that it considers that the new Reporting Standard 1 for the OFR will remain a best practice guide for companies to follow.

To make matters even more muddled, as a result of Friends of the Earth threatening to pursue judicial review proceedings, the Government has now announced that it will extend the scope of its consultation on the new ‘business review’ to include the possibility of bringing back the OFR! Consultation now ends on 24 March.

At one stage, it appeared there might have been be a realistic prospect of a move to greater use of administrative and regulatory sanctions against directors in place of some of the broad range of current criminal offences under the existing companies legislation. The Government said in July of last year, for example, that it was considering the implications of the March 2005 Hampton report ("Reducing Administrative Burdens: Effective Inspection and Enforcement") alongside the existing White Paper proposals for reform of the framework of liability attaching to Companies Act breaches:

Unfortunately, however, this has not translated into any specific reforming agenda in the Bill (and, to be fair, significant decriminalisation did not find favour with the CLR, nor with the Law Commission that preceded it).

We are, therefore, left with something that is a reasonable approximation of the status quo. The Bill does, however, set out the regime of sanctions in a clearer way, as recommended by the CLR, generally being structured so that the offences and the maximum penalties are set out closely together and in more logical places within the relevant sections of the legislation.

Conversely, it is also good news (of a sort) that the Government ultimately abandoned its proposals in the White Paper for an extension in the potential scope of criminal offences, through the new categories of "senior executive" and "responsible delegate".

The second reading of the Company Law Reform Bill in the House of Lords took place in January 2006. As this edition goes to print, the Bill is being referred to the Grand Committee of the House of Lords for detailed consideration. The Government’s current hope is to have the Bill passed before the summer break this year, with some provisions coming into force straightaway upon Royal Assent and the rest currently projected for April 2007.

In our view, the Bill, when it is finally enacted, is most likely to be met by a lukewarm welcome from directors. Although the Bill is unlikely to change directors’ exposures in any fundamental way, it will certainly reshape the landscape in some areas with unpredictable results. We have particular reservations about the concept of ‘enhanced shareholder value’ to which directors will be bound to have regard and also the statutory formulation of the right of individual shareholders to sue directors.

Nor should one fall into the trap of looking at the CLR process (itself as yet incomplete) in isolation. After many decades of slow and incremental development of the law on directors’ duties, we are in the middle of a period of complex and far-reaching change. Quite apart from our own legislative process, significant foreign laws affecting the duties of many hundreds of UK-based directors are well within sight of the horizon. Three such perhaps deserve particular mention:

1. Section 404 of the US Sarbanes-Oxley Act finally comes into force for non-US private companies that are subject to US filing requirements in respect of financial years ending on or after 15 July 2007, which means for most such companies this will apply to their next accounting period beginning after July this year. This extends to such companies the requirement to include in their annual reports a report by management on the company’s internal controls over financial reporting. Domestic US companies are already subject to this requirement, which has given rise to much controversy over the costs and consequences of compliance. Application of the requirement to non-US companies has been repeatedly extended in the past, but there is as yet no official word on any further extension.
2. Meanwhile, in Europe, the Commission is moving ahead with its proposed Directive to amend further the Accounting Directives. Key features include introducing a requirement for all European listed companies to provide an annual corporate governance statement, and also imposing collective responsibility at Board level for that statement and for the company’s accounts generally. The European Parliament has declared that this is not intended to create any new law on liability, and that "responsibility and liability are separate, the one does not automatically entail the other". This seems to us, however, to be a difficult distinction to draw, and is unlikely to provide much in the way of reassurance given the potentially fundamental nature of these reforms, at least on the traditional UK approach to individual rather than collective liability. The Directive is currently expected to be passed by mid-2006, to come into force on a day to be specified thereafter.
3. By 20 January 2007, the UK Government must have implemented the Transparency Directive. The aim of this Directive is to improve the information available to investors, allowing them to invest "more efficiently". It sets out various detailed requirements relating to the content and form of financial reporting and disclosure to be required of all European listed companies, as well as various other requirements relating to the operation of the European capital markets. The concern has repeatedly been expressed that both the specific requirements and also the broader purpose of the Directive will inevitably require the UK to abandon the ‘Caparo principle’, which protects directors from claims by investors based on faulty statutory accounts. This could help development of US-style securities litigation in the UK. In the little that has so far been said about this in public, the Government has expressed a desire to ensure that this important liability restriction remains in place. However, UK law differs in this regard from many other European states where such claims are often permitted, and the final arbiter of compatibility of the Caparo principle with the Transparency Directive will be the European Court of Justice. The Government is expected to publish its specific implementing proposals later this year.

Given the volume of law potentially affecting directors’ duties and the pace of reform (especially as concerns public companies) one may legitimately begin to ask how a diligent and prudent director is supposed to equip himself or herself with a sufficient grasp of the relevant laws to avoid breaching them whilst at the same time discharging his or her legal duty (soon to be imposed) at all times to promote the success of the company.

This is an update on our previous report on two Australian cases dealing with insurers’ liability to pay defence costs "upfront" to insureds: Silberman v CGU Insurance Ltd (2003) (heard together with Rich v CGU Insurance Ltd) and Wilke v Gordian Runoff Limited and another (2003).

In Silberman, the New South Wales Court of Appeal decided that where there was a discretion whether or not to advance defence costs, the insurer could rely on an allegation of fraud against the insured to refuse to pay the costs "upfront" even though the fraud exclusion in the policy required the fraud to be established by a "final judgment or other adjudication". Secondly, the insurer was entitled, in the same proceedings in which the insured sought the indemnity for its defence costs, to seek a judgment, order or other final adjudication adverse to the insured and thereby exclude liability. The insured did not challenge this second point, but did challenge the first finding. However, on appeal, the Australian High Court (equivalent to the English Court of Appeal) could not envisage how the insured’s challenge to the first finding could possibly result in their receiving advance "upfront" payment of the indemnity; their deemed acceptance of the second finding meant that no court would order such an advance payment to be made without also establishing whether or not the insured had been fraudulent/dishonest, thus reducing the insured’s challenge to one merely of principle. The High Court therefore reverted to the Court of Appeal’s finding and so the latter Court’s decision in the matter stands.

In Wilke, the outcome on appeal to the Australian High Court was the opposite. The High Court rejected the insurer’s submission that it could deny an "upfront" indemnity by relying on dishonesty exclusion in the policy, finding instead that the exclusion was only available when the dishonesty/fraud was established in "fact" by admittance, judgment or final order.

While, at first sight, these cases appear to be in direct conflict, they are distinguishable; the Silberman policy contained a discretionary obligation to pay the indemnity, whereas the Wilke policy was drafted in mandatory terms. Secondly, the insurer in Silberman based its challenge to the indemnity on other grounds in addition to the dishonesty exclusion, unlike the insurer in Wilke. In both cases, the court had careful regard to the precise wording of the policies used.

Following its review of progress by companies and investors in implementing the Combined Code since its publication in July 2003, the Financial Reporting Council (FRC) has concluded that the Code is having a positive impact on the quality of corporate governance reporting by listed companies with most adopting the "comply or explain" approach.

Given the general support for the Code in its current form, the FRC has not suggested a major rewrite. However, it has identified two changes for which there appears to be broad support:

• amending the provision concerning the composition of remuneration committees to enable the chairman to sit on the committee when he or she was considered independent on appointment; and

• amending the provisions relating to the AGM to provide shareholders voting by proxy with the option of withholding their vote, and to encourage companies to publish details of proxies lodged on resolution that were voted on a show of hands.

Consultation on these and a number of additional small changes closes on 21 April 2006.

In the last edition of the D&O Review, we focussed on some of the FSA’s recent enforcement actions against directors. Since then, Carl Rigby, former CEO and chairman of AIT Group plc and Gary Bailey, the software company’s finance director, have been sentenced to 18 months and nine months imprisonment respectively for misleading the market under criminal proceedings brought by the FSA under the Financial Services & Markets Act 2000. This follows Rigby and Bailey’s successful appeal against an original sentence of three and a half years and two years imprisonment respectively. Although expensive for the FSA (the prosecution cost a mammoth £2 million), the outcome of the AIT prosecution sends out a very strong message that the FSA now means business.

Ten years since the Law Commission’s 1996 recommendations for a then-named ‘corporate killing’ offence, the Corporate Manslaughter Bill still seems some way off from becoming law.

A report of a joint Home Office and Work and Pensions committee (the "Committee") published in December 2005 rejected the core proposal of the Bill which would hold a company guilty of corporate manslaughter where death is caused by management failure by ‘senior managers’.

The Committee expressed concern that this rule followed the common law ‘identification principle’ whereby a company can be convicted of an offence if a ‘directing mind’ of the company (a person sufficiently senior to be ‘identified as the embodiment of the company itself’) is individually guilty of the gross negligence which resulted in death. The Committee commented that it has proved notoriously difficult to bring successful prosecutions against large companies under common law. The current recommendation is the adoption of the Law Commission’s ‘management failure’ test, where an offence is committed by a company if a death is caused by "a failure in the way in which the corporation’s activities are managed or organised to ensure the health and safety of persons employed in or affected by those activities". The Home Office has acknowledged that further work is needed on the Bill and we will report on further developments in future issues of the Review.

In January 2006 the settlement was announced of a D&O claim brought against Royal Ahold and certain of its directors in the sum of US$1.1 billion. The settlement was in respect of a class action lawsuit commenced against Royal Ahold in February 2003 relating to allegedly inflated earnings of Ahold’s wholly-owned US Food Service Inc subsidiary. The lawsuit alleged that the defendants' conduct presented a misleading financial picture of Ahold to investors and artificially inflated the price of Ahold's common stock and ADRs during the period from 30 July 1999 through to 23 February 2003. The settlement is believed to be one of the largest ever involving a European based company with US subsidiaries.

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