The Duties And Liabilities Of Directors Of Limited Companies Incorporated In The UK

The Companies Act 1985 ("CA 85") also contained numerous provisions which imposed duties and obligations on directors of companies, and restrictions in respect of the manner in which they could behave in relation to their companies (often referred to as "fair dealing" provisions). CA 06 simply re-enacts many of these provisions without alteration, although some have been subject to significant changes. The most notable of these provisions are considered below.

All references to sections of an Act in this note are to sections of CA 06 unless specifically stated otherwise.

CA 06 does not contain a specific definition of the term "director". There is a general provision in section 250 which states that the expression "director" includes "any person occupying the position of director, by whatever name called", which includes a person who is treated by the board as such despite not having been validly appointed.

The law also recognises the concept of "shadow directors" and many of the statutory provisions which apply to directors also apply to "shadow directors". A shadow director is defined by section 251 as "a person (which may be an individual or a company) in accordance with whose directions or instructions the directors of the company are accustomed to act". A shadow director exerts control and may be held liable for his acts, particularly in cases of insolvency or where wrongful trading is alleged. A shadow director who exerts control but seeks to evade liability by not being appointed as a director will not be protected just because he has not been formally appointed.

Section 170 provides that the codified general duties of directors set out in sections 171-177 should be interpreted and applied in the same way as the common law rules and equitable principles which they replace, and regard should be had to the corresponding common law rules and equitable principles when interpreting and applying the statutory duties. Accordingly, courts will need to interpret and apply the general duties in a way that reflects the rules that they replace and it is thought that insofar as the newly codified duties do not encapsulate pre-existing duties, those duties will survive. It therefore remains to be seen quite how different the new directors’ duties regime will be from what went before.

The codified duties apply to all the directors of a company, including shadow directors and, in the case of the duties in sections 175 (duty to avoid conflicts of interests) and 176 (duty not to accept benefits from third parties), even former directors of the company. It should be noted that the law in this area is new and has not yet been the subject of interpretation by the courts.

From 1 October 2007, four of the seven new codified provisions on directors’ duties in CA 06 are in force:

Section 171 codifies the equitable rule that a director must act in accordance with the company’s constitution and must only exercise his powers for their proper purpose.

The section does not clarify aspects of the duty to exercise powers for proper purposes, such as how those purposes are to be ascertained, or the extent to which an improper purpose may taint a decision. Such matters will fall to be determined in accordance with previous case law, under which courts have approached the duty by first ascertaining the purpose for which the power was conferred, and then determining whether that was the director’s substantial purpose when exercising the power. The liability is strict: if the director’s substantial purpose was not the purpose for which the power was conferred, it will not matter if he exercised the power in good faith or in the belief that it would promote the success of the company for the benefit of the members as a whole.

Section 172 replaces both a fiduciary duty which was usually summarised as being "to act in good faith in the best interests of the company", and also the statutory duty to consider the interests of the company’s employees under section 309 of CA 85.

Section 172 provides that a director 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 so doing, the director must have regard (among other matters) to:

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

Where the company’s purposes consist of or include purposes other than the benefit of its members, the director must act in the way he considers, in good faith, would be most likely to achieve those purposes.

The duty is subject to any enactment or rule of law requiring directors in certain circumstances to consider or act in the interests of the creditors of the company. Accordingly, the duty is displaced when the company is insolvent, and may be modified by an obligation to have regard to the interests of creditors as the company nears insolvency.

It should be noted that:

• the duty will apply to all decisions made by a director, not merely formal decisions made by the whole board;
• "success" is not defined. It is thought that "success" in this context will usually mean "long-term increase in value" for commercial companies, and that what will promote the success of the company, and what constitutes such success, will be for the director’s good faith judgment;
• the obligation to have regard to the listed factors is clearly subordinate to the overarching duty to promote the success of the company for the benefit of its members as a whole. However, the obligation to have regard to at least the listed factors, in carrying out the overarching duty, is mandatory;
• the list of factors is not exhaustive - directors should have regard to other matters relevant to the duty to promote the success of the company; and
• in having regard to the listed factors, the duty to exercise reasonable care, skill and diligence (section 174) will apply. In some cases, to satisfy the duty, it may be necessary to seek expert advice, for example in relation to impact on the community or environment.

Concerns have been raised about this section, including:

• whether directors should now give precedence to the interests of current members over future members. Historically, the fiduciary duty to act in the best interests of the company has been interpreted by identifying the company with its shareholders, both present and future and requiring directors to balance short-term and long-term interests. It is not clear that this will continue to be the case, but until the meaning of the section is more settled, directors may wish to seek professional advice in circumstances where the interests of the company’s present members conflict with those of the company as a corporate body;
• how, or if, directors should document their compliance with the section. The current prevailing view appears to be that it will be sufficient for board minutes to state that the directors have taken the factors set out in section172 into account in carrying out their duty, and perhaps minuting in more detail the consideration of any particularly relevant factor; and
• that, in conjunction with the new derivative action provisions in CA 06 (see paragraph 4 below), it will lead to a rise in class-action style litigation from single-interest pressure groups which believe that a company has not given proper consideration to the issue in which they are interested However, this should prove difficult given the considerable procedural hurdles that members face in seeking to bring a derivative action.

Not withstanding this, for potentially controversial decisions, boards might want to seek the views of independent shareholders.

Section 173 also codifies the existing law. It provides that a director must exercise independent judgment. The duty will not be infringed by a director acting in accordance with an agreement entered into by the company that restricts the future exercise of the directors’ discretion or in a way authorised by the company’s constitution. It follows that any powers of delegation should be set out in the articles.

Section 174 codifies the commonly accepted understanding of a director’s duty of care, skill and diligence. Under section 174, a director must exercise the care, skill and diligence which would be exercised by a reasonably diligent person with both:

• 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 (the "objective" test); and
• the general knowledge, skill and experience that the director actually has (the "subjective" test).

So, at a minimum, a director must display the knowledge, skill and experience required by the objective test, but where a director has specialist knowledge, the higher subjective standard must be met. In applying the tests, regard must be had to the functions of the particular director, including his specific responsibilities and the circumstances of the company.

The three further codified provisions on directors’ duties in CA 06 come into force on 1 October 2008:

From 1 October 2008 section 175 will replace the no-conflict rule applying to directors, under which a director must not, without the company’s consent, place himself in a position where there is a conflict, or possible conflict, between the duties he owes the company and either his personal interests or other duties he owes to a third party. The duty applies, in particular, to the exploitation of property, information or opportunity, and whether or not the company could take advantage of the property, information or opportunity.

Until 1 October 2008 the existing fiduciary duty will continue to apply. However prior to that date companies may want to amend their articles to take advantage of a statutory relaxation of the equitable rule, which will permit independent board members (who must be able to constitute a quorum) to authorise conflicts of interest relating to the personal exploitation by a director of any property, information or opportunity of the company. Where there are not sufficient independent directors, a conflict can be approved by the company’s members (section 180(4)).

The section does not apply to a conflict of interest arising in relation to a transaction or arrangement with the company, as that is covered by sections 177 and 182.

The duty to avoid conflicts of interest will continue to apply after a person ceases to be a director as regards the exploitation of any property, information or opportunity of which he became aware when he was a director.

Section 176 codifies the equitable rule prohibiting the exploitation of the position of director for personal benefit. Until 1 October 2008 the equitable rule will apply.

Under the section, a director must not accept any benefit (including a bribe) from a third party which is conferred because of his being a director or his doing or not doing anything as a director. Benefits conferred by the company, its holding company or subsidiaries, and benefits received from a person who provides the director’s services to the company, are excluded.

Benefits will also be excluded from the prohibition if their acceptance cannot reasonably be regarded as likely to give rise to any conflict of interest. This should exempt the acceptance of moderate and proportionate "corporate hospitality" by directors, but for the sake of clarity companies may wish to amend their constitutions (as envisaged and permitted by section 180(4)) to provide that where directors accept benefits under a specified value, they will not be in breach of their duty to the company.

The duty will continue to apply after a person ceases to be a director in relation to things done or omitted by him before he ceased to be a director – so that, as before, a director cannot simply resign and then accept an opportunity which he has diverted from the company itself.

Section 177 will replace the equitable rule (in practice, already modified by the articles of most companies) that directors may not have an interest in a transaction with the company unless the interest has been authorised by the members. Until 1 October 2008 the equitable rule will continue to apply.

Under section 177, a director must declare to the other directors the nature and extent of any interest, direct or indirect, which he has or will have in a proposed transaction or arrangement with the company. The director need not be a party to the transaction for the duty to apply. An interest of another person in a contract with the company may require the director to make a disclosure under this duty, if the other person’s interest amounts to a direct or indirect interest on the part of the director. The declaration must be made before the company enters into the transaction or arrangement.

Where a declaration of interest proves to be, or becomes, inaccurate or incomplete, if the company has not yet entered into the transaction or arrangement a further declaration must be made, when the director becomes, or should reasonably have been, aware of the inaccuracy or incompleteness.

No declaration will be required:

• where the director is not aware of his interest or where the director is not aware of the transaction or arrangement, but directors will be treated as being aware of matters of which they ought reasonably to be aware; or
• if the interest cannot reasonably be regarded as likely to give rise to a conflict of interest, if the other directors are already aware of it, or if it concerns the terms of the director’s service contract which have been (or are to be) considered at a board meeting or board committee; or
• where the company has only one director. Section 177 only deals with proposed transactions or arrangements. Existing transactions and arrangements are covered by section 182, which provides that a director must declare the nature and extent of his direct or indirect interest in an existing transaction or arrangement entered into by the company, to the extent that the interest has not been declared under section 177.

Subject to certain exceptions, a director may not be interested, directly or indirectly, in a contract with the company unless such an interest is permitted by the articles of association or by the shareholders in general meeting.

At present, section 317 of CA 85 provides that it is the duty of a director who is in any way interested in a contract or proposed contract with the company to declare the nature of his interest at a full meeting of the directors of the company. Failure to disclose may result in a fine. From 1 October 2008 sections 177 (in respect of proposed contracts) and 182 (in respect of existing contracts) will replace section 317 of CA 85 (see paragraph 2.7 above).

Section 190 has replaced section 320 of CA 85 and provides that the approval of the company in general meeting is required if a director or connected person enters into a transaction to sell to or acquire from the company a substantial non-cash asset. Assets are deemed to be "substantial" where their value exceeds 10% of the company’s asset value and is greater than £5,000¹, or where their value exceeds £100,000. If the required approval is not given, or the acquisition is not made conditional upon such approval being obtained, the transaction is voidable at the company’s instance and the director or connected person is liable to account for any gain and indemnify the company for any loss or damage resulting from the transaction. There are various statutory exceptions, for example the section does not apply to the acquisition of an asset as payment for loss of office or termination of employment, nor to dealings in shares on a recognised investment exchange.

If a director’s service contract is for a fixed period of more than two years², section 188 provides that it must first be approved by the shareholders in general meeting. If the approval is not obtained, the company can terminate the contract at any time by giving reasonable notice.

A company may not make a loan to one of its directors unless the details of the loan have been disclosed and shareholder approval has been obtained via ordinary resolution (section 197). Companies can seek shareholder approval within a "reasonable time" of making a loan to a director. Shareholder approval is not, however, required for:

• loans of up to £10,⁰⁰⁰³; or
• loans in connection with company business that do not exceed £50,000⁴; or
• loans to a director to defend proceedings (including a regulatory investigation) against himself brought in connection with his role for the company, on the basis that any such loan must repaid on conviction or if final judgement is given against the director.

If the company enters into a transaction in contravention of these provisions, it is voidable at the instance of the company and the director or connected person (or the director who authorised the loan) is liable to account to the company for any gain that he has made and to indemnify the company for any loss or damage resulting from the transaction. In contrast to the position under CA 85, there are no criminal sanctions for breach of the provisions.

Section 217 provides that a company may not make any payment to a director as compensation for loss of office or as consideration for or in connection with his loss of office without the approval of the members in general meeting. "Loss of Office" now includes not only loss of the office of director but also the termination of any related employment; however, the bona fide settlement of a director’s contractual or legal entitlement is exempted and does not require shareholder approval. The section is aimed at "golden parachute" arrangements which are wholly or partly "ex gratia" in nature.

The "connected persons" of a director for the purposes of the provisions summarised above are defined by section 252 and include:

• members of a director’s family (see below);
• companies with which the director is connected (because he controls the company or has at least a 20% equity interest in it);
• trusts set up for the benefit of the director or his connected persons;
• business partners of the director or his connected persons.

The definition of family members has been significantly extended by CA06 and now includes:

• spouse or civil (ie, same-sex) partner;
• person (of either sex) with whom the director cohabits in an "enduring family relationship" and the infant children of such a person; and
• the directors’ parents and children including adult children.

The codified duties discussed above are owed to the company (section 170(1)). Only the company will be able to enforce them, although in certain circumstances shareholders may be able to bring a derivative action on the company’s behalf.

Previously, the right to bring a derivative action was a rarely-used common law remedy, available only when the wrongdoing of the director in relation to the company was such as to constitute a "fraud on the minority". The circumstances in which derivative actions may be brought have been extended by CA 06, and such actions are now expressly available for any breach of duty by a director, even if the director has not benefited personally from the breach. However, a member will face a number of procedural hurdles in bringing an action. For example, a court must refuse permission for a claimant to bring a derivative claim where it is satisfied that either:

• a person acting in accordance with the general duty to promote the success of the company (under section 172) would not seek to continue the claim; or
• the act or omission giving rise to the cause of action has been authorised or ratified by the company (section 263(2)).

In addition, section 263(3) prescribes factors that the court must particularly take into account when considering whether to give permission, which include:

• whether the member is acting in good faith in seeking to continue the claim;
• the importance that a person acting in accordance with the duty to promote the success of the company would attach to continuing the claim;
• whether the company has decided not to pursue the claim; and
• any evidence before the court as to the views of members of the company who have no personal interest (direct or indirect) in the matter.

Directors should also bear in mind the following deterrents to bringing a derivative claim:

• costs will usually be awarded against unsuccessful claimants; and
• even if a claim is successful, any damages will accrue to the company, not to the claimant.

For these reasons, it may not necessarily be the case that the derivative action procedure will be used any more than the previous common law remedy.

The ability of shareholders to bring an action in their own name, if they can show that the company’s affairs have been conducted in a manner which is unfairly prejudicial to their own interests, is carried forward essentially unchanged from CA 85 by section 944. As before, such an action could be brought against directors as well as against the company and the court could make such an order against a director, for example for damages, as it sees fit depending upon the circumstances.

Under section 178, the consequences of a breach or threatened breach of directors’ duties are the same as they were for breach of the corresponding common law or equitable principles.

The remedy for a breach of section 174 (duty to exercise reasonable care, skill and diligence) will usually be damages. Remedies for breaches of other general duties may include:

• an injunction;
• setting aside of the transaction, restitution and account of profits;
• restoration of company property held by the director;
• damages; and/or
• termination of the director’s service contract.

Generally, a director of a limited liability company has no personal liability arising from the acts of the company itself. There are occasions, however, where, as a penalty for abusing his position, a director can incur both civil and criminal liability. For example, a director may be personally liable if:

• he or the company knowingly acts outside the powers given to them by the memorandum and articles; or
• the company becomes insolvent and the director has been involved in fraudulent or wrongful trading.

Although, in general terms, a director is not liable for a breach of duty by other directors of which he was ignorant or which occurred before he became a director, liability may arise if he has failed to supervise the activities of a guilty director in circumstances where his duty of care placed him under an obligation to do so or where, with a degree of common sense, he should have known that his action amounted to a participation in or sanction of the conduct which constituted the breach of duty. For instance, a director who signs a cheque for an unauthorised loan may be liable, even though he had protested strongly against the making of the loan at the time.

As long as a transaction is within a company’s objects as stated in its memorandum of association and is not one which a director is precluded by statute from undertaking, a company in general meeting may ratify it retrospectively even though it was outside the powers conferred on the directors by the articles. Under the provisions of section 35 of CA 85 (which remains the current law until 1 October 2008), such a transaction, if entered into by the directors with a third party acting in good faith, is enforceable against the company by that third party even if it is not within the company’s objects as set out in its memorandum.

Certain breaches of duty cannot be ratified and these include:

n acts purporting to abrogate the rights of individual members or a class of shareholders; or

• acts which a company cannot lawfully do, either because the general law forbids them or they are ultra vires to the company; or
• acts which are fraudulent or dishonest.

Section 239 preserves the current law on ratification of acts of directors, but with a significant change. Any decision by a company to ratify conduct by a director amounting to negligence, default, breach of duty or breach of trust in relation to the company must be taken by a resolution of the shareholders without reliance upon votes in favour by the director or any connected person. A member "connected with" the director will include certain family members (section 252) and may include fellow directors (section 239(5)(d)).

Ratification will bar the bringing of a derivative claim. Even if the conduct has not been ratified, where a court is determining whether to permit a claimant to continue a derivative claim, it must consider whether the conduct could be, and is likely to be, ratified by the company.

Section 1157 provides that where proceedings for negligence, default, breach of duty or breach of trust are brought against a director, the court may relieve him from liability if it considers both that:

• he has acted honestly and reasonably; and
• considering all the circumstances of the case, he ought fairly to be excused.

A director may also apply to the court for relief where he has reason to expect that a claim may be made against him.

Directors should give consideration to insuring against their potential liabilities. Whilst insurance cannot cover all liabilities a director may face (for example in relation to criminal penalties), it can limit a director’s exposure. Section 233 permits a company to purchase insurance for its directors, and those of an associated company, against any liability attaching to them in connection with any negligence, default, breach of duty or breach of trust by them in relation to the company of which they are a director.

If permitted by the articles, the company could take out and fund a directors’ and officers’ insurance policy (commonly known as "D&O" insurance). These policies usually work on a "claims-made" basis, i.e. the insurer at the time the claim is made is obliged to provide cover, rather than the insurer at the time the act in respect of which the claim is being made was committed. D&O policies also tend to be offered on an aggregate basis whereby a single pot of money is available to cover all claims up to a certain limit over a specified period.

Specific directors’ liability insurance can also be obtained and the expenses may be met by the company if permitted under its articles of association.

It could be said that the extension of companies’ abilities to indemnify directors discussed below reduces the requirement for D&O insurance, as this is often provided principally for the peace of mind of the directors. Therefore, if this can be provided by way of an indemnity the need for insurance is reduced. However, D&O insurance may also be taken out to protect the company’s balance sheet.

Sections 232 and 234 contain provisions in respect of the ability of companies to indemnify directors. The position is similar to that under CA 85. The basic prohibition - that a company cannot exempt a director from any liability attaching to him in connection with any negligence, default, breach of duty or breach of trust by him in relation to the company - still stands. However, a company may enter into a specific indemnity agreement with its directors in respect of liabilities to third parties (known as a "qualifying third party indemnity provision") or liabilities which they may incur as a result of acting as directors of a pension scheme of the company (a "qualifying pension scheme indemnity provision"), or may simply resolve to indemnify them against such liabilities as and when they occur, provided that:

• the liability incurred is not to the company itself or an associated company (i.e. within the same group of companies);
• it is not permissible to indemnify against a fine imposed as a result of criminal proceedings or by a regulatory authority; and
• it is not permissible to indemnify against any liability incurred in defending civil proceedings where judgment is given against the director.

Companies may indemnify directors against the director’s costs of defence proceedings as they are incurred, or costs incurred in an application for relief under section 1157 (see paragraph 5.2 above), even if the action is brought by the company itself (subject to the director’s liability to repay those costs in certain circumstances). Funding provided for this purpose does not require shareholder approval under the provisions restricting loans to directors (sections 205 and 206).

The decision to indemnify directors can be taken by the board, subject to any restrictions in the company’s articles of association. However, details of indemnities must be disclosed in the directors’ annual report where they are for the benefit of one or more directors of the company.

Potential liabilities extend across most of the criminal law. If a director, acting as such, commits a criminal offence, he may make the company liable to criminal penalties (and thereby be in breach of his statutory duty of care to the company). Further, if a company commits an offence through the agency of some of its directors, or an employee, a director who has not directly participated in the offence may also become liable to penalties.

In both cases the liability arises because the courts may see the directors as the company’s "mind and will". The mental processes of the directors (e.g. in forming a criminal intention) may be attributed to the company itself. In such cases the courts see the directors (or indeed, in some cases, officers or employees who are not directors) not as acting on the company’s behalf, but as acting as the company itself.

There is no comprehensive statement of law on where the corporate "mind and will" is to be found. In criminal law, unlike the law of tort, an employer or principal does not have an almost automatic responsibility for the wrongful act of an employee or agent. The case law seems to suggest that the key is the degree of intention which has to be shown for an offence to be proved.

Many regulatory statutes which create offences of a strict liability contain a formula along the following lines:

A director is not necessarily guilty of a corporate offence if the relevant statute does not contain this formula. The position appears to be that offences of strict liability committed by a company cannot be made the vicarious responsibility of the directors unless the statute creating them so provides.

A company can both commit torts and have torts committed against it (except where such a tort requires the existence of a human body, such as assault and battery). In order for companies to be able to act, they require the assistance of a human agent or an individual. Liability will arise from the individual committing the wrongful act or being responsible for the omission. In many cases, this would be the employee of the company, but it could also be open for a plaintiff to consider to what extent a director should simultaneously be held liable as the company’s agent because he encouraged or authorised some act or omission or caused it to occur through his negligence.

A right of action in tort lies against directors who actively participate in a company’s tortious act or who authorise or instruct an employee to commit such an act. The exact extent of a director’s liability where he is less directly involved is not clear (e.g. if he simply voted in favour of a resolution which later gave rise to such an act). It seems that this would depend on the facts of the particular case. A director may be found liable in tort if he acts negligently by omission. It should be noted that the director may be liable to the company in addition to the third party where he exposes the company to damage/loss by reason of breach of his general duty to act with skill and care.

1. Under section 320 of CA 85 the de minimis limit was just £2,000. Section 320 of the CA 06 does not have retrospective application.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.