Company directors are duty-bound to the companies which employ them – inescapably so. These duties arise automatically out of the very essence of corporate existence under the law. The company can, if it wishes, make them more onerous (under its articles of association), but there is nothing to be done about watering them down. Now, directors’ duties have been put on a statutory footing for the first time. This article takes a closer look at what this will mean in practice.
Traditionally directors' duties included: exercising skill and care; acting in good faith and in the best interest of the company; acting within the powers set out in the company’s memorandum and articles (as well as using those powers for proper purposes); avoiding conflicting interests and conflicting duties; and not making a secret profit.
In this context ‘the company’ refers to its collective shareholders and so the duties owed to a company by its directors could be enforced only by the company or its shareholders. Shareholders could also bring what was known as a ‘derivative action’ on the company's behalf.
These duties applied to all directors and some extended to shadow directors. Certain duties, such as the duty to avoid conflicts of interest, applied even to former directors who had already resigned, moved on, or retired.
But, traditionally, these duties were not contained in statute; they had evolved through case law. If a dispute arose a court had to analyse previous case law to decide which duty, if any, had been breached.
Companies Act 2006
In an effort to simplify company law for the benefit of shareholders these traditional definitions have now been revamped and for the first time set out in an Act of Parliament, the Companies Act 2006.
The new duties are not intended to tell directors what to do, but to set out a code of conduct governing how directors are expected to behave. The original intention was to start with a clean slate, but old case law will still be used to interpret the new Act.
Broadly speaking there are seven ‘new’ duties.
1. To act within powers
Directors do not have unrestricted freedom to do as they please – even if they believe it is in the best interests of the company. They have to act at all times within the powers set out in the articles of association and these powers must be used for their "proper purpose". For example, issuing new shares may well be allowed by the articles, but if this is done merely to dilute an unpopular member's shareholding it would fail the "proper purpose" test.
2. To promote the success of the company
This is aimed at increasing the long-term value of the company for its shareholders. Directors are supposed to act in good faith and in ways in which they believe will "promote the success of the company for the benefit of the members as a whole". ‘Success’ (according to the parliamentary record Hansard) means a long-term increase in share value. In other words, the core principle of this duty is to swell the company's coffers for shareholders.
This is also the part of the Act where Parliament added what is arguably the most controversial aspect of the revamp; in promoting the company's success directors must have regard to the following:
- the likely consequence 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 members of the company.
That’s a lot to think about when taking a business decision! In fact the new legislation requires directors to have regard to these factors "amongst other matters". Parliament quite naturally wants companies to focus on responsible business behaviour and better relationships with customers, suppliers, employees and planet earth. But most of these factors – community, environment, high standards of conduct, acting fairly between members – are new requirements. Where will it all end? There appears to be no statutory limit to the things directors must bear in mind. Which should be given priority? What if they conflict?
The Government's guidance notes say that the key is to act in good faith at all times. Directors should consider the relevance of each factor. They can decide in good faith that some are irrelevant and disregard them in a particular instance. They should always use their skill and judgment before doing what they think is appropriate.
That said, remember that the primary duty is all about long-term gains for shareholders; the six "factors" are secondary to that. So, for example, closing a loss-making factory is unlikely to be in the interests of employees, but it might help shareholders and even benefit the environment, so the closure could still be justified. The key is to consider all six elements before arriving at a final decision.
3. To exercise independent judgment
It sounds obvious, but directors must exercise independent judgment and not submit to the will of others or act in ways which will restrict their future decisions.
There are, however, a few exceptions to this general principle:
- directors will be affected by terms of commercial contracts which the company has made with suppliers, customers, etc. (trading would be impossible otherwise);
- directors may delegate their powers to more junior employees, providing the delegation is reasonable;
- the company's articles may fetter directors' independence; and,
- directors may take professional advice from consultants, accountants and lawyers, etc. – though they must still exercise their own judgment as to whether to take that advice.
4. To exercise reasonable care, skill and diligence
This is not a new duty but it is now formally divided into two ‘limbs’.
- An objective limb – all directors are expected to have a certain level of competence in terms of knowledge, skill and experience;
- A subjective limb – the actual knowledge, skill and experience of the individual director is taken into account.
Thus a solicitor or accountant may be held to a higher standard than a director whose career began as an apprentice tradesman. However, the objective minimum standard applies whether or not the director has prior experience or relevant qualifications.
5. To avoid conflicts of interest
Directors should avoid situations in which they have an interest (direct or indirect) which may conflict with the interests of the company. The new Companies Act anticipates that conflicts may arise where directors:
- make personal use of information, property or opportunities belonging to the company;
- enter into a contract with the company; or,
- make a profit whilst a director and without the company's knowledge.
This duty covers all conflicts, actual or potential. There is an exception – if the situation "cannot reasonably be regarded as likely to give rise to the conflict of interest" – but directors wishing to rely on it would be sensible to record their reasoning.
Shareholders can ‘authorise’ conflicts and, from 1 October 2008, so can the directors not involved in the potential conflict unless the articles say otherwise (for private companies) or unless the articles do not expressly permit it (for PLCs). However, authorisation by directors is only valid if the conflicted director does not vote and is not counted for quorum purposes.
This duty also applies to former directors in relation to knowledge gained whilst in office.
Where one individual is a director of several group companies, he/she may find that certain duties – such as that of confidentiality – clash with the need to act in the best interests of each company respectively. In these situations directors may need to absent themselves from board meetings; in extreme cases they may need to consider resigning from one or more boards. Directors in this position should seek independent legal advice.
6. To accept benefits from third parties
This simply means that directors cannot accept benefits for doing/not doing something in their capacity as director. It is intended to prevent directors exploiting their position for personal benefit. Benefits do not have to be money – for example, an honorary position would qualify. Benefits given by the company, a holding company and/or subsidiaries are not prohibited.
There is no problem if accepting the benefit could not reasonably be regarded as likely to cause a conflict of interest. But again, we recommend that directors record why they believe this to be the case before they accept the benefit.
7. To declare interests in proposed transactions or arrangements
This is simply an extension of the conflict of interest duty. It applies to proposed transactions where the director is indirectly or directly involved. The nature and extent of the director's interest must be disclosed to the other directors.
From 1 October 2008 specific shareholder approval will no longer be required in this context, but what will be required is that directors disclose their interest before the transaction is completed.
Disclosure can be made at a board meeting or by written notice to the other directors. If the nature of the transaction changes the disclosure may require updating.
There is no need to disclose anything which the other directors already know about or ought reasonably to know. The duty will be breached, however, if the director fails to declare something he ought reasonably to have known.
For practical reasons this duty does not apply in sole director situations, and no declaration is required if a director's interest cannot reasonably be regarded as likely to cause a conflict.
Service contracts are excluded, but note that separate disclosure duties arise under the substantial property transaction rules and under section 182 of the Companies Act 2006. These are outside the scope of this article, except perhaps to note that breach of section 182 is a criminal offence.
Finally, and on a general note, since these duties can easily overlap, great care is needed in striking a balance, one against another. For example, directors considering the duty to promote the company's best interests and in so doing choosing actively to disregard the environment might need to be able to show that they had exercised reasonable care in so doing if they are to avoid liability.
When do they come into force?
The first four duties listed above became law on 1 October 2007. The remaining three will follow on 1 October 2008, thus providing a useful window of opportunity within which companies can amend their articles accordingly.
How should directors respond?
As we’ve seen, the new duties require directors to consider a large number of factors whenever they make a decision, even though many of these duties can conflict and directors can be forgiven for feeling a touch perplexed at this prospect.
Government guidance notes emphasise the need for directors to use good faith in reaching all decisions. Board minutes have only ever been a summary of the actual discussions at a board meeting and the new legislation should not change this. In recognising that the creation of an exhaustive paper trail is neither required by the Act nor likely to be practical in most situations, where directors are torn between different factors (such as employees, the community, the environment, shareholder value) it would nonetheless be wise to record the reasons for deciding that certain factors outweigh others.
Often decisions are made by a single director (not the whole board) or even employees, and companies may wish to issue standardised instructions to cover such scenarios. But these would never be more than guidelines and so no substitute for exercising independent judgment in good faith.
What if I breach my duties as a director?
The new Companies Act does not codify the consequences of getting it wrong; in this respect the old law still applies. Breach of the duty to exercise reasonable skill, care and diligence would give rise only to a damages claim, but the other six could lead to one or more of a number of legal remedies:
- damages and compensation;
- a court order to return company property/money;
- an order for an account of profit (ie, repayment of ill-gotten gains);
- rescission (setting aside a contract);
- a court declaration that a director's action breached his/her duties;
- injunctions (in extreme cases).
Unlucky directors on the wrong end of a claim may have a complete or a partial defence under Section 1157 of the new Act. This enables the courts to relieve directors of liability if they have acted honestly and reasonably and ought fairly to be excused. Courts always have discretion in this.
Finally, directors can mitigate their risk by obtaining directors' and officers' insurance cover or indemnities from their company. There is also the possibility of amending the articles in certain ways.
Companies in financial difficulty
We began by explaining that directors' duties are owed to the company/shareholders. But if a company is insolvent, what then? Shares lose their value in a formal insolvency situation because administrators and liquidators must repay creditors before shareholders and then the interests of creditors over-ride those of shareholders so that directors' duties also shift away from them and towards creditors.
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.