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The Companies Act 2006 Has Codified Directors' General Duties - With Some Changes - And Introduced New Provisions On Directors' Liability.

Introduction

Until the Companies Act 2006 came into force, directors' general duties to their company had developed by case law. Now, with a view to providing greater clarity and accessibility, they are for the first time set out in statute, albeit with some changes. In particular, the duty to promote the success of the company is wider than the old duty to act in the best interests of the Company and, from October 2008, it will be possible for the board, as opposed to the shareholders, to authorise a director's conflict of interest, subject to changing the articles of association (public companies) or passing a resolution (existing private companies) to permit such authorisation.

So far as directors' liability is concerned, a new statutory procedure for claims against directors has been introduced. This procedure is intended to make it easier for shareholders to bring claims against directors on behalf of a company and there is a new regime covering directors' liability for statements in reports.

SEVEN GENERAL DUTIES

1. To act in accordance with the company's constitution and only to exercise his/her powers for the purposes for which they were conferred.

2. To promote the success of the company for the benefit of its members as a whole, having regard to:

  • the interests of the company's employees;

  • the need to foster business relationships with the company's suppliers and customers;

  • 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;

  • the need to act fairly as between members of the company;

  • the likely consequences of any decision in the long term;

3. To exercise independent judgement.

4. To exercise reasonable care, skill and diligence.

5. To avoid conflicts of interest – in particular the exploitation of any business opportunities.

6. Not to accept benefits from third parties.

7. To declare to the other directors any interest in a proposed transaction or arrangement with the company.

DIRECTORS DUTIES

The Box "Seven General Duties" above summarises the seven general duties contained in the Companies Act 2006 which are intended to replace the equivalent common law and equitable rules. Most of these provisions came into force in October 2007, however the provisions relating to conflicts of interest, namely items 5, 6 and 7 in the box, come into force on 1 October 2008.

It is not intended to be an exhaustive list of directors' duties. There are of course many specific statutory duties and other duties remain uncodified, such as the duty to consider the interests of creditors in times of a company's threatened insolvency.

Duty to avoid conflicts of interest

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 will apply to situations arising on or after 1 October 2008.

This duty applies to all conflicts other than any that may arise due to a transaction with the company, as that is covered by the duty to disclose such interests.

It is, in particular, intended to cover the exploitation of any property, information or opportunity, whether or not the company could take advantage of it.

A classic example of a breach of this duty is where a director sets up in competition with the company by taking advantage of an opportunity that was available to the company or uses company information, such as customer and supplier details. For this reason this duty applies even when a person ceases to be a director so that they cannot circumvent the duty by resigning. However it may be that a director quite legitimately wants to take up an opportunity that the company has refused or a director is, or is connected with, a supplier, customer, shareholder or even a competitor and the circumstances are such that the directors are willing to approve the connection, subject to imposing safeguards to protect the company's interests such as preventing the disclosure of confidential information by providing, for example, that the director in question cannot attend meetings at which the third party, the subject of the conflict, is discussed and cannot receive papers relating to the relationship with that party.

There is a "safe harbour" to the effect that where a company's articles contain provision dealing with conflicts of interest, the general duties will not be breached by anything done, or omitted, by the directors in accordance with any such provision. A company could, for example, provide that a director will not be in breach of his duty if he does not disclose to the company confidential information of a third party which he obtains as a result of an authorised conflict situation.

A company cannot exempt a director from any liability to the company for negligence, breach of duty or breach of trust, but this provision does not prevent a company from including in its articles of association any provisions which are currently lawful for dealing with conflicts of interest.

The duty is not infringed if the situation cannot reasonably be regarded as likely to give rise to a conflict or if the matter has been authorised by the directors.

In allowing the directors to authorise a conflict of interest, the Companies Act 2006 represents a significant change to the requirement of shareholder approval under the existing law. To guard against abuse the director in question and any other interested director cannot vote or count in the quorum when making any decision to authorise a conflict. In addition, in making any decision to authorise a conflict, directors must act in accordance with their other general duties, such as the duty to promote the success of the company.

Directors of a public company can only authorise conflicts if it is permitted by their articles of association.

In the case of private companies formed before 1 October 2008, directors can only give authorisation if the members have passed a resolution permitting directors to authorise conflicts. For private companies formed after 1 October 2008 directors can authorise conflicts unless their articles of association contain express prohibition.

For listed companies the general view is that shareholders are unlikely to object provided they are satisfied that the company has a good corporate governance structure and record and appropriate procedures are in place for approving and dealing with conflicts. In the case of private companies, whether or not it is acceptable will depend on the individual circumstances.

Companies need to prepare for the change in October 2008 by, for example:

  • changing their articles of association with effect from that date;

  • informing directors of their duty to notify potential conflict situations, for example, as a result of other directorships or through close associates;

  • putting in place procedures and guidance to deal with conflicts.

Duty to declare interests

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

A director need not declare an interest if (a) it cannot reasonably be regarded as likely to give rise to a conflict of interest (b) the other directors are (or ought reasonably to be) aware of it or (c) it concerns the terms of his service contract for consideration by the board of directors.

Provided a director properly declares his interest, the transaction or arrangement can not be set aside by any legal principle requiring the consent of shareholders, subject to any contrary provision in the company's articles of association. This changes existing law under which shareholders' consent is required, although this is often given in specified circumstances in a company's articles of association.

If circumstances change so that the original declaration becomes inaccurate, a director must make a further declaration. Directors should reserve the right to review any authorisation and the conditions attached to it upon such further declaration.

Declarations may be given orally at a meeting of directors or by way of a specific or general written notice.

Another section of the Companies Act 2006 contains similar provisions requiring a director to declare an interest in an existing transaction or arrangement, as opposed to a proposed transaction or arrangement.

If a company's articles of association contain provisions regarding interests in contracts with the company, it would be sensible to review them in the light of this new law prior to 1 October 2008.

Duty not to accept benefits from third Parties

A director must not accept any benefit from a third party which is conferred because of his being a director, or his doing or not doing anything as a director. This duty is not infringed if the acceptance of the benefit cannot reasonably be regarded as likely to give rise to a conflict and does not apply to benefits given by the company or other members of its group.

Unlike the other provisions regarding conflicts of interest, there is no ability for the acceptance of benefits to be approved by the directors so shareholder approval must be obtained for the acceptance of any such benefit, unless it falls within the exception mentioned above.

There is concern as to the extent to which corporate entertainment will be caught by this provision. If they do not already have them, companies should consider putting in place guidelines on what can be accepted and what benefits require prior approval.

Duty to promote the success 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, having regard, amongst other matters, to the six factors set out in the box "Seven General Duties".

These factors reflect the Government's principle of "enlightened shareholder value" - combining the profit motive with wider expectations of responsible business behaviour by taking into account factors such as the interests of the company's employees and the impact of the company's operations on the community and the environment.

The duties are said to replace the corresponding common law and equitable rules and this duty is presumed to replace the duty to act in the best interests of the company, but the wording is different and of course the six factors to be taken into account are new.

The Government has published some guidance on the interpretation of this section. Success for a commercial company will normally mean long term increase in value, but it is for the members to define the objectives which they wish to achieve in the company's constitution.

There is concern over the weight to be given to each of the six factors. The Government's view is that "the decisions taken by a director and the weight given to the factors will continue to be a matter for his good faith judgement". However, it is not a box ticking exercise. Proper consideration must be given to the factors although they are subsidiary to the overriding duty to promote the success of the company for the benefit of its members.

There has been some debate about the extent to which the six factors should be documented in board minutes. The Government's guidance is that "the clause does not impose a requirement on directors to keep records, as some people have suggested, in any circumstances in which they would not have to do so now". The GC100, an influential group representing general counsel and company secretaries of the FTSE100 companies, has issued guidance which has been endorsed by the Institute of Chartered Secretaries and Administrators. They recommend that the six factors are referred to, if relevant, in the papers prepared for the board meeting but suggest that the board minutes only record the decisions and that it is not necessary to detail how those decisions were reached.

Duty to act in accordance with the company's constitution

A director of a company must act in accordance with the company's constitution and only exercise powers for the purposes for which they are conferred.

A company's constitution for this purpose includes its articles of association, resolutions and agreements affecting the constitution (which may include informal unanimous decisions of the shareholders) and decisions taken in accordance with the articles of association.

Duty to exercise independent judgement

A director of a company must exercise independent judgement.

There are however two exceptions included in the Companies Act 2006. The duty is not infringed by a director acting in accordance with an agreement duly entered into by the company that restricts the future exercise of discretion by its directors or in a way authorised by the company's constitution.

The key point of this duty is that directors should not be swayed by the views of the other directors or of, say, the parent company, or allow themselves to be affected by outside interests, but should make decisions independently based on their own appreciation of the benefits and risks that may be involved. They can of course seek professional or other outside advice, but the ultimate decision must be theirs.

The exceptions do recognise the realities of group structures and joint ventures by allowing directors to act in accordance with provisions laid out in the constitution or any agreement entered into by the company. Of course they are still bound by the other duties, such as the duty to promote the success of the company (which cannot be overridden by the articles of association) and accordingly they cannot be absolved from responsibility for any decision by provision in the articles of association or any agreement.

If the directors wish to delegate any function they should ensure that the power is contained in the articles of association so that any delegation falls within the stated exception.

Duty to exercise reasonable care, skill and diligence

A director of a company must exercise reasonable care, skill and diligence.

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

  • the general knowledge, skill and diligence that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company, and

  • the general knowledge, skill and experience that the director has.

The first leg is therefore an objective test and the second is a subjective one. The objective test effectively imposes a minimum standard whilst the subjective test will take into account any specific skills of the director in question. For example, a higher standard will be expected of a director with an accounting qualification on a question relating to accounting matters than of a director without such qualifications.

Consequences of breach of the general Duties

The Companies Act 2006 preserves the existing civil consequences of breach of any of the general duties. For breach of fiduciary duties (that is, all the duties except the duty to exercise reasonable care, skill and diligence) the consequences of breach may include:

  • damages or compensation where the company has suffered loss;

  • restoration of the company's property;

  • an account of profits made by the director;

  • rescission of a contract where the director has failed to disclose an interest.

For breach of the duty to exercise reasonable care, skill and diligence, the main remedy would be damages.

Shareholders, can, as at present, ratify most breaches, but a new provision means that in the case of any breach of duty or of trust or acts of negligence or default by a director, the vote of any person who is connected with the director in question must be disregarded. This is a significant change to the principle of majority rule, although it does provide increased protection for minority shareholders.

The definition of "connected person" has been extended under the Companies Act 2006. A person is connected with a director if they are a member of the director's family. That is, the director's spouse, civil partner, any person with whom the director lives as a partner in an enduring family relationship, a child or stepchild of the director, a child or step-child of a director's partner (if living with the director and under the age of 18), or the director's parents. A company is connected with a director if the director (and persons connected with him) is interested in 20% or more of the equity share capital of the company, or can exercise more than 20% of the voting power at a general meeting of the company. There are similar provisions which serve to connect persons to a director in relation to trusts set up for the benefit of that director or his family, and in relation to partners of a director.

There are also criminal sanctions (fines) for breach of the duty to declare an interest in a proposed contract.

As the general duties are owed to the company, it is only the company which can take action against a director for breach. This can of course be as a result of a decision of the majority of the directors, or an action could be initiated by a liquidator or, under the new derivative claims procedure, by one or more shareholders. See below for details.

The New Derivative Claims Procedure

In October 2007 a new derivative claims procedure was introduced by the Companies Act 2006 enabling one or more shareholders to bring proceedings against a director on behalf of the company in respect of that director's negligence, default, breach of duty or breach of trust. The new procedure is intended to make it easier for shareholders to bring claims on behalf of the company. To address difficulties with the previous derivative claims procedure, a claim can be brought even if the director in question has not benefited personally from the breach and it is no longer necessary for shareholders to show that the director or directors in question control the majority of the company's shares.

There is concern that the procedure will be used by pressure groups (eg environmental groups) to challenge directors' decisions on the basis that they have not properly taken into account the factors they are required to as part of the new duty to promote the success of the company. In this regard, the Companies Act 2006 makes clear that a claim can be brought in respect of a cause of action arising before, during or after a person becomes a shareholder, which has given rise to fears that activists could take a small stake just for the purpose of bringing a claim.

In order to alleviate concerns over increased and speculative litigation, provisions are included which require a claimant to present a good case to the court before the action can be continued. If the court is satisfied that a person acting in accordance with the general duty to promote the success of the company would not seek to continue the claim or that the act or omission giving rise to the cause of action has been authorised or ratified by the company, then it must refuse permission to bring the claim. In coming to its decision the court must take into account:

  • whether the shareholder is acting in good faith;

  • whether the act or omission giving rise to the cause of action could be (and in the circumstances would be likely to be) authorised or ratified by the company;

  • whether the company has decided not to pursue the claim;

  • whether the act or omission in respect of which the claim is brought gives rise to a cause of action that the shareholder could pursue in his own right rather than on behalf of the company;

  • any evidence before the court as to the views of shareholders of the company who have no personal interest, direct or indirect, in the matter.

In addition, the court has the ability to make a costs order against an applicant as a deterrent, if appropriate.

Directors Liability For Statements In Reports

The Companies Act 2006 introduced a new liability regime for untrue or misleading statements in a company's reports.

A director will be liable to compensate the company for any loss it suffers as a result of any untrue or misleading statement in, or omission from, the directors' report (including the business review), the remuneration report and information in summary financial statements derived from them.

There is a safe harbour in that a director is only liable if the director knew or was reckless as to whether the statement was untrue or misleading or knew the omission to be a dishonest concealment of a material fact.

Companies may wish to consider the structure of their annual reports to ensure that best use is made of the safe harbour. The provision applies to directors' reports, remuneration reports and summary financial statements first sent to members on or after 20 January 2007.

In addition, companies admitted to trading on the London Stock Exchange's main market and other regulated markets (not AIM) may be liable to compensate third parties who have acquired securities and suffered loss as a result of any untrue or misleading statement in certain reports.

Further information on this aspect of the regime is contained in our earlier newsletter on the Companies Act 2006 a copy of which can be downloaded from here:

Salans' Company Law Update - Companies Act 2006

Directors' Indemnities, Insurance And Defence Funding

Although the general rule is that a company cannot exempt a director from any liability in connection with any negligence, default, breach of duty or breach of trust in relation to the company, it is possible for a company to indemnify a director against certain liabilities incurred by a director to third parties, advance funds for defence of claims in certain circumstances and, of course, obtain insurance against liability both to the company and to third parties. Wider powers of indemnity were introduced in 2005 and these have been largely repeated but the Companies Act 2006 has gone further and it is now possible to provide an indemnity to directors who are trustees of an occupational pension scheme. There have also been some modifications to the rules permitting a company to advance money to a director to fund his defence (subject to repayment if he looses) without having to get shareholder approval in advance. The new provisions now clearly state that advances can be made in respect of regulatory actions and investigations and the new wording permits a company also to advance funds to a director of its holding company. However the wording under the Companies Act 2006 is narrower in one respect - it only permits advances to be made in respect of actions arising from a director's alleged negligence, default, breach of duty or breach of trust in relation to the company or an associated company, unlike the previous rules which covered any civil or criminal proceedings.

It would be prudent for companies to check that any provision in their articles of association covering these areas is consistent with the new law and that appropriate insurance cover is in place.

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.

AUTHOR(S)
Paul Salmon
Salans LLP
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