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In this issue, the Company Law Memo Newsletter looks at the controversial codification of directors’ duties in the Companies Bill, summarising each duty in turn and highlighting the issues directors will have to consider in anticipation of the Bill coming into force. |
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One of the most discussed aspects of the Companies Bill is its codification of directors’ common law and equitable duties. The aim of this codification is to ensure that directors, shareholders and those who deal with companies can easily find out what the duties are and the general standard directors are expected to achieve in carrying out their functions. The “general duties” imposed on a director by the Bill are: - to act within his powers; - to promote the success of his company; - to exercise independent judgment; - to exercise reasonable care, skill and diligence; - to avoid conflicts of interest; - not to accept benefits from third parties; and - to declare interests in transactions or arrangements. Each duty is considered further below. The consequences of breach of these duties are the same as for the current common law and equitable equivalent duties, so a failure to exercise reasonable care, skill and diligence would lead to an action in negligence against the director, and breach of the other duties would render him liable to the equitable remedies available for breach of fiduciary duties. As with the common law duties, more than one can – and often will – apply in any one situation (s 180). Directors must bear in mind that the duties listed as such in the Bill are their “general” duties towards the company, and they will still be subject to other duties relating to specific areas, for example preparing and delivering accounts (s 171). The Bill sets out the basic general duties; a company may impose more onerous obligations in its constitution and service contracts. Even if a director complies with these general duties, additional approval may still be required for his actions, e.g. in the case of substantial property transactions and loans to directors. These duties work together with other requirements so, for example, the board should only approve a loan to a director if it would promote the company’s success to do so. Memo points: This article refers to the Bill in its amended form as published by parliament on 28 July 2006. As a result of amendments during the parliamentary process, the section numbers differ to those used in Company Law Memo 2006.
To act within powers (s 172) See CLM ¶2348+, ¶2554+ A director must act within the company’s constitution and only exercise his powers for the purposes for which they were conferred. The company’s “constitution” refers to the new form memorandum and articles (see Focus on… in Issue 1), but also includes instructions given by the shareholders in accordance with the memorandum and articles (s 257).
To promote the success of the company (s 173) See CLM ¶2378+ A director must act in a way in which he believes, in good faith, will be most likely to promote the success of the company for its shareholders. In doing so, he must have regard to the following factors: - the likely long-term consequences of any decision; - the interests of the company’s employees; - the need to foster business relationships with suppliers, customers and others; - the impact of the company’s operations on the community and environment; - the desirability of the company maintaining a reputation for high standards of business conduct; and - the need to act fairly between the shareholders. This is what the government refers to as the “enlightened shareholder value” principle. How a director exercises this duty will clearly depend on his company. For instance, a company incorporated as a professional members’ society is more likely to measure its “success” according to its reputation and investment in its profession (in terms of education, knowledge-sharing and providing services to its members) than according to profitability. The Bill clarifies that if a company’s purposes include those which are not for the benefit of its shareholders, the directors must act to promote the success of those purposes. It would be sensible for companies to be clear about their goals to shareholders. Inevitably, some will be more important than others and directors will be put in a difficult situation where the factors clash – for example, where the long-term consequences of deciding to streamline a section of the business will mean increased efficiency and profitability, but many job losses; or where a company decides to set up a manufacturing plant in a new area that will bring jobs to the community, but damage the environment. Where the company’s solvency is in jeopardy, the directors are not expected to put the success of the company or any of these factors ahead of the interests of its creditors. Theoretically, a director should consider these factors each time he makes a decision and record his conclusions for future reference should a dispute arise. From a practical point of view, it is not clear how far directors are expected to go in “having regard” to the factors, for instance, would they be expected to take advice from relevant professionals and if a decision is clearly detrimental to one of these factors can they justify going ahead anyway? Until guidance can be taken from case law and experience, directors will have to take a pragmatic approach and try to consider each factor in an appropriate and proportionate manner depending on the decision before the board. At the very least, the board must ensure that any important or potentially controversial decisions are properly considered and minuted. Although imposing a requirement on directors to consider factors such as the environment, the interests of the employees and the company’s reputation is clearly intended to ensure that directors take corporate social responsibility seriously, non-shareholders who are affected by decisions (e.g. non-shareholding employees, local environmental groups etc) do not have any redress under the Bill if their interests are not properly considered.
To exercise independent judgment (s 174) See CLM ¶2342+ A director must exercise independent judgment. This duty can be lawfully restricted by the company’s constitution (e.g. which may stipulate that directors must act in a particular way) or by an agreement entered into by the company (e.g. the terms of a loan facility may require the board to consult and obtain sanction from the lender with regard to significant decisions). The Bill does not specifically address the issue of delegation, although if a company’s constitution allows a director to delegate his powers he will be acting within his authority by doing so.
To exercise reasonable care, skill and diligence (s 175) See CLM ¶2411+ A director must exercise the care, skill and diligence of a “reasonably diligent person” who has: - the general knowledge, skill and experience that can reasonably be expected of a person carrying out the same functions as those carried out by the director in relation to the company; and - the general knowledge, skill and experience of that director. This test mirrors that currently used in wrongful trading cases, which is increasingly being applied by the courts in cases of directors’ negligence as they find it helpful to apply an objective and subjective test, rather than just the common law subjective one. The application of this test may put highly skilled directors in a more onerous position because they are likely to be judged by a higher standard than that which is appropriate to their position, e.g. an experienced non-executive director who is only expected to commit a small amount of time to the company, or a legally qualified director. However, since such people are presumably engaged (partly) due to their particular skills, it is only reasonable that they are expected to act appropriately. The courts will be left to judge each case on the particular circumstances.
To avoid conflicts of interest (s 176) See CLM ¶2390+, ¶2405+ A director must avoid actual and potential conflicts between his interests and the company’s. This includes indirect interests and conflicts of duty, but does not include any situation that cannot be “reasonably regarded” as giving rise to a conflict. The Bill states that this duty particularly applies to the exploitation of any property, information or opportunity whether or not the company itself could have benefited from it, reflecting the common law. It does not, however, apply to: - conflicts arising from interests in transactions, which are dealt with separately; or - the following decisions, which require shareholder consent or may be excepted from the requirement for consent in any event (s 181(2)): ▪ approval of long term directors’ service contracts (s 189-190); ▪ approval of substantial property transactions (s 191-197); ▪ approval of loans and similar transactions to directors (s 198-213); and ▪ approval of payments to directors in compensation for loss of office (s 214-221). The wording of this duty is very wide, for example, every director who also holds a position within another company will have (at the very least) potential conflicts. To avoid directors being unduly restricted, the board may authorise its directors to have a conflict, provided its constitution does not prevent it (or, in the case of a public company, specifically allows it) and the interested director does not count in the quorum or the vote. This will preclude sole directors from benefiting from the new provision and they will have to refer to the shareholders, as they do now. The board’s ability to sanction conflicts of interest is not affected by any existing common law rule or equitable principle requiring shareholder consent instead (s 181(1)). If a company wishes to retain shareholder control over such issues, it will need to expressly require shareholder consent in its constitution.
Not to accept benefits from third parties (s 177) See CLM ¶2398+ A director must not accept any benefit given to him by a third party on account of his being a director or of him doing, or not doing, something as a director. He will not be in breach of this duty where the benefit was conferred upon him in return for his services, or where accepting the benefit could not reasonably be seen as giving rise to a conflict of interest and/or duty. Unlike the general “no conflict” duty, the board cannot authorise the receipt of benefits from third parties. Directors will therefore have to rely on shareholder consent, as they do now. If shareholders want to give the board the power to consent to directors keeping gifts etc, they can alter the constitution or give instructions to the board via a special resolution to this effect. As with the duty to avoid conflicts of interest, this restriction does not apply where a shareholder resolution is required (or is excepted from such a requirement) for the approval of (s 181(2)): - long term directors’ service contracts (s 189-190); - substantial property transactions (s 191-197); - loans and similar transactions to directors (s 198-213); and - payments to directors in compensation for loss of office (s 214-221).
To declare interests in transactions or arrangements (ss 178, 183) See CLM ¶3308+ A director must declare the extent and nature of any interest he has in a transaction or arrangement to which the company is a party to the board. This encompasses direct and indirect interests, and if the circumstances change after a declaration has been made the director must make a new declaration. A director is not expected to make a declaration if: - he is unaware of his interest or the transaction or arrangement in question; - the interest cannot be reasonably regarded as leading to a conflict; - the other directors are already aware of the interest; or - the interest is in his service contract which is/has been before the board or a committee. Rather unhelpfully, this duty is separated into: - declaring interests in proposed transactions or arrangements, which is treated as a fiduciary duty, so breach renders the director liable to equitable remedies; and - declaring interests in existing transactions or arrangements, which is treated as a statutory duty, breach of which is a criminal offence. In many cases, interests will be declared in advance as directors will be aware of transactions or arrangements as they come up. The second obligation ensures that a director must still declare his interest even if he only becomes aware of it, the transaction or arrangement at a later date, or where a new director joins the board for example. The two obligations are mutually exclusive: if a director has declared his interest before the transaction or arrangement was entered into, he does not have to re-declare it after the company has entered into it. The Bill does not set out any consequences of declaring an interest, leaving it to companies to decide whether or not an interested director should be allowed to participate in decisions which may be affected by his interest. The proposed model articles for private companies include a provision that interested directors’ views should be disregarded; in the case of public companies, an interested director cannot vote or count in the quorum. Memo point: Since a declaration of interests before a transaction or arrangement is entered into needs to be made “to the other directors”, a sole director will not be able to make it (an alternative method of declaration is not stipulated in the Bill). However, such a director is specifically required to make a declaration in writing of any interests after the transaction or arrangement has been entered into, so effectively sole directors have to declare the same interests as others (s 187).
Impact of codification This is one of the most controversial aspects of the Companies Bill. Although it cannot be denied that the current reliance on common law is unsatisfactory and confusing for many directors, the Bill’s critics have either questioned the necessity for full codification (for example, could the same result have been achieved by setting out directors’ duties in official guidance?) or argued that the Bill does not go far enough (for example, it does not codify the remedies available for breach of duty, nor does it cover all duties). The Bill attempts to occupy the middle ground between clarifying the duties by setting them out and retaining the flexibility of the common law system which allows the courts to decide cases as appropriate in their unique circumstances. However, the danger is that the apparently simple codified duties will become just as complicated as the common law duties over time, as case law builds up. Indeed, the existing common law rules and equitable principles are to be used in interpreting and applying these codified duties, which in itself is likely to cause some confusion from the outset where the wording of the codified duty is not quite the same as the original (s 171). Although codifying directors’ general duties gives a clear starting point, it may not make any significant difference in the long run as far as more detailed interpretation is concerned. Certainly, shareholders and third parties wishing to take action against directors, and directors needing to defend themselves, will still need expert advice on their particular circumstances. |
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CODIFICATION OF DIRECTORS’ GENERAL DUTIES |