Company Law of Directors’ Duties

Chapter 1: Directors’ Duties

Formulating a system for holding directors accountable has never been easy. As Roach put it, directors’ duties must be gleaned from “a confusing and compendious mass of case law and the occasional statutory measure.”[1] Given the vast variations in the types of companies that exist, and the types of directors that exist, a universal approach has not always been easy to apply. Nevertheless, the law sometimes seeks to impose a single standard of conduct on all directors, regardless of the nature and characteristics of the company, and the level of involvement of the director. While recent statutes have started to distinguish between private and public companies, and may vary the duties of a director depending on which type of company is concerned, the vast majority of the case law on directors’ duties makes no such distinction and is of general application. There is therefore a complex body of statutory and case law which attempts to both define the duties that a director owes to the company, as well as the level of care that must be exercised when performing such duties.[2]

As well as statute and case law, a number of standards and codes of practice have also been formulated which seek to define the nature of the duties owed by directors to companies. The first of these to be considered here is the Cadbury Committee, which was established in 1991 following a number of financial scandals that occurred during the previous decade. It was widely acknowledged that reform was needed in company law to allow shareholders and other stakeholders to hold directors more directly accountable for the consequences of their actions. The Cadbury Committee focused on financial control mechanisms to be used by the Board of Directors, and on auditing procedures, and published its report at the end of 1992.[3] The report focused mainly on larger listed companies and its main conclusion was that a Code of Best Practice should be drawn up and which the Boards of Directors of such companies would be obliged to follow. For smaller companies, it would not be obligatory to comply with the code, but if they chose not to, they would have to publish the reasons why they had chosen not to.[4] Adherence to the Code would be made a listing requirement, which would help ensure compliance among listed companies.

The benefits of the Code would be to make corporate governance more open and transparent, would make the equities markets more efficient, would make boards more accountable and also more responsive to the needs of the company, and would allow shareholders to exercise greater control and scrutiny over boards. The report was an early supporter of the importance and need of non-executive directors[5] and recognised that executive and non-executive directors play very important complimentary roles. This area proved to be controversial as many saw the creation of two classes of directors as a threat to the traditional unitary nature of boards. However, the report found that non-executive directors could play a vital role in “reviewing” the performance of the executive directors, as well as taking measures to avoid and deal with “potential conflicts of interest”[6].

While the report emphasised the importance of financial auditing of companies, it did not go into detail on what should be disclosed in such audits, nor did it consider the controversial area of auditor liability. These were issues which would later become the subject of heated debate.

The Report was also an important element in the growth of shareholder activism in the UK, and it concentrated on the steps that institutional shareholders could take to ensure compliance with the Code. In response to the issues raised in the Report, the Institutional Shareholders Committee[7] published its own paper, “The Responsibilities of Institutional Shareholders in the UK”[8] which dealt with many of the issues raised in the Cadbury report. The paper stated that “Because of the size of their shareholdings, institutional investors, as part proprietors of a company, are under a strong obligation to exercise their influence in a responsible manner.” This paper marked a new era in UK shareholder activism and promised to make shareholders more involved in making boards more accountable. The paper went so far as to recommend “regular, systematic contact at senior executive level to exchange views and information on strategy, performance, Board Membership and quality of management”[9]. Regarding the composition of boards, the paper recommended that institutional investors look carefully at “the concentration of decision-making power not formally constrained by checks and balances” and “the appointment of a core of non-executives of appropriate calibre, experience and independence.”[10] Therefore, this new investor oversight was taken for granted in the Cadbury report as another force that would improve the governance of large companies.

The Cadbury Report has not been without criticism. Many feared that its recommendations, which put a strong influence on non-executive board members, would lead to the creation of a two-tiered board, a development that was seen as unnecessary and inefficient.[11] The voluntary nature of the Code has also been criticised. As a listing requirement, the Code also drew some criticism on the London Stock exchange which was given the task of enforcing and implementing the Code. Concerns led to the establishment of a follow up report prepared by the Hampel Committee, which re-examined the issues at stake, the criticisms which had been raised, and the conclusions reached in the Cadbury Report. The conclusions of the Hempel Committee were strongly supportive of the Cadbury Report and it was not long before the ‘Combined Code’ was drawn up, and implemented by the London Stock Exchange which listed companies were bound to implement, or give reasons for not doing so.

The Combined Code now requires that boards implement a “sound system of internal control” which must consider all significant risks facing the company, the effect they might have on the company, and the costs and advantages of various means of dealing with such risks. The Code also deals with the terms and conditions on which directors are employed, including their pay packages incentive schemes, and termination payments.

When speaking of the duty owed by directors to a company therefore, this includes the legal duties imposed on directors by the case law and statutes dealing with the subject, as well as the soft-law measures implemented in the Combined Code. Such duties may be owed to the company itself, or to shareholders or other stakeholders such as shareholders, employees, creditors, and the general public.

That said, it must be remembered that in a legal sense, the duties owed by directors is to the company as a legal person, and not shareholders or other stakeholders. The case of Percival v Wright [1902] 2 Ch 421 established beyond a doubt that the duties of directors is to the company. This case concerned a transaction in which a number of directors purchased shares personally from shareholders at a price of £2 10s. The directors knew that another purchaser wanted the shares and was willing to pay a substantially higher price. The shareholders sought to have the transaction set aside as a breach of duty to the company. Swinfen-Eady J found that the directors had breached no duty to the company, and that no such duty was owed to the shareholders qua shareholders.[12] The case of Scottish Co-operative Wholesale Society Ltd v Meyer [1959] AC 324 also illustrates the point. In that case, a parent company appointed some of its directors as directors of a subsidiary. These directors proceeded to act in the best interests of the parent, but Lord Denning pointed out the directors “probably thought that ‘as nominees’ of the [parent company] their first duty was to the [parent company]. In this they were wrong.” The duty of directors is always to the company they are acting for, regardless of the external relationships that the company, or they personally, may have with other persons. Currently there are proposals afoot to allow directors to act in the interests of a group of companies, as this is what happens in reality in many cases, especially where the shareholders and directors of the various companies are identical.

Without shareholders seeking a profit from a company, it can be argued that a company is a meaningless concept, or a piece of paper without a purpose. The law therefore recognises that in most cases, the interests of the company, will be closely connected to the interests of the members of the company, the interest of both being to make a profit. However, as shown above, the interests of the members are not paramount, and difficulties will always arise in equating the interests of the company with the interests of the members due to the fact that in many situations, the members will have different opinions and conflicting interests which cannot all be met. Section 172 of the Companies Act 2006 also adopts the ‘enlightened’ approach which calls for the interests of the company to be interpreted widely and not only as the maximisation of profits at a cost to all other considerations. Employees are one group whose interests the directors must “have regard” to under section 172. This is part of the general duty owed to the company and as such, must be enforced by the company, and not the employees. Many have criticised this provision as meaningless, as employees cannot enforce it, however, given that it is a requirement of the Companies Act, it must be expected that the majority of boards will consider the impact their decisions will have on employees, and such consideration will be minuted. While the provision may not prove capable of persuading callous directors to act other than in the interest of profit maximisation, it will certainly support the efforts of directors who do wish to improve conditions for employees. It also remains to be seen how this provision will be enforced by companies and it may transpire that a strong line of case law will develop which will persuade directors to give genuine consideration to the interests of employees.

Another group whose interests must be considered under section 172 is creditors. In Lonrho v Shell Petroleum [1980] 1 WLR 627 Lord Diplock stated, at page 634, that the best interests of the company “are not exclusively those of its shareholders but may include those of its shareholders.” Since it is the members who appoint directors, it would be tempting for directors to seek to promote only their interests, however, as the court recognised, it is often the case that creditors have put significant money into a company and their interests must be taken into account. Lonrho concerned a company that was solvent at the relevant time. The position regarding an insolvent company arose in The Liquidator of the Property of West Mercia Safetywear Ltd v. Dodd and Another [1988] BCLC 250. In this case the Court of Appeal confirmed that when a company was insolvent, its interests include those of its creditors. In Winkworth v Edward Baron [1987] BCLC 193 Lord Templeman found that the duty was owed directly to the creditors and in Brady v Brady [1989] 1 AC 755 Nourse LJ stated that where a company was insolvent, or its solvency was at risk, the interests of the company and its creditors were identical. According to Finch therefore, the creditors interests must always be taken into account to a limited extent, but as the company approaches insolvency, the interests of creditors must be given greater weight, until the interests of both groups coincide on insolvency.[13]

The full extent of the “success of the company” as it is termed in section 172 of the 2006 Act includes a duty of directors to have regard to “(a) the likely consequences of any decision in the long term, (b) the interests of the company’s employees, (c) the need to foster the company’s business relationships with suppliers, customers and others, (d) the impact of the company’s operations on the community and the environment, (e) the desirability of the company maintaining a reputation for high standards of business conduct, and (f) the need to cat fairly as between members of the company.”

It can be seen that there has been a steady broadening of the concept of the interests of the company to include more and more interests that a pure profit motive would fail to embrace. In March 2000, the DTI Company Law Review Committee stated that an “inclusive approach” should be adopted.[14] They pointed out that society’s interest in company law was that it promote “wealth generation and competitiveness for the benefit of all”, and that this can better be achieved if directors are forced to take into account “all the relationships on which the company depends.” The approach adopted in the Companies Act 2006 towards the creation of a statutory “general duty” owed by directors to the company is a progression of this concept with section 170(3) stating that “The general duties are based on certain common law rules and equitable principles as they apply in relation to directors…” At subsection (4) it states “ The general duties shall be interpreted and applied in the same way as common law rules or equitable principles”. This is clearly maintaining the case law that has built up over the past centuries as the framework on which the new statutory general duties are based. It remains to be seen what effect the new statutory duties contained in section 172 of the 2006 Act will have on this case law. Therefore, in looking at the duties owed by directors, it is necessary to read both the statutory provisions and the pre-existing case law together. These both make a distinction between the ‘fiduciary’ duties that directors owe the company, and their duty to act with ‘reasonable care, skill and diligence.’

Under section 174 of the 2006 Act a director “must exercise reasonable care, skill and diligence.” The content of this duty has been long ago established by the courts and in The Marquis of Bute’s Case [1892] 2 Ch 100 the limits of the duty were clearly set out. That case concerned the Cardiff Savings Bank, which allowed by tradition the Marquis of Bute to inherit the presidency of the bank from his father. The Marquis in question became president at the age of six months, and in the following 38 years, he attended only one board meeting. He therefore had no awareness of the business or involvement in it, and the court found that he was not expected to be involved. When financial irregularities by the board were uncovered, the court found that the Marquis was not liable due to his remoteness from the business, despite his formal position on the board. However, it appears as if the courts quickly grew stricter and in Dovey v Cory [1901] AC 477 a director escaped liability for malpractice but only because he had relied on information given to him by the chairman and general manager of the company, and his decision to do so was reasonable and not negligent. The extension since the Marquis’ case therefore, was the application of a reasonableness test.

The standard was further developed in Re City Equitable Fire Insurance [1925] Ch 407 in which three rules were established. These were that: a director must show the skill and diligence that could be expected from a person with his knowledge and experience; his duties are intermittent, and exercised only at board meetings where he participates in decision making; where reasonable, a director is free to delegate tasks and responsibilities to other employees. These rules were affirmed in Dorchester Finance Co. Ltd v Stebbing [1989] BCLC 498 which stated that they applied equally to executive and non-executive directors.

One of the features of the standard set out in Re City Equitable Fire Insurance is the fact that the standard is not that of the professional man, but the reasonable man with the skill and experience that the director in question subjectively possesses. This subjective test is useful for most companies as the more complicated the operation and the more money that is at stake, the more qualified the director is likely to be and the higher the standard. The standard will fall short in cases such as the Marquis of Bute, but this is more to do with the fact that a woefully unsuitable candidate has been appointed to the board, such as a six month old baby. In all but such extreme cases therefore, the subjective case set out in Re City Equitable will be sufficient. The second rule only requires the director to attend meetings and make himself aware of the business of the company “whenever in the circumstances he is reasonably able to do so.” Again this approach gives the law flexibility to allow for very different types of director, depending on the nature of the business. So for example, you could have an elderly family member sitting on the board because he knows the history of the business, and he will not be required to pay constant attention to the business, but simply offer his guidance when reasonably practicable. You could also have, as most companies do, full time salaried directors who are paid to spend all of their time and attention on the affairs of the company. As both types of director will be useful in various circumstances, the law allows for both, and requires each of them to be as aware of the dealings of the company as is reasonable in the circumstances.

The third rule allows directors to delegate responsibility to others, and it might be feared that this will be used by directors to avoid responsibility. However, when taken together with the other rules of the test, it is apparent that a director cannot delegate all of his responsibilities and disallow all awareness of the dealings of the company. He will still be required to be reasonably aware of what is going on and only to delegate tasks which it is reasonable for him to do so, taking into account the nature of business and the circumstances of the case.

However, there are many instances in which these three rules will not protect investors or other stakeholders, for example in the Marquis of Bute case, and there have been calls for some time for an objective standard to be introduced into the law. The DTI Company Law Review Committee, in the 2000 report mentioned above, pointed out that an objective standard has been adopted for the protection of creditors by section 214 of the Insolvency Act 1986[15] and in the case of Re D’Jan of London Ltd [1993] BCC 646 Hoffman LJ found that the objective standard set out in section 214 of the 1986 Act reflected the standard that all directors were bound to meet when upholding their general duty. Therefore, the objective standard first set out in the insolvency context became the general standard owed by directors in all cases, and section 174 of the 2006 Act affirms that both the objective and subjective standards apply. At section 174(2) the 2006 Act states that the standard required is that which may be met by a “reasonably diligent person with (a) 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 (b) the general knowledge, skill and experience that the director has.” Therefore, as a minimum, the director will be required to demonstrate the care and skill that a reasonable director of a company of that type and standard would be expected to demonstrate. This allows for some flexibility as this minimum standard can still vary depending on the business, so that the director of a small family business will have a lower standard than the director of a FTSE 100 company. At the same time, if a director is chosen because of his particular characteristics, which make him qualified above and beyond what one might expect, he will be held to this higher, subjective standard.

This standard, which upholds an objective minimum standard, which may be increased if the director in question is unusually highly qualified, seeks to strike a balance between protecting the interests of the company, and allowing directors to feel relatively at ease with the personal liability they have taken on board. A different approach was adopted in the USA, where the Supreme Court of Delaware, in Smith v Van Gorkom [1985] 488 A.2d 858 found the ten directors of Trans Union Corporation liable in the sum of $23.5 million for agreeing to a takeover without first valuing the shares of the company. While this failure seems fundamental, the sale of the company’s shares was set to take place at a price significantly higher then the quoted price of the shares on the stock exchange, and the takeover would undoubtedly have benefited the company. The massive liability was imposed without any allegation of fraud or breach of fiduciary duty and resulted in a marked unwillingness of qualified persons taking on the role of non-executive director, at least for a time. It also resulted in a number of states, including Delaware where the decision was made, enacting legislation which allowed companies to exclude or limit the liability of directors for negligent breach of their fiduciary duties. Such a situation has not occurred in English company law, and the standard adopted in section 174 is measured to avoid the need for such a development.

The second main area of directors’ duties falls under the heading of fiduciary duties. At its most simple, this covers the requirement that directors act bona fides in respect of the company. The case law that developed however sets out a number of common instances in which directors are in danger of breaching this duty, and the 2006 Act has proceeded to specify these situations explicitly. While it is not set out as such, the duty to act bona fides can be seen as an overriding interest, which cannot be breached, even when authorised by the shareholders in general meeting. For example, in the case of (Re Attorney-General’s Reference (No. 2 of 1982) [1984] 2 ALR 447 the directors of the company were the only shareholders. They took money from the company and the interpretation given was that the directors had taken the money with the authorisation of the shareholders. Nevertheless, the court found that this was breach of the overriding duty to act bona fides. The case of R v Phillipou [1989] Crim LR 559 found the same overriding duty and these cases were upheld by the House of Lords in R v Gomez [1992] 3 WLR 1067. Therefore, it can be said that there is an overriding duty to act in good faith and even if a majority of the shareholders approve of the action, the directors may not breach it, and a minority of shareholders, or creditors, and possibly employees and other stakeholders, would be able to have the action set aside.

However, it is also possible for directors to breach one of the explicit fiduciary duties, such as using powers for one purpose to achieve a different purpose, which are not dishonest or mala fide. In such cases, the court can find that the breach of the particular fiduciary duty does not place the directors in breach of their overriding duty of good faith, and a majority of the shareholders can vote to authorise such acts. Section 239 of the Companies Act 2006 allows shareholders to ratify breaches of a fiduciary duty, but subsection (7) states “This section does not affect any other enactment or rule of law imposing additional requirements for valid ratification or any rule of law as to acts that are incapable of being ratified by the company”. Therefore, the previous case law which was upheld by the House of Lords in Gomez still limits the ability to ratify. In fact, the specific fiduciary duties have been described as “disabilities” and in Movitex Ltd v Bulfield and Others [1988] BCLC 104 it was upheld that companies could alter their Memorandum and Articles to amend the nature of any fiduciary duty owed by the directors to the company, subject always to the requirement that nothing purported to allow dishonesty. Movitex concerned the concept of self-dealing, which is ordinarily presumed to be a breach of duty. In this case, the company was able to remove this presumption, so that the director was able to engage in self-dealing, but subject to the requirement that he did in fact act in the best interests of the company. A simple example of this would be if a cheese producing company sought to appoint the owner of a supermarket as a director. Self dealing would disable the director from selling cheese to the supermarket he owned, as it would be self-dealing, and very easy for the director to breach his fiduciary duties to the cheese producing company. However, the company could authorise the director to sell to the supermarket concerned, on condition that he did not abuse this ability and breach his duty of good faith. An ordinarily disallowed activity would be allowed, but would still be subject to the requirements of good faith.

The explicit fiduciary duties of the director set out in the 2006 Act are: the duty to act within powers[16]; the duty to exercise independent judgment[17]; the duty to avoid conflicts of interest[18]; the duty to declare interests in proposed transactions or arrangements[19]; and the duty not to accept benefits from third parties[20].

Section 171 requires that the director “(a) act in accordance with the company’s constitution, and (b) only exercise powers for the purpose for which they are conferred.” This is an area where the courts have been quite willing to excuse directors if they have used a power for a collateral purpose and a majority of shareholders have been in favour of it. For example, in the cases of Punt v Symonds & Co [1903] 2 Ch 506 and Piercy v S Mills & Co [1920] 1 Ch 77, the court allowed the issue of shares by directors to prevent a hostile takeover and to dilute the influence of hostile shareholders, because the majority of shareholders approved. This was despite the fact that the power had been granted solely to allow the raising of capital. However, in Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821 the Privy Council held that where there were two purposes for issuing shares, to raise capital and to prevent a takeover, the proper purpose of raising capital had to be the dominant purpose. In Re Looe Fish Ltd [1993] BCC 368 the directors were disqualified under section 8 of the Company Directors Disqualification Act 1986 for allotting shares for an improper purpose.

Section 173 requires the directors to exercise independent judgment. This is a restatement of the common law duty on directors not to ‘fetter their discretion’. This has acted to reduce the risk of directors being in a conflict of interest situation be disabling them from entering agreements which might prevent them from acting in the best interests of the company in the future. In Fulham Football Clun and Others v Cabra Estates Plc [1994] 1 BCLC 363 the company was paid money in exchange for not opposing property development plans. As the planning process drew out, the question arose of whether the directors had fettered their discretion by agreeing never to oppose such plans. However, the Court of Appeal stated that where a “contract as a whole [was] bona fide for the benefit of the company” it was valid and the directors could bind themselves to do whatever was required to fulfil it.

Section 175 prohibits directors from entering a position where his interests actually or potentially conflict with those of the company. If the constitution of the company permits, the directors can authorise a conflicting situation to be entered into, so long as the relevant director does not vote. Section 175 also requires the director to declare their interests in any contracts, and under section 170, this duty extends after the director has ceased to hold office. The declaration is made to the board. The potential complexity of such situations can be seen in Menier v Hooper’s Telegraph Works [1874] LR 9 Ch D 350 in which the James LJ held that a majority shareholder could not prejudice the interests of the company because of its own conflicting interests. Similarly, in Cook v Deeks [1916] 1 AC 554 the directors sought to conclude the final round of contracts in a large railway development programme in their own names. The court held this was clearly in breach of their duty. In Scottish Co-operative Wholesale Society Ltd v Meyer [1959] AC 324 the directors say on the boards of both a parent and subsidiary company, and as soon as it emerged that the interests of the two companies were conflicting, the directors could not longer remain in that position. As Lord Cranworth said in Aberdeen Railway Co v Blaikie Bros (1854) 1 Macq 461 (HL), “it is a rule of universal application that no one, having [fiduciary] duties to discharge, shall be allowed to enter into engagements in which he has or can have a personal interest conflicting or which possibly may conflict with the interests of those whom he is bound to protect.” One area that the courts have found difficulty with is when a director comes across a profitable opportunity as a result of his position as director. This situation arose in Regal (Hastings) Ltd v Gulliver [1942] 1 All ER 378 in which a cinema company sought to lease two other cinemas. A subsidiary was formed for the purpose, but the owners of the two cinemas would only agree to the lease if the authorised share capital was paid up. As the parent could not afford to do so, some directors personally purchased shares in the subsidiary. When it came time to sell the shares in the subsidiary, the company demanded that the directors account to the company for the profits they had made, and the House of Lords held that they were liable to do so. This was despite the fact that the company would have been unable to exploit the situation because of its own lack of funds. The same principle was applied in Industrial Developments v Cooley [1972] 1 WLR 443 in which a director learned information which would have been profitable to the company and kept it to himself. He then used the information to secure a position at a rival firm and left his present company. His present company could not have secured this position itself and so could not have benefited in the manner in which the director had. Nevertheless, the court found that the director had to account to the company for the profit he had made as a result of information gleaned in the course of his directorship. Gencor ACP Ltd v Dalby [2000] 2 BCLC 734 affirmed that it is no defence that the company would not have exploited the opportunity, although the shareholders can approve of the action and this would justify the director.

As a result of the case law and the wording of the relevant provisions of the 2006 Act, it can be concluded that a director is disallowed from entering a position where one of his person

Bill Carlson