Directors’ duties – Do your directors know what their codified obligations are?
The codification of directors’ duties is one of the more important and controversial areas of the Companies Act 2006 (“the Act”). All provisions of Part 10 are now in force and all directors are required to comply with the following duties:
- to act within their powers;
- to promote the success of the company;
- to exercise independent judgment;
- to exercise reasonable care, skill and diligence;
- to avoid conflicts;
- not to accept benefits from third parties; and
- to declare an interest in a proposed transaction or arrangement.
The duties are in addition to other duties which a director may owe by virtue of other provisions of the Act (for example, the duty to deliver accounts) or by virtue of the common law (such as the duty to consider creditors’ interests in times of threatened insolvency). The codified duties set a minimum threshold but companies are free to provide for more onerous duties in their articles.
Whilst the new rules aim to codify certain common law and equitable duties of directors, the common law and equitable principles remain relevant for the purpose of interpreting and applying the new duties.
The duties apply to all directors, including shadow directors (but only to the extent that common law and equitable duties previously applied) and former directors (but only in relation to the duty to avoid conflicts of interest (s.175) and the duty not to accept benefits from third parties (s.176)).
The most significant changes which have resulted from the codification are:
- the requirement for a director to have regard to a list of factors when exercising his duty to act in a way which is most likely to promote the success of the company;
- the ability of independent directors to authorise a director’s conflict of interest; and
- the changes to the derivative action regime.
The role of the checklist
Section 172 introduced the concept of “enlightened shareholder value”. This requires a director to act in the way which he considers would be most likely to promote the success of the company for the benefit of its members as a whole. In carrying out this duty, a director is required to have regard to a list of factors (such as the likely consequences of any decision in the long term and the need to act fairly as between the members of the company). However, the list is not exhaustive and it is also subject to any enactment of rule of law requiring directors in certain circumstances to consider the interests of the creditors of the company (for example, where the company is insolvent or threatened by insolvency).
There is no clear definition of what ‘success’ means but the government has stated that it will usually mean “long-term increase in value” for commercial companies. There is also no guidance regarding the weight to be given to each factor and how conflicts between the factors should be resolved. This means that it will be up to directors to exercise their good faith judgment to resolve any conflicts, as they have done previously.
In the context of litigation, it could be useful to evidence compliance with s.172 by producing records of discussions which show that the directors have taken the listed factors into account. There is, however, no strict requirement to evidence directors’ thought process in detail. As such, it should suffice to record that the listed factors have been taken into account and, if appropriate, to reference any significant discussion regarding a factor which was particularly relevant to the decision. However, a negative statement regarding each of the factors should not be necessary.
The power of the independent director
By virtue of section 175, a director has a duty to avoid situations in which he has or can have a direct or indirect interest that conflicts with or may conflict with the company’s interests. This applies, in particular, to the exploitation of property, information or opportunity. However, if the situation cannot reasonably be regarded as likely to give rise to a conflict of interest or if the matter is authorised by the directors, the duty will not be infringed.
In a private company, the directors’ authorisation may be given where the constitution does not invalidate the authorisation. In a public company, it can be given where the constitution specifically allows the directors to authorise the matter proposed. Where the duty is complied with by authorisation by or disclosure to the directors, the transaction is not liable to be set aside by any common law or equitable principle requiring the consent or approval of the shareholders. This is without prejudice to any enactment or provision in the company’s constitution requiring such approval.
This represents a change in the law as it allows directors to authorise a director’s conflict of interest. Compliance with the duty is not however necessary where chapter 4 of part 10 (transactions requiring approval of the members) applies and either approval is given or approval is not required.
The activist shareholder
The circumstances in which a derivative action may be brought by a shareholder of a company has been extended as a result of Part 11 the Act. For example, an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director of the company may give rise to a cause of action and an action for breach of duty will even be available where the director has not benefited personally from the transaction. It will also not be necessary for the shareholder to show that those directors who carried out the wrongdoing control the majority of the company’s shares.
Concern has been expressed that the changes could lead to an increase in tactical litigation by activist shareholders; however, to date, such concerns appear to be unfounded. In any event, any member wanting to bring a derivative claim will need to surmount the considerable procedural hurdles and show an arguable case before the court will grant permission to pursue the claim. In addition, there is the risk of costs being awarded against the applicant if the claim is shown to be unfounded. Nevertheless, it may be prudent to review directors’ and officers’ liability insurance policies to ensure that the defence of derivative claims is covered by the polices.
Johanne Westcott is a solicitor in Fox Williams’ Dispute Resolution department. Johanne can be contacted on 0207 614 2665 or JWestcott@foxwilliams.com.