The duties owed by directors to their respective companies have now been codified by the new Companies Act, which received Royal Assent on 8 November 2006 (the “Act”). Although the part of the Act that deals with directors’ duties has not yet come into force (and no date has been announced, except that the Government’s intention is for the whole Act to be in force by October 2008 at the latest), all directors and companies should ready themselves for the new regime.

What does ‘codification’ mean and why was it necessary?

Historically the general duties that directors owed to their companies were laid down in a haphazard way: in various common law rules and equitable principles that had been developed by the courts over many years. Although it was well known what the basic obligations were (that directors owed fiduciary duties to act in good faith and honestly, as well as a separate duty to act with reasonable skill and care) to say what the precise obligations were in a specific factual scenario could require a detailed analysis of case-law.

Ultimately, Parliament considered that it was not fair to expect directors and companies to have to trawl through years of case reports simply to understand the nature and extent of their legal obligations. Also, if legal duties were left to the courts to develop that created uncertainty for directors as to whether they might face personal liability for acts that had not yet been considered by a court.

So, in order to bring a degree of certainty and consistency to the law on directors’ duties Parliament decided to codify the duties, by setting out in the Act the duties that are owed. When this part of the Act (Part 10) comes in to force, it will ‘replace’ the old common law and equitable rules regime, although the past will not be completely forgotten as the old case-law will still be relevant in interpreting the meaning of the new codified duties.

What does the Act say about Directors’ Duties?

The Act lists seven duties that directors owe to companies.  Under the Act, directors must:

1.       Act within the powers conferred by the company’s constitution and for the purpose conferred

This restates the current law.

2.       Promote the success of the company for the benefit of its members as a whole

This has been a very contentious section of the Act as it requires directors to have regard to several wide-ranging factors when making any decision. The factors include:

a.       the long term consequences of the decision;

b.       the interests of the company’s employees;

c.       the need to foster business relationships with third parties;

d.       the impact on the community and the environment; and

e.       the need to act fairly as between members.

However, there is no guidance as to how directors should weigh each factor or what they should do in the event of a conflict.

3.       Exercise independent judgement

This mirrors existing law and prohibits directors from making decisions that might bind them (or their successors) in the future.

4.       Exercise reasonable care, skill and diligence

This follows the existing law and sets out a two-pronged test. First, a director is expected to have the general knowledge, skill and experience of a person carrying out the same functions as that director. And, second, the director is required to use the actual knowledge, skill and experience which he has (which may hold him to a higher standard of care if the director is a trained professional or has other relevant knowledge, skills or experience).

5.       Avoid conflicts of interest

This will apply to direct or indirect conflicts or even to situations that ‘possibly may conflict’ with the interests of the company.

6.       Not accept benefits from third parties

This duty will apply to financial and non-financial benefits. Although benefits that cannot reasonably be regarded as giving rise to a conflict of interests will be permitted, as will benefits that have been authorised by the members of the company.

7.       Declare any interest in a proposed transaction or arrangement

This extends the current law as it requires directors to declare the nature and extent of any direct or indirect interest. It also covers the interests of a director’s spouse or children.

What happens if these duties are breached?

If directors do not act in accordance with these duties the company can sue them to recover compensation for any loss it has suffered or to require the wayward director to account to the company for any profit he has made. There are also provisions in the Act for members to bring a ‘derivative claim’ against a director in special circumstances, if the company refuses to act against the director.

With directors being increasingly held accountable for their decisions, it pays to ensure that proper controls are in place to ensure compliance with these duties, that there is a satisfactory directors’ and officers’ insurance policy in place and that prompt action is taken in the event of a breach of duty.

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