Companies act 2006: the impact on directors - update

July 2007

Directors’ duties

A new statutory statement of directors’ general duties

A statutory statement of directors’ general duties will largely replace the existing duties found in common law rules and equitable principles which have been built up over the years in case law. These establish that directors are subject to fiduciary duties of good faith and honesty, as well as separate duties of care and skill. Directors are also subject to various statutory duties contained principally in the CA and the Insolvency Act 1986 (IA) as well as in numerous other statutes which impose duties on directors in such areas as environmental hazards, health and safety, and competition law. A quoted company director is subject to yet more duties imposed by the Listing Rules and the new Disclosure and Transparency Rules. The new statutory statement does not replace these specific duties although the Act does restate and, in some instances, amend the specific duties set out in the CA. The general duties found in case law overlap with the existing statutory duties. Having duties set out in case law makes it difficult for those who become directors to understand their legal obligations.

In order to overcome the inaccessibility of the current case law, the Act sets out a statutory statement of seven general duties with which directors must comply. These are explained below. The duties are cumulative obligations: directors must comply with each one that applies to a particular case. They must also continue to comply with all other applicable laws. Four of the seven general duties come into force on 1 October 2007, and the remaining three new general duties will come into force on 1 October 2008. The general duties coming into effect on 1 October 2008 relate to directors’ conflicts of interest and their delayed implementation is to allow companies time to change their articles of association to deal with the changes to the conflicts duties made by the Act.

1. Duty to act within the company’s powers – from 1 October 2007

   “A director must act in accordance with the company’s constitution and only exercise powers for the purposes for which they are conferred.”

   This codifies the current common law position that directors should exercise their powers in accordance with the terms on which they were granted and for a proper purpose. Proper purpose is to be judged in the specific context under consideration. The company’s constitution for these purposes means its articles of association but extends to decisions taken in accordance with the articles and other decisions taken by members if they can be regarded as decisions of the company (for example, where the members informally, but unanimously, consent to an action).

2. Duty to promote the success of the company – from 1 October 2007

   “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, and in doing so have regard (amongst other matters) to –

   1. the likely consequences of any decision in the long term
   2. the interests of the company’s employees; (this replaces the existing s309 CA)
   3. the need to foster the company’s business relationships with suppliers, customers and others;
   4. the impact of the company’s operations on the community and the environment;
   5. the desirability of the company maintaining a reputation for high standards of business conduct; and
   6. the need to act fairly as between members of the company.”

   This is a new general duty which replaces the current common law duty on directors to act in good faith in the best interests of the company. The new duty requires directors to promote the success of the company (a subjective test) and in doing so they must also consider the principle of “enlightened shareholder value” which is embodied in factors (a) to (f) listed above (an objective test). The new duty thus imports wider corporate social responsibility factors into the issues directors must consider when making decisions. The list of factors is not exhaustive: it merely highlights particular areas to which the directors must have regard. It is not clear how directors are expected to balance the different factors they are required to consider or what weight they should attach to them.

   It is also unclear what “success” for the benefit of the company’s members as a whole means. Currently, the law requires directors to act in good faith in the best interests of the company, judged in most cases by reference to the interests of current and future shareholders as a body, employees and, in certain circumstances, creditors. Lord Goldsmith, the Attorney-General, said that for commercial companies “success” would normally mean “long-term increase in value”. For other companies such as charities, it means “achievement of their objectives”. TheDTI's  (now the DBERR ) guidance notes on the Act (the “Guidance”) state that the decision as to what will promote the success of the company, and what constitutes such success, is for the directors’ good faith judgment. The Government’s view is that provided that the directors make a decision in good faith, and have exercised reasonable care, skill and diligence in reaching that decision, it should not be open to challenge in the courts. This would preserve the courts’ reluctance to overturn directors’ commercial decisions provided they have been made in good faith, commonly called the business judgment rule.

   The Act preserves the current legal position that the duty to act in the interests of members is subject to any law requiring directors to act in the interests of creditors (for example, where the company is insolvent or threatened by insolvency).

   Whilst it is clear that the DTI (now the DBERR) expects to see action, and not merely words, in the exercise of this new duty (the Guidance states that it will not be sufficient to pay “lip service” to the factors), the lack of clarity as to what is required brings with it uncertainty.

   In addition, there is some concern that the need to satisfy this new duty and to take account of the factors listed (as well as any other relevant factors) will lead to increased bureaucracy to demonstrate compliance with the new duty. This would mean, for instance, that there would be more box-ticking and longer, more detailed board minutes. Margaret Hodge (for the Government) has, however, made clear that the duty to consider the six factors does not require boards to keep further records of their decisions; instead it is reflective of existing best practice by companies and an attempt to establish a level playing field for all companies.

   To comply with this new duty, boards should ensure that they do the following:

   • ensure that all the directors have had their new duties explained to them. The Association of General Counsel and Company Secretaries of the FTSE 100 (GC100) published guidance on compliance with the codified directors’ duties on 1 February 2007. This provides best practice outline guidance to assist directors in complying with the new law. It includes recommendations on how to ensure directors are aware of their duties;
   • ensure that those responsible for preparing briefing papers for the board are aware of the new duty and the six factors to be considered; and
     
   • consider the six factors (together with any other relevant factors) when reaching a board decision.

   As emphasised by the GC100 in their guidance paper, the briefing papers circulated in advance of board meetings usually address all the issues that directors are likely to take into account in decision making and so form documentary support to the decision process.

3. Duty to exercise independent judgment – from 1 October 2007

   “A director must exercise independent judgment.”

   This duty mirrors the current law, which prohibits directors from fettering their future discretion unless they act in accordance with an agreement duly entered into by the company or as authorised by the company’s constitution. Questions have been raised as to whether this duty precludes a director from delegating his functions to committees of the board. The Guidance, however, indicates that delegation is permitted if provided for in the company’s articles of association. The Government has confirmed that the Act does not change the position of a nominee director. A nominee must exercise his judgment in the interests of the company, ignoring the interests and wishes of his appointor, unless the nominee is authorised to act in accordance with those interests and wishes by the company’s constitution. However, it should be noted that although a nominee may follow instructions, he must also comply with all of his other duties as a director.

4. Duty to exercise reasonable care, skill and diligence – from 1 October 2007

   “A director must exercise reasonable care, skill and diligence.

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

   1. 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
   2. the general knowledge, skill and experience that the director has.”

   The new clause closely follows the wording of the current duty imposed on a director in the context of wrongful trading under section 214 of the IA. In recent years the courts have said that the common law duty of reasonable skill and care mirrors the section 214 tests in imposing both an objective and a subjective test when considering whether a director has discharged this duty. A director will be required to meet the higher of these two tests.

   The objective test sets the minimum standard expected of any director and requires that a director exercise the care, skill and diligence that would be exercised by a reasonably diligent person with the general knowledge, skill and experience that may be expected of a person carrying out the functions of that director. The subjective test requires a director to carry out his functions with the general knowledge, skill and experience that the director in fact possesses.

   This dual test recognises the fact that not every director will have an equal knowledge and understanding of a company’s business. Consequently, the duty imposed will vary according to the functions of the particular director, including his specific responsibilities and the circumstances of the company, such as its size and business. In effect, the test will ensure that those directors with more experience, including non-executive directors, will be subject to a higher test by virtue of their particular knowledge, skill and experience.

5. Duty to avoid conflicts of interest – from 1 October 2008

   “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.”

   The Government intended to relax the current strict duty that directors must avoid situations in which their obligations to the company conflict with their own personal interests or their duties to third parties. This provision will, in due course, replace the current no conflicts’ duty rule. It covers transactions between a director and a third party, such as the exploitation of any property, information or opportunity available to the company. It would catch, for example, a director taking advantage of a contract which came to him as a result of his directorship of the company. Such a situation will be capable of being authorised by the non-conflicted directors (referred to as “independent directors”) on the board. The director who is conflicted will not be able to be counted in the quorum for the meeting or vote on the proposal (or if he does vote, a majority in favour must have been achieved without his vote). Board authorisation will be the default position for private companies but public companies will need to amend their articles to permit authorisation. If the whole board is conflicted, then the shareholders will be able to approve a transaction which involves a conflict.

   Nor will the new duty be breached if the situation cannot “reasonably be regarded as likely to give rise to a conflict of interest”. It may, however, be difficult to tell with certainty whether, for instance, a potential new directorship would satisfy this test. The duty is likely to cause most concern amongst directors holding multiple directorships. In response to concerns about whether the duty would affect existing multiple directorships, Lord Goldsmith, the Attorney-General, suggested that a director who obtains his board’s consent to another appointment will be entitled to assume that such consent authorises any subsequent conflict that arises in practice. Most commentators, however, disagree with this and suggest that directors would need to seek specific board authorisation of the conflict when it arises. This would put directors in an awkward position as it may be impossible to disclose a conflict that involves confidential information. Currently, directors manage such conflicts by absenting themselves from the meetings at which the matter is discussed. The Act does not permit a conflict to be managed in this way. Instead, in due course, directors who wish to take on a new directorship might be advised to take the following steps to ensure compliance with the law:

   • obtain specific board authorisation of the new directorship and ensure the board discusses what should happen if an actual conflict arises subsequently; and
   • if an actual conflict does later arise, the director should seek independent advice as to how to manage it, especially where it relates to confidential information.

   The duty will not apply if the conflict arises in relation to a transaction or arrangement with the company itself (a director will be able to simply declare his interest in such a transaction at a board meeting, he will not need this to be authorised by the members or the board – see 7 below).

   The Government’s stated intention was to relax the existing strict rules which prevent a director from having any interest that could potentially conflict with that of the company of which he is a director. The way in which the duty will be codified, however, seems to make the existing rules more onerous leading to concerns that the Act could dissuade directors from taking on multiple directorships and could, as a result, reduce the already limited number of people willing to act as non-executive directors.

6. Duty not to accept benefits from third parties – from 1 October 2008

   “A director must not accept a benefit from a third party conferred by reason of his being a director, or his doing (or not doing) anything as director.”

   “A “third party” means a person other than the company, an associated body corporate or a person acting on behalf of the company or an associated body corporate.”

   This duty is an aspect of the current rule preventing a director from exploiting his directorship for personal gain. It will catch non-financial benefits (for example, the appointment of a director to an honorary or non-remunerative position) as well as items with a monetary value (including bribes). It will also catch the appointment of a director of company A as a non-executive director of another company (company B) where the appointment is made because the director is a director of company A if the acceptance of the non-executive directorship could reasonably be regarded as likely to give rise to a conflict of interest. It will not, however, prohibit directors from accepting a benefit from a third party as a result of their directorship if its acceptance cannot reasonably be regarded as likely to give rise to a conflict of interest or if its acceptance has been authorised by the members (note that the board of directors cannot authorise a director to accept a benefit from a third party). Benefits conferred by the company, its holding company or its subsidiaries will be excluded. There is no de minimis threshold because what can reasonably be regarded as giving rise to a conflict of interest will vary depending on the size of the company and the circumstances of the director concerned. Clearly, what may influence a director of a small private company may be immaterial to a director of a much larger company.

   This prohibition will give rise to debate and some uncertainty over what benefits may be regarded as likely to give rise to a conflict. Many listed companies already have policies on accepting benefits from third parties. It will be advisable for companies without such policies to consider introducing a specific policy regarding acceptance and disclosure of third party benefits.

7. Duty to declare interest in proposed transaction or arrangement with the company – from 1 October 2008

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

   The second aspect of the existing duty to avoid conflicts is that transactions between the director and the company are prohibited unless authorised by the shareholders. This is separately stated in the Act as a duty to declare interests in transactions with the company. These will no longer require board or shareholder authorisation. Instead, the Act will simply require such transactions to have been declared to the board. A director will not need to be party to the transaction for the duty to apply so the duty will catch the interests of persons “connected” with the director. Note that the definition of connected persons in section 346 of the CA is being extended from 1 October 2007 to cover a director’s parents, children or step-children over 18, the director’s unmarried partner and infant children of the director’s unmarried partner as well as fellow directors.

   The codified duty will extend the present law in requiring a director to:

   • declare the nature and extent of his interest, and not simply that he has an interest;
   • disclose matters of which he should reasonably be aware; and
   • update a declaration which proves to be or becomes inaccurate or incomplete before the company enters into the transaction (although there is no materiality threshold given to assist in determining inaccuracy or incompleteness).

   
   A director will have to declare his interest before the company enters into the transaction whereas currently, under section 317 CA, he has to declare it at the board meeting at which entering the transaction is first considered. The declaration may (but need not) be made at a meeting of the directors or by notifying the other directors, either in writing or by making a general notification of interest at a prior directors’ meeting.

   There is concern that the requirement to disclose matters of which a director “ought reasonably to be aware” may make it more difficult to recruit non-executive directors, as it could be interpreted as requiring directors to keep themselves fully up to date with the company’s affairs. The Government’s view is that the clause does no more than codify the current law. Currently, directors need not disclose interests of which it is unreasonable to expect them to have knowledge. The Government suggests that the Act codifies this by requiring directors to disclose interests of which they should reasonably be aware. The codified duty will, however, require a change in the form of conflict of interest declarations made to the board.

   No declaration will be required if the director’s interest cannot reasonably be regarded as likely to give rise to a conflict of interest (this will replace the materiality test in article 85 of Table A), or if the other directors are already aware of the interest or should have been aware of it, or if it concerns the terms of his service contract which have been or are to be considered by the board. A sole director will not need to comply with this duty as it requires disclosure to the other directors. This is a change from the current duty of disclosure contained in section 317 CA which has been held by the courts to require such a declaration by a sole director.

   In response to concerns that the codified conflicts’ duties will prevent directors from having multiple directorships and would reduce the number of non-executive directors willing to serve as such, the Act provides that articles will continue to allow directors to have certain conflicts with the company without further authorisation. These provisions of the articles will, however, only be allowed to the extent that they were previously lawful. No guidance is given as to what would be considered “previously lawful”.

   Companies will need to ensure that, before 1 October 2008:

   • directors become familiar with the new conflicts rules;
   • directors notify their interests to the board as soon as they become aware of them and update a declaration which is inaccurate or incomplete; and
   • the new categories of persons connected with directors (i.e. the director’s parents, adult children and unmarried partner and their infant children) are notified of the disclosure obligations and agree to notify the director if their interest in the company changes, requiring disclosure by the director.

To whom will the general duties apply?

As under the current law, the general duties will apply to directors, shadow directors and, in certain cases, to former directors. Former directors will continue to be subject to the duty to avoid conflicts of interest with the company in relation to opportunities which arose when they were directors, and the duty not to accept benefits from third parties in respect of things done or omitted to be done during their directorships. The duties are the same whether the directors are executive or non-executive directors, although the test of reasonable skill, care and diligence will in practice impose a higher standard on executive directors.

To whom will the duties be owed?

Again, as under the current law, the Act states that the statutory duties will be owed to the company and it follows that, as now, only the company will be able to enforce them. They are not owed to individual shareholders, although members will be able to enforce duties owed to the company in accordance with the new statutory derivative action (see Extended right for shareholders to sue directors).

Consequences of breach of duty

The existing civil remedies for breach are retained but it is unclear how these will apply to the codified duties, most of which are not identical to the existing duties found in case law. In particular, the remedy which will be available for breach of the new duty to promote the success of the company, which has no corresponding provision in the current law, is unclear. Although the remedies for breach of duty have not been codified the Government has introduced a new statutory procedure making it easier for shareholders to sue directors for breach of duty and other wrongs (see Extended right for shareholders to sue directors).

Ratification of directors’ breaches

The Act partially codifies the current law on shareholder ratification of directors’ acts but with one significant change. Although shareholders will remain able, by passing an ordinary resolution, (as at present) to ratify a director’s conduct amounting to breach of duty, breach of trust, negligence or other default, the votes of the director and any member connected with him must be disregarded. In the case of a ratification vote being taken at a meeting, those members whose votes are to be disregarded can still attend, participate in and count towards the quorum for the meeting. A member connected with the director will include certain family members (the definition of connected persons in section 346 CA will be extended to cover a director’s parents, children or step-children over 18, the director’s unmarried partner and infant children of the director’s unmarried partner) as well as fellow directors. The common law principle that all the members of the company acting together can unanimously vote to ratify directors’ conduct is preserved.

Relationship between the new statutory directors’ duties and case law

The new statutory duties are based on certain common law rules and equitable principles, and will have effect in place of them. This removes the need for directors and their advisors to “distil” the duties from principles established in case law, much of which dates back to the nineteenth century. However, case law retains a role in interpreting and applying the new duties. The new duties are to be interpreted and applied in the same way as the existing common law rules and equitable principles. However, there are substantive differences between the statutory duties and the case law duties they seek to replace, for example, there is a new duty to promote the success of the company. These differences may make it challenging for the courts to interpret the new duties in the light of existing case law. The Act does not address this issue.

Directors will not be able to take the duties at face value but will also need to understand case law both now and as it develops in the future. In June 2007, the DTI (now the DBERR) published on its website a collection of statements on the statutory duties of directors made by Ministers in Parliament during the passage of the Act. These statements have been selected to assist people in understanding what the new statutory provisions mean. The accompanying Ministerial Statement from Margaret Hodge, Minister of State for Industry and the Regions, makes it clear that the Government believes that the statutory statement of directors' duties is "essentially the same as the existing duties established by case law", the only major exception being the new rules on dealing with conflicts of interest, and that those hard-working directors who already put the company's interests first, will not need to change their behaviour. It is unclear to what extent directors will be able to rely on these statements to show that they did not breach a duty. The GC100 guidance paper referred to above will, potentially, be more useful to directors as it does recommend how directors should fulfil their duty to promote the success of the company and what documents should be used to evidence compliance, especially in light of the new statutory derivative action which is described more fully below. Margaret Hodge, in her June Ministerial Statement, notes that directors’ duties are likely to continue to evolve as times change. Directors will continue to require legal advice on their duties and what actions are and are not permitted.

On balance, the new statutory statement serves a useful function in setting out in one place the general duties to which directors are subject. It will be especially useful for new directors and those from overseas. The usefulness of codification has to be weighed against the loss of certainty that comes from replacing established case law, at least in the short term. It will take some time before it becomes clear what all of the new duties will mean for directors in practice.

Next section: Extended right for shareholders to sue directors