Ashfords Solicitors - Duties and Responsibilities of Directors of Private Companies

DUTIES OF COMPANY DIRECTORS

The Companies Act 2006 codifies 7 duties for directors. These will come into force on 1 st October 2007 apart from those that are marked 1 st October 2008, which will come into force on that date. In the meantime, the common law rules will remain applicable, which impose duties that have a very similar effect.

Companies may provide more onerous duties in their articles but the articles may not dilute the duties except to the extent expressly allowed by the 2006 Act.

Duty to Act within Powers (S.171 CA2006)

On 7 November 2007, it was announced by Mr Stephen Timms, Minister for Competitiveness, that upgrades required to Companies House systems necessitate that some of the provisions of the 2006 Act due to be implemented in October 2008 will now be delayed until October 2009. It has not been confirmed if the directors' duties sections, 175 to 177 which are due to come into force in October 2008 will also be delayed. A further announcement to be made in early December 2007 will confirm which provisions are to be delayed. Any possible delay will not effect the directors' duties, sections 171 to 174 which came into force on 1 October 2007.

A director must act in accordance with the company's constitution (i.e. the articles and any decisions taken in accordance with them) and must only exercise his powers for their proper purpose. It is therefore important to regularly consult the company's articles of association to ensure the directors are acting within the extent of their powers.

Duty to Promote the Success of the Company (S.172 CA 2006)

A director 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. If the company's purposes include purposes other than for the benefit of its members (for example, charitable companies), the director must act in the way he considers, in good faith, would be most likely to achieve these purposes.

In fulfilling this duty, a director must have regard to the principle of "enlightened shareholder value" which includes the following factors:

the likely consequences of any decision in the long term;
the interests of the company's employees;
the need to foster the company's business relationships with suppliers, customers and others;
the impact of the company's operations on the community and the environment;
the desirability of the company maintaining a reputation for high standards of business conduct;
the need to act fairly as between the members of the company.

The list of factors is not exhaustive and the director is subject to the over-riding duty to exercise reasonable care, skill and diligence and to any enactment or rule of law requiring directors in certain circumstances to consider or act in the interests of the creditors of the company (for example, where the company is insolvent or threatened by insolvency)

The duty to promote the success of the company broadly replaces the existing fiduciary duty to act in the company's best interests. However, the meaning of "success for the benefit of the company's members as a whole means" is unclear. The government has stated that "success" in this context will usually mean "long-term increase in value" for commercial companies. The government has also said that the decision as to what will promote the success of the company, and what constitutes such success, is one for the director's good faith judgment. The government's view is that this ensures that business decisions on, for example, strategy and tactics, are for the directors, and not subject to decision by the courts, subject to good faith.

Consideration of the above should not require boards to keep records of the thought processes influencing their decisions. Accordingly, it should be sufficient for board minutes to state that the directors, having regard to their duty to promote the success of the company, have considered the six factors (as well as any other relevant factors) in coming to their decisions. In most cases, there would be no need to formally minute discussion of any of the factors unless any one factor was particularly relevant to a decision.

Duty to Exercise Independent Judgement (S.173 CA2006)

A director must exercise independent judgement without the subordination of their powers to the will of others. This duty is not however infringed by a director acting in accordance with an agreement entered into by the company that restricts the future exercise of the directors' discretion or in a way authorised by the company's constitution. The duty does not prevent a director from exercising a power to delegate conferred by the company's constitution, provided that its exercise is in accordance with the company's constitution.

Duty to Exercise Reasonable Care, Skill and Diligence (S.174 CA2006)

A director must exercise the care, skill and diligence which would be exercised by a reasonably diligent person with both the general knowledge, skill and experience that may be reasonably expected of a person carrying out the functions carried out by the director in relation to the company and the general knowledge, skill and experience that the director actually has. In applying the test regard must be had to the functions of the particular director, including his specific responsibilities and the circumstances of the company. Section 178 makes clear that this statutory duty is not a fiduciary duty.

Duty to Avoid Conflicts of Interest(S.175 CA2006) (1 October 2008)

A director must 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, whether or not the company could take advantage of it.

This duty does not apply to a conflict of interest arising in relation to a transaction or arrangement with the company which are dealt with separately. The duty is not infringed if :

the situation cannot reasonably be regarded as likely to give rise to a conflict of interest, or
the matter is authorised by the directors. The authorisation may be given in a private company where the constitution does not invalidate the authorisation, or in a public company, where the constitution specifically allows the directors to authorise the matter being proposed. Board authorisation is only effective if the required quorum is met without counting the director in question or any other interested director and if the conflicted directors have not participated in the taking of the decision or if the decision would have been valid without the participation of the conflicted directors. Board authorisation is not allowed in respect of acceptance of benefits from third parties.

Duty Not to Accept Benefits from Third Parties(S.176 CA2006) (1 October 2008)

Directors must not accept any benefit (including a bribe) from a third party which is conferred because of his being a director or his doing or not doing anything as a director. This duty is not infringed if the acceptance of the benefit cannot reasonably be regarded as likely to give rise to a conflict of interest. This duty has been categorised separately from the general duty to avoid conflicts of interest (see above) so that a director obtaining a benefit from a third party can only be authorised by the members of the company, rather than by the board.

Duty to Declare Interest in Proposed Transaction or Arrangement with the Company(S.177 CA2006)(1 st October 2008)

Directors must declare to the other directors the nature and extent of any interest, direct or indirect in a proposed transaction or arrangement with the company. The director need not be a party to the transaction for the duty to apply. An interest of another person in a contract with the company may require the director to make a disclosure under this duty, if the other person's interest amounts to a direct or indirect interest on the part of the director.

Such declarations must be made before the company enters into the transaction or arrangement. The declaration may be made at a board meeting or by way of notice in writing relating to a specific transaction or by a general notice. No declaration is required where the director is not aware of his interest or where the director is not aware of the transaction or arrangement in question - for these purposes directors are treated as being aware of matters of which they ought reasonably to be aware. Further, a director need not make a declaration of interest if

his interest cannot reasonably be regarded as likely to give rise to a conflict of interest; or
the other directors are already aware of it; or
it concerns the terms of his service contract.

The DTI suggests that as the duty requires disclosure to be made to other directors, no disclosure is required where the company has only one director.

Where the duty to avoid conflicts of interest or the duty to declare an interest in a proposed transaction or arrangement is complied with by authorisation by or disclosure to the directors, the transaction or arrangement is not liable to be set aside by any common law rule or equitable principle requiring the consent or approval of the shareholders unless there is a specific enactment, or provision of the company's constitution, requiring such consent or approval. The transactions can still be approved by the members.

All other applicable duties continue to apply and compliance with the general duties does not remove the need for approval of certain transactions with a director, which are set out below.

More than one of the general duties may apply in any given case and, if so, the directors must comply with each applicable duty. For example, the duty to promote the success of the company will not authorise the director to breach his duty to act within his powers, even if he considers that it would be most likely to promote the success of the company. As well as complying with all the duties, the directors must continue to comply with all other applicable laws. The duties do not require or authorise a director to breach any other prohibition or requirement imposed on him by law.

STATUTORY DUTIES

The general duties identified above are augmented by a range of specific duties imposed by statute. Some of these duties are imposed not on the directors in their own right, but on the company. However, since the directors are responsible for the performance of the statutory duties imposed on the company, it is the directors who must ensure that the company does everything that is required of it. Consequently a vast range and number of managerial duties are indirectly imposed on directors. The following requirements are worthy of particular note:

Acquisitions by and Disposals to Directors

A director who wishes to acquire assets from or transfer assets to the company which exceed a certain value must have that contract or arrangement approved by the members of the company in general meeting. Otherwise the director can be compelled to make restitution to the company, or, if this is no longer possible, pay damages.

Share Dealings

A director must, within five days of his appointment, notify the company in writing of his interests in shares and debentures of the company and other companies in its group. Any subsequent change in these interests must also be notified within five days of the change.

Disclosure

A register of directors and secretaries must be maintained by every company. Any change in the details contained in the register must be notified to the Registrar of Companies within 14 days. In addition the directors are required to make certain documents available for inspection by the members including:

register of members;
minutes of general meetings;
register of directors and secretaries; and
directors' service contracts.

Annual Return

Every company must file with the Registrar of Companies an annual return signed by a director or the secretary. The return must be completed within a prescribed period and must be in a prescribed form.

Loans and Financial Accommodation

The Companies Act 2006 introduces new provisions with respect to loans to directors. The general prohibition on loans to directors has been replaced with an ability to make loans to directors subject to shareholder approval. Shareholders must be provided with a written memorandum setting out the nature of the loan, the amount and the extend of the company's liability before they give their approval by way of ordinary resolution.

The criminal sanctions associated with the breach of the loan provisions have in addition been abolished.

Accounting Responsibilities

The directors must prepare annual accounts for the company's financial year and ensure that they are delivered to the Registrar of Companies within a prescribed period.

General Meetings

An annual general meeting ("AGM") must be held in each calendar year within 15 months of the last one. The duty to call an AGM lies with the directors and failure to do so leaves the company and every officer responsible liable to a fine.

An extraordinary general meeting ("EGM") is any general meeting other than the AGM. The directors are usually empowered to call an EGM for any reason and must do so on the requisition of the members.

Board Meetings

Apart from the requirement to keep minutes, there are no statutory rules in relation to the calling and conduct of board meetings. In practice, large companies tend to retain a degree of formality while small private companies often dispense with formal meetings almost entirely.

Financial Difficulties

Fraudulent trading

If, in the course of the winding up of a company, it appears that any business of the company has been carried on with the intent to defraud creditors or for any fraudulent purpose, the liquidator can apply to the court to declare that anyone (whether or not a director) who was knowingly a party to carrying on the business in such a manner be liable to make a contribution to the company's assets.

Wrongful trading

If a director knew or ought to have concluded that there was no reasonable prospect that the company would avoid an insolvent liquidation but nevertheless allowed it to continue to trade, the court can make an order that the director should contribute to its assets.

The court will not make an order for wrongful trading if, knowing there was no reasonable prospect that the company would avoid going into insolvent liquidation, the director took every step with a view to minimising the potential loss to the company's creditors as he ought to have taken.

The test is both subjective and objective, the facts that a director of a company ought to know or ascertain, the conclusions which he ought to reach and the steps which he ought to take are those which would be known or ascertained, or reached or taken, by a reasonably diligent person having both the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by that director in relation to the company, and the general knowledge, skill and experience which that director in fact possess. Dishonesty is not required and accordingly there is a lower burden of proof than that required to prove fraudulent trading. It is therefore considerably easier for a liquidator to obtain an order in respect of wrongful trading than in respect of fraudulent trading.

Criminal Liabilities

There are a number of statutes which create potential liability for directors through offences committed by the company. A number of statutory provisions, for example, the Trade Descriptions Act 1968 and the Financial Services Act 1986 state that, where an offence has been committed by a company, with the consent or connivance of, or attributable to the neglect of, a director, such director may also be guilty of the offence. There are also a number of statutes which impose direct criminal liability, for example, the Health and Safety at Work Act 1974 which provides that a director may be charged with an offence if he has consented to a breach by the company of its duties to ensure, so far as reasonably practical, the health, safety and welfare at work of the company's employees, etc.

Tortious Liabilities

If a tort or civil wrong is committed by a company, a director is not liable for it merely because of the fact of his directorship. A personal liability can arise but only where the director has authorised, directed and procured the commission of the tort although the director need not have known that the act were in fact a tort. A director will rarely be liable where he has confined himself to exercising his constitutional functions as a director e.g. by voting at board meetings.

TO WHOM ARE THE DUTIES OWED

Directors are responsible to the company, not to the present members as individuals. This responsibility extends to the interests of both present and future members of the company as a whole. Courts tend, therefore, only to interfere with the directors' decision if there is evidence that:

they acted in bad faith intending to prejudice the interests of some of the shareholders; or
taking all the alternatives into account, no sensible board of directors could reasonably have come to the decision which the directors reached.

Statute supplements the common law to provide additional protection for minority shareholders. Statute determines that any member of a company may apply to the court for relief on the ground that the company's affairs are being or have been conducted in a manner unfairly prejudicial to the interests of one or more members (including himself), or that any actual or proposed act or omission of the company (including an act or omission on its behalf) is or would be prejudicial.

There are two elements to the requirement of unfair prejudice, and both must be present to succeed in a claim. These are that:

the conduct must be prejudicial in the sense of causing prejudice or harm to the relevant interest of the members or some part of the members of the company (i.e. the shareholders), and
it must be unfair

The test as to what amounts to unfair prejudice is objective. It is not necessary for the petitioning shareholder to show that anybody acted in bad faith or with the intention of causing prejudice. The courts will regard the prejudice as unfair if a hypothetical reasonable bystander would believe it to be unfair.

Common examples (although by all means not exhaustive list) of conduct what may amount to unfairly prejudicial conduct are:

exclusion from management in circumstances where there is a (legitimate) expectation of participation;
the diversion of business to another company in which the majority shareholder holds an interest;
the awarding by the majority shareholder to himself of excessive financial benefits; and
abuses of power and breaches of the company's articles.

If a court considers that there has been unfair prejudice it has a general power to make any order it sees fit. In the majority of cases, however the court will order the purchase of the minority shares but ultimately has power to wind up the company.

Furthermore, shareholders will be able to bring an action in the name of the company against a director in respect of any act or omission by a director amounting to negligence, breach of duty (including the duty to promote the success of the company) or breach of trust.

Directors of holding companies should remember that their principal duty is owed to the company of which they are a director, and in the case of a subsidiary it means that it is owed to that subsidiary. If the individual concerned is a director or employee of the holding company as well as of the subsidiary, this means that he owes a similar duty to two principals.

POWERS OF DIRECTORS

Power to Bind the Company

If a director deals with a third party and the third party acts in good faith, the power of the director to bind the company is unlimited. Therefore, to all intents and purposes, the directors have the power to enter into contracts and agreements with third parties and the company will be bound by those contracts, even though the director in question may be acting outside the scope of his authority. If a director does act outside the scope of his authority, he will be in breach of the duty to act within his powers answerable to the company for those actions.

Limitations on Directors' Powers

Even though directors are not limited in their dealings with the outside world, their powers can be limited by the constitution of the company. As stated above, these limitations will not affect third parties acting in good faith but may make the director responsible to the company for his actions.

Directors of Listed Companies

Directors of companies whose shares are listed on the Stock Exchange or AIM will have their duties imposed by the rules governing their listing and will also be required to comply with additional corporate governance rules. A description of these is beyond the scope of this note.

DERIVATIVE CLAIMS (S.260-264 CA2006)

The Companies Act 2006 introduces a new procedure to enable a shareholder to bring derivative actions against directors. The range of circumstances in with a shareholder may bring a claim has been extended and includes an action in respect of any act or omission by a director amounting to negligence, default, breach of duty. This includes the new duty to promote the company's success and a breach of trust. Any damages recoverable due to a successful action will however be awarded to the company and not to the shareholder personally.

The procedure for bringing an action is two-stage. Once a derivative claim has been made, the shareholder claimant must apply to court for permission to continue the action. The court will require the shareholder to show that it has a case based on the evidence alone produced by the shareholder. If the shareholder is unable to establish evidence of its claim, the court must dismiss the action, although claims are unlikely to fail due to limited evidence alone. Assuming sufficient evidence has been established the court then has the discretion to allow the action to continue. In exercising its discretion the court will consider amongst other things whether

the shareholder is acting in good faith in continuing the action;
a (hypothetical) director acting to promote the success of the company would continue the action.
whether the action or omission giving rise to the action is likely to be authorised or ratified and the views of (any) shareholders with no personal interest in the action.

Notable exercising its discretion will involve the court in a mixture of commercial and legal factors and is the sort of judgment the courts are typically reluctant to make.

There is concern that with shareholder activism generally on the rise, that the new law for derivative actions will encourage shareholders to test the boundaries of the new provisions through increased tactical litigation against directors.. It will be necessary to wait until the first derivative claims under CA 2006 come before the courts, and to see what approach the courts adopt and the extent to which we will see US-style class actions against directors, before a proper assessment of the impact of the reforms can be made.

Directors should now however be considering how the costs of defending a derivative action. There is a possibility that existing liability insurance policies will be insufficient to deal with the new legislation. In all instances directors are advised to consider this point with their insurance brokers.

Ashfords is regulated by the Solicitors Regulation Authority. The information in this article is intended to be general information about English law only and not comprehensive. It is not to be relied on as legal advice nor as an alternative to taking professional advice relating to specific circumstances.

9th November 2007

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Duties and Responsibilities of Directors of Private Companies

Introduction