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Companies Act 2006 and Directors Duties

October 11, 2011

This overview of the Companies Act 2006 and Directors Duties was first published in 2006, prior to the introduction of the Companies Act 2006.

Overview

Directors have powers to take majority business decisions on behalf of the companies. As such, it comes as no surprise that various duties are imposed on them to ensure that the companies’ interests are protected.

Under the current rules, directors’ duties including duty to act in good faith to the best interest of the companies; duty to avoid conflicts of interest; duty not to profit from their offices, and duty of care and skill are enshrined in the common law rules and equitable principles and also in statutes such as the Companies Act 1985 (the 1985 Act) as amended by Companies Act 1989.

The government considers that these principles while long established lack certainty and are not easily accessible. Very often, directors have to take advice in these areas so as to ensure that they do not inadvertently breach any duty enshrined in the case law.

The government therefore believes that codification of directors’ duties will make the law in these areas more consistent, certain and accessible. Companies Act 2006 (‘the Act’), which received Royal Assent on the 8th November 2006, codifies directors’ duties including the long-established fiduciary duties as well as the common law duty of care and skill into a statutory statement of seven general duties.

It is believed that codification could bring benefits of £30 million to £105 million per year (Data from the 2002 White Paper) as it is hoped that directors will no longer or less likely need to take advice on these areas.

Summarised below are the seven general duties set out in ss.170 to 181 of the Act with particular reference to the new additions introduced by the Act.

1. Duty to act within their powers.

This codifies the common law rules that directors should exercises their powers under the terms that were granted for a proper purpose. A director’s powers are normally derived from the company’s constitution, i.e. its memorandum and articles of association.

2. Duty to promote the success of the company

This duty is set out in section 172 of the Act. This is a new duty developed from one of the heads of the overriding principles of the fiduciary duties, i.e., duty of good faith to act in the company’s best interest.

The Act imposes a duty to act in the way a director considers, in good faith, would be most likely to promote the success of the company. Although this duty is still owned to the member as a whole, when exercising this duty the director is required to have regards to various non-exhaustive list of factors listed in s.172 (1) including the long term consequence of the decisions as well as the interests of the employees; the relationships with suppliers, customers; and the impact of the decision on community and environment; the desirability of maintaining a reputation for high standards of business conduct; and the need to act fairly as between members of the company.

It can be seen that among other things, this duty introduces wider corporate social responsibility into a director’s decision making process.

‘Success’ is not defined in the Act. The DTI’s guidance to the Bill suggests that a success in relation to a commercial company is considered to be its “long-term increases in value”.

It remains to be seen how in practice a director is to balance all these some times conflicting factors in his decisions, for example, an environmental consideration might not always consistent with shareholders’ interests.

However, it is suggested that a director will exercise the same level of care, skill and diligence as he carries out any other functions in deciding which factors he will take into consideration when making a decision subject to his overall responsibility to the success of the company. Inevitably, court will set out the ‘perimeters’ in the interpretation of this duty.

Giving the uncertainty in this area, it is important that detailed minutes are taken when exercising decisions to document the fact that directors have had regards to various factors listed in section 172.

3. Duty to exercise independent judgement

Section 173 of the Act imposes a positive duty on a director of a company to exercise independent judgement. There are presumably two elements to this section.

A director must first exercise a judgement and secondly he must exercise the judgement independently. Prima facie, this rule would impinge on so-called ‘sleeping directors’ who play no active role in the management and leave decisions to others. By analogy, this would impact on ‘shadow directors’.

Arguably, if a director is to exercise independent judgement, then there will be no scope for shadow directors. However, the government has confirmed in debate at the parliament that a director will not be in breach of this duty if he exercises his own judgment in deciding whether to follow someone else’s judgment on a matter.

In addition, this duty is not infringed upon if a director acts in accordance with an agreement that was duly entered into by the company. It remains to be seen how in practice this rule will impact on a director.

4. Duty to exercise reasonable care, skill and diligence

This duty is set out in s. 174(1). It codifies the common law rule of duty of care and skill. S. 174 (2) prescribes the degree of ‘care, skill and diligence’ expected from a director; that is: care, skill, diligence that would be exercised by a reasonably diligence 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

This is the same dual test imposed under s.214 of the Insolvency Act 1986 in the context of a director’s wrongful trading. The first element of the test sets out a minimum objective standard (a hypothetic reasonable person) expected of any director.

The subjective test requires a director to carry out his duty with the general knowledge, skill and diligence he in fact possess. Therefore, a director who has more experience, knowledge and skill will have a higher threshold in discharging this duty.

5. Duty to avoid conflicts of interest

The conflicts of interest provisions are previously contained in Part 10 of the Companies Act 1985 and are quite complex. The Act restates, amends, and simplifies these provisions to make them more accessible and with a view of assisting modern business practice.

Note that this duty applies to a transaction between a director and a third party, such as the exploration of any property, information, opportunity. In other words, the duty does not extend to a transaction between a director and his own company, in respect of which, different rule applies which requires a director to declare his interest to the other directors.

The Act makes it easier for directors to enter into transactions with third parties when directors’ interests conflict with company’s interests. Previously, shareholders’ approval is required to enable directors to enter into transactions with third parties. Now, such transactions can be authorised by the non-conflicted directors on the board provided that certain requirements as listed in s175 (5) (6) including who can participate and vote on such authorisation are complied with.

However, it is feared that this duty might impact on a director who holds multiple directorships and discourage a director to hold especially non-executive directorships. On the other hand, it should be noted that the saving provision, i.e., authorisation by non-conflicted directors on the board goes some way towards easing the concerns. Its practical implication remains to be seen.

6. Duty not to accept benefits from third parties

This reinstates the existing rule known as ‘non profit’ in that a director is not permitted to accept a benefit from a third party by reason of (a) his being a director or (b) his doing or not doing anything as a director.

Benefits cover both monetary and non monetary including for example, non executive directorship and even corporate entertainment. However, a director will not be in breach of this duty if the acceptance of such benefit cannot reasonably be regarded as likely to give rise to a conflict of interest. Nevertheless, because it is not always clear whether certain benefits will give rise to conflicts of interest, it is feared that directors might more likely to take advice on this area.

7. Duty to declare interest in proposed transaction or arrangement with the company

Section 177 of the Act reflects s.317 of the 1985 Act in that it requires a director to disclose his interest to the board of the company when a transaction is proposed between a director and his company. However, it goes further than the requirement of s.317 of the 1985 Act by requiring a director to declare the nature and the extent of the interest to the other directors. Further, disclosure must be made where a director is considered ‘ought reasonably to be aware of’ (s.177 (5)) the conflicting interest. Disclosure also extends to a person connected with the director, for example, his wife and children.

The requirement for disclosure is dispensed in circumstances where the interest cannot reasonably be regarded as likely to give rise to a conflict of interest or if other directors are already aware or ‘ought reasonably to be aware’ of the director’s interest.

As stated above, the statutory statement of general duties replaces the common law rules and equitable principles. This brings clarify and certainty to directors’ duties and will be of great benefits especially to new directors. However, the Act makes it clear that the statutory general duties are to be interpreted and applied in the same way as the existing common law rules and equitable principles. This somewhat weakens its effect. Further, it will be a challenge to the court to interpret the new duties using existing case law.

Although in the long term, it is believed that these changes will bring much benefits to companies; some critics argue in the short term that it may well create confusing and uncertainty in some areas, for example, the duty to promote company’s success. It has been suggested that this may well result in more claims been brought against directors in the short term as dissatisfied shareholders (especially in a hostile take over bid) armed with the new statutory right of ‘derivative actions’ would bring test cases.

The uncertainty can only be eased when the court sets out ‘perimeters’ in its interpretation of the duties. Meanwhile, the guidance which DTI promised to provide this year will no doubt be greatly welcomed.

In the light of this, we suggest that directors continuing to seek advice if unsure and in the meantime overhauling their decision making process and companies’ constitutions so as to minimise the risks of derivative claims and other potential legal challenges and also to take advantage of the benefits introduced by the Act when the Act are fully brought into force in October 2008.

If you need any advice on this area or any aspect of the Companies Act 2006, please contact commercial department, Chris Sykes, Senior Partner, or Peijun Xia, Commercial Solicitor (details below).

Please note that this area of the law is a complex subject and you should not take or refrain from taking any step without full legal advice on your particular circumstances. The content of this article is of a general nature and no liability is accepted in connection with it or if any reliance is placed on it.

Sykes Anderson LLP Solicitors
Bury House
31 Bury Street
London
EC2A 5JJ