Learning Focus
Demonstrate thorough knowledge of the legal principles underpinning business organisations;
Demonstrate critical awareness of the broader economic, political and economic implications of business organisations;
Locate and handle appropriate legal and non-legal materials;
Carry out research in the field of the law relating to business organisations;
Conduct effective research, including the use of legal information retrieval systems, to locate and collate information about the law applicable in a given situation;
Demonstrate an ability to analyse and present materials.
Week 4: Directors’ roles and responsibilities (part 1)
Learning objectives for Week 4:
This week you will learn about the following topics:
The statutory statement of directors duties: duties are owed to the company
Duty to act within constitution and powers
Duty to promote the success of the company
Duty to exercise independent judgment
Duty to exercise care, skill, and diligence
This week concentrates on the scope and nature of directors’ duties and particularly how these have been dealt with in the Companies Act 2006.
For the first time in any of the Companies Acts, the Companies Act 2006 included a statutory statement of directors’ general duties—at Part 10 Chapter 2.
This week focuses on four of the duties noted in the statutory statement and next weeks’ review focuses on the remaining three duties.
Background Info / Research / References / Reading
Textbook reading (Hannigan, Chapter 8) – Company Law – 4th Ed
This week concentrates on the scope and nature of directors’ duties and particularly how these have been dealt with in the Companies Act 2006. The courts developed director’s general duties in a piecemeal fashion over time.
For the first time in any of the Companies Acts, the CA 2006 included a statutory statement of directors’ general duties—at Part 10 Chapter 2 of the Act. The codification of the director’s duties represents one of the most significant changes brought about by the legislation. The inclusion of this statement was recommended for three main reasons:
On grounds of clarity and accessibility;
To enable the law to be updated to reflect modern business practices, especially on conflicts of interest; and
To address what the Company Law Review (CLR) called the ‘scope’ issue, that is, in whose interest company law should run.
The CLR intended a full codification of director’s duties replacing the corresponding equitable and common law rules, and at s 170(3) of the CA 2006 there is an express statement that the provisions of the statutory statement apply “in place of” the old (common law and equitable) rules. But there is now “an uncertain relationship between the statutory statement and the pre-existing law on directors’ duties” (Hannigan page 178) due to the rewording of some of the duties, and/or because of the ways in which they inter-relate.
The Statutory statement of directors duties is contained under Section 171-177 and includes:
Section 171 Duty to act within powers
Section 172 Duty to promote the success of the company
Section 173 Duty to exercise independent judgment
Section 174 Duty to exercise reasonable care, skill and diligence
Section 175 Duty to avoid conflicts of interest
Section 176 Duty not to accept benefits from third parties
Section 177 Duty to declare interest in proposed transaction or arrangement
This week you will focus on the first four of the duties noted in the statutory statement (Section 171-174). These duties are commonly referred to as the general management. The review next week focuses on the remaining three duties referred to as the director’s self-interest duties (Section 175-177).
Other than the duty to exercise reasonable care, skill and diligence (s 174, which reflects the common law of negligence) all the duties are fiduciary duties, which has implications for remedies if they are breached.
The statutory statement of general duties is not exhaustive—other specific duties are imposed on directors by other provisions of the Companies Act 2006 itself, and by other Acts (such as employment law and health and safety legislation).
The statement of “general duties” (above) is followed by four “supplementary provisions”:
178 Civil consequences of breach of general duties
179 Cases within more than one of the general duties
180 Consent, approval or authorisation by members
181 Modification of provisions in relation to charitable companies
Hannigan on page 178 notes that the government of the day was unable to draft a satisfactory statutory codification of the myriad remedies available for breach of fiduciary duties, so instead Section178 provides that:
The consequences of breach (or threatened breach) of sections 171 to 177 are the same as would apply if the corresponding common law rule or equitable principle applied.
The duties in those sections (with the exception of section 174 (duty to exercise reasonable care, skill and diligence)) are, accordingly, enforceable in the same way as any other fiduciary duty owed to a company by its directors.
While in general this might resolve the problem of remedies, it remains to be seen what will happen in certain situations—read Hannigan page 178-179 on this topic.
The statutory statement of directors’ duties: duties are owed to the company
Textbook reading (Hannigan, Chapter 8)
The statutory statement of directors’ general duties is included in the Companies Act 2006 at Part 10 Chapter 2. Part 10 Chapter 2 begins (at s 170) with the “scope and nature of general duties”.
It has long been an accepted common law principle devised in the case of Percival v Wright that directors owe their duties to the company and not to shareholders (individually or collectively), nor to creditors. This principle is now reiterated in s 170 (1): “The general duties specified in sections 171 to 177 are owed by a director of a company to the company.” An application of the principle can be seen in the case of Peskin v Anderson . In this case, the Court of Appeal confirmed that the duty was owed to the company and special circumstances are required to justify the imposition of the directors fiduciary duty to particular shareholders.
Note however Hannigan’s discussion on page 180 of special circumstances in which a fiduciary duty might be found to have existed toward a particular shareholder because of the special relationship between them (e.g., within a family company).
Duty to act within constitution and powers
Textbook reading (Hannigan, Chapter 9)
The first of the general duties in the statutory statement is the duty to act within powers (Section 171). The equivalent obligation at common law was:
To act bona fide for a proper purpose; and
Not to act for any collateral (i.e., personal or sectional) purpose. Section 171 states that “a director must—-
act in accordance with the company’s constitution, and
only exercise powers for the purposes for which they are conferred.”
In Week 2 you looked at the division of power within a company between shareholders and directors and issues of authority—actual and apparent. These are again relevant issues this week. Directors may have their usual wide-ranging authority to bind the company curbed by the provisions of the constitution (and by some shareholder resolutions and agreements, but such limitations will not be effective against a third party acting in good faith in ignorance of those limitations. Section 40 (1) provides protection ‘in favour of a person dealing with a company in good faith, the power of the directors to bind the company, or authorize others to do so, is deemed to be free of any limitation under the company’s constitution’. Hannigan provides a good illustration of this on page 193.
Where the company becomes bound to honour an agreement with a third party in this way, ‘after the event’ redress can only be sought from the directors themselves— although any member may obtain an injunction to “restrain the doing of an act which is beyond the powers of the directors although no such proceeding may lie in respect of an act to be done in fulfillment of a legal obligation arising from a previous act of the company” (Companies Act 2006, Section 40(4)).
Third parties are also afforded protection by what is known as the ‘indoor management rule’—a common law rule which states that ‘outsiders’ (i.e., third parties) are not obliged to inquire into the internal proceedings of a company, but rather can assume that all acts of internal management have been properly carried out (except where the third party knows, or has been put on inquiry as to the failure to adhere to procedures). A third party may look to the common law rules established in Royal British Bank v Turquand . The common law rule here provides that persons dealing with a company are not under an obligation to inquire into the internal proceedings of the company and can assume that all the internal management activities have been properly carried out. Hannigan discusses this on page 200.
The duty to “only exercise powers for the purposes for which they were conferred” is a more positive statement of the old common law rule (usually construed as the duty not to act for an “improper purpose”). The onus of showing improper purpose lies on the Claimant. Section 171(b) is based on Re Smith & Fawcett . Greene MR in this case states that ‘Directors must exercise their discretion bona fide in what they consider, not what a court may consider is in the interest of the company, and not for any collateral purpose.’
The case of Howard Smith Ltd v Ampol Petroleum Ltd is the leading authority on the proper purpose duty. Lord Wilberforce’s in this case set out the following steps courts should take in determining whether there has been a breach of Section 171(b):
Ascertain on a fair view the nature of the power
Define the limits within which the power may be exercised
Examine the substantial purpose for which it was exercised and finally
Reach a conclusion whether that purpose was proper or not
Furthermore, Lord Wilberforce stresses that ‘the court is entitled to look at the situation objectively in order to estimate how critical or pressing or substantial…an alleged requirement may have been. If it finds that a particular requirement, though real, was not urgent, or critical at the relevant time, it may have reason to doubt or discount, the assertions of individuals that they acted solely in order to deal with it, particularly when the action they took was unusual or even extreme’.
It brings with it some measure of objectivity— although clarifying the purpose for which powers were exercised as well as that for which they were conferred can require a difficult analysis of the facts in any particular case. The statutory statement uses the plural ‘purposes’, accepting that any one action may be taken to achieve multiple ends. The common law has long recognised this, and required only that a proper purpose be a substantial reason for the action or inaction.
Where directors are found to have acted substantially for an improper purpose, the courts have quite clearly stated that, as a matter of agency law, the directors, as agents of the company, have no authority to act other than in a way that benefits the company, and if, in acting for an improper purpose, they take an action that does not benefit the company, they are acting outside their actual authority and the transaction is void against the principal. There is an obvious crossover here between
this duty and the next duty (to promote the success of the company), which has a somewhat more subjective test. The relevant case law addresses that crossover. See Chapter 9 of the Hannigan text for a detailed explanation of the duty contained under Section 171 of the Companies Act 2006 and applicable case law provisions.
Duty to promote the success of the company
Textbook reading (Hannigan, Chapter 10)
The second of the general duties in the statutory statement contained under Section 172 is the duty to promote the success of the company. Section provides that the directors of a company must act in the way that they consider, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole. This duty preserves the fiduciary duty to act in good faith in the best interest of the company (Re Smith and Fawcett). The equivalent obligation at common law was:
To act bona fide in what the director considers to be in the interests of the company (interpreted as meaning in the interests of the shareholders as a general body); including
Balancing the short-term interests of current shareholders against the long-term interests of future shareholders (defined primarily in terms of enhancing shareholder value); and including
Having regard to the interests of creditors where the company is insolvent or of doubtful solvency. In order to understand why creditors have been included with the ‘owners’ of the company in this circumstance, you need to think about whose equity (‘capital’) supports the company in these circumstances .
Section 172 states that “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, and in doing so have regard (amongst other matters) to —
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, and
the need to act fairly as between members of the company.”
As noted above, there is an interrelationship between the duty to act for a proper purpose and the duty to promote the success of the company. If promoting the success of the company is clearly defined at law as including having regard to such elements as the long-term view and impact on the community and the environment, then it would seem clear that such concerns are, at the very least, not an improper purpose (as some have suggested when acting on such concerns has a negative impact on short-term profits).
The duty to act in good faith (the English translation of bonafide) relates to the director’s state of mind at the time of the decision to act—and state of mind is a subjective thing. The question here is what the director honestly believed to be in the interests of the company at that time with the knowledge s/he had then, not whether that belief was well-founded or sensible. The courts will not act as a judge of good thinking or good management in this regard, although they may get closer to that when it comes to the duty to exercise reasonable care, skill and diligence (see below). The key difference is that the duty to act in good faith is a fiduciary duty, the breach of which is essentially an act of disloyalty, while a failure duty to exercise care, skill and diligence is an act of negligence. A philosopher might say that one is a failure of mind, and the other one of the heart or soul.
A subjective test is applied to this duty. The meaning of success within the Section is not clearly defined. There are a number of ways of defining the ‘success’ of a company, and it would be impossible that all would agree on one criterion. The CA 2006, in the wording of section 172 and its “having regard to” list, has explicitly, and somewhat controversially, expanded the scope of the duty to promote the success of the company. The Section is considered to enshrine the principle of ‘enlightened shareholder value’ into statutory form. In addition, a link is made with ensuring and promoting effective corporate governance within the company. For those groups of shareholders who wish to expand the duty even further, it is possible to include other matters for inclusion in the wording of the constitution (a likely event in the case of charitable companies). Hannigan reviews some of the philosophic as well as legal discussions that surrounded the development of the wording of this duty, see Chapter 10 of Hannigan for a detailed review of the duty to promote the success of the company.
In addition, there is a need to consider the interest of creditors under Section 172(3). The requirement to have regard to the interest of the company’s creditor is now a well-recognized component of a director’s duty. Section 172(3) states that the duty imposed by this section has effect subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interest of creditors of the company. Such circumstances being generally those required by other legislation, or other circumstances in which the company is insolvent or of doubtful solvency. However directors have a duty to “consider” the interests of creditors. As with all directors’ duties, this duty is owed to the company according to Section 170(1) and not owed directly to the creditors.
Duty to exercise independent judgment
Textbook reading (Hannigan, Chapter 11)
The third of the general duties in the statutory statement is the duty to exercise independent judgment (s 173). This reflects the long-standing common law obligation not to ‘fetter’ directors’ judgment or discretion in the exercise of their power. Thus a director must not enter into an agreement with other parties as to how they will exercise their discretion.
Section 173 (1) states that “a director must exercise independent judgment” and, at subsection (2), that “this duty is not infringed by his (sic) acting:
in accordance with an agreement duly entered into by the company that restricts the future exercise of discretion by its directors, or
in a way authorised by the company’s constitution.”
The first of these provisos reflects clear prior case law, while the second opens up the possibility that ‘nominee’ directors, when so authorised by the constitution, may be relieved of the fiduciary obligation to exercise independent judgment (i.e. they could be required to be influenced by the person whose nominee they are). How they are then to continue to fulfill their other duties, of which they have not been relieved by this statutory provision—such as the duty to act in the way s/he considers, in good faith, would be most likely to promote the success of the company—remains an uncomfortable (and as yet unanswered) question.
According to the case of Thorby v Golberg if when a contract is negotiated on behalf of the company, the directors bona fide thinks it is in the interest of the company as a whole that the transaction should be entered into and carried into effect they may bind themselves by the contract to do whatever is necessary to effectuate it. The duty protects the rights of the directors to enter into agreements on behalf of the company that may in future require the director to act in a particular way, provided this is carried out in good faith and in the interest of the company (Fulham Football Club Ltd v Cabra Estates Plc ).
Hannigan notes on page 256 of the text that the duty to exercise independent judgment is not infringed by a director acting in a way authorized by the company’s constitution. The model articles provide that subject to the articles, the director may delegate any of the power conferred on them under the articles. To the extent that the articles allow for delegation, and subject to the need to exercise a residual duty of supervision, directors can be relieved of the obligation to exercise independent judgment with respect of the delegated task.
Section 173(2)(b) is pertinent to nominee directors. It has always been the position that a nominee once appointed owes his duty to the company and the nominee is not able to and is not required to follow the instructions of the person nominating him. Lord Denning’s reasoning in the case of Boulting v ACTT helps illustrates the complexity of the situation, where he states ‘Take a nominee director, that is, a director of a company who is nominated by a large shareholder to represent his interests. There is nothing wrong in it. It is done every day. Nothing wrong, that is, so long as the director is left free to exercise his best judgment in the interests of the company which he serves. But if he is put upon terms that he is bound to act in the affairs of the company in accordance with the directions of his patron, it is beyond doubt unlawful’
The Section contemplates a director being able to avoid breach if the company’s constitution permits the director not to exercise independent judgment. The provision only applies to that duty and the nominee director remains subject to all the other general duties in particular his duty under Section 172 to act in the way in which he considers in good faith would be most likely to promote the success of the company. Hannigan on page 256 of the text suggests that a nominee director continues to have an uncomfortable role in terms of managing the conflicting demands of duties to the company and the expectations of his nominating shareholder. Thus the nominee director is in a precarious position legally as the situation is commercially unrealistic.
Duty to exercise reasonable care, skill and diligence
Textbook reading (Hannigan, Chapter 11)
The fourth of the general duties in the statutory statement is the duty to exercise reasonable care, skill and diligence (s 174). According to Section 174:
(1) A director of a company must exercise reasonable care, skill and diligence.
(2) This means the care, skill and diligence that would be exercised by a reasonably diligent 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.
The equivalent obligation at common law was not a fiduciary duty, but rather was governed by the normal common law rules as to liability for negligence (a claim for which will lie in tort and possibly also in contract if the director is also an employee). The duty seeks to ensure that directors carry out their functions sufficiently carefully and competently. Section 174 duty provides for an objective standard, which is raised by the actual knowledge, skill and experience of a particular director (this differs from the approach laid down in the case of Re Equitable Fire and Insurance Co Ltd [1925] Ch 207 which provides a subjective standard of care and skill).
The Standard adopted from more recent case law such as Norman v Theodore [1991] BCC 14 and Re D’Jan of London Ltd [1994] BClC 561 is largely based on the test used in Section 214(4) of the Insolvency Act (1986) which states (in relation to wrongful trading, but applied by the court beyond that context) that:
“[T]he facts which 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 that that director has.”
As stated earlier, the standard set by Section 174 of the Companies Act 2006 is an ‘objective standard’ which reflects the standard required of each individual director – that of the “reasonably diligent person with the general knowledge, skills and experience that the director has (Section 174(2)(b), emphasis added).” The particular standard will vary depending on the functions and responsibilities of the director and the company circumstances (Roberts v Forhlich [2011] EWHC 257). Consequently, it may be necessary to consider the exercise of the functions in the context of the company’s financial position and the care and skill required and the acts, which might justifiably be undertaken in a solvent company, might be uniquely different from what would be appropriate in relation to a company of doubtful solvency.
The standard set by Section 174 of the Companies Act 2006 is also an ‘objective minimum standard’ that of the “reasonably diligent person with the general knowledge, skills and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company (Section 174(2)(a), emphasis added).” The higher the general knowledge, skills and experience of the director, the higher the standard is set. Thus no director, no matter their paucity of knowledge, skills or experience, is excused from performing at this minimum level.
The difficult part is to ascertain what performance could reasonably be expected at each level, as this can require some second guessing of management approaches, which the courts are loath to do. However some fairly tough decisions have been reached in relation to this duty, such as that:
A reasonably diligent director will not sign blank cheques ; nor sign cheques for a large amount without making enquiries into what they were actually for ;
A reasonably diligent finance director will not allow one group of directors to make key decisions on financial matters without reference to the rest of the board ;
A reasonably diligent non-executive director, on the audit committee of a listed company, when alerted to the possibility of serious financial impropriety by a reliable source, will not simply take that word of the finance manager that no problem exists without making further enquiries ; and
A reasonably diligent director of a private, family run business will not just leave the management to his or her spouse .
A director cannot escape liability under this duty by arguing that he delegated his responsibility lawfully to another director or person. Hannigan provides a comprehensive coverage of delegation and residuary duty of supervision on page 250-254. The director must exercise his power of supervision adequately (Re Barings Plc No 5 [2000] 1 BCLC 523). Parker J in the Re Baring case stated that directors owe a duty to the company to inform himself about its affairs and to join with his co-directors in supervising and controlling them. According to Parker J:
‘Directors have, both collectively and individually, a continuing duty to acquire and maintain a sufficient knowledge and understanding of the company’s business to enable them properly to discharge their duties as directors.
Whilst directors are entitled (subject to the articles of association of the company) to delegate particular functions to those below them in the management chain, and to trust their competence and integrity to a reasonable extent, the exercise of the power of delegation does not absolve a director from the duty to supervise the discharge of the delegated functions.
No rule of universal application can be formulated as to the duty referred to in (ii) above. The extent of the duty, and the question whether it has been discharged, must depend on the facts of each particular case, including the director’s role in the management of the company”.
In summary
This week’s work has concentrated on the scope and nature of directors’ duties and particularly how these have been dealt with in the Companies Act 2006. You were introduced to the seven duties contained under Section 171-177. In particular, the aim of this weeks review was to discuss the four general management duties of directors contained in the statutory statement namely the duties to act within power, to promote the success of the company and exercise reasonable care, skill and diligence. Applicable case law provisions were discussed in order to show the relationship between the common law and statutory provisions. Ensure you are familiar with these cases and others discussed by Hannigan in ensuring comprehensive understanding.
Next week you will go on to explore directors’ roles and responsibilities (part 2) which will focus on the last three of the ‘general duties’ listed in the statutory statement namely the self-interest duties of the director (duty to avoid conflict of interest and the duty not to accept benefit from third parties and the duty to disclose interest in proposed transactions or arrangements.
