Duties of a Director

CHAPTER 2

DIRECTORS’ DUTIES

Director’s duties is presently codified under part 10 of the Companies Act 2006.There is very little in terms of a formal requirement for who can be a director. Prior to the Companies Act 2006, there was no age limit on who could be a director. However, with the advent of the Companies Act of 2006 came a new age limit. The Act provides for the minimum age of 16years for any director [1] . The Act also made it compulsory to have at least one director that is a natural person [2] . It further provides that there must be at least one director for private companies [3] and at least two for public companies [4] .Section 250 of the Companies Act 2006 defines a director to include “any person occupying the position of a director, by whatever name called". The reason for this broad spectrum of definition of a director is to make provision for liability of de facto and shadow director.

A de facto director is a person who acts in the capacity of a director even though he has not been appointed as such for example an acting director. A shadow director on the other hand is one on whose directions or instructions, the directors are accustomed to act [5] . Though there are relatively few authorities, a shadow director is one who exercises, “real influence over the majority of board members" [6] although this does not have to extend to subservience. [7] It should also be stated that a company’s first directors are appointed by the subscribers to the memorandum.

Executive and Non- Executive directors (NED) are another category of directors. Non-executive and executive directors are held to have different responsibilities but from the perspective of the Companies Act 2006, all directors are equal. There is no difference in law between an executive director and a non-executive director. [8] Thus, the executive director and the non-executive both have an equal responsibility for the smooth running of the company. The duties of the director are examined below.

DUTIES OF A DIRECTOR

The scope of power of the directors of any company is found in the company’s constitution. However, various statutes control and prescribe the role and duties of a director. The duties of a director are regulated by the Companies Act 2006 [9] , the UK Corporate Governance Code 2010 [10] which applies to listed companies, Insolvency Act [11] , Draft Model Articles [12] and the Company Directors Disqualification Act [13] .

One of the main Principles of the Combined Code requires that every company “... be headed by an effective board which is collectively responsible for the long-term success of the company". [14] 

The Draft Model Articles for both Private Companies limited by shares and Public Companies reinforces this statement by stating the role of the board as

“...the management of the company’s business for which purpose they may exercise all the powers of the company" [15] 

The duty of directors which has its origin in the law of equity and the law of negligence are the fiduciary duty to act in good faith and the duty of skill and care respectively. These duties can be traced back to the historical development of the duties of a director where the director was regarded as agents of the shareholders who are the owners of the company. The shareholders were busy to run the company and the directors were employed to run the business in such as a way as to maximise profits for the shareholders. Nevertheless, common law and statues modified these duties over time [16] . The duty owed by the directors is not owed to an individual shareholder but all the shareholders as a whole [17] . However, if a director by his conducts or expressly holds out himself as an agent to any of the shareholders, then an agency relationship is said to exist between the director and that shareholder [18] . In Peskin v Anderson [19] , Mummer L J differentiated the duty the director owed to the company from the duty owed to shareholders when he stated that there has to be “a special factual relationship between the directors and the shareholders in the particular case" [20] .

Another form of relationship that could exist between the director and the company is one of trust. The director is seen as a trustee of the company. This might seem so because the director has the duty to manage the business of the company. However, unlike in a trust relationship, the directors’ duties allow him to take risk with the company’s money. But as will be examined below, the duty owed by the director becomes one that is owed to the company’s creditors when the company is insolvent and hence they will be held liable.

Although all directors owe a duty to the company and seem subject to the control of the shareholders, the shadow director seems not to be subject to control of the shareholders. In Ultraframe (UK) v Fielding [21] it was stated that generally a shadow director owes no duties, unless for example a special responsibility was assumed regarding a particular asset. However, under CA 2006, all duties owed by a director can apply to a shadow director. Section 170 (5) [22] states thus;

“The general duties apply to shadow directors where, and to the extent that, the corresponding common law rules or equitable principles so apply"

The practicalities remain unpredictable, given the absence of authorities, but it is axiomatic that liquidators will look for someone to sue when a company collapses. [23] 

To examine the extent to which directors are responsible for the management of the company, the duties of the director will be examined.

DIRECTORS’ DUTIES

As a fiduciary of a company, a director must act bona fide in the best interest of the company [24] This is the core fiduciary duty of a director, as it applies to every act and decision made in that capacity. The duties of the director are stipulated under Section 171 – 177 of the Companies Act 2006, and include:

Duty to act within powers - Section 171

Duty to promote the success of the company - Section 172

Duty to exercise independent judgment –Section 173

Duty to exercise reasonable care, skill and diligence– Section 174

Duty to avoid conflicts of interest –Section 175

Duty not to accept benefits from third parties– Section 176

Duty to declare interest in proposed transaction or arrangement –Section 177

Although all the director’s duties above are important ,for the purposes of analysis of the directors’ business judgment and their role in the success of the company in relation to the financial crisis, the duty to act within power (Section 171), the duty to promote the success of the company (Section 172) and the duty to exercise care, skill and diligence (section 174) will be more relevant. These duties are important with respect to the financial crisis as it encompasses the duty of directors to manage the company for the proper purpose of making a Company succeed. It is argued that the inefficiency in decision making by directors leading to poor management of companies is a major cause of the financial crisis. Was the success of the company paramount in their decisions and did they act in due diligence? It is pertinent to note that directors must act within powers before such actions will be considered to be for the success of the company or not. Therefore we must examine what this duty entails.

DUTY TO ACT WITHIN POWER

Section 171 of the Companies Act states that “a director of a company must

act in accordance with the company’s constitution, and

only exercise powers for the purpose for which they are conferred."

Acting according to the company’s constitution

Section 171 (a) is vital to the duty of the director because if the director performs acts which are not in the company’s constitution, those acts are ultra vires the constitution. Since the duties of the director is found in the constitution of the company, Section 257 of the Companies Act 2006 defines a company constitution to include:

(a)any resolution or other decision come to in accordance with the constitution, and [25] 

(b)any decision by the members of the company, or a class of members, that is treated by virtue of any enactment or rule of law as equivalent to a decision by the company [26] 

The directors’ powers are embedded in the company’s constitution, thus it is trite to stay that any power exercised by a director which is not provided for in the constitution is void and cannot be ratified by the members in general meeting.

Improper purpose

Section 171 (b) stipulates that that the powers of the directors should be exercised for the purpose it is conferred. This section codifies the common law rule of proper purpose [27] . The Act does not state how the director should carry out the duty as long as it is exercise for the purpose it is conferred. The criteria as to if the power was exercised for the purpose with which it was conferred lies in the wordings of the company’s constitution. If the power is so exercised, the courts will not interfere. If it is not so exercised, the decision of the board of directors becomes open to challenge that the board have not acted in good faith as stipulated in section 172 of the Act. Thus in Hogg v Cramphorn Ltd [28] the board of directors in opposing a takeover that would terminate their position as the board, they allotted shares to persons that would support their continual stay in the board. The court held that even though they had believed that their action was in the best interest of the company, its power was not conferred to be used for that purpose. [29] 

This duty is important as it is not sufficient for directors to state that they acted in good faith in the best interest of the company unless they can also establish that their actions where within the powers conferred on them. [30] 

Duty to promote the success of the company

Section 172 (1) of the Companies Act 2006 provides that

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)-

It is argued that Section 172 of the Companies Act is one of the most controversial sections that codified the common law rule. The essence of its codification is to resolve the ambiguity as to whom the duty of the director was owed to. In the eyes of the law, the shareholder is the owner of the company and the interest of the shareholder should at all times be protected. To achieve this, the CLRSG adopted a version of shareholder’s primacy known as the “Enlightened Shareholder Value" (ESV). However, ESV goes beyond the common law shareholders primacy idea which focuses solely on the collective interest of shareholder but involves the idea that while directors must promote the success of the company in the interest of the members as a whole, he must have regards to broader considerations like ;employees, customers and the environment. To understand the effect this section has in the way that directors are expected to carry out their duties, it is important that the section should be spilt and analysed.

“A director of a company must act in the way he considers... “

This suggest that the duty of the director be carried out without intervention from the court as to how the director is to carry out his duty. The salient point here is discretion and the test for if the director had carried out his duty effectively is a subjective test. This means that should the manner wherein the director conducted his duty be questioned, it would be difficult to prove that the director had broken this duty

....In good faith...

This replaced the common law principle of “bona fide". In Re Smith & Fawcett Ltd [31] Lord Greene MR held that directors are bound to exercise the powers conferred upon them bona fide in what they consider – not what the court may consider – is in the interest of the company [32] 

As stated per Jonathan Parker in Regent Crest Plc. (in liquidation) V Cohen, [33] good faith is ascertained by deference to actual subjective state of mind. Thus the test of good faith is subjective [34] . The question the court will ask is, if the director had not done what in his opinion was right. This intends to open up an excuse for erring directors in the sense that as long as it can be proved by them that their decision was made in good faith, they will hardly be liable for a breach of their duty.

...to promote the success of the company...

“What is success? The starting point is that it is essentially for the members of the company to define the objective they wish to achieve. Success means what the members collectively want the company to achieve. For a commercial company, success will usually mean long-term increase in value." [35] 

In drafting this line, the CLRSG were careful to include companies whose aim of business was not profits. The word success could have been replaced with other words such as interest or profit. It is suggested that Success was used because had another word been used, companies who for example, were in business but not making any profits would not have been included. Again, the Act left to the discretion of the companies, what in their interest is the success of the company. All that the law requires is that the director carries out his duty in what the company thinks would be to its success. The law also provided a number of factors that the director will have to consider when considering the success of the company. The analysis of these factors in relation to the performance of the directors’ duties is analysed below.

...for the benefits of its members as a whole...

This suggests shareholders primacy. Prior to the Companies Act 2006, there had always been an ambiguity as to who the directors owed a duty to. What was known was that the directors were to carry out their duties in the interest of the company.

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

The constructions of amongst other matters shows that the factors listed in (a) – (f) are not exhaustive. The factors are:

the likely consequences of the decision in the long term [36] 

the interest of the company’s employee [37] :

the need to foster the company’s business relationships with suppliers, customers and others, [38] 

the impact of the company’s operation on the community and the environment, [39] 

the desirability of the company maintaining a reputation for high standards of business conduct, and [40] 

The need to act fairly as between members of the company. [41] 

This provision tends to strike a balance between the traditional shareholder value approach and the pluralist approach. However it has been argued that under section 172 [42] the interest of members of the company is still paramount, since directors are to act in a way that would promote the success of the company for the benefit of its members as a whole. [43] As J.L Yap puts it, the factors listed in section 172 are only items to be considered in determining this overall question. [44] 

It is important to note that though stakeholder’s interest are identified and provided for under section 172, [45] there is no provision with respect to action to be taken when there is a breach of this provision by directors. Thus “a right without a remedy is worthless". [46] According to Keay, while members may bring statutory derivative action against directors on behalf of the company [47] it has been noted that the other stakeholders listed in Section 172(1) will not be able to take any action against the directors. [48] This is due to the fact that stakeholders have not been expressly classified as members of the company under the Companies Act 2006 [49] as it is only members of the company that has a right to bring derivative action on behalf of the company or ask for relief under unfair prejudice remedies. [50] Nevertheless, the fact that shares are held by employees and environmental groups could act as an advantage to enhance enforceability of Section 172.Whether it becomes an effective stakeholder provision may well depend less on ‘enlightened’ shareholders and directors but more on an ‘enlightened’ judiciary. [51] 

Daniel Attenborough argues that the provision of Section 172 allows directors to pay “Lip service to the factors listed in section 172…the requirement to consider 6 factors will make very little difference to how board makes decisions." [52] 

On the whole it is thought that the effect of section 172 is more likely to be educational rather than in any sense restrictive and that business decisions taken in good faith will not be any more easily challengeable than they were before this provision existed. [53] 

Conversely, Gower and Davis are of the view that a director’s failure to pay regard to a specific matter constitutes a breach of duty and as a result, renders the decision challengeable. [54] This seems harsh if the decision in question promotes the success of the company and the neglected matter is remotely relevant, meaning that a reasonable director who paid due regard to the issue would have acted in the same way. [55] 

It is suggested that although the law specifically provides that directors should act in the interest of both shareholders and stakeholders, it primarily considers the interest of shareholders. Thus it can be argued that the provision points to the fact that shareholders are the directors’ primary focus. All the listed factors are only to be considered with the primary aim of benefiting members. Section 172 (a) intends that the director considers not only the present members in its decision making, but to also consider the interest of the future members. This presupposes the need to ensure that the company sustains a long continual life as against a management that leads to its liquidation. Section 172 (b) clarifies the ambiguity that had always existed as to place of the employee vis-a-vis the members. It can be seen that the interest of the employee is only to be considered while maximising the success of the

members . In Section 172 (c), dissatisfied customers and suppliers are factors that can affect or prevent the achievement of the success of the company for the members. In Section 172 (f) the aim of the law is to maintain the place of class right among the members that the director ordinarily would have considered when carrying out its duties. These factors are in place to give the director a guideline as to what to consider when taking decision for the company.

Davey K. C. W. argues that if the policy of Enlightened Shareholder Value approach is to give more flexibility to directors to adopt a more inclusive business approach, then directors should be allowed to structure the business or affairs of the company in a way that may not be the best possible way to enhance its present member’s interest. [56] Thus can directors trade off some members interest for the interest of stakeholders without breaching section 172(1)? Andrew Keay thinks a director would be doing so at his own risk. [57] This is due to the fact that if directors fail to comply with the ultimate aim of section 172(1) which is to promote the interest of members as a whole, members may bring derivative action for breach of duty.

Furthermore, it is argued that the standard imposed on directors is apparently low. A literal interpretation of section 172 is to the effect that a director will not be held liable if he can show that he acted in good faith. There is no yard stick in measuring his intentions. Thus section 172 imposes “mainly a subjective test" [58] which is arguably in contrast with the Common Law duty of directors to act in good faith to the benefit of the company, which has an element of objectivity. The case of Charterbridge Corp. Ltd V Lloyds Bank Ltd [59] is illustrative as the court stated that the duty to act in good faith in the interest of the company could be impugned where what the director did was something which no intelligent and reasonable man could have reasonably considered to be in company’s interest. While section 170(4) of the Companies Act 2006 provides that regards should be had to the corresponding common law rules in applying the new statutory duties, the explicit words of section 172 suggest only a subjective standard which is leads to ambiguity. [60] 

Nevertheless, some have argued that the requirement for directors to take into account various factors may pose new challenges for directors as well as expose them to increased litigation. J.P Sykes persuasively argue that in practice, company directors are already selected by the members for their ability to balance many factors in fulfilling their role. Thus the most likely effect of the provision of directors duties coupled with part 11 of the Act relating to derivative claims is to invite increased litigation against directors, for example on the grounds that a party has suffered loss because one of the six factors was not properly taken into account. [61] 

However it is suggested that it is unlikely to create such negative results as it is very important to have statutory provisions that act as a standard as well as a check on directors as they occupy a very important position in the running and management of a company. Davey is of the view that section 172 will make a director of a company to take a more inclusive approach to business thus building a more sustainable relationship with its stakeholders and exhibiting responsible business behaviour. [62] 

It is argued that the low standard could be a criteria for directors to act without due diligence as there is a handy excuse and easy escape by stating that their decision was in good faith even when it was specifically for their personal interest. This is part of the cause of the financial crisis as some decisions where taken with director having their personal profit in mind or being negligent as to the state of company’s affairs. However this aspect will be handled in the next chapter.

Section 172 (2) Companies Act states

Where or to the extent that the purposes of the company consist of or include purposes other than the benefit of its members, subsection (1)has effect as if the reference to promoting the success of the company to the benefit of the members were to achieving those purposes. [63] 

The essence of this section is to leave it to the discretion of the members, what the intended success of the company is. And Section 172 (3) requires the director to consider the interest of the company under certain circumstances. The circumstance whereby the interest of the members will no longer be considered in the management of the company is when the company is insolvent or at the verge of insolvency. The interests of the creditors intrude, and they have power, through insolvency procedures to control the company’s assets which are practically their assets, not the shareholders assets. [64] In Liquidator of West Mercia Safetywear Ltd V Dodd, [65] Mr Dodds was a director of two companies, West Mercia Ltd and A J Dodd Ltd. He paid away #4,000 of West Mercia’s to discharge debt which it owed to Dodds Ltd at a time when both companies are proceeding towards liquidation and the liquidator had instructed the directors not to operate both banks. The court held that Mr Dodd should personally repay West Mercia on the basis that he was in breach of his duty to the creditors of West Mercia.

Thus, where a company goes into liquidation, the liquidator might be emboldened to bring an action under section 212 of the insolvency Act 1986 for breach of duty if any assets is worth pursuing or the court may become stricter in imposing disqualification orders for “unfitness" under section 6 of the Companies Directors Disqualification Act 1986. [66] However, the question to consider is when the interest to protect changes from the interest of the members to that of the creditor. This section has a corresponding liability with section 214 of the Insolvency Act which states;

“At some time before the commencement of the winding up the company, that person knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation..."

Thus when can the director be said to have known that the company could not avoid insolvency. This was dilemma of the CLRSG during the drafting of the Companies Act [67] . However, although the exact point where the director ought to have known could not be determined, it is suggested that the duty to consider the interest of the company could be well before the company enters into a state of insolvency.

DIRECTORS’ DUTY OF CARE, SKILL AND DILIGENCE.

The director’s duty of care, skill and diligence is the next type of duty that the director owes the company. The duty, though owed by all the directors of a company, it is particularly more to the Non- executive directors. The non-executive directors are employed to monitor and supervise the executive directors. The emergence of the Combined Code reformed the role of the non-executive directors and made them more significant in the management of the company. This duty of care, skill and diligence which is encapsulated in Section 174 of the Companies Act is similar to the duty in section 214 of the Insolvency Act of 1986. Section 174 (1) of the Companies Act requires the director to exercise reasonable care, skill and diligence. While section 174 (2) sets out the standard as that of a reasonable diligent person having ;

“ (a)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

(b) the general knowledge, skill and experience that the director has."

The duty of care and skill under the Common law was first expounded in City Equitable Fire Insurance Co Re [68] where Romer J. stated that a director need not exhibit in the performance of his duties a greater degree of skill than may reasonably be expected from a person of his knowledge and skill [69] 

However, the duty under Section 174 [70] is different from the common law duty. The common law duty imposes a subjective standard of test for the breach of duty. This test was one that is reasonably expected from the director’s skill and knowledge. The new duty in section 174 Companies Act 2006 sets a minimum standard for all directors and removes the test from the viewpoint of the director’s experience and skill to the view point of a reasonable diligent person with the same experience and skill. The first standard which is 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, sets a standard for all directors. It is argued that this is a minimum standard below which the director will be held liable. This standard is an objective standard as it is one by which all directors in the same position will be judged. The new duty in section 174 [71] also imposes a subjective standard of test. This standard is aimed at imposing an additional standard on the director. The reason for this is that directors vary from company to company depending on the size and whether it is a private company or a public company. Also, directors are different depending on the experience and the degree of each director’s skill. Thus even where there is a blanket provision that stipulate the standard reasonably expected, the skill of such directors dictates a higher standard. In Dorchester Finance Company Ltd v Stebbing [72] ., it was held that Non-Executive Directors, who had signed bank cheques that enable the Managing director of a company to misappropriate the funds of the company, were negligent in their duty because they were accountants or had some measure of experience in accounting.

However, this duty allows the director to delegate some of the duties. He could trust another to do the job as stated in Norman v Theodor Goddard [73] . Nevertheless, it was held in Barlows Manufacturing Company Ltd v R N Barrie Ppty Ltd [74] that although the law allows delegation of authority, the director is still responsible to ensure that the delegated duty is carried out efficiently.

It is important to note that as at the onset of the financial crisis the statutory duties of directors have not been implemented but the common law duties were in force. This does not suggest any much difference as the statutory duties is largely a codification of the common law duties. However the statutory duties were implemented in the mist of the financial crisis as there is presently no complete recovery from the financial crisis.

The question is, were directors diligent in the performance of their duties as prescribed by the law as to exculpate them from being part of the cause of the financial crisis? Some commentators argue that directors cannot escape the blame for the collapse and near collapse of certain companies during the present crisis; others argue that in most cases, directors were not aware of the real situation of the affected company until its collapse. Thus the extent to which directors are in breach of their duties in the management of the company as to be part of the cause of the financial crisis will be analysed in the next chapter.