Companies Act 2006 – implications for directors

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What are the implications of the codified duties?
What did the Government intend to achieve? 
What are the codified duties?
What changes are there to the consequences of a breach of duty?
Are there other changes for directors?

Part 10 of the Act (a company’s directors) is in force from 1 October 2007, other than the provisions relating to directors’ conflict of interest duties and the minimum age for directors, which come into force on 1 October 2008 and provisions relating to the register of directors, the disclosure of directors' residential addresses and the removal of directors by shareholder resolution, which come into force on 1 October 2009.

This page deals only with the law in force from 1 October 2007. (For a summary of all the provisions of the Act about directors’ duties, including the further provisions introduced from October 2009, click for more information, and for a  summary of the most important provisions of the Act affecting directors click for more information. 

What are the implications of the codified duties?

• The codified duties are based on the duties developed by the courts, so there are few dramatic changes, but they are set out in detail in legislation for the first time.
  
  
• The main common law duty of directors was to act as they considered in good faith to be in the interests of the shareholders as a whole, and a general duty to consider the interests of employees was added by legislation. That is expanded to bring in a concept of “enlightened shareholder value”.
  
  
• There is a list of factors the directors are required to take into account in making decisions.

The codification of directors’ duties has been much criticised. Concern has been raised as to the mandatory list of factors for directors to “have regard to”, which could create a box-ticking approach at board level or expose directors to greater potential liability.

The new objective of the directors is “to promote the success of the company”. The meaning of success will differ from company to company. For a commercial company with a continuing business, success will usually mean long-term increase in value.

There is no guidance in the Act about the weight to be given to each of the factors that the directors are required to take into account, or how conflicts between the factors should be resolved. Those are left for the directors to decide in the light of the overall objective. A checklist and detailed board minutes could be used to show that the directors have contemplated the list of section 172 factors. But recording the factors taken into account in reaching a decision could lead to the directors facing allegations that they should have taken account of other factors they did not record.

Directors can be sued for damages for breach of duty, as before. The directors’ duties are still owed to the company, not to individual shareholders or third parties, and only the company can normally sue a director, acting through its directors, liquidator or administrator. But the Act widens the circumstances in which an individual shareholder can bring a “derivative action" in the name of the company. For the first time, it is possible for a claim for negligence to be made against a director through a derivative action.

The Act increases the prospects of litigation against company directors, but perhaps not by as much as many had feared. The approach of the courts to the first few cases will be crucial.

Recommended action

• For major decisions, directors should consider reciting in the board minutes that they have considered all the statutory factors. Where formal board papers are prepared, they could contain an analysis of each of the factors.
  
  
• Articles can be reviewed, but there are no changes generally recommended, at least until October 2008.
  
  
• Companies with representative directors may add an article authorising them to take into account their appointor’s interests.
  
  
• Directors should review their directors’ and officers’ liability insurance policies. The cost of insurance may rise.

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What did the Government intend to achieve?

The Government’s approach has been to encourage – or oblige – directors to take a wider view of the interests of shareholders, embracing “society’s aspirations for people who work in the company or in supply chain companies, for the long-term well-being of the community and for the protection of the environment” as complementary objectives. Maximising profits or shareholder value are no longer to be seen as the directors’ only objective, if they ever were.

The Government has published the following high-level guidance for directors, intended to reflect the new duties:

• Act in the company's best interests, taking everything you think relevant into account;
  
  
• Obey the company’s constitution and decisions taken under it;
  
  
• Be honest, and remember that the company's property belongs to it and not to you or to its shareholders;
  
  
• Be diligent, careful and well informed about the company's affairs. If you have any special skills or experience, use them;
  
  
• Make sure the company keeps records of your decisions;
  
  
• Remember that you remain responsible for the work you give to others;
  
  
• Avoid situations where your interests conflict with those of the company. When in doubt disclose potential conflicts quickly;
  
  
• Seek external advice where necessary, particularly if the company is in financial difficulty.

The Government says “for most directors, who are working hard and put the interests of their company before their own, there will be no need to change their behaviour.” It remains to be seen whether the courts agree.

Quotations in this section are from ministerial statements on directors’ duties published by Margaret Hodge, Minister of State for Industry and the Regions, in June 2007.

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What are the codified duties?

The codified duties already in force are:

• Duty to act within powers (section 171)
  
  A director must act in accordance with the company’s constitution (the articles) and must only exercise his powers for their proper purpose.
  
  
• Duty to promote the success of the company (section 172).
  
  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.
  
  In doing so a director must have regard (amongst other matters) to:
  
  (a)     the likely consequences of any decision in the long term,
  (b)     the interests of the company's employees,
  (c)     the need to foster the company's business relationships with suppliers, customers and others,
  (d)     the impact of the company's operations on the community and the environment,
  (e)     the desirability of the company maintaining a reputation for high standards of business conduct, and
  (f)     the need to act fairly as between members (shareholders) of the company.
  
  Where the company’s purposes consist of or include purposes other than for the benefit of its members (e.g. charitable companies or community interest companies), a director must act in the way he considers, in good faith, would be most likely to achieve those purposes.
  
  
• Duty to exercise independent judgement (section 173).
  
  This requires each director to apply his own mind to decisions, thinking about the company’s interests and not about external pressures. For the first time it is clear that this duty is subject to anything in the articles: where directors are appointed specifically to represent the interests of a particular shareholder or group of shareholders, there will be advantages in specifying, in the articles, that the director may take into account the interests of the person or group appointing him.
  
  
• Duty to exercise reasonable care, skill and diligence (section 174).
  
  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. There is a significant change here, in that previously (except in insolvency legislation) there was no minimum standard of competence for directors – an honest and diligent fool could not be sued for negligence. The “reasonably expected” standard means a director who is out of his depth and under-qualified is now exposed to a claim.

The duty to consider creditors' interests when insolvency threatens has not been codified, but it remains effective and can override the duty to act in shareholders’ interests.

The conflict of interest duties in force from 1 October 2008 are:

• A duty to avoid conflicts of interest – but conflicts can be authorised by the board (so long as there are enough “independent” directors)

• A duty not to accept benefits from third parties – they can still only be approved by the shareholders

• A duty to declare to other directors any interest in a proposed transaction or arrangement – a “general” notice can be provided at a board meeting dealing with ongoing transactions with a particular company.

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What changes are there to the consequences of a breach of duty?

Ratification

The Act confirms the power of the shareholders to ratify, by ordinary resolution, a director's conduct amounting to negligence, default, breach of duty or breach of trust, with one big difference. There is a new requirement that the votes of the director and the votes of any person connected with him are to be disregarded. In the case of a family-controlled company, that may mean that ratification is controlled by a small minority of “independent” shareholders.

Recommended action: because of the risk of action against past directors from the company under new ownership, consider passing resolutions ratifying past transactions or misdemeanours before selling a company.

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Derivative actions

Part 11 of the Act allows shareholders a limited right to sue directors, in the company’s name and for its benefit, for negligence, default, breach of duty or breach of trust. Any damages recovered would go to the company, not the shareholder.

The old requirements for derivative actions - that the directors must have personally benefited from the alleged wrongdoing and that the wrongdoers are in control of the company so as to prevent it taking action against them – no longer apply. Any breach of duty, including negligence, can be pursued by derivative action.

There are procedural safeguards intended to prevent frivolous actions incurring major expense and inconvenience for companies, but it remains to be seen whether they will be effective. The temptation for pressure groups to buy shares and bring derivative actions over “interests of employees” or “impact on the environment” may be irresistible.

Most actions, though, are likely to be for the collective negligence of the directors in making business decisions. The courts will need to be robust if they are to avoid a rush of litigation against directors for decisions that look wrong with the benefit of hindsight.

The court must refuse permission to bring a derivative action if a person acting in accordance with the general duty to promote the success of the company would not seek to continue the claim, or if the act or omission giving rise to the cause of action has been authorised or ratified by the company. It is also likely to dismiss the claim if the act or omission would be likely to be ratified if the shareholders were asked, or if evidence shows that ordinary, disinterested shareholders would not want the claim pursued.

A derivative action can be taken as part of an action for “unfairly prejudicial conduct” by minority shareholders, and may become a standard weapon in shareholder disputes.

The new ability for auditors to limit their liability may increase the likelihood of directors being sued for losses over the cap.

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Are there other changes for directors?

Yes. These provisions are in force:

Substantial property transactions with directors

The minimum value of a transaction with a director or his connected person that needs shareholder approval is increased – it is now more than £5,000 and either more than 10% of net asset value or over £100,000.

Loans to directors

Loans to directors are no longer absolutely banned, but now need shareholder approval if the total of all loans exceeds £10,000. The exemption for legitimate business expenditure is widened.

Directors’ service contracts

Service contracts are now defined to include contracts with third parties who provide the services of a director, such as personal service companies or professional firms. The exemption from disclosure for contracts terminable within 12 months is removed. The maximum fixed term for service contracts not requiring shareholder approval is reduced to two years from five.

Notification of interests in shares

Directors no longer have to notifiy the company of their interests in its shares, and companies do not have to maintain a register of interest in shares - except quoted companies subject to the Disclosure and Transparency Rules.

Prohibitions removed

Paying tax-free (i.e. tax paid) remuneration to directors, and directors dealing in share options, are no longer banned.

Corporate directors

From 1 October 2008, every company must have at least one “natural” person as a director.

The age limit of 70 for directors has been abolished - click here for more information about age discrimination from the emw law employment team.

A new minimum age of 16 for company directors is introduced from 1 October 2008.

Directors' company addresses

From 1 October 2009, you will be able to use a “service address”, to appear on the public register instead of your home address.  Companies House will still need to be given your residential address but it will be kept on a private secure register. Existing addresses will not be removed from public view.

The company's own registers (e.g. register of members) can be withheld from inspection by members of the public if they cannot demonstrate a 'proper purpose'.

Directors acting without a secretary

There is a new mode of executing deeds, available to all companies: one director can execute a deed in the presence of a witness. That will be convenient, but some companies may think it reduces control. In force 6 April 2008.

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