Directors' duties and fair dealing reviewed

There is a commonly accepted view that boardroom performance is a key factor in corporate success. It is unfortunate, therefore, that the boardroom has grabbed the attention of the public more for the notorious behaviour of directors than for management achievements.

High-profile scandals such as Peachey Properties in the 70’s, Guinness in the 80’s and Maxwell in the 90’s spring to mind. The abuses exposed in the scandals of the 70’s in particular, were answered by ad hoc legislation aimed at controlling the improper activities of directors. As a result, many of these provisions, contained in Part X of the Companies Act 1985, are criticised for being complex, fragmented and excessive.

Last month the Law Commission and the Scottish Law Commission issued a joint report entitled Company Directors: Regulating Conflicts of Interests and Formulating a Statement of Duties1. It is the first consideration of the law on directors’ duties since the Jenkins Committee in 1962 and the first real consideration of the Part X provisions since enactment. Part X needed a review. In respect of directors’ duties, there has been a long running debate as to whether the core duties should be set out in legislation. The duties which a director owes to a company are currently derived from diverse case law. These are supplemented by detailed regulation in the 1985 Act of particular circumstances where a director faces a conflict of interests or a conflict of duties. In contrast, there is a conspicuous absence in statute of any statement as to the more fundamental duties which a director owes. This is anomalous. The argument in favour of legislation is strengthened by the increasing numbers of directors being disqualified for failure to observe their most basic obligations.

A statutory statement of duties

In examination both the complex structure of Part X and the general law of directors’ duties, the Commissions were persuaded that a director’s principal duties should be set out in a statement of some kind. This would make the law more accessible and encourage wider understanding among directors and other users of company law. The duties could be drafted generally2 in order to apply in different circumstances and to encompass many of the perilous situations presently regulated by Part X. This may allow some of the provisions to be dispensed with altogether3.

A statutory statement of a director’s main duties, therefore, is proposed. It is envisaged that the duties would be drafted as general principles, along the lines of the draft statement set out in the consultation paper4. This might best achieve a balance between making the law more accessible whilst ensuring that it is flexible enough to cope with the dynamism of directors’ duties. By setting out principles rather than detailed rules, this might also reduce the danger of the statement being interpreted by its letter rather than its spirit.

A drawback is that the statement would not be comprehensive. There are other statutory duties by which a director must abide and there will probably be other common law duties or mutations of existing duties which are not included in the statement.

During the consultation process, there was much support for a statement of duties in some shape or form. However, there was also demand for a more comprehensive education package for directors. Accordingly, the Commissions have proposed that any statutory statement of duties be included on prescribed forms – such as a director’s consent to act. As this form should be signed by a director on appointment, it would offer an important opportunity to bring basic duties to the director’s attention. As a supplementary measure, it was recommended to the DTI that pamphlets which explain director’s duties in more detail and contain practical examples of situations where a director may find himself in breach of duty, be issued by an appropriate body.

A statutory duty of care

A further recommendation is to set out in statute the duty of care which a director owes to a company under the common law. This statutory duty would set a standard similar to the current test for a director’s liability on wrongful trading contained in the Insolvency Act 1986. The courts have recently referred to this test as a basis for the general standard of care which a director must show, not just on impending insolvency but throughout the life of the company. As explained in the report, it imposes a dual objective/subjective test on directors. In effect, all directors will be subject to a minimum standard of care – that of a reasonable person with the knowledge and experience which might be expected of a person in the same position. However, in certain cases, a director may have additional experience or skills which are relevant to his or her directorship, such as lawyers, accountants or directors who have considerable board experience. Under the dual test, these additional skills will be taken into account.

An example

A and B are directors of companies X and Y respectively. A is employed as a manager of company X and his responsibilities as a director include reporting to the board on the finances of the company even though he has no financial or accounting qualifications. B has been recruited to the board of company Y as a finance director. He is a qualified accountant. In considering the accounts of company X, A would be expected to show the care, skill and diligence which a reasonable director without any professional knowledge of accounts might show. However, B has particular experience and knowledge in this area and would be expected to examine the accounts with the care, skill and diligence expected of someone with his particular accountancy skills and knowledge of company accounts.

In assessing the director’s behaviour, account will be taken also of the particular role and responsibilities which the director has in the company, including whether he or she is an executive or non-executive director.

It is not proposed, however, to introduce a statutory business judgment rule to complement the statutory duty of care. In other jurisdictions, this rule is used to prevent directors from being liable for claims if breach of duty or negligence where certain factors are established, e.g. where the director acted in good faith and had no financial interest in the transaction. In the UK there is a long-established judicial approach of not “second-guessing” commercial decisions of directors with the benefit of hindsight6. This approach works well in practice and is thought to be more flexible than a statutory rule.

Part X provisions

Although a statutory statement of duties is recommended, the repeal of many of the provisions in Part X is not proposed. There was little support for wholesale repeal during the consultation exercise or among directors surveyed. There is no evidence to suggest that the general law has developed sufficiently to address the mischiefs which it could not previously regulate. Therefore, while the provisions in the Act are complex, they offer protection which is superior to that of the general law.

Instead, substantive amendments to the existing provisions are proposed. They are intended to address some of the technical deficiencies arising from the individual sections and to improve the overall consistency of Part X. A structure of “graduated regulation” of conflicts of interests has been recommended. This means simply that Part X (i) prohibits transactions or actions as a last resort, e.g. where they pose a significant risk to persons other than directors or shareholders; (ii) requires shareholder approval in other cases where there is a real risk of prejudice to shareholders, thus helping to maintain the balance of power between the board and the shareholders; (iii) requires retrospective disclosure to the shareholders in all other cases; (iv) requires prior disclosure to the board where a director has a conflict of interests in a transactions involving the company.

There are numerous recommendations in the report to modernise the Part X provisions. Set out below is an overview of some of the main proposals.

• Further disclosure in a company’s annual accounts of compensation paid to every director for loss of office;
• The limitation of the interests which a director requires to disclose to the board with a register of these interests being maintained for inspection by the board. The introduction of civil remedies for non-disclosure is also proposed;
• The reduction from 5 years to 3 years of the maximum duration of a director’s service contract without shareholder approval and extension of control to rolling contracts;
• A provision to allow a company to agree a substantial property transaction with a director by a contract which is conditional on the company first obtaining shareholder approval;
• The introduction of an exemption for administrators of a company from the requirement to obtain shareholder approval for substantial property transactions with directors. Also to give administrative receivers (and receivers in Scotland) the option of applying to the court for approval of transactions where there is good reason to believe that the company’s assets are insufficient to make a payment to shareholders or where there is some other good reason why shareholder assent can be dispensed with;
• The extension of the prohibitions on companies making loans to, or entering into similar transactions with their directors (and directors of their holding companies) to all companies;
• The extension of the definition of persons connected with a director to include cohabitants7, adult children, parents and siblings;
• The introduction of a coherent code of civil remedies.

The wider review

Undertaken at the request of the Department of Trade and Industry, this project contributes to the wider Company Law Review which is being conducted by an independent Steering Group appointed by the DTI8. The Commissions’ proposal will be taken forward in the context of this wider Review. As a result, a number of matters which may have been of relevance to the project have been omitted9. In addition, the current recommendations may require further consideration as the Review develops.

To give an example, a new regime for small companies, whether set out in a rewritten Companies Act or in separate legislation, is an option under consideration by the Company Law Review10. The aim would be to offer more flexibility to small companies in the management of their affairs. As ownership and management are not separated in many small companies, the protection of shareholders may be of less importance and, therefore, there may be scope to disapply many of the detailed provisions in Part X, while providing in Part X, while providing protection to creditors, where that is required. In light of the work being undertaken by the Review on the position of small companies, the Commissions did not consider specifically how Part X applies to them.

The recommendations for the whole Review are not expected until 2001. In the meantime, this report is the first step towards making company law more accessible and understandable to its wide spectrum of users.

Hazel Moffat, a solicitor with McGrigor Donald, was formerly a member of the Scottish Law Commission team working on the Part X project

Footnotes

1. Law Com No 261; Scot Law Com No 173. Copies of the report are available either from the Stationery Office or on the Internet at http://www.open.gov.uk/lawcomm/   
2. Such as “a director must act in good faith in what he believes to be the interests of the company”.
3. A further potential argument for repeal of these provisions discussed in the consultation paper was that there is considerable self-regulation in this area. However, the issue of duplication of statute and market regulation is being looked at by a wider Company Law Review implemented by the Department of Trade and Industry, for the Companies Act as a whole. This Review is discussed in more detail below.
4. Although this statement was originally drafted as a non-statutory example, it could be adapted to become the basis for a statutory statement.
5. See the cases of Norman v Theodore Goddard [1991] BCC 14 and Re D’Jan of London Ltd [1993] BCC 646 which were followed in Bairstow v Queen’s Moat Houses plc 23 July 1999, unreported.
6. Howard Smith v Ampol Petroleum [1974] AC 821, Lord Wilberforce at p. 832.
7. Cohabitants are to include same sex cohabitants. There is no stipulated time limit for cohabitation.
8. The DTI launched their fundamental review of core company law in March 1998. A Consultation Document entitled Modern Company Law for a Competitive Economy: the Strategic Framework, was published in February 1999 setting out the key issues to be reviewed. This can be found on the Internet at: http://www.dti.gov.uk/
9. Such as directors’ remuneration, the stakeholder debate and the content of directors’ fiduciary duties.
10. See the DTI Strategic Framework, Chapter 5.2.