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Codification of Directors' Duties

The question of how to make corporate directors accountable has taxed scholars and businesspeople for centuries. A system of corporate governance must strike an appropriate balance between permitting entrepreneurship and risk-taking and the protection of shareholders. Corporate scandals including the demise of corporate behemoths such as Enron and Parmalat show that the current system may tilt the balance too much in favour of directors taking unnecessary risk. Director power is largely controlled in the UK through a series of directors’ duties contained within the Companies Act 2006. This report aims to outline the rationale for these duties, outline their ambit and to critically assess the advantages and disadvantages of the current UK approach with reference to other jurisdictions.

i. Historic Basis and Rationale of Directors’ Duties

With the creation of the Joint Stock Companies Act 1856, the limited liability company has been used to facilitate enterprise. However, the growth of this corporate form led to a consideration of the relationship between the owners and controllers of a company. The classic treatise by Berle and Means identified two key observations about modern American companies: first, shareholders were the owners of a company but were so vast in number that they could not organise themselves efficiently in order to control management; second, management possessed enormous economic power and this power could be harmful to society. Shareholders were cited as becoming disengaged from the running of the company thus allowing directors to have free reign. This has received judicial support and Article 3 of the Model Articles for Public Companies recognise this in that they state ‘[s]ubject to the articles, the directors of the company are responsible for the management of the company’s business, for which purpose they may exercise all the powers of the company’. Furthermore, the notion that shareholders controlled directors by virtue of appointing them was a fallacy as the board had control over the agenda of general meetings and therefore it was the directors who possessed this influence. This separation of ownership and control meant that shareholders had a ‘mere symbol of ownership’ but had little real impact on the running of the company.

The problem of separation and control meant that companies were largely ran under a shareholder profit maximisation approach whereby companies were run solely in the interests of shareholders. This led to the ‘characterisation of shareholder interests in strict economic terms’. Directors would be given unfettered control over the running of the company in order to achieve this aim: as long as directors were making money for the company then shareholders would be less likely to intervene. However, even as far back as 1976, it has been articulated that the problem of director power and shareholder passivity, is less pronounced than presented by Berle and Means. Nevertheless, in the UK lawmakers were concerned with the drawbacks of a system which placed shareholders’ interests at the pinnacle of corporate governance. As a result the Company Law Review Steering Group was tasked with a wholesale reform of this area. The review led to a move away from shareholder primacy in its purest form to an enlightened approach which involved directors promoting the success of the company for the benefit of shareholders ‘by taking due account of both the long-term and short-term, and wider factors such as employees, effects on the environment, suppliers and customers’. The Review led to the enactment of the Companies Act 2006 which was a codification exercise of common law directors’ duties. Directors’ duties ‘play an important role in constraining the discretion of directors and holding them accountable if they extract private benefits of control’. The next part of this report will summarise and critically examine to what extent the current construction of directors’ duties favour director power over protecting shareholders.

ii. Current Rules Governing Directors’ Duties

The Companies Act 2006 contains a range of general directors’ duties which are based on common law rules and equitable principles. Section 171 contains a duty to act within the powers of the company constitution and exercise powers for the purpose they were conferred. Section 172 contains a duty to promote the success of the company for the benefit of the company as a whole. Section 173 involves a duty to exercise independent judgment while section 174 asserts that directors should exercise reasonable care and skill. A duty to avoid conflicts of interest are contained within section 175 and section 176 involves a duty not to accept benefits from third parties. Section 177 imposes a duty to declare interests in proposed transactions. For the purpose of this research paper, the focus of discussion will be on sections 172, 173 and 174 as these are the most controversial.

iii. The Individual Duties

The first duty to consider is the duty to promote the success of the company. This is a reformulation of the common law duty to act bona fide in the interests of the company. This was judicially recognised in Cobden Investments Ltd v RWM Langport Ltd with Warren J stating that ‘[t]he perhaps old-fashioned phrase acting “bona fide in the interests of the company” is reflected in the statutory words acting “in good faith in a way most likely to promote the success of the company”’. Section 172 indicates that director should have regard to the interests of stakeholders such as employees, suppliers, the environment and consumers when deciding how best to promote the success of the company for the benefit of members as whole. The aim of this change was to move away from short-termism and shareholder wealth maximisation to an emphasis on the long-term effects of decisions and the social responsibility of business.

However, it is certainly questionable how successful section 172 has been. There are only occasional examples of a successful claim for breach of this duty. Only two cases have mentioned or considered the list of stakeholders such as suppliers and consumers in a direct way. Therefore, it appears that section 172 has been an inadequate check and balance on regulating directors’ powers. Grier offers several explanations for this. First, a director only has to ‘have regard’ to the interests of stakeholders as a more obligatory approach would have been ‘a positive deterrent to entrepreneurs setting up companies in the United Kingdom or existing businesses staying in the United Kingdom’. Second, directors may be unaware of the changes effected by section 172 and therefore this has not altered director behaviour. The author laments while there may be some awareness within small companies there is less awareness in larger companies. Third, there is a lack of enforcement in that a breach must be pursued as a derivative claim and there are considerable problems with this course of action as discussed later. Keay further adds that the section is not a wholesale march towards a stakeholder approach from a legal viewpoint and that shareholder wealth maximisation remains the primary aim of directors under the new provision. A further criticism of the provision is that the test is a subjective one, reflecting the common law, so that a director will not be in breach providing he believed what he was doing was in the best interests of the company. However, it is submitted that the duty may not be entirely subjective. Where a director’s actions are irrational, or where they cause considerable harm, the courts will be more cautious in finding that the standard has been met. The 2006 reform was a missed opportunity to introduce a more objective assessment of this duty. There is evidence that an objective approach has been used in relation to this duty previously, as in Charterbridge Corporation Ltd v Lloyds Bank Ltd where the court held that the proper test where the director has given no regard to this duty is whether ‘an intelligent and honest man in the position of the company concerned, could…have reasonably believed that the transaction was for the benefit of the company’. Therefore, this mixed objective/subjective approach allows for a higher threshold to judge directors’ actions. This would enhance the position of shareholders’ while still allowing directors to operate the company with an appropriate level of discretion.

The Irish Companies Bill s. 229(1), which has yet to be enacted as an Act, is similar to section 172 without the explicit mention of a list of stakeholders. There is instead an obligation to act in good faith in a way the director considers to be in the interests of the company and to act responsibly and honestly in conducting the affairs of the company. According to Grier this is an improvement on section 172 in that the words honestly and responsibly lack the specificity so that directors should act honestly and responsibly to other companies as well as their own and is easier to understand and harder to avoid than the duty in section 172. The Irish formulation also has the advantage of making it easier for a shareholder to identify whether a director’s action or omission showed a failure to act responsibly or honestly. It is submitted that such a system would be beneficial in the UK. The list of factors in section 172 could actually be having a counter-productive effect. A less specific approach, as that suggested from Ireland, would tip the balance more towards the protection of shareholders and enhance director accountability.


Section 173

The duty to exercise independent judgment has a long common law history. In short, directors were to refrain from fettering their discretion when exercising power. However, the common law recognised an exception in that discretion could be fettered in order for directors to exercise their discretion to act in a certain way in the future. Section 173(2)(a) retains this exception and states that the duty to exercise independent judgment will not be breached if a director ‘acts in accordance with an agreement duly entered into by the company that restricts the future exercise of discretion by its directors’. Furthermore, section 173(2)(b) asserts that the duty will not be breached if a director acts in a way which is authorised by the company constitution.

There have been some criticisms of this provision. Hannigan opines that the duty is meaningless to those who are not familiar with the pre-2006 case law and its application and therefore frustrates the aim of the legislation which was to provide clarity and accessibility. However, Keay submits that the new provision may actually represent a narrowing of the common law exceptions. In the cases under the common law, the ability to fetter future discretion have not always been made by the company, whereas under the new Act such acts must be, unless the board has the power to act on behalf of the company. If this is a narrowing of this exception then directors will be more limited in their discretion than under the previous common law.


Section 174

Section 174 dictates that directors should exercise reasonable care, skill and diligence. A similar duty was detected in the common law. The common law duty was highly subjective, and based on the actual level of skill and experience that a specific director possessed. Similar approaches could be detected in Australia and South Africa. This resulted in directors being assessed against a low standard of care. In short, incompetent directors could use their deficiencies to guard against a claim for failing to exercise reasonable care and skill. This had a negative impact on shareholders when poor decisions were made.

Section 174 states that the standard of care and skill is now based on a reasonably diligent person who has the general knowledge and experience that is to be expected of a person carrying out the functions carried out by the director and the general knowledge and experience that director actually possesses. Therefore, the first limb of the test imposes an objective standard which all directors will be assessed against, therefore, directors can no longer shield behind their incompetence to lower the standard expected. The second limb of the test allows for the standard to be altered where a director possesses a particular skill and has the effect of raising the standard.

The use of an objective baseline is to be commended. Sealy notes that ‘[c]oncepts, procedures, remedies and above all, fact-situations have not remained static, and we must expect the law to respond’. The previous law, which permitted incompetence, has necessarily been reformed. However, some commentators assert that the codification will stifle entrepreneurship. Bekin argues that ‘economic growth depends on risk taking and that directors are expected to display an entrepreneurial spirit’ and that codification prevents this. However, this argument is not defensible. The real risk to economic growth lies in companies being run by incompetent directors. The recent Financial Crisis 2008 is testimony to the fact that directors given the opportunity will not exercise reasonable care and skill. Any reform that attempts to compel them to do this is to be welcomed.

Advantages and Disadvantages of Current System

One of the proposed advantages of the current system is that the law has become clear now that it is in statutory form. However, the preceding discussion casts doubt on this assertion. Much of the law remains unclear. For example, the current system is that the remedies for breach are not identified within the 2006 Act. Instead, s. 178(1) asserts that the common law will continue to operate in this area. While this has the advantage of flexibility, and allows the remedies to develop in an incremental way, codification would provide clarity in this area and allow business people to regulate their affairs and more precisely predict the outcome of their actions. It is certainly doubtful whether this aim has been achieved. This means that directors can take advantage of ambiguities to enhance their position.

One of the ensuring problems of the UK system is the lack of an effective enforcement mechanism when a duty has been breached. If a company wishes to claim against someone then it is the company that must bring a claim. The company is the proper plaintiff as it is the party that has incurred the loss. However, where a director has breached their general duties, the board will have to decide if actions should be taken. Arguments against taking such action include the fact that the board are the wrongdoers, the board may be embarrassed by the breach and not want it to impact on the reputation of the company and socio-psychological factors such as having become close to the offending board member. The inability or difficult in claiming against the company led to the creation of the derivative action which allowed shareholders to claim against the company. This involved ‘shareholders bringing proceedings on behalf of their company against directors and perhaps others, and any relief being awarded to the company itself.’ However, this approach was subject to trenchant criticism with the Law Commission identifying four main problems: that the common law rules had been fashioned from very old case law which was difficult to apply in modern times, the concept of control was important in a derivative claim but was not clearly defined, a derivative claim for negligence involved a claimant having to show that the negligence conferred a benefit on controlling shareholders and the difficulty in showing standing to bring a claim and proving a prima facie case.

Part 11 of the Companies Act 2006 creates a new statutory derivative action which is the position in Australia, Canada and New Zealand. The new system was designed to make the law clearer and more accessible to shareholders. By virtue of section 261(1) of the 2006 Act a member who wishes to bring a derivative claim must make an application to court for a determination on whether such a claim can proceed. A similar system is operated in Germany. However, in several other countries including Austria, Croatia, Denmark and Sweden there are no such hurdles to an action. Section 261(2) indicates that the first stage of this is to ascertain if the claimant has a prima facie case. This is not an overly cumbersome hurdle and to date most claimants can satisfy this test, a test designed to weed out vexatious claims with no merit. If a prima facie case is established, then the court will apply the mandatory test which is aimed at assessing whether any of the conditions in section 263(2) apply against pursuing a claim; (a) where a person acting under section 172 – promoting the interests of the company – would not pursue the claim (b) where the act or omission is yet to occur and (c) the act or omission has occurred but has been authorised by the company or ratified by the company. Assuming none of these factors are engaged, s. 263(3) contains a list of factors as part of a discretionary test which the court will examine including the importance a director acting in accordance with section 172 would attach to continuing with the claim.

One of the criticisms of the common law derivative claim was that the courts were reluctant to allow such claims. A survey of case law from 2008-2013 indicates that this same reluctance may be evident under the new law. While there have been some successful applications, there are considerably more cases were permission has been rejected. Furthermore, given the balancing act involved in the admission procedure, there can be great uncertainty in how the court’s discretion will be applied. It is submitted that the current system is not seismic shift in favour of shareholders. What is needed is a more radical and liberal approach by the courts in order to facilitate these claims. Until this approach is adopted, shareholders will be left with a right with a right without a remedy.


Conclusion

The Companies Act 2006 codified directors’ duties but in many respects the law remains unaltered. The balance remains in favour of directors to a large extent, especially concerning enforcement. A more radical approach is needed to redress the balance towards shareholders.

2994 words (excluding footnotes).

List of Cases and Statutes

Cases

Automatic Self-Cleansing Filter Syndicate Co Ltd v Cuninghame [1906] 2 Ch 34 (CA)
Bamford v Harvey [2012] EWHC 2858 (Ch)
Cinematic Finance Ltd v Ryder [2010] EWHC 3387 (Ch)
Clark v Workman [1920] 1 IR 107
Cobden Investments Ltd v RWM Langport Ltd [2008] EWHC 2810 (Ch)
Foss v Harbottle (1843) 2 Hare 461
Franbar Holdings Ltd v Patel [2008] EWHC 1534 (Ch).
Fulham Football Club Ltd v Cabra Estates Plc [1992] BCC 863
Hughes v Weiss [2012] EWHC 2363 (Ch)
Hutton v West Cork Railway Co (1883) LR 32 ChD 654 (CA)
John Crowther Group Plc v International Plc [1990] BCLC 460
Kleanthous v Pahitis [2011] BCC 676
Langley Ward Ltd v Trevor [2011] EWHC 1893 (Ch)
Mission Capital plc v Sinclair [2008] EWHC 1339 (Ch)
Odyssey Entertainment Ltd (In liquidation) v Kamp [2012] EWHC 2316 (Ch)
Parry v Bartlett [2011] EWHC 3146 (Ch)
Phillips v Fryer [2012] BCC 176 (Ch)
Prudential Assurance Co Ltd v Newman Industries Ltd (No.2) [1982] Ch 204
Regentcrest plc v Lloyds Bank Ltd [2001] BCC 80 (Ch)
Re Cardiff Savings Bank [1892] 2 Ch 100 (Ch)
Re City Equitable Fire Insurance Co Ltd [1925] Ch 407 (CA)
Re Englefield Colliery Co (1878) LR 8 Ch D 388 (CA)
Re Smith and Fawcett Ltd (1942) Ch 304
Re Singh Brothers Contractors (North West) Ltd [2013] EWHC 2138 (Ch)
Ritchie v Union of Construction, Allied Trades and Technicians [2011] EWHC 3613
Stainer v Lee [2010] EWHC 1539 (Ch)


Statutes

Companies Act 2006















Bibliography

Textbooks

Berle A and Means G, The Modern Corporation and Private Property (Harcourt 1932)
Eisenberg M, The Structure of the Corporation: A Legal Analysis (Beard Books 1976)
Hannigan B, Company Law (2nd edn, OUP 2003)
Healy J, Corporate Governance and Wealth Creation in New Zealand (Dunmore Press 2003

Journal Articles

Bekink M, ‘Historical Overview of the Director’s Duty of Care and Skill: From the Nineteenth Century to the Companies Bill of 2007’ (2008) 20 South African Mercantile Law Journal 95
Blair M and Stout L, ‘Director Accountability and the Mediating Role of the Corporate Board’ (2001) 79(2) Washington University Law Quarterly 403
Clarke B, ‘Corporate Responsibility in Light of the Separation of Ownership and Control’ (1997) 19 Dublin University Law Journal 50
Fischel D, ‘The Corporate Governance Movement’ (1982) 35 Vanderbelt Law Review 1259
Gerner-Beuerle C and Philip-Schuste E, ‘The Evolving Structure of Directors’ Duties in Europe’ (2014) 15(2) European Business Organization Law Review 191,
Grant N, ‘Mandating Corporate Environmental Responsibility by Creating a New Directors’ Duty’ (2015) 17(4) Environmental Law Review 252
Grier N, ‘Enlightened Shareholder Value: Did Directors Deliver?’ (2014) 2 Juridical Review 95
Keay A, ‘Applications to Continue Derivative Proceedings on Behalf of Companies and the Hypothetical Director Test’ (2015) 34(4) Civil Justice Quarterly 346
Keay A, ‘The Duty of Directors to Exercise Independent Judgment’ (2008) 29(10) Company Lawyer 290
Lian Yap J, ‘Considering the Enlightened Shareholder Principle’ (2010) 31(2) Company Lawyer 35
Lynch E, ‘Section 172: A Ground-breaking Reform of Director's Duties, or the Emperor's New Clothes?’ (2012) 33(7) Company Lawyer 196
McConvill J, ‘The Separation of Ownership and Control Under a Hypothesis-Based Theory of the Corporation’ (2005) 26(2) Company Lawyer 35
Valsan R, ‘Board Gender Diversity and the Enlightened Shareholder Principle’ (2016) 37(6) Company Lawyer 171


Official Publications

Company Law Review Steering Group, Building on the Work of the Law Commission's 1998 (Paper 261 London 1999)
Law Commission, Shareholder Remedies: Report on a Reference Under Section 3(1)€ of the Law Commissions Act 1965 (Law Com No 246 1997)


Working Papers

Du Pleiss J, ‘A Comparative Analysis of Directors’ Duty of Care, Skill and Diligence in South Africa and in Australia’
Keay A, ‘Moving Towards Stakeholderism? Constituency Statutes, Enlightened Shareholder Value and All That: Much Ado About Little? (January 4 2010)
Kershaw D, ‘The Rule in Foss v Harbottle is Dead; Long Live the Rule in Foss v Harbottle’ (LSE Law, Society and Economy Working Papers 5/2013 2013)

Conference Papers

Sealy L, ‘Directors “Wider Responsibilities – Problems Conceptual, Practical and Procedural’ (Conference Paper AULSA Conference 25 August 1987)
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Article published 25/05/2017

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