Reforming The Liability Of Directors In UK Law

Should UK Company Law adopt the Business Judgment Rule with an Enhanced Duty of Good Faith?

Reforming Director Liability in UK Company Law

1.0 Introduction:

1.1 Statement of Problem:

Director liability is of especial concern within company law because there has to be the correct balance between lifting the corporate veil and holding the director who has failed in his/her duties to account^[1]. The Companies Act 2006 (CA 2006) has formulated a number of directors’ duties that are based upon the common law; however, there has been enhancement of this framework, which has given rise to the new enhanced shareholder value (ESV) model^[2]. The introduction of the ESV model is integrally linked to an attempt to increase the responsibility of directors, whilst retaining the internal management model^[3]. The system did not go as far as to introduce a statutory corporate governance model, which is the route that the USA went through the Sarbannes Oxley Act 2002 (SOX 2002). A potential problem that arises in the UK model is that it has not gone far enough to enforce directors’ duties. A better approach may have been to introduce an enhanced good faith obligation (as opposed to the weak reference in the CA 2006) and then provide the American-Style business judgment rule defence. The purpose of this research is to examine directors’ duties under the CA 2006, in order to ascertain whether they are fairly holding the director to account. The introduction of the business judgment rule is giving the director an additional defence but this defence is only appropriate when the directors’ duties have been developed to ensure that there is a high level of liability present^[4]. MacMillan identifies that:

“The business judgment rule ensures that decisions made by directors in good faith are protected even though, in retrospect, the decisions prove to be unsound or erroneous. It provides a deference to prevent courts from second-guessing business decisions that were made in good faith”^[5].

There is a link to the concept of good faith is present within English law under the CA 2006’s director’s duties, although there is the fundamental problem that arises in the fact there has been a failure to develop these principles into an effective model of ESV^[6]. The current model does not hold the director to account sufficiently, although in abstract the CA 2006 could^[7]. The next issue that one has to be consider is how the courts need to interpret director’s duties, in order to increase liability because this was the purpose of the CA 2006^[8]. This would need to be coupled with the business judgment defence because there may be instances of a good faith decision that turns out to be a breach of director’s duties^[9]. Thus, the defence applies to prevent an injustice^[10].

This research argues that a better approach to achieving the ESV envisaged by the CA 2006 is to increase the threshold for escaping liability for breach of director’s duties (i.e. enhancing the good faith application) and then applying the business judgment defence. This paper will examine the nature of director’s duties under the CA 2006, the effect of the English common law and then compare it to the approach taken in the American common law where good faith and the business judgment rule operates.

1.2 Aim and Objectives:

The aim of this research is to evaluate whether American-Style enhanced director’s duties based upon good faith coupled with the business judgment rule should be implemented into UK company law. To meet this aim, this research will:

• Examine the nature of company law within the Anglo-common law system;
• Examine the nature of directors’ duties within English law, considering both the common law and new statutory system under the CA 2006;
• Examine directors’ duties in the American common law and the operation of the business judgment rule;
• Analyse whether American style directors’ duties and the business judgment rule should be implemented into UK company law.

1.3 Methodology:

This research will undertake a comparative case law study of English and American approaches to the application of directors’ duties. The purpose of the comparative study is to ascertain whether it is possible to implement the American model in the UK^[11], whilst bearing in mind whether the American model is in fact an improvement on the current approach within the CA 2006. The American model provides a good case study country because its roots are in the English common law, which means that the same basic legal culture is present that enables the UK model to lend from the American model (and vice versa)^[12]. The fundamentals to validate a comparative legal approach is present. Although a case law review is at the centre of this comparative study, it will not be focusing upon a purely black letter law approach^[13]. Instead a purposive approach has to take place^[14], especially when the CA 2006 does enhance directors’ duties but the case law does not necessarily reflect this. Therefore, a comprehensive and purposive application of the law will take place, in order to determine whether there has to be further reform of directors’ duties and the implementation of the business judgment rule in the UK.

1.4 Chapter Synopsis:

This research will consist of four chapters, which are as follows:

Chapter 2.0: This chapter will examine the nature of company law within the Anglo-common law system, which underpins both English and American model. The Anglo-common law model of corporate governance relies upon the indoor management rule, which focuses on the autonomy of the company contract. The divergences of the US and UK approaches will be briefly touched upon.

Chapter 3.0: This chapter will examine directors’ duties within the CA 2006 and the common law development. The purpose of this chapter is to explore the traditional approach to directors’ duties and then engage with the ESV model that the CA 2006 duties are meant to embrace. Two questions will be raised, which are: (i) has the ESV model been achieved; and (ii) does there have to be further enhancement of directors’ duties.

Chapter 4.0: This chapter will explore American common law directors’ duties and compare them to the English approach, as identified in Chapter 3.0. The discussion will focus on the different approaches to good faith within the context of directors’ duties, in order to highlight how the American common law provides a more enhanced obligation. Then it applies the business judgment rule to soften the effect of the enhanced duties. Thus, this chapter will conclude by considering whether the American approach to directors’ duties with the business judgment rule should be implemented into UK company law.

Chapter 5.0: This chapter will conclude with a concise summary of findings and recommendations that answer the question whether there should be a good faith enhancement of directors’ duties and the introduction of the business judgment rule in the CA 2006.

2.0 The Anglo-Common Law Roots of Corporate Governance The Indoor Management Rule:

2.1 The Internal Management Rule An Overview:

The indoor management rule is at the centre of the English common law model where the primary concern is that the company is governed by itself with little intervention by the courts/legal framework^[15]. This means that any legal framework has to be based upon the general premise of supporting the company contract, although there is a valid concept of promoting sustainability in maintaining the company within a framework of national standards^[16]. Kraakman et al identify that within the Anglo-common law model, “the primary corporate governance issue is considered to be ameliorating managerial agency costs rather than limiting self-dealing by major shareholders”^[17]. This means that the primary concern of company law is to promote self-governance and policing by the shareholder body by ensuring that minimum standards of corporate governance are met. The exact implementation of this self-dealing varies because English law retains the voluntary code^[18], whilst the USA applies a legislative approach under the Sarbannes Oxley Act 2002 (SOX) and stakeholder legislation^[19]. This research is not going into the fine difference between the legislative and voluntary responses to corporate governance. The main principle that has to be borne in mind is that corporate governance is based upon internal management where the law supports the minimum standards that are owed to the company.

2.2 The Internal Manager The Director:

The director is the internal manager of the company who is governed by the company contract (Articles of Association and any other constitutional agreement) and decisions of the voting body (i.e. shareholders)^[20]. This integrative model stems from the theory of Adam Smith, which provides that:

“The directors of such companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own… Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company”^[21].

The general premise of the Smithian model is that a self-interested person is the best person to be involved in the policing and managing of the company^[22]. This means that the shareholder manager is the most appropriate party to promote the best interests of the company^[23], because if there is mismanagement there will be an economic effect on the company’s bottom line^[24]. This has proven not to be entirely the case of the most modern version of the Cadbury Code in the UK (i.e. the Corporate Governance Code 2012 (2012 Code)), which retains the comply and explain approach whilst introducing a number of minimum expectations that should be followed by directors to have a sustainably managed company.

2.3 The Indoor Management Rule, Corporate Governance Codes and Directors’ Duties:

The 2012 Code provides that the “comply or explain” approach is the trademark of corporate governance in the UK. It has been in operation since the Code’s beginnings and is the foundation of the Code’s flexibility”^[25]. This means that the flexibility of the model will retain the internal management model but the 2012 Code provides best practice^[26]. The SOX application of the USA applies a similar model but it is enshrined in a statutory duty as opposed a code of best practice. The fundamental common law principle of internal management is identified in the case of Shaw & Sons v Shaw^[27]where the management of the company is undertaken by the directors appointed in the company constitution, which is then policed by the shareholders through voting rights. Thus, for this model to operate effectively it is necessary that there is effective and proactive policing by the shareholder body, which is less prevalent due to the nature of large companies becoming dispersed with institutional investors becoming representative of mass shareholder units^[28]. The result of this is that shareholder governance is becoming more of a myth because the individual shareholder may not effectively exercise their rights^[29], which enables the potential for abuse by directors and the majority because the opposing voice may not be heard^[30] or there is such a dispersion that there is a lack of knowledge of wrongdoing because there is not a direct check and balance as seen the Enron scandal^[31]. Thus, the development of prudent legal principles, in order to ensure that there is an effective policing model in place within the context of the internal management rule.

The CA 2006 and SOX 2002 are examples of implementing legislation to bolster director liability within international law by adding additional tools to counter the dispersing of shareholder power. Friedman argues that:

“There is one and only one social responsibility of business–to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud”^[32].

The implication is that the director has a broad latitude in his/her management of the company, as long as he is acting within the scope of the company’s constitution and is promoting the success of the company^[33]. The main problem is that without an affective check and balance through shareholder policing then the internal management model can fail^[34]. Thus, the introduction of corporate governance codes (or laws in the USA) were implemented to raise standards.

2.4 The 2012 Code, Internal Management The Need for Further Implementation:

The Cadbury Code identified that “corporate governance cannot be achieved by structures and rules alone. They… encourage and support good governance, but what counts are the ways in which they are put to use”^[35], as long as coupled with responsible directors. The common law was identified as being insufficient, which resulted in the evolution of the Cadbury Code to the 2012 Code and the implementation of enhanced directors’ duties under the CA 2006. The 2012 Code provides that there has to be promotion of five core requirements for sustainability, which are: leadership, effectiveness, accountability, remuneration and relations with shareholders^[36]. The lynchpin of sustainable company management are the application of directors’ duties that promote responsibility. The 2012 Code supports this principle but identifies additional principles that directors and companies should follow to promote the success of the company.

Principle A1 of the 2012 Code states:

“Every company should be headed by an effective board which is collectively responsible for the long-term success of the company”^[37].

The long-term success of the company requires the directors to consider the role of shareholders and other parties that are essential to the effective management of the company^[38]. This means it builds upon the CA 2006 reforms, which emanates from the Law Commission’s Company Law Review in 2000, which provided that success requires “proper balanced view of the short and long term; the need to sustain effective ongoing relationships with employees, customers, suppliers and others”^[39]. The directors’ duties in the CA 2006 enshrines this principle through extending the application of tem where company success includes more normative concepts, such as reputation as opposed to merely the bottom line. Nonetheless, the traditional principles of company success and the bottom line has been retained within the case law, even after the implementation of the CA 2006^[40]. The inference is that it is necessary to heighten these directors’ duties further, which is what is being suggested within this research whilst adding the business judgment rule.

The UK has adopted a mixed statutory and voluntary model, in order to promote good company governance. For example, it was recognised that the traditional shareholder-director relationship has changed, which means that there has to be added safeguards. One such example is Principle A4 of the 2012 Code, which provides that “non-executive directors should constructively challenge and help develop proposals on strategy”^[41]. This means that non-interested directors has been introduced to provide an objective monitor. This monitor can help to achieve Principle E4 of the 2012 Code, which identifies that:

“There should be a dialogue with shareholders based on the mutual understanding of objectives. The board as a whole has responsibility for ensuring that a satisfactory dialogue with shareholders takes place”^[42].

This dialogue is essential to promote shareholder policing, which is at the centre of the internal management model. The fundamental problem is that this model may not have the correct balance between the statutory and voluntary elements of a modern internal management model. The ESV model that the CA 2006 may have the potential of achieving this aim, but there has to be examination of the application of these duties to determine whether further reform is required. This research is going to engage with directors’ duties under English law and then move on to the American model.

3.0 Directors’ Duties under the CA 2006 and the English Common Law:

3.1 The Basis of Director’s Duties:

Directors’ duties are fundamental to the indoor management rule because they are the check and balance to the power that the director has. The power of the director can be linked to the majority or certain elements of the shareholder body to create self-interested allegiances that may result in oppression of the minority and undermine the sustainability of the company^[43]. This means that the role of directors’ duties are important to ensure that such actions do not take place. This means that the court should have sufficient direction to uphold directors’ duties. If this is lacking then there will not be a balance between internal management and prudent legislation that is capable of providing the sufficient safeguards that are capable of preventing abuse of director power. Wan argues that:

“The court should scrutinise the decision-making process of the board to ensure that the board considers the stakeholders’ interests and that the board acts fairly in considering the long-term and short-term shareholders’ interests”^[44].

The fundamental problem that arises is that the internal management model relies upon minimal intervention by the law, which means that the balance between intervention and internal management is paramount. The basis of the English and American directors’ duties have the same foundations, which is identified by Eisenberg as a “standard of “care that an ordinarily prudent person would reasonably be expected to exercise in a like position and under similar circumstances”^[45]. This standard of care is “both subjective and objective. The director or officer must subjectively believe that his conduct is in the best interests of the corporation, and that belief must be objectively reasonable”^[46]. This means that if the prudent person would not act in a similar manner then it is unreasonable and there is a breach of directors’ duties if the intention is associated with either a willful or reckless act^[47]. The CA 2006 has attempted to find this balance through the ESV model; nevertheless, the problem is that this standard may not have been met due to the courts failing to apply a purposive approach to the enhanced directors’ duties.

3.2 Who is the Director?

If the internal management model is to be effective then it is necessary to implement legislation that creates an effective check on the power of directors. The ESV model of the CA 2006 has taken this aboard and extended the definition of a director. There are two potential director groups, which are: (i) those individuals that are named in the company’s constitution; and (ii) individuals that have the control or power to influence the management of the company (i.e. a de facto/shadow director). The first group is linked to the constitutional framework under s. 33 CA 2006 and confirmed in s. 250 CA 2006. The second group has been recognised in s. 251 CA 2006, which provides “in the Companies Acts “shadow director”, in relation to a company, means a person in accordance with whose directions or instructions the directors of the company are accustomed to act”^[48]. The statutory recognition of shadow/de facto directors is an important development because it means that there is an extension of the statutory directors’ duties to these individuals, which confirms the common law principle that a controlling shareholder that influences the management of the company will be treated as a director^[49]. A shadow director will be identified either through direct or implied used of power^[50]. Power can be held by a shareholder where there is a history of deference to the individual that is maintained^[51]. The primary question that is asked is whether there is a person outside of the board that has equal or more power than the directors named in the company constitution^[52]. The flexible principles that surround who is a director illustrates that the courts will take a purposive approach to identify who has controlling power in the company, even if s/he is not named in the company constitution. The implication is that the myth of the common law merely respecting the company constitution is not strictly true, which indicate that there are ways to challenge the sanctity of the company contract when it is reasonable to do so.

3.3 Directors’ Duties An Evolution:

The fundamental principle is that the director has to act reasonably within the powers provided for in the constitution, in order to promote the best interests of the company^[53]. There will not be liability for a bad decision, as long as the director has acted in a manner where it can be reasonably shown that his/her actions were grounded on promoting the best interests of the company^[54]. The fundamental problem is to ascertain what is in the “best interests” of the company (i.e. should it be based upon the bottom line or is there a need to consider a broader set of interests^[55]). The traditional interpretation has been linked to the bottom line and following the direction of the majority^[56]. The problem with this application is that it can result in the marginalisation of the minority and the sustainability of the company can be sacrificed for the bottom line^[57]. The introduction of the CA 2006 was to clarify directors’ duties, in order to promote sustainability within the management of the company^[58]. The following section is going to examine these duties and how they emanate out of the existing common law.

Section 170 provides that the existing directors’ duties are not to replace the common law; rather there is meant to be enhancement of the common law through codification. As s. 170(3) CA 2006 provides:

“The general duties are based on certain common law rules and equitable principles as they apply in relation to directors and have effect in place of those rules and principles as regards the duties owed to a company by a director”.

This means that the common law remains the source of interpreting the directors’ duties set out in ss. 171 to 177 CA 2006, which means that there may be little effect of the ESV model if the common law is not approached with purposive interpretation by the courts^[59]. The primacy of the deference to the company constitution and consequently the majority rule principle within the common law is retained in s. 171 CA 2006. Section 171 CA 2006 provides that a director must: “(a) within the powers that have been given through the company’s constitution; and (b) exercise these powers within the limits prescribed by the constitution”^[60]. This requirement is necessary to the internal management rule; however, the problem that arises is that without greater direction whether there should be an enhanced examination of the sustainability of the company then the enhancement of directors’ duties has not occurred.

Probably one of the most important sections on directors’ duties is s. 172 CA 2006 because it provides that the 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”^[61]. The use of this terminology could be broadly interpreted. Nonetheless, the fundamental problem that occurs is the terminology seems to be retaining the highly traditionalist approach set out in the common law. The traditional standard that is owed by the directors’ duties is set out in the seminal case of Aberdeen Railway Co v Blaikie Brothers^[62], which held that:

“A corporate body can only act by agents, and it is of course the duty of those agents so to act as best to promote the interests of the corporation whose affairs they are conducting”^[63].

The fact that s. 172 CA 2006 starts with the traditionalist internal management framework does seem to support the critics of the codification of directors’ duties for failing to meet the ESV that was envisaged^[64]. This seems to be confirmed in Re West Coast Capital (LIOS) Ltd^[65] and Cobden Investments Ltd v RWM Langport Ltd^[66] where the traditionalist view set out in Aberdeen Railway Co v Blaikie Brothers was maintained. Consequently, there seems to have been little difference in the interpretation of directors’ duties because the duty to promote the success of the company remains the primary obligation owed. Nevertheless, s. 172 CA 2006 has been enhanced by what factors should be considered by the directors when considering what is in the best interests of the company. These factors include: (i) the examination of the long term effects of a decision^[67]; (ii) what is in the interests of the employees^[68]; (iii) how to foster relationships with suppliers, customers and other business interests^[69]; (iv) to evaluate how a decision by a company will affect the environment and local communities^[70]; (v) whether the decision will uphold the reputation of the company, including maintaining industry standards of good corporate governance and social responsibility^[71]; and (vi) to ascertain whether the decision will be fair to all members (shareholders) of the company^[72]. The application of this section is not expected to be an exhaustive list of duties; rather, it is to identify that there are a broad set of considerations with every decision that the company makes. Nonetheless, it needs to be reiterated that the primary concern is the best interests of the company as identified in Re West Coast Capital (LIOS) Ltd^[73] and Cobden Investments Ltd v RWM Langport Ltd^[74] that links to the bottom line. Thus, it is unlikely that the other issues that are contained within s. 172 CA 2006 will be treated as the primary interest if it can be shown that the decision is promoting the majority financial interests and the bottom line of the company.

3.4 Directors’ Duties Merely a Reiteration of the Common Law:

The concept of enhancing directors’ duties through the codification of the common law is unlikely to promote more sustainable directors if there is a failure to promote the considerations of s. 172 CA 2006 above and beyond the bottom line^[75]. The obligation of the director is to promote the best interest interests of the company by exercising independent judgment utilising the powers given to the director within the company’s constitution^[76]. The standard that this owed is set out in s. 174 CA 2006. The preliminary obligation is set out in s. 174(1) CA 2006, which is that “a director of a company must exercise reasonable care, skill and diligence”. This standard represents the obligation linked to promoting the best interests of the company because this level of skill must be used^[77]. Section 174(2) CA goes on to clarify what is meant by reasonable care, skill and diligence where it is held that:

“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 operation of s. 174(2) CA 2006 identifies that there is both an objective and subjective standard, which makes sense because a legal or financial director should have heightened obligations due to the level of knowledge and skill that s/he has^[78]. The common law will allow for the director to delegate his/her duties, as long as it has been done in a reasonable manner^[79]. The standard has been set in Re City Equitable Fire Insurance Co. Ltd^[80], which has a low threshold to be satisfied. This indicates that as long as the director is generally acting in a reasonable manner with the intention to promote the best interests of the company then there will not be a breach of directors’ duties. Nonetheless, the case law does indicate that each case will be determined on its facts although the standard set in Re City Equitable Fire Insurance Co. Ltd^[81] remains the accepted obligation owed by the director^[82]. The use of reasonableness as the way to find liability indicates that the business judgment rule could be present within English law but it has to be breached for liability to be found, which means that it will be very difficult to show that there has been a breach of directors’ duties unless the actions of the director is absurd.

The remaining sections further clarify the common law standards seem to apply to the tests set out in ss. 172-174 CA 2006. Section 175 CA 2006 provides that “a director of a company must avoid a situation in which he has, or can have, a direct or indirect interest that conflicts, or possibly may conflict, with the interests of the company”^[83] unless authorisation has been given by the board to undertake the disclosed duties^[84]. All votes that are taken on authorisation has to take place without that of the interested director^[85]. The conflict of interest will be any contract/activity that will be competing with the business purpose of the company and/or reasonable restrictions identified in the company contract because there is a duty of loyalty owed by each director^[86]. It is also important to stress that authorisation does not have to be formal; rather it is possible for acceptance of potentially conflicting actions will be allowed as long as appropriately disclosed^[87]. The main concern is to show that the director has not acted in a conflictual manner that undermines the best interests of the company^[88]. It is the conflict of interest standard that gives rise to the duty not to accept benefits from third parties when related to activities of an individual is acting in his/her capacity as a director^[89]. Thus, the duties that have been developed in the CA 2006 are merely a codification and arguably a clarification of common law duties, which potentially will maintain the status quo (as identified in Re West Coast Capital (LIOS) Ltd^[90] and Cobden Investments Ltd v RWM Langport Ltd^[91]). Arguably there has to be a change in how di