Codification of Directors Duties was Unnecessary

The codification of directors’ duties was an unnecessary step. ‘The enacted duties do not differ substantially enough from their equitable and common law counterparts to warrant placing them in statute, and the courts will still need to refer to pre-2006 case law when determining whether or not a breach of duty has occurred.’

This paper will focus on who directors are, discuss their duties as performed under common law and equity and their general duties as codified under the 2006 Act. This paper will also reinforce arguments that the codification was unnecessary. The codification to a layman may seem as if it is a mere documentation of the common law rules, it is in fact an expression of the developmental changes in corporate practice over the years in more authoritative form. It remains a fact that this area of law had been built by the courts over the past 150 years and cannot be easily disposed of. However, ‘a higher sense of duty and better clarity for today’s company director’ prompted this change. This notwithstanding, case law precedence in this area has continuously reviewed itself with time and developmental changes.

The act [1] defines directors to ‘include any person occupying the position of a director, by whatever name called’. In this paper ‘directors’ will refer to executive and non-executive directors (NEDs); also shadow directors especially as concerns public limited companies. [2] This is because the act requires one and same level general duties of them; it does not factor in the possibility of information asymmetry which may occur due to the nature of duties required of them. This is not to say that the NEDs may not owe additional duties as specified by their contract of services [3] .

The relationship between directors and the company is an impersonal one of ‘agent’ and ‘company’. Similarly their duties include duty to the company itself and not the shareholders, the general public or its employees. The concept of the relationship will ordinarily be difficult to understand in contrast to the other stakeholders of a company. Therefore it is of importance to differentiate between accountability and responsibility. Directors have responsibility to use their powers in ways best for their company and its shareholders. They are accountable to the owners for the ways in which they exercise their powers and or the performance of their duties. Where a director is found in breach of his duty to the company, he may be liable to give account. This is peculiar to each individual company however in extreme cases of misbehavior one of the possible avenues of redress is an initiation of a legal proceeding by the shareholders on behalf of the company.

In the past directors had no duties but the company had a number of duties and obligations however they could be personally liable in certain circumstances as coveting company businesses for themselves. Before the companies act, the only common law duties of directors were fiduciary duties and duties of skill and care to the company. These duties are now enshrined in the new companies act. [4] It states that these general duties ‘are based on common law rules and equitable principles as they apply to directors, and have effect in place of those rules and principles as regards the duties owed to a company by a director’. [5] It furthers its wordings by saying that these general duties should be interpreted in the same way as the common law rules and equitable principles, bearing in mind that regard should be had to the corresponding common law and equitable principles in interpreting or applying the duties. [6] There are seven duties enumerated in the act and will be treated accordingly. [7]

Incidentally, understanding of the common law duties is of importance. Under the UK law, directors’ ‘fiduciary duty’ means to be given in trust for the benefit of another, the ‘company’. This was invented and promoted by the court of chancery in the eighteenth century as an obligation to ensure that people who held assets and acted as agents on behalf of others ‘did so in good faith and protected the interest of those they represented’. [8] This evolved into equitable principles based in loyalty and honesty. Where a director is found to be in breach of his fiduciary duty, a legal action could be instituted against him by the ‘company’ represented by a majority of the shareholders or a single controlling shareholder or even a majority of the board of directors. This breach could be a singular action or a series of actions by the director concerned. Where the courts find such a director in breach of his fiduciary duty, it might order him to compensate the company for any loss it has suffered and account to the company for any personal profit made just as available under the common law in trustee and beneficiary relationships. [9]

Similarly, the required duty of skill and care is ancillary to their fiduciary duty. A director is not expected to act negligently in carrying out his or her duties and may be personally liable for losses suffered by the company as a consequence of such negligence. [10] The standard of skill expected here is higher than that which would be objectively expected of a director of a company. In Dorchester Finance Co ltd v Stebbing, [11] it was held that directors were liable to damages as they were held to have failed to show necessary level of skill and care in performing their duties as directors, though in this case the NEDs were accepted to have acted in good faith. The common law duty of care was equated to the statutory test applied by the Insolvency Act 1986. [12] The duty of care and skill does not cover the time spent in the company, the reality is that directors are only expected to attend board and committee meetings were possible. Duty of skill and care does not also involve directors watching closely over the activities of the company’s management as this is delegated to them as a routine except where on particular grounds as gross incompetence or dishonesty; while this provision does not absolve them of the duty supervise and exercise independent judgment. It is pertinent to note that the courts are generally reluctant to condemn decisions made by NEDs which show negligence because reasonable care and skill could be taken and still result in a bad decision for a number of reasons. [13] For a personal action against a director to succeed the company would have to prove that serious negligence had occurred. However it must be noted that an action for an avoidable loss has no grounding as a result of the bad decision as if more care was taken. [14] In Re’Jan the director was found guilty of a breach of duty of care but was exonerated on other grounds because directors are rarely sued for negligence during the lifetime of a company but enforcement may take place during liquidation when the liquidator may proceed against the director for wrongful trading provisions or disqualification of proceedings. [15]

The general duties of directors as introduced into statute remain a re-enactment of its common law counterparts. The main reason given by the government for the codification of directors’ duties is to provide an authoritative identification of those duties. This was consequent to legitimatizing proposals of the company law review by the government. The recommendation was based on the need for clarity on the probity expected of directors. The law and Scottish law commissions also recommended a statutory recital of a director’s main fiduciary duties and the duty of care and skill. While it was the belief of the government that it will enhance certainty, accessibility and consistency. Professional advisors also believed that codification would bring benefits of £30 million to £105 million per year (Data from the 2002 White Paper) as it is envisaged that directors will require less advice in this area. [16]

Therefore no major divergence moreover precedence of case laws grounded in common law principles still form a major source of reference for any issues that may arise as a result of breach for any of these new duties. [17] It is still as vague, stirs interpretation problems and undeniably does not exhaust all the possible duties of directors. A conclusive effect of the codification has therefore not been reached with this step and this was confirmed by Lord Goldsmith, Attorney-General, [18] who said it was a way to enable the general duties develop in line with appropriate developments globally.

The general duties provide for directors to promote the success of the company; to function by the provisions of the company’s constitution and for proper purposes; to exercise reasonable care, skill and diligence; to exercise independent judgment; to avoid conflict of interests; to declare interests in proposed transactions and not to accept benefits from third parties. Most of which have existed in common law and equitable principles and also in statutes such as the companies act 1985 (the 1985 Act) as amended by companies act 1989.

There is no controversy about the duty of directors to act within their powers; [19] therefore no change in practice. Surely, directors’ derive their powers from their company constitutions and should exercise it for proper purposes only. A proper duty carried out in an improper way cannot be ratified while a proper duty outside the constitution may be ratified by members. [20] This is peculiar to each individual company but widely accepted in many jurisdictions.

The duties to exercise independent judgment and expend reasonable care, skill and diligence, [21] also do not also hold any significant changes in law. In reality they both work simultaneously and have actually existed in the form of the duty of reasonable care and skill under the common law; the split into two different duties is rather intricate. The level of care and skill required of a director had earlier been laid in Re City Equitable Fire Insurance Co that: [22] ‘a director need not exhibit any skill greater than that may reasonably be expected from a person of his knowledge and experience’. A more modern approach has been adopted in Dorchester finances’ whereby non-executive directors are now required by law to play more independent roles on the board. [23] The ‘exercise of independence ordinarily leaves no room for shadow directors, but in practice as seen in Dorchester’s case a director will not be in breach where he honestly follows someone else’s judgment in an area of specialty to inform his own ‘independent judgment’ or where the act is in accordance with the company constitution. The codification is therefore an unnecessary hype and paper work for professionals in this area to include the new rules in their work in order to demonstrate evidence of up to date research work since nothing has changed in reality. The law clearly shows that it refreshes it self and is not inactive as the new rules suggest.

The duty to promote the success of the company, [24] is newly developed from one of the common law fiduciary duties; i.e. duty of good faith to act in company’s best interest. This is the first time directors’ duties regarding environmental and social impact of their companies has become so important to be codified. This duty is divided into two parts which is the bona fide duty to the company and the subjective duty; the discharge of which is set out in the non-exhaustive list in section 172(1)(a)-(f). This includes the most important long term consequence of shareholders wealth which the act intends. The difference of the earlier from the latter can be seen in the language used by the courts to describe the obligations of a director as ‘bona fide in the best interest of the company’ while the act retains the obligation of good faith to the company, it extends this benefit ‘with regards to’ the members as a whole, employees; the community; and suppliers and other stakeholders. This is perhaps the most debated of the duties, first because of the language reconciliation differences and secondly as it allows the director to act in the way he ‘considers’ in good faith. Both which are relative in context and use. The word ‘to have regard’ used in this section allows the director to do what ‘he thinks’ good for the company which should ordinarily translate into promoting the company encompassing all the provisions. [25] The provisos also require some other obligations of directors such as their actions in the interests of creditors, for many companies, this is a regular issue. [26] One would ordinarily have thought that each company should be able to determine its own success strategy and not what the government or society who have no immediate or direct monetary interests.

The conflicts of interest duty provides that ‘a director must avoid a situation in which he has or can have a direct or indirect interest that conflicts, or possibly conflict with the interests of the company’. [27] This is a contradictory change to the previous conflict of interest rule established under the equitable principle of a fiduciary not to position himself in any act that may conflict with his personal interest and the trust in his care given that the company’s assets and business information is under the control of the director as it were. Before the commencement of this rule in October 2008, a director in this sort of situation would unsurprisingly absent himself from board meetings in order to at best avoid confrontations and mitigate a possible conflict of interest. It is however different under the new rule, as he is not allowed to be in that position in the first place except the board had assented to it previously. [28] This may allow for a formalization of the procedure of taking multiple directorships. It does not however change the position of the universal application that:

‘…no one, having such duties to discharge, shall be allowed to enter into engagements in which he has, or can have, a personal interest conflicting or which possibly may conflict, with the interests of those whom he is bound to protect… [29]

Though this rule has rather been mitigated; with the relaxation rule on authorization allowing the board of public companies to validate an interest of a director which conflicts with that of the company. This clearly leaves the shareholders powerless. Again, they are assured that the directors will act in the best way to promote the success of the company or else be liable for breach of duty. [30] Disclosure also extends to proposed transactions under section 177; [31] this is a replacement of the equitable rule that directors could not have interests in transactions unless authorized by shareholders. Today where directors have any interest in a transaction, full disclosure should be made to the board. Surely it will be impossible to compete with the company either directly or indirectly without conflicts of interests arising; [32] the intention of this provision also is far fetched because the common law position of avoidance is better now and in the future no matter the procedure taken to ratify such acts. At best the new position would have been to turn down certain directorships rather than full disclosure which are now to the board and pushing judgment day further. [33]

Directors should not accept benefits from third parties. [34] This easily takes queue from the duty to avoid conflict of interest because the of the existing common law rule prohibiting exploitation of the position for personal benefits. This does not relate remuneration from the company; it is actually calculated towards third party benefits. [35] Though a new rule, it also makes no difference; common sense should apply here. Conflict of interest between what a gift and a benefit received by a director should be weighed with the effect it will have on a decision to be made for the company. The only exception is where the company constitution allows for a declaration of such gifts or that it so minute to influence a decision. This proviso gives rise to criticisms as the point aspired to be made is not clear cut and should not have been separated from the conflict of interest rule. Therefore the common law rule which allows constitutions to allow directors accept gifts still suffices in this case.

Conclusively, the timing of the codification exercise appears premature since the legislature clearly did not have the imperative need for an overhaul of this area of law. The statement of the duties is not exhaustive and this will increasingly shove directors into circumventing the law rather knowing what is required of them as directors; shadow directors are still not aptly provided for and the common recourse still remains concerning them. The issue of long term success of the company in section 172 will allow for endless debates between the enlightened shareholder school of thought and the pluralists who think that the codification now accommodates their views as directors are now expected to give equal attention to shareholders, creditors and employees under the act. It will allow for a whole new load of paper work for everyone; directors, company secretaries, management executives and even the courts. The inflexibility of the codification will not allow for actual development; stalling proactive approach to corporate governance and understanding the company’s affairs until the statute is revised again unlike what the approach of the courts employed over the years to the duties and the breaches. It has ultimately allowed for unnecessary criticisms for the laudable inclusion of an authoritative form of the directors duties into statute for the first time since it did not depart from the common law counterpart even in breach. However, it is no news that the breach of directors’ duty remains civil violation and can obtain no more than civil remedies as injunctions, compensation, or recession of contract, [36] with exception to the duty exercise reasonable care, skill and diligence. For one thing, a director can identify with his fiduciary duties by simply acting loyally to the company and exercising the level of skill he required of him. He still needs legal advice because the statute is still as vague even though it has been campaigned to have been simplified. The codification of directors’ duties could instead serve to undermine certainty in this important area of the law.