Directors Duties and Corporate Governance

As I have discussed in the previous chapter that corporate governance aims for the efficiency of a company by protecting the interest of shareholders, customers, suppliers etc. In this chapter I will be focusing on the impact of corporate governance on to the director’s duties and how issues regarding the corporate governance in a company have led to the development of Director’s Duties in the modern world.

After the enactment of Limited Liability Act in 1855, it was clear that shareholders of a company are not liable for the debt of the company but there was a continuous need of a governing body to regulate the conduct of the company management [1] . As a result in 1862, First Major Consolidation in the companies act was formed [2] . The act established legislation which later became a part of the common law so as to govern the conduct of the companies. This led to formation of a uniform statutory framework for the limited liability companies but it still remained silent on the specific duties regarding the directors [3] . As a result the general issues regarding the corporate governance were left out [4] . Therefore, it was for the courts to interpret the duties of the director on the principle of equity, derived from the laws of trust along with the common law duties so as to overcome the issues related to corporate governance [5] . Latter on while addressing the corporate governance issues, it was made clear by the courts that directors of a company must be regarded as the trustees of a company whose role is to manage the firm assets [6] . Thus the court pointed out three duties on the part of the director i.e.

A director needs to act in a good faith and must act in accordance to the best interest of the trust.

The director must exercise his power for proper purpose

A director must avoid conflict of interest (fiduciary duty)

Although these duties were laid down but still there was a problem in determining the state of mind of a director so as to find out if he has acted in a good faith or not [7] . It was hard to prove the intention and look into the conduct of a director in order to determine the purpose. Similarly, it was a tough to challenge the motivation of director in context to his self interest and to make him liable under the breach of duties [8] . As a result the directors became negligent and started to ignore the interest of shareholders, suppliers, customers etc which ultimately started to affect the performance of a company [9] .

To address the growing concerns of the stakeholders regarding the effectiveness of corporate governance in a company, it was in the year 1980 that the principle of corporate governance was established [10] . The principles of corporate governance brought some relief to the stakeholders who were associated with the company. It focused on improving the corporate governance practice in the company by determining the role and responsibilities of the directors in context to their duties. But it in the year 1999, when the 1st publication of Company law Review Steering Group (CRLSG) [11] , that brought a revolution in the field of company law reform. On February 1999, CRLSG, published its 1st document [12] and demanded for “Enlightened shareholder value” model for effective corporate governance. In response to the CRLSG, in September 1999, Law Commission published its report and recommended that codification of Director’s duties needs to be recognized as the statutory duty and should be codified in the statue with the existing case laws [13] . However the recommendations made by the Law Commission were not very welcomed by the CRLSG as the report focused on to discretion of the courts in interpreting the director duties in context to the existing laws [14] . As a result in March 2000, CRLSG recommended a more exhaustive code so as to make the law regarding the duties of the director much clear and accessible to all the directors of a company [15] . It also recommended reforming of harsh equitable principles concerning the conflict of duty and interest on the part of directors.

Now let us examine the Company Act 2006 and analyze the important changes adopted by the act in context to the director duties and corporate governance.

DUTIES UNDER COMPANIES ACT 2006

Since the formation of a company, there were certain Fiduciary Duties and common law duties imposed on the directors, which evolved through the case law. But on October 2008, Director’s duties were codified in the Companies Act 2006 with slight amendments [16] . Section 170 – 181 of the companies act provides for Director’s duties. To further break it down, Section 171 – 177 of the act deals with the general duties of the director while section 178-181 deals with supplementary provisions [17] .

A director being separate from the shareholders is responsible for the company management and should act in accordance to the interest of shareholders. A director is an officer of the company who is entrusted with the powers through articles of association, containing the provisions and restrictions in respect of the exercise of his power [18] . As a director of the company, he owes certain fiduciary duties, imposed by the common law and duty of care and skill. Most of these duties are now codified in the companies’ act 2006 [19] . In context to their Duties, directors are classified into two categories i.e.

(1) Directors (”de jure” director, ”de facto” directors)

(2) Shadow Directors

(1) Directors: there is no specific definition of director provided by the statue but section 250, companies Act 2006 provides a guidance so as to explain the term director i.e. ” a director includes any person occupying the position of a director by whatever name called”. It includes both ”de jure” director (who is properly appointed), ”de facto” directors (who simply acts as a director [20]

(2) Shadow Director: section 251 of the Companies Act 2006 defines shadow director ”in relation to company means a person in accordance with whose directions or instructions the directors of a company are accustomed to act”. the act further provides that ”a person is not regarded as a shadow director by reason only that the director act on advice given by him in professional capacity” [21] .

It is to be noted that a shadow director is quite different person from a de facto director. for instance, Miller J in Re Hydrodam (corby) Ltd [1994] 2 BCLC 180 [22] contrasted that a de facto director is a person who acts and purports to act as a director even though he is not validly appointed, while a shadow director does not claim or purports to act as a director. he is more like a shadow who shelters behind others to whom he claims to be the director of the company.Now the question is to whom these duties are owed by the directors?. The directors owe these duties to the company, its shareholders and to the creditors. Before we move forward and examine the director duties in detail, it is essential to look at the regulatory framework for director duties.

Duties of the director: According to Alistair Darling, “the act provides a code of conduct that sets out how directors are expected to behave [23] ”

Following are the 7 General duties codified in the Companies act 2006 i.e.

Duty to Act within Power

Duty to promote the success of a Company

Duty to Exercise independent judgment

Duty to exercise reasonable care, skill and Diligence.

Duty to avoid conflict of Interest

Duty not to accept benefits from third parties

Duties to declare interest in proposed transactions or arrangements with company.

The First 4 duties came in force on October 2007 while the later three duties came on October 2008 [24]

Duty 1: To act within power (Section 171): “A Director must act in accordance with the Companies constitution and only exercise his power for the purposes for which they are intended”

The main purpose of this duty is to keep a check a check on the improper motivation of a director. This “improper purpose doctrine” came in force so as to keep a control on the power of director. For instance in Piercy vs Mills & Co [1920] 1 CH 77, it was held by the court that the directors have power to issue shares for the purpose of enabling capital and for the advantage to a company but if the company is not in a need of capital, directors are not entitled to use their power so as to issue shares merely for the purpose of control or to defeat the majority of shareholders in target company. Again In Howord Smith Ltd vs. Ampol Petroleum Ltd [1974] AC 821, it was held by the Privy Council that the improper motivation is essential to establish unfairly pre –judicial conduct so as to prove a breach of duty. Thus the act made it clear that a director should act within his power and for the proper purpose. In exercising his power, the director’s act should be in accordance with the company constitution.

Duty 2:To promote the success of a Company (section 172): “A director of a company 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, and in doing so have regard (amongst other matters) to:

likely long term consequences

employees interest

need to foster the company’s business relationships with suppliers, customers and others

impact on the community and the environment

desirability of reputation for high standards of business conduct

need to act fairly as between members of the company [25] ”

Before the enforcement of the companies Act 2006, there was a common law duty on the directors to act in the interest of company. This objective was not definitive so as to resolve the continuous debate over whose interest needs to be protected i.e. shareholders or stakeholders. Section 172, Companies act 2006 replaced the common law duty on directors to act in the interest of the company with the “shareholder enlightened approach” [26] . The section made it clear that the meaning of success is to achieve the desired result while acting in a good faith. For instance in Re Southern Counties fresh foods Ltd [2008] EWHC 2810 [27] , the court compared the best interest of the company with success of a company and for the benefit for its members and concluded that the new phrase provides more readily understanding of the scope of duty. Section 172(2) [28] , makes it clear that it depends on the individual judgment of a director to decide that 1whether the purpose of the company is for the benefit of its members or for any other purpose. Again in Moore Stephens vs. Stone & Rolls Limited [2009] UKHL 39 [29] , the House of Lords held that the rephrased duty is not only restricted to common law rules and equitable principles but is also focused on the requirements of a director which he needs to consider so as to protect the interest of creditors(section 172(3)) [30] .

Thus, in my view, section 172, Companies Act 2006, is more like a corrective approach which came in force in accordance with the shareholders enlightenment so to promote the success of a company.

Duty 3: To Exercise independent judgment (section 173): “A director has a duty to exercise an independent judgment and it will not amount to an infringement if he has acted in accordance with the agreement duly entered by the company which restricts him to the future exercise of his discretion or if he has acted as per the company’s constitution [31] ”

To explain this let us take an example, if some of the shareholders of a company are against a particular contract, which is being entered into by a director of a company in the interest of the company or to promote the success, he should exercise his own independent judgment and ignore the voice of its shareholders and must vote in the favor of that contract. However, in a similar situation, if all the shareholders are against the particular contract, then the director should listen to it but again if it involves the interest of the creditors, the direct has to duty to act in accordance to his own judgment and can override the voice of the shareholders.

Duty 4: To exercise reasonable care, skill and Diligence (section 174): “A director must exercise reasonable care sill and diligence and in doing so he should apply general knowledge, skill and experience, which is reasonably expected from a person carrying out the functions of a director. [32] ”

Section 174 [33] , companies act 2006, is a significant reform made to the act. To explain this duty let us take an example, where a company appoints a Business Graduate (Human Resource) as marketing Director and an unqualified individual as a HR Director. Both these directors will be anticipated to exercise their required skills of a marketing director and HR director of a company. In exercising their functions, both these directors will not be excused on any lack of skill on the ground of being unqualified. In the recent case of Abbey Forwarding Limited (in liquidation) vs. Richard John Hone & Others [2010] WC2A 2LL [34] , Lord Lewison J. had a contrary view on the allegations of breach of duty under section 174 which were made against directors of a company in context to the exercise of reasonable care, skill and diligence. Lewison J. held that it is hard to prove a breach of duty regarding the due diligence on the presentation of evidence by only one individual.

In the current market, where the business world is struggling to recover from the financial crises, the directors should be in forefront of their duties as codified by the Companies Act 2006. In Lexi Holdings Plc (In Administration) v Luqman [2009] EWCA Civ 117; [2009] B.C.C. 716 [35] , the court of appeal held that directors should act in accordance to their duties and they cannot get away from the breach of their duties by delegating their tasks to others.

Thus a Director should be honest with his duties and must take it seriously. It is to be noted that a director should is consider the duties under section so as to collide with the duty to promote success of a company as the interest of the members of a company are of vital importance and therefore cannot be ignored (section 172) [36] .

Duty 5: To avoid conflict of Interest (section 175): According to this section , in order “to avoid conflict of interest, a director must avoid a situation where he has or can have a direct or indirect interest which conflicts or possibly may conflict with the interest of the company. The section applies particularly to the exploitation of any property, information or opportunity (and it is immaterial whether the company could take advantage of the same). However the duty under this section does not apply to a conflict of interest arising in relation to a transaction or arrangement with the company [37] “. It is the duty of a director to declare his interest in any of the arrangements or transaction with the company, whether it is for a proposed transaction (section 177) [38] or for an existing transaction (section 182) [39] . The duty is not infringed if the situation is unlikely to give rise to a conflict of interest or if the matter has been authorized by the director himself [40] . The authorization by a director depends on company to company. For instance in a private company, its constitution does not invalidate the authorization given by a direction. Similarly, in public company, the constitution allows directors to authorize. However it is to be noted that any authorization made by the board which allows the acceptance of benefits from third party (section 176) is not valid [41] . The authorization will be regarded as valid if it is made by a director who is independent from the conflicted director. Section 175 (6) also requires that a director in conflict or interested director should not be counted in the quorum, where the matter would be dealt according to the voting [42] . Again it is to be noted that as section 172(1) provides to avoid conflict of interest on the part of a company director, section 172(7) “states that it is the duty of a director to avoid conflict of interest and duty and a conflict of duties. [43] ”

Duty 6: Not to accept benefits from third parties (section 176): “A director must not accept gift from a third party conferred by reason of his being a director, his doing or not doing anything as a director, unless this cannot reasonably be regarded as likely to give rise to a conflict of interest [44] ”

The section aims to define the secret profit of a director by virtue of his position in a company. This includes benefits accepted in a good faith. The accountability of a director depends upon the acceptance of benefits which may give rise to a conflict of interest. Again this section makes it clear that third party from whom a director has accepted the benefits needs to be a company other than the company of his position or any other person acting on behalf of the company or an associate body corporate i.e. any subsidiary company.

Duty 7: To declare interest in proposed transactions or arrangements with company (Section 177): “a director has a duty to declare interest in a proposed transaction or arrangement with the company and while doing so he must declare the nature and extent of any interest in which he is involved directly or indirectly. Such declaration may be made before company enters into a transaction or at a board meeting or by way of writing (section 184) [45] or by a general notice (section 185) [46] . However, no such declaration is required where director is not aware of interest or transaction or if the interest cannot be reasonably regarded as likely to give rise to a conflict of interest or in a situation where other directors are already aware of it”. This section made it clear that besides being a party to the transaction, a director’s interest must give rise to a conflict of interest and a mere declaration of interest is not sufficient i.e. a written notice or disclosure must be made before such transaction takes place [47] .

Now before we move on to the supplementary provisions provided in the Companies Act 2006, I would like to conclude this part by saying that the codification of director’s general duty in the statue has provided a relief to the business world. Besides being focused on the “Enlightened shareholder value”, it also aims for the effective corporate governance [48] . It was because of the growing concerns of the shareholders, stakeholders, social environment lobby that there was a continuous pressure on the law commission to make a strict and clear provision for the directors within which they have to perform their duties. Some of the key changes which are reflected in the new act are regarding the duty of directors to act in Good faith, Proper Purpose and the amount of care and skill required while performing their duties i.e. mainly focused on the corporate governance issues. DTI and CRLSR have made a significant contribution in developing the effective means for a healthy growth of business in UK [49] . Their findings and reports were mainly focused on the director duties in a company so as to enhance the performance by adopting an improved mechanism known as corporate governance.

Supplementary provisions under Companies Act 2006: section 178 – 181 deals with the supplementary provisions on the general duties of the Director [50] i.e.

civil consequences of breach of general duties (section 178)

cases within more than one of general duties (section 179)

consent, approval or authorization by members (section 180)

Modification of provisions in relation to charitable companies (section 181)

To make the duties enforceable, the companies act 2006 have provided for the Derivative claims (section 260) under which a claim can be brought against a director of a company for any negligence or breach of duty. For the purpose of this section, a director includes a former director and shadow director. The consequences for breach of duties are derived from the common law or equitable principles and are enforceable as fiduciary duties. However there is an exception in regard to the breach of duty while exercising reasonable care, skill and diligence. For instance in Pavlides v Jensen [1956] Ch 565 [51] , it was made clear by the courts that a “derivative claim can be brought against a director even if the allegations were made on mere allegations of negligence and not on the lack of good faith or benefit to the directors. [52] ” But under section 232 of the companies Act 2006, it is mentioned that a director can be exempted from a liability arising out of negligence or breach of a duty, provided that such exemption is approved by the company’s article and must be in accordance with law. Again section 179 provides that a director needs to comply with all the general duties provided in the act if the case requires so. For instance if a director has to comply with more than one duty in a particular matter, he needs to apply each and every duty. For example where a director has to duty to promote success of the company under section 172 [53] , he cannot ignore his duty to act within his power (section 171). In other words a director must obey all the duties made applicable by the governing law. It is to be noted that consequences of breach of duty are derived from the common law or equitable principles and are enforceable as fiduciary duties [54] . However there is an exception in regard to the breach of duty while exercising reasonable care, skill and diligence. It is for the company to enforce the duties on to the directors but however in some exceptional circumstances shareholders can also act on behalf of the company and enforce the duties by derivative action. [55]

Today, with the codification of the general duties of the directors in the companies act there has been an ease of relief for the directors so as to understand their duties and work in accordance to it. Liability for consequences of breach of duty has also been codified by the act, which makes them do their work in an effective manner. Thus with that I would like conclude this part that besides the efforts made by CRLSR and DTI there are certain other regulatory bodies which govern the conduct of director duties in context to the corporate governance. The regulatory framework has been discussed in the next part of this chapter.

REGULATORY FRAMEWORK OF DIRECTOR’S DUTY AND CORPORATE GOVERNANCE; UK CONTEXT: There are number of regulatory bodies which govern Corporate Governance and the conduct of directors in context to their duties. The regulatory framework of these governing bodies varies from company to company. The basic framework which applies to all the companies (public and private) is restricted in the Companies Act 2006, Constitutional Documents and Financial services & markets act 2000 (FSMA). But in this research paper I will be examining only those companies which are listed on the London Stock Exchange or applying to be listed. Therefore in addition to the above regulatory bodies, all the listed companies are subjected to these additional regulations i.e.

(a) Listing Rules: In order to get admission on the official stock exchange listings, there are certain rules and procedures which need to be followed and adopted by all the companies, willing to trade.

(b)UK Corporate Governance Code: Being applicable only to the listed companies, the code operates on the basis of comply or explain. It is not necessary for the companies to comply with the code but then they have to explain in their annual reports, the areas where they do not comply with. The main focus of this code is to strengthen the company by continuously enhancing the corporate governance. Later in this chapter we will be discussing in detail about the duties of the director in context to the code on corporate governance.

(c) Investor Protection committee Guidance: The purpose of this guidance is to make all the shareholders delegate in the internal company matters by encouraging to vote against any resolutions to which they have negative concerns. ABI and NAPF are the two biggest investor groups in UK who issues the guidance for the shareholders.