Directors Duties are an Ineffective Means

The modifications to the ratification procedure in s.239 Companies Act 2006 have done little to address the problems associated with director accountability for two reasons: (1) all breaches of the general duties contained in ss.171-177 Companies Act 2006 are now ratifiable; and (2) [t]he law is in considerable disarray as to what breaches may be ratified by shareholders. (Reisberg, A, (2007) Derivative Actions and Corporate Governance, OUP page 81).

As such directors’ duties are an ineffective means of controlling the behaviour or directors.

The regulation of director’s within the UK has always been relaxed in the interest of encouraging the growth of businesses. In recent years, new legislation has been introduced to add further checks on directors. The Companies Act 2006 established the first real ‘director’s duties,’ a codified set of rules for directors. Despite the implementation of this act, it is still widely held that the accountability of directors is still severely lacking, and that these directors duties do not go far enough in regulating the behaviour of directors.

In this essay I will explore the ramifications that the Companies act had on existing case law in terms of new checks on directors and modifications to the ratification process on breaches paying particular interest to sub section 171-177 of the act. I will also examine the differences between the past and present case law on the subject of duty breaches by directors, and whether these changes have benefitted and the accountability of directors in breach.

I will begin this essay by examining in brief the history of director’s duties and its origins in both case law and statutes. I will explain the concepts of director’s duties and go on to describe the ratification process, and its relevance in determining the effectiveness of director’s duties.

The company’s law act of 1985 was the first to introduce powers on directors. It highlighted issues such as conflicts of interests relating to any contracts of investments between directors and the companies they work for and provided remedies for specific situations. This was the limit of statutory regulation on director’s duties at the time. The bulk of the duties were made up of from the courts of equity, cases of which are as follows;

There is a need for directors to follow a company’s constitution. The case of Gething v Kilner outlines the need for directors to act in the interests of the company, ‘bona fide.’ Re Smith and Fawcett outlines the need to act for the greater good of the company, and not for ‘collateral purpose.’ Aberdeen Rly co v Blaikie Bros outlines the need for a duty to to avoid conflicts of interest and there is a duty to act with reasonable skill and care.

The Companies Act 2006 unveiled a much firmer degree of regulation in regards to directors duties than what had previously existed. The codification of duties, giving them an exact meaning and direction was an important development in cleaning up the existing confused case law. The Law Commission’s1 which suggested the changes in an effort to make the law more understandable to those whom it concerns. S.171-177 outline the general duties of the act. These are:

i)     Duty to act within powers (s 171)

ii)     Duty to promote the success of the company (s172)

iii)     Duty to exercise independent judgement (s 173)

iv)     Duty to exercise reasonable care, skill and diligence (s 174)

v)     Duty to avoid conflicts of interest (s 175)

vi)     Duty not to access benefits from third parties (s 176)

vii)     Duty to declare interest in a proposed or existing transaction or arrangement (s 177)

These duties essentially replaced the existing case law. S.239 of the act, changes to the ratification process have also contributed toward this weakening in the importance of the previous caseshowever the case law is still important as they helps to explain the statute.

FsCompany Directors: Regulating Conflicts of Interest and Formulating a Statement of Duties (Law Com no 261, cm 4436, 1999)

Introduce the area – clearly state how your essay is going to progress and give an indication of your conclusion(s).

You should briefly outline the general duties of directors and the ratification procedure, as contained in Companies Act 2006 before beginning your analysis of the question.

The corporate world is complex and often overwhelming. One of the best ways to understand corporate law is to learn from the previous mistakes of others. In 1985 Kenneth Lay established the Enron Corporation through the merger of two small US Gas Companies. The objective was to provide more than just natural gas distribution, but to dictate the price of gas and electricity on the futures markets [1] . Poor corporate governance and a failure on the part of active shareholders to keep a check on the actions of the company’s board of directors and Arthur Anderson, the company’s auditors, resulted in the company’s collapse. Provided that profits were good and the share price rose, the shareholders showed little concern about the actions of the directors even when suspicions were aroused about ultra vires behaviour [2] .

In the majority of listed companies, the shareholders have relinquished their principles of ownership and control to elected directors. The actions and behavior of the elected individuals is largely left unchecked until such time as a general meeting is held to consider the board’s activities. The board members conduct the company’s business in a manner in which they consider appropriate. Within listed companies it is unlikely that a breach of the objects, powers or authorities placed on the directors will occur. However breaches are more likely to occur and be subsequently ratified by shareholders in owner-managed companies. The difficulty is deciding whether such breaches should be ratifiable. If a director is Vires the company, and yet such act is confirmed by the shareholders in general meeting, it can be argued that no breach has occurred and therefore no party has suffered. Should such decisions therefore be ratifiable, or should the Vires action result in a breach of the duties imposed on directors by virtue of sections 171 to 177 Companies Act 2006?

Main Body

You should consider the changes to the ratification procedure as a result of s.239 Companies Act 2006 and the previous case law on ratification of directors’ breaches of duty.

Questions you may like to consider:

Will the changes to the ratification procedure result in previous case law becoming obsolete?

Do you agree with Dr Reisberg that the case law on ratification of directors’ breaches of duty is in disarray?

Should the legislature have gone further in its amendments to the ratification procedure?

Are directors’ duties an effective means of controlling the behaviour of directors given the apparent ease of ratification?

Consider the practical implications for closely held private companies and widely held public companies – does the efficacy of the duties and the ratification procedure depend on the size of the company or the dispersion of the shareholding?

Ratifying Ultra Vires acts of directors is not a new concept. The principle being that if a transaction or a decision is made that is Ultra Vires the authority of the directors, the shareholders can ratify such breach without regard to whether the authority was or was not conferred on the directors by virtue of the Company’s constitution [3] . The “liberalization” of section 35 of the Companies Act 1985, which was paraphrased into section 239 of the Companies Act 2006, does not constitute an authority for the validity of acts done by directors to be ratified by the members of the company.

Before examining the principles of liberalizing the ethics of director duties, I will consider the historical rational behind the basis that the company’s authority and power is not limited to that set out in the objectives of the company, whether such objects are contained in the Memorandum of Association or now provided for in the company’s Articles of Association.

Section 35 of the Companies Act 1985 has its origins in the European Communities Act 1972 section 9(1). The original provision was enacted in section 108 of the Companies Act 1989 and saw the introduction of section 35A to the 1985 Act with the intention to see the full implementation of Article 9 of the EEC Company Directive [4] . The provisions of section 35, 35A and 35B were designed to give the full effect that the European Court of Justice felt to be appropriate to enable the membership of a company to ratify decisions that would be in the best interest of the company but are not provided for in the company’s constitution. The principle was initially acted by the Courts as noted in Webb v EMO Air Cargo (UK) Limited [5] .

The intention behind section 35 of the 1985 Act was to ensure that Article 9.1 was implemented and used to the fullest extent. Article 9.1 provides that “Acts done by the organs of the company shall be binding upon it even if those acts are not within the objects of the company, unless such acts exceed the powers that the law confers or allows to be conferred on those organs. However, Member States may provide that the company shall not be bound where such acts are outside the objects of the company, if it proves that the third party knew that the act was outside those objects or could not in view of the circumstances have been unaware of it; disclosure of the statutes shall not of itself be sufficient proof thereof”. In essence, the principles of section 35 revoke the doctrine of Ultra Vires save that such position is preserved in relation to the charitable company where the doctrine of ultra Vires stands without such abrogation [6] .

The position is confirmed by the act which states “the validity of an act done by a company shall not be called into question on the ground of lack of capacity ‘by reason of anything in the company’s memorandum’. Under the ultra vires doctrine a company had power to do only those things which were expressly authorised by its memorandum or fairly incidental to the expressed objects. The section is therefore to be construed as though it provided that the validity of an act is not to be called into question on the ground of lack of capacity by reason of the fact that it was not authorised or was prohibited by the company’s memorandum” [7] .

However, such a position does not prevent the ability to call a transaction (or ‘action’) into question merely because of the grounds of validity on the doctrine of Vires; it is generally not possible for a transaction to be ratified where it was contrary to law such as the issue of shares in excess of the nominal capital; a dividend or a return of capital not authorised by the Companies Act; or a transaction being set aside due to it being at undervalue [8] .

The general presumption is that the objects of the company, whether under the old regime or new, are seen as covenants on the company in favour of the shareholders, and are generally seen as restrictions on the ability of a company to undertake particular tasks. As opposed to being expressed in the negative, the covenants are positive and note what the company can do as well as a presumption of what it can’t if not mentioned. This position has been well observed and commented on as sound law. Moreover the position was specifically referred to by Lord Cairns Ashbury Railway Carriage and Iron Co Ltd v Riche [9] . Here Lord Cairns noted “[t]he covenant, therefore, is not merely that every member will observe the conditions upon which the company is established, but that no change shall be made in those conditions; and if there is a covenant that no change shall be made in the objects for which the company is established, I apprehend that [the covenant] includes within it the engagement that no object shall be pursued by the company … except an object that is mentioned in the memorandum of association”.

This position is reinforced by the comments provided by Hoffmann J in ‘Aveling Barford Limited v Perion Limited & others’ [10] which I will outline later. Any remarks in relation to the authority conferred on directors and the ability for the company to be bound outside of the covenants contained in the objects has also been the subject of heavy litigation and was given a detailed appraisal by Slade LJ in ‘Rolled Steel Products v British Steel Corporation’ [11] – although it does need to be appreciated that this matter was decided before the implementation of the ECC Directive as noted above but yet would have received the same responses and commentary today as Slade provided. In the matter, Slade had to consider whether a guarantee to be given by the company was provided for in the company’s objects and, in particular whether the following was appropriately valid: “To lend . . . money or given credit to such persons, firms or companies and on such terms as may seem expedient, and . . . to give guarantees or become security for any persons, firms or companies”.

The Court of Appeal determined that the guarantee that was to be given to the supplier by ‘Rolled Steel’ was invalid and incapable of being enforced given that the directors did not have the appropriate power. There was a case put forward that the shareholders of the company had ratified the actions of the directors and considered the position themselves; the argument being proposed that the guarantee should be enforceable given that the act was no longer Vires the company given the authority conferred by the shareholders. Although the decision was made the Obiter comments of the Court were interesting, “First, if an act is beyond the corporate capacity of a company it is clear that it cannot be ratified… however, the clear general principle is that any act that falls within the corporate capacity of a company will bind it if it is done with the unanimous consent of all the shareholders or is subsequently ratified by such which (i) falls within the letter of the express or implied powers of a company conferred by its memorandum, and (ii) does not involve a fraud on its creditors, and (iii) is assented to by all the shareholders, will not bind a fully solvent company merely because the intention of the directors, or the shareholders, is to effect a purpose not authorised by the memorandum” [12] .

Despite this, does there need to be a degree of concern in relation to whether there is authority in the Company’s constitution to permit certain actions? If there is a provision in the constitution to permit particular activities; however, if the constitution is silent in this regard, we need to have further consideration of the principles of the old section 35 and the new Companies Act 2006 against the argument of reliance. Section 239 does provide that “This section applies to the ratification by a company of conduct by a director amounting to negligence, default, breach of duty or breach of trust in relation to the company. (2)The decision of the company to ratify such conduct must be made by resolution of the members of the company. (3) Where the resolution is proposed as a written resolution neither the director (if a member of the company) nor any member connected with him is an eligible member. (4) Where the resolution is proposed at a meeting, it is passed only if the necessary majority is obtained disregarding votes in favour of the resolution by the director (if a member of the company) and any member connected with him. This does not prevent the director or any such member from attending, being counted towards the quorum and taking part in the proceedings at any meeting at which the decision is considered. (5) For the purposes of this section— (a) “conduct” includes acts and omissions; (b) “director” includes a former director; (c) a shadow director is treated as a director; and (d) in section 252 (meaning of “connected person”), subsection (3) does not apply (exclusion of person who is himself a director). (6) Nothing in this section affects— (a) the validity of a decision taken by unanimous consent of the members of the company, or (b) any power of the directors to agree not to sue, or to settle or release a claim made by them on behalf of the company. (7) This section does not affect any other enactment or rule of law imposing additional requirements for valid ratification or any rule of law as to acts that are incapable of being ratified by the company”.

Contrast such comments alongside the old section 35 of the 1985 Act that provides “35(1) In favour of a person dealing with a company in good faith, any transaction decided on by the directors is deemed to be one which is within the capacity of the company to enter into, and the power of the directors to bind the company is deemed to be free of any limitation under the memorandum or articles. (2) A party of a transaction so decided on is not bound to enquire as to the capacity of the company to enter into it or as to any such limitation on the powers of the directors, and is presumed to have acted in good faith unless the contrary is proved”.

The general presumption is in that those dealing in good faith with the company are permitted and empowered to deal with the company in good faith and can expect to rely on the decision of directors acting in their capacity as directors of a company. It does presuppose the concept that directors, irrespective of whether acting in accordance with the provisions of sections 171 to 177, can bind the company and that those dealing with the company have no regard to the internal workings. Therefore, the principles of breach of director duty are more a shareholder protection as opposed to third party protections [13] .

If there is knowledge that a director is acting Vires their authority and, furthermore, a third party is on notice that directors are acting outside of their normal scope provided by the company’s constitution, then the provisions of ratification by shareholders could not be relied up. Again we draw example from ‘Rolled Steel’ in that the guarantee was invalid. As background to ‘Rolled Steel’ we are provided with “the guarantee given by the plaintiff company was in respect of the indebtedness of ‘Scottish Steel Sheet Limited’ which was owned by Mr Shenkman. He had earlier given a guarantee of Scottish Steel’s indebtedness to British Steel. He owned 51 per cent of Rolled Steel and was a director of both Rolled Steel and Scottish Steel. For Rolled Steel to give a guarantee (and debenture) to British Steel was obviously of benefit to Mr Shenkman – yet the board minute of Rolled Steel recording the resolution of directors, makes no mention of his declaring an interest” [14] . However, even though the board was ‘inquorate’ and their decision effectively void, the resolution passed by the shareholders ratifying the invalidity of their actions still carried no favour in permitting the enforcement of the guarantee.

Although there is a technical breach of duty in that the actions have been conduct by a director amounting to negligence, the shareholder sought to ratify the decision of the board, and unfortunately, reliance could not be relied upon and was considered to not validly bring into effect a Vires action. The position is relatively straightforward in relation to simple disputes such as that seen in Rolled Steel. The position becomes more complicated when examining insolvency events and matters that were ratified by the shareholders. A different set of circumstances occur when a transaction can be considered at an undervalue and the directors have sought to ensure that the transaction, although negligent and a technical breach of duty, is ratified by the shareholders ensuring that the transaction is then technically valid. The provisions of section 238 of the Insolvency Act have a bearing on matters in such situations.

We can examine the decision of Aveling Barford v Perion in relation to the insolvency position as this adds weight to Slade LJ’s comments. The remarks of Slade add favour to liquidation proceedings. Aveling was an engineering company based in Grantham. The most popular product manufactured by the company was steam rollers. As part of the asset base of the company, an 18 acre site and sports ground was owned by the company where planning approval had been obtained for the land to be redeveloped. The company was under the control of a single shareholder at the time where the planning consent had been granted in favour of a company in the control of the same shareholder, Dr Lee. Further complications occurred where the true value of the land was considered to be approximately £800,000 more than that paid for by the company controlled by Dr Lee. As the transaction was at an undervalue, the shareholders in Aveling had ratified the breach of duty and accepted that the transaction should go ahead. Unfortunately, shortly after the transaction completed, Aveling entered into administration and the receivers applied to have the transaction set aside.

Hoffmann J, in summary, concluded “that there was not a genuine disposal by Aveling Barford under its power to sell assets, but a sale at a gross undervalue to benefit its sole beneficial shareholder. Perion was accountable to Aveling Barford for the profit on the resale to the developer” [15] . The question posed to Hoffmann J was whether the transaction was capable of being set-aside given that the transaction had been approved by the shareholders unanimously. Furthermore, it was within the power of the Company to enter into such a transaction as provided for in the company’s constitution.

When it went to court, the arguments put forward were rejected on the basis that the sale was an obvious attempt deception and only amounted to entitling a shareholder to receive money and that the transaction ultimately, “was a disguised gift of capital and no ratification by shareholders could sanction that without leave of the court” [16] .

In the circumstances Hofmann LJ further continued that “as for the irrelevance of directors’ motives in transactions within a company’s corporate capacity, the general principle enunciated by Slade LJ in Rolled Steel had a qualification: an act within a company’s corporate capacity is binding on it if the shareholders unanimously consent, but such consent cannot bind the company to a transaction which amounts to a fraud on the creditors” [17] .

Irrespective of the ability to ratify the transaction at the shareholder level and account for the fact that the transaction was ultimately vires the company, the transaction amounted to nothing but placing monies out of the reach of creditors and other stakeholders in the company. Although Aveling Barford v Perion was determined on “special facts” the principles are well founded and that the transaction was clearly at an undervalue. Irrespective of whether a transaction has been ratified by the shareholders and approved, whether contrary to the principles of director duties or not, permitted by the constitution; if a transaction is at an undervalue – it is at an undervalue.

Effectively a breach of director duties which would result in the company either committing a fraud or a breach of statute cannot be subject to the ratification principles provided by the Companies Act 2006.

Conclusion

In conclusion, Gore-Browne informs us that where a where the act is Vires the company’s authority and power and where shareholder approval has been obtained if the act or transaction results in a fraud on the company’s creditors or other interested stakeholders, the transaction cannot be considered as void or voidable: “such a breach, (ie a fraud on creditors) seems likely to arise only when a company is in danger of going out of business in an insolvent state. In respect of a company which is a healthy going concern, the only limit on ratification would appear to be that of ultra vires” [18] .

The challenge that company law faces is that the principles of company law and director duties are there to ensure that appropriate abuses of position and power do not occur. Ultimately they are designed to ensure that the interests of shareholders are protected against directors taking advantage of their position of power. Directors should take care to ensure that transactions are entered into on appropriate commercial footings to avoid circumstances where they can be called into question. If a transaction requires ratification by the shareholders; director duties have already been breached and the transaction potentially set aside. The principle of shareholder ratification does make a mockery of the codification of director duties; however, the principle is designed, moreover, to protect shareholders in companies that are beyond the owner managed realm. The position should be reconsidered.