Equitable Principles Applying to Director's Duties

With regard to the general duties owed to a company by a director (specified in ss.171 – 177 Companies Act 2006) s.170(3) states that those 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.” S.170(4) then states that these “general duties shall be interpreted and applied in the same way as common law rules or equitable principles, and regard shall be had to the corresponding common law rules and equitable principles in interpreting and applying the general duties”.

Discuss the ss.171 and 172 Companies Act 2006.

Introduction

The Companies Act 2006 has introduced a statutory code of directors’ general duties for the first time. The primary purpose of the statutory code is to make the rules accessible and to formalise directors’ duties to assist non-lawyers in understanding their duties as directors more clearly [1] . The case law relates specifically to the common law of negligence on director’s duties and applies the equitable principles which govern the liabilities of fiduciary duties. The current essay deals with the equitable principles of ss 171 and 172 which are dealt with the duty to act within powers and the duty to promote the success of the company correspondingly.

Under s 170 of the Companies Act 2006 “the general duties specified in sections 171 to 177 are owed by a director of a company to the company”. Hence, the directors’ general duties are owed the company as the only legal person [2] and not for example to its creditors, shareholders or employees.

Regardless of s 170 however, s 172(3) Companies Act 2006 makes clear that in the case of insolvency, the directors are required to “consider or act in the interests of creditors of the company”. Hence, the duty owed to the company is extended to include its creditors as a whole (per Park J in Re MDA Investment [3] ).

This rule is based on the common law principle that directors of an insolvent company must have regard to the interests of its creditors – West Mercia Safetywear [4] . The rule has been extended to include cases where there is real risk of insolvency to the knowledge of the director [5] , in circumstances where the company “is insolvent or of doubtful insolvency or on the verge of insolvency” – Gwyer [6] .

However, it should be made clear that the Companies Act 2006 makes no suggestion that individual creditors will be able to sue directors for breach of duties. Hence, the law that only the company can sue for breach of duties under the old rule remains (see Multimonial Gas [7] ).

The new principles are a statutory replacement of the old equitable and common law duties; hence, the statute aims to simplify and limit the case law principles to an accessible, comprehensible code; in that sense, s 170(3) [8] states that the general duties imposed by statute are based on the common law and equitable principles and have effect “in place of those rules and principles”. This means that while the general duties are based on the case law which existed prior to the 2006 Act, the case law has been substituted by the statute.

However, s 170(4) of the 2006 Act [9] provides that directors’ general duties “shall be applied in the same way as common law rules or equitable principles”. Here a conflict emerges between the two subsections; while subsection (3) states that the statutory rules act “in place of” the pre-existing case law, subsection (4) states that the statutory rules are to be interpreted as though they were themselves case law principles.

Ss 171 and 172 are based on the equitable principles of fiduciary duty which applied to directors prior to the Companies Act 2006. The term “fiduciary” implies a relationship of trust and confidence by imposing on the fiduciary the duty of loyalty [10] . Therefore, the director – who always possesses a fiduciary position [11] – must deal with the company’s property in the interests of the company, without conflict of any personal interests.

There are three types of persons who are regarded as directors by law. A person who is lawfully appointed as a director is known as a “de jure” director. However, s 250 of the Companies Act 2006 states that a “director” is “any person occupying the position of director, by whatever name called”, allowing that way others who are not properly appointed as directors to be regarded as ones. Such categories of directors are the “de facto” directors and “shadow” directors.

Following Millett J’s judgment in Re Hydrodan (Corby) Ltd [12] a de facto director is someone who is held as a director by the company and claims and purports to be a director, but who was never validly appointed as such.

Shadow directors are defined in s 251 of the 2006 Act and unlikely to de facto directors, this type claims not to be directors. Hence, they seek to hide behind those who are – in that sense, “they lurk in the shadows”.

2.1 Duty to act within powers

S 171(a) of the Companies Act 2006 provides that “a director of a company must act in accordance with the company’s constitution”, whereas s 171(b) is based on the equitable principle that directors can “only exercise powers for the purposes for which they are conferred”. This means that the directors: (a) are obliged to exercise the powers given to them within the terms specified in the company’s constitution; and (b) they must not act for an improper purpose [13] .

The principle in the case law was first set out by Re Smith and Fawcett [14] where it was held that the directors were required to act “bona fide” in what they consider and not what a court may consider is in the interests of the company. Consequently, the case developed two statutory principles: the principle that directors must not act outside the company’s constitution and the powers given to them, and the principle that directors must promote the success of the company (as set out in s 172).

Therefore, it was observed by Byrne J in Punt v Symons [15] that whilst the power to issue shares had been given to the directors “for the purpose of enabling them to raise capital for the purposes of the company…” the issue of shares was limited to particular persons aiming to prevent a vote in favour of a takeover. Hence, this was not a fair and bona fide exercise of power.

It will be seen however, that in some circumstances, the fact that the directors have acted bona fide in the interests of the company, will not be relevant if their actions were outside the purpose for which the power was given. Hence, in Hogg v Cramphorn [16] it was held that the power to issue share capital was a fiduciary power which could be set aside if it was exercised with an improper motive even if the power was exercised in good faith in the belief that it was in the interests of the company. In this case, it was propounded that were the directors have more than one motives in exercising a power conferred to them, the court will look at the primary purpose of their conduct. Notwithstanding to the “improper purpose doctrine”, although the use of the power constituted breach it was eventually ratified by the shareholders and thus the exercise of the power became enforceable [17] .

A point to note is that s 171(b) imposes a positive obligation on the directors to act in accordance with the company’s constitution regardless of the Smith and Fawcett [18] formula which merely required the directors not to commit a breach of their duties. Hence, an uncertainty emerges here as to how the court will be able to determine the improper exercise of power. The test was set out by Jonathan Parker J in Cohen [19] . In this case, his Lordship argued that the duty to act bona fide is a subjective one; hence, if the director honestly believed that his act or omission was in the interests of the company, the court will not interfere.

Moreover, the test set out in the above case, gave birth to the “appropriateness” principle, be examining whether or not the director’s actions caused detriment to the company. Like this, Turner LJ, in Bennetts’ case [20] stated that while exercising the powers conferred to them, the directors must “keep within the proper limits” by using their powers for the one purpose for which they were given and not for another and different purpose. The test is an objective one – Fraser v Whalley [21] – and provides that where a power is exercised outside the purpose for which was conferred will be voidable. However, it should be acknowledged that each case depends on its own facts and merits; thus, it is not easy to list effectively the limits beyond which directors may never pass in exercising a particular power [22] .

To define the exact limits beyond which directors may never pass, in Howard Smith [23] , Lord Wilberorce, stated that the court must examine “the substantial purpose” for which a power was exercised and decide whether that power was proper or not. In this case, it was established that the primary purpose of the allotment was to destroy the existing majority shareholding rather than raising money despite the fact that the directors were motivated for the benefit of the company rather than for the benefit of their self-interest. Therefore, it was held that the court must examine the purpose for which the power was exercised and consider whether that purpose was proper or not. In that case, the allotment of the shares was held to be exercised improperly because it had been used solely to frustrate a takeover offer.

In Whitehouse [24] , it was established that where the exercise of a power is to achieve a proper purpose and thereafter an improper purpose the court will have to find whether achieving the improper effects was the directors’ “substantial” or “dominant” purpose. Here, the directors allotted shares for the “dominant purpose” of manipulating voting power by favouring particular shareholders and despite the lack of selfish motives it was held that the exercise of the power was for an improper purpose.

It is clear form the above case law that prior to the 2006 Act, the “improper purpose doctrine” emerged frequently in cases concerning the directors’ powers to allot shares.

Nonetheless, whereas the power to allot shares might properly be exercised to raise capital, it is not legitimate to use that power in order to block a takeover bid, although no legal principle in existence states that this is improper for directors [25] .

In the abstract, the law could either apply an objective test by asking what the director ought to have done, or it could apply a subjective test by considering whether or not the directors where acting in the best interests of the company. It seems that the law prefers to apply the subjective test; in Mutual Life Insurance, this was expressly explained by Goulding J, where his Lordship made a distinction between issues relating solely to the management of the company and issues relating in the approval of a rights issue not available to American shareholders. Regardless of the decision in Howard Smith, this arrangement did nothing more than maintaining the company’s investment policy.

If the director however, in abuse of his power enters into a contract with a third party it is clear that the members can ratify it [26] . But the question remains as to what extent that third party can enforce the contract against the company. This question was concerned in Criterion Properties [27] , where the managing director made the Criterion Company to look less attractive to outside predators – a situation known as the “poison pill”. Since the contract that the director entered into with the third party could cause loss and damage the property, this was an abuse of the power. Nevertheless, the question remained as to whether or not the contract could be enforced by the third party. The House of Lords concluded that if the director had the authority to make the particular contract, then it was enforceable, if contrary, then it was not.

2.2. Duty to promote the success of the company

S 172 is based on the equitable principle laid down in Re Smith and Fawcett [28] that directors of a company must act bona fide in what they consider – not a court may consider – is in the interests of the company, and not for any collateral purpose. It imposes an obligation on a director “to 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 –

the likely consequences of any decision in the long term;

the interests of the company’s employees;

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

the impact of the company’s operations on the community and the environment;

the desirability of the company maintaining a reputation for high standards of business conduct; and

the need to act fairly as between members of the company.”

To combine the two duties, Chadwick LJ, in Harrison [29] , said that the powers conferred upon the directors must be exercised for the purposes, and in the interests, of the company. Further, in Fassihi [30] it was argued that the duty to act in good faith, simply means to consider the best interests of the company and in doing so, it can be applied in cases were it was not previously been applied, provided the principle of the rule is applicable. This is now interpreted by the statutory provision of subsection (1) of s 172 which requires the directors to exercise their duties in the way they consider in good faith to be most likely to promote the success of the company for the benefit of its members as a whole.

Best Interests Test

S 172(2) replaced the duty to act in the interests of the company with the duty to consider what is most likely to promote the company’s success. Hence, the promotion of the benefit of the members of the company is regarded to be the primary objective of the directors’ duties in promoting the success of the company. The question to be made here is what constitutes the “best interests of the company”.

The test is a subjective one and was laid down in Cohen [31] . In this case, it was argued that the question is not whether the court objectively finds the act or omission to be in the interests of the company. Rather, the right question to make is whether the director honestly believed that his act or omission was in the best interests of the company.

In applying the test, in Scattergood [32] it was acknowledged that an act done in the belief that it was in the interests of the company, as much as unreasonable might be it can nevertheless be allowed provided it was honest. It is irrelevant however, whether the director may personally benefit from the act or omission to the bona fide [33] exercise of power issue.

In order to determine if the director’s actions were carried out in good faith, the court will look at the reasonableness of director’s conduct. The test is set out by s 214(4) of the Insolvency Act 1986, and examines the skill and knowledge which are expected by a reasonably diligent person performing the same functions in the director’s position [34] .

If the court is satisfied that the director believed that he was acting honestly it will not interfere despite the fact that the director may have not considered the company’s interests separately. The test is an objective one and was set out in Charterbridge [35] where it was stated that the question of bona fide must be examined on whether an intelligent and honest man in the director’s position would have reasonably believed that what he was doing was for the benefit of the company. If on the contrary, the director will be in breach of duty [36] .

So, in Colin [37] , it was stated that where the directors failed to keep their own interests separately from those of the company, allegations that they had acted in the best interests of the company should be examined by asking whether or not an intelligent and honest man in the director’s position would reasonably believe that this course of action was for the benefit of the company.

2.2.b Success of the company

S 172(1) provides that by exercising their duties, directors must promote “the success of the company for the benefit of its members as a whole”. This is interpreted by the principle that company is both regarded by the law as an association of its members and as a person separate from its members. Inevitably the question which arises is whose interests must be exercised bona fide in what is considered to be in the best interests of the company; the members as a whole, the company as a separate legal entity, or both? Hereupon, the Company Law Review Steering Group argued that the success of the company “is to be achieved by the directors successfully managing the complex of relationships and resources which comprise the company’s undertaking” [38] .

The matter was concerned in Mutual Life Insurance [39] where the directors had not acted in breach of their fiduciary duty in promoting the interests of the company as a separate person to the interests of its members. It was suggested that in particular circumstances the interests of the company as a separate legal entity may be preferred to the interests of its members. This was later confirmed in Re BSB Holdings [40] where Arden J stated that the interests of the company are not required to be “sacrificed” at law for the benefit of the shareholders.

However, in Gairman [41] , Megary J observed that it is not easy to determine what is in the best interests of the company without having in regard its members as a whole. His Lordship stated that the directors are bound “not merely by their duties towards the other members, but also their duties towards the corporation”.

Ultimately, where a director acts in breach of his fiduciary duty, the equitable principles require him to disclose the breach “if disclosure is required by the equitable duty to act bona fide in what the director considers to be in the interests of the company” (Fassihi [42] ).

Conclusion

Previously, the case law did not have a straightforward principle relating to the promotion of the success of the company. Nevertheless, cases such as Punt v Symons [43] , Hogg v Cramphorn [44] and Howard Smith [45] , provided that the directors should act in the best interests of the company. Concerning the matter from this point of view, the directors should use their powers for the purposes for which they were granted and not for any collateral purpose, but always in the best interest of the company. This also involved the proper purpose for which a power was exercised. However, the conflict cannot be avoided since the duties owed by directors to the company under s 170 imply that the directors must look to the company’s interests as a separate legal entity, whereas, s 172 (1) introduces that the directors must consider the interest of the shareholders as a whole.