Company Director's Duty of Care - Essay Example

UK COMPANY LAW AND THE COMPANY DIRECTOR'S DUTY OF CARE The longest Act ever formulated which ran up to 300 sections, the Companies Act 2006 introduces several reforms and is basically an amalgamation of practically all existing company legislations. Written in a straightforward manner, the Act has specific focus on small businesses. The Government believes that the Act will help firms and business owners save claims 250 million a year, including up to 100 million for small businesses. In particular, sections 171 to 177 of the Companies Act 2006 codify common law directors' duties owed to a company. In essence, the bill initiates significant proposals for reform that will have impact on Directors, Shareholders and Auditors of companies. This piece of legislation intends to 'strip away outdated regulation and generate savings for business.' More than anything else, the principle of 'enlightened shareholder value' exemplifies the focus for intensified corporate social responsibility, and empowers shareholders to pursue directors for negligence, defaults, and breaches of duty or trust. Generally, the responsibilities and liabilities of directors derive from various sources, including the constitution of the company, case law and statute law. If and when a person does not comply with his duties as a director he may and can be liable to civil or criminal proceedings and can be disbarred from performing his duties as a director. Duty of Care and Skill 1 1) Degree of Skill -directors will be liable for negligence in performance of duties -A director need not exhibit in the performance of his duties a greater degree of skill than may reasonably be expected from a person of his knowledge and experience - objective test -The level of skill required of a director is subjective, in that he is not expected, merely by virtue of his office, to possess any particular skills. His performance must be judged by the way he applies any skill which he actually has. 2) Attention to the Business -A director should diligently attend to the affairs of the Company. -In performing his duties, he must display the "reasonable carean ordinary man may be expected to take in the same circumstances on his own behalf" -But not expected to give continuous attention to the affairs -Should maintain sufficient knowledge of business 3) Reliance on Others -A director is not liable for the acts of co-directors or Company officers solely by virtue of his position. -A director is entitled to rely on a subordinate "put in a position of charge for the express purpose of attending to the detail of management" -Directors cannot absolve themselves entirely of their responsibility by delegation to others. "In fixing the director's duty of care and skill in the process of supervising the activities of management, UK law has sought to avoid the pitfalls of a purely objective and a purely subjective test, preferring to combine them." In the statement, the word "pitfalls" refer to various limitations of human behavior that in effect lead to mistakes. In the case of top level executives handling corporations and groups of people, these mistakes would tantamount to management errors and negligence, either in judgment or in the performance of one's duties and responsibilities. So as to tackle and address human factors in workplace settings, peoples' capabilities and limitations must first be understood. The modern working environment is very different to the settings that humans have evolved to deal with. As it is inevitable that errors will be committed, whether consciously or unconsciously, the focus of error management is placed on reducing the chance of these errors occurring and on minimising the impact of any errors that do occur (Chase & Simon, 1973; Tulving, 1979). Duty of care in English law In tort, there can be no liability in negligence unless the claimant establishes both that he or she was owed a duty of care by the defendant, and that there has been a breach of that duty (Buckley, 2005; Booth & Squires, 2006). The recurrent dilemma for the court in every situation has been to ascertain and decide whether a duty of care was owed and, if so, what its scope would be. The first judicial approach is to identify specific and distinctive situations in which a duty would exist. In Donoghue v Stevenson (1932) AC 562, Lord Atkin produced what came to be recognised as a ground-breaking statement of principle: "The rule that you are to love your neighbour becomes in law, you must not injure your neighbour; and the lawyer's question, who is my neighbour receives a restricted reply. You must take reasonable care to avoid acts or omissions which you can reasonably foresee would be likely to injure your neighbour. Who, then, in law is my neighbour The answer seems to be - persons who are so closely and directly affected by my act that I ought reasonably to have them in contemplation as being so affected when I am directing my mind to the acts or omissions which are called in question." The directors and officers of a corporation are responsible for managing and directing the business and affairs of the corporation. They often face difficult questions concerning whether to acquire other businesses, sell assets, and expand into other areas of business, or issue stocks and dividends. They may also face potential hostile takeovers by other businesses. To help directors and officers meet these challenges without fear of liability, courts have given substantial deference to the decisions the directors and officers must make. Under the business judgment rule, the officers and directors of a corporation are immune from liability to the corporation for losses incurred in corporate transactions within their authority, so long as the transactions are made in good faith and with reasonable skill and prudence. The rule originated in Otis & Co. v. Pennsylvania R. Co., 61 F. Supp. 905 (D.C. Pa. 1945).1 The business judgment rule has also been applied to directors' actions when corporations are faced with a hostile takeover. In Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. Super. 1985) 2, the Delaware Supreme Court upheld the defensive actions taken by a board of directors during a takeover struggle with a minority shareholder. Under the offer shareholders who sold their Unocal stock would receive $54 a share until Mesa acquired the 37 percent it sought, and then would receive highly speculative Mesa securities instead of cash for any stock sold beyond that 37 percent. To counteract the takeover bid Unocal's directors announced that if Mesa obtained 51 percent of its shares, Unocal would purchase the remaining 49 percent for an exchange of debt securities (securities reflected as debt on the books of the corporation) with an aggregate par (or face) value of $72 a share, but the offer would not be extended to the 51 percent of stock held by Mesa. Mesa filed suit, alleging that the directors had violated their fiduciary duty by excluding Mesa from the exchange. The court concluded that the directors' actions were protected by the business judgment rule. The court recognised that in responding to hostile takeover bids the directors of a corporation can face a conflict between their own interests and the interests of the corporation and its shareholders. The court stated that the Unocal directors had reasonable grounds to believe that a danger to the corporation existed because of Mesa's actions, and that the defensive actions they took were reasonable in relation to the threat they "rationally and reasonably" believed the offer posed. Despite the seemingly broad scope of the business judgment rule, corporate directors have not always been able to rely upon it as a way to escape liability for their actions. In Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), the Supreme Court of Delaware held that the directors of a corporation failed to exercise informed business judgment and instead acted in a grossly negligent manner by agreeing to sell the company for only $55 a share. The court looked to evidence indicating that the directors reached their decision to sell at that price after hearing only a twenty-minute oral presentation concerning the sale. The court also noted that the directors had received no documentation indicating that the sale price was adequate and had not requested a study to help them determine whether the price was fair. Although the directors were not accused __________________ 1In Otis, a shareholder's derivative action alleged that corporate directors failed to obtain the best price available in the sale of securities by dealing with only one investment house and by generally neglecting to "shop around" for the best possible price, resulting in a loss of nearly half a million dollars. The federal district court ruled that although the directors chose the wrong course of action, they acted in good faith and therefore were not liable to the shareholders. The court reasoned that "mistakes or errors in the exercise of honest business judgment do not subject the officers and directors to liability for negligence in the discharge of their appointed duties." 2 In this case Mesa Petroleum Company made an offer that would have made it the majority shareholder in Unocal Corporation. of acting in bad faith, the court stated that the directors' fiduciary duty toward their shareholders required more than merely an absence of bad faith. The directors, according to the court, had an affirmative duty to protect the shareholders by obtaining and reviewing information necessary to help the directors make sound business decisions. By failing to inform themselves they were therefore liable to the shareholders for their bad business decision. Even when a corporation faces a hostile takeover, the business judgment rule may not insulate its directors from liability. In Revlon v. MacAndrews & Forbes Holdings, 506 A.2d 173 (Del. 1985), the company attempting a takeover sought a preliminary injunction to prevent the corporation that was the target of the takeover from granting a lockup option, which gives a friendly third party the right to purchase part of the target company to help thwart a takeover. The Delaware Supreme Court held that the directors failed to fulfill their duty to preserve the company by not maximizing the sale value of the company for the benefit of its shareholders. According to the court, by instituting the lockup option and halting the bidding, the directors allowed "considerations other than the maximization of shareholder profits to affect their judgment" and thus acted to the detriment of the shareholders. Once the directors determined to sell the corporation, the court held, their role changed from that of "defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders at the sale of the company." As a result, the court held that the directors were not entitled to the protection of the business judgment rule. Courts have further held that the business judgment rule will cover the actions of directors only where the directors are disinterested and independent with respect to the action that is at issue. A director is independent when she or he is "in a position to base [her or his] decision on the merits of the issue rather being governed by extraneous considerations or influences"; conversely, a director is considered to be interested if she or he appears to be on both sides of a transaction or expects to derive personal financial benefit from it, as opposed to a benefit to be realized by the corporation or all shareholders generally (Aronson v. Lewis, 473 A.2d 805 [Del. 1984]). Thus, if one director stands to receive a substantial financial benefit from the issuance of stock nonetheless designed to counteract a takeover threat, the business judgment rule may not apply to the board of directors' actions. Such allegations of bias, lack of independence, or disinterest must be supported by tangible evidence. Traditionally, the level of care and skill which has to be demonstrated by a director has been framed largely with reference to the non-executive director. In Re City Equitable Fire Insurance Co [1925] Ch 407, it was expressed in purely subjective terms, where the court held that: "a director need not exhibit in the performance of his duties a greater degree of skill than may reasonably be expected from a person of his knowledge and experience." However, this decision was based firmly in the older notions (see above) that prevailed at the time as to the mode of corporate decision making, and effective control residing in the shareholders; if they elected and put up with an incompetent decision maker, they should not have recourse to complain. A more modern approach has since developed, and in Dorchester Finance Co v Stebbing [1989] BCLC 498 the court held that the rule in Equitable Fire related only to skill, and not to diligence. With respect to diligence, what was required was: "such care as an ordinary man might be expected to take on his own behalf." This was an objective test, and one deliberately pitched at a higher level. More recently, it has been suggested that both the tests of skill and diligence should be assessed objectively.3 When can a corporate director be liable Director's liabilities can be summarised simplistically under four distinct headings: Personal liability to third parties for acts of the company. A director can have a personal liability if he acts as the 'mind and will' of the company, i.e. where he is a sole or majority shareholder or a sole director. Companies can commit crimes and civil wrongs with the active participation of the directors, who can expect to be joined in any resultant proceedings. Regulatory/disciplinary proceedings and investigations. E.g. investigations carried out by the Financial Services Authority or proceedings brought by the DTI under the Company Director Disqualification Act 1986 (especially following a period of 'wrongful trading'). Civil liability to the Company at common law. The fundamental duties imposed upon a director at common law are a fiduciary duty and those of skill and care. Statutory liability. The failure to act in accordance with statute law, i.e. an Act of Parliament e.g. the Companies Act 1985, Insolvency Act 1986, Health and Safety at Work Act 1974 and the Environmental Protection Act 1990. 3Norman v Theodore Goddard [1991] BCLC 1027 References/Readings Chase, W.G. & Simon, H.A. (1973): Perception in chess. Cognitive Psychology, 4, pp. 55-81. Tulving, E. (1979): Relation between encoding specificity and levels of processing. In, L.S. Cernak & F.I.M. Craik (eds.) Levels of processing in human memory. Hillsdale: N.J.:Lawrence Erlbaum. Booth, C. & Squires, D. (2006). The negligence liability of public authorities. Oxford: Oxford University Press Buckley, R.A. (2005). The law of negligence. London Witting, C.. (2004). Liability for negligent misstatements. Oxford: Oxford University Press http://www.pinsure.co.uk/directorsandofficers.htm Read More