English Commercial Law Codification - Coursework Example

English Commercial Law Codification: Positive and Negative Views of Corporate Directors on the Codification of Directors’ Duties under the Companies Act 2006 OVERVIEW Directors have powers to take majority business decisions on behalf of the companies. As such, it comes as no surprise that various duties are imposed on them to ensure that the companies’ interests are protected. Under the current rules, directors’ duties including duty to act in good faith to the best interest of the companies; duty to avoid conflicts of interest; duty not to profit from their offices, and duty of care and skill are enshrined in the common law rules and equitable principles and also in statutes such as the Companies Act 1985 (the 1985 Act) as amended by Companies Act 1989. The government considers that these principles while long established lack certainty and are not easily accessible. Very often, directors have to take advice in these areas so as to ensure that they do not inadvertently breach any duty enshrined in the case law. INTRODUCTION The Companies Act 2006 (“the Act”) is the longest piece of legislation ever to be passed by the UK Parliament. Amongst the wide-ranging changes to company law contained in its 1,300 sections, two areas in particular are likely to be of concern to directors of UK companies and their D&O insurers. These are: (a) the codification of the general duties which a director owes to his company; and (b) new rules governing the means by which shareholders can sue directors for breach of those duties.1  It was announced in February 2007, that these parts of the Act will now come into force on October 1, 2007. (The provisions had widely been expected to come into force in October 2008.) The new statutory duties of directors set out in Part 10 of the Companies Act 2006 were keenly debated while the Bill was going through Parliament, and will be continued to be seen as one of the most significant parts of the Act.2 They have proved some of the most controversial during the Act’s gestation period, with a member of the House of Lords describing them in session as a “double whammy” for directors. The main purpose in codifying the general duties of directors is to make what is expected of directors clearer and to make the law more accessible to them and to others”.3 SUMMARY OF GENERAL DUTIES The seven general duties are as follows: 1. to act within powers (in other words, to exercise powers only for the purpose for which they were conferred) (section 171)4; 2. to promote the success of the company (section 172)5; 3. to exercise independent judgment (section 173)6; 4. to exercise reasonable care, skill and diligence (section 174)7; 5. to avoid conflicts of interest (section 175)8; 6. not to accept benefits from third parties (section 176)9; and 7. to declare interests in proposed transactions or arrangements (section 177)10. Previously, directors’ general duties had been developed over many years through the common law. The Government’s stated intention was to codify the existing duties without significantly altering them. The Act itself provides that the statutory duties are “based on” the existing common law rules and equitable principles, and that regard shall be had to those rules and principles in interpreting and applying the new general duties. The Act further provides that the consequences of a breach of duty are the same as if the corresponding common-law rule or equitable principle applied, so that (with the exception of the duty to exercise reasonable care) they are enforceable in the same way as any other fiduciary duty owed to a company by its directors.   Despite this, it is clear that some changes have been made. Some of the wording used in the Act is different from the language used in the existing cases, and this may lead to differences in approach when the courts consider whether a director has breached his statutory duties. Potentially the most significant change, and the one most likely to be the subject of claims against directors, is that relating to the duty to promote the success of the company.11 The duties are owed by the director to the company itself, and not to individual shareholders or to other stakeholders such as employees or the wider community. However, individual shareholders are afforded greater scope to enforce rights on behalf of the company (as discussed below). 12 Under the existing common law, when a company’s financial position has deteriorated to the point where its solvency is in question, the focus of the directors’ attention must shift away from the shareholders towards protecting the interests of creditors.13 This is the position classically set out in West Mercia Safetywear Ltd (in liquidation) v Dodd14 and it would seem that the expressed intention is not to change this. The same set of facts can give rise to the application of more than one duty. Compliance with one duty does not allow a director to escape liability for breach of other duties.15 The general duties are stated to have effect subject to "any rule of law enabling the company to give authority, specifically or generally, for anything to be done (or omitted) by the directors, or any of them, that would otherwise be a breach of duty", and in the case of conflict of interest duties subject further to any relevant provisions of the company’s articles of association. Accordingly, it would be open to the members to authorise or ratify transactions entered into by the directors which would ordinarily infringe the general duties (assuming the transactions were otherwise lawful). It should be noted though that any votes attaching to shares held by the directors (and presumably by persons connected to them, though this is not clearly stated in the Act) would be disregarded for the purposes of such resolutions, and such persons would not count towards the quorum for the meeting. ANALYSIS OF DUTIES The general duties are considered in more detail below. 1.Duty to promote the success of the company Although no order of priority is specified between the seven general duties, most attention and comment has been devoted to the duty of 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". In doing so, the director must have regard (amongst other matters) to: (a) the likely consequences of any decision in the long term; (b) the interests of the company’s employees; (c) the need to foster the company’s business relationships with suppliers, customers and others; (d) the impact of the company’s operations on the community and the environment; (e) the desirability of the company maintaining a reputation for high standards of business conduct; and (f) the need to act fairly as between members of the company. This duty was regarded as a fundamental part of the strategy for ensuring enlightened shareholder value,16 which requires that directors take a wider long term view of the interests of various stakeholders rather than simply seeking to maximise immediate financial returns. The duty is modified for "not for profit" companies such as charitable companies which are not intended to benefit members, in which case the duty is to achieve the relevant purposes of the company.17 “Directors will be required to promote the success of the company in the collective best interest of the shareholders, but in doing so they will have to have regard to a wider range of factors, including the interests of employees and the environment”. 18 The introduction of this list has caused some concern. However, it seems that although all the listed factors must be considered, in many cases it will be enough for the board briefly to conclude that a particular factor is not relevant, and move on.19 Helpfully, the government has made clear that the new provision is not intended to impose additional bureaucratic burdens on companies, and is intended to reflect what is already widely regarded as good practice. Most companies are unlikely to need to make significant changes to present procedures in relation to directors’ decision making, provided that they do the following:20 Consider at least the factors listed above in reaching a decision. Given the government’s assurance, it is viewed that there is no reason why companies should significantly change their procedure for documenting decisions. So, we believe it should normally be adequate for the minutes to refer generally to ‘the factors listed in the Companies Act 2006’. Where a factor (such as the environmental impact) is particularly relevant to a decision, companies may wish to continue to address this in board papers. In some circumstances, the board may also wish to refer specifically in the minutes to a particular factor or a discussion about it. Ensure that the directors (and those responsible for the production of board and other supporting papers) have had the new requirements explained to them generally so that when they come to a particular decision they take the factors set out in the Act into account. In deciding whether to include a more detailed record of discussions on a particular matter in board minutes, the directors should also take into account any general policy they have adopted in relation to record keeping and potential litigation. It is apparent from the drafting of the duty that: a) the duty is subjective, in that it refers to what the director considers in good faith to be appropriate; b) the list of matters to which the director must have regard is not exhaustive, and there could be other matters which are relevant to a particular decision; c) the listed matters are subordinate to the primary duty and are not separate duties, nor should they override the primary duty. If the directors decide to close down a factory, they must do so if this would best promote the success of the company even if the interests of the company’s employees are adversely affected. However, a number of uncertainties remain, for instance: (i) does the statutory duty "correspond" to the existing common law duty to act in the best interests of the company, or will the courts regard the difference in wording as intentional such that they will not necessarily follow previous case law; (ii) what is meant by "success", and does the phrase "members as a whole" refer just to the present members or (as under current law) the members present and future. The government has indicated that success means "what the members collectively want the company to achieve" and that for a commercial company this will usually mean a long term increase in value21; It is not clear how far it will be possible to rely on existing case law in interpreting these provisions.22 The Act provides that regard is to be had to the current common law rules in interpreting the new provisions: it may be that, although the new duty of loyalty is framed in very different terms from the current law, the courts will nonetheless apply it in a similar way. (iii) should assess the relative weighting of each matter to which they must have regard. Certain matters are clearly aligned with the company’s interests but others, such as the impact on the environment or community, may not be. In the absence of statutory guidance, the directors will have to determine the appropriate balancing in compliance with the duty to exercise reasonable care, skill and diligence. One can only hope that, in most circumstances, the new rules will not require directors to decide particular questions differently from the way they would decide them at present.23 But in a few cases – for example, where a proposal will lead to a significant change in the company’s membership or to the company ceasing to exist – the new rules may require a different approach. Particularly difficult questions are likely to arise in relation to competing, and hostile, bids for a company’s shares. Under the current law, it is an acceptable practice that directors can recommend the lower of two competing bids, or decline to recommend a bid, if they believe this course of action is in the long term interests of the company – even though it does not best serve the short term interests of its current members. It is not clear that they will be able to do this under the new law. Uncertainties will inevitably remain, at least until cases begin to come before the courts.24 2. Duty to act within powers A director must act in accordance with the company’s constitution, which includes the company’s articles of association, decisions taken in accordance with the articles, and other decisions of members or classes of members, which are equivalent to a decision of the company. A director must in addition only exercise powers for the proper purpose. For example, it may be compliant with the constitution to issue new shares, but this should only be done for genuine reasons and not, say, for the purpose of diluting a particular member’s holding. 3. Duty to exercise independent judgment Directors should not in exercising their powers be influenced by others or fetter their discretion. However, this duty should not prevent directors from: a) acting in accordance with the company’s constitution, or authorizations under the constitution; b) relying upon advice in areas where this is required for example legal advice (provided that they exercise their own judgment in deciding whether to follow such advice)25; c) delegating to appropriate individuals or committees where otherwise permitted; d) complying with contracts by which the company is bound. 4.Duty to exercise reasonable care This duty is modeled upon section 214 of the Insolvency Act 1986. The director is required to exercise the care, skill and diligence that would be exercised by a reasonably diligent person with: (a) the general knowledge, skill and experience that may reasonably be expected of person carrying out the functions carried out by the director, and (b) the general knowledge, skill and experience that the director has. It can be seen that the duty has both an objective and subjective element. It will not be open to a director to claim that his subjective lack of skill and experience excuses him from performing to at least the standards expected of a reasonably diligent person. If on the other hand he has a high level of skill and experience, he is expected to perform to that standard. 5. Duty to avoid conflicts of interest This duty is framed widely, stating that a director "must avoid a situation in which he has, or can have, a direct or indirect interest that conflicts, or possibly may conflict, with the interests of the company". The duty does not extend to conflicts of interest arising from transactions or arrangements with the company, for which a separate regime is provided. This duty clearly extends much further than actual and direct conflicts, and it is expressly stated to be immaterial as to whether the company could have taken advantage of any property, information or opportunity exploited by the director. The duty is qualified in certain respects. It is not infringed where the situation "cannot reasonably be regarded as likely to give rise to a conflict of interest", or where the matter has been authorised by the directors. For a private company, the directors are entitled to authorise such conflicts unless this is invalidated in the company’s constitution, whereas previously shareholder approval has always been required. For public companies, the constitution must expressly enable the directors to authorise conflict matters. Importantly, public company directors will be able to authorise a conflict only if this is permitted by the company’s articles of association26 – this will require express provision in all plc articles of association.27 At the same time, it would be sensible to amend any existing provisions in the articles that deal with conflicts to ensure they reflect the new statutory regime. Boards will also be able to give themselves more room for manoeuvre by taking advantage of a provision in the Act that allows companies to deal with conflicts of interest in their articles of association. Anything done in accordance with such a provision will not be a breach of duty. Companies are likely to find it helpful to make provision for particular areas where conflicts are likely to arise – for example, by providing that a director who takes on an additional directorship will not be regarded as being in breach of the no conflict rule and need not disclose confidential information received by virtue of that directorship. The duty continues to apply to a person ceasing to be a director as regards the exploitation of any property, information or opportunity of which he became aware at a time when he was a director. It is likely that most difficulty will be caused to directors who sit on more than one board, where the duty to disclose a conflict of interest to one company may be incompatible with the duty of confidentiality owed to the other company, but this is an issue under the existing common law principles. Ultimately, the director may have to resign from one board or at least absent himself from consideration of particular matters. 6. Duty not to accept benefits from third parties A director must not accept any benefit from a third party which is conferred because of his being a director, or his doing or not doing anything as a director. There is no "de minimis" threshold, and the benefit need not be financial so could include accepting appointment to an honorary position. This duty could perhaps have been included within the duty to avoid conflicts of interest, but is separated out as authorization by the directors is not available. However, there is a similar qualification where the acceptance of the benefit cannot reasonably be regarded as likely to give rise to a conflict of interest, and benefits from the company itself or its holding company are not caught. The duty continues to apply to a person ceasing to be a director in respect of things done or omitted to be done by him before he ceased to be a director. The clause codifies…[the] long-standing rule, prohibiting the exploitation of the position of director for personal benefit. It does not apply to benefits that the director receives from the company, or from any associated company, or from any person acting on behalf of any of those Companies. It is pertinent to note the fact that benefits are prohibited by the duty only if their acceptance is likely to give rise to a conflict of interest”.28 7. Duty to declare interests in proposed transactions or arrangements If a director is in any way, directly or indirectly, interested in a proposed transaction or arrangement with the company, he must declare the nature and extent of the interest to the other directors. The declaration can be made at a meeting of the directors, or by way of a general or specific notice to the directors (but other means are not excluded). Further declarations are required where the initial declaration proves to be, or becomes, inaccurate or incomplete. The following points arise in connection with this duty:- (i) it only applies to interests of which the director is aware or ought reasonably to be aware. It does not apply to interests which cannot reasonably be regarded as likely to give rise to a conflict of interest, or of which the other directors are already aware (or ought reasonably to be aware); (ii) if the duty to declare interests is complied with, the transaction or arrangement is not liable to be set aside under common law or equitable principles requiring members’ consent. However, compliance does not remove the need for members’ approval for certain transactions where the Act specifically provides for this - including substantial property transactions under section 190. There is a further duty to declare interests in existing (as opposed to proposed) transactions or arrangements with the company - this appears in a section outside of the general duties, but similar requirements and qualifications apply. Such a declaration is not required where a declaration of the proposed matter has already been made. CONSEQUENCES OF BREACH The consequences for a director in breach of the general duties are potentially very serious.29 The Act provides that the consequences of breach or threatened breach of the general duties are the same as for breach of the corresponding common law or equitable principles. Other than the duty to exercise reasonable care, skill and diligence, the statutory duties are enforceable in the same way as other fiduciary duties owed by directors to their company. As a result, the Explanatory Notes to the Act30 warn that the consequences of breach may include: • damages or compensation where the company has suffered loss; • restoration of the company’s property; • an account of profits made by the director; • rescission of a contract where a director failed to disclose an interest. In certain cases the remedy will be straightforward to assess, such as accounting to the company for secret profits, but it is less obvious how the courts will determine the loss arising from a breach of the duty to promote the success of the company but where no actual loss has occurred. DERIVATIVE ACTIONS The Act provides a new statutory regime under which a member can bring a cause of action in respect of negligence, breach of duty, default or breach of trust of a director. Such claims are known as "derivative actions", since the member is taking action on behalf of the company in circumstances where the company is unable to do so (since its directors will be able to prevent this). Under the common law, these have proved difficult for a member to bring. In response to fears that directors would be subjected to large volumes of claims from disgruntled shareholders (possibly calculated at disrupting the business of the company - scenarios envisaged commonly involved environmentalists purchasing shares in oil companies), the Act includes various procedural safeguards. The member must first apply to court for permission to continue a derivative claim, and will have to establish a prima facie case.31 The court will take into account various factors in deciding whether to give permission, including whether the member is acting in good faith, and whether the relevant acts of the directors was authorised or ratified. The discretion afforded to the courts by this two-stage procedure should go some way to allaying fears that the new regime will lead to significantly increased risks of tactical litigation against directors. It should also be remembered that, historically, the English courts have been largely unwilling to intervene in decisions which it believes directors have taken in good faith. There remains the possibility, however, that militant shareholders or pressure groups (who purchase shares in the company) will seek to use the new procedure for publicity purposes, at the very least. This is particularly the case given the recent changes to the English civil procedural rules, which make it easier for members of the public to access documents filed at court. Another feature which may discourage claims is that any damages awarded belong to the company and not the member personally (unlike certain class actions in other jurisdictions). It remains to be seen how the courts will approach derivative claims, and whether they will be willing to strike out claims that are frivolous or vexatious at the earliest opportunity. It can only be a matter of time before the first derivative action is brought under the new procedure alleging that directors have negligently failed to take into account one or more of the factors listed in section 172 of the Act. Until a process becomes clear, directors will face a difficult decision as to whether to simply oppose a claim on the grounds that it is clearly unmeritorious and should be refused permission to continue, or to oppose the claim on substantive grounds which may require disclosure of board minutes and other paperwork. Conceding the prima facie claim may seem to be giving credence to the allegation of wrongdoing, but to oppose permission unsuccessfully could be more damaging (even if the member is not ultimately successful at full trial). IMPACT OF THE NEW REGIME ON COMPANIES AND DIRECTORS Concerns were raised throughout the legislation’s passage through Parliament that the way in which the general duties have been drafted, coupled with changes to the procedures for derivative actions, will lead to an increase in actions against directors. Lord Hodgson (Conservative) expressed the point in Committee in the House of Lords during debates on the Companies Bill: "To put it in vulgar, non-legal terms, people who have spoken to us fear a double whammy. In Part 10 of the Bill, directors’ duties are widened, while Part 11 makes it easier for shareholders to commence actions against directors. There is concern. Is it justified? That is what we are trying to find out in Committee." The uncertainty over derivative actions prompts the question as to how directors should record their decisions so as to minimise the prospect of claims. One possible response would be to seek to document board meetings in exhaustive detail, stating expressly that for each decision that due and careful regard was given to the six requisite factors and setting out lengthy accounts of the discussions on each factor. The GC 100, a body comprising senior legal officers of more than 70 FTSE companies is strongly opposed to this approach and believes it would be harmful to UK business efficiency. It points out that the Attorney General stated in the House of Lords that "There is nothing in this Bill that says there is a need for a paper trail…I do not agree that the effect of passing the Bill will be that directors will be subject to a breach if they cannot demonstrate that they have considered every element". The GC100 recommends instead that: • Companies should ensure that all board members are aware of their duties under the new Act; • the terms of appointment and description of the role of every director should specifically refer to his duties; • Companies should review their existing policies in areas such as human resources, ethics, compliance and corporate responsibility against the background of the new duties; and • the company’s management team responsible for preparing background briefing papers and presentations for board meetings should ensure that the relevant factors are considered (and irrelevant factors discounted), in order to assist the directors in properly taking these into account in reaching their decision. The directors would of course have to exercise their judgment in considering such briefings and only delegate these tasks to appropriate persons, but the GC100 proposes that board minutes should not be used as the main medium for recording the extent to which the various factors were evaluated and discussed. Negative statements should not be required and there should be no inference from omission that the factors were not properly considered. This would mean that the length and complexity of board minutes did not have to increase.32 A number of arguments were advanced to support this conclusion: • only a minority of directors’ decisions are made at board meetings. Most will by commercial necessity be made by individual directors without any formal process or preparation of prior paperwork, and Companies will have to decide the best approach in these situations; • board minutes are only a summary of a meeting, and Companies have legitimate reasons for wanting to keep these brief (such as not wanting to undermine legal privilege by citing advice); • it has not previously been considered necessary for board minutes invariably to recite consideration of directors’ general duties. The Companies Act 1985 section 309 requires directors to have regard to the interests of employees but this is hardly ever referred to expressly in board minutes; • standardised instructions to directors to consider the six factors listed in the Act could prevent directors from exercising their own business judgment and identifying other relevant considerations. The large Companies which the GC100 represents will be in a better position than smaller private Companies to have management teams tasked with preparing supporting board papers, but even here the paper points out that this level of formality may not always be practicable. It is to be hoped that governmental guidance will be issued in this area rather than having to await the first decisions of the courts. CONCLUSION It will be apparent from the above analysis that the new regime represents more than a simple exercise, and raises a number of significant issues that companies and their directors will need to address. The most controversial and commented upon section of the Act was the codification of directors’ duties. The Government’s original intention was laudable - to implement current law on directors’ duties into the Act to improve clarity and accessibility of the law.33 However, this aim was arguably lost in translation resulting in seven “magnificent” general duties, two important new principles and a number of smaller changes to the current law. The codification of directors’ duties also puts the spotlight on company decision making processes, company constitutional documents and the way in which directors are protected against liability resulting from their office. Additionally, companies must now ensure that directors and senior management are fully aware of the effects of the Act on their actions.34 The proposed statutory statement of directors’ general duties will, at least initially, probably cause some confusion and concern for directors when a company is nearing insolvency. Directors are likely to require substantial advice as to whom their duties are owed in such circumstances and how to discharge them. There might also be an impact on director and officer liability insurance if it leads to increased litigation. It remains to be seen whether the Act will in fact lead to many more decisions of directors being challenged in the courts. What is clear is that it is vital for directors and advisers to take steps as soon as possible to ensure that directors are fully conversant with the new law, and that Companies have robust policies and procedures in place in relation to decision making of directors.35 BIBLIOGRAPHY BOOKS AND ARTICLES House of Commons Environmental Audit Committee (2005). Corporate Environmental Crime: Second Report of Session 2004-2005. White paper by Association of British Insurers (2006). Company Law Reform Bill. London: ABI. CORE (2006). Companies Bill: Making Corporate Irresponsibility History? Media Briefing, 10 Oct. 2006 Mohr, L.A and Webb, D.J. (2001). Do Consumers Expect Companies to Be Socially Responsible? The Impact of Corporate Social Responsibility on Buying Behavior. Journal of Consumer Affairs. 35(1), 45. Carroll, A.B. (1991). The Pyramid of Corporate Social Responsibility: Toward the Moral Management of Organizational Stakeholders. Business Horizons, 34(4), 39-48. Gilian Eastwood and Pauk Wortley ,Companies Act 2006—Directors Duties and the Impact on Directors’ and Officers’ (“D&O”) Insurance July 2007 - Issue XX, The Companies Act 2006: A look at how it affects restructuring and insolvency matters, Freshfields Bruckhaus Deringer, March 2007 available at http://www.freshfields.com/publications/pdfs/2007/apr04/18153.pdf "Duties of Directors in New Companies Act 2006," Personnel Today (May 2007) Online edition available at http://www.personneltoday.com/Articles/2007/ 05/08/40470/duties-of-directors-in-new-companies-act-2006-legal-q.htm INTERNET SOURCES www.autoindustry.co.uk/pressrelease/09-11-06, last visited 02/08/07. www.berr.gov.ik/files/file40139.pdf, last visited 04/08/07 www.bondpearce.com, last visited 03/08/07 www.burges_samon.com/publications/contentThe Companies Act 2006 BMM0126_02_07, last visited 03/08/07. www.bytestart.co.uk/content/legal, last visited 03/08/07 www.ffw.com/pubication fils/0d556998, last visited 02/08/07. www.freshfields.com/publications/pdf/2006/17062.pdf, last visited 02/08/07 www.londonstockexchange.com/analysis, last visited 04/08/07 www.mayerbrownrowe.com/publications/article.asp, last visited 04/08/07 www.netlawman.co.uk/info/directors_duties_companiesAct_2006, last visited 04/08/07. www.nonexecs.com/pdf/3444%20NED%2007'%20Roundtable.pdfbabinc.org/publications, last visited 02/08/07. www.opsi.gov.uk/acts/en2006/ukpgaen_20060046_en.pdf. last visited 03/08/07 www.opsi-gov.uk/acts2006/ukpga, last visited 02/08/07. www.practicallaw.om/jsp, last visited 03/08/07 www.uk.computershare.com/content/download.asp, last visited 02/08/07. 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