A Comparative Analysis of the Previous Legal Position and How It Was Changed by the CA 2006 Provisions - Assignment Example

Director’s duties at common law and in equitable principles are now codified in the Companies Act 2006. One of the most significant changes is the introduction of enlightened shareholder value in section 172. Moreover, the no-conflict and no-profit rules are codified with considerable changes in relation to disclosure and ratification. It is argued that directors are now more tightly controlled than before. Critically evaluate. Prior to the Companies Act 2006 (CA 2006), the 1989 Companies Act and the Companies Act 1985 provisions pertaining to directors’ duties provided positive obligations for directors to act in good faith and in the best interest of the company, to avoid conflicts of interest and not to profit from their office1. These statutory provisions applied in conjunction with established principles of common law and equity in relation to directors duties2. However, in the consultation phase leading to the implementation of the CA 2006, the Government expressed dissatisfaction at the inherent uncertainty of these provisions and have attempted to codify both the common law and statutory provisions pertaining to directors duties under the CA 20063. In turn this has lead to some commentators arguing that the CA 2006 codification of directors’ duties has resulted in tighter controls on the exercise of director’s duties. This paper critically evaluates this argument with a comparative analysis of the previous legal position and how far this has been changed by the CA 2006 provisions. If we firstly consider the previous position under common law and equity, the issue of fiduciary duty has commonly arisen in constructive trust and tracing cases. Additionally, issues have arisen regarding the interrelationship between director’s duties and the abuse of the corporate structure as exemplified by phoenix company syndrome4. The term “phoenix” company is utilised to define a corporate structure where assets of one limited company are moved to another legal entity5. Commonly, some or all of the directors and management will remain directors in the successor company and in some instances the successor company will have the same or similar name to the failed business6. In simple terms, a phoenix company is a limited liability company: “housing individuals, or the directors by name or otherwise, who abuse the corporate form by dissolving one company and creating another to avoid payment of debt”7. Furthermore, it has been commented that the Register of Companies is “littered with cases involving phoenix companies…… ones which fail and then seemingly reappear overnight in substantially the same form and with substantially the same management8”. Typically, a phoenix company will use all or some of the assets of the insolvent company and will trade in the same industry and similar manner to the failed predecessor9. Whilst it is perfectly legal to form a new company from the debris of a failed company, “phoenix syndrome” has repeatedly been criticised as a means of abusing the statutory provisions implemented to protect against wrongful trading and abuse of position10. For example, a director of a failed company can become a director of a new company unless they are bankrupt or subject to a disqualification11. One the hand, it is clear that not all legitimate businesses will succeed on first attempt and the Small Business Service12 estimates that one in three businesses shuts down within three years13. Nevertheless, it is submitted that reasons for failure are multifarious and it would be undesirable for the law to penalise honest individuals from acting as directors simply due to difficulties in running a business. Accordingly, it is propounded that in such circumstances, the phoenix company arrangement is beneficial in allowing a business to start again14. Moreover, the phoenix arrangement enables profitable aspects of the failed business to survive into the successor company, thereby preserving an element of continuity for both suppliers and employees15. Conversely however, in the past, some directors have deliberately forced their companies into insolvency in order to buy back assets at a reduced price while absolving their responsibility for liabilities16. In a minority of cases, directors have abused the phoenix company arrangement by transferring assets of a failing business at less than market value before insolvency, thereby reducing the funds available to creditors when the original company becomes insolvent17. Furthermore, in 2007, the Better Payment Practice Group (BPPG)18 found that a quarter of UK companies had been stung by a phoenix company. The poll asked businesses if they had ever fallen foul of a phoenix company. Of the 425 respondents, 26% had been adversely affected by a phoenix company19 and in response to the poll the BPPG issued a guidance note on its website20 to help identify abuse through the phoenix medium. In the event that a director is involved in phoenix activities, they are most likely to breach a number of directors’ duties stemming from common law and statute21. Equitable duties of a director arise from the fiduciary relationship between a director and company and as such, directors have a general duty to act in good faith and exercise their discretion bona fide in the interests of the company22. Moreover, directors must exercise independent judgment in order to prevent a claim for breach of duty of good faith23. The fiduciary duty to act in good faith and in the interests of the company is a duty as a whole and the duty is subjective. For example, in the case of Re Smith v Fawcett Ltd24it was held that directors must act “bona fide in what they consider is in the best interests of the company25”. Moreover, Directors must also make proper use of their position and the information they acquire through their position26 and the case of Cook v Deeks27 asserted that directors cannot take advantage of an opportunity or information that belongs to the company without prior approval of the company. The common law fiduciary duty is further bolstered by the provisions of the Company Directors Disqualification Act 1986, where the courts can disqualify directors whose companies have failed as a direct result of their misconduct for periods up to 15 years. This will disqualify an individual from being a director of a company, acting as a receiver of company property and being concerned or taking part in the promotion, formation or management of a company28. It also disqualifies them from being a member of a limited liability partnership or taking part in promotion formation or management of such a partnership29. The term “director” is wide in scope and applies to anyone in the position of director of a company, whether or not they are labelled a director30. Additionally, if a bankruptcy order has been made against an individual, they must get the court’s permission before becoming a member of a limited liability partnership or acting as director of or “directly or indirectly taking part in or being concerned in the promotion, formation or management of a company for the duration of the order”31. Whilst the provisions relating to breach of fiduciary duty, disqualification and bankruptcy are wide in scope and cover a broad range of directorial misconduct; the sanctions essentially create consequences for the individual directly and may not always be beneficial to a creditor of a company that has been a victim of phoenix syndrome in recovering monies and/or assets. Accordingly, insolvency law has tried to safeguard and bolster creditor protection in a new company to specifically address the abuses of the phoenix syndrome in order to minimise losses32. Moreover, the equitable and common law extrapolation of the director’s duty of care to the company and its members has also commonly arisen in trust cases involving knowing receipt. Fiduciary duty is a generic term that covers a wide range of situations that occur where someone is held to have particular obligations to another party because of their relationship with them33. There does not need to be a trust (although a trust will give rise to a fiduciary relationship) but similar obligations then occur. Where funds have been misappropriated in breach of fiduciary duty, the courts have enabled civil claims of tracing on the premise that the fiduciary duty imposed obligations as trustee of the funds and the misappropriation therefore constitutes knowing receipt of trust property34. Accordingly, the intrinsic complexity of applying the common law and equitable principles pertaining to director’s duties were perpetuated by the ad hoc judicial decisions. In turn, this not only created uncertainty with regard to the parameters of director’s duties, but it also rendered the position of shareholders and creditors increasingly dependent on ad hoc judicial determination. The CA 2006’s objectives were to address these issues and indeed, the government’s rhetoric in supporting the legislative reforms have suggested that the codification of common law and fiduciary duties now addresses the previous uncertainty pertaining to the parameters of director’s duties, particularly with the equitable fiduciary duty35. With regard to the CA 2006 provisions, firstly, the duty on directors to act within their powers codifies the common law principles regarding exercise of power for a proper purpose36. Moreover, under section 172 of the CA, there is a new duty deriving from the equitable fiduciary duty principle expressed as a duty to promote the success of the company. To this end, section 172(1) sets out a non-exhaustive list of guidelines that a directors should refer to including (without limitation) the relationship with suppliers and customers, impact of decision on environment and members of the company. This is important to ensure protect the company’s liability and failure to comply cannot only result in exposing the company to potential claims, but can also lead to piercing of the corporate veil for potential actions against the director37. However “success” is not expressly defined in the CA 2006 and the DTI guidance suggests that this relates to the commercial long term increases in value to a company particularly in commercial companies38. However, it remains to be seen how this will be in line with the director’s duties under section 172, particularly as now directors have to consider environmental and local factors when making decisions39. Furthermore, section 173 of the CA 2006 imposes a positive duty on a director of a company to exercise independent judgment. On this basis, it has been argued by some that the section 173 eliminates the possibility of shadow directors or sleeping directors. Furthermore, it again remains to be seen how this will impact directors in practice, however the argument regarding the continued use of shadow or sleeping directors would appear to support the argument that the CA 2006 codification has resulted in a more tightly controlled system for regulation of director powers. Section 174(1) sets out the common law duty of care and skill for directors and section 174(2) sets out an objective test similar to the dual obligations test extrapolated under section 214 of the Insolvency Act 1986 in relation to the wrongful trading provisions To this end, section 174 requires a consideration of firstly the hypothetical reasonable person and then the subjective director regarding actual knowledge when considering compliance with the section 174 duty. Accordingly, it is submitted that overall, the 2006 Act codifies, restates and simplifies the complex provisions pertaining to conflict of interest under the 1985 Companies Act and these provisions are only applicable in respect of transactions between a director and a third party in relation to property, information or opportunity40. As such, the 2006 Act prima facie makes it easier to enter into transactions with third parties without shareholder approval, which conversely would undermine the argument regarding tighter controls of director duties. Furthermore, in a review of the CA 2006 provisions in relation to director duties, it has been commented that there remain concerns regarding the practical impact of section 172 in particular especially where a director has multiple directorships41. Indeed, as highlighted above, the most significant difference between the common law extrapolation of the director’s duty and the statutory provisions is the section 172 requirement regarding the promotion of success and loyalty42. For example where the common law duty imposed a duty of good faith and to act in the interests of the company, the section 172 requirement under the 2006 Act goes further and requires directors 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”43. However, this has perpetuated uncertainty particularly in the absence of specific guidance44. For example, Lord Goldsmith who was the government’s spokesman regarding this aspect of the 2006 Act suggested that the duty was to promote the success of the company was for the benefit of the members as a collective body and that the concept of success was meant long term increase in value45. However, again it is not completely clear if previous case law can be relied upon in determining compliance with the section 172 requirement even though the 2006 Act specifically provides that reference should be made to the common law principles when applying section 172. It may be that the courts will apply this in the same way and as the Act states that should apply common law, it clearly questions the extent to which the Act has implemented meaningful changes regarding director’s duties in practice. Indeed, Freshfield Bruckhaus Deringer’s review of the impact of section 172 in practice suggests that “in our experience, the rules have not, in most circumstances required directors to decide particular questions differently from the way they would have decided before the Act came into force46.” Accordingly, it is submitted that overall, the intention of the 2006 Act’s reforms was to clarify the parameters of directors’ duties by codification of both the previous statutory provisions and common law principles within one framework. However, the CA 2006 highlights the fact that the provisions are to be interpreted in accordance with precedent, which in turn has been criticised for undermining the purpose of codification47. It remains to be seen how far the new provisions on director’s duties will manifest in practice, however whilst welcome in attempting to simplify the framework, it is submitted the new provisions on directors’ duties create uncertainty with the inherent ambiguity of the obligation to promote a company’s success, which increases the risk of litigious shareholders particularly in light of the CA 2006’s new provisions regarding derivative actions. Therefore, it is submitted that the extent to which the new provisions actually result in increased control of director’s powers and duties will depend on the judicial interpretation of the provisions and how far the courts deviate from the previous position prior to the CA. BIBLIOGRAPHY N. Bourne, Bourne on Company Law (Routledge, 5th Edition 2010) N, Couburn, “The Phoenix re-examined” (1998) 9 AJCL 321 M Crystal, M Phillips & G Davies., Butterworth’s Insolvency Law Handbook, (12th Edition Butterworths, 2010) A. Dignam & J. Lowry, Company Law (6th edition Oxford University Press, 2010) J. Dine & C. Ervine, Company Law and Core Statutes 2010-2011, (Palgrave Macmillan, 2010). I. Fletcher, Insolvency in Private International Law: National and International Approaches, (2nd Edition Oxford University Press, 2005). D. French, S. Mayson & C. Ryan, Mayson, French and Ryan., Company Law, ( 27th Edition Oxford University Press, 2010). Freshfields Bruckhaus Deringer, “Companies Act 2006- Directors’ Duties” (2008) 1 October 2008 at www.freshfields.com/publications/pdfs/2008/oct08/24288.pdf accessed January 2011. B. Hannigan, Company Law (2nd Edition, Oxford University Press, 2009). G. Morse, Palmer’s Company Law: Annotated Guide to the Companies Act 2006, (Sweet & Maxwell, 2nd Revised Edition, 2009). C. Wild, Smith & Keenan’s Company Law, (14th revised edition Pearson Longman, 2009) Legislation & Websites Company Directors Disqualification Act 1986 available at www.opsi.gov.uk accessed January 2011 Insolvency Act 1986 available at www.opsi.gov.uk accessed January 2011 Companies Act 2006 available at www.opsi.gov.uk accessed January 2011 Department for Business Enterprise and Regulatory Reform (BERR), at www.berr.gov.uk accessed January 2011. www.payontime.co.uk accessed January 2011 Read More