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In-Depth Analysis of the Companies Act aimed at Corporate Counsel

A detailed look at the provisions in the Companies Act 2006 affecting directors

Sources for the legal team:
The full text of the Companies Act 2006 is at: www.opsi.gov.uk/acts/acts2006/20060046.htm.

Explanatory notes are at www.opsi.gov.uk/acts/en2006/ukpgaen_20060046_en.pdf.

The Department for Business, Enterprise and Regulatory Reform (www.berr.gov.uk) has a number of resources available, including a set of FAQs.

Directors' Duties
Directors are responsible for carrying on the business of the company and exercising its powers. Their primary responsibility is to the Company, but they will also have obligations to their fellow directors, the employees and any creditors of the Company. The Companies Act 2006 makes no distinction between executive and non-executive directors.

The duties owed by directors to their companies were not codified previously. Instead they had evolved through case law. In reviewing company law in the run up to introducing the Companies Act 2006, the Law Commission formed the view that many directors struggled to access and interpret their duties and so the decision was made to codify them and with certain modifications to introduce the principle of enlightened shareholder value and provide new procedures for resolving conflicts of interest. However, codification is not exhaustive. Directors will continue to owe certain equitable and common law duties to the company, such as a duty of confidentiality and the duty to consider or act in the interests of creditors when the company is insolvent.

The Companies Act 2006 now sets out seven duties of directors as follows:

s.171: Duty to act within powers
s.172: Duty to promote success of the Company
s.173: Duty to exercise independent judgement
s.174: Duty to exercise reasonable care, skill and diligence
s.175: Duty to avoid conflicts of interest [October 2009 according to current government timelines]
s.176: Duty not to accept benefits from 3rd parties [October 2009 according to current government timelines]
s.177: Duty to declare interest in proposed transactions [October 2009 according to current government timelines]

s.171: Duty to act within powers.
This duty is a codification of the existing common law duty. It states that directors must act in accordance with the company's constitution and must only exercise their powers for their proper purpose.

A company's constitution for these purposes includes: the company's articles of association (and memorandum), decisions taken in accordance with the articles of association, other decisions taken by the shareholders or a class of them (where treated by law as equivalent to decisions of the company) and any resolutions and agreements affecting a company's constitution.

Unfortunately, s.171 does not clarify how a director might ascertain what the proper purposes of a company might be. Instead you have to look to previous case law, under which courts have approached the duty by first ascertaining the purpose for which the power was conferred, and then determining whether that was the director's "substantial purpose" when exercising the power. Liability is strict and a director will be in breach if the director's substantial purpose was not the purpose for which the power was conferred. It will not matter if he exercised the power in good faith or in the belief that it would promote the success of the company for the benefit of the shareholders as a whole.

s.172: Duty to promote the success of the Company
This is the most controversial duty. It states that directors must act in the way that they consider, in good faith, is most likely to promote the success of the company for the benefit of its shareholders as a whole, both now and in the future. This applies to all their actions, not just formal decisions made by the board.

"Success" is not defined. The government has stated that "success" in this context will usually mean "long-term increase in value" for commercial companies, and that what will promote the success of the company, and what constitutes such success, will be for the directors' good faith judgment. However, the Companies Act 2006 goes on to set out certain (non-exhaustive) factors which the directors must have regard to when making their decisions. Directors must consider (among other things):

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 the shareholders of the company.

However, in cases where the purpose of a company is set out in the constitution (common in charitable companies), then the director must act in the way he considers, in good faith, would be most likely to achieve those purposes.

s.172 is controversial because, with so many factors to take into account, it is easy to see how conflicts might arise. A decision by the board might be for the benefit of the company's employees but detrimental to the environment. No guidance has been issued that addresses how to weigh these factors up against each other. And, of course, this duty remains subject to any law requiring directors in certain circumstances to consider or act in the interests of the creditors. Therefore, the duty will be modified if the company is insolvent or is approaching insolvency.

The practical question for most boards is how they should document their compliance with this obligation. Government guidance (limited though it has been) and the published views of the GC 100 (a group of general counsel of top UK companies) suggests that the board does not need to consider in detail each of these factors whenever they make a decision. The GC100 in particular took the view that they should not venture down the path of creating a lengthy paper trail to evidence the fact that each of the factors had been considered. It will be sufficient for the minutes to state that the directors have taken the factors into account in carrying out their duty. Clearly if a decision is likely to be controversial or impacts severely on one of the parties mentioned above, then the board would be advised to set out how they reached their decision. Companies should also consider whether briefing papers produced in advance of a board meeting should address each of the factors (unless clearly irrelevant) along with any other relevant matters.

s.173: Duty to exercise independent judgement.
This duty does not prevent directors relying on advice as long as they exercise their own judgement in deciding whether to follow the advice. They may also act in accordance with agreements entered into by the company that restrict the exercise of the directors' discretion or in a way authorised by the company's constitution.

s.174: Duty to exercise reasonable care, skill and diligence
Before this duty was codified, the common law duty was generally accepted to be the objective/subjective test set out in s.214 Insolvency Act 1986. The codified duty is consistent with the common law approach and s.174 borrows heavily from the language used there. In exercising this duty, the directors must use the level of care, skill and diligence which would be exercised by a reasonably diligent person with both:

the general knowledge, skill and experience that may reasonably be expected of a person carrying out the director's specific functions in relation to the company (the "objective" test); and
the general knowledge, skill and experience that the director actually has (the "subjective" test).

So, at a minimum, a director must display the knowledge, skill and experience set out in the objective test. The subjective element will be relevant where the director has specialist knowledge. For example, an accountant might be expected to know more about the financial aspects of running a business than a director who came from a sales background. In applying the test consideration will also be given to the functions of the particular director, including his specific responsibilities and the circumstances of the company.

A director is still entitled to delegate to others within the firm but must supervise the discharge of the delegated functions.

s.175: Duty to avoid conflicts of interest [October 2009 according to current government timelines]
The common law duty which prevails until s.175 comes into force is more or less the same as the codified duty and requires that directors must not, without shareholder consent, put themselves in a position where there is a conflict (or possible conflict) between the duties they owe the company and either their own interests or the duties that they owe to a third party. The common law position is modified in that (subject to certain restrictions) independent directors may authorise such conflicts. Authorisation by this method will only be effective if the required quorum for a board meeting is met without counting the director in question or any other interested director and if the conflicted directors have not participated in the taking of the decision or if the decision would have been valid without the participation of the conflicted directors.

It is an obvious point but as it is set out in s.175, it is worth repeating: the duty is not infringed if the situation cannot reasonably be regarded as likely to give rise to a conflict of interests.

One issue from this duty arises in the context of multiple directorships. Directors are advised to obtain approval upfront from disinterested directors for any actual or potential conflicts arising from other directorships. One concern here is that a general disclosure of another directorship might not be informative enough but the disclosing director might be unable to say any more because of his duty of confidentiality to the other company. Companies might consider amending their articles to allow for such issues, for example, to provide that directors may hold additional directorships and need not disclose confidential information obtained through those other offices.

s.176: Duty not to accept benefits from 3rd parties [October 2009 according to current government timelines]
There is little difference between this duty and the existing common law duty requiring that directors shall not to exploit their position for their personal benefit. A director is liable to account to the company for any gain they achieve as a result of a breach of this duty. The new provision simply helps to define some of the terms used in the duty (particularly, in relation to what is a third party) and includes the safe harbour provision stating that the duty is not infringed if the acceptance of the benefit cannot reasonably be regarded as likely to give rise to a conflict of interest. Unlike conflicts under s.175 or s.177, independent directors cannot authorise a receipt of benefits, although shareholders can.

s.177: Duty to declare interest in proposed transactions [October 2009 according to current government timelines]
The common law rule is that directors may not have an interest in a transaction with the company unless the interest has been authorised by the shareholders. In practice, this rule is modified by the articles of most companies to allow a director to declare at a board meeting any interest in any proposed or existing transaction or arrangement with the company. Depending on how the articles are drafted, he may or may not be able to speak and vote on the transaction in which he is interested. The new duty reflects the position that is normally drafted into articles of association and the obligation is not much different to that under s.317 of the Companies Act 1985. By s.177, directors must declare to the other directors the nature and extent of any interest, direct or indirect, in a proposed transaction or arrangement with the company. The director need not be a party to the transaction for the duty to apply. An interest of another person in a contract with the company may require the director to make a disclosure under this duty, if the other person's interest amounts to a direct or indirect interest on the part of the director.

To satisfy the obligations in s.177, the declaration must be made before the company enters into the transaction or arrangement. Where a declaration of interest proves to be, or becomes inaccurate or incomplete, a further declaration must be made.

Note that s.182 provides for similar obligations in respect of existing transactions of the company. A s.182 declaration will not be required where:

a s.177 notification has already been made;
the other directors are already aware of the transaction;
it involves service contracts that have already been considered by the directors; or
(usual caveat) where the interest cannot reasonably be regarded as likely to give rise to a conflict of interest.

Cumulative nature of the duties
Where more than one duty applies in a given case, the directors must comply with each applicable duty. For example, the duty to promote the success of the company will not authorise directors to breach their duty to act within their powers, even if they consider that action would be most likely to promote the success of the company.

Consequences of breach
A breach of the duties owed as a director can result in disciplinary proceedings, the termination of the director's employment (if any), or court proceedings may be issued for an appropriate remedy. These include an award of damages, an injunction preventing the director from taking further action, an order setting aside of the transaction and giving restitution, an account of profits or restoration of any company property held by the director. In some cases, there may also be imprisonment or a fine.

As before, the Companies Act 2006 provides for a shareholder ratification procedure, however, in a departure from previous law, any decision by a company to ratify must be taken by the shareholders without reliance on the votes in favour by the director or any connected person.

Protecting directors from liability
As derivative claims are brought for and on behalf of the company it would be contrary to the company's interest to include any provision in its constitution exempting a director for liability for breach of duty. Similarly, any provision providing for a blanket indemnification of costs would run contrary to its interests. Accordingly any such provision is void by virtue of the Companies Act 2006. Directors are therefore exposed to the risk that they may have to pay their own costs of defending any action, something many directors (particularly non-executive directors) are aware of. Insurance, however, is allowed and so it is common for the articles to contain a provision entitling the company to purchase and maintain insurance for a director in defending the costs of an action brought personally against him. You should ensure that your own articles have this provision.

1. The New Derivative Action Procedure
As with the common law duties, the codified duties are owed to the company. The general rule is that only the company will be able to enforce them, although in certain circumstances shareholders may be able to bring a derivative action on the company's behalf. The procedure for bringing derivative actions is now enhanced by Companies Act 2006 giving rise to concerns about increased litigation against directors.

This has been addressed by making it a 3 stage process to bring a derivative action. First the applicant must establish a prima facie case against the director. This is a relatively straightforward stage and is not a particularly hard hurdle to overcome. Next, the applicant must apply for continuation of the action at a continuation hearing. In this hearing the court will consider a number of factors such as whether:

a person acting in accordance with the general duty to promote the success of the company would not seek to continue the claim;
the act or omission giving rise to the cause of action has been authorised or ratified by the company (or is likely to be ratified); or
whether the company has decided not to pursue the claim.

If the courts approve continuation, the matter will proceed to full trial. Even if a director is found guilty of the alleged breach, the courts still have the discretion to relieve a director of liability if they believe he acted "honestly, reasonably and ought reasonably to be excused".
In the event that an action against a director for breach of a codified duty is successful, the consequences are the same as for breach of the corresponding common law or equitable principles. For example, the remedy for a breach of s.174 (Duty to exercise reasonable care, skill and diligence) will usually be damages.

2. False/Misleading Statements in Company Reports
Where a company is required to produce a directors' report, directors' remuneration report or a summary financial statement, directors are potentially liable to the company (and not to shareholders or any other body of claimants) for untrue facts or omissions.

Under s.463 Companies Act 2006, a director will be liable to compensate the company for any loss suffered by the company in the case where, in such statutory reports, the director:

knowingly makes an untrue or misleading statement;
makes an untrue or misleading statement and was reckless as to whether it was untrue or misleading); or
knowingly omits fact(s) that are so important they amount to dishonest concealment of a material fact.

3. Relaxed Regime for Board Decisions
The Companies Act 2006 provides for a relaxed regime on decision-making by directors, however, most companies will not be able to take advantage of it because their articles of association provide for a more stringent regime. Any company can now change its articles to adopt the new regime and, from 1 October 2009 (according to current government timelines), it will be the default regime for all new companies.

Notices for board meetings do not need to be in writing but each director must be made aware of the time, date, place, subject matter and mode of communication to be employed in the board meeting.

Valid decisions of the directors can also be made outside of formal board meetings. Unanimous decisions of the board can be made by directors in different places, at different times and by any mode of communication. The only requirement is that they all are unanimous in the decision. Majority decisions can be made where:

a director becomes aware of a matter that requires a decision;
he makes the other directors aware of that matter/decision;
the directors have reasonable opportunity to communicate their views to each other; and
a majority vote in favour.

4. Relaxed Regime for Shareholder Decisions
Meetings
The approach to shareholder resolutions and meetings under the Companies Act 2006 are quite different to the Companies Act 1985. Private companies are no longer required to hold an annual general meeting, (unless required by their articles of association � many existing companies will be). If an annual general meeting is held, 14 clear days' notice of the meeting is required (previously 21 days), unless the articles of association provide for a longer period. Shorter notice may be given if 90% of the shareholders have consented to such short notice.
As before, 10% of the voting shareholders can requisition a general meeting. However, only 5% of the voting shareholders are now required to call a meeting or circulate resolutions if more than 12 months have passed since the time the shareholders last had the right to circulate resolutions. If the directors fail to convene a general meeting, the shareholders may do so in their stead and recoup the expenses from the company.

Written Resolutions
A company will be able to pass any resolution using the written resolution procedure, with the exception of:

a resolution to remove a director; or
a resolution to remove an auditor before the expiration of his/her period of office.

Previously written resolutions had to be passed by all the shareholders of the company entitled to attend and vote a general meeting. Now, there is only a requirement to obtain the same level of approval as would be required on a poll at a general meeting. So, special resolutions can be passed by holders of at least 75% of the voting shares and ordinary resolutions with 50%. Note that there is still a requirement to obtain the vote of the majority of shareholders by number and so substantial shareholders may struggle to pass a special resolution by written resolution if a large number of smaller shareholders vote against it.

Written resolutions may be proposed by the directors of a company or by shareholders of a company totalling at least 5% of the voting shares (although the articles of association may specify a lower percentage). The eligibility of those shareholders who may vote on the resolution is fixed on the day the resolution is circulated. A proposed written resolution will lapse if it is not passed before the end of (a) the period specified for this purpose in the articles of association; or (b) if the articles of association do not specify, the period of 28 days beginning with the date on which the resolution was circulated. A failure to return a signed resolution by the lapse date counts as a vote against the resolution.

Companies Act 2006 sets out the procedure for written resolutions at s.288-300.

5. Fair dealing: directors' transactions requiring shareholder approval
Companies Act 2006 contains new provisions governing the enforcement of fair dealing by directors. The new provisions (which for the most part apply to all companies, public or private) cover four specific situations in which directors face a potential conflict of interest. As a result, such transactions have to be approved by an ordinary resolution of the shareholders. They are as follows:

entry into a director's service contract of more than two years in duration (previously five years). The definition of "service contract" has also been broadened to include contracts for services and letters of appointment;
substantial property transactions: any transaction between a company and a director or a connected person in relation to a non-cash asset which either exceeds £100,000 in value or exceeds 10% of the company's asset value and is more than £5,000 (previously the threshold was £2,000). In addition, these contracts can now be entered into conditionally whereas previously they had to be approved in advance, something that often proved inconvenient;
loans to directors by companies (except certain small loans by private limited companies) used to be prohibited outright and breach would be a criminal offence. Now loans of up to £10,000 made by a private limited company to a director are lawful, provided the details of the loan are supplied to the shareholders and the shareholders then approve the loan. The rules are modified in respect of public limited companies where certain "quasi-loans" are also permitted. Breaches of these rules are no longer a criminal offence; and
Companies Act 2006 restates the previous law (with some modifications) requiring shareholder approval for payments to directors for loss of office, including payments in connection with retirement, a share sale or business transfer. The relevant payments include those made to persons connected to the director (including a director of a holding company). The relevant loss of office now relates to loss of any office or employment in connection with the management of the company and not merely, to his position as a director. There is a new exception for small payments (no more than £200) and the old exception allowing "bona fide payments by way of damages for breach of contract" is restated.

In relation to the approval to be sought, where the director involved is also a director of the holding company, the approval of the shareholders of the holding company (if it is a UK company) is also generally required.

Note that even with shareholder approval, the directors must still have regard to their general duties, including the requirement to promote the success of the company.

6. Directors' personal rights and restrictions
Directors as natural persons: A new provision has been introduced to prevent a company being governed entirely by corporate directors. Corporate directorships are still permitted but each UK company must have at least one natural person as a director. This introduces greater transparency and prevents UK companies from being able to obscure their management. A company's ultimate ownership has to be declared in accounts filed with Companies House.

Directors' age: the previous requirement for directors to retire at 70 was repealed in April 2007. There is now no maximum age at which a person can hold a directorship. A new minimum age of 16 was introduced.

Directors' address: currently each director has to list their home address with very restricted rights to provide an alternative address. From October 2009 (according to current government timelines) all directors will be able to lodge a service address with Companies House; they will still have to supply Companies House with their home address but this will not be added to the public record. Existing entries, however, will not be altered.