Simon Graham of Wragge & Co LLP reports on the steadily amassing case law governing the newly-codified general duties of directors, and discusses one seemingly unavoidable legacy of the financial crisis: more regulation in the boardroom.

The Companies Act 2006 (2006 Act) is not yet three years old. The statutory statement of directors' duties (the statutory statement) is younger still: a little less than two years of age in the case of sections 171 to 174, and not yet 12 months old in the case of sections 175 to 177.

There is, nevertheless, already a significant body of 2006 Act-related case law, in particular in relation to sections 171, 172 and 174. Taken together, these cases help to answer a question much debated by market participants in recent years: does the statutory statement merely codify the common law obligations of company directors, or does it mark a radical departure?

There are, at the same time, a number of reform proposals now circulating in the arena of directors' duties that have been stimulated by the ongoing financial crisis. It cannot have escaped anyone's notice that we are, only a decade on from the Company Law Review, barely six years after the Higgs report, at another critical juncture in the regulation of company directors.

The latest case law

In the debates on directors' duties that have raged since codification, the case law is a resource that is at risk of being overlooked. More weight has sometimes been placed on less authoritative sources such as ministerial statements and the explanatory notes to the 2006 Act.

The 2006 Act states, somewhat delphically, that:

  • The general 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 as regards the duties owed to a company by a director (section 170(3)).
  • The 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 (section 170(4)).

While it is always necessary to submit the pre-2006 Act cases to the "section 170(3) and (4) test", it cannot be doubted that the old common law rules and equitable principles remain, if not intact, then of continuing relevance.

The post-2006 Act cases vary in authoritativeness too, from persuasive opinions of the Scottish Court of Session to decisions of the Court of Appeal. Most recently, a dissenting opinion in a judgment handed down by the House of Lords addressed the relationship between the 2006 Act and case law. A number of the judicial statements referred to in this article are undeniably dicta of one sort or another.

Exercising powers for the purposes for which conferred

A director of a company must only exercise powers for the purposes for which they are conferred (section 171(b), 2006 Act) (section 171(b)).

The pre-2006 Act "improper purpose doctrine" frequently came to the fore in the context of the directors' power to allot shares in bid situations. There is already a post-2006 Act example, in West Coast Capital (Lios) Limited ([2008] CSOH 72). Tesco Holdings Ltd was thwarted in its attempt to obtain complete control of Dobbies Garden Centres Plc, in part because a rival bidder, West Coast Capital (Lios) Limited (WCC), bought shares in the market at above the offer price.

While Tesco succeeded in achieving a 65% holding, WCC remained a substantial minority shareholder. The re-constituted board of Dobbies subsequently decided not to pay dividends, and proposed to raise £150 million by way of an issue of new shares. Neither decision made much sense to WCC, except in the context of an effort on Tesco's part to squeeze it out of the company. WCC sought to block the share issue, alleging unfair prejudice under section 994 of the 2006 Act.

Lord Glennie, in the Court of Session, expressed the view that section 171 (and section 172 for that matter) did little more than set out the pre-existing case law. The test under section 171(b) remained a subjective one: essentially one looked at the purpose or purposes for which the directors were exercising their powers (that is, their motivation). However, improper motivation could be inferred from an objective assessment of all the surrounding circumstances (following the decision of the Privy Council in Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821). If improper motivation were shown, that might be the basis not only of unfairly prejudicial conduct but also of a breach of duty under section 171(b).

On the evidence, however, Lord Glennie found in Tesco's favour.

Promoting company's success

A director of a company must 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 (the first limb of section 172(1), 2006 Act) (section 172).

Such evidence as is available from the law reports suggests that section 172 simply codifies the common law obligations of company directors. In Re Southern Counties Fresh Foods Ltd, the court compared the new form of words with the old (acting "bona fide in the interests of the company") and concluded that they came to the same thing, with the modern formulation giving a more readily understood definition of the scope of the duty ([2008] EWHC 2810).

In the House of Lords decision in Moore Stephens v Stone & Rolls Limited (in liquidation), Lord Mance (dissenting) emphasised not only that the duty is expressly based on common law rules and equitable principles (section 170(3)) but also that it is expressly subject to requirements on directors, in certain circumstances, to consider or to act in creditors' interests (section 172(3)) ([2009] UKHL 39).

The court in Re Southern Counties also confirmed that the test under (at least the first limb of) section 172(1) remains subjective in nature (that is, one looks at whether the director honestly believed that he acted in a way most likely to promote the company's success). This mirrors the pre-2006 Act position as set out in Re Smith & Fawcett Ltd ([1942] Ch 304). It should not be taken to mean that directors' decisions are immune from challenge.

There is yet to be reported a judgment which directly addresses the "enlightened shareholder value" philosophy supporting the second limb of section 172(1) (but see Rolls-Royce PLC v Unite the Union [2009] EWCA Civ 387;). Stimpson v Southern Private Landlords Association provides an example of how section 172(1) is to be construed in the context of companies with mixed objects (that is, where a company's objects include purposes other than the benefit of members) ([2009] EWHC 2072).

Further light was always likely to be shed on section 172 by cases illuminating Part 11 of the 2006 Act (derivative claims). The courts must consider, when dealing with applications for permission to continue a derivative claim, whether a person acting in accordance with section 172 would either:

  • Not seek to continue the claim (section 263(2)(a), 2006 Act) (section 263(2)(a)); or 2 This article first appeared in the September 2009 issue of PLC Magazine.
  • Attach more or less importance to continuing it (section 263(3)(b), 2006 Act) (section 263(3)(b)). The following cases are illustrative of how courts anticipate that directors will arrive at their decisions, at least in the context of instituting legal proceedings:

Mission Capital. In Mission Capital Plc v Sinclair and another, the Sinclairs (father and daughter) failed in their attempt to mount a derivative claim against a non-executive majority which had terminated their contracts of employment and directorships ([2008] EWHC 1339).

The High Court was satisfied that the Sinclairs brought the action in good faith. However, although it could not be satisfied that what it called "the notional section 172 director" would have not sought to discontinue the claim, it did not believe that such a director would attach that much importance to it.

While a company which had wrongfully dismissed a director might conceivably take action against those responsible, Floyd J suspected that it would be more inclined to replace the directors responsible for the decision. He also considered that the damage suffered by Mission Capital was somewhat speculative: another reason why the section 172 director would not attach great weight to it. The Sinclairs' personal claim continued.

Franbar Holdings. Permission to continue was refused also in Franbar Holdings Ltd v Patel, in large part because the High Court concluded that the claimant should be able to achieve all it could properly want through a petition alleging unfair prejudice and a related shareholders' action ([2008] EWHC 1534). Again, the court was not satisfied that "the hypothetical director" acting in accordance with section 172 would not seek to continue the claim, although work remained to be done in adequately formulating it.

Specifically with regard to section 263(3)(b), the court considered that the hypothetical director would take a wide range of considerations into account when assessing the importance of continuing the claim. These would include:

  • The prospects of success.
  • The company's ability to recover damages should it win.
  • The disruption which would be caused to the development of the company's business by having to concentrate on the proceedings.
  • The costs of the proceedings.
  • Any damage to the company's reputation and business were the proceedings to fail.

On the facts, the court concluded that it would be open to the hypothetical director to decline to proceed with the derivative claim, at least at such an early stage.

Alexander Marshall Wishart. In the appeal case of Alexander Marshall Wishart, the Extra Division of the Inner House of the Court of Session considered, in relation to (the Scots law equivalents of) sections 263(2)(a) and 263(3)(b), what attitude a director acting in accordance with section 172 would take to proposed proceedings ([2009] Scot CS CSIH 65). In much the same vein as Franbar Holdings, the court visualised a director weighing the potential advantages of the case as a whole against the likely cost, disruption and potential risks to reputation and business relationships, on the basis of the information available. This time, however, leave was granted.

Independent judgment

A director of a company must exercise independent judgment (section 173(1), 2006 Act) (section 173).

While there have, as yet, been no reported cases on section 173, two recent judgments are noteworthy in the context of the duties owed by nominee directors of joint venture companies: that of the Court of Appeal in Hawkes v Cuddy and others; Re Neath Rugby Ltd ([2009] EWCA Civ 291), and that of the High Court in Re Southern Counties. These cases are also of considerable interest in helping practitioners to assess the extent to which the duties of a director may be qualified, in particular by the unanimous assent of shareholders (but see section 173(2)(b), 2006 Act).

Reasonable care, skill and diligence

A director of a company must exercise reasonable care, skill and diligence (section 174(1), 2006 Act) (section 174(1)).

Unsurprisingly, the High Court in Gregson v HAE Trustees Ltd and others expressed the view that section 174 merely codified the existing law ([2008] EWHC 1006).

Examining the recent history of the duty of care, the High Court in Lexi Holdings (in administration) v Luqman and others described section 214 of the Insolvency Act 1986 as the model from which section 174 was derived ([2008] EWHC 1639). While section 214 is concerned only with wrongful trading, the same standard was applied to company directors generally as long ago as 1991 (see Norman v Theodore Goddard and others [1992] BCC 14).

The facts in Lexi Holdings were not unlike those of the (still seminal) Re City Equitable Fire Insurance Company Limited in that a rogue, trusted by all, contrived to deceive co-directors and auditors alike ([1925] Ch 407). Gerrard Lee Bevan, the fêted chairman of City Equitable, turned out to be a "daring and unprincipled scoundrel"; Shaid Luqman, Managing Director of Lexi Holdings and one-time young entrepreneur of the year, misappropriated more than £53 million.

The High Court drew on City Equitable to add this gloss: a director is expected to apply to the management and custodianship of the company's property that same degree of care as he might reasonably be expected to apply in the management and custodianship of his own property. While the High Court's decision was reversed by the Court of Appeal, its analysis of directors' duties in this respect went undisturbed (Lexi Holdings (in administration) v Luqman [2009] EWCA Civ 117).

Disregarding votes on a ratification resolution

Section 239 of the 2006 Act (section 239) both codified and modified the common law procedure for the ratification of directors' acts. In particular, on a resolution to ratify the acts of a director, the votes in favour by that director and his connected persons must now be disregarded (sections 239(3) and (4)).

It was argued in Franbar Holdings that the effect of section 239 was that the "untainted majority" could now ratify any act not ultra vires the company. Not so, said the court, in whose opinion the decision of the Privy Council in North-West Transportation Company v Beatty remained, in relevant part, good law ((1887) 12 App Cas 589). Accordingly, where the question of ratification arises in the context of an application for permission to continue a derivative claim, as was the case in Franbar Holdings, the court must still ask itself whether the ratification resolution has the effect that the claimant is being improperly prevented from bringing the claim on behalf of the company.

Proposals for reform

The 2006 Act notoriously omits to regulate a number of factors which one might have thought to be among the most critical components of good governance:

  • The role of the board and of board committees as distinct from senior management.
  • The size and composition of the board.
  • The functions to be carried out by individual directors, including non-executive directors (NEDs) and the chair.
  • The director's role in risk management (save as implicit in, for example, section 174).
  • The need for appropriately qualified directors.
  • Boardroom behaviours felt to be conducive, or not inimical, to good governance.

(Remuneration is beyond the scope of this article.)

Unsurprisingly, it is precisely these considerations that have come under intense scrutiny as the financial crisis has worn on.

Consequently, among the most important questions for post-credit crunch reform in this area are:

  • To what extent is prescription desirable at a level beyond that of codes which lack legal effect and which, in any event, present explanation as a valid alternative to compliance?

Principal Reforms Proposal 2009: a timeline

  • Are the governance arrangements for banks and other financial institutions (BOFIs) to be regarded as unique (so as not to need to be applied to the generality of companies)?
  • Do listed companies also merit special treatment and, if so, in which respects? (See also box "Principal reform proposals 2009: a timeline".)

Statute, case law and code: a comparison

A more prescriptive regime?

In June 2009, the Organisation for Economic Co-operation and Development (OECD) reported that one item deserving to remain on the policy agenda was that of board member liability and how directors' duties were specified; it was not clear to the OECD that effective arrangements were yet in place.

(It added that it might also be necessary "to improve enforcement possibilities".)

To the contrary, the interim report of the Walker Review in July 2009 saw only disadvantages in a broadening of the statutory statement. In any event, ministers have apparently made it clear that they do not plan any "major changes" to company law "in the immediate short-term". The Department for Business, Innovation and Skills proposes to evaluate the impact of the 2006 Act "over the next few years".

It is, in short, one of the major themes of the Walker Review that, subject to "amplification" in a number of respects, the Combined Code on corporate governance (the Code) remains fit for purpose, even for BOFIs.

The Financial Reporting Council's (FRC) subsequent progress report on the occasion of its review of the Code in 2009, also issued in July 2009 after a first round of consultation, did not demur.

The Combined Code and company law

The latest version of the Code (June 2008) makes no reference to the statutory statement, which some respondents to the FRC's first call for comments in 2009 considered a deficiency. One respondent suggested that it might be helpful for the Code's preamble to be revised to reflect the statutory statement "in more accessible, that is, non-legal language".

Even a selective comparison of directors' legal duties with the roles assigned to directors in the Code discloses that to bring the two more closely into alignment would be no straightforward "dovetailing" exercise (see box "Statute, case law and code: a comparison"). And while it is one thing for the Walker Review to say that it is in the nature of the statutory statement to call out for interpretation and guidance, it is quite another thing to say that this would, in the normal course, be provided under the Code.

Put another way, it remains to be seen whether the courts in this jurisdiction will travel in the same direction, and as far, as their counterparts in Australia. In ASIC v Rich, for example, the Supreme Court of New South Wales held that it was at least arguable that the chairman of failed telecommunications company One.Tel had special responsibilities by virtue of his various positions (he also chaired the audit committee) and expertise ([2003] NSWSC 85).

Austin J was assisted in reaching this conclusion both the expert evidence of two experienced directors of Australian public companies and the corporate governance literature (including Sir Adrian Cadbury's publication "The Company Chairman", and the Higgs report).

Alternative governance models

The Walker Review does not shy away from addressing some of the more controversial proposals for governance reform, including:

  • Placing BOFI directors under an explicit responsibility to depositors and policyholders, or even to "society as a whole".
  • Promoting two-tier board structures.
  • Mandating employee or small shareholder representatives on the board.
  • Capping an individual NED's liability in a manner proportionate to his director's fee.

However, none of these proposals makes it all the way through to the Walker Review's 39 recommendations, at least as currently drafted.

Appropriately qualified directors

In July 2009, the Treasury Committee repeated its post-Northern Rock recommendation that senior bankers should possess a relevant qualification or, if they do not, that the onus be on them to prove to the FSA that they have relevant compensatory experience.

Specifically in the context of BOFI boards, the Walker Review stresses the need for financial industry experience among NEDs, balanced by deep experience from elsewhere and reinforced by a personalised approach to induction, training and development. The chair of a BOFI board should demonstrate, even more critically, a track record of successful leadership capability.

The Institute of Directors (IoD) has expressed disappointment that, for all this emphasis on the need to improve professionalism at board level, the Walker Review makes no reference to the IoD's Chartered Director qualification. The IoD cites 17 organisations, including business think-tank Tomorrow's Company, as among those to have formally endorsed its qualification (by no means solely in the BOFI context).

Better-behaved boards?

In connection with the FRC's review of the Code in 2009, the Institute of Chartered Secretaries and Administrators (ICSA) has offered to prepare a best practice guidance note on how boards can create the circumstances for improved boardroom behaviours. At the same time, as several of the more than 100 respondents to the FRC's first round of consultation point out, some things do tend to resist codification. Any author of guidance on appropriate boardroom behaviours would do well not to overlook the insights contained in the authoritative (if voluminous) case law. Directors should:

  1. Not allow themselves to be dominated or bamboozled by co-directors (for example, Re Westmid Packing Services Ltd [1998] 2 BCLC 646)
  2. Not be passive, let alone totally inactive as were the (non-professional) NEDs in Lexi Holdings.
  3. Act with integrity, whether in relation to dealings with company property (Green v Walkling [2007] EWHC 3251) or when floating a business and making statements to the market (Secretary of State for Business Enterprise and Regulatory Reform v Sullman and another [2008] EWHC 3179).

Some cases applaud directors for their sheer energy and even their indefatigability (see the wrongful trading case of Uno Plc and World of Leather Plc [2004] EWHC 933). They pinpoint moments when decisive, courageous and independent action by a NED is called for (Secretary of State for Trade and Industry v Swan (No 2) [2005] EWHC 603). A company may claim to look to its NEDs for independence of judgment (Equitable Life Assurance Society v Bowley and others [2004] 1 BCLC 180).

As for the propensity to challenge, rightly emphasised in the Walker Review, one need look no further than the Barings disqualification cases for evidence of a duty to question, to understand and to be proactive (Re Barings plc (No 5) [1999] 1 BCLC 433). A NED must consider and assess what he is told critically and objectively. He cannot take what the executives say at face value without considering it, and if on its face it does not stand up to scrutiny he must point this out and query it (Secretary of State for Trade and Industry v Collins and others, Re TLL Realisations Ltd [1998] All ER (D) 651). The circumstances may call not only for searching questions but also for NEDs to be on their guard and to hold out for a convincing explanation (Lexi Holdings).

Next steps

It now falls to the FRC to finalise its thoughts on Sir David Walker's recommendations, as the consultation clock for each review runs down. Incorporation of the recommendations into the Code raises a number of intriguing policy issues, however.

Sir David was emphatic that his draft recommendations were aimed at listed BOFIs and, in particular, banks. In a number of respects, however (as he recognised), they respond to concerns which all listed companies might share. Is the FRC to devise a regime for listed BOFIs, alongside a parallel regime for everyone else? Might it choose to extend the Walker recommendations selectively, to all FTSE 100 or FTSE 350 companies, say, or to those in specific sectors? Neither approach has been ruled out.

In relation to individual board members, the Walker Review recommends a greater time commitment for BOFI NEDs, a more demanding role for the chair and an expanded role for the senior independent director. But if society is to entertain higher, special expectations of bank boards, is it also to articulate the (presumably less demanding) specifications to which all other directors must match up?

Then there are Sir David's recommendations on upgrading boardroom procedures, relating to induction, training and development, evaluation and the best practice use of committees (to oversee remuneration and financial risk management, but also due diligence in advance of a proposed transaction). If it is true to say that corporate governance failures contributed to the financial crisis and that the current regime as regards BOFIs deserves to be rejected in favour of a superior version, is every other listed company to persevere with the "inferior" model?

Some might question the extent to which the recommendations of the Walker Review would, if implemented, add to the burden on BOFI directors under section 174, or even lessen the burden so far as other directors are concerned (see "Reasonable care, skill and diligence" above). But it would not be repugnant to say that some directors are to be held to a higher standard than others. That is effectively the current position. What is required of a director on the face of section 174 depends on the functions carried out by that director and, in part, on his general knowledge, skill and experience. Nor is it novel to say that the director's duty of care varies according to the size and business of his company.

Society's confidence in bank boards, and in experts in general, has been shaken, but that is not to say that our expectations of directors are reducing. To the contrary: the Walker and FRC reviews can be expected to raise the bar still higher .

Tempers have run high during this crisis. If the outcome proves to be more widespread enforcement of directors' duties, it would ultimately be for the courts to sit in judgment on individual directors, in a less febrile environment and apolitically. The individual could expect to be judged by reference to the precise legal duties owed, without the benefit of hindsight and, most importantly, after taking all the facts into account.  

This article was published in the September issue of Practical Law Company magazine