Up to now you’ve been operating as a sole trader. Your business is growing, your contracts are becoming more lucrative, and you want to limit your potential personal liability. You decide it’s time to incorporate a company and join the other 4 million private limited companies on the UK Company Register. The majority of these are also small owner-managed businesses, where the shareholders are also the directors (and in many cases where the sole shareholder is also the sole director).
The advantages of being the only director of your company may be fairly obvious to you. You will be able to make decisions quickly and with minimal disruption to your business. On the other hand, there are liabilities and responsibilities that can’t be escaped simply because there is only one director. Good corporate governance means a process whereby decisions are challenged and, if appropriate, changes are made.
With this in mind, if you are considering becoming or remaining a sole director, you should consider the following.
Directors owe certain duties to the company. These arise from various statutory and common law sources but the cornerstone of good corporate governance is the general duties regime set out in sections 172 to 177 of the Companies Act 2006 (the “Act”). These include a duty to promote the success of the company, a duty to exercise reasonable care, skill and diligence and a duty to avoid conflicts of interest.
As a sole director, you will have many demands on your time and you will be making decisions almost constantly. How can you factor such duties into your decision making? The answer is that you will need to think carefully about the nature of your business so that you put each duty into context. It may be helpful for you to document the key elements that you must always consider in any decision. In adding a bit more structure into the process of decision making, you may find that you are changing your behaviour and making slightly different decisions, but in doing so you are almost certainly making better, more balanced decisions which will benefit you and your business.
What might this mean in practice? Consider the following scenario:
You are the sole director of Cleaner Cups Ltd, a manufacturer of reusable plastic-free coffee cups. The cups are made from a mixture of bamboo and corn starch. The business is well known for promoting eco-sustainability throughout its entire business operation.
Ol’ Bamboo Limited has been the exclusive supplier of bamboo and corn starch to Cleaner Cups for the last 3 years. The contract is due to expire and Cleaner Cups has invited companies to bid for the new contract.
Cleaner Cups has received competing bids for the contract from Hot Flask Ltd and Dirty Mug International.
Hot Flask harvests bamboo using sustainable methods and combines it with corn starch at its carbon-neutral factory prior to shipping.
Dirty Mug International can fulfil the contract for a significantly lower price but its bamboo-corn starch mix contains 5% plastic. Dirty Mug International has also recently been the subject of negative press coverage due to the business being linked to deforestation and causing high levels of pollution.
Taking the duty to promote the success of the company as an example, what should you do when considering the bids?
The Act helpfully contains a non-exhaustive list of matters which a director should consider in connection with this duty. These include the need to foster business relationships with suppliers and customers, the impact of the company’s operations on the community and the environment, and the long term consequences of the decision.
In this scenario you will need to consider whether the addition of plastic to the composition of the cups would affect existing suppliers and customers, and whether the business’ reputation as an environmentally friendly company would be damaged. You will also need to consider any savings the business may make by entering into the cheaper contract and whether in the long term this could increase profitability.
It is difficult to balance competing interests but the interests of the business as a whole take priority.
Where there are a number of directors appointed, you will be scrutinising and challenging proposals as a group before making a decision (and you are obliged to keep a written record of what has been discussed and decided upon at your board meetings). As a sole director, even after you have added a bit more structure to the decision making process, it is not possible to have a board meeting with yourself, but you will still need to make a record of your decisions.
Even if you have made a decision which has a negative impact, if you take steps to record the process you have followed and the factors you have considered, then you are much less likely to have your decision challenged. If there are grounds to challenge your decision, then this may mean that you are found to be personally liable if others have suffered loss.
Directors' liability and relief
Taking the example of the duty not to accept benefits from third parties, what happens if a director breaches their duties?
Shortly after receiving the two bids, the directors of Hot Flask Ltd invite you to attend the British Grand Prix as their guest. You accept the invitation and attend the race. Before you leave, one of the directors gifts you a gold watch which you accept.
The problem in this scenario is that if you receive this benefit because of your position or because of anything you may do as a director (e.g. give Hot Flask’s bid preferential treatment) you may have breached your duty. Cleaner Cups may decide to remove you from office or make you reimburse the company to the value of the benefit you have received.
If you disclose the benefit to the shareholders, you may be relieved of liability.
How a company can relieve its directors of liability
There are several ways that a company can relieve its directors of liability. A potential relief commonly used by small businesses is ratification. This allows the shareholders to authorise the conduct of a director which may amount to negligence, default, breach of duty or breach of trust, after the event. In doing so, the company releases the director of any liability they may owe to the company as a result of their actions. A company cannot ratify acts that are illegal, fraudulent or which would put the company at risk of becoming insolvent.
Let’s assume that as well as being the sole director of Cleaner Cups, you are also the sole shareholder. With this in mind, can you relieve yourself from the liability you incurred as a director, in your capacity as the sole shareholder?
If the wrongdoing is automatically excluded (e.g. it is illegal) then the answer is clearly no. If the wrongful act is normally capable of ratification, it’s less clear. Case law to date has only considered matters where the wrongdoing is automatically excluded from ratification.
The Act prevents the director who has committed the wrongdoing (if they are also one of the company’s shareholders) from voting to ratify their behaviour. Therefore, it could be argued that a sole director-shareholder cannot ratify their own wrongdoing. We will need to wait for future case law to test this.
Your company’s constitution
Sole directors often fail to ensure that the business practice they adopt works in conjunction with their company’s constitution.
The primary document which forms a company’s constitution is its articles of association. A company’s articles (read together with the Act) set out the how the company is to be run, the powers of its director(s) and the company’s relationship with its shareholder(s).
If a company has not adopted bespoke articles, it will likely have the default Model Articles or, if incorporated prior to 1 October 2007, the previous default articles known as Table A.
The Act provides that limited companies need only have one director, and the Model Articles do not prescribe a minimum. However, Table A provides that a company must have a minimum of two directors. Table A also states that the minimum number of directors required to hold legitimate board meetings (i.e. the quorum) is two, and a director with an interest in a transaction cannot vote or count in the quorum.
From the above scenario, consider that:
Cleaner Cups Ltd was incorporated in 2005 and has Table A articles. Cleaner Cups has two directors. The second director wants to resign and you have decided to continue as the sole director.
In these circumstances, Cleaner Cups will need to amend its articles to allow the business to legitimately operate with only one director.
If no amendment is made, none of your decisions as sole director will be valid.
Death of a sole director or shareholder
No one wants to contemplate their own mortality, but for sole director-shareholders this may be one of the most important considerations.
If a company’s articles do not sufficiently deal with what happens on the death of a sole director-shareholder, this can provide practical difficulties which may prevent the company from carrying on business as usual.
In respect of shares held at the time of death, the company’s articles will likely require the personal representatives of the deceased to either transfer the shares or to elect to be registered as the new shareholder.
The Model Articles provide that, in the event that the company has no shareholders and no directors as a result of death, the personal representatives of the last shareholder to have died have the right to appoint a person to be a director without the need for them to be registered as a shareholder first.
Table A does not contain an equivalent provision so a company may find itself in a position where it is unable to appoint a director without leave of the court. This can be a lengthy process as the personal representatives will often need to await a grant of probate before the company can register them as the holder of the shares.
Such a delay can be disastrous for small businesses which may soon find themselves in a position where they cannot pay their creditors.
Tips for sole directors
Given the common pitfalls set out above, if you are a sole-director you should:
- Review your company’s existing articles of association to ensure they are suitable for the business practice you have adopted. Check the articles contain adequate provisions in the event of your death. If the articles are found to be unsuitable, consider adopting bespoke articles.
- Appoint a company secretary with the power to register a share transfer in the event of your death.
- Appoint a second director. You can retain control of decisions at board level by amending the company’s articles to allow the chairperson to have a casting vote when the board is divided.
A further benefit of appointing a second director or a company secretary is that the administrative responsibilities, such as annual filings to Companies House, can be shared.