The Companies Act 2006 (the Act) is the largest single piece of legislation ever enacted in the UK and it will come into force on 1 October 2007. But what impact will it have on D&O?
Codification of directors’ duties
Whilst the Act codifies the general duties owed by directors to their companies, these broadly reflect the existing common law, with one important exception. Under the Act, the primary duty of a director is to act: "in a 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 key issue is, therefore, what the director’s view is, not that of the court. The Act does not introduce a US style ‘business judgment rule’.
Whilst directors must have regard to all factors when deciding whether a particular decision is in the best interests of the company, the Act identifies six particular factors that directors should consider in fulfilling their primary duty to promote the success of the company:
- 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 members of the company.
These factors are potentially contradictory. For example, how should a director reconcile the closure of an unprofitable factory with the loss of employee jobs and the economic impact that it will have on the surrounding community? Perhaps unsurprisingly, the Act gives no guidance as to the relevant importance of each factor.
In our view, all that is required for a director to demonstrate is that he considered the factors and weighed them up. A court is unlikely to interfere with his ultimate decision as long as he has acted in good faith.
The Act does not change the standard of care expected from directors but for the first time sets it out expressly. S174 of the Act provides that directors must act with reasonable care, skill and diligence. This is based on existing law, however, the significance of this duty in our opinion will be greater going forwards.
Shareholder derivative claims
One of the most widely anticipated aspects of the Act is that it introduces a statutory right for any shareholder to commence a derivative claim against directors in a wider range of circumstances than was possible under the common law.
There has been speculation that this could give rise to a raft of claims against directors, materially increasing their exposure to litigation. However, the Act incorporates a number of safeguards that should still restrict the ability of litigants to bring derivative claims.
The Act explicitly retains the position under the common law that directors’ general duties are owed only to the company and, as a consequence, only the company’s loss that arises from the directors’ action can be recovered. This will limit the attractiveness of pursuing derivative claims to litigants who are seeking only to secure recompense for their own personal losses.
The most significant constraint on the right of shareholders to pursue a derivative claim is the requirement that the court give leave for a derivative claim to proceed. This is a two stage process. First, the court will consider the evidence filed in support of the claim. The claim can be dismissed at this point.
Second, if a hearing is ordered, the court will take into account evidence from both sides as to whether the claim should proceed. The court will consider a range of factors in making its decision, including the level of overall shareholder support for the claim, the extent to which the claim will promote the success of the company and whether it is brought in good faith.
The requirement that the claim be brought in good faith is likely to be a significant factor in preventing minority shareholders with their own personal motives from using the derivative claim framework to pursue claims.
Auditor liability caps
From 6 April 2008 auditors will be able to enter into liability limitation agreements with companies, providing that these are authorised by shareholders. Whilst such an agreement can provide for a specific financial liability cap it will be open to the court in any claim to determine whether it is fair and reasonable.
This change is unlikely to make claims against directors more common as directors are often parties to substantial claims against auditors in any event. However, where the auditor is able to rely on the terms of a liability limitation agreement and the directors have no such protection, it is likely to increase directors’ exposure in catastrophic claims.
It is important to note that the provisions of the Act do not presently apply to limited liability partnerships (LLPs) and these are still governed by the Companies Act 1985. The DTI is still consulting on the extent to which the Act should apply to LLPs but we see no reason why LLPs could not be subject to it in the future.
A new dawn for D&O?
The codification of directors’ duties and the introduction of the statutory shareholder derivative action are likely to lead to an increase in claims against directors, at least in the short term.
Whilst litigants are likely to seek to pursue derivative claims, there are significant safeguards in place that should prevent the abuse of this new statutory action. We expect that the court will provide early guidance as to the circumstances in which it is willing to grant permission for derivative claims to proceed and the effect of this will be to restrict their use.
The new duty to promote the success of the company is likely to be used by litigants as a basis on which to found claims against directors. However, as long as directors act reasonably and consider all relevant factors when making decisions it should not have any significant impact on their potential liability. The most likely basis of claims remains negligence (s174 of the Act).