Directors Duties and Liabilities – an outline

Introduction

The directors of a company are responsible for the management of the company’s affairs and are subject to a range of legal obligations. A director who breaches his duties runs the risk of being disqualified as a director, being sued by the company, having to pay the company’s debts himself or facing criminal sanctions including fines and even imprisonment.

This bulletin summarises some of the risks facing directors of private companies. Directors of plcs (especially listed companies) face additional obligations, but these are mostly outside the scope of this bulletin.

Directors’ duties and liabilities

English law has traditionally not provided a single, comprehensive code of conduct for directors and most of the rules governing directors are contained in a bewildering mass of legislation and court decisions.

The Companies Act 2006 (the “Act”) contains a statutory statement of directors’ duties, listing 7 general duties which were intended to codify the pre-existing law on directors’ duties.

Many directors are also subject to contractual obligations – for example, under their employment contracts.

In most cases, directors’ duties are owed to the company itself and not to individual shareholders. Directors must also consider the interests of the company’s employees and even those of creditors – particularly where the company may be insolvent.

Many of the same principles apply to all directors, whether they are executive directors (involved in the dayto-day running of the company), non-executive directors (advising the board but not involved in actual management), “shadow directors” (not actually appointed as directors but whose instructions are in practice followed by the company’s directors) or nominee directors (appointed to represent the interests of a particular shareholder or creditor – and who therefore
face potential conflicts of interest).

The general duties

  • Duty to act within powers (s.171): A director must act in accordance with the company’s constitution and only exercise his powers for the purposes for which they were conferred. In general, a director who acts without authority – or exceeds the authority he has been given – may be sued by the company. If he enters into a contract without authority, the other party to the contract may be able to sue him for breach of warranty of authority. A director may also be liable if he exercises his powers for a purpose for which they were not intended. In most cases, if a director exceeds his authority the shareholders can ratify his action, unless it is against the law.
  • Duty to promote the success of the company (s172): A director must act honestly and in good faith in the way he considers would be most likely to promote the success of the company for the benefit of its members as a whole. The test is subjective: if the director honestly believes he is acting in the company’s interests, a court will not substitute its own opinion. In practice, the company’s interests may be different from those of individual shareholders. Breach of this duty could expose the director to a claim by the company for any loss suffered as a result.
  • Duty to exercise independent judgment (s 173 CA 2006): This does not prevent a director from relying upon advice given by others e.g. a solicitor but the final judgment must be his responsibility.
  • Duty to exercise reasonable skill, care and diligence (s174): A director must act with the level of skill and care which may reasonably be expected from a person with his knowledge and experience. This is particularly relevant to executive directors who actually run the business but non-executive directors must also take an active interest in the company’s affairs – they cannot simply rely on the recommendations of the executive directors. In addition a director who has particular skills or experience will be judged against that higher level as well. A director who fails in this duty risks being sued by the company for any resulting losses.
  • Duty to avoid conflicts of interest (s 175): A director must avoid conflicts between his interests and those of the company. For example, a person who is a director of two companies may have a conflict if both companies are competing for the same contract.  If an actual or potential conflict arises, this must be disclosed to, and approved by, a meeting of the full board and the director should also obtain independent legal advice, as he risks being sued by the company for any resulting loss.
  • Duty not to accept benefits from third parties (s 176): A director is a trustee of the company’s assets and must not misapply them. If a director makes a profit from using the company’s property or from an opportunity which is only open to him because of his directorship then unless the opportunity has been disclosed to, and approved by, the board, the director must pay this “secret” profit to the company, even if he acted in good faith or if the company itself could not have made the profit.
  • Duty to declare interest in proposed transaction or arrangement (s 177): A director must declare his or her direct or indirect interest in a proposed transaction to the other directors, where the director is aware or ought reasonably to be aware of such an interest. This can be done at a meeting, or by notice, but in any case, before the transaction is entered into. A further declaration must be made if the original declaration becomes inaccurate for any reason. There are some limited exceptions to this requirement.

It should be noted however that a director’s duties are not limited to the principles set out in these seven sections of the Act. Other duties arise through different legislation and the Act also permits the consideration of common law rules and equitable principles when applying the new statutory regime.

There is a degree of uncertainty regarding the meaning of some of the general directors’ duties. How, for example, should one define the “success” of the company? Although this is not defined in the Act, some guidance is given in the Act which states that directors should have regard to the following factors:-

  • 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 company’s impact on the community and environment;
  • maintaining a reputation for high standards of business conduct; and
  • acting fairly between members of the company.

In practice, the directors will have to run through the mental process of ticking off each of these factors whenever making a decision. It may be advisable to put in place an audit trail as evidence of the decision-making process and the directors should consider taking independent legal advice before proceeding. This could have the negative effect of increasing bureaucracy. Directors may also find themselves in a no-win situation whereby they have to decide between two deals, one
which may place the company in a better position long term but has negative consequences for the employees as opposed to one which may be better for the employees but may not be as financially beneficial for the company. The government has stated that “success” in this context will usually mean a “long term increase in value” for commercial companies or achievement of its purposes if it is not a commercial organisation.

Claims by shareholders against directors

The Act also confers further power on shareholders to make claims against directors. Prior to the Act claims could only be brought where directors wrongfully conferred the benefit on themselves, whereas since the Act a shareholder may bring a claim on behalf of the company in relation to “an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director”. Such a “derivative claim” may be brought against a director or another person. The Act requires that a claimant show a prima facie case before being given permission by the court to proceed with any claim. Again, the Act provides a non-exhaustive list of factors that the court must take into account when considering whether or not to grant permission to proceed – e.g. whether a shareholder is acting in good faith, whether continuing the claim accords with the need to promote the success of the company and whether the shareholders would be likely to authorise the act or omission complained of.

Company accounts and business review

There are many requirements concerning company accounts. The accounts must comply with the Companies Act 2006 and must disclose the company’s financial position with reasonable accuracy. The directors must prepare and approve the annual accounts and the directors’ report. The accounts must be sent to the shareholders and laid before them in general meeting and must be delivered to the Registrar of Companies within 9 months (public companies 6 months) after the company’s year-end (accounting reference period). In most cases, breach of these duties is a criminal offence and the directors may be liable to fines or even imprisonment.

The Companies Act 2006 contains a requirement for a business review which must be included in the annual directors’ report unless the company is part of the small companies regime. To qualify for the small companies regime (and therefore avoid having to carry out a business review) a company must satisfy at least two of three requirements:

  • a turnover of not more than £5.6 million
  • a balance sheet total of not more than £2.8 million
  • no more than 50 employees

The purpose of the business review is to allow members to assess how the directors have performed their statutory duties including that of promoting the success of the company. It must be a balanced and comprehensive analysis of the business’s development and performance though should be consistent with the size and complexity of the business. Amongst other things the Review must contain a description of the principal risks and uncertainties facing the company. There is no need for companies to disclose information about future developments or matters pending negotiation if the disclosure, in the opinion of the directors, seriously prejudices the interests of the company.

Under Section 463 of the Act, directors also have a statutory liability for false or misleading statements arising in the directors’ report, the directors’ remuneration report or a summary financial statement. This statutory regime supplants the current common law duty of care. Under the Act the director is liable to compensate the company for any loss suffered as a result of any untrue or misleading statement in any of the above reports (or as the result of an omission) if the director knew or was reckless as to whether a statement was untrue or misleading or if he knew the omission dishonestly concealed a material fact.

Other statutory duties and liabilities

There is a wide range of statutory obligations on companies which could result in personal liability for a director if the company fails to comply and the director is implicated in the breach. These include:-

  • Employee discrimination or harassment: A director may be fined or sued for compensation if he has discriminated against an employee on grounds of sex, race or disability or if he has sexually harassed another employee.
  • Health and safety: A director may face disqualification, fines or even imprisonment if thecompany fails to ensure the health, safety and welfare of its employees in accordance with the Health and Safety at Work, etc Act 1974.
  • Environmental law: A director may be liable for fines, imprisonment and claims for damages if the company pollutes the environment or causes injury to persons in breach of the Environmental Protection Act 1990.
  • Data protection: A director may face fines if the company breaches the Data Protection Act 1998.
  • Loans: A company cannot generally make or guarantee a loan to a director, unless the transaction has been approved by a shareholders’ resolution. Certain details of the loan must be given to the shareholders before they pass or sign any such resolution. Approval is not required for loans or guarantees not exceeding £10,000. The transaction may be set aside, and any director who is involved must account to the company for any gain andindemnify the company for any loss.
  • Companies raising investment: If a company is raising funding from investors, various provisions could give rise to personal liability for the directors. For example, under the Financial Services and Markets Act 2000 (“FSMA”), if the company issues a business plan to non-exempt investors without having it approved by a FSMA “authorised person”,the company and the directors may be fined. It is also a criminal offence for a director to make false or misleading statements or forecasts to induce a person to acquire shares. The director may also be sued by any investor who suffers loss as a result. There aremany other provisions concerning the issuing, buying and selling of shares (such as the prohibition on insider dealing) which could expose a director to fines, imprisonment or claims for damages from investors.
  • Transactions between the company and a director: Shareholder approval is required before a director, or person connected with a director, can acquire noncash assets from the company or sell non-cash assets to the company if the value of the assets exceeds£100,000 or (if less) 10% of the company’s net asset value (and at least £5,000). Without shareholder approval, the transaction may be set aside, and the directors who authorised it must account to the company for any profit, and indemnify the company against any resulting loss.
  • DTI investigations: The Secretary of State has power under the Companies Act 2006 to investigate a company’s affairs if, for example, he suspects fraud or irregularities have occurred. A director can be required to produce documents relating to the company and to explain those documents and failure to do so could result in a fine or imprisonment for contempt of court. After an investigation the Secretary of State could apply to disqualify any director or shadow director of the company.
  • Competition law: A director or employee who dishonestly commits the cartel offence (including price-fixing, market-sharing, customer-sharing, bid-rigging or limiting or preventing supply or production) could face up to 5 years’ imprisonment and/or an unlimited fine. Directors whose companies have infringed competition law and been fined may be disqualified from acting as directors even in the absence of dishonesty.

Litigation

If the company is involved in litigation, a director could be personally liable in the following circumstances:-

  • Costs orders: The court has a discretion to make orders for costs against directors personally in certain situations.
  • Contempt of court: A director could be in contempt of court (and risk a fine or imprisonment) if he (a) fails to preserve documents which are relevant to a court case;(b) fails to ensure that the company obeys a court order; or (c) makes a false statement in a witness statement without honestly believing it to be true.

Insolvent companies

If a company is in financial difficulty, the directors must safeguard the creditors, as well as considering the interests of the company.

  • Wrongful trading: Under the Insolvency Act 1986, a director may have to contribute personally to the assets available to pay debts due to creditors, if the company becomes insolvent and he knew (or should have known, based on his actual skill, knowledge and experience or that expected of a director in his position) that there was no reasonable chance of the company avoiding liquidation and he failed to take every step he should have taken to minimise the loss to creditors.
  • Fraudulent trading: Any director who knowingly carries on a company’s business with the intent to defraud creditors or for any fraudulent purpose – for example, incurring credit on the company’s behalf without reasonable expecting that the company will be able to repay the debt – may have to contribute to the company’s assets and could be fined or even face imprisonment.
  • Transactions at undervalue and preferences: In some circumstances a court may set aside a transaction under which a director obtained assets from a company if (a) the assets were transferred to him at an undervalue when the company was unable to pay its debts or if the company became insolvent as a result or (b) he obtained them in the 6 months prior to insolvency and the transaction was a “preference”, which put him into a better position on insolvency than he would otherwise have been, as against other creditors.
  • Disqualification of directors: A court may disqualify a person from being a director for a stipulated period if he is or has been a director of a company which has become insolvent and his conduct as a director makes him unfit to manage a company (Company Directors Disqualification Act 1985). Other grounds for disqualification include (a) being convicted of an indictable offence relating to the formation, management or liquidation of a company; (b) persistently failing to file accounts or returns with the Registrar of Companies; and (c) a court declaring that the director must contribute to a company’s assets following fraudulent or wrongful trading. If a person acts as a director or takes part in the management of a company whilst disqualified, he could be imprisoned and made personally responsible for the company’s liabilities.

Contractual duties and liabilities

Many directors also have obligations under contracts which they enter into while they are directors.

These could include:

  • Employment: A director who is also an employee of the company will have bligations under his employment contract, which could require him to devote all his time and attention to the company’s business, perform his duties with a specified level of
  • skill, and not compete with the company’s business. Some duties are implied even where there is no written contract. Breach of these duties could result in claims by the company for any resulting loss.
  • Personal guarantees: A director may be required personally to guarantee liabilities of the company – such as a bank loan. If the company fails in its obligations, the director could be personally liable as guarantor and could lose his home if the guarantee is secured by a charge over the home.
  • Covenants under leases: A director may be asked to guarantee the company’s obligations under the lease of its premises – and would be personally liable, for example, to pay the rent if the company fails to pay promptly or becomes insolvent.


Indemnities and insurance

  • Indemnities: A company is permitted to indemnify a director against liability for negligence, default or breach of duty but subject to certain limitations.

    o The indemnity may cover liability of the director to any third party (including legal costs and the financial cost of an adverse judgment) but not to the company itself or an associated company.

    o The indemnity may not cover criminal fines, regulatory penalties or the costs of a criminal defence where the director is found guilty nor the costs of defending a civil claim successfully brought against the director.
     

  • Insurance: However, even though the indemnity a company can give a director as just mentioned is limited in certain respects, companies may still take out insurance against directors’ liabilities, including negligence claims, default or breach of statutory duty which would also cover claims by the company itself. There are three main types of insurance: (a) directors’ and officers’ liability insurance, taken out by the company to protect its directors from third party claims; (b) professional indemnity insurance, taken out by a director against liabilities incurred in the performance of his duties; and (c) directors’ liability insurance, which may protect a director against liability to the company in his capacity as a director. The insurance will not normally cover losses due to fraud, dishonesty, willful default or criminal behaviour, although the company could insure itself separately against its own risks. Insurance can be expensive and any premium paid by the company on the director’s behalf will normally be taxed as a benefit in kind.

For more information on any of the matters mentioned in this bulletin, please contact Peter Coats, a Partner in our Corporate Department (peter.coats@rlb-law.com).

Alternatively, if your situation may involve insolvency or result in a dispute, please contact Nigel West (nigel.west@rlb-law.com), a Partner specialising in insolvency and commercial litigation, with particular expertise in handling claims against directors.
Readers should take professional advice before acting on anything contained in this bulletin.

© RadcliffesLeBrasseur


Disclaimer

This briefing is for guidance purposes only. RadcliffesLeBrasseur accepts no responsibility or liability whatsoever for any action taken or not taken in relation to this note and recommends that appropriate legal advice be taken having regard to a client's own particular circumstances.