They say what’s important – what matters and what doesn’t – and that marks them out.
While being a company director brings its rewards, the position is subject to an increasing range of duties and responsibilities, which has come into sharp focus in recent times. This briefing note outlines a director’s role and provides a summary of directors’ duties under the Companies Act 2006 (Act). We also highlight further sources of duties and restrictions, including recent developments, along with potential consequences and liabilities for a breach of directors’ duties.
Although this may seem obvious, it is not necessarily just those people who are called ‘directors’ who will qualify as such. Company law provides that a director includes “any person occupying the position of director, by whatever name called”. This means that if, on the facts, a person is fulfilling the role of a director, then they may be deemed to be one and fully liable as such. Equally, if the directors are accustomed to act in accordance with the directions and instructions of a third party, that person may be deemed to be a ‘shadow director’ of the company and liable as such.
Although companies are legal entities in their own right, they can only act through human agents. Company directors fulfil this role and the operation and management of the company is typically delegated to them. The directors’ powers to manage the company are subject to the terms of its constitution and any restrictions that may be contained within it.
Directors exercise their powers principally through the board of directors, which is the body empowered and entrusted to ‘direct’ the affairs of the company. The board will meet periodically to consider matters relating to the management of the company and will make its decisions collectively through resolutions. However, in practice, the running of a company of any real size would be impossible if all decisions required a full board meeting. Whilst in small companies with few directors day-to-day decisions can be taken at meetings of all of the directors, board meetings of larger companies are relatively infrequent and are generally used to discuss and formulate policy or to approve and authorise important transactions.
The operation of most companies is delegated to their executive directors, who are usually employed by the company under the terms of a service contract. Except in the smallest companies, it is common to appoint one or more non-executive directors, who are selected for their commercial experience and expertise, but who are generally not involved in the day-to-day running of the company and do not devote their whole working time to it. Their relative distance from the daily operations of the company gives them an objective overview, which operates to the benefit of members. In addition, for publicly quoted companies, the UK Corporate Governance Code 2018 and the Quoted Companies Alliance Corporate Governance Code for Small and Mid-Size Quoted Companies 2018 (QCA Code) preserve the requirement for the appointment of non-executive directors and impose greater accountability on directors.
As directors have extensive powers, the law imposes certain duties on them to safeguard the rights of shareholders and others. Directors’ duties are now primarily set out in a statutory statement of directors’ duties introduced by the Act. The statement codifies (with some significant changes) and replaces the common law and fiduciary duties that have been developed by the courts in case law over many years. This case law remains highly relevant because the Act expressly states that in interpreting the statutory statement of directors’ duties, regard should be had to the case law that it replaces. It is important to note, however, that this statement is still not an exhaustive list of directors’ duties.
The seven main general duties owed by directors to a company are outlined below.
Duty to act within their powers
A director must act within the company’s constitution and exercise their powers only for the purposes for which they were granted. Most of the directors’ powers and their restrictions are contained in a company’s articles of association.
Duty to promote the success of the company
A director must act in a manner they consider, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole. This is often referred to as the ‘enlightened shareholder value’ or ‘section 172’ duty and requires a director to consider a number of other factors, including:
While directors are only obliged to have regard to the factors above, the list is non-exhaustive. Moreover, directors need to be in a position that, if a decision were challenged, they would be able to demonstrate that they did consider the matters above (and any other applicable factors) when making decisions affecting the company. Directors should therefore ensure that appropriate records of board discussions and decisions (including those of delegated committees) are maintained as they may have to evidence their consideration at a later stage.
More recently, as discussed below, this duty has come under renewed focus for large companies who are required to include a ‘section 172 statement’ in their strategic report.
Duty to exercise independent judgment
A director must exercise their own judgment in performing their role. Notably, a director should not act in the interest of any individual or group (for example, where a director is appointed by a shareholder with significant control). This duty does not prevent a director from delegating their powers where the company’s articles of association permit this, or relying upon advice provided that they have exercised their own judgment when applying such advice.
Duty to exercise reasonable care, skill and diligence
A director must exercise reasonable care, skill and diligence in their role using their own general knowledge, skill and experience, together with the care, skill and diligence that may reasonably be expected of a person who is carrying out the functions of a director. This duty imposes both subjective and objective standards. So a director with significant experience in a particular field (for example, an accountant well versed in financial matters), must exercise the appropriate level of diligence in performing their duties, in line with their higher level of expertise.
Duty to avoid conflicts of interest
A director must avoid any situation where they have or could have a conflict or possible conflict of interests with those of the company. For example, if in the course of running a company, a director discovered a business opportunity, they cannot exploit this for themselves or by setting up another business, even if the first company could not take advantage of that opportunity. There are a few exceptions to this, the most important being that the board of directors can authorise such a conflict.
Duty not to accept benefits from third parties
A director must not accept benefits from third parties that have arisen because of their directorship or their acts or omissions as a director. This duty is not breached if acceptance of the benefit cannot reasonably be regarded as likely to give rise to a conflict of interest.
Duty to declare interests in proposed or existing transactions or arrangements
A director must declare to the board the nature and extent of any interest they have in a transaction or arrangement with the company, whether directly or indirectly; therefore, it is important that directors are familiar with the interests of those people connected to them as well as their own. In the case of a proposed transaction, a director must declare their interest before it is entered into. This duty will come into play where, for example, a director is a shareholder in another organisation with whom the company is proposing to enter into a transaction.
Directors will also need to comply with this duty where they become interested in an existing transaction or arrangement with the company. This will be particularly relevant to new directors, who should declare their interests when they are appointed.
There are a few limited exceptions where a director need not declare their interest, including where the interest cannot reasonably be regarded as giving rise to a conflict of interest or the rest of the board is already aware (or ought to be aware) of the director’s interests.
Wider stakeholder engagement has been a key driver in recent corporate governance discussions, bolstering a range of areas such as environmental reporting along with recent guidelines on remuneration, board composition and diversity (to name a few).
Related reforms include the introduction of The Companies (Miscellaneous Reporting) Regulations 2018, which introduced requirements aimed at building confidence in the way that large private and quoted companies are run.
Directors will therefore need to go beyond the mere focus on the short-term financial performance of the company and carefully consider the implications of decisions for all key stakeholders, along with the impact on the company’s reputation and its long-term prospects.
The Wates Corporate Governance Principles for Large Private Companies (Wates Principles), introduced in December 2018, are designed to provide large private companies with a voluntary framework when complying with the corporate governance reporting requirements outlined above. While aimed at large private companies, the Wates Principles provide a useful tool for a wide range of businesses (not just those covered by the reporting requirements) to understand and adopt good practice in corporate governance.
Directors owe their general duties to the company; therefore it is usually the company itself, acting by board majority, that decides whether to take action against a director. Various remedies may be sought against directors for breach of their duties, including civil and criminal penalties, depending on the circumstances. A breach of directors’ duties can result in:
Further, current and former directors may be investigated by a third party, such as the Department of Trade, for breach of any of their duties and may be disqualified for a period of up to 15 years under the Company Directors Disqualification Act 1986. Moreover, imprisonment may apply for the most serious breaches.
Shareholders may also bring actions on the company’s behalf (known as ‘derivative actions’), with the court’s prior consent. Likewise, if a company becomes insolvent and a director breaches their duties (as discussed below), a claim may be brought against a director by an appointed liquidator or administrator.
In addition to the general duties set out in the Act’s statement of directors’ duties, there are a number of other duties imposed upon directors - for example, under health and safety legislation or by regulatory authorities in relation to publicly traded companies. The codified statutory position under the Act is by no means a ‘one-stop shop’ for a full understanding of all directors’ duties.
Other legislation, such as the Financial Services and Markets Act 2000, the Insolvency Act 1986, the Corporate Manslaughter, Modern Slavery and Bribery Acts, all impose additional duties. Breach of other types of regulation, such as those made under health and safety legislation, environmental legislation and data protection, can give rise to both civil and criminal action.
The assessment of whether a particular decision or course of action was negligent or non-compliant will always be a matter of detailed evaluation of the facts. For directors to protect themselves in advance they must ensure that decision processes are well documented, showing how and why decisions were reached. A defence to an allegation, that a decision was not reasonable or diligent, will be greatly assisted if the detailed reasoning is clearly set out in minutes with supporting papers showing how the decision was arrived at, any advice that was obtained and where appropriate consultation with relevant stakeholders, such as shareholders or possibly trade unions.
Sustainability – comprising environment, social and governance (ESG) factors – has fast risen to the top of the board agenda, becoming central to corporate competitiveness and businesses’ continued ability to operate. As the UK focuses on trying to meet its net zero commitments, we can expect a range of further rules and regulations which are designed to change the behaviour of businesses. These will create an additional burden for directors who are responsible for ensuring compliance.
Large companies and limited liability partnerships (LLPs) have been required since 2019 to annually report on emissions, energy consumption and efficiency action. More recently, the Companies (Strategic Report) (Climate-related Financial Disclosure) Regulations 2022 and the Limited Liability Partnerships (Climate-related Financial Disclosure) Regulations 2022, in force from 6 April 2022, makes changes to the reporting obligations for certain large companies and LLPs, requiring them to produce additional disclosures in line with the Taskforce on Climate-related Financial Disclosures (TCFD) recommendations. These disclosure obligations mirror the FCA Listing Rules which already required premium listed issuers in the UK to make disclosures in accordance with the TCFD recommendations on a “comply or explain basis”.
By the end of 2023, mandatory climate-related financial disclosures will apply to most UK companies and financial institutions, with a view to all companies being required to make these disclosures by 2025.
To read more about the potential impact on small and medium-sized enterprises, see our article here.
Further anticipated developments include, for example:
Investor pressure, internal governance and workplace issues, along with the proliferation of various reporting frameworks and standards in relation to sustainability makes this a complex area for boards to manage, with companies increasingly aware that a failure to address these matters can be detrimental to their businesses, both financially and through reputational damage. Indeed, we are already seeing a rise in ‘green’ litigation claims, with boards of directors facing mounting pressure and accountability over their commercial practices.
Directors of companies whose securities are listed on an investment exchange are subject to a further layer of regulation. For example, the Listing Rules of the UK Listing Authority impose a number of duties on the directors of a company listed on the Official List and the AIM Rules of the London Stock Exchange have the same effect in relation to that market. One requirement of the Listing Rules that is particularly important for such directors is that companies incorporated in the UK with a premium listing of equity shares must include in their annual reports and accounts a statement as to how they have applied the principles of good governance set out in the UK Corporate Governance Code, giving reasons for any non-compliance (frequently referred to as ‘comply or explain’). Likewise, boards of AIM listed companies are required to adopt a recognised corporate governance code (typically selecting the QCA Code), explaining how the company complies with it and how it departs from it (together with an explanation of the reasons for any departures from the chosen code).
It should be noted that although these corporate governance codes have been prescribed solely for publicly listed companies, they do provide helpful guidance, and are increasingly seen as relevant, to all companies on best practice in governance issues. The boards of all companies (however small) should consider having in place a corporate governance framework which is suitable for the company’s size, shareholders, other stakeholders and business model, since this will lead to a more effective board and, in turn, to a more efficient and successful business.
Directors of companies in financial difficulties face additional issues and directors of insolvent companies may be found liable for fraudulent or wrongful trading. This is a particularly nuanced area for directors to navigate, so where a company is in (or approaching) financial difficulties directors should seek independent legal advice as soon as possible if they are to avoid potential personal liability under insolvency legislation.
Liability can attach to directors for fraudulent or wrongful trading if the company continues trading when insolvent and the interests of creditors are prejudiced. Notably, where a company is insolvent or approaching insolvency, the general duty to promote the success of the company is modified so that a director must instead act in the best interests of the company’s creditors. Fraudulent trading occurs if, in the course of a winding up, it appears that any business of the company has been carried on with intent to defraud creditors or for any other fraudulent purpose. In such cases, the liquidator can seek a court declaration that anyone who was knowingly party to the fraudulent business should contribute to the company’s assets. Only those who were knowingly parties to the fraudulent trading are caught by this offence: there has to be “actual dishonesty, involving... real moral blame”.
The general position is that directors of an insolvent company may be found liable for wrongful trading if it is established that, at a time before the company went into insolvent liquidation, the director knew or ought to have concluded, that there was no reasonable prospect of the company avoiding an insolvent liquidation. There is no requirement for dishonesty by the director and a director’s actions will be judged based on what a reasonable director would have done in the circumstances with the same knowledge, skill and experience as the director in question. It will be a defence for a director to show that, after the point when they concluded (or should have concluded) that there was no reasonable prospect of the company avoiding an insolvent liquidation, they took every step a reasonably diligent director could be expected to take with a view to minimising the potential loss to the company’s creditors. A director found liable for wrongful trading may be required to make a personal contribution to the assets of the insolvent company.
Significantly, following recent legislative changes, the Insolvency Service’s powers have been extended to investigate and disqualify former directors who have dissolved companies to avoid paying their liabilities, including evading repayment of Government-backed loans put in place to support businesses during the Covid-19 pandemic. If misconduct is found, former directors may face disqualification for up to 15 years and prosecution in the most serious cases. Moreover, a disqualified director of a dissolved company may be liable to pay compensation to those of its creditors who have suffered loss due to the director’s fraudulent conduct.
Given the potential consequences of a breach of duty, directors should seek from the outset to understand the scope of their role, duties and responsibilities as fully as possible; obtaining timely and trusted legal advice is key to this. Other useful sources include Companies House literature, attending relevant legal training and keeping abreast of legal and commercial developments.
In some cases, there may be opportunities for directors to mitigate their liability. In certain situations, the court may grant relief from liability if the director has acted honestly and reasonably; in other circumstances, the shareholders of the company may ratify unauthorised acts.
A company may (but is not obliged to) indemnify its directors in respect of certain proceedings brought against them by third parties. An indemnity can potentially cover both the cost of the claim itself and the costs involved in defending it, but never the unsuccessful defence of fines imposed in criminal proceedings or penalties imposed by regulatory bodies.
Against this background, it is common for a company to take out directors’ and officers’ insurance on behalf of its directors. Policy cover and terms vary but typically deal with directors’ liabilities arising from claims of negligence, breach of duty or other default. Standard policy exclusions include fraud, dishonesty and criminal behaviour but the directors should ensure they understand any limitations on cover and that insurance policies are kept under regular review.
The way in which businesses govern themselves, manage risk and engage with their stakeholders is under unprecedented scrutiny. Amid the introduction of numerous legislative requirements by regulators, investor pressure, workplace issues and increasing accountability to those outside the organisation, directors are faced with a matrix of growing challenges.
We advise a range of clients across the full spectrum of governance-related risks and compliance matters and are well-equipped to help businesses and directors proactively manage these issues. Please contact us to discuss further.
This article is intended to provide a summary of the law in this area as at April 2022 and does not constitute legal advice. Should you wish to obtain advice based on specific facts and circumstances, please contact us.