There are various duties imposed on company directors by the Companies Act 2006, which codified some of the existing common law and equitable duties, and also by insolvency and health & safety legislation. The purpose of these duties is to protect shareholders by ensuring that directors can be held accountable for the way that they manage the affairs of a company. Given the number of new companies being formed each year (644,750 in 2016/2017, up from just 66,500 in 1979) and the extensive powers that directors hold over a company, these duties play a very important role.
Nevertheless, company directors can sometimes hold the misplaced belief that they are entitled to ‘do as they please’ in running a company, particularly in the context of SMEs and owner-managed businesses where the directors are sometimes also the sole shareholders of the company. In our experience, many directors are unaware of the full extent of their duties, and the reality is that in some circumstances and transactions it can be difficult to work out how the various directors’ duties need to be applied, and whether in fact they are being properly complied with.
In this article we will be looking primarily at the statutory duties that are imposed on company directors by the Companies Act 2006 (albeit with a couple of references to the Insolvency Act 1986, which is otherwise beyond the scope of this note), considering the repercussions if there is a breach of directors’ duties and thinking about some practical reasons why it is so important for directors to understand and comply with their duties.
As will become clear, if you are a company director and you think that you might be in breach of your duties it is very important that you seek legal advice as soon as possible.
What are Directors’ Duties?
Today, directors’ duties are principally found in sections 171 to 177 of the Companies Act 2006:
- Directors must act within their powers
Company directors must act in accordance with the company’s constitution, and only exercise powers for the purposes for which they are conferred. The company’s constitution primarily includes its articles of association.
Examples of ways in which directors might inadvertently overstep their authority include:
- allotting shares in excess of the threshold contained in the articles;
- allotting shares within the threshold, but where the purposes is to dilute another shareholder’s interest rather than to raise money for the company; and
- entering into a contract worth £100,000 when the articles only allow them to enter into contracts worth £50,000.
Directors should therefore take care to ensure that they actually have the authority that they need to enter into a given transaction or decision.
- Directors must promote the success of the company
The most important duty is that directors must, in good faith, act in the way that they consider most likely to promote the success of the company for the benefit of its members (typically shareholders).
There are various factors listed in s.172 of the Companies Act 2006 which directors must consider when making decisions. These include thinking about the long term consequences of decisions, the interests of any employees and even the impact of the company’s operation on the community and the environment. This is a subjective test, and so diligent directors will usually record in board minutes that consideration has been given to the s.172 factors prior to entering into important decisions.
Keeping thorough records of all decisions acts as a very important protection for directors against future claims that they have acted in breach of their duties. Clear, detailed contemporaneous notes will be highly relevant in the event that there is a claim or insolvency event.
- Directors must Exercise independent judgement
Directors are under a general duty to remain independent in their decision making. Whilst directors are able to take advice from lawyers and accountants, they must avoid being dominated or manipulated by a fellow director or shareholder. This can be difficult where, as is often the case, a director is appointed to represent the interest of a shareholder or body of shareholders.
Care should also be taken to ensure that directors are all actively involved in decision making, for example in a family company where certain family members take a lead role and others are less involved (or are reluctant to challenge more senior members of the family).
- Directors must exercise reasonable care, skill and diligence
Directors are expected to exercise the care, skill and diligence that would be expected from a reasonably diligent person with the knowledge and experience that the director actually has.
This means that there is both an objective test and a subjective test. As a baseline, company directors will be expected to exercise the care, skill and diligence that another director in a similar company would exercise. However, if the director has particular skills – because they are a qualified accountant or chartered surveyor, for example – then there will be a higher standard which they will be expected to meet. There is no lower standard, however, which means that a director cannot argue that they are less skilful or experienced than average!
- Directors must avoid conflicts of interest
One of the most commonly breached directors’ duties is the obligation to avoid situations where a director has a direct or indirect interest that conflicts – or may possibly conflict – with the interests of the company. The duty particularly applies to the exploitation of any property, information or opportunity, whether or not the company would in fact choose to take advantage of it.
Typical examples of possible conflicts would include transactions between the company and the director or a company connected to the director, such as a contract for the provision of services, or where the company turns down the opportunity to pursue a particular contract but the director wants to follow it up in a personal capacity.
- Directors must not accept benefits from third parties
There is a general duty not to accept benefits given because of a director’s position or because they do (or choose not to do) anything as a director.
However, receiving corporate hospitality is not prohibited, and directors can receive benefits as long as accepting the benefit wouldn’t reasonably be regarded as likely to give rise to a conflict of interest.
- Directors must declare any interest in a proposed transaction or arrangement with the company
The purpose of this duty is to ensure that the board are fully aware of a director’s interest in a proposed transaction before it is completed. This seems logical enough, particularly in the context of larger companies with multiple directors.
However, problems are more likely to arise where there is a sole director or a family business, particularly where assets are frequently transferred in and out of companies. If, for example, a director wanted to transfer a piece of land into the company, or enter into a contract with his brother’s company, this would need to be declared at a board meeting.
The duty also applies where a director becomes interested in an existing transaction or arrangement. This could occur where a director of Company A becomes a director of Company B, which is an existing supplier of Company A.
What happens if a director breaches their duties?
Directors owe a general duty to the company. This means that, first and foremost, it is the company – acting by a majority of the board of directors – who would usually decide whether or not to take action against a director. The company has a range of equitable remedies available to it, including asking the director to account to the company for any profits, to return company property, pay compensation and rescind contracts that have been entered into.
In addition to the general duties outlined above, directors are also responsible for ensuring that the company’s administrative requirements are met, such as submitting annual accounts and confirmation statements.
A breach of certain duties can be a criminal offence, resulting in fines and disqualification, and even imprisonment in the most serious cases. Clearly this could have very grave consequences for individual directors. However, as we have explained below there are also a number of commercial reasons why directors should be keen to uphold their general duties.
Does a breach of Directors’ Duties actually matter?
In the context of an SME or family business, where the directors may also be the sole shareholders in the business, there is sometimes a reluctance to engage with the regulatory nature of directors duties, particularly as this can result in additional paperwork and professional costs. The directors might argue – understandably – that because the directors are also members/shareholders, the interests of the owners and the managers automatically align.
However, even in the context where the directors are also the sole shareholders this is a potentially very dangerous view.
In the event that the company becomes insolvent, a director may become personally liable for any wrongful or fraudulent trading undertaken by the company. In other words, failure to adhere to directors’ duties could result in directors effectively losing the benefit of limited liability. When the directors have grounds to believe the company may become insolvent, the general duty to act in the best interest of the company’s members transitions to a duty to act in the best interest of the company’s creditors. Director-shareholders of an SME or family business might be very laissez faire about their duties when the company is trading successfully, but if things take a turn for the worse then the implications could be very serious indeed.
Alternatively, if the company are seeking to attract funding or third party investment – or indeed if the director/shareholders want to sell the company – the due diligence process underpinning such a transaction will almost certainly expose any historic breaches of directors’ duties.
On one level this would indicate that perhaps the company has not been run very well, discouraging potential buyers or investors from proceeding with the transaction.
A far more serious scenario would be where there have been historic breaches of directors’ duties (such as entering into transactions without authority) which results in the incoming directors (following a sale or third party investment) seeking to rescind contracts or transactions, or asking previous directors to account for gains made as a result of a breach of their duties.
What can be done to prevent a breach of Directors’ Duties?
Given the pervasive nature of directors’ duties – and the potential damage that can be caused by breaching these duties – it is important for directors to understand and adhere to the duties that are imposed upon them.
The best way to prevent a breach of directors’ duties is for company directors to make sure that they are aware of their responsibilities. Companies House send out a simple leaflet to every new director who is appointed setting out some of these duties, which is a good starting point. Some companies also arrange insurance for their directors, which would pay out in the event that there is a breach of directors’ duties resulting in losses.
If there are concerns about the solvency of a company, the directors should immediately seek external legal advice to establish the best way forward for the company and to ensure that they do not commit offences or become personally liable.
Ultimately, the possibility of losing the benefit of limited liability should be enough to motivate company directors to revisit the duties that are imposed upon them and take steps to ensure that they do not breach these duties – inadvertently or otherwise.