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Directors’ General Duties under the Companies Act 2006

September 2007

1 October 2007 – New statutory duties for directors

At the beginning of next month (1 October 2007), the provisions of the Companies Act 2006 (the Act) on directors' general duties will come into force. The provisions that relate to directors' conflicts of interests will come into force on 1 October 2008 (and will be outlined in a separate corporate clip). The general duties will apply to both executive and non-executive directors (e.g. a nominee director appointed by an investor) without distinction and, in certain circumstances, to former directors and shadow directors.[1] From 1 October 2007, the Act also introduces some changes on arrangements with directors, e.g. approval of property transactions with a director and loans to directors.

Why was the new statutory regime introduced?

At present, directors' duties are overwhelmingly based on case law and derived from equitable principles. In its guidance on the Act, the Government has made clear that the main objective of codifying directors' general duties in the Act is to make the law more accessible to directors and to others. However, codification has led to a number of uncertainties (in particular, as to the extent to which directors duties have changed) and, in some quarters, fears (generally thought to be unfounded) of an increased risk of claims against directors. The general duties in the Act are in addition to duties owed under other legislation and regulations, e.g. the Insolvency Act 1986 or (for directors of quoted companies) the Listing Rules.

The general duties coming into force on 1 October 2007

Duty to act within powers (section 171)

Directors must act “in accordance with the company's constitution and only exercise powers for the purpose for which they are conferred.” This provision codifies the existing common law position - what is a “proper purpose” will be, as ever, context dependent.

Duty to promote success (section 172)

This is one of the more important and controversial duties and enshrines the principle of “enlightened shareholder value”. It requires directors to act in a way which they consider, in good faith, would be most likely to promote the success of the company for the benefit of its shareholders as a whole. In doing so, directors must have regard to the following factors:

the likely long-term consequences of their decisions;
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 maintaining a reputation for high standards of business conduct; and
the need to act fairly as between members of the company.

Where there is conflict between these factors, it is for the board to exercise its good faith judgement to resolve the conflict so as to promote the success of the company.

In its guidance on section 172, the Government has made the following comments:

the list of success factors is not exhaustive;
for a commercial company, “success” will usually mean a long-term increase in value (although it will depend on what a company's specific objectives are – a charity may have a different set of objectives than a for-profit undertaking); and
the requirement “to have regard to” the success factors is not satisfied by “box ticking” exercises – directors need to give proper consideration to such issues.

In reality, most boards will already have taken such factors into account in their decision-making processes in the past where relevant, so the new statutory requirement should not require a substantive re-thinking of board procedures. Currently recommended board practice is that the factors should be brought to the attention of directors in briefing papers (and when educating directors more generally) rather than recording in a set of board minutes that the directors have considered all factors. Obviously, if a single factor is particularly relevant, this should be highlighted in minutes. The Government has also made clear that section 172 does not impose a more onerous record-keeping requirement on directors than they are already subject to under the current law.

Duty to exercise independent judgement (section 173)

Under the law as it currently stands, directors must not fetter their discretion to act or to take decisions in their capacity as directors. This prohibition is now included in the duty to exercise independent judgement. In its guidance on the Act, the Government has confirmed that directors can still delegate their functions to board committees if the company's articles allow this. Nominee directors must, as before, exercise their judgement in the interests of the company (rather than blindly following the instructions of the person appointing them).

Duty to exercise reasonable care, skill and diligence (section 174)

This duty is assessed using both an objective and a subjective standard. It requires a director to exercise the care, skill and diligence that would be exercised by a reasonably diligent person with:

[objective standard] the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company; and
[subjective standard] the general knowledge, skill and experience that director has.

This dual test recognises that not every director will have equal knowledge of and insight into a company's business. As a consequence, those directors with more experience - including sophisticated non-executive directors appointed by an investor - will be subject to a higher test due to their particular skill set and individual experience. The Government in its guidance has stressed that section 174 is not changing the standard of care of directors that is already well established by case law.

What is the position from 1 October 2007 on Conflicts of Interest?

As the general duties on conflicts of interest do not come into force until 1 October 2008, the current law still requires that directors:

must not make a personal profit at the expense of the company by reason of their office or put themselves into a position where their interests conflict with those of the Company; and
disclose at board meetings details of any personal interest in a contract or arrangement with the company under section 317 of the Companies Act 1985.

How do the general duties relate to each other?

Many of the general duties will frequently overlap, and their effect is also cumulative, so where more than one duty applies, the director must comply with each applicable duty. For example, the duty to promote the success of the company will not authorise the director to breach his duty to act within his powers, even if to act outside those powers could be a way to promote the company's success.

How onerous are the general duties?

To put the new provisions of the Act into perspective, it is important to remember that directors owe their general duties to the company, i.e. only the company can enforce them. The Act does provide for a new derivative right of action which will enable shareholders to sue directors on behalf of a company (and this right is wider than the existing common law position). However, given the number of substantive safeguards that need to be satisfied before such a derivative action can be brought, it is thought that the Act will not result in a significant increase in litigation against directors. Also, directors are able to obtain a limited indemnity from the company in relation to the cost of proceedings against them by a third party.

What should I be doing?

Ensuring that each member of the board understands his duties.
Reviewing board procedures to ensure that they are consistent with directors' duties under the Act.
Reviewing any indemnity given to the directors by the company.
Reviewing D&O insurance to ensure derivative rights of action are covered (as the company cannot indemnify the directors against such actions).
Updating directors' contracts/letters of appointments as appropriate.
Ensuring board meetings minutes and briefing papers are drawn up in a proportional manner.

General duties in plain English

Margaret Hodge, the Minister of State for Industry and the Regions, has recently published the following plain English basic guidance on directors' duties under the Act:

Act in the company's best interests, taking everything you think relevant into account.
Obey the company's constitution and decisions taken under it.
Be honest, and remember that the company's property belongs to it and not to you or to its shareholders.
Be diligent, careful and well informed about the company's affairs. If you have any special skills or experience, use them.
Make sure the company keeps records of your decisions.
Remember that you remain responsible for the work you give to others.
Avoid situations where your interests conflict with those of the company. When in doubt, disclose potential conflicts quickly.
Seek external advice where necessary, particularly if the company is in financial difficulty.

Further Information

If you have any questions or would like to discuss anything in this article in more detail, please contact Charles Claisse at Kemp Little LLP on 020 7600 8080.

[1] Being a person in accordance with whose directions or instructions the directors of a company are accustomed to act.