Sophie: Well, the official definition is, any person occupying the position of a director by whatever name called. Which is obviously very wide. There are various different categories of director that you've probably heard of and they're not all mutually exclusive, actually. So you might have heard of executive directors. So, they are usually full time employees who carry out executive functions within a company, looking after the day to day running of the company's business. Then you have non executive directors. They're generally not employees or holders of an executive office. They are expected to participate in board meetings, and on board committees, and although they have no day to day responsibilities for the company's operations, they are still responsible, in law, for decisions in the actions of the board. Usually, I think when we talk about a company director, is most people think about legal directors, so the people that have been formally appointed under the company's internal rules, and their appointments have been notified to companies house.
Sophie: Those legal directors could be either executive or non executive directors, but generally they're going to know that they're directors. So, the fact that they are subject to various duties isn't going to be a surprise for them. But you also have another category of directors, in fact or de facto directors. So that's somebody who acts as a director but without actually having been formally appointed. So they're part of the governing structure, they take part in director's decision making processes, and they undertake functions within the company that could only be done by directors. And the problem for those people, is that they don't think of themselves as directors, but they are actually subject to the same rules as the formally, legally appointed directors.
Host: So they could potentially then, have some personal liability there and not be aware of it?
Sophie: Absolutely. And the other problem is, there's no hard and fast rule as to when somebody will be a de facto director or won't be. And you'd have to look at the individual circumstances, the specific functions that they're carrying out within the company. The final category is shadow directors. And that's someone who, whilst again not appointed as a director, is actually the directing mind of the company, and exerts control over it. So basically, those formally appointed directors are accustomed to acting in accordance with the instructions of a shadow director. And the key thing for people listening to the podcast is that, all those different categories of directors are subject to the same duties. So, a de facto director is subject to duties even though they've not been formally appointed, and might not consider themselves to be a director. And a non executive director can't hide behind the fact that actually, they don't have any involvement in the day to day management decisions, in order to avoid director's duties.
Host: It's useful to get that overview. The next question really, is why are directors subject to these duties?
Sophie: Yeah, that's a really good point. And the answer lies in the relationship between the directors and the company. So, a company is a separate legal person, but obviously it's not actually a sentient being capable of acting for itself, and it can only act through its directors. So, the directors are the agents of the company. They have power to act and take decisions affecting the company's assets and interests. And that gives rise to a relationship of trust and confidence between the director, given his or her powers over the company's assets, and the company. And that's called a fiduciary relationship, and it's that fiduciary relationship that gives rise to a number of duties.
Host: Okay. So if I'm a director, where can I find out more about these duties?
Sophie: Well, that used to be really hard, because the fiduciary duties are derived from common law and legal cases over two centuries. So it wasn't possible for directors to look in a single place and find out what those general duties were. Very helpfully, the government decided that actually, it would be a good idea to write them down. So they were easily accessible and understood by all directors. So what they did was, they codified those general fiduciary duties into a statement of seven general duties, which are in the Companies Act 2006. But the one caveat with all of that is, there is that codified statement of seven general duties, but that's not everything. So, there are other duties that directors are subject to, both under the company's act, and also under other pieces of legislation. So, things like a health and safety legislation, and insolvency legislation, but for the rest of today, we're going to just focus on that statement of the seven general duties.
Host: Okay, excellent. So looking at those seven duties, which is most important?
Sophie: Well, they all rank equally and they're cumulative, so a director has to comply with all of the duties that apply in a particular circumstance. And if you act in a way that complies with one duty, that doesn't justify breaching another duty. So you have to comply with all of them, and they're all equally important. Having said that, the one that has attracted the most attention, is the one that's known as the Section 172 duty. And that duty says that a director has to act in the way 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. And not replaced the old duty that people might have heard about, to act in the best interest of the company or to act in good faith.
Sophie: So it's a subjective test. As long as the director acts in good faith, then what matters is the director's view. The reason it's attracted a lot of attention, is because the duty goes on to include a list of six specific factors, which director has to take into account when fulfilling that primary duty of promoting the success of the company. And that's things like the consequences of the decision in the long term, the interests of various stakeholders, so employees, customers, suppliers, and then wider factors, like the impact of the company's operations on the community and the environment.
Sophie: It's important to remember though, that those six factors that directors have to think about don't qualify the primary duty, they're just matters that the director has to think about when deciding what's going to promote the success of the company. So, if a particular course of action is proposed, which say would have an adverse effect on a company employees, maybe closing a factory, something like that, then provided the director considers the actions impact on the employees, or the other factors, the director won't be in breach if, in good faith, they still believe that taking that particular course of action is the thing that would promote the success of the company.
Host: Okay. So, could you tell us a little bit more about some of the other duties?
Sophie: Okay, so there's another duty, which says that a director has to act within their powers. There's two key strands to that. So, one is that, the director has to act in accordance with the company's constitution. So that's mainly the articles of association. So, if there are some provisions in there about conduct of board meetings or signing of documents, directors have a duty to comply with those provisions.
Sophie: And then the other strand of this duty is, that a director has to exercise their powers only for the purposes for which they were conferred. And when you think about that, the director might have a range of purposes for which they're exercising their powers, but the court would look at the dominant purpose behind the director's action. And if that dominant purpose is proper, then the exercise of the power will be valid, even if there's, perhaps another subservient improper purpose behind the director's powers.
Sophie: So, another duty is the duty to exercise independent judgement. And basically that means directors have to do what they, and no one else, decide is in the best interest of the company. That doesn't prevent directors taking advice from other people and relying on that advice, or delegating, perhaps, to other people, as long as, in the director's judgement, that's a reasonable thing for them to be doing. But the director has to use their own judgement when deciding whether or not to delegate, and when having received some advice, deciding how to proceed in the light of that advice.
Sophie: Then there's another duty, which says that directors have to exercise reasonable care, skill and diligence. And the particular level of care, skill and diligence, is whichever is the higher of the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions of that director, in relation to that particular company. So, that's an objective standard. And the actual knowledge, skill and experience of the director, a subjective standard. So what that means in practice is, that the more qualified and experienced a director is, then the greater the standard is placed on them by this duty.
Sophie: So, for example, if you have a director who is a director of a small widget making factory in Preston, they're not expected to have the business acumen, say of Richard Branson, unless they happen to have the business acumen of Richard Branson, in which case they might be held to that higher standard. So, a director is expected to have the necessary knowledge, skill and experience of a reasonably diligent person performing their particular role. So, say somebody is appointed to the role of a finance director, but actually they've no experience of financial matters, then they're going to be in breach of this duty. They don't have the level of skill and experience that would be required of a hypothetical person carrying out that role. And actually, the other directors who appointed that inexperienced finance director, would also be in breach of that duty, by not exercising reasonable care and skill when appointing that inexperienced person.
Host: Sure, that makes sense, thanks Sophie. So, that's four of the seven, what about the other three general duties?
Sophie: Okay, so the last three all relate, in one way or another, to conflicts of interest. So there's a primary duty to avoid conflicts of interest, and it's really widely drawn this duty. So the actual wording is, that a director must avoid a situation in which they have an interest that conflicts, or may, possibly conflict, with the interests of the company. So, like I say, really wide and effectively a blanket prohibition on a director being in a situation in which their own interests might, in any way, conflict with the company's interests, and both direct and indirect interest are caught here.
Sophie: So, this kind of conflict could arise between a director's own interests and the interests of the company or between the duties that the director owes to the company, and the duties that that director owes to another person, a third party. Some examples for you, perhaps a director is a shareholder or director of a supplier to a company, that would put them in a conflict situation. The director's spouse is a shareholder or director of a competitor or major customer. Again, that's a conflict situation. Even the director representing a major shareholder in the company, being a sort of nominee director, that would be a conflict situation. Or, something that's relevant for lawyers and accountants maybe, a director having an advisory relationship with the company. So, being the legal advisor to a company, or being its auditor, all of those things would be conflict situations.
Sophie: Sadly, although those are some examples, there's no exhaustive list that you can look to. So each director needs to examine their own individual circumstances, and also those of their connected persons, to identify whether or not there are actually any conflict situations.
Sophie: Fortunately, there are a few exceptions, and in particular that duty won't be breached where the situation cannot reasonably be regarded as likely to give rise to a conflict. So kind of nominal, immaterial situations. And also it won't be breached if the conflict situation has been authorised by the other directors. So if you've got, in your board, that kind of situation where you've got a major shareholder who has the right to appoint a nominee director, then you overcome the conflict by getting the other directors to approve that conflict situation. So, that's the primary duty to avoid conflicts of interest.
Sophie: There's another one which says that directors won't accept benefits from third parties. So that's somebody other than the company or an associated company. Obviously that's designed to prevent directors from taking advantage of their position. So, a director, couldn't accept a payment from a third party that's looking to win a lucrative contract with the company. It's aimed at preventing bribes, and other payments or gifts, which could compromise a director's independence. But again, sort of small, immaterial things that aren't going to give rise to a conflict of interest or excluded. So, small corporate gifts, routine hospitalities, golf days, those kinds of things are all fine.
Sophie: And then the final one, the last one of our seven, is a duty to declare an interest in a proposed transaction or arrangement with the company. So, if a director is in any way, interested in a transaction, they have to declare both the nature of their interest, and also the extent of that interest to the other directors, before the company enters into the relevant transaction or arrangement.
Sophie: And again, the director needs to think, not only about their own interests, but also those of their connected persons. So it doesn't have to be the director specifically, that's interested in the transaction or arrangement. It could be the interest of another person in a contract with the company, that might mean the director has to make a disclosure.
Host: Absolutely. That makes sense. So, who are the directors duties owed to?
Sophie: That's a really good question. And the key answer for directors is, that they are only owed to the company, and not any wider group. For example, the shareholders individually. So what that means is, it's only the company that can enforce the duties and bring a claim against a director for any breach of duty. And obviously when the company decides whether or not to bring that claim, the company would be acting via its board. So it would be a board decision, to decide whether or not to bring a claim for breach of duty against a specific director.
Sophie: Because of that, there are some circumstances in which shareholders can step in and bring an action in the name of the company, but to recover loss on behalf of the company, not personally as shareholders. And shareholders might want to do that, if the board collectively decides not to bring a claim against a particular director.
Sophie: The other thing to think about is that a claim for breach of duty could also be brought by a liquidator or administrator of the company on insolvency. Because in those situations, the insolvency practitioner effectively steps in and takes control of the company and may look to bring claims against the directors for historic breaches of duty.
Host: We've covered a number of ways in which that duty can be breached. What happens if from when it is?
Sophie: So, if the company makes a claim against the director, then there are various remedies that the company might look for, and therefore penalties or liabilities that the directors could face.
Sophie: So, a primary one is damages, basically to compensate the company for any loss suffered as a result of the breach. There's also a remedy of restitution, which is aimed at reversing any unjust enrichment, that the director has benefited from, as a result of breaching their duty. So whereas, damages look to compensate the company for any loss it has suffered, restitution focuses on the gain or benefit received by the director and makes them effectively account to the company for that.
Sophie: You could try and have a transaction set aside. So, if a contract has been entered into by the company as a result of a director's breach, you can try and rescind that contract, and basically put the parties back into the position they would have been in, had the contract not been entered into. There are limitations to that, and in particular, it's not going to be possible where a third party, innocently, relying on the director who's acted in breach has acquired rights or incurred liabilities on the basis of that director's unlawful actions.
Sophie: And then there's a remedy of restoring company property to the company. So a director can be required to return any property held by them, which actually rightfully belongs to the company. The other thing to think about as well as those claims by the company against the director is that if a director does breach their duty, that may well also give rise to a claim under their employment contract with the company. So the company might be entitled to dismiss them as an employee. And also, obviously depending on what's the nature of the breach is, and perhaps how high profile the company is, there could be reputational issues for a company where directors are in breach.
Host: A lot there for directors to think about. What can they do to protect themselves?
Sophie: Well, the good news is there are some ways in which directors can protect themselves against a breach of duty. One thing is that, it is always possible for the company to effectively ratify any breach. Because the duties are owed to the company, the company can bless any potential breach of duty by the directors. And that ratification is given by a shareholder resolution.
Sophie: The company could also agree to indemnify the director against liabilities incurred. There are really tight limits about what a company can and cannot indemnify a director about, because it would be unfair if the director could escape all liability just by relying on an indemnity from the company. So in particular, it would only relate to certain liabilities to third parties, that the director incurs in the course of acting as a director, and not liabilities incurred to the company.
Sophie: And then perhaps a really obvious one is insurance. Most companies nowadays will take out some form of DNO, Directors and Officers Insurance, to ensure the directors against liability arising in the course of their duties, including claims for things like negligence and breach of duty. But those policies will usually exclude any action considered fraudulent, or dishonest, or criminal in nature.
Host: Thanks Sophie. So given everything that we've covered, what would your top tips for directors be?
Sophie: I would say the first one is, know your responsibilities. Make sure you understand your duties, take advice on them, keep in mind what you can and cannot do, and also what you must do. Then I would say hold regular board meetings, and make sure you keep proper records of the decisions made and the reasons for those decisions. That could be really helpful to directors, if a claim for breach of duty subsequently made. Make sure that you manage and authorised conflicts of interest, and that they don't affect decisions taken by individual directors or the board. Ensure that the company has effective management and financial controls, including accurate and adequate accounting records, regular financial reports, and appropriate corporate governance policies and procedures in place. And then finally an obvious one, but take appropriate advice from a suitably qualified person when you need it. So, that could be looking at advice from lawyers generally, in relation to duties. It could be looking at advice from accountants, in relation to financial matters. An insolvency practitioner, in times of financial difficulties. But make sure you take advice and act accordingly.
Host: Excellent. Thank you Sophie. So, if anyone listening to this podcast has any further questions for Sophie, you'll be able to find her details alongside this podcast and on our website. Thank you.
Host: Thank you for listening to Straight Talking Business Success. To find out more about the series, please visit gateleyplc.com/businesssuccess. From here, you can subscribe for updates, meet our speakers, and get more information on all of the topics that we've covered.