Start-ups - directors' duties in a nutshell

INTRODUCTION

Types of director in the UK

Company directors are responsible for the management of a company. They owe certain fundamental legal duties to the company, which are set out in the Companies Act 2006 (“2006 Act”). In the UK, we distinguish between the following types of director:-

• Executive director: a director who carries out the management functions in the company and is usually a full or part-time employee;

• Non-executive director: a director who is not an employee or holder of an executive office. Such a director usually devotes part of his time to the company’s affairs as an independent adviser or supervisor;

• De jure director: a person validly appointed as a director at Companies House;

• De facto director: a person who acts as if he is a director and is treated as such by the board but has not been validly appointed; and

• Shadow director: Any person in accordance with whose instructions the company’s directors are accustomed to act. A person is not a shadow director merely because the directors act on advice given by him in a professional capacity.

Directors must be aged at least 16.

Who are the duties owed by?

The general duties set out in the 2006 Act will apply to all directors, including de facto directors. No distinction is made between executive and non-executive directors. However, there is still uncertainty regarding the application of directors’ duties to shadow directors.

Who are the duties owed to?

The duties in the 2006 Act are owed to the company and only the company will be able to enforce them, although in certain circumstances members may be able to bring a so-called derivative action on the company’s behalf.

Duration

Certain aspects of the duty to avoid conflicts of interest and the duty not to accept benefits (both summarised below) will continue to apply after a person ceases to be a director. For example the duty to avoid conflicts will continue as regards the exploitation of any opportunity of which the director became aware while he was a director.

Cumulative duties

Where more than one duty applies in a given case, the directors must comply with each applicable duty. For example, the duty to promote the success of the company will not authorise directors to breach their duty to act within their powers, even if they consider that action would be most likely to promote the company’s success.

The 2006 Act duties

Duty to act within powers

A director must act in accordance with the company’s constitution (for example, the procedure for directors’ meetings set out in a company’s articles) and must only exercise his powers for their proper purpose.

The 2006 Act does not clarify the duty to exercise powers for proper purposes, such as how those purposes are to be ascertained, or the extent to which an improper purpose may taint a decision. Such matters will usually be determined in accordance with previous case law – the directors should exercise common sense in this area.

Duty to promote the success of the company

A director must act in the way he considers, in good faith, would be most likely to promote the success of the company. In doing so, the director must have regard to the following matters:

• The likely consequence of any decision in the long term;

• The interests of the company’s employees;

• The need to foster the company’s relationships with others;

• The impact of the company’s operations on the community and the environment;

• The desirability of the company maintaining a reputation for high standards of conduct; and

• The need to act fairly.

The duty is subject to any law requiring directors in certain circumstances to consider or act in the interests of the creditors of the company. Accordingly, the duty is displaced when the company is insolvent and the directors must have regard to the interests of creditors as the company nears insolvency.

The following should be noted:-

• The duty will apply to all decisions made by a director, not merely formal decisions made by the whole board;

• The list of factors is not exhaustive; directors should have regard to other matters relevant to the duty to promote the success of the company.

• In having regard to the listed factors, the duty to exercise reasonable care, skill and diligence (see below) will apply.

• Equal consideration must be given to the interests of all shareholders.

Duty to exercise independent judgment

A director must exercise independent judgement. The duty will not be infringed by a director acting:

• in accordance with an agreement entered into by the company that restricts the future exercise of the directors’ discretion; or

• in a way authorised by the company’s constitution.

Duty to exercise reasonable care, skill and diligence

A director must exercise the care, skill and diligence which would be exercised by a reasonably diligent person with both:

• The general skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in question (the “objective” test); and

• The general knowledge, skill and experience that the director actually has (the “subjective” test).

So, at a minimum, a director must display the knowledge, skill and expertise set out in the objective test, but where a director has specialist knowledge, the higher subjective standard must be met. For example, a chartered accountant would usually be expected to know whether a company is solvent.

Duty not to accept benefits from third parties

Directors must not accept any benefit (including a bribe) from a third party which is conferred because of his being a director.

The duty will not be infringed if the acceptance of the benefit cannot reasonably be regarded as likely to give rise to a conflict. Benefits conferred by the company, its holding company or subsidiaries, and benefits received from a person who provides the director’s services to the company, are excluded.

The members of a company can authorise the acceptance of benefits that would otherwise be a breach of this duty and the company’s articles will also usually contain provisions dealing with conflicts.

Q & A on conflicts of interest

A director must avoid situations in which he has or can have an interest that conflicts with, or may conflict with, the company’s interests. For example, if companies A and B both operate in the same industry, and Mr Smith is a director of both companies, this can be seen as a potential conflict situation even if those companies do not have the same customer base.

Does this mean that I have to resign a directorship in order to avoid breaching my duty to avoid conflicts?

Not necessarily. Directors do not breach their duty if the situation cannot reasonably be regarded as likely to give rise to a conflict. There is little guidance here, and directors will need to take a sensible view. Also, nothing prevents shareholders from approving a conflict in advance or ratifying a breach of duty. The director concerned (if he is also a shareholder) is not allowed to vote on the ratifying resolution.

Do we have to convene a shareholder meeting or circulate a written resolution to the shareholders every time a potential conflict arises?

No. The 2006 Act also allows directors to authorise a conflict situation in advance, as long as the board meeting is quorate without the director concerned, and he does not participate in the vote. Directors of companies incorporated after 1 October 2008 can approve conflicts provided their articles do not specifically prevent this.

Should I adopt articles containing detailed provisions governing directors’ conflicts?

Yes if you think that you may not want to give directors an unlimited authority to approve conflicts. For example, you may wish to provide that an approval of a particular conflict automatically terminates if the other company in which the director concerned has an interest becomes a direct competitor.

Also, consider specifying whether the relevant director is allowed to vote on resolutions relating to the conflict situation, and/or whether he should be absolved from any duty to disclose confidential information which he obtains in respect of the other company. The 2006 Act specifies that directors will not breach their duty to avoid conflicts if they comply with provisions in a company’s articles for dealing with conflicts. Such articles will therefore provide a “safe haven” and welcome certainty for directors.

Do all private company articles need to contain detailed conflict provisions?

Not necessarily. If the shareholders and directors are the same people, and directors have few potentially conflicting interests, then you might be happy to rely on the ability of the shareholders to approve conflicts. If, on the other hand, some of the directors have other directorships or there are non-executive or investor/nominated directors who hold a number of other board appointments, the range of potential conflicts might change constantly, and you are unlikely to want to circulate written resolutions every time a new situation comes to light. In such a case, allowing the board to approve conflicts, and setting out a detailed procedure for doing so, would genuinely facilitate the smooth running of the company.

The George Green INTEGRAL template articles contain reasonably detailed conflict provisions which would normally be considered suitable for most small private companies.

What happens if, after the board has approved my other directorship, a specific conflict arises in relation to that company? For example, the companies might not have been competitors originally, but one of them subsequently infringes the other’s intellectual property rights and a dispute arises.

The directors’ initial approval might or might not seek to “frank” all actual conflicts which flow from the potential conflict situation. Either way, it is prudent to assume that the specific conflict is not approved, and to disclose it to the board for further consideration.

What is the difference between “situational” and “transactional” conflicts?

Many directors find this the most confusing aspect of the law. If Mr Smith is a director of company A and company B, operating in the same industry but not necessarily competing, this is a potential “situational” conflict which should be approved at board or shareholder level (as appropriate). If company A then proposes to enter into a contract with company B, that is a “transactional” conflict. Provided that the director declares his interest in that contract to company A and company B, the conflict does not need board or shareholder authorisation. The articles will detail whether Mr Smith can then vote on a resolution of company A or company B to approve the contract.

A director’s contract of employment must be approved by the shareholders in a general meeting, if the term exceeds two years.

Other duties

There are hundreds of other obligations in the 2006 Act e.g. obligation to file accounts, annual returns and various other statutory notices. Furthermore, directors will have many other duties under a wide variety of other laws and regulations, such as:

• insolvency law;

• environmental and health and safety legislation;

• employment law (in dealings with the company’s employees). George Green LLP offers a free e-mail employment law update service.

Directors can potentially incur personal liability if the company goes into insolvent liquidation and some time before commencement of the winding up the director knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation. Such an action would be taken on the application of a liquidator. However, there will be no such liability if the court is satisfied that the director took every step with a view to minimising the potential loss to the company’s creditors as he ought to have taken. We would normally recommend that the directors seek advice from a qualified insolvency practitioner.

Consequences of breach

The 2006 Act does not state which remedies are available for breach of the general duties. However, the consequences of a breach of a director’s general duties can include damages, compensation, restoration of the company’s property, rescission of a transaction or a requirement of a director to account for any profits made as a result. They may also include injunctions or declarations, although those methods are primarily employed when a breach is threatened but has not yet occurred. The consequences of a breach of duty of care and skill may include the court awarding compensation or damages.

Some types of conduct (such as trading while the company is insolvent) could result in disqualification. Certain actions such as misapplication of company funds could result in a criminal conviction.

Relief from liability

It is possible for members to ratify conduct of a director that amounts to negligence, default, breach of duty or breach of trust. It is also possible for a court to grant relief where proceedings for negligence, default, breach of duty or breach of trust are brought against a director if it considers both that (i) he has acted reasonably and (ii) considering all the circumstances of the case, he ought fairly to be excused. A director may also apply to the court for relief where he has reason to expect a claim to be made against him.

Indemnity and Insurance

A company will not be able to exempt a director from any liability for negligence, default, breach of duty or breach of trust in relation to the company. The company may, however, indemnify the director against defence costs, or costs incurred in an application for relief as summarised above, provided that the director repays the costs if he is unsuccessful.

A company may purchase insurance for its directors, and those of an associated company, against any liability attaching to them in connection with any negligence, default, breach of duty or breach of trust by them in relation to the company of which they are a director.

General tips for avoiding liability for breach of duty:

• monitor the company’s financial situation regularly;

• take steps to minimise losses to creditors if the company is likely to face financial difficulties. Ask an insolvency practitioner to advise the board. Keep a record of the meeting;

• ensure that minutes of all directors’ meetings are maintained;

• bear in mind the requirements of your employment contract and the procedures under the articles;

• whenever possible avoid personally guaranteeing the company’s obligations.

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