The Code of Directors' Duties
This article is based on UK law as at 1st April 2007, unless
otherwise stated.
When the Department of Trade and Industry began the task of
drafting a Companies Act for the 21st century, the law on
directors’ duties must have seemed an obvious candidate for reform.
Built up since the 19th century by judges deciding different cases,
it was in places uncertain, contradictory and anachronistic.
The code of directors’ duties, contained in the Act and
effective from October 2007, is the government’s solution to the
problem. This streamlines and clarifies the old rules and as such
can be seen as a welcome development. It’s important, however, to
realise that it is more than a consolidation or simplification of
what’s gone before. The DTI has introduced a new concept,
“Enlightened Shareholder Value”, and changed the
rules.
The old formula was clear that a director’s primary duties were
to the company and its shareholders. There was a subsidiary duty to
employees, and creditors always took precedence on insolvency, but
the law was settled that a director should act in the best
interests of all shareholders, including future shareholders. Now,
enlightened shareholder value requires directors to consider other
interests that may affect a company’s success. A varied group of
stakeholders has to be taken into account as well as
shareholders.
The code of directors’ duties applies to all companies, public
and private, holding and subsidiary (and is not to be confused with
the Combined Code on Corporate Governance, which applies only to
listed companies – see the section on Corporate Governance). It is a statutory
benchmark of best practice for all.
Duty to act within your powers
Directors have the job of managing the company and they are
given certain powers to enable them to do that. But they must act
according to the company’s constitution and use those powers in the
interests of the company, not to further their own narrow
interests. So, for example, their power to issue new shares must be
used for the purpose of raising capital for the business. Issuing
shares to your cronies just to keep voting control in friendly
hands is an abuse of power and a breach of duty.
Duty to promote the success of the company
This is a new duty, a re-casting of the old law that imposed a
duty to act in good faith in the best interests of the company as a
whole. The language is now subtly different; a director of a
company must 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.
Lawyers may worry about how you define “success”, but the
intention behind the “new” duty seems to be on the same lines as
the old. There is, though, one important new element. This can be
seen from the DTI’s commentary on the new wording: “this duty,
which codifies the current law, enshrines in statute what is
commonly referred to as the principle of Enlightened
Shareholder Value”.
Effectively, the Companies Act introduces on to the statute book
for the first time the concept of the “stakeholder” – that is,
someone other than a shareholder who has an indirect interest in
what a company may be doing. The duty to promote the success of the
company is not simply a codification of an old law, but the
introduction of a new one.
To fulfil this duty, the legislation says that directors must
have regard to six factors that demonstrate what the DTI calls
“responsible business behaviour” in reaching their decisions.
Note the wording here. “Have regard to” is key. There is no
requirement that any one factor is given precedence over another,
that employees must be favoured over the environment, for example,
or the community over customers. The final decision might ignore
all six factors – but the board needs to be able to
demonstrate that it has at least thought about them.
In practice, then, the new law may not represent a huge change.
The success of the company remains the paramount concern for
directors. The legislation prompts the board to think about these
different factors, but they must remain subsidiary to the
over-arching requirement the directors have to act in the way they
believe, in good faith, is most likely to promote the company’s
success. (Where a company is set up for other purposes than to
benefit its shareholders – where it’s a charity, for example – you
can substitute that other purpose.)
The new law does, however, have implications for decision taking
and record keeping. But for many companies the concept of
enlightened shareholder value is nothing revolutionary; they have
been thinking about these factors, or something like them, for
years. The duty merely gives statutory force to something that
responsible boards of directors should be doing anyway.
Duty to exercise independent judgment
A director is on the board to act in the best interests of the
company as a whole, not to represent the interests of just one
shareholder or even a group of like minded investors. That rule
applies irrespective of the circumstances in which the director has
been appointed.
In a company set up as a joint venture between two businesses,
each shareholder will commonly have the right to appoint an equal
number of directors. Similarly, a private equity investor will
commonly put a director on the board to safeguard its investment.
But in each case those directors risk trouble if they are seen to
act only in the narrow interests of the shareholder who appointed
them. Their duty is to the company as a whole and to all the
shareholders in the company. A director must not be a “plant” or a
partisan.
Duty to exercise reasonable care, skill and diligence
The law requires a director to use reasonable care, skill and
diligence in carrying out their tasks.
What does this mean in terms of the standards expected of a
director? At the most basic level, that you must work at it:
directorship is not a sinecure or an honorary position; it’s a
“proper” job, requiring “reasonable diligence”.
Then there is a double test. First, there is an objective
standard: a board member must have the knowledge, skill and
experience that would reasonably be expected of someone doing that
job. Second, a subjective standard must also be met: a director has
to perform according to the knowledge, skill and experience they
actually have.
So there is a basic level of competence that will be expected
from all a board’s members; but there is also a higher standard
expected of those with some special skill or experience. A
qualified accountant doing the job of finance director will be
judged against the standard of a fellow professional closely
following the detail of the company’s finances; if they have
particular knowledge or experience, they will be judged by that
higher standard as well.
A non-executive director may not have the detailed knowledge of
the company’s business and will not see all of the information
available to management, but they will have a broader experience
and therefore will be expected to use that to probe and challenge.
Just like executive directors, they will also be expected to bring
relevant professional skills and qualifications to bear. When
questions were raised over the financial shenanigans at Enron, much
was made of the fact that Lord Wakeham, a non-executive director
who sat on the company’s audit committee, was a chartered
accountant.
Duties relating to conflicts of interest
Directors’ obligations to the company must not clash with
obligations they owe (or feel they owe) to others; directors must
be incorruptible. These are the principles behind the following
three statutory duties:
- a general duty to avoid a conflict of interest;
- a duty not to accept benefits from third parties;
- a duty to declare an interest the director may have in a
proposed transaction or arrangement with the company.
