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THE DUTY OF LOYALTY OF COMPANY DIRECTORS: BRIDGING THE ACCOUNTABILITY GAP THROUGH EFFICIENT DISCLOSURE

Published online by Cambridge University Press:  16 December 2009

John Lowry
John Lowry
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Professor of Law, UCL.
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The Cambridge Law Journal , Volume 68 , Issue 3 , November 2009 , pp. 607 - 622
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Copyright © Cambridge Law Journal and Contributors 2009

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References

1 In Item Software (UK) Ltd v. Fassihi [2005] 2 B.C.L.C. 91, Arden L.J., at [41], having noted that “the fundamental duty [of a director]… is the duty to act in what he in good faith considers to be the best interests of his company” concluded that this duty of loyalty is the “time-honoured” rule (citing Goulding J. in Mutual Life Insurance Co of New York v. Rank Organisation Ltd [1985] B.C.L.C. 11, at 21). Part 10 of the 2006 Act restates seven duties: duty to act within powers (s.171); duty to promote the success of the company (s.172); duty to exercise independent judgment (s.173); duty to exercise reasonable care, skill and diligence (s.174); duty to avoid conflicts of interest (s.175); duty not to accept benefits from third parties (s.176); duty to declare interest in proposed transaction or arrangement (s.177); (the duty to declare interest in an existing transaction or arrangement is laid down by s. 182).

2 Company Law for a Competitive Economy: Final Report, July 2001 (DTI/Pub 5552/5k/7/01/NP), para. 3.7.

3 In addition to its Final Report, Consultation Documents issued by the Company Law Review Steering Group, the body established by the then DTI (now DBERR) to oversee the reform process, include: The Strategic Framework (URN 99/654) February 1999; Company General Meetings and Shareholder Communication (URN 99/1144) October 1999; Company Formation and Capital Maintenance (URN 99/1145) October 1999; Reforming the Law Concerning Overseas Companies (URN 99/1146) October 1999; Developing the Framework (URN 00/656) March 2000; Capital Maintenance: Other Issues (URN 00/880) June 2000; Registration of Company Charges (URN 00/1213) October 2000; Completing the Structure (URN 00/1335) November 2000; and Trading Disclosures (URN 01/542) January 2001.

4 The Limited Liability Act 1855.

5 Company Law for a Competitive Economy, March 1998 (DTI/Pub 3162/6.3k/3/98/NP).

6 Such additions were generally introduced to address deficiencies of the existing legislation in protecting investors and as knee jerk reactions to particulars scandals of the day. See, for example, the White Paper, “The Conduct of Company Directors” (Cmnd. 7037, 1977)).

7 Above, n. 5. The UK has not been alone in its quest for a modern economically efficient regime for companies. For example, a corporate law reform programme along similar strategic lines has been ongoing in Australia since 1990: see the Corporations Law Scheme which commenced operation on 1 January 1991; the Corporations Legislation Amendment Act (No 1) 1991; the Corporate Law Reform Act 1992; the Corporate Law Reform Act 1994; the Company Law Review Act 1998; the Corporations Act 2001. See also, the policy discussion papers of the Corporate Law Economic Reform Programme (Canberra, AGPS, 1997).

8 http://www.hm-treasury.gov.uk/press/2001/p67_01.html

9 See the Strategic Framework, above, n. 3, para. 5.6.3. For a detailed analysis of the policy objectives see, Ferran, E., “Company Law Reform in the UK” [2001] Singapore Journal of International and Comparative Law 516Google Scholar.

10 Above, n. 5, para. 7.1.

11 Above, n. 5, para. 7.2.

12 For the range of consultation documents issued by the CLR, see n. 3, above. The list of respondents to the CLR's consultations can be found on the DBIS website, see http://www.berr.gov.uk/whatwedo/businesslaw/co-act-2006/clr-review/page22794.html

13 Company Law for a Competitive Economy: Final Report, above, n. 2.

14 Published in two volumes, Modernising Company Law (Cm 5553-I); and Modernising Company law–Draft Clauses (Cm 5553-II).

15 Company Law Reform (Cm 6456).

16 The title of the Bill was changed during committee stage in the House of Commons in July 2006.

17 Final Report, above, n. 2, para. 9.

18 At the end of the 1997/98 year, when the CLR was launched, there were 1.32 million companies on the (UK's) Companies House register of which 12,000 (amounting to 1%) were public limited companies. See The Strategic Framework, above n. 3, Annex D.

19 Final Report, above, n. 2, para. 1.27.

20 Final Report, para. 1.53.

21 Final Report, para. 1.54.

22 For example, the Financial Reporting Standard for Smaller Entities and the DTI's (as it was called) work on simplifying SME accounts. See the Companies Act 1985 (Accounts of Small and Medium-sized Companies and Minor Accounting Amendments) Regulations 1997.

23 The Strategic Framework, above, n. 3, para. 5.2.5. The point in reinforced at para. 5.2.13 where the CLR concludes that the complexity of the 1985 Act is such that, from the perspective of smaller companies, it is burdensome and unwieldy: “These are general concerns, but smaller companies are precisely those which do not have the time or funds to devote to legal advice; their owners and managers cannot delegate and must focus on day-to-day survival and growth.”

24 Company Law Reform (Cm 6456), at 16.

25 See the joint consultation paper, Company Directors: Regulating Conflicts of Interests and Formulating a Statement of Duties, Consultation Paper No 153; Discussion Paper No 105. See also, the Law Commission and the Scottish Law Commission joint report, Company Directors: Regulating Conflicts of Interests and Formulating a Statement of Duties (Nos 261 and 173, respectively), Cm 4436, (London, TSO, 1999).

26 The Law Commissions favoured partial codification: a statement of the main, settled duties, including the director's duty of care. It would not be exhaustive so that the general law would continue to apply in those areas not covered by statute.

27 All of which are rehearsed in the Final Report, above, n. 2, para. 3.7. See also the March 2005 White Paper, above n. 4, at 20.

28 Final Report, above, n. 2, para. 9 of the Foreword. Although the Companies Act 1985 and its predecessors did contain provisions regulating directors' duties, particularly in relation to shareholder approval of conflict transactions, these operated as a “gloss” on the common law and could not be readily understood absent a sound understanding of the jurisprudence spanning some 150 years or more. See P. Davies and J. Rickford, “An Introduction to the New UK Companies Act” [2008] E.C.F.R. 49, at 61.

29 Final Report, above, n. 2, para. 3.7.

30 Above, ns. 14 and 15, respectively.

31 In 2004 the DTI launched a further consultation exercise, Company Law: Flexibility and Accessibility, http://www.dti.gov.uk/cld/condocs.htm, which reiterated the Government's commitment to introduce a major Bill, albeit after further consultation, clauses of which will provide: “… clarity on the responsibilities of directors by making statutory provisions setting out the duties of directors via a statement of duties, and introducing related reforms to the rules governing directors' conflicts of interests.”

32 See the March 2005 White Paper, above, n. 15, at 21.

33 See, in particular, the Companies Act 2006, ss.170(3) and (4), considered below.

34 Companies Act 2006, s.417(2).

35 See, for example, the concern expressed by the Law Society to the effect that the statutory duty could raise the spectre of courts reviewing business decisions taken in good faith by subjecting such decisions to objective tests, with serious resulting implications for the management of companies by their directors: the Law Society's “Proposed Amendments and Briefing for Parts 10 & 11”, (issued 23 January 2006). Doubtless s.172 generated more debate in Parliament than any other of the duties contained in Part 10 of the Act.

36 As is made clear by s.179.

37 Which provides:

  1. (1)

    (1) A director of a company must exercise reasonable care, skill and diligence.

  2. (2)

    (2) This means the care, skill and diligence that would be exercised by a reasonably diligent person with-

    1. (a)

      (a) 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

    2. (b)

      (b) the general knowledge, skill and experience that the director has.

38 Section 170(1). See Percival v Wright [1902] 2 Ch. 421.

39 This begs the proverbial question, what is meant by “the company”? The question itself has long been debated. One possible solution was put forward by Lord Evershed M.R. in Greenhalgh v. Arderne Cinemas Ltd [1950] 2 All E.R. 1120, where he said, at 1126, “the phrase ““the company as a whole”“ means the corporators as a general body”. He therefore seemingly rules out a free floating corporate interest that corporate realists would advocate and identifies the company's interests with the shareholders as a general body indicating a contractarian bias. The debate is likely to continue unless s.172 is taken as settling the matter.

40 See Part 11 of the Companies Act 2006 which places the derivative action on a statutory footing. See A. Reisberg Derivative Actions and Corporate Governance (Oxford 2007), ch. 4.

41 See n. 52, below.

42 This is particularly true for s. 177 (duty to declare interest in proposed transaction or arrangement). The decision to cast this as a disclosure duty rather than a situational disability is not well documented and can be confusing in relation to remedies. On the other hand, although the statutory formulations of the no-conflict duty (see ss. 175 and 176) depart from the common law rules or equitable principles, the decision to incorporate deliberate policy changes in relation to these particular duties is explained in the consultation papers and the Explanatory Notes to the Act.

43 See Chapter 3 of the Final Report, above n. 2.

44 [1942] Ch. 304. A century earlier Lord Cranworth LC in Aberdeen Railway Co v. Blaikie Bros (1854) 1 Macq. 461, noted, at 471, that: “The directors are a body to whom is delegated the duty of managing the general affairs of the company. A corporate body can only act by agents, and it is of course the duty of those agents so to act as best to promote the interests of the corporation whose affairs they are conducting.”

45 This non-interventionist policy (the internal management rule) was explained by Lord Eldon L.C. in Carlen v. Drury (1812) 1 Ves. & B. 154, who said: “This Court is not required on every Occasion to take the Management of every Playhouse and Brewhouse in the Kingdom.” Indeed, Lord Greene M.R. in Smith & Fawcett, placed particular emphasis on the point.

46 Above, n. 44, at 306. The meaning of the term “company” in this context was construed by the courts as referring to present and future members: see, for example, Gaiman v. Association for Mental Health [1971] Ch. 317, at 330, in which Megarry J. said “I would accept the interests of both present and future members of the company as a whole, as being a helpful expression of a human equivalent.” Similarly, in Dorchester Finance v. Stebbing [1989] B.C.L.C. 498, at 501–502, Foster J. stated “[a] director must exercise any power vested in him as such, honestly, in good faith and in the interests of the company…”

47 See Developing the Framework above n. 3, para. 3.52.

48 Mills v. Mills (1930) 60 C.L.R. 150. In the Lords Grand Committee, 6 February 2006 (column 256), Lord Goldsmith summarised the scope of s.172 thus: “it is for the directors, by reference to those things we are talking about – the objective of the company – to judge and form a good faith judgment about what is to be regarded as success for the members as a whole…the duty is to promote the success for the benefit of the members as a whole – that is, for the members as a collective body – not only to benefit the majority shareholders, or any particular shareholder or some of shareholders, still less the interests of directors who might happen to be shareholders themselves.”

49 See Howard Smith Ltd v. Ampol Petroleum Ltd [1974] A.C. 82, PC; and Regentcrest plc v. Cohen [2001] 2 B.C.L.C. 80.

50 [2005] 2 B.C.L.C. 91.

51 This provision replaces s.309 of the Companies Act 1985.

52 A notable omission from the list is any reference to creditors. However, s.172(3) goes on to provide that: “The duty imposed by this section has effect subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company.” It therefore leaves space for the continued operation of the “wrongful trading” provision in the Insolvency Act 1986, s.214; and the common law (that the CLR noted should be left to develop), which recognises that where the company is insolvent or is of doubtful solvency, the interests of creditors supersedes those of the company's members so that the focus of the duty switches accordingly. See, for example, West Mercia Safetywear Ltd v. Dodd [1988] B.C.L.C. 250, in which the Court of Appeal cited, with approval, the view expressed by Street CJ in Kinsela v. Russell Kinsela Pty Ltd (1986) 10 A.C.L.R. 395, at 401, that “where a company is insolvent the interests of the creditors intrude. They become prospectively entitled, through the mechanism of liquidation, to displace the power of the shareholders and directors to deal with the company's assets. It is in a practical sense their assets and not the shareholders” assets that, through the medium of the company, are under the management of the directors pending either liquidation, return to solvency, or the imposition of some alternative administration…” See also, Winkworth v. Edward Baron Development Co Ltd [1987] B.C.L.C. 193, HL.

53 See The Strategic Framework, above n. 3.

54 See Percival v. Wright, above n. 38 and Greenhalgh v. Arderne Cinemas Ltd, above, n. 39. See further the text in n. 39, above.

55 That is to say, whether UK company law should continue to uphold the primacy of members” long term interests as the driver underlying directors” duties, but with the proviso that the interests of others should be taken into account. See, J. Parkinson Corporate Power and Responsibility: Issues in the Theory of Company Law (Oxford 1993). See also, J. Parkinson, “Inclusive Company Law”, in J. de Lacy (ed), The Reform of United Kingdom Company Law (London 2002).

56 See G Kelly and J. Parkinson, “The Conceptual Foundations of the Company: A Pluralist Approach” in J. Parkinson, G. Kelly and A. Gamble (eds), The Political Economy of the Company (Oxford 2001).

57 See, Developing the Framework, above, n. 3, paras. 2.19–2.22; Completing the Structure, above, n. 3, para.3.5). The pluralist theory was rejected because it would have required the law to be fundamentally reformed so that a company would be required to serve other constituency interests in their own right. See Strategic Framework, above, n. 3, at para. 5.1.13.l.

58 [2004] 3 S.C.R. 461.

59 [2004] 3 S.C.R. 461, at [42]–[43]. It is noteworthy that in Re West Coast Capital (Lios) Ltd [2008] C.S.O.H. 72, a Court of Session decision, Lord Glennie expressed the view that although there was no equivalent in the earlier Companies Acts, this section does “little more than set out the pre-existing law on the subject” (at para. [21]). It will be interesting to see whether this interpretation is followed, because the provision sets out, for the first time in the companies legislation, certain factors that directors are required to consider.

60 Developing the Framework, above, n. 3, para. 3.51.

61 (1883) 23 Ch. D. 654, CA.

62 [1962] Ch. 927.

63 That said, the specific duty to have regard to the interests of employees introduced by the Companies Act 1985, s. 309 gave employees no means to enforce the obligation against directors. Other statutory controls such as the power to provide for company employees on cessation or transfer of the company's business contained in s.719 of the 1985 Act were framed in permissive rather than mandatory terms (see now s.247 of the 2006 Act).

64 (1972) 33 D.L.R. (3d). 288.

65 (1972) 33 D.L.R. (3d). 288, at 314.

66 June 2007. See www. dberr.gov.uk/files/file40139.pdf

67 A point emphasised during the parliamentary debates: see HL Rep, Hansard HL 681 9/05/06 Cols 845–846.

68 See further A. Reisberg, “Derivative Claims under the Companies Act 2006: Much Ado About Nothing?”, in J. Armour and J. Payne (eds), Rationality in Company Law: Essays in Honour of D. D. Prentice” (Oxford 2009).

69 As will be seen below, the real test here lies with whether the courts will adopt a liberal approach towards the leave requirements for bringing a derivative claim now contained in Part 11 of the 2006 Act.

70 [2005] 2 B.C.L.C. 91. Noted by J. Armour and M. Conaglen, [2005] C L.J. 48.

71 It is notable that American judicial and academic views are cited in reasoning towards this conclusion: see Cardozo J. in Meinhard v. Salmon 164 NE 545, at 548; and Professor R. C. Clark, Corporate Law (New York 1986), respectively. See also, British Midland Tool Ltd v. Midland International Tooling Ltd [2003] EWHC 466 (Ch).

72 [2005] 2 B.C.L.C. 91, at [63].

73 [2005] 2 B.C.L.C. 91, at [65].

74 [2005] 2 B.C.L.C. 91, at [65].

75 [2005] 2 B.C.L.C. 91, at [65].

76 Efficiency in economic terms had informed the Law Commission and the Scottish Law Commission's proposals for increased disclosure obligations in their joint report, Company Directors: Regulating Conflicts of Interests And Formulating A Statement Of Duties (Nos 261 and 173, respectively), above, n. 25. Perhaps it is no coincidence that at this time Dame Mary Arden DBE was Chair of the English Law Commission. For a fuller discussion of the proposals, see, J. Lowry and R. Edmunds, “Section 317: Injecting Rationality into Directorial Disclosure”, in D. Sugarman and M. Andenas (eds), Developments in European Company Law (London 2000).

77 Directive 2003/51/EC.

78 See s.417(1). There are also specific exemptions for medium sized and larger unquoted companies: see ss.465–467 and 385.

79 Developing the Framework, above, n. 3, paras. 2.19–2.26, 3.85, 5.74–5.100. See also, the Final Report, Vol. 1, above, n. 3, paras. 3.28–3.45; and Completing the Structure, above, n. 3, paras. 3.7–3.10; 3.32–3.42.

80 Developing the Framework, above, n. 3, para. 5.74.

81 The provision does not adopt the term ‘stakeholders” presumably on the basis that it could lead the courts towards holding that the requirement amounted to a change in the law.

82 [1990] B.C.L.C. 833. See Lowry, J. and Edmunds, R., “The Continuing Value of Relief for Director's Breach of Duty” [2003] M.L.R. 195Google Scholar.

83 Early indications suggest that the courts will be loath to grant permission under s.263(3) to continue a derivative claim: see, Mission Capital plc v. Sinclair [2008] EWHC1339 (Ch); and Franbar Holdings Ltd v. Patel and others [2009] 1 B.C.L.C. 1.

84 Developing the Framework, above, n. 3, at para. 3.54. See also Lord Goldsmith's speech in the House of Lords Grand Committee, 6 February 2006 (column 258).

85 As commented above, the “factors” are now matters of substance going to good faith.

86 See, for example, Hansmann, H. and Kraakman, R., “The End of History for Corporate Law” [2001] Georgetown Law Journal 439Google Scholar; and Jensen, M., “Value Maximisation, Stakeholder Theory and the Corporate Objective Function” [2001] European Financial Management 297CrossRefGoogle Scholar.