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'The codification of directors' duties was an unnecessary step. The enacted duties do not differ substantially enough from their equitable and common law counterparts to warrant placing them in statute, and the courts will still need to refer to pre-2006 case law when determining whether or not a breach of duty has occurred. Discuss

Introduction

This paper discusses the assertion that the codification of directors’ duties set down in the Companies Act 2006 was a fruitless exercise. The new framework of law will be considered against the backdrop of established case law in the field. Analysis will be devoted to an evaluation of the utility of the new regime and conclusions are drawn based on the commentary provided.

In summary, this paper will conclude that the assertion made in the title to this work is plainly wrong. The codification of directors’ duties was not unnecessary, the enacted duties do differ from the traditional common law in this field in significant respects and the measures set down in the 2006 Act will prove invaluable in at least one specific instance. This aim of this paper is to prove this thesis.

The issue of directors’ duties

The importance of the law relating to directors’ duties is hard to overstate. At the outset it is submitted that company directors occupy positions of unique power and influence over the undertakings they represent, which are in turn responsible for generating much of the wealth on which modern UK society depends to fund itself. Directors are in a position to lead the companies they represent either towards stability and prosperity or spectacular failure, with all the entailed consequences that these futures yield for the community at large.

The courts are well aware of this fact and long have been. Generations of judges have enforced a rigorous, inflexible and comprehensive corpus of fiduciary duties against directors in recognition of the importance of the role of responsibility and trust invested in those individuals (the very word ‘fiduciary’ means trust). On the other hand, common law duties of skill and care have traditionally proved considerably more lenient and benevolent when applied to incompetent directors. This situation provoked widespread criticism.

What follows is an analysis of the applicable provisions of the Companies Act 2006 combined with a comparative commentary that considers the longstanding case law, extending back over approximately the last one hundred and fifty years (see inter alia, Aberdeen Railway Co. v Blaikie Bros (1854)). This analysis leads us to a conclusion in regards to the question as to whether ‘the codification of directors' duties was an unnecessary step’ as the title to this work suggests.

The Companies Act 2006

By any measure the 2006 Act is a momentous and monumental piece of legislation. The largest statute ever enacted by the Westminster Parliament, it has engineered the modernisation, consolidation and codification of the vast panoply of UK company law. The Act subsumed the compendious 1985 Companies Act, the Companies Act 1989 and also the 2004 Companies (Audit, Investigations and Community Enterprise) Act.

The modernisation of UK company law necessitated reform, redrafting and reorganisation in many fields. The law relating to directors’ duties received particular attention. Indeed, it is submitted that the reforms made in the context of the law on directors’ duties constitute some of the most important and valuable innovations incorporated in the new Act.

The codified law on directors’ duties

In sections 170 to 181 of the 2006 Act, the equitable and common law principles of the fiduciary duty and precepts of negligence as they apply to company directors are codified. The quote featured in the title to this work suggests that ‘the enacted duties do not differ substantially enough from their equitable and common law counterparts’ and that ‘the courts will still need to refer to pre-2006 case law when determining whether or not a breach of duty has occurred’. The immediate response of this commentator is - good. Why should reform and reorganisation necessarily entail root and branch upheaval or the disposal of principles, many of which are more than a century old and tried and trusted? Moreover, why shouldn’t courts refer back to the extensive and comprehensive bank of existing case law, opinion and precedent in order to inform their interpretation and application of the law? To ignore the past would be to turn our backs on an invaluable resource of insightful jurisprudence set in almost infinitely variable practical contexts.

Respect for the established common law and equity in this field is positively enshrined in the Act. For example section 170(3) provides that the general duties laid down in sections 171 to 177:

            “are based on certain common law rules and equitable principles as they apply in relation to directors and have effect in place of those rules and principles as   regards the duties owed to a company by a director.”

There is one concern that is not mentioned in the quote featured in the title, and that is that codification risks rendering the law inflexible and unresponsive. A system based on the common law is highly adaptable and adjustable, whereas codification often threatens to ossification of the law. However, section 170(4) of the Act strives to harness both the accessibility, clarity and certainty that codification brings and the flexibility and adaptability of the common law in the following terms:

            “The general duties shall be interpreted and applied in the same way as common law rules or equitable principles, and regard shall be had to the       corresponding common law rules and equitable principles in interpreting and applying the general duties.”

Mayson, French and Ryan comment that this is an attempt “to have the best of both worlds” and it is submitted by this commentator that what is seemingly portrayed as a weakness in the quote featured in the title is actually a strength of the new system, given that it ensures consistency and continuity and allows the law to draw on strengths available under both the pre-2006 and post-2006 regimes.

It should thus come as no surprise that section 171 of the 2006 Act mirrors fundamental and seminal jurisprudence derived from the leading precedent on the question of the fiduciary duty. Section 171 stipulates:

            “A director of a company must -
            (a) act in accordance with the company’s constitution, and
            (b) only exercise powers for the purposes for which they are conferred.”

The new formulation reflects longstanding fiduciary duty precepts. In Hogg v Cramphorn Ltd (1967) company directors took it upon themselves to block a takeover bid by issuing a batch of new shares. It was readily accepted and acknowledged by the court that the directors had been motivated so to act without self-interest and in good faith, because they believed the takeover would prove detrimental to the interests of the company. Notwithstanding this, the court found that the directors were exercising their powers for a purpose other than one for which those powers had been conferred and as a result the directors were held to be in breach of their fiduciary duty.

The Hogg v Cramphorn Ltd line was later pursued in Howard Smith Ltd v Ampol Petroleum Ltd (1974) by the Privy Council and has been applied in a veritable multiplicity of subsequent cases. Section 171 of the 2006 Act has done little more than to put this jurisprudence on a statutory footing, but it has done so with a clarity and simplicity that aids accessibility. Indeed, the ruling in O’Donnell v Shanahan and others (2008), suggests that many of the newly codified statutory provisions are essentially declaratory of longstanding common law rules. Again, this is not a weakness of the Act. The raison d’être of the new legislation was not, generally speaking, massive change, but useful clarification and simplification. It is clear that many if not most of the provisions codified in the 2006 Act do not require the courts to approach directors’ duties cases in a manner that is substantially different from the way in which those cases were handled and dispatched prior to the new legislation. This is not something that deserves criticism. Continuity in the law, in particular in a law that has been diligently and intricately developed over hundreds of years, is important.

Section 172(1) of the 2006 Act elaborates on the general duty by providing a non-exhaustive list of specific interests and factors that directors must take into account in the discharge of their duties. These include, the long term consequences of decisions, the environmental impact of corporate operations, and the interests of employees. This is a useful provision, in terms of adding clarity to the law, although it remains to be seen in the years to come exactly how it will be interpreted and enforced.

Section 173 demands that directors exercise ‘independent judgment’ and this is appropriate given the predilections of human nature and existing common law on the issue: Re Smith and Fawcett Ltd [1942]. Conflicts of interest are specifically forbidden by section 175 and this is an entirely apposite reflection of common law principle. It would have been nonsensical to depart from the tenor of rulings such as Aberdeen Railway Co. v Blaikie Bros (1854), Regal (Hastings) Ltd v Gulliver (1942) and CMS Dolphin Ltd v Simonet (2002). The fact that this provision merely restates common law precept in legislative form does not undermine the utility of the legislation, because as Crown Dilmun v Sutton (2004) illustrates legal clarity is always a useful attribute. The same conclusion can be drawn from section 176 which prohibits the exploitation of a fiduciary position for personal benefit in similar fashion to the common law: Boardman v Phipps [1967] and Industrial Development Consultants v Cooley (1972).

Section 177 requires company directors to declare any personal interest in a proposed transaction or arrangement. Similarly this provision merely reflects well established common law rules on declaration of an interest, however section 177 is manifestly more easily understandable and accessible than the subtle and nuanced cobweb of common law jurisprudence that was hitherto available: Cook v Deeks (1916), Bell v Lever Bros Ltd [1932], Scottish CWS v Meyer [1958] and Baker v Gibbons [1972].

Strengthening the rules on skill and care

Section 174 of the 2006 Act deals effectively with the thorny issue of the company director’s personal duty to discharge his responsibilities with skill and care. The venerable common law applicable to this question has been widely and vociferously criticised as lackadaisical and unduly generous to incompetent directors.

The main problem with the old law in this field is that it was reliant on a subjective measure or performance. In the case Re Brazilian Rubber Plantations and Estates Ltd (1911), three individuals were appointed as directors of a multinational undertaking. They behaved with extreme incompetence and caused the company to suffer prodigious losses. However Neville J refused hold any of the directors liable to the company for the consequences of their gross ineptitude. The court found that the individuals were inexperienced, unqualified and poorly skilled. Paraphrasing the reasoning of the court it was held that if a company decides to appoint idiots to directorial posts, it should not later be permitted to complain if those individuals behave and perform like idiots in discharging their responsibilities.

There is undoubtedly a certain simple beauty in Neville J’s ruling. It was formalised into a basic and baseline subjective test in Re City Equitable Fire Insurance Co Ltd (1925), where Romer J declared:

            “a director need not, in the performance of his duties, exhibit a greater degree of skill than may reasonably be expected from a person of his knowledge and            experience”.

However, this benchmark of competence proved far too lax and excessively forgiving as it was applied in cases throughout the twentieth century. In plain English, the subjective test for care and skill featherbedded generations of negligent directors. Towards the end of the twentieth century Lord Hoffman became the standard-bearer for reform in this field and in decisions including Norman v Theodore Goddard [1991], Bishopsgate Investment Management Limited v Maxwell (No 2) (1993) and Re D’Jan of London [1994] it was argued that the law should be stiffened by the use of a dual objective/subjective test. The test employed by Lord Hoffman was drawn from section 214(4) of the Insolvency Act 1986 and guaranteed a reasonable objective baseline of directorial competency.

The Law Commission concurred with this new jurisprudence and in Company Directors: Regulating Conflicts of Interests and Formulating Statement of Duties, a new objective/subjective test was proposed. Prior to the enactment of the 2006 statute courts were already applying such a test as illustrated by Re Landhurst Leasing plc [1999] and Base Metal Trading Ltd v Shamurin [2005]

Section 174 of the 2006 Act now provides as follows:

            “(1) A director of a company must exercise reasonable care, skill and diligence.
            (2) This means the care, skill and diligence that would be exercised by a reasonably diligent person with—
                        (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
                        (b) the general knowledge, skill and experience that the director has.”

This formulation accommodates both the traditional common law subjectivity (in s174(2)(b)) and a new objectively-defined requirement (in s174(2)(a)). This innovation seems quite trivial at first sight, but in fact it constitutes a major and entirely apposite advance in the legal regime. Under section 174 the performance of directors will henceforth be judged not merely by reference to their own competency, experience and qualifications (as was exclusively the case under Re City Equitable Fire Insurance), but also with regards to a minimum objective threshold of performance that should reasonably be expected of a notional individual discharging the same functions. This allows individual standards to be judged not only against their own standards (which may well be high in the case of highly experienced and well qualified director) but also against an objective measure of reasonable performance, below which behaviour will not be tolerated.

Long awaited, this reform is probably the single most important innovation of the 2006 Act, at least in terms of the law relating to directors’ duties. Its existence defeats, with one resounding blow, the assertion set out in the title to this work that codification was unnecessary.

Thus far this paper has examined the new statutory framework applicable to directors’ duties and considered what has been found to be a symbiotic relationship with existing case law. In the concluding section of this work arguments are summarised, the codification exercise is justified and the assertion contained in the title to this paper is refuted.

Concluding Commentary

The title to this work asserts that ‘the codification of directors' duties was an unnecessary step’. It is submitted that this assertion is simply and plainly incorrect. If all the other advantages of codification were set aside and ignored, the framework set in place by the 2006 Act would be amply justified by the sole innovation incorporated in section 174(2)(a). By itself, this stiffening of the traditional lax subjective standard with an objective baseline of competence, must be celebrated as directly addressing a frailty and anomaly, if not an obvious lacuna, that has long persisted in the law on directors’ duties.

The general law of negligence, which applies to all of us in all our actions everyday of our lives, imposes an objective threshold of performance: that of the reasonable man. It was utterly nonsensical and logically indefensible that a company director should be judged by that standard as he walked to work, but then judged by a potentially lower and laxer subjective standard once he took a seat in his office and started taking decisions involving millions of pounds of other peoples’ money and the livelihoods of thousands of employees. This wrong has now been righted by the 2006 Act. If the codification of director’s duties had contributed nothing else to the law in this field it would still have been worthwhile due to this long awaited innovation. It has however brought with it many other benefits.

These advantages include clarity and simplicity of exposition. Codification, was, after all, recommended by both the Law Commission and the Scottish Law Commission after lengthy deliberation and consideration in 1999 in Company Directors: Regulating Conflicts of Interests and Formulating Statement of Duties. The Commissions made it clear that their prime motivation for recommending codification was to render the rules on directors’ duties more accessible. There is no doubt that clarity and accessibility have been enhanced by the 2006 Act and that the new statutory provisions represent a considerable improvement in this regard on the complex and nuanced patchwork quilt of dozens of leading case law opinions and precedents on the issue. This is an important improvement. If directors can more clearly access and understand the parameters of their legal obligations and the shape and form of the law’s expectations as to the discharge of the duties it is likely that their performance will improve, to the benefit of all. At the very least, one commonly employed excuse raised in defence of poor performance has been rendered nugatory.

In addition to the above, and from a slightly different perspective, legal certainty has been increased by codification. The 2006 Act empowers and informs shareholders and other so-called ‘stakeholders’ in conformity with policies emanating from the European Union and in a manner that reflects twenty-first century principles of corporate governance theory, including, inter alia, the Combined Code on Corporate Governance. In codifying the law on directors’ duties the 2006 Act has both refocused, streamlined and sharpened the UK corporate governance regime. This has been achieved as a consequence of the cogent specification, definition and delineation of directors’ duties. There is no doubt that this constitutes an improvement on the previously existing status quo in this field of law.

In conclusion, the title to this work contains an assertion that is manifestly ill-founded. The Law Commission did not recommend codification without substantial justification, nor did the courts, led by Lord Hoffman, push for reform of the subjective duty of skill and care for no reason. Of course, the 2006 Act should not be viewed as a panacea or the ultimate and definitive statement on modern UK company law. The law will continue to evolve during its ongoing journey of amendment and reform. The 2006 Act does not represent a final destination for the law on directors’ duties on that journey. However, it does represent a step along that journey. For the reasons set out above, and in contradiction of the assertion made in the title, it is concluded that it was a necessary and valuable step. Inevitably the courts will still need to refer back to pre-2006 case law when judging cases. To do otherwise would be to fly in the face of hundreds of years of legal tradition and undermine the very operation, tone and tenor of the English legal system. It is simply ridiculous to suggest that codification could only be useful and necessary if it rendered vast tracts of existing case law and precedent obsolete. The fact that the old law is still respected as necessary and important in no way undermines the significance and utility of the recent reform. Indeed, recognition of the pre-2006 case law strengthens rather than weakens the new codified regime, because it preserves continuity and adds a depth and detail that legislation could never achieve. The assertion in the title is thus rejected.

BIBLIOGRAPHY

Case law as footnoted to standard citation

Armour J., Deakin S. and Konzelmann S. (2003) "Shareholder Primacy and the Trajectory of UK Corporate Governance", British Journal of Industrial Relations, Vol 41, 531-555

Companies Act 2006, Office of Public Sector Information Archive: http://www.opsi.gov.uk/ACTS/acts2006/ukpga_20060046_en.pdf.

Davies P., Gower and Davies: The Principles of Modern Company Law, (2008) Sweet & Maxwell

Dignam A. and Lowry J., Company Law, (2008) Oxford University Press

Financial Reporting Council, The Combined Code on Corporate Governance, June 2008

French D., Mayson S. and Ryan C., Mayson, French and Ryan on Company Law, (2009) Oxford University Press

Garner B. (ed), Blacks Law Dictionary (1999) West Publishing Company

Keay A., Enlightened shareholder value, the reform of the duties of company directors and the corporate objective, [2006] Lloyd's Maritime and Commercial Law Quarterly, 335.

Law Commission, Company Directors: Regulating Conflicts of Interests and Formulating Statement of Duties, Law Com No 261, Scot Law Com No 173, September 1999

Lele, P. and Siems, M. (2007) ‘Shareholder protection: a leximetric approach’ Journal of Corporate Law Studies, Vol. 7: pp17-50

Lord Wedderburn of Charlton, ‘Companies and employees: common law or social dimension?’ (1993) 109 LQR 220

Sealy L.S., Worthington S., Cases and Materials in Company Law, (2007) Oxford University Press

Worthington S., Reforming Directors' Duties, Modern Law Review 64, No. 3 (2001), pp. 439-458

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