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What the key differences between new legislation and existing common law principles are ?

Directors will have a statutory obligation to comply with duties under the new Companies Act

After eight years of review and debate, the new UK Companies Act finally received Royal Assent on 8 November 2006. One of the most significant changes effected by the new legislation is the consolidation into statute of certain directors' duties that previously existed at common law or in equity. For the first time, directors of all UK companies will have a statutory obligation to comply with the following duties:

  • Duty to act within their powers
  • Duty to promote the success of the company for the benefit of members
  • Duty to exercise independent judgement,without subordinating their powers as director to the will of others, for example, by following the instructions of others or delegating their powers (unless authorised by the articles of the company to do so)
  • Duty to exercise reasonable care, skill and diligence ' to be judged by both a subjective standard (taking into account the particular circumstance of the director) as well as an objective standard (which assumes all directors have a certain 'threshold of competence')
  • Duty to avoid conflicts of interest
  • Duty not to accept benefits from third parties, except where such acceptance could not reasonably be regarded as likely to give rise to a conflict of interest
  • Duty to declare any interest of the director in a proposed transaction or arrangement with the company.

Q: What are the key differences between new legislation and existing common law principles?
A: These statutory duties come into force on 1 October 2007, (except for the conflict of interest obligations, which will be implemented on 1 October 2008). The duties will be owed by both de facto directors and properly appointed directors, and will apply regardless of the size of the relevant company.

Most of the new statutory duties are similar to and codify existing common law duties of directors. However, the statutory duties incorporate different terminology from corresponding case law, resulting in a degree of uncertainty about how they will be interpreted by the courts and, in particular, whether the new wording will be considered to have changed the scope of the existing common law duties.

The new legislation also departs from existing common law principles in a number of important respects. The most controversial change is the incorporation into the duty to promote the success of the company of a requirement to take into account a list of 'corporate responsibility factors', which include certain social and environmental considerations.

This has caused particular concern in connection with the new statutory provisions regarding derivative actions that give shareholders broader rights to sue directors in the name of the company. The combination of these provisions has led to concern that the changes may expose directors to a greater risk of litigation by activist shareholders or pressure groups.

Q: What is the new duty to promote the success of the company?
A: Historically, directors have been required to comply with the common law duty to act in good faith in the best interests of their company, which includes the company's present and future shareholders, employees and, where the company is insolvent, also its creditors. The new provisions of the Companies Act require directors 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 the members as a whole.

While this appears similar to the existing common law duty, in assessing how to promote the success of the company, the new legislation departs from common law by requiring directors to have regard to a set of statutory criteria which embody the concept of 'enlightened shareholder value', and includes social and environmental considerations.

The government's aim in introducing this requirement is to promote the principle of corporate and social responsibility and to modify the narrow view that companies exist simply to maximise shareholder value with a recognition that it is in a company's long-term interests to take account of wider social and environmental concerns.

The list of factors that directors are required to have regard to now includes (among other factors):

  • The likely consequences of any decision in the long term
  • The interests of the company's employees
  • The need to foster the company's business relationships with suppliers, customers and others
  • The impact of the company's operation on the community and the environment
  • The desirability of the company maintaining a reputation for high standards of business conduct
  • The need to act fairly as between the members of the company.

In the Explanatory Notes published with a late draft of the Bill, the government stressed that the obligation 'to have regard to' these statutory factors could not be discharged merely by paying 'lip service' to them. Directors are expected to do all that they reasonably can to take the statutory factors into account, and the more significant a decision, the more important it will be to have a paper trail showing that the board actively considered the listed factors.

Cause for concern
Concerns have been raised about the consequent risk of increased administrative burden for directors, including greater bureaucracy at board level, and greater levels of documentation which directors may feel they need to prepare in order to show they have adequately considered the statutory factors.Concerns have also been raised that not all of the statutory factors will be relevant to each decision that needs to be made and that the new legislation does notinclude a range of additional factors that directors have been required to take into consideration at common law.

It is not clear how much weight directors are required to give to these different types of considerations, and how any conflicts that may arise between the different factors should be resolved. There is also concern that the introduction of a statutory list of factors may mean that directors are less likely to look at the overall situation and consider factors that are not included within the legislation, with the unintended consequence that the statutory list may lead to inappropriate decisions being made in some circumstances.There is also concern that directors may be subject to increased risk of litigation in connection with claims that they failed to take proper account of the statutory factors, particularly when considered in connection with the changes that have been made to the law on derivative actions.

Q: What impact will statutory derivative action have on companies?
A: Since directors owe their duties to the company rather than shareholders, it is generally only the company that can sue directors for breach of their duties. However, for a company to bring such an action, the directors would have to decide to pursue the claim. The rule is therefore open to abuse if directors decide not to pursue one another.

Consequently, the courts have developed exceptions to the rule over the years allowing shareholders to bring such actions in the company's name in certain circumstances. However, these exceptions have historically been limited in scope to situations such as 'fraud on the minority' where wrongdoers control the company and knowingly benefit at the expense of the minority; where the company has committed an illegal act or act outside its powers that cannot be ratified; where an act of the company required a special or extraordinary resolution but the resolution was not passed; where there is an infringement of a shareholder's personal rights; or where minority shareholders bring an action for 'unfair prejudice'.

The new Companies Act introduces a statutory version of derivative action to replace the existing common law rules, that is much broader in scope. The Act now states that such claims may be brought in respect of any 'cause of action arising from an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director of the company'.

There is no longer a requirement to show that the directors in question benefited personally from their breach or that those directors controlled the company. All that is needed is for the claim to be brought by a member (which could be the holder of just one share in the company), that the cause of action vests in the company and that the claim is made on behalf of the company.

Given the wider circumstances in which shareholders can bring derivative claims, and the new statutory requirement that directors take into account certain social and environmental considerations in fulfilling their duty to promote the success of the company, there is concern that the new Companies Act could expose directors to a greater risk of litigation, particularly from activist shareholders and pressure groups.

Q: How can directors reduce the risk of liability for infringing the new legislation?
A: In order to reduce the risk of liability for infringing the new legislative provisions directors will need to:

  • Ensure they are fully aware of the scope of their duties under the Act, including obtaining training if required
  • Adopt a consistent approach to recording decisions in minutes and determining the level of documentation needed to evidence the board's consideration of the corporate responsibility factors in connection with the duty to promote the success of the company
  • Establish internal risk management policies and review D&O insurance policies (both in scope and level of cover) to help manage risks associated with increased exposure to litigation.

3rd May 2007

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