Directors Liability

13 December 2006

Directors of companies manage a company and the shareholders own it. This separation partly explains the public policy reasons for many of the duties imposed on directors and also explains why some rules seem strange to owner-managers of private companies where they are, in effect, being protected from themselves.

Background

Shareholders are generally protected by the principle of limited liability where the liability of owners of shares in a company is limited to the paid-up value of the shares.

The Industrial Revolution was founded upon partnerships and family firms but by the mid nineteenth century it was felt that such models did not handle succession and investment at all well and a number of Acts of Parliament introduced the concept of the limited liability joint-stock company

Limited Liability

A theme of ‘rouge trader’ stories and features in the media is often that owners of companies can allegedly fleece the public, losing only what they put in to the venture, and set up another company to carry on the dubious work. The public perception of this kind of activity is not too dissimilar from the preamble to the Statute of Westminster of 1285 which complained where “diverse and sundry persons, craftily obtaining into their own hands great substance of other men’s goods, do suddenly flee to parts unknown, or keep their houses, not minding to pay or restore to any of their creditors their debts and duties…”

The introduction of limited liability was controversial and at the time commentators such as the free market economist Adam Smith decried the innovation as an unwanted subsidy, believing that entrepreneurs should stand or fall by their business acumen. The contrary argument was a pragmatic one, that the founding firms of the Industrial Revolution were falling apart due to the lack of investment and the almost inevitable second and third generation family disputes. It was further argued that people would not invest in businesses and risk losing all of their possessions should the venture not succeed.

Limited liability protects shareholders to the extent that they remain shareholders. If they play a role in management then there is a risk that they will be considered by a court to be de facto directors and will be treated the same as formally appointed directors.  As a general matter of public policy, liability follows culpability and those who err in certain circumstances must pay, notwithstanding the ‘corporate veil’ of limited liability.

The Duties

Directors are responsible for the management of a company yet remain merely agents of the company in law, so certain duties have arisen in case law and have also been imposed by statute in order to regulate their actions.

The basic position derived from case law is that directors have a fiduciary duty to act honestly and in good faith in the best interests of the company. At a very basic level, directors must take proper care of the assets of the company and must not allow their personal interests to conflict with those of the company.  Directors will not generally be penalised for being bad at their job in the sense of making poor commercial decisions.

Statutory duties derive largely from the Companies Act 1985 and the Insolvency Act 1986 which are mostly concerned with shareholder and creditor protection but these two Acts also form part a myriad of legislation and regulation covering environmental and health and safety responsibilities, to competition law and securities regulation. The list continues to grow and in March 2005 the Home Office published a consultation paper on a Corporate Manslaughter Bill.

Extent of the duty

This depends entirely upon the nature of the duty and a detailed consideration is far beyond the scope of this note but, very briefly, statutory duties can impose criminal liability and sanctions including imprisonment. Civil sanctions, which can arise by way of breach of statute or common law fiduciary duties can result in personal liability for errant directors.

Duty to whom?

One answer could be the individual shareholders of the company but this is not strictly true, the general duty is to the ‘company’ as a whole and legislation has extended this to other ‘stakeholders’ such as employees, and to creditors where the company is in financial difficulties.

Can the Company assist?

A Company could not until recently exempt directors from, or indemnify them against, liability where they are negligent, in default, or in breach of duty but companies can buy liability insurance for directors and reimburse directors legal costs if (and only if) they successfully defend legal proceedings against them in relation to their office.

The terms of particular policies vary and should be carefully checked but it is common for cover to extend to damages awarded against an insured person, as well as out of court settlements and costs of proceedings. Cover is often also provided for “wrongful acts” done in the capacity of director but again the definitions should be carefully checked.  Defence of criminal and regulatory proceedings is often excluded but cover is not unknown.

Recent developments

New provisions contained in the Companies (Audit, Investigations and Community Enterprise) Act 2004 which took effect from 6th April 2005 mean that companies are able to pay director’s costs of proceedings as they are incurred subject to an obligation to repay in the event that the proceedings are unsuccessful.

The position remains that a company cannot assist (by way or exemption or indemnity) where the director has been negligent, in default or in breach of trust in relation to the company.  In addition the company cannot indemnify the directory against loss where he has been fined in criminal proceedings or is subject to a penalty from a regulatory authority.

The key point here is that this will be the case only when the matter has been decided by the court, hence the ability for the company to pay costs incurred until such time, provided that these costs are reimbursed by the director if he or she is unsuccessful in those proceedings.
 

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