Road Legal

UK law has never placed any substantial obstacles in the way of persons wanting to become directors of limited companies. There has never been any test of pre-appointment competence and the standards of conduct expected from directors under the law have traditionally been modest at best.

In recent years the courts have gradually adopted a harder line in dealing with cases of misconduct and negligence on the part of company directors. This gradual toughening-up has proceeded hand-in–hand  with increased expectations on the part of shareholders and society generally and numerous scandals which have seen creditors lose huge amounts of money. This harder line adopted by the courts has in some cases led directly to piecemeal changes in legislation. As from October 2007, new rules come into effect which should leave company directors of all backgrounds in no doubt at all that the law will expect more from them in the future than ever it did in the past.

The changes to the law on directors’ duties form one of the central pillars of the Companies Act 2006, the biggest shake-up of companies legislation in 40 years and, at 1,300 sections, the biggest single statute in the history of UK law.

Codifying principles

One of the most striking things that the new Act does is, for the first time, to ‘codify’, or set out in legislation, the main principles of the law on directors' duties.  Up until now, the law in this area has been virtually the sole preserve of the courts, and anybody who wanted to understand this area of the law has had to familiarise themselves with the accumulated case law principles. Thus, the law on directors’ duties has tended to remain the domain of specialists in the field. Now though, these principles are set out, in intentionally accessible language, in the Companies Act. It is hoped that doing it this way will enable more non-experts to understand the law and, consequently, to help reduce companies’ professional costs.

Apart from this presentational aspect, there are two crucial elements of the rules which need to be understood by all directors.

The first of these concerns the pivotal provision in section 172 of the Act which says that directors "must act in the way they consider, in good faith, to be most likely to promote the success of their company for the benefit of its members as a whole": in doing so, they must "have regard" to a number of specified factors, which include the likely consequences of any decision in the long term, the need to foster the company’s relationships with suppliers, customers and others, and the impact of the company’s operations on the community and the environment.

What this means is that consideration of these specified factors is an integral element of compliance with the requirement to make decisions which promote the success of the company. So in carrying out their functions, directors must routinely take into account the possible implications of these various factors for the success of their company.

While this measure may sound intimidating to some directors, the Act underlines the long-standing position that directors owe their duties to the company and not to individual shareholders or any outside party. So there is no question that directors should feel pressurised to satisfy the demands of any individual member or third party.

Skill and care

The second crucial element of the new statutory code of duties is that the law now provides expressly for the standard of skill and care that directors are expected to satisfy in carrying out their functions. They will be judged by reference to a ‘subjective’ test and an ‘objective test’. Of these, the subjective test is the long-established test in company law which holds that a director is expected to bring to his or her company whatever skills and experience he or she happens to have as an individual.

The second test, the objective test, is the one that strengthens the law as regards skill and care. It says that the conduct of all directors should be judged against a benchmark of what is reasonable bearing in mind the functions that they are actually carrying out. So irrespective of a person’s background, qualifications or experience, a director’s conduct will in future be judged against an objective benchmark. This benchmark will vary according to the sort of functions carried out – there will doubtless be different benchmarks for sole directors of small companies, for finance directors of listed companies and for non-executive directors.

Compliance with the various elements of the new statutory code of duties will not only be relevant when a director is charged with breach of a statutory responsibility, for example, failing to prepare his company’s accounts in good time. Its other significance is related to another important reform being introduced by the Act, which is a new power for a company’s shareholders to instigate legal proceedings – in the name of the company – against one or more of the directors for breach of their duties. This reform expands materially the range of circumstances in which shareholders can cause their company to take legal action against another party. It means that shareholders, or even one of them, can try to enforce directors’ duties via the courts.

Two other significant reforms are worthy of mention. First, for the first time ever, there is to be a minimum age for service as a director. This minimum age will be 16. Second, while it will still be possible to appoint so-called ‘corporate directors’, it will in future only be possible to appoint a company as a director of another limited company if there is another director who is a human being.

Both these reforms should be seen in the wider context of trying to raise standards of director conduct. They both come into effect in October 2008, so as to give companies plenty of time to make necessary adjustments to their affairs.

John Davies is Head of Business Law at the ACCA.