Duty bound

Posted on 18 Aug 2008 by The Manufacturer

The staggered implementation of the Companies Act 2006 is due to reach its conclusion in October this year. Alan Wood examines just how radical the legislators have been and what the new law means for manufacturing company directors

The directors of British manufacturing companies are used to having to deal with new legislation. However, by October this year – 10 years after the reform process was begun – we will have in force a fully codified set of directors’ duties. After more than a century of judge-made law on what a director can and cannot do, Parliament has set down in black and white a new code for all to follow.

On first look it appears that, after 10 years of waiting, the changes will be far reaching, not least because the Companies Act 2006 introduces seven duties which apply to all directors, from those in the boardrooms of FTSE 100 companies to the husband and wife team running a business from home. Everyone is covered, whether they are parent company directors or sit on a subsidiary board. However, when you look a little deeper, you see that not all of this is new law.

A principle example of this, and an area of focus for corporate lawyers, has been the new duty to promote the success of the company. However, on closer scrutiny, it becomes clear that although the wording may be new, there is little difference here from the old duty for a director to act in the best interests of his company, taking into account all shareholders both present and future. The truly new aspect is the need for the board to consider what the Government has dubbed ‘enlightened shareholder value’, or rather the need for directors to look beyond the narrow interests of shareholders and to consider wider stakeholder concerns.

So, when deciding what will promote their company’s success, directors are given six headings to consider, though it is clear the list is not meant to be exclusive:

• likely long-term consequences
• interests of employees
• relationships with suppliers, customers and others
• impact on the community and the environment
• high standards of business conduct
• the need to act fairly between shareholders

Does that mean directors must sit with this checklist in front of them at every board meeting? Can decisions only be made once you have ticked off each heading? When appointing a new finance director, do you need to consider his environmental impact? One hopes not. Common sense should prevail and these factors will only come into play where they have some relevance to the decision to be made.

But what if they conflict? The correct longterm decision may be to close a manufacturing facility, but it is easy to imagine how that may not be in the interests of the employees or the community. The answer is that there is no hierarchy and all these factors (where relevant) are meant to go into the mix which ultimately produces the best decision to promote the company’s success. What this means in practice is that directors must ‘have regard’ to these things, to think about them, but always in the knowledge that the overriding obligation is to arrive at the right decision for the company’s success. If that means closing the manufacturing facility or choosing the shortterm fix, rather than the long-term view, then so be it.

So companies and their boards are being asked to take the broader view, to see their company’s success in the light of these longer term considerations, not just the year end bottom line. Does this mean government is interfering with the market economy, artificially skewing the decision making process towards today’s fashionable concerns? While only time will truly answer this, for now government will say no. Directors are simply being asked to follow what the best companies have been doing for many years: favouring long-term strategic solutions over short-term fixes.

But what is the risk with this new regime? What is the sanction a director faces if he is found to be in breach of his duties? The first point to realise is that the directors owe their duties to the company, not to individual shareholders. It is only the company that can complain of a breach, and a complaint is only likely to be pursued if the company can show a loss as a consequence. Employees, trade unions and pressure groups have no ability to go after a director for a breach, and even shareholders (and there remain suggestions that trade unions and other aggrieved stakeholders will purchase shares so as to be able to become activist shareholders) can only complain when they convince a court the company is acting improperly in not pursuing a claim.

Nonetheless, it would be an unwise board member who ignores this or any other duty. It may be his fellow directors who will decide whether it really benefits the company to launch a claim against him, but boards and their priorities change. The hapless Equitable Life board members who were sued for millions were targeted by a new board brought in to find someone to blame for their company’s huge losses. And if current press speculation proves to be true, then the former Northern Rock board members may soon find themselves in a similar position.

If these examples seem too extreme, then consider also that companies get sold, with new owners putting their own nominees on the board who may look again at questionable decisions from the past. No director can rely on his friends still being around to protect him from a claim for a previous breach of duty.

So if the threat of a claim is a real one, how can a director protect himself from liability? In some cases, proper minutes which record the board’s reasoning for a particular decision and its consideration of any relevant factors will be enough; in others, a board paper may rehearse the arguments and show a proper evaluation of the pros and cons. But avoid formulaic minutes which recite the Companies Act six factors without proper consideration – a judge is unlikely to be convinced that proper thought was given to a matter when all he can see is a tick box approach from a standard set of minutes.

Promoting their company’s success is not the only duty placed on board members by the new code of directors’ duties. They must act within their powers and use them properly for their intended purpose. For example, directors have a general power to issue shares to raise capital; they can’t abuse that power and issue shares to ensure voting control stays in friendly hands (for example, to fend off a hostile take-over).

And directors have a duty to exercise independent judgement. That means a director cannot excuse a bad decision by claiming he only did what a shareholder told him. Put simply, a director owes shareholders his best decision, not blind obedience to their will. This issue is most likely to become a dilemma in relation to joint venture and subsidiary companies. In relation to the former, each 50:50 shareholder may appoint a director in the full expectation that its appointee will vote to protect its own interests. But the law says that directors are in post to protect the interests of all shareholders, not just the person who put them on the board. Similar issues will arise for subsidiary boards who cannot blindly hide behind the argument that they were exercising a group strategy. This conflict between the law on the one hand, and commercial reality on the other, again shows the need for careful thought when board minutes record key decisions.

How good do directors have to be? A seat on the board is one of the few jobs these days which still does not require a formal qualification. But all directors have a duty to exercise reasonable care, skill and diligence as they go about their duties. This duty combines objective and subjective tests, since it means that directors must perform to the standard which might reasonably be expected of a director in the same role at the same type of company; but in addition, directors must perform to their own individual strengths. So a chartered accountant will be expected to have general accounting skills above and beyond those of the average company director.

All these duties have been codified into law since October 2007. The final piece of the jigsaw slots into place this October, when three duties focusing on directors and conflicts of interest come into force. First, there is a general duty for a director to avoid a conflict of interest, whether an actual or potential conflict, direct or indirect. But any harm can be cured by the board authorising the conflict, though the directors must convince themselves it is in the company’s interests to give that authority.

Second, where a board is considering an issue in which a board member has an interest, he must formally declare that interest to his colleagues. Subject to anything else the company’s Articles may say, once the interest is declared and the board is happy, there is nothing to stop the matter going through.

And finally, there is a bar on a director accepting any benefit from an outsider offered to him because of his role as a director. This won’t apply if no real conflict of interest is likely to arise, but where a conflict exists, it cannot be waived through by the rest of the board. Here again, while there may be some very clear cut examples: perhaps accepting a supplier’s offer of an all-expenses-paid trip to the Beijing Olympics shortly before a large tender is decided, the picture will be much less clear in the case of more modest types of corporate hospitality, which for so long have oiled the wheels of commerce.

Alan Wood is corporate partner at law firm Pinsent Masons.