Directors' Duties and Claims by Shareholders

by John Noctor

One of the biggest changes effected by the Companies Act 2006, is the introduction of a statutory statement of directors’ duties.  The Government has just announced that these provisions will come into force on 1 October 2007, which is somewhat earlier than anticipated. The purpose of this article is to outline some of the more important changes which directors need to bear in mind, when making business decisions, and how the changes might impact on claims by shareholders against directors.

Directors’ Duties

The Act contains a list of duties owed by a director to his company including a duty to “promote the success of the company for the benefit of the members as a whole.”  The duty to “promote the success of the company” is new and somewhat controversial.  When exercising this particular duty, a director must have regard to a number of factors, including the following:

* The likely long term consequences of any decision.
* 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 operations 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.

The matters listed above impose an obligation on a director to consider a company’s long term sustainable growth.  To date, actions against directors have usually centred on short term decisions or deals.   The emphasis on wide ranging considerations may pave the way for a new sort of claim to be launched against directors, for example, where a decision produces a short term profit, but leads to a company acquiring a poor reputation in the market place, which eventually leads to a long term loss.

The Government has voiced the opinion that it is up to directors to decide what will “promote the success” of a company and what constitutes success.  Thus, decisions on strategy and tactics are for the directors, not the courts, provided the directors are acting in good faith.  This is all well and good, but if directors have to take into account a broader spectrum of values when making decisions, there may be conflicts between the immediate requirements of a business, and the long term impact of the actions taken to address those requirements.   That conflict could provide fertile ground for disputes and claims.

The Government has conceded that the new obligation to promote the success of a company is a “radical” change to the existing law.   Ultimately, the extent of that change will have to be measured by the courts.  That could result in the courts passing judgment on the wisdom of decisions which are normally reserved to management, notwithstanding the Government’s professed desire to leave strategy and tactics to the directors.

This is not a prospect that will be welcomed by the courts or by businessmen, and it remains to be seen how this area of the law will develop.

Actions by Shareholders

In principle, a director owes his duties to the company, not to the shareholders of the company.   However, in certain circumstances a shareholder can bring a claim on behalf of the company.   Claims of this nature are known as derivative actions.

In reality, the circumstances in which a shareholder can bring a derivative action are limited.  Normally, those circumstances are confined to situations where there would be a fraud upon minority shareholders, if the company remained in the control of the wrongdoers.  Such actions have a reputation for both expense and complexity, and are rarely seen in practice.

The Act provides shareholders with a new right to bring a claim against directors.   There is no longer any requirement to show a fraud on the minority.  Instead, it is only necessary to show negligence or some other breach of duty on the part of the director.

At first glance, this seems to give shareholders a new raft of rights, and this has caused some disquiet amongst directors.   However, on closer examination, the rights of the shareholders are not as extensive as they first appear, and the prospect of claims by shareholders are quite limited. If a shareholder wishes to bring a claim, he will have to clear a number of preliminary hurdles, as follows:

* In order to bring a claim on behalf of the company, the shareholder must first obtain the permission of the court.
* The court must refuse permission if it decides that the claim is not in the interests of the company (i.e. if it is primarily for the benefit of the shareholder).
* Likewise, the court must also refuse permission if the act or omission complained of has been authorised or ratified by the shareholders of the company.

Even if a shareholder can overcome these preliminary hurdles, and avoid automatic refusal, the court must then consider a list of factors before granting or refusing permission to proceed.   When considering those factors, the court has to pay “particular regard to the views of shareholders of the company who have no personal interest in the matter”.   Thus, the court has to look at the matter from the perspective of all the shareholders, not just the shareholder who is bringing the complaint.

In practice, a minority shareholder will be prevented from bringing a claim against a director, in circumstances where the majority of the shareholders have approved the act or omission complained of.  This is understandable, since it maintains the principle of “majority rule”.  Therefore, a minority shareholder cannot bring a claim on behalf of the company against the wishes of the body of shareholders.

It should also be remembered that litigation of this nature will not be cheap, and that in itself will discourage the pursuit of litigation, particularly if the loser has to pay all the costs.   Even if a shareholder wins, any damages have to be paid to the company not the shareholder.   If a shareholder asks “what is in it for me?” the answer may be “not a lot”.

Thus, although the scope of the new form of derivative action remains to be established, it is certainly not a licence for shareholders to sue directors, and it may even turn out to be something of a damp squib.

Looking Forward

The Government is set to publish some further guidelines, showing how directors can comply with the new duties, and this may assist in interpreting the scope of those duties.   In the meantime, directors need to be mindful of their new obligations, and should be taking the following practical steps, which are simply good practice, and ought to be followed regardless of any new obligations:

* To keep proper minutes of meetings, and the reasons why decisions are taken.
* To review the scope of any directors and officers’ insurance cover, to see whether it extends to liabilities arising from derivative actions.

The onus is increasingly on good practice and high standards of corporate governance.   Directors need to be aware of their new responsibilities and to act accordingly.   Hopefully, by observing those responsibilities, the prospect of a costly and distracting claim will be reduced if not entirely diminished.

John Noctor is a Partner and Head of Corporate Law at Burnetts Solicitors, Carlisle, Cumbria.

For more information on directors’ duties or claims by shareholders, contact Burnetts’ Corporate Law team on 01228 552222 or visit the Corporate Law pages.

May 2007