The code of directors' duties

Out-Law Guide | 04 Jul 2007 | 9:57 am | 10 min. read

This guide is based on UK law as at 1st April 2007, unless otherwise stated. Before the Companies Act 2006, the law on directors’ duties was in places uncertain, contradictory and anachronistic.

It was ripe for reform, and the code of directors’ duties, contained in the Act, was the government’s response. This streamlined and clarified the old rules but was more than a consolidation or simplification of what had gone before. There were some subtle changes to the rules, and Parliament introduced a new concept: ‘enlightened shareholder value’.

The old formula was clear that a director’s primary duties were to the company and its shareholders. There was an ineffectual reference to employees, and creditors always took precedence on insolvency, but the law was settled that a director should act in the best interests of all shareholders, and that included future shareholders. With the Companies Act 2006, directors were required to consider other concerns that may affect a company’s success. The focus for directors shifted from looking solely at shareholders’ interests: enlightened shareholder value means taking account of other stakeholders as well.

The code of directors’ duties applies to all companies, public and private, holding and subsidiary (and is not to be confused with the UK Corporate Governance Code, which applies only to listed companies – see: our Corporate Governance page.) It needs to be understood by all directors and by the level of management who report to and work with the board. There are seven duties in all.

1. Duty to act within your powers

Directors have the job of managing the company and they are given certain powers to enable them to do that. But they must act according to the company’s constitution and use those powers in the interests of the company, not to further their own narrow interests. So, for example, their power to issue new shares must be used for the purpose of raising capital for the business. Issuing shares to your cronies just to keep voting control in friendly hands is an abuse of power and a breach of duty.

2. Duty to promote the success of the company

The 2006 Act subtly re-cast the old law, which imposed a duty to act in good faith in the best interests of the company as a whole. Now, a director of a company must act in the way they consider, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole.

Lawyers in 2006 might have worried about how you define ‘success’, but the reality was that there was no practical difference between this wording and the old duty to act in the ‘best interests’ of the company. The change lay, instead, in the addition of the principle of ‘enlightened shareholder value’ and the idea that the interests of other stakeholders, not just those of shareholders, need to be considered.

To fulfil their duty to promote the success of the company, the legislation requires directors, in reaching their decisions, to have regard to six factors that demonstrate what the government has called ‘responsible business behaviour’. These six factors are described in Directors' duties: Six factors that boards cannot ignore, an OUT-LAW guide.

Note the wording here: ‘have regard to’ is key. There is no requirement that any one factor is given precedence over another, that employees must be favoured over the environment, for example, or the community over customers. The final decision might discount all six factors – but the board needs to be able to demonstrate that, where relevant, it has at least considered them and taken them into account.

The success of the company remains the paramount concern for directors. The legislation prompts the board to think about these different factors, but they must remain subsidiary to the over-arching requirement the directors have to act in the way they believe, in good faith, is most likely to promote the company’s success. (Where a company is set up for other purposes than to benefit its shareholders – where it’s a charity, for example – you can substitute that other purpose.)

The requirement to take these six factors into account where they have a bearing on the matter under consideration has implications for decision taking and record keeping, and these are examined briefly in Directors' duties: Decision taking and record keeping, an OUT-LAW guide. Most companies, in any event, will consider these factors, or something like them, as a matter of good practice. The duty merely gives statutory force to something that responsible boards of directors will be doing anyway. (See: Directors' duties: Case studies on the duty to promote the success of a company, an OUT-LAW guide.)

3. Duty to exercise independent judgment

A director is on the board to act in the best interests of the company as a whole, not to represent the interests of just one shareholder or even a group of like minded investors. That rule applies irrespective of the circumstances in which the director has been appointed.

In a company set up as a joint venture between two businesses, each shareholder will commonly have the right to appoint an equal number of directors. Similarly, a private equity investor will commonly put a director on the board to safeguard its investment. But in each case those directors risk trouble if they are seen to act only in the narrow interests of the shareholder who appointed them. Their duty is to the company as a whole and to all the shareholders in the company. A director must not be a “plant” or a partisan.

Nor can directors ‘fetter their discretion’, which means they can’t give away their decision-making role. Of course, they can sign agreements that commit the company to a particular course of action, and they can do anything that the articles authorise them to do, but as a general rule they can’t delegate their powers without the ability to take them back or to change their mind.

4. Duty to exercise reasonable care, skill and diligence

The law requires a director to use reasonable care, skill and diligence in carrying out their tasks.

What does this mean in terms of brainpower, time commitment, the attention you give the job? No directorship is a sinecure or an honorary position; it’s a ‘proper’ job, requiring a reasonable input, even from an unpaid non-executive.

The Act sets out a double test. First, there is an objective standard: a board member must have the knowledge, skill and experience that would reasonably be expected of anyone doing that job. Second, a subjective standard must also be met: a director has to perform according to the knowledge, skill and experience they actually have.

So there is a basic level of competence that will be expected from all board members; but there is also a higher standard expected of those with some special skill or experience. A qualified accountant doing the job of finance director, for example, will be judged against the standard of a fellow professional with a detailed understanding of the company’s finances. Any director with particular knowledge or experience will be expected to use those attributes for the company’s benefit and, to that extent, will be judged by a higher standard.

A non-executive director may not have day-to-day knowledge of the company’s business and will not see all of the information available to management, but they will have a broader experience and will be expected to use that to probe and challenge their executive colleagues. Just like them, they will also be expected to bring relevant professional skills and qualifications to bear. That is why a board’s audit committee is expected to have at least one member with relevant financial experience.

The next three duties relate to conflicts of interest.

Directors’ obligations to the company must not clash with other interests they may have, or with obligations they owe to others. Transparency in their dealings and relationships is vital. These are the principles behind the statutory duties described in this section.

As with the other directors’ duties, the Companies Act 2006 codified the old law on conflicts of interest, replacing some of the (at times) confusing judge-made law with new rules set down in statute.

5. Avoiding a ‘situational’ conflict

A director must avoid a situation in which he or she: "has, or can have, a direct or indirect interest that conflicts, or possibly may conflict, with the interests of the company."

This is very broad drafting, covering both actual and potential conflicts and direct and indirect interests. It applies both to a conflict of interest and a conflict of duty, so it may catch:

  • having an interest in a commercial opportunity that could also be exploited by the company – if you are a director of a property development company, for example, working on similar projects for your own benefit can give rise to a conflict;
  • a director’s use for their own purpose of information belonging to the company;
  • a director who sits on two boards where the duties to each may conflict – even a parent and its subsidiary company can have different interests, and the parties to a joint venture may not have the same interests as their joint venture vehicle.

It is these ‘situations’ that can amount to a breach of duty, not any specific transaction that may arise from them (but see below for ‘transactional’ conflicts).

At first sight, these rules seem to threaten paralysis on the board. How can directors avoid such conflicts without decision-making grinding to a halt?

Fortunately, there is some relief. There is no breach of duty:

  • if the situation cannot ‘reasonably be regarded as likely to give rise to a conflict’ – if the director’s potential interest is so indirect or remote that no reasonable person would see a problem, it can be ignored; or
  • it has been authorised by the rest of the board. (Note that the interested director cannot vote or be counted in the quorum when deciding whether to authorise or not.)

The articles need to be checked on this latter point. Only the board of a private company incorporated on or after 1 October 2008 is able to authorise a director’s conflict without its articles making special provision to that effect. Private companies formed before that date, and all plcs, need to have specific powers in their articles to do so.

The board’s authorisation will apply indefinitely but if the nature of the interest changes, a new authorisation will be needed.

If neither get-out is available, the director must avoid the conflict, which may mean giving up the ‘other’ interest or, alternatively, stepping down from the board.

6. Disclosing a ‘transactional’ conflict

If the basic principle is that a company and a director should not have conflicting interests, it must follow that there should be restrictions on them entering into a contract with each other.

When a company is entering into a contract (or any other transaction or arrangement), a director must disclose any interest they have in the contract, whether direct or indirect, before the contract is signed. The disclosure must be full and frank so that, before the board approves the contract, it is aware of the nature and extent of the director’s interest.

Again, the company’s articles need to be checked. They may stipulate that the interested director cannot vote on the matter, or even that shareholder approval is required.

A director can declare an interest in a proposed contract orally at a board meeting, or in a written statement, sent to each director (in hard or soft copy form) before the meeting. Where there is a continuing interest, perhaps as a shareholder or director of a regular supplier or customer, the director can give a general notice saying that they are to be regarded as having an interest in any transaction or arrangement entered into with that other company. If, once made, the declaration becomes inaccurate, it must be updated.

No declaration is needed where:

  • the director was not aware of their own interest (and that lack of awareness was reasonable);
  • the director was not aware of the transaction or arrangement with the company (and that lack of awareness was reasonable);
  • the interest cannot reasonably be regarded as giving rise to a conflict;
  • the rest of the board is already aware of the director’s interest (or ought to be aware of it);
  • the interest arises from the director’s service contract – a contract that has either already been considered by the board or a board committee or is due to go before them.

Those are the rules for contracts under discussion. What about contracts that already exist? What if a contract, arrangement or transaction has already been concluded but a director later becomes aware that they have an interest in it? Supposing a director new to the board discovers they have an interest in one (or more) of the company’s contracts? In these circumstances, a declaration must be made ‘as soon as reasonably practicable’. The requirements for the declaration will be similar, and the same exemptions will apply.

Note that, unlike the other duties described here, failure to declare an interest in an existing contract is a criminal offence, punishable by a fine.

Where the contract between the company and a director involves an asset above a certain value, shareholder approval will be needed. (See: Directors and 'substantial' transactions, an OUT-LAW guide.)

7. Accepting benefits from third parties

Taking a bribe from a supplier is clearly wrong. But what about accepting an invitation to Wimbledon or Ascot? Where do you draw the line between fostering good relations with contractors and feathering your own nest or compromising your own integrity?

The Companies Act says that a director must not accept a benefit from a third party that was offered because of the director’s position or because of anything they may do or not do as a director.

If a large contract is up for tender, the director who will make the decision should not accept hospitality or a gift from one of the potential bidders. There is no need to show that the company has suffered harm: it is the director’s acceptance of the benefit and the reason it was offered that are key.

A director is free to accept the benefit if no reasonable person would see it as giving rise to a conflict, but that may not always be an easy call to make. Having a company policy on the acceptance of gifts and hospitality will help set an appropriate standard.

See also: OUT-LAW's stories and guides on the Bribery Act