Business and Corporate Law: Directors’ Duty of Care

Introduction

Directors’ duties under English Courts are based on the company’s principle that a company is a separate legal entity from its members. With such a foundation, the directors act under the fiduciary duty. Their duties establish a fiduciary relationship between them and the members of the company. In recent years, courts have extended that duty to cover creditors and other persons who have a direct or indirect interest in the well-being of the company. Such parties include creditors and employees. Other duties are founded under the fiduciary relationship established between the company’s directors and its shareholders. In the case of Salomon v Salomon, it was held that a company is a separate legal entity, which is also known as corporate legal personality. A director of a company is, thus, a mere agent but not an employee. It, therefore, implies that the company is a legal entity that can be sued, as well as sue. The holding in Salomon v Salomon¹ clearly indicated that a company has perpetual succession, thus it can exist even upon the demise of its members. It is upon the foregoing proposition that the duties of the directors are created.² This essay will critically discuss the director’s duty of care and skill and whether it has been applied far too leniently by the English Courts to the extent that directors are not sufficiently accountable for their bad business decisions.

In offering an elaborate discussion on the directors’ duty of care and skill, it is imperative to note that the said duty is pegged on other main duties of directors. It, therefore, follows that other duties may also be put in jeopardy if a director breaches his duty of care. The appointment of a director is on the basis that he or she is a competent person who is capable of making a judgement based on care and skill. It is to be understood that the director may be held negligent for his acts upon breach since the director has a duty of care to the company. The exercise of reason, skill and care in executing directors’ functions has been provided for under the statute. The Companies Act of 2006 has clearly laid out such duties. Section 174(1) of the Companies Act (2006) provides that companies’ directors should act in due diligence, while at the same time exercising care and skill in a reasonable manner.³ The test of reasonable care and skill is provided under subsection 2. The section states that care and skill that would be exercised by a diligent person under similar circumstances should be exercised. The standard has been classified as the objective standard test. It has been observed that there are various flexibilities exercised upon application of the duty to exercise due care and diligence as provided for under the statute⁴.

Application of the duty of care and skill in case law

Reference is made on the nature of the decision reached in identifying whether the acts of the director were within the reasonable duty of care and skill. This assessment is only arrived at upon making reference to the duty assigned to the director. On the other hand, the kind of business that the company transacts, the memorandum and articles of association are highly needed in making such a decision. Courts have to answer two questions in such an instance. First, the court is mandated to determine whether the director is an executive or a non-executive director. Secondly, the court clarifies whether the company is a public or a private limited liability company. Courts’ decisions in reference to the duty of care and skill are guided by the above-stated considerations. Courts decide in favor of the director in some cases. This is perceived as leniency on the part of courts. However, it should be remembered that the two main documents that govern the company must be considered, as well as the decision made by the director in such an instance.⁵ Courts are justified in putting into consideration the above factors in the best interest of justice and the company.

English Courts have been criticized for some of their decisions in respect to the directors’ breach of their duty of skill and care. In the case of Re Barings Plc⁶, some directors in the company were found unfit and disqualified for their failure to supervise a rogue trader. Their failure led to the company’s loss of 827 million pounds. The bank collapsed as a result of this loss. In the decision of Parker J, the directors were supposed to acquire and maintain ample knowledge and understanding of the company’s business, both collectively and individually. This knowledge equips directors in the course of executing their roles. Secondly, while directors may delegate their duties depending on the provisions of the articles of association, the exercise of delegation does not give immunity to directors if such acts are considered negligent. The mere fact that the director has entrusted the competence of those below him or her in the chain of management does not mean that the director is not liable when such a person does not employ skills in discharging the said function. The court based the holding on the fact that the director would be perceived to have acted himself if he acted through others. In addition, upon delegation, the director ought to supervise the exercise of the delegated function to ensure that it is per the company’s articles and memorandum of association.

A court in the above case further observed that there are no universal rules set to apply in every company. Court decides whether there was a breach of the said duty depending on the rules and the regulations of the company. In addition, it was held that each case of breach depends on its facts.⁷

In the case of Re Brian D Pierson (Contractors) Ltd⁸, Court stated that there are various expectations on the directors that are considered in determining a breach of a duty. Court held that it is impractical for the director to be expected to have detailed knowledge of the day-to-day running of the company’s affairs. However, directors are expected to have such knowledge to enable them diligently supervise the company’s dealings, individually and collectively. The foregoing decision portrays some leniency on the courts in ascertaining the nature of knowledge that the directors should have. Holding that the directors should not be expected to have detailed knowledge leaves a leeway for breach. This is based on the reasoning that a director who has limited knowledge about the running of the company is likely to breach the duty of due diligence, care and skill. The right position would be to the effect that the director is the agent of the company, thus he should be aware of the running of the company’s business. He can achieve this goal by having sufficient knowledge.

Agents of the company ought to act in the best interest of the company, thus directors should have a clear understanding of the company’s business in all circumstances. Such a duty may not be achieved without sufficient knowledge. In the case of the Secretary of the State for Trade and Industry v Bairstow⁹, a declaration of the dividends on the strength of accounts was found not to give a true and fair view of the company’s affairs. The information was misleading in this instance. Court held that directors’ knowledge would be ascertained basing on what a reasonable diligent person in the position of a senior executive or chairman of the company would do. Secondly, there was consideration as to what would be expected from a director of the company given his experience in the affairs, which is to be examined in the form of the knowledge available. Similarly, in the case of Re Westmid Packing Services Ltd¹⁰, court stated that it is the duty of a director to acquaint himself or herself with the company’s affairs. Special knowledge should be in respect to the financial standing of the company. The duty is not only limited to the directors of the company holding the position at the material time, but the duty extends to the former directors of the company who are not excused from failure to be informed about the company’s position.¹¹ Court further held that a director could not excuse himself from liability by claiming that the board was dominated by someone else.

The holdings in the two cases discussed clearly indicate that courts have exercised their powers, thus it would not be correct to state that courts of law have been lenient on directors. The holdings in the cases discussed above show that courts have put a test in regard to determining if a director has breached his duty. The test of a diligent person acting in the same position imposes a higher test, which the directors must meet. In essence, courts will consider the business of the company before determining whether there was a breach. The duty of due diligence and skill is strict and fundamental in the sense that its breach may occasion the breach of other duties. It should also be borne in mind that courts will highly put into consideration the well being of the company and the effect of one decision as opposed to another. In so doing, the company’s well being is a determining factor in the decisions reached. On the side of the shareholders and other people who have interest in the company, it may look like a decision promoting breach of director’s duty to the company. However, such a decision may be inevitable given the fact that companies do not operate using general rules, but using codified rules in the articles and memorandum of association.

Courts have used all forms of interpretation to make sure that directors do not act without due care and skill. The position is well illustrated in the case of Dorchester Finance Ltd v Stebbing¹². A money lending company transacted its money lending business without holding board of directors meetings in the case in question. In the same company, three directors left the affairs of the company to be solely managed by the third director. The third director only advanced loans to companies owned by his brothers. Court held that the two directors were liable for not exercising supervision upon delegating their duties. They could not be excused from liability even if they did not act personally. Court found that the three directors were collectively liable. Such a strict decision clearly shows that courts of law are not lenient whenever a director has breached a duty.¹³ The position of the court fosters the interest of the company, as well as punishing liable directors.

The holding that directors are to be held liable for acts that disclose breach is a principle of law that has a long standing in English Courts. It should be remembered that such liability will be sanctioned by court once it is clear that the director exceeded his or her powers. The threshold of such acts was laid down in the case of Re City Equitable Fire Insurance Co Ltd¹⁴, where court observed that a director need not exercise a greater skill than what would be expected from a person of his standing in knowledge and skill. The decision is subject to criticism for establishing a test that is based on the bare minimum. The test is lower in that the courts will consider what an average reasonable director would have done given similar circumstances in a normal setting of a company. A higher standard is required to avoid breach of the duties.

In Henderson v Merret Syndicate Ltd¹⁵, the House of Lords held that the duty of a director to act in due care and skill arises from the point when the director assumes full or partial liability of the affairs of the company. This establishes the principle that the duty stated does not apply, unless one is a director. Secondly, the director must have assumed responsibility of the company. Lack of the two elements will make a director reluctant in reaching a decision whenever a breach occurs. The duty of care must be established for there to be negligence. In Re Brazilian Rubber Plantations and Estates Ltd¹⁶, Courts became specific in respect to the situations that a director can be held liable. Court was of the opinion that a director is not held liable unless he or she is under a contractual duty to perform some duties under a clear contract of employment. The director will only be held liable for negligence. The negligence is confined to what the director does, but it does not extend to liability for not omitting to carry on the company’s business.¹⁷

In Re Continental Assurance Co. of London Plc¹⁸, Court imposed an unreasonable test in respect to knowledge. In this case a small insurance company collapsed. The liquidators were of the view that the directors were to be held liable for wrongful trading. Court held that directors would have been presumed to be experts if they were expected to know when the company was becoming insolvent. It was stated that such a determination required experts, thus court could not impose such unrealistic high standard of skill. The holding falls under the category of court decisions whereby lenience has been exercised. The criteria of appointing a director should always bear in mind the business of the company. In the appointment, suitable candidates should be determined bearing in mind their knowledge in the area that the company will be doing business. Therefore, a director should be appointed only upon exhibiting knowledge in a certain area to avoid a case whereby he or she avoids liability. The directors have duty of engaging experts in cases whereby they fall short of given knowledge. Failure to exercise that duty may occasion a breach of another. Courts should be firm in establishing a higher standard.¹⁹

The directors were manipulated and deceived by a member of the board in the case of Re Westmid Packing Ltd, Secretary of State for Trade and Industry v Griffiths²⁰. The member had a dominant controlling effect in the running of the company’s business. Their failure to prevent him from acting allowed the director to divert the company’s assets for his businesses. Court disqualified the two directors from acting for the company. A similar position was in the case of Re Landhurst Leasing Plc, Secretary of State for Trade and Industry v Ball²¹ . Court disqualified two directors who had taken a secondary role in this case, thus allowing two forceful managers to take control of the company. The two directors failed to inform the board about sham transactions that they were aware of.

The issue of abdication of responsibility was considered in Re Westminster Property Management Ltd, Official Receiver v Stern²². A father and a son were directors of a company in the case, but the son only acted upon the directions of the father. In considering whether the son could be held liable for failure of exercising due diligence and skill, court held that the son was abrogated from responsibility. In the given case, the father was entirely liable. The factors that were considered in the holding above are grounded on the common law principle of undue influence.²³ However, the holding shows lenience in the essence that the son should not have been a director if such influence was anticipated.

The general duty of care and skill

The general duty of care imposed on every individual under the normal day-to-day transactions has been codified, thus designing the duty of care and diligence. An individual is not supposed to breach the duty of care just like a director is liable when he or she breaches such a duty. Courts’ reasoning in reaching a decision of breach has been based on several factors. It is contentious on whether courts of law have been lenient in reaching such decisions. The main challenge in answering such a question is the fact that courts do not exercise universal rules in decisions. Additionally, the articles and memorandum of association are the working rules before courts reach a decision.

Courts have been strict in many of the decisions concerning the directors’ breach of duty. The courts’ justification in such cases has been on the following factors: The shareholders need to have depended on the directors for information and advice. The reliance of advice must be coupled with a relationship of confidence between the directors and the shareholders. The significance of the transaction in question for each party is a basic consideration. Finally, the extent of any positive act done by the directors in the furtherance of the transaction is considered. The fact that a director is placed in a position whereby he or she can exercise undue influence to the detriment of the company requires strong mechanisms to regulate such powers. It is the sole duty of the courts to offer deterrence punishments to limit the said breach. Failure to do so will expose the company to great dangers of losing financially.

Any person appointed as a director must act in conformity with the provisions of the articles of association. A shadow director may issue directives during a board meeting, but such a case does not mean that all other directors in the meeting are not liable in case the decision is found to be negligent. In Ultraframe (UK) Ltd v Fielding²⁴, court held that the directors were liable upon breach even if they acted on the direction of a shadow director. The duties of an acting director are the same as a director appointed by the company during its general meetings. It, therefore, means that the liability of the directors in a company is individual-based and one cannot use the incorporation test to shield themselves from liability.²⁵

It is imperative to note that the duty of acting in due care and diligence has an overlapping effect on the other duties. The best interest of the company is compromised in a simple act of a person not exercising the duty to act diligently. Courts may in certain circumstances extend their roles in order to ascertain the liability. This will call for a wider scope of consideration where other duties are looked into. It is the mandate of the director of a company to perform duties with the interest of the company at heart. Failure to observe his or her duty of care follows that the best interest of the company is affected. Courts are lenient is such instances to avoid a case whereby the director is held liable for breach of more than one duty. It would be unfair to punish a director for other duties that were interfered with as a consequence of breaching a duty of care. In some occasions, the company is directed to limit itself to the damages that occurred as a direct consequence of the director’s acts.

There ought to be the extent under which the company should recover. Court imposing severe punishments on directors may lead to commercial effects, whereby people begin rejecting appointments to serve in the company. The decisions must have a reflection of the day-to-day commercial situations. Courts are guided by public policy in their decisions, in addition to the law and facts. Courts have a duty to promote the success of companies by reaching at judgments that make commercial sense. Any deviation from such a position will be seen as a way of trying to muzzle business advancements in the companies. It is the said position that has made courts to come up with some lenient rules and decisions. The rationale is to provide for enough precedents that are not punitive in nature.²⁶

The fundamental role of the court is to make sure that directors observe the contract between them and the company, while at the same time promoting the business of the company. There are some effects that would be felt by other people if courts would be rigid in their decisions since the duties of a director are not only limited to the company. A court’s decision may worsen the business of the company, thus affecting the duties to the employees, present and future creditors of the company. The disqualification of a director may not compensate the company for the loss incurred, thus courts should consider charging the directors monetary fines. With the monetary fines, the company is taken back to its position before the breach of the contract.

There are various impediments to sound court decisions. Many companies are managed by directors who are the majority shareholders in the company. Punishing such a person is difficult since they influence the decision during meetings. It is very easy to manipulate other directors in board meetings to foster his or her interests. Courts are in such situations keen to consider the consequences of disqualifying such a director from being a board member. The salient elements in the law of negligence differ from the breach of duty of care diligence and skill. A crucial distinction is drawn bearing in mind that the duty of care in company law is based on the director, while the one in tort is based on an individual defendant.²⁷

It is observed that the duty of directors is based on a fiduciary relationship. The relationship is to the effect that the director’s duty is subordinate to the duty that is held to the company. The duty to the company prevails whenever a conflict arises between the duty of the director to the company and the director acting in his or her interest. Courts of laws have a unique duty of making sure that such duties are not breached by the directors. If courts demonstrate high level of leniency, then the directors will find a way of breaching the duties and getting away with it. The only way to lower the rates of such incidents is by making sure that courts issue stern decisions that act as a deterrence. The duty of a director to act in the best interest of the company is a dominant duty that encompasses the duty to act in due care and diligence. It follows that courts of law must act within those lines to safeguard the interests of the company.

The existence of bad decisions by directors of a company cannot be attributed to lenient decisions of courts. The appointment of the directors has a high influence on the kinds of decisions that a director makes. Many companies do not consider the competence of a director depending on their academic and other qualifications. This has made it a matter of majority shareholding in the company; as long as one holds majority of the shares in the company, he or she will be appointed a director. The trend of appointment based on majority shareholding has led to some absurd decisions in the corporate world. It has occurred that many of the directors do not understand their corporate social responsibility. The main focus has been profit making. This explains why lately many companies are being held culpable due to their directors. Such kinds of directors are not expected to understand their duties and responsibilities and the consequences of breaching any of the duties. Soundness in the management of companies has been realized during appointments. Shareholders at this stage have the power to determine the kind of decisions that will be made by appointing the right persons to hold the office of the director.²⁸

It would be improper to require courts to regulate the conduct of directors through their decisions since courts’ intervention is mostly sought upon breach. The best of all solutions is to make sure that the intended powers of directors are enshrined in the articles and memorandum of association. Doing so will make the directors maintain control of what they should do. Shareholders should be quick to hold a meeting to discuss the conduct of a director if they feel that he or she is not conducting business according to the articles and memorandum of association. This will ensure competence and any wrong committed by a director will be addressed early enough. The company should establish a way of dealing with some of the conflicts in the company before they resort to court.²⁹

There should be an established mechanism of dealing with directors’ breach of duties. The regulating mechanism in the company can serve as a remedy to the company’s indoor problems. Courts in these situations will consider the practicability of their decisions in the working of the company. This may be seen by the aggrieved parties as a lenient stand. However, the duty of the court in such an instance is to serve justice and not every party will celebrate the court’s decision.³⁰ Such cases have been decided following the precedents already set by courts. It is, thus, unrealistic to expect the court to adopt an interpretation far away from what they have established throughout time. Previous decisions with the same principles will be followed, thereby appearing lenient to others. English Courts have a long history of decisions based on the principle of precedents. This principle is the founding doctrine of the common law system. Courts only deviate from the doctrine of precedents upon getting solid reasons to do so. Courts are custodians of justice and their role in doing so does not always make the aggrieved party happy.³¹

Conclusion

The discussion above has offered a critical analysis of the decisions that have gone to court before. The reasons for reaching such decisions have been provided. It has been established that some of the decisions are not in conformity with the wishes of litigants in such cases. The practicability of some of the decisions in English Courts has been questioned. Some of the leading decisions have been termed as lenient decisions. The main points of contention have been the separate tests applied by courts when determining whether a director was in breach of the duty of care and skill. The tests have varied, but courts have defended such positions by stating that each case depends on its circumstances and the wording of the articles and memorandum of association. It has been understood that courts are lenient³². The company’s memorandum and articles of association aid courts in seeking an interpretation to the business of the company and whether a breach of duty has been occasioned. The decisions are not lenient, but they have been reached by application of different tests. Shareholders should engage in a thorough process of recruiting their directors. The process should ensure that the ones appointed are competent enough to steer the affairs of the company in the right direction. The only way that courts can adopt another mode is by making sure that they get strict interpretation on the duties of the directors to the company. This would be an essential solution to adopt.

Bibliography

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Table of Cases

1. Dorchester Finance Ltd v Stebbing [1989] BCLC 498
2. Henderson v Merret Syndicate Ltd [1994] UKHL 5
3. Re Barings Plc [1999] 1 BCLC 433
4. Re Brian D Pierson (Contractors) Ltd [1999] BCC 26
5. Re Westmid Packing Services Ltd [1998] 2 All ER 124
6. Re Continental Assurance Co. of London Plc [2007] 2 BCLC 287
7. Re Westmid Packing Ltd, Secretary of State for Trade and Industry v Griffiths [1998] 2 BCLC 646
8. Re Landhurst Leasing Plc, Secretary of State for Trade and Industry v Ball [1999] 1 BCLC 286
9. Re Westminster Property Management Ltd, Official Receiver v Stern [2001] BCC
10. Re Brazilian Rubber Plantations and Estates Ltd [1911] 1 Ch 425305
11. Re City Equitable Fire Insurance Co Ltd [1925] Ch 407
12. Salomon v Salomon [1897] AC 22
13. Secretary of the State for Trade and Industry v Bairstow [2005] 1BCLC 136

Footnotes

1. Salomon v Salomon [1897] AC 22.
2. M Adenas, European comparative company law, (Cambridge University Press, Port Chester, 2004), p. 21.
3. SM Bartman, European company law in accelerated progress, (Kluwer Law International, Alphen aan den Rijn, 2006), p. 33.
4. H Anderson, Directors’ personal liability for corporate fault: A comparative analysis, (Kluwer Law International, Alphen aan den Rijn, 2008), p. 32.
5. M Blowfield & A Murray, Corporate responsibility, (Oxford University Press, Oxford, 2011), p. 44.
6. Re Barings Plc [1999] 1 BCLC 433.
7. R Baxt, Duties and responsibilities of directors and officers, (Australian Institute of Co. Directors, Sydney, 2005), p. 41.
8. Re Brian D Pierson (Contractors) Ltd [1999] BCC 26.
9. Secretary of the State for Trade and Industry v Bairstow [2005] 1BCLC 136.
10. Re Westmid Packing Services Ltd [1998] 2 All ER 124.
11. RP Austin, HAJ Ford & MR Ian, Company directors: Principles of law and corporate governance, (LexisNexis, Chatswood, 2004), p. 31.
12. Dorchester Finance Ltd v Stebbing [1989]BCLC 498.
13. N Boeger, R Murray & C Villiers, Perspectives on corporate social responsibility, (Edward Elgar, Cheltenham, 2008), p. 28.
14. Re City Equitable Fire Insurance Co Ltd [1925] Ch 407.
15. Henderson v Merret Syndicate Ltd [1994] UKHL 5.
16. Re Brazilian Rubber Plantations and Estates Ltd [1911] 1 Ch 425.
17. M Bruce, Rights and duties of directors, (Bloomsbury Professional, Bloomsbury, 2013), p. 32.
18. Re Continental Assurance Co. of London Plc [2007] 2 BCLC 287.
19. RP Austin, The role and duties of Australian company directors: A restatement (University of Queensland Press, St Lucia, 2010), p. 51.
20. Re Westmid Packing Ltd, Secretary of State for Trade and Industry v Griffiths [1998] 2 BCLC 646.
21. Re Landhurst Leasing Plc, Secretary of State for Trade and Industry v Ball [1999] 1 BCLC 286.
22. Re Westminster Property Management Ltd, Official Receiver v Stern [2001] BCC 305.
23. S Bruno & R Eugenio, Public companies and the role of shareholders: National models towards global integration, (Kluwer Law International, Alphen aan den Rijn, 2011), p. 77.
24. Ultraframe (UK) Ltd v Fielding [2005] EWHC 1638.
25. A Calder, Corporate governance: a practical guide to the legal frameworks and international codes of practice, (Kogan Page, London, 2008), p. 7.
26. T Cannon, Corporate responsibility: a textbook on business ethics, governance, environment : roles and responsibilities,( Pitman, London, 1994), p. 75.
27. CT Campbell, international liability of corporate directors, (Yorkhill Law Publishers, London: 2006), p. 75.
28. J Cassidy, Concise corporations law, (Federation Press, Annandale, 2006), p. 13.
29. The Law City School, Company law in practice, (Oxford University Press, Oxford, 2008), p. 67.
30. K Degenhardt, Companies Act 2006, (Hochsch.-Verl, Bremen, 2010), p. 34.
31. G Gibson, Law for directors, (Federation Press, Leichhardt, 2003), p. 76.
32. G Gibson, Law for directors, (Federation Press, Leichhardt, 2003), p. 82.