Directors Beware!

Originally published June 2004

English law does not provide a single, comprehensive code of conduct for directors and most of the rules governing directors are contained in a bewildering mass of legislation and court decisions. Many directors are also subject to contractual obligations – for example, under their employment contracts.

In most cases, directors’ duties are owed to the company itself and not to individual shareholders. Directors must also consider the interests of the company’s employees and even those of creditors – particularly where the company may be insolvent.

Many of the same principles apply to all directors, whether they are executive directors (involved in the day-to-day running of the company), non-executive directors (advising the board but not involved in actual management), "shadow directors" (not actually appointed as directors but whose instructions are in practice followed by the company’s directors) or nominee directors (appointed to represent the interests of a particular shareholder or creditor – and who therefore face potential conflicts of interest).

• Duties of skill and care: A director must act with the level of skill and care which may reasonably be expected from a person with his knowledge and experience. This is particularly relevant to executive directors who actually run the business but non-executive directors must also take an active interest in the company’s affairs - they cannot simply rely on the recommendations of the executive directors. Adirector who fails in this duty risks being sued by the company for any resulting losses.

• Good faith: A director must act honestly and in good faith in the interests of the company. The test is subjective: if the director honestly believes he is acting in the company’s interests, a court will not substitute its own opinion. In practice, the company’s interests may be different from those of individual shareholders. Breach of this duty could expose the director to a claim by the company for any loss suffered as a result.

• Conflicts of interest: A director must avoid conflicts between his interests and those of the company. For example, a person who is a director of two companies may have a conflict if both companies are competing for the same contract. If an actual or potential conflict arises, this must be disclosed to, and approved by, a meeting of the full board and the director should also obtain independent legal advice, as he risks being sued by the company for any resulting loss.

• Secret profits: A director is a trustee of the company’s assets and must not misapply them. If a director makes a profit from using the company’s property or from an opportunity which is only open to him because of his directorship then unless the opportunity has been disclosed to, and approved by, the board, the director must pay this "secret" profit to the company, even if he acted in good faith or if the company itself could not have made the profit.

• Abuse of authority: A director who acts without authority - or exceeds the authority he has been given - may be sued by the company. If he enters into a contract without authority, the other party to the contract may be able to sue him for breach of warranty of authority. A director may also be liable if he exercises his powers for a purpose for which they were not intended. In most cases, if a director exceeds his authority the shareholders can ratify his action, unless it is against the law.

• Confidentiality: Directors must keep confidential any information which they obtain in their capacity as directors.

There is a wide range of statutory obligations on companies which could result in personal liability for a director if the company fails to comply and the director is implicated in the breach. These include:-

• Employee discrimination or harassment: A director may be fined or sued for damages if the company has discriminated against an employee on grounds of sex, race or disability or if the director himself has sexually harassed another employee.

• Health and safety: A director may face disqualification, fines or even imprisonment if the company fails to ensure the health and safety of its employees in accordance with the Health and Safety at Work, etc Act 1974.

• Environmental law: A director may be liable for fines, imprisonment and claims for compensation if the company pollutes the environment or causes injury to persons in breach of the Environmental Protection Act 1990.

• Data protection: A director may face fines if the company commits a breach of the Data Protection Act 1998.

• Company accounts: There are many requirements concerning company accounts. The accounts must comply with the Companies Act 1985 ("CA 1985") and must disclose the company’s financial position with reasonable accuracy. The directors must prepare and approve the annual accounts and the directors’ report. The accounts must be sent to the shareholders and laid before them in general meeting and must be delivered to the Registrar of Companies within 10 months after the company’s year-end. In most cases, breach of these duties is a criminal offence and the directors may be liable to fines or even imprisonment.

• Companies raising investment: If a company is raising funding from investors, various provisions could give rise to personal liability for the directors. For example, under the Financial Services and Markets Act 2000 ("FSMA"), if the company issues a business plan to non-exempt investors without having it approved by a FSMA "authorised person", the company and the directors may be fined. It is also a criminal offence for a director to make false or misleading statements or forecasts to induce a person to acquire shares. The director may also be sued by any investor who suffers loss as a result. There are many other provisions concerning the issuing, buying and selling of shares (such as the prohibition on insider dealing) which could expose a director to fines, imprisonment or claims for damages from investors.

• Loans: A company cannot generally make or guarantee a loan to a director, although private companies may in certain circumstances make loans (or short-term quasi-loans) of up to £5,000 (in total) to a director. These provisions are often breached and yet in each case the company and the director risk being fined and the director may face imprisonment. The transaction may also be set aside, and any director who is involved must account to the company for any gain and indemnify the company for any loss.
• Transactions between the company and a director: Shareholder approval is required before a director, or person connected with a director, can acquire non-cash assets from the company or sell non-cash assets to the company if the value of the assets exceeds £100,000 or (if less) 10% of the company’s net asset value (and at least £2,000). Without shareholder approval, the transaction may be set aside, and the directors who authorised it must account to the company for any profit, and indemnify the company against any resulting loss.

• Interests in shares: It is a criminal offence if a director fails to disclose to the company his interests (and those of his spouse or infant children) in the company’s shares or debentures and does not notify the company of any changes in those interests within five days. The definition of "interests" is very wide and includes share options and warrants.

• Competition law: A director or employee who dishonestly commits the cartel offence (including price-fixing, market-sharing, customer-sharing, bid-rigging or limiting or preventing supply or production) could face up to 5 years’ imprisonment and/or an unlimited fine. Directors whose companies have infringed competition law and been fined may be disqualified from acting as directors even in the absence of dishonesty.

• Corporate killing: The Government has produced detailed proposals to introduce new laws to make directors personally accountable for deaths resulting from actions taken by the company.

Many directors also have obligations under contracts which they enter into while they are directors. These could include:

• Employment: A director who is also an employee of the company will have obligations under his employment contract, which could require him to devote all his time and attention to the company’s business, perform his duties with a specified level of skill, and not compete with the company’s business. Some duties are implied even where there is no written contract. Breach of these duties could result in claims by the company for any resulting loss.

• Shareholders’ agreements: A director who is also a shareholder of the company may have entered into a shareholders’ agreement in his capacity as a shareholder, under which he owes additional duties and obligations to the other shareholders and the company and which may impose restrictions which could affect his conduct as a director.

• Personal guarantees: A director may be required to personally guarantee liabilities of the company – such as a bank loan. If the company fails in its obligations, the director could be personally liable as guarantor and could lose his home if the guarantee is secured by a charge over the home.
• Covenants under leases: A director may be asked to guarantee the company’s obligations under the lease of its premises – and will be personally liable, for example, to pay the rent if the company fails to pay promptly or becomes insolvent.

If the company is involved in litigation, a director could be personally liable in the following circumstances:-

• Costs orders: The court has a discretion to make orders for costs against directors personally in certain situations.

• Contempt of court: A director could be in contempt of court (and risk a fine or imprisonment) if he (a) fails to preserve documents which are relevant to a court case; (b) fails to ensure that the company obeys a court order; or (c) makes a false statement in a witness statement without honestly believing it to be true.

If a company is in financial difficulty, the directors must safeguard the creditors, as well as considering the interests of the company.

• Wrongful trading: Under the Insolvency Act 1986, a director may have to contribute personally to the assets available to pay debts due to creditors, if the company becomes insolvent and he knew (or should have known, based on his actual skill, knowledge and experience or that expected of a director in his position) that there was no reasonable chance of the company avoiding liquidation and he failed to take every step he should have taken to minimise the loss to creditors.

• Fraudulent trading: Any director who knowingly carries on a company’s business with the intent to defraud creditors or for any fraudulent purpose - for example, incurring credit on the company’s behalf without reasonably expecting that the company will be able to repay the debt - may have to contribute to the company’s assets and could be fined or even face imprisonment.

• Transactions at undervalue and preferences: In some circumstances a court may set aside a transaction under which a director obtained assets from a company if (a) the assets were transferred to him at an undervalue when the company was unable to pay its debts or if the company became insolvent as a result or (b) he obtained them in the 6 months prior to insolvency and the transaction was a "preference", which put him into a better position on insolvency than he would otherwise have been, as against other creditors.

• Co-operation: A director of a company in liquidation (or other insolvency) is under a statutory duty to co-operate with the liquidator (or office holder) and could be fined if he does not.

• Fiduciary duty: A director could face a claim for breach of fiduciary duty if he disregards the interests of creditors when a company’s solvency is in doubt.

A court may disqualify a person from being a director for up to 15 years if he is or has been a director of a company which has become insolvent and his conduct as a director makes him unfit to manage a company (Company Directors Disqualification Act 1985). Other grounds for disqualification include (a) being convicted of an indictable offence relating to the formation, management or liquidation of a company; (b) persistently failing to file accounts or returns with the Registrar of Companies; and (c) a court declaring that the director must contribute to a company’s assets following fraudulent or wrongful trading. If a person acts as a director or takes part in the management of a company whilst disqualified, he could be imprisoned and made personally responsible for the company’s liabilities.

The Secretary of State has power under the Companies Act 1985 to investigate a company’s affairs if, for example, he suspects fraud or irregularities have occurred. A director can be required to produce documents relating to the company and to explain those documents. Failure to do so could result in a fine or imprisonment for contempt of court. After an investigation the Secretary of State could apply to disqualify any director or shadow director of the company.

A director of a company who is a professional - such as an accountant or surveyor - could face professional disciplinary proceedings for misconduct as a director.

A director who is not a citizen of the EU could be at risk of imprisonment and deportation if he works in the EU without obtaining a work permit (and if he can not rely on other provisions of the immigration rules).

• Indemnities: The Companies Act 1985 prohibits a company from undertaking to indemnify a director in advance against liability for negligence, default or breach of duty but the company can indemnify the director after the event (within certain limits). Normally, any payment must be approved by the company’s shareholders before it is made.

• Insurance: Companies may take out insurance against directors’ liabilities, including negligence claims, default or breach of statutory duty. There are three main types of insurance: (a) directors’ and officers’ liability insurance, taken out by the company to protect its directors from third party claims; (b) professional indemnity insurance, taken out by a director against liabilities incurred in the performance of his duties; and (c) directors’ liability insurance, which may protect a director against liability to the company in his capacity as a director. The insurance will not normally cover losses due to fraud, dishonesty, wilful default or criminal behaviour, although the company could insure itself separately against its own risks. Insurance can be very expensive and any premium paid by the company on the director’s behalf will normally be taxed as a benefit in kind.

© RadcliffesLeBrasseur

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.