LL4CF Lecture Handout 5 PDF

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Lecture Handout Lecture 5 Directors Duties II

Core Reading Hannigan: Chapter 9 at 9.49 – 9.74 (proper purposes rule), Chapter 10 at 10.41-10.55, Chapter 11 (duty of care, independent judgement) and Chapter 14 at 14.66 – 14.82 (indemnities and relief from liability) OR Gower: Chapter 16 (excluding 16.52 – 16.127) in particular 16.15-16.36 and 16.128 – 16.141. Cases and Materials Sealy and Worthington: Chapter 7 pages 341-356, 373-386. BTI v Sequana SA & others [2019] EWCA Civ 112 (CA) (extracts on Moodle) Further Reading Worthington: “Directors’ duties and improper purpose” [2016] CLJ 213 (Case Note on Eclairs Group v JKX Oil & Gas) Introduction Agency problem: directors normally have exclusive power to manage the company’s business but the risk is they may manage the company in their own personal interests rather than the interests of those they are supposed to serve. (Sealy & Worthington).  Role of directors duties in addressing this risk. Basic Content of the Duties (Recap from Last Week) The general duties of directors are today set out in sections 171-177 (+ s 182) of the CA 06: (a) Loyalty and the exercise of directors’ powers Duty to: • Act within powers (s 171) • Promote the success of the company (s 172) • Exercise independent judgment (s 173) (b) Competence / negligence • Duty to exercise reasonable care, skill and diligence (s 174) (c) Honesty, loyalty / self-dealing Duty to: • Avoid conflicts of interest (s 175) • Not accept benefits from third parties (s 176) • Declare interest in proposed/existing transaction or arrangement (ss 177 & 182) S 179: the duties are cumulative; more than one can apply in any situation.

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The general duties of directors in CA 06 have effect in place of the previous common law rules and principles in this regard (s 170(3)) BUT – The old common law rules will still be relevant as a judicial aid for interpreting and applying the statutory general duties in specific factual scenarios (s 170(4)) 1. Loyalty and the Exercise of Powers a) Duty to act within powers (s 171): s 171 CA 06: ‘A director of a company must – (a) act in accordance with the company’s constitution, and (b) only exercise powers for the purposes for which they are conferred.’ s 171(a): the scope of authority given to directors under the constitution. NB wider definition of constitution under s 171(a) (see s 257 CA 06 i.e. includes any resolution or decision of member). See earlier lectures on corporate contracting. s 171(b): only exercise powers for the purpose for which they are conferred; the ‘proper purpose’ rule. The proper purpose doctrine Main rationale for the rule relates to protecting the existing balance of power within the company. Punt v Symons & Co Ltd [1913] 2 Ch 506, Byrne J: ‘If…shares have been issued under the general fiduciary power of the directors for the express purpose of acquiring an unfair majority for the purpose of altering the rights of parties under the articles, I think [the court] ought to interfere [and] grant an injunction.’ Many cases concern the directors’ power to issue shares, often as a frustrative tactic in the face of a hostile takeover bid: Hogg v Cramphorn [1967] Ch 254, Buckley J: ‘[T]his court should not and will not…permit directors to exercise powers, which have been delegated to them by the company in circumstances which put the directors in a fiduciary position when exercising those powers, in such a way as to interfere with the exercise by the majority of its constitutional rights’ ‘It is not…open to the directors in such a case to say, ‘We genuinely believe that what we seek to prevent the majority from doing will harm the company and therefore our act in arming ourselves or our party with sufficient shares to outvote the majority is a conscientious exercise of our powers under the articles, which should not be interfered with’.’ The ’Substantial Purpose’ Test The modern approach – examine the context: Howard Smith Ltd v Ampol Ltd [1974] 1 All ER 1126 (Privy Council) (key authority), Lord Wilberforce:

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‘So far as authority goes, an issue of shares purely for the purpose of creating voting power has repeatedly been condemned.’ ‘[I]t must be unconstitutional for directors to use their fiduciary powers over the shares in the company for the purpose of (emphasis added) destroying an existing majority, or creating a new majority which did not previously exist. To do so is to interfere with that element of the company’s constitution which is separate from and set against their powers.’ ‘[I]t is necessary to start with a consideration of the power whose exercise is in question…it is then necessary for the court…to examine the substantial purpose (emphasis added) for which it was exercised, and to reach a conclusion whether that purpose was proper or not.’ NB an important statutory supplement to s171 with respect to improper allotments of shares: ss 551(1) & 561 – 577 (limiting the freedom of the board to influence voting control). Note also the application of the City Code on Takeovers and Mergers in relation to frustrative tactics by directors of public companies. Which Purposes are Proper and Which are Improper? Criterion Properties plc v Stratford UK Properties LLC [2003] BCC 50 (HL) ‘poison pill’ agreements, (where the lower courts held this to be disproportionate to the threat faced by the company – see esp. Carnwarth LJ (CA) paras 24-27) Eclairs Group v JKX Oil & Gas Plc [2015] UKSC 71 (key authority). (NB The decision of Mann J at first instance [2013] EWHC 2631 was upheld by the Supreme Court, reversing the decision of the majority of the Court of Appeal [2014] EWCA Civ 640, [2014] 2 BCLC 164 (Briggs LJ dissenting). Lord Sumption, para 30: ‘Ascertaining the purpose of a power where the instrument is silent depends on an inference from the mischief of the provision conferring it, which is itself deduced from its express terms, from an analysis of their effect, and from the court's understanding of the business context.’ Problem of Mixed Purposes - when is a Power Exercised for Improper Purposes? Eclairs Group, Lord Sumption, para 21: ‘One has to focus on the improper purpose and ask whether the decision would have been made if the directors had not been moved by it. If the answer is that without the improper purpose(s) the decision impugned would never have been made, then it would be irrational to allow it to stand simply because the directors had other, proper considerations in mind as well.’ (NB Majority of the court declined to commit themselves to this as a statement of law). Impact of breach of s171(b)? It remains possible for the company to ratify an improperly motivated act of the directors by means of an ordinary resolution of shareholders in general meeting, although the director(s) concerned will be barred from voting as shareholders in the resolution in question (s239 (1) – (4)). Bamford v Bamford [1970] Ch 212 (CA), Harman LJ:

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‘[I]f directors…are actuated by improper motives…, such directors can, by making a full and frank disclosure and calling together the general body of shareholders, obtain absolution and forgiveness of their sins.’ b) Duty to Promote the Success of the Company (s172) (see last week’s lecture) Creditors - 172(3) Duty to Creditors? A duty on the directors to have regard to the interests of creditors as insolvency approaches has been recognised at common law and is preserved by s172(3): ‘The duty imposed by this section has effect subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company.’ Common law obligation has its origins in influential Australian and New Zealand decisions: As per Chief Justice Street in Kinsela v Russell Kinsela Pty (1986) 10 ACLR 395 (New South Wales CA), Street CJ: ‘W]here a company is insolvent the interests of the creditors intrude. They become [prospectively] entitled, through the mechanism of liquidation, to displace the power of the shareholders and directors to deal with the company’s assets. It is in a practical sense their assets and not the shareholders’ assets…’ The approach was endorsed by the Court of Appeal in West Mercia Safetywear v Dodd [1988] 4 BCC 30 (CA). When is the Duty Triggered? When the company is solvent – no need for directors to consider or act in interests of the creditors. When the company is insolvent – the focus of directors’ decisions is the interests of the creditors. What about when the company is under financial pressure and may be approaching insolvency? There appears general acceptance that the duty can bite in advance of the company being insolvent but there have been various formulations over the years: E.g. Brady v Brady [1989] AC 755 (CA) Nourse LJ, ‘[W]here the company is insolvent, or even doubtfully solvent, the interests of the company are in reality the interests of the existing creditors alone.’ Re HLC Environmental Projects Ltd [2013] EWHC 2876 (Ch), John Randall QC: ‘For my part, I do not detect any difference in principle behind these varying verbal formulations. It is clear that established, definite insolvency before the transaction or dealing in question is not a prerequisite for a duty to consider the interests of creditors to arise. The underlying principle is that directors are not free to take action which puts at real (as opposed to remote) risk (emphasis added) the creditors' prospects of being paid, without first having considered their interests rather than those of the company and its shareholders.

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BUT: BTI 2014 LLC v Sequana SA & others [2019] EWCA Civ 112 (CA) The Court of Appeal held that the common law duty to have regard to the interests of creditors was recognised to exist in CA 2006, s 172(3) but it was difficult to identify when the duty was triggered. The authorities suggested 4 possibilities: (1) when the company is actually insolvent; (2) when it is on the verge of insolvency; (3) when the company is or is likely to become insolvent; or (4) when there is a real, as opposed to a remote, risk of insolvency. Descriptions such as the company being in a parlous financial state or in financial difficulties were too vague to serve as a useful test. The CA considered that the first category (actual insolvency) was clearly within the test. Equally, the test of a real, as opposed to a remote, risk of insolvency (category 4) is not part of the present law. Nevertheless, the duty may be triggered when a company’s circumstances fall short of actual, established insolvency. This shown from the authorities. The precise moment at which a company becomes insolvent is often difficult to pinpoint. Since directors may often not know, nor be expected to know, that the company is actually insolvent until sometime after it had occurred, a test falling short of established insolvency is justified. David Richards LJ therefore held, on the basis of the decided authorities, that the creditors’ interest duty arises when the directors know or should know that the company is or is likely to become insolvent. In this context “likely” meant probable. The Court of Appeal concluded that that Rose J (at 1st instance) was correct to reject the argument that the applicable trigger for the creditors’ interests duty was a real, as opposed to a remote, risk of insolvency. Since there was no justification for a finding that AWA was insolvent or likely to become insolvent at the date of the dividend payment, the judge had been entitled to dismiss the claim in relation to a breach of s 172(3). The judgment provides a useful review of the case law at [105] – [191]. Assessing Conduct in light of s172(3) Consider interests of the creditors as paramount; consider or act in the creditors’ interests as a class: GHLM Trading v Maroo [2012] EWHC 61: “Where creditors' interests are relevant, it will similarly, in my view, be a director's duty to have regard to the interests of the creditors as a class. If a director acts to advance the interests of a particular creditor, without believing the action to be in the interests of creditors as a class, it seems to me that he will commit a breach of duty.” (see also IA 1986, s 239 re voidable ‘preferences’ in favour of individual creditors of an insolvent company) As with s172(1) the test is as to the director’s honest belief their act or omission is in the interests of the creditors. Mainly subjective test of honest belief. Where director never actually considered creditors’ interests, test is whether the intelligent and honest person in the director’s position could, in all the circumstances, have reasonably believed that the transaction was for the benefit of the company: Re HLC Environmental Projects Ltd [2013] EWHC 2876 (Ch), Enforcement

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The duty is enforceable only by the company, while it remains solvent, or later by the liquidator if it is insolvent and wound up. It cannot be enforced by individual creditors. In practice, the better remedy for the liquidator is often a claim against the directors for ‘wrongful trading’ under s214 Insolvency Act 1986.

c) Duty to exercise independent judgement (s 173) The basic rule at common law was that directors must not ‘fetter their discretion’. BUT – See Fulham Football Club v Cabra Estates plc [1994] 1 BCLC 363 (CA) This principle is codified in s 173: ‘(1) A director of a company must exercise independent judgment. (2) This duty is not infringed by his acting— (a) in accordance with an agreement duly entered into by the company that restricts the future exercise of discretion by its directors, or (b) in a way authorised by the company's constitution.’ 2. Duty of Care – Negligence/Competence (s 174 Duty of care, skill and diligence) What was the traditional position historically? Re Cardiff Savings Bank, Marquis of Bute’s Case [1892] 2 Ch 100 Early development of the doctrine: Re City Equitable Fire Insurance Company Ltd [1925] 1 Ch 407 Modern Developments: The situation changes in the late 1980s and 1990s: Dorchester Finance Co v Stebbing [1989] BCLC 498 Norman v Theodore Goddard [1992] BCLC 1028: In this case, Lord Hoffman accepted the counsel submission that the established common law standard of care and skill was accurately stated by the test of diligence for wrongful trading set out in s 214(4) of the Insolvency Act 1986: ‘The facts which a director of a company ought to know or ascertain, the conclusions which he ought to reach and the steps which he ought to take are those which would be known or ascertained, or reached or taken, by a reasonably diligent person having both– (a) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by that director in relation to the company, and (b) the general knowledge, skill and experience that that director has.’

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Re D’Jan of London [1994] 1 BCLC 561 Company Directors Disqualification Act 1986 cases: Re Barings Plc (No.5) [1999] 1 BCLC 433 (approved [2001] BCC 273 (CA)), Jonathan Parker J: ‘Directors have, both collectively and individually, a continuing duty to acquire and maintain a sufficient knowledge and understanding of the company's business to enable them properly to discharge their duties as directors.’ ‘Whilst directors are entitled (subject to the articles of association of the company) to delegate particular functions to those below them in the management chain, and to trust their competence and integrity to a reasonable extent, the exercise of the power of delegation does not absolve a director from the duty to supervise (emphasis added) the discharge of the delegated functions.’ ‘Where there is an issue as to the extent of a director’s duties and responsibilities in any particular case, the level of reward (emphasis added) which he is entitled to receive…from the company may be a relevant factor in resolving that issue.’  ‘[T]he higher the level of reward, the greater the responsibilities which may reasonably be expected…to go with it.’  ‘[T]he higher the office within an organisation that is held by an individual, the greater the responsibilities that fall upon him.’ Equitable Life v Bowley [2004] 1 BCLC 180 ‘I do not think [City Equitable Fire Insurance] does represent the modern law at least if…it means unquestioning reliance upon others to do their job.’ ‘[T]he extent to which a non-executive director may reasonably rely on the executive directors and other professionals to perform their duties is one in which the law can fairly be said to be developing and is plainly 'fact sensitive’.’ ‘It is plainly arguable, I think, that a company may reasonably at least look to non-executive directors for independence of judgment and supervision of the executive management.’ The Impact of s 174 s 174 (essentially a restatement of the s 214(4) Insolvency Act 1986 test): A director of a company must exercise the care, skill and diligence that would be exercised by a reasonably diligent person with: (a) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as the director in relation to the company, and – (b) the general knowledge, skill and experience that the director has. Gregson v HAE Trustees Ltd [2008] EWHC 1006 (Ch) (court confirmed that s 174 codifies the preexisting law). Collective and Individual Responsibilities

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Starting point: Re Westmid Packing Services Ltd, Secretary of State for Trade and Industry v Griffiths [1998] 2 BCLC 646, Lord Woolf MR: ‘The collegiate or collective responsibility of the board of directors of a company is of fundamental importance to corporate governance under English company law. That collegiate or collective responsibility must however be based on individual responsibility. Each individual director owes duties to the company to inform himself about its affairs and to join with his co-directors in supervising or controlling them.; ‘A proper degree of delegation and division of responsibility is of course permissible, and often necessary, but total abrogation of responsibility is not. A board of directors must not permit one individual to dominate them and use them’ Recent Case Law Re Pro4Sport Ltd, Hedger v Adams [2015] EWHC 2540 (Ch) (a reasonable decision need not be the optimal one that could have been made under the circumstances, and the court will not retrospectively second-guess a director’s commercial judgement). Lexi Holdings plc (in admin) v Luqman [2009] EWCA Civ 117 (CA), Morritt C: ‘[I]t is in itself a breach of duty by the remaining directors to allow themselves to be dominated or bamboozled by one of their number.’ Other Directors’ Duties Sections 175, 176, 177 (and s182) – see next week. Court’s Power to Grant Relief from Liability in Certain Circumstances s 1157: If in proceedings for negligence, default, breach of duty or breach of trust against a director or other officer of a company, it appears to the court hearing the case that the officer is or may be liable but that: (a) he acted honestly and reasonably, and (b) having regard to all the circumstances of the case he ought fairly to be excused, the court may relieve him, either wholly or in part, from his liability on such terms as it thinks fit. If any such officer has reason to apprehend that a claim will or might be made against him in respect of negligence, default, breach of duty or breach of trust, he may apply to the court (on the same grounds) for pre-emptive relief from any potential liability. Re D’Jan of London Ltd [1994] 1 BCLC 561 (see also above; partial relief of a director from negligence liability), Hoffman LJ: ‘[i]t may seem odd that a person found to have been guilty of negligence, which involves failing to take reasonable care, can ever satisfy the court that he acted reasonably.’ The section is only available in respect of corporate claims against a director and does not apply to claims by third parties. 8

Managing Potential Liabilities Exemption Provisions s 232(1): ‘Any provision [whether contained in the articles or any contract with the company] that purports to exempt a director of a company (to any extent) from any liability that would otherwise attach to him in connection with any negligence, default, bre...