D&O insurance aspects to consider
Stay in the know
We’ll send you the latest insights and briefings tailored to your needs
19 Jun 2024
Insight
The predictability and depth of development of company law in the UK has long been seen as a competitive advantage and national asset for the UK, including by politicians across the divide in developing the Companies Act 2006 (CA2006).
Directors’ duties and liabilities are a central part of that company law regime. Until their codification in the CA2006, the general duties owed by directors to their appointing companies were encapsulated in, and developed through, the common law. For years, landmark decisions such as Aberdeen Railway Co v Blaikie Bros and Re City Equitable Fire Insurance have been pored over by law students and legal practitioners alike, as the guiding authorities on the scope of the duties owed; decisions which have been tested and expanded by subsequent judicial rulings. Part 10 of the CA2006 set out for the first time a statutory statement of the general duties owed by directors to their appointing companies. The Act made clear however that the rules and principles developed through case law remained relevant: Section 170(3) states (emphasis added): "The general duties are based on certain common law rules and equitable principles as they apply in relation to directors and have effect in place of those rules and principles as regards the duties owed to a company by a director".
Notwithstanding the codification, which sought to make limited changes in practice to the duties, the core of the duties remains consistent with the pre-codification law. The courts have retained a key role in the interpretation of directors' duties and they continue to be reluctant to interfere with management decisions, absent clear evidence of conflict or default. Although they arose in very different circumstances, the claims advanced in both the Carillion proceedings seeking disqualification of the former non-executive directors (NEDs) and the ClientEarth derivative shareholder proceedings sought to test the limits of the statutory statement of directors' duties and the courts' role in their interpretation. Had the applicants in either of these proceedings succeeded, the impact would have represented a fundamental change to the legal role of directors and added significant liability burden and risk to those carrying out their roles as directors. The good news is that neither case has caused such a challenge or rethink for directors.
Carillion: no strict duty to know
The proceedings against the former Carillion NEDs were part of a series of actions brought in the wake of the collapse of the company. The failure of Carillion, as a significant and high-profile company, triggered enormous media interest and political activity, and resulted in numerous investigations and proceedings. For its part, the Secretary of State through the Insolvency Service (IS) commenced disqualification proceedings in 2021 against eight former directors of the company (five of whom were NEDs), as a follow-on to an investigation carried out by the Official Receiver into the insolvency of the company and the conduct of its former directors. Over two years into these proceedings, the three executive directors each accepted disqualification undertakings, though without any admission of alleged fraud or any direct knowledge or involvement in the preparation of incorrect accounts, which were at the heart of the IS's allegations in the proceedings.
The proceedings against the NEDs however were due to go to trial in October 2023, where the court would have considered the allegations made by the IS that the NEDs were in breach of an asserted strict duty to know the “true” financial position of Carillion at all times (described as the so-called “NED Duty”). On the basis of the alleged breach of this asserted NED Duty, the IS argued that the NEDs were unfit to be involved in the management of any company. The idea of a strict duty on directors to know was novel and runs counter to the statutory statement of duties in CA2006 (in particular section 174, where the duty of care, skill and diligence owed by a director to the company is considered both objectively, by way of a reasonableness test, and subjectively, against the situation of the individual director).
There is no strict duty to know for any director, executive or non-executive, for the simple reason that it would subject them to an almost impossible standard - akin to omniscience extending to every aspect of a company's business. That standard would be unattainable by any executive director and is even more obviously incompatible with the concept of non-executive directorship, where the expectations of a non-executive's role are fundamentally different to that of an executive director.
Director disqualification proceedingsDirector disqualification orders require a formal court application, which entails substantive civil proceedings before a court, including a trial and a decision by a judge - neither the IS nor the Secretary of State has the power themselves to disqualify. These proceedings are conducted under Part 8 of the Civil Procedure Rules which, unusually, do not require the filing of formal pleadings. As such, this can present certain challenges for defendants in terms of understanding the precise case they have to meet. Depending on the grounds for disqualification, the court may disqualify individuals from acting as directors for between two and 15 years under the Company Directors Disqualification Act 1986. That Act prescribes various grounds for disqualification, including failure to comply with statutory provisions regarding accounts; conduct in relation to a corporate insolvency making the director unfit to be concerned in the management of any company; and wrongful trading under the Insolvency Act 1986. In terms of "unfitness", it is not necessary to establish breach of a director's duty, but nor will a breach of duty necessarily amount to unfitness, given the high bar for disqualification to be justified. There is no statutory definition of "unfitness", but it has generally been understood in case law to amount to a want of probity or gross (or very serious) incompetence, given that disqualification sufficiently constrains work opportunities for many directors, and is a standard of unfitness to be a director of any company at all, including for example a small charitable company. A disqualification order would prevent a director from acting as a director of, and from being concerned in the management of, a relevant company. As an alternative to a disqualification order, the IS may request an undertaking from a director that he or she will not act as a director for a period of between two and 15 years. |
Had the applicants in either of these proceedings succeeded, the impact would have represented a fundamental change to the legal role of directors and added significant liability burden and risk to those carrying out their roles as directors.
James Palmer
Partner, London
ClientEarth: courts will respect good faith decisions of the board
The court had to consider an equally novel contended extension of directors' duties as part of the claims made by ClientEarth in its application for permission to commence a derivative shareholder action on behalf of Shell plc against its directors. ClientEarth alleged that the directors had breached their statutory duties to Shell through their response to the risks posed to Shell's business by climate change. As well as the statutory duties set out in the CA2006, ClientEarth argued that the directors were subject to six “necessary incidents” of the statutory duties, which applied “when considering climate risk for a company such as Shell”.
The court, both on the papers and then following an oral hearing, rejected this argument and determined that these incidental duties were both misconceived (in trying to impose specific obligations on the directors on how to manage the business of the company) and irreconcilable with the duty to exercise reasonable care, skill and diligence, as set out in section 174. The court was critical of the way in which ClientEarth put its case, seeking to impose new and absolute duties on the directors in the performance of their duty to promote the success of the company and act with care, skill and diligence. The case illustrates the general reluctance of the judiciary to interfere in company management decisions, including how the directors determine to best promote the success of the company.
Seeking permission to bring a derivative action under CA2006The procedure for bringing a derivative action is different to commencing other legal claims since derivative claims are an exception to the principle of company law that the company itself, not its shareholders, must determine whether or not to pursue a cause of action that may be available to the company. Accordingly in order for a shareholder to bring a derivative action under Part 11 of the CA2006, section 261 CA2006 requires the shareholder to obtain the court’s permission to bring the claim. The court will dismiss the application, if the application itself and the evidence filed in support of it do not disclose a prima facie case for giving permission. The purpose of this permission stage of the process has been said to provide a filter for “unmeritorious” or “clearly undeserving” cases and it imposes an evidential burden on the applicant at the outset. The court considers the matter on the papers in the first instance, and the defendant parties are not made respondents to the application at this stage. If the application is dismissed, the applicant shareholder has a 7-day window in which to request an oral hearing to reconsider the decision. If the court concludes that a prima facie case for giving permission has been established, the court will then order the defendant parties to be made respondents to the permission application and give directions for a substantive hearing of that application. |
Post Carillion and ClientEarth: the status quo prevails
Despite the intense interest that these two situations generated, if there are lessons to be learnt from their outcomes then these lessons include that the law on directors' duties in England and Wales remains well developed and the courts will generally not be amenable to novel extensions of these duties. The Carillion and ClientEarth proceedings can act as a useful opportunity to remind directors of the practical steps that they can take to comply with the duties they owe (see checklist below).
Whilst ultimately these proceedings have not changed this area of law, there is a development potentially still on the horizon which could have a significant impact. As part of its consultation on reforms to audit and corporate governance, which was instigated originally in 2017, in part in reaction to the collapse of Carillion, in May 2022 the then government proposed empowering the Audit, Reporting and Governance Authority (ARGA), the successor regulator to the Financial Reporting Council, to have expanded direct regulatory authority over directors. The proposed expanded remit would include regulating and then bringing and adjudicating enforcement actions against larger company directors for alleged breaches of their duties in relation to the preparation and audit of company accounts and other disclosures, notwithstanding the pre-existing roles of the courts and the Financial Conduct Authority (FCA) in this area.
Since then, these reform proposals, along with the trend for ever greater burdens on legitimate businesses, have been more widely challenged (see our article "All change please: Governance reform proposals round-up" for more on reforms in this areas). The asserted benefits of various measures have been questioned in a recent more evidence-based political context for business regulation. However, uncertainty remains as to which, if any, of the proposed ARGA reforms will be adopted going forward. There is widespread support for a number of the proposed reforms regarding the ARGA’s status, funding and information powers. In contrast, there are considerable concerns about the proposal for the ARGA effectively to become the rule maker and prosecutor for directors’ disclosure responsibilities and for its tribunals to replace, or duplicate, the courts and the FCA tribunals as the relevant judges of these issues. Such a proposal would in practice supplant the role of the courts as the trusted and experienced adjudicators of directors’ duties, as well as duplicating the remit of the FCA in relation to directors of listed companies.
If reform of enforcement of directors’ disclosure duties are further considered, the importance of preserving the longstanding trust in and value of the courts’ role in regulating directors’ duties must not be underestimated. It is suggested that any further reforms in this area need to be approached with an evidence-based mindset, care for UK competitiveness and recognition of the realities of what individuals can and cannot achieve in governing businesses. That approach was largely absent from the development of the 2022 proposals, where the company law and directors’ duties and liability implications were barely acknowledged.
Selected advice for NEDs following these cases[1]
|
[1] For more detailed guidance on directors' duties, see the GC100's "Guidance on directors' duties: Section 172 and stakeholder considerations" (October 2018)
More from this series
19 June 2024
"Understanding is a two-way street" – Improving dialogue with investors
19 June 2024
All change please? Governance reform proposals round-up
19 June 2024
Seeing the wood for the trees – Are we at peak reporting?
19 June 2024
What's up in the world of executive pay?
19 June 2024
'Think for yourself' – FRC chief on the future of corporate governance
19 June 2024
Podcast: Manifesto pledges & corporate governance
Key contacts
Legal Notice
The contents of this publication are for reference purposes only and may not be current as at the date of accessing this publication. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on this publication.
© Herbert Smith Freehills 2024