The of directors to manage the company and take

The effectiveness of
section 172 Companies Act 2006

 

1. Introduction

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Companies can act through two main bodies
of persons: its shareholders and the board of directors. It is the job of the
board of directors to manage the company and take care of its day-to-day
business. As such, the board of directors has the task to make the companies’
strategic and operational decisions and to make sure that the company fulfils
its statutory obligations.

 

The directors can be seen as agents of
the company as they are appointed by the companies’ shareholders in the annual
general meeting (AGM). The directors typically act as one board, but certain
powers may be delegated to individual directors or committees. The law then
imposes certain duties upon directors because they are in a position of trust
and have a lot of decision-making power1 within
the company. These directors’ duties are laid down in section 171-177 Companies
Act (CA) 2006 and aim to prevent abuse of the directors’ power as much as
possible. As such, much of the current UK company law regime can be seen as a
balance between directors’ discretion in decision-making and limitation of this
discretion to prevent abuse of power.

 

In order to assess whether directors’
duties ensure that a good job, this essay will focus and critically analyze one
specific directors’ duty under the current CA 2006 regime: the duty to promote
the success of the company (section 172 CA 2006). One could argue that the duty
to promote the success of the company is the most fundamental of the general
duties and is “crucial to the performance of directors’ duties under the new
legislation.”2
Consequently, the duty to promote the success of the company is an essential
provision in safeguarding that directors do a good job, but this essay will
later show that, at the same time, it can also raise difficult questions for directors,
courts and scholars. Ultimately, ‘success’ is a subjective definition and it
may be perceived differently by shareholders and stakeholders. Consequently, one
may wonder how far the interests of non-shareholding groups need to be taken
into account when ‘promoting the success of the company’.

 

Firstly, this essay will describe the
overall directors’ duties as stipulated under the CA 2006 and provide
background information about the CA 2006. Secondly, this essay will analyze the
effectiveness of section 172 CA 2006, by examining the wording of the section,
compliance issues and enforcement issues. Finally, this essay will critically
assess whether this directors’ duty under the CA 2006 ensures that directors do
a good job. 

 

2. Directors’ duties
under the CA 2006

 

Following the consultation paper of the
Law Commission and Scottish Law Commission in 1999 a large part of the
directors’ duties that were previously unwritten, were codified and can now be
found in section 171-177 CA 2006.3 The
outcome of the reform was the concept of ‘Enlightened Shareholder Value’ (ESV)
which has led to directors being required to give a wider range of
consideration towards stakeholders interests.

 

The directors’ duties in section
171-177 CA 2006 are the following:

 

1. Section 171: to
act within powers

2. Section 172: to
promote the success of the company

3. Section 173: to
exercise independent judgment

4. Section 174: to
exercise reasonable care, skill and diligence

5. Section 175: to
avoid conflict of interest

6. Section 176: not
to accept benefits from third parties

7. Section 177: to
declare interest in a proposed action or arrangement of the company

 

These duties are owed to the company
following section 170 CA 2006 and they apply to every director within the
company and it is the company that has the power to enforce them. One could
argue that directors will greatly benefit from codification of these duties as
they provide a clear overview. However, one may also argue that codification
has led to some confusion and uncertainty in some circumstances. For instance,
it could prove very difficult to define ‘success’ in section 172 CA 2006 as
directors may not only look at just making profits for shareholders, but they
may adopt a wider stakeholder view and look at other factors such as the
environment. Consequently, this begs the question how directors will weigh the
interests of shareholders and other stakeholders when they make decisions in
order to promote the success of the company. This highlights that it is
difficult to assess whether directors are in breach of their duties. In the the
remainder of the essay we will critically analyze the effectiveness of one
specific and fundamental directors’ duty: the duty to promote the success of the
company.

 

3. Analysis of section 172 CA 2006

 

This paragraph will give a critical
analysis of the directors’ duty to promote the success of the company (section
172 CA 2006) by examining the law, literature and case law.

 

3.1 Duty to promote the success of the company

 

The duty to promote the success of the
company in section 172(1) CA 2006 can be split in two parts. The first part is
an objective statement which stipulates that the director “must act in a way
he considers, in good faith, would be most likely to promote the success of the
company for the benefit of its members as a whole.” This part codifies the
position laid down in Smith & Fawcett Ltd 1942 Ch 304 that
directors must act bona fide in what they consider as the best interests of the
corporation and not what the courts might consider is in the best interests of
the corporation. As long as directors live up to this standard, they are
allowed to make honest mistakes and there will not be any reason to hold them
liable for negligence. As such, courts have always been very reluctant to
review commercial business decisions. 

 

The objective statement consists of
three main elements. The first element is ‘good faith’ which implies that as
long as directors make decisions in an honest manner and keepings their
responsibilities at all times in mind, they can freely exercise their
decision-making powers. The second element is the previously discussed
‘success’. The CA 2006 does not give any insight what constitutes success, but
explanatory notes by the Department of Trade and Industry (DTI) highlight that
what constitutes success is a matter of good faith judgment by directors.4 The
Association of Chartered Certified Accountants (ACCA) mentions that success
would imply achieving any objectives that the company has set for itself,
whether they are strategic, financial or otherwise.5 The
third element is that the success of the company must be ‘promoted for the
members as a whole’. This implies that success of the company must be achieved
all the members of the company and not just for a few selected individuals.6

 

The second part of section 172(1) CA
2006 then gives a non-exhaustive list of matters directors need to have regard
to. The listed matters can be seen as further codification of the ESV. ESV embodies
the believe that the interest of the members of the company are best promoted
when the interests of stakeholders are also taken into account.7 The list
is as follows:

 

“(a) the likely
consequences of any decision in the long term,

(b) the interests
of the company’s employees,

(c) the need to
foster the company’s business relationships with suppliers, customers and
others,

(d) the impact of
the company’s operations on the community and the environment,

(e) the
desirability of the company maintaining a reputation for high standards of
business conduct, and

(f) the need to
act fairly as between members of the company.”

 

Two main questions
arise out of this part of the statement: (1) what constitutes directors ‘having
regard’ to the listed matters and (2) how should directors handle a potential
conflict between any of these matters?

 

The CA 2006 does
not give any definition of ‘having regard’ and the DTI’s explanatory note
merely remark that it would not be sufficient “to pay lip service” to the
listed factors.8
Moreover, it is mentioned that when ‘having regard’ to the listed factors,
directors must meet the test of reasonable care, skill and diligence as
stipulated in section 174 CA 2006. However, it is not defined what weight ought
given to the listed factors when directors have to make a decision. It does
seem obvious that directors can not be expected to make decisions which favor
all of the listed factors as they may conflict with each other. For instance, a
company could shut down one of its underperforming factories in a location with
high employment which would negatively affect the local community at the place
of that factory. It would therefore definitely be a decision that goes against
the interest of (many) employees. On the other hand, the decision to cut off an
underperforming part of the business could positively affect the company’s
long-term economic interests and protect the rest of the employees from losing
their jobs.9
This highlights the difficulty for directors in complying with section 172 CA
2006 which naturally leads to courts being reluctant in reviewing honest
business decisions.

 

As previously
stated, section 172(1) CA 2006 creates a formal obligation for directors to
consider stakeholders’ interests in the process of decision-making. However, it
is of importance to note that the interests of shareholders remain dominant. The
interests of stakeholders are only to be considered only as long as it would
“promote the success of the company for the benefit of its members”.10 As
such, directors would not be obliged to consider stakeholder interests beyond
the point where would be in dispute with the overriding duty to promote the
success of the company.11
Furthermore, the section does not state that any separate duty is owed to
stakeholders.12
Consequently, section 172 CA 2006 can ultimately be regarded as a
representation of the dominant shareholder approach.13 The
considerations that directors make must be as such that they do not impinge on
the benefits of shareholders.14

 

The formal obligation
to consider interests of stakeholders may appear appear as a novelty. However,
when it comes to the interests of creditors, section 172(3) CA 2006 is in fact
a restatement of existing law as it does require directors to consider the
interests of creditors in certain circumstances. This is in line with existing
statutory provisions that seek to protect creditors such as wrongful trading in
section 214 Insolvency Act 1986. At the same time, it confirms the common law
approach that posits a duty on directors to consider creditors’ interest in
financially difficult times.15

 

Finally, section
170(3) CA 2006 states that the duties are based on common law and equitable
principles and they are therefore to interpreted and applied in the same
manner. In addition, the few cases about section 172 CA 2006  suggest that the section simply forms a
codification of pre-existing law.16 This
further weakens the notion that section 172(1) CA 2006 actually fortifies the
position of stakeholders. Section 172 CA 2006 can, thus, ultimately be seen as
a reiteration of the dominant shareholder-orientated view to corporate law and
corporate governance. 

 

3.2 Compliance with section 172 CA 2006

 

For individual
directors, compliance with the decision-making procedure as stipulated in
section 172(1) CA 2006 is of the utmost importance. The CA 2006 does not give
any leads on how directors should demonstrate their compliance with section 172
CA 2006 in the board minutes. Usually, the board minutes will only include the
record decisions and not the factors that were considered before making that
particular decision. Since the purpose of the CA 2006 seems to be to bring more
structure and clarity in  the
decision-making process, it seems only logical to include the considered
factors in the board minutes when a decision is being made. When directors are
being accused of being in breach with section 172 CA 2006 by shareholders or a
liquidator, they will have a better time to defend their decisions if they can
show evidence that they attempted to comply with statutory provisions. It might
therefore be better to adopt a ‘better safe than sorry’ approach and include at
least a reference in their board minutes that they complied with the
decision-making procedure as set out in section 172 CA 2006.17 Thus,
in the situation where directors have to make a decision that includes multiple
opposing factors, directors would clearly benefit from recording the reasons as
to why a certain option was considered to be the most likely to promote the
success of the company.18

 

3.3 Enforcement of section 172 CA 2006

 

The effectiveness
of section 172 CA 2006 greatly depends on its degree of enforceability. Following
section 260(3) CA 2006 a derivative action may be brought as a procedure to
enforce directors’ duties. However, only shareholders may bring a derivative
action against the company contrary to stakeholders, who have no such right.19 The
reason for this is that, in some circumstances, the duty to promote the success
of the company under section 172 CA 2006 is owed to the company.20 As a
result, only shareholders can, in some circumstances, start derivate actions on
behalf of the company. Consequently, stakeholders are completely dependent on
shareholders to start a derivative action to challenge a directors’ failure to
comply with section 172 CA 2006. As such, for stakeholders, the enforceability
of section 172 CA 2006 is deeply limited as they have to rely on altruistic or
activist shareholders to enforce stakeholder interests.21

 

However, even shareholders
have a hard time to start a derivative action as a number of obstacles need to
be overcome to successfully start a claim. The process in itself is very
complex, costly and time-consuming. First, the claimant must demonstrate that
there is a prima facie case.22 In case
that the court accepts this, then a hearing follows to obtain permission to
start a derivative action. Section 263(3) then sets out six aspects that courts
must consider when they assess whether the application. The procedure gives the
court the task to decide whether litigation is actually in the best interest of
the company.23
Most claims will fail here due to the discretion that directors have in the
decision-making process. In the end, it is always up to the directors to decide
in good faith what ‘success’ constitutes and what is most likely to promote the
success of the company. In addition, courts have always been very reluctant to
review business decisions as they will not use hindsight.24 It was
always the intention that derivative claims would be subjected to strict
judicial control25
as the derivative claim remains a remedy of last resort.26

 

Finally, the cost
of litigation is a very prominent practical obstacle as the procedure is
lengthy and all potential rewards will go into the company’s purse. As a
result, the procedure to start a derivative claim does not incentivize
shareholders whatsoever to enter into litigation. On the contrary, it is more
probable that dissatisfied shareholders will sell their shares and seek other
investment opportunities that are more in line with their views.27

 

4. Conclusion

 

The aim of this essay was to examine
whether section 172 CA 2006, which sets out the directors’ duty to promote the
success of the company, ensures that directors do a good job. While section 172
CA 2006 definitely provides some educational insight for directors in what is
expected of them in the decision-making process, this essay remains skeptical
about whether it actually ensures that directors’ do a good job. The duty to
promote the success of the company in section 172 CA 2006 can be more
problematic than one would think as there is no clear definition of ‘success’
and therefore it may be interpreted differently by shareholders and
stakeholders. Moreover, the enforcement of section 172 2006 has proven to be
very limited for various reasons. Stakeholders have no remedy whatsoever which
makes one question as to why their interests are mentioned in section 172 in
the first place. In the end one could say that a right without a remedy is essentially
useless. Furthermore, even shareholders will find it difficult to enforce
section 172 CA 2006 as the derivative action is costly, complex and
time-consuming. In addition, perceived non-compliance with section 172 CA 2006
will be very difficult to prove as it is highly subjective what is most likely
to promote the success of the company. As a result, courts have always been and
will rightly continue to be reluctant to review business judgments as it is not
their job to decide, in hindsight, what is most likely to promote the success
of the company. This leads this essay to conclude that section 172 CA 2006 has
limited influence on managerial performance as managerial discretion is wide
and enforcement of the statutory provision is limited.

1 The directors’ decision-making power can be derived from article 3 of
the Companies (Model Articles) Association 2008.

2 This essay will also briefly mention the other directors’ duties as they
naturally are also important in ensuring that directors’ do a good job.

However, since the essay is limited to a maximum of 3000 words, the choice was
made to especially focus on section 172 CA 2006 as it could be argued this
duties is the most fundamental one of all the general duties in ensuring that
directors do a good job. See ACCA, ‘A guide to directors’ responsibilities
under the Companies Act 2006′, July 2007, p. 34.

 

3 Before this codification, the law on directors’ duties could be found
in both common law and some statutory law. One may refer to Regal (Hastings) Ltd v Gulliver 1942 1
All ER 378, 1967 2 AC 134 which states that directors have a fiduciary duty
towards the company.

4 Department of Trade and Industry, Explanatory Notes Companies Act 2006,
para. 327.

5 ACCA, ‘A guide to directors’ responsibilities under the Companies Act
2006′, July 2007, p. 34.

6 ACCA, ‘A guide to directors’ responsibilities under the Companies Act
2006′, July 2007, p. 35.

7 See Department of Trade and Industry, Explanatory Notes Companies Act
2006, para. 325.

8 Department of Trade and Industry, Explanatory Notes Companies Act 2006,
para. 328.

9 ACCA, ‘A guide to directors’ responsibilities under
the Companies Act 2006′, July 2007, p. 35-36.

10 Davies (2008), p.

509.

11 Ibid.

12 Keay (2012), p. 17.

13 Davies (2008), p. 509 and ICSA International, Guidance on Directors’
General Duties (2007) 3.2.

14 Keay (2011), p. 28.

15 Gwyer v London
Wharf (Limehouse) Ltd 2003 2 BCLC 153.

16 One may refer to Re Southern
Fresh Foods Ltd 2008 EWHC 2810 and Re West Coast Capital (LIOS) Ltd 2008
CSOH 72.

 

17 Under the
assumption that they also actually have followed the required procedure.

18 ACCA, ‘A guide to directors’ responsibilities under the Companies Act
2006′, July 2007, p. 37.

19 Keay (2007), p. 109.

20 Section
260(1) CA 2006.

21 Keay (2007), p. 609.

22 Section
261(2) CA 2006.

23 Davies (2008), p. 614.

24 Re Welfab
Engineers Ltd 1990 BCC 600.

25 Law Commission (n 36) 6.13.

26 Gibbs (2011), p. 82.

27 Dignam & Lowry (2009), p. 190-191.

 

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