Reforming Director Liability in UK Company Law:
Should UK Company Law adopt the Business Judgment Rule with an Enhanced Duty
of Good Faith?
Abstract:
This research will examine directors’ duties in the English common law and the statutory reform
of these duties under the Companies Act (CA) 2006 in order to determine whether they are
effective in the 21st Century. The reform of directors’ duties was envisaged to develop a much
more responsible system that fits with the nature of modern business, as well as to create a direct
obligation to the shareholder and other interested parties in a company (as identified in s. 172 CA
2006). The aim was to create an Enhanced Shareholder Value (ESV) model. It may be averred that
the fundamental problem that arises is that it does not meet this aim. Thus, it is clear that there has
to be reform of directors’ duties in the CA 2006 to ensure that the common law does not revert
them to the weakened rights of the common law.
This research argues that it is necessary to implement the heightened obligations owed by directors
in the American/US common law, which includes a standalone principle of good faith. However,
to prevent an overly onerous set of obligations, it is necessary that the business judgment rule is
treated as a defence. Thus, this research undertakes a comparative case law review to illustrate
why this reform is necessary.
Table of Contents
Abstract: ........................................................................................................................................ 1
1.0
Introduction: ...................................................................................................................... 3
1.1 Statement of Problem: ........................................................................................................... 3
1.2 Aim and Objectives: .............................................................................................................. 4
1.3 Methodology: ........................................................................................................................ 4
2.0 The Anglo-Common Law Roots of Corporate Governance – The Indoor Management
Rule: ............................................................................................................................................... 6
2.2 The Internal Manager – The Director: ................................................................................. 6
2.3 The Indoor Management Rule, Corporate Governance Codes and Directors’ Duties: ....... 7
2.4 The 2012 Code, Internal Management – The Need for Further Implementation: ................ 8
3.0 Directors’ Duties under the CA 2006 and the English Common Law: ............................ 10
3.1 The Basis of Director’s Duties: ........................................................................................... 10
3.2
Who is the Director? ...................................................................................................... 10
3.3 Directors’ Duties – An Evolution: ...................................................................................... 11
3.4 Directors’ Duties – Merely a Reiteration of the Common Law: ......................................... 13
4.0 Directors’ Duties in the USA and the Business Judgment Rule – Should they be
Implemented in the UK? ............................................................................................................ 14
4.1 The Business Judgment Rule and the American Directors’ Duty: ...................................... 14
4.2 A Case Law Review of the Business Judgment Rule: .......................................................... 15
5.0 Conclusion: Should the Business Judgment be Implemented in the UK? ....................... 18
1.0 Introduction
1.1 Statement of Problem
Director liability is of particular concern within company law because there has to be the correct
balance between lifting the corporate veil and holding the director who has failed in his/her duties
to account.1 The CA 2006 has formulated a number of directors’ duties that are based upon the
common law. There has, however, been an enhancement of this framework, which has given rise
to the new enhanced shareholder value (ESV) model.2 The introduction of the ESV model is
integrally linked to an attempt to increase the responsibility of directors, whilst retaining the
internal management model.3 The system did not go as far as to introduce a statutory corporate
governance model, which is approach taken in the US under the Sarbannes Oxley Act (SOX) 2002.
A potential problem that arises in the UK model is that it has not gone far enough to enforce
directors’ duties. A better approach may have been to introduce an enhanced good faith obligation
(as opposed to the weak reference in the CA 2006) and then provide the American-Style business
judgment rule defence. The purpose of this research is to examine directors’ duties under the CA
2006 to ascertain whether they are adequately holding the director to account. The introduction of
the business judgment rule affords the director an additional defence but this defence is only
appropriate when the directors’ duties have been developed to ensure that there is a high level of
liability present4. MacMillan identifies that:
…The business judgment rule ensures that decisions made by directors in good faith are
protected even though, in retrospect, the decisions prove to be unsound or erroneous. It
provides a deference to prevent courts from second-guessing business decisions that were
made in good faith…5
There is a link to the concept of good faith which is present within English law under the CA 2006
director’s duties, although there is the fundamental problem that arises in the failure to develop
these principles into an effective model of ESV.6 The current model does not hold the director to
account sufficiently, although in abstract the CA 2006 could.7 Courts should interpret director’s
duties in order to increase liability because this was the purpose of the CA 2006.8 This would need
to be coupled with the business judgment defence as there may be instances of a good faith decision
that turns out to be a breach of director’s duties9. Thus, the defence applies to prevent an injustice10.
It may be argued that a better approach to achieving the ESV envisaged by the CA 2006 is to
increase the threshold for escaping liability for breach of director’s duties (i.e. enhancing the good
faith application) and then applying the business judgment defence. This paper will examine the
Parker, H. “Directors' Duties Under the Companies Act 2006: Clarity or Confusion?” (2013) 13 Journal of
Corporate Legal Studies 1, 5
2
Keay, A The Enlightened Shareholder Value Principle and Corporate Governance (Routledge, 2012), 230
3
Ibid, 230
4
MacMillan, L “The Business Judgment Rule as an Immunity Doctrine” (2013) William and Mary Business Law
Review 4(521), 524
5
Ibid, 526-527
6
Keay (n2), 230
7
Ibid, 231
8
Ibid, 231
9
MacMillan (n4), 524
10
Ibid, 524
1
nature of director’s duties under the CA 2006, the effect of the English common law and then
compare it to the approach taken in the American common law where good faith and the business
judgment rule operates.
1.2 Aim and Objectives:
The aim of this research is to evaluate whether American-Style enhanced director’s duties based
upon good faith coupled with the business judgment rule should be implemented into UK company
law. To meet this aim, this research will:
(1) Examine the nature of company law within the Anglo-common law system;
(2) Examine the nature of directors’ duties within English law, considering both the common
law and new statutory system under the CA 2006;
(3) Examine directors’ duties in the American common law and the operation of the business
judgment rule;
(4) Analyse whether American style directors’ duties and the business judgment rule should
be implemented into UK company law.
1.3 Methodology:
This research will undertake a comparative case law study of English and American approaches
to the application of directors’ duties. The purpose of the comparative study is to ascertain whether
it is possible to implement the American model in the UK11, whilst bearing in mind whether the
American model is in fact an improvement on the current approach within the CA 2006. The
American model provides a good case study country because its roots are in the English common
law; the same basic legal footing is present that enables the UK model to lend from the American
model (and vice versa).12 Although a case law review is at the centre of this comparative study, it
will not focus on a purely black-letter law approach13. Instead a purposive approach has to take
place14, especially when the CA 2006 does enhance directors’ duties but the case law does not
necessarily reflect this. Therefore, a comprehensive and purposive application of the law will take
place, in order to determine whether there has to be further reform of directors’ duties and the
implementation of the business judgment rule in the UK.
1.4 Chapter Synopsis:
This research will consist of four chapters, which are as follows:
Chapter 2.0: This chapter will examine the nature of company law within the Anglo-common law
system, which underpins both English and American model. The Anglo-common law model of
corporate governance relies upon the indoor management rule, which focuses on the autonomy of
the company contract. The divergences of the US and UK approaches will be briefly touched upon.
Chapter 3.0: This chapter will examine directors’ duties within the CA 2006 and the common law
development. The purpose of this chapter is to explore the traditional approach to directors’ duties
11
Zweigert, K and Kotz, H An Introduction to Comparative Law (trans Tony Weir) (3rd Edition, OUP, 1988), 40
Nelken, D “Culture, Legal” in Clark, DS. (ed.) Encyclopedia of Law and Society: American and Global
Perspective (Sage, 2007), 369
13
Hill, DK “Law School, Legal Education and the Black Letter Law Student” (1986) 12 T Marshall Law Review
557, 452
14
Zweigert, & Kotz (n11), 40
12
and then engage with the ESV model that the CA 2006 duties are meant to embrace. Two questions
will be raised, which are: (i) has the ESV model been achieved; and (ii) does there have to be
further enhancement of directors’ duties.
Chapter 4.0: This chapter will explore American common law directors’ duties and compare them
to the English approach, as identified in Chapter 3.0. The discussion will focus on the different
approaches to good faith within the context of directors’ duties, in order to highlight how the
American common law provides a more enhanced obligation. Then it applies the business
judgment rule to soften the effect of the enhanced duties. Thus, this chapter will conclude by
considering whether the American approach to directors’ duties with the business judgment rule
should be implemented into UK company law.
Chapter 5.0: This chapter will conclude with a concise summary of findings and
recommendations that answer the question whether there should be a good faith enhancement of
directors’ duties and the introduction of the business judgment rule in the CA 2006.
2.0 The Anglo-Common Law Roots of Corporate Governance – The Indoor Management
Rule:
2.1 The Internal Management Rule – An Overview:
The indoor management rule is at the centre of the English common law model where the primary
concern is that the company is governed by itself with little intervention by the courts and
judiciary.15 This means that any legal framework has to be based upon the general premise of
supporting the company contract, although there is a valid concept of promoting sustainability in
maintaining the company within a framework of national standards16. Kraakman et al identify that
within the Anglo-common law model, “the primary corporate governance issue is considered to
be ameliorating managerial agency costs rather than limiting self-dealing by major
shareholders”.17 A primary concern of company law is to promote self-governance and policing
by the shareholder body by ensuring that minimum standards of corporate governance are met.
The exact implementation of this self-dealing varies because English law retains the voluntary
code18, whilst the US applies a legislative approach under the Sarbannes SOX 2002 with other
stakeholder legislative measures19. Corporate governance is based upon internal management
where the law supports the minimum standards that are owed to the company.
2.2 The Internal Manager – The Director:
The director is the internal manager of the company who is governed by the company contract (i.e.
the articles of association and any other constitutional agreement) and decisions of the voting body
(i.e. shareholders).20 This integrative model stems from the theory of Adam Smith, which provides
that:
…The directors of such companies, however, being the managers rather of other people’s
money than of their own, it cannot well be expected, that they should watch over it with
the same anxious vigilance with which the partners in a private copartnery frequently watch
over their own… Negligence and profusion, therefore, must always prevail, more or less,
in the management of the affairs of such a company…21
The general premise of the Smithian model is that a self-interested person is the best person to be
involved in the policing and managing of the company.22 This means that the shareholder manager
is the most appropriate party to promote the best interests of the company23, because if there is
.Armour, J, B.S. Black, B.R .Cheffins and R. Nolan, ‘Private Enforcement of Corporate Law: An Empirical
Comparison of the UK and the US’ (2009) 6 Journal of Empirical Legal Studies 687
16
Parker, H. “Directors' Duties Under the Companies Act 2006: Clarity or Confusion?” (2013) 13 Journal of
Corporate Legal Studies 1, 5
17
Armour (n4) 690
18
.Armour, ‘Enforcement Strategies in UK Corporate Governance: A Roadmap and Empirical Assessment’; in J
Armour and J Payne (eds), Rationality in Company Law (Oxford: Hart Publishing 2009) copy available at:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1133542 accessed June 25, 2015, 5
19
Mallen, C Corporate Governance (3rd Ed, OUP, 2009), 10
20
French , D, Mayson, S and Ryan, C Mayson Ryan and French on Company Law, (OUP, 2010) 89
21
Smith, A (1776) The Wealth of Nations (Digireads, 2004) 439
22
Carrillo, E “Corporate Governance: Shareholders’ Interests and other Stakeholders’ Interests”, (2007) Corporate
Ownership and Control 4, 98
23
Jensen, M. and Meckling, W. “Theory of the firm managerial behaviour, agency costs and
ownership structure”, (1976), Journal of Financial Economics, 32(305), 359
15
mismanagement there will be an economic effect on the company’s bottom line24. This has proven
not to be entirely the case of the most modern version of the Cadbury Code in the UK (i.e. the
Corporate Governance Code 2012 (2012 Code)), which retains the “comply and explain” approach
whilst introducing a number of minimum expectations that should be followed by directors to have
a sustainably managed company.
2.3 The Indoor Management Rule, Corporate Governance Codes and Directors’ Duties:
The 2012 Code provides that the “comply or explain” approach is the trademark of corporate
governance in the UK. It has been in operation since the Code’s beginnings and is the foundation
of the Code’s flexibility”.25 This means that the flexibility of the model will retain the internal
management model but the 2012 Code provides best practice.26 The SOX application of the USA
applies a similar model but it is enshrined in a statutory duty as opposed a code of best practice.
The fundamental common law principle of internal management is identified in the case of Shaw
& Sons v Shaw27where the management of the company was undertaken by the directors appointed
in the company constitution, which was policed by the shareholders through voting rights. For this
model to operate effectively it is necessary that there is effective and proactive policing by the
shareholder body, which is less prevalent due to the nature of large companies becoming dispersed
with institutional investors becoming representative of mass shareholder units28. Shareholder
governance is more of a myth because the individual shareholder may not effectively exercise their
rights29, which enables the potential for abuse by directors and the majority because the opposing
voice may not be heard30 or there is such a dispersion that there is a lack of knowledge of
wrongdoing because there is not a direct check and balance as seen the Enron scandal31. Thus, the
development of prudent legal principles, in order to ensure that there is an effective policing model
in place within the context of the internal management rule.
The CA 2006 and SOX 2002 are examples of implementing legislation to bolster director liability
within international law by adding additional tools to counter the dispersing of shareholder power.
Friedman argues that:“There is one and only one social responsibility of business--to use its
resources and engage in activities designed to increase its profits so long as it stays within the rules
of the game, which is to say, engages in open and free competition without deception or fraud"32.
The implication is that the director has a broad latitude in his/her management of the company, as
long as he is acting within the scope of the company’s constitution and is promoting the success
of the company33. The main problem is that without effective checks and balances through
Eisenberg, M ‘The divergent standards of conduct and standards of review in corporate law’ (1993) 62 Fordham
Law Review. 438, 440
25
Financial Reporting Council The UK Corporate Governance Code September 2013, 4 (2012 Code)
26
Stokes, M “Company and Legal Theory” in Twining W Legal Theory and the Common Law (Basil-Blackwell,
1986), 163
27
Shaw & Sons (Salford) Ltd v Shaw [1935]2 K.B. 113
28
Bebchuk, LA “The Case for Increasing Shareholder Power” (2005) Harvard Law Review 118(833), 885
29
Nolan, RC ‘The Continuing Evolution of Shareholder Governance’, (2006) 65 Cambridge Law Journal 92, 93
30
Moore, MT Corporate Governance in the Shadow of the State (Hart, 2013), 273
31
Li, Y "The Case Analysis of the Scandal of Enron” (2010) International Journal of Business and Management
5(37), 37
32
Friedman, M. “The Social Responsibility of Business is to Increase its Profits” (1970)The New York Times
Magazine (September 13)
33
Bloomfield, S Theory and Practice of Corporate Governance: An Integrated Approach (CUP, 2013), 203
24
shareholder policing, the internal management model can fail34. Thus, the introduction of corporate
governance codes (or laws in the USA) were implemented to raise standards.
2.4 The 2012 Code, Internal Management – The Need for Further Implementation:
The Cadbury Code identified that “corporate governance cannot be achieved by structures and
rules alone. They... encourage and support good governance, but what counts are the ways in which
they are put to use”35, as long as coupled with responsible directors. Common law was identified
as being insufficient, which resulted in the evolution of the Cadbury Code to the 2012 Code and
the implementation of enhanced directors’ duties under the CA 2006.
The 2012 Code provides that there has to be promotion of five core requirements for sustainability,
which are: leadership, effectiveness, accountability, remuneration and relations with
shareholders36. The lynchpin of sustainable company management is the application of directors’
duties that promote responsibility. The 2012 Code supports this principle but identifies additional
principles that directors and companies should follow to promote the success of the company.
Principle A1 of the 2012 Code states that“Every company should be headed by an effective board
which is collectively responsible for the long-term success of the company”37.
The long-term success of the company requires the directors to consider the role of shareholders
and other parties that are essential to the effective management of the company38. This builds upon
the CA 2006 reforms, which emanate from the Law Commission’s Company Law Review in 2000,
which requires a “proper balanced view of the short and long term; the need to sustain effective
ongoing relationships with employees, customers, suppliers and others”39. The directors’ duties
in the CA 2006 enshrines this principle through extending the application of tem where company
success includes more normative concepts, such as reputation as opposed to merely the bottom
line. Nonetheless, the traditional principles of company success and the bottom line has been
retained within the case law, even after the implementation of the CA 2006.40 The inference is that
it is necessary to heighten these directors’ duties further, which is what is being suggested within
this research whilst adding the business judgment rule.
The UK has adopted a mixed statutory and voluntary model, in order to promote good company
governance. For example, it was recognised that the traditional shareholder-director relationship
has changed, which means that there has to be added safeguards. One such example is Principle
A4 of the 2012 Code, which provides that “non-executive directors should constructively
challenge and help develop proposals on strategy”41. This means that non-interested directors has
been introduced to provide an objective monitor. This monitor can help to achieve Principle E4 of
the 2012 Code, which identifies that:
34
La Porta, Rafael & Lopez-de-Silanes, Florencio & Schleifer, Andrei & Vishny, Robert, "Investor Protection and
Corporate Governance," (2001) Working Paper Series rwp01-017, Harvard University, John F. Kennedy School of
Government, 15
35
Cadbury Report of the Committee on the Financial Aspects of Corporate Governance, December 1992, para. 3.13.`
36
Financial Reporting Council, (n25), 6-7
37
Ibid, 8
38
Ibid
39
Company Law Review, Modern Company Law for a Competitive Economy, Developing the Framework (DTI,
2000), para 2.19
40
Re West Coast Capital (LIOS) Ltd (2008) CSOH 72; Cobden Investments Ltd v RWM Langport Ltd (2008)
EWHC 2810 (Ch)
41
Financial Reporting Council, (n25), 10
“There should be a dialogue with shareholders based on the mutual understanding of
objectives. The board as a whole has responsibility for ensuring that a satisfactory dialogue
with shareholders takes place”42.
This dialogue is essential to promote shareholder policing, which is at the centre of the internal
management model. The fundamental problem is that this model may not have the correct balance
between the statutory and voluntary elements of a modern internal management model. The ESV
model that the CA 2006 may have the potential of achieving this aim, but there has to be
examination of the application of these duties to determine whether further reform is required.
42
Ibid, 24
3.0 Directors’ Duties under the CA 2006 and the English Common Law:
3.1 The Basis of Director’s Duties:
Directors’ duties are fundamental to the indoor management rule because seek to ensure the checks
and balances in the power of the director. The power of the director can be linked to the majority
or certain elements of the shareholder body to create self-interested allegiances that may result in
oppression of the minority and undermine the sustainability of the company43. This means that the
role of directors’ duties are important to ensure that such actions do not take place. This means
that the court should have sufficient direction to uphold directors’ duties. If this is lacking then
there will not be a balance between the internal management and statutory measures that are
capable of providing sufficient safeguards which prevent an abuse by a director. Wan argues that:
“The court should scrutinise the decision-making process of the board to ensure that the
board considers the stakeholders’ interests and that the board acts fairly in considering the
long-term and short-term shareholders’ interests”44.
The fundamental problem that arises is that the internal management model relies upon minimal
intervention by the law, which means that the balance between intervention and internal
management is paramount. The basis of the English and American directors’ duties have the same
foundations, which is identified by Eisenberg as a “standard of "care that an ordinarily prudent
person would reasonably be expected to exercise in a like position and under similar
circumstances".45 This standard of care is “both subjective and objective. The director or officer
must subjectively believe that his conduct is in the best interests of the corporation, and that belief
must be objectively reasonable”46. This means that if the prudent person would not act in a similar
manner then it is unreasonable and there is a breach of directors’ duties if the intention is associated
with either a willful or reckless act47. The CA 2006 has attempted to find this balance through the
ESV model. Nevertheless, the problem is that this standard may not have been met due to the
courts failing to apply a purposive approach to the enhanced directors’ duties.
3.2 Who is the Director?
If the internal management model is to be effective then it is necessary to implement legislation
that creates an effective check on the power of directors. The ESV model of the CA 2006 has taken
this aboard and extended the definition of a director. There are two potential director groups, which
are: (i) those individuals that are named in the company’s constitution; and (ii) individuals that
have the control or power to influence the management of the company (i.e. a de facto/shadow
director). The first group is linked to the constitutional framework under s. 33 CA 2006 and
confirmed in s. 250 CA 2006. The second group has been recognised in s. 251 CA 2006, which
provides “in the Companies Acts “shadow director”, in relation to a company, means a person in
accordance with whose directions or instructions the directors of the company are accustomed to
act”48. The statutory recognition of shadow/de facto directors is an important development because
Wan, WY “Takeovers and Countering Short-termism in Target Boardrooms: Part 1” (2013) Company Lawyer
34(43), 43
44
Ibid, 68
45
Eisenberg, M ‘The divergent standards of conduct and standards of review in corporate law’ (1993) 62 Fordham
Law Review. 438, 440
46
Ibid, 440
47
Ibi
48
S. 251(1) CA 2006
43
it means that there is an extension of the statutory directors’ duties to these individuals. This
confirms the common law principle that a controlling shareholder that influences the management
of the company will be treated as a director.49 A shadow director will be identified either through
direct or implied used of power.50 Power can be held by a shareholder where there is a history of
deference to the individual that is maintained.51 The primary question that is asked is whether there
is a person outside of the board that has equal or more power than the directors named in the
company constitution.52 The flexible principles that surround who is a director illustrates that the
courts will take a purposive approach to identify who has controlling power in the company, even
if s/he is not named in the company constitution. The implication is that the myth of the common
law merely respecting the company constitution is not strictly true, which indicate that there are
ways to challenge the sanctity of the company contract when it is reasonable to do so.
3.3 Directors’ Duties – An Evolution:
The fundamental principle is that the director has to act reasonably within the powers set down in
the constitution and which encourage directors topromote the best interests of the company.53
There will not be liability for a bad decision, as long as the director has acted in a manner where
it can be reasonably shown that his/her actions were grounded on promoting the best interests of
the company54. The fundamental problem is to ascertain what is in the “best interests” of the
company (i.e. should it be based upon the bottom line or is there a need to consider a broader set
of interests).55 The traditional interpretation has been linked to the bottom line and following the
direction of the majority56. The problem with this application is that it can result in the
marginalisation of the minority and the sustainability of the company can be sacrificed for the
bottom line.57 The introduction of the CA 2006 was to clarify directors’ duties, in order to promote
sustainability within the management of the company.58
Section 170 provides that the existing directors’ duties are not to replace the common law; rather
there is meant to be enhancement of the common law through codification. As s. 170(3) CA 2006
provides:
“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”.
This means that the common law remains the source of interpreting directors’ duties set out in ss.
171 to 177 CA 2006, which means that there may be little effect of the ESV model if the common
law is not approached with purposive interpretation by the courts.59 The primacy of the deference
49
Bushell v Faith [1969] 1 All ER 1002
Secretary of State for Trade and Industry v Devrell [2000] 2 WLR 9070
51
Kuwait Asia Bank EC v National Mutual Life Nominees Ltd [1990] BCC 567
52
Re Hydrodan (Corby) Ltd [1994] BCC 161
53
Riley, CA ‘The Director’s Duty of Care and Skill: The Case For an Onerous But Subjective Standard’ (1999)
Modern Law Review 697, 697-8
54
Ibid, 698
55
Reisberg, A ‘Shadows of the Past and Back to the Future: Part 11 of the UK Companies Act 2006 (in)action’
(2009) 6 European and Company Financial Law Review 219, 221
56
Ibid, 221
57
Ibid, 222
58
Ibid
59
Ibid, 222
50
to the company constitution and consequently the majority rule principle within the common law
is retained in s. 171 CA 2006. Section 171 CA 2006 provides that a director must: “(a) within the
powers that have been given through the company’s constitution; and (b) exercise these powers
within the limits prescribed by the constitution”.60 This requirement is necessary to the internal
management rule; however, the problem that arises is that without greater direction whether there
should be an enhanced examination of the sustainability of the company then the enhancement of
directors’ duties has not occurred.
Probably one of the most important sections on directors’ duties is s. 172 CA 2006 because it
provides that the director “must act in the 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”61. The use of this
terminology could be broadly interpreted. Nonetheless, the fundamental problem that occurs is the
terminology seems to be retaining the highly traditionalist approach set out in the common law.
The traditional standard that is owed by the directors’ duties is set out in the seminal case of
Aberdeen Railway Co v Blaikie Brothers62, which held that:
•
“A corporate body can only act by agents, and it is of course the duty of those agents so
to act as best to promote the interests of the corporation whose affairs they are
conducting”63.
The fact that s. 172 CA 2006 starts with the traditionalist internal management framework does
seem to support the critics of the codification of directors’ duties for failing to meet the ESV that
was envisaged.64 This seems to be confirmed in Re West Coast Capital (LIOS) Ltd65 and Cobden
Investments Ltd v RWM Langport Ltd66 where the traditionalist view set out in Aberdeen Railway
Co v Blaikie Brothers was maintained. Consequently, there seems to have been little difference in
the interpretation of directors’ duties because the duty to promote the success of the company
remains the primary obligation owed. Nevertheless, s. 172 CA 2006 has been enhanced by the
factors that should be borne in mind by directors when considering what is in the best interests of
the company. These factors include: (i) the examination of the long term effects of a decision67;
(ii) what is in the interests of the employees68; (iii) how to foster relationships with suppliers,
customers and other business interests69; (iv) to evaluate how a decision by a company will affect
the environment and local communities70; (v) whether the decision will uphold the reputation of
the company, including maintaining industry standards of good corporate governance and social
responsibility71; and (vi) to ascertain whether the decision will be fair to all members
(shareholders) of the company72. The application of this section is not expected to be an exhaustive
list of duties; rather, it is to identify that there are a broad set of considerations with every decision
60
S. 171 CA 2006
S. 172(1) CA 2006
62
Aberdeen Railway Co v Blaikie Brothers (1854) 1 Macq 461
63
Ibid 471
64
Reisberg (n55), 222
65
Re West Coast Capital (LIOS) Ltd (2008) CSOH 72
66
Cobden Investments Ltd v RWM Langport Ltd (2008) EWHC 2810 (Ch).
67
s. 172(1)(a) CA 2006
68
s. 172(1)(b) CA 2006
69
s. 172(1)(c) CA 2006
70
s. 172(1)(d) CA 2006
71
s. 172(1)(e) CA 2006
72
s. 172(1)(f) CA 2006
61
that the company makes.It needs to be reiterated that the primary concern is the best interests of
the company as identified in Re West Coast Capital (LIOS) Ltd73 and Cobden Investments Ltd v
RWM Langport Ltd74 that links to the bottom line. Thus, it is unlikely that the other issues that are
contained within s. 172 CA 2006 will be treated as the primary interest if it can be shown that the
decision is promoting the majority financial interests and the bottom line of the company.
3.4 Directors’ Duties – Merely a Reiteration of the Common Law:
The concept of enhancing directors’ duties through the codification of the common law is unlikely
to promote more sustainable directors if there is a failure to promote the considerations of s. 172
CA 2006 above and beyond the bottom line.75 The obligation of the director is to promote the best
interest interests of the company by exercising independent judgment utilising the powers given
to the director within the company’s constitution76. The standard that this owed is set out in s. 174
CA 2006. The preliminary obligation is set out in s. 174(1) CA 2006, which is that “a director of
a company must exercise reasonable care, skill and diligence”. This standard represents the
obligation linked to promoting the best interests of the company because this level of skill must be
used77. Section 174(2) CA 2006 goes on to clarify what is meant by reasonable care, skill and
diligence where it is held that:
“This means 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 functions carried out by the director in relation to the
company, and (b)the general knowledge, skill and experience that the director has”.
The operation of s. 174(2) CA 2006 identifies an objective and subjective standard which makes
sense because a legal or financial director should have heightened obligations due to the level of
knowledge and skill that s/he has78. The common law allows for the director to delegate his/her
duties, as long as it has been done in a reasonable manner79. The standard has been set in Re City
Equitable Fire Insurance Co. Ltd80 which has a low threshold to be satisfied. This indicates that
as long as the director is generally acting in a reasonable manner with the intention to promote the
best interests of the company then there will not be a breach of directors’ duties. Nonetheless, the
case law does indicate that each case will be determined on its facts although the standard set in
Re City Equitable Fire Insurance Co. Ltd81 remains the accepted obligation owed by the director82.
The use of reasonableness as the way to determine liability indicates that the business judgment
rule could be present within English law but it has to be breached for liability to be found, which
means that it will be very difficult to show that there has been a breach of directors’ duties unless
the actions of the director is absurd.
The remaining sections further clarify the common law standards seem to apply to the tests set out
in ss. 172-174 CA 2006. Section 175 CA 2006 provides that “a director of a company must avoid
73
Re West Coast Capital (LIOS) Ltd (2008) CSOH 72
Cobden Investments Ltd v RWM Langport Ltd (2008) EWHC 2810 (Ch).
75
Reisberg (n55), 222-3
76
S. 173 CA 2006
77
Lister v Romford Ice and Cold Storage Co. Ltd [1957] A.C. 555
78
Keay (n2), 234
79
Re D'Jan of London Ltd [1994] 1 B.C.L.C. 561, CA; Cohen v Selby [2001] 1 BCLC 176, CA
80
Re City Equitable Fire Insurance Co. Ltd [1925] Ch. 407
81
Ibid
82
Equitable Life Assurance Society v Bowley [2004] 1 B.C.L.C. 180; Re Barings plc (No. 5) [2000] 1 B.C.L.C. 523
74
a situation in which he has, or can have, a direct or indirect interest that conflicts, or possibly may
conflict, with the interests of the company”83 unless authorisation has been given by the board to
undertake the disclosed duties84. All votes that are taken on authorisation have to take place
without that of the interested director85. The conflict of interest will be any contract/activity that
will be competing with the business purpose of the company and/or reasonable restrictions
identified in the company contract because there is a duty of loyalty owed by each director86. It is
also important to stress that authorisation does not have to be formal; rather it is possible for
acceptance of potentially conflicting actions will be allowed as long as appropriately disclosed 87.
The main concern is to show that the director has not acted in a conflictual manner that undermines
the best interests of the company88. It is the conflict of interest standard that gives rise to the duty
not to accept benefits from third parties when related to activities of an individual is acting in
his/her capacity as a director89. Thus, the duties that have been developed in the CA 2006 are
merely a codification and arguably a clarification of common law duties, which potentially will
maintain the status quo (as identified in Re West Coast Capital (LIOS) Ltd90 and Cobden
Investments Ltd v RWM Langport Ltd91). Arguably there has to be a change in how director’s
duties are treated, in order to ensure that they are enhanced. The response could be by making a
stringent set of directors’ duties and then applying the reasonable skill and care as a defence (i.e.
the business judgement rule).
4.0 Directors’ Duties in the USA and the Business Judgment Rule – Should they be
Implemented in the UK?
4.1 The Business Judgment Rule and the American Directors’ Duty
It may be averred that the business judgment rule with its heightened obligations to reinforce
directors’ duties could be introduced, instead of having to breach this rule to be held liable as in
the English model. The basis of directors’ duties in the US are similar to that as in English law.
However, the Dodge v Ford Motor Company92 espouses this in a duty to protect the interests of
the shareholder (i.e. the best interest of the company are the interests of the shareholders). This is
a shift from the English model because there is a clear fiduciary obligation owed by the director to
the shareholder. The business judgment rule is contained within the common law and in some
states has been codified. An example of a codified business judgment rule is in the California
Corporations Code § 309(a), which provides that:
“A director shall perform the duties of a director, including duties as a member of any
committee of the board upon which the director may serve, in good faith, in a manner such
director believes to be in the best interests of the corporation and its shareholders and with
such care, including reasonable inquiry, as an ordinarily prudent person in a like position
would use under similar circumstances”.
83
S. 175(1) CA 2006
S. 175(5) CA 2006
85
S. 175(6) CA 2006
86
Item Software (UK) Ltd v. Fassihi [2005] 2 B.C.L.C. 91
87
Murad v Al-Saraj [2005] EWCA Civ 959; Foster v Bryant [2007] Bus LR 1565
88
Edwards v Halliwell [1950] 2 All ER 1064
89
S. 176(1) CA 2006
90
Re West Coast Capital (LIOS) Ltd (2008) CSOH 72
91
Cobden Investments Ltd v RWM Langport Ltd (2008) EWHC 2810 (Ch).
92
Dodge v. Ford Motor Co., 170 N.W. 668 (Michigan Supreme Court, 1919)
84
The obligation of the director is identified in the first part of the rule where the director must
conform to the prescribed duties93. This is then followed by a defence that the director has acted
reasonably in the best interests of the company akin to that of a reasonable inquiry of a prudent
person in a similar positon (i.e. it is a reasonable response in a range of reasonable responses)94.
Thus, it starts from liability for breach of duty and then applies a defence, which means that it is a
reverse of English law. Additionally, there is a shareholder focus in American law that is not
present in the English common law.95
The starting point to understand the business judgment rule is the seminal case of Unocal
Corporation v Mesa Petroleum96, which has been upheld in Revlon Inc v MacAndrews & Forbes
Holdings Inc97 and a series of other cases. Unocal held that the business judgment rule is a defence
to the high obligation that directors’ duties impose. As this case held:
“If a defensive measure is to come within the ambit of the business judgment rule, it must
be reasonable in relation to the threat posed”.98
This means that a breach of duty may occur but it was a reasonable response given the nature of
the decision or it is thought to be the best approach in the given circumstances. It is important to
note that generally the fiduciary duty that the director owes is just to the shareholder99, unless the
legislature has enhanced this duty in a particular state (e.g. the environmental obligations in
Oregon100). The implication is that there is a dual duty present to promote the best interests of the
company and the interests of the shareholders101, which means that minority as well as majority
shareholder interests must be considered. The rationale is that there is a direct claim for the
shareholder that has been harmed by the director that has breached his/her duty. Once this breach
is shown then the director can defend his/herself through the business judgment rule. Resultantly,
there are similarities between the American and English common law; however, the burden of
proof is different. The question that this research seeks to answer is whether the American
approach should be implemented into the UK, in order to solidify the ESV model that were
envisaged by the CA 2006.
4.2 A Case Law Review of the Business Judgment Rule:
This research is going to focus on the Delaware case law because it has the closest roots to the
English common law. It is not possible to examine the business judgment rule in the USA as a
Adams, MS “United States: The Director’s Friend: The Business Judgement Rule” Mondaq Sepetember 6, 2012
available at:
http://www.mondaq.com/unitedstates/x/195214/Directors+Officers/The+Directors+Friend+The+Business+Judgmen
t+Rule accessed June 27, 2015
94
Ibid
95
Simpson, S & Brody, K “The Evolving Role of Special Committees in M&A Transactions: Seeking Business
Judgment Rules Protection in the Context of Controlling Shareholder Transactions and Other Corporate
Transactions Involving Conflicts of Interest” (2014) Business Lawyer 69(1117), 1120
96
Unocal Corporation v Mesa Petroleum (1985) 493 A 2d 946 (Delaware Supreme Court).
97
Revlon Inc v MacAndrews & Forbes Holdings Inc (1986) 506 A 2d 173; See also Paramount Communications
Inc v Time Inc (1990) 571 A 2d 1140, Nixon v Blackwell (1993) 626 A 2d 1366, Paramount Communications Inc v
QVC Network Inc (1994) 637 A 2d 34, Herald Co v Seawell (1972) 472 F 2d 1081
98
Unocal Corporation v Mesa Petroleum (1985) 493 A 2d 946 (Delaware Supreme Court), [at pg. 955].
99
Paulman v. Kritzer, 219 N.E.2d 541, 543 (Illinois Appellate Court, 1966).
100
Sneirson, J Race to the Left: A Legislator’s Guide to Greening the Corporate Code, (2009) Oregon Law Review,
88,498.
101101
Fletcher v. Atex, Inc., 68 F.3d 1451, 1456 (2d Cir. 1995)
93
whole because of the number of different systems. As VantagePoint Venture Partners v. Examen,
Inc102 held only the states “should have the authority to regulate a corporation’s internal affairs—
the state of incorporation”.103 This means that it is easier to undertake a case law review of a state.
The links between Delaware and the English common law is the fact that directors’ duties have
been developed upon the backbone of Charitable Corp. v. Sutton.104 Here directors were described
as both agents and trustees of the company and should act with “fidelity and reasonable
diligence”.105 This approach was confirmed in Bodell v. General Gas & Electric Corp106. The
Bodell approach was confirmed in Cole v. Nat’l Cash Credit Ass’n107 where it was held that fidelity
and reasonable diligence are the “elemental requirements for invoking the Delaware business
judgment rule—good faith and a ‘bona fide’ purpose”108. This approach was reaffirmed in the
1971 case of Sinclair Oil Corp. v. Levien109 where the business judgment rule will be valid if for
a valid business purpose. This was supported in Aronson v. Lewis where the held that the business
judgment rule “is a presumption that in making a business decision the directors of a corporation
acted on an informed basis, in good faith and in the honest belief that the action was taken in the
best interests of the company110 . As Stone v. Ritter111 identifies, the director owes a duty to the
shareholders and companies that is based upon the “triad [of] due care, loyalty and good faith”112.
This triad is similar to the construction of the directors’ duties in the English common law and
under the CA 2006. In fact, the Stone Case recognised that the business judgment rule allows for
a balance when these duties compete. This seems to be very similar to Shaw & Sons v Shaw113
where the internal management model requires that the best interests of the company be upheld
above all else.
There has been a breach of directors’ duties when the board failed to act on an informed basis.114
This links to the obligation of due skill and care set in s 174 CA 2006, which means that there are
the similarities which may facilitate the importing of the American model into the UK. This can
also be seen in Guth v. Loft115 where it was held that “corporate officers and directors are not
permitted to use their position of trust and confidence to further their private interests”116. This
means that the conflict of interest obligation in the US model is similar to s. 175 CA 2006, although
it is identified in a strictly prohibited language. Thus, there is a breach for acting this way and then
the director can defend his/herself by showing it is permitted. The enhancement of directors’ duties
under the US model lies upon the fact that directors are fiduciaries that have a “quasi-trustee and
102
VantagePoint Venture Partners v. Examen, Inc., 871 A.2d 1108, 1112 (Del. 2005).
ibid
104
Charitable Corp. v. Sutton, 2 Atk. 400, 406, 26 Eng. Rep. 642, 645 (Ch. 1742);
105
ibid
106
Bodell v. Gen. Gas & Elec. Corp., 132 A. 442 (Del. Ch. 1926),
107
Cole v. Nat’l Cash Credit Ass’n, 156 A. 183, 188 (Del. Ch. 1931)
108
ibid
109
Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971)
110
Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984)
111
Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006)
112
I bid
113
Shaw & Sons (Salford) Ltd v Shaw [1935]2 K.B. 113
114
Smith v. Van Gorkom, 488 A.2d 858, 873 (Del. 1985).
115
Guth v. Loft, Inc., 5 A.2d 503 (Del. 1939)
116
ibid
103
agency relationship” that is owed to the company and its shareholders117. Therefore, the nature of
the duty is heightened due to the direct trustee relationship.
In fact, the business judgment rule cannot be used when there is a potential conflict of interest, as
Aronson identifies this rule “can only be claimed by disinterested directors whose conduct
otherwise meets the tests of business judgment”118. The impact of this is that directors who are
identified to be in breach of their duties have to show that they are not on either side of the
transaction or “expect to derive any personal financial benefit from it in the sense of self-dealing,
as opposed to a benefit which devolves upon the corporation or all stockholders general”.119 The
presence of such an interest will mean that the business judgment rule will not be applied.120
Therefore, the benefit of this approach is that conflict of interest is more strictly applied because
it does not benefit from the defence of the business judgment rule. Conversely, the obligation that
is owed by the director in the English common law merely requires the act to be reasonable to
promote the company’s best interests.
The concept of good faith within US case law is also heightened. For example re Walt Disney Co.
Derivative Litigation121 held that due care “may overlap with the conduct that comes within the
rubric of good faith in a psychological sense, but from a legal standpoint those duties are and must
remain quite distinct”.122 The implication is that good faith is not part of the obligation of skill and
care, which seems to be the approach that has taken under English law because good faith is not a
standalone ground. Consequently, it may be that the lynchpin of heightened directors; duties in the
US model relies upon a standalone obligation to act in good faith, which means that it is necessary
to examine what is meant by good faith in the ambit of directors’ duties.
The Delaware Supreme Court in Stone v. Ritter123 identified that “good faith may be described
colloquially as part of a “triad” of fiduciary duties that includes the duties of care and loyalty, the
obligation to act in good faith does not establish an independent fiduciary duty”124. However, it
goes on to identify that this colloquial approach is not in fact true because a “director cannot act
loyally towards the corporation unless she acts in the good faith belief that her actions are in the
corporation’s best interest”125. This means that the good faith principle has to be a standalone
obligation. The colloquial description is clearly the obligation that is owed in the English common
law; whereas the US duty is heightened. The English common law approach is identified in
Charitable Corp. v. Sutton where it is held that “it is by no means just in a judge, after bad
consequences have arisen from [any exercise of] power, to say [the director] foresaw at the time
what [would] happen, and therefore were guilty of a breach of trust”126. The rationale is that a
standalone obligation of good faith cannot be applied in hindsight to hold the director to account
because a seemingly good decision became a bad one. All that needs to be shown for a breach not
to be identified is that the decision was not made in bad faith. This may seem to be fair, but it fails
Moran v. Household Int’l, Inc., 500 A.2d 1346, 1357 (Del. 1985)
Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984)
119
ibid
120
ibid
121
Re Walt Disney Co. Derivative Litig., 906 A.2d 27, 65 (Del. 2006)
122
ibid
123
Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006)
124
ibid
125
ibid
126
Charitable Corp. v. Sutton, 2 Atk. 400, 406, 26 Eng. Rep. 642, 645 (Ch. 1742)
117
118
to engage the potential responsibilities of the director (especially when there is a potential harm to
a certain sector of the company).
The case of Stone v Ritter illustrates that there is a distinctly different approach that is applied in
the US model. In this case the Delaware Supreme Court held that:
“In the absence of red flags, good faith in the context of oversight must be measured by the
directors’ actions ‘to assure a reasonable information and reporting system exists’ and not
by second-guessing after the occurrence of employee conduct that results in an unintended
adverse outcome”127.
The engagement with the different factors that could arise from a decision has to be examined in
full, as there is an obligation to ensure that a reasonable decision has been made. Consequently,
there is a higher threshold imposed upon identifying what is expected to be a reasonable business
decision as opposed to the broad range of reasonable responses in the English common law. This
distinction lies in the fact that the director owes his/her duty not only to the company in general
but also the individual shareholders. Therefore, there are sound grounds to apply the US style
directors’ duties (especially the good faith duty that is sound alone) and then apply the business
judgement rule.
5.0 Conclusion: Should the Business Judgment be Implemented in the UK?
The Delaware Supreme Court in Aronson v. Lewis identified that the operation of the business
judgment rule is based upon the “presumption that in making a business decision the directors of
a corporation acted on an informed basis, in good faith and in the honest belief that the action was
taken in the best interests of the company”.128 This means that a business decision may harm
shareholders but is necessary to promote the welfare of the company and the majority. The
application of this approach seems similar to that of the English common law, although it is the
point to defend a breach not the threshold to prove a breach. The obligation to act in good faith to
promote the interests of the business are clearly identified in the English common law129, although
this obligation does not extend to the individual shareholder (except through an enhanced
application of s. 172 CA 2006). The operation of the good faith principle is enhanced in the UK
when there is a conflict of interest because it implies that the intention is personal and not to
promote the interests of the company.130 Nonetheless, this still does not have the effect of
increasing the liability of directors. There are attempts in the common law to recognise an
enhanced duty on non-executive directors because they are acting without self-interest. The
Australian courts in Australian Securities and Investments Commission v Healey131 identified that
there is an obligation on the non-executive director “to take a diligent and intelligent interest in the
information available to him or her, to understand that information, and apply an enquiring mind
to the responsibilities placed upon him or her”.132 The rationale of this approach is that there is a
special relationship of trust because the non-executive director has no interest in the company but
to promote the company’s interests. This approach does not satisfy the formation of effective
127
Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006)
Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984)
129
Mutual Life Insurance Co of New York v. Rank Organisation Ltd [1985] B.C.L.C. 11
130
Scottish Cooperative Wholesale Society Lttd v Meyer [1959] AC 324; Bhullar v Bhullar [2003] EWCA Civ 424
131
Australian Securities and Investments Commission v Healey [2011] FCA 717
132
Ibid at , 20
128
directors’ duties. Rather, it is necessary to create a heightened fiduciary duty in the UK for directors
in general
The standalone duty of good faith should be developed in the UK because the fact that a breach is
difficult to prove indicates that there will not be enhancement of shareholder value. R. (on the
application of People & Planet) v HM Treasury133 illustrates the problem with failing to provide
a standalone duty of good faith. In this case, the applicants wanted to get the government to enforce
the RBS’ own policy that it promoted it held in combating climate change and promoting human
rights on the board of RBS. The government has this power because of the state’s majority
ownership of RBS. However, the court held that it did not have the power to enforce this obligation
because it would be contrary to the board who are acting in their power. This argument may be
true, but the company is acting in bad faith because it is promoting a policy to its shareholders and
customers and not following it through, which is misrepresentation. This act would be deemed a
breach of good faith in the USA because it is unreasonable to lie. Therefore, it seems that it is
necessary to implement the US’ heightened directors’ duties but to provide the business judgment
rule to prevent liability when there has been a truly reasonable set of actions. The benefit of this
approach is that it will create a more onerous duty of care, which is necessary to ensure that there
is truly an ESV model in the UK.
The development of an ESV model was envisaged when the CA 2006 directors’ duties were
implemented. The fundamental problem that arose is that this has not been the case because the
threshold to show that there is a breach is set to high. The main problem in the English model is
that the business judgment defence is not a defence; rather, it is the standard to prove that there
has not been a breach of directors’ duties. Consequently, the English model’s liability for breach
of duty is too easy to avoid, which is supported by the fact that there is no standalone duty of good
faith. It may be argued that the US model should be implemented where there is a standalone duty
of good faith and breach of duty can be proven with a lower threshold. However, the business
judgment rule operates as a defence when there has been a breach of duty, but the action is in good
faith and was considered to be reasonable in the given circumstances. These changes will create a
system where there is ESV, but in order for the US model to be effectively implemented in the UK
it is necessary that a standalone duty of good faith is adopted. This will be the greatest obstacle to
the proposed reform. Nonetheless, it is necessary to create the ESV model that was envisaged in
the CA 2006 directors’ duty reform.
133
R (on the application of People & Planet) v HM Treasury [2009] EWHC 3020 (Admin).
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Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971)
Smith v. Van Gorkom, 488 A.2d 858, 873 (Del. 1985).
Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006)
Unocal Corporation v Mesa Petroleum (1985) 493 A 2d 946 (Delaware Supreme Court).
VantagePoint Venture Partners v. Examen, Inc., 871 A.2d 1108, 1112 (Del. 2005).