Scottish Law Commission (Discussion Papers)

Part 11




Section B The Case for a Statutory Statement of Directors' Suties under the General Law

Part 11 Fiduciary Duties: the Current law

Introduction

11.1      In this part we examine the fiduciary duties of directors under the general law, the persons to whom those duties are owed and the circumstances in which the company in general meeting can ratify a breach of those duties. We then examine the ways in which the liabilities of directors can be capped, and describe D&O insurance which can be used to protect directors.^[1]

Directors as fiduciaries

11.2      A director is not strictly a trustee but in respect of the company's property he may come under the same liabilities as a trustee. In Re Lands Allotment Co^[2] Lindley LJ said:

Although directors are not properly speaking trustees, yet they have always been considered and treated as trustees of money which comes to their hands or which is actually under their control; and ever since joint stock companies were invented directors have been held liable to make good moneys which they have misapplied upon the same footing as if they were trustees …

11.3      It is well established that directors are fiduciaries. That term is not capable of comprehensive definition but the characteristics of the fiduciary relationship can be identified and the principal duties stated:

A fiduciary is someone who has undertaken to act for or on behalf of another in a particular matter in circumstances which give rise to a relationship of trust and confidence. The distinguishing obligation of a fiduciary is the obligation of loyalty. The principal is entitled to the single-minded loyalty of his fiduciary. This core liability has several facets. A fiduciary must act in good faith; he must not make a profit out of his trust; he must not place himself in a position where his duty and his interest may conflict; he may not act for his own benefit or the benefit of a third person without the informed consent of his principal. This is not intended to be an exhaustive list, but it is sufficient to indicate the nature of fiduciary obligations. They are the defining characteristics of the fiduciary. As Dr Finn pointed out in his classic work Fiduciary Obligations (1977) p 2, he is not subject to fiduciary obligations because he is a fiduciary; it is because he is subject to them that he is a fiduciary.^[3]

The classification of directors' fiduciary duties

11.4      We consider the fiduciary duties of directors under the following headings: loyalty,^[4] proper purpose,^[5] no fetters on discretion,^[6] the no-conflict and no-profit rules,^[7] the duty to act in accordance with the company's constitution,^[8] and the duty to deal fairly as between different classes of shareholders.^[9] There are other views as to how they should be classified.^[10] For instance, one textbook^[11] states that there is one fundamental duty - the duty to act in good faith for the benefit of the company - and that conduct which is in breach of the other duties which we have identified is conduct which causes the director to be likely to be in breach of that fundamental duty. It is further said that a breach of duty can be ratified unless it is a breach of the fundamental duty to act in good faith in the interests of the company. However, the way in which we have classified the duties follows the more conventional approach in this field.^[12]

Loyalty

11.5      Directors must act bona fide in what they consider is in the best interests of the company, and those are the words used by Lord Greene MR in Re Smith and Fawcett Ltd.^[13] Directors therefore cannot use their powers to benefit third parties or themselves. The duty is a subjective one, which is not broken merely because the court would not have reached the same conclusion as the directors as to what was in the company's interests. Provided that the directors act in good faith in what they believe to be the company's interests, it does not matter that their decision also promotes their own interests.^[14]

Proper purpose

11.6      Directors must exercise their powers for the purpose for which those powers are conferred. This is a different and additional requirement from the first. It has been applied, for example, in relation to the power to allot shares. It is not enough that the directors consider that the allotment of shares will be in the company's interests. The allotment must be for one of the purposes for which the power is permitted to be exercised under the company's constitution.
11.7      This particular duty has long been part of our law. It was analysed by the Privy Council in Howard Smith Ltd v Ampol Petroleum Ltd.^[15] In that case there were two shareholders, Ampol and Bulkships, who held 55 per cent of the shares of Millers Limited. Ampol made an offer for the issued shares of Millers. Howard Smith announced its intention to make a higher offer. The board of Millers quickly allotted shares to Howard Smith with the result that the 55 per cent majority shareholding of Ampol and Bulkships was reduced to 36 percent. Ampol Ltd sought a declaration that this allotment was invalid.
11.8      The Privy Council rejected the argument that, once it was shown that the directors had acted in good faith in what they considered to be the company's interests, that was the end of the matter. Before it could be said that a fiduciary power had been properly exercised, the purpose for which it might be exercised had first to be investigated.

Having ascertained, on a fair view, the nature of this power, and having defined as best as can be done in the light of modern conditions, the, or some, limits within which it may be exercised, it is then necessary for the court, if a particular exercise of it is challenged, to examine the substantial purpose for which it was exercised and to reach a conclusion as to whether that purpose was proper or not. In doing so it will necessarily give credit to the bona fide opinion of the directors, if such is found to exist, and will respect their judgment as to matters of management; having done this, the ultimate conclusion has to be as to the side of a fairly broad line on which the case falls.^[16]

11.9      This passage shows that on commercial issues, the courts defer to the judgment of directors.^[17] Furthermore, the courts do not seek to test what directors do by reference to what objectively speaking is in the interests of the company. Courts cannot effectively test what is or is not objectively, speaking in the interests of the company. But they can scrutinise what directors do by such matters as proper purpose.^[18]
11.10      The proper purposes principle has been applied to the exercise by directors of a range of discretionary powers, for example, the power to forfeit shares,^[19] to make calls,^[20] to refuse to register a transfer of shares,^[21] or to allot shares. It is with respect to the last power, the power of allotment that the proper purposes principle is most frequently invoked. Thus the power of allotment cannot be used to entrench the directors in office or to deprive an existing majority of its majority position.^[22] What constitutes a proper purpose cannot be stated in advance but must be ascertained in the context of the specific sitiuation under consideration, and once ascertained the court has to determine the substantial purpose for which the power was exercised in order to determine the validity of its exercise.^[23]

No fetters on discretion

11.11      Directors must in general not fetter their discretion. This means that they must not enter into an agreement with a third party as to how they will exercise their discretion. To do so would prevent them from exercising an independent judgment at the appropriate time. An exception to this is where directors decide that it is in the best interests of the company to enter into a contract and to carry it into effect. In this situation they can themselves enter into any undertaking to exercise their powers in a particular way if it is necessary for them to do so to effectuate the contract. In Fulham Football Club Ltd v Cabra Estates plc,^[24] the Court of Appeal stated:

It is trite law that directors are under a duty to act bona fide in the interests of their company. However, it does not follow from that proposition that directors can never make a contract by which they bind themselves to the future exercise of their powers in a particular manner, even though the contract taken as a whole is manifestly for the benefit of the company. Such a rule could well prevent companies from entering into contracts which were commercially beneficial to them.^[25]

11.12      The Court of Appeal went on to hold:

The true rule was stated by the High Court of Australia in Thorby v Goldberg.^[26] The relevant part of the headnote reads:

If, when a contract is negotiated on behalf of a company, the directors bona fide think it in the interests of the company as a whole that the transaction should be entered into and carried into effect they may bind themselves by the contract to do whatever is necessary to effectuate it.

The no-conflict and no-profit rules

11.13      Under the no-conflict rule certain consequences can flow if directors place themselves in a position where their personal interests or duties to other persons are liable to conflict with their duties to the company unless the company gives its informed consent.^[27] This consent may be given in the company's articles or in a resolution of the company in general meeting. If the necessary consent is not obtained, the contract is voidable at the instance of the company unless the right to rescind has been lost under the general law. There is a second "no-profit" rule under which, directors cannot keep secret profits which they make by using information or property or opportunities which belong to their company.
11.14      There are many cases which illustrate these rules. In Industrial Development Consultants Ltd v Cooley,^[28] for example, the defendant was the former managing director of the plaintiffs. He resigned his office in order to enable him to take up in his own name a valuable contract which had previously been sought by his own company. The company's approach had been rejected. The defendant then learnt that there was a possibility of getting the contract himself and so he resigned as managing director. Subsequently he indeed got the contract. It was held that he was accountable to the plaintiff company for all the profit that he made on the contract, because he had allowed his interest and duty to conflict and had failed to disclose to the company the information which he had obtained before he resigned. Roskill J (as he then was) referred to well known authorities such as Keech v Sandford,^[29] Regal (Hastings) Ltd v Gulliver^[30] and Phipps v Boardman^[31] and he also cited the following passage from the judgment of James LJ in Parker v McKenna:^[32]

I do not think it is necessary but it appears to me very important that we should concur in laying down again and again the general principle that in this court no agent in the course of his agency, in the matter of his agency, can be allowed to make any profit without the knowledge and consent of his principal; that that rule is an inflexible rule, and must be applied inexorably by this court, which is not entitled, in my judgment, to receive evidence, or suggestion or argument as to whether the principal did or did not suffer any injury in fact by reason of the dealing of the agent; for the safety of mankind requires that no agent shall be able to put his principal to the danger of such an inquiry as that.

11.15      Roskill J continued:

In the nuclear age that last sentence may perhaps seem something of an exaggeration, but, nonetheless it is eloquent of the strictness with which throughout the last century, and indeed in the present century, courts of the highest authority have always applied this rule.^[33]

11.16      The defendant had to account for all the profit that he had received notwithstanding that the court found that there was only a 10 percent chance that the company could have got the contract itself. This case accordingly demonstrates the fact that the remedies for breach of fiduciary duty go further than simply compensating the company. The reason for this as a matter of legal analysis is that the court's reasoning was that the defendant had misappropriated the company's property, namely the information which ought to have been reported to it.^[34] As we saw in Part 3,^[35] the economic justification is that the severe liabilities imposed by law operate as an incentive to directors to comply with their duties and (in this case) to convey information to shareholders. Another way of analysing Cooley is to see it as a conflict of interest situation: once Cooley decided to seek to obtain the contract for himself and not the company, this resulted in a conflict between his interests and those of the company which entitled the company to oblige him to account.^[36]
11.17      The Cooley case should be contrasted with Island Export Finance Ltd v Umanna.^[37] In that case the company had a business in providing postal caller boxes and the defendant had been its managing director. However he resigned because he was dissatisfied with the company. Subsequently he obtained two new contracts for postal caller boxes. The possibility of these contracts had been known to him when he was a director. His resignation had been for independent reasons and at the time of his resignation the company was not searching for new business. The court held that a director could be liable for misappropriating a business opportunity of the company even after he ceased to be a director. However in this case the claim for an account against the director failed on the basis that the chance to obtain the contracts in question was not a sufficiently maturing business opportunity at the time he ceased to be a director. Moreover, the defendant had not improperly exploited any confidential information which the company could prevent him from using.

Duty to act in accordance with the company's constitution

11.18      Directors must act in accordance with the company's constitution.^[38] So, for example, if the articles say that dividends must not be paid otherwise than out of revenue profits, it will be a breach of duty for directors to pay dividends out of capital profits. Section 35A of the Companies Act 1985 protects third parties who deal with the company in good faith by deeming the directors' powers to be free of any limitation under the company's constitution. Section 322A^[39] deals with the consequences of this provision where one of the parties to the transaction is a director of the company or a connected person of his or a company with which he is associated.

Duty to deal fairly as between different shareholders

11.19      In Mutual Life Insurance v Rank Organisation Ltd,^[40] the directors of Rank had given shareholders, other than North American shareholders, the right to subscribe for new shares of the same class. There was evidence that the North Americans had been excluded because the company did not wish to comply with the requirements for registration of the Securities and Exchange Commission in the United States and comparable commissions in Canada. The directors had had advice from merchant bankers, which they had accepted, and which was in turn based on an investigation by accountants, that to register with the SEC would not be in the interests of the company. The plaintiffs were North Americans. They owned shares in Rank and they claimed that Rank had acted in breach of the membership contract contained in the articles. They claimed that their shares entitled them to equal treatment without discriminating one from another. Goulding J rejected the argument. In the light of the wide powers which the directors had under the articles he held that the directors' power of allotment was only to be cut down by two implied terms:

First, the time honoured rule that the directors' powers are to be exercised in good faith in the interests of the company, and secondly, that they must be exercised fairly as between different shareholders. I doubt whether it is possible to formulate either of these stipulations more precisely because of the infinity of circumstances in which they may fall to be applied.^[41]

11.20      On the facts of the case, Goulding J held that it was abundantly clear that the directors had indeed acted in the best interests of Rank and that there had been no unfairness between the two groups of shareholders.

To whom do the directors owe their fiduciary duties?

11.21      The duties of a director discussed above are owed to the company.^[42] The question is whose interests constitute the company's interests for this purpose? The company is an artificial entity. In reality it has no interests of its own. In Greenhalgh v Arderne Cinemas^[43] the issue was whether a special resolution has been passed bona fide for the benefit of the company. Sir Raymond Evershed MR said:

the phrase, "the company as a whole," does not (at any rate in such a case as the present) mean the company as a commercial entity as distinct from the corporators. It means the corporators as a general body. That is to say, you may take the case of an individual hypothetical member and ask whether what is proposed is, in the honest opinion of those who voted in its favour, for that person's benefit.

11.22      On the other hand, regard should not be had only to present members. Regard should also be had to the interests of future members (or the long-term interests of the present members). In an appropriate case, the interests of the company may mean the interests of its creditors. The directors must have regard to the interests of the company's creditors where there is a danger of the company becoming insolvent because they are then the persons interested in the company's assets. In Winkworth v Edward Baron Development Co Ltd^[44] a man and his wife occupied a property which their company owned. The company became heavily insolvent and the wife sought to argue that the company had agreed to sell her an interest in the property, and that that arose when she paid money to the company which was used to pay off the overdraft which had been incurred to buy the property in the first place. It was argued on her behalf that there was a resulting trust. The House of Lords refused to hold that there was a resulting trust in her favour. Lord Templeman was particularly influenced by the fact that the company was insolvent. He held:

A duty is owed by the directors of the company to the company and the creditors of the company to ensure that the affairs of the company are properly administered and that its property is not dissipated or exploited for the benefit of the directors themselves to the prejudice of the creditors.^[45]

11.23      Far from holding, therefore, that the wife had a share in the property which she and her husband occupied, their Lordships held that since she and her husband had committed a misfeasance towards the company in withdrawing from the company monies to pay for their shares in it, the money which she paid in simply went to pay off some of the amount that she owed the company as the result of her misfeasance. The House of Lords recognised in this case that in some circumstances the duty to the company becomes in reality a duty to the creditors.^[46] However, the duty continues to be one owed to the company and not to the creditors.^[47]
11.24      As with creditors, the case law also establishes that directors must take account of the interests of employees where that is in the best interests of the company. In a passage often quoted, Bowen LJ said:^[48]

A railway company, or the directors of the company, might send down all the porters at a railway station to have tea in the country at the expense of the company. Why should they not? It is for the directors to judge, provided it is a matter which is reasonably incidental to the carrying on of the business of the company, and a company which always treated its employees with Draconian severity, and never allowed them a single inch more than the strict letter of the bond, would soon find itself deserted - at all events, unless the labour was very much more easy to obain in the market than it is. The law does not say that there are to be no cakes and ale, but there are to be no cakes and ale except such as are required for the benefit of the company. ... It is not charity sitting at the board of directors, because as it seems to me charity has no business to sit at boards of directors qua charity. There is, however, a kind of charitable dealing which is for the interest of those who practise it, and to that extent and in that garb (I admit not a very philanthropic garb) charity may sit at the board, but not for any other purpose.

11.25      The City Code requires directors of an offeree company to have regard to the interests of employees as well as shareholders and creditors when advising shareholders on the merits of a bid.^[49]
11.26      In relation to employees the Act now makes special provision in section 309 in these terms:

(1) The matters to which the directors of a company are to have regard in the performance of their functions include the interests of the company's employees in general, as well as the interests of its members.

(2) Accordingly, the duty imposed by this section on the directors is owed by them to the company (and the company alone) and is enforceable in the same way as any other fiduciary duty owed to a company by its directors.

(3) This section applies to shadow directors as it does to directors.

11.27      Section 309^[50] first appeared in 1980. At the same time section 719 first appeared. The latter section reversed the celebrated case of Parke v Daily News^[51] and established a procedure which enabled companies to obtain approval for voluntary payments to employees on the cessation or transfer of its business. It provides that this power can be exercised "notwithstanding that its exercise is not in the best interests of the company."^[52]
11.28      Section 309 of the Companies Act 1985 has been referred to in a number of cases: Fulham Football v Cabra Estates;^[53] Re Saul D Harrison^[54]; and Re London Life Association Ltd.^[55] However, it has not been fully considered in any of these cases, and in particular the courts have not expressed a view on the question of whether section 309 requires directors in exercising their functions to have regard to the interests of employees in general even if their interests are not the same as those of the company in the sense of the corporators. A possible consequence of this view is that the directors would have a discretion to balance the interests of these various groups appropriately. In the Fulham Football Club case, the Court of Appeal obiter were minded to reject an argument that the company was bound by undertakings merely because all the shareholders had signed them on the basis that:

The duties owed by directors are to their company and the company is more than the sum of its members. Creditors, both present and potential, are interested, while section 309 of the Companies Act 1985 imposes a specific duty on directors to have regard to the interests of the company's employees in general.

This can be read as suggesting that section 309 is not limited to requiring directors to have regard to the interests of employees when to do so is conducive to the interests of the general body of shareholders. But if this is so, then "the company" in section 309 has a different meaning from its meaning in section 719(2). There is accordingly doubt as to what section 309 means, but it is outside the scope of this project to review it and make recommendations as to its reform.^[56]

11.29      Where the company is a member of a group of companies, the directors may have regard to the interests of the group if, but only if, it is in the interests of the company so to do. Thus, a director of a subsidiary company is not in breach of duty if he fails to consider the interests of the subsidiary separately from those of the group, provided that an intelligent and honest man in the same position could reasonably have come to the same conclusion that the transaction was for the benefit of the subsidiary.^[57]

Ratification by the company in general meeting

Where no question of insolvency or illegality arises

11.30      In its consultation paper on shareholder remedies,^[58] the Law Commission discussed the circumstances in which a breach of duty by a director could be ratified so as to prevent a minority shareholder's action. The description that follows under this heading is largely based on that paper.^[59]
11.31      A classic case on ratification is North-West Transportation Co Ltd v Beatty.^[60] In that case one of the directors was interested in a contract with the company for the sale to it of a ship. The sale was at a proper price and the company required the ship for the purposes of its business. The transaction was approved by the shareholders, but the directors held a majority of the votes. The Privy Council held that any shareholder could vote at a general meeting as he thought fit. Ratification rendered the transaction binding on the company.
11.32      This case should be contrasted with Cook v Deeks.^[61] The directors had breached their fiduciary duties by diverting business which belonged to the company for their own benefit. The Privy Council held that such a transaction could not be ratified by a resolution which was carried because the wrongdoing directors held the majority of the votes. Lord Buckmaster referred to earlier authorities on fraud on the minority^[62] and commented:

... even supposing it be not ultra vires of a company to make a present to its directors, it appears quite certain that directors holding a majority of votes would not be permitted to make a present to themselves. This would be to allow a majority to oppress the minority.^[63]

11.33      In Regal (Hastings) Ltd v Gulliver,^[64] the directors took shares in a subsidiary company when the plaintiff holding company could not afford to take them up. The directors made a profit when both the holding company and the subsidiary were sold to a third party purchaser and they were held liable to account to the plaintiff holding company for that profit on the ground that they were in a fiduciary relationship with the company and had made the profit solely because of their position as its directors and in the course of carrying out their duties as such. Lord Russell suggested, however, that they could have protected themselves "... by a resolution (either antecedent or subsequent) of the Regal shareholders in general meeting".^[65]
11.34      Academic writers have questioned why ratification should have been considered effective in Regal (Hastings) Ltd v Gulliver^[66] but not in Cooks v Deeks.^[67] However, there are many points of distinction between the two cases, which may explain Lord Russell's statement. Regal (Hastings) Ltd v Gulliver was not, like Cook v Deeks, a minority shareholder's action. It was not a case of fraud; the directors in the Regal case had acted in good faith intending to benefit the company. There is no suggestion that they controlled a majority of the votes in general meeting. They were held liable because of the strict rule of substantive law that makes a fiduciary liable to account for a secret profit that he receives by reason of his fiduciary relationship, but it is a rule that can be displaced by ratification.
11.35      In Queensland Mines v Hudson,^[68] the Privy Council considered the case of a managing director who, by reason of his position as such, was able to secure and exploit for himself a mining exploration licence. The company itself was not in a position to do this^[69] and its board, on which representatives of its two shareholders sat, had, following full disclosure of the nature of the transaction, approved the defendant's actions.^[70] The Privy Council held that the director was not liable to account for such benefits to the plaintiff company. It is considered that under UK law a board of directors could not ratify a breach of duty; only the company's general meeting can do.
11.36      North-West Transportation Ltd v Beatty, Regal (Hastings) Ltd v Gulliver and Queensland Mines v Hudson are distinguishable from Cook v Deeks. In the first three cases, a reasonable shareholder could consider that the terms were beneficial to the company. In Cook v Deeks, however, the ratification procured by the directors involved a gift by the company to the directors.^[71] In Regal (Hastings) Ltd v Gulliver and Queensland Mines v Hudson, the company could not itself benefit from the transaction. In Queensland Mines v Hudson, the director made full disclosure of the nature of the transaction and obtained approval from the company.
11.37      In Hogg v Cramphorn,^[72] the directors had used their powers to issue shares for the purpose of forestalling a takeover bid in breach of the proper purposes principle.^[73] A minority shareholder brought a derivative action to have the issue set aside. The exercise of power for this purpose is a breach of fiduciary duty, even if the directors believe it to be in the interests of the company. In Bamford v Bamford,^[74] there was a point of law argued as to whether ratification in similar circumstances would be effective. In both cases the court held that the allotment could be cured by ratification.^[75]
11.38      We have referred above to the need for any circular accompanying a notice of meeting to give full and proper disclosure of the purpose of the meeting.^[76] Where the directors have acted in breach of their duty to the company and subsequently seek ratification by the company in general meeting of their wrongful act, they must make full and frank disclosure of the breach of duty. This means where they have wrongfully received a benefit, particulars as to the amount received must be disclosed.^[77]

Where the company's solvency is prejudiced

11.39      The company in general meeting cannot ratify a breach of duty if the company is insolvent or may thereby become unable to pay its creditors:

In a solvent company the proprietary interests of the shareholders entitle them as a general body to be regarded as the company when questions of the duty of directors arise. If, as a general body, they authorise or ratify a particular action of the directors, there can be no challenge to the validity of what the directors have done. But where a company is insolvent the interests of the creditors intrude. They become prospectively entitled, through the mechanism of liquidation, to displace the power of the shareholders and directors to deal with the company's assets. It is in a practical sense their assets and not the shareholders' assets that, through the medium of the company, are under the management of the directors pending either liquidation, return to solvency, or the imposition of some alternative administration."^[78]

Where the act is illegal or outside the company's powers

11.40      The company cannot ratify an illegal act by a director or one which is outside its powers and not binding on it.^[79]

Capping directors' liabilities 1: By order of the court under section 727 of the Companies Act 1985^[80]

11.41      Section 727 provides:

(1) If in any proceedings for negligence, default, breach of duty or breach of trust against an officer of a company or a person employed by a company as auditor (whether he is or is not an officer of the company) it appears to the court hearing the case that that officer or person is or may be liable in respect of the negligence, default, breach of duty or breach of trust, but that he has acted honestly and reasonably, and that having regard to all the circumstances of the case (including those connected with his appointment) he ought fairly to be excused for the negligence, default, breach of duty or breach of trust, that court may relieve him, either wholly or partly, from his liability on such terms as it thinks fit.

(2) If any such officer or person as above-mentioned has reason to apprehend that any claim will or might be made against him in respect of any negligence, default, breach of duty or breach of trust, he may apply to the court for relief; and the court on the application has the same power to relieve him as under this section it would have had if it had been a court before which proceedings against that person for negligence, default, breach of duty or breach of trust had been brought.

(3) Where a case to which subsection (1) applies is being tried by a judge with a jury, the judge, after hearing the evidence, may, if he is satisfied that the defendant or defender ought in pursuance of that subsection to be relieved either in whole or in part from the liability sought to be enforced against him, withdraw the case in whole or in part from the jury and forthwith direct judgment to be entered for the defendant or defender on such terms as to costs or otherwise as the judge may think proper.

11.42      Relief under this section is not lightly given. In the recent decision of Re Duckwari plc (No 1)^[81] referred to above, the Court of Appeal confirmed that section 727 relief was available for a default under section 320 of the Companies Act 1985, but declined to give relief. The director had been told there was a possibility that certain formalities might be waived, but that it was not enough to show that he had acted reasonably and that he ought to be released from his liability to indemnify the company for the loss it suffered by reason of the default. In Gibson's Executor v Gibson^[82] the directors had made an ex gratia payment to one of their number as the company had not made any provision for a pension for him. They were liable to replace this sum as it was in breach of what is now section 312. Lord Dunpark in the Outer House refused relief to the directors on a misfeasance summons on the basis that it would not be fair to do so, so far as the applicant shareholder was concerned.
11.43      In re D'Jan of London Ltd,^[83] the question arose whether a director who had been found negligent could indeed be given relief under the section, which requires a director to have acted reasonably. Hoffmann LJ (sitting as a judge of the Chancery Division) held that a director can nonetheless be given relief under the section on the grounds that the section clearly contemplated that relief could be so given and that it followed that conduct could be reasonable for the purposes of section 727 despite amounting to a lack of reasonable care at common law.^[84]
11.44      The court in Re D'Jan actually granted relief under section 727 and the reason for doing so illustrates the width of the jurisdiction. The director held 99 of the issued shares and his wife held the other share. The company was in winding up. The director was also an unsecured creditor of the company. In those circumstances the court held that in consequence of his negligence he was liable in the winding up of the company to pay to the company the amount of any dividends he would receive as an unsecured creditor, but was not otherwise liable to pay sums to the company to compensate it for its loss.
11.45      Theoretically under the section an application can be made to the court before the act in question occurs, but in most situations this is a luxury which neither time nor funds allow. Accordingly this section is scant comfort to a director who is concerned as to whether he will be held liable if he does what he proposes to do. This is unfortunate because in very many situations, a director is forced to take some action unless he resigns. While section 727 of the Companies Act 1985 is an important part of the background to this project,^[85] it is not a section which we have reviewed. We have proceeded on the basis that the interpretation given to the section in Re D'Jan will be upheld by later decisions. We consider that it will.

Capping directors' liabilites 2: Statutory prohibition of indemnities under section 310^[86] of the Companies Act 1985 and the possibility of ad hoc releases

11.46      We start with a description of section 310 of the Companies Act 1985 which prohibits contracts which limit or exclude the liabilities of directors and, because of the wide terms in which it is cast, has resulted in the courts analysing the nature of the no-conflict rule discussed above.
11.47      Section 310 provides:

(1) This section applies to any provision, whether contained in a company's articles or in any contract with the company or otherwise, for exempting any officer of the company or any person (whether an officer or not) employed by the company as auditor from, or indemnifying him against, any liability which by virtue of any rule of law would otherwise attach to him in respect of any negligence, default, breach of duty or breach of trust of which he may be guilty in relation to the company.

(2) Except as provided by the following subsection, any such provision is void.

[(3) This section does not prevent a company—

(a) from purchasing and maintaining for any such officer or auditor insurance against any such liability, or

(b) from indemnifying any such officer or auditor against any liability incurred by him—

(i) in defending any proceedings (whether civil or criminal) in which judgment is given in his favour or he is acquitted, or

(ii) in connection with any application under section 144(3) or (4) (acquisition of shares by innocent nominee) or section 727 (general power to grant relief in case of honest and reasonable conduct) in which relief is granted to him by the court.]^[87]

History of section 310

11.48      This section was first introduced following a recommendation of the Greene Committee.^[88] Prior to the introduction of the predecessor of section 310 in 1928, it was common for companies to have wide exculpatory provisions in their articles. In Re City Equitable Fire Insurance Co Ltd^[89] the directors and auditors escaped liability because the articles of the company exonerated them for breach of duty unless the breach was wilful. The section now provides an absolute bar on arrangements for capping liabilities of directors, other company officers^[90] and auditors to the company. It is considered that, but for subsection (3)(a) (which was introduced by the Companies Act 1989), the section prohibited the purchase by the company of D&O cover since it would then be a party to a contract which indemnified a director in breach of duty, but the Companies Act 1989 amended section 310 so as to permit this.^[91] It is to be noted that the section prohibits contractual and other arrangements and not one-off payments as such.

Relationship between section 310 and articles which modify the no conflict rule

11.49      There is little authority on the section but a great deal of academic debate as to how it interrelates with articles which modify directors' fiduciary duties.^[92] For instance, there are articles in the current version of Table A which permit directors to receive remuneration and expenses and to be interested in certain transactions with the company, or in any company formed by the company or in which the company is interested, without in either such case being liable to account for the profit to the company and in certain cases allowing them to vote on transactions in which they are interested. In private companies the articles are commonly wider than those in Table A. In practice parties may want to modify fiduciary duties; for instance, the parties to a joint venture agreement may agree that the directors of a joint venture company should be free to pass information to one of the joint venturers, even though this may not be in the interests of the joint venture company.
11.50      The issue of the relationship between section 310 and articles modifying the no conflicts rule was considered by Vinelott J in Movitex v Bulfield.^[93] Vinelott J held that such articles did not infringe section 310:

The true principle is that if a director places himself in a position in which his duty to the company conflicts with his personal interest or his duty to another, the court will intervene to set aside the transaction without inquiring whether there was any breach of the director's duty to the company. That is an over-riding principle of equity. The shareholders of the company, in formulating the articles, can exclude or modify the application of this principle. In doing so they do not exempt the director from or from the consequences of a breach of a duty owed to the company.

11.51      This decision, by establishing that directors are not under a duty to avoid placing themselves in a position of conflict, explains as a legal matter why Table A contains clauses which modify the no conflicts rule, and it preserves their effectiveness. However it does not provide a policy reason why the no conflicts rule should be capable of being modified but (as result of the introduction of section 310) other fiduciary duties cannot be modified. It would seem unlikely that any thought was given to the distinction drawn by Vinelott J when section 310 or section 727 were introduced. Nor does the decision explain whether there are other fiduciary duties whose effect can be mitigated or varied in some way without bringing section 310 into operation.^[94]

Release of claims arising against directors

11.52      Section 310 clearly prevents a company and a director limiting the latter's liabilities by contract. The question is whether the parties can compromise or release a liability once a breach of duty has occured. There is no authority on the question whether section 310 makes void any resolution that the company in general meeting or the board of directors^[95] may pass to release a director from liability for breach of duty. The better view^[96] is that section 310 is directed to arrangements which apply to future claims rather than to compromises of claims that have already arisen.^[97] Likewise the better view is that section 310 does not prevent a company from entering into a compromise with a director of any claim that it may have against him. However there is no authority on this point.^[98] The fact that section 310 does not apply does not of course mean that the transaction cannot be challenged on appropriate facts as having been made by the directors in breach of duty.

D&O insurance

11.53      D&O insurance protects a director or officer against claims that may be made by the company^[99] or others^[100] for breach of duty to the company. As we explain above,^[101] the company itself was apparently prohibited by section 310(1) from purchasing this insurance itself. This was changed by the Companies Act 1989 which added subsection (3)(a). We understand that it is now common for larger public companies to purchase this insurance, particularly if the company has business activities in the USA.^[102] Indeed, this is demonstrated by the fact that when the amendment first took effect companies were required to state in their annual accounts whether the company had paid for such insurance.^[103] This requirement was later dropped^[104] on the grounds that such insurance had become common.^[105] This is borne out by our own enquiries in the insurance industry. Exact figures are not available but we further understand that the premium income written in the UK for this type of business in 1997 was approaching £300m.^[106] This indicates that a significant amount of D&O insurance is taken up. We also understand that the individual director is not taxed on the benefit of the insurance as a benefit in kind provided that the cover is for a period which does not exceed 24 months and the insurance is not mixed with other cover.^[107]
11.54      There is no market standard wording for this type of insurance but we have examined one policy which is available and which we understand to contain reasonably usual terms. There are a number of exclusions but we have been told that it is possible to arrange an extension in respect of many of these. It covers a director for any loss by reason of a wrongful act (which includes breach of statutory or other duty, breach of trust, neglect, error, misleading statement, breach of warranty of authority, or wrongful trading) in the capacity of director or officer; and costs by reason of investigations or disqualification proceedings, except to the extent actually recovered by the director. It will also pay on behalf of the company for these reasons, but only if, and to the extent that, the company is required or permitted to indemnify the director. The policy does not cover fines, penalties or (in general) punitive damages, as it is generally not possible to obtain insurance against these matters.^[108]
11.55      The claim must be made against the director within the period of the insurance. There is an exclusion for claims brought by fellow directors and claims brought by the company itself unless the claim is brought by shareholders on behalf of the company (in a derivative action or in Scotland a shareholder's action). The insurer's liability for loss or costs is also excluded inter alia where:

(1) brought about by or consequent upon any circumstance existing prior to a specified date and which the director knew or ought reasonably to have known was likely to give rise to a claim;

(2) resulting from any wrongful act etc subsequent to the effective date on which the company is taken over or merged, unless otherwise agreed by the underwriters; or

(3) where there is dishonesty, fraud or malicious conduct of the director.

Cover is severable so that the policy conditions and exclusions are not applied to deny cover to anyone by imputing a wrong done by any other person in the proposal or in relation to any other claims.

11.56      The insurer is entitled at any time to take over and conduct in the name of the director the defence of any claim, conduct negotiations and (subject to the consent of the director) the settlement of any loss or costs. But no director or officer shall be required to contest or settle a claim unless counsel (mutually appointed) shall otherwise advise.

There is an expectation that the market for this kind of insurance will increase with greater awareness of the responsibilities of directors.^[109]

Note 1   The discussion on capping liabilities and D&O insurance applies also to liability for breach of the duty of care, which we examine in the next part.    [Back]

Note 2   [1894] 1 Ch 616 at p 631; cf [1891–94] All ER 1032 at p 1034.    [Back]

Note 3   Bristol and West Building Society v Mothew [1998] Ch 1 per Millett LJ.    [Back]

Note 4   See para 11.5 below.     [Back]

Note 5   See paras 11.6-11.10 below.     [Back]

Note 6   See paras 11.11-11.12 below.     [Back]

Note 7   See paras 11.13-11.17 below.     [Back]

Note 8   In many cases, this will involve a misapplication of company assets and thus a breach of fiduciary duty. In other circumstances, the directors may simply be liable for breach of the terms of their contract of appointment.    [Back]

Note 9   See paras 11.19-11.20.     [Back]

Note 10   On the classification of fiduciary duties generally, see Finn, Fiduciary Obligations (1997).    [Back]

Note 11   Dine, Company Law (3rd ed, 1998) pp 189-198.    [Back]

Note 12   Eg Gower's Principles of Modern Company Law (6th ed, 1997); and see s 232 of the Australian Corporations Law (Appendix H) and ss 131-134 of the Companies Act 1993 of New Zealand (Appendix I).     [Back]

Note 13   [1942] Ch 304, at 306.     [Back]

Note 14   Hirsche v Sims [1894] AC 654.     [Back]

Note 15   [1974] AC 821; see also Re a Company (No 00370 of 1987), ex p Glossop [1988] BCLC 570, 577; and Re BSB Holdings Ltd (No 2) [1996] 1 BCLC 155, at pp 243-246.    [Back]

Note 16   [1974] AC 821 at p 835.    [Back]

Note 17   Ibid, at p 832E-F and at pp 835G to 836A.    [Back]

Note 18   See further R C Nolan, "The Proper Purpose Doctrine and Company Directors" in The Realm of Company Law (1998), which contains an analysis of the proper purpose doctrine and draws parallels with the judicial review of administrative action, and examines how the doctrine might be developed in the future.    [Back]

Note 19   Spackman v Evans (1868) LR 3 HL 171, 186.    [Back]

Note 20   Alexander v Automatic Telephone Co [1890] 2 Ch 233.    [Back]

Note 21   Penningtion, Company Law (7th ed) pp 998-1002.    [Back]

Note 22   The cases are collected and analysed in Howard Smith Ltd v Ampol Ltd [1974] AC 821.    [Back]

Note 23   Ibid, at 835.    [Back]

Note 24   [1994]1 BCLC 363.    [Back]

Note 25   Ibid, at p 392.    [Back]

Note 26   (1964) 112 CLR 597.    [Back]

Note 27   The directors do not have a duty not to place themselves in a position of conflict; the no-conflict rule imposes a disability and not a duty: see Movitex Ltd v Bullfield [1988] BCLC 104. Moreover, a director cannot be restrained from acting as a director of a competing company on the ground that he is in the position of a partner: London & Mashonaland Exploration Co v New Mashonaland Exploration Co [1891] WN 165.    [Back]

Note 28   [1972] 1 WLR 443; more fully reported in [1972] 2 All ER 162.    [Back]

Note 29   (1726) Sel Cas Ch61.    [Back]

Note 30   [1967] 2 AC 134n.    [Back]

Note 31   Ibid, at p 46.    [Back]

Note 32   (1874) 10 Ch App 96, 124-125.    [Back]

Note 33   [1972] 1 WLR 443, 452.    [Back]

Note 34   The reasoning that information is property was doubted before Cooley in Boardman v Phipps [1967] 2 AC 67, and has been rejected in Australia since then; see Bream v Williams (1996) 186 CLR 71.    [Back]

Note 35   See para 3.34 above. Cf Hong Kong Consultancy report, para 6.23, Appendix L.    [Back]

Note 36   See Prentice (1972) 50 Can B Rev 623.    [Back]

Note 37   [1986] BCLC 460.    [Back]

Note 38   The company's constitution includes its memorandum and articles of asscoiation (cf s 322A of the Companies Act 1985).    [Back]

Note 39   Considered at paras 4.205-4.209 above.    [Back]

Note 40   [1985] BCLC 11. Applied in Re BSB Holdings Ltd (No 2) [1996] 1 BCLC 155.    [Back]

Note 41   Ibid, at p 21g-h.    [Back]

Note 42   There can however be special circumstances in which directors can come under a fiduciary duty of disclosure to shareholders: see Re Chez Nico (Restaurants) Ltd [1992] BCLC 192, 208.    [Back]

Note 43   [1951] Ch 286.     [Back]

Note 44   [1986] 1 WLR 1512.    [Back]

Note 45    Ibid, at 1516E-F.    [Back]

Note 46   See also Facia Footwear Ltd v Hincliffe [1998] BCLC 218.    [Back]

Note 47   Yukong Line Ltd v Rendsburg Investments Corporation (No 2) [1998] 1 WLR 294.    [Back]

Note 48   Hutton v West Cork Railway Co (1883) 23 Ch D 654, 672-673.    [Back]

Note 49   General Principle 9. The Amended Proposal for a Thirteenth EC Directive on Takeover Bids (COM (97) 565 OJC 378/10 13 December 1997) requires Member States to ensure that rules made pursuant to that directive require the board of an offeree company to act in "all the interests of the company, including employment" (see art 5(c)). It is not clear whether this would require any extension of UK law.    [Back]

Note 50   As to which see eg Gore-Browne on Companies (1998) para 27.2.1; Parkinson, Corporate Law and Theory (1993), pp 82-87, Prentice (1980) Ind L J 1; and Pettet (1981) Current Legal Problems 199.    [Back]

Note 51   [1962] Ch 927. See also Gibson's Executor v Gibson (1980) SLT 2.    [Back]

Note 52   Section 719(2). It was for this reason that the court held in Parke that such payments could not be made.    [Back]

Note 53   [1994] 1 BCLC 363.    [Back]

Note 54   [1995] 1 BCLC 14, 33.    [Back]

Note 55   Unreported, 21 February 1989 per Hoffmann LJ (Chancery Division, Companies Court)    [Back]

Note 56   See para 1.55 above. See generally, Tomorrow's Company, published by the Royal Society of Arts (1995), para 3.2.    [Back]

Note 57   Charterbridge Corporation Ltd v Lloyds Bank [1970] Ch 62. This is different from the special provision made for directors of subsidiary and joint venture companies by s 131 of the New Zealand Companies Act 1993; see Appendix I below.    [Back]

Note 58   Consultation Paper No 142, paras 5.6-5.17.    [Back]

Note 59   It is outside the scope of this project to propose any changes to these rules.    [Back]

Note 60   (1887) 12 App Cas 589 (PC).    [Back]

Note 61   [1916] 1 AC 554 (PC).    [Back]

Note 62   Including Menier v Hooper's Telegraph Works (1874) 9 Ch App 350.    [Back]

Note 63   Cook v Deeks [1916] 1 AC 554 (PC), 564.    [Back]

Note 64   [1967] 2 AC 134n.    [Back]

Note 65   Ibid, at p 150. See also n 68 below.    [Back]

Note 66   [1967] 2 AC 134n (PC).    [Back]

Note 67   [1916] 1 AC 554 (PC). Cook v Deeks was not referred to in the judgmentsin Regal (Hastings) Ltd v Gulliver. Gower's Principles of Modern Company Law (6th ed, 1997) at p 647 concludes that "[a] satisfactory answer, consistent with common sense and with the decided cases is difficult (and perhaps impossible) to provide". See also L S Sealy, "The Director as Trustee" [1967] CLJ 83,102; and L S Sealy, Cases and Materials in Company Law (6th ed 1996) p 296.     [Back]

Note 68   (1978) 52 ALJR 399 (PC).    [Back]

Note 69   See Regal (Hastings) Ltd v Gulliver [1967] 2 AC 134n (PC).    [Back]

Note 70   See also dicta in Bamford v Bamford [1970] Ch 212.    [Back]

Note 71   The Privy Council in Cook v Deeks distinguished North-West Transportation Co Ltd v Beatty on the grounds that the asset in that case on which the director had made a profit was his own rather than the company's (see [1916] 1 AC 554 (PC), 563-564). However, it is doubtful whether this point is enough in itself to make the transaction ratifiable.    [Back]

Note 72   [1967] Ch 254.    [Back]

Note 73   See paras 11.6-11.10 above.    [Back]

Note 74   [1970] Ch 212.    [Back]

Note 75   In both Hogg v Cramphorn andBamford v Bamford, ratification defeated the actions, but the votes attached to the "tainted" shares were not exercised.    [Back]

Note 76   See para 4.50, n 50 above.    [Back]

Note 77   Baillie v Oriental Telephone and Electric Company, Limited [1915] 1 Ch 503; see also Jacobus Marler Estates Ltd v Marler [1916-17] All ER 291.    [Back]

Note 78   Per Street CJ in Kinsela v Russell Kinsela Pty Ltd (in liq) (1986) 4 NSWLR 722 at 730, approved by Dillon LJ in West Mercia Safetywear v Dodd [1988] 1WLR 250, at pp 251-253.    [Back]

Note 79   Though in either case it may release the claim against the director: Smith v Croft No 2 [1988] Ch 114, at pp 178-183. As to the circumstances in which a transaction which is outside a company's powers is not binding on it, see ss 35A and 322A. The latter is discussed in paras 4.205-4.209 above.    [Back]

Note 80   We have not considered any changes to s 727 for the purpose of this paper. They may fall within the DTI's own review of company law.    [Back]

Note 81   [1997] 2 BCLC 713 at 722: see para 4.174, n 270 above.    [Back]

Note 82   (1980) SLT 2.     [Back]

Note 83   [1994] 1 BCLC 561.    [Back]

Note 84   Section 727 was amended following the recommendations of the Greene Committee who "in order to remove any possible hardship" recommended that the court granting relief under section 727 should have regard to all the circumstances relating to the director's appointment, although they thought that the general law of negligence was sufficient to deal with this (para 46).    [Back]

Note 85   In Fiduciary Duties and Regulatory Rules (1995) Law Com No 236, para 15.13, The Law Commission expressed the view that there was a need to take a global look at exculpatory clauses, examining s 61 of the Trustee Act 1925 and s 727 of the Companies Act 1925 as well as the position of fiduciaries and others.     [Back]

Note 86   We have not considered any changes to s 310 for the purposes of this project. They may fall within the DTI's own review of company law.    [Back]

Note 87   Subsection (3) substituted by CA 1989, s 137(1), as from 1 April 1990.    [Back]

Note 88   Para 46. The Greene Committee rejected the argument that the shareholders must be taken to have agreed to the articles. "The articles are drafted on the instructions of those concerned in the formation of the company , and it is obviously a matter of great difficulty and delicacy for shareholders to attempt to alter such an article as that under consideration."    [Back]

Note 89   [1925] Ch 409.    [Back]

Note 90   The term "officer" is defined in s 744 as including any director, manager or secretary.    [Back]

Note 91   It is doubtful whether despite the wide wording of s 310, contracts to which the company is not a party are caught by s 310: see Burgorgne v London Borough of Waltham Forest [1997] BCC 347.    [Back]

Note 92   See eg Baker (1985) JBL 181; Birds [1976] 39 MLR 394; Parkinson (1981) JBL 335; Gregory (1982) 98 LQR 413; and Rogerson, "Modification and Exclusion of Directors' Duties" published in The Realm of Company Law (1998).    [Back]

Note 93   [1988] BCLC 403.     [Back]

Note 94   See the valuable discussion on these and other issues to which s 310 gives rise: eg Rogerson, "Modification and Exclusion of Directors' Duties" published in The Realm of Company Law (1998).    [Back]

Note 95   The board of directors would require the power to do so in the articles. Otherwise it is only the members who could grant such release.     [Back]

Note 96   See eg Gore-Browne on Companies (44th ed) at 27.21;     [Back]

Note 97   If any resolution is proposed to the company in general meeting for the purpose of releasing directors from liability or ratifying what they have done, there must be full disclosure to the shareholders entitled to vote of the purpose of the meeting: see Kaye v Croydon Tramways Co [1989] 1 Ch 358.    [Back]

Note 98   In Gray v New Augarita Porcupine Mines Ltd [1952] 3 DLR 1, the Privy Council held that a board could release a director from his liability to the company for breach of duty but there is no reference in the case to any equivalent in Canadian law at that time to s 310 of the Companies Act 1985.    [Back]

Note 99   But see para 11.55 below.     [Back]

Note 100   Including shareholders, who bring a derivative action to enforce a right of action that the company has, or a liquidator.    [Back]

Note 101   Para 11.48.     [Back]

Note 102   For a detailed study of D&O insurance with some valuable comparisons with the position in the USA, see Colin Baxter, "Demystifying D&O Insurance" (1995) 15 OJLS 537.    [Back]

Note 103   Sched 7, para 5A (as amended).    [Back]

Note 104   Companies Act 1986 (Miscellaneous Accounting Amendments) Regulations 1986, SI 1996 No189, reg 14(4)(b), 16(1).    [Back]

Note 105   See Accounting Simplifications, DTI consultation document (May 1995) para 42, p 30.    [Back]

Note 106   Estimated figure for the Lloyd's and company market. This figure excludes non-UK business written in London.    [Back]

Note 107   Income and Corporation Taxes Act 1988, s 201AA.    [Back]

Note 108   See generally, Aggravated, Exemplary and Restitutionary Damages (1997) Law Com No 247, paras 5.234-5.273. Nor does insurance cover protect directors who are involved in litigation against harm thereby incurred to their reputation: see para 3.88 above.    [Back]

Note 109   It should be noted, however, that the availability of insurance may, of itself, lead to an increase in the number of claims being brought.    [Back]