Scottish Law Commission (Discussion Papers)

Part 12




Part 12 Duty of Care: The Current Law

12.1      In this part we examine the present law on the duty of care owed by a director to his company. The duty of care is a common law duty, owed by directors to their companies in the performance of their functions. The duty has been described as one in tort, or in Scotland in delict, rather than one in contract arising from a director's voluntary assumption of responsibility for a company's property and affairs.^[1] Falling below the standard, where loss results, will expose the director in question to an action in negligence by the company.
12.2      We begin by examining the 'traditional view' of the duty of care which implied a very low standard of care. Next we consider the 'modern view' under which a more exacting standard of care has been imposed by recent cases. We then consider the extent to which directors can place reliance on co-directors, officers, auditors and professional advisers. Next we look at the duties of skill and care in an analogous relationship, namely that of trusteeship. Finally, we look briefly at the duties of directors under German law.

The traditional view

12.3      As indicated above, the traditional view implies generally a low standard of care. In Overend, Gurney & Co v Gibb,^[2] a test of 'ordinary prudence' was put forward. The question which the court had to answer was:

whether or not the directors exceeded the powers entrusted to them, or whether, if they did not ... they were cognisant of facts of such a character, so plain, so manifest, and so simple of appreciation, that no men with any ordinary degree of prudence, acting on their own behalf, would have entered into such a transaction as they entered into.

12.4      Where, moreover, a director was not cognisant of relevant facts by reason of inattention to the business of the company and avoidance of situations where they would have been made known to him, he would be excused. So it was that in the Marquis of Bute's case^[3] an action against the Marquis of Bute, who was appointed bank president at the age of six months and attended only one meeting of the board in 39 years, was unsuccessful.^[4]
12.5      In the same vein, a director who failed to attend relevant board meetings, and whose credentials were those of a 'country gentleman not a skilled accountant', was held not liable for recommending payment of a dividend from capital.^[5] In Re Brazilian Rubber Plantations and Estates Ltd,^[6] Neville J held that a director was:

not bound to bring any special qualifications to his office and may undertake the management of a rubber company in complete ignorance of everything connected with rubber without incurring responsibility for the mistakes which may result from such ignorance.^[7]

12.6      Re Brazilian Rubber also laid down that if a director did bring special expertise to his office, he was bound to give the company the advantage of it and would be judged accordingly.^[8] The position on general business experience was less clear. Some cases seem to have required that a director exercise his judgment, at such board meetings as he did attend, 'as a man of business'.^[9] Others, however, required only that he exercise the skill and care of an ordinary prudent man notwithstanding other business experience.^[10]
12.7      The traditional line culminated in the case of Re City Equitable Fire Insurance Co^[11] where Romer J, while recognising that the authorities were not entirely clear,^[12] reviewed and summarised them. He held that:

(1) A director need not exhibit in the performance of his duties a greater degree of skill than may reasonably be expected from a person with his knowledge and experience ... It is perhaps only another way of stating the same proposition to say that directors are not liable for mere errors of judgment. (2) A director is not bound to give continuous attention to the affairs of his company. His duties are of an intermittent nature to be performed at periodical board meetings...He is not, however, bound to attend all such meetings, though he ought to attend whenever, in the circumstances, he is reasonably able to do so. (3) In respect of all duties that, having regard to the exigencies of a business, and the articles of association, may properly be left to some other official, a director is, in the absence of grounds for suspicion, justified in trusting that official to perform such duties honestly.^[13]

The modern view

A stricter duty in negligence

12.8      In Dorchester Finance v Stebbing, ^[14] Foster J accepted that the law in this area could be accurately stated as (i) requiring a director to show the degree of skill as may be reasonably expected from a person with his knowledge and experience, and (ii) requiring a director to take such care as an ordinary man might be expected to take on his own behalf.
12.9      Real developments in the law did not occur until cases such as Norman v Theodore Goddard,^[15] where it was accepted, Hoffmann J declining to hear argument on the point, that the common law duty was accurately set out in section 214(4) of the Insolvency Act 1986. Two years later, in Re D'Jan of London Ltd,^[16] Hoffmann LJ (sitting as an additional judge of the Chancery Division) held that the duty of care of a director is accurately set out in section 214(4) and that it was the conduct of "... a reasonably diligent person having both (a) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by that director in relation to the company, and (b) the general knowledge, skill and experience that that director has."
12.10      In Bishopsgate Investment Management Ltd (in liq) v Maxwell^[17] Hoffman LJ suggested, obiter, that the time may now have come for a more objective approach:

[I]n the older cases the duty of a director to participate in the management of a company is stated in very undemanding terms. The law may be evolving in response to changes in public attitudes to corporate governance ... Even so, the existence of a duty to participate must depend upon how the particular business is organised and the part which the director could be reasonably expected to play.^[18]

12.11      There has been no distinction drawn between care, skill and diligence in more recent cases.^[19]

Reliance on co-directors, officers, auditors and professional advisers

12.12      As noted previously, the traditional line taken in Re City Equitable Fire Insurance was that:

In respect of all duties that, having regard to the exigencies of a business, and the articles of association, may properly be left to some other official, a director is, in the absence of grounds for suspicion, justified in trusting that official to perform such duties honestly.

Co-directors and officers

12.13      On the basis of Re City Equitable, a director may, as a statement of general principle, rely on his co-directors to the extent that the matter in question is, in terms of the board's internal 'division of labour', within their remit. A director may thus rely on a co-director appointed to the board by reason of his expertise in a particular area, and is 'entitled to rely upon the advice of his fellow directors in matters in which they are, or should be, experts'.^[20]
12.14      Re City Equitable itself involved total reliance by two directors appointed to a board finance committee, on a third director, the Chairman. Notwithstanding that he was a person of the highest reputation, it was held that this abdication by the two co-directors of a responsibility with which the board as a whole had been charged by shareholders, would have been found to have constituted a breach of duty, 'however reasonable and however safe it might have seemed to the directors', but for an exculpatory article. There had been a division of labour which had not been adhered to by the two directors in question.
12.15      As far as officers are concerned, the emphasis has been to an even greater extent on business efficacy. In Dovey v Corey^[21] Lord Halsbury stated that:

I cannot think it can be expected of a director that he should be watching either the inferior officers ... or verifying the calculations of the auditor himself. The business of life could not go on if people could not trust those who are put into a position of trust for the express purpose of attending to details of management.

12.16      Thus the emphasis is largely on the exercise of proper judgment in selection of matters which it is proper for directors to leave to some only of their number, or some other individual or organisation, rather than on any monitoring which should be undertaken once a delegation has been properly made.

Auditors, solicitors and other outside advisers

12.17      As something of a contrast, directors will in certain circumstances be in breach of their duties if they fail to take appropriate, especially legal, advice.^[22] The approach in respect of co-directors and officers, that "business cannot be carried on upon principles of distrust",^[23] has been applied in relation to outside advisers, notwithstanding a hardening of attitude in other respects, by Hoffmann J in Norman v Theodore Goddard. In that case a director who was a chartered surveyor with no knowledge of company law was entitled to rely on a senior solicitor administering the company's property, whose conduct had given no, or no sufficient grounds for concern.
12.18      Lord Halsbury's speech in Dovey v Corey, insofar as it relates to auditors, has already been noted.^[24] An auditor is, however, entitled to rely on the honesty of other company officers in the absence of suspicious circumstances.^[25] He is not an insurer and does not guarantee that a company's books correctly show the true state of its affairs.^[26] His own duty, however, to exercise 'reasonable skill, care and caution'^[27] and the necessarily defined and delegated nature of his duties, will go a long way towards satisfying a director's duty when reliance is placed on him.
12.19      In the case of all outside advice, nonetheless, slavish reliance is not acceptable. The obtaining of outside advice does not absolve directors from the duty of exercising their judgment on such advice:^[28] where, for example, a discretion is given, it must be exercised.^[29]

Trustees' duty of skill and care

12.20      The developments in the law governing the trustees' duties of care are not dissimilar from those that have occurred in relation to directors.
12.21      Under the traditional common law rule:

[I]t is the duty of a trustee to conduct the business of the trust with the same care as an ordinary prudent man of business would extend towards his own affairs.^[30]

12.22      However, higher standards are expected of trustees who hold themselves out as having special expertise. Thus in Barclays Bank v Bartlett^[31] Brightman J held that:

a professional corporate trustee is liable for breach of trust if loss is caused to the trust fund because it neglects to exercise the special care and skill which it professes to have.^[32]

12.23      There are, however, dicta to the contrary,^[33] and recent Commonwealth authority seems to favour a single standard.^[34]
12.24      In its recent consultation document on trustees' powers and duties^[35] the Law Commission considered whether there should be a statutory statement of the duty of care to be exercised by a trustee when they delegate their powers. Five options for the appropriate test were put forward for consultees' views,^[36] namely good faith, strict liability, a statutory statement of specified safe harbour criteria, the conduct of a reasonable prudent person and a dual subjective/objective test based on the Model Trustee Code for Australian States and Territories.^[37] The latter requires a trustee to:

act with care, skill, prudence, and diligence having regard to-

(a) the nature, composition and purposes of the trust; and

(b) the skills which the trustee possesses or ought, by reason of his business or calling, to possess.

Therefore the duty is defined by regard to-

the characteristics of the particular trust; and

the skills which the trustee actually has; or

if he or she is professional, the skills which the trustee ought to have.

12.25      This standard allows greater flexibility, and enables fuller account to be taken of the attributes of the particular trustee.^[38] The issue might not simply be whether the trustee was either paid, or held him or herself out as having a particular skill in trust administration in order to secure the trusteeship.^[39] The conduct of an unpaid trustee who had a particular expertise would also be judged according to that skill, and not as if he or she was in all respects a lay person. Furthermore professional trustees who hold themselves out as having a particular expertise should be judged according to that standard, even if they do not in fact have it.

Duties of directors under German law

12.26      Many countries in the European Union have legal systems which are based on codes and the legal environment is very different from our own. We did not consider that it would be useful to carry out a pan-European survey of the law of other member states of the European Union having such systems, but we have considered the duty of care owed by directors under Article 93 of the German Stock Corporation Act ("AktG").^[40] The summary of the position set out in paragraphs 12.26-12.30 is based upon a study of the position by Professor Frank Wooldridge.^[41]

Introductory remarks: Director's liability for due care

12.27      Executive board members of a German public company (hereinafter called directors) must exercise the care of a sound and conscientious business manager.^[42] The standard is not that of an ordinary business man, but that of a man in a leading and responsible position as the manager of other persons' property in a specific enterprise. The test is an objective one, and individual abilities are not taken account of.^[43] Furthermore, unfitness or inexperience is not an excuse. When an action is brought against them, it appears that directors have to show compliance with this strict rule.^[44] The general view is that the due care requirement is an absolute one, irrespective of subjective fault involving some degree of blameworthiness (Vorwerfbarkeit) and any failure, however slight, may result in a requirement to pay damages. However, the German courts and text writers do not always seem to have adopted this view.
12.28      A higher degree of care may be required from professionally qualified directors, such as lawyers, certified accountants, or bankers. This was made apparent in a case heard by the Landgericht of Düsseldorf in 1994,^[45] in which the court held that the manager of a private company who was an experienced lawyer and who had also served on the board of a large public company, could not escape liability towards the private company by pleading that he had relied on an expert opinion which he had requested.
12.29      A director is also liable for failure to control his colleagues. If each director has particular functions allocated to him by the statutes of the company, the contract of employment or the company rules (Geschäftsordnung),^[46] then such a director is in principle liable in respect of his own sphere of activity. However, he may become liable for the activities of fellow directors if he has exercised inadequate supervision over them, or has failed to intervene where the wrongful conduct of a director has become known throughout the business, or where such conduct has failed to become public knowledge through his own lack of care. The division of functions between different directors in one of the ways described in this paragraph does not release any of them from their duty of supervision (Überwachungspflicht), which may be exercised with the help of agents, where necessary. Many of the decisions of the courts concerning the duties of directors involve this duty of supervision.
12.30      It appears that in the past, the German courts have given insufficient attention to the need for directors faced with difficult choices to exercise their business judgment, but their approach to this question now seems to be changing.

Burden of proof

12.31      In an action under AktG, paragraph 93, the company is required to produce evidence of acts of the directors which have caused damage. As far as the proof of causation is concerned, inference from the surrounding circumstances or the rules of prima facie evidence will support the company's action. Furthermore, the question of causation is left to the discretion of the judge in accordance with the provisions of paragraph 287 of the Civil Procedure Code. Damage is presumed in the special cases mentioned in AktG, paragraph 93(3): a detailed account of which is beyond the scope of this brief overview. The general view is that the burden of proof is placed upon the director to show that he exercised the care of a diligent and conscientious manager.^[47] However, it has been argued by some writers that this reversal of the normal civil burden of proof (which has also been held to apply to private companies and co-operative societies), only applies to the extent that a director has to show that he has not been guilty of subjective fault.^[48]

Release from liability

12.32      Directors will not be liable to the company in damages if their action depends on a lawful resolution of the general meeting.^[49] Such a resolution may be passed because the directors have referred a question of the management of the company to the general meeting,^[50] or because a matter is otherwise within the competence of the general meeting. However, the general view is that subsequent ratification of a breach of duty does not relieve the directors from liability. Such liability is also not precluded by reason of the fact that the supervisory board has approved the transaction.^[51] The company may, as a general rule, waive the damage claim or enter into a settlement only after three years, and if a minority representing at least ten per cent of the stated capital does not object.^[52] Thus the discharge (Entlastung) of the directors by the general meeting only expresses a general approval of the management's performance: it does not effect a waiver of claims for damages.^[53] However, it has somewhat controversially been held that there is an exception to this rule if the discharge is voted unanimously by all shareholders.^[54] It should be emphasised that no one may exercise voting rights, whether by voting in respect of his own shares or acting as a proxy, or a resolution whereby he is to be discharged or released from an obligation, or on a determination whether the company shall assent a claim against him.^[55]

Note 1   Henderson v Merrett Syndicates Ltd [1994] 3 WLR 761, 799, per Lord Browne-Wilkinson.    [Back]

Note 2   (1872) LR 5 HL 40, 486-7.    [Back]

Note 3   Re Cardiff Savings Bank [1892] 2 Ch 100.     [Back]

Note 4   Although falling asleep at meetings, having attended them, was viewed differently in Land Credit Co of Ireland v Lord Fermoy (1870) LR 5 Ch App 763.    [Back]

Note 5   Re Denham & Co (1884) 25 ChD 752.    [Back]

Note 6   [1911] 1 Ch 425.     [Back]

Note 7   Ibid, per Neville J, at p 437.    [Back]

Note 8   "If he is acquainted with the rubber business he must give the company the advantage of his knowledge when transacting the company's business."Ibid, at p 437.     [Back]

Note 9   Dovey v Corey [1901] AC 477, per Lord Davey.    [Back]

Note 10   Overend, Gurney & Co v Gib, loc cit at p 495.    [Back]

Note 11   [1925] Ch 407.    [Back]

Note 12   Ibid, at p 427.    [Back]

Note 13   Ibid, at pp 428-9.    [Back]

Note 14   Dorchester Finance Co v Stebbing [1989] BCLC 498.    [Back]

Note 15   [1992] BCC 14.    [Back]

Note 16   [1993] BCC 646.    [Back]

Note 17   [1993] BCLC 1282.    [Back]

Note 18   See para 12.7 above.    [Back]

Note 19   See paras 13.18-13.19 and 15.23-15.24 below.    [Back]

Note 20   Palmer's Company Law, para 8.408.    [Back]

Note 21   [1901] AC 477, at p 485.    [Back]

Note 22   See Re Duomatic [1969] 2 Ch 365, 377.    [Back]

Note 23   Re City Equitable Fire Insurance, at p 429.    [Back]

Note 24   See para 12.14 above.    [Back]

Note 25   Re Kingston Cotton Mill Co (No 2) [1896] 2 Ch 279 (CA).    [Back]

Note 26   Re London and General Bank (No 2) [1895] 2 Ch 673 (CA).    [Back]

Note 27   Ibid, at p 683.    [Back]

Note 28   Palmers Company Law, para 8.409.    [Back]

Note 29   See Re Faure Electric Accumulator Co (1880) 40 Ch D 141; Re New Mashonaland Exploration Co [1892] 3 Ch 577; and Leeds Estate Building and Investment Company v Shepherd (1887) 36 Ch D 787.    [Back]

Note 30   Bartlett v Barclays Bank Trust Co Ltd (No 1) [1980] Ch 515, at p 531, per Brightman J, on the basis of cases such as: Speight v Gaunt (1883) 9 App Cas 1, 19 (HL); Learoyd v Whitley (1887) 12 App Cas 727; Eaton v Buchanan [1911] AC 253 (HL); and Raes v Meek (1886) 16 R HL 31, at p 33.    [Back]

Note 31   [1980] 1 Ch 515.    [Back]

Note 32   Ibid, at p 534.    [Back]

Note 33   Jobson v Palmer [1893] 1 Ch 71, per Romer J.    [Back]

Note 34   Australian Securities Commission v A S Nominees Ltd (1995) 133 ALR 1; Fales v Canada Permanent Trustee Co (1976) 70 DLR (3d) 257.    [Back]

Note 35   (1997) Consultation Paper No 146.    [Back]

Note 36   Ibid, para 6.55. The Law Commission is currently preparing a report on this subject.    [Back]

Note 37   (1989) vol 1 pp 24-26.    [Back]

Note 38   The court does not take such attributes into account under the common law test of reasonable prudence: see Learoyd v Whitlely (1887) 12 App Cas 727, at pp 731-732.    [Back]

Note 39   Cf Bartlett v Barclays Bank Trust Co Ltd (No 1) [1980] Ch 515, at p 534.    [Back]

Note 40   See Appendix K below.    [Back]

Note 41   Now Professor at the Notre Dame University in London. Professor Wooldridge has written extensively on German Company Law and we are indebted to him for permission to use this summary. Paras 12.26-12-30 and n 48 below were drawn from the text of an article due to be published inAmicus Curiae, the Journal of the Society for Advanced Legal Studies, at the Institute of Advanced Legal Studies, University of London.    [Back]

Note 42   AktG, para 93(1) No 1. The management board (vorstand) of a German public company (AG) has the exclusive responsibility for managing the corporation. The company also has a supervisory board (Aufsichstrat) which is elected by the shareholder. This appoints and supervises the management board. No person may be a member of both boards.    [Back]

Note 43   See Management and Control of Marketable Share Companies Ch 4 International Encyclopaedia of Comparative Law at p 50.    [Back]

Note 44   AktG, para 93(2) No 2.    [Back]

Note 45   Die Aktiengesellschaft 1994, p 330.    [Back]

Note 46   See AktG, para 77.    [Back]

Note 47   See Willi Joachim, "Liability of Supervisory Directors in Germany" The International Lawyer vol 25, no 1, p 41, at p 63.    [Back]

Note 48   The Supreme Court may have somewhat alleviated the burden of proof placed on the officer of a co-operative society who had delegated duties to a possibly dishonest or incompetent consultant in a recent case: see NJW 1997, 1905. It required the co-operative society to prove that the officer had allowed the consultant to receive payment for advisory services which were not included in the settlement agreed upon, whilst the officer was required to prove that she had made payments to a competent consultant, who had rendered the appropriate services for such payment, which held to concrete results which were beneficial to the co-operative society. Thus in this case, the burden of proving that no breach of duty had occurred in relation to particular matters was laid on each party. Such an approach is perhaps justified in particular cases, especially perhaps where certain duties are delegated. The application of the relevant German rules governing the burden of proof, whatever their precise nature, may well depend upon the facts and circumstances of the particular case and in many cases it may be hard to predict the outcome. Although the German rules would generally seem to impose a greater burden on directors than do those applicable in the United Kingdom, they appear workable, although the operation of para 93(2) No 2 is open to some dispute. In some situations (in which the burden placed on that company is lessened) its effect is easy to understand. Thus, for example, a company might assert that its actual assets and resources were less than those shown in the books. The directors would then be called on to explain this deficiency, the reason for which should be within their knowledge. They might well hope to convince the court that this depletion did not take place through any fault of their own, but resulted from inaccurate bookkeeping, for which they could not be held responsible, the assets having been disposed of in specified ways (see BGH BB95, 1754, a case which concerned a private company).    [Back]

Note 49   AktG, para 93(4) No 1.    [Back]

Note 50   AktG, para 119(2).    [Back]

Note 51   AktG, para 93(4) No 2.    [Back]

Note 52   AktG, para 93(4) No 3.    [Back]

Note 53   AktG, para 1202(2).    [Back]

Note 54   BGHZ 29.385.    [Back]

Note 55   AktG, para 136(1).    [Back]