Scottish Law Commission (Discussion Papers)

Part 15




Part 15 Duty of Care: Options for Reform

Introduction

15.1      In this part, we examine the ways in which the law on the director's duty of care to his company could be reformed. There is no doubt that a director owes a duty to his company to exercise care in carrying out his functions. However, what is not so clear is the standard of care which the director must show.
15.2      We begin by summarising the current position in respect of the standard of care which was discussed in detail in Part 12. We then go on to consider whether there should be a statutory statement of the duty of skill and care. Next, we examine what the content of such a statutory statement should be and set out a number of possible options. We then go on to consider the rule that the courts do not investigate bona fide decisions involving matters of business judgment (known as "the business judgment rule") and discuss the question whether there should be a statutory business judgment rule.^[1] Next, we consider whether there should be statutory provisions dealing with reliance and delegation.^[2] Finally we ask whether there should be a statutory statement of the duty of care even if there is no statutory statement of fiduciary duties.^[3]

Current position in respect of the standard of care

15.3      As explained in Part 12 of this consultation paper, the effect of the older cases in this field is that the required standard of care is low: directors discharge their duty if they exercise such care as is reasonably to be expected of them, having regard to their knowledge and experience. They are not therefore required to act as (say) reasonably competent directors. If they do not have the knowledge and experience that a reasonably competent director would have, account is taken of that fact and their conduct is judged by reference to the knowledge that they actually have. Furthermore non-executive directors are not required to perform their duties except at board meetings.^[4] While all directors should attend board meetings when they reasonably can, the law (as established in the older authorities) does not oblige them to attend.
15.4      However, we also referred in Part 12 to section 214 of the Insolvency Act 1986, which imposes a liability on directors to contribute to the assets of the company if they have caused their company to trade at a time when it could not avoid entering insolvent liquidation. This requires the conduct of directors to be judged both purely objectively and subjectively by reference to their own personal characteristics. Thus, to decide what steps the director ought to have taken, two questions are asked :

(1) what steps would have been taken by a reasonably diligent director who has the knowledge skill and experience reasonably to be expected of a director carrying out the same functions;^[5] and

(2) what steps would a reasonably diligent person with this director's knowledge skill and experience have taken?

15.5      More recently the courts have used this section as a basis for saying that the standard of care which a director must now show under the general law requires the director to act as a reasonably diligent person having not only the same general knowledge and experience as the director but also the general knowledge and skill to be expected of a person having the same functions.^[6] The better view is that this more modern statement of the duty of care of a director now represents the law and would be followed by the higher courts.

Should there be a statutory statement of the duty of care?

15.6      As we see it there are a number of possible purposes to be served by a statutory statement of the director's duty of care to the company:

(1) it would clarify the law and result in certainty as to the effect of the recent decisions;^[7]

(2) it would make the law more accessible to directors. Directors may well not have a copy of the Act or be able to find their way around it, but the Act would provide a convenient statement of the law. This could be used by Companies House, representative professional bodies and commercial publishers in books and pamphlets produced for directors; and

(3) by stating the essential proposition of law in more modern language, the law should be more easily understood by directors.

Consultees are asked whether they consider that there are objectives that might be achieved by a statutory statement of the director's duty of care other than those set out in paragraph 15.6.

15.7      A statutory statement of the director's duty of care could set out the standard of care to be exercised by a director comprehensively and accordingly if there were to be a statutory statement of the directors' duty of care it would naturally replace the common law, avoiding the need to define the relationship between it and the common law and difficulties which can arise in doing so.
15.8      However, there is an important question to ask, which is whether this is an area of law where it would be better if development were left to the courts rather than Parliament. The courts could develop the law on a case by case basis. This would be slower and more costly for litigants but it would allow the law to be worked out in actual situations, thus enabling the law to react to and take account of any problems that arise as it is developed. In this area it is not a question of codifying law that has already become well settled because, as we have seen, the law here has been evolving. On the other hand it is equally clear that at the present moment at least the courts are likely to develop a twofold test on the lines of section 214 of the Insolvency Act 1986. If it is not considered satisfactory to apply a twofold test, then there may be a case for a statutory statement of the duty of care setting a purely subjective standard (option 1 below). If it can be seen that the law is evolving towards a twofold test and it is considered that there is nothing noticeably unsatisfactory about the new standard which the courts are setting, there may be little objection to setting this out in statute (option 2 below).^[8] Indeed a statutory statement of the duty of skill and care would help remove uncertainty. It would also make the duties of directors more accessible and comprehensible to directors. However, it is also said that if the duty of care of a director were made statutory, people would be deterred from becoming directors and in particular there would be few who would wish to accept appointment as a non-executive director.^[9]
15.9      We explain in this part that we consider that the standard of care to be exercised by a director generally should be no less than that which must be exercised when the company is on the verge of insolvent liquidation - so it should be the same as is required by the courts in interpreting section 214. In our view, this approach would be fair and workable.

Consultees are asked whether or not they favour a statutory statement of the duty of care. Consultees may wish to consider the options for that statement^[10] before deciding how to respond.

Content of a statutory statement of the duty of care

15.10      The next issue is the standard by which a director's conduct should be judged in determining whether he has discharged his duty of care. We consider three options:

Option 1: a subjective test

Option 2: a dual subjective/objective test

Option 3: an objective test only

Option 1: A subjective test

15.11      Under this option, it would be stated that a director owes a duty to his company to exercise the care, diligence and skill that would be exercised by a reasonable person having his knowledge and experience.^[11] Account would be taken of the responsibilities of the director in question and the circumstances of the particular company.^[12] We refer to this as the low standard of care because it will lead to a lower standard of care if the director has inadequate knowledge and experience.
15.12      Various justifications are advanced for a low standard. It is argued that management is not a profession and that directors do not require particular skills to discharge their duties. However, many areas of business now require specialised skills and knowledge beyond those possessed by the layman. The academic literature on management studies is voluminous and various qualifications are available to existing and aspiring managers. Possession of an MBA qualification is becoming increasingly a pre-requisite for recruitment to executive positions or further advancement. Thus, although an Institute of Directors survey in 1990 showed that only a quarter of directors possessed any professional or management qualification,^[13] this figure may well rise further in the relatively near future.
15.13      It is also argued that to raise the standard of care may encourage litigation whereas management should be supervised by shareholders, not the courts.^[14] As to this argument, to the majority of smaller shareholders in listed or quoted companies, share ownership is simply an investment without the incidents of management control which may have existed formerly. The appointment of directors, although subject to the approval of the company in general meeting, is in reality a matter for the Chairman or board appointments committee, alternative appointments not generally being put to shareholders. Shareholders have, since 1948, had the right to remove directors by ordinary resolution,^[15] a power described by Palmer as 'one of the most important principles of modern company law'.^[16] The extent to which it is actually used by smaller shareholders is, however, doubtful.^[17] Since the beginning of this century, shareholders have had virtually no general supervisory power over the board.^[18]
15.14      A further factor is that the power of institutional shareholders to assess and act upon managerial incompetence is often not as strong as may at first appear. Although institutions may be represented on the board:

[I]t is difficult for [outside directors] to pose questions of a challenging nature to knowledgeable persons without appearing superficial or incompetent. It is also considered bad form to ask questions that imply doubts about motives and competence... .^[19]

15.15      It is also argued with some force that the courts are not well placed to second- guess matters of business judgment:^[20]

Directors ... are charged with the responsibility of maximising profits. To do this it will frequently be necessary for them to take risks. Whether a risk is worth running depends on an estimate of its magnitude in the light of the potential reward. Assuming ... that directors have sufficiently researched a project, it is not evident how a court could determine whether the expected profits justify the risks involved, and this is likely to be the case with respect to much business decision-making.^[21]

15.16      Another reason is that in some cases a company appoints a person as a director for some attribute that he has, for example he may be a former civil servant or diplomat and the company may wish to take advantage of the knowledge and experience that he has built up in that capacity. Where the candidate was formerly a diplomat in a particular part of the world in which the company is seeking to establish itself it may be useful for the company to have a director who is familiar with the language and culture of that part of the world. He may however have limited knowledge of corporate finance and accounting. It can be argued that the law should take account of his lack of knowledge and skill in this regard.^[22]
15.17      As against these points:

(1) The purely subjective test for directors is out of line with the duty generally imposed on persons who agree to provide services. This is especially anomalous where, as is usually the case for executive directors and is often the case for non-executive directors, they are paid.

(2) It is not suggested that the duty of care imposed on directors should be higher than that which is being evolved in the cases in any event.^[23]

(3) Insurance cover is marketed to protect directors who do not wish to take the risk of being held liable.^[24]

(4) The present law fails to provide an adequate sanction for mismanagement. Mr Edgar Speyer in a minority report attached to the Report of the Company Law Amendment Committee^[25] in 1906 said:

The suggestion that men will not so easily accept directorships under such conditions^[26] is, it is submitted, no answer. It is not directors who need protection, but the public. There is small moral sanction for the position of a man who has ten or more directorships, whose companies go into liquidation through mismanagement and who, apart from what he may have paid for his qualification shares, loses nothing, not even his market value as a director, for he is free to reap an income by joining other boards. A trader who is negligent in the management of his business and ends in bankruptcy has to bear the stigma and the disabilities of the status of a bankrupt. I submit that a director ought not to and need not be in any better position than an ordinary trader.

This gap in the law has to some extent been filled by the Company Directors Disqualification Act 1986, which enables the court to disqualify a director whose conduct makes him unfit to be a director. However, a serious case of negligence would have to be made out if the only allegation against him was one of mismanagement. Moreover disqualification serves a different purpose of protecting the public for the future. It does not provide compensation for the company which has lost money through the mismanagement.

(5) There are many other jurisdictions where directors are bound to act as reasonable competent directors or businessmen.^[27]

15.18      Finally, we have pointed out above^[28] that it is said that if the duty of care of a director were made statutory, people would be deterred from becoming directors and in particular there would be few who would wish to accept appointment as non-executive directors. It is said that this is less likely to be the case if the standard of care contained in a statutory statement was subjective but this may not turn out to be the case because for some directors with special qualification the subjective standard will be higher than the objective standard.
15.19      Our provisional view is that this option should be rejected. It is out of line with the standard applied to a director's conduct for the purposes of wrongful trading under section 214(4) of the Insolvency Act 1985, and with recent case law.

Consultees are asked whether they consider that the standard of care expected of a director should be judged by a subjective test - so as to be that expected of a reasonable person having the same knowledge and experience that the director has.

Option 2: A dual objective/subjective test

15.20      Section 214 of the Insolvency Act 1986 (Wrongful trading) imposes a dual test. A director can avoid liability if he takes those steps

(1) which would be taken by a reasonably diligent person with the knowledge skill and experience reasonably to be expected of a director carrying out the same functions; and also

(2) which would be taken by a reasonably diligent person with his knowledge skill and experience.

15.21      This enables the court to ask what it would be reasonable to expect the director to have done both by reference to the responsibilities that he undertook, and by reference to his own special knowledge and skills, eg as a lawyer. It has been said with reference to section 214(4), that the former is only a minimum standard and "observance of the minimum standard is not necessarily sufficient. The director must also meet such higher standard as is appropriate to his own general knowledge, skill and experience."^[29] We provisionally consider that such a dual test is appropriate generally, and not merely where the company is on the verge of insolvency. We do not consider it appropriate for the test to be only subjective, since that would mean that a director could rely on his own particular lack of knowledge or experience. In our view, all directors should be subject to a general standard of care, and a particular director should not be able to rely on his own particular lack of knowledge or experience to avoid being subject to that general standard. On the other hand, we consider it fair that if he has some special expertise, he should have to exercise it.^[30]
15.22      On the other hand we are aware that there is anxiety in some quarters that to state the director's duty of care in this way could lead to an increase in the number of claims against directors. It might for instance encourage the company itself or shareholders on its behalf (through the derivative action or in Scotland, the shareholder's action) to bring claims. The statutory statement might also lead to anxiety that that would be the result so that people would decline to act as directors (particularly as non-executive directors) or conduct themselves as a directors in an overcautious way to avoid any claim being mounted against them. There has been a concern along these lines in Australia and we examine that below.^[31] Our proposed empirical survey may shed light on this issue. One solution may be the development by private sector bodies of the check lists for compliance with due diligence proposed in paragraph 3.90 above.
15.23      We have considered whether the law should draw a distinction between skill, care and diligence.^[32]
15.24      To make a distinction between skill, care and diligence runs the risk that arguments will arise as to whether that which it is alleged the director ought to have done (eg cause the company to diversify into different products) was something which a reasonably careful person in the position of the director would have done or something which the director should have done because the director had some special skill (eg in knowing when the market in the company's existing product line was about to fall). Accordingly, we do not propose to draw a distinction, and instead consider that the same standard should apply to each of skill, care and diligence.
15.25      It is useful to see how the courts have applied section 214(4) of the Insolvency Act 1986 in practice. The first case to be decided under this section was Re Produce Marketing Consortium Ltd (No 2).^[33] In that case the company had a small number of directors and shareholders and none of the directors had any special qualification. The company had a large overdraft and its audited accounts showed that it was trading at a loss. Those accounts were late and of course did not show the current position, but the directors knew from their own knowledge of the business that there had been a substantial drop in turnover and Knox J held that they ought to have realised that that meant that they had been trading at a loss. The court was satisfied that this knowledge should be imputed to them. The court however accepted that it should take into account the particular circumstances of the company and that the knowledge skill and experience required in a small company with simple accounting systems would be less than it would be in a larger company. Another case where the court has applied section 214(4) is Re DKG Contractors Ltd.^[34] The court expressed the view that the directors' skills were "hopelessly inadequate" but that that was insufficient to protect them from liability under section 214.^[35]

Consultees are asked whether the standard of care expected of a director should be judged by a twofold subjective/objective test.

15.26      For illustrative purposes a draft clause setting out a director's duty of care skill and diligence has been drafted and appears in Appendix A (draft clause 1 containing a new draft section 309A for the Companies Act 1985). We would draw attention to the following points in particular about the policy which the draft clause is intended to illustrate. First, the intention is to attribute to the director both the notional knowledge and experience which may reasonably be expected of a person in the same position as the director (subsection (1)(a)) and the actual knowledge and experience which the director has (subsection (1)(b)). The intention is that the former would be a minimum standard required by law of all directors. If the particular director possesses greater knowledge or experience than that which may reasonably be expected of directors generally, he would have to meet a higher standard of care, skill and diligence appropriate to his knowledge and experience. If he happens to possess less knowledge or experience than that which may reasonably be expected generally of directors, he would nevertheless be required by law to meet the minimum standard applied to all. The intention is that the two tests should be aggregated in this way. A director would not be able to rely on his own particular lack of knowledge or experience to avoid being subject to the general minimum standard of care to be required of all directors.
15.27      The draft clause has been modelled on section 214(4) of the Insolvency Act 1986, which has been interpreted to achieve the desired effect.^[36] It can also be said that the new section should follow section 214 so as to achieve consistency in the position of directors both during the life of the company and as the company approaches insolvent liquidation, and because the courts have had experience of the wording of section 214 for over 12 years. We are aware, however, that the interpretation of that provision has been questioned.^[37] Draft clause 1 in Appendix A is for illustrative purposes only at this stage. We shall return to the detail of the drafting when preparing our Report. Consultees should not assume that if this option is finally recommended, the clause we recommend would necessarily be in this form.
15.28      Secondly, we consider it important that the standard of care set out in statute should take account of the differences of fact between the responsibilities of directors of different types and in different situations,^[38] for example between what executive directors and non-executive directors are expected to do. The test at subsection (1)(a) therefore looks at the notional knowledge and experience that may reasonably be expected of a person in the same position as the director, enabling the court to take account of such differences.

Option 3: An objective test only

15.29      A further possibility can be seen in section 137 of the New Zealand Companies Act 1993 which simply applies an objective test to the standard of care to be exercised by a director.^[39] The special qualifications that a director has are ignored, even if they were the reason why the company appointed him a director in the first place. This may have merit where the director does not hold himself out as having any additional knowledge skill and experience or is not known to have it, but it may be doubted whether there are many cases where a director has a special skill or special knowledge and experience and this is not known to the company at the time of his appointment and did not constitute one of the reasons for appointing him. Moreover, there are reasons for rejecting this option even if this is a case where the director's special knowledge was not known to the company. If this option were adopted, it would mean that during the life of the company a director's conduct was judged by a purely objective standard, but, once there was a situation in which it was clear that the company would have to go into liquidation and that not all creditors would be paid in full in the liquidation, he was judged by a separate and different standard and that extensive personal liability could be imposed on him under section 214 not merely if he failed to comply with the objective test, but also if he failed to exercise some special skill that he had, for example as an accountant or lawyer. This would not produce a coherent and consistent scheme for imposing liability for negligence on directors.

Consultees are asked whether they consider that the standard of care expected of a director should be judged solely by an objective test - so as to be that expected of a reasonable person having the knowledge and experience which may reasonably be expected of a person in the same position as the director without taking account of any special expertise that the particular director possesses.

Matters of commercial judgment

15.30      The courts of both Australia and the United Kingdom have expressed an unwillingness to second guess directors on commercial matters. Thus in Howard Smith v Ampol Petroleum, Lord Wilberforce, giving the advice of the Privy Council, said:

it would be wrong for the court to substitute its opinion for that of the management, or indeed to question the correctness of the management's decision ... if bona fide arrived at. ^[40]

15.31      This approach is comparable to the rule known in the United States as the business judgment rule, which is described in the next paragraphs. The next question is whether, if a statutory duty of care is introduced, there needs to be a statutory statement of the principle of non-interference by the courts in commercial decisions made in good faith. We discuss this question in paragraph 15.41 below. Before that, we examine the business judgment rule in the United States, and recent developments in Australia and South Africa.

The business judgment rule in the United States

15.32      There is in many states of the United States a judge-made rule which prevents directors from being liable for claims for breach of duty/negligence where certain factors are established.^[41] Those factors can vary in different states but the American Law Institute endeavoured to distil its principles in their work on the Principles of Corporate Governance:

4.01 Duty of care of Directors and Officers; the Business Judgment Rule

(a) A director or officer has a duty to the corporation to perform the director's or officer's functions in good faith, in a manner that he or she reasonably believes to be in the best interests of the corporation, and with the care that an ordinarily prudent person would reasonably be expected to exercise in a like position and under similar circumstances. This Subsection (a) is subject to the provisions of Subsection (c) (the business judgment rule) where applicable.

The duty in Subsection (a) includes the obligation to make, or cause to be made, an enquiry when, but only when, the circumstances would alert a reasonable director or officer to the need therefor. The extent of such enquiry shall be such as the director or officer reasonably believes to be necessary.

In performing any of his or her functions (including oversight functions) a director or officer is entitled to rely on materials and persons in accordance with (( 4.02 and 4.03 (reliance on directors, officers, employees, experts, other persons, and committees of the board).

(b) Except as otherwise provided by statute or by the standard of the corporation [( 1.36] and subject to the board's ultimate responsibility for oversight, in performing its functions (including oversight functions), the board may delegate, formally or informally by course of conduct, any function (including the function of identifying matters requiring the attention of the board or to directors, officers, employees, experts, or other persons: a director may rely on such committees and persons in fulfilling the duty under this Section with respect to any delegated function if the reliance is in accordance with (( 4.02 and 4.03.

(c) A director or officer who makes a business judgment in good faith fulfils the duty under this Section if the director or officer:

(1) is not interested^[42] in the subject of the business judgment;

(2) is informed with respect to the subject to the extent the director or officer reasonably believes to be appropriate under the circumstances; and

(3) rationally believes that the business judgment is in the best interests of the corporation.

(d) A person challenging the conduct of a director or officer under this Section has the burden of proving a breach of the duty of care, including the inapplicability of the provisions as to the fulfilment of duty under Subsection (b) or (c), and, in a damage action, the burden of proving that the breach was the legal cause of damage suffered by the corporation.

15.33      For present purposes it is paragraph (c) of the above rule which is of most interest. The commentary states that each of the requirements of this paragraph are supported by authority. The purpose is to protect directors (and officers) from "hindsight reviews of their unsuccessful decisions and to avoid the risk of stifling innovation and venturesome business activity. The business judgment rule (set forth in ( 4.01(c)) is a judicial gloss on duty of care standards which sharply reduces exposure to liability."^[43] "This standard is intended to provide directors and officers with a wide ambit of discretion."^[44] The phrase "rationally believes" in (4.01 (c) (3) is intended to bear a wider meaning than "reasonably believes" and "to give a director a safe harbour from liability for business judgments that might arguably fall outside the term 'reasonable' but are not so removed from the realm of reason when made that liability should be incurred."^[45] The principle as stated by the American Law Institute is consistent with decisions of the courts which when applying the business judgment rule "have often stated that a "presumption" exists in favour of the propriety or regularity of the actions of directors and officers."^[46]
15.34      The business judgment rule will not protect a director who fails to consider exercising his judgment, as opposed to a director who considered whether to take a particular course of action but decided not to do so. The business judgment rule does not protect a director who does not act in good faith or who has a conflict of interest. A director must have the information which he reasonably believes is appropriate before he makes his decision, but he will not be liable for failure to realise that he should have certain information unless he was grossly negligent in reaching the view that he did not require this information.^[47] The time available for obtaining the relevant information and the cost of obtaining it are factors which the director can take into account in reaching a view as to what information is appropriate.

The Australian approach

15.35      Different views have been expressed in Australia about the need for a statutory business judgment rule. In its Report No 10, Company Directors and Officers: Indemnification, Relief and Insurance, the Companies and Securities Law Review Committee (CSLRC) recommended the enactment of a statutory business judgment rule on the ground that the rule would reinforce directors' ability to make operational decisions which would not be reviewable on their merits in the courts. In 1989, in their Report on the Social and Fiduciary Obligations of Company Directors, the Australian Senate Standing Committee on Legal and Constitutional affairs also recommended the introduction of a statutory business judgment rule.
15.36      However the Australian Government rejected the need for a statutory business judgment rule. In 1992 a Corporate Law Reform Bill was introduced which restated the duty of care owed by a director. The Explanatory Memorandum to that Bill stated that the Government considered that the development of a business judgment rule was best left to the courts. The Explanatory Memorandum said that the courts had recognised that directors are not liable for mere errors of judgment and were reluctant to review decisions taken in good faith and not for irrelevant purposes. As a result of the Corporate Law Reform Bill, section 232(4) of the Australian Corporations Code, which is set out in Appendix H, was enacted.
15.37      In November 1997, new proposals for reform were issued for consultation as part of the Corporate Law Economic Reform Program.^[48] It was noted that recent case law, in particular the decision in Daniels v Anderson,^[49] had increased the liability of directors and that subsequent decisions had given rise to uncertainty as to the extent of that liability. The consultation paper stated that

While it is accepted that directors should be subject to a high level of accountability a failure to expressly acknowledge that directors should not be liable for decisions made in good faith and with due care can have the effect of encouraging business behaviour which is risk-averse.

15.38      The consultation paper noted that the uncertainty might be causing an increase in agency costs,^[50] and might also increase the remuneration that had to be paid to directors. An increase could undermine agency costs in company performance. The consultation paper noted that if liability rules were to be "efficient tools of corporate governance, liability rules need to be tempered against the need to ensure that the attention of directors is not significantly diverted from the pursuit of maximising shareholder wealth". The fact that the court had power^[51] to relieve directors from liability after the event was insufficient. While the courts already decline to review business decisions, a business judgment rule would create a presumption in favour of a director's judgment and would thus lead to greater certainty. On the other hand the rule should be framed so as to encourage proper corporate practices and not protect directors from ill-informed decisions.
15.39      The draft bill issued for consultation following the issue of the consultation paper contains the following draft business judgment rule:

(2) A director or other officer of a corporation who makes a business judgment is taken to meet the requirements of subsection (1) [duty of care and diligence], and their equivalent duties at common law and equity, in respect of the judgment if they:

(a) make the judgment in good faith for a proper purpose; and

(b) do not have a material personal interest in the subject matter of the decision; and

(c) inform themselves about the subject matter of the decision to the extent they reasonably believe to be appropriate; and

(d) rationally believe that the decision is in the best interests of the corporation.

The director's or officer's belief that the decision is in the best interests of the corporation is a rational one unless the belief is one that no reasonable person in their position would hold.

Note: This subsection only operates in relation to duties under this section and their equivalent duties at common law or in equity (including the duty of care that arises under the common law principles governing liability for negligence - it does not operate in relation to duties under any other provision of this Law or under any other laws).

(3) in this section:

business judgment means any decision to take or not take action in respect of a matter relevant to the business operations of the corporation.

South Africa

15.40      In South Africa, the King Committee has also recommended that there should be a statutory business judgment rule. It considered that, particularly in the case of non-executive directors, the duty of care and skill was onerous, and that a director should not be liable for breach of the duty of care if he exercised a business judgment in good faith, provided that the decision was an informed one based on all the facts and was a rational decision, and that the director had no self-interest. The King Committee considered that such an approach would encourage the competitiveness of South African companies and therefore recommended that consideration be given to amending the Companies Act so that the duty of skill and care was so limited.^[52]

If there is to be a statutory statement of the director's duty of care, should there be a statutory business judgment rule?

15.41      The question arises whether if the director's duty of care is made statutory, the Companies Act should also include a business judgment rule. The courts already adopt the policy of not reviewing commercial decisions or judging directors with the wisdom of hindsight. The Hong Kong Consultancy Report^[53] considered that there should be no statutory formulation of the business judgment rule: it did not consider that a case had been made out.^[54] The initiatives in Australia seem to be directed at easing uncertainty in the minds of directors about a statutory statement of the duty of care. If any such concern were found in the United Kingdom in the course of the empirical survey, that would be a strong reason for having a business judgment rule. Likewise if there was any evidence that it might lead to a raising of standards of behaviour by directors, for example, by encouraging them to make appropriate enquiries, as opposed to making them more cautious, that too would be a strong reason for having a business judgment rule.

Consultees are asked whether they consider that there should be a business judgment rule and if so whether it should be on the lines proposed in Australia or on the lines identified by the American Law Institute or in some other way.

Reliance and delegation^[55]

15.42      As noted in paragraph 12.7, it was held in Re City Equitable Fire Insurance Company Ltd that a director might delegate matters to one of the company's employees where the articles of association permitted this and the needs of the business required it, in the absence of grounds for suspicion.^[56] Likewise, a director might need to rely on information provided to him by employees and others. The question arises whether it is necessary for the Companies Act to state the circumstances in which a director can properly delegate his responsibilities and when he might properly rely on advice from others.
15.43      The present trend in larger companies is towards a monitoring role for company directors. This was highlighted in the recent AWA litigation in Australia.
15.44      In AWA Ltd v Daniels^[57] the court had to decide whether the chief executive and non-executive directors of a company were negligent in the following circumstances. The company and management of AWA Ltd relied on one person and had set in place no system of control of its foreign exchange dealings. The auditors (Daniels) were aware of the weaknesses in the system in this respect but failed to report this to the management, and eventually to report it to the board when it was clear that the management failed to do so. AWA sued its directors and auditors when substantial losses were made. Rogers CJ at trial held that more recent wisdom suggested that it is of the essence of the responsibilities of directors that they take reasonable steps to place themselves in a position to guide and monitor the management of the company:^[58] A board's usual functions in addition to the statutory ones were said to be four-fold:

(a) to set goals for the corporation;

(b) to appoint the corporation's chief executive;

(c) to oversee the plans of managers for the acquisition and organisation of financial and human resources towards attainment of the corporation's goals; and

(d) to review, at reasonable intervals, the corporations progress towards attaining its goals.^[59]

In relation to the non-executive directors: the court held that they were not bound to give continuous attention to the affairs of the corporation. There is no objective standard as with executive directors. On the facts they were entitled to have confidence in the senior management. As a result, at trial, the non-executive directors were held not liable by the trial judge but the chief executive was found liable in negligence.

15.45      This decision was the subject of an appeal to the New South Wales Court of Appeal, sub nom Daniels v Anderson.^[60] The Court endorsed the view that the law required directors to take reasonable steps to place themselves in a position to guide and monitor the management of the company.^[61] The Court observed a person who accepts the office of director of a particular company undertakes the responsibility of ensuring that he or she understands the nature of the duty a director is called to perform. That duty will vary according to the size and business of the particular company and the experience and skill of a particular director. The duty is a common law duty to take reasonable care owed severally by persons who as fiduciary agents are bound not to exercise the powers conferred upon them for a private purpose or for any person foreign to the power and placed, at the apex of the structure of direction and management. The duty includes that of acting collectively to manage the company.^[62] The appeal against the finding of liability on the part of the executive directive was reversed. The appeal against the finding that the non-executive directors were not liable was dismissed.
15.46      The decision on appeal has lead to a certain amount of uncertainty in Australia as to the circumstances in which a director can delegate his responsibilities to others and rely on them. The court stressed that the directors could not blindly rely on the judgments of others and that they needed to take positive steps to satisfy themselves that the company was being properly run. The Companies Act 1993 of New Zealand already contains provisions which provide that directors remain responsible for the exercise of powers they delegate unless they believed on reasonable grounds at all times before the exercise of the power that the delegate would exercise the power in conformity with the duties imposed on the directors of the company and have properly monitored the exercise of the power by the delegate.^[63] The Companies Act 1993 of New Zealand further provides that a director may rely on information provided by an employee, expert, professional adviser or other directors where the matter falls within their area of responsibility and the director acted in good faith, made proper enquiries and had no grounds for suspicion.^[64] These provisions were enacted following recommendations of the New Zealand Law Commission.^[65]
15.47      The Australian Government has now issued for consultation draft legislation on the lines of the Companies Act of 1993 of New Zealand. They propose that a director should not be liable for the acts of a delegate^[66] if:

(a) the director believed on reasonable grounds at all times before the exercise of the power that the delegate would exercise the power in conformity with the duties imposed on directors of the company by this Law and the company's constitution (if any); and

(b) the directors have monitored, by means of reasonable methods properly used, the exercise of the power by the delegate.

15.48      Likewise the Australian Government proposes where reliance permitted by the new legislation occurs, the reliance should be deemed to be reasonable unless the contrary is proved:

10 Reliance on information or advice provided by others

If:

(a) a director relies on information, or professional or expert advice, given or prepared by:

(i) an employee of the corporation whom the director believes on reasonable grounds to be reliable and competent in relation to the matters concerned; or

(ii) a professional adviser or expert in relation to matters that the director believes on reasonable grounds to be within the person's professional or expert competence; or

(iii) another director or officer in relation to matters within the director's or officer's authority; or

(iv) a committee of directors on which the director did not serve in relation to matters within the committee's authority; and

(b) the reliance was made:

(i) in good faith; and

(ii) after making proper inquiry if the circumstances indicated the need for inquiry; and

(c) the reasonableness of the director's reliance on the information or advice arises in proceedings brought to determine whether a director has performed a duty under this Part or an equivalent general law duty;

the director's reliance on the information or advice is taken to be reasonable unless the contrary is proved.

15.49      The reason for the action being taken in Australia is a concern that the present uncertainty could lead to an over-conservative approach to management and impede decision-making by directors. "This is a less than optimal outcome and is not conducive to the development of sound corporate governance practices such as putting in place appropriate board committee systems".^[67]
15.50      Again this may be an area where empirical research may throw light whether there is similar uncertainty and a similar tendency in the United Kingdom. If there is not then we consider that there is probably no reason for supposing that the present judge-made law is not working satisfactorily in the area of delegation and reliance by directors.

Consultees are asked whether they consider that there should be a statutory provision which sets out the liability of directors when they delegate their powers to others and the circumstances in which they may rely on information provided by third parties.

Statutory statement of the duty of care without a statutory statement of fiduciary duties

15.51      The final issue is this: if it were decided that there should be no statutory statement of the fiduciary duties of directors but it appeared that there were strong arguments for a statutory statement of the duty of care of directors, do consultees consider that there would be any objection to having a statutory statement of the duty of care on its own?

Note 1   See paras 15.30-15.41 below.    [Back]

Note 2   See paras 15.42-15.50 below.    [Back]

Note 3   See para 15.51 below.     [Back]

Note 4   See Gower's Principles of Modern Company Law (6th ed, 1997), pp 641-4.    [Back]

Note 5   Or entrusted with the same functions: s 214(5).    [Back]

Note 6   See Gower's Principles of Modern Company Law (6th ed, 1997) pp 641-4.    [Back]

Note 7   See paras 12.8-12.10 above.     [Back]

Note 8   But see para 14.13 above.    [Back]

Note 9   See para 15.22 below.    [Back]

Note 10   See paras 15.10-15.29 below.    [Back]

Note 11   This in effect is the traditional view described at paras 12.3-12.7 above.    [Back]

Note 12   See Department of Health and Social Security v Evans [1985] 2 All ER 471, where the question was whether a director could reasonably be expected to know of the failure of his company to pay national insurance contributions for the purposes of section 152(4) of the Social Security Act 1975 (now repealed). The court held that it had to take account of the position held by the director in the company and the responsibilities and duties he in fact discharged.    [Back]

Note 13   Professional Development of and for the Board (1990).     [Back]

Note 14   Ibid, at p 105.    [Back]

Note 15   Companies Act 1985, s 303.    [Back]

Note 16   Palmer's Company Law, vol 2, para 8.032.     [Back]

Note 17   See generally the Jenkins Report, paras 103-105.    [Back]

Note 18   Article 70 of Table A, which confers on directors the power to manage the company's business, is subject only to the provisions of the Act and to directions given by special resolution. The equivalent power in earlier versions of this article (for example regulation 80 in Table A in the first schedule to the Companies Act 1948) was subject to "regulations" prescribed by the company in general meeting but this was held not to entitle shareholders to control the directors by ordinary resolution: see Quinn & Axtens v Salmon [1909] AC 442.    [Back]

Note 19   Herman, Corporate Control, Corporate Power (1981) p 47.    [Back]

Note 20   See Shareholder Remedies, Law Com Consultation Paper No 142, paras 9.44-9.48, for discussion of the court's reluctance to hold that anything less than serious mismanagement could amount to unfair prejudice.    [Back]

Note 21   Parkinson, op cit, p 109.    [Back]

Note 22   It must be borne in mind that it will not be possible for the company either to agree that a director need show some lesser standard of care than that provided for by statute or to agree to limit his liability to the company; on the latter point see Part 11 below. However the court has power to grant relief from liability under section 727 of the Companies Act 1985, which is also discussed in Part 11 below.    [Back]

Note 23   See para 12.9 above.     [Back]

Note 24   See paras 11.53-11.57 above.    [Back]

Note 25   Report of the Company Law Amendment Committee (1906) Cd 3052, p 31.    [Back]

Note 26   Ie under conditions similar to those in Germany.    [Back]

Note 27   For example Germany, USA , New Zealand, Australia, Canada (see appendices H-K). In addition, the majority of US States have statutory statements of the director's duty of care.    [Back]

Note 28   See para 15.8.     [Back]

Note 29   Professor R M Goode, Principles of Corporate Insolvency Law (2nd ed, 1997). It must be borne in mind that section 214 was highly innovative: never before had a director's conduct been subjected to an objective test. The proposal (then for a purely objective standard) was derived from the Report of the Review Committeee on Insolvency Law and Practice under the chairmanship of Sir Kenneth Cork. Section 214 had itself an innovative effect on the general law because it enabled the courts to increase the standard of care to be shown by a director under the general law. See also Prentice, Corporate Personality, Limited Liability and the Protection of Creditors in Corporate Personality in the Twentieth Century (1998), ed Grantham and Rickett at p112:"It seems reasonably clear that in this standard [section 214(4)] sub-section(a) set the floor (the objective standard), and sub-section (b) set the ceiling (the subjective standard)." We are aware, however, that the interpretation of that provision has been questioned. And see Wardman, "Directors, Their Duty to Exercise Skill and Care: Do the provisions of the Directors Disqualification Act 1986 provide a basis for the establishment of a more objective standard?" (1994) Business LR 71, at p 75 who states without elaborating the point: "This second assessment [ie what did the past knowledge, skill and experience of the director in question indicate as to what might be reasonably expected of him] could in, theory at least, raise the standard set at the first stage, or, as is more likely to be the case, introduce elements in mitigation where the standard shown falls short of that expected".    [Back]

Note 30   Under English law the standard of care which a solicitor is expected to show if he is an expert in a particular branch of the law has been said to be that which "is commensurate with the skill and experience which the solicitor actually has": see Duchess of Argyll v Beuselinck [1972] 2 Lloyd's Rep 172, 183. "The uniform standards postulated for the world at large in tort hardly seem appropriate when the duty is not only imposed by the law of tort but arises from a contractual obligation existing between the client and the particular solicitor in question." Ibid at p 183. Scots law also requires a professional to exercise the skill and competence which he has. See Gordon v Wilson 1992 SLT 849. It is likely that the Scottish courts would adopt the approach taken inDuchess of Argyll v Beuselinck. The same applies in the context of a director who has a contract with his company and who was appointed because of the particular skills that he could bring to bear. We considered whether the subjective element of the two fold test was unfair where for example a person had qualified as a barrister but then not practised. We do not consider that this is a difficulty since that person would be judged by the standard to be expected of a barrister who had qualified but had no post-qualification experience.    [Back]

Note 31   Section 232(4) of the Australian Corporations Law, which sets out the standard of care to be exercised by directors, only refers to care and diligence and not skill, but s 232(11) states that this provision is in addition to and in derogation of the general law. It is proposed that the Corporate and Economic Reform Bill will clarify this provision so that it is clear that the standard of care must be assessed by reference to the particular circumstances of the director concerned.    [Back]

Note 32   As was done in the Clause 46 of the Companies Bill 1978. See also n 31 above.    [Back]

Note 33   [1989] BCLC 520.    [Back]

Note 34   [1990] BCC 903.    [Back]

Note 35   Ibid, at p 912.    [Back]

Note 36   See para 15.21 above. See Goode, Principles of Corporate Insolvency Law (2nd ed, 1997) referred to at para 15.21; and Prentice, Corporate Personality, Limited Liability and the Protection of Creditors in Corporate Personality in the Twentieth Century (1998) ed Grantham and Rickett, referred to at n 29 above.    [Back]

Note 37   See Wardman, "Directors, Their Duty to Exercise Skill and Care: Do the provisions of the Directors Disqualification Act 1986 provide a basis for the establishment of a more objective standard?" (1994) Business LR 71, at p 75 referred to at n 29 above.    [Back]

Note 38   SeeRe Produce Marketing Consortium Ltd, and para 15.21 above.    [Back]

Note 39   See Appendix I. See also s 232(4) of the Australian Corporations Law, which is set out in Appendix H; and s 122(1) of the Canadian Business Corporations Act 1985, in Appendix J.    [Back]

Note 40   [1974] AC 821, at p 832.    [Back]

Note 41   See generally eg M E Eisenberg, "The Duty of Care and the Business Judgment Rule in American Corporate Law" [1997] 2 CFILR 185.    [Back]

Note 42   Because eg he has a financial interest in the transaction which might affect his judgment (Principles of Corporate Covernance, para 1.23).    [Back]

Note 43   American Law Institute Principles of Corporate Governance, Analysis and Recommendations (1992) p 141.    [Back]

Note 44   Ibid, at pp 141-2.    [Back]

Note 45   Ibid, at p 142.    [Back]

Note 46   Ibid, at p 144.    [Back]

Note 47   See Smith v Van Gorkom 488 A 2d 858 (Del 1985).    [Back]

Note 48   Directors' Duties and Corporate Governance: Corporate Law Reform Program. Proposals for Reform: Paper No 3.    [Back]

Note 49   See para 15.45 below.     [Back]

Note 50   For an analysis of the economic aspects to this issue, see also Part 3, above paras 3.10-3.14, 3.26 and 3.80.     [Back]

Note 51   Under the Australian equivalent of section 727, which is considered in Part 11 below.    [Back]

Note 52   The King Report on Corporate Governance, Institute of Directors in South Africa (November 1994), paras 3.3-3.5.    [Back]

Note 53   Set out in Appendix L.    [Back]

Note 54   Ibid, para 6.20.    [Back]

Note 55   For an analysis of economic aspects of this issue, see para 3.11 above.    [Back]

Note 56   See also Dovey v Cory [1901] AC 477. The reliance must be reasonable and a director who signed share transfers for nil consideration would not have been able to rely on assurances from his fellow directors: Bishopsgate Investment Managment Ltd v Maxwell No 2 [1994] 1 All ER 261.    [Back]

Note 57   (1991-2) 7 ACSR 759.    [Back]

Note 58   Cf Commonwealth Bank v Friedrich (1991) 5 ASCR 115 at p 187.    [Back]

Note 59   (1991-2) 7 ACSR 759, at p 865, line 50.    [Back]

Note 60   (1995) 16 ACSR 607.    [Back]

Note 61   Ibid, at p 664, line 17.    [Back]

Note 62   Ibid, at p 668, line 14    [Back]

Note 63   Section 130, see Appendix I.    [Back]

Note 64   Section 138, see Appendix I. See also s 123(4) of the Canadian Business Corporations Act 1985 in Appendix J and recommendation 6.14 of the Hong Kong Consultancy Report in Appendix L below.    [Back]

Note 65   In paras 512 and 513 of Company Law Reform and Restatement, Report No 9 (1989). The report noted that what is now s 128 "establishes a degree of predictability in a difficult area which is productive of disputes."    [Back]

Note 66   Under an another draft section directors will be permitted to delegate to a committee of directors, a fellow director, an employee or any other person : s 22.    [Back]

Note 67   Consultation Paper No 3, p 46.    [Back]