Scottish Law Commission (Discussion Papers)

Part 17




Part 17 How Should the Law Apply to Different Categories of Director?

Introduction

17.1      This part discusses the different types of director for the purposes of Part X and any statement of directors' duties, and the distinction if any to be drawn between executive and non-executive directors. We also mention briefly nominee directors.

The classification of directors

17.2      Section 741(1) of the Companies Act 1985 provides a non-exhaustive definition of "director":

In this Act, "director" includes any person occupying the position of director by whatever name called.

17.3      This does not amount to a complete definition. It merely provides that certain persons are included within the meaning of the term. In Re Lo-Line Electric Motors Ltd,^[1] Sir Nicholas Browne-Wilkinson VC held that the words "by whatever name called" show that the subsection is dealing with nomenclature, for example where the company's articles provide that the conduct of the company is committed to "governors" or "managers". In practice it is necessary to distinguish, firstly, between a director properly appointed in accordance with the articles of association known as a de jure director; secondly, a person who acts without being appointed (either because a purported appointment was invalid or because there never was any appointment) known as a de facto director; and thirdly, a category which supposes the existence of a board of directors who act in accordance with the instructions from someone else - the shadow director. It is also relevant to consider alternate directors.

De jure directors

17.4      All registered companies must now have directors and normally there must be at least two, unless the company is a private company.^[2] The Act does not however provide for the means of appointing directors, leaving this to the articles of association.^[3] Directors so appointed act as directors de jure by the authority of their appointment. All the references in Part X to "directors" include de jure directors.

De facto directors

17.5      Directors who have not been legally appointed but nevertheless act as or assume the position are de facto directors. A de facto director openly acts as though he has been validly appointed despite a lack of authority and right to act. A director whose appointment is irregular^[4] falls into this category. Equally, a person who is not appointed at all but is held out as a director is also, de facto, a director.
17.6      A de facto director is capable of coming under the definition of director in section 741. But this is not necessarily the case. Ultimately, the meaning of "director" varies according to the context in which it is to be found, and it is a matter of construction whether a particular section covers a person who is a de facto director.^[5]
17.7      An important question which may arise in practice is what is meant by the description that a de facto director is a person who acts as or assumes the position of a director. This is particularly important in relation to a person who usurps his position.
17.8      In Re Hydrodam (Corby) Ltd^[6] Millett J said that:

It is necessary to plead and prove that ... he undertook functions in relation to the company which could properly be discharged only by a director. It is not sufficient to show that he was concerned with the management of the company's affairs or undertook tasks in relation to its business which can properly be performed by a manager below board level.^[7]

17.9      However, in Re Richborough Furniture Ltd,^[8] despite performing, essentially, the functions of a finance director, it was held that regular negotiations with pressing creditors, though consistent with directorship, could be done by a professional or an employee; and that in a small quasi-partnership type company, decisions which are ordinarily day-to-day matters for the Board could easily be regarded, especially at a time of crisis, as a question for the shareholders to decide, or at least express a view on.^[9]
17.10      We consider that the provisions of Part X, and any amendment to the Companies Act to set out the duty of care and any statement of a directors' duties, should apply to both de facto and de jure directors. The provisions regulating conflicts of interest and self-dealing should not (in our provisional view) differ in their effect on directors because of a difference in their manner of appointment.

Do consultees agree with our provisional view that the provisions of Part X, the statutory duty of care and the statement of duties should apply to directors who have not been legally appointed?

Shadow directors

17.11      Since 1917 the Companies Acts^[10] have recognised the position of those who, not being directors themselves, exercise control over the management decisions of the directors of the company. Such persons are known as shadow directors.
17.12      The term 'shadow director' is a statutory creation. Section 741(2) states that:

In relation to a company, "shadow director" means a person in accordance with whose directions or instructions the directors of the company are accustomed to act.^[11]

17.13      Many of the modern statutory controls over directors have been applied expressly to shadow directors.^[12] The difference between liability as a de facto director and a shadow director is that the former has openly acted as if he had been validly appointed, whereas the definition of a shadow director presupposes that there is a board of directors who act in accordance with instructions from someone else, the shadow director. The terms are alternatives and mutually exclusive. The purpose of this provision is plainly to prevent the people who really exercise control from sheltering behind a puppet board.^[13]
17.14      The view has been expressed that because the concept of shadow director is a statutory creation it only applies where statutory provisions specify it. Pennington^[14] states:

The Companies Act 1985 merely uses the category of shadow director to impose certain liabilities or prohibitions on persons who would not otherwise be classed as directors, and such persons do not thereby acquire any rights nor powers in connection with the management of the company, nor are they subject to the common law or equitable duties of directors.^[15]

17.15      However the better view is that the shadow director is to be regarded as akin to a de facto director and that he can incur the liability of a de jure director under the general law where he effectively acts as a director through the people whom he can influence.^[16] So far as statutory liabilities are concerned, the position is clear when a provision expressly states that it includes a shadow director, but where it does not, the question arises whether shadow directors are included. Since the statute contains a large number of references to shadow directors, it is doubtful whether the Companies Act applies to them unless they are expressly mentioned.
17.16      The following provisions of Part X are not expressed to apply to shadow directors: sections 311, 312, 313, 314, 315, 316 and 322A. There appears to be no reason why they should not apply to shadow directors in the same way as the other provisions of Part X. The draft statement of duties does not refer to shadow directors, but it will apply to shadow directors so far as the rules of law which it summarises do so.

Do consultees consider that (a) Part X, and (b) the statutory duty of care^[17] should apply to shadow directors?

Alternate directors

17.17      An alternate director may be appointed to act for and on behalf of another director if the other director is unable to act at any time. Such an alternate may be another director, or a third person. The extent of the alternate's powers and the conditions attached to his role, such as whether he is entitled to remuneration from the company or from the director appointing him, depend on the terms of the relevant article. Regulations 65-69^[18] of Table A if adopted go far to clarify the alternate's functions.
17.18      Whilst the alternate is acting as a director, he stands in a fiduciary position in relation to the company, and accordingly owes the company all the same duties as are owed by a director. Having regard to the statutory definition in section 741,^[19] it would appear that he also is subject to the statutory obligations which are imposed on directors. However, he has no legal status when he is not acting as a director.^[20]
17.19      It appears that the disqualification of a director from voting in relation to a particular matter does not prevent an alternate director appointed by the disqualified director from voting in relation to that matter.^[21]
17.20      The Jenkins Committee^[22] took the view that in the eyes of the law an alternate director was in the same position as any other director, and did not consider that special mention needed to be made of alternate directors in the Companies Act.

Do consultees consider that any provision in Part X is difficult to apply in relation to alternate directors so that special provision is needed for them?

Executive and non-executive directors

17.21      Most larger companies now have two types of directors sitting on their board: executive and non-executive directors. Executive directors will generally have extensive powers delegated to them by the articles. They will also have separate service contracts with the company. In contrast, non-executive directors do not have service contracts with the company and are less concerned with the day to day running of the company, but rather bring an outside perspective to the board's deliberations with more concern for general policy and overall supervision, and are compensated by fees for expenses incurred in this role.^[23]
17.22      However, both types of directors have overall and equal responsibility for the leadership of the company. Traditionally the law has not distinguished between executive and non-executive directors. The Companies Act 1985 also makes no distinction between the two. In practice the functions and duties of directors vary according to their position and day to day management responsibilities. In most larger companies, whose boards comprise both executive and non-executive directors, the executive directors will have additional responsibilities and duties arising out of their executive position as a result of their service contracts. Non-executive directors will not, by definition, owe any additional duties to their companies.
17.23      Non-executive directors are subject to the same legal framework as their executive counterparts. Accordingly, their position can be somewhat invidious in many cases where they are expected to act without the executives day to day decision making power and detailed knowledge of the business.^[24] The duty of care owed by non-executive directors would also appear to be the same as that expected of executive directors.^[25] However the non-executive is likely to have to do less than an executive director to discharge his duty.
17.24      In Dorchester Finance Co Ltd v Stebbing^[26] Foster J held that it was unacceptable for even non-executive directors not to attend board meetings or take active interest in the company's affairs. He laid stress on the fact that the two non-executive directors were experienced in accountancy, but made it clear that even directors with no accounting experience were not entitled to blindly accept documents laid before them by auditors:

For a chartered accountant ... to put forward the proposition that a non-executive director has no duties to perform I find quite alarming. It would be an argument, if put forward by a director with no accountancy experience ... would involve total disregard of many sections of the Companies Act ... In the Companies Act 1948 the duties of a director whether executive or not are the same.

17.25      In Norman v Theodore Goddard^[27] Hoffmann J said that he was willing to assume that the test of a director's duty of care, in considering what he ought reasonably to have known or inferred, empowered the court to take into account the knowledge, skill and experience which he actually had, in addition to that which a person carrying out his functions should be expected to have.^[28]
17.26      The role of non-executive directors and the independence which such individuals were thought to bring to the boardroom was one of the main themes of the Cadbury Report.^[29] The London Stock Exchange currently requires UK companies whose securities are listed on the Exchange to include statements in their annual report as to whether or not they have complied throughout that accounting period with the Code of Best Practice and section A of the best practice provisions annexed to the Listing Rules.^[30] Reasons for non compliance must be given.^[31] For company reports and accounts published in respect of the year ending 31 December 1998 onwards, the required statement will relate to compliance with provisions of the Combined Code.^[32]
17.27      The Hampel Report noted the view that non-executive directors should face less onerous duties than executive directors, since they will inevitably be less well informed about the company's business. However, it supported the retention of common duties "in the interests of the unity and cohesion of the board"^[33] and thought that the English Courts' recognition of the practical situation was helpful.^[34]
17.28      No distinction has been drawn in the statutory duty of care or statement of duties considered in this consultation paper between an executive and a non-executive director. The court will, however, be able to take into account that a director is only non-executive under our draft section 309A, since the comparator has to be a person "in the same position" as the director in question.

Nominee directors

17.29      Occasionally, groups or individuals are likely to have the requisite voting power or influence to appoint a director. They may represent a major shareholder, a class of shareholders or debentureholders, a major creditor or an employee group. ^[35]
17.30      Nominee directors have been defined as:

... persons who, independently of the method of their appointment, but in relation to their office, are expected to act in accordance with some understanding or arrangement which creates an obligation or mutual expectation of loyalty to some person or persons other than the company as a whole.^[36]

17.31      As fiduciaries, directors are under a duty to act bona fide in the best interests of the company and not for any collateral purpose. This is a subjective test based on what the director believes in good faith in exercising their power is in the best interest of the company.^[37] By definition nominee directors represent sectional interest groups whose interests may differ from the interests of the company as a whole.^[38] But they are precluded from placing themselves in a position where their duty to exercise their powers for the company's benefit may be fettered. There is no authority in English law for a nominee to act in the interests of his appointor rather than in the company's interest.
17.32      The English courts have taken a strict view of the duties of nominee directors. Scottish Co-operative Wholesale Society Ltd v Meyer^[39] confirms the view that a nominated director must not put his principal's interests above those of the company.^[40]
17.33      The Australian courts have taken a more liberal approach. In Australia there is authority for the view that although directors must not fetter their discretion or act as mere mouthpieces of another, the fact that they have an extraneous loyalty will not in itself make their acts invalid. Provided that a director has a bona fide belief that promoting the interests of his appointor is consistent with his own appreciation of the interests of the company and provided that belief is not totally unreasonable, the nominee will not be in breach of his fiduciary duty.^[41] There is also authority that a nominee director's duty may be modified by the company's constituent documents and by the wishes of all those to whom the fiduciary duty is owed, although without denying the general requirement that directors act in the best interests of the company.^[42]
17.34      In a number of jurisdictions there is specific legislation which recognises the fact that nominee directors may give special consideration to the interests of their appointor where this is permitted by the company's constitution.^[43]
17.35      The issues concerning nominee directors are tied up closely with the whole question of group structures.^[44] They must therefore be left to the DTI's wider review of company law and we do not propose to deal with it in the context of this project.

Note 1   [1988] BCLC 698, at p 706.    [Back]

Note 2   Although one suffices for a company registered before 1929: see s 282.    [Back]

Note 3   However appointed, though, s 303 provides that a director can be removed by ordinary resolution in addition to any other means of removal that may be provided in the articles.    [Back]

Note 4   For example, where there was not a requisite quorum present at the general meeting purporting to appoint him, this would invalidate the appointing resolution.    [Back]

Note 5   See Re Lo-Line Electric Motors Ltd [1988] BCLC 698, 705 per Browne-Wilkinson V-C. In that case it was held that as a matter of construction s 300 of the Companies Act 1985 (now repealed) did include a person who was a de facto director. See also Re Hydrodam (Corby) Ltd [1994] 2 BCLC 180 (concerning wrongful trading under s 214 of the Insolvency Act 1986); and Re Moorgate Metals Ltd [1995] 1 BCLC 503, Re Richborough Furniture Ltd [1996] 1 BCLC 507 and Secretary of State v Laing [1996] 2 BCLC 324 (all of which concerned s 6 of the Company Directors Disqualification Act 1986).    [Back]

Note 6   [1994] 2 BCLC 180.    [Back]

Note 7   Ibid, at p 183.     [Back]

Note 8   [1996] 1 BCLC 507.    [Back]

Note 9   See also the later cases of Re Pinemoor Limited (unreported) 16 January 1996 (Ch D) and Re Land Travel Limited 2 May 1997 (Ch D) which interpreted and applied the tests laid down in these cases.    [Back]

Note 10   Companies (Particulars as to Directors) Act 1917.    [Back]

Note 11   However a person is not deemed a shadow director by reason only that the directors act on advice given by him in a professional capacity.    [Back]

Note 12   This is the case, for example, in relation to ss: 288; 305; 309; 317-319; 320-322; 322B; 232-239; 330-346 and 733 (note however, s 741(3) which disapplies treating a body corporate as a shadow director of its subsidiaries for the purposes of specified sections). See also s 214 of the Insolvency Act 1986 (other section of this Act may apply eg ss 212-213; and ss 6-9 and 22(4) of the Company Directors Disqualification Act 1986. A shadow director will also be a director for all the purposes of the Financial Services Act 1986.    [Back]

Note 13   It is important to appreciate that shadow directorship is not prohibited by law and no specific penalty attaches to the status of a shadow director. The most obvious application is to those who choose to act as the corporate governance of a company through nominee directors (see paras 17.29-17.35 below), but the statutory definition is capable of much wider application. In particular, third parties (such as lenders) seeking to protect their own legitimate interests in the context of company rescues may sometimes have little commercial alternative but to become shadow directors.    [Back]

Note 14   Pennington's Company Law (7th ed, 1995), p 712.    [Back]

Note 15   This view was also expressed by the Financial Law Panel Report on Shadow Directorships (April 1994).     [Back]

Note 16   Thus in Yukong Line Ltd v Rendsburg Investments Corporation (No 2) [1998] 1 WLR 294, at p 311, Toulson J proceeded, in our view correctly, on the basis that a shadow director could be in breach of the fiduciary duties as a director. See also Shareholder Remedies (1997) Law Com No 246, para 6.36.    [Back]

Note 17   See Part 15 above.    [Back]

Note 18   Regulation 69 provides that "an alternate director shall be deemed for all purposes to be a director".     [Back]

Note 19   See para 17.2 above.    [Back]

Note 20   See Playcorp Pty Ltd v Shaw (1993) 10 ACSR 212.    [Back]

Note 21   In Anaray Pty Ltd v Sydney Futures Exchange Ltd (1982) 6 ACLC 271 Foster J held that an alternate director had not been disqualified from voting since the articles of the company did not make the alternate director the agent of the appointor. Regulation 69 of Table A expressly states that the alternate director shall not be deemed to the agent of the director appointing him and so the same result is likely to apply in the United Kingdom.    [Back]

Note 22   Jenkins Report, para 83.    [Back]

Note 23   Despite this, however, there is a growing trend towards more formalised letters of appointment, although their status does not change to that of employee under a service contract.    [Back]

Note 24   In performing their duties, non-executive directors often have to rely on the goodwill of executive directors and so it is not uncommon for them to take out insurance policies in addition to any D&O policies taken out by the company.    [Back]

Note 25   In the case of executive directors, however, the service contract may impose obligations upon the director that go beyond his duties qua director.    [Back]

Note 26   [1989] BCLC 498.    [Back]

Note 27   [1991] BCLC 1028.    [Back]

Note 28   See the further decision of Hoffmann LJ in Re D'Jan of London [1994] 1 BCLC 561, at 563f, who held an executive director to have breached both the objective and subjective tests in s 214(4).     [Back]

Note 29   The Committee envisaged that "non-executive directors should bring an independent judgment to bear on issues of strategy, performance, resources, including key appointments, and standards of conduct." The Code of Best Practice stated that: "The board should include non-executive directors of 'sufficient calibre and number' for their views to carry significant weight (minimum of 3); the majority should be independent of management and free from any relationship which could materially affect their independent judgment; they should be appointed for specified periods and be a matter for the board as a whole; and they should be able to consult independent professional advisers as necessary at the company's expense."    [Back]

Note 30   See paras 1.34-1.35 above. The Code of Best Practice was published in December 1992 by the Cadbury Committee. The best practice provisions were adopted as an annex to the Listing Rules following publication of the Greenbury Report in July 1995.    [Back]

Note 31   Paras 12.43(j) and (w) of the Listing Rules. There is no requirement to explain or justify any areas of non-compliance with section B of the best practice provisions, although paragraph 12.43(x)(ii) of the Listing Rules requires a statement to be made in relation to full consideration being given to the best practice provisions in framing remuneration policy.    [Back]

Note 32   See paras 12.43A(a) and (b) of the Listing Rules (introduced on 25 June 1998), which supersede rules 12.43(j) and (w) for company reports and accounts published for the year ending 31 December 1998 onwards.    [Back]

Note 33   It stated that what matters in every case is that the non-executive directors should command the respect of the executives and should be able to work with them in a cohesive team to further the company's interests. See para 3.8.    [Back]

Note 34   That when called on to decide whether a director has fulfilled his or duty, they have recently tended to take into account such factors as the position of the director concerned and the type of company. In the Australian case AWA Ltd v Daniels (1992) 7 ACSR 759, although the judge did not find that a different degree of performance or standard could be expected of non-executive as opposed to executive directors, he did accept that executive directors were required to carry out additional duties and responsibilities arising from their contracts as executives.    [Back]

Note 35   Australia is the only jurisdiction where nominee directors are referred to specifically in the companies legislation and even this does little more than assume the existence of nominee directors in public companies. Section 317 of the Companies Act 1985 may however apply. There is no judicial authority on this point but it is likely that a nominee director's indirect interest would include an interest of an appointor.    [Back]

Note 36   Companies and Securities Law Review Committee (NSW, Australia) Nominee Directors and Alternate Directors: Report No 8, 2 March 1989, at p 7.    [Back]

Note 37   Re Smith & Fawcett Ltd [1942] Ch 304.    [Back]

Note 38   What is encompassed within the "interests of the company as a whole" may vary. Traditionally confined to the interests of members and particular classes of members, directors are also now required to have regard to the interests of creditors and employees in particular situations.    [Back]

Note 39   [1959] AC 324.    [Back]

Note 40   This was a case under s 210 of the Companies Act 1948 (now s 459 of the Companies Act 1985) in which it was held that a parent company had, via its nominee directors, conducted the affairs of a subsidiary in a manner which was oppressive to the other members of the subsidiary. In pointing out that the directors had done nothing to defend the interests of the subsidiary against the conduct of the parent company, Lord Denning stated: "They probably thought 'as nominees' of the [parent company] their first duty was to [the parent company]. In this they were wrong ...".    [Back]

Note 41   See Re Broadcasting Station 2GB Ltd [1964-65] NSWR 1662; but cf Bennetts v Board of Fire Commissioners of New South Wales (1967) 87 WN (NSW) 307.    [Back]

Note 42   See also Levin v Clark [1962] NSWR 686. There is support for this approach also in New Zealand: see Berlei Hestia (NZ) Ltd v Fernyhough [1980] 2 NZLR 150.    [Back]

Note 43   See s 131(2) of the New Zealand Companies Act 1993 and s 203(3) of the Ghana Companies Code.    [Back]

Note 44   These include the issue of whether the liability of a nominee director should be extended to his appointor. See Kuwait Asia Bank EC v National Mutual Life Nominees Ltd [1990] BCC 567 1 AC 187; cf Dairy Containers Ltd v NZI Bank Ltd [1995] 2 NZLR 30.    [Back]