Cap in hand

A company director’s lot is not, usually, an unhappy one. But if the Confederation of British Industry (CBI), the Institute of Directors (IoD) and the audit profession are to be believed, it is an existence so unrewarding and full of danger that many are now thinking twice before taking on a job at the top.

That is what the business community would like us to think, as it makes the case for limiting the liability of directors. Certainly, the historic view of the role of non-executive directors as being one of life’s cushier numbers, well paid and part time, is being quickly revised in light of the rumbling Equitable Life saga and the ever increasing demands of corporate governance. Earlier this month, the stricken insurer revealed that the costs of pursuing its two multibillion-pound actions against its former directors, including nine non-execs and auditors, had hit £13m.

This is the backdrop against which ministers are mulling over responses to a consultation exercise looking at whether to limit the amount that directors may be liable to pay out in negligence or breach of duty claims. The same review is also considering similar protections for auditors, who face virtually unlimited liability. The consultation closed last month and a decision as to whether to amend the legislation, through the Companies Bill, is expected any day now. If it does not come soon, the boat will be missed for another few years.

As an area of reform, limiting directors’ and auditors’ liability is hardly likely to win many votes from a grateful electorate. However, it is a cause to which the CBI, the IoD and the audit profession have all signed up. They fear that, without some cap, the number of people prepared to take on directorships, or for that matter firms prepared to undertake audits (particularly of the larger companies), is going to shrink in today’s increasingly litigious climate.

Freshfields Bruckhaus Deringer felt so strongly about the issue that it wrote to its FTSE 350 clients seeking “concerted action” for a change to the law to enable directors to limit their liability. The magic circle firm’s concerns were reciprocated. The firm has persuaded 50 of its largest clients to back its submission to the Department of Trade and Industry (DTI). “The need to relieve directors from the prospect of unlimited liability for innocent mistakes is urgent,” the firm argues. “Likewise, it should be permissible for directors to receive an indemnity from the company against legal expenses when faced with Equitable Life-style claims.”

Towards the end of last year, ministers decided to postpone a review of company law, but pledged to carry on with a bill dealing with the further regulation of accountants in the wake of the Enron and WorldCom collapses. At the same time, the DTI published its consultation paper on director and auditor liability, in which ministers floated the idea of reforming the Companies Act 1985, Section 310, to allow companies to limit the liability of directors for claims of negligence and to allow auditors to limit their liability by contract.

“One of the most important issues is the ability for a director to be indemnified against his legal expenses when a claim is brought against him arising out of the performance or alleged non-performance of his duties. That, more perhaps than limiting the liability of directors, is the cause for greatest concern here,” comments Barry O’Brien, head of corporate finance at Freshfields.

It is a view endorsed by the firm’s clients. “We aren’t lobbyists, and when you approach around 60 of your clients there’s always a danger of getting back as many different views,” O’Brien says. “Fortunately, we got a pretty unanimous response.”

Perhaps unsurprisingly, the Freshfields study has hit a corporate nerve. “There’s an increasing risk of a ruinous claim against a director – and that’s in essence the Equitable Life scenario,” says Gavin Foggo, a partner at Fox Williams, who is advising two of the directors being sued by the insurer. He points out that much of the present debate was informed by the spate of Enron-style corporate scandals, in which there was fraud. By contrast, Equitable Life is about negligence and breach of fiduciary duty. “The Equitable litigation started in April 2002, the trial should start in April next year and is expected to last six months – and so you’re talking four years before you even get a result,” says Foggo. “That has a huge impact on the reputation of the directors involved.”

The role of the non-executive was brought to the fore by the recent Government-backed report by Sir Derek Higgs. This recommended that at least half of the board should comprise independent non-executives. “There’s a real tension between the Higgs requirement for a greater number of independent non-execs and recruiting them from non-traditional areas, such as academia, the profession and civil service, and the increasing risks of being sued for making a mistake,” says Foggo. It is a tension that needs to be resolved through law reform, Foggo argues. The DTI is proposing three options in its consultation paper (see box below).

The first option is essentially the ‘do nothing’ alternative for those that believe that existing legislation strikes the right balance. The second alternative is amending Section 310, which prohibits directors from limiting their liability and securing indemnity from their companies. The third option proposes lowering the standards expected of directors to a US standard.

Foggo opts for the US model, which the ministers note (no doubt disapprovingly) would be “a very radical step” for UK company law. Many US states opt for ‘the business judgment rule’, which provides that directors must discharge their duties with the care that a person in a like position would reasonably believe appropriate. “It is basically to prevent the courts from having to make commercial decisions,” comments Foggo. “Provided directors have appropriately informed themselves of all matters before they have taken a decision and acted in good faith and in the best interests of the company, the courts won’t be interested.

“Section 310 [of the Companies Act 1985] causes problems for innocent directors, because if there’s some kind of case brought against them, they can’t claim any kind of indemnity until they’re proven innocent,” he argues. “And that can be many years and hundreds and thousands of pounds later.”

Nobody would argue that people who have actually committed fraud should have any indemnity against the company, says Foggo, and Section 310 does not offer that protection at the moment. “But the more litigious culture is coming over from the US,” he argues. “There needs to be a balancing between different interests – the interest of directors who want to run the company properly, and investors, who want properly qualified and competent directors. If we want to attract high-quality people as directors, then we need to relax the liability for the making of innocent mistakes.”

The Freshfields submission made the argument for amendments to the Companies Act 1985, Section 310, which would effectively allow, subject to shareholder approval, a company to limit or exclude directors’ liability to pay compensation to the company for failure to discharge their duty of care, except to the extent that any claim arose as a result of the director’s dishonesty. Under their proposals, companies could also indemnify against legal expenses in defending a claim as well as indemnify against third-party claims.

“If you want the best-qualified people to join boards, then you have somehow got to eliminate the possibility that they can be sued for their entire wealth,” O’Brien at Freshfields notes. “Non-executive directors aren’t insurance companies [for shareholders]. They should be there to do a job which is one step removed from the executive.”

Similarly, the CBI is concentrating on amending the existing legislation. It argues that directors should remain fully liable for losses directly caused by their negligence. “For non-executives on £20,000 a year to have total unlimited liability is something that clearly needs looking at,” comments Rod Armitage, the CBI’s head of company affairs. “The news we’re getting from headhunters is that it’s becoming progressively more difficult to fill non-exec positions, even for companies that are large and reputable. And if businesses are trying to employ people that are more and more expert at analysing risk and reward, those people are increasingly looking at their own position.”

The CBI argues that the board should cease to have joint and several liability and that both auditor and director liability be “solely proportionate”. “The Government takes the view that there are some legal complications about the mechanics of how you decide proportionality,” comments Armitage. “But a strictly proportional approach does exist in other countries.”

By contrast, the Freshfields response does not consider auditors’ liability other than to say that it would be unfair of auditors to be permitted to limit their liability; as a consequence, the liability of directors increased.

“Auditors are perfectly capable of looking after themselves,” says O’Brien. “Auditing the UK’s largest companies is now on a burning platform which could collapse at any time,” claimed big four accountancy firm PwC in its submission to the DTI, published last week. “The risks are uninsurable, unquantifiable, unmanageable and could at any time destroy our firm, or any of our competitors,” it argued. If the £2.6bn negligence action by insurer Equitable Life against Ernst & Young is successful, the big four could become three.

While there is a lively consensus for reform in UK business, whatever the shape it might take, unsurprisingly there is little enthusiasm from the investor community.

“It looks rather unseemly in the aftermath of a raft of global scandals to be talking about cutting liability. It can do nothing to restore confidence in business legitimacy,” comments David Somerlinck, the corporate governance policy manager at investor lobby group Pensions & Investment Research Consultants (Pirc).

There may be a case for reviewing the liability of both directors and auditors, he argues, but now is not the time. For a start, he says that the greater responsibilities expected of directors of listed companies under the Combined Code, revamped by the Higgs review, have not had time to be tested.

What about the concerns of companies having problems filling boardroom vacancies? “We haven’t seen any evidence of it yet,” Somerlinck replies. “Obviously, Equitable Life is going to concentrate minds and you can understand the need for certainty, but the response needs to be adequate about what the appropriate level of liability is.”

Director liability: the options as set down by the DTI

OPTION A, or the ‘do nothing’ alternative, proposes retaining the current legal position on the grounds that the 1985 Companies Act strikes “a reasonable balance” between the concerns of directors and their personal liability.

OPTION B implements the proposals of the Company Law Review (CLR) by tackling Section 310 – in particular, by limiting its application to directors’ general duties and restricting the ban on indemnities to those given by the company as opposed to third parties. It also proposes allowing directors to be indemnified against the costs of successfully defending proceedings and reasonable bona fide deductibles under a D&O (directors and officers) liability insurance policy. The option also considers broadening the relief available under Section 727 of the 1985 act, whereby a director can apply to court for relief from potential liabilities if they acted “reasonably and honestly” (the CLR argued that they should be granted relief if they ought to be fairly excused).

OPTION C takes its inspiration from across the Atlantic and, controversially, contemplates lowering the standard expected of directors. The legislative model is based on the American Bar Association’s Model Business Corporation Act, which provides that directors must discharge their duties with the care that a person in a like position would reasonably believe appropriate (known as ‘the business judgment rule’). Most US states allow for companies to eliminate or limit directors’ liability with shareholder approval.