Company Law Reform Bill should worry lawyers
22 May 2006
The Company Law Reform Bill envisages major changes to directors' duties and the ability of shareholders to bring derivative actions against company directors.
During House of Lords debates, a number of government amendments were accepted. For the most part, these addressed concerns expressed by the business community.
Under the new law, there will be six factors to which a director must 'have regard' in promoting the success of the company for the benefit of its members - the new formulation in place of the old 'best interests' test. These factors include: the interests of employees; long-term consequences of the decision; community and environmental impact; fairness between members; relationships with others; and reputation.
A director will be required to give regard to all of these factors in every decision, even if a factor is plainly irrelevant and even if it would be outweighed by other considerations.
The new formulation poses a number of questions. What does it mean to 'have regard' to a particular factor? Can a director properly 'have regard' to a factor without full and proper investigation? What if the director decides not to investigate? Would the reasons matter?
What if a factor had been outweighed in the context of an almost identical recent decision? An example might be a proposal to vary a decision reached on a previous occasion, when the ultimate choice had come down to the balance between two considerations. On the second occasion, would the failure to have regard to all six factors amount to a breach?
What if the director is wrong about one of the factors? Have they nevertheless 'had regard' to the impact, rather than simply their erroneous perception of the impact? What if the director's mistake is itself a breach of the separate duty to exercise reasonable care, skill and diligence?
There is no clear answer to many of these issues. Assuming the bill is passed, they will require detailed consideration by the courts over forthcoming years. It will be some time before any certainty is achieved.
Any uncertainty will be exacerbated by reforms expanding the scope of the derivative action. The bill replaces the restrictive 'wrongdoer control' and 'fraud on the minority' preconditions with a general discretion for the courts to allow such claims to proceed. There is a list of considerations that must be taken into account by the court in exercising this discretion. Even so, the discretion is very broad.
The new provisions may mean that derivative actions become a more common feature of the corporate landscape. They will almost certainly provide a means for a disaffected shareholder to seek further public debate about the merits of a challenged decision. As the court has a general discretion, companies may well feel compelled to justify the substance of their decisions to the court, rather than simply focusing on why this applicant should not be permitted to bring the claim.
In the short term, the likely consequence of all these reforms will be an increase in the procedural requirements of decision-making as directors strive to ensure that they have records reflecting proper consideration of each factor so as to minimise any prospect for challenge by means of the derivative action or otherwise.
Even so, the result is likely to be more breaches by directors, many of which will be largely technical. This may have consequences in terms of reporting and insurance. It may also trigger contractual provisions, perhaps in joint ventures or financing arrangements.
The hope had been that the reforms would foster responsible decision-making by directors without adding unduly to regulations and costs associated with that decision-making. It is too early to venture any view as to how matters will develop in practice, but there remain real areas for concern.