Directors’ cut

Increased shareholder power places a greater burden on company directors, say Neil Mirchandani and Rebecca Huntsman

Has the liability risk for directors increased or is it business as usual? Is the role of a company director more onerous today than, say, five years ago? To the latter question, many would answer ‘yes’.

This year has seen the scope of directors’ duties widen, alongside substantive changes to the law governing derivative actions, making directors potentially more vulnerable as targets. Margaret Hodge, Minister of State for Industry, in a ministerial statement on the new provisions stated that: “For most directors, who are working hard and put the interests of their company before their own, there will be no need to change their behaviour.” But is this really the case?

The two changes brought in by the Companies Act 2006, much of which came into force on 1 October this year, suggest not. For directors of businesses regulated by the Financial Services Authority (FSA), these changes to the law are combined with an increased focus by the FSA on senior management responsibility. Coupled with a rise in shareholder activism, directors are right to be wary.

Directors’ obligations

The Government’s stated aim behind the codification of directors’ duties is to give directors a clear statement of what their duties are. Possibly the most contentious among the duties set out in the act is the duty to promote the success of the company. In fulfilling this duty, a director must have regard to, for example, the impact of the company’s operations on the community and the environment.

This raises a range of issues which, until considered by the courts, create uncertainty for directors as to what is required of them. For example, how does a director balance the need to pursue success by increasing the company’s bottom line with the need to consider the impact of a company’s operations on the environment? Building a new factory may increase revenue, but will it have an adverse impact on the community and the environment? Neither the Companies Act nor published guidelines suggest how such conflicts should be resolved.

The act has also increased risk for directors through a new regime for derivative actions (an action brought by a shareholder on behalf of a company against the company’s directors). To date, derivative actions could only be brought if wrongdoers who had misappropriated a company’s assets were in control of the company. Permission of the court was also required to bring an action. As a result, derivative actions were very rare.

The act relaxes these conditions: shareholders no longer need to demonstrate that wrongdoers are in control of the company and there is no need to show that a director has benefited personally from the wrongdoing. Further, shareholders will now be able to bring actions against directors personally not just for fraud, but also for negligence.

This means that, for the first time, if a company is fined by the FSA for breach of its rules, directors could face personal claims if shareholders feel that directors should have done more to prevent the breach. The cause of action can arise before or after the person bringing the derivative claim becomes a shareholder in the company.

This apparent relaxation in the rules under which shareholders can bring claims has concerned directors. Could shareholder activists use the new route to bring claims in respect of decisions on controversial areas of company policy such as environmental policy or animal testing? Or, even more concerning, might activists become shareholders solely for the purpose of bringing such claims? In theory, every time a board takes a decision that is remotely controversial, or with which some shareholders disagree, the directors could face a derivative action.

The Attorney General indicated that, in his view, the new procedure makes no major change of principle. He cited a number of factors as to why the number of derivative actions is unlikely to increase: damages awarded are payable to the company and not the litigant shareholder, the high costs of bringing an action (although under the act there is a provision for the court to order that the company pay the shareholder’s costs) and the tight judicial control that is expected to be exercised over the new machinery preventing things from getting out of hand.

The judicial control referred to is the ‘filter’ process built into the act whereby a claimant must establish a primary case for permission and, if successful, must then proceed to a full hearing for permission. While these safeguards sound good in theory, will they deter unmeritorious claims?

FSA influence

For directors of firms regulated by the FSA, concerns regarding personal liability are likely to be all the more acute. The FSA has given a number of recent indications that it is focusing on the role and responsibilities of senior management. It recently fined both the chief executive of Hadenglen Home Finance and the company for inadequate systems and controls in relation to payment protection insurance.

In fining the chief executive, FSA director of enforcement Margaret Cole, said: “The penalty imposed on Mr Hayes should leave senior management within firms in no doubt that the FSA will hold them to account if they fail to treat their customers fairly.”

It is arguable that the FSA’s move towards more principles-based regulation will lead to greater scope for senior management censure.

The rise in shareholder activism has also not passed unnoticed by directors. Trends seen in both the US and Europe may hit these shores soon and, if they do, given the new derivative action procedure, directors may face increased liability risk. On the Continental side, the Royal Dutch Shell case highlights the power of shareholders: Shell agreed to pay $352.6m (£168.17m) to investors covered by the settlement.

While the Government message in relation to the Companies Act changes outlined above seems to be that it is business as usual, is this really the case? It seems not, for a number of reasons.

The codification of directors’ duties means that aggrieved parties are more likely to bring claims: they no longer need to rely solely upon case law but have a set of duties upon which to pin breaches. Further, the scope of the duties owed by a director has widened, as have the factors a director must take into account in reaching a decision on company matters. All of this in an environment where shareholder activism is on the increase and the FSA has high on its agenda the responsibilities of senior management.

The key to avoiding or minimising these risks is preparation – personal preparation for directors, preparation of policies and preparation of relevant company documents. The GC100 (a group of senior in-house lawyers of FTSE100 companies) has produced best-practice guidelines for compliance with the duties outlined in the Companies Act.

The aim of the guidelines is, among other things, to reduce directors’ potential liability, whether direct liability or through derivative actions. Helpful suggestions include ensuring directors are aware of their duties and making sure that, in preparing papers in support of board and committee decisions, all relevant factors are considered so that directors are alive to key issues.

There are a number of other practical steps companies and individual directors should take to minimise the risk of personal liability, including ensuring appropriate director and officers cover and indemnities are in place and reviewing the structure and terms of board committees to ensure appropriate consideration is being given to the statutory factors and that the balancing exercise directors now have to undertake is being carried out properly. Directors, beware – the landscape has changed.

Neil Mirchandani is a partner and Rebecca Huntsman is a senior associate at Lovells