Companies Act 2006 (1)

The Companies Act 2006 (the 2006 Act) received Royal Assent on 8 November 2006. It runs to 47 parts and 1,300 sections, and will, when brought into force, almost entirely replace the Companies Act 1985 (the 1985 Act). The 2006 Act is the result of extensive consultation in the field, adopting most of the recommendations of the Company Law Review Steering Group. It aims to: make it easier to set up and grow a business; encourage shareholder confidence; increase shareholder engagement; and improve the UK's position as 'one of the most attractive places in the world to set up and run a business' (see p 9 of the government's March 2005 White Paper, 'Company Law Reform').

The 2006 Act attempts to meet these objectives by consolidating, and making a number of substantial changes to, company law. For instance, the burden on small companies is eased by new rules relating to model articles of association, company secretaries, AGMs, written resolutions, capital maintenance and share capital. Clarity of legal rights and obligations is promoted, with the Act containing statutory provisions relating to derivative actions, together with a statutory statement of directors' duties. Auditor transparency is also increased, but auditors are permitted, for the first time, to limit their liability. Shareholders are given a variety of enhanced rights (many of which also apply to indirect investors), while provision is made for protecting the private details of both shareholders and company directors. Provisions for e-communications attempt to increase efficiency. And institutional shareholder engagement is encouraged by rules that may force institutional investors to explain how they have used (or failed to use) the rights attaching to shares that they hold or control.

This is the first of three articles that will attempt to explain the practical effect of the most significant changes introduced by the 2006 Act. This article will deal with the statutory statement of directors' duties, perhaps the biggest single change introduced by the 2006 Act, together with the smaller issues of disclosure of directors' details and institutional shareholder reporting.

Statutory statement of directors' duties

General approach

The government adopted the Law Commission and Company Law Review Steering Group recommendation that the law relating to directors' duties should be made more 'consistent, certain, accessible and comprehensible' by the introduction of a statutory statement of directors' general duties. The elegantly drafted statutory statement is contained in ss 170 to 181 of the 2006 Act. It begins uncontroversially by obliging directors to 'act in accordance with the company's constitution' (s 171(a)), 'only exercise powers for the purposes for which they are conferred' (s 171(1)(b)), and to exercise independent judgment (s 173(1)).

Reasonable care, skill and diligence

More interesting is the obligation of directors to act with reasonable care, skill and diligence, imposed by s 174(1). In assessing whether a director has complied with this obligation, the court must, as under the wrongful trading provisions of the Insolvency Act 1986, bear in mind both 'the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company', and 'the general knowledge, skill and experience that the director has' (ss 174(2)(a) and (b)). This provision is particularly welcome, offering an adaptable test catering for different situations and directors of varying levels of knowledge, skill and experience. The insolvency cases analysing this combined objective and subjective test will no doubt be applied by analogy when the Act comes into force (see, for instance, Re DKG Contractors Ltd [1990] BCC 903 and Rubin v Gunner [2004] EWHC 316 (Ch)). The introduction of this test also clarifies an issue on which there was conflicting common law authority.

Duty to promote the success of the company

This brings us to one of the 2006 Act's key developments '“ the director's duty to promote the success of the company. This new, and somewhat controversial, duty requires a director to act in a way that he 'considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (among other matters) to: (a) the likely consequences of any decision in the long term, (b) the interests of the company's employees, (c) the need to foster the company's business relationship with suppliers, customers and others, (d) the impact of the company's operations on the community and the environment, (e) the desirability of the company maintaining a reputation for high standards of business conduct, and (f) the need to act fairly as between members of the company' (s 172(1)).

The matters specifically listed in s 172(1) are noteworthy because they impose an obligation on directors to consider a company's long-term sustainable growth. To date, actions against directors have usually centred on short-term decisions or deals (for instance, an allegation that a director committed a company to a particular loss-making transaction). The 2006 Act's emphasis on wide-ranging considerations may pave the way for a new sort of claim to be launched against directors (say, for example, where a series of decisions produce a short-term profit, but lead, over time, to a company acquiring a poor reputation and being shunned by its former customers, causing large losses). It is for this reason that the government was right to concede that the new s 172(1) duty constitutes a 'radical' change to the existing common law rules.

Importantly, the 2006 Act gives guidance as to how the common law decisions on directors' duties are to interact with the new statutory formulae. While the statutory provisions 'have effect in place of the common law rules and equitable principles', regard 'shall be had to the corresponding common law rules and equitable principles in interpreting and applying the general duties' (s 170(3) and (4)). Furthermore, the government has promised to publish plain English guidance explaining what directors must do to comply with the new codified duties.

Conflicts of interest

Also embodied in the 2006 Act is the hitherto equitable duty of company directors to avoid situations in which their duties to the company may conflict with their own interests or their duties to third parties. As one would expect, the breadth of the equitable principle is retained, with a director being required to 'avoid a situation in which he has, or can have, a direct or indirect interest that conflicts, or possibly may conflict, with the interests of the company' (s 175(1)). This duty is said to apply, in particular, to the exploitation 'of any property, information or opportunity (and it is immaterial whether the company could take advantage of the property, information or opportunity)' (s 175(2)). However, two subsequent rules, which deal with when the no-conflict rule is infringed and how otherwise improper behaviour can be authorised, clarify, and arguably dilute, the previous limits of the no-conflict principle.

The early cases laid down a very strict test for ascertaining when a director had breached the no-conflict rule. This was subject to some relaxation in, for example, Wilkinson v West Coast Capital [2005] EWHC 3009 (Ch) so that there would be no conflict where the opportunity fell outside the scope of a company's business. The 2006 Act reflects the recent trend, providing that the statutory duty is not infringed 'if the situation cannot reasonably be regarded as likely to give rise to a conflict of interest' (s 175(4)(a)). Thus, company directors will avoid having to disgorge profits made where there has only been a hypothetical or extremely remote possibility of conflict of interest.

The second important change comes from the statutory recognition that a company's board can (subject to that company's constitution), authorise a director to enter into a transaction that would otherwise involve a conflict as long as: (a) the relevant board meeting is quorate without counting the director in question or any other interested director; and (b) the matter is agreed without counting the votes of the director in question or any other interested director (see ss 175(4), (5), and (6)). This is important as the case law was unclear as to whether board or shareholder approval was necessary to authorise such a conflict.

Directors' details

The 1985 Act was amended by the Criminal Justice and Police Act 2001 by the introduction of s 723B. This section empowered the Secretary of State to make a confidentiality order in relation to a director's residential address if satisfied that a director (or any person living with him or her) is subject to a serious risk of violence or intimidation. The government did not see this provision as going far enough, not least because of the demanding requirement of showing a 'serious risk', and because the expense of obtaining confidentiality orders could deter potential corporate customers or suppliers of controversial (but economically important) companies such as Huntingdon Life Sciences Ltd.

The new regime is far simpler. Directors can opt to provide the registrar with a service address, in which case that director's company and the registrar are prohibited from disclosing the director's residential address save in specific circumstances (see ss 240 to 242). Those circumstances are:

(i) where a court orders disclosure on the application of a public authority or a credit reference agency (s 243);

(ii) where a court orders disclosure on the application of the registrar or any other person with a 'sufficient interest' in circumstances where service of documents has proved ineffective at bringing them to the relevant director's notice, or where disclosure is necessary for the enforcement of a court order or decree (s 244); and

(iii) where the registrar (without making an application to court, but after giving the relevant director notice) is of the view that service at the director's service address is ineffective at bringing documents to the director's notice (ss 245 to 246).

The new regime does not require the registrar to omit material registered before the 2006 Act comes into effect (s 242(2)(b)), and so will not have a significant practical effect for some time.

Institutional shareholder reporting

Over half of UK equities are held by institutional investors (on behalf of those who invest in pensions, unit and investment trusts, collective investment schemes etc). These institutional investors have a significant opportunity to hold company directors to account by virtue of the rights conferred on them by their huge shareholdings. However, the government has concerns as to how effectively these rights have been exercised. It therefore included within the 2006 Act power to create subsequent regulations that have the effect of forcing institutional investors to explain how they have exercised (or failed to exercise) voting rights attaching to shares that they hold and to shares held on their behalf (ss 1277 to 1280). It remains to be seen whether the introduction of these regulations will be necessary, or whether the carrot and stick approach embodied in the Act will be sufficient to engage institutional shareholders to the extent sought by the government.

• Next week's article will deal with how the 2006 Act has changed the rights of shareholders (in particular in relation to obtaining information and to launching derivative claims), and how it has attempted to streamline provisions relating to private companies.