In the line of duty: navigating directors' duties through times of crisis
Published on 1st Oct 2020
A combination of disgruntled shareholders, increased regulatory scrutiny and the threat of insolvency-related offences is causing a sharp upturn in the risk profile for directors.
The global pandemic and the ensuing economic impact has required directors in all industries to take tough decisions, often under extreme time pressure and in the face of major uncertainty. The vast majority have taken those decisions for the good of the company, acting independently, in good faith, and using reasonable care and diligence. Where this is the case, they are likely to have discharged their duties whether or not that decision turned out to be correct.
When things go wrong, however, the scrutiny from shareholders, regulators and (in extreme cases) insolvency practitioners can be intense. In order to avoid any criticism, or worse, it is important to ensure you understand exactly what your duties are and have evidenced how decisions were reached.
The Companies Act 2006 sets out a list of seven statutory duties on directors, which are supplemented by certain common law duties. We outline these duties in this video. In essence, the statutory duties are a codification of the 'fiduciary' or 'good faith' obligations that have been established by the courts over the decades, and represent a statement of sensible, prudent business practice. Central to this are the 'cornerstone duties':
- To promote the success of the company.
- To exercise reasonable care, skill and diligence.
- To exercise independent judgement.
Promoting the success of the company
The concept of 'success' in this context is interpreted as the long-term increase in the value of the company, for the benefit of the company's members as a whole. The second element of this duty means that if there is a conflict between the interests of shareholders and the company, the directors need to act in the company's interests. It is important to be alive to the potential in times of economic or other stresses for the interests of majority shareholders, for example, to diverge from those of the company.
This is a good faith duty. The law does not exist to second-guess directors' commercial judgement: if a director takes a decision that ultimately proves to be wrong, they will not be in breach, provided they have acted in a way they consider will promote the success of the company.
It is, though, necessary to balance the short- and long-term impacts of decision making. This includes taking account of the interests of other stakeholders, including trading partners and customers. For example, stretching out creditor days from, say, 30 to 60 days to manage cashflow could affect the viability of key suppliers. In those circumstances, the company might be expected to engage in a dialogue with suppliers and consider flexing the policy for certain suppliers that are heavily reliant on the business. Ultimately, it will be the company's interests that trump those of any other stakeholders, but in order to ensure that decisions taken in the moment are defensible with the benefit of hindsight, it is important to make sure that material decisions are carefully evidenced.
Exercising reasonable care, skill and diligence
This duty involves a two-part test to establish the standard expected of the individual director:
- An objective test, based on what would be expected of a person carrying out the functions of that director in relation to the company.
- A subjective test, based on what could reasonably be expected of a person with the knowledge, skill and experience that the director actually has.
Discharging the first duty requires directors to acquire and maintain a sufficient knowledge and understanding of the company's business to enable them properly to discharge their duties as directors. Directors are expected to act proactively, seeking out information from other directors and from external advisers, and challenging information where necessary. They are also expected to become and remain familiar with the company's business, along with the commercial, legal and regulatory environment in which it operates. This will include keeping up to date with the company's financial position, and with changes to that environment that have been wrought by Covid-19.
The subjective element means that if a director has a high level of knowledge in a particular area or a particular skillset, they will be expected to use that knowledge and exercise those skills in relation to the company.
Exercising independent judgement
This does not mean that the director needs to be independent of the company. Rather, when they are acting they must use their own judgement, instead of going along blindly with the wishes of other board members or shareholders.
It is legitimate, and expected, that directors will discuss relevant matters with other stakeholders to understand their views, but ultimately, the individual director needs to be able to stand by their decisions and be able to explain their reasoning if later called into question.
A good audit trail
Directors are not expected to get every decision right. But there is a risk that choices made with honest intentions and on good grounds at the time can look irrational with the benefit of hindsight. With the focus on the process around the decision-making, it is crucial to ensure that the logic is properly explained and recorded. A good audit trail may include the information that was sought, any consultation with other stakeholders and the respective weight given to competing considerations.
Where major decisions are being taken, consider, for example, whether additional information needs to be included in board packs, or more detailed minutes being taken of meetings. It may also be necessary to increase the frequency of meetings in light of the speed at which the situation is developing.
These considerations are particularly important where there is potential regulatory liability. Directors can face personal sanctions under certain regulatory regimes, such as health and safety or environmental law. While each will involve different sets of considerations and standards, a failure to discharge statutory duties under company law may be an indication of falling below other relevant standards.
Where there is a risk of insolvency, directors need to take extra care. The duty to promote the company's success for the benefit of its members applies only so far as the company remains solvent. When the company is at risk of insolvency, in broad terms, the focus switches to safeguarding the interests of creditors. Directors can face liability under insolvency law for fraudulent or, more commonly, wrongful trading. Specific advice should be sought if there appears to be any risk of tripping into these areas.
The law recognises that directors need to be free to take the decisions that they consider to be best for the company, without worrying unduly about being second-guessed if all does not pan out as intended. But with shareholder activism on the rise, regulators sharpening their focus and trading conditions challenging in many sectors, directors need to ensure that decisions taken now can withstand questioning in the future.