#19676 - 4. Directors Enforcement Of Duties - Company Law

TOPIC 4:

ENFORCING DIRECTORS’ DUTIES

Essential Reading:

Dignam and Lowry, ch.10

Additional Reading:

Worthington, ch 13.

Hannigan, ch 20

Chapter 10 is about derivative action. Derivative action is a means of safeguarding minority shareholders against abusers of power and its implication for the principle of majority rule.

(1) Important cases:

1. Foss v Harbottle [1843] – translates the doctrine of separate legal personality, the statutory contract, the ‘internal management principle’ and the principle of majority rule into a rule of procedure governing standing (locus standi)

(2) Various types of shareholder actions – 1) personal claims 2) representative actions (group litigation) and 3) derivative claims.

(3) Derivative claims under CA 2006 – 2 stage process of the application for permission to continue a derivative claim

- Section 261(1), the threshold test at the first stage for permission is relatively low. The role of the court is to filter out cases that stand little or no chance of success such that they should not be permitted to proceed to the second stage.

- s 263(2) sets out the criteria which the court must take into account when determining whether to grant permission to a member to continue a derivative claim.

- s 263(3) which sets out the factors which the court must, in particular, take into account when exercising its discretion to grant permission to continue a derivative claim

(4) Bars to a derivative action + liability insurance + qualifying third party indemnity provisions.

Recap:

A company can be sued in its own name. It is not generally open to individual shareholders to initiate a claim on the company’s behalf – this decision is normally left to the ‘organ of the company’ which is usually the board of directors.

The majority rule is a fundamental principle of company law; by s.33 CA every member of a company is contractually bound by the terms of its constitution and to the company’s other shareholders; the statutory contract therefore lays down the basis of the legal relationship between the company, its members, and the members inter se.

• A member therefore agrees to be bound by the decisions of the majority taken at the general meeting of the company in the context of an unfair prejudice petition

Non-intervention of the judiciary – Carlen v Drury (1812) ‘this court is not required on every occasion to take the management of every playhouse and brewhouse in the Kingdom’

Considerable power is thus given to the board of directors and those who control the general meeting – minority shareholders are in a particularly weak position within the company’s matrix.

A: AVOIDING, OR RELIEVING FROM, LIABILITY

1. Contracting out of directors’ duties?

These provisions were introduced because the Higgs Review revealed that 2 factors affected recruitment and behaviour of directors: an increase in litigation against directors and the cost of defending lengthy proceedings resulting in financial ruin. Consequently, it is thought that companies should be able to assist their directors financially while litigation and proceedings are in progress and to indemnify their directions against certain liabilities to third parties even if the directors are at fault

(1) Any provision that purports to exempt a director of a company (to any extent) from any liability that would otherwise attach to him in connection with any negligence, default, breach of duty or breach of trust in relation to the company is void.

- where does that leave insurance? CA 2006 s.233.

ss 232(2)–233 allow companies to purchase and maintain insurance cover against such liability (D&O liability cover)

Similarly, by s. 234, the prohibition against provisions indemnifying directors laid down by

s 232(2) does not apply to ‘qualifying third party indemnity provisions’ (QTPIPs)

• Eg. A provision will qualify if it indemnifies directors against liabilities (damages, costs, and interest), in a civil claim by a person other than the company (i.e. a third party) or an associated company, and against the costs of their defence, even if judgment is given against the directors or the litigation is settled out of court or otherwise comes to an end without judgment being obtained.

Companies can also indemnify directors against costs incurred in connection with applications for relief from liability made under, for example, s 1157

2. Authorisation and Ratification:

Authorisation: ‘ex ante’ approval for what the directors are going to do: prevents a breach of duty occurring.

It seems that every shareholder is entitled to vote (even shareholders who are interested in the vote, say because they are also the director whose prospective breach is being authorised).

175(5)(a) therefore implements the CLRSG’s (Company Law Review Steering Group) recommendation that conflicts may be authorised by independent directors unless, in the case of a private company, its constitution otherwise provides.

For a public company the directors will only be able to authorise such conflicts if its constitution expressly permits (s 175(5)(b)).

Section 175(6) provides that board authorisation is effective only if the conflicted directors have not participated in the taking of the decision or if the decision would have been valid even without the participation of the conflicted directors.

• The votes of the conflicted directors in favour of the decision will be ignored and the conflicted directors are not counted in the quorum

Ratification: ‘ex post’ excusing of what the directors have done – releases them from liability for a breach of duty that’s already occurred.

By (s239(4)): It must be effected without the votes of the wrongdoing director, or those ‘connected’ with her (remember: on being connected with a director, see section 252).

• While broadly based on equitable rules, it imposes stricter requirements

• s 239(7) makes it clear that to the extent that the statutory process is more lax, if at all, than the equitable rules and those in any enactment, then those rules prevail so as to supplement or increase the requirements laid down in the provision

• s.239(1) - extends the ratification process to all breaches of the duties set out in the CA 2006, Part 10.

• Ratification is also relevant to the court’s consideration of whether to allow a derivative claim to succeed under s 263.

But are all breaches of duty capable of being authorised/ratified? Or are some breaches too harmful, or wrongful, to be excused in this way?

CA 2006 does not answer this. It leaves the matter to be settled by the old common law.

The trouble is the common law was notoriously confused about this issue. To simplify, some breaches of duty (not quite clear which ones) were categorised as ‘fraud’ on the company and were treated restrictively. The orthodox view was such breaches simply could not be authorised/ratified by shareholders, however disinterested the vote to ratify might be.

The alternative view was that even fraudulent wrongs could be ratified/authorised, but only if this were done by entirely disinterested shareholders.

A recent case - Franbar Holdings v Patel [2008] BCC 885 – does give some support to this alternative view. But for a fraud to be ratified, it seems to suggest, it would have to be done in a ‘super independent/disinterested’ way - in other words, in a way that ensures the wrongdoers cannot in any way influence the majority vote to authorise/ratify. Merely following s239 would not be sufficient (s239 does require a degree of independence in votes to excuse directors, but it only applies to ratifications, and it only excludes wrongdoers/connected persons from voting).

On a different matter, ratification (and, presumably, authorisation too) only valid if shareholders are fully informed about what they are voting to ratify (or authorise, presumably):

• Instant Access Properties Ltd v Rosser [2018] EWHC 756 (Ch)

3. Invoking Ex turpi causa: a plaintiff will be unable to pursue legal relief and damages if it arises in connection with their own tortious act.

Stone & Rolls Ltd v Moore Stephens [2009] 2BCLC 563

Where a "one-man company" had deliberately engaged in serious fraud, the principle of ex turpi causa prevented it from claiming that its auditors were in breach of their duty of care in failing to detect that fraud.

• M accepted, for the purposes of the instant proceedings, that they were in breach of their duty to exercise reasonable care and skill in carrying out their responsibilities as auditors and that but for their breach the fraud perpetrated by S would have been discovered earlier.

• M submitted, however, that the action could not succeed because it was founded on R's fraud and was met by the defence of ex turpi causa.

Bilta UK Ltd (in Liq) v Nazir [2015] UKSC 23 - the wrongful acts of company directors in breach of their duties cannot be attributed to the company

• An illegality defence could not bar a claim brought by the liquidators of a company which had been the vehicle for a VAT fraud, against its former directors and overseas suppliers who were alleged to have been involved in the fraud.

• The conduct of the directors could not be attributed to the company where there was a claim against the directors for a breach of their duties.

4. Court relief:

(1) If in proceedings for negligence, default, breach of duty or breach of trust against—

(a) an officer of a company, or

(b) a person employed by a company as auditor (whether he is or is not an officer of...