Directors’ duties in the context of local authority companies

Richard Medd, Browne Jacobson

Introduction

Directors’ duties have existed for the past 300 years and were codified by the Companies Act 2006. These duties are owed by directors of private companies but also extend to shadow directors and any person performing the same functions without having been formally appointed as a director. Duties are owed to the company and it is only the company that can bring an action against a director for breach of duty, breach of trust or negligence. In very limited circumstances, a minority shareholder can bring a derivative action claim against directors. However, the criteria needed to bring a valid claim are onerous.

The remedies for breach of a director’s duties include damages, an injunction, setting transactions aside, accounting for profits and the return of the company’s property. There could also be grounds for terminating a director’s service contract or disqualification as a director.

The general duties

The Companies Act 2006 sets out seven general duties:

Duty to act within powers (section 171)

A director must act in accordance with the company’s constitution and must only exercise powers for their proper purpose.

Duty to promote the success of the company (section 172)

A director must act in good faith and in a way that would be most likely to promote the success of the company for the benefit of its members as a whole. The Companies Act 2006 contains six factors that must be considered:

  • the likely consequences of the decision in the long term;
  • the interests of the company’s employees;
  • the need to foster the company’s business relationships with suppliers, customers and others;
  • the impact of the company’s operations on the community and the environment;
  • the desirability of the company to maintain a reputation for high standards of business conduct; and
  • the need to act fairly as between the members of the company.

This is not an exhaustive list; other factors such as profitability can also be considered, and the factors are in no particular order. Indeed there is no guidance on which should take priority in the event of a conflict. In order to demonstrate compliance with this duty, directors should document the factors that have been considered for each decision in the minutes of meetings.

Duty to exercise independent judgment (section 173)

A director must exercise their own judgement, independent of the views of others on the board. This duty does not prevent a director from taking advice but their own judgement must be used in deciding whether to follow the advice.

Duty to exercise reasonable care, skill and diligence (section 174)

A director must act as a reasonably diligent person. This takes into account:

  • the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as that director; and
  • the specific general knowledge, skill and experience of that particular director.

The first element is an objective test and the second analyses a director’s particular expertise. For example, a director with accountancy qualifications or experience would be expected to exercise greater scrutiny of the company’s accounts.

Duty to avoid conflicts of interest (section 175)

A director must avoid situations where there could be an interest that conflicts with the interests of the company, although the directors who are not conflicted may be able to authorise a director to continue to act despite there being a conflict. This duty is interpreted widely and applies to the use of any property, information or opportunity available to the company. The duty will be breached even if a director exploits an opportunity that the company considered but decided not to pursue and continues to apply after a person ceases to be a director.

Duty not to accept benefits from third parties (section 176)

A director must not accept any benefit from a third party that is given due to their position as a director or their actions, or omissions, as a director unless the benefit cannot reasonably be regarded as likely to cause a conflict of interest. The benefits covered by this duty include financial and non-financial benefits. It is important to consider what would be regarded as ‘normal’ in the circumstances and whether the benefit is excessive.

Duty to declare an interest in a proposed transaction or arrangement with the company (section 177)

There is no duty to avoid interest in transactions or arrangements with the company. However, a director must disclose to the other directors the nature and extent of any interest in a proposed transaction or arrangement with the company, whether direct or indirect. Such a declaration must be made before the company enters into the transaction or arrangement at a board meeting, by written notice or by general notice and must be updated should the interest change. There is also a duty under section 182 of the Companies Act 2006 to declare any interest in an existing transaction or arrangement.

There are certain exemptions where declaration of an interest is not required, including the following:

  • the director is unaware of the interest or of the transaction. However, ignorance is not a complete defence and the director will be deemed to be aware of matters that they ought reasonably to be aware of;
  • there is no reasonable possibility of a conflict of interest;
  • the other directors know of the interest, therefore no disclosure is required if the company has only one director. It will be for a director seeking to rely on this exemption to prove that the other directors knew, or ought reasonably to have known, of the interest. It is therefore best to declare an interest in order to avoid any doubt; and
  • the transaction is a service contract between the company and the director.

The Companies Act 2006 sets out certain types of transaction where a conflict of interest is likely to arise that includes substantial property transactions, directors’ loans, payment for loss of office and directors’ service contracts for more than two years. In general, should these circumstances be met, the transaction will need to be approved by an ordinary resolution of the shareholders.

Additional duties

Directors will owe a number of other duties under company law, including ensuring that the company complies with filing requirements and other legal duties. In addition to company law, directors will also owe duties under specific legislation. For example, directors will owe specific duties in relation to insolvency, health and safety, environmental, anti-bribery, competition, and pension issues.

Directors’ protection

The vast majority of people who are directors of companies carry out their roles without any problems. Directors’ indemnity insurance is available to offer some protection in the event of a claim being made. Where proceedings are brought against a director, the court has the discretion to relieve them of their liability if it considers that the director acted honestly and reasonably and, considering all the circumstances, they ought fairly to be excused. In addition, shareholders can in some circumstances ratify the conduct of a director by way of an ordinary resolution, unless otherwise stated in the company’s articles of association.

Difficulties facing local authority nominees

The most important point to bear in mind for local authority appointed directors is that although the council makes the initial nomination or appointment, after appointment the director holds office according to the constitution of the company. Once an individual, whether officer or elected member, accepts an appointment as a director, they take on all the responsibilities of that position and their duty when acting as a director is to the company, not to their appointing council. They must therefore act in accordance with what they consider necessary to promote the success of the company.

It would, for example, in theory be a breach of a director’s duty to the company to disclose confidential company information to their appointing council, even if it were relevant to something that the council was discussing. This applies both ways and it would be equally wrong to disclose confidential information belonging to a council to the company.

The duty towards the company only applies when the member is acting in their capacity as a director. When at council meetings or acting in a role as a local authority officer or elected member, he or she must act in the best interests of the council, subject to the above point about confidentiality. It is therefore very important that directors have a clear understanding of ‘which hat they are wearing’ at any time.

It may often be the case that a director has been appointed to an outside body because he or she has a particular interest in the subject matter. In those circumstances it would not be unusual if the director’s own views and those of the particular organisation were closely aligned.

Alternatively, a director may have gained particular knowledge about a subject because of their involvement on another body. It is perfectly proper that the director should express those views or use that special knowledge during council debates because they are his or her own views.

However, a director should never be seen to use their position as a council officer or elected member to act as an advocate on behalf of an outside organisation, because that would be putting the other organisation’s interests ahead of the council’s. This applies regardless of whether or not they were appointed by the council.

Where local authority officers or elected members serve as members or directors of outside bodies, it is inevitable that conflicts will arise, from time to time, between the duties they owe to the outside body, and the duties they owe to the council. Conflicting interests should be declared on every occasion and the rules in the company’s articles or in relevant council codes of conduct, in terms of conduct in the event of conflict, should be carefully followed.